The statements contained in this Report that are not historical facts are forward-looking statements as defined in the US Private Securities Litigation Reform Act of 1995. The following are words that identify such forward-looking statements: believe, estimate, target, intend, may, expect, anticipate, predict, project, counting on, plan, continue, want, forecast, should, would, is confident, will, and similar expressions as they relate to our Company. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Such risks and uncertainties include but are not limited to the following:
MLLIC conducts its business primarily in the annuity markets and to a lesser extent in the life insurance markets of the financial services industry. As of September 30, 2009, the Company, in addition to no longer issuing life insurance products, is no longer issuing variable annuity and market value adjusted annuity products. The Company offered the following guaranteed benefits within its variable annuity product suite: guaranteed minimum death benefits (“GMDB”), guaranteed minimum income benefits (“GMIB”) and guaranteed minimum withdrawal benefits (“GMWB”).
At December 31, 2009 and 2008, approximately, $161.4 million (or 12%) and $166.1 million (or 12%), respectively, of the Company’s fixed maturity and equity securities portfolio consisted of non-publicly traded securities. 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.
Derivatives are financial instruments in which the value changes in response to an underlying variable, that require little or no net initial investment and are settled at a future date. All derivatives recognized on the Balance Sheets are carried at fair value. All changes in fair value are recognized in the Statements of Income. The fair value for exchange traded derivatives, such as futures, are calculated net of the interest accrued to date and is based on quoted market prices. Net settlements on the futures occur daily. As of December 31, 2009, the Company had 570 outstanding short futures contracts with a notional amount of $158.3 million. As of December 31, 2008, the Company had 990 outstanding short futures contracts with a notional amount of $222.8 million.
Mortgage loans on real estate are carried at unpaid principal balances adjusted for amortization of premiums and accretion of discounts and are net of valuation allowances. The fair value for mortgage loans on real estate is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and/or similar remaining maturities. Interest income is accrued on the principal balance of the loan based on the loan’s contractual interest rate. Premiums and discounts are amortized using the effective yield method over the life of the loan. Interest income and amortization of premiums and discounts are reported in net investment income along with mortgage loan fees, which are recorded as they are incurred. Loans are considered impaired when it is probable that based upon current information and events, the Company will be unable to collect all amounts due under the contractual terms of the loan agreement.
When the Company determines that a loan is impaired, a valuation allowance is established for the excess carrying value of the loan over its estimated value. The Company does not accrue interest on impaired loans and loans ninety days past due. The company also establishes a valuation allowance based on a percentage of the outstanding loan balance. At December 31, 2009 and 2008, there was $70.9 million and $77.1 million, respectively, in mortgage loans on real estate recorded on the Balance Sheet. The valuation allowance at December 31, 2009 was less than $0.1 million. The valuation allowance at December 31, 2008 was $0.1 million.
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 based on the estimated future gross profits for a group of contracts. DAC are subject to recoverability testing at the time of policy issuance and loss recognition testing at the end of each reporting period. At December 31, 2009 and 2008, variable annuities accounted for the Company’s entire DAC asset of $26.7 million and $24.3 million, respectively.
Future gross profit estimates are subject to periodic evaluation with necessary revisions applied against amortization to date. The impact of revisions and assumptions to estimates on cumulative amortization is recorded as a charge or credit to current operations, commonly referred to as “unlocking”. Changes in assumptions can have a significant impact on the amount of DAC reported and the related amortization patterns. In general, increases in the estimated Separate Accounts return and decreases in surrender or mortality assumptions increase the expected future profitability of the underlying business and may lower the rate of DAC amortization. Conversely, decreases in the estimated Separate Accounts returns and increases in surrender or mortality assumptions reduce the expected future profitability of the underlying business and may increase the rate of DAC amortization. For the years ended December 31, 2009, 2008 and 2007, there was a favorable (unfavorable) impact to pre-tax income related to DAC unlocking of ($2.6) million, ($7.3) million, and $26.5 million, respectively. See Note 6 to the Financial Statements for a further discussion.
