This Management’s Discussion and Analysis of Financial Condition and 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 "Merrill Lynch Life" for purposes of Items 7 and 7A).
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 earnings 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
Additionally, Merrill Lynch Life is impacted by the U.S. equity markets through its trading account investments. Merrill Lynch Life’s trading account is invested in convertible debt and convertible preferred stocks. The valuations of these types of securities are impacted by changes in value of the underlying equity security. The trading account is carried at market value with changes in market value included in earnings as a component of net realized investment losses.
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). 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. During 2002, credit spreads widened approximately 20 basis points and ended the year at 198 basis points. During 2001,
Merrill Lynch Life sells variable and interest-sensitive life insurance and annuity products through Merrill Lynch & Co.’s retail network of Financial Advisors. Merrill Lynch Life competes for Merrill Lynch & Co.’s clients’ life insurance and annuity business with unaffiliated insurers whose products are also sold through Merrill Lynch & Co.’s retail network, and with insurers who solicit this business directly. The product lines that Merrill Lynch Life offers are focused in the highly competitive market segment of retirement and death benefit planning. Merrill Lynch Life competes in this market segment by integrating its products into Merrill Lynch & Co.’s planning-based financial management program.
Merrill Lynch Life has strategically placed its marketing emphasis on the sale of variable annuities and modified guaranteed annuities. These products are designed to address the retirement planning needs of Merrill Lynch & Co.’s clients. Merrill Lynch Life offers 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 the opportunity for diversified investing in a wide selection of underlying mutual fund portfolios. Merrill Lynch Life’s variable life insurance product provides life insurance protection with maximum cash value accumulation. This product allows the contract owner to allocate the cash value of the policy to underlying diversified mutual fund portfolios. The modified guaranteed annuity products also provide tax-deferred retirement savings through guaranteed fixed interest rates for a period selected by the contract owner, but impose a market value adjustment for withdrawals prior to the expiration of the guarantee period. Total direct premiums by product type for the three years ended December 31 were as follows:
(a) Merrill Lynch Life’s L-Share variable annuity product was introduced in the fourth quarter 2001.
Merrill Lynch Life’s total direct premiums decreased $534.7 million (or 44%) during 2002, as compared to a $379.6 million (or 24%) decrease during 2001. Variable annuity premiums decreased $516.6 million (or 47%) during 2002 as compared to 2001. Management attributes the decrease in variable annuity premiums to increasing customer demand for annuity products that offer guarantee provisions, such as fixed rate products, variable products with fixed account options, variable products with guaranteed minimum income benefits, or variable products with guaranteed minimum account values. During 2002, sales of non-proprietary products with these types of guarantee features have been strong within the Merrill Lynch & Co. distribution system. During the fourth quarter 2002, Merrill Lynch Life introduced a new B-Share variable annuity product designed for the qualified market, which included a guaranteed minimum income benefit provision. Sales of the new variable annuity were $53.9 million during the eleven-week period ended December 31, 2002. Also, during the fourth quarter 2002, Merrill Lynch Life added a guaranteed minimum income benefit to its existing B-Share variable annuity.
During the third quarter 2002, Merrill Lynch Life introduced a new C-Share variable annuity product. This product differs from Merrill Lynch Life’s existing C-Share product by offering investment options managed by different investment advisors and a fee structure that varies with asset size. Sales of the new variable annuity product were $66.3 million during 2002.
Management believes that the increasing demand for annuity products with guarantee provisions has been fueled by the increasing volatility and general negative performance of the equity markets that has occurred over the past three years. As such, future sales of Merrill Lynch Life’s variable annuity products without these provisions could be negatively impacted if this trend continues.
Modified guaranteed annuity sales increased $11.5 million (or 36%) during 2002 as compared to 2001. The increase is primarily due to increasing demand for products with guarantee features, as noted above.
The continuing decline in overall credit quality among corporate bonds has placed added pressure on Merrill Lynch Life’s fixed income portfolio. As of December 31, 2002 and 2001, approximately $114.7 million (or 6%) and $83.4 million (or 4%), 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 do not have a rating equivalent to Standard and Poor’s BBB- or higher (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, 2002, approximately $233.6 million (or 13%) 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 $262.7 million (or 13%) of Merrill Lynch Life’s fixed maturity securities as of December 31, 2001. Merrill Lynch Life closely monitors such investments.
