10-Q 1 b10qsep30.txt THE HARTFORD FINANCIAL SERVICES GROUP, INC. ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2002 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ____________ to ______________ Commission file number 0-19277 THE HARTFORD FINANCIAL SERVICES GROUP, INC. (Exact name of registrant as specified in its charter) DELAWARE 13-3317783 (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) HARTFORD PLAZA, HARTFORD, CONNECTICUT 06115-1900 (Address of principal executive offices) (860) 547-5000 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No[ ] As of October 31, 2002, there were outstanding 255,152,830 shares of Common Stock, $0.01 par value per share, of the registrant. ================================================================================ INDEX PAGE ---- Independent Accountants' Review Report 3 PART I. FINANCIAL INFORMATION ------------------------------ ITEM 1. FINANCIAL STATEMENTS 4 Consolidated Statements of Income - Third Quarter and Nine Months Ended September 30, 2002 and 2001 4 Consolidated Balance Sheets - September 30, 2002 and December 31, 2001 5 Consolidated Statements of Changes in Stockholders' Equity - Nine Months Ended September 30, 2002 and 2001 6 Consolidated Statements of Cash Flows - Nine Months Ended September 30, 2002 and 2001 7 Notes to Consolidated Financial Statements 8 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 19 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 42 ITEM 4. CONTROLS AND PROCEDURES 42 PART II. OTHER INFORMATION --------------------------- ITEM 1. LEGAL PROCEEDINGS 42 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K 43 Signature 45 Certifications 46 - 2 - INDEPENDENT ACCOUNTANTS' REVIEW REPORT Board of Directors and Stockholders The Hartford Financial Services Group, Inc. Hartford, Connecticut We have reviewed the accompanying consolidated balance sheet of The Hartford Financial Services Group, Inc. and subsidiaries (the "Company") as of September 30, 2002, and the related consolidated statements of income for the third quarter and nine months then ended, and changes in stockholders' equity and cash flows for the nine months then ended. These consolidated financial statements are the responsibility of the Company's management. We conducted our review in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data and of making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with auditing standards generally accepted in the United States of America, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our review, we are not aware of any material modifications that should be made to such consolidated financial statements for them to be in conformity with accounting principles generally accepted in the United States of America. The accompanying consolidated financial information as of December 31, 2001, and for the third quarter and nine months ended September 30, 2001, were not audited or reviewed by us and, accordingly, we do not express an opinion or any other form of assurance on them. Deloitte & Touche LLP Hartford, Connecticut November 12, 2002 - 3 - PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS
THE HARTFORD FINANCIAL SERVICES GROUP, INC. CONSOLIDATED STATEMENTS OF INCOME THIRD QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ----------------------------- ----------------------------- (IN MILLIONS, EXCEPT FOR PER SHARE DATA) 2002 2001 2002 2001 ------------------------------------------------------------------------------------------------------------------------------------ (Unaudited) (Unaudited) REVENUES Earned premiums $ 2,650 $ 2,287 $ 7,609 $ 6,954 Fee income 627 654 1,961 1,942 Net investment income 729 714 2,161 2,124 Other revenue 115 121 348 362 Net realized capital losses (160) (54) (333) (91) ------------------------------------------------------------------------------------------------------------------------------------ TOTAL REVENUES 3,961 3,722 11,746 11,291 -------------------------------------------------------------------------------------------------------------------------- BENEFITS, CLAIMS AND EXPENSES Benefits, claims and claim adjustment expenses 2,433 2,886 7,064 7,435 Amortization of deferred policy acquisition costs and present value of future profits 568 556 1,696 1,630 Insurance operating costs and expenses 567 513 1,661 1,461 Goodwill amortization -- 15 -- 43 Other expenses 199 178 563 532 ------------------------------------------------------------------------------------------------------------------------------------ TOTAL BENEFITS, CLAIMS AND EXPENSES 3,767 4,148 10,984 11,101 -------------------------------------------------------------------------------------------------------------------------- INCOME (LOSS) BEFORE INCOME TAXES AND CUMULATIVE EFFECT OF ACCOUNTING CHANGES 194 (426) 762 190 Income tax (benefit) expense (71) (323) 20 (207) ------------------------------------------------------------------------------------------------------------------------------------ INCOME (LOSS) BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGES 265 (103) 742 397 Cumulative effect of accounting changes, net of tax -- -- -- (34) ------------------------------------------------------------------------------------------------------------------------------------ NET INCOME (LOSS) $ 265 $ (103) $ 742 $ 363 -------------------------------------------------------------------------------------------------------------------------- BASIC EARNINGS (LOSS) PER SHARE Income (loss) before cumulative effect of accounting changes $ 1.06 $ (0.43) $ 3.00 $ 1.69 Cumulative effect of accounting changes, net of tax -- -- -- (0.15) ------------------------------------------------------------------------------------------------------------------------------------ NET INCOME (LOSS) $ 1.06 $ (0.43) $ 3.00 $ 1.54 DILUTED EARNINGS (LOSS) PER SHARE [1] Income (loss) before cumulative effect of accounting changes $ 1.06 $ (0.43) $ 2.96 $ 1.66 Cumulative effect of accounting changes, net of tax -- -- -- (0.14) ------------------------------------------------------------------------------------------------------------------------------------ NET INCOME (LOSS) $ 1.06 $ (0.43) $ 2.96 $ 1.52 ------------------------------------------------------------------------------------------------------------------------------------ Weighted average common shares outstanding 248.9 238.0 247.4 235.6 Weighted average common shares outstanding and dilutive potential common shares [1] 250.5 238.0 250.3 239.5 ------------------------------------------------------------------------------------------------------------------------------------ Cash dividends declared per share $ 0.26 $ 0.25 $ 0.78 $ 0.75 ==================================================================================================================================== [1] In the absence of the third quarter 2001 net loss, 241.7 weighted average common shares and dilutive potential common shares outstanding would have been used in the calculation of diluted earnings per share for the quarter ended September 30, 2001.
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. - 4 -
THE HARTFORD FINANCIAL SERVICES GROUP, INC. CONSOLIDATED BALANCE SHEETS SEPTEMBER 30, DECEMBER 31, (IN MILLIONS, EXCEPT FOR SHARE DATA) 2002 2001 --------------------------------------------------------------------------------------------------------------------------------- (Unaudited) ASSETS Investments ----------- Fixed maturities, available for sale, at fair value (amortized cost of $45,616 and $39,154) $ 48,085 $ 40,046 Equity securities, available for sale, at fair value (cost of $1,082 and $1,289) 985 1,349 Policy loans, at outstanding balance 2,980 3,317 Other investments 2,051 1,977 --------------------------------------------------------------------------------------------------------------------------------- Total investments 54,101 46,689 Cash 413 353 Premiums receivable and agents' balances 2,628 2,432 Reinsurance recoverables 5,046 5,162 Deferred policy acquisition costs and present value of future profits 6,853 6,420 Deferred income taxes 281 693 Goodwill 1,722 1,722 Other assets 2,962 3,044 Separate account assets 101,533 114,720 --------------------------------------------------------------------------------------------------------------------------------- TOTAL ASSETS $ 175,539 $ 181,235 ========================================================================================================================= LIABILITIES Future policy benefits, unpaid claims and claim adjustment expenses Property & Casualty $ 16,782 $ 16,678 Life 9,327 8,819 Other policyholder funds and benefits payable 22,336 19,355 Unearned premiums 3,973 3,436 Short-term debt 615 599 Long-term debt 2,595 1,965 Company obligated mandatorily redeemable preferred securities of subsidiary trusts holding solely junior subordinated debentures 1,461 1,412 Other liabilities 5,974 5,238 Separate account liabilities 101,533 114,720 --------------------------------------------------------------------------------------------------------------------------------- 164,596 172,222 COMMITMENTS AND CONTINGENCIES (NOTE 5) STOCKHOLDERS' EQUITY Common stock - par value $0.01, 750,000,000 and 400,000,000 shares authorized, 257,952,460 and 248,477,367 shares issued 3 2 Additional paid-in capital 2,766 2,362 Retained earnings 6,701 6,152 Treasury stock, at cost - 2,943,565 and 2,941,340 shares (37) (37) Accumulated other comprehensive income 1,510 534 --------------------------------------------------------------------------------------------------------------------------------- TOTAL STOCKHOLDERS' EQUITY 10,943 9,013 ------------------------------------------------------------------------------------------------------------------------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 175,539 $ 181,235 =========================================================================================================================
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. - 5 -
THE HARTFORD FINANCIAL SERVICES GROUP, INC. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY NINE MONTHS ENDED SEPTEMBER 30, 2002 Accumulated Other Comprehensive Income (Loss) -------------------------------------------------- Common Net Gain on Minimum Stock/ Unrealized Cash-Flow Cumulative Pension Outstanding Additional Treasury Gain on Hedging Translation Liability Shares Paid-in Retained Stock, Securities, Instruments, Adjustments, Adjustment, (In (In millions) (Unaudited) Capital Earnings at Cost net of tax net of tax net of tax net of tax Total thousands) ---------------------------------------------------------------------------------------------------------------------------------- BALANCE, BEGINNING OF PERIOD $2,364 $6,152 $(37) $606 $63 $(116) $(19) $9,013 245,536 Comprehensive income Net income 742 742 Other comprehensive income, net of tax [1] Unrealized gain on securities [2] 899 899 Net gain on cash-flow hedging instruments [3] 81 81 Translation adjustments (4) (4) -------- Total other comprehensive income 976 -------- Total comprehensive income 1,718 -------- Issuance of shares under incentive and stock purchase plans 89 89 2,170 Issuance of common stock in underwritten offering 330 330 7,303 Issuance of equity units (33) (33) Tax benefit on employee stock options and awards 19 19 Dividends declared on common stock (193) (193) ---------------------------------------------------------------------------------------------------------------------------------- BALANCE, END OF PERIOD $2,769 $6,701 $(37) $1,505 $144 $(120) $(19) $10,943 255,009 ================================================================================================================================== NINE MONTHS ENDED SEPTEMBER 30, 2001 Accumulated Other Comprehensive Income (Loss) -------------------------------------------------- Common Unrealized Net Gain on Minimum Stock/ Gain Cash-Flow Cumulative Pension Outstanding Additional Treasury (Loss) on Hedging Translation Liability Shares Paid-in Retained Stock, Securities, Instruments, Adjustments, Adjustment, (In (In millions) (Unaudited) Capital Earnings at Cost net of tax net of tax net of tax net of tax Total thousands) ---------------------------------------------------------------------------------------------------------------------------------- BALANCE, BEGINNING OF PERIOD $1,688 $5,887 $(480) $497 $-- $(113) $(15) $7,464 226,290 Comprehensive income Net income 363 363 Other comprehensive income, net of tax [1] Cumulative effect of accounting change [4] (1) 24 23 Unrealized gain on securities [2] 334 334 Net gain on cash-flow hedging instruments [3] 68 68 Translation adjustments (10) (10) ------- Total other comprehensive income 415 ------- Total comprehensive income 778 ------- Issuance of shares under incentive and stock purchase plans 76 4 80 1,924 Issuance of common stock in underwritten offering 169 446 615 10,000 Tax benefit on employee stock options and awards 14 14 Treasury stock acquired (7) (7) (127) Dividends declared on common stock (178) (178) ---------------------------------------------------------------------------------------------------------------------------------- BALANCE, END OF PERIOD $1,947 $6,072 $(37) $830 $92 $(123) $(15) $8,766 238,087 ================================================================================================================================== [1] Unrealized gain (loss) on securities is net of tax expense of $484 and $180 for the nine months ended September 30, 2002 and 2001, respectively. Net gain on cash-flow hedging instruments is net of tax expense of $44 and $37 for the nine months ended September 30, 2002 and 2001, respectively. For the nine months ended September 30, 2001, cumulative effect of accounting change is net of tax benefit of $12. Translation adjustments are net of tax benefits of $2 and $5 for the nine months ended September 30, 2002 and 2001, respectively. [2] Net of reclassification adjustment for gains (losses) realized in net income of $(207) and $2 for the nine months ended September 30, 2002 and 2001, respectively. [3] Net of amortization adjustment of $3 and $5 to net investment income for the nine months ended September 30, 2002 and 2001, respectively. [4] For the nine months ended September 30, 2001, unrealized gain (loss) on securities, net of tax, includes cumulative effect of accounting change of $(23) to net income and $24 to net gain on cash-flow hedging instruments.
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. - 6 -
THE HARTFORD FINANCIAL SERVICES GROUP, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS NINE MONTHS ENDED SEPTEMBER 30, ---------------------------------- (IN MILLIONS) 2002 2001 -------------------------------------------------------------------------------------------------------------------------------- (Unaudited) OPERATING ACTIVITIES Net income $ 742 $ 363 ADJUSTMENTS TO RECONCILE NET INCOME TO NET CASH PROVIDED BY OPERATING ACTIVITIES Change in receivables, payables and accruals (168) (54) Change in reinsurance recoverables and other related assets 208 (527) Amortization of deferred policy acquisition costs and present value of future profits 1,696 1,630 Additions to deferred policy acquisition costs and present value of future profits (2,129) (2,047) Change in accrued and deferred income taxes 229 (210) Increase in liabilities for future policy benefits, unpaid claims and claim adjustment expenses and unearned premiums 1,086 1,866 Net realized capital losses 333 91 Depreciation and amortization 61 38 Cumulative effect of accounting changes, net of tax -- 34 Other, net 34 (125) -------------------------------------------------------------------------------------------------------------------------------- NET CASH PROVIDED BY OPERATING ACTIVITIES 2,092 1,059 ================================================================================================================================ INVESTING ACTIVITIES Purchase of investments (15,992) (12,512) Sale of investments 8,304 7,523 Maturity of investments 2,033 2,139 Purchase of business/affiliate -- (1,105) Sale of affiliates 3 15 Additions to property, plant and equipment (128) (141) -------------------------------------------------------------------------------------------------------------------------------- NET CASH USED FOR INVESTING ACTIVITIES (5,780) (4,081) ================================================================================================================================ FINANCING ACTIVITIES Issuance of short-term debt 16 -- Issuance of long-term debt 617 400 Issuance of company obligated mandatorily redeemable preferred securities of subsidiary trusts holding solely junior subordinated debentures -- 200 Issuance of common stock in underwritten offering 330 615 Net proceeds from investment and universal life-type contracts 2,885 2,027 Dividends paid (192) (176) Acquisition of treasury stock -- (7) Proceeds from issuance of shares under incentive and stock purchase plans 84 61 -------------------------------------------------------------------------------------------------------------------------------- NET CASH PROVIDED BY FINANCING ACTIVITIES 3,740 3,120 ================================================================================================================================ Foreign exchange rate effect on cash 8 -- -------------------------------------------------------------------------------------------------------------------------------- Net increase in cash 60 98 Cash - beginning of period 353 227 -------------------------------------------------------------------------------------------------------------------------------- CASH - END OF PERIOD $ 413 $ 325 ================================================================================================================================ SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION ------------------------------------------------ NET CASH (RECEIVED) PAID DURING THE PERIOD FOR: Income taxes $ (162) $ 37 Interest $ 167 $ 150
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. - 7 - THE HARTFORD FINANCIAL SERVICES GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar amounts in millions except per share and per unit data or unless otherwise stated) (Unaudited) NOTE 1. BASIS OF PRESENTATION AND ACCOUNTING POLICIES (A) BASIS OF PRESENTATION The accompanying unaudited consolidated financial statements of The Hartford Financial Services Group, Inc. and its subsidiaries ("The Hartford" or the "Company") have been prepared in accordance with accounting principles generally accepted in the United States of America. Less than majority-owned subsidiaries in which The Hartford has at least a 20% interest are reported on the equity basis. In the opinion of management, these financial statements include all normal recurring adjustments necessary to present fairly the consolidated financial position, results of operations and cash flows for the periods presented. On April 2, 2001, The Hartford acquired the U.S. individual life insurance, annuity and mutual fund businesses of Fortis, Inc. (operating as "Fortis Financial Group" or "Fortis"). The acquisition was accounted for as a purchase transaction and, as such, the revenues and expenses generated by this business from April 2, 2001 forward are included in the Company's Consolidated Statements of Income. Certain reclassifications have been made to prior year financial information to conform to the current year classifications. (B) SIGNIFICANT ACCOUNTING POLICIES For a description of accounting policies, see Note 1 of Notes to Consolidated Financial Statements included in The Hartford's 2001 Form 10-K Annual Report. (C) ADOPTION OF NEW ACCOUNTING STANDARDS In April 2002, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections". Under historical guidance, all gains and losses resulting from the extinguishment of debt were required to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect. SFAS No. 145 rescinds that guidance and requires that gains and losses from extinguishment of debt be classified as extraordinary items only if they are both unusual and infrequent in occurrence. SFAS No. 145 also amends SFAS No. 13, "Accounting for Leases" for the required accounting treatment of certain lease modifications that have economic effects similar to sale-leaseback transactions. SFAS No. 145 requires that those lease modifications be accounted for in the same manner as sale-leaseback transactions. The provisions of SFAS No. 145 related to the rescission of SFAS No. 4 are applicable in fiscal years beginning after May 15, 2002 and will be effective for The Hartford January 1, 2003. Adoption of the provisions of SFAS No. 145 related to the rescission of SFAS No. 4 is not expected to have a material impact on the Company's consolidated financial condition or results of operations. The provisions of SFAS No. 145 related to SFAS No. 13 are effective for transactions occurring after May 15, 2002. Adoption of the provisions of SFAS No. 145 related to SFAS No. 13 did not have a material impact on the Company's consolidated financial condition or results of operations. In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets". SFAS No. 144 establishes an accounting model for long-lived assets to be disposed of by sale that applies to all long-lived assets, including discontinued operations. SFAS No. 144 requires that those long-lived assets be measured at the lower of carrying amount or fair value less cost to sell, whether reported in continuing operations or in discontinued operations. The provisions of SFAS No. 144 are effective for financial statements issued for fiscal years beginning after December 15, 2001. Adoption of SFAS No. 144 did not have a material impact on the Company's consolidated financial condition or results of operations. In June 2001, the FASB issued SFAS No. 141, "Business Combinations". SFAS No. 141 eliminates the pooling-of-interests method of accounting for business combinations, requiring all business combinations to be accounted for under the purchase method. Accordingly, net assets acquired are recorded at fair value with any excess of cost over net assets assigned to goodwill. SFAS No. 141 also requires that certain intangible assets acquired in a business combination be recognized apart from goodwill. The provisions of SFAS No. 141 apply to all business combinations initiated after June 30, 2001. Adoption of SFAS No. 141 did not have a material impact on the Company's consolidated financial condition or results of operations. In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible Assets". Under SFAS No. 142, amortization of goodwill is precluded, however, its recoverability must be periodically (at least annually) reviewed and tested for impairment. Goodwill must be tested at the reporting unit level for impairment in the year of adoption, including an initial test performed within six months of adoption. If the initial test indicates a potential impairment, then a more detailed analysis to determine the extent of impairment must be completed within twelve months of adoption. During the second quarter of 2002, the Company completed the review and analysis of its goodwill asset in accordance with the provisions of SFAS No. 142. The result of the analysis indicated that each reporting unit's fair value exceeded its carrying amount, including goodwill. As a result, goodwill for each reporting unit was not considered impaired. Adoption of all other provisions of SFAS No. 142 did not have a material impact on the Company's consolidated financial condition or results of operations. SFAS No. 142 also requires that useful lives for intangibles other than goodwill be reassessed and remaining amortization periods be adjusted accordingly. (For further discussion of the impact of SFAS No. 142, see Note 2.) - 8 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 1. BASIS OF PRESENTATION AND ACCOUNTING POLICIES (CONTINUED) (D) FUTURE ADOPTION OF NEW ACCOUNTING STANDARDS In July 2002, the FASB issued SFAS No. 146 "Accounting for Certain Costs Associated with Exit or Disposal Activities", which nullifies Emerging Issues Task Force ("EITF") Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." SFAS No. 146 establishes a change in the requirements for recognition of a liability for a cost associated with an exit or disposal activity. This statement now requires liabilities to be recognized when a company actually incurs the liability. Previously, under EITF Issue No. 94-3, liabilities were recognized at the date an entity committed to an exit plan. Provisions of SFAS No. 146 are effective for activities initiated after December 31, 2002. Adoption of this statement is not expected to have a material impact on the Company's consolidated financial condition or results of operations. (E) EXPENSING STOCK OPTIONS Beginning in January 2003, the Company will adopt the fair-value recognition provisions of accounting for employee stock options under SFAS No. 123, "Accounting for Stock-Based Compensation". The Company believes the use of the fair-value method to record employee stock-based compensation expense is consistent with the Company's accounting for all other forms of compensation. This method of accounting for stock options will be used for all awards granted or modified after January 1, 2003. The Company currently applies the intrinsic value based provisions set forth in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees". SFAS No. 123 permits companies either to use the fair-value method and recognize compensation expense upon the issuance of stock options, thereby lowering earnings, or, alternatively, to disclose the pro-forma impact of the issuance. Under current accounting rules, if the Company had expensed options issued in 2002, the impact on earnings for the full year would have been approximately $0.08 to $0.09 per diluted share. If future options grants remain at the same level, the annual impact would increase to approximately $0.25 to $0.27 per diluted share, considering the Company's three-year vesting period. The FASB is conducting a fast-track project, which proposes three optional transition methods for entities that decide to voluntarily adopt the fair value recognition principles of SFAS No. 123 and modifies the disclosure requirements of that Statement. Under the guidance contained in an exposure draft issued by the FASB, entities would have the ability to select any one of the three proposed transition methods. While the Company is committed to expensing the fair value of its option grants, the ultimate transition method to be used by the Company will be determined at the completion of the FASB project. NOTE 2. GOODWILL AND OTHER INTANGIBLE ASSETS Effective January 1, 2002, the Company adopted SFAS No. 142 and accordingly ceased all amortization of goodwill. The following tables show net income and earnings per share for the third quarter and nine months ended September 30, 2002 and 2001, with the 2001 periods adjusted for goodwill amortization recorded during the specified period.
