<PAGE>
[LETTERHEAD OF ERNST & YOUNG LLP APPEARS HERE]
Report of Independent Auditors
To the Board of Directors
Capitol Life Insurance Company
and Contract Owners
Capitol Life Separate Account M
We have audited the accompanying statements of assets and liabilities, including
the schedules of investments, of Capitol Life Separate Account M (comprised of
Series HI, BV, CF, RA and SV) as of December 31, 1996, and the related statement
of operations and changes in net assets for the year then ended. These
financial statements are the responsibility of the Separate Account's
management. Our responsibility is to express an opinion on these financial
statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards.
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. Our procedures
included confirmation of securities owned as of December 31, 1996, by
correspondence with the respective mutual fund managers. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Capitol Life Separate Account M
(comprised of the above referenced Series) at December 31, 1996, the results of
their operations and changes in their net assets for the year then ended, in
conformity with generally accepted accounting principles.
/s/ Ernst & Young LLP
---------------------
Ernst & Young LLP
Los Angeles, California
April 24, 1997
<PAGE>
CAPITOL LIFE SEPARATE ACCOUNT M
STATEMENT OF ASSETS AND LIABILITIES
DECEMBER 31, 1996
<TABLE>
<CAPTION>
Series HI Series BV Series CF Series RA Series SV
----------- ---------- ---------- --------- ---------
<S> <C> <C> <C> <C> <C>
ASSETS
Investments
Merrill Lynch Corporate Bond Fund, Inc. - High Income Portfolio
(2,157,134 shares at net asset value of $8.01 per share;
cost $16,219,638) $17,278,643
Merrill Lynch Basic Value Fund, Inc. (57,388 shares at net asset
value of $31.00 per share; cost $1,352,030) $1,779,017
Merrill Lynch Capital Fund, Inc. (54,528 shares at net asset value
of $31.05 per share; cost $1,410,306) $1,693,085
Merrill Lynch Ready Assets Trust (659,145 shares at net asset value
of $1.00 per share; cost $659,145) $ 659,145
Merrill Lynch Special Value Fund, Inc. (581 shares at net asset
value of $17.83 per share; cost $9,898) $ 10,362
Other assets 374 2,399
----------- ---------- ---------- --------- ---------
TOTAL ASSETS 17,278,643 1,779,017 1,693,085 659,519 12,761
</TABLE>
1
<PAGE>
CAPITOL LIFE SEPARATE ACCOUNT M
STATEMENT OF ASSETS AND LIABILITIES (Continued)
<TABLE>
<CAPTION>
Series HI Series BV Series CF Series RA Series SV
----------- ---------- ---------- --------- ---------
<S> <C> <C> <C> <C> <C>
LIABILITIES
Payable to the Capitol Life Insurance Company for mortality and
expense risk $ 15,975 $ 4,537 $ 1,575 $ 2,774 $ 1,316
Payable to the Capitol Life Insurance Company for redemptions 27,252 111 2,456 2,288 169
Other liabilities 1,213 1,084 318
----------- ---------- ---------- --------- ---------
TOTAL LIABILITIES 44,440 5,732 4,349 5,062 1,485
NET ASSETS
Cost to Investors:
Series HI Non-qualified Accumulation Units 16,175,198
Series BV Non-qualified Accumulation Units 1,346,298
Series CF Non-qualified Accumulation Units 1,405,957
Series RA Non-qualified Accumulation Units 654,457
Series SV Non-qualified Accumulation Units 10,812
Accumulated Undistributed Income
Net unrealized appreciation 1,059,005 426,987 282,779 464
----------- ---------- ---------- --------- ---------
NET ASSETS APPLICABLE TO OUTSTANDING
UNITS OF CAPITAL $17,234,203 $1,773,285 $1,688,736 $ 654,457 $ 11,276
=========== ========== ========== ========= =========
</TABLE>
The accompanying notes are an integral part of these financial statements.
2
<PAGE>
CAPITOL LIFE SEPARATE ACCOUNT M
STATEMENT OF OPERATIONS
YEAR ENDED DECEMBER 31, 1996
<TABLE>
<CAPTION>
Series HI Series BV Series CF Series RA Series SV
----------- ---------- ---------- --------- ----------
<S> <C> <C> <C> <C> <C>
INVESTMENT INCOME
Dividends $ 1,575,228 $ 131,639 $ 161,616 $ 28,931 $ 1,653
Other income (expense) (983) (5,046) (138) 456 2,554
----------- ---------- ---------- --------- ----------
1,574,245 126,593 161,478 29,387 4,207
EXPENSES
Charges for mortality and expense risk 168,300 18,737 15,981 6,050 153
----------- ---------- ---------- --------- ----------
Net Investment Income 1,405,945 107,856 145,497 23,337 4,054
REALIZED AND UNREALIZED INVESTMENT GAINS (LOSSES)
Realized investment gains (losses) (40,377) 192,916 22,776 2,543
Unrealized appreciation (depreciation) of investments 424,724 (22,865) 7,631 (7,823)
----------- ---------- ---------- --------- ----------
Net investment gains (losses) 384,347 170,051 30,407 (5,280)
----------- ---------- ---------- --------- ----------
Increase (decrease) in net assets resulting from operations $ 1,790,292 $ 277,907 $ 175,904 $ 23,337 $ (1,226)
=========== ========== ========== ========= ==========
</TABLE>
The accompanying notes are an integral part of these financial statements.
