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 currently offers the following guaranteed benefits within its variable annuity product suite: guaranteed minimum death benefits (GMDB’s), guaranteed minimum income benefits (GMIB’s) and guaranteed minimum withdrawal benefits (GMWB’s). 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 guaranteed benefits.
Merrill Lynch Life’s principal investments are available-for-sale fixed maturity and equity securities as defined by 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. For non-publicly traded fixed maturity and equity securities, Merrill Lynch Life utilizes pricing services and broker quotes to determine fair value. 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, 2006 and December 31, 2005, approximately, $203.2 million (or 12%) and $238.2 million (or 12%), respectively, of Merrill Lynch Life’s fixed maturity and equity securities portfolio consisted of non-publicly traded securities.
The most significant assumptions involved in the estimation of future gross profits are future net separate accounts performance, surrender rates, mortality rates and reinsurance costs. For variable annuities, Merrill Lynch Life generally establishes a long-term rate of net separate accounts growth. If returns over a determined historical period differ from the long-term assumption, returns for future determined periods are calculated so that the long-term assumption is achieved. The result is that the long-term rate is assumed to be realized over a period of approximately ten years. However, the long-term rate may be adjusted if expectations change. This method for projecting market returns is known as reversion to the mean, a standard industry practice. Merrill Lynch Life adopted this methodology in 2004. For variable life insurance, Merrill Lynch Life generally assumes a level long-term rate of net variable life separate accounts growth for all future years and the long-term rate may be adjusted if expectations change. Additionally, Merrill Lynch Life may modify the rate of net separate accounts growth over the short term to reflect near-term expectations of the economy and financial market performance in which separate accounts assets are invested. Surrender and mortality rates for all variable contracts are based on historical experience and a projection of future experience.
Merrill Lynch Life uses the asset and liability method in providing income taxes on all transactions that have been recognized in the financial statements. The asset and liability method requires that deferred taxes be adjusted to reflect the tax rates at which future taxable amounts will be settled or realized. Merrill Lynch Life provides for federal income taxes based on amounts it believes it will ultimately owe. Inherent in the provision for federal income taxes are estimates regarding the realization of certain tax deductions and credits.
Specific estimates include the realization of dividend-received deductions (“DRD”) and foreign tax credits (“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, within the current year’s provision, management makes estimates regarding the future tax deductibility of these items. These estimates are primarily based on recent historic experience. See Note 7 to the Financial Statements for period-to-period differences in DRD and FTC adjustments. During 2006, 2005 and 2004, Merrill Lynch Life reduced its provision for federal income taxes by $4.4 million, $9.2 million and $6.0 million, respectively, due to DRD and FTC adjustments.
In September 2006, the FASB issued SFAS No. 157 Fair Value Measurements. SFAS No. 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 is effective for Financial Statements issued for fiscal years beginning after November 15, 2007 with early adoption permitted. Merrill Lynch Life intends to early adopt SFAS No. 157 as of the first quarter of fiscal 2007. The adoption is not expected to have a material impact on Merrill Lynch Life’s Financial Statements.
In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a company’s Financial Statements and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. Merrill Lynch Life will adopt FIN 48 in the first quarter of 2007. The adoption of FIN 48 is not expected to have a material impact on Merrill Lynch Life’s Financial Statements.
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 required the establishment of a liability for contracts that contain death or other insurance benefits using a reserve methodology that was different from the methodology that Merrill Lynch Life previously employed. As a result, Merrill Lynch Life recorded a $41,304 increase in policyholder liabilities and a $850 decrease in deferred policy acquisition costs resulting in a charge to earnings of $27,400, net of a federal income tax benefit of $14,754, which was reported as a cumulative effect of a change in accounting principle during 2004.
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 13%, 14% and 15% for 2006, 2005 and 2004, respectively.
Total direct deposits by product for the three years ended December 31 were as follows:
Total direct deposits increased $75.4 million (or 11%) to $786.8 million for the period ended December 31, 2006, as compared to the period ended December 31, 2005. During 2006, variable annuity deposits increased $76.2 million (or 11%) to $753.6 million as compared to 2005. The increase is primarily due to a full year of ICA sales, as well as post-launch enhancements to the product line. In addition, management believes that deposits were favorably impacted by the continuing client demand for guaranteed benefit provisions.
At December 31, 2006, Merrill Lynch Life’s assets were $14.6 billion or $261.0 million higher than the $14.4 billion in assets at December 31, 2005. Assets excluding separate accounts assets decreased $152.2 million (or 4%) primarily due to the $180.0 million dividend payment. Separate accounts assets, which represent 77% of total assets, increased $413.2 million (or 4%) to $11.3 billion. Changes in separate accounts assets during each quarter of 2006 were as follows:
During 2006, Merrill Lynch Life experienced contract owner withdrawals that exceeded deposits on all products by $909.1 million. The components of contract owner transactions were as follows:
equivalents. Merrill Lynch Life has no mortgage or real estate holdings and its investment in below investment grade fixed maturity securities are below the industry average.
