The 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.
Regulatory changes relating to the insurance industry in the jurisdictions in which we operate;
Competitive, legal, regulatory or tax changes that affect the distribution cost of or demand for our products; and
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’s), guaranteed minimum income benefits (GMIB’s) and guaranteed minimum withdrawal benefits (GMWB’s). MLLIC believes that the demand for retirement products containing guarantee features will continue to increase in the future. MLLIC believes it is positioned to continue meeting these demands for guaranteed benefits.
On December 28, 2007, AUSA completed the acquisition of MLLIC and its affiliate MLLICNY. In accordance with Statement of Financial Accounting Standard (“SFAS”) No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangibles, the acquisition is being accounted for by AUSA using the purchase method of accounting, which requires the assets and liabilities of MLLIC to be identified and measured at their estimated fair values as of the Acquisition Date. The estimated fair values are subject to adjustment of the initial allocation for a one-year period as more information relative to the fair values as of the Acquisition Date becomes available.
MLLIC’s critical accounting policies and estimates are discussed below. See Note 2 to the Financial Statements for additional information regarding accounting policies.
MLLIC’s principal 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 value of publicly traded fixed maturity and equity securities are based on independently quoted market prices. For non-publicly traded fixed maturity and equity securities, MLLIC utilizes pricing services and broker quotes to determine fair value. Since significant judgment is required for the valuation of non-publicly traded securities, the estimated fair value of these securities may differ from amounts realized upon an immediate sale. At December 31, 2007 and December 31, 2006, approximately, $144.5 million (or 10%) and $203.2 million (or 12%), respectively, of MLLIC’s fixed maturity and equity securities portfolio consisted of non-publicly traded securities.
Changes in the fair value of fixed maturity and equity securities are reported as a component of accumulated other comprehensive loss, net of taxes on the Balance Sheets and are not reflected in the Statements of Earnings until a sale transaction occurs or when declines in fair value are deemed other-than-temporary.
MLLIC 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 MLLIC’s portfolio managers and credit analysts, information obtained from external sources (i.e. company announcements, ratings agency announcements, or news wire services) and MLLIC’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. OTT impairment losses result in a permanent reduction of the cost basis of the investment. MLLIC did not experience any realized investment losses due to OTT declines in fair value for the years ended December 31, 2007 and December 31, 2006. For the year ended December 31, 2005, MLLIC realized investment losses due to OTT declines in fair value of $1.9 million.
VOBA represents the portion of the purchase price that is allocated to the value of the right to receive future cash flows from the insurance and annuity contracts inforce at the Acquisition Date. VOBA is based on actuarially determined projections, by each block of business, of future policy and contract charges, premiums, mortality, policyholder behavior, separate account performance, operating expenses, investment returns, and other factors. Actual experience on the purchased business may vary from these projections. Revisions in estimates result in changes to the amounts expensed in the reporting period in which the revisions are made and could result in the impairment of the asset and a charge to income if estimated future gross profits are less than the unamortized balance. In addition, MLLIC utilizes the reversion to the mean assumption, a common industry practice, in its determination of the amortization of VOBA.
Goodwill is the excess of the purchase price over the estimated fair value of net assets acquired. Under SFAS No. 142, Goodwill and Other Intangible Assets, 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 “reporting unit” level. A reporting unit represents the operating segment which is the level at which the financial information is prepared and regularly reviewed by management. Goodwill is reviewed for indications of value impairment, with consideration given to financial performance and other relevant factors. In addition, certain events including a significant adverse change in legal factors or the business climate, an adverse action or assessment by a regulator, or unanticipated competition would cause MLLIC to review the carrying amounts of goodwill for impairment. When considered impaired, the carrying amounts are written down to fair value based primarily on discounted cash flows. 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 acquired goodwill. At December 31, 2007, the goodwill asset was $156.9 million. There was no goodwill asset at December 31, 2006. The entire asset amount has been allocated to annuities.
MLLIC’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 the account balance. Policyholder account balances at December 31, 2007 and December 31, 2006 were $1.9 billion and $2.0 billion, respectively.
