Equity Price Risk - The significant decrease in the U.S. equity market that occurred after the Attacks has negatively impacted ML of New York's earnings and future earnings via the following:
Technology - ML of New York's policy administration systems were not impacted by the Attacks and contract owner processing for all fixed product transactions continued as normal. Variable product processing was suspended during the closure of the stock exchanges and resumed on Monday, September 17. Also, ML of New York relocated certain financial systems to a designated disaster recovery location in accordance with Merrill Lynch & Co. policy.
Demographically, the population is aging, which favors life insurance and annuity products. During June 2001, Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001 (the "Act"). The primary provision in the Act that impacted the insurance industry was the reform and eventual repeal of the estate tax. Under the new tax law, the annual estate tax exemption will increase from $0.675 million in 2001 to $3.5 million in 2009, with an anticipated complete repeal of the estate tax in 2010. ML of New York does not offer estate planning life insurance products.
During the second quarter 2001, ML of New York announced plans to consolidate its life and annuity policy administration service centers into one location. The objective of this initiative is to provide high quality service with a single point of contact for all of ML of New York's touchpoints, including contract owners, Financial Advisors, District Annuity Specialists, and Wealth Management Specialists. In addition, the consolidation is consistent with Merrill Lynch & Co.'s goals of integrating for efficiency, minimizing business risk, and maximizing the client experience. The consolidation was completed during the third quarter 2001. Costs incurred related to the consolidation were $1.0 million, with the majority of these costs reported in the third quarter. ML of New York anticipates future annual expense savings of approximately $0.5 million.
- - fluctuations in medium term interest rates - - fluctuations in credit spreads - - equity market performance
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 2001, medium term interest rates decreased approximately 101 basis points to yield, on average, 4.12% at December 31, 2001.
ML of New York defines credit spreads as the interest rate spread between the 5-year U.S Treasury Bond Index and the 5-year Corporate Industrial Bond Index. During 2001, credit spreads contracted approximately 32 basis points to end the year at 146 basis points.
ML of New York has strategically placed its marketing emphasis on the sale of variable annuities, variable life insurance products, and modified guaranteed annuities. These products are designed to address the retirement and death benefit planning needs of Merrill Lynch & Co.'s clients. ML or New York offers three types of variable annuity products. These products are differentiated by the degree of liquidity afforded to the contract owner. The B-Share variable annuity contains a seven year surrender charge period, the L-Share variable annuity (introduced in the fourth quarter 2001) contains a three year surrender charge period, and the C-Share variable annuity has no surrender charge period. Each variable annuity product provides tax-deferred retirement savings with the opportunity for diversified investing in a wide selection of underlying mutual fund portfolios. ML of New York offers a variable life insurance product that provides life insurance protection and allows the contract owner to allocate the cash value of the policy to underlying diversified mutual fund portfolios. The modified guaranteed annuity product also provides tax-deferred retirement savings through a guaranteed fixed interest rate for a period selected by the contract owner, but imposes a market value adjustment for withdrawals prior to the expiration of the guarantee period. The following table summarizes ML of New York's sales activity for the three years ending December 31, 2001:
- - equity market volatility, or - - the decline in the equity markets from what was experienced during 2001 and 2000
Merrill Lynch & Co. offers an optional asset allocation service to ML of New York's B-Share variable annuity contract owners. An investment advisor allocates the participating contract owner's account value among the available underlying mutual fund portfolios based on the contract owner's investment objectives and risk tolerance. ML of New York does not receive any financial remuneration from Merrill Lynch & Co. for this service; however, management believes that its availability has had a positive effect on variable annuity sales volume.
Modified guaranteed annuity sales decreased $2.3 million (or 74%) during 2001 as compared to 2000. Modified guaranteed annuity products offer a fixed interest crediting rate reflective of the current interest rate environment, thus increases or decreases in sales tend to have a direct relationship to changes in interest rates. During 2001, modified guaranteed annuity sales were negatively impacted by the lower interest rate environment as compared to 2000.
At December 31, 2001, ML of New York's assets were $1,301.6 million, or $43.8 million lower than the $1,345.4 million in assets at December 31, 2000 primarily due to a decrease in separate account assets. During the same time, separate accounts assets decreased $42.5 million (or 4%) to $993.1 million primarily due to unfavorable investment performance associated with the general decline in the U.S. equity market. Changes in separate account assets during 2001 by quarter were as follows:
ML of New York maintains a conservative general account investment portfolio. ML of New York has no mortgage or real estate investments. The following schedule identifies ML of New York's general account invested assets by type:
ML of New York's investment in collateralized mortgage obligations ("CMO") and mortgage backed securities ("MBS") had a carrying value of $2.9 million as of December 31, 2001. At December 31, 2001, 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.
