Good morning, everyone. Welcome to The Hartford. I'm Sabra Purtill, Head of Investor Relations, and I'd like to be the first to welcome you here today. Before we start on the presentation, I just wanted to go through the agenda and a couple logistics. This morning's presentation will begin with Liam McGee, our Chairman, President, and CEO. He'll be followed by Beth Bombara, President of Talcott Resolution, which is the focus of today's presentation. Following Beth's prepared comments, we'll have Bob Rupp, our Chief Risk Officer, who will update you on our expanded Japan VA hedging program, which we announced this morning. We'll have a short break in between. For the purposes of people listening to the webcast, we expect to start the presentations again at approximately 10:10 or 10:15.
After the break, we'll start with Chris Swift, our CFO, who's going to update you on VA metrics and capital margins. Then we've allowed for about an hour of consolidated Q&A. For those of you with us here in Hartford, we offer luncheon after the presentation, which will be downstairs in the atrium there where you checked in this morning. I just wanted to note that obviously our presentations are covered by Regulation FD, and as you're aware, we're in a quiet period for earnings. I have to ask you to appreciate the fact that during the coffee break in the middle, management will be available, but they won't be able to answer any questions about sensitivities, projections, outlooks, and the rest because that would not be Reg FD compliant.
However, feel free to ask your questions during the webcast portion of the Q&A because that is Reg FD friendly. Finally, I'd like to note that our presentation today is covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. There are forward-looking statements in our presentations today. Those forward-looking statements are subject to risk factors which are available in our 10-K, and in addition, in our press releases and other materials filed with the SEC. I would note that our actual results could be materially different from these projections. Management does not undertake responsibilities to update these. With that, I'd now like to turn the presentation over to Liam.
Thank you, Sabra. Good morning, everyone. Good morning, everyone.
Good morning.
That's the kind of crowd I like. It's great to have all of you here and officially welcome to The Hartford's investor meeting. I do want to thank all of you who made the trip to Hartford, and particularly to our home office. I know for many of you, it's at least a two-hour train ride, car ride, and having done it myself many times, I want you to know I personally appreciate it. I also appreciate those of you who are joining us on the webcast. As you know, we issued a news release this morning with a number of important updates, which we will cover today.
I want to start with the key takeaway from today's meeting is that the risk profile of The Hartford's Life runoff businesses, which we refer to as Talcott Resolution, has dramatically improved due to actions we've taken and the benefit of recent global market improvements. With Talcott Resolution now self-sufficient from a capital perspective, The Hartford has transitioned to an operating structure in which the excess capital generated by the P&C, Group Benefits, and Mutual Funds businesses will be used for potential capital management actions and reinvestment in our go-forward businesses to drive profitable growth. Also importantly, today's news is fully aligned with the strategy we announced last March to create greater shareholder value.
As you recall, we said then that the sharper focus would lead to an organization that over time would generate higher returns on equity, have reduced sensitivity to capital markets, a lower cost of capital, and increased financial flexibility. To achieve those goals, we did the following. First, we focused the company on the property and casualty, Group Benefits, and Mutual Funds businesses. These businesses have competitive market positions, strong capital-generating ability, and lower aggregate market sensitivity. We're improving profitability in these go-forward businesses with sustained margin and pricing improvement and momentum in P&C Commercial and Consumer and Group Benefits. We believe that these businesses have the potential to generate future profitable growth. Second, we completed the sale of the Individual Life, Woodbury Financial Services, and Retirement Plans businesses.
As you know, the transactions generated a statutory capital benefit of $2.2 billion, and in the first quarter, we secured the necessary regulatory approval to upstream $1.5 billion to the holding company. Third, we stopped sales of new annuities and placed the annuity business into runoff in Talcott Resolution, which has the mandate to prudently and economically reduce the size and risk of legacy annuity blocks. The actions we're taking will improve the return on equity for The Hartford. We are targeting a 2013 core earnings ROE of 7.5%-8% for the enterprise, including Talcott. The 2013 core earnings ROE outlook for the go-forward businesses alone is stronger at 9.5%-10%. We're expecting the ROEs in the go-forward businesses in 2014 to grow to the range of 10%-10.5%. I think you'd agree these are competitive results in today's low interest rate environment.
The overall risk profile of The Hartford has improved significantly since 2009. It's improved that way as a result of the strategic actions we've taken, the healing global economy, and the company's greatly improved enterprise risk management capabilities. As examples, first, The Hartford's investment portfolio has a much improved risk profile. Distressed investments as a percentage of the portfolio have declined by 93%. Second, The Hartford's balance sheet is much less leveraged as measured by debt to total capitalization, which is down already five points over the past more than three years. Finally, risk from the variable annuity book is significantly reduced. This is one measure that you see here as indicated by the net amount at risk declining by 74% over the last three-plus years. Of course, this is where we'll spend most of our time with you today.
Our key takeaway today is that the risk profile of Talcott Resolution has dramatically improved. When today's meeting is concluded, I believe you will share our beliefs that first, The Hartford's VA risk has been dramatically reduced. The recently expanded Japan hedge program effectively eliminates FX and equity risk in the Japan VA block and takes advantage of the recovery of the economics over the past five months. Second, as a result of actions we've taken and market improvements, the U.S. and Japan VA blocks are getting smaller at an accelerating pace. Third, our life runoff business, Talcott Resolution, is now capital self-sufficient. Finally, The Hartford's capital margins and flexibility have improved significantly, enabling us to create increased shareholder value through capital management actions and reinvestment in the businesses for future profitable growth.
Again, on a personal level, on behalf of my teammates, thank you for being here. We greatly appreciate your interest in The Hartford. Now let me introduce Beth Bombara, who's President of Talcott Resolution. I'd say before Beth gets here, I and we are very pleased with the progress Beth and her team are making. Beth, welcome.
Thank you, Liam. Good morning. Today, I will be reviewing several key developments in our Talcott Resolution businesses. The themes you will hear throughout the discussion are, first, we are managing Talcott Resolution to reduce risk while maximizing shareholder value. We view all our activities through both an economic lens and a capital lens, balancing cost with risk reduction in order to ensure that we are driving shareholder value. Second, the terms of our VA guarantees are comparatively modest and their risk is manageable. As we will demonstrate, we have multiple tools at our disposal to mitigate these risks. Third, we have expanded our Japan VA hedging to effectively eliminate equity and FX risk. An important tool has been and will continue to be the active hedging of our VA blocks.
Recently, we have substantially increased our hedge positions for the Japan block that effectively eliminates both equity and FX market risk. Fourth, we are focused on in-force management initiatives to accelerate the runoff and reduce the risk of the VA book. We are currently working on a series of customer and distributor communications and product initiatives aimed at achieving this goal. I view this as an important part of our strategy for creating value and mitigating risk. I'll provide you an update on some of our recent efforts, including product changes made as part of our annual prospectus filing and updates on the U.S. variable annuity enhanced surrender value offer that we previously announced.
This morning, our agenda will cover an overview of the businesses within Talcott, an update on the financial profile of our Japan variable annuity block, including the significant developments in the Japan hedging program, and an update on the financial profile of our U.S. variable annuity block with a focus on in-force management initiatives and activities. The Talcott Resolution business has a total account value of $163 billion, with variable annuity making up about 58% of the total. While variable annuities comprise over half of the account value, they represent a greater percentage of our risk profile, given the nature of the embedded guarantees. The other 42% of account value is comprised of $38 billion in private placement life insurance, $16 billion of institutional business, and $14 billion in fixed annuities. We collectively refer to these businesses as the non-VA block.
We have a dedicated team in charge of managing the non-VA block, which is primarily exposed to more traditional interest rate, mortality, and longevity risk. We've provided a more detailed overview of these blocks in the appendix. For today, we are going to focus on our variable annuity business. The variable annuity block represents about $94 billion of account value, 69% in the U.S., 29% in Japan, and a small portion in the U.K. We have almost 1.3 million contracts in total. Due to the size and risks of the U.S. and Japan blocks, I will focus my discussion on these businesses. From 2007 to 2012, variable annuity contract counts have decreased by 30%, primarily driven by the U.S. business, which has experienced higher surrender rates.
If we just assumed the natural attrition rates we see in these blocks, we would expect to see a 50% decline in the number of VA contracts over the next five years due to surrenders, annuitizations, and mortality. You can think of this as the baseline. We believe that through in-force management initiatives and the impact of improving market conditions, this decline will accelerate in ways that make sense for both us and our customers. We are already seeing evidence of this acceleration through the successful launch of our U.S. enhanced surrender value offering and through increased surrender activity in Japan as markets there have improved. I will cover both of these topics in more detail. As we stated in the past, our objective is to reduce the size and risk of the VA block.
The levers we use include robust risk management and focus on hedge programs, in-force management initiatives such as product communications and customer offerings, and third-party transactions to the extent reasonable terms are available. I'd like to quickly touch upon how we approach transactional opportunities. First, we are mobilized to explore potential transactions. We continue to work with our advisors to engage the market for opportunities that are consistent with our goals. Transactions that we would consider would be evaluated by balancing the sales price and underlying economics with the capital that would be released. I want to be clear. We believe our risks are manageable, and we do not need to transact in order to effectively manage this business. However, we do view transactions as a powerful tool to accelerate the accomplishment of our goals.
We would seek transactions that offer a permanent reduction in risk and only those that can be executed at reasonable terms. I'll now walk you through a more detailed analysis of the Japan and U.S. variable annuity blocks and the actions that we have already taken that align with our objectives. Let's start with Japan. Our Japan VA account value is about $27 billion and is comprised of approximately $2 billion of death benefit only business, $22 billion of business with both a death benefit and a guaranteed minimum income benefit. The balance of the block has age-based income benefits. It's important to note a contract holder can use one guarantee or the other, not both, meaning you either receive the death benefit or you elect the income benefit.
The Japan block is predominantly comprised of simple return of premium type benefits, as opposed to some of the more aggressive guarantees that were offered in the Japanese market. All of our GMIB, or guaranteed minimum income benefit guarantees, are return of initial premium. If the income benefit is elected, the contract holder is guaranteed to receive their original premium back over a 10 year or 15 year payout period. Investment income earned during this time accrues to the benefit of the company and can be used to pay the income benefit claims. 82% of the death benefits on this block are also return of premium guarantees. A small percentage has step ups, meaning that the death benefit can be higher than the original premium. The assets underlying the variable accounts are allocated approximately 60% to fixed income funds and 40% to equity funds.
There is also a currency dynamic with about 50% of the assets being invested in non-JPY denominated assets while the underlying liabilities are all JPY denominated. With the recent improvements in currency and equity markets, we have seen a dramatic improvement in the underlying economics of this block. Since September 2012, JPY-USD has improved 21%, and Japan equities have improved over 40%. These market dynamics have resulted in a significant decline in retained net amount at risk, or NAR, which measures the difference between the guarantee amount and the account value for all contracts within the money guarantees. As of March, the retained net amount at risk for guaranteed income benefits declined to $1.3 billion as compared to $6.1 billion at September 30, 2012. We have also seen a corresponding improvement in the moneyness of the guarantees.
