The following statutory information as of and for the years ended December 31, 2002, 2001, 2000, 1999, and 1998 has been derived from our audited statutory financial statements. The 2002, 2001, 2000 and 1999 statutory financial statements have been audited by Deloitte & Touche LLP, independent auditors’. The statutory financial statements for 1998 were audited by other auditors.
The accompanying statutory financial statements are different in some respects from financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The more significant differences between accounting principles pursuant to statutory and GAAP are as follows:
deferred income taxes, which provide for book/tax temporary differences, are subject to limitation and are charged directly to shareholder’s equity, whereas GAAP would include deferred taxes as a component of net income;
payments received for universal and variable life products and variable annuities are reported as premium income and changes in reserves, whereas, under GAAP, these payments would be recorded as deposits to policyholders’ account balances;
majority-owned subsidiaries are accounted for using the equity method, whereas GAAP would consolidate these entities;
reinsurance recoverables are reported as a reduction of policyholders’ reserves and funds, while under GAAP, these recoverables are reported as an asset.
We record our investments in accordance with rules established by the NAIC. Generally, we value:
policy loans at the outstanding loan balance less amounts unsecured by the cash surrender value of the policy,
other investments (which include other financial instruments at fair value and preferred stocks at cost), and
We develop reserves for life insurance contracts using accepted actuarial methods computed principally on the net level premium, the Commissioners’ Reserve Valuation Method and the California Method bases using the 1980 Commissioners’ Standard Ordinary mortality tables with assumed interest rates ranging from 4.00 to 4.50 percent.
We maintain an Asset Valuation Reserve (“AVR”) and an Interest Maintenance Reserve (“IMR”), in compliance with regulatory requirements. The AVR and other investment reserves stabilize shareholder’s equity against fluctuations in the value of stocks, bonds, mortgage loans and real estate investments. The IMR defers all interest related after-tax realized capital gains and losses. These interest related capital gains and losses are amortized into net investment income using the grouped method over the remaining life of the investment sold or over the remaining life of the underlying asset.
Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the audited Statutory Financial Statements, Notes to Statutory Financial Statements, and Selected Historical Financial Data. This Management’s Discussion and Analysis reviews our financial condition at December 31, 2002 and 2001, our results of operations for the past three years and, where appropriate, factors that may affect our future financial performance.
Costs related to the production of new business include commissions and other variable producer compensation, management fees assessed by MassMutual and business issuance and processing costs, which include policy assembly and other customer service activities, including fluctuations in the market value of variable funds during the processing
of deposits. During 2002 and 2001, costs related to the production of new business as a percentage of premiums were higher, primarily due to strong fixed annuity sales and a lower portion of new business generated through variable annuity exchange programs with MassMutual contract owners. See Related party transactions, footnote 7, Notes to Statutory Financial Statements, for further information on the annuity exchange programs with MassMutual.
Premium income decreased in 2001 primarily due to decreases in premiums of annuity products. The overall decrease in premium income was primarily the result of a reduction in premium received from variable annuity exchange programs with MassMutual.
In 2002, our business mix has shifted as a result of increasing sales of annuity products. Annuity products comprised 82% of total net premium income during 2002, compared to 75% in 2001 and 84% in 2000. In contrast, universal and other life products were 18% of total net premium income in 2002, compared to 25% in 2001, and 16% in 2000.
The increase in 2002 and 2001 gross investment income from bonds is due to increased investment levels, partially offset by lower yields. Annualized gross investment yields decreased as older, higher yielding bonds mature and are replaced with new bonds that have lower yields.
The increase in mortgage loans’ investment income in 2002 and 2001 is primarily due to an increase in the level of commercial mortgages, partially offset by a decrease in mortgage yields.
The increase in policy loan gross investment income in 2002 and 2001 is primarily due to an increase in average policy loan balances between years.
Policyholders’ benefits and payments increased in 2002, primarily due to an increase in annuity surrenders and benefit payments on individual annuity products. Annuity surrenders increased $157.6 million, or 43%, while annuity benefit payments increased $20.6 million, or 70%, from 2001, primarily due to lower market returns on separate account assets and continued business growth. The increase in policyholders’ benefits and payments in 2001 is primarily attributable to increased death benefits due to higher mortality, partially offset by lower annuity surrender benefits. Individual annuity surrenders decreased $21.4 million, or 6% in 2001.
The life insurance lapse rate, which is based on the amount of life insurance in force, improved to 5.9% for 2002 from 6.0% in 2001 and 7.4% in 2000. This decrease is due to improved customer service efforts and asset retention rates over the last two years. Death claims, net of reinsurance increased $9.4 million in 2002 and $24.3 million in 2001, primarily due to less favorable direct mortality.
The decrease in addition to policyholders’ reserves and funds during 2001 was primarily due to a $928.8 million decrease in separate account deposits, partially offset by a $98.4 million decrease in separate account withdrawals and other transfers and a $209.9 million increase in general account reserves. The $209.9 million increase in 2001 in the general account reserves is primarily attributable to a $193.9 million increase in annuity reserves and a $16.0 million increase in life reserves. The 2001 increase in annuity reserves is primarily due to increases in the reserves of our fixed annuity products. The 2001 increase in life reserves is primarily due to new universal life products.
Operating expenses, state taxes, licenses and fees decreased in 2002, primarily due to lower first year life insurance premium, partially offset by an increase in expenses associated with sales of annuity products. The decrease in operating expenses, state taxes, licenses and fees during 2001 was primarily attributable to the decrease in sales of annuity products. Management fees charged by MassMutual include increases in agency allowances and other expenses associated with the production of new business.
The increase in federal income taxes during 2002 is primarily attributable to the timing of the tax deductibility of policyholder acquisition costs and the difference between statutory insurance and tax reserves. The decrease in federal income taxes during 2001 is primarily attributable to the higher net loss from operations before federal income taxes plus the timing of the tax deductibility of policyholder acquisition costs and the difference between statutory insurance reserves and tax reserves.
Total assets at December 31, 2002, increased by $850.5 million, or 16%, from December 31, 2001 primarily due to the growth in the Company’s general account and the contribution of MML Bay State Life Insurance Company (“Bay State”) to the Company by MassMutual, partially offset by decreases in the Company’s separate account assets.
Bonds increased 30% from December 31, 2001 to December 31, 2002. During the year $840.1 million of bonds were purchased, while maturities and sales proceeds totaled $486.2 million. There was a change in the mix of bonds at December 31, 2002, compared to December 31, 2001. Bond investments in U.S. Treasury and other government holdings decreased to 4% of the total portfolio at December 31, 2002, from 10% as of December 31, 2001 while mortgage backed securities increased from 9% to 16% during the same period.
Bonds and short-term securities in NAIC classes 1 and 2 increased to 68% at December 31, 2002 from 67% of general account invested assets at December 31, 2001. The percentage of our general account invested assets representing bonds and short-term investments in NAIC classes 3 through 6 decreased to 4% at December 31, 2002 from 7% at December 31, 2001. See “Investments” section for a related discussion of NAIC investment classes.
Other investments, consisting of interest rate swaps, financial options, forwards, asset, equity and currency swaps, real estate, unaffiliated common stocks, preferred stocks, and joint venture interests increased, primarily due to increases in the market value of derivative instruments and increases in unaffiliated common stock and joint venture interests. At December 31, 2002, the Company had interest rate swaps, financial options and currency swaps with notional amounts of $1,104.0 million, $379.5 million and $17.3 million, respectively. At December 31, 2001, the Company had interest rate swaps, financial options and currency swaps with notional amounts of $594.9 million, $669.5 million and $11.9 million, respectively.
The increase in shareholder’s equity at December 31, 2002 is primarily due to:
Net cash provided by operating activities increased $558.9 million in 2002. We attribute this increase primarily to increased fixed annuity sales, higher investment income, higher fees and other income and lower operating expenses.
Our principal sources of liquidity are operating cash flow and holdings of cash, cash equivalents, and other readily marketable assets. Our primary cash flow sources are investment income, principal repayments on invested assets, and premium.
Our liquid assets include U.S. Treasury bond holdings, short-term money market investments, stocks, and marketable long-term fixed income securities. Cash and short-term investments totaled $722.5 million at December 31, 2002. The carrying value of highly liquid securities, comprised of NAIC Class 1 and 2 publicly traded bonds, was approximately $1,639.1 million at December 31, 2002.
Based on our ongoing monitoring and analysis of our liquidity sources and demands, we believe that we are in a strong liquidity position.
As directed by our policyholders, a portion of our assets are policyholders’ investments in our separate accounts. We record the assets in our separate accounts at market value, and we pass all investment risks on to our policyholders. The following discussion focuses on the general investment account portfolio, which does not include our separate account assets.
The table below sets forth the NAIC SVO ratings for our bond portfolio (including short-term securities) and, what we believe are the equivalent rating agency designations. At December 31, 2002 and 2001, 94% and 91%, respectively, of the portfolio was invested in NAIC Classes 1 and 2 securities.