THIRD QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------------------------------------------------ NET INCOME (LOSS) 2002 2001 2002 2001 ----------------------------------------------------------------------------------------------------------------------------------- Income (loss) before cumulative effect of accounting changes $ 265 $ (103) $ 742 $ 397 Goodwill amortization, net of tax -- 13 -- 38 ----------------------------------------------------------------------------------------------------------------------------------- Adjusted income (loss) before cumulative effect of accounting changes 265 (90) 742 435 Cumulative effect of accounting changes, net of tax -- -- -- (34) ----------------------------------------------------------------------------------------------------------------------------------- Adjusted net income (loss) $ 265 $ (90) $ 742 $ 401 =================================================================================================================================== BASIC EARNINGS (LOSS) PER SHARE ----------------------------------------------------------------------------------------------------------------------------------- Income (loss) before cumulative effect of accounting changes $ 1.06 $ (0.43) $ 3.00 $ 1.69 Goodwill amortization, net of tax -- 0.05 -- 0.16 ----------------------------------------------------------------------------------------------------------------------------------- Adjusted income (loss) before cumulative effect of accounting changes 1.06 (0.38) 3.00 1.85 Cumulative effect of accounting changes, net of tax -- -- -- (0.15) ----------------------------------------------------------------------------------------------------------------------------------- Adjusted net income (loss) $ 1.06 $ (0.38) $ 3.00 $ 1.70 =================================================================================================================================== DILUTED EARNINGS (LOSS) PER SHARE ----------------------------------------------------------------------------------------------------------------------------------- Income (loss) before cumulative effect of accounting changes $ 1.06 $ (0.43) $ 2.96 $ 1.66 Goodwill amortization, net of tax -- 0.05 -- 0.15 ----------------------------------------------------------------------------------------------------------------------------------- Adjusted income (loss) before cumulative effect of accounting changes 1.06 (0.38) 2.96 1.81 Cumulative effect of accounting changes, net of tax -- -- -- (0.14) ----------------------------------------------------------------------------------------------------------------------------------- Adjusted net income (loss) $ 1.06 $ (0.38) $ 2.96 $ 1.67 ===================================================================================================================================
- 9 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 2. GOODWILL AND OTHER INTANGIBLE ASSETS (CONTINUED) The following table shows the Company's acquired intangible assets that continue to be subject to amortization and aggregate amortization expense. Except for goodwill, the Company has no intangible assets with indefinite useful lives.
AS OF SEPTEMBER 30, 2002 ---------------------------------------------- GROSS CARRYING ACCUMULATED NET AMORTIZED INTANGIBLE ASSETS AMOUNT AMORTIZATION ------------------------------------------------------------------------------------------------------------------------------------ Present value of future profits $ 1,406 $ 244 Renewal rights 42 26 ------------------------------------------------------------------------------------------------------------------------------------ Total $ 1,448 $ 270 ====================================================================================================================================
Net amortization expense for the third quarter and nine months ended September 30, 2002 was $35 and $87, respectively. Estimated future net amortization expense for the succeeding five years is as follows. For the year ended December 31, -------------------------------------- -- ----------- 2002 $ 122 2003 $ 120 2004 $ 114 2005 $ 104 2006 $ 93 ====================================== == =========== The carrying amounts of goodwill as of September 30, 2002 and December 31, 2001 are shown below.
SEPTEMBER 30, 2002 DECEMBER 31, 2001 ------------------------------------------------------------------------------------------------------------------------------------ Life $ 796 $ 796 Property & Casualty 154 154 Corporate 772 772 ------------------------------------------------------------------------------------------------------------------------------------ Total $ 1,722 $ 1,722 ====================================================================================================================================
NOTE 3. DERIVATIVES AND HEDGING ACTIVITIES The Company utilizes a variety of derivative instruments in the ordinary course of business, including swaps, caps, floors, forwards and exchange traded futures and options, to manage risk through one of four Company-approved objectives: to hedge risk arising from interest rate, price or currency exchange rate volatility; to manage liquidity; to control transaction costs; or to enter into income enhancement and replication transactions. All of the Company's derivative transactions are permitted uses of derivatives under the derivatives use plan filed and/or approved, as applicable, by the State of Connecticut and State of New York insurance departments. For a detailed discussion of the Company's use of derivative instruments, see Note 1(e) of Notes to Consolidated Financial Statements included in The Hartford's December 31, 2001 Form 10-K Annual Report. As of September 30, 2002, the Company reported $329 of derivative assets in other investments and $204 of derivative liabilities in other liabilities. Cash-Flow Hedges For the third quarter and nine months ended September 30, 2002, the Company's gross gains and losses representing the total ineffectiveness of all cash-flow hedges were immaterial, with the net impact reported as realized capital gains or losses. All components of each derivative's gain or loss are included in the assessment of hedge effectiveness. Gains and losses on derivative contracts that are reclassified from other comprehensive income to current period earnings are included in the line item in the Consolidated Statements of Income in which the hedged item is recorded. As of September 30, 2002, approximately $5 of after-tax deferred net gains on derivative instruments accumulated in other comprehensive income are expected to be reclassified to earnings during the next twelve months. This expectation is based on the anticipated interest payments on hedged investments in fixed maturity securities that will occur over the next twelve months, at which time the Company will recognize the deferred net gains/losses as an adjustment to interest income over the term of the investment cash flows. The maximum term over which the Company is hedging its exposure to the variability of future cash flows (for all forecasted transactions, excluding interest payments on variable-rate debt) is twelve months. As of September 30, 2002, the Company held approximately $2.9 billion in derivative notional value related to strategies categorized as cash-flow hedges. For the third quarter and nine months ended September 30, 2002 and 2001, the net gain reclassifications from other comprehensive income to earnings resulting from the discontinuance of cash-flow hedges were immaterial. - 10 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 3. DERIVATIVES AND HEDGING ACTIVITIES (CONTINUED) Fair-Value Hedges For the third quarter and nine months ended September 30, 2002, the Company's gross gains and losses representing the total ineffectiveness of all fair-value hedges were immaterial, with the net impact reported as realized capital gains or losses. All components of each derivative's gain or loss are included in the assessment of hedge effectiveness. As of September 30, 2002, the Company held approximately $845 in derivative notional value related to strategies categorized as fair-value hedges. Other Risk Management Activities The Company's other risk management activities primarily relate to strategies used to reduce economic risk or enhance income, and do not receive hedge accounting treatment. Swap agreements, interest rate cap and floor agreements and option contracts are used to reduce economic risk. Income enhancement and replication transactions include the use of written covered call options which offset embedded equity call options, total return swaps and synthetic replication of cash market instruments. The change in the value of all derivatives held for other risk management purposes is reported in current period earnings as realized capital gains or losses. As of September 30, 2002, the Company held approximately $5.4 billion in derivative notional value related to strategies categorized as Other Risk Management Activities. NOTE 4. EARNINGS PER SHARE The following tables present a reconciliation of net income and shares used in calculating basic earnings per share to those used in calculating diluted earnings per share.
Third Quarter Ended Nine Months Ended -------------------------------------- ------------------------------------- Net Income Per Share Net Per Share SEPTEMBER 30, 2002 (Loss) Shares Amount Income Shares Amount ------------------------------------------------------------------------------------------------------------------------------------ BASIC EARNINGS PER SHARE Income available to common shareholders $ 265 248.9 $ 1.06 $ 742 247.4 $ 3.00 ============== ============ DILUTED EARNINGS PER SHARE Options and contingently issuable shares -- 1.6 -- 2.9 ------------------------ ------------------------- Income available to common shareholders plus assumed conversions $ 265 250.5 $ 1.06 $ 742 250.3 $ 2.96 ==================================================================================================================================== SEPTEMBER 30, 2001 ------------------------------------------------------------------------------------------------------------------------------------ BASIC EARNINGS (LOSS) PER SHARE Income (loss) available to common shareholders $ (103) 238.0 $ (0.43) $ 363 235.6 $ 1.54 ============== ============ DILUTED EARNINGS (LOSS) PER SHARE Options and contingently issuable shares [1] -- -- -- 3.9 ------------------------ ------------------------- Income (loss) available to common shareholders plus assumed conversions [1] $ (103) 238.0 $ (0.43) $ 363 239.5 $ 1.52 ==================================================================================================================================== [1] As a result of the net loss in the quarter ended September 30, 2001, SFAS No. 128, "Earnings Per Share", requires the Company to use basic weighted average shares outstanding in the calculation of third quarter 2001 diluted earnings per share, as the inclusion of options and contingently issuable shares of 3.7 would have been antidilutive to the earnings per share calculation. In the absence of the net loss, weighted average common shares outstanding and dilutive potential common shares would have totaled 241.7.
Basic earnings per share reflects the actual weighted average number of shares outstanding during the period. Diluted earnings per share includes the dilutive effect of outstanding options, using the treasury stock method, and contingently issuable shares. Under the treasury stock method, exercise of options is assumed, with the proceeds used to repurchase common stock at the average market price for the period. Contingently issuable shares are included upon satisfaction of certain conditions related to the contingency. NOTE 5. COMMITMENTS AND CONTINGENCIES (A) LITIGATION The Hartford is involved in claims litigation arising in the ordinary course of business, both as a liability insurer defending third-party claims brought against insureds or as an insurer defending coverage claims brought against it. The Hartford accounts for such activity through the establishment of unpaid claim and claim adjustment expense reserves. Subject to the discussion of the litigation involving MacArthur Company and its subsidiary, Western MacArthur Company, both former regional distributors of asbestos products (collectively or individually, "MacArthur") in (d) below under the caption "Subsequent Events" and the uncertainties discussed in (b) below under the caption "Asbestos and Environmental Claims," management expects that the ultimate liability, if any, with respect to such ordinary-course claims litigation, after consideration of provisions made for potential losses and costs of defense, will not be material to the consolidated financial condition, results of operations or cash flows of The Hartford. The Hartford is also involved in other kinds of legal actions, some of which assert claims for substantial amounts. These actions include, among others, putative state and federal class actions seeking certification of a state or national class. Such putative class actions have alleged, for example, underpayment of claims or improper underwriting practices in connection with various kinds of insurance policies, such as personal and commercial - 11 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 5. COMMITMENTS AND CONTINGENCIES (CONTINUED) (A) LITIGATION (CONTINUED) automobile, premises liability, and inland marine. The Hartford also is involved in individual actions in which punitive damages are sought, such as claims alleging bad faith in the handling of insurance claims. Management expects that the ultimate liability, if any, with respect to such lawsuits, after consideration of provisions made for potential losses and costs of defense, will not be material to the consolidated financial condition of The Hartford. Nonetheless, given the large or indeterminate amounts sought in certain of these actions, and the inherent unpredictability of litigation, it is possible that an adverse outcome in certain matters could, from time to time, have a material adverse effect on the Company's consolidated results of operations or cash flows in particular quarterly or annual periods. On March 15, 2002, a jury in the U.S. District Court for the Eastern District of Missouri issued a verdict in Bancorp Services, LLC ("Bancorp") v. Hartford Life Insurance Company ("HLIC"), et al. in favor of Bancorp in the amount of $118. The case involved claims of patent infringement, misappropriation of trade secrets, and breach of contract against HLIC and its affiliate International Corporate Marketing Group, Inc. ("ICMG"). The judge dismissed the patent infringement claim on summary judgment. The jury's award was based on the last two claims. On August 28, 2002, the Court entered an order awarding Bancorp prejudgment interest on the breach of contract claim in the amount of $16. HLIC and ICMG have moved the district court for, among other things, judgment as a matter of law or a new trial, and intend to appeal the judgment if the district court does not set it aside or substantially reduce it. In either event, the Company's management, based on the opinion of its legal advisers, believes that there is a substantial likelihood that the jury award will not survive at its current amount. Based on the advice of legal counsel regarding the potential outcome of this litigation, the Company recorded an $11 after-tax charge in the first quarter of 2002 to increase litigation reserves associated with this matter. Should HLIC and ICMG not succeed in eliminating or reducing the judgment, a significant additional expense would be recorded in the future related to this matter. The Company is involved in arbitration with one of its primary reinsurers relating to policies with death benefit guarantees written from 1994 to 1999. The arbitration involves alleged breaches under the reinsurance treaties. Although the Company believes that its position in this pending arbitration is strong, an adverse outcome could result in a decrease to the Company's statutory surplus and capital and potentially increase the death benefit costs incurred by the Company in the future. The arbitration hearing began in October 2002. (B) ASBESTOS AND ENVIRONMENTAL CLAIMS The Hartford continues to receive claims that assert damages from asbestos and environmental-related exposures. Asbestos claims relate primarily to injuries asserted by those who came in contact with asbestos or products containing asbestos. Environmental claims relate primarily to pollution and related clean-up costs. The Hartford receives asbestos and environmental claims made pursuant to several different categories of insurance coverage. First, The Hartford wrote policies as a primary liability insurance carrier. Second, The Hartford wrote excess insurance policies that provide additional coverage for insureds that exhaust their primary liability insurance coverage. Third, The Hartford acted as a reinsurer assuming a portion of risks previously assumed by other insurers writing primary, excess and reinsurance coverages. Writers of excess insurance and reinsurance often receive information regarding potential exposures significantly later than primary writers covering the same risk. The Hartford may experience more difficulty and delays in estimating its exposures arising from excess and reinsurance policies than it does in estimating exposures arising from its activity as a primary insurance writer. With regard to both environmental and particularly asbestos claims, uncertainty exists which affects the ability of insurers and reinsurers to estimate the ultimate reserves necessary for unpaid losses and related settlement expenses. Conventional reserving techniques cannot reasonably estimate the ultimate cost of these claims, particularly during periods where theories of law are in flux. As a result of the factors discussed in the following paragraphs, the degree of variability of reserve estimates for these exposures is significantly greater than for other more traditional exposures. In particular, The Hartford believes there is a high degree of uncertainty in the estimation of asbestos loss reserves. In the case of the reserves for asbestos exposures, factors contributing to the high degree of uncertainty include inadequate development patterns, plaintiffs' expanding theories of liability, the risks inherent in major litigation and inconsistent emerging legal doctrines. There are complex legal issues concerning the interpretation of various insurance policy provisions and whether those losses are, or were ever intended to be, covered. Courts have reached inconsistent conclusions as to when losses are deemed to have occurred and which policies provide coverage; what types of losses are covered; whether there is an insurer obligation to defend; how policy limits are determined; whether or not particular claims are product/completed operation claims subject to an aggregate limit and how policy exclusions and conditions are applied and interpreted. Furthermore, insurers in general, including The Hartford, have recently experienced an increase in the number of asbestos-related claims due to, among other things, more intensive advertising by lawyers seeking asbestos claimants, the increasing focus by plaintiffs on new and previously peripheral defendants and an increase in the number of entities seeking bankruptcy protection as a result of asbestos-related liabilities. Plaintiffs and insureds have sought to utilize bankruptcy proceedings to accelerate and increase loss payments by insurers. In addition, new classes of claims have been arising whereby some asbestos-related defendants are asserting that their asbestos-related claims fall within so-called non-products liability coverage contained within their policies rather than products liability coverage and that the claimed non-products coverage is not subject to any aggregate limit. Recently, many insurers, including, in a limited number of instances, The Hartford, also have been sued directly by asbestos claimants asserting that insurers had a duty to protect the public from the dangers of asbestos. Management believes these issues are not likely to be resolved in the near future. An adverse determination of issues - 12 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 5. COMMITMENTS AND CONTINGENCIES (CONTINUED) (B) ASBESTOS AND ENVIRONMENTAL CLAIMS (CONTINUED) relating to The Hartford's liability for asbestos claims could have a material adverse effect on The Hartford's results of operations, financial condition and liquidity. Given the factors and emerging trends described above, The Hartford believes the actuarial tools and other techniques it employs to estimate the ultimate cost of paying claims for more traditional areas of insurance exposure are less effective in estimating the necessary reserves for its asbestos exposures. The Hartford continually evaluates new information and new methodologies to use in evaluating its potential asbestos exposures. At any time, including the current reporting period, The Hartford may be conducting one or more evaluations of individual exposures, classes of exposures or all of its current and potential exposures to asbestos claims. At any time analysis of newly identified information or completion of one or more analyses could cause The Hartford to change its estimates of its asbestos exposures and the effect of these changes could be material to the Company's consolidated operating results and financial condition in future periods. Reserves and reserve activity in the Other Operations segment are categorized and reported as either Asbestos, Environmental, or All Other activity. Constantly evolving legal theories create significant uncertainties with respect to what types of claims may ultimately arise from the generally older policies and liabilities managed in the Other Operations segment. The Hartford's experience has been that while this group of policies has over time produced significantly higher claims and losses than were initially contemplated at inception, the areas of active claim activity have shifted over time based on changes in plaintiff focus and the overall litigation environment. A significant portion of the claim reserves of the Other Operations segment relates to exposure to the insurance businesses of other insurers or reinsurers ("whole account" exposure). Many of these whole account exposures arise from reinsurance agreements previously written by The Hartford. The Hartford's net exposure in these arrangements has increased for a variety of reasons, including, but not limited to, situations where The Hartford has commuted previous retrocessions of such business. Due to the reporting practices of cedants to their reinsurers, determination of the nature of the individual risks involved in these whole account exposures (such as asbestos, environmental, or other exposures) requires various assumptions and estimates, which are subject to variability and uncertainty. Consistent with the reports of other insurers, The Hartford has been experiencing an increase in the number of new asbestos claims by policyholders not previously identified as potentially significant claimants, including installers or handlers of asbestos-containing products. In addition, new classes of claims are beginning to arise whereby some asbestos-related defendants are asserting that their asbestos-related claims fall within so-called non-products liability coverage contained within their policies rather than products liability coverage and that the claimed non-products coverage is not subject to any aggregate limit. (An example of these non-products claims is presented in the MacArthur litigation discussed in (d) below.) On May 14, 2002, The Hartford announced its participation, along with several dozen other insurance carriers, in a settlement in principle with its insured, PPG Industries ("PPG"), of litigation arising from asbestos exposures involving Pittsburgh Corning Corporation ("Pittsburgh Corning"), which is 50% owned by PPG. The structure of the settlement will allow The Hartford to make fixed payments to a settlement trust over a 20-year period beginning in 2004 and allows The Hartford to prepay its obligations at any time at a fixed discount rate of 5.5%. The settlement is subject to a number of contingencies, including the negotiation of a definitive agreement among the parties and approval of the bankruptcy court supervising the reorganization of Pittsburgh Corning. The Hartford estimated the settlement amount to be approximately $130 (non tax-effected) on a discounted basis and net of anticipated reinsurance recoveries. The settlement was covered by existing asbestos reserves, and as a result, did not have a material impact on The Company's consolidated financial condition or results of operations. As of September 30, 2002, the Company reported $1,133 and $642 of net Asbestos and Environmental reserves, respectively. Based on currently known facts and the Company's methodologies for estimating asbestos and environmental reserves, The Hartford believes that the level of recorded reserves at September 30, 2002 is reasonable and appropriate. Because of the significant uncertainties described in this Note 5, principally those related to asbestos, the ultimate liabilities may exceed the currently recorded reserves. Any such additional liability (or any range of additional amounts) cannot be reasonably estimated now but could be material to The Hartford's future consolidated operating results and financial condition. Consistent with the Company's longstanding reserving practices, The Hartford will continue to regularly review and monitor these reserves and, where future circumstances indicate, make appropriate adjustments to the reserves. (C) TAX MATTERS The Company's Federal income tax returns are routinely audited by the Internal Revenue Service ("IRS"). Throughout the audit of the 1996-1997 years, the Company and the IRS have been engaged in an ongoing dispute regarding what portion of the separate account dividends-received deduction ("DRD") is deductible by the Company. During 2001 the Company continued its discussions with the IRS. As part of the Company's due diligence with respect to this issue, the Company closely monitored the activities of the IRS with respect to other taxpayers on this issue and consulted with outside tax counsel and advisors on the merits of the Company's separate account DRD. The due diligence was completed during the third quarter of 2001 and the Company concluded that it was probable that a greater portion of the separate account DRD claimed on its filed returns would be realized. Based on the Company's assessment of the probable outcome, the Company concluded an additional $130 tax benefit was appropriate to record in the third quarter of 2001, relating to the tax years 1996-2000. Additionally, the Company increased its estimate of the separate account DRD recognized with respect to tax year 2001 from $44 to $60. - 13 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 5. COMMITMENTS AND CONTINGENCIES (CONTINUED) (C) TAX MATTERS (CONTINUED) Earlier in 2002, the Company and its IRS agent requested advice from the National Office of the IRS with respect to certain aspects of the computation of the separate account DRD that had been claimed by the Company for the 1996-1997 audit period. During September 2002 the IRS National Office issued a ruling that confirmed that the Company had properly computed the items in question in the separate account DRD claimed on its 1996-1997 tax returns. Additionally, during the third quarter, the Company reached agreement with the IRS on all other issues with respect to the 1996-1997 tax years. The Company recorded a benefit of $76 during the third quarter of 2002, primarily relating to the tax treatment of such issues for the 1996-1997 tax years, as well as appropriate carryover adjustments to the 1998-2002 years. The Company will continue to monitor further developments surrounding the computation of the separate account DRD, as well as other items, and will adjust its estimate of the probable outcome of these issues as developments warrant. Management believes that adequate provision has been made in the financial statements for any potential assessments that may result from tax examinations and other tax-related matters for all open tax years. (D) SUBSEQUENT EVENTS On October 7, 2002, an action was filed in the Superior Court in Alameda County, California, against Hartford Accident & Indemnity Company ("Hartford A&I"), a subsidiary of the Company, and two other insurers. The principal plaintiffs are MacArthur Company and its subsidiary, Western MacArthur Company, both former regional distributors of asbestos products (collectively or individually, "MacArthur"). MacArthur seeks a declaration of coverage and damages for asbestos bodily-injury claims. Five asbestos claimants who allegedly have obtained default judgments against MacArthur also are joined as plaintiffs; they seek to recover the amount of their default judgments and additional damages directly from the defendant insurers and assert a right to an accelerated trial. Hartford A&I issued primary general liability policies to MacArthur during the period 1967-76. MacArthur sought coverage for asbestos-related claims from Hartford A&I under these policies beginning in 1978. During the period 1978 to 1987, Hartford A&I paid out its full aggregate limits under these policies plus defense costs. In 1987, Hartford A&I notified MacArthur that its available limits under these policies had been exhausted, and MacArthur ceased submitting claims to Hartford A&I under these policies. On June 3, 2002, The St. Paul Companies, Inc. ("St. Paul") announced a settlement of a coverage action brought by MacArthur against United States Fidelity and Guaranty Company ("USF&G"), a subsidiary of St. Paul. Under the settlement, St. Paul agreed to pay a total of $975 to resolve its asbestos liability to MacArthur in conjunction with a proposed bankruptcy petition and pre-packaged plan of reorganization that MacArthur is to file. USF&G provided at least 12 years of primary general liability coverage to MacArthur, but, unlike Hartford A&I, had denied coverage and had refused to pay for defense or indemnity. In its October 7, 2002 complaint, MacArthur alleges that it has approximately $1.8 billion of unpaid asbestos liability judgments against it to date. MacArthur seeks additional coverage from Hartford A&I on the theory that Hartford A&I has exhausted only its products aggregate limit of liability, not separate limits MacArthur alleges to be available for non-products liability. The ultimate amount of MacArthur's alleged non-products asbestos liability, including any unresolved current and future claims, is currently unknown. MacArthur indicates in its complaint that it will seek to have the full amount of its current and future asbestos liability estimated in its anticipated bankruptcy proceeding. If such an estimation is made, MacArthur intends to seek a judgment against the defendants for the amount of its total liability, including estimated claims, less the amount ultimately paid by St. Paul. Hartford A&I intends to defend the MacArthur action vigorously. Based on the information currently available, management believes that Hartford A&I's liability, if any, to MacArthur will not be finally resolved for at least a year and most probably not for several years. In the opinion of management, the ultimate outcome is highly uncertain for many reasons. It is not yet known, for example, in which venue Hartford A&I's liability, if any, will be determined; whether Hartford A&I's defenses based on MacArthur's long delay in asserting claims for further coverage will be successful; how other significant coverage defenses will be decided; or the extent to which the claims and default judgments against MacArthur involve injury outside of the products and completed operations hazard definitions of the policies. In the opinion of management, an adverse outcome could have a material adverse effect on the Company's results of operations, financial condition and liquidity. NOTE 6. SEGMENT INFORMATION The Hartford is organized into two major operations: Life and Property & Casualty. Within these operations, The Hartford conducts business principally in nine operating segments. Additionally, the capital raising and purchase accounting adjustment activities related to the June 27, 2000 acquisition of all of the outstanding shares of Hartford Life, Inc. ("HLI") that the Company did not already own ("The HLI Repurchase") are included in Corporate. Life is organized into four reportable operating segments: Investment Products, Individual Life, Group Benefits and Corporate Owned Life Insurance ("COLI"). Investment Products offers individual variable and fixed annuities, mutual funds, retirement plan services and other investment products. Individual Life sells a variety of life insurance products, including variable life, universal life and term life insurance. Group Benefits sells group insurance products, including group life and group disability insurance as well as other products, including stop loss and supplementary medical coverages to employers and employer sponsored plans, accidental death and dismemberment, travel accident and other special risk coverages to employers and associations. COLI primarily offers variable products used by employers to fund non-qualified benefits or other postemployment benefit obligations as well as leveraged COLI. Life also includes in an Other category its international operations, which are primarily located in Latin America and Japan, as well as corporate - 14 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 6. SEGMENT INFORMATION (CONTINUED) items not directly allocable to any of its reportable operating segments, principally interest expense. In January 2002, Property & Casualty integrated its Affinity Personal Lines and Personal Insurance segments, now reported as Personal Lines. As a result, Property & Casualty is now organized into five reportable operating segments: the North American underwriting segments of Business Insurance, Personal Lines, Specialty Commercial and Reinsurance (collectively, "North American"); and the Other Operations segment, which includes substantially all of the Company's asbestos and environmental exposures. Business Insurance provides standard commercial insurance coverage to small commercial and middle market insureds. This segment also provides commercial risk management products and services to small and mid-sized members of affinity groups in addition to marine coverage. Personal Lines provides automobile, homeowners' and home-based business coverages to the members of AARP through a direct marketing operation; to individuals who prefer local agent involvement through a network of independent agents in the standard personal lines market; and through the Omni Insurance Group in the non-standard automobile market. Personal Lines also operates a member contact center for health insurance products offered through AARP's Health Care Options. The Specialty Commercial segment offers a variety of customized insurance products and risk management services. Specialty Commercial provides standard commercial insurance products including workers' compensation, automobile and liability coverages to large-sized companies. Specialty Commercial also provides bond, professional liability, specialty casualty and agricultural coverages, as well as core property and excess and surplus lines coverages not normally written by standard lines insurers. In addition, Specialty Commercial provides third party administrator services for claims administration, integrated benefits, loss control and performance measurement through Specialty Risk Services. The Reinsurance segment assumes reinsurance mainly in North America and primarily writes treaty reinsurance through professional reinsurance brokers covering various property, casualty, specialty and marine classes of business. The Other Operations segment consists of certain property and casualty insurance operations of The Hartford which have discontinued writing new business and includes substantially all of the Company's asbestos and environmental exposures. The Other Operations segment results also include activity for the Company's international property and casualty businesses up until their dates of sale, and for 2002 include the activity in the exited international lines of HartRe as a result of its restructuring in October 2001. (For further discussion of this restructuring, see Note 9.) The measure of profit or loss used by The Hartford's management in evaluating performance is operating income, except for its North American underwriting segments, which are evaluated by The Hartford's management primarily based upon underwriting results. Underwriting results represent premiums earned less incurred claims, claim adjustment expenses and underwriting expenses. "Operating income" is defined as after-tax operational results excluding, as applicable, net realized capital gains or losses, the cumulative effect of accounting changes and certain other items. While not considered segments, the Company also reports and evaluates operating income results for Life, Property & Casualty and North American. Property & Casualty includes operating income for North American and the Other Operations segment. North American includes the combined underwriting results of the North American underwriting segments along with income and expense items not directly allocable to these segments, such as net investment income. Certain transactions between segments occur during the year that primarily relate to tax settlements, insurance coverage, expense reimbursements, services provided and capital contributions. Certain reinsurance stop loss agreements exist between the segments which specify that one segment will reimburse another for losses incurred in excess of a predetermined limit. Also, one segment may purchase group annuity contracts from another to fund pension costs and claim annuities to settle casualty claims. In addition to the above transactions, certain intersegment transactions occur in Life. These transactions include interest income on allocated surplus and the allocation of net realized capital gains and losses through net invested income utilizing the duration of the segment's investment portfolios. The following tables present revenues and operating income (loss). Underwriting results are presented for the Business Insurance, Personal Lines, Specialty Commercial and Reinsurance segments, while operating income is presented for all other segments, along with Life and Property & Casualty, including North American. - 15 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 6. SEGMENT INFORMATION (CONTINUED)
REVENUES THIRD QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ---------------------------------------------------------- 2002 2001 2002 2001 ------------------------------------------------------------------------------------------------------------------------------------ Life Investment Products $ 637 $ 622 $ 1,946 $ 1,869 Individual Life 239 236 720 639 Group Benefits 645 617 1,943 1,871 COLI 145 171 451 536 Other (125) (41) (252) (25) ------------------------------------------------------------------------------------------------------------------------------------ Total Life 1,541 1,605 4,808 4,890 ------------------------------------------------------------------------------------------------------------------------------------ Property & Casualty North American Earned premiums and other revenue Business Insurance 795 680 2,293 1,940 Personal Lines 789 732 2,308 2,157 Specialty Commercial 414 334 1,037 922 Reinsurance 178 220 521 699 Ceded premiums related to September 11 -- (114) -- (114) ------------------------------------------------------------------------------------------------------------------------------------ Total North American earned premiums and other revenue 2,176 1,852 6,159 5,604 Net investment income 225 227 676 679 Net realized capital losses (28) (4) (49) (28) ------------------------------------------------------------------------------------------------------------------------------------ Total North American 2,373 2,075 6,786 6,255 Other Operations 42 38 138 133 ------------------------------------------------------------------------------------------------------------------------------------ Total Property & Casualty 2,415 2,113 6,924 6,388 ------------------------------------------------------------------------------------------------------------------------------------ Corporate 5 4 14 13 ------------------------------------------------------------------------------------------------------------------------------------ TOTAL REVENUES $ 3,961 $ 3,722 $ 11,746 $ 11,291 ====================================================================================================================================
- 16 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 6. SEGMENT INFORMATION (CONTINUED)
OPERATING INCOME THIRD QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ---------------------------------------------------------- 2002 2001 2002 2001 ------------------------------------------------------------------------------------------------------------------------------------ Life Investment Products $ 100 $ 116 $ 335 $ 344 Individual Life 33 30 99 86 Group Benefits 34 26 92 76 COLI 10 8 20 27 Other 55 102 40 86 ------------------------------------------------------------------------------------------------------------------------------------ Total Life 232 282 586 619 ------------------------------------------------------------------------------------------------------------------------------------ Property & Casualty North American Underwriting results Business Insurance 21 6 17 (7) Personal Lines (13) (17) (48) (44) Specialty Commercial 3 (18) 1 (56) Reinsurance (4) (47) (17) (109) ------------------------------------------------------------------------------------------------------------------------------------ Underwriting results excluding September 11 7 (76) (47) (216) September 11 -- (647) -- (647) ------------------------------------------------------------------------------------------------------------------------------------ Total North American underwriting results 7 (723) (47) (863) Net servicing and other income [1] 4 5 7 17 Net investment income 225 227 676 679 Other expenses (75) (50) (184) (153) Income tax (expense) benefit (23) 222 (73) 209 ------------------------------------------------------------------------------------------------------------------------------------ Total North American 138 (319) 379 (111) Other Operations 1 -- 2 2 ------------------------------------------------------------------------------------------------------------------------------------ Total Property & Casualty 139 (319) 381 (109) ------------------------------------------------------------------------------------------------------------------------------------ Corporate (6) (15) (18) (47) ------------------------------------------------------------------------------------------------------------------------------------ OPERATING INCOME (LOSS) 365 (52) 949 463 Cumulative effect of accounting changes, net of tax -- -- -- (34) Net realized capital losses, after-tax (100) (51) (207) (66) ------------------------------------------------------------------------------------------------------------------------------------ NET INCOME (LOSS) $ 265 $ (103) $ 742 $ 363 ==================================================================================================================================== [1] Net of expenses related to service business.
NOTE 7. DEBT On September 13, 2002 The Hartford issued 6.6 million 6% equity units at a price of $50.00 per unit and received net proceeds of $319. Each equity unit offered initially consists of a corporate unit with a stated amount of $50.00 per unit. Each corporate unit consists of one purchase contract for the sale of a certain number of shares of the Company's stock and fifty dollars principal amount of senior notes due November 16, 2008. The corporate unit may be converted by the holder into a treasury unit consisting of the purchase contract and a 5% undivided beneficial interest in a zero-coupon U.S. Treasury security with a principal amount of one thousand dollars that matures on November 15, 2006. The holder of an equity unit owns the underlying senior notes or treasury portfolio but has pledged the senior notes or treasury portfolio to the Company to secure the holder's obligations under the purchase contract. The purchase contract obligates the holder to purchase, and obligates The Hartford to sell, on November 16, 2006, for fifty dollars, a variable number of newly issued common shares of The Hartford. The number of The Hartford's shares to be issued will be determined at the time the purchase contracts are settled based upon the then current applicable market value of The Hartford's common stock. If the applicable market value of The Hartford's common stock is equal to or less than $47.25, then the Company will deliver 1.0582 shares to the holder of the equity unit, or an aggregate of 7.0 million shares. If the applicable market value of The Hartford's common stock is greater than $47.25 but less than $57.645, then the Company will deliver the number of shares equal to fifty dollars divided by the then current applicable market value of The Hartford's common stock to the holder. Finally, if the applicable market value of The Hartford's common - 17 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 7. DEBT (CONTINUED) stock is equal to or greater than $57.645, then the Company will deliver 0.8674 shares to the holder, or an aggregate of 5.7 million shares. Accordingly, upon settlement of the purchase contracts on November 16, 2006, The Hartford will receive proceeds of approximately $330 and will deliver between 5.7 million and 7.0 million common shares in the aggregate. The proceeds will be credited to stockholders' equity and allocated between the common stock and additional paid-in-capital accounts. The Hartford will make quarterly contract adjustment payments to the equity unit holders at a rate of 1.90% of the stated amount per year until the purchase contract is settled. Each corporate unit also includes fifty dollars principal amount of senior notes that will mature on November 16, 2008. The aggregate maturity value of the senior notes is $330. The notes are pledged by the holders to secure their obligations under the purchase contracts. The Hartford will make quarterly interest payments to the holders of the notes initially at an annual rate of 4.10%. On August 11, 2006, the notes will be remarketed. At that time, The Hartford's remarketing agent will have the ability to reset the interest rate on the notes in order to generate sufficient remarketing proceeds to satisfy the holder's obligation under the purchase contract. In the event of an unsuccessful remarketing, the Company will exercise its rights as a secured party to obtain and extinguish the notes. The total distributions payable on the equity units are at an annual rate of 6.0%, consisting of interest (4.10%) and contract adjustment payments (1.90%). The corporate units are listed on the New York Stock Exchange under the symbol "HIG PrA". The present value of the contract adjustment payments of $24 was accrued upon the issuance of the equity units as a charge to additional paid-in capital and are included in other liabilities in the accompanying consolidated balance sheet as of September 30, 2002. Subsequent contract adjustment payments will be allocated between this liability account and interest expense based on a constant rate calculation over the life of the transaction. Additional paid-in capital as of September 30, 2002, also reflected a charge of $9 representing a portion of the equity unit issuance costs that was allocated to the purchase contracts. The equity units have been reflected in the diluted earnings per share calculation using the treasury stock method, which would be used for the equity units at any time before the settlement of the purchase contracts. Under the treasury stock method, the number of shares of common stock used in calculating diluted earnings per share is increased by the excess, if any, of the number of shares issuable upon settlement of the purchase contracts over the number of shares that could be purchased by The Hartford in the market, at the average market price during the period, using the proceeds received upon settlement. The Company anticipates that there will be no dilutive effect on its earnings per share related to the equity units, except during periods when the average market price of a share of the Company's common stock is above the threshold appreciation price of $57.645. Because the average market price of The Hartford's common stock during the quarter ended September 30, 2002, was below this threshold appreciation price, the shares issuable under the purchase contract component of the equity units have not been included in the diluted earnings per share calculation. On August 29, 2002 The Hartford issued 4.7% senior notes due September 1, 2007 and received net proceeds of $298. Interest on the notes is payable semi-annually on March 1 and September 1, commencing on March 1, 2003. The Company used the proceeds to repay senior notes that matured on November 1, 2002. NOTE 8. STOCKHOLDERS' EQUITY On September 13, 2002, The Hartford issued approximately 7.3 million shares of common stock pursuant to an underwritten offering at a price of $47.25 per share and received net proceeds of $330. Also on September 13, 2002, The Hartford issued 6.6 million 6% equity units. Each equity unit contains a purchase contract obligating the holder to purchase and The Hartford to sell, a variable number of newly-issued shares of The Hartford's common stock. Upon settlement of the purchase contracts on November 16, 2006, The Hartford will receive proceeds of approximately $330 and will deliver between 5.7 million and 7.0 million shares in the aggregate. (For further discussion of this issuance, see Note 7.) At the Company's annual meeting of shareholders held on April 18, 2002, shareholders approved an amendment to Section (a) Article Fourth of the Amended and Restated Certificate of Incorporation to increase the aggregate authorized number of shares of common stock from 400 million to 750 million. NOTE 9. RESTRUCTURING During the fourth quarter of 2001, the Company approved and implemented plans for restructuring the operations of both HartRe and The Hartford Bank, FSB ("The Hartford Bank"). HartRe announced a restructuring of its entire international and domestic operations, with the purpose of centralizing the underwriting organization in Hartford, Connecticut. Also, the Boards of Directors for both The Hartford Bank and The Hartford Financial Services Group, Inc. approved The Hartford Bank's dissolution plan. Both plans will be completed during 2002. As a result of these restructuring plans, the Company recorded a 2001 pre-tax charge and accrual of approximately $16. This amount included $8 in employee-related costs, $5 in occupancy-related costs and the remaining $3 in other restructuring costs. The 79 employees terminated under these restructuring plans primarily relate to all levels of the underwriting and claims areas. The occupancy-related costs represent the remaining lease liabilities for both the domestic and international offices of HartRe to be closed pursuant to the restructuring plan. As of September 30, 2002, the Company has paid approximately $5 in employee-related restructuring costs, $1 in occupancy related costs and $1 in other restructuring costs. - 18 - ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Dollar amounts in millions except share data unless otherwise stated) Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") addresses the financial condition of The Hartford Financial Services Group, Inc. and its subsidiaries (collectively, "The Hartford" or the "Company") as of September 30, 2002, compared with December 31, 2001, and its results of operations for the third quarter and nine months ended September 30, 2002, compared with the equivalent 2001 periods. This discussion should be read in conjunction with the MD&A in The Hartford's 2001 Form 10-K Annual Report. Certain of the statements contained herein (other than statements of historical fact) are forward-looking statements. These forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and include estimates and assumptions related to economic, competitive and legislative developments. These forward-looking statements are subject to change and uncertainty which are, in many instances, beyond the Company's control and have been made based upon management's expectations and beliefs concerning future developments and their potential effect upon the Company. There can be no assurance that future developments will be in accordance with management's expectations or that the effect of future developments on The Hartford will be those anticipated by management. Actual results could differ materially from those expected by the Company, depending on the outcome of various factors. These factors include: the difficulty in predicting the Company's potential exposure for asbestos and environmental claims and related litigation, in particular, significant uncertainty with regard to the outcome of the Company's current dispute with MacArthur Company and its subsidiary, Western MacArthur Company (collectively or individually, "MacArthur"); the uncertain nature of damage theories and loss amounts and the development of additional facts related to the September 11 terrorist attack ("September 11"); the response of reinsurance companies under reinsurance contracts, the impact of increasing reinsurance rates, and the adequacy of reinsurance to protect the Company against losses; the possibility of more unfavorable loss experience than anticipated; the possibility of general economic and business conditions that are less favorable than anticipated; the incidence and severity of catastrophes, both natural and man-made; the effect of changes in interest rates, the stock markets or other financial markets; stronger than anticipated competitive activity; unfavorable legislative, regulatory or judicial developments; the Company's ability to distribute its products through distribution channels, both current and future; the uncertain effects of emerging claim and coverage issues; the effect of assessments and other surcharges for guaranty funds and second-injury funds and other mandatory pooling arrangements; a downgrade in the Company's claims-paying, financial strength or credit ratings; the ability of the Company's subsidiaries to pay dividends to the Company; and other factors described in such forward-looking statements. Certain reclassifications have been made to prior year financial information to conform to the current year presentation. -------------------------------------------------------------------------------- INDEX -------------------------------------------------------------------------------- Critical Accounting Policies 19 Consolidated Results of Operations: Operating Summary 22 Life 24 Investment Products 26 Individual Life 26 Group Benefits 27 Corporate Owned Life Insurance ("COLI") 27 Property & Casualty 28 Business Insurance 29 Personal Lines 29 Specialty Commercial 30 Reinsurance 31 Other Operations (Including Asbestos and Environmental Claims) 31 Investments 34 Capital Markets Risk Management 36 Capital Resources and Liquidity 39 Accounting Standards 42 -------------------------------------------------------------------------------- CRITICAL ACCOUNTING POLICIES -------------------------------------------------------------------------------- The preparation of financial statements, in conformity with accounting principles generally accepted in the United States, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The Company has identified the following policies as critical accounting policies because they involve a higher degree of judgment. In applying these policies management makes subjective and complex judgments that frequently require estimates about matters that are inherently uncertain. Although variability is inherent in these estimates, management believes the amounts provided are appropriate based upon the facts available at the time. DEFERRED ACQUISITION COSTS LIFE Policy acquisition costs, which include commissions and certain other expenses that vary with and are primarily associated with acquiring business, are deferred and amortized over the estimated lives of the contracts, usually 20 years. Deferred policy acquisition costs ("DAC") related to investment contracts and universal life-type contracts are deferred and amortized using the retrospective deposit method. Under the retrospective deposit method, acquisition costs are amortized in proportion to the present value of expected gross profits from - 19 - investment, mortality and expense margins and surrender charges. Actual gross profits vary from management's estimates, resulting in increases or decreases in the rate of amortization. Management periodically reviews these estimates and evaluates the recoverability of the deferred acquisition cost asset. When appropriate, management revises its assumptions on the estimated gross profits of these contracts and the cumulative amortization for the books of business are re-estimated and adjusted by a cumulative charge or credit to income. The average long-term rate of assumed investment yield used in estimating expected gross profits related to variable annuity and variable life business was 9.0% at September 30, 2002, and for all other products including fixed annuities and other universal life-type contracts the average assumed investment yield ranged from 5.0% - 8.5%. Deferred policy acquisition costs related to traditional policies are amortized over the premium-paying period of the related policies in proportion to the ratio of the present value of annual expected premium income to the present