<PAGE>
PROSPECTUS
SEPTEMBER 26, 1997
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.
P.O. Box 9011, Princeton, New Jersey 08543-9011 . Phone No. (609) 282-2800
----------------
Merrill Lynch Variable Series Funds, Inc. (the "Company") is an open-end
management investment company which has a wide range of investment objectives
among its sixteen separate funds. Those funds offered pursuant to this
Prospectus are hereinafter referred to as the "Funds" or individually as a
"Fund". Two separate classes of common stock ("Common Stock"), Class A Common
Stock and Class B Common Stock, are issued for each Fund. The Company is
offering shares of its Class A Common Stock pursuant to this Prospectus.
The shares of the Funds are sold to separate accounts ("Separate Accounts")
of certain insurance companies (the "Insurance Companies") to fund benefits
under variable annuity contracts ("Variable Annuity Contracts") and/or
variable life insurance contracts (together with the Variable Annuity
Contracts, the "Contracts") issued by such companies. The Insurance Companies
will redeem shares to the extent necessary to provide benefits under the
respective Contracts or for such other purposes as may be consistent with the
respective Contracts. Certain insurance companies are wholly owned
subsidiaries of Merrill Lynch & Co., Inc., as is the Company's investment
adviser, Merrill Lynch Asset Management, L.P. (the "Investment Adviser"). The
investment objectives and certain investment policies of the Funds, each of
whose name is preceded by "Merrill Lynch," are as follows:
PRIME BOND FUND. As high a level of current income as is consistent with
prudent investment management, and as a secondary objective, capital
appreciation when consistent with the foregoing objective, by investing
primarily in long-term corporate bonds rated A or better by either Moody's
Investors Service, Inc. ("Moody's") or Standard & Poor's Ratings Group
("Standard & Poor's").
HIGH CURRENT INCOME FUND. As high a level of current income as is
consistent with its investment policies and prudent investment management,
and as a secondary objective, capital appreciation when consistent with the
foregoing objective. The Fund invests principally in fixed-income
securities that are rated in the lower rating categories of the established
rating services or in unrated securities of comparable quality.
SPECIAL VALUE FOCUS FUND (FORMERLY, THE EQUITY GROWTH FUND). Long-term
capital growth by investing primarily in common shares of small companies
and of emerging growth companies regardless of size.
INTERNATIONAL EQUITY FOCUS FUND. Capital appreciation and, secondarily,
income, through investment in securities, principally equities, of issuers
in countries other than the United States.
AMERICAN BALANCED FUND. A level of current income and a degree of
stability of principal not normally available from an investment solely in
equity securities and the opportunity for capital appreciation greater than
is normally available from an investment solely in debt securities by
investing in a balanced portfolio of fixed income and equity securities.
THE HIGH CURRENT INCOME AND INTERNATIONAL EQUITY FOCUS FUNDS MAY INVEST IN
HIGH YIELD-HIGH RISK SECURITIES INCLUDING HIGH YIELD BONDS (COMMONLY KNOWN AS
"JUNK BONDS"), WHICH INVOLVE SPECIAL RISKS. SEE "INVESTMENT OBJECTIVES AND
POLICIES OF THE FUNDS--RISKS OF HIGH YIELD SECURITIES."
----------------
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION NOR HAS THE SECURITIES AND EXCHANGE COMMISSION PASSED
UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO
THE CONTRARY IS A CRIMINAL OFFENSE.
----------------
THIS PROSPECTUS SETS FORTH IN CONCISE FORM THE INFORMATION ABOUT THE COMPANY
THAT A PROSPECTIVE INVESTOR SHOULD KNOW BEFORE INVESTING IN THE COMPANY.
INVESTORS SHOULD READ AND RETAIN THIS PROSPECTUS FOR FUTURE REFERENCE. A
STATEMENT CONTAINING ADDITIONAL INFORMATION ABOUT THE COMPANY HAS BEEN FILED
WITH THE SECURITIES AND EXCHANGE COMMISSION IN A STATEMENT OF ADDITIONAL
INFORMATION, DATED APRIL 25, 1997, AND IS AVAILABLE ON REQUEST AND WITHOUT
CHARGE BY CALLING OR WRITING THE COMPANY AT THE ADDRESS AND TELEPHONE NUMBER
SET FORTH ABOVE. THE STATEMENT OF ADDITIONAL INFORMATION IS HEREBY
INCORPORATED BY REFERENCE INTO THIS PROSPECTUS.
----------------
MERRILL LYNCH ASSET MANAGEMENT--INVESTMENT ADVISER
MERRILL LYNCH FUNDS DISTRIBUTOR, INC.--DISTRIBUTOR
<PAGE>
For more information on the Funds' investment objectives and policies,
please see "Investment Objectives and Policies of the Funds," page 8.
NO PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY
REPRESENTATIONS, OTHER THAN THOSE CONTAINED IN THIS PROSPECTUS AND IN THE
STATEMENT OF ADDITIONAL INFORMATION, IN CONNECTION WITH THE OFFER MADE BY THIS
PROSPECTUS, AND, IF GIVEN OR MADE, SUCH OTHER INFORMATION OR REPRESENTATIONS
MUST NOT BE RELIED UPON AS HAVING BEEN AUTHORIZED BY THE FUND OR ITS
DISTRIBUTOR. THIS PROSPECTUS DOES NOT CONSTITUTE AN OFFER TO SELL OR A
SOLICITATION OF AN OFFER TO BUY BY THE FUND OR BY THE DISTRIBUTOR IN ANY STATE
IN WHICH SUCH OFFER TO SELL OR SOLICITATION OF AN OFFER TO BUY MAY NOT
LAWFULLY BE MADE.
----------------
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Financial Highlights....................................................... 3
The Insurance Companies.................................................... 8
Investment Objectives and Policies of the Funds............................ 8
Directors.................................................................. 19
Investment Adviser......................................................... 20
Portfolio Transactions and Brokerage....................................... 21
Purchase of Shares......................................................... 22
Redemption of Shares....................................................... 22
Dividends, Distributions and Taxes......................................... 22
Performance Data........................................................... 23
Additional Information..................................................... 24
Appendix A................................................................. A-1
Appendix B................................................................. B-1
</TABLE>
2
<PAGE>
FINANCIAL HIGHLIGHTS
The financial information in the tables below has been audited in
conjunction with annual audits of the financial statements of each of the
Company's Funds by Deloitte & Touche LLP, independent auditors. Financial
Statements and the independent auditors' report thereon for the fiscal year
ended December 31, 1996 are included in the Statement of Additional
Information. The following per share data and ratios have been derived from
information provided in the Company's audited financial statements. Further
information about the performance of the Company is contained in the Company's
most recent annual report to shareholders which may be obtained, without
charge, by calling or by writing the Company at the telephone number or
address on the front cover of this prospectus.
<TABLE>
<CAPTION>
AMERICAN BALANCED FUND
--------------------------------------------------------------------------------------
FOR THE
PERIOD
JUNE 1,
FOR THE YEAR ENDED DECEMBER 31, 1988+ TO
------------------------------------------------------------------------ DECEMBER 31,
1996 1995 1994 1993 1992 1991 1990 1989 1988
-------- -------- -------- -------- ------- ------ ------ ------ ------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
INCREASE (DECREASE) IN
NET ASSET VALUE:
PER SHARE OPERATING
PERFORMANCE:
Net asset value,
beginning of period.... $ 15.17 $ 13.08 $ 14.08 $ 12.85 $ 12.82 $11.26 $11.74 $10.41 $10.00
-------- -------- -------- -------- ------- ------ ------ ------ ------
Investment income--net.. .53 .59 .48 .32 .31 .47 .47 .44 .29
Realized and unrealized
gain (loss) on
investments and foreign
currency transactions--
net.................... .89 2.06 (1.06) 1.37 .37 1.76 (.35) 1.40 .12
-------- -------- -------- -------- ------- ------ ------ ------ ------
Total from investment
operations............. 1.42 2.65 (.58) 1.69 .68 2.23 .12 1.84 --
-------- -------- -------- -------- ------- ------ ------ ------ ------
Less dividends and
distributions:
Investment income--
net................... (.56) (.56) (.37) (.34) (.37) (.49) (.46) (.50) --
Realized gain on
investments--net...... (.02) -- -- (.12) (.28) (.18) (.14) (.01) --
In excess of realized
gain on investments--
net................... -- -- (.05) -- -- -- -- -- --
-------- -------- -------- -------- ------- ------ ------ ------ ------
Total dividends and
distributions.......... (.58) (.56) (.42) (.46) (.65) (.67) (.60) (.51) --
-------- -------- -------- -------- ------- ------ ------ ------ ------
Net asset value, end of
period................. $ 16.01 $ 15.17 $ 13.08 $ 14.08 $ 12.85 $12.82 $11.26 $11.74 $10.41
======== ======== ======== ======== ======= ====== ====== ====== ======
TOTAL INVESTMENT
RETURN:**
Based on net asset value
per share.............. 9.73% 20.81% (4.19%) 13.49% 5.72% 20.65% 1.22% 18.11% 4.10%#
======== ======== ======== ======== ======= ====== ====== ====== ======
RATIOS TO AVERAGE NET
ASSETS:
Expenses, net of
reimbursement.......... .60% .61% .63% .70% .97% 1.20% 1.25% 1.25% 1.25%*
======== ======== ======== ======== ======= ====== ====== ====== ======
Expenses................ .60% .61% .63% .70% .97% 1.20% 1.50% 2.29% 1.25%*
======== ======== ======== ======== ======= ====== ====== ====== ======
Investment income--net.. 3.39% 4.22% 3.95% 3.20% 3.71% 4.16% 4.71% 4.71% 5.13%*
======== ======== ======== ======== ======= ====== ====== ====== ======
SUPPLEMENTAL DATA:
Net assets, end of
period (in thousands).. $212,047 $212,912 $158,951 $115,420 $24,918 $7,937 $5,675 $3,854 $2,276
======== ======== ======== ======== ======= ====== ====== ====== ======
Portfolio turnover...... 236.50% 38.40% 35.36% 12.55% 36.34% 50.82% 23.52% 37.60% 2.04%
======== ======== ======== ======== ======= ====== ====== ====== ======
Average commission rate
paid##................. $ .0610 -- -- -- -- -- -- -- --
======== ======== ======== ======== ======= ====== ====== ====== ======
</TABLE>
- --------
* Annualized.
** Total investment returns exclude insurance-related fees and expenses.
+ Commencement of Operations.
# Aggregate total investment return.
## For fiscal years beginning on or after September 1, 1995, the Fund is
required to disclose its average commission rate per share for purchases
and sales of equity securities.
3
<PAGE>
FINANCIAL HIGHLIGHTS (CONTINUED)
<TABLE>
<CAPTION>
SPECIAL VALUE FOCUS FUND**
------------------------------------------------------------------------------------------
FOR THE YEAR ENDED DECEMBER 31,
------------------------------------------------------------------------------------------
1996+ 1995+ 1994+ 1993+ 1992+ 1991 1990 1989 1988 1987
-------- -------- -------- ------- ------- ------- ------- ------ ------ -------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
INCREASE (DECREASE) IN
NET ASSET VALUE:
PER SHARE OPERATING
PERFORMANCE:
Net asset value,
beginning of year...... $ 27.98 $ 19.26 $ 20.96 $ 17.80 $ 17.96 $ 11.98 $ 13.70 $11.75 $11.47 $ 18.42
-------- -------- -------- ------- ------- ------- ------- ------ ------ -------
Investment income
(loss)--net............ .13 .17 .05 (.01) .01 .09 .05 (.07) (.10) (.09)
Realized and unrealized
gain (loss) on
investments--net....... 1.84 8.64 (1.56) 3.17 (.10) 5.91 (1.77) 2.02 .60 (4.01)
-------- -------- -------- ------- ------- ------- ------- ------ ------ -------
Total from investment
operations............. 1.97 8.81 (1.51) 3.16 (.09) 6.00 (1.72) 1.95 .50 (4.10)
-------- -------- -------- ------- ------- ------- ------- ------ ------ -------
Less dividends and
distributions:
Investment income--net.. (.14) (.09) -- --++ (.07) (.02) -- -- -- (.03)
Realized gain on
investments--net....... (3.59) -- (.19) -- -- -- -- -- (.22) (2.82)
-------- -------- -------- ------- ------- ------- ------- ------ ------ -------
Total dividends and
distributions.......... (3.73) (.09) (.19) -- (.07) (.02) -- -- (.22) (2.85)
-------- -------- -------- ------- ------- ------- ------- ------ ------ -------
Net asset value, end of
year................... $ 26.22 $ 27.98 $ 19.26 $ 20.96 $ 17.80 $ 17.96 $ 11.98 $13.70 $11.75 $ 11.47
======== ======== ======== ======= ======= ======= ======= ====== ====== =======
TOTAL INVESTMENT
RETURN:*
Based on net asset value
per share.............. 8.11% 45.90% (7.27)% 17.78% (.53)% 50.10% (12.55)% 16.60% 4.25% (22.29)%
======== ======== ======== ======= ======= ======= ======= ====== ====== =======
RATIOS TO AVERAGE NET
ASSETS:
Expenses, net of
reimbursement.......... .81% .81% .83% .96% 1.18% 1.25% 1.25% 1.25% 1.25% 1.24%
======== ======== ======== ======= ======= ======= ======= ====== ====== =======
Expenses................ .81% .81% .83% .96% 1.18% 1.28% 1.47% 1.53% 1.25% 1.24%
======== ======== ======== ======= ======= ======= ======= ====== ====== =======
Investment income
(loss)--net............ .50% .72% .27% (.05)% .04% .51% .14% (.68)% (.56)% (.60)%
======== ======== ======== ======= ======= ======= ======= ====== ====== =======
SUPPLEMENTAL DATA:
Net assets, end of year
(in thousands)......... $453,029 $339,921 $170,044 $98,976 $23,167 $11,318 $ 6,851 $6,811 $5,521 $ 6,707
======== ======== ======== ======= ======= ======= ======= ====== ====== =======
Portfolio turnover...... 80.84% 96.79% 88.48% 131.75% 98.64% 79.10% 135.24% 100.49% 68.73% 94.91%
======== ======== ======== ======= ======= ======= ======= ====== ====== =======
Average commission rate
paid#.................. $ .0598 -- -- -- -- -- -- -- -- --
======== ======== ======== ======= ======= ======= ======= ====== ====== =======
</TABLE>
- --------
* Total investment returns exclude insurance-related fees and expenses.
** Formerly, the Equity Growth Fund.
+ Based on average number of shares outstanding during the period.
++ Amount is less than $.01 per share.
# For fiscal years beginning on or after September 1, 1995, the Fund is
required to disclose its average commission rate per share for purchases
and sales of equity securities.
