Prior to the Acquisition Date, the services were pursuant to the Registrant’s Management Services agreement with MLIG. An allocable share of the cost of each of the above mentioned premises was paid by the Registrant through the service agreement with MLIG.
We undertake no obligation to publicly update and 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 writing. Actual results may differ materially from expectations conveyed in forward-looking statements due to changes caused by various risks and uncertainties. The reader should, however, consult any further disclosures MLLICNY may make in future filings of its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, and Current Reports on Form 8-K.
MLLICNY 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. MLLICNY 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). MLLICNY believes that the demand for retirement products containing guarantee features will continue to increase in the future. MLLICNY believes it is positioned to continue meeting these demands for guaranteed benefits.
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 MLLICNY has been “pushed down” to the financial statements of MLLICNY, thereby establishing a new basis of accounting. As a result, MLLICNY follows AUSA’s accounting policies subsequent to the Acquisition Date. This new basis of accounting is referred to as the “successor basis”, while the historical basis of accounting is referred to as the “predecessor basis’’. In general, Balance Sheet amounts at December 31, 2007 are
MLLICNY’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, MLLICNY 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, $9.8 million (or 10%) and $19.7 million (or 15%), respectively, of MLLICNY’s fixed maturity and equity securities portfolio consisted of non-publicly traded securities.
MLLICNY 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 MLLICNY’s portfolio managers and credit analysts, information obtained from external sources (i.e. Company announcements, ratings agency announcements, or news wire services) and MLLICNY’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. MLLICNY did not experience any realized investment losses due to OTT declines in fair value for the years ended December 31, 2007, 2006, and 2005.
Deferred Policy Acquisition Costs (“DAC”) for Variable Annuities and Variable Life Insurance
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 $16.1 million (or 71%) and $6.4 million (or 29%), respectively, of MLLICNY’s DAC asset.
DAC for variable annuities is amortized with interest over the anticipated lives of the insurance contracts in relation to the present values of estimated future gross profits from asset-based fees, contract fees, and surrender charges, less provisions for guaranteed death and living benefit expenses, policy maintenance expenses, and non-capitalized commissions.
DAC for variable life insurance is amortized with interest over the anticipated lives of the insurance contracts in relation to the present values of estimated future gross profits from fees related to contract loans, asset-based fees, and cost of insurance charges, less claims (net of reinsurance), cost of mortality reinsurance, policy maintenance expenses, and non-capitalized commissions.
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, MLLICNY 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 specific 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, MLLICNY 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, MLLICNY 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.
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, MLLICNY utilizes the reversion to the mean assumption, a common industry practice, in its determination of the amortization of VOBA. 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 $44.0 million. There was no VOBA asset balance at December 31, 2006.
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 MLLICNY 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 $6.9 million. There was no goodwill asset at December 31, 2006. The entire asset amount has been allocated to annuities.
MLLICNY 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.
the account balance. Policyholder account balances at December 31, 2007 and December 31, 2006 were $140.8 million and $152.8 million, respectively.
Included within future policy benefits are liabilities for GMDB and GMIB provisions contained in the variable products that MLLICNY issues. At December 31, 2007 and December 31, 2006, GMDB and GMIB liabilities included within future policy benefits were $2.2 million and $2.9 million, respectively. MLLICNY 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 $1.2 million and $0.5 million, respectively. See Note 6 to the Financial Statements for a further discussion of GMDB and GMIB liabilities.
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 $0.2 million and $0.3 million, respectively. See Note 6 to the Financial Statements for a further discussion of GMWB and GMIB reinsurance liabilities.
MLLICNY 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. MLLICNY 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.
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. MLLICNY 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 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, MLLICNY had early adopted SFAS No. 157 as of the first quarter 2007, which did not have a material impact on MLLICNY’s Financial Statements. However, AUSA has not elected early adoption, and therefore as a result of the acquisition by AUSA and the resulting new basis of accounting, MLLICNY will adopt SFAS No. 157 on January 1, 2008 and it is not expected to have a material impact on MLLICNY’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. MLLICNY adopted FIN No. 48 in the first quarter of 2007. The adoption of FIN No. 48 did not have an impact on MLLICNY’s Financial Statements.
MLLICNY offers products in the highly competitive retirement planning market by selling variable and interest-sensitive annuity products through the retail network of Merrill Lynch, Pierce, Fenner & Smith, Incorporated, a wholly owned broker-dealer subsidiary of ML&Co. MLLICNY competes for ML&Co.’s clients’ retirement planning business with i) unaffiliated insurers whose products are also sold through ML&Co.’s retail network, ii) insurers who solicit this business directly, and iii) other investment products sold through ML&Co.’s retail network. MLLICNY competes in this market segment by integrating its products into ML&Co.’s planning-based financial management program.
MLLICNY 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, MLLICNY 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. MLLICNY 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.
Total direct deposits decreased $24.6 million (or 40%) to $36.7 million for the period ended December 31, 2007, as compared to the period ended December 31, 2006. During 2007, variable annuity deposits decreased $24.3 million (or 40%) to $36.6 million as compared to 2006. The decrease in variable annuity deposits is primarily due to increased third party competition for similar variable annuity products containing guaranteed living benefit provisions and features. MLLICNY is currently examining its product features and evaluating potential enhancements.
At December 31, 2007, MLLICNY’s assets were $1,225.8 million or $22.7 million lower than the $1,248.5 million in assets at December 31, 2006. Assets excluding separate accounts assets increased $21.5 million (or 8%) 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 $44.2 million (or 5%) to $925.8 million. Changes in separate accounts assets were as follows:
At December 31, 2007 and 2006, approximately $99.3 million (or 99%) and $132.4 million (or 100%), respectively, of fixed maturity securities were considered investment grade. MLLICNY 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 $3.1 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 $4.9 million (or 4%) of BBB- rated fixed maturity securities at December 31, 2006.
MLLICNY’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.
The investment performance of the underlying U.S. equity-based mutual funds supporting MLLICNY’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”). U.S. equity indices steadily increased during 2007, finishing the year substantially higher than 2006. The Dow, NASDAQ and S&P ended the year 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 78% 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, MLLICNY’s financial condition will be impacted by fluctuations in investment performance of equity-based separate accounts assets.
Fluctuations in the U.S. equity market also directly impact MLLICNY’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 MLLICNY 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, credit spreads expanded approximately 153 basis points and ended the period at 230 basis points. During 2006, credit spreads contracted approximately 29 basis points and ended the period at 77 basis points. MLLIC defines credit spreads according to the Merrill Lynch U.S. Corporate Bond Index for BBB-A Rated bonds with three to five year maturities.
At December 31, 2007, MLLICNY had 1,340 life insurance and annuity contracts inforce with interest rate guarantees. The estimated average rate of interest credited on behalf of contract owners was 4.64% and 4.36% during 2007 and 2006, respectively. Total invested assets supporting these liabilities with interest rate guarantees had an estimated average effective yield of 5.08% and 4.65% during 2007 and 2006, respectively. The number of life insurance and annuity contracts inforce with interest rate guarantees decreased 142 (or 10%) as compared to 2006.
MLLICNY receives claims paying ability ratings from various rating agencies. The following table summarizes MLLICNY’s ratings prior to (Predecessor) and subsequent to (Successor) the Acquisition Date:
MLLICNY paid an ordinary cash dividend to MLIG during 2007 and 2006 of $5.5 million and $4.1 million, respectively. MLLICNY did not pay a dividend during 2005.
MLLICNY recorded net earnings of $10.6 million and $7.6 million for 2007 and 2006, respectively.
Policy charge revenue increased $1.2 million (or 6%) to $20.8 million during 2007 as compared to $19.6 million in 2006. The following table provides the changes in policy charge revenue by type for each respective period:
The decrease in variable annuity benefit expense is primarily due to decreased GMDB liability accumulations resulting from the application of the mean reversion technique. In addition, GMWB liabilities were impacted by favorable market valuation adjustments. See the Critical Accounting Policies section above for a further discussion of variable annuity guaranteed benefit liabilities.
The increase in life insurance benefit expense is primarily due to an increase in the number of death claims and amounts per claim during the 2007 as compared 2006.
The decrease in general insurance expenses is primarily due to decreased compensation and auditing expenses.
The decrease in interest credited is primarily due to the reduction of fixed rate contracts inforce.
Net realized investment gains decreased $1.9 million during 2006 as compared to 2005 primarily due to one large credit related gain earned in the third quarter 2005.
MLLICNY’s operating results are categorized into two business segments: Annuities and Life Insurance. MLLICNY’s Annuity segment consists of variable annuity and interest-sensitive annuity contracts. MLLICNY’s Life Insurance segment consists of variable life insurance and interest-sensitive life insurance contracts. MLLICNY 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.
Select financial information by segment for the years ended December 31 as follows:
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 MLLICNY’s consolidated financial condition and results of operations presented herein.
During 2007, 2006 and 2005, MLLICNY did not incur any OTT impairment losses on investments for any of the business segments.