The NAIC defines under-performing bonds as those whose deferral of interest and/or principal payments are deemed to be caused by the inability of the obligor to make such payments as called for in the bond contract. At December 31, 2002, we had $16.9 million of under-performing bonds. At December 31, 2001, we had $5.1 million of under-performing bonds.
As a result of our conservative monitoring process, we generate an internal watch list, which includes certain securities that would not be classified as under-performing under the SVO credit rating system. At December 31, 2002, bonds having a carrying value of $60.2 million, or 3%, of the total bond portfolio including short-term securities, had been placed on our internal watch list. The internal watch list is comprised of bonds that have the following NAIC ratings:
At December 31, 2002, mortgage loans represented 14% of the total investments in the general account compared to 18% at December 31, 2001. Mortgage loans consist of commercial mortgage loans and residential mortgage loan pools. At December 31, 2002, commercial mortgage loans comprised 64% of the mortgage loan portfolio compared to 68% at December 31, 2001.
At December 31, 2002, 91.6% of our commercial mortgage loan portfolio consisted of bullet loans compared to 95.5% at December 31, 2001. Bullet loans are loans that do not fully amortize over their term.
Our residential mortgage loan portfolio consists of conventional and Federal Home Administration and Veterans Administration (“FHA/VA”) mortgage pools. We impose rigorous investment standards, including governmental agency guarantees, seasoned pools, and discount pricing as protection against prepayment risk.
We actively monitor, manage and directly service our commercial mortgage loan portfolio. We review all aspects of loan origination and portfolio management, including:
There were no current and potential problem mortgage loans consisting of restructure mortgage loans at December 31, 2002. The carrying value of current and potential problem mortgage loans, consisting of restructured mortgage loans, was $2.8 million at December 31, 2001. There were no problem commercial mortgage loans in process of foreclosure, in default, or in actively managed properties.
our evaluation of the borrower’s ability to compete in a relevant market.
In compliance with regulatory requirements, we maintain the AVR. The AVR stabilizes surplus against non-interest rate related fluctuations in the value of stocks and bonds.
The following table presents the change in total investment reserves for the years 2002 and 2001:
These amounts offset unrealized capital gains (losses), recorded as a change in shareholder’s equity. Amounts primarily include unrealized losses due to market value reductions of bonds and preferred stock and unrealized losses due to market value reductions of other invested assets.
Amounts represent the reserve contribution (note 2) less amounts already recorded (notes 3 and 4). This net change in reserves is recorded as a change in shareholder’s equity.
As discussed in Note 3 to the statutory financial statements, the Company effective January 1, 2001 adopted certain statutory accounting practices as a result of the State of Connecticut Insurance Department’s adoption of the National Association of Insurance Commissioners’ Accounting Practices and Procedures Manual.
The accompanying statutory financial statements have been prepared in conformity with the statutory accounting practices, except as to form, of the National Association of Insurance Commissioners (“NAIC”) and the accounting practices prescribed or permitted by the State of Connecticut Insurance Department (“Department”).
On January 1, 2001, the Company adopted the Codification of Statutory Accounting Principles (“Codification”). Codification provides a comprehensive guide of statutory accounting principles for use by insurers in the United States of America. See Note 3 for additional information with respect to the adoption of new accounting standards.
Statutory accounting practices are different in some respects from financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The more significant differences between accounting principles pursuant to statutory and GAAP are as follows: (a) acquisition costs, such as commissions and other variable costs that are directly related to acquiring new business, are charged to current operations as incurred, whereas GAAP would require these expenses to be capitalized and recognized over the life of the policies; (b) statutory policy reserves are based upon the Commissioners’ Reserve Valuation Methods and statutory mortality and interest assumptions, whereas GAAP reserves would generally be based upon net level premium or the estimated gross margin method with appropriate estimates of future mortality and interest assumptions; (c) bonds are generally carried at amortized cost, whereas GAAP generally requires reporting at fair value; (d) deferred income taxes, which provide for book/tax temporary differences, are subject to limitation and are charged directly to shareholder’s equity, whereas GAAP would include deferred taxes as a component of net income; (e) payments received for universal and variable life products and variable annuities are reported as premium income and changes in reserves, whereas, under GAAP, these payments would be recorded as deposits to policyholders’ account balances; (f) majority-owned subsidiaries are accounted for using the equity method, whereas GAAP would consolidate these entities; (g) assets are reported at “admitted asset” value and “non-admitted assets” are excluded through a charge against shareholder’s equity, while under GAAP, “non-admitted assets” are recorded, net of any valuation allowance; and (h) reinsurance recoverables are reported as a reduction of policyholders’ reserves and funds, while under GAAP, these recoverables are reported as an asset.
