The Hartford 2008 Annual Report Download - page 100

Table of Contents
In valuing the embedded derivative, the Company attributes to the derivative a portion of fees collected from the contract
holder equal to the present value of future claims (the “Attributed Fees”). Attributed Fees in dollars are determined at the
inception of each quarterly cohort by setting the dollars equal to the present value of expected claims. The Attributed Fees,
in basis points, are determined by dividing the Attributed Fees in dollars by the present value of account value. The
Attributed Fees in basis points are locked-in for each quarterly cohort. Recent capital markets conditions, in particular high
equity index volatility and low interest rates have increased the Attributed Fees for recent cohorts to a level above our rider
fees.
Capital market assumptions can significantly change the value of embedded derivative living benefit guarantees. For
example, independent future decreases in equity market returns, future decreases in interest rates and future increases in
equity index volatility will all have the effect of increasing the value of the embedded derivative liability as of December 31,
2008 resulting in a realized loss in net income. Furthermore, changes in policyholder behavior can also significantly change
the value of the GMWB. For example, independent future increases in fund mix towards equity based funds vs. bond funds,
future increases in withdrawals, future decreasing mortality, future increasing usage of the step-up feature and decreases in
lapses will all have the effect of increasing the value of the GMWB embedded derivative liability as of December 31, 2008
resulting in a realized loss in net income. Independent changes in any one of these assumptions moving in the opposite
direction will have the effect of decreasing the value of the embedded derivative liability as of December 31, 2008 resulting
in a realized gain in net income. As markets change, mature and evolve and actual policyholder behavior emerges,
management continually evaluates the appropriateness of its assumptions. In addition, management regularly evaluates the
valuation model, incorporating emerging valuation techniques where appropriate, including drawing on the expertise of
market participants and valuation experts.
Valuation of Investments and Derivative Instruments
The Hartford’s investments in fixed maturities include bonds, redeemable preferred stock and commercial paper. These
investments, along with certain equity securities, which include common and non-redeemable preferred stocks, are classified
as “available-for-sale” and are carried at fair value. The after-tax difference from cost or amortized cost is reflected in
stockholders’ equity as a component of Accumulated Other Comprehensive Income (“AOCI”), after adjustments for the
effect of deducting the life and pension policyholders’ share of the immediate participation guaranteed contracts and certain
life and annuity deferred policy acquisition costs and reserve adjustments. The equity investments associated with the
variable annuity products offered in Japan are recorded at fair value and are classified as “trading” with changes in fair value
recorded in net investment income. Policy loans are carried at outstanding balance. Mortgage loans on real estate are
recorded at the outstanding principal balance adjusted for amortization of premiums or discounts and net of valuation
allowances, if any. Short-term investments are carried at amortized cost, which approximates fair value. Limited
partnerships and other alternative investments are reported at their carrying value with the change in carrying value
accounted for under the equity method and accordingly the Company’s share of earnings are included in net investment
income. Recognition of limited partnerships and other alternative investment income is delayed due to the availability of the
related financial statements, as private equity and other funds are generally on a three-month delay and hedge funds are on a
one-month delay. Accordingly, income at December 31, 2008 may not include the full impact of current year changes in
valuation of the underlying assets and liabilities. Other investments primarily consist of derivatives instruments which are
carried at fair value.
Valuation of Fixed Maturity, Short-Term and Equity Securities, Available-for-Sale
The fair value for fixed maturity, short-term and equity securities, available-for-sale, is determined by management after
considering one of three primary sources of information: third party pricing services, independent broker quotations or
pricing matrices. Security pricing is applied using a “waterfall” approach whereby publicly available prices are first sought
from third party pricing services, the remaining unpriced securities are submitted to independent brokers for prices, or lastly,
securities are priced using a pricing matrix. Typical inputs used by these three pricing methods include, but are not limited
to, reported trades, benchmark yields, issuer spreads, bids, offers, and/or estimated cash flows and prepayments speeds.
Based on the typical trading volumes and the lack of quoted market prices for fixed maturities, third party pricing services
will normally derive the security prices through recent reported trades for identical or similar securities making adjustments
through the reporting date based upon available market observable information as outlined above. If there are no recent
reported trades, the third party pricing services and brokers may use matrix or model processes to develop a security price
where future cash flow expectations are developed based upon collateral performance and discounted at an estimated market
rate. Included in the pricing of asset-backed securities (“ABS”), collateralized mortgage obligations (“CMOs”), and
mortgage-backed securities (“MBS”) are estimates of the rate of future prepayments of principal over the remaining life of
the securities. Such estimates are derived based on the characteristics of the underlying structure and prepayment speeds
previously experienced at the interest rate levels projected for the underlying collateral. Actual prepayment experience may
vary from these estimates.
Prices from third party pricing services are often unavailable for securities that are rarely traded or are traded only in
privately negotiated transactions. As a result, certain securities are priced via independent broker quotations which utilize
inputs that may be difficult to corroborate with observable market based data. Additionally, the majority of these
independent broker quotations are non-binding. A pricing matrix is used to price securities for which the Company is unable
Source: HARTFORD FINANCIAL S, 10-K, February 12, 2009