o RiverSource Life of NY is a stock life insurance company domiciled in New York, which holds Certificates of Authority in New York and North Dakota. RiverSource Life of NY issues insurance and annuity products.
On December 31, 2006, IDS Life Insurance Company completed an Agreement and Plan of Merger with both American Enterprise Life Insurance Company ("American Enterprise Life") and American Partners Life Insurance Company ("American Partners Life") whereby both companies merged with and into IDS Life Insurance Company. As a result of the merger, American Enterprise Life and American Partners Life ceased to exist. Prior to the merger, both companies were wholly-owned operating subsidiaries of IDS Life Insurance Company. Immediately following the merger, IDS Life Insurance Company changed its name to RiverSource Life Insurance Company.
No material effect on the United States generally accepted accounting principles ("U.S. GAAP") consolidated financial condition and results of operations is expected for RiverSource Life as a result of the mergers.
The following discussion and management's narrative analysis of the financial condition and results of operations should be read in conjunction with the "Forward-Looking Statements," "Item 1A - Risk Factors" and the Consolidated Financial Statements and Notes. Management's narrative analysis is presented pursuant to General Instructions I(2) (a) of Form 10-K in lieu of Management's Discussion and Analysis of Financial Condition and Results of Operations.
RESULTS OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 2006 COMPARED TO THE YEAR ENDED DECEMBER 31, 2005
Consolidated net income was $486 million for the year ended December 31, 2006 compared to $459 million for the year ended December 31, 2005, an increase of $27 million. The net income growth was positively impacted by strong growth in separate account assets, both from variable annuity net flows and market appreciation. Net flows of client assets are a measure of new sales of, or deposits into, RiverSource Life's products offset by redemptions of, or withdrawals from, RiverSource Life's products. Net flows can have a significant impact on RiverSource Life's results of operations due to their impact on revenues and expenses. These positive impacts were partially offset by lower account balances and spread compression in the fixed annuity products.
Total revenues for the year ended December 31, 2006 were $3.4 billion, an increase of $106 million from the year ended December 31, 2005 of $3.3 billion. Total premiums increased $24 million or 6.5% to $394 million for the year ended December 31, 2006.
Mortality and expense risk and other fees increased $147 million or 30.1% to $636 million for the year ended December 31, 2006 reflecting higher average values of separate account assets due to positive net flows and market appreciation.
Net realized investment gains were $51 million for the year ended December 31, 2006 compared to $48 million for the year ended December 31, 2005. For the year ended December 31, 2006, $61 million of gross realized investment gains were partially offset by $10 million of gross realized investment losses classified as Available-for-Sale.
Total benefits and expenses for the year ended December 31, 2006 were $2.7 billion, an increase of $69 million from the year ended December 31, 2005 total of $2.6 billion.
Death and other benefits for DI and LTC insurance increased $7 million or 9.2% to $83 million for the year ended December 31, 2006 reflecting unfavorable claims experience relative to 2005.
Amortization of DAC increased $40 million to $356 million for the year ended December 31, 2006 from $316 million for the year ended December 31, 2005.
For the years ended December 31, 2006 and 2005, RiverSource Life incurred $131 million and $121 million, respectively, in separation costs. Separation costs incurred during 2006 and 2005 primarily related to technology costs and marketing and rebranding. Separation costs incurred during 2005 also included costs related to advisor retention programs.
Other insurance and operating expenses increased $53 million or 9.0% to $641 million for the year ended December 31, 2006 primarily reflecting increased corporate overhead expenses, business reinvestment initiatives and compensation costs offset by a decrease in business services expenses.
RiverSource Life's effective tax rate was 28.3% and 28.4% for the years ended December 31, 2006 and 2005, respectively.