In September, 98% of the GMIB block was in the money an average of 19%, meaning account values were approximately 19% less than the guaranteed value. By March, as a result of the favorable market conditions, one-third of the block has moved out of the money, meaning the account value now exceeds the guaranteed value. For the portion of the block that remains in the money, the contracts are now, on average, only 7% in the money. With this improvement in economics, we have seen a significant increase in surrender rates. Our annualized surrender rates for 2012 were in the 3%-4% range. In February, the annualized surrender rate increased to 11%, and in March, it increased to 14%, resulting in a 10% rate for the quarter. We believe this activity is directly correlated to two factors. The first factor is improving market conditions.
Over 50% of the first quarter surrenders have come from accounts that were out of the money. The second factor is the aging of the block. As of March, 68% of the block is outside the surrender charge period, and that will increase to 80% by year end. While we expect surrenders to be higher than historical norms due to the improved market conditions, at this point, it is difficult for us to predict how much of this activity will be sustained because the last time our NARs were at these levels, all of the block was within the surrender charge period. Because this increase in surrender rates is a recent change in behavior, we have not incorporated it into our models. If we ultimately conclude that the increased surrenders reflect a sustained change, then our models would be updated accordingly.
While we would not expect an increased surrender assumption to result in a sizable release of reserves or required capital immediately, over time, an increase in actual surrenders will result in a reduction in required risk capital. Let me now share with you the recent developments in our Japan hedge program. As I said earlier, we utilize three key levers to reduce the size and risk of the VA block, and hedging has been one of the levers we've utilized the most. In order to take advantage of improved market conditions, we have significantly modified our Japan hedge and are now fully hedging our exposures to equities and FX, effectively eliminating FX and equity risk. Our revised hedging strategy, coupled with the current moneyness levels, substantially improves our Japan VA risk profile.
Through the effective elimination of open risk positions related to equity and FX markets, we are preserving the economics we see today. Talcott in total is now capital self-sufficient. Bob Rupp, our Chief Risk Officer, will provide an update on our overall hedging strategy, including more detail on this modification to our Japan program. I would like to provide you background on why we chose to supplement the hedge now and some of the positive results we see as a consequence of this change. Although we continue to focus on managing the economics of our Japan block, we will see beneficial impacts on the volatility of our statutory surplus profile as a result of the incremental hedge. This exhibit shows the cumulative 2013 and 2014 pre-tax impact to statutory surplus attributed to our Japan variable annuity business before and after the modification to our hedge program.
Results are shown for two economic scenarios, a base and a stress. A summary of the key assumptions underlying each of these scenarios can be found in the appendix. As you can see, the additional hedging provides significant protection in a stress scenario with a cumulative two-year improvement of roughly $1.8 billion pre-tax. The statutory impacts post-hedge are significantly less volatile across the scenarios. We have essentially traded the potential statutory surplus upside for improved protection in the stress scenario. Why change the hedge program now, and what does this do for us? First, the value of the underlying economics of the Japan block has limited upside. As markets improve, customer account values will exceed guaranteed amounts and decrease the marginal economic value we derive from further market improvements. In fact, much of the improvement that can take place has taken place.
In addition, the downside risk without any hedge protection is significant, as shown here. Increasing the hedge now to more completely preserve today's economics will greatly reduce the sensitivity of the block to market movements. To fund a supplemental hedge, future earnings will be impacted by additional hedge costs, thus eliminating expected future gross profits. This reduction in future gross profits results in a complete write-off of our Japan DAC balance. Chris Swift will discuss this further later this morning. In addition, based on current market conditions, we expect the existing Japan account values, plus a conservative estimate of future net investment income, would be sufficient to fund our income benefit obligations without using existing reserves or surplus.
As of March, our account value for guaranteed minimum income benefit contracts that were in the money was roughly $15 billion versus a guaranteed value of approximately $16 billion, or 93% of the guaranteed amount. Again, for these products, the account value is moved to the company's general account upon a contract holder's election to annuitize. Investment earnings of the general account accrue to the benefit of the company and can be used to fund contract holder guarantees. Our best estimate is that we would need to earn roughly 100 basis points of net investment earnings over the 10-15 year payout period in order to fund the income guarantee. Based on our expected investment strategy and interest rate hedges already in place, our current projections indicate we would be able to exceed this return requirement.
We believe that increasing our hedging for equity and FX now more completely ensures that we preserve this funding dynamic for our GMIB contracts and decreases the likelihood that we would need additional resources to fund these liabilities if markets were to decline. This revised hedging strategy makes it much more likely that current reserves and capital supporting this business will be released over time. What will drive this reserve and capital release, and what is our expected timing? Simply put, we will reduce required risk capital as contracts annuitize or surrender. As contract holders reach their annuitization commencement date, they have two options. One, they can do nothing and maintain their existing contract, or two, they can annuitize as described earlier. In addition, at any time, they have the option to surrender their contract and receive their current account value, which would reduce required risk capital.
The percentage of customers that elect annuitization will ultimately be driven by how far contracts are in or out of the money. Over the next 3 years, 50% of the Japan account value becomes eligible for annuitization. Our best estimate assumptions for contracts that are 0-10% in the money is that in their first year of eligibility, we would see a 50%-60% annuitization rate and then a 20% annuitization rate each year thereafter. In the Japan book, moneyness levels vary. The larger, more immediate cohorts of eligibility range from 3% out of the money to 11% in the money and are therefore expected to be in the 50%-60% range for first-year annuitizations. As contract values increase above guaranteed amounts, annuitizations are expected to decrease, but we would expect contract surrenders to increase.
Based on today's account values, we would expect that over the next 3 years, a significant number of contracts will elect annuitization, which will reduce the required risk capital associated with those GMIB contracts. Funding for contracts that have guaranteed minimum death benefits will come from existing reserves. To conclude on Japan, we have taken significant action to effectively hedge our FX and equity risks. As a result, we now believe Talcott in total is capital self-sufficient. Let's turn to the USVA book. In general, while we appreciate that all variable annuity blocks contain a level of complexity, our block has relatively modest guarantees and substantial reinsurance. With regard to our variable annuity death benefits, 72% is covered by external reinsurance, substantially reducing our retained exposure.
As of March, our GMDB NAR was $5.4 billion on a gross basis, which is reduced to $1.5 billion on a retained basis. This reinsurance coverage is substantial and targeted at the richest guarantees on the block, our full and capped step ups and reset guarantees. While we do have a large element of the block that has various type of step-up guarantees, generally variations on maximum anniversary style benefits, they are largely reinsured. In addition, the retained exposure is subject to our existing macro hedge program. Turning to living benefits. Our risk philosophy for these guarantees is to seek protection from third party and capital market reinsurance coverage and to maintain a robust hedging program for retained risk. It is important to note that of the $65 billion in USVA account value, $31 billion or 48% does not have a living benefit guarantee.
Of the $34 billion that does carry a living benefit, $21 billion carries a non-lifetime GMWB benefit. 66% of these non-lifetime riders are covered by reinsurance, and the balance is covered by our dynamic hedging program. The rest of the account value carries a lifetime income benefit and is not reinsured, but is subject to our ongoing hedge programs, consistent with other retained rider exposures. While these living benefits carry some level of risk, we didn't pursue some of the richer benefits offered in the annuity marketplace, like high deferral bonuses and uncapped step-ups. We believe our block is rather modest in the types of benefits we've offered. We have significant reinsurance protection and the remaining risks continue to be well hedged. Let's discuss where these guarantees stand given current market conditions. Retained NAR has significantly declined since September 2011.
As of March, the retained net amount at risk for our GMWB block declined to $300 million from $2.5 billion in the third quarter of 2011. Retained net amount at risk is undiscounted and does not reflect future surrenders or the benefits of hedging, but it does exclude contracts that are reinsured. The moneyness on the block has significantly improved. As of March, almost 90% of living benefit contracts are out of the money, and contracts in the money are now, on average, only 9% in the money. 2012 surrender rate activity for the U.S. block remained at fairly high levels with a total surrender rate that ranged from 15%-17% during the year. This experience has closely tracked with the estimates that underlie reserves and capital.
In the first quarter, we've seen an increase to an annualized surrender rate of 23% on contracts with living benefits, which primarily is due to the introduction of our ESV offering, as I will discuss further. Excluding ESV, the first quarter annualized surrender rate was at about 17%. Like our Japan VA block, much of our U.S. VA block has moved beyond its surrender charge period, which we anticipate should increase surrender rates. As of March, 65% of GMWB contracts were beyond the surrender charge period, and we expect that percentage to grow to about 73% by year-end. Back to one of our major themes. We feel the risks of our variable annuity blocks are manageable. We've shown the composition of our U.S. VA blocks and policyholder experience and the relative moneyness of our guarantees, all of which support this assertion.
Our objective is to further reduce the size and risk on this block. I will now discuss how we are using in-force management initiatives to target our more significant risks in U.S. variable annuities. We view in-force management initiatives in two categories: active communication with contract holders and their advisors, and product-based initiatives. Our communication plans are focused on providing transparency to contract holders so that they can work with their advisors to determine whether their existing contracts are consistent with their current needs. Product-based initiatives have been targeted to accelerate the runoff of our blocks, limit the risk of our liabilities, or to do both. We look to balance the cost of these initiatives with the resulting reduction in required capital. Every year, annuity prospectuses are reviewed and filed with the SEC. Our next filing, which will be effective in May, includes several changes.
We will be increasing certain rider fees, some to the contractual maximum, helping us to manage the cost of providing customers these benefits. We will also begin to restrict asset allocations where contracts allow us to do so, thus reducing the amount of equity exposure we have in these products. In addition to reducing the risk in the business, we have also sought to reduce the size of the book. We launched our Enhanced Surrender Value, our ESV offer in January. It has proven to be an attractive additional option for some customers. ESV was targeted to the block of business that had the most in-the-money guarantees, our Live 2 lifetime income block. At the time we started this offering, this rider accounted for about $5 billion in account value, or roughly 8% of our total US VA account value.
More importantly, it also represented 52% of the retained GMWB NAR at the time of launch. We view ESV as a way to effectively reduce a meaningful contributor to our US VA risk profile. How does this option work? Prior to the introduction of ESV, Live 2 contract holders who chose to surrender their contract would receive their account values less the applicable surrender charge and fees. With ESV, customers will first have any surrender charges and fees waived. In addition, they are titled to the greater of their current account value or their current account value plus 20% of their payment base, subject to an overall cap of 90% of the payment base. In our illustrative example, let's assume we have a contract with an account value of $60,000 and with a payment base of $100,000.
