Hartford Financial Services (NYSE:HIG)
Q4 2007 Earnings Call
January 25, 2008 10:30 am
Ramani Ayer – CEO, Chairman of Exec. Committee
Thomas Marra – President, Chief Operating Officer
Neal Wolin – President of Property Casualty Operations
David Johnson – Executive VP and Chief Financial Officer
Mark Finkelstein – Fox-Pitt Kelton
Thomas Gallagher – Credit Suisse
Darin Arita – Deutsche Bank Securities
Andrew Kligerman – UBS
Jay Cohen – Merrill Lynch
Good morning everyone. I am going to touch on several highlights for 2007 and where are headed in 2008. We are very pleased with company’s strong 2007 results. If you turn to slide3, you will see that our solid fourth quarter finished off a record setting year for us. Net income for 2007 came in at $2.9 billion, a record for the company. Core earnings rose to another full year record $3.5 billion. Core earnings per share were up 21% over 2006 to $10.99 driven by double digit core earnings growth both in our property causality and life operations. Book value growth again in last 12 months exceeded our long term growth goal of double digit growth even with market challenges we face in the second half of 2007. Since the end of 2006, book value per share excluding AOCI is up 11% and our return on equity topped 15%. As you know, the credit markets remained extremely volatile in the fourth quarter. This volatility contributed to the $429 million of net realized losses recorded in the fourth quarter. Obviously, we do not like seeing losses of this magnitude in our portfolio. Our investment professionals are actively managing a diversified $95 billion general accounts portfolio. With most of the portfolio invested in fix maturities, it is difficult to avoid credit losses in markets like these.
Now, the first few weeks of 2008 have seen a continuation of market volatility. Investors are now looking at credit risk across a number of investment categories and the latest area of concern is muni bonds in light of the issues faced by bond insurance. We hold about $13.5 billion in muni bonds and slightly half of these securities are wrapped with insurance. As David will cover later in the call we don’t expect the bond insurer’s current trouble to have a material impact on The Hartford.
Now, turning to slide 4 you will see that we continued to execute well in competitive markets. In our life, operations 2007 saw record core earnings of $2 billion up significantly over 2006. Large record profitability was driven by successful asset accumulation over the past 12 months with $53 billion in deposits. US variable annuity deposits represented over $13 billion of that total, up 9% over 2006. The recent decline in US equities may put some pressure on near term industry sales. Over the longer term though, we think periods of heightened volatility will reinforce the value of living benefit guarantees for customers and financial advisers. This is exactly the type of market where benefit guarantees prove their worth, giving increasing longevity the typical retiree must allocate a meaningful proportion of their assets to equities.
And so, if you take a hypothetical 69-year-old retiree. Assume she has an investment portfolio consisting of several mutual funds, some cash and a variable annuity with living benefits. With headlines clamoring about Wall Street volatility, she is going to be sleeping much better at night than if she did not have the safety of a guarantee. She knows that she has an income stream that will continue to deliver regardless of what happens of these markets. So, with that in mind I am looking forward to the new VA product we will be introducing in May. This new product should help us improve deposit and flows in the second half of the year.
Tom will discuss our Fourth Quarter life performance in more detail, but I have to say that I am impressed by the progress we made in 2007 in our retail mutual fund and retirement plans businesses. Assets under management in these two businesses grew at a combined rate of 22% last year. These fast growing segments are important elements of our longer terms strategies to diversify our life earning space. In property and casualty, I am please to report record core earnings for 2007 up 10% over the prior year. We benefited from favorable weather, our underwriting profitability was healthy and investment income was strong. PNC competition has been and continues to be intense with new business difficult to come by.
During 2007, we introduced a number of initiatives aimed at retaining more of our most profitable business. These efforts did bear fruit in the Third and Fourth Quarters of increase Policy Retention Levels in several lines. We think competition will remain tough in the coming year, but we do not expect pricing to be come broadly irrational. That is why we believe we can achieve modest premium growth in 2008.
And finally, we finish 2007 in a strong capital position. We spend the last few years building our capital resources and enhancing our risk management capabilities in order to navigate the types of markets we are facing today. When we first introduced the concept of a capital margin, our goal was $500 million. As our business grew we increased the margin to $1.5 billion and that margin is in place today, and we have tremendous liquidity. The company has the capital resources and flexibility to ride out the current market instability while competing vigorously in our business line.
And before I hand out to Tom, I would like to comment briefly on last week’s announcement that David Johnson will step down as The Hartford’s chief financial officer. I really say that with regret as the board of directors and I accepted David’s resignation. David has been a highly valued advisor and partner on financial and strategic matters on last seven years to me and my management team. He has consistently challenged our organization to improve the quality and transparency of our financial reporting and all our public disclosures. And it is important to note that David will be staying on as our CFO until the middle of the year. In the meantime, we are committed to finding the very best candidate to fill this critical role. Let me now turn this over to Tom to provide additional details.
Before I start, I just want to echo Ramani’s comments on David Johnson. I think everyone on this call knows David to be enormously talented and has contributed greatly to The Hartford’s success but just want to add on the behalf of the management team that he has also been a great teammate and a superb business partner and I personally look forward to working with him as does the rest of the management team over the next few months.
