Exhibit 17(o)
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE
-------------------------------------------------------------------------
SERIES FUNDS, INC.
-------------------------------------------------------------------------
<Table>
<Caption>
PAGE
----
American Balanced V.I. Fund........... 1
Basic Value V.I. Fund................. 17
Core Bond V.I. Fund................... 33
Developing Capital Markets V.I.
Fund................................ 54
Domestic Money Market V.I. Fund....... 74
Focus Twenty V.I. Fund................ 86
Fundamental Growth V.I. Fund.......... 100
Global Allocation V.I. Fund........... 113
Global Growth V.I. Fund............... 140
Government Bond V.I. Fund............. 155
High Current Income V.I. Fund......... 171
Index 500 V.I. Fund................... 189
Large Cap Core V.I. Fund.............. 206
Large Cap Value V.I. Fund............. 220
Reserve Assets V.I. Fund.............. 234
Small Cap Value V.I. Fund............. 245
Utilities and Telecommunications V.I.
Fund................................ 263
</Table>
Annual Report
December 31, 2002
- --------------------------------------------------------------------------------
This report is only for distribution to shareholders of the Funds of Merrill
Lynch Variable Series Funds, Inc. Past performance results shown in this report
should not be considered a representation of future performance. Investment
return and principal value of non-money market fund shares will fluctuate so
that shares, when redeemed, may be worth more or less than their original cost.
An investment in the Domestic Money Market V.I. Fund or Reserve Assets V.I. Fund
is not insured or guaranteed by the Federal Deposit Insurance Corporation or any
other government agency. Although the money market Funds seek to preserve the
value of your investment at $1.00 per share, it is possible to lose money by
investing in money market funds. Statements and other information herein are as
dated and are subject to change.
Merrill Lynch Variable Series Funds, Inc.
Box 9011
Princeton, NJ
08543-9011
#16897-12/02
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--AMERICAN BALANCED V.I. FUND
DECEMBER 31, 2002--ANNUAL REPORT
- --------------------------------------------------------------------------------
DEAR SHAREHOLDER:
ECONOMIC ENVIRONMENT
During the six-month period ended December 31, 2002, U.S. equity markets fell
sharply as investors struggled through a "crisis of confidence" driven by
uncertain economic and corporate earnings prospects, a series of corporate
governance scandals and geopolitical concerns. During the first half of the
period, the bear market in U.S. equities reached historic proportions with a
decline comparable to that of the third quarter of 1987, which included the
October crash, and the third quarter of 1974, which ended the 1973--1974 bear
market. Most major U.S. market indexes, as well as those of the United Kingdom
and Europe, declined approximately 20%. Decelerating economic growth, continued
reductions in corporate earnings expectations, a growing fear of a military
attack in Iraq and investor capitulation combined to drive prices dramatically
lower.
During the second half of the six-month period ended December 31, 2002, stock
prices posted gains, beginning their recovery from the early October lows and
repairing some of the damage inflicted in the third quarter's decline. An
accumulation of positive economic reports, additional monetary policy
initiatives by the Federal Reserve Board, corporate earnings results, which
generally met or exceeded expectations, and attractive valuation combined to
propel the unmanaged benchmark Standard & Poor's (S&P) 500 Index higher. Third
quarter gross domestic product growth was revised upward to a 4% pace, driven by
personal consumption expenditures and residential construction activity, while
inflation trends remained benign. The Index of Leading Economic Indicators rose
for the first time since May 2002, housing activities remained strong and
employment trends rebounded. While holiday retail sales activity was sluggish,
auto sales trends remained robust. Third quarter earnings showed the first
year-over-year improvement in six quarters and we believe this should continue
to accelerate into 2003. Finally, the dividend yield of the S&P 500 Index
exceeded the interest rate on U.S. Treasury bills for the first time since 1991.
These favorable conditions drove the rebound in equity prices. For the six-month
period ended December 31, 2002, the unmanaged benchmark S&P 500 Index had a
total return of -10.3%. Bonds continued to be the preferred asset class as
sluggish economic growth, low inflation and a flight to quality drove investors
to the fixed income market. U.S. government securities benefited from their
safety and soundness in this uncertain period while the attractive yields
available in the corporate sector of the market enhanced their appeal. The
unmanaged benchmark Merrill Lynch Domestic Bond Master Index had a +6.5% total
return for the six-month period ended December 31, 2002.
PORTFOLIO MATTERS
For the six-month period ended December 31, 2002, American Balanced V.I.
Fund's Class A Shares had a -8.65% total return. Each asset class within the
Fund underperformed its respective benchmark for the period. Within the equity
portfolio, positive contributions from our positions in the consumer staple,
media and entertainment, pharmaceutical and insurance sectors were more than
offset by weakness in the retail, diversified industrial, technology and capital
markets sectors. Within the fixed income portfolio, the benefits of a
contraction in yield spreads between government and corporate bonds as well as
our neutral duration position of five years were offset by weakness in the high
yield sector of the bond market and credit quality deterioration in selected
holdings.
At December 31, 2002, 65.4% of the Fund's net assets were invested in
equities, 30.8% in fixed income securities and 3.3% in cash equivalents. This
compares to 66% in equities, 30.7% in fixed income securities and 2.8% in cash
equivalents at June 30, 2002. While near-term prospects for the equity markets
remain cloudy given sluggish economic conditions, uncertain corporate earnings
prospects and poor investor psychology, we remain constructive on the
longer-term outlook for stocks and believe our strategy of maintaining a
relatively high equity exposure will ultimately prove rewarding. Reminiscent of
the late 1999 and early 2000 period when high valuations could not be justified
and our conservative position proved appropriate, we believe the current low
valuation level of the market is equally unjustified and our constructive
position will prove appropriate in the period ahead. Simply put, the lower stock
prices go, the more value we perceive and the more opportunities we will seek to
exploit. We believe that this is the appropriate strategy to generate
above-average risk adjusted returns and expect our disciplined investment
approach to prove valuable as we move through this challenging period.
During the six-month period ended December 31, 2002, we continued to adjust
our holdings in response to ongoing price volatility. Within the equity
portfolio, we further increased our energy exposure, initiating positions in
1
- --------------------------------------------------------------------------------
Devon Energy Corporation, Murphy Oil Corporation and Exxon Mobil Corporation.
Resurgent economic growth should benefit hydrocarbon demand while supply remains
constrained because of political problems in Iraq and Venezuela and low levels
of drilling activity in North America. These factors should produce improved
energy commodity prices and create a favorable backdrop for the stocks. We
believe that Exxon Mobil remains one of the world's best-managed and most
profitable companies, while Devon and Murphy offer a superior production profile
and exciting exploration prospects. We also increased our technology exposure,
raising positions in Microsoft Corporation and Accenture Ltd. The recent sharp
correction in technology stock prices has afforded us an opportunity to begin to
invest in several superior companies that offer strong competitive positions,
solid financial characteristics, high returns and proven managements, while
selling at attractive valuation levels for the first time in many years. We
further increased our position in the industrial sector, adding to existing
positions in SPX Corporation and United Technologies Corporation, while
introducing Tyco International Ltd. to the portfolio. Recent price declines,
driven by actual or perceived earnings risk in a decelerating economy, have
driven these stocks to record-low valuation levels, creating attractive
opportunities in the shares of what we believe are fine companies. Tyco appears
particularly interesting given the quality of its new management team, low
investor expectations and very low valuation levels. We eliminated holdings in
selected retailers such as The Home Depot, Inc. and Circuit City where
deteriorating fundamental trends have yet to be fully reflected in reduced
valuations, suggesting high near-term risk. We also reduced or eliminated
holdings in a number of companies including Anheuser-Busch Companies, Inc.,
Minnesota Mining and Manufacturing Company (3M), Harrah's Entertainment Inc. and
Wells Fargo Company, where strong relative stock performance reduced their
attractiveness.
At December 31, 2002, within the fixed income portfolio, investment-grade
corporate bonds continued to represent the largest sector at 71% of fixed income
assets, reflecting this sector's very attractive total return potential. High
yield corporate bonds represented 15.4% of fixed income assets and U.S. Treasury
securities represented 13.6% of fixed income assets. This compares to 72.4% in
investment-grade corporate bonds, 10.9% in high yield corporate bonds and 16.7%
in U.S. Treasury securities at June 30, 2002. Average quality ratings were
stable at Baa1/BBB+, while average yield to maturity declined 35 basis points
(.35%) to 7%.
FISCAL YEAR IN REVIEW
At December 31, 2002, 65.4% of the Fund's net assets were invested in
equities, 30.8% in fixed income securities and 3.3% in cash equivalents. This
compares to 66.9% in equities, 30.4% in fixed income securities and 2.8% in cash
equivalents at December 31, 2001. 2002 was a challenging year for the Fund. Our
bullish investment position extracted a performance penalty as bonds
significantly outperformed stocks during the year. We anticipate a more
hospitable environment for equities in 2003 as the combination of low interest
rates, high levels of liquidity and rising government spending are expected to
drive an acceleration in economic and corporate earnings growth. Bonds, by
contrast, look expensive, particularly U.S. Treasury securities, as investors
are willing to pay very high prices to avoid risk. Just as the investment
pendulum swung too far in the bullish direction in late 1999 and early 2000, we
believe it has swung too far in the bearish direction today, creating many very
attractive investment opportunities. This view supports our current asset
allocation position and we believe it will produce superior returns for our
investors in the periods ahead.
For the year ended December 31, 2002, the Fund's Class A Shares had a total
return of -13.68%. This compares favorably to the -22.10% total return for the
S&P 500 Index for the same period. Our equity holdings outpaced the performance
of the benchmark S&P 500 Index as positive contributions from our positions in
consumer staple, basic material, media and aerospace/defense sectors overcame
weakness in the technology, pharmaceutical, diversified industrials and capital
markets.
During the 12-month period ended December 31, 2002, our bond positions
considerably underperformed the benchmark Merrill Lynch Domestic Bond Master
Index, which had a total return of +10.41%, as deteriorating credit quality,
aggressive rating agency downgrade actions and investors' heightened risk
aversion drove investment-grade corporate and high yield corporate spreads to
near record wide levels. Given our concentration in such sectors within the
fixed income portfolio, these conditions produced relatively weak results.
2
- --------------------------------------------------------------------------------
IN CONCLUSION
We appreciate your investment in American Balanced V.I. Fund of Merrill Lynch
Variable Series Funds, Inc., and we look forward to serving your investment
needs in the months and years ahead.
Sincerely,
/s/ Terry K. Glenn
Terry K. Glenn
President and Director
/s/ Kurt Schansinger
Kurt Schansinger
Senior Vice President and Portfolio Manager
January 17, 2003
3
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--AMERICAN BALANCED V.I. FUND
TOTAL RETURN BASED ON A $10,000 INVESTMENT--CLASS A SHARES
- --------------------------------------------------------------------------------
<Table>
<Caption>
AMERICAN BALANCED V.I. STANDARD & POOR'S 500 MERRILL LYNCH DOMESTIC
FUND+--CLASS A SHARES* INDEX++ MASTER BOND INDEX+++
---------------------- --------------------- ----------------------
12/92 10000 10000 10000
12/93 11349 11008 11002
12/94 10873 11153 10691
12/95 13136 15344 12671
12/96 14414 18867 13126
12/97 16880 25162 14393
12/98 19169 32353 15670
12/99 20842 39161 15520
12/00 20492 35596 17340
12/01 18978 31365 18783
12/02 16382 24433 20738
</Table>
* Assuming transaction costs and other operating expenses, including advisory
fees. Does not include insurance-related fees and expenses.
+ The Fund invests in a balanced portfolio of fixed income and equity
securities.
++ This unmanaged Index covers 500 industrial, utility, transportation and
financial companies of the U.S. markets (mostly NYSE issues), representing
about 75% of NYSE market capitalization and 30% of NYSE issues.
+++ This unmanaged Index is comprised of the entire universe of domestic
investment grade bonds including U.S. Treasury bonds, corporate bonds and
mortgages.
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--AMERICAN BALANCED V.I. FUND
AVERAGE ANNUAL TOTAL RETURN--CLASS A SHARES*
- --------------------------------------------------------------------------------
<Table>
<Caption>
PERIOD COVERED % RETURN
- -----------------------------------------------------------------------------------------
One Year Ended 12/31/02 -13.68%
- -----------------------------------------------------------------------------------------
Five Years Ended 12/31/02 - 0.60
- -----------------------------------------------------------------------------------------
Ten Years Ended 12/31/02 + 5.06
- -----------------------------------------------------------------------------------------
</Table>
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--AMERICAN BALANCED V.I. FUND
RECENT PERFORMANCE RESULTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
6-MONTH 12-MONTH
AS OF DECEMBER 31, 2002 TOTAL RETURN TOTAL RETURN
- -----------------------------------------------------------------------------------------
Class A Shares* - 8.65% -13.68%
- -----------------------------------------------------------------------------------------
Standard & Poor's 500 Index** -10.30 -22.10
- -----------------------------------------------------------------------------------------
Merrill Lynch Domestic Master Bond Index*** + 6.51 +10.41
- -----------------------------------------------------------------------------------------
</Table>
* Total investment returns are based on changes in net asset values for the
periods shown, and assume reinvestment of all dividends and capital gains
distributions at net asset value on the ex-dividend date. Insurance-related
fees and expenses are not reflected in these returns.
** This unmanaged Index covers 500 industrial, utility, transportation and
financial companies of the U.S. markets (mostly NYSE issues), representing
about 75% of NYSE market capitalization and 30% of NYSE issues.
*** This unmanaged Index is comprised of the entire universe of domestic
investment grade bonds including U.S. Treasury bonds, corporate bonds and
mortgages.
Past results shown should not be considered a representation of future
performance.
4
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--AMERICAN BALANCED V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
INDUSTRY++ HELD COMMON STOCKS VALUE NET ASSETS
- -----------------------------------------------------------------------------------------------------------------------
AEROSPACE & DEFENSE 5,000 General Dynamics Corporation................. $ 396,850 0.4%
40,000 Honeywell International Inc. ................ 960,000 1.1
10,000 Raytheon Company............................. 307,500 0.3
25,000 United Technologies Corporation.............. 1,548,500 1.7
----------- -----
3,212,850 3.5
- -----------------------------------------------------------------------------------------------------------------------
AIRLINES 15,000 +AMR Corporation............................. 99,000 0.1
- -----------------------------------------------------------------------------------------------------------------------
BANKS 25,000 FleetBoston Financial Corporation............ 607,500 0.7
40,000 Mellon Financial Corporation................. 1,044,400 1.1
7,500 PNC Bank Corp. .............................. 314,250 0.4
30,000 Wells Fargo & Co. ........................... 1,406,100 1.5
----------- -----
3,372,250 3.7
- -----------------------------------------------------------------------------------------------------------------------
BEVERAGES 30,000 Anheuser-Busch Companies, Inc. .............. 1,452,000 1.6
- -----------------------------------------------------------------------------------------------------------------------
BUILDING PRODUCTS 20,000 Masco Corporation............................ 421,000 0.5
- -----------------------------------------------------------------------------------------------------------------------
CHEMICALS 35,000 E.I. du Pont de Nemours and Company.......... 1,484,000 1.6
- -----------------------------------------------------------------------------------------------------------------------
COMMUNICATIONS EQUIPMENT 60,000 +CommScope, Inc. ............................ 474,000 0.5
50,000 Motorola, Inc. .............................. 432,500 0.5
----------- -----
906,500 1.0
- -----------------------------------------------------------------------------------------------------------------------
COMPUTERS & PERIPHERALS 15,001 Hewlett-Packard Company...................... 260,417 0.3
20,000 International Business Machines
Corporation................................ 1,550,000 1.7
----------- -----
1,810,417 2.0
- -----------------------------------------------------------------------------------------------------------------------
DIVERSIFIED FINANCIALS 45,000 Citigroup Inc. .............................. 1,583,550 1.7
20,000 Fannie Mae................................... 1,286,600 1.4
40,000 J.P. Morgan Chase & Co. ..................... 960,000 1.1
20,000 Morgan Stanley............................... 798,400 0.9
20,000 Prudential Financial, Inc. .................. 634,800 0.7
45,000 +Stilwell Financial, Inc. ................... 588,150 0.6
----------- -----
5,851,500 6.4
- -----------------------------------------------------------------------------------------------------------------------
DIVERSIFIED 40,000 Verizon Communications....................... 1,550,000 1.7
TELECOMMUNICATION SERVICES
- -----------------------------------------------------------------------------------------------------------------------
ELECTRONIC EQUIPMENT & 40,000 +Agilent Technologies, Inc. ................. 718,400 0.8
INSTRUMENTS
- -----------------------------------------------------------------------------------------------------------------------
FOOD PRODUCTS 15,000 General Mills, Inc. ......................... 704,250 0.8
6,500 Nestle SA (Registered Shares)................ 1,377,378 1.5
----------- -----
2,081,628 2.3
- -----------------------------------------------------------------------------------------------------------------------
HEALTH CARE PROVIDERS & 25,000 Aetna Inc. (New Shares)...................... 1,028,000 1.1
SERVICES
25,000 HCA Inc. .................................... 1,037,500 1.2
----------- -----
2,065,500 2.3
- -----------------------------------------------------------------------------------------------------------------------
HOTELS, RESTAURANTS & 30,000 Carnival Corporation......................... 748,500 0.8
LEISURE
50,000 McDonald's Corporation....................... 804,000 0.9
5,000 Starwood Hotels & Resorts Worldwide, Inc. ... 118,700 0.1
----------- -----
1,671,200 1.8
- -----------------------------------------------------------------------------------------------------------------------
HOUSEHOLD PRODUCTS 25,000 Kimberly-Clark Corporation................... 1,186,750 1.3
- -----------------------------------------------------------------------------------------------------------------------
IT CONSULTING & SERVICES 22,500 +Accenture Ltd. 'A'.......................... 404,775 0.4
10,000 +Computer Sciences Corporation............... 344,500 0.4
----------- -----
749,275 0.8
- -----------------------------------------------------------------------------------------------------------------------
INDUSTRIAL CONGLOMERATES 35,000 General Electric Company..................... 852,250 0.9
25,000 Tyco International Ltd. ..................... 427,000 0.5
----------- -----
1,279,250 1.4
- -----------------------------------------------------------------------------------------------------------------------
</Table>
5
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--AMERICAN BALANCED V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
INDUSTRY++ HELD COMMON STOCKS VALUE NET ASSETS
- -----------------------------------------------------------------------------------------------------------------------
INSURANCE 45,000 ACE Limited.................................. $ 1,320,300 1.5%
27,500 American International Group, Inc. .......... 1,590,875 1.7
20,000 XL Capital Ltd. (Class A).................... 1,545,000 1.7
----------- -----
4,456,175 4.9
- -----------------------------------------------------------------------------------------------------------------------
MACHINERY 30,000 Dover Corporation............................ 874,800 1.0
20,000 ITT Industries, Inc. ........................ 1,213,800 1.3
30,000 +SPX Corporation............................. 1,123,500 1.2
----------- -----
3,212,100 3.5
- -----------------------------------------------------------------------------------------------------------------------
MEDIA 40,000 +Clear Channel Communications, Inc. ......... 1,491,600 1.6
60,000 +Liberty Media Corporation (Class A)......... 536,400 0.6
20,000 The New York Times Company (Class A)......... 914,600 1.0
10,000 Tribune Company.............................. 454,600 0.5
40,000 +Viacom, Inc. (Class B)...................... 1,630,400 1.8
25,000 The Walt Disney Company...................... 407,750 0.4
----------- -----
5,435,350 5.9
- -----------------------------------------------------------------------------------------------------------------------
METALS & MINING 30,000 Alcoa Inc. .................................. 683,400 0.8
20,000 Nucor Corporation............................ 826,000 0.9
----------- -----
1,509,400 1.7
- -----------------------------------------------------------------------------------------------------------------------
MULTILINE RETAIL 32,500 The May Department Stores Company............ 746,850 0.8
- -----------------------------------------------------------------------------------------------------------------------
OIL & GAS 12,500 Anadarko Petroleum Corporation............... 598,750 0.6
25,000 Devon Energy Corporation..................... 1,147,500 1.3
15,000 Exxon Mobil Corporation...................... 524,100 0.6
15,000 Murphy Oil Corporation....................... 642,750 0.7
25,000 Royal Dutch Petroleum Company (NY Registered
Shares).................................... 1,100,500 1.2
----------- -----
4,013,600 4.4
- -----------------------------------------------------------------------------------------------------------------------
PAPER & FOREST PRODUCTS 35,000 International Paper Company.................. 1,223,950 1.3
15,000 Weyerhaeuser Company......................... 738,150 0.8
----------- -----
1,962,100 2.1
- -----------------------------------------------------------------------------------------------------------------------
PERSONAL PRODUCTS 30,000 Avon Products, Inc. ......................... 1,616,100 1.8
25,000 The Gillette Company......................... 759,000 0.8
----------- -----
2,375,100 2.6
- -----------------------------------------------------------------------------------------------------------------------
PHARMACEUTICALS 25,000 Pharmacia Corporation........................ 1,045,000 1.1
27,500 Schering-Plough Corporation.................. 610,500 0.7
30,000 Wyeth........................................ 1,122,000 1.2
----------- -----
2,777,500 3.0
- -----------------------------------------------------------------------------------------------------------------------
SEMICONDUCTOR EQUIPMENT & 75,000 +Agere Systems Inc. (Class A)................ 108,000 0.1
PRODUCTS 41,000 +Agere Systems Inc. (Class B)................ 57,400 0.1
30,000 +Micron Technology, Inc. .................... 292,200 0.3
20,000 Texas Instruments Incorporated............... 300,200 0.3
----------- -----
757,800 0.8
- -----------------------------------------------------------------------------------------------------------------------
SOFTWARE 20,000 +Microsoft Corporation....................... 1,034,200 1.1
- -----------------------------------------------------------------------------------------------------------------------
SPECIALTY RETAIL 50,000 The Gap, Inc. ............................... 776,000 0.9
60,000 The Limited, Inc. ........................... 835,800 0.9
----------- -----
1,611,800 1.8
- -----------------------------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS
(COST--$74,091,329) 59,803,495 65.4
- -----------------------------------------------------------------------------------------------------------------------
<Caption>
FACE
AMOUNT FIXED INCOME INVESTMENTS
- -----------------------------------------------------------------------------------------------------------------------
AEROSPACE & DEFENSE $1,000,000 Raytheon Company, 6.15% due 11/01/2008....... 1,078,829 1.2
- -----------------------------------------------------------------------------------------------------------------------
AUTO COMPONENTS 1,000,000 The Goodyear Tire & Rubber Company, 6.625%
due 12/01/2006............................. 810,786 0.9
- -----------------------------------------------------------------------------------------------------------------------
</Table>
6
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--AMERICAN BALANCED V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
FACE PERCENT OF
INDUSTRY++ AMOUNT FIXED INCOME INVESTMENTS VALUE NET ASSETS
- -----------------------------------------------------------------------------------------------------------------------
BANKS $1,000,000 FleetBoston Financial Corporation, 6.375% due
5/15/2008.................................. $ 1,093,136 1.2%
500,000 PNC Funding Corp., 6.125% due 2/15/2009...... 540,020 0.6
500,000 Provident Bank, 6.375% due 1/15/2004......... 521,835 0.5
----------- -----
2,154,991 2.3
- -----------------------------------------------------------------------------------------------------------------------
CHEMICALS 500,000 Equistar Chemicals LP, 6.50% due 2/15/2006... 440,000 0.5
- -----------------------------------------------------------------------------------------------------------------------
COMMERCIAL SERVICES & 500,000 Waste Management Inc., 6.375% due
SUPPLIES 11/15/2012(a).............................. 514,525 0.5
- -----------------------------------------------------------------------------------------------------------------------
COMMUNICATIONS EQUIPMENT 660,000 Harris Corporation, 6.35% due 2/01/2028...... 690,633 0.7
- -----------------------------------------------------------------------------------------------------------------------
DIVERSIFIED FINANCIALS 750,000 GATX Capital Corporation, 6.86% due
10/13/2005................................. 701,115 0.8
General Electric Capital Corporation:
500,000 4.25% due 1/15/2008........................ 512,777 0.5
500,000 6% due 6/15/2012........................... 539,837 0.6
1,500,000 General Motors Acceptance Corp., 5.85% due
1/14/2009.................................. 1,441,187 1.6
900,000 Hertz Corp., 6.25% due 3/15/2009............. 830,608 0.9
1,000,000 Household Finance Corp., 6.50% due
11/15/2008................................. 1,075,213 1.2
----------- -----
5,100,737 5.6
- -----------------------------------------------------------------------------------------------------------------------
DIVERSIFIED 500,000 Pacific Telecom, Inc., 6.625% due
TELECOMMUNICATION SERVICES 10/20/2005................................. 541,458 0.6
1,000,000 Sprint Capital Corporation, 6.90% due
5/01/2019.................................. 820,000 0.9
----------- -----
1,361,458 1.5
- -----------------------------------------------------------------------------------------------------------------------
ELECTRIC UTILITIES 500,000 Empresa Nacional de Electricidad SA (Endesa),
7.325% due 2/01/2037....................... 461,433 0.5
- -----------------------------------------------------------------------------------------------------------------------
FOOD PRODUCTS 500,000 Conagra Inc., 6.70% due 8/01/2027............ 569,588 0.6
- -----------------------------------------------------------------------------------------------------------------------
GAS UTILITIES 500,000 The Coastal Corporation, 6.70% due
2/15/2027.................................. 390,000 0.4
- -----------------------------------------------------------------------------------------------------------------------
HEALTH CARE PROVIDERS & 500,000 Columbia/HCA Healthcare Corp., 8.70% due
SERVICES 2/10/2010.................................. 570,412 0.6
1,000,000 HealthSouth Corporation, 7.375% due
10/01/2006................................. 865,000 1.0
----------- -----
1,435,412 1.6
- -----------------------------------------------------------------------------------------------------------------------
HOUSEHOLD DURABLES 1,000,000 Champion Enterprises, Inc., 7.625% due
5/15/2009.................................. 441,250 0.5
- -----------------------------------------------------------------------------------------------------------------------
MARINE 1,000,000 Transportacion Maritima Mexicana, SA de
CV,10.25% due 11/15/2006................... 620,000 0.7
- -----------------------------------------------------------------------------------------------------------------------
MEDIA 1,000,000 AOL Time Warner Inc., 6.875% due 5/01/2012... 1,056,104 1.2
Comcast Cable Communications:
500,000 6.875% due 6/15/2009....................... 531,946 0.6
500,000 8.50% due 5/01/2027........................ 521,198 0.6
1,000,000 News America Inc., 6.75% due 1/09/2038....... 1,023,698 1.1
1,000,000 Univision Communication Inc., 7.85% due
7/15/2011.................................. 1,134,170 1.2
----------- -----
4,267,116 4.7
- -----------------------------------------------------------------------------------------------------------------------
OIL & GAS 1,000,000 Anderson Exploration Ltd., 6.75% due
3/15/2011.................................. 1,096,637 1.2
475,000 Pecom Energia SA, 8.125% due 7/15/2010(a).... 318,250 0.3
500,000 Transocean Offshore, 6.625% due 4/15/2011.... 550,548 0.6
----------- -----
1,965,435 2.1
- -----------------------------------------------------------------------------------------------------------------------
</Table>
7
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--AMERICAN BALANCED V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONCLUDED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
FACE PERCENT OF
INDUSTRY++ AMOUNT FIXED INCOME INVESTMENTS VALUE NET ASSETS
- -----------------------------------------------------------------------------------------------------------------------
PAPER & FOREST PRODUCTS $ 500,000 Champion International Corp., 6.65% due
12/15/2037................................. $ 556,637 0.6%
500,000 International Paper Company, 5.85% due
10/30/2012(a).............................. 523,521 0.6
500,000 Weyerhaeuser Company, 6.75% due 3/15/2012.... 545,169 0.6
----------- -----
1,625,327 1.8
- -----------------------------------------------------------------------------------------------------------------------
U.S. GOVERNMENT & AGENCY U.S. Treasury Notes:
OBLIGATIONS 3,000,000 4.75% due 11/15/2008....................... 3,274,686 3.6
500,000 5.50% due 5/15/2009........................ 567,285 0.6
- -----------------------------------------------------------------------------------------------------------------------
WIRELESS TELECOMMUNICATION 500,000 Nextel Communications, Inc., 9.375% due
SERVICES 11/15/2009................................. 452,500 0.5
- -----------------------------------------------------------------------------------------------------------------------
TOTAL FIXED INCOME INVESTMENTS
(COST--$28,021,689).......................... 28,221,991 30.8
- -----------------------------------------------------------------------------------------------------------------------
PARTNERSHIP
INTEREST SHORT-TERM SECURITIES
- -----------------------------------------------------------------------------------------------------------------------
$3,018,409 Merrill Lynch Liquidity Series, LLC Cash
Sweep Series II(b)......................... 3,018,409 3.3
- -----------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN SHORT-TERM SECURITIES
(COST--$3,018,409) 3,018,409 3.3
- -----------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS (COST--$105,131,427)....... 91,043,895 99.5
OTHER ASSETS LESS LIABILITIES................ 460,274 0.5
----------- -----
NET ASSETS................................... $91,504,169 100.0%
=========== =====
- -----------------------------------------------------------------------------------------------------------------------
</Table>
+ Non-income producing security.
++ For Fund compliance purposes, "Industry" means any one or more of the
industry sub-classifications used by one or more widely recognized market
indexes or ratings group indexes, and/or as defined by Fund management. This
definition may not apply for purposes of this report, which may combine such
industry sub-classifications for reporting ease. These industry classifications
are unaudited.
(a) The security may be offered and sold to "qualified institutional buyers"
under Rule 144A of the Securities Act of 1933.
(b) Investments in companies considered to be an affiliate of the Fund (such
companies are defined as "Affiliated Companies" in Section 2(a)(3) of the
Investment Company Act of 1940) are as follows:
<Table>
<Caption>
- ------------------------------------------------------------------------------------------------
NET INTEREST
AFFILIATE ACTIVITY NET COST INCOME
- ------------------------------------------------------------------------------------------------
Merrill Lynch Liquidity Series, LLC Cash Sweep Series II.... $3,018,409 $3,018,409 $6,160
- ------------------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
8
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--AMERICAN BALANCED V.I. FUND
STATEMENT OF ASSETS AND LIABILITIES AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
ASSETS:
Investments, at value (including securities loaned of
$1,438,775) (identified cost--$105,131,427)............... $ 91,043,895
Investments held as collateral for loaned securities, at
value..................................................... 1,480,002
Cash........................................................ 1,884
Receivables:
Interest.................................................. $ 445,610
Dividends................................................. 65,378
Securities sold........................................... 27,215
Loaned securities income.................................. 54 538,257
------------
Prepaid expenses............................................ 638
------------
Total assets................................................ 93,064,676
------------
- -----------------------------------------------------------------------------------------
LIABILITIES:
Collateral on securities loaned, at value................... 1,480,002
Payables:
Investment adviser........................................ 44,720
Securities purchased...................................... 16,110
Capital shares redeemed................................... 3,894 64,724
------------
Accrued expenses............................................ 15,781
------------
Total liabilities........................................... 1,560,507
------------
- -----------------------------------------------------------------------------------------
NET ASSETS.................................................. $ 91,504,169
============
- -----------------------------------------------------------------------------------------
NET ASSETS CONSIST OF:
Class A Shares of Common Stock, $.10 par value, 100,000,000
shares authorized+........................................ $ 970,019
Paid-in capital in excess of par............................ 118,183,926
Undistributed investment income--net........................ $ 34,136
Accumulated realized capital losses on investments and
foreign currency transactions--net........................ (13,599,006)
Unrealized depreciation on investments and foreign currency
transactions--net......................................... (14,084,906)
------------
Total accumulated losses--net............................... (27,649,776)
------------
NET ASSETS.................................................. $ 91,504,169
============
- -----------------------------------------------------------------------------------------
NET ASSET VALUE:
Class A--Based on net assets of $91,504,169 and 9,700,193
shares outstanding........................................ $ 9.43
============
- -----------------------------------------------------------------------------------------
</Table>
+ The Fund is also authorized to issue 100,000,000 Class B Shares.
See Notes to Financial Statements.
9
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--AMERICAN BALANCED V.I. FUND
STATEMENT OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
INVESTMENT INCOME:
Interest.................................................... $ 2,473,740
Dividends (net of $4,635 foreign withholding tax)........... 1,069,809
Securities lending--net..................................... 3,360
------------
Total income................................................ 3,546,909
------------
- -----------------------------------------------------------------------------------------
EXPENSES:
Investment advisory fees.................................... $ 606,506
Accounting services......................................... 38,750
Custodian fees.............................................. 21,568
Professional fees........................................... 20,717
Transfer agent fees......................................... 13,968
Printing and shareholder reports............................ 10,972
Pricing services............................................ 5,862
Directors' fees and expenses................................ 5,026
Registration fees........................................... 710
Other....................................................... 8,380
------------
Total expenses.............................................. 732,459
------------
Investment income--net...................................... 2,814,450
------------
- -----------------------------------------------------------------------------------------
REALIZED & UNREALIZED GAIN (LOSS) ON INVESTMENTS AND FOREIGN
CURRENCY TRANSACTIONS--NET:
Realized gain (loss) on:
Investments--net.......................................... (9,122,103)
Foreign currency transactions--net........................ 119 (9,121,984)
------------
Change in unrealized appreciation/depreciation on:
Investments--net.......................................... (9,783,001)
Foreign currency transactions--net........................ 2,423 (9,780,578)
------------ ------------
Total realized and unrealized loss on investments and
foreign currency transactions--net........................ (18,902,562)
------------
NET DECREASE IN NET ASSETS RESULTING FROM OPERATIONS........ $(16,088,112)
============
- -----------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
10
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--AMERICAN BALANCED V.I. FUND
STATEMENTS OF CHANGES IN NET ASSETS
- --------------------------------------------------------------------------------
<Table>
<Caption>
FOR THE YEAR ENDED
DECEMBER 31,
----------------------------
INCREASE (DECREASE) IN NET ASSETS: 2002 2001
- ------------------------------------------------------------------------------------------
OPERATIONS:
Investment income--net...................................... $ 2,814,450 $ 3,250,330
Realized loss on investments and foreign currency
transactions--net......................................... (9,121,984) (370,561)
Change in unrealized appreciation/depreciation on
investments and foreign currency transactions--net........ (9,780,578) (13,398,574)
------------ ------------
Net decrease in net assets resulting from operations........ (16,088,112) (10,518,805)
------------ ------------
- ------------------------------------------------------------------------------------------
DIVIDENDS TO SHAREHOLDERS:
Investment income--net:
Class A................................................... (2,801,637) (3,362,126)
------------ ------------
Net decrease in net assets resulting from dividends to
shareholders.............................................. (2,801,637) (3,362,126)
------------ ------------
- ------------------------------------------------------------------------------------------
CAPITAL SHARE TRANSACTIONS:
Net increase (decrease) in net assets derived from capital
share transactions........................................ (20,110,275) 11,294,734
------------ ------------
- ------------------------------------------------------------------------------------------
NET ASSETS:
Total decrease in net assets................................ (39,000,024) (2,586,197)
Beginning of year........................................... 130,504,193 133,090,390
------------ ------------
End of year*................................................ $ 91,504,169 $130,504,193
============ ============
- ------------------------------------------------------------------------------------------
* Undistributed investment income--net...................... $ 34,136 $ 39,972
============ ============
- ------------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
11
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--AMERICAN BALANCED V.I. FUND
FINANCIAL HIGHLIGHTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
THE FOLLOWING PER SHARE DATA AND RATIOS HAVE BEEN DERIVED FROM CLASS A
INFORMATION PROVIDED IN THE FINANCIAL STATEMENTS. ----------------------------------------------------
FOR THE YEAR ENDED DECEMBER 31,
----------------------------------------------------
INCREASE (DECREASE) IN NET ASSET VALUE: 2002 2001 2000 1999 1998
- --------------------------------------------------------------------------------------------------------------------
PER SHARE OPERATING PERFORMANCE:
Net asset value, beginning of year........................... $ 11.27 $ 12.49 $ 14.80 $ 16.74 $ 16.59
-------- -------- -------- -------- --------
Investment income--net....................................... .27+ .28+ .34+ .45 .40
Realized and unrealized gain (loss) on investments and foreign
currency transactions--net................................. (1.81) (1.20) (.58) .83 1.60
-------- -------- -------- -------- --------
Total from investment operations............................. (1.54) (.92) (.24) 1.28 2.00
-------- -------- -------- -------- --------
Less dividends and distributions:
Investment income--net..................................... (.30) (.30) (.38) (.85) (.54)
In excess of investment income--net........................ -- -- --++ -- --
Realized gain on investments--net.......................... -- -- (1.33) (2.37) (1.31)
In excess of realized gain on investments--net............. -- -- (.36) -- --
-------- -------- -------- -------- --------
Total dividends and distributions............................ (.30) (.30) (2.07) (3.22) (1.85)
-------- -------- -------- -------- --------
Net asset value, end of year................................. $ 9.43 $ 11.27 $ 12.49 $ 14.80 $ 16.74
======== ======== ======== ======== ========
- --------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENT RETURN:*
Based on net asset value per share........................... (13.68%) (7.39%) (1.68%) 8.73% 13.56%
======== ======== ======== ======== ========
- --------------------------------------------------------------------------------------------------------------------
RATIOS TO AVERAGE NET ASSETS:
Expenses..................................................... .66% .68% .62% .61% .62%
======== ======== ======== ======== ========
Investment income--net....................................... 2.55% 2.42% 2.32% 2.70% 2.37%
======== ======== ======== ======== ========
- --------------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL DATA:
Net assets, end of year (in thousands)....................... $ 91,504 $130,504 $133,090 $166,405 $187,084
======== ======== ======== ======== ========
Portfolio turnover........................................... 32.00% 134.43% 85.30% 105.48% 102.47%
======== ======== ======== ======== ========
- --------------------------------------------------------------------------------------------------------------------
</Table>
* Total investment returns exclude insurance-related fees and expenses.
+ Based on average shares outstanding.
++ Amount is less than $.01 per share
See Notes to Financial Statements.
12
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--AMERICAN BALANCED V.I. FUND
NOTES TO FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
1. SIGNIFICANT ACCOUNTING POLICIES:
Merrill Lynch Variable Series Funds, Inc. (the "Company") is an open-end
management investment company that is comprised of 17 separate funds. Each fund
offers two classes of shares to the Merrill Lynch Life Insurance Company, ML
Life Insurance Company of New York (indirect, wholly-owned subsidiaries of
Merrill Lynch & Co., Inc. ("ML & Co.")), and other insurance companies that are
not affiliated with ML & Co., for their separate accounts to fund benefits under
certain variable annuity and variable life insurance contracts. American
Balanced V.I. Fund (the "Fund") (formerly American Balanced Fund) is classified
as "diversified," as defined in the Investment Company Act of 1940. Class A and
Class B Shares have equal voting, dividend, liquidation and other rights, except
that only shares of the respective classes are entitled to vote on matters
concerning only that class and Class B Shares bear certain expenses related to
the distribution of such shares. The Fund's financial statements are prepared in
conformity with accounting principles generally accepted in the United States of
America, which may require the use of management accruals and estimates. The
following is a summary of significant accounting policies followed by the Fund.
(a) Valuation of investments--Portfolio securities that are traded on stock
exchanges are valued at the last sale price as of the close of business on the
day the securities are being valued, or lacking any sales, at the closing bid
price. Securities traded in the over-the-counter market are valued at the last
available bid price prior to the time of valuation. In cases where securities
are traded on more than one exchange, the securities are valued on the exchange
designated by or under the authority of the Board of Directors as the primary
market. Portfolio securities that are traded both in the over-the-counter 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. Options written or purchased are
valued at the last sale price in the case of exchange-traded options. In the
case of options traded in the over-the-counter market, valuation is the last
asked price (options written) or the last bid price (options purchased).
Short-term securities are valued at amortized cost, which approximates market
value. 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.
(b) Derivative financial instruments--The Fund may engage in various portfolio
investment strategies to increase or decrease the level of risk to which the
Fund is exposed more quickly and efficiently than transactions in other types of
instruments. Losses may arise due to changes in the value of the contract or if
the counterparty does not perform under the contract.
- - Options--The Fund may write covered call options. When the Fund writes an
option, an amount equal to the premium received by the Fund is reflected as an
asset and an equivalent liability. The amount of the liability is subsequently
marked to market to reflect the current market value of the option written. When
a security is purchased or sold through an exercise of an option, the related
premium paid (or received) is added to (or deducted from) the basis of the
security acquired or deducted from (or added to) the proceeds of the security
sold. When an option expires (or the Fund enters into a closing transaction),
the Fund realizes a gain or loss on the option to the extent of the premiums
received or paid (or gain or loss to the extent the cost of the closing
transaction exceeds the premium paid or received).
Written options are non-income producing investments.
(c) Income taxes--It is the Fund's policy to comply with the requirements of
the Internal Revenue Code applicable to regulated investment companies and to
distribute substantially all of its taxable income to its shareholders.
Therefore, no Federal income tax provision is required. Under the applicable
foreign tax law, a withholding tax may be imposed on interest, dividends and
capital gains at various rates.
(d) Security transactions and investment income--Security transactions are
recorded on the dates the transactions are entered into (the trade dates).
Realized gains and losses on security transactions are determined on the
identified cost basis. Dividend income is recorded on the ex-dividend dates.
Interest income is recognized on the accrual basis. The Fund amortizes all
premiums and discounts on debt securities.
(e) Dividends and distributions--Dividends and distributions paid by the Fund
are recorded on the ex-dividend dates.
(f) Expenses--Certain expenses have been allocated to the individual funds in
the Company on a pro rata basis based upon the respective
13
- --------------------------------------------------------------------------------
aggregate net asset value of each fund included in the Company.
(g) Securities lending--The Fund may lend securities to financial institutions
that provide cash or securities issued or guaranteed by the U.S. government as
collateral, which will be maintained at all times in an amount equal to at least
100% of the current market value of the loaned securities. Where the Fund
receives cash collateral, it may invest such collateral and retain the amount
earned on such investment, net of any amount rebated to the borrower. The Fund
typically receives the income on the loaned securities but does not receive the
income on the collateral. Where the Fund receives securities as collateral for
the loaned securities, it collects a fee from the borrower. Loans of securities
are terminable at any time and the borrower, after notice, is required to return
borrowed securities within five business days. The Fund may pay reasonable
finder's, lending agent, administrative and custodial fees in connection with
its loans. In the event that the borrower defaults on its obligation to return
borrowed securities because of insolvency or for any other reason, the Fund
could experience delays and costs in gaining access to the collateral. The Fund
also could suffer a loss where the value of the collateral falls below the
market value of the borrowed securities, in the event of borrower default or in
the event of losses on investments made with cash collateral.
(h) Reclassification--Accounting principles generally accepted in the United
States of America require that certain components of net assets be adjusted to
reflect permanent differences between financial and tax reporting. Accordingly,
the current year's permanent book/tax difference of $18,649 have been
reclassified between undistributed net investment income and accumulated net
realized capital losses. This reclassification has no effect on net assets or
net asset value per share.
2. INVESTMENT ADVISORY AGREEMENT AND TRANSACTIONS WITH AFFILIATES:
The Company has entered into an Investment Advisory Agreement with Merrill Lynch
Investment Managers, L.P. ("MLIM"). The general partner of MLIM is Princeton
Services, Inc. ("PSI"), an indirect, wholly-owned subsidiary of ML & Co., which
is the limited partner.
MLIM is responsible for the management of the Company's funds and provides the
necessary personnel, facilities, equipment and certain other services necessary
to the operations of the Fund. For such services, the Fund pays a monthly fee at
the annual rate of .55% of the average daily value of the Fund's net assets.
MLIM and Merrill Lynch Life Agency, Inc. ("MLLA") have entered into an
agreement that limits the operating expenses paid by the Fund, exclusive of any
distribution fees imposed on Class B Shares, to 1.25% of its average daily net
assets. Any such expenses in excess of 1.25% of average daily net assets will be
reimbursed to the Fund by MLIM which, in turn, will be reimbursed by MLLA.
The Company has received an exemptive order from the Securities and Exchange
Commission permitting it to lend portfolio securities to Merrill Lynch, Pierce,
Fenner & Smith Incorporated ("MLPF&S") a subsidiary of ML & Co., or its
affiliates. Pursuant to that order, the Company also has retained Merrill Lynch
Investment Managers, LLC ("MLIM, LLC"), an affiliate of MLIM, as the securities
lending agent for a fee based on a share of the returns on investment of cash
collateral. MLIM, LLC may, on behalf of the Company and the Fund, invest cash
collateral received by the Fund for such loans, among other things, in a private
investment company managed by MLIM, LLC or in registered money market funds
advised by MLIM or its affiliates. As of December 31, 2002, cash collateral of
$784,401 was invested in the Money Market Series of the Merrill Lynch Liquidity
Series, LLC and $695,601 was invested in the Merrill Lynch Premier Institutional
Fund. As of December 31, 2002, the Fund lent securities with a value of $280,025
to MLPF&S or its affiliates. For the year ended December 31, 2002, MLIM, LLC
received $1,370 in securities lending agent fees from the Fund.
For the year ended December 31, 2002, MLPF&S earned $7,665 in commissions in
the execution of portfolio security transactions.
For the year ended December 31, 2002, Merrill Lynch Security Pricing Service,
an affiliate of MLPF&S, earned $1,374 for providing security price quotations to
compute the Fund's net asset value.
Financial Data Services, Inc. ("FDS"), a wholly-owned subsidiary of ML & Co.,
is the Company's transfer agent.
FAM Distributors, Inc., ("FAMD"), which is a wholly-owned subsidiary of
Merrill Lynch Group, Inc., is the Fund's distributor.
For the year ended December 31, 2002, the Fund reimbursed MLIM $3,558 for
certain accounting services.
Certain officers and/or directors of the Company are officers and/or directors
of MLIM, PSI, FDS, FAMD, and/or ML & Co.
3. INVESTMENTS:
Purchases and sales of investments, excluding short-term securities, for the
year ended
14
- --------------------------------------------------------------------------------
December 31, 2002 were $34,206,151 and $54,188,988, respectively.
Net realized gains (losses) for the year ended December 31, 2002 and net
unrealized gains (losses) as of December 31, 2002 were as follows:
<Table>
<Caption>
- ------------------------------------------------------------------
Realized Unrealized
Gains Gains
(Losses) (Losses)
- ------------------------------------------------------------------
Long-term investments................. $(9,122,103) $(14,087,532)
Foreign currency transactions......... 119 2,626
----------- ------------
Total................................. $(9,121,984) $(14,084,906)
=========== ============
- ------------------------------------------------------------------
</Table>
At December 31, 2002, net unrealized depreciation for Federal income tax
purposes aggregated $14,575,776, of which $3,758,513 related to appreciated
securities and $18,334,289 related to depreciated securities. At December 31,
2002, the aggregate cost of investments for Federal income tax purposes was
$105,619,671.
4. CAPITAL SHARE TRANSACTIONS:
Transactions in capital shares were as follows:
<Table>
<Caption>
- ------------------------------------------------------------------
Class A Shares for the Year Ended Dollar
December 31, 2002 Shares Amount
- ------------------------------------------------------------------
Shares sold............................ 20,394 $ 209,197
Shares issued to shareholders in
reinvestment of dividends............. 297,719 2,801,637
---------- ------------
Total issued........................... 318,113 3,010,834
Shares redeemed........................ (2,195,345) (23,121,109)
---------- ------------
Net decrease........................... (1,877,232) $(20,110,275)
========== ============
- ------------------------------------------------------------------
</Table>
<Table>
<Caption>
- ------------------------------------------------------------------
Class A Shares for the Year Ended Dollar
December 31, 2001 Shares Amount
- ------------------------------------------------------------------
Shares sold............................ 52,740 $ 614,674
Shares issued to shareholders in
reinvestment of dividends............. 297,270 3,362,126
Shares issued resulting from
reorganization........................ 3,272,316 38,741,380
---------- ------------
Total issued........................... 3,622,326 42,718,180
Shares redeemed........................ (2,700,801) (31,423,446)
---------- ------------
Net increase........................... 921,525 $ 11,294,734
========== ============
- ------------------------------------------------------------------
</Table>
5. SHORT-TERM BORROWINGS:
The Fund, along with certain other funds managed by MLIM and its affiliates, is
a party to a credit agreement with Bank One, N.A. and certain other lenders.
Effective November 29, 2002, in conjunction with the renewal for one year at the
same terms, the total commitment was reduced from $1,000,000,000 to
$500,000,000. The Fund may borrow under the credit agreement to fund shareholder
redemptions and for other lawful purposes other than for leverage. The Fund may
borrow up to the maximum amount allowable under the Fund's current prospectus
and statement of additional information, subject to various other legal,
regulatory or contractual limits. The Fund pays a commitment fee of .09% per
annum based on the Fund's pro rata share of the unused portion of the credit
agreement. Amounts borrowed under the credit agreement bear interest at a rate
equal to, at each fund's election, the Federal Funds rate plus .50% or a base
rate as determined by Bank One, N.A. The Fund did not borrow under the credit
agreement during the year ended December 31, 2002.
6. DISTRIBUTIONS TO SHAREHOLDERS:
The tax character of distributions paid during the fiscal years ended December
31, 2002 and December 31, 2001 was as follows:
<Table>
<Caption>
- ------------------------------------------------------------------
12/31/2002 12/31/2001
- ------------------------------------------------------------------
Distributions paid from:
Ordinary income......................... $2,801,637 $3,362,126
---------- ----------
Total taxable distributions.............. $2,801,637 $3,362,126
========== ==========
- ------------------------------------------------------------------
</Table>
As of December 31, 2002, the components of accumulated losses on a tax basis
were as follows:
<Table>
- ---------------------------------------------------------------
Undistributed ordinary income--net............... --
Undistributed long-term capital gains--net....... --
------------
Total undistributed earnings--net................ --
Capital loss carryforward........................ $(12,940,687)*
Unrealized losses--net........................... (14,709,089)**
------------
Total accumulated losses--net.................... $(27,649,776)
============
- ---------------------------------------------------------------
</Table>
* On December 31, 2002, the Fund had a net capital loss carryforward of
$12,940,687, of which $593,021 expires in 2007, $3,283,129 expires in 2009
and $9,064,537 expires in 2010. This amount will be available to offset like
amounts of any future taxable gains.
** The difference between book-basis and tax-basis net unrealized losses is
attributable primarily to the tax deferral of losses on wash sales, the
difference between book and tax amortization methods for premiums and
discounts on fixed income securities, and the deferral of post-October
capital losses for tax purposes and other book/tax temporary differences.
15
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--AMERICAN BALANCED V.I. FUND
INDEPENDENT AUDITORS' REPORT
- --------------------------------------------------------------------------------
THE BOARD OF DIRECTORS AND SHAREHOLDERS,
AMERICAN BALANCED V.I. FUND OF
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.:
We have audited the accompanying statement of assets and liabilities,
including the schedule of investments, of American Balanced V.I. Fund (formerly,
American Balanced Fund) of Merrill Lynch Variable Series Funds, Inc. as of
December 31, 2002, the related statements of operations for the year then ended
and changes in net assets for each of the years in the two-year period then
ended, and the financial highlights for each of the years presented. These
financial statements and the financial highlights are the responsibility of the
Fund's management. Our responsibility is to express an opinion on these
financial statements and the financial highlights based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements and the financial highlights are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. Our procedures included confirmation of
securities owned at December 31, 2002 by correspondence with the custodian and
brokers; where replies were not received from brokers, we performed other
auditing procedures. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such financial statements and financial highlights present
fairly, in all material respects, the financial position of American Balanced
V.I. Fund of Merrill Lynch Variable Series Funds, Inc. as of December 31, 2002,
the results of its operations, the changes in its net assets, and the financial
highlights for the respective stated periods in conformity with accounting
principles generally accepted in the United States of America.
Deloitte & Touche LLP
Princeton, New Jersey
February 14, 2003
16
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--BASIC VALUE V.I. FUND
DECEMBER 31, 2002--ANNUAL REPORT
- --------------------------------------------------------------------------------
DEAR SHAREHOLDER:
For the six-month period ended December 31, 2002, Basic Value V.I. Fund's
Class A and Class B Shares had total returns of -10.10% and -10.21%,
respectively, compared to the unmanaged benchmark Standard & Poor's (S&P) 500
Barra Value Index's return of -12.58%. As has been the case in recent years,
extraordinary volatility ruled the markets as investors continued to question
the direction of the economy as well as the ultimate conclusion of several
global crises. In fact, the industry groups that performed relatively poorly
tended to be companies in the consumer discretionary, materials and information
technology industries, all groups that are highly correlated toward the level of
economic activity. During these uncertain times, we decided to focus our
investments on those companies that, in our opinion, have done an exceptional
job in managing their costs and allocating capital toward balance sheet repair
rather than capacity additions. We believe that companies such as these will
benefit the most once the economic sluggishness abates. Additionally, we were
very focused on adding companies that were trading at historically low valuation
levels.
Much of our activity during the six-month period ended December 31, 2002 was
focused on existing companies that were being sold off because of the economic
concerns mentioned previously. Materials stocks such as Arch Coal, Inc. and
Boise Cascade Corporation were added at historically low valuation levels
despite the fact that they have become marginally profitable companies during
tough economic conditions. Activity was also concentrated in numerous
industrial-related companies such as Honeywell International Inc. Technology
companies such as Unisys Corporation, National Semiconductor Corporation and
Motorola, Inc. traded near historical lows despite possessing very strong
balance sheets, significant market share and large earnings recovery potential
given their lean cost structures and modest inventory levels. New additions to
the portfolio were primarily in economically sensitive issues such as Foot
Locker, Inc. and Hasbro, Inc. (retail), The Boeing Company, Raytheon Company and
Kimberly-Clark Corporation (industrials) and Royal Dutch Petroleum Company and
Exxon Mobil Corporation (energy). All of these companies suffered short-term
operational problems because of a decreased level of business activity. However,
even during these depressed times, all of these companies threw off a
significant amount of free cash flow that was used to pay down debt, buy back
shares and/or pay a dividend. We believe that the substantial cost cutting that
took place within these companies during the last couple of years will enable a
disproportionate amount of revenue to fall to the bottom line once business
conditions improve. In our opinion, their current equity prices are attractive
relative to their future earnings potential.
On the sell side, we cut our exposure to a number of groups that performed
relatively well. Consumer staples were viewed as a safe haven during these
turbulent times so, as a result, stock prices were bid up to levels that leave
the stocks at unattractive levels. We decreased our exposure to this sector by
lowering our holdings in The Procter & Gamble Company, The Gillette Company and
The Clorox Company. We also exited Vivendi Universal and Adelphia
Communications, two unsuccessful investments tainted by questionable accounting
practices.
We continued to aggressively position the portfolio in those companies that
are very economically sensitive. Industries such as materials, industrials and
technology (which we have learned is a very economically driven industry),
remain an overweight while we are underweight in financial and utility stocks.
Of the financial stocks that we do own, a good majority are correlated to the
capital markets where we also expect a rebound during the upcoming year. Our
country has moved quickly to address the earnings quality concerns that
prevailed during the first part of the year ended December 31, 2002. We believe
the significant monetary and proposed fiscal stimulus that has and will be
introduced by the Federal government will go a long way in improving the level
of business activity. We believe that the one wildcard remains geopolitical
risks, which are much more difficult to analyze. While we wait for a resolution
of the tensions, we remain focused on owning modestly valued companies that have
good balance sheets, are generating free cash flow and possess management teams
that have managed through the difficult environment successfully and have
positioned their companies for better economic times ahead.
FISCAL YEAR IN REVIEW
For the year ended December 31, 2002, the Fund's Class A and Class B Shares
had total returns of -17.77% and -17.89%, respectively, compared to the
unmanaged benchmark S&P 500 Barra Value Index's return of -20.85%. Despite the
fact that the economy grew at roughly a 3% rate for the year, productivity
advanced 5.5%, there was no inflation to speak
17
- --------------------------------------------------------------------------------
of, and the Federal Fund's rate was 1.25%, stocks had a miserable year,
primarily because of extraneous events. Corporate mistrust following the Enron
Corporation situation, questionable accounting policies, terrorism and potential
global conflicts combined to weigh heavily on stock market performance.
Unfortunately, we were unable to avoid all of the corporate fraud as a
significant part of the year's negative return can be attributed to our faulty
investments in WorldCom, Inc. and Adelphia Communications, two of the largest
accounting frauds ever perpetrated. Subsequent to these investments, our focus
shifted to companies with better balance sheets because we did not feel the
returns from highly leveraged companies were dramatically different from other
contrarian investments. The Fund's performance was also negatively impacted by
our cyclical holdings, which had a difficult year as investors constantly
questioned the economic strength that was being reported.
We exited the year ended December 31, 2002 as we entered it. We are heavily
positioned in those companies that we believe should benefit from an uptick in
economic activity and whose earnings are very sensitive to the slightest change
in revenues. We continue to believe that the underlying health of the economy is
strong, that years of restructuring has made this country's companies some of
the most efficient in the world and that the economic stimulus being introduced
into the system will eventually have its desired effect.
IN CONCLUSION
We appreciate your investment in Basic Value V.I. Fund of Merrill Lynch
Variable Series Funds, Inc., and we look forward to serving your investment
needs in the months and years ahead.
Sincerely,
/s/ Terry K. Glenn
Terry K. Glenn
President and Director
/s/ Kevin M. Rendino
Kevin M. Rendino
Senior Vice President and Co-Portfolio Manager
/s/ Robert J. Martorelli
Robert J. Martorelli
Senior Vice President and Co-Portfolio Manager
January 17, 2003
18
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--BASIC VALUE V.I. FUND
TOTAL RETURN BASED ON A $10,000 INVESTMENT--CLASS A AND CLASS B SHARES
- --------------------------------------------------------------------------------
<Table>
<Caption>
BASIC VALUE V.I. FUND+-- S&P 500 BARRA VALUE STANDARD & POOR'S 500
CLASS A SHARES* INDEX++ INDEX+++
------------------------ ------------------- ---------------------
7/01/93** 10000 10000 10000
12/93 10950 10431 10539
12/94 11208 10365 10678
12/95 14065 14200 14691
12/96 16975 17323 18064
12/97 20475 22517 24091
12/98 22408 25821 30976
12/99 27141 29106 37494
12/00 30574 30876 34080
12/01 31876 27261 30029
12/02 26212 21576 23392
</Table>
<Table>
<Caption>
BASIC VALUE V.I. FUND+-- S&P 500 BARRA VALUE STANDARD & POOR'S 500
CLASS B SHARES* INDEX++ INDEX+++
------------------------ ------------------- ---------------------
11/03/97** 10000 10000 10000
12/97 9969 10222 10172
12/98 10894 11722 13079
12/99 13178 13213 15831
12/00 14820 14017 14390
12/01 15420 12376 12680
12/02 12661 9795 9878
</Table>
* Assuming transaction costs and other operating expenses, including advisory
fees. Does not include insurance-related fees and expenses.
** Commencement of operations.
+ The Fund invests primarily in equities that Fund management believes are
undervalued.
++ This unmanaged index is a capitalization-weighted index of those stocks in
the S&P 500 Index that have lower price-to-book ratios. The starting date
for the Index in each of the graphs is from 7/31/93 and 11/30/97,
respectively.
+++ This unmanaged Index covers 500 industrial, utility, transportation and
financial companies of the U.S. markets (mostly NYSE issues), representing
about 75% of NYSE market capitalization and 30% of NYSE issues. The starting
date for the Index in each of the graphs is from 7/31/93 and 11/30/97,
respectively.
Past results shown should not be considered a representation of future
performance.
19
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--BASIC VALUE V.I. FUND
AVERAGE ANNUAL TOTAL RETURN--CLASS A SHARES*
- --------------------------------------------------------------------------------
PERIOD COVERED % RETURN
- --------------------------------------------------------------------------------
One Year Ended 12/31/02 -17.77%
- --------------------------------------------------------------------------------
Five Years Ended 12/31/02 + 5.06
- --------------------------------------------------------------------------------
Inception (7/01/93) through 12/31/02 +10.67
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--BASIC VALUE V.I. FUND
AVERAGE ANNUAL TOTAL RETURN--CLASS B SHARES*
- --------------------------------------------------------------------------------
PERIOD COVERED % RETURN
- --------------------------------------------------------------------------------
One Year Ended 12/31/02 -17.89%
- --------------------------------------------------------------------------------
Five Years Ended 12/31/02 + 4.90
- --------------------------------------------------------------------------------
Inception (11/03/97) through 12/31/02 + 4.68
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--BASIC VALUE V.I. FUND
RECENT PERFORMANCE RESULTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
6-MONTH 12-MONTH
AS OF DECEMBER 31, 2002 TOTAL RETURN TOTAL RETURN
- -----------------------------------------------------------------------------------------
Class A Shares* -10.10% -17.77%
- -----------------------------------------------------------------------------------------
Class B Shares* -10.21 -17.89
- -----------------------------------------------------------------------------------------
S&P 500 Barra Value Index** -12.58 -20.85
- -----------------------------------------------------------------------------------------
</Table>
* Total investment returns are based on changes in net asset values for the
periods shown, and assume reinvestment of all dividends and capital gains
distributions at net asset value on the ex-dividend date. Insurance-related
fees and expenses are not reflected in these returns.
** This unmanaged index is a capitalization-weighted index of those stocks in
the S&P 500 Index that have lower price-to-book ratios.
Past results shown should not be considered a representation of future
performance.
20
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--BASIC VALUE V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
INDUSTRY++ HELD STOCKS VALUE NET ASSETS
- -------------------------------------------------------------------------------------------------------------------------
LOW PRICE TO BOOK VALUE
- -------------------------------------------------------------------------------------------------------------------------
COMMUNICATIONS EQUIPMENT 5,096,400 +3Com Corporation.......................... $ 23,545,368 2.2%
INSURANCE 394,300 ACE Limited................................ 11,568,762 1.1
SEMICONDUCTOR EQUIPMENT & 1,405,000 +Advanced Micro Devices, Inc. ............. 9,076,300 0.8
PRODUCTS
METALS & MINING 260,400 Arch Coal, Inc. ........................... 5,622,036 0.5
PAPER & FOREST PRODUCTS 958,700 Boise Cascade Corporation.................. 24,178,414 2.2
SPECIALTY RETAIL 332,100 Circuit City Stores--Circuit City Group.... 2,464,182 0.2
MEDIA 236,681 +Comcast Corporation (Class A)............. 5,576,204 0.5
ENERGY EQUIPMENT & SERVICE 471,000 ENSCO International Incorporated........... 13,870,950 1.3
MEDIA 480,600 +Fox Entertainment Group, Inc. (Class A)... 12,461,958 1.2
INSURANCE 213,800 The Hartford Financial Services Group,
Inc. .................................... 9,712,934 0.9
SEMICONDUCTOR EQUIPMENT & 2,448,500 +LSI Logic Corporation..................... 14,127,845 1.3
PRODUCTS
MEDIA 3,684,928 +Liberty Media Corporation (Class A)....... 32,943,256 3.0
COMMUNICATIONS EQUIPMENT 5,954,900 +Lucent Technologies Inc. ................. 7,503,174 0.7
METALS & MINING 479,800 Massey Energy Company...................... 4,663,656 0.4
COMMUNICATIONS EQUIPMENT 1,736,770 Motorola, Inc. ............................ 15,023,061 1.4
AEROSPACE & DEFENSE 178,000 Raytheon Company........................... 5,473,500 0.5
ELECTRONIC EQUIPMENT & 1,523,800 Symbol Technologies, Inc. ................. 12,525,636 1.2
INSTRUMENTS
SPECIALTY RETAIL 1,314,900 +Toys 'R' Us, Inc. ........................ 13,149,000 1.2
MEDIA 213,900 Tribune Company............................ 9,723,894 0.9
MEDIA 744,300 The Walt Disney Company.................... 12,139,533 1.1
-------------- -----
245,349,663 22.6
- -------------------------------------------------------------------------------------------------------------------------
BELOW-AVERAGE PRICE/EARNINGS RATIO
- -------------------------------------------------------------------------------------------------------------------------
INSURANCE 449,700 The Allstate Corporation................... 16,634,403 1.5
COMPUTERS & PERIPHERALS 408,100 +Apple Computer, Inc. ..................... 5,848,073 0.5
BANKS 394,800 Bank One Corporation....................... 14,429,940 1.3
AEROSPACE & DEFENSE 261,400 The Boeing Company......................... 8,623,586 0.8
MACHINERY 224,200 Caterpillar Inc. .......................... 10,250,424 1.0
DIVERSIFIED FINANCIALS 1,210,820 Citigroup Inc. ............................ 42,608,756 3.9
MACHINERY 456,500 Deere & Company............................ 20,930,525 1.9
AUTO COMPONENTS 1,248,500 Delphi Automotive Systems Corporation...... 10,050,425 0.9
ENERGY EQUIPMENT & SERVICE 713,400 Diamond Offshore Drilling, Inc. ........... 15,587,790 1.4
CHEMICALS 603,700 E.I. du Pont de Nemours and Company........ 25,596,880 2.4
SPECIALTY RETAIL 937,600 Foot Locker, Inc. ......................... 9,844,800 0.9
AUTOMOBILES 247,800 General Motors Corporation................. 9,133,908 0.8
ENERGY EQUIPMENT & SERVICE 1,779,200 +Grant Prideco, Inc. ...................... 20,709,888 1.9
HEALTH CARE EQUIPMENT & 180,400 +Guidant Corporation....................... 5,565,340 0.5
SUPPLIES
LEISURE EQUIPMENT & PRODUCTS 700,000 Hasbro, Inc. .............................. 8,085,000 0.8
COMPUTERS & PERIPHERALS 826,631 Hewlett-Packard Company.................... 14,350,314 1.3
COMPUTERS & PERIPHERALS 196,610 International Business Machines
Corporation.............................. 15,237,275 1.4
DIVERSIFIED FINANCIALS 500,000 J.P. Morgan Chase & Co. ................... 12,000,000 1.1
HOUSEHOLD PRODUCTS 318,400 Kimberly-Clark Corporation................. 15,114,448 1.4
HOUSEHOLD DURABLES 573,100 Koninklijke (Royal) Philips Electronics NV
(NY Registered Shares)................... 10,132,408 0.9
BANKS 433,400 Mellon Financial Corporation............... 11,316,074 1.1
DIVERSIFIED FINANCIALS 390,000 Morgan Stanley............................. 15,568,800 1.4
SEMICONDUCTOR EQUIPMENT & 719,300 +National Semiconductor Corporation........ 10,796,693 1.0
PRODUCTS
HOUSEHOLD PRODUCTS 186,300 The Procter & Gamble Company............... 16,010,622 1.5
ENERGY EQUIPMENT & SERVICE 764,800 Rowan Companies, Inc. ..................... 17,360,960 1.6
PAPER & FOREST PRODUCTS 1,445,900 Sappi Limited (ADR)*....................... 19,114,798 1.8
FOOD PRODUCTS 900,000 Sara Lee Corporation....................... 20,259,000 1.9
DIVERSIFIED FINANCIALS 981,100 +Stilwell Financial, Inc. ................. 12,822,977 1.2
INDUSTRIAL CONGLOMERATES 400,000 Textron, Inc. ............................. 17,196,000 1.6
</Table>
21
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--BASIC VALUE V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
INDUSTRY++ HELD STOCKS VALUE NET ASSETS
- -------------------------------------------------------------------------------------------------------------------------
BELOW-AVERAGE PRICE/EARNINGS RATIO (CONCLUDED)
- -------------------------------------------------------------------------------------------------------------------------
INSURANCE 949,542 +Travelers Property Casualty Corp. (Class
A)....................................... $ 13,910,790 1.3%
IT CONSULTING & SERVICES 2,660,500 +Unisys Corporation........................ 26,338,950 2.5
BANKS 716,300 Wachovia Corporation....................... 26,101,972 2.4
-------------- -----
497,531,819 45.9
- -------------------------------------------------------------------------------------------------------------------------
ABOVE-AVERAGE YIELD
- -------------------------------------------------------------------------------------------------------------------------
DIVERSIFIED 202,800 AT&T Corp. ................................ 5,295,108 0.5
TELECOMMUNICATION SERVICES
METALS & MINING 296,200 Alcoa Inc. ................................ 6,747,436 0.6
BANKS 200,500 Bank of America Corporation................ 13,948,785 1.3
PHARMACEUTICALS 455,500 Bristol-Myers Squibb Company............... 10,544,825 1.0
AUTOMOBILES 357,700 DaimlerChrysler AG......................... 10,963,505 1.0
OIL & GAS 803,100 Exxon Mobil Corporation.................... 28,060,314 2.6
AUTOMOBILES 577,500 Ford Motor Company......................... 5,370,750 0.5
PERSONAL PRODUCTS 500,000 The Gillette Company....................... 15,180,000 1.4
AEROSPACE & DEFENSE 828,300 Honeywell International Inc. .............. 19,879,200 1.8
INSURANCE 157,200 Lincoln National Corporation............... 4,964,376 0.5
HOTELS, RESTAURANTS & 952,900 McDonald's Corporation..................... 15,322,632 1.4
LEISURE
PHARMACEUTICALS 260,700 Merck & Co., Inc. ......................... 14,758,227 1.4
METALS & MINING 513,500 +Phelps Dodge Corporation.................. 16,252,275 1.5
OIL & GAS 586,400 Royal Dutch Petroleum Company
(NY Registered Shares)................... 25,813,328 2.4
DIVERSIFIED 373,500 SBC Communications Inc. ................... 10,125,585 0.9
TELECOMMUNICATION SERVICES
PHARMACEUTICALS 742,100 Schering-Plough Corporation................ 16,474,620 1.5
ELECTRICAL EQUIPMENT 988,300 +Thomas & Betts Corporation................ 16,702,270 1.5
OIL & GAS 633,600 Unocal Corporation......................... 19,375,488 1.8
DIVERSIFIED 552,200 Verizon Communications..................... 21,397,750 2.0
TELECOMMUNICATION SERVICES
-------------- -----
277,176,474 25.6
- -------------------------------------------------------------------------------------------------------------------------
SPECIAL SITUATIONS
- -------------------------------------------------------------------------------------------------------------------------
ELECTRONIC EQUIPMENT & 636,900 +Agilent Technologies, Inc. ............... 11,438,724 1.1
INSTRUMENTS
INSURANCE 381,000 American International Group, Inc. ........ 22,040,850 2.0
SOFTWARE 1,510,200 +Borland Software Corporation.............. 18,484,848 1.7
SOFTWARE 555,500 Computer Associates International, Inc. ... 7,499,250 0.7
SEMICONDUCTOR EQUIPMENT & 378,100 +Micron Technology, Inc. .................. 3,682,694 0.3
PRODUCTS
-------------- -----
63,146,366 5.8
- -------------------------------------------------------------------------------------------------------------------------
TOTAL STOCKS
(COST--$1,286,999,424) 1,083,204,322 99.9
- -------------------------------------------------------------------------------------------------------------------------
</Table>
22
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--BASIC VALUE V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONCLUDED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
PARTNERSHIP PERCENT OF
INTEREST SHORT-TERM SECURITIES VALUE NET ASSETS
- -------------------------------------------------------------------------------------------------------------------------
$11,680,294 Merrill Lynch Liquidity Series, LLC Cash
Sweep Series II**........................ $ 11,680,294 1.0%
- -------------------------------------------------------------------------------------------------------------------------
TOTAL SHORT-TERM SECURITIES
(COST--$11,680,294) 11,680,294 1.0
- -------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS (COST--$1,298,679,718)... 1,094,884,616 100.9
LIABILITIES IN EXCESS OF OTHER ASSETS...... (10,286,276) (0.9)
-------------- -----
NET ASSETS................................. $1,084,598,340 100.0%
============== =====
- -------------------------------------------------------------------------------------------------------------------------
</Table>
+ Non-income producing security.
++ For Fund compliance purposes, "Industry" means any one or more of the
industry sub-classifications used by one or more widely recognized market
indexes or ratings group indexes, and/or as defined by Fund management. This
definition may not apply for purposes of this report, which may combine such
industry sub-classifications for reporting ease. These industry
classifications are unaudited.
* American Depositary Receipts (ADR).
