Hartford Financial Services Group Inc. - Special Call

Oct. 6.11 | About: Hartford Financial (HIG)

Hartford Financial Services Group Inc. (NYSE:HIG)

October 06, 2011 10:00 am ET


Gregory G. McGreevey - Chief Investment Officer, Executive Vice President and President of Hartford Investment Management Company

Sabra Purtill - Head of Investor Relations and Senior Vice President

Graham Bird -

Liam E. McGee - Chairman, Chief Executive Officer, President and Member of Finance, Investment & Risk Management Committee

Lizabeth H. Zlatkus - Chief Risk Officer and Executive Vice President

Christopher John Swift - Chief Financial Officer and Executive Vice President


Andrew Kligerman - UBS Investment Bank, Research Division

Thomas G. Gallagher - Crédit Suisse AG, Research Division

Randy Binner - FBR Capital Markets & Co., Research Division

Edward A. Spehar - BofA Merrill Lynch, Research Division

Eric N. Berg - RBC Capital Markets, LLC, Research Division

Jeffrey R. Schuman - Keefe, Bruyette, & Woods, Inc., Research Division

Nigel P. Dally - Morgan Stanley, Research Division

John M. Nadel - Sterne Agee & Leach Inc., Research Division

Tamara Kravec - Banc of America

Christopher John Swift

Good morning, everyone. Good morning, Liam. Thank you for joining us today. I want to welcome those of you here in The Hartford and those who are participating in the audiocast. We really appreciate that so many of you are able to make the trip to Hartford and join us at our headquarters today.

We first started discussing holding a session like this several months ago based on your input. We appreciate the challenges and perspectives that you've offered, and that's why we're here today. We have a financially orientated discussion that will address the balance sheet topics in depth. You will hear from the executives most directly involved and knowledgeable in those issues we'll discuss.

Please take a moment and just look at Slide 2 here, where we make cautionary remarks about our forward-looking statements in the actual presentation. Events may materially differ going forward.

So let's look at the agenda and just set everything for today. Liam will make a few opening remarks, Greg McGreevey will review the investment portfolio, and then we'll move to enterprise risk management, where we'll hear the progress we've made from Liz Zlatkus and Graham Bird, including the U.S. and Japan VA books and the hedging programs. Then I will provide an overall financial impacts for the Japan hedge, and we'll take a break. I'll come back after the break, and we'll walk through a few third quarter items and review the balance sheet and the capital position. We will hold a Q&A before the end, which will be moderated by our Head of Investor Relations, Sabra Purtill, and we'll conclude with a lunch.

We have a number of other executives with us today. They will be around during the breaks as well as during lunch: Doug Elliott, Head of Commercial Markets; Andy Napoli, Head of Consumer Markets; Dave Levenson, Head of Wealth Management, cannot be with us here today due to previously scheduled travel; Alan Kreczko, our General Counsel; also from our finance organization, Beth Bombara, our Controller; Robert Paiano, our Treasurer; Ryan Greenier, Investor Relations; Pete Sanzero [ph], CFO of Annuities; and Kim Johnson, who now is with HIMCO.

I'm sure some of you peeked ahead in the deck. For those who haven't, we will provide a few updates on the third quarter, namely DAC, catastrophes, and market impacts, none of which should be a surprise to you. Our real goal here is to -- is for you to leave today with a better understanding of the steps the company has taken to reduce risk across the enterprise and explain why we believe we have the capital to support our risk exposures even in adverse scenarios.

Welcome again to Hartford, and with that, I'll ask Liam to come up and make a few opening remarks.

Liam E. McGee

Thanks, Chris. Good morning, everyone. It's great to have you all here, and I do want to thank all of you for taking the time to travel to Hartford. We thought it was really important that you be here in our headquarters to experience us and our management team and our messages. So as Chris mentioned, we decided to hold a session like this several months ago. As he said, many of you have been quite open with us, and we do take your feedback very seriously. So I'll make just a few brief opening remarks before I turn it over to the team.

As we look ahead, we are realistic about the environment in which we're operating. The U.S. economy is growing very slowly, and any recovery is fragile. Recent economic news has shown some modest improvement, but job growth and consumer confidence are very challenged.

At The Hartford, we still don't see a repeat of the 2008 financial crisis, but the economy and the country have real challenges, and we are expecting slow economic growth at best for the balance of 2011 and at least through the first half of 2012. But we are not counting on an economic recovery to drive near-term results and are aggressively managing the levers within our control, census, pricing and risk management, for example, to effectively manage the company in this environment. Now as he mentioned, Chris will talk about capital in detail. We feel good about where we are, particularly when you factor in the economic headwinds, market volatility and higher cat activity.

As you'll see today, even in the adverse scenarios we've modeled, The Hartford statutory capital margins remain above our minimum capital threshold. But with the markets becoming significantly more volatile since our equity repurchase announcement, which was in early August, we've chosen the path of prudence and have not yet begun buying back shares. Of course, we'll watch markets and economic developments closely to determine when to best start with repurchases, and we still expect to complete the program in early 2012.

We're down a path towards significantly transforming The Hartford into a more effective, cost-efficient and contemporary organization, one that is responsive to changing market dynamics and that takes a forward-looking, proactive approach to managing the business and its associated risks.

Last week marked my 2-year anniversary with The Hartford. And when I look back at my first few weeks here, I was impressed with the company's strong brand, values, business franchises, talented employees and enduring relationships with our distribution partners. All that continues to be true today.

But there were also significant challenges to be addressed. One of the most important and foundational was The Hartford's approach and expertise in risk management. Since I've been here, risk management has been a critical priority for the organization and for me, personally. When I first joined the Hartford, we had reasonable risk management processes within each of the business units, but what was lacking was a full understanding and robust management of the firm's aggregate risk, the transparency and control of risk appetite, correlations and concentrations. This deficiency was part of what contributed to the significant capital stress the organization faced and highlighted why an outstanding enterprise-wide approach is so important. And clearly, even within the specific business areas, we could have done a better job managing risk.

The fact is that the company's risk mitigation strategy was challenged by the extraordinary economic environment we were facing then. And in hindsight, it is clear that the company had too much risk in the investment portfolio, particularly in real estate instruments, and there was not enough hedging in place. And as a result, the excess capital we held proved to be insufficient for the total exposure of the company.

So we are now managing risk in a very different way and have developed the company's capabilities and expertise. We built a team of enterprise risk professionals, who manage market, credit, insurance and operational risks across the organization. We also formed a board-level risk committee, comprised of the entire board, that is very engaged on these important topics.

Now Liz Zlatkus will speak more about the work that we have done shortly, but under her leadership, the enterprise risk management team has made very good progress. As you know, Liz will retire before the end of the year, and I want to take a moment to personally thank her for the nearly 3 decades that she's devoted to The Hartford. Liz, thank you.

I think it's important to note that we have a strong team in place under Liz, including Graham Bird, who's here with us today. Graham oversees enterprise risk management for market risks. Now you'll hear from him shortly, and both Liz and Graham will participate in the question-and-answer session. An external and internal search for Liz's successor is nearing completion, and I am confident we will complete the search in the near future.

The Hartford's approach to the investment portfolio is much more sophisticated and disciplined than it was 2 years ago. You'll hear from Greg McGreevey today on the aggressive steps we've taken to successfully position the investment portfolio and build a high-performing operation at HIMCO. We now have an ongoing ability to review the portfolio under various stress scenarios, a rigorous re-underwriting process for securities and a capability to understand trends in the global economy, and we use that to take targeted, proactive actions as we've done, as you'll see in Europe and in our municipal bond portfolio as examples. Greg will share detail we believe demonstrates that investment losses, even under future market turmoil or severe stress scenarios, will be well within our capital resources. I want to make it clear: we are in a fundamentally stronger credit position compared to 2008.

Another good example of how we're managing risk differently today is Japan. The program that the team has put in place was developed in conjunction with a leading risk management consulting firm, Oliver Wyman. It was developed against thousands of potential market and economic scenarios and is tested and stressed regularly. And so I have confidence today that the Japan risk is now within the appropriate risk parameters for The Hartford.

We'll close with Chris covering the balance sheet and capital strength, incorporating the data that will have been provided to you earlier in the day. We'll show why we are confident The Hartford can absorb additional capital stress while maintaining resources consistent with our current ratings.

Now since this is a session focused on the balance sheet, we will not be covering the strategy and the plans for the businesses. At the Investor Day on December 8, we'll cover the actions we're taking to improve profitability and generate ROEs in excess of the cost of capital over time.

So when we finish up today, my goal is that you share our beliefs that first, The Hartford's balance sheet is strong. Next, while challenges exist, our risks are significantly reduced and manageable. The Hartford's risk management capabilities are meaningfully enhanced. The Hartford has the strength to maintain sufficient capital levels consistent with current ratings, even under significant economic stress. And finally, management is running the company with discipline and a focus on generating value for shareholders.

So to sum up, Hartford is well positioned today for the possibility of an adverse market scenario. Thanks for your time, and with that, I'll turn it over to Greg McGreevey. Greg?

Gregory G. McGreevey

A long walk from the back. Thank you, Liam, and good morning, everyone. It's a pleasure to be with you today. Let's spend the next 25 minutes, as Liam said, walking through our investment portfolio. And in doing so, I wanted to really focus on 3 takeaways from today's presentation: first, we've developed a very strong ability to manage our portfolio in a manner aligned to shareholders; and second, we significantly changed the composition and risk of our portfolio through balancing income, economics and capital; and third, we're highly confident we've taken actions over the last 2.5 years that have resulted in a portfolio that is well positioned to deal with economic uncertainty.

To accomplish this, I've divided, as you can see on Slide 9, today's presentation into 3 sections. First, I'm going to focus on portfolio construction. We're going to provide you with some details on how we manage the investment portfolio, as well as actions we've taken to improve the credit quality of the portfolio and reduce correlated risk. Next, I'm going to cover performance, and you'll see that we significantly reduced risk in our portfolio while maintaining strong investment income and economic returns, a very important thing when we look at our performance overall. And finally, I'm going to share with you results of our stress testing, as Liam indicated. Let's get started.

