MML Bay State Life Insurance Company Management s Discussion and Analysis Of the 2005 Financial Condition and Results of Operations

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1 MML Bay State Life Insurance Company Management s Discussion and Analysis Of the 2005 Financial Condition and Results of Operations General 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 Statutory Annual Statements. This Management s Discussion and Analysis reviews the financial condition of MML Bay State Life Insurance Company ( MML Bay State ) at December 31, 2005 and 2004, our results of operations for the past two years and, where appropriate, factors that may affect our future financial performance. Together with our parent, C.M. Life Insurance Company ( C.M. Life ) and its parent, Massachusetts Mutual Life Insurance Company ( MassMutual ) and its subsidiaries, we comprise a growth-oriented, diversified financial services organization that seeks to provide superior value for policyholders and other customers by achieving exceptional results. We are in the business of helping our customers achieve financial success while protecting their families and businesses. We are committed to maintaining a position of preeminent financial strength by achieving consistent and long-term profitable growth. This will be accomplished by developing and distributing a broad and superior portfolio of innovative financial products and services, sophisticated asset/liability management, rigorous expense control, prudent underwriting standards, continued efforts to improve persistency and retention levels, and continued commitment to the high credit quality and disciplined diversification of our general account investment portfolio. Our statutory net income was $44 million in 2005 and $47 million in At December 31, 2005, we had $4.4 billion in total statutory assets, over 61,000 individual policyholders and $20.7 billion of direct life insurance in force. Our total adjusted capital, as defined by the National Association of Insurance Commissioners ( NAIC ), was $221 million at December 31, 2005 compared to $225 million at December 31, The following table sets forth the calculation of total adjusted capital: December 31, (In Millions) Surplus $ 218 $ 222 Asset valuation reserve 3 3 One-half of the apportioned dividend liability - - Total adjusted capital (1) $ 221 $ 225 (1) Defined by the NAIC as surplus plus consolidated Asset Valuation Reserve ( AVR ) and one half of the consolidated apportioned dividend liability. 1

2 MML Bay State Life Insurance Company ( the Company, us, we or our ), C.M. Life and MassMutual s ratings are AAA (Extremely Strong) from Standard & Poor s, A++ (Superior) from A.M. Best Company, AAA (Exceptionally Strong) from Fitch Ratings, and Aa1 (Excellent) from Moody s Investors Services. Each rating agency independently assigns ratings based on its own separate review and takes into account a variety of factors in making its decision. Accordingly, there can be no assurance of the ratings that will be afforded us in the future. Financial strength ratings are assigned to us based on a number of factors, including our financial strength and the industry in which we operate. A rating s trigger refers to a contractual clause requiring action by us or resulting in financial consequences in the event of a downgrade of our and/or MassMutual s financial strength rating below a specified level. We do not have any financial covenant requirements or triggers embedded in financing agreements, or other financial contracts. At December 31, 2005, two group life insurance contracts with account values of $279.0 million contained rating s triggers. If MassMutual or MML Bay State s financial strength ratings fall significantly, we are required to pursue the transfer of the risks of the contracts to another company. At December 31, 2005, there were no significant statutory or regulatory issues which would impair our financial position, or liquidity, but there can be no assurance that such issues will not arise in the future. To the best of management s knowledge, we are not included on any regulatory or similar watch list. Forward-Looking Information The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements, which are identified as such and are accompanied by the identification of important factors, which could cause a material difference from the forward-looking statements. Certain information contained in this discussion is or may be considered forward-looking. Forward-looking statements are those not based on historical information, but rather, relate to future operations, strategies, financial results or other developments, and contain terms such as may, expects, should, believes, anticipates, intends, estimates, projects, goals, objectives or similar expressions. Forward-looking statements are based upon estimates and assumptions. These statements may change due to business uncertainties, economic uncertainties, competitive uncertainties, and other factors, many of which are beyond our control. Additionally, our business decisions are also subject to change. We do not publicly update or revise any forward-looking statements as a result of new information, future developments, or otherwise. 2