** Investments in companies considered to be an affiliate of the Fund (such
companies are defined as "Affiliated Companies" in Section 2(a)(3) of the
Investment Company Act of 1940) are as follows:
<Table>
<Caption>
- --------------------------------------------------------------------------------------------------
NET INTEREST
AFFILIATE ACTIVITY NET COST INCOME
- --------------------------------------------------------------------------------------------------
Merrill Lynch Liquidity Series, LLC Cash Sweep Series II.... $11,680,294 $11,680,294 $44,082
- --------------------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
23
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--BASIC VALUE V.I. FUND
STATEMENT OF ASSETS AND LIABILITIES AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
ASSETS:
Investments, at value (including securities loaned of
$265,610,705)
(identified cost--$1,298,679,718)......................... $1,094,884,616
Investments held as collateral for loaned securities, at
value..................................................... 273,936,151
Cash........................................................ 35,735
Receivables:
Capital shares sold....................................... $ 2,171,588
Dividends................................................. 1,657,459
Securities sold........................................... 102,654
Interest.................................................. 29,738
Loaned securities income.................................. 16,865 3,978,304
-------------
Prepaid expenses............................................ 10,208
--------------
Total assets................................................ 1,372,845,014
--------------
- --------------------------------------------------------------------------------------------
LIABILITIES:
Collateral on securities loaned, at value................... 273,936,151
Payables:
Securities purchased...................................... 13,335,534
Investment adviser........................................ 589,349
Capital shares redeemed................................... 311,054
Distributor............................................... 4,558 14,240,495
-------------
Accrued expenses............................................ 70,028
--------------
Total liabilities........................................... 288,246,674
--------------
- --------------------------------------------------------------------------------------------
NET ASSETS.................................................. $1,084,598,340
==============
- --------------------------------------------------------------------------------------------
NET ASSETS CONSIST OF:
Class A Shares of Common Stock, $.10 par value, 300,000,000
shares authorized......................................... $ 9,687,114
Class B Shares of Common Stock, $.10 par value, 100,000,000
shares authorized......................................... 309,802
Paid-in capital in excess of par............................ 1,320,099,644
Undistributed investment income--net........................ $ 118,193
Accumulated realized capital losses on investments--net..... (41,821,311)
Unrealized depreciation on investments--net................. (203,795,102)
-------------
Total accumulated losses--net............................... (245,498,220)
--------------
NET ASSETS.................................................. $1,084,598,340
==============
- --------------------------------------------------------------------------------------------
NET ASSET VALUE:
Class A--Based on net assets of $1,051,062,881 and
96,871,143 shares outstanding............................. $ 10.85
==============
Class B--Based on net assets of $33,535,459 and 3,098,022
shares outstanding........................................ $ 10.82
==============
- --------------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
24
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--BASIC VALUE V.I. FUND
STATEMENT OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
INVESTMENT INCOME:
Dividends (net of $254,166 foreign withholding tax)......... $ 19,455,542
Interest.................................................... 1,084,379
Securities lending--net..................................... 365,229
-------------
Total income................................................ 20,905,150
-------------
- ------------------------------------------------------------------------------------------
EXPENSES:
Investment advisory fees.................................... $ 7,403,816
Accounting services......................................... 429,304
Professional fees........................................... 140,639
Printing and shareholder reports............................ 118,970
Transfer agent fees......................................... 75,919
Custodian fees.............................................. 68,371
Distribution fees--Class B.................................. 60,336
Directors' fees and expenses................................ 54,311
Pricing services............................................ 851
Registration fees........................................... 800
Other....................................................... 33,395
------------
Expenses.................................................... 8,386,712
-------------
Investment income--net...................................... 12,518,438
-------------
- ------------------------------------------------------------------------------------------
REALIZED & UNREALIZED LOSS ON INVESTMENTS--NET:
Realized loss from investments--net......................... (32,703,730)
Change in unrealized appreciation/depreciation on
investments--net.......................................... (232,551,310)
-------------
Total realized and unrealized loss on investments--net...... (265,255,040)
-------------
NET DECREASE IN NET ASSETS RESULTING FROM OPERATIONS........ $(252,736,602)
=============
- ------------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
25
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--BASIC VALUE V.I. FUND
STATEMENTS OF CHANGES IN NET ASSETS
- --------------------------------------------------------------------------------
<Table>
<Caption>
FOR THE YEAR ENDED
DECEMBER 31,
--------------------------------
INCREASE (DECREASE) IN NET ASSETS: 2002 2001
- ------------------------------------------------------------------------------------------------
OPERATIONS:
Investment income--net...................................... $ 12,518,438 $ 12,829,826
Realized gain (loss) on investments--net.................... (32,703,730) 45,882,129
Change in unrealized appreciation/depreciation on
investments--net.......................................... (232,551,310) (3,651,565)
-------------- --------------
Net increase (decrease) in net assets resulting from
operations................................................ (252,736,602) 55,060,390
-------------- --------------
- ------------------------------------------------------------------------------------------------
DIVIDENDS & DISTRIBUTIONS TO SHAREHOLDERS:
Investment income--net:
Class A................................................... (12,073,026) (12,800,752)
Class B................................................... (327,037) (380,219)
Realized gain on investments--net:
Class A................................................... (12,660,695) (63,303,028)
Class B................................................... (436,927) (2,071,756)
-------------- --------------
Net decrease in net assets resulting from dividends and
distributions to shareholders............................. (25,497,685) (78,555,755)
-------------- --------------
- ------------------------------------------------------------------------------------------------
CAPITAL SHARE TRANSACTIONS:
Net increase in net assets derived from capital share
transactions.............................................. 6,667,208 165,220,758
-------------- --------------
- ------------------------------------------------------------------------------------------------
NET ASSETS:
Total increase (decrease) in net assets..................... (271,567,079) 141,725,393
Beginning of year........................................... 1,356,165,419 1,214,440,026
-------------- --------------
End of year*................................................ $1,084,598,340 $1,356,165,419
============== ==============
- ------------------------------------------------------------------------------------------------
* Undistributed investment income--net...................... $ 118,193 --
============== ==============
- ------------------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
26
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--BASIC VALUE V.I. FUND
FINANCIAL HIGHLIGHTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
THE FOLLOWING PER SHARE DATA AND RATIOS HAVE BEEN DERIVED CLASS A
FROM INFORMATION PROVIDED IN THE FINANCIAL STATEMENTS. ------------------------------------------------------------
FOR THE YEAR ENDED DECEMBER 31,
------------------------------------------------------------
INCREASE (DECREASE) IN NET ASSET VALUE: 2002 2001 2000 1999 1998
- --------------------------------------------------------------------------------------------------------------------------
PER SHARE OPERATING PERFORMANCE:
Net asset value, beginning of year.......................... $ 13.47 $ 13.71 $ 13.60 $ 14.67 $ 15.84
---------- ---------- ---------- ---------- --------
Investment income--net+..................................... .12 .14 .24 .22 .19
Realized and unrealized gain (loss) on investments and
foreign currency transactions--net........................ (2.48) .44 1.41 2.37 1.10
---------- ---------- ---------- ---------- --------
Total from investment operations............................ (2.36) .58 1.65 2.59 1.29
---------- ---------- ---------- ---------- --------
Less dividends and distributions:
Investment income--net.................................... (.13) (.13) (.24) (.38) (.19)
Realized gain on investments--net......................... (.13) (.69) (1.30) (3.28) (2.27)
---------- ---------- ---------- ---------- --------
Total dividends and distributions........................... (.26) (.82) (1.54) (3.66) (2.46)
---------- ---------- ---------- ---------- --------
Net asset value, end of year................................ $ 10.85 $ 13.47 $ 13.71 $ 13.60 $ 14.67
========== ========== ========== ========== ========
- --------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENT RETURN:*
Based on net asset value per share.......................... (17.77%) 4.26% 12.65% 21.12% 9.44%
========== ========== ========== ========== ========
- --------------------------------------------------------------------------------------------------------------------------
RATIOS TO AVERAGE NET ASSETS:
Expenses.................................................... .67% .68% .65% .66% .66%
========== ========== ========== ========== ========
Investment income--net...................................... 1.02% 1.00% 1.75% 1.59% 1.26%
========== ========== ========== ========== ========
- --------------------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL DATA:
Net assets, end of year (in thousands)...................... $1,051,063 $1,310,134 $1,179,853 $1,042,885 $754,519
========== ========== ========== ========== ========
Portfolio turnover.......................................... 41.31% 61.04% 67.31% 86.46% 113.44%
========== ========== ========== ========== ========
- --------------------------------------------------------------------------------------------------------------------------
</Table>
* Total investment returns exclude insurance-related fees and expenses.
+ Based on average shares outstanding.
See Notes to Financial Statements.
27
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--BASIC VALUE V.I. FUND
FINANCIAL HIGHLIGHTS (CONCLUDED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
THE FOLLOWING PER SHARE DATA AND RATIOS HAVE BEEN DERIVED FROM CLASS B
INFORMATION PROVIDED IN THE FINANCIAL STATEMENTS. ----------------------------------------------------
FOR THE YEAR ENDED DECEMBER 31,
----------------------------------------------------
INCREASE (DECREASE) IN NET ASSET VALUE: 2002 2001 2000 1999 1998
- --------------------------------------------------------------------------------------------------------------------
PER SHARE OPERATING PERFORMANCE:
Net asset value, beginning of year........................... $ 13.43 $ 13.68 $ 13.58 $ 14.65 $ 15.84
-------- -------- -------- -------- --------
Investment income--net+...................................... .11 .11 .22 .21 .16
Realized and unrealized gain (loss) on investments and foreign
currency transactions--net................................. (2.48) .45 1.40 2.36 1.10
-------- -------- -------- -------- --------
Total from investment operations............................. (2.37) .56 1.62 2.57 1.26
-------- -------- -------- -------- --------
Less dividends and distributions:
Investment income--net..................................... (.11) (.12) (.22) (.36) (.18)
Realized gain on investments--net.......................... (.13) (.69) (1.30) (3.28) (2.27)
-------- -------- -------- -------- --------
Total dividends and distributions............................ (.24) (.81) (1.52) (3.64) (2.45)
-------- -------- -------- -------- --------
Net asset value, end of year................................. $ 10.82 $ 13.43 $ 13.68 $ 13.58 $ 14.65
======== ======== ======== ======== ========
- --------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENT RETURN:*
Based on net asset value per share........................... (17.89%) 4.05% 12.46% 20.97% 9.28%
======== ======== ======== ======== ========
- --------------------------------------------------------------------------------------------------------------------
RATIOS TO AVERAGE NET ASSETS:
Expenses..................................................... .82% .83% .80% .81% .82%
======== ======== ======== ======== ========
Investment income--net....................................... .87% .85% 1.60% 1.49% 1.12%
======== ======== ======== ======== ========
- --------------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL DATA:
Net assets, end of year (in thousands)....................... $ 33,535 $ 46,031 $ 34,587 $ 19,051 $ 3,385
======== ======== ======== ======== ========
Portfolio turnover........................................... 41.31% 61.04% 67.31% 86.46% 113.44%
======== ======== ======== ======== ========
- --------------------------------------------------------------------------------------------------------------------
</Table>
* Total investment returns exclude insurance-related fees and expenses.
+ Based on average shares outstanding.
See Notes to Financial Statements.
28
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--BASIC VALUE V.I. FUND
NOTES TO FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
1. SIGNIFICANT ACCOUNTING POLICIES:
Merrill Lynch Variable Series Funds, Inc. (the "Company") is an open-end
management investment company that is comprised of 17 separate funds. Each fund
offers two classes of shares to the Merrill Lynch Life Insurance Company, ML
Life Insurance Company of New York (indirect, wholly-owned subsidiaries of
Merrill Lynch & Co., Inc. ("ML & Co.")), and other insurance companies that are
not affiliated with ML & Co., for their separate accounts to fund benefits under
certain variable annuity and variable life insurance contracts. Basic Value V.I.
Fund (the "Fund") (formerly Basic Value Focus Fund) is classified as
"diversified," as defined in the Investment Company Act of 1940. Class A and
Class B Shares have equal voting, dividend, liquidation and other rights, except
that only shares of the respective classes are entitled to vote on matters
concerning only that class and Class B Shares bear certain expenses related to
the distribution of such shares. Income, expenses (other than expenses
attributable to a specific class) and realized and unrealized gains and losses
on investments are allocated daily to each class based on its relative net
assets. The Fund's financial statements are prepared in conformity with
accounting principles generally accepted in the United States of America, which
may require the use of management accruals and estimates. The following is a
summary of significant accounting policies followed by the Fund.
(a) Valuation of investments--Portfolio securities that are traded on stock
exchanges are valued at the last sale price as of the close of business on the
day the securities are being valued, or lacking any sales, at the closing bid
price. Securities traded in the over-the-counter market are valued at the last
available bid price prior to the time of valuation. In cases where securities
are traded on more than one exchange, the securities are valued on the exchange
designated by or under the authority of the Board of Directors as the primary
market. Portfolio securities that are traded both in the over-the-counter 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. Options written are valued at
the last sale price in the case of exchange-traded options. In the case of
options traded in the over-the-counter market, valuation is the last asked
price. Short-term securities are valued at amortized cost, which approximates
market value. 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.
(b) Derivative financial instruments--The Fund may engage in various portfolio
investment strategies to increase or decrease the level of risk to which the
Fund is exposed more quickly and efficiently than transactions in other types of
instruments. Losses may arise due to changes in the value of the contract or if
the counterparty does not perform under the contract.
- - Options--The Fund may write covered call options. When the Fund writes an
option, an amount equal to the premium received by the Fund is reflected as an
asset and an equivalent liability. The amount of the liability is subsequently
marked to market to reflect the current market value of the option written. When
a security is purchased or sold through an exercise of an option, the related
premium received is added to (or deducted from) the basis of the security
acquired or deducted from (or added to) the proceeds of the security sold. When
an option expires (or the Fund enters into a closing transaction), the Fund
realizes a gain or loss on the option to the extent of the premiums received (or
gain or loss to the extent the cost of the closing transaction exceeds the
premium received).
Written options are non-income producing investments.
(c) Income taxes--It is the Fund's policy to comply with the requirements of
the Internal Revenue Code applicable to regulated investment companies and to
distribute substantially all of its taxable income to its shareholders.
Therefore, no Federal income tax provision is required. Under the applicable
foreign tax law, a withholding tax may be imposed on interest, dividends and
capital gains at various rates.
(d) Security transactions and investment income--Security transactions are
recorded on the dates the transactions are entered into (the trade dates).
Realized gains and losses on security transactions are determined on the
identified cost basis. Dividend income is recorded on the ex-dividend dates.
Interest income is recognized on the accrual basis.
(e) Dividends and distributions to shareholders--Dividends and distributions
paid by the Fund are recorded on the ex-dividend dates.
29
- --------------------------------------------------------------------------------
(f) Expenses--Certain expenses have been allocated to the individual funds in
the Company on a pro rata basis based upon the respective aggregate net asset
value of each fund included in the Company.
(g) Securities lending--The Fund may lend securities to financial institutions
that provide cash or securities issued or guaranteed by the U.S. government as
collateral, which will be maintained at all times in an amount equal to at least
100% of the current market value of the loaned securities. Where the Fund
receives securities as collateral for the loaned securities, it collects a fee
from the borrower. The Fund typically receives the income on the loaned
securities but does not receive the income on the collateral. Where the Fund
receives cash collateral, it may invest such collateral and retain the amount
earned on such investment, net of any amount rebated to the borrower. Loans of
securities are terminable at any time and the borrower, after notice, is
required to return borrowed securities within five business days. The Fund may
pay reasonable finder's, lending agent, administrative and custodial fees in
connection with its loans. In the event that the borrower defaults on its
obligation to return borrowed securities because of insolvency or for any other
reason, the Fund could experience delays and costs in gaining access to the
collateral. The Fund also could suffer a loss where the value of the collateral
falls below the market value of the borrowed securities, in the event of
borrower default or in the event of losses on investments made with cash
collateral.
(h) Reclassification--Accounting principles generally accepted in the United
States of America require that certain components of net assets be adjusted to
reflect permanent differences between financial and tax reporting. These
reclassifications have no effect on net assets or net asset values per share.
There were no significant reclassifications in the current year.
2. INVESTMENT ADVISORY AGREEMENT AND TRANSACTIONS WITH AFFILIATES:
The Company has entered into an Investment Advisory Agreement with Merrill Lynch
Investment Managers, L.P. ("MLIM"). The general partner of MLIM is Princeton
Services, Inc. ("PSI"), an indirect, wholly-owned subsidiary of ML & Co., which
is the limited partner. The Company has also entered into a Distribution
Agreement and Distribution Plan with FAM Distributors, Inc. ("FAMD" or the
"Distributor"), which is a wholly-owned subsidiary of Merrill Lynch Group, Inc.
MLIM is responsible for the management of the Company's funds and provides the
necessary personnel, facilities, equipment and certain other services necessary
to the operations of the Fund. For such services, the Fund pays a monthly fee at
the annual rate of .60% of the average daily value of the Fund's net assets.
Pursuant to the Distribution Plan adopted by the Company, pursuant to Rule
12b-1 under the Investment Company Act of 1940, the Fund pays the Distributor an
ongoing distribution fee each month at the annual rate of .15% of the average
daily value of the Fund's Class B net assets.
MLIM and Merrill Lynch Life Agency, Inc. ("MLLA") have entered into an
agreement which limits the operating expenses paid by the Fund, exclusive of any
distribution fees imposed on Class B Shares, to 1.25% of its average daily net
assets. Any expenses in excess of 1.25% of average daily net assets will be
reimbursed to the Fund by MLIM which, in turn, will be reimbursed by MLLA.
The Company has received an exemptive order from the Securities and Exchange
Commission permitting it to lend portfolio securities to Merrill Lynch, Pierce,
Fenner & Smith Incorporated ("MLPF&S"), a subsidiary of ML & Co., or its
affiliates. Pursuant to that order, the Company also has retained Merrill Lynch
Investment Managers, LLC ("MLIM, LLC"), an affiliate of MLIM, as the securities
lending agent for a fee based on a share of the returns on investment of cash
collateral. MLIM, LLC may, on behalf of the Company and the Fund, invest cash
collateral received by the Fund for such loans, among other things, in a private
investment company managed by MLIM, LLC or in registered money market funds
advised by MLIM or its affiliates. As of December 31, 2002, cash collateral of
$145,186,160 was invested in the Money Market Series of the Merrill Lynch
Liquidity Series, LLC and $128,749,991 was invested in the Merrill Lynch Premier
Institutional Fund. As of December 31, 2002, the Fund lent securities with a
value of $64,401,420 to MLPF&S or its affiliates. For the year ended December
31, 2002, MLIM, LLC received $156,588 in securities lending agent fees from the
Fund.
For the year ended December 31, 2002, MLPF&S earned $373,476 in commissions on
the execution of portfolio security transactions.
Financial Data Services, Inc. ("FDS"), a wholly-owned subsidiary of ML & Co.,
is the Company's transfer agent.
For the year ended December 31, 2002, the Fund reimbursed MLIM $37,512 for
certain accounting services.
30
- --------------------------------------------------------------------------------
Certain officers and/or directors of the Company are officers and/or directors
of MLIM, PSI, FDS, FAMD, and/or ML & Co.
3. INVESTMENTS:
Purchases and sales of investments, excluding short-term securities, for the
year ended December 31, 2002 were $532,472,315 and $489,062,944, respectively.
Net realized gains (losses) for the year ended December 31, 2002 and net
unrealized losses as of December 31, 2002 were as follows:
<Table>
<Caption>
- -------------------------------------------------------------------
Realized Unrealized
Gains (Losses) Losses
- -------------------------------------------------------------------
Long-term investments.............. $(32,704,300) $(203,795,102)
Short-term investments............. 570 --
------------ -------------
Total.............................. $(32,703,730) $(203,795,102)
============ =============
- -------------------------------------------------------------------
</Table>
At December 31, 2002, net unrealized depreciation for Federal income tax
purposes aggregated $214,112,464, of which $50,358,582 related to appreciated
securities and $264,471,046 related to depreciated securities. At December 31,
2002, the aggregate cost of investments for Federal income tax purposes was
$1,308,997,080.
4. CAPITAL SHARE TRANSACTIONS:
Net increase in net assets derived from capital share transactions was
$6,667,208 and $165,220,758 for the years ended December 31, 2002 and December
31, 2001, respectively.
Transactions in capital shares for each class were as follows:
<Table>
<Caption>
- -----------------------------------------------------------------
Class A Shares for the Year Ended Dollar
December 31, 2002 Shares Amount
- -----------------------------------------------------------------
Shares sold........................ 10,531,910 $ 132,044,513
Shares issued to shareholders in
reinvestment of dividends and
distributions..................... 2,032,101 24,733,721
----------- -------------
Total issued....................... 12,564,011 156,778,234
Shares redeemed.................... (12,963,969) (146,573,813)
----------- -------------
Net increase (decrease)............ (399,958) $ 10,204,421
=========== =============
- -----------------------------------------------------------------
</Table>
<Table>
<Caption>
- -----------------------------------------------------------------
Class A Shares for the Year Ended Dollar
December 31, 2001 Shares Amount
- -----------------------------------------------------------------
Shares sold......................... 13,352,667 $ 179,176,410
Shares issued to shareholders in
reinvestment of dividends and
distributions...................... 5,574,026 76,103,780
---------- -------------
Total issued........................ 18,926,693 255,280,190
Shares redeemed..................... (7,688,531) (102,348,813)
---------- -------------
Net increase........................ 11,238,162 $ 152,931,377
========== =============
- -----------------------------------------------------------------
</Table>
<Table>
<Caption>
- -----------------------------------------------------------------
Class B Shares for the Year Ended Dollar
December 31, 2002 Shares Amount
- -----------------------------------------------------------------
Shares sold............................. 193,346 $ 2,473,430
Shares issued to shareholders in
reinvestment of dividends and
distributions.......................... 61,992 763,964
-------- -----------
Total issued............................ 255,338 3,237,394
Shares redeemed......................... (583,761) (6,774,607)
-------- -----------
Net decrease............................ (328,423) $(3,537,213)
======== ===========
- -----------------------------------------------------------------
</Table>
<Table>
<Caption>
- -----------------------------------------------------------------
Class B Shares for the Year Ended Dollar
December 31, 2001 Shares Amount
- -----------------------------------------------------------------
Shares sold............................ 1,015,056 $13,792,531
Shares issued to shareholders in
reinvestment of dividends and
distributions......................... 180,131 2,451,975
--------- -----------
Total issued........................... 1,195,187 16,244,506
Shares redeemed........................ (296,342) (3,955,125)
--------- -----------
Net increase........................... 898,845 $12,289,381
========= ===========
- -----------------------------------------------------------------
</Table>
5. SHORT-TERM BORROWINGS:
The Fund, along with certain other funds managed by MLIM and its affiliates, is
a party to a credit agreement with Bank One, N.A. and certain other lenders.
Effective November 29, 2002, in conjunction with the renewal for one year at the
same terms, the total commitment was reduced from $1,000,000,000 to
$500,000,000. The Fund may borrow under the credit agreement to fund shareholder
redemptions and for other lawful purposes other than for leverage. The Fund may
borrow up to the maximum amount allowable under the Fund's current prospectus
and statement of additional information, subject to various other legal,
regulatory or contractual limits. The Fund pays a commitment fee of .09% per
annum based on the Fund's pro rata share of the unused portion of the credit
agreement. Amounts borrowed under the credit agreement bear interest at a rate
equal to, at each fund's election, the Federal Funds rate plus .50% or a base
rate as determined by Bank One, N.A. The Fund did not borrow under the credit
agreement during the year ended December 31, 2002.
6. DISTRIBUTIONS TO SHAREHOLDERS:
The tax character of distributions paid during the fiscal years ended December
31, 2002 and December 31, 2001 was as follows:
<Table>
<Caption>
- ------------------------------------------------------------------
12/31/2002 12/31/2001
- ------------------------------------------------------------------
Distributions paid from:
Ordinary income....................... $17,124,038 $52,767,426
Net long-term capital gains........... 8,373,647 25,788,329
----------- -----------
Total taxable distributions............ $25,497,685 $78,555,755
=========== ===========
- ------------------------------------------------------------------
</Table>
As of December 31, 2002, the components of accumulated losses on a tax basis
were as follows:
<Table>
- -----------------------------------------------------------------
Undistributed ordinary income--net................ $ 118,193
Undistributed long-term capital gains--net........ --
-------------
Total undistributed earnings--net................. 118,193
Capital loss carryforward......................... (31,503,948)*
Unrealized losses--net............................ (214,112,465)**
-------------
Total accumulated losses--net..................... $(245,498,220)
=============
- -----------------------------------------------------------------
</Table>
* On December 31, 2002, the Fund had a net capital loss carryforward of
$31,503,948, all of which expires in 2010. This amount will be available to
offset like amounts of any future taxable gains.
** The difference between book-basis and tax-basis net unrealized losses is
attributable primarily to the tax deferral of losses on wash sales.
31
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--BASIC VALUE V.I. FUND
INDEPENDENT AUDITORS' REPORT
- --------------------------------------------------------------------------------
THE BOARD OF DIRECTORS AND SHAREHOLDERS,
BASIC VALUE V.I. FUND OF
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.:
We have audited the accompanying statement of assets and liabilities,
including the schedule of investments, of Basic Value V.I. Fund (formerly, Basic
Value Focus Fund) of Merrill Lynch Variable Series Funds, Inc. as of December
31, 2002, the related statements of operations for the year then ended and
changes in net assets for each of the years in the two-year period then ended,
and the financial highlights for each of the periods presented. These financial
statements and the financial highlights are the responsibility of the Fund's
management. Our responsibility is to express an opinion on these financial
statements and the financial highlights based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements and the financial highlights are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. Our procedures included confirmation of
securities owned at December 31, 2002 by correspondence with the custodian and
brokers; where replies from brokers were not received, we performed other
auditing procedures. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such financial statements and financial highlights present
fairly, in all material respects, the financial position of Basic Value V.I.
Fund of Merrill Lynch Variable Series Funds, Inc. as of December 31, 2002, the
results of its operations, the changes in its net assets, and the financial
highlights for the respective stated periods in conformity with accounting
principles generally accepted in the United States of America.
Deloitte & Touche LLP
Princeton, New Jersey
February 14, 2003
32
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--CORE BOND V.I. FUND
DECEMBER 31, 2002--ANNUAL REPORT
- --------------------------------------------------------------------------------
DEAR SHAREHOLDER:
ECONOMIC ENVIRONMENT
The U.S. economy grew throughout 2002, although the pace of the growth was
quite uneven from quarter to quarter. For the year as a whole, the economy quite
likely grew at an annual pace of approximately 3.0% -- modest for sure, but
hardly the source for "double dip" recessionary concerns that dominated the
headlines from time to time. Inflation remained virtually non-existent, with the
core personal consumption expenditure deflator, the inflation gauge watched by
the Federal Reserve Board, rising by only 1.8%.
In past economic recoveries, businesses have contributed significantly to
growth. However, the continuing corporate profit drought in the face of
significant excess capacity left businesses holding back on capital spending and
achieving productivity gains through paring down payrolls. The consumer sector,
on the other hand, held up remarkably well, despite the weak employment outlook,
declining equity markets, and terrorism and geopolitical concerns adding to the
decline in consumer confidence. Nevertheless, the sharp drop in mortgage rates
during the past year contributed to a healthy housing market and a refinancing
boom, helping out the consumer, while heavy economic incentives (such as
zero-cost financing) helped keep consumption of durable goods, such as
automobiles, robust.
Looking ahead, we anticipate the economy to grow at a sub-par rate of below 3%
in 2003, with risks to the forecast more evenly balanced. While the prospects
for a strong fiscal stimulus package from Washington, D.C. have improved
markedly, the timing of the legislation, its scope and its potential positive
impact on the economy over the near term remain uncertain. At the same time, the
possible end of the mortgage refinancing boom and a murky labor market could
further erode consumer confidence, posing downside risks to the economy. Capital
spending by businesses is also likely to remain somewhat subdued as the sectors
that have contributed historically to capital spending--telecommunications,
utility and the energy sectors--still work out past excesses. Government
spending is not likely to contribute very much, given the potential for the
growing fiscal deficits at state and local government levels somewhat offsetting
the spending from Washington.
INTEREST RATES
Interest rates essentially followed the economic news through most of the
year. The Federal Reserve Board started the year with the Federal Funds rate at
1.75%, and an economic bias that was tilted toward "weakness." Following a
strong first quarter in 2002, the Federal Reserve Board at the March Federal
Open Market Committee (FOMC) meeting changed its bias to "balanced," signaling
that the risks toward economic weakness on the one hand and inflationary
concerns on the other were equally balanced. With the economy showing signs of
stress in the third quarter of 2002, at the August FOMC meeting, the Federal
Reserve Board switched the bias once again toward "weakness" in the economy.
Amid growing deflationary concerns, and the potential for the economy to slip
back into a recession, the Federal Reserve Board surprised investors at its
November FOMC meeting, by lowering the Federal Funds rate by 50 basis points
(.50%) to 1.25%, but changing the bias once again to "balanced."
Most Treasury yields reacted to the changing economic prospects throughout the
year. Sensing a strong recovery, Treasury yields rose significantly in the first
quarter, with the two-year note rising by 70 basis points, and the ten-year note
and the 30-year bond by 35 basis points. However, with the waning prospects of
an economic recovery, Treasury yields fell sharply from early April, with most
of the declines occurring in the third quarter through October 10, 2002. During
this period, two-year note yields declined by 197 basis points, ten-year notes
by 177 basis points and 30-year bonds by 111 basis points. Although yields have
backed up toward year end, for the year as a whole, the investment-grade sector
in general, and Treasuries in particular, had a solid year.
Going forward, we expect the Federal Reserve Board to remain on hold, at least
through the first half of 2003. While a slow growing economy, with little threat
of inflation, should keep interest rates range bound, the risks to the fixed
income markets have become somewhat asymmetric. The growing budget deficits at
the Federal and state levels, along with the absolute low levels of current
interest rates, not to mention the stellar performance of the fixed income
market over the past three years, give us little reason to hope for a sustained
drop in interest rates. Accordingly, we anticipate interest rates to have an
upward bias and the yield
33
- --------------------------------------------------------------------------------
curve to have a bearish steepening bias over the next few months.
FISCAL YEAR IN REVIEW
During the 12-month period ended December 31, 2002, Core Bond V.I. Fund's
Class A Shares had a total return of +9.57%, compared to +10.25% for the Fund's
benchmark, the unmanaged Lehman Brothers Aggregate Bond Index.
As 2002 began, with all signs pointing to a slowly but steadily improving
economy, the portfolio was positioned to take advantage of the interest rate
conditions usually associated with such an environment. The portfolio maintained
overweight positions between 3% - 8% in the major credit sectors, including
corporate bonds, mortgage-backed securities (MBS) and commercial mortgage-backed
securities (CMBS). Through May, these allocations proved to be quite positive
from a performance standpoint. MBS and CMBS had the highest excess return
relative to duration-neutral Treasury securities of any major Lehman Brothers
Aggregate Bond Index sector, and while corporate bond spreads were static during
the period, the yield advantage available made our overweight profitable. In
addition, we kept the duration of the portfolio very close to that of the
benchmark, as we believed that yields would not move much. In spite of the
month-to-month volatility, yields ended May essentially unchanged from the
beginning of the year.
However, during the last two weeks of May, warning signals began to emerge
that caused us to question our optimistic view of the economy and the markets.
After peaking at about 10,350, the Dow Jones Industrial Average plunged more
than 2,500 points in just over eight weeks. Consumer confidence, estimates of
gross domestic product growth, and Treasury yields also fell, and by the
beginning of August the markets were in a crisis mode. Although we made major
adjustments in portfolio construction by reducing our corporate and mortgage
overweight positions to neutral and adding duration, performance suffered
slightly as market liquidity dried up. This caused our restructuring to take
longer than expected, and execution delays invariably cost money in such
volatile market conditions.
In the last quarter of 2002, the summer's extreme volatility gave way to a
market in which Treasury yields have traded in a narrow range. As was true at
the beginning of the year, the credit sectors have again taken a leading role.
While we have reestablished overweight positions in the corporate and mortgage
sectors, we remain mindful of the potential for a return of volatility. As such,
our overweights are smaller--about 2% - 3%--and more liquid, which will enable
us to move quickly back to a neutral profile should it become necessary. We have
continued to actively manage portfolio duration and to aggressively finance our
to-be-announced mortgage holdings, which are sound strategies designed to
incrementally increase Fund performance.
Going forward, we expect to maintain a portfolio profile reflective of our
pro-cyclical bias--spread sector overweights and duration less than that of the
benchmark. While we believe there is a high probability that there will be a
military confrontation with Iraq during the first quarter of 2003, we anticipate
that this will ultimately result in a decline in volatility as uncertainty is
removed from the markets. We expect this to provide the basis for solid, if
unspectacular, economic growth as the year progresses.
IN CONCLUSION
We appreciate your investment in Core Bond V.I. Fund of Merrill Lynch Variable
Series Funds, Inc., and we look forward to serving your investment needs in the
months and years ahead.
Sincerely,
/s/ Terry K. Glenn
Terry K. Glenn
President and Director
/s/ Patrick Maldari
Patrick Maldari
Vice President and Portfolio Manager
/s/ James J. Pagano
James J. Pagano
Vice President and Portfolio Manager
January 17, 2003
34
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--CORE BOND V.I. FUND
TOTAL RETURN BASED ON A $10,000 INVESTMENT--CLASS A SHARES
- --------------------------------------------------------------------------------
<Table>
<Caption>
CORE BOND V.I. FUND+--CLASS A LEHMAN BROTHERS AGGREGATE
SHARES* BOND INDEX++
----------------------------- -------------------------
12/92 10000.00 10000.00
12/93 11202.00 10975.00
12/94 10664.00 10655.00
12/95 12812.00 12623.00
12/96 13095.00 13081.00
12/97 14226.00 14344.00
12/98 15343.00 15590.00
12/99 14982.00 15462.00
12/00 16482.00 17260.00
12/01 17586.00 18717.00
12/02 19269.00 20636.00
</Table>
* Assuming transaction costs and other operating expenses, including advisory
fees. Does not include insurance-related fees and expenses.
+ The Fund invests at least 90% of its net assets in fixed income securities.
++ This unmanaged market-weighted Index is comprised of U.S. government and
agency securities, mortgage-backed securities issued by the Government
National Mortgage Association, Freddie Mac or Fannie Mae and
investment-grade (rated BBB or better) corporate bonds.
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--CORE BOND V.I. FUND
AVERAGE ANNUAL TOTAL RETURN--CLASS A SHARES*
- --------------------------------------------------------------------------------
PERIOD COVERED % RETURN
- --------------------------------------------------------------------------------
One Year Ended 12/31/02 +9.57%
- --------------------------------------------------------------------------------
Five Years Ended 12/31/02 +6.25
- --------------------------------------------------------------------------------
Ten Years Ended 12/31/02 +6.78
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--CORE BOND V.I. FUND
RECENT PERFORMANCE RESULTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
6-MONTH 12-MONTH STANDARDIZED
AS OF DECEMBER 31, 2002 TOTAL RETURN TOTAL RETURN 30-DAY YIELD
- --------------------------------------------------------------------------------------------------------
Class A Shares* +5.96% + 9.57% 3.99%
- --------------------------------------------------------------------------------------------------------
Lehman Brothers Aggregate Bond Index** +6.23 +10.25 --
- --------------------------------------------------------------------------------------------------------
</Table>
* Total investment returns are based on changes in net asset values for the
periods shown, and assume reinvestment of all dividends and capital gains
distributions at net asset value on the payable date. Insurance-related fees
and expenses are not reflected in these returns.
** This unmanaged market-weighted index is comprised of U.S. government and
agency securities, mortgage-backed securities issued by the Government
National Mortgage Association, Freddie Mac or Fannie Mae and
investment-grade (rated BBB or better) corporate bonds.
Past results shown should not be considered a representation of future
performance.
35
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--CORE BOND V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
<Caption>
S&P MOODY'S FACE
RATINGS++ RATINGS++ AMOUNT ASSET-BACKED SECURITIES+--8.6% VALUE
- ----------------------------------------------------------------------------------------------------------------------------
AAA Aaa $ 4,000,000 Advanta Mortgage Loan Trust, 7.75% due
10/25/2026............................. $ 4,320,388
AAA Aaa 4,551,000 CIT Equipment Collateral, Series
2002-VT1, Class A2, 2.90% due
6/21/2004.............................. 4,574,237
California Infrastructure PG&E, Series
1997-1:
AAA Aaa 1,450,000 Class A6, 6.38% due 9/25/2008.......... 1,583,603
AAA Aaa 2,100,000 Class A7, 6.42% due 9/25/2008.......... 2,285,985
AAA Aaa 3,034,818 EQCC Home Equity Loan Trust, Series
1999-1, Class A3F, 5.915% due
11/20/2024............................. 3,096,368
A A3 6,000,000 First Dominion Funding I, 2.60% due
7/10/2013(a)(b)........................ 5,486,250
Household Automotive Trust:
AAA Aaa 5,700,000 Series 2002-1, Class A2, 2.75% due
5/17/2005.............................. 5,735,215
AAA Aaa 3,200,000 Series 2002-3, Class A3A, 2.75% due
6/18/2007.............................. 3,247,231
AAA Aaa 4,595,214 Household Home Equity Loan Trust, Series
2002-2, Class A, 1.688% due
4/20/2032(a)........................... 4,587,334
AAA Aaa 5,700,000 Ikon Receivables LLC, Series 2002-1,
Class A2, 2.91% due 2/15/2005.......... 5,723,833
A+ A2 2,222,200 MBNA Master Credit Card Trust, Series
1999-F, Class B, 1.79% due
1/16/2007(a)........................... 2,221,756
AAA Aaa 5,273,461 Option One Mortgage Loan Trust, Series
2002-4, Class A, 1.68% due
7/25/2032(a)........................... 5,254,660
AAA Aaa 5,000,000 Residential Asset Securities Corporation,
Series 2002-KS8, Class A2, 3.04% due
6/25/2023.............................. 5,039,063
A A2 4,500,000 Superior Wholesale Inventory Financing
Trust, Series 2001, Class A7, 1.82% due
6/15/2006(a)........................... 4,489,470
- ----------------------------------------------------------------------------------------------------------------------------
TOTAL ASSET-BACKED SECURITIES
(COST--$57,795,243) 57,645,393
- ----------------------------------------------------------------------------------------------------------------------------
<Caption>
GOVERNMENT & AGENCY OBLIGATIONS--22.7%
- ----------------------------------------------------------------------------------------------------------------------------
Fannie Mae:
AAA Aaa 17,130,000 7% due 7/15/2005....................... 19,204,957
AAA Aaa 10,430,000 5.25% due 6/15/2006.................... 11,366,030
AAA Aaa 2,910,000 7.125% due 3/15/2007................... 3,404,441
AAA Aaa 6,290,000 6.375% due 6/15/2009................... 7,278,203
AAA Aaa 4,390,000 6% due 5/15/2011....................... 4,962,294
AAA Aaa 7,260,000 7.125% due 1/15/2030................... 8,959,152
Freddie Mac:
AAA Aaa 14,400,000 7% due 7/15/2005....................... 16,153,891
AAA Aaa 8,230,000 6.625% due 9/15/2009................... 9,654,119
U.S. Treasury Bonds & Notes:
AAA Aaa 455,000 1.875% due 9/30/2004................... 458,181
AAA Aaa 2,610,000 7.50% due 2/15/2005.................... 2,926,666
AAA Aaa 10,270,000 6.50% due 5/15/2005.................... 11,400,101
AAA Aaa 1,630,000 5.75% due 11/15/2005................... 1,801,851
AAA Aaa 4,340,000 6.25% due 2/15/2007.................... 4,979,304
AAA Aaa 2,738,000 3.25% due 8/15/2007.................... 2,805,809
AAA Aaa 5,310,000 6.125% due 8/15/2007................... 6,106,086
AAA Aaa 465,000 3% due 11/15/2007...................... 470,594
AAA Aaa 3,790,000 4.75% due 11/15/2008................... 4,137,020
AAA Aaa 2,280,000 6.50% due 2/15/2010.................... 2,725,311
AAA Aaa 3,270,000 5% due 2/15/2011....................... 3,592,912
AAA Aaa 3,720,000 7.50% due 11/15/2016................... 4,864,770
AAA Aaa 2,270,000 8.125% due 8/15/2019................... 3,161,863
AAA Aaa 7,910,000 7.25% due 8/15/2022.................... 10,294,430
AAA Aaa 1,630,000 6.25% due 8/15/2023.................... 1,914,996
</Table>
36
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--CORE BOND V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
S&P MOODY'S FACE
RATINGS++ RATINGS++ AMOUNT GOVERNMENT & AGENCY OBLIGATIONS VALUE
- ----------------------------------------------------------------------------------------------------------------------------
U.S. Treasury Bonds & Notes (concluded):
AAA Aaa $ 1,630,000 6.625% due 2/15/2027................... $ 2,013,687
AAA Aaa 7,410,000 5.375% due 2/15/2031................... 8,078,056
- ----------------------------------------------------------------------------------------------------------------------------
TOTAL GOVERNMENT & AGENCY OBLIGATIONS
(COST--$144,815,929) 152,714,724
- ----------------------------------------------------------------------------------------------------------------------------
<Caption>
GOVERNMENT AGENCY
MORTGAGE-BACKED SECURITIES+--34.2%
- ----------------------------------------------------------------------------------------------------------------------------
COLLATERALIZED MORTGAGE Freddie Mac:
OBLIGATIONS--0.5%
AAA Aaa 1,415,333 Series 2113, Class MA, 5.57% due
7/15/2022.............................. 1,424,921
AAA Aaa 1,954,487 Series 2140, Class KE, 6.30% due
05/15/2026............................. 1,988,474
-------------
3,413,395
- ----------------------------------------------------------------------------------------------------------------------------
PASS-THROUGH Fannie Mae:
SECURITIES--33.7%
AAA Aaa 36,800,000 6%(c).................................. 38,100,549
AAA Aaa 2,243,214 6.50%(c)............................... 2,364,330
AAA Aaa 3,700,000 6.50%(c)............................... 3,847,963
AAA Aaa 12,500,000 7.50%(c)............................... 13,233,100
AAA Aaa 7,425,000 8%(c).................................. 7,958,798
AAA Aaa 952,008 6% due 6/01/2016....................... 996,576
AAA Aaa 2,701,705 6% due 6/01/2016....................... 2,828,186
AAA Aaa 1,401,076 6% due 7/01/2016....................... 1,466,667
AAA Aaa 6,621,269 6% due 2/01/2017....................... 6,931,244
AAA Aaa 1,608,478 7% due 11/18/2027...................... 1,635,877
AAA Aaa 972,013 8% due 9/01/2030....................... 1,047,872
AAA Aaa 9,945,058 7% due 5/01/2031....................... 10,460,648
AAA Aaa 2,049,913 6.50% due 6/01/2031.................... 2,135,383
AAA Aaa 23,191,325 6.50% due 6/01/2031.................... 24,158,276
AAA Aaa 1,283,155 7% due 6/01/2031....................... 1,349,678
AAA Aaa 3,518,529 7% due 9/01/2031....................... 3,700,943
AAA Aaa 8,876,205 6.50% due 1/01/2032.................... 9,246,294
AAA Aaa 2,834,308 7% due 3/01/2032....................... 2,981,150
AAA Aaa 4,033,162 6.50% due 4/01/2032.................... 4,201,249
Freddie Mac:
AAA Aaa 3,300,000 5%(c).................................. 3,388,747
AAA Aaa 3,300,000 5.50%(c)............................... 3,369,185
AAA Aaa 15,300,000 6%(c).................................. 15,845,506
AAA Aaa 11,841,449 6.50%(c)............................... 12,323,218
AAA Aaa 1,500,000 6.50% due 3/01/2016.................... 1,587,008
AAA Aaa 7,285,900 6.50% due 6/01/2016.................... 7,704,885
AAA Aaa 271,075 6.50% due 7/01/2016.................... 286,664
AAA Aaa 20,012 6.50% due 9/01/2016.................... 21,162
AAA Aaa 18,072 6.50% due 10/01/2016................... 19,112
AAA Aaa 904,938 6.50% due 2/01/2017.................... 956,977
AAA Aaa 1,020,907 6% due 4/01/2017....................... 1,068,261
AAA Aaa 1,705,577 6% due 8/01/2017....................... 1,784,688
AAA Aaa 1,762,220 7.50% due 11/01/2029................... 1,875,679
AAA Aaa 508,172 7.50% due 9/01/2030.................... 540,592
AAA Aaa 4,793,766 7% due 6/01/2031....................... 5,038,522
AAA Aaa 1,669,242 7.50% due 8/01/2031.................... 1,775,152
AAA Aaa 4,234,666 7% due 10/01/2031...................... 4,450,876
AAA Aaa 3,138,656 7% due 4/01/2032....................... 3,298,918
AAA Aaa 2,412,952 7.50% due 5/01/2032.................... 2,566,000
AAA Aaa 7,706,229 7% due 9/01/2032....................... 8,099,713
</Table>
37
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--CORE BOND V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
S&P MOODY'S FACE GOVERNMENT AGENCY
RATINGS++ RATINGS++ AMOUNT MORTGAGE-BACKED SECURITIES+ VALUE
- ----------------------------------------------------------------------------------------------------------------------------
PASS-THROUGH SECURITIES Government National Mortgage Association:
(CONCLUDED)
AAA Aaa $ 3,128,719 6.50% due 5/15/2031.................... $ 3,287,325
AAA Aaa 8,251,194 6.50% due 4/15/2032.................... 8,666,180
-------------
226,599,153
- ----------------------------------------------------------------------------------------------------------------------------
TOTAL GOVERNMENT AGENCY
MORTGAGE-BACKED SECURITIES
(COST--$225,200,922) 230,012,548
- ----------------------------------------------------------------------------------------------------------------------------
<Caption>
NON-GOVERNMENT AGENCY MORTGAGE-
BACKED SECURITIES+--10.5%
- ----------------------------------------------------------------------------------------------------------------------------
COLLATERALIZED MORTGAGE AAA Aaa 1,995,322 ABN AMRO Mortgage Corporation, Series
OBLIGATIONS--4.7% 2001-8, Class 2A1, 6.50% due
1/25/2032.............................. 2,018,748
NR* Aaa 1,522,601 Bank of America Mortgage Securities,
Series 2002-IA, Class 1B, 4.64% due
8/25/2032.............................. 1,532,853
NR* Aaa 4,421,009 Chase Mortgage Finance Corporation,
Series 1999-S4, Class A1, 6.50% due
4/25/2029.............................. 4,540,734
NR* Aaa 2,987,145 CountryWide Home Loan, Series 2001-24,
Class 1A6, 6% due 1/25/2032............ 3,052,268
AAA NR* 2,441,505 General Motors Acceptance Corporation,
Mortgage Corporation Loan Trust, 6.25%
due 1/25/2032.......................... 2,490,310
AAA Aaa 3,614,159 Structured Asset Securities Corporation,
Series 2002-9, Class A2, 1.72% due
10/25/2027(a).......................... 3,587,870
Washington Mutual Inc.:
AAA Aaa 1,600,000 Series 2002-AR4, Class A7, 5.58% due
4/25/2032.............................. 1,640,452
AAA Aaa 3,691,463 Series 2002-S3, Class 1A1, 6.50% due
6/25/2032.............................. 3,788,301
Wells Fargo Mortgage-Backed Securities
Trust:
AAA NR* 6,992,265 Series 2002-3, Class A1, 5.50% due
3/25/2032.............................. 7,118,475
AAA Aaa 1,711,804 Series 2002-A, Class A2, 5.90% due
3/25/2032.............................. 1,717,225
-------------
31,487,236
- ----------------------------------------------------------------------------------------------------------------------------
COMMERCIAL MORTGAGE- AAA Aaa 5,000,000 Banc of America Commercial Mortgage Inc.,
BACKED SECURITIES--5.8% 7.197% due 5/15/2010................... 5,838,793
AAA NR* 5,500,000 Bank of America-First Union NB, Series
2001-3, Class A2, 5.464% due
4/11/2037.............................. 5,876,435
NR* Aaa 5,000,000 First Union-Chase Commercial Mortgage,
Series 1999-C2, Class A2, 6.645% due
4/15/2009.............................. 5,659,626
AAA NR* 4,000,000 General Electric Capital Commercial
Mortgage Corporation, Series 2001-3,
Class A2, 6.07% due 6/10/2038.......... 4,414,137
AAA Aaa 6,300,000 Greenwich Capital Commercial Funding
Corporation, Series 2002-C1, Class A4,
4.948% due 11/11/2025.................. 6,430,922
AAA Aaa 4,900,000 LB-UBS Commercial Mortgage Trust, Series
2002-C1, Class A3, 6.226% due
3/15/2026.............................. 5,460,277
AAA NR* 5,000,000 Nationslink Funding Corporation, Series
1999-2, Class A3, 7.181% due
12/20/2006............................. 5,627,761
-------------
39,307,951
- ----------------------------------------------------------------------------------------------------------------------------
TOTAL NON-GOVERNMENT AGENCY
MORTGAGE-BACKED SECURITIES
(COST--$66,474,700) 70,795,187
- ----------------------------------------------------------------------------------------------------------------------------
</Table>
38
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--CORE BOND V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
S&P MOODY'S FACE
INDUSTRY RATINGS++ RATINGS++ AMOUNT CORPORATE BONDS & NOTES -36.1% VALUE
- ----------------------------------------------------------------------------------------------------------------------------
BANKS & THRIFTS--3.2% A- A2 $ 1,950,000 BB&T Corporation, 4.75% due 10/01/2012... $ 1,956,993
A- A1 1,050,000 Banc One Corp., 8% due 4/29/2027......... 1,318,297
A+ Aa2 1,595,000 Bank of America Corporation, 5.125% due
11/15/2014............................. 1,622,195
A+ Aa3 805,000 The Bank of New York, 5.20% due
7/01/2007.............................. 866,562
A+ Aa2 2,425,000 BankAmerica Corp., 5.875% due
2/15/2009.............................. 2,660,979
A+ A1 1,365,000 Golden West Financial Corporation, 4.75%
due 10/01/2012......................... 1,372,554
BB+ NR* 425,000 Hudson United Bancorp Inc., 8.20% due
9/15/2006.............................. 463,792
MBNA America Bank NA:
BBB+ Baa1 1,000,000 6.875% due 7/15/2004(b)................ 1,040,221
BBB Baa2 710,000 7.125% due 11/15/2012.................. 743,023
A+ Aa3 670,000 Marshall & Ilsley Bank, 4.125% due
9/04/2007.............................. 691,811
A- A2 595,000 Regions Financial Corporation, 6.375% due
5/15/2012.............................. 663,581
A+ Aa3 810,000 Suntrust Bank, 5.45% due 12/01/2017...... 799,875
A Aa3 2,070,000 US Bancorp, 1.56% due 9/16/2005(a)....... 2,071,304
A Aa3 1,030,000 Wachovia Corporation, 4.95% due
11/01/2006............................. 1,099,079
Washington Mutual Inc.:
BBB+ A3 900,000 7.50% due 8/15/2006.................... 1,012,015
BBB+ A3 1,250,000 4.375% due 1/15/2008................... 1,273,713
A+ Aa2 1,021,000 Wells Fargo & Co., 5.125% due 2/15/2007.. 1,096,568
A+ Aa2 560,000 Wells Fargo Bank, 6.45% due 2/01/2011.... 628,652
-------------
21,381,214
- ----------------------------------------------------------------------------------------------------------------------------
BEVERAGE BREWING & BBB+ Baa2 945,000 Coors Brewing Company, 6.375% due
DISTILLING--0.2% 5/15/2012.............................. 1,056,080
- ----------------------------------------------------------------------------------------------------------------------------
BROADCASTING/ MEDIA--0.2% BBB- Baa3 1,355,000 Liberty Media Corporation, 7.875% due
7/15/2009.............................. 1,469,518
- ----------------------------------------------------------------------------------------------------------------------------
BUILDING & BBB- Baa3 1,180,000 Toll Brothers Inc., 6.875% due
CONSTRUCTION--0.2% 11/15/2012(b).......................... 1,215,206
- ----------------------------------------------------------------------------------------------------------------------------
CANADIAN BBB- Ba1 230,000 Abitibi Consolidated Inc., 8.55% due
CORPORATES**--0.0% 8/01/2010(3)........................... 255,270
- ----------------------------------------------------------------------------------------------------------------------------
CANADIAN AAA Aaa 889,000 Canada Government Bond, 5.25% due
SOVEREIGNS**--0.7% 11/05/2008(2).......................... 982,507
AA Aa2 2,040,000 Province of Ontario, 3.50% due
9/17/2007(2)........................... 2,072,312
A+ A1 1,135,000 Province of Quebec, 5% due 7/17/2009(2).. 1,212,830
A+ Aa3 454,000 Province of Saskatchewan, 8% due
7/15/2004(2)........................... 494,005
-------------
4,761,654
- ----------------------------------------------------------------------------------------------------------------------------
CHEMICALS--0.1% BBB- Ba1 445,000 Methanex Corporation, 8.75% due
8/15/2012.............................. 471,700
- ----------------------------------------------------------------------------------------------------------------------------
COMMERCIAL SERVICES & BBB Baa1 990,000 Cendant Corporation, 6.875% due
SUPPLIES--0.2% 8/15/2006.............................. 1,027,285
- ----------------------------------------------------------------------------------------------------------------------------
FINANCE--8.1% A+ A2 1,110,000 American Honda Finance, 1.65% due
10/03/2005(a)(b)....................... 1,108,938
Anadarko Finance Company:
BBB+ Baa1 165,000 6.75% due 5/01/2011.................... 185,918
BBB+ Baa1 290,000 7.50% due 5/01/2031.................... 344,826
A+ A3 300,000 Boeing Capital Corporation, 7.10% due
9/27/2005.............................. 324,965
BBB- Baa2 1,201,000 Capital One Bank, 6.50% due 7/30/2004.... 1,174,568
Chrysler Financial Company LLC(a):
BBB+ A3 1,111,000 1.60% due 2/03/2003.................... 1,110,644
BBB+ A3 1,111,000 1.59% due 3/06/2003.................... 1,110,212
</Table>
39
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--CORE BOND V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
S&P MOODY'S FACE
INDUSTRY RATINGS++ RATINGS++ AMOUNT CORPORATE BONDS & NOTES VALUE
- ----------------------------------------------------------------------------------------------------------------------------
FINANCE (CONCLUDED) A A3 $ 1,685,000 CountryWide Home Loan, 5.625% due
7/15/2009.............................. $ 1,782,973
A- Baa1 1,485,000 Equifax Inc., 4.95% due 11/01/2007(b).... 1,510,983
Ford Motor Credit Company:
BBB A3 8,700,000 2.493% due 4/17/2003(a)................ 8,681,408
BBB A3 1,775,000 6.50% due 1/25/2007.................... 1,753,201
BBB A3 945,000 7.25% due 10/25/2011................... 918,234
AAA Aaa 5,095,000 General Electric Capital Corp., 5.45% due
1/15/2013.............................. 5,292,360
General Motors Acceptance Corp.:
BBB A2 13,000,000 3.23% due 10/16/2003(a)................ 12,948,624
BBB A2 1,540,000 6.875% due 8/28/2012................... 1,518,055
BBB A2 1,264,000 8% due 11/01/2031...................... 1,270,882
Household Finance Corporation:
A- A2 6,300,000 2.91% due 12/16/2004(a)................ 6,295,155
A- A2 2,955,000 5.875% due 2/01/2009................... 3,033,030
A- A2 2,100,000 7% due 5/15/2012....................... 2,300,107
AA- A1 990,000 International Lease Finance Corporation,
4.375% due 12/15/2005.................. 1,001,833
AA Aa3 420,000 Texaco Capital Inc., 8.625% due
6/30/2010.............................. 529,111
-------------
54,196,027
- ----------------------------------------------------------------------------------------------------------------------------
FINANCE--OTHER--4.4% Citigroup Inc.:
AA- Aa1 1,050,000 5.70% due 2/06/2004.................... 1,092,165
AA- Aa1 1,100,000 5.75% due 5/10/2006.................... 1,194,136
A+ Aa2 2,200,000 7.25% due 10/01/2010................... 2,553,912
AA- Aa1 644,000 6.50% due 1/18/2011.................... 722,569
A+ Aa2 1,300,000 6.625% due 6/15/2032................... 1,419,246
A+ Aa3 2,635,000 Goldman Sachs Group, Inc., 6.875% due
1/15/2011.............................. 2,941,292
A A3 960,000 John Hancock Financial Services, 5.625%
due 12/01/2008......................... 1,006,490
AAA Aaa 2,380,000 KFW International Finance, 2.50% due
10/17/2005............................. 2,394,951
Lehman Brothers Holdings, Inc.:
A A2 1,200,000 6.625% due 4/01/2004................... 1,265,082
A A2 2,120,000 6.625% due 1/18/2012................... 2,346,480
MBNA Corporation:
BBB Baa2 405,000 6.25% due 1/17/2007.................... 422,781
BBB Baa2 250,000 5.625% due 11/30/2007.................. 255,331
A A2 2,225,000 Mellon Funding Corporation, 5% due
12/01/2014............................. 2,261,479
A+ A2 520,000 Progressive Corporation, 6.25% due
12/01/2032............................. 533,509
NR* NR* 7,750,000 Security Life of Denver, 4.66% due
3/31/2003.............................. 8,020,501
A+ A2 1,170,000 Verizon Global Funding Corporation,
7.375% due 9/01/2012................... 1,346,131
-------------
29,776,055
- ----------------------------------------------------------------------------------------------------------------------------
HOTELS--0.2% BBB- Ba1 1,400,000 Hilton Hotels Corporation, 7.625% due
12/01/2012............................. 1,413,793
- ----------------------------------------------------------------------------------------------------------------------------
INDUSTRIAL--CONSUMER A+ A1 1,040,000 Archer-Daniels-Midland, 5.935% due
GOODS--0.7% 10/01/2032............................. 1,037,712
BBB+ Baa1 655,000 Newell Rubbermaid Inc., 4.625% due
12/15/2009............................. 668,177
BBB+ NR* 1,555,000 SC Johnson & Son Inc., 5% due
12/15/2012(b).......................... 1,569,531
BBB Baa3 1,390,000 Tyson Foods, Inc., 6.625% due
10/01/2004............................. 1,477,931
-------------
4,753,351
- ----------------------------------------------------------------------------------------------------------------------------
</Table>
40
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--CORE BOND V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
S&P MOODY'S FACE
INDUSTRY RATINGS++ RATINGS++ AMOUNT CORPORATE BONDS & NOTES VALUE
- ----------------------------------------------------------------------------------------------------------------------------
INDUSTRIAL--ENERGY--0.9% BBB+ Baa1 $ 400,000 Anadarko Petroleum Corporation, 5.375%
due 3/01/2007.......................... $ 427,459
BB- Ba2 475,000 The Coastal Corporation, 6.50% due
6/01/2008.............................. 356,250
A A2 1,010,000 Colonial Pipeline, 7.63% due
4/15/2032(b)........................... 1,205,444
BBB- Baa2 2,555,000 FirstEnergy Corp., 6.45% due 11/15/2011.. 2,541,824
A+ A1 1,765,000 Motiva Enterprises LLC, 5.20% due
9/15/2012(b)........................... 1,762,058
-------------
6,293,035
- ----------------------------------------------------------------------------------------------------------------------------
INDUSTRIAL-- A A2 900,000 Alcoa Inc., 1.70% due 12/06/2004(a)...... 902,311
MANUFACTURING--0.9%
A- A3 1,025,000 Cooper Industries Inc., 5.50% due
11/01/2009............................. 1,068,305
A A2 300,000 Emerson Electric Company, 6% due
8/15/2032.............................. 304,577
BBB Baa1 1,700,000 Ford Motor Company, 7.45% due
7/16/2031.............................. 1,478,777
BBB Baa2 660,000 Martin Marietta Corp., 7.375% due
4/15/2013.............................. 774,231
BBB- Baa3 830,000 Raytheon Company, 6.75% due 3/15/2018.... 869,799
BBB Baa3 480,000 Sealed Air Corporation, 6.95% due
5/15/2009(b)........................... 491,353
-------------
5,889,353
- ----------------------------------------------------------------------------------------------------------------------------
INDUSTRIAL-- BBB+ Baa1 1,137,000 AOL Time Warner Inc., 6.875% due
SERVICES--2.7% 5/01/2012.............................. 1,200,790
Aramark Services Inc.:
BBB- Baa3 1,035,000 6.75% due 8/01/2004.................... 1,076,849
BBB- Baa3 1,020,000 6.375% due 2/15/2008................... 1,056,059
BB+ Ba2 1,980,000 Circus Circus Enterprises, Inc., 6.70%
due 11/15/2096......................... 1,989,260
Clear Channel Communications:
BBB- Baa3 867,000 7.875% due 6/15/2005................... 949,207
BBB- Baa3 995,000 7.65% due 9/15/2010.................... 1,127,188
BBB Baa2 1,130,000 Cox Communications Inc., 7.125% due
10/01/2012............................. 1,255,129
A+ A1 1,635,000 First Data Corporation, 6.75% due
7/15/2005.............................. 1,779,444
BBB- Ba1 1,310,000 HCA Inc., 6.30% due 10/01/2012........... 1,321,189
Tele-Communications Inc.:
BBB Baa3 1,160,000 8.25% due 1/15/2003.................... 1,160,340
BBB Baa3 1,102,000 9.80% due 2/01/2012.................... 1,324,629
BBB- Baa3 830,000 USA Interactive, 7% due 1/15/2013(b)..... 858,240
A- A3 1,060,000 Viacom Inc., 7.875% due 7/30/2030........ 1,319,520
BBB Ba1 1,840,000 Waste Management Inc., 7.375% due
8/01/2010.............................. 2,013,218
-------------
18,431,062
- ----------------------------------------------------------------------------------------------------------------------------
INDUSTRIAL-- AAA Aaa 600,000 Continental Airlines, 6.563% due
TRANSPORTATION--0.3% 2/15/2012.............................. 641,302
Southwest Airlines Co.:
A Baa1 190,000 8% due 3/01/2005....................... 210,240
A Baa1 940,000 7.875% due 9/01/2007................... 1,057,914
-------------
1,909,456
- ----------------------------------------------------------------------------------------------------------------------------
METAL--OTHER--0.2% Kinder Morgan Energy:
BBB+ Baa1 755,000 5.35% due 8/15/2007.................... 790,037
BBB+ Baa1 745,000 6.75% due 3/15/2011.................... 809,256
-------------
1,599,293
- ----------------------------------------------------------------------------------------------------------------------------
</Table>
41
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--CORE BOND V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
S&P MOODY'S FACE
INDUSTRY RATINGS++ RATINGS++ AMOUNT CORPORATE BONDS & NOTES VALUE
- ----------------------------------------------------------------------------------------------------------------------------
MULTI-SECTOR NR* Baa3 $ 1,680,000 Lehman Brothers, TRAINS, 6.259% due
HOLDINGS--1.5% 8/15/2008(a)(b)(e)..................... $ 1,729,997
Morgan Stanley TRACERS(b)(d):
NR* A3 5,700,000 5.854% due 3/01/2007(a)................ 6,073,521
NR* Baa1 2,370,000 6.726% due 6/15/2012................... 2,608,872
-------------
10,412,390
- ----------------------------------------------------------------------------------------------------------------------------
PAPER--0.0% BBB- Baa3 230,000 Domtar Inc., 7.875% due 10/15/2011....... 268,814
- ----------------------------------------------------------------------------------------------------------------------------
REAL ESTATE INVESTMENT BBB Baa3 575,000 Developers Diversified Realty, 6.625% due
TRUST--1.4% 1/15/2008.............................. 578,111
BBB+ Baa1 2,575,000 EOP Operating LP, 7.375% due
11/15/2003............................. 2,679,305
BBB+ Baa2 300,000 Health Care Properties Inc., 7.48% due
4/05/2004.............................. 316,594
Health Care Properties Investors Inc.:
BBB+ Baa2 700,000 6.50% due 2/15/2006.................... 727,011
BBB+ Baa2 1,260,000 6.45% due 6/25/2012.................... 1,269,345
BBB- Baa3 775,000 Nationwide Health Properties, 6.59% due
7/07/2038.............................. 802,730
BBB+ Baa1 3,055,000 Prologis Trust, 7% due 10/01/2003........ 3,141,075
-------------
9,514,171
- ----------------------------------------------------------------------------------------------------------------------------
RETAIL--STORES--0.2% A- A3 385,000 Kohl's Corporation, 6% due 1/15/2033..... 387,044
BBB+ Baa1 645,000 Limited Brands Inc., 6.125% due
12/01/2012............................. 678,953
BBB Baa3 220,000 SuperValu Inc., 7.50% due 5/15/2012...... 237,137
-------------
1,303,134
- ----------------------------------------------------------------------------------------------------------------------------
SPECIAL SERVICES--0.2% AA Aa3 960,000 Principal Life Global, 6.25% due
2/15/2012(b)........................... 1,017,591
- ----------------------------------------------------------------------------------------------------------------------------
SUPRANATIONAL--0.4% A A2 775,000 Corporacion Andina de Fomento, 6.875% due
3/15/2012.............................. 812,470
AAA Aaa 1,930,000 European Investment Bank, 7.125% due
9/18/2006.............................. 2,234,342
-------------
3,046,812
- ----------------------------------------------------------------------------------------------------------------------------
UTILITIES-- BBB Baa3 1,343,000 AT&T Broadband Corporation, 8.375% due
COMMUNICATIONS--2.1% 3/15/2013.............................. 1,525,542
AT&T Corporation:
BBB+ Baa2 134,000 6% due 3/15/2009....................... 133,808
BBB+ Baa2 465,000 7.30% due 11/15/2011................... 508,248
AT&T Wireless Services Inc.:
BBB Baa2 772,000 8.125% due 5/01/2012................... 775,860
BBB Baa2 551,000 8.75% due 3/01/2031.................... 539,980
A A2 340,000 Alltel Corporation, 7% due 7/01/2012..... 391,835
BBB+ Baa2 1,595,000 CenturyTel Inc., 7.875% due
8/15/2012(b)........................... 1,887,797
A+ A3 2,120,000 GTE Corporation, 6.84% due 4/15/2018..... 2,201,807
Sprint Capital Corporation:
BBB- Baa3 2,335,000 5.70% due 11/15/2003................... 2,323,325
BBB- Baa3 1,570,000 8.375% due 3/15/2012................... 1,562,150
B- Ba3 1,077,000 US West Communications, 7.20% due
11/01/2004............................. 1,023,150
A+ A2 1,005,000 Verizon New York Inc., 6.875% due
4/01/2012.............................. 1,129,005
-------------
14,002,507
- ----------------------------------------------------------------------------------------------------------------------------
UTILITIES--ELECTRIC--2.3% BBB+ A3 585,000 Alabama Power Capital Trust, 5.50% due
10/01/2042(a).......................... 588,246
BBB Baa1 2,210,000 Cincinnati Gas & Electric Company, 5.70%
due 9/15/2012.......................... 2,265,358
</Table>
42
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--CORE BOND V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
S&P MOODY'S FACE
INDUSTRY RATINGS++ RATINGS++ AMOUNT CORPORATE BONDS & NOTES VALUE
- ----------------------------------------------------------------------------------------------------------------------------
UTILITIES--ELECTRIC Commonwealth Edison Company:
(CONCLUDED)
A- A3 $ 50,000 6.15% due 3/15/2012.................... $ 55,316
BBB+ Baa1 830,000 6.95% due 7/15/2018.................... 913,235
A+ A1 1,530,000 Consolidated Edison Company of New York,
4.875% due 2/01/2013................... 1,551,215
Dominion Resources Inc.:
BBB+ Baa1 1,051,000 7.625% due 7/15/2005................... 1,152,965
BBB+ Baa1 1,480,000 8.125% due 6/15/2010................... 1,721,833
BBB+ Baa1 485,000 6.75% due 12/15/2032................... 497,761
BBB+ Baa2 465,000 Exelon Corporation, 6.75% due 5/01/2011.. 508,991
Florida Power & Light:
A Aa3 365,000 4.85% due 2/01/2013.................... 372,861
A Aa3 565,000 5.85% due 2/01/2033.................... 578,716
A A2 920,000 Georgia Power Company, 5.125% due
11/15/2012............................. 951,997
BBB- Baa3 905,000 Mid-American Energy Holdings, 5.875% due
10/01/2012(b).......................... 917,427
A A1 830,000 Mississippi Power, 6.05% due 5/01/2003... 840,020
BBB Baa1 1,030,000 PSE&G Power, 6.95% due 6/01/2012......... 1,045,795
BBB+ Baa1 1,110,000 Southern Power Company, 6.25% due
7/15/2012.............................. 1,172,743
-------------
15,134,479
- ----------------------------------------------------------------------------------------------------------------------------
YANKEE CORPORATES**--3.4% A- A2 400,000 BSCH Issuances Ltd., 7.625% due
9/14/2010(1)........................... 454,973
A- Baa1 2,354,000 British Telecom PLC, 8.375% due
12/15/2010(4).......................... 2,822,206
A- A2 1,145,000 Codelco Inc., 6.375% due
11/30/2012(3)(b)....................... 1,200,141
Daimler-Chrysler NA Holdings(3):
BBB+ A3 9,035,000 7.125% due 4/10/2003................... 9,130,120
BBB+ A3 1,250,000 6.40% due 5/15/2006.................... 1,347,449
BBB+ A3 975,000 7.30% due 1/15/2012.................... 1,094,095
BBB+ Baa1 830,000 Deutsche Telekom International Finance,
8.50% due 6/15/2010(4)................. 955,939
France Telecom(4):
BBB- Baa3 375,000 9.25% due 3/01/2011.................... 433,601
BBB- Baa3 440,000 10% due 3/01/2031...................... 535,627
BBB Baa3 1,040,000 Koninklijke (KPN) NV, 8% due
10/01/2010(3).......................... 1,164,800
A A2 600,000 Norsk Hydro A/S, 6.36% due
1/15/2009(3)........................... 650,876
Pemex Project Funding Master Trust(1):
BBB- Baa1 1,000,000 9.125% due 10/13/2010.................. 1,145,000
BBB- Baa1 1,055,000 7.375% due 12/15/2014(b)............... 1,081,375
BBB+ Baa1 560,000 UPM-Kymmene Corporation, 5.625% due
12/01/2014(3)(b)....................... 581,096
-------------
22,597,298
- ----------------------------------------------------------------------------------------------------------------------------
YANKEE SOVEREIGNS**--1.4% Korea Development Bank(1):
A- A3 1,265,000 7.125% due 4/22/2004................... 1,344,733
A- A3 1,035,000 4.25% due 11/13/2007................... 1,050,871
AAA Aaa 1,345,000 Republic of Finland, 5.875% due
2/27/2006(2)........................... 1,473,048
AA Aa2 2,841,000 Republic of Italy, 4.375% due
10/25/2006(2).......................... 2,997,673
BBB- Baa2 1,870,000 United Mexican States, 9.875% due
2/01/2010(2)........................... 2,295,612
-------------
9,161,937
- ----------------------------------------------------------------------------------------------------------------------------
TOTAL CORPORATE BONDS & NOTES
(COST--$234,135,874) 242,358,485
- ----------------------------------------------------------------------------------------------------------------------------
</Table>
43
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--CORE BOND V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONCLUDED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
FACE
AMOUNT SHORT-TERM SECURITIES--3.4% VALUE
- ----------------------------------------------------------------------------------------------------------------------------
COMMERCIAL PAPER***--3.4% $12,788,000 ITT Industries, Inc., 1.36% due
1/02/2003.............................. $ 12,787,034
10,000,000 Ryder System, Inc., 1.40% due 1/02/2003.. 9,999,222
- ----------------------------------------------------------------------------------------------------------------------------
TOTAL SHORT-TERM SECURITIES
(COST--$22,786,256) 22,786,256
- ----------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS
(COST--$751,208,924)--115.5%............. 776,312,593
LIABILITIES IN EXCESS OF OTHER ASSETS--
(15.5%).................................. (104,007,251)
-------------
NET ASSETS--100.0%....................... $ 672,305,342
=============
- ----------------------------------------------------------------------------------------------------------------------------
</Table>
* Not Rated.
** Corresponding industry groups for foreign securities:
(1) Financial Institution.
(2) Government Entity.
(3) Industrial.
(4) Telecommunications.
*** Commercial Paper is traded on a discount basis; the interest rates shown
reflect the discount rates paid at the time of purchase by the Fund.
(a) Floating rate note.
(b) The security may be offered and sold to "qualified institutional buyers"
under Rule 144A of the Securities Act of 1933.
(c) Represents a "to-be-announced" (TBA) transaction. The Fund has committed to
purchasing securities for which all specific information is not available at
this time.
(d) Tradable Custodial Receipts (TRACERS).
(e) Target Return Index Securities (TRAINS).
+ Mortgage-Backed Obligations are subject to principal paydowns as a result of
prepayments or refinancings of the underlying mortgage instruments. As a
result, the average life may be substantially less than the original
maturity.
++ Ratings of issues shown are unaudited.
See Notes to Financial Statements.
44
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--CORE BOND V.I. FUND
STATEMENT OF ASSETS AND LIABILITIES AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
ASSETS:
Investments, at value (identified cost--$751,208,924)....... $776,312,593
Cash........................................................ 1,931
Receivables:
Securities sold........................................... $ 63,313,896
Interest.................................................. 7,290,240
Capital shares sold....................................... 180,670 70,784,806
------------
Prepaid expenses............................................ 3,369
------------
Total assets................................................ 847,102,699
------------
- -----------------------------------------------------------------------------------------
LIABILITIES:
Payables:
Securities purchased...................................... 162,773,602
Capital shares redeemed................................... 11,707,118
Investment adviser........................................ 262,798 174,743,518
------------
Accrued expenses............................................ 53,839
------------
Total liabilities........................................... 174,797,357
------------
- -----------------------------------------------------------------------------------------
NET ASSETS.................................................. $672,305,342
============
- -----------------------------------------------------------------------------------------
NET ASSETS CONSIST OF:
Class A Shares of Common Stock, $.10 par value, 600,000,000
shares authorized+........................................ $ 5,549,827
Paid-in capital in excess of par............................ 664,812,174
Undistributed investment income--net........................ $ 2,767,716
Accumulated realized capital losses on investments--net..... (25,928,044)
Unrealized appreciation on investments--net................. 25,103,669
------------
Total accumulated earnings--net............................. 1,943,341
------------
NET ASSETS.................................................. $672,305,342
============
- -----------------------------------------------------------------------------------------
NET ASSET VALUE:
Class A--Based on net assets of $672,305,342 and 55,498,270
shares outstanding........................................ $ 12.11
============
- -----------------------------------------------------------------------------------------
</Table>
+ The Fund is also authorized to issue 100,000,000 Class B Shares.
See Notes to Financial Statements.
