The Registrant’s home office is located in Little Rock, Arkansas. In addition, personnel performing services for the Registrant pursuant to its Management Services Agreement operate in MLIG office space. MLIG occupies certain office space in Pennington, New Jersey through Merrill Lynch & Co. An allocable share of the cost of each of these premises is paid by the Registrant through the service agreement with MLIG. Merrill Lynch Insurance Group Services, Inc. (“MLIGS”), an affiliate of MLIG, owns office space in Jacksonville, Florida.
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, actions and initiatives taken by 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 this report. See Risk Factors that Could Affect Merrill Lynch Life. 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 future filings of its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K.
During 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 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 Merrill Lynch Life’s portfolio managers and credit analysts, information obtained from external sources (i.e. company announcements, ratings agency announcements, or news wire services) and Merrill Lynch Life’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. Merrill Lynch Life did not experience any realized investment losses due to OTT declines in fair value for the year ended December 31, 2006. For the years ended December 31, 2005 and 2004, Merrill Lynch Life realized investment losses due to OTT declines in fair value of $1.9 million and $2.1 million, respectively.
Deferred Policy Acquisition Costs for Variable Annuities and Variable Life Insurance
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 SFAS 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”) are subject to recoverability testing at the time of policy issuance and loss recognition testing at the end of each reporting period. At December 31, 2006, variable annuities and variable life insurance accounted for $191.9 million (or 67%) and $83.2 million (or 29%), respectively, of Merrill Lynch Life’s DAC asset. At December 31, 2005, variable annuities and variable life insurance accounted for $181.9 million (or 61%) and $103.2 million (or 35%), respectively, of Merrill Lynch Life’s DAC asset.
DAC for variable life insurance is amortized with interest over the anticipated lives of the insurance contacts in relation to the present values of estimated future gross profits from fees related to contract loans, asset-based fees, and cost of insurance charges, less claims (net of reinsurance), cost of mortality reinsurance, policy maintenance expenses, and non-capitalized commissions.
Future gross profit estimates are subject to periodic evaluation with necessary revisions applied against amortization to date. The impact of revisions and assumptions to estimates on cumulative amortization is recorded as a charge or benefit to current operations, commonly referred to as “unlocking”. Changes in assumptions can have a significant impact on the amount of DAC reported and their related amortization patterns. In general, increases in the estimated separate accounts return and decreases in surrender or mortality assumptions increase the expected future profitability of the underlying business and may lower the rate of DAC amortization. Conversely, decreases in the estimated separate accounts returns and increases in surrender or mortality assumptions reduce the expected future profitability of the underlying business and may increase the rate of DAC amortization. For the years ended December 31, 2006, 2005 and 2004 the favorable (unfavorable) impact on pre-tax earnings related to DAC unlocking was $16.7 million, ($81.9) million, and $41.3 million, respectively. See Note 4 to the Financial Statements for a further discussion of period-to-period differences in DAC unlocking.
Merrill Lynch Life’s liability for policyholder account balances represents the contract value that has accrued to the benefit of the policyholder as of the balance sheet date. The liability is generally equal to the accumulated account deposits plus interest credited less policyholders’ withdrawals and other charges assessed against the account balance. Policyholder account balances at December 31, 2006 and 2005 were $2.0 billion and $2.2 billion, respectively.
Merrill Lynch Life’s variable universal life insurance product includes a premium load that is higher in early policy years than in later years. The excess of the initial load over the ultimate load is accreted into revenue over time in the same manner that DAC is amortized. In addition, the unearned policy charge revenue liability is subject to the same periodic reassessment as DAC. For the years ended December 31, 2006 and 2005 the favorable impact on pre-tax earnings related to UPCR unlocking was $1.5 million and $67.9 million, respectively. There was no UPCR unlocking during 2004. At December 31, 2006 and December 31, 2005, Merrill Lynch Life’s UPCR liability was $35.5 million and $45.6 million, respectively.
In February 2007, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS No. 159 provides a fair value option election that allows companies to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and liabilities, with changes in fair value recognized in earnings as they occur. SFAS No. 159 permits the fair value option election on an instrument by instrument basis at initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument. SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. Early adoption is permitted as of the beginning of a fiscal year that begins on or before November 15, 2007 provided that the entity makes that choice in the first 120 days of that fiscal year, has not yet issued financial statements for any interim period of the fiscal year of adoption, and also elects to apply the provisions of Statement No. 157, Fair Value Measurements (“SFAS No. 157”). Merrill Lynch Life intends to early adopt SFAS No. 159 as of the first quarter of fiscal 2007. The adoption is not expected to have a material impact on Merrill Lynch Life’s Financial Statements.