Before ESV, they would have received $58,000 upon surrender, their account value less the applicable surrender charge. As a result of ESV, the customer would now receive $80,000, the full $60,000 account value, plus 20% of the $100,000 payment base. This total falls below the maximum cap, which again is 90% of the payment base or $90,000, the cap would not be applicable. Where are we in the launch? Our experience to date has been trending more favorably than I expected. As I have mentioned previously, we were hopeful that our historical 5% surrender rate on this block would increase to 10%-15%. Offers are being made to contract holders in phases based on state regulatory approval. For the first phase, sent to customers in February, we have had an acceptance rate of 22%.
The second round of offers, sent to customers in early March, is experiencing an acceptance rate of 12%. As I shared earlier in this presentation, this activity has increased our annualized first quarter surrender rate to 23%. We do not expect surrender rates to remain at this level as we expect acceptance rate for the offering to taper off over time. We are very pleased with these results given how new the program is and how beneficial it is to our risk profile. To date, we have spent approximately $45 million on this program and expect a reduction in required capital of about twice that amount. We believe that our in-force management initiatives will continue to be an important tool in helping eliminate excessive risks in the VA block. In conclusion, I would like to reiterate our major themes.
We are managing Talcott Resolution to reduce risk while maximizing shareholder value. The terms of our VA guarantees are comparatively modest, and their risk is manageable. We have multiple tools at our disposal to mitigate this collective set of risks over time. We have expanded our Japan VA hedging to effectively eliminate equity and FX risk. Finally, we are focused on in-force management initiatives to accelerate the runoff and reduce the risk of our VA book. Thank you for your time, and I look forward to answering your questions later in today's Q&A session. I would like to now introduce Bob Rupp, our Chief Risk Officer.
Thank you, Beth. Good morning, everyone. It is good to be here with you to talk about the substantial progress we have made with our variable annuity hedging programs. The result is a significant reduction in the risk profile of our firm. I will start with an overview to our approach to hedging. Then I will review each of the three programs, the U.S. GMWB program, the U.S. macro program, and the Japan hedge program. The key takeaways are, first, our hedging programs have performed effectively against selected targets. Second, during the past year, equity and foreign exchange markets have improved significantly. Third, this improvement has allowed us to expand the scope of the programs and increase their efficiency. Lastly, it is important to note that there are certain residual exposures which cannot be perfectly hedged. For those, we take a strategic approach, which I will discuss in a moment.
Let us start with a quick overview of our global VA hedge programs. These programs cover all of our policies, including the U.S., Japan, and the U.K. In the U.S., we utilize an active dynamic hedge program for the VA liabilities and a less active macro program for the remaining U.S. risk. Turning to our Japan block, during 2011, we instituted a dynamic tail hedge approach for these liabilities, which I will also discuss in a few minutes. Regardless of the type of program, our focus is on minimizing the sensitivities of the economics of the block using a market-consistent valuation, which Chris will review during his presentation. Now, let us turn to the nature of our risks and how we manage them. Beth outlined the profile of separate account assets that underlie our annuity liabilities. Those assets are allocated to both equity and fixed income products.
Our basic risk is that these investments perform poorly, thus creating a gap between their value and the total amount of payments we will make over time to policyholders. As a result, our hedging programs are specifically designed to target these equity and interest rate risks. With regard to our Japan liabilities, the payments we make to policyholders over time will be delivered in yen, not dollars. About half of the assets underlying these liabilities are in yen-denominated instruments. So for that segment of our block, we have no foreign exchange risk. However, the remaining assets are primarily invested in dollar and euro-denominated instruments. As a result, we have a certain amount of currency exposure, which is also targeted by our hedging programs. In our previous disclosures, we have described our hedging programs as capturing first-order Greeks. These three risks, equity, rates, and foreign exchange, are those primary Greek exposures.
As I mentioned earlier, there are certain residual risks that exist with any variable annuity product. They include policyholder behavior, volatility, basis risk, and cross-Greeks. We take a two-pronged approach to managing these residual risks, which include, first, opportunistically transferring risk to third parties. Second, strategically managing the remainder. We have in place fairly large amounts of reinsurance across different parts of our VA business. In addition, we've entered into a few large structured derivative contracts whose basic design is to replicate the economic effect of reinsurance. One major benefit of both kinds of transactions is that they transfer residual risks to our counterparties. For the portion of residual risks we retain, we actively monitor each risk and take a strategic approach to management. This means we constantly assess the cost versus benefit of actively hedging those risks.
Our aim is to strike a balance between costly overtrading, at the same time, maintaining an adequate amount of risk protection. Now let's walk through each of the main hedging programs. We'll start with the U.S. GMWB program. A little more than half of our U.S. variable annuities include withdrawal benefits. Our U.S. GMWB program has been in place since 2003, and it targets the GAAP liability, which closely aligns to economics. This is a dynamic program that matches hedge assets against target liabilities. With a fully hedged dynamic program, our goal is to target the movement of the liability, whether up or down with a corresponding movement in the hedge. As a result, we're basically indifferent to directional movements in markets. In this instance, the results speak for themselves.
The chart reflects the quarterly change in the absolute value of the hedge asset and the related target of the liabilities. You can see that the aggregate movements in our target have been closely matched by offsetting movements in our hedges. Importantly, this correlation has worked in both improving and declining markets. Next, let's turn to our second hedge program, which we refer to as the macro program, the U.S. macro program. We began this program in 2009. It's an options-based strategy intended to protect against severe movements in equity markets and thereby prevent a material reduction in statutory surplus during stress events. Since equity markets generally improved during 2012, I haven't included a performance chart for this program. However, we continually monitor the expected payoff of these hedges to assure that they provide very substantial benefits in adverse market scenarios.
That said, there were some meaningful changes made to the program towards the end of last year. During 2012, not only did equity markets improve, but volatility also declined. The combined impact of these developments was a significant reduction in market prices for equity put options. As our existing macro program options matured, we were able to replace them with less expensive options. As a result, we expect to achieve an annual cost savings of approximately $100 million. This brings the cost down to an annual cash spend of approximately $100 million. In addition, the profile of our hedges were previously somewhat shorter in duration when compared to the related liabilities. The beneficial movements in option prices also allowed us to extend the duration of our hedges to better match them with longer-dated liabilities.
Importantly, both the cost reduction and the duration extension were accomplished while maintaining a similar amount of loss protection in an adverse market scenario. Our third hedging program covers the Japan VA block. We began the Japan tail hedge program in 2011 with the goal of managing our economic risks, including global equities, interest rates, and foreign exchange. At our October 2011 Investor Day, we described it as a tail approach. The Japan program was designed to be actively traded but didn't target full hedge coverage of the related liabilities. Let me take a moment to explain what I mean by hedge coverage. Depending on the market environment, the program requires a portion of each Greek to be hedged and allows a portion to remain as open risk.
For example, in a reasonably positive environment, the program might call for 40% of the equity exposure to be hedged and allow 60% to remain open. If equity markets declined, these percentages would shift, for example, to 60% hedged and 40% open. The basic design provided protection against further deterioration in markets while allowing ourselves the benefit of upside in the event of improving markets. As Beth mentioned, we benefited from significant improvement in both equity and foreign exchange markets. As a result, we've determined that it's prudent at this point to increase our hedge coverage. We've transitioned our coverage of equity and FX risk away from a tail approach to a full dynamic hedge program. This revised hedging strategy helps assure that Talcott, in total, is capital self-sufficient.
In order to understand the increased de-risking of this block, let's dive into the mechanics of the tail approach to hedging and how we've supplemented it. The mechanics of this program respond directly to market moves. To understand this, let's look first at the economic value of the VA liability. As shown here, the magnitude of our risk changes as markets move. Think of this as a depiction of our policyholders' moneyness. Moving from right to left, in declining markets, policyholders become further in the money, and as a result, our risk increases. In contrast, moving from left to right, as markets improve, their moneyness declines and our risk is reduced ultimately to zero. Let's look at the hedges. The fundamental design of our tail program is to allow our risk profile to respond to changing market environments.
Notice that neither the movement of the gross liability nor the movement of the hedge coverage target are straight lines. In declining markets, the liability grows at an increasing pace, and by design, our hedge coverage target increases rapidly. In improving markets, we allow ourselves to take more risk, but at a relatively controlled and deliberate pace. Let's review the results of the Japan tail program. During the past five quarters, we've experienced both positive and negative market movements. The positive movements include stronger equity and weaker yen. The negative market movement was the decrease in Japanese interest rates. Even with this blend of positive and negative movements, the tail hedge program performed as expected. You can see the change in value of the hedge assets has closely matched the change in value of the liabilities. Let's discuss recent revisions to our tail program.
First, equity markets have improved significantly. Since January 2012, the S&P 500 index is up about 25%, and the Japan TOPIX index is up about 42%. As a result, we've decided to take action to preserve the economic benefit of these favorable market developments. To accomplish this goal, we've transitioned from a tail approach to a full dynamic hedge of the equity exposure in the Japan block. To effectuate this transition, we've added derivative instruments. About two-thirds of our equity hedges are in equity swaps and futures. The remaining one-third are in option form. In addition, each day, we dynamically adjust our hedge instruments such that our net economic exposure to equity is effectively eliminated. Now, let's look at foreign exchange. Over the past 15 months, the yen has weakened both against the dollar by 23% and against the euro by 21%.
Again, we've decided to take action to preserve the economic benefits of this favorable market development by moving from a tail hedge approach to a full dynamic hedging of foreign exchange risk. In this case, we've also added derivative instruments both in the form of forwards and options. Approximately 60% of our total FX derivatives are now in option form, with the remaining 40% in forwards. Just as I explained on equity, each day we dynamically adjust our hedge instruments such that our net economic exposure to foreign exchange risk is effectively eliminated. Currently, interest rates in Japan are hovering at or near historic lows. Additional hedging at this point would provide a minimal amount of added value. As a result, we've chosen to retain the tail approach to interest rate hedging. The tail program has worked very well.
We've experienced a significant improvement in the economics of our Japan VA liability as a result of these market moves. That said, our intent was to benefit from positive market moves and, at the appropriate point, further reduce our risk profile. With regard to equity and foreign exchange risk, we believe that point has been reached. As a result, we've taken the opportunity to preserve these economic gains and reduce our open positions by adding coverage to fully hedge these Greeks. For interest rates, we continue to retain a tail approach, allowing for upside in the event that interest rates rise. Of course, the residual risks, which I mentioned at the outset, will continue to be present, and we will continue to manage those risks as described earlier. In summary, our hedging programs are well-designed and have performed effectively against our selected targets.
