UNITED STATESSECURITIES AND EXCHANGE COMMISSION
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 September 30, 2004
OR
o 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
THE HARTFORD FINANCIAL SERVICES GROUP, INC.
Hartford Plaza, Hartford, Connecticut 06115-1900(Address of principal executive offices)
(860) 547-5000(Registrant’s telephone number, including area code)
Indicate by check mark 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.
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
As of October 31, 2004, there were outstanding 293,711,412 shares of Common Stock, $0.01 par value per share, of the registrant.
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INDEX
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PART I. FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders ofThe 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 September 30, 2004, and the related condensed consolidated statements of operations and comprehensive income (loss) for the third quarters and nine months ended September 30, 2004 and 2003, and changes in stockholders’ equity and cash flows for the nine months ended September 30, 2004 and 2003. These interim financial statements are the responsibility of the Company’s management.
We conducted our reviews in accordance with 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 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 standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of the Company as of December 31, 2003, and the related consolidated statements of operations, changes in stockholders’ equity, comprehensive income, and cash flows for the year then ended (not presented herein); and in our report dated February 25, 2004, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2003 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.
DELOITTE & TOUCHE LLPHartford, ConnecticutNovember 3, 2004
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See Notes to Condensed Consolidated Financial Statements.
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Note 1. Basis of Presentation and Accounting Policies
Basis of Presentation
The Hartford Financial Services Group, Inc. and its consolidated subsidiaries (“The Hartford” or the “Company”) provide investment products, life insurance and group benefits, automobile and homeowners products, and business property-casualty insurance to both individual and business customers in the United States and internationally.
On December 31, 2003, the Company acquired the group life and accident, and short-term and long-term disability businesses of CNA Financial Corporation. Accordingly, the Company’s results of operations for the third quarter and nine months ended September 30, 2004 reflect the inclusion of these businesses. For further discussion of the CNA Financial Corporation acquisition, see Note 6 of these Notes to Condensed Consolidated Financial Statements and Note 18 of Notes to Consolidated Financial Statements included in The Hartford’s 2003 Form 10-K Annual Report.
The condensed consolidated financial statements have been prepared on the basis of accounting principles generally accepted in the United States of America, which differ materially from the accounting practices prescribed by various insurance regulatory authorities. Subsidiaries in which The Hartford has at least a 20% interest, but less than a majority ownership interest, are reported on the equity method. All material intercompany transactions and balances among The Hartford, its subsidiaries and affiliates have been eliminated.
The accompanying condensed consolidated financial statements and the condensed notes as of September 30, 2004, and for the third quarter and nine months ended September 30, 2004 and 2003 are unaudited. These financial statements reflect all adjustments (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. These condensed consolidated financial statements and condensed notes should be read in conjunction with the consolidated financial statements and notes thereto included in The Hartford’s 2003 Form 10-K Annual Report. The results of operations for the interim periods should not be considered indicative of results to be expected for the full year.
Reclassifications
Certain reclassifications have been made to prior period financial information to conform to the current period classifications.
Use of Estimates
The preparation of financial statements, in conformity with accounting principles generally accepted in the United States of America, 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 from those estimates.
The most significant estimates include those used in determining reserves for future policy benefits and unpaid claims and claim adjustment expenses; deferred policy acquisition costs and present value of future profits; investments; pension and other postretirement benefits; and contingencies.
Significant Accounting Policies
For a description of accounting policies, see Note 1 of Notes to Consolidated Financial Statements included in The Hartford’s 2003 Form 10-K Annual Report.
Investments
As discussed in Note 9 below, on January 1, 2004, the Company reclassified certain separate account assets to the general account and classified a portion of these assets as trading securities. Trading securities are recorded at fair value with subsequent changes in fair value recognized in net investment income.
Stock-Based Compensation
In January 2003, the Company began expensing all stock-based compensation awards granted or modified after January 1, 2003 under the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation”. The fair value of stock-based awards granted or modified during the nine months ended September 30, 2004 and 2003
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)(Unaudited)
Note 1. Basis of Presentation and Accounting Policies (continued)
was $41 and $40, after-tax, respectively. The fair value of these awards will be expensed over the awards’ vesting period, generally three years.
Prior to January 1, 2004, the Company used the Black-Scholes model to determine the fair value of the Company’s stock-based compensation. For all awards granted or modified on or after January 1, 2004, the Company uses a binomial option-pricing model that incorporates the possibility of early exercise of options into the valuation. The binomial model also incorporates the Company’s historical forfeiture and exercise experience to determine the option value. For these reasons, the Company believes the binomial model provides a fair value that is more representative of actual historical experience than the value calculated under the Black-Scholes model.
All stock-based awards granted or modified prior to January 1, 2003 continue to be valued using the intrinsic value-based provisions set forth in Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees”. Under the intrinsic value method, compensation expense is determined on the measurement date, which is the first date on which both the number of shares the employee is entitled to receive and the exercise price are known. Compensation expense, if any, is measured based on the award’s intrinsic value, which is the excess of the market price of the stock over the exercise price on the measurement date. The expense related to stock-based employee compensation, including non-option plans, included in the determination of net income for the third quarters and nine months ended September 30, 2004 and 2003 is less than that which would have been recognized if the fair value method had been applied to all awards since the effective date of SFAS No. 123. (For further discussion of the Company’s stock compensation plans, see Note 11 of Notes to Consolidated Financial Statements included in The Hartford’s 2003 Form 10-K Annual Report.)
The following table illustrates the effect on net income (loss) and earnings (loss) per share as if the fair value method had been applied to all outstanding and unvested awards in each period. The pro forma fair values disclosed below related to awards granted prior to 2004 were calculated using the Black-Scholes option-pricing model and were not recalculated using the binomial model. The change in valuation methodology would have an immaterial impact on the pro forma net income amounts disclosed.
Adoption of New Accounting Standards
During September 2004, the American Institute of Certified Public Accountants released a set of technical questions and answers on financial accounting and reporting issues related to Statement of Position 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long Duration Contracts and for Separate Accounts” (SOP 03-1). The questions and answers focused on the application of certain provisions of SOP 03-1 to components of universal life-type contracts, including the definition of an insurance benefit feature, the definition of an assessment, the appropriate level of aggregation in determining additional liabilities required by SOP 03-1, situations where the amounts assessed against the contract holder for an insurance benefit feature are expected to result in losses in early and subsequent years of a contract’s life, the impact of reinsurance and the accounting for contracts that provide annuitization benefits. Adoption of this guidance did not have a material impact on the Company’s balance sheet or statement of operations.
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Future Adoption of Accounting Standards
EITF 03-1
In March 2004, the Emerging Issues Task Force (“EITF”) reached a final consensus on Issue 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”. EITF 03-1 was effective for periods beginning after June 15, 2004 and adopts a three-step impairment model for securities within its scope. The three-step model must be applied on a security-by-security basis as follows:
Subsequent to an other-than-temporary impairment loss, a debt security should be accounted for in accordance with SOP 03-3, “Accounting for Loans and Certain Debt Securities Acquired in a Transfer”. EITF 03-1 does not replace the impairment guidance for investments accounted for under EITF 99-20, “Recognition of Interest Income and Impairments on Purchased and Retained Beneficial Interests in Securitized Financial Assets”, however, it requires investors to determine if a security is other-than-temporarily impaired under EITF 03-1 if the security is determined not to be other-than-temporarily impaired under EITF 99-20.
In September 2004, the FASB staff issued clarifying guidance for comment in FSP EITF Issue 03-1-a, “Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1, ‘The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments’”, (FSP 03-1-a) and subsequently voted to delay the implementation of the impairment measurement and recognition guidance contained in paragraphs 10–20 of EITF 03-1 in order to reconsider certain aspects of the consensus as well as the implementation guidance included in FSP 03-1-a. The disclosure guidance in paragraphs 21 and 22 of the standard remains effective.
The ultimate impact the adoption of EITF 03-1 will have on the Company’s consolidated financial condition and results of operations is still unknown. Depending on the nature of the ultimate guidance, adoption of the standard could potentially result in the recognition of unrealized losses, including those declines in value that are attributable to interest rate movements, as other-than-temporary impairments, except those deemed to be minor in nature. As of September 30, 2004, the Company had $309 of total gross unrealized losses. The amount of impairments to be recognized, if any, will depend on the final standard, market conditions and management’s intent and ability to hold securities with unrealized losses at the time of the impairment evaluation.
Note 2. Earnings (Loss) Per Share
The following tables present a reconciliation of net income (loss) and shares used in calculating basic earnings (loss) per share to those used in calculating diluted earnings (loss) per share.
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Note 2. Earnings (Loss) Per Share (continued)
Basic earnings (loss) per share reflects the actual weighted average number of shares outstanding during the period. Diluted earnings (loss) per share includes the dilutive effect, if any, of outstanding options and equity units, using the treasury stock method. Under the treasury stock method exercise of options and equity units are assumed, with the proceeds used to purchase common stock at the average market price for the period.
Note 3. Segment Information
The Hartford is organized into two major operations: Life and Property & Casualty. In the quarter ended March 31, 2004, and as more fully described below, the Company changed its reporting segments to reflect the current manner by which its chief operating decision maker views and manages the business. All segment data for prior reporting periods have been adjusted to reflect the current segment reporting. Within the Life and Property & Casualty operations, The Hartford conducts business principally in eight operating segments. Additionally, Corporate now includes all of the Company’s debt financing and related interest expense, as well as certain capital raising and purchase accounting adjustment activities.
Life has changed its reportable operating segments from Investment Products, Individual Life, Group Benefits and Corporate Owned Life Insurance (“COLI”) to Retail Products Group (“Retail”), Institutional Solutions Group (“Institutional”), Individual Life and Group Benefits. Retail offers individual variable and fixed annuities, mutual funds, retirement plan products and services to corporations under Section 401(k) plans and other investment products. Institutional primarily offers retirement plan products and services to municipalities under Section 457 plans, other institutional investment products and private placement life insurance. Individual Life sells a variety of life insurance products, including variable universal life, universal life, interest sensitive whole life and term life insurance. Group Benefits sells group insurance products, including group life and group disability insurance as well as other products, including medical stop loss and supplementary medical coverages to employers and employer sponsored plans, accidental death and dismemberment, travel accident and other special risk coverages to employers and associations. Life also includes in an Other category its international operations, which are primarily located in Japan and Brazil; net realized capital gains and losses other than periodic net coupon settlements on non-qualifying derivatives and net realized capital gains and losses related to guaranteed minimum withdrawal benefits; corporate items not directly allocated to any of its reportable operating segments; and intersegment eliminations. Periodic net coupon settlements on non-qualifying derivatives and net realized capital gains and losses related to guaranteed minimum withdrawal benefits are reflected in each applicable segment in net realized capital gains and losses.
Property & Casualty is now organized into four reportable operating segments: the underwriting segments of Business Insurance, Personal Lines, and Specialty Commercial (collectively “Ongoing Operations”); and the Other Operations segment. Prior to the first quarter of 2004, Property & Casualty had also included a Reinsurance segment. With the discontinuance of writing new reinsurance assumed business, the reinsurance assumed business is now included in the Other Operations segment for all periods presented.
Business Insurance provides standard commercial insurance coverage to small commercial and middle market commercial businesses primarily throughout the United States. This segment offers workers’ compensation, property, automobile, liability, umbrella and marine coverages. Commercial risk management products and services are also provided.
Personal Lines provides automobile, homeowners’ and home-based business coverages to the members of AARP through a direct marketing operation; to individuals who prefer local agent involvement through a network of independent agents in the standard personal lines market; and through the Omni Insurance Group in the non-standard automobile market. Personal Lines also operates a member contact center for health insurance products offered through AARP’s Health Care Options.
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Note 3. Segment Information (continued)
The Specialty Commercial segment offers a variety of customized insurance products and risk management services. Specialty Commercial provides standard commercial insurance products including workers’ compensation, automobile and liability coverages to large-sized companies. Specialty Commercial also provides bond, professional liability, specialty casualty and agricultural coverages, as well as core property and excess and surplus lines coverages not normally written by standard lines insurers. Alternative markets, within Specialty Commercial, provides insurance products and services primarily to captive insurance companies, pools and self-insurance groups. In addition, Specialty Commercial provides third party administrator services for claims administration, integrated benefits, loss control and performance measurement through Specialty Risk Services, a subsidiary of the Company.
The Other Operations segment consists of certain property and casualty insurance operations of The Hartford which have discontinued writing new business and includes substantially all of the Company’s asbestos and environmental exposures.
The measure of profit or loss used by The Hartford’s management in evaluating the performance of its Life segments is net income. The Property & Casualty segments are evaluated by The Hartford’s management primarily based upon underwriting results. Underwriting results represent premiums earned less incurred claims, claim adjustment expenses and underwriting expenses.
The following tables present revenues and net income (loss). Underwriting results are presented for the Business Insurance, Personal Lines, Specialty Commercial and Other Operations segments, while net income is presented for Life, Property & Casualty and Corporate. Segment information for the previous periods have been restated to reflect the change in composition of reportable operating segments.
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Note 4. Investments and Derivative Instruments
The following table identifies the Company’s fixed maturity investments by sector, as of September 30, 2004 and December 31, 2003.
Components of Fixed Maturity Investments
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Note 4. Investments and Derivative Instruments (continued)
Components of Fixed Maturity Investments (continued)
Included in the fair value of total fixed maturities as of September 30, 2004 are $11.1 billion of guaranteed separate account assets. Guaranteed separate account assets were reclassified to the general account on January 1, 2004 as a result of the adoption of SOP 03-1 (for further discussion see Note 9 of Notes to Condensed Consolidated Financial Statements).
Derivative Instruments
The Company utilizes a variety of derivative instruments, including swaps, caps, floors, forwards, futures and options designed to achieve one of four Company-approved objectives: to hedge risk arising from interest rate, price or currency exchange rate volatility; to manage liquidity; to control transaction costs; or to enter into replication transactions.
On the date the derivative contract is entered into, the Company designates the derivative as (1) a hedge of the fair value of a recognized asset or liability (“fair value” hedge), (2) a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability (“cash flow” hedge), (3) a foreign-currency fair value or cash flow hedge (“foreign-currency” hedge), (4) a hedge of a net investment in a foreign operation or (5) held for other investment and risk management activities, which primarily involve managing asset or liability related risks that do not qualify for hedge accounting under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”.
The Company’s derivative transactions are permitted uses of derivatives under the derivatives use plan filed and/or approved, as applicable, by the State of Connecticut, the State of Illinois and the State of New York insurance departments. The Company does not make a market or trade in these instruments for the express purpose of earning short-term trading profits.
For a detailed discussion of the Company’s use of derivative instruments, see Notes 1 and 3 of Notes to Consolidated Financial Statements included in The Hartford’s 2003 Form 10-K Annual Report.
The following table summarizes the notional amount and fair value of derivatives by hedge designation as of September 30, 2004 and December 31, 2003. The notional amount of derivative contracts represents the basis upon which pay or receive amounts are calculated and are not necessarily reflective of credit risk. The fair value amounts of derivative assets and liabilities are presented on a net basis in the following table.
The increase in notional amount since December 31, 2003 is primarily due to an increase in embedded derivatives associated with guaranteed minimum withdrawal benefits (“GMWB”) product sales, and, to a lesser extent, derivatives transferred to the general account as a result of the adoption of SOP 03-1 and new hedging strategies. The decrease in the net fair value of derivative instruments since December 31, 2003 was primarily due to the rise in short-term interest rates during the third quarter of 2004 and derivatives transferred to the general account pursuant to the adoption of SOP 03-1, partially offset by the increase in derivatives associated with GMWB.
Due to the adoption of SOP 03-1, derivatives previously included in separate accounts were reclassified into various other balance sheet classifications. On January 1, 2004, the notional amount and net fair value of derivative instruments reclassified totaled $2.9 billion and $(71), respectively. As of September 30, 2004, $28 of the derivatives were reported in other investments, $(114) in other liabilities, and $4 of embedded derivatives in fixed maturities in the condensed consolidated balance sheets. Management’s objectives with regard to the reclassified derivatives along with the notional amount and net fair value are as follows:
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Derivative Instruments (continued)
In addition to the derivatives transferred to the general account as a result of the adoption of SOP 03-1, during the first quarter of 2004, the Company entered into a series of interest rate swap agreements with a combined notional value of $350 to hedge a portion of the Company’s floating rate guaranteed investment contracts. These swaps have been designated as cash flow hedges, with the objective of hedging changes in the benchmark interest rate (LIBOR), and were structured to offset the payments associated with the guaranteed investment contracts. As of September 30, 2004, the notional amount and net fair value of these swaps totaled $350 and $2, respectively.
During the nine months ended September 30, 2004, the Company entered into credit default swap agreements in which the Company pays a derivative counterparty a periodic fee in exchange for compensation from the counterparty should a credit event occur on the part of the referenced security issuer. The Company entered into these agreements as an efficient means to reduce credit exposure to the specified issuers. As of September 30, 2004, the notional amount and net fair value of these swaps totaled $614 and $(1), respectively.
During the nine months ended September 30, 2004, the Company also entered into a series of forward starting swap agreements to hedge interest rate exposure on anticipated fixed-rate asset purchases and anticipated variable cash flows on floating rate assets due to changes in the benchmark interest rate (LIBOR). These swaps have been designated as cash flow hedges and were structured to hedge interest rate exposure inherent in the assumptions used to price primarily certain long-term disability products. As of September 30, 2004, the notional amount and net fair value of these swaps totaled $850 and $12, respectively.
During the nine months ended September 30, 2004, the Company entered into interest swaps and swaptions to reduce duration risk in the investment portfolio. These derivative instruments are structured to hedge the durations of fixed maturity investments to match certain life product liabilities in accordance with the Company’s asset and liability management policy. As of September 30, 2004, the notional and fair value of these swaps and swaptions totaled $1.2 billion and $7, respectively.
Periodically the Company enters into interest rate swap agreements to terminate existing swaps in hedging relationships, thereby offsetting the prospective changes in value in the original swap. During the nine months ended September 30, 2004, the Company cash settled both the original and offsetting swap agreements, resulting in a reduction in notional amount of approximately $3.3 billion from December 31, 2003. No net realized gain or loss was recorded as a result of the settlement.
