Merrill Lynch Life conducts its business in the life insurance and annuity 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, which favors life insurance and annuity products.
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. Pending future Congressional action, these federal income tax rate reductions are set to expire after 2008. These recently enacted tax rate reductions may impact the relative attractiveness of non-qualified annuities.
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 claim payments. GMDB claim payments are recorded as a component of policy benefits.
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”). The following table provides the increase (decrease) for each equity market index for the years ended December 31:
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”) is subject to recoverability testing at the time of policy issuance and loss recognition testing at the end of each reporting period. At December 31, 2003, variable annuities and variable life insurance account for $173.6 million (or 48%) and $178.9 million (or 49%), respectively, of Merrill Lynch Life’s DAC asset.
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 (“DAC unlocking”). During 2003 and 2002, Merrill Lynch Life reduced earnings by $21.9 million and $27.0 million, respectively, via an increase in amortization of deferred policy acquisition costs. 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 return and increases in surrender or mortality assumptions reduce the expected future profitability of the underlying business and may increase the rate of DAC amortization.
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.
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, as well as information obtained from external sources (i.e. company announcements, ratings agency announcements, or news wire services). The factors that give rise to potential impairments include, but are not limited to, i) certain credit-related events such as default of principal or interest payments, ii) bankruptcy of issuer, and iii) certain security restructurings. In absence of a readily ascertainable market value, the estimated fair value on these securities represents management’s estimate of the security’s ultimate recovery value. OTT impairment losses result in a permanent reduction of the cost basis of the underlying investment. OTT impairments on investments in fixed maturity securities were $9.1 million and $24.0 million during 2003 and 2002, 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. During 2003 and 2002, Merrill Lynch Life reduced its provision for federal income taxes by $5.7 million and $7.8 million, respectively, due to DRD and FTC adjustments.
On July 7, 2003, the American Institute of Certified Public Accountants issued Statement of Position (“SOP”) 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts. The SOP provides guidance on accounting and reporting by insurance companies for certain nontraditional long-duration contracts and for separate accounts. The SOP is effective for financial statements for Merrill Lynch Life beginning in 2004. The SOP requires the establishment of a liability for contracts that contain death or other insurance benefits using a specified reserve methodology that is different from the methodology that Merrill Lynch Life currently employs. The adoption of SOP 03-1, which is effective January 1, 2004, will approximately result in a $43.0 million increase in policyholder liabilities and a corresponding pre-tax charge to earnings. The adoption of SOP 03-1 is considered a change in accounting principle.
Merrill Lynch Life’s financial management is based on conservative investment and liability management and regular monitoring of its risk profile. Merrill Lynch Life also seeks to provide superior customer service and financial management to promote the competitiveness of its products. Merrill Lynch Life’s customer service center has established standards of performance that are monitored on a regular basis. Managers and employees in the customer service center are periodically evaluated based on their performance in meeting these standards.
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 contain a seven year surrender charge period, L-Share variable annuities contain a three year surrender charge period, and C-Share variable annuities have no surrender charge period. Each variable annuity product provides tax-deferred retirement savings with
During 2003 variable life insurance premiums decreased $12.8 million (or 26%) to $35.6 million as compared to 2002. The decrease in variable life insurance premiums is primarily due to the discontinuation of manufacturing variable life insurance products during the first quarter 2003.
Modified guaranteed annuity sales decreased $29.3 million (or 68%) to $13.9 million during 2003 as compared to 2002. The decrease is primarily due to the lower interest rate environment during 2003 as compared to 2002.
$675.3 million. Management attributes the decrease in variable annuity surrenders to the general decline in the equity markets occurring over the past three years whereby variable annuity contract owners are less inclined to give up contracts in which GMDB provisions are in excess of the variable account balance. In addition, modified guaranteed annuity surrenders decreased $34.8 million (or 25%) as compared to 2002 to $104.5 million. Management also attributes the decrease in modified guaranteed annuity surrenders to the general decline in the equity markets occurring over the past three years, whereby modified guaranteed annuity contract owners have less incentive to give up guaranteed income. Partially offsetting the decreases in variable annuity and modified guaranteed annuity surrenders was an increase in variable life surrenders, which increased $28.9 million (or 13%) to $254.3 million as compared to 2002. The increase in variable life surrenders primarily represents movement by contract owners to other unaffiliated insurance products. As previously noted, Merrill Lynch Life no longer manufactures variable life insurance products.