On January 1, 2007, Merrill Lynch Life adopted Statement of Position (“SOP”) 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts. SOP 05-1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97. SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights, or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. Since Merrill Lynch Life’s practice of accounting for deferred acquisition costs, in connection with modifications or exchanges, substantially meets the provisions prescribed within SOP 05-1, the adoption of SOP 05-1 did not have a material impact on Merrill Lynch Life’s Financial Statements.
As of December 31, 2006, Merrill Lynch Life adopted Staff Accounting Bulletin (“SAB”) No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. The interpretations in the SAB provide the Staff’s views regarding the process of quantifying financial statement misstatements. Specifically, the SEC staff believes that registrants must quantify the impact on current period financial statements of correcting all misstatements, including both those occurring in the current period and the effect of reversing those that have accumulated from prior periods. Since Merrill Lynch Life’s method for quantifying financial statement misstatements already considers those occurring in the current period and the effect of reversing those that have accumulated from prior periods, the adoption of the SAB did not have an impact on Merrill Lynch Life’s Financial Statements.
Merrill Lynch Life 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 center are periodically evaluated based on their performance in meeting these standards.
Merrill Lynch Life has strategically placed its marketing emphasis on the sale of variable annuity products. These products are designed to address the retirement planning needs of Merrill Lynch & Co.’s clients. Each variable annuity product is designed to provide tax-deferred retirement savings with the opportunity for diversified investing in a wide selection of underlying mutual fund portfolios. During March 2005, Merrill Lynch Life introduced a new variable annuity product line called Merrill Lynch Investor Choice Annuity (“ICA”), which replaced all new sales of existing variable annuity products. ICA provides the ability to customize variable annuity products with specific contract features including guaranteed minimum death, income and withdrawal benefits, charge structures, and investment options. ICA is offered in B-Share, C-Share and L-Share classes similar to previous variable annuity products. These classes are differentiated by the surrender charge period and the types of contract fees charged to the contract owner. Additionally, ICA offers a bonus class in which a specified amount is added to the contract value with each deposit.
Merrill Lynch Life maintains a conservative general account investment portfolio comprised primarily of investment grade fixed maturity securities, policy loans, and cash and cash
The following schedule identifies Merrill Lynch Life’s general account invested assets by type for the years ended December 31:
At December 31, 2006 and 2005, approximately $17.5 million (or 1%) and $26.8 million (or 1%), respectively, of 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. These investment grade holdings were the result of ratings downgrades on existing securities as Merrill Lynch Life does not purchase below investment grade securities. Merrill Lynch Life closely monitors such investments.
Merrill Lynch Life’s investment in collateralized mortgage obligations (“CMO”) and mortgage backed securities (“MBS”) had a carrying value of $91.8 million and $22.7 million at December 31, 2006 and 2005, respectively. At December 31, 2006 and 2005, approximately $68.4 million (or 74%) and $7.6 million (or 34%), respectively, of 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.
At December 31, 2006, Merrill Lynch Life had 21,550 life insurance and annuity contracts inforce with interest rate guarantees. The estimated average rate of interest credited on behalf of contract owners was 4.26% and 4.20% during 2006 and 2005, respectively. Total invested assets supporting these liabilities with interest rate guarantees had an estimated average effective yield of 4.88% and 4.73% during 2006 and 2005, respectively. The number of life insurance and annuity contracts inforce with interest rate guarantees decreased 1,993 (or 8%) as compared to 2005.
Fluctuations in the U.S. equity market also directly impact Merrill Lynch Life’s exposure to guaranteed benefit provisions contained in the variable contracts it manufactures. Minimal or negative investment performance generally results in greater exposure to guaranteed provisions, to the extent there is an increase in the number of variable contracts (and amount per contract) in
During 2006 average variable account balances increased $229.2 million (or 2%) to $11.0 billion as compared to 2005. The increase in average variable account balances contributed to a $6.4 million (or 4%) increase in asset-based policy charge revenue during the period ended December 31, 2006 as compared to the same period in 2005.
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 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.
Merrill Lynch Life defines medium term interest rates as the average interest rate on U.S. Treasury securities with terms of 1 to 5 years.
