Massachusetts Mutual Life Insurance Company Management s Discussion and Analysis

Transcription

1 Massachusetts Mutual 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 Massachusetts Mutual Life Insurance Company ( MassMutual ) at December 31, 2005 and 2004, our results of operations for the past two years and, where appropriate, factors that may affect its future financial performance. We are a growth-oriented, diversified financial services company 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 efforts have produced strong financial performance, with statutory net income of $663 million in 2005 and $297 million in As of and for the year ended December 31, 2005, we had approximately $68.1 billion in general account statutory assets, $100.7 billion in total statutory assets, net gain from operations (after dividends to policyholders and taxes) of $449 million, approximately 2.4 million individual policies in force and $316.6 billion of life insurance in force. Our total adjusted capital, as defined by the National Association of Insurance Commissioners (the NAIC ), increased to $8.8 billion as of December 31, 2005 versus $8.0 billion as of December 31, The following table sets forth the calculation of total adjusted capital: December 31, (In Millions) Policyholders contingency reserves (1) $6,688 $6,291 Asset valuation reserves 1,518 1,185 One-half of the apportioned dividend liability Total adjusted capital (2) $8,787 $ 7,978 (1) Includes $250 million of surplus notes, maturing in 2033, $100 million of surplus notes maturing in 2024, and $250 million of surplus notes maturing in (2) Defined by the NAIC as policyholders contingency reserves plus consolidated Asset Valuation Reserve ( AVR ) and one half of the consolidated apportioned dividend liability. 1

2 Our strong performance and market position is reflected in our financial strength ratings as of December 31, 2005: 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 Service. 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 based upon an independent review of MassMutual and its domestic insurance subsidiaries and that of the industry in which we operate. A ratings trigger refers to any contractual clause in our contracts requiring action by us or resulting in financial consequences in the event of a downgrade of our 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, we had one group life insurance contract with a December 31, 2005 account value of $353 million that contained a rating s trigger. If our financial strength ratings fall significantly, we are required to pursue the transfer of the risks of the contract to another company. We, through our subsidiary MassMutual Funding LLC, have shortterm obligations consisting of commercial paper issued generally with a maturity of less than 180 days. During 2005, we, through MassMutual Funding LLC, renewed a $500 million senior unsecured 364-day revolving credit facility to support our commercial paper borrowings. If our financial strength ratings fall two levels or more we will incur additional bank costs related to our credit facility. 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. Our insurance products include a wide range of products and services through a network of general agents, agents and affiliated distributors, broker dealers and banks, to customers primarily in the United States. Products include whole life insurance, universal life insurance, variable universal life insurance, term life insurance, bank owned and corporate owned life insurance, structured settlements, individual annuities, individual disability income insurance, and long-term care insurance. In 2005, we added a renewable term rider for whole life policies that provides added protection at a lower premium, as well as the flexibility to convert term coverage to permanent insurance as needs change. Also, a competitive universal life product was introduced that provides flexible premiums and guarantee periods, as well as numerous riders to personalize coverage. In 2005 we refined several annuity products to offer added flexibility and security. Purchase payment minimums on select contracts were reduced, making them more accessible to a larger number of clients. New guarantee features were added to help those who seek an additional measure of principal protection, and charges were reduced on certain product features. In 2004, we added a new survivorship variable life product, which offers a lifetime insurance premium payment and death benefit flexibility along with a guaranteed death benefit premium. Two new term products were added during the year with automatic annual renewal at various levels of guaranteed premium years. Also in 2004, three new deferred annuity products were introduced in MassMutual Evolution SM is designed to be a high-end, variable product offering attractive options to distributors looking to build and maintain relationships with investors who are at or near retirement. It offers living benefits; a range of investment sub-account choices, and the option to begin receiving a lifetime income 30 days after the contract is purchased. MassMutual Transitions Select SM, an upgrade of our former flagship variable annuity product, MassMutual Transitions, was introduced in This upgrade was aimed at simplifying the product by eliminating some of the options that were underutilized, adding investment features such as professionally managed directed allocation models, and building more flexibility into the living benefits offered. 2