The expense and the subsequent capitalization and amortization are recorded as a component of policy benefits in the Statements of Income. At December 31, 2009 and 2008, variable annuities accounted for the Company’s entire DSI asset of $6.3 million and $7.2 million, respectively. See Note 6 to the Financial Statements for a further discussion.
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 in force at the acquisition date. VOBA is based on actuarially determined projections, for each block of business, of future policy and contract charges, premiums, mortality, policyholder behavior, Separate Account performance, operating expenses, investment returns, and other factors. Actual experience on the purchased business may vary from these projections. Revisions in estimates result in changes to the amounts expensed in the reporting period in which the revisions are made and could result in the impairment of the asset and a charge to income if estimated future gross profits are less than the unamortized balance. In addition, MLLIC utilizes the reversion to the mean assumption, a common industry practice, in its determination of the amortization of VOBA. 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. At December 31, 2009, the reversion to the mean assumption was 7.25% gross short-term equity growth rate for five years and thereafter a 9% gross long-term growth rate, while at December 31, 2008, the reversion to the mean assumption was 15% gross short-term equity growth rate for five years and thereafter a 9% gross long-term growth rate. At December 31, 2009 and 2008, the Company’s VOBA asset was $374.7 million and $581.1 million, respectively. For the years ended December 31, 2009 and 2008, the unfavorable impact to pre-tax income related to VOBA unlocking was $79.4 million and $40.4 million, respectively. For the years ended December 31, 2009 and 2008, there was an impairment charge of $63.9 million and $28.0 million, respectively. See Note 5 to the Financial Statements for a further discussion.
Other intangible assets acquired at the acquisition date are a distribution agreement, a tradename and a non-compete agreement. At December 31, 2008, the Company made a business decision to commence selling similar products on affiliate companies through the ML&Co. distribution channel instead of continuing to sell new variable annuities on the Company.
As a result of this decision, an impairment charge was taken for the entire unamortized other intangible balance of $76.1 million at December 31, 2008. Prior to December 31, 2008, the tradename and the non-compete agreements were amortized on a straight-line basis over their useful life of five years. The distribution intangible was 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 was thirty years. The entire asset amount had been allocated to annuities. See Note 5 to the Financial Statements for further discussion.
Goodwill is the excess of the purchase price over the estimated fair value of net assets acquired. 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. The entire asset amount has been allocated to annuities. 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 the Company 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. At December 31, 2008, the Company made a business decision to commence selling similar products on affiliate companies through the ML&Co. distribution channel instead of continuing to sell new variable annuities on MLLIC. As a result of this decision, an impairment charge was taken for the majority of the goodwill balance ($139.3 million) at December 31, 2008. The remaining amount of $2.8 million at December 31, 2009 and 2008 relates to the Company’s state licenses. See Note 5 to the Financial Statements for further discussion.
Future policy benefits are actuarially determined liabilities, which are calculated to meet future obligations and are generally payable over an extended period of time. Principal assumptions used in the establishment of liabilities for future policy benefits are mortality, surrender rates, policy expenses, equity returns, interest rates, and inflation. These estimates and assumptions are influenced by historical experience, current developments and anticipated market trends. At December 31, 2009 and 2008, future policy benefits were $439.6 million and $499.3 million, respectively.
At December 31, 2009 and 2008, GMWB liability and GMIB reinsurance asset included within future policy benefits were as follows:
The Company files a return in the U.S. federal tax jurisdiction and various state tax jurisdictions. As a result of the Company’s election for federal income tax purposes of Internal Revenue Code Section 338, the predecessor is responsible for uncertain tax positions that existed prior to the acquisition date.
The following outlines the adoption of recent accounting guidance. See Note 1 to the Financial Statements for a further discussion.