When I came to The Hartford 3 years ago, I observed a couple of things. We had a number of very talented investment professionals that provided a foundation to build upon. At the same time however, the investment process and decision making needed improvement. It was not clear who was accountable for the key decisions around portfolio construction, and risk management was not integrated into the investment process. As a result, we had a portfolio that had high concentrations of correlated risk, as evidenced by our overweight positions to structured securities, real estate and down the cap structure financials, and these allocations were the primary drivers of the credit losses that we took in both 2008 and 2009. So my first priority given that was to construct a long-term model portfolio designed to provide strong risk-adjusted returns, be consistent with the broad insurance industry overall and within the risk tolerances of The Hartford.

I think we've made significant progress in moving ourselves towards that long-term model portfolio. This progress has and will continue to be based on 2 items: first, ensuring that we balance economics, income and capital, a key part of our process; and second, that we overlay our view of economic formations against prudent trading decisions.

So in addition to setting a long-term model portfolio objective, we significantly made changes to our people, our process and our platform, as you can see on this slide. These change have strengthened our ability to generate strong risk-adjusted returns. We made significant changes to leadership roles for a number of key asset classes. We put in place a dedicated portfolio management team responsible for monitoring high-risk securities. This team continually underwrites our view of fair value that we can then compare to market value, that support our de-risking efforts in our portfolio.

And in addition, we have improved our investment process, decision making and accountability. Our new structure fully incorporates macroeconomic views and risk management into our portfolio management decision making, something that was lacking when I first came onboard.

And finally, we've invested both time and financial resources in our investment platform overall to build sophisticated econometric modeling, as well as proprietary structured credit models, and this enhanced credit model and allows us to now underwrite our structured security portfolio on a very granular, loan-by-loan level basis and has strengthened our overall portfolio management capabilities.

These models and others in our process improvements are incorporated into our day-to-day surveillance of our portfolio. So said simply, we have the right people in the right jobs that have both clear accountability and appropriate tools to make prudent portfolio management actions that are aligned with you as shareholders.

Now we can turn to Slide 12. I wanted to spend a couple of minutes on our view of the economy, which as I told you before, informs our portfolio management actions. In order to determine relative value, our understanding of security and issuer fundamentals has to coincide with our expected view of the economy overall.

Since early 2010, we've consistently projected 2 overarching themes. First, within the developed markets, due to significant debt burdens, those markets would experience lower growth due to reduced government spending on a prospective basis. Specifically, we believe we would have a protracted time period of slow growth in both the U.S. and significant headwinds out of Europe. And as the U.S. and Europe slowed, we would expect the global economy to contract, given that 60% of global GDP comes from those 2 regions.

So against that backdrop, let me tell you what we've done in our portfolio since the end of 2008. And let's start with real estate overall, something that Liam mentioned and I mentioned at the beginning where we had of significant overweight in our portfolio at the beginning of 2008. In that portfolio, we had overweight positions in structured securities and subordinated loans at the end of 2008, and we've reduced over that time period our real estate exposure by over $10 billion. CMBS was reduced by almost $7 billion or about half of where we were at the end of 2008. This reduction was across different parts of the capital structure.

We also reduced commercial mortgage loan portfolio by over $1 billion. And remember, most of the sales that were in that portfolio were in Mezzanine holdings, which were the higher risk portion of that asset class. Today, our mortgage loan portfolio is almost exclusively senior whole loans on solid commercial properties in markets that we like.

And finally, we had over $2 billion of reductions in RMBS and re-holdings.

As we look at our portfolio today, I believe the quality of our real estate holdings has improved dramatically. We reduced our overall systematic risk, our average credit quality on real estate assets has improved and remained strong. And as you can see from this slide, one of the most important things we look at is our market-to-book value ratio on this segment has improved dramatically over the last couple of years.

Now we took a large portion of the cash from that de-risking from real estate and invested it in high-quality corporate bonds. This was an area in corporate securities what we believed offered good relative value and was also a significant underweight from a portfolio standpoint when I joined the firm. So we focused our purchases on companies that were well positioned for slow economic growth and at the same time, we sold high beta, more economically sensitive names. For example, when prices improved dramatically in financials, we took the opportunity to reduce our deeply subordinated holdings by over $2.5 billion.

As we look at our financial exposure today, we think it's well positioned to global firms that are systemically important to their region, as well as to the global economy. As a result of our action, we maintained our overall credit quality despite the level of downgrades that was occurred by the rating agencies, and our market-to-book value has increased dramatically, primarily due to portfolio construction and lower interest rates.

Now let's turn to the muni portfolio for a minute. While our allocation to municipals was in line with our long-term model portfolio, we also proactively look to reposition by improving both the composition and quality of that portfolio. As mentioned previously, our expected view of slower economic growth was believed to impact overall tax receipt. As a result, we focused purchases on general obligation bonds in high-quality states, as well as revenue bonds from the central service segment. These purchases were higher up in the waterfall of uses of tax collection, as well as on services that will always be needed like sewer and water. We also reduced exposure to insured bonds due to potential credit concerns, as well as prefunded securities, which we believed offered little relative value in the muni market. So again, we improved our credit quality while at the same time, like other asset classes, we saw a significant increase in our market-to-book value over that time period.

And finally, given the view that I had mentioned on Europe before, you would expect us to take action in Europe and we did. We made significant rebalancing decisions in our European holdings within the general account. Today, we have no direct exposure and essentially no bank exposure to the higher risk countries in Europe. Our financial exposure is limited to the largest and most important banks in stronger European countries, and our subordinated bank exposure overall has been reduced dramatically and is now at around $600 million. This exposure, again, is to strong multinational banks that are integral to the global economy. If you look at the remainder of our holdings in Europe, we primarily invested in multinational companies with strong balance sheets and a global revenue base. Because of our actions on holdings, our portfolio has held up well against the backdrop of the turmoil that we've seen in Europe. You can see, on Slide 16, our European holdings were in an overall gain position at the end of August of this year.

So taken together, our actions have significantly strengthened the quality of the general account portfolio. We've moved closer to our desired long-term model portfolio, we've reduced our risk profile overall, and concentrations in those asset classes that I talked about at the beginning have been reduced, while at the same time increasing our overall credit quality.

Portfolio reposition clearly is going to be something we're going to do on an ongoing basis, but we feel good about the portfolio actions we've taken today. We'll continue to incorporate our views of economic formation while balancing income, capital and risk-adjusted returns. Well, that's a lot of reposition that we've done.

Now let's take a look at how we performed over the last 2.5 years. When we think about performance, we measure it really in 3 ways: net investment income, realized and unrealized gains and losses, and total returns. We believe the combination of these factors helps drive shareholder returns over time.

In terms of net investment income, our portfolio results were strong. We've seen an increase in net investment income despite declining interest rates and our de-risking actions that I've mentioned before. The main contributors to these favorable results have been strong alternative returns, good relative value decisions that we've made within our portfolio, and a focus on ensuring that we balance income and our de-risking actions.

As you would expect, our de-risking actions through both sales and impairments have significantly lowered credit losses. Year-to-date, 2011 impairments are around $120 million, which compare very favorably to the impairments that we took in 2010, and also very favorably to the almost $2 billion of impairments that we took in 2009. Now, included in that number for 2011 is around $60 million of impairment that we plan to take in the third quarter of this year. We're pleased with the powerful downward trend of credit losses in our portfolio.

So as you can see on Slide 21, our gross unrealized loss position has also improved by about $12 billion since the end of 2008. This was the result of lower interest rates, as well as de-risking actions and impairments that we took in our portfolio. We saw a significant improvement in both structured and nonstructured securities over that time.

So at the end of August, our portfolio was in a net gain position of $2.1 billion pretax. I wanted to break that down a little bit from that $2.6 billion that you see on the slide of gross unrealized losses. $900 million of that $2.6 billion is on nonstructured securities. These assets are almost all longer dated, variable-rate corporate bonds and municipal bonds. The remaining 2/3 or about $1.7 billion is in our structured security portfolio. Within structured securities, these unrealized losses are in a variety of different asset classes, most of which have materially repriced over the last couple of years.

Based on our modeling and analysis, we certainly would expect further price recovery on these securities over time and indeed, we've seen market values start to move towards our fair valuation that we've done in our portfolio over the last couple of years. What's really important to note, as I've mentioned before, we significantly improved our structured securities modeling, our underwriting and our surveillance capabilities to evaluate and make decisions on these assets.

Now let's turn to Slide 22 and look at total return relative performance. So for us, the total return is an important risk management and assessment tool. It allows us to compare our portfolio to similar liability-driven benchmarks on a real-time basis. It also allows us to compare our portfolio against the best and largest fixed income managers in the world. These results demonstrate in my mind how well, at the end of the day, we're making economic-based decisions. We selected here a representative benchmark of core and core plus managers to serve as a useful reference point to evaluate our performance.

On a cumulative basis, as you can see on the bottom of that chart, we outperformed the Lipper median peer group by 6% over that time period, which would put us in the top 10 percentile of leading fixed income managers. So at the end, the combination of strong net investment income, improvements in both realized and unrealized losses, as well as strong total return, has significantly added to shareholder value.

So we feel good about our performance overall on our de-risking actions we've taken to date, but we also need to continue to look at our portfolio and how it could perform under different economic conditions.

Let's recap today's portfolio as a starting point. Our general account portfolio is well diversified, with strong liquidity, and is of high quality. As of the end of August of this year, we're in an unrealized gain position, as I've mentioned before, of $2.1 billion. We have ample liquidity, with 8% of our portfolio in cash and treasuries, and despite significant rating agency downgrades, the portfolio's current rating is at A+. We repositioned over 14 billion of securities, consistent with our long-term model portfolio, with notable reductions in subordinated securities, structured securities and down the cap structure financials. The average market-to-book value of our remaining structured securities is at 91%, an absolutely significant improvement from the 63% that we saw at the end of 2008.

