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HARTFORD FINANCIAL SERVICES GROUP, INC. - Quarter Report: 2012 March (Form 10-Q)

Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2012

or

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ____________ to ______________

Commission file number 001-13958

 

 

 

LOGO

THE HARTFORD FINANCIAL SERVICES GROUP, INC.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   13-3317783
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification No.)

One Hartford Plaza, Hartford, Connecticut 06155

(Address of principal executive offices) (Zip Code)

(860) 547-5000

(Registrant’s telephone number, including area code)

 

 

 

Indicate by check mark:

        Yes         No   

•     whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

     x         ¨   

•     whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

     x         ¨   

•     whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

         

 

Large accelerated filer x

  Accelerated filer  ¨   Non-accelerated filer  ¨   Smaller reporting company  ¨

 

•     whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.)

  x

As of April 26, 2012, there were outstanding 440,865,405 shares of Common Stock, $0.01 par value per share, of the registrant.

 

 

 


Table of Contents

THE HARTFORD FINANCIAL SERVICES GROUP, INC.

QUARTERLY REPORT ON FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2012

TABLE OF CONTENTS

 

Item   Description    Page
  Part I. FINANCIAL INFORMATION   

1.      

  Financial Statements   
  Report of Independent Registered Public Accounting Firm    5
  Condensed Consolidated Statements of Operations — For the Three Months Ended March 31, 2012 and 2011    6
  Condensed Consolidated Statements of Comprehensive Income — For the Three Months Ended March 31, 2012 and 2011    7
  Condensed Consolidated Balance Sheets — As of March 31, 2012 and December 31, 2011    8
  Condensed Consolidated Statements of Changes in Stockholders’ Equity — For the Three Months Ended March 31, 2012 and 2011    9
  Condensed Consolidated Statements of Cash Flows — For the Three Months Ended March 31, 2012 and 2011    10
  Notes to Condensed Consolidated Financial Statements    11

2.      

  Management’s Discussion and Analysis of Financial Condition and Results of Operations    55

3.      

  Quantitative and Qualitative Disclosures About Market Risk    112

4.      

  Controls and Procedures    112
  Part II. OTHER INFORMATION   

1.      

  Legal Proceedings    113

1A.   

  Risk Factors    115

2.      

  Unregistered Sales of Equity Securities and Use of Proceeds    117

6.      

  Exhibits    117
  Signature    118
  Exhibits Index    119

 

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Forward-Looking Statements

Certain of the statements contained herein are forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements can be identified by words such as “anticipates,” “intends,” “plans,” “seeks,” “believes,” “estimates,” “expects,” “projects,” and similar references to future periods.

Forward-looking statements are based on our current expectations and assumptions regarding economic, competitive, legislative and other developments. Because forward-looking statements relate to the future, they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict. They have been made based upon management’s expectations and beliefs concerning future developments and their potential effect upon The Hartford Financial Services Group, Inc. and its subsidiaries (collectively, the “Company” or “The Hartford”). Future developments may not be in line with management’s expectations or may have unanticipated effects. Actual results could differ materially from expectations, depending on the evolution of various factors, including those set forth in Part I, Item 1A, Risk Factors in The Hartford’s 2011 Form 10-K Annual Report. These important risks and uncertainties include:

 

 

challenges related to the Company’s current operating environment, including continuing uncertainty about the strength and speed of the recovery in the United States and other key economies and the impact of governmental stimulus and austerity initiatives, sovereign credit concerns, including the potential consequences associated with recent and further potential downgrades to the credit ratings of debt issued by the United States government, European sovereigns and other adverse developments on financial, commodity and credit markets and consumer spending and investment, including in respect of Europe, and the effect of these events on our returns in our life and property and casualty investment portfolios and our hedging costs associated with our variable annuities business;

 

 

the risks, challenges and uncertainties associated with our March 21, 2012 announcement that we will focus on our Property and Casualty, Group Benefits and Mutual Fund businesses, place our Individual Annuity business into runoff and pursue sales or other strategic alternatives for the Individual Life, Woodbury Financial Services and Retirement Plans businesses and related implementation plans and goals and objectives, as set forth in our Current Report on Form 8-K dated March 21, 2012;

 

 

the success of our initiatives relating to the realignment of our business, including the continuing realignment of our hedge program for our variable annuity business, and plans to improve the profitability and long-term growth prospects of our key divisions, including through opportunistic acquisitions or divestitures or other actions or initiatives, and the impact of regulatory or other constraints on our ability to complete these initiatives and deploy capital among our businesses as and when planned;

 

 

market risks associated with our business, including changes in interest rates, credit spreads, equity prices, market volatility and foreign exchange rates, and implied volatility levels, as well as continuing uncertainty in key sectors such as the global real estate market;

 

 

the impact on our investment portfolio if our investment portfolio is concentrated in any particular segment of the economy;

 

 

volatility in our earnings and potential material changes to our results resulting from our adjustment of our risk management program to emphasize protection of statutory surplus and cash flows;

 

 

the impact on our statutory capital of various factors, including many that are outside the Company’s control, which can in turn affect our credit and financial strength ratings, cost of capital, regulatory compliance and other aspects of our business and results;

 

 

risks to our business, financial position, prospects and results associated with negative rating actions or downgrades in the Company’s financial strength and credit ratings or negative rating actions or downgrades relating to our investments;

 

 

the potential for differing interpretations of the methodologies, estimations and assumptions that underlie the valuation of the Company’s financial instruments that could result in changes to investment valuations;

 

 

the subjective determinations that underlie the Company’s evaluation of other-than-temporary impairments on available-for-sale securities;

 

 

losses due to nonperformance or defaults by others;

 

 

the potential for further acceleration of deferred policy acquisition cost amortization;

 

 

the potential for further impairments of our goodwill or the potential for changes in valuation allowances against deferred tax assets;

 

 

the possible occurrence of terrorist attacks and the Company’s ability to contain its exposure, including the effect of the absence or insufficiency of applicable terrorism legislation on coverage;

 

 

the possibility of unfavorable loss development including with respect to long-tailed exposures;

 

 

the difficulty in predicting the Company’s potential exposure for asbestos and environmental claims;

 

 

the possibility of a pandemic, earthquake, or other natural or man-made disaster that may adversely affect our businesses and cost and availability of reinsurance;

 

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weather and other natural physical events, including the severity and frequency of storms, hail, winter storms, hurricanes and tropical storms, as well as climate change and its potential impact on weather patterns;

 

 

the response of reinsurance companies under reinsurance contracts and the availability, pricing and adequacy of reinsurance to protect the Company against losses;

 

 

actions by our competitors, many of which are larger or have greater financial resources than we do;

 

 

the Company’s ability to distribute its products through distribution channels, both current and future;

 

 

the cost and other effects of increased regulation as a result of the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), which, among other effects, has resulted in the establishment of a newly created Financial Services Oversight Council with the power to designate “systemically important” institutions, will require central clearing of, and/or impose new margin and capital requirements on, derivatives transactions, and created a new “Federal Insurance Office” within the U.S. Department of the Treasury (“Treasury”);

 

 

unfavorable judicial or legislative developments;

 

 

the uncertain effects of emerging claim and coverage issues;

 

 

the potential effect of other domestic and foreign regulatory developments, including those that could adversely impact the demand for the Company’s products, operating costs and required capital levels, including changes to statutory reserves and/or risk-based capital requirements related to secondary guarantees under universal life and variable annuity products or changes in U.S. federal or other tax laws that affect the relative attractiveness of our investment products;

 

 

regulatory limitations on the ability of the Company and certain of its subsidiaries to declare and pay dividends;

 

 

the Company’s ability to effectively price its property and casualty policies, including its ability to obtain regulatory consents to pricing actions or to non-renewal or withdrawal of certain product lines;

 

 

the Company’s ability to maintain the availability of its systems and safeguard the security of its data in the event of a disaster, cyber or other information security incident or other unanticipated event;

 

 

the risk that our framework for managing business risks may not be effective in mitigating material risk and loss to the Company;

 

 

the potential for difficulties arising from outsourcing relationships;

 

 

the impact of potential changes in federal or state tax laws, including changes affecting the availability of the separate account dividend received deduction;

 

 

the impact of potential changes in accounting principles and related financial reporting requirements;

 

 

the Company’s ability to protect its intellectual property and defend against claims of infringement; and

 

 

other factors described in such forward-looking statements.

Any forward-looking statement made by the Company in this document speaks only as of the date of the filing of this Form 10-Q. Factors or events that could cause the Company’s actual results to differ may emerge from time to time, and it is not possible for the Company to predict all of them. The Company undertakes no obligation to publicly update any forward-looking statement, whether as a result of new information, future developments or otherwise.

 

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Table of Contents

Part I. FINANCIAL INFORMATION

Item 1. Financial Statements

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of

The Hartford Financial Services Group, Inc.

Hartford, Connecticut

We have reviewed the accompanying condensed consolidated balance sheet of The Hartford Financial Services Group, Inc. and subsidiaries (the “Company”) as of March 31, 2012, and the related condensed consolidated statements of operations, comprehensive income, changes in stockholders’ equity, and cash flows for the three-month periods ended March 31, 2012 and 2011. These interim financial statements are the responsibility of the Company’s management.

We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our reviews, we are not aware of any material modifications that should be made to such condensed consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.

We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of the Company as of December 31, 2011, and the related consolidated statements of operations, comprehensive income, changes in stockholders’ equity, and cash flows for the year then ended prior to retrospective adjustment for the adoption of Accounting Standards Update (“ASU”) No. 2010-26 Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts, (not presented herein); and in our report dated February 24, 2012 (which report includes an explanatory paragraph relating to the Company’s change in its method of accounting and reporting for variable interest entities and embedded credit derivatives as required by accounting guidance adopted in 2010, and for other-than-temporary impairments as required by accounting guidance adopted in 2009), we expressed an unqualified opinion on those consolidated financial statements. We also audited the adjustments described in Note 1 that were applied to retrospectively adjust the December 31, 2011 consolidated balance sheet of the Company (not presented herein). In our opinion, such adjustments are appropriate and have been properly applied to the previously issued consolidated balance sheet in deriving the accompanying retrospectively adjusted condensed consolidated balance sheet as of December 31, 2011.

DELOITTE & TOUCHE LLP

Hartford, Connecticut

May 2, 2012

 

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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

Condensed Consolidated Statements of Operations

 

     Three Months Ended  
     March 31,  

(In millions, except for per share data)

   2012     2011
As currently
reported,  see
Note 1
 
     (Unaudited)  

Revenues

    

Earned premiums

   $ 3,442      $ 3,519   

Fee income

     1,134        1,209   

Net investment income:

    

Securities available-for-sale and other

     1,070        1,108   

Equity securities, trading

     2,866        803   
  

 

 

   

 

 

 

Total net investment income

     3,936        1,911   

Net realized capital gains (losses):

    

Total other-than-temporary impairment (“OTTI”) losses

     (36     (119

OTTI losses recognized in other comprehensive income (“OCI”)

     7        64   
  

 

 

   

 

 

 

Net OTTI losses recognized in earnings

     (29     (55

Net realized capital losses, excluding net OTTI losses recognized in earnings

     (881     (348
  

 

 

   

 

 

 

Total net realized capital losses

     (910     (403

Other revenues

     59        64   
  

 

 

   

 

 

 

Total revenues

     7,661        6,300   

Benefits, losses and expenses

    

Benefits, losses and loss adjustment expenses

     3,038        3,178   

Benefits, losses and loss adjustment expenses – returns credited on international variable annuities

     2,864        803   

Amortization of deferred policy acquisition costs and present value of future profits

     321        450   

Insurance operating costs and other expenses

     1,312        1,354   

Interest expense

     124        128   
  

 

 

   

 

 

 

Total benefits, losses and expenses

     7,659        5,913   

Income from continuing operations before income taxes

     2        387   

Income tax expense (benefit)

     (95     48   
  

 

 

   

 

 

 

Income from continuing operations, net of tax

     97        339   

Income (loss) from discontinued operations, net of tax

     (1     162   
  

 

 

   

 

 

 

Net income

   $ 96      $ 501   
  

 

 

   

 

 

 

Preferred stock dividends

     10        10   
  

 

 

   

 

 

 

Net income available to common shareholders

   $ 86      $ 491   
  

 

 

   

 

 

 

Income from continuing operations, net of tax, available to common shareholders per common share

    

Basic

   $ 0.20      $ 0.74   

Diluted

   $ 0.19      $ 0.67   

Net income available to common shareholders per common share

    

Basic

   $ 0.20      $ 1.10   

Diluted

   $ 0.18      $ 0.99   
  

 

 

   

 

 

 

Cash dividends declared per common share

   $ 0.10      $ 0.10   
  

 

 

   

 

 

 

See Notes to Condensed Consolidated Financial Statements.

 

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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

Condensed Consolidated Statements of Comprehensive Income

 

     Three Months Ended
March 31,
 

(In millions)

   2012     2011
As  currently
reported,
see Note 1
 
     (Unaudited)  

Comprehensive Income

    

Net income

   $ 96      $ 501   
  

 

 

   

 

 

 

Other comprehensive income (loss)

    

Change in net unrealized gain / loss on securities

     241        322   

Change in OTTI losses recognized in other comprehensive income

     (8     5   

Change in net gain / loss on cash-flow hedging instruments

     (53     (68

Change in foreign currency translation adjustments

     (136     (29

Change in pension and other postretirement plan adjustments

     33        22   
  

 

 

   

 

 

 

Total other comprehensive income

     77        252   
  

 

 

   

 

 

 

Total comprehensive income

   $ 173      $ 753   
  

 

 

   

 

 

 

See Notes to Condensed Consolidated Financial Statements.

 

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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

Condensed Consolidated Balance Sheets

 

(In millions, except for share and per share data)

   March 31,
2012
    December 31,
2011

As currently
reported, see
Note 1
 
     (Unaudited)  

Assets

  

Investments:

    

Fixed maturities, available-for-sale, at fair value (amortized cost of $80,021 and $78,978) (includes variable interest entity assets, at fair value, of $235 and $153)

   $ 83,157      $ 81,809   

Fixed maturities, at fair value using the fair value option (includes variable interest entity assets of $339 and $338)

     1,291        1,328   

Equity securities, trading, at fair value (cost of $30,212 and $32,928)

     30,722        30,499   

Equity securities, available-for-sale, at fair value (cost of $1,001 and $1,056)

     938        921   

Mortgage loans (net of allowances for loan losses of $88 and $102)

     6,275        5,728   

Policy loans, at outstanding balance

     1,970        2,001   

Limited partnerships and other alternative investments (includes variable interest entity assets of $7 as of March 31, 2012 and December 31,2011)

     2,732        2,532   

Other investments

     1,259        2,394   

Short-term investments (includes variable interest entity assets, at fair value, of $10 as of March 31, 2012)

     5,256        7,736   
  

 

 

   

 

 

 

Total investments

     133,600        134,948   

Cash

     2,059        2,581   

Premiums receivable and agents’ balances, net

     3,565        3,446   

Reinsurance recoverables, net

     4,559        4,768   

Deferred policy acquisition costs and present value of future profits

     6,577        6,556   

Deferred income taxes, net

     2,375        2,131   

Goodwill

     1,006        1,006   

Property and equipment, net

     1,017        1,029   

Other assets

     3,388        2,274   

Separate account assets

     152,402        143,870   
  

 

 

   

 

 

 

Total assets

   $ 310,548      $ 302,609   
  

 

 

   

 

 

 

Liabilities

    

Reserve for future policy benefits and unpaid losses and loss adjustment expenses

   $ 40,532      $ 41,016   

Other policyholder funds and benefits payable

     44,080        45,612   

Other policyholder funds and benefits payable – international variable annuities

     30,677        30,461   

Unearned premiums

     5,325        5,222   

Long-term debt

     6,220        6,216   

Consumer notes

     310        314   

Other liabilities (includes variable interest entity liabilities of $461 and $471)

     9,728        8,412   

Separate account liabilities

     152,402        143,870   
  

 

 

   

 

 

 

Total liabilities

     289,274        281,123   

Commitments and Contingencies (Note 9)

    

Stockholders’ Equity

    

Preferred stock, $0.01 par value — 50,000,000 shares authorized, 575,000 shares issued, liquidation preference $1,000 per share

     556        556   

Common stock, $0.01 par value — 1,500,000,000 shares authorized, 469,746,638 and

469,750,171 shares issued

     5        5   

Additional paid-in capital

     10,031        10,391   

Retained earnings

     11,042        11,001   

Treasury stock, at cost — 28,881,233 and 27,211,115 shares

     (1,688     (1,718

Accumulated other comprehensive income, net of tax

     1,328        1,251   
  

 

 

   

 

 

 

Total stockholders’ equity

     21,274        21,486   
  

 

 

   

 

 

 

Total liabilities and stockholders’ equity

   $ 310,548      $ 302,609   
  

 

 

   

 

 

 

See Notes to Condensed Consolidated Financial Statements.

 

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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

Condensed Consolidated Statements of Changes in Stockholders’ Equity

 

     Three Months Ended
March 31,
 

(In millions, except for share data)

   2012     2011
As currently
reported,  see
Note 1
 
     (Unaudited)  

Preferred Stock

   $ 556      $ 556   

Common Stock

     5        5   

Additional Paid-in Capital, beginning of period

     10,391        10,448   

Repurchase of warrants

     (300     —     

Issuance of shares under incentive and stock compensation plans

     (58     (47

Tax expense on employee stock options and awards

     (2     (10
  

 

 

   

 

 

 

Additional Paid-in Capital, end of period

     10,031        10,391   

Retained Earnings, beginning of period

     11,001        10,509   

Net income

     96        501   

Dividends on preferred stock

     (10     (10

Dividends declared on common stock

     (45     (45
  

 

 

   

 

 

 

Retained Earnings, end of period

     11,042        10,955   

Treasury Stock, at Cost, beginning of period

     (1,718     (1,774

Treasury stock acquired

     (42     —     

Issuance of shares under incentive and stock compensation plans from treasury stock

     79        57   

Return of shares under incentive and stock compensation plans and other to treasury stock

     (7     (5
  

 

 

   

 

 

 

Treasury Stock, at Cost, end of period

     (1,688     (1,722

Accumulated Other Comprehensive Income (Loss), net of tax, beginning of period

     1,251        (990

Total other comprehensive income

     77        252   
  

 

 

   

 

 

 

Accumulated Other Comprehensive Income (Loss), net of tax, end of period

     1,328        (738

Total Stockholders’ Equity

   $ 21,274      $ 19,447   
  

 

 

   

 

 

 

Preferred Shares Outstanding (in thousands)

     575        575   

Common Shares Outstanding, at beginning of period (in thousands)

     442,539        444,549   

Treasury stock acquired

     (2,550     —     

Issuance of shares under incentive and stock compensation plans

     1,202        727   

Return of shares under incentive and stock compensation plans and other to treasury stock

     (326     (168
  

 

 

   

 

 

 

Common Shares Outstanding, at end of period

     440,865        445,108   
  

 

 

   

 

 

 

See Notes to Condensed Consolidated Financial Statements.

 

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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

Condensed Consolidated Statements of Cash Flows

 

     Three Months Ended
March 31,
 

(In millions)

   2012     2011
As currently
reported,  see
Note 1
 
     (Unaudited)  

Operating Activities

    

Net income

   $ 96      $ 501   

Adjustments to reconcile net income to net cash provided by operating activities

    

Amortization of deferred policy acquisition costs and present value of future profits

     321        450   

Additions to deferred policy acquisition costs and present value of future profits

     (439     (419

Change in reserve for future policy benefits and unpaid losses and loss adjustment expenses and unearned premiums

     (624     (39

Change in reinsurance recoverables

     (14     59   

Change in receivables and other assets

     (474     (49

Change in payables and accruals

     1,184        (23

Change in accrued and deferred income taxes

     121        57   

Net realized capital (gains) losses

     910        176   

Net receipts (disbursements) from investment contracts related to policyholder funds—international variable annuities

     216        (496

Net (increase) decrease in equity securities, trading

     (223     481   

Depreciation and amortization

     98        128   

Other operating activities, net

     (32     (352
  

 

 

   

 

 

 

Net cash provided by operating activities

     1,140        474   

Investing Activities

    

Proceeds from the sale/maturity/prepayment of:

    

Fixed maturities, available-for-sale

     14,442        8,860   

Fixed maturities, fair value option

     12        —     

Equity securities, available-for-sale

     59        24   

Mortgage loans

     112        70   

Partnerships

     43        58   

Payments for the purchase of:

    

Fixed maturities, available-for-sale

     (13,048     (7,588

Fixed maturities, fair value option

     —          (531

Equity securities, available-for-sale

     (18     (25

Mortgage loans

     (660     (326

Partnerships

     (319     (55

Proceeds from business sold

     —          278   

Derivatives, net

     (2,017     (465

Change in policy loans, net

     31        —     

Other investing activities, net

     (4     (46
  

 

 

   

 

 

 

Net cash provided by (used for) investing activities

     (1,367     254   

Financing Activities

    

Deposits and other additions to investment and universal life-type contracts

     3,623        3,338   

Withdrawals and other deductions from investment and universal life-type contracts

     (5,963     (6,174

Net transfers from separate accounts related to investment and universal life-type contracts

     2,218        2,418   

Repayments at maturity or settlement of consumer notes

     (4     —     

Proceeds from net issuance of shares under incentive and stock compensation plans, excess tax benefit and other

     (4     (2

Treasury stock acquired

     (48     —     

Dividends paid on preferred stock

     (11     (11

Dividends paid on common stock

     (44     (19

Changes in bank deposits and payments on bank advances

     —          (1
  

 

 

   

 

 

 

Net cash used for financing activities

     (233     (451

Foreign exchange rate effect on cash

     (62     (22

Net increase (decrease) in cash

     (522     255   

Cash – beginning of period

     2,581        2,062   
  

 

 

   

 

 

 

Cash – end of period

   $ 2,059      $ 2,317   
  

 

 

   

 

 

 

Supplemental Disclosure of Cash Flow Information

    

Income taxes paid (received)

   $ (548   $ 26   

Interest paid

   $ 89      $ 89   

See Notes to Condensed Consolidated Financial Statements

 

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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Dollar amounts in millions, except for per share data, unless otherwise stated)

(Unaudited)

1. Basis of Presentation and Accounting Policies

Basis of Presentation

The Hartford Financial Services Group, Inc. is a holding company for insurance and financial services subsidiaries that provide investment products and life and property and casualty insurance to both individual and business customers in the United States (collectively, “The Hartford”, the “Company”, “we” or “our”). Also, The Hartford continues to administer business previously sold in Japan and the U.K.

On March 21, 2012, the Company announced the completion of its businesses and strategy evaluation. As a result of this review, which was conducted by the Company’s management and Board of Directors over the past several quarters, the Company announced that it will focus on its Property and Casualty, Group Benefits and Mutual Fund businesses, place its existing Individual Annuity business into runoff and pursue sales or other strategic alternatives for the Individual Life and Retirement Plans businesses and Woodbury Financial Services, an indirect wholly-owned subsidiary.

On April 26, 2012, the Company announced that it had entered into an agreement to sell its individual annuity new business capabilities to a third party. Effective May 1, 2012, all new annuity policies sold by the Company will be reinsured to a third party. The Company will cease the sale of annuity policies and the reinsurance agreement will terminate as to new business in the second quarter of 2013. The reinsurance agreement has no impact on in-force policies issued on or before April 27, 2012.

The Condensed Consolidated Financial Statements have been prepared on the basis of accounting principles generally accepted in the United States of America (“U.S. GAAP”), which differ materially from the accounting practices prescribed by various insurance regulatory authorities. These Condensed Consolidated Financial Statements and Notes should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in The Hartford’s 2011 Form 10-K Annual Report. The results of operations for the interim periods should not be considered indicative of the results to be expected for the full year.

The accompanying Condensed Consolidated Financial Statements and Notes as of March 31, 2012, and for the three months ended March 31, 2012 and 2011 are unaudited. These financial statements reflect all adjustments (generally consisting only of normal accruals) which are, in the opinion of management, necessary for the fair presentation of the financial position, results of operations and cash flows for the interim periods.

On January 1, 2012, the Company retrospectively adopted Accounting Standards Update (“ASU”) No. 2010-26, Financial Services – Insurance (Topic 944): Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts which clarifies the definition of policy acquisition costs that are eligible for deferral. Previously reported financial information has been revised to reflect the effect of the Company’s adoption of this accounting standard. As a result of this accounting change, total stockholders’ equity as of January 1, 2011, decreased by approximately $1.6 billion, after-tax from $20.3 billion, as previously reported, to $18.7 billion due to a reduction of the Company’s deferred acquisition cost asset balance related to certain costs that do not meet the provisions of the revised standard. The effect of adoption of this accounting standard on the Company’s Condensed Consolidated Balance Sheet and Condensed Consolidated Statements of Operations was as follows:

 

 

     December 31, 2011  
     As previously
reported
     Effect of change     As currently
reported
 

Deferred policy acquisition costs and present value of future profits

   $ 8,744       $ (2,188   $ 6,556   

Deferred income taxes, net

   $ 1,398       $ 733      $ 2,131   

Other liabilities

   $ 8,443       $ (31   $ 8,412   

Retained earnings

   $ 12,519       $ (1,518   $ 11,001   

Accumulated other comprehensive income (loss), net of tax

   $ 1,157       $ 94      $ 1,251   

Total stockholders’ equity

   $ 22,910       $ (1,424   $ 21,486   

 

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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

1. Basis of Presentation and Accounting Policies (continued)

 

     Three Months Ended March 31, 2011  
     As previously
reported
     Effect of change     As currently
reported
 

Amortization of deferred policy acquisition costs and present value of future profits

   $ 664       $ (214   $ 450   

Insurance operating costs and other expenses

   $ 1,125       $ 229      $ 1,354   

Income (loss) from continuing operations before income taxes

   $ 410       $ (23   $ 387   

Income tax expense (benefit)

   $ 59       $ (11   $ 48   

Net income (loss)

   $ 511       $ (10   $ 501   

Net income (loss) available to common shareholders

   $ 501       $ (10   $ 491   

Income (loss) from continuing operations, net of tax, available to common shareholders per common share

       

Basic

   $ 0.77       $ (0.03   $ 0.74   

Diluted

   $ 0.69       $ (0.02   $ 0.67   

Net income (loss) available to common shareholders per common share

       

Basic

   $ 1.13       $ (0.03   $ 1.10   

Diluted

   $ 1.01       $ (0.02   $ 0.99   

Consolidation

The Condensed Consolidated Financial Statements include the accounts of The Hartford Financial Services Group, Inc., companies in which the Company directly or indirectly has a controlling financial interest and those variable interest entities (“VIEs”) in which the Company is required to consolidate. Entities in which the Company has significant influence over the operating and financing decisions but are not required to consolidate are reported using the equity method. Material intercompany transactions and balances between The Hartford and its subsidiaries and affiliates have been eliminated. For further discussions on VIEs see Note 5 of the Notes to Condensed Consolidated Financial Statements.

Discontinued Operations

The results of operations of a component of the Company that either has been disposed of or is classified as held-for-sale are reported in discontinued operations if the operations and cash flows of the component have been or will be eliminated from the ongoing operations of the Company as a result of the disposal transaction and the Company will not have any significant continuing involvement in the operations of the component after the disposal transaction.

The Company is presenting the operations of certain businesses that meet the criteria for reporting as discontinued operations. Amounts for prior periods have been retrospectively reclassified. See Note 12 of the Notes to Condensed Consolidated Financial Statements for information on the specific subsidiaries and related impacts.

Use of Estimates

The preparation of financial statements, in conformity with U.S. GAAP, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

The most significant estimates include those used in determining property and casualty insurance product reserves, net of reinsurance; estimated gross profits used in the valuation and amortization of assets and liabilities associated with variable annuity and other universal life-type contracts; evaluation of other-than-temporary impairments on available-for-sale securities and valuation allowances on investments; living benefits required to be fair valued; goodwill impairment; valuation of investments and derivative instruments; pension and other postretirement benefit obligations; valuation allowance on deferred tax assets; and contingencies relating to corporate litigation and regulatory matters. Certain of these estimates are particularly sensitive to market conditions, and deterioration and/or volatility in the worldwide debt or equity markets could have a material impact on the Condensed Consolidated Financial Statements.

Mutual Funds

The Company maintains a retail mutual fund operation whereby the Company provides investment management, administrative and distribution services to The Hartford Mutual Funds, Inc. and The Hartford Mutual Funds II, Inc. (collectively, “mutual funds”). These mutual funds are registered with the Securities and Exchange Commission (“SEC”) under the Investment Company Act of 1940. The mutual funds are owned by the shareholders of those funds and not by the Company. As such, the mutual fund assets and liabilities and related investment returns are not reflected in the Company’s Condensed Consolidated Financial Statements since they are not assets, liabilities and operations of the Company.

 

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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

1. Basis of Presentation and Accounting Policies (continued)

 

Significant Accounting Policies

For a description of significant accounting policies, see Note 1 of the Notes to Consolidated Financial Statements included in The Hartford’s 2011 Form 10-K Annual Report, which should be read in conjunction with these accompanying Condensed Consolidated Financial Statements.

Income Taxes

A reconciliation of the tax provision at the U.S. Federal statutory rate to the provision for income taxes is as follows:

 

 

     Three Months Ended
March 31,
 
     2012     2011  

Tax expense (benefit) at U.S. Federal statutory rate

   $ 1      $ 135   

Tax-exempt interest

     (36     (37

Dividends-received deduction

     (33     (37

Valuation allowance

     (20     (2

Other

     (7     (11
  

 

 

   

 

 

 

Income tax expense (benefit)

   $ (95   $ 48   
  

 

 

   

 

 

 

The separate account dividends-received deduction (“DRD”) is estimated for the current year using information from the prior year-end, adjusted for current year equity market performance and other appropriate factors, including estimated levels of corporate dividend payments and level of policy owner equity account balances. The actual current year DRD can vary from estimates based on, but not limited to, changes in eligible dividends received by the mutual funds, amounts of distribution from these mutual funds, amounts of short-term capital gains at the mutual fund level and the Company’s taxable income before the DRD. The Company evaluates its DRD computations on a quarterly basis.

The Company’s unrecognized tax benefits were unchanged during the three months ended March 31, 2012, remaining at $48 as of March 31, 2012. This entire amount, if it were recognized, would affect the effective tax rate in the period it is released.

The Company’s federal income tax returns are routinely audited by the Internal Revenue Service (“IRS”). Audits have been concluded for all years through 2006. The audit of the years 2007—2009 commenced during 2010 and is expected to conclude by the end of 2012.

The Company has recorded a deferred tax asset valuation allowance that is adequate to reduce the total deferred tax asset to an amount that will more likely than not be realized. The deferred tax asset valuation allowance, which related predominantly to foreign net operating losses, was $75 as of March 31, 2012 and $95 as of December 31, 2011. In assessing the need for a valuation allowance, management considered future taxable temporary differences reversals, future taxable income exclusive of reversing temporary differences and carryforwards, taxable income in open carry back years, as well as other tax planning strategies.

Included in the Company’s March 31, 2012 $2.4 billion net deferred tax asset is $2.9 billion relating to items treated as ordinary for federal income tax purposes, and a $482 net deferred tax liability for items classified as capital in nature. The $482 capital items are comprised of $682 of gross deferred tax assets related to realized capital losses and $1.2 billion of gross deferred tax liabilities related to net unrealized capital gains.

 

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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

2. Earnings (Loss) Per Common Share

The following table presents a reconciliation of net income and shares used in calculating basic earnings (loss) per common share to those used in calculating diluted earnings (loss) per common share.

 

 

     Three Months Ended
March  31,
 

(In millions, except for per share data)

   2012     2011  

Earnings

    

Income from continuing operations

    

Income from continuing operations, net of tax

   $ 97      $ 339   

Less: Preferred stock dividends

     10        10   
  

 

 

   

 

 

 

Income from continuing operations, net of tax, available to common shareholders

     87        329   

Add: Dilutive effect of preferred stock dividends

     —          10   
  

 

 

   

 

 

 

Income from continuing operations, net of tax, available to common shareholders and assumed conversion of preferred shares

   $ 87      $ 339   
  

 

 

   

 

 

 

Income (loss) from discontinued operations, net of tax

   $ (1   $ 162   

Net income

    

Net income

   $ 96      $ 501   

Less: Preferred stock dividends

     10        10   
  

 

 

   

 

 

 

Net income available to common shareholders

     86        491   

Add: Dilutive effect of preferred stock dividends

     —          10   
  

 

 

   

 

 

 

Net income available to common shareholders and assumed conversion of preferred shares

   $ 86      $ 501   
  

 

 

   

 

 

 

Shares

    

Weighted average common shares outstanding, basic

     440.7        444.6   

Dilutive effect of warrants

     26.4        41.1   

Dilutive effect of stock compensation plans

     1.9        1.8   

Dilutive effect of mandatory convertible preferred shares

     —          20.7   
  

 

 

   

 

 

 

Weighted average shares outstanding and dilutive potential common shares

     469.0        508.2   
  

 

 

   

 

 

 

Earnings (loss) per common share

    

Basic

    

Income from continuing operations, net of tax, available to common shareholders

   $ 0.20      $ 0.74   

Income (loss) from discontinued operations, net of tax

     —          0.36   
  

 

 

   

 

 

 

Net income available to common shareholders

   $ 0.20      $ 1.10   
  

 

 

   

 

 

 

Diluted

    

Income from continuing operations, net of tax, available to common shareholders

   $ 0.19      $ 0.67   

Income (loss) from discontinued operations, net of tax

     (0.01     0.32   
  

 

 

   

 

 

 

Net income available to common shareholders

   $ 0.18      $ 0.99   
  

 

 

   

 

 

 

 

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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

2. Earnings (Loss) Per Common Share (continued)

 

For the three months ended March 31, 2012, 20.9 million shares for mandatory convertible preferred shares, along with the related dividend adjustment, would have been antidilutive to the earnings per share calculations. Assuming the impact of the mandatory convertible preferred shares was not antidilutive, weighted average common shares outstanding and dilutive potential common shares would have totaled 489.9 million.

The declaration of a quarterly common stock dividend of $0.10 during the first quarter of 2012 triggered a provision in The Hartford’s Warrant Agreement with The Bank of New York Mellon, relating to warrants to purchase common stock issued in connection with the Company’s participation in the Capital Purchase Program, resulting in an adjustment to the warrant exercise price to $9.676 from $9.699.

In addition, the declaration also triggered a provision in The Hartford’s Fixed Conversion Rate Agreement, relating to the Company’s mandatory convertible preferred stock, resulting in an adjustment to the minimum conversion rate to 29.8831 from 29.536 shares of Common Stock per share of Series F Preferred Stock and the maximum conversion rate to 36.4596 from 36.036 shares of Common Stock per share of Series F Preferred Stock.

On March 30, 2012 the Company entered into an agreement with Allianz and repurchased the outstanding Series B and Series C warrants. As a result, Allianz no longer holds potentially dilutive outstanding warrants.

3. Segment Information

The Company is organized into four divisions: Commercial Markets, Consumer Markets, Wealth Management and Runoff Operations and conducts business principally in nine reporting segments, as well as the Corporate category. Starting in the second quarter of 2012, financial results for the Individual Annuity segment, which consists of U.S. variable, fixed and fixed indexed annuities, will be reported in the Life Other Operations segment. The Company’s reporting segments as of March 31, 2012 are as follows:

Commercial Markets

Property & Casualty Commercial

Property & Casualty Commercial provides workers’ compensation, property, automobile, marine, livestock, liability and umbrella coverages primarily throughout the United States (“U.S.”), along with a variety of customized insurance products and risk management services including professional liability, fidelity, surety, and specialty casualty coverages.

Group Benefits

Group Benefits provides employers, 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.

Consumer Markets

Consumer Markets provides standard automobile, homeowners and home-based business coverages to individuals across the U.S., including a special program designed exclusively for members of AARP. Consumer Markets also operates a member contact center for health insurance products offered through the AARP Health program.

Wealth Management

Individual Annuity

Individual Annuity offers individual variable, fixed market value adjusted (“fixed MVA”), fixed index and single premium immediate annuities in the U.S.

Individual Life

Individual Life sells a variety of life insurance products, including variable universal life, universal life, and term life.

Retirement Plans

Retirement Plans provides products and services to corporations pursuant to Section 401(k) of the Internal Revenue Code of 1986, as amended (the “Code”), and products and services to municipalities and not-for-profit organizations under Sections 457 and 403(b) of the Code, collectively referred to as government plans.

Mutual Funds

Mutual Funds offers retail mutual funds, investment-only mutual funds and college savings plans under Section 529 of the Code (collectively referred to as non-proprietary) and proprietary mutual funds supporting insurance products issued by The Hartford.

 

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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

3. Segment Information (continued)

 

Runoff Operations

Life Other Operations

Life Other Operations encompasses the administration of investment retirement savings and other insurance and savings products to individuals and groups outside of the U.S., primarily in Japan and Europe, as well as institutional annuity products and private placement life insurance.

Property & Casualty Other Operations

Property & Casualty Other Operations includes the Company’s management of certain property and casualty operations that have discontinued writing new business and substantially all of the Company’s asbestos and environmental exposures.

Corporate

The Company includes in the Corporate category the Company’s debt financing and related interest expense, as well as other capital raising activities; banking operations; certain fee income and commission expenses associated with sales of non-proprietary products by broker-dealer subsidiaries; and certain purchase accounting adjustments and other charges not allocated to the segments.

Financial Measures and Other Segment Information

Certain transactions between segments occur during the year that primarily relate to tax settlements, insurance coverage, expense reimbursements, services provided, security transfers and capital contributions. Also, one segment may purchase group annuity contracts from another to fund pension costs and annuities to settle casualty claims. In addition, certain inter-segment transactions occur that relate to interest income on allocated surplus. Consolidated net investment income is unaffected by such transactions.

The following table presents net income (loss) for each reporting segment, as well as the Corporate category.

 

 

     Three Months Ended  
     March 31,  

Net income (loss)

   2012     2011  

Property & Casualty Commercial

   $ 189      $ 323   

Group Benefits

     18        11   

Consumer Markets

     108        108   

Individual Annuity

     198        143   

Individual Life

     19        18   

Retirement Plans

     18        5   

Mutual Funds

     20        28   

Life Other Operations

     (405     (70

Property & Casualty Other Operations

     27        21   

Corporate

     (96     (86
  

 

 

   

 

 

 

Net income

   $ 96      $ 501   
  

 

 

   

 

 

 

 

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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

3. Segment Information (continued)

 

The following table presents revenues by product line for each reporting segment, as well as the Corporate category.

 

 

     Three Months Ended
March 31,
 

Revenues

   2012     2011  

Earned premiums, fees, and other considerations

    

Property & Casualty Commercial

    

Workers’ compensation

   $ 733      $ 665   

Property

     125        135   

Automobile

     146        146   

Package business

     292        283   

Liability

     141        135   

Fidelity and surety

     52        55   

Professional liability

     68        79   
  

 

 

   

 

 

 

Total Property & Casualty Commercial

     1,557        1,498   

Group Benefits

    

Group disability

     443        477   

Group life and accident

     479        517   

Other

     50        50   
  

 

 

   

 

 

 

Total Group Benefits

     972        1,044   

Consumer Markets

    

Automobile

     632        672   

Homeowners

     277        284   
  

 

 

   

 

 

 

Total Consumer Markets [1]

     909        956   

Individual Annuity

    

Variable annuity

     349        436   

Fixed / MVA and other annuity

     19        4   
  

 

 

   

 

 

 

Total Individual Annuity

     368        440   

Individual Life

    

Variable life

     87        90   

Universal life

     126        106   

Term / Other life

     14        13   
  

 

 

   

 

 

 

Total Individual Life

     227        209   

Retirement Plans

    

401(k)

     84        84   

Government plans

     12        13   
  

 

 

   

 

 

 

Total Retirement Plans

     96        97   

Mutual Funds

    

Non-Proprietary

     136        162   

Proprietary

     15        16   
  

 

 

   

 

 

 

Total Mutual Funds

     151        178   
  

 

 

   

 

 

 

Life Other Operations

     244        254   

Property & Casualty Other Operations

     —          —     

Corporate

     52        52   
  

 

 

   

 

 

 

Total earned premiums, fees, and other considerations

     4,576        4,728   

Net investment income:

    

Securities available-for-sale and other

     1,070        1,108   

Equity securities, trading

     2,866        803   
  

 

 

   

 

 

 

Total net investment income

     3,936        1,911   

Net realized capital losses

     (910     (403

Other revenues

     59        64   
  

 

 

   

 

 

 

Total revenues

   $ 7,661      $ 6,300   
  

 

 

   

 

 

 

 

[1] For the three months ended March 31, 2012 and 2011, AARP members accounted for earned premiums of $676 and $698, respectively.

 

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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

4. Fair Value Measurements

The following financial instruments are carried at fair value in the Company’s Condensed Consolidated Financial Statements: fixed maturity and equity securities, available-for-sale (“AFS”), fixed maturities at fair value using fair value option (“FVO”), equity securities, trading, short-term investments, freestanding and embedded derivatives, separate account assets and certain other liabilities.

The following section applies the fair value hierarchy and disclosure requirements for the Company’s financial instruments that are carried at fair value. The fair value hierarchy prioritizes the inputs in the valuation techniques used to measure fair value into three broad Levels (Level 1, 2 or 3).

 

Level 1 Observable inputs that reflect quoted prices for identical assets or liabilities in active markets that the Company has the ability to access at the measurement date. Level 1 securities include highly liquid U.S. Treasuries, money market funds and exchange traded equity securities, open-ended mutual funds reported in separate account assets and derivative securities.

 

Level 2 Observable inputs, other than quoted prices included in Level 1, for the asset or liability or prices for similar assets and liabilities. Most fixed maturities and preferred stocks, including those reported in separate account assets, are model priced by vendors using observable inputs and are classified within Level 2.

 

Level 3 Valuations that are derived from techniques in which one or more of the significant inputs are unobservable (including assumptions about risk). Level 3 securities include less liquid securities, guaranteed product embedded and reinsurance derivatives and other complex derivative securities. Because Level 3 fair values, by their nature, contain one or more significant unobservable inputs as there is little or no observable market for these assets and liabilities, considerable judgment is used to determine the Level 3 fair values. Level 3 fair values represent the Company’s best estimate of an amount that could be realized in a current market exchange absent actual market exchanges.

In many situations, inputs used to measure the fair value of an asset or liability position may fall into different levels of the fair value hierarchy. In these situations, the Company will determine the level in which the fair value falls based upon the lowest level input that is significant to the determination of the fair value. Transfers of securities among the levels occur at the beginning of the reporting period. For the three months ended March 31, 2012, transfers of $138 from Level 1 to Level 2 occurred, which represented previously on-the-run U.S. Treasury securities that are now off-the-run. No transfers from Level 2 to 1 occurred during the first quarter. In most cases, both observable (e.g., changes in interest rates) and unobservable (e.g., changes in risk assumptions) inputs are used in the determination of fair values that the Company has classified within Level 3. Consequently, these values and the related gains and losses are based upon both observable and unobservable inputs. The Company’s fixed maturities included in Level 3 are classified as such because these securities are primarily priced by independent brokers and/or within illiquid markets.

 

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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

4. Fair Value Measurements (continued)

 

These disclosures provide information as to the extent to which the Company uses fair value to measure financial instruments and information about the inputs used to value those financial instruments to allow users to assess the relative reliability of the measurements. The following tables present assets and (liabilities) carried at fair value by hierarchy level.

 

 

     March 31, 2012  
     Total     Quoted Prices in
Active Markets
for Identical
Assets

(Level 1)
    Significant
Observable
Inputs

(Level 2)
    Significant
Unobservable
Inputs

(Level 3)
 

Assets accounted for at fair value on a recurring basis

        

Fixed maturities, AFS

        

ABS

   $ 3,087      $ —        $ 2,788      $ 299   

CDOs

     3,043        —          2,140        903   

CMBS

     6,774        —          5,773        1,001   

Corporate

     43,329        —          41,335        1,994   

Foreign government/government agencies

     3,352        —          3,297        55   

States, municipalities and political subdivisions (“Municipal”)

     13,838        —          13,213        625   

RMBS

     6,595        —          5,486        1,109   

U.S. Treasuries

     3,139        802        2,337        —     
  

 

 

   

 

 

   

 

 

   

 

 

 

Total fixed maturities

     83,157        802        76,369        5,986   

Fixed maturities, FVO

     1,291        —          783        508   

Equity securities, trading

     30,722        2,041        28,681        —     

Equity securities, AFS

     938        369        480        89   

Derivative assets

        

Credit derivatives

     5        —          (17     22   

Equity derivatives

     10        —          —          10   

Foreign exchange derivatives

     370        —          370        —     

Interest rate derivatives

     —          —          42        (42

U.S. guaranteed minimum withdrawal benefit (“GMWB”) hedging instruments

     421        —          (13     434   

U.S. macro hedge program

     133        —          —          133   

International program hedging instruments

     227        —          94        133   

Other derivative contracts

     27        —          —          27   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total derivative assets [1]

     1,193        —          476        717   

Short-term investments

     5,256        727        4,529        —     

Reinsurance recoverable for U.S. GMWB

     308        —          —          308   

Separate account assets [2]

     148,127        109,213        37,568        1,346   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total assets accounted for at fair value on a recurring basis

   $ 270,992      $ 113,152      $ 148,886      $ 8,954   
  

 

 

   

 

 

   

 

 

   

 

 

 

Percentage of level to total

     100     42     55     3
  

 

 

   

 

 

   

 

 

   

 

 

 

Liabilities accounted for at fair value on a recurring basis

Other policyholder funds and benefits payable

        

U.S guaranteed withdrawal benefits

   $ (1,683   $ —        $ —        $ (1,683

International guaranteed withdrawal benefits

     (37     —          —          (37

International other guaranteed living benefits

     (1     —          —          (1

Equity linked notes

     (10     —          —          (10
  

 

 

   

 

 

   

 

 

   

 

 

 

Total other policyholder funds and benefits payable

     (1,731     —          —          (1,731

Derivative liabilities

        

Credit derivatives

     (522     —          (26     (496

Equity derivatives

     29        —          —          29   

Foreign exchange derivatives

     54        —          54        —     

Interest rate derivatives

     (447     —          (432     (15

U.S. GMWB hedging instruments

     104        —          (56     160   

U.S. macro hedge program

     40        —          —          40   

International program hedging instruments

     (26     —          (8     (18
  

 

 

   

 

 

   

 

 

   

 

 

 

Total derivative liabilities [3]

     (768     —          (468     (300

Other Liabilities

     (21     —          —          (21

Consumer notes [4]

     (4     —          —          (4
  

 

 

   

 

 

   

 

 

   

 

 

 

Total liabilities accounted for at fair value on a recurring basis

   $ (2,524   $ —        $ (468   $ (2,056
  

 

 

   

 

 

   

 

 

   

 

 

 

 

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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

4. Fair Value Measurements (continued)

 

     December 31, 2011  
     Total     Quoted Prices in
Active Markets
for Identical
Assets

(Level 1)
    Significant
Observable
Inputs

(Level 2)
    Significant
Unobservable
Inputs

(Level 3)
 

Assets accounted for at fair value on a recurring basis

        

Fixed maturities, AFS

        

ABS

   $ 3,153      $ —        $ 2,792      $ 361   

CDOs

     2,487        —          2,119        368   

CMBS

     6,951        —          6,363        588   

Corporate

     44,011        —          41,756        2,255   

Foreign government/government agencies

     2,161        —          2,112        49   

States, municipalities and political subdivisions (“Municipal”)

     13,260        —          12,823        437   

RMBS

     5,757        —          4,694        1,063   

U.S. Treasuries

     4,029        750        3,279        —     
  

 

 

   

 

 

   

 

 

   

 

 

 

Total fixed maturities

     81,809        750        75,938        5,121   

Fixed maturities, FVO

     1,328        —          833        495   

Equity securities, trading

     30,499        1,967        28,532        —     

Equity securities, AFS

     921        352        476        93   

Derivative assets

        

Credit derivatives

     (24     —          (11     (13

Equity derivatives

     31        —          —          31   

Foreign exchange derivatives

     519        —          519        —     

Interest rate derivatives

     195        —          147        48   

U.S. GMWB hedging instruments

     494        —          11        483   

U.S. macro hedge program

     357        —          —          357   

International program hedging instruments

     731        —          692        39   

Other derivative contracts

     28        —          —          28   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total derivative assets [1]

     2,331        —          1,358        973   

Short-term investments

     7,736        750        6,986        —     

Reinsurance recoverable for U.S. GMWB

     443        —          —          443   

Separate account assets [2]

     139,432        101,644        36,757        1,031   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total assets accounted for at fair value on a recurring basis

   $ 264,499      $ 105,463      $ 150,880      $ 8,156   
  

 

 

   

 

 

   

 

 

   

 

 

 

Percentage of level to total

     100     40     57     3
  

 

 

   

 

 

   

 

 

   

 

 

 

 

20


Table of Contents

THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

4. Fair Value Measurements (continued)

 

     December 31, 2011  
     Total     Quoted Prices in
Active Markets
for Identical
Assets

(Level 1)
     Significant
Observable
Inputs

(Level 2)
    Significant
Unobservable
Inputs

(Level 3)
 

Liabilities accounted for at fair value on a recurring basis

         

Other policyholder funds and benefits payable

         

U.S guaranteed withdrawal benefits

   $ (2,538   $ —         $ —        $ (2,538

International guaranteed withdrawal benefits

     (66     —           —          (66

International other guaranteed living benefits

     (5     —           —          (5

Equity linked notes

     (9     —           —          (9
  

 

 

   

 

 

    

 

 

   

 

 

 

Total other policyholder funds and benefits payable

     (2,618     —           —          (2,618

Derivative liabilities

         

Credit derivatives

     (573     —           (25     (548

Equity derivatives

     9        —           —          9   

Foreign exchange derivatives

     134        —           134        —     

Interest rate derivatives

     (527     —           (421     (106

U.S. GMWB hedging instruments

     400        —           —          400   

International program hedging instruments

     19        —           23        (4
  

 

 

   

 

 

    

 

 

   

 

 

 

Total derivative liabilities [3]

     (538     —           (289     (249

Other Liabilities

     (9     —           —          (9

Consumer notes [4]

     (4     —           —          (4
  

 

 

   

 

 

    

 

 

   

 

 

 

Total liabilities accounted for at fair value on a recurring basis

   $ (3,169   $ —         $ (289   $ (2,880
  

 

 

   

 

 

    

 

 

   

 

 

 

 

[1] Includes over-the-counter derivative instruments in a net asset value position which may require the counterparty to pledge collateral to the Company. As of March 31, 2012 and December 31, 2011, $97 and $1.4 billion, respectively, of cash collateral liability was netted against the derivative asset value in the Condensed Consolidated Balance Sheet and is excluded from the table above. See footnote 3 below for derivative liabilities.
[2] Approximately $4.3 billion and $4.0 billion of investment sales receivable that are not subject to fair value accounting are excluded as of March 31, 2012 and December 31, 2011, respectively.
[3] Includes over-the-counter derivative instruments in a net negative market value position (derivative liability). In the Level 3 roll-forward table included below in this Note 4, the derivative asset and liability are referred to as “freestanding derivatives” and are presented on a net basis.
[4] Represents embedded derivatives associated with non-funding agreement-backed consumer equity linked notes.

