Equity Price Risk - The significant decrease in the U.S. equity market that occurred after the Attacks has negatively impacted Merrill Lynch Life's earnings and future earnings via the following:
- - Increased exposure to guaranteed minimum death benefits. Due to decreasing variable contract owner account values, there is an increasing number of contracts, and amounts per contract, in which guaranteed minimum death benefits exceed those contract owner account values. This may result in greater future mortality expense given the current reduced level of variable account balances.
- - Reductions in trading account assets. Merrill Lynch Life's trading account is carried at market value with changes in market value included in earnings. The trading account is subject to equity price risk because the portfolio is invested in convertible debt and convertible preferred stocks. The valuations of these types of securities are each impacted by changes in value of the underlying equity security. Trading account losses for the month of September 2001 were $1.2 million. Trading account losses for the year ended 2001 were $1.4 million.
Merrill Lynch Life conducts its business in the life insurance and annuity markets of the financial services industry. These markets are highly regulated with particular emphasis on company solvency and sales practice monitoring.
Effective August 20, 2001, Merrill Lynch Life discontinued manufacturing and marketing estate planning life insurance products. Given both limited resources and market potential, Merrill Lynch Life could not justify the investments necessary to compete against carriers who have the scale required to make frequent improvements to their products. These factors, combined with recent estate tax legislation (discussed above), also contributed to the decision. Merrill Lynch Life's product manufacturing and marketing resources will be committed to products that Merrill Lynch Life believes has strong growth prospects, those products where Merrill Lynch Life has strategic advantages relative to other manufacturers within the Merrill Lynch & Co. distribution system, and those that leverage the marketing and distribution capabilities of Merrill Lynch & Co.'s U.S. Private Client Division. Merrill Lynch Life will continue to issue its single premium variable life insurance product that was introduced in March 2001. Also, Merrill Lynch Life remains committed to servicing all its life insurance contracts in force.
The decision to discontinue manufacturing and marketing estate planning life insurance products is not expected to have a material impact on earnings. Pre-tax earnings related to these products have historically contributed less than 6% of Merrill Lynch Life's total pre-tax earnings.
During the second quarter 2001, Merrill Lynch Life announced plans to consolidate its life and annuity policy administration service centers into one location. The objective of this initiative is to provide high quality service with a single point of contact for all of Merrill Lynch Life's touchpoints, including contract owners, Financial Advisors, District Annuity Specialists, and Wealth Management Specialists. In addition, the consolidation is consistent with Merrill Lynch & Co.'s goals of integrating for efficiency, minimizing business risk, and maximizing the client experience. The consolidation was completed during the third quarter 2001. Costs incurred related to the consolidation were $10.7 million, with the majority of these costs reported in the third quarter. Merrill Lynch Life anticipates future annual expense savings of approximately $5.5 million.
Merrill Lynch Life's financial position and/or results of operations are primarily impacted by the following economic factors:
Merrill Lynch Life defines medium term interest rates as the average interest rate on U.S. Treasury securities with terms of 1 to 10 years. During 2001, medium term interest rates decreased approximately 101 basis points to yield, on average, 4.12% at December 31, 2001.
Merrill Lynch Life's financial management is based on conservative investment and liability management and regular monitoring of its risk profile. Merrill Lynch Life also seeks to provide superior customer service and financial management to promote the competitiveness of its products. Merrill Lynch Life's customer service centers have established standards of performance that are monitored on a regular basis. Managers and employees in the customer service centers are periodically evaluated based on their performance in meeting these standards.
Merrill Lynch Life has strategically placed its marketing emphasis on the sale of variable annuities, variable life insurance products, and modified guaranteed annuities. These products are designed to address the retirement and death benefit 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 annuity contains a seven year surrender charge period, the L-Share variable annuity (introduced in the fourth quarter 2001) contains a three year surrender charge period, and the C-Share variable annuity has 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. As previously noted, Merrill Lynch Life discontinued manufacturing and marketing estate planning life insurance during the third quarter 2001. 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. The following table summarizes Merrill Lynch Life's sales activity for the three years ending December 31, 2001:
- - the decline in the equity markets from what was experienced during 2001 and 2000
As previously stated, one of Merrill Lynch Life's core goals is to provide superior customer service to its clients. As evidence of Merrill Lynch Life's commitment towards this goal Merrill Lynch Life received the DALBAR Annuity Service Award from 1997 through 2000.
Merrill Lynch & Co. offers an optional asset allocation service to Merrill Lynch Life's B-Share variable annuity contract owners. An investment advisor allocates the participating contract owner's account value among the available underlying mutual fund portfolios based on the contract owner's investment objectives and risk tolerance. Merrill Lynch Life does not receive any financial remuneration from Merrill Lynch & Co. for this service; however, management believes that its availability has had a positive effect on variable annuity sales volume.
