During the first quarter 2003, Merrill Lynch Life discontinued manufacturing its single premium variable life insurance product. As a result, Merrill Lynch Life currently does not manufacture, market, or issue life insurance products. Merrill Lynch Life continues to service all life insurance contracts inforce.
Despite positive equity market performance during 2003, average separate accounts assets, and in turn, average variable contract owner account balances, were lower as compared to 2002. The average monthly Dow and S&P indices were slightly lower during 2003 as compared to 2002.
The investment performance of the underlying U.S. equity-based mutual funds supporting Merrill Lynch Life’s variable products do not replicate the returns on any specific U.S. equity market index. However, investment performance will generally increase or decrease with corresponding increases or decreases in the overall U.S. equity market.
Changes in interest rates affect the value of investments, primarily fixed maturity securities and preferred equity securities, as well as interest sensitive liabilities. Changes in interest rates have an inverse relationship to the value of investments and interest sensitive liabilities. See Note 3 to the Financial Statements for the impact of changes in medium term interest rates on the value of investments and liabilities. Also, since Merrill Lynch Life has certain fixed products that contain guaranteed minimum crediting rates, decreases in interest rates can decrease the amount of interest spread earned by Merrill Lynch Life.
Merrill Lynch Life defines medium term interest rates as the average interest rate on U.S. Treasury securities with terms of 1 to 10 years. During 2003, average medium term interest rates decreased approximately 77 basis points to yield, on average, 2.42%. During 2002, average medium term interest rates decreased approximately 68 basis points to yield, on average, 3.19%.
Merrill Lynch Life defines credit spreads according to the Merrill Lynch U.S. Corporate Bond Index for BBB-A Rated bonds with three to five year maturities. During 2003, credit spreads contracted approximately 113 basis points and ended the year at 85 basis points. During 2002, credit spreads widened approximately 20 basis point and ended the year at 198 basis points.
The most significant assumptions involved in the estimation of future gross profits are future net separate accounts performance, surrender rates, and mortality rates. Merrill Lynch Life generally assumes a level long-term rate of net separate accounts growth for all future years. The long-term rate may be adjusted if Merrill Lynch Life’s long-term expectations change. Additionally, Merrill Lynch Life may modify the rate of net separate accounts growth over the short term to reflect Merrill Lynch Life’s near-term expectations of the economy and financial market performance in which separate accounts assets are invested.
Merrill Lynch Life uses the asset and liability method in providing income taxes on all transactions that have been recognized in the financial statements. The asset and liability method requires that deferred taxes be
adjusted to reflect the tax rates at which future taxable amounts will be settled or realized. Merrill Lynch Life provides for federal income taxes based on amounts Merrill Lynch Life believes it will ultimately owe. Inherent in the provision for federal income taxes are estimates regarding the realization of certain tax deductions and credits.
Merrill Lynch & Co. offers for sale numerous non-proprietary variable annuity products issued by unaffiliated insurers. Merrill Lynch Life’s market share of variable annuity sales within the Merrill Lynch & Co. distribution system was 18%, 13% and 40% for 2003, 2002 and 2001, respectively.
the opportunity for diversified investing in a wide selection of underlying mutual fund portfolios. In addition, Merrill Lynch Life also issues modified guaranteed annuity products. The modified guaranteed annuity products also provide tax-deferred retirement savings through guaranteed fixed interest rates for a period selected by the contract owner, but impose a market value adjustment for withdrawals prior to the expiration of the guarantee period. Total direct premiums by product type for the three years ended December 31 were as follows:
Merrill Lynch Life’s L-Share variable annuity product was introduced in the fourth quarter 2001.
During 2003, Merrill Lynch Life’s total direct premiums increased $306.3 million (or 45%) to $985.3 million as compared to 2002. Variable annuity premiums increased $345.9 million (or 60%) to $921.5 million during 2003 as compared to 2002. Management attributes the increase in variable annuity premiums to i) the introduction of a new B-Share variable annuity product and ii) the inclusion of guaranteed living benefit provisions within certain products. The new B-Share variable annuity product is designed for the tax-qualified IRA market and includes a guaranteed living benefit provision. Sales of the new B-Share variable annuity product, which was introduced in the fourth quarter 2002, were $535.8 million and $53.9 million during 2003 and 2002, respectively. Also, during the fourth quarter 2002, Merrill Lynch Life added a guaranteed living benefit provision to its existing B-Share variable annuity. Sales of this product were $278.6 million and $246.5 million, during 2003 and 2002, respectively. Prior to the fourth quarter of 2002 Merrill Lynch Life did not offer guaranteed living benefit provisions on its variable annuity products. Living benefit provisions have increased in popularity due to consumers’ increasing demand for guaranteed benefits. Management believes that the generally decreasing equity markets over the past three years has been the catalyst for this demand. C-Share and L-Share variable annuity premiums, which during 2003 decreased $121.0 million (or 58%) and $47.1 million (or 72%), respectively, do not contain guaranteed living benefit provisions.