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 its cash requirements utilizing cash from operations, normal investment maturities and anticipated calls and repayments, consistent with prior years. As of December 31, 2006 and 2005, Merrill Lynch Life’s assets included $1.8 billion and $2.0 billion, respectively, of cash, cash equivalents, and investment grade publicly traded available-for-sale securities that could be liquidated if funds were required.
Merrill Lynch Life receives claims paying ability ratings from Standard and Poor’s and A.M. Best. During 2006, Standard and Poor’s upgraded Merrill Lynch Life’s rating to “AA-” from “A+” while Merrill Lynch Life’s A.M. Best rating of “A” was affirmed during 2006.
Merrill Lynch Life has developed a comprehensive capital management plan that will continue to provide appropriate levels of capital for the risks assumed, but will allow Merrill Lynch Life to reduce its absolute level of statutory surplus. In implementing this plan, Merrill Lynch Life paid a cash dividend during 2006 of $180.0 million to MLIG, of which $39.8 million was considered an ordinary dividend and $140.2 million was extraordinary. Merrill Lynch Life did not pay a dividend during 2005. In 2004, Merrill Lynch Life paid a cash dividend of $97.5 million to MLIG, of which $29.3 million was considered an ordinary dividend. Pending regulatory approval, Merrill Lynch Life intends to pay a cash dividend to MLIG during 2007.
The National Association of Insurance Commissioners utilizes the 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, 2006 and 2005, based on the RBC formula, Merrill Lynch Life’s total adjusted capital level was well in excess of the minimum amount of capital required to avoid regulatory action.
The following table summarizes Merrill Lynch Life’s contractual obligations as of December 31, 2006:
During 2000, Merrill Lynch Life committed to participate in a limited partnership. During the first quarter 2006, Merrill Lynch Life committed the remaining $0.3 million of a $10.0 million obligation and has no further commitment.
Merrill Lynch Life recorded net earnings of $94.7 million and $67.4 million for 2006 and 2005, respectively.
See the Critical Accounting Policies section above for further discussion of UPCR unlocking.
The increase in guaranteed benefit based policy charge revenue is due to the increase in inforce variable annuity contracts containing guaranteed benefit riders resulting from increased demand for these provisions.
The increase in non-asset based policy charge revenue is primarily due an increase in UPCR accretion.
See the Critical Accounting Policies section above for further discussion of variable annuity benefit reserve unlocking.
The decrease in life insurance benefit expense is primarily due to period-to-period differences in reinsurance activity.
Merrill Lynch Life recorded earnings before change in accounting principle of $67.4 million and $92.7 million for 2005 and 2004, respectively.
The decrease in interest credited is primarily due to the reduction in fixed rate contracts inforce. In addition, interest credited was favorably impacted during 2005 by mortality gains on annuitized contracts.
The decrease in interest related gains is primarily due decreases to asset market valuations resulting from the increasing interest rate environment during 2005 as compared to 2004.
The trading account is comprised of convertible debt and convertible preferred equity securities. The valuations of these securities generally fluctuate in a direct relationship to changes in the valuations of the underlying common equity.
During 2005 life insurance benefit expense was favorably impacted by a decrease in net amount at risk per death claim as compared to 2004. Additionally, Merrill Lynch Life performed an analysis on its incurred but not reported (“IBNR”) claim liability during 2004. Based on mortality experience, Merrill Lynch Life increased its IBNR liability by $2.1 million during 2004.
The decrease in variable annuity guaranteed benefit expense is primarily due to favorable GMDB liability unlocking during 2005 as noted in the Critical Accounting Policies section above.
Amortization of DAC increased $121.4 million to $126.3 million during 2005 as compared to $4.9 million in 2004 primarily as a result of period-to-period differences in DAC unlocking of $123.2 million as noted in the Critical Accounting Policies section above.
Insurance expenses and taxes increased $1.8 million (or 3%) to $59.4 million during 2005 as compared to $57.6 million in 2004. The following table provides the changes in insurance expenses and taxes by type:
The increase in commissions is primarily due to an increase in variable annuity asset-based commissions.
Merrill Lynch Life’s operating results are categorized into two business segments: Annuities and Life Insurance. Merrill Lynch Life’s Annuity segment consists of variable annuities and interest-sensitive annuities. Merrill Lynch Life’s Life Insurance segment consists of variable life insurance products and interest-sensitive life products. The “Other” earnings category represents earnings on invested assets that do not support contract owner liabilities. Select financial information by segment for the years ended December 31 is as follows: