The Hartford 2011 Annual Report Download - page 108

108
Foreign Currency Exchange Risk
Foreign currency exchange risk is defined as the risk of financial loss due to changes in the relative value between currencies. The
Company’ s foreign currency exchange risk is related to non-U.S. dollar denominated liability contracts, including its GMDB, GMAB,
GMWB and GMIB benefits associated with its Japanese and U.K. variable annuities, the investment in and net income of the Japanese
and U.K. operations, non-U.S. dollar denominated investments, which primarily consist of fixed maturity investments, and a yen
denominated individual fixed annuity product. In addition, the Company’ s Life Other Operations issued non-U.S. dollar denominated
funding agreement liability contracts. A portion of the Company’ s foreign currency exposure is mitigated through the use of
derivatives.
The company manages the market risk, including foreign currency exchange risk, associated with the guaranteed benefits related to the
Japanese and U.K. variable annuities through its comprehensive International Hedge Program. For more information on the
International Hedge Program, including the foreign currency exchange risk sensitivity analysis, see the Variable Product Guarantee
Risks and Risk Management section.
In order to manage the currency exposure related to non-U.S. dollar denominated investments and the non-U.S. dollar denominated
funding agreement liability contracts, the Company enters into foreign currency swaps and forwards to hedge the variability in cash
flows or fair value. These foreign currency swap and forward agreements are structured to match the foreign currency cash flows of the
hedged foreign denominated securities and liabilities.
The yen denominated individual fixed annuity product was written by Hartford Life Insurance K.K. (“HLIKK”), a wholly-owned
Japanese subsidiary of Hartford Life, Inc. (“HLI”), and subsequently reinsured to Hartford Life Insurance Company, a U.S. dollar based
wholly-owned indirect subsidiary of HLI. During 2009, the Company suspended new sales of the Japan business. The underlying
investment involves investing in U.S. securities markets, which offer favorable credit spreads. The yen denominated fixed annuity
product (“yen fixed annuities”) is recorded in the consolidated balance sheets with invested assets denominated in dollars while
policyholder liabilities are denominated in yen and converted to U.S. dollars based upon the December 31 yen to U.S. dollar spot rate.
The difference between U.S. dollar denominated investments and yen denominated liabilities exposes the Company to currency risk.
The Company manages this currency risk associated with the yen fixed annuities primarily with pay variable U.S. dollar and receive
fixed yen currency swaps.
Although economically an effective hedge, a divergence between the yen denominated fixed annuity product liability and the currency
swaps exists primarily due to the difference in the basis of accounting between the liability and the derivative instruments (i.e. historical
cost versus fair value). The yen denominated fixed annuity product liabilities are recorded on a historical cost basis and are only
adjusted for changes in foreign spot rates and accrued income. The currency swaps are recorded at fair value, incorporating changes in
value due to changes in forward foreign exchange rates, interest rates and accrued income. A portion of the Company’ s foreign
currency exposure is mitigated through the use of derivatives.
Fixed Maturity Investments
The risk associated with the non-U.S. dollar denominated fixed maturities relates to potential decreases in value and income resulting
from unfavorable changes in foreign exchange rates. The fair value of the non-U.S. dollar denominated fixed maturities, which are
primarily denominated in euro, sterling, yen and Canadian dollars, at December 31, 2011 and 2010, were approximately $2.3 billion and
$1.4 billion, respectively. Included in these amounts are $1.9 billion and $1.0 billion at December 31, 2011 and 2010, respectively,
related to non-U.S. dollar denominated fixed maturity securities that directly support liabilities denominated in the same currencies. At
December 31, 2011 and 2010, the derivatives used to hedge currency exchange risk related to the remaining non-U.S. dollar
denominated fixed maturities had a total notional amount of $399 and $431, respectively, and total fair value of $12 and ($6),
respectively.
Based on the fair values of the Company’ s non-U.S. dollar denominated securities, including the associated yen denominated fixed
annuity product liabilities, and derivative instruments as of December 31, 2011 and 2010, management estimates that a 10%
unfavorable change in exchange rates would decrease the fair values by a before-tax total of approximately $113 and $87, respectively.
The estimated impact was based upon a 10% change in December 31 spot rates. The selection of the 10% unfavorable change was
made only for illustration of the potential hypothetical impact of such an event and should not be construed as a prediction of future
market events. Actual results could differ materially from those illustrated above due to the nature of the estimates and assumptions
used in the above analysis.
Liabilities
The Company’ s Wealth Management operations issued non-U.S. dollar denominated funding agreement liability contracts. The
Company hedges the foreign currency risk associated with these liability contracts with currency rate swaps. At December 31, 2011 and
2010, the derivatives used to hedge foreign currency exchange risk related to foreign denominated liability contracts had a total notional
amount of $771 and a total fair value of ($57) and ($17), respectively.
The Company uses currency swaps to manage the foreign currency risk associated with the yen denominated individual fixed annuity
product. As of December 31, 2011 and 2010, the notional value of the currency swaps was $1.9 billion and $2.1 billion and the fair
value was $514 and $608, respectively. The currency swaps are recorded at fair value, incorporating changes in value due to changes in
forward foreign exchange rates, interest rates and accrued income. A before-tax net gain of $3 and $27 for the years ended December
31, 2011 and 2010, respectively, which includes the changes in value of the currency swaps, excluding net periodic coupon settlements,
and the yen fixed annuity contract remeasurement, was recorded in net realized capital gains and losses.