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 ML of New York’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 and Economic Environment sections listed below, as well as actions and initiatives taken by both current and potential competitors, the effect of current, pending, and future legislation and regulation, and the other risks and uncertainties detailed in ML of New York’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. ML of New York 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 ML of New York may make in its Quarterly Reports on Form 10-Q.
The financial services industry continues to be affected by an intensifying competitive environment as demonstrated by consolidation through mergers and competition from new and established competitors using the internet or other technology to provide financial services. In addition, the Gramm-Leach-Bliley Act, passed in 1999, represented a significant accomplishment in the effort to modernize the financial services industry in the U.S. by repealing Depression-era barriers between commercial banking, investment banking, and insurance activities. This legislation, together with other changes in the financial services industry made possible by previous reforms, has increased the number of companies competing for a similar customer base.
In 2002, the U.S. Congress passed the Sarbanes-Oxley Act of 2002 which is a broad overhaul of existing corporate and securities laws. In addition, various Federal and state securities regulators, self-regulatory organizations (including the New York Stock Exchange) and industry participants reviewed and in many cases adopted sweeping changes to their established rules including rules in the areas of corporate governance and auditor independence.
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, ML of New York’s earnings will be impacted by fluctuations in investment performance of separate accounts assets. Fluctuations in the U.S. equity market also directly impact ML of New York’s exposure to guaranteed
There are several standard indices published on a daily basis that measure performance of selected components of the U.S. equity market. Examples include the Dow Jones Industrial Average (“Dow”), NASDAQ Composite Index (“NASDAQ”) and the Standard & Poor’s 500 Composite Stock Price Index (“S&P Index”). The following table provides the decrease for each equity market index for the years ended December 31:
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 2002, medium term interest rates decreased approximately 112 basis points to yield, on average, 2.53%. During 2001, medium term interest rates decreased approximately 148 basis points to yield, on average, 3.65%.
Changes in the corporate credit environment directly impact the value of ML of New York’s investments, primarily fixed maturity securities. ML of New York largely invests in investment-grade corporate debt to support its fixed rate product liabilities. During 2002, corporate debt defaults on a dollar-weighted volume basis increased significantly as a result of continuing weakness in the economy, as well as several large high-profile defaults. ML of New York holds corporate debt of certain of these companies and has adjusted its carrying value in these investments to reflect amounts anticipated to ultimately be recovered. The decrease in book value is recorded as a component of net realized investment losses.
Credit spreads represent the credit risk premiums required by market participants for a given credit quality, e.g. the additional yield that a debt instrument issued by a AA-rated entity must produce over a risk-free alternative (e.g., U.S. Treasury instruments). ML of New York defines credit spreads according to the Merrill Lynch U.S. Corporate Bond Index for BBB-A Rated bonds with three to five year maturities. During 2002, credit spreads widened approximately 20 basis points and ended the year at 198 basis points. During 2001, credit spreads contracted approximately 9 basis point and ended the year at 178 basis points. Widening credit spreads have a negative impact on the value of fixed maturity securities.
ML of New York sells variable and interest sensitive life insurance and annuity products through Merrill Lynch & Co.’s retail network of Financial Advisors. ML of New York competes for Merrill Lynch & Co.’s clients’ life insurance and annuity business with unaffiliated insurers whose products are also sold through Merrill Lynch & Co.’s retail network, and with insurers who solicit this business directly. The product lines that ML of New York offers are focused in the highly competitive market segment of retirement and death benefit planning. ML of New York competes in this market segment by integrating its products into Merrill Lynch & Co.’s planning-based financial management program.
ML of New York’s financial management is based on conservative investment and liability management and regular monitoring of its risk profile. ML of New York also seeks to provide superior customer service and financial management to promote the competitiveness of its products. ML of New York’s customer service center has established standards of performance that are monitored on a regular basis. Managers and employees in the customer service centers are periodically evaluated based on their performance in meeting these standards.
ML of New York has strategically placed its marketing emphasis on the sale of variable annuities and modified guaranteed annuities. These products are designed to address the retirement planning needs of Merrill Lynch & Co.’s clients. ML of 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 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. Total direct premiums by product type for the three years ended December 31 were as follows:
ML of New York offers two C-Share variable annuity products that were introduced in the fourth quarter 2002 and the first quarter 2001, respectively.
