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 (referred to as “ML of New York” for purposes of Items 7 and 7A).
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, Industry Environment, Regulatory Environment, Tax Legislation, and Economic Environment sections listed below, as well as actions and initiatives taken by both 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 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 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.
The financial services industry continues to be affected by an intensifying competitive environment, as demonstrated by consolidation through mergers, competition from new and established competitors, and diminishing margins in many mature products and services.
The financial services industry is also impacted by the regulatory and legislative environment. In 2003 and 2004, additional aspects of the Sarbanes-Oxley Act of 2002 were implemented as rules relating to corporate governance, auditor independence and disclosure became effective and/or were adopted in their final form. Various federal and state securities regulators and self-regulatory organizations (including the Securities and Exchange Commission, New York Stock Exchange, and the NASD, Inc.), as well as industry participants continued to review and, in many cases, adopt changes to their established rules and policies in areas such as corporate governance, mutual fund trading, mutual fund and variable annuity distribution practices, disclosure practices and auditor independence.
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 for each equity market index for the years ended December 31 as compared to the prior year ended December 31:
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. During 2004, positive investment performance contributed to an increase in asset-based policy charge revenue of $1.8 million and a decrease in GMDB expense of $0.6 million as compared to 2003.
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, 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). Changes in credit spreads have an inverse relationship to the value of investments.
ML of New York’s principal investments are available-for-sale fixed maturity securities as defined by Statement of Financial Accounting Standards (“SFAS”) No. 115, Accounting for Certain Investments in Debt and Equity Securities. The fair value of publicly traded fixed maturity 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 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, 2004 and 2003, approximately, $31.8 million (or 18%) and $22.6 million (or 12%), respectively, of ML of New York’s fixed maturity securities portfolio consisted of non-publicly traded securities.
New York’s DAC asset. At December 31, 2003, variable annuities and variable life insurance accounted for $14.8 million (or 59%) and $10.2 million (or 41%), respectively, of ML of New York’s DAC asset.
DAC for variable annuities is amortized with interest over the lives of the policies in relation to the present values of estimated future gross profits from asset-based fees, contract fees, and surrender charges, less a provision for GMDB expenses, policy maintenance expenses, and non-capitalized commissions.
Future gross profit estimates are subject to periodic evaluation by ML of New York, 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, commonly referred to as “DAC unlocking”. See Note 4 to the Financial Statements for period-to-period differences in DAC unlocking. During 2004, ML of New York elected to adopt new assumptions for market returns associated with assets held in the ML of New York variable annuity separate accounts. If returns over a determined historical period differ from the ML of New York long-term assumption, returns for future determined periods are calculated so that the long-term assumption is achieved. This method for projecting market returns is known as reversion to the mean, a standard industry practice. ML of New York previously established estimates for market returns based on actual historical results and on future anticipated market returns without the use of a mean reversion technique. 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 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.
ML of New York establishes liabilities for amounts payable for its life insurance and annuity contracts. At December 31 2004 and 2003, life and annuity policyholder liabilities were $207.6 million and $216.2 million, respectively. These liabilities are actuarially determined reserves, which are calculated to meet ML of New York’s future obligations. Reserves are calculated using actuarial methods and mortality tables in general use in the United States and in accordance with SFAS 60, Accounting and Reporting by Insurance Enterprises, SFAS 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments, and Statement of Position (“SOP”) 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts. Inherent in these standards are estimates and assumptions regarding mortality, surrender rates, policy expenses, investment yields, and inflation. These estimates and assumptions are influenced by ML of New York’s historical experience, current developments, and anticipated market trends. Changes in actuarial
estimates and assumptions or differences between actual and expected experience can significantly affect ML of New York’s reserve liabilities and subsequently impact future operations.
Specific estimates include the realization of the dividend-received deduction (“DRD”) and the foreign tax credit (“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, 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. See Note 6 to the Financial Statements for period-to-period differences in DRD and FTC adjustments.
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 requires the establishment of a liability for contracts that contain death or other insurance benefits using a reserve methodology that is 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. For the year ended December 31, 2004, changes in policyholder liabilities, excluding the change in accounting principle, did not have a material impact on ML of New York’s Statements of Earnings.
