Certain statements contained in this Report may be considered forward-looking, including statements about management expectations, strategic objectives, business prospects, anticipated financial performance, and other similar matters. These forward-looking statements are not statements of historical fact and represent only management’s beliefs regarding future events, which are inherently uncertain. There are a variety of factors, many of which are beyond Merrill Lynch Life’s control, which affect its operations, performance, business strategy, and results and could cause its actual results and experience to differ materially from the expectations and objectives expressed in any forward-looking statements. These factors include, but are not limited to, the factors listed in the Business Environment and Economic Environment sections listed below, as well as actions and initiatives taken by both current and potential competitors, the effect of current, pending, and future legislation and regulation, and the other risks and uncertainties detailed in Merrill Lynch Life’s Financial Statements and Notes to Financial Statements. Accordingly, readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the dates on which they are made. Merrill Lynch Life does not undertake to update forward-looking statements to reflect the impact of circumstances or events that arise after the dates the forward-looking statements are made. The reader should, however, consult any further disclosures Merrill Lynch Life may make in its Quarterly Reports on Form 10-Q.
Merrill Lynch Life’s financial position and/or results of operations are primarily impacted by the following economic factors: equity market performance, fluctuations in medium term interest rates, and the corporate credit environment via credit quality and fluctuations in credit spreads. The following discusses the impact of each economic factor.
minimum death benefit (“GMDB”) provisions contained in the variable annuities it manufactures. Negative investment performance generally results in greater exposure to GMDB provisions, as there is an increase in the number of variable contracts (and amount per contract) in which the GMDB exceeds the variable account balance. Prolonged periods of negative investment performance may result in greater GMDB claim payments. GMDB claim payments are recorded as a component of policy benefits.
The investment performance in 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.
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 2002, medium term interest rates decreased approximately 112 basis points to yield, on average, 2.53%. During 2001, medium term interest rates decreased approximately 148 basis points to yield, on average, 3.65%.
Changes in the corporate credit environment directly impact the value of Merrill Lynch Life’s investments, primarily fixed maturity securities. Merrill Lynch Life largely invests in investment-grade corporate debt to support its fixed rate product liabilities. During 2002, corporate debt defaults on a dollar-weighted volume basis increased significantly as a result of continuing weakness in the economy, as well as several large high-profile defaults. Merrill Lynch Life holds corporate debt of certain of these companies and has adjusted its carrying value in these investments to reflect amounts anticipated to ultimately be recovered. The decrease in book value is recorded as a component of net realized investment losses.
credit spreads contracted approximately 9 basis point and ended the year at 178 basis points. Widening credit spreads have a negative impact on the value of fixed maturity securities.
Merrill Lynch Life’s financial management is based on conservative investment and liability management and regular monitoring of its risk profile. Merrill Lynch Life also seeks to provide superior customer service and financial management to promote the competitiveness of its products. Merrill Lynch Life’s customer service center has established standards of performance that are monitored on a regular basis. Managers and employees in the customer service centers are periodically evaluated based on their performance in meeting these standards.
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 were 14%, 40% and 43% for 2002, 2001 and 2000, respectively. The decrease in 2002 market share was primarily due to the absence of proprietary variable annuity products with guarantee features until late in 2002, as noted above.
During 2002 variable life insurance premiums decreased $31.5 million (or 39%) as compared to 2001. The decrease in variable life insurance premiums is primarily due to Merrill Lynch Life discontinuing the manufacturing and marketing of its estate planning life insurance products during the third quarter 2001. Merrill Lynch Life continued to issue in 2002 a single premium variable life insurance product that was introduced in 2001.
At December 31, 2002, Merrill Lynch Life’s assets were $13.1 billion, or $2.4 billion lower than the $15.5 billion in assets at December 31, 2001 primarily due to a decrease in separate accounts assets. Separate accounts assets decreased $2.2 billion (or 20%) to $9.1 billion primarily due to unfavorable investment performance and an increase in net cash outflow. Changes in separate accounts assets during 2002 by quarter were as follows:
During 2002, Merrill Lynch Life experienced contract owner withdrawals that exceeded deposits by $829.3 million. The components of contract owner transactions were as follows:
Merrill Lynch Life’s investment in collateralized mortgage obligations (“CMO”) and mortgage backed securities (“MBS”) had a carrying value of $41.3 million as of December 31, 2002. At December 31, 2002, approximately 96% 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 exposure to selected emerging markets that include securities issued by sovereigns or corporations of Asia (excluding Japan), Eastern Europe, Latin America and Mexico. At December 31, 2002,
Merrill Lynch Life held $35.6 million in emerging market securities with an approximate unrealized loss of $6.5 million.
As of December 31, 2002, Merrill Lynch Life had 31,937 life insurance and annuity contracts inforce with interest rate guarantees. The estimated average rate of interest credited on behalf of contract owners was 4.46% during 2002. Invested assets supporting liabilities with interest rate guarantees had an estimated effective yield of 6.31% during 2002. The number of life insurance and annuity contracts inforce with interest rate guarantees decreased 8% as compared to 2001.