3 MassMutual Odyssey Plus SM, a fixed deferred annuity, was introduced in 2004 to augment our very popular MasssMutual Odyssey fixed annuity product, introduced in This product offers a niche option for advisors and investors willing to trade off liquidity and flexibility for improved rates. Retirement and financial products include defined contribution/401(k), defined benefit and non-qualified deferred compensation retirement products and services for corporate, union, nonprofit and governmental clients and participants across the U.S. In addition, we offer guaranteed investment contracts ( GIC ) for U.S. retirement plans, funding agreements for domestic and international institutional investors, and terminalfunding contracts for defined benefit plans. Our retirement products primarily serve companies with $10 million to $150 million in retirement plan assets and meet the needs of more than 5,100 plan sponsors and more than one million participants, providing companies with the valuable ability to entirely outsource their retirement benefit operations. In 2005, we introduced e4 sm, the industry s first wireless enrollment system. This technology has achieved retirement plan enrollment success rates averaging 90 percent, and as high as 100 percent among eligible employees. Our financial products consists of specialized institutional investment products including GICs for U.S. retirement plans, funding agreements for non-qualified plans and domestic and international institutional investors, and single premium annuity contracts for terminating defined benefit plans. We introduced a guaranteed indexed separate account product that generated a $1.0 billion sale in 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. 3

4 Results of Operations Total Company The following table sets forth the components of statutory net income, which are supported by the Annual Statement: Years Ended December 31, % Change 05 vs. 04 % Change 04 vs Revenue: Premium income $ 11,854 $ 12,500 $ 12,152 (5)% 3% Net investment income 4,022 3,838 3,870 5 (1) Fees and other income Total revenue 16,219 16,649 16,279 (3) 2 Benefits and expenses: Policyholders benefits and payments 9,531 7,795 7, Addition to policyholders reserves and funds 3,498 5,827 6,105 (40) (5) Commissions (6) (5) Operating expenses, state taxes, licenses & fees 1,025 1, (16) 25 Total benefits and expenses 14,542 15,361 14,739 (5) 4 Net gain from operations before dividends and taxes 1,677 1,288 1, (16) Dividends to policyholders 1, , (9) Net gain from operations before federal income taxes (34) Federal income tax expense (benefit) (122) (45) 208 Net gain from operations (72) Net realized capital gains (losses) (190) Net income $ 663 $ 297 $ % (21)% The $366 million increase in net income in 2005 is primarily due to the one time class action settlement agreement ( Global Settlement ) reserve of $268 million we recognized in In 2005, we received final approval of this nationwide class action 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, term life policies or disability income policies issued between January 1, 1983 and December 31, The settlement agreement resulted in the establishment of a liability of $268 million in This estimated amount represents the cost to the Company of the settlement including related expenses. As of December 31, 2005, the Company has paid $81 million of the original estimated liability, resulting in a remaining estimated liability of $187 million. No additional Global Settlement reserves were recorded in Other impacts to net income include, increased net investment income of $184 million and net realized capital gains of $77 million, lower addition to policyholders reserves and funds of $2.3 billion and operating expenses, state taxes, licenses and fees of $194 million, partially offset by decreased premium of $646 million, increased policyholders benefits and payments of $1.7 billion and increased policyholders dividends of $159 million. The $77 million decrease in net income in 2004 is primarily due to increased policyholders benefits and payments and operating expenses, state taxes, licenses and fees of $928 million and income tax expense of 4

5 $254 million, partially offset by decreased policyholders reserves and funds of $278 million, increased net realized capital gains of $327 million and a decrease in dividends to policyholders of $102 million. The increase in operating expenses, state taxes, licenses and fees is primarily due to the Global Settlement accrual of $268 million recorded in Selected premium income information is presented below: Years Ended December 31, % Change 05 vs. 04 % Change 04 vs Premium income: Whole life... $ 2,687 $ 2,722 $ 2,749 (1)% (1)% Term life (3) - Universal, variable & group life ,286 1,904 (24) (32) Annuities and supplemental contracts... 1,373 1, (4) 44 Disability income Defined contribution... 5,131 5,285 4,832 (3) 9 Defined benefit (13) GIC and single premium annuity contracts (92) 293 Separate accounts (39) (31) Other (30) Total... $ 11,854 $ 12,500 $ 12,152 (5)% 3% Premium income includes premium and annuity considerations on life, annuity, supplementary contracts, accident and health contracts, traditional guaranteed investment contracts ( GIC ), single premium annuities, defined contributions and defined benefit considerations. Registered product deposits, deposits from domestic and international funding agreements, and guaranteed indexed separate account products are not included in premium. Premium income decreased $646 million in 2005 primarily due to a $476 million decline in GIC premium as core insurance spread lending business remained weak due to a lack of adequate new debt issuance with attractive yields to support pricing and a $282 million decrease in bank-owned life insurance sales as portfolio products have become less attractive. Premium income increased $348 million in 2004 primarily due to an increase in premium from traditional GIC sales, partially offset by a decrease in reinsurance due to the termination of several reinsurance agreements with our subsidiary and decreased bank owned life insurance sales due to increased competition. 5

