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 2004, the Federal Reserve Board increased the federal funds effective rate from .94% at December 31, 2003 to 1.97% at December 31, 2004. The successive increases in the short term interest rates raised the medium term interest rate yield to 3.44% at December 31, 2004 as compared to 2.60% at December 31, 2003. 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. Also, since ML of New York has certain fixed products that contain guaranteed minimum crediting rates, decreases in interest rates can decrease the amount of interest spread earned by ML of New York.
Changes in the fair value of fixed maturity securities are reported as a component of the accumulated other comprehensive income on the Balance Sheets and are not reflected in the Statements of Earnings until a sale transaction occurs or when declines in fair value are deemed other-than-temporary.
ML of New York regularly reviews each investment in its fixed maturity 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, information obtained from external sources (i.e. company announcements, ratings agency announcements, or news wire services) and ML of New York’s ability and intent to hold the investments for a period of time sufficient for a forecasted market price recovery up to or beyond the amortized cost of the investment. The factors that may give rise to a potential OTT impairment include, but are not limited to, i) certain credit-related events such as default of principal or interest payments by the issuer, ii) bankruptcy of issuer, iii) certain security restructurings, and iv) fair market value less than amortized cost for an extended period of time. In the absence of a readily ascertainable market value, the estimated fair value on these securities represents management’s best estimate and is based on comparable securities and other assumptions as appropriate. Management bases this determination on the most recent information available. OTT impairment losses result in a permanent reduction of the cost basis of the investment. There were no realized investment losses due to OTT declines in fair value for the year ended December 31, 2004. ML of New York recorded realized investment losses due to OTT declines in fair value of $0.8 million and $3.5 million for the years ended December 31, 2003 and 2002 respectively.
The most significant assumptions involved in the estimation of future gross profits are future net separate accounts performance, surrender rates, and mortality rates. For variable annuities, ML of New York generally establishes a long-term rate of net separate accounts growth. The long-term rate may be adjusted if ML of New York’s long-term expectations change. Using the mean reversion technique, ML of New York modifies the rate of net variable annuity separate accounts growth over the near term, based on recent historical returns. The result is that the long-term rate is assumed to be realized over a period of approximately ten years. For variable life, ML of New York generally assumes a level long-term rate of net variable life 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 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. ML of New York provides for federal income taxes based on amounts ML of New York believes it will ultimately owe. Inherent in the provision for federal income taxes are estimates regarding the realization of certain tax deductions and credits.
ML of New York competes for Merrill Lynch & Co.’s clients’ annuity business with unaffiliated insurers whose products are also sold through Merrill Lynch & Co.’s retail network, and with insurers who solicit this business 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.
During 2005, ML of New York plans to introduce a new variable annuity product line which will replace the existing variable annuity products (subject to state approval). The new variable annuity product line provides the ability to customize variable annuity products with specific contract features, charge structures, and investment options tailored to meet clients’ specific financial objectives.
During 2004, total direct deposits increased $15.9 million (or 26%) to $76.3 million as compared to 2003. Variable annuity deposits increased $16.2 million (or 28%) to $74.4 million during 2004 as compared to 2003. Management attributes the increase in variable annuity deposits primarily to the introduction of a new B-Share variable annuity product during the third quarter of 2003. Sales of the new B-Share variable annuity product were $41.3 million and $20.8 million during 2004 and 2003, respectively. The new B-Share variable annuity product is designed for the tax-qualified IRA market and includes a GMIB provision. Also, during the second
quarter of 2003 ML of New York added a GMIB provision to its existing B-Share variable annuity. GMIB provisions have increased in popularity due to consumers’ increasing demand for guaranteed living benefits. Management believes that the volatility in the equity markets over the past three years has been the catalyst for this demand. C-Share and L-Share variable annuity deposits decreased $5.8 million (or 56%) and $5.6 million (or 57%), respectively, during 2004. ML of New York’s C-Share and L-Share variable annuities do not contain GMIB provisions.
Modified guaranteed annuity deposits increased $1.1 million (or 550%) to $1.3 million during 2004 as compared to 2003. This increase is primarily due to a single large contract sale during the fourth quarter 2004. Excluding this contract sale, modified guaranteed annuity deposits were relatively unchanged as compared to 2003.
During 2004, other deposits decreased $1.2 million (or 92%) to $0.1 million as compared to 2003. Other deposits displayed above generally represent deposits for individual fixed annuities and single premium immediate annuities.