Determination of Fair Values

The valuation methodologies used to determine the fair values of assets and liabilities under the “exit price” notion, reflect market-participant objectives and are based on the application of the fair value hierarchy that prioritizes relevant observable market inputs over unobservable inputs. The Company determines the fair values of certain financial assets and financial liabilities based on quoted market prices where available and where prices represent a reasonable estimate of fair value. The Company also determines fair value based on future cash flows discounted at the appropriate current market rate. Fair values reflect adjustments for counterparty credit quality, the Company’s default spreads, liquidity and, where appropriate, risk margins on unobservable parameters. The following is a discussion of the methodologies used to determine fair values for the financial instruments listed in the above tables.

The fair value process is monitored by the Valuation Committee, which is a cross-functional group of senior management within the Company that meets at least quarterly. The Valuation Committee is co-chaired by the Heads of Investment Operations and Accounting and has representation from various investment sector professionals, accounting, operations, legal, compliance and risk management. The purpose of the committee is to oversee the pricing policy and procedures by ensuring objective and reliable valuation practices and pricing of financial instruments, as well as addressing fair valuation issues and approving changes to valuation methodologies and pricing sources. There is also a Fair Value Working Group (“Working Group”) which includes the Heads of Investment Operations and Accounting, as well as other investment, operations, accounting and risk management professionals that meet monthly to review market data trends, pricing and trading statistics and results, and any proposed pricing methodology changes described in more detail in the following paragraphs.

 

 

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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

4. Fair Value Measurements (continued)

 

Available-for-Sale Securities, Fixed Maturities, FVO, Equity Securities, Trading, and Short-term Investments

The fair value of AFS securities, fixed maturities, FVO, equity securities, trading, and short-term investments in an active and orderly market (e.g. not distressed or forced liquidation) are determined by management after considering one of three primary sources of information: third-party pricing services, independent broker quotations or pricing matrices. Security pricing is applied using a “waterfall” approach whereby publicly available prices are first sought from third-party pricing services, the remaining unpriced securities are submitted to independent brokers for prices, or lastly, securities are priced using a pricing matrix. 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 from 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 recently reported trades, the third-party pricing services and independent 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 pricing of ABS and RMBS 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.

Prices from third-party pricing services are often unavailable for securities that are rarely traded or are traded only in privately negotiated transactions. As a result, certain securities are priced via independent broker quotations which utilize inputs that may be difficult to corroborate with observable market based data. Additionally, the majority of these independent broker quotations are non-binding.

A pricing matrix is used to price private placement securities for which the Company is unable to obtain a price from a third-party pricing service by discounting the expected future cash flows from the security by a developed market discount rate utilizing current credit spreads. Credit spreads are developed each month using market based data for public securities adjusted for credit spread differentials between public and private securities which are obtained from a survey of multiple private placement brokers. The appropriate credit spreads determined through this survey approach are based upon the issuer’s financial strength and term to maturity, utilizing an independent public security index and trade information and adjusting for the non-public nature of the securities.

The Working Group performs ongoing analysis of the prices and credit spreads received from third parties to ensure that the prices represent a reasonable estimate of the fair value. This process involves quantitative and qualitative analysis and is overseen by investment and accounting professionals. As a part of this analysis, the Company considers trading volume, new issuance activity and other factors to determine whether the market activity is significantly different than normal activity in an active market, and if so, whether transactions may not be orderly considering the weight of available evidence. If the available evidence indicates that pricing is based upon transactions that are stale or not orderly, the Company places little, if any, weight on the transaction price and will estimate fair value utilizing an internal pricing model. In addition, the Company ensures that prices received from independent brokers represent a reasonable estimate of fair value through the use of internal and external cash flow models developed based on spreads, and when available, market indices. As a result of this analysis, if the Company determines that there is a more appropriate fair value based upon the available market data, the price received from the third party is adjusted accordingly and approved by the Valuation Committee. The Company’s internal pricing model utilizes the Company’s best estimate of expected future cash flows discounted at a rate of return that a market participant would require. The significant inputs to the model include, but are not limited to, current market inputs, such as credit loss assumptions, estimated prepayment speeds and market risk premiums.

The Company conducts other specific activities to monitor controls around pricing. Daily analyses identify price changes over 3-5%, sale trade prices that differ over 3% from the prior day’s price and purchase trade prices that differ more than 3% from the current day’s price. Weekly analyses identify prices that differ more than 5% from published bond prices of a corporate bond index. Monthly analyses identify price changes over 3%, prices that haven’t changed, missing prices and second source validation on most sectors. Analyses are conducted by a dedicated pricing unit that follows up with trading and investment sector professionals and challenges prices with vendors when the estimated assumptions used differ from what the Company feels a market participant would use. Any changes from the identified pricing source are verified by further confirmation of assumptions used. Examples of other procedures performed include, but are not limited to, initial and on-going review of third-party pricing services’ methodologies, review of pricing statistics and trends and back testing recent trades. For a sample of structured securities, a comparison of the vendor’s assumptions to our internal econometric models is also performed; any differences are challenged in accordance with the process described above.

The Company has analyzed the third-party pricing services’ valuation methodologies and related inputs, and has also evaluated the various types of securities in its investment portfolio to determine an appropriate fair value hierarchy level based upon trading activity and the observability of market inputs. Most prices provided by third-party pricing services are classified into Level 2 because the inputs used in pricing the securities are market observable. Due to a general lack of transparency in the process that brokers use to develop prices, most valuations that are based on brokers’ prices are classified as Level 3. Some valuations may be classified as Level 2 if the price can be corroborated with observable market data.

 

 

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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

4. Fair Value Measurements (continued)

 

Derivative Instruments, including embedded derivatives within investments

Derivative instruments are fair valued using pricing valuation models that utilize independent market data inputs, quoted market prices for exchange-traded derivatives, or independent broker quotations. Excluding embedded and reinsurance related derivatives, as of both March 31, 2012 and December 31, 2011, 98% of derivatives, based upon notional values, were priced by valuation models or quoted market prices. The remaining derivatives were priced by broker quotations.

The Company performs various controls on derivative valuations which include both quantitative and qualitative analysis. Analyses are conducted by a dedicated derivative pricing team that works directly with investment sector professionals to analyze impacts of changes in the market environment and investigate variances. There is a monthly analysis to identify market value changes greater than pre-defined thresholds, stale prices, missing prices and zero prices. Also on a monthly basis, a second source validation, typically to broker quotations, is performed for certain of the more complex derivatives, as well as for all new deals during the month. A model validation review is performed on any new models, which typically includes detailed documentation and validation to a second source. The model validation documentation and results of validation are presented to the Valuation Committee for approval. There is a monthly control to review changes in pricing sources to ensure that new models are not moved to production until formally approved.

The Company utilizes derivative instruments to manage the risk associated with certain assets and liabilities. However, the derivative instrument may not be classified with the same fair value hierarchy level as the associated assets and liabilities. Therefore the realized and unrealized gains and losses on derivatives reported in Level 3 may not reflect the offsetting impact of the realized and unrealized gains and losses of the associated assets and liabilities.

Valuation Techniques and Inputs for Investments

Generally, the Company determines the estimated fair value of its AFS securities, fixed maturities, FVO, equity securities, trading, and short-term investments using the market approach. The income approach is used for securities priced using a pricing matrix, as well as for derivative instruments. For Level 1 investments, which are comprised of on-the-run U.S. Treasuries, exchange-traded equity securities, short-term investments, and exchange traded futures and option contracts, valuations are based on observable inputs that reflect quoted prices for identical assets in active markets that the Company has the ability to access at the measurement date.

For most of the Company’s debt securities, the following inputs are typically used in the Company’s pricing methods: reported trades, benchmark yields, bids and/or estimated cash flows. For securities except U.S. Treasuries, inputs also include issuer spreads, which may consider credit default swaps. Derivative instruments are valued using mid-market inputs that are predominantly observable in the market.

A description of additional inputs used in the Company’s Level 2 and Level 3 measurements is listed below:

 

Level 2 The fair values of most of the Company’s Level 2 investments are determined by management after considering prices received from third party pricing services. These investments include most fixed maturities and preferred stocks, including those reported in separate account assets.

 

   

ABS, CDOs, CMBS and RMBS – Primary inputs also include monthly payment information, collateral performance, which varies by vintage year and includes delinquency rates, collateral valuation loss severity rates, collateral refinancing assumptions, credit default swap indices and, for ABS and RMBS, estimated prepayment rates.

 

   

Corporates, including investment grade private placements – Primary inputs also include observations of credit default swap curves related to the issuer.

 

   

Foreign government/government agencies—Primary inputs also include observations of credit default swap curves related to the issuer and political events in emerging markets.

 

   

Municipals – Primary inputs also include Municipal Securities Rulemaking Board reported trades and material event notices, and issuer financial statements.

 

   

Short-term investments – Primary inputs also include material event notices and new issue money market rates.

 

   

Equity securities, trading – Consist of investments in mutual funds. Primary inputs include net asset values obtained from third party pricing services.

 

   

Credit derivatives – Significant inputs primarily include the swap yield curve and credit curves.

 

   

Foreign exchange derivatives – Significant inputs primarily include the swap yield curve, currency spot and forward rates, and cross currency basis curves.

 

   

Interest rate derivatives – Significant input is primarily the swap yield curve.

 

 

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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

4. Fair Value Measurements (continued)

 

Level 3 Most of the Company’s securities classified as Level 3 include less liquid securities such as lower quality asset-backed securities (“ABS”), commercial mortgage-backed securities (“CMBS”), commercial real estate (“CRE”) CDOs and residential mortgage-backed securities (“RMBS”) primarily backed by below-prime loans. Securities included in level 3 are primarily valued based on broker prices or broker spreads, without adjustments. Primary inputs for non-broker priced investments, including structured securities, are consistent with the typical inputs used in Level 2 measurements noted above, but are Level 3 due to their less liquid markets. Additionally, certain long-dated securities are priced based on third party pricing services, including municipal securities, foreign government/government agencies, bank loans and below investment grade private placement securities. Primary inputs for these long-dated securities are consistent with the typical inputs used in Level 1 and Level 2 measurements noted above, but include benchmark interest rate or credit spread assumptions that are not observable in the marketplace. Also included in Level 3 are certain derivative instruments that either have significant unobservable inputs or are valued based on broker quotations. Significant inputs for these derivative contracts primarily include the typical inputs used in the Level 1 and Level 2 measurements noted above.

Significant Unobservable Inputs for Level 3 Assets Measured at Fair Values

The following table presents information about significant unobservable inputs used in Level 3 assets measured at fair value.

 

 

Securities

   As of March 31, 2012

Assets accounted for at fair

value on a recurring basis

   Fair
Value
   

Predominant
Valuation
Method

  

Significant

Unobservable Input

  

Range of Values –
Unobservable Inputs
(Weighted Average) [1]

  

Impact of
Increase in Input
on Fair Value [2]

CMBS

   $ 1,001     

Discounted

cash flows

   Spread (encompasses prepayment, default risk and loss severity)    317 – 3,771 bps (1,087 bps)    Decrease

Corporate

     1,204 [3]   

Discounted

cash flows

   Spread    87 – 800 bps (342 bps)    Decrease

Municipal

     625     

Discounted

cash flows

   Treasury yield beyond 30 years    3.3% (3.3%)    Decrease

RMBS

     1,109     

Discounted

cash flows

   Spread    60 – 1,976 bps (691 bps)    Decrease
        Constant prepayment rate    0% – 12% (2%)    Decrease [4]
        Constant default rate    1% – 28% (8%)    Decrease
        Loss severity    45% – 100% (75%)    Decrease

 

[1] The weighted average is determined based on the fair value of the securities.
[2] Conversely, the impact of a decrease in input would have the opposite impact to the fair value as that presented in the table above.
[3] Level 3 corporate securities excludes those for which the Company bases fair value on broker quotations as discussed below.
[4] Decrease for above market rate coupons and increase for below market rate coupons.

 

 

Freestanding Derivatives    As of March 31, 2012
     Fair
Value
   

Predominant
Valuation Method

  

Significant Unobservable Input

  

Range of Values –

Unobservable Inputs

  

Impact of Increase in

Input on Fair Value [1]

Equity derivatives

             

Equity options

   $ 39      Option model    Equity volatility    13% – 24%    Increase

Interest rate derivative

             

Interest rate swaps

     (93  

Discounted

cash flows

   Swap curve beyond 30 years    3.0% – 3.1%    Increase

Long interest rate swaptions

     36      Option model    Interest rate volatility    25% – 32%    Increase

U.S. GMWB hedging instruments

             

Equity options

     355      Option model    Equity volatility    24% – 32%    Increase

Customized swaps

     239     

Discounted

cash flows

   Equity volatility    10% – 50%    Increase

U.S. macro hedge program

             

Equity options

     173      Option model    Equity volatility    22% – 31%    Increase

International program hedging

             

Equity options

     141      Option model    Equity volatility    20% – 28%    Increase

Short interest rate swaptions

     (26   Option model    Interest rate volatility    22% – 25%    Decrease

 

[1] Conversely, the impact of a decrease in input would have the opposite impact to the fair value as that presented in the table. Changes are based on long positions, unless otherwise noted. Changes in fair value will be inversely impacted for short positions.

 

24


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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

4. Fair Value Measurements (continued)

 

Securities and derivatives for which the Company bases fair value on broker quotations predominately include ABS, CDOs, corporate, fixed maturities, FVO and certain credit derivatives. Due to the lack of transparency in the process brokers use to develop prices for these investments, the Company does not have access to the significant unobservable inputs brokers use to price these securities and derivatives. The Company believes however, the types of inputs brokers may use would likely be similar to those used to price securities and derivatives for which inputs are available to the Company, and therefore may include, but not be limited to, loss severity rates, constant prepayment rates, constant default rates and counterparty credit spreads. Therefore, similar to non broker priced securities and derivatives, generally, increases in these inputs would cause fair values to decrease. For the three months ended March 31, 2012, no significant adjustments were made by the Company to broker prices received.

Product Derivatives

The Company currently offers certain variable annuity products with GMWB riders in the U.S., and formerly in the U.K. and Japan. The GMWB represents an embedded derivative in the variable annuity contract. When it is determined that (1) the embedded derivative possesses economic characteristics that are not clearly and closely related to the economic characteristics of the host contract, and (2) a separate instrument with the same terms would qualify as a derivative instrument, the embedded derivative is bifurcated from the host for measurement purposes. The embedded derivative is carried at fair value, with changes in fair value reported in net realized capital gains and losses. The Company’s GMWB liability is reported in other policyholder funds and benefits payable in the Condensed Consolidated Balance Sheets.

In valuing the embedded derivative, the Company attributes to the derivative a portion of the expected fees to be collected over the expected life of the contract from the contract holder equal to the present value of future GMWB claims (the “Attributed Fees”). The excess of fees collected from the contract holder in the current period over the current period’s Attributed Fees are associated with the host variable annuity contract and reported in fee income.

U.S. GMWB Reinsurance Derivative

The Company has reinsurance arrangements in place to transfer a portion of its risk of loss due to GMWB. These arrangements are recognized as derivatives and carried at fair value in reinsurance recoverables. Changes in the fair value of the reinsurance agreements are reported in net realized capital gains and losses.

The fair value of the U.S. GMWB reinsurance derivative is calculated as an aggregation of the components described in the Living Benefits Required to be Fair Valued discussion below and is modeled using significant unobservable inputs, as well as policyholder behavior inputs, identical to those used in calculating the underlying liability, such as lapses, fund selection, resets and withdrawal utilization and risk margins.

Living Benefits Required to be Fair Valued (in Other Policyholder Funds and Benefits Payable)

Living benefits required to be fair valued include U.S. GMWB, international GMWB and international other guaranteed living benefits. Fair values for GMWB and guaranteed minimum accumulation benefit (“GMAB”) contracts are calculated using the income approach based upon internally developed models because active, observable markets do not exist for those items. The fair value of the Company’s guaranteed benefit liabilities, classified as embedded derivatives, and the related reinsurance and customized freestanding derivatives is calculated as an aggregation of the following components: Best Estimate Claim Payments; Credit Standing Adjustment; and Margins. The resulting aggregation is reconciled or calibrated, if necessary, to market information that is, or may be, available to the Company, but may not be observable by other market participants, including reinsurance discussions and transactions. The Company believes the aggregation of these components, as necessary and as reconciled or calibrated to the market information available to the Company, results in an amount that the Company would be required to transfer or receive, for an asset, to or from market participants in an active liquid market, if one existed, for those market participants to assume the risks associated with the guaranteed minimum benefits and the related reinsurance and customized derivatives. The fair value is likely to materially diverge from the ultimate settlement of the liability as the Company believes settlement will be based on our best estimate assumptions rather than those best estimate assumptions plus risk margins. In the absence of any transfer of the guaranteed benefit liability to a third party, the release of risk margins is likely to be reflected as realized gains in future periods’ net income. Each component described below is unobservable in the marketplace and require subjectivity by the Company in determining their value.

Oversight of the Company’s valuation policies and processes for product and U.S. GMWB reinsurance derivatives is performed by a multidisciplinary group comprised of finance, actuarial and risk management professionals. This multidisciplinary group reviews and approves changes and enhancements to the Company’s valuation model as well as associated controls.

 

 

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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

4. Fair Value Measurements (continued)

 

Best Estimate

Claim Payments

The Best Estimate Claim Payments is calculated based on actuarial and capital market assumptions related to projected cash flows, including the present value of 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. For the customized derivatives, policyholder behavior is prescribed in the derivative contract. Because of the dynamic and complex nature of these cash flows, best estimate assumptions and a Monte Carlo stochastic process is used in valuation. The Monte Carlo stochastic process involves the generation of thousands of scenarios that assume risk neutral returns consistent with swap rates and a blend of observable implied index volatility levels. Estimating these cash flows involves numerous estimates and subjective judgments regarding a number of variables –including expected market rates of return, market volatility, correlations of market index returns to funds, fund performance, discount rates and assumptions about policyholder behavior which emerge over time.

At each valuation date, the Company assumes expected returns based on:

 

 

risk-free rates as represented by the euro dollar futures, LIBOR deposits and swap rates to derive forward curve rates;

 

 

market implied volatility assumptions for each underlying index based primarily on a blend of observed market “implied volatility” data;

 

 

correlations of historical returns across underlying well known market indices based on actual observed returns over the ten years preceding the valuation date; and

 

 

three years of history for fund indexes compared to separate account fund regression.

On a daily basis, the Company updates capital market assumptions used in the GMWB liability model such as interest rates, equity indices and the blend of implied equity index volatilities. The Company monitors various aspects of policyholder behavior and may modify certain of its assumptions, including living benefit lapses and withdrawal rates, if credible emerging data indicates that changes are warranted. At a minimum, all policyholder behavior assumptions are reviewed and updated, as appropriate, in conjunction with the completion of the Company’s comprehensive study to refine its estimate of future gross profits during the third quarter of each year.

Credit Standing Adjustment

This assumption makes an adjustment that market participants would make, in determining fair value, to reflect the risk that guaranteed benefit obligations or the GMWB reinsurance recoverables will not be fulfilled (“nonperformance risk”). The Company incorporates a blend of observable Company and reinsurer credit default spreads from capital markets, adjusted for market recoverability. The credit standing adjustment assumption, net of reinsurance, resulted in pre-tax realized gains (losses) of $(49) and ($1), for the three months ended March 31, 2012 and 2011. As of March 31, 2012 and December 31, 2011 the credit standing adjustment was $31 and $80, respectively.

Margins

The behavior risk margin adds a margin that market participants would require, in determining fair value, for the risk that the Company’s assumptions about policyholder behavior could differ from actual experience. The behavior risk margin is calculated by taking the difference between adverse policyholder behavior assumptions and best estimate assumptions.

There were no policyholder behavior assumption updates for the three months ended March 31, 2012 and 2011. As of March 31, 2012 and December 31, 2011 the behavior risk margin was $355 and $419, respectively.

In addition to the non-market-based updates described above, the Company recognized non-market-based updates driven by the relative outperformance (underperformance) of the underlying actively managed funds as compared to their respective indices resulting in pre-tax realized gains (losses) of approximately $13 and $25, for the three months ended March 31, 2012 and 2011, respectively.

 

 

26


Table of Contents

THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

4. Fair Value Measurements (continued)

 

Significant unobservable inputs used in the fair value measurement of living benefits required to be fair valued and the U.S. GMWB reinsurance derivative are withdrawal utilization and withdrawal rates, lapse rates, reset elections and equity volatility. The following table provides quantitative information about the significant unobservable inputs and is applicable to all of the Living Benefits Required to be Fair Valued and the U.S. GMWB Reinsurance Derivative. Significant increases in any of the significant unobservable inputs, in isolation, will generally have an increase or decrease correlation with the fair value measurement, as shown in the table.

 

 

Significant Unobservable Input

  

Range of Values-Unobservable Inputs

  

Impact of Increase in Input

on Fair Value Measurement [1]

Withdrawal Utilization[2]

   20% to 100%    Increase

Withdrawal Rates [2]

   0% to 8%    Increase

Lapse Rates [3]

   0% to 75%    Decrease

Reset Elections [4]

   20% to 75%    Increase

Equity Volatility [5]

   10% to 50%    Increase

 

[1] Conversely, the impact of a decrease in input would have the opposite impact to the fair value as that presented in the table.
[2] Ranges represent assumed cumulative percentages of policyholders taking withdrawals and the annual amounts withdrawn.
[3] Range represents assumed annual percentages of full surrender of the underlying variable annuity contracts across all policy durations for in force business.
[4] Range represents assumed cumulative percentages of policyholders that would elect to reset their guaranteed benefit base.
[5] Range represents implied market volatilities for equity indices based on multiple pricing sources.

Generally a change in withdrawal utilization assumptions would be accompanied by a directionally opposite change in lapse rate assumptions, as the behavior of policyholders that utilize GMWB or GMAB riders is typically different from policyholders that do not utilize these riders.

Separate Account Assets

Separate account assets are primarily invested in mutual funds. Other separate account assets include fixed maturities, limited partnerships, equity securities, short-term investments and derivatives that are valued in the same manner, and using the same pricing sources and inputs, as those investments held by the Company. Separate account assets classified as Level 3 primarily include limited partnerships in which fair value represents the separate account’s share of the fair value of the equity in the investment (“net asset value”) and are classified in level 3 based on the Company’s ability to redeem its investment.

Assets and Liabilities Measured at Fair Value on a Recurring Basis Using Significant Unobservable Inputs (Level 3)

The tables below provide fair value roll-forwards for the three months ended March 31, 2012 and 2011, for the financial instruments classified as Level 3.

Roll-forward of Financial Instruments Measured at Fair Value on a Recurring Basis Using Significant Unobservable Inputs (Level 3) for the three months from January 1, 2012 to March 31, 2012.

 

     Fixed Maturities, AFS        

Assets

   ABS     CDOs     CMBS     Corporate     Foreign
govt./govt.
agencies
    Municipal     RMBS     Total  Fixed
Maturities,
AFS
    Fixed
Maturities,
FVO
 

Fair value as of January 1, 2012

   $ 361      $ 368      $ 588      $ 2,255      $ 49      $ 437      $ 1,063      $ 5,121      $ 495   

Total realized/unrealized gains (losses)

                  

Included in net income [1], [2], [6]

     —          2        (5     (3     —          —          7        1        27   

Included in OCI [3]

     9        63        23        10        —          (11     26        120        —     

Purchases

     —          —          12        134        7        212        80        445        —     

Settlements

     (35     (10     (32     (20     (1     —          (33     (131     —     

Sales

     (12     (3     —          (53     —          —          (34     (102     (14

Transfers into Level 3 [4]

     —          483        450        202        —          —          —          1,135        —     

Transfers out of Level 3 [4]

     (24     —          (35     (531     —          (13     —          (603     —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Fair value as of March 31, 2012

   $ 299      $ 903      $ 1,001      $ 1,994      $ 55      $ 625      $ 1,109      $ 5,986      $ 508   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Changes in unrealized gains (losses) included in net income related to financial instruments still held at March 31, 2012 [2] [7]

   $ —        $ —        $ (5   $ —        $ —        $ —        $ (6   $ (11   $ 18   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

27


Table of Contents

THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

4. Fair Value Measurements (continued)

 

           Freestanding Derivatives [5]  

Assets (Liabilities)

   Equity
Securities,
AFS
    Credit     Equity     Interest
Rate
    U.S.
GMWB
Hedging
    U.S.
Macro
Hedge
Program
    Intl.
Program
Hedging
Instr.
    Other
Contracts
    Total Free-
Standing
Derivatives [5]
 

Fair value as of January 1, 2012

   $ 93      $ (561   $ 40      $ (58   $ 883      $ 357      $ 35      $ 28      $ 724   

Total realized/unrealized gains (losses)

                  

Included in net income [1], [2], [6]

     3        92        (17     1        (312     (184     85        (1     (336

Included in OCI [3]

     —          —          —          —          —          —          —          —          —     

Purchases

     2        —          35        —          —          —          (53     —          (18

Settlements

     —          (5     (19     —          —          —          40        —          16   

Sales

     (9     —          —          —          —          —          —          —          —     

Transfers into Level 3 [4]

     —          —          —          —          —          —          —          —          —     

Transfers out of Level 3 [4]

     —          —          —          —          23        —          8        —          31   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Fair value as of March 31, 2012

   $ 89      $ (474   $ 39      $ (57   $ 594      $ 173      $ 115      $ 27      $ 417   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Changes in unrealized gains (losses) included in net income related to financial instruments still held at March 31, 2012 [2] [7]

   $ —        $ 80      $ (5   $ 1      $ (312   $ (183   $ 85      $ (1   $ (335
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

Assets

   Reinsurance Recoverable
for U.S. GMWB
    Separate Accounts  

Fair value as of January 1, 2012

   $ 443      $ 1,031   

Total realized/unrealized gains (losses)

    

Included in net income [1], [2], [6]

     (143     17   

Included in OCI [3]

     —          —     

Purchases

     —          215   

Settlements

     8        —     

Sales

     —          (342

Transfers into Level 3 [4]

     —          439   

Transfers out of Level 3 [4]

     —          (14
  

 

 

   

 

 

 

Fair value as of March 31, 2012

   $ 308      $ 1,346   
  

 

 

   

 

 

 

Changes in unrealized gains (losses) included in net income related to financial instruments still held at March 31, 2012 [2] [7]

   $ (143   $ 6   
  

 

 

   

 

 

 

 

     Other Policyholder Funds and Benefits Payable              

Liabilities

   U.S.
Guaranteed
Withdrawal
Benefits
    International
Guaranteed
Living
Benefits
    International
Other Living
Benefits
    Equity
Linked
Notes
    Total Other
Policyholder
Funds and
Benefits
Payable
    Other
Liabilities
    Consumer
Notes
 

Fair value as of January 1, 2012

   $ (2,538   $ (66   $ (5   $ (9   $ (2,618   $ (9   $ (4

Total realized/unrealized gains (losses)

              

Included in net income [1], [2], [6]

     896        30        5        (1     930        (12     —     

Included in OCI [3]

     —          1        —          —          1        —          —     

Settlements

     (41     (2     (1     —          (44     —          —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Fair value as of March 31, 2012

   $ (1,683   $ (37   $ (1   $ (10   $ (1,731   $ (21   $ (4
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Changes in unrealized gains (losses) included in net income related to financial instruments still held at March 31, 2012 [2] [7]

   $ 896      $ 30      $ 5      $ (1   $ 930      $ (12   $ —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

28


Table of Contents

THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

4. Fair Value Measurements (continued)

 

Roll-forward of Financial Instruments Measured at Fair Value on a Recurring Basis Using Significant Unobservable Inputs (Level 3) for the three months from January 1, 2011 to March 31, 2011.

 

     Fixed Maturities, AFS        

Assets

   ABS     CDOs     CMBS     Corporate     Foreign
govt./govt.
agencies
    Municipal      RMBS     Total  Fixed
Maturities,
AFS
    Fixed
Maturities,
FVO
 

Fair value as of January 1, 2011

   $ 477      $ 2,581      $ 689      $ 2,129      $ 56      $ 272       $ 1,285      $ 7,489      $ 522   

Total realized/unrealized gains (losses)

                   

Included in net income [1], [2], [6]

     (5     (15     (2     (22     —          —           (9     (53     58   

Included in OCI [3]

     20        113        113        (8     —          —           41        279        —     

Purchases

     —          —          —          17        2        —           —          19        —     

Settlements

     (11     (35     (10     (31     (1     —           (34     (122     (1

Sales

     —          —          (122     (73     (2     —           (16     (213     —     

Transfers into Level 3 [4]

     49        30        73        195        11        4         —          362        —     

Transfers out of Level 3 [4]

     (84     —          —          (111     (3     —           (143     (341     —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Fair value as of March 31, 2011

   $ 446      $ 2,674      $ 741      $ 2,096      $ 63      $ 276       $ 1,124      $ 7,420      $ 579   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Changes in unrealized gains (losses) included in net income related to financial instruments still held at March 31, 2011 [2] [7]

   $ (5   $ (15   $ (1   $ (17   $ —        $ —         $ (3   $ (41   $ 58   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

 

           Freestanding Derivatives [5]  

Assets (Liabilities)

   Equity
Securities,
AFS
    Credit     Equity      Interest
Rate
    U.S.
GMWB
Hedging
    U.S.
Macro
Hedge
Program
    Intl.
Program
Hedging
Instr.
    Other
Contracts
    Total Free-
Standing
Derivatives [5]
 

Fair value as of January 1, 2011

   $ 154      $ (390   $ 4       $ (53   $ 600      $ 203      $ 5      $ 32      $ 401   

Total realized/unrealized gains (losses)

                   

Included in net income [1], [2], [6]

     (10     11        1         (3     (119     (80     (3     (1     (194

Included in OCI [3]

     (1     —          —           —          —          —          —          —          —     

Purchases

     13        1        —           64        23        —          —          —          88   

Settlements

     —          (4     —           1        (16     —          —          —          (19

Sales

     —          —          —           —          —          —          —          —          —     

Transfers into Level 3 [4]

     —          —          —           —          —          —          —          —          —     

Transfers out of Level 3 [4]

     (76     —          —           —          —          —          —          —          —     
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Fair value as of March 31, 2011

   $ 80      $ (382   $ 5       $ 9      $ 488      $ 123      $ 2      $ 31      $ 276   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Changes in unrealized gains (losses) included in net income related to financial instruments still held at March 31, 2011 [2] [7]

   $ (10   $ 11      $ 1       $ (1   $ (113   $ (80   $ (2   $ (1   $ 185   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

Assets

   Reinsurance Recoverable
for U.S. GMWB
    Separate Accounts  

Fair value as of January 1, 2011

   $ 280      $ 1,247   

Total realized/unrealized gains (losses)

    

Included in net income [1], [2], [6]

     (65     19   

Included in OCI [3]

     —          —     

Purchases

     —          128   

Settlements

     9        —     

Sales

     —          (147

Transfers into Level 3 [4]

     —          8   

Transfers out of Level 3 [4]

     —          (48
  

 

 

   

 

 

 

Fair value as of March 31, 2011

   $ 224      $ 1,207   
  

 

 

   

 

 

 

Changes in unrealized gains (losses) included in net income related to financial instruments still held at March 31, 2011 [2] [7]

   $ (65   $ (3
  

 

 

   

 

 

 

 

29


Table of Contents

THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

4. Fair Value Measurements (continued)

 

     Other Policyholder Funds and Benefits Payable              

Liabilities

   U.S.
Guaranteed
Withdrawal
Benefits
    International
Guaranteed
Living
Benefits
    International
Other Living
Benefits
    Equity
Linked
Notes
    Total Other
Policyholder
Funds and
Benefits
Payable
    Other
Liabilities
    Consumer
Notes
 

Fair value as of January 1, 2011

   $ (1,611   $ (36   $ 3      $ (9   $ (1,653   $ (37   $ (5

Total realized/unrealized gains (losses)

              

Included in net income [1], [2], [6]

     348        15        1        (1     363        (14     —     

Included in OCI [3]

     —          —          —          —          —          —          —     

Settlements

     (38     (2     (1     —          (41     —          —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Fair value as of March 31, 2011

   $ (1,301   $ (23   $ 3      $ (10   $ (1,331   $ (51   $ (5
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Changes in unrealized gains (losses) included in net income related to financial instruments still held at March 31, 2011 [2] [7]

   $ 348      $ 15      $ 1      $ (1   $ 363      $ (14   $ —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

[1] The Company classifies gains and losses on GMWB reinsurance derivatives and Guaranteed Living Benefit embedded derivatives as unrealized gains (losses) for purposes of disclosure in this table because it is impracticable to track on a contract-by-contract basis the realized gains (losses) for these derivatives and embedded derivatives.
[2] All amounts in these rows are reported in net realized capital gains/losses. The realized/unrealized gains (losses) included in net income for separate account assets are offset by an equal amount for separate account liabilities, which results in a net zero impact on net income for the Company. All amounts are before income taxes and amortization DAC.
[3] All amounts are before income taxes and amortization of DAC.
[4] Transfers in and/or (out) of Level 3 are primarily attributable to the availability of market observable information and the re-evaluation of the observability of pricing inputs.
[5] Derivative instruments are reported in this table on a net basis for asset/(liability) positions and reported in the Condensed Consolidated Balance Sheet in other investments and other liabilities.
[6] Includes both market and non-market impacts in deriving realized and unrealized gains (losses).
[7] Amounts presented are for Level 3 only and therefore may not agree to other disclosures included herein.

Fair Value Option

The Company holds fair value option investments that contain an embedded credit derivative with underlying credit risk primarily related to corporate bonds and commercial real estate. Also included are foreign government securities that align with the accounting for yen-based fixed annuity liabilities, which are adjusted for changes in spot rates through realized gains and losses. Similar to other fixed maturities, income earned from these securities is recorded in net investment income. Changes in the fair value of these securities are recorded in net realized capital gains and losses.

The Company previously elected the fair value option for one of its consolidated VIEs in order to apply a consistent accounting model for the VIE’s assets and liabilities. The VIE is an investment vehicle that holds high quality investments, derivative instruments that reference third-party corporate credit and issues notes to investors that reflect the credit characteristics of the high quality investments and derivative instruments. The risks and rewards associated with the assets of the VIE inure to the investors. The investors have no recourse against the Company. As a result, there has been no adjustment to the market value of the notes for the Company’s own credit risk.

The following table presents the changes in fair value of those assets and liabilities accounted for using the fair value option reported in net realized capital gains and losses in the Company’s Condensed Consolidated Statements of Operations.

 

 

     Three Months Ended March 31,  
     2012     2011  

Assets

    

Fixed maturities, FVO

    

Corporate

   $ 1      $ 12   

CRE CDOs

     19        46   

Foreign government

     (49     (6

Other liabilities

    

Credit-linked notes

     (12     (14
  

 

 

   

 

 

 

Total realized capital gains (losses)

   $ (41   $ 38   
  

 

 

   

 

 

 

 

30


Table of Contents

THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

4. Fair Value Measurements (continued)

 

The following table presents the fair value of assets and liabilities accounted for using the fair value option included in the Company’s Condensed Consolidated Balance Sheets.

 

 

     As of  
     March 31, 2012      December 31, 2011  

Assets

     

Fixed maturities, FVO

     

ABS

   $ 65       $ 65   

CRE CDOs

     240         225   

Corporate

     270         272   

Foreign government

     716         766   
  

 

 

    

 

 

 

Total fixed maturities, FVO

   $ 1,291       $ 1,328   
  

 

 

    

 

 

 

Other liabilities

     

Credit-linked notes [1]

   $ 21       $ 9   
  

 

 

    

 

 

 

 

[1] As of March 31, 2012 and December 31, 2011, the outstanding principal balance of the notes was $243.

Financial Instruments Not Carried at Fair Value

The following table presents carrying amounts and fair values of The Hartford’s financial instruments not carried at fair value and not included in the above fair value discussion as of March 31, 2012 and December 31, 2011.

 

 

    

March 31, 2012

     December 31, 2011  
    

Fair Value

Hierarchy

Level

   Carrying
Amount
     Fair
Value
     Carrying
Amount
     Fair
Value
 

Assets

              

Policy loans

   Level 3    $ 1,970       $ 2,136       $ 2,001       $ 2,153   

Mortgage loans

   Level 3      6,275         6,524         5,728         5,977   
  

 

  

 

 

    

 

 

    

 

 

    

 

 

 

Liabilities

              

Other policyholder funds and benefits payable [1]

   Level 3    $ 9,888       $ 10,725       $ 10,343       $ 11,238   

Senior notes [2]

   Level 2      4,481         4,817         4,481         4,623   

Junior subordinated debentures [2]

   Level 2      500         534         500         498   

Private placement junior subordinated debentures [2]

   Level 3      1,239         2,125         1,235         1,932   

Consumer notes [3]

   Level 3      306         313         310         305   
  

 

  

 

 

    

 

 

    

 

 

    

 

 

 

 

[1] Excludes guarantees on variable annuities, group accident and health and universal life insurance contracts, including corporate owned life insurance.
[2] Included in long-term debt in the Condensed Consolidated Balance Sheets, except for current maturities, which are included in short-term debt.
[3] Excludes amounts carried at fair value and included in disclosures above.

The Company has not made any changes in its valuation methodologies for the following assets and liabilities since December 31, 2011.

 

 

Fair value for policy loans and consumer notes were estimated using discounted cash flow calculations using current interest rates adjusted for estimated loan durations.

 

 

Fair values for mortgage loans were estimated using discounted cash flow calculations based on current lending rates for similar type loans. Current lending rates reflect changes in credit spreads and the remaining terms of the loans.

 

 

Fair values for other policyholder funds and benefits payable, not carried at fair value, are estimated based on the cash surrender values of the underlying policies or by estimating future cash flows discounted at current interest rates adjusted for credit risk.

 

 

Fair values for senior notes and junior subordinated debentures are determined using the market approach based on reported trades, benchmark interest rates and issuer spread for the Company which may consider credit default swaps.

 

 

Fair values for private placement junior subordinated debentures are based primarily on market quotations from independent third party brokers, except as of March 31, 2012 which is based on the negotiated repurchase price.

 

31


Table of Contents

THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

5. Investments and Derivative Instruments

Significant Investment Accounting Policies

Recognition and Presentation of Other-Than-Temporary Impairments

The Company deems debt securities and certain equity securities with debt-like characteristics (collectively “debt securities”) to be other-than-temporarily impaired (“impaired”) if a security meets the following conditions: a) the Company intends to sell or it is more likely than not the Company will be required to sell the security before a recovery in value, or b) the Company does not expect to recover the entire amortized cost basis of the security. If the Company intends to sell or it is more likely than not the Company will be required to sell the security before a recovery in value, a charge is recorded in net realized capital losses equal to the difference between the fair value and amortized cost basis of the security. For those impaired debt securities which do not meet the first condition and for which the Company does not expect to recover the entire amortized cost basis, the difference between the security’s amortized cost basis and the fair value is separated into the portion representing a credit other-than-temporary impairment (“impairment”), which is recorded in net realized capital losses, and the remaining impairment, which is recorded in OCI. Generally, the Company determines a security’s credit impairment as the difference between its amortized cost basis and its best estimate of expected future cash flows discounted at the security’s effective yield prior to impairment. The remaining non-credit impairment, which is recorded in OCI, is the difference between the security’s fair value and the Company’s best estimate of expected future cash flows discounted at the security’s effective yield prior to the impairment, which typically represents current market liquidity and risk premiums. The previous amortized cost basis less the impairment recognized in net realized capital losses becomes the security’s new cost basis. The Company accretes the new cost basis to the estimated future cash flows over the expected remaining life of the security by prospectively adjusting the security’s yield, if necessary. The following table presents the change in non-credit impairments recognized in OCI as disclosed in the Company’s Condensed Consolidated Statements of Comprehensive Income (Loss) for the three ended March 31, 2012 and 2011, respectively.

 

 

     Three Months Ended
March 31,
 
     2012     2011  

OTTI losses recognized in OCI

   $ (7   $ (64

Changes in fair value and/or sales

     10        64   

Tax and deferred acquisition costs

     (11     5   
  

 

 

   

 

 

 

Change in non-credit impairments recognized in OCI

   $ (8   $ 5   
  

 

 

   

 

 

 

The Company’s evaluation of whether a credit impairment exists for debt securities includes but is not limited to, the following factors: (a) changes in the financial condition of the security’s underlying collateral, (b) whether the issuer is current on contractually obligated interest and principal payments, (c) changes in the financial condition, credit rating and near-term prospects of the issuer, (d) the extent to which the fair value has been less than the amortized cost of the security and (e) the payment structure of the security. The Company’s best estimate of expected future cash flows used to determine the credit loss amount is a quantitative and qualitative process that incorporates information received from third-party sources along with certain internal assumptions and judgments regarding the future performance of the security. The Company’s best estimate of future cash flows involves assumptions including, but not limited to, various performance indicators, such as historical and projected default and recovery rates, credit ratings, current and projected delinquency rates, and loan-to-value (“LTV”) ratios. In addition, for structured securities, the Company considers factors including, but not limited to, average cumulative collateral loss rates that vary by vintage year, commercial and residential property value declines that vary by property type and location and commercial real estate delinquency levels. These assumptions require the use of significant management judgment and include the probability of issuer default and estimates regarding timing and amount of expected recoveries which may include estimating the underlying collateral value. In addition, projections of expected future debt security cash flows may change based upon new information regarding the performance of the issuer and/or underlying collateral such as changes in the projections of the underlying property value estimates.

For equity securities where the decline in the fair value is deemed to be other-than-temporary, a charge is recorded in net realized capital losses equal to the difference between the fair value and cost basis of the security. The previous cost basis less the impairment becomes the security’s new cost basis. The Company asserts its intent and ability to retain those equity securities deemed to be temporarily impaired until the price recovers. Once identified, these securities are systematically restricted from trading unless approved by a committee of investment and accounting professionals (“Committee”). The Committee will only authorize the sale of these securities based on predefined criteria that relate to events that could not have been reasonably foreseen. Examples of the criteria include, but are not limited to, the deterioration in the issuer’s financial condition, security price declines, a change in regulatory requirements or a major business combination or major disposition.

The primary factors considered in evaluating whether an impairment exists for an equity security include, but are not limited to: (a) the length of time and extent to which the fair value has been less than the cost of the security, (b) changes in the financial condition, credit rating and near-term prospects of the issuer, (c) whether the issuer is current on preferred stock dividends and (d) the intent and ability of the Company to retain the investment for a period of time sufficient to allow for recovery.

 

 

 

32


Table of Contents

THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

5. Investments and Derivative Instruments (continued)

 

Mortgage Loan Valuation Allowances

The Company’s security monitoring process reviews mortgage loans on a quarterly basis to identify potential credit losses. Commercial mortgage loans are considered to be impaired when management estimates that, based upon current information and events, it is probable that the Company will be unable to collect amounts due according to the contractual terms of the loan agreement. Criteria used to determine if an impairment exists include, but are not limited to: current and projected macroeconomic factors, such as unemployment rates, and property-specific factors such as rental rates, occupancy levels, LTV ratios and debt service coverage ratios (“DSCR”). In addition, the Company considers historic, current and projected delinquency rates and property values. These assumptions require the use of significant management judgment and include the probability and timing of borrower default and loss severity estimates. In addition, projections of expected future cash flows may change based upon new information regarding the performance of the borrower and/or underlying collateral such as changes in the projections of the underlying property value estimates.

For mortgage loans that are deemed impaired, a valuation allowance is established for the difference between the carrying amount and the Company’s share of either (a) the present value of the expected future cash flows discounted at the loan’s effective interest rate, (b) the loan’s observable market price or, most frequently, (c) the fair value of the collateral. A valuation allowance has been established for either individual loans or as a projected loss contingency for loans with an LTV ratio of 90% or greater and consideration of other credit quality factors, including DSCR. Changes in valuation allowances are recorded in net realized capital gains and losses. Interest income on impaired loans is accrued to the extent it is deemed collectible and the loans continue to perform under the original or restructured terms. Interest income ceases to accrue for loans when it is probable that the Company will not receive interest and principal payments according to the contractual terms of the loan agreement, or if a loan is more than 60 days past due. Loans may resume accrual status when it is determined that sufficient collateral exists to satisfy the full amount of the loan and interest payments, as well as when it is probable cash will be received in the foreseeable future. Interest income on defaulted loans is recognized when received.

Net Realized Capital Gains (Losses)

 

 

     Three Months Ended
March 31,
 

(Before-tax)

   2012     2011  

Gross gains on sales

   $ 259      $ 61   

Gross losses on sales

     (97     (133

Net OTTI losses recognized in earnings

     (29     (55

Valuation allowances on mortgage loans

     1        (3

Japanese fixed annuity contract hedges, net [1]

     (20     (17

Periodic net coupon settlements on credit derivatives/Japan

     (5     (7

Results of variable annuity hedge program

    

U.S. GMWB derivatives, net

     185        56   

U.S. macro hedge program

     (189     (84
  

 

 

   

 

 

 

Total U.S. program

     (4     (28

International program

     (1,219     (319
  

 

 

   

 

 

 

Total results of variable annuity hedge program

     (1,223     (347

Other, net [2]

     204        98   
  

 

 

   

 

 

 

Net realized capital gains (losses), before-tax

   $ (910   $ (403
  

 

 

   

 

 

 

 

[1] Relates to the Japanese fixed annuity product (adjustment of product liability for changes in spot currency exchange rates, related derivative hedging instruments, excluding net period coupon settlements, and Japan FVO securities).
[2] Primarily consists of gains and losses on non-qualifying derivatives and fixed maturities, FVO, Japan 3Win related foreign currency swaps, and other investment gains and losses.

Net realized capital gains and losses from investment sales, after deducting the life and pension policyholders’ share for certain products, are reported as a component of revenues and are determined on a specific identification basis. Gross gains and losses on sales and impairments previously reported as unrealized gains (losses) in AOCI were $133 and ($127), respectively, for the three months ended March 31, 2012 and 2011. Proceeds from sales of AFS securities totaled $12.7 billion and $7.5 billion, respectively, for the three months ended March 31, 2012 and 2011.

 

33


Table of Contents

THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

5. Investments and Derivative Instruments (continued)

 

Other-Than-Temporary Impairment Losses

The following table presents a roll-forward of the Company’s cumulative credit impairments on debt securities held.

 

 

     Three Months Ended
March 31,
 

(Before-tax)

   2012     2011  

Balance as of beginning of period

   $ (1,676   $ (2,072

Additions for credit impairments recognized on [1]:

    

Securities not previously impaired

     (12     (28

Securities previously impaired

     (5     (17

Reductions for credit impairments previously recognized on:

    

Securities that matured or were sold during the period

     160        109   

Securities due to an increase in expected cash flows

     3        5   
  

 

 

   

 

 

 

Balance as of end of period

   $ (1,530   $ (2,003
  

 

 

   

 

 

 

 

[1] These additions are included in the net OTTI losses recognized in earnings in the Condensed Consolidated Statements of Operations.

Available-for-Sale Securities

The following table presents the Company’s AFS securities by type.

 

 

     March 31, 2012     December 31, 2011  
     Cost or
Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
    Fair
Value
     Non-Credit
OTTI [1]
    Cost or
Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
    Fair
Value
     Non-Credit
OTTI [1]
 

ABS

   $ 3,346       $ 47       $ (306   $ 3,087       $ (6   $ 3,430       $ 55       $ (332   $ 3,153       $ (7

CDOs [2]

     3,351         40         (305     3,043         (43     2,819         16         (348     2,487         (44

CMBS

     6,847         305         (378     6,774         (25     7,192         271         (512     6,951         (31

Corporate [2]

     40,383         3,508         (562     43,329         (2     41,161         3,661         (739     44,011         —     

Foreign govt./govt. agencies

     3,248         128         (24     3,352         —          2,030         141         (10     2,161         —     

Municipal

     12,991         914         (67     13,838         —          12,557         775         (72     13,260         —     

RMBS

     6,778         240         (423     6,595         (108     5,961         252         (456     5,757         (105

U.S. Treasuries

     3,077         83         (21     3,139         —          3,828         203         (2     4,029         —     
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

 

Total fixed maturities, AFS

     80,021         5,265         (2,086     83,157         (184     78,978         5,374         (2,471     81,809         (187

Equity securities, AFS

     1,001         69         (132     938         —          1,056         68         (203     921         —     
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

 

Total AFS securities

   $ 81,022       $ 5,334       $ (2,218   $ 84,095       $ (184   $ 80,034       $ 5,442       $ (2,674   $ 82,730       $ (187
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

 

 

[1] Represents the amount of cumulative non-credit OTTI losses recognized in OCI on securities that also had credit impairments. These losses are included in gross unrealized losses as of March 31, 2012 and December 31, 2011.
[2] Gross unrealized gains (losses) exclude the change in fair value of bifurcated embedded derivative features of certain securities. Changes in fair value are recorded in net realized capital gains (losses).

The following table presents the Company’s fixed maturities, AFS, by contractual maturity year.

 

 

     March 31, 2012  

Contractual Maturity

   Amortized Cost      Fair Value  

One year or less

   $ 2,127       $ 2,146   

Over one year through five years

     15,678         16,520   

Over five years through ten years

     14,566         15,712   

Over ten years

     27,328         29,280   
  

 

 

    

 

 

 

Subtotal

     59,699         63,658   

Mortgage-backed and asset-backed securities

     20,322         19,499   
  

 

 

    

 

 

 

Total fixed maturities, AFS

   $ 80,021       $ 83,157   
  

 

 

    

 

 

 

Estimated maturities may differ from contractual maturities due to security call or prepayment provisions. Due to the potential for variability in payment speeds (i.e. prepayments or extensions), mortgage-backed and asset-backed securities are not categorized by contractual maturity.

 

34


Table of Contents

THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

5. Investments and Derivative Instruments (continued)

 

Securities Unrealized Loss Aging

The following tables present the Company’s unrealized loss aging for AFS securities by type and length of time the security was in a continuous unrealized loss position.

 

 

     March 31, 2012  
     Less Than 12 Months     12 Months or More     Total  
     Amortized
Cost
     Fair
Value
     Unrealized
Losses
    Amortized
Cost
     Fair
Value
     Unrealized
Losses
    Amortized
Cost
     Fair
Value
     Unrealized
Losses
 

ABS

   $ 192       $ 159       $ (33   $ 1,098       $ 825       $ (273   $ 1,290       $ 984       $ (306

CDOs [1]

     62         42         (20     3,187         2,860         (285     3,249         2,902         (305

CMBS

     852         803         (49     1,955         1,626         (329     2,807         2,429         (378

Corporate

     4,076         3,941         (135     2,543         2,116         (427     6,619         6,057         (562

Foreign govt./govt. agencies

     647         627         (20     29         25         (4     676         652         (24

Municipal

     823         799         (24     425         382         (43     1,248         1,181         (67

RMBS

     1,246         1,166         (80     1,171         828         (343     2,417         1,994         (423

U.S. Treasuries

     1,011         990         (21     —           —           —          1,011         990         (21
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

Total fixed maturities

     8,909         8,527         (382     10,408         8,662         (1,704     19,317         17,189         (2,086

Equity securities

     206         181         (25     400         293         (107     606         474         (132
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

Total securities in an unrealized loss

   $ 9,115       $ 8,708       $ (407   $ 10,808       $ 8,955       $ (1,811   $ 19,923       $ 17,663       $ (2,218
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

 

     December 31, 2011  
     Less Than 12 Months     12 Months or More     Total  
     Amortized
Cost
     Fair
Value
     Unrealized
Losses
    Amortized
Cost
     Fair
Value
     Unrealized
Losses
    Amortized
Cost
     Fair
Value
     Unrealized
Losses
 

ABS

   $ 629       $ 594       $ (35   $ 1,169       $ 872       $ (297   $ 1,798       $ 1,466       $ (332

CDOs

     81         59         (22     2,709         2,383         (326     2,790         2,442         (348

CMBS

     1,297         1,194         (103     2,144         1,735         (409     3,441         2,929         (512

Corporate [1]

     4,388         4,219         (169     3,268         2,627         (570     7,656         6,846         (739

Foreign govt./govt. agencies

     218         212         (6     51         47         (4     269         259         (10

Municipal

     299         294         (5     627         560         (67     926         854         (72

RMBS

     415         330         (85     1,206         835         (371     1,621         1,165         (456

U.S. Treasuries

     343         341         (2     —           —           —          343         341         (2
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

Total fixed maturities

     7,670         7,243         (427     11,174         9,059         (2,044     18,844         16,302         (2,471

Equity securities

     167         138         (29     439         265         (174     606         403         (203
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

Total securities in an unrealized loss

   $ 7,837       $ 7,381       $ (456   $ 11,613       $ 9,324       $ (2,218   $ 19,450       $ 16,705       $ (2,674
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

 

[1] Unrealized losses exclude the change in fair value of bifurcated embedded derivative features of certain securities. Changes in fair value are recorded in net realized capital gains (losses).

As of March 31, 2012, AFS securities in an unrealized loss position, comprised of 2,458 securities, primarily related to corporate securities within the financial services sector, commercial real estate and RMBS which have experienced price deterioration. As of March 31, 2012, 78% of these securities were depressed less than 20% of cost or amortized cost. The decline in unrealized losses during 2012 was primarily attributable to credit spread tightening, partially offset by rising interest rates.

Most of the securities depressed for twelve months or more relate to structured securities with exposure to commercial and residential real estate, as well as certain floating rate corporate securities or those securities with greater than 10 years to maturity, concentrated in the financial services sector. Current market spreads continue to be significantly wider for structured securities with exposure to commercial and residential real estate, as compared to spreads at the security’s respective purchase date, largely due to the economic and market uncertainties regarding future performance of commercial and residential real estate. The majority of securities have a floating-rate coupon referenced to a market index where rates have declined substantially. In addition, equity securities include investment grade perpetual preferred securities that contain “debt-like” characteristics where the decline in fair value is not attributable to issuer-specific credit deterioration, none of which have nor are expected to miss a periodic dividend payment. These securities have been depressed due to the securities’ floating-rate coupon in the current low interest rate environment, general market credit spread widening since the date of purchase and the long-dated nature of the securities. The Company neither has an intention to sell nor does it expect to be required to sell the securities outlined above.

 

35


Table of Contents

THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

5. Investments and Derivative Instruments (continued)

 

Mortgage Loans

 

 

     March 31, 2012      December 31, 2011  
     Amortized
Cost [1]
     Valuation
Allowance
    Carrying
Value
     Amortized
Cost [1]
     Valuation
Allowance
    Carrying
Value
 

Commercial

   $ 6,363       $ (88   $ 6,275       $ 5,830       $ (102   $ 5,728   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Total mortgage loans

   $ 6,363       $ (88   $ 6,275       $ 5,830       $ (102   $ 5,728   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

 

[1] Amortized cost represents carrying value prior to valuation allowances, if any.

As of March 31, 2012, the carrying value of mortgage loans associated with the valuation allowance was $548. Included in the table above are mortgage loans held-for-sale with a carrying value and valuation allowance of $57 and $4, respectively, as of March 31, 2012 and $74 and $4, respectively, as of December 31, 2011. The carrying value of these loans is included in mortgage loans in the Company’s Condensed Consolidated Balance Sheets. As of March 31, 2012, loans within the Company’s mortgage loan portfolio that have had extensions or restructurings other than what is allowable under the original terms of the contract are immaterial.

The following table presents the activity within the Company’s valuation allowance for mortgage loans. These loans have been evaluated both individually and collectively for impairment. Loans evaluated collectively for impairment are immaterial.

 

 

     2012     2011  

Balance as of January 1

   $ (102   $ (155

(Additions)/Reversals

     1        (3

Deductions

     13        5   
  

 

 

   

 

 

 

Balance as of March 31

   $ (88   $ (153
  

 

 

   

 

 

 

The current weighted-average LTV ratio of the Company’s commercial mortgage loan portfolio was 65% as of March 31, 2012, while the weighted-average LTV ratio at origination of these loans was 62%. LTV ratios compare the loan amount to the value of the underlying property collateralizing the loan. The loan values are updated no less than annually through property level reviews of the portfolio. Factors considered in the property valuation include, but are not limited to, actual and expected property cash flows, geographic market data and capitalization rates. DSCRs compare a property’s net operating income to the borrower’s principal and interest payments. The current weighted average DSCR of the Company’s commercial mortgage loan portfolio was 1.95x as of March 31, 2012. The Company held only two delinquent commercial mortgage loans past due by 90 days or more. The total carrying value and valuation allowance of these loans totaled $3 and $51, respectively, as of March 31, 2012, and are not accruing income.

The following table presents the carrying value of the Company’s commercial mortgage loans by LTV and DSCR.

 

 

Commercial Mortgage Loans Credit Quality  
     March 31, 2012      December 31, 2011  

Loan-to-value

   Carrying
Value
     Avg. Debt-Service
Coverage Ratio
     Carrying
Value
     Avg. Debt-Service
Coverage Ratio
 

Greater than 80%

   $ 636         1.34x       $ 707         1.45x   

65% - 80%

     2,782         1.61x         2,384         1.60x   

Less than 65%

     2,857         2.44x         2,637         2.40x   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total commercial mortgage loans

   $ 6,275         1.95x       $ 5,728         1.94x   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

36


Table of Contents

THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

5. Investments and Derivative Instruments (continued)

 

The following tables present the carrying value of the Company’s mortgage loans by region and property type.

 

 

Mortgage Loans by Region  
     March 31, 2012     December 31, 2011  
     Carrying
Value
     Percent of
Total
    Carrying
Value
     Percent of
Total
 

East North Central

   $ 89         1.4   $ 94         1.6

Middle Atlantic

     501         8.0     508         8.9

Mountain

     125         2.0     125         2.2

New England

     337         5.4     294         5.1

Pacific

     1,850         29.5     1,690         29.5

South Atlantic

     1,443         23.0     1,149         20.1

West North Central

     16         0.3     30         0.5

West South Central

     395         6.3     224         3.9

Other [1]

     1,519         24.1     1,614         28.2
  

 

 

    

 

 

   

 

 

    

 

 

 

Total mortgage loans

   $ 6,275         100.0   $ 5,728         100.0
  

 

 

    

 

 

   

 

 

    

 

 

 

 

[1] Primarily represents loans collateralized by multiple properties in various regions.

 

 

Mortgage Loans by Property Type  
     March 31, 2012     December 31, 2011  
     Carrying
Value
     Percent of
Total
    Carrying
Value
     Percent of
Total
 

Commercial

          

Agricultural

   $ 198         3.2   $ 249         4.3

Industrial

     1,847         29.4     1,747         30.5

Lodging

     92         1.5     93         1.6

Multifamily

     1,208         19.3     1,070         18.7

Office

     1,307         20.8     1,078         18.8

Retail

     1,369         21.8     1,234         21.5

Other

     254         4.0     257         4.6
  

 

 

    

 

 

   

 

 

    

 

 

 

Total mortgage loans

   $ 6,275         100.0   $ 5,728         100.0
  

 

 

    

 

 

   

 

 

    

 

 

 

Variable Interest Entities

The Company is involved with various special purpose entities and other entities that are deemed to be VIEs primarily as a collateral manager and as an investor through normal investment activities, as well as a means of accessing capital. A VIE is an entity that either has investors that lack certain essential characteristics of a controlling financial interest or lacks sufficient funds to finance its own activities without financial support provided by other entities.

The Company performs ongoing qualitative assessments of its VIEs to determine whether the Company has a controlling financial interest in the VIE and therefore is the primary beneficiary. The Company is deemed to have a controlling financial interest when it has both the ability to direct the activities that most significantly impact the economic performance of the VIE and the obligation to absorb losses or right to receive benefits from the VIE that could potentially be significant to the VIE. Based on the Company’s assessment, if it determines it is the primary beneficiary, the Company consolidates the VIE in the Company’s Condensed Consolidated Financial Statements.

 

37


Table of Contents

THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

5. Investments and Derivative Instruments (continued)

 

Consolidated VIEs

The following table presents the carrying value of assets and liabilities, and the maximum exposure to loss relating to the VIEs for which the Company is the primary beneficiary. Creditors have no recourse against the Company in the event of default by these VIEs nor does the Company have any implied or unfunded commitments to these VIEs. The Company’s financial or other support provided to these VIEs is limited to its investment management services and original investment.

 

 

     March 31, 2012      December 31, 2011  
     Total
Assets
     Total
Liabilities  [1]
     Maximum
Exposure

to Loss [2]
     Total
Assets
     Total
Liabilities  [1]
     Maximum
Exposure
to Loss [2]
 

CDOs [3]

   $ 484       $ 460       $ 21       $ 491       $ 471       $ 29   

Investment fund [4]

     100         —           101         —           —           —     

Limited partnerships

     7         1         6         7         —           7   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 591       $ 461       $ 128       $ 498       $ 471       $ 36   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

[1] Included in other liabilities in the Company’s Condensed Consolidated Balance Sheets.
[2] The maximum exposure to loss represents the maximum loss amount that the Company could recognize as a reduction in net investment income or as a realized capital loss and is the cost basis of the Company’s investment.
[3] Total assets included in fixed maturities, AFS, and fixed maturities, FVO, in the Company’s Condensed Consolidated Balance Sheets.
[4] Total assets included in fixed maturities, AFS, and short-term investments in the Company’s Condensed Consolidated Balance Sheets.

CDOs represent structured investment vehicles for which the Company has a controlling financial interest as it provides collateral management services, earns a fee for those services and also holds investments in the securities issued by these vehicles. Investment fund represents a wholly-owned fixed income fund established in 2012 for which the Company has exclusive management and control including management of investment securities which is the activity that most significantly impacts its economic performance. Limited partnerships represent one hedge fund for which the Company holds a majority interest in the fund as an investment.

Non-Consolidated VIEs

The Company holds a significant variable interest for one VIE for which it is not the primary beneficiary and, therefore, was not consolidated on the Company’s Condensed Consolidated Balance Sheets. This VIE represents a contingent capital facility (“facility”) that has been held by the Company since February 2007 for which the Company has no implied or unfunded commitments. Assets and liabilities recorded for the facility were $27 and $25, respectively as of March 31, 2012 and $28 and $28, respectively, as of December 31, 2011. Additionally, the Company has a maximum exposure to loss of $3 as of March 31, 2012 and December 31, 2011, which represents the issuance costs that were incurred to establish the facility. The Company does not have a controlling financial interest as it does not manage the assets of the facility nor does it have the obligation to absorb losses or the right to receive benefits that could potentially be significant to the facility, as the asset manager has significant variable interest in the vehicle. The Company’s financial or other support provided to the facility is limited to providing ongoing support to cover the facility’s operating expenses. For further information on the facility, see Note 14 of the Notes to Consolidated Financial Statements included in The Hartford’s 2011 Form 10-K Annual Report.

In addition, the Company, through normal investment activities, makes passive investments in structured securities issued by VIEs for which the Company is not the manager which are included in ABS, CDOs, CMBS and RMBS in the Available-for-Sale Securities table and fixed maturities, FVO, in the Company’s Condensed Consolidated Balance Sheets. The Company has not provided financial or other support with respect to these investments other than its original investment. For these investments, the Company determined it is not the primary beneficiary due to the relative size of the Company’s investment in comparison to the principal amount of the structured securities issued by the VIEs, the level of credit subordination which reduces the Company’s obligation to absorb losses or right to receive benefits and the Company’s inability to direct the activities that most significantly impact the economic performance of the VIEs. The Company’s maximum exposure to loss on these investments is limited to the amount of the Company’s investment.

Dollar Roll Agreements

The Company entered into a dollar roll agreement during the three months ended March 31, 2012. A dollar roll is a type of repurchase agreement where a mortgage backed security is sold with an agreement to repurchase substantially the same security at specified time in the future. The Company accounts for the dollar roll transactions as collateralized borrowings and, accordingly, retains the mortgage-backed securities within fixed maturities. Transaction proceeds were invested in short-term investments with the obligation to repurchase the mortgage-backed securities recorded in Other Liabilities. The Company did not reinvest the cash collateral associated with the dollar roll agreement as of March 31, 2012. Securities sold under agreement to repurchase were $346 as of March 31, 2012.

 

38


Table of Contents

THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

5. Investments and Derivative Instruments (continued)

 

Derivative Instruments

The Company utilizes a variety of over-the-counter and exchange traded derivative instruments as a part of its overall risk management strategy, as well as to enter into replication transactions. Derivative instruments are used to manage risk associated with interest rate, equity market, credit spread, issuer default, price, and currency exchange rate risk or volatility. Replication transactions are used as an economical means to synthetically replicate the characteristics and performance of assets that would otherwise be permissible investments under the Company’s investment policies. The Company also purchases and issues financial instruments and products that either are accounted for as free-standing derivatives, such as certain reinsurance contracts, or may contain features that are deemed to be embedded derivative instruments, such as the GMWB rider included with certain variable annuity products.

Cash flow hedges

Interest rate swaps

Interest rate swaps are primarily used to convert interest receipts on floating-rate fixed maturity securities. These derivatives are predominantly used to better match cash receipts from assets with cash disbursements required to fund liabilities. The Company also enters into forward starting swap agreements to hedge the interest rate exposure related to the purchase of fixed-rate securities. These derivatives are primarily structured to hedge interest rate risk inherent in the assumptions used to price certain liabilities.

Foreign currency swaps

Foreign currency swaps are used to convert foreign currency-denominated cash flows related to certain investment receipts and liability payments to U.S. dollars in order to reduce cash flow fluctuations due to changes in currency rates.

Fair value hedges

Interest rate swaps

Interest rate swaps are used to hedge the changes in fair value of certain fixed rate liabilities and fixed maturity securities due to fluctuations in interest rates.

Foreign currency swaps

Foreign currency swaps are used to hedge the changes in fair value of certain foreign currency-denominated fixed rate liabilities due to changes in foreign currency rates by swapping the fixed foreign payments to floating rate U.S. dollar denominated payments.

Non-qualifying strategies

Interest rate swaps, swaptions, caps, floors, and futures

The Company uses interest rate swaps, swaptions, caps, floors, and futures to manage duration between assets and liabilities in certain investment portfolios. In addition, the Company enters into interest rate swaps to terminate existing swaps, thereby offsetting the changes in value of the original swap. As of March 31, 2012 and December 31, 2011, the notional amount of interest rate swaps in offsetting relationships was $7.8 billion.

Foreign currency swaps and forwards

The Company enters into foreign currency swaps and forwards to convert the foreign currency exposures of certain foreign currency-denominated fixed maturity investments to U.S. dollars.

Japan 3Win foreign currency swaps

Prior to the second quarter of 2009, The Company offered certain variable annuity products with a guaranteed minimum income benefit (“GMIB”) rider through a wholly-owned Japanese subsidiary. The GMIB rider is reinsured to a wholly-owned U.S. subsidiary, which invests in U.S. dollar denominated assets to support the liability. The U.S. subsidiary entered into pay U.S. dollar, receive yen swap contracts to hedge the currency and interest rate exposure between the U.S. dollar denominated assets and the yen denominated fixed liability reinsurance payments.

Japanese fixed annuity hedging instruments

Prior to the second quarter of 2009, The Company offered a yen denominated fixed annuity product through a wholly-owned Japanese subsidiary and reinsured to a wholly-owned U.S. subsidiary. The U.S. subsidiary invests in U.S. dollar denominated securities to support the yen denominated fixed liability payments and entered into currency rate swaps to hedge the foreign currency exchange rate and yen interest rate exposures that exist as a result of U.S. dollar assets backing the yen denominated liability.

 

39


Table of Contents

THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

5. Investments and Derivative Instruments (continued)

 

Credit derivatives that purchase credit protection

Credit default swaps are used to purchase credit protection on an individual entity or referenced index to economically hedge against default risk and credit-related changes in value on fixed maturity securities. These contracts require the Company to pay a periodic fee in exchange for compensation from the counterparty should the referenced security issuers experience a credit event, as defined in the contract.

Credit derivatives that assume credit risk

Credit default swaps are used to assume credit risk related to an individual entity, referenced index, or asset pool, as a part of replication transactions. These contracts entitle the Company to receive a periodic fee in exchange for an obligation to compensate the derivative counterparty should the referenced security issuers experience a credit event, as defined in the contract. The Company is also exposed to credit risk due to credit derivatives embedded within certain fixed maturity securities. These securities are primarily comprised of structured securities that contain credit derivatives that reference a standard index of corporate securities.

Credit derivatives in offsetting positions

The Company enters into credit default swaps to terminate existing credit default swaps, thereby offsetting the changes in value of the original swap going forward.

Equity index swaps and options

The Company offers certain equity indexed products, which may contain an embedded derivative that requires bifurcation. The Company enters into S&P index swaps and options to economically hedge the equity volatility risk associated with these embedded derivatives. In addition, during the third quarter of 2011, the Company entered into equity index options and futures with the purpose of hedging the impact of an adverse equity market environment on the investment portfolio.

U.S GMWB product derivatives

The Company currently offers certain variable annuity products with a GMWB rider in the U.S. The GMWB is a bifurcated embedded derivative that provides the policyholder with a guaranteed remaining balance (“GRB”) if the account value is reduced to zero through a combination of market declines and withdrawals. The GRB is generally equal to premiums less withdrawals. Certain contract provisions can increase the GRB at contractholder election or after the passage of time. The notional value of the embedded derivative is the GRB.

U.S. GMWB reinsurance contracts

The Company has entered into reinsurance arrangements to offset a portion of its risk exposure to the GMWB for the remaining lives of covered variable annuity contracts. Reinsurance contracts covering GMWB are accounted for as free-standing derivatives. The notional amount of the reinsurance contracts is the GRB amount.

U.S. GMWB hedging instruments

The Company enters into derivative contracts to partially hedge exposure associated with a portion of the GMWB liabilities that are not reinsured. These derivative contracts include customized swaps, interest rate swaps and futures, and equity swaps, options, and futures, on certain indices including the S&P 500 index, EAFE index, and NASDAQ index.

The following table represents notional and fair value for U.S. GMWB hedging instruments.

 

     Notional Amount      Fair Value  
     March 31, 
2012
     December 31,
2011
     March 31, 
2012
    December 31,
2011
 

Customized swaps

   $ 8,760       $ 8,389       $ 239      $ 385   

Equity swaps, options, and futures

     5,695         5,320         329        498   

Interest rate swaps and futures

     4,834         2,697         (43     11   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total

   $ 19,289       $ 16,406       $ 525      $ 894   
  

 

 

    

 

 

    

 

 

   

 

 

 

 

40


Table of Contents

THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

5. Investments and Derivative Instruments (continued)

 

U.S. macro hedge program

The Company utilizes equity options and futures contracts to partially hedge against a decline in the equity markets and the resulting statutory surplus and capital impact primarily arising from guaranteed minimum death benefit (“GMDB”), GMIB and GMWB obligations.

The following table represents notional and fair value for the U.S. macro hedge program.

 

     Notional Amount      Fair Value  
     March 31, 
2012
     December 31,
2011
     March 31, 
2012
     December 31,
2011
 

Equity futures

   $ —         $ 59       $ —         $ —     

Equity options

     5,458         6,760         173         357   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 5,458       $ 6,819       $ 173       $ 357   
  

 

 

    

 

 

    

 

 

    

 

 

 

International program product derivatives

The Company formerly offered certain variable annuity products with GMWB or GMAB riders in the U.K. and Japan. The GMWB and GMAB are bifurcated embedded derivatives. The GMWB provides the policyholder with a GRB if the account value is reduced to zero through a combination of market declines and withdrawals. The GRB is generally equal to premiums less withdrawals. Certain contract provisions can increase the GRB at contractholder election or after the passage of time. The GMAB provides the policyholder with their initial deposit in a lump sum after a specified waiting period. The notional amount of the embedded derivatives are the foreign currency denominated GRBs converted to U.S. dollars at the current foreign spot exchange rate as of the reporting period date.

International program hedging instruments

The Company utilizes equity futures, options and swaps, and currency forwards and options to partially hedge against a decline in the debt and equity markets or changes in foreign currency exchange rates and the resulting statutory surplus and capital impact primarily arising from GMDB, GMIB and GMWB obligations issued in the U.K. and Japan. The Company also enters into foreign currency denominated interest rate swaps and swaptions to hedge the interest rate exposure related to the potential annuitization of certain benefit obligations.

The following table represents notional and fair value for the international program hedging instruments.

 

 

     Notional Amount      Fair Value  
     March 31, 
2012
     December 31,
2011
     March 31, 
2012
    December 31,
2011
 

Currency forwards [1]

   $ 12,713       $ 8,622       $ (105   $ 446   

Currency options

     10,135         7,357         83        127   

Equity futures

     2,784         3,835         —          —     

Equity options

     2,872         1,565         142        74   

Equity swaps

     1,287         392         4        (8

Interest rate futures

     531         739         —          —     

Interest rate swaps and swaptions

     14,893         11,216         77        111   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total

   $ 45,215       $ 33,726       $ 201      $ 750   
  

 

 

    

 

 

    

 

 

   

 

 

 

 

[1] As of March 31, 2012 and December 31, 2011 net notional amounts are $4.7 billion and $7.2 billion, respectively, which include $8.7 billion and $7.9 billion, respectively, related to long positions and $4.0 billion and $0.7 billion, respectively, related to short positions.

Contingent capital facility put option

The Company entered into a put option agreement that provides the Company the right to require a third-party trust to purchase, at any time, The Hartford’s junior subordinated notes in a maximum aggregate principal amount of $500. Under the put option agreement, The Hartford will pay premiums on a periodic basis and will reimburse the trust for certain fees and ordinary expenses.

 

41


Table of Contents

THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

5. Investments and Derivative Instruments (continued)

 

Derivative Balance Sheet Classification

The table below summarizes the balance sheet classification of the Company’s derivative related fair value amounts, as well as the gross asset and liability fair value amounts. For reporting purposes, the Company offsets the fair value amounts, income accruals, and cash collateral held related to derivative instruments executed in a legal entity and with the same counterparty under a master netting agreement, which provides the Company with the legal right of offset. The fair value amounts presented below do not include income accruals or cash collateral held amounts, which are netted with derivative fair value amounts to determine balance sheet presentation. Derivative fair value reported as liabilities after taking into account the master netting agreements, is $2.5 billion and $3.2 billion as of March 31, 2012, and December 31, 2011, respectively. Derivatives in the Company’s separate accounts are not included because the associated gains and losses accrue directly to policyholders. The Company’s derivative instruments are held for risk management purposes, unless otherwise noted in the table below. The notional amount of derivative contracts represents the basis upon which pay or receive amounts are calculated and is presented in the table to quantify the volume of the Company’s derivative activity. Notional amounts are not necessarily reflective of credit risk.

 

 

     Net Derivatives     Asset Derivatives      Liability Derivatives  
     Notional Amount      Fair Value     Fair Value      Fair Value  

Hedge Designation/ Derivative Type

   Mar. 31,
2012
     Dec. 31,
2011
     Mar. 31,
2012
    Dec. 31,
2011
    Mar. 31,
2012
     Dec. 31,
2011
     Mar. 31,
2012
    Dec. 31,
2011
 

Cash flow hedges

                    

Interest rate swaps

   $ 8,646       $ 8,652       $ 180      $ 329      $ 204       $ 329       $ (24   $ —     

Foreign currency swaps

     285         291         2        6        26         30         (24     (24
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Total cash flow hedges

     8,931         8,943         182        335        230         359         (48     (24
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Fair value hedges

                    

Interest rate swaps

     1,226         1,007         (65     (78     2         —           (67     (78

Foreign currency swaps

     185         677         71        (39     71         63         —          (102
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Total fair value hedges

     1,411         1,684         6        (117     73         63         (67     (180
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Non-qualifying strategies

                    

Interest rate contracts

                    

Interest rate swaps, caps, floors, and futures

     9,614         10,144         (562     (583     393         531         (955     (1,114

Foreign exchange contracts

                    

Foreign currency swaps and forwards

     393         380         (16     (12     5         6         (21     (18

Japan 3Win foreign currency swaps

     2,054         2,054         3        184        15         184         (12     —     

Japanese fixed annuity hedging instruments

     1,933         1,945         364        514        371         540         (7     (26

Credit contracts

                    

Credit derivatives that purchase credit protection

     1,368         1,721         3        36        27         56         (24     (20

Credit derivatives that assume credit risk [1]

     3,001         2,952         (511     (648     7         2         (518     (650

Credit derivatives in offsetting positions

     8,645         8,189         (51     (57     122         164         (173     (221

Equity contracts

                    

Equity index swaps and options

     550         1,501         24        27        39         40         (15     (13

Variable annuity hedge program

                    

U.S. GMWB product derivatives [2]

     33,227         34,569         (1,683     (2,538     —           —           (1,683     (2,538

U.S. GMWB reinsurance contracts

     6,872         7,193         308        443        308         443         —          —     

U.S. GMWB hedging instruments

     19,289         16,406         525        894        670         1,022         (145     (128

U.S. macro hedge program

     5,458         6,819         173        357        173         357         —          —     

International program product derivatives [2]

     2,694         2,710         (38     (71     —           —           (38     (71

International program hedging instruments

     45,215         33,726         201        750        642         887         (441     (137

Other

                    

Contingent capital facility put option

     500         500         27        28        27         28         —          —     
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Total non-qualifying strategies

     140,813         130,809         (1,233     (676     2,799         4,260         (4,032     (4,936
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Total cash flow hedges, fair value hedges, and non-qualifying strategies

   $ 151,155       $ 141,436       $ (1,045   $ (458   $ 3,102       $ 4,682       $ (4,147   $ (5,140
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Balance Sheet Location

                    

Fixed maturities, available-for-sale

   $ 703       $ 703       $ (43   $ (72   $ —         $ —         $ (43   $ (72

Other investments

     50,201         60,227         1,193        2,331        1,748         3,165         (555     (834

Other liabilities

     57,368         35,944         (768     (538     1,046         1,074         (1,814     (1,612

Consumer notes

     35         35         (4     (4     —           —           (4     (4

Reinsurance recoverables

     6,872         7,193         308        443        308         443         —          —     

Other policyholder funds and benefits payable

     35,976         37,334         (1,731     (2,618     —           —           (1,731     (2,618
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Total derivatives

   $ 151,155       $ 141,436       $ (1,045   $ (458   $ 3,102       $ 4,682       $ (4,147   $ (5,140
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

 

[1] The derivative instruments related to this strategy are held for other investment purposes.
[2] These derivatives are embedded within liabilities and are not held for risk management purposes.

 

42


Table of Contents

THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

5. Investments and Derivative Instruments (continued)

 

Change in Notional Amount

The net increase in notional amount of derivatives since December 31, 2011, was primarily due to the following:

 

 

The net notional amount related to the international program hedging instruments as of March 31, 2012, was $37.2 billion and consisted of $41.2 billion of long positions and $4.0 billion offsetting short positions. The net notional amount as of December 31, 2011, was $32.3 billion and consisted of $33.0 billion of long positions and $0.7 billion offsetting short positions. The increase in net notional of $4.9 billion primarily resulted from an increase in foreign currency denominated interest rate swaps and swaptions.

 

 

The U.S. macro hedge program notional decreased $1.4 billion primarily due to the expiration of certain out of the money options in January of 2012.

Change in Fair Value

The net decrease in the total fair value of derivative instruments since December 31, 2011, was primarily related to the following:

 

 

The fair value related to the international program hedging instruments decreased as a result of depreciation of the yen in relation to the euro and the U.S. dollar, and an increase in global and domestic equity markets.

 

 

The increase in the combined GMWB hedging program, which includes the GMWB product, reinsurance, and hedging derivatives, was primarily a result of an improvement in equity markets, lower equity volatility, favorable policyholder behavior, and a general increase in long-term interest rates.

 

 

The fair value related to the Japanese fixed annuity hedging instruments and Japan 3Win foreign currency swaps decreased primarily due to the U.S. dollar strengthening in comparison to the Japanese yen and strengthening of the currency basis swap spread between U.S. dollar and Japanese yen.

Cash Flow Hedges

For derivative instruments that are designated and qualify as cash flow hedges, the effective portion of the gain or loss on the derivative is reported as a component of OCI and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. Gains and losses on the derivative representing hedge ineffectiveness are recognized in current period earnings. All components of each derivative’s gain or loss were included in the assessment of hedge effectiveness.

The following table presents the components of the gain or loss on derivatives that qualify as cash flow hedges:

Derivatives in Cash Flow Hedging Relationships For The Three Months Ended March 31,

 

     Gain (Loss) Recognized
in OCI on Derivative
(Effective Portion)
    Net Realized Capital Gains
(Losses) Recognized in
Income on Derivative
(Ineffective Portion)
 
     2012     2011     2012      2011  

Interest rate swaps

   $ (33   $ (66   $ —         $ (2

Foreign currency swaps

     (5     —          —           —     
  

 

 

   

 

 

   

 

 

    

 

 

 

Total

   $ (38   $ (66   $ —         $ (2
  

 

 

   

 

 

   

 

 

    

 

 

 

 

Derivatives in Cash Flow Hedging Relationships For The Three Months Ended March 31,  
    

Gain or (Loss) Reclassified from AOCI into Income (Effective Portion)

 
    

Location

   2012      2011  

Interest rate swaps

   Net realized capital gain/(loss)    $ 5       $ 2   

Interest rate swaps

   Net investment income      36         32   

Foreign currency swaps

   Net realized capital gain/(loss)      3         5   
     

 

 

    

 

 

 

Total

      $ 44       $ 39   
     

 

 

    

 

 

 

As of March 31, 2012, the before-tax deferred net gains on derivative instruments recorded in AOCI that are expected to be reclassified to earnings during the next twelve months are $120. This expectation is based on the anticipated interest payments on hedged investments in fixed maturity securities that will occur over the next twelve months, at which time the Company will recognize the deferred net gains (losses) as an adjustment to interest income over the term of the investment cash flows. The maximum term over which the Company is hedging its exposure to the variability of future cash flows (for forecasted transactions, excluding interest payments on existing variable-rate financial instruments) is approximately three years.

During the three months ended March 31, 2012 and 2011, the Company had no net reclassifications from AOCI to earnings resulting from the discontinuance of cash-flow hedges due to forecasted transactions that were no longer probable of occurring.

 

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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

5. Investments and Derivative Instruments (continued)

 

Fair Value Hedges

For derivative instruments that are designated and qualify as a fair value hedge, the gain or loss on the derivative, as well as the offsetting loss or gain on the hedged item attributable to the hedged risk are recognized in current earnings. The Company includes the gain or loss on the derivative in the same line item as the offsetting loss or gain on the hedged item. All components of each derivative’s gain or loss were included in the assessment of hedge effectiveness.

The Company recognized in income gains (losses) representing the ineffective portion of fair value hedges as follows:

Derivatives in Fair-Value Hedging Relationships

 

     Gain or (Loss) Recognized in Income [1]  
     Derivative     Hedge Item  
     Three Months Ended
March 31,
    Three Months Ended
March 31,
 
     2012     2011     2012     2011  

Interest rate swaps

        

Net realized capital gain/(loss)

   $ 11      $ 10      $ (10   $ (9

Foreign currency swaps

        

Net realized capital gain/(loss)

     9        14        (9     (14

Benefits, losses and loss adjustment expenses

     (3     (8     3        8   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total

   $ 17      $ 16      $ (16   $ (15
  

 

 

   

 

 

   

 

 

   

 

 

 

 

[1] The amounts presented do not include the periodic net coupon settlements of the derivative or the coupon income (expense) related to the hedged item. The net of the amounts presented represents the ineffective portion of the hedge.

Non-qualifying Strategies

For non-qualifying strategies, including embedded derivatives that are required to be bifurcated from their host contracts and accounted for as derivatives, the gain or loss on the derivative is recognized currently in earnings within net realized capital gains (losses). The following table presents the gain or loss recognized in income on non-qualifying strategies:

Derivatives Used in Non-Qualifying Strategies

Gain or (Loss) Recognized within Net Realized Capital Gains and Losses

 

     Three Months Ended
March 31,
 
     2012     2011  

Interest rate contracts

    

Interest rate swaps, caps, floors, and forwards

   $ 2      $ 5   

Foreign exchange contracts

    

Foreign currency swaps and forwards

     (5     (5

Japan 3Win foreign currency swaps [1]

     (181     (58

Japanese fixed annuity hedging instruments [2]

     (128     (62

Credit contracts

    

Credit derivatives that purchase credit protection

     (36     (17

Credit derivatives that assume credit risk

     149        19   

Equity contracts

    

Equity index swaps and options

     (19     —     

Variable annuity hedge program

    

U.S. GMWB product derivatives

     896        348   

U.S. GMWB reinsurance contracts

     (143     (65

U.S. GMWB hedging instruments

     (568     (227

U.S. macro hedge program

     (189     (84

International program product derivatives

     35        16   

International program hedging instruments

     (1,254     (335

Other

    

Contingent capital facility put option

     (2     (2
  

 

 

   

 

 

 

Total

   $ (1,443   $ (467
  

 

 

   

 

 

 

 

[1] The associated liability is adjusted for changes in spot rates through realized capital gains and was $118 and $42 for the three months ended March 31, 2012 and 2011, respectively.
[2] The associated liability is adjusted for changes in spot rates through realized capital gains and was $157 and $53 for the three months ended March 31, 2012 and 2011, respectively.

 

44


Table of Contents

THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

5. Investments and Derivative Instruments (continued)

 

For the three months ended March 31, 2012, the net realized capital gain (loss) related to derivatives used in non-qualifying strategies was primarily comprised of the following:

 

 

The net loss associated with the international program hedging instruments was primarily driven by depreciation of the yen in relation to the euro and the U.S. dollar, and an increase in global and domestic equity markets.

 

 

The net loss on the U.S. macro hedge program was primarily driven by an increase in the domestic equity market and lower equity market volatility.

 

 

The net gain related to the combined GMWB hedging program, which includes the GMWB product, reinsurance, and hedging derivatives, was primarily a result of lower equity and interest rate volatility, favorable policyholder behavior, and a general increase in long-term interest rates.

 

 

The net loss related to the Japanese fixed annuity hedging instruments and Japan 3Win foreign currency swaps was primarily due to the U.S. dollar strengthening in comparison to the Japanese yen and strengthening of the currency basis swap spread between U.S. dollar and Japanese yen.

For the three months ended March 31, 2011, the net realized capital gain (loss) related to derivatives used in non-qualifying strategies was primarily comprised of the following:

 

 

The net loss associated with the international program hedging instruments was primarily due to weakening of the Japanese yen, higher global and domestic equity markets valuation and lower implied market volatility.

 

 

The net loss related to the Japanese fixed annuity hedging instruments and Japan 3Win foreign currency swaps was primarily due to the U.S. dollar strengthening in comparison to the Japanese yen, partially offset by an increase in long-term U.S. interest rates.

 

 

The gain related to the combined GMWB hedging program, which includes the GMWB product, reinsurance, and hedging derivatives was primarily a result of lower implied market volatility and a general increase in long-term interest rates.

Refer to Note 9 for additional disclosures regarding contingent credit related features in derivative agreements.

Credit Risk Assumed through Credit Derivatives

The Company enters into credit default swaps that assume credit risk of a single entity, referenced index, or asset pool in order to synthetically replicate investment transactions. The Company will receive periodic payments based on an agreed upon rate and notional amount and will only make a payment if there is a credit event. A credit event payment will typically be equal to the notional value of the swap contract less the value of the referenced security issuer’s debt obligation after the occurrence of the credit event. A credit event is generally defined as a default on contractually obligated interest or principal payments or bankruptcy of the referenced entity. The credit default swaps in which the Company assumes credit risk primarily reference investment grade single corporate issuers and baskets, which include standard and customized diversified portfolios of corporate issuers. The diversified portfolios of corporate issuers are established within sector concentration limits and may be divided into tranches that possess different credit ratings.

 

45


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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

5. Investments and Derivative Instruments (continued)

 

The following tables present the notional amount, fair value, weighted average years to maturity, underlying referenced credit obligation type and average credit ratings, and offsetting notional amounts and fair value for credit derivatives in which the Company is assuming credit risk as of March 31, 2012 and December 31, 2011.

As of March 31, 2012

 

                         Underlying Referenced Credit
Obligation(s) [1]
             

Credit Derivative type by derivative risk exposure

   Notional
Amount
[2]
     Fair
Value
    Weighted
Average
Years to
Maturity
     Type      Average
Credit
Rating
   Offsetting
Notional
Amount [3]
     Offsetting
Fair
Value [3]
 

Single name credit default swaps

                   

Investment grade risk exposure

   $ 1,693       $ (12     3 years        
 
Corporate Credit/
Foreign Gov.
  
  
   A    $ 1,424       $ (29

Below investment grade risk exposure

     160         (2     2 years         Corporate Credit       BB-      144         (5

Basket credit default swaps [4]

                   

Investment grade risk exposure

     3,866         (6     3 years         Corporate Credit       BBB+      2,229         —     

Investment grade risk exposure

     525         (80     5 years         CMBS Credit       A      525         80   

Below investment grade risk exposure

     555         (465     3 years         Corporate Credit       BBB      —           —     

Embedded credit derivatives

                   

Investment grade risk exposure

     25         24        3 years         Corporate Credit       BBB-      —           —     

Below investment grade risk exposure

     500         441        5 years         Corporate Credit       BB+      —           —     
  

 

 

    

 

 

   

 

 

    

 

 

    

 

  

 

 

    

 

 

 

Total

   $ 7,324       $ (100            $ 4,322       $ 46   
  

 

 

    

 

 

            

 

 

    

 

 

 

As of December 31, 2011

 

                         Underlying Referenced
Credit Obligation(s) [1]
             

Credit Derivative type by derivative risk exposure

   Notional
Amount [2]
     Fair
Value
    Weighted
Average
Years to
Maturity
     Type      Average
Credit
Rating
   Offsetting
Notional
Amount [3]
     Offsetting
Fair
Value [3]
 

Single name credit default swaps

                   

Investment grade risk exposure

   $ 1,628       $ (34     3 years        
 
Corporate Credit/
Foreign Gov.
  
  
   A+    $ 1,424       $ (15

Below investment grade risk exposure

     170         (7     2 years         Corporate Credit       BB-      144         (5

Basket credit default swaps [4]

                   

Investment grade risk exposure

     3,645         (92     3 years         Corporate Credit       BBB+      2,001         29   

Investment grade risk exposure

     525         (98     5 years         CMBS Credit       BBB+      525         98   

Below investment grade risk exposure

     553         (509     3 years         Corporate Credit       BBB+      —           —     

Embedded credit derivatives

                   

Investment grade risk exposure

     25         24        3 years         Corporate Credit       BBB-      —           —     

Below investment grade risk exposure

     500         411        5 years         Corporate Credit       BB+      —           —     
  

 

 

    

 

 

   

 

 

    

 

 

    

 

  

 

 

    

 

 

 

Total

   $ 7,046       $ (305            $ 4,094       $ 107   
  

 

 

    

 

 

            

 

 

    

 

 

 

 

[1] The average credit ratings are based on availability and the midpoint of the applicable ratings among Moody’s, S&P, and Fitch. If no rating is available from a rating agency, then an internally developed rating is used.
[2] Notional amount is equal to the maximum potential future loss amount. There is no specific collateral related to these contracts or recourse provisions included in the contracts to offset losses.
[3] The Company has entered into offsetting credit default swaps to terminate certain existing credit default swaps, thereby offsetting the future changes in value of, or losses paid related to, the original swap.
[4] Includes $4.4 billion and $4.2 billion as of March 31, 2012 and December 31, 2011, respectively, of standard market indices of diversified portfolios of corporate issuers referenced through credit default swaps. These swaps are subsequently valued based upon the observable standard market index. Also includes $553 as of both March 31, 2012 and December 31, 2011 of customized diversified portfolios of corporate issuers referenced through credit default swaps.

 

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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

6. Deferred Policy Acquisition Costs and Present Value of Future Profits

The Company capitalizes policy acquisition costs that are directly related to the successful acquisition of new and renewal insurance contracts in accordance with ASU No. 2010-26. On January 1, 2012, the Company adopted ASU No. 2010-26 as further discussed in Note 1 of the Notes to Condensed Consolidated Financial Statements. As a result of this change in accounting policy, deferred policy acquisition costs and present value of future profits as of January 1, 2011 decreased by approximately $2.4 billion from $9.9 billion, as previously reported.

Changes in the DAC balance are as follows:

 

 

     Three Months Ended  
     March 31,  
     2012     2011  

Balance, beginning of period, as currently reported

   $  6,556      $  7,473   

Deferred Costs

     439        421   

Amortization – DAC

     (445     (488

Amortization – Unlock benefit, pre-tax

     124        38   

Adjustments to unrealized gains and losses on securities available-for-sale and other

     (21     48   

Effect of currency translation

     (76     (32
  

 

 

   

 

 

 

Balance, end of period

   $ 6,577      $ 7,460   
  

 

 

   

 

 

 

The Unlock benefit, pre-tax for the three months ended March 31, 2012 and 2011 was driven by actual separate account returns being above our aggregated estimated returns.

