<PAGE>
THE AMERICAN FRANKLIN LIFE INSURANCE COMPANY
SEPARATE ACCOUNT VUL-2
DECEMBER 31, 1998
ANNUAL REPORT
SEPARATE ACCOUNT VUL-2 FUNDING
EQUIBUILDER II-TM- AND EQUIBUILDER III-TM- FLEXIBLE PREMIUM VARIABLE
LIFE INSURANCE POLICIES
Principal office located at:
#1 Franklin Square
Springfield, Illinois 62713
Annual Report Dated December 31, 1998
- -------------------------------------------------------------------------------
DECEMBER 31, 1998
ANNUAL REPORTS
VARIABLE INSURANCE PRODUCTS FUND
VARIABLE INSURANCE PRODUCTS FUND II
PRINCIPAL OFFICE LOCATED AT:
82 Devonshire Street
Boston, Massachusetts 02109
MFS VARIABLE INSURANCE TRUST
PRINCIPAL OFFICE LOCATED AT:
500 Boylston Street
Boston, Massachusetts 02116
ANNUAL REPORTS DATED DECEMBER 31, 1998
- -------------------------------------------------------------------------------
The Annual Report of Separate Account VUL-2 is prepared and provided by The
American Franklin Life Insurance Company. The Annual Reports of the Variable
Insurance Products Fund and the Variable Insurance Products Fund II are prepared
by Fidelity Investments. The Annual Report of MFS Variable Insurance Trust is
prepared by MFS Investment Management.
- -------------------------------------------------------------------------------
This Annual Report is not to be construed as an offering for sale of any
American Franklin Life policy. No offering is made except in conjunction with a
prospectus which must precede or accompany this report.
<PAGE>
THE AMERICAN FRANKLIN LIFE INSURANCE COMPANY
SEPARATE ACCOUNT VUL-2
STATEMENT OF NET ASSETS
DECEMBER 31, 1998
<TABLE>
<CAPTION>
VARIABLE INSURANCE PRODUCTS FUND
--------------------------------------------------------------------
VIP VIP VIP
MONEY EQUITY- VIP VIP HIGH
MARKET INCOME GROWTH OVERSEAS INCOME
DIVISION DIVISION DIVISION DIVISION DIVISION
--------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Investments in Funds at fair value
(cost: see below) $ 4,437,445 $54,194,406 $81,878,257 $11,233,509 $ 2,882,181
Due from (to) general account 64,823 (28,710) (18,565) 78,106 (1,342)
--------------------------------------------------------------------
NET ASSETS $ 4,502,268 $54,165,696 $81,859,692 $11,311,615 $ 2,880,839
--------------------------------------------------------------------
--------------------------------------------------------------------
Unit value $ 132.28 $ 329.63 $ 373.90 $ 191.40 $ 156.98
-------------------------------------------------------------------
-------------------------------------------------------------------
Units outstanding 34,035 164,324 218,934 59,098 18,351
-------------------------------------------------------------------
-------------------------------------------------------------------
Cost of investments $ 4,521,180 $43,041,827 $54,801,021 $10,004,212 $3,088,375
-------------------------------------------------------------------
-------------------------------------------------------------------
</TABLE>
SEE NOTES TO FINANCIAL STATEMENTS
1
<PAGE>
THE AMERICAN FRANKLIN LIFE INSURANCE COMPANY
SEPARATE ACCOUNT VUL-2
STATEMENT OF NET ASSETS (CONTINUED)
DECEMBER 31, 1998
<TABLE>
<CAPTION>
VARIABLE INSURANCE PRODUCTS FUND II
------------------------------------------------------------------
VIPII VIPII
INVESTMENT VIPII VIPII ASSET VIPII
GRADE ASSET INDEX MANAGER: CONTRA-
BOND MANAGER 500 GROWTH FUND
DIVISION DIVISION DIVISION DIVISION DIVISION
-----------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Investments in Funds at fair value
(cost: see below) $2,312,465 $31,731,884 $33,286,972 $7,838,860 $25,393,704
Due from (to) general account 3,602 (40,989) (55,710) (9,125) (17,633)
-----------------------------------------------------------------
NET ASSETS $2,316,067 $31,690,895 $33,231,262 $7,829,735 $25,376,071
-----------------------------------------------------------------
-----------------------------------------------------------------
Unit value $ 157.66 $ 232.11 $ 295.61 $ 196.85 $ 229.00
-----------------------------------------------------------------
-----------------------------------------------------------------
Units outstanding 14,690 136,532 112,414 39,775 110,811
-----------------------------------------------------------------
-----------------------------------------------------------------
Cost of investments $2,156,277 $26,788,005 $24,496,035 $6,792,472 $19,033,712
-----------------------------------------------------------------
-----------------------------------------------------------------
</TABLE>
SEE NOTES TO FINANCIAL STATEMENTS
2
<PAGE>
THE AMERICAN FRANKLIN LIFE INSURANCE COMPANY
SEPARATE ACCOUNT VUL-2
STATEMENT OF NET ASSETS (CONTINUED)
DECEMBER 31, 1998
<TABLE>
<CAPTION>
MFS VARIABLE INSURANCE TRUST
