The Registrant’s home office is located in Little Rock, Arkansas. Personnel performing services for the Registrant operate in MLIG office space, which occupies certain office space in Pennington, New Jersey through ML&Co. In addition, personnel performing services for the Registrant also operate in office space in Jacksonville, Florida, which is owned by ML&Co.
Subsequent to the Acquisition Date, ML&Co. and AUSA entered into a transition services agreement whereby ML&Co. is to provide certain outsourced services required for the normal operations of the business. An allocable share of the cost of each of the abovementioned premises is paid by the Registrant through the transition service agreement with ML&Co.
Changes affecting interest rate levels and continuing low or rapidly changing interest rate levels;
Our failure to achieve anticipated levels of earnings or operational efficiencies as well as other cost saving initiatives
In addition, as required by the U.S. Securities and Exchange Commission Staff Accounting Bulletin 54, Push Down Basis of Accounting in Financial Statements of a Subsidiary, the purchase method of accounting applied by AUSA to the acquired assets and liabilities associated with MLLIC has been “pushed down” to the financial statements of MLLIC, thereby establishing a new basis of accounting.
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 is subject to recoverability testing at the time of policy issuance and loss recognition testing at the end of each reporting period. As of December 31, 2007, the DAC balance 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, variable annuities and variable life insurance accounted for $191.9 million (or 67%) and $83.2 million (or 29%), respectively, of MLLIC’s DAC asset.
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, MLLIC 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. For variable life insurance, MLLIC generally assumes 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, MLLIC 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.
This practice assumes that the expectations for long-term appreciation in equity markets is not changed by minor short-term market fluctuations, but that it does change when large interim deviations have occurred. 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 VOBA. At December 31, 2007, the VOBA asset was $575.0 million. There was no VOBA asset balance at December 31, 2006.
Other intangible assets that were acquired at the Acquisition Date include a distribution agreement, a tradename, and a non-compete agreement. The tradename and the non-compete are required to be amortized on a straight-line basis over their useful life of five years. The distribution intangible will be amortized over the expected economic benefit period and at a pace consistent with the expected future gross profit streams generated from the distribution agreement, which is 30 years. The carrying values of the intangibles will be reviewed periodically for indicators of impairment in value including unexpected or adverse changes in the following: (1) the economic or competitive environments in which MLLIC operates, (2) the profitability analyses, (3) cash flow analyses, and (4) the fair value of the relevant business operation. If there was an indication of impairment, then the cash flow method would be used to measure the impairment, and the carrying value would be adjusted as necessary. Since there were no events or circumstances to indicate that there may be any significant change in the fair value of net assets acquired on December 28, 2007, management did not perform an impairment test for the other intangibles. At December 31, 2007, other intangible assets were $74.9 million. There were no other intangible assets at December 31, 2006. The entire asset amount has been allocated to annuities.
MLLIC establishes liabilities for amounts payable on its life and annuity contracts based on methods and underlying assumptions in accordance with SFAS No. 60, Accounting and Reporting by Insurance Enterprises, 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, and Statement of Position (“SOP”) 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts and applicable actuarial standards.
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 represents the present value of future reinsurance deposits net of reinsurance recoverables less a provision for required profit. At December 31, 2007 and December 31, 2006, GMDB and GMIB reinsurance liabilities included within future policy benefits were $14.6 million and $5.1 million, respectively. See Note 6 to the Financial Statements for a further discussion of GMWB and GMIB reinsurance liabilities.
MLLIC uses the asset and liability method in providing income taxes on all transactions that have been recognized in the financial statements. The asset and liability method requires that deferred taxes be adjusted to reflect the tax rates at which future taxable amounts will be settled or realized. MLLIC provides for federal income taxes based on amounts it believes it will ultimately owe. Inherent in the provision for federal income taxes are estimates regarding the realization of certain tax deductions and credits.
Specific estimates include the realization of dividend-received deductions (“DRD”) and foreign tax credits (“FTC”). A portion of MLLIC’s investment income related to separate accounts business qualifies for the DRD and FTC. Information necessary to calculate these tax adjustments is typically not available until the following year. However, within the current year’s provision, management makes estimates regarding the future tax deductibility of these items. These estimates are primarily based on recent historic experience. See Note 7 to the Financial Statements for period-to-period differences in DRD and FTC adjustments. During 2007, 2006, and 2005, MLLIC reduced its provision for federal income taxes by $6.8 million, $4.4 million and $9.2 million, respectively, due to DRD and FTC adjustments.
