Morning, everyone. Morning, Liam. Thank you for joining us today. I want to welcome those of you here in Hartford and those that are participating in the audiocast. We really appreciate that so many of you were able to make the trip to Hartford and join us at our headquarters today. We first started discussing holding a session like this several months ago based on your input. We appreciate the challenges and perspectives that you've offered, and that's why we're here today. We have a financially oriented discussion that will address the balance sheet topics in depth. You will hear from the executives most directly involved and knowledgeable in those issues we'll discuss. Please take a moment and just look at slide two here, where we make cautionary remarks about our forward-looking statements. In the actual presentation, events may materially different going forward.
Let's look at the agenda and just set everything for today. Liam will make a few opening remarks. Greg McGreevy will review the investment portfolio, and then we'll move to Enterprise Risk Management, where we'll hear the progress we've made from Liz Zlatkus and Graham Bird, including the U.S. and Japan VA books and the hedging programs. I will provide an overall financial impact for the Japan hedge, and we'll take a break. I'll come back after the break, and we'll walk through a few third quarter items and review the balance sheet and the capital position. We will hold a Q&A for the end, which will be moderated by our Head of Investor Relations, Sabra Purtell, and we'll conclude with a lunch. We have a number of other executives with us today. They'll be around during the breaks as well as during lunch.
Doug Elliott, Head of Commercial Markets, Andy Napoli, Head of Consumer Markets. Dave Levinson, Head of Wealth Management, could not be with us here today due to previously scheduled travel. Alan Kresko, our General Counsel. Also from our Finance organization, Scott Bambara, our Controller, Robert Plaiano, our Treasurer, Brian Grenier, Investor Relations, Pete Sannizzaro, CFO of Annuities, and Kim Johnson, who now is with HIMCO. I'm sure some of you have peeked ahead in the deck. For those who haven't, we will provide a few updates on the third quarter, namely DAC, catastrophes, and market impacts, none of which should be a surprise to you. Our real goal here is for you to leave today with a better understanding of the steps the company has taken to reduce risk across the enterprise and explain why we believe we have the capital to support our risk exposures, even in adverse scenarios.
Welcome again to Hartford. With that, I'll ask Liam to come up and make a few opening remarks.
Thanks, Chris. Good morning, everyone. It's great to have you all here, and I do want to thank all of you for taking the time to travel to Hartford. We thought it was really important that you be here in our headquarters to experience us and our management team and our messages. As Chris mentioned, we decided to hold a session like this several months ago because, as he said, many of you have been quite open with us, and we do take your feedback very seriously. I'll make just a few brief opening remarks before I turn it over to the team. As we look ahead, we're realistic about the environment in which we're operating. The U.S. economy is growing very slowly, and any recovery is fragile. Recent economic news has shown some modest improvement, but job growth and consumer confidence are very challenged.
At The Hartford, we still don't see a repeat of the 2008 financial crisis, but the economy and the country have real challenges, and we are expecting slow economic growth at best for the balance of 2011 and at least through the first half of 2012. We are not counting on an economic recovery to drive near-term results and are aggressively managing the levers within our control, expenses, pricing, and risk management, for example, to effectively manage the company in this environment. As he mentioned, Chris will talk about capital in detail. We feel good about where we are, particularly when you factor in the economic headwinds, market volatility, and higher cat activity. As you'll see today, even in the adverse scenarios we've modeled, The Hartford statutory capital margins remain above our minimum capital threshold.
With the markets becoming significantly more volatile since our equity repurchase announcement, which was in early August, we've chosen the path of prudence and have not yet begun buying back shares. Of course, we'll watch markets and economic developments closely to determine when to best start with repurchases. We still expect to complete the program in early 2012. We're down a path towards significantly transforming The Hartford into a more effective, cost-efficient, and contemporary organization. One that is responsive to changing market dynamics and that takes a forward-looking, proactive approach to managing the business and its associated risks. Last week marked my two-year anniversary with The Hartford. When I look back at my first few weeks here, I was impressed with the company's strong brand, values, business franchises, talented employees, and enduring relationships with our distribution partners. All that continues to be true today.
There were also significant challenges to be addressed. One of the most important and foundational was The Hartford's approach and expertise in risk management. Since I've been here, risk management has been a critical priority for the organization and for me personally. When I first joined The Hartford, we had reasonable risk management processes within each of the business units. What was lacking was a full understanding and robust management of the firm's aggregate risk with transparency and control of risk appetite, correlations, and concentrations. This deficiency was part of what contributed to the significant capital stress the organization faced and highlighted why an outstanding enterprise-wide approach is so important. Clearly, even within the specific business areas, we could have done a better job managing risk. The fact is that the company's risk mitigation strategy was challenged by the extraordinary economic environment we were facing then.
In hindsight, it is clear that the company had too much risk in the investment portfolio, particularly in real estate instruments, and there was not enough hedging in place. As a result, the excess capital we held proved to be insufficient for the total exposure of the company. We are now managing risk in a very different way and have developed the company's capabilities and expertise. We've built a team of enterprise risk professionals who manage market, credit, insurance, and operational risks across the organization. We also formed a board-level risk committee comprised of the entire board that is very engaged on these important topics. Liz Zlatkus will speak more about the work that we have done shortly, but under her leadership, the enterprise risk management team has made very good progress.
As you know, Liz will retire before the end of the year, and I want to take a moment to personally thank her for the nearly three decades that she's devoted to The Hartford. Liz, thank you. I think it's important to note that we have a strong team in place under Liz, including Graham Bird, who's here with us today. Graham oversees enterprise risk management for market risks. You'll hear from him shortly, and both Liz and Graham will participate in the question and answer session. An external and internal search for Liz's successor is nearing completion. I am confident we will complete the search in the near future. The Hartford's approach to the investment portfolio is much more sophisticated and disciplined than it was two years ago.
You'll hear from Greg McGreevy today on the aggressive steps we've taken to successfully position the investment portfolio and build a high-performing operation at HIMCO. We now have an ongoing ability to review the portfolio under various stress scenarios, a rigorous re-underwriting process for securities, and the capability to understand trends in the global economy. We use that to take targeted, proactive actions as we've done, as you'll see in Europe and in our municipal bond portfolio as examples. Greg will share detail we believe demonstrates that investment losses, even under future market turmoil or severe stress scenarios, will be well within our capital resources. I want to make it clear, we are in a fundamentally stronger credit position compared to 2008. Another good example of how we're managing risk differently today is Japan.
The program that the team has put in place was developed in conjunction with the leading risk management consulting firm, Oliver Wyman. It was developed against thousands of potential market and economic scenarios and is tested and stressed regularly. I have confidence today that the Japan risk is now within the appropriate risk parameters for The Hartford. We'll close with Chris covering the balance sheet and capital strength, incorporating the data that will have been provided to you earlier in the day. He'll show why we are confident The Hartford can absorb additional capital stress while maintaining resources consistent with our current ratings. Since this is a session focused on the balance sheet, we will not be covering the strategy and the plans for the businesses.
At the Investor Day on December 8th, we'll cover the actions we're taking to improve profitability and generate ROEs in excess of the cost of capital over time. When we finish up today, my goal is that you share our beliefs that first, The Hartford's balance sheet is strong. Next, while challenges exist, our risks are significantly reduced and manageable. The Hartford's risk management capabilities are meaningfully enhanced. The Hartford has the strength to maintain sufficient capital levels consistent with current ratings, even under significant economic stress. Finally, management is running the company with discipline and a focus on generating value for shareholders. To sum up, The Hartford is well-positioned today for the possibility of an adverse market scenario. Thanks for your time, and with that, I'll turn it over to Greg McGreevy. Greg? Long walk from the back.
Thank you, Liam, and good morning, everyone. It's a pleasure to be with you today. I'm going to spend the next 25 minutes, as Liam said, walking through our investment portfolio. In doing so, I wanted to really focus on three takeaways from today's presentation. First, we've developed a very strong ability to manage our portfolio in a manner aligned to shareholders. Second, we significantly changed the composition and risk of our portfolio through balancing income, economics, and capital. Third, we're highly confident that we've taken actions over the last two and a half years that have resulted in a portfolio that is well-positioned to deal with economic uncertainty. To accomplish this, I've divided, as you can see on slide nine, today's presentation into three sections. First, I'm going to focus on portfolio construction.
This is going to provide you with some details on how we manage the investment portfolio, as well as actions we've taken to improve the credit quality of the portfolio and reduce correlated risks. Next, I'm going to cover performance. You'll see that we significantly reduced risk in our portfolio while maintaining strong investment income and economic returns, a very important thing when we look at our performance overall. Finally, I'm going to share with you results of our stress testing, as Liam indicated. Let's get started. When I came to The Hartford three years ago, I observed a couple of things. We had a number of very talented investment professionals that provided a foundation to build upon. At the same time, however, the investment process and decision making needed improvement.
It was not clear who was accountable for the key decisions around portfolio construction, and risk management was not integrated into the investment process. As a result, we had a portfolio that had high concentrations of correlated risk, as evidenced by our overweight positions to structured securities, real estate, and down in cap structure financials. These allocations were the primary drivers of the credit losses that we took in both 2008 and 2009. My first priority, given that, was to construct a long-term model portfolio designed to provide strong risk-adjusted returns, be consistent with the broad insurance industry overall, and within the risk tolerances of The Hartford. I think we've made significant progress in moving ourselves towards that long-term model portfolio. This progress has and will continue to be based on two items.