3 Results of Operations The following table sets forth the components of statutory net income: Years Ended December 31, % Change % Change vs vs. 03 ($ in Millions) Revenue: Premium income $ 76 $ 84 $ 92 (10)% (9)% Net investment income Fees and other income (9) Total revenue (2) (8) Benefits and expenses: Policyholders benefits and payments (6) Decrease to policyholders reserves and funds (23) (6) (12) (283) 50 Commissions (14) - Operating expenses, state taxes, licenses & fees (36) 57 Total benefits and expenses (11) 4 Net gain from operations before federal income taxes (44) Federal income tax (benefit) expense (6) (22) (320) Net gain from operations (6) 34 Net realized capital gains Net income $ 44 $ 47 $ 35 (6)% 34% The decrease in net income in 2005 was primarily due to a $16 million reduction in federal income tax benefits in 2005 and a $10 million increase in policyholders benefits and payments, partially offset by a $17 million decrease to policyholders reserves and funds and an $8 million decline in operating expenses, state taxes, licenses and fees. The reduction in expenses in 2005 is primarily attributable to a class action settlement agreement ( Global Settlement ), which we entered into in In 2005, we received final approval of the Global settlement resolving litigation proceedings involving alleged sales practices claims. The settlement class includes all policyholders, with certain limited exceptions, who have or had an ownership interest in permanent life policies issued between January 1, 1983 and December 31, The settlement agreement resulted in the establishment of a liability of $10 million in This estimated amount represents the cost to us of the settlement including related expenses. As of December 31, 2005, we had paid $2 million of the original estimated liability of $10 million, resulting in a remaining estimated liability of approximately $8 million. Net income for 2004 increased $12 million primarily due to a federal income tax benefit incurred in 2004 versus a federal income tax expense incurred in 2003 partially offset by an increase in expenses. The increases in reserves and operating expenses are primarily attributable to the Global Settlement reserve of $10 million which was recorded in Premium income includes premium and annuity consideration on life, supplementary contracts and corporate owned life insurance deposits. Premium income in 2005 decreased $8 million primarily due to a $7 million direct premium decrease in variable life insurance products as we no longer sell these 3

4 products. Premium income decreased $8 million in 2004 due primarily to new sales of life insurance partially offset by increased experience refunds related to reinsurance contracts. In 2005, net investment income, including amortization of the Interest Maintenance Reserve ( IMR ) increased $2 million, primarily due to increased bond earnings of $1 million and short-term investment earnings of $1 million. Short-term investment yields increased from 2.0% in 2004 to 4.4% in 2005 while bond yields increased from 5.0% in 2004 to 5.2% in In 2004, net investment income increased $1 million primarily due to an increase in average bond balances from 2003 to In 2005, fees and other income, which includes miscellaneous income and commissions and expense allowances on reinsurance ceded, increased $3 million, primarily due to an increase in separate investment account fees attributable to a fluctuation in the cost of insurance charges. In 2004, fees and other income decreased $7 million, primarily due to a decrease in administrative fees. Reserve adjustments on reinsurance ceded decreased $1 million in 2005, primarily due to an increase in death claims. We have a modified coinsurance quota-share agreement with MassMutual, whereby we cede substantially all of the premium on new issues of certain life insurance policies. In return, MassMutual pays us a stipulated expense allowance, death and surrender benefits and a modified coinsurance adjustment based upon experience. We hold the assets and related reserves for payment of future benefits on the ceded policies. Policyholders benefits and payments which include supplementary contract payments, matured endowments, death, annuity, and surrender benefits, and interest and adjustments on contract or deposittype contract funds, increased $10 million in 2005, primarily due to an increase in death claims. In 2004, policyholders benefits and payments decreased by $8 million primarily due to a decrease in death claims. Life insurance lapse rates for 2005 and 2004, which are based upon the amount of insurance in force, were 6.5% and 6.9%, respectively. Decrease to policyholders reserves and funds includes transfers to and from the separate account, based upon policyholder elections, and the change in general account reserves. The 2005 decrease of $17 million was primarily due to a reduction of $14 million in net transfers to separate accounts due to a decrease in variable life premium. The 2004 increase of $6 million in addition to policyholders reserves and funds was primarily due to a decrease in the change in transfers from separate accounts of $9 million, reserves established for the Global Settlement of $4 million, partially offset by a decrease in the change in life reserves of $7 million. Commissions, including commissions and expense allowances on reinsurance assumed, remained relatively unchanged from 2004 to 2005 and from 2003 to Operating expenses, state taxes, licenses and fees decreased $8 million in 2005 primarily due to the 2004 expenses related to the Global Settlement. In 2004, the $8 million increase was primarily due to expenses related to the Global Settlement. Federal income tax benefit decreased $16 million in 2005, primarily due to the large reduction in 2004 of tax liabilities related to separate investment account related items. This was also the primary driver of the $32 million federal income tax expense decrease in 2004 as compared to

