This Management’s Narrative Analysis of Results of Operations should be read in conjunction with the Financial Statements and Notes to Financial Statements included herein for the Registrant.
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, actions and initiatives taken by current and potential competitors, general economic conditions, the effects of current, pending and future legislation, regulation and regulatory actions, and the other risks and uncertainties detailed in this report. See Risk Factors that Could Affect ML of New York. 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 future filings of its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K.
ML of New York 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. ML of New York believes that the demand for retirement products containing guarantee features will continue to increase in the future. ML of New York 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. ML of New York currently offers guaranteed minimum death benefits, guaranteed minimum income benefits, and is launching guaranteed minimum withdrawal benefits in January 2006.
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 judgment 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.
ML of New York’s critical accounting policies and estimates are discussed below. See Note 1 to the Financial Statements for additional information regarding accounting policies.
ML of New York’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. ML of New York 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, 2005 and December 31, 2004, approximately, $27.2 million (or 17%) and $31.8 million (or 18%), respectively, of ML of New York’s fixed maturity and equity securities portfolio consisted of non-publicly traded securities.
ML of New York 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 ML of New York’s portfolio managers and credit analysts, information obtained from external sources (i.e. company announcements, ratings agency announcements, or news wire services) and ML of New York’s ability and intent to hold the investments for a period of time sufficient for a forecasted market price recovery up to or beyond the amortized cost of the investment. The factors that may give rise to a potential OTT impairment include, but are not limited to, i) certain credit-related events such as default of principal or interest payments by the issuer, ii) bankruptcy of issuer, iii) certain security restructurings, and iv) fair market value less than amortized cost for an extended period of time. In the absence of a readily ascertainable market value, the estimated fair value on these securities represents management’s best estimate and is based on comparable securities and other assumptions as appropriate. Management bases this determination on the most recent information available. OTT impairment losses result in a permanent reduction of the cost basis of the investment. ML of New York did not incur realized investment losses due to OTT declines in fair value for the years ended December 31, 2005 and December 31, 2004. ML of New York recorded realized investment losses due to OTT declines in fair value of $0.8 million for the year ended December 31, 2003.
and loss recognition testing at the end of each reporting period. At December 31, 2005, variable annuities and variable life insurance accounted for $15.4 million (or 67%) and $7.6 million (or 33%), respectively, of ML of New York’s DAC asset. At December 31, 2004, variable annuities and variable life insurance accounted for $19.0 million (or 68%) and $9.1 million (or 32%), respectively, of ML of New York’s DAC asset.
DAC for variable life insurance is amortized with interest over the lives of the policies in relation to the present values of estimated future gross profits from fees related to contract loans, asset-based fees, and cost of insurance charges, less claims (net of reinsurance), cost of mortality reinsurance, policy maintenance expenses, and non-capitalized commissions.
Future gross profit estimates are subject to periodic evaluation with necessary revisions applied against amortization to date. The impact of revisions and assumptions to estimates on cumulative amortization is recorded as a charge or benefit to current operations, commonly referred to as “unlocking”. Changes in assumptions can have a significant impact on the amount of DAC reported 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 returns and increases in surrender or mortality assumptions reduce the expected future profitability of the underlying business and may increase the rate of DAC amortization. For the years ended December 31, 2005, 2004 and 2003 the favorable (unfavorable) impact on pretax earnings related to unlocking on variable life insurance and annuity products was ($3.2) million, $3.0 million and ($1.0) million respectively. During 2005, ML of New York lowered its future gross profit assumptions on certain variable life insurance and annuity products by increasing future surrender and mortality rates which resulted in unfavorable unlocking. During 2004, ML of New York adopted the reversion to the mean technique for projecting future returns on separate account assets. The adoption resulted in increased equity market return assumptions which contributed to favorable unlocking. In addition to the adoption of the mean reversion technique, unlocking during 2004 was also favorably impacted by changes in lapse assumptions on variable annuity products.
ML of New York’s liability for policyholder account balances represents the contract value that has accrued to the benefit of the policyholder as of the balance sheet date. The liability is generally equal to the accumulated account deposits plus interest credited less policyholders’ withdrawals and other charges assessed against the account balance. Policyholder account balances at December 31, 2005 and 2004 were $168.9 million and $185.5 million, respectively.
On January 1, 2004, ML of New York 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 ML of New York previously employed. As a result, ML of New York recorded a $3.1 million increase in policyholder liabilities resulting in a charge to earnings of $2.0 million, net of a federal income tax benefit of $1.1 million, which was reported as a cumulative effect of a change in accounting principle during 2004. Excluding the cumulative effect of a change in accounting principle during 2004, the changes in policyholder liabilities related to SOP 03-1 did not have a
ML of New York 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. Each variable annuity product is designed to provide tax-deferred retirement savings with the opportunity for diversified investing in a wide selection of underlying mutual fund portfolios. During May 2005, ML of New York introduced a new variable annuity product line, Merrill Lynch Investor Choice Annuity (“ICA”), which replaced all new sales of existing variable annuity products. ICA provides the ability to customize variable annuity products with specific contract features, charge structures, and investment options. ICA is offered in B-Share, C-Share and L-Share classes similar to previous variable annuity products. These classes are differentiated by the surrender charge period and the types of contract fees charged to the contract owner. Additionally, ICA offers a bonus class in which a specified amount is added to the contract value with each deposit. Since its introduction, total deposits for ICA were $24.8 million.