6 The components of net investment income are set forth below: Years Ended December 31, % Change % Change vs vs. 03 Net investment income: Bonds $ 2,286 $ 2,089 $ 1,966 9% 6% Common stocks Mortgage loans Policy loans Real estate (10) (3) Derivative financials instruments (28) (17) Cash, cash equivalents and short-term investments (20) Other investments (10) Total gross investment income 4,475 4,234 4, Amortization of interest maintenance reserve (24) (171) (71) Net gain from separate accounts NM Investment expenses (455) (441) (444) (3) 1 Net investment income $ 4,022 $ 3,838 $ 3,870 5% (1)% NM = Not Meaningful Net investment income, including interest maintenance reserve ( IMR ) amortization and net gains from separate accounts, increased $184 million in 2005 due to an increase in income from bonds, common stocks, mortgage loans, policy loans, other investments, net gain from separate accounts, and cash, cash equivalents and short-term investments. These increases were partially offset by decreases in real estate, derivative financial instruments, IMR amortization, and an increase in investment expenses. In 2004, net investment income, including the amortization of the IMR and net gain from separate accounts, decreased $32 million due to a decrease in IMR amortization, decreases in income from derivative financial instruments, short-term investments, other investments including partnerships and limited liability companies ( LLCs ), and affiliated common stock and real estate, partially offset by increased income from bonds, mortgage loans, common stocks and policy loans. Our overall gross portfolio yields were 7.1% and 6.8% in 2005 and 2004, respectively. In 2005, yields on bonds, common stocks, real estate, and cash, cash equivalents and short-term investments increased while mortgage loans, policy loans and other investment yields decreased. Bond income increased $197 million in 2005 due to interest collection on past due bonds and increased prepayment fee income while yields increased from 6.1% in 2004 to 6.2% in Average bond investments were $36.7 billion and $35.5 billion in 2005 and 2004, respectively. Bond income also increased in 2004 due to a growing asset base, partially offset by lower yields. Average bond investments were $35.5 billion and $30.2 billion in 2004 and 2003, respectively while yields dropped from 6.8% in 2003 to 6.1% in Income from common stocks increased in 2005 and Yields on common stock increased from 3.5% in 2004 to 5.4% in The 2004 increase was due to increases in assets and increasing yields. Mortgage loan gross investment income for 2005 remained relatively flat with a gain of 1% compared to Mortgage loan investment income was $585 million and $578 million for 2005 and 2004, respectively. The $7 million increase was due to increases in prepayment fees and contingent interest, partially offset by 6

7 decreased yields from 7.3% in 2004 to 7.0% in Mortgage loan gross income increased $48 million in 2004 due to a 12% increase in average asset base, driven by large purchases of residential loan pools, while yields decreased to 7.3% in 2004 from 7.5% in The increase in policy loan gross investment income in 2005 is primarily due to increases in the asset balance, which rose from $6.9 billion in 2004 to $7.3 billion in The 2004 increase was due to increased average policy loans. While the real estate yield, net of expenses and depreciation, increased from 11.1% to 12.1% in 2005, the $28 million decrease was primarily due to a shrinking asset base, which decreased from $1.5 billion in 2004 to $1.3 billion in 2005 primarily due to the sale of five hotel properties to a new real estate separate account. In 2004, the decrease in real estate income of $10 million was due to a significant decrease in the asset base as approximately 20% of the real estate portfolio was transferred into a real estate separate investment account offered to contract holders. In 2005, the decrease in derivative instruments gross investment income of $104 million was primarily due to a decrease in interest rate swap income from $337 million in 2004 to $243 million in The average market value of derivative financial instruments decreased from $1.6 billion in 2004 to $1.4 billion in In 2004, the $78 million decrease was driven by decreasing yields and a decrease in the average market value of derivative financial instruments from $1.7 billion in 2003 to $1.6 billion in The cash, cash equivalents and short-term investments gross investment income increased from $111 million in 2004 to $130 million in The increase was due to increased yields, which were 4.3% in 2005 compared to 2.6% in 2004 partially offset by a $1.3 billion decrease in the average investment from $4.4 billion to $3.0 billion in In 2004, gross investment income on cash, cash equivalents and short-term investments decreased $27 million due to a decrease in the short-term investments portfolio s average investment. While yield increased to 2.6% in 2004, the average investment decreased by $3.0 billion to $4.4 billion in Other investments gross investment income increased $112 million in The main driver was an increase in income from partnerships and LLCs, which contributed $105 million primarily due to increased gains on sales of underlying partnership investments. In 2004, gross investment income from other investments decreased $31 million primarily due to a $33 million decrease in affiliated common stock partially offset by a $3 million decrease in partnerships and LLCs income. Decreasing yields also contributed to the decrease in income from other investments for IMR amortization decreased from $34 million in 2004 to $(24) million in 2005 due to a decrease in mortgage backed securities forward gains which dropped from $67 million in 2004 to $14 million in For 2004, the IMR amortization compared to the prior year decreased $83 million, or 71%. The decrease is primarily due to a drop of $77 million in mortgage forward gains for Fees and other income, which includes miscellaneous income, commissions and expense allowances and reserve adjustments on reinsurance ceded, increased $32 million in 2005 primarily due to a $22 million increase in separate investment account fees attributable to growth in both our registered retirement product and asset based fee charges on separate account assets. Commissions and expense allowances on reinsurance ceded (net of reserve adjustments) increased $8 million primarily due to an increase in fees attributable to a reinsurance agreement with our long-term care third party administrator. In 2004, an increase of $54 million was primarily due to fees earned on higher assets under management ( AUM ) and fees attributable to a new reinsurance agreement with a long-term care third party administrator fees and other income balances were reclassified to conform to current year presentation. Policyholders benefits and payments, which include supplementary contract payments, matured endowments, death, annuity, disability and surrender benefits, and interest and adjustments on contract or deposit-type contract funds, such as medium-term notes ( MTN s ) increased $1.7 billion in 2005 primarily due to a $1.6 billion increase in redemptions of retirement products. The $685 million increase in 2004 was primarily due to an increase in retirement and financial product redemptions and maturity payments of $397 7