5 Statement of Financial Position The following table sets forth the Company s significant assets, liabilities and shareholder s equity: Years Ended December 31, % Change 05 vs. 04 Assets: Bonds $ 177 $ 190 (7)% Mortgage loans Policy loans Cash, cash equivalents and short-term investments Total invested assets Other assets Separate account assets 4,083 4,014 2 Total assets $ 4,377 $ 4,307 2% Liabilities and Shareholder s Equity: Policyholders reserves and deposit fund balances $ 87 $ 83 5% Policyholders claims and other benefits Transfers due (from) separate accounts (43) (46) 7 Payable to affiliate Federal income taxes 1 9 (89) Other liabilities (12) Separate account liabilities 4,083 4,014 2 Total liabilities 4,159 4,085 2 Total shareholder s equity Total liabilities and shareholder s equity $ 4,377 $ 4,307 2% Assets Total assets increased $70 million, or 2% in 2005 to $4.4 billion from $4.3 billion in 2004, primarily due to a 2% increase in separate account assets. Invested assets totaled $276 million at December 31, 2005 and 2004, respectively. Bonds decreased $13 million, or 7%, during Maturities and sales proceeds were $40 million, which were partially offset by purchases of $29 million. We maintained a similar mix of bonds at December 31, 2005, as compared to December 31, At December 31, 2005, corporate debt, mortgage-backed, asset backed and U.S. Treasury securities were 44%, 40%, 13% and 3% of the total bond portfolio. Policy loans increased $5 million, or 8%, in 2005 due to normal business growth. Cash, cash equivalents and short-term investments increased $8 million, or 47%, in 2005 due to the sale and maturity of bonds that were not reinvested. 5

6 Insurance amounts receivable increased $1 million in 2005 primarily due to higher reinsurance recoverables from non-affiliates. Separate account assets increased $69 million in 2005 primarily due to market appreciation from the portfolios backing bank owned life insurance and variable life insurance products. Liabilities The $74 million increase in total liabilities in 2005 was primarily due to an increase in separate account liabilities. Our policyholders reserves and deposit fund balances increased $4 million in 2005 primarily due to a $7 million increase in variable life insurance reserves. Policyholders claims and other benefits increased $8 million in 2005 to $13 million from $5 million in 2004, primarily due to higher bank owned life insurance products claims payable. Transfers due from separate accounts represents policyholders account values in excess of statutory benefit reserves. Transfers due from separate accounts decreased $3 million to $43 million in 2005 primarily due to an increase in Life policyholders reserves. Federal income taxes payable decreased $8 million primarily due to the current year s $6 million tax benefit and net payments of $2 million resulting from the 2004 extension payment made in Other liabilities primarily include general expenses due and accrued, payable to affiliates, and remittances and items not allocated. Other liabilities decreased $2 million in 2005, primarily due to payments made in 2005 related to the Global Settlement liability that was established in Capital and Surplus Our 2005 decrease in surplus of $4 million was primarily attributable to a $47 million dividend paid to our parent C.M. Life, partially offset by 2005 net income of $44 million. Liquidity and Capital Resources Liquidity We manage our liquidity position by matching our exposure to cash demands with adequate sources of cash and other liquid assets. 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 include investment income, principal repayments on invested assets, and life insurance premium. In 2005 cash, cash equivalents and short-term investments increased $8 million as funds from long term investments were not reinvested by year-end. In 2004 cash, cash equivalents and short-term investments decreased $7 million as funds were shifted into long-term investments such as bonds. In 2005, net cash from operations decreased $33 million primarily due to a $35 million increase in federal income taxes paid due to larger federal income tax recoveries in 2004 versus In 2004, net cash from operations increased $35 million primarily due to an increase of $56 million in federal income taxes 6