The Company offers certain variable annuity products with a GMWB rider. As of September 30, 2004 and December 31, 2003, $14.7 billion, or 57%, and $6.2 billion, or 36%, respectively, of account value with the GMWB feature was unreinsured. In order to minimize the volatility associated with the unreinsured GMWB liabilities, the Company has established an alternative risk management strategy. In 2003, the Company began hedging its unreinsured GMWB exposure using interest rate futures, and Standard and Poor’s (“S&P”) 500 and NASDAQ index options and futures contracts. During 2004, the Company began using Europe, Australasia and Far East (“EAFE”) Index swaps to hedge GMWB exposure to international equity markets.
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The total notional amount of derivative contracts purchased to hedge the GMWB exposure, as of September 30, 2004 and December 31, 2003, was $2.9 billion and $544, respectively, and net fair value was $151 and $21, respectively. For the third quarter and nine months ended September 30, 2004, net realized capital gains and losses included the change in market value of both the embedded derivative related to the GMWB liability and the related derivative contracts that were purchased as economic hedges, the net effect of which was a gain of $0 and $4, respectively, before deferred policy acquisition costs and tax effects.
Derivative instruments are recorded at fair value and presented in the condensed consolidated balance sheets as follows:
For the third quarter and nine months ended September 30, 2004 and 2003, the Company’s gross gains and losses representing the total ineffectiveness of all fair value and net investment hedges were less than $1, with the net impact reported as net realized capital gains and losses. For the third quarter and nine months ended September 30, 2004, the Company recorded a net loss due to ineffectiveness on cash flow hedges of $(3) and $(6), after-tax, respectively, primarily associated with interest rate swap hedges, in net realized capital gains and losses. For the third quarter and nine months ended September 30, 2003, the cash flow hedge ineffectiveness was less than $1.
The total change in value for other derivative-based strategies which do not qualify for hedge accounting treatment, including periodic net coupon settlements, are reported as net realized capital gains and losses in the condensed consolidated statements of operations. For the third quarter and nine months ended September 30, 2004, the Company recognized an after-tax net (loss) gain of $(9) and $19, respectively, for derivative-based strategies which do not qualify for hedge accounting treatment. For the third quarter and nine months ended September 30, 2003, the after-tax net loss was $(8) and $(19), respectively.
As of September 30, 2004, the after-tax deferred net gains on derivative instruments in accumulated other comprehensive income (“AOCI”) that are expected to be reclassified to earnings during the next twelve months are $10. 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 or 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 all forecasted transactions, excluding interest payments on variable-rate fixed maturities) is twenty-four months. For the third quarter and nine months ended September 30, 2004 and 2003, there were no reclassifications from AOCI to earnings resulting from the discontinuance of cash flow hedges.
The net investment hedge of the Japanese Life operation was established in the fourth quarter of 2003. The after-tax amount of net gain (loss) included in the foreign currency cumulative translation adjustment associated with the net investment hedge was $4 and $(3) as of September 30, 2004 and December 31, 2003, respectively.
Note 5. Reinsurance Recoverables
During the second quarter of 2004, the Company completed an evaluation of the reinsurance recoverable asset associated with older, long-term casualty liabilities reported in the Other Operations segment, including asbestos liabilities. As a result of this evaluation, the Company reduced its net reinsurance recoverable by $181. The after-tax income effect of this action was $118.
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Note 6. Goodwill and Other Intangible Assets
Effective January 1, 2002, the Company adopted SFAS No. 142, “Goodwill and Other Intangible Assets”, and accordingly ceased all amortization of goodwill. Except for goodwill, the Company has no material intangible assets with indefinite useful lives. The carrying amount of goodwill as of September 30, 2004 and December 31, 2003, is shown below.
The following table shows the Company’s acquired intangible assets that continue to be subject to amortization and accumulated amortization expense.
Net amortization expense for the third quarters ended September 30, 2004 and 2003 was $28 and $25, respectively. Net amortization expense for the nine months ended September 30, 2004 and 2003 was $101 and $77, respectively.
The following is detail of the net acquired intangible asset activity for the nine months ended September 30, 2004 and 2003, respectively.
Estimated future net amortization expense for the succeeding five years is as follows:
On December 31, 2003, the Company acquired CNA Financial Corporation’s group life and accident, and short-term and long-term disability businesses for $485 in cash. The purchase price paid on December 31, 2003 was based on September 30, 2003 statutory surplus. During the second quarter of 2004, the purchase price was finalized for $543 in cash based on the actual statutory surplus at December 31, 2003. The Company continues to integrate this acquired operation and obtain the information necessary to finalize the initial estimates in purchase accounting. The Company expects to finalize those initial fair value estimates within the one year allocation period, ending December 31, 2004.
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Note 7. Death Benefits and Other Insurance Benefit Features
The Company issues variable annuity contracts, with separate account investment options, that offer various guaranteed death benefits. The Company currently reinsures a significant portion of these death benefit guarantees associated with its in-force block of business. Upon adoption of SOP 03-1, the Company recorded a liability for GMDB and other benefits sold with variable annuity products of $225 and a related reinsurance recoverable asset of $108. As of September 30, 2004, the liability from GMDB and other benefits sold with variable annuity products was $203 with a related reinsurance recoverable asset of $71. The net GMDB liability is established by estimating the expected value of net reinsurance costs and death benefits in excess of the projected account balance. The excess death benefits and net reinsurance costs are recognized ratably over the accumulation period based on total expected assessments. The determination of the GMDB liability and related reinsurance recoverable is based on models that involve a range of scenarios and assumptions, including those regarding expected market rates of return and volatility, contract surrender rates and mortality experience. The assumptions used are consistent with those used in determining estimated gross profits for purposes of amortizing deferred acquisition costs.
The following table provides details concerning GMDB exposure for the Retail Products Group segment which comprises substantially all of the GMDB exposure:
Breakdown of Variable Annuity Account Value by GMDB Type
The Individual Life segment sells universal life-type contracts with and without certain secondary guarantees, such as a guarantee that the policy will not lapse, even if the account value is reduced to zero, as long as the policyholder makes scheduled premium payments. The cumulative effect on net income upon recording additional liabilities for universal life-type contracts and the related secondary guarantees, in accordance with SOP 03-1, was not material.
Note 8. Sales Inducements
The Company currently offers enhanced crediting rates or bonus payments to contractholders on certain of its individual and group annuity products. Through December 31, 2003, the expense associated with offering certain of these bonuses was deferred and amortized over the contingent deferred sales charge period. Others were expensed as incurred. Effective January 1, 2004, upon the Company’s adoption of SOP 03-1, the expense associated with offering a bonus is deferred and amortized over the life of the related contract in a pattern consistent with the amortization of deferred policy acquisition costs. Also, effective January 1, 2004, amortization expense associated with expenses previously deferred is recorded over the remaining life of the contract rather than over the contingent deferred sales charge period.
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Note 8. Sales Inducements (continued)
Changes in deferred sales inducement activity were as follows:
Note 9. Separate Account Presentation
The Hartford maintains separate account assets and liabilities, which are reported at fair value. Separate account assets are segregated from other investments. Investment income and gains and losses from those separate account assets accrue directly to the policyholder. See Note 7 for a discussion of death benefit guarantees offered in variable annuity contracts sold through separate accounts. The fees earned for administrative and contractholder maintenance services performed for these separate accounts are included in fee income. During 2004, there were no gains or losses on transfers of assets from the general account to the separate account. The Company had recorded certain market value adjusted (“MVA”) fixed annuity products and modified guarantee life insurance (primarily the Company’s Compound Rate Contract (“CRC”) and associated assets) as separate account assets and liabilities through December 31, 2003. Notwithstanding the market value adjustment feature in this product, all of the investment performance of the separate account assets is not being passed to the contractholder. Therefore, it does not meet the conditions for separate account reporting under SOP 03-1. Separate account assets and liabilities related to CRC of $11 billion were reclassified to, and revalued in, the general account upon adoption of SOP 03-1.
Prior to the adoption of SOP 03-1, the Company had also recorded its variable annuity products offered in Japan in separate account assets and liabilities through December 31, 2003. These assets are not legally insulated from general creditors and therefore did not meet the conditions for separate account reporting under SOP 03-1. On January 1, 2004, separate account assets and liabilities in Japan of $6.2 billion were reclassified to the general account with no change in value. The investment assets were recorded at fair value in a trading securities portfolio. As of September 30, 2004, due to strong sales of Japan variable annuity products and positive performance of the Japanese equity markets these assets had increased to $11.1 billion.
Note 10. Commitments and Contingencies
Litigation
The Hartford is involved in claims litigation arising in the ordinary course of business, both as a liability insurer defending 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 claim and claim adjustment expense reserves. Subject to the uncertainties discussed in Note 16 of Notes to Consolidated Financial Statements under the caption “Asbestos and Environmental Claims,” included in The Hartford’s 2003 Form 10-K Annual Report, 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, 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, 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 mutual funds. 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. 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, it is possible that an adverse outcome in certain matters could, from time to time, have a material adverse effect on the Company’s consolidated results of operations or cash flows in particular quarterly or annual periods.
Broker Compensation Litigation – On October 14, 2004, the New York Attorney General’s Office filed a civil complaint (the “NYAG Complaint”) against Marsh Inc. and Marsh & McLennan Companies, Inc. (collectively, “Marsh”) alleging, among other things, 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. The Hartford is not joined as a defendant in the action. Since the filing of the NYAG Complaint, the Company has become aware of several private actions against it asserting claims arising from the allegations of the NYAG Complaint.
The Company is aware of two securities class actions filed in the United States District Court for the District of Connecticut alleging claims against the Company and five of its executive officers under Section 10(b) of the Securities Exchange Act and SEC Rule 10b-5. The complaints allege on behalf of a putative class of shareholders that the Company and the five named individual defendants, as control persons of the Company, “disseminated false and misleading financial statements” by concealing that “the Company was paying illegal and concealed ‘contingent commissions’ pursuant to illegal
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‘contingent commission agreements.’” The class period alleged is November 5, 2003 through October 13, 2004, the day before the NYAG Complaint was filed. The complaints seek damages and attorneys’ fees. The Company and the individual defendants dispute the allegations and intend to defend these actions vigorously.
In addition, the Company is aware of three putative class actions filed in the same court on behalf of participants in the Company’s 401(k) plan against The Hartford, Hartford Fire Insurance Company, the Company’s Pension Fund Trust and Investment Committee, the Company’s Pension Administration Committee, the Company’s Chief Financial Officer, and John/Jane Does 1-15. The suits assert claims under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), alleging that the Company and the other named defendants breached their fiduciary duties to plan participants by, among other things, failing to inform them of the risk associated with investment in the Company’s stock as a result of the activity alleged in the NYAG Complaint. The class period alleged is November 5, 2003 through the present. The complaints seek restitution of losses to the plan, declaratory and injunctive relief, and attorneys’ fees. All defendants dispute the allegations and intend to defend these actions vigorously.
The Company also is aware of two corporate derivative actions filed in the same court. The complaints, brought in each case by a shareholder on behalf of the Company against its directors and an executive officer, allege that the defendants knew adverse non-public information about the activities alleged in the NYAG Complaint and concealed and misappropriated that information to make profitable stock trades, thereby breaching their fiduciary duties, abusing their control, committing gross mismanagement, wasting corporate assets, and unjustly enriching themselves. The complaints seek damages, injunctive relief, disgorgement, and attorneys’ fees. All defendants dispute the allegations and intend to defend these actions vigorously.
The Company also is aware of an amended complaint filed on or about October 19, 2004 by OptiCare Health Systems, Inc., on behalf of a putative class of policyholders, against Marsh, other brokers and consultants, and the insurers named in the NYAG Complaint, including certain of their respective writing companies. The putative class action was filed in August 2004 in the United States District Court for the Southern District of New York and originally asserted only claims against the broker/consultant defendants. The amended complaint alleges additional claims against both the broker/consultant defendants and the insurer defendants. These claims include a claim under the Racketeer Influenced and Corrupt Organizations Act (“RICO”) alleging that the insurer defendants are co-liable with the broker/consultant defendants for alleged misrepresentations or non-disclosures of contingent commission agreements and the solicitation or submission of inflated bids. The amended complaint also asserts claims under the Sherman Act and state antitrust and unfair competition laws alleging that the insurer defendants acted in concert with the broker/consultant defendants to restrain trade. The class period alleged is August 26, 1994 through the date of class certification, which has not yet occurred. The amended complaint seeks treble damages, injunctive and declaratory relief, and attorneys’ fees. The Company disputes the allegations in the amended complaint and intends to defend the action vigorously.
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Additional complaints may be filed against the Company in various courts alleging claims under federal or state law arising from the conduct alleged in the NYAG Complaint. The Company’s ultimate liability, if any, in the pending and possible future suits is highly uncertain and subject to contingencies that are not yet known, such as how many suits will be filed, in which courts they will be lodged, what claims they will assert, what the outcome of investigations by the New York Attorney General’s Office and other regulatory agencies will be, the success of defenses that the Company may assert, and the amount of recoverable damages if liability is established. In the opinion of management, it is possible that an adverse outcome in one or more of these suits could have a material adverse effect on the Company’s consolidated results of operations or cash flows in particular quarterly or annual periods.
Asbestos and Environmental Claims – As discussed in Note 16 of Notes to Consolidated Financial Statements under the caption “Asbestos and Environmental Claims,” included in The Hartford’s 2003 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 (or any range of additional amounts) cannot be reasonably estimated now but could be material to The Hartford’s future consolidated operating results, financial condition and liquidity.
The MacArthur Litigation – On December 19, 2003, Hartford Accident and Indemnity Company (“Hartford A&I”) entered into a conditional settlement to resolve all claims relating to general liability policies that Hartford A&I issued to Mac Arthur Company and its subsidiary, Western MacArthur Company, both former regional distributors of asbestos products (collectively or individually, “MacArthur”), during the period 1967 to 1976. MacArthur had filed a pre-negotiated bankruptcy and plan of reorganization in November 2002 pursuant to a settlement with another of its insurers, United States Fidelity and Guaranty Company. The Hartford settlement was contingent on the occurrence of certain conditions, including the entry of final, non-appealable court orders approving the settlement agreement and confirming a bankruptcy plan under which, among other things, all claims against the Company relating to the asbestos liability of MacArthur would be enjoined. Under the settlement agreement, Hartford A&I paid $1.15 billion into an escrow account in the first quarter of 2004, pending the occurrence of the conditions. On April 22, 2004, all conditions to the settlement were satisfied, and the escrowed funds were disbursed to a trust established for the benefit of present and future asbestos claimants pursuant to the bankruptcy plan. The completion by the Company of the settlement resolves all disputes concerning Hartford A&I’s alleged obligations from MacArthur’s asbestos liability.
Regulatory Developments
In June 2004, the Company received a subpoena from the New York Attorney General’s Office in connection with its inquiry into compensation arrangements between brokers and carriers. On September 17, 2004, the New York Attorney General’s Office issued two additional subpoenas to the Company seeking information about possible anti-competitive activity among brokers and insurers. Subsequently, the Company has received additional subpoenas from the New York Attorney General’s Office, the Connecticut Attorney General’s Office, the Massachusetts Attorney General’s Office, the Minnesota Department of Commerce and the Ohio Attorney General’s Office regarding broker compensation and possible anti-competitive activity. The Company may receive additional subpoenas and other information requests from these or other regulatory agencies regarding similar issues. The Company intends to continue cooperating fully with these investigations, and has initiated an internal review, with the assistance of outside counsel, regarding the issues under investigation.
On October 14, 2004, the New York Attorney General’s Office filed a civil complaint against Marsh & McLennan Companies, Inc., and Marsh, Inc. (collectively, “Marsh”). The complaint alleges, among other things, that certain insurance companies, including the Company, 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. The Company is not joined as a defendant in the action. Although no regulatory action has been initiated against the Company in connection with the allegations described in the civil complaint, it is possible that the New York Attorney General’s Office or one or more other regulatory agencies may pursue action against the Company or one or more of its employees in the future. The potential timing of any such action is difficult to predict. If such an action is brought, it could have a material adverse effect on the Company.
There continues to be significant federal and state regulatory activity relating to financial services companies, particularly mutual funds companies. These regulatory inquiries have focused on a number of mutual fund issues. The Company has received requests for information and subpoenas from the Securities and Exchange Commission (“SEC”), subpoenas from the New York Attorney General’s Office, and requests for information from the Connecticut Securities and Investments Division of the Department of Banking, in each case requesting documentation and other information regarding various mutual fund regulatory issues. The Company continues to respond to requests for documents and information from representatives from the SEC’s Office of Compliance Inspections and Examinations in connection with their ongoing compliance examinations regarding market timing and late trading, revenue sharing and directed brokerage, fees, fund service providers and transfer agents, and other mutual fund-related issues. In addition, the SEC’s Division of Enforcement and the New York Attorney General’s Office are investigating aspects of the Company’s variable annuity and mutual fund operations. The Company continues to cooperate fully with the SEC, the New York Attorney General’s Office and other regulatory agencies.
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Note 10. Commitments and Contingencies (continued)
Regulatory Developments (continued)
The Company’s mutual funds are available for purchase by the separate accounts of different variable life insurance policies, variable annuity products, and funding agreements, and they are offered directly to certain qualified retirement plans. Although existing products contain transfer restrictions between subaccounts, some products, particularly older variable annuity products, do not contain restrictions on the frequency of transfers. In addition, as a result of the settlement of litigation against the Company with respect to certain owners of older variable annuity products, the Company’s ability to restrict transfers by these owners is limited.
A number of companies have announced settlements of enforcement actions with various regulatory agencies, primarily the SEC and the New York Attorney General’s Office, which have included a range of monetary penalties and restitution. While no such action has been initiated against the Company, it is possible that the SEC, the New York Attorney General’s Office or other regulatory agencies may pursue action against the Company in the future. The potential timing of any such action is difficult to predict. If such an action is brought, it could have a material adverse effect on the Company.
Tax Matters
The Company’s Federal income tax returns are routinely audited by the Internal Revenue Service (“IRS”). During the third quarter of 2004, the IRS completed its examination of the 1998-2001 tax years, and the IRS and the Company have agreed upon all adjustments. As a result, during the third quarter of 2004 the Company booked a $216 tax benefit to reflect the impact of the audit settlement on tax years prior to 2004. The benefit relates primarily to the separate account dividends-received deduction (“DRD”) and interest. (For further discussion of the Company’s separate account DRD, see Note 16 of Notes to Consolidated Financial Statements included in the Company’s 2003 Form 10-K Annual Report.) Management believes that adequate provision has been made in the financial statements for any potential assessments that may result from future tax examinations and other tax-related matters for all open tax years.