Let's move to potential credit losses. We look at a variety of different scenarios and assumptions stressing our portfolio. Today, I wanted to focus on 3 modeled scenarios. Each of these scenarios is aligned with different S&P levels for ease of comparison. I'm not going to get into all of the detailed assumptions, you can look at that on Slide 25, but instead I wanted to highlight a couple of very important points.

First, the assumptions for these scenarios were built on macro views, including GDP, unemployment and real estate valuations. Our base case is not an optimistic economic projection. It includes slow economic growth, consistent with what I mentioned before, with persistently high unemployment. Nonetheless, it does represent our best assessment of where we think the global economy is headed, and despite this economic outlook, we remain hopeful that both leaders in Europe and the U.S. will take appropriate fiscal and monetary actions to help drive future economic activity.

Now let's move to the stress test outlined on Slide 25, and you'll see that our assumptions for the stress scenario are considerably worse than what I just mentioned. We assume in the stress scenario that the U.S. slips into a protracted recession, with unemployment that rises and stays there above 10%, and recovery in that scenario doesn't begin until late 2013. As you would expect in such a significant market downturn, real estate values also decline.

The results of these modeled scenarios are on Slide 26. Let's look at those for a minute.

In our base case, we project -- we could see $450 million of credit losses in the next 2.5 years. Potential losses in the stress scenario would likely not exceed $1.25 billion. Now these projected losses for all of these scenarios are on a pre-DAC, pretax basis. Chris later in the presentation is going to provide more clarity on capital impacts on investments. So in all of these cases, we'd expect losses to emerge predominantly from our structured security portfolio. As I've mentioned before, represents the largest portion of our unrealized loss position.

So before I move on, I wanted to remind you that the economic conditions we project in a stress scenario are severe. It includes significant deterioration for economic conditions. It's also quite volatile. We've included loss projections in our stress scenario really to provide transparency of how credit losses may develop in our portfolio in a protracted recession.

There's been a lot of discussion around interest rates of late, a lot of news articles that are coming out in the media. We felt it was going to be important to spend a couple of minutes talking about the impact on our net investment income, given a protracted period of low interest rates. That said, we expect that the Federal Reserve actions and the slower economic growth that I talked about will likely keep rates low for some time.

So if the 10-year treasury and the 5-year treasury rates remain flat over the next several years, the impact in our net investment income is quite manageable. Over the next few years, we're going to expect to invest in our portfolio about $7.5 billion annually in new cash flow generation. If we did that investment of $7.5 billion at current new money rates, we would see lower after-tax core earnings in the range of about $50 million to $75 million in 2012. We would expect this impact to not exceed $150 million in 2013. Really important to remember that these assumptions assume no change in credit spreads and that no management actions would be taken.

Let's turn to Slide 28, where I'll detail some of the actions we have or can take to mitigate the impact of lower interest rates. First, we've already started, as I think we've mentioned on several calls before, to increase our holdings in alternative investments, and this is investing in strategies that will perform well at quite the low interest rate environment. These strategies provide solid, uncorrelated returns in different capital market scenarios. Such allocations to alternatives will be in the form of private equity and hedge funds. We have a very strong capability within the organization that has invested in these areas with success for some time. Second, we're showing an ability, as I've mentioned in my performance slides, to make good relative-value trading decisions within the portfolio on a consistent basis. Third, we have a liquidity in our portfolio that can be used to purchase attractive, higher-yielding assets when the time is right. And finally, the organization will continue to look at product pricing decisions across all of our businesses to make sure we're earning reasonable returns in light of current market conditions.

So finally, in closing, I wanted to reiterate a couple of very key, critical points. This is not the same investment portfolio or investment theme that was in place during the financial crisis. The risk composition of our portfolio is vastly different. We have a laser focus on improving portfolio quality while balancing income, economics and capital. Our portfolio, we believe, is well positioned to deal with economic uncertainty and a low interest rate environment, and we're quite confident that in a significant market downturn, today's portfolio will have significantly lower loss emergence than what we saw during the financial crisis.

I wanted to thank you for your time, allowing me to share some views on the investment portfolio and our results. Look forward to having lunch, to answer any questions that you have at a later time. Now I wanted to turn it over to Liz.

Lizabeth H. Zlatkus

Thank you, Greg. It's a real pleasure to be here with you this morning to talk to you about a subject that I really do feel pretty strongly about, and that's the progress that we've made in advancing the company's risk management capabilities. I know Liam talked about it and Greg did. The Hartford, along really with the entire financial services industry clearly learned lessons from the past financial crisis. I saw them first-hand and armed with those learnings, we did change our risk management approach to ensure we better manage risk both at the individual level and at the enterprise level.

So let me provide some specific examples of what's different today at The Hartford. In the interest of time, I'm not going to cover every risk area. Rather, in light of some of the challenges in the past, I'm going to highlight 2 areas: risk management around credit and variable annuities. Suffice to say however, we do have improvement of our other major risk categories, that being insurance, operations and market risk, the broader market risk, which includes interest rate, equity and currency.

I know Greg spoke a lot about credit, but I'm just going to give you a view from the enterprise how we're having additional governance around, for example, variable annuities and credit. So as to our approach to credit understanding and managing that risk, it's definitely more sophisticated and disciplined than it was several years ago, and certainly, Greg just spoke of the changes that we made both to the general account portfolio and all the de-risking, and the people and the processes and systems within the investment operations.

Credit risk management, I think you've heard, is clearly essential tenet to the investment process at HIMCO. But in addition, we have more transparency and controls on credit exposure at the enterprise level. For example, we expanded the framework around how we measure our individual and aggregate credit risk limit against risk limits. We look not just to potential ultimate losses, but we also look at credit spread volatility and compare that to our limits. And we strengthened our internal ratings methodology for determining credit worthiness. Greg spoke of that, particularly on structured securities, but we've done that more wholesale. We also have substantially increased our independent validation of our models and the tools that we use to measure risk. We have back-tested our assumptions, analyzed our correlations, and we regularly subject the portfolio to significant stress scenarios. So in some of our back testing, we went back and look and said, "With our new methodology, would it have captured much of the risk that did emerge?" And the answer was yes.

So in addition though to monitoring the absolute level of credit risk in the portfolio, we review it relative to the risk that is in our long-term model portfolio. So what does that really mean? It means that our CEO and my team now independently can monitor changes to the investment risk profiles and the component drivers of that change, so again, to set an independent view. So again, while individual credit risk underwriting responsibilities lie with Greg and his team, we have strong governance and oversight at the enterprise level.

Now let's talk about VA. We certainly have significantly upgraded our capabilities and substantially increased the level of hedging that we now have on our global variable annuities book. We now have a robust and dynamic hedge program that's designed to limit our losses under severe market conditions. I'm not going to go into further details on this, as Graham will be really covering that in detail today, but just the ability for us to see the market value changes every night on the global VA book is certainly an enhancement.

So what else did we change? Well, we changed how -- those were 2 specific areas that we have oversight on, but how do we just look at it from a total enterprise level? Well, we changed that by building a strong and independent risk management organization. Liam referenced that. We enhanced our tools and capabilities, again, at the enterprise level and we strengthened the governance throughout the firm.

Let's turn to the next slide, 32, to dive a little bit deeper into those 3 areas. My position as Chief Risk Officer, was elevated to report directly to the CEO, Liam, with independent access to the board. This enables the ERM organization to have oversight of risk independent of the business, and it certainly ensures that, long-term, we have a seat at the table for strategic risk decisions.

One of my first priorities then was to restructure and expand the ERM organization. We appointed dedicated chief risk officers from each of our major risks, so you can see -- you're going to hear from Graham Bird, who's in charge of all market risks for the firm. We have an insurance risk officer, an operational risk officer and a chief investment risk officer. And basically we just increased their focus, so let me give you an example:

Before when we looked at insurance risk, we certainly have lots of people in the C&C [ph] operation, that today are consumer and commercial, that would have been evaluating insurance risks. And that on the Life side now is called Wealth Management. What we've done though is we have one individual who looks at, for example, mortality and morbidity risk in total. So we still have all of our underwriting processes within the line, but now we have someone dedicated that's always looking at the aggregate level of risk.

And of course, my team, in addition to their primary responsibilities, they work together to ensure that we're seeing risk holistically. So it's just a lot more independent and focused by risk category rather than looking at it more by line of business, again, still having risk within the line.

What else did we do? We also deepened our bench strength. We hired over 50 net new hires with diverse backgrounds in capital markets, investments, insurance and risk.

Turning to Slide 33. We implemented more robust risk measures across the enterprise. We more routinely look at our risk through 3 lenses, so economics, GAAP and stat. Again, we had those -- certainly GAAP and stat we had, but the capabilities on economics we've really enhanced, and you're going to see that in the work when Graham talks about risk management around global VA.

Our scenario and stress tests include enhanced correlation of metrics, particularly around market and credit, but of course, we also model correlations to nonmarket events. And we've updated and expanded our economic capital model. As you know, there's a lot of talk about economic capital these days, and how we see this is, it's another lens into our risk, a very fulsome process, and we use it to really inform risk-return decision making across the enterprise.

Risk management is also stronger today -- excuse me, risk governance, and I think that a really important point is, how do you govern and act around risk? Not just what your models say, but what are the actions you take every day? As Liam mentioned, the Finance, Investment and Risk Management Committee, our FIRM Co, is comprised of our full board and it does convene every board meeting. The dialogue is robust and focused on the key issues facing the firm. And I can tell you that first hand, it's a very fulsome meeting every single board meeting.

We also have other formalized risk committees. The main one would be the Enterprise Risk and Capital Committee. This is the senior committee chaired by Liam and is comprised of the senior leaders from business, finance, investments and risk. This committee approved the firm's overall risk appetite and all of the cascading tolerances and limits for all of our major risks. These policies and limits ensure that we manage the firm within our risk appetite under various market conditions.

And as you would expect. We have other committees, we have emerging risk, we have asset liability committees, et cetera. Of course, we had a lot of that before. What's different is just the focus has been increased. Accountabilities are clear. There's more, what do we do if events happen? Who is in charge? What actions will be taken?