7 recovered and a decrease of $17 million in benefit payments, partially offset by an increase in commissions paid of $14 million and decreases in premium and other income received of $11 million and $7 million, respectively. In 2005 purchases of investments decreased $81 million, or 71%, from $114 million in 2004 to $33 million in Sales and maturities of investments and receipts from repayment of mortgage loans decreased $20 million, from $65 million in 2004 to $45 million in Purchases of investments increased $43 million to $114 million in 2004, from $71 million in Sales and maturities of investments and receipts from repayment of mortgage loans increased $27 million to $65 million in 2004 from $38 million in In 2005, the decrease in net cash from financing and miscellaneous sources of $11 million was primarily due to an increase in dividend payments of $13 million. In 2004, the increase in net cash applied to financing and miscellaneous sources of $11 million was primarily due to an increase in dividends paid to its stockholder of $15 million. Our investment portfolio is structured to ensure a strong liquidity position in order to permit timely payment of policy and contract benefits without requiring an uneconomic sale of assets. We classify our liquid assets into four categories: cash equivalents, highly liquid, reasonably liquid, and other potential liquidity sources, with estimated fair values at December 31, 2005 totaling $178 million. Cash equivalents are assets that can be converted to cash in one day, such as cash, short-term investments and U.S. Treasury securities. Highly liquid assets are those for which a ready market exists at all times, with large numbers of buyers willing to pay approximately the same price for a security, such as agency mortgagebacked pass-through securities. Reasonably liquid instruments are those for which there is normally a good market with large numbers of buyers, but which may have higher-than-usual transaction costs in some market conditions, such as collateralized mortgage obligations, and publicly traded corporate bonds rated A or better. Other potential liquidity sources are those assets whose fair value should be realizable in the marketplace, but which may require time to sell or have higher-than-usual transaction costs in some market conditions, such as publicly traded corporate bonds rated BBB or lower and corporate private placement bonds. We utilize sophisticated asset/liability analysis techniques in the management of the investments supporting our liabilities. Additionally, we test the adequacy of the projected cash flow provided by assets to meet all of our future policyholder and other obligations. We perform these studies using stress tests regarding future credit and other asset losses, market interest rate fluctuations, claim losses, and other considerations. The result is a complete picture of the adequacy of our underlying assets, reserves, and capital. We analyze a variety of scenarios modeling potential demands on liquidity, taking into account the provisions of policies and contracts in force, our cash flow position, and the volume of cash and readily marketable securities in our portfolio. We proactively manage our liquidity position on an ongoing basis to meet cash needs while minimizing adverse impacts on investment returns. Capital Resources As of December 31, 2005 and 2004, our total adjusted capital as defined by the NAIC was $221 million and $225 million, respectively. The NAIC developed a Risk Based Capital ( RBC ) model to compare total adjusted capital with a standard design in order to reflect an insurance company s risk profile. Although we believe that there is no single appropriate means of measuring capital needs, we feel that the NAIC approach to RBC measurement is reasonable, and we manage our capital position with significant attention to maintaining adequate total adjusted capital relative to RBC. Our total adjusted capital was well in excess of all RBC standards at December 31, 2005 and We believe that we enjoy a strong capital position in light of our risks and that we are well positioned to meet policyholder and other obligations. 7

8 Investments General As directed by our policyholders, the majority of our assets are policyholders investments in our separate accounts. 20% of our separate account assets are at book value; 80% are at market value and are not available to satisfy liabilities that arise from any of our other businesses. The following discussion focuses on the general investment account portfolio, which does not include our separate account assets. We had $276 million of invested assets in our general investment account at December 31, 2005 and We manage the portfolio of invested assets to support the general account liabilities of the business in light of yield, liquidity and diversification considerations. The following table sets forth our invested assets in the general investment account and the related gross investment yield: Carrying Value December 31, % of Total Yield Carrying Value % of Total Yield Bonds $ % 5.2% $ % 5.0% Mortgage loans Policy loans Cash, cash equivalent and shortterm investments Total investments $ % 5.5% $ % 5.0% We calculate the yield on each investment category before federal income taxes as: (a) two times gross investment income, divided by (b) the sum of assets at the beginning of the year and assets at the end of the year, less gross investment income. After investment expenses and IMR amortization were deducted, our net annualized yields were 5.4% and 4.9% for the years ended December 31, 2005 and 2004, respectively. Bonds Bonds consist primarily of government securities, mortgage-backed securities and high quality marketable corporate securities. We invest a significant portion of our investment funds in high quality publicly traded bonds in order to maintain and manage liquidity and reduce the risk of default in the portfolio. The NAIC Securities Valuation Office ( SVO ) rates investment credit risk based upon the issuer s credit profile. NAIC rating designations range from 1 to 6. An NAIC designation of 1 denotes obligations of the highest quality in which credit risk is at its lowest and the issuer s credit profile is stable, whereas an NAIC designation of 6 is assigned to obligations that are in or near default. Classes 1 and 2 are investment grade, Class 3 is medium quality and Classes 4, 5 and 6 are non-investment grade. The following table sets forth the NAIC SVO ratings for our bond portfolio along with what we believe are the equivalent rating agency designations. Our 2005 bond portfolio consists of long-term bonds, short-term securities and cash equivalents whereas the 2004 bond portfolio only consists of long-term bonds and shortterm securities. The difference in presentation between 2005 and 2004 is due to the statutory accounting change in presentation of the cash equivalents during In 2004, cash equivalents were presented 8

