Merrill Lynch Life conducts its business primarily in the annuity markets and to a lesser extent in the life insurance markets of the financial services industry. These markets are highly regulated with particular emphasis on company solvency and sales practice monitoring. Demographically, the population is aging and there is a growing number of individuals preparing for retirement, which favors life insurance and annuity products. Merrill Lynch Life believes that the demand for retirement products containing guarantee features will continue to increase in the future. Merrill Lynch Life believes it is well positioned to continue meeting these demands for product guarantees with the introduction of its new variable annuity product line during 2005.
As evidenced in the above table, the U.S. equity markets improved in 2004. This improvement primarily occurred in the latter part of the year. The major U.S. equity indices ended 2004 at new post-2000 highs despite rising oil prices and uncertainties over interest rates and geo-political events.
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 judgement and available information. Therefore, actual results could differ and could have a material impact on the Financial Statements, and it is possible that such changes could occur in the near term.
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, 2004 and 2003, approximately, $220.9 million (or 11%) and $260.9 million (or 12%), respectively, of Merrill Lynch Life’s fixed maturity and equity securities portfolio consisted of non-publicly traded securities.
Changes in the fair value of fixed maturity and equity 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.
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 Statement of Financial Accounting Standards 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, 2004, variable annuities and variable life insurance accounted for $211.4 million (or 54%) and $170.2 million (or 43%), respectively, of Merrill Lynch Life’s DAC asset. At December 31, 2003, variable annuities and variable life insurance accounted for $173.6 million (or 48%) and $178.9 million (or 49%), respectively, of Merrill Lynch Life’s DAC asset.
One of Merrill Lynch Life’s variable life insurance products 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 revenue liability is subject to the same periodic reassessment as DAC. At December 31, 2004 and 2003, Merrill Lynch Life’s unearned policy charge revenue liability was $112.2 million and $107.8 million, respectively.
Specific estimates include the realization of the dividend-received deduction (“DRD”) and the foreign tax credit (“FTC”). A portion of Merrill Lynch Life’s investment income related to separate accounts business qualifies for the DRD and FTC. Information necessary to calculate these tax adjustments is typically not available until the following year. However, during the current year’s provision, management makes estimates regarding the future deductibility of these items. These estimates are primarily based on recent historic experience. See Note 6 to the Financial Statements for period-to-period differences in DRD and FTC adjustments.
On January 1, 2004, Merrill Lynch Life adopted the provisions of SOP 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts. SOP 03-1 requires the establishment of a liability for contracts that contain death or other insurance benefits using a reserve methodology that is different from the methodology that Merrill Lynch Life previously employed. As a result, Merrill Lynch Life recorded a $41.3 million increase in policyholder liabilities and a $0.9 million decrease in DAC resulting in a charge to earnings of $27.4 million, net of a federal income tax benefit of $14.8
In March 2004, the Emerging Issues Task Force (“EITF”) reached a final consensus on Issue 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. EITF 03-1 requires that when the fair value of an investment security is less than its carrying value, an impairment exists for which the determination must be made as to whether the impairment is other-than-temporary. The EITF 03-1 impairment model applies to all investment securities accounted for under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and to investment securities accounted for under the cost method to the extent an impairment indicator exists. Under the guidance, the determination of whether an impairment is other-than-temporary and therefore would result in a recognized loss depends on market conditions and management’s intent and ability to hold the securities with unrealized losses. In September 2004, the Financial Accounting Standards Board (“FASB”) approved FASB Staff Position EITF 03-1, which defers the effective date for recognition and measurement guidance contained in EITF 03-1 until certain issues are resolved. The impact on Merrill Lynch Life’s Financial Statements will be determined when the final EITF 03-1 is issued. Merrill Lynch Life will adopt the guidance at the time it is issued. Merrill Lynch Life previously implemented the disclosure requirements of EITF 03-1 in its 2003 Financial Statements. See Note 3 to the Financial Statements for additional information .
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. Merrill Lynch Life issues three types of variable annuity products. These products are differentiated by the degree of liquidity afforded to the contract owner. The B-Share variable annuities offer a guaranteed minimum income benefit (“GMIB”) provision and contain a seven year surrender charge period, L-Share variable annuities do not offer a GMIB provision and contain a three year surrender charge period, and C-Share variable annuities do not offer a GMIB provision and have no surrender charge period. All variable annuity products offer some form of GMDB. Each variable annuity product provides tax-deferred retirement savings with the opportunity for diversified investing in a wide selection of underlying mutual fund portfolios. In addition, Merrill Lynch Life also issues modified guaranteed annuity products. The modified guaranteed annuity products also provide tax-deferred retirement savings through guaranteed fixed interest rates for a period selected by the contract owner, but impose a market value adjustment for withdrawals prior to the expiration of the guarantee period.
