The Registrant’s home office is located in Little Rock, Arkansas. In addition, personnel performing services for the Registrant pursuant to its Management Services Agreement operate in MLIG office space. MLIG occupies certain office space in Pennington, New Jersey through Merrill Lynch & Co. An allocable share of the cost of each of these premises is paid by the Registrant through the service agreement with MLIG. Merrill Lynch Insurance Group Services, Inc. (“MLIGS”), an affiliate of MLIG, owns office space in Jacksonville, Florida. MLIGS also leases certain office space in Springfield, Massachusetts from Picknelly Family Limited Partnership. During 2001, MLIGS consolidated operations into the Jacksonville, Florida location. MLIGS continues to lease the office space in Springfield, Massachusetts, although there are no personnel at that location.
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 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 product guarantees with the introduction of its new variable annuity product line during 2005. Merrill Lynch Life currently offers guaranteed minimum death benefits, guaranteed minimum income benefits, and is launching guaranteed minimum withdrawal benefits in January 2006.
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.
Changes in the fair value of fixed maturity and equity securities are reported as a component of accumulated other comprehensive income (loss) on the Balance Sheets and are not reflected in the Statements of Earnings until a sale transaction occurs or when declines in fair value are deemed other-than-temporary.
Merrill Lynch Life 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 Merrill Lynch Life’s portfolio managers and credit analysts, information obtained from external sources (i.e. company announcements, ratings agency announcements, or news wire services) and Merrill Lynch Life’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. Merrill Lynch Life recorded realized investment losses due to OTT declines in fair value of $1.9 million, $2.1 million and $9.1 million for the years ended December 31, 2005, 2004 and 2003, respectively.
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 assumption 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.
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 pre-tax earnings related to unlocking on variable life insurance and annuity products was ($81.9) million, $41.3 million, and ($21.9) million, respectively. During 2005, Merrill Lynch Life lowered its future gross profit assumptions on certain variable life insurance and annuity products by increasing future surrender and mortality rates. Additionally, variable life insurance was impacted by the revision of projected reinsurance premiums and recoveries on certain products. These assumption changes resulted in unfavorable unlocking. During 2004, Merrill Lynch Life adopted the reversion to the mean technique for projecting future investment 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.
Merrill Lynch Life’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 $2.2 billion and $2.3 billion, respectively.
Future policy benefits are actuarially determined reserves, which are calculated to meet future obligations and are generally payable over an extended period of time. Principle assumptions used in the establishment of liabilities for future policy benefits are mortality, surrender rates, policy expenses, investment yields and inflation. These estimates and assumptions are influenced by historical experience, current developments and anticipated market trends. At December 31, 2005 and 2004, future policy benefits were $420.5 million and $439.1 million, respectively. Included within future policy benefits are liabilities for GMDB and guaranteed minimum income benefit (“GMIB”) provisions contained in the variable products that Merrill Lynch Life issues. See Note 6 to the Financial Statements for further discussion of GMDB and GMIB liabilities as well as period-to-period differences in unlocking.
At December 31, 2005 and December 31, 2004, Merrill Lynch Life’s unearned policy charge revenue liability was $45.6 million and $112.2 million, respectively.
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.
In September 2005, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued SOP 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts.” SOP 05-1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97. The SOP defines an internal replacement as a modification in product benefits, features, rights, or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. This SOP is effective for internal replacements occurring in fiscal years
beginning after December 15, 2006. Merrill Lynch Life will adopt SOP 05-1 on January 1, 2007. Merrill Lynch Life is currently assessing the Financial Statement impact related to the adoption of SOP 05-1.
Total direct deposits decreased $63.9 million (or 8%) to $711.4 million for the period ended December 31, 2005, as compared to the period ended December 31, 2004. During 2005, variable annuity deposits decreased $57.7 million (or 8%) to $677.4 million as compared to 2004. As noted above, ICA was not launched until March 2005 with certain state approvals added subsequently. 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.
At December 31, 2005, Merrill Lynch Life’s assets were $14.4 billion or $389.3 million lower than the $14.8 billion in assets at December 31, 2004. Assets excluding separate accounts assets decreased $253.7 million (or 7%) 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 76% of total assets, decreased $135.6 million (or 1%) to $10.9 billion. Changes in separate accounts assets during each quarter of 2005 were as follows:
During 2005, Merrill Lynch Life experienced contract owner withdrawals that exceeded deposits on all products by $946.1 million. The components of contract owner transactions were as follows:
Merrill Lynch Life’s investment in collateralized mortgage obligations (“CMO”) and mortgage backed securities (“MBS”) had a carrying value of $22.7 million and $22.0 million at December 31, 2005 and 2004, respectively. At December 31, 2005 and 2004, approximately $7.6 million (or 34%) and $11.7 million (or 53%), 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 corporate securities with similar credit ratings.
