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 ML of New York’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, general economic conditions, the effects of current, pending, and future legislation, regulation and regulatory actions, and the other risks and uncertainties detailed in ML of New York’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. ML of New York 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 ML of New York may make in its Quarterly Reports on Form 10-Q.
The financial services industry is also impacted by the regulatory and legislative environment. In 2003, additional aspects of the Sarbanes-Oxley Act of 2002 were implemented as rules relating to corporate governance, auditor independence and disclosure became effective and/or was adopted in their final form. Various federal and state securities regulators and self-regulatory organizations (including the Securities and Exchange Commission, New York Stock Exchange, and the National Association of Securities Dealers), as well as industry participants, continued to review and, in many cases, adopt changes to their established rules and policies in areas such as corporate governance, mutual fund trading, disclosure practices and auditor independence.
Changes in the U.S. equity market directly affect the values of the underlying U.S. equity-based mutual funds supporting separate accounts assets and, accordingly, the values of variable contract owner account balances. Since asset-based fees collected on inforce variable contracts represent a significant source of revenue, ML of New York’s financial condition will be impacted by fluctuations in investment performance of separate accounts assets. Fluctuations in the U.S. equity market also directly impact ML of New York’s exposure to guaranteed minimum death benefit (“GMDB”) provisions contained in the variable annuities it manufactures. Negative investment performance generally results in greater exposure to GMDB provisions, to the extent 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 of the underlying U.S. equity-based mutual funds supporting ML of New York’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 ML of New York has certain fixed products that contain guaranteed minimum crediting rates, decreases in interest rate can decrease the amount of interest spread earned by ML of New York.
ML of New York 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%.
The costs of acquiring business, principally commissions, certain expenses related to policy issuance, and certain variable sales expenses that relate to and vary with the production of new and renewal business, are deferred and amortized in accordance with Statement of Financial Accounting Standards No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments. Deferred policy acquisition costs (“DAC”) is subject to recoverability testing at the time of policy issuance and loss recognition testing at the end of each reporting period. At December 31, 2003, variable annuities and variable life insurance account for $14.8 million (or 59%) and $10.2 million (or 41%), respectively, of ML of New York’s DAC asset.
The most significant assumptions involved in the estimation of future gross profits are future net separate accounts performance, surrender rates, and mortality rates. ML of New York generally assumes a level long-term rate of net separate accounts growth for all future years. The long-term rate may be adjusted if ML of New York’s long-term expectations change. Additionally, ML of New York may modify the rate of net separate accounts growth over the short term to reflect ML of New York’s near-term expectations of the economy and financial market performance in which separate accounts assets are invested.
ML of New York regularly reviews each investment in its fixed maturity and equity securities portfolio to evaluate the necessity of recording impairment losses for other-than-temporary (“OTT”) declines in the fair value of investments. Management makes this determination through a series of discussions with ML of New York’s portfolio managers and credit analysts, as well as information obtained from external sources (i.e. company announcements, ratings agency announcements, or news wire services). The factors that give rise to potential impairments include, but are not limited to, i) certain credit-related events such as default of principal or interest payments, ii) bankruptcy of issuer, and iii) certain security restructurings. In absence of a readily ascertainable market value, the estimated fair value on these securities represents management’s estimate of the security’s ultimate recovery value. OTT impairment losses result in a permanent reduction of the cost basis of the underlying investment. OTT impairments on investments in fixed maturity securities were $0.8 million and $3.5 million during 2003 and 2002, respectively.
On July 7, 2003, the American Institute of Certified Public Accountants issued Statement of Position (“SOP”) 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts. The SOP provides guidance on accounting and reporting by insurance companies for certain nontraditional long-duration contracts and for separate accounts. The SOP is effective for financial statements for ML of New York beginning in 2004. The SOP requires the establishment of a liability for contracts that contain death or other insurance benefits using a specified reserve methodology that is different from the methodology that ML of New York currently employs. The adoption of SOP 03-1 will approximately result in a $3.0 million increase in policyholder liabilities and a corresponding pre-tax charge to earnings. The adoption of SOP 03-1 is considered a change in accounting principle.
directly. The product lines that ML of New York offers are focused in the highly competitive market segment of retirement planning. ML of New York competes in this market segment by integrating its products into Merrill Lynch & Co.’s planning-based financial management program.
years has been the catalyst for this demand. C-Share and L-Share variable annuity premiums decreased $10.4 million (or 50%) and $0.6 million (or 6%), respectively, during 2003. C-Share and L-Share variable annuities do not contain guaranteed living benefit provisions.