So again, while all of these steps are critical ingredients to an enhanced risk management function, I believe it's the day-to-day change in how we operate that matters most. These new policies that I've mentioned contain certain mandates that require us to take action when limits are breached. A realized example occurred earlier this year. We breached a currency limit that we had set as we were building out our Japan hedge design. No debate occurred about, was the yen going to strengthen further? Rather more hedging was put on that day. Accountability was clear and action was taken.

So clearly we recognize risk as ever evolving and that it requires really a culture of continuous improvement and continuously challenging the status quo and assumptions. So while much work has been done, there will always be more to do and we are dedicated to continuous improvement.

So to summarize, clearly, we learned from the past. We took strong actions and reduced risks, and we created a much higher level of independent oversight, and we truly upgraded our risk management practices.

This will be my last meeting with investors, with all of you today, as I retire from my 28 years of service with The Hartford at the end of this month. I just truly enjoyed my career at The Hartford, and I could say so much about the wonderful people and experiences I've had, but that would take too long. So instead, what I will say is that I leave the company knowing it is stronger, that risk management practices and governance have been enhanced, and that my team is seasoned to taking risk management to the next level.

For that, I'm going to turn it -- I'm going to introduce our Chief Market Risk Officer, Graham Bird. Graham joined The Hartford in May of 2010, and he does oversee all of market risk for the enterprise, as I mentioned earlier. He has held various senior business and risk management leadership positions with leading financial institutions, his extensive background in both trading and risk has really been invaluable, and he's just been such a great addition to our enterprise risk management functions. So I'm very pleased to turn it over to Graham. Thank you.

Graham Bird

Thanks, Liz, and I am pleased to be here and have this opportunity to provide greater insight into our VA portfolio and risk management. I have 3 main messages this morning: firstly, we have in place a comprehensive approach to manage our global VA risk; secondly, we now have a robust dynamic hedging program for the closed block in Japan; and thirdly, we are hedging more of the market risk embedded in our VA guarantees.

My agenda this morning is straightforward. By way of background, I will briefly address the global VA portfolio characteristics and our approach to risk management. Then, I'll review the Japan portfolio. This is where we get many investor questions, so I'll spend some time to help you understand the Japan VA product and associated risks. Finally, I will cover the dynamic hedge for Japan in some detail. Implementation is advanced, and we remain on track to fully implement the hedge by year end. We have a lot to cover, so let's get started.

In total, we have over $100 billion of global VA assets under management. Almost 70% of the VA assets relate to our U.S. business. Most of the remaining 30% is our Japan VA block. The core objective of our risk management is to ensure total risk exposure remains within our risk appetite and tolerance. We use a variety of risk mitigation strategies, including product design, reinsurance and capital markets hedging. Beyond this, our risks are backed by net income and capital. Finally, we measure and monitor risk through 3 lenses: economic, statutory and GAAP.

Let's take a closer look at the evolution of our risk management on Slide 38. GAAP, stat and economic views have always been important to us and all 3 continue to be relevant. The balance or weighting of these factors has, however, changed over time. Initially, GAAP was our main focus. During the financial crisis, statutory efficiency became a more dominant consideration. Going forward, economics will be our primary target, although economic targets do, of course, remain subject to statutory considerations.

We have stress tested our VA portfolio for many years. However, stress testing today is more comprehensive. It fully addresses concentrations of risk and correlations between our portfolios.

Finally, the scope of our risk management has expanded. Initially, we were U.S. centric and now, risk portfolios in Japan and Europe are fully addressed. In summary, our risk management approach today is comprehensive, with a greater focus on programs that more precisely target our liabilities.

Slide 39 provides greater detail on our U.S. VA business. We have $72 billion of assets under management, and the portfolio is split roughly 50-50 between products with a death benefit only and products that have both a living benefit and a death benefit. Separate account returns in the U.S. roughly follow the S&P 500 because over 2/3 of the assets, the bank depositories, are invested in equities.

The bullets on this slide show the evolution of our U.S. VA risk management. Our initial VA products were highly successful. To manage the associated risk, we moved quickly to put reinsurance in place. However, market capacity for reinsurance turned out to be limited. In 2003, we instituted a fully dynamic capital markets hedging program designed to cover the market risk associated with the withdrawal benefit or GMWB option. Under this program, we rebalanced hedges against the risk sensitivities or Greeks of the FAS 157 liabilities. Since I have been at The Hartford, I have had the opportunity to look at the performance of the hedging program. I can tell you that the program has been successful over time, and that we do have effective modeling, risk management and trading capabilities in place.

But, as Liam mentioned, it became clear through the financial crisis that The Hartford had retained too much risk. While the GMWB hedge more than covered the statutory impact of that risk, the retained death benefit was mainly unhedged. To address this in 2008 and 2009, we did 2 things: we changed the GMWB hedge targets to further protect statutory capital and we added macro hedges. The move towards greater statutory efficiency supported our surplus position at year-end 2008 and continues to provide statutory protection today. As we expected, the revised hedging targets increased GAAP net income variability. The GAAP variability we've seen since 2008 is largely due to the level of hedging on GMWB and the difference in the accounting treatment of hedged assets and the GMDB liabilities.

Let me summarize where we stand on -- today on U.S. hedging. As we measure it, approximately 80% of the economic market risk associated with the U.S. GMDB and GMWB guarantees is now hedged. We do retain the majority of policyholder behavior risk, and we're likely to do so for some time, given limited reinsurance capacity. VA hedging programs also support statutory capital. Chris will cover this when he discusses enterprise capital sensitivities.

Slide 40 gives an overview of our Japan VA portfolio. As you can see in the pie chart, the vast majority of policies in Japan have both a guaranteed minimum income benefit, or GMIB, and a guaranteed death benefit. The guarantees in Japan are more limited than those sold in the U.S. First, the guarantee is only a return of premium. There are no roll-ups or step-ups and no lifetime income guarantees. Second, customers in Japan have fewer options. Contracts have a minimum 10-year deferral period, and most have a 15-year payout period. This is not to say the portfolio is without risk. Income and death benefit guarantees are denominated in yen while the separate account assets are invested in a mix of global bonds and equities. This means that the Japan block has a significant currency risk, in addition to equity and rate risk.

With that overview, I'd now like to look at the Japan VA products and risks in more detail. On this slide, I provided a simple representation of a typical Japan policy. At issue, the customer pays us JPY 1.5 million. This amount is invested in a separate account. For the deferral period, the separate account value fluctuates with market conditions. In this example, markets decline and the value of the account falls below the original principal amount.

If the policy lapses during the deferral period, the customer receives only the value in the separate account, less any surrender charges. After 10 years, the policyholder has more choice. He may choose to withdraw the account value, in this case JPY 1.2 million, without penalty. He may choose to receive his principal back in equal annual installments over the 15 years, or he may defer annuitization and retain his income and death benefit guarantee.

Once the customer decides to take his income benefit, JPY 1.2 million is withdrawn from the separate account and invested in the general account. The customer will receive his original principal back, without interest, in equal annual installments over the next 15 years, in this case JPY 100,000 per annum. All of the investment income that The Hartford earns on the funds in the general account can be used to fund our obligations. We clearly have time on our side.

Before leaving this slide, I want to briefly address the concept of net amount at risk or NAR. NAR is simply the difference between the guarantee and the separate account value for in-the-money guarantees. In the example -- in this example, the GMDB net amount at risk at the end of year 10 is JPY 300,000, being the difference between the death benefit guarantee of JPY 1.5 million and the account value of JPY 1.2 million. The GMIB NAR is also -- at year 10 is also JPY 300,000 since the customer can elect to receive their full principal back over 15 years. The GMDB NAR and the GMIB NAR is not additive. A customer can collect either the guaranteed death benefit or the guaranteed income benefited but not both.

With that as background, let's now take a closer look at some of the net amount at risk numbers we publish in our financial statement. We get a lot of questions on retained net amount at risk. I want to take a minute to explain what retained NAR is and what it is not. At The Hartford, retained NAR is the difference between the guarantee and the account value for all in-the-money accounts, offset by reinsurance. Retained NAR is not a good measure of true risk.

A simplistic NAR calculation significantly overstates The Hartford's retained risk for several reasons. First, GMDB NAR assumes all policyholders die on the valuation date, clearly unrealistic. Secondly, GMIB NAR does not reflect the investment income that the company can earn during the payout period. Finally, retained NAR reflects reinsurance but not hedging.

The NAR data from our financial supplement provides investors a directional proxy, the changes in GMIB or GMDB liabilities. As you can see in the table, Japan's retained net amount at risk dropped by $400 million in the year ended June 2011. You might have expected the NAR to decline more rapidly, given the market rebound over the period. The primary reason we saw only modest declines in NAR was that positive returns on the separate account were largely offset by yen strengthening, and a stronger yen increases the value of the guarantees relative to the underlying assets. To sum up, NAR is not a good measure of economic risk, but trends in NAR can be used as a directional proxy for changes in value of the underlying guarantees.

We believe that many customers will elect to begin income payments once they are eligible. Virtually all of the contracts are in the money. We have reflected these assumptions in our reserving and modeling. The chart on this slide shows the account value by year of initial income benefit eligibility. This information, along with the current net amount at risk for each year, is in our 10-Q. The point that I would like to highlight is that we do have some time for markets to recover. In fact, more than 55% of policyholders are not eligible to receive income benefits until 2016 or later.

Once income benefits start, they are paid out over many years, and our risk profile changes significantly. Funds move from the separate account to the general account. Separate account equity and currency risk exposure ceases. Death benefits and policy fees cease, and primary risks shift to credit and rate, similar to a period-certain fixed annuity. The diagram on this slide provides a simple stylized representation of movement of assets from the separate account to the general account. Time is on our side.

Pre-annuitization, account values could recover. After annuitization, all of the net investment income we earn on the general account can be used to fund future income payments. As a matter of fact, if the separate account grew by 2% per annum, net of fees, and we earn 2% per annum on the balance in the general account during the payout period, the policyholder funds plus the investment income is sufficient to meet all benefit guarantees.