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Note 11. Pension Plans and Postretirement Health Care and Life Insurance Benefit Plans
Components of Net Periodic Benefit Cost
Total net periodic benefit cost for the nine months ended September 30, 2004 and 2003 include the following components:
Employer Contributions
On April 15, 2004, the Company made a $312 voluntary contribution into its U.S. qualified defined benefit pension plan. No additional contributions are expected to be made in 2004.
Note 12. Debt
During the nine months ended September 30, 2004, the Company repaid $477 of commercial paper utilizing the proceeds from its common stock offering and internal sources. For further discussion of the common stock offering, see Note 13.
On June 15, 2004, HLI repaid $200 of 6.9% senior notes at maturity.
On March 15, 2004, HLI redeemed $250 of its 7.2% junior subordinated debentures underlying the trust preferred securities issued by Hartford Life Capital I.
On March 9, 2004, the Company issued 4.75% senior notes due March 1, 2014, and received net proceeds of $197. Interest on the notes is payable semi-annually on March 1 and September 1.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 12. Debt (continued)
Shelf Registrations
On December 3, 2003, The Hartford’s shelf registration statement (Registration No. 333-108067) for the potential offering and sale of debt and equity securities in an aggregate amount of up to $3.0 billion was declared effective by the SEC. The Registration Statement allows for the following types of securities to be offered (i) debt securities, preferred stock, common stock, depositary shares, warrants, stock purchase contracts, stock purchase units and junior subordinated deferrable interest debentures of the Company, and (ii) preferred securities of any of one or more capital trusts organized by The Hartford (“The Hartford Trusts”). The Company may enter into guarantees with respect to the preferred securities of any of The Hartford Trusts. As of September 30, 2004, The Hartford had $2.4 billion remaining on its shelf.
On May 15, 2001, HLI filed with the SEC a shelf registration statement (Registration No. 333-60944) for the potential offering and sale of up to $1.0 billion in debt and preferred securities. The registration statement was declared effective on May 29, 2001. As of September 30, 2004, HLI had $1.0 billion remaining on its shelf.
Junior Subordinated Debentures
The Hartford and its subsidiary HLI have formed statutory business trusts which exist for the exclusive purposes of (i) issuing Trust Securities representing undivided beneficial interests in the assets of the Trust; (ii) investing the gross proceeds of the Trust Securities in Junior Subordinated Deferrable Interest Debentures (“Junior Subordinated Debentures”) of The Hartford or HLI; and (iii) engaging in only those activities necessary or incidental thereto. The Company may enter into guarantees with respect to the preferred securities of any of The Hartford Trusts.
Commercial Paper and Revolving Credit Facilities
Interest Expense
The following table presents interest expense incurred during the third quarters and nine months ended September 30, 2004 and 2003, respectively.
Note 13. Stockholders’ Equity
On January 22, 2004, The Hartford issued approximately 6.3 million shares of common stock pursuant to an underwritten offering at a price to the public of $63.25 per share and received net proceeds of $388. Subsequently, on January 30, 2004, The Hartford issued approximately 377 thousand shares of common stock pursuant to an underwritten offering at a price to the public of $63.25 per share and received net proceeds of $23. The Company used the proceeds from these issuances to repay $411 of commercial paper issued in connection with the acquisition of the group life and accident, and short-term and long-term disability businesses of CNA Financial Corporation. (For further discussion of this acquisition, see Note 18 of Notes to Consolidated Financial Statements included in The Hartford’s 2003 Form 10-K Annual Report.).
In September 2004, the Company’s Board of Directors authorized the Company to repurchase up to $1 billion of its securities. The Company’s repurchase authorization permits purchases of common stock and equity units, which may be in the open market or through privately negotiated transactions. The Company also may enter into derivative transactions to facilitate future repurchases of common stock and equity units.
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Note 14. Accumulated Other Comprehensive Income (Loss)
Comprehensive income (loss) is defined as all changes in stockholders’ equity, except those arising from transactions with stockholders. Comprehensive income (loss) includes net income (loss) and other comprehensive income (loss), which for the Company consists of changes in unrealized appreciation or depreciation of investments carried at market value, changes in gains or losses on cash-flow hedging instruments, changes in foreign currency translation gains or losses and changes in the Company’s minimum pension liability.
The components of accumulated other comprehensive income (loss) were as follows:
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Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONAND 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 September 30, 2004, compared with December 31, 2003, and its results of operations for the third quarter and nine months ended September 30, 2004, compared to the equivalent 2003 periods. This discussion should be read in conjunction with the MD&A in The Hartford’s 2003 Form 10-K Annual Report.
Certain of the statements contained herein are forward-looking statements. These forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and include estimates and assumptions related to economic, competitive and legislative developments. These forward-looking statements are subject to change and uncertainty which are, in many instances, beyond the Company’s control and have been made based upon management’s expectations and beliefs concerning future developments and their potential effect upon the Company. There can be no assurance that future developments will be in accordance with management’s expectations or that the effect of future developments on The Hartford will be those anticipated by management. Actual results could differ materially from those expected by the Company, depending on the outcome of various factors. These factors include: the difficulty in predicting the Company’s potential exposure for asbestos and environmental claims and related litigation; the possible occurrence of terrorist attacks; the response of reinsurance companies under reinsurance contracts and the availability, pricing and adequacy of reinsurance to protect the Company against losses; changes in the stock markets, interest rates or other financial markets, including the potential effect on the Company’s statutory capital levels; the inability to effectively mitigate the impact of equity market volatility on the Company’s financial position and results of operations arising from obligations under annuity product guarantees; the difficulty in predicting the Company’s potential exposure arising out of regulatory proceedings or private claims relating to incentive compensation or payments made to brokers and alleged anti-competitive conduct; the uncertain effect on the Company of regulatory and market-driven changes in practices relating to the payment of incentive compensation to brokers and other distribution intermediaries, including changes that have been announced and those which may occur in the future; the uncertain effect on the Company of the Jobs and Growth Tax Relief Reconciliation Act of 2003, in particular the reduction in tax rates on long-term capital gains and most dividend distributions; the possibility of more unfavorable loss experience than anticipated; the incidence and severity of catastrophes, both natural and man-made; stronger than anticipated competitive activity; unfavorable judicial or legislative developments, including the possibility that the Terrorism Risk Insurance Act of 2002 is not extended beyond 2005; the potential effect of domestic and foreign regulatory developments, including those which could increase the Company’s business costs and required capital levels; the possibility of general economic and business conditions that are less favorable than anticipated; the Company’s ability to distribute its products through distribution channels, both current and future; the uncertain effects of emerging claim and coverage issues; the effect of assessments and other surcharges for guaranty funds and second-injury funds and other mandatory pooling arrangements; a downgrade in the Company’s claims-paying, financial strength or credit ratings; the ability of the Company’s subsidiaries to pay dividends to the Company; and other factors described in such forward-looking statements.
CRITICAL ACCOUNTING ESTIMATES
The preparation of financial statements, in conformity with accounting principles generally accepted in the United States of America (“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 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: reserves for future policy benefits and unpaid claim and claim adjustment expenses; Life operations deferred policy acquisition costs and present value of future profits; investments; pension and other postretirement benefits; and contingencies. 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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Deferred Policy Acquisition Costs and Present Value of Future Profits
Life
Policy acquisition costs, which include commissions and certain other expenses that vary with and are primarily associated with acquiring business, are deferred and amortized over the estimated lives of the contracts, usually 20 years. These deferred costs, together with the present value of future profits of acquired business, are recorded as an asset commonly referred to as deferred policy acquisition costs and present value of future profits (“DAC”). At September 30, 2004 and December 31, 2003, the carrying value of the Company’s Life operations’ DAC was $7.1 billion and $6.6 billion, respectively. For statutory accounting purposes, such costs are expensed as incurred.
The Company has developed sophisticated modeling capabilities to evaluate its DAC asset, which allowed it to run a large number of stochastically determined scenarios of separate account fund performance. These scenarios were then utilized to calculate a statistically significant range of reasonable estimates of gross profits or “EGPs”. This range was then compared to the present value of EGPs currently utilized in the DAC amortization model. As of September 30, 2004, the present value of the EGPs utilized in the DAC amortization model falls within a reasonable range of statistically calculated present value of EGPs. As a result, the Company does not believe there is evidence to suggest that a revision to the EGPs (and therefore, a revision to the DAC) as of September 30, 2004 is necessary; however, if in the future the EGPs utilized in the DAC amortization model were to exceed the margin of the reasonable range of statistically calculated EGPs, a revision could be necessary. Furthermore, the Company has estimated that the present value of the EGPs is likely to remain within a reasonable range if overall separate account returns decline by 30% or less from September 30 levels for the balance of 2004, or 20% or less over the next twelve months, and if certain other assumptions that are implicit in the computations of the EGPs are achieved. For further discussion of these assumptions, see the Critical Accounting Estimates section of the Company’s 2003 Form 10-K Annual Report under the heading “Deferred Policy Acquisition Costs and Present Value of Future Profits”.
Additionally, the Company continues to perform analyses with respect to the potential impact of a revision to future EGPs. If such a revision to EGPs were deemed necessary, the Company would adjust, as appropriate, all of its assumptions for products accounted for in accordance with Statement of Financial Accounting Standards No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments”, and reproject its future EGPs based on current account values at the end of the quarter in which a revision is deemed to be necessary. To illustrate the effects of this process, assume the Company had concluded that a revision of the Company’s EGPs was required at September 30, 2004. If the Company assumed a 9% average long-term rate of growth from September 30, 2004 forward along with other appropriate assumption changes in determining the revised EGPs, the Company estimates the cumulative increase to amortization would be approximately $65-$70 after-tax. If instead the Company were to assume a long-term growth rate of 8% in determining the revised EGPs, the adjustment would be approximately $95-$105, after-tax. Assuming that such an adjustment were to have been required, the Company anticipates that there would have been immaterial impacts on its DAC amortization for the 2004 and 2005 years exclusive of the adjustment, and that there would have been positive earnings effects in later years. Any such adjustment would not affect statutory income or surplus, due to the prescribed accounting for such amounts that is discussed above.
The overall recoverability of the DAC asset is dependent on the future profitability of the business. The Company tests the aggregate recoverability of the DAC asset by comparing the amounts deferred to the present value of total EGPs. In addition, the Company routinely stress tests its DAC asset for recoverability against severe declines in its separate account assets, which could occur if the equity markets experienced another significant sell-off, as the majority of policyholders’ funds in the separate accounts is invested in the equity market. As of September 30, 2004, the Company believed variable annuity separate account assets could fall by at least 45% before portions of its DAC asset would be unrecoverable.
Other Critical Accounting Estimates
There have been no material changes to the identification of the Company’s critical accounting estimates regarding reserves for future policy benefits and unpaid claims and claim adjustment expenses; investments; pension and other postretirement benefits; and contingencies since the filing of the Company’s 2003 Form 10-K Annual Report.
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CONSOLIDATED RESULTS OF OPERATIONS
Operating Summary
The Hartford defines “NM” as not meaningful for increases or decreases greater than 200%, or changes from a net gain to a net loss position, or vice versa.
Operating Results
Net income for the third quarter ended September 30, 2004 increased $151 from the comparable prior year period. Included in this increase was a $216 tax benefit, $190 recorded in Life and $26 recorded in Property & Casualty, related to tax years prior to 2004, primarily consisting of the benefit related to the separate account dividends-received deduction (“DRD”) and interest. For further discussion, see Note 10 of Notes to Condensed Consolidated Financial Statements. Also contributing to the change in net income was a $33 increase in net income for the Retail Products Group segment, a $32 increase in net income for the Group Benefits segment and a $41 increase in net income for the Institutional Solutions Group segment, which was primarily the result of $40 of after-tax expense recorded in the quarter ended September 30, 2003 related to the settlement of litigation with Bancorp Services, LLC (“Bancorp”). Offsetting these increases was a decrease in net income for Property & Casualty, which was substantially related to a $201 increase in after-tax catastrophe losses, primarily from hurricanes Charley, Frances, Ivan and Jeanne, and a $49 after-tax increase in environmental reserves.
Net income for the nine months ended September 30, 2004 increased $2.0 billion, due primarily to $1.7 billion, after-tax, in reserve strengthening resulting from the completion of the Company’s asbestos reserve study in the first quarter of 2003. Also contributing to the increase was the $216 tax benefit recognized in the third quarter ended September 30, 2004, increased net income in the Group Benefits and Retail Products Group segments, and improved underwriting results in the Business Insurance segment. Offsetting these increases were increased Property & Casualty catastrophe losses, substantially related to hurricanes Charley, Frances, Ivan and Jeanne, and a $118 provision related to the completion of the Company’s evaluation of the reinsurance recoverable asset associated with older, long-term casualty liabilities.
Revenues for the third quarter and nine months ended September 30, 2004 increased $469 and $2.6 billion, respectively, over the comparable prior year periods, primarily due to higher earned premiums in the Group Benefits, Business Insurance, Personal Lines and Specialty Commercial segments, increased fee income in the Retail Products Group segment, and an increase in net investment income. The increase in net investment income was due primarily to the adoption of Statement of Position 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts” (“SOP 03-1”).
As the Company has disclosed previously, the Company pays brokers and independent agents commissions and other forms of incentive compensation in connection with the sale of many of the Company’s insurance products. Since the New York Attorney General’s Office filed a civil complaint against Marsh & McLennan Companies, Inc. and Marsh, Inc. (collectively, “Marsh”) on October 14, 2004, several of the largest national insurance brokers, including Marsh, have announced their intention to discontinue the use of incentive compensation arrangements. Other industry participants may make similar, or different, determinations in the future. In addition, new regulations may require changes to industry practices relating to incentive compensation. At this time, it is not possible to predict the effect of these announced or potential changes on the Company’s business or distribution strategies.
Income Taxes
The effective tax rate for the third quarter and nine months ended September 30, 2004 was (61%) and 11%, respectively, as compared with 21% and 53%, respectively, for the comparable periods in 2003. The principal causes of the difference between the 2004 effective rates and the U.S. statutory rate of 35% were tax-exempt interest earned on invested assets, the dividends-received deduction and the tax benefit associated with the settlement of the 1998-2001 IRS audit. The principal causes of the differences in 2003 were tax-exempt interest earned on invested assets and the dividends-received deduction.
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Organizational Structure
The Hartford is organized into two major operations: Life and Property & Casualty. In the first quarter 2004, and as more fully described below, the Company changed its reporting segments to reflect the current manner by which its chief operating decision maker views and manages the business. All segment data for prior reporting periods have been adjusted to reflect the current segment reporting. Within the Life and Property & Casualty operations, The Hartford conducts business principally in eight operating segments. Additionally, Corporate now includes all of the Company’s debt financing and related interest expense, as well as certain capital raising and purchase accounting adjustment activities.
Life has changed its reportable operating segments from Investment Products, Individual Life, Group Benefits and Corporate Owned Life Insurance (“COLI”) to Retail Products Group (“Retail”), Institutional Solutions Group (“Institutional”), Individual Life and Group Benefits. Retail offers individual variable and fixed annuities, mutual funds, retirement plan products and services to corporations under Section 401(k) plans and other investment products. Institutional primarily offers retirement plan products and services to municipalities under Section 457 plans, other institutional investment products and private placement life insurance. Individual Life sells a variety of life insurance products, including variable universal life, universal life, interest sensitive whole life and term life insurance. Group Benefits sells group insurance products, including group life and group disability insurance as well as other products, including medical stop loss and supplementary medical coverages to employers and employer sponsored plans, accidental death and dismemberment, travel accident and other special risk coverages to employers and associations. Life also includes, in an Other category, its international operations, which are primarily located in Japan and Brazil; net realized capital gains and losses other than periodic net coupon settlements on non-qualifying derivatives and net realized capital gains and losses related to guaranteed minimum withdrawal benefits; corporate items not directly allocated to any of its reportable operating segments; and intersegment eliminations. Periodic net coupon settlements on non-qualifying derivatives and net realized capital gains and losses related to guaranteed minimum withdrawal benefits are reflected in each applicable segment in net realized capital gains and losses.
Property & Casualty is now organized into four reportable operating segments: the underwriting segments of Business Insurance, Personal Lines, and Specialty Commercial (collectively “Ongoing Operations”); and the Other Operations segment. Prior to the first quarter of 2004, Property & Casualty had also included a Reinsurance segment. With the discontinuance of writing new assumed reinsurance business, the assumed reinsurance business is now included in the Other Operations segment for all periods presented.
Segment Results
The following is a summary of net income (loss) for each of the Company’s Life segments and aggregate net income (loss) for the Company’s Property & Casualty operations.
Net Income (Loss)
Underwriting Results (before-tax)
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LIFE
[1] With the adoption of SOP 03-1, certain annuity products were required to be accounted for in the general account. This change in accounting resulted in increases of $40 and $988 in net investment income and a (decrease) increase of ($18) and $836 in benefits, claims and claim adjustment expenses for the third quarter and nine months ended September 30, 2004, respectively.
[2] For the nine months ended September 30, 2004, represents the cumulative impact of the Company’s adoption of SOP 03-1.
Life’s net income increased for the third quarter of 2004 compared to 2003 due primarily to lower income tax expense, increases in net income in all lines of business and higher net realized capital gains. (See the Investments section for further discussion of investment results and related realized capital gains.) During the third quarter of 2004, the Internal Revenue Service completed its examination of the 1998-2001 tax years. (For further discussion see Note 10 of Notes to Condensed Consolidated Financial Standards under Tax Matters). Life recorded in the third quarter of 2004 an after-tax benefit of $190, consisting primarily of a change in estimate of the DRD tax benefit reported during 2003 and prior years and interest, and changed the estimate of the after-tax benefit for the DRD benefit related to the 2004 tax year. As a result of this change in estimate approximately $20 of additional DRD benefit was recorded in the third quarter ended September 30, 2004 to reflect the change in estimate applicable to the first three quarters of 2004.