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, 2005 and 2004, Merrill Lynch Life’s estimated net liability for future guaranty fund assessments was $6.8 and $7.1 million, respectively. Merrill Lynch Life regularly monitors public information regarding insurer insolvencies and adjusts its estimated liability as appropriate.
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.
During 2005 asset-based policy fees increased $3.9 million (or 2%) while average variable account balances increased $96.8 million (or 1%) to $10.8 billion as compared to 2004.
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 Merrill Lynch Life has certain fixed products that contain guaranteed minimum crediting rates, decreases in interest rates can decrease the amount of interest spread earned by Merrill Lynch Life.
Interest rates continued to trend upward and the yield curve flattened throughout 2005, at times becoming inverted. The U.S. Federal Reserve System’s Federal Open Market Committee raised the federal funds rate eight times during 2005 to 4.25%, up from 2.25%. The successive increases in short-term interest rates raised the medium-term interest rate to 4.36% at December 31, 2005 as compared to 3.16% at December 31, 2004. Merrill Lynch Life defines medium term interest rates as the average interest rate on U.S. Treasury securities with terms of 1 to 5 years.
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. 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.
Merrill Lynch Life’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. Merrill Lynch Life 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. Merrill Lynch Life anticipates funding all its cash requirements utilizing cash from operations, normal investment maturities and anticipated calls and repayments, consistent with prior years. As of December 31, 2005 and 2004, Merrill Lynch Life’s assets included $2.0 billion and $2.1 billion, respectively, of cash, short-term investments, and investment grade publicly traded available-for-sale securities that could be liquidated if funds were required.
During 2000, Merrill Lynch Life committed to participate in a limited partnership. As of December 31, 2005, $9.8 million had been advanced towards the $10.0 million commitment to the limited partnership. The contractual commitment expires June 2006.
Merrill Lynch Life receives claims paying ability ratings from Standard and Poors and A.M. Best. At December 31, 2005, Merrill Lynch Life 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, 2004.
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 2005, the market value adjustment expense decreased $1.9 million (or 69%) to $0.8 million as compared to $2.7 million in 2004. The decrease in market value adjustment expense is primarily due to the higher interest rate environment during 2005 as compared to 2004. The market value adjustment expense has an inverse relationship to changes in interest rates.
During 2005 life insurance mortality expense was favorably impacted by a decrease in net amount at risk per death claim as compared to 2004. Additionally, Merrill Lynch Life performed an analysis on its incurred but not reported (“IBNR”) claim liability during 2004. Based on mortality experience, Merrill Lynch Life increased its IBNR liability by $2.1 million during 2004.
Merrill Lynch Life’s effective federal income tax rate decreased to 25% for 2005 from 30% for 2004 primarily due to period-to-period differences in DRD and FTC adjustments as noted in the Critical Accounting Policies section above.
Decreases in credit related net realized losses are primarily due to the reduction in OTT declines in the carrying value of fixed maturity securities and asset sales of several large security holdings. OTT declines during 2004 were $2.1 million. OTT declines were $9.1 million and losses on credit related asset sales were $3.2 million during 2003.
The decrease in variable annuity mortality expense is due to decreased death benefit expense incurred under GMDB provisions due to improving equity markets.
Amortization of DAC decreased $71.5 million (or 94%) to $4.9 million during 2004 as compared to $76.4 million in 2003. Excluding the impact of period-to-period differences in DAC unlocking as noted in the Critical Accounting Policies section above, amortization of DAC decreased $8.3 million as compared to 2003. The decrease is primarily due to the increased life insurance mortality expense.
Merrill Lynch Life’s effective federal income tax rate increased to 30% for 2004 from 25% for 2003 primarily due to period-to-period differences in DRD and FTC adjustments as noted in the Critical Accounting Policies section above.
Merrill Lynch Life’s operating results are categorized into two business segments: Life Insurance and Annuities. Merrill Lynch Life’s Life Insurance segment consists of variable life insurance products and interest-sensitive life products. Merrill Lynch Life’s Annuity segment consists of variable annuities and interest-sensitive annuities. The “Other” earnings category represents earnings on invested assets that do not support contract owner liabilities.