ML of New York maintains a conservative general account investment portfolio. ML of New York has no mortgage or real estate investments and its investment in non-investment grade fixed maturity securities are below the industry average. The following schedule identifies ML of New York’s general account invested assets by type:
At December 31, 2003 and 2002, approximately $1.3 million (or 1%) and $4.1 million (or 3%), respectively, of ML of New York’s fixed maturity securities were considered non-investment grade. ML of New York defines non-investment grade as unsecured debt obligations that have a rating equivalent to Standard and Poor’s BB+ or lower (or similar rating agency). Non-investment grade securities are speculative and are subject to
ML of New York’s investment in collateralized mortgage obligations (“CMO”) and mortgage backed securities (“MBS”) had a carrying value of $1.4 million and $2.1 million at December 31, 2003 and 2002, respectively. At December 31, 2003, all of ML of New York’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 similarly rated corporate securities.
At December 31, 2003, ML of New York had 2,005 life insurance and annuity contracts inforce with interest rate guarantees. The estimated average rate of interest credited on behalf of contract owners was 4.34% during 2003. Invested assets supporting liabilities with interest rate guarantees had an estimated average effective yield of 4.91% during 2003. The number of life insurance and annuity contracts inforce with interest rate guarantees decreased 149 (or 7%) as compared to 2002.
ML of New York has developed a comprehensive capital management plan that will continue to provide appropriate levels of capital for the risks that ML of New York assumes, but will allow ML of New York to reduce its absolute level of surplus. No dividends were paid during 2003, 2002 or 2001.
The costs associated with acquiring contract owner deposits (deferred policy acquisition costs) are amortized over the period in which ML of New York anticipates holding those funds, as noted in the Critical Accounting Policies section above. Insurance expenses and taxes reported in the statements of earnings are net of amounts deferred. In addition, ML of New York incurs expenses associated with the maintenance of inforce contracts.
Net earnings derived from interest spread decreased $1.0 million (or 24%) to $3.0 million during 2003 as compared to $4.0 million in 2002. The decrease in interest spread is primarily a result of the reduction in yields on invested assets resulting from (i) the lower interest rate environment during 2003 as compared to 2002 and (ii) the increase in credit quality of the portfolio.
ML of New York experienced net realized investment gains (losses) of $0.6 million and ($3.2) million during 2003 and 2002, respectively. The following table provides net realized investment gains (losses) by type:
Amortization of deferred policy acquisition costs decreased $0.7 million (or 12%) to $4.8 million during 2003 as compared to $5.5 million in 2002 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 remained relatively unchanged during 2003 as compared to 2002.
ML of New York’s effective federal income tax rate increased to 28% for 2003 from 16% for 2002 primarily due to a reduction of certain permanent adjustments recorded during 2003 as compared to 2002. Also, during 2003, deferred tax components have been significantly impacted by fluctuations in GMDB tax reserves. The reserve fluctuations have resulted in a decreased deferred tax expense during 2003 as compared to 2002.
Policy benefits increased $1.4 million (or 47%) to $4.5 million during 2002 as compared to $3.1 million in 2001. During 2002, life insurance mortality expense increased $0.8 million as compared to 2001 primarily due to an increase in the number of death claims. In addition, variable annuity mortality expense increased $0.5 million as compared to 2001 primarily due to increased death benefit payments incurred under GMDB provisions.
Reinsurance premium ceded decreased $0.2 million (or 10%) to $1.7 million during 2002 as compared to $1.9 million in 2001. The decrease is attributable to the decrease in life insurance inforce.
ML of New York’s operating results are categorized into two business segments: Life Insurance and Annuities. ML of New York’s Life Insurance segment consists of variable life insurance products and interest-sensitive life products. ML of New York’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:
ML of New York is not dependent upon any single customer, and no single customer accounted for more than 10% of its revenues during 2003.