4
<PAGE>
FINANCIAL HIGHLIGHTS (CONTINUED)
<TABLE>
<CAPTION>
HIGH CURRENT INCOME FUND
------------------------------------------------------------------------------------------
FOR THE YEAR ENDED DECEMBER 31,
------------------------------------------------------------------------------------------
1996+ 1995 1994 1993 1992 1991 1990 1989 1988 1987
-------- -------- -------- -------- ------- ------ ------ ------- ------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
INCREASE (DECREASE) IN
NET ASSET VALUE:
PER SHARE OPERATING
PERFORMANCE:
-------- -------- -------- -------- ------- ------ ------ ------- ------- -------
Investment income--net.. 1.08 1.09 1.05 .95 1.07 1.19 1.40 1.29 1.21 1.23
Realized and unrealized
gain (loss) on
investments--net....... .12 .65 (1.47) .95 .90 2.10 (2.08) (.64) .20 (.79)
-------- -------- -------- -------- ------- ------ ------ ------- ------- -------
Total from investment
operations............. 1.20 1.74 (.42) 1.90 1.97 3.29 (.68) .65 1.41 .44
-------- -------- -------- -------- ------- ------ ------ ------- ------- -------
Less dividends and
distributions:
Investment income--
net................... (1.06) (1.10) (1.03) (.97) (1.07) (1.20) (1.39) (1.29) (1.11) (1.23)
Realized gain on
investments--net...... -- -- -- -- -- -- -- -- -- (.08)
-------- -------- -------- -------- ------- ------ ------ ------- ------- -------
Total dividends and
distributions.......... (1.06) (1.10) (1.03) (.97) (1.07) (1.20) (1.39) (1.29) (1.11) (1.31)
======== ======== ======== ======== ======= ====== ====== ======= ======= =======
TOTAL INVESTMENT RE-
TURN:*
Based on net asset value
per share.............. 11.27% 17.21% (3.59)% 17.84% 20.05% 43.00% (7.63)% 6.14% 13.87% 3.82%
======== ======== ======== ======== ======= ====== ====== ======= ======= =======
RATIOS TO AVERAGE NET
ASSETS:
Expenses................ .54% .55% .61% .72% .89% 1.10% 1.15% 1.22% 1.07% 1.01%
======== ======== ======== ======== ======= ====== ====== ======= ======= =======
Investment income--net.. 9.50% 9.92% 9.73% 8.62% 10.06% 12.49% 14.52% 11.98% 11.22% 10.88%
======== ======== ======== ======== ======= ====== ====== ======= ======= =======
SUPPLEMENTAL DATA:
Net assets, end of year
(in thousands)......... $414,615 $356,352 $255,719 $163,428 $26,343 $9,649 $8,106 $12,942 $13,960 $13,075
======== ======== ======== ======== ======= ====== ====== ======= ======= =======
Portfolio turnover...... 48.92% 41.60% 51.88% 35.67% 28.21% 51.54% 26.43% 53.52% 33.91% 56.07%
======== ======== ======== ======== ======= ====== ====== ======= ======= =======
</TABLE>
- --------
* Total investment returns exclude insurance-related fees and expenses.
+ Based on average shares outstanding during the year.
5
<PAGE>
FINANCIAL HIGHLIGHTS (CONTINUED)
<TABLE>
<CAPTION>
INTERNATIONAL EQUITY FOCUS FUND
------------------------------------------
FOR THE
PERIOD
FOR THE YEAR ENDED JULY 1,
DECEMBER 31, 1993+ TO
---------------------------- DECEMBER 31,
1996++ 1995 1994 1993
-------- -------- -------- ------------
<S> <C> <C> <C> <C>
INCREASE (DECREASE) IN NET ASSET
VALUE:
PER SHARE OPERATING PERFORMANCE:
Net asset value, beginning of year.. $ 11.06 $ 10.90 $ 11.03 $ 10.00
-------- -------- -------- -------
Investment income--net.............. .23 .20 .19 .01
Realized and unrealized gain (loss)
on investments and foreign currency
transactions--net.................. .49 .37 (.13) 1.02
-------- -------- -------- -------
Total from investment operations.... .72 .57 .06 1.03
-------- -------- -------- -------
Less dividends and distributions:
Investment income--net............ (.15) (.01) (.18) --
Realized gain on investments--
net.............................. -- (.17) (.01) --
In excess of realized gain on
investments--net................. -- (.23) -- --
-------- -------- -------- -------
Total dividends and distributions... (.15) (.41) (.19) --
-------- -------- -------- -------
Net asset value, end of year........ $ 11.63 $ 11.06 $ 10.90 $ 11.03
======== ======== ======== =======
TOTAL INVESTMENT RETURN:**
Based on net asset value per share.. 6.62% 5.48% .55% 10.30%#
======== ======== ======== =======
RATIOS TO AVERAGE NET ASSETS:
Expenses............................ .89% .89% .97% 1.14%*
======== ======== ======== =======
Investment income net............... 1.96% 1.95% 1.09% .30%*
======== ======== ======== =======
SUPPLEMENTAL DATA:
Net assets, end of year (in
thousands)......................... $349,080 $265,602 $247,884 $76,906
======== ======== ======== =======
Portfolio turnover.................. 49.87% 100.02% 58.84% 17.39%
======== ======== ======== =======
Average commission rate paid##...... $ .0004 -- -- --
======== ======== ======== =======
</TABLE>
- --------
* Annualized.
** Total investment returns exclude insurance-related fees and expenses.
+ Commencement of Operations.
++ Based on average shares outstanding during the period.
# Aggregate total investment return.
## For fiscal years beginning on or after September 1, 1995, the Fund is
required to disclose its average commission rate per share for purchases and
sales of equity securities. The "Average Commission Rate Paid" includes
commissions paid in foreign currencies, which have been converted into U.S.
dollars using the prevailing exchange rate on the date of the transaction.
Such conversions may significantly affect the average rate shown.
6
<PAGE>
FINANCIAL HIGHLIGHTS (CONCLUDED)
<TABLE>
<CAPTION>
PRIME BOND FUND
---------------------------------------------------------------------------------------------
FOR THE YEAR ENDED DECEMBER 31,
---------------------------------------------------------------------------------------------
1996 1995 1994 1993 1992 1991 1990 1989 1988 1987
-------- -------- -------- -------- ------- ------- ------- ------- ------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
INCREASE (DECREASE) IN
NET ASSET VALUE:
PER SHARE OPERATING
PERFORMANCE:
Net asset value,
beginning of year...... $ 12.45 $ 11.12 $ 12.64 $ 12.04 $ 12.02 $ 11.18 $ 11.29 $ 10.81 $ 10.89 $ 12.04
-------- -------- -------- -------- ------- ------- ------- ------- ------- -------
Investment income--net.. .80 .82 .77 .70 .79 .90 .88 .90 .87 .87
Realized and unrealized
gain (loss) on
investments and foreign
currency transactions--
net.................... (.55) 1.34 (1.36) .71 .04 .84 (.12) .48 (.15) (1.00)
-------- -------- -------- -------- ------- ------- ------- ------- ------- -------
Total from investment
operations............. .25 2.16 (.59) 1.41 .83 1.74 .76 1.38 .72 (.13)
-------- -------- -------- -------- ------- ------- ------- ------- ------- -------
Less dividends and
distributions:
Investment income--
net................... (.79) (.83) (.76) (.70) (.81) (.90) (.87) (.90) (.80) (.87)
Realized gain on
investments--net...... -- -- -- (.11) -- -- -- -- -- (.15)
In excess of realized
gain on investments--
net................... -- -- (.17) -- -- -- -- -- -- --
-------- -------- -------- -------- ------- ------- ------- ------- ------- -------
Total dividends and
distributions.......... (.79) (.83) (.93) (.81) (.81) (.90) (.87) (.90) (.80) (1.02)
-------- -------- -------- -------- ------- ------- ------- ------- ------- -------
Net asset value, end of
year................... $ 11.91 $ 12.45 $ 11.12 $ 12.64 $ 12.04 $ 12.02 $ 11.18 $ 11.29 $ 10.81 $ 10.89
======== ======== ======== ======== ======= ======= ======= ======= ======= =======
TOTAL INVESTMENT
RETURN:*
Based on net asset value
per share.............. 2.21% 20.14% (4.80)% 12.02% 7.27% 16.41% 7.13% 13.29% 6.75% (1.10)%
======== ======== ======== ======== ======= ======= ======= ======= ======= =======
RATIOS TO AVERAGE NET
ASSETS:
Expenses................ .49% .50% .54% .63% .78% .78% 1.06% 1.16% 1.07% 1.07%
======== ======== ======== ======== ======= ======= ======= ======= ======= =======
Investment income--net.. 6.67% 7.00% 6.74% 5.86% 6.76% 7.94% 8.01% 8.12% 8.05% 7.66%
======== ======== ======== ======== ======= ======= ======= ======= ======= =======
SUPPLEMENTAL DATA:
Net assets, end of year
(in thousands)......... $538,394 $489,838 $391,234 $314,091 $84,810 $39,743 $34,655 $29,593 $22,499 $17,385
======== ======== ======== ======== ======= ======= ======= ======= ======= =======
Portfolio turnover...... 91.88% 90.12% 139.89% 115.26% 82.74% 152.18% 155.17% 144.52% 225.81% 129.46%
======== ======== ======== ======== ======= ======= ======= ======= ======= =======
</TABLE>
- --------
*Total investment returns exclude insurance-related fees and expenses.
7
<PAGE>
THE INSURANCE COMPANIES
The Company was organized to fund benefits under variable annuity and
variable life Contracts issued by the Insurance Companies. Through this
Prospectus, the Company is offering shares in five Funds to certain Separate
Accounts of certain Insurance Companies to fund benefits under the Contracts.
Those five Funds are: the American Balanced Fund, the Special Value Focus Fund
(formerly, the Equity Growth Fund), the High Current Income Fund, the
International Equity Focus Fund, and the Prime Bond Fund. Through separate
Prospectuses, the Company offers shares in some or all of its funds to certain
other separate accounts of the Insurance Companies to fund benefits under
variable life and/or variable annuity contracts issued by them.
The rights of the Insurance Companies as shareholders should be
distinguished from the rights of a Contract Owner, which are set forth in the
Contract. A Contract Owner has no interest in the shares of a Fund, but only
in the Contract. The Contract is described in the Prospectus for each
Contract. That Prospectus describes the relationship between increases or
decreases in the net asset value of shares of a Fund, and any distributions on
such shares, and the benefits provided under a Contract. The Prospectus for
the Contracts also describes various fees payable to the Insurance Companies
and charges to the Separate Accounts made by the Insurance Companies with
respect to the Contracts. Since shares of the Funds will be sold only to the
Insurance Companies for the Separate Accounts, the terms "shareholder" and
"shareholders" in this Prospectus refer to the Insurance Companies.
INVESTMENT OBJECTIVES AND POLICIES OF THE FUNDS
INVESTMENT OBJECTIVES
Each Fund of the Company has a different investment objective, which it
pursues through separate investment policies as described below. The
differences in objectives and policies among the Funds can be expected to
affect the return of each Fund and the degree of market and financial risk to
which each Fund is subject. Each Fund is classified as "diversified," as
defined in the Investment Company Act of 1940, as amended (the "Investment
Company Act" or the "Act"). The investment objectives and classification of
each Fund may not be changed without the approval of the holders of a majority
of the outstanding shares of each Fund affected. The investment objectives and
policies of each Fund are discussed below. There can be no assurance that any
Fund will achieve its investment objective.
Fixed Income Security Ratings. No Fund other than the International Equity
Focus Fund and High Current Income Fund invests in fixed-income securities
which are rated below investment grade (i.e., securities rated Ba or below by
Moody's or BB or below by Standard & Poor's. However, securities purchased by
a Fund may subsequently be downgraded. Such securities may continue to be held
and will be sold only if, in the judgement of the Investment Adviser, it is
advantageous to do so. Securities in the lowest category of investment grade
debt securities may have speculative characteristics which may lead to
weakened capacity to pay interest and principal during periods of adverse
economic conditions. See Appendix A for a fuller description of corporate bond
ratings.
PRIME BOND FUND
The principal investment objective of the Prime Bond Fund is to provide
shareholders with as high a level of current income as is consistent with the
investment policies of the Fund and with prudent investment management. As a
secondary objective, the Fund seeks capital appreciation when consistent with
its principal objective. There can be no assurance that the Fund's investment
objectives will be achieved.
The Prime Bond Fund invests primarily in securities rated in the top three
rating categories of either Standard & Poor's (AAA, AA and A) or Moody's (Aaa,
Aa and A). Additional information regarding various bond ratings is set forth
in Appendix A to the Prospectus. The financial risk of the Fund should be
minimized by the credit quality of the bonds in which it will invest, but the
long maturities that typically provide the best yield will subject the Fund to
possible substantial price changes resulting from market yield fluctuations.
The market prices of fixed-income securities such as those purchased by the
Fund are affected by changes in interest rates generally. As interest rates
rise, the market value of fixed-income securities will fall, adversely
affecting the net asset value of the Fund.
8
<PAGE>
Fund management strategy will attempt to mitigate adverse price changes and
optimize favorable price changes through active trading that shifts the
maturity and/or quality structure of the Fund within the overall investment
guidelines. The Fund's investments will vary from time to time depending upon
the judgement of management as to prevailing conditions in the economy and the
securities markets and the prospects for interest rate changes among different
categories of fixed-income securities. The Fund anticipates that under normal
circumstances more than 90% of the assets of the Fund will be invested in
fixed-income securities, including convertible and non-convertible debt
securities and preferred stock. The Fund does not intend to invest in common
stock, rights or other equity securities. Under unusual market or economic
conditions, the Fund for defensive or other purposes may invest up to 100% of
its assets in U.S. Government or Government agency securities, money market or
other fixed-income securities deemed by the Investment Adviser to be
consistent with the objectives of the Fund, or the Fund may hold its assets in
cash.
HIGH CURRENT INCOME FUND
The primary investment objective of the High Current Income Fund, like the
Prime Bond Fund, is to obtain the highest level of current income that is
consistent with the investment policies of the Fund and with prudent
investment management. As a secondary objective, the Fund seeks capital
appreciation when consistent with its primary objective. There can be no
assurance that the Fund's investment objectives will be achieved.
The High Current Income Fund seeks high current income by investing
principally in fixed-income securities that are rated in the lower rating
categories of the established rating services (Baa or lower by Moody's and BBB
or lower by Standard & Poor's), or in unrated securities of comparable
quality. Securities rated below Baa by Moody's and below BBB by Standard &
Poor's are commonly known as "junk bonds." Additional information regarding
various bond ratings is set forth in Appendix A to the Prospectus. The market
price of fixed-income securities such as those purchased by the Fund is
affected by changes in interest rates generally. As interest rates rise, the
market value of fixed-income securities will fall, adversely affecting the net
asset value of the Fund.