With that overview of the policy benefits, let's talk about the advances we've made in our risk management approach for the Japan portfolio. We now have all of the analytical tools and models we need to manage a dynamic multi-Greek hedging program. We have evaluated a number of approaches to transfer or mitigate the Japan risk, and we firmly believe that, that dynamic hedge program provide the best risk return to shareholders today.

The Japan hedge program is comprehensive and robust. Essentially, it is very similar to our GMWB program that we have been running successfully for 7 years. It also addresses the currency component associated with our Japan VA block. The program covers major market risks, and it employs a wide range of financial market instruments. Option cover will balance the trade-off between the cost of implied volatility and the related dynamic rebalancing costs. Furthermore, the benefit of gammer and jompriss [ph] protection increases as we approach annuitization and there is less time for markets to recover from any discontinuity. Our use of options cover will reflect this.

Hedges are dynamically rebalanced against a range of preset risk sensitivity or Greek limits. Liz already mentioned the significant investment in our ERM resources and capabilities. Our hedging is subject to complete risk management oversight, including regular stress and scenario testing to ensure the impact of adverse market conditions remain well bounded and within risk capacity. In effect, what I've described and what has been implemented is what you would expect to see from a robust, well-managed dynamic hedge program.

However, there is an additional component I also want to address. With the Japan block in runoff, we are doing extensive runoff cash flow stress testing. Our goal is to ensure that our hedging program delivers realized cash flows within our risk tolerance, even under adverse market conditions. We project all cash flows associated with the runoff, including fees, claims and expenses and the benefits and costs of our hedging program. The cash flow projections and runoff stress tests extend out over 15 years. Again, our aim here is to ensure that runoff costs or net unfunded cash flows remain well bounded within our risk tolerance.

Let's take a closer look at our approach. This slide shows a stylized representation of the components of cash flow runoff. The green bar represents the contract fees, net of expenses. The gray bar represents the cumulative benefit payments under the income or death benefit guarantees. We earn investment income on the general account during the annuitization phase, the light green bar. We have payoffs and costs from our hedge program and existing reinsurance, represented by the light blue bar. Together, these items constitute a simple representation of the cumulative cash flows of our Japan VA block as it rolls off our books.

By way of summary, modeled cash flows are cumulative over 15 years, independent of any accounting regime, pretax and not discounted. The Japan hedge strategy is designed to limit net unfunded cash flows even in very adverse market scenarios. Net unfunded cash flow is the difference between cumulative cash flows and the on-balance-sheet financial resources supporting the block. The on-balance-sheet resources are represented by the solid blue bar. They include our Japan VA statutory reserves, whether held in the U.S. or in Japan, and the statutory surplus in Japan. We model cumulative cash flow and any net unfunded cash flows across a wide range of different scenarios.

Slide 51 shows that in a benign market scenario, net cash flow is positive. The chart on the left shows the market assumptions underlying this benign scenario. The scenario run was performed on August 31 policy and market data. In terms of market developments, we assume interest rates follow August 31 market-implied forward rates.

For example, the Japan 10-year swap rate is 2.4% after 5 years. The U.S. dollar/yen exchange rate is held flat at 76.5, and the equity market has been set to grow only at the current swap level, such that the S&P is at 1206 after 5 years and the Nikkei at 8,424. So while I have labeled this scenario benign, I expect a number of you may consider this actually a rather harsh scenario. Cumulative cash flows on this scenario are negative $2.1 billion, which is offset by our June 30 reserve and surplus. The net cash flow in this scenario is positive $1 billion.

Even in an adverse market scenario, the net unfunded cash flow is manageable. This slide follows a similar format to the previous one, albeit with more severe market assumptions. This time, we assume interest rates move down from their August 31 levels by 100 basis points and remain flat thereafter. Resulting rate levels are floored at 50 basis points. For example, the Japan 10-year swap is held at 0.5%. The yen strengthens by 20% against the dollar to 61, and this is held flat. The equity market is modeled to decline to an S&P of 741 over the next 4 years and remain flat thereafter. I'm sure you will agree that this is indeed a very severe scenario. The net unfunded cash flow on this scenario remains very manageable at $700 million. During the development and calibration of our Japan hedge program, we performed many cash flow runoff stress tests.

While this scenario is indeed severe, some scenarios could produce larger net unfunded cash flows. This could occur, for example, when market levels are less stressed but follow a path that leads to higher hedging costs. Our program requires regular stress testing of runoff scenarios to ensure that any net unfunded cash flow remains within our risk tolerance. You will appreciate even from the 2 simple runs that I've shown today that our hedge program is designed to significantly reduce the convexity impact of adverse market conditions on the unhedged Japan guarantees. Indeed, as market conditions deteriorate, more hedging is required to protect our risk tolerance, such that in very adverse scenarios, all guarantee liabilities are fully hedged.

To reiterate, our hedge design and dynamic rebalancing narrows the range of potential cash flow outcomes, keeps net unfunded cash flows within our risk tolerance, and because we retain some risk, it allows us to benefit if markets recover.

To summarize, we have an effective dynamic hedge for the Japan business. The hedge is robust and is designed to limit any unfunded runoff cash flows to within our risk limits. The program is subject to ongoing scenario and stress testing, including cash flow runoffs. The hedging already in place has been effective, providing protection during the most recent downturn in the financial markets. As we measure it today, more than 90% of our required Japan hedge is in place, and program implementation is fully on track to be complete by year end.

Before I pass the podium over to Chris to address the GAAP and the statutory accounting implications associated with our VA hedging, I'd just like to return to my 3 key points: we have a comprehensive approach to manage our global variable annuity risk, we now have in place a robust dynamic hedging program in Japan, and we are hedging more of the market risk embedded in our variable annuity guarantees. We are pleased with the progress we've made and the level of protection we now have in place.

Thank you for your time. And now, I'd like to ask Chris to talk about the stat and GAAP implications. Chris?

Christopher John Swift

Good morning again to everyone. Thank you, Graham, for taking us through a very critical and highly complex topic that is important to the company. I believe the entire risk management team has made meaningful progress towards our objectives in this area.

So let's wrap up the Japan discussion. As you may recall, every third quarter, we perform an annual review of assumptions underlying estimates of gross profits that are used to calculate DAC and SOP reserves. As part of this year's assumption review, we incorporated an estimate of the long-term costs associated with the Japan hedge program into our accounting model. The estimated long-term hedge costs are 70 basis points and resulted in a DAC unlock charge of approximately $245 million after tax. This charge will not be recorded in core earnings since the hedge costs are reported in realized gains and losses, which are not part of core earnings.

As these costs are reflected in future earnings, return on net assets on a net income basis will be about 35 basis points lower. Just as a reminder, we start with a product in Japan that has approximately 70 basis points of ROA. Of course, the actual returns will fluctuate as mark-to-market impacts flow through the income statement. We also updated other assumptions that resulted in $135 million after-tax benefit to core earnings. This was primarily due to favorable policyholder development.

The Japan hedge will also impact our third quarter statutory results with the incorporation of the strategy into the reserve calculations. We estimate for this impact to consume statutory surplus of approximately $250 million. In addition to the DAC impact, the Japan hedge program will result in GAAP earnings variability. This variability is a result of the hedge assets being mark-to-market, reflected in realized capital gains and losses. However, the liabilities being hedged are not marked to market.

The chart on Slide 58 reflects a simplified view of the GAAP sensitivities. As you can see, the sensitivities have increased over the year. This is due to increases in the hedge program, as well as movements in the capital markets over the course of the year. In Slide 58, these are only the sensitivities for the Japan program. We will include updated GAAP sensitivities for all our global VA hedging programs in our third quarter Q.

I did notice a lot of attention being paid to the last section, so I think we'll take a break right now. We'll regroup in 15 minutes. And when we come back, I'll provide an update on the third quarter, and we'll finish the discussion with capital and our sensitivities. So 15 minutes, and we'll be back.


Christopher John Swift

Why don't you grab a beverage and we'll get started here and finish up with the Q&A and then we'll break for lunch. So we have time. Don't rush.

All right, welcome back, now that you're ready to go.

So let's start with third quarter updates. With the quarter just ended, we are still updating the third quarter DAC impact. As you can see on Slide 60 as a result of our annual assumption review, we will report an unlock charge of $230 million after tax to net income and an unlock benefit of $20 million after tax to core earning. Japan was about $110 million of the net income charge and the remainder was in the other segments.

In addition to the assumption update, we also reflect impacts of actual market levels, which have decreased since the second quarter closed. Using the midpoint of the sensitivities highlighted here, we would estimate a core earnings charge for the third quarter of $250 million. Combined with the impact of assumption changes, this results in a core earnings DAC unlock charge for the quarter of approximately $230 million after tax. The net income charge for the quarter is estimated to be approximately $500 million after tax.

We are still compiling results for the quarter, but I wanted to share a few additional items with you. We are estimating our catastrophe losses for the quarter to be approximately $200 million pretax or $130 million after tax. Roughly half of these losses relate to Hurricane Irene. As it relates to prior year reserve development, 2 items to note. First, we completed the annual environmental reserve study, which resulted in an increase to reserves of $19 million pretax. This was primarily due to increases in severity on a small number of the insurance. Secondly, for our ongoing operation, we recorded net favorable prior year development of approximately $21 million pretax.

With respect to investment, the net unrealized gain in our investment portfolio increased approximately $2.6 billion at the end of September 30, largely due to lower interest rate.

As it relates to statutory surplus, with equity markets down 14%, yen strengthening and historically low interest rates and because we are not fully hedged on a statutory basis, expect a decline in statutory surplus for the quarter. Some of the additional factors that will impact statutory surplus include the previously mentioned impact of the Japan hedge of approximately $250 million, our normal quarterly dividends from the Property & Casualty companies of $200 million, and $130 million of cat losses after tax.

