The Hartford 2008 Annual Report Download - page 98

Table of Contents
Pre-SFAS 157 Fair Value
Prior to January 1, 2008, the Company used the guidance prescribed in SFAS 133 and other related accounting literature on
fair value which represented the amount for which a financial instrument could be exchanged in a current transaction
between knowledgeable, unrelated willing parties. However, under that accounting literature, when an estimate of fair value
was made for liabilities where no market observable transactions existed for that liability or similar liabilities, market risk
margins were only included in the valuation if the margin was identifiable, measurable and significant. If a reliable estimate
of market risk margins was not obtainable, the present value of expected future cash flows under a risk neutral framework,
discounted at the risk free rate of interest, was the best available estimate of fair value in the circumstances (“Pre-SFAS 157
Fair Value”). 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
Source: HARTFORD FINANCIAL S, 10-K, February 12, 2009