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Hartford Financial (NYSE:HIG), prior to the financial crisis, had a history of reaching for yield. That played out poorly, and contributed to the company's current status as a speculative value play. New management doesn't seem to have changed the culture.

In line with my interest in word search as an analytical tool, I recently checked Hartford's 10-Q for occurrences of the words "synthetic" and "replicate." Here is what I found:

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According to the company, replication transactions are used as an economical means to synthetically replicate the characteristics and performance of assets that would otherwise be permissible investments under the Company's investment policies.

Hartford is writing credit default swap (CDS) protection. That's how AIG got in trouble.

CDS as Insurance

These transactions aren't being regulated as insurance. They're being passed off as investments. We have no way of ascertaining whether these CDS are naked or not. Naked CDS are bad insurance practice, since the lack of insurable interest creates moral hazard, as well as adverse selection. If a counterparty had some bonds and wanted to offload the risk, Hartford could have bought them outright.

Insurance contracts require that losses be carefully defined, to avoid the possibility that policyholders will profit from loss. For credit risk insurance, losses should be defined as principal and interest when due. That prevents the transfer of market and liquidity risk during episodes of market panic. These CDS don't incorporate a proper loss definition.

Peers Aren't Selling CDS

A search of financial statements for P&C industry peers Chubb (NYSE:CB) and Travelers (NYSE:TRV) doesn't find any similar transactions. MetLife (NYSE:MET), a life insurer, does some of it, although considerably less than what Hartford is doing.

If Hartford wants to get the same respect as Chubb and Travelers, and trade at a P/B in excess of 1.0, instead of their current 0.39, they are going to have to be more conservative about their investments.

In 2009, Hartford's replication operation was half what it is today. This is moving in the wrong direction.

Information Available in Statutory Reports

The statutory reports of Hartford's various insurance subsidiaries include detail on synthetic replications. Here's a sample, from Hartford Life and Accident Insurance Company's 2011 Annual Report:

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With sufficient patience, an investor could compile a list of these transactions, and develop an opinion of their contribution to the company's investment returns and risk profile.

Update on Divestiture of Non-core Life Operations

The company recently announced an agreement to sell the Retirement Plans business to MassMutual, a favorable development that is expected to release $600 million of statutory capital. This will increase financial flexibility and provide funds that can be deployed to create shareholder value.

Investment Implications

Hartford continues as an interesting speculative value play. In order to achieve the same valuation as P&C peers, the company must not only focus on that line of business, it must also change its investment strategies to reflect the conservatism that has stood Chubb and Travelers in such good stead since the financial crisis.

John Paulson has management's attention here. Maybe he should get on the phone with CEO Liam McGee, raise the topic of synthetic replications, and tell him: "I wish you wouldn't do that."

Source: To Hartford Management: I Wish You Wouldn't Do That