Turning to Slide 62, we also wanted to provide you with an initial estimate of the impact of adapting EITF 9G, which redefines the criteria for determining the acquisition costs that can be deferred. We will be adapting this new accounting guidance on January 1, 2012. We will apply it on a retrospective basis. This means that we will recast all prior periods under this guidance. We estimate our DAC balance will be reduced by approximately 22% to 26% for a diluted book value per share reduction in the range of $2.78 to $3.38. This charge will be recorded directly against shareholders' equity, not 2012 earnings, and it will have no statutory effect.

It's premature to quantify the run rate impact to future earnings, but in general, we do not expect it to be material. DAC amortization expense will be reduced. This is positive to earnings, but the amount of cost that can be deferred will also be reduced, which is negative to earnings.

So with that, let's take a step back and take a broader view in discussing capital management. I thought it would be helpful to look back over the last 2 years and put both the environment and our activities into perspective.

First, from a macro view, the economic environment has been challenging with low interest rates, equity market volatility and a stronger yen. We have also seen increased expectations regarding appropriate levels of capitalization. This is true throughout the whole financial services industry, including the insurance sector. There has also been a recalibration of insurance rating, our cat experience and the de-risking of VA products in general.

At The Hartford, we have taken a number of steps. We've refinanced the CPP funds with a successful capital raise. We paid down debt, repositioned the investment portfolio and expanded our hedging of our variable annuity risk. We have also maintained strong capital resources while increasing our capital management activity, most recently announcing a $500 million equity repurchase program.

Turning to Slide 64 -- excuse me, 65, let's look at our capital resources. At June 30, we had approximately $16.9 billion of statutory capital. This includes the $1.3 billion in Hartford Life Insurance K.K., our Japan legal entity, a fact sometimes overlooked. Holding company liquidity is also strong at $2.1 billion as of August 31. This includes funds for the $400 million debt maturity later this month. We continue to actively manage our capital resources.

As I mentioned, we announced our equity repurchase back in August. However, given the economic and capital market environment, we have not yet begun the program. We will continue to be prudent and assess market conditions as we move forward with the program and completing it in early 2012.

Looking ahead, I expect P&C companies to generate annual statutory earnings of approximately $900 million. This assumes normal catastrophe losses and no prior year reserve development. We typically plan to dividend $800 million annually, which is consistent with maintaining strong capitalization of our Property & Casualty operation. On the Life side, statutory capital generation will be constrained in current levels. We do not expect statutory surplus generation in our Life operations through 2012, which has been factored into our capital management planning.

GAAP equity has significantly increased over the last several years, in large part due to the recovery in unrealized loss position of the investment portfolio. Book value per share is up 19% and debt leverage has declined to 27%. So in summary, our capital resources are strong and we continue to manage them prudently.

Turning to Slide 66. In managing capital, we balance a number of considerations. Regulatory requirements; risk management strategies; insurance company needs; and of course, shareholder considerations are also factored into our approach. With that said, we are managing the balance sheet to ensure sufficient capital and financial resources in a stress scenario.

We have learned from the past. Confidence in our capital position is paramount, particularly in times of stress. As a result, we assess our capital resources to ensure that in aggregate, we have capital in excess of 325% RBC ratio for our U.S. Life operations, 125% RBC ratio at White River Re, and AA capital at our P&C operations.

Many of you have asked about our capital targeted levels. To be clear, while these are threshold measures, we measure our capital resources in stress scenarios. They are not absolute targets. In the end, we must balance all of the different constituencies and considerations I mentioned earlier. Most importantly, we want to ensure our insurance operations are capitalized to effectively compete in their market segments.

Turning to Slide 67, we have assessed our capital resources against the same scenarios that Greg reviewed for the investment portfolio. I'm not going to go through all the specifics but will highlight a few key points.

In the stress scenario, we assumed the S&P drops to 800 by December 31, 2011 and increases 7.2% to 2012. The drop to 800 reflects a 30% decline from recent levels in today's environment. We have also various assumptions for interest rates, foreign exchange and investment-related impact. For example, you can see that we have included an additional 10% yen strengthening beyond an already historically strong yen in the S&P 800 scenario. We have also included incremental credit-related impacts in the stress scenario. Lastly, we assumed a low interest-rate environment in all the scenarios.

Let's look at Slide 68 and the results of the capital margins. Measured against the minimum capital threshold I described, we project a $3.9 billion capital margin in the baseline scenario. This scenario reflects the impact of the current economic environment through the third quarter and its impact on our margin. The margin increases in the bull market scenario to $4.4 billion. Most importantly, in a stress scenario, we project a capital margin of $1.3 billion in 2012. This incorporates pessimistic market conditions, including the impact of lower rates, stronger yen, lower equity markets on variable annuity reserves and required capital. Also included are higher incremental credit-related impacts as compared to the baseline scenario.

These projections do not include the $500 million equity repurchase, since we have not initiated the program yet. The margins also do not include other available resources, including our $500 million contingent capital facility or the utilization of our $1.9 billion credit facility. That said, as you can see from these projections, we have sufficient resources to support our businesses even in a stress scenario and execute the $500 million equity repurchase.

Turning to Slide 69, I also wanted to provide you a look at what drives the changes in capital margin. You can see the effect of hedging in the different scenarios and the impact to net VA result. Also reflected are the impacts of investments and lower interest rates. In the bull scenario, at the end of 2012, we create about $500 million of additional capital margin compared to the baseline scenario. This is largely due because of the decline in variable annuity reserves. However, because many of the hedges will decrease in value, they will largely offset the decline in VA reserves. We did not incorporate a benefit related to lower credit impacts or higher interest rates that reasonably could occur in that scenario.

In the S&P 800 scenario, you can see the opposite effect. Our VA operating impacts include an increase in reserves, reducing our capital margin by $8.5 billion, but the impact is meaningfully offset by $6.8 billion of hedge gains and lower capital requirements. As I think about it, the impact of hedging covers about 75% of the increase in required reserves in this scenario. This relationship would not necessarily exist in all scenarios. However, this does illustrate the dynamics of the VA result, net of hedging, in a declining market. This is why I referenced earlier that we would expect statutory surplus to decline in the quarter due to lower market.

Also, in the S&P 800 scenario, we have additional adverse impacts related to investment. These impacts -- these estimated impacts are significantly lower than what we experienced through the last crisis as a result of the de-risking actions Greg discussed earlier. And finally, we have included the effects of lower interest rates and other impacts to capital margin.

So in summary, we are committed to ensuring adequate capital and financial flexibility to support strong capitalization of our insurance operations and sufficient flexibility to meet holding company obligations. As you can see from our capital projections, we believe The Hartford has sufficient resources in a deteriorating economic environment supportive of our current ratings. I expect the Property & Casualty companies to continue to generate surplus in excess of their current requirements. Annual dividends from the P&C companies essentially fund the holding company obligations. The Life companies surplus generation will be constrained through 2012. And finally, we will continue to actively manage debt and the capital structure to maintain future financial flexibility.

All right. So let's wrap up in total. As I started with today, The Hartford has a strong balance sheet. We spend a good amount of time discussing the tools developed and the steps taken to actively manage the risk embedded in our variable annuity books of business. Greg and his team have made significant progress in repositioning the investment portfolio. We assess our capital resources in a stress scenario and believe we have sufficient capacity to maintain capitalization consistent with our current rating. All of these taken together is why I'm confident about our ability to manage the balance sheet and capital margins even in a challenging economic environment.

With that, let me ask Sabra to come up and lead us through Q&A session.

Question-and-Answer Session

Sabra Purtill

Thank you, Chris. I'd also like to ask the presenters to come join us up on the podium. And also moving into position, we have members of our finance leadership development program here with mics to give to people for the Q&A. I just wanted to note we have about 650 people on the webcast, so I'd appreciate it if you could all make sure you're speaking directly into the mic and also just indicate your firm and your name. With that, if you can turn around, Jeff Schuman, right there and we will -- sequence.

Jeffrey R. Schuman - Keefe, Bruyette, & Woods, Inc., Research Division

Jeff Schuman from KBW. Chris, it's interesting to see kind of the measures of the capital margin and the scenarios, and we've all probably kind of estimated similar numbers. But I guess, that still leaves us with a really difficult question of sort of what to do with those numbers. In other words, under your core scenario, you have $3.9 billion of capital margin, but the share repurchase authorization is $500 million and it's currently not being executed. So one could argue that one definition of capital margin is capital that you could lose, that you could redeploy today, and that number is apparently 0. So how should we take those capital measures and those scenarios and translate them into an expectation of what you manage to going forward?

Christopher John Swift

Thank you, Jeff. I don't think I would agree with your premise there. We have taken -- I'll call it, we haven't taken action yet on the share repurchase, but we based all those decisions earlier this summer on these, I'll call it, scenarios. I think you people have heard me. We talked about -- we've met with all the agencies with a great deal of transparency. We actually take a great deal of comfort with these results even in a stress scenario, where we have additional flexibility beyond that, and that's why we were comfortable doing that. I think when we announced the program in early August, I think arguably, you could say things had dramatically changed, even though we've modeled results consistent with some of those activities. So we thought it was just again prudent. There wasn't a sprint to get the share re-buyback done in a shorter period of time. We wanted to, I'll call it, pace it through a reasonable point in time, early 2012. I still believe that we can get that done and we plan to get it done in early 2012.

Jeffrey R. Schuman - Keefe, Bruyette, & Woods, Inc., Research Division

Scenario a good way to kind of think about what you need to manage to. In other words, a year from now, 2 years from now, would you want to be standing at a meeting like this and saying that you have $1 billion or several hundred million against a scenario like that?

Christopher John Swift

Yes, I think we said it 3 or 4 times, hopefully in the presentation, hopefully it was clear. I mean, we are managing the balance sheet to stress scenarios. I mean, we're very conscious of the impacts from the past and I want to ensure capital margin in those stress scenarios. So I can't make a projection of the future of what we would -- what those scenarios would ultimately plan for, but we do want to have a buffer in those scenarios, yes.

Sabra Purtill

[indiscernible] remind everyone, we've got a big room full of people. I'd appreciate if you could limit yourself to one question and then we can circle around and get back to you if you have follow-ups on others. Andrew has the mic here. Andrew and then Ed.