At December 31, 2004, ML of New York’s assets were $1,281.6 million or $29.8 million higher than the $1,251.8 million in assets at December 31, 2003. Assets excluding separate accounts assets decreased $7.3 million (or 2%) primarily due to a reduction in the number of fixed rate contracts inforce, a dividend payment to Merrill Lynch Insurance Group, Inc. (“MLIG”), and a decrease in market values on investment securities as a result of the rising interest rate environment during 2004. Separate accounts assets, which represent 76% of total assets, increased $37.2 million (or 4%) to $980.4 million. Changes in separate accounts assets during each quarter of 2004 were as follows:
During 2004, ML of New York experienced contract owner withdrawals that exceeded deposits on all products by $53.7 million. The components of contract owner transactions were as follows:
At December 31, 2004 and 2003, approximately $179.8 million (or 100%) and $180.9 million (or 99%), respectively, of ML of New York’s fixed maturity securities were considered investment grade. ML of New York defines investment grade securities as unsecured debt obligations that have a rating equivalent to Standard and Poor’s BBB- or higher (or similar rating agency). Also, at December 31, 2004, approximately $7.5 million (or 4%) of ML of New York’s fixed maturity securities were rated BBB-, which is the lowest investment grade rating given by Standard and Poor’s, compared to $3.5 million (or 2%) of ML of New York’s fixed maturity securities at December 31, 2003.
At December 31, 2004, ML of New York had no fixed maturity securities that were considered below investment grade. At December 31, 2003, approximately $1.3 million (or 1%) of ML of New York’s fixed maturity securities were considered below investment grade. Below investment grade securities are speculative and are subject to significantly greater risks related to the creditworthiness of the issuers and the liquidity of the market for such securities. ML of New York does not, currently, purchase below investment grade securities.
ML of New York’s investment in collateralized mortgage obligations (“CMO”) and mortgage backed securities (“MBS”) had a carrying value of $1.4 million at December 31, 2004 and 2003. At December 31, 2004 and 2003, approximately $1.0 million (or 71%) and $1.4 million (or 100%), respectively, 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. The decrease during 2004 is primarily due to the reinvestment of call proceeds into other MBS securities with higher yields. 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.
ML of New York’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. ML of New York 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. ML of New York 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, 2004 and 2003, ML of New York’s assets included $154.6 million and $190.4 million, respectively, of cash, short-term investments, and investment grade publicly traded available-for-sale securities that could be liquidated if funds were required.
Liabilities for future policyholder benefits of approximately $187.6 million have been excluded from this table. These amounts primarily relate to contracts where i) ML of New York is not currently making payments and will not make payments in the future until the occurrence of an insurable event or ii) the occurrence of a payment triggering event (i.e. death or withdrawal) is outside the control of ML of New York. Such amounts are not determinable.
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, 2004 and 2003, based on the RBC formula, ML of New York’s total adjusted capital level was well in excess of the minimum amount of capital required to avoid regulatory action.
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. In implementing this plan, ML of New York paid an ordinary cash dividend of $2.5 million to MLIG during 2004. No dividends were paid during 2003 or 2002.
• the net earnings from investment of fixed rate life insurance and annuity contract owner deposits less interest credited to contract owners, commonly known as interest spread
ML of New York recorded earnings before change in accounting principle of $7.9 and $4.4 million for 2004 and 2003, respectively.
Policy charge revenue increased $2.0 million (or 12%) to $18.4 million during 2004 as compared to $16.4 million in 2003. The increase in policy charge revenue is attributable to the increase in average variable account balances during 2004. Average variable account balances increased $92.5 million (or 11%) as compared to 2003. During the same comparative period, asset-based policy charge revenue increased $1.8 million (or 17%). Non-asset based policy charge revenue was relatively unchanged during the 2004 as compared to 2003.
ML of New York experienced net realized investment gains of $0.1 and $0.6 million during 2004 and 2003, respectively. The following table provides the changes in net realized investment gains (losses) by type:
(1) The decrease is due to a decrease in net amount at risk per death claim.
Insurance expenses and taxes increased $0.4 million (or 12%) to $4.0 million during 2004 as compared to $3.6 million in 2003. The increase in insurance expenses and taxes is primarily due to increased New York State franchise tax expense.
ML of New York recorded net earnings of $4.4 million and $3.1 million for 2003 and 2002, respectively.
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 the changes in net realized investment gains (losses) by type:
(1) The increase in interest related gains is primarily attributable to increases in invested asset market valuations resulting from generally lower interest rates and contracting credit spreads during 2003 as compared to 2002.
Insurance expenses and taxes increased $0.2 million (or 5%) to $3.6 million during 2003 as compared to $3.4 million in 2002. The increase in insurance expenses and taxes is primarily due to increased New York State Insurance Department assessments.
ML of New York’s effective federal income tax rate increased to 28% for 2003 from 15% for 2002 primarily due to period-to-period differences in DRD and FTC adjustments as noted in the Critical Accounting Policies section above. Also, during 2003, deferred tax components have been significantly impacted by fluctuations in