The Hartford 2011 Annual Report Download - page 157

THE HARTFORD FINANCIAL SERVICES GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
F-22
4. Fair Value Measurements (continued)
Derivative Instruments, including embedded derivatives within investments
Derivative instruments are fair valued using pricing valuation models that utilize independent market data inputs, quoted market prices
for exchange-traded derivatives, or independent broker quotations. Excluding embedded and reinsurance related derivatives, as of
December 31, 2011 and 2010, 98% and 97%, respectively, of derivatives, based upon notional values, were priced by valuation models
or quoted market prices. The remaining derivatives were priced by broker quotations.
The Company performs various controls on derivative valuations which include both quantitative and qualitative analysis. Analyses are
conducted by a dedicated derivative pricing team that works directly with investment sector professionals to analyze impacts of changes
in the market environment and investigate variances. There is a monthly analysis to identify market value changes greater than pre-
defined thresholds, stale prices, missing prices and zero prices. Also on a monthly basis, a second source validation, typically to broker
quotations, is performed for certain of the more complex derivatives, as well as for all new deals during the month. A model validation
review is performed on any new models, which typically includes detailed documentation and validation to a second source. The model
validation documentation and results of validation are presented to the Valuation Committee for approval. There is a monthly control to
review changes in pricing sources to ensure that new models are not moved to production until formally approved.
The Company utilizes derivative instruments to manage the risk associated with certain assets and liabilities. However, the derivative
instrument may not be classified with the same fair value hierarchy level as the associated assets and liabilities. Therefore the realized
and unrealized gains and losses on derivatives reported in Level 3 may not reflect the offsetting impact of the realized and unrealized
gains and losses of the associated assets and liabilities.
Valuation Techniques and Inputs for Investments
Generally, the Company determines the estimated fair value of its AFS securities, fixed maturities, FVO, equity securities, trading, and
short-term investments using the market approach. The income approach is used for securities priced using a pricing matrix, as well as
for derivative instruments. For Level 1 investments, which are comprised of on-the-run U.S. Treasuries, exchange-traded equity
securities, short-term investments, and exchange traded futures and option contracts, valuations are based on observable inputs that
reflect quoted prices for identical assets in active markets that the Company has the ability to access at the measurement date.
For most of the Company’ s debt securities, the following inputs are typically used in the Company’ s pricing methods: reported trades,
benchmark yields, bids and/or estimated cash flows. For securities except U.S. Treasuries, inputs also include issuer spreads, which
may consider credit default swaps. Derivative instruments are valued using mid-market inputs that are predominantly observable in the
market.
A description of additional inputs used in the Company’ s Level 2 and Level 3 measurements is listed below:
Level 2 The fair values of most of the Company’ s Level 2 investments are determined by management after considering prices
received from third party pricing services. These investments include most fixed maturities and preferred stocks, including
those reported in separate account assets.
• ABS, CDOs, CMBS and RMBS – Primary inputs also include monthly payment information, collateral performance,
which varies by vintage year and includes delinquency rates, collateral valuation loss severity rates, collateral
refinancing assumptions, credit default swap indices and, for ABS and RMBS, estimated prepayment rates.
• Corporates, including investment grade private placements – Primary inputs also include observations of credit default
swap curves related to the issuer.
• Foreign government/government agencies – Primary inputs also include observations of credit default swap curves
related to the issuer and political events in emerging markets.
• Municipals – Primary inputs also include Municipal Securities Rulemaking Board reported trades and material event
notices, and issuer financial statements.
• Short-term investments – Primary inputs also include material event notices and new issue money market rates.
• Equity securities, trading – Consist of investments in mutual funds. Primary inputs include net asset values obtained
from third party pricing services.
• Credit derivatives – Significant inputs primarily include the swap yield curve and credit curves.
• Foreign exchange derivatives – Significant inputs primarily include the swap yield curve, currency spot and forward
rates, and cross currency basis curves.
• Interest rate derivatives – Significant input is primarily the swap yield curve.