The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities as well as disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during reporting periods. The most significant estimates include those used in determining investment valuation reserves, other than temporary impairments and the liability for future policyholders’ reserves and funds. Future events, including, but not limited to, changes in the levels of mortality, interest rates, persistency and asset valuations, could cause actual results to differ from the estimates used in the financial statements. Although some variability is inherent in these estimates, management believes the amounts presented are appropriate.
During 2002, MML Bay State Life Insurance Company (“Bay State”) became a wholly-owned stock life insurance subsidiary of the Company through the contribution of all of Bay State’s outstanding shares of common stock from MassMutual to the Company. The Company’s investment in Bay State is classified as Common stock-subsidiary on the Statutory Statements of Financial Position. The Company accounts for the value of its investment in Bay State at its underlying statutory net equity. Bay State operating results, less dividends declared, are reflected as net unrealized capital gains in the Statutory Statements of Changes in Shareholder’s Equity.
Separate accounts reflect two categories of risk assumption: non-guaranteed separate accounts for which the policyholder assumes the investment risk and guaranteed separate accounts. The Company did not have any guaranteed separate accounts at December 31, 2002 or 2001. Premium income, benefits and expenses of the separate accounts are reported in the Statutory Statements of Income. Investment income and realized and unrealized capital gains and losses on the assets of separate accounts accrue directly to policyholders and, accordingly, are not reflected in the Statutory Statements of Income.
Assets designated as “non-admitted” by the NAIC include prepaid agent commissions, other prepaid expenses and disallowed interest maintenance reserves and are excluded from the Statutory Statements of Financial Position by an adjustment to shareholder’s equity.
Policyholders’ reserves provide amounts adequate to discharge estimated future obligations in excess of estimated future premiums on policies in force. Reserves for life insurance contracts are developed using accepted actuarial methods computed principally on the net level premium, the Commissioners’ Reserve Valuation Method and the California Method bases using the 1980 Commissioners’ Standard Ordinary mortality tables with assumed interest rates ranging from 4.00% to 4.50%.
Tabular interest, tabular less actual reserves released and tabular cost for all life contracts are determined based upon statutory regulations. Traditional life permanent and term products use a formula that applies a weighted average interest rate determined from a seriatim valuation file to the mean average reserves.
The reserve method applied to standard policies is used for substandard reserve calculations which are based on a substandard mortality rate (a multiple of standard reserve tables).
During 2002, the Company reflected Actuarial Guidelines XXXVII and XXXVIII related to reserves on certain universal life policies issued prior to December 31, 2001, resulting in a $36.1 million decrease in shareholder’s equity.
All policy liabilities and accruals are based on the various estimates discussed above. Management believes that policy liabilities and accruals will be sufficient, in conjunction with future revenues, to meet future obligations of policies and contracts in force.
Reserves for supplemental contracts and annuities certain are based on account value or accepted actuarial methods.
The Company enters into reinsurance agreements with MassMutual and other insurance companies in the normal course of business in order to limit its insurance risk. Assets and liabilities related to reinsurance ceded contracts are reported on a net basis. Premium income, benefits to policyholders and reserves are stated net of reinsurance.
Reinsurance premium, commissions, expense reimbursements, benefits and reserves related to reinsured business are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. The Company remains primarily liable to the insured for the payment of benefits if the reinsurer cannot meet its obligations under the reinsurance agreements.
On January 1, 2001, the Codification of Statutory Accounting Principles (“Codification”) became effective and was adopted by the Company. Codification provides a comprehensive guide of statutory accounting principles for use by insurers in the United States of America. The cumulative effect of this change in statutory accounting principles on shareholder’s equity of $15.9 million was principally due to a change in accounting for certain investments in derivatives, the exclusion of a cost of collection liability and the admission of a net deferred tax asset.
Certain 2001 and 2000 balances have been reclassified to conform to current year presentation.
The carrying value and estimated fair value of bonds at December 31, 2002 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without prepayment penalties.
The Company is not exposed to any significant credit concentration risk of a single or group non-governmental issue.
During 2002, MML Bay State Life Insurance Company (“Bay State”) became a wholly-owned stock life insurance subsidiary of the Company through the contribution of all of Bay State’s outstanding shares of common stock from MassMutual to the Company.
Mortgage loans, comprised primarily of commercial mortgage loans, were $420.9 million, net of valuation reserves of $0.1 million at December 31, 2002. Mortgage loans were $329.0 million at December 31, 2001. There was no valuation reserve at December 31, 2001. The Company’s mortgage loans primarily finance various types of commercial properties throughout the United States. There were no other than temporary impairments recorded for the years ended December 31, 2002 and 2001. There were no restructured loans at December 31, 2002. The book value of restructured loans was $2.8 million at December 31, 2001. These loans typically have been modified to defer a portion of the contractual interest payments to future periods. Interest deferred to future periods was immaterial in 2002 and 2001.
