Certain statements contained in this Report that are not historical facts are forward-looking statements as defined in the US Private Securities Litigation Reform Act of 1995. The following are words that identify such forward-looking statements: believe, estimate, target, intend, may, expect, anticipate, predict, project, counting on, plan, continue, want, forecast, should, would, is confident, will, and similar expressions as they relate to our company. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Such risks and uncertainties include but are not limited to the following:
representative of the successor basis of accounting while Statements of Earnings, Comprehensive Income, and Cash Flows amounts for 2007 are representative of the predecessor basis of accounting. Financial Statements included herein for periods prior and subsequent to the Acquisition Date are labeled “Predecessor” and “Successor”, respectively. Since the actual results between the period December 28, 2007 and December 31, 2007 were not material, MLLICNY has utilized December 31, 2007 as the Acquisition Date herein.
MLLICNY’s critical accounting policies and estimates are discussed below. See Note 2 to the Financial Statements for additional information regarding accounting policies.
Future gross profit estimates are subject to periodic evaluation with necessary revisions applied against amortization to date. The impact of revisions and assumptions to estimates on cumulative amortization is recorded as a charge or benefit to current operations, commonly referred to as “unlocking”. Changes in assumptions can have a significant impact on the amount of DAC reported and their related amortization patterns. In general, increases in the estimated separate accounts return and decreases in surrender or mortality assumptions increase the expected future profitability of the underlying business and may lower the rate of DAC amortization. Conversely, decreases in the estimated separate accounts returns and increases in surrender or mortality assumptions reduce the expected future profitability of the underlying business and may increase the rate of DAC amortization. For the years ended December 31, 2007, 2006, and 2005 the favorable (unfavorable) impact on pretax earnings related to DAC unlocking was $1.8 million, $0.9 million and ($3.2) million respectively. See Note 5 to the Financial Statements for a further discussion of period-to-period differences in DAC unlocking.
Other intangible assets that were acquired at the Acquisition Date include a distribution agreement, a tradename, and a non-compete agreement. The tradename and the non-compete are required to be amortized on a straight-line basis over their useful life of five years. The distribution intangible will be amortized over the expected economic benefit period and at a pace consistent with the expected future gross profit streams generated from the distribution agreement, which is 30 years. The carrying values of the intangibles will be reviewed periodically for indicators of impairment in value including unexpected or adverse changes in the following: (1) the economic or competitive environments in which MLLICNY operates, (2) the profitability analyses, (3) cash flow analyses, and (4) the fair value of the relevant business operation. If there was an indication of impairment, then the cash flow method would be used to measure the impairment, and the carrying value would be adjusted as necessary. Since there were no events or circumstances to indicate that there may be any significant change in the fair value of net assets acquired on December 28, 2007, management did not perform an impairment test for the other intangibles. At December 31, 2007, other intangible assets were $8.3 million. There were no other intangible assets at December 31, 2006. The entire asset amount has been allocated to annuities.
MLLICNY’s liability for policyholder account balances represents the contract value that has accrued to the benefit of the policyholder as of the balance sheet date. The liability is generally equal to the accumulated account deposits plus interest credited less policyholders’ withdrawals and other charges assessed against
Specific estimates include the realization of dividend-received deductions (“DRD”) and foreign tax credits (“FTC”). A portion of MLLICNY’s investment income related to separate accounts business qualifies for the DRD and FTC. Information necessary to calculate these tax adjustments is typically not available until the following year. However, within the current year’s provision, management makes estimates regarding the future tax deductibility of these items. These estimates are primarily based on recent historic experience. See Note 7 to the Financial Statements for period-to-period differences in DRD and FTC adjustments. During 2007, 2006, and 2005, MLLICNY reduced its provision for federal income taxes by $0.6 million, $0.4 million and $0.8 million, respectively, due to DRD and FTC adjustments.
MLLICNY adopted the provisions of FASB Interpretation (”FIN”) No. 48, Accounting for Uncertainty in Income Taxes, on January 1, 2007. MLLICNY has analyzed all material tax positions under the provisions of FIN No. 48, and has determined that there are no tax benefits that should not be recognized as of December 31, 2007 or as of December 31, 2006. There are no unrecognized tax benefits that would affect the effective tax rate. It is not anticipated that the total amounts of unrecognized tax benefits will significantly increase within twelve months of the reporting date.
MLLICNY files a return in the U.S. Federal tax jurisdiction, and various state tax jurisdictions. As a result of the MLLICNY’s election for Federal income tax purposes of Internal Revenue Code Section 338, the predecessor is responsible for any FIN No. 48 obligations that existed prior to the Acquisition Date.
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements” (“SFAS 160”). This statement amends Accounting Research Bulletin No. 51, “Consolidated Financial Statements” (“ARB 51”). Noncontrolling interest refers to the minority interest portion of the equity of a subsidiary that is not attributable directly or indirectly to a parent. SFAS 160 establishes accounting and reporting standards that require for-profit entities that prepare consolidated financial statements to: (a) present noncontrolling interests as a component of equity, separate from the parent’s equity, (b) separately present the amount of consolidated net income attributable to noncontrolling interests in the income statement, (c) consistently account for changes in a parent’s ownership interests in a subsidiary in which the parent entity has a controlling financial interest as equity transactions, (d) require an entity to measure at fair value its remaining interest in a subsidiary that is deconsolidated, (e) require an entity to provide sufficient disclosures that identify and clearly distinguish between interests of the parent and interests of noncontrolling owners. SFAS 160 applies to all for-profit entities that prepare consolidated financial statements, and affects those for-profit entities that have outstanding noncontrolling interests in one or more subsidiaries or that deconsolidate a subsidiary. SFAS 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008 with earlier adoption prohibited. MLLICNY expects to adopt SFAS 160 on January 1, 2009 and has not yet determined the effect of SFAS 160 on its Financial Statements.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS No. 159 provides a fair value option election that allows companies to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and liabilities, with changes in fair value recognized in earnings as they occur. SFAS No. 159 permits the fair value option election on an instrument by instrument basis at initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument. SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. Early adoption is permitted as of the beginning of a fiscal year that begins on or before November 15, 2007 provided that the entity makes that choice in the first 120 days of that fiscal year, has not yet issued financial statements for any interim period of the fiscal year of adoption, and also elects to apply the provisions of SFAS No. 157, Fair Value Measurements. Prior to the acquisition by AUSA, MLLICNY early adopted SFAS No. 159 as of the first quarter 2007, but did not elect the fair value option for any of its existing assets or liabilities and therefore, the adoption did not have an impact on MLLICNY’s Financial Statements. However, AUSA has not elected early adoption, and therefore as a result of the acquisition by AUSA and the resulting new basis of accounting, MLLICNY will adopt SFAS No. 159 on January 1, 2008 and it is not expected to have a material impact on MLLICNY’s Financial Statements.
On January 1, 2007, MLLICNY adopted Statement of Position (“SOP”) 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts. SOP 05-1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97. SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights, or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. Since MLLICNY’s practice of accounting for deferred acquisition costs, in connection with modifications or exchanges, substantially meets the provisions prescribed within SOP 05-1, the adoption of SOP 05-1 did not have a material impact on MLLICNY’s Financial Statements.
Total direct deposits by product, including internal exchanges for the three years ended December 31 were as follows:
During 2007, MLLICNY experienced contract owner withdrawals that exceeded deposits on all products by $121.5 million. The components of contract owner transactions were as follows:
MLLICNY maintains a conservative general account investment portfolio comprised primarily of investment grade fixed maturity securities, policy loans, and cash and cash equivalents. MLLICNY has no mortgage or real estate investments and its investment in below investment grade fixed maturity securities are below the industry average.
The following schedule identifies MLLICNY’s general account invested assets by type for the years ended December 31:
accept. It is this level of risk that determines the degree to which the yields on CMO and MBS securities will exceed the yields that can be obtained from similarly rated corporate securities.
Subprime mortgages are loans to homebuyers who have weak or impaired credit histories. In recent years, the market for these loans has expanded rapidly. During that time, however, lending practices and credit assessment standards grew steadily weaker. As a result, the market is now experiencing a sharp increase in the number of loan defaults. Investors in subprime assets include not only mortgage lenders, but also brokers, hedge funds, and insurance companies. MLLICNY does not sell or buy subprime mortgages directly. As of December 31, 2007 and 2006, MLLICNY had no material exposure to subprime mortgage investments.
During 2007, average variable account balances increased $11.1 million (or 1%) to $961.2 million as compared to 2006. The increase in average variable account balances contributed to a $1.5 million (or 12%) increase in asset-based policy charge revenue during the period ended December 31, 2007 as compared to the same period in 2006.
Changes in interest rates affect the value of investments, primarily fixed maturity securities and preferred equity securities, as well as interest sensitive liabilities. Changes in interest rates have an inverse relationship to the value of investments and interest sensitive liabilities. Also, since MLLICNY has certain fixed products that contain guaranteed minimum crediting rates, decreases in interest rates can decrease the amount of interest spread earned.