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 decreased $210.0 million (or 21%) to $775.3 million as compared to 2003. Variable annuity deposits decreased $186.4 million (or 20%) to $735.1 million as compared to 2003. Variable annuity deposits were impacted by a planned reduction in the number of annuity wholesalers and the resulting geographical realignment of annuity sales territories. Management also attributes the reduction in variable annuity deposits to general economic conditions and to uncertainties regarding the regulatory environment relating to the distribution practices of annuity products. As financial markets improve, variable annuities may be viewed as less attractive as compared to other investment products available within the Merrill Lynch & Co. retail network.
During 2004, variable life insurance deposits decreased $7.1 million (or 20%) to $28.5 million as compared to 2003. The decrease in variable life insurance deposits is primarily due to the discontinuation of manufacturing variable life insurance products during the first quarter 2003. Variable life insurance deposits displayed above generally represent renewal deposits on existing life insurance contracts.
At December 31, 2004, Merrill Lynch Life’s assets were $14.8 billion or $102.7 million higher than the $14.6 billion in assets at December 31, 2003. Assets excluding separate accounts assets decreased $213.8 million (or 5%) 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 75% of total assets, increased $316.5 million to $11.1 billion. Changes in separate accounts assets during each quarter of 2004 were as follows:
At December 31, 2004 and 2003, approximately $1,991.5 million (or 99%) and $2,059.2 million (or 95%), respectively, of Merrill Lynch Life’s 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, 2004, approximately $156.4
million (or 8%) of Merrill Lynch Life’s fixed maturity securities were rated BBB-, which is the lowest investment grade rating given by Standard and Poor’s, compared to $177.0 million (or 8%) of Merrill Lynch Life’s fixed maturity securities at December 31, 2003.
At December 31, 2004, Merrill Lynch Life had 26,117 life insurance and annuity contracts inforce with interest rate guarantees. The estimated average rate of interest credited on behalf of contract owners was 4.19% and 4.33% during 2004 and 2003, respectively. Invested assets supporting liabilities with interest rate guarantees had an estimated average effective yield of 4.86% and 5.27% during 2004 and 2003, respectively. The number of life insurance and annuity contracts inforce with interest rate guarantees decreased 2,852 (or 10%) as compared to 2003.
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 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, Merrill Lynch Life’s assets included $2.1 billion and $2.2 billion, 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 $2.4 billion have been excluded from this table. These amounts primarily relate to contracts where i) Merrill Lynch Life 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 Merrill Lynch Life. 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, 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 receives claims paying ability ratings from Standard and Poors and A.M. Best. At December 31, 2004, Merrill Lynch Life received ratings from Standard and Poors and A.M. Best of “A+” and “A”, respectively. These ratings were unchanged from the ratings at December 31, 2003.
Policy charge revenue increased $7.8 million (or 3%) to $236.7 million during 2004 as compared to $228.9 million in 2003. During 2004, asset-based policy charge revenue increased $21.7 million (or 16%) as compared to 2003. The increase in asset-based policy charge revenue is attributable to higher average variable account balances. During the same comparative period, average variable account balances increased $1.0 billion (or 11%). Partially offsetting the increase in asset-based policy charge revenue was a decrease in non-asset based policy charge revenue. Non-asset based policy charge revenue decreased $13.9 million (or 16%) during 2004 as compared to 2003 primarily due to a decrease in deferred policy load amortization resulting from increased mortality on certain life insurance products.
Merrill Lynch Life experienced net realized investment gains of $4.0 million and $1.0 million during 2004 and 2003, respectively. The following table provides the changes in net realized investment gains (losses) by type:
(2) 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.
(3) Decreases in credit related net realized losses are primarily due to the reduction in OTT declines in the carrying value of fixed maturity securities and asset sales of several large security holdings. OTT declines during 2004 were $2.1 million. OTT declines were $9.1 million and losses on credit related asset sales were $3.2 million during 2003.
(2) The increase is primarily due to an increase in the number of death claims.
Merrill Lynch Life recorded net earnings of $41.4 million and $47.6 million for 2003 and 2002, respectively.
(4) Merrill Lynch Life sold its remaining real estate holding during 2002.
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 2003, the market value adjustment expense increased $1.1 million (or 30%) to $4.8 million as compared to $3.7 million in 2002. The increase is primarily due to the lower interest rate environment during 2003 as compared to 2002. The market value adjustment expense has an inverse relationship to changes in interest rates.
Amortization of DAC decreased $24.7 million (or 24%) to $76.4 million during 2003 as compared to $101.1 million in 2002. Excluding the impact of period-to-period differences in DAC unlocking as noted in the Critical Accounting Policies section above, amortization of DAC decreased $19.6 million as compared to
Insurance expenses and taxes increased $3.6 million (or 7%) to $52.1 million during 2003 as compared to $48.5 million in 2002. The following table provides the changes in insurance expenses and taxes by type for each respective period:
(1) The increase in commissions is primarily due to increases in variable annuity asset-based commissions.
(2) The increase in taxes, licenses, and fees is primarily due to guaranty fund association refunds received during 2002. Guaranty fund association refunds received during the first quarter of 2002 were $1.1 million.
Merrill Lynch Life is not dependent upon any single customer, and no single customer accounted for more than 10% of its revenues during 2004, 2003, or 2002.