The Hartford 2008 Annual Report Download - page 304

Table of Contents
Life’s Equity Product Risk Management
The Company has made considerable investment in analyzing current and potential future market risk exposures arising
from a number of factors, including but not limited to, product guarantees (GMDB, GMWB, GMAB, and GMIB), equity
market and interest rate risks (in both the U.S. and Japan), and foreign currency exchange rates. The Company evaluates
these risks individually and, increasingly, in the aggregate to determine the risk profiles of all of its products and to judge
their potential impacts on financial metrics including U.S. GAAP earnings and statutory surplus. The Company manages the
equity market, interest rate and foreign currency exchange risks embedded in these product guarantees through product
design, reinsurance, customized derivatives, and dynamic hedging and macro hedging programs.
In consideration of current market conditions, the Company’s risk management program for the variable annuity market will
include redesigned product features which serve to lessen the financial risk of the product guarantees and increased rider
fees charged for the product guarantees. Depending upon competitors’ reactions with respect to product suites and related
rider charges, the Company’s strategies of reducing product risk and increasing fees may cause a decline in market share.
Reinsurance
The Company uses reinsurance to manage the risk exposure for a portion of contracts issued with GMWB riders prior to the
third quarter of 2003 and, in addition, in 2008, the Company entered into a reinsurance agreement to reinsure GMWB risks
associated with a block of business sold between the third quarter of 2003 and the second quarter of 2006. The Company’s
GMWB reinsurance is accounted for as a freestanding derivative and is reported at fair value under SFAS 157.
The Company also uses reinsurance to manage the risk exposure for a majority of the death benefit riders issued in the U.S.
and a portion of the death benefit riders issued in Japan.
Derivative Hedging Programs
The Company maintains derivative hedging programs for its product guarantee risk to meet multiple, and in some cases,
competing risk management objectives, including providing protection against tail scenario equity market events, providing
resources to pay product guarantee claims, and minimizing U.S. GAAP earnings volatility, statutory surplus volatility and
other economic metrics. For reinsurance and derivatives, the Company retains credit risk associated with the third parties.
Refer to preceding section “Credit Risk” for the Company’s discussion of credit risk.
The Company is continually exploring new ways and new markets to manage or layoff the capital markets and policyholder
behavior risks associated with its U.S. GMWB living benefits. During 2007 and 2008, the Company entered into customized
derivative contracts to hedge certain capital market risk components for the remaining term of specific blocks of
non-reinsured U.S. GMWB riders. These customized derivative contracts provide protection from capital markets risks
based on policyholder behavior assumptions specified by the Company at the inception of the derivative transactions. The
Company retains the risk for actual policyholder behavior that is different from assumptions within the customized
derivatives.
The Company’s dynamic hedging program uses derivative instruments to manage the U.S. GAAP earnings volatility
associated with variable annuity product guarantees including equity market declines, equity implied volatility, declines in
interest rates and foreign currency exchange risk. The Company uses hedging instruments including interest rate futures and
swaps, variance swaps, S&P 500, NASDAQ and EAFE index put options and futures contracts. The dynamic hedging
program involves a detailed monitoring of policyholder behavior and capital markets conditions on a daily basis and
rebalancing of the hedge position as needed depending upon the risk strategy employed. While the Company actively
manages this dynamic hedging program, increased U.S. GAAP earnings volatility may result from factors including, but not
limited to, policyholder behavior, capital markets dislocation or discontinuity, divergence between the performance of the
underlying funds and the hedging indices, and the relative emphasis placed on various risk management objectives.
The Company’s macro hedge program uses derivative instruments to partially hedge the statutory tail scenario risk
associated primarily with its U.S. and Japan living and death benefit statutory reserves, providing an additional measure of
protection, under tail scenarios, on statutory surplus and the associated RBC ratios. A consequence of the macro hedge
program will be additional cost and volatility, under non-tail scenarios, as the macro hedge is intended to partially hedge
certain equity-market sensitive liabilities calculated under statutory accounting (see Capital Resources and Liquidity) and
changes in the value of the derivatives may not be closely aligned to changes in liabilities determined in accordance with
U.S. GAAP, causing volatility in U.S. GAAP earnings.
In the fourth quarter of 2008, the global economy experienced severe weakening resulting from the dramatic decline in the
equity markets, increasing equity index implied volatility, widening of credit spreads, significant declines in interest rates,
and volatility in foreign currency exchanges rates. These significant and precipitous economic events increased, to varying
degrees, the Company’s exposure to death and living benefit guarantees, the statutory product guarantee liabilities, and the
level of statutory surplus required to maintain the Company’s RBC ratios.
Source: HARTFORD FINANCIAL S, 10-K, February 12, 2009