45
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--CORE BOND V.I. FUND
STATEMENT OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
INVESTMENT INCOME:
Interest.................................................... $35,309,986
Securities lending--net..................................... 8,066
-----------
Total income................................................ 35,318,052
-----------
- --------------------------------------------------------------------------------------
EXPENSES:
Investment advisory fees.................................... $2,853,998
Accounting services......................................... 224,999
Professional fees........................................... 72,642
Printing and shareholder reports............................ 58,516
Custodian fees.............................................. 50,870
Transfer agent fees......................................... 35,032
Directors' fees and expenses................................ 27,173
Pricing services............................................ 23,273
Registration fees........................................... 1,726
Other....................................................... 23,797
----------
Total expenses.............................................. 3,372,026
-----------
Investment income--net...................................... 31,946,026
-----------
- --------------------------------------------------------------------------------------
REALIZED & UNREALIZED GAIN ON INVESTMENTS--NET:
Realized gain on investments--net........................... 6,438,955
Change in unrealized appreciation on investments--net....... 23,601,964
-----------
Total realized and unrealized gain on investments--net...... 30,040,919
-----------
NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS........ $61,986,945
===========
- --------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
46
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--CORE BOND V.I. FUND
STATEMENTS OF CHANGES IN NET ASSETS
- --------------------------------------------------------------------------------
<Table>
<Caption>
FOR THE YEAR ENDED
DECEMBER 31,
----------------------------
INCREASE (DECREASE) IN NET ASSETS: 2002 2001
- --------------------------------------------------------------------------------------------
OPERATIONS:
Investment income--net...................................... $ 31,946,026 $ 28,846,303
Realized gain on investments--net........................... 6,438,955 9,803,669
Change in unrealized appreciation on investments--net....... 23,601,964 (5,011,111)
------------ ------------
Net increase in net assets resulting from operations........ 61,986,945 33,638,861
------------ ------------
- --------------------------------------------------------------------------------------------
DIVIDENDS TO SHAREHOLDERS:
Dividends to Class A shareholders from investment
income--net............................................... (31,795,952) (29,010,817)
------------ ------------
- --------------------------------------------------------------------------------------------
CAPITAL SHARE TRANSACTIONS:
Net increase (decrease) in net assets derived from capital
share transactions........................................ (3,913,287) 134,151,763
------------ ------------
- --------------------------------------------------------------------------------------------
NET ASSETS:
Total increase in net assets................................ 26,277,706 138,779,807
Beginning of year........................................... 646,027,636 507,247,829
------------ ------------
End of year*................................................ $672,305,342 $646,027,636
============ ============
- --------------------------------------------------------------------------------------------
* Undistributed investment income--net...................... $ 2,767,716 $ 2,558,961
============ ============
- --------------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
47
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--CORE BOND V.I. FUND
FINANCIAL HIGHLIGHTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
THE FOLLOWING PER SHARE DATA AND RATIOS HAVE BEEN DERIVED FROM CLASS A
INFORMATION PROVIDED IN THE FINANCIAL STATEMENTS. ----------------------------------------------------
FOR THE YEAR ENDED DECEMBER 31,
----------------------------------------------------
INCREASE (DECREASE) IN NET ASSET VALUE: 2002 2001 2000 1999 1998
- --------------------------------------------------------------------------------------------------------------------
PER SHARE OPERATING PERFORMANCE:
Net asset value, beginning of year........................... $ 11.59 $ 11.49 $ 11.14 $ 12.25 $ 12.11
-------- -------- -------- -------- --------
Investment income--net....................................... .56++ .63 .78 .77 .77
Realized and unrealized gain (loss) on investments--net...... .52 .12 .29 (1.05) .15
-------- -------- -------- -------- --------
Total from investment operations............................. 1.08 .75 1.07 (.28) .92
-------- -------- -------- -------- --------
Less dividends from investment income--net................... (.56) (.65) (.72) (.83) (.78)
-------- -------- -------- -------- --------
Net asset value, end of year................................. $ 12.11 $ 11.59 $ 11.49 $ 11.14 $ 12.25
======== ======== ======== ======== ========
- --------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENT RETURN:*
Based on net asset value per share........................... 9.57% 6.68% 10.01% (2.35%) 7.85%
======== ======== ======== ======== ========
- --------------------------------------------------------------------------------------------------------------------
RATIOS TO AVERAGE NET ASSETS:
Expenses..................................................... .50% .51% .49% .47% .48%
======== ======== ======== ======== ========
Investment income--net....................................... 4.76% 5.50% 6.96% 6.53% 6.35%
======== ======== ======== ======== ========
- --------------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL DATA:
Net assets, end of year (in thousands)....................... $672,305 $646,028 $507,248 $543,578 $594,301
======== ======== ======== ======== ========
Portfolio turnover........................................... 274.08% 277.86% 120.99% 97.14% 103.24%
======== ======== ======== ======== ========
- --------------------------------------------------------------------------------------------------------------------
</Table>
* Total investment returns exclude insurance-related fees and expenses.
++ Based on average shares outstanding.
See Notes to Financial Statements.
48
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--CORE BOND V.I. FUND
NOTES TO FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
1. SIGNIFICANT ACCOUNTING POLICIES:
Merrill Lynch Variable Series Funds, Inc. (the "Company") is an open-end
management investment company that is comprised of 17 separate funds. Each fund
offers two classes of shares to the Merrill Lynch Life Insurance Company, ML
Life Insurance Company of New York (indirect, wholly-owned subsidiaries of
Merrill Lynch & Co., Inc. ("ML & Co.")), and other insurance companies that are
not affiliated with ML & Co., for their separate accounts to fund benefits under
certain variable annuity and variable life insurance contracts. Core Bond V.I.
Fund (the "Fund") (formerly Core Bond Focus Fund) is classified as
"diversified," as defined in the Investment Company Act of 1940. Class A and
Class B Shares have equal voting, dividend, liquidation and other rights, except
that only shares of the respective classes are entitled to vote on matters
concerning only that class and Class B Shares bear certain expenses related to
the distribution of such shares. The Fund's financial statements are prepared in
conformity with accounting principles generally accepted in the United States of
America, which may require the use of management accruals and estimates. The
following is a summary of significant accounting policies followed by the Fund.
(a) Valuation of investments--Portfolio securities that are traded on stock
exchanges are valued at the last sale price as of the close of business on the
day the securities are being valued, or lacking any sales, at the closing bid
price. Securities traded in the over-the-counter market are valued at the last
available bid price prior to the time of valuation. Portfolio securities that
are traded both in the over-the-counter 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. Options written or purchased are valued at the last sale price in the
case of exchange-traded options. In the case of options traded in the
over-the-counter market, valuation is the last asked price (options written) or
the last bid price (options purchased). Financial futures contracts and options
thereon, which are traded on exchanges, are valued at their closing price at the
close of such exchanges. Short-term securities are valued at amortized cost,
which approximates market value. 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.
(b) Derivative financial instruments--The Fund may engage in various portfolio
investment strategies to increase or decrease the level of risk to which the
Fund is exposed more quickly and efficiently than transactions in other types of
instruments. Losses may arise due to changes in the value of the contract or if
the counterparty does not perform under the contract.
- Interest rate spreadlocks--The Fund is authorized to enter into interest
rate spreadlock agreements, which are over-the-counter contracts in which one
party agrees to make periodic payments based on the change in the market value
of a specified security, basket of securities or index in exchange for periodic
payments based on a fixed or variable interest rate or the change in the market
value of a different security, basket of securities or index. Agreements may be
used to obtain exposure to the underlying Investments without taking physical
custody of the securities in circumstances where direct investment is restricted
by law or is otherwise impractical.
- Options--The Fund may write and purchase call and put options. When the Fund
writes an option, an amount equal to the premium received by the Fund is
reflected as an asset and an equivalent liability. The amount of the liability
is subsequently marked to market to reflect the current market value of the
option written. When a security is purchased or sold through an exercise of an
option, the related premium paid (or received) is added to (or deducted from)
the basis of the security acquired or deducted from (or added to) the proceeds
of the security sold. When an option expires (or the Fund enters into a closing
transaction), the Fund realizes a gain or loss on the option to the extent of
the premiums received or paid (or loss or gain to the extent the cost of the
closing transaction exceeds the premium paid or received).
Written and purchased options are non-income producing investments.
(c) Repurchase agreements--The Fund invests in U.S. government securities
pursuant to repurchase agreements. Under such agreements, the counterparty
agrees to repurchase the security at a mutually agreed upon time and price. The
Fund takes possession of the underlying securities, marks to market such
securities and, if necessary, receives additional securities daily to ensure
that the contract is fully collateralized. If the seller defaults and the fair
value of the collateral declines, liquidation of the collateral by the Fund may
be delayed or limited.
49
- --------------------------------------------------------------------------------
(d) Income taxes--It is the Fund's policy to comply with the requirements of
the Internal Revenue Code applicable to regulated investment companies and to
distribute substantially all of its taxable income to its shareholders.
Therefore, no Federal income tax provision is required.
(e) Security transactions and investment income--Security transactions are
recorded on the dates the transactions are entered into (the trade dates).
Realized gains and losses on security transactions are determined on the
identified cost basis. Interest income is recognized on the accrual basis. The
Fund amortizes all premiums and discounts on debt securities.
(f) Dividends and distributions--Dividends from net investment income are
declared and paid monthly. Distributions of capital gains are recorded on the
ex-dividend date.
(g) Expenses--Certain expenses have been allocated to the individual funds in
the Company on a pro rata basis based upon the respective aggregate net asset
value of each fund included in the Company.
(h) Securities lending--The Fund may lend securities to financial institutions
that provide cash or securities issued or guaranteed by the U.S. government as
collateral, which will be maintained at all times in an amount equal to at least
100% of the current market value of the loaned securities. Where the Fund
receives securities as collateral for the loaned securities, it collects a fee
from the borrower. The Fund typically receives the income on the loaned
securities but does not receive the income on the collateral. Where the Fund
receives cash collateral, it may invest such collateral and retain the amount
earned on such investment, net of any amount rebated to the borrower. Loans of
securities are terminable at any time and the borrower, after notice, is
required to return borrowed securities within five business days. The Fund may
pay reasonable finder's, lending agent, administrative and custodial fees in
connection with its loans. In the event that the borrower defaults on its
obligation to return borrowed securities because of insolvency or for any other
reason, the Fund could experience delays and costs in gaining access to the
collateral. The Fund also could suffer a loss where the value of the collateral
falls below the market value of the borrowed securities, in the event of
borrower default or in the event of losses on investments made with cash
collateral.
(i) Reclassification--Accounting principles generally accepted in the United
States of America require that certain components of net assets be adjusted to
reflect permanent differences between financial and tax reporting. Accordingly,
the current year's permanent book/tax difference of $58,681 has been
reclassified between accumulated net realized capital losses and undistributed
net investment income. This reclassification has no effect on net assets or net
asset value per share.
2. INVESTMENT ADVISORY AGREEMENT AND TRANSACTIONS WITH AFFILIATES:
The Company has entered into an Investment Advisory Agreement with Merrill Lynch
Investment Managers, L.P. ("MLIM"). The general partner of MLIM is Princeton
Services, Inc. ("PSI"), an indirect, wholly-owned subsidiary of ML & Co., which
is the limited partner.
MLIM is responsible for the management of the Company's funds and provides the
necessary personnel, facilities, equipment and certain other services necessary
to the operations of the Fund. For such services, the Fund pays a monthly fee
based upon the aggregate daily value of net assets of the Fund and the Company's
High Current Income V.I. Fund at the following annual rates: .50% of average
daily net assets not exceeding $250 million; .45% of average daily net assets in
excess of $250 million but not exceeding $500 million; .40% of average daily net
assets in excess of $500 million but not exceeding $750 million; and .35% of
average daily net assets in excess of $750 million. For the year ended December
31, 2002, the aggregate average daily net assets of the Fund and the Company's
High Current Income V.I. Fund was approximately $993,794,000.
MLIM and Merrill Lynch Life Agency, Inc. ("MLLA") have entered into an
agreement that limits the operating expenses paid by the Fund, exclusive of any
distribution fees imposed on Class B Shares, to 1.25% of its average daily net
assets. Any such expenses in excess of 1.25% of average daily net assets will be
reimbursed to the Fund by MLIM which, in turn, will be reimbursed by MLLA.
The Company has received an exemptive order from the Securities and Exchange
Commission permitting it to lend portfolio securities to Merrill Lynch, Pierce,
Fenner & Smith Incorporated ("MLPF&S"), a subsidiary of ML & Co., or its
affiliates. Pursuant to that order, the Company also has retained Merrill Lynch
Investment Managers, LLC ("MLIM, LLC"), an affiliate of MLIM, as the securities
lending agent for a fee based on a share of the returns on investment of cash
collateral. MLIM, LLC may, on behalf of the Company and the Fund, invest cash
collateral received by the Fund for such loans, among other things, in a private
investment company managed by MLIM, LLC or in
50
- --------------------------------------------------------------------------------
registered money market funds advised by MLIM or its affiliates. For the year
ended December 31, 2002, MLIM, LLC received $2,696 in securities lending agent
fees from the Fund.
For the year ended December 31, 2002, the Fund paid Merrill Lynch Pricing
Service, an affiliate of MLPF&S, $5,516 for providing security price quotations
to compute the net asset value of the Fund.
Financial Data Services, Inc. ("FDS"), a wholly-owned subsidiary of ML & Co.,
is the Company's transfer agent.
FAM Distributors, Inc. ("FAMD"), which is a wholly-owned subsidiary of Merrill
Lynch Group, Inc., is the Fund's distributor.
For the year ended December 31, 2002, the Fund reimbursed MLIM $17,385 for
certain accounting services.
Certain officers and/or directors of the Company are officers and/or directors
of MLIM, PSI, FDS, FAMD, and/or ML & Co.
3. INVESTMENTS:
Purchases and sales of investments, excluding short-term securities, for the
year ended December 31, 2002 were $2,049,427,306 and $1,948,577,762,
respectively.
Net realized gains (losses) for the year ended December 31, 2002 and net
unrealized gains as of December 31, 2002 were as follows:
<Table>
<Caption>
- ------------------------------------------------------------------
Realized
Gains Unrealized
(Losses) Gains
- ------------------------------------------------------------------
Long-term investments................... $7,317,910 $25,103,669
Short-term investments.................. 3,649 --
Options written......................... 151,575 --
Interest rate spreadlocks............... 223,108 --
Financial futures contracts............. (1,257,287) --
---------- -----------
Total................................... $6,438,955 $25,103,669
========== ===========
- ------------------------------------------------------------------
</Table>
At December 31, 2002, net unrealized appreciation for Federal income tax
purposes aggregated $24,542,241, of which $25,856,260 related to appreciated
securities and $1,314,019 related to depreciated securities. At December 31,
2002, the aggregate cost of investments for Federal income tax purposes was
$751,770,352.
Transactions in call options written for the year ended December 31, 2002 were
as follows:
<Table>
<Caption>
- ------------------------------------------------------------------
Nominal Value Premiums
Covered Received
- ------------------------------------------------------------------
Outstanding call options written,
beginning of year..................... -- $ --
Options written........................ 14,500,000 58,340
Options closed......................... (14,500,000) (58,340)
----------- --------
Outstanding call options written, end
of year............................... -- $ --
=========== ========
- ------------------------------------------------------------------
</Table>
Transactions in put options written for the year ended December 31, 2002 were
as follows:
<Table>
<Caption>
- ------------------------------------------------------------------
Nominal Value Premiums
Covered Received
- ------------------------------------------------------------------
Outstanding put options written,
beginning of year..................... -- $ --
Options written........................ 90,000 84,375
Options expired........................ (90,000) (84,375)
----------- --------
Outstanding put options written, end of
year.................................. -- $ --
=========== ========
- ------------------------------------------------------------------
</Table>
4. CAPITAL SHARE TRANSACTIONS:
Transactions in capital shares were as follows:
<Table>
<Caption>
- -----------------------------------------------------------------
Class A Shares for the Year Ended Dollar
December 31, 2002 Shares Amount
- -----------------------------------------------------------------
Shares sold......................... 5,850,115 $ 68,631,745
Shares issued to shareholders in
reinvestment of dividends.......... 2,719,874 31,795,952
---------- -------------
Total issued........................ 8,569,989 100,427,697
Shares redeemed..................... (8,813,803) (104,340,984)
---------- -------------
Net decrease........................ (243,814) $ (3,913,287)
========== =============
- -----------------------------------------------------------------
</Table>
<Table>
<Caption>
- -----------------------------------------------------------------
Class A Shares for the Year Ended Dollar
December 31, 2001 Shares Amount
- -----------------------------------------------------------------
Shares sold.......................... 12,209,879 $141,143,507
Shares issued to shareholders in
reinvestment of dividends........... 2,499,981 29,010,817
---------- ------------
Total issued......................... 14,709,860 170,154,324
Shares redeemed...................... (3,109,967) (36,002,561)
---------- ------------
Net increase......................... 11,599,893 $134,151,763
========== ============
- -----------------------------------------------------------------
</Table>
5. SHORT-TERM BORROWINGS:
The Fund, along with certain other funds managed by MLIM and its affiliates, is
a party to a credit agreement with Bank One, N.A. and certain other lenders.
Effective November 29, 2002, in conjunction with the renewal for one year at the
same terms, the total commitment was reduced from $1,000,000,000 to
$500,000,000. The Fund may borrow under the credit agreement to fund shareholder
redemptions and for other lawful purposes other than for leverage. The Fund may
borrow up to the maximum amount allowable under the Fund's current prospectus
and statement of additional information, subject to various other legal,
regulatory or contractual limits. The Fund pays a commitment fee of .09% per
annum based on the Fund's pro rata share of the unused portion of the credit
agreement. Amounts borrowed under the credit agreement bear interest at a rate
equal to, at each fund's election, the Federal Funds rate plus .50% or a base
rate as determined by Bank One, N.A. The Fund did not borrow under the credit
agreement during the year ended December 31, 2002.
6. DISTRIBUTIONS TO SHAREHOLDERS:
The Fund paid an ordinary income dividend of $.048306 on January 2, 2003
51
- --------------------------------------------------------------------------------
to shareholders of record on December 31, 2002.
The tax character of distributions paid during the fiscal years ended December
31, 2002 and December 31, 2001 was as follows:
<Table>
<Caption>
- -----------------------------------------------------------------
12/31/2002 12/31/2001
- -----------------------------------------------------------------
Distributions paid from:
Ordinary income...................... $31,795,952 $29,010,817
----------- -----------
Total taxable distributions........... $31,795,952 $29,010,817
=========== ===========
- -----------------------------------------------------------------
</Table>
As of December 31, 2002, the components of accumulated earnings on a tax basis
were as follows:
<Table>
<Caption>
- -----------------------------------------------------------------
Undistributed ordinary income--net................. $ 2,651,011
Undistributed long-term capital gains--net......... --
------------
Total undistributed earnings--net.................. 2,651,011
Capital loss carryforward.......................... (24,442,384)*
Unrealized gains--net.............................. 23,734,714**
------------
Total accumulated earnings--net.................... $ 1,943,341
============
- -----------------------------------------------------------------
</Table>
* On December 31, 2002, the Fund had a net capital loss carryforward of
$24,442,384, of which $7,216,222 expires in 2007 and $17,226,162 expires in
2008. This amount will be available to offset like amounts of any future
taxable gains.
** The difference between book-basis and tax-basis net unrealized gains is
attributable primarily to the tax deferral of losses on wash sales, the tax
deferral of losses on straddles and the difference between book and tax
amortization methods for premiums and discounts on fixed income securities.
52
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--CORE BOND V.I. FUND
INDEPENDENT AUDITORS' REPORT
- --------------------------------------------------------------------------------
THE BOARD OF DIRECTORS AND SHAREHOLDERS,
CORE BOND V.I. FUND OF
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.:
We have audited the accompanying statement of assets and liabilities,
including the schedule of investments, of Core Bond V.I. Fund (formerly, Core
Bond Focus Fund) of Merrill Lynch Variable Series Funds, Inc. as of December 31,
2002, the related statements of operations for the year then ended and changes
in net assets for each of the years in the two-year period then ended, and the
financial highlights for each of the years presented. These financial statements
and the financial highlights are the responsibility of the Fund's management.
Our responsibility is to express an opinion on these financial statements and
the financial highlights based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements and the financial highlights are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. Our procedures included confirmation of
securities owned at December 31, 2002 by correspondence with the custodian and
brokers; where replies were not received from brokers, we performed other
auditing procedures. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe our audits provide a
reasonable basis for our opinion.
In our opinion, such financial statements and financial highlights present
fairly, in all material respects, the financial position of Core Bond V.I. Fund
of Merrill Lynch Variable Series Funds, Inc. as of December 31, 2002, the
results of its operations, the changes in its net assets, and the financial
highlights for the respective stated periods in conformity with accounting
principles generally accepted in the United States of America.
Deloitte & Touche LLP
Princeton, New Jersey
February 14, 2003
53
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DEVELOPING CAPITAL MARKETS V.I. FUND
DECEMBER 31, 2002--ANNUAL REPORT
- --------------------------------------------------------------------------------
DEAR SHAREHOLDER:
FISCAL YEAR IN REVIEW
For the 12-month period ended December 31, 2002, Developing Capital Markets
V.I. Fund's Class A and Class B Shares had total returns of -10.24% and -10.28%,
respectively, compared to its benchmark, the unmanaged Morgan Stanley Capital
International (MSCI) Emerging Markets Free Index, which returned -6.00%.
(References to securities markets of all countries in this letter to
shareholders correspond to those countries' market weightings in the MSCI
Emerging Markets Free Index, unless otherwise noted, and are for the 12-month
period ended December 31, 2002.)
We maintained a slight cyclical bias throughout the year and were thus
overweighted in Asia and slightly underweighted in the other regions.
Significant overweight selections were made in Thailand and South Korea, both of
which were successful as these markets outperformed because of strong domestic
economies. The small underweight in South Africa proved to be incorrect but the
relatively small size of the holding (approximately 1%) reduced the negative
impact on performance. During the 12 months ended December 31, 2002, the Fund
was exposed to markets that were leveraged to a global recovery. However, risk
premiums remained higher than expected, causing defensive stocks and sectors to
outperform despite stretched valuations in many cases.
We have increasingly found that the large regional mispricings so evident
prior to the Asian crisis, and the sector mispricings brought about by the
technology, media and telecommunications bubble have been corrected. There are
some clear themes such as convergence in Central Europe, but for the most part
our strategy is increasingly stock specific, focusing on companies delivering
good returns at a reasonable price. We are finding many of these throughout the
asset class.
INVESTMENT ENVIRONMENT
Emerging markets outperformed developed markets in what was a highly volatile
environment. Valuations have been attractive throughout the year and emerging
market economies have generally performed well, especially in Asia.
In Brazil, politics were a dominant feature, with the market expecting a Serra
victory in the Presidential elections for the first six--eight months of the
year. However, by the third quarter it became clear that Lula, the left-wing
candidate, was ahead in the polls. The market reacted negatively to this at
first and, despite a brief rally at the end of the fourth quarter, the market
ended the year sharply down. In Mexico the market was down 26.53%. The Mexican
economy is the most heavily dependent upon a U.S. recovery in the region and was
consequently the most directly impacted by renewed growth concerns. The peso,
which had been unusually strong to the second quarter of 2002, finally began to
weaken mid-period along with the equity market.
Europe, the Middle East and Africa were dominated by South Africa, which
outperformed strongly, ending the year up 8.61%. The currency and the equity
market have both benefited from the high gold price as well as from strong
capital flows and the absence of any spillover from the political crisis in
Zimbabwe. The trade situation has improved markedly with an increase in exports
that has filtered through to benefit the economy in general. The first half of
2002 saw little significant equity market activity but the second half saw bank
and gold stocks do particularly well. Russia outperformed as a result of the
strong oil price, despite being dragged lower towards the end of the year by the
slowing of reforms and an increase in risk aversion ahead of possible conflict
in the Middle East. In Central Europe, European Union convergence was the main
issue and a positive vote in the Irish referendum led to most of the markets
ending the year strongly. Bank stocks in particular benefited from the
convergence story but the positive sentiment also extended to most other
sectors. Israel was a very poor market, falling 41.66% in 2002. The domestic
economy was very weak, the high-technology industry suffered from the global
technology malaise, while civil/regional unrest compounded these fundamental
problems.
Markets in Asia were mixed. Indonesia and Thailand were the best performers in
the region. The focus was on domestic stories therefore the smaller markets
benefited rather than those dependent on the U.S. economy, such as Taiwan. Most
currencies strengthened over the year and central banks across the region tried
to maintain export competitiveness. South Korea's strength lay in its domestic
economic recovery since the 1997--1998 disaster, as well as in attractive
valuations. China has a strong economy with high foreign direct investment,
domestic consumption, and real gross domestic
54
- --------------------------------------------------------------------------------
product (GDP) growth of 8%. However, the equity market performed poorly, falling
27.12% in 2002. The oversupply of new equity issues has been partly to blame as
has the persistent price deflation that makes it very hard for companies to make
sustainable profits. India outperformed during the year but was kept lower by
the worst monsoon season in a decade that negatively impacted the large
agricultural sector. Consumption held up fairly well, as did government spending
on infrastructure, and GDP growth should be around 6%. The tensions with
Pakistan in the second and third quarters of the year negatively impacted the
market, as did NASDAQ weakness throughout the year. Export-orientated sectors
such as software did however manage to do well and a recovery toward the end of
the year did much to salvage overall performance.
MARKET OUTLOOK
Emerging market equities have been strong relative performers in 2002,
declining significantly less than world equities. There is no change to our view
that these markets offer strong absolute and relative upside. Not only are
valuations attractive, but return on equity is better than that available in
developed markets while corporate governance and capital management are
improving. When risk premium eventually declines, and with it the cost of
capital, this should be reflected in markets.
We are very comfortable that the medium- to long-term prospects for the asset
class are attractive. Economic fundamentals are sound, liquidity is strong, and
valuations are close to the lows of the past 18 months. These markets will
benefit as the global economy recovers. In the very short term the outlook is
more uncertain. The asset class has continued to outperform so far in the face
of headwinds from global equity markets, but with risk premiums at very high
levels this may be difficult to sustain in the next few months. However, we
believe that the risk/return equation for investing in emerging markets equities
is presently at highly attractive levels. We are finding fundamental value at a
stock level in most markets, although our preference for those markets and
sectors that will benefit from an eventual global recovery remains intact.
IN CONCLUSION
We thank your for your interest in Developing Capital Markets V.I. Fund of
Merrill Lynch Variable Series Funds, Inc., and we look forward to serving your
investment needs in the months and years ahead.
Sincerely,
/s/ Terry K. Glenn
Terry K. Glenn
President and Director
/s/ Josephine Ragni
Josephine Ragni
Portfolio Manager
/s/ Nicholas D. Moakes
Nicholas D. Moakes
Portfolio Manager
January 17, 2003
- ---------------------------------------------------------
We are pleased to announce that both Josephine Ragni and Nicholas Moakes have
been named Portfolio Managers of Developing Capital Markets V.I. Fund and are
primarily responsible for the day-to-day management of the Fund. Ms. Ragni has
joined Merrill Lynch Investment Managers, L.P. (MLIM) in 1998 and prior thereto,
was employed at Foreign & Colonial from 1993 to 1997. Mr. Moakes joined MLIM in
1997. Mr. Moakes is a CFA charterholder.
- ---------------------------------------------------------
55
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DEVELOPING CAPITAL MARKETS V.I. FUND
TOTAL RETURN BASED ON A $10,000 INVESTMENT--CLASS A & CLASS B SHARES
- --------------------------------------------------------------------------------
<Table>
<Caption>
DEVELOPING CAPITAL MARKETS V.I. MSCI EMERGING MARKETS FREE
FUND+--CLASS A SHARES* INDEX++
------------------------------- --------------------------
05/02/94** 10000 10000
12/94 9510 10054
12/95 9407 9530
12/96 10403 10105
12/97 9724 8934
12/98 6866 6670
12/99 11365 11099
12/00 8104 7702
12/01 8223 7519
12/02 7381 7068
</Table>
<Table>
<Caption>
MORGAN STANLEY CAPITAL
DEVELOPING CAPITAL MARKETS V.I. INTERNATIONAL EMERGING MARKETS
FUND+--CLASS B SHARES* FREE INDEX++
------------------------------- ------------------------------
11/03/97** 10000 10000
12/97 9914 10241
12/98 6988 7646
12/99 11557 12724
12/00 8226 8829
12/01 8334 8620
12/02 7477 8103
</Table>
* Assuming transaction costs and other operating expenses, including advisory
fees. Does not include insurance-related fees and expenses.
** Commencement of operations.
+ The Fund generally invests in securities, at least 65% of its assets in
equities, of issuers in countries having smaller capital markets.
++ This unmanaged Index measures the total returns of emerging foreign stock
markets in Europe, Asia and the Far East. The starting date for the Index in
the Class A Shares' graph is from 5/31/94 and in the Class B Shares' graph is
from 11/28/97.
Past results shown should not be considered a representation of future
performance.
56
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DEVELOPING CAPITAL MARKETS V.I. FUND
AVERAGE ANNUAL TOTAL RETURN--CLASS A SHARES*
- --------------------------------------------------------------------------------
PERIOD COVERED % RETURN
- --------------------------------------------------------------------------------
One Year Ended 12/31/02 -10.24%
- --------------------------------------------------------------------------------
Five Years Ended 12/31/02 - 5.36
- --------------------------------------------------------------------------------
Inception (5/02/94) through 12/31/02 - 3.44
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DEVELOPING CAPITAL MARKETS V.I. FUND
AVERAGE ANNUAL TOTAL RETURN--CLASS B SHARES*
- --------------------------------------------------------------------------------
PERIOD COVERED % RETURN
- --------------------------------------------------------------------------------
One Year Ended 12/31/02 -10.28%
- --------------------------------------------------------------------------------
Five Years Ended 12/31/02 - 5.49
- --------------------------------------------------------------------------------
Inception (11/03/97) through 12/31/02 - 5.48
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DEVELOPING CAPITAL MARKETS V.I. FUND
RECENT PERFORMANCE RESULTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
6-MONTH 12-MONTH
AS OF DECEMBER 31, 2002 TOTAL RETURN TOTAL RETURN
- -----------------------------------------------------------------------------------------
Class A Shares* -10.74% -10.24%
- -----------------------------------------------------------------------------------------
Class B Shares* -10.78 -10.28
- -----------------------------------------------------------------------------------------
MSCI Emerging Markets Free Index** - 7.90 - 6.00
- -----------------------------------------------------------------------------------------
</Table>
* Total investment returns are based on changes in net asset values for the
periods shown, and assume reinvestment of all dividends and capital gains
distributions at net asset value on the ex-dividend date. Insurance-related
fees and expenses are not reflected in these returns.
** This unmanaged index measures the total returns of emerging foreign stock
markets in Europe, Asia and the Far East.
Past results shown should not be considered a representation of future
performance.
57
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DEVELOPING CAPITAL MARKETS V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
AFRICA INDUSTRY++ HELD COMMON STOCKS VALUE NET ASSETS
- ----------------------------------------------------------------------------------------------------------------------------
SOUTH AFRICA BANKS 60,658 ABSA Group Limited.......................... $ 223,389 0.8%
120,769 FirstRand Limited........................... 103,591 0.3
7,683 Nedcor Limited.............................. 99,479 0.3
152,538 Sanlam Limited.............................. 135,107 0.5
46,994 Standard Bank Investment Corporation
Limited................................... 165,127 0.6
----------- -----
726,693 2.5
-----------------------------------------------------------------------------------------------------
INSURANCE 235,463 Old Mutual PLC.............................. 330,672 1.2
-----------------------------------------------------------------------------------------------------
METALS & MINING 78,210 Anglo American PLC.......................... 1,153,029 4.1
4,488 Anglo American Platinum Corporation
Limited................................... 165,283 0.6
5,850 AngloGold Limited (ADR)(a).................. 200,421 0.7
35,150 Gold Fields Limited......................... 491,170 1.7
2,388 Impala Platinum Holdings Limited............ 151,676 0.5
----------- -----
2,161,579 7.6
-----------------------------------------------------------------------------------------------------
OIL & GAS 38,374 Sasol Limited............................... 469,584 1.7
- ----------------------------------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS IN AFRICA
(COST--$3,401,709) 3,688,528 13.0
- ----------------------------------------------------------------------------------------------------------------------------
<Caption>
EUROPE
- ----------------------------------------------------------------------------------------------------------------------------
CZECH REPUBLIC BANKS 2,880 Komercni Banka AS (GDR)(b).................. 65,664 0.3
-----------------------------------------------------------------------------------------------------
DIVERSIFIED 8,000 +Cesky Telecom A.S. (GDR)(b)................ 63,200 0.2
TELECOMMUNICATION
SERVICES
-----------------------------------------------------------------------------------------------------
ELECTRIC 17,500 CEZ......................................... 53,060 0.2
UTILITIES
-----------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS IN THE CZECH REPUBLIC 181,924 0.7
- ----------------------------------------------------------------------------------------------------------------------------
HUNGARY BANKS 6,300 +OTP Bank (GDR)(b).......................... 121,905 0.5
-----------------------------------------------------------------------------------------------------
DIVERSIFIED 6,150 Magyar Tavkozlesi Rt (ADR)(a)............... 109,470 0.4
TELECOMMUNICATION
SERVICES
-----------------------------------------------------------------------------------------------------
PHARMACEUTICALS 3,588 Gedeon Richter (GDR)(b)..................... 231,426 0.8
-----------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS IN HUNGARY 462,801 1.7
- ----------------------------------------------------------------------------------------------------------------------------
POLAND BANKS 7,360 Bank Pekao SA (GDR)(b)...................... 181,383 0.6
-----------------------------------------------------------------------------------------------------
DIVERSIFIED 24,500 +Telekomunikacja Polska SA (GDR)(b)......... 79,625 0.3
TELECOMMUNICATION
SERVICES
-----------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS IN POLAND 261,008 0.9
- ----------------------------------------------------------------------------------------------------------------------------
RUSSIA OIL & GAS 7,135 LUKoil Holding (ADR)(a)..................... 438,380 1.6
27,000 OAO Gazprom (ADR)(a)........................ 315,900 1.1
27,548 Surgutneftegaz (ADR)(a)..................... 437,600 1.5
3,462 YUKOS (ADR)(a).............................. 487,898 1.7
-----------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS IN RUSSIA 1,679,778 5.9
- ----------------------------------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS IN EUROPE
(COST--$2,236,931) 2,585,511 9.2
- ----------------------------------------------------------------------------------------------------------------------------
LATIN
AMERICA
- ----------------------------------------------------------------------------------------------------------------------------
BRAZIL AEROSPACE & 7,900 Embraer-Empresa Brasileira de Aeronautica SA
DEFENSE (ADR)(a).................................. 125,610 0.4
-----------------------------------------------------------------------------------------------------
BEVERAGES 8,269 Companhia de Bebidas das Americas
(Preferred) (ADR)(a)...................... 128,666 0.5
-----------------------------------------------------------------------------------------------------
DIVERSIFIED 3,509 Brasil Telecom Participacoes SA (ADR)(a).... 88,602 0.3
TELECOMMUNICATION
SERVICES
11,250 Tele Norte Leste Participacoes SA
(ADR)(a).................................. 82,688 0.3
----------- -----
171,290 0.6
-----------------------------------------------------------------------------------------------------
FOOD & DRUG 6,863 Companhia Brasileira de Distribuicao Grupo
RETAILING Pao de Acucar (ADR)(a).................... 105,004 0.4
-----------------------------------------------------------------------------------------------------
</Table>
58
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DEVELOPING CAPITAL MARKETS V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED) (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES
LATIN HELD/
AMERICA FACE PERCENT OF
(CONCLUDED) INDUSTRY++ AMOUNT COMMON STOCKS VALUE NET ASSETS
- ----------------------------------------------------------------------------------------------------------------------------
BXBRAZIL METALS & MINING 6,760 Companhia Siderurgica Nacional (ADR)(a)..... $ 96,938 0.3%
(CONCLUDED) Brl10,296
Companhia Vale do Rio Doce, 0% due
12/31/2049(c)............................. 0 0.0
16,040 Companhia Vale do Rio Doce (ADR)(a)......... 441,100 1.6
23,700 Gerdau SA (ADR)(a).......................... 210,930 0.7
----------- -----
748,968 2.6
-----------------------------------------------------------------------------------------------------
OIL & GAS 40,664 Petroleo Brasileiro SA (ADR)(a)............. 532,991 1.9
-----------------------------------------------------------------------------------------------------
PAPER & FOREST 5,671 Aracruz Celulose SA (ADR)(a)................ 105,254 0.4
PRODUCTS
6,000 Votorantim Celulose e Papel SA (ADR)(a)..... 98,640 0.3
----------- -----
203,894 0.7
-----------------------------------------------------------------------------------------------------
WIRELESS 5,560,682 Tele Centro Sul Participacoes SA............ 21,677 0.1
TELECOMMUNICATION
SERVICES
-----------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS IN BRAZIL 2,038,100 7.2
- ----------------------------------------------------------------------------------------------------------------------------
CHILE BANKS 4,795 Banco Santander Chile SA (ADR)(a)........... 89,331 0.3
-----------------------------------------------------------------------------------------------------
DIVERSIFIED 8,790 Compania de Telecomunicaciones de Chile SA
TELECOMMUNICATION (ADR)(a).................................. 84,296 0.3
SERVICES
-----------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS IN CHILE 173,627 0.6
- ----------------------------------------------------------------------------------------------------------------------------
MEXICO BANKS 245,914 +Grupo Financiero BBVA Bancomer, SA de CV... 185,893 0.7
-----------------------------------------------------------------------------------------------------
BEVERAGES 5,042 Coca-Cola Femsa SA (ADR)(a)................. 90,252 0.3
96,733 Grupo Modelo, SA de CV 'C'.................. 235,639 0.9
----------- -----
325,891 1.2
-----------------------------------------------------------------------------------------------------
CONSTRUCTION 10,245 Cemex SA de CV (ADR)(a)..................... 220,370 0.8
MATERIALS
-----------------------------------------------------------------------------------------------------
DIVERSIFIED 21,689 Telefonos de Mexico SA (ADR)(a)............. 693,614 2.4
TELECOMMUNICATION
SERVICES
-----------------------------------------------------------------------------------------------------
INDUSTRIAL 58,300 Alfa, SA 'A'................................ 93,211 0.3
CONGLOMERATES
-----------------------------------------------------------------------------------------------------
MEDIA 6,946 +Grupo Televisa SA (ADR)(a)................. 194,002 0.7
-----------------------------------------------------------------------------------------------------
MULTILINE RETAIL 1,828 Wal-Mart de Mexico SA de CV 'C'............. 3,524 0.0
66,743 Wal-Mart de Mexico SA de CV 'V'............. 151,805 0.5
----------- -----
155,329 0.5
-----------------------------------------------------------------------------------------------------
WIRELESS 32,100 America Movil SA de CV 'L' (ADR)(a)......... 460,956 1.6
TELECOMMUNICATION
SERVICES
-----------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS IN MEXICO 2,329,266 8.2
- ----------------------------------------------------------------------------------------------------------------------------
PERU METALS & MINING 11,353 Compania de Minas Buenaventura SA
(ADR)(a).................................. 299,606 1.1
-----------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS IN PERU 299,606 1.1
- ----------------------------------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS IN LATIN AMERICA
(COST--$5,527,175) 4,840,599 17.1
- ----------------------------------------------------------------------------------------------------------------------------
MIDDLE
EAST
- ----------------------------------------------------------------------------------------------------------------------------
ISRAEL BANKS 57,800 Bank Hapoalim............................... 82,624 0.3
-----------------------------------------------------------------------------------------------------
DIVERSIFIED 54,360 Bezeq Israeli Telecommunication Corporation
TELECOMMUNICATION Ltd. ..................................... 52,884 0.2
SERVICES
-----------------------------------------------------------------------------------------------------
IT CONSULTING & 12,090 +Check Point Software Technologies Ltd. .... 156,445 0.5
SERVICES
-----------------------------------------------------------------------------------------------------
</Table>
59
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DEVELOPING CAPITAL MARKETS V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED) (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
<Table>
<Caption>
MIDDLE
EAST SHARES PERCENT OF
(CONCLUDED) INDUSTRY++ HELD COMMON STOCKS VALUE NET ASSETS
- ----------------------------------------------------------------------------------------------------------------------------
INDUSTRIAL 110 +Koor Industries Ltd. ...................... $ 1,125 0.0%
CONGLOMERATES
-----------------------------------------------------------------------------------------------------
ISRAEL PHARMACEUTICALS 10,038 Teva Pharmaceutical Industries Ltd.
(CONCLUDED) (ADR)(a).................................. 387,366 1.4
-----------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS IN ISRAEL 680,444 2.4
- ----------------------------------------------------------------------------------------------------------------------------
TURKEY BANKS 22,738,000 +Turkiye Is Bankasi (Isbank) 'C'............ 59,585 0.2
-----------------------------------------------------------------------------------------------------
DIVERSIFIED 25,484,431 +Haci Omer Sabanci Holdings AS.............. 66,781 0.2
FINANCIALS
11,189,700 +Koc Holding AS............................. 116,279 0.4
----------- -----
183,060 0.6
-----------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS IN TURKEY 242,645 0.8
- ----------------------------------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS IN THE MIDDLE EAST
(COST--$1,218,697) 923,089 3.2
- ----------------------------------------------------------------------------------------------------------------------------
PACIFIC
BASIN/ASIA
- ----------------------------------------------------------------------------------------------------------------------------
CHINA AUTOMOBILES 1,182,318 Brilliance China Automotive Holdings
Limited................................... 215,287 0.8
-----------------------------------------------------------------------------------------------------
COMPUTERS & 95,000 Legend Holdings Limited..................... 31,369 0.1
PERIPHERALS
-----------------------------------------------------------------------------------------------------
DIVERSIFIED 94,000 China Resources Enterprise Limited.......... 83,171 0.3
FINANCIALS
-----------------------------------------------------------------------------------------------------
ELECTRIC 448,000 Beijing Datang Power Generation Company
UTILITIES Limited 'H'............................... 145,055 0.5
332,000 Huaneng Power International, Inc. 'H'....... 266,080 0.9
----------- -----
411,135 1.4
-----------------------------------------------------------------------------------------------------
WIRELESS 225,000 +China Mobile (Hong Kong) Limited........... 536,649 1.9
TELECOMMUNICATION
SERVICES
-----------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS IN CHINA 1,277,611 4.5
- ----------------------------------------------------------------------------------------------------------------------------
HONG KONG FOOD PRODUCTS 268,000 Tingyi (Cayman Islands) Holding
Corporation............................... 69,591 0.2
-----------------------------------------------------------------------------------------------------
SPECIALTY RETAIL 276,000 Giordano International Limited.............. 107,945 0.4
-----------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS IN HONG KONG 177,536 0.6
- ----------------------------------------------------------------------------------------------------------------------------
INDIA AUTOMOBILES 25,500 Hero Honda Motors Ltd. ..................... 144,332 0.5
-----------------------------------------------------------------------------------------------------
BANKS 39,600 State Bank of India......................... 233,429 0.8
-----------------------------------------------------------------------------------------------------
IT CONSULTING & 2,657 Infosys Technologies Limited................ 264,378 1.0
SERVICES
-----------------------------------------------------------------------------------------------------
OIL & GAS 38,700 Bharat Petroleum Corporation Ltd. .......... 174,937 0.6
-----------------------------------------------------------------------------------------------------
PHARMACEUTICALS 21,000 Dr. Reddy's Laboratories Limited............ 393,350 1.4
-----------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS IN INDIA 1,210,426 4.3
- ----------------------------------------------------------------------------------------------------------------------------
INDONESIA DIVERSIFIED 971,600 PT Telekomunikasi Indonesia................. 417,951 1.5
TELECOMMUNICATION
SERVICES
-----------------------------------------------------------------------------------------------------
FOOD PRODUCTS 1,345,900 PT Indofood Sukses Makmur Tbk............... 90,228 0.3
-----------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS IN INDONESIA 508,179 1.8
- ----------------------------------------------------------------------------------------------------------------------------
MALAYSIA AUTOMOBILES 86,900 Perusahaan Otomobil Nasional Berhad......... 201,242 0.7
-----------------------------------------------------------------------------------------------------
BANKS 162,225 Public Bank Berhad 'Foreign'................ 110,996 0.4
-----------------------------------------------------------------------------------------------------
</Table>
60
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DEVELOPING CAPITAL MARKETS V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED) (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
<Table>
<Caption>
PACIFIC
BASIN/ASIA SHARES PERCENT OF
(CONTINUED) INDUSTRY++ HELD COMMON STOCKS VALUE NET ASSETS
- ----------------------------------------------------------------------------------------------------------------------------
MALAYSIA CONSTRUCTION & 100,000 Gamuda Berhad............................... $ 144,737 0.5%
(CONCLUDED) ENGINEERING
119,900 IJM Corporation Berhad...................... 160,918 0.6
----------- -----
305,655 1.1
-----------------------------------------------------------------------------------------------------
HOTELS, 50,800 Resorts World Berhad........................ 124,995 0.4
RESTAURANTS &
LEISURE
-----------------------------------------------------------------------------------------------------
INDUSTRIAL 91,100 Sime Darby Berhad........................... 118,909 0.4
CONGLOMERATES
-----------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS IN MALAYSIA 861,797 3.0
- ----------------------------------------------------------------------------------------------------------------------------
SOUTH KOREA AIRLINES 8,920 +Korean Air Co., Ltd. ...................... 85,737 0.3
-----------------------------------------------------------------------------------------------------
AUTOMOBILES 15,586 Hyundai Motor Company Ltd. ................. 364,665 1.3
20,100 +Kia Motors Corporation..................... 149,134 0.5
----------- -----
513,799 1.8
-----------------------------------------------------------------------------------------------------
BANKS 29,449 Kookmin Bank................................ 1,042,838 3.7
41,880 +Koram Bank................................. 261,298 0.9
----------- -----
1,304,136 4.6
-----------------------------------------------------------------------------------------------------
CHEMICALS 6,200 LG Chem, Ltd. .............................. 212,234 0.8
-----------------------------------------------------------------------------------------------------
DIVERSIFIED 10,790 +Samsung Securities Company Ltd. ........... 260,641 0.9
FINANCIALS
-----------------------------------------------------------------------------------------------------
DIVERSIFIED 5,800 KT Corporation.............................. 247,932 0.9
TELECOMMUNICATION
SERVICES
-----------------------------------------------------------------------------------------------------
ELECTRIC 16,320 Korea Electric Power Corporation............ 251,119 0.9
UTILITIES
-----------------------------------------------------------------------------------------------------
ELECTRICAL 3,730 Samsung Electro Mechanics Co., Ltd. ........ 136,803 0.5
EQUIPMENT
-----------------------------------------------------------------------------------------------------
ELECTRONIC 2,050 Samsung Display Devices Co., Ltd. .......... 118,397 0.4
EQUIPMENT &
INSTRUMENTS
-----------------------------------------------------------------------------------------------------
FOOD PRODUCTS 3,080 Tong Yang Confectionery Corporation......... 150,618 0.5
-----------------------------------------------------------------------------------------------------
METALS & MINING 3,130 POSCO....................................... 311,403 1.1
-----------------------------------------------------------------------------------------------------
MULTILINE RETAIL 1,010 Shinsegae Co., Ltd. ........................ 127,309 0.5
-----------------------------------------------------------------------------------------------------
OIL & GAS 21,520 SK Corporation.............................. 237,690 0.8
-----------------------------------------------------------------------------------------------------
SEMICONDUCTOR 8,409 Samsung Electronics......................... 2,226,235 7.9
EQUIPMENT & PRODUCTS
-----------------------------------------------------------------------------------------------------
TEXTILES, APPAREL 23,750 Cheil Industries Inc. ...................... 311,380 1.1
& LUXURY GOODS
-----------------------------------------------------------------------------------------------------
WIRELESS 4,500 +KT Freetel................................. 106,994 0.4
TELECOMMUNICATION
SERVICES
2,450 SK Telecom Co., Ltd. ....................... 473,041 1.6
----------- -----
580,035 2.0
-----------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS IN SOUTH KOREA 7,075,468 25.0
- ----------------------------------------------------------------------------------------------------------------------------
TAIWAN BANKS 618,522 +SinoPac Holdings Company................... 258,829 0.9
441,000 +Taishin Financial Holdings Co., Ltd. ...... 225,764 0.8
----------- -----
484,593 1.7
-----------------------------------------------------------------------------------------------------
CHEMICALS 162,000 Formosa Plastic Corporation................. 212,459 0.8
273,260 Nan Ya Plastic Corporation.................. 235,772 0.8
----------- -----
448,231 1.6
-----------------------------------------------------------------------------------------------------
COMMUNICATIONS 122,000 +Accton Technology Corporation.............. 124,561 0.4
EQUIPMENT
-----------------------------------------------------------------------------------------------------
</Table>
61
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DEVELOPING CAPITAL MARKETS V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED) (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
<Table>
<Caption>
PACIFIC
BASIN/ASIA SHARES PERCENT OF
(CONCLUDED) INDUSTRY++ HELD COMMON STOCKS VALUE NET ASSETS
- ----------------------------------------------------------------------------------------------------------------------------
TAIWAN COMPUTERS & 44,000 Ambit Microsystems Corp..................... $ 142,997 0.5%
(CONCLUDED) PERIPHERALS
80,000 Benq Corporation............................ 89,502 0.3
131,890 Compal Electronics Inc...................... 136,556 0.5
101,200 Quanta Computer Inc......................... 165,902 0.6
----------- -----
534,957 1.9
-----------------------------------------------------------------------------------------------------
DIVERSIFIED 239,534 Fubon Financial Holding Co., Ltd. .......... 190,139 0.7
FINANCIALS
-----------------------------------------------------------------------------------------------------
ELECTRONIC 23,850 Hon Hai Precision Industry.................. 82,312 0.3
EQUIPMENT &
INSTRUMENTS
-----------------------------------------------------------------------------------------------------
INSURANCE 8,903 Cathay Financial Holding Co., Ltd. ......... 9,448 0.0
-----------------------------------------------------------------------------------------------------
METALS & MINING 332,200 China Steel Corporation..................... 185,352 0.7
-----------------------------------------------------------------------------------------------------
SEMICONDUCTOR 380,000 +Advanced Semiconductor Engineering Inc. ... 222,951 0.8
EQUIPMENT &
PRODUCTS
334,000 +Siliconware Precision Industries Company... 162,341 0.6
353,476 +Taiwan Semiconductor Manufacturing
Company................................... 433,077 1.5
460,713 +United Microelectronics Corporation,
Ltd. ..................................... 279,581 1.0
----------- -----
1,097,950 3.9
-----------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS IN TAIWAN 3,157,543 11.2
- ----------------------------------------------------------------------------------------------------------------------------
THAILAND BANKS 254,100 +Bangkok Bank Public Company Limited
'Foreign'................................. 353,736 1.2
399,200 +Thai Farmers Bank Public Company Limited
'Foreign'................................. 277,865 1.0
----------- -----
631,601 2.2
-----------------------------------------------------------------------------------------------------
CONSTRUCTION 24,800 The Siam Cement Public Company Limited...... 719,258 2.5
MATERIALS
-----------------------------------------------------------------------------------------------------
OIL & GAS 255,100 PTT Public Company Limited.................. 250,069 0.9
-----------------------------------------------------------------------------------------------------
WIRELESS 398,300 Advanced Info Service Public Company Limited
TELECOMMUNICATION (Foreign Registered)...................... 330,376 1.2
SERVICES
-----------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS IN THAILAND 1,931,304 6.8
- ----------------------------------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS IN THE PACIFIC
BASIN/ASIA (COST--$16,871,710) 16,199,864 57.2
- ----------------------------------------------------------------------------------------------------------------------------
</Table>
62
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DEVELOPING CAPITAL MARKETS V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONCLUDED) (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
<Table>
ofINTEREST SHORT-TERM SECURITIES VALUE NET ASSETS
- ------------------------------------------------------------------------------------------------------------------------------
BX
$94,049 Merrill Lynch Liquidity Series, LLC Cash
Sweep Series II(d)........................ $ 94,049 0.3%
- ------------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN SHORT-TERM SECURITIES
(COST--$94,049) 94,049 0.3
- ------------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS (COST--$29,350,271)....... 28,331,640 100.0
LIABILITIES IN EXCESS OF OTHER ASSETS....... (1,793) 0.0
------------ ---------
NET ASSETS.................................. $ 28,329,847 100.0%
============ =========
- ------------------------------------------------------------------------------------------------------------------------------
</Table>
+ Non-income producing security.
++ For Fund compliance purposes, "Industry" means any one or more of the
industry sub-classifications used by one or more widely recognized market
indexes or ratings group indexes, and/or as defined by Fund management.
This definition may not apply for purposes of this report, which may
combine such industry sub-classifications for reporting ease. These
industry classifications are unaudited.
(a) American Depositary Receipts (ADR).
(b) Global Depositary Receipts (GDR).
(c) Received through a bonus issue from Companhia Vale do Rio Doce. As of
December 31, 2002, the bonds have not commenced trading and the coupon rate
has not been determined.
(d) Investments in companies considered to be an affiliate of the Fund (such
companies are defined as "Affiliated Companies" in Section 2(a)(3) of the
Investment Company Act of 1940) are as follows:
<Table>
<Caption>
- ---------------------------------------------------------------------------------------------
NET NET INTEREST
AFFILIATE ACTIVITY COST INCOME
- ---------------------------------------------------------------------------------------------
Merrill Lynch Liquidity Series, LLC
Cash Sweep Series II........................................ $94,049 $94,049 $462
- ---------------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
63
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DEVELOPING CAPITAL MARKETS V.I. FUND
STATEMENT OF ASSETS AND LIABILITIES AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
ASSETS:
Investments, at value (identified cost--$29,350,271)........ $ 28,331,640
Cash........................................................ 6,718
Foreign cash (cost--$14,662)................................ 14,674
Receivables:
Dividends................................................. $ 46,332
Securities sold........................................... 8,797
Interest.................................................. 310
Capital shares sold....................................... 90 55,529
------------
Prepaid expenses............................................ 213
------------
Total assets................................................ 28,408,774
------------
- -----------------------------------------------------------------------------------------
LIABILITIES:
Payables:
Securities purchased...................................... 14,106
Investment adviser........................................ 9,019
Capital shares redeemed................................... 3,764
Distributor............................................... 193 27,082
------------
Accrued expenses............................................ 51,845
------------
Total liabilities........................................... 78,927
------------
- -----------------------------------------------------------------------------------------
NET ASSETS.................................................. $ 28,329,847
============
- -----------------------------------------------------------------------------------------
NET ASSETS CONSIST OF:
Class A Shares Common Stock, $.10 par value,100,000,000
shares authorized......................................... $ 409,730
Class B Shares Common Stock, $.10 par value,100,000,000
shares authorized......................................... 20,847
Paid-in capital in excess of par............................ 80,141,916
Accumulated distributions in excess of investment
income--net............................................... $ (42,324)
Accumulated realized capital losses on investments and
foreign currency transactions--net........................ (51,180,193)
Unrealized depreciation on investments and foreign currency
transactions--net......................................... (1,020,129)
------------
Total accumulated losses--net............................... (52,242,646)
------------
NET ASSETS.................................................. $ 28,329,847
============
- -----------------------------------------------------------------------------------------
NET ASSET VALUE:
Class A--Based on net assets of $26,958,936 and 4,097,303
shares outstanding........................................ $ 6.58
============
Class B--Based on net assets of $1,370,911 and 208,474
shares outstanding........................................ $ 6.58
============
- -----------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
64
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DEVELOPING CAPITAL MARKETS V.I. FUND
STATEMENT OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
INVESTMENT INCOME:
Dividends (net of $112,500 withholding tax on foreign
dividends)................................................ $ 633,353
Interest.................................................... 8,776
-----------
Total income................................................ 642,129
-----------
- ---------------------------------------------------------------------------------------
EXPENSES:
Investment advisory fees.................................... $ 356,230
Custodian fees.............................................. 128,842
Professional fees........................................... 16,526
Transfer agent fees......................................... 13,485
Accounting services......................................... 12,635
Printing and shareholder reports............................ 3,672
Distribution fees--Class B.................................. 2,467
Pricing services............................................ 1,670
Directors' fees and expenses................................ 1,637
Registration fees........................................... 867
Other....................................................... 5,312
-----------
Total expenses before reimbursement......................... 543,343
Reimbursement of expenses................................... (98,565)
-----------
Total expenses after reimbursement.......................... 444,778
-----------
Investment income--net...................................... 197,351
-----------
- ---------------------------------------------------------------------------------------
REALIZED & UNREALIZED GAIN (LOSS) ON INVESTMENTS & FOREIGN
CURRENCY TRANSACTIONS--NET:
Realized loss on:
Investments--net (net of $957 withholding tax on foreign
capital gains).......................................... (1,667,639)
Foreign currency transactions--net........................ (92,313) (1,759,952)
-----------
Change in unrealized appreciation/depreciation on:
Investments--net.......................................... (1,606,798)
Foreign currency transactions--net........................ 4,090 (1,602,708)
----------- -----------
Total realized and unrealized loss on investments and
foreign currency transactions--net........................ (3,362,660)
-----------
NET DECREASE IN NET ASSETS RESULTING FROM OPERATIONS........ $(3,165,309)
===========
- ---------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
65
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DEVELOPING CAPITAL MARKETS V.I. FUND
STATEMENTS OF CHANGES IN NET ASSETS
- --------------------------------------------------------------------------------
<Table>
<Caption>
FOR THE YEAR ENDED
DECEMBER 31,
---------------------------
INCREASE (DECREASE) IN NET ASSETS: 2002 2001
- -------------------------------------------------------------------------------------------
OPERATIONS:
Investment income--net...................................... $ 197,351 $ 464,610
Realized loss on investments and foreign currency
transactions--net......................................... (1,759,952) (12,307,518)
Change in unrealized appreciation/depreciation on
investments and foreign currency transactions--net........ (1,602,708) 12,002,957
----------- ------------
Net increase (decrease) in net assets resulting from
operations................................................ (3,165,309) 160,049
----------- ------------
- -------------------------------------------------------------------------------------------
DIVIDENDS TO SHAREHOLDERS:
Investment income--net:
Class A................................................... (126,699) (357,232)
Class B................................................... (3,713) (13,551)
----------- ------------
Net decrease in net assets resulting from dividends to
shareholders.............................................. (130,412) (370,783)
----------- ------------
- -------------------------------------------------------------------------------------------
CAPITAL SHARE TRANSACTIONS:
Net decrease in net assets derived from capital share
transactions.............................................. (6,509,246) (10,668,342)
----------- ------------
- -------------------------------------------------------------------------------------------
NET ASSETS:
Total decrease in net assets................................ (9,804,967) (10,879,076)
Beginning of year........................................... 38,134,814 49,013,890
----------- ------------
End of year*................................................ $28,329,847 $ 38,134,814
=========== ============
- -------------------------------------------------------------------------------------------
* Accumulated distributions in excess of investment
income--net............................................... $ (42,324) $ (89,554)
=========== ============
- -------------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
66
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DEVELOPING CAPITAL MARKETS V.I. FUND
FINANCIAL HIGHLIGHTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
THE FOLLOWING PER SHARE DATA AND RATIOS HAVE BEEN DERIVED FROM CLASS A
INFORMATION PROVIDED IN THE FINANCIAL STATEMENTS. ---------------------------------------------------
FOR THE YEAR ENDED DECEMBER 31,
---------------------------------------------------
INCREASE (DECREASE) IN NET ASSET VALUE: 2002 2001 2000 1999 1998
- -------------------------------------------------------------------------------------------------------------------
PER SHARE OPERATING PERFORMANCE:
Net asset value, beginning of year........................... $ 7.36 $ 7.32 $ 10.34 $ 6.43 $ 9.22
-------- ------- -------- -------- --------
Investment income--net+...................................... .04 .08 .06 .11 .18
Realized and unrealized gain (loss) on investments and foreign
currency transactions--net................................. (.79) .03 (3.01) 4.01 (2.86)
-------- ------- -------- -------- --------
Total from investment operations............................. (.75) .11 (2.95) 4.12 (2.68)
-------- ------- -------- -------- --------
Less dividends on investment income--net..................... (.03) (.07) (.07) (.21) (.11)
-------- ------- -------- -------- --------
Net asset value, end of year................................. $ 6.58 $ 7.36 $ 7.32 $ 10.34 $ 6.43
======== ======= ======== ======== ========
- -------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENT RETURN:*
Based on net asset value per share........................... (10.24%) 1.47% (28.69%) 65.52% (29.39%)
======== ======= ======== ======== ========
- -------------------------------------------------------------------------------------------------------------------
RATIOS TO AVERAGE NET ASSETS:
Expenses, net of reimbursement............................... 1.24% 1.15% 1.22% 1.25% 1.25%
======== ======= ======== ======== ========
Expenses..................................................... 1.52% 1.21% 1.36% 1.67% 1.42%
======== ======= ======== ======== ========
Investment income--net....................................... .56% 1.09% .72% 1.47% 2.30%
======== ======= ======== ======== ========
- -------------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL DATA:
Net assets, end of year (in thousands)....................... $ 26,959 $36,462 $ 46,858 $107,079 $ 64,312
======== ======= ======== ======== ========
Portfolio turnover........................................... 88.96% 94.42% 57.05% 97.79% 121.06%
======== ======= ======== ======== ========
- -------------------------------------------------------------------------------------------------------------------
</Table>
* Total investment return excludes insurance-related fees and expenses. If
applicable, the Company's Investment Adviser waived a portion of its
management fee. Without such a waiver, the Fund's performance would have been
lower.
+ Based on average shares outstanding.
See Notes to Financial Statements.
67
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DEVELOPING CAPITAL MARKETS V.I. FUND
FINANCIAL HIGHLIGHTS (CONCLUDED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
THE FOLLOWING PER SHARE DATA AND RATIOS HAVE BEEN DERIVED FROM CLASS B
INFORMATION PROVIDED IN THE FINANCIAL STATEMENTS. --------------------------------------------------
FOR THE YEAR ENDED DECEMBER 31,
--------------------------------------------------
INCREASE (DECREASE) IN NET ASSET VALUE: 2002 2001 2000 1999 1998
- ------------------------------------------------------------------------------------------------------------------
PER SHARE OPERATING PERFORMANCE:
Net asset value, beginning of year........................... $ 7.35 $ 7.31 $ 10.33 $ 6.42 $ 9.22
-------- ------- -------- ------- --------
Investment income--net+...................................... .03 .07 .03 .07 .17
Realized and unrealized gain (loss) on investments and foreign
currency transactions--net................................. (.78) .03 (2.99) 4.04 (2.86)
-------- ------- -------- ------- --------
Total from investment operations............................. (.75) .10 (2.96) 4.11 (2.69)
-------- ------- -------- ------- --------
Less dividends on investment income--net..................... (.02) (.06) (.06) (.20) (.11)
-------- ------- -------- ------- --------
Net asset value, end of year................................. $ 6.58 $ 7.35 $ 7.31 $ 10.33 $ 6.42
======== ======= ======== ======= ========
- ------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENT RETURN:*
Based on net asset value per share........................... (10.28%) 1.31% (28.82%) 65.38% (29.51%)
======== ======= ======== ======= ========
- ------------------------------------------------------------------------------------------------------------------
RATIOS TO AVERAGE NET ASSETS:
Expenses, net of reimbursement............................... 1.39% 1.30% 1.40% 1.40% 1.40%
======== ======= ======== ======= ========
Expenses..................................................... 1.68% 1.36% 1.51% 1.87% 1.72%
======== ======= ======== ======= ========
Investment income--net....................................... .38% .95% .42% .83% 2.37%
======== ======= ======== ======= ========
- ------------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL DATA:
Net assets, end of year (in thousands)....................... $ 1,371 $ 1,673 $ 2,156 $ 1,313 $ 241
======== ======= ======== ======= ========
Portfolio turnover........................................... 88.96% 94.42% 57.05% 97.79% 121.06%
======== ======= ======== ======= ========
- ------------------------------------------------------------------------------------------------------------------
</Table>
* Total investment return excludes insurance-related fees and expenses. If
applicable, the Company's Investment Adviser waived a portion of its
management fee. Without such a waiver, the Fund's performance would have been
lower.
+ Based on average shares outstanding.
See Notes to Financial Statements.
68
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DEVELOPING CAPITAL MARKETS V.I. FUND
NOTES TO FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
1. SIGNIFICANT ACCOUNTING POLICIES:
Merrill Lynch Variable Series Funds, Inc. (the "Company") is an open-end
management investment company that is comprised of 17 separate funds. Each fund
offers two classes of shares to the Merrill Lynch Life Insurance Company, ML
Life Insurance Company of New York (indirect, wholly-owned subsidiaries of
Merrill Lynch & Co., Inc. ("ML & Co.")), and other insurance companies, that are
not affiliated with ML & Co., for their separate accounts to fund benefits under
certain variable annuity and variable life insurance contracts. Developing
Capital Markets V.I. Fund (the "Fund") (formerly Developing Capital Markets
Focus Fund) is classified as "non-diversified," as defined in the Investment
Company Act of 1940. Class A and Class B Shares have equal voting, dividend,
liquidation and other rights, except that only shares of the respective classes
are entitled to vote on matters concerning only that class and Class B Shares
bear certain expenses related to the distribution of such shares. The Fund's
financial statements are prepared in conformity with accounting principles
generally accepted in the United States of America, which may require the use of
management accruals and estimates. Income, expenses (other than expenses
attributable to a specific class) and realized and unrealized gains and losses
on investments and foreign currency transactions are allocated daily to each
class based on its relative net assets. The following is a summary of
significant accounting policies followed by the Fund.
(a) Valuation of investments--Portfolio securities that are traded on stock
exchanges are valued at the last sale price as of the close of business on the
day the securities are being valued, or lacking any sales, at the closing bid
price. Securities traded in the over-the-counter market are valued at the last
available bid price prior to the time of valuation. In cases where securities
are traded on more than one exchange, the securities are valued on the exchange
designated by or under the authority of the Board of Directors as the primary
market. Portfolio securities that are traded both in the over-the-counter 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. Options written or purchased are
valued at the last sale price in the case of exchange-traded options. In the
case of options traded in the over-the-counter market, valuation is the last
asked price (options written) or the last bid price (options purchased). Futures
contracts are valued at the settlement price at the close of the applicable
exchange. Short-term securities are valued at amortized cost, which approximates
market value. 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.
(b) Derivative financial instruments--The Fund may engage in various portfolio
investment strategies to increase or decrease the level of risk to which the
Fund is exposed more quickly and efficiently than transactions in other types of
instruments. Losses may arise due to changes in the value of the contract or if
the counterparty does not perform under the contract.
- - Forward foreign exchange contracts--The Fund is authorized to enter into
forward foreign exchange contracts as a hedge against either specific
transactions or portfolio positions. The contract is marked to market daily and
the change in market value is recorded by the Fund as an unrealized gain or
loss. When the contract is closed, the Fund records a realized gain or loss
equal to the difference between the value at the time it was opened and the
value at the time it was closed.
- - Options--The Fund may write and purchase call and put options. When the Fund
writes an option, an amount equal to the premium received by the Fund is
reflected as an asset and an equivalent liability. The amount of the liability
is subsequently marked to market to reflect the current market value of the
option written. When a security is purchased or sold through an exercise of an
option, the related premium paid (or received) is added to (or deducted from)
the basis of the security acquired or deducted from (or added to) the proceeds
of the security sold. When an option expires (or the Fund enters into a closing
transaction), the Fund realizes a gain or loss on the option to the extent of
the premiums received or paid (or gain or loss to the extent the cost of the
closing transaction exceeds the premium paid or received).
Written and purchased options are non-income producing investments.
- - Financial futures contracts--The Fund may purchase or sell financial futures
contracts and options on such futures contracts for the purpose of hedging the
market risk on existing securities or the intended purchase of securities.
Futures contracts are contracts for delayed delivery of securities at a specific
future date
69
- --------------------------------------------------------------------------------
and at a specific price or yield. Upon entering into a contract, the Fund
deposits and maintains as collateral such initial margin as required by the
exchange on which the transaction is effected. Pursuant to the contract, the
Fund agrees to receive from or pay to the broker an amount of cash equal to the
daily fluctuation in value of the contract. Such receipts or payments are known
as variation margin and are recorded by the Fund as unrealized gains or losses.
When the contract is closed, the Fund records a realized gain or loss equal to
the difference between the value of the contract at the time it was opened and
the value at the time it was closed.
- - Foreign currency options and futures--The Fund may also purchase or sell
listed or over-the-counter foreign currency options, foreign currency futures
and related options on foreign currency futures as a short or long hedge against
possible variations in foreign exchange rates. Such transactions may be effected
with respect to hedges on non-U.S. dollar denominated securities owned by the
Fund, sold by the Fund but not yet delivered, or committed or anticipated to be
purchased by the Fund.
(c) Foreign currency transactions--Transactions denominated in foreign
currencies are recorded at the exchange rate prevailing when recognized. Assets
and liabilities denominated in foreign currencies are valued at the exchange
rate at the end of the period. Foreign currency transactions are the result of
settling (realized) or valuing (unrealized) assets and liabilities expressed in
foreign currencies into U.S. dollars. Realized and unrealized gains or losses
from investments include the effects of foreign exchange rates on investments.
(d) Income taxes--It is the Fund's policy to comply with the requirements of
the Internal Revenue Code applicable to regulated investment companies and to
distribute substantially all of its taxable income to its shareholders.
Therefore, no Federal income tax provision is required. Under the applicable
foreign tax law, a withholding tax may be imposed on interest, dividends and
capital gains at various rates.
(e) Security transactions and investment income--Security transactions are
recorded on the dates the transactions are entered into (the trade dates).
Realized gains and losses on security transactions are determined on the
identified cost basis. Dividend income is recorded on the ex-dividend dates.
Dividends from foreign securities where the ex-dividend date may have passed are
subsequently recorded when the Fund has determined the ex-dividend date.
Interest income is recognized on the accrual basis.
(f) Dividends and distributions--Dividends and distributions paid by the Fund
are recorded on the ex-dividend dates.
(g) Expenses--Certain expenses have been allocated to the individual funds in
the Company on a pro rata basis based upon the respective aggregate net asset
value of each fund included in the Company.
(h) Reclassification--Accounting principles generally accepted in the United
States of America require that certain components of net assets be adjusted to
reflect permanent differences between financial and tax reporting. Accordingly,
the current year's permanent book/tax difference of $19,708 have been
reclassified between accumulated distributions in excess of net investment
income and accumulated net realized capital losses. This reclassification has no
effect on net assets or net asset values per share.
2. INVESTMENT ADVISORY AGREEMENT AND
TRANSACTIONS WITH AFFILIATES:
The Company has entered into an Investment Advisory Agreement with Merrill Lynch
Investment Managers, L.P. ("MLIM"). The general partner of MLIM is Princeton
Services, Inc. ("PSI"), an indirect, wholly-owned subsidiary of ML & Co., which
is the limited partner. The Company has also entered into a Distribution
Agreement and Distribution Plan with FAM Distributors, Inc. ("FAMD" or the
"Distributor"), which is a wholly-owned subsidiary of Merrill Lynch Group, Inc.
MLIM is responsible for the management of the Company's funds and provides the
necessary personnel, facilities, equipment and certain other services necessary
to the operations of the Fund. For such services, the Fund pays a monthly fee at
the annual rate of 1.00% of the average daily value of the Fund's net assets.
MLIM has entered into a Sub-Advisory Agreement with Merrill Lynch Asset
Management, Ltd. ("MLAM UK"), an affiliate of MLIM. For the year ended December
31, 2002, no fees were paid to MLAM UK.
Pursuant to the Distribution Plan adopted by the Company in accordance with
Rule 12b-1 under the Investment Company Act of 1940, the Fund pays the
Distributor an ongoing distribution fee each month at the annual rate of .15% of
the average daily value of the Fund's Class B net assets.
MLIM and Merrill Lynch Life Agency, Inc. ("MLLA") have entered into an
agreement which limits the operating expenses paid by the Fund, exclusive of any
distribution fees imposed on Class B Shares, to 1.25% of its average daily
70
- --------------------------------------------------------------------------------
net assets. Any such expenses in excess of 1.25% of average daily net assets
will be reimbursed to the Fund by MLIM which, in turn, will be reimbursed by
MLLA. For the year ended December 31, 2002, MLIM earned fees of $356,230, of
which $98,565 was waived.
For the year ended December 31, 2002, Merrill Lynch, Pierce, Fenner & Smith
Incorporated ("MLPF&S"), a subsidiary of ML & Co., earned $6,499 in commissions
on the execution of portfolio security transactions.
Financial Data Services, Inc. ("FDS"), a wholly-owned subsidiary of ML & Co.,
is the Company's transfer agent.
For the year ended December 31, 2002, the Fund reimbursed MLIM $1,430 for
certain accounting services.
Certain officers and/or directors of the Company are officers and/or directors
of MLIM, PSI, FDS, FAMD, MLAM UK, and/or ML & Co.
3. INVESTMENTS:
Purchases and sales of investments, excluding short-term securities, for the
year ended December 31, 2002 were $30,872,753 and $37,720,147, respectively.
Net realized losses for the year ended December 31, 2002 and net unrealized
gains losses as of December 31, 2002 were as follows:
<Table>
<Caption>
- ------------------------------------------------------------------
Realized Unrealized
Losses Losses
- ------------------------------------------------------------------
Long-term investments.................. $(1,667,639) $(1,018,631)
Foreign currency transactions.......... (92,313) (1,498)
----------- -----------
Total.................................. $(1,759,952) $(1,020,129)
=========== ===========
- ------------------------------------------------------------------
</Table>
At December 31, 2002, net unrealized depreciation for Federal income tax
purposes aggregated $1,236,598, of which $2,562,769 related to appreciated
securities and $3,799,367 related to depreciated securities. At December 31,
2002, the aggregate cost of investments for Federal income tax purposes was
$29,568,238.
4. CAPITAL SHARE TRANSACTIONS:
Net decrease in net assets derived from capital share transactions was
$6,509,246 and $10,668,342 for the years ended December 31, 2002 and December
31, 2001, respectively.