The Company adopted guidance requiring disclosures about fair value of financial instruments in interim reporting periods as well as annual periods as of the period ended June 30, 2009. This guidance was formerly known as FSP No. FAS 107-1 and Accounting Principles Board Opinion No. 28-1, Interim Disclosures about Fair Value of Financial Instruments.
The Company adopted guidance that establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued as of the period ended June 30, 2009. In addition, the Company adopted revisions to this guidance for the period ending December 31, 2009. This guidance was formerly known as SFAS No. 165, Subsequent Events.
In January 2010, the FASB issued ASU 2010-06, Improving Disclosures about Fair Value Measurements, which includes new disclosures and clarifications of existing disclosures about fair value measurements. The guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2009 except for disclosures about purchases, sales, issuances, and settlements in the Level 3 roll forward, which are effective for fiscal years beginning after December 15, 2010. The Company will adopt the guidance on January 1, 2010 and 2011, as appropriate.
At December 31, 2009, the Company’s assets were $11.6 billion or $499.2 million higher than the $11.1 billion in assets at December 31, 2008. Assets excluding Separate Accounts assets decreased $357.5 million. Separate Accounts assets, which represent 72% of total assets, increased $856.7 million (or 11%) to $8.3 billion. Changes in Separate Accounts assets were as follows:
During 2009, 2008 and 2007, fixed contract owner deposits were $1.9 million, $0.2 million and $0.4 million, respectively. During 2009, 2008 and 2007, fixed contract owner withdrawals were $162.0 million, $189.2 million and $166.5 million, respectively.
As permitted by the guidance, the Company recorded an increase of $3.5 million to the opening balance of retained earnings with a corresponding decrease to accumulated OCI on the Statement of Stockholder’s Equity to reclassify the non credit portion of previously other-than-temporarily impaired available-for-sale securities held as of April 1, 2009.
MLLIC’s $4.8 million of gross unrealized losses within the financial services sector has an estimated fair value of $68.2 million. The majority of the unrealized loss in the financial services sector relates to the banking sub-sector which has $4.8 million of gross unrealized losses on securities with an estimated fair value of $62.0 million. Companies within MLLIC’s financial services sector are generally high in credit quality and, as a whole, represent a large portion of the corporate debt market. The extreme stress on the capital base of banks within the sector has been significantly reduced following unprecedented liquidity and capital support from major governments over the last year.
MLLIC’s $3.4 million of gross unrealized losses and OTTI within the Industrial sector has an estimated fair value of $169.1 million. The majority of the unrealized loss in the Industrial sector relates to the following sub-sectors: Basic Industries and Capital Goods, Consumer Cyclical, Communications, Energy and Transportation. The Basic Industries and Capital Goods sector has of $0.8 million of gross unrealized losses with a fair value of $20.1 million. The Consumer Cyclical sub-sector has of $0.3 million of gross unrealized losses with a fair value of $28.4 million. The Communications sub-sector has of $0.5 million of gross unrealized losses with a fair value of $26.9 million. The Energy sub-sector has of $0.7 million of gross unrealized losses with a fair value of $65.4 million. The Transportation sub-sector has of $0.6 million of gross unrealized losses with a fair value of $7.8 million.
Fundamentals in the gaming industry remain weak due to increased debt and related interest costs due to leveraged buyout activity and a material reduction in discretionary consumer spending. A deteriorating homebuilding environment and a material drop-off in consumer confidence, coupled with concerns over unemployment resulted in declining demand. Recent supply additions have come at a very difficult time and have added to the supply/demand imbalance. Discounted rooms have been offered to entice demand, which will have a negative effect on margins.
There are no individual issuers rated below investment grade in the energy sector which have unrealized loss positions greater than $2.5 million.
The Communications sector can be further divided into the media non-cable, wireless and wirelines sub-sectors. The majority of weakness to date has been within the media non-cable category. All media companies, but especially newspaper and directory companies have been suffering from a tepid advertising environment related to the weak economy. This has made it difficult for companies to offset declining revenues with sufficient cost cutting initiatives, leading to significantly lower profits. Historically, this space has been a focus for activist shareholders and private equity firms, forcing management to respond by increasing financial leverage, performing consolidations or divesting assets. The net effect of this was a weaker credit profile for many companies just as the market started to slow down. The Company evaluated the near-term prospects of the issuers in relation to the severity and duration of the unrealized loss and does not consider those investments to be impaired as of December 31, 2009.
There are no individual issuers rated below investment grade in the communications sector which have unrealized loss positions greater than $2.5 million.
The Company evaluated the near-term prospects of the issuers in relation to the severity and duration of the unrealized loss and does not consider those investments to be impaired as of December 31, 2009.
All ABS housing related securities are monitored and reviewed on a monthly basis with detailed cash flow models using the current collateral pool and capital structure on the portfolio quarterly. Model output is generated under base and several stress-case scenarios. ABS housing asset specialists utilize widely recognized industry modeling software to perform a loan-by-loan, bottom-up approach to modeling. The ABS housing models incorporate external estimates on property valuations, borrower characteristics, propensity of a borrower to default or prepay and the overall security structure. Defaults were estimated by identifying the loans that are in various delinquency buckets and defaulting a certain percentage of them over the near-term and long-term. Recent payment history, a percentage of on-going delinquency rates and a constant prepayment rate are also incorporated into the model. Once the entire pool is modeled, the results are closely analyzed by the asset specialist to determine whether or not our particular tranche or holding is at risk for payment interruption. Holdings are impaired to the net present value of projected future cash flows where loss events have taken place or are projected to take place that would affect future cash flows on our particular tranche. Securities expected to have future cash flow interruptions within the Company’s ABS subprime mortgage portfolio have been impaired to the net present value of projected future cash flows and remaining positions are not considered impaired as of December 31, 2009.
Where holdings are not projected to pay principal and interest in full, securities were impaired to the net present value of projected future cash flows. As the remaining unrealized losses in the ABS-housing related portfolio relate to holdings where the Company expects to receive full principal and interest, the Company does not consider the underlying investments to be impaired as of December 31, 2009.
There are no other individual issuers rated below investment grade in this sector which have an unrealized loss position greater than $2.5 million.
The gross unrealized loss on CMBS is $15.5 million. Over the past 18 months, the commercial real estate market has continued to soften. As property fundamentals deteriorate, CMBS loan delinquencies have been climbing at the same time. The introduction of the 20% and 30% credit enhanced classes within the 2005-2008 vintage deals provide some offset to these negative fundamentals. While the CMBS sector is beginning to show signs of improvement, the lending market remains limited as lenders have become more conservative with underwriting standards, property transactions have diminished greatly, and higher mortgage spreads have curtailed borrowing. A lack of liquidity in the market combined with a broad re-pricing of risk has led to increased credit spreads across the credit classes. As the unrealized losses in the CMBS portfolio relate to holdings where the Company expects to receive full principal and interest, the Company does not consider the underlying investments to be impaired as of December 31, 2009.
The unrealized loss and OTTI on RMBS is $7.6 million, of which, $3.6 million is attributed to the B rated generic shelf name, GSR MTGE LN TR 2005-AR5 (“GSR”). The Company’s amortized cost in GSR is $17.1 million and the deal contains its own unique pool of collateral and represents a separate and distinct trust. The combination of low floating-rate reset margins, slow prepayment speeds, severe illiquidity in the market for near-prime securities, and the unprecedented level of mortgage-related credit spread widening have pushed the overall market value as a percent of amortized cost on all RMBS bonds in an unrealized loss position to 84%.
Where holdings are not projected to pay principal and interest in full, securities were impaired to the net present value of projected future cash flows. As the remaining unrealized losses in the RMBS portfolio relate to holdings where the Company expects to receive full principal and interest, the Company does not consider the underlying investments to be impaired as of December 31, 2009.