Turning to the quarter, our property and casualty results are highlighted on slide 5. Our property casualty operation finished a record year for core earnings with solid performance in the fourth quarter. Core earnings were $414 million. This marks the fourth time in the last five quarters that core earnings pushed above the $400 million mark. Good underwriting results, favorable weather and prior year reserve releases has helped us achieve these very good results. Written premiums were $2.5 billion in fourth quarter, 4% below last year. Even though our top line has declined, we grew policies in force in personal lines, small commercial and middle market over the past year.
Our fourth quarter combined ratio is 91.1% in ongoing operation, including 2.6 points of cap losses. That is a very good result, considering recent industry trends. Of course a number of items affected the quarter, including 4.8 points of prior year reserve releases. The releases were partially off set by some reverse strengthening for the ’07 accident year in higher than usual policy holder dividends. The impact of each of these items varies by business and since all the details are in our IFS I would not go through every segment. Instead I would like to focus on the key trans we see shaping our outlook for ’08.
Slide 6 shows the underlying trends in Accident Year Combine Ratios. It shows the underlying trends in accidents combine year ratios for the past two years, alongwith our ‘08 outlook. These numbers exclude catastrophies. We also have adjusted ’06 and ’07 to exclude the divested omni business and the benefits we received from citizens’ assessments and recruitments.
I want to make a couple observations. First, our ’08 guidance reflects only a modest increase in the combined ratio for ongoing operations. We believe our property casualty business will deliver return on equity at or above our targets with up to 3% top line growth. Of course, this all assumes a normal cat year. Our 2007 accident year combined ratio for ongoing operations, excluding catastrophies, was 2 ½ points, higher that the prior year. In 2008, we expect continued margin compression from lower pricing and higher loss cost. That said The Hartford is well prepared to navigate the space of this cycle. We have specific tailored action plans for each segment of our business. We have seen more competition in personal lines of small commercial, but these lines remain largely rational. Loss cost will trend in slightly higher are still quite manageable. We have the opportunity to grow these businesses in ’08 at very attractive margins. Our game plan is to grow our top line through expanded distribution and we will all drive our competitive position and profitability through product enhancements, leading edge pricing and underwriting technologies and ease of doing business.
We are planning to increase marketing and add another one thousand new agents in personal lines. We are also introducing refined rating plans for both AARP and Dimensions for early in the year. In small commercial, process improvement and technologies such as expressway are making it easier for agents to do business with us. And our recent product enhancement are showing promise. The commercial auto-product we launched last December is generating more opportunities to quote and more sales. Overall, I am optimistic that we have the right initiatives underway in personal lines in small commercial. In 2008, we should see continued increases in policies in force and modest growth in premium, all at attractive returns.
In middle market, we are seeing the effects of several years of moderate pricing declines on a written premium in combined ratio. State mandate reductions in workers’ compensation rates are also dampening premium growth. Even so, our outlook for ’08 is for solid mid-90s, accident year combined ratios, excluding catastrophies. We believe that we can achieve these results through our relentless focus on retaining our profitable costumers and managing our business mix. We are competing aggressively for new businesses in select classes and regions, where historically, we have earned very good returns. In addition, the new commercial auto product is generating new business opportunities, particularly for companies with fleets of less than 25 vehicles.
Our discipline and underwriting expertise in the middle market is clearly paying off. This is the second quarter that we have improved premium retention even with the lower written pricing. In 2008, we expect modest premium decline with good underwriting margins. Specialty commercial wrote about $1.5 billion of premiums last year, and reported excellent accident year combined ratios. Industry profitability has driven excess capacity in many of these lines and competition is intense.
Our focus for businesses like professional liability is to expand our product offerings to middle market and small commercial customers. In other specialty lines, we are selectively writing and renewing business that meets our target returns. So, no doubt that competition has increased in every segment of our property casualty business. That said, we believe that we have initiatives in place to strengthen our position in the market while delivering good returns for our shareholders.
Now, turning to slide 7, life operations had another quarter of strong performance. Core earnings for the quarter were $457 million, a 16% increase over last year. The total assets under management were up 14%. The chart on the left breaks out the growth of our asset management businesses. As you can see, strong net flows in the markets drove AUM growth. Total deposits were $11 billion in the fourth quarter and $53 billion for the full year. Net flows for the full year were $15 billion, up 26% over 2006.
In our US variable annuity business, fourth quarter deposits were $3.1 billion, flat to last year. Variable annuity net outflows for the quarter were in line with guidance at $1.1 billion. Given current competition and market conditions, we expect first quarter variable annuity sales of $2.4 billion to $2.8 billion. As you know, we will be launching a new product in May. For competitive reasons, I can’t provide you with product details now, but our guidance reflects stronger sales and net flows in the second half of the year.
As Ramani said, the performance of our mutual funds continues to be outstanding. More than half the equity funds we offer are ranked four or five stars by Morningstar on a load rate basis. Our portfolio of strong retail mutual funds helped to drive fully year net flows above $5 billion. Fourth Quarter retail mutual fund deposits were $3.5 billion, a 14% increase over the last year. The net flows for the Fourth Quarter were $1.3 billion. I am pleased to say that our efforts to diversify our fund flows are also gaining traction.