MLLIC adopted the provisions of FASB Interpretation (“FIN”) No. 48, Accounting for Uncertainty in Income Taxes, on January 1, 2007. MLLIC has analyzed all material tax positions under the provisions of FIN No. 48, and has determined that there are no tax benefits that should not be recognized as of December 31, 2007 or as of December 31, 2006.
There are no unrecognized tax benefits that would affect the effective tax rate. It is not anticipated that the total amounts of unrecognized tax benefits will significantly increase within twelve months of the reporting date.
In December 2007, Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 141 (revised 2007), “Business Combinations” (“SFAS 141(R)”). This statement replaces SFAS No. 141, “Business Combinations” (“SFAS 141”) and establishes the principles and requirements for how the acquirer in a business combination: (a) measures and recognizes the identifiable assets acquired, liabilities assumed, and any noncontrolling interests in the acquired entity, (b) measures and recognizes positive goodwill acquired or a gain from bargain purchase (negative goodwill), and (c) determines the disclosure information that is decision-useful to users of financial statements in evaluating the nature and financial effects of the business combination. SFAS 141(R) is effective for and shall be applied prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008, with earlier adoption prohibited. Assets and liabilities that arose from business combinations with acquisition dates prior to the SFAS 141(R) effective date shall not be adjusted upon adoption of SFAS 141(R) with certain exceptions for acquired deferred tax assets and acquired income tax positions. MLLIC expects to adopt SFAS 141(R) on January 1, 2009, and has not yet determined the effect of SFAS 141(R) on its Financial Statements.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS No. 159 provides a fair value option election that allows companies to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and liabilities, with changes in fair value recognized in earnings as they occur. SFAS No. 159 permits the fair value option election on an instrument by instrument basis at initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument. SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. Early adoption is permitted as of the beginning of a fiscal year that begins on or before November 15, 2007 provided that the entity makes that choice in the first 120 days of that fiscal year, has not yet issued financial statements for any interim period of the fiscal year of adoption, and also elects to apply the provisions of SFAS No. 157, Fair Value Measurements.
Prior to the acquisition by AUSA, MLLIC early adopted SFAS No. 159 as of the first quarter 2007, but did not elect the fair value option for any of its existing assets or liabilities and therefore, the adoption did not have an impact on 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. 159 on January 1, 2008 and it is not expected to have a material impact on MLLIC’s Financial Statements.
In June 2006, the FASB issued FIN No. 48, Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109. FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized in a company’s Financial Statements and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN No. 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. MLLIC adopted FIN No. 48 in the first quarter of 2007. The adoption of FIN No. 48 did not have an impact on MLLIC’s Financial Statements.
ML&Co. offers for sale numerous variable annuity products issued by unaffiliated insurers. MLLIC’s market share of variable annuity sales within the ML&Co. distribution system was 10%, 13%, and 14% for 2007, 2006 and 2005, respectively.
MLLIC has strategically placed its marketing emphasis on the sale of variable annuity products. These products are designed to address the retirement planning needs of ML&Co.’s clients. Each variable annuity product is designed to provide tax-deferred retirement savings with the opportunity for diversified investing in a wide selection of underlying mutual fund portfolios.
During the first quarter 2005, MLLIC introduced a new variable annuity product line called Merrill Lynch Investor Choice Annuity (“ICA”), which replaced all new sales of existing variable annuity products. ICA provides the ability to customize variable annuity products with specific contract features including guaranteed minimum death, income, and withdrawal benefits, charge structures, and investment options. MLLIC has also enhanced ICA income and withdrawal benefits and investment options in the succeeding two years. ICA is offered in B-Share, C-Share, and L-Share classes similar to previous variable annuity products. These classes are differentiated by the surrender charge period and the types of contract fees charged to the contract owner. Additionally, ICA offers a bonus class in which a specified amount is added to the contract value with each deposit.
All other deposits include deposits on modified guaranteed annuities and immediate annuities as well as renewal deposits on existing life insurance and fixed annuity contracts that are no longer manufactured.
Policy and contract surrenders increased $152.7 million (or 11%) to $1,519.0 million during 2007, as compared to the same period in 2006. The increase is primarily due to increased variable annuity surrenders resulting from the anticipated increase in lapse rates on variable annuity contracts reaching the end of their surrender charge period.