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, 2002, Merrill Lynch Life had accrued an estimated net liability for future guaranty fund assessments of $7.2 million. Merrill Lynch Life regularly monitors public information regarding insurer insolvencies and adjusts its estimated liability as appropriate.
Merrill Lynch Life’s liquidity requirements include the payment of sales commissions and other underwriting expenses and the funding of its contractual obligations for the life insurance and annuity contracts it has inforce. Merrill Lynch Life has developed and utilizes a cash flow projection system and regularly performs asset / liability duration matching in the management of its asset and liability portfolios. Merrill Lynch Life anticipates funding all its cash requirements utilizing cash from operations, normal investment maturities and anticipated calls and repayments, consistent with prior years. As of December 31, 2002, Merrill Lynch Life’s assets included $2.1 billion of cash, short-term investments and investment grade publicly traded available-for-sale securities that could be liquidated if funds were required.
In order to continue to issue life insurance and 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.
The National Association of Insurance Commissioners utilizes the Risk Based Capital (“RBC”) adequacy monitoring system. The RBC calculates the amount of adjusted capital that a life insurance company should have based upon that company’s risk profile. As of December 31, 2002 and 2001, based on the RBC formula, Merrill Lynch Life’s total adjusted capital level was in excess of the minimum amount of capital required to avoid regulatory action.
Lynch Life’s future marketing efforts could be hampered should its parent and/or affiliates be unwilling to commit additional funding.
the charges imposed on variable life insurance and variable annuity contracts, and
The costs associated with acquiring contract owner deposits (deferred policy acquisition costs) are amortized over the period in which Merrill Lynch Life anticipates holding those funds, as noted in the Management Estimates section above. Deferred policy acquisition costs are principally commissions and a portion of certain other expenses relating to policy acquisition, underwriting and issuance that are primarily related to and vary with the production of new business. Insurance expenses and taxes reported in the statements of earnings are net of amounts deferred. In addition, Merrill Lynch Life incurs expenses associated with the maintenance of inforce contracts.
Policy charge revenue decreased $14.8 million (or 6%) during 2002 as compared to 2001. The decrease in policy charge revenue is primarily attributable to reductions in asset-based fees collected on variable account balances. Variable annuity and variable life asset-based fees 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 fees were 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.
Merrill Lynch Life experienced net realized investment losses of $9.1 million and $13.8 million during 2002 and 2001, respectively. The following table provides net realized investment gains (losses) by type:
The trading account is comprised of convertible debt and convertible preferred equity securities. The valuations of these securities will generally fluctuate in a direct relationship to changes in the valuations of the underlying common equity.
Merrill Lynch Life sold one property during 2002 that resulted in a $3.5 million gain.
Reinsurance premium ceded decreased $1.4 million (or 6%) during 2002 as compared to 2001. The decrease is attributable to the decrease in life insurance inforce.
Amortization of deferred policy acquisition costs increased $41.8 million (or 70%) during 2002 as compared to 2001 primarily due to period-to-period differences in DAC unlocking as noted in the Management Estimates 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.
Insurance expenses and taxes decreased $17.8 million (or 27%) during 2002 as compared to 2001. The decrease in insurance expenses and taxes is primarily due to i) cost savings resulting from Merrill Lynch Life’s consolidation of its life and annuity policy administration service centers, which was completed during the third quarter 2001, ii) reductions in employee compensation expense, and iii) reductions in asset-based commissions resulting from decreased average variable account balances.
Merrill Lynch Life’s effective federal income tax rate decreased to 22% for 2002 from 34% for 2001. The changes in the effective federal income tax rate during the respective periods are due to certain permanent adjustments recorded in 2002. Also during 2002, Merrill Lynch Life’s current and deferred tax components have been significantly impacted by fluctuations in tax reserves for guaranteed minimum death benefits. The reserve fluctuations have resulted in an increased current tax benefit and an increased deferred tax expense during 2002 as compared to 2001.
Policy charge revenue decreased $14.4 million (or 5%) during 2001 as compared to 2000. The decrease in policy charge revenue is primarily attributable to the decrease in average variable account balances. During 2001, average variable account balances decreased $1.4 billion (or 11%) as compared to 2000. During the same time period, asset-based policy charges decreased $15.3 million (or 9%).
Merrill Lynch Life experienced net realized investment gains (losses) of ($13.8) million and $0.1 million during 2001 and 2000, respectively. The following table provides net realized investment gains (losses) by type:
Merrill Lynch Life’s operating results are categorized into two business segments: Life Insurance and Annuities. Merrill Lynch Life’s Life Insurance segment consists of variable life insurance products and interest-sensitive life products. Merrill Lynch Life’s Annuity segment consists of variable annuities and interest-sensitive annuities. The “Other” earnings category represents earnings on assets that do not support contract owner liabilities. Net earnings by segment were as follows:
Merrill Lynch Life is not dependent upon any single customer, and no single customer accounted for more than 10% of its revenues during 2002.
Merrill Lynch Life’s operations have not been materially impacted by inflation and changing prices during the preceding three years.