9 separately for statutory reporting. Bond Credit Quality NAIC Bond Classes Rating Agency Equivalent Designation Carrying Value December 31, % of Carrying Total Value % of Total 1 Aaa/Aa/A $ % $ % 2 Baa Ba B Caa and lower In or near default Total $ % $ % The tables below set forth the NAIC SVO ratings for our publicly traded and privately placed bond portfolios, including short-term securities and cash equivalents for 2005 and short-term securities for 2004: NAIC Bond Publicly Traded Bond Credit Quality December 31, Rating Agency Carrying % of Carrying % of Classes Equivalent Designation Value Total Value Total 1 Aaa/Aa/A $ % $ % 2 Baa Ba B Caa and lower In or near default Total $ % $ % 9

10 NAIC Bond Privately Placed Bond Credit Quality December 31, Rating Agency Carrying % of Carrying % of Classes Equivalent Designation Value Total Value Total 1 Aaa/Aa/A $ 19 51% $ 19 56% 2 Baa Ba B Caa and lower In or near default Total $ % $ % We utilize our investments in the privately placed bond portfolio to enhance the value of the overall portfolio, increase diversification and obtain higher yields than can be earned by investing in comparable quality public market securities. To control risk, when utilizing privately placed securities, we rely upon broader access to management information, stronger negotiated protective covenants, call protection features, and a higher level of collateralization than can customarily be achieved in the public market. The strength of the privately placed bond portfolio is demonstrated by the predominance of NAIC Class 1 and 2 securities. The following table sets forth by industry category the total bond portfolio, including short-term securities and cash equivalents at December 31, 2005: Industry Category Bond Portfolio by Industry December 31, 2005 Public Private Total Carrying Carrying % of Carrying Value % of Total Value Total Value Mortgage-backed securities $ 69 41% $ 3 8% $ 72 35% Utilities Finance Consumer services Media Capital goods Asset-backed securities Consumer goods Government Natural resources Technology Healthcare Telecommunications Transportation Retail Total $ % $ % $ % % of Total 10

11 Mortgage-backed securities consist mainly of residential mortgage-backed securities and collateralized mortgage obligations (both primarily government-backed or government agency-backed) as well as commercial mortgage-backed securities of generally high quality, which are supported by well-diversified collateral. Two other industry groups, utilities and finance, exceed 10% of the total bond portfolio. The utility industry group holdings include a number of issuers. The finance industry group holdings are very diversified and include a number of issuers, which are effectively supported by large pools of assets that are themselves diversified by industry and issuer. Bond Portfolio Surveillance and Under-Performing Investments To identify under-performing investments, we conduct a quarterly management review that includes all bonds in default or not-in-good standing as well as securities valued below 80% of cost. For a non-interest related decline in value to determine the existence of other than temporary impairments, we consider the following factors: (a) the financial condition and near-term prospects of the issuer; (b) the likelihood that we will be able to collect all amounts due according to the contractual terms of a debt security in effect at the date of acquisition; (c) our ability and intent to retain the investment for a period of time sufficient to allow for an anticipated recovery in value; and (d) the period and degree to which the market value has been below cost. For an interest related decline in value to determine the existence of other than temporary impairments, we also consider: (a) our near term intent to sell; (b) our contractual and regulatory obligations; and (c) the investments' forecasted recovery in value. Additionally, we consider qualitative and quantitative factors such as material declines in issuer revenues or margins, significant uncertainty regarding the issuer s industry, debt service coverage or cash flow ratios that fall below industry-specific thresholds, violation of financial covenants, trading of public securities at a substantial discount due to specific credit concerns, and other subjective factors that relate to the issuer. We actively review the bond portfolio to estimate the likelihood and amount of financial defaults or writedowns in the portfolio and to make timely decisions as to the potential sale or re-negotiation of terms of specific investments. 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. As of December 31, 2005, there were only three bonds with NAIC Class 6 ratings totaling less than $1 million. As of December 31, 2004 there were only three bonds with NAIC Class 6 ratings with minimal carrying values. The following is an analysis of the fair values and gross unrealized losses aggregated by bond category and length of time that the securities have been in a continuous unrealized loss position. 11