-----------------------------------------------------------------------------
MFS
MFS GROWTH MFS
EMERGING MFS WITH TOTAL MFS MFS
GROWTH RESEARCH INCOME RETURN UTILITIES VALUE
DIVISION DIVISION DIVISION DIVISION DIVISION DIVISION
-----------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Investments in Funds at fair value
(cost: see below) $1,505,947 $1,284,799 $ 619,319 $ 591,362 $ 454,919 $ 627,301
Due from (to) general account (242) (52) (76) 35 (56) (1,392)
-----------------------------------------------------------------------------
NET ASSETS $1,505,705 $1,284,747 $ 619,243 $ 591,397 $ 454,863 $ 625,909
-----------------------------------------------------------------------------
-----------------------------------------------------------------------------
Unit value $ 113.74 $ 104.90 $ 107.39 $ 103.73 $ 106.58 $ 105.18
-----------------------------------------------------------------------------
-----------------------------------------------------------------------------
Units outstanding 13,238 12,247 5,767 5,701 4,268 5,951
-----------------------------------------------------------------------------
-----------------------------------------------------------------------------
Cost of investments $1,253,528 $1,144,706 $ 561,750 $ 558,494 $ 424,494 $ 572,986
-----------------------------------------------------------------------------
-----------------------------------------------------------------------------
</TABLE>
SEE NOTES TO FINANCIAL STATEMENTS
3
<PAGE>
THE AMERICAN FRANKLIN LIFE INSURANCE COMPANY
SEPARATE ACCOUNT VUL-2
STATEMENT OF OPERATIONS
YEAR ENDED DECEMBER 31, 1998
<TABLE>
<CAPTION>
VARIABLE INSURANCE PRODUCTS FUND
-----------------------------------------------------------------------------
VIP VIP VIP
MONEY EQUITY- VIP VIP HIGH
MARKET INCOME GROWTH OVERSEAS INCOME
DIVISION DIVISION DIVISION DIVISION DIVISION
-------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
NET INVESTMENT INCOME (EXPENSE)
Income
Dividends $ 143,599 $ 2,655,378 $ 7,473,038 $ 738,344 $ 285,271
Expenses
Mortality and expense risk charge 26,798 371,485 505,739 81,400 21,335
-------------------------------------------------------------------------------
Net investment income (expense) 116,801 2,283,893 6,967,299 656,944 263,936
NET REALIZED AND UNREALIZED GAIN (LOSS)
ON INVESTMENTS
Net realized gain (loss) - 405,037 876,982 150,702 27,178
Net unrealized appreciation
(depreciation)
Beginning of year (14,560) 8,098,752 11,954,335 928,734 243,620
End of year (83,735) 11,152,579 27,077,236 1,229,297 (206,194)
-------------------------------------------------------------------------------
Net change in unrealized appreciation
(depreciation) during the year (69,175) 3,053,827 15,122,901 300,563 (449,814)
-------------------------------------------------------------------------------
Net realized and unrealized gain (loss)
on investments (69,175) 3,458,864 15,999,883 451,265 (422,636)
-------------------------------------------------------------------------------
Net increase (decrease) in net assets
resulting from operations $ 47,626 $ 5,742,757 $ 22,967,182 $ 1,108,209 $ (158,700)
-------------------------------------------------------------------------------
-------------------------------------------------------------------------------
</TABLE>
SEE NOTES TO FINANCIAL STATEMENTS
4
<PAGE>
THE AMERICAN FRANKLIN LIFE INSURANCE COMPANY
SEPARATE ACCOUNT VUL-2
STATEMENT OF OPERATIONS (CONTINUED)
YEAR ENDED DECEMBER 31, 1998
<TABLE>
<CAPTION>
VARIABLE INSURANCE PRODUCTS FUND II
---------------------------------------------------------------------
VIPII VIPII
INVESTMENT VIPII VIPII ASSET VIPII
GRADE ASSET INDEX MANAGER: CONTRA-
BOND MANAGER 500 GROWTH FUND
DIVISION DIVISION DIVISION DIVISION DIVISION
---------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
NET INVESTMENT INCOME (EXPENSE)
Income
Dividends $ 106,859 $ 3,425,567 $ 730,351 $ 524,069 $ 830,942
Expenses
Mortality and expense risk charge 17,044 228,879 188,527 45,053 143,634
---------------------------------------------------------------------
Net investment income (expense) 89,815 3,196,688 541,824 479,016 687,308
NET REALIZED AND UNREALIZED GAIN
(LOSS) ON INVESTMENTS
Net realized gain (loss) 46,148 203,507 397,039 10,497 165,251
Net unrealized appreciation
(depreciation)
Beginning of year 134,208 4,103,907 3,002,532 508,809 1,890,354
End of year 156,188 4,943,879 8,790,937 1,046,388 6,359,992
---------------------------------------------------------------------
Net change in unrealized appreciation
(depreciation) during the year 21,980 839,972 5,788,405 537,579 4,469,638
---------------------------------------------------------------------
Net realized and unrealized gain (loss)
on investments 68,128 1,043,479 6,185,444 548,076 4,634,889