In the fourth quarter of 2007, deposits through the company’s equity funds, beyond our most popular equity fund more than doubled over the prior year. Our Japan variable annuity business topped of a strong year with another quarter of good performance. Solid net flows over the past year drove assets under management up to 13% to 4 trillion Yen or $36 billion. And the earnings contribution from Japan is growing significantly with over 14% of 2007 life core earnings coming from Japan.
As we expected, the implementation of the Financial Instruments and Exchange Law (FIEL) slowed sales of investment products in the fourth quarter. Our deposits for the quarter were 123 billion Yen, or $1.1 billion representing a 11% decline on a Yen basis compared to last year. We continue to believe the changes adopted under FIEL should work their way through the system by the end of the first quarter.
As FIEL settles into the mainstream, our Japan operations remain focused on the capabilities that have proven successful, offering a compelling value to customers, building a market leading distribution system, and introducing innovative products.
In February, we will be introducing a new VA product in nine of our distribution partners. We also plan to introduce another variable annuity, as well as mutual funds later this year.
Turning to institutional solutions, full year total deposits surpassed $11 billion in 2007. Strong sales were reported in bank and life insurance, structured settlements, and institutional mutual funds. Our deposits for the fourth quarter were $1.5 billion. But given the current low-interest rate environment, it may be difficult to match our 2007 sales results in ’08. But we now have $68 billion of assets in institutional solutions and it is that asset base that will drive our earnings.
Life protection businesses also performed well this quarter. Total life insurance in force for individual life was up 9% over the fourth quarter of 2006. Solid full year sales combined with very strong persistency drove this growth. In group benefits, fully insured premiums were up 1% over the fourth quarter of 2006. That figure understates our true growth though. Premiums rose 5% if you back out the medical staff loss business that we sold in the spring of 2007. Core earnings also rose by 5% driven in part by favorable mortality and morbidity. Competition in group benefits remains intense particularly in the small case market. As we move into 2008, you should expect us to continue to balance top line growth in profitability while deepening relationships with our customers.
I want to take a minute to talk about our retirement plans business. Now I am on slide 8.
Strong net flows and market appreciation drove assets under management in retirement plans up 16% from December ’06 to more than $28.5 billion at the end of the year. And also we announced three strategic acquisitions in December. I am happy to say we have already closed one of those deals and we expect to complete the other two in the first quarter. In aggregate these acquisitions will expand our presence in mid size market. In addition they bring us industry leading service platform. For example we will now have the ability to service the defined benefit plan. More and more service providers are now seeking to combine the defined benefit plan administration with the sale or takeover of their 401K plan. This provides us greater flexibility to package our services to our customers needs. These acquisitions nearly doubled our retirement plan assets. Its worth mentioning though that the ROA for these businesses is lower than the ROAs we have been reporting. So we will update the 2008 outlook for the retirement plans group at the first quarter call assuming that the transactions are closed.
In summary, our life operations had an outstanding year. We had a record year in terms of core earnings with solid contributions from each of our businesses. And with that I will turn it over to David Johnson.
Let’s turn to slide 9. I am pleased to report that our capital loss came in at bit better than what we predicted in December. Long term volatility subsided somewhat at year end but credit spreads continued to widen. Overall impairments were a little higher than projected and losses in our hedged GMWB liability were substantially lower. These realized losses effect GAAP book value but not our capital position.
As a US insurer, our capital is measured under Statutory accounting, which differs from GAAP. We estimate that our roughly $430 million GAAP realized loss pre-tax, will translate to more than $100 million gain, under statutory accounting. The largest reason for this anomaly is the accounting treatment for GMWB Hedging. Under GAAP our GMWB liability and hedge assets are both fair valued. When the hedging works as it did in this quarter, the change in the liability is substantially offset by a similar change in the hedge assets. Under statutory accounting, on the other hand, the hedge assets are fair valued, but the GMWB liability is not. On our stat books, the change in fair value of our hedge assets drove an increase in surplus. Also, bond impairments under GAAP are now largely driven by changes in market value. Under the current stat rules it still requires a fundamental credit development to trigger impairment, so we did not see the same level of impairments on our statutory books. Bottom line is that at year end, our statutory capital position remained very strong and our $1.5 billion capital margin was completely untouched.
Also, I want to comment briefly on our guidance, given the impact of market levels on our asset-based fee revenues. As we noted in our press release, we will be at the low end of our guidance range if the market does not recover and further market deterioration would take us below our range. Remember for every percent the S&P is down at the beginning of the year, we lose about $6 million in after tax core earnings or roughly 2 cents. Our guidance also does not include any estimate of the effect of the third quarter DAC unlock on EPS. Were we to do our annual DAC study today, market losses since our last study would generate a negative unlock. Using the sensitivities that we provided you in our third quarter 10-Q, the impact of market changes would likely between $200 and $400 million after tax were we to do the study today. As a reminder, DAC was $213 million “good guy” in our 2007 study.
