The effects of corporate bankruptcies and/or accounting restatements on the financial markets and the resulting decline in the value of equity and debt securities we hold;
We undertake no obligation to publicly update or revise any forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which merely reflect Company expectations at the time of the writing. Actual results may differ materially from expectations conveyed in forward-looking statements due to changes caused by various
MLLIC conducts its business primarily in the annuity markets and to a lesser extent in the life insurance markets of the financial services industry. These markets are highly regulated with particular emphasis on company solvency and sales practice monitoring. Demographically, the population is aging and there are a growing number of individuals preparing for retirement, which favors life insurance and annuity products. MLLIC currently offers the following guaranteed benefits within its variable annuity product suite: guaranteed minimum death benefits (“GMDB”), guaranteed minimum income benefits (“GMIB”) and guaranteed minimum withdrawal benefits (“GMWB”). MLLIC believes that the demand for retirement products containing guarantee features will continue to increase in the future.
On December 28, 2007, the Company and its affiliate, MLLICNY, were acquired by AUSA. In accordance with Statement of Financial Accounting Standard (“SFAS”) No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangibles, the acquisition was accounted for by AUSA using the purchase method of accounting, which required the assets and liabilities of MLLIC to be identified and measured at their estimated fair values as of the acquisition date.
The Company’s investments are available-for-sale fixed maturity and equity securities as defined by SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. The fair values of fixed maturity and equity securities are determined by management after taking into consideration several sources of data. The Company’s valuation policy dictates that publicly available prices are initially sought from several third party pricing services. In the event that pricing is not available from these services, those securities are submitted to brokers to obtain quotes. Lastly, securities are priced using internal cash flow modeling techniques. These valuation methodologies commonly use reported trades, bids, offers, issuer spreads, benchmark yields, estimated prepayment speeds, and/or estimated cash flows.
Mortgage loans on real estate are carried at unpaid principal balances adjusted for amortization of premiums and accretion of discounts and are net of valuation allowances. The fair value for mortgage loans on real estate is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and/or similar remaining maturities. Interest income is accrued on the principal balance of the loan based on the loan’s contractual interest rate. Premiums and discounts are amortized using the effective yield method over the life of the loan. Interest income and amortization of premiums and discounts are reported in net investment income along with mortgage loan fees, which are recorded as they are incurred. Loans are considered impaired when it is probable that based upon current information and events, the Company will be unable to collect all amounts due under the contractual terms of the loan agreement. When the Company determines that a loan is impaired, a valuation allowance is established for the excess carrying value of the loan over its estimated value. The Company does not accrue interest on impaired loans and loans 90 days past due. At December 31, 2008, there was $77.1 million in mortgage loans on real estate recorded on the Balance Sheet. The valuation allowance at December 31, 2008 was $0.1 million. There were no mortgages loans on real estate at December 31, 2007.
The Company regularly reviews each investment in its fixed maturity and equity securities portfolio to evaluate the necessity of recording impairment losses for other-than-temporary (“OTT”) declines in the fair value of investments. Management makes this determination through a series of discussions with the Company’s portfolio managers and credit analysts, information obtained from external sources (i.e. company announcements, ratings agency announcements, or news wire services) and the Company’s ability and intent to hold the investments for a period of time sufficient for a forecasted market price recovery up to or beyond the amortized cost of the investment. The factors that may give rise to a potential OTT impairment include, but are not limited to, i) certain credit-related events such as default of principal or interest payments by the issuer, ii) bankruptcy of issuer, iii) certain security restructurings, and iv) fair market value less than amortized cost for an extended period of time. In the absence of a readily ascertainable market value, the estimated fair value on these securities represents management’s best estimate and is based on comparable securities and other assumptions as appropriate. Management bases this determination on the most recent information available. Once impaired, the discount or reduced premium recorded for the debt security, based on the new cost basis, is amortized over the remaining life of the debt security in a prospective manner based on the amount and timing of future estimated cash flows. During 2008, the Company recorded an OTT impairment, net of value of business acquired amortization, of $8.3 million. The Company did not experience any realized investment losses due to OTT declines in fair value for the years ended December 31, 2007 and 2006.