---------------------------------------------------------------------
Net increase (decrease) in net assets
resulting from operations $ 157,943 $ 4,240,167 $ 6,727,268 $ 1,027,092 $ 5,322,197
---------------------------------------------------------------------
---------------------------------------------------------------------
</TABLE>
SEE NOTES TO FINANCIAL STATEMENTS
5
<PAGE>
THE AMERICAN FRANKLIN LIFE INSURANCE COMPANY
SEPARATE ACCOUNT VUL-2
STATEMENT OF OPERATIONS (CONTINUED)
YEAR ENDED DECEMBER 31, 1998
<TABLE>
<CAPTION>
MFS VARIABLE INSURANCE TRUST*
-------------------------------------------------------------------------------------
MFS
MFS GROWTH MFS
EMERGING MFS WITH TOTAL MFS MFS
GROWTH RESEARCH INCOME RETURN UTILITIES VALUE
DIVISION DIVISION DIVISION DIVISION DIVISION DIVISION
-------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
NET INVESTMENT INCOME (EXPENSE)
Income
Dividends $ - $ - $ - $ - $ - $ -
Expenses
Mortality and expense risk charge 2,485 2,082 688 1,042 1,577 1,230
-------------------------------------------------------------------------------------
Net investment income (expense) (2,485) (2,082) (688) (1,042) (1,577) (1,230)
NET REALIZED AND UNREALIZED GAIN
(LOSS) ON INVESTMENTS
Net realized gain (loss) (880) (1,176) 140 (502) (10) 13,534
Net unrealized appreciation
(depreciation)
Beginning of year - - - - - -
End of year 252,419 140,093 57,569 32,868 30,425 54,315
-------------------------------------------------------------------------------------
Net change in unrealized
appreciation(depreciation) during
the year 252,419 140,093 57,569 32,868 30,425 54,315
-------------------------------------------------------------------------------------
Net realized and unrealized gain
(loss) on investments 251,539 138,917 57,709 32,366 30,415 67,849
-------------------------------------------------------------------------------------
Net increase (decrease) in net
assets resulting from operations $ 249,054 136,835 $ 57,021 $ 31,324 $ 28,838 $ 66,619
-------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------
</TABLE>
*FOR THE PERIOD FROM MAY 1, 1998 (DATE OF INCEPTION) TO DECEMBER 31, 1998.
SEE NOTES TO FINANCIAL STATEMENTS
6
<PAGE>
THE AMERICAN FRANKLIN LIFE INSURANCE COMPANY
SEPARATE ACCOUNT VUL-2
STATEMENT OF CHANGES IN NET ASSETS
<TABLE>
<CAPTION>
VARIABLE INSURANCE PRODUCTS FUND
------------------------------------------------------------------------------------
VIP VIP VIP
MONEY EQUITY- VIP VIP HIGH
MARKET INCOME GROWTH OVERSEAS INCOME
DIVISION DIVISION DIVISION DIVISION DIVISION
------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
YEAR ENDED DECEMBER 31, 1998
CHANGE IN NET ASSETS
FROM OPERATIONS:
Net investment income (expense) $ 116,801 $ 2,283,893 $ 6,967,299 $ 656,944 $ 263,936
Net realized gain (loss) on investments - 405,037 876,982 150,702 27,178
Net change in unrealized appreciation
(depreciation) on investments (69,175) 3,053,827 15,122,901 300,563 (449,814)
------------------------------------------------------------------------------------
Net increase (decrease) in net assets from
operations 47,626 5,742,757 22,967,182 1,108,209 (158,700)
FROM POLICY RELATED TRANSACTIONS:
Net contract purchase payments 18,043,987 14,163,958 16,320,192 3,010,083 1,104,184
Withdrawals (1,147,285) (8,392,173) (11,303,864) (1,817,197) (606,904)
Transfers between Separate Account
VUL-2 divisions, net (15,552,224) 2,808,460 2,158,143 (203,758) 127,361
------------------------------------------------------------------------------------
Net increase in net assets from policy
related transactions 1,344,478 8,580,245 7,174,471 989,128 624,641
------------------------------------------------------------------------------------
Net increase in net assets 1,392,104 14,323,002 30,141,653 2,097,337 465,941
Net assets, beginning of year 3,110,164 39,842,694 51,718,039 9,214,278 2,414,898
------------------------------------------------------------------------------------
Net assets, end of year $ 4,502,268 $ 54,165,696 $ 81,859,692 $ 11,311,615 $ 2,880,839
------------------------------------------------------------------------------------
------------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 1997
CHANGE IN NET ASSETS
FROM OPERATIONS:
Net investment income (expense) $ 158,416 $ 2,318,177 $ 988,029 $ 545,926 $ 96,953
Net realized gain on investments - 241,758 381,365 61,268 16,743
Net change in unrealized appreciation
(depreciation) on investments (6,214) 3,810,380 5,587,827 141,789 170,480
------------------------------------------------------------------------------------
Net increase in net assets from operations 152,202 6,370,315 6,957,221 748,983 284,176
FROM POLICY RELATED TRANSACTIONS:
