The Hartford 2008 Annual Report Download - page 383

Table of Contents
THE HARTFORD FINANCIAL SERVICES GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
4. Fair Value Measurements (continued)
The Pre-SFAS 157 Fair Value was calculated based on actuarial and capital market assumptions related to projected cash
flows, including benefits and related contract charges, over the lives of the contracts, incorporating expectations concerning
policyholder behavior such as lapses, fund selection, resets and withdrawal utilization (for the customized derivatives,
policyholder behavior is prescribed in the derivative contract). Because of the dynamic and complex nature of these cash
flows, best estimate assumptions and a Monte Carlo stochastic process involving the generation of thousands of scenarios
that assume risk neutral returns consistent with swap rates and a blend of observable implied index volatility levels were
used. Estimating these cash flows involved numerous estimates and subjective judgments including those regarding
expected markets rates of return, market volatility, correlations of market index returns to funds, fund performance, discount
rates and policyholder behavior. At each valuation date, the Company assumed expected returns based on:
• risk-free rates as represented by the current LIBOR forward curve rates;
• forward market volatility assumptions for each underlying index based primarily on a blend of observed market
“implied volatility” data;
• correlations of market returns across underlying indices based on actual observed market returns and relationships over
the ten years preceding the valuation date;
• three years of history for fund regression; and
• current risk-free spot rates as represented by the current LIBOR spot curve to determine the present value of expected
future cash flows produced in the stochastic projection process.
As many guaranteed benefit obligations are relatively new in the marketplace, actual policyholder behavior experience is
limited. As a result, estimates of future policyholder behavior are subjective and based on analogous internal and external
data. As markets change, mature and evolve and actual policyholder behavior emerges, management continually evaluates
the appropriateness of its assumptions for this component of the fair value model.
Fair Value Under SFAS 157
The Company’s SFAS 157 fair value is calculated as an aggregation of the following components: Pre-SFAS 157 Fair
Value; Actively-Managed Volatility Adjustment; Credit Standing Adjustment; Market Illiquidity Premium; and Behavior
Risk Margin. The resulting aggregation is reconciled or calibrated, if necessary, to market information that is, or may be,
available to the Company, but may not be observable by other market participants, including reinsurance discussions and
transactions. The Company believes the aggregation of each of these components, as necessary and as reconciled or
calibrated to the market information available to the Company, results in an amount that the Company would be required to
transfer, for a liability or receive for an asset, to market participants in an active liquid market, if one existed, for those
market participants to assume the risks associated with the guaranteed minimum benefits and the related reinsurance and
customized derivatives required to be fair valued. The SFAS 157 fair value is likely to materially diverge from the ultimate
settlement of the liability as the Company believes settlement will be based on our best estimate assumptions rather than
those best estimate assumptions plus risk margins. In the absence of any transfer of the guaranteed benefit liability to a third
party, the release of risk margins is likely to be reflected as realized gains in future periods’ net income. Each of the
components described below are unobservable in the marketplace and require subjectivity by the Company in determining
their value.
• Actively-Managed Volatility Adjustment. This component incorporates the basis differential between the observable
index implied volatilities used to calculate the Pre-SFAS 157 component and the actively-managed funds underlying
the variable annuity product. The Actively-Managed Volatility Adjustment is calculated using historical fund and
weighted index volatilities.
• Credit Standing Adjustment. This component makes an adjustment that market participants would make to reflect the
risk that guaranteed benefit obligations or the GMWB reinsurance recoverables will not be fulfilled (“nonperformance
risk”). SFAS 157 explicitly requires nonperformance risk to be reflected in fair value. The Company calculates the
Credit Standing Adjustment by using default rates provided by rating agencies, adjusted for market recoverability,
reflecting the long-term nature of living benefit obligations and the priority of payment on these obligations versus
long-term debt.
• Market Illiquidity Premium. This component makes an adjustment that market participants would require to reflect
that guaranteed benefit obligations are illiquid and have no market observable exit prices in the capital markets.
•
Source: HARTFORD FINANCIAL S, 10-K, February 12, 2009