8 million and $122 million, respectively. The life insurance lapse rate, which is based on the amount of life insurance in force, improved to 4.8 % from 4.9% and 5.1% in 2005, 2004 and 2003, respectively. Addition to policyholders reserves, which includes transfers to and from separate accounts, based upon policyholder elections, and the change in general account reserves, decreased $2.3 billion in 2005 primarily due to a $1.5 billion decrease in retirement product reserves due to a 46% increase in redemptions. In addition, transfers to separate accounts decreased $858 million primarily due to the $1.0 billion decline in retirement products attributable to the overall increase in redemptions noted above. Addition to policyholders reserves in 2004 decreased $278 million primarily due to the release of reserves on surrenders and lower paid up additions, partially offset by reserves established for the Global Settlement of $268 million addition to policyholders reserves balances were reclassified to conform to current year presentation. Commissions, including commissions and expense allowances on reinsurance assumed, decreased $32 million in 2005 primarily due to a decrease in life commissions which are consistent with a reduction in sales. Commissions decreased $28 million in 2004 primarily due to lower reinsurance expense allowances than had been experienced in the prior year. Commissions do not necessarily correlate to total premium income since commission rates vary by product. Commission schedules are relatively greater for individual life and annuity products versus retirement products, which do not generate significant commissions. Operating expenses, including state taxes, licenses and fees and loading on deferred and uncollected premiums, decreased $194 million in 2005 primarily due to the Global Settlement expenses incurred in In 2004, operating expenses increased primarily due to expenses relating to the Global Settlement and sales growth. Dividends to policyholders increased $159 million in 2005, primarily due to the change in the dividend scale for 2006 and normal business growth. Dividends to policyholders decreased $102 million in 2004, primarily due to the change in dividend scale, partially offset by normal growth. Federal income taxes decreased $59 million in 2005, primarily due to the increase in policyholders dividends, deductions associated with Global Settlement litigation payments and greater foreign tax credits, partially offset by higher taxes associated with Internal Revenue Service ( IRS ) settlements. 8