Policy and contract surrenders decreased $88.5 million (or 8%) to $1,079.0 million during 2003 as compared to 2002. During 2003, variable annuity surrenders decreased $77.8 million (or 10%) as compared to 2002 to
Merrill Lynch Life maintains a conservative general account investment portfolio. Merrill Lynch Life has no mortgage or real estate holdings and its investment in non-investment grade fixed maturity securities are below the industry average. The following schedule identifies Merrill Lynch Life’s general account invested assets by type:
Merrill Lynch Life’s investment in collateralized mortgage obligations (“CMO”) and mortgage backed securities (“MBS”) had a carrying value of $20.3 million and $41.3 million at December 31, 2003 and 2002, respectively. At December 31, 2003, approximately 94% of Merrill Lynch Life’s CMO and MBS holdings were fully collateralized by the Government National Mortgage Association, the Federal National Mortgage Association or the Federal Home Loan Mortgage Corporation. CMO and MBS securities are structured to allow the investor to determine, within certain limits, the amount of interest rate risk, prepayment risk and default risk that the investor is willing to accept. It is this level of risk that determines the degree to which the yields on CMO and MBS securities will exceed the yields that can be obtained from corporate securities with similar credit ratings.
Merrill Lynch Life has utilized public information to estimate the future assessments it will incur as a result of life insurance company insolvencies. At December 31, 2003, Merrill Lynch Life’s estimated net liability for future guaranty fund assessments was $7.1 million. Merrill Lynch Life regularly monitors public information regarding insurer insolvencies and adjusts its estimated liability as appropriate.
In order to continue to issue annuity products, Merrill Lynch Life must meet or exceed the statutory capital and surplus requirements of the insurance departments of the states in which it conducts business. Statutory accounting practices differ from generally accepted accounting principles (“GAAP”) in two major respects. First, under statutory accounting practices, the acquisition costs of new business are charged to expense, while under GAAP they are amortized over a period of time. Second, under statutory accounting practices, the
required additions to statutory reserves for new business in some cases may initially exceed the statutory revenues attributable to such business. These practices result in a reduction of statutory income and surplus at the time of recording new business.
Merrill Lynch Life receives claims paying ability ratings from Standard and Poors and A.M. Best. At December 31, 2003, Merrill Lynch Life received ratings from Standard and Poors and A.M. Best of “A+” and “A”, respectively.
During 2000, Merrill Lynch Life committed to participate in a limited partnership. As of December 31, 2003, $4.3 million had been advanced towards the Merrill Lynch Life’s $10.0 million commitment to the limited partnership.
Reflective of the generally stronger corporate credit environment during 2003 as compared to 2002.
Merrill Lynch Life sold its remaining real estate holding during 2002.
Policy benefits increased $6.6 million (or 11%) to $64.6 million during 2003 as compared to $58.0 million in 2002 primarily due to increased variable annuity death benefit payments incurred under GMDB provisions.
Amortization of deferred policy acquisition costs decreased $24.7 million (or 24%) to $76.4 million during 2003 as compared to $101.1 million in 2002. Excluding the impact of period-to-period differences in DAC unlocking as noted in the Critical Accounting Policies section above, amortization of deferred policy
acquisition costs decreased $19.6 million as compared to 2002. This decrease is primarily due to the decreases in interest-related realized gains and policy charge revenue.
Insurance expenses and taxes increased $4.1 million (or 8%) to $52.0 million during 2003 as compared to $47.9 million in 2002. The following table provides the changes in insurance expenses and taxes by type for each respective period:
Policy charge revenue decreased $14.8 million (or 6%) to $239.0 million during 2002 as compared to $253.8 million in 2001. The decrease in policy charge revenue is primarily attributable to reductions in asset-based policy charge revenue collected on variable account balances. Variable annuity and variable life asset-based policy charge revenue decreased $14.6 million (or 11%) and $3.8 million (or 14%), respectively, generally consistent with decreases in average variable account balances for those products. Asset-based policy charge revenue was favorably impacted by increases in rates charged to unaffiliated fund investment managers for administrative services. Non-asset based policy charge revenue increased $3.6 million (or 4%) during 2002 as compared to 2001.
The market value adjustment expense is attributable to a contract provision in Merrill Lynch Life’s modified guaranteed annuity products. This contract provision results in a market value adjustment to the cash surrender value of those contracts that are surrendered before the expiration of their interest rate guarantee period. During 2002, the market value adjustment expense increased $1.4 million (or 60%) to $3.7 million as compared to $2.3 million in 2001. The increase is primarily due to the lower interest rate environment during 2002 as compared to 2001. The market value adjustment expense has an inverse relationship to changes in interest rates.
Amortization of deferred policy acquisition costs increased $41.8 million (or 70%) to $101.1 million during 2002 as compared to $59.3 million in 2001 primarily due to period-to-period differences in DAC unlocking as noted in the Critical Accounting Policies section above. Excluding DAC unlocking, amortization of deferred policy acquisition costs increased $12.1 million as compared to 2001 primarily due to the increase in interest related realized gains.
The products that comprise the Life Insurance and Annuity segments generally possess similar economic characteristics. As such, the financial condition and results of operations of each business segment are generally consistent with Merrill Lynch Life’s consolidated financial condition and results of operations presented herein.
Merrill Lynch Life is not dependent upon any single customer, and no single customer accounted for more than 10% of its revenues during 2003.