 

7. Separate Accounts, Death Benefits and Other Insurance Benefit Features

U.S. GMDB, International GMDB/GMIB, and UL Secondary Guarantee Benefits

Changes in the gross U.S. GMDB, International GMDB/GMIB, and UL secondary guarantee benefits are as follows:

 

 

     U.S.
GMDB
    International
GMDB/GMIB
    UL Secondary
Guarantees
 

Liability balance as of January 1, 2012

   $  1,104      $ 975      $  228   

Incurred

     56        33        24   

Paid

     (50     (53     —     

Unlock

     (134     (139     11   

Currency translation adjustment

     —          (61     —     
  

 

 

   

 

 

   

 

 

 

Liability balance as of March 31, 2012

   $ 976      $ 755      $ 263   
  

 

 

   

 

 

   

 

 

 

Reinsurance recoverable asset, as of January 1, 2012

   $ 724      $ 40      $ 22   

Incurred

     35        2        (3

Paid

     (33     (7     —     

Unlock

     (72     13        —     

Currency translation adjustment

     —          (3     —     
  

 

 

   

 

 

   

 

 

 

Reinsurance recoverable asset, as of March 31, 2012

   $ 654      $ 45      $ 19   
  

 

 

   

 

 

   

 

 

 

 

     U.S.
GMDB
    International
GMDB/GMIB
    UL Secondary
Guarantees
 

Liability balance as of January 1, 2011

   $  1,053      $  696      $  113   

Incurred

     57        31        13   

Paid

     (51     (40     —     

Unlock

     (55     (17     —     

Currency translation adjustment

     —          (14     —     
  

 

 

   

 

 

   

 

 

 

Liability balance as of March 31, 2011

   $ 1,004      $ 656      $ 126   
  

 

 

   

 

 

   

 

 

 

Reinsurance recoverable asset, as of January 1, 2011

   $ 686      $ 36      $ 30   

Incurred

     34        1        2   

Paid

     (35     —          —     

Unlock

     (29     4        —     

Currency translation adjustment

     —          (1     —     
  

 

 

   

 

 

   

 

 

 

Reinsurance recoverable asset, as of March 31, 2011

   $ 656      $ 40      $ 32   
  

 

 

   

 

 

   

 

 

 

 

47


Table of Contents

THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

7. Separate Accounts, Death Benefits and Other Insurance Benefit Features (continued)

 

The following table provides details concerning GMDB and GMIB exposure as of March 31, 2012:

 

 

Individual Variable and Group Annuity Account Value by GMDB/GMIB Type  

Maximum anniversary value (“MAV”) [1]

   Account
Value
(“AV”) [8]
     Net Amount
at Risk
(“NAR”) [10]
     Retained Net
Amount

at Risk
(“RNAR”) [10]
     Weighted Average
Attained Age of
Annuitant
 

MAV only

   $ 21,849       $ 4,352       $ 907         69   

With 5% rollup [2]

     1,567         398         124         69   

With Earnings Protection Benefit Rider (“EPB”) [3]

     5,618         680         87         65   

With 5% rollup & EPB

     615         135         29         68   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total MAV

     29,649         5,565         1,147      

Asset Protection Benefit (“APB”) [4]

     23,135         1,522         988         66   

Lifetime Income Benefit (“LIB”) – Death Benefit [5]

     1,153         47         47         64   

Reset [6] (5-7 years)

     3,343         165         163         68   

Return of Premium (“ROP”) [7]/Other

     22,950         425         405         66   
  

 

 

    

 

 

    

 

 

    

 

 

 

Subtotal U.S. GMDB

     80,230         7,724         2,750         67   

Less: General Account Value with U.S. GMDB

     7,335            
  

 

 

    

 

 

    

 

 

    

 

 

 

Subtotal Separate Account Liabilities with GMDB

     72,895            

Separate Account Liabilities without U.S. GMDB

     79,507            
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Separate Account Liabilities

   $ 152,402            
  

 

 

    

 

 

    

 

 

    

 

 

 

Japan GMDB [9], [11]

   $ 29,396       $ 7,580       $ 6,469         70   

Japan GMIB [9], [11]

   $ 27,350       $ 4,785       $ 4,785         70   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

[1] MAV GMDB is the greatest of current AV, net premiums paid and the highest AV on any anniversary before age 80 (adjusted for withdrawals).
[2] Rollup GMDB is the greatest of the MAV, current AV, net premium paid and premiums (adjusted for withdrawals) accumulated at generally 5% simple interest up to the earlier of age 80 or 100% of adjusted premiums.
[3] EPB GMDB is the greatest of the MAV, current AV, or contract value plus a percentage of the contract’s growth. The contract’s growth is AV less premiums net of withdrawals, subject to a cap of 200% of premiums net of withdrawals.
[4] APB GMDB is the greater of current AV or MAV, not to exceed current AV plus 25% times the greater of net premiums and MAV (each adjusted for premiums in the past 12 months).
[5] LIB GMDB is the greatest of current AV, net premiums paid, or for certain contracts a benefit amount that ratchets over time, generally based on market performance.
[6] Reset GMDB is the greatest of current AV, net premiums paid and the most recent five to seven year anniversary AV before age 80 (adjusted for withdrawals).
[7] ROP GMDB is the greater of current AV or net premiums paid.
[8] AV includes the contract holder’s investment in the separate account and the general account.
[9] GMDB includes a ROP and MAV (before age 80) paid in a single lump sum. GMIB is a guarantee to return initial investment, adjusted for earnings liquidity which allows for free withdrawal of earnings, paid through a fixed payout annuity, after a minimum deferral period of 10, 15 or 20 years. The GRB related to the Japan GMIB was $31.4 billion and $34.1 billion as of March 31, 2012 and December 31, 2011, respectively. The GRB related to the Japan GMAB and GMWB was $646 as of March 31, 2012 and $701 as of December 31, 2011. These liabilities are not included in the Separate Account as they are not legally insulated from the general account liabilities of the insurance enterprise. As of March 31, 2012, 55 % of the GMDB RNAR and 69% of the GMIB NAR is reinsured to a Hartford affiliate.
[10] NAR is defined as the guaranteed benefit in excess of the current AV. RNAR represents NAR reduced for reinsurance. NAR and RNAR are highly sensitive to equity markets movements and increase when equity markets decline. Additionally Japan’s NAR and RNAR are highly sensitive to currency movements and increase when the Yen strengthens.
[11] Policies with a guaranteed living benefit (GMIB in Japan) also have a guaranteed death benefit. The NAR for each benefit is shown in the table above, however these benefits are not additive. When a policy terminates due to death, any NAR related to GMWB or GMIB is released. Similarly, when a policy goes into benefit status on a GMWB or GMIB, its GMDB NAR is released.

In the U.S., account balances of contracts with guarantees were invested in variable separate accounts as follows:

 

Asset type

   As of March 31, 2012      As of December 31, 2011  

Equity securities (including mutual funds)

   $ 65,862       $ 61,472   

Cash and cash equivalents

     7,033         7,516   
  

 

 

    

 

 

 

Total

   $ 72,895       $ 68,988   
  

 

 

    

 

 

 

As of March 31, 2012 and December 31, 2011, approximately 16% and 17%, respectively, of the equity securities above were invested in fixed income securities through these funds and approximately 84% and 83%, respectively, were invested in equity securities.

See Note 4 for further information on guaranteed living benefits that are accounted for at fair value, such as GMWB.

 

48


Table of Contents

THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

8. Sales Inducements

Changes in deferred sales inducement activity were as follows for the three months ended March 31:

 

 

     2012     2011  

Balance, January 1

   $  434      $  459   

Sales inducements deferred

     1        4   

Amortization—Unlock

     5        3   

Amortization charged to income

     (10     (9
  

 

 

   

 

 

 

Balance, March 31

   $ 430      $ 457   
  

 

 

   

 

 

 

 

9. Commitments and Contingencies

Litigation

The Hartford is involved in claims litigation arising in the ordinary course of business, both as a liability insurer defending or providing indemnity for third-party claims brought against insureds and as an insurer defending coverage claims brought against it. The Hartford accounts for such activity through the establishment of unpaid loss and loss adjustment expense reserves. Subject to the uncertainties discussed below under the caption “Asbestos and Environmental Claims,” management expects that the ultimate liability, if any, with respect to such ordinary-course claims litigation, after consideration of provisions made for potential losses and costs of defense, will not be material to the consolidated financial condition, results of operations or cash flows of The Hartford.

The Hartford is also involved in other kinds of legal actions, some of which assert claims for substantial amounts. These actions include, among others, and in addition to the matters described below, putative state and federal class actions seeking certification of a state or national class. Such putative class actions have alleged, for example, underpayment of claims or improper underwriting practices in connection with various kinds of insurance policies, such as personal and commercial automobile, property, life and inland marine; improper sales practices in connection with the sale of life insurance and other investment products; and improper fee arrangements in connection with investment products. The Hartford also is involved in individual actions in which punitive damages are sought, such as claims alleging bad faith in the handling of insurance claims. Like many other insurers, The Hartford also has been joined in actions by asbestos plaintiffs asserting, among other things, that insurers had a duty to protect the public from the dangers of asbestos and that insurers committed unfair trade practices by asserting defenses on behalf of their policyholders in the underlying asbestos cases. Management expects that the ultimate liability, if any, with respect to such lawsuits, after consideration of provisions made for estimated losses, will not be material to the consolidated financial condition of The Hartford. Nonetheless, given the large or indeterminate amounts sought in certain of these actions, and the inherent unpredictability of litigation, the outcome in certain matters could, from time to time, have a material adverse effect on the Company’s results of operations or cash flows in particular quarterly or annual periods.

Apart from the inherent difficulty of predicting litigation outcomes, the Mutual Funds Litigation identified below purports to seek substantial damages for unsubstantiated conduct spanning a multi-year period based on novel and complex legal theories. The alleged damages are not quantified or factually supported in the complaint, and, in any event, the Company’s experience shows that demands for damages often bear little relation to a reasonable estimate of potential loss. The matter is in the earliest stages of litigation, with no substantive legal decisions by the court defining the scope of the claims or the potentially available damages. The Company has not yet answered the complaint or asserted its defenses, and fact discovery has not yet begun. Accordingly, management cannot reasonably estimate the possible loss or range of loss, if any, or predict the timing of the eventual resolution of this matter.

Mutual Funds Litigation — In February 2011, a derivative action was brought on behalf of six Hartford retail mutual funds in the United States District Court for the District of New Jersey, alleging that Hartford Investment Financial Services, LLC (“HIFSCO”), an indirect subsidiary of the Company, received excessive advisory and distribution fees in violation of its statutory fiduciary duty under Section 36(b) of the Investment Company Act of 1940. HIFSCO moved to dismiss and, in September 2011, the motion was granted in part and denied in part, with leave to amend the complaint. In November 2011, plaintiffs filed an amended complaint on behalf of The Hartford Global Health Fund, The Hartford Conservative Allocation Fund, The Hartford Growth Opportunities Fund, The Hartford Inflation Plus Fund, The Hartford Advisors Fund, and The Hartford Capital Appreciation Fund. Plaintiffs seek to rescind the investment management agreements and distribution plans between HIFSCO and these funds and to recover the total fees charged thereunder or, in the alternative, to recover any improper compensation HIFSCO received, in addition to lost earnings. HIFSCO disputes the allegations and has filed a partial motion to dismiss.

 

49


Table of Contents

THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

9. Commitments and Contingencies (continued)

 

Broker Compensation Litigation – Following the New York Attorney General’s filing of a civil complaint against Marsh & McLennan Companies, Inc., and Marsh, Inc. (collectively, “Marsh”) in October 2004 alleging that certain insurance companies, including The Hartford, participated with Marsh in arrangements to submit inflated bids for business insurance and paid contingent commissions to ensure that Marsh would direct business to them, private plaintiffs brought several lawsuits against the Company predicated on the allegations in the Marsh complaint, to which the Company was not party. Among these is a multidistrict litigation in the United States District Court for the District of New Jersey. Two consolidated amended complaints were filed in the multidistrict litigation, one related to conduct in connection with the sale of property-casualty insurance and the other related to alleged conduct in connection with the sale of group benefits products. The Company and various of its subsidiaries are named in both complaints. The complaints assert, on behalf of a putative class of persons who purchased insurance through broker defendants, claims under the Sherman Act, the Racketeer Influenced and Corrupt Organizations Act (“RICO”), state law, and in the case of the group benefits complaint, claims under the Employee Retirement Income Security Act of 1974 (“ERISA”). The claims are predicated upon allegedly undisclosed or otherwise improper payments of contingent commissions to the broker defendants to steer business to the insurance company defendants. The district court dismissed the Sherman Act and RICO claims in both complaints for failure to state a claim and has granted the defendants’ motions for summary judgment on the ERISA claims in the group-benefits products complaint. The district court further declined to exercise supplemental jurisdiction over the state law claims and dismissed those claims without prejudice. The plaintiffs appealed the dismissal of the claims in both consolidated amended complaints, except the ERISA claims. In August 2010, the United States Court of Appeals for the Third Circuit affirmed the dismissal of the Sherman Act and RICO claims against the Company. The Third Circuit vacated the dismissal of the Sherman Act and RICO claims against some defendants in the property casualty insurance case and vacated the dismissal of the state-law claims as to all defendants in light of the reinstatement of the federal claims. In September 2010, the district court entered final judgment for the defendants in the group benefits case. In March 2011, the Company reached an agreement in principle to settle on a class basis the property casualty insurance case for an immaterial amount. The district court gave final approval to the settlement in March 2012. An objector has noticed an appeal to the Third Circuit; management believes that the possibility that the settlement will be overturned on appeal is remote. Following the settlement, only three non-class action lawsuits remain. Management believes that the possibility of a material adverse outcome with respect to these lawsuits, when considered separately or in the aggregate, is remote.

Investment and Savings Plan ERISA and Shareholder Securities Class Action Litigation – In November and December 2008, following a decline in the share price of the Company’s common stock, seven putative class action lawsuits were filed in the United States District Court for the District of Connecticut on behalf of certain participants in the Company’s Investment and Savings Plan (the “Plan”), which offers the Company’s common stock as one of many investment options. These lawsuits have been consolidated, and a consolidated amended class-action complaint was filed on March 23, 2009, alleging that the Company and certain of its officers and employees violated ERISA by allowing the Plan’s participants to invest in the Company’s common stock and by failing to disclose to the Plan’s participants information about the Company’s financial condition. The lawsuit seeks restitution or damages for losses arising from the investment of the Plan’s assets in the Company’s common stock during the period from December 10, 2007 to the present. In January 2010, the district court denied the Company’s motion to dismiss the consolidated amended complaint. In February 2011, the parties reached an agreement in principle to settle on a class basis for an immaterial amount. The district court gave final approval to the settlement in April 2012.

Asbestos and Environmental Claims – As discussed in Note 12, Commitments and Contingencies, of the Notes to Consolidated Financial Statements under the caption “Asbestos and Environmental Claims”, included in the Company’s 2011 Form 10-K Annual Report, The Hartford continues to receive asbestos and environmental claims that involve significant uncertainty regarding policy coverage issues. Regarding these claims, The Hartford continually reviews its overall reserve levels and reinsurance coverages, as well as the methodologies it uses to estimate its exposures. Because of the significant uncertainties that limit the ability of insurers and reinsurers to estimate the ultimate reserves necessary for unpaid losses and related expenses, particularly those related to asbestos, the ultimate liabilities may exceed the currently recorded reserves. Any such additional liability cannot be reasonably estimated now but could be material to The Hartford’s consolidated operating results, financial condition and liquidity.

 

 

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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

9. Commitments and Contingencies (continued)

 

Derivative Commitments

Certain of the Company’s derivative agreements contain provisions that are tied to the financial strength ratings of the individual legal entity that entered into the derivative agreement as set by nationally recognized statistical rating agencies. If the legal entity’s financial strength were to fall below certain ratings, the counterparties to the derivative agreements could demand immediate and ongoing full collateralization and in certain instances demand immediate settlement of all outstanding derivative positions traded under each impacted bilateral agreement. The settlement amount is determined by netting the derivative positions transacted under each agreement. If the termination rights were to be exercised by the counterparties, it could impact the legal entity’s ability to conduct hedging activities by increasing the associated costs and decreasing the willingness of counterparties to transact with the legal entity. The aggregate fair value of all derivative instruments with credit-risk-related contingent features that are in a net liability position as of March 31, 2012, is $701. Of this $701 the legal entities have posted collateral of $687 in the normal course of business. Based on derivative market values as of March 31, 2012, a downgrade of one level below the current financial strength ratings by either Moody’s or S&P could require approximately an additional $28 to be posted as collateral. Based on derivative market values as of March 31, 2012, a downgrade by either Moody’s or S&P of two levels below the legal entities’ current financial strength ratings could require approximately an additional $41 of assets to be posted as collateral. These collateral amounts could change as derivative market values change, as a result of changes in our hedging activities or to the extent changes in contractual terms are negotiated. The nature of the collateral that we would post, if required, would be primarily in the form of U.S. Treasury bills and U.S. Treasury notes.

On March 21, 2012, Standard & Poor’s (“S&P”) Rating Services lowered its counterparty credit and insurer financial strength ratings on Hartford Life and Annuity Insurance Company to BBB+. Given this downgrade action, termination rating triggers in three derivative counterparty relationships have been impacted totaling a notional amount of $4.7 billion with a corresponding fair value of $77 as of March 31, 2012. The counterparties have the right to terminate these relationships and would have to settle the outstanding derivatives prior to exercising their termination right. Accordingly, as of March 31, 2012 these counterparties would owe the Company the derivatives fair value of $77. The counterparties have not exercised this termination right and the Company has re-negotiated the rating triggers with one counterparty and is in the process of re-negotiating the rating triggers with the remaining two counterparties.

 

10. Employee Benefit Plans

Components of Net Periodic Benefit Cost

Total net periodic benefit cost for the three months ended March 31, 2012 and 2011 includes the following components:

 

 

     Pension Benefits     Other Postretirement Benefits  
     2012     2011     2012     2011  

Service cost

   $ 26      $ 28      $ 1      $ 1   

Interest cost

     63        64        5        5   

Expected return on plan assets

     (78     (74     (3     (4

Amortization of prior service credit

     (2     (2     —          —     

Amortization of actuarial loss

     53        37        —          —     
  

 

 

   

 

 

   

 

 

   

 

 

 

Net periodic benefit cost

   $ 62      $ 53      $ 3      $ 2   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

11. Stock Compensation Plans

The Company’s stock-based compensation plans include The Hartford 2010 Incentive Stock Plan, The Hartford Employee Stock Purchase Plan and The Hartford Deferred Stock Unit Plan. For a description of these plans, see Note 18 of the Notes to Consolidated Financial Statements included in The Hartford’s 2011 Form 10-K Annual Report.

Shares issued in satisfaction of stock-based compensation may be made available from authorized but unissued shares, shares held by the Company in treasury or from shares purchased in the open market. The Company typically issues shares from treasury in satisfaction of stock-based compensation.

 

 

     Three Months Ended
March  31,
 
     2012     2011  

Stock-based compensation plans expense

   $ 40      $ 22   

Income tax benefit

     (14     (8
  

 

 

   

 

 

 

Total stock-based compensation plans expense, after-tax

   $ 26      $ 14   
  

 

 

   

 

 

 

In 2010 and 2009, the Company issued awards that will ultimately be settled in cash. As a result, these awards are re-measured at the end of each reporting period until settlement. The net stock-based compensation plans expense recognized during the three months ended March 31, 2012 was a result of an increase in the Company’s share price during the reporting period.

The Company did not capitalize any cost of stock-based compensation. As of March 31, 2012, the total compensation cost related to non-vested awards not yet recognized was $127, which is expected to be recognized over a weighted average period of 2.3 years.

 

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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

12. Discontinued Operations

The following table presents the combined amounts related to the operations of Federal Trust Corporation and Specialty Risk Services, which have been reflected as discontinued operations in the Condensed Consolidated Statements of Operations. For further explanation of the Company’s discontinued operations refer to Note 20 of the Notes to Consolidated Financial Statements in The Hartford’s 2011 Form 10-K Annual Report.

 

 

     Three Months Ended
March  31,
 
     2012     2011  

Revenues

    

Net investment income

   $ —        $ 8   

Net realized capital gains (losses)

     —          (4

Other revenues

     —          47   
  

 

 

   

 

 

 

Total revenues

     —          51   

Benefits, losses and expenses

    

Insurance operating costs and other expenses

     2        32   
  

 

 

   

 

 

 

Total benefits, losses and expenses

     2        32   

Income (loss) before income taxes

     (2     19   

Income tax expense (benefit)

     (1     7   
  

 

 

   

 

 

 

Income (loss) from operations of discontinued operations, net of tax

     (1     12   

Net realized capital gain on disposal, net of tax

     —          150   
  

 

 

   

 

 

 

Income (loss) from discontinued operations, net of tax

   $ (1   $ 162   
  

 

 

   

 

 

 

 

13. Goodwill

The carrying value of goodwill allocated to reporting units is as follows:

 

 

     March 31, 2012      December 31, 2011  
     Gross      Accumulated
Impairments
    Discontinued
Operations
     Carrying
Value
     Gross      Accumulated
Impairments
    Discontinued
Operations [1]
    Carrying
Value
 

Commercial Markets

                    

Property & Casualty Commercial

   $ 30       $ (30   $ —         $ —         $ 30       $ (30   $ —        $ —     

Consumer Markets

     119         —          —           119         119         —          —          119   

Wealth Management

                    

Individual Life

     224         —          —           224         224         —          —          224   

Retirement Plans

     87         —          —           87         87         —          —          87   

Mutual Funds

     159         —          —           159         159         —          —          159   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Total Wealth Management

     470           —           470         470         —          —          470   

Corporate

     772         (355     —           417         787         (355     (15     417   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Total Goodwill

   $ 1,391       $ (385   $ —         $ 1,006       $ 1,406       $ (385   $ (15   $ 1,006   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

 

[1] Represents goodwill written off related to Federal Trust Corporation which is currently recorded in discontinued operations.

During the first quarter of 2012, the Company determined that a triggering event requiring an impairment assessment had occurred as a result of its decision to pursue sales or other strategic alternatives for the Individual Life and Retirement Plans reporting units. The Company completed an interim impairment test during the first quarter of 2012 for these two reporting units which resulted in no impairment of goodwill. Retirement Plans passed the first step of the interim goodwill impairment test with a significant margin. Individual Life passed the first step of the interim goodwill impairment test with a margin of less than 10% between the fair value and book value of the reporting unit as of February 29, 2012. The Company will continue to monitor the impact to fair value from certain assumptions such as product sales and lapse rates which may be more sensitive following the announcement of its decision and from information developed through the effort to market the reporting units.

The fair value of the Individual Life reporting unit is based on discounted cash flows using earnings projections on in force business and product sales. There could be a positive or negative impact on the result of step one in future periods if assumptions change about the level of economic capital, product sales, earnings projections or the weighted average cost of capital.

 

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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

14. Debt

Senior Notes

On April 5, 2012, the Company issued $1.55 billion aggregate principal amount of senior notes. The issuance consisted of $325 of 4.000% senior notes due 2017, $800 of 5.125% senior notes due 2022 and $425 of 6.625% senior notes due 2042 (collectively, the “Senior Notes”) for net proceeds of approximately $1.5 billion, after deducting underwriting discounts and offering expenses. The Senior Notes bear interest at their respective rate, payable semi-annually in arrears on April 15 and October 15 of each year, beginning on October 15, 2012.

Junior Subordinated Debentures

On April 17, 2012, the Company (i) repurchased all outstanding 10% fixed-to-floating rate junior subordinated debentures due 2068 with a $1.75 billion aggregate principal amount held by Allianz SE (“Allianz”) (the “10% Debentures”) for $2.125 billion (plus a payment by the Company of unpaid interest on the 10% Debentures) and (ii) settled the repurchase of the Series B and Series C warrants held by Allianz to purchase shares of the Company’s common stock, see Note 15. In addition, the 10% Debentures replacement capital covenant (the “10% Debentures RCC”) was terminated on April 12, 2012 with the consent of the holders of a majority in aggregate principal amount of the Company’s outstanding 6.1% senior notes due 2041. Upon closing, the Company recognized a loss on extinguishment in the second quarter of 2012 of approximately $600, after-tax, representing the premium associated with repurchasing the 10% Debentures at an amount greater than the face amount, the write-off of the unamortized discount and debt issuance costs related to the 10% Debentures and other costs related to the repurchase transaction. On April 5, 2012, the Company issued $600 aggregate principal amount of 7.875% fixed-to-floating rate junior subordinated debentures due 2042 (the “Debentures”) for net proceeds of approximately $586, after deducting underwriting discounts and offering expenses. The Company financed the repurchase of the 10% Debentures through the issuance of the Senior Notes and the Debentures.

The Debentures bear interest from the date of issuance to but excluding April 15, 2022 at an annual rate of 7.875%, payable quarterly in arrears on January 15, April 15, July 15 and October 15 of each year, commencing on July 15, 2012, to and including April 15, 2022. Commencing on April 15, 2022 the Debentures bear interest at an annual rate equal to three-month LIBOR, reset quarterly, plus 5.596%, payable quarterly in arrears on January 15, April 15, July 15 and October 15 of each year, commencing on July 15, 2022. The Company has the right, on one or more occasions, to defer the payment of interest on the Debentures. The Company may defer interest for up to ten consecutive years without giving rise to an event of default. Deferred interest will accumulate additional interest at an annual rate equal to the annual interest rate then applicable to the Debentures. If the Company defers interest payments on the Debentures, the Company generally may not make payments on or redeem or purchase any shares of its capital stock or any of its debt securities or guarantees that rank upon liquidation, dissolution or winding up equally with or junior to the Debentures, subject to certain limited exceptions.

The Company may elect to redeem the Debentures in whole at any time or in part from time to time on or after April 15, 2022, at a redemption price equal to the principal amount of the Debentures being redeemed plus accrued and unpaid interest to but excluding the date of redemption. If the Debentures are not redeemed in whole, at least $25 aggregate principal amount of the Debentures must remain outstanding after giving effect to such redemption. The Debentures may be redeemed in whole at any time prior to April 15, 2022, within 90 days of the occurrence of a tax event or rating agency event, at a redemption price equal to the greater of (i) the principal amount of the Debentures being redeemed, or (ii) the present value of the (a) outstanding principal and (b) remaining scheduled payments of interest that would have been payable from the redemption date to and including April 15, 2022 on the Debentures to be redeemed (not including any portion of such payments of interest accrued and unpaid to but excluding the redemption date), discounted from their respective interest payment dates to but excluding the redemption date at a discount rate equal to the Treasury Rate plus a spread of 0.700%, in each case, plus accrued and unpaid interest to but excluding the redemption date.

The Debentures are unsecured, subordinated and junior in right of payment and upon liquidation to all of the Company’s existing and future senior indebtedness. In addition, the Debentures are effectively subordinated to all of the Company’s subsidiaries’ existing and future indebtedness and other liabilities, including obligations to policyholders. The Debentures do not limit the Company’s or the Company’s subsidiaries’ ability to incur additional debt, including debt that ranks senior in right of payment and upon liquidation to the Debentures.

The Debentures rank equally in right of payment and upon liquidation with (i) any indebtedness the terms of which provide that such indebtedness ranks equally with the Debentures, including guarantees of such indebtedness, (ii) the Company’s existing 8.125% fixed-to-floating rate junior subordinated debentures due 2068 (the “8.125% Debentures”), (iii) the Company’s Income Capital Obligation Notes due 2067, issuable pursuant to the Junior Subordinated Indenture, dated as of February 12, 2007, between us and Wilmington Trust Company (the “ICON securities”), (iv) our trade accounts payable, and (v) any of our indebtedness owed to a person who is our subsidiary or employee.

 

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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

14. Debt (continued)

 

Revolving Credit Facility

In January 2012, the Company entered into a senior unsecured revolving credit facility (the “Credit Facility”) that provides for borrowing capacity up to $1.75 billion (which is available in U.S. dollars, and in Euro, Sterling, Canadian dollars and Japanese Yen) through January 6, 2016. Of the total availability under the Credit Facility, up to $250 is available to support letters of credit issued on behalf of the Company or subsidiaries of the Company. Under the Credit Facility, the Company must maintain a minimum level of consolidated net worth, as defined. In the first quarter of 2012, the minimum level of consolidated net worth was reduced by approximately $1.1 billion, after-tax from $16.0 billion as of December 31, 2011 to $14.9 billion as of March 31, 2012 following the adoption of a new DAC accounting standard during the quarter. The definition of consolidated net worth under the terms of the Credit Facility, excludes AOCI and includes the Company’s outstanding junior subordinated debentures and perpetual preferred securities, net of discount. In addition, the Company’s maximum ratio of consolidated total debt to consolidated total capitalization is 35%, and the ratio of consolidated total debt of subsidiaries to consolidated total capitalization is limited to 10%. As of March 31, 2012, the Company was in compliance with all financial covenants under the Credit Facility.

 

15. Equity

During the first quarter of 2012, the Company repurchased 2.6 million common shares, or $42, through its existing $500 equity repurchase program authorized on July 27, 2011 (the “repurchase program”).

On March 30, 2012 the Company repurchased all of the outstanding Series B and Series C warrants (collectively, the “warrants”) held by Allianz for $300. These warrants authorized Allianz to purchase 69,351,806 shares of the Company’s common stock at a current exercise price of $25.23 per share. The repurchase was settled on April 17, 2012 and funded through the repurchase program, resulting in remaining authorized repurchases under this program of approximately $106.

 

16. Subsequent Event

On April 23, 2012, the Company amended The Hartford Retirement Plan for US Employees, its non-contributory, tax qualified defined benefit pension plan, to freeze participation and benefit accruals. The freeze will be effective December 31, 2012. Compensation earned by employees up to December 31, 2012 shall be used for purposes of calculating benefits under the Plan but there will be no future benefit accruals after this date. Participants as of December 31, 2012 will continue to earn vesting credit with respect to their frozen accrued benefits as they continue to work. The Company also amended and froze The Harford Excess Pension Plan, its non-qualified excess benefit plan for certain highly compensated employees. As a result of the amendment to freeze these plans, The Hartford will re-measure the benefit obligations of the affected plans effective April 30, 2012, which will be recorded in the second quarter of 2012. A curtailment of benefits occurs because the amendment eliminates all future service for active employees in the pension plans. Accordingly, the Company will recognize an after-tax curtailment gain of $7 during the second quarter of 2012, which is the remaining unamortized prior service cost at December 31, 2012.

Effective January 1, 2013, The Company will increase benefits under The Hartford’s Investment and Savings Plan, its defined contribution 401(k) savings plan, and The Hartford Excess Savings Plan. The Company contribution will be increased to include a 2% non-elective contribution and dollar for dollar matching contribution up to 6% of eligible compensation contributed by the employee each pay period. The plan will qualify for a “safe harbor” from annual discrimination testing. Currently, contributions are matched, up to 3% of base salary, by the Company. Additionally, in 2011, employees who had earnings of less than $110,000 in the preceding year received a contribution of 1.5% of base salary and employees who had earnings of $110,000 or more in the preceding year received a contribution of 0.5% of base salary.

Also, on April 23, 2012 the Company amended its postretirement medical, dental and life insurance coverage plans for all current employees who retire on or after January 1, 2014. As a result of the amendment to freeze these plans, The Company will re-measure the benefit obligations of the affected plans as of April 30, 2012, which will be recorded in the second quarter of 2012. A curtailment of benefits occurs because the amendments eliminate all future service for active employees. Accordingly, the Company will recognize an after-tax curtailment gain of less than $1, during the second quarter of 2012, which is the remaining unamortized prior service cost at April 30, 2012.

 

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Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

(Dollar amounts in millions except share data unless otherwise stated)

Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) addresses the financial condition of The Hartford Financial Services Group, Inc. and its subsidiaries (collectively, “The Hartford” or the “Company”) as of March 31, 2012, compared with December 31, 2011, and its results of operations for the three months ended March 31, 2012, compared to the equivalent 2011 period. This discussion should be read in conjunction with the MD&A in The Hartford’s 2011 Form 10-K Annual Report. Certain reclassifications have been made to prior period financial information to conform to the current period classifications. Also, prior period amounts have been retrospectively reclassified to reflect discontinued operations, see Note 12 of the Notes to Condensed Consolidated Financial Statements for further information on discontinued operations.

On January 1, 2012, the Company retrospectively adopted Accounting Standards Update (“ASU”) No. 2010-26, Financial Services – Insurance (Topic 944): Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts which clarifies the definition of policy acquisition costs that are eligible for deferral. Previously reported financial information has been revised to reflect the effect of the Company’s adoption of this accounting standard. For further information regarding the effect of adoption of this accounting standard, see Note 1 and Note 6 of the Notes to Condensed Consolidated Financial Statements.

The Hartford defines increases or decreases greater than or equal to 200%, or changes from a net gain to a net loss position, or vice versa, as “NM” or not meaningful.

INDEX

 

Description

   Page  

Consolidated Results of Operations

     56   

Outlooks

     58   

Critical Accounting Estimates

     60   

The Hartford’s Operations Overview

     68   

Key Performance Measures and Ratios

     68   

Property & Casualty Commercial

     75   

Group Benefits

     77   

Consumer Markets

     78   

Individual Annuity

     80   

Individual Life

     81   

Retirement Plans

     82   

Mutual Funds

     83   

Life Other Operations

     84   

Property & Casualty Other Operations

     85   

Corporate

     85   

Enterprise Risk Management

     86   

Capital Resources and Liquidity

     105   

Impact of New Accounting Standards

     112   

 

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Table of Contents

CONSOLIDATED RESULTS OF OPERATIONS

 

Operating Summary    Three Months Ended  
     March 31,  
     2012     2011     Change  

Earned premiums

   $ 3,442      $ 3,519        (2 %) 

Fee income

     1,134        1,209        (6 %) 

Net investment income:

      

Securities available-for-sale and other

     1,070        1,108        (3 %) 

Equity securities, trading [1]

     2,866        803        NM   
  

 

 

   

 

 

   

 

 

 

Total net investment income

     3,936        1,911        106

Net realized capital gains (losses)

     (910     (403     (126 %) 

Other revenues

     59        64        (8 %) 
  

 

 

   

 

 

   

 

 

 

Total revenues

     7,661        6,300        22

Benefits, losses and loss adjustment expenses

     3,038        3,178        (4 %) 

Benefits, losses and loss adjustment expenses – returns credited on international variable annuities [1]

     2,864        803        NM   

Amortization of deferred policy acquisition costs and present value of future profits (“DAC”)

     321        450        (29 %) 

Insurance operating costs and other expenses

     1,312        1,354        (3 %) 

Interest expense

     124        128        (3 %) 
  

 

 

   

 

 

   

 

 

 

Total benefits, losses and expenses

     7,659        5,913        30

Income from continuing operations before income taxes

     2        387        (99 %) 

Income tax expense (benefit)

     (95     48        NM   
  

 

 

   

 

 

   

 

 

 

Income from continuing operations, net of tax

     97        339        (71 %) 

Income (loss) from discontinued operations, net of tax

     (1     162        NM   
  

 

 

   

 

 

   

 

 

 

Net income

   $ 96      $ 501        (81 %) 
  

 

 

   

 

 

   

 

 

 

Supplemental Operating Data

      
      

Income from continuing operations, net of tax, available to common shareholders per diluted common share

   $ 0.19      $ 0.67        (72 %) 

Net income available to common shareholders per diluted common share

     0.18        0.99        (82 %) 

Total revenues, excluding net investment income on equity securities, trading

     4,795        5,497        (13 %) 
      

 

     March 31,      December 31,  

Summary of Financial Condition

   2012      2011  

Total assets

   $ 310,548       $ 302,609   

Total investments, excluding equity securities, trading

     102,878         104,449   

Total stockholders’ equity

     21,274         21,486   
  

 

 

    

 

 

 

 

[1] Includes investment income and mark-to-market effects of equity securities, trading, supporting the international variable annuity business, which are classified in net investment income with corresponding amounts credited to policyholders within benefits, losses and loss adjustment expenses.

 

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Table of Contents
     Three Months Ended
March 31,
 

Net income (loss) by segment

   2012     2011     Increase
(Decrease) From
2012 to 2011
 

Property & Casualty Commercial

   $ 189      $ 323      $ (134

Group Benefits

     18        11        7   
  

 

 

   

 

 

   

 

 

 

Commercial Markets

     207        334        (127

Consumer Markets

     108        108        —     

Individual Annuity

     198        143        55   

Individual Life

     19        18        1   

Retirement Plans

     18        5        13   

Mutual Funds

     20        28        (8
  

 

 

   

 

 

   

 

 

 

Wealth Management

     255        194        61   

Life Other Operations

     (405     (70     (335

Property & Casualty Other Operations

     27        21        6   

Corporate

     (96     (86     (10
  

 

 

   

 

 

   

 

 

 

Total net income (loss)

   $ 96      $ 501      $ (405
  

 

 

   

 

 

   

 

 

 

Three months ended March 31, 2012 compared to the three months ended March 31, 2011

The decrease in net income from 2011 to 2012 was primarily due to the following items:

 

 

Net realized capital losses increased primarily due the results of the international variable annuity hedge program. The losses resulted from weakening of the yen and rising equity markets, as certain hedge assets are used to hedge liabilities that are not carried at fair value. For further discussion of the results, see Net Realized Capital Gains (Losses) within Investment Results of Key Performance Measures and Ratios. For information on the related sensitivities of the variable annuity hedging program, see Variable Product Guarantee Risks and Risk Management within Enterprise Risk Management.

 

 

Income (loss) from discontinued operations, net of tax, decreased, primarily due to the realized capital gain on the sale of Specialty Risk Services of $150, after-tax, in the first quarter of 2011. This gain was recorded in the Property & Casualty Commercial segment’s net income.

Partially offsetting the decrease in net income were the following items:

 

 

An increase in the Unlock benefit to $214, after-tax, in 2012 from $57, after-tax, in 2011. The Unlock benefit in both periods was driven by actual separate account returns being above our aggregated estimated returns. For further discussion of Unlocks see the Critical Accounting Estimates within the MD&A.

 

 

Income tax expense in 2012 includes a valuation allowance benefit of $20 compared to a benefit of $2 in 2011. See Note 1 of the Notes to Condensed Consolidated Financial Statements for a reconciliation of the tax provision at the U.S. Federal Statutory rate to the provision for income taxes.

See the segment sections of MD&A for a discussion on their respective performances.

 

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OUTLOOKS

The Hartford provides projections and other forward-looking information in the following discussions, which contain many forward-looking statements, particularly relating to the Company’s future financial performance. These forward-looking statements are estimates based on information currently available to the Company, are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and are subject to the precautionary statements set forth on pages 3-4 of this Form 10-Q. Actual results are likely to differ, and in the past have differed, materially from those forecast by the Company, depending on the outcome of various factors, including, but not limited to, those set forth in each discussion below and in Part I, Item 1A, Risk Factors in The Hartford’s 2011 Form 10-K Annual Report.

Overview

In the first quarter of 2012, The Hartford concluded an evaluation of its strategy and business portfolio deciding to focus on its property and casualty and group benefits businesses of the Commercial Markets and Consumer Markets divisions, and the mutual funds business of the Wealth Management division. This focus is expected to position the organization for higher returns on equity, reduced sensitivity to capital markets, a lower cost of capital and increased financial flexibility. As a result, in the second quarter of 2012, the Company placed its existing Individual Annuity business into runoff and will pursue sales or other strategic alternatives for the Individual Life and Retirement Plans businesses and Woodbury Financial Services, an indirect wholly-owned subsidiary. In addition, the Company entered into an agreement to sell its individual annuity new business capabilities to a third party. Effective May 1, 2012, all new annuity policies sold by the Company will be reinsured to a third party. The Company will cease the sale of annuity policies and the reinsurance agreement will terminate as to new business in the second quarter of 2013. The reinsurance agreement has no impact on in-force policies issued on or before April 27, 2012.

The performance of The Hartford’s insurance protection and asset accumulation businesses may be adversely impacted due to slow economic and employment expansion where customers may change their levels of insurance and/or savings based on anticipated economic conditions. In addition, the performance of The Hartford’s divisions is subject to uncertainty due to capital market conditions, which impact the earnings of its asset management businesses and valuations and earnings in its investment portfolio. The current and future interest rate environment also affects the performance of the Company’s divisions. A sustained low interest rate environment would result in lower net investment income, lower estimated gross profits on certain Wealth Management products, lower margins and increased pension expense.

Commercial Markets

Commercial Markets focuses on growth through market-differentiated products and services while maintaining a disciplined underwriting approach. In Property & Casualty Commercial, improving market conditions are expected to continue, which should enable the Company to achieve price increases, while a slowly recovering economy is anticipated to drive an increase in insurance exposures. As such, written premium increased 3% in the first quarter of 2012 and the Company expects low to mid single-digit written premium growth for the full year. This growth reflects the combination of our current market position, a broadening of underwriting expertise focused on selected industries, a leveraging of the payroll model, and numerous initiatives launched in the past several years. More specifically, this growth is anticipated to be driven by continued momentum in small commercial, including programs aimed at growing total policy counts, the rollout of new product enhancements and the continued expansion of ease of doing business technology, while management expects middle market and specialty growth to be tempered as a result of pricing actions taken to restore returns to adequate levels. The Property & Casualty Commercial combined ratio before catastrophes and prior accident year development is expected to remain in the mid to upper 90s for full year 2012 as compared to the 97.3% achieved in 2011. Earned price increases are expected to flow through the book, while loss costs are not expected to change dramatically. In Group Benefits, premiums declined in the first quarter of 2012 and are expected to decline for the full year, as compared to 2011, reflecting the competitive environment coupled with pricing actions implemented with the goal of improving profitability. Over time, 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 expand. The Company believes that this combined with the significant number of employees who currently do not have coverage or adequate levels of coverage, creates continued opportunities for our products and services. The Company expects Group Benefits’ loss ratio to remain elevated for full year 2012 given the expectation of persistent heightened disability incidence, lower claim terminations and higher severity.

 

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Consumer Markets

The Company expects written premium to decline for full year 2012, as compared to 2011, including a decrease in AARP direct and in business sold through independent agents other than to AARP members. Despite an improvement in policy retention in the first quarter of 2012 and an expected further increase in new business in 2012, management expects that non-renewed premium will exceed new business in 2012 resulting in an overall decline in written premium. In 2012, management expects it will sustain its improvement in policy retention but that retention will continue to be affected by the impact of renewal written pricing increases in a price sensitive market. Within the Agency channel, policy retention will also be affected by continued pricing and underwriting actions to improve profitability, including efforts to reposition the book into more mature, preferred market business. The Company expects new business to continue to increase in 2012, primarily driven by AARP member business, both direct and through independent agents, as well as new business from affinities other than AARP and other targeted consumer direct marketing. New business is expected to benefit from the recent rollouts of the Open Road Advantage and the Hartford Home Advantage products. Management expects that the combined ratio before catastrophes and prior accident year development will be flat to slightly lower for full year 2012, as compared to the 91.9% achieved in 2011, as an improvement in the current accident year loss and loss adjustment expense ratio before catastrophes will be largely offset by an expected increase in the underwriting expense ratio. For both auto and home, the current accident year loss and loss adjustment expense ratio before catastrophes is expected to improve during 2012, driven by earned pricing increases and lower claim frequency, partially offset by an expected increase in average claim severity. While management expects that industry non-catastrophe claim frequency will be relatively flat to slightly increasing throughout 2012, management expects The Hartford will have slightly lower claim frequency given its continued shift to a more preferred book of business.

Wealth Management

In light of The Hartford’s strategic review, Wealth Management currently focuses on growing the Mutual Fund business and pursuing sales or other strategic alternatives for Individual Life and Retirement Plans. During April 2012, the Company entered into an agreement to sell the individual annuity new business capabilities to a third party and placed this business into runoff. Effective May 1, 2012, all new annuity policies will be fully reinsured to the third party. This reinsurance agreement will remain in place through the close of the transaction which is expected to be mid 2013. The Hartford will continue to manage, service and meet all obligations under existing annuity contracts. Our focus is on mitigating and isolating the risks of the in-force annuities. Our Mutual Fund business has been offering new funds to improve our participation in asset classes where we see potential growth opportunities. In addition, the Company has partnered with Wellington Management Company, LLP (“Wellington Management”) to serve as the sole sub-advisor for The Hartford’s non-proprietary mutual funds and certain proprietary fixed income funds. Due to the Company’s recent announcement and certain actions taken by ratings agencies, we expect a decline in Individual Life sales for the full year, as compared to 2011, and certain distributers have suspended sales of our products. Retirement Plans is focused on customer retention as well as preserving the value of the business. The Hartford seeks to maximize the business value of its Individual Life and Retirement Plans businesses and its Woodbury financial Services Broker-Dealer as we pursue sales or other strategic alternatives for these businesses.

Runoff Operations

The Runoff Operations division consists of Life Other Operations and Property & Casualty Other Operations. The objective of the Runoff Operations division is to focus on managing profitability, improving capital efficiency and effectiveness, and limiting and managing risk associated with the businesses residing in the division with the ultimate objective of isolating or separating these risks from the ongoing businesses of the Company. Life Other Operations consists of the Hartford’s international variable annuity business, institutional annuities business and Private Placement Life Insurance business. The international variable annuity business within Life Other Operations will continue to be a significant driver of earnings variability as a result of the hedge program associated with the Company’s international annuities. This hedge program generates mark to market gains and losses while the underlying liabilities being hedged are primarily not marked to market resulting in unpredictable earnings volatility period to period. Property & Casualty Other Operations is focused on managing our asbestos, environmental and other legacy liabilities. The results of the annual ground up studies of asbestos and environmental reserves will be the primary driver impacting the results for this segment.

 

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CRITICAL ACCOUNTING ESTIMATES

The preparation of financial statements, in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”), requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ, and in the past have differed, from those estimates.

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 insurance product reserves, net of reinsurance;

 

 

estimated gross profits used in the valuation and amortization of assets and liabilities associated with variable annuity and other universal life-type contracts;

 

 

evaluation of other-than-temporary impairments on available-for-sale securities and valuation allowances on investments;

 

 

living benefits required to be fair valued (in other policyholder funds and benefits payable);

 

 

goodwill impairment;

 

 

valuation of investments and derivative instruments;

 

 

pension and other postretirement benefit obligations;

 

 

valuation allowance on deferred tax assets; and

 

 

contingencies relating to corporate litigation and regulatory matters.

Certain of these estimates are particularly sensitive to market conditions, and deterioration and/or volatility in the worldwide debt or equity markets could have a material impact on the Consolidated Financial Statements. 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.

 

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Property and Casualty Insurance Product Reserves, Net of Reinsurance

Based on the results of the quarterly reserve review process, the Company determines the appropriate reserve adjustments, if any, to record. Recorded reserve estimates are changed after consideration of numerous factors, including but not limited to, the magnitude of the difference between the actuarial indication and the recorded reserves, improvement or deterioration of actuarial indications in the period, the maturity of the accident year, trends observed over the recent past and the level of volatility within a particular line of business. In general, adjustments are made more quickly to more mature accident years and less volatile lines of business. Such adjustments of reserves 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.

Reserve Roll Forwards and Development

A roll-forward follows of property and casualty insurance product liabilities for unpaid losses and loss adjustment expenses for the three months ended March 31, 2012:

 

Three Months Ended March 31, 2012

 
     Property &
Casualty
Commercial
    Consumer
Markets
    Property &
Casualty
Other
Operations
    Total
Property and
Casualty
Insurance
 

Beginning liabilities for unpaid losses and loss adjustment expenses, gross

   $
 
 
15,437
  
  
  $
 
 
2,061
  
  
  $
 
 
4,052
  
  
  $
 
 
21,550
  
  

Reinsurance and other recoverables

     2,343        9        681        3,033   
  

 

 

   

 

 

   

 

 

   

 

 

 

Beginning liabilities for unpaid losses and loss adjustment expenses, net

     13,094        2,052        3,371        18,517   
  

 

 

   

 

 

   

 

 

   

 

 

 

Provision for unpaid losses and loss adjustment expenses

        

Current accident year before catastrophes

     1,027        574        —          1,601   

Current accident year catastrophes

     32        39        —          71   

Prior accident years

     20        (55     6        (29
  

 

 

   

 

 

   

 

 

   

 

 

 

Total provision for unpaid losses and loss adjustment expenses

     1,079        558        6        1,643   

Payments

     (1,031     (656     (104     (1,791
  

 

 

   

 

 

   

 

 

   

 

 

 

Ending liabilities for unpaid losses and loss adjustment expenses, net

     13,142        1,954        3,273        18,369   

Reinsurance and other recoverables

     2,366        8        681        3,055   
  

 

 

   

 

 

   

 

 

   

 

 

 

Ending liabilities for unpaid losses and loss adjustment expenses, gross

   $ 15,508      $ 1,962      $ 3,954      $ 21,424   
  

 

 

   

 

 

   

 

 

   

 

 

 

Earned premiums

   $ 1,557      $ 909       

Loss and loss expense paid ratio [1]

     66.2        72.2       

Loss and loss expense incurred ratio

     69.3        61.4       

Prior accident years development (pts) [2]

     1.3        (6.1    
  

 

 

   

 

 

     

 

[1] The “loss and loss expense paid ratio” represents the ratio of paid losses and loss adjustment expenses to earned premiums.
[2] “Prior accident years development (pts)” represents the ratio of prior accident years development to earned premiums.

 

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Prior accident years development recorded in 2012

Included within prior accident years development for the three months ended March 31, 2012 were the following reserve strengthenings (releases):

 

Three Months Ended March 31, 2012

 
     Property &
Casualty
Commercial
    Consumer
Markets
    Property &
Casualty
Other
Operations
     Total Property and
Casualty Insurance
 

Auto liability

   $ 12      $ (30   $ —         $ (18

Homeowners

     —          (5     —           (5

Professional liability

     9        —          —           9   

Package business

     (16     —          —           (16

Workers’ compensation

     8        —          —           8   

General liability

     (16     —          —           (16

Fidelity and surety

     1        —          —           1   

Commercial property

     (10     —          —           (10

Net environmental reserves

     —          —          5         5   

Change in workers’ compensation discount, including accretion

     29        —          —           29   

Catastrophes

     3        (14     —           (11

Other reserve re-estimates, net

     —          (6     1         (5
  

 

 

   

 

 

   

 

 

    

 

 

 

Total prior accident years development

   $ 20      $ (55   $ 6       $ (29
  

 

 

   

 

 

   

 

 

    

 

 

 

During the three months ended March 31, 2012, the Company’s re-estimates of prior accident years reserves included the following significant reserve changes:

 

 

Released reserves for personal auto liability claims, primarily for accident years 2008 through 2010. As these accident years matured, favorable bodily injury severity trends were observed and management has placed more weight on the emerged experience.