In addition to our annual study, we do test DAC on a quarterly basis and if it is necessary we would unlock immediately, but that is a far removed event. We would need to see roughly twice as much as the worst market deterioration we have seen since July for us to unlock our cycle. We have not changed our four-year outlook for our alternative investment income, either. Our plans calls for income of this kind at roughly $240 million pre-tax or about a 9% annualized return. That also could be volatile in a down market. Bottom line is that the current market environment is challenging and it will certainly have some impact on our earnings. That being said, we are not yet ready to abandon the plan we described to you last month.
Turn to Slide 10 please.
We have added a great deal of investment disclosure to the appendices to our slides. I would like to make a few comments on two categories, Monoline Wrap Securities and Commercial Real Estates. You could see that the vast majority of our Monoline wrapped securities are munis with the balance in structures and corporate. It is not a hard and fast rule, but in general, we would say that for investments where underline credit is single-layer or better the wrap is not getting much value in today’s market. The bonds are already trading close to the underlying credit. This process had already started in the fourth quarter and is partially reflected in our year end marks.
Underlying credits below single-layer still get some benefits from their wraps, but were all the insurance to disappear tomorrow, it would be immaterial to our muni portfolio, which has an average underline rating of AA-. Of that total portfolio, over 50% is insured and 95% of the insured bonds have underlying ratings of A- or better. The balance of our Monoline Wrap investment, I just note that roughly half the structured investment are sub-prime bonds, we previously disclosed here, so do not double count them, they show up in two different places in our appendix slide.
Turn to Slide 11 please.
Historically, life insurers have always been major holders of commercial mortgages and we are no exception. We hold a balance portfolio of $22.4 billion. Versus our peers The Hartford does hold the larger portion of its investment in the CMBS format and we provide extensive disclosure about these holdings in our appendix. The CMBS format has pluses and minuses. While in most market condition, they are more liquid than other loans, this liquidity means they are accounted for at market value, while whole loans are carried at amortized cost. CMBS also benefits from diversification and if you buy the senior trunches subordination, though in today’s market, structural protection often does not get the highest value from investors.
On the fundamental, the commercial mortgage business is still in very good shape. Delinquencies remain near historical lows. Property values, while down in the last 12 months, never experienced the hyperinflation of residential property over the last 5 years. At this point in the credit cycle, I much rather be overweight commercial mortgages than high-yield corporate. You may have noted that roughly $1.9 billion of our commercial mortgages are held in commercial real estate CDOs. I would like to stress of that roughly $1 billion are not CDO in the sense you might remember them from residential mortgages.
The largest part of so-called, “the spokes CDOs,” which repackages only AAA tranches as CMBS Securities. The balance of that $1 billion consists of managed CDOs, which are really much like a CMBS, but the collateral flows in and out, like a conduit, as long as it meets the appropriate criteria for the tranch. The rest of our CRE CDOs do involve the retranching of seasoned, lower credit commercial mortgages. Again, fundamentals still remained very strong here, but these will be on our list for watching.
Finally, turn to Slide 11 please.
I would like to give you a brief update on SFAS 157. The derivatives primarily show up in two places at the Hartford, in our investment portfolio and in a portion of the living benefit embedded in our variable annuities. Prior to this year, these were accounted for under SFAS 133, now we will use SFAS157. This change has little impact on our investment, which generally are subject to traditional price discovery. On the other hand, our VA derivative is embedded and not really tradable. We have always had to build a valuation model to account for it. Under SFAS 133, we are required to incorporate any observable market input in our valuation model and I am proud that The Hartford has certainly incorporated new input as they became observable over time.
The most notable of them, the new markets that emerged from increasingly long tenures of index volatility. When a market does not exist for a key model input, for example policy holder behavior, under 133 we use our best estimate. Under 157, on the other hand, we are required to incorporate market values to all input, even when a market does not exist. In particular, it requires you to add margins that you think a market participant would charge for the risk that the input might change. Our calculations are still being finalized and audited, but I would like to describe some of the risk margins we adding in order of importance.
The largest is policy holder behavior. Remember our living benefits give the policy holder a lot of choices, particularly, when and what amount to withdraw their money. We make assumptions, not only based on the person’s age, qualified versus non-qualified account, past behavior, but also on market conditions. We generally assume people will value the benefit more in adverse markets. For 157 we have developed the method that tries to emulate what a hypothetical trader might charge us to take on the risk that our behavior assumptions are wrong. This was by far the hardest part of our exercise and it also contributes to the largest increase in our evaluation.
The second item is illiquidity and complexity. It is an observable fact that illiquid markets with few very complex transactions trade with a wider bid-ask. We have included an estimate of what would it take to induce a trader to take on our very complex compound option as opposed to a simple 10-year S&P put.
The third element is basis risk. Our benefit is based on protecting account values that are invested in hundreds of individual mutual funds. Our hedge instruments and the observable market input associated with them are based on indexes. A trader would likely factor in a charge for the risk that the mutual fund sand the aggregate do not exactly track the index as they are regressed against.
And the final element is actually a minor positive. We are required to discount our payment stream in a derivative valuation using a rate reflective of The Hartford credit standing as supposed to the risk free rate. As we have continued our work we have been able to tighten our implementation estimates to between $200 to $300 million after tax and DAC, to be booked in the first quarter of 2008. As a reminder, this is GAAP only and does not affect capital. I look forward to discussing the final number with you on our first quarter earnings call.
Question and Answer Session
Our first question comes from the line of Jay Cohen with Merrill Lynch.
Jay Cohen – Merrill Lynch
I just want to ask one question on the property casualty side and on the lifeside, as well. On the property casualty side I guess one thing that stood out a little bit was the accident year number and the personal lines business. I know that included some current year development, a smaller issue is certainly weather I am sure. When you see that number does it make you rethink your pricing at all? Are you going take that information and may boost pricing in certain markets in the personal lines area just given what maybe some underlying pressure on margins?
I guess the first thing I would say Jay is we want to look at this on a year over year basis full year, because as you say there are some one time unusual items in the fourth quarter and I think on that basis, if you have to look at it on an ex-cap, ex-prior year basis, the development is not that big. In the quarter, obviously, there was some development based on current accident year, adjustments, most of those relating to some of the things we have been talking about, with respect to what we have seen on frequency over the course of the year. We said that we are going to look at pricing by geography, maybe make some adjustments here and there, but fundamentally we are still feeling good about our margins and making target returns. The other thing is obviously what we said before is that we expect that loss cost development will moderate a little bit ’08 over at ’07, so that plays into how we think about it as well.
Jay Cohen – Merrill Lynch
And, just one follow-up on that, in public too early in the year, they even gauged that, but that view, is that yet being supported by the data you are saying on claims?
I guess what I said Jay, as you say very early days, but what we have seen at the very end of ’07 as we pivot in to ’08, it is consistent with that view.
Jay Cohen – Merrill Lynch
What are the scribed fees are now, so basis points on assets related to VA business with living benefit features.
There is no one answer to that because it varies by product, but they are up for the cohorts that we are writing in the latter part of the quarter with market volatility up, so the answer is any where up probably from 10 to 25 basis points, depending on the product. That moves around a fair amount, we reset that weekly, I think, in terms of the cohorts that we book. So it is quite granular and it is a different answer for each week.
Your next question comes from the line of Andrew Kligerman with UBS.
Andrew Kligerman – UBS
Where do you think you will appear when we see you in your the next role? Will it be similar to the CFO type role you are in or something quite extremely different?
Well, courtesy of the good efforts of the folks here at The Hartford, I am here for a fair amount of time and I have really not begun to explore my next opportunity. Generally, people like each other, they want to start right away and I cannot do that. So I am going to take the opportunity of the next few months to think about that. I love being a CFO, it is a great job, but I have the luxury at this point to think about, whether I might want to do something else. I love good disclosure, but what I am disclosuring right now is that I really do not know. It is going to be fun to think about.
Andrew Kligerman – UBS
Shifting over to the PNC business, with written premiums down 4% for the quarter and targeted 0-3% growth in ‘08, I am just kind of a rattling of, small commercial down 3, personal line only up 1, then your target is better than that. I know Tom was mentioning potential growth in agents or personal lines, maybe some new products, but given that in the past year guidance is not a net on written premium growth. What is you confidence level in your ability to make that 0-3 and maybe some of the reasons why you may or may not have confidence in some of the more predictable lines, like small commercial and personal line.
Let met start that Andrew, since I have been downtown here and watching the property causality team, I have been impressed. Literally they are looking at every place, within the discipline that’s really is the hallmark of The Hartford. They are looking in each line or pockets of opportunity, in places, in geographies and industries where we can be successful and that is across all lines, our commendable numbers given the market environment and the discipline which we are approaching at. I turn it over to Neal to get a little bit more specific.
Let me start with the fourth quarter premium and then pivot over to how we are thinking about that as we go in to ’08. If you look at personal lines, for example, if you x out omnis, the modest one is a +1 and in the commercial lines area, a meaningful amount of the top line pressure is the result of state mandated rate changes and in particular, in New York, where there was one time requirement to give back rate with respect to the unearned premium reserve for comp business written in the state. If you adjust all that out, I think the year over year quarter comparisons are rather better than those that you sighted and so, we start with that and then, we think about pivoting it to ’08.
We feel very good about a range of initiatives that we have underway, across our segments. So in personal lines we are releasing, as Tom mentioned in his opening comments, product both in the agency and in the AARP businesses. We feel very good about that, those will be rolling in over the course of ’08. We are going to be putting a thousand new agents on our rolls, and so forth. In small commercial again, we expect in ’08 product improvement, some new releases, as well as, meaningful enhancements to our service capabilities and ease of doing business. And in the middle market, an awful lot of attention to retention and our retention numbers have picked up. As you see within the quarter, they picked up sequentially within the quarter and we are really focusing on retaining what is for us a very profitable book of business. We have really had a lot of success in doing that. So all those things, as well as, a number of new business initiatives, where we feel, for example, middle market, that there are still good opportunities for us to go profitable business by line, by geography and so forth. All of that makes us feel good about the guidance that we have provided you.