For annuity and life, DI and LTC insurance products, key assumptions underlying these long-term projections include interest rates (both earning rates on invested assets and rates credited to policyholder accounts), equity market performance, mortality and morbidity rates and the rates at which policyholders are expected to surrender their contracts, make withdrawals from their contracts and make additional deposits to their contracts. Assumptions about interest rates are the primary factor used to project interest margins, while assumptions about rates credited to policyholder accounts and equity market performance are the primary factors used to project client asset value growth rates, and assumptions about surrenders, withdrawals and deposits comprise projected persistency rates. Management must also make assumptions to project maintenance expenses associated with servicing its annuity and insurance business during the DAC amortization period.
For additional information about RiverSource Life's accounting policies for amortization and capitalization of DAC, see Note 2 and Note 3 to the Consolidated Financial Statements. For details regarding the balances of and changes in DAC for the years ended December 31, 2006, 2005 and 2004, see Note 6 to the Consolidated Financial Statements.
LIABILITIES FOR FUTURE POLICY BENEFITS AND POLICY CLAIMS AND OTHER POLICYHOLDERS' FUNDS
Future policy benefits and policy claims and other policyholders' funds related to fixed annuities and variable annuity guarantees include liabilities for fixed account values on fixed and variable deferred annuities, guaranteed benefits associated with variable annuities, equity indexed annuities and fixed annuities in a payout status.
In determining the liabilities for variable annuity death benefits and GMIB, RiverSource Life projects these benefits and contract assessments using actuarial models to simulate various equity market scenarios. Significant assumptions made in projecting future benefits and assessments relate to customer asset value growth rates, mortality, persistency and investment margins and are consistent with those used for DAC asset valuation for the same contracts. As with DAC, management will review, and where appropriate, adjust its assumptions each quarter. Unless management identifies a material deviation over the course of quarterly monitoring, management will review and update these assumptions annually in the third quarter of each year. The variable annuity death benefit liability is determined by estimating the expected value of death benefits in excess of the projected contract accumulation value and recognizing the excess over the estimated meaningful life based on expected assessments (e.g., mortality and expense fees, contractual administrative charges and similar fees).
Liabilities for fixed annuities in a benefit or payout status are based on future estimated payments using established industry mortality tables and interest rates, ranging from 4.6% to 9.5% at December 31, 2006, depending on year of issue, with an average rate of approximately 5.9%.
Liabilities for estimates of benefits that will become payable on future claims on term life, whole life, DI and LTC policies are based on the net level premium method, using anticipated premium payments, mortality and morbidity rates, policy persistency and interest rates earned on assets supporting the liability. Anticipated mortality and morbidity rates are based on established industry mortality and morbidity tables, with modifications based on RiverSource Life's experience. Anticipated premium payments and persistency rates vary by policy form, issue age, policy duration and certain other pricing factors. Anticipated interest rates for term and whole life range from 4.0% to 10.0% at December 31, 2006, depending on policy form, issue year and policy duration. Anticipated interest rates for DI are 7.5% at policy issue grading to 5.0% over 5 years. Anticipated discount rates for LTC are currently 5.4% at December 31, 2006 grading up to 9.4% over 40 years.
Where applicable, benefit amounts expected to be recoverable from other insurers who share in the risk are separately recorded as reinsurance recoverable within receivables.
RiverSource Life issues only non-participating life and health insurance policies, which do not pay dividends to policyholders from realized policy margins.
The fair value of RiverSource Life's derivative financial instruments is determined using either market quotes or valuation models that are based upon the net present value of estimated future cash flows and incorporate current market data inputs. In certain instances, the fair value includes structuring costs incurred at the inception of the transaction. The accounting for the change in the fair value of a derivative financial instrument depends on its intended use and the resulting hedge designation, if any. RiverSource Life currently designates derivatives as cash flow hedges or, in certain circumstances, does not designate derivatives as accounting hedges.
For derivative financial instruments that qualify as cash flow hedges, the effective portions of the gain or loss on the derivative instruments are reported in accumulated other comprehensive income (loss) and reclassified into earnings when the hedged item or transactions impact earnings. Any ineffective portion of the gain or loss is also reported currently in earnings as a component of net investment income.