 

 

Strengthened reserves for commercial auto liability claims, primarily for accident year 2011. Higher than expected bodily injury severity has been observed for this accident year.

 

 

Released reserves in package business liability coverages and general liability, primarily for accident years 2006 through 2010. Claim severity emergence for these years was lower than expected and management has placed more weight on the emerged experience.

 

 

Released reserves in commercial property for accident year 2011. Loss emergence for this accident year was favorable to expectations.

 

 

The change in workers’ compensation discount, including accretion, primarily reflects a decrease in the number of tabular claims, and to a lesser extent, the decrease in interest rates.

 

 

Refer to the Property & Casualty Other Operations Claims section for further discussion on net asbestos and net environmental reserves.

 

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A roll forward follows of property and casualty insurance product liabilities for unpaid losses and loss adjustment expenses for the three months ended March 31, 2011:

 

Three Months Ended March 31, 2011

 
     Property &
Casualty
Commercial
    Consumer
Markets
    Property &
Casualty
Other
Operations
    Total
Property and
Casualty
Insurance
 

Beginning liabilities for unpaid losses and loss adjustment expenses, gross

   $  14,727      $  2,177      $  4,121      $  21,025   

Reinsurance and other recoverables

     2,361        17        699        3,077   
  

 

 

   

 

 

   

 

 

   

 

 

 

Beginning liabilities for unpaid losses and loss adjustment expenses, net

     12,366        2,160        3,422        17,948   
  

 

 

   

 

 

   

 

 

   

 

 

 

Provision for unpaid losses and loss adjustment expenses

        

Current accident year before catastrophes

     962        616        —          1,578   

Current accident year catastrophes

     46        32        —          78   

Prior accident years

     (6     (49     4        (51
  

 

 

   

 

 

   

 

 

   

 

 

 

Total provision for unpaid losses and loss adjustment expenses

     1,002        599        4        1,605   

Payments

     (887     (709     (117     (1,713
  

 

 

   

 

 

   

 

 

   

 

 

 

Ending liabilities for unpaid losses and loss adjustment expenses, net

     12,481        2,050        3,309        17,840   

Reinsurance and other recoverables

     2,350        8        655        3,013   
  

 

 

   

 

 

   

 

 

   

 

 

 

Ending liabilities for unpaid losses and loss adjustment expenses, gross

   $ 14,831      $ 2,058      $ 3,964      $ 20,853   
  

 

 

   

 

 

   

 

 

   

 

 

 

Earned premiums

   $ 1,498      $ 956       

Loss and loss expense paid ratio [1]

     59.2        74.2       

Loss and loss expense incurred ratio

     66.9        62.6       

Prior accident years development (pts) [2]

     (0.4     (5.1    
  

 

 

   

 

 

     

 

[1] The “loss and loss expense paid ratio” represents the ratio of paid losses and loss adjustment expenses to earned premiums.
[2] “Prior accident years development (pts)” represents the ratio of prior accident years development to earned premiums.

Prior accident years development recorded in 2011

Included within prior accident years development for the three months ended March 31, 2011 were the following reserve strengthenings (releases):

 

Three Months Ended March 31, 2011

 
     Property & Casualty
Commercial
    Consumer
Markets
    Property &
Casualty
Other
Operations
     Total Property and
Casualty Insurance
 

Auto liability

   $ (1   $ (55   $ —         $ (56

Professional liability

     (9     —          —           (9

General liability

     6        —          —           6   

Commercial property

     2        —          —           2   

Package business

     (7     —          —           (7

Workers’ compensation

     (1     —          —           (1

Net environmental reserves

     —          —          2         2   

Homeowners

     —          (14     —           (14

Change in workers’ compensation discount, including accretion

     7        —          —           7   

Catastrophes

     (5     19        —           14   

Other reserve re-estimates, net

     2        1        2         5   
  

 

 

   

 

 

   

 

 

    

 

 

 

Total prior accident years development

   $ (6     (49     4         (51
  

 

 

   

 

 

   

 

 

    

 

 

 

During the three months ended March 31, 2011, the Company’s re-estimates of prior accident years reserves included the following significant reserve changes:

 

 

Released reserves for personal auto liability claims. Favorable trends in reported severity have persisted, primarily for accident years 2005 through 2010. As these accident years developed, the uncertainty around the ultimate losses is reduced and management places more weight on the emerged experience.

 

 

Favorable emergence of homeowners’ losses is primarily for accident years 2009 and 2010. This is partially driven by an increase in the speed at which claims are being settled, a trend that is expected to continue as these accident years develop.

 

 

Prior year catastrophes primarily relates to a severe wind and hail storm event in Arizona during the fourth quarter of 2010.

 

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Property & Casualty Other Operations Claims

Reserve Activity

Reserves and reserve activity in Property & Casualty Other Operations 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.

The following table presents reserve activity, inclusive of estimates for both reported and incurred but not reported claims, net of reinsurance, categorized by asbestos, environmental and all other claims, for the three months ended March 31, 2012.

Property & Casualty Other Operations Losses and Loss Adjustment Expenses

 

For the Three Months Ended March 31, 2012

   Asbestos     Environmental     All Other [1]     Total  

Beginning liability—net [2][3]

   $ 1,892      $ 320      $ 1,159      $ 3,371   

Losses and loss adjustment expenses incurred

     —          5        1        6   

Losses and loss adjustment expenses paid

     (52     (14     (37     (103
  

 

 

   

 

 

   

 

 

   

 

 

 

Ending liability – net [2][3]

   $ 1,840  [4]    $ 311      $ 1,123      $ 3,274   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

[1] “All Other” includes unallocated loss adjustment expense reserves. “All Other” also includes The Company’s allowance for uncollectible reinsurance. When the Company commutes a ceded reinsurance contract or settles a ceded reinsurance dispute, the portion of the allowance for uncollectible reinsurance attributable to that commutation or settlement, if any, is reclassified to the appropriate cause of loss.
[2] Excludes amounts reported in Property & Casualty Commercial and Consumer Markets reporting segments (collectively “Ongoing Operations”) for asbestos and environmental net liabilities of $15 and $8, respectively, as of March 31, 2012 and $15 and $8, respectively, as of December 31, 2011; total net losses and loss adjustment expenses incurred for the three months ended March 31, 2012 includes $3 related to asbestos and environmental claims; and total net losses and loss adjustment expenses paid for the three months ended March 31, 2012 includes $3 related to asbestos and environmental claims.
[3] Gross of reinsurance, asbestos and environmental reserves, including liabilities in Ongoing Operations, were $2,388 and $357, respectively, as of March 31, 2012 and $2,442 and $367, respectively, as of December 31, 2011.
[4] The one year and average three year net paid amounts for asbestos claims, including Ongoing Operations, are $193 and $234, respectively, resulting in a one year net survival ratio of 9.6 and a three year net survival ratio of 7.9. Net survival ratio is the quotient of the net carried reserves divided by the average annual payment amount and is an indication of the number of years that the net carried reserve would last (i.e. survive) if the future annual claim payments were consistent with the calculated historical average.

For paid and incurred losses and loss adjustment expenses reporting, the Company classifies its asbestos and environmental reserves into three categories: Direct, Assumed Reinsurance and London Market. Direct insurance includes primary and excess coverage. Assumed reinsurance includes both “treaty” reinsurance (covering broad categories of claims or blocks of business) and “facultative” reinsurance (covering specific risks or individual policies of primary or excess insurance companies). London Market business includes the business written by one or more of the Company’s subsidiaries in the United Kingdom, which are no longer active in the insurance or reinsurance business. Such business includes both direct insurance and assumed reinsurance.

Of the three categories of claims (Direct, Assumed Reinsurance and London Market), direct policies tend to have the greatest factual development from which to estimate the Company’s exposures.

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.

London Market exposures are the most uncertain of the three categories of claims. As a participant in the London Market (comprised of both Lloyd’s of London and London Market companies), certain subsidiaries of the Company wrote business on a subscription basis, with those subsidiaries’ involvement being limited to a relatively small percentage of a total contract placement. Claims are reported, via a broker, to the “lead” underwriter and, once agreed to, are presented to the following markets for concurrence. This reporting and claim agreement process makes estimating liabilities for this business the most uncertain of the three categories of claims.

 

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The following table sets forth, for the three months ended March 31, 2012, 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 Environmental

 

     Asbestos [1]      Environmental [1]  

Three Months Ended March 31, 2012

   Paid
Losses &  LAE
    Incurred
Losses &  LAE
     Paid
Losses &  LAE
    Incurred
Losses &  LAE
 

Gross

         

Direct

   $ 38      $ —         $ 14      $ 5   

Assumed Reinsurance

     12        —           —          —     

London Market

     4        —           1        —     
  

 

 

   

 

 

    

 

 

   

 

 

 

Total

     54        —           15        5   

Ceded

     (2     —           (1     —     
  

 

 

   

 

 

    

 

 

   

 

 

 

Net

   $ 52      $ —         $ 14      $ 5   
  

 

 

   

 

 

    

 

 

   

 

 

 

 

[1] Excludes asbestos and environmental paid and incurred loss and LAE reported in Ongoing Operations. Total gross losses and LAE incurred in Ongoing Operations for the three months ended March 31, 2012 includes $4 related to asbestos and environmental claims. Total gross losses and LAE paid in Ongoing Operations for the three months ended March 31, 2012 includes $4 related to asbestos and environmental claims.

Uncertainties Regarding Adequacy of Asbestos and Environmental Reserves

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 March 31, 2012 of $2.17 billion ($1.86 billion and $319 for asbestos and environmental, respectively) is within an estimated range, unadjusted for covariance, of $1.69 billion to $2.52 billion. The process of estimating asbestos and environmental reserves remains subject to a wide variety of uncertainties, which are detailed in the Company’s 2011 Form 10-K Annual Report. The Company believes that its current asbestos and environmental reserves are appropriate. However, analyses of future 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.

Consistent with the Company’s long-standing reserve practices, the Company will continue to review and monitor its reserves in Property & Casualty Other Operations regularly, including its annual reviews of asbestos liabilities, reinsurance recoverables and the allowance for uncollectible reinsurance, and environmental liabilities, and where future developments indicate, make appropriate adjustments to the reserves. The company will complete its annual ground-up asbestos and environmental reserve studies during the second quarter of 2012. For a discussion of the Company’s reserving practices, see the Critical Accounting Estimates — Property and Casualty Insurance Product Reserves, Net of Reinsurance section of the MD&A included in the Company’s 2011 Form 10-K Annual Report.

 

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Estimated Gross Profits Used in the Valuation and Amortization of Assets and Liabilities Associated with Variable Annuity and Other Universal Life-Type Contracts

Estimated gross profits (“EGPs”) are used in the amortization of the DAC asset, which includes the present value of future profits; sales inducement assets (“SIA”); and unearned revenue reserves (“URR”). See Note 1 and Note 6 of the Notes to Condensed Consolidated Financial Statements for additional information on DAC. See Note 8 of the Notes to Condensed Consolidated Financial Statements for additional information on SIA. Portions of EGPs are also used in the valuation of reserves for death and other insurance benefit features on variable annuity and universal life-type contracts. See Note 7 of the Notes to Condensed Consolidated Financial Statements for additional information on death and other insurance benefit reserves.

The most significant EGP based balances as of March 31, 2012 and 2011 are as follows:

 

     Individual Annuity      Individual Life      Retirement Plans      Life Other Operations  
     2012      2011      2012      2011      2012      2011      2012      2011  

DAC

   $ 2,403       $ 2,784       $ 2,034       $ 2,085       $ 313       $ 388       $ 1,200       $ 1,558   

SIA

   $ 289       $ 325       $ 47       $ 46       $ 21       $ 24       $ 52       $ 42   

URR

   $ 89       $ 100       $ 1,621       $ 1,427       $ —         $ —         $ 30       $ 53   

Death and Other Insurance Benefit Reserves

   $ 976       $ 1,003       $ 263       $ 126       $ —         $ 1       $ 755       $ 656   

Unlocks

The after-tax (charge) benefit to net income (loss) by asset and liability as a result of the Unlocks for the three months ended March 31, 2012 and 2011 are as follows:

 

     Individual
Annuity
    Individual Life     Retirement Plans      Life Other
Operations
    Total  
     2012     2011     2012     2011     2012      2011      2012      2011     2012     2011  

DAC

   $ 49      $ 26      $ (1   $ (1   $ 7       $ 2       $ 26       $ (1   $ 81      $ 26   

SIA

     3        16        —          —          —           —           —           14        3        30   

URR

     (1     2        —          —          —           —           —           —          (1     2   

Death and Other Insurance Benefit Reserves

     39        (1     (7     —          —           —           99         —          131        (1
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Total

   $ 90      $ 43      $ (8   $ (1   $ 7       $ 2       $ 125       $ 13      $ 214      $ 57   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

The Unlock benefit for the first quarter of 2012 and 2011 was driven by actual separate account returns being above our aggregated estimated returns.

An Unlock revises EGPs, on a quarterly basis, to reflect market updates of policyholder account value and the Company’s current best estimate assumptions. Modifications to the Company’s hedging programs may impact EGPs, and correspondingly impact DAC recoverability. After each quarterly Unlock, the Company also tests the aggregate recoverability of DAC by comparing the DAC balance to the present value of future EGPs. The margin between the DAC balance and the present value of future EGPs for U.S. and Japan individual variable annuities was 36% and 43%, respectively, as of March 31, 2012. If the margin between the DAC asset and the present value of future EGPs is exhausted, then further reductions in EGPs would cause portions of DAC to be unrecoverable and the DAC asset would be written down to equal future EGPs.

The Company expects to complete a comprehensive non-market related policyholder behavior assumption study in the third quarter of 2012 and incorporate the results of the study into its projections of future gross profits. All assumptions changes are considered an Unlock in the period of revision.

 

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Goodwill Impairment

The carrying value of goodwill allocated to reporting units as of March 31, 2012 and December 31, 2011 is as follows:

 

     Segment
Goodwill
     Goodwill  in
Corporate
     Total  

Group Benefits

   $ —         $ 138       $ 138   

Consumer Markets

     119         —           119   

Individual Life

     224         118         342   

Retirement Plans

     87         69         156   

Mutual Funds

     159         92         251   
  

 

 

    

 

 

    

 

 

 

Total

   $ 589       $ 417       $ 1,006   
  

 

 

    

 

 

    

 

 

 

During the first quarter of 2012, the Company determined that a triggering event requiring an impairment assessment had occurred as a result of its decision to pursue sales or other strategic alternatives for the Individual Life and Retirement Plans reporting units. The Company completed an interim goodwill impairment test during the first quarter of 2012 for these two reporting units which resulted in no impairment of goodwill. Retirement Plans passed the first step of the interim goodwill impairment test with a significant margin. Individual Life passed the first step of the interim goodwill impairment test with a margin of less than 10% between the fair value and book value of the reporting unit as of February 29, 2012. The Company will continue to monitor the impact to fair value from certain assumptions such as product sales and lapse rates which may be more sensitive following the announcement of its decision and from information developed through the effort to market the reporting units.

The fair value of the Individual Life reporting unit is based on discounted cash flows using earnings projections on in force business and product sales. There could be a positive or negative impact on the result of step one in future periods if assumptions change about the level of economic capital, product sales, earnings projections or the weighted average cost of capital.

 

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THE HARTFORD’S OPERATIONS OVERVIEW

The Hartford is a financial holding company for a group of subsidiaries that provide property and casualty and life insurance and investment products to both individual and business customers in the United States and continues to administer business previously sold in Japan and the U.K.

The Company conducts business in four divisions, Commercial Markets, Consumer Markets, Wealth Management and Runoff Operations, each containing reporting segments. The Commercial Markets division consists of the reporting segments of Property & Casualty Commercial and Group Benefits. The Consumer Markets division is also the reporting segment. The Wealth Management division consists of the following reporting segments: Individual Annuity, Individual Life, Retirement Plans and Mutual Funds. The Runoff division consists of Life Other Operations and Property & Casualty Other Operations. For additional discussion regarding The Hartford’s reporting segments, see Note 3 of the Notes to Condensed Consolidated Financial Statements.

KEY PERFORMANCE MEASURES AND RATIOS

The Company considers several measures and ratios to be the key performance indicators for its businesses. The following discussions include the more significant ratios and measures of profitability for the three months ended March 31, 2012 and 2011. Management believes that these ratios and measures are useful in understanding the underlying trends in The Hartford’s businesses. However, these key performance indicators should only be used in conjunction with, and not in lieu of, the results presented in the segment discussions that follow in this MD&A. These ratios and measures may not be comparable to other performance measures used by the Company’s competitors. For additional information on key performance measures and ratios, see Definitions of Non-GAAP and other measures and ratios within MD&A of The Hartford’s 2011 Form 10-K Annual Report.

Definitions of Non-GAAP and other measures and ratios

Account Value

Account value includes policyholders’ balances for investment contracts and reserves for future policy benefits for insurance contracts.

After-tax Margin, Core Earnings excluding Unlock

After-tax margin, core earnings excluding Unlock, is a non-GAAP financial measure that the Company uses to evaluate, and believes is an important measure of, certain of the segment’s operating performance. After-tax margin, core earnings excluding Unlock is calculated by dividing core earnings excluding Unlocks by total core revenues excluding Unlocks. After-tax margin is the most directly comparable U.S. GAAP measure. A reconciliation of after-tax margin to after-tax margin, core earnings excluding Unlock, for the three months ended March 31, 2012 and 2011 is set forth in the After-tax Margin section within Key Performance Measures and Ratios.

Assets Under Management

Assets under management (“AUM”) include account values and mutual fund assets.

Catastrophe ratio

The catastrophe ratio (a component of the loss and loss adjustment expense ratio) represents the ratio of catastrophe losses incurred in the current calendar year (net of reinsurance) to earned premiums and includes catastrophe losses incurred for both the current and prior accident years. A catastrophe is an event that causes $25 or more in industry insured property losses and affects a significant number of property and casualty policyholders and insurers. The catastrophe ratio includes the effect of catastrophe losses, but does not include the effect of reinstatement premiums.

Combined ratio

The combined ratio is the sum of the loss and loss adjustment expense ratio, the expense ratio and the policyholder dividend ratio. This ratio is a relative measurement that describes the related cost of losses and expenses for every $100 of earned premiums. A combined ratio below 100.0 demonstrates underwriting profit; a combined ratio above 100.0 demonstrates underwriting losses.

Combined ratio before catastrophes and prior accident year development

The combined ratio before catastrophes and prior accident year development, a non-GAAP financial measure, represents the combined ratio for the current accident year, excluding the impact of catastrophes. Combined ratio is the most directly comparable U.S.GAAP measure. A reconciliation of combined ratio to combined ratio before prior accident year reserve development for the three months ended March 31, 2012 and 2011 is set forth in the Combined ratio before catastrophes and prior year development section within Key Performance Measures and Ratios.

 

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Core Earnings

Core earnings, a non-GAAP measure is an important measure of the Company’s operating performance. Core earnings excludes the effect of realized gains and losses (net of tax and the effects of deferred policy acquisition costs (“DAC”)) and discontinued operations. The Hartford believes, however, that some realized capital gains and losses are integrally related to the insurance operations, so core earnings includes net realized gains and losses such as net periodic settlements on credit derivatives and net periodic settlements on the Japan fixed annuity cross-currency swap. These net realized gains and losses are directly related to an offsetting item included in the income statement such as net investment income. Net income is the most directly comparable U.S. GAAP measure. A reconciliation of net income to core earnings for the three months ended March 31, 2012 and 2011 is set forth below.

 

     Three Months Ended
March 31,
 
     2012     2011  

Net income

   $ 96      $ 501   

Less: Income (loss) from discontinued operations, net of tax

     (1     162   

Less: Net realized capital gains (losses), net of tax and DAC, excluded from core earnings

     (515     (235
  

 

 

   

 

 

 

Core earnings

   $ 612      $ 574   
  

 

 

   

 

 

 

DAC amortization ratio, Core Earnings excluding Unlock

DAC amortization ratio, core earnings excluding Unlock, is a non-GAAP financial measure that the Company uses to evaluate, and believes is an important measure of, certain of the segment’s operating performance. DAC amortization ratio, core earnings excluding Unlock is calculated by dividing Core DAC amortization costs by pre-tax core earnings before DAC amortization costs. DAC amortization ratio is the most directly comparable U.S. GAAP measure. A reconciliation of DAC amortization ratio to DAC amortization ratio, core earnings excluding Unlock for the three months ended March 31, 2012 and 2011 is set forth in the Individual Annuity operating summary within MD&A.

Mutual Fund Assets

Mutual fund assets include retail, investment-only and college savings plan assets under Section 529 of the Code, collectively referred to as non-proprietary, and proprietary mutual funds. Non-proprietary mutual fund assets are owned by the shareholders of those funds and not by the Company. Proprietary mutual funds include mutual funds sponsored by the Company which are owned by the separate accounts of the Company to support insurance and investment products sold by the Company. The non-proprietary mutual fund assets are not reflected in the Company’s consolidated financial statements.

Net Investment Spread

Management evaluates performance of certain products based on net investment spread. These products include those that have insignificant mortality risk, such as fixed annuities, certain general account universal life contracts and certain institutional contracts. Net investment spread is determined by taking the difference between the annualized earned rate, (excluding the effects of realized capital gains and losses, including those related to the Company’s GMWB product and related reinsurance and hedging programs), and the related annualized crediting rates on average general account assets under management. Some realized capital gains and losses are primarily driven by investment decisions and external economic developments, the nature and timing of which are unrelated to insurance aspects of our businesses. Accordingly, net investment spread excludes the effect of all realized gains and losses that tend to be highly variable from period to period based on capital market conditions. The Hartford believes, however, that some realized capital gains and losses are integrally related to our insurance operations and they are included in the net investment spread calculation.

Return on Assets (“ROA”), Core Earnings excluding Unlock

ROA, core earnings excluding Unlock, is a non-GAAP financial measure that the Company uses to evaluate, and believes is an important measure of, certain of the segment’s operating performance. ROA is the most directly comparable U.S. GAAP measure. A reconciliation of ROA to ROA, core earnings excluding Unlock for the three months ended March 31, 2012 and 2011 is set forth in the ROA section within Key Performance Measures and Ratios.

Underwriting results

Underwriting results is a before-tax measure that represents earned premiums less incurred losses, loss adjustment expenses, underwriting expenses and policyholder dividends. Net Income is the most directly comparable U.S. GAAP measure. A reconciliation of underwriting results to net income for Property & Casualty Commercial and Consumer Markets is set forth in their respective operating summaries within MD&A.

Written and earned premiums

Written premium is a statutory accounting financial measure which represents the amount of premiums charged for policies issued, net of reinsurance, during a fiscal period. Earned premium is a U.S. GAAP and statutory measure. The difference between written and earned premium is the change in unearned premium reserve.

 

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Combined ratio before catastrophes and prior year development

Combined ratio before catastrophes and prior accident year development is a key indicator of overall profitability for the property and casualty underwriting segments of Property & Casualty Commercial and Consumer Markets since it removes the impact of volatile and unpredictable catastrophe losses and prior accident year reserve development.

 

     Three Months Ended
March  31,
 
     2012     2011  

Property & Casualty Commercial

    

Combined ratio

     99.7        97.9   

Catastrophe ratio

     2.2        2.7   

Non-catastrophe prior year development

     1.1        (0.1
  

 

 

   

 

 

 

Combined ratio before catastrophes and prior year development

     96.4        95.3   
  

 

 

   

 

 

 

Consumer Markets

    

Combined ratio

     87.0        87.3   

Catastrophe ratio

     2.8        5.4   

Non-catastrophe prior year development

     (4.5     (7.1
  

 

 

   

 

 

 

Combined ratio before catastrophes and prior year development

     88.8        89.0   
  

 

 

   

 

 

 

Three months ended March 31, 2012 compared to the three months ended March 31, 2011

 

   

Property & Casualty Commercial’s combined ratio before catastrophes and prior year development deteriorated primarily due to an increase in current accident year losses and loss adjustment expenses ratio before catastrophes. The ratio increased in workers’ compensation primarily due to increased estimates of claim frequency, partially offset by moderating severity trends and earned pricing increases.

 

   

Consumer Markets combined ratio before catastrophes and prior year development improved primarily due to a lower ratio of current accident year losses and loss adjustment expenses before catastrophes for home, driven by earned pricing increases and a decrease in the frequency of non-catastrophe weather claims, largely offset by an increase in the expense ratio.

 

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Return on Assets

Return on assets is a key indicator of overall profitability for the Individual Annuity, Retirement Plans, Mutual Funds and Life Other Operations reporting segments as a significant portion of their earnings is based on average assets under management.

 

      Three Months Ended
March  31,
 

Ratios

   2012      2011  

Individual Annuity

     

ROA

     96.5   bps         60.1   bps   

Effect of Unlock on ROA

     42.9   bps         18.1   bps   

Effect of net realized gains (losses), net of tax and DAC on ROA

     6.8   bps         (3.4) bps   
  

 

 

    

 

 

 

ROA, core earnings excluding Unlock

     46.8   bps         45.4   bps   
  

 

 

    

 

 

 

Retirement Plans

     

ROA

     13.2   bps         3.7   bps   

Effect of Unlock on ROA

     5.8   bps         1.5   bps   

Effect of net realized gains (losses), net of tax and DAC on ROA

     4.4   bps         (4.4) bps   
  

 

 

    

 

 

 

ROA, core earnings excluding Unlock

     3.0   bps         6.6   bps   
  

 

 

    

 

 

 

Mutual Funds

     

ROA

     9.0   bps         11.0   bps   

Effect of net realized gains /(losses), net of tax and DAC on ROA

     —   bps         0.4   bps   
  

 

 

    

 

 

 

ROA, core earnings excluding Unlock

     9.0   bps         10.6   bps   
  

 

 

    

 

 

 

Life Other Operations

     

ROA

     (179.7) bps         (30.4) bps   

Effect of Unlock on ROA

     46.2   bps         5.7   bps   

Effect of net realized gains (losses), net of tax and DAC on ROA

     (263.6) bps         (73.0) bps   
  

 

 

    

 

 

 

ROA, core earnings excluding Unlock

     37.7   bps         36.9 bps   
  

 

 

    

 

 

 

Three months ended March 31, 2012 compared to three months ended March 31, 2011

 

 

Individual Annuity ROA, core earnings excluding Unlock, increased in 2012 primarily due to higher net income as a result of lower operating costs and other expenses.

 

 

Retirement Plans ROA, core earnings excluding Unlock, decreased in 2012 primarily due to increased benefits, losses and loss adjustment expenses.

 

 

Mutual Funds ROA, core earnings excluding Unlock, decreased in 2012 primarily due to lower fee income and other driven by lower AUM, compared to March 31, 2011.

 

 

Life Other Operations ROA, core earnings excluding Unlock, increased in 2012 primarily due to lower benefits, losses and loss adjustment expenses as a result of improvements in equity markets.

 

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After-tax margin

After-tax margin is a key indicator of overall profitability for the Individual Life and Group Benefits reporting segments as a significant portion of their earnings are a result of the net margin from losses incurred on earned premiums, fees and other considerations.

 

     Three Months Ended
March  31,
 
     2012     2011  

Individual Life

    

After-tax margin

     5.5     6.2

Effect of Unlock

     (2.3 %)      (0.6 %) 

Effect of net realized losses, net of tax and DAC

     (2.0 %)      (5.0 %) 
  

 

 

   

 

 

 

After-tax margin, core earnings excluding Unlock

     9.8     11.8
  

 

 

   

 

 

 

Group Benefits

    

After-tax margin, excluding buyouts

     1.7     1.0

Effect of net realized gains (losses), net of tax

     1.2     (0.7 %) 
  

 

 

   

 

 

 

After-tax margin, excluding buyouts and realized gains (losses)

     0.5     1.7
  

 

 

   

 

 

 

Three months ended March 31, 2012 compared to the three months ended March 31, 2011

 

 

The decrease in Individual Life after-tax margin, core earnings excluding Unlock, was primarily due to increased claim reserves, as well as lower limited partnership and alternative investment income.

 

 

The decrease in Group Benefits after-tax margin, excluding buyouts and realized gains (losses), was primarily driven by a decrease in fully insured ongoing premiums due to the Company’s pricing actions and a challenging economic environment, as well as higher severity in group disability. The Company continues to experience elevated claims incidence and lower terminations in long-term disability.

 

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Investment Results

Composition of Invested Assets

 

     March 31, 2012     December 31, 2011  
     Amount      Percent     Amount      Percent  

Fixed maturities, AFS, at fair value

   $ 83,157         80.8   $ 81,809         78.3

Fixed maturities, at fair value using the fair value option

     1,291         1.3     1,328         1.3

Equity securities, AFS, at fair value

     938         0.9     921         0.9

Mortgage loans

     6,275         6.1     5,728         5.5

Policy loans, at outstanding balance

     1,970         1.9     2,001         1.9

Limited partnerships and other alternative investments

     2,732         2.7     2,532         2.4

Other investments [1]

     1,259         1.2     2,394         2.3

Short-term investments

     5,256         5.1     7,736         7.4
  

 

 

    

 

 

   

 

 

    

 

 

 

Total investments excluding equity securities, trading

     102,878         100.0     104,449         100.0

Equity securities, trading, at fair value [2]

     30,722           30,499      
  

 

 

      

 

 

    

Total investments

   $ 133,600         $ 134,948      
  

 

 

      

 

 

    

 

[1] Primarily relates to derivative instruments.
[2] As of March 31, 2012 and December 31, 2011, approximately $28.7 billion and $28.5 billion, respectively, of equity securities, trading, support Japan variable annuities. Those equity securities, trading, were invested in mutual funds, which, in turn, invested in the following asset classes, Japan equity 20%, Japan fixed income (primarily government securities) 15%, global equity 21%, global government bonds 42% and cash and other 1% for both periods presented.

Total investments declined since December 31, 2011 primarily due to decreases in short-term and other investments, partially offset by an increase in fixed maturities, AFS and mortgage loans. The decline in short-term investments primarily relates to a decline in derivative collateral due to decreases in derivative market values, as well as increased allocations to mortgage loans and limited partnerships and other alternative investments. The decrease in other investments primarily related to decreases in value of derivatives largely due to an increase in the equity market, depreciation of the Japanese yen in comparison to the U.S. dollar and an increase in interest rates. The increase in fixed maturities, AFS, was largely the result of improved valuations as a result of credit spread tightening, partially offset by rising interest rates. Mortgage loans increased due to the continued funding of commercial whole loans.

Net Investment Income (Loss)

 

     Three Months Ended
March 31,
 
     2012     2011  

(Before-tax)

   Amount     Yield [1]     Amount     Yield [1]  

Fixed maturities [2]

   $ 858        4.2   $ 846        4.2

Equity securities, AFS

     10        3.9     11        4.4

Mortgage loans

     79        5.3     63        5.4

Policy loans

     30        6.1     33        6.0

Limited partnerships and other alternative investments

     52        8.0     100        21.0

Other [3]

     69          81     

Investment expense

     (28       (26  
  

 

 

   

 

 

   

 

 

   

 

 

 

Total securities AFS and other

     1,070        4.3     1,108        4.6

Equity securities, trading

     2,866          803     
  

 

 

     

 

 

   

Total net investment income (loss), before-tax

   $ 3,936        $ 1,911     
  

 

 

   

 

 

   

 

 

   

 

 

 

Total securities, AFS and other excluding limited partnerships and other alternative investments

   $ 1,018        4.2   $ 1,008        4.2
  

 

 

   

 

 

   

 

 

   

 

 

 

 

[1] Yields calculated using annualized investment income before investment expenses divided by the monthly average invested assets at cost, amortized cost, or adjusted carrying value, as applicable, excluding consolidated variable interest entity noncontrolling interests. Included in the fixed maturity yield is other, which primarily relates to derivatives (see footnote [3] below). Included in the total net investment income yield is investment expense.
[2] Includes net investment income on short-term investments.
[3] Includes income from derivatives that qualify for hedge accounting and hedge fixed maturities.

Three months ended March 31, 2012 compared to the three months ended March 31, 2011

Total net investment income increased largely due to equity securities, trading, resulting from improved market performance of the underlying investment funds supporting the Japanese variable annuity product. Total net investment income, excluding equity securities, trading, declined due to lower income on limited partnerships and other alternative investments as a result of greater price appreciation experienced in the underlying funds in the prior year period. These declines were partially offset by increased mortgage loan income due to additional investments in commercial whole loans. Based on the current interest rate and credit environment, the Company expects the 2012 portfolio yield, excluding limited partnerships, to be relatively consistent throughout the remainder of 2012.

 

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Net Realized Capital Gains (Losses)

 

     Three Months Ended
March 31,
 

(Before-tax)

   2012     2011  

Gross gains on sales

   $ 259      $ 61   

Gross losses on sales

     (97     (133

Net OTTI losses recognized in earnings

     (29     (55

Valuation allowances on mortgage loans

     1        (3

Japanese fixed annuity contract hedges, net [1]

     (20     (17

Periodic net coupon settlements on credit derivatives/Japan

     (5     (7

Results of variable annuity hedge program

    

U.S. GMWB derivatives, net

     185        56   

U.S. macro hedge program

     (189     (84
  

 

 

   

 

 

 

Total U.S. program

     (4     (28

International program

     (1,219     (319
  

 

 

   

 

 

 

Total results of variable annuity hedge program

     (1,223     (347

Other, net [2]

     204        98   
  

 

 

   

 

 

 

Net realized capital gains (losses), before-tax

   $ (910   $ (403
  

 

 

   

 

 

 

 

[1] Relates to the Japanese fixed annuity product (adjustment of product liability for changes in spot currency exchange rates, related derivative hedging instruments, excluding net period coupon settlements, and Japan FVO securities).
[2] Primarily consists of gains and losses on non-qualifying derivatives and fixed maturities, FVO, Japan 3Win related foreign currency swaps, and other investment gains and losses.

Details on the Company’s net realized capital gains and losses are as follows:

 

Gross gains and     losses on sales   

•      Net gains on sales for the three months ended March 31, 2012 were predominately from investment grade corporate securities, asset backed securities and municipals bonds due to tactical repositioning of the portfolio.

 

•      Net losses on sales for the three months ended March 31, 2011 were predominately from sales of U.S. Treasuries as the Company reinvested in spread product.

Net OTTI losses   

•      For further information, see Other-Than-Temporary Impairments within the Investment Portfolio Risks and Risk Management section of the MD&A.

Variable annuity hedge program   

•      For the three months ended March 31, 2012, the gain on U.S. GMWB related derivatives, net, was primarily due to lower equity and interest rate volatility of $107, favorable policyholder behavior which resulted in a gain of $57, and a general increase in long-term interest rates of $37. The loss on U.S. macro hedge program for the three months ended March 31, 2012 was primarily driven by an increase in the domestic equity market and lower equity market volatility. The loss associated with the international program for the three months ended March 31, 2012 was primarily driven by depreciation of the yen in relation to the euro and the U.S. dollar of approximately ($619), and an improvement in global and domestic equity markets resulting in a loss of approximately ($583).

 

•      The gain on GMWB related derivatives, net, for the three months ended March 31, 2011 was primarily due to lower implied market volatility of $39, and a general increase in long-term rates of $24. The net loss on the macro hedge program was primarily the result of weakening of the Japanese yen, higher equity market valuation and lower implied market volatility.

Other, net   

•      Other, net gain for the three months ended March 31, 2012, was primarily due to gains of $189 on transactional foreign currency re-valuation associated with the internal reinsurance of the Japan variable annuity business, which is offset in AOCI, due to depreciation of the Japanese yen versus the U.S. dollar. Additional gains of $126 are related to credit derivatives driven by credit spread tightening. These gains were partially offset by losses of ($63) related to Japan 3Win foreign currency swaps primarily driven by strengthening of the currency basis swap spread between U.S. dollar and Japanese yen..

 

•      Other, net gain for the three months ended March 31, 2011 was primarily due to gains of $61 on transactional foreign currency re-valuation due to a decrease in value of the Japanese yen versus the U.S. dollar associated with the internal reinsurance of the Japan variable annuity business, which is offset in AOCI and gains of $55 on credit derivatives driven by credit spread tightening.

 

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PROPERTY & CASUALTY COMMERCIAL

 

     Three Months Ended
March 31,
 

Underwriting Summary

   2012     2011     Change  

Written premiums

   $ 1,687      $ 1,645        3

Change in unearned premium reserve

     130        147        (12 %) 
  

 

 

   

 

 

   

 

 

 

Earned premiums

     1,557        1,498        4

Losses and loss adjustment expenses

      

Current accident year before catastrophes

     1,027        962        7

Current accident year catastrophes

     32        46        (30 %) 

Prior accident years

     20        (6     NM   
  

 

 

   

 

 

   

 

 

 

Total losses and loss adjustment expenses

     1,079        1,002        8

Amortization of deferred policy acquisition costs

     231        228        1

Underwriting expenses

     245        234        5

Dividends to policyholders

     (2     4        NM   
  

 

 

   

 

 

   

 

 

 

Underwriting results

     4        30        (87 %) 

Net servicing income

     4        —          —     

Net investment income

     235        242        (3 %) 

Net realized capital gains (losses)

     43        (23     NM   

Other expenses

     (30     (40     25
  

 

 

   

 

 

   

 

 

 

Income from continuing operations before income taxes

     256        209        22

Income tax expense

     66        46        43
  

 

 

   

 

 

   

 

 

 

Income from continuing operations, net of tax

     190        163        17

Income (loss) from discontinued operations, net of tax [1]

     (1     160        NM   
  

 

 

   

 

 

   

 

 

 

Net income

   $ 189      $ 323        (41 %) 
  

 

 

   

 

 

   

 

 

 

 

[1] Represents the income from operations and sale of Specialty Risk Services (“SRS”). For additional information, see Note 12 of the Notes to Condensed Consolidated Financial Statements.

 

     Three Months Ended
March 31,
 

Premium Measures [1]

   2012     2011  

New business premium

   $ 268      $ 303   

Standard commercial lines policy count retention

     83     83

Standard commercial lines renewal written pricing increase

     7     3

Standard commercial lines renewal earned pricing increase

     4     1

Standard commercial lines policies in-force as of end of period

     1,261,154        1,230,495   

 

[1] Standard commercial lines represents the Company’s small commercial and middle market property and casualty lines.

 

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Table of Contents
     Three Months Ended
March 31,
 

Ratios

   2012     2011     Change  

Loss and loss adjustment expense ratio

      

Current accident year before catastrophes

     66.0        64.3        (1.7

Current accident year catastrophes

     2.1        3.0        0.9   

Prior accident years

     1.3        (0.4     (1.7
  

 

 

   

 

 

   

 

 

 

Total loss and loss adjustment expense ratio

     69.3        66.9        (2.4

Expense ratio

     30.6        30.8        0.2   

Policyholder dividend ratio

     (0.1     0.3        0.4   
  

 

 

   

 

 

   

 

 

 

Combined ratio

     99.7        97.9        (1.8
  

 

 

   

 

 

   

 

 

 

Catastrophe ratio

      

Current accident year

     2.1        3.0        0.9   

Prior accident years

     0.2        (0.3     (0.5
  

 

 

   

 

 

   

 

 

 

Total catastrophe ratio

     2.2        2.7        0.5   
  

 

 

   

 

 

   

 

 

 

Combined ratio before catastrophes

     97.5        95.2        (2.3

Combined ratio before catastrophes and prior accident year development

     96.4        95.3        (1.1
  

 

 

   

 

 

   

 

 

 

Other revenues [1]

   $ 22      $ 23        (4 %) 
  

 

 

   

 

 

   

 

 

 

 

[1] Represents servicing revenues.

Three ended March 31, 2012 compared to the three months ended March 31, 2011

Net income decreased for the three months ended March 31, 2012, as compared to the prior year period, primarily due to the gain on sale of SRS in 2011, partially offset by an increase in net realized capital gains in 2012.

Current accident year catastrophe losses for the three months ended March 31, 2012 of $32, pre-tax, primarily included tornadoes in the Midwest and South. In 2011, current accident year catastrophe losses of $46, pre-tax, primarily included winter storms in the Northeast and Midwest.

For information regarding prior accident years reserve development, including reserve (releases) strengthenings by reserve line, see the Property and Casualty Insurance Product Reserves, Net of Reinsurance section within Critical Accounting Estimates.

The increase in earned premiums for the three months ended March 31, 2012, is primarily due to improvements in workers’ compensation, driven by earned premium increases from higher new business premium in the later half 2011, renewal earned pricing increases and an increase in policies-in-force. The earned pricing changes were primarily a reflection of written pricing changes over the last year. Renewal written pricing increased for all standard commercial lines driven by improving market conditions.

Current accident year losses and loss adjustment expenses before catastrophes increased, due primarily to increases in earned premiums and current accident year loss and loss adjustment expense ratio before catastrophes in workers’ compensation. The ratio increased in workers’ compensation primarily due to increased estimates of claim frequency, partially offset by moderating severity trends and earned pricing increases.

Net realized capital gains increased primarily due to gains on asset backed and investment grade corporate securities. For additional information, see the Investment Results section within Key Performance Measures and Ratios.

The effective tax rate in both periods differs from the U.S. Federal statutory rate primarily due to permanent differences related to investments in tax exempt securities. For further discussion, see Income Taxes within Note 1 of the Notes to Condensed Consolidated Financial Statements.

 

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GROUP BENEFITS

 

      Three Months Ended
March 31,
 

Operating Summary

   2012     2011     Change  

Premiums and other considerations

   $ 972      $ 1,044        (7 %) 

Net investment income

     99        104        (5 %) 

Net realized capital gains (losses)

     20        (14     NM   
  

 

 

   

 

 

   

 

 

 

Total revenues

     1,091        1,134        (4 %) 

Benefits, losses and loss adjustment expenses

     807        828        (3 %) 

Amortization of deferred policy acquisition costs

     8        9        (11 %) 

Insurance operating costs and other expenses

     258        291        (11 %) 
  

 

 

   

 

 

   

 

 

 

Total benefits, losses and expenses

     1,073        1,128        (5 %) 

Income before income taxes

     18        6        NM   

Income tax expense

     —          (5     100
  

 

 

   

 

 

   

 

 

 

Net income

   $ 18      $ 11        64
  

 

 

   

 

 

   

 

 

 

Premiums and other considerations

      

Fully insured – ongoing premiums

   $ 954      $ 1,028        (7 %) 

Buyout premiums

     3        —          —     

Other

     15        16        (6 %) 
  

 

 

   

 

 

   

 

 

 

Total premiums and other considerations

   $ 972      $ 1,044        (7 %) 
  

 

 

   

 

 

   

 

 

 

Fully insured ongoing sales, excluding buyouts

   $ 228      $ 244        (7 %) 
  

 

 

   

 

 

   

 

 

 

Ratios, excluding buyouts

      

Loss ratio

     83.0     79.3  

Loss ratio, excluding financial institutions

     87.4     84.4  

Expense ratio

     27.5     28.7  

Expense ratio, excluding financial institutions

     24.2     23.6  

Three months ended March 31, 2012 compared to the three months ended March 31, 2011

Net income increased, relative to the comparable prior year period, primarily due to improvements in realized capital gains (losses), partially offset by lower premiums and other considerations. Fully insured ongoing premiums decreased 7% due to the competitive marketplace, while the Company remains disciplined in meeting pricing expectations.

The increase in the loss ratio was primarily due to higher severity in group disability. In addition, the Company continues to experience elevated claims incidence and lower terminations in long-term disability.

The change in insurance operating costs and other expenses is due to lower commission payments as a result of lower sales and a one-time payment to a third party administrator in the first quarter of 2011.

The effective tax rate, in both periods, differs from the U.S. Federal statutory rate primarily due to permanent differences related to investments in tax exempt securities. For further discussion, see Income Taxes within Note 1 of the Notes to Condensed Consolidated Financial Statements.

 

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CONSUMER MARKETS

 

     Three Months Ended
March 31,
 

Operating Summary

   2012     2011     Change  

Written premiums

   $ 861      $ 884        (3 %) 

Change in unearned premium reserve

     (48     (72     33
  

 

 

   

 

 

   

 

 

 

Earned premiums

     909        956        (5 %) 

Losses and loss adjustment expenses

      

Current accident year before catastrophes

     574        616        (7 %) 

Current accident year catastrophes

     39        32        22

Prior accident years

     (55     (49     (12 %) 
  

 

 

   

 

 

   

 

 

 

Total losses and loss adjustment expenses

     558        599        (7 %) 

Amortization of deferred policy acquisition costs

     83        85        (2 %) 

Underwriting expenses

     150        149        1
  

 

 

   

 

 

   

 

 

 

Underwriting results

     118        123        (4 %) 

Net servicing income

     6        6        —     

Net investment income

     43        50        (14 %) 

Net realized capital gains (losses)

     7        (4     NM   

Other expenses

     (15     (14     (7 %) 
  

 

 

   

 

 

   

 

 

 

Income before income taxes

     159        161        (1 %) 

Income tax expense

     51        53        (4 %) 
  

 

 

   

 

 

   

 

 

 

Net income

   $ 108      $ 108        —     
  

 

 

   

 

 

   

 

 

 
     Three Months Ended
March 31,
 

Written Premiums

   2012     2011     Change  

Product Line

      

Automobile

   $ 620      $ 641        (3 %) 

Homeowners

     241        243        (1 %) 
  

 

 

   

 

 

   

 

 

 

Total

   $ 861      $ 884        (3 %) 
  

 

 

   

 

 

   

 

 

 

Earned Premiums

      

Product Line

      

Automobile

   $ 632      $ 672        (6 %) 

Homeowners

     277        284        (2 %) 
  

 

 

   

 

 

   

 

 

 

Total

   $ 909      $ 956        (5 %) 
  

 

 

   

 

 

   

 

 

 

 

     Three Months Ended
March 31,
 

Premium Measures

   2012     2011  

Policies in-force end of period

    

Automobile

     2,065,317        2,178,719   

Homeowners

     1,330,117        1,402,264   
  

 

 

   

 

 

 

Total policies in-force end of period

     3,395,434        3,580,983   
  

 

 

   

 

 

 

New business written premium

    

Automobile

   $ 86      $ 66   

Homeowners

   $ 25      $ 19   
  

 

 

   

 

 

 

Policy count retention

    

Automobile

     84     82

Homeowners

     85     83
  

 

 

   

 

 

 

Renewal written pricing increase

    

Automobile

     4     7

Homeowners

     6     9
  

 

 

   

 

 

 

Renewal earned pricing increase

    

Automobile

     4     7

Homeowners

     7     10
  

 

 

   

 

 

 

 

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Table of Contents
$00000.00 $00000.00 $00000.00
     Three Months Ended
March 31,
 

Ratios and Supplemental Data

   2012     2011     Change  

Loss and loss adjustment expense ratio

      

Current accident year before catastrophes

     63.1        64.3        1.2   

Current accident year catastrophes

     4.3        3.4        (0.9

Prior accident years

     (6.1     (5.1     1.0   
  

 

 

   

 

 

   

 

 

 

Total loss and loss adjustment expense ratio

     61.4        62.6        1.2   

Expense ratio

     25.6        24.7        (0.9
  

 

 

   

 

 

   

 

 

 

Combined ratio

     87.0        87.3        0.3   
  

 

 

   

 

 

   

 

 

 

Catastrophe ratio

      

Current year

     4.3        3.4        (0.9

Prior years

     (1.5     2.0        3.5   
  

 

 

   

 

 

   

 

 

 

Total catastrophe ratio

     2.8        5.4        2.6   
  

 

 

   

 

 

   

 

 

 

Combined ratio before catastrophes

     84.3        81.9        (2.4

Combined ratio before catastrophes and prior accident years development

     88.8        89.0        0.2   
  

 

 

   

 

 

   

 

 

 

Other revenues [1]

   $ 37      $ 40        (8 %) 
  

 

 

   

 

 

   

 

 

 

 

[1] Represents servicing revenues.

 

$000000.00 $000000.00 $000000.00
     Three Months Ended
March 31,
 

Product Line Combined Ratios

   2012      2011      Change  

Automobile

     88.4         85.2         (3.2

Homeowners

     83.8         91.5         7.7   
  

 

 

    

 

 

    

 

 

 

Total

     87.0         87.3         0.3   
  

 

 

    

 

 

    

 

 

 

Three months ended March 31, 2012 compared to the three months ended March 31, 2011

Net income remained flat, as compared to the prior year, as lower earned premium was largely offset by a corresponding decrease in current accident year loss and loss adjustment expenses ratio before catastrophes. In addition, an increase in net realized capital gains was largely offset by a decrease in net investment income.