Markets have improved, we've taken action by first effectively eliminating all of our equity and foreign exchange risk in Japan. Second, reducing the cost of the U.S. macro program by approximately $100 million per year. Third, extending duration of our macro coverage to better match our long-dated liabilities. We also continue to strategically manage residual risks and look for additional opportunities to further minimize costs and further reduce our risk profile. With that, our schedule includes a break right now, after which Chris will address the group. Thank you.
Thank you, Bob. For those on the webcast, we're going to take about 20 minutes of a break. We'll be back together in the room at about 10:20. Thank you.
Thank you.
If we can all take our seats again to begin the second part of the presentation. Give another few minutes for people to get back from the coffee. We're going to start. Thank you, everyone. Hope you enjoyed the coffee break. The people on the webcast, I hope you got a chance to get a cup, too. Now I'll turn the presentation over to Chris Swift, our CFO.
Thank you, Sabra. Welcome back from coffee break, everyone. It's great to see everyone here in The Hartford. Bob and Beth covered a lot of material this morning. I know you appreciate the significant progress both have made in reducing the size and risk of Talcott. My presentation will cover three areas today. First, I'll update you on our first quarter activities and full year outlook. Second, I will cover some new data and metrics for variable annuities, including market consistent value, or MCV, and cash flow projections. Finally, I'll provide an update on our capital margins under various scenarios. There are four key takeaways from my presentation today. First, MCV is a better metric of the economic value for VA liabilities compared to either GAAP or statutory. It's the basis of our VA hedging activities.
You will also see there is significant intrinsic value in our VA block of business. Second, our capital margins are strong, and as we have previously mentioned, Talcott is self-sufficient from a capital perspective in aggregate. Third, I want to update you on our capital management goals, which focus on returning excess capital to shareholders, reducing debt leverage, and improving earnings coverage ratios. Finally, today's presentation will show we are on the right path to creating shareholder value. We are optimistic about our capital generation abilities heading into 2014 and beyond. There's a lot to cover, so let me get started. During the first quarter, we completed several capital actions. After closing on individual life and retirement plans transactions, the life companies paid a $1.5 billion dividend to the holding company.
We used about $1 billion of these proceeds for the $800 million debt tender, which reduced debt outstanding to $6.3 billion. As a result of the debt tender, our pro forma annual interest expense declines by $51 million. In addition, on April 1st, the 575 mandatory convertible preferred stock converted into common, which increased shares outstanding by 21 million. Our previous diluted share calculations included this impact. The conversion reduces holding company dividend expense by 33 million, as we replaced 42 million of annual dividends on the preferred shares with nine million of annual dividends on common. In addition, pro forma 2012 earnings to fixed charges improved from four times to 4.8 times, approaching our long-term goal of five to six times. Finally, we began our $500 million share repurchase program by buying 2.1 million shares and 200,000 warrants at a total cost of $58 million.
Going forward, we expect to repurchase about $100 million a quarter. We are adjusting our 2013 core earnings outlook upward by $75 million to $1.45 billion-$1.55 billion. This change reflects the elimination of the Japan VA DAC amortization expenses following the first quarter write-off, as Beth previously discussed. We expect first quarter net income to include charges of approximately $600 million for the Japan DAC and $140 million charge for the debt tender costs. First quarter catastrophes were $22 million after tax, $35 million favorable to the previous outlook. We will report first quarter results on April 29th with a call on April 30th, and we look forward to updating you on our complete financial results. Now let's turn to Talcott. As I indicated earlier, our VA block has significant intrinsic value as the MCVs and cash flows will demonstrate.
I'm going to start with MCV, which we believe is a better metric of economic value for VA liabilities. MCV reflects the present value of expected cash flows based on market consistent assumptions. This methodology is similar to fair value under GAAP, but is applied to all our VA guarantees, including guaranteed benefit riders and base contract fees. MCV is calculated by averaging the present value of expected cash flows of more than five different stochastic scenarios using current observed market inputs. These projections do not include investment income on capital, risk premiums for the cost of capital or hedging gains and losses. We believe MCV is important for several reasons. First, we think of it as a better measure of economic value compared to either GAAP or statutory accounting. Second, as Bob told you, our hedging programs are based on economics or MCV.
As of March 31st, the estimated liability of the combined U.S. and Japan VA block is about $500 million. The U.S. block is an asset of $700 million. This means that the average net present value of the fees on the U.S. block exceed claims and expenses by $700 million. On the other hand, the Japan MCV is a net liability of $1.2 billion. This has improved with the rise in global equity markets and the weakening of the yen. As Bob and Beth have discussed, we have expanded our hedging program to effectively eliminate FX and equity risk in Japan. In other words, going forward, changes in MCV for FX and equity, those moves should be effectively offset by moves in our hedge assets. We find MCV to be a very useful metric, which is why we wanted to share it with you today.
One way to use MCV is to compare it to current GAAP and statutory reserves and the resulting impact on equity or surplus. If you were to convert the GAAP reserves net of DAC to an MCV basis, that would imply GAAP equity would be reduced by $900 million before tax. In contrast, if you were to convert statutory reserves to an MCV basis, that would imply statutory surplus would increase by $1.7 billion before tax. What this means is, our statutory reserves exceed the MCV liability by $1.7 billion. To summarize, our statutory reserves meaningfully exceed market consistent value of the block. We consider MCV an important data point in assessing its intrinsic value, how we hedge it, and the evaluation of potential transactions. In addition to MCV, today we are providing cash flow projections on the U.S. and Japan blocks under three different economic scenarios.
These are the same scenarios we use for our capital margin projections. Let me describe the market parameters used in our three deterministic scenarios. Focusing on the stress scenario, you can see we assume significant declines in global equity markets as indicated by the S&P index declining to 900. We also assume significant strengthening of the yen to 70 and declining interest rates. We feel this is an appropriate framework to assess our capital resources. In addition to the MCV framework, I'd like now to share with you how actual cash flows actually emerge. This cash flow analysis builds on a similar methodology to MCV with a couple of clear points. First, we just laid out the three scenarios that we will use. Second, cash flows include modeled hedged gains and losses, including the impact of the expanded hedging program.
In the base scenario, cash flows are positive on the U.S. block, but negative for Japan. Total net cash flows before hedging are positive $5.1 billion. However, because of the favorable market bias in this base scenario, we project hedge losses at $3.6 billion over the life of the block for a positive cumulative VA present value of cash flows of $1.5 billion before tax. In this scenario, the Japan block has a negative $500 million PV of cash flows as the hedging losses of $2 billion exceed the $1.5 billion of policyholder cash flows. These losses do not suggest we are over-hedged. Rather, they reflect the cost of hedging, primarily the option time value decay in this scenario. Turning to slide 14, you can see the cash flow details for the favorable and stress scenarios.
In both these scenarios, the U.S. and Japan blocks are either cash flow positive or break even. In the favorable scenario, the present value of the cash flows, including hedge losses, totals a positive $2.3 billion. Importantly, in the stress scenario, the present value of cash flows with the benefit of hedge gains is still positive, totaling $600 million. In summary, MCV is the better value metric for VA liabilities, and it is the basis of our hedging activities. Both MCV and cash flows demonstrate that there is intrinsic value in our VA block. Hope you find this additional perspective useful as you evaluate risk and the economics of our VA block. Now let's turn to our capital margins. Before discussing margins, let's review our capital management goals. Our principles start with maintaining capital to support the go-forward businesses and their current ratings, as well as investing for profitable growth.
With respect to Talcott, we expect it to remain capital self-sufficient. Holding company resources are used principally to pay interest and dividends and for equity repurchase or debt repayment. Our short-term capital management goal is to continue to execute on the plan we announced in February. We have approximately $450 million remaining under our share repurchase plan. We also plan to repay the $520 million of scheduled debt maturities in 2013 and 2014 and do not expect to tender for additional debt over this time period. Beyond the short-term objective, we are focused on returning excess capital to shareholders and over time, reducing our leverage ratio to the low twenties and improving our ratio of earnings to fixed charges to a range of five to six times. This is the framework within which we will develop our future capital management initiatives.
Before covering the numbers, let me review how we define capital margin, which has not changed. Capital margin is the amount of capital above the 325% RBC in our primary U.S. life companies, 125% RBC in White River Re, and AA capital levels in our P&C operations. We begin 2013 with a capital margin of $4.9 billion. This includes the capital benefit from the business sales as well as the capital for the announced plan in February. Adjusting for the dividends paid in the first quarter, life company risk-based capital remains strong, in excess of 400% for The Hartford Life and Accident Group and 150% at White River Re. P&C capital margins also remain strong. Let's review the legal entity structure along with statutory capital allocations. It's important to note we manage Talcott in the aggregate as we have capital allocated among multiple legal entities and product lines.
HLIKK, our Japan operation, and White River Re are part of the Talcott organization, but are owned by holding companies outside the life company legal entity chain. This is in the context within which we think about capital, its adequacy, and where it's located. At year-end 2012, about 60% of our statutory capital is allocated to support the go-forward businesses or $7.7 billion for P&C and $1.5 billion for Group Benefits. Group Benefits is currently written in two legal entities, and our goal is to have one legal entity supporting this business going forward. Talcott's statutory capital allocation totals $6.2 billion. VA capital is $3.6 billion, of which $1.4 billion is U.S. VA and $2.2 billion is international VA. International includes $1.1 billion of capital in HLIKK and $700 million in Hartford Life Limited, our U.K. operation.
Let me share with you a couple of key takeaways in thinking about our capital resources and their distribution across the operations. First, with the actions taken to sharpen our focus on businesses with competitive advantage, 60% of total statutory surplus is dedicated to businesses we expect to generate capital organically. This capital will be used to support growth in the go-forward businesses and holding company dividend and interest requirements, with excess capital available for capital management actions. Second, we have $6.2 billion of capital currently supporting our life run-off operations. With the steps we have taken to improve capitalization and reduce its risk profile, the Talcott operations are now capital self-sufficient. Given the expected surrender activity and the benefit of policyholder initiatives to accelerate the run-off of these books, we expect the capital required to support Talcott to decline over time. Now let's turn to our capital margin.
For the purposes of the capital margin discussion, the same three scenarios we used in the cash flow analysis are utilized here. Please note the differences in the underlying assumptions as compared to 2011, including reduced U.S. and Japan equity return. In addition, there have been business profile changes. The life and retirement plans businesses have been sold, the VA block is now in run-off, and we have expanded our VA hedging programs in Japan. As you can see on this slide, the projected base scenario capital margin at the end of 2014 is $5.5 billion, which includes the completion of our current capital management plan. The improvement from the beginning of 2013 reflects statutory capital generation as well as continued risk reduction at Talcott. In the stress scenario, we project a $2.2 billion capital margin.