Although they can be expected to provide higher yields, lower-rated
securities such as those purchased by the Fund may be subject to greater
market fluctuations and risks of loss of income and principal than lower-
yielding, higher-rated fixed-income securities. Such securities are generally
issued by corporations which are not as financially secure or as creditworthy
as issuers of higher-rated securities. There is, accordingly, a greater risk
that the issuers of higher-yielding securities will not be able to pay
principal and interest on such securities, especially during periods of
adverse economic conditions. Because investment in such high-yield securities
entails relatively greater risk of loss of income or principal, an investment
in the High Current Income Fund may not be appropriate as the exclusive
investment to fund the Contracts for all Contract Owners. See "Risks of High
Yield Securities."
Selection and supervision by the management of the Company of investments in
lower-rated fixed-income securities involves continuous analysis of individual
issuers, general business conditions and other factors which may be too time
consuming or too costly for the average investor. The furnishing of these
services does not, of course, guarantee successful results. The analysis of
issuers may include, among other things, historic and current financial
condition, current and anticipated cash flow and borrowing requirements, value
of assets in relation to historical cost, strength of management,
responsiveness to business conditions, credit standing, and current and
anticipated results of operations. Analysis of general business conditions and
other factors may include anticipated changes in economic activity and
interest rates, the availability of new investment opportunities, and the
economic outlook for specific industries. While the Investment Adviser
considers as one factor in its credit analysis the ratings assigned by the
rating services, the Investment Adviser performs its own independent credit
analysis of issuers and consequently, the Fund may invest, without limit, in
unrated securities if such securities offer, in the opinion of the Investment
Adviser, a relatively high yield without undue risk. As a result, the High
Current Income Fund's ability to achieve its investment objective may depend
to a greater extent on the Investment Adviser's own credit analysis than the
Funds which invest in higher-rated securities. Although the High Current
Income Fund will invest primarily in lower-rated securities, it will not
invest in securities rated Ca or lower by Moody's and CC or lower by Standard
& Poor's unless the Investment Adviser believes that the financial condition
of the issuer or the protection afforded to the particular securities is
stronger than would
9
<PAGE>
otherwise be indicated by such low ratings. However, securities purchased by
the Fund may subsequently be downgraded. Such securities may continue to be
held and will be sold only if, in the judgement of the Investment Adviser, it
is advantageous to do so.
When changing economic conditions and other factors cause the yield
difference between lower-rated and higher-rated securities to narrow, the Fund
may purchase higher-rated securities if the Investment Adviser believes that
the risk of loss of income and principal may be substantially reduced with
only a relatively small reduction in yield.
The securities in the Fund will be varied from time to time depending upon
the judgement of management as to prevailing conditions in the economy and the
securities markets and the prospects for interest rate changes among different
categories of fixed-income securities. It is anticipated that under normal
circumstances more than 90% of the Fund's assets will be invested in fixed-
income securities, including convertible and non-convertible debt securities
and preferred stock. Although it is expected that, in general, the Fund will
not invest in common stocks, rights or other equity securities, it will
acquire or hold such securities (if consistent with the objectives of the
Fund) when such securities are acquired in unit offerings with fixed-income
securities or in connection with an actual or proposed conversion or exchange
of fixed-income securities. In addition, under unusual market or economic
conditions, the High Current Income Fund for defensive purposes may invest up
to 100% of its assets in U.S. Government or Government agency securities,
money market securities or other fixed-income securities deemed by the
Investment Adviser to be consistent with a defensive posture, or may hold its
assets in cash. The yield on such securities may be lower than the yield on
lower-rated fixed-income securities.
The table below shows the average monthly dollar-weighted market value, by
Standard & Poor's rating category, of the securities held by the High Current
Income Fund during the year ended December 31, 1996.
<TABLE>
<CAPTION>
% MARKET
% VALUE
NET CORPORATE
RATING* ASSETS BONDS
------- ------ ---------
<S> <C> <C>
BBB....................................................... 0.7% 0.8%
BB........................................................ 29.2 33.8
B......................................................... 47.5 55.2
CCC....................................................... 4.2 4.7
NR**...................................................... 5.0 5.5
-----
100.0%
=====
</TABLE>
- --------
* A description of corporate bond ratings of Standard & Poor's is set forth
in Appendix A to the Prospectus.
** Bonds which are not rated by Standard & Poor's. Such bonds may be rated by
nationally recognized statistical rating organizations other than Standard
& Poor's, or may not be rated by any other organizations.
AMERICAN BALANCED FUND
The investment objective of the American Balanced Fund is to seek a level of
current income and a degree of stability of principal not normally available
from an investment solely in equity securities and the opportunity for capital
appreciation greater than is normally available from an investment solely in
debt securities by investing in a balanced portfolio of fixed income and
equity securities. This investment objective is a fundamental policy and may
not be changed without a vote of the majority of the outstanding shares of the
Fund. The Fund will seek current income by investing a portion of its assets
in a portfolio of intermediate to long-term debt, convertible debt, non-
convertible and convertible term preferred stock and money market securities.
The Fund will seek capital appreciation primarily by investing a portion of
its assets in equity securities, including perpetual preferred and convertible
perpetual preferred stock. At all times the Fund will maintain at least 25% of
its net assets in senior fixed income securities. As a non-fundamental policy,
the Fund is not permitted to invest in securities of foreign issuers. There
can be no assurance that the Fund's investment objective will be achieved.
The Fund will normally limit its allocation of assets to equity securities
to no more than 65% of its net assets. To the extent its equity position
exceeds this limitation, because of changes in the value of portfolio
10
<PAGE>
securities or otherwise, the Fund will seek to reduce its equity position to
less than 65% of net assets by selling such securities at such times and in
such amounts as management of the Company deems appropriate in light of market
conditions and other pertinent factors. See "Dividends, Distributions and
Taxes--Tax Treatment of the Company."
The Fund will generally emphasize investment in common stocks of larger-
capitalization issuers and in investment-grade debt obligations. The Fund may
also seek to enhance the return on its common stock portfolio by writing
covered call options listed on United States securities exchanges. Under
unusual market or economic conditions, the Fund for defensive purposes may
invest up to 100% of its assets in short-term U.S. Government or Government
agency securities, money market securities or other fixed-income securities
deemed by the Investment Adviser to be consistent with a defensive posture, or
cash.
INTERNATIONAL EQUITY FOCUS FUND
The investment objective of the International Equity Focus Fund is to seek
capital appreciation and, secondarily, income by investing in a diversified
portfolio of equity securities of issuers located in countries other than the
United States. Under normal conditions, at least 65% of the Fund's net assets
will be invested in such equity securities and at least 65% of the Fund's
total assets will be invested in the securities of issuers from at least three
different foreign countries. The investment objective of the Fund is a
fundamental policy and may not be changed without approval of a majority of
the Fund's outstanding shares. There can be no assurance that the Fund's
investment objective will be achieved. The Fund may employ a variety of
investments and techniques to hedge against market and currency risk. See
Appendix B. Investing on an international basis involves special
considerations. Investing in smaller capital markets entails the risk of
significant volatility in the Fund's security prices. See "Other Portfolio
Strategies--Foreign Securities." The Fund is designed for investors seeking to
complement their U.S. holdings through foreign investments. The Fund should be
considered as a long-term investment and a vehicle for diversification and not
as a balanced investment program.
The International Equity Focus Fund will invest in an international
portfolio of securities of foreign companies located throughout the world.
While there are no prescribed limits on the geographic allocation of the
Fund's investments, management of the Fund anticipates that a substantial
portion of its assets will be invested in the developed countries of Europe
and the Far East. For the reasons stated below, management of the Fund will
give special attention to investment opportunities in the developing countries
of the world, including, but not limited to Latin America, the Far East and
Eastern Europe. It is anticipated that a significant portion of the Fund's
assets may be invested in such developing countries.
The allocation of the Fund's assets among the various foreign securities
markets will be determined by the Investment Adviser based primarily on its
assessment of the relative condition and growth potential of the various
economies and securities markets, currency and taxation considerations and
other pertinent financial, social, national and political factors. Within such
allocations, the Investment Adviser will seek to identify equity investments
in each market which are expected to provide a total return which equals or
exceeds the return of such market as a whole.
A significant portion of the Fund's assets may be invested in developing
countries. This allocation of the Fund's assets reflects the belief that
attractive investment opportunities may result from an evolving long-term
international trend favoring more market-oriented economies, a trend that may
especially benefit certain developing countries with smaller capital markets.
This trend may be facilitated by local or international political, economic or
financial developments that could benefit the capital markets of such
countries. Certain such countries, particularly so-called "emerging" countries
(such as Malaysia, Mexico and Thailand), which may be in the process of
developing more market-oriented economies, may experience relatively high
rates of economic growth. Because of the general illiquidity of the capital
markets in certain developing countries, the Fund may invest in a relatively
small number of leading or relatively actively traded companies in the capital
markets of such a country in the expectation that the investment experience of
the securities of such companies will substantially represent the investment
experience of that country's capital markets as a whole.
11
<PAGE>
While the Fund will primarily emphasize investments in common stock, the
Fund may also invest in preferred stocks, convertible debt securities and
other instruments the return on which is linked to the performance of a common
stock or a basket or index of common stocks (collectively, "equity
securities"). The Fund may also invest in non-equity securities, including
debt securities, cash or cash equivalents denominated in U.S. dollars or
foreign currencies and short-term securities, including money market
instruments. Under certain adverse investment conditions, for defensive
purposes, the Fund may restrict the markets in which its assets will be
invested and may increase the proportion of assets invested in short-term
obligations of U.S. issuers. Investments made for defensive purposes will be
maintained only during periods in which the Investment Adviser determines that
economic or financial conditions are adverse for holding or being fully,
invested in equity securities of foreign issuers.
The Fund may invest in the securities of foreign issuers in the form of
American Depositary Receipts ("ADRs"), European Depositary Receipts ("EDRs"),
Global Depositary Receipts ("GDRs") or other securities convertible into
securities of foreign issuers. These securities may not necessarily be
denominated in the same currency as the securities into which they may be
converted. ADRs are receipts, typically issued by an American bank or trust
company, that evidence ownership of underlying securities issued by a foreign
corporation. EDRs are receipts issued in Europe that evidence a similar
ownership arrangement. GDRs are receipts issued throughout the world that
evidence a similar ownership arrangement. Generally, ADRs, in registered form,
are designed for use in the U.S. securities markets, and EDRs, in bearer form,
are designed for use in European securities markets. GDRs are tradeable both
in the U.S. and Europe and are designed for use throughout the world.
The Fund also may invest up to 35% of its net assets in longer-term, non-
convertible debt securities emphasizing debt securities which offer the
opportunity for capital appreciation. Capital appreciation in debt securities
may arise as a result of a favorable change in relative foreign exchange
rates, in relative interest rate levels, or in the creditworthiness of
issuers. In accordance with its investment objective, the Fund will not seek
to benefit from anticipated short-term fluctuations in currency exchange
rates. The Fund may, from time to time, invest in debt securities with
relatively high yields (as compared to other debt securities meeting the
Fund's investment criteria), notwithstanding that the Fund may not anticipate
that such securities will experience substantial capital appreciation. Such
income can be used, however, to offset the operating expenses of the Fund.
The Fund may invest in debt securities issued or guaranteed by foreign
governments (including foreign states, provinces and municipalities) or their
agencies and instrumentalities ("governmental entities"), issued or guaranteed
by international organizations designated or supported by multiple foreign
governmental entities (which are not obligations of foreign governments) to
promote economic reconstruction or development ("supranational entities"), or
issued by foreign corporations or financial institutions.
Supranational entities include international organizations designated or
supported by governmental entities to promote economic reconstruction or
development and international banking institutions and related government
agencies. Examples include the International Bank for Reconstruction and
Development (the "World Bank"), the European Steel and Coal Community, the
Asian Development Bank and the Inter-American Development Bank. The
governmental members, or "stockholders," usually make initial capital
contributions to the supranational entity and in many cases are committed to
make additional capital contributions if the supranational entity is unable to
repay its borrowings.
The Fund has established no rating criteria for the debt securities in which
it may invest, and such securities may not be rated at all for
creditworthiness. Securities rated in the medium to lower rating categories of
nationally recognized statistical rating organizations and unrated securities
of comparable quality are predominantly speculative with respect to the
capacity to pay interest and repay principal in accordance with the terms of
the security and generally involve a greater volatility of price than
securities in higher rating categories. In purchasing such securities, the
Fund will rely on the Investment Adviser's judgement, analysis and experience
in evaluating the creditworthiness of an issuer of such securities. The
Investment Adviser will take into consideration, among other things, the
issuer's financial resources, its sensitivity to economic conditions and
trends, its operating history, the quality of the issuer's management and
regulatory matters. The Fund does not
12
<PAGE>
intend to purchase debt securities that are in default or which the Investment
Adviser believes will be in default. See "Other Portfolio Strategies--Foreign
Securities" and "Risk of High Yield Securities" below.
SPECIAL VALUE FOCUS FUND (FORMERLY, THE EQUITY GROWTH FUND)
The investment objective of the Special Value Focus Fund is to seek long-
term growth of capital by investing in a diversified portfolio of securities,
primarily common stocks, of relatively small companies that management of the
Company believes have special investment value, and of emerging growth
companies regardless of size. There can be no assurance that the Fund's
investment objective will be achieved. Companies are selected by management on
the basis of their long-term potential for expanding their size and
profitability or for gaining increased market recognition for their
securities. Current income is not a factor in the selection of securities. The
Fund is intended to provide an opportunity for Contract Owners who are not
ordinarily in a position to perform the specialized type of research or
analysis of small and emerging growth companies.
Management seeks to identify those small emerging growth companies which can
show significant and sustained increases in earnings over an extended period
of time and are in sound financial condition. Management
believes that, while these companies present above-average risks, properly
selected companies of this type also have the potential to increase their
earnings at a rate substantially in excess of the general growth of the
economy. The Fund attempts to achieve its objective by focusing on the long-
range view of a company's prospects through a fundamental analysis of its
management, financial structure, product development, marketing ability and
other relevant factors. Full development of these companies frequently takes
time and, for this reason, the Fund should be considered as a long-term
investment and not as a vehicle for seeking short-term profits.
Small companies. Management seeks small companies that offer special
investment value in terms of their product or service, research capability, or
other unique attributes, and are relatively undervalued in the marketplace
when compared with similar, but larger, enterprises. These companies typically
have total market capitalizations in the $50-$300 million range and generally
are little known to most individual investors, although some may be dominant
in their respective industries. Underlying this strategy is management's
belief that relatively small companies will continue to have the opportunity
to develop into significant business enterprises. Some such companies may be
in a relatively early stage of development; others may manufacture a new
product or perform a new service. Such companies may not be counted upon to
develop into major industrial companies, but management believes that eventual
recognition of their special value characteristics by the investment community
can provide above-average long-term growth to the portfolio.
Emerging growth companies. In selecting investments for the Special Value
Focus Fund, management also seeks emerging growth companies that either occupy
a dominant position in an emerging industry or subindustry or have a
significant and growing market share in a large, fragmented industry.