At December 31, 2006 and 2005, approximately $1,552.9 million (or 99%) and $1,857.2 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, 2006, approximately $58.7 million (or 4%) of fixed maturity securities were rated BBB-, which is the lowest investment grade rating given by Standard and Poor’s. This compares to $132.0 million (or 7%) of BBB- rated fixed maturity securities at December 31, 2005.
Merrill Lynch Life has utilized public information to estimate the future assessments it will incur as a result of life insurance company insolvencies. At December 31, 2006 and 2005, Merrill Lynch Life’s estimated net liability for future guaranty fund assessments was $6.0 million and $6.8 million, respectively. Merrill Lynch Life regularly monitors public information regarding insurer insolvencies and adjusts its estimated liability as appropriate.
The investment performance of the underlying U.S. equity-based mutual funds supporting Merrill Lynch Life’s variable products do not replicate the returns of any specific U.S. equity market index. However, investment performance will generally increase or decrease with corresponding increases or decreases of the overall U.S. equity market. 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”), the NASDAQ Composite Index (“NASDAQ”) and the Standard & Poor’s 500 Composite Stock Price Index (“S&P”). U.S. equity indices steadily increased during 2006, finishing the year substantially higher than 2005. The Dow, NASDAQ and S&P ended the year with increases of 16.3%, 9.5% and 13.6%, respectively.
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 78% of separate accounts assets were invested in equity-based mutual funds at December 31, 2006. 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.
which the guaranteed benefit exceeds the variable account balance. Prolonged periods of minimal or negative investment performance may result in greater guaranteed benefit costs as compared to assumptions. If Merrill Lynch Life determines that it needs to increase its estimated long term cost of guaranteed benefits, it will result in establishing greater guaranteed benefit liabilities as compared to current practice.
Merrill Lynch Life defines credit spreads according to the Merrill Lynch U.S. Corporate Bond Index for BBB-A Rated bonds with three to five year maturities.
Despite the slow and steady increase in medium term interest rates during 2006, market valuations were favorably impacted by the tightening of credit spreads in 2006 as compared to 2005. Market valuations during 2005 were unfavorably impacted by the substantial increase in medium term interest rates.
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 are calculated under different rules than GAAP.
Merrill Lynch Life’s gross earnings are principally derived from two sources:
Policy benefits decreased $8.1 million (or 17%) to $39.2 million during 2006 as compared to $47.3 million in 2005. The following table provides the changes in policy benefits by type:
Amortization of DAC decreased $84.0 million to $42.3 million during 2006 as compared to $126.3 million in 2005 primarily as a result of period-to-period differences in DAC unlocking as noted in the Critical Accounting Policies section above. Offsetting the impact of DAC unlocking is an increase in normal amortization due to higher policy charge revenue.
Merrill Lynch Life’s effective federal income tax rate increased to 32% for 2006 from 25% for 2005 primarily due to period-to-period differences in DRD and FTC adjustments as noted in the Critical Accounting Policies section above.
Policy charge revenue increased $69.0 million (or 29%) to $305.7 million during 2005 as compared to $236.7 million in 2004 due to period-to-period differences in unearned policy charge revenue unlocking of $67.9 million as noted in the Critical Accounting Policies section above.
Net earnings derived from interest spread increased $4.0 million (or 11%) to $41.3 million during 2005 as compared to $37.3 million in 2004. The following table provides the components and changes in interest spread:
The increase in credit related gains is primarily due to one large credit related gain incurred during the third quarter 2005.
Policy benefits decreased $7.0 million (or 13%) to $47.3 million during 2005 as compared to $54.3 million in 2004. The following table provides the changes in policy benefits by type:
Reinsurance premium ceded increased $1.1 million (or 4%) to $26.3 million during 2005 as compared to $25.2 million in 2004. The increase is attributable to the reinsurance of variable annuity products containing GMIB provisions.
The products that comprise the Annuity and Life Insurance segments generally possess similar economic characteristics. As such, the financial condition and results of operations of each business segment are generally consistent with Merrill Lynch Life’s consolidated financial condition and results of operations presented herein.
Merrill Lynch Life is not dependent upon any single customer, and no single customer accounted for more than 10% of its revenues during 2006, 2005, or 2004.
The financial statements of Registrant are set forth in Part IV hereof and are incorporated herein by reference.