This reflects the cumulative impact of the actions we have taken, and it is a major accomplishment for The Hartford in its transformation. Let's look at the favorable scenario. The projected capital margin totals $6.1 billion, slightly better than the base scenario due to higher interest rates, which is partially offset by VA impacts due to hedge losses. In the stress scenario, capital margins total $2.2 billion, a $3.3 billion decrease from the base scenario. This is largely due to interest rates and credit impacts that are unrelated to the VA block. Importantly, under the stress scenario, the holding company maintains meaningful capital flexibility and ample liquidity. Given Talcott's current capital resources of $6.2 billion, it remains capital self-sufficient in this scenario. In other words, Talcott absorbs the $1.1 billion of VA impacts along with other credit and interest rate impacts within its current resources.
The primary takeaway of capital margin in the surplus information that I've shared with you today is that we have significant capital flexibility. Additionally, our capital generation outlook is improving, reflecting expanding margins. As such, we are at the beginning of the next phase of our capital management planning. I believe The Hartford is making solid progress in creating greater shareholder value. Let's conclude so we can open up for Q&A. I hope our presentation today has provided you with valuable information, and thanks for coming. We think MCV is a better measure of the economic value of VA liabilities. That metric, along with our scenario-specific cash flows, should give you an appreciation of the intrinsic value in our VA blocks of business. In addition, capital margins are strong and protected against VA volatility by our hedging programs. With respect to capital management, our principles are unchanged.
We have made significant strides this year with the $800 million debt tender and the share repurchase program. We are at the beginning of the next phase of our capital management planning. The Hartford is on the right path to create greater shareholder value with increasing financial flexibility. I know we have more work to do, but I am pleased with our progress to date. Thank you. With that, I'll open up for questions. Please give us a moment while Liam and Beth and Bob join me here on stage and the members of our IR team get out there with the mics for your questions. We're going to get organized right now and Not so close. I know that one's too close there.
Great. We got all the chairs here. We have about an hour for Q&A time, and as I promised you, this is open mic, Reg FD friendly. I just wanted to note that in addition to the presenters today, we also have Andy Napoli, who runs our consumer markets business, and Doug Elliot, who runs commercial markets here as well. I'm presuming most questions are going to be about Talcott, but if you do have a question for them, they're available as well. Would just note, we've got the other members of the IR team here, Sean Rourke, Stephanie Wallace, and myself. We all have mics and we'll take turns passing around. Just out of consideration, it's a crowded room. There's a lot of people. Please limit yourself to one question and one follow-up to let somebody else then take a turn.
In addition, for those on the webcast, I will keep an eye on my BlackBerry, and if you email me a question, I'll try to get that in the queue as well. With that, I'm going to go forward.
Thank you. Happen to be sitting in the right spot. John Nadel from Sterne Agee. My first question is, Chris, looking at your slide 21, which talked about the capital margins under the base and stress scenario, what would prevent you, given all the activities that have been undertaken, what would prevent you from accessing some portion of that $2.2 billion of capital margin that's available under a stress scenario today?
Well, I appreciate the question. Thanks for coming, as always. If you put it in the context of the accomplishments that we've had over the last 15 months, transforming the organization, focusing on the business we did going forward, as Beth and Bob just explained, the significant actions we've taken on Japan. We view that that base scenario, stress that we're running the firm, that a meaningful portion of that $2.2 billion would be available for capital management actions.
Just to be clear, that $2.2 billion is after taking into account the capital management actions that are already part of your 2013 plan?
Yes. Clearly.
My second question is, you guys recently put up a slide presentation on your website, and you've touched on it today, too, on the idea of moving the group insurance business from the two separate subsidiaries into one. Can you explain the significance of what that will do?
Well, again, thank you for the question. The context is group benefits is a strategically important business for us. We like that business. It has significant market share. Its earnings profile is improving as we've taken corrective action. We want to align it with one legal entity. The management team has a legal entity separated from Talcott. It allows us then to have just a self-contained business unit and really with the strategies of what we've said with Talcott being now capital self-sufficient, Talcott in its legal entities would stand on its own. One, it's an operating structure in a principle, and that's what we'd like to try to do for our strategically go forward businesses.
As just a quick follow-up on that is moving that, I think it's the piece that's co-mingled right now, right? Is the group insurance business and the annuity business inside one of the legal entities. To the extent that you move the group insurance business out and all the annuity and other run-off businesses are in standalone entities, is there a chance of going to the rating agencies and saying, "We want to manage these at a lower rating," and therefore accelerating some capital free up? Thank you.
Yeah. I think clearly once we've had that strategically important business separated, our flexibility is enhanced generally. That could mean lower RBCs, could mean just a different profile in general. That could be a benefit and outcome from that action also.
Thank you.
Certainly, John, one of Doug's sensitivities is in addition to all the things Chris just said, is putting in an entity where its ratings will reflect its true credit worthiness, which I think leads to Chris's answer to your supposition.
Thank you.
Sean, can you give the mic to the next questioner? Stephanie, if you can give it to Tom after Andy.
Thanks. Randy Binner from FBR. Just one quick follow-up to what John was asking. Is there a timing you're given or a time frame you're given for when Talcott can be separated out as a legal entity? Also are there any cost saves or anything that you might pick up out of that by separating it out?
Let's go back to the legal entity chart. That's why we developed it. When we think about Talcott, Randy, it's not one legal entity. It's a series of legal entities. Once we get group benefits out, the way I think about it is there's four different balance sheets and four different legal entities that make up Talcott that we manage in the aggregate. That's what we're thinking. As far as expense savings, I'll let Beth talk about that, but I think from our CEO downward, she feels the need to be efficient.
Yeah, absolutely. Our organization in Talcott, like the rest of the organization, is very focused on how we maintain our expense efficiency and, given the fact that we are in a block that will decline over time, we're very focused on that as well. As it relates to specifically the question on, if group benefits wasn't in a legal entity, does that in and of itself create expense efficiencies? No, not necessarily. More broadly, we are very focused on that.
Randy, just a follow-up too. Just on group benefits, we have a 49-state licensed company and a New York State licensed company. Operationally, I want to give people the sense that this can happen fairly quickly. There's some administrative things that we need to do, but we need to get Hartford Life and Accident New York licensed. We need to do some system administration things to connect that into that new license and new chassis. Then over time, renew new business into Hartford Life. Operationally, it's pretty straightforward. We're working with, I'll call it our New York friends to get HLA licensed, and we hope to have that here done in the near term.
Great. Then just to try this from a higher level. There's a lot of good news today as it relates to NAR and in the moneyness and surrenders improving. I guess for a potential counterparty, the runoff's getting maybe more expensive. How should we think about triangulating the kind of good news we're hearing today that you're getting from your management actions in the market and how that relates to the potential transfer of these risks? I know you said that you're looking at all economic options, to me, it feels like they're kind of staying, and that's a real debatable point for a lot of people on the stock. I'd just be kind of interested in how you're viewing the permanency of this resolution.
Randy, thank you for recognizing the effectiveness of the actions we've taken. I would describe our point of view as the following. We think we've positioned the firm in an appropriate fashion to create shareholder value. Capital will be generated, as Chris has said, by the go-forward businesses, whose performance is improving. Just the pricing actions alone that Andy and Doug have put into the business are going to be very advantageous for us. I think the de-risking that we described, the improved policyholder behavior, whether it's in lapsing, the declining in the moneyness is very encouraging. We don't have to sell the business. We can manage it. We are, as Beth said, very clearly, we're engaged with our advisors and are looking with great seriousness. If there are transactions to be done that are permanent solutions that are economic and prudent, of course, we're open to them.
They need to be economic and prudent. I think, I hope what we demonstrated today is the firm is very capable of managing the risk. We don't have to, but we are sparing no effort or intensity to explore all options. Chris, anything you'd say to that?
I think you said it well. Beth described it, the word we use internally is it's an accelerant, right? We have other policyholder initiatives, the natural surrender rate. We think those are cheaper from a shareholder value side to explore those. Make no mistake, we still want to exit the runoff business as quickly as possible, M&A is a tool that we will use when it's prudent.
Go ahead, Tom.
Thanks, Liam. Just to come back to how do we think about the pace at which capital is going to be returned? If we take Talcott being now self-sufficient, that would imply to me that any shrinkage of the block going forward, the lapsation, starting from this point forward, can be used for alternative purposes, meaning either debt reduction or share buybacks. Is that a safe assumption now, and are we going to start to see kind of a pathway to that? A related question. Most of the proceeds, if you kind of rank order them between the three buckets you had for uses, went toward debt reduction. Is that still an appropriate way to think about what you would do with capital that's getting freed up over the medium term, or is it going to be more balanced from this point forward?
Let me take the last one first. I was trying to be as clear as possible, Tom. The next phase is more about equity. We have, I think, taken a great first capital management step in the plan we announced. It was the right plan. The next phase is more geared towards equity. I don't envision tendering for debt anymore through end of year 2014. We have said that our goals of low 20s in coverage ratios, that's a time horizon. I think we're on a great path to achieve that in the appropriate time frame compared to the earnings growth of our go-forward businesses compared to the runoff of earnings. Let me be clear. The next phase is more about the equity. Your comment on capital release, I think we've talked about it with certain groups.
The way we think about it now that Talcott is self-sufficient, we have more capital flexibility within the holding company and our P&C operations. That's the first order. The second order of when capital will come out of Talcott is a little more complicated, so I'll try to be as simple as possible. That's why we put the legal entities up there. When you think about Talcott, don't forget there's a Japan legal entity that has capital in it, there's a U.K. legal entity that has capital in it, and then we have capital in the two remaining U.S. entities. If risk is being released in Japan quicker than the U.S., I need to be sensitive to managing the Japan balance sheet, capital flows, any constraints that the Japanese regulators might have.
I wouldn't say it's necessarily one for one exactly in time parallel, but over time, that's when the capital can be harvested and redeployed for other reasons.
I think it's a very important description that Chris just gave, Tom, so let me reiterate it because I think it is important that investors understand this. The fact that Talcott now is capital sufficient means that the capital that's generated from those go-forward businesses is not going to be needed to support Talcott. After holding company needs for dividends, interest payments, et cetera, we've got a lot of capital flexibility at the holding company, which I think is the primary reason for Chris saying we're already beginning our thinking about capital management plans. Our first priority is around equity. Clearly, the other information we've shared with you suggests that we're going to need less capital in Talcott. It's going to come out. I think what we're just saying is we can't give you a precise time yet, but we understand our opportunity to do that.
It's just not as clear cut as the first order, and I think we've got a lot of flexibility in the first order, as Chris has said. This is a company I hope we've demonstrated that has the ability and willingness to both return capital to shareholders and invest in its businesses for profitable growth, which I think shareholders want us to do as well.
Sorry, just one last follow-up on that. Is there any complexity with getting money out of the VA captive as it relates to that? Because it's capitalized at, what, a 150-
150
RBC, which is low. I'm just curious because I know that's a big area of regulatory focus. Is that going to be one of the impediments to drawing capital out of the business or the Talcott block?