For derivative financial instruments that do not qualify for hedge accounting or are not designated as hedges, changes in fair value are recognized in current period earnings, generally as a component of net investment income. These derivatives primarily provide economic hedges to equity market exposures. Examples include structured derivatives and options and futures that economically hedge the equity components of certain annuities.
Income taxes, as reported in the Consolidated Financial Statements, represent the net amount of income taxes that RiverSource Life expects to pay to or receive from various taxing jurisdictions in connection with its operations. RiverSource Life provides for income taxes based on amounts that it believes it will ultimately owe. Inherent in the provision for income taxes are estimates and judgments regarding the tax treatment of certain items and the realization of certain offsets and credits. In the event that the ultimate tax treatment of items or the realization of offsets or credits differs from RiverSource Life's estimates, it may be required to significantly change the provision for income taxes recorded in its Consolidated Financial Statements.
RiverSource Life will not be able to file a consolidated U.S. federal income tax return with the other members of the Ameriprise Financial affiliated group for five tax years following the Distribution, which will result in net operating and capital losses, credits and other tax attributes generated by one group not being available to offset income earned or taxes owed by the other group during the period of non-consolidation. This lack of consolidation could affect RiverSource Life's ability to fully realize certain deferred tax assets, including the capital losses.
RiverSource Life is required to establish a valuation allowance for any portion of deferred tax assets that management believes will not be realized. It is likely that management will need to identify and implement appropriate planning strategies to ensure its ability to realize deferred tax assets relating to capital losses and avoid the establishment of a valuation allowance with respect to it. In the opinion of management, it is currently more likely than not that RiverSource Life will realize the benefit of deferred tax assets, including capital loss deferred tax assets; therefore, no such valuation allowance has been established.
RiverSource Life's total assets and liabilities increased in 2006 primarily due to higher separate account assets and liabilities, which increased as a result of positive variable annuity net flows and market appreciation.
Investments primarily include corporate debt securities and mortgage and other asset-backed securities. At December 31, 2006, RiverSource Life's corporate debt securities comprise a diverse portfolio with the largest concentrations accounting for approximately 67% of the portfolio in the following industries: banking and finance, utilities, and communications and media. Investments also include $3.7 billion and $4.0 billion of mortgage loans on real estate, policy loans and other investments at December 31, 2006 and 2005, respectively. Investments are principally funded by sales of insurance and annuities and by reinvested income. Maturities of these investment securities are largely matched with the expected future payments of insurance and annuity obligations.
RiverSource Life paid $300 million of dividends to Ameriprise Financial during 2006 comprised of $100 million of extraordinary cash dividends in each of the second and third quarters of 2006 and $100 million of ordinary cash dividends in the fourth quarter of 2006. Prior to the payment of the extraordinary cash dividends, RiverSource Life made the required advance notices to the Minnesota Department of Commerce, its primary state regulator, and received responses stating there were no objections to the payment of these dividends. In connection with the Separation, RiverSource Life received a capital contribution of $650 million from Ameriprise Financial during the third quarter of 2005 to support its current financial strength ratings and to cover the allocated separation costs. During the fourth quarter of 2005, RiverSource Life paid dividends to Ameriprise Financial of $380 million.
During the years ended December 31, 2005 and 2004, RiverSource Life consolidated three secured loan trusts ("SLTs") which provided returns to investors primarily based on the performance of an underlying portfolio of high-yield loans and which were managed by an affiliate. One SLT was liquidated in 2004, resulting in a cumulative pretax charge of $24 million. An additional $4 million pretax charge was incurred in 2004 due to the expected liquidation of the two remaining SLTs in 2005. Those remaining SLTs were liquidated in 2005, resulting in a $14 million pretax gain for the year ended December 31, 2005. There was no remaining exposure in 2006 related to these SLTs as a result of their liquidation.
In 2001, RiverSource Life placed a majority of its rated CDO securities and related accrued interest, as well as a relatively minor amount of other liquid securities, having an aggregate book value of $675 million, into a securitization trust. In return, RiverSource Life received $90 million in cash (excluding transaction expenses) relating to sales to unaffiliated investors and retained interests with allocated book amounts aggregating $586 million. During the second quarter of 2005, RiverSource Life sold all of its retained interest in the CDO-related securitization trust and realized a net pretax gain of $25 million.
RiverSource Life is assessing a comment from the Minnesota Department of Commerce related to the actuarial calculation of disability income insurance unpaid claims, received as part of its routine financial examination of RiverSource Life Insurance Company for each of the five years in the period ended December 31, 2005. RiverSource Life's management does not believe that there will be a material adverse effect on its consolidated financial condition and results of operations upon resolution of this comment.
RiverSource Life has developed an asset/liability management approach with separate investment objectives to support specific product liabilities, such as insurance and annuities. As part of this approach, RiverSource Life develops specific investment guidelines that are designed to optimize trade offs between risk and return and help ensure RiverSource Life is able to support future benefit payments under its insurance and annuity obligations. These same objectives must be consistent with management's overall investment objectives for the general account investment portfolio.
RiverSource Life's owned investment securities are primarily invested in long-term and intermediate-term fixed maturity securities to provide clients with a competitive rate of return on their investments while managing risk. Investment in fixed maturity securities is designed to provide RiverSource Life with a targeted margin between the yield earned on investments and the interest rate credited to clients' accounts. RiverSource Life does not trade in securities to generate short-term profits for its own account.
As part of RiverSource Life's investment process, management, with the assistance of its investment advisors, conducts a quarterly review of investment performance. The review process involves the review of certain invested assets which the committee evaluates to determine whether or not any investments are other-than-temporarily impaired and/or which specific interest earning investments should be put on an interest non-accrual basis.
With variable annuities and VUL products, the policyholder chooses how the premiums are invested. They can choose equity or non-equity investments and those investments are carried in separate account assets. Annuity payouts, VUL cash value and death benefits fluctuate with the performance of the investments that the policyholder chooses. Therefore, for these products, policyholders assume the bulk of the investment risk. RiverSource Life faces interest rate and equity price risk on these products from two primary sources: the guaranteed benefits associated with variable annuities and the management fees earned on separate account assets.
The total value of all variable annuity contracts has grown from $39.8 billion at December 31, 2005 to $49.2 billion at December 31, 2006. These contract values include GMWB contracts which have grown from $2.5 billion at December 31, 2005 to $7.2 billion at December 31, 2006. Reserve liabilities for the guaranteed benefits are recorded in future policy benefits on RiverSource Life's Consolidated Balance Sheets. At December 31, 2006, the reserve for the GMWB was a negative $12 million compared with a reserve of a positive $9 million at December 31, 2005. The negative reserve indicates that RiverSource Life expects the GMWB fees charged to more than offset the future benefits to be paid to policyholders under the guaranteed benefit provisions. At December 31, 2006, the reserve for the other variable annuity guaranteed benefits, GMAB, GMDB and GMIB, was $26 million compared with $21 million at December 31, 2005.
RiverSource Life manages the market risk on the guaranteed benefits by product design and by the use of financial derivatives which hedge the GMWB. The design of the GMWB is an example of how RiverSource Life uses product design to manage risk. First, the GMWB provision requires that policyholders invest their funds in one of five asset allocation models, thus ensuring diversification across asset classes and underlying funds, reducing the likelihood that payouts from the guaranteed benefits will be required to compensate policyholders for investment losses. Second, the GMWB provision does not offer automatic annual percentage increases to the guaranteed amount, thus preventing the guaranteed amount from growing during a down market.