Net income in the Institutional segment was higher as a result of a decrease in other expenses related to private placement life insurance business compared to the respective prior year period. The decrease in other expenses for the current year period is attributed to a $40 after-tax charge, recorded in the third quarter ended September 30, 2003, associated with the settlement of the Bancorp Services, LLC (“Bancorp”) litigation. Net income in the Retail segment increased, principally driven by growth in the variable annuity and mutual fund businesses as a result of increasing assets under management. Partially offsetting the increase in the Retail segment was lower spread income on market value adjusted (“MVA”) fixed annuities due to the adoption of SOP 03-1. Net income in the Group Benefits segment increased due primarily to increased earned premiums and net investment income growth, primarily resulting from the Company’s acquisition of the group life and accident, and short-term and long-term disability businesses of CNA Financial Corporation (“CNA Acquisition”). In addition, the Group Benefits segment was favorably impacted by a lower benefit ratio in the group life line. Additionally, net income was higher for Individual Life and the international operations. The increase in Individual Life earnings was primarily driven by higher net investment income including the effects of prepayments, growth in account values and life insurance in force. Net income for the international operations, which is included in the other category, increased over the comparable prior year period primarily driven by the increase in assets under management of the Japan annuity business. Japan’s assets under management have grown to $11.1 billion at September 30, 2004 from $4.8 billion at September 30, 2003. During the quarter, the Company has also introduced market value adjusted fixed annuity products to provide a diversified product portfolio to customers in Japan.
For the nine months ended September 30, 2004 compared to 2003, net income increased primarily due to higher net income in the Retail segment, Group Benefits segment, Institutional segment and international operations as discussed in the previous paragraph, higher net realized capital gains, and a lower effective tax rate. The effective tax rate was 10% for the nine months ended September 30, 2004 as compared to an effective tax rate of 18% for the respective prior year period. The lower effective tax rate for the nine months ended September 30, 2004 was attributed to tax related items, as discussed above, of $190 and a year–to-date 2004 tax year benefit of $85, as compared to tax related items of $30 and a year-to-date 2003 tax year DRD benefit of $65 reported for the nine months ended September 30, 2003, respectively. Partially offsetting the positive earnings drivers for the nine months ended September 30, 2004 was the cumulative effect of accounting change from the Company’s adoption of SOP 03-1. The adoption of SOP 03-1 also resulted in certain changes in presentation in the Company’s financial statements, including reporting of the spreads on the Company’s MVA fixed annuities and variable annuity products offered in Japan on a gross basis in net investment income and benefits expense. Exclusive of
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the cumulative effect, overall application of SOP 03-1 resulted in an immaterial reduction in net income. (For further discussion of the impact of the Company’s adoption of SOP 03-1, see Note 1 of Notes to Condensed Consolidated Financial Statements).
Retail Products Group
[1] For the nine months ended September 30, 2004, represents the cumulative impact of the Company’s adoption of SOP 03-1.
[2] Includes policyholder balances for investment contracts and reserves for future policy benefits for insurance contracts.
Net income in the Retail segment increased for the third quarter and nine months ended September 30, 2004, principally driven by significant growth in the assets under management within the variable annuity and mutual fund businesses. The Company uses assets under management as an internal performance measure. Relative profitability of the Retail segment is highly correlated to the growth in assets under management since the segment generally earns fee income on a daily basis on its assets under management. Assets under management are driven by the performance of the equity markets and net flows. Net flows are comprised of new sales less surrenders, death benefits and annuitizations of variable annuity contracts. In the mutual fund business, net flows are known as net sales. Net sales are comprised of new sales less redemptions of mutual fund customers.
Fee income generated by the variable annuity operation increased, as average account values were higher in the third quarter and nine months ended September 30, 2004 compared to the respective prior year periods. The increase in average account values can be attributed to market appreciation of $8.0 billion and net flows of $6.5 billion over the past four quarters. The Company uses the S&P 500 Index as an indicator for evaluating market returns of the underlying account portfolios, more specifically the average daily value of the S&P 500, which rose by approximately 10% from September 30, 2003 to September 30, 2004. Another contributing factor to the increase in fee income was the mutual fund business. Retail mutual fund assets under management increased 32% principally due to net sales of $3.1 billion and market appreciation of $2.5 billion over the past four quarters.
Additionally, for the third quarter ended September 30, 2004, the segment experienced a lower effective tax rate, primarily attributed to additional DRD benefit of $18 recorded in the third quarter ended September 30, 2004 to reflect the change in estimate applicable to the first three quarters of 2004. The effective tax rate for the third quarter ended September 30, 2004 was 11% as compared to 20% for the comparable prior year period.
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Partially offsetting the positive earnings drivers discussed above was a decrease in net income in the individual fixed annuity business and higher amortization of deferred policy acquisition costs for the third quarter and nine months ended September 30, 2004 as compared to the respective prior year periods. The decrease in net income in the individual fixed annuity business was attributed to a lower investment spread from the MVA fixed annuity product for the third quarter and nine months ended September 30, 2004 as compared to the comparable prior year periods. In addition, with the adoption of SOP 03-1, the Company includes the investment return from the product in net investment income and includes interest credited to contract holders in the benefits, claims and claim adjustment expenses line in the operating summary rather than reporting the net spread in fee income and other. The resulting cumulative effect of the accounting change from the Company’s adoption of SOP 03-1 recorded in the first quarter of 2004 also provided an offset to the positive earnings growth for the nine months ended September 30, 2004. Additionally, income tax expense was higher for the nine months ended September 30, 2004 due primarily to higher income earned by the segment and the $20 tax benefit recorded in the second quarter of 2003 related to the change in estimate of the DRD reported during 2002. This increase was largely offset by a higher DRD tax benefit of $77 related to the 2004 tax year reported for the nine months ended September 30, 2004, as discussed above, as compared to the DRD tax benefit of $59 related to the 2003 tax year reported in the comparable prior year period.
Institutional Solutions Group
Net income for the third quarter and nine months ended September 30, 2004 increased primarily due to decreases in other expenses related to private placement life insurance business compared to the respective prior year periods. The decrease in other expenses for the current year period is attributed to a $40 after-tax charge, recorded in the third quarter ended September 30, 2003, associated with the settlement of the Bancorp litigation. In addition, the governmental business contributed higher income for the third quarter and nine months ended September 30, 2004. This increase was primarily attributable to higher revenues earned from the growth in the average account values as a result of positive net flows and market appreciation since the third quarter of 2003. Partially offsetting this increase in net income for the third quarter and nine months ended September 30, 2004 was lower income from the institutional business, which includes structured settlements and institutional annuities. Lower net income in the institutional business was due primarily to lower spread income as a result of the lower interest rates and slightly higher insurance operating costs for the third quarter and nine months ended September 30, 2004 as compared to the respective prior year periods. In addition, the institutional business reported lower earnings for the third quarter and nine months ended September 30, 2004 compared to the same periods in 2003 due to favorable mortality experience in 2003. Private placement life insurance also experienced lower revenues earned for the third quarter and nine
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months ended September 30, 2004 as compared to the prior year periods due to the declining leveraged COLI account values, which resulted from surrenders that occurred in 2003. Additionally, income tax expense was higher for the nine months ended September 30, 2004 due primarily to decreases in other expenses related to the private placement life insurance business, as discussed above. This increase in income tax expense was partially offset by a higher DRD tax benefit of $4 related to the 2004 tax year reported for the nine months ended September 30, 2004, as discussed above, as compared to the DRD tax benefit of $3 related to the 2003 tax year reported in the comparable prior year period.
Individual Life
Net income in the Individual Life segment increased for the third quarter and nine months ended September 30, 2004 as compared to the respective prior year periods. These increases were primarily driven by higher net investment income due to prepayments on bonds, growth in account values and life insurance in force and reserve refinements. Net investment income increased for the third quarter and nine months ended September 30, 2004 as compared to the prior year periods primarily due to the adoption of SOP 03-1 and prepayments on bonds. The adoption of SOP 03-1 also resulted in an increase in benefits, claims and claim adjustment expenses and a decrease to fee income and other for the third quarter and nine months ended September 30, 2004 as compared to the respective prior year periods for the segment’s Modified Guarantee Life Insurance product, which was formerly classified as a separate account product. For the third quarter ended September 30, 2004, the impact of SOP 03-1 on benefits, claims and claim adjustment expenses was more than offset by lower mortality and morbidity costs. The increase in overall benefits, claims and claim adjustment expenses for the nine months ended September 30, 2004 also reflects higher mortality costs. Increased insurance operating costs and expenses for the quarter and year to date over the same periods last year reflect the impact of business growth. Additionally, income tax expense was higher for the nine months ended September 30, 2004 due primarily to earnings growth, as discussed above. This increase in income tax expense was partially offset by a higher DRD tax benefit of $4 related to the 2004 tax year reported for the nine months ended September 30, 2004, as discussed above, as compared to the DRD tax benefit of $3 related to the 2003 tax year reported in the comparable prior year period.
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Group Benefits
Net income in the Group Benefits segment increased for the third quarter and nine months ended September 30, 2004 as compared to the respective prior year periods due to earned premium growth and net investment income growth, both in the pre-acquisition Group Benefits business as well as the result of the CNA Acquisition. The increase in earned premiums was driven by sales (excluding buyouts) of $552 for the nine months ended September 30, 2004, representing an increase of 33% over sales reported in the comparable prior year period, and favorable persistency. Although benefits, claims and claim adjustment expenses increased, the segment’s loss ratio (defined as benefits, claims and claim adjustment expenses as a percentage of premiums and other considerations excluding buyouts) was 73% and 75% for the third quarter and nine months ended September 30, 2004, respectively, down from 79% for both the comparable periods of 2003, which contributed favorably to net income. The unusually low loss ratio for the quarter was the result of improved mortality experience as well as favorable development in premium waiver reserves. Based on historical experience trends and variability in the Group Benefits business, management expects the loss ratio in future periods to be higher than 73%. Partially offsetting these favorable items for the nine months ended September 30, 2004 as compared to the prior year period were higher commissions due to higher sales and premiums previously discussed. Additionally, operating costs increased due to the growth in the segment and the CNA Acquisition. Consistent with the increase in operating costs, the segment’s ratio of insurance operating costs and other expenses to premiums and other considerations (excluding buyouts) increased to 26% and 27% for the third quarter and nine months ended September 30, 2004, respectively, from 24% for both the comparable prior year periods. As part of the CNA Acquisition, a larger block of affinity business is now included in the Group Benefits segment. This business typically has lower expected loss ratios and higher expected commission ratios than other products within the business. Due to this change in business mix in 2004, the segment, as expected, has a lower loss ratio and higher commission ratio than in 2003.
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PROPERTY & CASUALTY
[1] Represents servicing revenue.
[3] Excludes Other Operations.
Total revenues for Property & Casualty increased $214 for the third quarter and $420 for the nine months ended September 30, 2004. The increase for both periods was due primarily to earned premium growth. The nine month increase is partially offset by the $114 decrease in realized capital gains. The increase in earned premiums for the third quarter and nine months ended September 30, 2004 in the Business Insurance, Personal Lines and Specialty Commercial segments was due primarily to earned pricing increases, but was negatively impacted by $17 of catastrophe treaty reinstatement premium. Additionally, earned premium growth in Specialty Commercial for the nine months ended September 30, 2004 was partially offset by a $90 decrease reflecting a reduction in estimated earned premium under retrospectively-rated policies.
Net income decreased $194 for the third quarter ended September 30, 2004, primarily due to a $201 after-tax increase in catastrophes as a result of significant hurricane activity and a $49 after-tax increase in environmental reserves, discussed further under Other Operations. Total catastrophe losses in the third quarter were $252, after-tax, including after-tax losses of $76 from Hurricane Charley, $73 from Hurricane Frances, $42 from Hurricane Ivan and $65 from Hurricane Jeanne. The losses on these four hurricanes were partially offset by $11, after-tax, of reserve releases on prior year catastrophes. Net income for the nine month period increased $1,550 primarily due to the net asbestos reserve strengthening of $1.7 billion, after-tax, in the first quarter ended March 31, 2003, a $98 after-tax decrease in catastrophes and improved underwriting results in the Business Insurance segment. These improvements were partially offset by a $118 after-tax provision related to a reduction in the reinsurance recoverable asset on older, long-term casualty liabilities, a $49 after-tax increase in environmental reserves and a $75 after-tax decrease in net realized capital gains. Before considering the September 11 reserve release of $257, after tax, during the first quarter of 2004, catastrophe losses for the nine month period ended September 30, 2004 increased by $159 over catastrophe losses for the first nine months of 2003.
During 2004 and 2003, the Company’s Property & Casualty operations have experienced earned pricing increases in excess of loss cost increases. The Company expects that at some point over the next twelve months, loss costs will begin to outpace earned pricing, although the Company still expects to earn targeted returns in each of its businesses in 2005.
Ratios
The previous table and the following segment discussions for the third quarter and nine months ended September 30, 2004 and 2003 include various operating ratios. Management believes that these ratios are useful in understanding the underlying trends in The Hartford’s insurance underwriting business. However, these measures should only be used in conjunction with, and not in lieu of,
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underwriting income and net income for the Property & Casualty segments and may not be comparable to other performance measures used by the Company’s competitors. The “loss and loss adjustment expense ratio” is the ratio of claims and claim adjustment expenses to earned premiums. The “expense ratio” is the ratio of underwriting expenses (amortization of deferred policy acquisition costs, as well as other underwriting expenses) to earned premiums. The “policyholder dividend ratio” is the ratio of policyholder dividends to earned premiums. The “combined ratio” is the sum of the loss and loss adjustment expense ratio, the expense ratio and the policyholder dividend ratio. These ratios are relative measurements that describe for every $100 of earned premiums, the cost of losses and expenses, respectively. A combined ratio below 100 demonstrates underwriting profit; a combined ratio above 100 demonstrates underwriting losses. The “loss and loss expense paid ratio” represents the ratio of paid claims and claim adjustment expenses to earned premiums. The “catastrophe ratio” (a component of the loss ratio) represents the ratio of catastrophe losses to earned premiums. 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. See the Reserve section for explanation of prior accident year development.
Premium Measures
Written premiums are a non-GAAP financial measure which represent the amount of premiums charged for policies issued, net of reinsurance, during a fiscal period. Earned premiums are a GAAP measure. Premiums are considered earned and are included in the financial results on a pro rata basis over the policy period. The following segment discussions for the quarters and nine months ended September 30, 2004 and 2003 include the presentation of written premiums in addition to earned premiums. Management believes that this performance measure is useful to investors as it reflects current trends in the Company’s sales of property and casualty insurance products, as compared to earned premiums. Premium renewal retention is defined as renewal premium written in the current period divided by total premium written in the prior period.
Reserves
Reserving for property and casualty losses is an estimation process. As additional experience and other relevant claim data become available, reserve levels are adjusted accordingly. Such adjustments of reserves related to claims incurred in prior years are a natural occurrence in the loss reserving process and are referred to as “reserve development”. Reserve development that increases previous estimates of ultimate cost is called “reserve strengthening”. Reserve development that decreases previous estimates of ultimate cost is called “reserve releases”. Reserve development can influence the comparability of year over year underwriting results and is set forth in the paragraphs and tables that follow. The “prior accident year development” in the following table represents the ratio of reserve development to earned premiums. For a detailed discussion of the Company’s reserve policies, see Notes 1, 7 and 16 of Notes to Consolidated Financial Statements and the Critical Accounting Estimates section of the MD&A included in The Hartford’s 2003 Form 10-K Annual Report.
During the third quarter of 2004, the Company recorded before-tax estimated loss and allocated loss adjustment expenses for hurricanes Charley, Frances, Ivan and Jeanne of $117, $112, $65, and $100, respectively. The Company’s estimation process for catastrophe losses uses information from reported claims, information from catastrophe loss models and estimates of reinsurance recoverable. A couple of factors made the third quarter’s estimation process particularly difficult. First, because the hurricanes occurred in the last seven weeks of the third quarter, only a portion of the claims that will ultimately be reported had been reported by quarter end. Because hurricane Jeanne made landfall on September 25, 2004, loss and loss expense reserves for Hurricane Jeanne as of September 30, 2004 rely heavily on estimates derived from catastrophe loss models. Second, because the paths of several of the hurricanes overlapped, there is additional uncertainty in estimating losses. This additional uncertainty stems from the difficulty in determining losses when more than one hurricane cause damage to a single property and from the uncertain impact on loss costs caused by increased demand for building materials and contractors needed to complete repair work. Because of the reliance on catastrophe loss models and the inherent uncertainty in how reported claims will ultimately develop, ultimate loss and loss expenses paid after September 30, 2004 for the four third quarter hurricanes could vary significantly from the reserves recorded as of September 30, 2004. In addition, based on information currently available, the Company does not expect future assessments from residual markets or guaranty funds attributable to the third quarter 2004 hurricanes. If assessments do occur, additional accruals would be required.
Significant before-tax reserve actions in the third quarter ended September 30, 2004 include $75 of environmental reserve strengthening in Other Operations, and $25 of auto liability reserve strengthening in Business Insurance, partially offset by a reduction in prior year catastrophe loss and loss adjustment expense reserves of $8 in Business Insurance and $9 in Personal Lines.
For the nine months ended September 30, 2004, the amount of reserve development for each of the Company’s Property & Casualty segments varied. As indicated in the Company’s segment level reserve discussion in the 2003 Annual Report on Form 10-K, at the end of 2003 several areas of reserve exposure were being closely monitored. Consistent with the Company’s practices to regularly review its reserves, the Company continued to monitor these reserve exposures throughout the first quarter and completed several reserve studies, including studies related to September 11 reserves and construction defects claims. As a result of these monitoring activities and studies, the Company made reserve adjustments with regard to certain of those reserve exposures, most notably related to September 11, construction defects and certain assumed reinsurance reserves. These reserve adjustments and the effects on the Company’s segments are more fully discussed in the paragraphs that follow.
With respect to September 11 claim reserves, in the first quarter of 2004, the Company observed continued favorable developments, including the closure of all but 44 primary insurance property cases, no additional significant anticipated loss notices on assumed reinsurance property treaties, a high participation rate within the Victim’s Compensation Fund and the expiration of the deadline for
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filing a liability claim in March 2004. Based on these sustained favorable events, the Company determined in the first quarter that it was appropriate to reduce both the gross and net estimate of loss from September 11. The Company’s gross estimate of loss of $1.1 billion was reduced to $845. The corresponding reduction in net reserves for September 11 was $175 in Business Insurance, $116 in Specialty Commercial, $7 in Personal Lines and $97 in Other Operations. As of September 30, 2004, gross reserves and net reserves remaining related to September 11 were $407 and $144, respectively. Most of the remaining September 11 net reserves carried by the Company relate to incurred but not reported (“IBNR”) reserves for workers compensation exposures.