value of total expected premium income. Adjustments are made each year to recognize actual experience as compared to assumed experience for the current period. To date, our experience has generally been comparable to the assumptions used in determining DAC amortization. However, if the Company was to experience a material adverse deviation in certain critical assumptions, including surrender rates, mortality experience, or investment performance, there could be a negative effect on the Company's consolidated results of operations or financial condition. PROPERTY & CASUALTY The Property & Casualty operations also incur costs related to the acquisition of new and renewal insurance policies. These costs include agent and broker commissions, premium taxes and certain other underwriting expenses. These costs are deferred and amortized over policy terms. Estimates of the present value of future revenues, including net investment income and tax benefits, are compared to estimates of the present value of future costs, including amortization of policy acquisition costs, to determine if the deferred acquisition costs are recoverable, and if not, they are charged to expense. For the third quarter and nine months ended September 30, 2002 and 2001 no material amounts of deferred acquisition costs were charged to expense based on the results of these estimates of recoverability. RESERVES LIFE In accordance with applicable insurance regulations under which Life operates, life insurance subsidiaries of The Hartford establish and carry as liabilities actuarially determined reserves which are calculated to meet The Hartford's future obligations. Reserves for life insurance and disability contracts are based on actuarially recognized methods using prescribed morbidity and mortality tables in general use in the United States, which are modified to reflect The Hartford's actual experience when appropriate. These reserves are computed at amounts that, with additions from estimated premiums to be received and with interest on such reserves compounded annually at certain assumed rates, are expected to be sufficient to meet The Hartford's policy obligations at their maturities or in the event of an insured's death. Reserves also include unearned premiums, premium deposits, claims incurred but not reported ("IBNR") and claims reported but not yet paid. Reserves for assumed reinsurance are computed in a manner that is comparable to direct insurance reserves. The liability for policy benefits for universal life-type contracts and interest-sensitive whole life policies is equal to the balance that accrues to the benefit of policyholders, including credited interest, amounts that have been assessed to compensate the Company for services to be performed over future periods, and any amounts previously assessed against policyholders that are refundable on termination of the contract. Certain contracts include provisions whereby a guaranteed minimum death benefit is provided in the event that the contractholder's account value at death is below the guaranteed value. Although the Company reinsures the majority of the death benefit guarantees associated with its in-force block of business, declines in the equity market may increase the Company's net exposure to death benefits under these contracts. The Company records the death benefit costs, net of reinsurance, as they are incurred. For investment contracts, policyholder liabilities are equal to the accumulated policy account values, which consist of an accumulation of deposit payments plus credited interest, less withdrawals and amounts assessed through the end of the period. For the Company's group disability policies, the level of reserves is based on a variety of factors including particular diagnoses, termination rates and benefit levels. The persistency of The Hartford's annuity and other interest-sensitive life insurance reserves is enhanced by policy restrictions on the withdrawal of funds. Withdrawals in excess of allowable penalty-free amounts are assessed a surrender charge during a penalty period, which is usually at least seven years. This surrender charge is initially a percentage of either the accumulation value or considerations received, which varies by product, and generally decreases gradually during the penalty period. Surrender charges are set at levels to protect The Hartford from loss on early terminations and to reduce the likelihood of policyholders terminating their policies during periods of increasing interest rates, thereby lengthening the effective duration of policy liabilities and improving the Company's ability to maintain profitability on such policies. PROPERTY & CASUALTY The Hartford establishes property and casualty reserves to provide for the estimated costs of paying claims made by policyholders or against policyholders. These reserves include estimates for both claims that have been reported and those that have been incurred but not reported, and include estimates of all expenses associated with processing and settling these claims. Estimating the ultimate cost of future claims and claim adjustment expenses is an uncertain and complex process. This estimation process is based largely on the assumption that past developments are an appropriate predictor of future events, and involves a variety of actuarial techniques that analyze experience, trends and other relevant factors. The uncertainties involved with the reserving process have become increasingly unpredictable due to a number of complex factors including social and economic trends and changes in the concepts of legal liability and damage awards. Accordingly, final claim settlements may vary from the present estimates, particularly when those payments may not occur until well into the future. - 20 - The Hartford continually reviews the adequacy of its estimated claims and claim adjustment expense reserves on an overall basis. As additional experience and other relevant data become available, reserve levels are adjusted accordingly. Adjustments to previously established reserves, if any, are reflected in the operating results of the period in which the adjustment is made. For the third quarter and nine months ended September 30, 2002 and 2001 there were no changes to these reserving assumptions that had a significant impact on the reserves or results of operations. In the judgment of management, all information currently available has been properly considered in the reserves established for claims and claim adjustment expenses. ENVIRONMENTAL & ASBESTOS CLAIMS The Hartford continues to receive claims that assert damages from asbestos and environmental-related exposures. Asbestos claims relate primarily to injuries asserted by those who came in contact with asbestos or products containing asbestos. Environmental claims relate primarily to pollution and related clean-up costs. The Hartford receives asbestos and environmental claims made pursuant to several different categories of insurance coverage. First, The Hartford wrote policies as a primary liability insurance carrier. Second, The Hartford wrote excess insurance policies that provide additional coverage for insureds that exhaust their primary liability insurance coverage. Third, The Hartford acted as a reinsurer assuming a portion of risks previously assumed by other insurers writing primary, excess and reinsurance coverages. Writers of excess insurance and reinsurance often receive information regarding potential exposures significantly later than primary writers covering the same risk. The Hartford may experience more difficulty and delays in estimating its exposures arising from excess and reinsurance policies than it does in estimating exposures arising from its activity as a primary insurance writer. With regard to both environmental and particularly asbestos claims, uncertainty exists which affects the ability of insurers and reinsurers to estimate the ultimate reserves necessary for unpaid losses and related settlement expenses. Conventional reserving techniques cannot reasonably estimate the ultimate cost of these claims, particularly during periods where theories of law are in flux. As a result of the factors discussed in the following paragraphs, the degree of variability of reserve estimates for these exposures is significantly greater than for other more traditional exposures. In particular, The Hartford believes there is a high degree of uncertainty in the estimation of asbestos loss reserves. In the case of the reserves for asbestos exposures, factors contributing to the high degree of uncertainty include inadequate development patterns, plaintiffs' expanding theories of liability, the risks inherent in major litigation and inconsistent emerging legal doctrines. There are complex legal issues concerning the interpretation of various insurance policy provisions and whether those losses are, or were ever intended to be, covered. Courts have reached inconsistent conclusions as to when losses are deemed to have occurred and which policies provide coverage; what types of losses are covered; whether there is an insurer obligation to defend; how policy limits are determined; whether or not particular claims are product/completed operation claims subject to an aggregate limit and how policy exclusions and conditions are applied and interpreted. Furthermore, insurers in general, including The Hartford, have recently experienced an increase in the number of asbestos-related claims due to, among other things, more intensive advertising by lawyers seeking asbestos claimants, the increasing focus by plaintiffs on new and previously peripheral defendants and an increase in the number of entities seeking bankruptcy protection as a result of asbestos-related liabilities. Plaintiffs and insureds have sought to utilize bankruptcy proceedings to accelerate and increase loss payments by insurers. In addition, new classes of claims have been arising whereby some asbestos-related defendants are asserting that their asbestos-related claims fall within so-called non-products liability coverage contained within their policies rather than products liability coverage and that the claimed non-products coverage is not subject to any aggregate limit. Recently, many insurers, including, in a limited number of instances, The Hartford, also have been sued directly by asbestos claimants asserting that insurers had a duty to protect the public from the dangers of asbestos. Management believes these issues are not likely to be resolved in the near future. An adverse determination of issues relating to The Hartford's liability for asbestos claims could have a material adverse effect on The Hartford's results of operations, financial condition and liquidity. Given the factors and emerging trends described above, The Hartford believes the actuarial tools and other techniques it employs to estimate the ultimate cost of paying claims for more traditional areas of insurance exposure are less effective in estimating the necessary reserves for its asbestos exposures. The Hartford continually evaluates new information and new methodologies to use in evaluating its potential asbestos exposures. At any time, including the current reporting period, The Hartford may be conducting one or more evaluations of individual exposures, classes of exposures or all of its current and potential exposures to asbestos claims. At any time analysis of newly identified information or completion of one or more analyses could cause The Hartford to change its estimates of its asbestos exposures and the effect of these changes could be material to the Company's consolidated operating results and financial condition in future periods. INVESTMENTS The Hartford's investments in both fixed maturities, which include bonds, redeemable preferred stock and commercial paper, and equity securities, which include common and non-redeemable preferred stocks, are classified as "available for sale" in accordance with Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities". Accordingly, these securities are carried at fair value with the after-tax difference from amortized cost reflected in stockholders' equity as a component of accumulated other comprehensive income. Policy loans are carried at outstanding balance, which approximates fair value. Other invested assets consist primarily of limited partnership investments that are accounted for by the equity method, except in instances in which the Company's interest is so minor that it exercises virtually no influence over operating and financial policies. In such instances, the Company applies the cost method of accounting. The Company's net income from partnerships is included in net investment income. Other investments also include mortgage loans at amortized cost and derivatives at fair value. - 21 - The Company's accounting policy for impairment recognition requires other than temporary impairment charges to be recorded when it is determined that the Company is unable to recover its cost basis in the investment. Impairment charges on investments are included in net realized capital gains and losses. Factors considered in evaluating whether a decline in value is other than temporary include: (a) the length of time and the extent to which the fair value has been less than cost, (b) the financial condition and near-term prospects of the issuer, and (c) the intent and ability of the Company to retain the investment for a period of time sufficient to allow for any anticipated recovery. In addition, for certain asset-backed and other securities, the Company evaluates the future cash flows expected from the securitized assets in determining whether a decline in fair value is other than temporary. Furthermore, for securities expected to be sold, an other than temporary impairment charge is recognized if the Company does not expect the fair value of a security to recover to cost or amortized cost prior to the expected date of sale. Once an impairment charge has been recorded, the Company then continues to review the other than temporarily impaired securities for appropriate valuation on an ongoing basis. The Company utilizes a variety of derivative instruments, including swaps, caps, floors, forwards and exchange traded futures and options, in order to achieve one of four Company-approved objectives: to hedge risk arising from interest rate, price or currency exchange rate volatility; to manage liquidity; to control transaction costs; or to enter into income enhancement and replication transactions. When derivatives meet specific criteria, they may be designated as hedges and accounted for as fair value or cash-flow hedges. -------------------------------------------------------------------------------- CONSOLIDATED RESULTS OF OPERATIONS: OPERATING SUMMARY --------------------------------------------------------------------------------
OPERATING SUMMARY THIRD QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, --------------------------------------------------------- 2002 2001 2002 2001 ------------------------------------------------------------------------------------------------------------------------------------ TOTAL REVENUES $ 3,961 $ 3,722 $ 11,746 $ 11,291 ------------------------------------------------------------------------------------------------------------------------------------ NET INCOME (LOSS) $ 265 $ (103) $ 742 $ 363 Less: Cumulative effect of accounting changes, net of tax [1] -- -- -- (34) Net realized capital losses, after-tax (100) (51) (207) (66) ------------------------------------------------------------------------------------------------------------------------------------ OPERATING INCOME (LOSS) $ 365 $ (52) $ 949 $ 463 ==================================================================================================================================== [1] For the nine months ended September 30, 2001, represents the cumulative impact of the Company's adoption of Emerging Issues Task Force ("EITF") Issue No. 99-20, "Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets" and SFAS No. 133, as amended, "Accounting for Derivative Instruments and Hedging Activities".
"Operating income" is defined as after-tax operational results excluding, as applicable, net realized capital gains or losses, the cumulative effect of accounting changes and certain other items. Management believes that this performance measure delineates the results of operations of the Company's ongoing businesses in a manner that allows for a better understanding of the underlying trends in the Company's current business. However, operating income should only be analyzed in conjunction with, and not in lieu of, net income and may not be comparable to other performance measures used by the Company's competitors. OPERATING RESULTS Revenues for the third quarter and nine months ended September 30, 2002 increased $239, or 6%, and $455, or 4%, respectively, over the comparable prior year periods. Excluding the effects of reinsurance cessions of $114 related to September 11, revenues increased $125, or 3%, and $341, or 3%, for the third quarter and nine months ended September 30, 2002, respectively, as compared to the third quarter and nine months ended September 30, 2001. The increases were related to continued new business growth in Group Benefits, increased net investment income in Other Investment Products and earned premium growth in the Business Insurance, Personal Lines and Specialty Commercial segments. Partially offsetting the increased earned premiums were higher net realized capital losses, primarily as a result of write-downs of corporate bonds and asset-backed securities. Included in operating income for the third quarter ended September 30, 2002 are $76 in Hartford Life, Inc. ("HLI") tax benefits. Included in operating income for the third quarter ended September 30, 2001 are $130 in HLI tax benefits, $440 in after-tax losses related to September 11, and $13 in after-tax goodwill amortization. (For further discussion of the HLI tax benefits and the after-tax goodwill amortization, see Note 5(c) and Note 2, respectively, of Notes to Consolidated Financial Statements.) Excluding these effects, operating income for the third quarter ended September 30, 2002 increased $18, or 7%, over the comparable prior year period. This increase was due to significantly improved underwriting results in the Specialty Commercial, Reinsurance and Business Insurance segments as well as strong operating results within Life's Other Investment Products business and the Group Benefits segment. Partially offsetting these results was a decrease in Life's Individual Annuity operating income. Included in operating income for the nine months ended September 30, 2002 are the aforementioned $76 in HLI tax benefits, $8 of after-tax benefit related to the reduction of HLI's reserves associated with September 11 and $11 in after-tax expenses at HLI related to litigation with Bancorp Services, LLC ("Bancorp"). (For further discussion of the Bancorp litigation, see Note 5 (a) of Notes to Consolidated Financial Statements.) Included in operating income for the nine months ended September 30, 2001 are the aforementioned $130 in HLI tax benefits, $440 in after-tax losses related to September 11, and $38 in after-tax goodwill amortization. Excluding these items, operating income for the nine months ended September 30, 2002 increased $65, or 8%, over the comparable prior year period. The increase for the nine months ended September 30, 2002 over the prior year period was a result of improvements in underwriting results in the Specialty Commercial, Reinsurance and Business Insurance segments as well as increased operating income in Life's Other Investment Products, Individual Life and Group Benefits segments. - 22 - INCOME TAXES Excluding the impacts of September 11, the HLI tax benefits and net realized capital losses, the effective tax rate for the third quarter and nine months ended September 30, 2002 was 18% and 20%, respectively, compared with 16% and 19%, respectively, for the comparable periods in 2001. The increase in the effective tax rates was primarily the result of tax benefits received in 2001 in connection with the sales of the Company's Spain-based Hartford Seguros and Singapore-based Hartford Insurance Company (Singapore), Ltd. subsidiaries and the sale of the Company's ownership interest in an Argentine subsidiary, Sudamerica Holding S.A. Tax exempt interest earned on invested assets, together with the dividends-received deduction ("DRD"), were the primary reasons for the effective tax rates being lower than the 35% U.S. statutory rate. SEGMENT RESULTS The Hartford is organized into two major operations: Life and Property & Casualty. Within these operations, The Hartford conducts business principally in nine operating segments. Additionally, the capital raising and purchase accounting adjustment activities related to the June 27, 2000 acquisition of all of the outstanding shares of HLI that the Company did not already own ("The HLI Repurchase") are included in Corporate. Life is organized into four reportable operating segments: Investment Products, Individual Life, Group Benefits and Corporate Owned Life Insurance ("COLI"). Life also includes in an Other category its international operations, which are primarily located in Latin America and Japan, as well as corporate items not directly allocable to any of its reportable operating segments, principally interest expense. In January 2002, Property & Casualty integrated its Affinity Personal Lines and Personal Insurance segments, now reported as Personal Lines. As a result, Property & Casualty is now organized into five reportable operating segments: the North American underwriting segments of Business Insurance, Personal Lines, Specialty Commercial and Reinsurance (collectively, "North American"); and the Other Operations segment, which includes substantially all of the Company's asbestos and environmental exposures. The measure of profit or loss used by The Hartford's management in evaluating performance is operating income, except for its North American underwriting segments, which are evaluated by The Hartford's management primarily based upon underwriting results. Underwriting results represent premiums earned less incurred claims, claim adjustment expenses and underwriting expenses. While not considered segments, the Company also reports and evaluates operating income results for Life, Property & Casualty and North American. Property & Casualty includes operating income for North American and the Other Operations segment. North American includes the combined underwriting results of the North American underwriting segments along with income and expense items not directly allocable to these segments, such as net investment income. Certain transactions between segments occur during the year that primarily relate to tax settlements, insurance coverage, expense reimbursements, services provided and capital contributions. Certain reinsurance stop loss agreements exist between the segments which specify that one segment will reimburse another for losses incurred in excess of a predetermined limit. Also, one segment may purchase group annuity contracts from another to fund pension costs and claim annuities to settle casualty claims. In addition to the above transactions, certain intersegment transactions occur in Life. These transactions include interest income on allocated surplus and the allocation of net realized capital gains and losses through net invested income utilizing the duration of the segment's investment portfolios. The following is a summary of North American underwriting results by underwriting segment within Property & Casualty.
UNDERWRITING RESULTS (BEFORE-TAX) THIRD QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, --------------------------------------------------------- North American 2002 2001 2002 2001 ------------------------------------------------------------------------------------------------------------------------------------ Business Insurance $ 21 $ 6 $ 17 $ (7) Personal Lines (13) (17) (48) (44) Specialty Commercial 3 (18) 1 (56) Reinsurance (4) (47) (17) (109) ------------------------------------------------------------------------------------------------------------------------------------ Underwriting results excluding September 11 7 (76) (47) (216) September 11 -- (647) -- (647) ------------------------------------------------------------------------------------------------------------------------------------ TOTAL NORTH AMERICAN UNDERWRITING RESULTS $ 7 $ (723) $ (47) $ (863) ====================================================================================================================================
- 23 - The following is a summary of operating income and net income.
OPERATING INCOME (LOSS) THIRD QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, -------------- -------------- -------------- ----------- 2002 2001 2002 2001 --------------------------------------------------------------------------- -------------- -------------- -------------- ----------- Life Investment Products $ 100 $ 116 $ 335 $ 344 Individual Life 33 30 99 86 Group Benefits 34 26 92 76 COLI 10 8 20 27 Other 55 102 40 86 ------------------------------------------------------------------------------------------------------------------------------------ Total Life 232 282 586 619 Property & Casualty North American 138 (319) 379 (111) Other Operations 1 -- 2 2 ------------------------------------------------------------------------------------------------------------------------------------ Total Property & Casualty 139 (319) 381 (109) Corporate (6) (15) (18) (47) ------------------------------------------------------------------------------------------------------------------------------------ TOTAL OPERATING INCOME (LOSS) $ 365 $ (52) $ 949 $ 463 ====================================================================================================================================
NET INCOME (LOSS) THIRD QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, -------------- -------------- -------------- ----------- 2002 2001 2002 2001 --------------------------------------------------------------------------- -------------- -------------- -------------- ----------- Life Investment Products $ 100 $ 116 $ 335 $ 344 Individual Life 33 30 99 86 Group Benefits 34 26 92 76 COLI 10 8 20 27 Other (16) 70 (114) 17 ------------------------------------------------------------------------------------------------------------------------------------ Total Life 161 250 432 550 Property & Casualty North American 119 (339) 347 (146) Other Operations (9) 1 (19) 6 ------------------------------------------------------------------------------------------------------------------------------------ Total Property & Casualty 110 (338) 328 (140) Corporate (6) (15) (18) (47) ------------------------------------------------------------------------------------------------------------------------------------ TOTAL NET INCOME (LOSS) $ 265 $ (103) $ 742 $ 363 ====================================================================================================================================
An analysis of the operating results summarized above is included on the following pages. Investment results are discussed in the Investments section. -------------------------------------------------------------------------------- LIFE --------------------------------------------------------------------------------
OPERATING SUMMARY THIRD QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ----------------------------- -------------------------- 2002 2001 2002 2001 --------------------------------------------------------------------------- -------------- -------------- -------------- ----------- Revenues $ 1,541 $ 1,605 $ 4,808 $ 4,890 Expenses 1,380 1,355 4,376 4,314 Cumulative effect of accounting changes, net of tax [1] -- -- -- (26) ------------------------------------------------------------------------------------------------------------------------------------ NET INCOME [2], [3] 161 250 432 550 Less: Cumulative effect of accounting changes, net of tax [1] -- -- -- (26) Net realized capital losses, after-tax (71) (32) (154) (43) ------------------------------------------------------------------------------------------------------------------------------------ OPERATING INCOME [2] [3] $ 232 $ 282 $ 586 $ 619 ==================================================================================================================================== [1] For the nine months ended September 30, 2001 represents the cumulative impact of the Company's adoption of EITF Issue No. 99-20 and SFAS No. 133. [2] Includes $76 and $130 for the third quarter and nine months ended September 30, 2002 and 2001, respectively, related to favorable tax items. [3] Includes $20 of after-tax losses for the third quarter and nine months ended September 30, 2001 related to September 11, and an $8 benefit for the nine months ended September 30, 2002 due to favorable development related to September 11. Additionally, for the nine months ended September 30, 2002, includes $11 after-tax expense related to the Bancorp litigation.