Andrew Kligerman - UBS Investment Bank, Research Division

Okay. This is -- all right -- I have 3 very short ones, really short ones.

Sabra Purtill

One, Andrew, one.

Andrew Kligerman - UBS Investment Bank, Research Division

The $250 million of statutory surplus, the costs from the hedging, is that an annual number? Or is that long term, you don't anticipate any more costs?

Christopher John Swift

Yes. The $250 million is the implementation cost, reflecting the Japan hedge program in our statutory AG43 accounting models, onetime.

Andrew Kligerman - UBS Investment Bank, Research Division

Could you give a sense of what the going forward cost would be?

Christopher John Swift

Again, it depends on how you define cost. We define it as 70 basis points for our DAC scenarios, but that is sort of a deterministic asset we have selected. I think we've always said, whether it be Graham, Liz, myself, that the ultimate cost of the program are sort of capital markets dependent and path dependent. So in up markets, the program will sort of consume resources. In down markets, actually, the program will provide benefits. So it really depends on how you view it. But again, for accounting purposes, Andrew, it's the 70 basis points that we estimated.

Andrew Kligerman - UBS Investment Bank, Research Division

And then I think I heard correctly. With regard to the U.S. variable annuity book, you hedge or reinsure 80% of it. Why not do the whole 100%?

Christopher John Swift

I'm going to ask Liz or Graham to respond to that, but hedge 80% of the U.S. book. That's what you heard?

Andrew Kligerman - UBS Investment Bank, Research Division

I think that's what I heard.

Christopher John Swift

Do you want to clarify that?

Andrew Kligerman - UBS Investment Bank, Research Division


Lizabeth H. Zlatkus

Yes, I mean, we always look at cost benefit. I think 80% is a large proportion of the total book and remember, we're looking at it on the totality of it. So it's not just WB [ph]. It's WB [ph], it's the death benefit, it's the entirety, and that incorporates the fact that we are a bit under-hedged, for example, on rate. So I think that, that's a good risk reward tradeoff. That still gives us opportunity, if markets go up, that we'll be able to share some benefit of that.

Christopher John Swift

Andrew, go back to the slide. I think what I referred to 75% effective hedging relationship with that -- in that scenario. So we were trying to illustrate and give you the details to show you the various components between increases in reserves and hedge benefit in different scenarios. I think we're trying to say that's illustrative in that scenario.

Andrew Kligerman - UBS Investment Bank, Research Division

And then just lastly, just -- I mean, for road map, what would trigger a buyback? I know you can't be completely explicit, but where does the market need to be? Where does -- where do interest rates need to be for us to be comfortable that there's a good likelihood Hartford's going to buy back those shares by the end of the year?

Christopher John Swift

Well, just to be clear, we've said early 2012. So...

Andrew Kligerman - UBS Investment Bank, Research Division

I am sorry. By early 2012. I was pushing you.

Christopher John Swift

We listen closely. So early 2012. Again, as we've said before, since we announced it, things changed a little bit. We wanted to be prudent. I think also, we had various restrictions from a securities laws perspective. We are in a blackout period right now with the quarter. So I mean, there's things that we need to manage around to execute that. But I would say, again, in early 2012, I think you could see us to begin to actually activate the program.

Andrew Kligerman - UBS Investment Bank, Research Division

So assuming everything is comped [ph] right now...

Sabra Purtill

You're at 4 now, Andrew. So I'm passing the debt. You're cut off. You overran your limit.

Edward A. Spehar - BofA Merrill Lynch, Research Division

Ed Spehar from BofA Merrill. Chris, can you give us a sense what you consider to be the total annual hedge costs on an economic basis, and -- so not just Japan? And how much of that is actually reflected in the core earnings number?

Christopher John Swift

Thank you for the question, Ed. It's -- when you look at things in totality, I'll let Liz and Graham speak about it too, I don't think you could look at it that way, because the way I look at it is each of the risk in the programs that we manage are structured differently. So -- or maybe for instance, the WB [ph] program in the U.S. has one set of tolerances. The Japan tail hedge program has another set of tolerances. We do other certain macro overlays for the entire portfolio that we've talked about, sort of from an option premium side has set a cost. So it's very hard to sort of generalize what do we spend, what's reflected in core earnings. I think all our disclosures, hopefully, will give you a path where you could see at least the components and put it together overall, but I don't think about it, what are we spending that's reflected in core earnings? I think about the risk exposures, what do we want to manage to from an outcome incident [ph]. Sure, we have positions and programs that protect us in that scenario, but there clearly is a cost.

Edward A. Spehar - BofA Merrill Lynch, Research Division

No, but the primary question isn't, what's reflected in core earnings? It's, what's the economic cost? And I guess from the outside looking in, I'm not smart enough to figure that out from your disclosures and I'm not sure there are that many people in this room are that smart either. Sorry, I don't mean to insult you. But I mean, I guess the question is how do you -- if you can't sort of put of a number on what the economic costs are, forget about the core earnings, how do you figure out how to price a product? I mean, I don't understand the whole idea of, it's path dependent. Does that mean there's a lot of roll risk? The hedges are 70 basis points, but if something bad happens, it could go to much higher than that.

Christopher John Swift

I would break it up into 2 things and I'll let Liz comment. Some of it's from, what I was referring to, is the balance sheet and managing the existing positions and where we are today and the outcomes we're trying to manage to. I mean, from a new product side, and I'll call it a rollout of new products, I mean, we have a clear understanding of the hedging cost and the impacts on IRRs and return on equity. So again, I was just talking more from a balance sheet side and not necessarily a new product side. But Liz, would you add anything additional?

Lizabeth H. Zlatkus

Yes. So, Ed, I understand your question. So a couple of things. First of all, try to see it in the financials because as Chris has alluded to, you're going to have different -- some assets are mark-to-market, where the benefit of the hedges -- for example, if you have hedge gains and down markets, that's a benefit, right? So first thing I'd say is, if you want to look at the income statements on the WB [ph] hedge, you see the sensitivities in the Q and you also see them for the rest of the Japan hedges. So I guess I'm saying in the Q...

Edward A. Spehar - BofA Merrill Lynch, Research Division

That's GAAP, but that's GAAP again...

Lizabeth H. Zlatkus

That's GAAP...

Edward A. Spehar - BofA Merrill Lynch, Research Division

Yes, I don't care about that...

Lizabeth H. Zlatkus

On an economic basis, we run a lot of scenarios. So on a new products, we run a kind of a range of stochastic scenarios and that's when we say up front, we think to hedge this cost, hedge this book at the money, because you're selling a new product at the money. It could be 30 or 40 or 50 basis points, whatever the feature is, depending on the features and volatility levels, et cetera, at that time. The reason to say what's the economic cost of our imports book is a little bit more challenging is because we're already in the money in some of the cases, so that cost is obviously higher than what we had originally priced for. But bottom line, if markets go up, then you want to assume that in your models, like a DAC reversion to the mean upward in your models, then that's where the numbers that Chris has alluded to would be the economic cost also.

Sabra Purtill

Tom, and then we'll do Randy.

Thomas G. Gallagher - Crédit Suisse AG, Research Division

Chris, the $1.3 billion capital margin in the bad scenario, what does that assume for the holding company? Does that assume you need a minimum buffer there?

Christopher John Swift

Yes, that's a good question, Tom. Thank you. Like we've said with capital and liquidity, it needs to flex during times of stress. Those structural targets that we've talked about and some of the targets that I've talked about, holding 2x holding company cash currently needs. I think realistically, we need to flex it in that scenario. But the way we look at it in aggregate, the capital and the liquidity resources are available in the firm and we've gotten the experience moving it around the firm in different scenarios to manage the different outcomes to ensure that the capitalization of the entities are appropriately capitalized.

Thomas G. Gallagher - Crédit Suisse AG, Research Division

So the [indiscernible]

Christopher John Swift

No, it's a good, good point. Thank you. I mean, I think some of the additional tools that we've added from experience in the crisis is we've gotten a preapproved Connecticut sort of $2 billion liquidity facility amongst all the legal entities. So it sort of looks like an automatic lending agreement, so that all the Connecticut-based legal entities, we could lend money to. We also have other tools in place that I think we've learned from the crisis, to help with the fungibility of capital and the fungibility of liquidity in the organization. So I'm pretty confident, Tom, that we could manage the appropriate holding company needs and legal entity needs.

Thomas G. Gallagher - Crédit Suisse AG, Research Division

But just to follow-up, so if one was to make the assumption that you need a minimum, say, $500 million to $700 million at the holding company, you'd need to deduct that off of your buffer.

Christopher John Swift

Yes, that's the total buffer. So again, it depends on how you want to define in a stress scenario what you think the holding company needs are. Right now, we're holding 2x holding company needs, but I would say that has the ability to flex during a stressed environment.

Sabra Purtill


Randy Binner - FBR Capital Markets & Co., Research Division

Randy Binner, FBR Capital Markets. I'd like to try and bridge some of the scenario testing for the Japan VA that Graham made up to the overall capital margin comments, and so -- we appreciate the cash flow scenarios that Graham laid out, but they do involve you using up all your reserves and perhaps some or all of your surplus. So I guess the first question is, what happens there? Does that become a capital call? And if so, when? And are these scenarios reflected in the other scenarios for the higher level of the overall company?

Christopher John Swift

Graham, I could take that one. There's 2 aspects here to your questions, scenarios and then sort of the capital implications of them. I think from the scenarios, these are cash flow scenarios of how we're projecting the block would run off. The overall capital margin scenarios are the ones that we defined. Clearly, I mean, down markets, whether it be yen strengthening, down global equity markets, low interest rates, are reflective of a stress scenario including how the Japanese book would be reflected. So we think the overall capital scenarios that we put together are reflective of reasonable stresses. Graham was trying to illustrate in a couple different cash flow scenarios how the block would run off.

Randy Binner - FBR Capital Markets & Co., Research Division

But just to be clear, I mean, if you breached the end of the capital over in Japan, I would assume the Japanese would want more capital. So is that a capital call against the rest of the company? And if it happened, would it not happen until like, 2016?