Management believes that capable and flexible management is one of the most
important criteria of emerging growth companies and that such companies should
employ sound financial and accounting policies and also demonstrate effective
research, successful product development and marketing, efficient service and
pricing flexibility. Emphasis is given to companies with rapid historical
growth rates, above-average returns on equity and strong current balance
sheets, all of which should enable the company to finance its continued
growth. Management of the Company also analyzes and weighs relevant factors
beyond the company itself, such as the level of competition in the industry,
the extent of governmental regulation, the nature of labor conditions and
other related matters.
The Special Value Focus Fund emphasizes investments in companies that do
most of their business in the United States and therefore are free of the
currency exchange problems, foreign tax considerations and potential political
and economic upheavals that many multinational corporations face. Moreover,
the size and kinds of markets that they serve make these companies less
susceptible than larger companies to intervention from the federal government
by means of price controls, regulations or litigation.
While the process of selection and continuous supervision by management does
not, of course, guarantee successful investment results, it does provide
ingredients not available to the average individual due to the time and cost
involved. Careful initial selection is particularly important in this area as
many new enterprises have promise but lack certain of the ingredients
necessary to prosper.
13
<PAGE>
It should be apparent that an investment in a fund such as the Special Value
Focus Fund involves greater risk than is customarily associated with more
established companies. The securities of smaller or emerging growth companies
may be subject to more abrupt or erratic market movements than larger, more
established companies or the market average in general. These companies may
have limited product lines, markets or financial resources, or they may be
dependent upon a limited management group. Because of these factors,
management of the Company believes that shares in the Special Value Focus Fund
are suitable for Contract Owners who are in a financial position to assume
above-average investment risk in search of above-average long-term reward. As
indicated, the Fund is designed for Contract Owners whose investment objective
is growth rather than income. It is definitely not intended for exclusive
funding of Contracts but is designed for Contract Owners who are prepared to
experience above-average fluctuations in net asset value.
The securities in which the Special Value Focus Fund invests will often be
traded only in the over-the-counter market or on a regional securities
exchange and may not be traded every day or in the volume typical of trading
on a national securities exchange. As a result, the disposition by the Fund of
portfolio securities to meet redemptions or otherwise may require the Fund to
sell these securities at a discount from market prices or during periods when
in management's judgement such disposition is not desirable or to make many
small sales over a lengthy period of time.
The investment emphasis of the Special Value Focus Fund is on equities,
primarily common stock and, to a lesser extent, securities convertible into
common stocks and rights to subscribe for common stock, and the Fund will
maintain at least 80% of its net assets invested in equity securities of small
or emerging growth companies except during defensive periods. The Fund
reserves the right as a defensive measure and to provide for redemptions to
hold other types of securities, including non-convertible preferred stocks and
debt securities, U.S. Government and Government agency securities, money
market securities or other fixed-income securities deemed by the Investment
Adviser to be consistent with a defensive posture, or cash, in such
proportions as, in the opinion of management, prevailing market or economic
conditions warrant.
INVESTMENT RESTRICTIONS
The Company has adopted a number of restrictions and policies relating to
the investment of its assets and its activities which are fundamental policies
and may not be changed without the approval of the holders of the Company's
outstanding voting securities (including a majority of the shares of each
Fund). Investors are referred to the Statement of Additional Information for a
complete description of such restrictions and policies.
OTHER PORTFOLIO STRATEGIES
Restricted Securities. Each of the Funds is subject to limitations on the
amount of illiquid securities it may purchase; however, each Fund may purchase
without regard to that limitation certain securities that are not registered
under the Securities Act of 1933, as amended (the "Securities Act"), including
(a) commercial paper exempt from registration under Section 4(2) of the
Securities Act, and (b) securities that can be offered and sold to "qualified
institutional buyers" under Rule 144A under the Securities Act, provided that
the Company's Board of Directors continuously determines, based on the trading
markets for the specific Rule 144A security, that it is liquid. The Board of
Directors may adopt guidelines and delegate to the Investment Adviser the
daily function of determining and monitoring liquidity of restricted
securities. The Board has determined that securities sold under Rule 144A
which are freely tradeable in their primary market offshore should be deemed
liquid. The Board, however, will retain sufficient oversight and be ultimately
responsible for the determinations.
Since it is not possible to predict with assurance exactly how the market
for restricted securities sold and offered under Rule 144A will develop, the
Board of Directors will carefully monitor the Funds' investments in these
securities, focusing on such factors, among others, as valuation, liquidity
and availability of information. This investment practice could have the
effect of increasing the level of illiquidity in a Fund to the extent that
qualified institutional buyers become for a time uninterested in purchasing
these restricted securities.
Certain indexed and inverse securities may have the effect of providing
investment leverage because the rate of interest or amount of principal
payable increases or decreases at a rate that is a multiple of the changes in
14
<PAGE>
the relevant index. As a consequence, the market value of such securities may
be substantially more volatile than the market values of other debt
securities. The Company believes that indexed and inverse securities may
provide portfolio management flexibility that permits a Fund to seek enhanced
returns, hedge other portfolio positions or vary the degree of portfolio
leverage with greater efficiency than would otherwise be possible under
certain market conditions.
Foreign Securities. The High Current Income, Prime Bond, International
Equity Focus and Special Value Focus Funds may invest in securities of foreign
issuers. Investments in foreign securities, particularly those of non-
governmental issuers, involve considerations and risks which are not
ordinarily associated with investing in domestic issuers. These considerations
and risks include changes in currency rates, currency exchange control
regulations, the possibility of expropriation, the unavailability of financial
information or the difficulty of interpreting financial information prepared
under foreign accounting standards, less liquidity and more volatility in
foreign securities markets, the impact of political, social or diplomatic
developments, and the difficulty of assessing economic trends in foreign
countries. If it should become necessary, a Fund could encounter greater
difficulties in invoking legal processes abroad than would be the case in the
United States. Transaction costs in foreign securities may be higher. The
operating expense ratio of a Fund investing in foreign securities can be
expected to be higher than that of an investment company investing exclusively
in United States securities because the expenses of the Fund, such as
custodial costs, are higher. In addition, net investment income earned by a
Fund on a foreign security may be subject to withholding and other taxes
imposed by foreign governments which will reduce a Fund's net investment
income. The Investment Adviser will consider these and other factors before
investing in foreign securities, and will not make such investments unless, in
its opinion, such investments will meet the standards and objectives of a
particular Fund. No Fund which may invest in foreign securities will
concentrate its investments in any particular country. The International
Equity Focus Fund may from time to time be substantially invested in non-
dollar-denominated securities of foreign issuers. For a Fund that invests in
foreign securities denominated or quoted in currencies other than the United
States dollar, changes in foreign currency exchange rates may affect the value
of securities in the portfolio and the unrealized appreciation or depreciation
of investments insofar as United States investors are concerned, and a Fund's
return on investments in non-dollar-denominated securities may be reduced or
enhanced as a result of changes in foreign currency rates during the period in
which the Fund holds such investments. Foreign currency exchange rates are
determined by forces of supply and demand in the foreign exchange markets.
These forces are, in turn, affected by international balance of payments and
other economic and financial conditions, government intervention, speculation
and other factors. With respect to certain countries, there may be the
possibility of expropriation of assets, confiscatory taxation, high rates of
inflation, political or social instability or diplomatic developments which
could affect investment in those countries. Each Fund other than the
International Equity Focus Fund will purchase securities issued only in dollar
denominations.
The International Equity Focus Fund may invest a significant portion of its
assets in securities of foreign issuers in smaller capital markets, while each
of the other Funds which is permitted to invest in foreign securities may from
time to time invest in securities of such foreign issuers. Foreign investments
involve risks, including fluctuations in foreign exchange rates, future
political and economic developments, different legal systems, the existence or
possible imposition of exchange controls, or other foreign or United States
governmental laws or restrictions, which are often heightened for investments
in smaller capital markets.
There may be less publicly available information about an issuer in a
smaller capital market than would be available about a United States company,
and it may not be subject to accounting, auditing and financial reporting
standards and requirements comparable to those of United States companies. As
a result, traditional investment measurements, such as price/earnings ratios,
as used in the United States, may not be applicable in certain capital
markets.
Smaller capital markets, while often growing in trading volume, have
substantially less volume than United States markets, and securities in many
smaller capital markets are less liquid and their prices may be more volatile
than securities of comparable United States companies. Brokerage commissions,
custodial services, and other costs relating to investment in smaller capital
markets are generally more expensive than in the United States. Such markets
have different clearance and settlement procedures, and in certain markets
there have been
15
<PAGE>
times when settlements have been unable to keep pace with the volume of
securities transactions, making it difficult to conduct such transactions.
Further, satisfactory custodial services for investment securities may not be
available in some countries having smaller capital markets, which may result
in a Fund which invests in these markets incurring additional costs and delays
in transporting and custodying such securities outside such countries. Delays
in settlement could result in temporary periods when assets of such a Fund are
uninvested and no return is earned thereon. The inability of a Fund to make
intended security purchases due to settlement problems could cause the Fund to
miss attractive investment opportunities. Inability to dispose of a portfolio
security due to settlement problems could result either in losses to the Fund
due to subsequent declines in value of the portfolio security or, if the Fund
has entered into a contract to sell the security, could result in possible
liability to the purchaser. There is generally less government supervision and
regulation of exchanges, brokers and issuers in countries having smaller
capital markets than there is in the United States.
As a result, management of a Fund which invests in foreign securities may
determine that, notwithstanding otherwise favorable investment criteria, it
may not be practicable or appropriate to invest in a particular country. A
Fund may invest in countries in which foreign investors, including management
of the Fund, have had no or limited prior experience. Due to its emphasis on
securities of issuers located in smaller capital markets, the International
Equity Focus Fund should be considered as a vehicle for diversification and
not as a balanced investment program.
Certain of the Funds may invest in debt securities issued by foreign
governments. Investments in foreign government debt securities, particularly
those of emerging market country governments, involve special risks. Certain
emerging market countries have historically experienced, and may continue to
experience, high rates of inflation, high interest rates, exchange rate
fluctuations, large amounts of external debt, balance of payments and trade
difficulties and extreme poverty and unemployment. The issuer or governmental
authority that controls the repayment of an emerging market country's debt may
not be able or willing to repay the principal and/or interest when due in
accordance with the terms of such debt. A debtor's willingness or ability to
repay principal and interest due in a timely manner may be affected by, among
other factors, its cash flow situation, and, in the case of a government
debtor, the extent of its foreign reserves, the availability of sufficient
foreign exchange on the date a payment is due, the relative size of the debt
service burden to the economy as a whole and the political constraints to
which a government debtor may be subject. Government debtors may default on
their debt and may also be dependent on expected disbursements from foreign
governments, multilateral agencies and others abroad to reduce principal and
interest arrearages on their debt. Holders of government debt, including the
Fund, may be requested to participate in the rescheduling of such debt and to
extend further loans to government debtors.
As a result of the foregoing, a government obligor may default on its
obligations. If such an event occurs, a Fund may have limited legal recourse
against the issuer and/or guarantor. Remedies must, in some cases, be pursued
in the courts of the defaulting party itself, and the ability of the holder of
foreign government debt securities to obtain recourse may be subject to the
political climate in the relevant country. Government obligors in developing
and emerging market countries are among the world's largest debtors to
commercial banks, other governments, international financial organizations and
other financial institutions. The issuers of the government debt securities in
which a Fund may invest have in the past experienced substantial difficulties
in servicing their external debt obligations, which led to defaults on certain
obligations and the restructuring of certain indebtedness. Restructuring
arrangements have included, among other things, reducing and rescheduling
interest and principal payments by negotiating new or amended credit
agreements.
The International Equity Focus Fund intends to invest in securities of
foreign issuers in smaller capital markets. Some countries with smaller
capital markets prohibit or impose substantial restrictions on investments in
their capital markets, particularly their equity markets, by foreign entities
such as the Fund. As illustrations, certain countries require governmental
approval prior to investments by foreign persons, or limit the amount of
investment by foreign persons in a particular company, or limit the investment
by foreign persons to only a specific class of securities of a company which
may have less advantageous terms than securities of the company available for
purchase by nationals.
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A number of countries, such as South Korea, Taiwan and Thailand, have
authorized the formation of closed-end investment companies to facilitate
indirect foreign investment in their capital markets. In accordance with the
Investment Company Act, the International Equity Focus Fund may invest up to
10% of its total assets in securities of such closed-end investment companies.
This restriction on investments in securities of closed-end investment
companies may limit opportunities for the Fund to invest indirectly in certain
smaller capital markets. Shares of certain closed-end investment companies may
at times be acquired only at market prices representing premiums to their net
asset values. If a Fund acquires shares in closed-end investment companies,
shareholders would bear both their proportionate share of expenses in the Fund
(including management and advisory fees) and, indirectly, the expenses of such
closed-end investment companies. A Fund also may seek, at its own cost, to
create its own investment entities under the laws of certain countries.
In some countries, banks or other financial institutions may constitute a
substantial number of the leading companies or the companies with the most
actively traded securities. Also, the Investment Company Act restricts a
Fund's investments in any equity security of an issuer which, in its most
recent fiscal year, derived more than 15% of its revenues from "securities
related activities," as defined by the rules thereunder. These provisions may
also restrict a Fund's investments in certain foreign banks and other
financial institutions.
Lending of Portfolio Securities. Each Fund of the Company may from time to
time lend securities (but not in excess of 20% of its total assets) from its
portfolio to brokers, dealers and financial institutions and receive
collateral in cash or securities issued or guaranteed by the U.S. Government
which, while the loan is outstanding, will be maintained at all times in an
amount equal to at least 100% of the current market value of the loaned
securities plus accrued interest. Such cash collateral will be invested in
short-term securities, the income from which will increase the return to the
Fund.
Forward Commitments. Each of the Funds may purchase securities on a when-
issued basis, and they may purchase or sell such securities for delayed
delivery. These transactions occur when securities are purchased or sold by a
Fund with payment and delivery taking place in the future to secure what is
considered an advantageous yield and price to the Fund at the time of entering
into the transaction. The value of the security on the delivery date may be
more or less than its purchase price. A Fund entering into such transactions
will maintain a segregated account with its custodian of cash or liquid
securities in an aggregate amount equal to the amount of its commitments in
connection with such delayed delivery and purchase transactions.
Standby Commitment Agreements. The High Current Income Fund may from time to
time enter into standby commitment agreements. Such agreements commit the
Fund, for a stated period of time, to purchase a stated amount of a fixed
income security which may be issued and sold to the Fund at the option of the
issuer. The price and coupon of the security is fixed at the time of the
commitment. At the time of entering into the agreement the Fund is paid a
commitment fee which is typically approximately 0.5% of the aggregate purchase
price of the security which the Fund has committed to purchase. The Fund will
at all times maintain a segregated account with its custodian of cash or
liquid securities an amount equal to the purchase price of the securities
underlying the commitment. There can be no assurance that the securities
subject to a standby commitment will be issued, and the value of the security,
if issued, on the delivery date may be more or less than its purchase price.