Transactions in capital shares were as follows:
<Table>
<Caption>
- -----------------------------------------------------------------
Class A Shares for the Year Ended Dollar
December 31, 2002 Shares Amount
- -----------------------------------------------------------------
Shares sold.......................... 3,527,652 $ 27,172,264
Shares issued to shareholders in
reinvestment of dividends........... 17.329 126,699
---------- ------------
Total issued......................... 3,544,981 27,298,963
Shares redeemed...................... (4,402,928) (33,685,378)
---------- ------------
Net decrease......................... (857,947) $ (6,386,415)
========== ============
- -----------------------------------------------------------------
</Table>
<Table>
<Caption>
- -----------------------------------------------------------------
Class A Shares for the Year Ended Dollar
December 31, 2001 Shares Amount
- -----------------------------------------------------------------
Shares sold.......................... 728,719 $ 5,497,004
Shares issued to shareholders in
reinvestment of dividends........... 48,400 357,232
---------- ------------
Total issued......................... 777,119 5,854,236
Shares redeemed...................... (2,224,809) (16,036,709)
---------- ------------
Net decrease......................... (1,447,690) $(10,182,473)
========== ============
- -----------------------------------------------------------------
</Table>
<Table>
<Caption>
- -----------------------------------------------------------------
Class B Shares for the Year Ended Dollar
December 31, 2002 Shares Amount
- -----------------------------------------------------------------
Shares sold............................. 29,245 $ 229,359
Shares issued to shareholders in
reinvestment of dividends.............. 474 3,713
------- ------------
Total issued............................ 29,719 233,072
Shares redeemed......................... (48,766) (355,903)
------- ------------
Net decrease............................ (19,047) $ (122,831)
======= ============
- -----------------------------------------------------------------
</Table>
<Table>
<Caption>
- -----------------------------------------------------------------
Class B Shares for the Year Ended Dollar
December 31, 2001 Shares Amount
- -----------------------------------------------------------------
Shares sold............................ 41,437 $ 298,098
Shares issued to shareholders in
reinvestment of dividends............. 1,833 13,551
-------- ------------
Total issued........................... 43,270 311,649
Shares redeemed........................ (110,678) (797,518)
-------- ------------
Net decrease........................... (67,408) $ (485,869)
======== ============
- -----------------------------------------------------------------
</Table>
5. SHORT-TERM BORROWINGS:
The Fund, along with certain other funds managed by MLIM and its affiliates, is
a party to a credit agreement with Bank One, N.A. and certain other lenders.
Effective November 29, 2002, in conjunction with the renewal for one year at the
same term, the total commitment was reduced from $1,000,000,000 to $500,000,000.
The Fund may borrow under the credit agreement to fund shareholder redemptions
and for other lawful purposes other than for leverage. The Fund may borrow up to
the maximum amount allowable under the Fund's current prospectus and statement
of additional information, subject to various other legal, regulatory or
contractual limits. The Fund pays a commitment fee of .09% per annum based on
the Fund's pro rata share of the unused portion of the credit agreement. Amounts
borrowed under the credit agreement bear interest at a rate equal to, at each
fund's election, the Federal Funds rate plus .50% or a base rate as determined
by Bank One, N.A. The
71
- --------------------------------------------------------------------------------
Fund did not borrow under the credit agreement during the year ended December
31, 2002.
6. DISTRIBUTIONS TO SHAREHOLDERS:
The tax character of distributions paid during the fiscal years ended December
31, 2002 and December 31, 2001 was as follows:
<Table>
<Caption>
- -------------------------------------------------------------------
12/31/2002 12/31/2001
- -------------------------------------------------------------------
Distributions paid from:
Ordinary income.......................... $130,412 $370,783
-------- --------
Total taxable distributions............... $130,412 $370,783
======== ========
- -------------------------------------------------------------------
</Table>
As of December 31, 2002, the components of accumulated losses on a tax basis
were as follows:
<Table>
- -----------------------------------------------------------------
Undistributed ordinary income--net................ --
Undistributed long-term capital gains--net........ --
------------
Total undistributed earnings--net................. --
Capital loss carryforward......................... $(50,890,692)*
Unrealized losses--net............................ (1,351,954)**
------------
Total accumulated losses--net..................... $(52,242,646)
============
- -----------------------------------------------------------------
</Table>
* On December 31, 2002, the Fund had a net capital loss carryforward of
$50,890,692, of which $28,033,925 expires in 2006, $3,974,688 expires in
2007, $9,930,235 expires in 2009, and $8,951,844 expires in 2010. This amount
will be available to offset like amounts of any future taxable gains.
** The difference between book-basis and tax-basis net unrealized losses is
attributable primarily to the tax deferral of losses on wash sales, the
realization for tax purposes of unrealized gains on investments in passive
foreign investment companies, the deferral of post-October currency and
capital losses for tax purposes and other book/tax temporary differences.
72
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DEVELOPING CAPITAL MARKETS V.I. FUND
INDEPENDENT AUDITORS' REPORT
- --------------------------------------------------------------------------------
THE BOARD OF DIRECTORS AND SHAREHOLDERS,
DEVELOPING CAPITAL MARKETS V.I. FUND OF
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.:
We have audited the accompanying statement of assets and liabilities,
including the schedule of investments, of Developing Capital Markets V.I. Fund
(formerly, Developing Capital Markets Focus Fund) of Merrill Lynch Variable
Series Funds, Inc. as of December 31, 2002, the related statements of operations
for the year then ended, and changes in net assets for each of the years in the
two-year period then ended, and the financial highlights for each of the periods
presented. These financial statements and the financial highlights are the
responsibility of the Fund's management. Our responsibility is to express an
opinion on these financial statements and the financial highlights based on our
audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements and the financial highlights are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. Our procedures included confirmation of
securities owned at December 31, 2002 by correspondence with the custodian and
brokers; where replies were not received from brokers, we performed other
auditing procedures. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such financial statements and financial highlights present
fairly, in all material respects, the financial position of Developing Capital
Markets V.I. Fund of Merrill Lynch Variable Series Funds, Inc. as of December
31, 2002, the results of its operations, the changes in its net assets, and the
financial highlights for the respective stated periods in conformity with
accounting principles generally accepted in the United States of America.
Deloitte & Touche LLP
Princeton, New Jersey
February 14, 2003
73
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DOMESTIC MONEY MARKET V.I. FUND
DECEMBER 31, 2002--ANNUAL REPORT
- --------------------------------------------------------------------------------
DEAR SHAREHOLDER:
For the 12 months ended December 31, 2002, Domestic Money Market V.I. Fund's
Class A Shares had a net annualized yield of 1.49%. For the six-month period
ended December 31, 2002, the Fund's Class A Shares had a net annualized yield of
1.30%. The Fund had a 7-day yield of .95% at December 31, 2002. The Fund's
average portfolio maturity was 54 days at December 31, 2002, compared to 50 days
at June 30, 2002.
ECONOMIC ENVIRONMENT
By December 31, 2002, the U.S. economy appeared to be on track for annual
growth of roughly 2.5%, with growth in the fourth quarter of 2002 declining to
an estimated 1% from a relatively strong 4% in the third quarter. Most analysts
do not expect consumers to continue to support economic growth in 2003 as they
had in 2002. Large-scale layoff announcements in the fourth quarter and
uncertainty over Iraq led to a decline in consumer confidence. Industry surveys
indicated that consumers were still uneasy about the employment situation. These
factors contributed to the anemic holiday season, with modest gains in overall
sales limited by heavy discounting needed to bring buyers into the stores. The
strength in the housing market and mortgage refinancing activity provided
household well-being during the six-month period ended December 31, 2002, but
there are signs this trend is tapering off as mortgage rates have stopped
dropping. After more than two years of retrenchment, corporate balance sheets
improved during the six-month period. It remains unclear if this will lead to an
increase in capital expenditures unless revenues show signs of growth. However,
the combination of low interest rates and proposed fiscal stimulus may yet bring
improvement to the economic outlook.
The impact of economic data continued to be muted in light of other events
that have brought increased volatility to the markets. The short end of the U.S.
Treasury market (two years and under) was subject to a safe-haven trade during
the last few months, with U.S. Treasury yields approaching historical lows. The
equity and corporate bond markets continued to slide from the disclosure of
questionable accounting and business practices. The threat of a U.S. military
conflict with Iraq cast a pall on financial markets, with volatility
accelerating along with the rhetoric. Increasingly, the decline in the U.S.
dollar compared to other major currencies and recent highs in oil and gold
prices added another element to the uncertainties facing the markets. We believe
that fiscal stimulus will lead to increased borrowing by the U.S. Treasury, and
changes in the borrowings mix are likely to produce structural changes to the
yield curve. These factors influenced the markets during the fourth quarter of
2002, and we believe are likely to continue, to varying degrees, into the first
quarter of 2003.
PORTFOLIO MATTERS
Our desired portfolio mix and average duration remained relatively unchanged
during the six-month period ended December 31, 2002. To target a 50-day-60-day
average life, we favored an overweighted position in variable rate notes, and
for fixed rate exposure, we preferred callable agency structures. The universe
of available first-tier corporate credits declined throughout the year, thus
collapsing spreads because of scarcity value. Somewhat surprisingly, spreads on
agency issues remained unchanged. We added floating rate agency securities on a
one-month London Interbank Offered Rate (LIBOR) less an eight basis point (.08%)
equivalent, which represents a similar level to that of first-tier commercial
paper. As we expect higher interest rates to eventually produce a steeper curve,
sufficient exposure in variable rate product should provide adequate protection
against higher interest rates and allow us greater flexibility with our fixed
rate purchases. Amid the flat-to-inverted yield curve that existed within the
one-year sector, we became increasingly involved in callable agency paper. We
believed the premiums we received by selling these imbedded call options created
valuable investment opportunities, especially given the inversion of the LIBOR
curve in the front end. This scenario enabled us to generate yields that were
otherwise unavailable for the higher-quality credits, which we were primarily
focused on. At these volatility levels, callable bonds offered superior
option-adjusted spreads in addition to their higher coupons.
Recently, we have become increasingly cautious about adding any new longer
fixed rate exposure as volatility has declined, quality spreads have collapsed
and U.S. Treasury yields have retested their lows. Hence, we currently do not
see value in callable structures, as their option-adjusted spreads are far less
compelling. We remain content to allow our duration target to passively drift
lower, awaiting better buying opportunities, which we believe may arise if
sustained economic growth becomes more apparent and the safe-haven trade
diminishes.
74
- --------------------------------------------------------------------------------
The Fund's composition at the end of December and as of our last report to
shareholders is detailed below:
<Table>
<Caption>
- -------------------------------------------------------
12/31/02 6/30/02
- -------------------------------------------------------
Bank Notes........................ 1.8% 2.8%
Commercial Paper.................. 57.9 42.5
Corporate Notes................... 0.3 8.7
Funding Agreements................ 6.6 7.6
Medium Term Notes................. 5.2 --
Municipal Bonds................... 0.7 --
Repurchase Agreements............. 2.9 2.0
U.S. Government, Agency &
Instrumentality Obligations--
Discount........................ -- 1.6
U.S. Government, Agency &
Instrumentality Obligations--
Non-Discount.................... 27.8 31.1
Other Assets Less Liabilities..... -- 3.7
Liabilities in Excess of Other
Assets.......................... (3.2) --
----- -----
Total............................. 100.0% 100.0%
===== =====
- -------------------------------------------------------
</Table>
IN CONCLUSION
We appreciate your investment in Domestic Money Market V.I. Fund of Merrill
Lynch Variable Series Funds, Inc., and we look forward to discussing our
investment outlook and strategy with you in our next report to shareholders.
Sincerely,
/s/ Terry K. Glenn
Terry K. Glenn
President and Director
/s/ Jacqueline Rogers
Jacqueline Rogers
Vice President and Portfolio Manager
January 17, 2003
75
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DOMESTIC MONEY MARKET V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
<Caption>
FACE INTEREST MATURITY
AMOUNT ISSUE RATE* DATE VALUE
- ------------------------------------------------------------------------------------------------------------------------
BANK NOTES--1.8% $ 5,000,000 National City Bank of Indiana+... 1.40 % 5/19/2003 $ 5,000,574
5,000,000 U.S. Bank, NA+................... 1.34 4/30/2003 4,999,404
- ------------------------------------------------------------------------------------------------------------------------
TOTAL BANK NOTES
(COST--$9,999,978) 9,999,978
- ------------------------------------------------------------------------------------------------------------------------
COMMERCIAL PAPER--57.9% 10,000,000 Apreco, Inc...................... 1.35 2/05/2003 9,987,250
10,000,000 Asset Securitization Cooperative
Corp........................... 1.32 1/24/2003 9,991,807
10,000,000 Blue Ridge Asset Funding Corp.... 1.37 1/03/2003 9,999,619
7,000,000 Blue Ridge Asset Funding Corp.... 1.33 1/07/2003 6,998,707
10,000,000 Blue Ridge Asset Funding Corp.... 1.35 2/03/2003 9,988,001
10,000,000 Clipper Receivables Corp......... 1.35 1/15/2003 9,995,125
8,644,000 Clipper Receivables Corp......... 1.35 1/28/2003 8,635,572
8,000,000 Corporate Asset Funding Co.,
Inc............................ 1.33 2/04/2003 7,990,247
9,000,000 Dorada Finance Inc............... 1.32 2/04/2003 8,989,028
6,383,000 Dorada Finance Inc............... 1.55 2/20/2003 6,371,445
4,088,000 Edison Asset Securitization,
LLC............................ 1.32 1/09/2003 4,086,958
10,726,000 Edison Asset Securitization,
LLC............................ 1.33 1/17/2003 10,720,056
5,200,000 Enterprise Funding Corp.......... 1.35 1/24/2003 5,195,710
12,000,000 Enterprise Funding Corp.......... 1.34 2/10/2003 11,982,580
13,000,000 Eureka Securitization Inc........ 1.35 1/13/2003 12,994,638
9,000,000 Eureka Securitization Inc........ 1.34 2/21/2003 8,983,376
10,000,000 FCAR Owner Trust................. 1.78 1/16/2003 9,994,827
14,600,000 FCAR Owner Trust................. 1.36 2/03/2003 14,582,350
6,500,000 Falcon Asset Securitization...... 1.35 1/07/2003 6,498,781
12,104,000 Falcon Asset Securitization...... 1.35 1/21/2003 12,095,376
5,000,000 Falcon Asset Securitization...... 1.35 1/22/2003 4,996,250
5,074,000 Fleet National Bank.............. 1.33 1/23/2003 5,070,033
7,309,000 Forrestal Funding Master Trust... 1.33 1/28/2003 7,301,929
10,000,000 General Electric Capital Corp.... 1.35 2/13/2003 9,984,600
12,000,000 Goldman Sachs Group, Inc......... 1.76 10/09/2003 11,998,800
10,000,000 International Lease Finance
Corporation.................... 1.35 1/14/2003 9,995,500
3,041,000 International Lease Finance
Corporation.................... 1.33 1/17/2003 3,039,315
10,000,000 Kitty Hawk Funding Corp.......... 1.35 1/15/2003 9,995,125
4,765,000 Kitty Hawk Funding Corp.......... 1.37 1/15/2003 4,762,643
10,000,000 Kitty Hawk Funding Corp.......... 1.32 1/23/2003 9,992,182
10,000,000 Morgan Stanley................... 1.37 1/10/2003 9,996,956
10,000,000 Morgan Stanley................... 1.393 4/15/2003 10,000,000
5,100,000 Paccar Financial Corp............ 1.29 3/06/2003 5,087,933
10,000,000 Park Avenue Receivables Corp..... 1.37 1/06/2003 9,998,478
11,500,000 Park Avenue Receivables Corp..... 1.34 2/05/2003 11,485,446
5,800,000 Park Avenue Receivables Corp..... 1.35 2/10/2003 5,791,518
- ------------------------------------------------------------------------------------------------------------------------
TOTAL COMMERCIAL PAPER
(COST--$315,576,175) 315,578,161
- ------------------------------------------------------------------------------------------------------------------------
CORPORATE NOTES--0.3% 1,800,000 Wal-Mart Stores, Inc............. 4.878 6/01/2003 1,823,778
- ------------------------------------------------------------------------------------------------------------------------
TOTAL CORPORATE NOTES
(COST--$1,816,847) 1,823,778
- ------------------------------------------------------------------------------------------------------------------------
</Table>
76
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DOMESTIC MONEY MARKET V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
FACE INTEREST MATURITY
AMOUNT ISSUE RATE* DATE VALUE
- ------------------------------------------------------------------------------------------------------------------------
FUNDING AGREEMENTS--6.6% $ 5,000,000 Allstate Life Insurance Co....... 1.509% 7/01/2003 $ 5,000,000
5,000,000 Allstate Life Insurance Co....... 1.509 11/03/2003 5,000,000
6,000,000 Jackson National Life Insurance
Co............................. 1.519 5/01/2003 6,000,000
5,000,000 Metropolitan Life Insurance
Company........................ 1.509 4/01/2003 5,000,000
10,000,000 Monumental Life Insurance
Company........................ 1.599 11/24/2003 10,000,000
5,000,000 New York Life Insurance
Company........................ 1.478 5/30/2003 5,000,000
- ------------------------------------------------------------------------------------------------------------------------
TOTAL FUNDING AGREEMENTS
(COST--$36,000,000) 36,000,000
- ------------------------------------------------------------------------------------------------------------------------
MEDIUM-TERM NOTES--5.2% 3,250,000 General Electric Capital Corp.... 1.756 11/03/2003 3,251,527
8,500,000 General Electric Capital Corp.... 1.45 1/16/2004 8,500,000
700,000 Goldman Sachs Group, Inc......... 2.025 1/13/2004 700,000
2,500,000 Household Finance Corp........... 1.52 2/14/2003 2,500,000
1,000,000 Morgan Stanley................... 1.87 8/07/2003 1,001,519
5,550,000 Morgan Stanley................... 1.52 1/16/2004 5,550,000
6,600,000 Salomon, Smith Barney Holdings,
Inc............................ 1.615 2/11/2003 6,601,516
- ------------------------------------------------------------------------------------------------------------------------
TOTAL MEDIUM-TERM NOTES
(COST--$28,104,961) 28,104,562
- ------------------------------------------------------------------------------------------------------------------------
MUNICIPAL BONDS--0.7% 4,000,000 California State, Revenue
Anticipation Notes............. 1.42 6/20/2003 4,000,000
- ------------------------------------------------------------------------------------------------------------------------
TOTAL MUNICIPAL BONDS
(COST--$4,000,000) 4,000,000
- ------------------------------------------------------------------------------------------------------------------------
REPURCHASE 15,705,000 Credit Suisse First Boston Corp.,
AGREEMENTS**--2.9% purchased on 12/31/2002 to
yield 1.25% to 1/02/2003....... 15,705,000
- ------------------------------------------------------------------------------------------------------------------------
TOTAL REPURCHASE AGREEMENTS
(COST--$15,705,000) 15,705,000
- ------------------------------------------------------------------------------------------------------------------------
U.S. GOVERNMENT AGENCY & 10,000,000 Fannie Mae+...................... 1.28 2/03/2003 10,000,000
INSTRUMENTALITY 6,000,000 Fannie Mae....................... 2.25 2/07/2003 6,004,961
OBLIGATIONS--
NON-DISCOUNT--27.8% 5,000,000 Fannie Mae+...................... 1.248 2/19/2003 4,999,787
5,000,000 Fannie Mae....................... 4.00 8/15/2003 5,084,235
10,000,000 Fannie Mae+...................... 1.447 1/14/2004 10,000,000
11,000,000 Fannie Mae+...................... 1.285 5/27/2004 10,993,040
3,000,000 Fannie Mae....................... 2.46 8/19/2004 3,021,813
1,500,000 Fannie Mae....................... 2.70 8/19/2004 1,502,812
2,000,000 Fannie Mae....................... 2.72 8/27/2004 2,004,374
2,000,000 Fannie Mae....................... 2.80 9/03/2004 2,004,940
1,960,000 Fannie Mae....................... 2.50 10/01/2004 1,978,114
1,615,000 Fannie Mae....................... 2.60 10/29/2004 1,621,560
1,250,000 Fannie Mae....................... 2.65 11/04/2004 1,264,452
10,000,000 Federal Home Loan Bank+.......... 1.308 3/06/2003 9,999,104
10,000,000 Federal Home Loan Bank+.......... 1.22 3/12/2003 10,001,390
2,250,000 Federal Home Loan Bank+.......... 4.50 4/25/2003 2,272,644
3,000,000 Federal Home Loan Bank+.......... 1.44 11/07/2003 3,000,705
4,400,000 Federal Home Loan Bank+.......... 1.253 12/04/2003 4,403,150
2,600,000 Federal Home Loan Bank+.......... 1.235 12/29/2003 2,602,306
2,600,000 Federal Home Loan Bank+.......... 1.625 1/02/2004 2,598,833
13,600,000 Federal Home Loan Bank+.......... 1.303 1/06/2004 13,594,814
1,500,000 Federal Home Loan Bank+.......... 3.375 6/15/2004 1,539,678
2,000,000 Federal Home Loan Bank+.......... 1.709 8/05/2004 2,000,212
9,750,000 Federal Home Loan Mortgage
Corporation.................... 2.45 1/16/2003 9,753,998
5,000,000 Federal Home Loan Mortgage
Corporation.................... 5.75 7/15/2003 5,119,695
3,325,000 Federal Home Loan Mortgage
Corporation.................... 3.25 1/15/2004 3,390,353
</Table>
77
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DOMESTIC MONEY MARKET V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONCLUDED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
FACE INTEREST MATURITY
AMOUNT ISSUE RATE* DATE VALUE
- ------------------------------------------------------------------------------------------------------------------------
U.S. GOVERNMENT AGENCY & LX$5,000,000 FEDERAL HOME LOAN MORTGAGE
INSTRUMENTALITY Corporation.................... 3.50 % 2/20/2004 $ 5,114,230
OBLIGATIONS--
NON-DISCOUNT--(CONCLUDED)
1,575,000 Federal Home Loan Mortgage
Corporation.................... 3.75 4/15/2004 1,621,836
10,000,000 Student Loan Marketing
Association+................... 1.427 2/12/2004 9,997,810
3,000,000 Student Loan Marketing
Association.................... 3.375 7/15/2004 3,080,922
1,075,000 U.S. Treasury Notes.............. 2.125 8/31/2004 1,086,967
- ------------------------------------------------------------------------------------------------------------------------
TOTAL U.S. GOVERNMENT AGENCY & INSTRUMENTALITY
OBLIGATIONS--NON-DISCOUNT
(COST--$151,297,433) 151,658,735
- ------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS
(COST--$562,500,394)--103.2%..... 562,870,214
LIABILITIES IN EXCESS OF
OTHER ASSETS--(3.2%)............. (17,240,698)
------------
NET ASSETS--100.0%............... $545,629,516
============
- ------------------------------------------------------------------------------------------------------------------------
</Table>
* Commercial Paper and certain U.S. Government & Agency Obligations are traded
on a discount basis; the interest rates shown reflect the discount rates paid
at the time of purchase by the Fund. Other securities bear interest at the
rates shown, payable at fixed dates or upon maturity. The interest rates on
variable rate securities are adjusted periodically based upon appropriate
indexes; the interest rates shown are the rates in effect at December 31,
2002.
** Repurchase Agreements are fully collateralized by U.S. Government & Agency
Obligations.
+ Variable rate notes.
See Notes to Financial Statements.
78
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DOMESTIC MONEY MARKET V.I. FUND
STATEMENT OF ASSETS AND LIABILITIES AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
ASSETS:
Investments, at value (identified cost--$562,500,394*)...... $562,870,214
Receivables:
Interest.................................................. $ 1,036,045
Capital shares sold....................................... 647,174 1,683,219
-----------
Prepaid expenses and other assets........................... 2,739
------------
Total assets................................................ 564,556,172
------------
- ----------------------------------------------------------------------------------------
LIABILITIES:
Payables:
Securities purchased...................................... 13,594,814
Capital shares redeemed................................... 5,039,328
Investment adviser........................................ 235,552 18,869,694
-----------
Accrued expenses and other liabilities...................... 56,962
------------
Total liabilities........................................... 18,926,656
------------
- ----------------------------------------------------------------------------------------
NET ASSETS.................................................. $545,629,516
============
- ----------------------------------------------------------------------------------------
NET ASSETS CONSIST OF:
Class A Shares of Common Stock, $.10 par value,
1,300,000,000 shares authorized+.......................... $ 54,525,970
Paid-in capital in excess of par............................ 490,733,726
Unrealized appreciation on investments--net................. 369,820
------------
NET ASSETS.................................................. $545,629,516
============
- ----------------------------------------------------------------------------------------
NET ASSET VALUE:
Class A--Based on net assets of $545,629,516 and 545,259,696
shares outstanding........................................ $ 1.00
============
- ----------------------------------------------------------------------------------------
</Table>
* Cost for Federal income tax purposes. As of December 31, 2002, net unrealized
appreciation for Federal income tax purposes amounted to $369,820, of which
$372,380 related to appreciated securities and $2,560 related to depreciated
securities.
+The Fund is also authorized to issue 1,300,000,000 Class B Shares.
See Notes to Financial Statements.
79
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DOMESTIC MONEY MARKET V.I. FUND
STATEMENT OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
INVESTMENT INCOME:
Interest and discount earned................................ $11,187,575
- --------------------------------------------------------------------------------------
EXPENSES:
Investment advisory fees.................................... $2,742,479
Accounting services......................................... 190,049
Professional fees........................................... 67,072
Printing and shareholder reports............................ 49,605
Transfer agent fees......................................... 42,064
Custodian fees.............................................. 23,821
Directors' fees and expenses................................ 23,100
Pricing services............................................ 1,975
Registration fees........................................... 820
Other....................................................... 9,599
----------
Total expenses.............................................. 3,150,584
-----------
Investment income--net...................................... 8,036,991
-----------
- --------------------------------------------------------------------------------------
REALIZED & UNREALIZED GAIN (LOSS) ON INVESTMENTS--NET:
Realized gain on investments--net........................... 20,989
Change in unrealized appreciation on investments--net....... (372,029)
-----------
Total realized and unrealized loss on investments--net...... (351,040)
-----------
NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS........ $ 7,685,951
===========
- --------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
80
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DOMESTIC MONEY MARKET V.I. FUND
STATEMENTS OF CHANGES IN NET ASSETS
- --------------------------------------------------------------------------------
<Table>
<Caption>
FOR THE YEAR ENDED
DECEMBER 31,
--------------------------------
INCREASE (DECREASE) IN NET ASSETS: 2002 2001
- ------------------------------------------------------------------------------------------------
OPERATIONS:
Investment income--net...................................... $ 8,036,991 $ 19,506,561
Realized gain on investments--net........................... 20,989 94,101
Change in unrealized appreciation/depreciation on
investments--net.......................................... (372,029) 666,699
------------- ---------------
Net increase in net assets resulting from operations........ 7,685,951 20,267,361
------------- ---------------
- ------------------------------------------------------------------------------------------------
DIVIDENDS & DISTRIBUTIONS TO SHAREHOLDERS:
Investment income--net:
Class A................................................... (8,036,991) (19,506,561)
Realized gain on investments--net:
Class A................................................... (20,989) (94,101)
------------- ---------------
Net decrease in net assets resulting from dividends and
distributions to shareholders............................. (8,057,980) (19,600,662)
------------- ---------------
- ------------------------------------------------------------------------------------------------
CLASS A CAPITAL SHARE TRANSACTIONS:
Net proceeds from sale of shares............................ 533,787,930 1,552,924,489
Value of shares issued to shareholders in reinvestment of
dividends and distributions............................... 8,056,121 19,603,334
------------- ---------------
541,844,051 1,572,527,823
Cost of shares redeemed..................................... (576,451,838) (1,447,844,261)
------------- ---------------
Net increase (decrease) in net assets derived from Class A
capital share transactions................................ (34,607,787) 124,683,562
------------- ---------------
- ------------------------------------------------------------------------------------------------
NET ASSETS:
Total increase (decrease) in net assets..................... (34,979,816) 125,350,261
Beginning of year........................................... 580,609,332 455,259,071
------------- ---------------
End of year................................................. $ 545,629,516 $ 580,609,332
============= ===============
- ------------------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
81
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DOMESTIC MONEY MARKET V.I. FUND
FINANCIAL HIGHLIGHTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
THE FOLLOWING PER SHARE DATA AND RATIOS HAVE BEEN DERIVED CLASS A
FROM INFORMATION PROVIDED IN THE FINANCIAL STATEMENTS. --------------------------------------------------------
FOR THE YEAR ENDED DECEMBER 31,
--------------------------------------------------------
INCREASE (DECREASE) IN NET ASSET VALUE: 2002 2001 2000 1999 1998
- ------------------------------------------------------------------------------------------------------------------------
PER SHARE OPERATING PERFORMANCE:
Net asset value, beginning of year.......................... $ 1.00 $ 1.00 $ 1.00 $ 1.00 $ 1.00
-------- -------- -------- -------- --------
Investment income--net...................................... .0147 .0384 .0588 .0473 .0506
Realized and unrealized gain (loss) on investments--net..... (.0007) .0015 .0008 (.0006) --+
-------- -------- -------- -------- --------
Total from investment operations............................ .0140 .0399 .0596 .0467 .0506
-------- -------- -------- -------- --------
Less dividends and distributions:
Investment income--net.................................... (.0147) (.0384) (.0588) (.0473) (.0508)
Realized gain on investments--net......................... --+ (.0002) --+ --+ --+
-------- -------- -------- -------- --------
Total dividends and distributions........................... (.0147) (.0386) (.0588) (.0473) (.0508)
-------- -------- -------- -------- --------
Net asset value, end of year................................ $ 1.00 $ 1.00 $ 1.00 $ 1.00 $ 1.00
======== ======== ======== ======== ========
- ------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENT RETURN:*
Based on net asset value per share.......................... 1.49% 3.89% 6.00% 4.84% 5.20%
======== ======== ======== ======== ========
- ------------------------------------------------------------------------------------------------------------------------
RATIOS TO AVERAGE NET ASSETS:
Expenses.................................................... .57% .57% .55% .55% .56%
======== ======== ======== ======== ========
Investment income--net, and realized gain on
investments--net.......................................... 1.47% 3.69% 5.88% 4.76% 5.03%
======== ======== ======== ======== ========
- ------------------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL DATA:
Net assets, end of year (in thousands)...................... $545,630 $580,609 $455,259 $467,781 $408,517
======== ======== ======== ======== ========
- ------------------------------------------------------------------------------------------------------------------------
</Table>
*Total investment returns exclude insurance-related fees and expenses.
+ Amount is less than $.0001 per share.
See Notes to Financial Statements.
82
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DOMESTIC MONEY MARKET V.I. FUND NOTES
TO FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
1. SIGNIFICANT ACCOUNTING POLICIES:
Merrill Lynch Variable Series Funds, Inc. (the "Company") is an open-end
management investment company that is comprised of 17 separate funds. Each fund
offers two classes of shares to the Merrill Lynch Life Insurance Company, ML
Life Insurance Company of New York (indirect, wholly-owned subsidiaries of
Merrill Lynch & Co., Inc. ("ML & Co.")), and other insurance companies that are
not affiliated with ML & Co., for their separate accounts to fund benefits under
certain variable annuity and variable life insurance contracts. Domestic Money
Market V.I. Fund (the "Fund") (formerly Domestic Money Market Fund) is
classified as "diversified," as defined in the Investment Company Act of 1940.
Class A and Class B Shares have equal voting, dividend, liquidation and other
rights, except that only shares of the respective classes are entitled to vote
on matters concerning only that class and Class B Shares bear certain expenses
related to the distribution of such shares. The Fund's financial statements are
prepared in conformity with accounting principles generally accepted in the
United States of America, which may require the use of management accruals and
estimates. The following is a summary of significant accounting policies
followed by the Fund.
(a) Valuation of investments--Portfolio securities with remaining maturities
of greater than sixty days, for which market quotations are readily available,
are valued at market value. As securities transition from sixty-one to sixty
days to maturity, the difference between the valuation existing on the
sixty-first day before maturity and maturity value is amortized on a
straight-line basis to maturity. Securities maturing sixty days or less from
their date of acquisition are valued at amortized cost, which approximates
market value. For the purposes of valuation, the maturity of a variable rate
security is deemed to be the next coupon date on which the interest rate is to
be adjusted. Other investments for which market quotations are not readily
available are valued at their fair value as determined in good faith by or under
the direction of the Company's Board of Directors.
(b) Repurchase agreements--The Fund invests in U.S. government securities
pursuant to repurchase agreements. Under such agreements, the counterparty
agrees to repurchase the security at a mutually agreed upon time and price. The
Fund takes possession of the underlying securities, marks to market such
securities and, if necessary, receives additional securities daily to ensure
that the contract is fully collateralized. If the seller defaults and the fair
value of the collateral declines, liquidation of the collateral by the Fund may
be delayed or limited.
(c) Income taxes--It is the Fund's policy to comply with the requirements of
the Internal Revenue Code applicable to regulated investment companies and to
distribute substantially all of its taxable income to its shareholders.
Therefore, no Federal income tax provision is required.
(d) Security transactions and investment income--Security transactions are
recorded on the dates the transactions are entered into (the trade dates).
Realized gains and losses on security transactions are determined on the
identified cost basis. Interest income is recognized on the accrual basis.
(e) Dividends and distributions to shareholders--The Fund declares dividends
daily and reinvests monthly such dividends (net of non-resident alien tax and
backup withholding tax withheld) in additional Fund shares at net asset value.
Dividends and distributions are declared from the total of net investment income
and net realized gain or loss on investments.
(f) Expenses--Certain expenses have been allocated to the individual Funds in
the Company on a pro rata basis based upon the respective aggregate net asset
value of each Fund included in the Company.
2. INVESTMENT ADVISORY AGREEMENT AND TRANSACTIONS WITH AFFILIATES:
The Company has entered into an Investment Advisory Agreement with Merrill Lynch
Investment Managers, L.P. ("MLIM"). The general partner of MLIM is Princeton
Services, Inc. ("PSI"), an indirect, wholly-owned subsidiary of ML & Co., which
is the limited partner.
MLIM is responsible for the management of the Company's funds and provides the
necessary personnel, facilities, equipment and certain other services necessary
to the operations of the Fund. For such services, the Fund pays a monthly fee at
the annual rate of .50% of the average daily value of the Fund's net assets.
MLIM and Merrill Lynch Life Agency, Inc. ("MLLA") have entered into an
agreement which limits the operating expenses paid by the Fund, exclusive of any
distribution fees imposed on Class B Shares, to 1.25% of its average daily
83
- --------------------------------------------------------------------------------
net assets. Any such expenses in excess of 1.25% of average daily net assets
will be reimbursed to the Fund by MLIM which, in turn, will be reimbursed by
MLLA.
Financial Data Services, Inc. ("FDS"), a wholly-owned subsidiary of ML & Co.,
is the Company's transfer agent.
FAM Distributors, Inc. ("FAMD"), which is a wholly-owned subsidiary of Merrill
Lynch Group, Inc., is the Fund's distributor.
For the year ended December 31, 2002, the Fund reimbursed MLIM $15,739 for
certain accounting services.
Certain officers and/or directors of the Fund are officers and/or directors of
MLIM, PSI, FDS, FAMD, and/or ML & Co.
3. CAPITAL SHARE TRANSACTIONS:
The number of shares sold, reinvested and redeemed during the periods
corresponds to the amounts included in the Statements of Changes in Net Assets
with respect to net proceeds from sale of shares, value of shares reinvested and
cost of shares redeemed, respectively, since shares are recorded at $1.00 per
share.
4. DISTRIBUTIONS TO SHAREHOLDERS:
The tax character of distributions paid during the fiscal years ended December
31, 2002 and December 31, 2001 was as follows:
<Table>
<Caption>
- ------------------------------------------------------------------
12/31/2002 12/31/2001
- ------------------------------------------------------------------
Distributions paid from:
Ordinary income........................ $8,057,980 $19,600,662
---------- -----------
Total taxable distributions............. $8,057,980 $19,600,662
========== ===========
- ------------------------------------------------------------------
</Table>
As of December 31, 2002, there were no significant differences between the book
and tax components of net assets.
84
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--DOMESTIC MONEY MARKET V.I. FUND
INDEPENDENT AUDITORS' REPORT
- --------------------------------------------------------------------------------
THE BOARD OF DIRECTORS AND SHAREHOLDERS,
DOMESTIC MONEY MARKET V.I. FUND OF
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.:
We have audited the accompanying statement of assets and liabilities,
including the schedule of investments, of Domestic Money Market V.I. Fund
(formerly, Domestic Money Market Fund) of Merrill Lynch Variable Series Funds,
Inc. as of December 31, 2002, the related statements of operations for the year
then ended and changes in net assets for each of the years in the two-year
period then ended, and the financial highlights for each of the years presented.
These financial statements and the financial highlights are the responsibility
of the Fund's management. Our responsibility is to express an opinion on these
financial statements and the financial highlights based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements and the financial highlights are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. Our procedures included confirmation of
securities owned at December 31, 2002 by correspondence with the custodian and
brokers; where replies were not received from brokers, we performed other
auditing procedures. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such financial statements and financial highlights present
fairly, in all material respects, the financial position of Domestic Money
Market V.I. Fund of Merrill Lynch Variable Series Funds, Inc. as of December 31,
2002, the results of its operations, the changes in its net assets, and the
financial highlights for the respective stated periods in conformity with
accounting principles generally accepted in the United States of America.
Deloitte & Touche LLP
Princeton, New Jersey
February 14, 2003
85
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--FOCUS TWENTY V.I. FUND
DECEMBER 31, 2002--ANNUAL REPORT
- --------------------------------------------------------------------------------
DEAR SHAREHOLDER:
We are pleased to provide you with this annual report for Focus Twenty V.I.
Fund. The Fund's investment objective is long-term capital appreciation. The
Fund is a non-diversified aggressive growth Fund that seeks to achieve its
investment objective by investing in a portfolio of approximately 20 companies
that we believe have strong earnings growth and capital appreciation potential.
INVESTMENT ENVIRONMENT
Although Focus Twenty V.I. Fund has been in existence for just under three
years, the last 33 months have proven exceedingly difficult for aggressive
growth investors. The Fund's third fiscal year began on a good note, as the
market was in the final stages of the very strong rally that followed the
September 11, 2001-driven sell off. This upward move was enabled by the
liquidity created by a series of Federal Reserve Board interest rate cuts, the
return to more normal business conditions following the macroeconomic shock of
September 11 and the typical fourth quarter "budget flush" of business capital
spending. The rally also represented a snapback from the extreme, oversold
conditions that resulted from the drubbing stocks took following the terrorist
attacks. Unfortunately, however, one of the Fund's benchmark indexes, the
unmanaged Standard & Poor's (S&P) 500 Barra Growth Index, reached its high point
for the fiscal year on January 4, 2002, only three trading days into the Fund's
year. The Index declined seven out of the first nine months of 2002, before
finally rallying in October and November 2002.
Most of the turmoil occurred during the second and third calendar quarters of
2002. The market essentially remained unchanged through most of the first
quarter of the calendar year; on March 19, 2002, the Index was up 1.52% for the
year. However, the market then experienced a harrowing four-month sell off, as
the S&P 500 Barra Growth Index declined 31.66% between March 19 and July 23,
2002. The market rallied strongly in late July and August 2002, but worries
about a potential double-dip recession sent the market back to its lows in
September and October 2002. In the end, the eight week rally in October and
November was not nearly enough to make up for the sharp declines earlier in the
year and the Index and the Fund's net asset value declined for the third year in
a row. In a departure from historical norms, stocks declined in 2002 despite the
backdrop of an accommodative Federal Reserve Board interest rate policy and the
end of the mild recession that occurred in 2001. In fact, some of our investors
may be surprised to learn that the S&P 500 Barra Growth Index declined more
during the Fund's current fiscal year than it did in the previous year (the
Index had a 23.59% decline for fiscal year 2002 compared to a 12.73% decline for
fiscal year 2001).
Beyond the steeper overall market declines that occurred in 2002, the year was
different from the previous two because there were significantly fewer places
for investors to hide. Morningstar, Inc. divides diversified equity investing
into nine "style-boxes" based on market capitalization (size of company) and
investment style (growth, core and value). Unlike in 2000 and 2001, all nine of
these style categories experienced negative returns during 2002. Furthermore,
all ten S&P 500 industry sectors finished 2002 with negative returns and eight
of the ten sectors suffered double-digit negative returns.
The year 2002 was similar to 2000 and 2001, in that investors continued to be
unkind to stocks with high expected rates of earnings growth. Importantly,
though, we began to see some interesting trends emerge during the year.
Specifically, the style strategies that drive our investment process (positive
earnings surprise, upwards earnings revision and relative strength) did show
some signs of life at several points during the year. This is in stark contrast
to 2001, when selecting stocks with strong positive earnings surprises and
upwards earnings revisions resulted in marked underperformance. That is, stocks
with the best positive earnings surprises and upwards earnings revisions badly
underperformed stocks with the worst fundamentals in these categories.
Our investment style (which we call earnings momentum) certainly worked better
than it did last year, but it did not perform equally well in all parts of the
market because stocks with higher expected rates of earnings growth continued to
lag the rest of the market. In addition, the periods of outperformance for the
style remained sporadic and inconsistent at best. While the signs of progress
are certainly there, other selection metrics worked better than earnings
momentum in 2002. Beyond the continuing style struggle, we were also plagued by
a lack of "inventory," as the number of companies exhibiting the kinds of high
relative growth rates we look for continued to dwindle because of the difficult
economic environment. Also, the volatile
86
- --------------------------------------------------------------------------------
economic environment coupled with the higher-than-normal level of accounting and
corporate governance issues resulted in a higher-than-normal level of stock
"blow-ups" throughout the market and the Fund was not immune. While we were able
to avoid several problems, we were also hit with disappointments.
In the end, 2002 failed to provide the kind of rapid recovery in the financial
markets that we would have all liked to see and our investment style continued
to struggle in a very challenging environment. It is clear to us that the huge
gains that occurred during the late 1990s and the excesses that accompanied them
will require more time to work through. The end result was disappointing, and
process of style recovery has certainly been subtle and very slow. However, we
believe that the relative performance of our style did incrementally improve
during 2002 and continue to believe that this progress will carry on and that
our process can and will bring success over the long term.
FISCAL YEAR IN REVIEW
For the 12-month period ended December 31, 2002, Focus Twenty V.I. Fund's
Class A Shares had a total return of -38.96%. This performance lagged that of
the unmanaged benchmark indexes, the S&P 500 Barra Growth Index and the S&P 500
Index, which had returns of -23.59% and -22.10%, respectively. The NASDAQ
Composite Index, which, over time, has correlated more closely to the Fund's
performance, returned -31.26% for the 12-month period ended December 31, 2002.
The Fund's performance compared to the S&P 500 Barra Growth Index was hurt by
its high exposure to more rapidly growing, higher earnings multiple stocks.
Higher growth, higher multiple stocks tend to be more volatile than other parts
of the equity market. (The Fund's focus in a small number of investments
(approximately 20 companies) in order to achieve a potentially greater return
may increase the Fund's volatility because each investment has a greater effect
on the Fund's performance.)
Compared to the S&P 500 Barra Growth Index, the Fund's performance was also
hurt by our significantly higher-than-Index weighting in the technology sector,
which performed poorly. While our technology weighting did decline throughout
the year, we still maintained an overweight position at our fiscal year end.
Unfortunately, the business momentum that our technology companies exhibited at
the end of 2001 turned out to be largely seasonal and not cyclical as we had
hoped. In hindsight, the deep economic trough that occurred post-September 11,
2001 created a large recovery that was not sustainable. One sector of
technology, semiconductors, managed to exhibit strong momentum throughout the
first three quarters of 2002. In fact, unit growth actually reached the peak
levels of previous cycles. Unfortunately, however, pricing failed to recover in
a meaningful way and momentum for the sector began to fade as unsustainable low
levels of inventories were refilled.
As we saw technology fundamentals begin to deteriorate meaningfully in early
August 2002, we aggressively reduced our semiconductor holdings and our overall
technology weighting. These changes helped the Fund outperform the S&P 500 Barra
Growth Index as it declined precipitously from late August to early October
2002. Investors enjoyed a strong rally from October 8, 2002 to our fiscal year
end, and semiconductor stocks were among the leaders in this rally.
Our turnover was high during the fiscal year, as we attempted to adjust the
portfolio to a constantly changing, volatile environment. All but one of our six
largest positions through the year, Harley-Davidson, Inc., Microsoft
Corporation, Cisco Systems, Inc. Forest Laboratories, Inc., Viacom, Inc. and
Microchip Technology outperformed the S&P 500 Barra Growth Index and one of them
was up for the fiscal year. Unfortunately, beyond this strong "starting lineup,"
we found it very challenging to find enough companies that both met the criteria
of our investment process and could succeed in what was an exceedingly difficult
environment. The overcapacity as a result of the investment boom of the late
1990s created a lot of pricing pressure, and many of our portfolio
disappointments were a direct result of this phenomenon.
One particularly significant change in portfolio strategy involved the sale of
what had been our largest position, IDEC Pharmaceuticals Corporation. We sold
IDEC because we saw multiple signs that growth of the company's lead product,
Rituxan, was slowing. As a result of this and several other factors, we believed
that street earnings expectations for the company were too high and would have
to be reduced. The sale of IDEC was part of a bigger move away from the
biotechnology sector early in our fiscal year and, fortunately, these shifts in
portfolio strategy took place before large declines in the stocks and the
biotechnology sector in general. Diligent channel checks helped us make sell
decisions on Polycom and Photronics before negative earnings announcements that
led to drastic declines in the stocks. Finally, we also sold AOL Time Warner
Inc. early in the year before a significant decline.
87
- --------------------------------------------------------------------------------
IN CONCLUSION
As we have said in previous letters to shareholders, we cannot and will not
try to predict when the market will improve. Instead, we will continue to invest
in as disciplined and consistent a manner as possible. Our earnings momentum
investment strategy involves investing in companies that we believe are growing
earnings faster than the market or that we believe may be experiencing upwards
earnings revisions or positive earnings surprises. While we cannot foretell when
the market will improve, we believe that we will be following our investment
process when it does, as we believe that this stated discipline is the proper
way to insure market outperformance over the long term.
We appreciate your continued support in
Merrill Lynch Focus Twenty V.I. Fund of Merrill Lynch Variable Series Funds,
Inc. While the environment continues to be challenging, we remain confident that
our process will prove itself over the long term, and we look forward to sharing
our outlook and strategy in our next report to shareholders.
Sincerely,
/s/ Terry K. Glenn
Terry K. Glenn
President and Director
/s/ Michael S. Hahn
Michael S. Hahn
Senior Vice President and Portfolio Manager
January 17, 2003
88
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--FOCUS TWENTY V.I. FUND
TOTAL RETURN BASED ON A $10,000 INVESTMENT--CLASS A SHARES
- --------------------------------------------------------------------------------
<Table>
<Caption>
FOCUS TWENTY V.I. FUND+-- STANDARD & POOR'S 500 STANDARD & POOR'S 500
CLASS A SHARES* INDEX++ BARRA GROWTH INDEX+++
------------------------- --------------------- ---------------------
7/10/00** 10000 10000 10000
12/00 7520 9273 7950
12/01 2313 8171 6938
12/02 1412 6365 5302
</Table>
* Assuming transaction costs and other operating expenses, including advisory
fees. Does not include insurance-related fees and expenses.
** The Fund commenced operations on 7/10/00.
+ The Fund invests primarily in common stocks of approximately 20 companies that
Fund management believes have strong earnings growth and capital appreciation
potential.
++ This unmanaged Index covers 500 industrial, utility, transportation and
financial companies of the U.S. markets (mostly NYSE issues), representing
about 75% of NYSE market capitalization and 30% of NYSE issues. The starting
date for the Index in the graph is from 7/31/00.
+++ This unmanaged Index is a capitalization-weighted index of all the stocks in
the Standard & Poor's Barra Growth Index that have higher price-to-book
ratios. The starting date for the Index is from 7/31/00.
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--FOCUS TWENTY V.I. FUND
AVERAGE ANNUAL TOTAL RETURN--CLASS A SHARES*
- --------------------------------------------------------------------------------
PERIOD COVERED % RETURN
- --------------------------------------------------------------------------------
One Year Ended 12/31/02 -38.96%
- --------------------------------------------------------------------------------
Inception (7/10/00) to 12/31/02 -54.63
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--FOCUS TWENTY V.I. FUND
RECENT PERFORMANCE RESULTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
6-MONTH 12-MONTH
AS OF DECEMBER 31, 2002 TOTAL RETURN TOTAL RETURN
- -----------------------------------------------------------------------------------------
Class A Shares* -18.02% -38.96%
- -----------------------------------------------------------------------------------------
Standard & Poor's 500 Index** -10.30 -22.10
- -----------------------------------------------------------------------------------------
Standard & Poor's 500 Barra Growth Index*** - 8.02 -23.59
- -----------------------------------------------------------------------------------------
</Table>
*Total investment returns are based on changes in net asset value for the period
shown, and assume reinvestment of all dividends and capital gains distributions
at net asset value on the ex-dividend date. Insurance-related fees and expenses
are not reflected in these returns.
**This unmanaged Index covers 500 industrial, utility, transportation and
financial companies of the U.S. markets (mostly NYSE issues), representing
about 75% of NYSE market capitalization and 30% of NYSE issues.
***This unmanaged Index is a capitalization-weighted index of all the stocks in
the Standard & Poor's 500 Index that have higher price-to-book ratios.
Past results shown should not be considered a representation of future
performance.
89
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--FOCUS TWENTY V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
COUNTRY INDUSTRY++ HELD COMMON STOCKS VALUE NET ASSETS
- ---------------------------------------------------------------------------------------------------------------------------
ISRAEL PHARMACEUTICALS 3,000 Teva Pharmaceutical Industries Ltd. (ADR) (a).... $ 115,770 2.6%
-------------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS IN ISRAEL 115,770 2.6
- ---------------------------------------------------------------------------------------------------------------------------
UNITED AUTOMOBILES 3,000 Harley-Davidson, Inc. ........................... 138,600 3.2
STATES
-------------------------------------------------------------------------------------------------------
BIOTECHNOLOGY 2,500 +Amgen Inc. ..................................... 120,875 2.8
-------------------------------------------------------------------------------------------------------
COMMERCIAL 1,000 +Apollo Group, Inc. (Class A).................... 44,000 1.0
SERVICES &
SUPPLIES
2,800 +CheckFree Corp. ................................ 44,604 1.0
5,500 +Corinthian Colleges, Inc. ...................... 207,680 4.7
7,100 Manpower Inc. ................................... 226,490 5.2
----------- -----
522,774 11.9
-------------------------------------------------------------------------------------------------------
COMMUNICATIONS 23,000 +Cisco Systems, Inc. ............................ 301,070 6.8
EQUIPMENT
-------------------------------------------------------------------------------------------------------
COMPUTERS & 13,500 Hewlett-Packard Company.......................... 234,360 5.3
PERIPHERALS
-------------------------------------------------------------------------------------------------------
DIVERSIFIED 7,100 +Nasdaq-100 Shares (c)........................... 173,240 3.9
FINANCIALS
-------------------------------------------------------------------------------------------------------
ENERGY EQUIPMENT 1,700 +BJ Services Company............................. 54,927 1.3
& SERVICE
-------------------------------------------------------------------------------------------------------
HEALTH CARE 4,400 Medtronic, Inc. ................................. 200,640 4.6
EQUIPMENT &
SUPPLIES
2,700 +Zimmer Holdings, Inc. .......................... 112,104 2.5
----------- -----
312,744 7.1
-------------------------------------------------------------------------------------------------------
HEALTH CARE 3,600 +Accredo Health, Incorporated.................... 126,900 2.9
PROVIDERS &
SERVICES
4,500 HCA Inc. ........................................ 186,750 4.2
1,500 +LifePoint Hospitals, Inc........................ 44,805 1.0
----------- -----
358,455 8.1
-------------------------------------------------------------------------------------------------------
MEDIA 8,100 +Clear Channel Communications, Inc. ............. 302,049 6.8
10,200 The Walt Disney Company.......................... 166,362 3.8
----------- -----
468,411 10.6
-------------------------------------------------------------------------------------------------------
OIL & GAS 3,000 Devon Energy Corporation......................... 137,700 3.1
-------------------------------------------------------------------------------------------------------
PHARMACEUTICALS 2,600 +Forest Laboratories, Inc. ...................... 255,372 5.8
7,300 Pfizer Inc. ..................................... 223,161 5.1
----------- -----
478,533 10.9
-------------------------------------------------------------------------------------------------------
SOFTWARE 10,000 +BEA Systems, Inc. .............................. 114,700 2.6
8,100 +Microsoft Corporation........................... 418,851 9.5
----------- -----
533,551 12.1
-------------------------------------------------------------------------------------------------------
SPECIALTY RETAIL 2,700 +Bed Bath & Beyond Inc. ......................... 93,312 2.1
-------------------------------------------------------------------------------------------------------
WIRELESS 19,000 +AT&T Wireless Services Inc. .................... 107,350 2.4
TELECOMMUNICATION
SERVICES
-------------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS IN THE UNITED STATES 4,035,902 91.6
- ---------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN COMMON STOCKS
(COST--$4,161,745) 4,151,672 94.2
- ---------------------------------------------------------------------------------------------------------------------------
</Table>
90
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--FOCUS TWENTY V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONCLUDED) (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
<Table>
<Caption>
PARTNERSHIP PERCENT OF
INTEREST SHORT-TERM SECURITIES VALUE NET ASSETS
- ---------------------------------------------------------------------------------------------------------------------------
$ 343,997
Merrill Lynch Liquidity Series, LLC Cash Sweep
Series II (b).................................. $ 343,997 7.8%
- ---------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN SHORT-TERM SECURITIES
(COST--$343,997) 343,997 7.8
- ---------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS
(COST--$4,505,742)............................... 4,495,669 102.0
LIABILITIES IN EXCESS OF OTHER ASSETS............ (86,458) (2.0)
----------- -----
NET ASSETS....................................... $ 4,409,211 100.0%
=========== =====
- ---------------------------------------------------------------------------------------------------------------------------
</Table>
(a) American Depositary Receipts (ADR).
(b) Investments in companies considered to be an affiliate of the Fund (such
companies are defined as "Affiliated Companies" in Section 2(a)(3) of the
Investment Company Act of 1940) are as follows:
<Table>
<Caption>
- --------------------------------------------------------------------------------------------
NET INTEREST
AFFILIATE ACTIVITY NET COST INCOME
- --------------------------------------------------------------------------------------------
Merrill Lynch Liquidity Series, LLC Cash Sweep Series II.... $343,997 $343,997 $190
- --------------------------------------------------------------------------------------------
</Table>
(c) Represents ownership in the Nasdaq-100 Trust, a registered unit
investment trust. The investment objective of the Nasdaq-100 Trust is to
provide investment results that generally correspond to the price
performance and dividend yield of the component stocks of the Nasdaq-100
Index.
+ Non-income producing security.
++ For Fund compliance purposes, "Industry" means any one or more of the
industry sub-classifications used by one or more widely recognized market
indexes or ratings group indexes, and/or as defined by Fund management.
This definition may not apply for purposes of this report, which may
combine such industry sub-classifications for reporting ease. These
industry classifications are unaudited.
See Notes to Financial Statements.
91
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--FOCUS TWENTY V.I. FUND
STATEMENT OF ASSETS AND LIABILITIES AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
ASSETS:
Investments, at value (identified cost--$4,505,742)......... $ 4,495,669
Cash........................................................ 10
Receivables:
Securities sold........................................... $ 72,439
Capital shares sold....................................... 3,903
Dividends................................................. 2,457
Interest.................................................. 144 78,943
------------
Prepaid expenses............................................ 39
------------
Total assets................................................ 4,574,661
------------
- -----------------------------------------------------------------------------------------
LIABILITIES:
Payables:
Securities purchased...................................... 154,837
Investment adviser........................................ 3,231 158,068
------------
Accrued expenses and other liabilities...................... 7,382
------------
Total liabilities........................................... 165,450
------------
- -----------------------------------------------------------------------------------------
NET ASSETS.................................................. $ 4,409,211
============
- -----------------------------------------------------------------------------------------
NET ASSETS CONSIST OF:
Class A Shares of Common Stock, $.10 par value, 100,000,000
shares authorized+........................................ $ 312,051
Paid-in capital in excess of par............................ 69,339,273
Accumulated realized capital losses on investments--net..... $(65,232,040)
Unrealized depreciation on investments--net................. (10,073)
------------
Total accumulated losses--net............................... (65,242,113)
------------
NET ASSETS.................................................. $ 4,409,211
============
- -----------------------------------------------------------------------------------------
NET ASSET VALUE:
Class A--Based on net assets of $4,409,211 and 3,120,507
shares outstanding........................................ $ 1.41
============
- -----------------------------------------------------------------------------------------
</Table>
+ The Fund is also authorized to issue 100,000,000 Class B Shares.
See Notes to Financial Statements.
92
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--FOCUS TWENTY V.I. FUND
STATEMENT OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
INVESTMENT INCOME:
Dividends................................................... $ 12,007
Interest.................................................... 4,352
-----------
Total income................................................ 16,359
-----------
- ------------------------------------------------------------------------------------
EXPENSES:
Investment advisory fees.................................... $ 55,286
Professional fees........................................... 10,065
Custodian fees.............................................. 9,801
Transfer agent fees......................................... 7,658
Accounting services......................................... 2,410
Printing and shareholder reports............................ 1,436
Registration fees........................................... 895
Pricing services............................................ 835
Directors' fees and expenses................................ 343
Other....................................................... 5,142
--------
Total expenses before reimbursement......................... 93,871
Reimbursement of expenses................................... (12,568)
--------
Total expenses after reimbursement.......................... 81,303
-----------
Investment loss--net........................................ (64,944)
-----------
- ------------------------------------------------------------------------------------
REALIZED & UNREALIZED LOSS ON INVESTMENTS--NET:
Realized loss on investments--net........................... (2,662,421)
Change in unrealized appreciation/depreciation on
investments--net.......................................... (703,412)
-----------
Total realized and unrealized loss on investments--net...... (3,365,833)
-----------
NET DECREASE IN NET ASSETS RESULTING FROM OPERATIONS........ $(3,430,777)
===========
- ------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
93
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--FOCUS TWENTY V.I. FUND
STATEMENTS OF CHANGES IN NET ASSETS
- --------------------------------------------------------------------------------
<Table>
<Caption>
FOR THE YEAR ENDED
DECEMBER 31,
----------------------------------
DECREASE IN NET ASSETS: 2002 2001
- --------------------------------------------------------------------------------------------------
OPERATIONS:
Investment loss--net........................................ $ (64,944) $ (222,873)
Realized loss on investments--net........................... (2,662,421) (60,821,285)
Change in unrealized appreciation/depreciation on
investments--net.......................................... (703,412) 11,097,902
----------- ------------
Net decrease in net assets resulting from operations........ (3,430,777) (49,946,256)
----------- ------------
- --------------------------------------------------------------------------------------------------
CAPITAL SHARE TRANSACTIONS:
Net decrease in net assets derived from capital share
transactions.............................................. (2,558,811) (4,471,540)
----------- ------------
- --------------------------------------------------------------------------------------------------
NET ASSETS:
Total decrease in net assets................................ (5,989,588) (54,417,796)
Beginning of year........................................... 10,398,799 64,816,595
----------- ------------
End of year................................................. $ 4,409,211 $ 10,398,799
=========== ============
- --------------------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
94
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--FOCUS TWENTY V.I. FUND
FINANCIAL HIGHLIGHTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
CLASS A
THE FOLLOWING PER SHARE DATA AND RATIOS HAVE -----------------------------------------
BEEN DERIVED FROM INFORMATION PROVIDED IN THE
FINANCIAL STATEMENTS. FOR THE YEAR ENDED FOR THE PERIOD
DECEMBER 31, JULY 10, 2000+
----------------------- TO DEC. 31,
DECREASE IN NET ASSET VALUE: 2002 2001 2000
- ---------------------------------------------------------------------------------------------------------
PER SHARE OPERATING PERFORMANCE:
Net asset value, beginning of period........................ $ 2.31 $ 7.51 $ 10.00
-------- -------- --------
Investment income (loss)--net............................... (.02)++++ (.02)++++ .01
Realized and unrealized loss on investments--net............ (.88) (5.18) (2.49)
-------- -------- --------
Total from investment operations............................ (.90) (5.20) (2.48)
-------- -------- --------
Less dividends:
Investment income--net.................................... -- -- (.01)
In excess of investment income--net....................... -- -- --(++)
-------- -------- --------
Total dividends............................................. -- -- (.01)
-------- -------- --------
Net asset value, end of period.............................. $ 1.41 $ 2.31 $ 7.51
======== ======== ========
- ---------------------------------------------------------------------------------------------------------
TOTAL INVESTMENT RETURN:**
Based on net asset value per share.......................... (38.96%) (69.24%) (24.80%)++
======== ======== ========
- ---------------------------------------------------------------------------------------------------------
RATIOS TO AVERAGE NET ASSETS:
Expenses, net of reimbursement.............................. 1.25% 1.09% 1.08%*
======== ======== ========
Expenses.................................................... 1.44% 1.10% 1.12%*
======== ======== ========
Investment income (loss)--net............................... (1.00%) (.60%) .74%*
======== ======== ========
- ---------------------------------------------------------------------------------------------------------
SUPPLEMENTAL DATA:
Net assets, end of period (in thousands).................... $ 4,409 $ 10,399 $ 64,817
======== ======== ========
Portfolio turnover.......................................... 312.52% 182.76% 32.05%
======== ======== ========
- ---------------------------------------------------------------------------------------------------------
</Table>
*Annualized.
**Total investment returns exclude insurance-related fees and expenses. If
applicable, the Company's Investment Adviser waived a portion of its
management fee. Without such waiver, the Fund's performance would have been
lower.
+Commencement of operations.
++Aggregate total investment return.
(++)Amount is less than $.01 per share.
++++Based on average shares outstanding.
See Notes to Financial Statements.
95
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--FOCUS TWENTY V.I. FUND
NOTES TO FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
1. SIGNIFICANT ACCOUNTING POLICIES:
Merrill Lynch Variable Series Funds, Inc. (the "Company") is an open-end
management investment company that is comprised of 17 separate funds. Each fund
offers two classes of shares to the Merrill Lynch Life Insurance Company
("MLLIC"), ML Life Insurance Company of New York (indirect, wholly-owned
subsidiaries of Merrill Lynch & Co., Inc. ("ML & Co.")), and other insurance
companies that are not affiliated with ML & Co., for their separate accounts to
fund benefits under certain variable annuity and variable life insurance
contracts. Focus Twenty V.I. Fund (the "Fund") (formerly Focus Twenty Select
Fund) is classified as "non-diversified," as defined in the Investment Company
Act of 1940. Class A and Class B Shares have equal voting, dividend, liquidation
and other rights, except that only shares of the respective classes are entitled
to vote on matters concerning only that class and Class B Shares bear certain
expenses related to the distribution of such shares. The Fund's financial
statements are prepared in conformity with accounting principles generally
accepted in the United States of America, which may require the use of
management accruals and estimates. The following is a summary of significant
accounting policies followed by the Fund.
(a) Valuation of investments--Portfolio securities that are traded on stock
exchanges are valued at the last sale price on the exchange on which such
securities are traded, 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
that are traded in the over-the-counter market are valued at the last available
bid price prior to the time of valuation. In cases where securities are traded
on more than one exchange, the securities are valued on the exchange designated
by or under the authority of the Board of Directors as the primary market.
Portfolio securities that are traded both in the over-the-counter 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 would be the
over-the-counter market. Options written or purchased are valued at the last
sale price in the case of exchange-traded options. In the case of options traded
in the over-the-counter market, valuation is the last asked price (options
written) or the last bid price (options purchased). Short-term securities are
valued at amortized cost, which approximates market value. Futures contracts are
valued at the 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.
(b) Derivative financial instruments--The Fund may engage in various portfolio
investment strategies to increase or decrease the level of risk to which the
Fund is exposed more quickly and efficiently than transactions in other types of
instruments. Losses may arise due to changes in the value of the contract or if
the counterparty does not perform under the contract.
- - Forward foreign exchange contracts--The Fund is authorized to enter into
forward foreign exchange contracts as a hedge against either specific
transactions or portfolio positions. The contract is marked to market daily and
the change in market value is recorded by the Fund as an unrealized gain or
loss. When the contract is closed, the Fund records a realized gain or loss
equal to the difference between the value at the time it was opened and the
value at the time it was closed.
- - Options--The Fund may write and purchase call and put options. When the Fund
writes an option, an amount equal to the premium received by the Fund is
reflected as an asset and an equivalent liability. The amount of the liability
is subsequently marked to market to reflect the current market value of the
option written. When a security is purchased or sold through an exercise of an
option, the related premium paid or received is added to (or deducted from) the
basis of the security acquired or deducted from (or added to) the proceeds of
the security sold. When an option expires (or the Fund enters into a closing
transaction), the Fund realizes a gain or loss on the option to the extent of
the premiums received or paid (or gain or loss to the extent the cost of the
closing transaction exceeds the premium paid or received).
Written and purchased options are non-income producing investments.
- - Financial futures contracts--The Fund may purchase or sell financial futures
contracts and options on such futures contracts for the purpose of hedging the
market risk on existing securities or the intended purchase of securities.
Futures contracts are contracts for delayed delivery of securities at a specific
future date and at a specific price or yield. Upon entering into a contract, the
Fund deposits and maintains as collateral such initial margin as required by the
exchange on which the transaction is
96
- --------------------------------------------------------------------------------
effected. Pursuant to the contract, the Fund agrees to receive from or pay to
the broker an amount of cash equal to the daily fluctuation in value of the
contract. Such receipts or payments are known as variation margin and are
recorded by the Fund as unrealized gains or losses. When the contract is closed,
the Fund records a realized gain or loss equal to the difference between the
value of the contract at the time it was opened and the value at the time it was
closed.
- - Foreign currency options and futures--The Fund may also purchase or sell
listed or over-the-counter foreign currency options, foreign currency futures
and related options on foreign currency futures as a short or long hedge against
possible variations in foreign exchange rates. Such transactions may be effected
with respect to hedges on non-U.S. dollar denominated securities owned by the
Fund, sold by the Fund but not yet delivered, or committed or anticipated to be
purchased by the Fund.
(c) Foreign currency transactions--Transactions denominated in foreign
currencies are recorded at the exchange rate prevailing when recognized. Assets
and liabilities denominated in foreign currencies are valued at the exchange
rate at the end of the period. Foreign currency transactions are the result of
settling (realized) or valuing (unrealized) assets and liabilities expressed in
foreign currencies into U.S. dollars. Realized and unrealized gains or losses
from investments include the effects of foreign exchange rates on investments.
(d) Income taxes--It is the Fund's policy to comply with the requirements of
the Internal Revenue Code applicable to regulated investment companies and to
distribute substantially all of its taxable income to its shareholders.
Therefore, no Federal income tax provision is required. Under the applicable
foreign tax law, a withholding tax may be imposed on interest, dividends and
capital gains at various rates.
(e) Security transactions and investment income--Security transactions are
recorded on the dates the transactions are entered into (the trade dates).
Realized gains and losses on security transactions are determined on the
identified cost basis. Dividend income is recorded on the ex-dividend dates.
Dividends from foreign securities where the ex-dividend date may have passed are
subsequently recorded when the Fund has determined the ex-dividend date.
Interest income is recognized on the accrual basis.
(f) Dividends and distributions--Dividends and distributions paid by the Fund
are recorded on the ex-dividend dates.
(g) Expenses--Certain expenses have been allocated to the individual funds in
the Company on a pro rata basis based upon the respective aggregate net asset
value of each fund included in the Company.
(h) Reclassification--Accounting principles generally accepted in the United
States of America require that certain components of net assets be adjusted to
reflect permanent differences between financial and tax reporting. Accordingly,
the current year's permanent book/tax difference of $64,944 has been
reclassified between paid-in capital in excess of par and accumulated net
investment loss. This reclassification has no effect on net assets or net asset
value per share.
2. INVESTMENT ADVISORY AGREEMENT AND TRANSACTIONS WITH AFFILIATES:
The Company has entered into an Investment Advisory Agreement with Merrill Lynch
Investment Managers, L.P. ("MLIM"). The general partner of MLIM is Princeton
Services, Inc. ("PSI"), an indirect, wholly-owned subsidiary of ML & Co., which
is the limited partner.
MLIM is responsible for the management of the Company's funds and provides the
necessary personnel, facilities, equipment and certain other services necessary
to the operations of the Fund. For such services, the Fund pays a monthly fee at
the annual rate of .85% of the average daily value of the Fund's net assets. For
the year ended December 31, 2002, MLIM earned fees of $55,286, of which $12,568
was waived.
MLIM and Merrill Lynch Life Agency, Inc. ("MLLA") have entered into an
agreement which limits the operating expenses paid by the Fund, exclusive of any
distribution fees imposed on Class B Shares, to 1.25% of its average daily net
assets. Any expenses in excess of 1.25% of average daily net assets will be
reimbursed to the Fund by MLIM which, in turn, will be reimbursed by MLLA.
For the year ended December 31, 2002, Merrill Lynch, Pierce, Fenner & Smith
Incorporated, a subsidiary of ML & Co., earned $3,689 in commissions on the
execution of portfolio security transactions.
Financial Data Services, Inc. ("FDS"), a wholly-owned subsidiary of ML & Co.,
is the Company's transfer agent.
FAM Distributors, Inc. ("FAMD"), which is a wholly-owned subsidiary of Merrill
Lynch Group, Inc., is the Fund's distributor.
For the year ended December 31, 2002, the Fund reimbursed MLIM $293 for
certain accounting services.
97
- --------------------------------------------------------------------------------
Certain officers and/or directors of the Company are officers and/or directors
of MLIM, PSI, FDS, FAMD, and/or ML & Co.
3. INVESTMENTS:
Purchases and sales of investments, excluding short-term securities, for the
year ended December 31, 2002 were $19,486,701 and $20,709,935, respectively.
Net realized gains (losses) for the year ended December 31, 2002 and net
unrealized losses as of December 31, 2002 were as follows:
<Table>
<Caption>
- ---------------------------------------------------------------------
Realized Unrealized
Gains (Losses) Losses
- ---------------------------------------------------------------------
Long-term investments................... $(2,663,016) $(10,073)
Short-term investments.................. 2 --
Options written......................... (2,308) --
Options purchased....................... 2,901 --
----------- --------
Total................................... $(2,662,421) $(10,073)
=========== ========
- ---------------------------------------------------------------------
</Table>
Transactions in options written for the year ended December 31, 2002 were as
follows:
<Table>
<Caption>
- -------------------------------------------------------------------
Nominal Value
Covered by
Options Premiums
Call Options Written Written Received
- -------------------------------------------------------------------
Outstanding call options written,
beginning of year....................... -- --
Options written.......................... 48,400 $ 71,878
Options closed........................... (48,400) (71,878)
------- --------
Outstanding call options written, end of
year.................................... -- $ --
======= ========
- -------------------------------------------------------------------
</Table>
<Table>
<Caption>
- --------------------------------------------------------------------
Nominal Value
Covered by
Options Premiums
Put Options Written Written Received
- --------------------------------------------------------------------
Outstanding put options written, beginning
of year.................................. -- --
Options written........................... 2,200 $ 2,596
Options closed............................ (2,200) (2,596)
------ -------
Outstanding put options written, end of
year..................................... -- $ --
====== =======
- --------------------------------------------------------------------
</Table>
At December 31, 2002, net unrealized depreciation for Federal income tax
purposes aggregated $205,299, of which $139,221 related to appreciated
securities and $344,520 related to depreciated securities. At December 31, 2002,
the aggregate cost of investments for Federal income tax purposes was
$4,700,968.
4. CAPITAL SHARE TRANSACTIONS:
Transactions in capital shares were as follows:
<Table>
<Caption>
- ------------------------------------------------------------------
Class A Shares for the Year Ended Dollar
December 31, 2002 Shares Amount
- ------------------------------------------------------------------
Shares sold............................. 417,888 $ 767,673
Shares redeemed......................... (1,796,887) (3,326,484)
---------- -----------
Net decrease............................ (1,378,999) $(2,558,811)
========== ===========
- ------------------------------------------------------------------
</Table>
<Table>
<Caption>
- ------------------------------------------------------------------
Class A Shares for the Year Ended Dollar
December 31, 2001 Shares Amount
- ------------------------------------------------------------------
Shares sold............................. 3,308,614 $13,928,628
Shares redeemed......................... (7,437,200) (18,400,168)
---------- -----------
Net decrease............................ (4,128,586) $(4,471,540)
========== ===========
- ------------------------------------------------------------------
</Table>
5. SHORT-TERM BORROWINGS:
The Fund, along with certain other funds managed by MLIM and its affiliates, is
a party to a credit agreement with Bank One, N.A. and certain other lenders.
Effective November 29, 2002, in conjunction with the renewal for one year at the
same terms, the total commitment was reduced from $1,000,000,000 to
$500,000,000. The Fund may borrow under the credit agreement to fund shareholder
redemptions and for other lawful purposes other than for leverage. The Fund may
borrow up to the maximum amount allowable under the Fund's current prospectus
and statement of additional information, subject to various other legal,
regulatory or contractual limits. The Fund pays a commitment fee of .09% per
annum based on the Fund's pro rata share of the unused portion of the credit
agreement. Amounts borrowed under the credit agreement bear interest at a rate
equal to, at each fund's election, the Federal Funds rate plus .50% or a base
rate as determined by Bank One, N.A. The Fund did not borrow under the credit
agreement during the year ended December 31, 2002.
