The Hartford 2015 Annual Report Download - page 104

104
Derivative Instruments
The Company utilizes a variety of OTC, OTC-cleared and exchange-traded derivative instruments as a part of its overall risk
management strategy, as well as to enter into replication transactions. Derivative instruments are used to manage risk associated with
interest rate, equity market, commodity market, credit spread, issuer default, price, and currency exchange rate risk or volatility.
Replication transactions are used as an economical means to synthetically replicate the characteristics and performance of assets that are
permissible investments under the Company’s investment policies. For further information on the Company’s use of derivatives, see
Note 6 Investments and Derivative Instruments of Notes to Consolidated Financial Statements.
Derivative activities are monitored and evaluated by the Company’s compliance and risk management teams and reviewed by senior
management. In addition, the Company monitors counterparty credit exposure on a monthly basis to ensure compliance with Company
policies and statutory limitations. The notional amounts of derivative contracts represent the basis upon which pay or receive amounts
are calculated and are not reflective of credit risk. Downgrades to the credit ratings of The Hartford’s insurance operating companies
may have adverse implications for its use of derivatives including those used to hedge benefit guarantees of variable annuities. In some
cases, downgrades may give derivative counterparties for OTC derivatives and clearing brokers for OTC-cleared derivatives the right to
cancel and settle outstanding derivative trades or require additional collateral to be posted. In addition, downgrades may result in
counterparties and clearing brokers becoming unwilling to engage in or clear additional derivatives or may require collateralization
before entering into any new trades. This would restrict the supply of derivative instruments commonly used to hedge variable annuity
guarantees, particularly long-dated equity derivatives and interest rate swaps.
The Company uses various derivative counterparties in executing its derivative transactions. The use of counterparties creates credit risk
that the counterparty may not perform in accordance with the terms of the derivative transaction. The Company has derivative
counterparty exposure policies which limit the Company’s exposure to credit risk. The Company’s policies with respect to derivative
counterparty exposure establishes market-based credit limits, favors long-term financial stability and creditworthiness of the
counterparty and typically requires credit enhancement/credit risk reducing agreements. The Company minimizes the credit risk of
derivative instruments by entering into transactions with high quality counterparties primarily rated A or better, which are monitored and
evaluated by the Company’s risk management team and reviewed by senior management. The Company also generally requires that
OTC derivative contracts be governed by an International Swaps and Derivatives Association ("ISDA") Master Agreement, which is
structured by legal entity and by counterparty and permits right of offset.
The Company has developed credit exposure thresholds which are based upon counterparty ratings. Credit exposures are measured using
the market value of the derivatives, resulting in amounts owed to the Company by its counterparties or potential payment obligations
from the Company to its counterparties. The Company enters into credit support annexes in conjunction with the ISDA agreements,
which require daily collateral settlement based upon agreed upon thresholds. For purposes of daily derivative collateral maintenance,
credit exposures are generally quantified based on the prior business day’s market value and collateral is pledged to and held by, or on
behalf of, the Company to the extent the current value of the derivatives exceed the contractual thresholds. In accordance with industry
standard and the contractual agreements, collateral is typically settled on the next business day. The Company has exposure to credit risk
for amounts below the exposure thresholds which are uncollateralized, as well as for market fluctuations that may occur between
contractual settlement periods of collateral movements.
For the company’s derivative programs, the maximum uncollateralized threshold for a derivative counterparty for a single legal entity is
$10. The Company currently transacts OTC derivatives in five legal entities that have a threshold greater than zero; therefore, the
maximum combined threshold for a single counterparty across all legal entities that use derivatives is $50. In addition, the Company
may have exposure to multiple counterparties in a single corporate family due to a common credit support provider. As of December 31,
2015, the maximum combined threshold for all counterparties under a single credit support provider across all legal entities that use
derivatives was $100. Based on the contractual terms of the collateral agreements, these thresholds may be immediately reduced due to a
downgrade in either party’s credit rating. For further discussion, see the Derivative Commitments section of Note 12 Commitments and
Contingencies of Notes to Consolidated Financial Statements.
For the year ended December 31, 2015, the Company incurred no losses on derivative instruments due to counterparty default.
In addition to counterparty credit risk, the Company may also introduce credit risk through the use of credit default swaps that are
entered into to manage credit exposure. Credit default swaps involve a transfer of credit risk of one or many referenced entities from one
party to another in exchange for periodic payments. The party that purchases credit protection will make periodic payments based on an
agreed upon rate and notional amount, and for certain transactions there will also be an upfront premium payment. The second party,
who assumes credit risk, will typically only make a payment if there is a credit event as defined in the contract and such payment will
typically be equal to the notional value of the swap contract less the value of the referenced security issuer’s debt obligation. A credit
event is generally defined as default on contractually obligated interest or principal payments or bankruptcy of the referenced entity.