Portfolio Strategies Involving Indexed and Inverse Securities, Options,
Futures and Foreign Exchange Transactions. Certain Funds may use derivative
instruments, including indexed and inverse securities, options and futures and
purchase and sell foreign exchange. Transactions involving such instruments
expose these Funds to certain risks. Each Fund's use of these instruments and
the associated risks are described in detail in Appendix B attached to this
Prospectus.
RISKS OF HIGH YIELD SECURITIES
The International Equity Focus Fund and High Current Income Fund may invest
a substantial portion of their assets in high yield, high risk securities or
junk bonds, which are regarded as being predominantly speculative as to the
issuer's ability to make payments of principal and interest. Investment in
such securities
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involves substantial risk. Issuers of junk bonds may be highly leveraged and
may not have available to them more traditional methods of financing.
Therefore, the risks associated with acquiring the securities of such issuers
generally are greater than is the case with higher-rated securities. For
example, during an economic downturn or a sustained period of rising interest
rates, issuers of high yield securities may be more likely to experience
financial stress, especially if such issuers are highly leveraged. During
recessionary periods, such issuers may not have sufficient revenues to meet
their interest payment obligations. The issuer's ability to service its debt
obligations also may be adversely affected by specific issuer developments, or
the issuer's inability to meet specific projected business forecasts, or the
unavailability of additional financing. The risk of loss due to default by the
issuer is significantly greater for the holders of junk bonds because such
securities may be unsecured and may be subordinated to other creditors of the
issuer. While the high yield securities in which the International Equity
Focus Fund or High Current Income Fund may invest normally do not include
securities which, at the time of investment, are in default or the issuers of
which are in bankruptcy, there can be no assurance that such events will not
occur after a Fund purchases a particular security, in which case a Fund may
experience losses and incur costs.
In an effort to minimize the risk of issuer default or bankruptcy, the
International Equity Focus Fund and High Current Income Fund each will
diversify its holdings among many issuers. However, there can be no assurance
that diversification will protect a Fund from widespread defaults brought
about by a sustained economic downturn.
High yield securities tend to be more volatile than higher-rated fixed-
income securities, so that adverse economic events may have a greater impact
on their prices and yields than on higher-rated fixed-income securities. Zero
coupon bonds and bonds which pay interest and/or principal in additional bonds
rather than in cash are especially volatile. Like higher-rated fixed-income
securities, junk bonds are generally purchased and sold through dealers who
make a market in such securities for their own accounts. However, there are
fewer dealers in this market, which may be less liquid than the market for
higher-rated fixed-income securities, even under normal economic conditions.
Also, there may be significant disparities in the prices quoted for such bonds
by various dealers. Adverse economic conditions or investor perceptions
(whether or not based on economic fundamentals) may impair the liquidity of
this market, and may cause the prices the International Equity Focus Fund and
High Current Income Fund receive for their junk bonds to be reduced, or a Fund
may experience difficulty in liquidating a portion of its portfolio when
necessary to meet the Fund's liquidity needs or in response to a specific
economic event such as a deterioration in the creditworthiness of the issuer.
Under such conditions, judgement may play a greater role in valuing certain of
each Fund's portfolio securities than in the case of securities trading in a
more liquid market.
Adverse publicity and investor perceptions, which may not be based on
fundamental analysis, also may decrease the value and liquidity of junk bonds,
particularly in a thinly traded market. Factors adversely affecting the market
value of such securities are likely to affect adversely the net asset value of
the International Equity Focus Fund and High Current Income Fund. In addition,
each Fund may incur additional expenses to the extent that it is required to
seek recovery upon a default on a portfolio holding or to participate in the
restructuring of the obligation.
Sovereign Debt. The junk bonds in which the International Equity Focus Fund
and High Current Income Fund may invest include junk bonds issued by sovereign
entities. Investment in such sovereign debt involves a high degree of risk.
The governmental entity that controls the repayment of sovereign debt may not
be able or willing to repay the principal and/or interest when due in
accordance with the terms of such debt. A governmental entity's willingness or
ability to repay principal and interest due in a timely manner may be affected
by, among other factors, its cash flow situation, the extent of its foreign
reserves, the availability of sufficient foreign exchange on the date a
payment is due, the relative size of the debt service burden to the economy as
a whole, the governmental entity's policy towards the International Monetary
Fund and the political constraints to which a governmental entity may be
subject. Governmental entities may also be dependent on expected disbursements
from foreign governments, multilateral agencies and others abroad to reduce
principal and interest arrearages on their debt. The commitment on the part of
these governments, agencies and others to make such disbursements may be
conditioned on a governmental entity's implementation of economic reforms
and/or economic
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<PAGE>
performance and the timely service of such debtor's obligations. Failure to
implement such reforms, achieve such levels of economic performance or repay
principal or interest when due may result in the cancellation of such third
parties' commitments to lend funds to the governmental entity, which may
further impair such debtor's ability or willingness to timely service its
debts. Consequently, governmental entities may default on their sovereign
debt.
Holders of sovereign debt, including the International Equity Focus Fund and
High Current Income Fund, may be requested to participate in the rescheduling
of such debt and to extend further loans to governmental entities. In the
event of a default by a governmental entity, there may be few or no effective
legal remedies available to a Fund and there can be no assurance a Fund will
be able to collect on defaulted sovereign debt in whole or in part.
INSURANCE LAW RESTRICTIONS
In order for shares of the Company's Funds to remain eligible investments
for the Separate Accounts, it may be necessary, from time to time, for a Fund
to limit its investments in certain types of securities in accordance with the
insurance laws or regulations of the various states in which the Contracts are
sold.
The New York insurance law requires that investments of each Fund be made
with the degree of care of an "ordinarily prudent person." The Investment
Adviser believes that compliance with this standard will not have any negative
impact on the performance of any of the Funds.
OTHER CONSIDERATIONS
The Investment Adviser will use its best efforts to assure that each Fund of
the Company complies with certain investment limitations of the Internal
Revenue Service to assure favorable income tax treatment for the Contracts. It
is not expected that such investment limitations will materially affect the
ability of any Fund to achieve its investment objective.
DIRECTORS
The Directors of the Company consist of six individuals, five of whom are
not "interested persons" of the Company as defined in the Investment Company
Act of 1940. The Directors of the Company are responsible for the overall
supervision of the operations of the Company and perform the various duties
imposed on the directors of the investment companies by the Investment Company
Act of 1940. The Board of Directors elects officers of the Company annually.
The Directors of the Company and their principal employment are as follows:
Arthur Zeikel*--President of the Investment Adviser and its affiliate,
Fund Asset Management, L.P. ("FAM"); President and Director of Princeton
Services, Inc. ("Princeton Services"); Executive Vice President of ML&Co.;
and Director of Merrill Lynch Funds Distributor, Inc. (the "Distributor")
Joe Grills--Member of the Committee on Investment of Employee Benefit
Assets of the Financial Executives Institute ("CIEBA"); member of CIEBA's
Executive Committee; and Member of the Investment Advisory Committee of the
State of New York Common Retirement Fund and the Howard Hughes Medical
Institute; Director, Duke Management Company, LaSalle Street Fund and Kimco
Realty Corporation.
Walter Mintz--Special Limited Partner of Cumberland Partners (investment
partnership).
Robert S. Salomon, Jr.--Principal of STI Management (investment adviser).
Melvin R. Seiden--Director of Silbanc Properties, Ltd. (real estate,
consulting and investments).
Stephen B. Swensrud--Chairman of Fernwood Associates (financial
consultants).
- --------
* Interested person, as defined in the Investment Company Act of 1940, of the
Company.
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INVESTMENT ADVISER
Merrill Lynch Asset Management L.P. ("MLAM"), an indirect wholly owned
subsidiary of Merrill Lynch & Co., Inc., is the investment adviser (the
"Investment Adviser") for the Fund. The general partner of the Investment
Adviser is Princeton Services, Inc., a wholly owned subsidiary of Merrill
Lynch & Co., Inc. The principal address of the Investment Adviser is 800
Scudders Mill Road, Plainsboro, New Jersey 08536 (mailing address: Box 9011,
Princeton, New Jersey 08543-9011). The Investment Adviser or its affiliate,
Fund Asset Management, L.P. ("FAM"), acts as the investment adviser for over
130 other registered investment companies. The Investment Adviser also offers
portfolio management and portfolio analysis services to individuals and
institutions. In the aggregate, as of March 31, 1997, the Investment Adviser
and FAM had a total of approximately $247.2 billion in investment company and
other portfolio assets under management including assets of certain
affiliates.
While the Investment Adviser is at all times subject to the direction of the
Board of Directors of the Company, the Investment Advisory Agreements provide
that the Investment Adviser, subject to review by the Board of Directors, is
responsible for the actual management of the Funds and has responsibility for
making decisions to buy, sell or hold any particular security. The Investment
Adviser provides the portfolio managers for the Funds, who consider
information from various sources, make the necessary investment decisions and
effect transactions accordingly. The Investment Adviser is also obligated to
perform certain administrative and management services for the Company
(certain of which it may delegate to third parties) and is obligated to
provide all the office space, facilities, equipment and personnel necessary to
perform its duties under the Agreements. The Investment Adviser has access to
the full range of the securities and economic research facilities of Merrill
Lynch.
During the Company's fiscal year ended December 31, 1996, the advisory fees
expense incurred by the Company totalled $24,131,430 of which $2,160,063
related to the Prime Bond Fund (representing .44% of its average net assets),
$1,881,541 related to the High Current Income Fund (representing .49% of its
average net assets), $2,358,140 related to the International Equity Focus
(representing .75% of its average net assets), $3,010,613 related to the
Special Value Focus Fund (representing .75% of its average net assets) and
$1,186,936 related to the American Balanced Fund (representing .55% of its
average net assets).
During the Company's fiscal year ended December 31, 1996, the total
operating expenses of the Company's Funds (including the advisory fees paid to
the Investment Adviser), before any fee waiver or reimbursement of a portion
of such expenses were as follows: $2,418,846 related to the Prime Bond Fund
(representing .49% of its average net assets), $2,096,102 related to the High
Current Income Fund (representing .54% of its average net assets), $2,802,938
related to the International Equity Focus Fund (representing .89% of its
average net assets), $3,240,858 related to the Special Value Focus Fund
(representing .81% of its average net assets) and $1,300,476 related to the
American Balanced Fund (representing .60% of its average net assets).
The Investment Adviser has entered into a sub-advisory agreement (the "Sub-
Advisory Agreement") with MLAM U.K., an indirect wholly owned subsidiary of ML
& Co., and an affiliate of the Investment Adviser, pursuant to which the
Investment Adviser pays MLAM U.K. a fee for providing investment advisory
services to the Investment Adviser with respect to the Funds in an amount to
be determined from time to time by the Investment Adviser and MLAM U.K. but in
no event in excess of the amount that the Investment Adviser actually receives
for providing services to the Funds pursuant to the Investment Advisory
Agreement.
The Investment Adviser and Merrill Lynch Life Agency, Inc. ("MLLA") have
entered into two agreements which limit the operating expenses paid by each
Fund in a given year to 1.25% of its average daily net assets (the
"Reimbursement Agreements"). The reimbursement agreements, dated April 30,
1985 and February 11, 1992, provide that any expenses in excess of 1.25% of
average daily net assets will be reimbursed to the Fund by the Investment
Adviser which, in turn, will be reimbursed by MLLA.
The Investment Adviser has entered into administrative services agreements
with certain Insurance Companies pursuant to which the Investment Adviser
compensates such companies for administrative responsibilities relating to the
Company which are performed by such Insurance Companies.
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CODE OF ETHICS
The Board of Directors of the Company has adopted a Code of Ethics under
Rule 17j-1 of the Act which incorporates the Code of Ethics of the Investment
Adviser (together, the "Codes"). The Codes significantly restrict the personal
investing activities of all employees of the Investment Adviser and, as
described below, impose additional, more onerous, restrictions on fund
investment personnel.
The Codes require that all employees of the Investment Adviser preclear any
personal securities investment (with limited exceptions, such as government
securities). The preclearance requirement and associated procedures are
designed to identify any substantive prohibition or limitation applicable to
the proposed investment. The substantive restrictions applicable to all
employees of the Investment Adviser include a ban on acquiring any securities
in a "hot" initial public offering and a prohibition from profiting on short-
term trading in securities. In addition, no employee may purchase or sell any
security which at the time is being purchased or sold (as the case may be), or
to the knowledge of the employee is being considered for purchase or sale, by
any fund advised by the Investment Adviser. Furthermore, the Codes provide for
trading "blackout periods" which prohibit trading by investment personnel of
the Company within periods of trading by the Company in the same (or
equivalent) security (15 or 30 days depending upon the transaction).
PORTFOLIO MANAGERS
The following is information with respect to the Portfolio Managers for each
of the Company's Funds.
Thomas R. Robinson has served as the Portfolio Manager of the American
Balanced Fund since November 1995, and is primarily responsible for the Fund's
day-to-day management. He has served as a Senior Portfolio Manager of MLAM
since November 1995. From 1989 to 1995, he served as Manager of International
Strategy for Merrill Lynch & Co. Global Securities Research & Economics Group.
Aldona Schwartz has served as the High Current Income Fund's Portfolio
Manager since July 1993, and is primarily responsible for the Fund's day-to-
day management. She has served as Vice President of MLAM since 1991 and
employee of the Investment Adviser since 1986.
Andrew Bascand has served as the International Equity Focus Fund's Co-
Portfolio Manager since July 1993 and became sole Portfolio Manager in March
1997. He is primarily responsible for the Fund's day-to-day management. He has
been the director of MLAM U.K. and Vice President of Merrill Lynch Global
Asset Management Limited (MLGAM) since 1993; Chief Economist with A.M.P.
Investment (NZ) in New Zealand from 1989 to 1993; Economic Adviser to the
Chief Economist of the Reserve Bank of New Zealand from 1987 to 1989; and
Senior Research Officer of the Bank of England's International Department from
1986 to 1987.
Daniel V. Szemis has served as the Portfolio Manager of the Special Value
Focus Fund (formerly, the Equity Growth Fund) since May 1997 and is primarily
responsible for the day-to-day management of the Special Value Focus Fund. Mr.
Szemis has served as Vice President of MLAM since 1996. From 1990 to 1996, Mr.
Szemis was a Portfolio Manager with Prudential Mutual Fund Investment
Management Advisors.
Jay Harbeck has served as the Prime Bond Fund's Portfolio Manager since July
1992 and is primarily responsible for the Fund's day-to-day management. He has
served as Vice President of MLAM since 1986.
PORTFOLIO TRANSACTIONS AND BROKERAGE
None of the Company's Funds has any obligation to deal with any dealer or
group of dealers in the execution of transactions in portfolio securities.
Subject to policy established by the Board of Directors of the Company, the
Investment Adviser is primarily responsible for the Company's portfolio
decisions and the placing of the Company's portfolio transactions. In placing
orders, it is the policy of each Fund to obtain the most favorable net
results, taking into account various factors, including price, dealer spread
or commission, if any, size of the transactions and difficulty of execution.