6. DISTRIBUTIONS TO SHAREHOLDERS:
As of December 31, 2002, the components of accumulated losses on a tax basis
were as follows:
- ---------------------------------------------------------
<Table>
Undistributed ordinary income--net............... $ --
Undistributed long-term capital gains--net....... --
------------
Total undistributed earnings--net................ --
Capital loss carryforward........................ (64,876,173)*
Unrealized losses--net........................... (365,940)**
------------
Total accumulated losses--net.................... $(65,242,113)
============
- ---------------------------------------------------------------
</Table>
* On December 31, 2002, the Fund had a net capital loss carryforward of
$64,876,173, of which $917,027 expires in 2008, $52,586,441 expires in 2009
and $11,372,705 expires in 2010. This amount will be available to offset like
amounts of any future taxable gains.
** The difference between book-basis and tax-basis net unrealized losses is
attributable primarily to the tax deferral of losses on wash sales, the tax
deferral of losses on straddles and the deferral of post-October capital
losses for tax purposes.
98
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--FOCUS TWENTY V.I. FUND
INDEPENDENT AUDITORS' REPORT
- --------------------------------------------------------------------------------
THE BOARD OF DIRECTORS AND SHAREHOLDERS,
FOCUS TWENTY V.I. FUND OF
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.:
We have audited the accompanying statement of assets and liabilities,
including the schedule of investments, of Focus Twenty V.I. Fund (formerly,
Focus Twenty Select Fund) of Merrill Lynch Variable Series Funds, Inc. as of
December 31, 2002, the related statements of operations for the year then ended,
changes in net assets for each of the years in the two-year period then ended
and the financial highlights for each of the periods presented. These financial
statements and the financial highlights are the responsibility of the Fund's
management. Our responsibility is to express an opinion on these financial
statements and the financial highlights based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements and the financial highlights are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. Our procedures included confirmation of
securities owned at December 31, 2002 by correspondence with the custodian and
brokers; where replies from brokers were not received, we performed other
auditing procedures. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such financial statements and financial highlights present
fairly, in all material respects, the financial position of Focus Twenty V.I.
Fund of Merrill Lynch Variable Series Funds, Inc. as of December 31, 2002, the
results of its operations, the changes in its net assets, and the financial
highlights for the respective stated periods in conformity with accounting
principles generally accepted in the United States of America.
Deloitte & Touche LLP
Princeton, New Jersey
February 14, 2003
99
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--FUNDAMENTAL GROWTH V.I. FUND
DECEMBER 31, 2002--ANNUAL REPORT
- --------------------------------------------------------------------------------
DEAR SHAREHOLDER:
FISCAL YEAR IN REVIEW
For the 12 months ended December 31, 2002, the Fund's Class A Shares had a
total return of -27.51%, compared to a total return of -28.63% for the Lipper
Large Cap Growth Fund Average. For the same 12-month period, the Fund's
unmanaged benchmarks had a return of -22.10% as measured by the Standard &
Poor's (S&P) 500 Index and -23.59% as measured by the S&P 500 Barra Growth
Index. This was an unprecedented third consecutive calendar year with negative
investment returns for large cap growth stocks in the post-World War II period.
The most negative influence on the Fund's investment performance during the
fiscal year was the decline of selected holdings in the hospital management and
information technology industries. The single most negative stock investment on
a comparative basis was the Fund's investment holding in AOL Time Warner Inc.
Positive comparative influences on the Fund's investment returns came from
selected holdings in the specialty retailing, restaurant, media, food and
financial services industries. Equity investments in the following companies had
a positive effect on the comparative investment performance over the calendar
year 2002. These companies were: Bed, Bath & Beyond Inc., Lowe's Companies,
Inc., Target Corporation, YUM! Brands, Inc. and Brinker International, Inc. in
the retailing and restaurant industries; Unilever N.V., Anheuser-Busch
Companies, Inc. and Coca-Cola Enterprises Inc. in the food and beverage
industries; and Marsh & McLennan Companies, Inc., Wells Fargo Company, MBNA
Corp., T. Rowe Price Group Inc. and American Express Co. in the financial
services industry.
INVESTMENT ENVIRONMENT
In our opinion, a negative influence on stock market valuations is the "war on
terrorism" policy, which is being pursued by the Bush administration.
Historically, on average the U.S. equity markets have not provided above-
average investment returns during periods of pending or actual armed conflict.
However, typically U.S. stock markets have risen meaningfully after the
resolution of war as they did after the conclusion of the Gulf War in 1991 and
the end of the Vietnam War in late 1974 and early 1975.
PORTFOLIO MATTERS
The Fund's largest sector for investment is consumer discretionary at over 17%
of net assets at year-end 2002. In our opinion, we should be optimistic about
the U.S. Congress passing President Bush's tax bill with potentially positive
developments in terms of increases in the rate of real growth of consumer
spending. More than 12% of the net assets at December 31, 2002 were invested in
stocks in the bank, diversified financials and insurance industries, which could
see price appreciation if overall U.S. equity markets and interest rates rise
with a recovery in the rate of real economic growth in the United States as a
result of fiscal policy initiatives at the Federal level of government.
IN CONCLUSION
We appreciate your investment in Fundamental Growth V.I. Fund of Merrill Lynch
Variable Series Funds, Inc., and we look forward to discussing our investment
outlook and strategies with you in our next report to shareholders.
Sincerely,
/s/ Terry K. Glenn
Terry K. Glenn
President and Director
/s/ Lawrence R. Fuller
Lawrence R. Fuller
Senior Vice President and Portfolio Manager
January 17, 2003
100
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--FUNDAMENTAL GROWTH V.I. FUND
TOTAL RETURN BASED ON A $10,000 INVESTMENT--CLASS A SHARES
- --------------------------------------------------------------------------------
<Table>
<Caption>
FUNDAMENTAL GROWTH V.I. STANDARD & POOR'S 500 STANDARD & POOR'S 500
FUND+--CLASS A SHARES* INDEX++ BARRA GROWTH INDEX+++
----------------------- --------------------- ---------------------
4/03/00** 10000.00 10000.00 10000.00
12/00 9273.00 9161.00 7874.00
12/01 7593.00 8072.00 6871.00
12/02 5504.00 6288.00 5250.00
</Table>
* Assuming transaction costs and other operating expenses, including advisory
fees. Does not include insurance-related fees and expenses.
** The Fund commenced operations on 4/03/00.
+ The Fund invests primarily in equity securities with a particular emphasis on
companies that have exhibited above-average rates of growth earnings over the
long term.
++ This unmanaged Index covers 500 industrial, utility, transportation and
financial companies of the U.S. markets (mostly NYSE issues), representing
about 75% of NYSE market capitalization and 30% of NYSE issues. The starting
date for the Index in the graph is from 4/28/00.
+++ This unmanaged Index is a capitalization-weighted index of all the stocks in
the Standard & Poor's 500 Index that have higher price-to-book ratios. The
starting date for the Index is from 4/28/00.
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--FUNDAMENTAL GROWTH V.I. FUND
AVERAGE ANNUAL TOTAL RETURN--CLASS A SHARES*
- --------------------------------------------------------------------------------
<Table>
<Caption>
PERIOD COVERED % RETURN
- ----------------------------------------------------------------------
One Year Ended 12/31/02 -27.51%
- ----------------------------------------------------------------------
Inception (4/03/00) to 12/31/02 -19.55
- ----------------------------------------------------------------------
</Table>
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--FUNDAMENTAL GROWTH V.I. FUND
RECENT PERFORMANCE RESULTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
6-MONTH 12-MONTH
AS OF DECEMBER 31, 2002 TOTAL RETURN TOTAL RETURN
- -----------------------------------------------------------------------------------------
Class A Shares* -12.41% -27.51%
- -----------------------------------------------------------------------------------------
Standard & Poor's 500 Index** -10.30 -22.10
- -----------------------------------------------------------------------------------------
Standard & Poor's 500 Barra Growth Index*** - 8.02 -23.59
- -----------------------------------------------------------------------------------------
</Table>
* Total investment returns are based on changes in net asset value for the
periods shown, and assume reinvestment of all dividends and capital gains
distributions at net asset value on the ex-dividend date. Insurance-related
fees and expenses are not reflected in these returns.
**This unmanaged Index covers 500 industrial, utility, transportation and
financial companies of the U.S. markets (mostly NYSE issues), representing
about 75% of the NYSE market capitalization and 30% of NYSE issues.
***This unmanaged Index is a capitalization-weighted index of all the stocks in
the Standard & Poor's 500 Index that have higher price-to-book ratios.
Past results shown should not be considered a representation of future
performance.
101
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--FUNDAMENTAL GROWTH V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
INDUSTRY++ HELD COMMON STOCKS VALUE NET ASSETS
- ----------------------------------------------------------------------------------------------------------------------
AEROSPACE & DEFENSE 31,600 General Dynamics Corporation.............. $ 2,508,092 1.3%
- ----------------------------------------------------------------------------------------------------------------------
AIR FREIGHT & LOGISTICS 52,800 United Parcel Service, Inc. (Class B)..... 3,330,624 1.7
- ----------------------------------------------------------------------------------------------------------------------
BANKS 74,700 Northern Trust Corporation................ 2,605,536 1.3
58,300 Washington Mutual, Inc. .................. 2,013,099 1.0
------------ -----
4,618,635 2.3
- ----------------------------------------------------------------------------------------------------------------------
BEVERAGES 77,100 Anheuser-Busch Companies, Inc. ........... 3,731,640 1.9
114,800 The Coca-Cola Company..................... 5,030,536 2.5
72,200 Coca-Cola Enterprises Inc. ............... 1,568,184 0.8
------------ -----
10,330,360 5.2
- ----------------------------------------------------------------------------------------------------------------------
BIOTECHNOLOGY 91,600 +Amgen Inc. .............................. 4,428,860 2.2
- ----------------------------------------------------------------------------------------------------------------------
CHEMICALS 35,700 Ecolab Inc. .............................. 1,767,150 0.9
- ----------------------------------------------------------------------------------------------------------------------
COMMERCIAL SERVICES & 77,900 First Data Corporation.................... 2,758,439 1.4
SUPPLIES
70,800 H & R Block, Inc. ........................ 2,846,160 1.4
------------ -----
5,604,599 2.8
- ----------------------------------------------------------------------------------------------------------------------
COMMUNICATIONS EQUIPMENT 260,300 +Cisco Systems, Inc. ..................... 3,407,327 1.7
- ----------------------------------------------------------------------------------------------------------------------
COMPUTERS & PERIPHERALS 67,900 International Business Machines
Corporation............................. 5,262,250 2.6
- ----------------------------------------------------------------------------------------------------------------------
DIVERSIFIED FINANCIALS 88,900 American Express Company.................. 3,142,615 1.6
51,100 Fannie Mae................................ 3,287,263 1.6
104,600 State Street Corporation.................. 4,079,400 2.0
71,300 T. Rowe Price Group Inc. ................. 1,942,925 1.0
------------ -----
12,452,203 6.2
- ----------------------------------------------------------------------------------------------------------------------
FOOD & DRUG RETAILING 75,800 SYSCO Corporation......................... 2,258,082 1.1
- ----------------------------------------------------------------------------------------------------------------------
FOOD PRODUCTS 52,300 Unilever NV (NY Registered Shares)........ 3,227,433 1.6
- ----------------------------------------------------------------------------------------------------------------------
HEALTH CARE EQUIPMENT & 42,400 +Alcon, Inc. ............................. 1,672,680 0.8
SUPPLIES
85,100 +Boston Scientific Corporation............ 3,618,452 1.8
34,500 Medtronic, Inc. .......................... 1,573,200 0.8
26,300 Stryker Corporation....................... 1,765,256 0.9
42,100 +Zimmer Holdings, Inc. ................... 1,747,992 0.9
------------ -----
10,377,580 5.2
- ----------------------------------------------------------------------------------------------------------------------
HEALTH CARE PROVIDERS & 93,200 HCA Inc. ................................. 3,867,800 1.9
SERVICES
96,700 Health Management Associates, Inc. (Class
A)...................................... 1,730,930 0.9
79,000 +Tenet Healthcare Corporation............. 1,295,600 0.6
------------ -----
6,894,330 3.4
- ----------------------------------------------------------------------------------------------------------------------
HOTELS, RESTAURANTS & 26,800 +Brinker International, Inc. ............. 864,300 0.4
LEISURE
100,400 +YUM! Brands, Inc. ....................... 2,431,688 1.2
------------ -----
3,295,988 1.6
- ----------------------------------------------------------------------------------------------------------------------
HOUSEHOLD PRODUCTS 39,100 The Clorox Company........................ 1,612,875 0.8
34,800 Colgate-Palmolive Company................. 1,824,564 0.9
63,100 The Procter & Gamble Company.............. 5,422,814 2.7
------------ -----
8,860,253 4.4
- ----------------------------------------------------------------------------------------------------------------------
INDUSTRIAL CONGLOMERATES 28,900 3M Co. ................................... 3,563,370 1.8
- ----------------------------------------------------------------------------------------------------------------------
INSURANCE 25,400 American International Group, Inc. ....... 1,469,390 0.7
52,000 Everest Re Group, Ltd. ................... 2,875,600 1.5
74,000 Marsh & McLennan Companies, Inc. ......... 3,419,540 1.7
------------ -----
7,764,530 3.9
- ----------------------------------------------------------------------------------------------------------------------
</Table>
102
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--FUNDAMENTAL GROWTH V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONCLUDED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
INDUSTRY++ HELD COMMON STOCKS VALUE NET ASSETS
- ----------------------------------------------------------------------------------------------------------------------
MEDIA 263,100 +AOL Time Warner Inc. .................... $ 3,446,610 1.7%
86,900 +Clear Channel Communications, Inc. ...... 3,240,501 1.6
58,400 +Fox Entertainment Group, Inc. (Class
A)...................................... 1,514,312 0.8
112,500 +Rogers Communications, Inc. (Class B).... 1,043,961 0.5
100,000 +Viacom, Inc. (Class B)................... 4,076,000 2.0
------------ -----
13,321,384 6.6
- ----------------------------------------------------------------------------------------------------------------------
MULTILINE RETAIL 12,000 +Kohl's Corporation....................... 671,400 0.3
145,700 Wal-Mart Stores, Inc. .................... 7,359,307 3.7
------------ -----
8,030,707 4.0
- ----------------------------------------------------------------------------------------------------------------------
SEMICONDUCTOR EQUIPMENT & 272,500 Intel Corporation......................... 4,240,100 2.1
PRODUCTS
- ----------------------------------------------------------------------------------------------------------------------
SOFTWARE 36,500 +Electronic Arts Inc. .................... 1,814,415 0.9
156,800 +Microsoft Corporation.................... 8,108,128 4.0
------------ -----
9,922,543 4.9
- ----------------------------------------------------------------------------------------------------------------------
SPECIALTY RETAIL 45,100 +Bed Bath & Beyond Inc. .................. 1,558,656 0.8
67,100 Lowe's Companies, Inc. ................... 2,516,250 1.3
85,700 The TJX Companies, Inc. .................. 1,672,864 0.8
------------ -----
5,747,770 2.9
- ----------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN COMMON STOCKS
(COST--$166,290,097) 141,214,170 70.4
- ----------------------------------------------------------------------------------------------------------------------
<Caption>
PARTNERSHIP
INTEREST SHORT-TERM SECURITIES
- ----------------------------------------------------------------------------------------------------------------------
$17,848,295 Merrill Lynch Liquidity Series, LLC Cash
Sweep Series II (a)..................... 17,848,295 8.9
- ----------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN SHORT-TERM SECURITIES
(COST--$17,848,295) 17,848,295 8.9
- ----------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS
(COST--$184,138,392)...................... 159,062,465 79.3
OTHER ASSETS LESS LIABILITIES............. 41,461,856 20.7
------------ -----
NET ASSETS................................ $200,524,321 100.0%
============ =====
- ----------------------------------------------------------------------------------------------------------------------
</Table>
(a) Investments in companies considered to be an affiliate of the Fund (such
companies are defined as "Affiliated Companies" in Section 2(a)(3) of the
Investment Company Act of 1940) are as follows:
<Table>
<Caption>
- ------------------------------------------------------------------------------------------------------
NET INTEREST
AFFILIATE ACTIVITY NET COST INCOME
- ------------------------------------------------------------------------------------------------------
Merrill Lynch Liquidity Series, LLC Cash Sweep Series II.... $17,848,295 $17,848,295 $20,130
- ------------------------------------------------------------------------------------------------------
</Table>
+ Non-income producing security.
++ For Fund compliance purposes, "Industry" means any one or more of the
industry sub-classifications used by one or more widely recognized market
indexes or ratings group indexes, and/or as defined by Fund management. This
definition may not apply for purposes of this report, which may combine such
industry sub-classifications for reporting ease. These industry
classifications are unaudited.
See Notes to Financial Statements.
103
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--FUNDAMENTAL GROWTH V.I. FUND
STATEMENT OF ASSETS AND LIABILITIES AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
ASSETS:
Investments, at value (including securities loaned of
$18,939,028) (identified cost--$184,138,392).............. $159,062,465
Investments held as collateral for loaned securities, at
value..................................................... 19,288,552
Receivables:
Capital shares sold....................................... $ 42,201,692
Securities sold........................................... 591,975
Dividends................................................. 108,099
Interest.................................................. 16,681
Loaned securities income.................................. 1,507 42,919,954
------------
Prepaid expenses............................................ 867
------------
Total assets................................................ 221,271,838
------------
- -----------------------------------------------------------------------------------------
LIABILITIES:
Collateral on securities loaned, at value................... 19,288,552
Payables:
Securities purchased...................................... 1,283,605
Investment adviser........................................ 92,261
Capital shares redeemed................................... 40,269 1,416,135
------------
Accrued expenses............................................ 42,830
------------
Total liabilities........................................... 20,747,517
------------
- -----------------------------------------------------------------------------------------
NET ASSETS.................................................. $200,524,321
============
- -----------------------------------------------------------------------------------------
NET ASSETS CONSIST OF:
Class A Shares of Common Stock, $.10 par value, 100,000,000
shares authorized+........................................ $ 3,674,136
Paid-in capital in excess of par............................ 255,999,417
Accumulated distributions in excess of investment
income--net............................................... $ (13,625)
Accumulated realized capital losses on investments and
foreign currency transactions--net........................ (34,059,760)
Unrealized depreciation on investments and foreign currency
transactions--net......................................... (25,075,847)
------------
Total accumulated losses--net............................... (59,149,232)
------------
NET ASSETS.................................................. $200,524,321
============
- -----------------------------------------------------------------------------------------
NET ASSET VALUE:
Class A--Based on net assets of $200,524,321 and 36,741,355
shares outstanding........................................ $ 5.46
============
- -----------------------------------------------------------------------------------------
</Table>
+ The Fund is also authorized to issue 100,000,000 Class B Shares.
See Notes to Financial Statements.
104
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--FUNDAMENTAL GROWTH V.I. FUND
STATEMENT OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
INVESTMENT INCOME:
Dividends (net of $12,497 foreign withholding tax).......... $ 1,052,998
Interest.................................................... 279,018
Securities lending--net..................................... 8,746
------------
Total income................................................ 1,340,762
------------
- -----------------------------------------------------------------------------------------
EXPENSES:
Investment advisory fees.................................... $ 1,028,228
Accounting services......................................... 54,004
Custodian fees.............................................. 27,071
Professional fees........................................... 22,908
Transfer agent fees......................................... 16,812
Printing and shareholder reports............................ 13,324
Offering costs.............................................. 12,343
Directors' fees and expenses................................ 6,565
Pricing services............................................ 3,195
Registration fees........................................... 759
Other....................................................... 8,130
------------
Total expenses.............................................. 1,193,339
------------
Investment income--net...................................... 147,423
------------
- -----------------------------------------------------------------------------------------
REALIZED & UNREALIZED LOSS ON INVESTMENTS & FOREIGN CURRENCY
TRANSACTIONS--NET:
Realized loss from:
Investments--net.......................................... (22,618,868)
Foreign currency transactions--net........................ (4,342) (22,623,210)
------------
Change in unrealized appreciation/depreciation on:
Investments--net.......................................... (26,926,594)
Foreign currency transactions--net........................ (1,725) (26,928,319)
------------ ------------
Total realized and unrealized loss on investments and
foreign currency transactions--net........................ (49,551,529)
------------
NET DECREASE IN NET ASSETS RESULTING FROM OPERATIONS........ $(49,404,106)
============
- -----------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
105
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--FUNDAMENTAL GROWTH V.I. FUND
STATEMENTS OF CHANGES IN NET ASSETS
- --------------------------------------------------------------------------------
<Table>
<Caption>
FOR THE YEAR ENDED
DECEMBER 31,
----------------------------
INCREASE (DECREASE) IN NET ASSETS: 2002 2001
- ------------------------------------------------------------------------------------------
OPERATIONS:
Investment income--net...................................... $ 147,423 $ 342,526
Realized loss on investments and foreign currency
transactions--net......................................... (22,623,210) (9,841,560)
Change in unrealized appreciation/depreciation on
investments and foreign currency transactions--net........ (26,928,319) 2,577,663
------------ ------------
Net decrease in net assets resulting from operations........ (49,404,106) (6,921,371)
------------ ------------
- ------------------------------------------------------------------------------------------
DIVIDENDS TO SHAREHOLDERS:
Investment income--net:
Class A................................................... (161,537) (353,430)
------------ ------------
Net decrease in net assets resulting from dividends to
shareholders.............................................. (161,537) (353,430)
------------ ------------
- ------------------------------------------------------------------------------------------
CAPITAL SHARE TRANSACTIONS:
Net increase in net assets derived from capital share
transactions.............................................. 86,872,424 138,012,447
------------ ------------
- ------------------------------------------------------------------------------------------
NET ASSETS:
Total increase in net assets................................ 37,306,781 130,737,646
Beginning of year........................................... 163,217,540 32,479,894
------------ ------------
End of year*................................................ $200,524,321 $163,217,540
============ ============
- ------------------------------------------------------------------------------------------
* Accumulated distributions in excess of investment
income--net............................................... $ (13,625) $ (7,513)
============ ============
- ------------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
106
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--FUNDAMENTAL GROWTH V.I. FUND
FINANCIAL HIGHLIGHTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
CLASS A
THE FOLLOWING PER SHARE DATA AND RATIOS HAVE BEEN DERIVED ----------------------------------------
FROM INFORMATION PROVIDED IN THE FINANCIAL STATEMENTS. FOR THE YEAR ENDED FOR THE PERIOD
DECEMBER 31, APRIL 3, 2000+
---------------------- TO DECEMBER 31,
DECREASE IN NET ASSET VALUE: 2002 2001 2000
- ------------------------------------------------------------------------------------------------------
PER SHARE OPERATING PERFORMANCE:
Net asset value, beginning of period........................ $ 7.54 $ 9.23 $ 10.00
-------- -------- -------
Investment income--net...................................... .01++++ .04++++ .03
Realized and unrealized loss on investments and foreign
currency transactions--net................................ (2.08) (1.71) (.76)
-------- -------- -------
Total from investment operations............................ (2.07) (1.67) (.73)
-------- -------- -------
Less dividends:
Investment income--net.................................... (.01) (.02) (.04)
In excess of investment income--net....................... -- -- --++
-------- -------- -------
Total dividends............................................. (.01) (.02) (.04)
-------- -------- -------
Net asset value, end of period.............................. $ 5.46 $ 7.54 $ 9.23
======== ======== =======
- ------------------------------------------------------------------------------------------------------
TOTAL INVESTMENT RETURN:**
Based on net asset value per share.......................... (27.51%) (18.12%) (7.27%)(++)
======== ======== =======
- ------------------------------------------------------------------------------------------------------
RATIOS TO AVERAGE NET ASSETS:
Expenses, net of reimbursement.............................. .75% .79% 1.09%*
======== ======== =======
Expenses.................................................... .75% .79% 1.12%*
======== ======== =======
Investment income--net...................................... .09% .57% 1.18%*
======== ======== =======
- ------------------------------------------------------------------------------------------------------
SUPPLEMENTAL DATA:
Net assets, end of period (in thousands).................... $200,524 $163,218 $32,480
======== ======== =======
Portfolio turnover.......................................... 89.61% 94.56% 95.44%
======== ======== =======
- ------------------------------------------------------------------------------------------------------
</Table>
*Annualized.
**Total investment returns exclude insurance-related fees and expenses. If
applicable, the Company's Investment Adviser waived a portion of its
management fee. Without such waiver, the Fund's performance would have been
lower.
+Commencement of operations.
++Amount is less than $.01 per share.
(++)Aggregate total investment return.
++++Based on average shares outstanding.
See Notes to Financial Statements.
107
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--FUNDAMENTAL GROWTH V.I. FUND
NOTES TO FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
1. SIGNIFICANT ACCOUNTING POLICIES:
Merrill Lynch Variable Series Funds, Inc. (the "Company") is an open-end
management investment company that is comprised of 17 separate funds. Each fund
offers two classes of shares to the Merrill Lynch Life Insurance Company
("MLLIC"), ML Life Insurance Company of New York (indirect, wholly-owned
subsidiaries of Merrill Lynch & Co., Inc. ("ML & Co.")), and other insurance
companies that are not affiliated with ML & Co., for their separate accounts to
fund benefits under certain variable annuity and variable life insurance
contracts. Fundamental Growth V.I. Fund (the "Fund") (formerly Fundamental
Growth Focus Fund) is classified as "diversified," as defined in the Investment
Company Act of 1940. Class A and Class B Shares have equal voting, dividend,
liquidation and other rights, except that only shares of the respective classes
are entitled to vote on matters concerning only that class and Class B Shares
bear certain expenses related to the distribution of such shares. The Fund's
financial statements are prepared in conformity with accounting principles
generally accepted in the United States of America, which may require the use of
management accruals and estimates. The following is a summary of significant
accounting policies followed by the Fund.
(a) Valuation of investments--Portfolio securities that are traded on stock
exchanges are valued at the last sale price on the exchange on which such
securities are traded, 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
that are traded in the over-the-counter market are valued at the last available
bid price prior to the time of valuation. In cases where securities are traded
on more than one exchange, the securities are valued on the exchange designated
by or under the authority of the Board of Directors as the primary market.
Securities that are traded both in the over-the-counter 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 would be the
over-the-counter market. Options written or purchased are valued at the last
sale price in the case of exchange-traded options. In the case of options traded
in the over-the-counter market, valuation is the last asked price (options
written) or the last bid price (options purchased). Short-term securities are
valued at amortized cost, which approximates market value. Futures contracts are
valued at the 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.
(b) Derivative financial instruments--The Fund may engage in various portfolio
investment strategies to increase or decrease the level of risk to which the
Fund is exposed more quickly and efficiently than transactions in other types of
instruments. Losses may arise due to changes in the value of the contract or if
the counterparty does not perform under the contract.
- - Forward foreign exchange contracts--The Fund is authorized to enter into
forward foreign exchange contracts as a hedge against either specific
transactions or portfolio positions. The contract is marked to market daily and
the change in market value is recorded by the Fund as an unrealized gain or
loss. When the contract is closed, the Fund records a realized gain or loss
equal to the difference between the value at the time it was opened and the
value at the time it was closed.
- - Options--The Fund may write and purchase call and put options. When the Fund
writes an option, an amount equal to the premium received by the Fund is
reflected as an asset and an equivalent liability. The amount of the liability
is subsequently marked to market to reflect the current market value of the
option written. When a security is purchased or sold through an exercise of an
option, the related premium paid or received is added to (or deducted from) the
basis of the security acquired or deducted from (or added to) the proceeds of
the security sold. When an option expires (or the Fund enters into a closing
transaction), the Fund realizes a gain or loss on the option to the extent of
the premiums received or paid (or gain or loss to the extent the cost of the
closing transaction exceeds the premium paid or received).
Written and purchased options are non-income producing investments.
- - Financial futures contracts--The Fund may purchase or sell financial futures
contracts and options on such futures contracts for the purpose of hedging the
market risk on existing securities or the intended purchase of securities.
Futures contracts are contracts for delayed delivery of securities at a specific
future date and at a specific price or yield. Upon entering into a contract, the
Fund deposits and maintains as collateral such initial margin as required by the
exchange on which the transaction is
108
- --------------------------------------------------------------------------------
effected. Pursuant to the contract, the Fund agrees to receive from or pay to
the broker an amount of cash equal to the daily fluctuation in value of the
contract. Such receipts or payments are known as variation margin and are
recorded by the Fund as unrealized gains or losses. When the contract is closed,
the Fund records a realized gain or loss equal to the difference between the
value of the contract at the time it was opened and the value at the time it was
closed.
- - Foreign currency options and futures--The Fund may also purchase or sell
listed or over-the-counter foreign currency options, foreign currency futures
and related options on foreign currency futures as a short or long hedge against
possible variations in foreign exchange rates. Such transactions may be effected
with respect to hedges on non-U.S. dollar denominated securities owned by the
Fund, sold by the Fund but not yet delivered, or committed or anticipated to be
purchased by the Fund.
(c) Foreign currency transactions--Trans-
actions denominated in foreign currencies are recorded at the exchange rate
prevailing when recognized. Assets and liabilities denominated in foreign
currencies are valued at the exchange rate at the end of the period. Foreign
currency transactions are the result of settling (realized) or valuing
(unrealized) assets and liabilities expressed in foreign currencies into U.S.
dollars. Realized and unrealized gains or losses from investments include the
effects of foreign exchange rates on investments.
(d) Income taxes--It is the Fund's policy to comply with the requirements of
the Internal Revenue Code applicable to regulated investment companies and to
distribute substantially all of its taxable income to its shareholders.
Therefore, no Federal income tax provision is required. Under the applicable
foreign tax law, a withholding tax may be imposed on interest, dividends and
capital gains at various rates.
(e) Security transactions and investment income--Security transactions are
recorded on the dates the transactions are entered into (the trade dates).
Realized gains and losses on security transactions are determined on the
identified cost basis. Dividend income is recorded on the ex-dividend dates.
Dividends from foreign securities where the ex-dividend date may have passed are
subsequently recorded when the Fund has determined the ex-dividend date.
Interest income is recognized on the accrual basis.
(f) Dividends and distributions--Dividends and distributions paid by the Fund
are recorded on the ex-dividend dates.
(g) Expenses--Certain expenses have been allocated to the individual funds in
the Company on a pro rata basis based upon the respective aggregate net asset
value of each fund included in the Company.
(h) Securities lending--The Fund may lend securities to financial institutions
that provide cash or securities issued or guaranteed by the U.S. government as
collateral, which will be maintained at all times in an amount equal to at least
100% of the current market value of the loaned securities. Where the Fund
receives securities as collateral for the loaned securities, it collects a fee
from the borrower. The Fund typically receives the income on the loaned
securities but does not receive the income on the collateral. Where the Fund
receives cash collateral, it may invest such collateral and retain the amount
earned on such investment, net of any amount rebated to the borrower. Loans of
securities are terminable at any time and the borrower, after notice, is
required to return borrowed securities within five business days. The Fund may
pay reasonable finder's, lending agent, administrative and custodial fees in
connection with its loans. In the event that the borrower defaults on its
obligation to return borrowed securities because of insolvency or for any other
reason, the Fund could experience delays and costs in gaining access to the
collateral. The Fund also could suffer a loss where the value of the collateral
falls below the market value of the borrowed securities, in the event of
borrower default or in the event of losses on investments made with cash
collateral.
(i) Reclassification--Accounting principles generally accepted in the United
States of America require that certain components of net assets be adjusted to
reflect permanent differences between financial and tax reporting. Accordingly,
the current year's permanent book/tax differences of $4,341 has been
reclassified between accumulated distributions in excess of net investment
income and accumulated net realized capital losses and $12,343 has been
reclassified between paid-in capital in excess of par and accumulated
distributions in excess of net investment income. These classifications have no
effect on net assets or net asset values per share.
2. INVESTMENT ADVISORY AGREEMENT AND TRANSACTIONS WITH AFFILIATES:
The Company has entered into an Investment Advisory Agreement with Merrill Lynch
Investment Managers, L.P. ("MLIM"). The general partner of MLIM is Princeton
Services, Inc. ("PSI"), an indirect, wholly-owned
109
- --------------------------------------------------------------------------------
subsidiary of ML & Co., which is the limited partner.
MLIM is responsible for the management of the Company's funds and provides the
necessary personnel, facilities, equipment and certain other services necessary
to the operations of the Fund. For such services, the Fund pays a monthly fee at
the annual rate of .65% of the average daily value of the Fund's net assets.
MLIM and Merrill Lynch Life Agency, Inc. ("MLLA") have entered into an
agreement which limits the operating expenses paid by the Fund, exclusive of any
distribution fees imposed on Class B Shares, to 1.25% of its average daily net
assets. Any expenses in excess of 1.25% of average daily net assets will be
reimbursed to the Fund by MLIM which, in turn, will be reimbursed by MLLA.
The Company has received an exemptive order from the Securities and Exchange
Commission permitting it to lend portfolio securities to Merrill Lynch, Pierce,
Fenner & Smith Incorporated ("MLPF&S"), a subsidiary of ML & Co., or its
affiliates. Pursuant to that order, the Company also has retained Merrill Lynch
Investment Managers, LLC ("MLIM, LLC"), an affiliate of MLIM, as the securities
lending agent for a fee based on a share of the returns on investment of cash
collateral. MLIM, LLC may, on behalf of the Company and the Fund, invest cash
collateral received by the Fund for such loans, among other things, in a private
investment company managed by MLIM, LLC or in registered money market funds
advised by MLIM or its affiliates. As of December 31, 2002, cash collateral of
$10,222,932 was invested in the Money Market Series of the Merrill Lynch
Liquidity Series, LLC and $9,065,620 was invested in the Merrill Lynch Premier
Institutional Fund. As of December 31, 2002, the Fund lent securities with a
value of $8,543,765 to MLPF&S or its affiliates. For the year ended December 31,
2002, MLIM, LLC received $3,831 in securities lending agent fees from the Fund.
For the year ended December 31, 2002, MLPF&S earned $65,539 in commissions on
the execution of portfolio security transactions.
Financial Data Services, Inc. ("FDS"), a wholly-owned subsidiary of ML & Co.,
is the Company's transfer agent.
FAM Distributors, Inc. ("FAMD"), which is a wholly-owned subsidiary of Merrill
Lynch Group, Inc., is the Fund's distributor.
For the year ended December 31, 2002, the Fund reimbursed MLIM $4,415 for
certain accounting services.
Certain officers and/or directors of the Company are officers and/or directors
of MLIM, PSI, FDS, FAMD, and/or ML & Co.
3. INVESTMENTS:
Purchases and sales of investments, excluding short-term securities, for the
year ended December 31, 2002 were $190,924,215 and $127,462,448, respectively.
Net realized gains (losses) for the year ended December 31, 2002 and net
unrealized gains (losses) as of December 31, 2002 were as follows:
<Table>
<Caption>
- --------------------------------------------------------------------
Realized Unrealized
Gains (Losses) Gains (Losses)
- --------------------------------------------------------------------
Long-term investments............. $(22,619,123) $(25,075,927)
Short-term investments............ 255 --
Foreign currency transactions..... (4,342) 80
------------ ------------
Total............................. $(22,623,210) $(25,075,847)
============ ============
- --------------------------------------------------------------------
</Table>
At December 31, 2002, net unrealized depreciation for Federal income tax
purposes aggregated $26,029,324, of which $1,020,839 related to appreciated
securities and $27,050,163 related to depreciated securities. At December 31,
2002, the aggregate cost of investments for Federal income tax purposes was
$185,091,789.
4. CAPITAL SHARE TRANSACTIONS:
Transactions in capital shares were as follows:
<Table>
<Caption>
- -----------------------------------------------------------------
Class A Shares for the Year Ended Dollar
December 31, 2002 Shares Amount
- -----------------------------------------------------------------
Shares sold.......................... 22,309,012 $137,179,860
Shares issued to shareholders in
reinvestment of dividends........... 29,280 161,537
---------- ------------
Total issued......................... 22,338,292 137,341,397
Shares redeemed...................... (7,255,296) (50,468,973)
---------- ------------
Net increase......................... 15,082,996 $ 86,872,424
========== ============
- -----------------------------------------------------------------
</Table>
<Table>
<Caption>
- -----------------------------------------------------------------
Class A Shares for the Year Ended Dollar
December 31, 2001 Shares Amount
- -----------------------------------------------------------------
Shares sold.......................... 19,886,781 $151,112,743
Shares issued to shareholders in
reinvestment of dividends........... 46,511 353,430
---------- ------------
Total issued......................... 19,933,292 151,466,173
Shares redeemed...................... (1,793,093) (13,453,726)
---------- ------------
Net increase......................... 18,140,199 $138,012,447
========== ============
- -----------------------------------------------------------------
</Table>
5. SHORT-TERM BORROWINGS:
The Fund, along with certain other funds managed by MLIM and its affiliates, is
a party to a credit agreement with Bank One, N.A. and certain other lenders.
Effective November 29, 2002, in conjunction with the renewal for one year at the
same terms, the total commitment was reduced from $1,000,000,000 to
$500,000,000. The Fund may borrow under the credit agreement to fund shareholder
redemptions and for other lawful purposes other
110
- --------------------------------------------------------------------------------
than for leverage. The Fund may borrow up to the maximum amount allowable under
the Fund's current prospectus and statement of additional information, subject
to various other legal, regulatory or contractual limits. The Fund pays a
commitment fee of .09% per annum based on the Fund's pro rata share of the
unused portion of the credit agreement. Amounts borrowed under the credit
agreement bear interest at a rate equal to, at each fund's election, the Federal
Funds rate plus .50% or a base rate as determined by Bank One, N.A. The Fund did
not borrow under the credit agreement during the year ended December 31, 2002.
6. DISTRIBUTIONS TO SHAREHOLDERS:
The tax character of distributions paid during the fiscal years ended December
31, 2002 and December 31, 2001 was as follows:
<Table>
<Caption>
- ------------------------------------------------------------------
12/31/2002 12/31/2001
- ------------------------------------------------------------------
Distributions paid from:
Ordinary income......................... $161,537 $353,430
-------- --------
Total taxable distributions.............. $161,537 $353,430
======== ========
- ------------------------------------------------------------------
</Table>
As of December 31, 2002, the components of accumulated losses on a tax basis
were as follows:
<Table>
- -----------------------------------------------------------------
Undistributed ordinary income--net................. $ --
Undistributed long-term capital gains--net......... --
------------
Total undistributed earnings--net.................. --
Capital loss carryforward.......................... (31,096,958)*
Unrealized losses--net............................. (28,052,274)**
------------
Total accumulated losses--net...................... $(59,149,232)
============
- -----------------------------------------------------------------
</Table>
* On December 31, 2002, the Fund had a net capital loss carryforward of
$31,096,958, of which $110,592 expires in 2008, $10,750,741 expires in 2009
and $20,235,625 expires in 2010. This amount will be available to offset like
amounts of any future taxable gains.
** The difference between book-basis and tax-basis net unrealized losses is
attributable primarily to the tax deferral of losses on wash sales, the
deferral of post-October capital losses for tax purposes and other book/tax
temporary differences.
111
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--FUNDAMENTAL GROWTH V.I. FUND
INDEPENDENT AUDITORS' REPORT
- --------------------------------------------------------------------------------
THE BOARD OF DIRECTORS AND SHAREHOLDERS,
FUNDAMENTAL GROWTH FOCUS FUND OF
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.:
We have audited the accompanying statement of assets and liabilities,
including the schedule of investments, of Fundamental Growth V.I. Fund
(formerly, Fundamental Growth Focus Fund) of Merrill Lynch Variable Series
Funds, Inc. as of December 31, 2002, the related statements of operations for
the year then ended, changes in net assets for each of the years in the two year
period then ended, and the financial highlights for each of the periods
presented. These financial statements and the financial highlights are the
responsibility of the Fund's management. Our responsibility is to express an
opinion on these financial statements and the financial highlights based on our
audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements and the financial highlights are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. Our procedures included confirmation of
securities owned at December 31, 2002 by correspondence with the custodian and
brokers; where replies from brokers were not received, we performed other
auditing procedures. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such financial statements and financial highlights present
fairly, in all material respects, the financial position of Fundamental Growth
V.I. Fund of Merrill Lynch Variable Series Funds, Inc. as of December 31, 2002,
the results of its operations, the changes in its net assets, and the financial
highlights for the respective stated periods in conformity with accounting
principles generally accepted in the United States of America.
Deloitte & Touche LLP
Princeton, New Jersey
February 14, 2003
112
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL ALLOCATION V.I. FUND
DECEMBER 31, 2002--ANNUAL REPORT
- --------------------------------------------------------------------------------
DEAR SHAREHOLDER:
INVESTMENT STRATEGY
Global Allocation V.I. Fund seeks to provide high total investment return
through a flexible, value-oriented approach. The Fund invests in U.S. and global
equity and fixed income securities and is broadly diversified across asset
classes, countries and securities. Within the equity portion of the portfolio,
we look for undervalued companies that we believe are expected to generate
above-average rates of return. In selecting fixed income securities, we focus on
total return and credit analysis. Diversification is used as the key means of
risk management.
INVESTMENT ENVIRONMENT
During the 12-month period ended December 31, 2002, the unmanaged S&P 500
Index decreased by 22.10%, the unmanaged NASDAQ Composite Index declined by
31.26%, the unmanaged Dow Jones Euro Stoxx 50 Index declined by 35.65%, and the
unmanaged Nikkei 225 Index decreased by 17.96%. The uncertain U.S. economic
recovery was mirrored across economies globally and was reflected by poor equity
market performances. The U.S. equity market enjoyed a small rally in March 2002,
however, the overall trend was downward since that time, with market upturns
occurring in August and October of 2002. The year was marked by high volatility
in the equity markets driven by a rash of negative earnings announcements,
regulatory investigations and corporate accounting irregularities highlighted by
the bankruptcies of Enron Corporation (in December 2001) and WorldCom Inc. (in
July 2002). During the 12-month period ended December 31, 2002, the Federal
Reserve Board lowered the Federal Funds rate only once from 1.75% to 1.25% in
early November 2002 to its lowest rate since 1961.
The fiscal year ended December 31, 2002 began in the wake of the Enron
bankruptcy scandal and investors reacted by focusing on the corporate accounting
practices of the market's issuers. Announcements of regulatory investigations
into accounting for off-balance sheet partnerships and transactions disturbed
the markets in January 2002. Credit rating agency actions on corporate debt
ratings also moved to the forefront of investors' attention. Economic and
currency difficulties in Latin America impacted financial and energy companies
with Latin operations. Positive economic news prompted a rally in February 2002,
which continued into March. Federal Reserve Board Chairman Alan Greenspan
commented that the "expansion is well under way." The Federal Open Market
Committee announced that interest rates would be held steady, and until November
2002, they were. Toward the end of March 2002, investors became more focused on
company-specific issues as first quarter earnings releases loomed. The
Securities and Exchange Commission continued to disclose probes into accounting
practices at major U.S. companies. Corporations continued to announce lower
earnings reports, further employee reductions and balance sheet restructuring
initiatives. Liquidity in the capital markets continued to dry up in the context
of credit rating downgrades and continued negative newsflow from corporate
America.
Economic data released in early April 2002 was mixed. The NASDAQ Composite
Index hit a six-month low in late April, while the Dow Jones Industrial Average
touched its February low. The U.S. equity market had a short-lived rally in late
April on news that gross domestic product was up a seasonally adjusted 5.8% for
the first quarter because of strong growth in housing, consumer and government
spending. The month of April closed with news that earnings for S&P 500 Index
companies were down 11% on a year-over-year basis, and the expectation that the
Federal Reserve Board probably would not raise interest rates before the summer.
Global equity markets performed poorly in May and June 2002. The U.S. stock
market continued to slide downward on mixed economic data, which indicated a
weaker-than-expected recovery, coupled with negative newsflow from corporate
America. June brought better economic news with indications of strong growth in
manufacturing, expansion of the service economy and a fall in unemployment
claims for May 2002. Investor confidence was curbed by renewed concerns because
of violence in the Middle East and tensions between India and Pakistan.
Difficulties in Latin America continued as concerns about Brazil's ability to
pay its debt mounted. On the domestic front, questions on the reliability of
reported data were raised as major corporations admitted to wrongdoing. At the
end of June, economic data indicated that the recovery had slowed and that
consumer confidence had slipped further.
In July 2002, WorldCom Inc., with over $9 billion in misstated income,
declared the largest U.S. bankruptcy, sparking a marked sell-off in the equity
markets. Weaker-than-expected economic indicators also contributed to the
decline.
113
- --------------------------------------------------------------------------------
The market lifted on the announcement that the International Monetary Fund had
agreed to $30 billion of financing for Brazil, only to drop off dramatically in
September 2002 to hit four-year lows. Consumer confidence fell on concerns about
the faltering economic recovery and the possibility of a military conflict with
Iraq. The U.S. economy grew less than expected at 3.1% in the third quarter of
2002, restrained by a wider trade deficit and a decline in commercial
construction to the lowest level since 1996. The stock market rallied and U.S.
Treasury bond yields rose throughout October and November as investors reacted
to good housing data and as stronger consumer confidence data was reported at
the end of October and November. In November 2002, unemployment rates rose to
6%, matching the April 2002 level, which was an eight-year high for
unemployment. Most world markets fell in December 2002, unable to sustain their
October/November rallies in the shadow of higher unemployment, a weaker U.S.
dollar and the increasing likelihood of a military conflict between the United
States and Iraq.
FISCAL YEAR IN REVIEW
For the 12-month period ended December 31, 2002, the Fund's Class A Shares had
a total return of -8.15%. The Fund underperformed relative to its Reference
Portfolio, which returned -5.77% for the same period. The Fund outperformed the
equity components of its Reference Portfolio, while it underperformed the fixed
income components. For the year ended December 31, 2002, the Reference
Portfolio's components performed as follows: the unmanaged Standard & Poor's
(S&P) 500 Index had a return of -22.10%; the unmanaged FTSE World Index
(Ex-U.S.) had a return of -14.72%; the Merrill Lynch Treasury Index GA05
returned +12.34%; and the Salomon Brothers Non-US$ World Government Bond Index
returned +21.99%.
The Fund slightly underperformed relative to its Reference Portfolio for the
first half of the fiscal year ended December 31, 2002, with the Fund's Class A
Shares returning -2.36% at June 30, 2002, compared to the Reference Portfolio's
return of -2.31% for the same period. The Fund's underweight in fixed income
securities and its overweight in equities negatively impacted its performance.
At the end of the first half of the year, the U.S. Treasury market began a rally
that it sustained and continued into the fourth quarter of 2002. Although more
than 60% of the Fund's fixed income exposure was in high-grade U.S. and European
bonds, which performed quite well over the period, the Fund's weighting in fixed
income securities at June 30, 2002 was 31.2% of net assets as compared to its
Reference Portfolio's fixed income weighting of 40%. Adding to the Fund's
underperformance was its position in convertible securities and U.S.
non-investment grade fixed income securities, which closely correlated with the
downward trend in the equity markets. With 65.9% of net assets invested in
equities at June 30, 2002, the Fund was overweight compared to its Reference
Portfolio's equity weighting of 60%. During the six-month period, we increased
the Fund's weighting across equity markets, notably in the United States where
we increased its position from 34.5% of net assets to 39.2%, focusing on
undervalued large-capitalization companies in the financials, health care and
technology sectors. For this same six-month period, the Fund's equity weighting
in Europe increased slightly from 12.2% of net assets to 12.9%, and in the
Pacific Basin, we decreased the Fund's position from 14.9% of net assets to
12.5%. The Fund's cash position decreased during this period from 5.6% of net
assets to 2.9%.
Most of the Fund's underperformance relative to its Reference Portfolio
occurred during the second half of the fiscal year ended December 31, 2002. We
decreased the Fund's equity exposure during this period, ending the year with
60.1% of net assets invested in equities. The Fund continued to be overweight in
the energy, financials, materials, technology, telecommunications and utilities
sectors. With 60.1% of net assets invested in equities at December 31, 2002, the
Fund was essentially evenly weighted in equities as compared to its Reference
Portfolio's equity weighting of 60%. In addition, the Fund was significantly
underweight in fixed income securities at December 31, 2002, with 23.3% of the
Fund invested in bonds worldwide compared to the Reference Portfolio's weighting
of 40%. During the second half of the fiscal year, U.S. equities decreased from
39.2% of net assets to 38.0%, while non-U.S. equity holdings decreased from
26.3% of net assets to 22.1% for this period. Pacific Basin equities decreased
from 12.2% of net assets to 8.4% and European equity exposure remained
relatively unchanged at 12.9% of net assets for the period. We decreased the
Fund's weighting in U.S. dollar-denominated fixed income securities from 10.2%
of net assets to 8.7%, and decreased its weighting in euro-denominated bonds by
5.7%. Most of this reduction in European bond exposure resulted from a decrease
in weighting in high-grade bonds, which declined during the sixth-month period
from 21.2% of net assets to 13.3%. (The Fund's U.S. fixed income exposure
includes bonds of non-U.S. issuers denominated in U.S. dollars.) Approximately
4.4% of the Fund's net assets were invested in
114
- --------------------------------------------------------------------------------
convertible securities at December 31, 2002, and are reported as a portion of
the Fund's fixed income securities, although some of these securities may tend
to perform similarly to equities. Cash reserves increased from 2.9% of net
assets to 16.6% from June 30, 2002 to December 31, 2002. The Fund's net
weighting in the U.S. dollar was 65.0%, including both U.S. dollar-denominated
assets and the portion of the non-U.S. assets hedged back into dollars.
IN CONCLUSION
We appreciate your investment in Global Allocation V.I. Fund of Merrill Lynch
Variable Series Funds, Inc., and we look forward to serving your investment
needs in the months and years ahead.
Sincerely,
/s/ Terry K. Glenn
Terry K. Glenn
President and Director
/s/ Dennis W. Stattman
Dennis W. Stattman
Senior Vice President
January 17, 2003
- ---------------------------------------------------------
Merrill Lynch Investment Managers, L.P. regrets to announce the resignation of
Bryan Ison as one of the two co-portfolio managers of Global Allocation V.I.
Fund due to health reasons. We thank Bryan for his many years of extraordinary
service and wish him the very best for the future.
The Fund will continue to be managed by the other members of the portfolio
team. Dennis W. Stattman CFA is primarily responsible for the day-to-day
management of the Fund. Mr. Stattman has been Portfolio Manager of the Fund
since 2000 and Associate Portfolio Manager of the Fund since its inception in
1992.
The investment team includes Dan Chamby CFA, Karen Morely CFA, Lisa O'Donnell
JD, Catherine Brady Raushcer CFA and James Wei CFA, each of whom has been a
member of the Global Allocation Team for seven years or longer.
- ---------------------------------------------------------
115
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL ALLOCATION V.I. FUND
TOTAL RETURN BASED ON A $10,000 INVESTMENT--CLASS A SHARES
- --------------------------------------------------------------------------------
<Table>
<Caption>
GLOBAL ALLOCATION V.I.
FUND+--CLASS A SHARES* REFERENCE PORTFOLIO+++ FTSE WORLD INDEX++
---------------------- ---------------------- ------------------
12/92 10000 10000 10000
12/93 12103 11605 11976
12/94 11926 11893 12394
12/95 13190 14629 14492
12/96 14927 16217 16139
12/97 16709 18313 18134
12/98 18191 21976 21945
12/99 22078 24866 27311
12/00 19954 23787 23970
12/01 18186 21934 19781
12/02 16704 20668 15705
</Table>
* Assuming transaction costs and other operating expenses, including advisory
fees. Does not include insurance-related fees and expenses.
+ The Fund invests primarily in a portfolio of equity and fixed-income
securities of U.S. and foreign issuers.
++ This unmanaged market capitalization-weighted Index is comprised of nearly
2000 equities from 24 countries in 12 regions, including the United States.
+++ The unmanaged Reference Portfolio is a weighted index comprised of 36% of
the unmanaged Standard & Poor's 500 Index, 24% Financial Times/Standard &
Poor's -- Actuaries World Index (Ex-US), 24% Merrill Lynch Treasury Index
GA05, and 16% Salomon Brothers World Government Bond Index (Ex-US). The
starting date for the Index in the graph is from 12/31/92.
----------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL ALLOCATION V.I. FUND
AVERAGE ANNUAL TOTAL RETURN--CLASS A SHARES*
----------------------------------------------------------------------------
PERIOD COVERED % RETURN
----------------------------------------------------------------------------
One Year Ended 12/31/02 -8.15%
----------------------------------------------------------------------------
Five Years Ended 12/31/02 0.00
----------------------------------------------------------------------------
Ten Years Ended 12/31/02 +5.27
----------------------------------------------------------------------------
----------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL ALLOCATION V.I. FUND
RECENT PERFORMANCE RESULTS
----------------------------------------------------------------------------
<Table>
<Caption>
6-MONTH 12-MONTH
AS OF DECEMBER 31, 2002 TOTAL RETURN TOTAL RETURN
- -----------------------------------------------------------------------------------------
Class A Shares* -5.92% -8.15%
- -----------------------------------------------------------------------------------------
FTSE World Index** -12.46 -20.60
- -----------------------------------------------------------------------------------------
Reference Portfolio*** -3.54 -5.77
- -----------------------------------------------------------------------------------------
</Table>
* Total investment returns are based on changes in net asset values for the
periods shown, and assume reinvestment of all dividends and capital gains
distributions at net asset value on the ex-dividend date. Insurance-related fees
and expenses are not reflected in these returns.
** This unmanaged market capitalization-weighted Index is comprised of nearly
2000 equities from 24 countries in 12 regions, including the United States.
*** The Reference Portfolio is an unmanaged weighted index comprised as follows:
36% of the Standard & Poor's 500 Index, 24% FTSE World Index (Ex-US) Equities,
24% Merrill Lynch Treasury Index GA05; and 16% Salomon Brothers World Government
Bond Index (Ex-US).
Past results shown should not be considered a representation of future
performance.
116
- --------------------------------------------------------------------------------
SUMMARY OF FUND'S OVERALL ASSET MIX
- --------------------------------------------------------------------------------
<Table>
<Caption>
PERCENT OF FUND'S REFERENCE PORTFOLIO+
AS OF 12/31/02 NET ASSETS PERCENTAGES
- ------------------------------------------------------------------------------------------------------
North & South American Equities 38.8%* 36.0%
- ------------------------------------------------------------------------------------------------------
European Equities 12.9 11.0
- ------------------------------------------------------------------------------------------------------
Pacific Basin Equities 8.4 13.0
- ------------------------------------------------------------------------------------------------------
TOTAL EQUITIES 60.1 60.0
- ------------------------------------------------------------------------------------------------------
U.S. Dollar Denominated Fixed Income Securities 8.7 24.0
- ------------------------------------------------------------------------------------------------------
U.S. Issuer 7.4 --
- ------------------------------------------------------------------------------------------------------
Non-U.S. Issuer 1.3 --
- ------------------------------------------------------------------------------------------------------
Non-U.S. Dollar Denominated Fixed Income Securities 14.6 16.0
- ------------------------------------------------------------------------------------------------------
TOTAL FIXED INCOME SECURITIES 23.3 40.0
- ------------------------------------------------------------------------------------------------------
CASH & CASH EQUIVALENTS 16.6** --
- ------------------------------------------------------------------------------------------------------
</Table>
* Includes value of Financial Futures Contracts.
** Cash & Cash Equivalents are reduced by the market (or nominal) value of long
financial futures contracts.
+ The unmanaged Reference Portfolio is a weighted index comprised of 36% of the
unmanaged Standard & Poor's 500 Index, 24% Financial Times/Standard &
Poor's -- Actuaries World Index (Ex-US), 24% Merrill Lynch Treasury Index GA05,
and 16% Salomon Brothers World Government Bond Index (Ex-US).
117
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL ALLOCATION V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
COUNTRY INDUSTRY++ HELD STOCKS VALUE NET ASSETS
- ----------------------------------------------------------------------------------------------------------------------
AUSTRALIA BANKS 22,000 +National Australia Bank Limited
(7.875% Convertible Preferred)..... $ 716,100 0.2%
-----------------------------------------------------------------------------------------------------
METALS & MINING 159,700 Alumina Limited...................... 440,643 0.1
187,000 +WMC Resources Limited............... 444,365 0.2
------------ -----
885,008 0.3
-----------------------------------------------------------------------------------------------------
TOTAL STOCKS IN AUSTRALIA 1,601,108 0.5
- ----------------------------------------------------------------------------------------------------------------------
BELGIUM DIVERSIFIED FINANCIALS 11,534 Fortis............................... 203,343 0.1
-----------------------------------------------------------------------------------------------------
TOTAL STOCKS IN BELGIUM 203,343 0.1
- ----------------------------------------------------------------------------------------------------------------------
BRAZIL OIL & GAS 36,300 Petroleo Brasileiro SA--Petrobras
(ADR)*............................. 542,322 0.1
-----------------------------------------------------------------------------------------------------
TOTAL STOCKS IN BRAZIL 542,322 0.1
- ----------------------------------------------------------------------------------------------------------------------
CANADA COMMUNICATIONS 98,028 +Nortel Networks Corporation......... 157,825 0.0
EQUIPMENT
-----------------------------------------------------------------------------------------------------
METALS & MINING 62,200 +Inco Limited........................ 1,319,884 0.4
49,700 Placer Dome Inc. .................... 571,550 0.2
------------ -----
1,891,434 0.6
-----------------------------------------------------------------------------------------------------
SEMICONDUCTOR 37,700 +Genesis Microchip Incorporated...... 491,985 0.1
EQUIPMENT & PRODUCTS
-----------------------------------------------------------------------------------------------------
TOTAL STOCKS IN CANADA 2,541,244 0.7
- ----------------------------------------------------------------------------------------------------------------------
DENMARK COMMERCIAL SERVICES & 10,440 +ISS A/S............................. 376,102 0.1
SUPPLIES
-----------------------------------------------------------------------------------------------------
TOTAL STOCKS IN DENMARK 376,102 0.1
- ----------------------------------------------------------------------------------------------------------------------
FINLAND COMMUNICATIONS 40,961 Nokia Oyj (Series A)................. 651,215 0.2
EQUIPMENT
-----------------------------------------------------------------------------------------------------
TOTAL STOCKS IN FINLAND 651,215 0.2
- ----------------------------------------------------------------------------------------------------------------------
FRANCE AUTOMOBILES 14,623 PSA Peugeot Citroen.................. 596,321 0.2
-----------------------------------------------------------------------------------------------------
BANKS 23,402 BNP Paribas SA....................... 953,589 0.3
-----------------------------------------------------------------------------------------------------
CONSTRUCTION MATERIALS 1,120 Lafarge SA (Ordinary)................ 84,389 0.0
-----------------------------------------------------------------------------------------------------
ELECTRICAL EQUIPMENT 29,794 +Alstom.............................. 148,513 0.0
-----------------------------------------------------------------------------------------------------
HOTELS, RESTAURANTS & 12,174 Accor SA............................. 368,698 0.1
LEISURE
-----------------------------------------------------------------------------------------------------
MEDIA 32,119 Vivendi Universal SA................. 518,730 0.1
-----------------------------------------------------------------------------------------------------
METALS & MINING 44,009 +Arcelor............................. 541,265 0.2
11,758 Pechiney SA 'A'...................... 412,611 0.1
------------ -----
953,876 0.3
-----------------------------------------------------------------------------------------------------
MULTI-UTILITIES & 20,896 Suez SA.............................. 362,693 0.1
UNREGULATED POWER
-----------------------------------------------------------------------------------------------------
MULTILINE RETAIL 3,156 Pinault-Printemps-Redoute SA......... 232,165 0.1
-----------------------------------------------------------------------------------------------------
OIL & GAS 10,763 +TotalFinaElf SA..................... 1,537,208 0.4
-----------------------------------------------------------------------------------------------------
PHARMACEUTICALS 7,055 Aventis SA........................... 383,502 0.1
-----------------------------------------------------------------------------------------------------
TOTAL STOCKS IN FRANCE 6,139,684 1.7
- ----------------------------------------------------------------------------------------------------------------------
GERMANY AUTOMOBILES 7,876 Volkswagen AG........................ 285,145 0.1
-----------------------------------------------------------------------------------------------------
CHEMICALS 3,134 Henkel KGaA.......................... 172,663 0.1
9,059 Henkel KGaA (Preferred).............. 573,243 0.2
------------ -----
745,906 0.3
-----------------------------------------------------------------------------------------------------
DIVERSIFIED 39,060 +Deutsche Telekom AG (Registered
TELECOMMUNICATION Shares)............................ 500,892 0.1
SERVICES
-----------------------------------------------------------------------------------------------------
ELECTRIC UTILITIES 12,336 E.On AG.............................. 497,103 0.1
-----------------------------------------------------------------------------------------------------
</Table>
118
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL ALLOCATION V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED) (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
COUNTRY INDUSTRY++ HELD STOCKS VALUE NET ASSETS
- ----------------------------------------------------------------------------------------------------------------------
GERMANY INSURANCE 2,462 Muenchener Rueckversicherungs-
(CONCLUDED) Gesellschaft AG (Registered
Shares)............................ $ 294,275 0.1%
-----------------------------------------------------------------------------------------------------
MACHINERY 11,643 Linde AG............................. 427,636 0.1
-----------------------------------------------------------------------------------------------------
TOTAL STOCKS IN GERMANY 2,750,957 0.8
- ----------------------------------------------------------------------------------------------------------------------
HONG KONG DIVERSIFIED FINANCIALS 70,400 HSBC Holdings PLC.................... 769,594 0.2
-----------------------------------------------------------------------------------------------------
INDUSTRIAL 160,380 Hutchison Whampoa Limited............ 1,003,609 0.3
CONGLOMERATES
-----------------------------------------------------------------------------------------------------
TOTAL STOCKS IN HONG KONG 1,773,203 0.5
- ----------------------------------------------------------------------------------------------------------------------
IRELAND BANKS 45,436 Bank of Ireland...................... 466,792 0.1
-----------------------------------------------------------------------------------------------------
TOTAL STOCKS IN IRELAND 466,792 0.1
- ----------------------------------------------------------------------------------------------------------------------
ISRAEL COMMUNICATIONS 166,100 +ECI Telecom Limited (U.S. Registered
EQUIPMENT Shares)............................ 330,539 0.1
-----------------------------------------------------------------------------------------------------
TOTAL STOCKS IN ISRAEL 330,539 0.1
- ----------------------------------------------------------------------------------------------------------------------
ITALY BANKS 365,019 Intesa BCI SpA....................... 769,932 0.2
138,332 Unicredito Italiano SpA.............. 553,081 0.2
------------ -----
1,323,013 0.4
-----------------------------------------------------------------------------------------------------
DIVERSIFIED 54,193 Telecom Italia SpA................... 411,171 0.1
TELECOMMUNICATION
SERVICES
-----------------------------------------------------------------------------------------------------
INSURANCE 31,607 Assicurazioni Generali............... 650,100 0.2
-----------------------------------------------------------------------------------------------------
OIL & GAS 55,652 ENI SpA.............................. 884,778 0.2
-----------------------------------------------------------------------------------------------------
TRANSPORTATION 28,413 Autostrade-Concessioni e Costruzioni
INFRASTRUCTURE Autostrade SpA..................... 282,661 0.1
-----------------------------------------------------------------------------------------------------
TOTAL STOCKS IN ITALY 3,551,723 1.0
- ----------------------------------------------------------------------------------------------------------------------
JAPAN AUTO COMPONENTS 11,500 TOYOTA INDUSTRIES CORPORATION........ 172,980 0.1
-----------------------------------------------------------------------------------------------------
AUTOMOBILES 122,000 Fuji Heavy Industries, Ltd. ......... 483,189 0.1
48,000 Suzuki Motor Corporation............. 521,783 0.2
------------ -----
1,004,972 0.3
-----------------------------------------------------------------------------------------------------
BEVERAGES 20,700 Coca-Cola West Japan Company
Limited............................ 309,619 0.1
13,000 Kinki Coca-Cola Bottling Co.,
Ltd. .............................. 73,506 0.0
------------ -----
383,125 0.1
-----------------------------------------------------------------------------------------------------
CHEMICALS 71,000 Shin-Etsu Chemical Co., Ltd. ........ 2,327,378 0.7
-----------------------------------------------------------------------------------------------------
ELECTRONIC EQUIPMENT & 33,000 Murata Manufacturing Co., Ltd. ...... 1,293,082 0.4
INSTRUMENTS
-----------------------------------------------------------------------------------------------------
HOUSEHOLD DURABLES 3,500 Nintendo Company Ltd. ............... 327,083 0.1
-----------------------------------------------------------------------------------------------------
HOUSEHOLD PRODUCTS 26,300 Rohto Pharmaceutical Co., Ltd. ...... 182,174 0.0
-----------------------------------------------------------------------------------------------------
INSURANCE 495,000 Aioi Insurance Company, Limited...... 955,212 0.2
573 +Millea Holdings, Inc. .............. 4,123,553 1.2
748,000 Mitsui Marine and Fire Insurance
Company, Ltd. ..................... 3,441,544 1.0
98,000 The Nippon Fire & Marine Insurance
Co., Ltd. ......................... 369,141 0.1
------------ -----
8,889,450 2.5
-----------------------------------------------------------------------------------------------------
MULTILINE RETAIL 11,300 Ito-Yokado Co., Ltd. ................ 333,277 0.1
-----------------------------------------------------------------------------------------------------
OFFICE ELECTRONICS 14,000 Canon, Inc. ......................... 527,345 0.1
-----------------------------------------------------------------------------------------------------
PHARMACEUTICALS 40,000 Sankyo Company, Ltd. ................ 501,896 0.1
12,500 Takeda Chemical Industries, Ltd. .... 522,457 0.2
------------ -----
1,024,353 0.3
-----------------------------------------------------------------------------------------------------
</Table>
119
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL ALLOCATION V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED) (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
COUNTRY INDUSTRY++ HELD STOCKS VALUE NET ASSETS
- ----------------------------------------------------------------------------------------------------------------------
JAPAN WIRELESS 335 NTT DoCoMo, Inc. .................... $ 618,227 0.2%
(CONCLUDED) TELECOMMUNICATION
SERVICES
-----------------------------------------------------------------------------------------------------
TOTAL STOCKS IN JAPAN 17,083,446 4.9
- ----------------------------------------------------------------------------------------------------------------------
MEXICO BEVERAGES 4,400 Fomento Economico Mexicano, SA de CV
(ADR)*............................. 160,248 0.0
-----------------------------------------------------------------------------------------------------
MEDIA 22,600 +Grupo Televisa SA (ADR)*............ 631,218 0.2
-----------------------------------------------------------------------------------------------------
TOTAL STOCKS IN MEXICO 791,466 0.2
- ----------------------------------------------------------------------------------------------------------------------
NETHERLANDS BANKS 15,025 ABN AMRO Holding NV.................. 245,654 0.1
-----------------------------------------------------------------------------------------------------
CHEMICALS 19,237 Akzo Nobel NV........................ 610,262 0.2
-----------------------------------------------------------------------------------------------------
COMMERCIAL SERVICES & 37,131 Buhrmann NV.......................... 162,095 0.0
SUPPLIES
34,834 Vedior NV 'A'........................ 198,858 0.1
------------ -----
360,953 0.1
-----------------------------------------------------------------------------------------------------
DIVERSIFIED FINANCIALS 22,107 Fortis............................... 386,497 0.1
33,717 ING Groep NV......................... 571,075 0.2
------------ -----
957,572 0.3
-----------------------------------------------------------------------------------------------------
HOUSEHOLD DURABLES 26,423 Koninklijke (Royal) Philips
Electronics NV..................... 463,063 0.1
-----------------------------------------------------------------------------------------------------
INSURANCE 25,981 Aegon NV............................. 334,262 0.1
-----------------------------------------------------------------------------------------------------
MEDIA 32,081 Wolters Kluwer NV 'A'................ 558,852 0.1
-----------------------------------------------------------------------------------------------------
OIL & GAS 45,892 Royal Dutch Petroleum Company........ 2,020,273 0.6
25,000 Royal Dutch Petroleum Company (NY
Registered Shares)................. 1,100,500 0.3
------------ -----
3,120,773 0.9
-----------------------------------------------------------------------------------------------------
TRADING COMPANIES & 16,237 Imtech NV............................ 214,182 0.1
DISTRIBUTORS
-----------------------------------------------------------------------------------------------------
TOTAL STOCKS IN THE NETHERLANDS 6,865,573 2.0
- ----------------------------------------------------------------------------------------------------------------------
PORTUGAL ELECTRIC UTILITIES 128,466 Electricidade de Portugal, SA
(EDP).............................. 214,351 0.1
-----------------------------------------------------------------------------------------------------
TOTAL STOCKS IN PORTUGAL 214,351 0.1
- ----------------------------------------------------------------------------------------------------------------------
SINGAPORE ELECTRONIC EQUIPMENT & 47,100 +Flextronics International Ltd. ..... 383,865 0.1
INSTRUMENTS
-----------------------------------------------------------------------------------------------------
TOTAL STOCKS IN SINGAPORE 383,865 0.1
- ----------------------------------------------------------------------------------------------------------------------
SOUTH AFRICA PAPER & FOREST 18,700 Sappi Limited (ADR)*................. 247,214 0.1
PRODUCTS
-----------------------------------------------------------------------------------------------------
TOTAL STOCKS IN SOUTH AFRICA 247,214 0.1
- ----------------------------------------------------------------------------------------------------------------------
SOUTH KOREA DIVERSIFIED 141,900 KT Corporation (ADR)*................ 3,057,945 0.9
TELECOMMUNICATION
SERVICES
-----------------------------------------------------------------------------------------------------
WIRELESS 2,600 +SK Telecom Co., Ltd. ............... 502,002 0.1
TELECOMMUNICATION
SERVICES
24,600 SK Telecom Co., Ltd. (ADR)*(a)....... 525,210 0.2
------------ -----
1,027,212 0.3
-----------------------------------------------------------------------------------------------------
TOTAL STOCKS IN SOUTH KOREA 4,085,157 1.2
- ----------------------------------------------------------------------------------------------------------------------
SPAIN DIVERSIFIED 47,836 +Telefonica SA....................... 428,198 0.1
TELECOMMUNICATION
SERVICES
-----------------------------------------------------------------------------------------------------
TOTAL STOCKS IN SPAIN 428,198 0.1
- ----------------------------------------------------------------------------------------------------------------------
SWEDEN BANKS 109,743 Nordbanken Holding AB................ 483,643 0.2
52,165 Skandinaviska Enskilda Banken (SEB)
'A'................................ 434,045 0.1
------------ -----
917,688 0.3
-----------------------------------------------------------------------------------------------------
HOUSEHOLD DURABLES 3,263 Electrolux AB 'B'.................... 51,492 0.0
-----------------------------------------------------------------------------------------------------
</Table>
120
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL ALLOCATION V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED) (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
COUNTRY INDUSTRY++ HELD STOCKS VALUE NET ASSETS
- ----------------------------------------------------------------------------------------------------------------------
SWEDEN PAPER & FOREST 11,707 Svenska Cellulosa AB (SCA) 'B'....... $ 395,012 0.1%
(CONCLUDED) PRODUCTS
-----------------------------------------------------------------------------------------------------
TOTAL STOCKS IN SWEDEN 1,364,192 0.4
- ----------------------------------------------------------------------------------------------------------------------
SWITZERLAND BANKS 19,890 Credit Suisse Group.................. 431,547 0.1
-----------------------------------------------------------------------------------------------------
CONSTRUCTION MATERIALS 2,797 Holcim Ltd. 'B'...................... 507,736 0.1
-----------------------------------------------------------------------------------------------------
FOOD PRODUCTS 5,926 Nestle SA (Registered Shares)........ 1,255,745 0.4
-----------------------------------------------------------------------------------------------------
PHARMACEUTICALS 26,722 Novartis AG (Registered Shares)...... 974,994 0.3
10,755 Roche Holding AG..................... 749,435 0.2
------------ -----
1,724,429 0.5
-----------------------------------------------------------------------------------------------------
TOTAL STOCKS IN SWITZERLAND 3,919,457 1.1
- ----------------------------------------------------------------------------------------------------------------------
UNITED KINGDOM BANKS 167,366 Barclays PLC......................... 1,037,354 0.3
48,023 HSBC Holdings PLC.................... 530,748 0.2
52,175 Royal Bank of Scotland Group PLC..... 1,249,868 0.4
------------ -----
2,817,970 0.9
-----------------------------------------------------------------------------------------------------
COMMERCIAL SERVICES & 182,192 Chubb PLC............................ 257,380 0.1
SUPPLIES
-----------------------------------------------------------------------------------------------------
DIVERSIFIED 180,888 BT Group PLC......................... 567,863 0.2
TELECOMMUNICATION
SERVICES
-----------------------------------------------------------------------------------------------------
FOOD & DRUG RETAILING 52,717 Boots Company PLC.................... 497,333 0.1
134,315 J Sainsbury PLC...................... 602,752 0.2
------------ -----
1,100,085 0.3
-----------------------------------------------------------------------------------------------------
FOOD PRODUCTS 162,067 Unilever PLC......................... 1,541,988 0.4
-----------------------------------------------------------------------------------------------------
HOTELS, RESTAURANTS & 46,676 Six Continents PLC................... 377,221 0.1
LEISURE
-----------------------------------------------------------------------------------------------------
INDUSTRIAL 44,947 Smiths Industries PLC................ 503,265 0.1
CONGLOMERATES
-----------------------------------------------------------------------------------------------------
INSURANCE 70,080 AVIVA PLC............................ 499,801 0.1
53,987 Prudential Corporation PLC........... 381,551 0.1
------------ -----
881,352 0.2
-----------------------------------------------------------------------------------------------------
METALS & MINING 28,643 Anglo American PLC................... 425,387 0.1
-----------------------------------------------------------------------------------------------------
OIL & GAS 183,029 BP Amoco PLC......................... 1,258,191 0.4
-----------------------------------------------------------------------------------------------------
PHARMACEUTICALS 91,744 GlaxoSmithKline PLC.................. 1,760,568 0.5
-----------------------------------------------------------------------------------------------------
TRANSPORTATION 60,805 BAA PLC.............................. 493,365 0.1
INFRASTRUCTURE
-----------------------------------------------------------------------------------------------------
WIRELESS 685,794 Vodafone Group PLC................... 1,250,348 0.4
TELECOMMUNICATION
SERVICES
-----------------------------------------------------------------------------------------------------
TOTAL STOCKS IN THE UNITED KINGDOM 13,234,983 3.8
- ----------------------------------------------------------------------------------------------------------------------
UNITED STATES AIR FREIGHT & 12,300 Airborne, Inc. ...................... 182,409 0.0
LOGISTICS
4,600 FedEx Corp. ......................... 249,412 0.1
------------ -----
431,821 0.1
-----------------------------------------------------------------------------------------------------
AUTO COMPONENTS 38,200 The Goodyear Tire & Rubber Company... 260,142 0.1
-----------------------------------------------------------------------------------------------------
AUTOMOBILES 29,000 +General Motors Corporation (Class
H)................................. 310,300 0.1
-----------------------------------------------------------------------------------------------------
BANKS 18,600 The Bank of New York Company, Inc. .. 445,656 0.1
15,650 Charter One Financial, Inc. ......... 449,625 0.1
13,500 Riggs National Corporation........... 207,090 0.1
------------ -----
1,102,371 0.3
-----------------------------------------------------------------------------------------------------
BEVERAGES 12,700 PepsiAmericas, Inc. ................. 170,561 0.1
-----------------------------------------------------------------------------------------------------
</Table>
121
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL ALLOCATION V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED) (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
COUNTRY INDUSTRY++ HELD STOCKS VALUE NET ASSETS
- ----------------------------------------------------------------------------------------------------------------------
UNITED STATES CHEMICALS 7,900 E.I. du Pont de Nemours and
(CONTINUED) Company............................ $ 334,960 0.1%
-----------------------------------------------------------------------------------------------------
COMMERCIAL SERVICES & 113,100 +Cendant Corporation................. 1,185,288 0.3
SUPPLIES
62,900 +Information Resources, Inc. ........ 100,011 0.0
26,900 +TeleTech Holdings, Inc. ............ 193,949 0.1
------------ -----
1,479,248 0.4
-----------------------------------------------------------------------------------------------------
COMMUNICATIONS 93,400 +3Com Corporation.................... 431,508 0.1
EQUIPMENT
123,600 +ADC Telecommunications, Inc. ....... 258,324 0.1
37,500 +Cisco Systems, Inc. ................ 490,875 0.2
12,300 +Comverse Technology, Inc. .......... 123,123 0.0
15,400 +Corning Incorporated................ 50,974 0.0
101,800 +Lucent Technologies Inc. ........... 128,268 0.0
550 +Lucent Technologies Inc.(a)......... 272,422 0.1
1,440 +Lucent Technologies Inc.