At December 31, 2002, scheduled mortgage loan maturities were as follows (in millions):
Options grant the purchaser the right to buy or sell a security or enter into a derivative transaction at a stated price within a stated period. The Company’s option contracts have terms of up to fifteen years. The fair value of options is included in other investments on the Statutory Statements of Financial Position. Changes in the value of these contracts are recorded as realized capital gains and losses when contracts are closed and at each reporting date.
The Company is exposed to credit related losses in the event of nonperformance by counterparties to derivative financial instruments. In many instances, the Company enters into agreements with the counterparties which allow for contracts in a positive position, where the Company is due amounts, to be offset by contracts in a negative position. This right of offset combined with collateral obtained from counterparties, reduces the Company’s exposure. The amounts at risk in a net gain position, were $78.7 million and $12.5 million at December 31, 2002 and 2001, respectively. The Company monitors exposure to ensure counterparties are credit worthy and concentration of exposure is minimized.
Bonds, common and preferred stocks: Estimated fair value of bonds and stocks is based on quoted market prices when available. If quoted market prices are not available, fair values are determined by discounting expected future cash flows using current market rates applicable to yield, credit quality and maturity of the investment or using quoted market prices for comparable investments.
Policy loans, cash and short-term investments: Estimated fair value for these instruments approximates the carrying amounts reported in the Statutory Statements of Financial Position.
The Company participates in variable annuity exchange programs with its parent whereby certain MassMutual variable annuity contract holders can make a non-taxable exchange of their contract for an enhanced Company variable annuity contract. The Company received premium income of $256.2 million, $295.6 million and $1,090.9 million in 2002, 2001 and 2000, respectively, related to these exchange programs. The Company has an agreement with MassMutual to compensate MassMutual for the lost revenue associated with the exchange of these contracts. As a result of these exchanges, the Company has recorded commissions payable of $5.3 million and $0.4 million as of December 31, 2002 and 2001, respectively and has paid $5.2 million and $15.0 million for the years ended December 31, 2002 and 2001, respectively. There were no commissions paid to MassMutual for the year ended December 31, 2000.
The Company has a coinsurance agreement with MassMutual, whereby the Company cedes substantially 100% of the premium on new issues of certain universal life policies. In return, MassMutual pays to the Company a stipulated expense allowance and death and surrender benefits.
The Company records a receivable for reinsured benefits paid and reduces policyholders’ reserves and funds for the portion of insurance liabilities that are reinsured. The cost of reinsurance is accounted for over the life of the underlying reinsured policies using assumptions consistent with those used to account for the underlying policies.
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities as of December 31, 2002 and 2001 were as follows (in millions):
The provision for federal income taxes incurred is different from that which would be obtained by applying the statutory federal income tax rate to income before taxes. The significant items causing this difference are as follows (in millions):
The Company plans to file its 2002 federal income tax return on a consolidated basis with its parent, MassMutual, and certain MassMutual affiliates. MassMutual and certain of its affiliates are subject to a written tax allocation agreement, which allocates the group’s tax liability for payment purposes. Generally, the agreement provides that group members shall be compensated for the use of their losses by other group members.
Substantially all of the statutory shareholder’s equity is subject to dividend restrictions relating to various state regulations, which limit the payment of dividends to the shareholder without prior approval. The Company is required to obtain prior approval for dividend payments in 2003.
The Company is subject to insurance guaranty fund laws in the states in which it does business. These laws assess insurance companies amounts to be used to pay benefits to policyholders and policy claimants of insolvent insurance companies. Many states allow these assessments to be credited against future premium taxes. The Company believes such assessments in excess of amounts accrued will not materially affect its financial position, results of operations or liquidity.
The Company is involved in litigation arising in and out of the normal course of business, including class action and purported class action suits which seek both compensatory and punitive damages. While the Company is not aware of any actions or allegations that should reasonably give rise to any material adverse effect, the outcome of litigation cannot be foreseen with certainty. It is the opinion of management, after consultation with legal counsel, that the ultimate resolution of these matters will not materially affect its financial position, results of operations or liquidity.
The withdrawal characteristics of the Company’s annuity actuarial reserves and deposit fund liabilities at December 31, 2002 are illustrated below (in millions):
Information regarding the withdrawal characteristics of the separate account liabilities of the Company at December 31, 2002 is as follows (in millions):