No. It's a U.S. captive, it's a Vermont captive, it's not an impediment at all, Tom.
Thanks.
Just related to your comments on capital extraction from Talcott, what are the limitations or constraints as capital frees up because the VA block is smaller in Japan or the U.S.? How much of the capital can you take out? Are there limitations based on earnings in those businesses or something else where you'd need special permission from the regulators to upstream the capital? I understand how the capital would be freed up as the blocks are smaller, but what are the constraints on you.
That's the constraint in Japan I was referring to.
Yeah.
I'll call it a retained earnings positive constraint.
We have negative retained earnings right now in Japan. We would have to engage in the process with the FSA to extract or in essence, return capital.
Which would be like a multi-year process or at least more than a year or two years, right?
Well, it just depends on when we want to start. Again, we're in the position right now where a lot of the hedging for Japan is done in U.S. legal entities here, given that there is significant reinsurance. Most of the hedging that we put on incrementally, as Bob and Beth talked about, is done here in U.S. entities. When you get into Japan, you have to put both those balance sheets together and think about how to approach the FSA.
As it relates to the U.S., I think we've demonstrated through our billion and a half dollar upstreaming that our relationship is very constructive with the Department of Insurance, and I think that's pretty straightforward.
It would be through special permission as opposed to given the.
Until our retained earnings are positive, yes.
Yeah. Can you talk a little bit more about the hedges that you put on the currency and also on the equity market in Japan? What's the duration of the hedges that you put on? What's been the amount that you've spent, and how much do you think you'll, assuming this type of an environment, stable environment from here, how much do you expect to spend on an ongoing basis?
Let me maybe answer the second question first. I think Chris' charts that showed the cash flow analyses, I'd look at those carefully. Those are probably the best representation of spend on an ongoing basis, and of course, that is dependent upon scenarios and how things play out. In terms of the actual hedges that we put on, I'd say we added about $7 billion in hedges since year-end. Prior to that, we had added about $6 billion or so in options. We generally try and have a good mix between options and outright trades, first of all. Then secondly, one of the things we, I think just as a general policy, is we try and extend the duration of our hedges as long as feasible, and by that I mean economically feasible.
There's some markets where you can buy hedges in longer-dated form in very liquid markets, and there's others where you can't. Wherever we can, we do.
Just on the expenses, how do you get an idea on what it is? These numbers are like $5 billion, $4 billion.
Yeah.
How much of that is expenses that you spent or because I'm assuming the expenses are netted with the fees, right? In your charts.
Again, the cash flows Bob was speaking to is what we talk about is that's the ultimate cost of hedging in that scenario because it's the cash spend up front, and it's the mark-to-market losses on futures and forwards. You call it your outrights, as Bob calls them. I wouldn't dismiss it. That is the expected total cost of our hedging program over the next 25 years. Now, you want to annualize that, you could divide it by the numbers of years. We generally have talked about from our VAWB hedging program and our macro program in the US, that we're spending on an annualized basis around 30 to 40 basis points of account value.
In Japan, you saw that we're writing off all of DAC, which means that we don't have any EGPs, which then means our hedging costs are basically almost at 200 basis points, because there's no future EGPs that are going to come out of the Japan block.
200 basis points a year?
On Japan.
On Japan. Just lastly, given that the overall risk profile of the business is getting a little bit better, the environment's been favorable.
I think it's a lot better.
A lot better.
Thank you.
Why not be a little bit more balanced in how you're deploying capital? If it is a lot better, why not deploy a little bit more towards buybacks as opposed to using most of it for debt reduction?
Well, the first thing I'd say, Jimmy, is we just got the first plan approved and implemented, number one. Number two, we have improved the risk profile of the firm a lot in five weeks, which we're sharing with you today. Thirdly, I think Chris and I have made it abundantly clear that we understand the capital flexibility we have, We've begun a process to think about the next generation of capital management. We'll do what we always do with our constituents. You appreciate that process. Our first order of priority is to return capital to shareholders.
Thanks.
Thanks. I think the next question is with Chris Giovanni.
Thanks. Chris Giovanni, Goldman Sachs. I guess if we look at the capital margins that you guys provided today versus where we were in October of 2011, you're maybe $1.6 billion or so higher in the base and favorable scenarios and $900 million higher in the stress scenario. I guess along the lines of questioning, how should we be thinking about that coming back? You gave the indication maybe $100 million or so of share repurchases a quarter from here. I guess, is that a sustainable run rate? If so, that clearly puts you ahead of the $500 million that you indicated by the end of 2014. Just a little bit more context in terms of the capital and how you're thinking about it.
Well, I think as I said to Jimmy's question, Chris, we announced a capital management plan. It's relatively new. We've taken some very decisive actions to lock in the economics of Japan and de-risk the firm, as you kindly noted. I think Chris' comments were on the existing plan. We'll exercise about $100 million a month. What Chris and I very much want to be is consistent and predictable in capital management, and particularly buybacks. I think we're giving you that clarity on that plan. However, as both of us have said, we're entering a different phase in thinking about capital management. As we make those decisions and communicate, I think you should expect a similar kind of predictable, consistent approach to capital management.
I think we're in the place now where we can do that, and I think investors would like that, for us to be more consistent and more predictable.
To be clear, it's $100 million a quarter, right? Not $100 million a month.
Did I say a month? I apologize if I did. Thank you for clarifying that. That would've been a big boo-boo. $100 million a quarter. Yes. Thank you. We'd run out pretty fast per month. I'm surprised the CFO wasn't giving me the ugly eye here.
The next question, just the MCV approach. Can you comment what kind of assumptions are around policyholder behavior? Because I guess the pieces around the fees and benefit payments, I think that's kind of easily calculated. I guess in terms of sensitivities for behavior, can you talk what the assumptions are and how different the approaches could be if it works against you from a policyholder behavior standpoint?
No, it's a great question. I think first, we have a lot of history, at least here in the U.S., with policyholder behavior. As Beth said, we still have 1.1 million customers, I think we understand policyholder behavior well here and in Japan. Generally, I think our policyholder behavior assumptions that we've used in our earnings model, our DAC models, have been pretty correct. We haven't had to make any big adjustments one way or another. The other part of the equation is that they are dynamic in different market conditions. Those scenarios, the 5,000 that we run, it's not the consistent policyholder behavior. It tries to pattern what a capital markets efficient policyholder would do in those scenarios.
They would flex up and down, and that's what we're trying to reflect, and that's what we do reflect ultimately in all the net present values of cash flows.
Thank you.
For the next question, Scott Frost.
Thank you. Could you give us an idea on the hedging program overall? What's the breakdown between, say, open market type solutions versus structured solutions, and how should we think about, and how do you think about counterparty risk here? The second question is for your planned debt issuance, is it more likely before or after your release?
I'll do the first and you do the second.
Well, I think that the simplest point is from a counterparty perspective, we aim for very highly rated counterparties, first of all. Secondly, we put in place very strict collateral maintenance requirements, where the collateral is basically highly liquid treasuries and government type products. From that perspective, I feel like we're in very good shape and enter into safe contracts.
What's the breakdown between structure with a counterparty versus open market type solutions?
Right.
Would you say?
Well, I think you got a bit of the insight from Beth's slide on reinsurance. Let me set that one aside as described in Beth's presentation. The structure trades that we put in, I'd say are roughly 10, 12% of the book. They are essentially a mirror image of a reinsurance contract. Highly structured, completely collateralized, mark to market on a daily basis, and most importantly, very long-term.
As far as the debt, I believe we'll have a window prior to earnings.
Thank you. Jay Gelb from Barclays. I'm trying to get a better handle on how we should think about the core earnings power of Talcott going forward as the block declines over time, my guess is the earnings contribution should as well. I understand that the property casualty and group benefits and mutual funds business is certainly going to be a majority of the earnings power. Just to help baseline our models, how should we think about Talcott going forward?
What I would say, the models that we use to make decisions and run the firm with is I believe over the near term, two, three years, Jay, that the earnings power of the go-forward businesses will, in aggregate, counteract and exceed the earnings decline of Talcott, plus or minus. The franchise and the go-forward businesses that we've committed to have good growth prospects, good earnings prospects, and the decline in earnings in Talcott should be offset by their earnings growth going forward.
If you roll that forward, what does that imply for all-in return on equity for the business?
As Liam mentioned in his slides, we see where we are for 2013. You saw the 7.5%-8%. When you get beyond that, I'd prefer to update you on that after we think through the next phase of the capital management, because that'll be a main driver of it. I think organically, we think in terms of 50 basis points annual improvement over the next couple of years without any enhanced capital management activities is very achievable from the actions that Doug and Andy are taking, the efficiency activities that we've got going in the organization. That's how we think about it, Jay.
Sorry, my third point. Just to clarify that last point. Without enhanced capital management actions, that means just based on what you've announced that Hartford will do so far based on deployed on the proceeds of the sold businesses.
Yes. 50 basis points.
Bob Glasspiegel from Langen McAlenney. I'm going to push Randy's question a little harder on the third party transaction lever on slide 26. Beth, you gave your three doors third party transactions, and you're going sort of door 2, door 3 for now. You did leave third party transactions as door number 1, so I'm probably overanalyzing the importance that that might provide. Maybe you could amplify on, is it a bid-ask spread that's keeping you from pursuing door 1 today? How vibrant is the third party transaction market, and were you close to anything, or how close did you get?
Well, Bob, first of all, let me say we're clearly not going to talk about the dynamics of conversations we may be having or not having. I think you can understand that. Secondly, I think I've made it perfectly clear, and Beth may want to amplify herself, that all energy and focus and advisors that should be involved in exploring that as a viable outcome for us, we would love to get rid of the risk permanently, is being employed at this time. For us to talk about the deal dynamics, I think would not be a wise or prudent move on our part, and I think you'd agree with that. Beth, anything you'd add?
Yeah. The only thing I'll add is that I was not rank ordering them. They were the order in which I spoke to them in the presentation. I'll just clarify that. I agree with Liam on that, and again, it's something that we'll be continuing to explore. As we've said, we do have other ways of managing and mitigating the risk associated with these businesses.
From a capital perspective, again, we have tremendous interest in permanently moving blocks or books if it is economic and prudent and it creates shareholder value. That's the test. If you look at the lapse rates and the change in the moneyness, that is arguably the most capital efficient way
Most shareholder-friendly way for us to reduce these books. My job and Chris's job and Beth's job and Bob's job is to create shareholder value. We understand very clearly the appeal of permanently removing it, and we're all over it. We're going to create shareholder value. I hope that the tenor of today and our actions leading up today are tangible evidence of that.
My follow-up is.
Bob, that's why we presented MCV. You think about it, just a simple equation. Why would we pay someone to take a block when we think it has value?