In addition to product design, RiverSource Life has implemented a comprehensive hedging program which utilizes a primarily static hedging approach. A primarily static approach improves mitigation of market dislocation and operational risks as compared to a primarily dynamic hedging approach. Currently, RiverSource Life only hedges GMWB. The notional amounts and fair value assets (liabilities) of derivatives hedging GMWB were as follows:
Separate account assets are held for the exclusive benefit of variable annuity and VUL contract holders. RiverSource Life does, however, receive asset-based investment management fees on fixed income investments the annuity and VUL policyholders have in the separate accounts. An increase in interest rates would decrease fixed rate separate account assets and decrease related fees with a negative impact to pretax income. At December 31, 2006, RiverSource Life estimates the interest rate risk from this exposure on pretax income if, hypothetically, interest rates had increased immediately by 100 basis points and remain at that level for 12 months to be a negative $5 million for the 12 month period. RiverSource Life does not hedge this exposure.
The variable annuity guaranteed benefits guarantee payouts to the annuity holder under certain specific conditions, regardless of the performance of the investment assets. For this reason, when equity markets decline, the returns from the separate account assets coupled with guaranteed benefit fees from annuity holders may not be sufficient to fund expected payouts. In that case, reserves must be increased with a negative impact to earnings. RiverSource Life estimates the negative impact on pretax income before hedging to be $42 million if, hypothetically, equity markets had declined by 10% at December 31, 2006 and remain at that level for 12 months. Of the $42 million, $7 million is attributable to GMWB.
Currently RiverSource Life only hedges GMWB. RiverSource Life's hedging program is static which reduces risk to major disruptions in the market and severe liquidity events because its program does not rely on frequent dynamic rebalancing and the ability to trade in the market. In addition, the primarily static nature of the hedge reduces the likelihood of operational and execution errors. The core derivative instrument with which RiverSource Life hedges the equity price risk of GMWB is a long-dated structured equity put contract; this core instrument is supplemented with equity futures. The equity put contracts had a notional amount of $1.4 billion at December 31, 2006. If, hypothetically, equity markets had declined by 10% at December 31, 2006 and remain at that level for 12 months, RiverSource Life estimates a positive impact to pretax income of $4 million from the puts and futures. The net equity price exposure to pretax income from all variable annuity guarantee benefits would be a negative $38 million.
FIXED ANNUITIES, FIXED PORTION OF VARIABLE ANNUITIES, FIXED PORTION OF VUL AND FIXED INSURANCE PRODUCTS
Therefore, in an increasing rate environment, higher interest rates are reflected in crediting rates to clients sooner than in rates earned on invested assets resulting in a reduced spread between the two rates, reduced earned income and a negative impact on pretax income. RiverSource Life had $26.5 billion in reserves in future policy benefits on its Consolidated Balance Sheets at December 31, 2006 to recognize liabilities created by these products. To hedge against the risk of higher interest rates, RiverSource Life has purchased swaption contracts which had the notional amounts and fair value assets as follows:
The equity-linked return is based on a participation rate initially set at between 50% and 90% of the S&P 500 Index which is guaranteed for the initial seven-year term when the contract is held to full term. Of the $29.6 billion in future policy benefits at December 31, 2006, $317 million relates to the liabilities created by this product. The notional amounts and fair value assets (liabilities) of derivatives hedging this product were as follows:
A decline in equity markets would result in reduced fee revenue and an increase in guaranteed death and living benefit reserves associated with RiverSource Life's variable annuity products, with the increase partly offset by changes in hedge asset values. This would result in decreased estimated gross profits and decreased DAC amortization. RiverSource Life estimates that if, hypothetically, equity markets declined by 10% at December 31, 2006, the positive impact to pretax income from decreased DAC amortization would be $16 million over a 12 month period.