3
<PAGE>
CAPITOL LIFE SEPARATE ACCOUNT M
STATEMENT OF CHANGES IN NET ASSETS
YEAR ENDED DECEMBER 31, 1996
<TABLE>
<CAPTION>
Series HI Series BV Series CF Series RA Series SV
------------ ------------ ------------- ------------ ----------
<S> <C> <C> <C> <C> <C>
Operations
Net investment income $ 1,405,945 $ 107,856 $ 145,497 $ 23,337 $ 4,054
Net realized investment gains (losses) (40,377) 192,916 22,776 2,543
Net unrealized investment appreciation (depreciation)
during the year 424,724 (22,865) 7,631 (7,823)
------------ ------------ ------------- ------------ ----------
Increase (decrease) in net assets resulting from
operations 1,790,292 277,907 175,904 23,337 (1,226)
Decrease in net assets resulting from capital unit
transactions (1,176,518) (178,333) (51,834) (76,445) (19,059)
------------ ------------ ------------- ------------ ----------
Total increase (decrease) 613,774 99,574 124,070 (53,108) (20,285)
Net Assets at December 31, 1995 16,620,429 1,673,711 1,564,666 707,565 31,561
------------ ------------ ------------- ------------ ----------
Net Assets at December 31, 1996 $ 17,234,203 $ 1,773,285 $ 1,688,736 $ 654,457 $ 11,276
============ ============ ============= ============ ==========
</TABLE>
The accompanying notes are an integral part of these financial statements.
4
<PAGE>
CAPITOL LIFE SEPARATE ACCOUNT M
INVESTMENTS
DECEMBER 31, 1996
<TABLE>
<CAPTION>
SCHEDULE I
Carrying Value Unrealized Cost
Name of Issue Shares (Note A) Appreciation (Note B)
- -------------------------------------------------------------- ----------- -------------- ------------ ------------
<S> <C> <C> <C> <C>
Merrill Lynch Corporate Bond Fund, Inc. - High Income
Portfolio - capital shares 2,157,134 $ 17,278,643 $ 1,059,005 $ 16,219,638
Merrill Lynch Basic Value Fund, Inc. -
capital shares 57,388 $ 1,779,017 $ 426,987 $ 1,352,030
Merrill Lynch Capital Fund, Inc. -
capital shares 54,528 $ 1,693,085 $ 282,779 $ 1,410,306
Merrill Lynch Ready Assets Trust -
capital shares 659,145 $ 659,145 $ 659,145
Merrill Lynch Special Value Fund, Inc. -
capital shares 581 $ 10,362 $ 464 $ 9,898
</TABLE>
Note A The carrying value of the investments is the reported net asset
value of the investment companies capital shares.
Note B Cost is determined by using the first-in, first-out cost method.
The accompanying notes are an integral part of these financial statements.
5
<PAGE>
CAPITOL LIFE SEPARATE ACCOUNT M
NOTES TO FINANCIAL STATEMENTS (continued)
DECEMBER 31, 1996
NOTE 1 -- BASIS OF PRESENTATION
Capitol Life Separate Account M (Separate Account) was established on September
22, 1978 as a separate account of The Capitol Life Insurance Company (Capitol
Life), the sponsor company, and is qualified under the Investment Company Act of
1940 as a unit investment trust. The Separate Account is designed to provide
annuity benefits pursuant to certain variable annuity contracts (the Contracts)
issued by Capitol Life.
Capitol Life currently is not issuing any new Contracts funded in the Separate
Account, nor is it issuing any Certificates under previously issued group
Contracts funded in the Separate Account. This is because on September 25, 1981,
the Internal Revenue Service issued Revenue Ruling 81-225, which holds that the
owner of a variable annuity contract that is funded by a publicly distributed
mutual fund will be treated as the owner of the underlying mutual fund shares
for federal income tax purposes, and will not be entitled to tax deferral under
such contract. In so far as the shares of the underlying Merrill Lynch funds are
publicly distributed, Capitol Life suspended the offer and sale of the Contracts
funded in the Separate Account. Contract owners who were issued a Contract prior
to September 25, 1981 were not affected by the ruling in that their Contracts
continue to have tax - deferral status until the Contract is surrendered or
annuitized. These Contract holders can continue to shift (transfer) between the
underlying funds, but have not been allowed to put new funds in the Separate
Account since September 25, 1981.