9 Net realized capital gains (losses) were comprised of the following: Years Ended December 31, % Change % Change vs vs. 03 Realized capital gain (loss) Bonds $ (33) $ (30) $ (27) (10)% (11)% Common stocks Mortgage loans 63 (4) (2) NM (100) Real estate NM Derivatives financial instruments (219) (28) (214) NM 87 Other investments 23 (39) (56) Federal and state taxes 1 (21) NM Net realized capital gain (loss) before deferral to IMR (243) (11) 149 Net losses deferred to IMR NM (66) Less taxes on net deferred losses (59) (9) (29) NM 69 Net after tax losses deferred to IMR NM (64) Total net realized capital gains (losses) $ 214 $ 137 $ (190) 56% 172% NM = Not Meaningful Net realized capital gains increased $77 million in 2005 primarily due to net after-tax losses deferred to the IMR, mortgage loans, other investments, real estate and common stock which increased $90 million, $67 million, $62 million, $19 million and $11 million, respectively, and a decrease in federal and state taxes of $22 million. These increases were partially offset by an increased loss of $191 million from closed derivative financial instruments. In 2005, we sold real estate with a fair value of $225 million and packaged these assets into a real estate separate account fund offered to contract holders and recognized a gain of $117 million. Net realized capital gains increased $327 million in 2004 primarily due to decreases in closed derivatives losses of $186 million, real estate gains of $114 million and common stock gains of $70 million offset by an increase in federal and state taxes of $21 million. Realized capital gains (losses) do not reflect the changes in AVR and other investment reserves, which are recorded as a change in policyholders contingency reserves (surplus). For 2005, $109 million of net after-tax losses were deferred into the IMR due to losses from derivatives of $145 million. Partially offsetting these losses were gains from mortgage loans of $34 million. In 2004, $19 million of losses were deferred into the IMR due to $76 million in capital gains from forwards, which were partially offset by capital losses of $48 million, $38 million and $9 million due to swaps, options and futures, respectively. Losses deferred to the IMR are amortized into income over the approximate life of the investment sold. Mortgage loans net realized capital gains increased $67 million in 2005 due to the sale of affordable housing mortgage loans that generated pre-tax gains of $53 million, and foreign exchange gains of $10 million from a Canadian commercial loan payoff. Other investments net realized capital gains increased $62 million primarily due to partnerships and LLC s, which had greater gains from dispositions during 2005 than in 2004, and a decrease in impairments. 9

10 Derivative instrument realized losses increased to $219 million in 2005 from $28 million in The primary drivers were interest rate swaps, financial options and MBS forwards, which had losses of $120 million, $50 million and $20 million, respectively, in These derivative losses are primarily driven by changes in interest rates and, as such, can have large fluctuations period over period. Derivative unrealized losses increased $64 million primarily due to a $151 million decline in the valuation of currency swaps partially offset by an increase in the value of interest rate swaps and mortgage forwards. Fluctuations in market conditions will impact future investment results. Net realized capital gains (losses) from the sale of bonds were comprised of the following: Years Ended December 31, % Change 05 vs. 04 % Change 04 vs Gross realized capital gains $ 105 $ 84 $ % (57)% Gross realized capital losses (138) (114) (222) (21) 49 Net realized capital (losses) $ (33) $ (30) $ (27) (10)% (11)% The following table sets forth the realized and unrealized capital losses (charged directly to policyholder s contingency reserves) from derivatives: Years Ended December 31, % Change 05 vs. 04 % Change 04 vs Net realized capital losses (219) (28) (214) NM 87 Net unrealized capital losses (274) (209) (90) (31) (132) Net realized and unrealized capital losses $ (493) $ (237) $ (304) (108)% 22% NM = Not Meaningful 10

11 Statement of Financial Position The following table sets forth MassMutual s significant assets, liabilities and policyholder s contingency reserves: Years Ended December 31, % Change 05 vs. 04 Assets: Bonds $ 37,263 $ 38,493 (3)% Common stocks (1) Mortgage loans 8,556 8,805 (3) Policy loans 7,284 6,912 5 Real estate 1,298 1,485 (13) Other investments 7,034 5, Cash, cash equivalents and short-term investments 3,884 2, Total invested assets 66,280 64,352 3 Other assets 1,839 1,860 (1) Separate account assets 32,575 29, Total assets $100,694 $ 95,587 5% Liabilities and Policyholders Contingency Reserves: Policyholders reserves and deposit fund balances $ 57,235 $ 55,791 3% Policyholders dividends 1,172 1, Policyholders claims and other benefits Federal income taxes (80) Asset valuation reserves 1,466 1, Other liabilities 1,902 2,009 (5) Separate account liabilities 31,904 28, Total liabilities 94,006 89,296 5 Policyholders contingency reserves 6,688 6,291 6 Total liabilities and policyholders contingency reserves $100,694 $ 95,587 5% Assets Total assets increased $5.1 billion, or 5% in 2005 primarily due to increases in separate account assets of $3.2 billion, cash and short-term investments of $1.6 billion and other investments of $1.6 billion, partially offset by a decrease in bonds of $1.2 billion. Separate account assets increased 11% primarily due to market appreciation from annuity products of $623 million and positive net customer cash flows from retirement product mutual funds separate accounts of $2.1 billion. Cash and short-term investments increased 69% due to repayment of $1.2 billion in affiliated debt. Bonds decreased $1.2 billion in 2005 due to repayment of intercompany debt. In 2005, we had $21.7 billion in maturities and sales proceeds and purchases of $20.3 billion. Bonds and short-term securities in NAIC Classes 1 and 2 were 57% of total general invested assets at December 31, 2005 and The percentage of total invested assets representing bonds and short-term investments in NAIC Classes 3 through 6 was 5% at December 31, 2005 and See Investments for more discussion of NAIC Investment classes. 11

