The Hartford 2011 Annual Report Download - page 156

THE HARTFORD FINANCIAL SERVICES GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
F-21
4. Fair Value Measurements (continued)
Available-for-Sale Securities, Fixed Maturities, FVO, Equity Securities, Trading, and Short-term Investments
The fair value of AFS securities, fixed maturities, FVO, equity securities, trading, and short-term investments in an active and orderly
market (e.g. not distressed or forced liquidation) are determined by management after considering one of three primary sources of
information: third-party pricing services, independent broker quotations or pricing matrices. Security pricing is applied using a
“waterfall” approach whereby publicly available prices are first sought from third-party pricing services, the remaining unpriced
securities are submitted to independent brokers for prices, or lastly, securities are priced using a pricing matrix. Based on the typical
trading volumes and the lack of quoted market prices for fixed maturities, third-party pricing services will normally derive the security
prices from recent reported trades for identical or similar securities making adjustments through the reporting date based upon available
market observable information as outlined above. If there are no recently reported trades, the third-party pricing services and
independent brokers may use matrix or model processes to develop a security price where future cash flow expectations are developed
based upon collateral performance and discounted at an estimated market rate. Included in the pricing of ABS and RMBS are estimates
of the rate of future prepayments of principal over the remaining life of the securities. Such estimates are derived based on the
characteristics of the underlying structure and prepayment speeds previously experienced at the interest rate levels projected for the
underlying collateral. Actual prepayment experience may vary from these estimates.
Prices from third-party pricing services are often unavailable for securities that are rarely traded or are traded only in privately
negotiated transactions. As a result, certain securities are priced via independent broker quotations which utilize inputs that may be
difficult to corroborate with observable market based data. Additionally, the majority of these independent broker quotations are non-
binding.
A pricing matrix is used to price private placement securities for which the Company is unable to obtain a price from a third-party
pricing service by discounting the expected future cash flows from the security by a developed market discount rate utilizing current
credit spreads. Credit spreads are developed each month using market based data for public securities adjusted for credit spread
differentials between public and private securities which are obtained from a survey of multiple private placement brokers. The
appropriate credit spreads determined through this survey approach are based upon the issuer’ s financial strength and term to maturity,
utilizing an independent public security index and trade information and adjusting for the non-public nature of the securities.
The Working Group performs ongoing analysis of the prices and credit spreads received from third parties to ensure that the prices
represent a reasonable estimate of the fair value. This process involves quantitative and qualitative analysis and is overseen by
investment and accounting professionals. As a part of this analysis, the Company considers trading volume, new issuance activity and
other factors to determine whether the market activity is significantly different than normal activity in an active market, and if so,
whether transactions may not be orderly considering the weight of available evidence. If the available evidence indicates that pricing is
based upon transactions that are stale or not orderly, the Company places little, if any, weight on the transaction price and will estimate
fair value utilizing an internal pricing model. In addition, the Company ensures that prices received from independent brokers represent
a reasonable estimate of fair value through the use of internal and external cash flow models developed based on spreads, and when
available, market indices. As a result of this analysis, if the Company determines that there is a more appropriate fair value based upon
the available market data, the price received from the third party is adjusted accordingly and approved by the Valuation Committee. The
Company's internal pricing model utilizes the Company's best estimate of expected future cash flows discounted at a rate of return that a
market participant would require. The significant inputs to the model include, but are not limited to, current market inputs, such as credit
loss assumptions, estimated prepayment speeds and market risk premiums.
The Company conducts other specific activities to monitor controls around pricing. Daily analyses identify price changes over 3-5%,
sale trade prices that differ over 3% from the prior day’ s price and purchase trade prices that differ more than 3% from the current day’ s
price. Weekly analyses identify prices that differ more than 5% from published bond prices of a corporate bond index. Monthly
analyses identify price changes over 3%, prices that haven’ t changed, missing prices and second source validation on most sectors.
Analyses are conducted by a dedicated pricing unit who follows up with trading and investment sector professionals and challenges
prices with vendors when the estimated assumptions used differ from what the Company feels a market participant would use. Any
changes from the identified pricing source are verified by further confirmation of assumptions used. Examples of other procedures
performed include, but are not limited to, initial and on-going review of third-party pricing services’ methodologies, review of pricing
statistics and trends and back testing recent trades. For a sample of structured securities, a comparison of the vendor’ s assumptions to
our internal econometric models is also performed; any differences are challenged in accordance with the process described above.
The Company has analyzed the third-party pricing services’ valuation methodologies and related inputs, and has also evaluated the
various types of securities in its investment portfolio to determine an appropriate fair value hierarchy level based upon trading activity
and the observability of market inputs. Most prices provided by third-party pricing services are classified into Level 2 because the
inputs used in pricing the securities are market observable. Due to a general lack of transparency in the process that brokers use to
develop prices, most valuations that are based on brokers’ prices are classified as Level 3. Some valuations may be classified as Level 2
if the price can be corroborated with observable market data.