The Company has exposure to losses from construction defects, particularly from contractors in California. The Company has been evaluating and closely monitoring these reserves over time. Based on the Company’s first quarter 2004 study that used various predictive models and reflected the increasing severity of construction defect claims, the Company concluded an increase in reserves of $190 was required during the first quarter. This increase consisted of $23 for Business Insurance and $167 for Specialty Commercial.
In addition to the foregoing reserve adjustments in the first quarter of 2004, within the Specialty Commercial segment, there were other offsetting positive and negative adjustments. The principal offsetting adjustments related to a strengthening in specialty large deductible workers compensation reserves and a release in other liability reserves, each approximately $150.
As indicated in the Company’s year-end 2003 reserve discussion, assumed casualty reinsurance reserves in Other Operations have been difficult to project. The Company has been evaluating and closely monitoring these reserves over time and during 2003 and 2002 booked unfavorable reserve development of $129 and $77, respectively. Unfavorable trends continued in the first quarter of 2004 and, as a result, the Company increased reserves by $130 in the first quarter. The majority of the $130 was for assumed casualty treaty reinsurance for the years 1997-2001, with $30 for certain alternative risk transfer contracts.
A rollforward of liabilities for unpaid claims and claim adjustment expenses by segment for the third quarter and nine months ended September 30, 2004 for Property & Casualty follows:
Third Quarter Ended September 30, 2004
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Nine Months Ended September 30, 2004
Reinsurance
The Hartford utilizes reinsurance to manage risk and transfer exposures to well-established and financially secure reinsurers. Reinsurance is used to manage both aggregate exposures as well as specific risks based on accumulated property and casualty liabilities in certain geographic zones. Reinsurance treaties in place include both excess of loss occurrence-based products, protecting aggregate property and workers compensation exposures, and individual risk or quota share products, protecting specific classes or lines of business.
The Hartford’s principal catastrophe reinsurance program provides coverage, on average, for 88 percent of the $695 of catastrophic property losses incurred from a single event in excess of a $125 retention. The exact amount and percentage of coverage varies by layer. The Hartford also participates in, and has additional coverage from, the Florida Hurricane Catastrophe Fund and other reinsurance programs relating to particular risks or specific lines of business. Based on gross loss estimates for Hurricanes Charley and Frances as of September 30, 2004, under the Company’s principal catastrophe reinsurance program, a portion of the loss and loss adjustment expenses incurred from these two hurricanes will be recovered from reinsurers. Included as a reduction in written and earned premium for the third quarter of 2004 is an estimated $17 of ceded premium to reinstate limits exhausted by losses due to Hurricanes Charley and Frances. In addition to the reinstated limits on the first layer under the program, the Company purchased additional reinsurance for losses of $50 in excess of $125 that may arise from subsequent events, including losses associated with Hurricane Jeanne, if necessary.
The Company’s net reinsurance recoverables from various property and casualty reinsurance arrangements amounted to $5.1 billion and $5.4 billion as of September 30, 2004 and December 31, 2003, respectively. Of the total net reinsurance recoverables as of December 31, 2003, $446 relates to the Company’s mandatory participation in various involuntary assigned risk pools, which are backed by the financial strength of the property and casualty insurance industry. Of the remainder, $3.5 billion, or 71%, were rated by A.M. Best. Of the total rated by A.M. Best, 92% were rated A- (excellent) or better. The remaining $1.4 billion, or 29%, of net recoverables from reinsurers were comprised of the following: 5% related to voluntary pools, 2% related to captive insurance companies, and 22% related to companies not rated by A.M. Best. As of September 30, 2004, the Company has observed no material changes in the credit quality distribution of its reinsurers.
Where its contracts permit, the Company secures future claim obligations with various forms of collateral including irrevocable letters of credit, secured trusts, funds held accounts and group wide offsets. The allowance for uncollectible reinsurance was $399 and $381 as of September 30, 2004 and December 31, 2003, respectively. The allowance for uncollectible reinsurance is based on an assessment of the credit quality of the Company’s reinsurers as well as an estimate of the cost of resolution of reinsurer disputes.
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During the second quarter of 2004, the Company completed an evaluation of the reinsurance recoverable asset associated with older, long-term casualty liabilities reported in the Other Operations segment, including asbestos liabilities. As a result of this evaluation, the Company reduced its net reinsurance recoverable by $181. The after-tax income effect of this action was $118. The $181 primarily relates to a reduction of the amount of liabilities, principally asbestos, that it expects to cede to reinsurers and, to a lesser extent, an increase in the allowance for uncollectible reinsurance recoverables.
Business Insurance
Earned premiums for the segment increased $148 for the third quarter and $450 for the nine month period ended September 30, 2004, primarily due to earned pricing increases and new business premium outpacing non-renewals during the last three months of 2003 and first nine months of 2004. During the third quarter and nine month period, respectively, earned pricing increases of 6% and 8% for small commercial and 2% and 4% for middle market contributed to earned premium growth of $77 and $207 in small commercial and $71 and $243 in middle market.
As substantially all premiums in the segment are earned over a 12 month policy period, earned pricing increases in the third quarter and nine month period were primarily driven by written pricing increases of 6% in the last three months of 2003 and 2% in the first nine months of 2004. New business premium in the third quarter and nine month period ended September 30, 2004 was $287 and $852, respectively, which was up from $250 and $772, respectively, for the comparable periods of the prior year.
Premium renewal retention, which includes the impact of written pricing increases, increased from 85% in the third quarter of 2003 to 86% in the third quarter of 2004 and decreased from 88% in the first nine months of 2003 to 85% in the first nine months of 2004. The moderation in written pricing increases from 2003 to 2004 contributed to the decrease in premium renewal retention for the nine months ended September 30, 2004.
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Underwriting results decreased $59, with a corresponding 5.9 point increase in the combined ratio for the third quarter ended September 30, 2004. The deterioration was due largely to a $59, or 4.9 point increase in catastrophes, including losses from Hurricane Charley, Hurricane Frances, Hurricane Ivan and Hurricane Jeanne, and prior accident year development of $30, or 2.8 points. Prior accident year development includes $25 of automobile liability reserve strengthening, partially offset by a reduction in catastrophe loss and loss adjustment expense reserves of $8. Before catastrophes and prior accident year development, underwriting results improved $38, with a corresponding 2.6 point decrease in the combined ratio, primarily as a result of earned premium growth and decreased commissions as a result of a change in business mix.
Underwriting results improved $206, with a corresponding 6.1 point decrease in the combined ratio, for the nine months ended September 30, 2004. The improvement was due, in part, to a reduction in reserves for September 11 of $175, which was partially offset by an increase in reserves of $23 for construction defects. These reserve actions represent 4.8 points of the combined ratio favorable development. The catastrophe ratio includes 5.5 points of favorable development related to the $175 decrease in September 11 reserves, offset partially by catastrophe losses related to the third quarter hurricanes. Before the favorable impact of reducing September 11 reserves, catastrophe losses for the nine months ended September 30, 2004 increased by 0.5 points from the same period in the prior year.
Before catastrophes and all prior accident year development, underwriting results improved $141 with a corresponding 3.5 point decrease in the combined ratio for the nine months ended September 30, 2004 due to a lower loss and loss adjustment expense ratio and a lower expense ratio. The improvement in the loss and loss adjustment expense ratio was primarily due to improved property claim frequency, partially offset by increased severity, and to earned pricing increases which drove a decrease in the loss and loss adjustment expense ratio. The expense ratio improved over the prior year due to earned premium growth.
Personal Lines
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Earned premiums increased $62 for the third quarter, but were negatively impacted by $7 of catastrophe treaty reinstatement premium due to Hurricane Charley. Earned premiums increased $201 for the nine months ended September 30, 2004 due primarily to growth in AARP and Agency, partially offset by a reduction in Other Affinity earned premium. AARP increased $41 for the third quarter and $150 for the nine months ended September 30, 2004 and Agency increased $27 for the third quarter and $70 for the nine month period primarily as a result of earned pricing increases and because new business growth over the prior 6 to 12 months has exceeded non-renewals. Both AARP and Agency have experienced increased earned premiums in both automobile and homeowners business and the growth in Agency earned premium is due, in part, to the new Dimensions automobile and homeowners class plans. The new Dimensions auto class plan has been rolled out to an additional six states in 2004 bringing the total number of states to 37. The new Dimensions homeowners class plan was introduced in the first quarter of 2004 and has been rolled out to 25 states through September, 2004.
Earned pricing increases in automobile of 4% and 5% in the third quarter and nine month period ended September 30, 2004, respectively, primarily reflect written pricing increases of 7% in the last 3 months of 2003 and 4% in the first nine months of 2004. Earned pricing increases of 10% and 12% in homeowners for the third quarter and nine month period ended September 30, 2004, respectively, primarily reflect written pricing increases of 11% in the last 3 months of 2003 and 9% in the first 9 months of 2004. In addition to earned pricing increases, homeowners earned premiums included the effect of automatic increases in the amount of insurance coverage to adjust for construction cost inflation. During the third quarter and nine months ended September 30, 2004, there was an increase in new business premiums for both automobile and homeowners. Automobile new business premiums in the third quarter and nine month period ended September 30, 2004 were $122 and $364, respectively, which was up from $96 and $265, respectively, for the comparable periods of the prior year. Homeowners new business premiums in the third quarter and nine month period ended September 30, 2004 were $33 and $86, respectively, which was up from $23 and $55, respectively, for the comparable periods of the prior year.
Premium renewal retention for automobile, which includes the impact of written pricing increases, decreased from 91% and 92% in the third quarter and first nine months of 2003, respectively, to 90% and 89% in the third quarter and first nine months of 2004, respectively. The decrease in premium renewal retention for automobile is driven largely by the impact of declining written pricing increases. Homeowners premium renewal retention remains consistent with 2003 as the third quarter premium retention was 101% for both 2003 and 2004 and premium retention for the nine month period was 102% and 101% for 2003 and 2004, respectively.
Underwriting results decreased $177 for the third quarter and $60 for the nine months ended September 30, 2004, with a corresponding 20.7 point and 2.7 point increase in the combined ratio, respectively, primarily as a result of significant hurricane activity during the third quarter. Pre-tax catastrophes, including losses from Hurricane Charley, Hurricane Frances, Hurricane Ivan and Hurricane Jeanne, increased $184 for the third quarter and $147 for the nine months ended September 30, 2004, or 20.9 points and 5.4 points, respectively. Before catastrophes and prior accident year development, underwriting results for the three month period ended September 30, 2004 increased $18, with a corresponding 1.4 point decrease in the combined ratio, reflecting an improvement in homeowner’s results, partially offset by a decrease in automobile results. Before catastrophes, automobile results deteriorated 1.3 points for the three month period due to $7, or 1.0 points, of Omni reserve strengthening. Before catastrophes, homeowners results improved 4.8 points for the three month period due to earned pricing increases and favorable claim frequency, partially offset by increased claim severity.
Underwriting results, before catastrophes and prior year development, for the nine month period ended September 30, 2004, increased $105, with a corresponding 3.4 point decrease in the combined ratio due to favorable earned pricing increases and favorable frequency
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offset by increasing severity. Automobile and homeowners results, before catastrophes, improved 1.7 and 4.6 combined ratio points, respectively, for the nine months ended September 30, 2004 as earned pricing increases outpaced loss cost increases.
The underwriting expense ratio for the third quarter and nine months ended September 30, 2004 deteriorated 1.1 and 0.6 points, respectively due to higher commissions as a result of increased Agency business, increased other underwriting expenses to expand and service increased business and $7 of catastrophe treaty reinstatement premium due to Hurricane Charley.
Specialty Commercial
Earned premiums for the Specialty Commercial segment grew $82 and $110, respectively, for the third quarter and nine month period ended September 30, 2004 due primarily to earned pricing increases partially offset by a decline in new business premium and renewal retention over the comparable periods of the prior year. The increase in earned premium for the nine month period is also offset by a $90 reduction in premiums receivable under retrospectively-rated policies, reflecting a decrease in estimated earned premium under the terms of these policies. As substantially all premiums in the segment are earned over a 12 month policy period, the earned pricing increases resulted from written pricing increases over the prior 12 months. All lines within Specialty Commercial, except property, experienced earned pricing increases in the nine months ended September 30, 2004.
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Written pricing during the nine months ended September 30, 2004 has continued to be positive for casualty and bond, but has decreased for property and professional liability. While market conditions are still favorable in property and professional liability, the written pricing decreases contributed to a business decision to write less new business and not to renew more premium in those lines.
Property experienced decreases in written pricing and new business growth. Despite these decreases, written premium is up $19 and $11 for the third quarter and nine month period ended September 30, 2004, respectively, primarily due to an increase in multi-peril crop insurance premiums.
On September 30, 2004, the Company agreed to transfer its entire book of multi-peril crop insurance (MPCI) to Rural Community Insurance Company (RCIC), a subsidiary of Wells Fargo & Company. The agreement transfers in bulk all 2005 crop year policies to RCIC in exchange for an initial payment and renewal fees based upon retention of the transferred business over a three year period. The Company will retain responsibility for the MPCI business written for the 2004 crop year and prior years. The transaction, involving Federal Crop Insurance, was approved by the United States Department of Agriculture (USDA) on October 22, 2004. Closing of the transaction occurred on October 29, 2004. Earned premium for MPCI for the nine months ended September 30, 2004 was $87.
Casualty written premiums were up $18 in the third quarter and $56 in the nine months ended September 30, 2004, primarily because of written premium growth in alternative markets business and single-digit written pricing increases, partially offset by a decrease in premium renewal retention. Of the total written premium for the nine months ended September 30, 2004, $154 was attributable to a single alternative markets insured program. This program will be non-renewed effective December 1, 2004, although it will continue to earn premium into 2005. The non-renewal is not expected to have a significant impact on Specialty Commercial’s underwriting results.
Bond written premium grew $9 and $26 for the third quarter and nine month period ended September 30, 2004, respectively, primarily as a result of ceding reinstatement premium of $12 in the third quarter of 2003, as well as written pricing increases, partially offset by a decrease in premium renewal retention.
In professional liability, written premium is down $7 for the third quarter due to the decrease in written pricing, new business and renewal retention. Despite these decreases, written premium is up for professional liability for the nine month period due to a decrease in the portion of risks ceded to reinsurers.
Within the “other” category, written and earned premiums increased $5 and $16, respectively, in the third quarter and $32 and $44, respectively, for the nine month period ended September 30, 2004 due to increased premiums on internal reinsurance arrangements.
Underwriting results decreased $12 for the third quarter ended September 30, 2004 primarily due to a $70 increase in catastrophes as a result of significant hurricane activity, including Hurricane Charley, Hurricane Frances, Hurricane Ivan and Hurricane Jeanne. Before catastrophes, underwriting results improved $58 for the third quarter ended September 30, 2004 due to improvements in bond and professional liability.
Underwriting results decreased $123 for the nine months ended September 30, 2004, primarily due to the $90 decrease in earned premiums under retrospectively-rated policies and net unfavorable prior accident year loss development. Prior accident year loss development for the nine months ended September 30, 2004 included $167 of reserve strengthening for construction defect claims, a release of $116 in September 11 reserves, and strengthening in large deductible workers compensation reserves and a release in other liability reserves, each approximately $150. The combined effect of all prior accident year loss development and the earned premium adjustment on retrospectively-rated policies caused a 11.2 point increase in the total loss and loss expense ratio, and a 12.7 point increase in the combined ratio for the nine months ended September 30, 2004. Before considering the $116 release in September 11 reserves, the catastrophe ratio was 7.1 points for the nine months ended September 30, 2004, which is up from the prior year period due to the significant hurricane activity in the third quarter of 2004.
Before catastrophes, all prior accident year development, and the earned premium adjustment on retrospectively-rated policies, underwriting results improved $60 with a corresponding 3.7 point decrease in the combined ratio for the nine months ended September 30, 2004, primarily due to underwriting improvement over the prior year period in the casualty, professional liability and bond lines of business. The expense ratio for the third quarter and nine months ended September 30, 2004 improved over the comparable prior year periods due primarily to earned premium growth.
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Other Operations (Including Asbestos and Environmental Claims)
The Other Operations segment includes operations that are under a single management structure, Heritage Holdings, which is responsible for two related activities. The first activity is the management of certain subsidiaries and operations of The Hartford that have discontinued writing new business. The second is the management of claims (and the associated reserves) related to asbestos and environmental exposures. Also, the financial results of the Company’s Reinsurance operations are reported in Other Operations.
Earned premiums continue to decline in Other Operations for the quarter and nine months ended September 30, 2004 as a result of the Company’s decision to exit from the assumed domestic reinsurance business in the second quarter of 2003. Underwriting results decreased $88 for the third quarter ended September 30, 2004 primarily due to $75 of strengthening of environmental reserves following the completion of an environmental reserve evaluation in the third quarter. Underwriting results increased $2.4 billion for the nine months ended September 30, 2004, primarily due to the impact of $2.6 billion of asbestos reserve strengthening in the first quarter 2003, and a reduction in September 11 reserves of $97 in the first quarter of 2004. These favorable variances were partially offset by the $75 strengthening of environmental reserves in the third quarter of 2004, the $181 provision associated with the evaluation of the reinsurance recoverable asset in the second quarter of 2004 and the strengthening of assumed reinsurance reserves of $130 in the first quarter of 2004.
Asbestos and Environmental Claims
With regard to environmental and particularly asbestos claims, significant uncertainty limits the ability of insurers and reinsurers to estimate the ultimate reserves necessary for unpaid losses and related expenses. Traditional actuarial reserving techniques cannot reasonably estimate the ultimate cost of these claims, particularly during periods when theories of law are in flux. The degree of variability of reserve estimates for these exposures is significantly greater than for other more traditional exposures. In particular, the Company believes there is a high degree of uncertainty inherent in the estimation of asbestos loss reserves.