Merrill Lynch Life receives claims paying ability ratings from Standard and Poors and A.M. Best. During 2002, Standard and Poors downgraded Merrill Lynch & Co. to “A+” from “AA-”. As a result, Merrill Lynch Life’s rating was similarly downgraded to “A+”. At December 31, 2002, A.M. Best’s rating of Merrill Lynch Life was “A+”. However, the rating was downgraded to “A” during January 2003.
Merrill Lynch Life has developed a comprehensive capital management plan that will continue to provide appropriate levels of capital for the risks Merrill Lynch Life assumes, but will allow Merrill Lynch Life to reduce its absolute level of surplus. In implementing this plan, Merrill Lynch Life paid cash dividends to MLIG of $30.9 million and $65.0 million during 2002 and 2000, respectively. No dividend was paid during 2001.
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
Merrill Lynch Life amortizes deferred policy acquisition costs based on the expected future gross profits for each group of contracts. In estimating future gross profits, management makes assumptions regarding such factors as policy charge revenue, investment performance, policy lapse rates, mortality, and expenses for the expected life of each group of contracts. Actual gross profits can vary from management’s estimates resulting in increases or decreases in the rate of amortization. Management periodically updates these estimates and evaluates the recoverability of deferred policy acquisition costs. The impact of revisions to estimates on cumulative amortization is recorded as a charge or credit to current operations (commonly referred to as “DAC unlocking”). During 2002 Merrill Lynch Life reduced earnings by $27.0 million, via an increase in amortization of deferred policy acquisition costs. During 2001 Merrill Lynch Life increased earnings by $2.7 million, via a reduction in amortization of deferred policy acquisition costs.
Merrill Lynch Life recorded net earnings of $47.9 million and $78.2 million for 2002 and 2001, respectively.
Net earnings derived from interest spread decreased $3.1 million (or 4%) during 2002 as compared to 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 market value adjustment expense is attributable to a contract provision in Merrill Lynch Life’s modified guaranteed annuity products. This contract provision results in a market value adjustment to the cash surrender value of those contracts that are surrendered before the expiration of their interest rate guarantee period. During 2002, the market value adjustment expense increased $1.4 million (or 60%) as compared to 2001. The increase is primarily due to the lower interest rate environment during 2002 as compared to 2001. The market value adjustment expense has an inverse relationship to changes in interest rates.
Policy benefits increased $20.3 million (or 54%) during 2002 as compared to 2001 primarily due to increased death benefit payments incurred under guaranteed minimum death benefit provisions.
Merrill Lynch Life recorded net earnings of $78.2 million and $125.7 million for 2001 and 2000, respectively.
Net earnings derived from interest spread decreased $6.2 million during 2001 as compared to 2000. Overall, net investment income and interest credited to policyholders’ account balances continue to decline due to the reduction in fixed rate contracts inforce. The reduction in interest spread during 2001 is primarily due to a $2.4 million reduction in real estate income, as well as the reduction in invested assets resulting from the stockholder dividend payment in the fourth quarter 2000.
The increase in interest related gains is primarily attributable to increases in invested asset market valuations as compared to the same period in 2000. The increases in invested asset market valuations are primarily due to period-to-period decreases in interest rates and credit spreads.
Credit related losses included book value writedowns and asset sales of several large security holdings.
Merrill Lynch Life sold one property during 2000 that resulted in a $0.8 million gain.
The market value adjustment expense is attributable to a contract provision in Merrill Lynch Life’s modified guaranteed annuity products. This contract provision results in a market value adjustment to the cash surrender value of those contracts that are surrendered before the expiration of their interest rate guarantee period. During 2001, the market value adjustment expense increased $1.8 million as compared to 2000. The increase is primarily due to the lower interest rate environment during 2001 as compared to 2000. The market value adjustment expense has an inverse relationship to changes in interest rates.
Policy benefits increased $16.2 million (or 75%) during 2001 as compared to 2000. The increase in policy benefits is primarily due to a $15.2 million increase in variable annuity death benefit payments incurred under guaranteed minimum death benefit provisions.
Amortization of deferred policy acquisition costs increased $5.8 million (or 11%) during 2001 as compared to 2000 primarily due to period-to-period difference in DAC unlocking as noted in the Management Estimates section above. Excluding DAC unlocking, amortization of deferred policy acquisition costs decreased $7.1 million as compared to 2000. This decrease was primarily due to the decrease in asset-based policy charge revenue.
Insurance expenses and taxes increased $8.1 million (or 14%) during 2001 as compared to 2000. The increase in insurance expenses and taxes is primarily due to $10.7 million in costs related to the consolidation of Merrill Lynch Life’s policy administration service centers.