During 2002, ML of New York’s total direct premiums decreased $50.2 million (or 44%) as compared to 2001. Variable annuity premiums decreased $61.2 million (or 56%) to $48.0 million during 2002 as compared to 2001. Management attributes the decrease in variable annuity premiums to increasing customer demand for annuity products that offer guarantee provisions, such as fixed rate products, variable products with fixed account options, variable products with guaranteed minimum income benefits, or variable products with guaranteed minimum account values. With the exception of ML of New York’s modified guaranteed annuity product, which offers a fixed interest crediting rate, ML of New York currently does not offer these types of guarantees in its products. During 2002, sales of non-proprietary products with these types of guarantee features have been strong within the Merrill Lynch & Co. distribution system. ML of New York is currently developing a guaranteed minimum income benefit provision for placement in certain of its existing variable annuity products and anticipates offering this feature in 2003.
Management believes that the increasing demand for annuity products with guarantee provisions has been fueled by the increasing volatility and general negative performance of the equity markets that has occurred over the past three years. As such, future sales of ML of New York’s variable annuity products without these provisions could be negatively impacted if this trend continues.
Policy and contract surrenders increased $11.8 million (or 17%) to $80.0 million during 2002 as compared to 2001. During 2002, variable annuity surrenders increased $10.7 million (or 25%) to $54.2 million as compared to 2001. The increase is primarily a result of the anticipated increase in lapse rates on variable annuity contracts reaching the end of their surrender charge period. In addition, variable life surrenders increased $6.9 million (or 63%) during 2002 as compared to 2001. Partially offsetting the increases in variable annuity and variable life surrenders was a decrease in modified guaranteed annuity surrenders, which decreased $5.4 million (or 40%) during 2002 as compared to 2001. Management attributes the decrease to volatility in the equity markets, whereby modified guaranteed annuity contract owners have less incentive to give up guaranteed income.
At December 31, 2002, ML of New York’s assets were $1.1 billion, or $0.2 billion lower than the $1.3 billion in assets at December 31, 2001 primarily due to a decrease in separate accounts assets. Separate accounts assets decreased $182.7 million (or 18%) to $810.4 million primarily due to unfavorable investment performance and an increase in net cash outflow. Changes in separate accounts assets during 2002 by quarter were as follows:
ML of New York’s investment in collateralized mortgage obligations (“CMO”) and mortgage backed securities (“MBS”) had a carrying value of $2.1 million as of December 31, 2002. At December 31, 2002, 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.
ML of New York’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. ML of New York 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. ML of New York 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, 2002, ML of New York’s assets included $183.0 million of cash, short-term investments and investment grade publicly traded available-for-sale securities that could be liquidated if funds were required.
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, 2002 and 2001, based on the RBC formula, ML of New York’s total adjusted capital level was in excess of the minimum amount of capital required to avoid regulatory action.
ML of New York receives claims paying ability ratings from Standard and Poors and A.M. Best. During 2002, Standard and Poors downgraded Merrill Lynch & Co. to “A+” from “AA-”. As a result, ML of New York’s rating was similarly downgraded to “A+”. At December 31, 2002, A.M. Best’s rating of ML of New York was “A+”. However, the rating was downgraded to “A” during January 2003.
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 2002 and 2001.
of deferred policy acquisition costs. During 2001 ML of New York increased earnings by $0.8 million, via a reduction in amortization of deferred policy acquisition costs.
Net earnings derived from interest spread decreased $1.0 million (or 20%) during 2002 as compared to 2001. The decrease in interest spread is primarily a result of the reduction in yields on invested assets resulting from the lower interest rate environment as compared to 2001.
Reinsurance premium ceded decreased $0.2 million (or 10%) during 2002 as compared to 2001. The decrease is attributable to the decrease in life insurance inforce.
Insurance expenses and taxes decreased $1.5 million (or 31%) during 2002 as compared to 2001. The decrease in insurance expenses and taxes is primarily due to i) cost savings resulting from ML of New York’s consolidation of its life and annuity policy administration service centers, which was completed during the third quarter 2001, and ii) reductions in employee compensation expense.
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.
Net realized investment losses increased $2.4 million during 2001 as compared to 2000. The increase in net realized investment losses is due to an increase in credit related losses primarily losses on investments in fixed maturity securities issued by Enron Corp.
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.
Insurance expenses and taxes increased $0.7 million (or 16%) during 2001 as compared to 2000. The increase in insurance expenses and taxes is primarily due to $1.0 million of costs related to the consolidation of ML of New York’s policy administration service centers.