During 2003, Merrill Lynch Life experienced contract owner withdrawals that exceeded deposits by $410.6 million. The components of contract owner transactions were as follows:
At December 31, 2003 and 2002, approximately $97.9 million (or 5%) and $114.7 million (or 6%), respectively, of Merrill Lynch Life’s fixed maturity securities were considered non-investment grade. Merrill Lynch Life defines non-investment grade as unsecured debt obligations that have a rating equivalent to Standard and Poor’s BB+ or lower (or similar rating agency). Non-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 non-investment grade holdings are the result of ratings downgrades on Merrill Lynch Life’s portfolio as Merrill Lynch Life does not purchase non-investment grade securities. Also, as of December 31, 2003, approximately $177.0 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 $233.6 million (or 13%) of fixed maturity securities as of December 31, 2002. Merrill Lynch Life closely monitors such investments. The reductions in non-investment grade and BBB- holdings are attributable to management actions taken during 2003 to improve the overall credit quality of the fixed maturity security portfolio.
At December 31, 2003, Merrill Lynch Life had 28,969 life insurance and annuity contracts inforce with interest rate guarantees. The estimated average rate of interest credited on behalf of contract owners was 4.32% during 2003. Invested assets supporting liabilities with interest rate guarantees had an estimated average effective yield of 5.37% during 2003. The number of life insurance and annuity contracts inforce with interest rate guarantees decreased 2,968 (or 9%) as compared to 2002.
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, 2003, Merrill Lynch Life’s assets included $2.2 billion of cash, short-term investments, and investment grade publicly traded available-for-sale securities that could be liquidated if funds were required.
Merrill Lynch Life believes that it will be able to fund the capital and surplus requirements of projected new business from current statutory earnings and existing statutory capital and surplus. If sales of new business significantly exceed projections, Merrill Lynch Life may have to look to its parent and other affiliated companies to provide the capital or borrowings necessary to support its current marketing efforts. Merrill Lynch Life’s future marketing efforts could be hampered should its parent and/or affiliates be unwilling to commit additional funding.
The costs associated with acquiring contract owner deposits (deferred policy acquisition costs) 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.
Merrill Lynch Life recorded net earnings of $41.5 million and $47.9 million for 2003 and 2002, respectively.
Merrill Lynch Life experienced net realized investment gains (losses) of $1.0 million and ($9.1) million during 2003 and 2002, respectively. The following table provides net realized investment gains (losses) by type:
The increase in commissions is primarily due to increases in variable annuity asset-based commissions.
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’s effective federal income tax rate increased to 25% for 2003 from 22% for 2002 primarily due to period-to-period differences in DRD and FTC adjustments as noted in the Critical Accounting Policies section above. Also, during 2003, deferred tax components have been significantly impacted by fluctuations in GMDB tax reserves. The reserve fluctuations have resulted in a decreased deferred tax expense during 2003 as compared to 2002.
Net earnings derived from interest spread decreased $3.1 million (or 4%) to $65.7 million during 2002 as compared to $68.8 million in 2001. 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 lower interest rate environment as compared to 2001. Net earnings derived from interest spread were favorably impacted by a $2.3 million increase in real estate income.
The increase in interest related gains is primarily attributable to increases in invested asset market valuations resulting from the lower interest rate environment as compared to 2001.
Policy benefits increased $20.3 million (or 54%) to $58.1 million during 2002 as compared to $37.8 million in 2001 primarily due to increased variable annuity death benefit payments incurred under GMDB provisions.
Reinsurance premium ceded decreased $1.4 million (or 6%) to $23.1 million during 2002 as compared to $24.5 million in 2001. The decrease is attributable to the decrease in life insurance inforce.
Insurance expenses and taxes decreased $17.8 million (or 27%) to $47.9 million during 2002 as compared to $65.7 million in 2001. The decrease in insurance expenses and taxes is primarily due to i) cost savings resulting from Merrill Lynch Life’s consolidation of its life and annuity policy administration service centers, which was completed during the third quarter 2001, ii) reductions in employee compensation expense, and iii) reductions in asset-based commissions resulting from decreased average variable account balances.
Merrill Lynch Life’s effective federal income tax rate decreased to 22% for 2002 from 34% for 2001 primarily due to period-to-period differences in DRD and FTC adjustments as noted in the Critical Accounting Policies section above. Also during 2002, Merrill Lynch Life’s current and deferred tax components have been significantly impacted by fluctuations in GMDB tax reserves. The reserve fluctuations have resulted in an increased current tax benefit and an increased deferred tax expense during 2002 as compared to 2001.