Total direct deposits decreased $33.3 million (or 44%) to $43.0 million for the period ended December 31, 2005, as compared to the period ended December 31, 2004. During 2005, variable annuity deposits decreased $32.3 million (or 43%) to $42.1 million as compared to 2004. As noted above, ICA was not launched until May 2005. Additionally, as a result of the unique product structure and features, the sales force required specialized marketing, training and education, which extended throughout 2005. Management believes future deposits will be positively impacted by these marketing and training efforts. Further, management believes variable annuity
At December 31, 2005, ML of New York’s assets were $1,231.6 million or $49.9 million lower than the $1,281.5 million in assets at December 31, 2004. Assets excluding separate accounts assets decreased $15.8 million (or 5%) primarily due to a reduction in the number of fixed rate contracts inforce and a decrease in market values on investment securities as a result of the rising interest rate environment during 2005. Separate accounts assets, which represent 77% of total assets, decreased $34.1 million (or 3%) to $946.3 million. Changes in separate accounts assets during each quarter of 2005 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 and its investment in below investment grade fixed maturity securities are below the industry average. The following schedule identifies ML of New York’s general account invested assets by type for the years ended December 31:
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 70% of separate accounts assets are in equity-based mutual funds at December 31, 2005. Since asset-based fees collected on inforce variable contracts represent a significant source of revenue, ML of New York’s financial condition will be impacted by fluctuations in investment performance of equity-based separate accounts assets.
Fluctuations in the U.S. equity market also directly impact ML of New York’s exposure to GMDB and GMIB provisions contained in the variable annuities it manufactures. Minimal or negative investment performance generally results in greater exposure to GMDB and GMIB provisions, to the extent there is an increase in the number of variable contracts (and amount per contract) in which the GMDB and GMIB exceeds the variable account balance. Prolonged periods of minimal or negative investment performance may result in greater GMDB and GMIB expense because it may change ML of New York’s assumptions regarding the long term cost of GMDB’s and GMIB’s. If ML of New York increases its estimated long term cost of GMDB’s and GMIB’s, it will result in establishing greater GMDB and GMIB liabilities as compared to current practice. GMDB and GMIB expenses are recorded as a component of policy benefits.
The investment performance of the underlying U.S. equity-based mutual funds supporting ML of New York’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 declined during the first half of the year and spent the latter part of the year recovering. The Dow ended the year essentially unchanged from 2004. Both the S&P and the NASDAQ finished the year with modest gains of 3.0% and 1.4% respectively.
Changes in interest rates affect the value of investments, primarily fixed maturity securities and preferred equity securities, as well as interest sensitive liabilities. Changes in interest rates have an inverse relationship to the value of investments and interest sensitive liabilities. Also, since ML of New York has certain fixed products that contain guaranteed minimum crediting rates, decreases in interest rates can decrease the amount of interest spread earned by ML of New York.
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. Credit spreads represent the credit risk premiums required by market participants for a given credit quality, i.e. 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). Changes in credit spreads have an inverse relationship to the value of investments.
In order to continue to issue 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, 2005 and 2004, 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 developed a comprehensive capital management plan that will continue to provide appropriate levels of capital for the risks that assumed, but will allow ML of New York to reduce its absolute level of surplus. In implementing this plan, ML of New York paid an ordinary cash dividend of $2.5 million to MLIG during 2004. ML of New York did not pay a dividend during 2005 or 2003. Pending regulatory approval, ML of New York intends to pay a cash dividend during 2006.
ML of New York’s gross earnings are principally derived from two sources:
The decrease in life insurance mortality expense is primarily due to a decrease in the number of death claims.
The decrease in variable annuity mortality expense is due to favorable GMDB liability unlocking during 2005 as noted in the Critical Accounting Policies section above.
Reinsurance premium ceded increased $0.1 million (or 7%) to $1.8 million during 2005 as compared to $1.7 million in 2004. The increase is primarily attributable to the increased reinsurance of variable annuity products containing GMIB provisions.
Net earnings derived from interest spread decreased $0.9 million (or 30%) to $2.1 million during 2004 as compared to $3.0 million in 2003. 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 increase in credit quality of the portfolio and a higher level of call activity.
The decrease in credit related net realized losses is primarily due to the reduction in OTT declines in the carrying value of fixed maturity securities and asset sales of several large security holdings. There were no OTT declines or credit related asset sales during 2004. OTT declines were $0.8 million and losses on credit related asset sales were $1.0 million during 2003.
Policy benefits decreased $1.0 million (or 25%) to $3.0 million during 2004 as compared to $4.0 million in 2003. The following table provides the changes in policy benefits by type:
ML of New York is not dependent upon any single customer, and no single customer accounted for more than 10% of its revenues during 2005, 2004, or 2003.