Net contract purchase payments 15,768,314 12,119,616 14,879,501 2,855,311 936,633
Withdrawals (1,274,078) (5,951,910) (7,325,640) (1,502,429) (374,337)
Transfers between Separate Account
VUL-2 divisions, net (14,692,099) 3,478,823 2,739,351 369,757 339,645
------------------------------------------------------------------------------------
Net increase (decrease) in net assets from
policy related transactions (197,863) 9,646,529 10,293,212 1,722,639 901,941
------------------------------------------------------------------------------------
Net Increase (decrease) in net assets (45,661) 16,016,844 17,250,433 2,471,622 1,186,117
Net assets, beginning of year 3,155,825 23,825,850 34,467,606 6,742,656 1,228,781
------------------------------------------------------------------------------------
Net assets, end of year $ 3,110,164 $ 39,842,694 $ 51,718,039 $ 9,214,278 $ 2,414,898
------------------------------------------------------------------------------------
------------------------------------------------------------------------------------
</TABLE>
SEE NOTES TO FINANCIAL STATEMENTS
7
<PAGE>
THE AMERICAN FRANKLIN LIFE INSURANCE COMPANY
SEPARATE ACCOUNT VUL-2
STATEMENT OF CHANGES IN NET ASSETS (CONTINUED)
<TABLE>
<CAPTION>
VARIABLE INSURANCE PRODUCTS FUND II
---------------------------------------------------------------------
VIPII VIPII
INVESTMENT VIPII VIPII ASSET VIPII
GRADE BOND ASSET INDEX MANAGER: CONTRA-
BOND MANAGER 500 GROWTH FUND
DIVISION DIVISION DIVISION DIVISION DIVISION
-----------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
YEAR ENDED DECEMBER 31, 1998
CHANGE IN NET ASSETS
FROM OPERATIONS:
Net investment income (expense) $ 89,815 $ 3,196,688 $ 541,824 $ 479,016 $ 687,308
Net realized gain (loss) on investments 46,148 203,507 397,039 10,497 165,251
Net change in unrealized appreciation
(depreciation) on investments 21,980 839,972 5,788,405 537,579 4,469,638
-----------------------------------------------------------------------
Net increase (decrease) in net assets from
operations 157,943 4,240,167 6,727,268 1,027,092 5,322,197
FROM POLICY RELATED TRANSACTIONS:
Net contract purchase payments 485,792 5,773,958 10,353,647 3,131,484 8,348,551
Withdrawals (439,642) (4,714,381) (5,713,776) (1,426,100) (3,884,561)
Transfers between Separate Account
VUL-2 divisions, net 101,464 (90,460) 4,513,723 1,021,698 2,413,432
-----------------------------------------------------------------------
Net increase in net assets from policy
related transactions 147,614 969,117 9,153,594 2,727,082 6,877,422
-----------------------------------------------------------------------
Net Increase in net assets 305,557 5,209,284 15,880,862 3,754,174 12,199,619
Net assets, beginning of year 2,010,510 26,481,611 17,350,400 4,075,561 3,176,452
-----------------------------------------------------------------------
Net assets, end of year $ 2,316,067 $31,690,895 $33,231,262 $ 7,829,735 $25,376,071
-----------------------------------------------------------------------
-----------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 1997
CHANGE IN NET ASSETS
FROM OPERATIONS:
Net investment income (expense) $ 87,142 $ 2,345,559 $ 165,303 $ (15,396) $ 111,472
Net realized gain on investments 11,679 150,118 203,061 18,249 65,136
Net change in unrealized appreciation
(depreciation) on investments 43,713 1,171,913 2,139,824 430,039 1,306,437
-----------------------------------------------------------------------
Net increase in net assets from operations 142,534 3,667,590 2,508,188 432,892 1,483,045
FROM POLICY RELATED TRANSACTIONS:
Net contract purchase payments 525,371 5,954,601 6,747,739 1,946,149 6,031,891
Withdrawals (329,478) (3,858,162) (2,283,537) (707,474) (1,947,161)
Transfers between Separate Account
VUL-2 divisions, net (21,180) 109,203 3,935,049 1,105,963 2,638,620
-----------------------------------------------------------------------
Net increase (decrease) in net assets from
policy related transactions 174,713 2,205,642 8,399,251 2,344,638 6,723,350
-----------------------------------------------------------------------
Net increase (decrease) in net assets 317,247 5,873,232 10,907,439 2,777,530 8,206,395
Net assets, beginning of year 1,693,263 20,608,379 6,442,961 1,298,031 4,970,057
-----------------------------------------------------------------------
Net assets, end of year $ 2,010,510 $26,481,611 $17,350,400 $ 4,075,561 $13,176,452
-----------------------------------------------------------------------
-----------------------------------------------------------------------
</TABLE>
SEE NOTES TO FINANCIAL STATEMENTS
8
<PAGE>
THE AMERICAN FRANKLIN LIFE INSURANCE COMPANY
SEPARATE ACCOUNT VUL-2
STATEMENT OF CHANGES IN NET ASSETS (CONTINUED)
<TABLE>
<CAPTION>
MFS VARIABLE INSURANCE TRUST
------------------------------------------------------------------------------------
MFS
MFS GROWTH MFS
EMERGING MFS WITH TOTAL MFS MFS
PERIOD FROM MAY 1, 1998 (DATE OF GROWTH RESEARCH INCOME RETURN UTILITIES VALUE
INCEPTION) TO DECEMBER 31, 1998 DIVISION DIVISION DIVISION DIVISION DIVISION DIVISION
------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
CHANGE IN NET ASSETS
FROM OPERATIONS:
Net investment income (expense) $ (2,485) $ (2,082) $ (688) $ (1,042) $ (1,577) $ (1,230)
Net realized gain (loss) on investments (880) (1,176) 140 (502) (10) 13,534
Net change in unrealized appreciation
(depreciation) on investments 252,419 140,093 57,569 32,868 30,425 54,315
------------------------------------------------------------------------------------
Net increase (decrease) in net assets from
operations 249,054 136,835 57,021 31,324 28,838 66,619
FROM POLICY RELATED TRANSACTIONS:
Net contract purchase payments 616,401 526,652 233,241 218,045 253,967 275,910
Withdrawals (105,620) (78,873) (9,664) (33,304) (37,203) (38,438)
Transfers between Separate Account
VUL-2 divisions, net 745,870 700,133 338,645 375,332 209,261 321,818
------------------------------------------------------------------------------------
Net increase in net assets from
policy related transactions 1,256,651 1,147,912 562,222 560,073 426,025 559,290
------------------------------------------------------------------------------------
Net increase in net assets 1,505,705 1,284,747 619,243 591,397 454,863 625,909
Net assets, beginning of year - - - - - -
------------------------------------------------------------------------------------
Net assets, end of year $ 1,505,705 $ 1,284,747 $ 619,243 $ 591,397 $ 454,863 $ 625,909
------------------------------------------------------------------------------------
------------------------------------------------------------------------------------
</TABLE>
SEE NOTES TO FINANCIAL STATEMENTS
9
<PAGE>
THE AMERICAN FRANKLIN LIFE INSURANCE COMPANY
SEPARATE ACCOUNT VUL-2
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1998
1. NATURE OF OPERATIONS
The American Franklin Life Insurance Company (American Franklin) is a
wholly-owned subsidiary of The Franklin Life Insurance Company. American
Franklin established Separate Account VUL-2 (Account) as a unit investment
trust registered under the Investment Company Act of 1940. The Account,
which consists of sixteen investment divisions at December 31, 1998, was
established in April 1991 in conformity with Illinois Insurance Law.
The assets in each division are invested in units of beneficial interest
(shares) of a designated portfolio (Portfolio) of three mutual funds:
Variable Insurance Products Fund and Variable Insurance Products Fund II,
sponsored by Fidelity Investments, and beginning May 1, 1998, the MFS
Variable Insurance Trust, sponsored by MFS Investment Management
(collectively, the Funds). The VIP Money Market, VIP Equity-Income, VIP
Growth, VIP Overseas, and VIP High Income Divisions of the Account are
invested in shares of a corresponding Portfolio of Variable Insurance
Products Fund; the VIPII Investment Grade Bond, VIPII Asset Manager, VIPII
Index 500, VIPII Asset Manager: Growth and VIPII Contrafund Divisions of the
Account are invested in shares of a corresponding Portfolio of Variable
Insurance Products Fund II; and the MFS Emerging Growth, MFS Research, MFS
Growth With Income, MFS Total Return, MFS Utilities, and MFS Value Divisions
of the Account are invested in shares of a corresponding Portfolio of MFS
Variable Insurance Trust. The Account's financial statements should be read
in conjunction with the financial statements of the Funds. The Account
commenced operations on September 30, 1991. The initial unit value for each
investment division was set at $100.
The Account was established by American Franklin to support the operations
of American Franklin's EquiBuilder II-TM- Flexible Premium Variable Life
Insurance Policies (EquiBuilder II Policies). American Franklin no
longer offers new EquiBuilder II Policies. The Account also supports the
operations of American Franklin's EquiBuilder III-TM- Flexible Premium
Variable Life Insurance Policies (EquiBuilder III Policies) (the
Equibuilder II Policies and the EquiBuilder III Policies are referred to
collectively as the Policies).
Franklin Financial Services Corporation, a wholly-owned subsidiary of The
Franklin Life Insurance Company, acts as the principal underwriter, as
defined in the Investment Company Act of 1940, of the Policies. The assets
of the Account are the property of American Franklin. The portion of the
Account's assets applicable to the Policies is not chargeable with
liabilities arising out of any other business American Franklin may conduct.