In accordance with the terms of the Contracts, all payments allocated to the
Separate Account by the contract owners must in turn be invested by the Separate
Account in shares of any or all of five mutual funds: Merrill Lynch Corporate
Bond Fund, Inc.-High Income Portfolio, Merrill Lynch Capital Fund, Inc., Merrill
Lynch Basic Value Fund, Inc., Merrill Lynch Special Value Fund, Inc., and
Merrill Lynch Ready Assets Trust, each of which is a diversified, open-end
management investment company registered under the Investment Company Act of
1940. The Separate Account is correspondingly divided into five Series of
Accumulation Units, Series HI, Series CF, Series BV, Series SV, and Series RA,
relating to investments in the Funds respectively.
6
<PAGE>
CAPITOL LIFE SEPARATE ACCOUNT M
NOTES TO FINANCIAL STATEMENTS (continued)
DECEMBER 31, 1996
The Separate Account and each series therein are administered and accounted for
as part of the business of Capitol Life, but the investment income and capital
gains and losses of each Separate Account series are identified with the assets
held for that series in accordance with the terms of the Contracts, without
regard to investment income and capital gains and losses arising out of any
other business Capitol Life may conduct.
The Separate Account incurs no liability for remuneration to directors, advisory
boards, officers or such other persons who may from time to time perform
services for the Separate Account.
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts and disclosures in the financial statements. Actual
results could differ from these estimates.
NOTE 2 -- SIGNIFICANT ACCOUNTING POLICIES
VALUATION OF INVESTMENTS -- Investments are carried at fair value, which is
determined by multiplying the investment company's shares owned by the Separate
Account by the reported net asset value per share of each respective investment
company. Purchases and sales of investments are recorded on the transaction
date. Realized investment gains and losses are determined on the first-in,
first-out cost basis.
EXPENSES AND CHARGES -- The Separate Account accrues charges incurred for the
mortality and expense risk assumed by Capitol Life. The charges are calculated
daily by multiplying the value of the assets of the Separate Account by .000027
(1% on an annual basis). Capitol Life has the option of calling for payment of
such charges at any time.
The following charges are deducted from a contract holder's account by Capitol
Life as a capital transaction by reducing the separate account units held, and
such charges are not an expense of the Separate Account. An administration
charge (contract charge) of $20 is deducted from each contract and paid to
Capitol Life at the end of each contract year prior to the annuity date, and
when the entire contract value is withdrawn on any date other than a contract
anniversary.
7
<PAGE>
CAPITOL LIFE SEPARATE ACCOUNT M
NOTES TO FINANCIAL STATEMENTS (continued)
DECEMBER 31, 1996
NOTE 2 -- SIGNIFICANT ACCOUNTING POLICIES (continued)
In addition, transaction charges of $10 are incurred for each surrender or
annuitization. There is no contingent deferred sales charge applied against
contracts that are redeemed. Upon conversion of either accumulation or annuity
units from one series to another, a $10 conversion charge is incurred. The
amount deducted for contract charges was $6,515 for the year ended December 31,
1996.
INCOME RECOGNITION AND REINVESTMENT -- Income is recognized as declared payable
by the investment companies. All distributions received are reinvested in the
investment companies.
NOTE 3 -- FEDERAL INCOME TAXES
The operations of the Separate Account form a part of, and are taxed with, the
operations of Capitol Life, which is taxed as a "life insurance company" under
the Internal Revenue Code, and as such, Capitol Life is liable for income taxes,
if any, which become payable with respect to the Separate Account's operations.
NOTE 4 -- CAPITAL TRANSACTIONS
Additions and deductions to Units of Capital consisting of the effect of capital
share transactions and service fees, were as follows:
<TABLE>
<CAPTION>
Year Ended December 31, 1996
- ----------------------------
Additions Deductions
to Capital From Capital
$ Units $ Units
-------- ------- ---------- -------
<S> <C> <C> <C> <C>
Series HI 36,503 1,194 1,213,021 42,274
Series BV 175,858 4,365 354,191 8,199
Series CF 51,834 1,066
Series RA 205,857 13,597 282,302 18,894
Series SV 19,059 1,133
</TABLE>
8
<PAGE>
CAPITOL LIFE SEPARATE ACCOUNT M
NOTES TO FINANCIAL STATEMENTS (continued)
DECEMBER 31, 1996
NOTE 5 -- UNITS OF CAPITAL
The following are the units outstanding and corresponding unit values as of
December 31,1996.
<TABLE>
<CAPTION>
Units Unit
Description Outstanding Value
- ----------- ----------- -------
<S> <C> <C>
Series HI Non-Qualified Accumulation Units 559,213 $ 30.82
Series BV Non-Qualified Accumulation Units 37,842 46.86
Series CF Non-Qualified Accumulation Units 31,626 53.40
Series RA Non-Qualified Accumulation Units 42,581 15.37
Series SV Non-Qualified Accumulation Units 523 21.55
</TABLE>
9