Negative amortization mortgages (also known as option ARMs) are loans whereby the payment made by the borrower is less than the accrued interest due and the difference is added to the loan balance. When the accrued balance of the loan reaches the negative amortization limit (typically 110% to 125% of the original loan amount), the loan recalibrates to a fully amortizing level and a new minimum payment amount is determined. The homeowner’s new minimum payment amount can be dramatically higher than the original minimum payment amount. The timing of when these loans reach their negative amortization cap will vary, and is a function of the accrual rate on each loan, the minimum payment rate on each loan and the negative amortization limit itself. Typically, these loans are estimated to reach their negative amortization limit between 3 and 5 years from the date of origination. The Company’s exposure to negative amortization mortgages ($3.1 million) is all AAA rated, with all of these positions being super-senior AAA rated securities.
At December 31, 2009 and 2008, approximately $98.4 million (or 36%) and $108.9 million (or 44%), respectively, of RMBS and CMBS holdings were fully collateralized by the Government National Mortgage Association, the Federal National Mortgage Association or the Federal Home Loan Mortgage Corporation. RMBS and CMBS securities are structured to allow the investor to determine, within certain limits, the amount of interest rate risk, prepayment risk and default risk that the investor is willing to accept. It is this level of risk that determines the degree to which the yields on RMBS and CMBS will exceed the yields that can be obtained from corporate securities with similar credit ratings.
The Company defines investment grade securities as unsecured debt obligations that have a rating equivalent to S&P’s BBB- or higher (or similar rating agency). At December 31, 2009 approximately $38.9 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 $39.9 million (or 3%) of fixed maturity securities at December 31, 2008. Below investment grade securities are speculative and are subject to significantly greater risks related to the creditworthiness of the issuers and the liquidity of the market for such securities. The Company closely monitors such investments.
Details underlying securities in a continuous gross unrealized loss and OTTI position for below investment grade securities were as follows:
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 experiencing a sharp increase in the number of loan defaults. Investors in subprime mortgage assets include not only mortgage lenders, but also brokers, hedge funds, and insurance companies. The Company does not currently invest in or originate whole loan residential mortgages. The Company categorizes ABS issued by a securitization trust as having subprime mortgage exposure when the average credit score of the underlying mortgage borrowers in a securitization trust is below 660 at issuance. The Company also categorizes ABS issued by a securitization trust with second lien mortgages as subprime mortgage exposure, even though a significant percentage of second lien mortgage borrowers may not necessarily have credit scores below 660 at issuance.
The following tables provide the ABS subprime mortgage exposure by rating and estimated fair value by vintage at December 31:
The fair value for mortgage loans on real estate is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and/or similar remaining maturities. The estimated fair value of the mortgage loans on commercial real estate at December 31, 2009 and 2008 was $67.7 million and $70.8 million, respectively.
The investment performance of the underlying U.S. equity-based mutual funds supporting the Company’s variable products do not replicate the returns of any specific U.S. equity market index. However, investment performance will generally increase or decrease with corresponding increases or decreases of the overall U.S. equity market. There are several standard indices published on a daily basis that measure performance of selected components of the U.S. equity market. Examples include the Dow Jones Industrial Average (“Dow”), the NASDAQ Composite Index (“NASDAQ”) and the Standard & Poor’s 500 Composite Stock Price Index (“S&P”). The Dow, NASDAQ and S&P ended 2009 with increases of 19%, 44% and 23%, respectively, from 2008. The Dow, NASDAQ and S&P ended 2008 with decreases of 34%, 41% and 38%, respectively, from 2007.
Credit spreads represent the credit risk premiums required by market participants for a given credit quality, i.e. the additional yield that a debt instrument issued by a AA-rated entity must produce over a risk-free alternative (e.g., U.S. Treasury instruments). Changes in credit spreads have an inverse relationship to the value of interest sensitive investments.
