During the first quarter 2005, Merrill Lynch Life transitioned the policy administration of its inforce life insurance contracts to an unaffiliated third party service provider. Merrill Lynch Life remains committed to the delivery of high quality services for all life insurance contracts inforce.
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the reported amounts of revenues and expenses. Estimates, by their nature, are based on judgment and available
Merrill Lynch Life’s principal investments are available-for-sale fixed maturity and equity securities as defined by Statement of Financial Accounting Standards (“SFAS”) No. 115, Accounting for Certain Investments in Debt and Equity Securities. The fair value of publicly traded fixed maturity and equity securities are based on independently quoted market prices. Merrill Lynch Life primarily utilizes pricing services and broker quotes to determine the fair value of non-publicly traded fixed maturity and equity securities. Since significant judgment is required for the valuation of non-publicly traded securities, the estimated fair value of these securities may differ from amounts realized upon an immediate sale. At December 31, 2005 and December 31, 2004, approximately, $238.2 million (or 12%) and $220.9 million (or 11%), respectively, of Merrill Lynch Life’s fixed maturity and equity securities portfolio consisted of non-publicly traded securities.
DAC for variable annuities is amortized with interest over the lives of the policies in relation to the present values of estimated future gross profits from asset-based fees, contract fees, and surrender charges, less a provision for guaranteed minimum death benefit (“GMDB”) expenses, policy maintenance expenses, and non-capitalized commissions.
Merrill Lynch Life establishes liabilities for amounts payable on its life and annuity contracts based on methods and underlying assumptions in accordance with SFAS 60, Accounting and Reporting by Insurance Enterprises, SFAS 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments, and Statement of Position (“SOP”) 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts and applicable actuarial standards.
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 recognized as income 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 year ended December 31, 2005 unlocking related to variable life insurance products was favorable in the amount of $67.9 million. During 2005, Merrill Lynch Life lowered its future gross profit assumptions on certain life insurance products resulting from historical surrender experience and reinsurance assumptions. There was no unlocking during 2004. For the year ended December 31, 2003 unlocking related to variable life insurance products was favorable in the amount of $5.5 million.
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 14%, 15%, and 18% for 2005, 2004 and 2003, respectively.
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, 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, 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. Since its introduction, total deposits for ICA were $499.5 million.
At December 31, 2005 and 2004, approximately $1,857.2 million (or 99%) and $1,991.5 million (or 99%), respectively, of fixed maturity securities were considered investment grade. Merrill Lynch Life 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, 2005, approximately $132.0 million (or 7%) of fixed maturity securities were rated BBB-, which is the lowest investment grade rating given by Standard and Poor’s. This compares to $156.4 million (or 8%) of BBB- rated fixed maturity securities at December 31, 2004.
At December 31, 2005, Merrill Lynch Life had 23,543 life insurance and annuity contracts inforce with interest rate guarantees. The estimated average rate of interest credited on behalf of contract owners was 4.15% and 4.32% during 2005 and 2004, respectively. Total investments and cash and cash equivalents supporting liabilities with interest rate guarantees had an estimated average effective yield of 4.75% and 4.69% during 2005 and 2004, respectively. The number of life insurance and annuity contracts inforce with interest rate guarantees decreased 2,574 (or 10%) as compared to 2004.
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. Approximately 71% of separate accounts assets are in equity-based mutual funds at December 31, 2005. 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 equity-based separate accounts assets.
Additionally, Merrill Lynch Life is impacted by the U.S. equity market 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.
The long-term liabilities include the portion of future policy benefits 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.
In order to continue to issue 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, 2005 and 2004, 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.
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 surplus. In implementing this plan, Merrill Lynch Life paid a cash dividend during 2004 of $97.5 million to
MLIG, of which $29.3 million was considered an ordinary dividend. Merrill Lynch Life did not pay a dividend during 2005 or 2003. Merrill Lynch Life received a $50.0 million capital contribution from MLIG during 2003. Pending regulatory approval, Merrill Lynch Life intends to pay a cash dividend during the first half of 2006.
Net realized investment gains decreased $1.4 million to $2.6 million during 2005 as compared to $4.0 million in 2004. The following table provides the changes in net realized investment gains (losses) by type:
The decrease in variable annuity mortality expense is primarily due to favorable GMDB liability unlocking during 2005 as noted in the Critical Accounting Policies section above.
Net realized investment gains increased $3.0 million to $4.0 million during 2004 as compared to $1.0 million in 2003. The following table provides the changes in net realized investment gains (losses) by type:
Policy benefits decreased $10.3 million (or 16%) to $54.3 million during 2004 as compared to $64.6 million in 2003. The following table provides the changes in policy benefits by type:
The increase in life insurance mortality expense is primarily due to an increase in the number of death claims.
Insurance expenses and taxes increased $5.5 million (or 10%) to $57.6 million during 2004 as compared to $52.1 million in 2003. The increase in insurance expenses and taxes is primarily due to increases in variable annuity asset-based commission expense as compared to 2003.
Merrill Lynch Life is not dependent upon any single customer, and no single customer accounted for more than 10% of its revenues during 2005, 2004, or 2003.