In March 2004, the Emerging Issues Task Force (“EITF”) reached a final consensus on Issue 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. EITF 03-1 requires that when the fair value of an investment security is less than its carrying value, an impairment exists for which the determination must be made as to whether the impairment is other-than-temporary. The EITF 03-1 impairment model applies to all investment securities accounted for under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and to investment securities accounted for under the cost method to the extent an impairment indicator exists. Under the guidance, the determination of whether an impairment is other-than-temporary and therefore would result in a recognized loss depends on market conditions and management’s intent and ability to hold the securities with unrealized losses. In September 2004, the Financial Accounting Standards Board (“FASB”) approved FASB Staff Position EITF 03-1, which defers the effective date for recognition and measurement guidance contained in EITF 03-1 until certain issues are resolved. The impact on ML of New York’s Financial Statements will be determined when the final EITF 03-1 is issued. ML of New York will adopt the guidance at the time it is issued. ML of New York previously implemented the disclosure requirements of EITF 03-1 in its 2003 Financial Statements. See Note 3 to the Financial Statements for additional information.
ML of New York sells 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 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. ML of New York 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 offer a guaranteed minimum income benefit (“GMIB”) provision and contain a seven year surrender charge period, L-Share variable annuities do not offer a GMIB provision and contain a three year surrender charge period, and C-Share variable annuities do not offer a GMIB provision and have no surrender charge period. All variable annuity products offer some form of GMDB. Each variable annuity product provides tax-deferred retirement savings with the opportunity for diversified investing in a wide selection of underlying mutual fund portfolios. In addition, ML of New York issues a modified guaranteed annuity product. 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.
Policy and contract surrenders increased $23.0 million (or 28%) to $104.6 million during 2004 as compared to 2003. During 2004, variable annuity surrenders increased $21.4 million (or 43%) to $70.6 million as compared to 2003. Management attributes the increase in variable annuity surrenders to the increasing consumer demand for variable annuity products containing guaranteed living benefit provisions. As contracts reach the end of their surrender charge period, contract owners are more willing to surrender variable annuities without guaranteed living benefit provisions in favor of variable annuities with guaranteed living benefit provisions. In addition, variable life surrenders increased $5.0 million (or 23%) to $26.1 million during 2004. The increase in variable life surrenders primarily represents movement by contract owners to other insurance products issued by insurance companies unaffiliated with ML of New York. As previously noted, ML of New York no longer manufactures life insurance products.
At December 31, 2004, ML of New York had 1,853 life insurance and annuity contracts inforce with interest rate guarantees. The estimated average rate of interest credited on behalf of contract owners was 4.30% and 4.35% during 2004 and 2003, respectively. Invested assets supporting liabilities with interest rate guarantees had an estimated average effective yield of 4.43% and 4.82% during 2004 and 2003, respectively. The number of life insurance and annuity contracts inforce with interest rate guarantees decreased 152 (or 8%) as compared to 2003.
(1) The long-term liabilities include policyholder liabilities for which ML of New York believes the amount and timing of the payments are essentially fixed and determinable. These amounts primarily relate to contracts where ML of New York is currently making payments to policyholders and will continue to do so until the occurrence of a specific event.
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.
ML of New York receives claims paying ability ratings from Standard and Poors and A.M. Best. At December 31, 2004, ML of New York received ratings from Standard and Poors and A.M. Best of “A+” and “A”, respectively. These ratings were unchanged from the ratings at December 31, 2003.
During June 2003, ML of New York and Merrill Lynch & Co. executed a “keepwell” agreement. The agreement obligates Merrill Lynch & Co. to maintain a level of capital in ML of New York in excess of minimum regulatory capital requirements.
(2) 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.
(2) The decrease is due to decreased death benefit expense incurred under GMDB provisions due to improving equity markets.
Reinsurance premium ceded increased $0.1 million (or 9%) to $1.7 million during 2004 as compared to $1.6 million in 2003. Reinsurance premium ceded related to ML of New York’s annuity products increased $0.2 million during 2004 as compared to 2003. The increase is attributable to the reinsurance of variable annuity products containing GMIB provisions. Reinsurance premium ceded related to ML of New York’s life insurance products decreased $0.1 million during 2004 as compared to 2003. The decrease is attributable to the decrease in life insurance inforce.
Amortization of DAC decreased $4.0 million (or 83%) to $0.8 million during 2004 as compared to $4.8 million in 2003 primarily due to period-to-period differences in DAC unlocking as noted in the Critical Accounting Policies section above. Excluding DAC unlocking, amortization of DAC remained relatively unchanged during 2004 as compared to 2003.
ML of New York’s effective federal income tax rate increased to 29% for 2004 from 28% for 2003 primarily due to period-to-period differences in DRD and FTC adjustments as noted in the Critical Accounting Policies section above.
Amortization of DAC decreased $0.7 million (or 12%) to $4.8 million during 2003 as compared to $5.5 million in 2002 primarily due to period-to-period differences in DAC unlocking as noted in the Critical Accounting Policies section above. Excluding DAC unlocking, amortization of DAC remained relatively unchanged during 2003 as compared to 2002.
GMDB tax reserves. The reserve fluctuations have resulted in a decreased deferred tax expense during 2003 as compared to 2002.