Information called for by this item is omitted pursuant to General Instruction I. of Form 10-K.
This Management’s Narrative Analysis of Results of Operations should be read in conjunction with the Financial Statements and Notes to Financial Statements included herein for the Registrant (referred to as “Merrill Lynch Life” for purposes of Items 7 and 7A).
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, Industry Environment, Regulatory Environment, Tax Legislation, 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 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 future filings of its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K.
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.
During the first quarter 2005, Merrill Lynch Life will transition the policy administration of its inforce life insurance contracts to an unaffiliated third party service provider, which is considered a leading provider of insurance products administration services. Merrill Lynch Life remains committed to the delivery of high quality services for all life insurance contracts inforce.
During May 2003, Congress passed the Jobs and Growth Tax Relief Reconciliation Act of 2003 (the “Act”). A key provision in the Act is reduced federal income tax rates on dividends and capital gains paid to investors on stocks and mutual funds held individually. These reduced rates would not apply to distributions from variable annuity contracts. Pending future Congressional action, these federal income tax rate reductions are set to expire after 2008. These enacted tax rate reductions may impact the relative attractiveness of annuities as compared to stocks and mutual funds.
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, Merrill Lynch Life’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 Merrill Lynch Life’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 expense because it may change Merrill Lynch Life’s assumptions regarding the long term cost of GMDBs. If Merrill Lynch Life increases its estimated long term GMDB cost, it will result in establishing greater GMDB reserves as compared to current practice. GMDB expense is recorded as a component of policy benefits.
Additionally, Merrill Lynch Life is impacted by the U.S. equity markets through its trading account investments. Merrill Lynch Life’s trading account is invested in convertible debt and convertible preferred stocks. The valuations of these types of securities are impacted by changes in value of the underlying equity security. The trading account is carried at market value with changes in market value included in earnings as a component of net realized investment gains (losses).
Merrill Lynch Life’s critical accounting policies and estimates are discussed below. See Note 1 to the Financial Statements for additional information regarding accounting policies.
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 recorded realized investment losses due to OTT declines in fair value of $2.1 million, $9.1 million and $24.0 million for the years ended December 31, 2004, 2003 and 2002, respectively.
Future gross profit estimates are subject to periodic evaluation by Merrill Lynch Life, with necessary revisions applied against amortization to date. The impact of revisions to estimates on cumulative amortization is recorded as a charge or benefit to current operations, commonly referred to as “DAC unlocking”. See Note 4 to the Financial Statements for period-to-period differences in DAC unlocking. During 2004, Merrill Lynch Life elected to adopt new assumptions for market returns associated with assets held in Merrill Lynch Life’s variable annuity separate accounts. If returns over a determined historical period differ from Merrill Lynch Life’s long-term assumption, returns for future determined periods are calculated so that the long-term assumption is achieved. This method for projecting market returns is known as reversion to the mean, a standard industry practice. Merrill Lynch Life previously established estimates for market returns based on actual historical results and on future anticipated market returns without the use of a mean reversion technique. Changes in assumptions can have a significant impact on the amount of DAC reported for variable annuities and variable life insurance products 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.
term to reflect Merrill Lynch Life’s near-term expectations of the economy and financial market performance in which separate accounts assets are invested.
million, which was reported as a cumulative effect of a change in accounting principle. For the year ended December 31, 2004, changes in policyholder liabilities, excluding the change in accounting principle, did not have a material impact on Merrill Lynch Life’s Statements of Earnings.
Merrill Lynch & Co. offers for sale numerous 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 15%, 18% and 13% for 2004, 2003 and 2002, respectively.
During 2005, Merrill Lynch Life 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
During 2004, other deposits decreased $13.7 million (or 96%) to $0.6 million as compared to 2003. Other deposits displayed above generally represent deposits for single premium immediate annuities and renewal deposits for single premium whole life. Merrill Lynch Life currently does not manufacture single premium whole life contracts.
Policy and contract surrenders increased $200.2 million (or 19%) to $1,279.2 million during 2004 as compared to 2003. During 2004, variable annuity surrenders increased $177.8 million (or 26%) to 853.1 million as compared to 2003. Management attributes the increases in variable annuity surrenders to the increasing consumer demand for variable annuity products containing guaranteed living benefit provisions. As contracts reach the end of their surrender charge period, contract owners are more willing to surrender variable annuities without guaranteed living benefit provisions in favor of variable annuities with guaranteed living benefit provisions. In addition, variable life surrenders increased $23.9 million (or 9%) to $278.2 million as compared to 2003. The increase in variable life surrenders primarily represents movement by contract owners to other insurance products issued by insurance companies unaffiliated with Merrill Lynch Life. As previously noted, Merrill Lynch Life no longer manufactures life insurance products.