12 December 31, 2005 Less than 12 months 12 months or longer Number Unrealized of Fair Unrealized Losses Issuers Value Losses Fair Value Number of Issuers U.S. Treasury securities and obligations of U.S. government, corporations and agencies $ 1 $ - 1 $ - $ - - Asset-backed securities Mortgage-backed securities Corporate debt securities Utilities $ 64 $ $ 53 $ 2 75 The following is an analysis of the fair values and gross unrealized losses aggregated by bond category, length of time that the securities have been in a continuous unrealized loss position and investment grade. December 31, 2005 Less than 12 months Below Investment Grade 12 months or longer Below Investment Grade Investment Grade Total Investment Grade Total U.S. Treasury securities and obligations of U.S. government, corporations and agencies $ - $ - $ - $ - $ - $ - Asset-backed securities Mortgage-backed securities Corporate debt securities Utilities $ 1 $ - $ 1 $ 2 $ - $ 2 Through the Company s comprehensive evaluation, management concluded that the unrealized losses at December 31, 2005 were caused by interest rate increases and, for mortgage-backed and corporate debt securities, were partially offset by the underlying quality improvement related to strengthening economic conditions. For mortgage-backed securities which were greater than 12 months duration, unrealized losses were $1 million, none of which were below investment grade. The contractual cash flows of the majority of these securities are guaranteed by Federal National Mortgage Association. It is expected that the securities would not be settled at a price less than the amortized cost of the investment. For corporate debt securities which were greater than 12 months duration, unrealized losses were less than $1 million, of which approximately 83% carried an investment grade rating. Based upon the Company s impairment review process, the decline in the value of these investments is not considered to be other-than-temporary. The Company is not exposed to any significant concentrations of credit risk from a single or group nongovernmental issuer. 12

13 Investment Reserves In compliance with regulatory requirements, we maintain an Asset Valuation Reserve. This reserve stabilizes surplus against non-interest rate related fluctuations in the value of bonds. As of and for the two years ended December 31, 2005 and 2004, investment reserve balances and related activity were not significant. Quantitative and Qualitative Information about Market Risk Assets, such as bonds and policy loans are financial instruments and are subject to the risk of market volatility and potential market disruptions. These risks may reduce the value of our financial instruments, or impact future cash flows and earnings from those instruments. We do not hold or issue any financial instruments for the purposes of trading. Our primary market risk exposure is changes in interest rates, which can cause changes in the fair value, cash flows, and earnings of certain financial instruments. To manage our exposure to interest rate changes, we use sophisticated quantitative asset/liability management techniques. Through asset/liability management, we match the market sensitivity of assets with the liabilities they support. If these sensitivities are closely matched, the impact of interest rate changes is effectively offset on an economic basis as the change in value of the asset is offset by a corresponding change in the value of the supported liability. In addition, we invest a significant portion of our investment funds in high quality bonds in order to maintain and manage liquidity and reduce the risk of default in the portfolio. Based upon the information and assumptions we used in our asset/liability analysis as of December 31, 2005, we estimate that a hypothetical immediate 10% increase in interest rates would decrease the net fair value of our financial instruments by $3 million. A change in interest rates of 10% would not have a material impact on our future earnings or cash flows. A significant portion of our liabilities, such as insurance policy and claim reserves, are not considered financial instruments and are excluded from the above analysis. Because of our asset/liability management, a corresponding change in fair values of these liabilities, based on the present value of estimated cash flows, would significantly offset the net decrease in fair value of assets estimated above. Revenues and profitability from variable products will vary from period to period, driven in part by changes in the capital and equity markets. Specifically, certain fees we charge for variable product separate accounts are based on the separate account asset levels. Separate account asset levels change as the underlying investments market values change. Based on our experience, management believes that a 10% change in the equity markets would change the annualized fees by approximately $300,000. The profitability of our individual variable annuity products can also vary as our obligation related to secondary guarantees changes with capital and equity market volatility. Substantially all new individual variable annuity products contain secondary guarantees in the form of guaranteed minimum death benefits ( GMDBs ). The reserves related to these secondary guarantees amounted to $1 million at December 31, Specifically, these reserves approximate one half of one percent of the related account value. There were no significant payments of GMDBs during the year ended December 31, There were no significant payments for other secondary guarantees during We assess the risks associated with secondary guarantees in the overall context of risk management, but do not reinsure the risk associated with secondary guarantees. In addition, certain of our investments are subject to credit risk. Credit risk is the risk that issuers of investments owned by us may default or that other parties may not be able to pay amounts due to us. We manage our investments to limit credit risk by diversifying our portfolio among various industry sectors. 13

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