Andrew Kligerman – UBS
Last, quickly on group benefit, 16% fall in the first nine months, up 26% in the fourth quarter, in terms of sales. Does the momentum carry it to the next year and what are the competitive dynamics?
I would say that sales tend to be lumpy over the quarters. We are in all markets, small all the way to national accounts and so, I would not read so much into the fourth quarter run up. Having said that we do feel good about our core lines, life and disability for the first quarter, but there is less competition out there, I think that small case market will be little bit more challenging and that all is reflected in our guidance.
Andrew Kligerman – UBS
Your next question comes from Darin Arita with Deutsche Bank Securities
Darin Arita – Deutsche Bank Securities
Good morning. I was hoping to talk on Japanese annuity business. Tom, you mentioned that you expect the FIEL system to work its way through by the end of the first quarter. Can you explain a little more on what that means and why you think that might potentially increase sales in Japan.
I will have Liz give the real color on that and I think in part just comes from our people on the ground and also just looking at sales. In the beginning of FIEL really fell precipitously and it crawled back. Liz you want to add on that?
Ramani Ayer – CEO, Chairman of Exec. Committee, Chairman of Hartford Fire
Let me just give a little bit of color on FIEL again, as a reminder, it was an industry issues so it affected sales of everything, from mutual, funds to JZBs, to variable annuities. For example, if you look at mutual funds sales for the fourth quarter of ’07, they were down about 19% and index fund flows were down about 50%. We do not have formal data on VA sales, but our best estimate is bank sales, which comprise most of the markets were down about 25% to 30% for the fourth quarter, so clearly we see this as an industry issue. However, we do believe that December sales started to tick up, so that is why between that and all of the conversations we had with our distributors we do believe that it will work itself through by the end of March.
Now, having said that we all know that the Japanese market has really taken a hit, so down close to a third in about six months, although it rebounded yesterday and so forth. That is giving Japanese customers pause in their buying behavior, so lots going on in Japan and in the near term that is reflected in our guidance, lots of competition, but I will say again and stress, we are bullish over the long term in Japan. Variable annuity assets at about 150 billion as of September, only represents 1% of the financial assets in the country, so we think guarantees, especially in light of what we seen will play well, we think the industry will grow and so, the second half of the year uptick in our guidance and certainly we believe more bullish over longer term. Finally we are launching a product in the first quarter and so, that is all the reflect in our guidance.
Darin, I think an important point that Liz wants to make is you comment on the Japanese equity market being weighed down. I think it is important that everyone out there understand that because of the diversification of our portfolio within the VA products , the actual investment return in our products is down a lot less and this is one of the areas where our allocations within the portfolio has really helped the customer.
Absolutely and I think that they will see that, I mean we see that there returns were flat for the year before fees, were less in equities typically than the US about 44%, with only about 23% of our in force in Japanese equities, and of course the rest in Japanese bonds and global bonds. Clearly, we have more diversified mix and that should bode well for our customers, but I am saying new customer thinking about making purchases right now were little tepid.
Darin Arita – Deutsche Bank Securities
And then, sticking with that and taking it a little bit more broad. Can you talk about some of the metrics that you are looking at, with respect to your living benefit liabilities and how that is tracking first in Japan then also in the US.
Question on our living benefit liabilities, are we tracking that?
Darin are you GAAP or stat or you …
Darin Arita – Deutsche Bank Securities
I would be curious on whatever is important here, but I would say both.
Let us start with the US, you saw the net results of derivative activity from GMWB in the fourth quarter was relatively low, that is obviously been a volatile ride. In December we shared with you where the mark was at the end of November, which was over $100 million. The big impact there is when you have the big spikes in market volatility. The hedges have done, as one would expect, extremely well on Delta, on interest rate, its big spike in Vega and volatility, which are difficult to rebalance again, where you see the slippage and we always expected that to happen. As long term ball came back in through the month of December, you have the mark that you see in our financial statement. Again on that aspect of it, we feel pretty good. On the statutory aspect of it, again, which I believed is the real issue that ensures need to track with regards to these liabilities. Again, we are in good shape as of year end. The principal mark date per statutory surpluses and annual mark, but that one again as we have talked to investors before if you had a very dramatic movement down in the market that could create a large statutory margin cost, we have talked about, but we are in a pretty good shape right now.
In Japan again, as I think Liz pointed out, this is a very diversified book, so while the liability will probably will mark up a tiny bit, you are not seeing giant surges with regards to our exposure there the way you would if it was all in one Asian equity class. So far so good for volatile markets.
Darin Arita – Deutsche Bank Securities
Just to follow up, I mean, are there any specific numbers that you are looking at in terms of the benefits that are in the money and things that you can share along those lines.
The disclosure on our IFS is on page L6, so you could just look at our our IFS and you will see it.
Our next questions comes from the line of Thomas Gallagher – Credit Suisse
Thomas Gallagher – Credit Suisse
I just want to understand your comments about sort of the DAC sensitivity to equity market. If I understood you correctly, should we assume that you could withstand roughly another 15% drop in the equity market before you would sort of trigger an out of period impairment, potentially?
Yes. I have to go figure out how that percentage lines up, as what I said. But basically about the same as bad as it has been since last July will have to happen again. Now again, there is a separate analysis for Japan versus the US so you can have scenario where one triggered but the other did not, but yes, that is a pretty good rule of thumb.
Thomas Gallagher – Credit Suisse
Okay, second question is, your comment about the lower statutory capital loses, can you just give us a sense for, if you had $318 million of impairment on a GAAP basis this quarter, what was that actual number on a stat counting basis and why would it be meaningfully different?
The rough estimate was that the stat impairment impact was kind a 125 to 150 range, so was significantly less. Particularly the principal reason is that GAAP framework for impairment has evolved over the last three or four years, and it is now one where in the phase of a significant change in the trading value of the security, the rebuttable presumption is that you will impair that bond and that can happen if the market value shifts dramatically even if there is no downgrade, if the analysis of the cash flows underlying the security don’t indicate any recoverability issue, any of the kind of a traditional matrix associated with credit impairment, which are still the rules under current stat accounting. So you could have a save something trades down to 75% of book for GAAP, that is going to be a hard presumption not to impair there even if it is not been downgraded and you think the fundamentals are pretty good, stat on the other would not look for you to impair in that scenario
Thomas Gallagher – Credit Suisse
Okay, so we are going to see some kind of divergence between a loss recognition on GAAP and stat as we go forward here with GAAP being a lower threshold in terms of loss expectation going more toward a market value based approach.
Well, I would not want to assert that there is a fixed relationship between the two and the stat will always be lower. There are other things in stat on the other hand that are much more sensitive to different things than GAAP. So for example, interest rates can sometimes having interesting impact on your stat liability, and can create loses or statutory surplus and scenarios where you see nothing in GAAP. Also as I was talking before hand, stat in terms of a CTE capital requirement is much more sensitive to absolute mocves in the stock price, and would product a larger loss than probably our SFAS 133 and now SFAS 157 liability might indicate to the big market, it was like a 30% drop.
So if there is, stat can be worse than some scenarios too, but with respect to credit impairment I think that is true. You will generally see stat being less than GAAP.
Thomas Gallagher – Credit Suisse
The last question I had is just want to understand there is obviously a lot of accounting noise with the variable annuity hedging, but to try and simplify if that is possible, as I understand it, you all run about 30 basis points through the GAAP P&L or if you can remind us how much is being run through operating earnings, and then the separate question is, if you look at the breakage we have had on an economic basis your estimative breakage on economic basis, what would that incremental cost have been. Is it trued up this quarter or maybe the last few quarters?
The exact amount of the writer fee which is attributed to core earnings as a fee revenue varies by cohorts and those who go over time, but I think it is fair to say that over most of the life of the product that has been between 10 and 30 basis points and then it is only move out of that range in extreme market condition.
When you talk about economic breakage, it is interesting, I kind a have to almost form and redefine the answer in order to try to give it to you because there has actually been no breakage in that. We have never paid a claim that I am aware of, of any material size under any of our living benefit program, they require you to exhaust, for almost in every circumstances, you have to exhaust your principal before our withdrawal of benefit liabilities would actually cause a cash claim for us. So there is a breakage in terms of the fair value reported on our books, when you see net breakage every quarter that is the gap between the liability and hedge assets.
The other breakage you can say is “how much money have we spent on hedging” and “ is there been a rebalancing cost” and kind of a bid-ask, kind of a loss of economic value from the higher volatility. Difficult to put a cost on that but that could usually range anywhere from, in a good scenario, five basis points over the life of the hedging and in a real volatile hedging scenario that could be 10 to 15 basis or more rebalancing cost over the life of the hedging program.
So, certainly there has been a period in the last quarter where __ that were persistent for 10 years, you are definitely will be at the higher end of the trading breakage. Difficult to frame a one version of an answer but hopefully those two or three different versions are helpful to you.
I just want to reinforce, David gave a very comprehensive answer to your question, I mean the way we think about economic loss is really at the end of the day when all liabilities are resolved, does that go against the dot and that is very-very far in to the future. What you are seeing is The Hartford basically following accounting rules to mark everything to the market and David gave you the components to that, says the important distinction that both you and I hope investors get and how we report our liabilities and changes in our liabilities through income.
Your next question comes from Eric Berg
My first question is as regards to the capital losses, you recorded pretax as much capital losses outside of the credit area as you did inside of it , probably half as much but still significant number, $165 million is referenced on page 9 and also in the realized gains page in the supplement.
I understand that this is all about hedge ineffectiveness and about certain hedges that do not qualify for hedge accounting but how should we think about these losses, are they economic? Should we ignore them in your opinion, David? How do you think about this because they are running through your P&L so clearly the SEC feels they are meaningful. They are hitting your book value, what is your view on these $165 million and similar charges and previous periods?
Eric, the vast majority of what you saw in the fourth quarter was loss as associated with credit derivative position that is what is recorded in that line and I look at that in two different ways depending on the credit derivative strategy. Portion of that loss is the credit derivative strategies where we did effectively replication trade and took credit risk, very similar to the risk we would take by owning a corporate bond, by assuming credit risk through buying or selling credit derivative and then also getting other fixed income investment associated with it.
What you are seeing here is akin to the swing in the fair value of that replicated trade that otherwise would have been reported in AOCI if this had just been a traditional corporate bond. So I look at that as when I look at this as accounting noise is because these reflects a change in fair value. On the other hand I look at the fact that fair value is going to swing a fair bit when credit spreads cap out as they are in the current scenario and we would look for the vast majority of our corporate bond portfolio losses that you are seeing in unrealized loss in AOCI to come back and I would feel the same way about the credit default swaps which tend to be a tenured contract that you see marked in this line.
Now on the other hand, there is another strategy and these are roughly half each in terms of the credit derivative loss that you see in that line associated with ownership of index swaps where we basically took the risk of changes in value in some indexes, index associated with commercial mortgages and that is a short term strategy, if we do not decide to roll over the positions in the first half of this year, that will be real economic loss.
Okay, and then I have one business question for Liz; it is actually a follow up to Andrew’s earlier question on group insurance. I notice that you reported 1% year over year premium growth in the quarter, 4% for the year. I tend to look at that number even though it is simple, I do not think it is simplistic in the sense that that is your GAAP revenue or your largest component of the GAAP revenue towards everything else in the revenue section of the P&L. Do you think Liz that the1% and the 4% for the quarter and the year are being held down by being distorted or are those number representative of the said ongoing growth power of the business?
I tend to think of the on growing growth power of the business more in the 4-5% range. So some of that is again two core lines life and disability and we sell some other supplemental products and we see a lot of choppiness in those, so, I see the underlying and we had the IMS business, so some of that is noise, obviously that the business is in a saturated market, we are a very big player in the market. We are number two in both in force and disability, and number three in life and from my new sales perspective as of 9/30 we were number two in both.
So, there are big player, huge employers are not being created everyday, but I would say is we still see earnings power probably in that line but maybe higher over time as we continue to manage loss cost price well and gain efficiencies. But in the near term you are looking at a probably a 4-6% kind of runrate over time and you will have some higher or lower depending on some of that noise.
That was great! Actually one more just a quick question, in the past I have asked you about your retirement businesses and it certainly is encouraging and it is noteworthy and encouraging that the assets are growing rapidly, and I understand that you are investing in these businesses with the new wholesalers and spending money in other ways to build out a platform. What sort of timetable can you offer up for the earnings to begin trending upward? They seem in the supplement to be sort of stuck in the low 20’s area, and while I understand that, again this is the ratings, the patterns of earnings is being sort of break to retarded by the investment spending that you are doing. When are we going to get the good stuff, so to speak, the high earnings?
Let me comment on the retirement business. We made some significant investments in the retirement business in 2007, both investments in the technology and infrastructure that supports it, and the three acquisitions that we announced in the fourth quarter. So this is the business that we are very excited about and these have been one of our fastest growing businesses and we expect it to continue to be in the future.
What you should expect to see is as we close these three acquisitions, one of which is Tom said is already closed here in the first quarter, then we will be working on integrating all of those acquisitions and bringing these together and we will have doubled the assets we had before, that should give us economies of scale and the ability to invest in the business, while the earnings start to materialize.
Our estimate is that the integration will take about two years to fully complete. We got to bring three different platforms together into one platform which is what our intent is. We have not yet finalized which direction we are going with that but we expect to do that by the end of the second quarter, and then we will be moving on the inauguration plan.
So my sense is that you will get little impact from these acquisitions for the scale of the business in 2008, and probably most of 2009 as we do the integration and then it should improve the earning levels after that point.
Just to add to that, obviously the long term strategic intent is to make this a big part of our overall portfolio given that it plays right to our sweet spot in terms of capabilities and just looking at the demographic and rounding out the offering that we could bring to the retail financial advisers, so we are investing now but we plan on having retirement plans be a huge part our overall business
It is very clear that you are succeeding in the asset growth areas. So a job well done.
Your next question comes from Mark Finkelstein with Fox-Pitt Kelton
Mark Finkelstein – Fox-Pitt Kelton
I just have two quick questions. David on the last call you talked about potentially hedging certain element of SFAS157, knowing that there were some kinds of economic or non economic considerations with that. I am just curious where you at and how should we be thinking about the volatility around results if you do not go down that path going forward.
That it is a good question, short answer is that we are still thinking about it. We continue to refine our understanding of 157 and our implementation of. I think the good news is, it is looking like the implementation of the new 157 model will have an impact on the sensitivity of the liability to market changes versus what it was under 133, but perhaps not as much, so that takes a little bit of the urgency off to make wholesale changes. But we are still on about the same analysis that we were before, which is to get that done in the first quarter or so.
Operator we have time for one more question. Is Paul Newsome still on the line?
That was the last question
Well, I am going to bring this call to a close. We are please to report the record year for 2007. As I mentioned to the core earnings exceeded $3.5 billion and our return on equity has exceeded 15% this year on the net income basis and our capital position in an excellent shape.
And I know 2008 will bring some market related challenges. We certainly look forward to meeting those challenges and continue to execute well in all of our businesses.
I want to thank everybody for joining us on the call today.
That concludes today’s conference call. You may now disconnect.
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