The Hartford 2008 Annual Report Download - page 292

Table of Contents
CAPITAL MARKETS RISK MANAGEMENT
The Hartford has a disciplined approach to managing risks associated with its capital markets and asset/liability management
activities. Investment portfolio management is organized to focus investment management expertise on the specific classes
of investments, while asset/liability management is the responsibility of a dedicated risk management unit supporting Life
and Property & Casualty operations. Derivative instruments are utilized in compliance with established Company policy and
regulatory requirements and are monitored internally and reviewed by senior management. During 2008, the continued
deterioration in the U.S. housing market, tightened lending conditions, the market’s flight to quality securities, the U.S.
recession, and the declining global economy contributed to substantial spread widening in the Company’s fixed maturity
portfolio.
Market Risk
The Hartford is exposed to market risk, primarily relating to the market price and/or cash flow variability associated with
changes in interest rates, credit spreads including issuer defaults, equity prices or market indices, and foreign currency
exchange rates. The Hartford is also exposed to credit and counterparty repayment risk. The Company analyzes interest rate
risk using various models including parametric models that forecast cash flows of the liabilities and the supporting
investments, including derivative instruments, under various market scenarios.
Interest Rate Risk
The Company’s exposure to interest rate risk relates to the market price and/or cash flow variability associated with the
changes in market interest rates. The Company manages its exposure to interest rate risk through asset allocation limits,
asset/liability duration matching and through the use of derivatives. The Company analyzes interest rate risk using various
models including parametric models and cash flow simulation of the liabilities and the supporting investments, including
derivative instruments under various market scenarios. Measures the Company uses to quantify its exposure to interest rate
risk inherent in its invested assets and interest rate sensitive liabilities include duration and key rate duration. Duration is the
weighted average term-to-maturity of a security’s cash flows, and is used to approximate the percentage change in the price
of a security for a 100 basis point change in market interest rates. For example, a duration of 5 means the price of the
security will change by approximately 5% for a 1% change in interest rates. The key rate duration analysis considers the
expected future cash flows of assets and liabilities assuming non-parallel interest rate movements.
To calculate duration, projections of asset and liability cash flows are discounted to a present value using interest rate
assumptions. These cash flows are then revalued at alternative interest rate levels to determine the percentage change in fair
value due to an incremental change in rates. Cash flows from corporate obligations are assumed to be consistent with the
contractual payment streams on a yield to worst basis. The primary assumptions used in calculating cash flow projections
include expected asset payment streams taking into account prepayment speeds, issuer call options and contract holder
behavior. ABS, CMOs and MBS are modeled based on estimates of the rate of future prepayments of principal over the
remaining life of the securities. These estimates are developed using prepayment speeds provided in broker consensus data.
Such estimates are derived from prepayment speeds previously experienced at the interest rate levels projected for the
underlying collateral. Actual prepayment experience may vary from these estimates.
The Company is also exposed to interest rate risk based upon the discount rate assumption associated with the Company’s
pension and other postretirement benefit obligations. The discount rate assumption is based upon an interest rate yield curve
comprised of bonds rated Aa or higher with maturities primarily between zero and thirty years. For further discussion of
interest rate risk associated with the benefit obligations, see the Critical Accounting Estimates section of the MD&A under
“Pension and Other Postretirement Benefit Obligations” and Note 17 of Notes to Consolidated Financial Statements.
As interest rates decline, certain securities such as MBS and CMOs, as well as, other mortgage loan backed securities are
more susceptible to paydowns and prepayments. During such periods, the Company generally will not be able to reinvest the
proceeds at comparable yields, however in 2008, in general, increases in credit spreads off-set lower interest rates. Lower
interest rates will also likely result in lower net investment income, increased hedging cost associated with variable annuities
and, if declines are sustained for a long period of time, it may subject the Company to reinvestment risks, higher pension
costs expense and possibly reduced profit margins associated with guaranteed crediting rates on certain Life products.
Conversely, the fair value of the investment portfolio will increase when interest rates decline and the Company’s interest
expense will be lower on its variable rate debt obligations.
The Company believes that an increase in interest rates from the current levels is generally a favorable development for the
Company. Rate increases are expected to provide additional net investment income, increase sales of fixed rate Life
investment products, reduce the cost of the variable annuity hedging program, limit the potential risk of margin erosion due
to minimum guaranteed crediting rates in certain Life products and, if sustained, could reduce the Company’s prospective
pension expense. Conversely, a rise in interest rates will reduce the fair value of the investment portfolio, increase interest
expense on the Company’s variable rate debt obligations and, if long-term interest rates rise dramatically within a six to
twelve month time period, certain Life businesses may be exposed to disintermediation risk. Disintermediation risk refers to
the risk that policyholders will surrender their contracts in a rising interest rate environment requiring the Company to
Source: HARTFORD FINANCIAL S, 10-K, February 12, 2009