12 Mortgage loans decreased $249 million in 2005 due to excess of sales over new loans and additional funding. In 2005, we had $2.7 billion in maturities and sales proceeds, including prepayments of $785 million, partially offset by $2.5 billion of mortgage loans purchases. Policy loans increased $372 million in 2005 due to business growth in corporate and whole life insurance. Real estate decreased $187 million in 2005, primarily due to sales activity exceeding acquisitions and capital improvements. In 2005, we sold real estate with a fair value of $225 million and packaged these assets into a real estate separate account fund offered to contract holders and recognized a gain of $117 million. We received $434 million in proceeds from the sale of real estate excluding encumbrances of $194 million and invested $177 million in new properties and capital improvements excluding encumbrances of $174 million. Depreciation expense recorded during 2005 totaled $93 million compared to $103 million in At December 31, 2005, hotels and commercial office buildings remaining in the general account represented 47% and 51%, respectively, of our real estate portfolio compared to 51% and 47% for the same property types at December 31, We believe that investing in hotels and commercial office buildings leverages our expertise in this field. Other investments, consisting of derivatives, partnerships and LLCs, common stock investments in unconsolidated subsidiaries and affiliates, preferred stocks, and other miscellaneous investments increased $1.6 billion in The increase is primarily due to a $1.1 billion increase in affiliated common stocks due to appreciation of subsidiaries values and a $806 million increase in partnerships and LLCs, partially offset by a $204 million decrease in derivative instruments and a $29 million decrease in preferred stock. The increase in affiliated common stock was driven by a $904 million increase in MassMutual Holding, LLC, primarily attributable to $517 million in capital contributions, which includes the $184 million purchase of Baring Asset Management, and an increase of $171 million in the value of Oppenheimer. Cash, cash equivalents and short-term investments increased $1.6 billion in 2005 due to the sale of long-term investments such as bonds and mortgage loans which were reinvested in cash, cash equivalents and shortterm investments. We continue to maintain a significant cash investment position to support our credit risk management strategy. Rather than increase our credit risk, we use a combination of derivatives and shortterm investments to economically create temporary investment positions, which are highly liquid and of high quality. These combined investments perform like bonds and are held to improve the quality and performance of the general account until other suitable investments become available. Some of these combinations are considered replication (synthetic asset) transactions as permitted under statutory accounting principles. Other assets were relatively unchanged from 2004 as the decrease in accrued investment income driven by the change in the invested asset mix offset the increases in the net deferred tax assets, deferred premium, intercompany receivables and uncollected premium. Liabilities Total liabilities increased $4.7 billion, or 5% in 2005 primarily due to an increase of $3.1 billion in separate account liabilities and $2.2 billion in policyholders reserves, partially offset by a decrease in deposit fund balances of $708 million as three medium-term notes matured in Policyholders reserves and deposit fund balances increased $1.4 billion, or 3% in The increase in policyholders reserves of $2.2 billion is primarily due to an increase in Life reserves of $1.3 billion reflecting normal growth of life insurance products and an increase in Large Corporate Markets reserves of $722 million due to new growth and new product sales; partially offset by a decrease of $708 million in deposit fund balances attributable to the maturities of three large medium term-notes during The liability for policyholders dividends increased $156 million in 2005 due to a change in the dividend scale in 2006 and normal business growth. 12