While the Investment Adviser generally seeks reasonably competitive spreads or
commissions, the Company will not necessarily be paying the lowest spread or
commission available.
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Under the Investment Company Act of 1940, persons affiliated with the
Company are prohibited from dealing with the Company as a principal in the
purchase and sale of the Company's portfolio securities unless an exemptive
order allowing such transactions is obtained from the Securities and Exchange
Commission. Affiliated persons of the Company may serve as its broker in over-
the-counter transactions conducted on an agency basis. During the year ended
December 31, 1996, the Company engaged in 16 transactions pursuant to such
order involving approximately $64.9 million of securities. For the year ended
December 31, 1996, the Company paid brokerage commissions of $6,656,814, of
which $266,405 was paid to Merrill Lynch.
PURCHASE OF SHARES
The Company continuously offers shares of Class A Common Stock in each of
its Funds to the Insurance Companies at prices equal to the respective per
share net asset value of the Funds. Merrill Lynch Funds Distributor, Inc., a
wholly owned subsidiary of the Investment Adviser, acts as the distributor of
the shares. Net asset value is determined in the manner set forth below under
"Additional Information--Determination of Net Asset Value."
The Company and the Distributor reserve the right to suspend the sale of
shares of each Fund in response to conditions in the securities markets or
otherwise.
REDEMPTION OF SHARES
The Company is required to redeem all full and fractional shares of the
Funds for cash. The redemption price is the net asset value per share next
determined after the initial receipt of proper notice of redemption.
DIVIDENDS, DISTRIBUTIONS AND TAXES
It is the Company's intention to distribute substantially all of the net
investment income, if any, of each Fund. For dividend purposes, net investment
income of each Fund, other than the Company's Domestic Money Market and
Reserve Assets Funds, will consist of all payments of dividends or interest
received by such Fund less the estimated expenses of such Fund (including fees
payable to the Investment Adviser).
Dividends from net investment income of the Prime Bond and High Current
Income are declared and reinvested monthly in additional full and fractional
shares of the respective Funds at net asset value. Dividends from net
investment income of the International Equity Focus, American Balanced and
Special Value Focus Funds are declared and reinvested at least annually in
additional full and fractional shares of the respective Funds.
All net realized long-term or short-term capital gains of the Company, if
any, are declared and distributed annually after the close of the Company's
fiscal year to the shareholders of the Fund or Funds to which such gains are
attributable. Short-term capital gains are taxable as ordinary income.
TAX TREATMENT OF THE COMPANY
Each Fund intends to continue to qualify as a regulated investment company
under certain provisions of the Internal Revenue Code of 1986, as amended (the
"Code"). Under such provisions, a Fund will not be subject to federal income
tax on such part of its net ordinary income and net realized capital gains
which it distributes to shareholders. One of the requirements to qualify for
treatment as a regulated investment company under the Code is that a Fund,
among other things, derive less than 30% of its gross income in each taxable
year from gains (without deduction of losses) from the sale or other
disposition of stocks, securities and certain options, futures or forward
contracts held for less than three months. This requirement may limit the
ability of certain Funds to dispose of certain securities at times when
management of the Company might otherwise deem such disposition appropriate or
desirable.
If a Fund earns original issue discount income in a taxable year which is
not represented by correlative cash income, or if a Fund receives property
rather than cash in payment of interest, shareholders will be allocated
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<PAGE>
income greater than the amount of cash distributed to them. In addition, the
Fund may have to dispose of securities and use the proceeds thereof to make
distributions in amounts necessary to satisfy its distribution requirements
under the Code.
TAX TREATMENT OF INSURANCE COMPANIES AS SHAREHOLDERS
Dividends paid by the Company from its ordinary income and distributions of
the Company's net realized capital gains are includable in the respective
Insurance Company's gross income. Distributions of the Company's net realized
long-term capital gains retain their character as long-term capital gains in
the hands of the Insurance Companies if certain requirements are met. The tax
treatment of such dividends and distributions depends on the respective
Insurance Company's tax status. To the extent that income of the Company
represents dividends on common or preferred stock, rather than interest
income, its distributions to the Insurance Companies will be eligible for the
present 70% dividends received deduction applicable in the case of a life
insurance company as provided in the Code. See the Prospectus for the
Contracts for a description of the respective Insurance Company's tax status
and the charges which may be made to cover any taxes attributable to the
Separate Account. Not later than 60 days after the end of each calendar year,
the Company will send to the Insurance Companies a written notice required by
the Code designating the amount and character of any distributions made during
such year.
PERFORMANCE DATA
From time to time the average annual total return and yield of one or more
of the Company's Funds for various specified time periods may be included in
advertisements or information furnished by the Insurance Companies to present
or prospective Contract owners. Average annual total return and yield are
computed in accordance with formulas specified by the Securities and Exchange
Commission.
Average annual total return quotations for the specified periods will be
computed by finding the average annual compounded rates of return (based on
net investment income and any realized and unrealized capital gains or losses
on portfolio investments over such periods) that would equate the initial
amount invested to the redeemable value of such investment at the end of each
period. Average annual total return will be computed assuming all dividends
and distributions are reinvested and taking into account all applicable
recurring and nonrecurring expenses.
Yield quotations will be computed based on a 30-day period by dividing (a)
the net income based on the yield to maturity of each security earned during
the period by (b) the average daily number of shares outstanding during the
period that were entitled to receive dividends multiplied by the offering
price per share on the last day of the period. The yield for the 30-day period
ending December 31, 1996 was 6.23% for the Prime Bond Fund and 9.30% for the
High Current Income Fund.
Total return and yield figures are based on the Fund's historical
performance and are not intended to indicate future performance. The Fund's
total return and yield will vary depending on market conditions, the
securities comprising the Fund's portfolio, the Fund's operating expenses and
the amount of realized and unrealized net capital gains or losses during the
period. The value of an investment in the Fund will fluctuate and an
investor's shares, when redeemed, may be worth more or less than their
original cost. The yield and total return quotations may be of limited use for
comparative purposes because they do not reflect charges imposed at the
Separate Account level, which, if included, would decrease the yield.
On occasion, one or more of the Company's Funds may compare its performance
to that of the Standard & Poor's 500 Composite Stock Price Index, the Value
Line Composite Index, the Dow Jones Industrial Average, or performance data
published by Lipper Analytical Services, Inc., or Variable Annuity Research
Data Service or contained in publications such as Morningstar Publications,
Inc., Chase Investment Performance Digest, Money Magazine, U.S. News & World
Report, Business Week, Financial Services Weekly, Kiplinger Personal Finances,
CDA Investment Technology, Inc., Forbes Magazine, Fortune Magazine, Wall
Street Journal, USA Today, Barrons, Strategic Insight, Donaghues, Investors
Business Daily and Ibbotson Associates. As with other performance data,
performance comparisons should not be considered indicative of the Fund's
relative performance for any future period.
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ADDITIONAL INFORMATION
DETERMINATION OF NET ASSET VALUE
The net asset value of the shares of each Fund is determined once daily by
the Investment Adviser immediately after the declaration of dividends, if any,
and is determined as of fifteen minutes following the close of trading on each
day the New York Stock Exchange is open for business. The New York Stock
Exchange is open on business days other than national holidays (except for
Martin Luther King Day, when it is open) and Good Friday. The net asset value
per share of each Fund is computed by dividing the sum of the value of the
securities held by that Fund plus any cash or other assets (including interest
and dividends accrued) minus all liabilities (including accrued expenses) by
the total number of shares outstanding of that Fund at such time, rounded to
the nearest cent. Expenses, including the investment advisory fees payable to
the Investment Adviser, are accrued daily.
Securities held by each Fund will be valued as follows: Portfolio securities
that are traded on stock exchanges are valued at the last sale price (regular
way) as of the close of business on the day the securities are being valued,
or, lacking any sales, at the last available bid price. Securities traded in
the over-the-counter ("OTC") market are valued at the last available bid price
in the OTC market prior to the time of valuation. Portfolio securities that
are traded both in the OTC market and on a stock exchange are valued according
to the broadest and most representative market, and it is expected that for
debt securities this ordinarily will be the over-the-counter market. When a
Fund writes an option, the amount of the premium received is recorded on the
books as an asset and an equivalent liability. The amount of the liability is
subsequently valued to reflect the current market value of the option written,
based upon the last sale price in the case of exchange-traded options or, in
the case of options being traded in the OTC market, the last asked price.
Options purchased are valued at their last sale price in the case of exchange-
traded options or, in the case of options traded in the OTC market, the last
bid price. Futures contracts are valued at settlement price at the close of
the applicable exchange. Securities and assets for which market quotations are
not readily available are valued at fair value as determined in good faith by
or under the direction of the Board of Directors of the Company. Any assets or
liabilities initially expressed in terms of non-U.S. dollar currencies are
translated into U.S. dollars at the prevailing market rates as quoted by one
or more banks or dealers on the day of valuation.
The Company has used pricing services, including Merrill Lynch Securities
Pricing SM Service ("MLSPS"), to value securities held by the High Current
Income Fund and Prime Bond Fund, and to value bonds held by certain other of
the Company's Funds. The Board of Directors of the Company has examined the
methods used by the pricing services in estimating the value of securities
held by the Funds and believes that such methods will reasonably and fairly
approximate the price at which those securities may be sold and result in a
good faith determination of the fair value of such securities; however, there
is no assurance that securities can be sold at the prices at which they are
valued. During the fiscal year ended December 31, 1996, American Balanced
Fund, High Current Income Fund, and Prime Bond Fund paid MLSPS $278, $7,269,
and $5,884, respectively.
ORGANIZATION OF THE COMPANY
The Company was incorporated on October 16, 1981. Operations of the Prime
Bond, High Current Income, and Special Value Focus Funds commenced on April
20, 1982. The American Balanced Fund commenced operations on June 1, 1988. The
International Equity Focus Fund commenced operations on July 1, 1993. The
authorized capital stock of the Company consists of 3,400,000,000 shares of
Class A Common Stock, par value $0.10 per share, and 3,400,000,000 shares of
Class B Common Stock, par value $0.10 per share. The shares of Class A and
Class B Common Stock are each divided into sixteen classes designated Merrill
Lynch Reserve Assets Fund Common Stock, Merrill Lynch Prime Bond Fund Common
Stock, Merrill Lynch High Current Income Fund Common Stock, Merrill Lynch
Quality Equity Fund Common Stock, Merrill Lynch Special Value Focus Fund
Common Stock, Merrill Lynch Natural Resources Focus Fund Common Stock, Merrill
Lynch American Balanced Fund Common Stock, Merrill Lynch Global Strategy Focus
Fund Common Stock, Merrill Lynch Domestic Money Market Fund Common Stock,
Merrill Lynch Basic Value Focus Fund Common Stock, Merrill Lynch Global Bond
Focus Fund, Merrill Lynch Global Utility Focus Fund Common Stock, Merrill
Lynch International Equity Focus Fund Common Stock, Merrill Lynch Developing
Capital Markets Focus Fund Common Stock, Merrill Lynch Government Bond Fund
Common Stock and Merrill Lynch Index 500 Common
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Stock, respectively. The Company may, from time to time, at the sole
discretion of its Board of Directors and without the need to obtain the
approval of its shareholders or of Contract Owners, offer and sell shares of
one or more of such classes. Each class consists of 100,000,000 Class A shares
and 100,000,000 Class B shares except for Domestic Money Market Fund Common
Stock which consists of 1,300,000,000 Class A shares and 1,300,000,000 Class B
shares, Reserve Assets Fund Common Stock which consists of 500,000,000 Class A
shares and 500,000,000 Class B shares and Global Bond Focus Fund Common Stock
and Global Strategy Focus Fund Common Stock, each of which consists of
200,000,000 Class A shares and 200,000,000 Class B shares. All shares of
Common Stock have equal voting rights, except that only shares of the
respective classes are entitled to vote on matters concerning only that class.
Pursuant to the Investment Company Act of 1940 and the rules and regulations
thereunder, certain matters approved by a vote of all shareholders of the
Company may not be binding on a class whose shareholders have not approved
such matter. Each issued and outstanding share of a class is entitled to one
vote and to participate equally in dividends and distributions declared with
respect to such class and in net assets of such class upon liquidation or
dissolution remaining after satisfaction of outstanding liabilities. The
shares of each class, when issued, will be fully paid and nonassessable, have
no preference, preemptive, conversion, exchange or similar rights, and will be
freely transferable. Holders of shares of any class are entitled to redeem
their shares as set forth under "Redemption of Shares." Shares do not have
cumulative voting rights and the holders of more than 50% of the shares of the
Company voting for the election of directors can elect all of the directors of
the Company if they choose to do so and in such event the holders of the
remaining shares would not be able to elect any directors. The Company does
not intend to hold meetings of shareholders unless under the Investment
Company Act of 1940 shareholders are required to act on any of the following
matters: (i) election of directors; (ii) approval of an investment advisory
agreement; (iii) approval of a distribution agreement; and (iv) ratification
of the selection of independent accountants.
The Board of Directors of the Company has authorized the issuance of shares
of such Class B Common Stock with respect to each of the Company's Funds, with
the existing shares of Common Stock of each Fund to be designated Class A
Common Stock of such Fund. The Board of Directors have also authorized the
Company to enter into a Distribution Plan with Merrill Lynch Funds
Distributor, Inc. under which the Company would pay distribution fees in
respect of the shares of its Class B Common Stock. No shares of Class B Common
Stock have been issued; however, the Company may commence issuing shares of
Class B Common Stock later in 1997 pursuant to a separate or amended
Prospectus.
Family Life Insurance Company ("Family Life") purchased $1,000 worth of
shares of the American Balanced Fund on April 29, 1988 and $1,999,000 worth of
shares of that Fund on May 27, 1988. Family Life also provided the initial
capitalization for each of the Company's other Funds other than the Funds
named below for which Merrill Lynch Life Insurance Company ("MLLIC") provided
the initial capitalization. MLLIC purchased $100 worth of shares of the
International Equity Focus Fund on June 28, 1993. MLLIC purchased, on July 1,
1993, $8,000,000 worth of shares of the International Equity Focus Fund. The
organizational expenses of each of the Company's Funds are paid by the
Investment Adviser. The Investment Adviser is reimbursed by MLLIC for all such
expenses over a five-year period.
INDEPENDENT AUDITORS
Deloitte & Touche, LLP, 117 Campus Drive, Princeton, New Jersey 08540, has
been selected as the independent auditors of the Company. The selection of
independent auditors is subject to annual ratification by the Company's
shareholders.
CUSTODIAN
The Bank of New York ("BONY"), 110 Washington Street, New York, New York
10286, acts as Custodian of the Company's assets, except that Brown Brothers
Harriman & Co., 40 Water Street, Boston, Massachusetts 02102, acts as
Custodian for assets of the Company's Developing Capital Markets Focus Fund.