The costs of acquiring business, principally commissions, certain expenses related to policy issuance, and certain variable sales expenses that relate to and vary with the production of new and renewal business, are deferred and amortized in accordance with SFAS No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments. DAC are subject to recoverability testing at the time of policy issuance and loss recognition testing at the end of each reporting period. At December 31, 2008, variable annuities insurance accounted for the Company’s entire DAC asset of $24.3 million. At December 31, 2007, the DAC balance was zero as a result of push down accounting at the acquisition date.
The most significant assumptions involved in the estimation of future gross profits are future net Separate Accounts performance, surrender rates, mortality rates and reinsurance costs. For variable annuities, the Company generally establishes a long-term rate of net Separate Accounts growth. If returns over a determined historical period differ from the long-term assumption, returns for future determined periods are calculated so that the long-term assumption is achieved. The result is that the long-term rate is assumed to be realized over a specified period. However, the long-term rate may be adjusted if expectations change. This method for projecting market returns is known as reversion to the mean, a standard industry practice. At December 31, 2008, the reversion to the mean assumption was 15% gross short-term equity growth rate for five years and thereafter a 9% gross long-term growth rate. For variable life insurance, prior to acquisition, the Company generally assumed a level long-term rate of net variable life Separate Accounts growth for all future years and the long-term rate may be adjusted if expectations change. Additionally, the Company may modify the rate of net Separate Accounts growth over the short term to reflect near-term expectations of the economy and financial market performance in which Separate Accounts assets are invested. Surrender and mortality rates for all variable contracts are based on historical experience and a projection of future experience.
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
The expense and the subsequent capitalization and amortization are recorded as a component of policy benefits in the Statements of Income. At December 31, 2008, variable annuities insurance accounted for the Company’s entire DSI asset of $7.2 million. At December 31, 2007, the DSI balance was zero as a result of push down accounting at the acquisition date. See Note 6 to the Financial Statements for a further discussion.
Other intangibles 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 thirty years. The carrying values of the intangibles are reviewed periodically for indicators of impairment in value, including unexpected or adverse changes in the following: (1) the economic or competitive environments in which MLLIC operates, (2) the profitability analyses, (3) cash flow analyses, and (4) the fair value of the relevant business operation. If there is an indication of impairment, then the cash flow method is used to measure the impairment, and the carrying value is adjusted as necessary. A review was performed at September 30, 2008 and there was no indication of impairment for goodwill or other intangibles. However during the 4th quarter the Company made a business decision to commence selling similar products on affiliate companies through the ML&Co. distribution channel instead of continuing to sell new variable annuities on MLLIC. As a result of this decision, an impairment charge was taken for the unamortized other intangible balance of $76.1 million. See Note 5 to the Financial Statements for a further discussion. At December 31, 2007, the other intangibles were $74.9 million. The entire asset amount was allocated to annuities.
Goodwill is the excess of the purchase price over the estimated fair value of net assets acquired. Under SFAS No. 142, goodwill and intangible assets with indefinite lives are not amortized, but are subject to impairment tests conducted at least annually. Impairment testing is to be performed using the fair value approach, which requires the use of estimates and judgment, at the
The Company’s liability for policyholder account balances represents the contract value that has accrued to the benefit of policyholders 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 the account balance. Policyholder account balances at December 31, 2008 and 2007 were $1.8 billion and $1.9 billion, respectively.
Future policy benefits are actuarially determined liabilities, which are calculated to meet future obligations and are generally payable over an extended period of time. Principal assumptions used in the establishment of liabilities for future policy benefits are mortality, surrender rates, policy expenses, equity returns, interest rates, and inflation. These estimates and assumptions are influenced by historical experience, current developments and anticipated market trends. At December 31, 2008 and 2007, future policy benefits were $499.3 million and $396.8 million, respectively.
The Company regularly evaluates the assumptions used to establish these liabilities, as well as actual experience and adjusts GMDB and GMIB liabilities with a related charge or credit to earnings (“unlocking”), if actual experience or evidence suggests that the assumptions should be revised. For 2008, the unfavorable impact to pre-tax earnings related to GMDB and GMIB unlocking was $95.8 million. For 2007, the favorable impact to pre-tax earnings related to GMDB and GMIB unlocking was $22.0 million.
Future policy benefits also include liabilities, which can be either positive or negative, for contracts containing GMWB provisions and for the reinsurance of GMIB provisions (“GMIB reinsurance”) for variable annuities based on the fair value of the underlying benefit. The GMWB provision is treated as an embedded derivative and is required to be reported separately from the host variable annuity contract. The fair value of the GMWB obligation is calculated based on actuarial and capital market assumptions related to the projected cash flows, including benefits and related contract charges, over the anticipated life of the related contracts. The cash flow estimates are produced using stochastic techniques under a variety of market return scenarios and other best estimate assumptions. In general, the GMIB reinsurance liability (asset) represents the present value of future reinsurance deposits net of reinsurance recoverables less a provision for required profit.
MLLIC files a return in the U.S. Federal tax jurisdiction, and various state tax jurisdictions. As a result of the MLLIC’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 May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles. This Statement identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements. SFAS No. 162 became effective on November 15, 2008. The adoption of this Statement did not have a material impact on the Company’s 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. The Company adopted SFAS No. 159 on January 1, 2008. The adoption did not have a material impact on the Company’s financial statements. See Note 3 to the Financial Statements for additional disclosures.
In April 2008, the FASB issued FSP No. FAS 142-3, Determination of the Useful Life of Intangible Assets. The FSP amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, Goodwill and Other Intangible Assets. FSP No. FAS 142-3 requires entities estimating the useful life of a recognized intangible asset to consider their historical experience in renewing or extending similar arrangements or, in the absence of historical experience, to consider assumptions that market participants would use about renewal or extension as adjusted for entity-specific factors included in SFAS No. 142. The guidance in FSP No. FAS 142-3 is effective for fiscal years beginning after December 15, 2008. The Company expects to adopt FSP No. FAS 142-3 on January 1, 2009, which affects disclosures and therefore will not impact the Company’s results of operations or financial position.
In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities - an amendment of FASB Statement No. 133. This Statement amends and expands the disclosure requirements in SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities to provide users of financial statements with an enhanced
understanding of (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under SFAS No. 133 and its related interpretations, and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. SFAS No. 161 is effective for fiscal years and interim periods beginning after November 15, 2008 with early application permitted. The Company expects to adopt SFAS No. 161 on January 1, 2009, which affects disclosures and therefore will not impact the Company’s results of operations or financial position.
Total direct deposits decreased $325.4 million to $447.6 million during 2008, as compared to 2007. Total direct deposits (including internal exchanges) were as follows:
At December 31, 2008, the Company’s assets were $11.1 billion or $3.6 billion lower than the $14.7 billion in assets at December 31, 2007. Assets excluding Separate Accounts assets increased $180.5 million. Separate Accounts assets, which represent 67% of total assets, decreased $3.8 billion (or 34%) to $7.5 billion. Changes in Separate Accounts assets on a year to date basis were as follows:
The Financial sector is further subdivided into Banking, Insurance, REIT’s and Financial other. These sub-sectors account for respectively 70%, 4%, 19% and 7% of the unrealized losses in the financial sector. The capital bases of banks and other financial firms have been strained as they are forced to retain assets on their balance sheets that had previously been securitized and to write down certain mortgage-related and corporate credit-related assets. Financial companies within MLLIC’s financial sector are generally high in credit quality, and as a whole represent a large portion of the corporate debt market. For all these sub-sectors the fundamentals are weakening. However, the financial sector has seen a larger impact to valuations from the broader market volatility given it is a focal point of the current concerns. Governments across the world have attempted to stabilize market liquidity and investor confidence via extraordinary measures, including providing substantial support to banks and insurance companies. Of the securities in an unrealized loss position, 93% of the unrealized loss relates to securities rated investment grade.
MLLIC has exposure to deeply subordinated investment grade securities within the banking sector which have the characteristics of both debt and equity. These bonds, broadly referred to as capital securities, allow the borrower to defer payments without defaulting and are subordinated to traditional bonds in a company’s capital structure. The value of our investments in these securities may be significantly impacted if the issuers of such securities exercise the option to defer payment of optional coupons or dividends, are forced to accept government support or intervention, or grant majority equity stakes to their respective governments. As of December 31, 2008, MLLIC held capital securities within the banking sector that were either categorized as Hybrid or Upper Tier 2.
The ‘Hybrid’ category is comprised of capital securities issued by U.S. financial services entities which typically have an original maturity of more than 30 years and may be perpetual. In addition, Hybrids have other features that may not be consistent across issues such as a cumulative or non-cumulative coupon, capital replacement language and an alternative payment mechanism, and could also be subordinate in the company’s capital structure. Capital securities categorized as ‘Upper Tier 2’ are issued by non-US banks but these positions are generally perpetual where the deferrable coupon is cumulative.
There are no individual issuers rated below investment grade in this sub-sector which have an unrealized loss position greater than $2.5 million. The following table highlights MLLIC’s credit risk to capital securities within the banking sector at December 31:
The unrealized losses in the insurance and other finance sub-sector are concentrated primarily in a few investment grade securities. These unrealized losses primarily reflect general spread widening on financial services companies (due to broad housing, mortgage market, equity market and economic issues plus increased liquidity and capital markets concerns that were referenced in the above market backdrop section), compounded in some cases by the structure of the securities (subordination or other structural features and duration). While the sub-sector has some exposure to the US residential mortgage market, the issuers are highly diversified. There are no individual issuers rated below investment grade in this sub-sector which have an unrealized loss position greater than $2.5 million.
The unrealized losses in the REIT sub-sector are a result of general spread widening in the Commercial Mortgage-Backed Securities (“CMBS”) market and the REIT unsecured market. Despite real estate values falling and capitalization rates rising, REIT’s operating fundamentals continue to perform at levels sufficient to support their debt structure. However, further fundamental deterioration is expected as unemployment rises, consumer discretionary spending falls, and tenant bankruptcies increase. The majority of REITs have exhibited financial discipline and have focused on maintaining financial flexibility during the difficult financing environment. All of the securities in an unrealized loss in this sub-sector are rated investment grade.
The Industrial sector is further subdivided into Basic Industries and Capital Goods, Consumer Cyclical, Consumer Non-Cyclical, Communications, Energy, Transportation, Technology, and Industrial other. These sub-sectors account for respectively 20%, 35%, 11%, 11%, 16%, 2%, 5% and less than 1% of the unrealized losses in the industrial sector.
The more significant of these sub-sectors from an unrealized loss perspective are retailers, automotive and gaming. Retail has been negatively impacted by a consumer pull-back in spending, particularly discretionary purchases, as increased unemployment, a weak housing market, credit market tightening and historically low consumer confidence weighed on the consumer. Margins have also been under increased pressure as many retailers have implemented aggressive promotion activity and increased discounts in an effort to drive store traffic, manage inventories and maintain market share.
Fundamentals in the gaming industry have weakened due to increased debt and related interest costs due to leveraged buyout activity and a material reduction in discretionary consumer spending. A deteriorating homebuilding environment and a material drop-off in consumer confidence, coupled with concerns over unemployment are resulting in declining demand. However, in some cases the industry is still increasing the supply of gaming products that were initiated prior to the economic downturn. There are no individual issuers rated below investment grade in this sub-sector which have an unrealized loss position greater than $2.5 million.
The Consumer Non-Cyclical industry encompasses various sub-sectors ranging from consumer products to supermarkets. The more significant of these sub-sectors from an unrealized loss perspective are food and beverages and consumer products. Food and beverages and consumer products fundamentals have modestly weakened due to higher input costs and the industries’ limited ability to pass along these higher costs to the customer. Also, the price gap between branded products and private label products became more compelling to the consumer in the fourth quarter. Additionally, shareholder friendly actions and related restructurings done earlier in 2008 were completed at the expense of bondholders.
The energy sector includes independent oil and natural gas exploration and production companies, refiners, integrated energy companies active in both exploration/production and refining, and oil field service companies. For the independent exploration and production companies, underlying long term fundamentals remain strong in the sector; however, there has been heightened near term uncertainty given the dramatic decline in commodity prices. The industry has responded by reducing capital expenditures and share buyback programs as they focus on remaining free cash flow positive. Given the low market values currently, consolidation by the larger companies is likely in the sector.
All media companies, but especially newspaper and directory companies are suffering from a tepid advertising environment related to the weak economy. This has made it difficult for companies to offset declining revenues with sufficient cost cutting initiatives, leading to significantly lower profits. In addition, this space had been a focus for activist shareholders and private equity firms, forcing management to respond by increasing financial leverage, performing consolidations or divesting assets. The net effect of this was a weaker credit profile for many companies just as the market started to slow down.
The Technology sector can be further divided into software, hardware, and technology services sub-sectors. In general the software and technology service related companies have experienced relatively stable fundamentals; however, the hardware sector has been negatively impacted by lower consumer spending (notebooks, cell phones, desktops, automotive). Despite slowing hardware demand, and excluding a few highly levered private equity semiconductor companies, a majority of technology credits have strong balance sheets that offset the negative trends. There are no individual issuers rated below investment grade in the technology sub-sector which have unrealized loss positions greater than $2.5 million.
The Transportation sector includes railroads, transportation services companies, and airlines. Underlying fundamentals remain intact for most companies in the railroad and transportation services sectors, although the weak economy has begun to pressure margins throughout the space. The railroad sector experienced volume weakness throughout 2008, particularly in the fourth quarter as the economy slowed, factories went on extended shutdowns over the holidays, and international trade volumes deteriorated. This weakness in volumes was offset by strong pricing power, the lag effect of the fuel surcharge mechanism most railroads have in place, and efficiency gains. Transportation services is a diversified sector, but as a general rule, companies began to see margin deterioration in the second half of the year as the weaker global economy resulted in reduced demand for their services.
Some sub-sectors within transportation services saw harsher operating conditions than others, with car rental companies and dry bulk shippers being hit particularly hard by the combined impact of a slowing global economy and sharply reduced access to credit. Balance sheets for most railroads and transportation services companies remain intact and are well positioned to weather the current economic cycle. Airline fundamentals deteriorated significantly through the first three quarters of 2008 due to rapidly increasing fuel costs which were not entirely passed through to the consumer. Liquidity risk over the near-term has been decreased as fuel costs moderated in the fourth quarter. Airlines continue to have high cash balances by historical standards. All of the securities in an unrealized loss in this sub-sector are rated investment grade.
The utility sector is further sub divided into Electric, Natural Gas and Other. These sub-sectors account for respectively 29%, 65% and 6% of the unrealized losses in the utility sector. Of the securities in an unrealized loss position, 82% of the unrealized loss relates to securities rated investment grade.
ABS Housing securities are secured by pools of residential mortgage loans primarily those which are categorized as subprime. The unrealized loss is primarily due to decreased liquidity and increased credit spreads in the market commensurate with significant increases in expected losses on loans within the underlying pools. Expected losses within the underlying pools are generally higher than original expectations, primarily in certain later-vintage adjustable rate mortgage loan pools, which has led to some rating downgrades in these securities and impairments within this portfolio. While most of MLLIC’s ABS housing positions are secured by pools of subprime residential mortgages, MLLIC has exposure to one asset backed security collateralized by manufactured housing loans. The market value of this security is $3.0 million with an amortized cost balance of $4.4 million. The security has a vintage of 2001.
scenarios. ABS-housing asset specialists utilize widely recognized industry modeling software to perform a loan-by-loan, bottom-up approach to modeling. The ABS-housing models incorporate external estimates on property valuations, borrower characteristics, propensity of a borrower to default or prepay and the overall security structure. Defaults were estimated by identifying the loans that are in various delinquency buckets and defaulting a certain percentage of them over the near-term and long-term. Recent payment history, a percentage of on-going delinquency rates and a constant prepayment rate are also incorporated into the model. Once the entire pool is modeled, the results are closely analyzed by the asset specialist to determine whether or not our particular tranche or holding is at risk for payment interruption. Holdings are impaired to fair value where loss events have taken place (or are projected to take place on structured securities) that would affect future cash flows on our particular tranche.
The unrealized loss on ABS - credit cards is $16.0 million. The unrealized loss in the ABS credit card sector is primarily a function of decreased liquidity and increased credit spreads in the structured finance and financial institution market. While the credit card ABS portfolios with large subprime segments may be negatively impacted by the slowing domestic economy and housing market, there has been little rating migration of the bonds held by MLLIC. All of the ABS credit card bonds held by MLLIC are rated investment grade.
The unrealized loss on ABS - autos is $2.6 million. The unrealized loss in the ABS auto sector is primarily a function of decreased liquidity and increased credit spreads with additional pressure coming from depressed auto sales and lower margins on incremental sales. While the auto ABS portfolio may be negatively impacted by the slowing domestic economy and concern over the future of the Big 3, there has been little rating migration of the bonds held by MLLIC. The Company’s entire structured auto portfolio has been stress tested. Results of these stress tests indicate that while downgrades within the portfolio may occur, all of our Class A positions are projecting payment in full. The Company does not hold any structured auto position below class “A”. As there has been no impact to expected future cash flows, MLLIC does not consider the underlying investments to be impaired as of December 31, 2008.
All CMBS securities are monitored and modeled under base and several stress-case scenarios by asset specialists. For conduit securities, a widely recognized industry modeling software is used to perform a loan-by-loan, bottom-up approach. For non-conduit securities a CMBS asset specialist works closely with AEGON USA Realty Advisors’ real estate valuation group to determine underlying asset valuation and risk. Both methodologies incorporate external estimates on the property market, capital markets, property cash flows, and loan structure. Results are then closely analyzed by the asset specialist to determine whether or not a principal or interest loss is expected to occur. If cash flow models indicate a credit event will impact future cash flows, the security is impaired to fair value.
The unrealized loss on CMBS is $39.5 million. The fundamentals of the CMBS market are, on average, strong but are starting to show some signs of deterioration in some markets. The introduction of the 20% and 30% credit enhanced, super senior AAA classes provide an offset to these negative fundamentals. The lending market has become virtually frozen as lenders have become more conservative with underwriting standards, property transactions have diminished greatly, and higher mortgage spreads have curtailed lending. A lack of liquidity in the market combined with a broad re-pricing of risk has led to increased credit spreads across the credit classes.
The unrealized loss on RMBS is $14.2 million. Of the RMBS unrealized losses, $6.9 million is attributed to the AAA rated generic shelf name, GSR MTGE LN TR 2005-AR5. MLLIC’s amortized cost in GSR is $20.2 million and the deal contains its own unique pool of collateral and represents a separate and distinct trust. The combination of low floating-rate reset margins, slow prepayment speeds, severe illiquidity in the market for near-prime securities, and the unprecedented level of mortgage-related credit spread widening have pushed the overall market value as a percent of amortized cost on all RMBS bonds in an unrealized loss position to 55%.
Negative amortization mortgages (also known as option ARMs) are loans whereby the payment made by the borrower is less than the accrued interest due and the difference is added to the loan balance. When the accrued balance of the loan reaches the negative amortization limit (typically 110% to 125% of the original loan amount), the loan recalibrates to a fully amortizing level and a new minimum payment amount is determined. The homeowner’s new minimum payment amount can be dramatically higher than the original minimum payment amount. The timing of when these loans reach their negative amortization cap will vary, and is a function of the accrual rate on each loan, the minimum payment rate on each loan and the negative amortization limit itself. Typically, these loans are estimated to reach their negative amortization limit between 3 and 5 years from the date of origination. MLLIC’s exposure to negative amortization mortgages ($4.2 million) is all AAA rated, with virtually all of these positions being super-senior AAA rated securities.
The Company defines investment grade securities as unsecured debt obligations that have a rating equivalent to Standard and Poor’s BBB- or higher (or similar rating agency). At December 31, 2008, approximately $39.9 million (or 3%) of fixed maturity securities were rated BBB-, which is the lowest investment grade rating given by Standard and Poor’s. This compares to $61.1 million (or 4%) of BBB- rated fixed maturity securities at December 31, 2007. Below investment grade securities are speculative and are subject to significantly greater risks related to the creditworthiness of the issuers and the liquidity of the market for such securities. The Company closely monitors such investments.
Details underlying securities in a continuous gross unrealized loss position for investment grade securities were as follows:
Details underlying fixed maturity securities below investment grade and in an unrealized loss position were as follows:
The majority of assets depressed over 30% as well as over 60% for up to 180 consecutive days are primarily related to subprime ABS housing and RMBS. As there has been no impact to expected future cash flows, MLLIC does not consider the underlying investments to be impaired as of December 31, 2008.
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. The Company does not currently invest in or originate whole loan residential mortgages. The Company categorizes asset backed securities issued by a securitization trust as having subprime mortgage exposure when the average credit score of the underlying mortgage borrowers in a securitization trust is below 660 at issuance. The Company also categorizes asset backed securities issued by a securitization trust with second lien mortgages as subprime mortgage exposure, even though a significant percentage of second lien mortgage borrowers may not necessarily have credit scores below 660 at issuance.
The following tables provide the subprime mortgage exposure by rating and estimated fair value by vintage at December 31:
The fair value for mortgage loans on real estate is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and/or similar remaining maturities. The estimated fair value of the mortgages on commercial real estate at December 31, 2008 was $70.8 million. There were no mortgages loans on real estate at December 31, 2007.
The investment performance of the underlying U.S. equity-based mutual funds supporting the Company’s variable products do not replicate the returns of any specific U.S. equity market index. However, investment performance will generally increase or decrease with corresponding increases or decreases of the overall U.S. equity market. There are several standard indices published on a daily basis that measure performance of selected components of the U.S. equity market. Examples include the Dow Jones Industrial Average (“Dow”), the NASDAQ Composite Index (“NASDAQ”) and the Standard & Poor’s 500 Composite Stock Price Index (“S&P”). The Dow, NASDAQ and S&P ended 2008 with decreases of 34%, 41% and 38%, respectively. The Dow, NASDAQ and S&P ended 2007 with increases of 6.4%, 9.8% and 3.5%, respectively. The Dow, NASDAQ and S&P ended 2006 with increases of 16.3%, 9.5%, and 13.6%, respectively.
During 2008, the Company did not pay any cash dividends. During 2008, the Company received a $250.0 million capital contribution from AUSA. During 2007, the Company paid extraordinary and ordinary dividends of $152.1 million and $41.6 million, respectively to MLIG. MLLIC paid a cash dividend during 2006 of $180.0 million to MLIG, of which $39.8 million was considered an ordinary dividend and $140.2 million was extraordinary.
The following table summarizes MLLIC’s ratings as of March 24, 2009:
The Company has utilized public information to estimate the future assessments it will incur as a result of life insurance company insolvencies. At December 31, 2008 and 2007, the Company’s estimated net liability for future guaranty fund assessments was $5.7 million and $5.7 million, respectively. The Company regularly monitors public information regarding insurer insolvencies and adjusts its estimated liability as appropriate.
Amortization of VOBA was $37.7 million for 2008, which included $68.5 million of unfavorable unlocking. The unlocking includes an impairment charge of $28.0 million as estimated future gross profits were less than the unamortized balance. There was no VOBA amortization in 2007.
The decrease in non-asset based policy charge revenue is primarily due to a decrease in UPCR accretion resulting from higher mortality during 2007 as compared to 2006.
The increase in credit related gains is primarily due to one large credit related gain earned in the second quarter 2007.
See the Critical Accounting Policies section above for a further discussion of variable annuity benefit reserve unlocking.
Reinsurance premium ceded increased $1.4 million (or 5%) during 2007 as compared to 2006. The increase is attributable to an increase in net amount at risk for certain variable life insurance policies containing reinsurance provisions.
Amortization of DAC decreased $20.2 million to $22.1 million during 2007 as compared to $42.3 million in 2006. Excluding the impact of DAC unlocking as noted in the Critical Accounting Policies section above, DAC amortization decreased $10.4 million
during 2007 as compared to 2006. The decrease in amortization is primarily due to higher life insurance mortality as compared to 2006.
MLLIC’s operating results are categorized into two business segments: Annuities and Life Insurance. MLLIC’s Annuity segment consists of variable annuity and interest-sensitive annuity contracts. MLLIC’s Life Insurance segment consists of variable life insurance and interest-sensitive life insurance contracts. MLLIC currently does not manufacture, market, or issue life insurance contracts. The accounting policies of the business segments are the same as those described in the summary of significant accounting policies. All revenue and expense transactions are recorded at the contract level and accumulated at the business segment level for review by management. The “Other” category, presented in the following segment financial information, represents net revenues and income on invested assets that do not support life or annuity policyholder liabilities. Subsequent to the acquisition date, management no longer considers “Other” a category for segment reporting purposes. It is impracticable to restate the prior period segment information as well as disclosing the information under both the old basis and the new basis of reporting. Therefore, the predecessor information is shown under the old basis, three segments - Annuities, Life Insurance and Other, while the successor information is shown under the new basis, two segments - Annuities and Life Insurance.