13 Current federal income taxes payable in 2005 decreased $270 million due to tax payments made for the third and fourth quarter federal tax estimates, the 2004 federal tax return extension, and an advance payment on audit cycle settlement with the IRS, partially offset by the current period s tax expense. Asset valuation reserves increased $326 million in 2005 primarily due to a $168 million increase in the common stock reserves, $120 million increase in the real estate and other invested assets reserve, and $36 million increase in the bonds, preferred stocks, short term investments and derivatives reserve. For a roll forward of these reserve balances, see Investment Reserves. Other liabilities, including general expenses due or accrued, payable for securities purchased, and remittances and items not allocated, decreased $107 million in 2005 primarily due to decreases in remittances and items not allocated and security settlements, partially offset by an increase in reverse repurchase agreements and deferred liabilities. Capital and Policyholders Contingency Reserves (Surplus) The increase of $397 million in policyholders contingency reserves (surplus) was primarily due to $663 million in net income, an increase in net unrealized capital gains of $293 million, primarily due to an increase in affiliated common stock and an increase of $29 million in the change in deferred income taxes, partially offset by a $326 million increase in the change in asset valuation reserves, a $193 million increase in the change in non-admitted assets, and a $61 million prior year disability reserve change. The change in non-admitted assets increased $193 million in 2005 primarily due to a $94 million increase in net deferred tax assets, a $84 million increase in the interest maintenance reserve and a $37 million increase in the pension plan assets partially offset by a $19 million decrease in refundable deposits. During 2005, the Company implemented a new disability income active life reserve system. As a result, we recorded a prior period disability reserve adjustment. The active life reserves increased $52 million and the disabled life reserves increased $9 million, and theses increases were recorded as a $61 million change to policyholders contingency reserves in accordance with Statutory Statement of Accounting Principles ( SSAP ) No. 3 Accounting for Changes and Corrections of Errors. 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, life insurance premium, annuity premium and deposits, and financial product deposits. Historically, we have consistently experienced net positive cash flow from operations. Cash, cash equivalents and short-term investments increased $1.6 billion or 69% at December 31, 2005 as money was shifted from long-term investments such as bonds and mortgage loans. We continue to maintain a significant cash investment position to support our credit risk management strategy. Rather than increase our credit risk, we use a combination of derivatives and short-term investments to economically create temporary investment positions, which are highly liquid and of high quality. These investments perform like bonds and are held to improve the quality and performance of the general account until other suitable investments become available. Net cash provided from operations decreased $621 million or 21% to $2.4 billion in 2005, from $3.0 billion in The decrease in 2005 is attributable to an increase of $1.7 billion in benefit payments and a decrease of 13

14 $691 million in premiums, partially offset by a decrease of $1.8 billion in funds transferred to separate accounts. Net cash provided from operations decreased $541 million or 15% to $3.0 billion in 2004, from $3.6 billion in The decrease in 2004 is attributable to an increase of $621 million in funds transferred to separate accounts, $505 million increase in benefit payments, and a $368 million increase in commissions and expenses, partially offset by an increase in premiums of $413 million, an increase in net investment income of $211 million, a decrease in federal and foreign income taxes paid of $195 million, and a decrease in dividends paid of $80 million. Purchases of investments increased $2.8 billion, or 13%, to $25.5 billion in 2005 from $22.7 billion in Sales and maturities of investments and receipts from repayments of loans increased $10.3 billion or 65% to $26.0 billion in 2005 from $15.7 billion in Purchases of investments increased $1.8 billion or 8% to $22.7 billion in 2004 from $20.9 billion in Sales and maturities of investments and receipts from repayments of loans increased $654 million or 4% to $15.7 billion in 2004 from $15.1 billion in Net cash from financing activities and miscellaneous sources decreased $925 million to $903 million of net cash applied to financing activities and miscellaneous sources in This decrease is due to increased withdrawals on deposit type contracts, partially offset by changes in foreign exchange items, reverse repurchase agreements and changes in amounts due from separate accounts. Net cash provided by financing activities and miscellaneous sources decreased to $22 million in 2004 from $936 million in This decrease is attributable to a decrease in cash provided by surplus notes and changes in separate account assets and liabilities partially offset by increased deposits on deposit-type contracts. 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. Our liquid assets are classified into four categories: cash equivalents, highly liquid, reasonably liquid, and other potential liquidity sources with estimated fair values at December 31, 2005 totaling $28.1 billion. Cash equivalents are assets that can be converted to cash in one day, and include cash, short-term investments and U.S. Treasury securities, including zero-coupons. 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 mortgage-backed passthrough securities, and publicly traded common stock. Reasonably liquid instruments are those for which there is normally a good market with large numbers of buyers, but which may not have a ready market at all times. Other potential liquidity sources are those assets whose fair value should be realizable in the marketplace and which may require time to sell. 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 flows 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 provides a picture of the adequacy of the 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. Even in the most extreme scenarios we have tested, negative cash flow is extremely unlikely and operating cash flow is sufficient to satisfy our obligations without the sale of any but the most liquid assets. As part of those stress test scenarios, we assume no new business is written. In the event of significantly negative cash flow, in order to meet cash demands we would first utilize our cash and short-term positions. Stress testing shows this would be sufficient to meet needs except under very unusual conditions. If the short-term position were in danger of becoming depleted, selling other liquid investments would raise additional cash. 14

