The investment performance of the underlying U.S. equity-based mutual funds supporting Merrill Lynch Life’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 in the overall U.S. equity market. During 2004, positive investment performance contributed to an increase in asset-based policy charge revenue of $21.7 million and a decrease in GMDB expense of $17.5 million as compared to 2003. Despite positive investment performance, Merrill Lynch Life’s trading account produced $1.4 million in net realized investment gains in 2004, a decrease of $2.3 million as compared to 2003.
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 2004, the Federal Reserve Board increased the federal funds effective rate from .94% at December 31, 2003 to 1.97% at December 31, 2004. The successive increases in the short term interest rates raised the medium term interest rate yield to 3.44% at December 31, 2004 as compared to 2.60% at December 31, 2003. 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.
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, 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.
Merrill Lynch Life establishes liabilities for amounts payable for its life insurance and annuity contracts. At December 31 2004 and 2003, life and annuity policyholder liabilities were $2.8 billion and $2.9 billion, respectively. These liabilities are actuarially determined reserves, which are calculated to meet Merrill Lynch Life’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 Merrill Lynch Life’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 Merrill Lynch Life’s reserve liabilities and subsequently impact future operations.
Merrill Lynch Life 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. Merrill Lynch Life competes for Merrill Lynch & Co.’s clients’ 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 planning. Merrill Lynch Life competes in this market segment by integrating its products into Merrill Lynch & Co.’s planning-based financial management program.
Reinsurance premium ceded increased $2.6 million (or 11%) to $25.2 million during 2004 as compared to $22.6 million in 2003. Reinsurance premium ceded related to Merrill Lynch Life’s annuity products increased $3.4 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 Merrill Lynch Life’s life insurance products decreased $0.8 million during 2004 as compared to 2003. The decrease is attributable to the decrease in life insurance inforce.