Included within future policy benefits are liabilities for GMDB and GMIB provisions contained in the variable products MLLIC issues. At December 31, 2007 and December 31, 2006, GMDB and GMIB liabilities included within future policy benefits were $74.6 million and $101.0 million, respectively. MLLIC regularly evaluates the assumptions used to establish these liabilities, as well as actual experience and adjusts GMDB and/or GMIB liabilities with a related charge or credit to earnings (“unlocking”), if actual experience or evidence suggests that the assumptions should be revised. For the year ended December 31, 2007 and December 31, 2006, the favorable impact to pre-tax earnings related to GMDB and GMIB unlocking was $22.0 million and $10.7 million, respectively. See Note 6 to the Financial Statements for a further discussion of GMDB and GMIB liabilities.
MLLIC’s variable universal life insurance product includes a premium load that is higher in early policy years than in later years. The excess of the initial load over the ultimate load is accreted into revenue over time in the same manner that DAC is amortized. In addition, the unearned policy charge revenue liability is subject to the same periodic reassessment as DAC. For the year ended December 31, 2007, the unfavorable impact on pre-tax earnings related to UPCR unlocking was $4.8 million. For the years ended December 31, 2006 and 2005, the favorable impact on pre-tax earnings related to UPCR was $1.5 million, and $67.9 million, respectively. See Note 5 to the Financial Statements for a further discussion of period-to-period differences in UPCR unlocking. As of December 31, 2007, the UPCR liability was zero as a result of the push-down accounting at the Acquisition Date. See Note 3 to the Financial Statements for a further discussion of push-down accounting adjustments. At December 31, 2006 MLLIC’s UPCR liability was $35.5 million.
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 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. MLLIC expects to adopt SFAS 160 on January 1, 2009 and has not yet determined the effect of SFAS 160 on its Financial Statements.
On January 1, 2007, MLLIC 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 MLLIC’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 MLLIC’s Financial Statements.
In September 2006, the FASB issued SFAS No. 157 Fair Value Measurements. SFAS No. 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 with early adoption permitted, provided the entity has not yet issued financial statements for the fiscal year, including any interim periods. The provisions of SFAS No. 157 are to be applied prospectively. Prior to the acquisition by AUSA, MLLIC had early adopted SFAS No. 157 as of the first quarter 2007, which did not have a material impact on MLLIC’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, MLLIC will adopt SFAS No. 157 on January 1, 2008 and it is not expected to have a material impact on MLLIC’s Financial Statements.
Total direct deposits by product, including internal exchanges, for the three years ended December 31 were as follows:
Total direct deposits decreased $13.8 million (or 2%) to $773.0 million for the period ended December 31, 2007, as compared to the same period ended December, 31, 2006 primarily due to a decrease in other deposits. During 2007, variable annuity deposits which represent 97% to total direct deposits were relatively unchanged as compared to 2006.
During 2007, MLLIC experienced contract owner withdrawals that exceeded deposits on all products by $1,083.5 million. The components of contract owner transactions were as follows:
At December 31, 2007 and 2006, approximately $1,399.3 million (or 99%) and $1,552.9 million (or 99%), respectively, of fixed maturity securities were considered investment grade. MLLIC 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). Also, at December 31, 2007, approximately $61.1 million (or 4%) of fixed maturity securities were rated BBB-, which is the lowest investment grade rating given by Standard and Poor’s. This compares to $58.7 million (or 4%) of BBB- rated fixed maturity securities at December 31, 2006.
MLLIC’s investment in collateralized mortgage obligations (“CMO”) and mortgage backed securities (“MBS”) had a carrying value of $208.6 million and $91.8 million at December 31, 2007 and 2006, respectively. At December 31, 2007 and 2006, approximately $151.3 million (or 73%) and $68.4 million (or 74%), respectively, of CMO and MBS holdings were fully collateralized by the Government National Mortgage Association, the Federal National Mortgage Association or the Federal Home Loan Mortgage Corporation. CMO and MBS securities are structured to allow the investor to determine, within certain limits, the amount of interest rate risk, prepayment risk and default risk that the investor is willing to 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 corporate securities with similar credit ratings.