In the case of the reserves for asbestos exposures, factors contributing to the high degree of uncertainty include inadequate development patterns, plaintiffs’ expanding theories of liability, the risks inherent in major litigation, and inconsistent emerging legal doctrines. Furthermore, insurers in general, including the Company, have recently experienced an increase in the number of asbestos-related claims due to, among other things, plaintiffs’ increased focus on new and previously peripheral defendants, and an increase in the number of insureds seeking bankruptcy protection as a result of asbestos-related liabilities. Plaintiffs and insureds have sought to use bankruptcy proceedings, including “pre-packaged” bankruptcies, to accelerate and increase loss payments by insurers. In addition, some policyholders have asserted new classes of claims for so-called “non-products” coverages to which an aggregate limit of liability may not apply. Recently, many insurers, including The Hartford, also have been sued directly by asbestos claimants asserting that insurers had a duty to protect the public from the dangers of asbestos. Management believes these issues are not likely to be resolved in the near future.
Further uncertainties include whether some policyholders’ liabilities will reach the umbrella or excess layers of their coverage; the resolution or adjudication of some disputes pertaining to the amount of available coverage for asbestos claims in a manner inconsistent with The Hartford’s previous assessment of these claims; insolvencies of other carriers; the number and outcome of direct actions against The Hartford; and unanticipated developments pertaining to The Hartford’s ability to recover reinsurance for asbestos and environmental claims. It is also not possible to predict changes in the legal and legislative environment and their impact on the future development of asbestos and environmental claims. It is unknown whether potential Federal asbestos-related legislation will be enacted and, if so, what its effect will be on The Hartford’s aggregate asbestos liabilities.
The reporting pattern for reinsurance claims is much longer than for direct claims. In many instances, it takes months or years to determine that the policyholder’s own obligations have been met and how the reinsurance in question may apply to such claims. The delay in reporting reinsurance claims adds to the uncertainty of estimating the related reserves.
In the case of the reserves for environmental exposures, factors contributing to the high degree of uncertainty include court decisions that have interpreted the insurance coverage to be broader than originally intended; inconsistent decisions, especially across jurisdictions; and uncertainty as to the monetary amount being sought.
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Given the factors and emerging trends described above, The Hartford believes the actuarial tools and other techniques it employs to estimate the ultimate cost of claims for other kinds of insurance exposure are less precise in estimating reserves for its asbestos and environmental exposures. For this reason, the Company relies on an exposure-based analysis to estimate the ultimate costs of these claims and regularly evaluates new information in assessing its potential asbestos and environmental exposures.
Reserve Activity
Reserves and reserve activity in the Other Operations segment are categorized and reported as asbestos, environmental or “all other” activity. The following discussion relates to reserves and reserve activity, net of applicable reinsurance.
There are a wide variety of claims that drive the reserves within each category of Other Operations. Asbestos claims relate primarily to bodily injuries asserted by those who came in contact with asbestos or products containing asbestos. Environmental claims relate primarily to pollution and related clean-up costs. The “all other” category of reserves covers a wide range of insurance and assumed reinsurance coverages, including, but not limited to, potential liability for breast implants, construction defects, lead paint, silica, pharmaceutical products and other long-tail liabilities.
The Other Operations book of business contains policies written from the 1940’s to 2003. With the transfer of certain additional assumed reinsurance into Other Operations in both 2001 and 2003, Other Operations has exposure related to more recent assumed casualty reinsurance reserves, particularly for the underwriting years 1997 through 2001. The Hartford’s experience has been that this book of runoff business has over time produced significantly higher claims and losses than were contemplated at inception. The areas of active claim activity have also shifted based on changes in plaintiff focus and the overall litigation environment. A significant portion of the claim reserves of the Other Operations segment relates to exposure to the insurance businesses of other insurers or reinsurers (“whole account” exposure). Many of these whole account exposures arise from reinsurance agreements previously written by The Hartford. The Hartford’s net exposure in these arrangements has increased for a variety of reasons, including The Hartford’s commutation of previous retrocessions of such business. Due to the reporting practices of cedants to their reinsurers, determination of the nature of the individual risks involved in these whole account exposures (such as asbestos, environmental, or other exposures) requires various assumptions and estimates, which are subject to uncertainty, as previously discussed.
Consistent with the Company’s long-standing reserving practices, The Hartford will continue to review and monitor these reserves regularly and, where future developments indicate, make appropriate adjustments to the reserves. The loss reserving assumptions, drawn from both industry data and the Company’s experience, have over time been applied to all of this business and have resulted in strengthening or reserve releases at various times over the past decade.
The following table presents reserve activity, inclusive of estimates for both reported and incurred but not reported claims, net of reinsurance, for Other Operations, categorized by asbestos, environmental and “all other” claims, for the third quarter and nine months ended September 30, 2004. Also included are the remaining asbestos and environmental exposures of Ongoing Operations.
Other Operations Claims and Claim Adjustment Expenses
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At September 30, 2004, asbestos reserves were $2.5 billion, a decrease of $1.3 billion compared to $3.8 billion as of December 31, 2003. The decrease in asbestos reserves is primarily driven by the MacArthur settlement payment made in the first quarter of 2004. The increase in environmental reserves is a result of the environmental reserve analysis completed in the third quarter 2004.
In the third quarter 2004, The Hartford completed an account-by-account review of its environmental exposures. During the course of this review, the Company found estimates for individual cases changed based upon the particular circumstances of each account, although the review found no apparent underlying cause or change in the claim environment. The net effect of these changes resulted in a $75 before tax increase in gross and net environmental liabilities.
The following table displays gross environmental reserves and other statistics by category as of September 30, 2004:
Gross Environmental Reserves
In reporting gross environmental results, the Company has divided the gross exposure into Direct (accounts with future exposure greater than $2.5, accounts with future exposure less than $2.5, and Other direct), Assumed reinsurance, and London market. The unallocated amounts in the other category include historical paid loss and expense on closed accounts and an estimate of the necessary reserves for environmental claims related to direct insureds who have not previously tendered environmental claims to the Company.
During the first quarter of 2004, the Company completed a gross asbestos reserve evaluation. As part of this evaluation, the Company reviewed all of its open direct domestic insurance accounts exposed to asbestos liability as well as assumed reinsurance accounts and certain closed accounts. The Company also examined its London Market exposures for both direct insurance and assumed reinsurance. The evaluation indicated no change in the overall required gross asbestos reserves. During the second quarter of 2004, the Company then completed an evaluation of the reinsurance recoverable asset associated with older, long-term casualty liabilities reported in the Other Operations segment, including asbestos liabilities. In conducting its Other Operations reinsurance recoverable review, the Company used its most recent detailed studies of gross asbestos, environmental and all other liabilities reported in the segment, including its estimate of the type and potential timing of future claims, and analyzed the legal entities through which each exposed coverage was written, the reinsurance arrangements in place at each of these legal entities and the years of potential reinsurance available. As part of its Other Operations reinsurance recoverable review, the Company also analyzed recent developments in commutation activity between reinsurers and cedants, recent trends in arbitration and litigation outcomes in disputes between cedants and reinsurers and the overall credit quality of the Company’s reinsurers. As a result of this evaluation, the Company reduced its net reinsurance recoverable by $181, which was comprised of a $126 reduction of ceded amounts, and a $55 increase in the allowance for uncollectible reinsurance. The after-tax effect of this action was $118. The Company also consolidated within the “all other” category its allowance for insolvencies and disputes that might impact reinsurance coverage associated with Other Operations into a single allowance. As of September 30, 2004, the allowance for uncollectible reinsurance totals $345, which is 10% of the Other Operations total ceded recoverable as of September 30, 2004.
The Company currently expects to perform a comprehensive review of Other Operations reinsurance recoverables at least annually. In addition, at any time there are significant developments that affect particular exposures, reinsurance arrangements or the financial condition of particular reinsurers, the Company will respond by making adjustments in the portion of liabilities it expects to cede or in its allowance for uncollectible reinsurance.
The Company classifies its asbestos and environmental reserves into three categories: direct insurance; 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 Hartford’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.
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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 reflecting changes in the asbestos tort litigation and direct insurance coverage environments.
Estimating liabilities for London Market business is the most uncertain of the three categories of claims (direct, assumed reinsurance and London Market). As a participant in the London Market (comprised of both Lloyd’s of London and London Company Markets), the Company wrote business on a subscription basis, with the Company’s 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.
On December 19, 2003, Hartford Accident and Indemnity Co. (“Hartford A&I”) entered into a settlement agreement with MacArthur Co. and its subsidiary, Western MacArthur Co. Under the settlement agreement, during the first quarter of 2004, Hartford A&I paid $1.15 billion into an escrow account owned by Hartford A&I. The funds were held in the escrow account until conditions precedent to the settlement occurred in April. On April 22, 2004, the funds were disbursed from the escrow account into a trust established for the benefit of present and future asbestos claimants pursuant to the bankruptcy plan. The settlement payments have been accounted for as a reduction in unpaid claim and claim adjustment expenses during the first quarter of 2004.
The following table sets forth, for the third quarter and nine months ended September 30, 2004, paid and incurred loss activity by the three categories of claims for asbestos and environmental:
Paid and Incurred Loss and Loss Adjustment Expense (“LAE”) Development – Asbestos and Environmental
INVESTMENTS
General
The Hartford’s investment portfolios are primarily divided between Life and Property & Casualty. The investment portfolios are managed based on the underlying characteristics and nature of each operation’s respective liabilities and within established risk parameters. (For further discussion of The Hartford’s approach to managing risks, see the Investment Credit Risk section.)
The investment portfolios of Life and Property & Casualty are managed by Hartford Investment Management Company and its affiliates (“Hartford Investment Management”), a wholly-owned subsidiary of The Hartford. Hartford Investment Management is responsible for monitoring and managing the asset/liability profile, establishing investment objectives and guidelines, and determining, within specified risk tolerances and investment guidelines, the appropriate asset allocation, duration, convexity and other characteristics of the portfolios. Security selection and monitoring are performed by asset class specialists working within dedicated portfolio management teams.
Pursuant to the adoption of SOP 03-1, as discussed in Note 9 of Notes to Condensed Consolidated Financial Statements, on January 1, 2004, the Company reclassified $17.9 billion of separate account assets to the general account. Of this amount, $11.7 billion was associated with guaranteed separate accounts and was primarily comprised of fixed maturities. These assets are classified as available-for-sale securities with changes in fair value reported in other comprehensive income. The remaining $6.2 billion is primarily
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comprised of equity securities related to variable annuity products offered in Japan. These assets are classified as trading securities with changes in fair value reported in net investment income.
Return on invested assets is an important element of the Company’s financial results. Significant fluctuations in the fixed income or equity markets could weaken the Company’s financial condition or its results of operations. Additionally, changes in market interest rates may impact the period of time over which certain investments, such as mortgage-backed securities, are repaid and whether certain investments are called by the issuers. Such changes may, in turn, impact the yield on these investments and also may result in reinvestment of funds received from calls and prepayments at rates below the average portfolio yield. Net investment income and net realized capital gains accounted for 18% and 17% of the Company’s consolidated revenues for the third quarter ended September 30, 2004 and 2003, respectively. For the nine months ended September 30, 2004 and 2003, net investment income and net realized capital gains accounted for approximately 23% and 19%, respectively, of the Company’s consolidated revenues. The increase in the percentage of consolidated revenues for the third quarter and nine months ended September 30, 2004, as compared to the respective prior year periods, is primarily due to income earned on separate account assets reclassified to the general account as a result of the adoption of SOP 03-1.
Fluctuations in interest rates and credit spreads affect the Company’s return on, and the fair value of, fixed maturity investments, which comprised approximately 82% and 93% of the fair value of its invested assets as of September 30, 2004 and December 31, 2003, respectively. Other events beyond the Company’s control could also adversely impact the fair value of these investments. Specifically, a downgrade of an issuer’s credit rating or default of payment by an issuer could reduce the Company’s investment return.
The Company invests in private placement securities, mortgage loans and limited partnership arrangements in order to further diversify its investment portfolio. These investment types comprised approximately 16% and 17% of the fair value of its invested assets as of September 30, 2004 and December 31, 2003, respectively. These security types are typically less liquid than direct investments in publicly traded fixed income or equity investments. However, generally these securities have higher yields to compensate for the liquidity risk.
A decrease in the fair value of any investment that is deemed other-than-temporary would result in the Company’s recognition of a net realized capital loss in its financial results prior to the actual sale of the investment. (For further discussion, see the Company’s discussion of the evaluation of other-than-temporary impairments in Critical Accounting Estimates under the “Investments” section in The Hartford’s 2003 Form 10-K Annual Report.)
The primary investment objective of Life is to maximize after-tax returns consistent with acceptable risk parameters, including the management of the interest rate sensitivity of invested assets and the generation of sufficient liquidity relative to that of policyholder and corporate obligations.
The following table identifies Life’s invested assets by type as of September 30, 2004 and December 31, 2003.
Composition of Invested Assets
Fixed maturity investments and equity securities held for trading increased 34% and 100%, respectively, since December 31, 2003, primarily the result of fixed maturities and equity securities that were reclassified from separate accounts to the general account as a result of the adoption of SOP 03-1 coupled with positive operating cash flow.
Mortgage loans increased $317, or 68%, since December 31, 2003 as a result of a decision to increase Life’s investment in this asset class primarily due to its attractive yields and diversification opportunities.
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Investment Results
The following table summarizes Life’s investment results.
For the third quarter and nine months ended September 30, 2004, net investment income, excluding income on policy loans and trading securities, increased $219, or 48%, and $647, or 48%, respectively, compared to the respective prior year periods. The increases in net investment income were primarily due to income earned on a higher average invested assets base, as compared to the respective prior year periods, and an increase in income from prepayment penalties primarily associated with commercial mortgage-backed securities (“CMBS”) and prepayment speed adjustments related to mortgage-backed securities (“MBS”). The increase in the average invested assets base, as compared to the prior year periods, was primarily the result of separate account assets reclassified to the general account pursuant to the adoption of SOP 03-1 and, to a lesser extent, assets acquired in the CNA acquisition and operating cash flows. Income earned on separate account assets reclassified to the general account was $155 and $459 for the third quarter and nine months ended September 30, 2004, respectively. Income earned on assets acquired in the CNA transaction was $30 and $85 for the third quarter and nine months ended September 30, 2004, respectively.
For the nine months ended September 30, 2004, the yield on average invested assets decreased slightly from the respective prior year period as a result of new investment purchases at rates below the average portfolio yield due to the continued low interest rate environment and decreased policy loan income. Since the Company invests primarily in long-term fixed rate debt securities, current period changes in long-term interest rates impact the yield on new asset purchases and, therefore, have a gradual impact on the overall portfolio yield. The weighted average yield on new invested asset purchases in the third quarter and nine months ended September 30, 2004 of approximately 4.9%, before-tax, continues to be below the average portfolio yield.
Net realized capital gains for the third quarter and nine months ended September 30, 2004 increased by $24 and $111, respectively, compared to the respective prior year periods, primarily the result of higher net realized gains on sales of fixed maturity securities in 2004 and lower other-than-temporary impairments. (For further discussion of other-than-temporary impairments, see the Other-Than-Temporary Impairments commentary in this section of the MD&A.)
Gross gains on sales for the third quarter and nine months ended September 30, 2004 were primarily within fixed maturities and were the result of decisions to reposition the portfolio primarily due to the spread tightening in certain sectors and changes in interest rates and foreign currency exchange rates. Gross gains on sales of fixed maturity investments were concentrated in the corporate, government, CMBS and asset-backed securities (“ABS”) sectors. The majority of the gains on sales in the corporate, CMBS and ABS sectors were the result of divesting securities that had appreciated in value due to a decline in interest rates and an improved corporate credit environment. Foreign government securities were sold primarily to realize gains associated with the decline in value of the U.S. Dollar against foreign currencies.
Gross losses on sales for the third quarter and nine months ended September 30, 2004 resulted predominantly from sales of U.S. government securities, corporate securities, ABS and CMBS that were in an unrealized loss position primarily due to changes in long-term interest rates.
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Net realized capital gains on sales for the third quarter and nine months ended September 30, 2003 primarily resulted from portfolio rebalancing of securities that had appreciated in value due to historically low interest rates.
Property & Casualty
The investment objective for Property & Casualty’s ongoing operations is to maximize economic value while generating after-tax income and sufficient liquidity to meet policyholder and corporate obligations. For Property & Casualty’s Other Operations segment, the investment objective is to ensure the full and timely payment of all liabilities. Property & Casualty’s investment strategies are developed based on a variety of factors including business needs, regulatory requirements and tax considerations.
The following table identifies Property & Casualty’s invested assets by type as of September 30, 2004 and December 31, 2003.
Total fixed maturities increased $217, or 1%, since December 31, 2003, primarily due to positive operating cash flow, partially offset by $1.15 billion of payments made pursuant to the MacArthur settlement.
The table below summarizes Property & Casualty’s investment results.
For the third quarter and nine months ended September 30, 2004, before-tax net investment income increased $12, or 4%, and $51, or 6%, respectively, and after-tax net investment income increased $6, or 3%, and $27, or 4%, respectively, compared to the respective prior year periods. The increases in net investment income for the third quarter and nine months ended September 30, 2004, were primarily due to income earned on a higher average invested assets base, as compared to the respective prior year periods.
For the nine months ended September 30, 2004, the yield on average invested assets decreased slightly from the respective prior year period as a result of new investment purchases at rates below the average portfolio yield due to the continued low rate environment. Since the Company invests primarily in long-term fixed rate debt securities, current period changes in long-term interest rates impact the yield on new asset purchases and, therefore, have a gradual impact on the overall portfolio yield. The weighted average yield on new asset purchases in the third quarter and nine months ended September 30, 2004 of approximately 4.9%, before-tax, continues to be below the average portfolio yield.
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Net realized capital gains for the third quarter ended September 30, 2004 decreased by $1 as compared to the respective prior year quarter primarily due to the gain realized on the sale of Trumbull Associates, LLC in the prior year period, partially offset by higher net realized gains on sales of fixed maturity securities in the third quarter of 2004. Net realized capital gains for the nine months ended September 30, 2004 decreased $114 as compared to the respective prior year period as a result of lower net realized gains on sales of fixed maturity securities in 2004, partially offset by lower other-than-temporary impairments. (For further discussion of other-than-temporary impairments, see the Other-Than-Temporary Impairments commentary in this section of the MD&A.)