The net assets of the Account may not be less than the reserves applicable
to the Policies. Assets may also be set aside in American Franklin's General
Account based on the amounts allocated under the Policies to American
Franklin's Guaranteed Interest Division and for policy loans. Additional
assets are set aside in American Franklin's General Account to provide for
(i) the unearned portion of the monthly charges for mortality and expense
risk charges made under the Policies and (ii) other policy benefits.
2. SIGNIFICANT ACCOUNTING POLICIES
The significant accounting policies of the Account are as follows:
Investments in shares of the Funds are carried at fair value. Investments
in shares of the Funds are valued at the net asset values of the respective
Portfolios of the Funds. Investment transactions are recorded on the trade
date. Dividends are recorded as received. Realized gains
10
<PAGE>
THE AMERICAN FRANKLIN LIFE INSURANCE COMPANY
SEPARATE ACCOUNT VUL-2
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
and losses on sales of the Account's shares are determined based on the
specific identification method.
The operations of the Account are included in the federal income tax return
of American Franklin. Under the provisions of the Policies, American
Franklin has the right to charge the Account for federal income tax
attributable to the Account. No charge is currently being made against the
Account for such tax since, under current tax law, American Franklin pays
no tax on investment income and capital gains reflected in variable life
insurance policy reserves. However, American Franklin retains the right to
charge for any federal income tax incurred which is attributable to the
Account if the law is changed. Charges for state and local taxes, if any,
attributable to the Account may also be made.
3. SALES AND ADMINISTRATIVE CHARGES
Certain jurisdictions require that deductions be made from premium payments
for taxes. The amount of such deductions varies and may be up to 5% of the
premium. With respect to the EquiBuilder III Policies, American Franklin
makes a sales expense deduction equal to 5% of each premium paid during any
policy year up to a "target" premium, which is based on the annual premium
for a fixed whole life insurance policy on the life of the insured person
(no sales expense deduction is made for premiums in excess of the target
premium paid during that policy year). The balance remaining after any such
deduction, the net premium, is placed by American Franklin in a Policy
Account established for each policyowner. Each month American Franklin makes
a charge against each Policy Account for: administrative expenses
(currently $6 per month plus an additional charge of $24 per month for each
of the first 12 months a policy is in effect); and cost of insurance, which
is based on the insured person's age, sex, risk class, amount of insurance,
and additional benefits, if any. In addition, American Franklin will make
charges for the following: a partial withdrawal of net cash surrender value
(currently $25 or 2% of the amount withdrawn, whichever is less); an
increase in the face amount of insurance (currently a $1.50 administrative
charge for each $1,000 increase up to a maximum charge of $300); and a
transfer between investment divisions in any policy year in which four
transfers have already been made (up to $25 for each additional transfer in
a given policy year). Charges may also be made for providing more than one
illustration of policy benefits to a given policyholder. American Franklin
assumes mortality and expense risks related to the operations of the Account
and deducts a charge from the assets of the Account at an effective annual
rate of .75% of the Account's net assets to cover these risks. The total
charges paid by the Account to American Franklin were $26,329,000 and
$18,890,000 in 1998 and 1997, respectively.
During the first ten years a Policy is in effect, a surrender charge may be
deducted from a Policy Account by American Franklin if the Policy is
surrendered for its net cash surrender value, the face amount of the Policy
is reduced or the Policy is permitted to lapse. The maximum total surrender
charge applicable to a particular Policy is specified in the Policy and is
equal to 50% of one "target" premium. This maximum will not vary based on
the amount of premiums paid or when they are paid. At the end of the sixth
policy year and at the end of each of the four succeeding policy years, the
maximum surrender charge is reduced by an amount equal to 20% of the initial
maximum surrender charge until, after the end of the tenth policy year,
there is no surrender charge. Subject to the maximum surrender charge, the
surrender charge with respect to the EquiBuilder II Policies will equal 30%
of actual premiums paid during the first policy year up to one "target"
premium, plus 9% of all other premiums actually paid during the first ten
policy years, and the surrender charge with respect to the EquiBuilder III
Policies will equal 25% of actual premiums paid during the first policy
year up to one "target" premium, plus 9% of all other premiums actually
paid during the first ten policy years.