(Preferred)........................ 713,249 0.2
87,700 Motorola, Inc. ...................... 758,605 0.2
31,300 +QUALCOMM Incorporated............... 1,137,129 0.3
33,100 +Tellabs, Inc. ...................... 239,313 0.1
------------ -----
4,603,790 1.3
-----------------------------------------------------------------------------------------------------
COMPUTERS & 23,400 +Apple Computer, Inc. ............... 335,322 0.1
PERIPHERALS
188,060 +EMC Corporation..................... 1,154,688 0.3
74,211 Hewlett-Packard Company.............. 1,288,303 0.4
11,600 International Business Machines
Corporation........................ 899,000 0.3
120,400 +Sun Microsystems, Inc. ............. 373,240 0.1
------------ -----
4,050,553 1.2
-----------------------------------------------------------------------------------------------------
CONSTRUCTION & 6,200 Chicago Bridge & Iron Company NV (NY
ENGINEERING Registered Shares)................. 187,240 0.1
157,000 +Foster Wheeler Ltd. ................ 182,120 0.0
306,000 +McDermott International, Inc. ...... 1,340,280 0.4
63,000 +Quanta Services, Inc. .............. 220,500 0.1
6,200 +The Shaw Group Inc. ................ 101,990 0.0
------------ -----
2,032,130 0.6
-----------------------------------------------------------------------------------------------------
CONTAINERS & PACKAGING 37,600 +Crown Cork & Seal Company, Inc. .... 298,920 0.1
-----------------------------------------------------------------------------------------------------
DIVERSIFIED FINANCIALS 6,300 American Express Company............. 222,705 0.1
112,900 CIT Group Inc. ...................... 2,212,840 0.6
131,400 Citigroup Inc.(l).................... 4,623,966 1.3
43,925 J.P. Morgan Chase & Co. ............. 1,054,200 0.3
166,700 +Knight Trading Group, Inc. ......... 810,162 0.2
15,700 MBNA Corporation..................... 298,614 0.1
17,000 Morgan Stanley....................... 678,640 0.2
62,200 +Nasdaq-100 Shares(c)................ 1,517,680 0.4
22,100 Prudential Financial, Inc. .......... 701,454 0.2
20,000 +Saxon Capital, Inc.(a).............. 250,200 0.1
------------ -----
12,370,461 3.5
-----------------------------------------------------------------------------------------------------
</Table>
122
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL ALLOCATION V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED) (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
COUNTRY INDUSTRY++ HELD STOCKS VALUE NET ASSETS
- ----------------------------------------------------------------------------------------------------------------------
UNITED STATES DIVERSIFIED 28,200 ALLTEL Corporation................... $ 1,438,200 0.4%
(CONTINUED) TELECOMMUNICATION
SERVICES
20,080 AT&T Corp. .......................... 524,289 0.2
50,100 BellSouth Corporation................ 1,296,087 0.4
80,700 +Broadwing Inc. ..................... 284,064 0.1
9,829 +McLeodUSA Incorporated
(Preferred)(Series A).............. 40,397 0.0
21,779 McLeodUSA Incorporated
(Warrants)(d)...................... 2,178 0.0
90,000 +Metromedia Fiber Network, Inc.
(Class A).......................... 900 0.0
4,747,597 Metromedia Fiber Network
(Warrants)(d)...................... 4,748 0.0
55,600 SBC Communications Inc. ............. 1,507,316 0.4
24,600 Sprint Corporation................... 356,208 0.1
67,900 Verizon Communications............... 2,631,125 0.7
26,380 +WilTel Communications, Inc. ........ 416,540 0.1
------------ -----
8,502,052 2.4
-----------------------------------------------------------------------------------------------------
ELECTRIC UTILITIES 6,300 DQE, Inc. ........................... 96,012 0.0
15,800 DTE Energy Company................... 733,120 0.2
34,500 PPL Corporation...................... 1,196,460 0.4
------------ -----
2,025,592 0.6
-----------------------------------------------------------------------------------------------------
ELECTRONIC EQUIPMENT & 51,600 +Agilent Technologies, Inc. ......... 926,736 0.3
INSTRUMENTS
71,195 +Solectron Corporation............... 252,742 0.1
19,000 +Waters Corporation.................. 413,820 0.1
------------ -----
1,593,298 0.5
-----------------------------------------------------------------------------------------------------
ENERGY EQUIPMENT & 16,500 ENSCO International Incorporated..... 485,925 0.1
SERVICE
34,000 GlobalSantaFe Corporation............ 826,880 0.2
18,500 +Input/Output, Inc. ................. 78,625 0.0
4,650 +Nabors Industries, Ltd. ............ 164,006 0.0
24,700 Rowan Companies, Inc. ............... 560,690 0.2
29,300 Schlumberger Limited................. 1,233,237 0.4
8,100 +Veritas DGC Inc. ................... 63,990 0.0
------------ -----
3,413,353 0.9
-----------------------------------------------------------------------------------------------------
FOOD & DRUG RETAILING 11,800 +The Kroger Co. ..................... 182,310 0.1
-----------------------------------------------------------------------------------------------------
FOOD PRODUCTS 94,100 Tyson Foods, Inc. (Class A).......... 1,055,802 0.3
-----------------------------------------------------------------------------------------------------
HEALTH CARE PROVIDERS 15,500 Aetna Inc. (New Shares).............. 637,360 0.2
& SERVICES
494,000 +Beverly Enterprises, Inc. .......... 1,407,900 0.4
15,400 +Humana Inc. ........................ 154,000 0.1
18,800 +Manor Care, Inc. ................... 349,868 0.1
51,000 +Stewart Enterprises, Inc. (Class
A)................................. 283,050 0.1
24,700 +Tenet Healthcare Corporation........ 405,080 0.1
6,200 +WellChoice Inc. .................... 148,490 0.0
------------ -----
3,385,748 1.0
-----------------------------------------------------------------------------------------------------
HOTELS, RESTAURANTS & 10,400 McDonald's Corporation............... 167,232 0.0
LEISURE
-----------------------------------------------------------------------------------------------------
HOUSEHOLD PRODUCTS 8,400 Kimberly-Clark Corporation........... 398,748 0.1
-----------------------------------------------------------------------------------------------------
IT CONSULTING & 3,100 +Computer Sciences Corporation....... 106,795 0.0
SERVICES
18,700 Electronic Data Systems
Corporation........................ 344,641 0.1
43,800 +Unisys Corporation.................. 433,620 0.1
------------ -----
885,056 0.2
-----------------------------------------------------------------------------------------------------
INDUSTRIAL 161,600 General Electric Company............. 3,934,960 1.1
CONGLOMERATES
103,600 Tyco International Ltd. ............. 1,769,488 0.5
------------ -----
5,704,448 1.6
-----------------------------------------------------------------------------------------------------
</Table>
123
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL ALLOCATION V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED) (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
COUNTRY INDUSTRY++ HELD STOCKS VALUE NET ASSETS
- ----------------------------------------------------------------------------------------------------------------------
UNITED STATES INSURANCE 66,200 ACE Limited(l)....................... $ 1,942,308 0.6%
(CONTINUED)
25,300 The Allstate Corporation............. 935,847 0.3
43,800 American International Group,
Inc. .............................. 2,533,830 0.7
30,900 Horace Mann Educators Corporation.... 473,697 0.1
20,400 MetLife, Inc. ....................... 551,616 0.2
27,171 +Travelers Property Casualty Corp.
(Class A).......................... 398,055 0.1
10,625 +Travelers Property Casualty Corp.
(Class B).......................... 155,656 0.0
9,500 XL Capital Ltd. (Class A)............ 733,875 0.2
------------ -----
7,724,884 2.2
-----------------------------------------------------------------------------------------------------
INTERNET SOFTWARE & 70,100 +Broadband HOLDRs Trust(i)........... 529,255 0.2
SERVICES
-----------------------------------------------------------------------------------------------------
MACHINERY 6,200 Deere & Company...................... 284,270 0.1
25,000 +Flowserve Corporation............... 369,750 0.1
22,000 Pall Corporation..................... 366,960 0.1
------------ -----
1,020,980 0.3
-----------------------------------------------------------------------------------------------------
MEDIA 32,479 +Comcast Corporation (Class A)....... 765,205 0.2
16,700 The Walt Disney Company.............. 272,377 0.1
------------ -----
1,037,582 0.3
-----------------------------------------------------------------------------------------------------
METALS & MINING 22,900 Alcoa Inc. .......................... 521,662 0.2
6,200 Arch Coal, Inc. ..................... 133,858 0.0
6,200 CONSOL Energy Inc. .................. 107,136 0.0
41,800 Commonwealth Industries, Inc. ....... 282,150 0.1
74,600 +Freeport-McMoRan Copper & Gold, Inc.
(Class B).......................... 1,251,788 0.4
37,300 Newmont Mining Corporation(l)........ 1,082,819 0.3
3,200 Nucor Corporation.................... 132,160 0.0
------------ -----
3,511,573 1.0
-----------------------------------------------------------------------------------------------------
MULTI-UTILITIES & 221,900 +The AES Corporation................. 670,138 0.2
UNREGULATED POWER
55,600 +Calpine Corporation................. 181,256 0.1
37,600 Duke Energy Corporation.............. 734,704 0.2
214,100 El Paso Corporation.................. 1,490,136 0.4
112,400 +Mirant Corporation.................. 212,436 0.1
9,500 SCANA Corporation.................... 294,120 0.1
191,600 The Williams Companies, Inc. ........ 517,320 0.1
------------ -----
4,100,110 1.2
-----------------------------------------------------------------------------------------------------
OIL & GAS 3,400 Amerada Hess Corporation............. 187,170 0.1
31,818 ChevronTexaco Corporation............ 2,115,261 0.6
9,704 ConocoPhillips....................... 469,577 0.2
12,600 Exxon Mobil Corporation.............. 440,244 0.1
31,900 Kerr-McGee Corporation............... 1,413,170 0.4
50,000 Marathon Oil Corporation............. 1,064,500 0.3
9,800 Noble Energy, Inc. .................. 367,990 0.1
40,000 Occidental Petroleum Corporation..... 1,138,000 0.3
24,600 +Stone Energy Corporation............ 820,656 0.2
38,200 Unocal Corporation................... 1,168,156 0.3
6,400 Valero Energy Corporation............ 236,416 0.1
------------ -----
9,421,140 2.7
-----------------------------------------------------------------------------------------------------
PAPER & FOREST 22,000 Bowater Incorporated................. 922,900 0.3
PRODUCTS
16,600 Deltic Timber Corporation............ 443,220 0.1
95,900 +Louisiana-Pacific Corporation....... 772,954 0.2
------------ -----
2,139,074 0.6
-----------------------------------------------------------------------------------------------------
</Table>
124
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL ALLOCATION V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED) (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
COUNTRY INDUSTRY++ HELD STOCKS VALUE NET ASSETS
- ----------------------------------------------------------------------------------------------------------------------
UNITED STATES PERSONAL PRODUCTS 15,800 The Gillette Company................. $ 479,688 0.1%
(CONCLUDED)
-----------------------------------------------------------------------------------------------------
PHARMACEUTICALS 62,500 Bristol-Myers Squibb Company......... 1,446,875 0.4
18,900 Eli Lilly and Company................ 1,200,150 0.3
56,700 Merck & Co., Inc. ................... 3,209,787 0.9
125,200 Pfizer Inc. ......................... 3,827,364 1.1
35,350 Pharmacia Corporation................ 1,477,630 0.4
61,800 Schering-Plough Corporation.......... 1,371,960 0.4
25,000 Wyeth................................ 935,000 0.3
------------ -----
13,468,766 3.8
-----------------------------------------------------------------------------------------------------
REAL ESTATE 28,300 +American Financial Realty Trust..... 339,600 0.1
27,800 Archstone-Smith Trust................ 654,412 0.2
24,700 CarrAmerica Realty Corporation....... 618,735 0.2
43,200 +Catellus Development Corporation.... 857,520 0.2
9,200 FBR Asset Investment Corporation..... 311,880 0.1
523,000 +La Quinta Corporation............... 2,301,200 0.7
30,900 +Nationwide Health Properties,
Inc. .............................. 461,337 0.1
12,300 The St. Joe Company.................. 369,000 0.1
61,700 Trizec Properties, Inc. ............. 579,363 0.2
------------ -----
6,493,047 1.9
-----------------------------------------------------------------------------------------------------
ROAD & RAIL 6,200 +Swift Transportation Co., Inc. ..... 123,690 0.0
4,900 Union Pacific Corporation............ 293,363 0.1
------------ -----
417,053 0.1
-----------------------------------------------------------------------------------------------------
SEMICONDUCTOR 123,100 +Advanced Micro Devices, Inc. ....... 795,226 0.2
EQUIPMENT & PRODUCTS
110,505 +Agere Systems Inc. (Class A)........ 159,127 0.1
34,499 +Agere Systems Inc. (Class B)........ 48,299 0.0
10,000 +Analog Devices, Inc. ............... 238,700 0.1
25,200 Intel Corporation.................... 392,112 0.1
125,500 +Lattice Semiconductor Corporation... 1,100,635 0.3
49,700 +Micron Technology, Inc. ............ 484,078 0.1
62,500 +National Semiconductor
Corporation........................ 938,125 0.3
43,500 Semiconductor HOLDRs Trust(h)........ 963,525 0.3
------------ -----
5,119,827 1.5
-----------------------------------------------------------------------------------------------------
SOFTWARE 15,500 +Activision, Inc. ................... 225,525 0.1
25,650 +Amdocs Limited...................... 251,883 0.1
206,700 Computer Associates International,
Inc. .............................. 2,790,450 0.8
94,000 +Microsoft Corporation(l)............ 4,860,740 1.4
15,800 +THQ Inc. ........................... 209,350 0.0
------------ -----
8,337,948 2.4
-----------------------------------------------------------------------------------------------------
SPECIALTY RETAIL 43,500 Circuit City Stores--Circuit City
Group.............................. 322,770 0.1
68,800 The Home Depot, Inc. ................ 1,648,448 0.5
44,500 +Toys 'R' Us, Inc. .................. 445,000 0.1
------------ -----
2,416,218 0.7
-----------------------------------------------------------------------------------------------------
TEXTILES, APPAREL & 34,400 +Unifi, Inc. ........................ 180,600 0.1
LUXURY GOODS
-----------------------------------------------------------------------------------------------------
TOBACCO 34,400 Philip Morris Companies Inc. ........ 1,394,232 0.4
-----------------------------------------------------------------------------------------------------
WIRELESS 210,900 +AT&T Wireless Services Inc. ........ 1,191,585 0.3
TELECOMMUNICATION
SERVICES
163,000 +Sprint Corp. (PCS Group)............ 713,940 0.2
------------ -----
1,905,525 0.5
-----------------------------------------------------------------------------------------------------
TOTAL STOCKS IN THE UNITED STATES 124,456,398 35.6
-----------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN STOCKS
(COST--$242,639,700) 194,002,532 55.5
- ----------------------------------------------------------------------------------------------------------------------
</Table>
125
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL ALLOCATION V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED) (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
<Table>
<Caption>
FACE PERCENT OF
COUNTRY AMOUNT FIXED INCOME SECURITIES VALUE NET ASSETS
- -------------------------------------------------------------------------------------------------------------------------
CHILE US$ 4,730,193 Empresa Electricidade del Norte,
4% due 11/05/2017..................... $ 2,483,351 0.7
- -------------------------------------------------------------------------------------------------------------------------
TOTAL FIXED INCOME SECURITIES IN CHILE 2,483,351 0.7
- -------------------------------------------------------------------------------------------------------------------------
FRANCE E 500,000 Crown Cork & Seal SA,
6% due 12/06/2004..................... 445,995 0.1%
426,860 Societe Fonciere Lyonnaise SA,
4% due 10/31/2004..................... 499,150 0.2
- -------------------------------------------------------------------------------------------------------------------------
TOTAL FIXED INCOME SECURITIES IN FRANCE 945,145 0.3
- -------------------------------------------------------------------------------------------------------------------------
GERMANY 19,000,000 Bundesobligation,
3.25% due 2/17/2004................... 20,079,107 5.8
Bundesrepublic Deutschland:
3,040,000 6.50% due 10/14/2005.................. 3,476,826 1.0
18,580,000 5.25% due 1/04/2011................... 21,081,448 6.0
DM 1,900,000 Colt Telecom Group PLC,
2% due 8/06/2005...................... 512,260 0.1
- -------------------------------------------------------------------------------------------------------------------------
TOTAL FIXED INCOME SECURITIES IN GERMANY 45,149,641 12.9
- -------------------------------------------------------------------------------------------------------------------------
LUXEMBOURG E 1,750,000 European Investment Bank,
5.25% due 4/15/2004................... 1,890,611 0.5
525,000 Tyco International Group SA,
4.375% due 11/19/2004................. 504,106 0.2
- -------------------------------------------------------------------------------------------------------------------------
TOTAL FIXED INCOME SECURITIES IN
LUXEMBOURG 2,394,717 0.7
- -------------------------------------------------------------------------------------------------------------------------
MEXICO Petroleos Mexicanos:
L 200,000 14.50% due 3/31/2006.................. 367,859 0.1
US$ 500,000 9.50% due 9/15/2027................... 575,000 0.1
- -------------------------------------------------------------------------------------------------------------------------
TOTAL FIXED INCOME SECURITIES IN MEXICO 942,859 0.2
- -------------------------------------------------------------------------------------------------------------------------
SWEDEN 50,000 Stena AB,
9.625% due 12/01/2012(a).............. 51,375 0.0
- -------------------------------------------------------------------------------------------------------------------------
TOTAL FIXED INCOME SECURITIES IN SWEDEN 51,375 0.0
- -------------------------------------------------------------------------------------------------------------------------
UNITED KINGDOM E 950,000 Colt Telecom Group PLC,
2% due 3/29/2006...................... 451,111 0.1
US$ 1,420,000 Crown Cork & Seal Finance PLC, 7% due
12/15/2006............................ 1,121,800 0.3
L 900,000 +NTL Incorporated, Series B,
0/10.75% due 4/01/2003(j)............. 105,046 0.1
- -------------------------------------------------------------------------------------------------------------------------
TOTAL FIXED INCOME SECURITIES IN THE
UNITED KINGDOM 1,677,957 0.5
- -------------------------------------------------------------------------------------------------------------------------
UNITED STATES The AES Corporation:
US$ 520,000 8.75% due 6/15/2008................... 301,600 0.1
850,000 9.50% due 6/01/2009................... 510,000 0.2
320,000 9.375% due 9/15/2010.................. 190,400 0.1
250,000 Abgenix Inc.,
3.50% due 3/15/2007................... 169,219 0.0
360,000 Advanced Micro Devices, Inc.,
4.50% due 12/01/2007.................. 411,300 0.1
Avaya Inc.:
1,060,000 11.125% due 4/01/2009................. 975,200 0.3
1,125,000 5.488% due 10/31/2021(b).............. 450,000 0.1
Avnet Inc.:
250,000 7.875% due 2/15/2005.................. 239,375 0.1
250,000 8% due 11/15/2006..................... 237,500 0.1
Calpine Corporation:
1,330,000 4% due 12/26/2006(a).................. 650,869 0.2
645,000 4% due 12/26/2006..................... 315,647 0.1
325,000 Computer Associates International, Inc.,
5% due 3/15/2007(a)................... 325,000 0.1
</Table>
126
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL ALLOCATION V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED) (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
<Table>
<Caption>
FACE PERCENT OF
COUNTRY AMOUNT FIXED INCOME SECURITIES VALUE NET ASSETS
- -------------------------------------------------------------------------------------------------------------------------
UNITED STATES US$ 600,000 Constar International,
(CONTINUED) 11% due 12/01/2012.................... $ 591,000 0.2%
500,000 Corning Glass,
7% due 3/15/2007...................... 420,000 0.1
Corning Incorporated:
675,000 3.50% due 11/01/2008.................. 439,594 0.1
2,950,000 5.150% due 11/08/2015(b).............. 1,640,940 0.5
145,000 Finova Group Inc.,
7.50% due 11/15/2009.................. 48,575 0.0
Foster Wheeler Ltd.:
2,000,000 6.75% due 11/15/2005.................. 1,090,000 0.3
950,000 6.50% due 6/01/2007(a)................ 155,563 0.0
2,675,000 6.50% due 6/01/2007................... 438,031 0.1
1,150,000 Hynix Semiconductor America,
8.25% due 5/15/2004(g)................ 759,000 0.2
260,000 ICN Pharmaceuticals Inc.,
6.50% due 7/15/2008................... 211,088 0.1
Inhale Therapeutic Systems:
155,000 5% due 2/08/2007...................... 95,325 0.0
180,000 3.50% due 10/17/2007.................. 98,100 0.0
625,000 LSI Logic Corporation,
4% due 11/01/2006..................... 505,078 0.1
600,000 Level 3 Communications Inc.,
11% due 3/15/2008..................... 379,500 0.1
500,000 Lucent Technologies Inc.,
6.50% due 1/15/2028................... 210,000 0.1
300,000 Manugistics Group Inc.,
5% due 11/01/2007..................... 141,000 0.0
250,000 McDermott Inc.,
7.84% due 4/04/2005................... 210,625 0.1
Metromedia Fiber Network:
3,196,931 8.75% due 9/30/2006(g)................ 2,829,284 0.8
1,400,000 +10% due 12/15/2009................... 7,000 0.0
E 700,000 +10% due 12/15/2009................... 14,692 0.0
US$ 325,000 Mirant Americas Generation Inc.,
8.30% due 5/01/2011................... 149,500 0.0
350,000 Mirant Corporation,
5.75% due 7/15/2007................... 142,844 0.0
Nextel Communications:
725,000 4.75% due 7/01/2007................... 608,094 0.2
1,350,000 5.25% due 1/15/2010................... 936,563 0.3
210,000 Northwestern Bell Telephone,
7.75% due 5/01/2030................... 163,800 0.0
545,000 +Olympus Communications LP/ Capital
Corp.,
10.625% due 11/15/2006................ 419,650 0.1
530,000 PG&E Corp.,
6.25% due 8/01/2003................... 526,025 0.2
50,000 Quantum Corporation,
7% due 8/01/2004...................... 43,250 0.0
1,950,000 Shaw Group Inc.,
3.317% due 5/01/2021(b)............... 1,131,000 0.3
Solectron Corporation(b):
90,000 3.706% due 5/08/2020.................. 55,238 0.0
6,250,000 4.589% due 11/20/2020................. 3,187,500 0.9
948,864 TSI Telecom,
5.88% due 12/31/2006.................. 877,699 0.3
160,000 US West Communications,
7.25% due 9/15/2025................... 124,800 0.0
Williams Communications Group, Inc.:
290,323 6.34% due 9/08/2006................... 247,500 0.1
211,538 Term B, due 09/08/2006................ 180,337 0.1
</Table>
127
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL ALLOCATION V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED) (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
<Table>
FACE AMOUNT/
PARTNERSHIP PERCENT OF
COUNTRY INTEREST FIXED INCOME SECURITIES VALUE NET ASSETS
- ----------------------------------------------------------------------------------------------------------------------------
UNITED STATES WorldCom Inc.:
(CONCLUDED)
E 2,895,000 +6.75% due 5/15/2008.................. $ 702,541 0.2%
L 2,840,000 +7.25% due 5/15/2008.................. 1,074,447 0.3
US$ 2,455,000 +7.50% due 5/15/2011.................. 552,375 0.2
- ----------------------------------------------------------------------------------------------------------------------------
TOTAL FIXED INCOME SECURITIES IN UNITED
STATES 26,183,668 7.5
- ----------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN FIXED INCOME
SECURITIES (COST--$74,685,862) 79,828,713 22.8
- ----------------------------------------------------------------------------------------------------------------------------
</Table>
<Table>
<Caption>
SHORT-TERM SECURITIES
- ------------------------------------------------------------------------------------------------------------------------
FOREIGN COMMERCIAL PAPER*** A$ 13,600,000 Perry, 4.85% due 1/08/2003............ 7,641,848 2.2
- ------------------------------------------------------------------------------------------------------------------------
TOTAL SHORT-TERM INVESTMENTS IN
AUSTRALIA 7,641,848 2.2
- ------------------------------------------------------------------------------------------------------------------------
US$55,800,700 Merrill Lynch Liquidity Series,
LLC Cash Sweep Series II(k)......... 55,800,700 16.0
- ------------------------------------------------------------------------------------------------------------------------
TOTAL SHORT-TERM INVESTMENTS IN THE
UNITED STATES 55,800,700 16.0
- ------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN SHORT-TERM
SECURITIES (COST--$63,473,795) 63,442,548 18.2
- ------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS
(COST--$380,799,357) 337,273,793 96.5
- ------------------------------------------------------------------------------------------------------------------------
</Table>
<Table>
<Caption>
NOMINAL VALUE
OPTIONS COVERED
WRITTEN BY OPTIONS ISSUE
- ------------------------------------------------------------------------------------------------------------------------
CALL OPTIONS 22,700 AT&T Wireless Services Inc., expiring
WRITTEN April 2003 at USD 7.5............... (12,485) 0.0
15,500 Activision, Inc., expiring February
2003 at USD 12.5.................... (43,400) 0.0
Advanced Micro Devices, Inc.:
61,400 expiring April 2003 at USD 7.5...... (52,190) (0.1)
30,800 expiring July 2003 at USD 7.5....... (40,040) 0.0
18,400 expiring July 2003 at USD 10........ (11,960) 0.0
6,400 expiring July 2003 at USD 12.5...... (2,560) 0.0
12,600 CIT Group Inc., expiring April 2003 at
USD 20.............................. (23,940) 0.0
Circuit City Stores--Circuit City
Group:
24,700 expiring April 2003 at USD 10....... (12,350) 0.0
18,800 expiring July 2003 at USD 7.5....... (27,260) 0.0
12,800 Cisco Systems, Inc., expiring April
2003 at USD 12.5.................... (23,680) 0.0
6,500 Comverse Technology, Inc., expiring
July 2003 at USD 12.5............... (6,500) 0.0
Corning Incorporated:
14,900 expiring January 2003 at USD 10..... (745) 0.0
20,000 expiring January 2003 at USD 10..... (1,000) 0.0
33,700 EMC Corporation, expiring April 2003
at USD 7.5.......................... (15,165) 0.0
25,200 Intel Corporation, expiring January
2003 at USD 17.5.................... (6,300) 0.0
3,300 International Business Machines
Corporation, expiring April 2003
at USD 75........................... (27,390) 0.0
26,000 Knight Trading Group, Inc., expiring
July 2003 at USD 5.................. (26,000) 0.0
12,600 Lattice Semiconductor Corporation,
expiring June 2003 at USD 12.5...... (12,600) 0.0
15,700 MBNA Corporation, expiring January
2003 at USD 22.5.................... (2,355) 0.0
6,100 Merck & Co., Inc., expiring July 2003
at USD 55........................... (35,380) 0.0
</Table>
128
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL ALLOCATION V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED) (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
<Table>
<Caption>
NOMINAL VALUE
OPTIONS COVERED PERCENT OF
WRITTEN BY OPTIONS ISSUE VALUE NET ASSETS
- ------------------------------------------------------------------------------------------------------------------------
CALL OPTIONS Micron Technology, Inc.:
WRITTEN
(CONCLUDED)
18,300 expiring April 2003 at USD 17.5..... $ (4,575) 0.0%
18,800 expiring April 2003 at USD 20....... (2,820) 0.0
12,600 expiring July 2003 at USD 12.5...... (16,380) 0.0
12,500 Microsoft Corporation, expiring April
2003 at USD 55...................... (36,875) 0.0
18,400 Nextel Communications, expiring
January 2004 at USD 25.............. (16,560) 0.0
28,900 Sun Microsystems, Inc., expiring
January 2003 at USD 10.............. (1,445) 0.0
15,800 THQ Inc., expiring June 2003 at USD
15.................................. (33,970) 0.0
6,200 Tenet Healthcare Corporation, expiring
February 2003 at USD 20............. (2,480) 0.0
33,100 Tyco International Ltd., expiring
April 2003 at USD 17.5.............. (66,200) (0.1)
21,400 Unisys Corporation, expiring April
2003 at USD 10...................... (23,540) 0.0
6,400 Valero Energy Corporation, expiring
March 2003 at USD 37.5.............. (18,240) 0.0
9,900 Verizon Communications, expiring April
2003 at USD 42.5.................... (14,850) 0.0
- ------------------------------------------------------------------------------------------------------------------------
TOTAL CALL OPTIONS WRITTEN
(PREMIUMS RECEIVED--$999,581)......... (621,235) (0.2)
- ------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS, NET OF OPTIONS
WRITTEN (COST--$379,799,776).......... 336,652,558 96.3
TIME DEPOSIT**........................ 4,836,888 1.4
VARIATION MARGIN ON FINANCIAL FUTURES
CONTRACTS(e).......................... 83,071 0.0
UNREALIZED DEPRECIATION ON FORWARD
FOREIGN EXCHANGE CONTRACTS(F)......... (470,951) (0.1)
OTHER ASSETS LESS LIABILITIES......... 8,412,210 2.4
------------ -----
NET ASSETS............................ $349,513,776 100.0%
============ =====
- ------------------------------------------------------------------------------------------------------------------------
</Table>
* American Depositary Receipts (ADR).
** Time deposit bears interest at 3.90% and matures on 1/10/2003.
*** Foreign Commercial Paper is traded on a discount basis; the interest rate
shown reflects the discount rate paid at the time of purchase by the Fund.
+ Non-income producing security.
++ For Fund compliance purposes, "Industry" means any one or more of the
industry sub-classifications used by one or more widely recognized market
indexes or ratings group indexes, and/or as defined by Fund management. This
definition may not apply for purposes of this report, which may combine such
industry sub-classifications for reporting ease. These industry classifications
are unaudited.
(a) The security may be offered and sold to "qualified institutional buyers"
under Rule 144A of the Securities Act of 1933.
(b) Represents a zero coupon; the interest rate shown reflects the effective
yield at the time of purchase by the Fund.
(c) Represents ownership in the Nasdaq-100 Trust, a registered unit investment
trust. The investment objective of the Nasdaq-100 Trust is to provide investment
results that generally correspond to the price performance and dividend yield of
the component.
(d) Warrants entitle the Fund to purchase a predetermined number of shares of
common stock and are non-income producing. The purchase price and number of
shares are subject to adjustment under certain conditions until the expiration
date.
(e) Financial futures contracts purchased as of December 31, 2002 were as
follows:
<Table>
<Caption>
- -------------------------------------------------------------------------
NUMBER OF EXPIRATION
CONTRACTS ISSUE EXCHANGE DATE VALUE
- -------------------------------------------------------------------------
119 DJ Euro Stoxx Euronext Paris March 2003 $ 2,990,842
31 FTSE 100 LIFFE March 2003 1,952,108
43 Nikkei 225 Index Osaka March 2003 3,087,217
38 S&P 500 Index NYSE March 2003 8,349,550
32 Topix Index Tokyo March 2003 2,250,274
- -------------------------------------------------------------------------
TOTAL FINANCIAL FUTURES CONTRACTS PURCHASED (TOTAL CONTRACT
PRICE--$18,932,259) $18,629,991
===========
- -------------------------------------------------------------------------
</Table>
129
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL ALLOCATION V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONCLUDED) (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
(f) Forward foreign exchange contracts as of December 31, 2002 were as follows:
<Table>
<Caption>
- -------------------------------------------------------------------------------
FOREIGN CURRENCY EXPIRATION UNREALIZED
SOLD DATE DEPRECIATION
- -------------------------------------------------------------------------------
Y1,484,000,000 January 2003 $(470,951)
- -------------------------------------------------------------------------------
TOTAL UNREALIZED DEPRECIATION ON FORWARD FOREIGN
EXCHANGE CONTRACTS--NET (US$
COMMITMENT--$12,035,685) $(470,951)
=========
- -------------------------------------------------------------------------------
</Table>
(g) Restricted securities as to resale. The value of the Fund's investment in
restricted securities was approximately $3,588,000, representing 1.0% of net
assets.
<Table>
<Caption>
- ---------------------------------------------------------------------------------------------------------------
ISSUE ACQUISITION DATE(S) COST VALUE
- ---------------------------------------------------------------------------------------------------------------
Hynix Semiconductor America,
8.25% due 5/15/2004....................................... 6/13/2001-6/15/2001 $1,033,337 $ 759,000
Metromedia Fiber Network,
8.75% due 9/30/2006....................................... 10/01/2001 2,569,134 2,829,284
- ---------------------------------------------------------------------------------------------------------------
TOTAL $3,602,471 $3,588,284
========== ==========
- ---------------------------------------------------------------------------------------------------------------
</Table>
(h) Represents ownership in Semiconductor HOLDRs Trust. The Semiconductor HOLDRs
Trust holds shares of common stock issued by 20 specified companies generally
considered to be involved in various segments of the semiconductor industry.
(i) Represents ownership in Broadband HOLDRs Trust. The Broadband HOLDRs Trust
holds shares of common stock issued by 20 specified companies generally
considered to be involved in various segments of the broadband industry.
(j) Represents a step bond. The interest rate shown represents the fixed rate of
interest that will commence its accrual on a predetermined date until maturity.
(k) Investments in companies considered to be an affiliate of the Fund (such
companies are defined as "Affiliated Companies" in Section 2(a)(3) of the
Investment Company Act of 1940) are as follows:
<Table>
<Caption>
- ----------------------------------------------------------------------------------------------------
NET NET INTEREST
AFFILIATE ACTIVITY COST INCOME
- ----------------------------------------------------------------------------------------------------
Merrill Lynch Liquidity Series, LLC
Cash Sweep Series II...................................... $55,800,700 $55,800,700 $84,390
- ----------------------------------------------------------------------------------------------------
</Table>
(l) All or a portion of security held as collateral in connection with open
financial futures contracts.
See Notes to Financial Statements.
130
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL ALLOCATION V.I. FUND
STATEMENT OF ASSETS AND LIABILITIES AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
ASSETS:
Investments, at value (including securities loaned of
$11,073,518) (identified cost--$380,799,357).............. $ 337,273,793
Investments held as collateral for loaned securities, at
value..................................................... 11,469,851
Foreign time deposits....................................... 4,836,888
Foreign cash (cost--$6,197,170)............................. 6,296,349
Receivables:
Interest.................................................. $ 2,177,803
Dividends................................................. 643,879
Securities sold........................................... 166,845
Variation margin.......................................... 83,071 3,071,598
------------
Prepaid expenses............................................ 2,185
-------------
Total assets................................................ 362,950,664
-------------
- ------------------------------------------------------------------------------------------
LIABILITIES:
Collateral on securities loaned, at value................... 11,469,851
Options written, at value (premiums received--$999,581)..... 621,235
Unrealized depreciation on forward foreign exchange
contracts................................................. 470,951
Payables:
Securities purchased...................................... 455,569
Investment adviser........................................ 201,095
Capital shares redeemed................................... 112,832 769,496
------------
Accrued expenses and other liabilities...................... 105,355
-------------
Total liabilities........................................... 13,436,888
-------------
- ------------------------------------------------------------------------------------------
NET ASSETS.................................................. $ 349,513,776
=============
- ------------------------------------------------------------------------------------------
NET ASSETS CONSIST OF:
Class A Shares of Common Stock, $.10 par value, 200,000,000
shares authorized+........................................ $ 4,053,694
Paid-in capital in excess of par............................ 456,471,733
Accumulated distributions in excess of investment
income--net............................................... $ (1,701,796)
Accumulated realized capital losses on investments and
foreign currency transactions--net........................ (65,695,467)
Unrealized depreciation on investments and foreign currency
transactions--net......................................... (43,614,388)
------------
Total accumulated losses--net............................... (111,011,651)
-------------
NET ASSETS.................................................. $ 349,513,776
=============
- ------------------------------------------------------------------------------------------
NET ASSET VALUE:
Class A--Based on net assets of $349,513,776 and 40,536,942
shares outstanding........................................ $ 8.62
=============
- ------------------------------------------------------------------------------------------
</Table>
+ The Fund is also authorized to issue 200,000,000 Class B Shares.
See Notes to Financial Statements.
131
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL ALLOCATION V.I. FUND
STATEMENT OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
INVESTMENT INCOME:
Interest (net of $36 foreign withholding tax)............... $ 9,699,095
Dividends (net of $217,923 foreign withholding tax)......... 3,955,167
Securities lending--net..................................... 30,665
------------
Total income................................................ 13,684,927
------------
- -------------------------------------------------------------------------------------------
EXPENSES:
Investment advisory fees.................................... $ 2,514,180
Custodian fees.............................................. 138,671
Accounting services......................................... 137,171
Professional fees........................................... 60,793
Printing and shareholder reports............................ 36,985
Transfer agent fees......................................... 29,344
Directors' fees and expenses................................ 16,710
Pricing services............................................ 9,197
Registration fees........................................... 867
Other....................................................... 24,637
------------
Total expenses.............................................. 2,968,555
------------
Investment income--net...................................... 10,716,372
------------
- -------------------------------------------------------------------------------------------
REALIZED & UNREALIZED GAIN (LOSS) ON INVESTMENTS & FOREIGN
CURRENCY TRANSACTIONS--NET:
Realized gain (loss) on:
Investments--net.......................................... (33,328,373)
Foreign currency transactions--net........................ 3,135,436 (30,192,937)
------------
Change in unrealized appreciation/depreciation on:
Investments--net.......................................... (12,714,524)
Foreign currency transactions--net........................ (1,862,263) (14,576,787)
------------ ------------
Total realized and unrealized loss on investments and
foreign currency transactions--net........................ (44,769,724)
------------
NET DECREASE IN NET ASSETS RESULTING FROM OPERATIONS........ $(34,053,352)
============
- -------------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
132
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL ALLOCATION V.I. FUND
STATEMENTS OF CHANGES IN NET ASSETS
- --------------------------------------------------------------------------------
<Table>
<Caption>
FOR THE YEAR ENDED
DECEMBER 31,
-----------------------------
INCREASE (DECREASE) IN NET ASSETS: 2002 2001
- -------------------------------------------------------------------------------------------
OPERATIONS:
Investment income--net...................................... $ 10,716,372 $ 11,263,595
Realized loss on investments and foreign currency
transactions--net......................................... (30,192,937) (18,318,618)
Change in unrealized appreciation/depreciation on
investments and foreign currency transactions--net........ (14,576,787) (40,543,050)
------------ -------------
Net decrease in net assets resulting from operations........ (34,053,352) (47,598,073)
------------ -------------
- -------------------------------------------------------------------------------------------
DIVIDENDS TO SHAREHOLDERS:
Investment income--net:
Class A................................................... (12,725,017) (6,400,021)
------------ -------------
Net decrease in net assets resulting from dividends to
shareholders.............................................. (12,725,017) (6,400,021)
------------ -------------
- -------------------------------------------------------------------------------------------
CAPITAL SHARE TRANSACTIONS:
Net decrease in net assets derived from capital share
transactions.............................................. (28,249,971) (74,313,285)
------------ -------------
- -------------------------------------------------------------------------------------------
NET ASSETS:
Total decrease in net assets................................ (75,028,340) (128,311,379)
Beginning of year........................................... 424,542,116 552,853,495
------------ -------------
End of year*................................................ $349,513,776 $ 424,542,116
============ =============
- -------------------------------------------------------------------------------------------
* Accumulated distributions in excess of investment
income--net............................................... $ (1,701,796) $ (2,822,833)
============ =============
- -------------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
133
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL ALLOCATION V.I. FUND
FINANCIAL HIGHLIGHTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
THE FOLLOWING PER SHARE DATA AND RATIOS HAVE BEEN
DERIVED FROM INFORMATION PROVIDED IN THE FINANCIAL CLASS A
STATEMENTS. ------------------------------------------------------------
FOR THE YEAR ENDED DECEMBER 31,
------------------------------------------------------------
INCREASE (DECREASE) IN NET ASSET VALUE: 2002 2001 2000 1999 1998
- ----------------------------------------------------------------------------------------------------------------------
PER SHARE OPERATING PERFORMANCE:
Net asset value, beginning of year.................... $ 9.74 $ 10.85 $ 14.13 $ 13.41 $ 14.71
-------- -------- -------- -------- --------
Investment income--net................................ .26+ .24+ .27+ .20+ .34
Realized and unrealized gain (loss) on investments and
foreign currency transactions--net.................. (1.05) (1.20) (1.62) 2.58 .76
-------- -------- -------- -------- --------
Total from investment operations...................... (.79) (.96) (1.35) 2.78 1.10
-------- -------- -------- -------- --------
Less dividends and distributions:
Investment income--net.............................. (.33) (.15) (.24) (.30) (.55)
In excess of investment income--net................. -- -- (.06) (.05) --
Realized gain on investments--net................... -- -- (1.20) (1.71) (1.70)
In excess of realized gain on investments--net...... -- -- (.43) -- (.15)
-------- -------- -------- -------- --------
Total dividends and distributions..................... (.33) (.15) (1.93) (2.06) (2.40)
-------- -------- -------- -------- --------
Net asset value, end of year.......................... $ 8.62 $ 9.74 $ 10.85 $ 14.13 $ 13.41
======== ======== ======== ======== ========
- ----------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENT RETURN:*
Based on net asset value per share.................... (8.15%) (8.86%) 9.62% 21.37% 8.87%
======== ======== ======== ======== ========
- ----------------------------------------------------------------------------------------------------------------------
RATIOS TO AVERAGE NET ASSETS:
Expenses.............................................. .77% .75% .73% .73% .72%
======== ======== ======== ======== ========
Investment income--net................................ 2.77% 2.42% 2.03% 1.49% 2.40%
======== ======== ======== ======== ========
- ----------------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL DATA:
Net assets, end of year (in thousands)................ $349,514 $424,542 $552,853 $727,040 $766,026
======== ======== ======== ======== ========
Portfolio turnover.................................... 55.50% 107.28% 118.64% 103.76% 120.59%
======== ======== ======== ======== ========
- ----------------------------------------------------------------------------------------------------------------------
</Table>
* Total investment returns exclude insurance-related fees and expenses.
+ Based on average shares outstanding.
See Notes to Financial Statements.
134
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL ALLOCATION V.I. FUND
NOTES TO FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
1. SIGNIFICANT ACCOUNTING POLICIES:
Merrill Lynch Variable Series Funds, Inc. (the "Company") is an open-end
management investment company that is comprised of 17 separate funds. Each fund
offers two classes of shares to the Merrill Lynch Life Insurance Company, ML
Life Insurance Company of New York (indirect, wholly-owned subsidiaries of
Merrill Lynch & Co., Inc. ("ML & Co.")), and other insurance companies, that are
not affiliated with ML & Co., for their separate accounts to fund benefits under
certain variable annuity and variable life insurance contracts. Global
Allocation V.I. Fund (the "Fund") (formerly Global Allocation Focus Fund) is
classified as "non-diversified," as defined in the Investment Company Act of
1940. Class A and Class B Shares have equal voting, dividend, liquidation and
other rights, except that only shares of the respective classes are entitled to
vote on matters concerning only that class and Class B Shares bear certain
expenses related to the distribution of such shares. The Fund's financial
statements are prepared in conformity with accounting principles generally
accepted in the United States of America, which may require the use of
management accruals and estimates. The following is a summary of significant
accounting policies followed by the Fund.
(a) Valuation of investments--Portfolio securities that are traded on stock
exchanges are valued at the last sale price as of the close of business on the
day the securities are being valued, or lacking any sales, at the closing bid
price. Securities traded in the over-the-counter market are valued at the last
available bid price prior to the time of valuation. In cases where securities
are traded on more than one exchange, the securities are valued on the exchange
designated by or under the authority of the Board of Directors as the primary
market. Portfolio securities that are traded both in the over-the-counter 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. Options written or purchased are
valued at the last sale price in the case of exchange-traded options. In the
case of options traded in the over-the-counter market, valuation is the last
asked price (options written) or the last bid price (options purchased).
Short-term securities are valued at amortized cost, which approximates market
value. Futures contracts are valued at the 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.
(b) Derivative financial instruments--The Fund may engage in various portfolio
investment strategies to increase or decrease the level of risk to which the
Fund is exposed more quickly and efficiently than transactions in other types of
instruments. Losses may arise due to changes in the value of the contract or if
the counterparty does not perform under the contract.
- - Forward foreign exchange contracts--The Fund is authorized to enter into
forward foreign exchange contracts as a hedge against either specific
transactions or portfolio positions. The contract is marked to market daily and
the change in market value is recorded by the Fund as an unrealized gain or
loss. When the contract is closed, the Fund records a realized gain or loss
equal to the difference between the value at the time it was opened and the
value at the time it was closed.
- - Options--The Fund may write and purchase call and put options. When the Fund
writes an option, an amount equal to the premium received by the Fund is
reflected as an asset and an equivalent liability. The amount of the liability
is subsequently marked to market to reflect the current market value of the
option written. When a security is purchased or sold through an exercise of an
option, the related premium paid or received is added to (or deducted from) the
basis of the security acquired or deducted from (or added to) the proceeds of
the security sold. When an option expires (or the Fund enters into a closing
transaction), the Fund realizes a gain or loss on the option to the extent of
the premiums received or paid (or gain or loss to the extent the cost of the
closing transaction exceeds the premium paid or received).
Written and purchased options are non-income producing investments.
- - Financial futures contracts--The Fund may purchase or sell financial futures
contracts and options on such futures contracts for the purpose of hedging the
market risk on existing securities or the intended purchase of securities.
Futures contracts are contracts for delayed delivery of securities at a specific
future date and at a specific price or yield. Upon entering into a contract, the
Fund deposits and maintains
135
- --------------------------------------------------------------------------------
as collateral such initial margin as required by the exchange on which the
transaction is effected. Pursuant to the contract, the Fund agrees to receive
from or pay to the broker an amount of cash equal to the daily fluctuation in
value of the contract. Such receipts or payments are known as variation margin
and are recorded by the Fund as unrealized gains or losses. When the contract is
closed, the Fund records a realized gain or loss equal to the difference between
the value of the contract at the time it was opened and the value at the time it
was closed.
- - Foreign currency options and futures--The Fund may also purchase or sell
listed or over-the-counter foreign currency options, foreign currency futures
and related options on foreign currency futures as a short or long hedge against
possible variations in foreign exchange rates. Such transactions may be effected
with respect to hedges on non-U.S. dollar denominated securities owned by the
Fund, sold by the Fund but not yet delivered, or committed or anticipated to be
purchased by the Fund.
(c) Foreign currency transactions--Transactions denominated in foreign
currencies are recorded at the exchange rate prevailing when recognized. Assets
and liabilities denominated in foreign currencies are valued at the exchange
rate at the end of the period. Foreign currency transactions are the result of
settling (realized) or valuing (unrealized) assets and liabilities expressed in
foreign currencies into U.S. dollars. Realized and unrealized gains or losses
from investments include the effects of foreign exchange rates on investments.
(d) Income taxes--It is the Fund's policy to comply with the requirements of
the Internal Revenue Code applicable to regulated investment companies and to
distribute substantially all of its taxable income to its shareholders.
Therefore, no Federal income tax provision is required. Under the applicable
foreign tax law, a withholding tax may be imposed on interest, dividends and
capital gains at various rates.
(e) Security transactions and investment income--Security transactions are
recorded on the dates the transactions are entered into (the trade dates).
Realized gains and losses on security transactions are determined on the
identified cost basis. Dividend income is recorded on the ex-dividend dates.
Dividends from foreign securities where the ex-dividend date may have passed are
subsequently recorded when the Fund has determined the ex-dividend date.
Interest income is recognized on the accrual basis. The Fund amortizes all
premiums and discounts on debt securities.
(f) Dividends and distributions--Dividends and distributions paid by the Fund
are recorded on the ex-dividend dates.
(g) Securities lending--The Fund may lend securities to financial institutions
that provide cash or securities issued or guaranteed by the U.S. government as
collateral, which will be maintained at all times in an amount equal to at least
100% of the current market value of the loaned securities. Where the Fund
receives securities as collateral for the loaned securities, it collects a fee
from the borrower. The Fund typically receives the income on the loaned
securities but does not receive the income on the collateral. Where the Fund
receives cash collateral, it may invest such collateral and retain the amount
earned on such investment, net of any amount rebated to the borrower. Loans of
securities are terminable at any time and the borrower, after notice, is
required to return borrowed securities within five business days. The Fund may
pay reasonable finder's, lending agent, administrative and custodial fees in
connection with its loans. In the event that the borrower defaults on its
obligation to return borrowed securities because of insolvency or for any other
reason, the Fund could experience delays and costs in gaining access to the
collateral. The Fund also could suffer a loss where the value of the collateral
falls below the market value of the borrowed securities, in the event of
borrower default or in the event of losses on investments made with cash
collateral.
(h) Expenses--Certain expenses have been allocated to the individual Funds in
the Company on a pro rata basis based upon the respective aggregate net asset
value of each Fund included in the Company.
(i) Reclassification--Accounting principles generally accepted in the United
States of America require that certain components of net assets be adjusted to
reflect permanent differences between financial and tax reporting. Accordingly,
the current year's permanent book/tax difference of $3,129,682 has been
reclassified between accumulated realized capital losses and accumulated
distributions in excess of net investment income. This reclassification has no
effect on net assets or net asset value per share.
2. INVESTMENT ADVISORY AGREEMENT AND TRANSACTIONS WITH AFFILIATES:
The Company has entered into an Investment Advisory Agreement with Merrill Lynch
Investment Managers, L.P. ("MLIM"). The general partner of MLIM is Princeton
Services, Inc.
136
- --------------------------------------------------------------------------------
("PSI"), an indirect, wholly-owned subsidiary of ML & Co., which is the limited
partner.
MLIM is responsible for the management of the Company's funds and provides the
necessary personnel, facilities, equipment and certain other services necessary
to the operations of the Fund. For such services, the Fund pays a monthly fee at
the annual rate of .65% of the average daily value of the Fund's net assets.
MLIM and Merrill Lynch Life Agency, Inc. ("MLLA") have entered into an
agreement which limits the operating expenses paid by the Fund, exclusive of any
distribution fees imposed on Class B Shares, to 1.25% of its average daily net
assets. Any expenses in excess of 1.25% of average daily net assets will be
reimbursed to the Fund by MLIM which, in turn, will be reimbursed by MLLA.
The Company has received an exemptive order from the Securities and Exchange
Commission permitting it to lend portfolio securities to Merrill Lynch, Pierce,
Fenner & Smith Incorporated ("MLPF&S"), a subsidiary of ML & Co., or its
affiliates. Pursuant to that order, the Company also has retained Merrill Lynch
Investment Managers, LLC ("MLIM, LLC"), an affiliate of MLIM, as the securities
lending agent for a fee based on a share of the returns on investment of cash
collateral. MLIM, LLC may, on behalf of the Company and the Fund, invest cash
collateral received by the Fund for such loans, among other things, in a private
investment company managed by MLIM, LLC or in registered money market funds
advised by MLIM or its affiliates. As of December 31, 2002, cash collateral of
$6,079,022 was invested in the Money Market Series of the Merrill Lynch
Liquidity Series, LLC and $5,390,829 was invested in the Merrill Lynch Premier
Institutional Fund. For the year ended December 31, 2002, MLIM, LLC received
$12,776 in securities lending agent fees from the Fund.
For the year ended December 31, 2002, MLPF&S, earned $43,115 in commissions on
the execution of portfolio security transactions
For the year ended December 31, 2002, Merrill Lynch Security Pricing Service,
an affiliate of MLPF&S, earned $176 for providing security price quotations to
compute the Fund's net asset value.
Financial Data Services, Inc. ("FDS"), a wholly-owned subsidiary of ML & Co.,
is the Company's transfer agent.
FAM Distributors, Inc. ("FAMD"), which is a wholly-owned subsidiary of Merrill
Lynch Group, Inc., is the Fund's distributor.
For the year ended December 31, 2002, the Fund reimbursed MLIM $14,508 for
certain accounting services.
Certain officers and/or directors of the Company are officers and/or directors
of MLIM, PSI, FDS, FAMD, and/or ML & Co.
3. INVESTMENTS:
Purchases and sales of investments, excluding short-term securities, for the
year ended December 31, 2002 were $169,396,191 and $221,904,637, respectively.
Net realized gains (losses) for the year ended December 31, 2002 and net
unrealized gains (losses) as of December 31, 2002 were as follows:
<Table>
<Caption>
- ------------------------------------------------------------------
Realized Unrealized
Gains Gains
(Losses) (Losses)
- ------------------------------------------------------------------
Long-term investments................ $(26,209,307) $(43,494,317)
Short-term investments............... 219,678 (31,247)
Options written...................... 934,829 378,346
Financial futures contracts.......... (8,273,573) (302,268)
Forward foreign exchange contracts... (1,218,951) (470,951)
Foreign currency transactions........ 4,354,387 306,049
------------ ------------
Total................................ $(30,192,937) $(43,614,388)
============ ============
- ------------------------------------------------------------------
</Table>
At December 31, 2002, net unrealized depreciation for Federal income tax
purposes aggregated $45,252,016, of which $16,308,220 related to appreciated
securities and $61,560,236 related to depreciated securities. At December 31,
2002, the aggregate cost of investments, net of options written for Federal
income tax purposes was $381,904,573.
Transactions in call options written for the year ended December 31, 2002 were
as follows:
<Table>
<Caption>
- --------------------------------------------------------------------
Nominal Value
Covered by Premiums
Options Written Received
- --------------------------------------------------------------------
Outstanding call options written,
beginning of year.................... 136,800 $ 354,978
Options written....................... 1,033,100 2,019,897
Options exercised..................... (33,600) (90,607)
Options expired....................... (160,400) (410,803)
Options closed........................ (385,500) (873,884)
--------- ----------
Outstanding call options written, end
of year.............................. 590,400 $ 999,581
========= ==========
- --------------------------------------------------------------------
</Table>
137
- --------------------------------------------------------------------------------
4. CAPITAL SHARE TRANSACTIONS:
Transactions in capital shares were as follows:
<Table>
<Caption>
- -----------------------------------------------------------------
Class A Shares for the Year Ended Dollar
December 31, 2002 Shares Amount
- -----------------------------------------------------------------
Shares sold........................... 658,300 $ 6,272,669
Shares issued to shareholders in
reinvestment of dividends............ 1,481,376 12,725,017
---------- ------------
Total issued.......................... 2,139,676 18,997,686
Shares redeemed....................... (5,183,284) (47,247,657)
---------- ------------
Net decrease.......................... (3,043,608) $(28,249,971)
========== ============
- -----------------------------------------------------------------
</Table>
<Table>
<Caption>
- -----------------------------------------------------------------
Class A Shares for the Year Ended Dollar
December 31, 2001 Shares Amount
- -----------------------------------------------------------------
Shares sold........................... 154,024 $ 1,539,399
Shares issued to shareholders in
reinvestment of dividends............ 657,086 6,400,021
---------- ------------
Total issued.......................... 811,110 7,939,420
Shares redeemed....................... (8,205,080) (82,252,705)
---------- ------------
Net decrease.......................... (7,393,970) $(74,313,285)
========== ============
- -----------------------------------------------------------------
</Table>
5. SHORT-TERM BORROWINGS:
The Fund, along with certain other funds managed by MLIM and its affiliates, is
a party to a credit agreement with Bank One, N.A. and certain other lenders.
Effective November 29, 2002 in conjunction with the renewal for one year at the
same terms, the total commitment was reduced from $1,000,000,000 to
$500,000,000. The Fund may borrow under the credit agreement to fund shareholder
redemptions and for other lawful purposes other than for leverage. The Fund may
borrow up to the maximum amount allowable under the Fund's current prospectus
and statement of additional information, subject to various other legal,
regulatory or contractual limits. The Fund pays a commitment fee of .09% per
annum based on the Fund's pro rata share of the unused portion of the credit
agreement. Amounts borrowed under the credit agreement bear interest at a rate
equal to, at each fund's election, the Federal Funds rate plus .50% or a base
rate as determined by Bank One, N.A. The Fund did not borrow under the credit
agreement during the year ended December 31, 2002.
6. DISTRIBUTIONS TO SHAREHOLDERS:
The tax character of distributions paid during the fiscal years ended December
31, 2002 and December 31, 2001 was as follows:
<Table>
<Caption>
- ------------------------------------------------------------------
12/31/2002 12/31/2001
- ------------------------------------------------------------------
Distributions paid from:
Ordinary income........................ $12,725,017 $6,400,021
----------- ----------
Total taxable distributions............. $12,725,017 $6,400,021
=========== ==========
- ------------------------------------------------------------------
</Table>
As of December 31, 2002, the components of accumulated losses on a tax basis
were as follows:
<Table>
- -----------------------------------------------------------------
Undistributed ordinary income--net................ $ 195,598
Undistributed long-term capital gains--net........ --
-------------
Total undistributed earnings--net................. 195,598
Capital loss carryforward......................... (54,905,419)*
Unrealized losses--net............................ (56,301,830)**
-------------
Total accumulated losses--net..................... $(111,011,651)
=============
- -----------------------------------------------------------------
</Table>
* On December 31, 2002, the Fund had a net capital loss carryforward of
$54,905,419, of which $30,500,017 expires in 2009 and $24,405,402 expires in
2010. This amount will be available to offset like amounts of any future
taxable gains.
** The difference between book-basis and tax-basis net unrealized losses is
attributable primarily to the tax deferral of losses on wash sales, the tax
deferral of losses on straddles, the realization for tax purposes of
unrealized gains (losses) on certain futures and forward foreign currency
contracts, the difference between book and tax amortization methods for
premiums and discounts on fixed income securities, the realization for tax
purposes of unrealized gains on investments in passive foreign investment
companies, the deferral of post-October capital losses for tax purposes, the
book/tax differences in the accrual of income on securities in default and
other book/tax temporary differences.
138
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL ALLOCATION V.I. FUND
INDEPENDENT AUDITORS' REPORT
- --------------------------------------------------------------------------------
THE BOARD OF DIRECTORS AND SHAREHOLDERS, GLOBAL ALLOCATION V.I. FUND OF MERRILL
LYNCH VARIABLE SERIES FUNDS, INC.:
We have audited the accompanying statement of assets and liabilities,
including the schedule of investments, of Global Allocation V.I. Fund (formerly,
Global Allocation Focus Fund) of Merrill Lynch Variable Series Funds, Inc. as of
December 31, 2002, the related statements of operations for the year then ended
and changes in net assets for each of the years in the two-year period then
ended, and the financial highlights for each of the years presented. These
financial statements and the financial highlights are the responsibility of the
Fund's management. Our responsibility is to express an opinion on these
financial statements and the financial highlights based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements and the financial highlights are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. Our procedures included confirmation of
securities owned at December 31, 2002 by correspondence with the custodian and
brokers; where replies were not received from brokers, we performed other
auditing procedures. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such financial statements and financial highlights present
fairly, in all material respects, the financial position of Global Allocation
V.I. Fund of Merrill Lynch Variable Series Funds, Inc. as of December 31, 2002,
the results of its operations, the changes in its net assets, and the financial
highlights for the respective stated periods in conformity with accounting
principles generally accepted in the United States of America.
Deloitte & Touche LLP
Princeton, New Jersey
February 14, 2003
139
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL GROWTH V.I. FUND
DECEMBER 31, 2002--ANNUAL REPORT
- --------------------------------------------------------------------------------
DEAR SHAREHOLDER:
FISCAL YEAR IN REVIEW
For the 12 months ended December 31, 2002, the Fund's Class A Shares had a
total return of -27.74%, compared to a total return of -19.53% for the Lipper
Global Funds Average. For the same 12-month period, the unmanaged Morgan Stanley
Capital International World Stock Index (in U.S. dollars) had a total investment
return of -19.89%. Managers of large-capitalization growth stock funds had
materially worse overall investment performance in 2002 than value style
investment managers for the third consecutive year.
The most negative influence on the Fund's investment results during the fiscal
year was the stock price declines of holdings in the European insurance
industry, where even the largest global companies had to make substantial
additions to reserves for the guarantees of customer investment returns as a
result of the declines in the asset values of portfolios of stocks supporting
the guarantees. The most negative stock in this sector was Allianz AG in
Germany. As a result, we sold out of all of our insurance stock holdings. The
next most negative influence was the Fund's investments in U.S. media and
advertising companies. Despite a cyclical upturn in advertising revenue growth
and operating profits starting in mid-March 2002, the stock values of the major
companies declined to record low levels. AOL Time Warner Inc.'s stock price
decline had the most negative influence on the Fund's investment performance.
The third negative influence on investment returns was the Fund's investment
exposure to the information technology sector. After successfully exiting this
sector in August--September 2000, it is obvious to us now that we should have
not re-entered the sector even once during the last two years. There has been a
cyclical capital spending upturn in the United States in computing equipment and
related electronics. This upturn is reflected in U.S. Commerce Department
statistics as well as the Semiconductor Industry Association data on global
spending on semiconductor devices. However, there has been so much excess
capacity in the world from manufacturers that the upturn has not turned into a
profitable cyclical upturn for private corporations. Presently, the Fund has a
relatively modest weighting with equity holdings in only a few of what we
believe are the profitable companies in a long-run shake-out of the industry.
Positive comparative influences on the Fund's investment returns were from
selected stock holdings in the U.S. and U.K. retailing industries. Also, equity
holdings in Japanese and European consumer electronics and automotive stocks had
a positive comparative effect on investment results. The Fund started the year
2002 with meaningful investments in European and Japanese equities in the
consumer electronics, appliances and motor vehicle sectors. The outlook was
positive for real consumer spending growth in the United States, which was
realized until late in the second quarter of 2002 when President Bush started to
focus on U.S. military action against Iraq. Since that time the rate of real
growth of U.S. consumer spending and U.S. corporate capital spending has ground
to a halt in terms of cyclical upside momentum. The U.S. stock market as well as
most other global stock markets have declined.
INVESTMENT ENVIRONMENT
In our opinion, a negative influence on stock market valuations is the "war on
terrorism" policy, which is being highlighted and pursued by the Bush
administration. Historical analysis shows that the U.S. equity markets have not
provided above-average investment returns during periods of pending or actual
armed conflict. Most global markets are closely correlated in terms of movements
up and down in today's world. However, U.S. stock markets typically have risen
meaningfully after the resolution of war as they did after the conclusion of the
Gulf War in January 1991 and the end of the Vietnam War in late 1974 and early
1975.
PORTFOLIO MATTERS
The Fund's largest sector for investment is consumer discretionary with about
20% of net assets at year-end 2002. In our opinion, we should be optimistic
about the U.S. Congress passing President Bush's tax bill with potentially
positive developments in terms of increases in the rate of real growth of
consumer spending. On the other hand, the real economic picture in the United
Kingdom and Europe is becoming problematic. The European Central Bank, in our
opinion, is likely to become more aggressive in providing liquidity and lower
interest rates to the euro-markets. Also, European budget deficit limitations,
in our view, are likely to be relaxed as the magnitude of the slow down in real
growth rates becomes larger. We have selectively added equity investments, which
we
140
- --------------------------------------------------------------------------------
believe will benefit from a continuation of above-average real economic growth
in China over the next year. The equities of these companies trade on the stock
exchanges in Hong Kong and South Korea and are involved in the energy,
electronic components, electric power and semi-conductor industries.
IN CONCLUSION
We appreciate your continued investment in Global Growth V.I. Fund of Merrill
Lynch Variable Series Funds, Inc., and we look forward to discussing our
investment outlook and strategies with you in our next report to shareholders.
Sincerely,
/s/ Terry K. Glenn
Terry K. Glenn
President and Director
/s/ Lawrence R. Fuller
Lawrence R. Fuller
Senior Vice President and Portfolio Manager
January 17, 2003
141
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL GROWTH V.I. FUND
TOTAL RETURN BASED ON A $10,000 INVESTMENT--CLASS A SHARES
- --------------------------------------------------------------------------------
<Table>
<Caption>
MORGAN STANLEY CAPITAL
GLOBAL GROWTH FOCUS FUND++-- INTERNATIONAL WORLD STOCK
CLASS A SHARES* INDEX++
---------------------------- -------------------------
6/05/98** 10000 10000
12/98 10820 10660
12/99 15006 13318
12/00 12755 11563
12/01 9818 9618
12/02 7094 7705
</Table>
* Assuming transaction costs and other operating expenses, including advisory
fees. Does not include insurance-related fees and expenses.
** The Fund commenced operations on 6/05/98.
+ The Fund invests in a diversified portfolio of equity securities of issuers
located in various foreign countries and the United States, placing particular
emphasis on companies that have exhibited above-average earnings growth.
++ This unmanaged market capitalization-weighted Index is comprised of a
representative sampling of large-, medium- and small-capitalization companies
in 22 countries, including the United States. The starting date for the Index
in the graph is from 6/30/98.
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL GROWTH V.I. FUND
AVERAGE ANNUAL TOTAL RETURN--CLASS A SHARES*
- --------------------------------------------------------------------------------
PERIOD COVERED % RETURN
- --------------------------------------------------------------------------------
One Year Ended 12/31/02 -27.74%
- --------------------------------------------------------------------------------
Inception (6/05/98) to 12/31/02 - 7.23
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL GROWTH V.I. FUND
RECENT PERFORMANCE RESULTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
6-MONTH 12-MONTH
AS OF DECEMBER 31, 2002 TOTAL RETURN TOTAL RETURN
- -----------------------------------------------------------------------------------------
Class A Shares* -14.04% -27.74%
- -----------------------------------------------------------------------------------------
MSCI World Index** -12.14 -19.89
- -----------------------------------------------------------------------------------------
</Table>
* Total investment returns are based on changes in net asset values for the
periods shown, and assume reinvestment of all dividends and capital gains
distributions at net asset value on the ex-dividend date. Insurance-related
fees and expenses are not reflected in these returns.
** This unmanaged market-capitalization weighted Index is comprised of a
representative sampling of large-, medium- and small-capitalization companies
in 22 countries, including the United States.
Past results shown should not be considered a representation of future
performance.