As of December 31, 2001, ML of New York had 2,169 life insurance and annuity contracts inforce with interest rate guarantees. The estimated average rate of interest credited on behalf of contract owners was 4.86% during 2001. Invested assets supporting liabilities with interest rate guarantees had an estimated effective yield of 6.39% during 2001. The number of life insurance and annuity contracts inforce with interest rate guarantees decreased 10% as compared to 2000.
In order to continue to issue life insurance and annuity products, ML of New York 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, 2001 and 2000, 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 received claims paying ability ratings from the major insurance rating agencies as follows: A.M. Best - "A+" and Standard and Poors - "AA-".
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 $35.0 million in dividends to MLIG during 2000. No dividends were paid during 2001 and 1999.
ML of New York amortizes deferred policy acquisition costs based on the expected future gross profits for each group of contracts. In estimating future gross profits, management makes assumptions regarding such factors as policy charge revenue, investment performance, policy lapse rates, mortality, and expenses for the expected life of each group of contracts. Actual gross profits can vary from management's estimates resulting in increases or decreases in the rate of amortization. Management periodically updates these estimates and evaluates the recoverability of deferred policy acquisition costs. The impact of revisions to estimates on cumulative amortization is recorded as a charge or credit to current operations. During 2001 and 2000, ML of New York credited earnings, via a reduction in amortization of deferred policy acquisition costs, $0.8 million and $0.7 million, respectively.
- - the charges imposed on variable life insurance and variable annuity contracts, and - - 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 net earnings of $4.3 million and $10.1 million for 2001 and 2000, respectively.
Policy charge revenue decreased $1.5 million (or 7%) during 2001 as compared to 2000. The decrease in policy charge revenue is primarily attributable to the decrease in average variable account balances. Average variable account balances decreased $108.3 million (or 10%) during 2001 as compared to 2000. During the same time period, asset based policy charges decreased $1.1 million (or 9%) consistent with the reduction in the separate accounts assets. Non-asset based charges decreased $0.4 million (or 5%) as compared to 2000 primarily due to a decrease in cost of insurance charges.
Policy benefits increased $1.3 million (or 71%) during 2001 as compared to 2000. The increase in policy benefits is primarily due to a $1.7 million increase in variable annuity death benefit expense incurred under guaranteed minimum death benefit provisions. Partially offsetting this increase is decreased mortality for variable life insurance products.
Amortization of deferred policy acquisition costs decreased $0.5 million (or 12%) to $3.5 million during 2001. The decrease in amortization of deferred policy acquisition costs is primarily due to the decrease in asset based variable annuity policy charge revenue.
ML of New York recorded net earnings of $10.1 million and $6.6 million for 2000 and 1999, respectively.
Net earnings derived from interest spread decreased $0.6 million during 2000 as compared to 1999. The reduction in interest spread is primarily a result of the declining number of fixed rate contracts inforce.
Net realized investment losses decreased $3.0 million during 2000 as compared to 1999. The decrease in net realized investment losses is primarily due to a $4.0 million decrease in credit related losses. Prior period credit related losses were impacted by book value writedowns and asset sales of several large security holdings. ML of New York did not incur any credit related losses during 2000. Partially offsetting the $4.0 million decrease in credit related losses is a $1.0 million decrease in interest related gains. The decrease in interest related gains, during 2000, is primarily due to reductions in trading activity attributable to decreases in fixed product surrenders.
Amortization of deferred policy acquisition costs decreased $0.9 million (or 18%) to $4.0 million during 2000. The retrospective adjustment of deferred policy acquisition costs that occurred during 2000 resulted in a $0.8 million decrease in amortization of deferred policy acquisition costs as compared to 1999 (see Management Estimates, above).
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. Other earnings represent earnings on assets that do not support contract owner liabilities. Net earnings by segment were as follows:
The products that comprise the Life Insurance and Annuity segments generally possess similar economic characteristics. As such, the financial condition and results of operations of each business segment are generally consistent with ML of New York's consolidated financial condition and results of operations presented herein.
The decrease in other net earnings during 2001 as compared to 2000 is primarily due to a reduction in net investment income resulting from the Company's $35.0 million dividend payment to MLIG during the fourth quarter 2000.
ML of New York is not dependent upon any single customer, and no single customer accounted for more than 10% of its revenues during 2001.