The investment performance of the underlying U.S. equity-based mutual funds supporting MLLIC’s variable products does 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 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.
Changes in the U.S. equity market directly affect the values of the underlying U.S. equity-based mutual funds supporting separate accounts assets and, accordingly, the values of variable contract owner account balances. Approximately 79% of separate accounts assets were invested in equity-based mutual funds at December 31, 2007. Since asset-based fees collected on inforce variable contracts represent a significant source of revenue, MLLIC’s financial condition will be impacted by fluctuations in investment performance of equity-based separate accounts assets.
During 2007, average variable account balances increased $445.4 million (or 4%) to $11.5 billion as compared to 2006. The increase in average variable account balances contributed to a $9.8 million (or 6%) 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 MLLIC has certain fixed products that contain guaranteed minimum crediting rates, decreases in interest rates can decrease the amount of interest spread earned.
MLLIC’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. MLLIC 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. MLLIC 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, MLLIC’s assets included $1.5 billion and $1.8 billion, respectively, of cash, cash equivalents, and investment grade publicly traded available-for-sale securities that could be liquidated if funds were required.
MLLIC 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, MLLIC may have to look to its parent and other affiliated companies to provide the capital or borrowings necessary to support its current marketing efforts. MLLIC’s future marketing efforts could be hampered should its parent and/or affiliates be unwilling to commit additional funding.
Prior to the Acquisition Date, MLLIC and ML&Co. were parties to a “keepwell” agreement which obligated ML&Co. to maintain a level of capital in MLLIC in excess of minimum regulatory requirements. Subsequent to the Acquisition Date, MLLIC and AUSA are parties to a “keepwell” agreement which commits AUSA to maintain MLLIC at a minimum net worth.
In order to continue to issue annuity products, MLLIC must meet or exceed the statutory capital and surplus requirements of the insurance departments of the states in which it conducts business. Statutory accounting practices differ from generally accepted accounting principles (“GAAP”) in two major respects. First, under statutory accounting practices, the acquisition costs of new business are charged to expense, while under GAAP they are amortized over a period of time. Second, under statutory accounting practices, the required additions to statutory reserves are calculated under different rules than under GAAP.
The National Association of Insurance Commissioners utilizes the 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, MLLIC’s total adjusted capital level was well in excess of the minimum amount of capital required to avoid regulatory action.
The following table summarizes MLLIC’s policyholder obligations as of December 31, 2007:
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.
Net realized investment gains increased $0.9 million (or 75%) to $2.1 million during 2007 as compared to $1.2 million in 2006. The following table provides the changes in realized investment gains by type:
Policy benefits increased $3.1 million (or 8%) to $42.3 million during 2007 as compared to $39.2 million in 2006. The following table provides the changes in policy benefits by type:
MLLIC’s effective federal income tax rate decreased to 31% for 2007 from 32% for 2006 primarily due to period-to-period differences in DRD and FTC adjustments as noted in the Critical Accounting Policies section above.
Policy charge revenue decreased $40.1 million (or 13%) to $264.7 million during 2006 as compared to $304.8 million in 2005. The following table provides the changes in policy charge revenue by type for each respective period:
The increase in non-asset based policy charge revenue is primarily due an increase in UPCR accretion resulting from lower mortality during 2006 as compared to 2005.
Net realized investment gains decreased $1.4 million to $1.2 million during 2006 as compared to $2.6 million in 2005 primarily due to period-to-period differences in credit related gains. Prior year credit related gains were favorably impacted by a large gain on one security.
The increase in variable annuity benefit expense is due to increased accruals for variable annuity liabilities resulting from the higher asset-based policy charge revenue.
MLLIC’s effective federal income tax rate increased to 32% for 2006 from 25% for 2005 primarily due to period-to-period differences in DRD and FTC adjustments as noted in the Critical Accounting Policies section above.
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 earnings 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.
MLLIC is not dependent upon any single customer, and no single customer accounted for more than 10% of its revenues during 2007, 2006, or 2005.
MLLIC’s operations have not been materially impacted by inflation and changing prices during the preceding three years.