The Company defines credit spreads according to the Merrill Lynch U.S. Corporate Bond Index for BBB-A Rated bonds with three to five year maturities.
The Company’s liquidity requirements include the payment of sales commissions and other underwriting expenses and the funding of its contractual obligations for the life insurance and annuity contracts it has in force. The Company has developed and utilizes a cash flow projection system and regularly performs asset/liability duration matching in the management of its asset and liability portfolios. The Company anticipates funding its cash requirements utilizing cash from operations, normal investment maturities and anticipated calls and repayments, consistent with prior years. As of December 31, 2009 and 2008, The Company’s assets included $1.8 billion and $1.7 billion, respectively, of cash, short-term investments and investment grade publicly traded available-for-sale securities that could be liquidated if funds were required.
The Company and AUSA are parties to a “keepwell” agreement which, subject to its terms, commits AUSA to maintain MLLIC at a minimum net worth.
the charges imposed on variable annuity and variable life insurance contracts, and
Policy charge revenue decreased $36.8 million (or 15%) to $203.9 million during 2009, as compared to $240.7 million in 2008. The following table provides the changes in policy charge revenue by type for each respective period:
Asset-based policy charge revenue was negatively impacted by the decrease in average variable account balances during late 2008 and early 2009.
The decrease in non-asset based policy charge revenue is primarily due to the run-off of the life business as well as less paid up additions in the first quarter 2009 as a result of poor equity market performance in 2008.
The increase in credit related losses as compared to 2008 was primarily due to losses on securities whereby the Company had the intent to sell as of the balance sheet date, as well as securities of issuers that had filed for bankruptcy during the year.
The decrease in interest related losses during 2009 was primarily due to impairments taken in 2008.
The decrease in annuity benefit expense was primarily driven by the change in reserve for the embedded derivatives as compared to the same period in 2008. This was primarily a result of the positive equity markets relative to the same period in 2008.
The increase in amortization of deferred sales inducements is principally due to increasing gross profits resulting from improved equity markets.
Policy charge revenue decreased $26.9 million (or 10%) to $240.7 million during 2008 as compared to $267.6 million in 2007. The following table provides the changes in policy charge revenue by type for each respective period:
Asset-based policy charge revenue was negatively impacted by the decrease in average variable account balances during 2008 as compared to 2007.
The increase in guaranteed benefit based policy charge revenue during 2008 was due to the increase in inforce variable annuity contracts containing guaranteed benefit riders.
The increase in credit related losses during 2008 were primarily due to one large credit impairment in third quarter 2008 compared to a large credit gain during the second quarter 2007.
The increase in equity related gains principally relates to net gains on futures contracts in 2008 as there were no futures contracts in 2007.
Policy benefits increased $148.3 million during 2008, as compared to 2007. The following table provides the changes in policy benefits by type:
See the Critical Accounting Policies and Estimates section above for further discussion of variable benefit unlocking.
During the year 2008, the Company experienced lower than expected gross profits as a result of market losses which reduced amortization expense and unlocking.
Amortization of VOBA was $37.7 million for 2008, which included $40.5 million of unfavorable unlocking. In addition, 2008 includes an impairment charge of $28.0 million as estimated future gross profits were less than the unamortized balance. There was no VOBA amortization in 2007.
Insurance expenses and taxes increased $8.9 million (or 15%) in 2008 as compared to 2007. The following table provides the changes in insurance expenses and taxes for each respective period:
MLLIC’s operating results are categorized into two business segments: Annuity and Life Insurance. MLLIC’s Annuity segment consists of variable annuity and interest-sensitive annuity contracts. MLLIC’s Life Insurance segment consists of variable life insurance and interest-sensitive life insurance contracts. 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 income 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 - Annuity, Life Insurance and Other, while the successor information is shown under the new basis, two segments - Annuity and Life Insurance.