During 2007, medium term interest rates decreased 139 basis points to end the year at 3.38%. During 2006, medium term interest rates increased 41 basis points to end the year at 4.77%. MLLICNY defines medium term interest rates as the average interest rate on U.S. Treasury securities with terms of 1 to 5 years.
Changes in the corporate credit environment directly impact the value of MLLICNY’s investments, primarily fixed maturity securities. MLLICNY primarily invests in investment-grade corporate debt to support its fixed rate product liabilities.
Credit spreads represent the credit risk premiums required by market participants for a given credit quality, e.g. the additional yield that a debt instrument issued by a AA-rated entity must produce over a risk-free alternative (for example, U.S. Treasury instruments). Changes in credit spreads have an inverse relationship to the value of investments.
MLLICNY’s liquidity requirements include the payment of sales commissions and other underwriting expenses and the funding of its contractual obligations for the life insurance and annuity contracts it has in force. MLLICNY has developed and utilizes a cash flow projection system and regularly performs asset / liability duration matching in the management of its asset and liability portfolios. MLLICNY anticipates funding its cash requirements utilizing cash from operations, normal investment maturities and anticipated calls and repayments, consistent with prior years. As of December 31, 2007 and 2006, MLLICNY’s assets included $161.8 million and $169.7 million, respectively, of cash, short-term investments, and investment grade publicly traded available-for-sale securities that could be liquidated if funds were required.
MLLICNY believes that it will be able to fund the capital and surplus requirements of projected new business from current statutory earnings and existing statutory capital and surplus. If sales of new business significantly exceed projections, MLLICNY may have to look to its parent and other affiliated companies to provide the capital or borrowings necessary to support its current marketing efforts. MLLICNY’s future marketing efforts could be hampered should its parent and/or affiliates be unwilling to commit additional funding.
Prior to the Acquisition Date, MLLICNY and ML&Co. were parties to a “keepwell” agreement which obligated ML&Co. to maintain a level of capital in MLLICNY in excess of minimum regulatory requirements. Subsequent to the Acquisition Date, MLLICNY and AUSA are parties to a “keepwell” agreement which commits AUSA to maintain MLLICNY at a minimum net worth.
The National Association of Insurance Commissioners utilizes RBC adequacy monitoring system. The RBC calculates the amount of adjusted capital that a life insurance company should have based upon that Company’s risk profile. As of December 31, 2007 and 2006, based on the RBC formula, MLLICNY’s total adjusted capital level was well in excess of the minimum amount of capital required to avoid regulatory action.
The following table summarizes MLLICNY’s policyholder obligations as of December 31, 2007:
The policyholder liabilities include benefit and claim liabilities of which a significant portion represents policies and contracts that do not have a stated contractual maturity. The projected cash benefit payments in the table above are based on managements’ best estimates of the expected gross benefits and expenses, partially offset by the expected gross premiums, fees and charges relating to the existing business inforce. Estimated cash benefit payments are based on mortality and lapse assumptions comparable with MLLICNY’s historical experience, modified for recently observed trends. Actual payment obligations may differ if experience varies from these assumptions. The cash benefit payments are presented on an undiscounted basis and are before deduction of tax and before reinsurance. The liability amounts in our Financial Statements reflect the discounting for interest as well as adjustments for the timing of other factors as described above. As a result, the sum of the cash benefit payments shown for all years in the table above exceeds the corresponding policyholder liability amounts.
The costs associated with acquiring contract owner deposits (DAC) are amortized over the period in which MLLICNY anticipates holding those funds, as noted in the Critical Accounting Policies section above. Insurance expenses and taxes reported in the statements of earnings are net of amounts deferred. In addition, MLLICNY incurs expenses associated with the maintenance of inforce contracts.
Policy charge revenue increased $1.2 million (or 7%) to $19.6 million during 2006 as compared to $18.4 million in 2005. The following table provides the changes in policy charge revenue by type for each respective period:
Net earnings derived from interest spread increased $0.6 million (or 19%) to $3.7 million during 2006 as compared to $3.1 million in 2005. The following table provides the components and changes in interest spread:
Despite the reduction in fixed rate contracts inforce, net investment income was favorably impacted by an increase in asset yields during 2006 as compared to 2005.
MLLICNY’s effective federal income tax rate increased to 31% for 2006 from 24% for 2005 primarily due to period-to-period differences in DRD and FTC adjustments as noted in the Critical Accounting Policies section above.
MLLICNY is not dependent upon any single customer, and no single customer accounted for more than 10% of its revenues during 2007, 2006, or 2005.
MLLICNY’s operations have not been materially impacted by inflation and changing prices during the preceding three years.