During 2001, modified guaranteed annuity sales decreased $10.8 million (or 25%) as compared to 2000. Modified guaranteed annuity products offer a fixed interest crediting rate reflective of the current interest rate environment, thus increases or decreases in sales tend to have a direct relationship to changes in interest rates. During 2001, modified guaranteed annuity sales were negatively impacted by the lower interest rate environment as compared to 2000.
At December 31, 2001, Merrill Lynch Life's assets were $15.5 billion, or $1.0 billion lower than the $16.5 billion in assets at December 31, 2000 primarily due to a decrease in separate accounts assets. During the same period, separate accounts assets decreased $1.1 billion (or 9%) to $11.3 billion primarily due to unfavorable investment performance associated with the general decline in the U.S. equity market. Reductions in variable annuity sales also contributed to the decrease in separate accounts assets. Changes in separate account assets during 2001 by quarter were as follows:
Merrill Lynch Life maintains a conservative general account investment portfolio. Merrill Lynch Life's investment in non-investment grade fixed maturity securities and real estate are below the industry average. The following schedule identifies Merrill Lynch Life's general account invested assets by type:
Merrill Lynch Life has exposure to selected emerging markets that include securities issued by sovereigns or corporations of Asia (excluding Japan), Eastern Europe, Latin America and Mexico. At December 31, 2001, Merrill Lynch Life held $77.4 million in emerging market securities with an approximate unrealized loss of $3.5 million.
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, 2001, Merrill Lynch Life had accrued an estimated net liability for future guaranty fund assessments of $8.4 million. Merrill Lynch Life regularly monitors public information regarding insurer insolvencies and adjusts its estimated liability as appropriate. During 2001, Merrill Lynch Life determined that its estimated liability was in excess of amounts required to fund future assessments and reduced the liability by $2.5 million.
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, 2001, Merrill Lynch Life's assets included $2.2 billion of cash, short-term investments and investment grade publicly traded available-for-sale securities that could be liquidated if funds were required.
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, 2001 and 2000, based on the RBC formula, Merrill Lynch Life's total adjusted capital level was well in excess of the minimum amount of capital required to avoid regulatory action.
Merrill Lynch Life has received claims paying ability ratings from the major insurance rating agencies as follows: A.M. Best - "A+" and Standard and Poors - "AA-".
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 Lynch Life's future marketing efforts could be hampered should its parent and/or affiliates be unwilling to commit additional funding.
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. During 2001 and 2000, Merrill Lynch Life credited earnings, via a reduction in amortization of deferred policy acquisition costs, $2.7 million and $15.6 million, respectively.
Merrill Lynch Life's gross earnings are principally derived from two sources:
- - the net earnings from investment of fixed rate life insurance and annuity contract owner deposits less interest credited to contract owners, commonly known as interest spread
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.
(2) Credit related losses included book value writedowns and asset sales of several large security holdings.
Amortization of deferred policy acquisition costs increased $5.8 million (or 11%) during 2001 as compared to 2000. Excluding the impact of the retrospective adjustments of deferred policy acquisition costs recorded in 2001 and 2000 (see Management Estimates, above), 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.
(1) The decrease in interest related gains is primarily attributable to a 76% reduction in sales of investments supporting fixed rate contracts. The decrease in current year sales is due to lower surrender activity on fixed rate products as compared to 1999, as well as an overall reduction in trading activity.
(2) Prior year credit related losses included book value writedowns and asset sales of several large security holdings.
The market value adjustment expense is attributable to 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 2000, the market value adjustment expense decreased $1.9 million (or 80%) as compared to 1999, primarily due to the generally higher interest rate environment during 2000 as compared to 1999. The market value adjustment expense has an inverse relationship to changes in interest rates.
Policy benefits decreased $11.4 million (or 34%) as compared to 1999, primarily due to a reduction in mortality benefit accrual accumulations.
Amortization of deferred policy acquisition costs decreased $12.1 million (or 18%) during 2000 as compared to 1999. The retrospective adjustment of deferred policy acquisition costs that occurred during 2000 resulted in a $14.5 million decrease in amortization of deferred policy acquisition costs as compared to 1999 (see Management Estimates, above). Excluding this adjustment, amortization of deferred policy acquisition costs increased $2.4 million as compared to 1999 primarily due to the growth in policy charge revenue.
Insurance expenses and taxes increased $4.2 million (or 8%) during 2000 as compared to 1999. During 2000, Merrill Lynch Life's liability for guaranty fund assessments was determined to be in excess of amounts required resulting in a $5.8 million reduction in guaranty fund expenses. Excluding this adjustment, insurance expenses and taxes increased $10.0 million during 2000 as compared to 1999. The increase is primarily due to increases in employee related expense allocations from Merrill Lynch & Co., expenditures related to financial systems enhancements, and non-capitalizable asset-based commissions paid on inforce life and annuity contracts.
The products that comprise the Life Insurance and Annuity segments generally possess similar economic characteristics. As such, the financial condition and results of operations of each business segment are generally consistent with Merrill Lynch Life's consolidated financial condition and results of operations presented herein.