Stressed Hartford Announces Split

After resisting its largest shareholder, John Paulson’s incessant pressure for almost two months, Hartford Financial Services Group Inc. (HIG - Analyst Report) finally gave in to the demands of segregating its life insurance and property and casualty (P&C) businesses on Wednesday. Consequently, the company is on the lookout for suitable divestiture opportunities for its Individual Life and Retirement Plans segments along with Woodbury Financial Services. Woodbury is an indirectly-held, wholly-owned retail broker-dealer subsidiary, included in the Individual Life segment’s distribution network. Hartford has hired The Goldman Sachs Group Inc. (GS - Analyst Report) and Greenhill & Co. Inc. (GHL - Snapshot Report) as financial advisors for the same but expects the divestitures to take about two years.

The company has also decided to terminate its Individual Annuity business, which offers individual variable, fixed market value adjusted (fixed MVA), fixed index and single premium immediate annuities in the U.S. Hartford will stop selling annuities from April 27, 2012. Moreover, the Individual Annuity segment will be integrated into the Life Other Operations segment, which is included in the Runoff Operations division, from the second quarter of 2012.

Subsequent to the developments, the Wealth Management division of Hartford will be left with only the Mutual Funds segment, while the Commercial Markets, Consumer Markets and Corporate divisions will stay unaltered. However, Hartford will carry on its operations in the segments intended for sale until the divestitures are made.

The proposed structural changes are intended to increase Hartford’s focus on its P&C, Mutual Funds and Group Benefits segments, which not only generate strong revenues, but also have admirable market standing and are not too sensitive to capital market fluctuations either. The company intends to utilize its proficiency in underwriting, distribution and claims management to boost the earnings of the Commercial Markets and Consumer Markets divisions.

The Mutual Funds business had already been gaining considerable spotlight as it traditionally generates higher growth and return on equity for the company. In order to boost its mutual fund business, Hartford hired Wellington Management as the sole sub-adviser for its mutual funds business in December 2011. Thus, the modifications are expected to amplify Hartford’s return on equity, enhance its financial flexibility, reduce the cost of capital and ease the sensitivity to capital markets.

Effect on Financials

The company expects an after-tax charge of $15-20 million in the second quarter of 2012 related to the structural changes. Additionally, Hartford even anticipates a $100 million cut in the annual run-rate pre-tax operating expenses from 2013. Moreover, the return on equity for the retained businesses is expected to be about 12-13% in 2012.

Paulson’s Anxiety

Hartford’s announcement came amid mounting pressure from hedge fund manager John Paulson to spin-off its P&C business. Paulson is the largest shareholder of the company with an 8.51% stake held through Paulson & Co.

Paulson was anxious about Hartford’s valuation, which is significantly lower than its peers such as MetLife Inc. (MET - Analyst Report), Prudential Financial Inc. (PRU - Analyst Report) and American International Group Inc. (AIG - Analyst Report) who focus on either life insurance or P&C business. The hedge fund manager opined that the undervaluation was an outcome of Hartford’s complex business model and a split would unlock the value of the company’s shares.

While the management of Hartford had been assessing the company’s business structure and policies since mid-2011, it initially seemed unenthusiastic about a division of its business. Management held the opinion that a split would not create shareholder value in the present environment and also cited various challenges to a spin-off such as allocation of debt, impact of the spin-off on ratings and regulatory hurdles, when Paulson initially suggested a spin-off in February 2012.

Nevertheless, investors’ pressure seems to have acted as a catalyst for streamlining operations. However, Paulson is not satisfied with the alterations and holds on to his demand for a spin-off of the P&C segment as he feels that Hartford’s P&C business is a strong contender in the commercial insurance market but gets overshadowed by the company’s large scale and fails to realize its full potential.

Ratings Action

Hartford’s declarations resulted in a flurry of activity by the rating agencies. Standard and Poor’s Rating Services downgraded the life insurance business of the company to “A-” and annuities business to “BBB+”. The rating agency also dropped Hartford Life’s Senior debt to “BBB-”, which is the lowest investment grade rating. A further downgrade will push the debt into junk category.

Nevertheless, the “BBB” rating of the holding company and its P&C units were affirmed by S&P. Meanwhile, Fitch affirmed the Insurer Financial Strength (ISF) of Hartford’s life insurance subsidiaries at “A-” and P&C units at “A+”.

Further, A.M. Best Co. placed the Issuer Credit Rating (ICR) of “bbb+” and debt ratings of Hartford, ICR of “a+” and financial strength rating (FSR) of “A” of Hartford Insurance Pool. Moreover, the rating agency also placed the FSR of “A” and ICR of “a+” of Hartford’s life insurance subsidiaries under review with a negative outlook.

Currently, the shares of the company carry a Zacks #3 Rank (short-term ‘Hold’ rating). Also, we maintain a long-term ‘Neutral’ recommendation on the shares.