TRANSFER AND DIVIDEND DISBURSING AGENT
Merrill Lynch Financial Data Services, Inc. ("MLFDS"), which is a wholly
owned subsidiary of Merrill Lynch & Co., Inc., acts as the Company's Transfer
Agent and is responsible for the issuance, transfer and redemption of shares
and the opening and maintenance of shareholder accounts. MLFDS will receive an
annual fee of $5,000 per Fund and will be entitled to reimbursement of out-of-
pocket expenses.
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LEGAL COUNSEL
Rogers & Wells, New York, New York, is counsel for the Company.
REPORTS TO SHAREHOLDERS
The fiscal year of the Company ends on December 31 of each year. The Company
will send to its shareholders at least semi-annually reports showing the
Funds' portfolio securities and other information. An annual report containing
financial statements, audited by independent auditors, will be sent to
shareholders each year.
ADDITIONAL INFORMATION
This Prospectus does not contain all of the information included in the
Registration Statement filed with the Securities and Exchange Commission under
the Securities Act of 1933 and the Investment Company Act of 1940, with
respect to the securities offered hereby, certain portions of which have been
omitted pursuant to the rules and regulations of the Securities and Exchange
Commission.
The Statement of Additional Information, dated April 25, 1997, which forms a
part of the Registration Statement, is incorporated by reference into this
Prospectus. The Statement of Additional Information may be obtained without
charge as provided on the cover page of this Prospectus. The Registration
Statement, including the exhibits filed therewith, may be examined at the
office of the Securities and Exchange Commission in Washington, D.C.
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APPENDIX A
U.S. GOVERNMENT SECURITIES
For temporary or defensive purposes, each of the Funds may invest in the
various types of marketable securities issued by or guaranteed as to principal
and interest by the U.S. Government and supported by the full faith and credit
of the U.S. Treasury. U.S. Treasury obligations differ mainly in the length of
their maturity. Treasury bills, the most frequently issued marketable
government security, have a maturity of up to one year and are issued on a
discount basis.
GOVERNMENT AGENCY SECURITIES
For temporary or defensive purposes, each of the Funds may invest in
government agency securities, which are debt securities issued by government
sponsored enterprises, federal agencies and international institutions. Such
securities are not direct obligations of the Treasury but involve government
sponsorship or guarantees by government agencies or enterprises. The Funds may
invest in all types of government agency securities currently outstanding or
to be issued in the future.
DEPOSITORY INSTITUTIONS MONEY INSTRUMENTS
For temporary or defensive purposes, each of the Funds may invest in
depositary institutions money instruments, such as certificates of deposit,
including variable rate certificates of deposit, bankers' acceptances, time
deposits and bank notes. Certificates of deposit are generally short-term,
interest-bearing negotiable certificates issued by commercial banks, savings
banks or savings and loan associations against funds deposited in the issuing
institution. Variable rate certificates of deposit are certificates of deposit
on which the interest rate is periodically adjusted prior to their stated
maturity, usually at 30, 90 or 180 day intervals ("coupon dates"), based upon
a specified market rate. As a result of these adjustments, the interest rate
on these obligations may be increased or decreased periodically. Often,
dealers selling variable rate certificates of deposit to the Funds agree to
repurchase such instruments, at the Funds' option, at par on the coupon dates.
The dealers' obligations to repurchase these instruments are subject to
conditions imposed by the various dealers; such conditions typically are the
continued credit standing of the issuer and the existence of reasonably
orderly market conditions. The Funds are also able to sell variable rate
certificates of deposit in the secondary market. Variable rate certificates of
deposit normally carry a higher interest rate than comparable fixed rate
certificates of deposit because variable rate certificates of deposit
generally have a longer stated maturity than comparable fixed rate
certificates of deposit.
A bankers' acceptance is a time draft drawn on a commercial bank by a
borrower usually in connection with an international commercial transaction
(to finance the import, export, transfer or storage of goods). The borrower is
liable for payment as well as the bank, which unconditionally guarantees to
pay the draft at its face amount on the maturity date. Most acceptances have
maturities of six months or less and are traded in secondary markets prior to
maturity.
For temporary or defensive purposes, the International Equity Focus Fund may
invest in certificates of deposit and bankers' acceptances issued by foreign
branches or subsidiaries of U.S. banks ("Eurodollar" obligations) or U.S.
branches or subsidiaries of foreign banks ("Yankeedollar" obligations). The
Fund may invest only in Eurodollar obligations which by their terms are
general obligations of the U.S. parent bank and meet the other criteria
discussed below. Yankeedollar obligations in which the Fund may invest must be
issued by U.S. branches or subsidiaries of foreign banks which are subject to
state or federal banking regulations in the U.S. and by their terms must be
general obligations of the foreign parent. In addition, the Fund will limit
its investments in Yankeedollar obligations to obligations issued by banking
institutions with more than $1 billion in assets.
For temporary or defensive purposes, the International Equity Focus Fund may
also invest in U.S. dollar-denominated obligations of foreign depository
institutions and their foreign branches and subsidiaries, such as certificates
of deposit, bankers' acceptances, time deposits and deposit notes. The
obligations of such foreign branches and subsidiaries may be the general
obligation of the parent bank or may be limited to the issuing branch or
subsidiary by the terms of the specific obligation or by government
regulation.
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Except as otherwise provided above with respect to investment in
Yankeedollar and other foreign bank obligations no Fund may invest in any bank
money instrument issued by a commercial bank or a savings and loan association
unless the bank or association is organized and operating in the United
States, has total assets of at least $1 billion and its deposits are insured
by the Federal Deposit Insurance Corporation (the "FDIC"); provided that this
limitation shall not prohibit the investment of up to 10% of the total assets
of a Fund (taken at market value at the time of each investment) in
certificates of deposit issued by banks and savings and loan associations with
assets of less than $1 billion if the principal amount of each such
certificate of deposit is fully insured by the FDIC.
SHORT-TERM DEBT INSTRUMENTS
For temporary or defensive purposes, each of the Funds may invest in
commercial paper (including variable amount master demand notes and insurance
company funding agreements), which refers to short-term, unsecured promissory
notes issued by corporations, partnerships, trusts and other entities to
finance short-term credit needs and by trusts issuing asset-backed commercial
paper. Commercial paper is usually sold on a discount basis and has a maturity
at the time of issuance not exceeding nine months. Variable amount master
demand notes are demand obligations that permit the investment of fluctuating
amounts at varying market rates of interest pursuant to arrangements between
the issuer and a commercial bank acting as agent for the payees of such notes,
whereby both parties have the right to vary the amount of the outstanding
indebtedness on the notes. Because variable amount master notes are direct
lending arrangements between the lender and borrower, it is not generally
contemplated that such instruments will be traded and there is no secondary
market for the notes. Typically, agreements relating to such notes provide
that the lender may not sell or otherwise transfer the note without the
borrower's consent. Such notes provide that the interest rate on the amount
outstanding is adjusted periodically, typically on a daily basis, in
accordance with a stated short-term interest rate benchmark. Because the
interest rate of a variable amount master note is adjusted no less often than
every 60 days and since repayment of the note may be demanded at any time, the
Investment Adviser values such a note in accordance with the amortized cost
basis described under "Determination of Net Asset Value" in the Statement of
Additional Information.
For temporary or defensive purposes, the International Equity Focus Fund may
also invest in U.S. dollar-denominated commercial paper and other short-term
obligations issued by foreign entities. Such investments are subject to
quality standards similar to those applicable to investments in comparable
obligations of domestic issuers. Investments in foreign entities in general
involve the same risks as those described in the Statement of Additional
Information in connection with investments in Eurodollar, Yankeedollar and
foreign bank obligations.
REPURCHASE AGREEMENTS
Repurchase Agreements; Purchase and Sale Contracts. Each Fund may invest in
securities pursuant to repurchase agreements or purchase and sale contracts.
Under a repurchase agreement, the seller agrees, upon entering into the
contract with the Fund, to repurchase a security (typically a security issued
or guaranteed by the U.S. government) at a mutually agreed upon time and
price, thereby determining the yield during the term of the agreement. This
results in a fixed yield for the Fund insulated from fluctuations in the
market value of the underlying security during such period, although, to the
extent the repurchase agreement is not denominated in U.S. dollars, the Fund's
return may be affected by currency fluctuations. Repurchase agreements may be
entered into only with a member bank of the Federal Reserve System, a primary
dealer in U.S. government securities or an affiliate thereof. A purchase and
sale contract is similar to a repurchase agreement, but purchase and sale
contracts, unlike repurchase agreements, allocate interest on the underlying
security to the purchaser during the term of the agreement and generally do
not require the seller to provide additional securities in the event of a
decline in the market value of the purchased security during the term of the
agreement. In all instances, the Fund takes possession of the underlying
securities when investing in repurchase agreements or purchase and sale
contracts. If the seller were to default on its obligation to repurchase a
security under a repurchase agreement or purchase and sale contract and the
market value of the underlying security at such time was less than the Fund
had paid to the seller, the Fund would realize a loss. Repurchase agreements
maturing in more than seven days will be considered "illiquid securities."
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DESCRIPTION OF CORPORATE BOND RATINGS
Moody's Investors Service, Inc.:
Aaa--Bonds which are rated Aaa are judged to be of the best quality. They
carry the smallest degree of investment risk and are generally referred to
as "gilt-edge." Interest payments are protected by a large or by an
exceptionally stable margin and principal is secure. While the various
protective elements are likely to change, such changes as can be visualized
are most unlikely to impair the fundamentally strong position of such
issues.
Aa--Bonds which are rated Aa are judged to be of high quality by all
standards. Together with the Aaa group they comprise what are generally
known as high-grade bonds. They are rated lower than the best bonds because
margins of protection may not be as large as in Aaa securities or
fluctuation of protective elements may be of greater amplitude or there may
be other elements present which make the long-term risks appear somewhat
larger than in Aaa securities.
A--Bonds which are rated A possess many favorable investment attributes
and are to be considered as upper medium-grade obligations. Factors giving
security to principal and interest are considered adequate but elements may
be present which suggest a susceptibility to impairment sometime in the
future.
Baa--Bonds which are rated Baa are considered medium-grade obligations,
i.e., they are neither highly protected nor poorly secured. Interest
payments and principal security appear adequate for the present but certain
protective elements may be lacking or may be characteristically unreliable
over any length of time. Such bonds lack outstanding investment
characteristics and in fact have speculative characteristics as well.
Ba--Bonds which are rated Ba are judged to have speculative elements;
their future cannot be considered as well assured. Often the protection of
interest and principal payments may be very moderate and thereby not well
safeguarded both during good and bad times over the future. Uncertainty of
position characterizes bonds in this class.
B--Bonds which are rated B generally lack characteristics of a desirable
investment. Assurance of interest and principal payments or of maintenance
of other terms of the contract over any period of time may be small.
Caa--Bonds which are rated Caa are of poor standing. Such issues may be
in default or there may be present elements of danger with respect to
principal or interest.
Ca--Bonds which are rated Ca represent obligations which are speculative
in a high degree. Such issues are often in default or have other market
shortcomings.
C--Bonds which are rated C are the lowest rated class of bonds and issues
so rated can be regarded as having extremely poor prospects of ever
attaining any real investment standing.
Note: Moody's applies numerical modifiers, 1, 2 and 3 in each generic rating
classification from Aa through B in its corporate bond rating system. The
modifier 1 indicates that the security ranks in the higher end of its generic
rating category; the modifier 2 indicates a mid-range ranking; and the
modifier 3 indicates that the issue ranks in the lower end of its generic
rating category.
Standard & Poor's Corporation:
AAA--This is the highest rating assigned by Standard & Poor's to a debt
obligation and indicates an extremely strong capacity to pay principal and
interest.
AA--Bonds rated AA also qualify as high-quality debt obligations.
Capacity to pay principal and interest is very strong, and in the majority
of instances they differ from AAA issues only in small degree.
A--Bonds rated A have a strong capacity to pay principal and interest,
although they are somewhat more susceptible to the adverse effects of
changes in circumstances and economic conditions.
BBB--Bonds rated BBB are regarded as having an adequate capacity to pay
principal and interest. Whereas they normally exhibit adequate protection
parameters, adverse economic conditions or changing circumstances are more
likely to lead to a weakened capacity to pay principal and interest for
bonds in this category than for bonds in the A category.
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BB--B--CCC--CC--Bonds rated BB, B, CCC, and CC are regarded, on balance,
as predominantly speculative with respect to the issuer's capacity to pay
interest and repay principal in accordance with the terms of the
obligations. BB indicates the lowest degree of speculation and CC the
highest degree of speculation. While such bonds will likely have some
quality and protective characteristics, these are outweighed by large
uncertainties or major risk exposures to adverse conditions.
NR--Not rated by the indicated rating agency.
Plus (+) or Minus (-): The ratings from "AA" to "B" may be modified by the
addition of a plus or minus sign to show relative standing within the major
rating categories.
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APPENDIX B
Certain Funds of the Company are authorized to use derivative instruments,
including indexed and inverse securities, options, and futures, and to
purchase and sell foreign exchange, as described below. Such instruments are
referred to collectively herein as "Strategic Instruments."
INDEXED AND INVERSE SECURITIES
The Prime Bond Fund and the International Equity Focus Fund may invest in
securities the potential return of which is based on the change in particular
measurements of value or rate (an "index"). As an illustration, a Fund may
invest in a debt security that pays interest and returns principal based on
the change in the value of an interest rate index (such as the prime rate or
federal funds rate), a securities index (such as the S&P 500 or a more
narrowly-focused index such as the AMEX Oil & Gas Index) or a basket of
securities, or based on the relative changes of two indices. In addition, the
International Equity Focus Fund may invest in securities the potential return
of which is based inversely on the change in an index. For example, the Fund
may invest in securities that pay a higher rate of interest when a particular
index decreases and pay a lower rate of interest (or do not fully return
principal) when the value of the index increases. If the Fund invests in such
securities, it may be subject to reduced or eliminated interest payments or
loss of principal in the event of an adverse movement in the relevant index or
indices.
Certain indexed and inverse securities may have the effect of providing
investment leverage because the rate of interest or amount of principal
payable increases or decreases at a rate that is a multiple of the changes in
the relevant index. As a consequence, the market value of such securities may
be substantially more volatile than the market values of other debt
securities. The Company believes that indexed and inverse securities may
provide portfolio management flexibility that permits Funds to seek enhanced
returns, hedge other portfolio positions or vary the degree of portfolio
leverage with greater efficiency than would otherwise be possible under
certain market conditions.
OPTIONS ON SECURITIES AND SECURITIES INDICES
Purchasing Options. The International Equity Focus Fund is authorized to
purchase put options on securities held in its portfolio or securities indices
the performance of which is substantially correlated with securities held in
its portfolio. When a Fund purchases a put option, in consideration for an
upfront payment (the "option premium") the Fund acquires a right to sell to
another party specified securities owned by the Fund at a specified price (the
"exercise price") on or before a specified date (the "expiration date"), in
the case of an option on securities, or to receive from another party a
payment based on the amount a specified securities index declines below a
specified level on or before the expiration date, in the case of an option on
a securities index. The purchase of a put option limits the Fund's risk of
loss in the event of a decline in the market value of the portfolio holdings
underlying the put option prior to the option's expiration date. If the market
value of the portfolio holdings associated with the put option increases
rather than decreases, however, the Fund will lose the option premium and will
consequently realize a lower return on the portfolio holdings than would have
been realized without the purchase of the put.