Earned premiums decreased in both auto and homeowners as non-renewal of existing policies more than offset the impacts of new business written premium. Compared to 2011, the number of policies in-force as of March 31, 2012 decreased for both auto and home, driven by non-renewals.

Policy count retention for auto and home increased as moderating renewal written price increases improved the Company’s price competitiveness.

Auto and home new business written premium increased primarily due to more competitive new business pricing in AARP Direct and, to a lesser extent, an increase in the sale of the AARP auto product through independent agents.

The lower auto and homeowners renewal earned pricing in the three months ended March 31, 2012 was primarily due to lower rate increases. For both auto and homeowners, the increase in average earned premium for the three months ended March 31, 2012 was lower than the increase in earned pricing, reflecting changes in the mix of business by territory, class plan and pricing tier, including the effect of the continued shift to more preferred market business which has lower average earned premium,

Current accident year losses and loss adjustment expenses before catastrophes decreased primarily due to lower earned premiums and a decrease in the overall current accident year loss and loss adjustment expense ratio before catastrophes. The current accident year loss and loss adjustment expense ratio before catastrophes decreased primarily due to a decrease in home, partially offset by an increase in auto. The decrease for home was primarily due to earned pricing increases and a decrease in the frequency of non-catastrophe weather claims. The increase for auto was primarily due to higher auto physical damage loss cost severity, largely offset by the effect of earned pricing increases and lower estimated auto liability severity.

Current accident year catastrophe losses for the three months ended March 31, 2012 of $39, pre-tax, primarily included losses from tornadoes and thunderstorms in the Midwest and South. In 2011, current accident year catastrophe losses of $32, pre-tax, primarily included losses from winter storms in the Northeast and Midwest.

For information regarding prior accident years reserve development, see the Property and Casualty Insurance Product Reserves, Net of Reinsurance section within Critical Accounting Estimates.

The effective tax rate, in both periods, differs from the U.S. Federal statutory rate primarily due to permanent differences related to investments in tax exempt securities. For further discussion, see Income Taxes within Note 1 of the Notes to Condensed Consolidated Financial Statements.

 

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INDIVIDUAL ANNUITY

 

     Three Months Ended March, 31  

Operating Summary

   2012     2011     Change  

Fee income and other

   $ 321      $ 375        (14 %) 

Earned premiums

     47        65        (28 %) 

Net investment income

     199        197        1

Net realized capital gains (losses)

     20        (28     NM   
  

 

 

   

 

 

   

 

 

 

Total revenues

     587        609        (4 %) 
  

 

 

   

 

 

   

 

 

 

Benefits, losses and loss adjustment expenses

     182        251        (27 %) 

Amortization of DAC

     9        42        (79 %) 

Insurance operating costs and other expenses

     128        142        (10 %) 
  

 

 

   

 

 

   

 

 

 

Total benefits, losses and expenses

     319        435        (27 %) 
  

 

 

   

 

 

   

 

 

 

Income before income taxes

     268        174        54

Income tax expense

     70        31        126
  

 

 

   

 

 

   

 

 

 

Net income

   $ 198      $ 143        38
      

Assets Under Management

      

Fixed MVA annuity and other account values

   $ 11,507      $ 12,136        (5 %) 

Variable annuity account values

     72,235        82,977        (13 %) 
  

 

 

   

 

 

   

 

 

 

Total assets under management

   $ 83,742      $ 95,113        (12 %) 
  

 

 

   

 

 

   

 

 

 

Account Value Roll Forward

      

Variable Annuities

      

Account value, beginning of period

   $ 68,760      $ 83,013        (17 %) 

Net flows

     (2,641     (3,179     17

Change in market value and other

     6,116        3,143        95
  

 

 

   

 

 

   

 

 

 

Account value, end of period

   $ 72,235      $ 82,977        (13 %) 
  

 

 

   

 

 

   

 

 

 

Net Investment Spread

     43 bps        31 bps        12 bps   
  

 

 

   

 

 

   

 

 

 

Expense Ratios

      

General insurance expense ratio

     6 bps        5 bps     
  

 

 

   

 

 

   

DAC amortization ratio

     3.2     19.4  

Effect of realized gains (losses) on DAC amortization

     0.1     (4.6 %)   

Effect of Unlocks on DAC amortization

     (39.0 %)      (20.0 %)   
  

 

 

   

 

 

   

DAC amortization ratio, core earnings, excluding Unlock

     42.1     44.0  
  

 

 

   

 

 

   

Three months ended March 31, 2012 compared to the three months ended March 31, 2011

Net income increased in 2012 compared to 2011 primarily due to an increase in the Unlock benefit, net realized capital gains in 2012 compared to losses in 2011 and lower operating costs and other expenses. These improvements were offset by lower fee income in 2012 related to lower account values driven by net outflows.

The Unlock benefit was $90, after-tax, in 2012 as compared to $43, after-tax, in 2011. The Unlock benefit in 2012 was driven primarily by actual separate account returns above our aggregate estimated returns. For further discussion of the Unlock see the Critical Accounting Estimates within the MD&A.

Net realized capital gains in 2012 were primarily due to decreased losses on the variable annuity hedging program. Variable annuity hedging program losses were $4 in 2012 compared with losses of $28 in 2011. For further discussion on the results of the variable annuity hedging program see Investment Results, Net Realized Capital Gains (Losses) within Key Performance Measures and Ratios of the MD&A.

Net investment spread increased by 12 bps in 2012 compared to 2011, driven by lower crediting rates and higher investment returns. Crediting rates decreased by 10 bps driven by lower crediting rates on renewal business in contrast to in-force business with higher crediting rates. In addition, yields increased by 2 bps.

Individual Annuity’s effective tax rate differs from the statutory rate of 35% primarily due to permanent differences for the separate account DRD on annuity products. Income tax expense includes separate account DRD benefits of $23 in 2012 compared to $28 in 2011. The separate account DRD is expected to decrease in 2012 primarily due to net outflows associated with the announced runoff of the Individual Annuity business. For further discussion, see Note 1 of the Notes to Condensed Consolidated Financial Statements.

 

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INDIVIDUAL LIFE

 

     Three Months Ended March 31,  

Operating Summary

   2012     2011     Change  

Fee income and other

   $ 255      $ 233        9

Earned premiums

     (28     (24     (17 %) 

Net investment income

     122        111        10

Net realized capital losses

     (1     (30     97
  

 

 

   

 

 

   

 

 

 

Total revenues

     348        290        20
  

 

 

   

 

 

   

 

 

 

Benefits, losses and loss adjustment expenses

     216        182        19

Insurance operating costs and other expenses

     70        61        15

Amortization of DAC

     39        25        56
  

 

 

   

 

 

   

 

 

 

Total benefits, losses and expenses

     325        268        21
  

 

 

   

 

 

   

 

 

 

Income before income taxes

     23        22        5

Income tax expense

     4        4        —     
  

 

 

   

 

 

   

 

 

 

Net income

   $ 19      $ 18        6
  

 

 

   

 

 

   

 

 

 

Account Values

      

Individual variable universal life insurance

   $ 5,996      $ 6,235        (4 %) 

Universal life, interest sensitive whole life, modified guaranteed life insurance and other

     6,932        6,235        11
  

 

 

   

 

 

   

 

 

 

Total account values

   $ 12,928      $ 12,470        4
  

 

 

   

 

 

   

 

 

 

Individual Life Insurance In-force

      

Variable universal life insurance

   $ 68,642      $ 72,946        (6 %) 

Universal life, interest sensitive whole life, modified guaranteed life insurance

     65,400        59,613        10

Term life

     82,659        77,138        7
  

 

 

   

 

 

   

 

 

 

Total life insurance in-force

   $ 216,701      $ 209,697        3
  

 

 

   

 

 

   

 

 

 

Net Investment Spread

     144 bps        162 bps        (18 ) bps 
  

 

 

   

 

 

   

 

 

 

Death Benefits

   $ 105      $ 105        —     
  

 

 

   

 

 

   

 

 

 

Three months ended March 31, 2012 compared to the three months ended March 31, 2011

Net income remained flat in 2012 compared to 2011 as increased revenues in the first quarter of 2012 were largely offset by increased expenses during the period. While total net investment income increased due to improved equity market performance in 2012, net investment income, excluding equity securities, trading, declined in 2012 due to lower income on limited partnerships and other alternative investments as a result of greater price appreciation experienced in the underlying funds in 2011. The increase in expenses was driven primarily by increased claim reserves.

The Unlock charge was $8, after-tax, for 2012 compared to $1, after-tax, for 2011. As separate account returns in the first quarter of 2012 were below our aggregated estimated return for the period, the Unlock charge increased in 2012 compared to 2011 resulting in increases in fee income, benefit and claim expense and DAC amortization. For further discussion of Unlocks see the Critical Accounting Estimates within the MD&A.

Net investment spread decreased by 18 bps in 2012 compared to 2011, driven by lower yields of 16 bps and higher crediting rates of 2 bps. Death benefits remained flat in 2012 compared to 2011 although mortality experience during the quarter was slightly favorable.

Individual Life’s effective tax rate differs from the statutory rate of 35% primarily due to permanent differences for the separate account DRD. Income tax expense includes separate account DRD benefits of $3 in 2012 and 2011. For further discussion, see Note 1 of the Notes to Condensed Consolidated Financial Statements.

In March 2012, the Company announced its decision to pursue sales or other strategic alternatives for the Individual Life business. For further discussion of this announcement, see MD&A – Outlooks.

 

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RETIREMENT PLANS

 

     Three Months Ended March 31,  

Operating Summary

   2012      2011     Change  

Fee income and other

   $ 94       $ 94        —     

Earned premiums

     2         3        (33 %) 

Net investment income

     101         99        2

Net realized capital gains (losses)

     14         (9     NM   
  

 

 

    

 

 

   

 

 

 

Total revenues

     211         187        13
  

 

 

    

 

 

   

 

 

 

Benefits, losses and loss adjustment expenses

     81         72        13

Insurance operating costs and other expenses

     109         108        1

Amortization of DAC

     —           7        (100 %) 
  

 

 

    

 

 

   

 

 

 

Total benefits, losses and expenses

     190         187        2
  

 

 

    

 

 

   

 

 

 

Income (loss) before income taxes

     21         —          —     

Income tax expense (benefit)

     3         (5     NM   
  

 

 

    

 

 

   

 

 

 

Net income

   $ 18       $ 5        NM   
  

 

 

    

 

 

   

 

 

 

Assets Under Management

       

401(k) account values

   $ 23,378       $ 21,891        7

403(b)/457 account values

     13,725         13,133        5

401(k)/403(b) mutual funds

     20,052         20,324        (1 %) 
  

 

 

    

 

 

   

 

 

 

Total assets under management

   $ 57,155       $ 55,348        3
  

 

 

    

 

 

   

 

 

 

Assets Under Management Roll Forward

       

Assets under management, beginning of period

   $ 52,302       $ 52,518        —     

Net flows

     425         662        (35 %) 

Change in market value and other

     4,428         2,168        104
  

 

 

    

 

 

   

 

 

 

Assets under management, end of period

   $ 57,155       $ 55,348        3
  

 

 

    

 

 

   

 

 

 

Net Investment Spread

     84 bps         140 bps        (56 ) bps 
  

 

 

    

 

 

   

 

 

 

Three Months ended March 31, 2012 compared to the three months ended March 31, 2011

Net income increased in 2012 compared to 2011 largely due to realized capital gains in 2012 compared to losses in 2011 and a more favorable Unlock benefit. In addition, benefits losses and loss adjustment expenses increased due to higher interest credited on general account assets. In March 2012 the Company announced its decision to pursue sales or other strategic alternatives for the Retirement Plans business.

The Unlock benefit was $7, after-tax, in 2012 as compared $2, after-tax, in 2011. The Unlock benefits in both 2012 and 2011were primarily due to actual separate account returns above our aggregated estimated returns. For further discussion of Unlocks see the Critical Accounting Estimates within the MD&A.

Net investment income increased in 2012 compared to 2011 although portfolio yields were lower in 2012. Net investment spread decreased by 56 bps driven by lower yields of 53 bps and higher crediting rates of 3 bps.

Retirement Plans’ effective tax rate differs from the statutory rate of 35% primarily due to permanent differences for the separate account DRD. For 2012 and 2011 income taxes include separate account DRD benefits of $5. For further discussion, see Note 1 of the Notes to Condensed Consolidated Financial Statements.

 

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MUTUAL FUNDS

 

     Three Months Ended March 31,  

Operating Summary

   2012     2011     Change  

Fee income and other

   $ 151      $ 178        (15 %) 

Net investment loss

     (1     (1     —     

Net realized capital gains

     1        1        —     
  

 

 

   

 

 

   

 

 

 

Total revenues

     151        178        (15 %) 
  

 

 

   

 

 

   

 

 

 

Insurance operating costs and other expenses

     111        123        (10 %) 

Amortization of DAC

     9        12        (25 %) 
  

 

 

   

 

 

   

 

 

 

Total benefits, losses and expenses

     120        135        (11 %) 
  

 

 

   

 

 

   

 

 

 

Income before income taxes

     31        43        (28 %) 

Income tax expense

     11        15        (27 %) 
  

 

 

   

 

 

   

 

 

 

Net income

   $ 20      $ 28        (29 %) 
  

 

 

   

 

 

   

 

 

 

Assets Under Management

      

Retail mutual fund assets

   $ 43,575      $ 51,064        (15 %) 

Investment Only mutual fund assets

     7,929        7,298        9

529 College Savings Plan assets

     1,740        1,583        10
  

 

 

   

 

 

   

 

 

 

Total non-proprietary assets

     53,244        59,945        (11 %) 

Proprietary mutual fund assets

     39,161        44,044        (11 %) 
  

 

 

   

 

 

   

 

 

 

Total mutual fund assets under management

   $ 92,405      $ 103,989        (11 %) 
  

 

 

   

 

 

   

 

 

 

Non-Proprietary AUM Roll Forward

      

Non-Proprietary Mutual Fund AUM, beginning of period

   $ 48,768      $ 56,884        (14 %) 

Net flows

     (1,037     994        NM   

Change in market value and other

     5,513        2,067        167
  

 

 

   

 

 

   

 

 

 

Non-Proprietary Mutual Fund AUM, end of period

   $ 53,244      $ 59,945        (11 %) 
  

 

 

   

 

 

   

 

 

 

Proprietary Mutual Fund AUM Roll Forward

      

Proprietary Mutual Fund AUM, beginning of period

   $ 36,770      $ 43,602        (16 %) 

Net flows

     (1,372     (1,507     9

Change in market value

     3,763        1,949        93
  

 

 

   

 

 

   

 

 

 

Proprietary Mutual Fund AUM, end of period

   $ 39,161      $ 44,044        (11 %) 
  

 

 

   

 

 

   

 

 

 

Three months ended March 31, 2012 compared to the three months ended March 31, 2011

Net income decreased in 2012 primarily due to lower fee income and other driven by lower AUM compared to March 31, 2011. AUM decreased in 2012 compared to 2011 due to lower new business deposit activity and a higher redemption rate, offset by a significant improvement in equity market performance. AUM at March 31, 2012 compared to December 31, 2011 has increased as equity markets rebound and the redemption rate trends lower.

 

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LIFE OTHER OPERATIONS

 

     Three Months Ended March 31,  

Operating Summary

   2012     2011     Change  

Fee income and other

   $ 246      $ 260        (5 %) 

Earned premiums

     (2     (6     67

Net investment income

      

Securities available-for-sale and other

     240        251        (4 %) 

Equity securities trading [1]

     2,865        803        NM   
  

 

 

   

 

 

   

Total net investment income

     3,105        1,054        195

Net realized capital losses

     (1,040     (282     NM   
  

 

 

   

 

 

   

 

 

 

Total revenues

     2,309        1,026        125
  

 

 

   

 

 

   

 

 

 

Benefits, losses and loss adjustment expenses

     109        239        (54 %) 

Benefits, losses and loss adjustment expenses – returns credited on international variable annuities [1]

     2,864        803        NM   

Amortization of DAC

     (58     42        NM   

Insurance operating costs and other expenses

     56        64        (13 %) 
  

 

 

   

 

 

   

 

 

 

Total benefits, losses and expenses

     2,971        1,148        159
  

 

 

   

 

 

   

 

 

 

Loss before income taxes

     (662     (122     NM   

Income tax benefit

     (257     (52     NM   
  

 

 

   

 

 

   

 

 

 

Net loss

   $ (405   $ (70     NM   
  

 

 

   

 

 

   

 

 

 

Assets Under Management [2]

      

Variable annuity account values

   $ 31,392      $ 33,027        (5 %) 

Fixed MVA annuity and other account values [3]

     4,469        4,463        —     

Institutional annuity account values [4]

     18,622        19,326        (4 %) 

Private Placement Life Insurance (“PPLI”)

     36,830        36,424        1
  

 

 

   

 

 

   

 

 

 

Account Value Roll Forward

      

Variable Annuities

      

Account value, beginning of period

   $ 31,162      $ 33,507        (7 %) 

Net flows

     (505     (476     (6 %) 

Change in market value and other

     2,681        610        NM   

Effect of currency translation

     (1,946     (614     NM   
  

 

 

   

 

 

   

 

 

 

Account value, end of period

   $ 31,392      $ 33,027        (5 %) 
  

 

 

   

 

 

   

 

 

 

 

[1] Includes investment income and mark-to-market effects of equity securities, trading, supporting the international variable annuity business, which are classified in net investment income with corresponding amounts credited to policyholders within benefits, losses and loss adjustment expenses.
[2] International and institutional annuities were transferred retrospectively from Individual Annuity; PPLI was transferred retrospectively from Individual Life.
[3] Includes approximately $1.9 billion and $1.8 billion related to the triggering of the guaranteed minimum income benefit for the 3 Win product as of March 31, 2012 and 2011, respectively. This account value is not expected to generate material future profit or loss to the Company.
[4] Included in the balance is approximately $1.3 billion for the three months ended March 31, 2012 and $1.4 billion for the three months ended March 31, 2011 related to an intrasegment funding agreement which is eliminated in consolidation.

Three months ended March 31, 2012 compared to the three months ended March 31, 2011

Net loss increased in 2012 compared to 2011 primarily due to higher net realized capital losses, offset in part by an increased Unlock benefit in 2012. In addition, benefits, losses and loss adjustment expenses decreased in 2012 reflecting the improvement in equity market performance.

The net increase in realized capital losses in 2012 compared to 2011 was primarily due to losses in the variable annuity hedging program. Variable annuity hedging program losses were $1.2 billion in 2012 compared to losses of $319 in 2011. For further discussion on the results of the variable annuity hedging program see Investment Results, Net Realized Capital Gains (Losses) within Key Performance Measures and Ratios of the MD&A.

The Unlock benefit was $125, after-tax, in 2012 compared to $13, after-tax, in 2011. The Unlock benefit in 2012 was primarily a result of actual separate account returns above our aggregated estimated returns. For further discussion of the Unlock see the Critical Accounting Estimates within the MD&A.

Life Other Operations effective tax rate for 2012 differs from the statutory rate of 35% primarily due to the utilization of foreign net operating losses resulting in the release of approximately $19 of the foreign deferred tax asset valuation allowance. In 2011, varying tax rates by country drove the difference in Life Other Operations effective tax rate compared to the statutory rate. For further discussion, see Note 1 of the Notes to Consolidated Financial Statements.

 

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PROPERTY & CASUALTY OTHER OPERATIONS

 

$000,000 $000,000 $000,000
     Three Months Ended
March 31,
 

Operating Summary

   2012      2011     Change  

Net investment income

     39         39        —     

Net realized capital gains (losses)

     11         (3     NM   

Other revenue

     —           1        —     
  

 

 

    

 

 

   

 

 

 

Total revenues

     50         37        35

Benefits, losses and loss adjustment expenses

     6         4        50

Insurance operating costs and other expenses

     8         7        14
  

 

 

    

 

 

   

 

 

 

Total benefits, losses and expenses

     14         11        27

Income before income taxes

     36         26        38

Income tax benefit

     9         5        80
  

 

 

    

 

 

   

 

 

 

Net income

   $ 27       $ 21        29
  

 

 

    

 

 

   

 

 

 

Three months ended March 31, 2012 compared to the three months ended March 31, 2011

The net income in Property & Casualty Other Operations increased in 2012, as compared to 2011, primarily due to an increase in net realized capital gains (losses). The change in net realized capital gains (losses) is a result of increases in trading and derivative gains, primarily due to gains on asset backed and investment grade corporate securities.

For information on net asbestos and environmental reserves, see Property & Casualty Other Operations Claims within the Property and Casualty Insurance Product Reserves, Net of Reinsurance section in Critical Accounting Estimates.

CORPORATE

 

     Three Months Ended
March 31,
 

Operating Summary

   2012     2011     Change  

Earned premiums

   $ —        $ (1     100

Fee income [1]

     52        53        (2 %) 

Net investment income

     (6     16        NM   

Net realized capital gains (losses)

     15        (11     NM   
  

 

 

   

 

 

   

 

 

 

Total revenues

     61        57        7

Benefits, losses and loss adjustment expenses

     —          1        (100 %) 

Insurance operating costs and other expenses

     85        60        42

Interest expense

     124        128        (3 %) 
  

 

 

   

 

 

   

 

 

 

Total benefits, losses and expenses

     209        189        11

Loss from continuing operations before income taxes

     (148     (132     (12 %) 

Income tax benefit

     (52     (44     (18 %) 
  

 

 

   

 

 

   

 

 

 

Loss from continuing operations, net of tax

     (96     (88     (9 %) 

Income (loss) from discontinued operations, net of tax [2]

     —          2        (100 %) 
  

 

 

   

 

 

   

 

 

 

Net loss

   $ (96   $ (86     (12 %) 
  

 

 

   

 

 

   

 

 

 

 

[1] Fee income includes the income associated with the sales of non-proprietary insurance products in the Company’s broker-dealer subsidiaries that has an offsetting commission expense in insurance operating costs and other expenses.
[2] Represents the loss from operations and sale of Federal Trust Corporation. For additional information, see Note 12 of the Notes to Condensed Consolidated Financial Statements.

Three months ended March 31, 2012 compared to the three months ended March 31, 2011

The net loss in Corporate increased primarily due to an increase in insurance operating costs and other expenses as a result of severance charges due to the Company’s ongoing efficiency and expense reduction initiatives and a compensation related accrual recorded in the three months ended March 31, 2012.

See Note 1 of the Notes to Condensed Consolidated Financial Statements for a reconciliation of the tax provision at the U.S. Federal statutory rate to the provision (benefit) for income taxes.

 

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ENTERPRISE RISK MANAGEMENT

The Company has an enterprise risk management function (“ERM”) that is charged with providing analysis of the Company’s risks on an individual and aggregated basis and with ensuring that the Company’s risks remain within its risk appetite and tolerances. The Company has established the Enterprise Risk and Capital Committee (“ERCC”) that includes the Company’s CEO, Chief Financial Officer (“CFO”), Chief Investment Officer (“CIO”), Chief Risk Officer, the divisional Presidents and the General Counsel. The ERCC is responsible for managing the Company’s risks and overseeing the enterprise risk management program.

The Company categorizes its main risks as follows:

   

Insurance Risk

 

   

Operational Risk

 

   

Financial Risk

Refer to the MD&A in The Hartford’s 2011 Form 10-K Annual Report for an explanation of the Company’s Insurance and Operational Risks.

Financial Risk Management

The Company identifies the following categories of financial risk:

 

   

Liquidity Risk

 

   

Interest Rate Risk

 

   

Variable Product Guarantee Risks

 

   

Foreign Currency Exchange Risk

 

   

Credit Risk

Financial risks include direct, and indirect risks to the Company’s financial objectives coming from events that impact market conditions or prices. Financial risk also includes exposure to events that may cause correlated movement in multiple risk factors. The primary source of financial risks are the Company’s general account assets and the liabilities which those assets back, together with the guarantees which the company has written over various liability products, particularly its portfolio of variable annuities. The Company assesses its financial risk on a U.S. GAAP, statutory and economic basis. The Hartford has developed a disciplined approach to financial risk management that is well integrated into the Company’s underwriting, pricing, hedging, claims, asset and liability management, new product, and capital management processes. Consistent with its risk appetite, the Company establishes financial risk limits to control potential loss. Exposures are actively monitored, and mitigated where appropriate. The Company uses various risk management strategies, including reinsurance and over-the-counter and exchange traded derivatives to transfer risk to well-established and financially secure counterparties. The Company’s Chief Market Risk Officer has enterprise responsibility for establishing and maintaining the framework, principles, and guidelines of The Hartford’s financial risk management program.

Liquidity Risk

Liquidity risk is the risk to current or prospective earnings or capital arising from the company’s inability or perceived inability to meet its contractual cash obligations at the legal entity level when they come due over given horizons without incurring unacceptable costs and without relying on uncommitted funding sources. Liquidity risk includes the inability to manage unplanned increases or accelerations in cash outflows, decreases or changes in funding sources, and changes in market conditions that affect the ability to liquidate assets quickly to meet obligations with minimal loss in value. Components of liquidity risk include funding risk, transaction risk and market liquidity risk. Funding risk is the gap between sources and uses of cash under normal and stressed conditions taking into consideration structural, regulatory and legal entity constraints. Changes in institution-specific conditions that affect the Company’s ability to sell assets or otherwise transact business without incurring a significant loss in value is transaction risk. Changes in general market conditions that affect the institution’s ability to sell assets or otherwise transact business without incurring a significant loss in value is market liquidity risk.

The Company has defined ongoing monitoring and reporting requirements to assess liquidity across the enterprise. The Company measures and manages liquidity risk exposures and funding needs within prescribed limits and across legal entities, business lines and currencies, taking into account legal, regulatory and operational limitations to the transferability of liquidity. The Company also monitors internal and external conditions, identifies material risk changes and emerging risks that may impact liquidity. The Company’s CFO has primary responsibility for liquidity risk.

For further discussion on liquidity see the section on Capital Resources and Liquidity.

 

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Interest Rate Risk

Interest rate risk is the risk of financial loss due to adverse changes in the value of assets and liabilities arising from movements in interest rates. Interest rate risk encompasses exposures with respect to changes in the level of interest rates, the shape of the term structure of rates and the volatility of interest rates. Interest rate risk does not include exposure to changes in credit spreads. The Company has exposure to interest rates arising from its fixed securities, interest sensitive liabilities and discount rate assumptions associated with the Company’s pension and other post retirement benefit obligations.

An increase in interest rates from current levels is generally a favorable development for the Company. Rate increases are expected to provide additional net investment income, increase sales of fixed rate Wealth Management and Life Other Operations investment products, reduce the cost of the variable annuity hedging program, limit the potential risk of margin erosion due to minimum guaranteed crediting rates in certain Wealth Management and Life Other Operations products and, if sustained, could reduce the Company’s prospective pension expense. Conversely, a rise in interest rates will reduce the fair value of the investment portfolio, increase interest expense on the Company’s variable rate debt obligations and, if long-term interest rates rise dramatically within a six to twelve month time period, certain Wealth Management and Life Other Operations businesses may be exposed to disintermediation risk. Disintermediation risk refers to the risk that policyholders will surrender their contracts in a rising interest rate environment requiring the Company to liquidate assets in an unrealized loss position. In conjunction with the interest rate risk measurement and management techniques, certain of Wealth Management and Life Other Operation’s fixed income product offerings have market value adjustment provisions at contract surrender. An increase in interest rates may also impact the Company’s tax planning strategies and in particular its ability to utilize tax benefits associated with certain previously recognized realized capital losses.

A decline in interest rates results in certain mortgage-backed securities being more susceptible to paydowns and prepayments. During such periods, the Company generally will not be able to reinvest the proceeds at comparable yields. Lower interest rates will also likely result in lower net investment income, increased hedging cost associated with variable annuities and, if declines are sustained for a long period of time, it may subject the Company to reinvestment risks, higher pension costs expense and possibly reduced profit margins associated with guaranteed crediting rates on certain Wealth Management and Life Other Operations products. Conversely, the fair value of the investment portfolio will increase when interest rates decline and the Company’s interest expense will be lower on its variable rate debt obligations.

The Company manages its exposure to interest rate risk by constructing investment portfolios that maintain asset allocation limits and asset/liability duration matching targets which may include the use of derivatives. The Company analyzes interest rate risk using various models including parametric models and cash flow simulation under various market scenarios of the liabilities and their supporting investment portfolios, which may include derivative instruments. Measures the Company uses to quantify its exposure to interest rate risk inherent in its invested assets and interest rate sensitive liabilities include duration, convexity and key rate duration. Duration is the price sensitivity of a financial instrument or series of cash flows to a parallel change in the underlying yield curve used to value the financial instrument or series of cash flows. For example, a duration of 5 means the price of the security will change by approximately 5% for a 100 basis point change in interest rates. Convexity is used to approximate how the duration of a security changes as interest rates change in a parallel manner. Key rate duration analysis measures the price sensitivity of a security or series of cash flows to each point along the yield curve and enables the Company to estimate the price change of a security assuming non-parallel interest rate movements.

The Company is also exposed to interest rate risk based upon the discount rate assumption associated with the Company’s pension and other postretirement benefit obligations. The discount rate assumption is based upon an interest rate yield curve comprised of bonds rated Aa with maturities primarily between zero and thirty years. For further discussion of interest rate risk associated with the benefit obligations, see the Critical Accounting Estimates Section of the MD&A under Pension and Other Postretirement Benefit Obligations and Note 17 of the Notes to Consolidated Financial Statements in The Hartford’s 2011 Form 10-K Annual Report. In addition, management evaluates performance of certain Wealth Management and Life Other Operations products based on net investment spread which is, in part, influenced by changes in interest rates. For further discussion, see the Individual Annuity, Individual Life, and Retirement Plans sections of the MD&A.

 

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Variable Product Guarantee Risks and Risk Management

The Company’s variable products are significantly influenced by the U.S., Japanese, and other equity markets. Increases or declines in equity markets impact 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 annuity contracts, mutual funds, and variable life insurance.

Generally, declines in equity markets will:

 

   

reduce the value of assets under management and the amount of fee income generated from those assets;

 

   

reduce the value of equity securities trading supporting the international variable annuities, the related policyholder funds and benefits payable, and the amount of fee income generated from those variable annuities;

 

   

increase the liability for GMWB benefits resulting in realized capital losses;

 

   

increase the value of derivative assets used to hedge product guarantees resulting in realized capital gains;

 

   

increase the costs of the hedging instruments we use in our hedging program;

 

   

increase the Company’s net amount at risk for GMDB and GMIB benefits;

 

   

decrease the Company’s actual gross profits, resulting in increased DAC amortization;

 

   

increase the amount of required assets to be held backing variable annuity guarantees to maintain required regulatory reserve levels and targeted risk based capital ratios; and

 

   

decrease the Company’s estimated future gross profits. See Estimated Gross Profits Used in the Valuation and Amortization of Assets and Liabilities Associated with Variable Annuity and Other Universal Life-Type Contracts within the Critical Accounting Estimates section of the MD&A for further information.

Generally, increases in equity markets will reduce the value of the dynamic hedge program and macro hedge derivative assets, resulting in realized capital losses, and will generally have the inverse impact of those listed above. See section on Variable Annuity Hedging Program for more information.

Variable Annuity Guaranteed Benefits

The majority of the Company’s U.S., Japan, and U.K. variable annuities include optional living benefit and guaranteed minimum death benefit features. The net amount at risk (“NAR”) is generally defined as the guaranteed minimum benefit amount in excess of the contractholder’s current account value. Global variable annuity account values with guarantee features were $103.6 billion and $99.8 billion as of March 31, 2012 and December 31, 2011, respectively.

The following table summarizes the account values of the Company’s U.S. and Japan variable annuities with guarantee features and the NAR split between various guarantee features (retained net amount at risk does not take into consideration the effects of the variable annuity hedge programs currently in place):

 

 

Total Variable Annuity Guarantees  
As of March 31, 2012  

($ in billions)

   Account
Value
     Gross Net
Amount at Risk
     Retained Net
Amount at Risk
     % of
Contracts In
the Money
    % In the
Money[4]
 

U. S Variable Annuity [1]

             

GMDB [2]

   $ 72.2       $ 7.7       $ 2.7         56     12

GMWB

     38.3         0.9         0.7         28     9

Japan Variable Annuity [1]

             

GMDB

     29.4         7.6         6.5         98     21

GMIB [3]

     27.4         4.8         4.8         99     15

UK Variable Annuity [1]

             

GMDB

     2.0         0.1         0.1         100     3

GMWB

     1.8         0.0         0.0         31     N/A   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

 

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Total Variable Annuity Guarantees  
As of December 31, 2011  

($ in billions)

   Account
Value
     Gross Net
Amount at Risk
     Retained Net
Amount at Risk
     % of
Contracts In
the Money
    % In the
Money[4]
 

U. S Variable Annuity [1]

             

GMDB [2]

   $ 68.7       $ 12.0       $ 5.1         77     15

GMWB

     36.6         1.9         1.6         45     12

Japan Variable Annuity [1]

             

GMDB

     29.2         10.9         9.4         99     27

GMIB [3]

     27.3         7.5         7.5         99     22

UK Variable Annuity [1]

             

GMDB

     1.9         0.08         0.08         100     4

GMWB

     1.8         0.07         0.07         57     3
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

 

[1] Policies with a guaranteed living benefits (a GMWB in the US or UK, or a GMIB in Japan) also have a guaranteed death benefit. The net amount at risk (“NAR”) for each benefit is shown; however these benefits are not additive. When a policy terminates due to death, any NAR related to GMWB or GMIB is released. Similarly, when a policy goes into benefit status on a GMWB or, by contract, the GMDB NAR is reduced to $0. When a policy goes into benefit status on a GMIB, its GMDB NAR is released
[2] Excludes group annuity contracts with GMDB benefits.
[3] Includes small amount of GMWB and GMAB
[4] For all contracts that are “in the money”, this represents the percentage by which the average contract was in the money.

Many policyholders with a GMDB also have a GMWB in the U.S. or GMIB in Japan. Policyholders that have a product that offer both guarantees can only receive the GMDB or the GMIB benefit in Japan or the GMDB or GMWB in the U.S. For additional information on the Company’s GMDB liability, see Note 9 of the Notes to Consolidated Financial Statements.

The Company expects to incur these payments in the future only if the policyholder has an “in the money” GMWB at their death or their account value is reduced to a specified level, through contractually permitted withdrawals and/or market declines. If the account value is reduced to the specified level, the contract holder will receive an annuity equal to the guaranteed remaining benefit (“GRB”) . For the Company’s “life-time” GMWB products, this annuity can continue beyond the GRB. As the account value fluctuates with equity market returns on a daily basis and the “life-time” GMWB payments can exceed the GRB, the ultimate amount to be paid by the Company, if any, is uncertain and could be significantly more or less than the Company’s current carried liability. For additional information on the Company’s GMWB liability, see Note 4 of the Notes to Consolidated Financial Statements.

For GMIB contracts, in general, the policyholder has the right to elect to annuitize benefits, beginning (for certain products) on the tenth or fifteenth anniversary year of contract commencement, receive lump sum payment of the then current account value, or remain in the variable sub-account. For GMIB contracts, if the policyholder makes the election, the policyholder is entitled to receive the original investment value over a 10- to 15- year annuitization period. A small percentage of the contracts will first become eligible to elect annuitization beginning in 2013. The remainder of the contracts will first become eligible to elect annuitization from 2014 to 2022. Because policyholders have various contractual rights to defer their annuitization election, the period over which annuitization election can take place is subject to policyholder behavior and therefore indeterminate. In addition, upon annuitization the contractholder surrenders access to the account value and the account value is transferred to the Company’s general account where it is invested and the additional investment proceeds are used towards payment of the original investment value. If the original investment value exceeds the account value upon annuitization then the contract is “in the money”. As of March 31, 2012, 69% of retained NAR is reinsured to an affiliate of The Hartford. For additional information on the Company’s GMIB liability, see Note 7 of the Notes to Condensed Consolidated Financial Statements.

The following table represents the timing of account values eligible for annuitization under the Japan GMIB as of March 31, 2012, as well as the NAR. The account values reflect 100% annuitization at the earliest point allowed by the contract and no adjustments for future market returns and policyholder behaviors. Future market returns, changes in the value of the Japanese yen and policyholder behaviors will impact account values eligible for annuitization in the years presented.

 

     GMIB [1]  

($ in billions)

   Account Value      Net Amount at Risk  

2013

   $ 0.3       $ 0.0   

2014

     4.5         0.5   

2015

     7.4         1.2   

2016

     2.4         0.5   

2017

     2.8         0.7   

2018 & beyond [2]

     6.9         1.3   
  

 

 

    

 

 

 

Total

   $ 24.3       $ 4.2   
  

 

 

    

 

 

 

 

[1] Excludes certain non-GMIB living benefits of $3.0 billion of account value and $0.6 billion of NAR.
[2] In 2018 & beyond, $2.6 billion of the $6.9 billion is primarily associated with account value that is eligible in 2021.

 

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Variable Annuity Market Risk Exposures

The following table summarizes the broad Variable Annuity Guarantees offered by the Company and the market risks to which the guarantee is most exposed from a U.S. GAAP accounting perspective.

 

Variable Annuity Guarantees [1]

 

U.S. GAAP Treatment [1]

 

Primary Market Risk Exposures [1]

U.S. Variable Guarantees

GMDB

  Accumulation of the portion of fees required to cover expected claims, less accumulation of actual claims paid   Equity Market Levels

GMWB

  Fair Value   Equity Market Levels / Implied Volatility / Interest Rates

For Life Component of GMWB

  Accumulation of the portion of fees required to cover expected claims, less accumulation of actual claims paid   Equity Market Levels

International Variable Guarantees

GMDB & GMIB

  Accumulation of the portion of fees required to cover expected claims, less accumulation of actual claims paid   Equity Market Levels / Interest Rates / Foreign Currency

GMWB

  Fair Value   Equity Market Levels / Implied Volatility / Interest Rates / Foreign Currency

GMAB

  Fair Value   Equity Market Levels / Implied Volatility / Interest Rates / Foreign Currency

 

[1] Each of these guarantees and the related U.S. GAAP accounting volatility will also be influenced by actual and estimated policyholder behavior.

Risk Hedging

Variable Annuity Hedging Program

The Company’s variable annuity hedging is primarily focused on reducing the economic exposure to market risks associated with guaranteed benefits that are embedded in our global VA contracts through the use of reinsurance and capital market derivative instruments. The variable annuity hedging also considers the potential impacts on Statutory accounting results.

Reinsurance

The Company uses reinsurance for a portion of contracts with GMWB riders issued prior to the third quarter of 2003 and GMWB risks associated with a block of business sold between the third quarter of 2003 and the second quarter of 2006. The Company also uses reinsurance for a majority of the GMDB issued in the U.S. and a portion of the GMDB issued in Japan.

Capital Market Derivatives

GMWB Hedge Program

The Company enters into derivative contracts to hedge market risk exposures associated with the GMWB liabilities that are not reinsured. These derivative contracts include customized swaps, interest rate swaps and futures, and equity swaps, options, and futures, on certain indices including the S&P 500 index, EAFE index, and NASDAQ index.

Additionally, the Company holds customized derivative contracts to provide protection from certain capital market risks for the remaining term of specified blocks of non-reinsured GMWB riders. These customized derivative contracts are based on policyholder behavior assumptions specified at the inception of the derivative contracts. The Company retains the risk for differences between assumed and actual policyholder behavior and between the performance of the actively managed funds underlying the separate accounts and their respective indices.

While the Company actively manages this dynamic hedging program, increased U.S. GAAP earnings volatility may result from factors including, but not limited to: policyholder behavior, capital markets, divergence between the performance of the underlying funds and the hedging indices, changes in hedging positions and the relative emphasis placed on various risk management objectives.

Macro Hedge Program

The Company’s macro hedging program uses derivative instruments such as options, futures, swaps, and forwards on equities and interest rates to provide protection against the statutory tail scenario risk arising from U.S., GMWB and GMDB liabilities, on the Company’s statutory surplus. These macro hedges cover some of the residual risks not otherwise covered by specific dynamic hedging programs. Management assesses this residual risk under various scenarios in designing and executing the macro hedge program. The macro hedge program will result in additional U.S. GAAP earnings volatility as changes in the value of the macro hedge derivatives, which are designed to reduce statutory reserve and capital volatility, may not be closely aligned to changes in U.S. GAAP liabilities.

 

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International Hedge Programs

The Company enters into derivative contracts to hedge market risk exposures associated with the guaranteed benefits which are embedded in the international variable annuity contracts. These derivative contracts include foreign currency forwards and options, interest rate swaps and futures, and equity swaps, options, and futures on certain broadly traded global equity indices including the S&P500 index, Nikkei 225 index, FTSE 100 index, and Euro Stoxx 50. During 2011, the Company increased its equity, currency, and interest rate hedge cover.

While the Company actively manages these dynamic hedging programs, increased U.S. GAAP earnings volatility may result from factors including, but not limited to: focus on reducing the economic exposure to market risks associated with guaranteed benefits, capital markets, changes in hedging positions and the relative emphasis placed on various risk management objectives.

Variable Annuity Hedging Program Sensitivities

The following table presents the accounting treatment of the underlying guaranteed living benefits and the related hedge assets by hedge program.

 

U.S. Programs

 

International Programs

GMWB

 

Macro

 

Japan/UK

Hedge Assets

  Liabilities   Hedge Assets   Liabilities   Hedge Assets   Liabilities [1]

Fair Value

  Fair Value   Fair Value   Not Fair Value   Fair Value   Not Fair Value

 

[1] The liabilities for international variable annuity are primarily not measured on a fair value basis. However there is an immaterial portion of the international variable annuity with a GMWB or GMAB which is measured on a fair value basis.

The following table presents our estimates of the potential instantaneous impacts from sudden market stresses related to equity market prices, interest rates, implied market volatilities, and foreign currency exchange rates. The sensitivities below represent: (1) the net estimated difference between the change in the fair value of GMWB liabilities and the underlying hedge instruments and (2) the estimated change in fair value of the hedge instruments for the macro and international hedge programs, before the impacts of amortization of DAC, and taxes. As noted in the table above, certain hedge assets are used to hedge liabilities that are not carried at fair value and will not have a liability offset in the U.S. GAAP sensitivity analysis. All sensitivities are measured as of March 31, 2012, and are related to the fair value of liabilities and hedge instruments in place as of that date for the Company’s variable annuity hedge programs. The impacts presented in the table below are estimated individually as of March 31, 2011, and performed without consideration of any correlation among market risk factors.

 

U.S. GAAP Sensitivity Analysis

(pre Tax/DAC) [1]

   U.S. Programs     International Programs  
     GMWB     Macro     Japan/UK  

Equity Market Return

     -20     -10     +10     -20     -10     +10     -20     -10     +10

Potential Net Fair Value Impact

   $ (95   $ (32   $ 6      $ 289      $ 90      $ (47   $ 760      $ 373      $ (348
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Interest Rates

     -50 bps        -25bps        +25bps        -50 bps        -25bps        +25bps        -50 bps        -25bps        +25bps   

Potential Net Fair Value Impact

   $ (94   $ (44   $ 39      $ 7      $ 4      $ (3   $ 423      $ 209      $ (219
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Implied Volatilities

     +10     +2     -10     +10     +2     -10     +10     +2     -10

Potential Net Fair Value Impact

   $ (596   $ (115   $ 511      $ 106      $ 22      $ (116   $ 93      $ 19      $ (95
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Yen Strengthens +/ Weakens -

     +20     +10     -10     +20     +10     -10     +20     +10     -10

Potential Net Fair Value Impact

     N/A        N/A        N/A        N/A        N/A        N/A      $ 2,164      $ 734      $ (518
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

[1] These sensitivities are based on the following key market levels as of March 31, 2012: 1) S&P of 1,408.4; 2) 10yr US swap rate of 2.38%; 3) S&P 10yr volatility of 27.17% and 4) FX rates of USDJPY @82.87 and EURJPY @ 110.56.

The above sensitivity analysis is an estimate and should not be used to predict the Company’s future financial performance of its variable annuity hedge programs. The actual net changes in the fair value liability and the hedging assets illustrated in the above table may vary materially depending on a variety of factors which include but are not limited to:

 

 

The sensitivity analysis is only valid as of the measurement date and assumes instantaneous changes in the capital market factors and no ability to rebalance hedge positions prior to the market changes;

 

 

Changes to the underlying hedging program, policyholder behavior, and variation in underlying fund performance relative to the hedged index, which could materially impact the liability; and

 

 

The impact of elapsed time on liabilities or hedge assets, any non-parallel shifts in capital market factors, or correlated moves across the sensitivities.

 

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Foreign Currency Exchange Risk

Foreign currency exchange risk is defined as the risk of financial loss due to changes in the relative value between currencies. The Company’s foreign currency exchange risk is related to non-U.S. dollar denominated liability contracts, including its GMDB, GMAB, GMWB and GMIB benefits associated with its Japanese and U.K. variable annuities, the investment in and net income of the Japanese and U.K. operations, non-U.S. dollar denominated investments, which primarily consist of fixed maturity investments, and a yen denominated individual fixed annuity product. In addition, the Company’s Life Other Operations issued non-U.S. dollar denominated funding agreement liability contracts. A portion of the Company’s foreign currency exposure is mitigated through the use of derivatives.

Liabilities

The company manages the market risk, including foreign currency exchange risk, associated with the guaranteed benefits related to the Japanese and U.K. variable annuities through its comprehensive International Hedge Program. For more information on the International Hedge Program, including the foreign currency exchange risk sensitivity analysis, see the Variable Product Guarantee Risks and Risk Management section.

The yen denominated individual fixed annuity product was 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. During 2009, the Company suspended new sales of the Japan business. 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.

The Company’s Wealth Management operations issued non-U.S. dollar denominated funding agreement liability contracts. The Company hedges the foreign currency risk associated with these liability contracts with currency rate swaps.

Fixed Maturity Investments

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. In order to manage currency exposures, the Company enters into foreign currency swaps to hedge the variability in cash flows as the fair value associated with certain foreign denominated fixed maturities decline. These foreign currency swaps are structured to match the foreign currency cash flows of the hedged foreign denominated securities.

 

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Financial Risk on Statutory Capital

Statutory surplus amounts and risk-based capital (“RBC”) ratios may increase or decrease in any period depending upon a variety of factors and may be compounded in extreme scenarios or if multiple factors occur at the same time. At times the impact of changes in certain market factors or a combination of multiple factors on RBC ratios can be counterintuitive. Factors include:

 

 

In general, as equity market levels and interest rates decline, the amount and volatility of both our actual potential obligation, as well as the related statutory surplus and capital margin for death and living benefit guarantees associated with U.S. variable annuity contracts can be materially negatively affected, sometimes at a greater than linear rate. Other market factors that can impact statutory surplus, reserve levels and capital margin include differences in performance of variable subaccounts relative to indices and/or realized equity and interest rate volatilities. In addition, as equity market levels increase, generally surplus levels will increase. RBC ratios will also tend to increase when equity markets increase. However, as a result of a number of factors and market conditions, including the level of hedging costs and other risk transfer activities, reserve requirements for death and living benefit guarantees and RBC requirements could increase with rising equity markets, resulting in lower RBC ratios. Non-market factors, which can also impact the amount and volatility of both our actual potential obligation, as well as the related statutory surplus and capital margin, include actual and estimated policyholder behavior experience as it pertains to lapsation, partial withdrawals, and mortality.

 

 

Similarly, for guaranteed benefits (GMDB, GMIB, and GMWB) reinsured from our international operations to our U.S. insurance subsidiaries, the amount and volatility of both our actual potential obligation, as well as the related statutory surplus and capital margin can be materially affected by a variety of factors, both market and non-market. Market factors include declines in various equity market indices and interest rates, changes in value of the yen versus other global currencies, difference in the performance of variable subaccounts relative to indices, and increases in realized equity, interest rate, and currency volatilities. Non-market factors include actual and estimated policyholder behavior experience as it pertains to lapsation, withdrawals, mortality, and annuitization. Risk mitigation activities, such as hedging, may also result in material and sometimes counterintuitive impacts on statutory surplus and capital margin. Notably, as changes in these market and non-market factors occur, both our potential obligation and the related statutory reserves and/or required capital can increase or decrease at a greater than linear rate.

 

 

As the value of certain fixed-income and equity securities in our investment portfolio decreases, due in part to credit spread widening, statutory surplus and RBC ratios may decrease.

 

 

As the value of certain derivative instruments that do not get hedge accounting decreases, statutory surplus and RBC ratios may decrease.