Life has the following reportable operating segments: Investment Products, Individual Life, Group Benefits and COLI. In addition, Life includes in an "Other" category corporate items not directly allocable to any of its reportable operating segments, principally - 24 - interest expense, as well as its international operations, which are primarily located in Japan and Latin America. On April 2, 2001, The Hartford acquired the U.S. individual life insurance, annuity and mutual fund businesses of Fortis, Inc. (operating as "Fortis Financial Group" or "Fortis"). (For further discussion, see Note 18(a) of Notes to Consolidated Financial Statements included in The Hartford's December 31, 2001 Form 10-K Annual Report.) Revenues in the Life operation decreased $64, or 4%, and $82, or 2%, for the third quarter and nine months ended September 30, 2002, respectively, as compared to the equivalent periods in 2001. The decreases were primarily driven by realized capital losses of $118 and $253 for the third quarter and nine months ended September 30, 2002, respectively, as compared to capital losses of $50 and $67 for the equivalent periods in 2001. (See the Investments section for further discussion of investment results and related realized capital losses.) In addition, COLI experienced a decline in revenues as a result of the decrease in leveraged COLI account values as compared to a year ago. However, the Life operation experienced revenue growth across its other operating segments. Revenues related to the Investment Products segment increased as a result of continued growth related to its institutional investment product business, which more than offset the decline in revenues within the individual annuity operation. The individual annuity operation was impacted by lower assets under management due to the decline in the equity markets. The Group Benefits segment continued to experience an increase in revenues as a result of strong sales to new customers and solid persistency within the in-force block of business. Additionally, Individual Life revenues were higher as the result of the Fortis acquisition and increased life insurance in force for the nine months ended September 30, 2002. Expenses increased $25, or 2%, for the third quarter ended September 30, 2002, primarily due to a lower benefit recorded related to favorable resolution of DRD-related tax items as compared to the same period in 2001. Expenses for the nine months ended September 30, 2002 increased $62, or 1%, as compared to the equivalent prior year period, which was primarily driven by the Fortis acquisition and the Investment Products segment, principally related to the growth in the institutional investment product business and an increase in death benefits related to the individual annuity operation, as a result of the lower equity markets. In addition, expenses for the nine months ended September 30, 2002 include $11, after-tax, of accrued expenses recorded within the COLI segment related to the Bancorp litigation. (For a discussion of the Bancorp litigation, see Note 5(a) of Notes to Consolidated Financial Statements.) Also included in expenses for the nine months ended September 30, 2002 was an after-tax benefit of $8, recorded within "Other", associated with favorable development related to Life's estimated September 11 exposure. Operating income decreased $50, or 18%, and $33, or 5%, for the third quarter and nine months ended September 30, 2002, respectively. Excluding the impact of September 11 in the third quarter of 2001, operating income decreased $70, or 23%, for the third quarter ended September 30, 2002. For the nine months ended September 30, 2002 Life recognized an $8 after-tax benefit due to favorable development related to September 11. Excluding the impact of September 11, operating income for the nine months ended September 30, 2002 decreased $61, or 10%. For the third quarter and nine months ended September 30, 2002, Group Benefits earnings increased $8, or 31%, and $16, or 21%, respectively. Excluding the impact of September 11, Group Benefits earnings increased $6, or 21%, and $14, or 18%, for the third quarter and nine months ended September 30, 2002, respectively. The increases were principally driven by ongoing premium growth and stable loss and expense ratios. Individual Life earnings increased $3, or 10%, and $13, or 15%, for the third quarter and nine months ended September 30, 2002 respectively. Excluding the impact of September 11, Individual Life's earnings remained consistent and increased $10, or 11%, for the third quarter and nine months ended September 30, 2002, respectively as the result of higher fee income from the Fortis acquisition. COLI earnings increased $2, or 25%, for the third quarter of 2002 due to lower death benefits, interest credited expenses, and other insurance expenses, which more than offset the decline in revenues discussed above. Excluding the impact of September 11, COLI's earnings remained consistent for the third quarter ended September 30, 2002. For the nine months ended September 30, 2002, COLI operating income decreased $7, or 26%. Excluding the impact of September 11, COLI's earnings decreased $9, or 31%, primarily the result of the charge associated with the Bancorp litigation. Operating income for the Investment Products segment was down $16, or 14%, and $9 or 3%, for the third quarter and nine months ended September 30, 2002, respectively, as growth in the other investment products businesses, particularly institutional investment products, was more than offset by the decline in revenues in the individual annuity operation, which was negatively impacted by the lower equity markets. - 25 - -------------------------------------------------------------------------------- INVESTMENT PRODUCTS --------------------------------------------------------------------------------
THIRD QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ----------------------------- ----------------------------- 2002 2001 2002 2001 ------------------------------------------------------------------------ -------------- -------------- -------------- -------------- Revenues $ 637 $ 622 $ 1,946 $ 1,869 Expenses 537 506 1,611 1,525 ------------------------------------------------------------------------------------------------------------------------------------ OPERATING INCOME $ 100 $ 116 $ 335 $ 344 ------------------------------------------------------------------------------------------------------------------------------------ Individual variable annuity account values $ 59,618 $ 68,545 Other individual annuity account values 10,513 9,421 Other investment products account values 19,368 17,638 ------------------------------------------------------------------------------------------------------------------------------------ TOTAL ACCOUNT VALUES 89,499 95,604 Mutual fund assets under management 14,092 14,380 ------------------------------------------------------------------------------------------------------------------------------------ TOTAL INVESTMENT PRODUCTS ASSETS UNDER MANAGEMENT $ 103,591 $ 109,984 ====================================================================================================================================
Revenues in the Investment Products segment increased $15, or 2%, and $77, or 4%, for the third quarter and nine months ended September 30, 2002, respectively, primarily driven by growth in the institutional investment product business, where related assets under management increased $1.2 billion, or 14%, to $9.7 billion as of September 30, 2002. The revenue increase described above was partially offset by lower fee income related to the individual annuity operation as average account values decreased from prior year levels, primarily due to the lower equity markets. Expenses increased $31, or 6%, and $86, or 6%, for the third quarter and nine months ended September 30, 2002, respectively, primarily driven by increases in benefits and claim expenses and operating expenses as a result of the growth in the institutional investment products business and an increase in the death benefit costs incurred by the individual annuity operation, as a direct result of the lower equity markets. Partially offsetting these increases were decreases in amortization of policy acquisition costs related to the individual annuity business, which declined as a result of lower estimated gross profits, driven by the decrease in fee income and the increase in death benefit costs. Operating income decreased $16, or 14%, and $9, or 3%, for the third quarter and nine months ended September 30, 2002, respectively. The growth in revenues was related to other investment products, particularly the institutional investment product business. This growth was almost completely offset by the decline in revenues in the individual annuity operation, which was negatively impacted by the lower equity markets. Additionally, increases in the death benefit costs incurred by the individual annuity operation as the result of the lower equity markets contributed to the decreased earnings as compared to the equivalent period in 2001. (For discussion of the potential future financial statement impact of continued declines in the equity market on the Investment Products segment, see the Capital Markets Risk Management section under "Market Risk".) -------------------------------------------------------------------------------- INDIVIDUAL LIFE --------------------------------------------------------------------------------
THIRD QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ----------------------------- ----------------------------- 2002 2001 2002 2001 ------------------------------------------------------------------------ -------------- -------------- -------------- -------------- Revenues $ 239 $ 236 $ 720 $ 639 Expenses 206 206 621 553 ------------------------------------------------------------------------------------------------------------------------------------ OPERATING INCOME $ 33 $ 30 $ 99 $ 86 ------------------------------------------------------------------------------------------------------------------------------------ Variable life account values $ 3,458 $ 3,460 Total account values $ 7,360 $ 7,322 ------------------------------------------------------------------------------------------------------------------------------------ Variable life insurance in force $ 65,797 $ 59,466 Total life insurance in force $ 125,138 $ 118,510 ====================================================================================================================================
Revenues in the Individual Life segment increased $3, or 1%, and $81, or 13%, for the third quarter and nine months ended September 30, 2002, respectively. For the third quarter, the revenue growth was primarily driven by an increase in fee income as the result of an increase in life insurance in force of $6.6 billion, or 6%, as of September 30, 2002 as compared to the equivalent period in the prior year. The revenue growth related to the nine months ended September 30, 2002 was attributed to higher fee income and investment income related to the Fortis transaction. Expenses for the nine months ended September 30, 2002 increased $68, or 12%, compared with the nine months ended September 30, 2001, principally driven by the growth in the business resulting from the Fortis acquisition. In addition, mortality experience (expressed as death claims as a percentage of net amount at risk) for the nine months ended September 30, 2002 was higher than the comparable prior year period primarily due to a higher than expected occurrence of large claims during the first quarter of 2002. Operating income increased $3, or 10%, and $13, or 15%, for the third quarter and nine months ended September 30, 2002, - 26 - respectively. Individual Life incurred an after-tax charge of $3 related to September 11 in the third quarter of 2001. Excluding this charge, Individual Life's earnings remained consistent for the third quarter of 2002 and increased $10, or 11%, for the nine months ended September 30, 2002. The increase for the nine months ended September 30, 2002 was due to the contribution to earnings from the Fortis transaction, which more than offset the unfavorable mortality experience. -------------------------------------------------------------------------------- GROUP BENEFITS --------------------------------------------------------------------------------
THIRD QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ----------------------------- ----------------------------- 2002 2001 2002 2001 ------------------------------------------------------------------------ -------------- -------------- -------------- -------------- Revenues $ 645 $ 617 $ 1,943 $ 1,871 Expenses 611 591 1,851 1,795 ------------------------------------------------------------------------------------------------------------------------------------ OPERATING INCOME $ 34 $ 26 $ 92 $ 76 ====================================================================================================================================
Revenues in the Group Benefits segment increased $28, or 5%, and $72, or 4%, and excluding buyouts, increased $22, or 4%, and $126, or 7%, for the third quarter and nine months ended September 30, 2002, respectively. These increases were driven by growth in fully insured ongoing premiums, which increased $63, or 12%, and $248, or 17%, for the third quarter and nine months ended September 30, 2002, respectively. The growth in premium revenues was due to steady persistency and pricing actions on the in-force block of business and strong sales to new customers. Offsetting these increases were decreases in military Medicare supplement premiums of $43 and $127 for the third quarter and nine months ended September 30, 2002, respectively, resulting from federal legislation effective in the fourth quarter of 2001. This legislation provides retired military officers age 65 and older with full medical insurance paid for by the government, eliminating the need for Medicare supplement insurance. Additionally, premium revenues for the nine months ended September 30, 2002 were offset by a $54 decrease in total buyouts. Fully insured ongoing sales for the nine months ended September 30, 2002 were $532, an increase of $108, or 25%, as compared to the equivalent prior year period. Expenses increased $20, or 3%, and $56, or 3%, and excluding buyouts, increased $14, or 2%, and $110, or 6%, for the third quarter and nine months ended September 30, 2002, respectively. The increase in expenses is consistent with the growth in revenues described above. Benefits and claims expenses, excluding buyouts, increased $10, or 2%, and $80, or 6%, for the third quarter and nine months ended September 30, 2002, respectively. The segment's loss ratio (defined as benefits and claims as a percentage of premiums and other considerations excluding buyouts) was approximately 81% and 82% for third quarter and nine months ended September 30, 2002, respectively, down slightly from 82% and 83% for the third quarter and nine months ended September 30, 2001, respectively. Other insurance expenses increased $2, or 2%, and $27, or 7%, for the third quarter and nine months ended September 30, 2002, respectively, due to the revenue growth previously described and continued investments in the business. The segment's expense ratio (defined as insurance expenses as a percentage of premiums and other considerations excluding buyouts) was approximately 23% for both the third quarter and nine months ended September 30, 2002, respectively, and essentially consistent with the prior year periods. Operating income increased $8, or 31%, and $16, or 21%, for the third quarter and nine months ended September 30, 2002, respectively. Group Benefits incurred an after-tax charge of $2 related to September 11 in the third quarter of 2001. Excluding this charge, earnings increased $6, or 21%, and $14, or 18%, for the third quarter and nine months ended September 30, 2002, respectively, due to the increase in premium revenue and the continued focus on maintaining loss costs and other expenses as described above. -------------------------------------------------------------------------------- CORPORATE OWNED LIFE INSURANCE (COLI) --------------------------------------------------------------------------------
THIRD QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ----------------------------- ----------------------------- 2002 2001 2002 2001 ------------------------------------------------------------------------ -------------- -------------- -------------- -------------- Revenues $ 145 $ 171 $ 451 $ 536 Expenses 135 163 431 509 ------------------------------------------------------------------------------------------------------------------------------------ OPERATING INCOME $ 10 $ 8 $ 20 $ 27 ------------------------------------------------------------------------------------------------------------------------------------ Variable COLI account values $ 19,298 $ 16,915 Leveraged COLI account values 3,601 4,835 ------------------------------------------------------------------------------------------------------------------------------------ TOTAL ACCOUNT VALUES $ 22,899 $ 21,750 ====================================================================================================================================
COLI revenues decreased $26, or 15%, and $85, or 16%, for the third quarter and nine months ended September 30, 2002, respectively, primarily related to lower net investment and fee income related to the declining block of leveraged COLI, where related account values declined by $1.2 billion, or 26%. Net investment income decreased $21, or 24%, and $59, or 22%, for the third quarter and nine months ended September 30, 2002, respectively, while fee income decreased $5, or 6%, and $25, or 10%, over the comparable prior year periods. Expenses decreased $28, or 17%, and $78, or 15%, for the third quarter and nine months ended September 30, 2002, respectively, consistent with the decrease in revenues described above. However, the decrease for the nine months ended September 30, - 27 - 2002 was partially offset by $11, after-tax, in accrued litigation expenses related to the Bancorp dispute. (For a discussion of the Bancorp litigation, see Note 5(a) of Notes to Consolidated Financial Statements.) Operating income in the third quarter increased $2, or 25%, compared to prior year. COLI incurred an after-tax charge of $2 related to September 11 in the third quarter of 2001. Excluding this charge, COLI's earnings remained consistent for the third quarter ended September 30, 2002 as the decrease in benefits and claims expenses and other insurance expenses offset the decrease in revenues discussed above. Operating income decreased $7, or 26%, for the nine months ended September 30, 2002. Excluding the impact of September 11, COLI's earnings decreased $9, or 31%, principally due to the $11 after-tax expense accrued in connection with the Bancorp litigation. -------------------------------------------------------------------------------- PROPERTY & CASUALTY --------------------------------------------------------------------------------
OPERATING SUMMARY THIRD QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ----------------------------- ----------------------------- 2002 2001 2002 2001 ------------------------------------------------------------------------ -------------- -------------- -------------- -------------- TOTAL REVENUES [1] $ 2,415 $ 2,113 $ 6,924 $ 6,388 ------------------------------------------------------------------------------------------------------------------------------------ NET INCOME (LOSS) [2] $ 110 $ (338) $ 328 $ (140) Less: Cumulative effect of accounting change, net of tax [3] -- -- -- (8) Net realized capital losses, after-tax (29) (19) (53) (23) ------------------------------------------------------------------------------------------------------------------------------------ OPERATING INCOME (LOSS) [2] $ 139 $ (319) $ 381 $ (109) ==================================================================================================================================== [1] 2001 includes $114 of reinsurance cessions related to September 11. [2] 2001 includes $420 of after-tax losses related to September 11. [3] Represents the cumulative impact of the Company's adoption of EITF Issue No. 99-20.
Revenues for Property & Casualty increased $302, or 14%, for the third quarter and $536, or 8%, for the nine months ended September 30, 2002, compared with the same periods in 2001. The increase in revenues for both periods was due primarily to earned premium growth in the Business Insurance, Personal Lines and Specialty Commercial segments primarily as a result of price increases. New business growth and strong premium renewal retention also contributed to the increase. The 2001 reinsurance cessions related to September 11 increased the third quarter and nine months earned premium variances by $114. Partially offsetting the increase in revenues for both periods were additional capital losses of $38 and $56, respectively, primarily due to impairments on securities. Operating income increased $458 for the third quarter and $490 for the nine months ended September 30, 2002, as compared to the same prior year periods. Excluding the $420 impact of September 11 in the prior year, operating income increased $38, or 38%, and $70, or 23%, for the third quarter and nine month periods, respectively. The increases for both periods were primarily due to strong earned pricing in the Business Insurance and Specialty Commercial segments, the impact of underwriting initiatives in Reinsurance and lower catastrophes. Partially offsetting the improvement was an increase in other expenses primarily as a result of $9 in after-tax expenses incurred related to the transfer of the Company's New Jersey personal lines agency auto business to Palisades Safety and Insurance Association and Palisades Insurance Co. Ratios The following sections discuss the operations of the North American underwriting segments for the third quarter and nine months ended September 30, 2002 and include various operating ratios. Management believes that these ratios are useful in understanding the underlying trends in the Company's current business. However, these measures should only be used in conjunction with, and not in lieu of, underwriting income and may not be comparable to other performance measures used by the Company's competitors. The "loss ratio" is the ratio of claims expense (exclusive of claim adjustment expenses) to earned premiums. The "loss adjustment expense ratio" represents the ratio of claim adjustment expenses to earned premiums. The "expense ratio" is the ratio of underwriting expenses (commissions; taxes, licenses, and fees; as well as other underwriting expenses) to written premiums. The "policyholder dividend ratio" is the ratio of policyholder dividends to earned premiums. The "combined ratio" is the sum of the loss ratio, the loss adjustment expense ratio, the expense ratio and the policyholder dividend ratio. - 28 - -------------------------------------------------------------------------------- BUSINESS INSURANCE --------------------------------------------------------------------------------
OPERATING SUMMARY THIRD QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ----------------------------- ----------------------------- 2002 2001 2002 2001 ------------------------------------------------------------------------ -------------- -------------- -------------- -------------- Written premiums [1] $ 867 $ 703 $ 2,527 $ 2,119 Earned premiums [1] $ 795 $ 665 $ 2,293 $ 1,925 ------------------------------------------------------------------------------------------------------------------------------------ Underwriting results excluding September 11 [2] $ 21 $ 6 $ 17 $ (7) September 11 -- (245) -- (245) ------------------------------------------------------------------------------------------------------------------------------------ Underwriting results $ 21 $ (239) $ 17 $ (252) ==================================================================================================================================== Loss ratio [2] 50.1 52.2 51.6 53.2 Loss adjustment expense ratio [2] 11.5 12.1 11.7 12.2 Expense ratio [2] 32.4 32.3 32.0 31.6 Combined ratio excluding September 11 [2] [3] 95.6 97.5 96.8 98.3 Combined ratio impact of September 11 [3] -- 36.7 -- 12.7 Combined ratio [3] 95.6 134.2 96.8 111.0 ==================================================================================================================================== [1] 2001 includes $15 of reinsurance cessions related to September 11. [2] 2001 excludes any impacts of September 11. [3] Includes policyholder dividend ratios of 1.6 and 1.0 for the third quarter ended September 30, 2002 and 2001, respectively, and 1.5 and 1.3 for the nine months ended September 30, 2002 and 2001, respectively.
Business Insurance written premiums increased $164, or 23%, for the third quarter and $408, or 19%, for the nine months ended September 30, 2002, compared to the same periods in 2001 due to strong growth in both small commercial and middle market. Small commercial increased $59, or 16%, for the third quarter and $169, or 16%, for the nine month period reflecting double-digit price increases, particularly in the property line of business. The increase in middle market of $90, or 25%, for the third quarter and $224, or 21%, for the nine month period was due primarily to double-digit price increases as well as continued strong new business growth and premium renewal retention. The 2001 reinsurance cessions related to September 11 increased the third quarter and nine months premium variances by $15. Underwriting results, excluding September 11, improved $15, with a corresponding 1.9 point decrease in the combined ratio, for the third quarter and improved $24, with a corresponding 1.5 point decrease in the combined ratio, for the nine months ended September 30, 2002, as compared with the same periods in 2001. The improvement in underwriting results and combined ratio for both periods was primarily due to double-digit earned pricing and minimal loss costs. The loss ratio improved 2.1 points and 1.6 points for the third quarter and nine months ended September 30, 2002, respectively, compared with the same prior year periods. -------------------------------------------------------------------------------- PERSONAL LINES --------------------------------------------------------------------------------
OPERATING SUMMARY THIRD QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ----------------------------- ----------------------------- 2002 2001 2002 2001 ------------------------------------------------------------------------ -------------- -------------- -------------- -------------- Written premiums $ 779 $ 742 $ 2,294 $ 2,147 Earned premiums $ 758 $ 694 $ 2,218 $ 2,040 ------------------------------------------------------------------------------------------------------------------------------------ Underwriting results excluding September 11 [1] $ (13) $ (17) $ (48) $ (44) September 11 -- (9) -- (9) ------------------------------------------------------------------------------------------------------------------------------------ Underwriting results $ (13) $ (26) $ (48) $ (53) ==================================================================================================================================== Loss ratio [1] 67.0 66.5 66.5 66.3 Loss adjustment expense ratio [1] 11.1 11.9 11.7 11.6 Expense ratio [1] 22.2 23.8 23.0 24.1 Combined ratio excluding September 11 [1] 100.3 102.2 101.2 102.1 Combined ratio impact of September 11 -- 1.2 -- 0.4 Combined ratio 100.3 103.4 101.2 102.5 ==================================================================================================================================== [1] 2001 excludes any impacts of September 11.
Written premiums increased $37, or 5%, for the third quarter and $147, or 7%, for the nine months ended September 30, 2002, compared to the same periods in 2001, primarily driven by growth in AARP, partially offset by a reduction in Standard. AARP increased $53, or 12%, for the third quarter and $171, or 14%, for the nine months ended September 30, 2002, primarily as a result of pricing increases and continued steady premium renewal retention. Standard decreased $15, or 7%, for the third quarter and $28, or 5%, for the nine months ended September 30, 2002, - 29 - due primarily to the conversion to six month policies in certain states. Underwriting results, excluding the impact of September 11, improved $4 for the third quarter, with a corresponding 1.9 point decrease in the combined ratio. For the nine month period, underwriting results declined $4, while the combined ratio decreased 0.9 points, excluding September 11. While automobile results improved for the third quarter and nine month periods due to favorable frequency loss costs, the line of business continues to be negatively impacted by automobile severity loss costs as a result of medical inflation and higher repair costs. Despite an increase in homeowners' severity loss costs, underwriting results for both periods remained favorable due to negative frequency. An improvement in the underwriting expense ratio, primarily due to written pricing increases and prudent expense management, resulted in a 1.6 point and 1.1 point decrease in the expense ratio for the third quarter and nine months ended September 30, 2002, respectively, over comparable prior year periods. -------------------------------------------------------------------------------- SPECIALTY COMMERCIAL --------------------------------------------------------------------------------
OPERATING SUMMARY THIRD QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ----------------------------- ----------------------------- 2002 2001 2002 2001 ------------------------------------------------------------------------ -------------- -------------- -------------- -------------- Written premiums [1] $ 383 $ 264 $ 1,028 $ 775 Earned premiums [1] $ 357 $ 274 $ 870 $ 766 ------------------------------------------------------------------------------------------------------------------------------------ Underwriting results excluding September 11 [2] $ 3 $ (18) $ 1 $ (56) September 11 -- (167) -- (167) ------------------------------------------------------------------------------------------------------------------------------------ Underwriting results $ 3 $ (185) $ 1 $ (223) ------------------------------------------------------------------------------------------------------------------------------------ Loss ratio [2] 57.8 62.7 56.2 60.7 Loss adjustment expense ratio [2] 11.4 12.8 12.4 14.0 Expense ratio [2] 28.6 31.8 28.6 31.3 Combined ratio excluding September 11 [2] [3] 98.3 107.6 97.9 106.4 Combined ratio impact of September 11 [3] -- 61.6 -- 22.0 ------------------------------------------------------------------------------------------------------------------------------------ Combined ratio [3] 98.3 169.2 97.9 128.4 ==================================================================================================================================== [1] 2001 includes $7 of reinsurance cessions related to September 11. [2] 2001 excludes any impacts of September 11. [3] Includes policyholder dividend ratios of 0.5 and 0.3 for the third quarter ended September 30, 2002 and 2001, respectively, and 0.6 and 0.4, for the nine months ended September 30, 2002 and 2001, respectively.
Specialty Commercial written premiums increased $119, or 45%, for the third quarter and $253, or 33%, for the nine months ended September 30, 2002, compared with the same prior year periods. The improvement was driven by the Property, Specialty Casualty and Professional Liability lines of business. Written premiums for Property grew $33, or 31%, for the third quarter and $102, or 44%, for the nine months ended September 30, 2002, compared with the same periods in 2001. Specialty Casualty written premiums grew $44, or 81%, and $83, or 55%, for the third quarter and nine month periods, respectively. The written premium growth in both lines of business was primarily due to significant price increases and new business growth reflecting an improving business environment. Professional Liability written premiums grew $22, or 45%, for the third quarter and $54, or 49%, for the nine months ended September 30, 2002, compared with the respective prior year periods, due to significant price increases and, for the nine month period, lower premium cessions. Also contributing to the increases in written premiums for the third quarter and nine month periods was $7 of reinsurance cessions in the prior year related to September 11. Underwriting results, excluding September 11, improved $21, with a corresponding 9.3 point decrease in the combined ratio for the third quarter and improved $57, with a corresponding 8.5 point decrease in the combined ratio for the nine months ended September 30, 2002, as compared with the same periods in 2001. Improved underwriting and combined ratio results for the third quarter and nine month periods were primarily due to favorable Property, Specialty Casualty and Professional Liability results. In addition, an improvement in the underwriting expense ratio, primarily due to written pricing increases and prudent expense management, resulted in a 3.2 point and 2.7 point decrease in the expense ratio for the third quarter and nine months ended September 30, 2002, respectively. For the nine month period, lower catastrophes, primarily as a result of the Seattle earthquake in the first quarter of 2001, also contributed to the improvement in underwriting results. - 30 - -------------------------------------------------------------------------------- REINSURANCE --------------------------------------------------------------------------------
OPERATING SUMMARY THIRD QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ----------------------------- ----------------------------- 2002 2001 2002 2001 ------------------------------------------------------------------------ -------------- -------------- -------------- -------------- Written premiums [1] $ 167 $ 89 $ 550 $ 657 Earned premiums [1] $ 178 $ 128 $ 521 $ 607 ------------------------------------------------------------------------------------------------------------------------------------ Underwriting results excluding September 11 [2] $ (4) $ (47) $ (17) $ (109) September 11 -- (226) -- (226) ------------------------------------------------------------------------------------------------------------------------------------ Underwriting results $ (4) $ (273) $ (17) $ (335) ------------------------------------------------------------------------------------------------------------------------------------ Loss ratio [2] 68.3 83.8 71.0 85.0 Loss adjustment expense ratio [2] 6.2 4.7 4.7 3.9 Expense ratio [2] 28.5 33.6 26.2 26.4 Combined ratio excluding September 11 [2] 103.1 122.1 101.9 115.3 Combined ratio impact of September 11 -- 202.7 -- 39.2 ------------------------------------------------------------------------------------------------------------------------------------ Combined ratio 103.1 324.8 101.9 154.5 ==================================================================================================================================== [1] 2001 includes $92 of reinsurance cessions related to September 11. [2] 2001 excludes any impacts of September 11.
Reinsurance written premiums increased $78, or 88%, for the third quarter and decreased $107, or 16%, for the nine months ended September 30, 2002, compared to the same periods in 2001. Excluding $92 of reinsurance cessions related to September 11 in the prior year, written premiums decreased $14, or 8%, for the third quarter and $199, or 27%, for the nine month period due to the planned exit from nearly all international lines and a reduction in the Alternative Risk Transfer ("ART") line of business written premiums. ART written premiums are traditionally low in the third quarter, but decreased $90, or 52%, for the nine month period due primarily to the expiration of a non-recurring loss portfolio reinsurance contract and the non-renewal of a quota share treaty with one ceding company. Excluding ART and international, third quarter written premiums increased 10% for the quarter and 2% for the nine month periods, due primarily to significant pricing increases as a result of continued market firming, partially offset by premium reductions due to underwriting requirements to maintain profitability targets. Underwriting results, excluding September 11, improved $43, with a corresponding 19.0 point decrease in the combined ratio for the third quarter and improved $92, with a corresponding 13.4 point decrease in the combined ratio for the nine months ended September 30, 2002, as compared with the same periods in 2001. The improvement for both periods was primarily due to underwriting initiatives including a shift to excess of loss policies and increased property business mix, as well as the exit from nearly all international lines and an intense focus on returns. For the nine month period, significantly lower catastrophes also contributed to the improvement. -------------------------------------------------------------------------------- OTHER OPERATIONS (INCLUDING ASBESTOS AND ENVIRONMENTAL CLAIMS) --------------------------------------------------------------------------------
OPERATING SUMMARY THIRD QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ----------------------------- ----------------------------- 2002 2001 2002 2001 ------------------------------------------------------------------------ -------------- -------------- -------------- -------------- TOTAL REVENUES $ 42 $ 38 $ 138 $ 133 ------------------------------------------------------------------------------------------------------------------------------------ NET INCOME (LOSS) $ (9) $ 1 $ (19) $ 6 Less: Net realized capital gains (losses), after-tax (10) 1 (21) 4 ------------------------------------------------------------------------------------------------------------------------------------ OPERATING INCOME $ 1 $ -- $ 2 $ 2 ====================================================================================================================================
The Other Operations segment includes operations that are under a single management structure, that was finalized in late 2001 to be responsible for two related activities. The first activity is the management of certain subsidiaries and operations of The Hartford that have discontinued writing new business. The second is the management of claims (and the associated reserves) related to asbestos and environmental exposures. The companies in this segment which are not writing new business are primarily focused on managing claims, resolving disputes and collecting reinsurance proceeds related largely to business underwritten and reinsured in 1985 and prior years. While the business that was written in these units on either a direct or reinsurance basis spanned a wide variety of insurance and reinsurance policies and coverages, a significant and increasing proportion of current and future claims activity arising from these businesses relates to environmental and, to a greater extent, asbestos exposures. Other Operations also includes the results of The Hartford's international property-casualty businesses (substantially all of which were disposed of in a series of transactions concluding in 2001) and the international reinsurance businesses of HartRe, exited in the fourth quarter of 2001. (For further discussion of the restructuring, see Note 9 of Notes to Consolidated Financial Statements.) In 2001, The Hartford consolidated management and claims handling of all of its asbestos and environmental exposures under the Other Operations' management structure. This action was - 31 - taken to maximize The Hartford's management expertise in this area. As part of this organizational change, the Company consolidated substantially all of its asbestos and environmental loss reserves into one legal entity within Other Operations through intercompany reinsurance agreements. These reinsurance agreements ceded $602 of the then-carried reserves (net of reinsurance), primarily related to asbestos and environmental exposures from 1985 and prior, from the Specialty Commercial segment to Other Operations. Discussion of Operations Revenues for the third quarter and nine months ended September 30, 2002 were relatively flat compared to the same prior year periods as higher earned premium was offset by net realized capital losses. The increase in earned premium was primarily renewal premium from the exited HartRe international business, which was transferred to Other Operations in the first quarter of 2002. Operating income also was relatively flat for the third quarter and nine months ended September 30, 2002 compared to the same prior year periods. Asbestos and Environmental Claims The Hartford continues to receive claims that assert damages from asbestos and environmental-related exposures, both of which affect Other Operations. Asbestos claims relate primarily to injuries asserted by those who came in contact with asbestos or products containing asbestos. Environmental claims relate primarily to pollution and related clean-up costs. The Hartford receives asbestos and environmental claims made pursuant to several different categories of insurance coverage. First, The Hartford wrote policies as a primary liability insurance carrier. Second, The Hartford wrote excess insurance policies that provide additional coverage for insureds that exhaust their primary liability insurance coverage. Third, The Hartford acted as a reinsurer assuming a portion of risks previously assumed by other insurers writing primary, excess and reinsurance coverages. Writers of excess insurance and reinsurance often receive information regarding potential exposures significantly later than primary writers covering the same risk. The Hartford may experience more difficulty and delays in estimating its exposures arising from excess and reinsurance policies than it does in estimating exposures arising from its activity as a primary insurance writer. With regard to both environmental and particularly asbestos claims, uncertainty exists which affects the ability of insurers and reinsurers to estimate the ultimate reserves necessary for unpaid losses and related settlement expenses. Conventional reserving techniques cannot reasonably estimate the ultimate cost of these claims, particularly during periods where theories of law are in flux. As a result of the factors discussed in the following paragraphs, the degree of variability of reserve estimates for these exposures is significantly greater than for other more traditional exposures. In particular, The Hartford believes there is a high degree of uncertainty in the estimation of asbestos loss reserves. In the case of the reserves for asbestos exposures, factors contributing to the high degree of uncertainty include inadequate development patterns, plaintiffs' expanding theories of liability, the risks inherent in major litigation and inconsistent emerging legal doctrines. There are complex legal issues concerning the interpretation of various insurance policy provisions and whether those losses are, or were ever intended to be, covered. Courts have reached inconsistent conclusions as to when losses are deemed to have occurred and which policies provide coverage; what types of losses are covered; whether there is an insurer obligation to defend; how policy limits are determined; whether or not particular claims are product/completed operation claims subject to an aggregate limit and how policy exclusions and conditions are applied and interpreted. Furthermore, insurers in general, including The Hartford, have recently experienced an increase in the number of asbestos-related claims due to, among other things, more intensive advertising by lawyers seeking asbestos claimants, the increasing focus by plaintiffs on new and previously peripheral defendants and an increase in the number of entities seeking bankruptcy protection as a result of asbestos-related liabilities. Plaintiffs and insureds have sought to utilize bankruptcy proceedings to accelerate and increase loss payments by insurers. In addition, new classes of claims have been arising whereby some asbestos-related defendants are asserting that their asbestos-related claims fall within so-called non-products liability coverage contained within their policies rather than products liability coverage and that the claimed non-products coverage is not subject to any aggregate limit. Recently, many insurers, including, in a limited number of instances, The Hartford, also have been sued directly by asbestos claimants asserting that insurers had a duty to protect the public from the dangers of asbestos. Management believes these issues are not likely to be resolved in the near future. An adverse determination of issues relating to The Hartford's liability for asbestos claims could have a material adverse effect on The Hartford's results of operations, financial condition and liquidity. Given the factors and emerging trends described above, The Hartford believes the actuarial tools and other techniques it employs to estimate the ultimate cost of paying claims for more traditional areas of insurance exposure are less effective in estimating the necessary reserves for its asbestos exposures. The Hartford continually evaluates new information and new methodologies to use in evaluating its potential asbestos exposures. At any time, including the current reporting period, The Hartford may be conducting one or more evaluations of individual exposures, classes of exposures or all of its current and potential exposures to asbestos claims. At any time analysis of newly identified information or completion of one or more analyses could cause The Hartford to change its estimates of its asbestos exposures and the effect of these changes could be material to the Company's consolidated operating results and financial condition in future periods. Reserve Activity Reserves and reserve activity in the Other Operations segment are categorized and reported as either Asbestos, Environmental, or All Other activity. The discussion below relates to reserves and reserve activity, net of applicable reinsurance. Constantly evolving legal theories create significant uncertainties with respect to what types of claims may ultimately arise from the generally older policies and liabilities managed in the Other Operations segment. The Hartford's experience has been that while this group of policies has over time produced significantly higher claims and losses than were initially contemplated at - 32 - inception, the areas of active claim activity have shifted over time based on changes in plaintiff focus and the overall litigation environment. A significant portion of the claim reserves of the Other Operations segment relates to exposure to the insurance businesses of other insurers or reinsurers ("whole account" exposure). Many of these whole account exposures arise from reinsurance agreements previously written by The Hartford. The Hartford's net exposure in these arrangements has increased for a variety of reasons, including, but not limited to, situations where The Hartford has commuted previous retrocessions of such business. Due to the reporting practices of cedants to their reinsurers, determination of the nature of the individual risks involved in these whole account exposures (such as asbestos, environmental, or other exposures) requires various assumptions and estimates, which are subject to variability and uncertainty. The following table presents reserve activity, inclusive of estimates for both reported and incurred but not reported claims, net of reinsurance, for Other Operations, categorized by Asbestos, Environmental, and All Other claims, for the third quarter and nine months ended September 30, 2002. Also included are the remaining Asbestos and Environmental exposures of North American.
OTHER OPERATIONS CLAIMS AND CLAIM ADJUSTMENT EXPENSES ------------------------------------------------------------------------------------------------------------------------------------ THIRD QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, 2002 SEPTEMBER 30, 2002 --------------------------------------------- ---------------------------------------------- Asbestos Environ. All Other Total Asbestos Environ. All Other Total --------------------------------------------- ---------------------------------------------- Beginning liability - net $ 1,142 $ 658 $ 1,261 $ 3,061 $ 616 $ 654 $ 1,593 $ 2,863 Claims and claim adjustment expenses incurred 25 (2) 17 40 58 (7) 80 131 Claims and claim adjustment expenses paid (34) (14) (33) (81) (81) (65) (128) (274) Transfer of HartRe International [1] -- -- -- -- -- -- 300 300 Other [2] -- -- -- -- 540 60 (600) -- ------------------------------------------------------------------------------------------------------------------------------------ ENDING LIABILITY - NET [3] [4] $ 1,133 $ 642 $ 1,245 $ 3,020 $ 1,133 $ 642 $ 1,245 $ 3,020 ==================================================================================================================================== [1] Represents the January 1, 2002 transfer of reserves from the exited international reinsurance business of HartRe from the Reinsurance segment to Other Operations. [2] The nature of these reallocations is described in the two paragraphs immediately following this table. [3] Ending liabilities include reserves for Asbestos and Environmental reported in North American of $11 and $15, respectively, as of September 30, 2002; $11 and $16, respectively as of June 30, 2002; and $6 and $32, respectively, as of December 31, 2001. [4] Gross of reinsurance, reserves for Asbestos and Environmental were $1,804 and $743, respectively, as of September 30, 2002; $1,874 and $807, respectively, as of June 30, 2002; and $1,633 and $919, respectively, as of December 31, 2001.
During 2001, the Company observed a decrease in newly reported environmental claims as well as favorable settlements with respect to certain existing environmental claims. Both observations were consistent with longer-term positive development trends for environmental liabilities. In the same timeframe, consistent with the reports of other insurers, The Hartford was experiencing an increase in the number of new asbestos claims by policyholders not previously identified as potentially significant claimants, including installers or handlers of asbestos-containing products. In addition, new classes of claims were beginning to arise whereby some asbestos-related defendants were asserting that their asbestos-related claims fall within so-called non-products liability coverage contained within their policies rather than products liability coverage and that the claimed non-products coverage is not subject to any aggregate limit. Also, as previously noted, The Hartford consolidated management and claims handling responsibility of all of its asbestos and environmental exposures within Other Operations in 2001. Based on a review of the environmental claim trends that was completed in the fourth quarter of 2001 under the supervision of the then newly consolidated management structure and in light of the further uncertainties posed by the foregoing asbestos trends, the Company reclassified $100 of Environmental reserves to Asbestos reserves in 2001. In the second quarter of 2002, The Hartford completed a review of its Other Operations reserves and liabilities then categorized as "All Other". This review was part of the Company's ongoing monitoring of reserves. The Hartford's primary records of the reserves and policies managed in the Other Operations segment are organized by individual insurance contract and by the type of insurance coverage originally written. The review was conducted within the recently consolidated asbestos and environmental management structure and was largely focused on the appropriateness of the categorization of the All Other reserves, net of reinsurance. In evaluating the appropriateness of the categorization of these net reserves, management utilized the best information that was available to ascertain the nature of the underlying exposures and focused significantly on the reserves attributable to The Hartford's whole account reinsurance, including those reserves that related to commutations of previous cessions of business. The review also incorporated the most current information and payment and settlement trends related to latent exposures that are not asbestos and environmental exposures. As a result of this review, the Company reclassified $600 of reserves from the All Other category, with $540 reclassified to Asbestos and $60 reclassified to Environmental. The increase in reserves categorized as Environmental of $60 in the second quarter (as contrasted with the $100 decrease in the fourth quarter of 2001) occurred because the reviews in each of the two periods employed actuarial techniques to analyze distinct and non-overlapping blocks of reserves and associated exposures. Facts and circumstances associated with each block then determined the resulting changes in category. - 33 - A portion of the 2002 reclassification relates to re-estimates of the appropriate allocation between Asbestos, Environmental, and All Other categories of the aggregate reserves (net of reinsurance) carried for certain assumed reinsurance, commuted cessions and commuted retrocessions of whole account business. As part of the 2002 reclassification, The Hartford also revised formulas that it will use to allocate (between the Asbestos, Environmental and All Other categories) future claim payments for which reinsurance arrangements were commuted and to allocate claim payments made to effect commutations. As a result of these revisions, payments categorized as asbestos and environmental exposures will be higher in future periods than in prior periods. The Hartford believes that any percent increase in claim payments caused by the reclassification would be significantly less than the percent increase in total Asbestos and Environmental reserves. For the third quarter ended September 30, 2002, favorable pollution development in North American of $2 was offset by unfavorable incurred development in the international reinsurance business of HartRe of $17 as well as $25 of adverse asbestos development primarily in assumed reinsurance. Based on currently known facts and the Company's methodologies for estimating and categorizing reserves for Other Operations, The Hartford believes that the level of recorded reserves for Other Operations at September 30, 2002 is reasonable and appropriate. Because of the significant uncertainties described in the foregoing paragraphs, principally those related to asbestos, the ultimate liabilities may exceed the currently recorded reserves. Any such additional liability (or any range of additional amounts) cannot be reasonably estimated now but could be material to The Hartford's future consolidated operating results and financial condition. Consistent with the Company's long-standing reserving practices, The Hartford will continue to regularly review and monitor these reserves and, where future circumstances indicate, make appropriate adjustments to the reserves. -------------------------------------------------------------------------------- INVESTMENTS -------------------------------------------------------------------------------- Return on invested assets is an important element of The Hartford's financial results. Significant fluctuations in the fixed income or equity markets could have a material impact on the Company's consolidated financial condition or its results of operations. Additionally, changes in market interest rates may impact the period of time over which certain investments, such as mortgage-backed securities, are repaid and whether certain investments are called by the issuers. Such changes may, in turn, impact the yield on these investments and also may result in reinvestment of funds received from calls and prepayments at rates below the average portfolio yield. Fluctuations in interest rates affect the Company's return on, and the fair value of, fixed maturity investments, which comprised 89% and 86% of the fair value of its invested assets as of September 30, 2002 and December 31, 2001, respectively. Other events beyond the Company's control also could impact adversely the fair value of these investments. For example, a downgrade of an issuer's credit rating or default of payment by an issuer could reduce the fair value of the investment and the Company's investment return. A significant decrease in the fair value of any investment that is deemed other than temporary would result in the Company's recognition of a loss in its consolidated financial results prior to the actual sale of the investment and may result in the recognition of either a gain or an additional loss upon the ultimate disposition of the investment. The Hartford's investment portfolios are divided between Life and Property & Casualty. The investment portfolios are managed based on the underlying characteristics and nature of each operation's respective liabilities and within established risk parameters. (For a further discussion on The Hartford's approach to managing risks, see the Capital Markets Risk Management section.) Please refer to the Investments section of the MD&A in The Hartford's 2001 Form 10-K Annual Report for a description of the Company's investment objectives and policies. LIFE The following table identifies invested assets by type held in the Life general account as of September 30, 2002 and December 31, 2001.
COMPOSITION OF INVESTED ASSETS ------------------------------------------------------------------------------------------------------------------------------------ SEPTEMBER 30, 2002 DECEMBER 31, 2001 AMOUNT PERCENT AMOUNT PERCENT -------------- -------------- -------------- ----------- Fixed maturities, at fair value $ 28,539 85.8% $ 23,301 82.1% Equity securities, at fair value 374 1.1% 428 1.5% Policy loans, at outstanding balance 2,980 9.0% 3,317 11.7% Limited partnerships, at fair value 672 2.0% 811 2.9% Other investments 687 2.1% 520 1.8% ------------------------------------------------------------------------------------------------------------------------------------ TOTAL INVESTMENTS $ 33,252 100.0% $ 28,377 100.0% ====================================================================================================================================
Fixed maturity investments increased 22% since December 31, 2001, primarily due to increased institutional and retail operating cash flows, transfers into the general account from the variable annuity separate account, and an increase in fair value due to a lower interest rate environment. Other investments increased 32% since December 31, 2001 primarily due to market value appreciation of derivative instruments in cash-flow hedging relationships. The following table identifies fixed maturities by type held in the Life general account as of September 30, 2002 and December 31, 2001. - 34 -
FIXED MATURITIES BY TYPE ------------------------------------------------------------------------------------------------------------------------------------ SEPTEMBER 30, 2002 DECEMBER 31, 2001 FAIR VALUE PERCENT FAIR VALUE PERCENT --------------------------------------------------------- Corporate $ 13,713 48.1% $ 11,419 49.0% Commercial mortgage-backed securities (CMBS) 4,073 14.3% 3,029 13.0% Asset-backed securities (ABS) 3,873 13.6% 3,427 14.7% Municipal - tax-exempt 2,021 7.1% 1,565 6.7% Mortgage-backed securities (MBS) - agency 1,713 6.0% 981 4.2% Collateralized mortgage obligations (CMO) 816 2.8% 767 3.3% Government/Government agencies - Foreign 524 1.8% 390 1.7% Government/Government agencies - United States 262 0.9% 374 1.6% Municipal - taxable 31 0.1% 47 0.2% Short-term 1,479 5.2% 1,245 5.3% Redeemable preferred stock 34 0.1% 57 0.3% ------------------------------------------------------------------------------------------------------------------------------------ TOTAL FIXED MATURITIES $ 28,539 100.0% $ 23,301 100.0% ====================================================================================================================================
INVESTMENT RESULTS The table below summarizes Life's investment results.
THIRD QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ----------------------------- -------------------------- (before-tax) 2002 2001 2002 2001 --------------------------------------------------------------------------- -------------- -------------- -------------- ----------- Net investment income - excluding policy loan income $ 401 $ 368 $ 1,164 $ 1,085 Policy loan income 61 79 196 235 --------------------------------------------------------- Net investment income - total $ 462 $ 447 $ 1,360 $ 1,320 Yield on average invested assets [1] 6.0% 6.7% 6.1% 7.0% Net realized capital losses $ (118) $ (50) $ (253) $ (67) ==================================================================================================================================== [1] Represents annualized net investment income (excluding net realized capital gains (losses)) divided by average invested assets at cost (fixed maturities at amortized cost).
For the third quarter and nine months ended September 30, 2002, net investment income, excluding policy loans, increased $33, or 9%, and $79, or 7%, compared to the respective prior year periods. The increase was primarily due to income earned on a higher invested asset base partially offset by lower investment yields. Invested assets increased 19% from September 30, 2001 primarily due to operating cash flows, transfers into the general account from the variable annuity separate account, and an increase in fair value due to a lower interest rate environment. Yields on average invested assets decreased as a result of lower rates on new investment purchases and decreased policy loan income. Net realized capital losses for the third quarter and nine months ended September 30, 2002 increased $68 and $186 compared to the respective prior year periods. Included in the third quarter and nine months ended September 30, 2002 were write-downs for other than temporary impairments on fixed maturities of $118 and $277, respectively. The third quarter impairments were concentrated in asset-backed securities principally due to weakness in the airline industry. The year to date impairment losses were primarily due to write-downs on bonds in the telecommunications industry. Also included in the third quarter and nine months ended September 30, 2002 were write-downs for other than temporary impairments on equity securities of $14. PROPERTY & CASUALTY The following table identifies invested assets by type as of September 30, 2002 and December 31, 2001.
COMPOSITION OF INVESTED ASSETS ------------------------------------------------------------------------------------------------------------------------------------ SEPTEMBER 30, 2002 DECEMBER 31, 2001 AMOUNT PERCENT AMOUNT PERCENT -------------- -------------- -------------- ----------- Fixed maturities, at fair value $ 18,899 93.5% $ 16,742 91.5% Equity securities, at fair value 611 3.0% 921 5.0% Limited partnerships, at fair value 412 2.1% 561 3.0% Other investments 280 1.4% 85 0.5% ------------------------------------------------------------------------------------------------------------------------------------ TOTAL INVESTMENTS $ 20,202 100.0% $ 18,309 100.0% ====================================================================================================================================
Fixed maturity investments increased 13% since December 31, 2001, due to the investment of increased operating cash flows and an increase in fair value due to a lower interest rate environment. Total equity securities decreased 34% since December 31, 2001, due to the liquidation of foreign equity holdings and declines in domestic equity market values. Other investments also increased since December 31, 2001 due to the purchase of a corporate owned life insurance contract and increased investment in mortgage loans. The following table identifies fixed maturities by type as of September 30, 2002 and December 31, 2001. - 35 -
FIXED MATURITIES BY TYPE ------------------------------------------------------------------------------------------------------------------------------------ SEPTEMBER 30, 2002 DECEMBER 31, 2001 FAIR VALUE PERCENT FAIR VALUE PERCENT -------------- -------------- -------------- ----------- Municipal - tax-exempt $ 8,931 47.2% $ 8,401 50.2% Corporate 4,813 25.5% 4,179 25.0% Commercial mortgage-backed securities (CMBS) 1,637 8.7% 1,145 6.8% Government/Government agencies - Foreign 834 4.4% 613 3.6% Asset-backed securities (ABS) 737 3.9% 717 4.3% Mortgage-backed securities (MBS) - agency 589 3.1% 381 2.3% Collateralized mortgage obligations (CMO) 98 0.5% 97 0.6% Government/Government agencies - United States 66 0.3% 201 1.2% Municipal - taxable 52 0.3% 47 0.3% Short-term 1,073 5.7% 862 5.1% Redeemable preferred stock 69 0.4% 99 0.6% ------------------------------------------------------------------------------------------------------------------------------------ TOTAL FIXED MATURITIES $ 18,899 100.0% $ 16,742 100.0% ====================================================================================================================================
INVESTMENT RESULTS The table below summarizes Property & Casualty's investment results.
THIRD QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ----------------------------- -------------------------- 2002 2001 2002 2001 --------------------------------------------------------------------------- -------------- -------------- -------------- ----------- Net investment income, before-tax $ 262 $ 263 $ 787 $ 791 Net investment income, after-tax [1] $ 204 $ 205 $ 612 $ 616 --------------------------------------------------------- Yield on average invested assets, before-tax [2] 5.6% 6.1% 5.7% 6.2% Yield on average invested assets, after-tax [1] [2] 4.4% 4.8% 4.5% 4.8% Net realized capital losses, before-tax $ (42) $ (4) $ (80) $ (24) ==================================================================================================================================== [1] Due to the significant holdings in tax-exempt investments, after-tax net investment income and after-tax yield also are included. [2] Represents annualized net investment income (excluding net realized capital gains (losses)) divided by average invested assets at cost (fixed maturities at amortized cost).
For the third quarter and nine months ended September 30, 2002, both before- and after-tax net investment income remained essentially unchanged compared to the same periods in 2001. Yields on average invested assets declined due to the lower interest rate environment, offsetting the impact of increased invested assets. Net realized capital losses for the third quarter and nine months ended September 30, 2002 increased $38 and $56, respectively, compared to the respective prior year periods. Included in the third quarter and nine months ended September 30, 2002 were write-downs for other than temporary impairments on fixed maturities of $35 and $129, respectively, and $8 and $32 on equities, respectively, partially offset by net realized capital gains on sales of equity securities. The fixed maturity impairment losses primarily reflect weakness in the telecommunications and airline industries. CORPORATE In connection with The HLI Repurchase, the carrying value of the purchased fixed maturity investments was adjusted to fair market value as of the date of the repurchase. This adjustment was reported in Corporate. The amortization of the adjustment to the fixed maturity investments' carrying values is reported in Corporate's net investment income. The total amount of amortization for the third quarter and nine months ended September 30, 2002 was $4 and $13, respectively, before-tax. Also reported in Corporate as of September 30, 2002 were $647 of proceeds from third quarter Company debt and equity issuances. The proceeds are invested in short-term fixed maturities and earned $1 of related income. -------------------------------------------------------------------------------- CAPITAL MARKETS RISK MANAGEMENT -------------------------------------------------------------------------------- The Hartford has a disciplined approach to managing risks associated with its capital markets and asset/liability management activities. Investment portfolio management is organized to focus investment management expertise on specific classes of investments, while asset/liability management is the responsibility of separate and distinct risk management units supporting Life and Property & Casualty operations. Derivative instruments are utilized in compliance with established Company policy and regulatory requirements and are monitored internally and reviewed by senior management. The Company is exposed to two primary sources of investment and asset/liability management risk: credit risk, relating to the uncertainty associated with the ability of an obligor or counterparty to make timely payments of principal and/or interest, and market risk, relating to the market price and/or cash flow variability associated with changes in interest rates, securities prices, market indices, yield curves or currency exchange rates. The Company does not hold any financial instruments purchased for trading purposes. - 36 - Please refer to the Capital Markets Risk Management section of the MD&A in The Hartford's 2001 Form 10-K Annual Report for a description of the Company's objectives, policies and strategies. CREDIT RISK The Company invests primarily in securities which are rated investment grade and has established exposure limits, diversification standards and review procedures for all credit risks including borrower, issuer or counterparty. Creditworthiness of specific obligors is determined by an internal credit assessment and ratings assigned by nationally recognized ratings agencies. Obligor, asset sector and industry concentrations are subject to established limits and are monitored at regular intervals. The Hartford is not exposed to any credit concentration risk of a single issuer greater than 10% of the Company's stockholders' equity. The following tables identify fixed maturity securities for Life, including guaranteed separate accounts of $11.1 billion and $9.8 billion as of September 30, 2002 and December 31, 2001, respectively, and Property & Casualty, by credit quality. The ratings referenced in the tables are based on the ratings of a nationally recognized rating organization or, if not rated, assigned based on the Company's internal analysis of such securities. LIFE As of September 30, 2002 and December 31, 2001, over 95% and 96%, respectively, of the fixed maturity portfolio was invested in securities rated investment grade. While the overall credit quality of the fixed maturity portfolio has remained essentially unchanged, the percentage of BB & below holdings has increased due to downgraded credit ratings primarily in public corporate bonds.
FIXED MATURITIES BY CREDIT QUALITY ------------------------------------------------------------------------------------------------------------------------------------ SEPTEMBER 30, 2002 DECEMBER 31, 2001 FAIR VALUE PERCENT FAIR VALUE PERCENT -------------- -------------- -------------- ----------- United States Government/Government agencies $ 3,685 9.3% $ 2,639 8.0% AAA 6,736 17.0% 5,070 15.3% AA 4,196 10.6% 3,644 11.0% A 12,262 30.9% 11,528 34.8% BBB 9,205 23.2% 7,644 23.1% BB & below 1,791 4.5% 1,148 3.4% Short-term 1,766 4.5% 1,470 4.4% ------------------------------------------------------------------------------------------------------------------------------------ TOTAL FIXED MATURITIES $ 39,641 100.0% $ 33,143 100.0% ====================================================================================================================================
PROPERTY & CASUALTY As of September 30, 2002 and December 31, 2001, over 95% and 94%, respectively, of the fixed maturity portfolio was invested in securities rated investment grade. While the overall credit quality of the fixed maturity portfolio has remained essentially unchanged, the percentage of BBB holdings has increased due to downgraded credit ratings primarily in public corporate bonds.
FIXED MATURITIES BY CREDIT QUALITY ------------------------------------------------------------------------------------------------------------------------------------ SEPTEMBER 30, 2002 DECEMBER 31, 2001 FAIR VALUE PERCENT FAIR VALUE PERCENT -------------- -------------- -------------- ----------- United States Government/Government agencies $ 713 3.8% $ 639 3.8% AAA 7,226 38.2% 6,160 36.8% AA 3,432 18.2% 3,126 18.7% A 3,257 17.2% 3,193 19.1% BBB 2,288 12.1% 1,876 11.2% BB & below 910 4.8% 886 5.3% Short-term 1,073 5.7% 862 5.1% ------------------------------------------------------------------------------------------------------------------------------------ TOTAL FIXED MATURITIES $ 18,899 100.0% $ 16,742 100.0% ====================================================================================================================================
MARKET RISK The Hartford has material exposure to both interest rate and equity market risk. The Company analyzes interest rate risk using various models including multi-scenario cash flow projection models that forecast cash flows of the liabilities and their supporting investments, including derivative instruments. The Company's Life operations are significantly influenced by changes in the equity markets. Life's profitability depends largely on the amount of assets under management, which is primarily driven by the level of sales, equity market appreciation and depreciation, and the persistency of the in-force block of business. A prolonged and precipitous decline in the equity markets, as has been experienced of late, can have a significant impact on the Company's operations, as sales of variable products may decline and surrender activity may increase, as customer sentiment towards the equity market turns negative. The lower assets under management will have a negative impact on the Company's financial results, primarily due to lower fee income related to the Investment Products and Individual Life segments, where a heavy concentration of equity linked products are administered and sold. Furthermore, the Company may experience a reduction in profit margins if a significant portion of the assets held in the variable annuity separate accounts move to the general account and the - 37 - Company is unable to earn an acceptable investment spread, particularly in light of the low interest rate environment and the presence of contractually guaranteed minimum interest credited rates, which for the most part are at a 3% rate. (For further discussion of the Company's exposure to interest rate risk, please refer to the Capital Markets Risk Management section of the MD&A in The Hartford's 2001 Form 10-K Annual Report.) In addition, prolonged declines in the equity market may also decrease the Company's expectations of future gross profits, which are utilized to determine the amount of DAC to be amortized in a given financial statement period. A significant decrease in the Company's expected gross profits would require the Company to accelerate the amount of DAC amortization in a given period, potentially causing a material adverse deviation in that period's net income. Although an acceleration of DAC amortization would have a negative impact on the Company's earnings, it would not affect the Company's cash flow or liquidity position. Additionally, the Investment Products segment sells variable annuity contracts that offer various guaranteed death benefits. For certain guaranteed death benefits, The Hartford pays the greater of (1) the account value at death; (2) the sum of all premium payments less prior withdrawals; or (3) the maximum anniversary value of the contract, plus any premium payments since the contract anniversary, minus any withdrawals following the contract anniversary. The Company currently reinsures a significant portion of these death benefit guarantees associated with its in-force block of business. The Company currently records the death benefit costs, net of reinsurance, as they are incurred. Declines in the equity market may increase the Company's net exposure to death benefits under these contracts. The Company's total gross exposure (i.e. before reinsurance) to these guaranteed death benefits as of September 30, 2002 is $25.9 billion. Due to the fact that 81% of this amount is reinsured, the Company's net exposure is $4.9 billion. This amount is often referred to as the net amount at risk. However, the Company will only incur these guaranteed death benefit payments in the future if the policyholder has an in-the-money guaranteed death benefit at their time of death. In order to analyze the total costs that the Company may incur in the future related to these guaranteed death benefits, the Company performed an actuarial present value analysis. This analysis included developing a model utilizing 250 stochastically generated investment performance scenarios and best estimate assumptions related to mortality and lapse rates. A range of projected costs was developed and discounted back to the statement date utilizing the Company's cost of capital, which for this purpose was assumed to be 9.25%. Based on this analysis, the Company estimated that the present value of the retained death benefit costs to be incurred in the future fell within a range of $91 to $378. This range was calculated utilizing a 95% confidence interval. The median of the 250 stochastically generated scenarios was $184. Furthermore, the Company is involved in arbitration with one of its primary reinsurers relating to policies with such death benefit guarantees written from 1994 to 1999. The arbitration involves alleged breaches under the reinsurance treaties. Although the Company believes that its position in this pending arbitration is strong, an adverse outcome could result in a decrease to the Company's statutory surplus and capital and potentially increase the death benefit costs incurred by the Company in the future. The arbitration hearing began in October 2002. DERIVATIVE INSTRUMENTS The Hartford utilizes a variety of derivative instruments, including swaps, caps, floors, forwards and exchange traded futures and options, in compliance with Company policy and regulatory requirements in order to achieve one of four Company-approved objectives: to hedge risk arising from interest rate, price or currency exchange rate volatility; to manage liquidity; to control transaction costs; or to enter into income enhancement and replication transactions. The Company does not make a market or trade derivatives for the express purpose of earning trading profits. (For further discussion on The Hartford's use of derivative instruments, see Note 3 of Notes to Consolidated Financial Statements.) - 38 - -------------------------------------------------------------------------------- CAPITAL RESOURCES AND LIQUIDITY -------------------------------------------------------------------------------- Capital resources and liquidity represent the overall financial strength of The Hartford and its ability to generate strong cash flows from each of the business segments and borrow funds at competitive rates to meet operating and growth needs. The capital structure of The Hartford consists of debt and equity summarized as follows:
SEPTEMBER 30, 2002 DECEMBER 31, 2001 ------------------------------------------------------------------------------------------------------------------------------------ Short-term debt $ 615 $ 599 Long-term debt 2,595 1,965 Company obligated mandatorily redeemable preferred securities of subsidiary trusts holding solely junior subordinated debentures (trust preferred securities) 1,461 1,412 ------------------------------------------------------------------------------------------------------------------------------------ TOTAL DEBT 4,671 3,976 ----------------------------------------------------------------------------------------------------------------------------- Equity excluding unrealized gain on securities and other, net of tax [1] 9,294 8,344 Unrealized gain on securities and other, net of tax [1] 1,649 669 ------------------------------------------------------------------------------------------------------------------------------------ TOTAL STOCKHOLDERS' EQUITY 10,943 9,013 ----------------------------------------------------------------------------------------------------------------------------- TOTAL CAPITALIZATION [2] $ 13,965 $ 12,320 ----------------------------------------------------------------------------------------------------------------------------- Debt to equity [2] [3] 50% 48% Debt to capitalization [2] [3] 33% 32% ==================================================================================================================================== [1] Other represents the net gain on cash-flow hedging instruments as a result of the Company's adoption of SFAS No. 133. [2] Excludes unrealized gain on securities and other, net of tax. [3] Excluding trust preferred securities, the debt to equity ratio was 35% and 31% and the debt to capitalization ratio was 23% and 21% as of September 30, 2002 and December 31, 2001, respectively.
CONTRACTUAL OBLIGATIONS AND COMMITMENTS There have been no significant changes to The Hartford's contractual obligations and commitments since December 31, 2001. CAPITALIZATION The Hartford endeavors to maintain a capital structure that provides financial and operational flexibility to its insurance subsidiaries, ratings that support its competitive position in the financial services marketplace (see the Ratings section below for further discussion), and strong shareholder returns. Consistent with these objectives, during the third quarter of 2002, the Company increased its capitalization by $649 through the issuance of $330 in common stock and $319 in equity units. Proceeds of $300 were contributed to the property and casualty insurance subsidiaries, while the balance has been held for general corporate purposes, which may include additional capital contributions to the insurance subsidiaries. During the nine months ended September 30, 2002, The Hartford's total capitalization, excluding unrealized gain on securities and other, net of tax, increased by $1,645. This increase was a result of the aforementioned third quarter 2002 capital raising activities; the issuance of $298 in senior notes in August 2002, the proceeds of which were used to repay senior notes that matured on November 1, 2002; earnings; and stock issued related to stock compensation plans. These increases were partially offset by dividends declared. DEBT On September 13, 2002 The Hartford issued 6.6 million 6% equity units at a price of $50.00 per unit and received net proceeds of $319. Each equity unit offered initially consists of a corporate unit with a stated amount of $50.00 per unit. Each corporate unit consists of one purchase contract for the sale of a certain number of shares of the Company's stock and fifty dollars principal amount of senior notes due November 16, 2008. The corporate unit may be converted by the holder into a treasury unit consisting of the purchase contract and a 5% undivided beneficial interest in a zero-coupon U.S. Treasury security with a principal amount of one thousand dollars that matures on November 15, 2006. The holder of an equity unit owns the underlying senior notes or treasury portfolio but has pledged the senior notes or treasury portfolio to the Company to secure the holder's obligations under the purchase contract. The purchase contract obligates the holder to purchase, and obligates The Hartford to sell, on November 16, 2006, for fifty dollars, a variable number of newly issued common shares of The Hartford. The number of The Hartford's shares to be issued will be determined at the time the purchase contracts are settled based upon the then current applicable market value of The Hartford's common stock. If the applicable market value of The Hartford's common stock is equal to or less than $47.25, then the Company will deliver 1.0582 shares to the holder of the equity unit, or an aggregate of 7.0 million shares. If the applicable market value of The Hartford's common stock is greater than $47.25 but less than $57.645, then the Company will deliver the number of shares equal to fifty dollars divided by the then current applicable market value of The Hartford's common stock to the holder. Finally, if the applicable market value of The Hartford's common stock is equal to or greater than $57.645, then the Company will deliver 0.8674 shares to the holder, or an aggregate of 5.7 million shares. Accordingly, upon settlement of the purchase contracts on November 16, 2006, The Hartford will receive proceeds of approximately $330 and will deliver between 5.7 million and 7.0 million common shares in the aggregate. The proceeds will be credited to stockholders' equity and allocated between the common stock and additional paid-in-capital accounts. The Hartford will make quarterly contract adjustment payments to the equity unit holders at a rate of 1.90% of the stated amount per year until the purchase contract is settled. - 39 - Each corporate unit also includes fifty dollars principal amount of senior notes that will mature on November 16, 2008. The aggregate maturity value of the senior notes is $330. The notes are pledged by the holders to secure their obligations under the purchase contracts. The Hartford will make quarterly interest payments to the holders of the notes initially at an annual rate of 4.10%. On August 11, 2006, the notes will be remarketed. At that time, The Hartford's remarketing agent will have the ability to reset the interest rate on the notes in order to generate sufficient remarketing proceeds to satisfy the holder's obligation under the purchase contract. In the event of an unsuccessful remarketing, the Company will exercise its rights as a secured party to obtain and extinguish the notes. The total distributions payable on the equity units are at an annual rate of 6.0%, consisting of interest (4.10%) and contract adjustment payments (1.90%). The corporate units are listed on the New York Stock Exchange under the symbol "HIG PrA". The present value of the contract adjustment payments of $24 was accrued upon the issuance of the equity units as a charge to additional paid-in capital and are included in other liabilities in the accompanying consolidated balance sheet as of September 30, 2002. Subsequent contract adjustment payments will be allocated between this liability account and interest expense based on a constant rate calculation over the life of the transaction. Additional paid-in capital as of September 30, 2002, also reflected a charge of $9 representing a portion of the equity unit issuance costs that was allocated to the purchase contracts. The equity units have been reflected in the diluted earnings per share calculation using the treasury stock method, which would be used for the equity units at any time before the settlement of the purchase contracts. Under the treasury stock method, the number of shares of common stock used in calculating diluted earnings per share is increased by the excess, if any, of the number of shares issuable upon settlement of the purchase contracts over the number of shares that could be purchased by The Hartford in the market, at the average market price during the period, using the proceeds received upon settlement. The Company anticipates that there will be no dilutive effect on its earnings per share related to the equity units, except during periods when the average market price of a share of the Company's common stock is above the threshold appreciation price of $57.645. Because the average market price of The Hartford's common stock during the quarter ended September 30, 2002, was below this threshold appreciation price, the shares issuable under the purchase contract component of the equity units have not been included in the diluted earnings per share calculation. On August 29, 2002 The Hartford issued 4.7% senior notes due September 1, 2007 and received net proceeds of $298. Interest on the notes is payable semi-annually on March 1 and September 1, commencing on March 1, 2003. The Company used the proceeds to repay senior notes that matured on November 1, 2002. In March 2002, the Company borrowed $16 of short-term commercial notes for general corporate purposes. STOCKHOLDERS' EQUITY Issuance of common stock - On September 13, 2002, The Hartford issued approximately 7.3 million shares of common stock pursuant to an underwritten offering at a price of $47.25 per share and received net proceeds of $330. Also on September 13, 2002, The Hartford issued 6.6 million 6% equity units and received net proceeds of $319. For further discussion of the equity units issuance, see the Debt section above. Increase in authorized shares - At the Company's annual meeting of shareholders held on April 18, 2002, shareholders approved an amendment to Section (a) Article Fourth of the Amended and Restated Certificate of Incorporation to increase the aggregate authorized number of shares of common stock from 400 million to 750 million. Dividends - On April 18, 2002, The Hartford declared a dividend on its common stock of $0.26 per share payable on July 1, 2002 to shareholders of record as of June 3, 2002. On July 18, 2002, The Hartford declared a dividend on its common stock of $0.26 per share payable on October 1, 2002 to shareholders of record as of September 3, 2002. On October 24, 2002, The Hartford declared a dividend on its common stock of $0.27 per share payable on January 2, 2003 to shareholders of record as of December 2, 2002. Minimum pension liability adjustment - The funded status of the Company's pension and postretirement plans is dependent upon many factors, including returns on invested assets and the level of market interest rates. Recent declines in the value of securities traded in equity markets coupled with declines in long-term interest rates have had a negative impact on the funded status of the plans. As a result, the Company expects to record a minimum pension liability as of December 31, 2002 which would result in an after-tax reduction of stockholders' equity of approximately $200-$300. This minimum pension liability will not affect the Company's results of operations. CASH FLOWS NINE MONTHS ENDED SEPTEMBER 30, -------------------------- 2002 2001 ------------------------------------------------------------------ Cash provided by operating activities $ 2,092 $ 1,059 Cash used for investing activities $ (5,780) $ (4,081) Cash provided by financing activities $ 3,740 $ 3,120 Cash - end of period $ 413 $ 325 ================================================================== The increase in cash provided by operating activities was primarily the result of higher net income reported for the nine months ended September 30, 2002 than for the comparable prior year period as well as income tax refunds received in 2002 compared with income tax payments made in the prior year period. The increase in cash provided by financing activities was primarily the result of increased proceeds from investment and universal life-type contracts. The increase in cash from financing activities accounted for the majority of the change in cash for investing activities. Operating cash flows in both periods have been adequate to meet liquidity requirements. RATINGS Ratings are an important factor in establishing the competitive position in the insurance and financial services marketplace. There can be no assurance that the Company's ratings will continue for any given period of time or that they will not be changed. In the event the Company's ratings are downgraded, the - 40 - level of revenues or the persistency of the Company's business may be adversely impacted. The following table summarizes The Hartford's significant United States member companies' financial ratings from the major independent rating organizations as of November 12, 2002. A.M. STANDARD BEST FITCH & POOR'S MOODY'S ----------------------------------------------------------------- INSURANCE RATINGS: Hartford Fire A+ AA AA Aa3 Hartford Life Insurance Company A+ AA AA Aa3 Hartford Life & Accident A+ AA AA Aa3 Hartford Life & Annuity A+ AA AA Aa3 ----------------------------------------------------------------- OTHER RATINGS: The Hartford Financial Services Group, Inc.: Senior debt a+ A A A2 Commercial paper AMB-1 F-1 A-1 P-1 Hartford Capital I quarterly income preferred securities a- A- BBB+ A3 Hartford Capital III trust originated preferred securities a- A- BBB+ A3 Hartford Life, Inc.: Senior debt a+ A A A2 Commercial paper -- F-1 A-1 P-1 Hartford Life, Inc.: Capital I and II trust preferred securities a- A- BBB+ A3 ================================================================= The agencies consider many factors in determining the final rating of an insurance company. One consideration is the relative level of statutory surplus necessary to support the business written. Statutory surplus represents the capital of the insurance company reported in accordance with accounting practices prescribed by the applicable state insurance department. The table below sets forth statutory surplus for the Company's insurance companies. SEPT. 30, DEC. 31, 2002 2001 ------------------------------------------------------------------ Life Operations $ 2,667 $ 2,991 Property & Casualty Operations 3,615 3,178 ------------------------------------------------------------------ TOTAL $ 6,282 $ 6,169 ================================================================== The decrease in life operations' surplus is primarily due to the decline in the equity markets and the difficult investment credit cycle. The increase in the property and casualty operations' surplus is primarily due to the $300 capital contribution from its parent and statutory net income. On October 16, 2002, Standard & Poor's placed its ratings on The Hartford Financial Services Group, Inc. and related entities on credit watch with negative implications, reflecting concerns over the recent downturn in the equity markets and the increasingly competitive environment for spread-based and equity-linked retirement and savings products. In terms of possible outcomes, Standard & Poor's stated it does not expect any downgrade to exceed one notch. On September 19, 2002, Fitch Ratings lowered the ratings of the Hartford Life Group as part of a comprehensive industry review of all North American life insurance company ratings. For the Hartford Life Group, Fitch stated the rating action was driven primarily by Fitch's opinion that most of the very strong, publicly owned insurance organizations are more appropriately rated in the `AA' rating category. Fitch also changed its view on the variable annuity business and stated that it believes that the associated risks, mainly variable earnings, are greater than previously considered. Fitch's long-term fixed income ratings on The Hartford Financial Services Group, Inc. were also lowered, while the affiliated property and casualty insurer financial strength ratings were affirmed. The rating outlooks are stable. On September 4, 2002, Moody's revised its outlook on The Hartford's debt ratings to Stable from Negative citing The Hartford's commitment to maintaining its capital strength in the event of a significant unforeseen loss or adverse development that would weaken its capital position. EQUITY MARKETS For a discussion of equity markets impact to capital and liquidity, see the Capital Markets Risk Management section under "Market Risk". CONTINGENCIES Legal proceedings - The Hartford is involved in claims litigation arising in the ordinary course of business, both as a liability insurer defending third-party claims brought against insureds or as an insurer defending coverage claims brought against it. The Hartford accounts for such activity through the establishment of unpaid claim and claim adjustment expense reserves. Subject to the discussion of the litigation involving MacArthur in Part II, Item 1. Legal Proceedings and the uncertainties related to asbestos and environmental claims discussed in the MD&A under the caption "Other Operations," management expects that the ultimate liability, if any, with respect to such ordinary-course claims litigation, after consideration of provisions made for potential losses and costs of defense, will not be material to the consolidated financial condition, results of operations or cash flows of The Hartford. The Hartford is also involved in other kinds of legal actions, some of which assert claims for substantial amounts. These actions include, among others, putative state and federal class actions seeking certification of a state or national class. Such putative class actions have alleged, for example, underpayment of claims or improper underwriting practices in connection with various kinds of insurance policies, such as personal and commercial automobile, premises liability, and inland marine. The Hartford also is involved in individual actions in which punitive damages are sought, such as claims alleging bad faith in the handling of insurance claims. Management expects that the ultimate liability, if any, with respect to such lawsuits, after consideration of provisions made for potential losses and costs of defense, will not be material to the consolidated financial condition of The Hartford. Nonetheless, given the large or indeterminate amounts sought in certain of these actions, and the inherent unpredictability of litigation, it is possible that an adverse outcome in certain matters could, from time to time, have a material adverse effect on the Company's consolidated results of operations or cash flows in particular quarterly or annual periods. Dependence on Certain Third Party Relationships - The Company distributes its annuity, life and certain property and - 41 - casualty insurance products through a variety of distribution channels, including broker-dealers, banks, wholesalers, its own internal sales force and other third party organizations. The Company periodically negotiates provisions and renewals of these relationships, and there can be no assurance that such terms will remain acceptable to the Company or such third parties. An interruption in the Company's continuing relationship with certain of these third parties could materially affect the Company's ability to market its products. -------------------------------------------------------------------------------- ACCOUNTING STANDARDS -------------------------------------------------------------------------------- For a discussion of accounting standards, see Note 1 of Notes to Consolidated Financial Statements. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The information contained in the Capital Markets Risk Management section of Management's Discussion and Analysis of Financial Condition and Results of Operations is incorporated herein by reference. ITEM 4. CONTROLS AND PROCEDURES EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES The Company's principal executive officer and its principal financial officer, based on their evaluation of the Company's disclosure controls and procedures (as defined in Exchange Act Rule 13a-14(c)) as of a date within 90 days prior to the filing of this Quarterly Report on Form 10-Q, have concluded that the Company's disclosure controls and procedures are adequate and effective for the purposes set forth in the definition thereof in Exchange Act Rule 13a-14(c). CHANGES IN INTERNAL CONTROLS There were no significant changes in the Company's internal controls or in other factors that could significantly affect the Company's internal controls subsequent to the date of their evaluation. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The Hartford is involved in claims litigation arising in the ordinary course of business, both as a liability insurer defending third-party claims brought against insureds or as an insurer defending coverage claims brought against it. The Hartford accounts for such activity through the establishment of unpaid claim and claim adjustment expense reserves. Subject to the discussion of the litigation involving MacArthur Company and its subsidiary, Western MacArthur Company, both former regional distributors of asbestos products as discussed below and the uncertainties discussed in Note 5(b) of Notes to Consolidated Financial Statements under the caption "Asbestos and Environmental Claims," management expects that the ultimate liability, if any, with respect to such ordinary-course claims litigation, after consideration of provisions made for potential losses and costs of defense, will not be material to the consolidated financial condition, results of operations or cash flows of The Hartford. The Hartford is also involved in other kinds of legal actions, some of which assert claims for substantial amounts. These actions include, among others, putative state and federal class actions seeking certification of a state or national class. Such putative class actions have alleged, for example, underpayment of claims or improper underwriting practices in connection with various kinds of insurance policies, such as personal and commercial automobile, premises liability, and inland marine. The Hartford also is involved in individual actions in which punitive damages are sought, such as claims alleging bad faith in the handling of insurance claims. Management expects that the ultimate liability, if any, with respect to such lawsuits, after consideration of provisions made for potential losses and costs of defense, will not be material to the consolidated financial condition of The Hartford. Nonetheless, given the large or indeterminate amounts sought in certain of these actions, and the inherent unpredictability of litigation, it is possible that an adverse outcome in certain matters could, from time to time, have a material adverse effect on the Company's consolidated results of operations or cash flows in particular quarterly or annual periods. As further discussed in the MD&A under the caption "Other Operations," The Hartford continues to receive environmental and asbestos claims that involve significant uncertainty regarding policy coverage issues. Regarding these claims, The Hartford continually reviews its overall reserve levels, methodologies and reinsurance coverages. On October 7, 2002, an action was filed in the Superior Court in Alameda County, California, against Hartford Accident & Indemnity Company ("Hartford A&I"), a subsidiary of the Company, and two other insurers. The principal plaintiffs are MacArthur Company and its subsidiary, Western MacArthur Company, both former regional distributors of asbestos products (collectively or individually, "MacArthur"). MacArthur seeks a declaration of coverage and damages for asbestos bodily-injury claims. Five asbestos claimants who allegedly have obtained default judgments against MacArthur also are joined as plaintiffs; they seek to recover the amount of their default judgments and additional damages directly from the defendant insurers and assert a right to an accelerated trial. Hartford A&I issued primary general liability policies to MacArthur during the period 1967-76. MacArthur sought coverage for asbestos-related claims from Hartford A&I under these policies beginning in 1978. During the period 1978 to 1987, Hartford A&I paid out its full aggregate limits under these policies plus defense costs. In 1987, Hartford A&I notified MacArthur that its available limits under these policies had been exhausted, and MacArthur ceased submitting claims to Hartford A&I under these policies. - 42 - On June 3, 2002, The St. Paul Companies, Inc. ("St. Paul") announced a settlement of a coverage action brought by MacArthur against United States Fidelity and Guaranty Company ("USF&G"), a subsidiary of St. Paul. Under the settlement, St. Paul agreed to pay a total of $975 to resolve its asbestos liability to MacArthur in conjunction with a proposed bankruptcy petition and pre-packaged plan of reorganization that MacArthur is to file. USF&G provided at least 12 years of primary general liability coverage to MacArthur, but, unlike Hartford A&I, had denied coverage and had refused to pay for defense or indemnity. In its October 7, 2002 complaint, MacArthur alleges that it has approximately $1.8 billion of unpaid asbestos liability judgments against it to date. MacArthur seeks additional coverage from Hartford A&I on the theory that Hartford A&I has exhausted only its products aggregate limit of liability, not separate limits MacArthur alleges to be available for non-products liability. The ultimate amount of MacArthur's alleged non-products asbestos liability, including any unresolved current and future claims, is currently unknown. MacArthur indicates in its complaint that it will seek to have the full amount of its current and future asbestos liability estimated in its anticipated bankruptcy proceeding. If such an estimation is made, MacArthur intends to seek a judgment against the defendants for the amount of its total liability, including estimated claims, less the amount ultimately paid by St. Paul. Hartford A&I intends to defend the MacArthur action vigorously. Based on the information currently available, management believes that Hartford A&I's liability, if any, to MacArthur will not be finally resolved for at least a year and most probably not for several years. In the opinion of management, the ultimate outcome is highly uncertain for many reasons. It is not yet known, for example, in which venue Hartford A&I's liability, if any, will be determined; whether Hartford A&I's defenses based on MacArthur's long delay in asserting claims for further coverage will be successful; how other significant coverage defenses will be decided; or the extent to which the claims and default judgments against MacArthur involve injury outside of the products and completed operations hazard definitions of the policies. In the opinion of management, an adverse outcome could have a material adverse effect on the Company's results of operations, financial condition and liquidity. In addition, on May 14, 2002, The Hartford announced its participation, along with several dozen other insurance carriers, in a settlement in principle with its insured, PPG Industries ("PPG"), of litigation arising from asbestos exposures involving Pittsburgh Corning Corporation, which is 50% owned by PPG. (For further discussion, see Note 5(b) of Notes to Consolidated Financial Statements.) On March 15, 2002, a jury in the U.S. District Court for the Eastern District of Missouri issued a verdict in Bancorp Services, LLC ("Bancorp") v. Hartford Life Insurance Company ("HLIC"), et al. in favor of Bancorp in the amount of $118. The case involved claims of patent infringement, misappropriation of trade secrets, and breach of contract against HLIC and its affiliate International Corporate Marketing Group, Inc. ("ICMG"). The judge dismissed the patent infringement claim on summary judgment. The jury's award was based on the last two claims. On August 28, 2002, the Court entered an order awarding Bancorp prejudgment interest on the breach of contract claim in the amount of $16. HLIC and ICMG have moved the district court for, among other things, judgment as a matter of law or a new trial, and intend to appeal the judgment if the district court does not set it aside or substantially reduce it. In either event, the Company's management, based on the opinion of its legal advisers, believes that there is a substantial likelihood that the jury award will not survive at its current amount. Based on the advice of legal counsel regarding the potential outcome of this litigation, the Company recorded an $11 after-tax charge in the first quarter of 2002 to increase litigation reserves associated with this matter. Should HLIC and ICMG not succeed in eliminating or reducing the judgment, a significant additional expense would be recorded in the future related to this matter. The Hartford also is involved in arbitration with one of its primary reinsurers relating to variable annuity contracts with death benefit guarantees. The arbitration is discussed more fully in the MD&A under the caption "Capital Markets Risk Management - Market Risk". ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits - See Exhibit Index. (b) Reports on Form 8-K. During the quarterly period ended September 30, 2002, the Company filed the following current reports on Form 8-K: o Dated September 9, 2002, Item 7, Financial Statements, Pro Forma Financial Information and Exhibits, to incorporate by reference into the Registration Statement the Underwriting Agreement General Terms and Conditions, dated September 9, 2002, including the Pricing Agreement, dated September 9, 2002 by and among the Company, BOA, Morgan Stanley and Salomon Smith Barney, Inc. ("Salomon Smith Barney") for the issuance and sale of the Company's Common Stock; to incorporate by reference into the Registration Statement the Underwriting Agreement General Terms and Conditions, dated September 9, 2002, including the Pricing Agreement, dated September 9, 2002, by and among the Company, BOA, Morgan Stanley and Salomon Smith Barney for the issuance and sale of the Company's 6% Corporate Units; to incorporate by reference into the Registration Statement Supplemental Indenture No. 2, dated as of September 13, 2002, to the Senior Indenture, dated as of October 20, 1995, between ITT Hartford Group, Inc. and The Chase Manhattan Bank (National Association) as Trustee, between the Company and JPMorgan Chase Bank, as Trustee; to incorporate into the Registration Statement the Purchase Contract Agreement, dated as of September 13, 2002, between the Company and JPMorgan Chase Bank, as Purchase Contract Agent; to incorporate into the Registration Statement the Pledge Agreement, dated as of September 13, 2002, among the Company and JPMorgan Chase Bank, as Collateral Agent, Custodial Agent, Securities Intermediary and JPMorgan Chase Bank as Purchase Contract Agent; to incorporate by reference into the Registration Statement the Remarketing Agreement, dated as of September 13, 2002 by and between the Company, Morgan Stanley as Remarketing Agent and JPMorgan Chase Bank as Purchase Contract Agent; to incorporate by reference into the Registration Statement the opinion of Debevoise & Plimpton rendered in connection with the issuance and sale of the Company's Common Stock; and to incorporate by reference into the Registration - 43 - Statement the opinion of Debevoise & Plimpton rendered in connection with the issuance and sale of the Company's 6% Corporate Units. o Dated September 9, 2002, Item 5, Other Events, to report the filing of an action on September 3, 2002 by Wal-Mart Stores, Inc. ("Wal-Mart") against Hartford Life Insurance Company ("HLIC") and International Corporate Marketing Group, LLC ("ICMG"), each a subsidiary of the Company, in the Court of Chancery of the State of Delaware, New Castle County, asserting claims arising from Wal-Mart's purchase of corporate-owned life insurance from HLIC. o Dated September 6, 2002, Item 5, Other Events, to report a press release issued by the Company on September 6, 2002 relating to the transfer of its New Jersey auto insurance book sold through independent agents to state insurance carrier Palisades Safety and Insurance Association and Palisades Insurance Company. o Dated September 3, 2002, Item 7, Financial Statements, Pro Forma Financial Information and Exhibits, to incorporate by reference into the Registration Statement the Underwriting Agreement General Terms and Conditions, dated August 26, 2002, including the Pricing Agreement, dated August 26, 2002, by and among the Company, Bank of America Securities LLC ("BOA") and Morgan Stanley & Co. Incorporated ("Morgan Stanley"), for the issuance and sale of the Company's 4.7% Senior Notes due September 1, 2007; and to incorporate by reference into the Registration Statement the opinion of Katherine Vines Trumbull. o Dated August 27, 2002, Item 7, Financial Statements, Pro Forma Financial Information and Exhibits, to incorporate by reference into the Company's Registration Statement on Form S-3 (File No. 333-88762) filed with the Securities and Exchange Commission on May 21, 2001 (the "Registration Statement") the Computation of Ratio of Earnings to Fixed Charges. o Dated August 12, 2002, Item 7, Financial Statements, Pro Forma Financial Information and Exhibits, to file the certification of Ramani Ayer, Chairman, President and Chief Executive Officer of the Company with the Securities and Exchange Commission pursuant to the Securities and Exchange Commission's Order of June 27, 2002 requiring the filing of sworn statements, pursuant to Section 21(a)(1) of the Securities Exchange Act of 1934 (the "Order"); to file the certification of David M. Johnson, Executive Vice President and Chief Financial Officer of the Company with the Securities and Exchange Commission pursuant to the Order; to report the filing of the certification of Ramani Ayer, Chairman, President and Chief Executive Officer of the Company, which accompanied the Company's Form 10-Q for the quarterly period ended June 30, 2002, pursuant to 18 United States Code section 1350, as enacted by section 906 of the Sarbanes-Oxley Act of 2002; and to report the filing of the certification of David M. Johnson, Executive Vice President and Chief Financial Officer of the Company, which accompanied the Company's Form 10-Q for the quarterly period ended June 30, 2002, pursuant to 18 United States Code Section 1350, as enacted by Section 906 of the Sarbanes-Oxley Act of 2002. - 44 - SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. The Hartford Financial Services Group, Inc. (Registrant) /s/ Robert J. Price ------------------------------------------- Robert J. Price Senior Vice President and Controller November 13, 2002 - 45 - CERTIFICATIONS I, Ramani Ayer, certify that: 1. I have reviewed this quarterly report on Form 10-Q of The Hartford Financial Services Group, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: November 13, 2002 By : /s/ Ramani Ayer ----------------------------------- Ramani Ayer Chairman, President and Chief Executive Officer (Signature and Title) - 46 - I, David M. Johnson, certify that: 1. I have reviewed this quarterly report on Form 10-Q of The Hartford Financial Services Group, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: November 13, 2002 By : /s/ David M. Johnson ------------------------------ David M. Johnson Executive Vice President and Chief Financial Officer (Signature and Title) - 47 - THE HARTFORD FINANCIAL SERVICES GROUP, INC. FORM 10-Q EXHIBIT INDEX EXHIBIT # 4.1 Senior Indenture, dated as of October 20, 1995, between ITT Hartford Group, Inc. ("ITT Hartford") and The Chase Manhattan Bank (National Association) as Trustee (incorporated herein by reference to Exhibit 4.08 to ITT Hartford's Report on Form 8-K, dated November 15, 1995). 4.2 Supplemental Indenture No.1, dated as of December 27, 2000, to the Senior Indenture filed as Exhibit 4.1 hereto, between the Company and The Chase Manhattan Bank, as Trustee (incorporated herein by reference to Exhibit 4.30 to the Registration Statement on Form S-3 (Registration No. 333-49666) of the Company, Hartford Capital III, Hartford Capital IV and Hartford Capital V). 4.3 Supplemental Indenture No. 2, dated as of September 13, 2002, to the Senior Indenture filed as Exhibit 4.1 hereto, between the Company and JPMorgan Chase Bank, as Trustee (incorporated herein by reference to Exhibit 4.1 to the Form 8-K of the Company, filed September 17, 2002). 4.4 Form of Global Security (included in Exhibit 4.3). 4.5 Purchase Contract Agreement, dated as of September 13, 2002, between the Company and JPMorgan Chase Bank, as Purchase Contract Agent (incorporated herein by reference to Exhibit 4.2 to the Form 8-K of the Company, filed September 17, 2002). 4.6 Form of Corporate Unit Certificate (included in Exhibit 4.5). 4.7 Pledge Agreement, dated as of September 13, 2002, among the Company and JPMorgan Chase Bank, as Collateral Agent, Custodial Agent, Securities Intermediary and JPMorgan Chase Bank as Purchase Contract Agent (incorporated herein by reference to Exhibit 4.3 to the Form 8-K of the Company, filed September 17, 2002). 4.8 Remarketing Agreement, dated as of September 13, 2002, between the Company and Morgan Stanley & Co. Incorporated, as Remarketing Agent, and JPMorgan Chase Bank, as Purchase Contract Agent (incorporated herein by reference to Exhibit 4.4 to the Form 8-K of the Company, filed September 17, 2002). 4.9 Global Security representing $300,000,000 of the Company's 4.7% senior notes due September 1, 2007. 15.1 Accountants' Letter of Awareness - 48 -