15 Some uses of cash would be suspended, including new investments in illiquid positions, acquisition activity, and the seeding of new investment funds for product development purposes. If necessary, we can issue, to the extent not already outstanding, up to $1.0 billion of commercial paper through our indirect, whollyowned subsidiary, MassMutual Funding, LLC, to avoid having to sell securities at less than fair value. Depending on the reasons for the cash drain, other borrowing, such as debt or surplus notes, would be considered in order to restore liquidity after the immediate needs were met. Another approach would be to securitize less liquid assets to restore liquidity. Institutional Investment Product Contract Terms We created trusts, which established a $2.0 billion European Medium-Term Note program and a $5.0 billion Global Medium-Term Note program. The purpose of both programs is to issue medium-term notes to domestic and international investors. Proceeds from the sale of the medium-term notes by an unconsolidated affiliated trust are used to purchase funding agreements from the Company. The payment terms of any particular series of notes are matched by the payment term of the funding agreement securing the series. As of December 31, 2005, we had cumulatively issued $3.8 billion of funding agreements under these programs. Guaranteed investment contracts ( GICs ) are pension plan investment contracts that pay a specified nonparticipating interest rate on contributions and pay book value at a specified maturity date. Contributions and withdrawals are largely fixed at the time of sale. As of December 31, 2005, approximately $144 million can be surrendered with a market-value adjustment. Structurally the same as GICs, funding agreements are investment contracts sold to the domestic and international non-qualified market. In general, the terms of the funding agreements do not give the holder the right to terminate the contract prior to the contractually stated maturity dates. No funding agreements have been issued with put provisions or ratings-sensitive triggers. Currency swaps are employed to eliminate foreign exchange risk from all funding agreements issued to back non-u.s. dollar denominated notes. As of December 31, 2005, the maturity schedule for investment contract liabilities was as follows: Funding Agreements Guaranteed Investment Contracts Total (In Millions) 2006 $ 767 $ 122 $ Thereafter $ 2,971 $ 669 $ 3,640 We set the prices for all institutional investment products by establishing target spreads prior to issuing these contracts. Through December 31, 2005 these target spreads have been achieved. 15

16 Dividends from Subsidiaries The Company s wholly owned subsidiary, MassMutual Holding LLC ( MMHLLC ), is the parent of subsidiaries which include retail and institutional asset management, registered broker dealers, and international life and annuity operations. We do not rely on dividends from our subsidiaries to meet our operating cash flow requirements. Dividend payments from insurance subsidiaries are generally subject to certain restrictions imposed by statutory authorities. Additionally, dividend payments from other subsidiaries are limited to their retained earnings. For our domestic insurance subsidiaries, substantially all of the statutory shareholder s equity of approximately $448 million at December 31, 2005 is subject to dividend restrictions. Dividend restrictions, imposed by various state regulations, limit the payment of dividends to MassMutual without the prior approval from the insurance department of the particular insurance subsidiary s state of domicile. Our domestic insurance subsidiaries are required to obtain prior approval for dividend payments they may make in For foreign insurance subsidiaries, the most significant insurance regulatory jurisdictions include Japan, Taiwan and Hong Kong. Historically, we have reinvested a substantial portion of our unrestricted earnings in our operations. Distributions by MMHLLC are recorded in net investment income and are limited to MassMutual s equity in MMHLLC. Distributions were $100 million in 2005 and Capital Resources As of December 31, 2005 and 2004, our total adjusted capital as defined by the NAIC was $8.8 billion and $8.0 billion, 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 in light of our risks and that we are well positioned to meet policyholder and other obligations. 16

17 Investments General Approximately 32% of our assets at December 31, 2005 are separate accounts assets. These assets consist principally of marketable securities reported at fair 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. At December 31, 2005, we have $66.3 billion of invested assets in our general account, an increase of $1.9 billion. We manage the portfolio of invested assets to support the general account liabilities in light of liability characteristics and yield, liquidity and diversification considerations. The following table sets forth our invested assets in the general account and the related gross investment yield thereon, after deducting real estate operating expenses and taxes, as of the dates indicated. Carrying Value December 31, % of Carrying % of Total Yield Value Total Bonds $ 37,263 56% 6.2% $ 38,493 60% 6.1% Common stocks Mortgage loans 8, , Policy loans 7, , Real estate 1, , Other investments 7, , Cash, cash equivalents and short term investments 3, , Total investments $ 66, % 6.9% $ 64, % 6.8% Yield We calculate the yield on each investment category before federal income taxes as: (a) two times gross investment income, which for real estate deducts operating expenses and real estate taxes, 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. If indirect expenses including depreciation on real estate investments were deducted, net yields on total investments would be 6.4% and 6.3% for the years ended December 31, 2005 and 2004, respectively. Bonds, Cash Equivalents and Short Term Investments Bonds consist primarily of government securities and high quality marketable corporate debt 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. A 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 a 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 SVO ratings for our portfolio along with what we believe are the equivalent rating agency designations. Our 2005 table presentation consists of long-term bonds, short-term securities and cash equivalents whereas the 2004 table presentation only consists of long-term bonds and short-term 17