RiverSource Life's potential derivative credit exposure to each counterparty is aggregated with all of its other exposures to the counterparty to determine compliance with established credit and market risk limits at the time RiverSource Life enters into a derivative transaction. Credit exposures may take into account enforceable netting arrangements. Before executing a new type or structure of derivative contract, RiverSource Life determines the variability of the contract's potential market and credit exposures and whether such variability might reasonably be expected to create exposure to a counterparty in excess of established limits.
o changes in the interest rate, equity market and other financial market environments; o changes in the regulatory environment and judicial or legislative developments, including the increasing focus on customer suitability, sales practices and disclosure, as well as ongoing legal proceedings and regulatory actions; o RiverSource Life's investment management performance; o effects of competition in the financial services industry and changes in RiverSource Life's product distribution mix and distribution channels; o RiverSource Life's capital structure as a subsidiary of Ameriprise Financial, including the ability of its parent to support its financial strength and ratings; o risks of default by issuers of investments RiverSource Life owns or by counterparties to derivative or reinsurance arrangements; o experience deviations from RiverSource Life's assumptions regarding morbidity, mortality and persistency in certain annuity and insurance products; o successfully cross-selling insurance and annuity products and services to Ameriprise Financial's customer base; o RiverSource Life's ability to effectively hedge risks relating to guaranteed benefit riders and certain other products; o the impact of the separation of Ameriprise Financial from American Express; o the impact of intercompany allocations to RiverSource Life from Ameriprise Financial and its affiliates; o Ameriprise Financial's ability to attract, recruit and retain qualified advisors and employees and its ability to distribute its products through current and future distribution channels; o RiverSource Life's ability to establish its new brands; o changes in U.S. federal income or estate tax laws potentially making RiverSource Life's products less attractive to clients; o RiverSource Life's ability to recover from catastrophes, both natural and man-made; and o general economic and political factors, including consumer confidence in the economy.
February 28, 2007 /s/ Brian J. McGrane - ----------------- ----------------------------------------------- Date Brian J. McGrane, Director, Executive Vice President and Chief Financial Officer
February 28, 2007 /s/ David K. Stewart - ----------------- ----------------------------------------------- Date David K. Stewart, Vice President and Controller
2.2 Copy of Articles of Merger by and between IDS Life Insurance Company and American Partners Life Insurance Company dated March 17, 2006, filed electronically as Exhibit 99.2 to Form 8-K filed on Jan. 5, 2007 is incorporated by reference.
3.1.1 Copy of Certificate of Amendment of Certificate of Incorporation of IDS Life Insurance Company dated June 22, 2006, filed electronically as Exhibit 3.1 to Form 8-K filed on Jan. 5, 2007 is incorporated by reference.
4.1 Instruments defining the rights of security holders, including indentures, are incorporated by reference to Registration Statement Nos. 333-92297, 333-139763, 333-73958, 333-139759, 333-74865, 333-139760, 333-82149, 333-139761, 333-85567, 333-139762, 33-47302, 333-79311, 333-114888 and 33-28976.
*10.3 Copy of Marketing Support Services Agreement between Ameriprise Financial Services, Inc. and RiverSource Life Insurance Company effective Jan. 1, 2007.
*10.5 Form of Federal Income Tax Sharing Agreement by and among RiverSource Life Insurance Company, RiverSource Life Insurance Co. of New York and Ameriprise Financial, Inc. effective Jan. 1, 2007.
*10.6 Copy of Agreement by and among RiverSource Life Insurance Company, Ameriprise India Private Limited, and Ameriprise Financial, Inc. (a/k/a/ Supplementary Agreement No. 1) effective Jan. 1, 2007.
*31.1 Certification of Mark E. Schwarzmann, Chief Executive Officer, pursuant to Rule 13a-14(a) promulgated under the Securities Exchange Act of 1934, as amended.
*31.2 Certification of Brian J. McGrane, Chief Financial Officer, pursuant to Rule 13a-14(a) promulgated under the Securities Exchange Act of 1934, as amended.