I'll answer that.
That's the dynamics.
I'll answer that question offline with you. I don't want to burn my second question.
Right. What's your next question, Bob?
Third question.
We'll give you a hall pass. What's your next question?
Stat earnings power of the remaining entity to me is pretty close to the standard. The cash flow from the subs will be the stat earnings of the P&C and the group business upstairs minus the holdco responsibilities. Your P&C and group, since they're not growing, it seems like the stat earnings are going to be pretty close to the free cash flow. Is that a reasonable way to think about it, or is there other factors in there?
No, I think that's the way to think about it. I think we talked about it in the last earnings call. We still see the P&C group generating about $900 million of statutory earnings in 2013. We see group benefits a little north of $100 million. I would not forget that the mutual fund operation is now owned by a holding company, so we'll have direct access to that cash flow, which is about $65 million-$75 million a year.
The holdco responsibilities per year running roughly what?
The way I think about it today, with the capital management actions that we announced, ±, we have about $400 million of interest payments and about $200 million of annual dividend.
Thank you.
Thanks. Could everyone who wants to ask a question, raise their hand? Then who's got the mic now? Okay, Eric's got the mic. Okay.
Thanks very much. Eric Berg from RBC Capital Markets. Chris, I just have two questions related to that portion of your presentation dealing with MCV. My first question is, with MCV, are you effectively taking your Japan business, which under U.S. GAAP is not fair valued and effectively trying to do exactly that? Is that what MCV does for the Japan business, take it from the SOP non-fair value approach and give us a more of a true economic sense of the liability there?
Exactly.
Okay. Perhaps then you've already answered my second question, which is, you state explicitly that you say that MCV is better than GAAP. Why? You say it explicitly. It's a superior measure. Why is it better than GAAP?
Well-
Are the reasons that we just said, or are there others?
This is an investor conference, not an accounting debate forum. I'll just share with you my view is that, 1, it treats all the contracts consistently.
Right.
I think, you know under GAAP, we have different contracts or different FASBs we follow depending on the contract.
Right.
Like any other financial instrument, it's the best representation of fair value. I think having a view of fair value on these blocks, particularly as we manage risk, is very important. That was the ultimate decision that Liam, Beth, Bob, and I took, is that to link all the stuff we've been trying to talk about, hedging, risk, de-risking transactions, we needed to harmonize our language and basically share it with you. That's what we did, Eric.
Okay, thank you.
Okay. Go ahead.
I guess this is for Chris. Just going back to the cumulative cash flow before tax chart, I think it's page 13. Just a clarification. Those numbers are gross of reserves utilization and before the investment income on the capital, correct?
Correct.
The way to think about the PV, ultimately of the cash flows is you take these numbers, you add the capital release, you add some PV of the investment income, and you consider the reserves.
Correct.
Those four pieces get you to the cumulative cash flow ultimately.
Correct.
Okay, perfect. Then just thinking about the capital, I guess, in Talcott, at least I don't think you talked about quite as much as the $2.6 billion non-VA capital. I know you have like $450 million that's still to support the reinsurance and the life and the retirement plan. How should we think about the capital release out of that block?
Well, I think in the appendix, Beth provided everyone with a profile of the non-VA stuff. I think you could understand those blocks of business. The way we think about it and talk about it's roughly $30 billion of fixed annuities, payout annuities. We have, in essence, $2.1 billion roughly backing that line of business. Some of those durations on those liabilities you'll see there are medium term, and some of them are a little bit longer term.
Is there any framework for how to think about it, five, eight, 10, 15% a year kind of thing?
Very difficult to predict because there's two pieces, as you know. Terminal fundings and structured payment. There is a payment stream, but it's usually a lifetime payment stream, so that's why those liabilities get long. There's not really a meaningful move in those liabilities over the next couple of years. The fixed annuities do have some policyholder behavior activities associated with it. If there's going to be a reduction in liabilities and the associated capital, it's probably going to come from those fixed based liabilities sooner, fixed annuities.
You get $200 million back from the retirement plan pretty quickly, right?
Yes.
Okay.
We would expect that business to roll largely in 2014?
Yes. Early 2014.
The life, as you understand, is just a little longer because of the long tail or a long duration of those liabilities. Other questions?
I think there was a mic handed out over on No?
No.
Okay, just, here's Brian.
Yeah. Brian, Meredith Whitney Advisory Group. Liam, I was wondering if you could just remind us, what is the strategic kind of benefit of having the benefits business and how does that pair with the P&C operations? From a P&C analyst perspective, it doesn't intuitively make a lot of sense in the mutual fund business also.
Let me start with the mutual fund business first. It's a pretty simple answer. It doesn't take a lot of capital, generates a lot of capital. We've got a great team in place. Our relationship with Wellington, which is one of the world's leading money manager, who is our sub-adviser now for both equity and fixed income, is very unique. We're seeing really good performance there. You understand the valuation dynamics of that business relative to the insurance business as well as I do, number one. In terms of the benefits business, I think Doug would tell you that the combination of having a benefits business and P&C business in its simplest form who are going after the same end customer, largely through, not exclusively, but largely through the same distribution, is very advantageous. It's given him some abilities to leverage our claims platforms.
Not only an expertise perspective, which has been helpful, in some of the improvement that you're seeing in the business, but also an expense benefit. Finally, I'd say, quite frankly, with the president's affordable health care plan and all the uncertainty that that's creating, we see the intersection of the benefits business, the life and disability business, and the comp business, and the evolution and emergence of the voluntary business. We've got two of the three legs of that stool, we're a market leader. We like our position in an environment that's likely to change. The sum of those parts might be much more than them individually today. Doug and Chris and their teams are spending a lot of time looking at that phenomenon. I think it makes more sense than ever today to keep those things side by side.
We're going to let John ask one more question.
Just one more? I thought we had more time.
No, you already asked four.
Just to be clear on Talcott as a whole, is Talcott going to generate, at least in a base scenario, positive statutory income beyond what would be used to continue to pay and roll hedges?
We've talked about it before, John. Talcott will generate some marginal surplus in the out years. We expect in 2013, a decent amount of actual surplus increase, particularly with market levels at this time. As reserves come off.
Yep
Our hedging losses are lower than the reserve releases, we are going to grow statutory surplus in 2013 in the life operations. Beyond that, it just becomes more sort of modest and slow, and I've always talked about in the $200 million range, sort of annual surplus growth out of the runoff operations.
The self-supportive commentary based on the $6.2 or so billion of statutory capital today, that self-supportive commentary, does that require keeping that earnings over time, retaining that statutory earnings over time, even though it might be modest?
Generally-
Is that just based on today's capital?
Today's capital, today's risk profile.
As things change, as the risk profile changes or markets change, those dynamics would change. I think I know what you're getting at is that there will be at a point in time a dividend capability coming out of Talcott as risk continues to run off.
Beyond just the idea of the book shrinking, correct? That's what I'm trying to get at. Over time, I expect as the book shrinks, capital comes out. Is there also an element of there's some level of earnings coming from this business, this group of businesses that will be available to dividend each year too?
Yes. Modest.
Thank you.
Okay. Any other questions, Abram? Oh, hi.
Hi. Good morning. Vincent D'Agostino with KBW.
Hey, Vincent.
Just two quick ones. From the debt tendering comment that you had made about not really tendering anything before 2014. If Doug and Andy are successful at boosting the P&C margins, would it be terribly too optimistic to assume if that's the case from an earnings growth standpoint that you actually wouldn't really need to reduce much debt because you'd be getting pretty close to your coverage targets anyway?
No, it's a great question. I think our coverage targets are very achievable in the near term. To think about getting into the low 20s as we aspire to, just might be a little bit longer. I think about as we head into to 2015, the natural growth, the natural progression of our business, and its earnings profile, we should be able to achieve those objectives.
Okay, perfect.
I just want to be clear, what Chris said was 2013 and 2014, when you'd be getting more.
I wouldn't normally be so concerned with timing on getting the hedges established more fully on Japan, but there's been a pretty big difference between where yen-dollar sat just two or three weeks ago versus where it sits now. Any color on when exactly you went full hedging, just to get an understanding of at what point did you lock in the economics?
Well, I'd remind you, then Bob or Beth can comment. This was a very intentional decision. We see the upside, if you will, of not having done what we've done is very limited, as I think Beth pointed out. We think we hit it at the right time and that any upside was not even close to what the downside was. The program is complete, but in terms of any other color commentary, I'll leave it to Beth and Bob.
Yep. Go ahead, Beth.
Yeah, it really was over the last several weeks that we concluded on starting with the program. That's how you should think about it.
Great. Thank you.
Tom's got another question here.
Okay. Do you want Tom?
Yeah. Tom, go.
Just a question on legal structure. Should we be thinking about one of the possibilities here being Talcott being separated legally from the rest of Hartford? Is that really just a wild card, would be tough to get through the regulators? Just hearing you describe it being self-sustaining leads me to conclude another way you could unlock value for shareholders would be some type of tax free spin-off of that business. Is that something that we should be considering?
Well, first of all, Tom, I think by creating capital self-sufficiency of Talcott, we have accomplished the ability to release capital over time from Talcott, which is what I think shareholders want. I think we've accomplished substantively some of that. Clearly, we looked at that possibility, and I don't really want to get into all the details here. I think you're as well aware of them as anybody. It didn't make sense from a lot of perspectives. Doesn't make any more sense today. I can't speculate on what opportunities might present themselves in the future. I think the construct that we have communicated to you, we feel very good about is our best opportunity to maximize shareholder value, both that two-step process that you and Chris and I reiterated about the capital-generating ability of the go-forward business we have, what we have at the holding company.
Over time, we're going to free up capital out of Talcott for all the reasons that you've seen today. I think we've substantively gotten to where we want to be. Are there things in the future that might make sense? I can't speculate on tax transaction, things of that nature. Chris, anything you'd say?
I think you summarized it right. It's an idea, but the path we're on, and particularly thinking about the next level of capital management plans and the focus on equity that I said that's going to be, I think I should probably give you a pretty good indication that we're not thinking about any split.
Got it. Just a question about thinking about debt and which businesses support your debt load, because Talcott, if it's only generating $200 million a year of capital, I would think about that as not being able to support its own weight of debt if you want to allocate it within the corporation. Am I thinking about that the right way? How would you think about the appropriate amount of debt? Do you not worry about that just because if there's no plans to legally separate it isn't of great consequence to you?
It's not of great consequence. We think it could support a small, modest amount of debt, but beyond that, we don't spend a lot of time with it. We have an internal methodology that allocates small debt interest cost to Talcott, but beyond that, we don't spend a lot of time with Tal.
Thanks.
If everyone could just put their hands up again. Sean?
Right here. Sean.
Yep.
This gentleman hasn't had a chance yet.