 

 

The life insurance subsidiaries’ exposure to foreign currency exchange risk exists with respect to non-U.S. dollar denominated assets and liabilities. Assets and liabilities denominated in foreign currencies are accounted for at their U.S. dollar equivalent values using exchange rates at the balance sheet date. As foreign currency exchange rates vary in comparison to the U.S. dollar, the remeasured value of those non-dollar denominated assets or liabilities will also vary, causing an increase or decrease to statutory surplus.

 

 

Our statutory surplus is also impacted by widening credit spreads as a result of the accounting for the assets and liabilities in our fixed market value adjusted (“MVA”) annuities. Statutory separate account assets supporting the fixed MVA annuities are recorded at fair value. In determining the statutory reserve for the fixed MVA annuities, we are required to use current crediting rates in the U.S. and Japanese LIBOR in Japan. In many capital market scenarios, current crediting rates in the U.S. are highly correlated with market rates implicit in the fair value of statutory separate account assets. As a result, the change in statutory reserve from period to period will likely substantially offset the change in the fair value of the statutory separate account assets. However, in periods of volatile credit markets, such as we have experienced, actual credit spreads on investment assets may increase sharply for certain sub-sectors of the overall credit market, resulting in statutory separate account asset market value losses. As actual credit spreads are not fully reflected in the current crediting rates in the U.S. or Japanese LIBOR in Japan, the calculation of statutory reserves will not substantially offset the change in fair value of the statutory separate account assets resulting in reductions in statutory surplus. This has resulted and may continue to result in the need to devote significant additional capital to support the product.

 

 

With respect to our fixed annuity business, sustained low interest rates may result in a reduction in statutory surplus and an increase in National Association of Insurance Commissioners (“NAIC”) required capital.

Most of these factors are outside of the Company’s control. The Company’s financial strength and credit ratings are significantly influenced by the statutory surplus amounts and RBC ratios of our insurance company subsidiaries. In addition, rating agencies may implement changes to their internal models that have the effect of increasing or decreasing the amount of statutory capital we must hold in order to maintain our current ratings.

The Company has reinsured approximately 16% of its risk associated with U.S. GMWB and 64% of its risk associated with the aggregate U.S. GMDB exposure. These reinsurance agreements serve to reduce the Company’s exposure to changes in the statutory reserves and the related capital and RBC ratios associated with changes in the capital markets. The Company also continues to explore other solutions for mitigating the capital market risk effect on surplus, such as internal and external reinsurance solutions, modifications to our hedging program, changes in product design, increasing pricing and expense management.

 

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Credit Risk

Credit risk is defined as the risk of financial loss due to uncertainty of obligor’s or counterparty’s ability or willingness to meet its obligations in accordance with agreed upon terms. The majority of the Company’s credit risk is concentrated in its investment holdings but is also present in reinsurance and insurance portfolios. Credit risk is comprised of three major factors: the risk of change in credit quality, or credit migration risk; the risk of default; and the risk of a change in value of a financial instrument due to changes in credit spread that are unrelated to changes in obligor credit quality. A decline in creditworthiness is typically associated with an increase in an investment’s credit spread, potentially resulting in an increase in other-than-temporary impairments and an increased probability of a realized loss upon sale.

The objective of the Company’s enterprise credit risk management strategy is to identify, quantify, and manage credit risk on an aggregate portfolio basis and to limit potential losses in accordance with an established credit risk appetite. The Company manages to its risk appetite by primarily holding a diversified mix of investment grade issuers and counterparties across its investment, reinsurance, and insurance portfolios. Potential losses are also limited within portfolios by diversifying across geographic regions, asset types, and sectors.

The Company manages a credit exposure from its inception to its maturity or sale. Both the investment and reinsurance areas have formulated procedures for counterparty approvals and authorizations. Although approval processes may vary by area and type of credit risk, approval processes establish minimum levels of creditworthiness and financial stability. Eligible credits are subjected to prudent and conservative underwriting reviews. Within the investment portfolio, private securities, such as commercial mortgages, and private placements, must be presented to their respective review committees for approval.

Credit risks are managed on an on-going basis through the use of various processes and analyses. At the investment, reinsurance, and insurance product levels, fundamental credit analyses are performed at the issuer/counterparty level on a regular basis. To provide a holistic review within the investment portfolio, fundamental analyses are supported by credit ratings, assigned by nationally recognized rating agencies or internally assigned, and by quantitative credit analyses. The Company utilizes an economic credit VaR to measure default and migration risk on a monthly basis. Issuer and security level risk measures are also utilized. In the event of deterioration in credit quality, the Company maintains watch lists of problem counterparties within the investment and reinsurance portfolios. The watch lists are updated based on regular credit examinations and management reviews. The Company also performs quarterly assessments of probable expected losses in the investment portfolio. The process is conducted on a sector basis and is intended to promptly assess and identify potential problems in the portfolio and to recognize necessary impairments.

Credit risk policies at the enterprise and operation level ensure comprehensive and consistent approaches to quantifying, evaluating, and managing credit risk under expected and stressed conditions. These policies define the scope of the risk, authorities, accountabilities, terms, and limits, and are regularly reviewed and approved by senior management and ERM. Aggregate counterparty credit quality and exposure is monitored on a daily basis utilizing an enterprise-wide credit exposure information system that contains data on issuers, ratings, exposures, and credit limits. Exposures are tracked on a current and potential basis. Credit exposures are reported regularly to the ERCC and to the Finance, Investment and Risk Management Committee (“FIRMCo”). Exposures are aggregated by ultimate parent across investments, reinsurance receivables, insurance products with credit risk, and derivative counterparties. The credit database and reporting system are available to all key credit practitioners in the enterprise.

The Company exercises various and differing methods to mitigate its credit risk exposure within its investment and reinsurance portfolios. Some of the reasons for mitigating credit risk include financial instability or poor credit, avoidance of arbitration or litigation, future uncertainty, and exposure in excess of risk tolerances. Credit risk within the investment portfolio is most commonly mitigated through the use of derivative instruments or asset sales. Counterparty credit risk is mitigated through the practice of entering into contracts only with highly creditworthy institutions and through the practice of holding and posting of collateral. Systemic credit risk is mitigated through the construction of high-quality, diverse portfolios that are subject to regular underwriting of credit risks. For further discussion of the Company’s investment and derivative instruments, see the Investment Management section and Note 5 of the Notes to Condensed Consolidated Financial Statements. Further discussion on managing and mitigating credit risk from the use of reinsurance via an enterprise security review process, see the Reinsurance section.

As of March 31, 2012, the Company’s only exposure to any credit concentration risk of a single issuer greater than 10% of the Company’s stockholders’ equity, other than U.S. government and certain U.S. government securities, was the Government of Japan, which represented $2.5 billion, or 12% of stockholders’ equity, and 2% of total invested assets. For further discussion of concentration of credit risk, see the Concentration of Credit Risk section in Note 5 of the Notes to Consolidated Financial Statements in The Hartford’s 2011 Form 10-K Annual Report.

 

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Derivative Instruments

The Company utilizes a variety of over-the-counter and exchange traded derivative instruments as a part of its overall risk management strategy, as well as to enter into replication transactions. Derivative instruments are used to manage risk associated with interest rate, equity market, credit spread, issuer default, price, and currency exchange rate risk or volatility. Replication transactions are used as an economical means to synthetically replicate the characteristics and performance of assets that would otherwise be permissible investments under the Company’s investment policies. For further information on the Company’s use of derivatives, see Note 5 of the Notes to Condensed Consolidated Financial Statements.

Derivative activities are monitored and evaluated by the Company’s compliance and risk management teams and reviewed by senior management. In addition, the Company monitors counterparty credit exposure on a monthly basis to ensure compliance with Company policies and statutory limitations. The notional amounts of derivative contracts represent the basis upon which pay or receive amounts are calculated and are not reflective of credit risk. Downgrades to the credit ratings of The Hartford’s insurance operating companies may have adverse implications for its use of derivatives including those used to hedge benefit guarantees of variable annuities. In some cases, downgrades may give derivative counterparties the unilateral contractual right to cancel and settle outstanding derivative trades or require additional collateral to be posted. In addition, downgrades may result in counterparties becoming unwilling to engage in additional over-the-counter (“OTC”) derivatives or may require collateralization before entering into any new trades. This will restrict the supply of derivative instruments commonly used to hedge variable annuity guarantees, particularly long-dated equity derivatives and interest rate swaps. Under these circumstances, the Company’s operating subsidiaries could conduct hedging activity using a combination of cash and exchange-traded instruments, in addition to using the available OTC derivatives.

The Company uses various derivative counterparties in executing its derivative transactions. The use of counterparties creates credit risk that the counterparty may not perform in accordance with the terms of the derivative transaction. The Company has derivative counterparty exposure policies which limit the Company’s exposure to credit risk. The Company’s policies with respect to derivative counterparty exposure establishes market-based credit limits, favors long-term financial stability and creditworthiness of the counterparty and typically requires credit enhancement/credit risk reducing agreements. The Company minimizes the credit risk of derivative instruments by entering into transactions with high quality counterparties primarily rated A or better, which are monitored and evaluated by the Company’s risk management team and reviewed by senior management. The Company also generally requires that derivative contracts, other than exchange traded contracts, certain forward contracts, and certain embedded and reinsurance derivatives, be governed by an International Swaps and Derivatives Association Master Agreement, which is structured by legal entity and by counterparty and permits right of offset.

The Company has developed credit exposure thresholds which are based upon counterparty ratings. Credit exposures are measured using the market value of the derivatives, resulting in amounts owed to the Company by its counterparties or potential payment obligations from the Company to its counterparties. For purposes of daily derivative collateral maintenance, credit exposures are generally quantified based on the prior business day’s market value and collateral is pledged to and held by, or on behalf of, the Company to the extent the current value of the derivatives exceed the contractual thresholds. In accordance with industry standard and the contractual agreements, collateral is typically settled on the next business day. The Company has exposure to credit risk for amounts below the exposure thresholds which are uncollateralized, as well as for market fluctuations that may occur between contractual settlement periods of collateral movements.

For the company’s domestic derivative programs, the maximum uncollateralized threshold for a derivative counterparty for a single legal entity is $10. The Company currently transacts OTC derivatives in five legal entities and therefore the maximum combined threshold for a single counterparty across all legal entities that use derivatives is $50. In addition, the Company may have exposure to multiple counterparties in a single corporate family due to a common credit support provider. As of March 31, 2012, for the company’s domestic derivative programs, the maximum combined threshold for all counterparties under a single credit support provider across all legal entities that use derivatives is $100. Based on the contractual terms of the collateral agreements, these thresholds may be immediately reduced due to a downgrade in either party’s credit rating. Beginning in the fourth quarter of 2011, the Company began hedging its Japan exposures within the legal entity HLIKK. The counterparty credit exposures at HLIKK generally follow the maximum uncollateralized threshold of the domestic program, however, for three counterparties, maximum uncollateralized exposures are higher. These three counterparties maintain credit ratings of A or better, and the Company actively monitors their credit standing. For further discussion, see the Derivative Commitments section of Note 9 of the Notes to Condensed Consolidated Financial Statements.

For the three months ended March 31, 2012, the Company has incurred no losses on derivative instruments due to counterparty default.

In addition to counterparty credit risk, the Company may also introduce credit risk through the use of credit default swaps that are entered into to manage credit exposure. Credit default swaps involve a transfer of credit risk of one or many referenced entities from one party to another in exchange for periodic payments. The party that purchases credit protection will make periodic payments based on an agreed upon rate and notional amount, and for certain transactions there will also be an upfront premium payment. The second party, who assumes credit risk, will typically only make a payment if there is a credit event as defined in the contract and such payment will be typically equal to the notional value of the swap contract less the value of the referenced security issuer’s debt obligation. A credit event is generally defined as default on contractually obligated interest or principal payments or bankruptcy of the referenced entity.

 

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The Company uses credit derivatives to purchase credit protection and to assume credit risk with respect to a single entity, referenced index, or asset pool. 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. The Company also enters into credit default swaps that assume credit risk as part of replication transactions. Replication transactions are used as an economical means to synthetically replicate the characteristics and performance of assets that would otherwise be permissible investments under the Company’s investment policies. These swaps reference investment grade single corporate issuers and baskets, which include customized diversified portfolios of corporate issuers, which are established within sector concentration limits and may be divided into tranches which possess different credit ratings.

Investment Portfolio Risks and Risk Management

Investment Portfolio Composition

The following table presents the Company’s fixed maturities, AFS, by credit quality. The ratings referenced below are based on the ratings of a nationally recognized rating organization or, if not rated, assigned based on the Company’s internal analysis of such securities

 

Fixed Maturities by Credit Quality  
     March 31, 2012     December 31, 2011  
     Amortized
Cost
     Fair Value      Percent of
Total Fair
Value
    Amortized
Cost
     Fair Value      Percent of
Total Fair
Value
 

United States Government/Government agencies

   $ 8,880       $ 9,193         11.1   $ 8,901       $ 9,364         11.4

AAA

     9,293         9,712         11.7     9,631         10,113         12.4

AA

     15,890         16,463         19.8     15,471         15,844         19.4

A

     19,131         20,773         25.0     19,501         21,053         25.7

BBB

     21,722         22,664         27.2     20,972         21,760         26.6

BB & below

     5,105         4,352         5.2     4,502         3,675         4.5
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

Total fixed maturities

   $ 80,021         83,157         100.0   $ 78,978         81,809         100.0
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

The movement in the overall credit quality of the Company’s portfolio was primarily attributable to the reinvestment in spread product and tactical portfolio repositioning associated with higher-yielding assets that provide superior risk-adjusted returns, as well as downgrades within financial services and commercial real estate securities. Fixed maturities, FVO, are not included in the above table. For further discussion on fair value option securities, see Note 4 of the Notes to Condensed Consolidated Financial Statements.

 

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The following table presents the Company’s AFS securities by type, as well as fixed maturities, FVO.

Securities by Type

 

     March 31, 2012     December 31, 2011  
     Cost or
Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
    Fair
Value
     Percent
of Total
Fair
Value
    Cost or
Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
    Fair
Value
     Percent
of Total
Fair
Value
 

Asset-backed securities (“ABS”)

                          

Consumer loans

   $ 2,660       $ 28       $ (194   $ 2,494         3.0   $ 2,688       $ 34       $ (208   $ 2,514         3.1

Small business

     396         1         (112     285         0.3     418         1         (123     296         0.4

Other

     290         18         —          308         0.4     324         20         (1     343         0.4

CDOs

                          

Collateralized loan obligations (“CLOs”)

     2,320         1         (146     2,175         2.6     2,334         —           (181     2,153         2.6

CREs

     475         23         (142     356         0.4     485         16         (167     334         0.4

Other [1]

     556         16         (17     512         0.7     —           —           —          —           —     

CMBS

                          

Agency backed [2]

     565         39         —          604         0.7     637         40         —          677         0.8

Bonds

     5,734         219         (350     5,603         6.7     5,992         182         (487     5,687         7.0

Interest only (“IOs”)

     548         47         (28     567         0.7     563         49         (25     587         0.7

Corporate

                          

Basic industry [1]

     3,762         294         (26     4,030         4.8     3,690         309         (19     3,979         4.9

Capital goods

     3,317         328         (22     3,623         4.4     3,327         331         (33     3,625         4.4

Consumer cyclical

     2,174         200         (7     2,367         2.8     2,277         206         (8     2,475         3.0

Consumer non-cyclical

     5,632         604         (13     6,223         7.5     5,985         644         (13     6,616         8.1

Energy

     3,631         354         (17     3,968         4.8     3,338         381         (15     3,704         4.5

Financial services

     7,311         390         (370     7,331         8.8     7,763         334         (526     7,571         9.3

Tech./comm.

     4,336         419         (48     4,707         5.7     4,357         443         (61     4,739         5.8

Transportation

     1,362         118         (8     1,472         1.8     1,285         123         (6     1,402         1.7

Utilities

     8,457         766         (47     9,176         11.1     8,236         857         (38     9,055         11.2

Other [1]

     401         35         (4     432         0.5     903         33         (20     845         1.0

Foreign govt./govt. agencies

     3,248         128         (24     3,352         4.0     2,030         141         (10     2,161         2.6

Municipal Taxable

     2,198         140         (54     2,284         2.7     1,688         120         (51     1,757         2.1

Tax-exempt

     10,793         774         (13     11,554         13.9     10,869         655         (21     11,503         14.1

RMBS

                          

Agency

     5,238         216         (4     5,450         6.5     4,436         222         —          4,658         5.7

Non-agency

     60         —           (1     59         0.1     62         —           (2     60         0.1

Alt-A

     110         6         (14     102         0.1     115         5         (21     99         0.1

Sub-prime

     1,370         18         (404     984         1.2     1,348         25         (433     940         1.1

U.S. Treasuries

     3,077         83         (21     3,139         3.8     3,828         203         (2     4,029         4.9
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

 

Fixed maturities, AFS

     80,021         5,265         (2,086     83,157         100.     78,978         5,374         (2,471     81,809         100

Equity securities

                          

Financial services

     432         —           (120     312           479         10         (187     302      

Other

     569         69         (12     626           577         58         (16     619      
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

Equity securities, AFS

     1,001         69         (132     938           1,056         68         (203     921      
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

Total AFS securities

   $ 81,022       $ 5,334       $ (2,218   $ 84,095         $ 80,034       $ 5,442       $ (2,674   $ 82,730      
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

Fixed maturities, FVO

           $ 1,291                 $ 1,328      
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

[1] Gross unrealized gains (losses) exclude the fair value of bifurcated embedded derivative features of certain securities. Changes in value are recorded in net realized capital gains (losses).
[2] Represents securities with pools of loans issued by the Small Business Administration which are backed by the full faith and credit of the U.S. government.

The Company continues to invest in a diversified portfolio with purchases focused on investment grade corporate, taxable municipal and foreign government securities, as well as the reinvestment of short-term securities into agency RMBS to generate an additional return. The Company’s AFS net unrealized position improved primarily as a result of improved security valuations largely due to credit spread tightening, partially offset by rising interest rates. Fixed maturities, FVO, represents Japan government securities supporting the Japan fixed annuity product, as well as securities containing an embedded credit derivative for which the Company elected the fair value option. The underlying credit risk of the securities containing credit derivatives are primarily investment grade CRE CDOs and a subordinated position on a basket of corporate bonds. For further discussion on fair value option securities, see Note 4 of the Notes to Condensed Consolidated Financial Statements.

 

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Table of Contents

European Exposure

Many economies within Europe continue to experience significant adverse economic conditions which have been precipitated in part by high unemployment rates and government debt levels. As a result, issuers in several European countries have experienced credit deterioration and rating downgrades and a reduced ability to access capital markets and/or higher borrowing costs. The concerns regarding the European countries have impacted the capital markets which, in turn, has made it more difficult to contain the European financial crisis. Austerity measures aimed at reducing sovereign debt levels, along with steps taken by the European Central Bank to provide liquidity and credit support to certain countries issuing debt, have helped to stabilize markets recently. However, risks remain elevated.

The Company manages the credit risk associated with the European securities within the investment portfolio on an on-going basis using several processes which are supported by macroeconomic analysis and issuer credit analysis. For additional details regarding the Company’s management of credit risk, see the Credit Risk section of this MD&A. The Company considers alternate scenarios, including a base-case and both a positive and negative “tail” scenario that includes a partial or full break-up of the Eurozone. The outlook for key factors is evaluated, including the economic prospects for key countries, the potential for the spread of sovereign debt contagion, and the likelihood that policymakers and politicians pursue sufficient fiscal discipline and introduce appropriate backstops. Given the inherent uncertainty in the outcome of developments in the Eurozone, however, the Company has been focused on controlling both absolute levels of exposure and the composition of that exposure through both bond and derivative transactions.

The Company has limited direct European exposure, totaling only 6% of total invested assets as of March 31, 2012. The following tables present the Company’s European securities included in the Securities by Type table above. The Company identifies exposures with the issuers’ ultimate parent country of domicile, which may not be the country of the security issuer. Certain European countries were separately listed below, Greece, Italy, Ireland, Portugal and Spain (“GIIPS”), because of the current significant economic strains persisting in these countries. The criteria used for identifying the countries separately listed includes credit default spreads that exceed the iTraxx SovX index level and an S&P credit quality rating of A or lower.

The following tables present the Company’s European securities included in the Securities by Type table above.

 

March 31, 2012  
     Corporate & Equity,
AFS Non-Finan. [1]
     Corporate & Equity,
AFS Financials
     Foreign Govt./
Govt. Agencies
     Total  
     Amortized
Cost
     Fair
Value
     Amortized
Cost
     Fair
Value
     Amortized
Cost
     Fair
Value
     Amortized
Cost
     Fair
Value
 

Italy

   $ 274       $ 242       $ —         $ —         $ —         $ —         $ 274       $ 242   

Spain [3]

     150         150         20         20         —           —           170         170   

Ireland

     166         168         —           —           —           —           166         168   

Portugal

     15         15         —           —           —           —           15         15   

Greece

     ––         ––         —           —           —           —           ––         ––   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Higher risk

     605         575         20         20         —           —           625         595   

Europe excluding higher risk

     4,227         4,662         1,192         1,163         900         952         6,319         6,777   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total Europe

   $ 4,832       $ 5,237       $ 1,212         1,183       $ 900         952       $ 6,944       $ 7,372   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Europe exposure net of credit default swap protection [2]

                     $ 6,486       $ 7,381   
                    

 

 

    

 

 

 

 

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Table of Contents
December 31, 2011  
     Corporate & Equity,
AFS Non-Finan. [1]
     Corporate & Equity,
AFS Financials
     Foreign Govt./
Govt. Agencies
     Total  
     Amortized
Cost
     Fair
Value
     Amortized
Cost
     Fair
Value
     Amortized
Cost
     Fair
Value
     Amortized
Cost
     Fair
Value
 

Italy

   $ 314       $ 255       $ —         $ —         $ —         $ —         $ 314       $ 255   

Spain[3]

     191         189         20         19         —           —           211         208   

Ireland

     163         162         —           —           —           —           163         162   

Portugal

     15         15         —           —           —           —           15         15   

Greece

     —           —           —           —           —           —           —           —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Higher risk

     683         621         20         19         —           —           703         640   

Europe excluding higher risk

     4,277         4,698         1,255         1,135         901         970         6,433         6,800   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total Europe

   $ 4,960       $ 5,316       $ 1,275       $ 1,154       $ 901       $ 970       $ 7,136       $ 7,440   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Europe exposure net of credit default swap protection [2]

                     $ 6,439       $ 7,467   
                    

 

 

    

 

 

 

 

[1] Includes amortized cost and fair value of $59 as of March 31, 2012 and $67 as of December 31, 2011 related to limited partnerships and other alternative investments, the majority of which is domiciled in the United Kingdom.
[2] Includes a notional amount and fair value of $458 and $9, respectively, as of March 31, 2012 and $697 and $27, respectively, as of December 31, 2011 related to credit default swap protection. This includes a notional amount of $104 and $89 as of March 31, 2012 and December 31, 2011, respectively, related to single name corporate issuers in the financial services sector.
[3] The Company has credit default swap protection with a notional amount of $20 related to the corporate and Equity, AFS Financials.

The Company’s European investment exposure largely relates to corporate entities which are domiciled in or generated a significant portion of its revenue within the United Kingdom, Germany, the Netherlands and Switzerland. As of March 31, 2012 and December 31, 2011, exposure to the United Kingdom totaled approximately 2% of total invested assets. The majority of investments are U.S. dollar-denominated, and those securities that are pound and euro-denominated are hedged to U.S. dollars or support foreign-denominated liabilities. For a discussion of foreign currency risks, see the Foreign Currency Exchange Risk section of this MD&A. The Company does not hold any sovereign exposure to the higher risk countries and does not hold any exposure to issuers in Greece. As of March 31, 2012 and December 31, 2011, the Company’s unfunded commitments associated with its investment portfolio was immaterial, and the weighted average credit quality of European investments was A- and A, respectively.

As of March 31, 2012 and December 31, 2011, the Company’s total credit default swaps that provide credit protection had a notional amount of $458 and $697, respectively, and a fair value of $9 and $27, respectively. Included in those notional amounts as of March 31, 2012 and December 31, 2011 were $432 and $407, respectively, on credit default swaps that reference single name corporate and financial European issuers, of which $134 and $125, respectively, related to the higher risk countries. The maturity dates of credit defaults swaps are primarily consistent with the hedged bonds. Also included are credit default swaps with a notional amount of $26 and $290, respectively, as of March 31, 2012 and December 31, 2011 which reference a standard basket of European corporate and financial issuers. For further information on the use of the Company’s credit derivatives and counterparty credit quality, see Derivative Instruments within the Credit Risk section of this MD&A.

Included in the Company’s equity securities, trading, portfolio are investments in World Government Bond Index Funds (“WGBI funds”). The fair value of the WGBI funds at March 31, 2012 and December 31, 2011 was $12.4 billion and $12.5 billion, respectively. Because several of these funds are managed by third party asset managers, the Company does not have access to detailed holdings; however, the WGBI funds investment mandate follows the Citigroup non-Japan World Government Fund Index (“the index”) and includes allocations to certain European sovereign debt. The estimated fair value of the European allocation based upon the index benchmark allocation was $5.4 billion as of March 31, 2012 and December 31, 2011. Included in this estimated European exposure were investments in Ireland, Italy, Portugal and Spain with an estimated fair value of $1.7 billion as of March 31, 2012 and December 31, 2011. The index guidelines allow investment in issuers rated BBB- or higher by Standard and Poors or Baa3 or higher by Moodys. Should an issuer’s credit rating fall below both of these rating levels they will be removed from the Index and the holdings will be liquidated. Because these assets support the international variable annuity business, changes in the value of these investments are reflected in the corresponding policyholder liabilities. The Company’s indirect exposure to these holdings is through any guarantees issued on the underlying variable annuity policies. For a discussion of the Company’s reinsurance arrangements, see Note 6 of the Notes to Consolidated Financial Statements included in The Hartford’s 2011 Form 10-K Annual Report.

 

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Table of Contents

Financial Services

The Company’s exposure to the financial services sector is predominantly through banking and insurance institutions. The following table presents the Company’s exposure to the financial services sector included in the Securities by Type table above.

 

     March 31, 2012     December 31, 2011  
     Amortized
Cost
     Fair
Value
     Net
Unrealized
    Amortized
Cost
     Fair
Value
     Net
Unrealized
 

AAA

   $ 156       $ 162       $ 6      $ 240       $ 245       $ 5   

AA

     1,456         1,452         (4     1,698         1,675         (23

A

     3,147         3,302         155        3,664         3,685         21   

BBB

     2,393         2,232         (161     2,335         1,998         (337

BB & below

     591         495         (96     305         270         (35
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

Total

   $ 7,743       $ 7,643       $ (100   $ 8,242       $ 7,873       $ (369
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

Domestic financial companies continued to stabilize in 2012 due to improved earnings performance, strengthening of asset quality and capital retention. However, spread volatility remains high due to concerns around European sovereign risks and potential contagion effects, as well as regulatory pressures. Financial institutions remain vulnerable to these concerns, as well as ongoing stress in the real estate markets which could adversely impact the Company’s net unrealized position.

Commercial Real Estate

The commercial real estate market continued to show signs of improving fundamentals, such as increases in transaction activities, more readily available financing and new issuances. While delinquencies still remain at historically high levels, they are expected to move lower in 2012.

The following table presents the Company’s exposure to commercial mortgage backed-securities (“CMBS”) bonds by current credit quality and vintage year, included in the Securities by Type table above. Credit protection represents the current weighted average percentage of the outstanding capital structure subordinated to the Company’s investment holding that is available to absorb losses before the security incurs the first dollar loss of principal and excludes any equity interest or property value in excess of outstanding debt.

CMBS – Bonds [1]

 

March 31, 2012

 
     AAA     AA     A     BBB     BB and Below     Total  
     Amortized
Cost
     Fair
Value
    Amortized
Cost
     Fair
Value
    Amortized
Cost
     Fair
Value
    Amortized
Cost
     Fair
Value
    Amortized
Cost
     Fair
Value
    Amortized
Cost
     Fair
Value
 

2003 & Prior

   $ 360       $ 370      $ 137       $ 136      $ 83       $ 82      $ 16       $ 14      $ 33       $ 30      $ 629       $ 632   

2004

     297         313        72         79        31         28        30         29        26         21        456         470   

2005

     505         542        101         101        155         147        184         156        85         68        1,030         1,014   

2006

     701         762        434         432        124         117        292         249        452         339        2,003         1,899   

2007

     204         226        350         352        72         61        217         191        195         149        1,038         979   

2008

     55         63        —           —          —           —          —           —          —           —          55         63   

2009

     28         29        —           —          —           —          —           —          —           —          28         29   

2010

     29         31        —           —          —           —          —           —          —           —          29         31   

2011

     398         419        —           —          —           —          —           —          —           —          398         419   

2012

     68         67        —           —          —           —          —           —          —           —          68         67   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 2,645       $ 2,822      $ 1,094       $ 1,100      $ 465       $ 435      $ 739       $ 639      $ 791       $ 607      $ 5,734       $ 5,603   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Credit protection

        27.3        23.2        20.8        14.5        10.1        22.0
     

 

 

      

 

 

      

 

 

      

 

 

      

 

 

      

 

 

 

 

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Table of Contents

December 31, 2011

 

     AAA     AA     A     BBB     BB and Below     Total  
     Amortized
Cost
     Fair
Value
    Amortized
Cost
     Fair
Value
    Amortized
Cost
     Fair
Value
    Amortized
Cost
     Fair
Value
    Amortized
Cost
     Fair
Value
    Amortized
Cost
     Fair
Value
 

2003 & Prior

   $ 408       $ 415      $ 148       $ 144      $ 83       $ 81      $ 16       $ 13      $ 33       $ 30      $ 688       $ 683   

2004

     333         349        68         75        45         41        30         28        26         21        502         514   

2005

     520         556        101         96        178         151        177         138        71         57        1,047         998   

2006

     713         762        516         493        180         159        362         298        430         302        2,201         2,014   

2007

     245         267        296         275        123         97        166         130        195         149        1,025         918   

2008

     55         60        —           —          —           —          —           —          —           —          55         60   

2009

     28         29        —           —          —           —          —           —          —           —          28         29   

2010

     29         31        —           —          —           —          —           —          —           —          29         31   

2011

     417         440        —           —          —           —          —           —          —           —          417         440   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 2,748       $ 2,909      $ 1,129       $ 1,083      $ 609       $ 529      $ 751       $ 607      $ 755       $ 559      $ 5,992       $ 5,687   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Credit protection

        27.3        22.7        19.7        13.8        8.2        21.6
     

 

 

      

 

 

      

 

 

      

 

 

      

 

 

      

 

 

 

 

[1] The vintage year represents the year the pool of loans was originated.

The Company also has AFS exposure to commercial real estate (“CRE”) collateralized debt obligations (“CDOs”) with an amortized cost and fair value of $475 and $356, respectively, as of March 31, 2012 and $485 and $334, respectively, as of December 31, 2011. These securities are comprised of diversified pools of commercial mortgage loans or equity positions of other CMBS securitizations. Although the Company does not plan to invest in this asset class going forward, we continue to monitor these investments as economic and market uncertainties regarding future performance impact market liquidity and result in higher risk premiums.

In addition to CMBS bonds and CRE CDOs, the Company has exposure to commercial mortgage loans as presented in the following table. These loans are collateralized by a variety of commercial properties and are diversified both geographically throughout the United States and by property type. These loans may be either in the form of a whole loan, where the Company is the sole lender, or a loan participation. Loan participations are loans where the Company has purchased or retained a portion of an outstanding loan or package of loans and participates on a pro-rata basis in collecting interest and principal pursuant to the terms of the participation agreement. In general, A-Note participations have senior payment priority, followed by B-Note participations and then mezzanine loan participations. As of March 31, 2012, loans within the Company’s mortgage loan portfolio that have had extensions or restructurings other than what is allowable under the original terms of the contract are immaterial.

Commercial Mortgage Loans

 

     March 31, 2012      December 31, 2011  
     Amortized
Cost [1]
     Valuation
Allowance
    Carrying
Value
     Amortized
Cost [1]
     Valuation
Allowance
    Carrying
Value
 

Agricultural

   $ 206       $ (7   $ 199       $ 268       $ (19   $ 249   

Whole loans

     5,491         (15     5,476         4,892         (17     4,875   

A-Note participations

     279         —          279         265         —          265   

B-Note participations

     278         (66     212         296         (66     230   

Mezzanine loans

     109         —          109         109         —          109   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Total

   $ 6,363       $ (88   $ 6,275       $ 5,830       $ (102   $ 5,728   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

 

[1] Amortized cost represents carrying value prior to valuation allowances, if any.

Since December 31, 2011, the Company funded $659 of commercial whole loans with a weighted average loan-to-value (“LTV”) ratio of 59% and a weighted average yield of 3.7%. The Company continues to originate commercial whole loans in primary markets, such as office, industrial and multi-family, focusing on loans with strong LTV ratios and high quality property collateral. As of March 31, 2012, the Company had mortgage loans held-for-sale with a carrying value and valuation allowance of $57 and $4, respectively, and $74 and $4, respectively, as of December 31, 2011.

Municipal Bonds

The Company holds investments in securities backed by states, municipalities and political subdivisions (“municipal”) with an amortized cost and fair value of $13.0 billion and $13.8 billion, respectively, as of March 31, 2012 and $12.6 billion and $13.3 billion, respectively, as of December 31, 2011. The Company’s municipal bond portfolio primarily consists of high quality essential service revenue and general obligation bonds. As of March 31, 2012, the largest issuer concentrations were the states of California, Massachusetts and Illinois, which each comprised less than 3.5% of the municipal bond portfolio and were primarily comprised of general obligation bonds. As of December 31, 2011, the largest issuer concentrations were the states of California, Massachusetts and Illinois, which each comprised less than 3% of the municipal bond portfolio and were primarily comprised of general obligation bonds.

 

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Limited Partnerships and Other Alternative Investments

The following table presents the Company’s investments in limited partnerships and other alternative investments which include hedge funds, mortgage and real estate funds, mezzanine debt funds, and private equity and other funds. Hedge funds include investments in funds of funds and direct funds. These hedge funds invest in a variety of strategies including global macro and long/short credit and equity. Mortgage and real estate funds consist of investments in funds whose assets consist of mortgage loans, mortgage loan participations, mezzanine loans or other notes which may be below investment grade, as well as equity real estate and real estate joint ventures. Mezzanine debt funds include investments in funds whose assets consist of subordinated debt that often incorporates equity-based options such as warrants and a limited amount of direct equity investments. Private equity and other funds primarily consist of investments in funds whose assets typically consist of a diversified pool of investments in small to mid-sized non-public businesses with high growth potential.

 

     March 31, 2012     December 31, 2011  
     Amount      Percent     Amount      Percent  

Hedge funds

   $ 1,087         39.8   $ 896         35.4

Mortgage and real estate funds

     492         18.0     479         18.9

Mezzanine debt funds

     116         4.2     118         4.7

Private equity and other funds

     1,037         38.0     1,039         41.0
  

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 2,732         100.0   $ 2,532         100.0
  

 

 

    

 

 

   

 

 

    

 

 

 

Since December 31, 2011, the increase in hedge funds relates to additional investments in the type of fund strategies that the Company expects to generate superior risk-adjusted returns over time, and are less sensitive to directional movements in the credit and equity markets.

Available-for-Sale Securities — Unrealized Loss Aging

The total gross unrealized losses were $2.2 billion as of March 31, 2012, which have improved $456, or 17%, from December 31, 2011 as credit spread tightening, partially offset by rising interest rates. As of March 31, 2012, $827 of the gross unrealized losses were associated with securities depressed less than 20% of cost or amortized cost.

The remaining $1.4 billion of gross unrealized losses were associated with securities depressed greater than 20%, which includes $161 associated with securities depressed over 50% for twelve months or more. These securities are backed primarily by commercial and residential real estate that have market spreads that continue to be wider than the spreads at the security’s respective purchase date. The unrealized losses remain largely due to the continued market and economic uncertainties surrounding residential and certain commercial real estate and less liquidity. Based upon the Company’s cash flow modeling and current market and collateral performance assumptions, these securities have sufficient credit protection levels to receive contractually obligated principal and interest payments. Also included in the gross unrealized losses depressed greater than 20% are financial services securities that have a floating-rate coupon and/or long-dated maturities.

As part of the Company’s ongoing security monitoring process, the Company has reviewed its AFS securities in an unrealized loss position and concluded that there were no additional impairments as of March 31, 2012 and that these securities are temporarily depressed and are expected to recover in value as the securities approach maturity or as real estate related market spreads continue to improve. For these securities in an unrealized loss position where a credit impairment has not been recorded, the Company’s best estimate of expected future cash flows are sufficient to recover the amortized cost basis of the security. Furthermore, the Company neither has an intention to sell nor does it expect to be required to sell these securities. For further information regarding the Company’s impairment analysis, see Other-Than-Temporary Impairments in the Investment Portfolio Risks and Risk Management section of this MD&A.

The following table presents the Company’s unrealized loss aging for AFS securities by length of time the security was in a continuous unrealized loss position.

 

     March 31, 2012     December 31, 2011  
     Items      Cost or
Amortized
Cost
     Fair
Value
     Unrealized
Loss [1]
    Items      Cost or
Amortized
Cost
     Fair
Value
     Unrealized
Loss [1]
 

Three months or less

     994       $ 6,209       $ 6,069       $ (140     855       $ 3,933       $ 3,672       $ (261

Greater than three to six months

     297         1,325         1,111         (214     485         2,617         2,517         (100

Greater than six to nine months

     171         979         953         (26     224         1,181         1,097         (84

Greater than nine to eleven months

     114         602         575         (27     42         106         95         (11

Greater than twelve months

     882         10,808         8,955         (1,811     943         11,613         9,324         (2,218
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

 

Total

     2,458       $ 19,923       $ 17,663       $ (2,218     2,549       $ 19,450       $ 16,705       $ (2,674
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

 

 

[1] Unrealized losses exclude the fair value of bifurcated embedded derivative features of certain securities as changes in value are recorded in net realized capital gains (losses).

 

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The following tables present the Company’s unrealized loss aging for AFS securities continuously depressed over 20% by length of time (included in the table above).

 

     March 31, 2012     December 31, 2011  

Consecutive Months

   Items      Cost or
Amortized
Cost
     Fair
Value
     Unrealized
Loss
    Items      Cost or
Amortized
Cost
     Fair
Value
     Unrealized
Loss
 

Three months or less

     100       $ 111       $ 83       $ (28     206       $ 1,823       $ 1,289       $ (500

Greater than three to six months

     108         932         626         (306     134         1,749         1,205         (544

Greater than six to nine months

     72         998         725         (273     42         406         269         (137

Greater than nine to eleven months

     22         282         195         (87     9         1         —           (1

Greater than twelve months

     231         1,740         1,043         (697     239         1,806         1,057         (749
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

 

Total

     533       $ 4,063       $ 2,672       $ (1,391     630       $ 5,785       $ 3,820       $ (1,931
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

 

The following tables present the Company’s unrealized loss aging for AFS securities continuously depressed over 50% by length of time (included in the tables above).

 

     March 31, 2012     December 31, 2011  

Consecutive Months

   Items      Cost or
Amortized
Cost
     Fair
Value
     Unrealized
Loss
    Items      Cost or
Amortized
Cost
     Fair
Value
     Unrealized
Loss
 

Three months or less

     34       $ 172       $ 79       $ (93     50       $ 152       $ 55       $ (97

Greater than three to six months

     29         95         33         (62     26         110         46         (64

Greater than six to nine months

     19         90         38         (52     7         33         11         (22

Greater than nine to eleven months

     4         3         1         (2     5         5         1         (4

Greater than twelve months

     48         238         77         (161     54         227         71         (156
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

 

Total

     134       $ 598       $ 228       $ (370     142       $ 527       $ 184       $ (343
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

 

Other-Than-Temporary Impairments

The following table presents the Company’s impairments recognized in earnings by security type.

 

     Three Months Ended
March 31,
 
     2012      2011  

ABS

   $ 9       $ 8   

CRE CDOs

     —           15   

CMBS

     

Bonds

     5         —     

IOs

     —           1   

Corporate

     —           18   

Equity

     8         10   

RMBS sub-prime

     7         3   
  

 

 

    

 

 

 

Total

   $ 29       $ 55   
  

 

 

    

 

 

 

Three months March 31, 2012

For the three months ended March 31, 2012, impairments recognized in earnings were comprised of credit impairments of $17, impairments on equity securities of $8 and securities that the Company intends to sell of $4.

Credit impairments were primarily concentrated in structured securities associated with residential and small balance real estate. The structured securities were impaired primarily due to property-specific deterioration of the underlying collateral. The Company calculated these impairments utilizing both a top down modeling approach and a security-specific collateral review. The top down modeling approach used discounted cash flow models that considered losses under current and expected future economic conditions. Assumptions used over the current period included macroeconomic factors, such as a high unemployment rate, as well as sector specific factors such as property values, delinquency levels, servicer behavior and severity rates. The macroeconomic assumptions considered by the Company did not materially change for the three months ended March 31, 2012, and, as such, the credit impairments recognized were primarily driven by actual collateral deterioration, largely as a result of the Company’s security-specific collateral review.

The security-specific collateral review is performed to estimate potential future losses. This review incorporates assumptions about expected future collateral cash flows, including projected rental rates and occupancy levels that varied based on property type and sub-market. The results of the security-specific collateral review allowed the Company to estimate the expected timing of a security’s first loss, if any, and the probability and severity of potential ultimate losses. The Company then discounted these anticipated future cash flows at the security’s book yield prior to impairment.

 

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Impairments on equity securities were comprised of one below investment grade preferred stock. Impairments on securities for which the Company has the intent to sell related to one CMBS fixed-rate bond as market pricing continues to improve and the Company would like the ability to reduce certain exposures.

In addition to the credit impairments recognized in earnings, the Company recognized non-credit impairments in other comprehensive income of $7 for the three months ended March 31, 2012, predominantly concentrated in RMBS. These non-credit impairments represent the difference between fair value and the Company’s best estimate of expected future cash flows discounted at the security’s effective yield prior to impairment, rather than at current market implied credit spreads. These non-credit impairments primarily represent increases in market liquidity premiums and credit spread widening that occurred after the securities were purchased, as well as a discount for variable-rate coupons which are paying less than at purchase date. In general, larger liquidity premiums and wider credit spreads are the result of deterioration of the underlying collateral performance of the securities, as well as the risk premium required to reflect future uncertainty in the real estate market.

Future impairments may develop as the result of changes in intent to sell of specific securities or if actual results underperform current modeling assumptions, which may be the result of, but are not limited to, macroeconomic factors and security-specific performance below current expectations. Ultimate loss formation will be a function of macroeconomic factors and idiosyncratic security-specific performance.

Three months ended March 31, 2011

Impairments recognized in earnings were comprised of credit impairments of $45 and impairments on equity securities of $10. Credit impairments primarily related to structured securities as a result of continued property-specific deterioration of the underlying collateral. The remaining credit impairments were primarily direct private equity investments that were impaired due to the likelihood of a disruption in contractual principal and interest payments due to the restructuring of the debtor’s obligation. Impairments on equity securities related to preferred stock associated with these direct private equity investments.

 

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CAPITAL RESOURCES AND LIQUIDITY

The following section discusses the overall financial strength of The Hartford and its insurance operations including their ability to generate cash flows from each of their business segments, borrow funds at competitive rates and raise new capital to meet operating and growth needs over the next twelve months.

Liquidity Requirements and Sources of Capital

The Hartford Financial Services Group, Inc. (Holding Company)

The liquidity requirements of the holding company of The Hartford Financial Services Group, Inc. (“HFSG Holding Company”) have been and will continue to be met by HFSG Holding Company’s fixed maturities, short-term investments and cash of $1.5 billion at March 31, 2012, dividends from its insurance operations, as well as the issuance of common stock, debt or other capital securities and borrowings from its credit facilities. Expected liquidity requirements of the HFSG Holding Company for the next twelve months include interest on debt of approximately $470, common stockholder dividends, subject to the discretion of the Board of Directors, of approximately $180, and preferred stock dividends of approximately $42.

Furthermore, the Company’s Board of Directors has authorized a $500 stock repurchase program that permits purchases of common stock, as well as warrants and other derivative securities. During the first quarter of 2012, the Company repurchased 2.6 million common shares, or $42, under this program. On April 17, 2012, the Company settled the repurchased of all the outstanding Series B and Series C warrants held by Allianz for $300, also funded through this program. As a result, the remaining authorized repurchases under this program is approximately $106. For additional information see Note 15 of the Notes to Condensed Consolidated Financial Statements.

In addition, in 2010 The Hartford entered into an intercompany liquidity agreement that allows for short-term advances of funds among the HFSG Holding Company and certain affiliates of up to $2.0 billion for liquidity and other general corporate purposes. The Connecticut Insurance Department granted approval for certain affiliated insurance companies that are parties to the agreement to treat receivables from a parent, including the HFSG Holding Company, as admitted assets for statutory accounting purposes.

Debt

Senior Notes

On April 5, 2012, the Company issued $1.55 billion aggregate principal amount of senior notes. The issuance consisted of $325 of 4.000% senior notes due 2017, $800 of 5.125% senior notes due 2022 and $425 of 6.625% senior notes due 2042 (collectively, the “Senior Notes”) for net proceeds of approximately $1.5 billion, after deducting underwriting discounts and offering expenses. The Senior Notes bear interest at their respective rate, payable semi-annually in arrears on April 15 and October 15 of each year, beginning on October 15, 2012.

Junior Subordinated Debentures

On April 17, 2012, the Company (i) repurchased all outstanding 10% fixed-to-floating rate junior subordinated debentures due 2068 with a $1.75 billion aggregate principal amount held by Allianz SE (“Allianz”) (the “10% Debentures”) for $2.125 billion (plus a payment by the Company of unpaid interest on the 10% Debentures) and (ii) settled the repurchase of the Series B and Series C warrants held by Allianz to purchase shares of the Company’s common stock. In addition, the 10% Debentures replacement capital covenant was terminated on April 12, 2012 with the consent of the holders of a majority in aggregate principal amount of the Company’s outstanding 6.1% senior notes due 2041.

On April 17, 2012, the Company issued $600 aggregate principal amount of 7.875% fixed-to-floating rate junior subordinated debentures due 2042 (the “Debentures”) for net proceeds of approximately $586, after deducting underwriting discounts and offering expenses. The Company financed the repurchase of the 10% Debentures through the issuance of the Senior Notes and the Debentures. The Debentures bear interest from the date of issuance to but excluding April 15, 2022 at an annual rate of 7.875%, payable quarterly in arrears on January 15, April 15, July 15 and October 15 of each year, commencing on July 15, 2012, to and including April 15, 2022. Commencing on April 15, 2022 the Debentures bear interest at an annual rate equal to three-month LIBOR, reset quarterly, plus 5.596%, payable quarterly in arrears on January 15, April 15, July 15 and October 15 of each year, commencing on July 15, 2022.

For additional information regarding debt, see Note 14 of the Notes to Condensed Consolidated Financial Statements. For additional information regarding the warrants, see Note 15 of the Notes to Condensed Consolidated Financial Statements.

Pension Plans and Other Postretirement Benefits

While the Company has significant discretion in making voluntary contributions to the U. S. qualified defined benefit pension plan (“The Plan”), the Employee Retirement Income Security Act of 1974, as amended by the Pension Protection Act of 2006 and further amended by the Worker, Retiree, and Employer Recovery Act of 2008, and Internal Revenue Code regulations mandate minimum contributions in certain circumstances. The Company does not have a required minimum funding contribution for the U.S. qualified defined benefit pension plan for 2012 and the funding requirements for all of the pension plans is expected to be immaterial. The Company presently anticipates contributing approximately $200 to its U. S. qualified defined benefit pension plan in 2012, 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.

 

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Dividends from Insurance Subsidiaries

Dividends to the HFSG Holding 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 Holding Company by its life 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 $1.4 billion in dividends to HFSG Holding Company in 2012 without prior approval from the applicable insurance commissioner. The Company’s life insurance subsidiaries are permitted to pay up to a maximum of approximately $625 in dividends to HLI in 2012 without prior approval from the applicable insurance commissioner. The aggregate of these amounts is the maximum the insurance subsidiaries could pay to HFSG Holding Company in 2012 without prior approval from the applicable insurance commissioner. In addition to statutory limitations on paying dividends, the Company also takes other items into consideration when determining dividends from subsidiaries. These considerations include, but are not limited to expected earnings and capitalization of the subsidiary, regulatory capital requirements and liquidity requirements of the individual operating company. For the three months ended March 31, 2012, HFSG Holding Company and HLI received no dividends from the life insurance subsidiaries, and HFSG Holding Company received $252 in dividends from its property-casualty insurance subsidiaries, including dividends of $52 to fund interest payments on an intercompany note between Hartford Holdings, Inc. and Hartford Fire Insurance Company.