Gross gains on sales for the third quarter and nine months ended September 30, 2004 were primarily within fixed maturities and were the result of decisions to reposition the portfolio primarily due to the spread tightening in certain sectors and changes in long-term interest rates. Gross gains on sales of fixed maturity investments were concentrated in the corporate, foreign government and ABS sectors. The majority of the gains on sales in the corporate and ABS sectors were the result of divesting securities that had appreciated in value due to a decline in interest rates and an improved corporate credit environment. Foreign government securities were sold primarily to realize gains associated with the decline in value of the U.S. Dollar against foreign currencies.
Gross losses on sales for the third quarter and nine months ended September 30, 2004 resulted predominantly from sales of corporate and CMBS securities that were in an unrealized loss position primarily due to changes in long-term interest rates.
Net realized capital gains on sales for the third quarter and nine months ended September 30, 2003 primarily resulted from sale of Trumbull Associates, LLC and portfolio rebalancing of securities that had appreciated in value due to historically low interest rates.
Corporate
The investment objective of Corporate is to raise capital through financing activities to support the Life and Property & Casualty operations of the Company and to maintain sufficient funds to support the cost of those financing activities including the payment of interest for Hartford Financial Services Group, Inc. (“HFSG”) issued debt and dividends to shareholders of The Hartford common stock. As of September 30, 2004 and December 31, 2003, Corporate held $144 and $86, respectively, of short-term fixed maturity investments. In addition, Corporate held $10 and $2, respectively, of other investments as of September 30, 2004 and December 31, 2003.
Other-Than-Temporary Impairments
For the third quarter and nine months ended September 30, 2004, total consolidated other-than-temporary impairments were $6 and $24, respectively, as compared with $29 and $145, respectively, for the comparable periods in 2003.
The following table identifies the Company’s other-than-temporary impairments by type for the nine months ended September 30, 2004 and 2003.
Other-Than-Temporary Impairments by Type
The decrease in other-than-temporary impairments during the nine months ended September 30, 2004, as compared to the respective prior year period, is due to an improvement in general economic conditions and operating fundamentals and improved pricing levels for ABS security types. In general, security issuers’ operating fundamentals have improved due to reduced company leverage, improved
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liquidity and successfully implementing various cost cutting measures. Improvement in pricing levels for ABS has been driven by a general stabilization in the performance of the underlying collateral and an increase in demand for these asset types due to improved economic and operating fundamentals of the underlying security issuers, better market liquidity and attractive yields.
Impairments during the nine months ended September 30, 2003 were primarily driven by increasing default rates and lower recovery rates on collateral supporting certain ABS security types and the decline in value of several corporate debt securities as a result of deteriorating earnings forecasts, debt restructuring issues and accounting irregularities. Impairments were also incurred as a result of the deterioration in the transportation sector, specifically issuers of airline debt, due to a significant decline in airline travel. Additionally, other-than-temporary impairments were recorded on various diversified mutual funds and interest only securities.
The favorable other-than-temporary impairments trend will depend on continued strong economic fundamentals, political stability and collateral performance. In addition, as discussed in Note 1 of Notes to Condensed Consolidated Financial Statements, the future adoption of EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”, could result in the recognition of additional other-than-temporary impairments. While the ultimate impact of the adoption of this standard is still unknown, depending on the nature of the ultimate guidance, adoption of this standard could potentially result in the recognition of unrealized losses, including those declines in value that are attributable to interest rate movements, as other-than-temporary impairments, except those deemed to be minor in nature. As of September 30, 2004, the Company had $309 of total gross unrealized losses. The amount of impairments to be recognized, if any, will depend on the final standard, market conditions and management’s intent and ability to hold securities with unrealized losses at the time of the impairment evaluation. (For further discussion of risk factors associated with sectors with significant unrealized loss positions, see the sector risk factor commentary under the Consolidated Total Available-for-Sale Securities with Unrealized Loss Greater than Six Months by Type schedule in the Investment Credit Risk section of the MD&A.)
INVESTMENT CREDIT RISK
The Hartford has established investment credit policies that focus on the credit quality of obligors and counterparties, limit credit concentrations, encourage diversification and require frequent creditworthiness reviews. Investment activity, including setting of policy and defining acceptable risk levels, is subject to regular review and approval by senior management and by the Finance Committee of the Company’s Board of Directors.
Please refer to the Investment Credit Risk section of the MD&A in The Hartford’s 2003 Form 10-K Annual Report for a description of the Company’s objectives, policies and strategies, including the use of derivative instruments.
The Company invests primarily in securities that are rated investment grade, and has established exposure limits, diversification standards and review procedures for all credit risks including borrower, issuer and counterparty. Creditworthiness of specific obligors is determined by an internal credit evaluation supplemented by consideration of external determinants of creditworthiness, typically ratings assigned by nationally recognized ratings agencies. Obligor, asset sector and industry concentrations are subject to established limits and are monitored on a regular basis. The Hartford is not exposed to any credit concentration risk of a single issuer greater than 10% of the Company’s stockholders’ equity.
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The following table identifies fixed maturity securities by type on a consolidated basis, as of September 30, 2004 and December 31, 2003.
Consolidated Fixed Maturities by Type
The Company’s fixed maturity portfolio gross unrealized gains and losses as of September 30, 2004 in comparison to December 31, 2003 were primarily impacted by changes in interest rates, credit spreads and security sales. The Company’s fixed maturity gross unrealized gains decreased $307 from December 31, 2003 to September 30, 2004 due to sales of securities in a gain position and the increase in short-term to five-year U.S. treasury rates partially offset by a decrease in long-term (ten-year and beyond) U.S. treasury rates. The gross unrealized loss amount decreased by $61 from December 31, 2003 to September 30, 2004 primarily due to credit spread tightening, improved pricing levels for certain CDOs and credit card ABS, a decrease in long-term interest rates (ten-year and beyond), security sales and, to a lesser extent, other-than-temporary impairments.
At the September 21, 2004 Federal Open Market Committee policy meeting, the overnight funds rate was raised a quarter-point for the third time in 2004 to 1.75%. The Fed members signaled that interest rates will continue to rise at a measured pace as long as inflation risks remain stable. The pace of the Fed rate increases has been widely anticipated by the market causing the U.S. interest rate yield curve to flatten during the nine months ended September 30, 2004. The five-year U.S. treasury rate increased approximately 12 basis points since December 31, 2003 primarily due to the impact of short-term interest rate increases, while the ten-year U.S. treasury rate decreased 13 basis points since December 31, 2003, largely the result of demand for higher yielding assets as well as slower than expected economic growth, reduced inflationary concerns and lack of significant job growth.
Investment allocations as a percentage of total fixed maturities have remained materially consistent since December 31, 2003, except for CMBS. CMBS increased as a result of a decision to increase the Company’s investment in the asset class due to its stable spreads, high quality and attractive yields.
(For further discussion of risk factors associated with sectors with significant unrealized loss positions, see the sector risk factor commentary under the Consolidated Total Available-for-Sale Securities with Unrealized Loss Greater than Six Months by Type schedule in this section of the MD&A.)
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The following table identifies fixed maturities by credit quality on a consolidated basis, as of September 30, 2004 and December 31, 2003. 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.
Consolidated Fixed Maturities by Credit Quality
As of September 30, 2004 and December 31, 2003, 95% or greater of the fixed maturity portfolio was invested in short-term securities or securities rated investment grade (BBB and above).
The following table presents the Below Investment Grade (“BIG”) fixed maturities by type, as of September 30, 2004 and December 31, 2003.
Consolidated BIG Fixed Maturities by Type
As of September 30, 2004 and December 31, 2003, the Company held no issuer of a BIG security with a fair value in excess of 3% of the total fair value for BIG securities. Total BIG securities decreased since December 31, 2003 as a result of decisions to reduce exposure to lower credit quality assets and re-invest in investment grade securities.
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The following table presents the Company’s unrealized loss aging for total fixed maturity and equity securities classified as available-for-sale on a consolidated basis, as of September 30, 2004 and December 31, 2003, by length of time the security was in an unrealized loss position.
Consolidated Unrealized Loss Aging of Total Available-for-Sale Securities
The decrease in the unrealized loss amount since December 31, 2003 is primarily the result of credit spread tightening, a slight decrease in long-term interest rates (ten-year and beyond), improved pricing levels for certain CDOs and credit card ABS, asset sales, and, to a lesser extent, other-than-temporary impairments. (For further discussion, see the economic commentary under the Consolidated Fixed Maturities by Type table in this section of the MD&A.)
As of September 30, 2004 and December 31, 2003, fixed maturities represented $288, or 93%, and $349, or 96%, of the Company’s total unrealized loss associated with securities classified as available-for-sale, respectively. There were no fixed maturities as of September 30, 2004 or December 31, 2003 with a fair value less than 80% of the security’s amortized cost basis for six continuous months other than certain asset-backed and commercial mortgage-backed securities. Other-than-temporary impairments for certain asset-backed and commercial mortgage-backed securities are recognized if the fair value of the security, as determined by external pricing sources, is less than its carrying amount and there has been a decrease in the present value of the expected cash flows since the last reporting period. There were no asset-backed or commercial mortgage-backed securities included in the table above, as of September 30, 2004 and December 31, 2003, for which management’s best estimate of future cash flows adversely changed during the reporting period. As of September 30, 2004 and December 31, 2003, no asset-backed or commercial mortgage-backed securities had an unrealized loss in excess of $14 and $15, respectively. (For further discussion of the other-than-temporary impairments criteria, see “Investments” included in the Critical Accounting Estimates section of the MD&A and in Note 1 of Notes to Consolidated Financial Statements both of which are included in The Hartford’s 2003 Form 10-K Annual Report.)
The Company held no securities of a single issuer that were at an unrealized loss position in excess of 6% and 5% of the total unrealized loss amount as of September 30, 2004 and December 31, 2003, respectively.
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The total securities classified as available-for-sale in an unrealized loss position for longer than six months by type as of September 30, 2004 and December 31, 2003 are presented in the following table.
Consolidated Total Available-for-Sale Securities with Unrealized Loss Greater Than Six Months by Type
The slight increase in the September 30, 2004 consolidated available-for-sale securities with unrealized loss greater than six months amounts in comparison to the December 31, 2003 amounts was primarily driven by the aging of securities depressed due to interest rate changes from the date of purchase. The securities in an unrealized loss position for six months or more as of September 30, 2004 and December 31, 2003, were primarily ABS supported by aircraft lease receivables and corporate fixed maturities primarily within the financial services sector. The Company’s current view of risk factors relative to these fixed maturity types is as follows:
Aircraft lease receivables — The increase in the unrealized loss position from December 31, 2003 to September 30, 2004 was primarily the result of rating agency downgrades for certain issuers in this sector, partially offset by other-than-temporary impairments taken during the year. In prior periods, these securities had suffered a considerable decrease in value as a result of a prolonged decline in airline travel and the uncertainty of a potential industry recovery. Although uncertainty surrounding the stability of domestic airlines continues to weigh heavily on this sector, worldwide travel and aircraft demand appears to be improving. While the Company has seen modest price increases and greater liquidity in this sector during 2004, any additional price recovery will depend on continued improvement in economic fundamentals, political stability and airline operating performance.
Financial services — As of September 30, 2004, the Company held approximately 59 different securities in the financial services sector that had been in an unrealized loss position for greater than six months. These securities are primarily investment grade with the majority priced at or greater than 90% of amortized cost as of September 30, 2004. These positions are a mixture of fixed rate and variable rate securities with extended maturity dates, which have been adversely impacted by changes in interest rates from the date of purchase. Additional changes in fair value of these securities are primarily dependent on future changes in interest rates.
As part of the Company’s ongoing security monitoring process by a committee of investment and accounting professionals, the Company has reviewed its investment portfolio and concluded that there were no additional other-than-temporary impairments as of September 30, 2004 and December 31, 2003. Due to the issuers’ continued satisfaction of the securities’ obligations in accordance with their contractual terms and the expectation that they will continue to do so, management’s intent and ability to hold these securities, as well as the evaluation of the fundamentals of the issuers’ financial condition and other objective evidence, the Company believes that the prices of the securities in the sectors identified above were temporarily depressed.
The evaluation for other-than-temporary impairments is a quantitative and qualitative process, which is subject to risks and uncertainties in the determination of whether declines in the fair value of investments are other-than-temporary. The risks and uncertainties include changes in general economic conditions, the issuer’s financial condition or near term recovery prospects and the effects of changes in interest rates. In addition, for securitized financial assets with contractual cash flows (e.g. ABS and CMBS), projections of expected future cash flows may change based upon new information regarding the performance of the underlying collateral. As of September 30, 2004 and December 31, 2003, management’s expectation of the discounted future cash flows on these securities was in excess of the associated securities’ amortized cost. (For further discussion, see “Investments” included in the Critical Accounting Estimates section
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of MD&A and in Note 1 of Notes to Consolidated Financial Statements both of which are included in The Hartford’s 2003 Form 10-K Annual Report.)
The following table presents the Company’s unrealized loss aging for BIG and equity securities classified as available-for-sale on a consolidated basis, as of September 30, 2004 and December 31, 2003.
Consolidated Unrealized Loss Aging of Available-for-Sale BIG and Equity Securities
The increase in the BIG and equity security unrealized loss amount for securities classified as available-for-sale from December 31, 2003 to September 30, 2004 was primarily the result of recent rating agency downgrades for certain issuers, and the impact of short-term interest rate increases on certain variable rate perpetual preferred securities, partially offset by other-than-temporary impairments taken during the year, and, to a lesser extent, slightly improved pricing levels for ABS securities and asset sales. (For further discussion, see the economic commentary under the Consolidated Fixed Maturities by Type table in this section of the MD&A.)
The BIG and equity securities classified as available-for-sale in an unrealized loss position for longer than six months by type as of September 30, 2004 and December 31, 2003 are presented in the following table.
Consolidated Available-for-Sale BIG and Equity Securities with Unrealized Loss Greater Than Six Months by Type
The decrease in the consolidated available-for-sale BIG and equity securities greater than six months unrealized loss amount since December 31, 2003 was primarily the result of improved pricing levels for certain CDOs and credit card ABS, other-than-temporary impairments taken during the year and, to a lesser extent, asset sales. This decrease was partially offset by rating agency downgrades for certain issuers in the aircraft lease receivables sector and the impact of short-term interest rate increases on certain variable rate perpetual preferred securities.
For additional discussion of the Company’s current view of risk factors relative to certain security types listed above, please refer to the Consolidated Total Available-for-Sale Securities with Unrealized Loss Greater Than Six Months by Type table in this section of the MD&A.
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CAPITAL MARKETS RISK MANAGEMENT
The Hartford has a disciplined approach to managing risks associated with its capital markets and asset/liability management activities. Investment portfolio management is organized to focus investment management expertise on specific classes of investments, while asset/liability management is the responsibility of dedicated risk management units supporting Life and Property & Casualty operations. Derivative instruments are utilized in compliance with established Company policy and regulatory requirements and are monitored internally and reviewed by senior management.
Market Risk
The Hartford has material exposure to both interest rate and equity market risk. The Company analyzes interest rate risk using various models including multi-scenario cash flow projection models that forecast cash flows of the liabilities and their supporting investments, including derivative instruments. (For further discussion of market risk see the Capital Markets Risk Management section of MD&A in The Hartford’s 2003 Form 10-K Annual Report.) There have been no material changes in market risk exposures from December 31, 2003.
The Hartford utilizes a variety of derivative instruments, including swaps, caps, floors, forwards and exchange traded futures and options, in compliance with Company policy and regulatory requirements designed to achieve one of four Company approved objectives: to hedge risk arising from interest rate, price or currency exchange rate volatility; to manage liquidity; to control transaction costs; or to enter into replication transactions. The Company does not make a market or trade in these instruments for the express purpose of earning short term trading profits. (For further discussion on The Hartford’s use of derivative instruments, refer to Note 4 of Notes to Condensed Consolidated Financial Statements.)
Life’s Equity Risk
The Company’s operations are significantly influenced by changes in the equity markets. The Company’s profitability depends largely on the amount of assets under management, which is primarily driven by the level of sales, equity market appreciation and depreciation and the persistency of the in-force block of business. Prolonged and precipitous declines in the equity markets can have a significant impact on the Company’s operations, as sales of variable products may decline and surrender activity may increase, and as customer sentiment towards the equity market turns negative. Lower assets under management will have a negative impact on the Company’s financial results, primarily due to lower fee income related to the Retail Products Group and Institutional Solutions Group and, to a lesser extent, Individual Life segments, where a heavy concentration of equity linked products are administered and sold. Furthermore, the Company may experience a reduction in profit margins if a significant portion of the assets held in the variable annuity separate accounts move to the general account and the Company is unable to earn an acceptable investment spread, particularly in light of the low interest rate environment and the presence of contractually guaranteed minimum interest credited rates, which for the most part are at a 3% rate.
In addition, prolonged declines in the equity market may also decrease the Company’s expectations of future gross profits, which are utilized to determine the amount of DAC to be amortized in a given financial statement period. A significant decrease in the Company’s estimated gross profits would require the Company to accelerate the amount of DAC amortization in a given period, potentially causing a material adverse deviation in that period’s net income. Although an acceleration of DAC amortization would have a negative impact on the Company’s earnings, it would not affect the Company’s cash flow or liquidity position.
The Company sells variable annuity contracts that offer various guaranteed death benefits. The Company maintains a liability for the death benefit costs, net of reinsurance, of $132, as of September 30, 2004. Declines in the equity market may increase the Company’s net exposure to death benefits under these contracts. The majority of the contracts with the guaranteed death benefit feature are sold by the Retail segment. For certain guaranteed death benefits, the Retail segment pays the greater of (1) the account value at death; (2) the sum of all premium payments less prior withdrawals; or (3) the maximum anniversary value of the contract, plus any premium payments since the contract anniversary, minus any withdrawals following the contract anniversary. For certain guaranteed death benefits sold with variable annuity contracts beginning in June of 2003, the Retail segment pays the greater of (1) the account value at death; or (2) the maximum anniversary value; not to exceed the account value plus the greater of (a) 25% of premium payments, or (b) 25% of the maximum anniversary value of the contract. The Retail segment currently reinsures a significant portion of these death benefit guarantees associated with its in-force block of business.
The Retail segment’s total gross exposure (i.e. before reinsurance) to these guaranteed death benefits as of September 30, 2004 is $10.8 billion. Due to the fact that 80% of this amount is reinsured, the net exposure is $2.2 billion. This amount is often referred to as the net amount at risk. However, the Retail segment will incur these guaranteed death benefit payments in the future only if the policyholder has an in-the-money guaranteed death benefit at their time of death.