11
<PAGE>
THE AMERICAN FRANKLIN LIFE INSURANCE COMPANY
SEPARATE ACCOUNT VUL-2
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
4. SUMMARY OF UNIT VALUES AND CHANGES IN OUTSTANDING UNITS
Unit value information and a summary of changes in outstanding units is
shown below:
YEAR ENDED DECEMBER 31, 1998
<TABLE>
<CAPTION>
VARIABLE INSURANCE PRODUCTS FUND
--------------------------------------------------------------------------
VIP VIP VIP
MONEY EQUITY- VIP VIP HIGH
MARKET INCOME GROWTH OVERSEAS INCOME
DIVISION DIVISION DIVISION DIVISION DIVISION
--------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Unit value, beginning of year $126.37 $ 291.45 $264.35 $170.08 $165.81
--------------------------------------------------------------------------
--------------------------------------------------------------------------
Unit value, end of year $132.28 $ 329.63 $373.90 $191.40 $156.98
--------------------------------------------------------------------------
--------------------------------------------------------------------------
Number of units outstanding,
beginning of year 24,611 136,705 195,644 54,175 14,564
Net contract purchase payments 139,608 45,371 52,816 16,324 6,720
Withdrawals (9,420) (26,883) (36,782) (10,271) (3,708)
Transfers between Separate Account
VUL-2 divisions, net (120,764) 9,131 7,256 (1,130) 775
--------------------------------------------------------------------------
Number of units outstanding,
end of year 34,035 164,324 218,934 59,098 18,351
--------------------------------------------------------------------------
--------------------------------------------------------------------------
<CAPTION>
VARIABLE INSURANCE PRODUCTS FUND II
--------------------------------------------------------------------------
VIPII VIPII
INVESTMENT VIPII VIPII ASSET VIPII
GRADE ASSET INDEX MANAGER: CONTRA-
BOND MANAGER 500 GROWTH FUND
DIVISION DIVISION DIVISION DIVISION DIVISION
--------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Unit value, beginning of year $146.29 $200.91 $226.02 $165.92 $174.12
--------------------------------------------------------------------------
--------------------------------------------------------------------------
Unit value, end of year $157.66 $232.11 $295.61 $196.85 $229.00
--------------------------------------------------------------------------
--------------------------------------------------------------------------
Number of units outstanding,
beginning of year 13,744 131,808 76,766 24,563 75,672
Net contract purchase payments 3,255 26,871 40,257 17,385 42,562
Withdrawals (2,942) (21,817) (22,184) (7,849) (19,811)
Transfers between Separate Account
VUL-2 divisions, net 633 (330) 17,575 5,676 12,388
--------------------------------------------------------------------------
Number of units outstanding,
end of year 14,690 136,532 112,414 39,775 110,811
--------------------------------------------------------------------------
--------------------------------------------------------------------------
</TABLE>
12
<PAGE>
THE AMERICAN FRANKLIN LIFE INSURANCE COMPANY
SEPARATE ACCOUNT VUL-2
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
4. SUMMARY OF UNIT VALUES AND CHANGES IN OUTSTANDING UNITS (continued)
Unit value information and a summary of changes in outstanding units is
shown below:
PERIOD FROM MAY 1, 1998 (DATE OF INCEPTION) TO DECEMBER 31, 1998
<TABLE>
<CAPTION>
MFS VARIABLE INSURANCE TRUST
---------------------------------------------------------------------------------------
MFS MFS MFS
EMERGING MFS GROWTH WITH TOTAL MFS MFS
GROWTH RESEARCH INCOME RETURN UTILITIES VALUE
DIVISION DIVISION DIVISION DIVISION DIVISION DIVISION
---------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Unit value, at May 1, 1998 (Date of
Inception) $100.00 $100.00 $100.00 $100.00 $100.00 $100.00
---------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------
Unit value, end of year $113.74 $104.90 $107.39 $103.73 $106.58 $105.18
---------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------
Number of units outstanding,
at inception - - - - - -
Net contract purchase payments 6,446 5,663 2,392 2,207 2,530 2,951
Withdrawals (1,098) (850) (121) (336) (366) (390)
Transfers between Separate
Account VUL-2 divisions, net 7,890 7,434 3,496 3,830 2,104 3,390
---------------------------------------------------------------------------------------
Number of units outstanding,
end of year 13,238 12,247 5,767 5,701 4,268 5,951
---------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------
</TABLE>
5. REMUNERATION OF MANAGEMENT
The Account incurs no liability for remuneration to directors, members of
advisory boards, officers or any other person who might provide a service
for the Account, except as described in Note 3.
6. YEAR 2000 (UNAUDITED)
INTERNAL SYSTEMS. American Franklin's ultimate parent, American General
Corporation (AGC), has numerous technology systems that are managed on a
decentralized basis. AGC's Year 2000 readiness efforts are therefore
being undertaken by its key business units with centralized oversight.
Each business unit, including American Franklin, has developed and is
implementing a plan to minimize the risk of a significant negative
impact on its operations.
While the specifics of the plans vary, the plans include the following
activities: (1) perform an inventory of the company's information
technology and non-information technology systems; (2) assess which items
in the inventory may expose the company to business interruptions due to
Year 2000 issues; (3) reprogram or replace systems that are not Year 2000
ready; (4) test systems to prove that they will function into the next
century as they do currently; and (5) return the systems to operations.
As of December 31, 1998, substantially all of American Franklin's critical
systems are Year 2000 ready and have been returned to operations. However,
activities (3) through (5) for certain systems are ongoing, with vendor
upgrades expected to be received during the first half of 1999.