Other Sources of Capital for the HFSG Holding Company

The Hartford endeavors to maintain a capital structure that provides financial and operational flexibility to its insurance subsidiaries, ratings that support its competitive position in the financial services marketplace (see the “Ratings” section below for further discussion), and shareholder returns. As a result, the Company may from time to time raise capital from the issuance of equity, equity-related debt or other capital securities and is continuously evaluating strategic opportunities. The issuance of common equity, equity-related debt or other capital securities could result in the dilution of shareholder interests or reduced net income due to additional interest expense.

Shelf Registrations

On August 4, 2010, The Hartford filed with the Securities and Exchange Commission (the “SEC”) an automatic shelf registration statement (Registration No. 333-168532) for the potential offering and sale of debt and equity securities. The registration statement allows for the following types of securities to be offered: debt securities, junior subordinated debt securities, preferred stock, common stock, depositary shares, warrants, stock purchase contracts, and stock purchase units. In that The Hartford is a well-known seasoned issuer, as defined in Rule 405 under the Securities Act of 1933, the registration statement went effective immediately upon filing and The Hartford may offer and sell an unlimited amount of securities under the registration statement during the three-year life of the registration statement.

Contingent Capital Facility

The Hartford is party to a put option agreement that provides The Hartford with the right to require the Glen Meadow ABC Trust, a Delaware statutory trust, at any time and from time to time, to purchase The Hartford’s junior subordinated notes in a maximum aggregate principal amount not to exceed $500. Under the Put Option Agreement, The Hartford will pay the Glen Meadow ABC Trust premiums on a periodic basis, calculated with respect to the aggregate principal amount of Notes that The Hartford had the right to put to the Glen Meadow ABC Trust for such period. The Hartford has agreed to reimburse the Glen Meadow ABC Trust for certain fees and ordinary expenses. The Company holds a variable interest in the Glen Meadow ABC Trust where the Company is not the primary beneficiary. As a result, the Company did not consolidate the Glen Meadow ABC Trust. As of March 31, 2012, The Hartford has not exercised its right to require Glen Meadow ABC Trust to purchase the Notes. As a result, the Notes remain a source of capital for the HFSG Holding Company.

 

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Commercial Paper and Revolving Credit Facility

The table below details the Company’s short-term debt programs and the applicable balances outstanding.

 

                   Maximum Available As of      Outstanding As of  
     Effective      Expiration      March 31,      March 31,  

Description

   Date      Date      2012      2011      2012      2011  

Commercial Paper

                 

The Hartford

     11/10/86         N/A       $ 2,000       $ 2,000       $ —         $ —     

Revolving Credit Facility

                 

4-year revolving credit facility

     1/6/12         1/6/16         1,750         N/A         —           —     

5-year revolving credit facility [1]

     8/9/07         8/9/12         N/A         1,900         —           —     
        

 

 

    

 

 

    

 

 

    

 

 

 

Total Commercial Paper and Revolving Credit Facility

         $ 3,750       $ 3,900       $ —         $ —     
        

 

 

    

 

 

    

 

 

    

 

 

 

 

[1] Terminated in January 2012.

While The Hartford’s maximum borrowings available under its commercial paper program are $2.0 billion, the Company is dependent upon market conditions to access short-term financing through the issuance of commercial paper to investors.

In January 2012, the Company entered into a senior unsecured revolving credit facility (the “Credit Facility”) that provides for borrowing capacity up to $1.75 billion (which is available in U.S. dollars, and in Euro, Sterling, Canadian dollars and Japanese Yen) through January 6, 2016. Of the total availability under the Credit Facility, up to $250 is available to support letters of credit issued on behalf of the Company or subsidiaries of the Company. Under the Credit Facility, the Company must maintain a minimum level of consolidated net worth, as defined. In the first quarter of 2012, the minimum level of consolidated net worth was reduced by approximately $1.1 billion, after-tax from $16.0 billion as of December 31, 2011 to $14.9 billion as of March 31, 2012 following the adoption of a new DAC accounting standard during the quarter. The definition of consolidated net worth under the terms of the Credit Facility, excludes AOCI and includes the Company’s outstanding junior subordinated debentures and perpetual preferred securities, net of discount. In addition, the Company’s maximum ratio of consolidated total debt to consolidated total capitalization is 35%, and the ratio of consolidated total debt of subsidiaries to consolidated total capitalization is limited to 10%. As of March 31, 2012, the Company was in compliance with all financial covenants under the Credit Facility.

The Hartford’s Japan operations also maintain two lines of credit in support of operations. Both lines of credit are in the amount of approximately $61, or ¥5 billion, and individually have expiration dates of September 30, 2012 and January 3, 2013.

Derivative Commitments

Certain of the Company’s derivative agreements contain provisions that are tied to the financial strength ratings of the individual legal entity that entered into the derivative agreement as set by nationally recognized statistical rating agencies. If the legal entity’s financial strength were to fall below certain ratings, the counterparties to the derivative agreements could demand immediate and ongoing full collateralization and in certain instances demand immediate settlement of all outstanding derivative positions traded under each impacted bilateral agreement. The settlement amount is determined by netting the derivative positions transacted under each agreement. If the termination rights were to be exercised by the counterparties, it could impact the legal entity’s ability to conduct hedging activities by increasing the associated costs and decreasing the willingness of counterparties to transact with the legal entity. The aggregate fair value of all derivative instruments with credit-risk-related contingent features that are in a net liability position as of March 31, 2012, is $701. Of this $701 the legal entities have posted collateral of $687 in the normal course of business. Based on derivative market values as of March 31, 2012, a downgrade of one level below the current financial strength ratings by either Moody’s or S&P could require approximately an additional $28 to be posted as collateral. Based on derivative market values as of March 31, 2012, a downgrade by either Moody’s or S&P of two levels below the legal entities’ current financial strength ratings could require approximately an additional $41 of assets to be posted as collateral. These collateral amounts could change as derivative market values change, as a result of changes in our hedging activities or to the extent changes in contractual terms are negotiated. The nature of the collateral that we would post, if required, would be primarily in the form of U.S. Treasury bills and U.S. Treasury notes.

On March 21, 2012, Standard & Poor’s (“S&P”) Rating Services lowered its counterparty credit and insurer financial strength ratings on Hartford Life and Annuity Insurance Company to BBB+. Given this downgrade action, termination rating triggers in three derivative counterparty relationships have been impacted totaling a notional amount of $4.7 billion with a corresponding fair value of $77 as of March 31, 2012. The counterparties have the right to terminate these relationships and would have to settle the outstanding derivatives prior to exercising their termination right. Accordingly, as of March 31, 2012 these counterparties would owe the Company the derivatives fair value of $77. The counterparties have not exercised this termination right and the Company has re-negotiated the rating triggers with one counterparty and is in the process of re-negotiating the rating triggers with the remaining two counterparties.

As March 31, 2012, the aggregate notional amount and fair value of derivative relationships that could be subject to immediate termination in the event of rating agency downgrades to (1) either BBB+ or Baa1 was $7.0 billion and $262, respectively, or (2) both BBB+ and Baa1 was $15.8 billion and $444, respectively, which includes the amounts in scenario (1). The notional and fair value amounts include a customized GMWB derivative with a notional amount of $4.4 billion and a fair value of $135, for which the Company has a contractual right to make a collateral payment in the amount of approximately $47 to prevent its termination. This customized GMWB derivative contains an early termination trigger such that if the unsecured, unsubordinated debt of the counterparty’s related party guarantor is downgraded two levels or more below the current ratings by Moody’s and one or more levels by S&P, the counterparty could terminate all transactions under the applicable International Swaps and Derivatives Association Master Agreement. As of March 31, 2012, the gross fair value of all affected derivative contracts is $142, which would approximate the settlement value.

 

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Insurance Operations

Current and expected patterns of claim frequency and severity or surrenders may change from period to period but continue to be within historical norms and, therefore, the Company’s insurance operations’ current liquidity position is considered to be sufficient to meet anticipated demands over the next twelve months, including any obligations related to the Company’s restructuring activities. For a discussion and tabular presentation of the Company’s current contractual obligations by period, refer to Off-Balance Sheet Arrangements and Aggregate Contractual Obligations within the Capital Resources and Liquidity section of the MD&A included in The Hartford’s 2011 Form 10-K Annual Report.

The principal sources of operating funds are premiums, fees earned from assets under management and investment income, while investing cash flows originate from maturities and sales of invested assets. The primary uses of funds are to pay claims, claim adjustment expenses, commissions and other underwriting expenses, to purchase new investments and to make dividend payments to the HFSG Holding Company.

The Company’s insurance operations consist of property and casualty insurance products (collectively referred to as “Property & Casualty Operations”) and life insurance products (collectively referred to as “Life Operations”).

Property & Casualty Operations

Property & Casualty Operations holds fixed maturity securities including a significant short-term investment position (securities with maturities of one year or less at the time of purchase) to meet liquidity needs.

The following table summarizes Property & Casualty Operations’ fixed maturities, short-term investments, and cash, as of March 31, 2012:

 

Fixed maturities

   $  26,097   

Short-term investments

     526   

Cash

     214   

Less: Derivative collateral

     (224
  

 

 

 

Total

   $ 26,613   
  

 

 

 

Liquidity requirements that are unable to be funded by Property & Casualty Operation’s short-term investments would be satisfied with current operating funds, including premiums received or through the sale of invested assets. A sale of invested assets could result in significant realized losses.

Life Operations

Life Operations’ total general account contractholder obligations are supported by $74 billion of cash and total general account invested assets, excluding equity securities, trading, which includes a significant short-term investment position to meet liquidity needs.

The following table summarizes Life Operations’ fixed maturities, short-term investments, and cash, as of March 31, 2012:

 

Fixed maturities

   $  58,202   

Short-term investments

     3,384   

Cash

     1,844   

Less: Derivative collateral

     (1,300

Cash associated with Japan variable annuities

     (695
  

 

 

 

Total

   $ 61,435   
  

 

 

 

Capital resources available to fund liquidity, upon contract holder surrender, are a function of the legal entity in which the liquidity requirement resides. Generally, obligations of Group Benefits will be funded by Hartford Life and Accident Insurance Company; obligations of Individual Annuity, Individual Life and private placement life insurance products will be generally funded by both Hartford Life Insurance Company and Hartford Life and Annuity Insurance Company; obligations of Retirement Plans and institutional investment products will be generally funded by Hartford Life Insurance Company; and obligations of the Company’s international annuity subsidiaries will be generally funded by the legal entity in the country in which the obligation was generated.

Hartford Life Insurance Company (“HLIC”), an indirect wholly-owned subsidiary, is a member of the Federal Home Loan Bank of Boston (“FHLBB”). Membership allows HLIC access to collateralized advances, which may be used to support various spread-based businesses or to enhance liquidity management. FHLBB membership requires HLIC to own member stock and borrowings require the purchase of activity-based stock in an amount (generally between 3% and 4.5% of the principal balance) based upon the term of the outstanding advances. FHLBB stock held by HLIC is classified within equity securities, available-for-sale in the Condensed Consolidated Balance Sheets.

The Connecticut Department of Insurance (“CTDOI”) will permit HLIC to pledge up to $1.48 billion in qualifying assets to secure FHLBB advances for 2012. The amounts of advances that can be taken are dependent on the asset types pledged to secure the advances. The pledge limit is recalculated annually based on statutory admitted assets and capital and surplus. HLIC would need to seek the prior approval of the CTDOI in order to exceed these limits.

 

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Contractholder Obligations

   As of
March 31, 2012
 

Total Life contractholder obligations

   $ 246,576   

Less: Separate account assets [1]

     (152,402

International statutory separate accounts [1]

     (30,677
  

 

 

 

General account contractholder obligations

   $ 63,497   
  

 

 

 

Composition of General Account Contractholder Obligations

  
  

 

 

 

Contracts without a surrender provision and/or fixed payout dates [2]

   $ 58,420   

Fixed MVA annuities [3]

     9,727   

Guaranteed investment contracts (“GIC”) [4]

     530   

Other [5]

     (5,180
  

 

 

 

General account contractholder obligations

   $ 63,497   
  

 

 

 

 

[1] In the event customers elect to surrender separate account assets or international statutory separate accounts, Life Operations will use the proceeds from the sale of the assets to fund the surrender, and Life Operations’ liquidity position will not be impacted. In many instances Life Operations will receive a percentage of the surrender amount as compensation for early surrender (surrender charge), increasing Life Operations’ liquidity position. In addition, a surrender of variable annuity separate account or general account assets (see below) will decrease Life Operations’ obligation for payments on guaranteed living and death benefits.
[2] Relates to contracts such as payout annuities or institutional notes, other than guaranteed investment products with an MVA feature (discussed below) or surrenders of term life, group benefit contracts or death and living benefit reserves for which surrenders will have no current effect on Life Operations’ liquidity requirements.
[3] Relates to annuities that are held in a statutory separate account, but under U.S. GAAP are recorded in the general account as Fixed MVA annuity contract holders are subject to the Company’s credit risk. In the statutory separate account, Life Operations is required to maintain invested assets with a fair value equal to the MVA surrender value of the Fixed MVA contract. In the event assets decline in value at a greater rate than the MVA surrender value of the Fixed MVA contract, Life Operations is required to contribute additional capital to the statutory separate account. Life Operations will fund these required contributions with operating cash flows or short-term investments. In the event that operating cash flows or short-term investments are not sufficient to fund required contributions, the Company may have to sell other invested assets at a loss, potentially resulting in a decrease in statutory surplus. As the fair value of invested assets in the statutory separate account are generally equal to the MVA surrender value of the Fixed MVA contract, surrender of Fixed MVA annuities will have an insignificant impact on the liquidity requirements of Life Operations.
[4] GICs are subject to discontinuance provisions which allow the policyholders to terminate their contracts prior to scheduled maturity at the lesser of the book value or market value. Generally, the market value adjustment reflects changes in interest rates and credit spreads. As a result, the market value adjustment feature in the GIC serves to protect the Company from interest rate risks and limit Life Operations’ liquidity requirements in the event of surrender.
[5] Surrenders of, or policy loans taken from, as applicable, these general account liabilities, which include the general account option for Individual Annuity’s individual variable annuities and Individual Life variable life contracts, the general account option for Retirement Plans’ annuities and universal life contracts sold by Individual Life may be funded through operating cash flows of Life Operations, available short-term investments, or Life Operations may be required to sell fixed maturity investments to fund the surrender payment. Sales of fixed maturity investments could result in the recognition of significant realized losses and insufficient proceeds to fully fund the surrender amount. In this circumstance, Life Operations may need to take other actions, including enforcing certain contract provisions which could restrict surrenders and/or slow or defer payouts.

Off-Balance Sheet Arrangements and Aggregate Contractual Obligations

Off-Balance Sheet Arrangements

There have been no material changes to the Company’s off-balance sheet arrangements since the filing of the Company’s 2011 Form 10-K Annual Report.

Aggregate Contractual Obligations

Since December 31, 2011, the Company issued $1.55 billion aggregate principal amount of senior notes and $600 aggregate principal amount of junior subordinated debentures. For additional information, see MD&A – Liquidity Requirements and Sources of Capital – Debt and Note 14 of Notes to Condensed Consolidated Financial Statements.

 

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Capitalization

The capital structure of The Hartford as of March 31, 2012 and December 31, 2011 consisted of debt and stockholders’ equity, summarized as follows:

 

     March 31,     December 31,        
     2012     2011     Change  

Long-term debt

   $ 6,220      $ 6,216        —     
  

 

 

   

 

 

   

 

 

 

Total debt [1]

     6,220        6,216        —     

Stockholders’ equity excluding accumulated other comprehensive loss, net of tax (“AOCI”)

     19,946        20,235        (1 %) 

AOCI, net of tax

     1,328        1,251        6
  

 

 

   

 

 

   

 

 

 

Total stockholders’ equity

   $ 21,274      $ 21,486        (1 %) 

Total capitalization including AOCI

   $ 27,494      $ 27,702        (1 %) 
  

 

 

   

 

 

   

 

 

 

Debt to stockholders’ equity

     29     29  

Debt to capitalization

     23     22  
  

 

 

   

 

 

   

 

[1] Total debt of the Company excludes $310 and $314 of consumer notes as of March 31, 2012 and December 31, 2011, respectively.

The Hartford’s total capitalization decreased $208, or 1%, from December 31, 2011 to March 31, 2012 due to decreases in stockholders’ equity, excluding AOCI, partially offset by improvements in AOCI, net of tax. The decrease in stockholders’ equity, excluding AOCI, was primarily due the repurchase of outstanding warrants held by Allianz for $300.

AOCI, net of tax, improved primarily due to improvements in the Company’s net unrealized position on available-for-sale securities of $232 primarily as a result of improved security valuations largely due to declining interest rates, partially offset by credit spread widening.

For additional information on debt and the repurchase of warrants, see MD&A – Liquidity Requirements and Sources of Capital and Note 14 and Note 15 of the Notes to Condensed Consolidated Financial Statements. For additional information on equity and AOCI, net of tax, see Notes 15 and 16, respectively, of the Notes to Consolidated Financial Statements in The Hartford’s 2011 Form 10-K Annual Report.

Cash Flows

 

     Three Months Ended
March  31,
 
     2012     2011  

Net cash provided by operating activities

   $ 1,140      $ 474   

Net cash provided by (used for) investing activities

   $ (1,367   $ 254   

Net cash used for financing activities

   $ (233   $ (451

Cash – end of period

   $ 2,059      $ 2,317   

Cash provided by operating activities increased primarily due to income taxes received of $548 in 2012, compared to income taxes paid of $26 in 2011.

Cash used for investing activities in 2012 primarily relates to net payments on derivatives of $2.0 billion and net purchases of mortgage loans of $548, partially offset by net proceeds of available-for-sale securities of $1.4 billion. Cash provided by investing activities in 2011 primarily relates to net proceeds of available-for-sale securities of $1.3 billion and proceeds from business sold of $278, partially offset by net purchases of fixed maturities, fair value option of $531, net payments on derivatives of $465 and net purchases of mortgage loans of $256.

Cash used for financing activities in 2012 consists primarily of net outflows on investment and universal life-type contracts and dividends paid on common and preferred stock. Cash used for financing activities in 2011 consists primarily of $418 of net outflows on investment and universal life-type contracts.

Operating cash flows for the three months ended March 31, 2012 and 2011 have been adequate to meet liquidity requirements.

Equity Markets

For a discussion of the potential impact of the equity markets on capital and liquidity, see the Enterprise Risk Management section of the MD&A.

 

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Ratings

Ratings impact the Company’s cost of borrowing and its ability to access financing and are an important factor in establishing competitive position in the insurance and financial services marketplace. There can be no assurance that the Company’s ratings will continue for any given period of time or that they will not be changed. In the event the Company’s ratings are downgraded, the Company’s cost of borrowing and ability to access financing, as well as the level of revenues or the persistency of its business may be adversely impacted.

On March 21, 2012, A.M. Best affirmed the financial strength and issuer credit ratings of the Company’s subsidiaries, and placed the holding company and property/casualty insurance subsidiaries under review with developing implications. The life subsidiaries were placed under review with negative implications.

On March 21, 2012, Fitch Ratings affirmed all debt and insurer financial strength ratings for the Company and maintained its stable rating outlook.

On March 21, 2012, Standard & Poor’s (“S&P”) Rating Services lowered its counterparty credit and insurer financial strength ratings on most of the life insurance subsidiaries. Hartford Life and Accident Insurance Co. and Hartford Life Insurance Co. were downgraded to A- with stable outlook. Hartford Life and Annuity Insurance Co. was downgraded to BBB+ with negative outlook. Hartford Life Inc. debt was downgraded to BBB-. The holding company and property/casualty insurance subsidiaries were affirmed with stable outlook.

On March 21, 2012, Moody’s Investors Service affirmed the credit ratings of the Company and changed the outlook on Hartford Life & Annuity Insurance Company (insurance financial strength at A3) to negative from stable. The outlook on the Company’s other life subsidiaries, property/casualty insurance subsidiaries and holding company remains stable.

The following table summarizes The Hartford’s significant member companies’ financial ratings from the major independent rating organizations as of April 26, 2012.

 

Insurance Financial Strength Ratings:

   A.M. Best      Fitch      Standard & Poor’s      Moody’s  

Hartford Fire Insurance Company

     A         A+         A         A2   

Hartford Life Insurance Company

     A         A-         A-         A3   

Hartford Life and Accident Insurance Company

     A         A-         A-         A3   

Hartford Life and Annuity Insurance Company

     A         A-         BBB+         A3   

Other Ratings:

           

The Hartford Financial Services Group, Inc.:

Senior debt

Commercial paper

    

 

bbb+

AMB-2

  

  

    

 

BBB-

F2

  

  

    

 

BBB

A-2

  

  

    

 

Baa3

P-3

  

  

These ratings are not a recommendation to buy or hold any of The Hartford’s securities and they may be revised or revoked at any time at the sole discretion of the rating organization.

The agencies consider many factors in determining the final rating of an insurance company. One consideration is the relative level of statutory surplus necessary to support the business written. Statutory surplus represents the capital of the insurance company reported in accordance with accounting practices prescribed by the applicable state insurance department.

Statutory Surplus

The table below sets forth statutory surplus for the Company’s insurance companies. The statutory surplus amount as of December 31, 2011 in the table below is based on actual statutory filings with the applicable regulatory authorities. The statutory surplus amount as of March 31, 2012 is an estimate, as the first quarter 2012 statutory filings have not yet been made.

 

     March 31,
2012
     December 31,
2011
 

U.S. life insurance subsidiaries, includes domestic captive insurance subsidiaries

   $ 7,451       $ 7,388   

Property and casualty insurance subsidiaries

     7,716         7,412   
  

 

 

    

 

 

 

Total

   $ 15,167       $ 14,800   
  

 

 

    

 

 

 

Total statutory capital and surplus for the U.S. life insurance subsidiaries, including domestic captive insurance subsidiaries, increased by $63, primarily due to statutory income from non-variable annuity business and other surplus changes, partially offset by variable annuity surplus impacts. Total statutory capital and surplus for property and casualty increased by $304, primarily due to net income, unrealized gains and other changes in surplus, partially offset by dividends to HFSG Holding Company.

The Company also holds regulatory capital and surplus for its operations in Japan. Under the accounting practices and procedures governed by Japanese regulatory authorities, the Company’s statutory capital and surplus was $1.2 billion and $1.3 billion as of March 31, 2012 and December 31, 2011, respectively. The statutory surplus amount as of March 31, 2012 is an estimate, as the year ended March 31, 2012 statutory filings have not yet been made.

 

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Contingencies

Legal Proceedings – For a discussion regarding contingencies related to The Hartford’s legal proceedings, please see the information contained under “Litigation” in Note 9 of the Notes to Condensed Consolidated Financial Statements and Part II, Item 1 Legal Proceedings, which are incorporated herein by reference.

Legislative Developments

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”) was enacted on July 21, 2010, mandating changes to the regulation of the financial services industry. The Dodd-Frank Act may affect our operations and governance in ways that could adversely affect our financial condition and results of operations.

In particular, the Dodd-Frank Act vests a newly created Financial Services Oversight Council with the power to designate “systemically important” financial institutions, which will be subject to special regulatory supervision and other provisions intended to prevent, or mitigate the impact of, future disruptions in the U.S. financial system. Systemically important institutions are limited to large bank holding companies and nonbank financial companies that are so important that their potential failure could “pose a threat to the financial stability of the United States.” The FSOC finalized its rule for designating systemically important nonbank financial institutions in April 2012, but has not yet indicated when it will begin its consideration of such companies. Based on its most current financial data, The Hartford does not meet the initial quantitative metrics that will be used to determine which nonbank companies merit consideration. The FSOC has indicated it will review on a quarterly basis whether non-bank financial institutions meet the metrics for further review.

If we are designated as a systemically important institution, The Hartford could be subject to higher capital requirements and additional regulatory oversight imposed by The Federal Reserve, as well as to post-event assessments imposed by the Federal Deposit Insurance Corporation (“FDIC”) to recoup the costs associated with the orderly liquidation of other systemically important institutions in the event one or more such institutions fails. Further, the FDIC is authorized to petition a state court to commence an insolvency proceeding to liquidate an insurance company that fails in the event the insurer’s state regulator fails to act. Other provisions will require central clearing of, and/or impose new margin and capital requirements on, derivatives transactions, which we expect will increase the costs of our hedging program. In addition, the Dodd-Frank Act may restrict us from sponsoring and investing in private equity and hedge funds, which would limit our discretion in managing our general account.

Other provisions in the Dodd-Frank Act that may impact us include: a new “Federal Insurance Office” within Treasury; discretionary authority for the SEC to impose a harmonized standard of care for investment advisers and broker-dealers who provide personalized advice about securities to retail customers; possible adverse impact on the pricing and liquidity of the securities in which we invest resulting from the proprietary trading and market making limitation of the Volcker Rule; possible prohibition of certain asset-backed securities transactions that could adversely impact our ability to offer insurance-linked securities; and enhancements to corporate governance, especially regarding risk management.

FY 2013, Budget of the United States Government

On February 13, 2012, the Obama Administration released its “FY 2013, Budget of the United States Government” (the “Budget”). Although the Administration has not released proposed statutory language, the Budget includes proposals which if enacted, would affect the taxation of life insurance companies and certain life insurance products. In particular, the proposals would affect the treatment of corporate owned life insurance (“COLI”) policies by limiting the availability of certain interest deductions for companies that purchase those policies. The proposals would also change the method used to determine the amount of dividend income received by a life insurance company on assets held in separate accounts used to support products, including variable life insurance and variable annuity contracts, that are eligible for the dividends received deduction (“DRD”). The DRD reduces the amount of dividend income subject to tax and is a significant component of the difference between the Company’s actual tax expense and expected amount determined using the federal statutory tax rate of 35%. If proposals of this type were enacted, the Company’s sale of variable life products and its profits on COLI policies and variable annuity contracts could be adversely affected and the Company’s actual tax expense could increase, reducing earnings.

IMPACT OF NEW ACCOUNTING STANDARDS

For a discussion of accounting standards, see Note 1 of the Notes to Consolidated Financial Statements included in The Hartford’s 2011 Form 10-K Annual Report and Note 1 of the Notes to Condensed Consolidated Financial Statements in this Form 10-Q.

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The information contained in the Capital Markets Risk Management section of Management’s Discussion and Analysis of Financial Condition and Results of Operations is incorporated herein by reference.

Item 4. CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures

The Company’s principal executive officer and its principal financial officer, based on their evaluation of the Company’s disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) have concluded that the Company’s disclosure controls and procedures are effective for the purposes set forth in the definition thereof in Exchange Act Rule 13a-15(e) as of March 31, 2012.

Changes in internal control over financial reporting

There was no change in the Company’s internal control over financial reporting that occurred during the Company’s current fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

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Part II. OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS

Litigation

The Hartford is involved in claims litigation arising in the ordinary course of business, both as a liability insurer defending or providing indemnity for third-party claims brought against insureds and as an insurer defending coverage claims brought against it. The Hartford accounts for such activity through the establishment of unpaid loss and loss adjustment expense reserves. Subject to the uncertainties discussed below under the caption “Asbestos and Environmental Claims,” management expects that the ultimate liability, if any, with respect to such ordinary-course claims litigation, after consideration of provisions made for potential losses and costs of defense, will not be material to the consolidated financial condition, results of operations or cash flows of The Hartford.

The Hartford is also involved in other kinds of legal actions, some of which assert claims for substantial amounts. These actions include, among others, and in addition to the matters described below, putative state and federal class actions seeking certification of a state or national class. Such putative class actions have alleged, for example, underpayment of claims or improper underwriting practices in connection with various kinds of insurance policies, such as personal and commercial automobile, property, life and inland marine; improper sales practices in connection with the sale of life insurance and other investment products; and improper fee arrangements in connection with investment products. The Hartford also is involved in individual actions in which punitive damages are sought, such as claims alleging bad faith in the handling of insurance claims. Like many other insurers, The Hartford also has been joined in actions by asbestos plaintiffs asserting, among other things, that insurers had a duty to protect the public from the dangers of asbestos and that insurers committed unfair trade practices by asserting defenses on behalf of their policyholders in the underlying asbestos cases. Management expects that the ultimate liability, if any, with respect to such lawsuits, after consideration of provisions made for estimated losses, will not be material to the consolidated financial condition of The Hartford. Nonetheless, given the large or indeterminate amounts sought in certain of these actions, and the inherent unpredictability of litigation, the outcome in certain matters could, from time to time, have a material adverse effect on the Company’s results of operations or cash flows in particular quarterly or annual periods.

Apart from the inherent difficulty of predicting litigation outcomes, the Mutual Funds Litigation identified below purports to seek substantial damages for unsubstantiated conduct spanning a multi-year period based on novel and complex legal theories. The alleged damages are not quantified or factually supported in the complaint, and, in any event, the Company’s experience shows that demands for damages often bear little relation to a reasonable estimate of potential loss. The matter is in the earliest stages of litigation, with no substantive legal decisions by the court defining the scope of the claims or the potentially available damages. The Company has not yet answered the complaint or asserted its defenses, and fact discovery has not yet begun. Accordingly, management cannot reasonably estimate the possible loss or range of loss, if any, or predict the timing of the eventual resolution of this matter.

Mutual Funds Litigation — In February 2011, a derivative action was brought on behalf of six Hartford retail mutual funds in the United States District Court for the District of New Jersey, alleging that Hartford Investment Financial Services, LLC (“HIFSCO”), an indirect subsidiary of the Company, received excessive advisory and distribution fees in violation of its statutory fiduciary duty under Section 36(b) of the Investment Company Act of 1940. HIFSCO moved to dismiss and, in September 2011, the motion was granted in part and denied in part, with leave to amend the complaint. In November 2011, plaintiffs filed an amended complaint on behalf of The Hartford Global Health Fund, The Hartford Conservative Allocation Fund, The Hartford Growth Opportunities Fund, The Hartford Inflation Plus Fund, The Hartford Advisors Fund, and The Hartford Capital Appreciation Fund. Plaintiffs seek to rescind the investment management agreements and distribution plans between HIFSCO and these funds and to recover the total fees charged thereunder or, in the alternative, to recover any improper compensation HIFSCO received, in addition to lost earnings. HIFSCO disputes the allegations and has filed a partial motion to dismiss.

 

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Broker Compensation Litigation – Following the New York Attorney General’s filing of a civil complaint against Marsh & McLennan Companies, Inc., and Marsh, Inc. (collectively, “Marsh”) in October 2004 alleging that certain insurance companies, including The Hartford, participated with Marsh in arrangements to submit inflated bids for business insurance and paid contingent commissions to ensure that Marsh would direct business to them, private plaintiffs brought several lawsuits against the Company predicated on the allegations in the Marsh complaint, to which the Company was not party. Among these is a multidistrict litigation in the United States District Court for the District of New Jersey. Two consolidated amended complaints were filed in the multidistrict litigation, one related to conduct in connection with the sale of property-casualty insurance and the other related to alleged conduct in connection with the sale of group benefits products. The Company and various of its subsidiaries are named in both complaints. The complaints assert, on behalf of a putative class of persons who purchased insurance through broker defendants, claims under the Sherman Act, the Racketeer Influenced and Corrupt Organizations Act (“RICO”), state law, and in the case of the group benefits complaint, claims under the Employee Retirement Income Security Act of 1974 (“ERISA”). The claims are predicated upon allegedly undisclosed or otherwise improper payments of contingent commissions to the broker defendants to steer business to the insurance company defendants. The district court dismissed the Sherman Act and RICO claims in both complaints for failure to state a claim and has granted the defendants’ motions for summary judgment on the ERISA claims in the group-benefits products complaint. The district court further declined to exercise supplemental jurisdiction over the state law claims and dismissed those claims without prejudice. The plaintiffs appealed the dismissal of the claims in both consolidated amended complaints, except the ERISA claims. In August 2010, the United States Court of Appeals for the Third Circuit affirmed the dismissal of the Sherman Act and RICO claims against the Company. The Third Circuit vacated the dismissal of the Sherman Act and RICO claims against some defendants in the property casualty insurance case and vacated the dismissal of the state-law claims as to all defendants in light of the reinstatement of the federal claims. In September 2010, the district court entered final judgment for the defendants in the group benefits case. In March 2011, the Company reached an agreement in principle to settle on a class basis the property casualty insurance case for an immaterial amount. The district court gave final approval to the settlement in March 2012. An objector has noticed an appeal to the Third Circuit; management belives that the possibility that the settlement will be over turned on appeal is remote. Following the settlement, only three non-class action lawsuits remain. Management believes that the possibility of a material adverse outcome with respect to these lawsuits, when considered separately or in the aggregate, is remote.

Investment and Savings Plan ERISA and Shareholder Securities Class Action Litigation – In November and December 2008, following a decline in the share price of the Company’s common stock, seven putative class action lawsuits were filed in the United States District Court for the District of Connecticut on behalf of certain participants in the Company’s Investment and Savings Plan (the “Plan”), which offers the Company’s common stock as one of many investment options. These lawsuits have been consolidated, and a consolidated amended class-action complaint was filed on March 23, 2009, alleging that the Company and certain of its officers and employees violated ERISA by allowing the Plan’s participants to invest in the Company’s common stock and by failing to disclose to the Plan’s participants information about the Company’s financial condition. The lawsuit seeks restitution or damages for losses arising from the investment of the Plan’s assets in the Company’s common stock during the period from December 10, 2007 to the present. In January 2010, the district court denied the Company’s motion to dismiss the consolidated amended complaint. In February 2011, the parties reached an agreement in principle to settle on a class basis for an immaterial amount. The district court gave final approval to the settlement in April 2012.

Asbestos and Environmental Claims – As discussed in Item 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations under the caption “Reserving for Asbestos and Environmental Claims within Other Operations,” The Hartford continues to receive asbestos and environmental claims that involve significant uncertainty regarding policy coverage issues. Regarding these claims, The Hartford continually reviews its overall reserve levels and reinsurance coverages, as well as the methodologies it uses to estimate its exposures. Because of the significant uncertainties that limit the ability of insurers and reinsurers to estimate the ultimate reserves necessary for unpaid losses and related expenses, particularly those related to asbestos, the ultimate liabilities may exceed the currently recorded reserves. Any such additional liability cannot be reasonably estimated now but could be material to The Hartford’s consolidated operating results, financial condition and liquidity.

 

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Item 1A. RISK FACTORS

Investing in The Hartford involves risk. In deciding whether to invest in The Hartford, you should carefully consider the following risk factors, any of which could have a significant or material adverse effect on the business, financial condition, operating results or liquidity of The Hartford. This information should be considered carefully together with the other information contained in this report and the other reports and materials filed by The Hartford with the SEC.

The risk factors set forth below update the risk factors section previously disclosed in Item 1A of Part I of the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

The actions announced by the Company on March 21, 2012, and related implementation plans and objectives, involve a number of challenges, uncertainties and risks that may prevent the Company from implementing any such action or initiative as currently contemplated or at all, or, if concluded, from achieving some or all of the anticipated benefits from such announced actions.

On March 21, 2012, the Company announced its decision to focus on its Property and Casualty, Group Benefits and Mutual Fund businesses, place its Individual Annuity business into runoff and pursue sales or other strategic alternatives for the Individual Life, Woodbury Financial Services and Retirement Plans businesses. On April 26, 2012, the Company announced that it had entered into an agreement to sell its individual annuity new business capabilities to a third party and, effective May 1, 2012, reinsure all new annuity policies issued by the Company to such third party for a limited period of time. The actions announced by the Company are subject to challenges, uncertainties and risks, including, among others, that the Company may be unable to sell the Individual Life, Woodbury Financial Services and Retirement Plans businesses at an appropriate price or at all or find strategic alternatives to their sale. No assurance can be given that the carrying value of any such business may not be impaired at some future time. All these announced actions may be subject to significant execution risks, costs and delays, and estimated charges may be subject, depending on subsequent events, to upward adjustments. The Company may not achieve all of the benefits it expects to derive from the actions announced, including in respect of enhanced shareholder value.

The Company’s announcement and related implementation plans and objectives could also adversely affect not only the businesses with respect to which the Company has announced its intention to sell or execute other strategic alternatives, but also on its ongoing businesses. These adverse effects may include loss of customers, surrenders, withdrawals, contract terminations or other adverse impacts on the Company’s relationships with its business partners and other stakeholders. Further, the Company may not be able to retain employees that are necessary to the success of its implementation plans and objectives. As a consequence, the matters described above may adversely affect the Company’s business, financial condition, results of operations and liquidity.

Downgrades in our financial strength or credit ratings, which may make our products less attractive, could increase our cost of capital and inhibit our ability to refinance our debt, which would have a material adverse effect on our business, financial condition, results of operations and liquidity.

Financial strength and credit ratings, including commercial paper ratings, are important in establishing the competitive position of insurance companies. Rating agencies assign ratings based upon several factors. While most of the factors relate to the rated company, some of the factors relate to the views of the rating agency, general economic conditions, and circumstances outside the rated company’s control. In addition, rating agencies may employ different models and formulas to assess the financial strength of a rated company, and from time to time rating agencies have, at their discretion, altered these models. Changes to the models, general economic conditions, or circumstances outside our control could impact a rating agency’s judgment of its rating and the rating it assigns us. We cannot predict what actions rating agencies may take, or what actions we may take in response to the actions of rating agencies, which may adversely affect us.

Our financial strength ratings, which are intended to measure our ability to meet policyholder obligations, are an important factor affecting public confidence in most of our products and, as a result, our competitiveness. A downgrade or a potential downgrade in the rating of our financial strength or of one of our principal insurance subsidiaries could affect our competitive position and reduce future sales of our products.

Our credit ratings also affect our cost of capital. A downgrade or a potential downgrade of our credit ratings could make it more difficult or costly to refinance maturing debt obligations, to support business growth at our insurance subsidiaries and to maintain or improve the financial strength ratings of our principal insurance subsidiaries. Downgrades could begin to trigger potentially material collateral calls on certain of our derivative instruments and counterparty rights to terminate derivative relationships, both of which could limit our ability to purchase additional derivative instruments. These events could materially adversely affect our business, financial condition, results of operations and liquidity.

On March 21, 2012, Standard & Poor’s Financial Services LLC downgraded Hartford Life Insurance Company and Hartford Life and Accident Insurance Company one notch to A- (stable outlook) and Hartford Life and Annuity Insurance Company two notches to BBB+ (negative outlook). In addition, Moody’s Investors Services, Inc. changed the outlook on Hartford Life and Annuity Insurance Company to negative and A.M. Best placed the Company’s life subsidiaries under review with negative implications. These ratings actions triggered counterparty termination and collateral call rights in a limited number of the Company’s derivative agreements. To date, no counterparties have terminated derivative relationships and we do not anticipate any material collateral calls as a result of these ratings actions.

 

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The impact of regulatory initiatives, including the enactment of the Dodd-Frank Act, could have a material adverse impact on our business, financial condition, results of operations and liquidity.

Regulatory developments relating to the recent financial crisis may significantly affect our operations and prospects in ways that we cannot predict. U.S. and overseas governmental and regulatory authorities, including the SEC, The Federal Reserve, the Federal Deposit Insurance Corporation (“FDIC”), the NYSE and the Financial Industry Regulatory Authority, Inc. (“FINRA”) are considering enhanced or new regulatory requirements intended to prevent future crises or otherwise stabilize the institutions under their supervision. Such measures are likely to lead to stricter regulation of financial institutions generally, and heightened prudential requirements for systemically important companies in particular. Such measures could include taxation of financial transactions and restrictions on employee compensation.

The Dodd-Frank Act was enacted on July 21, 2010, mandating changes to the regulation of the financial services industry. The Dodd-Frank Act may affect our operations and governance in ways that could adversely affect our financial condition and results of operations.

Certain provisions of the Dodd-Frank Act will require central clearing of, and/or impose new margin and capital requirements on, derivatives transactions, which we expect will increase the costs of our hedging program. Other provisions in the Dodd-Frank Act that may impact us include: a new “Federal Insurance Office” within Treasury; discretionary authority for the SEC to impose a harmonized standard of care for investment advisers and broker-dealers who provide personalized advice about securities to retail customers; possible adverse impact on the pricing and liquidity of the securities in which we invest resulting from the proprietary trading and market making limitation of the Volcker Rule; possible prohibition of certain asset-backed securities transactions that could adversely impact our ability to offer insurance-linked securities; and enhancements to corporate governance, especially regarding risk management.

In particular, the Dodd-Frank Act vests a newly created Financial Services Oversight Council (“FSOC”) with the power to designate “systemically important” institutions, which will be subject to special regulatory supervision and other provisions intended to prevent, or mitigate the impact of, future disruptions in the U.S. financial system. Systemically important institutions are limited to large bank holding companies and nonbank financial companies that are so important that their potential failure could “pose a threat to the financial stability of the United States.” The FSOC published a final rule setting forth the process they propose to follow when designating systemically important nonbank financial companies in April 2012, but has not yet indicated when the FSOC will begin designating systemically important nonbank financial companies. Based on its most current financial data, The Hartford does not meet the initial quantitative metrics that will be used to determine which nonbank companies merit consideration. The FSOC has indicted it will review on a quarterly basis whether nonbank financial institutions meet the metrics for further review.

If we are designated as a systemically important institution, we could be subject to higher capital requirements and additional regulatory oversight imposed by The Federal Reserve, as well as to post-event assessments imposed by the FDIC to recoup the costs associated with the orderly liquidation of other systemically important institutions in the event one or more such institutions fails. Further, the FDIC is authorized to petition a state court to commence an insolvency proceeding to liquidate an insurance company that fails in the event the insurer’s state regulator fails to act. We may also be restricted from sponsoring and investing in private equity and hedge funds, which would limit our discretion in managing our general account. The Federal Reserve issued a proposed rule in December 2011 that would apply capital and liquidity requirements, single-counterparty credit limits, and stress testing and risk management requirements to systemically important institutions, and subject such institutions to an early remediation regime based on these requirements. The Federal Reserve has noted that they may tailor the application of the proposed rule to the particular attributes of systemically important nonbank financial companies. If The Hartford were to be designated as systemically important by the FSOC, these requirements could apply to The Hartford. However, it is not yet clear how or to what extent these requirements would be applied to systemically important nonbank financial companies.

Potential changes in federal or state tax laws, including changes impacting the availability of the separate account dividend received deduction, could adversely affect our business, financial condition, results of operations and liquidity.

Many of the products that the Company currently sells benefit from one or more forms of tax-favored status under current federal and state income tax regimes. For example, the Company sells life insurance policies that benefit from the deferral or elimination of taxation on earnings accrued under the policy, as well as permanent exclusion of certain death benefits that may be paid to policyholders’ beneficiaries. We also sold annuity contracts that allowed policyholders to defer the recognition of taxable income earned within the contract. Other products that the Company sells or previously sold also enjoy similar, as well as other, types of tax advantages. The Company also benefits from certain tax items, including but not limited to, tax-exempt bond interest, dividends received deductions, tax credits (such as foreign tax credits), and insurance reserve deductions.

Due in large part to the recent financial crisis that has affected many governments, there is an increasing risk that federal and/or state tax legislation could be enacted that would result in higher taxes on insurance companies and/or their policyholders. For example, on February 13, 2012, the Obama Administration released its “FY 2013, Budget of the United States Government” that includes among many other proposals, a proposal which, if enacted, would adversely affect the amount of the dividends received deduction the Company currently enjoys. Although the specific form of any such potential legislation is uncertain, it could include lessening or eliminating some or all of the tax advantages currently benefiting the Company and/or its policyholders, not “grandfathering” the current tax treatment of existing life and annuity products, etc. This could occur in the context of deficit reduction or other tax reform. The effects of any such changes could have a material adverse effect on our profitability and financial condition, and could result in lapses of policies currently held, and/or our incurrence of materially higher corporate taxes.

 

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Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Purchases of Equity Securities by the Issuer

The following table summarizes the Company’s repurchases of its common stock for the three months ended March 31, 2012:

 

Period

   Total Number
of Shares
Purchased
    Average Price
Paid Per
Share
     Total Number of
Shares Purchased as
Part of Publicly
Announced Plans or
Programs
     Approximate Dollar Value
of Shares that May Yet Be
Purchased Under

the Plans or Programs
 
                         (in millions)  

January 1, 2012 – January 31, 2012

     2,550,000      $ 16.58         2,550,000       $ 407   

February 1, 2012 – February 29, 2012

     18,945  [1]    $ 20.11         —         $ 407   

March 1, 2012 – March 31, 2012

     307,007  [1]    $ 20.66         —         $ 407   
  

 

 

   

 

 

    

 

 

    

 

 

 

Total

     2,875,952      $ 17.04         —           N/A   
  

 

 

   

 

 

    

 

 

    

 

 

 

 

[1] Primarily represents shares acquired from employees of the Company for tax withholding purposes in connection with the Company’s stock compensation plans.

On July 27, 2011 the Company’s Board of Directors authorized a $500 stock repurchase program. The Company’s repurchase authorization, which expires on August 5, 2014, permits purchases of common stock, as well as warrants or other derivative securities. Repurchases may be made in the open market, through derivative, accelerated share repurchase and other privately negotiated transactions, and through plans designed to comply with Rule 10b5-1(c) under the Securities Exchange Act of 1934, as amended. The timing of any future repurchases will be dependent upon several factors, including the market price of the Company’s securities, the Company’s capital position, consideration of the effect of any repurchases on the Company’s financial strength or credit ratings, and other corporate considerations. The repurchase program may be modified, extended or terminated by the Board of Directors at any time. On April 17, 2012, The Hartford repurchased outstanding warrants held by Allianz for $300 under this program resulting in the remaining authorized repurchases of approximately $106 outstanding as of April 26, 2012.

Item 6. EXHIBITS

See Exhibits Index on page 119.

 

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SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.

 

    The Hartford Financial Services Group, Inc.
    (Registrant)
Date: May 2, 2012    

/s/ Beth A. Bombara

    Beth A. Bombara
    Senior Vice President and Controller
   

(Chief accounting officer and duly

authorized signatory)

 

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THE HARTFORD FINANCIAL SERVICES GROUP, INC.

FOR THE QUARTER ENDED MARCH 31, 2012

FORM 10-Q

EXHIBITS INDEX

 

Exhibit No.

  

Description

4.1    Third Supplemental Indenture, dated as of April 5, 2012, between The Hartford Financial Services Group, Inc. (“The Hartford”) and The Bank of New York Mellon Trust Company, N.A., as Trustee (incorporated by reference to Exhibit 4.3 to The Hartford’s Current Report on Form 8-K, filed April 6, 2012).
4.2    Global note for $325,000,000 aggregate principal amount of 4.000% Senior Notes due 2017 (incorporated by reference to Exhibit 4.4 to The Hartford’s Current Report on Form 8-K/A, filed April 6, 2012).
4.3    Global notes for $800,000,000 aggregate principal amount of 5.125% Senior Notes due 2022 (incorporated by reference to Exhibit 4.5 to The Hartford’s Current Report on Form 8-K/A, filed April 6, 2012).
4.4    Global note for $425,000,000 aggregate principal amount of 6.625% Senior Notes due 2042 (incorporated by reference to Exhibit 4.6 to The Hartford’s Current Report on Form 8-K/A, filed April 6, 2012).
4.5    Global notes for $600,000,000 aggregate principal amount of 7.875% Fixed-To-Floating Rate Junior Subordinated Debentures due 2042 (incorporated by reference to Exhibit 4.3 to The Hartford’s Current Report on Form 8-K/A, filed April 7, 2012).
10.01    Warrant and Debentures Purchase Agreement, dated as of March 30, 2012, between The Hartford Financial Services Group, Inc. and Allianz SE (incorporated by reference to Exhibit 10.1 to The Hartford’s Current Report on Form 8-K, filed April 2, 2012).
*10.02    Letter Agreement between David N. Levenson and The Hartford dated March 21, 2012.**
15.01    Deloitte & Touche LLP Letter of Awareness.**
31.01    Certification of Liam E. McGee pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.**
31.02    Certification of Christopher J. Swift pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.**
32.01    Certification of Liam E. McGee pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.**
32.02    Certification of Christopher J. Swift pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.**
101.INS    XBRL Instance Document.**
101.SCH    XBRL Taxonomy Extension Schema.**
101.CAL    XBRL Taxonomy Extension Calculation Linkbase.**
101.DEF    XBRL Taxonomy Extension Definition Linkbase.**
101.LAB    XBRL Taxonomy Extension Label Linkbase.**
101.PRE    XBRL Taxonomy Extension Presentation Linkbase.**
*    Management contract, compensatory plan or arrangement.
**    Filed with the Securities and Exchange Commission as an exhibit to this report.

 

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