First, ensuring that we balance economics, income, and capital, a key part of our process. Second, that we overlay our view of economic formation against prudent trading decisions. In addition to setting a long-term model portfolio objective, we significantly made changes to our people, our process, and our platform, as you can see on this slide. These changes have strengthened our ability to generate strong risk-adjusted returns. We've made significant changes to leadership roles for a number of key asset classes. We put in place a dedicated portfolio management team responsible for monitoring high-risk securities. This team continually underwrites our view of fair value that we can then compare to market value that support our de-risking efforts in our portfolio. In addition, we've improved our investment process, decision making, and accountability.
Our new structure fully incorporates macroeconomic views and risk management into our portfolio management decision making, something that was lacking when I first came on board. Finally, we've invested both time and financial resources in our investment platform overall. We built sophisticated econometric modeling, as well as proprietary structured credit models. This enhanced credit modeling allows us to now underwrite our structured security portfolio on a very granular, loan-by-loan level basis, and has strengthened our overall portfolio management capabilities. These models and others in our process improvements are incorporated into our day-to-day surveillance of our portfolio. Said simply, we have the right people in the right jobs that have both clear accountability and appropriate tools to make prudent portfolio management actions that are aligned with you as shareholders. Now if we can turn to slide 12.
I wanted to spend a couple of minutes on our view of the economy, which as I told you before, informs our portfolio management actions. In order to determine relative value, our understanding of security and issuer fundamentals has to coincide with our expected view of the economy overall. Since early 2010, we've consistently projected two overarching themes. First, that in the developed markets, due to significant debt burdens, those markets would experience lower growth due to reduced government spending on a prospective basis. Specifically, we believed we would have a protracted time period of slow growth in both the U.S. and significant headwinds out of Europe. As the U.S. and Europe slowed, we would expect the global economy to contract given that 60% of global GDP comes from those two regions.
Against that backdrop, let me tell you what we've done in our portfolio since the end of 2008. Let's start with real estate overall, something that Liam mentioned and I mentioned at the beginning. We had a significant overweight in our portfolio at the beginning of 2008. In that portfolio, we had overweight positions in structured securities and subordinated loans at the end of 2008. We've reduced over that time period our real estate exposure by over $10 billion. CMBS was reduced by almost $7 billion, or about half of where we were at the end of 2008. This reduction was across different parts of the capital structure. We also reduced commercial mortgage loan portfolio by over $1 billion. Remember, most of the sales that were in that portfolio were in mezzanine holdings, which are the higher risk portion of that asset class.
Today, our mortgage loan portfolio is almost exclusively senior whole loans on solid commercial properties in markets that we like. Finally, we had over $2 billion of reductions in RMBS and REIT holdings. As we look at our portfolio today, I believe the quality of our real estate holdings has improved dramatically. We reduced our overall systematic risk. Our average credit quality on real estate assets has improved and remains strong. As you can see from this slide, one of the most important things we look at is our market to book value ratio on this segment has improved dramatically over the last couple of years. We took a large portion of the cash from that de-risking from real estate and invested it in high-quality corporate bonds.
This was an area in corporate securities what we believed offered good relative value and was also a significant underweight from a portfolio standpoint when I joined the firm. We focused our purchases on companies that were well-positioned for slow economic growth. At the same time, we sold high beta or economically sensitive names. For example, when prices improved dramatically in financials, we took the opportunity to reduce our deeply subordinated holdings by over $2.5 billion. As we look at our financial exposure today, we think it's well positioned to global firms that are systemically important to their region, as well as to the global economy.
As a result of our action, we maintained our overall credit quality despite the level of downgrades that occurred by the rating agencies, and our market to book value has increased dramatically, primarily due to portfolio construction and lower interest rates. Let's turn to the muni portfolio for a minute. While our allocation to municipals was in line with our long-term model portfolio, we also proactively looked to reposition by improving both the composition and quality of that portfolio. As mentioned previously, our expected view of slower economic growth was believed to impact overall tax receipts. As a result, we focused purchases on general obligation bonds in high-quality states, as well as revenue bonds from essential service segments. These purchases were higher up in the waterfall of uses of tax collections, as well as on services that will always be needed, like sewer and water.
We also reduced exposure to insured bonds due to potential credit concerns, as well as pre-funded securities, which we believed offered little relative value in the muni market. Again, we improved our credit quality, while at the same time, like other asset classes, we saw a significant increase in our market to book value over that time period. Finally, given the view that I had mentioned on Europe before, you would expect us to take action in Europe and we did. We made significant rebalancing decisions in our European holdings within the general account. Today, we have no direct exposure and essentially no bank exposure to the higher risk countries in Europe. Our financial exposure is limited to the largest and most important banks in stronger European countries. Our subordinated bank exposure overall has been reduced dramatically and is now at around $600 million.
This exposure, again, is to strong multinational banks that are integral to the global economy. If you look at the remainder of our holdings in Europe, we primarily invested in multinational companies with strong balance sheets and a global revenue base. Because of our actions and holdings, our portfolio has held up well against the backdrop of the turmoil that we've seen in Europe. You can see on slide 16, our European holdings were in an overall gain position at the end of August of this year. Taken together, our actions have significantly strengthened the quality of the general account portfolio. We've moved closer to our desired long-term model portfolio. We've reduced our risk profile overall, and concentrations in those asset classes that I talked about at the beginning have been reduced, while at the same time increasing our overall credit quality.
Portfolio reposition clearly is going to be something we're going to do on an ongoing basis, but we feel good about the portfolio actions we've taken to date. We'll continue to incorporate our views of economic formation while balancing income, capital, and risk-adjusted returns. That's a lot of reposition that we've done. Now let's take a look at how we've performed over the last two and a half years. When we think about performance, we measure it really in three ways: net investment income, realized and unrealized gains and losses, and total return. We believe the combination of these factors helps drive shareholder returns over time. In terms of net investment income, our portfolio results are strong. We've seen an increase in net investment income despite declining interest rates and our de-risking actions that I mentioned before.
The main contributors to these favorable results have been strong alternative returns, good relative value decisions that we've made within our portfolio, and a focus on ensuring that we balance income in our de-risking actions. As you would expect, our de-risking actions through both sales and impairments have significantly lowered credit losses. Year to date 2011 impairments are around $120 million, which compare very favorably to the impairments that we took in 2010. Also very favorably to the almost $2 billion of impairments that we took in 2009. Included in that number for 2011 is around $60 million of impairment that we plan to take in the third quarter of this year. We're pleased with the powerful downward trend of credit losses in our portfolio. As you can see on slide 21, our gross unrealized loss position has also improved.
Improved by about $12 billion since the end of 2008. This is a result of lower interest rates as well as de-risking actions and impairments that we took in our portfolio. We saw a significant improvement in both structured and non-structured securities over that time. At the end of August, our portfolio was in a net gain position of $2.1 billion pre-tax. I wanted to break that down a little bit from that $2.6 billion that you see on the slide of gross unrealized losses. $900 million of that $2.6 billion is on non-structured securities. These assets are almost all longer-dated variable rate corporate bonds and municipal bonds. The remaining two-thirds are about $1.7 billion is in our structured security portfolio. Within structured securities, these unrealized losses are in a variety of different asset classes, most of which have materially re-priced over the last couple of years.
Based on our modeling and analysis, we certainly would expect further price recovery on these securities over time. Indeed, we've seen market values start to move towards our fair valuation that we've done in our portfolio over the last couple of years. What's really important to note, as I mentioned before, we've significantly improved our structured securities modeling, our underwriting, and our surveillance capabilities to evaluate and make decisions on these assets. Let's turn to slide 22 and look at total return relative performance. For us, the total return is an important risk management and assessment tool. It allows us to compare our portfolio to similar liability-driven benchmarks on a real-time basis. It also allows us to compare our portfolio against the best and largest fixed income managers in the world.
These results demonstrate in my mind how well, at the end of the day, we're making economic-based decisions. We've selected here a representative benchmark of core and core plus managers that serve as a useful reference point to evaluate our performance. On a cumulative basis, as you can see on the bottom of that chart, we outperformed the Lipper Median Peer Group by 6% over that time period, which would put us in the top 10 percentile of leading fixed income managers. At the end, the combination of strong net investment income, improvements in both realized and unrealized losses, as well as strong total return, has significantly added to shareholder value. We feel good about our performance overall and our de-risking actions we've taken to date. We also need to continue to look at our portfolio and how it could perform under different economic conditions.
Let's recap today's portfolio as a starting point. Our general account portfolio is well-diversified, with strong liquidity, and is of high quality. As of the end of August of this year, we are in an unrealized gain position, as I mentioned before, of $2.1 billion. We have ample liquidity with 8% of our portfolio in cash and treasuries. Despite significant rating agency downgrade, the portfolio's current rating is at A-plus. We repositioned over $14 billion of securities consistent with our long-term model portfolio, with notable reductions in subordinated securities, structured securities, and down in cap structure financials. The average market-to-book value of our remaining structured securities is at 91%, an absolutely significant improvement from the 63% that we saw at the end of 2008. Let's move to potential credit losses. We look at a variety of different scenarios and assumptions in stressing our portfolio.