142
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL GROWTH V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
<Table>
<Caption>
NORTH SHARES PERCENT OF
AMERICA INDUSTRY++ HELD INVESTMENTS VALUE NET ASSETS
- ------------------------------------------------------------------------------------------------------------------------
CANADA MEDIA 132,200 +Rogers Communications, Inc. 'B'............. $ 1,226,771 1.5%
---------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN CANADA 1,226,771 1.5
- ------------------------------------------------------------------------------------------------------------------------
UNITED STATES AEROSPACE & 16,600 General Dynamics Corporation................. 1,317,542 1.6
DEFENSE
---------------------------------------------------------------------------------------------------
AIR FREIGHT & 7,000 United Parcel Service, Inc. (Class B)........ 441,560 0.5
LOGISTICS
---------------------------------------------------------------------------------------------------
BANKS 29,800 Washington Mutual, Inc. ..................... 1,028,994 1.3
---------------------------------------------------------------------------------------------------
BEVERAGES 37,000 The Coca-Cola Company........................ 1,621,340 2.0
---------------------------------------------------------------------------------------------------
BIOTECHNOLOGY 48,200 +Amgen Inc. ................................. 2,330,470 2.9
---------------------------------------------------------------------------------------------------
COMMERCIAL 23,700 First Data Corporation....................... 839,217 1.0
SERVICES &
SUPPLIES
---------------------------------------------------------------------------------------------------
COMPUTERS & 10,500 International Business Machines
PERIPHERALS Corporation.................................. 813,750 1.0
---------------------------------------------------------------------------------------------------
DIVERSIFIED 46,800 American Express Company..................... 1,654,380 2.0
FINANCIALS
26,300 Fannie Mae................................... 1,691,879 2.1
------------ -----
3,346,259 4.1
---------------------------------------------------------------------------------------------------
FOOD & DRUG 43,600 SYSCO Corporation............................ 1,298,844 1.6
RETAILING
---------------------------------------------------------------------------------------------------
HEALTH CARE 17,600 Medtronic, Inc. ............................. 802,560 1.0
EQUIPMENT &
SUPPLIES
13,800 Stryker Corporation.......................... 926,256 1.2
21,800 +Zimmer Holdings, Inc. ...................... 905,136 1.1
------------ -----
2,633,952 3.3
---------------------------------------------------------------------------------------------------
HEALTH CARE 48,600 HCA Inc. .................................... 2,016,900 2.5
PROVIDERS &
SERVICES
52,000 Health Management Associates, Inc. (Class
A)........................................... 930,800 1.2
41,600 +Tenet Healthcare Corporation................ 682,240 0.8
------------ -----
3,629,940 4.5
---------------------------------------------------------------------------------------------------
HOUSEHOLD 20,600 The Clorox Company........................... 849,750 1.1
PRODUCTS
29,300 The Procter & Gamble Company................. 2,518,042 3.1
------------ -----
3,367,792 4.2
---------------------------------------------------------------------------------------------------
INDUSTRIAL 15,200 3M Co. ...................................... 1,874,160 2.3
CONGLOMERATES
---------------------------------------------------------------------------------------------------
INSURANCE 13,100 American International Group, Inc. .......... 757,835 0.9
---------------------------------------------------------------------------------------------------
MEDIA 138,100 +AOL Time Warner Inc. ....................... 1,809,110 2.2
46,400 +Clear Channel Communications, Inc. ......... 1,730,256 2.1
52,700 +Viacom, Inc. (Class B)...................... 2,148,052 2.7
------------ -----
5,687,418 7.0
---------------------------------------------------------------------------------------------------
MULTILINE RETAIL 35,900 Wal-Mart Stores, Inc. ....................... 1,813,309 2.2
---------------------------------------------------------------------------------------------------
OIL & GAS 57,700 Exxon Mobil Corporation...................... 2,016,038 2.5
---------------------------------------------------------------------------------------------------
SEMICONDUCTOR 45,600 Intel Corporation............................ 709,536 0.9
EQUIPMENT &
PRODUCTS
---------------------------------------------------------------------------------------------------
SOFTWARE 16,000 +Electronic Arts Inc. ....................... 795,360 1.0
30,700 +Microsoft Corporation....................... 1,587,497 1.9
------------ -----
2,382,857 2.9
---------------------------------------------------------------------------------------------------
SPECIALTY RETAIL 38,000 Lowe's Companies, Inc. ...................... 1,425,000 1.7
43,800 The TJX Companies, Inc. ..................... 854,976 1.1
------------ -----
2,279,976 2.8
---------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN THE UNITED STATES 40,190,789 49.5
- ------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN NORTH AMERICA
(COST--$50,226,922) 41,417,560 51.0
- ------------------------------------------------------------------------------------------------------------------------
</Table>
143
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL GROWTH V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED) (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
<Table>
<Caption>
PACIFIC SHARES PERCENT OF
BASIN INDUSTRY++ HELD INVESTMENTS VALUE NET ASSETS
- ------------------------------------------------------------------------------------------------------------------------
CHINA OIL & GAS 2,054,000 PetroChina Company Limited................... $ 408,250 0.5%
---------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN CHINA 408,250 0.5
- ------------------------------------------------------------------------------------------------------------------------
HONG KONG ELECTRICAL 520,000 Huaneng Power International, Inc. 'H'........ 416,752 0.5
EQUIPMENT
357,000 Johnson Electric Holdings Limited............ 393,696 0.5
------------ -----
810,448 1.0
---------------------------------------------------------------------------------------------------
OIL & GAS 316,500 CNOOC Limited................................ 413,970 0.5
---------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN HONG KONG 1,224,418 1.5
- ------------------------------------------------------------------------------------------------------------------------
JAPAN SPECIALTY RETAIL 15,000 Seven-Eleven Japan Co., Ltd.................. 457,571 0.5
---------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN JAPAN 457,571 0.5
- ------------------------------------------------------------------------------------------------------------------------
SOUTH KOREA SEMICONDUCTOR 3,000 Samsung Electronics.......................... 794,233 1.0
EQUIPMENT &
PRODUCTS
---------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN SOUTH KOREA 794,233 1.0
- ------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN THE PACIFIC BASIN
(COST--$2,841,943) 2,884,472 3.5
- ------------------------------------------------------------------------------------------------------------------------
<Caption>
WESTERN
EUROPE
- ------------------------------------------------------------------------------------------------------------------------
FRANCE AUTOMOBILES 21,200 PSA Peugeot Citroen.......................... 864,529 1.1
---------------------------------------------------------------------------------------------------
FOOD & DRUG 9,800 Carrefour SA................................. 436,355 0.5
RETAILING
---------------------------------------------------------------------------------------------------
MEDIA 20,500 Societe Television Francaise 1............... 547,713 0.7
---------------------------------------------------------------------------------------------------
OIL & GAS 4,600 TotalFinaElf SA.............................. 656,987 0.8
---------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN FRANCE 2,505,584 3.1
- ------------------------------------------------------------------------------------------------------------------------
GERMANY AUTOMOBILES 4,073 Porsche AG (Preferred)....................... 1,692,586 2.1
---------------------------------------------------------------------------------------------------
SOFTWARE 2,100 SAP AG (Systeme, Anwendungen, Produkte in der
Datenverarbeitung)........................... 164,619 0.2
---------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN GERMANY 1,857,205 2.3
- ------------------------------------------------------------------------------------------------------------------------
ITALY BANKS 359,850 Unicredito Italiano SpA...................... 1,438,757 1.8
---------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN ITALY 1,438,757 1.8
- ------------------------------------------------------------------------------------------------------------------------
NETHERLANDS OIL & GAS 34,200 Royal Dutch Petroleum Company................ 1,505,564 1.8
---------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN THE NETHERLANDS 1,505,564 1.8
- ------------------------------------------------------------------------------------------------------------------------
SPAIN BANKS 20,000 Banco Popular Espanol SA..................... 817,902 1.0
---------------------------------------------------------------------------------------------------
SPECIALTY RETAIL 28,000 Industria de Disenso Textil, SA.............. 661,416 0.8
---------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN SPAIN 1,479,318 1.8
- ------------------------------------------------------------------------------------------------------------------------
SWEDEN SPECIALTY RETAIL 44,700 Hennes & Mauritz AB 'B'...................... 861,855 1.1
---------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN SWEDEN 861,855 1.1
- ------------------------------------------------------------------------------------------------------------------------
SWITZERLAND FOOD PRODUCTS... 5,900 Nestle SA (Registered Shares)................ 1,250,235 1.5
---------------------------------------------------------------------------------------------------
HEALTH CARE 12,100 +Alcon, Inc.................................. 477,345 0.6
EQUIPMENT &
SUPPLIES
---------------------------------------------------------------------------------------------------
INSURANCE 15,000 Swiss Re (Registered Shares)................. 983,945 1.2
---------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN SWITZERLAND 2,711,525 3.3
- ------------------------------------------------------------------------------------------------------------------------
UNITED BANKS 178,600 HSBC Holdings PLC............................ 1,973,881 2.4
KINGDOM
42,300 Royal Bank of Scotland Group PLC............. 1,013,310 1.3
------------ -----
2,987,191 3.7
---------------------------------------------------------------------------------------------------
BEVERAGES 135,600 Allied Domecq PLC............................ 866,661 1.1
---------------------------------------------------------------------------------------------------
FOOD PRODUCTS 204,200 Unilever PLC................................. 1,942,863 2.4
---------------------------------------------------------------------------------------------------
</Table>
144
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL GROWTH V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONCLUDED) (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
<Table>
<Caption>
WESTERN
EUROPE SHARES PERCENT OF
(CONCLUDED) INDUSTRY++ HELD INVESTMENTS VALUE NET ASSETS
- ------------------------------------------------------------------------------------------------------------------------
UNITED HOUSEHOLD 25,000 Reckitt Benckiser PLC........................ $ 484,982 0.6%
KINGDOM PRODUCTS
(CONCLUDED)
---------------------------------------------------------------------------------------------------
MEDIA 40,000 +British Sky Broadcasting Group PLC
("BSkyB").................................... 411,490 0.5
---------------------------------------------------------------------------------------------------
OIL & GAS 202,800 BP Amoco PLC................................. 1,394,103 1.7
---------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN THE UNITED KINGDOM 8,087,290 10.0
- ------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN WESTERN EUROPE
(COST--$21,211,383) 20,447,098 25.2
- ------------------------------------------------------------------------------------------------------------------------
<Caption>
SHORT-TERM PARTNERSHIP
SECURITIES INTEREST
- ------------------------------------------------------------------------------------------------------------------------
$16,442,216 Merrill Lynch Liquidity Series, LLC Cash
Sweep Series II(a)........................... 16,442,216 20.3
- ------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN SHORT-TERM SECURITIES
(COST--$16,442,216) 16,442,216 20.3
- ------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS (COST--$90,722,464)........ 81,191,346 100.0
LIABILITIES IN EXCESS OF OTHER ASSETS........ (15,088) 0.0
------------ -----
NET ASSETS................................... $ 81,176,258 100.0%
============ =====
- ------------------------------------------------------------------------------------------------------------------------
</Table>
+ Non-income producing security.
++ For Fund compliance purposes, "Industry" means any one or more of the
industry sub-classifications used by one or more widely recognized market
indexes or ratings group indexes, and/or as defined by Fund management. This
definition may not apply for purposes of this report, which may combine such
industry sub-classifications for reporting ease. These industry
classifications are unaudited.
(a)Investments in companies considered to be an affiliate of the Fund (such
companies are defined as "Affiliated Companies" in Section 2(a)(3) of the
Investment Company Act of 1940) are as follows:
<Table>
<Caption>
- --------------------------------------------------------------------------------------------------
NET INTEREST
AFFILIATE ACTIVITY NET COST INCOME
- --------------------------------------------------------------------------------------------------
Merrill Lynch Liquidity Series, LLC Cash Sweep Series II.... $16,442,216 $16,442,216 $21,009
- --------------------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
145
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL GROWTH V.I. FUND
STATEMENT OF ASSETS AND LIABILITIES AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
ASSETS:
Investments, at value (including securities loaned of
$115,280) (identified cost--$90,722,464).................. $ 81,191,346
Investments held as collateral for loaned securities, at
value..................................................... 114,402
Receivables:
Securities sold........................................... $ 299,890
Dividends................................................. 157,015
Interest.................................................. 17,202
Capital shares sold....................................... 1,614
Loaned securities income.................................. 165 475,886
-------------
Prepaid expenses............................................ 614
------------
Total assets................................................ 81,782,248
------------
- ------------------------------------------------------------------------------------------
LIABILITIES:
Collateral on securities loaned, at value................... 114,402
Payables:
Securities purchased...................................... 393,432
Investment adviser........................................ 54,700
Capital shares redeemed................................... 19,795 467,927
-------------
Accrued expenses and other liabilities...................... 23,661
------------
Total liabilities........................................... 605,990
------------
- ------------------------------------------------------------------------------------------
NET ASSETS.................................................. $ 81,176,258
============
- ------------------------------------------------------------------------------------------
NET ASSETS CONSIST OF:
Class A Shares of Common Stock, $.10 par value, 100,000,000
shares authorized+........................................ $ 1,262,113
Paid-in capital in excess of par............................ 200,520,516
Accumulated distributions in excess of investment
income--net............................................... $ (28,422)
Accumulated realized capital losses on investments and
foreign currency transactions--net........................ (111,065,259)
Unrealized depreciation on investments and foreign currency
transactions--net......................................... (9,512,690)
-------------
Total accumulated losses--net............................... (120,606,371)
------------
NET ASSETS.................................................. $ 81,176,258
============
- ------------------------------------------------------------------------------------------
NET ASSET VALUE:
Class A--Based on net assets of $81,176,258 and 12,621,132
shares outstanding........................................ $ 6.43
============
- ------------------------------------------------------------------------------------------
</Table>
+ The Fund is also authorized to issue 100,000,000 Class B Shares.
See Notes to Financial Statements.
146
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL GROWTH V.I. FUND
STATEMENT OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
INVESTMENT INCOME:
Dividends (net of $96,737 foreign withholding tax).......... $ 931,126
Interest.................................................... 181,857
Securities lending--net..................................... 18,575
------------
Total income................................................ 1,131,558
------------
- -----------------------------------------------------------------------------------------
EXPENSES:
Investment advisory fees.................................... $ 746,057
Custodian fees.............................................. 38,919
Accounting services......................................... 35,235
Transfer agent fees......................................... 25,794
Professional fees........................................... 21,787
Printing and shareholder reports............................ 11,497
Directors' fees and expenses................................ 4,696
Pricing services............................................ 2,035
Registration fees........................................... 820
Other....................................................... 8,703
------------
Total expenses.............................................. 895,543
------------
Investment income--net...................................... 236,015
------------
- -----------------------------------------------------------------------------------------
REALIZED & UNREALIZED GAIN (LOSS) ON INVESTMENTS & FOREIGN
CURRENCY TRANSACTIONS--NET:
Realized loss on:
Investments--net.......................................... (35,852,003)
Foreign currency transactions--net........................ (102,423) (35,954,426)
------------
Change in unrealized appreciation/depreciation on:
Investments--net.......................................... 2,833,213
Foreign currency transactions--net........................ 18,138 2,851,351
------------ ------------
Total realized and unrealized loss on investments and
foreign currency transactions--net........................ (33,103,075)
------------
NET DECREASE IN NET ASSETS RESULTING FROM OPERATIONS........ $(32,867,060)
============
- -----------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
147
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL GROWTH V.I. FUND
STATEMENTS OF CHANGES IN NET ASSETS
- --------------------------------------------------------------------------------
<Table>
<Caption>
FOR THE YEAR ENDED
DECEMBER 31,
-----------------------------
INCREASE (DECREASE) IN NET ASSETS: 2002 2001
- -------------------------------------------------------------------------------------------
OPERATIONS:
Investment income--net...................................... $ 236,015 $ 1,348,898
Realized loss on investments and foreign currency
transactions--net......................................... (35,954,426) (62,998,643)
Change in unrealized appreciation/depreciation on
investments and foreign currency transactions--net........ 2,851,351 (3,830,092)
------------ -------------
Net decrease in net assets resulting from operations........ (32,867,060) (65,479,837)
------------ -------------
- -------------------------------------------------------------------------------------------
DIVIDENDS TO SHAREHOLDERS:
Investment income--net:
Class A................................................... (110,002) (1,354,010)
------------ -------------
Net decrease in net assets resulting from dividends to
shareholders.............................................. (110,002) (1,354,010)
------------ -------------
- -------------------------------------------------------------------------------------------
CAPITAL SHARE TRANSACTIONS:
Net decrease in net assets derived from capital share
transactions.............................................. (13,772,276) (83,692,698)
------------ -------------
- -------------------------------------------------------------------------------------------
NET ASSETS:
Total decrease in net assets................................ (46,749,338) (150,526,545)
Beginning of year........................................... 127,925,596 278,452,141
------------ -------------
End of year*................................................ $ 81,176,258 $ 127,925,596
============ =============
- -------------------------------------------------------------------------------------------
* Accumulated distributions in excess of investment
income--net............................................... $ (28,422) $ (52,012)
============ =============
- -------------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
148
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL GROWTH V.I. FUND
FINANCIAL HIGHLIGHTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
THE FOLLOWING PER SHARE DATA AND RATIOS HAVE CLASS A
BEEN DERIVED FROM INFORMATION PROVIDED IN THE -----------------------------------------
FINANCIAL STATEMENTS. FOR THE YEAR ENDED FOR THE PERIOD
DECEMBER 31, JUNE 5, 1998+
----------------------------------------- TO DEC. 31,
INCREASE (DECREASE) IN NET ASSET VALUE: 2002 2001 2000 1999 1998
- -------------------------------------------------------------------------------------------------------------
PER SHARE OPERATING PERFORMANCE:
Net asset value, beginning of period............ $ 8.91 $ 11.70 $ 14.78 $ 10.82 $ 10.00
-------- -------- -------- -------- -------
Investment income--net++...................... .02 .06 .06 .11 .03
Realized and unrealized gain (loss) on
investments and foreign currency
transactions--net........................... (2.49) (2.75) (2.26) 4.06 .79
-------- -------- -------- -------- -------
Total from investment operations................ (2.47) (2.69) (2.20) 4.17 .82
-------- -------- -------- -------- -------
Less dividends and distributions:
Investment income--net........................ (.01) (.10) (.05) (.12) --
Realized gain on investments--net............. -- -- (.26) (.09) --
In excess of realized gain on
investments--net............................ -- -- (.57) -- --
-------- -------- -------- -------- -------
Total dividends and distributions............... (.01) (.10) (.88) (.21) --
-------- -------- -------- -------- -------
Net asset value, end of period.................. $ 6.43 $ 8.91 $ 11.70 $ 14.78 $ 10.82
======== ======== ======== ======== =======
- -------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENT RETURN:**
Based on net asset value per share.............. (27.74%) (23.03%) (15.00%) 38.69% 8.20%(++)
======== ======== ======== ======== =======
- -------------------------------------------------------------------------------------------------------------
RATIOS TO AVERAGE NET ASSETS:
Expenses........................................ .90% .88% .83% .87% 1.03%*
======== ======== ======== ======== =======
Investment income--net.......................... .24% .59% .46% .97% .63%*
======== ======== ======== ======== =======
- -------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL DATA:
Net assets, end of period (in thousands)........ $ 81,176 $127,926 $278,452 $180,408 $19,657
======== ======== ======== ======== =======
Portfolio turnover.............................. 138.30% 155.91% 95.98% 99.09% 15.25%
======== ======== ======== ======== =======
- -------------------------------------------------------------------------------------------------------------
</Table>
* Annualized.
** Total investment returns exclude insurance-related fees and expenses.
+ Commencement of operations.
++ Based on average shares outstanding.
(++) Aggregate total investment return.
See Notes to Financial Statements.
149
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL GROWTH V.I. FUND
NOTES TO FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
1. SIGNIFICANT ACCOUNTING POLICIES:
Merrill Lynch Variable Series Funds, Inc. (the "Company") is an open-end
management investment company that is comprised of 17 separate funds. Each fund
offers two classes of shares to the Merrill Lynch Life Insurance Company, ML
Life Insurance Company of New York (indirect, wholly-owned subsidiaries of
Merrill Lynch & Co., Inc. ("ML & Co.")), and other insurance companies that are
not affiliated with ML & Co., for their separate accounts to fund benefits under
certain variable annuity and variable life insurance contracts. Global Growth
V.I. Fund (the "Fund") (formerly Global Growth Focus Fund) is classified as
"diversified," as defined in the Investment Company Act of 1940. Class A and
Class B Shares have equal voting, dividend, liquidation and other rights, except
that only shares of the respective classes are entitled to vote on matters
concerning only that class and Class B Shares bear certain expenses related to
the distribution of such shares. The Fund's financial statements are prepared in
conformity with accounting principles generally accepted in the United States of
America, which may require the use of management accruals and estimates. The
following is a summary of significant accounting policies followed by the Fund.
(a) Valuation of investments--Portfolio securities that are traded on stock
exchanges are valued at the last sale price as of the close of business on the
day the securities are being valued, or lacking any sales, at the closing bid
price. Securities traded in the over-the-counter market are valued at the last
available bid price prior to the time of valuation. In cases where securities
are traded on more than one exchange, the securities are valued on the exchange
designated by or under the authority of the Board of Directors as the primary
market. Portfolio securities that are traded both in the over-the-counter 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. Options written or purchased are
valued at the last sale price in the case of exchange-traded options. In the
case of options traded in the over-the-counter market, valuation is the last
asked price (options written) or the last bid price (options purchased).
Short-term securities are valued at amortized cost, which approximates market
value. Futures contracts are valued at the 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.
(b) Derivative financial instruments--The Fund may engage in various portfolio
investment strategies to increase or decrease the level of risk to which the
Fund is exposed more quickly and efficiently than transactions in other types of
instruments. Losses may arise due to changes in the value of the contract or if
the counterparty does not perform under the contract.
- - Forward foreign exchange contracts--The Fund is authorized to enter into
forward foreign exchange contracts as a hedge against either specific
transactions or portfolio positions. The contract is marked to market daily and
the change in market value is recorded by the Fund as an unrealized gain or
loss. When the contract is closed, the Fund records a realized gain or loss
equal to the difference between the value at the time it was opened and the
value at the time it was closed.
- - Options--The Fund may write and purchase call and put options. When the Fund
writes an option, an amount equal to the premium received by the Fund is
reflected as an asset and an equivalent liability. The amount of the liability
is subsequently marked to market to reflect the current market value of the
option written. When a security is purchased or sold through an exercise of an
option, the related premium paid or received is added to (or deducted from) the
basis of the security acquired or deducted from (or added to) the proceeds of
the security sold. When an option expires (or the Fund enters into a closing
transaction), the Fund realizes a gain or loss on the option to the extent of
the premiums received or paid (or gain or loss to the extent the cost of the
closing transaction exceeds the premium paid or received).
Written and purchased options are non-income producing investments.
- - Financial futures contracts--The Fund may purchase or sell financial futures
contracts and options on such futures contracts for the purpose of hedging the
market risk on existing securities or the intended purchase of securities.
Futures contracts are contracts for delayed delivery of securities at a specific
future date and at a specific price or yield. Upon entering into a contract, the
Fund deposits and maintains as collateral such initial margin as required by the
exchange on which the transaction is effected. Pursuant to the contract, the
Fund agrees to receive from or pay to the broker an
150
- --------------------------------------------------------------------------------
amount of cash equal to the daily fluctuation in value of the contract. Such
receipts or payments are known as variation margin and are recorded by the Fund
as unrealized gains or losses. When the contract is closed, the Fund records a
realized gain or loss equal to the difference between the value of the contract
at the time it was opened and the value at the time it was closed.
- - Foreign currency options and futures--The Fund may also purchase or sell
listed or over-the-counter foreign currency options, foreign currency futures
and related options on foreign currency futures as a short or long hedge against
possible variations in foreign exchange rates. Such transactions may be effected
with respect to hedges on non-U.S. dollar denominated securities owned by the
Fund, sold by the Fund but not yet delivered, or committed or anticipated to be
purchased by the Fund.
(c) Foreign currency transactions--Transactions denominated in foreign
currencies are recorded at the exchange rate prevailing when recognized. Assets
and liabilities denominated in foreign currencies are valued at the exchange
rate at the end of the period. Foreign currency transactions are the result of
settling (realized) or valuing (unrealized) assets and liabilities expressed in
foreign currencies into U.S. dollars. Realized and unrealized gains or losses
from investments include the effects of foreign exchange rates on investments.
(d) Income taxes--It is the Fund's policy to comply with the requirements of
the Internal Revenue Code applicable to regulated investment companies and to
distribute substantially all of its taxable income to its shareholders.
Therefore, no Federal income tax provision is required. Under the applicable
foreign tax law, a withholding tax may be imposed on interest, dividends and
capital gains at various rates.
(e) Security transactions and investment income--Security transactions are
recorded on the dates the transactions are entered into (the trade dates).
Realized gains and losses on security transactions are determined on the
identified cost basis. Dividend income is recorded on the ex-dividend dates.
Dividends from foreign securities where the ex-dividend date may have passed are
subsequently recorded when the Fund has determined the ex-dividend date.
Interest income is recognized on the accrual basis.
(f) Dividends and distributions--Dividends and distributions paid by the Fund
are recorded on the ex-dividend dates.
(g) Expenses--Certain expenses have been allocated to the individual Funds in
the Company on a pro rata basis based upon the respective aggregate net asset
value of each Fund included in the Company.
(h) Securities lending--The Fund may lend securities to financial institutions
that provide cash or securities issued or guaranteed by the U.S. government as
collateral, which will be maintained at all times in an amount equal to at least
100% of the current market value of the loaned securities. The market value of
the loaned security is determined at the close of business of the Fund and any
additional required collateral is delivered to the Fund on the next business
day. Where the Fund receives cash collateral, it may invest such collateral and
retain the amount earned on such investment, net of any amount rebated to the
borrower. The Fund typically receives the income on the loaned securities but
does not receive the income on the collateral. Where the Fund receives
securities as collateral for the loaned securities, it collects a fee from the
borrower. Loans of securities are terminable at any time and the borrower, after
notice, is required to return borrowed securities within five business days. The
Fund may pay reasonable finder's, lending agent, administrative and custodial
fees in connection with its loans. In the event that the borrower defaults on
its obligation to return borrowed securities because of insolvency or for any
other reason, the Fund could experience delays and costs in gaining access to
the collateral. The Fund also could suffer a loss where the value of the
collateral falls below the market value of the borrowed securities, in the event
of borrower default or in the event of losses on investments made with cash
collateral.
(i) Reclassification--Accounting principles generally accepted in the United
States of America require that certain components of net assets be adjusted to
reflect permanent differences between financial and tax reporting. Accordingly,
the current year's permanent book/ tax difference of $102,423 has been
reclassified between accumulated distributions in excess of net investment
income and accumulated net realized capital losses. This reclassification has no
effect on net assets or net asset value per share.
2. INVESTMENT ADVISORY AGREEMENT AND TRANSACTIONS WITH AFFILIATES:
The Company has entered into an Investment Advisory Agreement with Merrill Lynch
Investment Managers, L.P. ("MLIM"). The general partner of MLIM is Princeton
Services, Inc. ("PSI"), an indirect, wholly-owned
151
- --------------------------------------------------------------------------------
subsidiary of ML & Co., which is the limited partner.
MLIM is responsible for the management of the Company's funds and provides the
necessary personnel, facilities, equipment and certain other services necessary
to the operations of the Fund. For such services, the Fund pays a monthly fee at
the annual rate of .75% of the average daily value of the Fund's net assets.
MLIM and Merrill Lynch Life Agency, Inc. ("MLLA") have entered into an
agreement which limits the operating expenses paid by the Fund, exclusive of any
distribution fees imposed on Class B Shares, to 1.25% of its average daily net
assets. Any such expenses in excess of 1.25% of average daily net assets will be
reimbursed to the Fund by MLIM which, in turn, will be reimbursed by MLLA.
The Company has received an exemptive order from the Securities and Exchange
Commission permitting it to lend portfolio securities to Merrill Lynch, Pierce,
Fenner & Smith Incorporated ("MLPF&S"), a subsidiary of ML & Co. or its
affiliates. Pursuant to that order, the Company also has retained Merrill Lynch
Investment Managers, LLC ("MLIM, LLC"), an affiliate of MLIM, as the securities
lending agent for a fee based on a share of the returns on investment of cash
collateral. MLIM, LLC may, on behalf of the Company and the Fund, invest cash
collateral received by the Fund for such loans, among other things, in a private
investment company managed by MLIM, LLC or in registered money market funds
advised by MLIM or its affiliates. As of December 31, 2002, cash collateral of
$60,633 was invested in the Money Market Series of the Merrill Lynch Liquidity
Series, LLC and $53,769 was invested in the Merrill Lynch Premier Institutional
Fund. For the year ended December 31, 2002, MLIM, LLC received $8,292 in
securities lending agent fees from the Fund.
In addition, MLPF&S received $52,508 in commissions on the execution of
portfolio security transactions for the Fund for the year ended December 31,
2002.
Financial Data Services, Inc. ("FDS"), a wholly-owned subsidiary of ML & Co.,
is the Company's transfer agent.
FAM Distributors, Inc. ("FAMD"), which is a wholly-owned subsidiary of Merrill
Lynch Group, Inc., is the Fund's Distributor.
For the year ended December 31, 2002, the Fund reimbursed MLIM $3,217 for
certain accounting services.
Certain officers and/or directors of the Company are officers and/or directors
of MLIM, PSI, FDS, FAMD, and/or ML & Co.
3. INVESTMENTS:
Purchases and sales of investments, excluding short-term securities, for the
year ended December 31, 2002 were $121,996,751 and $142,089,382, respectively.
Net realized gains (losses) for the year ended December 31, 2002 and net
unrealized gains (losses) as of December 31, 2002 were as follows:
<Table>
<Caption>
- ---------------------------------------------------------------------
Realized Unrealized
Gains (Losses) Gains (Losses)
- ---------------------------------------------------------------------
Long-term investments............... $(35,852,073) $(9,531,118)
Short-term investments.............. 70 --
Foreign currency transactions....... (102,423) 18,428
------------ -----------
Total............................... $(35,954,426) $(9,512,690)
============ ===========
- ---------------------------------------------------------------------
</Table>
At December 31, 2002, net unrealized depreciation for Federal income tax
purposes aggregated $9,652,114, of which $812,467 related to appreciated
securities and $10,464,581 related to depreciated securities. At December 31,
2002, the aggregate cost of investments for Federal income tax purposes was
$90,843,460.
4. CAPITAL SHARE TRANSACTIONS:
Transactions in capital shares were as follows:
<Table>
<Caption>
- -----------------------------------------------------------------
Class A Shares for the Year Ended Dollar
December 31, 2002 Shares Amount
- -----------------------------------------------------------------
Shares sold........................... 1,887,962 $ 13,445,385
Shares issued to shareholders in
reinvestment of dividends............ 17,161 110,002
---------- ------------
Total issued.......................... 1,905,123 13,555,387
Shares redeemed....................... (3,648,439) (27,327,663)
---------- ------------
Net decrease.......................... (1,743,316) $(13,772,276)
========== ============
- -----------------------------------------------------------------
</Table>
<Table>
<Caption>
- -----------------------------------------------------------------
Class A Shares for the Year Ended Dollar
December 31, 2001 Shares Amount
- -----------------------------------------------------------------
Shares sold.......................... 1,108,417 $ 11,465,125
Shares issued to shareholders in
reinvestment of dividends........... 151,795 1,354,010
----------- ------------
Total issued......................... 1,260,212 12,819,135
Shares redeemed...................... (10,703,322) (96,511,833)
----------- ------------
Net decrease......................... (9,443,110) $(83,692,698)
=========== ============
- -----------------------------------------------------------------
</Table>
5. SHORT-TERM BORROWINGS:
The Fund, along with certain other funds managed by MLIM and its affiliates, is
a party to a credit agreement with Bank One, N.A. and certain other lenders.
Effective November 29, 2002, in conjunction with the renewal for one year at the
same terms, the total commitment was reduced from $1,000,000,000 to
$500,000,000. The Fund may borrow under the
152
- --------------------------------------------------------------------------------
credit agreement to fund shareholder redemptions and for other lawful purposes
other than for leverage. The Fund may borrow up to the maximum amount allowable
under the Fund's current prospectus and statement of additional information,
subject to various other legal, regulatory or contractual limits. The Fund pays
a commitment fee of .09% per annum based on the Fund's pro rata share of the
unused portion of the credit agreement. Amounts borrowed under the credit
agreement bear interest at a rate equal to, at each fund's election, the Federal
Funds rate plus .50% or a base rate as determined by Bank One, N.A. The Fund did
not borrow under the credit agreement during the year ended December 31, 2002.
6. DISTRIBUTIONS TO SHAREHOLDERS:
The tax character of distributions paid during the fiscal years ended December
31, 2002 and December 31, 2001 was as follows:
<Table>
<Caption>
- ------------------------------------------------------------------
12/31/2002 12/31/2001
- ------------------------------------------------------------------
Distributions paid from:
Ordinary income......................... $110,002 $1,354,010
-------- ----------
Total taxable distributions.............. $110,002 $1,354,010
======== ==========
- ------------------------------------------------------------------
</Table>
As of December 31, 2002, the components of accumulated losses on a tax basis
were as follows:
<Table>
<Caption>
- -----------------------------------------------------------------
Undistributed ordinary income--net............... --
Undistributed long-term capital gains--net....... --
-------------
Total undistributed earnings--net................ --
Capital loss carryforward........................ $(109,038,282)*
Unrealized losses--net........................... (11,568,089)**
-------------
Total accumulated losses--net.................... $(120,606,371)
=============
- -----------------------------------------------------------------
</Table>
* On December 31, 2002, the Fund had a net capital loss carryforward of
$109,038,282 of which $67,641,756 expires in 2009 and $41,396,526 expires in
2010. This amount will be available to offset like amounts of any future
taxable gains.
** The difference between book-basis and tax-basis net unrealized losses is
attributable primarily to the tax deferral of losses on wash sales, the
deferral of post-October currency and capital losses for tax purposes and
other book/tax differences.
153
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GLOBAL GROWTH V.I. FUND
INDEPENDENT AUDITORS' REPORT
- --------------------------------------------------------------------------------
THE BOARD OF DIRECTORS AND SHAREHOLDERS, GLOBAL GROWTH V.I. FUND OF MERRILL
LYNCH VARIABLE SERIES FUNDS, INC.:
We have audited the accompanying statement of assets and liabilities,
including the schedule of investments, of Global Growth V.I. Fund (formerly,
Global Growth Focus Fund) of Merrill Lynch Variable Series Funds, Inc. as of
December 31, 2002, the related statements of operations for the year then ended
and changes in net assets for each of the years in the two-year period then
ended, and the financial highlights for each of the periods presented. These
financial statements and the financial highlights are the responsibility of the
Fund's management. Our responsibility is to express an opinion on these
financial statements and the financial highlights based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements and the financial highlights are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. Our procedures included confirmation of
securities owned at December 31, 2002 by correspondence with the custodian and
brokers; where replies from brokers were not received, we performed other
auditing procedures. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such financial statements and financial highlights present
fairly, in all material respects, the financial position of Global Growth V.I.
Fund of Merrill Lynch Variable Series Funds, Inc. as of December 31, 2002, the
results of its operations, the changes in its net assets, and the financial
highlights for the respective stated periods in conformity with accounting
principles generally accepted in the United States of America.
Deloitte & Touche LLP
Princeton, New Jersey
February 14, 2003
154
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC. -- GOVERNMENT BOND V.I. FUND
DECEMBER 31, 2002--ANNUAL REPORT
- --------------------------------------------------------------------------------
DEAR SHAREHOLDER:
ECONOMIC ENVIRONMENT
The U.S. economy grew throughout 2002, although the pace of the growth was
quite uneven from quarter to quarter. For the year as a whole, the economy
likely grew at an annual pace of approximately 3% -- modest for sure, but hardly
the source for "double dip" recessionary concerns that dominated the headlines
from time to time. Inflation remained virtually non-existent, with the core
personal consumption expenditure deflator, the inflation gauge watched by the
Federal Reserve Board, rising by only 1.8%.
In past economic recoveries, businesses have contributed significantly to
growth. However, the continuing corporate profit drought in the face of
significant excess capacity left businesses holding back on capital spending and
achieving productivity gains by paring down payrolls. The consumer sector, on
the other hand, held up remarkably well, despite the weak employment outlook,
declining equity markets, and terrorism and geopolitical concerns adding to the
decline in consumer confidence. Nevertheless, the sharp drop in mortgage rates
during the past year contributed to a healthy housing market and a refinancing
boom, helping out the consumer, while heavy economic incentives (such as zero-
cost financing) helped keep consumption of durable goods, such as automobiles,
robust.
Looking ahead, we anticipate the economy to grow at a sub-par rate of below 3%
in 2003, with risks to the forecast more evenly balanced. While the prospects
for a strong fiscal stimulus package from Washington, D.C. have improved
markedly, the timing of the legislation, its scope and its potential positive
impact on the economy over the near term remain uncertain. At the same time, the
possible end of the mortgage refinancing boom and a murky labor market could
further erode consumer confidence, posing downside risks to the economy. Capital
spending by businesses is also likely to remain somewhat subdued as the sectors
that have contributed historically to capital spending - telecommunications,
utility and energy - must work out past excesses. Government spending is not
likely to contribute very much, given the potential for the growing fiscal
deficits at state and local government levels somewhat offsetting the spending
from Washington.
FISCAL YEAR IN REVIEW
During the 12 months ended December 31, 2002, Government Bond V.I. Fund's
Class A Shares had a total return of +9.78% compared to a return of +10.19% for
the unmanaged Salomon Smith Barney (SSB) Government/Mortgage Index.
As we began 2002, the Fund was generally positioned near the benchmark as it
pertains to sector exposure, duration and duration distribution. Late in the
first quarter, we began to increase our mortgage weighting in small increments,
as market opportunities became available, bringing the overweight to
approximately 8%. This trade proved to be beneficial to performance, as
mortgages produced an excess return of more than 130 basis points (1.30%)
compared to equivalent duration Treasury securities.
Unfortunately, as we increased the overall exposure to the mortgage component,
the Fund became exposed to a sharp decline in interest rates. The mortgage
sector generally has the shortest duration of the three sectors in the portfolio
benchmark, and an 8% overweight position in mortgages resulted in a portfolio
that was 5% short of the benchmark duration. Fund performance was adversely
affected as interest rates declined during the middle of the year.
As market opportunities became available during the months of September and
October, we began to increase the overall duration of the portfolio and reduce
the portfolio's sensitivity to prepayment risk by reducing exposure to
residential mortgages in favor of commercial mortgages. The decision to replace
the residential mortgages was based on our belief that there would be an
increase in refinancing activity, which would then translate into accelerated
prepayment speeds, creating a negative impact on the mortgage sector. This
duration decision helped the Fund as interest rates continued to decline in
December, but not being fully exposed to residential mortgages hurt slightly as
mortgages continued to outperform.
IN CONCLUSION
Going forward, we expect to continue our emphasis on commercial mortgage
product that has prepayment restrictions in order to protect the Fund from large
swings in interest rates, which historically have caused large gyrations in
duration. We will look to add back residential mortgages as well as maintain a
duration that is consistent with our peer group by overweighting lower coupon
mortgages, which tend to prepay much more slowly than higher coupon mortgages,
providing a longer duration. We
155
- --------------------------------------------------------------------------------
believe that building a yield advantage in the Fund with spread product will be
an effective strategy to gain relative outperformance in 2003.
We appreciate your investment in Government Bond V.I. Fund of Merrill Lynch
Variable Series Funds Inc., and we look forward to sharing our investment
outlook and strategies with you in our next report to shareholders.
Sincerely,
/s/ Terry K. Glenn
Terry K. Glenn
President and Director
/s/ Thomas F. Musmanno
Thomas F. Musmanno
Portfolio Manager
/s/ Frank Viola
Frank Viola
Portfolio Manager
January 17, 2003
- ---------------------------------------------------------
We are pleased to announce that Thomas Musmanno and Frank Viola have both been
named Portfolio Managers and are responsible for the day-to-day management of
Government Bond V.I. Fund of Merrill Lynch Variable Series Funds, Inc. Mr.
Musmanno has been employed at Merrill Lynch Investment Managers, L.P. (MLIM)
since 1993. Mr. Viola joined MLIM in 1997 as Portfolio Manager in the U.S. Fixed
Income Group. Mr. Musmanno and Mr. Viola are both CFA charterholders.
- ---------------------------------------------------------
156
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GOVERNMENT BOND V.I. FUND
TOTAL RETURN BASED ON A $10,000 INVESTMENT--CLASS A SHARES
- --------------------------------------------------------------------------------
<Table>
<Caption>
GOVERNMENT BOND V.I. FUND+-- SALOMON SMITH BARNEY
CLASS A SHARES* GOVERNMENT/MORTGAGE INDEX++
---------------------------- ---------------------------
5/02/94** 10000 10000
12/94 10179 10068
12/95 11689 11863
12/96 12023 12300
12/97 13091 13468
12/98 14238 14647
12/99 13982 14561
12/00 15590 16357
12/01 16688 17614
12/02 18320 19410
</Table>
* Assuming transaction costs and other operating expenses, including advisory
fees. Does not include insurance-related fees and expenses.
** Commencement of operations.
+ The Fund invests in debt securities issued or guaranteed by the U.S.
government, its agencies or instrumentalities and mortgage securities issued
by U.S. government agencies.
++ This unmanaged Index is comprised of the mortgage component of the Salomon
Smith Barney Broad Investment-Grade Bond Index(SM), which consists of 30-year
and 15-year GNMA, FNMA and FHLMC securities, and FNMA and FHLMC balloon
mortgages. The starting date for the Index in the graph is from 5/31/94.
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GOVERNMENT BOND V.I. FUND
AVERAGE ANNUAL TOTAL RETURN--CLASS A SHARES*
- --------------------------------------------------------------------------------
PERIOD COVERED % RETURN
- --------------------------------------------------------------------------------
One Year Ended 12/31/02 +9.78%
- --------------------------------------------------------------------------------
Five Years Ended 12/31/02 +6.95
- --------------------------------------------------------------------------------
Inception (5/02/94) through 12/31/02 +7.24
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GOVERNMENT BOND V.I. FUND
RECENT PERFORMANCE RESULTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
6-MONTH 12-MONTH
AS OF DECEMBER 31, 2002 TOTAL RETURN TOTAL RETURN
- -----------------------------------------------------------------------------------------
Class A Shares* +5.50% + 9.78%
- -----------------------------------------------------------------------------------------
Salomon Smith Barney Government/Mortgage Index** +5.78 +10.19
- -----------------------------------------------------------------------------------------
</Table>
* Total investment returns are based on changes in net asset values for the
periods shown, and assume reinvestment of all dividends and capital gains
distributions at net asset value on the payable date. Insurance-related fees
and expenses are not reflected in these returns.
** This unmanaged Index is comprised of 30-year and 15-year GNMA, FNMA and
FHLMC securities, and FNMA and FHLMC balloon mortgages.
Past results shown should not be considered a representation of future
performance.
157
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GOVERNMENT BOND V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
<Caption>
FACE
AMOUNT ISSUE VALUE
- ----------------------------------------------------------------------------------------------------------------------
U.S. GOVERNMENT & AGENCY OBLIGATIONS
- ----------------------------------------------------------------------------------------------------------------------
COLLATERALIZED MORTGAGE $ 7,000,000 FHLMC Structured Pass Through Securities, T-50 A2,
OBLIGATIONS+--13.7% 1.27% due 9/27/2005................................. $ 6,962,813
118,753,307 Fannie Mae-ACES 2002-M1 X, 1.197% due 5/25/2032(c).... 5,701,453
49,887,810 Fannie Mae-ACES 2002-M2 N, 1.683% due 8/25/2012(c).... 5,295,506
2,005,354 Fannie Mae-ACES 1998-M7 B, 6.097% due 5/25/2018....... 2,038,511
6,000,000 General Electric Capital Commercial Mortgage
Corporation, 2002-2A-A3, 5.349% due 8/11/2036....... 6,317,053
12,000,000 Government National Mortgage Association, 2002-81-B,
5.042% due 1/16/2029................................ 12,114,374
7,000,000 Government National Mortgage Association, 2002-83-C,
5.25% due 9/16/2027................................. 7,160,192
38,277,535 Government National Mortgage Association, 2002-83-IO,
1.571% due 10/16/2042(c)............................ 2,509,686
5,600,000 Greenwich Capital Commercial Funding Corporation,
2002-C1-A4, 4.948% due 11/11/2025................... 5,716,375
6,328,754 Lehman Brothers Floating Rate Commercial, 2002-LLFA-A,
1.71% due 6/14/2017(d).............................. 6,325,604
7,000,000 Residential Asset Securities Corporation,
2002-KS5-AIB2, 2.47% due 8/25/2022.................. 7,015,841
5,600,000 TEMP, 2002-4-C, 5.045% due 11/16/2028................. 5,692,966
7,000,000 Washington Mutual, 2002-AR19-A8,
4.556% due 2/25/2033................................ 7,091,875
- ----------------------------------------------------------------------------------------------------------------------
TOTAL COLLATERALIZED MORTGAGE OBLIGATIONS
(COST--$79,657,485) 79,942,249
- ----------------------------------------------------------------------------------------------------------------------
FANNIE MAE--35.9% Fannie Mae:
2,181,539 +8% due 4/01/2008................................... 2,342,111
8,942,146 4.79% due 10/01/2012................................ 9,072,307
10,756,647 4.80% due 10/01/2012................................ 10,926,776
5,588,986 4.87% due 10/01/2012................................ 5,747,923
3,995,622 4.60% due 11/01/2012................................ 3,996,383
7,828,617 4.72% due 11/01/2012................................ 7,985,189
7,000,000 4.81% due 11/01/2012................................ 7,181,160
7,142,759 4.87% due 11/01/2012................................ 7,284,289
4,200,000 4.785% due 12/01/2012............................... 4,299,456
5,900,000 5.18% due 12/01/2012................................ 6,214,942
8,050,000 4.78% due 1/01/2013................................. 8,237,565
6,300,000 5.15% due 1/01/2013................................. 6,624,324
3,958,926 +6% due 7/01/2016................................... 4,144,263
280,880 +7% due 6/01/2028................................... 295,841
409,872 +7% due 10/01/2028.................................. 431,705
460,232 +7% due 12/01/2028.................................. 484,747
662,528 +7% due 2/01/2029................................... 697,456
1,840,951 +7% due 3/01/2029................................... 1,938,004
3,630,915 +7% due 5/01/2029................................... 3,823,132
5,863,488 +7% due 6/01/2029................................... 6,173,141
993,780 +7% due 7/01/2029................................... 1,046,169
4,200,000 +6.50% due TBA(a)................................... 4,367,958
310,250 +7% due 8/01/2029................................... 326,607
187,981 +7% due 9/01/2029................................... 197,891
14,178 +7% due 2/01/2030................................... 14,917
295,482 +8% due 2/01/2030................................... 318,807
278,471 +7% due 4/01/2030................................... 292,989
3,406 +8% due 4/01/2030................................... 3,671
10,000,000 +6% due TBA(a)...................................... 10,353,410
1,920,954 +7.50% due 12/01/2030............................... 2,040,155
66,894 +8% due 12/01/2030.................................. 72,115
17,760,614 +6.50% due TBA(a)................................... 18,719,545
1,700,000 +8% due TBA(a)...................................... 1,822,216
16,098 +8% due 1/01/2031................................... 17,355
364,452 +8% due 2/01/2031................................... 392,895
</Table>
158
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GOVERNMENT BOND V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
FACE
AMOUNT ISSUE VALUE
- ----------------------------------------------------------------------------------------------------------------------
U.S. GOVERNMENT & AGENCY OBLIGATIONS
- ----------------------------------------------------------------------------------------------------------------------
FANNIE MAE $ 1,057,602 +7.50% due 5/01/2031................................ $ 1,122,898
(CONCLUDED) 2,932,108 +7% due 9/01/2031................................... 3,084,119
5,830,550 +6.50% due 12/01/2031............................... 6,073,652
704,996 +7% due 4/01/2032................................... 741,521
7,581,725 +7% due 5/01/2032................................... 7,974,524
3,284,740 +7.50% due 5/01/2032................................ 3,487,361
1,400,065 6.50% due 8/01/2032................................. 1,458,414
25,239,839 6.50% due 9/01/2032................................. 26,291,740
15,963,852 6% due 10/01/2032................................... 16,525,158
1,979,468 6.50% due 10/01/2032................................ 2,061,965
1,998,275 5.89% due 11/01/2032................................ 2,084,138
1,421,854 6.50% due 11/01/2032................................ 1,481,111
- ----------------------------------------------------------------------------------------------------------------------
TOTAL FANNIE MAE
(COST--$206,794,296) 210,274,015
- ----------------------------------------------------------------------------------------------------------------------
FEDERAL FARM CREDIT 7,000,000 Federal Farm Credit Bank, 2.375% due 10/01/2004....... 7,066,360
BANK--1.2%
- ----------------------------------------------------------------------------------------------------------------------
TOTAL FEDERAL FARM CREDIT BANK
(COST--$6,993,140) 7,066,360
- ----------------------------------------------------------------------------------------------------------------------
FEDERAL HOME LOAN BANK--5.2% Federal Home Loan Bank:
10,000,000 5.125% due 9/15/2003................................ 10,268,700
10,000,000 4.75% due 6/28/2004................................. 10,470,360
5,000,000 7.125% due 2/15/2005................................ 5,542,125
3,650,000 6.875% due 8/13/2010................................ 4,339,328
- ----------------------------------------------------------------------------------------------------------------------
TOTAL FEDERAL HOME LOAN BANK
(COST--$28,974,294) 30,620,513
- ----------------------------------------------------------------------------------------------------------------------
FREDDIE MAC--13.2% Freddie Mac -- Gold Program:
10,500,000 5.75% due 4/29/2009................................. 10,949,148
8,600,000 6% due 5/25/2012.................................... 8,981,014
8,930,593 6% due 4/01/2016.................................... 9,366,444
4,030,762 +6% due 4/01/2017................................... 4,217,726
4,199,583 5.50% due 6/01/2017................................. 4,360,817
1,954,487 6.30% due 5/15/2026................................. 1,988,474
61,663 +6.50% due 3/01/2029................................ 64,267
226,154 +6.50% due 6/01/2029................................ 235,723
4,718,264 +6.50% due 7/01/2029................................ 4,917,519
1,292,494 +7% due 7/01/2029................................... 1,359,963
43,570 +6.50% due 8/01/2029................................ 45,410
41,941 +6.50% due 9/01/2029................................ 43,712
57,574 +6.50% due 10/01/2029............................... 60,005
1,090,623 +8% due 12/01/2029.................................. 1,170,578
1,251,997 +8% due 4/01/2030................................... 1,342,654
687,672 +8% due 7/01/2030................................... 737,466
4,900,000 +5% due TBA(a)...................................... 5,031,776
7,000,000 +5.50% due TBA(a)................................... 7,146,755
8,365,000 +6.50% due TBA(a)................................... 8,705,330
6,401,885 +7% due 3/01/2031................................... 6,728,748
- ----------------------------------------------------------------------------------------------------------------------
TOTAL FREDDIE MAC
(COST--$75,843,298) 77,453,529
- ----------------------------------------------------------------------------------------------------------------------
GOVERNMENT NATIONAL Government National Mortgage Association:
MORTGAGE ASSOCIATION--6.0% 16,000,000 +6% due TBA(a)...................................... 16,683,872
7,258,571 +6.50% due 2/15/2028................................ 7,630,115
889,485 +6.50% due 5/15/2028................................ 935,015
9,452,044 +6.50% due 7/20/2031................................ 9,862,339
- ----------------------------------------------------------------------------------------------------------------------
TOTAL GOVERNMENT NATIONAL MORTGAGE ASSOCIATION
(COST--$34,029,870) 35,111,341
- ----------------------------------------------------------------------------------------------------------------------
</Table>
159
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GOVERNMENT BOND V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
FACE
AMOUNT ISSUE VALUE
- ----------------------------------------------------------------------------------------------------------------------
U.S. GOVERNMENT & AGENCY OBLIGATIONS
- ----------------------------------------------------------------------------------------------------------------------
TENNESSEE VALLEY Tennessee Valley Authority:
AUTHORITY--2.6%
$ 6,125,000 5.625% due 1/18/2011................................ $ 6,738,492
7,000,000 6.75% due 11/01/2025................................ 8,201,879
- ----------------------------------------------------------------------------------------------------------------------
TOTAL TENNESSEE VALLEY AUTHORITY
(COST--$12,895,327) 14,940,371
- ----------------------------------------------------------------------------------------------------------------------
U.S. TREASURY BONDS & U.S. Treasury Bonds:
NOTES--19.3%
3,410,000 7.50% due 11/15/2016................................ 4,459,373
2,590,000 8.125% due 8/15/2019................................ 3,607,588
8,110,000 7.25% due 8/15/2022................................. 10,554,719
10,150,000 6.25% due 8/15/2023................................. 11,924,667
2,590,000 6.625% due 2/15/2027................................ 3,199,663
7,640,000 6.125% due 8/15/2029................................ 8,969,238
1,500,000 5.375% due 2/15/2031................................ 1,635,234
U.S. Treasury Notes:
2,500,000 2% due 11/30/2004(b)................................ 2,520,702
10,200,000 6.50% due 5/15/2005................................. 11,322,398
2,360,000 6.25% due 2/15/2007................................. 2,707,640
9,750,000 3.25% due 8/15/2007................................. 9,991,468
7,970,000 6.125% due 8/15/2007................................ 9,164,878
2,000,000 3% due 11/15/2007................................... 2,024,062
6,550,000 4.75% due 11/15/2008................................ 7,149,731
3,890,000 6.50% due 2/15/2010................................. 4,649,764
3,400,000 4.875% due 2/15/2012................................ 3,692,053
14,900,000 4.375% due 8/15/2012................................ 15,574,568
- ----------------------------------------------------------------------------------------------------------------------
TOTAL U.S. TREASURY BONDS & NOTES
(COST--$107,747,612) 113,147,746
- ----------------------------------------------------------------------------------------------------------------------
TOTAL U.S. GOVERNMENT & AGENCY OBLIGATIONS
(COST--$552,935,322)--97.1% 568,556,124
- ----------------------------------------------------------------------------------------------------------------------
</Table>
160
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GOVERNMENT BOND V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONCLUDED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
FACE
AMOUNT ISSUE VALUE
- ----------------------------------------------------------------------------------------------------------------------
SHORT-TERM SECURITIES
- ----------------------------------------------------------------------------------------------------------------------
REPURCHASE AGREEMENTS*--5.6% $ 5,000,000 J.P. Morgan Securities Inc., purchased on 12/31/2002
to yield 1.05% to 1/02/2003......................... $ 5,000,000
28,095,000 UBS Warburg Corp. LLC, purchased on 12/31/2002 to
yield 1.10% to 1/02/2003............................ 28,095,000
------------
33,095,000
- ----------------------------------------------------------------------------------------------------------------------
U.S. GOVERNMENT AGENCY Fannie Mae:
OBLIGATIONS**--7.7%
26,000,000 1.28% due 1/08/2003................................. 25,992,604
13,000,000 1.28% due 1/14/2003................................. 12,993,529
6,000,000 Federal Home Loan Mortgage Corporation,
1.28% due 1/14/2003................................. 5,997,013
------------
44,983,146
- ----------------------------------------------------------------------------------------------------------------------
TOTAL SHORT-TERM SECURITIES
(COST--$78,078,146)--13.3% 78,078,146
- ----------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS
(COST--$631,013,468)--110.4%.......................... 646,634,270
UNREALIZED DEPRECIATION ON INTEREST RATE
SWAPS--(0.1%)......................................... (518,910)
VARIATION MARGIN ON FINANCIAL FUTURES
CONTRACTS--0.0%++..................................... 13,781
LIABILITIES IN EXCESS OF OTHER ASSETS--(10.3%)........ (60,340,478)
------------
NET ASSETS--100.0%.................................... $585,788,663
============
- ----------------------------------------------------------------------------------------------------------------------
</Table>
(a) Represents a "to-be-announced" (TBA) transaction. The Fund has committed
to purchasing securities for which all specific information is not
available at this time.
(b) All or a portion of security held as collateral in connection with open
financial futures contracts.
(c) Securities that receive some or all of the interest portion of the
underlying collateral and little or no principal. Interest-only securities
have either a nominal or a notional amount of principal.
(d) Floating rate note.
* Repurchase Agreements are fully collateralized by U.S. Government & Agency
Obligations.
** Certain U.S. Government Agency Obligations are traded on a discount basis;
the interest rates shown reflect the discount rates paid at the time of
purchase by the Fund.
+ Mortgage-Backed Obligations are subject to principal paydowns as a result of
prepayments or refinancing of the underlying mortgage instruments. As a
result, the average life may be substantially less than the original
maturity.
++ Financial futures contracts sold as of December 31, 2002 were as follows:
<Table>
<Caption>
- ------------------------------------------------------------
NUMBER OF EXPIRATION
CONTRACTS ISSUE DATE VALUE
- ------------------------------------------------------------
63 U.S. Treasury Bonds March 2003 $7,247,953
- ------------------------------------------------------------
TOTAL FINANCIAL FUTURES CONTRACTS SOLD
(TOTAL CONTRACT PRICE--$7,256,529) $7,247,953
==========
- ------------------------------------------------------------
</Table>
See Notes to Financial Statements.
161
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GOVERNMENT BOND V.I. FUND
STATEMENT OF ASSETS AND LIABILITIES AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
ASSETS:
Investments, at value (including loaned securities
of--$5,123,800) (identified cost--$631,013,468)........... $646,634,270
Investments held as collateral for loaned securities, at
value..................................................... 5,300,001
Cash........................................................ 1,151
Receivables:
Securities sold........................................... $ 35,528,704
Capital shares sold....................................... 13,525,912
Interest.................................................. 4,369,926
Variation margin.......................................... 13,781 53,438,323
------------
Prepaid expenses............................................ 2,601
------------
Total assets................................................ 705,376,346
------------
- -----------------------------------------------------------------------------------------
LIABILITIES:
Collateral on securities loaned, at value................... 5,300,001
Unrealized depreciation on interest rate swaps.............. 518,910
Payables:
Securities purchased...................................... 113,469,560
Investment adviser........................................ 248,653
Capital shares redeemed................................... 1,878 113,720,091
------------
Accrued expenses............................................ 48,681
------------
Total liabilities........................................... 119,587,683
------------
- -----------------------------------------------------------------------------------------
NET ASSETS.................................................. $585,788,663
============
- -----------------------------------------------------------------------------------------
NET ASSETS CONSIST OF:
Class A Shares of Common Stock, $.10 par value, 100,000,000
shares authorized+........................................ $ 5,298,180
Paid-in capital in excess of par............................ 559,875,251
Undistributed investment income--net........................ $ 1,994,585
Undistributed realized capital gains on investments--net.... 3,510,179
Unrealized appreciation on investments--net................. 15,110,468
------------
Total accumulated earnings--net............................. 20,615,232
------------
NET ASSETS.................................................. $585,788,663
============
- -----------------------------------------------------------------------------------------
NET ASSET VALUE:
Class A--Based on net assets of $585,788,663 and 52,981,795
shares outstanding........................................ $ 11.06
============
- -----------------------------------------------------------------------------------------
</Table>
+ The Fund is also authorized to issue 100,000,000 Class B Shares.
See Notes to Financial Statements.
162
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.-- GOVERNMENT BOND V.I. FUND
STATEMENT OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
INVESTMENT INCOME:
Interest.................................................... $26,008,010
Securities lending--net..................................... 3,729
-----------
Total income................................................ 26,011,739
-----------
- --------------------------------------------------------------------------------------
EXPENSES:
Investment advisory fees.................................... $2,614,705
Accounting services......................................... 176,103
Professional fees........................................... 51,877
Custodian fees.............................................. 49,827
Printing and shareholder reports............................ 41,785
Transfer agent fees......................................... 26,678
Directors' fees and expenses................................ 20,157
Pricing services............................................ 12,161
Registration fees........................................... 773
Other....................................................... 15,775
----------
Total expenses.............................................. 3,009,841
-----------
Investment income--net...................................... 23,001,898
-----------
- --------------------------------------------------------------------------------------
REALIZED & UNREALIZED GAIN ON INVESTMENTS--NET:
Realized gain on investments--net........................... 12,303,016
Change in unrealized appreciation on investments--net....... 12,873,139
-----------
Total realized and unrealized gain on investments--net...... 25,176,155
-----------
NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS........ $48,178,053
===========
- --------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
163
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GOVERNMENT BOND V.I. FUND
STATEMENTS OF CHANGES IN NET ASSETS
- --------------------------------------------------------------------------------
<Table>
<Caption>
FOR THE YEAR ENDED
DECEMBER 31,
----------------------------
INCREASE (DECREASE) IN NET ASSETS: 2002 2001
- --------------------------------------------------------------------------------------------
OPERATIONS:
Investment income--net...................................... $ 23,001,898 $ 20,126,334
Realized gain on investments--net........................... 12,303,016 10,513,645
Change in unrealized appreciation/depreciation on
investments--net.......................................... 12,873,139 (5,054,605)
------------ ------------
Net increase in net assets resulting from operations........ 48,178,053 25,585,374
------------ ------------
- --------------------------------------------------------------------------------------------
DIVIDENDS & DISTRIBUTIONS TO SHAREHOLDERS:
Investment income--net:
Class A................................................... (22,784,643) (20,018,265)
Realized gain on investments--net:
Class A................................................... (7,535,087) (1,591,198)
------------ ------------
Net decrease in net assets resulting from dividends and
distributions to shareholders............................. (30,319,730) (21,609,463)
------------ ------------
- --------------------------------------------------------------------------------------------
CAPITAL SHARE TRANSACTIONS:
Net increase in net assets derived from capital share
transactions.............................................. 94,165,032 137,570,286
------------ ------------
- --------------------------------------------------------------------------------------------
NET ASSETS:
Total increase in net assets................................ 112,023,355 141,546,197
Beginning of year........................................... 473,765,308 332,219,111
------------ ------------
End of year*................................................ $585,788,663 $473,765,308
============ ============
- --------------------------------------------------------------------------------------------
* Undistributed investment income--net...................... $ 1,994,585 $ 1,653,494
============ ============
- --------------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
164
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GOVERNMENT BOND V.I. FUND
FINANCIAL HIGHLIGHTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
THE FOLLOWING PER SHARE DATA AND RATIOS HAVE
BEEN DERIVED FROM INFORMATION PROVIDED IN THE CLASS A
FINANCIAL STATEMENTS. --------------------------------------------------------
FOR THE YEAR ENDED DECEMBER 31,
--------------------------------------------------------
INCREASE (DECREASE) IN NET ASSET VALUE: 2002 2001 2000 1999 1998
- ------------------------------------------------------------------------------------------------------------------------
PER SHARE OPERATING PERFORMANCE:
Net asset value, beginning of year.......................... $ 10.67 $ 10.54 $ 10.03 $ 10.88 $ 10.60
-------- -------- -------- -------- --------
Investment income--net...................................... .48++ .55++ .64++ .61 .59
Realized and unrealized gain (loss) on investments--net..... .50 .17 .47 (.80) .31
-------- -------- -------- -------- --------
Total from investment operations............................ .98 .72 1.11 (.19) .90
-------- -------- -------- -------- --------
Less dividends and distributions:
Investment income--net.................................... (.44) (.55) (.60) (.66) (.60)
In excess of investment income--net....................... -- -- -- --+ --
Realized gain on investments--net......................... (.15) (.04) -- -- (.02)
In excess of realized gain on investments--net............ -- -- -- -- --+
-------- -------- -------- -------- --------
Total dividends and distributions........................... (.59) (.59) (.60) (.66) (.62)
-------- -------- -------- -------- --------
Net asset value, end of year................................ $ 11.06 $ 10.67 $ 10.54 $ 10.03 $ 10.88
======== ======== ======== ======== ========
- ------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENT RETURN:*
Based on net asset value per share.......................... 9.78% 7.04% 11.50% (1.80%) 8.76%
======== ======== ======== ======== ========
- ------------------------------------------------------------------------------------------------------------------------
RATIOS TO AVERAGE NET ASSETS:
Expenses.................................................... .58% .59% .57% .55% .56%
======== ======== ======== ======== ========
Investment income--net...................................... 4.40% 5.13% 6.26% 5.86% 5.66%
======== ======== ======== ======== ========
- ------------------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL DATA:
Net assets, end of year (in thousands)...................... $585,789 $473,765 $332,219 $362,394 $350,416
======== ======== ======== ======== ========
Portfolio turnover.......................................... 208.26% 155.31% 70.01% 116.59% 43.10%
======== ======== ======== ======== ========
- ------------------------------------------------------------------------------------------------------------------------
</Table>
*Total investment returns exclude insurance-related fees and expenses.
+Amount is less than $.01 per share.
++Based on average shares outstanding.
See Notes to Financial Statements.
165
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GOVERNMENT BOND V.I. FUND
NOTES TO FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
1. SIGNIFICANT ACCOUNTING POLICIES:
Merrill Lynch Variable Series Funds, Inc. (the "Company") is an open-end
management investment company that is comprised of 17 separate funds. Each fund
offers two classes of shares to the Merrill Lynch Life Insurance Company, ML
Life Insurance Company of New York (indirect, wholly-owned subsidiaries of
Merrill Lynch & Co., Inc. ("ML & Co.")), and other insurance companies, that are
not affiliated with ML & Co., for their separate accounts to fund benefits under
certain variable annuity and variable life insurance contracts. Government Bond
V.I. Fund (the "Fund") (formerly Government Bond Fund) is classified as
"diversified," as defined in the Investment Company Act of 1940. Class A and
Class B Shares have equal voting, dividend, liquidation and other rights, except
that only shares of the respective classes are entitled to vote on matters
concerning only that class and Class B Shares bear certain expenses related to
the distribution of such shares. The Fund's financial statements are prepared in
conformity with accounting principles generally accepted in the United States of
America, which may require the use of management accruals and estimates. The
following is a summary of significant accounting policies followed by the Fund.
(a) Valuation of investments--Portfolio securities that are traded on stock
exchanges are valued at the last sale price as of the close of business on the
day the securities are being valued, or lacking any sales, at the mean between
closing bid and asked prices. Securities traded in the over-the-counter market
are valued at the most recent bid prices as obtained from one or more dealers
that make markets in the securities. Portfolio securities that are traded both
in the over-the-counter 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. Short-term
securities are valued at amortized cost, which approximates market value.
Options written or purchased are valued at the last sale price in the case of
exchange-traded options. In the case of options traded in the over-the-counter
market, valuation is the last asked price (options written) or the last bid
price (options purchased). Financial futures contracts and options thereon,
which are traded on exchanges, are valued at their closing price at the close of
such exchanges. 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 Fund, including valuations
furnished by a pricing service retained by the Fund which may use a matrix
system for valuations.
(b) Derivative financial instruments--The Fund may engage in various Fund
investment strategies to increase or decrease the level of risk to which the
Fund is exposed more quickly and efficiently than transactions in other types of
instruments. Losses may arise due to changes in the value of the contract or if
the counterparty does not perform under the contract.
- - Financial futures contracts--The Fund may purchase or sell financial futures
contracts and options on such futures contracts for the purpose of hedging the
market risk on existing securities or the intended purchase of securities.
Futures contracts are contracts for delayed delivery of securities at a specific
future date and at a specific price or yield. Upon entering into a contract, the
Fund deposits and maintains as collateral such initial margin as required by the
exchange on which the transaction is effected. Pursuant to the contract, the
Fund agrees to receive from or pay to the broker an amount of cash equal to the
daily fluctuation in value of the contract. Such receipts or payments are known
as variation margin and are recorded by the Fund as unrealized gains or losses.
When the contract is closed, the Fund records a realized gain or loss equal to
the difference between the value of the contract at the time it was opened and
the value at the time it was closed.
- - Options--The Fund is authorized to purchase and write call and put options.
When the Fund writes an option, an amount equal to the premium received by the
Fund is reflected as an asset and an equivalent liability. The amount of the
liability is subsequently marked to market to reflect the current market value
of the option written.
When a security is purchased or sold through an exercise of an option, the
related premium paid (or received) is added to (or deducted from) the basis of
the security acquired or deducted from (or added to) the proceeds of the
security sold. When an option expires (or the Fund enters into a closing
transaction), the Fund realizes a gain or loss on the option to the extent of
the premiums received or paid (or loss or gain to the extent the cost of the
closing transaction exceeds the premium paid or received).
Written and purchased options are non-income producing investments.
166
- --------------------------------------------------------------------------------
- - Interest rate swaps--The Fund is authorized to enter into swap agreements for
the purpose of hedging the market risk on existing securities. In a swap
agreement, the Fund exchanges with the counterparty their respective commitments
to pay or receive interest on a specified notional principal amount. If the
counterparty defaults on its obligation, the Fund's ability to receive interest
will be delayed or limited. Furthermore, if the Fund does not have sufficient
income to pay its obligation under the swap agreement, the Fund would be in
default and the counterparty would be able to terminate the swap agreement. When
the swap agreement is closed, the Fund records a realized gain or loss equal to
the difference between the value of the swap agreement at the time it was
entered into and the value at the time it was closed.
(c) Repurchase agreements--The Fund invests in U.S. government securities
pursuant to repurchase agreements. Under such agreements, the counterparty
agrees to repurchase the security at a mutually agreed upon time and price. The
Fund takes possession of the underlying securities, marks to market such
securities and, if necessary, receives additional securities daily to ensure
that the contract is fully collateralized. If the counterparty defaults and the
fair value of the collateral declines, liquidation of the collateral by the Fund
may be delayed or limited.
(d) Income taxes--It is the Fund's policy to comply with the requirements of
the Internal Revenue Code applicable to regulated investment companies and to
distribute substantially all of its taxable income to its shareholders.
Therefore, no Federal income tax provision is required.
(e) Security transactions and investment income--Security transactions are
recorded on the dates the transactions are entered into (the trade dates).
Realized gains and losses on security transactions are determined on the
identified cost basis. Interest income is recognized on the accrual basis. The
Fund amortizes all premiums on debt securities.
(f) Dividends and distributions--Dividends from net investment income are
declared and paid monthly. Distributions of capital gains are recorded on the
ex-dividend dates.
(g) Expenses--Certain expenses have been allocated to the individual funds in
the Company on a pro rata basis based upon the respective aggregate net asset
value of each fund included in the Company.
(h) Securities lending--The Fund may lend securities to financial institutions
that provide cash or securities issued or guaranteed by the U.S. Government as
collateral, which will be maintained at all times in an amount equal to at least
100% of the current market value of the loaned securities. Where the Fund
receives securities as collateral for the loaned securities, it collects a fee
from the borrower. The Fund typically receives the income on the loaned
securities but does not receive the income on the collateral. Where the Fund
receives cash collateral, it may invest such collateral and retain the amount
earned on such investment, net of any amount rebated to the borrower. Loans of
securities are terminable at any time and the borrower, after notice, is
required to return borrowed securities within five business days. The Fund may
pay reasonable finder's, lending agent, administrative and custodial fees in
connection with its loans. In the event that the borrower defaults on its
obligation to return borrowed securities because of insolvency or for any other
reason, the Fund could experience delays and costs in gaining access to the
collateral. The Fund also could suffer a loss where the value of the collateral
falls below the market value of the borrowed securities, in the event of
borrower default or in the event of losses on investments made with cash
collateral.
(i) Reclassification--Accounting principles generally accepted in the United
States of America require that certain components of net assets be adjusted to
reflect permanent differences between financial and tax reporting. Accordingly,
the current year's permanent book/tax difference of $123,836 has been
reclassified between undistributed net realized capital gains and undistributed
net investment income. This reclassification has no effect on net assets or net
asset value per share.
2. INVESTMENT ADVISORY AGREEMENT AND
TRANSACTIONS WITH AFFILIATES:
The Company has entered into an Investment Advisory Agreement with Merrill Lynch
Investment Managers, L.P. ("MLIM"). The general partner of MLIM is Princeton
Services, Inc. ("PSI"), an indirect, wholly-owned subsidiary of ML & Co., which
is the limited partner.
MLIM is responsible for the management of the Company's funds and provides the
necessary personnel, facilities, equipment and certain other services necessary
to the operations of the Fund. For such services, the Fund pays a monthly fee at
the annual rate of .50% of the average daily value of the Fund's net assets.
MLIM and Merrill Lynch Life Agency, Inc. ("MLLA") have entered into an
agreement which limits the operating expenses paid by the Fund, exclusive of any
distribution fees imposed on Class B Shares, to 1.25% of its average daily net
assets. Any such expenses in excess of 1.25% of average daily net assets will be
167
- --------------------------------------------------------------------------------
reimbursed to the Fund by MLIM which, in turn, will be reimbursed by MLLA.
The Company has received an exemptive order from the Securities and Exchange
Commission permitting it to lend portfolio securities to Merrill Lynch, Pierce,
Fenner & Smith Incorporated ("MLPF&S"), a subsidiary of ML & Co., or its
affiliates. Pursuant to that order, the Company also has retained Merrill Lynch
Investment Managers, LLC ("MLIM, LLC"), an affiliate of MLIM, as the securities
lending agent for a fee based on a share of the returns on investment of cash
collateral. MLIM, LLC may, on behalf of the Company and the Fund, invest cash
collateral received by the Fund for such loans, among other things, in a private
investment company managed by MLIM, LLC or in registered money market funds
advised by MLIM or its affiliates. As of December 31, 2002, cash collateral of
$2,809,000 was invested in the Money Market Series of the Merrill Lynch
Liquidity Series, LLC and $2,491,001 was invested in the Merrill Lynch Premier
Institutional Fund. For the year ended December 31, 2002, MLIM, LLC received
$1,530 in securities lending agent fees from the Fund.
For the year ended December 31, 2002, Merrill Lynch Securities Pricing
Service, an affiliate of MLPF&S, earned $4,243 for providing security price
quotations to complete the Fund's net asset value.
Financial Data Services, Inc. ("FDS"), a wholly-owned subsidiary of ML & Co.,
is the Company's transfer agent.
FAM Distributors, Inc. ("FAMD"), which is a wholly-owned subsidiary of Merrill
Lynch Group, Inc., is the Fund's distributor.
For the year ended December 31, 2002, the Fund reimbursed MLIM $13,315 for
certain accounting services.
Certain officers and/or directors of the Company are officers and/or directors
of MLIM, PSI, FDS, FAMD, and/or ML & Co.
3. INVESTMENTS:
Purchases and sales of investments, excluding short-term securities, for the
year ended December 31, 2002 were $1,196,834,632 and $1,063,876,586,
respectively.
Net realized gains (losses) for the year ended December 31, 2002 and net
unrealized gains (losses) as of December 31, 2002 were as follows:
<Table>
<Caption>
- ---------------------------------------------------------------------
Realized Unrealized
Gains Gains
(Losses) (Losses)
- ---------------------------------------------------------------------
Long-term investments............... $11,537,698 $15,620,802
Short-term investments.............. (324) --
Financial futures contracts......... 634,392 8,576
Options written..................... 131,250 --
Interest rate swaps................. -- (518,910)
----------- -----------
Total............................... $12,303,016 $15,110,468
=========== ===========
- ---------------------------------------------------------------------
</Table>
The Fund had entered into the following interest rate swaps as of December 31,
2002:
<Table>
<Caption>
- ------------------------------------------------------------
Interest Received Interest Paid
Notional Current Current Expiration
Amount Rate Type Rate Type Date
- ------------------------------------------------------------
$6,300,000 1.38% Variable+ 4.85% Fixed 12/31/2012
$7,000,000 1.38% Variable+ 4.2675% Fixed 12/16/2011
$7,700,000 1.38% Variable+ 4.18% Fixed 6/16/2011
- ------------------------------------------------------------
</Table>
+ 3-month LIBOR at quarterly reset date.
Transactions in options written for the year ended December 31, 2002 were as
follows:
<Table>
<Caption>
- -------------------------------------------------------------------
Nominal Value
Covered by Premiums
Put Options Written Written Options Received
- -------------------------------------------------------------------
Outstanding put options written,
beginning of year.................... -- --
Options written....................... 140,000 $ 131,250
Options expired....................... (140,000) (131,250)
-------- ---------
Outstanding put options written, end
of year.............................. -- $ --
======== =========
- -------------------------------------------------------------------
</Table>
At December 31, 2002, net unrealized appreciation for Federal income tax
purposes aggregated $14,926,047, of which $15,539,190 related to appreciated
securities and $613,143 related to depreciated securities. At December 31, 2002,
the aggregate cost of investments for Federal income tax purposes was
$631,708,223.
4. CAPITAL SHARE TRANSACTIONS:
Transactions in capital shares were as follows:
<Table>
<Caption>
- -----------------------------------------------------------------
Class A Shares for the Year Ended Dollar
December 31, 2002 Shares Amount
- -----------------------------------------------------------------
Shares sold......................... 15,235,963 $ 166,879,192
Shares issued to shareholders in
reinvestment of dividends and
distributions...................... 2,783,375 30,319,730
---------- -------------
Total issued........................ 18,019,338 197,198,922
Shares redeemed..................... (9,428,949) (103,033,890)
---------- -------------
Net increase........................ 8,590,389 $ 94,165,032
========== =============
- -----------------------------------------------------------------
</Table>
<Table>
<Caption>
- -----------------------------------------------------------------
Class A Shares for the Year Ended Dollar
December 31, 2001 Shares Amount
- -----------------------------------------------------------------
Shares sold.......................... 15,198,276 $162,374,299
Shares issued to shareholders in
reinvestment of dividends and
distributions....................... 2,026,588 21,609,473
---------- ------------
Total issued......................... 17,224,864 183,983,772
Shares redeemed...................... (4,357,743) (46,413,486)
---------- ------------
Net increase......................... 12,867,121 $137,570,286
========== ============
- -----------------------------------------------------------------
</Table>
168
- --------------------------------------------------------------------------------
5. SHORT-TERM BORROWINGS:
The Fund, along with certain other funds managed by MLIM and its affiliates, is
a party to a credit agreement with Bank One, N.A. and certain other lenders.
Effective November 29, 2002, in conjunction with the renewal for one year at the
same terms, the total commitment was reduced from $1,000,000,000 to
$500,000,000. The Fund may borrow under the credit agreement to fund shareholder
redemptions and for other lawful purposes other than for leverage. The Fund may
borrow up to the maximum amount allowable under the Fund's current prospectus
and statement of additional information, subject to various other legal,
regulatory or contractual limits. The Fund pays a commitment fee of .09% per
annum based on the Fund's pro rata share of the unused portion of the credit
agreement. Amounts borrowed under the credit agreement bear interest at a rate
equal to, at each fund's election, the Federal Funds rate plus .50% or a base
rate as determined by Bank One, N.A. The Fund did not borrow under the credit
agreement during the year ended December 31, 2002.