In addition, the Company offers certain variable annuity products with a GMWB rider. Declines in the equity market may increase the Company’s exposure to benefits under the GMWB contracts. For all contracts in effect through July 6, 2003, the Company entered into
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a reinsurance arrangement to offset its exposure to the GMWB for the remaining lives of those contracts. As of July 6, 2003, the Company exhausted all but a small portion of the reinsurance capacity for new business under the current arrangement and will be ceding only a very small number of new contracts subsequent to July 6, 2003. Substantially all new contracts with the GMWB are not covered by reinsurance. These unreinsured contracts are expected to generate volatility in net income as the underlying embedded derivative liabilities are recorded at fair value each reporting period, resulting in the recognition of net realized capital gains or losses in response to changes in certain critical factors including capital market conditions and policyholder behavior. In order to minimize the volatility associated with the unreinsured GMWB liabilities, the Company established an alternative risk management strategy. During the third quarter of 2003, the Company began hedging its unreinsured GMWB exposure using interest rate futures, Standard and Poor’s (“S&P”) 500 and NASDAQ index options and futures contracts. During the first quarter of 2004, the Company entered into Europe, Australasia and Far East (“EAFE”) Index swaps to hedge GMWB exposure to international equity markets. The hedging program involves a detailed monitoring of policyholder behavior and capital markets conditions on a daily basis and rebalancing of the hedge position as needed. While the Company actively manages this hedge position, hedge ineffectiveness may result due to factors including, but not limited to, policyholder behavior, capital markets dislocation or discontinuity and divergence between the performance of the underlying funds and the hedging indices.
The net impact of the change in value of the embedded derivative, net of the results of the hedging program was a $4 gain before deferred policy acquisition costs and tax effects for the nine months ended September 30, 2004.
Interest Rate Risk
The Company believes that a moderate increase in interest rates from the current levels is generally a favorable development for the Company. Rate increases are expected to provide additional net investment income, increased sales of fixed rate Life investment products, reduce the cost of the GMWB hedging program, limit the potential risk of margin erosion due to minimum guaranteed crediting rates in certain Life products and, if sustained through the end of 2004, could reduce the Company’s prospective pension expense. Conversely, a rise in interest rates will reduce the net unrealized gain position 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 Life 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. The Company analyzes interest rate risk using various models including multi-scenario cash flow-projections that forecast cash flows of the liabilities and their supporting investments, including derivative instruments and adjusts the asset/liability profile to help mitigate disintermediation risk. Measures used by the Company to quantify its exposure to interest rate risk inherent in its invested assets and interest rate sensitive liabilities are duration and key rate duration. In conjunction with the interest rate risk measurement and management techniques, significant portions of Life’s fixed income product offerings have market value adjustment provisions at contract surrender.
The Company believes that a gradual rise in interest rates should increase net investment income and sales of fixed rate Life investment products while the potential adverse consequences of increased rates, primarily the reduction of the investment portfolio’s net unrealized gain and disintermediation risk, is mitigated by the Company’s disciplined asset/liability management techniques and product design.
CAPITAL RESOURCES AND LIQUIDITY
Capital resources and liquidity represent the overall financial strength of The Hartford and its ability to generate strong cash flows from each of the business segments, borrow funds at competitive rates and raise new capital to meet operating and growth needs.
Liquidity Requirements
The liquidity requirements of The Hartford have been and will continue to be met by funds from operations as well as the issuance of commercial paper, common stock, debt securities and borrowings from its credit facilities. The principal sources of operating funds are premiums and investment income, while investing cash flows originate from maturities and sales of invested assets.
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 strong shareholder returns. As a result, the Company may from time to time raise capital from the issuance of stock, debt or other capital securities. The issuance of common stock, debt or other capital securities could result in the dilution of shareholder interests or reduced net income due to additional interest expense.
The Hartford Financial Services Group, Inc. (“HFSG”) and HLI are holding companies which rely upon operating cash flow in the form of dividends from their subsidiaries, which enable them to service debt, pay dividends, and pay certain business expenses.
Dividends to HFSG from its subsidiaries are subject to statutory limitations established for Connecticut-domiciled insurers under the insurance holding company laws of Connecticut. Under these laws, the insurance subsidiaries may only make their dividend payments out of unassigned surplus. 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
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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 policies. 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. Through October 31, 2004, the Company’s insurance subsidiaries had paid $767 to HFSG and HLI and are permitted to pay up to a maximum of approximately $589 in dividends to HFSG and HLI for the remainder of 2004 without prior approval from the applicable insurance commissioner.
The primary uses of funds are to pay claims, policy benefits, operating expenses and commissions and to purchase new investments. The Hartford has a policy of carrying a significant short-term investment position and accordingly does not anticipate selling intermediate and long-term fixed maturity investments to meet its liquidity needs. (For a discussion of the Company’s investment objectives and strategies, see the Investments and Capital Markets Risk Management sections.)
Sources of Liquidity
On December 3, 2003, The Hartford’s shelf registration statement (Registration No. 333-108067) for the potential offering and sale of debt and equity securities in an aggregate amount of up to $3.0 billion was declared effective by the Securities and Exchange Commission. The Registration Statement allows for the following types of securities to be offered: (i) debt securities, preferred stock, common stock, depositary shares, warrants, stock purchase contracts, stock purchase units and junior subordinated deferrable interest debentures of the Company, and (ii) preferred securities of any of one or more capital trusts organized by The Hartford (“The Hartford Trusts”). The Company may enter into guarantees with respect to the preferred securities of any of The Hartford Trusts.
In January 2004, the Company issued approximately 6.7 million shares of common stock pursuant to an underwritten offering at a price to the public of $63.25 per share and received net proceeds of $411. On March 9, 2004, the Company issued $200 of 4.75% senior notes due March 1, 2014. As of September 30, 2004, the Company had $2.4 billion remaining on its shelf.
The table below details the Company’s short-term debt programs and the applicable balances outstanding.
Off-Balance Sheet Arrangements and Aggregate Contractual Obligations
There have been no material changes to the Company’s off-balance sheet arrangements and aggregate contractual obligations since the filing of the Company’s 2003 Form 10-K Annual Report.
Pension Plans and Other Postretirement Benefits
While the Company has significant discretion in making voluntary contributions to the Plan, the Employee Retirement Income Security Act of 1974 regulations mandate minimum contributions in certain circumstances. On April 10, 2004, the Pension Funding Equity Act of 2004 was signed into law. This Act provided pension funding relief by replacing the defunct 30-year Treasury bond rate with a composite rate based on conservatively invested long-term corporate bonds. As a result of the passage of this legislation, the Company’s minimum funding requirement in 2004 was eliminated.
On April 15, 2004, the Company made a $312 voluntary contribution into its U.S. qualified defined benefit pension plan. No additional contributions are expected to be paid during the current fiscal year.
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Capitalization
The capital structure of The Hartford as of September 30, 2004 and December 31, 2003 consisted of debt and equity, summarized as follows:
The Hartford’s total capitalization increased $1.3 billion as of September 30, 2004 as compared with December 31, 2003. This increase was due to a $2.0 billion increase in equity partially offset by a $727 decrease in debt. The increase in total stockholders’ equity is primarily due to net income of $1.5 billion, the issuance of common stock of $411 and a $164 increase in AOCI. The increase in AOCI is primarily the result of Life’s adoption of SOP 03-1, which resulted in a $292 cumulative effect for unrealized gains on securities in the first quarter of 2004 related to the reclassification of investments from separate account assets to general account assets, partially offset by a decrease in unrealized gains due to an increase in interest rates. The decrease in total debt reflects repayments of commercial paper of $477 and senior notes of $200 and the redemption of $250 of junior subordinated debentures, offset by the issuance of $200 in 4.75% senior notes.
Debt
The following discussion describes the Company’s debt financing activities for the nine months ended September 30, 2004.
During the nine months ended September 30, 2004, the Company repaid $477 of commercial paper utilizing the proceeds from the equity offering and internal sources.
On March 15, 2004, HLI redeemed its 7.2% junior subordinated debentures underlying the trust preferred securities issued by Hartford Life Capital I.
On March 9, 2004, the Company issued 4.75% senior notes due March 1, 2014 and received net proceeds of $197. Interest on the notes is payable semi-annually on March 1 and September 1.
For additional information regarding debt, see Note 8 of Notes to Consolidated Financial Statements in The Hartford’s 2003 Form 10-K Annual Report.
Stockholders’ Equity
Issuance of Common Stock — On January 22, 2004, The Hartford issued approximately 6.3 million shares of common stock pursuant to an underwritten offering at a price to the public of $63.25 per share and received net proceeds of $388. Subsequently, on January 30, 2004, The Hartford issued approximately 377 thousand shares of common stock pursuant to an underwritten offering at a price to the public of $63.25 per share and received net proceeds of $23. The Company used the proceeds from these issuances to repay $411 of commercial paper issued in connection with the CNA Acquisition.
In September 2004, the Company’s Board of Directors authorized the Company to repurchase up to $1 billion of its securities. The Company’s repurchase authorization permits purchases of common stock and equity units, which may be in the open market or through privately negotiated transactions. The Company also may enter into derivative transactions to facilitate future repurchases of common stock and equity units. The timing of 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. As of October 29, 2004, the Company has made no repurchases under this program.
Dividends — On October 21, 2004, The Hartford declared a dividend on its common stock of $0.29 per share payable on January 3, 2005 to shareholders of record as of December 1, 2004.
On July 22, 2004, The Hartford declared a dividend on its common stock of $0.28 per share payable on October 1, 2004 to shareholders of record as of September 1, 2004.
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AOCI — AOCI increased by $164 as of September 30, 2004 compared with December 31, 2003. The increase in AOCI is primarily a result of a Life’s adoption of SOP 03-1 in the first quarter of 2004 which resulted in a $292 cumulative effect for unrealized gains on securities related to the reclassification of investments from separate account assets to general account assets, partially offset by the decrease in unrealized gains due to an increase in interest rates.
The funded status of the Company’s pension and postretirement plans is dependent upon many factors, including returns on invested assets and the level of market interest rates. Declines in the value of securities traded in equity markets coupled with declines in long- term interest rates have had a negative impact on the funded status of the plans. As a result, the Company recorded a minimum pension liability as of September 30, 2004 and December 31, 2003, which resulted in an after-tax reduction of stockholders’ equity of $375. This minimum pension liability did not affect the Company’s results of operations.
For additional information on stockholders’ equity and AOCI see Notes 9 and 19, respectively, of Notes to Consolidated Financial Statements in The Hartford’s 2003 Form 10-K Annual Report.
Cash from operating activities primarily reflects premium cash flows in excess of claim payments. The decrease in cash provided by operating activities was due primarily to the $1.15 billion settlement of the MacArthur litigation in 2004. Cash provided by financing activities decreased primarily due to lower proceeds from investment and universal life-type contracts as a result of the adoption of SOP 03-1, decreased capital raising activities, repayment of commercial paper and early retirement of junior subordinated debentures in 2004. The decrease in cash from financing activities and operating cash flows invested long-term accounted for the majority of the change in cash used for investing activities.
Operating cash flows for the nine months ended September 30, 2004 and 2003 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 Capital Markets Risk Management section under “Market Risk”.
Ratings
Ratings are an important factor in establishing the 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 level of revenues or the persistency of the Company’s business may be adversely impacted.
On August 4, 2004, Moody’s affirmed the Company’s and Hartford Life, Inc.’s A3 senior debt ratings as well as the Aa3 insurance financial strength ratings of both its property-casualty and life insurance operating subsidiaries. In addition, Moody’s changed the outlook for all of these ratings from negative to stable.
Since the announcement of the suit filed by the New York Attorney General’s Office against Marsh & McLennan Companies, Inc., and Marsh, Inc. on October 14, 2004, the major independent ratings agencies have indicated that they continue to monitor developments relating to the suit. On October 22, 2004, Standard & Poor’s revised its outlook on the U.S. property/casualty commercial lines sector to negative from stable. On October 29, 2004, Standard & Poor’s revised its outlook on the counterparty credit ratings of American International Group, Inc. and ACE Ltd. to negative from stable. It is not possible to predict whether Standard & Poor’s or any other agency will take similar action with respect to the Company’s ratings outlook.
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The following table summarizes The Hartford’s significant member companies’ financial ratings from the major independent rating organizations as of November 1, 2004.
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.
The table below sets forth statutory surplus for the Company’s insurance companies.
Contingencies - In June 2004, the Company received a subpoena from the New York Attorney General’s Office in connection with its inquiry into compensation arrangements between brokers and carriers. On September 17, 2004, the New York Attorney General’s Office issued two additional subpoenas to the Company seeking information about possible anti-competitive activity among brokers and insurers. Subsequently, the Company has received additional subpoenas from the New York Attorney General’s Office, the Connecticut Attorney General’s Office, the Massachusetts Attorney General’s Office, the Minnesota Department of Commerce and the Ohio Attorney General’s Office regarding broker compensation and possible anti-competitive activity. The Company may receive additional subpoenas and other information requests from these or other regulatory agencies regarding similar issues. The Company intends to continue cooperating fully with these investigations, and has initiated an internal review, with the assistance of outside counsel, regarding the issues under investigation.
On October 29, 2004, the New York Attorney General’s Office informed the Company that the Attorney General is conducting an investigation with respect to the timing of the previously disclosed sale by Thomas Marra, a director and executive officer of the Company, of 217,074 shares of the Company’s common stock on September 21, 2004. The sale occurred shortly after the issuance of the additional subpoenas dated September 17, 2004 by the New York Attorney General’s Office. The Company has engaged outside counsel to review the circumstances related to the transaction and is fully cooperating with the New York Attorney General’s Office. On the basis of the review, the Company has determined that Mr. Marra complied with the Company’s applicable internal trading procedures and has found no indication that Mr. Marra was aware of the additional subpoenas at the time of the sale.
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On October 21, 2004, the Financial Services Agency (“FSA”), the Company’s primary regulator in Japan, issued regulations concerning new reserving methodologies and Solvency Margin Ratio (“SMR”) standards for variable annuity contracts. The regulations are scheduled to become effective on April 1, 2005. The regulations propose a “Standard” methodology and allow for an “Alternative” methodology to determine required reserve levels and SMR standards. The FSA plans to issue detailed administrative guidelines by the end of 2004 that will describe the requirements for the permissible “Alternative” methodology.
The Company through the American Council of Life Insurers (ACLI), along with the European Business Community, and the Canadian Life and Health Insurance Association Inc. (CLHIA), has presented a joint proposal for adoption as the “Alternative” methodology to the FSA. The proposal reflects the methodologies already adopted in Canada and forthcoming in the United States. The proposal recognizes the complexity of principal guarantees offered in variable annuities and encourages insurance companies to conduct risk management in a more precise and comprehensive manner based on each product’s unique features and changing market risk. The joint proposal requires significantly less capital than the Standard Methodology in many situations but, depending on product design and economic conditions, the joint proposal may require additional capital in other situations.
Although the new reserve methodologies and SMR standards would only apply to capital requirements for Japanese regulatory purposes, and are not directly related to results under accounting principles generally accepted in the United States of America, it is likely that the Company will need to provide additional capital to support its Japanese operations, which would lower the Company’s return on invested capital for this business. Management is still evaluating the impact of the regulations on the Company’s Japanese operations. At this point in time, based on the Company’s preliminary assessment, the Standard methodology would require $400-$650 of additional capital during 2005. This estimate assumes the Company employs various capital strategies which may include but not be limited to product re-filing, hedging and other capital management strategies. Adoption of an “Alternative” methodology based on the joint proposal described above would require significantly less capital in most scenarios.
Any additional capital required will be obtained by redeploying capital from domestic Life operating companies to the Company’s Japanese subsidiary, Hartford Life Insurance, KK. Based on preliminary estimates under the “Standard Methodology” and current circumstances, the impact on capital adequacy for U.S. regulatory and rating agency risk based capital would be between $100 and $275.
The Company, industry organizations and Institute of Actuaries of Japan (“IAJ”) have been consulting with the regulators on the development of the “Alternative” methodology and SMR standards. The final guidelines may or may not reflect recommendations by the industry, the IAJ or others. Since the administrative guidelines for the “Standard” and the “Alternative” methodologies have not yet been specified, at this time it is not possible to predict the final form of any reserve methodology or SMR standard change. Participants in the Japanese market, including the Company, may need to reassess certain product terms and features depending on outcome of the final guidelines. This could have an impact on the Company’s sales.
For further information on other contingencies, see Note 16 of Notes to Consolidated Financial Statements included in The Hartford’s 2003 Form 10-K Annual Report.
Tax Matters — Prior to the Tax Reform Act of 1984, the Life Insurance Company Income Tax Act of 1959 permitted the deferral from taxation of a portion of statutory income under certain circumstances. In these situations, the deferred income was accumulated in a “Policyholders’ Surplus Account” and, would be taxable only under conditions which management considered to be remote; therefore, no federal income taxes have been provided on the balance in this account, which for tax return purposes was $104 as of September 30, 2004. In October 2004, the American Jobs Creation Act of 2004 was passed by the Congress, and the bill was signed by the President on October 22, 2004. This legislation allows distributions to be made from the Policyholders’ Surplus Account free of tax in 2005 and
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2006. The Company anticipates that, based on currently available information, this change will permanently eliminate the tax of $37 on this deferred income.
ACCOUNTING STANDARDS
For a discussion of accounting standards, see Note 1 of Notes to Condensed Consolidated Financial Statements.
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 adequate and effective for the purposes set forth in the definition thereof in Exchange Act Rule 13a-15(e) as of September 30, 2004.
Change in internal control over financial reporting
There was no change in the Company’s internal control over financial reporting that occurred during the third quarter ended September 30, 2004 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
Part II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
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ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND PURCHASES OF EQUITY SECURITIES BY THE ISSUER
Purchases of Equity Securities by the Issuer
The following table summarizes the Company’s repurchases of its common stock for the three months ended September 30, 2004:
Item 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits – See Exhibit Index.
(b) Reports on Form 8-K: None.
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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 thereunto duly authorized.
November 4, 2004
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THE HARTFORD FINANCIAL SERVICES GROUP, INC.FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004FORM 10-Q
EXHIBITS INDEX
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