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, 2006, 2005 and 2004.
The most significant assumptions involved in the estimation of future gross profits are future net separate accounts performance, surrender rates and mortality rates. For variable annuities, ML of New York 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. ML of New York adopted this methodology in 2004. For variable life insurance, ML of New York 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, ML of New York 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.
Specific estimates include the realization of dividend-received deductions (“DRD”) and foreign tax credits (“FTC”). A portion of ML of New York’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.
During 2006, 2005 and 2004, ML of New York reduced its provision for federal income taxes by $0.4 million, $0.8 million and $0.6 million, respectively, due to DRD and FTC adjustments.
In February 2007, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS No. 159 provides a fair value option election that allows companies to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and liabilities, with changes in fair value recognized in earnings as they occur. SFAS No. 159 permits the fair value option election on an instrument by instrument basis at initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument. SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. Early adoption is permitted as of the beginning of a fiscal year that begins on or before November 15, 2007 provided that the entity makes that choice in the first 120 days of that fiscal year, has not yet issued financial statements for any interim period of the fiscal year of adoption, and also elects to apply the provisions of Statement No. 157, Fair Value Measurements (“SFAS No. 157”). ML of New York intends to early adopt SFAS No. 159 as of the first quarter of fiscal 2007. The adoption is not expected to have a material impact on the ML of New York’s Financial Statements.
As of December 31, 2006 ML of New York adopted Staff Accounting Bulletin (“SAB”) No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. The interpretations in the SAB provide the Staff’s views regarding the process of quantifying financial statement misstatements. Specifically, the SEC staff believes that registrants must quantify the impact on current period financial statements of correcting all misstatements, including both those occurring in the current period and the effect of reversing those that have accumulated from prior periods. Since ML of New York’s method for quantifying financial statement misstatements already considers those occurring in the current period and the effect of reversing those that have accumulated from prior periods, the adoption of the SAB did not have an impact on ML of New York’s Financial Statements.
In June 2006, 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. ML of New York will adopt FIN 48 in the first quarter of 2007. The adoption of FIN 48 is not expected to have a material impact on ML of New York’s Financial Statements.
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 $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.
ML of New York offers products in the highly competitive retirement planning market by selling variable and interest-sensitive annuity products through the retail network of Merrill Lynch, Pierce, Fenner & Smith, Incorporated, a wholly owned broker-dealer subsidiary of Merrill Lynch & Co. ML of New York competes for Merrill Lynch & Co.’s clients’ retirement planning business with i) unaffiliated insurers whose products are also sold through Merrill Lynch & Co.’s retail network, ii) insurers who solicit this business directly, and iii) other investment products sold through Merrill Lynch & Co.’s retail network. ML of New York competes in this market segment by integrating its products into Merrill Lynch & Co.’s planning-based financial management program.
At December 31, 2006, ML of New York’s assets were $1,248.5 million or $16.9 million higher than the $1,231.6 million in assets at December 31, 2005. Assets excluding separate accounts assets decreased $6.9 million (or 2%) primarily due to the $4.1 million dividend payment and a reduction in the number of fixed rate contracts inforce. Separate accounts assets, which represent 78% of total assets, increased $23.8 million (or 3%) to $970.0 million. Changes in separate accounts assets during each quarter of 2006 were as follows:
During 2006, ML of New York experienced contract owner withdrawals that exceeded deposits on all products by $93.1 million. The components of contract owner transactions were as follows:
At December 31, 2006 and 2005, approximately $132.4 million (or 100%) and $162.1 million (or 99%), respectively, of fixed maturity securities were considered investment grade. ML of New York 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 $4.9 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 $5.7 million (or 3%) of BBB- rated fixed maturity securities at December 31, 2005.
At December 31, 2006, ML of New York did not hold any fixed maturity securities that were considered below investment grade. At December 31, 2005, approximately $2.2 million (or 1%) of fixed maturity securities were considered below investment grade. Below 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. These investment grade holdings were the result of ratings downgrades on existing securities as ML of New York does not purchase below investment grade securities. ML of New York closely monitors such investments.
ML of New York’s investment in collateralized mortgage obligations (“CMO”) and mortgage backed securities (“MBS”) had a carrying value of $7.1 million and $2.6 million at December 31, 2006 and 2005, respectively.
At December 31, 2006 and 2005, approximately $5.2 million (or 74%) and $0.7 million (or 29%), respectively, of 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 financial position and/or results of operations are primarily impacted by the following economic factors: equity market performance, fluctuations in medium term interest rates, and the corporate credit environment via credit quality and fluctuations in credit spreads. The following discusses the impact of each economic factor.
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 77% 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, the Company’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 the Company’s exposure to guaranteed benefit provisions contained in the variable contracts it manufactures. Minimal or negative investment performance generally results in greater exposure to guaranteed provisions, to the extent there is an increase in the number of variable contracts (and amount per contract) in 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 ML of New York 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.
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.
ML of New York defines medium term interest rates as the average interest rate on U.S. Treasury securities with terms of 1 to 5 years.
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.
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 its cash requirements utilizing cash from operations, normal investment maturities and anticipated calls and repayments, consistent with prior years. As of December 31, 2006 and 2005, ML of New York’s assets included $169.7 million and $172.8 million, respectively, of cash, short-term investments, and investment grade publicly traded available-for-sale securities that could be liquidated if funds were required.
ML of New York recorded net earnings of $7.6 million and $5.5 million for 2005 and 2004, respectively.
Amortization of DAC decreased $3.7 million to $3.3 million during 2006 as compared to $7.0 million in 2005 primarily as a result of period-to-period differences in DAC unlocking as noted in the Critical Accounting Policies section above.
ML of New York’s effective federal income tax rate increased to 31% for 2006 from 24% for 2005 primarily due to period-to-period differences in DRD and FTC adjustments as noted in the Critical Accounting Policies section above.
The decrease in interest credited is mainly due to the reduction of fixed rate contracts inforce.
Net realized investment gains increased $1.7 million to $1.8 million during 2005 as compared to $0.1 million in 2004. The increase in net realized investment gains is primarily due to one large credit related gain incurred during the third quarter 2005.
ML of New York is not dependent upon any single customer, and no single customer accounted for more than 10% of its revenues during 2006, 2005, or 2004.