Yeah. Thank you. Jonathan Sheehan from Tosca. Just a quick question on your MCV. I take it that the MCV is analogous to a present value of in-force as a gross basis just for the VA business. I'm interested if you think that's a good measure, why you haven't done that for the entire business, and whether you could what would be useful for us would be then to translate that into an economic value. I don't know whether you can give us a feel for that. Secondly, in terms of your actions to run off the book and to take the enhanced surrender option, can you talk us through what the IRR is on that calculation? Whether that creates value or not, we can't work out from these numbers. It'd be really quite useful if you could tell us what
IRR you think you're generating on the cash you're laying out on the enhancement?
What if I take the first, you take the second?
No, I appreciate it, the compliment. I took it as a compliment that MCV is helpful. You're welcome.
Take it while you can get it, Chris.
Applying it to the rest of the other business. Again, we talked about Talcott today, primarily, the VAs. You could apply it to other liabilities like the fixed block. We haven't shown you and shared that with you. It's feasible. I can tell you our current intention is, given that we don't operate in Europe, we're not going to develop an embedded value concept and disclose it regularly. We'll periodically keep you updated on our views of MCV and how it might be shifting our mindset. It's not a management metric we prefer to start to introduce for the holistic firm at this point in time. I think the only thing I would say that I think is important, particularly as you think about the other blocks, the $30 billion of fixed liabilities. Any financial institution in a low interest rate environment is going to feel some pain.
We're no different for those liabilities. I think what you also need to keep into consideration, particularly on a statutory basis, is how have we provided for that pain. I would say if I look at it in aggregate, we have over $950 million of interest rate-related liabilities, additional cash flow testing, reserves, voluntary reserves we've put up on that fixed block of business. When I think about the value of that surplus that we disclosed today, I feel pretty good about it.
Yeah. On your second question, I don't have the IRR that you're looking for specifically as it relates. The way I think about the program and the benefits, as I said, if we look at what we've spent to date, the $48 million, I look at that as a comparison then of what the required capital release is associated with that, and it was basically double of that. Again, double meaning absorbing the cost of the program, we would look for the capital release to be about double the cost. That's kind of how we think about it, because again, as we look at these types of programs, we're really looking at cost compared to what does it do to us from an overall capital perspective. That's something that we can think about going forward as to your specific question.
Okay. Just to follow up, the reason why it'd be useful would be to judge the economic value created or destroyed by your actions.
Right.
I guess what you're saying is, it's giving you capital, but you're not giving us any signal on whether this is economic value creation or economic value destruction.
We do look at it from an economic value as well and creating economic value, not destroying it. Again, we look at things from an economic lens, from a capital lens. That's how we balance the two.
Okay. Sabra?
Thanks. Ryan Krueger with Dowling.
Hi, Ryan.
I had a follow-up on the fixed annuity block and the capital associated with it. We've seen quite a few third-party transactions in the market for spread-based assets. Is that something you're still looking at today? If so, why not?
Beth will have a point of view, given that she's managing the business. There is a market out there. Our block is obviously fairly large. I think we've prioritized our strategic actions on policyholder behavior. You've seen the actions that we've taken on Japan. It's not like we don't think about it, Ryan. It's just a little bit of a lower priority, given trying to transact in a low interest rate environment. We probably wouldn't think as ultimately shareholder value creation friendly in this environment. That's how we think about it.
Yeah, no, that's exactly how we talk about it.
I guess is it the type of thing that if we see interest rates go up over time, that then you'd get a lot more interested in pursuing that?
I think that's fair.
Yeah.
Yeah.
Then just one last quick one. On the $700 million of capital that's in the U.K. sub for the VAs, are there similar restrictions on getting capital out of that entity like you have in the Japan entity?
I'm not familiar with the Irish restrictions or the Irish rules, I should say. I can't comment on if there's any restrictions at this point in time.
Thank you.
Jay?
Yeah. Jay Cohen at BofA Merrill. I may have missed this. Did you talk about the discount rate you're using on your MCV calculation?
View it as, in essence, the swap rate on that scenario. When we say market consistent, there is no arbitrage between markets, equities, FX, and interest rates. It's intended to be market consistent. View it as the swap rate in that scenario.
Got it. Right.
One more over here.
Thanks. Chris Giovanni, Sean, if you can run the mic over there. Is there anyone else on this side of the room that still has a question? We'll do Chris and then John, and I think we're about done with Q&A.
Okay, go ahead, Chris.
Liam, I guess on last quarter's call, you made a comment around the real accretion would come from a third-party transaction. I guess, is that still the view given the actions that you've taken today and how much better the book of business is today? Then I guess around a third party.
We'll have to go to the transcript, Chris. I think what I said was that third-party transactions could be accretive
I also said I've always been consistent, as Chris has been, that our priorities and the things that would drive our decisions are the things that we think would create shareholder value. Clearly, there's a different set of scenarios that have been added to that baseline scenario when we commented on that quarter call, the actions we've taken. I don't believe I've ever prioritized third-party transactions as necessarily the most accretive. I did say that we kept capital in the life subsidiaries. That's $700 million, $800 million after the $1.5 billion special dividend for possible transactions, which we think could be accretive for shareholders. It was not my intent to stack rank them.
Okay. That's fair. Then around the third-party transactions, could you comment maybe a bit in terms of where the delta is between you and others? Not a specific number, but where do you guys disagree in terms of value? Is it maybe just the size of your overall book in terms of someone being able to take something on? Is it policyholder behavior? I guess, where are there some discrepancies that draw that delta?
I know you're not going to like this answer, you can appreciate where we are in the process. To go anywhere near that would probably not been advantageous to us.
Okay, thanks.
One last one from John.
Thanks. Beth, I'm just curious whether, especially given modestly better success on the enhanced surrender plan in the U.S., given what's occurred with respect to in-the-money-ness and the quick little spike here in the last couple of months in surrenders in Japan, whether you can take a similar program over to Japan. Is that part of your plan?
The enhanced surrender value program?
Yeah.
Yeah. I think it's important to remember that the Japan environment is different than the U.S., and those types of programs that we've seen in the U.S. are just not something that you see occurring in Japan. Where we sit today, we don't see that type of program being successful. What we're really focused on is making sure that our customers in Japan understand what their options are under their policies, where their account values stand, how that relates to their guarantees. Our focus is really on customer education and education with the various distributors.
The follow-up is just, if the conditions have created an environment where that surrender rate in Japan, instead of a low- to mid-single-digit rate, is indeed going to stay elevated in the low- to mid-teens, how does that change some of the math that you provided, which I don't think was assuming that those surrender rates stay that high? How does that change the pace of runoff of capital? How does that change the pace of maybe even some of the hedging costs as the book shrinks quicker? Can you give us some sense?
Yeah.
Bob, I've heard you talk articulately about the size of the book and the impact on hedging.
Sure. I think the most direct answer to your question is we've got, A, a huge amount of data on policyholder behavior. B, these are significant events that are affecting policyholder behavior, but you have to think of these models as very long-dated models. These are 30, 40, 50-year behavioral models. You don't want to shift them around for a small amount of data. First point. Second point, we align our hedging directly with those models. We don't trade or move in different directions. We stay spot on with those models. Our groups, my group and Beth's group, are hand in glove. They sit next to each other. As we reassess, which we're doing constantly, as we shift that model, the hedging program will move exactly with it. Frankly, it's very fluid and very easy to move with it.
Chris, Beth, do you want to talk at all if the Bank of Japan keeps or its actions keep a weak yen, higher markets, lapse rates, and I think what John was saying, do you have a view of what that does for the size of the liability?
Yeah. To start with, even with the additional hedging that we're doing, when we see continued favorable markets and continued surrender activity as a positive. For some of the reasons that Bob was just mentioning, that as the size of the exposure shrinks, so would our hedge programs. When we talk about some of the hedge costs that are in those models, that would shrink over time. We see that all as very positive. As I said, we're monitoring it very closely to look at what point do we think we should put it into our models, and then how might that decrease that reserve over time. We see it all as very positive. We'll be continuing to watch it.
As I said in my prepared remarks, as we think about the risk capital that we have associated with this book of business, yes, as things annuitize, we see that going down. If things surrender, it absolutely goes down. Again, we see that all as positive.
One quick follow-up is just the reserve base and on a statutory basis in Japan. Can you just remind us what that was? I know we've got the $1.5 billion or so of statutory capital.
Yeah.
Japan, what's the reserve?
If you think about the Japan accounting base as $1.5 billion of surplus on their J-GAAP basis, and they have about $700 million-$800 million of contingency reserves, as they call them. All I would say it's a modified form of cash flow analysis. We do hold reserves here in the U.S. quite substantially for the reinsurance portion. Those reserves we hold in the U.S. on a VA carve-out basis for Japan are about $1.5 billion.
What Beth is really describing is the dynamics of Japan will be played out on our balance sheet first and the Japan legal entity second.
Thank you.
Just on the December 31st, it was $1,000,000,001 in HLI, KKR, and US Telephone.
Thank you.
I guess since John asked the first question, Mark's not going to let him ask the last question, too. I'll give one more, and then we'll wrap up.
Hi, Mark. Just talking about the Japan surrenders. Obviously, they're higher, markets are better, more people are surrendering. Is there some risk that people just that have an annuity, their markets are back, rather than surrendering it, they have no need to annuitize it, they just continue to hold the annuity. Is there any risk of actually extension on those people that don't immediately surrender as the markets have improved and the actual duration of those claims actually get extended?
Yeah. Again, as we talked about, they do have two options. One is to your point that they do nothing. They're not required to annuitize. Yes, as their account value goes up, there is that risk. I think that the way I think about it their guarantee amount can't go up, right? There's no step-ups or anything like that. At some point, they have to make a decision about do they want to stay in this type of contract or maybe move to something else. I think it remains to be seen. As you point out, they don't have to annuitize.
Their average age is much older than the U.S. which I think is a mitigant as well.
You don't see that as a meaningful risk towards the ultimate cumulative cash flows?
No, especially because of the way we're hedging and the way we think about the risk in total.
Okay. Thank you.
Thank you, everyone. That wraps up the Q&A portion. As I mentioned, we do have luncheon downstairs right near where you checked in. I warn you, the elevators get a little backed up here as we go down, so pace yourself. Chris and Liam, I don't know if you wanted to just add any quick concluding comments for the presentation today.
I would just say on behalf of the team first of all, thank you to Chris and to Beth and to Bob for the quality of their presentations. On behalf of all of us, thank you for coming here. Thank you for investing the time. Thank you for the quality of exchange that we have with you, and we hope we've been very successful in communicating with great credibility the takeaways that we left with you, which is I think the firm is in a much different place. Talcott is capital self-sufficient. We have a lot of capital flexibility. We are in the process of thinking about as we speak what we do with that flexibility and we understand our responsibility to create shareholder value, and we take that very seriously.