As an insurance company, MLLIC is in the “risk” business and as a result is exposed to a variety of risks. A description of our risk management and control systems is given below on the basis of significant identified risks for us. Our largest exposures are to changes in the financial markets (e.g. interest rate, credit and equity market risks) that affect the value of the investments, liabilities from products that we sold, deferred expenses, and value of business acquired.
Results of MLLIC’s sensitivity analyses are presented to show the estimated sensitivity of net income to various scenarios. For each type of market risk, the analysis shows how net income would have been affected by changes in the relevant risk variables that were reasonably possible at the reporting date. For each sensitivity test, the impact of a reasonably possible change in a single factor (or shock) is shown. The analysis considers the interdependency between interest rates and lapse behavior for products sold where there is clear evidence of dynamic lapse behavior. Management action is taken into account to the extent that it is part of MLLIC’s regular policies and procedures. However, incidental management actions that would require a change in policies and procedures are not considered.
Each sensitivity analysis reflects the extent to which the shock tested would affect management’s critical accounting estimates and judgment in applying MLLIC’s accounting policies (See Note 1 of the Financial Statements for a description of the critical accounting estimates and judgments). The shock may affect the measurement of assets and liabilities based on assumptions that are not observable in the market as well as market consistent assumptions. For example, a shock in interest rates may lead to changes in the amortization schedule of deferred policy acquisition costs or to increased impairment losses on equity investments. Although management’s short-term assumption may change if there is a reasonable change in a risk factor, long-term assumptions will generally not be revised unless there is evidence that the movement is permanent. This fact is reflected in the sensitivity analyses provided below.
The sensitivities do not reflect what the net income for the period would have been if risk variables had been different because the analysis is based on the exposures in existence at the reporting date rather than on those that actually occurred during the year. Nor are the results of the sensitivities intended to be an accurate prediction of MLLIC’s future income. The analysis does not consider all methods available to management to respond to changes in the financial environment, such as changing investment portfolio allocations or adjusting crediting rates. Furthermore, the results of the analyses cannot be extrapolated for wider variations since effects do not tend to be linear. No risk management process can clearly predict future results.
Interest rate risk arises from the possibility that changes in interest rates will affect the value of investments, primarily fixed maturity securities and preferred equity securities. Changes in interest rates have an inverse relationship to the value of investments. MLLIC manages interest rate risk as part of its asset/liability management strategy. For each portfolio, management monitors the expected changes in assets and liabilities, as produced by MLLIC’s model, resulting from various interest rate scenarios. Based on these results, management closely matches the duration of insurance liabilities to the duration of assets supporting those liabilities.
Credit risk represents the loss that MLLIC would incur if an issuer fails to perform its contractual obligations and the value of the security held has been impaired or is deemed worthless. MLLIC manages its credit risk by setting investment policy guidelines that assure diversification with respect to investment, issuer, geographic location and credit quality. Management regularly monitors compliance of each investment portfolio’s status with the investment policy guidelines, including timely updates of credit-related securities.
Sources of underwriting risk include policy lapses and policy claims such as mortality and expenses. In general, MLLIC is at risk if policy lapses increase as sometimes MLLIC is unable to fully recover up front expenses in selling a product despite the presence of commission recoveries or surrender charges and fees. Within variable annuity contracts with certain guarantee benefits, MLLIC is at risk if policy lapses decrease, as more contracts would remain in force until guaranteed payments are made. For mortality risk, MLLIC sells certain types of policies that are at risk if mortality increases, such as term life insurance or guaranteed minimum death benefits, and sells certain types of policies that are at risk if mortality decreases (longevity risk) such as certain annuity products. MLLIC is also at risk if expenses are higher than assumed by management.
During the fiscal quarter ended December 31, 2009, there have been no changes in MLLIC’s internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, MLLIC’s internal control over financial reporting.
Information called for by items 9 through 12 of this part is omitted pursuant to General instruction I. of form 10-K.