The International Equity Focus Fund is authorized to purchase call options
on securities it intends to purchase or securities indices the performance of
which are substantially correlated with the performance of the types of
securities it intends to purchase. When a Fund purchases a call option, in
consideration for the option premium the Fund acquires a right to purchase
from another party specified securities at the exercise price on or before the
expiration date, in the case of an option on securities, or to receive from
another party a payment based on the amount a specified securities index
increases beyond a specified level on or before the expiration date, in the
case of an option on a securities index. The purchase of a call option may
protect the Fund from having to pay more for a security as a consequence of
increases in the market value for the security during a period when the Fund
is contemplating its purchase, in the case of an option on a security, or
attempting to
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identify specific securities in which to invest in a market the Fund believes
to be attractive, in the case of an option on an index (an "anticipatory
hedge"). In the event the Fund determines not to purchase a security
underlying a call option, however, the Fund may lose the entire option
premium.
Each Fund is also authorized to purchase put or call options in connection
with closing out put or call options it has previously sold.
Writing Options. The American Balanced Fund, the Special Value Focus Fund
and the International Equity Focus Fund are each authorized to write (i.e.,
sell) call options on securities held in its portfolio or securities indices
the performance of which is substantially correlated with securities held in
its portfolio. When a Fund writes a call option, in return for an option
premium the Fund gives another party the right to buy specified securities
owned by the Fund at the exercise price on or before the expiration date, in
the case of an option on securities, or agrees to pay to another party an
amount based on any gain in a specified securities index beyond a specified
level on or before the expiration date, in the case of an option on a
securities index. The Fund may write call options to earn income, through the
receipt of option premiums. In the event the party to which the Fund has
written an option fails to exercise its rights under the option because the
value of the underlying securities is less than the exercise price, the Fund
will partially offset any decline in the value of the underlying securities
through the receipt of the option premium. By writing a call option, however,
the Fund limits its ability to sell the underlying securities, and gives up
the opportunity to profit from any increase in the value of the underlying
securities beyond the exercise price, while the option remains outstanding.
The International Equity Focus Fund may also write put options on securities
or securities indices. When the Fund writes a put option, in return for an
option premium the Fund gives another party the right to sell to the Fund a
specified security at the exercise price on or before the expiration date, in
the case of an option on a security, or agrees to pay to another party an
amount based on any decline in a specified securities index below a specified
level on or before the expiration date, in the case of an option on a
securities index. The Fund may write put options to earn income, through the
receipt of option premiums. In the event the party to which the Fund has
written an option fails to exercise its rights under the option because the
value of the underlying securities is greater than the exercise price, the
Fund will profit by the amount of the option premium. By writing a put option,
however, the Fund will be obligated to purchase the underlying security at a
price that may be higher than the market value of the security at the time of
exercise as long as the put option is outstanding, in the case of an option on
a security, or make a cash payment reflecting any decline in the index, in the
case of an option on an index. Accordingly, when the Fund writes a put option
it is exposed to a risk of loss in the event the value of the underlying
securities falls below the exercise price, which loss potentially may
substantially exceed the amount of option premium received by the Fund for
writing the put option. The Fund will write a put option on a security or a
securities index only if the Fund would be willing to purchase the security at
the exercise price for investment purposes (in the case of an option on a
security) or is writing the put in connection with trading strategies
involving combinations of options--for example, the sale and purchase of
options with identical expiration dates on the same security or index but
different exercise prices (a technique called a "spread").
Each Fund is also authorized to sell call or put options in connection with
closing out call or put options it has previously purchased.
Other than with respect to closing transactions, a Fund will only write call
or put options that are "covered." A call or put option will be considered
covered if the Fund has segregated assets with respect to such option in the
manner described in "Risk Factors in Options, Futures, and Currency
Instruments" below. A call option will also be considered covered if a Fund
owns the securities it would be required to deliver upon exercise of the
option (or, in the case of option on a securities index, securities which are
substantially correlated with the performance of such index) or owns a call
option, warrant or convertible instrument which is immediately exercisable
for, or convertible into, such security.
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Types of Options. A Fund may engage in transactions in options on securities
or securities indices on exchanges and in the over-the-counter ("OTC")
markets. In general, exchange-traded options have standardized exercise prices
and expiration dates and require the parties to post margin against their
obligations, and the performance of the parties' obligations in connection
with such options is guaranteed by the exchange or a related clearing
corporation. OTC options have more flexible terms negotiated between the buyer
and the seller, but generally do not require the parties to post margin and
are subject to greater risk of counterparty default. See "Additional Risk
Factors of OTC Transactions" below.
FUTURES
The International Equity Focus Fund may engage in transactions in futures
and options thereon. Futures are standardized, exchange-traded contracts which
obligate a purchaser to take delivery, and a seller to make delivery, of a
specific amount of a commodity at a specified future date at a specified
price. No price is paid upon entering into a futures contract. Rather, upon
purchasing or selling a futures contract the Fund is required to deposit
collateral ("margin") equal to a percentage (generally less than 10%) of the
contract value. Each day thereafter until the futures position is closed, the
Fund will pay additional margin representing any loss experienced as a result
of the futures position the prior day or be entitled to a payment representing
any profit experienced as a result of the futures position the prior day.
The sale of a futures contract limits a Fund's risk of loss through a
decline in the market value of portfolio holdings correlated with the futures
contract prior to the futures contract's expiration date. In the event the
market value of the portfolio holdings correlated with the futures contract
increases rather than decreases, however, the Fund will realize a loss on the
futures position and a lower return on the portfolio holdings than would have
been realized without the purchase of the futures contract.
The purchase of a futures contract may protect a Fund from having to pay
more for securities as a consequence of increases in the market value for such
securities during a period when the Fund was attempting to identify specific
securities in which to invest in a market the Fund believes to be attractive.
In the event that such securities decline in value or the Fund determines not
to complete an anticipatory hedge transaction relating to a futures contract,
however, the Fund may realize a loss relating to the futures position.
A Fund will limit transactions in futures and options on futures to
financial futures contracts (i.e., contracts for which the underlying
commodity is a currency or securities or interest rate index) purchased or
sold for hedging purposes (including anticipatory hedges). Each Fund will
further limit transactions in futures and options on futures to the extent
necessary to prevent the Fund from being deemed a "commodity pool" under
regulations of the Commodity Futures Trading Commission.
FOREIGN EXCHANGE TRANSACTIONS
The International Equity Focus Fund may engage in spot and forward foreign
exchange transactions and currency swaps, purchase and sell options on
currencies and purchase and sell currency futures and related options thereon
(collectively, "Currency Instruments") for purposes of hedging against the
decline in the value of currencies in which its portfolio holdings are
denominated against the US dollar.
Forward foreign exchange transactions are OTC contracts to purchase or sell
a specified amount of a specified currency or multinational currency unit at a
price and future date set at the time of the contract. Spot foreign exchange
transactions are similar but require current, rather than future, settlement.
A Fund will enter into foreign exchange transactions only for purposes of
hedging either a specific transaction or a portfolio position. A Fund may
enter into a foreign exchange transaction for purposes of hedging a specific
transaction by, for example, purchasing a currency needed to settle a security
transaction or selling a currency in which the Fund has received or
anticipates receiving a dividend or distribution. A Fund may enter into a
foreign exchange transaction for purposes of hedging a portfolio position by
selling forward a currency in which a portfolio position of the Fund is
denominated or by purchasing a currency in which the Fund anticipates
acquiring a
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portfolio position in the near future. A Fund may also hedge portfolio
positions through currency swaps, which are transactions in which one currency
is simultaneously bought for a second currency on a spot basis and sold for
the second currency on a forward basis.
The International Equity Focus Fund may also hedge against the decline in
the value of a currency against the US dollar through use of currency futures
or options thereon. Currency futures are similar to forward foreign exchange
transactions except that futures are standardized exchange-traded contracts.
See "Futures" above.
The International Equity Focus Fund may also hedge against the decline in
the value of a currency against the US dollar through the use of currency
options. Currency options are similar to options on securities, but in
consideration for an option premium the writer of a currency option is
obligated to sell (in the case of a call option) or purchase (in the case of a
put option) a specified amount of a specified currency on or before the
expiration date for a specified amount of another currency. The Fund may
engage in transactions in options on currencies either on exchanges or OTC
markets. See "Types of Options" above and "Additional Risk Factors of OTC
Transactions" below.
The International Equity Focus Fund will not speculate in Currency
Instruments. Accordingly, the International Equity Focus Fund will not hedge a
currency in excess of the aggregate market value of the securities which it
owns (including receivables for unsettled securities sales), or has committed
to or anticipates purchasing, which are denominated in such currency. The
International Equity Focus Fund may, however, hedge a currency by entering
into a transaction in a Currency Instrument denominated in a currency other
than the currency being hedged (a "cross-hedge"). The Fund will only enter
into a cross-hedge if the Investment Adviser believes that (i) there is a
demonstrable high correlation between the currency in which the cross-hedge is
denominated and the currency being hedged, and (ii) executing a cross-hedge
through the currency in which the cross-hedge is denominated will be
significantly more cost-effective or provide substantially greater liquidity
than executing a similar hedging transaction by means of the currency being
hedged.
Risk Factors in Hedging Foreign Currency Risks. While the International
Equity Focus Fund's use of Currency Instruments to effect hedging strategies
is intended to reduce the volatility of the net asset value of the Fund's
shares, the net asset value of the Fund's shares will fluctuate. Moreover,
although Currency Instruments will be used with the intention of hedging
against adverse currency movements, transactions in Currency Instruments
involve the risk that anticipated currency movements will not be accurately
predicted and that the Fund's hedging strategies will be ineffective. To the
extent that a Fund hedges against anticipated currency movements which do not
occur, the Fund may realize losses, and decrease its total return, as the
result of its hedging transactions. Furthermore, a Fund will only engage in
hedging activities from time to time and may not be engaging in hedging
activities when movements in currency exchange rates occur. It may not be
possible for a Fund to hedge against currency exchange rate movements, even if
correctly anticipated, in the event that (i) the currency exchange rate
movement is so generally anticipated that the Fund is not able to enter into a
hedging transaction at an effective price, or (ii) the currency exchange rate
movement relates to a market with respect to which Currency Instruments are
not available (such as certain developing markets) and it is not possible to
engage in effective foreign currency hedging.
RISK FACTORS IN OPTIONS, FUTURES, AND CURRENCY INSTRUMENTS
Use of Strategic Instruments for hedging purposes involves the risk of
imperfect correlation in movements in the value of the Strategic Instruments
and the value of the instruments being hedged. If the value of the Strategic
Instruments moves more or less than the value of the hedged instruments a Fund
will experience a gain or loss which will not be completely offset by
movements in the value of the hedged instruments.
Each Fund intends to enter into transactions involving Strategic Instruments
only if there appears to be a liquid secondary market for such instruments or,
in the case of illiquid instruments traded in OTC transactions, such
instruments satisfy the criteria set forth below under "Additional Risk
Factors of OTC Transactions." However, there can be no assurance that, at any
specific time, either a liquid secondary market will exist for a Strategic
Instrument or the Fund will otherwise be able to sell such instrument at an
acceptable price. It may therefore not be possible to close a position in a
Strategic Instrument without incurring substantial losses, if at all.
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Certain transactions in Strategic Instruments (e.g., forward foreign
exchange transactions, futures transactions, sales of put options) may expose
a Fund to potential losses which exceed the amount originally invested by the
Fund in such instruments. When a Fund engages in such a transaction, the Fund
will deposit in a segregated account at its custodian liquid securities with a
value at least equal to the Fund's exposure, on a mark-to-market basis, to the
transaction (as calculated pursuant to requirements of the Securities and
Exchange Commission). Such segregation will ensure that the Fund has assets
available to satisfy its obligations with respect to the transaction, but will
not limit the Fund's exposure to loss.
ADDITIONAL RISK FACTORS OF OTC TRANSACTIONS; LIMITATIONS ON THE USE OF OTC
STRATEGIC INSTRUMENTS
Certain Strategic Instruments traded in OTC markets, including indexed
securities and OTC options, may be substantially less liquid than other
instruments in which a Fund may invest. The absence of liquidity may make it
difficult or impossible for the Fund to sell such instruments promptly at an
acceptable price. The absence of liquidity may also make it more difficult for
the Fund to ascertain a market value for such instruments. A Fund will
therefore acquire illiquid OTC instruments (i) if the agreement pursuant to
which the instrument is purchased contains a formula price at which the
instrument may be terminated or sold, or (ii) for which the Investment Adviser
anticipates the Fund can receive on each business day at least two independent
bids or offers, unless a quotation from only one dealer is available, in which
case that dealer's quotation may be used.
The staff of the Securities and Exchange Commission has taken the position
that purchased OTC options and the assets underlying written OTC options are
illiquid securities. Each Fund has therefore adopted an investment policy
pursuant to which it will not purchase or sell OTC options (including OTC
options on futures contracts) if, as a result of such transactions, the sum of
the market value of OTC options currently outstanding which are held by the
Fund, the market value of the securities underlying OTC call options currently
outstanding which have been sold by the Fund and margin deposits on the Fund's
outstanding OTC options exceeds 15% of the total assets of the Fund, taken at
market value, together with all other assets of the Fund which are deemed to
be illiquid or are otherwise not readily marketable. However, if an OTC option
is sold by the Fund to a dealer in U.S. government securities recognized as a
"primary dealer" by the Federal Reserve Bank of New York and the Fund has the
unconditional contractual right to repurchase such OTC option at a
predetermined price, then the Fund will treat as illiquid such amount of the
underlying securities as is equal to the repurchase price less the amount by
which the option is "in-the-money" (i.e., current market value of the
underlying security minus the option's exercise price).
Because Strategic Instruments traded in OTC markets are not guaranteed by an
exchange or clearing corporation and generally do not require payment of
margin to the extent that a Fund has unrealized gains in such instruments or
has deposited collateral with its counterparty, the Fund is at risk that its
counterparty will become bankrupt or otherwise fail to honor its obligations.
A Fund will attempt to minimize the risk that a counterparty will become
bankrupt or otherwise fail to honor its obligations by engaging in
transactions in Strategic Instruments traded in OTC markets only with
financial institutions which have substantial capital or which have provided
the Fund with a third-party guaranty or other credit enhancement.
ADDITIONAL LIMITATIONS ON THE USE OF STRATEGIC INSTRUMENTS
No Fund may use any Strategic Instrument to gain exposure to an asset or
class of assets that it would be prohibited by its investment restrictions
from purchasing directly.
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