13
<PAGE>
THE AMERICAN FRANKLIN LIFE INSURANCE COMPANY
SEPARATE ACCOUNT VUL-2
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
THIRD PARTY RELATIONSHIPS. American Franklin has relationships with
various third parties who must also be Year 2000 ready. These third
parties provide (or receive) resources and services to (or from)
American Franklin and include organizations with which American Franklin
exchanges information. Third parties include vendors of hardware,
software, and information services; providers of infrastructure services
such as voice and data communications and utilities for office
facilities; investors; customers; distribution channels; and joint
venture partners. Third parties differ from internal systems in that
American Franklin exercises less, or no, control over Year 2000
readiness. American Franklin has developed a plan to assess and attempt
to mitigate the risks associated with the potential failure of third
parties to achieve Year 2000 readiness. The plan includes the following
activities: (1) identify and classify third party dependencies; (2)
research, analyze, and document Year 2000 readiness for critical third
parties; and (3) test critical hardware and software products and
electronic interfaces. As of December 31, 1998, AGC has identified and
assessed approximately 700 critical third party dependencies, including
those relating to American Franklin. A more detailed evaluation will be
completed during first quarter 1999 as part of American Franklin's
contingency planning efforts. Due to the various stages of third
parties' Year 2000 readiness, American Franklin's testing activities
will extend through 1999.
CONTINGENCY PLANS. American Franklin has commenced contingency planning
to reduce the risk of Year 2000-related business failures. The
contingency plans, which address both internal systems and third party
relationships, include the following activities: (1) evaluate the
consequences of failure of business processes with significant exposure
to Year 2000 risk; (2) determine the probability of a Year 2000-related
failure for those processes that have a high consequence of failure; (3)
develop an action plan to complete contingency plans for those processes
that rank high in consequence and probability of failure; and (4)
complete the applicable action plans. American Franklin is currently
developing contingency plans and expects to substantially complete all
contingency planning activities by April 30, 1999.
RISKS AND UNCERTAINTIES. Based on its plans to make internal systems
ready for Year 2000, to deal with third party relationships, and to
develop contingency actions, American Franklin believes that it will
experience at most isolated and minor disruptions of business processes
following the turn of the century. Such disruptions are not expected to
have a material effect on American Franklin's future results of
operations, liquidity, or financial condition. However, due to the
magnitude and complexity of this project, risks and uncertainties exist
and American Franklin is not able to predict a most reasonably likely
worst case scenario. If conversion of American Franklin's internal
systems is not completed on a timely basis (due to non-performance by
significant third party-vendors, lack of qualified personnel to perform
the Year 2000 work, or other unforeseen circumstances in completing
American Franklin's plans), or if critical third parties fail to achieve
Year 2000 readiness on a timely basis, the Year 2000 issues could have a
material adverse impact on American Franklin's operations following the
turn of the century.
COSTS. Through December 31, 1998, American Franklin has incurred, and
anticipates that it will continue to incur, costs for internal staff,
third party vendors, and other expenses to achieve Year 2000 readiness.
These costs are not passed to the divisions of the Account. The cost of
activities related to Year 2000 readiness has not had a material adverse
effect on American Franklin's results of operations or financial
condition. In addition, AGC has elected to accelerate the planned
replacement of certain systems as part of the Year 2000 plans. Costs of
the replacement systems are being capitalized and amortized over their
useful lives, in accordance with AGC's normal accounting policies.
14
<PAGE>
REPORT OF INDEPENDENT AUDITORS
Board of Directors
The American Franklin Life Insurance Company
Policyowners of Separate Account VUL-2
We have audited the accompanying statement of net assets of Separate Account
VUL-2 (comprising, respectively, the VIP Money Market, VIP Equity-Income, VIP
Growth, VIP Overseas, VIP High Income, VIPII Investment Grade Bond, VIPII
Asset Manager, VIPII Index 500, VIPII Asset Manager: Growth, and VIPII
Contrafund, MFS Emerging Growth, MFS Research, MFS Growth with Income, MFS
Total Return, MFS Utilities, and MFS Value Divisions) as of December 31,
1998, and the related statement of operations for the year then ended and the
statement of changes in net assets for each of the two years then ended for
the VIP Money Market, VIP Equity-Income, VIP Growth, VIP Overseas, VIP High
Income, VIPII Investment Grade Bond, VIPII Asset Manager, VIPII Index 500,
VIPII Asset Manager: Growth and VIPII Contrafund Divisions and the related
statements of operations and changes in net assets for the MFS Emerging
Growth, MFS Research, MFS Growth with Income, MFS Total Return, MFS
Utilities, and MFS Value Divisions for the period from May 1, 1998 (date of
inception) to December 31, 1998. These financial statements are the
responsibility of Separate Account VUL-2 management. Our responsibility is to
express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements.
Our procedures included confirmation of securities owned as of December 31,
1998 by correspondence with the custodian. An audit also includes assessing
the accounting principles used and significant estimates made by management,
as well as evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of each of the respective
Divisions constituting Separate Account VUL-2 at December 31, 1998, and the
results of their operations and changes in net assets for the periods
referred to above in conformity with generally accepted accounting principles.
/s/ Ernst & Young LLP
Chicago, Illinois
February 16, 1999
15