Christopher John Swift

There is time. I mean, we've always said, time is our friend because again, the guarantees don't need to be funded upon annuitization. They'd be funded through reinsurance back to the Japan entity over time. So again, I don't think there would be any immediate cash call on Japan. There's no shock scenario that we see right now that would require injection of capital into Japan. It would just slowly emerge, that we would just have to put up additional resources to cover the Japan liability.

Randy Binner - FBR Capital Markets & Co., Research Division

You really wouldn't know until 2015 and 2016, right? Because you don't know what you have until the money...

Christopher John Swift

Well, even beyond that, Randy, because I think people have heard me say in other settings, right? I mean, the annuitization window really begins in '14 in earnest to lock in those guarantees, but the cash has been paid out 15 years to the policyholders where in essence, 1/15 of the guarantee that is locked in at annuitization would need to be paid out. So there really is no upfront cash required and that's why, again, we've always felt comfortable managing the Japan capital. We think we have adequate capital there, and then with the reinsurance protection in place, that's how ultimately the policyholders would be made whole.

Sabra Purtill


John M. Nadel - Sterne Agee & Leach Inc., Research Division

John Nadel from Sterne Agee. Chris, I've got a question. I'm just trying to reconcile some data on Slide 58 and some data on Slide 60. I know you don't have it in front of you, so the Slide 58 talks about the Japan VA hedge and the GAAP sensitivities. It says at September 30, that an equity market move, plus or minus 1%, is $47 million either way pretax on DAC. On Slide 60, in one of the bullets, it says that your quarterly DAC unlock for 3Q is $5 million to $15 million in Japan. How do we reconcile the 2? Is Slide 58 a gross number and Slide 60 is the net? Is -- could you help explain that?

Christopher John Swift

Yes. The first slide, 58, I think that has the GAAP sensitivities, relates to the hedge assets only. So you would view it as sort of gross hedge assets only because the Japan liabilities aren't mark-to-market, so we don't have a natural net offset. So those are the gross impacts due to market movements, due to hedge positions that we would have that are reflected in realized capital gains and losses. Sensitivity is more from a DAC unlock perspective each quarter. So I view them somewhat separately, John.

John M. Nadel - Sterne Agee & Leach Inc., Research Division

Okay, okay. And then just my follow-up question, just following up on Ed's question, and maybe we could just focus on the 70 basis points and think about the duration of the hedges that you've put on, on the Japanese business. At what point does that 70 basis points have risk of shifting up or down?

Christopher John Swift

Again, that is the accounting perspective of sort of running the multiple scenarios and determining sort of the meaning of all the scenarios that we use to project that path. I think you could think about it the way we do, is that we're really hedging from now and through the annuitization windows mostly. Most of the FX and the equity protection are designed to protect us during the next time period, from starting now through the annuitization window. Then it becomes a cash management strategy, once all the assets come back onto the balance sheet, and it's how Greg and his team are going to earn gross NII for the benefit of the policyholders.

Sabra Purtill

Mic, where's the current mic? Can you give it to Nigel?

Nigel P. Dally - Morgan Stanley, Research Division

Actually, I want to follow up on that. I guess, just to understand the 70 basis points again, and then I want to reframe it back into earnings. So if the markets perform according to your EGP models, then theoretically you would have an economic cost of 70 basis points per year.

Christopher John Swift


Nigel P. Dally - Morgan Stanley, Research Division

Okay. So the way to think about it would be you have $200 million in core earnings roughly on the Japan business and then you're going to have a below the line hit of 70 basis points, but the real economic earnings is the difference between those 2 if the markets follow your EGP models. Is that the right way to think about it?

Christopher John Swift

The way I think about it -- I think people have heard me talk about the Japan product. It's a fairly rich product. We consider it right now making about 70 basis points after tax. Once we reflect all of these hedges are starting to flow through the income statement, we'd expect that 70 basis points to come down to about 35 basis points. We have less DAC amortization, more hedging cost. The Japan product on average, we expect to earn about 35 basis points net after tax right now.

Nigel P. Dally - Morgan Stanley, Research Division

Okay. So the way to think about it, putting the accounting to the side, is it's a $200 million a year business. That goes down to $100 million if it follows your EGP models.

Christopher John Swift

More or less, yes.

Nigel P. Dally - Morgan Stanley, Research Division

Okay, and then just a follow-up. From an earlier, I think it was Graham's presentation, we talked about the $700 million that would be needed to fund the Japan in that kind of dire scenario, but then you kind of used the words "risk tolerance" a couple of times. I mean, what is the number that you came to on an ultimate risk tolerance? We will not take more losses than this number.

Graham Bird

What I prefer to do here is refer you back to the examples that I showed to let -- we indicated what I call the benign scenario, and we also showed an adverse scenario, and you can see in both of those scenarios what the outcomes are. And in both cases, I said that they were manageable. We have lots of limits and tolerances across all of our market risks, whether they be credit, equity, rates, FX, and it's not really prudent for us to actually be absolutely specific about those limits, given that we are executing hedges in the market and with the information that we've already provided if we were prescriptive and specific about details of our market limits. That could actually be to our disadvantage as we were executing hedges, and I think that's pretty typical of most financial firms.

Sabra Purtill

Can everybody who's got a mic in their hand right now just hold their hand out? Okay, so let me do Eric, and then I'll do Nigel.

Eric N. Berg - RBC Capital Markets, LLC, Research Division

Eric Berg with RBC. So your message that The Hartford would fare well in difficult environments, that message is coming through loudly and clearly at least according to your models. You say that. But I guess my question is, because the 10-Qs show that there had been several occasions -- I don't know how many but certainly enough to think about -- in which your models predicted one level of earnings impact and the actual impact was materially different from what the model said it was going to be, why should we be comfortable that these models today are any better than those that had problems per the 10-Q?

Christopher John Swift

Eric, thank you for the question. To me -- Graham mentioned it. I mentioned it. I agree we looked at things fresher over the last 18 months, 2 years, and again, not knowing all the history or maybe [indiscernible] I can appreciate the perspective. I'd just say that, look, we've looked at things fresh. We've updated -- a lot of lessons learned. We've updated our understanding of particularly statutory accounting in all our models. I believe that the statutory impacts and the economic impacts that Graham is trying to manage to are closely aligned. We will always have some breakage, but I think you've heard me say we're going to manage on an economic basis and we'll explain the statutory and GAAP impacts and plan for them accordingly. And I think we have our arms around the model. I think we have our arms around the Japan situation. I think we know and learned from the past, Eric.

Eric N. Berg - RBC Capital Markets, LLC, Research Division

[indiscernible] this whole exercise sort of presupposes that the models correctly capture how the world will work from a cash flow statutory capital perspective. It might be a useful exercise to report down and highlight what you forecast on an ongoing basis, which is just a suggestion, what you forecast the models would do versus what actually happened. It would increase our confidence in your forecasting capability.

Sabra Purtill

Nigel, and I just wanted to note, we are -- got like 2 or 3 more minutes for questions, so what I wanted to note is obviously, we have a lunch and buffet afterwards, and we can catch up and answer more questions. We'll do Nigel and then Tamara and then we'll break for -- or have the concluding remarks.

Nigel P. Dally - Morgan Stanley, Research Division

Nigel Dally, Morgan Stanley. I wanted to focus on the different scenarios and look at the interest rate piece. It seems like the 2012, all of your scenarios have interest rates going higher, so what would be the sensitivity of capital to rates being at today's level or below? I guess there's a difference of 40 basis points between your base and stress. That equated to roughly $0.7 billion. Is that reasonable to use that?

Christopher John Swift

Yes, again just a background. We developed the models and updated our models as of August when things were a little different, so things have changed. Just given the preparation -- we have not actually rerun new models at that point in time, so I wouldn't want to speculate, but there would be a little more pressure from a rate side, but I don't think it would be significant. But I don't have a precise number for you.

Nigel P. Dally - Morgan Stanley, Research Division

But I guess to say, if it's going to -- looking at the difference between the base and the stress, that was $700 million. Is that going to be a linear-type function?

Christopher John Swift

In that $700 million we're referring to, it's -- we call it interest and other. So there's an other component, and I would say that other component is probably 40% of that number. So there is interest sensitivities that obviously you can see that we model, but that other category is about 40% of that total $700 million.

Tamara Kravec - Banc of America

Tamara Kravec, NWQ. Just looking at Slide 57, you're delineating there the 70-basis-point cost on non-core, but then you have the core increase of $135 million from policyholder behavior, so I'm just wondering what assumptions you've made. Is that a onetime impact or something that you'll be changing as these policies continue to go through time?

Christopher John Swift

Thank you for the question, Tamara. The $135 million, again, is a onetime assumption update. It is ultimately reflecting that policyholders are staying longer with us than we anticipated. They are lapse assumptions, I would say, or conservative or high for DAC purposes, so we really just have more fee income that we're earning during the accumulation period. So we think we've adjusted for what we think is the ultimate lapse rate in the book, which we think is low. So I would not view it as a recurring sort of adjustment to core earnings.

Sabra Purtill

Great. Well, with that, I'd like to turn the mic back over to Liam for some concluding remarks.

Liam E. McGee

Great, thank you very much. I just want to briefly, again, say to all of you, thanks for coming. Thanks for all of your questions and participating. I hope we were able to provide you with a more clear and thorough perspective of The Hartford's balance sheet, capital strength and risks.

But before we close, I want to -- I always like to begin with what we hope to accomplish and then go back to it. So I hope I can reiterate now a few key beliefs that I hope you now share.

First of all, The Hartford's balance sheet is strong. Second of all, I think we've been candid that while challenges exist, our risks are significantly reduced and manageable. The Hartford's risk management capabilities are meaningfully enforced, and we have the strength to maintain sufficient capital levels, consistent with current ratings, even under significant economic stress. And finally and perhaps most importantly to me, I hope you sense now that management is running the company with discipline and a focus on generating value for shareholders.

Again, I appreciate your time. The entire Hartford team does. I just want to thank you all for coming, and let's have lunch.

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