At December 31, 2007, MLLIC’s assets were $14.7 billion or $87.3 million higher than the $14.6 billion in assets at December 31, 2006. Assets excluding separate accounts assets increased $184.7 million (or 6%) primarily due to the push-down accounting adjustments recorded at December 28, 2007. See Note 3 to the Financial Statements for a summary of these adjustments. Separate accounts assets, which represent 76% of total assets, decreased $97.4 million (or 1%) to $11.2 billion.
MLLIC maintains a conservative general account investment portfolio comprised primarily of investment grade fixed maturity securities, policy loans, and cash and cash equivalents. MLLIC has no mortgage or real estate holdings and its investment in below investment grade fixed maturity securities are below the industry average.
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. MLLIC does not sell or buy subprime mortgages directly. As of December 31, 2007 and 2006, MLLIC had no material exposure to subprime mortgage investments.
MLLIC’s financial position and/or results of operations are primarily impacted by the following economic factors: equity market performance, fluctuations in medium term interest rates, and the corporate credit environment via credit quality and fluctuations in credit spreads. The following discusses the impact of each economic factor.
Fluctuations in the U.S. equity market also directly impact MLLIC’s exposure to guaranteed benefit provisions contained in the variable contracts it manufactures. Minimal or negative investment performance generally results in greater exposure to guaranteed provisions, to the extent there is an increase in the number of variable contracts (and amount per contract) in which the guaranteed benefit exceeds the variable account balance. Prolonged periods of minimal or negative investment performance may result in greater guaranteed benefit costs as compared to assumptions. If MLLIC determines that it needs to increase its estimated long term cost of guaranteed benefits, it will result in establishing greater guaranteed benefit liabilities as compared to current practice.
During 2007, medium term interest rates decreased 139 basis points to end the year at 3.38%. During 2006, medium term interest rates increased 41 basis points to end the year at 4.77%. MLLIC defines medium term interest rates as the average interest rate on U.S. Treasury securities with terms of 1 to 5 years.
Changes in the corporate credit environment directly impact the value of MLLIC’s investments, primarily fixed maturity securities. MLLIC primarily invests in investment-grade corporate debt to support its fixed rate product liabilities.
At December 31, 2007, MLLIC had 19,388 life insurance and annuity contracts inforce with interest rate guarantees. The estimated average rate of interest credited on behalf of contract owners was 4.17% and 4.26% during 2007 and 2006, respectively. Total invested assets supporting these liabilities with interest rate guarantees had an estimated average effective yield of 5.20% and 4.88% during 2007 and 2006, respectively. The number of life insurance and annuity contracts inforce with interest rate guarantees decreased 2,162 (or 10%) as compared to 2006.
The policyholder liabilities include benefit and claim liabilities of which a significant portion represents policies and contracts that do not have a stated contractual maturity. The projected cash benefit payments in the table above are based on managements’ best estimates of the expected gross benefits and expenses, partially offset by the expected gross premiums, fees and charges relating to the existing business inforce. Estimated cash benefit payments are based on mortality and lapse assumptions comparable with MLLIC’s historical experience, modified for recently observed trends.
MLLIC has utilized public information to estimate the future assessments it will incur as a result of life insurance company insolvencies. At December 31, 2007 and 2006, MLLIC’s estimated net liability for future guaranty fund assessments was $5.7 million and $6.0 million, respectively. MLLIC regularly monitors public information regarding insurer insolvencies and adjusts its estimated liability as appropriate.
The costs associated with acquiring contract owner deposits (DAC) are amortized over the period in which MLLIC anticipates holding those funds, as noted in the Critical Accounting Policies section above. Insurance expenses and taxes reported in the Statements of Earnings are net of amounts deferred. In addition, MLLIC incurs expenses associated with the maintenance of inforce contracts.
MLLIC recorded net earnings of $110.5 million and $94.7 million for 2007 and 2006, respectively.
Policy charge revenue increased $2.9 million (or 1%) to $267.6 million during 2007 as compared to $264.7 million in 2006. The following table provides the changes in policy charge revenue by type for each respective period:
The increase in life insurance benefit expense is primarily due to period-to-period differences in variable life reinsurance activity.
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.
Asset-based policy charge revenue was favorably impacted by the increase in average variable account balances during 2006 as compared to 2005.
The increase in amortization of deferred sales inducements coincide with the March 2005 introduction of the bonus feature contained in the variable annuity product line.
The products that comprise the Annuity and Life Insurance segments generally possess similar economic characteristics. As such, the financial condition and results of operations of each business segment are generally consistent with MLLIC’s consolidated financial condition and results of operations presented herein.