During 2004, Merrill Lynch Life experienced contract owner withdrawals that exceeded deposits on all products by $850.7 million. The components of contract owner transactions were as follows:
At December 31, 2004 and 2003, approximately $21.1 million (or 1%) and $97.9 million (or 5%), respectively, of Merrill Lynch Life’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. Current below investment grade holdings are the result of ratings downgrades on Merrill Lynch Life’s portfolio as Merrill Lynch Life does not purchase below investment grade securities. Merrill Lynch Life closely monitors such investments. The reductions in below investment grade holdings are attributable to management actions taken during 2004 to improve the overall credit quality of the fixed maturity security portfolio.
Merrill Lynch Life’s investment in collateralized mortgage obligations (“CMO”) and mortgage backed securities (“MBS”) had a carrying value of $22.0 million and $20.3 million at December 31, 2004 and 2003, respectively. At December 31, 2004 and 2003, approximately $11.7 million (or 53%) and $19.1 million (or 94%), respectively, 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. 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 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, 2004 and 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.
The following table summarizes Merrill Lynch Life’s contractual obligations as of December 31, 2004:
(1) The long-term liabilities include policyholder liabilities for which Merrill Lynch Life believes the amount and timing of the payments are essentially fixed and determinable. These amounts primarily relate to contracts where Merrill Lynch Life is currently making payments to policyholders and will continue to do so until the occurrence of a specific event.
(2) During 2000, Merrill Lynch Life committed to participate in a limited partnership. As of December 31, 2004, $7.4 million had been advanced towards Merrill Lynch Life’s $10.0 million commitment to the limited partnership. The contractual commitment expires June 2006.
Merrill Lynch Life has developed a comprehensive capital management plan that will continue to provide appropriate levels of capital for the risks Merrill Lynch Life assumes, but will allow Merrill Lynch Life to reduce its absolute level of surplus. In implementing this plan, Merrill Lynch Life paid cash dividends during 2004 and 2002 of $97.5 million and $30.9 million to MLIG, of which $29.3 million and $30.9 million, respectively, were ordinary dividends. No dividends were paid during 2003. Merrill Lynch Life received a $50.0 million capital contribution from MLIG during 2003.
During June 2003, Merrill Lynch Life and Merrill Lynch & Co. executed a “keepwell” agreement. The agreement obligates Merrill Lynch & Co. to maintain a level of capital in Merrill Lynch Life in excess of minimum regulatory capital requirements.
• the charges imposed on variable annuity and variable life insurance contracts, and
The costs associated with acquiring contract owner deposits (DAC) are amortized over the period in which Merrill Lynch Life 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, Merrill Lynch Life incurs expenses associated with the maintenance of inforce contracts.
Net earnings derived from interest spread decreased $8.4 million (or 18%) to $37.3 million during 2004 as compared to $45.7 million in 2003. The decrease in interest spread is primarily due to the reduction in fixed rate contracts inforce, as well as, reductions in invested asset yields resulting from the increase in credit quality of the portfolio and a higher level of call activity.
(1) The decrease in interest related net realized gains is primarily due to decreased invested asset sales and decreases to asset market valuations resulting from the increasing interest rate environment during 2004 as compared to 2003.
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 2004, the market value adjustment expense decreased $2.1 million (or 44%) to $2.7 million as compared to $4.8 million in 2003 The decrease is primarily due to the decrease in surrender volume resulting from the declining number of inforce contracts.
(1) The decrease is due to decreased death benefit expense incurred under GMDB provisions due to improving equity markets.
As noted in the Recent Developments section above, effective January 1, 2004, Merrill Lynch Life adopted SOP 03-1 and recorded a cumulative change in accounting principle of $27.4 million, net of a federal income tax benefit of $14.8 million.
Net earnings derived from interest spread decreased $20.0 million (or 30%) to $45.7 million during 2003 as compared to $65.7 million in 2002. The decrease in interest spread is primarily due to the reduction in fixed rate contracts inforce, as well as, reductions in invested asset yields resulting from (i) the lower interest rate environment during 2003 as compared to 2002 and (ii) the increase in credit quality of the portfolio. Additionally, during 2003, net earnings derived from interest spread were negatively impacted by a $3.2 million decrease in real estate income. Merrill Lynch Life sold its remaining real estate holding during the fourth quarter of 2002.
(2) Reflective of the generally stronger corporate credit environment during 2003 as compared to 2002.
2002. This decrease is primarily due to the decreases in interest-related realized gains and policy charge revenue.