Today I wanted to focus on three model scenarios. Each of these scenarios is aligned with different S&P levels for ease of comparison. I'm not going to get into all the detailed assumptions. You can look at that on slide 25. Instead I wanted to highlight a couple of very important points. First, the assumptions for these scenarios were built on macro views, including GDP, unemployment, and real estate valuations. Our base case is not an optimistic economic projection. It includes slow economic growth consistent with what I mentioned before, with persistently high unemployment. Nonetheless, it does represent our best assessment of where we think the global economy is headed. Despite this economic outlook, we remain hopeful that both leaders in Europe and the U.S. will take appropriate fiscal and monetary action to help drive future economic activity.
Let's move to the stress test outlined on slide 25, and you'll see that our assumptions for the stress scenario are considerably worse than what I just mentioned. We assume in the stress scenario that the U.S. slips into a protracted recession with unemployment that rises and stays there above 10%. Recovery in that scenario doesn't begin until late 2013. As you would expect in such a significant market downturn, real estate values also decline. The results of these model scenarios are on slide 26. Let's look at those for a minute. In our base case, we project we could see $450 million of credit losses in the next two and a half years. Potential losses in a stress scenario would likely not exceed $1.25 billion. These projected losses for all of these scenarios are on a pre-tax basis.
Chris, later in the presentation, is going to provide more clarity on capital impacts on investments. In all of these cases, we'd expect losses to emerge predominantly from our structured security portfolio. As I mentioned before, represents the largest portion of our unrealized loss position. Before I move on, I wanted to remind you that the economic conditions we project in a stress scenario are severe. They include significant deterioration in current economic conditions, which also are quite volatile. We've included loss projections in our stress scenario really to provide transparency of how credit losses may develop in our portfolio in a protracted recession. There's been a lot of discussion around interest rates of late, a lot of news articles that are coming out in the media.
We felt it was going to be important to spend a couple of minutes talking about the impact on our net investment income, given a protracted period of low interest rates. That said, we expect that the Federal Reserve actions and the slower economic growth that I talked about will likely keep rates low for some time. If the 10-year Treasury and the five-year Treasury rates remain flat over the next several years, the impact on our net investment income is quite manageable. Over the next few years, we are going to expect to invest in our portfolio about $7.5 billion annually in new cash flow generation. If we did that investment of $7.5 billion at current new money rates, we would see lower after-tax core earnings in the range of about $50 million-$75 million in 2012.
We would expect this impact to not exceed $150 million in 2013. Really important to remember that these assumptions assume no change in credit spreads and that no management actions would be taken. Let's turn to slide 28, where I'll detail some of the actions we have or can take to mitigate the impact of lower interest rates. First, we've already started, as I think we've mentioned on several calls before, to increase our holdings in alternatives investments. This is investing in strategies that will perform well despite the low interest rate environment. These strategies provide solid, uncorrelated returns in different capital market scenarios. Such allocations to alternatives will be in the form of private equity and hedge funds. We have a very strong capability within the organization that has invested in these areas with success for some time.
Second, we've shown an ability, as I mentioned in my performance slide, to make good relative value trading decisions within the portfolio on a consistent basis. Third, we have liquidity in our portfolio that can be used to purchase attractive, higher yielding assets when the time is right. Finally, the organization will continue to look at product pricing decisions across all of our businesses to make sure we're earning reasonable returns in light of current market conditions. Finally, in closing, I wanted to reiterate a couple of very key critical points. This is not the same investment portfolio or investment team that was in place during the financial crisis. The risk composition of our portfolio is vastly different. We have a laser focus on improving portfolio quality while balancing income, economics, and capital.
Our portfolio, we believe, is well-positioned to deal with economic uncertainty in a low interest rate environment, and we're quite confident that in a significant market downturn, today's portfolio will have significantly lower loss emergence than what we saw during the financial crisis. I wanted to thank you for your time, allowing me to share some views on the investment portfolio and our results. I look forward to having lunch to answer any questions that you have at a later time. Now I wanted to turn it over to Liz.
Thank you, Greg. It's a real pleasure to be here with you this morning to talk to you about a subject that I really do feel pretty strongly about, and that's the progress that we've made in advancing the company's risk management capabilities. I know Liam talked about it and Greg did, The Hartford, along really with the entire financial services industry, clearly learned lessons from the past financial crisis. I saw them firsthand. Armed with those learnings, we did change our risk management approach to ensure we better manage risks, both at the individual level and at the enterprise level. Let me provide some specific examples of what's different today at The Hartford. In the interest of time, I'm not going to cover every risk area.
Rather, in light of some of the challenges of the past, I'm going to highlight two areas, risk management around credit and variable annuities. Suffice to say, however, we do have improvement over our other major risk categories. That being insurance, operations, and market risks. The broader market risk, which includes interest rate, equity, and currency. I know Greg spoke a lot about credit, I'm just going to give you a view from the enterprise, how we're having additional governance around, for example, variable annuities and credit. As to our approach to credit understanding and managing that risk, it's definitely more sophisticated and disciplined than it was several years ago. Certainly, Greg just spoke of the changes that we made, both to the general account portfolio and all the de-risking, and the people and the processes and systems within the investment operation.
Our credit risk management, I think you've heard, is clearly essential tenet to the investment process at HIMCO. In addition, we have more transparency and controls on credit exposure at the enterprise level. For example, we expanded the framework around how we measure our individual and aggregate credit risk limit against limits. We looked not just at potential ultimate losses, but we also look at credit spread volatility and compare that to our limits. We strengthened our internal ratings methodology for determining credit worthiness. Greg spoke of that, particularly on structured securities, but we've done that more wholesale. We also have substantially increased our independent validation of our models and the tools that we use to measure risk. We have back-tested our assumptions, analyzed our correlations, we regularly subject the portfolio to significant stress scenarios.
In some of our back testing, we went back and looked and said, "Is our new methodology, would it have captured much of the risk that did emerge?" The answer was yes. In addition, though, to monitoring the absolute level of credit risk in the portfolio, we review it relative to the risk that is in our long-term model portfolio. What does that really mean? It means that I, CRO, and my team now independently can monitor changes to the investment risk profile and the component drivers of that change. Again, just that independent view. Again, while individual credit risk underwriting responsibilities lie with Greg and his team, we have strong governance and oversight at the enterprise level. Now let's talk about VA.
We certainly have significantly upgraded our capabilities and substantially increased the level of hedging that we now have on our global variable annuities book. We now have a robust and dynamic hedge program that's designed to limit our losses under severe market conditions. I'm not going to go into further detail on this, as Graham will be really covering that in detail today. Just the ability for us to see the market value changes every night on a global VA book is certainly an enhancement. What else did we change? We changed how those were two specific areas that we have oversight on, but how do we just look at it from a total enterprise level? We changed that by building a strong and independent risk management organization. Liam referenced that.
We enhanced our tools and capabilities, again, at the enterprise level, we strengthened the governance throughout the firm. Let's turn to the next slide, 32, to dive a little bit deeper into those three areas. My position as Chief Risk Officer was elevated to report directly to the CEO, Liam, with independent access to the board. This enables the ERM organization to have oversight of risk independent of the business, it certainly ensures that long term we have a seat at the table for strategic risk decisions. One of my first priorities was to restructure and expand the ERM organization. We appointed dedicated Chief Risk Officers for each of our major risks. You can see, you're going to hear from Graham Bird, who's in charge of all market risks for the firm.
We have an insurance risk officer, an operational risk officer, and a chief investment risk officer. Basically, we just increased their focus. Let me give you an example. Before, when we looked at insurance risk, we certainly have lots of people in the P&C operation today, our consumer and commercial, that would have been evaluating insurance risk and that on the life side. Now it's called wealth management. What we've done, though, is we have one individual who looks at, for example, mortality or morbidity risk in total. We still have all of our underwriting processes within the line, but now we have someone dedicated that's always looking at the aggregate level of risk. Of course, my team, in addition to their primary responsibilities, they work together to ensure that we're seeing risk holistically.
It's just a lot more independent and focused by risk category rather than looking at it more by line of business. Again, still having risk within the lines. What else did we do? We also deepened our bench strength. We hired over 50 net new hires from the out with diverse backgrounds in capital markets, investments, insurance, and risk. Turning to slide 33, we implemented more robust risk measures across the enterprise. We more routinely look at our risk through three lenses, so economics, GAAP, and stat. Again, we had those capabilities, certainly GAAP and stat we had, but the capabilities on economics, we've really enhanced. You're going to see that in the work when Graham talks about risk management around global VA. Our scenario and stress tests include enhanced correlation and metrics, particularly around market and credit.
Of course, we also model correlations to non-market events. We've updated and expanded our economic capital model. As you know, there's a lot of talk about economic capital these days, and how we see it is it's another lens into our risk. Very fulsome process, and we use it to really inform risk-return decision-making across the enterprise. Risk management is also stronger today. Excuse me, risk governance. I think that's a really important point is how do you govern and act around risk, not just what's your model say, but what are the actions you take every day? As Liam mentioned, for the Finance, Investment and Risk Management Committee, our FIRMCo is comprised of our full board, and it does convene every board meeting. The dialogue is robust and focused on the key issues facing the firm, and I can tell you that firsthand.
It's a very wholesome meeting every single board meeting. We also have other formalized risk committees. The main one would be the Enterprise Risk and Capital Committee. This is the senior committee chaired by Liam, and it's comprised of the senior leaders from business, finance, investments, and risk. This committee approved the firm's overall risk appetite and all of the cascading tolerances and limits for all of our major risks. These policies and limits ensure that we manage the firm within our risk appetite under various market conditions. As you would expect, we have other committees. We have emerging risks, we have asset liability committees, et cetera. Of course, we had a lot of that before. What's different is just the focus has been increased. Accountabilities are clear. There's more what do we do if events happen? Who's in charge? What actions will be taken?
Again, while all these steps are critical ingredients to an enhanced risk management function, I believe it's the day-to-day change in how we operate that matters most. These new policies that I've mentioned contain certain mandates that require us to take action when limits are breached. A real life example occurred earlier this year. We breached a currency limit that we had set as we were building out our Japan hedge design. No debate occurred about was the yen going to strengthen further. Rather, more hedging was put on that day. Accountability was clear, and action was taken. Clearly, we recognize risk is ever evolving and that it requires really a culture of continuous improvement and continuously challenging the status quo and assumptions. While much work has been done, there will always be more to do, and we are dedicated to continuous improvement.
To summarize, clearly, we learned from the past. We took strong actions and reduced risks. We created a much higher level of independent oversight, and we've truly upgraded our risk management practices. This will be my last meeting with investors with all of you today, as I retire from my 28 years of service with The Hartford at the end of this month. I just truly enjoyed my career at The Hartford, and I could say so much about the wonderful people and experiences I've had, but that would take too long. Instead, what I will say is that I leave the company knowing it is stronger, that risk management practices and governance have been enhanced, and that my team is seasoned to taking risk management to the next level. That, I'm going to introduce our Chief Market Risk Officer, Graham Bird.
Graham joined The Hartford in May of 2010. He does oversee all of market risk for the enterprise, as I mentioned earlier. He has held various senior business and risk management leadership positions with leading financial institutions. His extensive background in both trading and risk has really been invaluable, and he's just been such a great addition to our enterprise's management function. I'm very pleased to turn it over to Graham. Thank you.
Thanks, Liz. I am pleased to be here and have this opportunity to provide greater insight into our VA portfolio and risk management. I have three main messages this morning. Firstly, we have in place a comprehensive approach to manage our global VA risk. Secondly, we now have a robust dynamic hedging program for the closed block in Japan. Thirdly, we are hedging more of the market risk embedded in our VA guarantees. My agenda this morning is straightforward. By way of background, I will briefly address the global VA portfolio characteristics and our approach to risk management. I'll review the Japan portfolio. This is where we get many investor questions, so I'll spend some time to help you understand the Japan VA product and associated risks. Finally, I will cover the dynamic hedge for Japan in some detail.
Implementation is advanced, and we remain on track to fully implement the hedge by year-end. We have a lot to cover. Let's get started. In total, we have over $100 billion of global VA assets under management. Almost 70% of the VA assets relate to our U.S. business. Most of the remaining 30% is our Japan VA block. The core objective of our risk management is to ensure total risk exposure remains within our risk appetite and tolerance. We use a variety of risk mitigation strategies, including product design, reinsurance, and capital markets hedging. Beyond this, our risks are backed by net income and capital. Finally, we measure and monitor risk through three lenses, economic, statutory, and GAAP. Let's take a closer look at the evolution of our risk management on slide 38.
GAAP, stat, and economic views have always been important to us, and all three continue to be relevant. The balance or weighting of these factors has, however, changed over time. Initially, GAAP was our main focus. During the financial crisis, statutory efficiency became a more dominant consideration. Going forward, economics will be our primary target, although economic targets do of course remain subject to statutory considerations. We have stress tested our VA portfolio for many years. However, stress testing today is more comprehensive. It fully addresses concentrations of risk and correlations between our portfolios. Finally, the scope of our risk management has expanded. Initially, we were U.S.-centric and now risk portfolios in Japan and Europe are fully addressed. In summary, our risk management approach today is comprehensive with a greater focus on programs that more precisely target our liabilities. Slide 39 provides greater detail on our U.S. VA business.
We have $72 billion of assets under management, and the portfolio is split roughly 50/50 between products with a death benefit only and products that have both a living benefit and a death benefit. Separate account returns in the U.S. roughly follow the S&P 500 because over two-thirds of the assets that back the policies are invested in equities. The bullets on this slide show the evolution of our U.S. VA risk management. Our initial VA products were highly successful. To manage the associated risk, we moved quickly to put reinsurance in place. However, market capacity for reinsurance turned out to be limited. In 2003, we instituted a fully dynamic capital markets hedging program designed to cover the market risk associated with the withdrawal benefit or GMWB option. Under this program, we rebalance hedges against the risk sensitivities or Greeks of the FAS 157 liabilities.
Since I have been at The Hartford, I have had the opportunity to look at the performance of the hedging program. I can tell you that the program has been successful over time, and that we do have effective modeling, risk management, and trading capabilities in place. As Liam mentioned, it became clear through the financial crisis that The Hartford had retained too much risk. While the GMWB hedge more than covered the statutory impact of that risk, the retained death benefit was mainly unhedged. To address this in 2008 and 2009, we did two things. We changed the GMWB hedge targets to further protect statutory capital, and we added macro hedges. The move towards greater statutory efficiency supported our surplus position at year-end 2008 and continues to provide statutory protection today. As we expected, the revised hedging targets increased GAAP net income variability.
The GAAP variability we have seen since 2008 is largely due to the level of hedging on GMWB, and the difference in the accounting treatment of hedge assets and the GMDB liabilities. Let me summarize where we stand today on U.S. hedging. As we measure it, approximately 80% of the economic market risk associated with the U.S. GMDB and GMWB guarantees is now hedged. We do retain the majority of policyholder behavior risk, and we are likely to do so for some time, given limited reinsurance capacity. VA hedging programs also support statutory capital. Chris will cover this when he discusses enterprise capital sensitivities. Slide 40 gives an overview of our Japan VA portfolio. As you can see in the pie chart, the vast majority of policies in Japan have both a guaranteed minimum income benefit or GMIB and a guaranteed death benefit.
The guarantees in Japan are more limited than those sold in the U.S. First, the guarantee is only a return of premium. There are no roll-ups or step-ups, and no lifetime income guarantees. Second, customers in Japan have fewer options. Contracts have a minimum 10 year deferral period, and most have a 15 year payout period. This is not to say the portfolio is without risk. Income and death benefit guarantees are denominated in JPY, while the separate account assets are invested in a mix of global bonds and equities. This means that the Japan block has a significant currency risk in addition to equity and rate risk. With that overview, I'd now like to look at the Japan VA products and risks in more detail. On this slide, I've provided a simple representation of a typical Japan policy. At issue, the customer pays us JPY 1.5 million.
This amount is invested in a separate account. Through the deferral period, the separate account value fluctuates with market conditions. In this example, markets decline and the value of the account falls below the original principal amount. If the policy lapses during the deferral period, the customer receives only the value in the separate account, less any surrender charges. After 10 years, the policyholder has more choice. He may choose to withdraw the account value, in this case JPY 1.2 million, without penalty. He may choose to receive his principal back in equal annual installments over the 15 years. Or he may defer annuitization and retain his income and death benefit guarantee. Once the customer decides to take his income benefit, JPY 1.2 million is withdrawn from the separate account and invested in the general account.
The customer will receive his original principal back without interest in equal annual installments over the next 15 years. In this case, JPY 100,000 per annum. All of the investment income that The Hartford earns on the funds in the general account can be used to fund our obligations. We clearly have time on our side. Before leaving this slide, I want to briefly address the concept of net amount at risk or NAR. NAR is simply the difference between the guarantee and the separate account value for in-the-money guarantees. In this example, the GMDB net amount at risk at the end of year 10 is JPY 300,000, being the difference between the death benefit guarantee of JPY 1.5 million and the account value of JPY 1.2 million. The GMIB NAR at year 10 is also JPY 300,000, since the customer can elect to receive their full principal back over 15 years.
The GMDB NAR and the GMIB NAR is not additive. A customer can collect either the guaranteed death benefit or the guaranteed income benefit, but not both. With that as background, let's now take a closer look at some of the net amount at risk numbers we publish in our financial statement. We get a lot of questions on retained net amount at risk. I want to take a minute to explain what retained NAR is and what it is not. At The Hartford, retained NAR is the difference between the guarantee and the account value for all in the money accounts offset by reinsurance. Retained NAR is not a good measure of true risk. A simplistic NAR calculation significantly overstates The Hartford's retained risk for several reasons. First, GMDB NAR assumes all policyholders die on the valuation date. Clearly unrealistic.
Secondly, GMIB NAR does not reflect the investment income that the company can earn during the payout period. Finally, retained NAR reflects reinsurance, but not hedging. The NAR data in our financial supplement provides investors a directional proxy for changes in GMIB or GMDB liabilities. As you can see in the table, Japan's retained net amount at risk dropped by $400 million in the year ended June 2011. You might have expected the NAR to decline more rapidly, given the market rebound over the period. The primary reason we saw only modest declines in NAR was that positive returns on the separate account were largely offset by yen strengthening. A stronger yen increases the value of the guarantees relative to the underlying assets. To sum up, NAR is not a good measure of economic risk.
The trends in NAR can be used as a directional proxy for changes in value of the underlying guarantees. We believe that many customers will elect to begin income payments once they are eligible, since virtually all of the contracts are in the money. We have reflected these assumptions in our reserving and modeling. The chart on this slide shows the account value by year of initial income benefit eligibility. This information, along with the current net amount at risk for each year, is in our 10-Q. The point that I would like to highlight is that we do have some time for markets to recover. In fact, more than 55% of policyholders are not eligible to receive income benefits until 2016 or later. Once income benefits start, they are paid out over many years, and our risk profile changes significantly. Funds move from separate account to the general account.
Separate account equity and currency risk exposure ceases. Death benefits and policy fees cease. Primary risks shift to credit and rates similar to a period certain fixed annuity. The diagram on this slide provides a simple, stylized representation of movement of assets from the separate account to the general account. Time is on our side. Pre-annuitization, account values could recover. After annuitization, all of the net investment income we earn on the general account can be used to fund future income payments. As a matter of fact, if the separate account grew by 2% per annum net of fees, and we earn 2% per annum on the balance in the general account during the payout period, the policy holder funds plus the investment income is sufficient to meet all benefit guarantees.
With that overview of the policy benefits, let's talk about the advances we've made in our risk management approach for the Japan portfolio. We now have all of the analytical tools and models we need to manage a dynamic multi Greek hedging program. We have evaluated a number of approaches to transfer or mitigate the Japan risk, and we firmly believe that our dynamic hedge program provides the best risk return for shareholders to date. The Japan hedge program is comprehensive and robust. Essentially, it is very similar to our GMWB program that we have been running successfully for seven years. It also addresses the currency component associated with our Japan VA block. The program covers major market risks, and it employs a wide range of financial market instruments. Option cover will balance the trade-off between the cost of implied volatility and the related dynamic rebalancing costs.
The benefit of gamma and jump risk protection increases as we approach annuitization and there is less time for markets to recover from any discontinuity. Our use of options cover will reflect this. Hedges are dynamically rebalanced against a range of preset risk sensitivity or Greek limits. Liz already mentioned the significant investment in our ERM resources and capabilities. Our hedging is subject to complete risk management oversight, including regular stress and scenario testing, to ensure the impact of adverse market conditions remains well bounded and within risk capacity. In effect, what I've described and what has been implemented is what you would expect to see from a robust, well-managed dynamic hedge program. There is an additional component I also want to address. With the Japan block in run-off, we are doing extensive run-off cash flow stress testing.
Our goal is to ensure that our hedging program delivers realized cash flows within our risk tolerance, even under adverse market conditions. We project all cash flows associated with the run-off, including fees, claims, and expenses, and the benefits and costs of our hedging programs. The cash flow projections and run-off stress tests extend out over 15 years. Our aim here is to ensure that run-off costs or net unfunded cash flows remain well bounded within our risk tolerance. Let's take a closer look at our approach. This slide shows a stylized representation of the components of cash flow run-off. The green bar represents the contract fees net of expenses. The gray bar represents the cumulative benefit payments under the income or death benefit guarantees. We earn investment income on the general account during the annuitization phase, the light green bar.
We have payoffs and costs from our hedge program and existing reinsurance, represented by the light blue bar. Together, these items constitute a simple representation of the cumulative cash flows of our Japan VA block as it rolls off our books. By way of summary, modeled cash flows are cumulative over 15 years, independent of any accounting regime, pre-tax, and not discounted. The Japan hedge strategy is designed to limit net unfunded cash flows, even in very adverse market scenarios. Net unfunded cash flow is the difference between cumulative cash flows and the on-balance sheet financial resources supporting the block. The on-balance sheet resources are represented by the solid blue bar. They include our Japan VA statutory reserves, whether held in the U.S. or in Japan, and the statutory surplus in Japan. We model cumulative cash flow and any net unfunded cash flows across a wide range of different scenarios.
Slide 51 shows that in a benign market scenario, net cash flow is positive. The chart on the left shows the market assumptions underlying this benign scenario. The scenario run was performed on August 31 policy and market data. In terms of market developments, we assume interest rates follow August 31 market implied forward rates. For example, the Japan 10-year swap rate is 2.4% after five years. The U.S. dollar/JPY exchange rate is held flat at JPY 76.5, and the equity market has been set to grow only at the current swap level, such that the S&P is at 1206 after five years, and the Nikkei at 8424. While I have labeled this scenario benign, I expect a number of you may consider this actually a rather harsh scenario. Cumulative cash flows on this scenario are negative $2.1 billion, which is offset by our June 30 reserves and surplus.
The net cash flow on this scenario is positive $1 billion. Even in an adverse market scenario, the net unfunded cash flow is manageable. This slide follows a similar format to the previous one, albeit with more severe market assumptions. This time, we assume interest rates move down from their August 31 levels by 100 basis points and remain flat thereafter. Resulting rate levels are floored at 50 basis points. For example, the Japan 10-year swap is held at 0.5%. The JPY strengthens by 20% against the U.S. dollar to JPY 61, and this is held flat. The equity market is modeled to decline to an S&P of 741 over the next four years and remains flat thereafter. I'm sure you will agree that this is indeed a very severe scenario. The net unfunded cash flow on this scenario remains very manageable at $700 million.
During the development and calibration of our Japan hedge program, we performed many cash flow runoff stress tests. While this scenario is indeed severe, some scenarios could produce larger net unfunded cash flows. This could occur, for example, when market levels are less stressed but follow a path that leads to higher hedging costs. Our program requires regular stress testing of runoff scenarios to ensure that any net unfunded cash flow remains within our risk tolerance. You will appreciate even from the two simple runs that I have shown today, that our hedge program is designed to significantly reduce the convexity impact of adverse market conditions on the unhedged Japan guarantees. Indeed, as market conditions deteriorate, more hedging is required to protect our risk tolerance, such that in very adverse scenarios, all guarantee liabilities are fully hedged.
To reiterate, our hedge design and dynamic rebalancing narrows the range of potential cash flow outcomes, keeps net unfunded cash flows within our risk tolerance, and because we retain some risk, it allows us to benefit if markets recover. To summarize, we have an effective dynamic hedge for the Japan business. The hedge is robust and is designed to limit any unfunded runoff cash flows to within our risk limits. The program is subject to ongoing scenario and stress testing, including cash flow runoffs. The hedging already in place has been effective, providing protection during the most recent downturn in the financial markets. As we measure it today, more than 90% of our required Japan hedge is in place, and program implementation is fully on track to be complete by year end.
Before I pass the podium over to Chris to address the GAAP and the statutory accounting implications associated with our VA hedging, I'd just like to return to my three key points. We have a comprehensive approach to manage our global variable annuity risk. We now have in place a robust dynamic hedging program in Japan, and we are hedging more of the market risk embedded in our variable annuity guarantees. We are pleased with the progress we've made and the level of protection we now have in place. Thank you for your time, and now I'd like to ask Chris to talk about the stat and GAAP implications. Chris?
Morning again to everyone. Thank you, Graham, for taking us through a very critical and highly complex topic that is important to the company. I believe the entire risk management team has made meaningful progress towards our objectives in this area. Let's wrap up the Japan discussion. As you may recall, every third quarter, we perform an annual review of assumptions underlying estimates of gross profits that are used to calculate DAC and SOP reserves. As part of this year's assumption review, we incorporated an estimate of the long-term costs associated with the Japan hedge program into our accounting model. The estimated long-term hedge costs are 70 basis points and resulted in a DAC unlock charge of approximately $245 million after tax. This charge will not be recorded in core earnings since the hedge costs are reported in realized gains and losses, which are not part of core earnings.
As these costs are reflected in future earnings, return on net assets on a net income basis will be about 35 basis points lower. Just as a reminder, we start with a product in Japan that has approximately 70 basis points of ROA. Of course, the actual returns will fluctuate as mark-to-market impacts flow through the income statement. We also updated other assumptions that resulted in $135 million after-tax benefit to core earnings. This was primarily due to favorable policy holder development. The Japan hedge will also impact our third quarter statutory results with the incorporation of the strategy into the reserve calculation. We estimate this impact to consume statutory surplus of approximately $250 million. In addition to the DAC impact, the Japan hedge program will result in GAAP earnings variability.
This variability is the result of the hedge assets being marked to market reflected in realized capital gains and losses. However, the liabilities being hedged are not marked to market. The chart on slide 58 reflects a simplified view of the GAAP sensitivities. As you can see, the sensitivities have increased over the year. This is due to increases in the hedge program as well as movements in the capital markets over the course of the year. On slide 58, these are only the sensitivities for the Japan program. We will include updated GAAP sensitivities for all our global VA hedging programs in our third quarter 10-Q. I did notice a lot of attention being paid to the last section, I think we'll take a break right now.
We'll regroup in 15 minutes. Then when we come back, I'll provide an update on the third quarter. We'll finish the discussion with capital and our sensitivity. 15 minutes, we'll be back. Why don't you grab a beverage and we'll get started here and finish up with the Q&A. Then we'll break for lunch. We have time. Don't rush. All right. Welcome back, now that you're ready to go. Let's start with third quarter updates. With the quarter just ended, we are still updating the third quarter DAC impacts. As you can see on slide 60, as a result of our annual assumption review, we will report an unlocked charge of $230 million after tax to net income and an unlocked benefit of $20 million after tax to core earnings.
Japan was about $110 million of the net income charge. The remainder was in the other segments. In addition to the assumption update, we also reflect impacts of actual market levels, which have decreased since the second quarter close. Using the midpoint of the sensitivities highlighted here, we would estimate a core earnings charge for the third quarter of $250 million. Combined with the impact of assumption changes, this results in a core earnings DAC unlock charge for the quarter of approximately $230 million after tax. The net income charge for the quarter is estimated to be approximately $500 million after tax. We are still compiling results for the quarter, I wanted to share a few additional items with you. We are estimating our catastrophe losses for the quarter to be approximately $200 million pre-tax, or $130 million after tax. Roughly half these losses relate to Hurricane Irene.
As it relates to prior year reserve development, two items to note. First, we completed the annual environmental reserve study, which resulted in an increase to reserves of $19 million pre-tax. This was primarily due to increases in severity on a small number of the insureds. Secondly, for our ongoing operations, we recorded net favorable prior year development of approximately $21 million pre-tax. With respect to investments, the net unrealized gain in our investment portfolio increased approximately to $2.6 billion at the end of September 30th, largely due to lower interest rates. As it relates to statutory surplus, with equity markets down 14%, the JPY strengthening and historically low interest rates, because we are not fully hedged on a statutory basis, expect a decline in statutory surplus for the quarter.
Some of the additional factors that will impact statutory surplus include the previously mentioned impact of the Japan hedge of approximately $250 million, our normal quarterly dividends from the property casualty companies of $200 million, $130 million of cat losses after tax. Turning to slide 62. We also wanted to provide you with an initial estimate of the impact of adopting EITF 09-G, which redefines the criteria for determining the acquisition cost that can be deferred. We will be adopting this new accounting guidance January 1st, 2012. We will apply it on a retrospective basis. This means that we'll recast all prior periods under this guidance. We estimate our DAC balance will be reduced by approximately 22%-26%, or a diluted book value per share reduction in the range of $2.78-$3.38.
This charge will be recorded directly against shareholders' equity, net 2012 earnings, and it will have no statutory effect. It's premature to quantify the run rate impact to future earnings, but in general, we do not expect it to be material. DAC amortization expense will be reduced. This is positive to earnings, but the amount of cost that can be deferred will also be reduced, which is negative to earnings. With that, let's take a step back and take a broader view in discussing capital management. I thought it would be helpful to look back over the last two years and put both the environment and our activities into perspective. First, from a macro view, the economic environment has been challenging with low interest rates, equity market volatility, and a stronger yen. We have also seen increased expectations regarding appropriate levels of capitalization.
This is true throughout the whole financial services industry, including the insurance sector. There has also been a recalibration of insurance ratings, our cat experience, and the de-risking of VA products in general. At The Hartford, we have taken a number of steps. We've refinanced the CPP funds with a successful capital raise. We paid down debt, repositioned the investment portfolio, and expanded our hedging of our variable annuity risk. We have also maintained strong capital resources while increasing our capital management activities, most recently announcing a $500 million equity repurchase program. Turning to slide 64, excuse me, 65. Let's look at our capital resources. At June 30th, we had approximately $16.9 billion of statutory capital. This includes the $1.3 billion in Hartford Life Insurance K.K., our Japan legal entity, a fact sometimes overlooked. Holding company liquidity is also strong at $2.1 billion as of August 31st.
This includes funds for the $400 million debt maturity later this month. We continue to actively manage our capital resources. As I mentioned, we announced our equity repurchase back in August. However, given the economic and capital market environment, we have not yet begun the program. We will continue to be prudent and assess market conditions as we move forward with the program in completing it in early 2012. Looking ahead, I expect P&C companies to generate annual statutory earnings of approximately $900 million. This assumes normal catastrophe losses and no prior year reserve development. We typically plan to dividend $800 million annually, which is consistent with maintaining strong capitalization of our property and casualty operations. On the life side, statutory capital generation will be constrained in current levels.
We do not expect statutory surplus generation in our life operations through 2012, which has been factored into our capital management planning. GAAP equity has significantly increased over the last several years, in large part due to the recovery in unrealized loss position of the investment portfolio. Book value per share is up 19% and debt leverage has declined to 27%. In summary, our capital resources are strong, and we continue to manage them prudently. Turning to slide 66, in managing capital, we balance a number of considerations, regulatory requirements, risk management strategies, insurance company needs, and of course, shareholder considerations are also factored into our approach. With that said, we are managing the balance sheet to ensure sufficient capital and financial resources in a stress scenario. We have learned from the past. Confidence in our capital position is paramount, particularly in times of stress.
As a result, we assess our capital resources to ensure that in aggregate, we have capital in excess of 325% RBC ratio for our U.S. Life operation, 125% RBC ratio at White River Re, and double A capital at our P&C operations. Many of you have asked about our capital targeted levels. To be clear, while these are threshold measures to measure our capital resources in stress scenarios, they are not absolute targets. In the end, we must balance all of the different constituencies and considerations I mentioned earlier. Most importantly, we want to ensure our insurance operations are capitalized to effectively compete in their market segment. Turning to slide 67, we have assessed our capital resources against the same scenarios that Greg reviewed for the investment portfolio. I'm not going to go through all the specifics, but we'll highlight a few key points.
In the stress scenario, we assume the S&P drops to 800 by December 31st, 2011, and increases 7.2% in 2012. The drop to 800 reflects a 30% decline from recent levels in today's environment. We have also various assumptions for interest rates, foreign exchange, and investment related impact. For example, you can see that we have included an additional 10% JPY strengthening beyond an already historically strong JPY in the S&P 800 scenario. We have also included incremental credit related impacts in the stress scenario. Lastly, we assumed low interest rate environment in all the scenarios. Let's look at slide 68 and the results of the capital margin. Measured against the minimum capital threshold I described, we project a $3.9 billion capital margin in the baseline scenario. This scenario reflects the impact of the current economic environment through the third quarter and its impact on our margin.
The margin increases in a bull market scenario to $4.4 billion. Most importantly, in a stress scenario, we project a capital margin of $1.3 billion in 2012. This incorporates pessimistic market conditions, including the impact of lower rates, stronger JPY, lower equity markets on variable annuity reserves, and required capital. Also included are higher incremental credit related impacts as compared to the baseline scenario. These projections do not include the $500 million equity repurchase, since we have not initiated the program yet. The margins also do not include other available resources, including our $500 million contingent capital facility or the utilization of our $1.9 billion credit facility. That said, as you can see from these projections, we have sufficient resources to support our businesses, even in a stress scenario, and execute the $500 million equity repurchase.
Turning to slide 69, I also wanted to provide you a look at what drives the changes in capital margins. You can see the effect of hedging in the different scenarios and the impact the net VA results. Also reflected are the impacts of investments and lower interest rates. In the bull scenario at the end of 2012, we create about $500 million of additional capital margin compared to the baseline scenario. This is largely due because of the decline in variable annuity reserves. However, because many of the hedges will decrease in value, they will largely offset the decline in VA reserves. We did not incorporate a benefit related to lower credit impacts or higher interest rates that reasonably could occur in that scenario. In the S&P 800 scenario, you can see the opposite effect.
Our VA operating impacts include an increase in reserves, reducing our capital margin by $8.5 billion. The impact is meaningfully offset by $6.8 billion of hedge gains and lower capital requirements. As I think about it, the impact of hedging covers about 75% of the increase in required reserves in this scenario. This relationship would not necessarily exist in all scenarios. However, this does illustrate the dynamics of the VA results, net of hedging in a declining market. This is why I referenced earlier that we would expect statutory surplus to decline in the quarter due to lower markets. In the S&P 800 scenario, we have additional adverse impacts related to investment. These estimated impacts are significantly lower than what we experienced through the last crisis as a result of the de-risking actions Greg discussed earlier.
Finally, we have included the effects of lower interest rates and other impacts to capital margin. In summary, we are committed to ensuring adequate capital and financial flexibility to support strong capitalization of our insurance operations and sufficient flexibility to meet holding company obligations. As you can see from our capital projections, we believe The Hartford has sufficient resources in a deteriorating economic environment supportive of our current rating. I expect the property and casualty companies to continue to generate surplus in excess of their current requirements. Annual dividends from the P&C companies essentially fund the holding company obligations. The life company surplus generation will be constrained through 2012. Finally, we will continue to actively manage debt and the capital structure to maintain future financial flexibility. Let's wrap up. In total, as I started with today, The Hartford has a strong balance sheet.
We spent a good amount of time discussing the tools developed and the steps taken to actively manage the risk embedded in our variable annuity books of business. Greg and his team have made significant progress in repositioning the investment portfolio. We assess our capital resources in a stress scenario and believe we have sufficient capacity to maintain capitalization consistent with our current rating. All these taken together is why I'm confident about our ability to manage the balance sheet and capital margins even in a challenging economic environment. With that, let me ask Sabra to come up and lead us through a Q&A session.
Thank you, Chris. I'd also like to ask the presenters to come join us up on the podium. Also moving into position, we have members of our finance leadership development program here with mics to give to people for the Q&A. I just wanted to note, we have about 650 people on the webcast, so I'd appreciate it if you could all make sure you're speaking directly into the mic and also just indicate your firm and your name. With that, if you can turn around Jeff Schmitt right there and we'll sequence.
Okay. Thanks, Sabra. Jeff Schmitt from KBW. Chris, it's interesting to see kind of the measures of the capital margin and the scenarios. We've all probably kind of estimated similar numbers, but I guess it still leaves us with the really difficult question of sort of what to do with those numbers. In other words, under your core scenario, you have $3.9 billion of capital margin, but the share repurchase authorization is $500 million, and it's currently not being executed. One could argue that one definition of capital margin is capital that you could redeploy today, and that number is apparently zero. How should we take those capital measures and those scenarios and translate them into an expectation of what you manage to going forward?
Thank you, Jeff. I don't think I would agree with your premise there. We haven't taken action yet on the share repurchase, but we based all those decisions earlier this summer on these, I'll call it scenarios. I think you people have heard me. We've talked about we've met with all the agencies with a great deal of transparency. We actually take a great deal of comfort with these results, even in a stress scenario, and we have additional flexibility beyond that. That's why we were comfortable doing that. I think when we announced the program in early August, I think arguably you could say things had dramatically changed. Even though we've modeled results consistent with some of those activities, we thought it was just, again, prudent. There wasn't a sprint to get the share repurchase done in a shorter period of time.
We wanted to, I'll call it, pace it through a reasonable point in time, early 2012. I still believe that we can get that done, and we plan to get it done in early 2012.
Is a scenario a good way to kind of think about what you need to manage to? In other words, a year from now, two years from now, would you want to be standing in a meeting like this and saying that you have $1 billion or $several hundred million against a scenario like that?
Yeah. I think we said it three or four times, hopefully in the presentation, hopefully it was clear. I mean, we are managing the balance sheet to stress scenarios. I mean, we're very conscious of the impacts from the past and want to ensure capital margin in those stress scenarios. I can't make a projection of the future of what those scenarios would ultimately plan for. We do want to have a buffer in those scenarios, yes.
Just to remind everyone, we've got a big room full of people. I'd appreciate it if you could limit yourself to one question. Then we can circle around and get back to you if you have follow-ups on others. Andrew has the mic here. Andrew, and then Ed.
Okay. Yeah, this is on, right? Okay. I have a very short one.
One Andrew, one.
The $250 of stat surplus that the costs from the hedging, is that an annual number, or is that long term, you don't anticipate any more costs?
Yeah. The $250 is the implementation cost of reflecting the Japan hedge program in our statutory AG 43 accounting models.
One time. Could you give us a sense of what the going forward cost would be?
Well, again, it depends on how you define cost. We defined it as 70 basis points for our DAC scenarios. That is sort of the deterministic path that we have selected. I think we've always said, whether it be Graham, Liz, myself, the ultimate cost of the program are sort of capital markets dependent and path dependent. In up markets, the program will sort of consume resources. In down markets, actually, the program will provide benefits. It really depends on how you view it. Again, for accounting purposes, Andrew, that's the 70 basis points that we estimated.
I think I heard correctly with regard to the U.S. variable annuity book, you hedge or reinsure 80% of it. Why not do the whole 100%?
I'm going to ask Liz or Graham to respond to that, but hedge 80% of the U.S. book. That's what you heard?
I think that's what I heard, right?
You want to clarify that?
Yeah.
Yeah. I mean, we always look at cost benefit. I think 80% is a large proportion of the total book. Remember, we're looking at it on the totality of it. It's not just GMWB, it's GMWB, it's the death benefit, it's the entirety. That incorporates the fact that we are a bit under hedged, for example, on rates. I think that that's a good risk-reward trade-off that still gives us opportunity if markets go up, that we'll be able to share some benefit of that.
Andrew, go back to the slide. I think what I referred to 75% effective hedging relationship, it was in that scenario. We were trying to illustrate and give you the details to show you the various components between increases in reserves and hedge benefit in different scenarios. I think we're trying to say that's illustrative in that scenario.
Just lastly, just kind of a roadmap to what would trigger a buyback. I know you can't be completely explicit, but where does the market need to be? Where do interest rates need to be for us to be comfortable that there's a good likelihood Hartford's going to buy back those shares by the end of the year?
Well, just to be clear, we've said early 2012.
I'm sorry. By early 2012. I was pushing you.
We listen closely. Early 2012, again, as we've said before, since we announced it, things had changed a little bit. We wanted to be prudent. I think also we had various restrictions from a securities laws perspective. We're in a blackout period right now with the quarter. I mean, there's things that we need to manage around to execute that. I would say, again, in early 2012, I think you could see us begin to actually activate the program.
Assuming everything's calm right now.
You're at four now, Andrew, I'm passing to Ed. No, you're cut off. You overran your limit.
Ed Spehar from BofA Merrill. Chris, can you give us a sense what you consider to be the total annual hedge costs on an economic basis? Not just Japan. How much of that is actually reflected in the core earnings number?
Thank you for the question, Ed. When you look at things in totality, I'll let Liz and Graham speak about it, too. I don't think you can look at it that way, because the way I look at it is each of the risk and the programs that we manage are structured differently. For instance, the WB program in the U.S. has one set of tolerances. The Japan tail hedge program has another set of tolerances. We do other certain macro overlays for the entire portfolio that we've talked about from an option premium side has set a cost. It's very hard to generalize, what do we spend, what's reflected in core earnings? I think all our disclosures hopefully will give you a path where you could see at least the components and put it together overall.
I don't think about it, what are we spending that's reflected in core earnings? I think about the risk exposures, what do we want to manage to from an outcome and scenario. Sure we have positions and programs that protect us in that scenario. There clearly is a cost.
No, the primary question isn't what's reflected in core earnings, it's what's the economic cost. I guess, from the outside looking in, I'm not smart enough to figure that out from your disclosures, I'm not sure there are that many people in this room are that smart either. Sorry, I don't mean to insult you. I guess the question is, if you can't put a number on what the economic costs are, forget about the core earnings, how do you figure out how to price a product? I don't understand the whole idea of it's path dependent. Does that mean there's a lot of roll risk? The hedges are 70 basis points, but if something bad happens, it could go to some much higher number?
I would break it up into two things. I'll let Liz comment. Some of it's from what I was referring to is the balance sheet and managing the existing positions, and where we are today and the outcomes we're trying to manage to. From a new product side and our, call it a rollout of new products, we have a clear understanding of the hedging cost and the impacts in IRRs and return on equity. Again, I was just talking more from a balance sheet side and not necessarily a new product side. Liz, would you add anything additional?
Yeah. Ed, I understand your question. A couple of things. First of all, it's hard to see it in the financials because as Chris has alluded to, you're going to have different, some assets on mark-to-market where the benefit of the hedges. For example, if you have hedge gains in down markets, that's a benefit, right? The first thing I'd say is if you want to look at the income statement on the WB hedge, you see the sensitivities in the Q, and you also see them for the rest of the Japan hedges. I guess I'm saying in the Q.
That's GAAP again.
That's GAAP.
Yeah, I don't care about that.
On an economic basis, we run a lot of scenarios. On new products, we run a range of stochastic scenarios, and that's when we say up front, we think to hedge this cost, hedge this book at the money, because you're selling a new product at the money. It could be 30 or 40 or 50 basis points, whatever the feature is, depending on the features and volatility levels, et cetera, at that time. The reason to say what's the economic cost of our in-force book is a little bit more challenging is because we're already in the money in some of the cases. That cost is obviously higher than what we had originally priced for.
Bottom line, markets go up, you want to assume that in your models, like a DAC reversion to the mean upward in your models, that's where the numbers that Chris has alluded to would be the economic cost also.
Tom, we'll do Randy. Okay.
Chris, the $1 billion and three capital margin in the bad scenario, what does that assume for the holding company? Does that assume you need a minimum buffer there?
Yeah, that's a good question, Tom. Thank you. Like we've said with capital and liquidity, it needs to flex during times of stress. Those threshold targets that we've talked about and some of the targets that I've talked about holding two times, holding company cash currently needs. I think realistically, we need the flex in that scenario. The way we look at it in aggregate, the capital and the liquidity resources are available in the firm, and we've gotten experience moving it around the firm in different scenarios to manage the different outcomes to ensure that the capitalization of the entities are appropriately capitalized.
So the-
No, it's a good point. Thank you. I think some of the additional tools that we've added from experience in the crisis is we've gotten a pre-approved Connecticut sort of $2 billion liquidity facility amongst all the legal entities. It sort of works like an automatic lending agreement so that all the Connecticut-based legal entities we could lend money to. We've also have other tools in place that I think we've learned from the crisis that just to help with the fungibility of capital and the fungibility of liquidity in the organization. Pretty confident, Tom, that we could manage the appropriate holding company needs and legal entity needs.
Just to follow up, so if one was to make the assumption that you need a minimum, say, $5 million to $700 million at the holding company, you'd need to deduct that off of your buffer.
Yeah, that's the total buffer.
Got it.
Again, depends on how you want to define in a stress scenario what you think the holding company needs are. Right now, we're holding two times holding company needs, but I would say that has the ability to flex during a stress environment. Randy?
Thanks. Randy Binner, FBR Capital Markets. I'd like to try and bridge some of the scenario testing for the Japan VA that Graham made up to the overall capital margin comments. We appreciated the cash flow scenarios that Graham laid out, but they do involve you using up all your reserves and perhaps some or all of your surplus. I guess the first question is what happens there? Does that become a capital call, and if so, when? Are these scenarios reflected in the other scenarios for the higher level of the overall company?
Yeah, Graham, I could take that one. There's two aspects to your questions, scenarios and then sort of the capital implications of that. I think from the scenarios, these are cash flow scenarios of how we're projecting the block would run off. The overall capital margin scenarios are the ones that we defined. Clearly, down markets, whether it be JPY strengthening, down global equity markets, low interest rates, are reflective of a stress scenario, including how the Japanese book would be reflected. We think the overall capital scenarios that we've put together are reflective of reasonable stresses. Graham's is trying to illustrate in a couple different cash flow scenarios how the block would run off.
Just to be clear, if you breached into the capital over in Japan, I would assume the Japanese would want more capital. Is that a capital call against the rest of the company?
No.
If it happened, would it not happen till like 2016?
There is time, where we've always said time's our friend, because again, the guarantees don't need to be funded upon annuitization. They'd be funded through reinsurance back to the Japan entity over time. Again, I don't think there would be any immediate cash call on Japan. There's no shock scenario that we see right now that would require injection of capital into Japan. It would just slowly emerge that we would just have to put up additional resources to cover the Japan liability.
You really wouldn't know until 2015, 2016, right? You don't know what you have until the money comes in.
Even beyond that, Randy, I think people have heard me say in other settings, right? The annuitization window really begins in 2014 in earnest. You lock in those guarantees. The cash is then paid out 15 years to the policy holders, where, in essence, one-fifteenth of the guarantee that is locked in at annuitization would need to be paid out. There really is no upfront cash required, and that's why, again, we've always felt comfortable managing the Japan capital. We think we have adequate capital there. Then with the reinsurance protection in place, that's how ultimately the policy holders would be made whole.
John?
Thanks, Sabra. John Nadel from Sterne Agee. Chris, I've got a question. I'm just trying to reconcile some data on slide 58 and some data on slide 60. I know you don't have it in front of you. Slide 58 talks about the Japan VA hedge and the GAAP sensitivities. It says at September 30th that an equity market move ±1% is $47 million either way, pre-tax on DAC. On slide 60, in one of the bullets, it says that your quarterly DAC unlock for 3Q is $5 million-$15 million in Japan. How do we reconcile the two? Is slide 58 a gross number, and slide 60 is the net? Could you help explain that?
Yeah. The first slide, 58, I think that has the GAAP sensitivities relates to the hedge assets only. You would view it as sort of gross hedge assets only because the Japan liabilities aren't marked to market, so we don't have a natural net offset. Those are the gross impacts due to market movements, due to hedge positions that we would have that are reflected in realized capital gains and losses. The sensitivity is more from a DAC unlock perspective each quarter. I view them somewhat separately, John.
Okay. My follow-up question, just following up on Ed's question, and maybe we could just focus on the 70 basis points and think about the duration of the hedges that you've put on the Japanese business. At what point does that 70 basis points have risk of shifting up or down?
Again, that is the accounting perspective of sort of running multiple scenarios and determining sort of the mean of all the scenarios that we use to project that path. I think you could think about it the way we do, is that we're really hedging from now and through the annuitization windows mostly. Most of the FX and the equity protection are designed to protect us during the next time period from starting now through the annuitization window. It becomes a cash management strategy once all the assets come back onto the balance sheet, and it's how Greg and his team are going to earn gross NII for the benefit of the policy holders.
Thank you.
Mike. Where's the current mic? Great. Yep.
Mark Finkel.
Can you get the mic?
I have a question. I actually want to follow up on that. I guess just to understand the 70 basis points again, I want to reframe it back into earnings. If the markets perform according to your EGP models, theoretically you would have an economic cost of 70 basis points per year.
Exactly.
The way to think about it would be you have $200 million in core earnings roughly on the Japan business, and then you're going to have a below-the-line hit of 70 basis points. The real economic earnings is the difference between those two if the markets follow your EGP models. Is that the right way to think about it?
The way I think about it, I think people have heard me talk about the Japan product. It's a fairly rich product. We consider it right now making about 70 basis points after tax. 70 basis points after tax. Once we reflect in all these hedges are starting to flow through the income statement, we'd expect that 70 basis points to come down to about 35 basis points. We have less DAC amortization, more hedging costs. The Japan product, on average, we expect to earn about 35 basis points net after tax right now.
The way to think about it, putting the accounting to the side is, it's a $200 million a year business that goes down to $100 million if it follows your EGP models.
More or less.
Yeah. Okay. Just to follow up, from an earlier, I think it was Graham's presentation. We talked about the $700 million that would be needed to fund the Japan in that kind of dire scenario. He kind of used the words risk tolerance a couple times. What is the number that you came to on an ultimate risk tolerance? We will not take more losses than this number.
Yeah. What I'd prefer to do here is refer you back to the examples that I showed. We indicated what I called a benign scenario. We also showed an adverse scenario, and you can see in both of those scenarios what the outcomes are. In both cases, I said that they were manageable. We have lots of limits and tolerances across all of our market risks, whether they be credit, equity, rates, FX. It's not really prudent for us to actually be absolutely specific about those limits. Given that we are executing hedges in the market and with the information that we've already provided, if we were prescriptive and specific about details of our market limits, that could actually be to our disadvantage as we were executing hedges. I think that's pretty typical of most financial firms.
Can everybody who's got a mic in their hand right now just hold their hand up? Okay. Let me do Eric, then I'll do Nigel. We'll pass the mic.
Thanks very much. Eric Berg with RBC. Your message that The Hartford would fare well in difficult environments, that message is coming through loudly and clearly, at least according to your models, you say that. I guess my question is because the 10-Qs show that there have been several occasions, I don't know how many, but certainly enough to think about, in which your models predicted one level of earnings impact and the actual impact was materially different from what the model said it was going to be, why should we be comfortable that these models today are any better than those that had problems per the 10-Q?
Well, Eric, thank you for the question. To me, Graham mentioned it, I mentioned it. I think we've looked at things fresh, Eric, over the last 18 months, 2 years. Again, not knowing all the history or maybe but I can appreciate the perspective. I'd just say that, look, we've looked at things fresh. We've updated a lot of lessons learned. We've updated our understanding of particularly statutory accounting in all our models. I believe that the statutory impacts and the economics impacts that Graham is trying to manage to are closely aligned. You will always have some breakage. I think you've heard me say, we're going to manage on an economic basis, and we'll explain the statutory GAAP impacts and plan for them accordingly. I think we have our arms around the model. I think we have our arms around the Japan situation.
I think we know and learned from the past, Eric.
I just wanted to since this whole exercise sort of presupposes that the models correctly capture how the world will work from a cash flow statutory capital perspective, it might be a useful exercise to report out and highlight what you forecast on an ongoing basis. Which is a suggestion, what you forecast the models would do versus what actually happened. It would increase our confidence in your forecasting capability.
Thank you.
Nigel. I just wanted to note, we have two or three more minutes for questions. What I wanted to note is, obviously, we have a luncheon buffet afterwards, and we can catch up and answer more questions. I'll do Nigel and then Tamara, and then we'll break or have the concluding remarks.
Nigel Daly, Morgan Stanley. Chris, I wanted to focus on the different scenarios and look at the interest rate piece. Seems like for 2012, all of your scenarios have interest rates going higher. What would be the sensitivity of capital to rates being at today's level or below? I guess there's a difference of 40 basis points between your base and stress. That equated to roughly $0.7 billion. Is that reasonable to use?
Yeah. Again, just the background. We developed the models and updated our models as of August when things were a little different. Things have changed. Just given the preparation, we have not actually rerun new models at that point in time. I wouldn't want to speculate, but there would be a little more pressure from a rate side, but I don't think it would be significant. I don't have a precise number for you.
I guess if it's looking at the difference between the base and the stress, that was $700 million. Is that going to be a linear type function?
That $700 million we're referring to, we call it interest and other.
Right. Yeah. I guess how much interest-
There's another component. I would say that other component is probably 40% of that number. There is interest sensitivities that obviously you can see that we modeled, but that other category is about 40% of that total $700 million.
Tamara Kravec, NWQ. Just looking at slide 57, you're delineating there the 70 basis points cost on non-core, but then you have the core increase of $135 million from policyholder behavior. I'm just wondering what assumptions you've made. Is that a one-time impact or something that you'll be changing as these policies continue to go through time?
No, thank you for the question, Tamara. The $135 million is a one-time assumption update. It is ultimately reflecting that policyholders are staying longer with us than we anticipated. Our lapse assumptions, I would say, were conservative or high for DAC purposes. We really just have more fee income that we're earning during the accumulation period. We think we've adjusted for what we think is the ultimate lapse rate in the book, which we think is low. I would not view it as a recurring sort of adjustment to core earnings.
Great. With that, I'd like to turn the mic back over to Liam for some concluding remarks.
Chris, thank you very much. I just want to briefly, again, say to all of you, thanks for coming. Thanks for all of your questions and participating. I hope we were able to provide you with a more clear and thorough perspective of The Hartford's balance sheet, capital strength, and risks. Before we close, I always like to begin with what we hope to accomplish and then go back to it. I hope I can reiterate now a few key beliefs that I hope you now share. First of all, The Hartford's balance sheet is strong. Second of all, I think we've been candid that while challenges exist, our risks are significantly reduced and manageable. The Hartford's risk management capabilities are meaningfully enforced, and we have the strength to maintain sufficient capital levels consistent with current ratings, even under significant economic strength.
Finally, and perhaps most importantly to me, I hope you sense now that management is running the company with discipline and a focus on generating value for shareholders. Again, I appreciate your time. The entire Hartford team does. I want to thank you all for coming. Let's have lunch.