6. DISTRIBUTIONS TO SHAREHOLDERS:
On January 2, 2003, an ordinary income dividend of $.037180 was declared. The
dividend was paid on January 2, 2003, to shareholders of record on December 31,
2002.
The tax character of distributions paid during the fiscal years ended December
31, 2002 and December 31, 2001 was as follows:
<Table>
<Caption>
- ------------------------------------------------------------------
12/31/2002 12/31/2001
- ------------------------------------------------------------------
Distributions paid from:
Ordinary income....................... $28,455,393 $20,018,300
Net long-term capital gains........... 1,864,337 1,591,163
----------- -----------
Total taxable distributions............ $30,319,730 $21,609,463
=========== ===========
- ------------------------------------------------------------------
</Table>
As of December 31, 2002, the components of accumulated earnings on a tax basis
were as follows:
<Table>
- ---------------------------------------------------------------
Undistributed ordinary income--net................ $ 4,002,797
Undistributed long-term capital gains--net........ 2,205,298
-----------
Total undistributed earnings--net................. 6,208,095
Unrealized gains--net............................. 14,407,137*
-----------
Total accumulated earnings--net................... $20,615,232
===========
- ---------------------------------------------------------------
</Table>
* The difference between book-basis and tax-basis net unrealized gains is
attributable primarily to the tax deferral of losses on wash sales, the
realization for tax purposes of unrealized gains (losses) on certain futures
contracts and the difference between book and tax amortization methods for
premiums and discounts on fixed income securities.
169
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--GOVERNMENT BOND V.I. FUND
INDEPENDENT AUDITORS' REPORT
- --------------------------------------------------------------------------------
THE BOARD OF DIRECTORS AND SHAREHOLDERS, GOVERNMENT BOND V.I. FUND OF MERRILL
LYNCH VARIABLE SERIES FUNDS, INC.:
We have audited the accompanying statement of assets and liabilities,
including the schedule of investments, of Government Bond V.I. Fund (formerly,
Government Bond Fund) of Merrill Lynch Variable Series Funds, Inc. as of
December 31, 2002, the related statements of operations for the year then ended
and changes in net assets for each of the years in the two-year period then
ended, and the financial highlights for each of the years presented. These
financial statements and the financial highlights are the responsibility of the
Fund's management. Our responsibility is to express an opinion on these
financial statements and the financial highlights based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements and the financial highlights are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. Our procedures included confirmation of
securities owned at December 31, 2002 by correspondence with the custodian and
brokers; where replies were not received from brokers, we performed other
auditing procedures. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such financial statements and financial highlights present
fairly, in all material respects, the financial position of Government Bond V.I.
Fund of Merrill Lynch Variable Series Funds, Inc. as of December 31, 2002, the
results of its operations, the changes in its net assets, and the financial
highlights for the respective stated periods in conformity with accounting
principles generally accepted in the United States of America.
Deloitte & Touche LLP
Princeton, New Jersey
February 14, 2003
170
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUND, INC.--HIGH CURRENT INCOME V.I. FUND
DECEMBER 31, 2002--ANNUAL REPORT
- --------------------------------------------------------------------------------
DEAR SHAREHOLDER:
FISCAL YEAR IN REVIEW
The year ended December 31, 2002 was a volatile period for the high yield
asset class. The year started off strong, but experienced a dramatic sell-off as
the year progressed, plagued by corporate governance issues, credit downgrades,
several prominent defaults, stock market weakness and soft economic growth.
After a dismal third quarter, the market rebounded toward the end of the year,
as November's return of +5.29% as measured by the unmanaged Credit Suisse First
Boston (CSFB) High Yield Index, was one of the strongest in the history of the
asset class. The rally stemmed from a confluence of positive forces--compelling
valuation, strong inflows into high yield mutual funds, a light new-issue
calendar and a rising equity market. Indications of increased Securities and
Exchange Commission and corporate board vigilance probably also contributed to
the improved investor sentiment.
Against this backdrop, the Fund's Class A Shares had a total return of -1.39%
for the year ended December 31, 2002 compared to a +3.11% return for the CSFB
High Yield Index for the same period. The Fund slightly outperformed the Lipper
High Yield average, which returned -1.82% for the 12-month period ended December
31, 2002.
Fund performance stemmed from poor sector allocation decisions, and, to a
lesser extent, adverse security selection. In particular, overweights in the
utility (which includes independent power producers) and cable sectors, as well
as an underweight in telecommunications, were the impacting sector choices. The
power sector was plagued by overcapacity and weak spark spreads in 2002, a
situation that is likely to persist this year. We believe that our holdings have
adequate financial flexibility to weather these weak markets and expect that the
sector will begin to improve in 2004, as the economy strengthens. The cable
sector plunged with the revelations of self-dealing at Adelphia Communications,
which filed for bankruptcy in mid-year. Bellweather issuer Charter
Communications also came under pressure following news of inflated subscriber
counts and a grand jury investigation. The telecommunications sector rallied
strongly, led by Qwest Communications, which completed a debt exchange on
favorable terms, and by WorldCom, Inc., which remains in bankruptcy. Favorable
security selection in the wireless sector was more than offset by weak security
selection in telecommunications.
The high yield market saw strong mutual fund inflows in the first and fourth
quarters of 2002, but outflows in the middle two quarters. Toward the latter
part of the year, a number of high quality new issues came to market. Among the
purchases we made for the Fund were: the bonds of yellow pages publishers Dex
Media East and R.H. Donnelley Financial Corp.; Boyd Gaming (a multi-state gaming
company); homebuilder D. R. Horton; Del Monte Corp. (a large producer of
processed fruit, vegetables and other food products); K&F Industries (a
privately held manufacturer of aircraft wheels, brakes and anti-skid systems);
Lamar Media (an owner of outdoor advertising structures); and SPX Corp. (a
diversified industrial concern). Most of these credits are characterized by
stable cash flow, good margins and healthy free cash flow. Secondary market
purchases (all at discounts to par) during the year included the bonds of Anchor
Glass, Koppers Industries and Southern Natural Gas.
We sold distressed positions in Autopistas Del Sol, Century Communications,
Mission Resources, Neff Corp., PG&E National Energy and RBX Corp. We reduced our
exposure to Millicom, Lyondell Chemical and Owens Brockway, and sold our entire
position in Greif Bros.
By the end of the fiscal year, the Fund's largest overweight positions were in
packaging, energy-other (refiners, propane distributors and oil service
companies), and manufacturing. We favor packaging because of the sector's stable
end markets. We expect the oil service credits to benefit from increased
drilling activity owing to strong hydrocarbon prices, while refiners should
eventually benefit from tight capacity. Our manufacturing position is a play on
a recovery in the industrial sector. We were encouraged by the Institute for
Supply Management's data for December. At year end, the Fund's overall credit
quality was equivalent to a "B" rating as measured by Standard & Poor's, which
compares to a "B+" rating for our benchmark Index.
We believe that the high yield market will continue to see healthy fund
inflows in 2003, given the low yields available in other fixed income asset
classes. We also expect the default rate to decline from 2002's lofty figure of
15%, as much of the poor quality issues of the late 1990s has already defaulted.
Moreover, an improving economy bodes well for the default rate. New-issue volume
is also likely to pick up
171
- --------------------------------------------------------------------------------
as we expect significant refinancing activity. The level of price volatility is,
however, likely to remain high. In summary, while spreads have tightened by over
100 basis points (1.00%) since last October, we believe there is still further
tightening in store for patient investors.
IN CONCLUSION
We appreciate your investment in High Current Income V.I. Fund of Merrill
Lynch Variable Series Funds, Inc., and we look forward to sharing our investment
outlook and strategies with you in our next report to shareholders.
Sincerely.
/s/ Terry K. Glenn
Terry K. Glenn
President and Director
/s/ Robert F. Murray
Robert F. Murray
Vice President and Portfolio Manager
January 17, 2003
172
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--HIGH CURRENT INCOME V.I. FUND
TOTAL RETURN BASED ON A $10,000 INVESTMENT--CLASS A SHARES
- --------------------------------------------------------------------------------
<Table>
<Caption>
HIGH CURRENT INCOME V.I. FUND+-- CREDIT SUISSE FIRST BOSTON HIGH
CLASS A SHARES* YIELD INDEX++
-------------------------------- -------------------------------
12/92 10000 10000
12/93 11784 11891
12/94 11361 11775
12/95 13316 13822
12/96 14817 15539
12/97 16447 17501
12/98 15939 17603
12/99 16887 18180
12/00 15690 17233
12/01 16319 18233
12/02 16092 18799
</Table>
* Assuming transaction costs and other operating expenses, including advisory
fees. Does not include insurance-related fees and expenses.
+ The Fund invests principally in fixed income securities with lower credit
quality.
++ This unmanaged market-weighted Index is comprised of 1,625 high-yield debt
securities rated BBB or lower.
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--HIGH CURRENT INCOME V.I. FUND
AVERAGE ANNUAL TOTAL RETURN--CLASS A SHARES*
- --------------------------------------------------------------------------------
<Table>
<Caption>
PERIOD COVERED % RETURN
- ----------------------------------------------------------------------
One Year Ended 12/31/02 -1.39%
- ----------------------------------------------------------------------
Five Years Ended 12/31/02 -0.41
- ----------------------------------------------------------------------
Ten Years Ended 12/31/02 +4.88
- ----------------------------------------------------------------------
</Table>
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--HIGH CURRENT INCOME V.I. FUND
RECENT PERFORMANCE RESULTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
6-MONTH 12-MONTH STANDARDIZED
AS OF DECEMBER 31, 2002 TOTAL RETURN TOTAL RETURN 30-DAY YIELD
- ---------------------------------------------------------------------------------------------------------
Class A Shares* +1.43% -1.39% 11.43%
- ---------------------------------------------------------------------------------------------------------
Credit Suisse First Boston High Yield Index** +2.94 +3.11 --
- ---------------------------------------------------------------------------------------------------------
</Table>
* Total investment returns are based on changes in net asset values for the
periods shown, and assume reinvestment of all dividends and capital gains
distributions at net asset value on the payable date. Insurance-related fees and
expenses are not reflected in these returns.
** This unmanaged market-weighted Index is comprised of 1,625 high-yield debt
securities rated BBB or lower.
Past results shown should not be considered a representation of future
performance.
173
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--HIGH CURRENT INCOME V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
<Caption>
S&P MOODY'S FACE
INDUSTRY RATINGS+ RATINGS+ AMOUNT CORPORATE BONDS VALUE
- ---------------------------------------------------------------------------------------------------------------------------
AEROSPACE & B B3 $ 400,000 K & F Industries, 9.625% due
DEFENSE--0.1% 12/15/2010(e)............................ $ 407,000
- ---------------------------------------------------------------------------------------------------------------------------
AIRLINES--1.5% A- B1 1,500,000 American Airlines, 7.80% due 10/01/2006.... 1,050,553
BBB Ba2 2,319,322 Continental Airlines Inc., 7.033% due
6/15/2011................................ 1,555,731
D Ca 4,000,000 USAir Inc., 10.375% due 3/01/2013(c)....... 1,400,000
------------
4,006,284
- ---------------------------------------------------------------------------------------------------------------------------
AUTOMOTIVE--1.2% BB+ Ba2 1,000,000 AutoNation Inc., 9% due 8/01/2008.......... 1,010,000
BB Ba3 750,000 Dana Corporation, 9% due 8/15/2011......... 723,750
B B3 1,805,000 Metaldyne Corporation, 11% due 6/15/2012... 1,480,100
------------
3,213,850
- ---------------------------------------------------------------------------------------------------------------------------
BROADCASTING--2.7% B- B3 2,262,000 Emmis Communications Corporation, 12.50%
due 3/15/2011(d)......................... 1,815,255
B+ Ba3 500,000 Entercom Radio, 7.625% due 3/01/2014....... 525,000
B- B3 425,000 Entravision Communications Corporation,
8.125% due 3/15/2009..................... 442,000
B- B3 1,750,000 Nextmedia Operating Inc., 10.75% due
7/01/2011................................ 1,839,688
B- Ba3 500,000 Panamsat Corporation, 8.50% due
2/01/2012................................ 477,500
B- B3 1,500,000 Salem Communications Holding Corporation,
9% due 7/01/2011......................... 1,573,125
B B2 750,000 Sinclair Broadcasting Group, 8% due
3/15/2012(e)............................. 781,875
------------
7,454,443
- ---------------------------------------------------------------------------------------------------------------------------
CABLE-- CCC+ Caa2 1,000,000 Cable Satisfaction International, 12.75%
INTERNATIONAL--0.5% due 3/01/2010............................ 211,250
D Ca 2,000,000 Cablevision SA, 13.75% due 5/01/2009(c).... 480,000
D Ca 3,500,000 International Cabletel, Inc., 11.50% due
2/01/2006(c)(d).......................... 332,500
D Ca 2,000,000 NTL Incorporated, 10% due 2/15/2007(c)..... 190,000
C Ca 2,000,000 United Pan-Europe Communications, 13.75%
due 2/01/2010(c)(d)...................... 120,000
------------
1,333,750
- ---------------------------------------------------------------------------------------------------------------------------
CABLE--U.S.--2.3% NR* NR* 2,500,000 Century Communications Corporation, 8.375%
due 12/15/2007(c)........................ 650,000
Charter Communications Holdings:
CCC+ B3 3,500,000 10% due 4/01/2009........................ 1,557,500
CCC+ B3 1,000,000 10.75% due 10/01/2009.................... 452,500
B+ B1 500,000 Echostar DBS Corporation, 9.125% due
1/15/2009................................ 526,250
NR* NR* 4,000,000 Olympus Communications LP/Capital Corp.,
10.625% due 11/15/2006(c)................ 3,120,000
------------
6,306,250
- ---------------------------------------------------------------------------------------------------------------------------
CHEMICALS--2.5% B B3 1,400,000 Huntsman International LLC, 9.875% due
3/01/2009................................ 1,400,000
BB- B2 500,000 ISP ChemCo., 10.25% due 7/01/2011.......... 517,500
B- B2 1,000,000 Koppers Industries, Inc., 9.875% due
12/01/2007............................... 915,000
BB Ba3 1,500,000 Lyondell Chemical Company, 9.875% due
5/01/2007................................ 1,440,000
BB- Ba3 1,000,000 MacDermid, Inc., 9.125% due 7/15/2011...... 1,067,500
BBB- Ba1 1,500,000 Methanex Corporation, 8.75% due 8/15/2012.. 1,590,000
------------
6,930,000
- ---------------------------------------------------------------------------------------------------------------------------
</Table>
174
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--HIGH CURRENT INCOME V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
S&P MOODY'S FACE
INDUSTRY RATINGS+ RATINGS+ AMOUNT CORPORATE BONDS VALUE
- ---------------------------------------------------------------------------------------------------------------------------
CONSUMER PRODUCTS-- BB+ Ba3 $ 2,625,000 American Greetings, 11.75% due 7/15/2008... $ 2,874,375
2.5%
B- B2 1,325,000 Armkel LLC/Armkel Finance, 9.50% due
8/15/2009................................ 1,437,625
NR* NR* 3,000,000 Corning Consumer Products, 9.625% due
5/01/2008(c)............................. 150,000
B B2 2,000,000 Hockey Company, 11.25% due 4/15/2009....... 2,040,000
NR* NR* 4,000,000 Polysindo International Finance Company BV,
9.375% due 7/30/2007(c).................. 280,000
------------
6,782,000
- ---------------------------------------------------------------------------------------------------------------------------
DIVERSIFIED CCC+ NR* 500,000 AquaChem Inc., 11.25% due 7/01/2008........ 375,000
MANUFACTURING--0.9%
BB- Ba3 2,000,000 SPX Corporation, 7.50% due 1/01/2013....... 2,027,500
------------
2,402,500
- ---------------------------------------------------------------------------------------------------------------------------
DIVERSIFIED MEDIA--2.3% Dex Media East LLC:(e)
B B2 400,000 9.875% due 11/15/2009.................... 428,000
B B3 500,000 12.125% due 11/15/2012................... 553,750
B Ba3 1,000,000 Lamar Media Corporation, 7.25% due
1/01/2013(e)............................. 1,016,250
B B3 2,000,000 Primedia, Inc., 7.625% due 4/01/2008....... 1,780,000
R.H. Donnelley Financial Corporation I:(e)
B+ B1 150,000 8.875% due 12/15/2010.................... 160,500
B+ B2 550,000 10.875% due 12/15/2012................... 599,500
B B2 1,500,000 Yell Finance BV, 10.75% due 8/01/2011...... 1,650,000
------------
6,188,000
- ---------------------------------------------------------------------------------------------------------------------------
ENERGY--EXPLORATION & NR* Caa2 250,000 Kelley Oil & Gas Company, 14% due
PRODUCTION--2.4% 4/15/2003................................ 250,000
NR* NR* 1,829,000 Southwest Royalties Inc., 10.50% due
6/30/2004................................ 1,801,565
Tri-Union Development Corporation:
D Caa2 1,701,000 12.50% due 6/01/2006..................... 1,360,800
D Caa2 125,000 12.50% due 6/01/2006(e).................. 100,000
BB+ Ba2 3,000,000 Western Oil Sands Inc., 8.375% due
5/01/2012................................ 2,985,000
------------
6,497,365
- ---------------------------------------------------------------------------------------------------------------------------
ENERGY--OTHER--6.2% BB- Ba3 2,400,000 AmeriGas/Eagle Financial, 8.875% due
5/20/2011................................ 2,496,000
BB- B1 1,125,000 El Paso Energy Partners, 8.50% due
6/01/2011................................ 1,043,438
CCC- Caa3 4,000,000 Energy Corp. of America, 9.50% due
5/15/2007................................ 2,480,000
B B2 650,000 Ferrellgas Partners LP, 8.75% due
6/15/2012................................ 672,750
B- B3 1,500,000 Giant Industries, 11% due 5/15/2012........ 1,005,000
Hanover Equipment Trust:(e)
BB- B1 350,000 (Series A), 8.50% due 9/01/2008.......... 341,250
BB- B1 650,000 (Series B), 8.75% due 9/01/2011.......... 627,250
CCC B3 4,150,000 Ocean Rig Norway AS, 10.25% due 6/01/2008.. 3,735,000
BB- B1 2,000,000 SESI, LLC, 8.875% due 5/15/2011............ 2,040,000
B B3 1,250,000 Tesoro Petroleum Corp., 9% due 7/01/2008... 825,000
B B2 1,850,000 Trico Marine Services, 8.875% due
5/15/2012................................ 1,711,250
------------
16,976,938
- ---------------------------------------------------------------------------------------------------------------------------
FOOD & TOBACCO--2.0% B B3 950,000 American Seafood Group LLC, 10.125% due
4/15/2010................................ 969,000
NR* NR* 294,118 Archibald Candy Corporation, 10% due
11/01/2007............................... 264,706
CCC Caa3 1,000,000 Aurora Foods Inc., 9.875% due 2/15/2007.... 495,000
BB Ba2 1,000,000 Canandaigua Brands, 8.625% due 8/01/2006... 1,060,000
B B2 975,000 Del Monte Corporation, 8.625% due
12/15/2012(e)............................ 994,500
CCC- Caa1 1,000,000 New World Pasta Company, 9.25% due
2/15/2009................................ 545,000
BB+ Ba2 1,000,000 Smithfield Foods Inc., 8% due 10/15/2009... 1,020,000
------------
5,348,206
- ---------------------------------------------------------------------------------------------------------------------------
</Table>
175
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--HIGH CURRENT INCOME V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
S&P MOODY'S FACE
INDUSTRY RATINGS+ RATINGS+ AMOUNT CORPORATE BONDS VALUE
- ---------------------------------------------------------------------------------------------------------------------------
GAMING--3.8% Boyd Gaming Corporation:
B+ B1 $ 1,625,000 8.75% due 4/15/2012...................... $ 1,690,000
B+ B1 1,500,000 7.75% due 12/15/2012(e).................. 1,468,125
NR* NR* 2,410,000 GB Property Funding Corp., 11% due
9/29/2005................................ 1,590,600
BB+ Ba2 250,000 Park Place Entertainment, 7.875% due
3/15/2010................................ 254,375
CCC Caa1 5,000,000 Trump Atlantic City Associates/Funding
Inc., 11.25% due 5/01/2006............... 3,900,000
B- Caa1 1,500,000 Venetian Casino/LV Sands, 11% due
6/15/2010(e)............................. 1,567,500
------------
10,470,600
- ---------------------------------------------------------------------------------------------------------------------------
HEALTH CARE--1.6% B+ B1 2,000,000 Beverly Enterprises Inc., 9% due
2/15/2006................................ 1,680,000
B B3 1,000,000 Fisher Scientific International, 8.125% due
5/01/2012................................ 1,035,000
NR* NR* 500,000 Ivax Corporation, 5.50% due 5/15/2007...... 444,375
BB- Ba3 900,000 PerkinElmer Inc., 8.875% due 1/15/2013(e).. 886,500
B B2 425,000 Sybron Dental Specialties, 8.125% due
6/15/2012................................ 429,250
------------
4,475,125
- ---------------------------------------------------------------------------------------------------------------------------
HOUSING--2.1% BB Ba2 500,000 Beazer Homes USA, 8.375% due 4/15/2012..... 515,000
BB Ba1 1,375,000 D.R. Horton, Inc., 7.50% due 12/01/2007.... 1,347,500
BB- Ba3 375,000 Forest City Enterprises Inc., 8.50% due
3/15/2008................................ 375,000
NR* NR* 3,000,000 Tapco International Corporation, 12.50% due
8/01/2009(e)............................. 2,932,500
B Ba3 600,000 WCI Communities Inc., 9.125% due
5/01/2012................................ 540,000
------------
5,710,000
- ---------------------------------------------------------------------------------------------------------------------------
INFORMATION BB- Ba2 1,000,000 Celestica Inc., 4.69% due 8/01/2020(d)..... 458,750
TECHNOLOGY--1.7%
CCC+ B3 1,800,000 ON Semiconductor Corporation, 12% due
5/15/2008(e)............................. 1,323,000
BB+ Ba2 1,500,000 Seagate Technology HDD Holdings, 8% due
5/15/2009(e)............................. 1,552,500
BB Ba3 1,400,000 Solectron Corporation, 9.625% due
2/15/2009................................ 1,365,000
------------
4,699,250
- ---------------------------------------------------------------------------------------------------------------------------
LEISURE--4.3% BB- Ba3 959,000 Felcor Lodging LP, 8.50% due 6/01/2011..... 944,615
BB- Ba3 2,000,000 HMH Properties, Inc., 8.45% due
12/01/2008............................... 1,975,000
BB- Ba3 500,000 Host Marriott LP, 9.50% due 1/15/2007...... 507,500
BBB- Ba1 500,000 ITT Corporation (New), 7.75% due
11/15/2025............................... 455,000
B+ B1 2,000,000 Intrawest Corporation, 10.50% due
2/01/2010................................ 2,100,000
B B2 1,625,000 John Q. Hammons Hotels, 8.875% due
5/15/2012................................ 1,633,125
B B1 500,000 Meristar Hospitality Corp., 10.50% due
6/15/2009................................ 456,250
B B2 4,000,000 Premier Parks Inc., 9.75% due 6/15/2007.... 3,880,000
------------
11,951,490
- ---------------------------------------------------------------------------------------------------------------------------
MACHINERY/ BB+ Ba2 2,500,000 JLG Industries Inc., 8.375% due
CONSTRUCTION--0.8% 6/15/2012................................ 2,075,000
- ---------------------------------------------------------------------------------------------------------------------------
</Table>
176
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--HIGH CURRENT INCOME V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
S&P MOODY'S FACE
INDUSTRY RATINGS+ RATINGS+ AMOUNT CORPORATE BONDS VALUE
- ---------------------------------------------------------------------------------------------------------------------------
MANUFACTURING--5.4% CCC Caa2 $ 3,500,000 Blount Inc., 13% due 8/01/2009............. $ 2,178,750
CCC+ Caa1 4,000,000 Columbus McKinnon Corp., 8.50% due
4/01/2008................................ 2,880,000
B- Caa1 4,876,000 Eagle-Picher Industries, 9.375% due
3/01/2008................................ 3,437,580
B B3 825,000 Foamex LP/Capital Corporation, 10.75% due
4/01/2009(e)............................. 577,500
CCC+ Caa1 4,650,000 International Wire Group, Inc., 11.75% due
6/01/2005................................ 2,813,250
B+ B3 950,000 NMHG Holding Company, 10% due 5/15/2009.... 950,000
B- B3 325,000 Rexnord Corporation, 10.125% due
12/15/2012(e)............................ 333,125
BB- B1 1,750,000 Wolverine Tube Inc., 10.50% due 4/01/2009.. 1,785,000
------------
14,955,205
- ---------------------------------------------------------------------------------------------------------------------------
METAL--OTHER--2.1% B- B3 5,932,000 Great Lakes Carbon Corp., 7.175% due
5/15/2008(a)............................. 4,211,720
BB- B1 1,000,000 Oregon Steel Mills Inc., 10% due
7/15/2009(e)............................. 1,015,000
CCC- Caa3 1,000,000 Ormet Corporation, 11% due 8/15/2008(e).... 520,000
------------
5,746,720
- ---------------------------------------------------------------------------------------------------------------------------
METALS & MINING--1.9% BB Ba3 1,000,000 Luscar Coal Ltd., 9.75% due 10/15/2011..... 1,071,250
B+ B1 4,030,000 P & L Coal Holdings Corp., 9.625% due
5/15/2008................................ 4,256,688
------------
5,327,938
- ---------------------------------------------------------------------------------------------------------------------------
MULTI-SECTOR NR* NR* 500,000 Morgan Stanley TRACERS, 9.374% due
HOLDINGS--0.2% 12/15/2012(e)(g)......................... 502,635
- ---------------------------------------------------------------------------------------------------------------------------
PACKAGING--10.3% NR* Caa2 2,000,000 Anchor Glass, 11.25% due 4/01/2005......... 1,970,000
B- B3 1,075,000 Berry Plastics, 10.75% due 7/15/2012....... 1,144,875
B- B3 600,000 Bway Corporation, 10% due 10/15/2010(e).... 622,500
CCC Caa1 7,000,000 Consolidated Container Company, 10.125% due
7/15/2009................................ 4,698,750
Graham Packaging Company:
CCC+ NR* 250,000 10.75% due 1/15/2009(d).................. 247,812
CCC+ Caa1 375,000 8.75% due 1/15/2008...................... 367,969
B+ B2 250,000 Graphic Packaging Corporation, 8.625% due
2/15/2012................................ 263,125
B- Caa1 3,250,000 Huntsman Packaging Corporation, 13% due
6/01/2010................................ 2,981,875
BB B2 1,000,000 Owens-Brockway Glass Container, 8.875% due
2/15/2009................................ 1,030,000
B+ B3 2,500,000 Owens-Illinois Inc., 8.10% due 5/15/2007... 2,412,500
B+ B3 1,325,000 Plastipak Holdings Inc., 10.75% due
9/01/2011................................ 1,392,906
B B2 4,000,000 Portola Packaging Inc., 10.75% due
10/01/2005............................... 4,040,000
B- B3 6,500,000 Tekni-Plex Inc., 12.75% due 6/15/2010...... 6,077,500
CCC+ Caa1 2,150,000 US Can Corporation, 12.375% due
10/01/2010............................... 924,500
------------
28,174,312
- ---------------------------------------------------------------------------------------------------------------------------
PAPER--2.5% Ainsworth Lumber Company:
B- B3 2,250,000 12.50% due 7/15/2007(a).................. 2,340,000
B- B3 2,000,000 13.875% due 7/15/2007.................... 2,140,000
D Ca 5,000,000 Doman Industries Limited, 9.25% due
11/15/2007(c)............................ 625,000
B NR* 500,000 MDP Acquisitions PLC, 9.625% due
10/01/2012(e)............................ 520,000
B+ B3 500,000 Millar Western Forest, 9.875% due
5/15/2008................................ 475,000
BB+ Ba2 525,000 Norske Skog of Canada, 8.625% due
6/15/2011................................ 528,938
BB Ba3 200,000 Pope & Talbot, 8.375% due 6/01/2013........ 173,500
------------
6,802,438
- ---------------------------------------------------------------------------------------------------------------------------
PIPELINES--0.3% BB Ba1 1,000,000 Southern Natural Gas, 8% due 3/01/2032..... 880,000
- ---------------------------------------------------------------------------------------------------------------------------
</Table>
177
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--HIGH CURRENT INCOME V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
S&P MOODY'S FACE
INDUSTRY RATINGS+ RATINGS+ AMOUNT CORPORATE BONDS VALUE
- ---------------------------------------------------------------------------------------------------------------------------
SERVICES--4.4% B+ Ba2 $ 475,000 Airgas Inc., 9.125% due 10/01/2011......... $ 513,000
Allied Waste North America:
BB- Ba3 4,000,000 7.375% due 1/01/2004..................... 4,000,000
BB- Ba3 1,000,000 8.875% due 4/01/2008..................... 1,015,000
CCC- C 1,000,000 Anthony Crane Rental LP, 10.375% due
8/01/2008................................ 100,000
CCC- NR* 10,000,000 Anthony Crane Rentals, 13.375% due
8/01/2009(d)............................. 100,000
B B2 875,000 Coinmach Corporation, 9% due 2/01/2010..... 917,656
B- B3 3,000,000 IESI Corporation, 10.25% due 6/15/2012..... 2,895,000
NR* NR* 3,500,000 Mid-American Waste Systems, Inc., 12.25%
due 2/15/2003(c)......................... 0
B B3 300,000 National Waterworks Inc., 10.50% due
12/01/2012(e)............................ 313,125
CCC+ Caa3 1,250,000 Protection One Alarm Monitoring, 8.125% due
1/15/2009................................ 937,500
B B3 1,225,000 Synagro Technologies Inc., 9.50% due
4/01/2009................................ 1,277,063
------------
12,068,344
- ---------------------------------------------------------------------------------------------------------------------------
STEEL--0.4% B B3 1,250,000 UCAR Finance Inc., 10.25% due 2/15/2012.... 993,750
CCC- Caa3 1,925,000 Weirton Steel Corporation, 0.50% due
4/01/2008(c)(d).......................... 192,500
NR* NR* 3,500,000 Wheeling Pittsburgh Corp., 9.25% due
11/15/2007(c)............................ 35,000
------------
1,221,250
- ---------------------------------------------------------------------------------------------------------------------------
TELECOMMUNICATIONS-- NR* NR* 4,000,000 Energis PLC, 9.75% due 6/15/2009(c)........ 20,000
0.4%
B- Ba3 1,250,000 Qwest Corporation, 7.625% due 6/09/2003.... 1,225,000
------------
1,245,000
- ---------------------------------------------------------------------------------------------------------------------------
TRANSPORT SERVICES--0.1% BB- Ba3 250,000 Stena AB, 9.625% due 12/01/2012(e)......... 258,125
- ---------------------------------------------------------------------------------------------------------------------------
TRANSPORTATION--0.4% CCC Caa2 250,000 American Commercial LLC, 11.25% due
1/01/2008................................ 80,000
B+ B2 1,000,000 Sea Containers Ltd., 12.50% due
12/01/2004............................... 935,000
------------
1,015,000
- ---------------------------------------------------------------------------------------------------------------------------
UTILITY--8.9% The AES Corporation:
B- B3 3,000,000 9.50% due 6/01/2009...................... 1,837,500
B- B3 3,475,000 9.375% due 9/15/2010..................... 2,085,000
B- B3 650,000 8.875% due 2/15/2011..................... 377,000
C C 4,000,000 AES Drax Energy Ltd., 11.50% due
8/30/2010(c)............................. 50,000
BB+ Ba1 2,000,000 AES Eastern Energy, 9% due 1/02/2017....... 1,841,780
NR* NR* 1,750,000 CIA Saneamento Basico, 10% due
7/28/2005(e)............................. 1,277,500
CMS Energy Corporation:
B+ B3 2,000,000 7.50% due 1/15/2009...................... 1,700,000
NR* B3 500,000 8.50% due 4/15/2011...................... 435,000
BB Ba3 5,568,888 Caithness Coso Fund Corp., 9.05% due
12/15/2009............................... 5,457,510
Calpine Corporation:
B+ B1 135,000 4% due 12/26/2006(e)..................... 66,487
B+ B1 2,000,000 8.75% due 7/15/2007...................... 870,000
BB Ba1 2,641,000 ESI Tractebel Acquisition Corp., 7.99% due
12/30/2011............................... 2,378,458
BB- Ba3 1,250,000 Midland Funding II, 11.75% due 7/23/2005... 1,275,000
BB Ba3 1,000,000 Mirant Americas Generation LLC, 7.625% due
5/01/2006................................ 525,000
B- B3 1,300,000 Mission Energy Holdings, 13.50% due
7/15/2008................................ 299,000
A Baa2 2,311,000 Niagara Mohawk Power Corp., 8.77% due
1/01/2018................................ 2,418,475
BBB- Baa3 2,000,000 PSEG Energy Holdings, 8.625% due
2/15/2008................................ 1,670,000
------------
24,563,710
- ---------------------------------------------------------------------------------------------------------------------------
</Table>
178
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--HIGH CURRENT INCOME V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
S&P MOODY'S FACE
INDUSTRY RATINGS+ RATINGS+ AMOUNT CORPORATE BONDS VALUE
- ---------------------------------------------------------------------------------------------------------------------------
WIRELESS--4.2% B- Caa1 $ 2,300,000 American Tower Systems Corporation, 9.375%
due 2/01/2009............................ $ 1,794,000
CC Caa3 5,825,000 Millicom International Cellular SA, 13.50%
due 6/01/2006(d)......................... 2,854,250
NR* NR* 2,260,261 NII Holdings Inc., 13% due
11/01/2009(d)(e)......................... 1,627,388
CCC+ Caa1 5,975,000 Nextel Partners Inc., 14% due
2/01/2009(d)............................. 4,481,250
BBB Baa2 808,000 Tritel PCS Inc., 10.375% due 1/15/2011..... 864,560
------------
11,621,448
- ---------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN CORPORATE BONDS
(COST--$305,151,473)--82.9% 227,610,176
- ---------------------------------------------------------------------------------------------------------------------------
<Caption>
SHARES
HELD PREFERRED STOCKS
- ---------------------------------------------------------------------------------------------------------------------------
BROADCASTING--0.9% 2,149 Cumulus Media, Inc. (Series A), 13.75%(a).. 2,406,701
- ---------------------------------------------------------------------------------------------------------------------------
CABLE--INTERNATIONAL--0.0% 5,511 NTL Incorporated (Series B)(a)(c).......... 13,778
- ---------------------------------------------------------------------------------------------------------------------------
CABLE--U.S.--2.5% 72,551 CSC Holdings Inc., (Series A)(a)........... 6,747,243
- ---------------------------------------------------------------------------------------------------------------------------
DIVERSIFIED MEDIA--0.4% 20,000 Primedia, Inc. (Series H).................. 1,230,000
- ---------------------------------------------------------------------------------------------------------------------------
FINANCIAL SERVICES--1.1% 120,000 California Federal Bank (Series A)......... 3,121,200
- ---------------------------------------------------------------------------------------------------------------------------
STEEL--1.2% 120,000 United States Steel LLC (Preferred)........ 3,116,400
31,500 Weirton Steel Corporation(c)............... 31,500
------------
3,147,900
- ---------------------------------------------------------------------------------------------------------------------------
TELECOMMUNICATIONS--0.0% 1 Intermedia Communications Inc.
(Convertible)(a)(c)...................... 34
- ---------------------------------------------------------------------------------------------------------------------------
WIRELESS--1.3% 3,901 Nextel Communications, Inc. (Series
D)(a).................................... 3,588,874
- ---------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN PREFERRED STOCKS
(COST--$25,979,133)--7.4% 20,255,730
- ---------------------------------------------------------------------------------------------------------------------------
<Caption>
COMMON STOCKS
- ---------------------------------------------------------------------------------------------------------------------------
AUTOMOTIVE--0.0% 5,000 Allied Signal Litigation Trust(c).......... 0
5,000 Breed Creditors Litigation Trust(c)........ 0
------------
0
- ---------------------------------------------------------------------------------------------------------------------------
BROADCASTING--0.0% 24,865 UnitedGlobalCom Inc. (Class A)(c).......... 59,676
- ---------------------------------------------------------------------------------------------------------------------------
COMMUNICATIONS--0.9% 214,156 NII Holdings Inc. (Class B)(c)............. 2,452,086
- ---------------------------------------------------------------------------------------------------------------------------
ENERGY-EXPLORATION & PRODUCTION--0.2% 27,435 Southwest Royalties Inc.(c)................ 377,237
1,180 Tri-Union Development Corporation(c)....... 12
2,000 Tribo Petroleum Corporation (Class A)(c)... 20
------------
377,269
- ---------------------------------------------------------------------------------------------------------------------------
FINANCIAL--OTHER--0.0% 2,000,000 AMRESCO, Inc. Creditor Trust (Units)(c).... 50,000
- ---------------------------------------------------------------------------------------------------------------------------
FOOD & TOBACCO--0.1% 1,624 Archibald Candy Corporation(c)............. 151,032
- ---------------------------------------------------------------------------------------------------------------------------
GAMING--0.1% 117,808 GB Holdings Inc.(c)........................ 338,109
- ---------------------------------------------------------------------------------------------------------------------------
INFORMATION SYSTEMS--0.1% 34,087 Dictaphone Corporation(c).................. 136,348
3,000,000 Dictaphone Corporation Litigation Trust
(Units)(c)............................... 30
------------
136,378
- ---------------------------------------------------------------------------------------------------------------------------
METALS & MINING--0.0% 80,000 Horizon Natural Resources Company(c)....... 800
- ---------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN COMMON STOCKS
(COST--$18,317,579)--1.3% 3,565,350
- ---------------------------------------------------------------------------------------------------------------------------
<Caption>
WARRANTS(B)
- ---------------------------------------------------------------------------------------------------------------------------
FOOD & DRUG--0.0% 2,809 Grand Union Co............................. 3
- ---------------------------------------------------------------------------------------------------------------------------
INFORMATION SYSTEMS--0.0% 30,773 Dictaphone Corporation..................... 960
- ---------------------------------------------------------------------------------------------------------------------------
</Table>
179
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--HIGH CURRENT INCOME V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONCLUDED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES
INDUSTRY HELD WARRANTS(B) VALUE
- ---------------------------------------------------------------------------------------------------------------------------
[IX
PACKAGING--0.0% 4,000 Pliant Corporation......................... $ 4,000
- ---------------------------------------------------------------------------------------------------------------------------
RETAIL--0.0% 17,307 Bradlees Inc............................... 17
- ---------------------------------------------------------------------------------------------------------------------------
STEEL--0.0% 750 Republic Technologies...................... 8
- ---------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN WARRANTS
(COST--$4,615,533)--0.0% 4,988
- ---------------------------------------------------------------------------------------------------------------------------
PARTNERSHIP
INTEREST SHORT-TERM SECURITIES
- ---------------------------------------------------------------------------------------------------------------------------
[IX
$15,966,713 Merrill Lynch Liquidity Series, LLC Cash
Sweep Series II(f)....................... 15,966,713
- ---------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN SHORT-TERM SECURITIES
(COST--$15,966,713)--5.8% 15,966,713
- ---------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS
(COST--$370,030,431)--97.4%................ 267,402,957
OTHER ASSETS LESS LIABILITIES--2.6%........ 7,131,282
------------
NET ASSETS--100.0%......................... $274,534,239
============
- ---------------------------------------------------------------------------------------------------------------------------
</Table>
* Not Rated.
+ Ratings of issues shown are unaudited.
(a) Represents a pay-in-kind security which may pay interest/dividends in
additional face/shares.
(b) Warrants entitle the Fund to purchase a predetermined number of shares of
common stock and are non-income producing. The purchase price and number of
shares are subject to adjustment under certain conditions until the
expiration date.
(c) Non-income producing security.
(d) Represents a zero coupon or step bond; the interest rate shown reflects the
effective yield at the time of purchase by the Fund.
(e) The security may be offered and sold to "qualified institutional buyers"
under Rule 144A of the Securities Act of 1933.
(f) Investments in companies considered to be an affiliate of the Fund (such
companies are defined as "Affiliated Companies" in Section 2(a)(3) of the
Investment Company Act of 1940) are as follows:
<Table>
<Caption>
- ----------------------------------------------------------------------------------------------------
NET NET INTEREST
AFFILIATE ACTIVITY COST INCOME
- ----------------------------------------------------------------------------------------------------
Merrill Lynch Liquidity Series, LLC Cash Sweep Series II.... $15,966,713 $15,966,713 $26,489
- ----------------------------------------------------------------------------------------------------
</Table>
(g) Traded Custody Receipts (TRACERS).
See Notes to Financial Statements.
180
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--HIGH CURRENT INCOME V.I. FUND
STATEMENT OF ASSETS AND LIABILITIES AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
ASSETS:
Investments, at value (identified cost--$370,030,431)....... $ 267,402,957
Receivables:
Interest.................................................. $ 6,140,399
Securities sold........................................... 1,453,559
Dividends................................................. 387,889
Capital shares sold....................................... 152 7,981,999
-------------
Prepaid expenses............................................ 1,940
-------------
Total assets................................................ 275,386,896
-------------
- -------------------------------------------------------------------------------------------
LIABILITIES:
Payables:
Custodian bank............................................ 429,796
Capital shares redeemed................................... 163,142
Investment adviser........................................ 115,068
Securities purchased...................................... 112,240 820,246
-------------
Accrued expenses and other liabilities...................... 32,411
-------------
Total liabilities........................................... 852,657
-------------
- -------------------------------------------------------------------------------------------
NET ASSETS.................................................. $ 274,534,239
=============
- -------------------------------------------------------------------------------------------
NET ASSETS CONSIST OF:
Class A Shares of Common Stock, $.10 par value, 200,000,000
shares authorized+.......................................... $ 4,104,694
Paid-in capital in excess of par............................ 515,071,848
Undistributed investment income--net........................ $ 3,677,348
Accumulated realized capital losses on investments--net..... (145,692,177)
Unrealized depreciation on investments--net................. (102,627,474)
-------------
Total accumulated losses--net............................... (244,642,303)
-------------
NET ASSETS.................................................. $ 274,534,239
=============
- -------------------------------------------------------------------------------------------
NET ASSET VALUE:
Class A--Based on net assets of $274,534,239 and 41,046,943
shares outstanding.......................................... $ 6.69
=============
- -------------------------------------------------------------------------------------------
</Table>
+ The Fund is also authorized to issue 100,000,000 Class B Shares.
See Notes to Financial Statements.
181
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--HIGH CURRENT INCOME V.I. FUND
STATEMENT OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
INVESTMENT INCOME:
Interest.................................................... $ 30,811,792
Dividends................................................... 2,405,275
Other income................................................ 141,175
------------
Total income................................................ 33,358,242
------------
- ----------------------------------------------------------------------------------------
EXPENSES:
Investment advisory fees.................................... $1,535,881
Accounting services......................................... 112,738
Professional fees........................................... 47,981
Transfer agent fees......................................... 38,971
Printing and shareholder reports............................ 32,727
Custodian fees.............................................. 26,978
Pricing services............................................ 19,446
Directors' fees and expenses................................ 14,321
Registration fees........................................... 820
Other....................................................... 15,380
----------
Total expenses.............................................. 1,845,243
------------
Investment income--net...................................... 31,512,999
------------
- ----------------------------------------------------------------------------------------
REALIZED & UNREALIZED GAIN (LOSS) ON INVESTMENTS--NET:
Realized loss on investments--net........................... (71,478,950)
Change in unrealized depreciation on investments--net....... 30,512,074
------------
Total realized and unrealized loss on investments--net...... (40,966,876)
------------
NET DECREASE IN NET ASSETS RESULTING FROM OPERATIONS........ $ (9,453,877)
============
- ----------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
182
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--HIGH CURRENT INCOME V.I. FUND
STATEMENTS OF CHANGES IN NET ASSETS
- --------------------------------------------------------------------------------
<Table>
<Caption>
FOR THE YEAR ENDED
DECEMBER 31,
----------------------------
INCREASE (DECREASE) IN NET ASSETS: 2002 2001
- --------------------------------------------------------------------------------------------
OPERATIONS:
Investment income--net...................................... $ 31,512,999 $ 44,470,976
Realized loss on investments--net........................... (71,478,950) (34,286,627)
Change in unrealized depreciation on investments--net....... 30,512,074 6,504,510
------------ ------------
Net increase (decrease) in net assets resulting from
operations................................................ (9,453,877) 16,688,859
------------ ------------
- --------------------------------------------------------------------------------------------
DIVIDENDS TO SHAREHOLDERS:
Dividends to Class A shareholders from investment
income--net:.............................................. (33,490,518) (43,789,624)
------------ ------------
- --------------------------------------------------------------------------------------------
CAPITAL SHARE TRANSACTIONS:
Net decrease in net assets derived from capital share
transactions.............................................. (47,244,664) (12,520,404)
------------ ------------
- --------------------------------------------------------------------------------------------
NET ASSETS:
Total decrease in net assets................................ (90,189,059) (39,621,169)
Beginning of year........................................... 364,723,298 404,344,467
------------ ------------
End of year*................................................ $274,534,239 $364,723,298
============ ============
- --------------------------------------------------------------------------------------------
* Undistributed investment income--net...................... $ 3,677,348 $ 4,611,818
============ ============
- --------------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
183
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--HIGH CURRENT INCOME V.I. FUND
FINANCIAL HIGHLIGHTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
THE FOLLOWING PER SHARE DATA AND RATIOS HAVE BEEN
DERIVED FROM INFORMATION PROVIDED IN THE FINANCIAL
STATEMENTS. CLASS A
------------------------------------------------------------
FOR THE YEAR ENDED DECEMBER 31,
------------------------------------------------------------
INCREASE (DECREASE) IN NET ASSET VALUE: 2002 2001 2000 1999 1998
- ----------------------------------------------------------------------------------------------------------------------
PER SHARE OPERATING PERFORMANCE:
Net asset value, beginning of year.................... $ 7.53 $ 8.06 $ 9.59 $ 10.11 $ 11.52
-------- -------- -------- -------- --------
Investment income--net+............................... .68 .88 .96 1.00 1.05
Realized and unrealized loss on investments--net...... (.80) (.55) (1.59) (.43) (1.40)
-------- -------- -------- -------- --------
Total from investment operations...................... (.12) .33 (.63) .57 (.35)
-------- -------- -------- -------- --------
Less dividends and distributions:
Investment income--net.............................. (.72) (.86) (.90) (1.09) (1.02)
In excess of investment income--net................. -- -- -- --++ --
In excess of realized gain on investments--net...... -- -- -- -- (.04)
-------- -------- -------- -------- --------
Total dividends and distributions..................... (.72) (.86) (.90) (1.09) (1.06)
-------- -------- -------- -------- --------
Net asset value, end of year.......................... $ 6.69 $ 7.53 $ 8.06 $ 9.59 $ 10.11
======== ======== ======== ======== ========
- ----------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENT RETURN:*
Based on net asset value per share.................... (1.39%) 4.01% (7.09%) 5.95% (3.09%)
======== ======== ======== ======== ========
- ----------------------------------------------------------------------------------------------------------------------
RATIOS TO AVERAGE NET ASSETS:
Expenses.............................................. .57% .58% .54% .52% .53%
======== ======== ======== ======== ========
Investment income--net................................ 9.75% 10.82% 10.72% 10.10% 9.52%
======== ======== ======== ======== ========
- ----------------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL DATA:
Net assets, end of year (in thousands)................ $274,534 $364,723 $404,344 $498,392 $521,900
======== ======== ======== ======== ========
Portfolio turnover.................................... 51.73% 32.01% 28.63% 23.14% 33.63%
======== ======== ======== ======== ========
- ----------------------------------------------------------------------------------------------------------------------
</Table>
* Total investment returns exclude insurance-related fees and expenses.
+ Based on average shares outstanding.
++ Amount is less than $.01 per share
See Notes to Financial Statements.
184
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--HIGH CURRENT INCOME V.I. FUND
NOTES TO FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
1. SIGNIFICANT ACCOUNTING POLICIES:
Merrill Lynch Variable Series Funds, Inc. (the "Company") is an open-end
management investment company that is comprised of 17 separate funds. Each fund
offers two classes of shares to the Merrill Lynch Life Insurance Company, ML
Life Insurance Company of New York (indirect, wholly-owned subsidiaries of
Merrill Lynch & Co., Inc. ("ML & Co.")), and other insurance companies, which
are not affiliated with ML & Co., for their separate accounts to fund benefits
under certain variable annuity and variable life insurance contracts. Class A
and Class B Shares have equal voting, dividend, liquidation and other rights,
except that only shares of the respective classes are entitled to vote on
matters concerning only that class and Class B Shares bear certain expenses
related to the distribution of such shares. High Current Income V.I. Fund (the
"Fund") (formerly High Current Income Fund) is classified as "diversified," as
defined in the Investment Company Act of 1940. The Fund's financial statements
are prepared in conformity with accounting principles generally accepted in the
United States of America, which may require the use of management accruals and
estimates. The following is a summary of significant accounting policies
followed by the Fund.
(a) Valuation of investments--Portfolio securities that are traded on stock
exchanges are valued at the last sale price as of the close of business on the
day the securities are being valued, or lacking any sales, at the closing bid
price. Securities traded in the over-the-counter market are valued at the last
available bid price prior to the time of valuation. Portfolio securities that
are traded both in the over-the-counter 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. Short-term securities are valued at amortized cost, which approximates
market value. 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.
(b) Income taxes--It is the Fund's policy to comply with the requirements of
the Internal Revenue Code applicable to regulated investment companies and to
distribute substantially all of its taxable income to its shareholders.
Therefore, no Federal income tax provision is required.
(c) Security transactions and investment income--Security transactions are
recorded on the dates the transactions are entered into (the trade dates).
Realized gains and losses on security transactions are determined on the
identified cost basis. Dividend income is recorded on the ex-dividend dates.
Interest income is recognized on the accrual basis. The Fund amortizes all
premiums and discounts on debt securities.
(d) Dividends and distributions to shareholders--Dividends from net investment
income are declared and paid monthly. Distributions from capital gains are
recorded on the ex-dividend dates.
(e) Expenses--Certain expenses have been allocated to the individual funds in
the Company on a pro rata basis based upon the respective aggregate net asset
value of each fund included in the Company.
(f) Securities lending--The Fund may lend securities to financial institutions
that provide cash or securities issued or guaranteed by the U.S. government as
collateral, which will be maintained at all times in an amount equal to at least
100% of the current market value of the loaned securities. Where the Fund
receives securities as collateral for the loaned securities, it collects a fee
from the borrower. The Fund typically receives the income on the loaned
securities but does not receive the income on the collateral. Where the Fund
receives cash collateral, it may invest such collateral and retain the amount
earned on such investment, net of any amount rebated to the borrower. Loans of
securities are terminable at any time and the borrower, after notice, is
required to return borrowed securities within five business days. The Fund may
pay reasonable finder's, lending agent, administrative and custodial fees in
connection with its loans. In the event that the borrower defaults on its
obligation to return borrowed securities because of insolvency or for any other
reason, the Fund could experience delays and costs in gaining access to the
collateral. The Fund also could suffer a loss where the value of the collateral
falls below the market value of the borrowed securities, in the event of
borrower default or in the event of losses on investments made with cash
collateral.
(g) Custodian bank--The Fund recorded an amount payable to the custodian bank
reflecting an overnight overdraft, which resulted from a failed trade that
settled the next day.
185
- --------------------------------------------------------------------------------
(h) Reclassification--Accounting principles generally accepted in the United
States of America require that certain components of net assets be adjusted to
reflect permanent differences between financial and tax reporting. Accordingly,
the current year's permanent book/tax difference of $1,043,048 have been
reclassified between accumulated net realized capital losses and undistributed
net investment income. This reclassification has no effect on net assets or net
asset value per share.
2. INVESTMENT ADVISORY AGREEMENT AND TRANSACTIONS WITH AFFILIATES:
The Company has entered into an Investment Advisory Agreement with Merrill Lynch
Investment Managers, L.P. ("MLIM"). The general partner of MLIM is Princeton
Services, Inc. ("PSI"), an indirect, wholly-owned subsidiary of ML & Co., which
is the limited partner.
MLIM is responsible for the management of the Company's funds and provides the
necessary personnel, facilities, equipment and certain other services necessary
to the operations of the Fund. For such services, the Fund pays a monthly fee
based upon the aggregate daily value of net assets of the Fund and the Company's
Core Bond Fund at the following annual rates: .55% of such average daily net
assets not exceeding $250 million; .50% of such average daily net assets in
excess of $250 million but not more than $500 million; .45% of such average
daily net assets in excess of $500 million but not more than $750 million; and
..40% of such average daily net assets in excess of $750 million. For the year
ended December 31, 2002, the aggregate average daily net assets of the Fund and
Core Bond Fund was approximately $993,794,029.
MLIM and Merrill Lynch Life Agency, Inc. ("MLLA") have entered into an
agreement that limits the operating expenses paid by the Fund, exclusive of any
distribution fees imposed on Class B Shares, to 1.25% of its average daily net
assets. Any such expenses in excess of 1.25% of average daily net assets will be
reimbursed to the Fund by MLIM which, in turn, will be reimbursed by MLLA.
For the year ended December 31, 2002, Merrill Lynch, Pierce, Fenner & Smith
Incorporated ("MLPF&S"), a subsidiary of ML & Co., earned $7,094 in commissions
on the execution of portfolio security transactions.
For the year ended December 31, 2002, Merrill Lynch Securities Pricing
Service, an affiliate of MLPF&S, earned $2,587 for providing security price
quotations to compute the Fund's net asset value.
Financial Data Services, Inc. ("FDS"), a wholly-owned subsidiary of ML & Co.,
is the Company's transfer agent.
FAM Distributors, Inc. ("FAMD") which is a wholly-owned subsidiary of Merrill
Lynch Group, Inc., is the Fund's distributor.
For the year ended December 31, 2002, the Fund reimbursed MLIM $10,423 for
certain accounting services.
Certain officers and/or directors of the Company are officers and/or directors
of MLIM, PSI, FDS, FAMD, and/or ML & Co.
3. INVESTMENTS:
Purchases and sales of investments, excluding short-term securities, for the
year ended December 31, 2002 were $152,073,120 and $205,553,648, respectively.
Net realized losses for the year ended December 31, 2002 and net unrealized
losses as of December 31, 2002 were as follows:
<Table>
<Caption>
- ------------------------------------------------------------------
Realized Unrealized
Losses Losses
- ------------------------------------------------------------------
Long-term investments............... $(71,478,903) $(102,627,474)
Short-term investments.............. (47) --
------------ -------------
Total............................... $(71,478,950) $(102,627,474)
============ =============
- ------------------------------------------------------------------
</Table>
At December 31, 2002, net unrealized depreciation for Federal income tax
purposes aggregated $102,772,700, of which $4,877,612 related to appreciated
securities and $107,650,312 related to depreciated securities. At December 31,
2002, the aggregate cost of investments for Federal income tax purposes was
$370,175,657.
4. CAPITAL SHARE TRANSACTIONS:
Transactions in capital shares were as follows:
<Table>
<Caption>
- -----------------------------------------------------------------
Class A Shares for the Year Ended Dollar
December 31, 2002 Shares Amount
- -----------------------------------------------------------------
Shares sold......................... 1,746,518 $ 12,305,847
Shares issued to shareholders in
reinvestment of dividends.......... 4,806,450 33,490,518
----------- ------------
Total issued........................ 6,552,968 45,796,365
Shares redeemed..................... (13,922,404) (93,041,029)
----------- ------------
Net decrease........................ (7,369,436) $(47,244,664)
=========== ============
- -----------------------------------------------------------------
</Table>
186
- --------------------------------------------------------------------------------
<Table>
<Caption>
- -----------------------------------------------------------------
Class A Shares for the Year Ended Dollar
December 31, 2001 Shares Amount
- -----------------------------------------------------------------
Shares sold.......................... 1,525,803 $ 12,188,414
Shares issued to shareholders in
reinvestment of dividends........... 5,484,317 43,789,624
---------- ------------
Total issued......................... 7,010,120 55,978,038
Shares redeemed...................... (8,769,554) (68,498,442)
---------- ------------
Net decrease......................... (1,759,434) $(12,520,404)
========== ============
- -----------------------------------------------------------------
</Table>
5. SHORT-TERM BORROWINGS:
The Fund, along with certain other funds managed by MLIM and its affiliates, is
a party to a credit agreement with Bank One, N.A. and certain other lenders.
Effective November 29, 2002 in conjunction with the renewal for one year at the
same terms, the total commitment was reduced from $1,000,000,000 to
$500,000,000. The Fund may borrow under the credit agreement to fund shareholder
redemptions and for other lawful purposes other than for leverage. The Fund may
borrow up to the maximum amount allowable under the Fund's current prospectus
and statement of additional information, subject to various other legal,
regulatory or contractual limits. The Fund pays a commitment fee of .09% per
annum based on the Fund's pro rata share of the unused portion of the credit
agreement. Amounts borrowed under the credit agreement bear interest at a rate
equal to, at each fund's election, the Federal Funds rate plus .50% or a base
rate as determined by Bank One, N.A. The Fund did not borrow under the credit
agreement during the year ended December 31, 2002.
6. DISTRIBUTIONS TO SHAREHOLDERS:
The Fund paid an ordinary income dividend of $.066068 on January 2, 2003 to
shareholders of record on December 31, 2002.
The tax character of distributions paid during the fiscal years ended December
31, 2002 and December 31, 2001 was as follows:
<Table>
<Caption>
- ------------------------------------------------------------------
12/31/2002 12/31/2001
- ------------------------------------------------------------------
Distributions paid from:
Ordinary income....................... $33,490,518 $43,789,624
----------- -----------
Total taxable distributions............ $33,490,518 $43,789,624
=========== ===========
- ------------------------------------------------------------------
</Table>
As of December 31, 2002, the components of accumulated losses on a tax basis
were as follows:
<Table>
- -----------------------------------------------------------------
Undistributed ordinary income--net................ $ 4,555,601
Undistributed long-term capital gains--net........ --
-------------
Total undistributed earnings--net................. 4,555,601
Capital loss carryforward......................... (134,790,499)*
Unrealized losses--net............................ (114,407,405)**
-------------
Total accumulated losses--net..................... $(244,642,303)
=============
- -----------------------------------------------------------------
</Table>
* On December 31, 2002, the Fund had a net capital loss carryforward of
$134,790,499, of which $3,029,074 expires in 2006, $9,712,654, expires in
2007, $23,145,308 expires in 2008, $35,064,410 expires in 2009, and
$63,839,053 expires in 2010. This amount will be available to offset like
amounts of any future taxable gains.
** The difference between book-basis and tax-basis net unrealized losses is
attributable primarily to the tax deferral of losses on wash sales, the
difference between book and tax amortization methods for premiums and
discounts on fixed income securities, differences between book and tax in the
accrual of income on securities in default and the deferral of post-October
capital losses for tax purposes.
187
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MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--HIGH CURRENT INCOME V.I. FUND
INDEPENDENT AUDITORS' REPORT
- --------------------------------------------------------------------------------
THE BOARD OF DIRECTORS AND SHAREHOLDERS, HIGH CURRENT INCOME V.I. FUND OF
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.:
We have audited the accompanying statement of assets and liabilities,
including the schedule of investments, of High Current Income V.I. Fund
(formerly, High Current Income Fund) of Merrill Lynch Variable Series Funds,
Inc. as of December 31, 2002, the related statements of operations for the year
then ended and changes in net assets for each of the years in the two-year
period then ended, and the financial highlights for each of the years presented.
These financial statements and the financial highlights are the responsibility
of the Fund's management. Our responsibility is to express an opinion on these
financial statements and the financial highlights based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements and the financial highlights are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. Our procedures included confirmation of
securities owned at December 31, 2002 by correspondence with the custodian and
brokers; where replies were not received from brokers, we performed other
auditing procedures. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such financial statements and financial highlights present
fairly, in all material respects, the financial position of High Current Income
V.I. Fund of Merrill Lynch Variable Series Funds, Inc. as of December 31, 2002,
the results of its operations, the changes in its net assets, and the financial
highlights for the respective stated periods in conformity with accounting
principles generally accepted in the United States of America.
Deloitte & Touche LLP
Princeton, New Jersey
February 14, 2003
188
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--INDEX 500 V.I. FUND
DECEMBER 31, 2002--ANNUAL REPORT
- --------------------------------------------------------------------------------
DEAR SHAREHOLDER:
FISCAL YEAR IN REVIEW
For the year ended December 31, 2002, Index 500 V.I. Fund's Class A Shares had
a total return of -22.40%, compared to the unmanaged benchmark Standard & Poor's
(S&P) 500 Index's total return of -22.10%.
The year 2002 represented the third consecutive year whereby the S&P 500 Index
posted a negative return with the Index falling a total of 589.43 points during
the past three years and a three-year annualized total return of -14.55%. In
2002, value outperformed growth with the S&P 500 Barra Value Index posting a
total return of -20.85% compared to -23.59% for the S&P 500 Barra Growth Index
for the same period.
All ten S&P 500 Index sectors posted negative returns in 2002, further
evidence that the decline during the year was across the whole market, although
some sectors negatively impacted performance more than others. The technology
sector entered a bear market in early 2000, and continued to contribute to the
decline in 2002, with information technology and telecommunications posting the
worst returns for the year ended December 31, 2002, at -37.57% and-35.89%,
respectively. Sectors most resilient to the market decline were consumer
staples, which had a return of -6.31%, and materials, which had a -7.71% return
for the fiscal year.
The first quarter of 2002 was quiet and uneventful relative to the rest of the
year. A turn for the worse occurred in the second quarter as extreme volatility
overtook the markets. The excessive volatility was mainly because of high-
profile companies failing one after another and increased concerns over
accounting standards. Although U.S. markets experienced three weeks of
consecutive gains in August, the markets lost ground for the next five
consecutive weeks and closed with negative returns for the third quarter. A
significant rebound was seen in the fourth quarter with the S&P 500 Index
closing up 64.54 points at 879.82, with a total return of +8.44% for the last
quarter of 2002. Technology rebounded with telecommunications and information
technology posting the best sector returns, of +36.43% and +22.23%,
respectively. Better-than-estimated corporate earnings reports and the belief
that corporate earnings have "bottomed" spurred an improvement in market
conditions. The impressive fourth quarter rally can also be partially attributed
to the promise of fiscal stimulus from the Federal Reserve Board cutting
interest rates late in 2002.
After cutting interest rates 11 consecutive times in 2001, the Federal Reserve
Board left interest rates unchanged at 1.75% until the fourth quarter of 2002.
At the November 6, 2002 Federal Open Market Committee meeting, the Federal
Reserve Board decided to lower its target rate by an unexpected 50 basis points
(.50%) to 1.25%. Economic data indicated that greater uncertainty, in part
attributable to heightened geopolitical risks, was inhibiting spending,
production and employment. At its November 7, 2002 meeting, the Governing
Council of the European Central Bank (ECB) declined to match the half-point rate
reduction by the U.S. Federal Reserve Board and left its rate unchanged at
3.25%. However, at its December 5, 2002 meeting, the ECB cut rates by 50 basis
points to 2.75%, reflecting the persistently high degree of uncertainty. Over
time, the current accommodative stance of monetary policy, coupled with still
robust underlying growth in productivity, should be sufficient to foster an
improving business climate. However, considerable uncertainty persists about the
extent and timing of the expected pickup in production and employment.
After the worst returns of the year in September with the S&P 500 Index at
- -10.87% for the month, the fourth quarter of 2002 brought the positive returns
that investors were hoping for, but they did not come without volatility.
October and November were significantly positive months, but December again gave
way to negative returns. Looking ahead to 2003, investor confidence remains
shaken with the possibility of military action in Iraq, unexpectedly high
unemployment and disappointing holiday sales. Consumer confidence fell
unexpectedly fell in December for the sixth time in seven months as unemployment
threatens to undermine spending and U.S. economic growth early next year.
PORTFOLIO MATTERS
The Fund closed on December 31, 2002 with net assets of $319.7 million. The
principal investments of the Fund are in S&P 500 Index stocks with weightings of
individual stocks in proportion to that of the Index. Incremental cash flows are
typically invested through the use of S&P 500 Index futures contracts, which
serve as a means to invest cash balances. At December 31, 2002, the Fund's
equity portfolio was valued at $314 million in equity, which represented
approximately 98% of the Fund's net assets. In addition, the Fund held a long
189
- --------------------------------------------------------------------------------
position in S&P 500 March 2003 futures contracts. Through its holding of
equities and futures contracts, it is the Fund's goal to be 100% invested in the
S&P 500 Index at all times.
Twenty-four changes in the composition of the S&P 500 Index were made in 2002.
In response to these changes, we added the following equities to the Trust's
portfolio during the year: Plum Creek Timber Company Inc., MeadWestvaco
Corporation, ACE Limited, Rational Software Corporation, Marshall & Ilsley
Corporation, First Tennessee National Corporation, American Standard Companies,
Inc., BJ Services Company, Apollo Group, Inc., Simon Property Group, Inc., North
Fork Bancorporation, SunGard Data Systems Inc., Electronic Arts Inc., The
Principal Financial Group, Inc., eBay Inc., Prudential Financial, Inc., Goldman
Sachs Group, United Parcel Service, Inc., Anthem Inc., Monsanto Co., Travelers
Property Casualty Corp., RJ Reynolds Tobacco Holdings, Inc., Comcast Corporation
and Quest Diagnostics Incorporated.
IN CONCLUSION:
We appreciate your investment in Index 500 V.I. Fund of Merrill Lynch Variable
Series Funds, Inc., and we look forward to assisting you with your investment
needs in the months and years ahead.
Sincerely,
/s/ Terry K. Glenn
Terry K. Glenn
President and Director
January 17, 2003
190
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--INDEX 500 V.I. FUND
TOTAL RETURN BASED ON A $10,000 INVESTMENT--CLASS A SHARES
- --------------------------------------------------------------------------------
<Table>
<Caption>
INDEX 500 V.I. FUND+--CLASS A
SHARES* STANDARD & POOR'S 500 INDEX++
----------------------------- -----------------------------
12/13/96** 10000.00 10000.00
12/96 10168.00 10000.00
12/97 13504.00 13336.00
12/98 17323.00 17147.00
12/99 20874.00 20755.00
12/00 18918.00 18865.00
12/01 16595.00 16623.00
12/02 12878.00 12949.00
</Table>
* Assuming transaction costs and other operating expenses, including advisory
fees. Does not include insurance-related fees and expenses.
** Commencement of operations.
+ The Fund is required to invest at least 80% of its net assets in the common
stocks in the S&P 500 Index and in derivative instruments linked to the S&P
500.
++ This unmanaged Index covers 500 industrial, utility, transportation and
financial companies of the U.S. markets (mostly NYSE issues), representing
about 75% of NYSE market capitalization and 30% of NYSE issues. The starting
date for the Index in the graph is from 12/31/96.
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--INDEX 500 V.I. FUND
AVERAGE ANNUAL TOTAL RETURN--CLASS A SHARES*
- --------------------------------------------------------------------------------
PERIOD COVERED % RETURN
- --------------------------------------------------------------------------------
One Year Ended 12/31/02 -22.40%
- --------------------------------------------------------------------------------
Five Years Ended 12/31/02 - 0.95
- --------------------------------------------------------------------------------
Inception (12/13/96) to 12/31/02 + 4.27
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--INDEX 500 V.I. FUND
RECENT PERFORMANCE RESULTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
6-MONTH 12-MONTH
AS OF DECEMBER 31, 2002 TOTAL RETURN TOTAL RETURN
- -----------------------------------------------------------------------------------------
Class A Shares* -10.40% -22.40%
- -----------------------------------------------------------------------------------------
Standard & Poor's 500 Index** -10.30 -22.10
- -----------------------------------------------------------------------------------------
</Table>
* Total investment returns are based on changes in net asset values for the
periods shown, and assume reinvestment of all dividends and capital gains
distributions at net asset value on the ex-dividend date. Insurance-related fees
and expenses are not reflected in these returns.
** This unmanaged Index covers 500 industrial, utility, transportation and
financial companies of the U.S. markets (mostly NYSE issues), representing about
75% of NYSE market capitalization and 30% of NYSE issues.
Past results shown should not be considered a representation of future
performance.
191
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--INDEX 500 V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES
COMMON STOCKS HELD VALUE
- -------------------------------------------------------
3M Co. ...................... 15,273 $ 1,883,161
ACE Limited.................. 9,800 287,532
+ADC Telecommunications,
Inc. ...................... 34,249 71,580
+The AES Corporation......... 21,822 65,902
AFLAC Incorporated........... 19,842 597,641
ALLTEL Corporation........... 11,387 580,737
+AMR Corporation............. 6,735 44,451
+AOL Time Warner Inc. ....... 174,648 2,287,889
AT&T Corp. .................. 29,979 782,752
+AT&T Wireless Services
Inc. ...................... 106,759 603,188
Abbott Laboratories.......... 60,420 2,416,800
Adobe Systems Incorporated... 9,080 226,183
Adolph Coors Company (Class
B)......................... 741 45,386
+Advanced Micro Devices,
Inc. ...................... 12,172 78,631
Aetna Inc. (New Shares)...... 5,343 219,704
+Agilent Technologies,
Inc. ...................... 19,594 351,908
Air Products and Chemicals,
Inc. ...................... 9,089 388,555
Alberto-Culver Company (Class
B)......................... 2,521 127,058
Albertson's, Inc. ........... 13,347 297,104
Alcoa Inc. .................. 33,824 770,511
Allegheny Energy, Inc. ...... 3,922 29,650
Allegheny Technologies
Incorporated............... 3,561 22,185
Allergan Inc. ............... 4,827 278,132
+Allied Waste Industries,
Inc. ...................... 8,694 86,940
The Allstate Corporation..... 26,945 996,696
+Altera Corporation.......... 13,847 170,872
Ambac Financial Group,
Inc. ...................... 3,832 215,512
Amerada Hess Corporation..... 3,105 170,930
Ameren Corporation........... 5,997 249,295
American Electric Power
Company, Inc. ............. 12,018 328,452
American Express Company..... 50,478 1,784,397
+American Greetings
Corporation (Class A)...... 2,113 33,385
American International Group,
Inc. ...................... 101,507 5,872,180
+American Power Conversion
Corporation................ 6,276 95,081
+American Standard Companies,
Inc. ...................... 2,900 206,306
AmerisourceBergen
Corporation................ 3,935 213,710
+Amgen Inc. ................. 50,323 2,432,614
AmSouth Bancorporation....... 16,230 311,616
Anadarko Petroleum
Corporation................ 9,768 467,887
+Analog Devices, Inc. ....... 14,973 357,405
+Andrew Corporation.......... 3,625 37,265
Anheuser-Busch Companies,
Inc. ...................... 32,931 1,593,860
+Anthem, Inc. ............... 5,318 334,502
Aon Corporation.............. 11,475 216,763
Apache Corporation........... 5,222 297,602
+Apollo Group, Inc. (Class
A)......................... 6,400 281,600
+Apple Computer, Inc. ....... 13,395 191,950
Applera Corporation-Applied
Biosystems Group........... 9,252 162,280
+Applied Materials, Inc. .... 65,462 852,970
</Table>
<Table>
<Caption>
SHARES
COMMON STOCKS HELD VALUE
- -------------------------------------------------------
+Applied Micro Circuits
Corporation................ 9,421 $ 34,763
Archer-Daniels-Midland
Company.................... 27,682 343,257
Ashland Inc. ................ 3,091 88,186
Autodesk, Inc. .............. 3,126 44,702
Automatic Data Processing,
Inc. ...................... 22,255 873,509
+AutoZone, Inc. ............. 3,408 240,775
+Avaya Inc. ................. 12,413 30,412
Avery Dennison Corporation... 4,867 297,276
Avon Products, Inc. ......... 9,897 533,151
BB&T Corporation............. 19,496 721,157
The B.F. Goodrich Company.... 4,463 81,762
+BJ Services Company......... 5,400 174,474
+BMC Software, Inc. ......... 10,701 183,094
Baker Hughes Incorporated.... 14,108 454,137
Ball Corporation............. 2,418 123,777
Bank of America Corporation.. 57,739 4,016,902
The Bank of New York Company,
Inc. ...................... 27,432 657,271
Bank One Corporation......... 45,565 1,665,401
Bausch & Lomb Incorporated... 1,373 49,428
Baxter International Inc. ... 22,058 617,624
The Bear Stearns Companies
Inc. ...................... 3,153 187,288
Becton, Dickinson and
Company.................... 10,888 334,153
+Bed Bath & Beyond Inc. ..... 11,148 384,940
BellSouth Corporation........ 72,425 1,873,635
Bemis Company, Inc. ......... 2,378 118,020
+Best Buy Co., Inc. ......... 12,212 294,920
+Big Lots, Inc. ............. 2,745 36,316
+Biogen, Inc. ............... 5,423 217,245
Biomet, Inc. ................ 9,725 278,719
The Black & Decker
Corporation................ 3,285 140,894
The Boeing Company........... 33,028 1,089,594
Boise Cascade Corporation.... 2,579 65,042
+Boston Scientific
Corporation................ 15,691 667,181
Bristol-Myers Squibb
Company.................... 74,963 1,735,393
+Broadcom Corporation (Class
A)......................... 11,398 171,654
Brown-Forman Corporation
(Class B).................. 3,009 196,668
Brunswick Corporation........ 3,876 76,977
Burlington Northern Santa Fe
Corp. ..................... 16,066 417,877
Burlington Resources Inc. ... 8,768 373,955
+CIENA Corporation........... 11,903 61,181
CIGNA Corporation............ 5,163 212,303
CMS Energy Corporation....... 3,554 33,550
C.R. Bard, Inc. ............. 2,227 129,166
CSX Corporation.............. 7,254 205,361
CVS Corporation.............. 16,257 405,937
+Calpine Corporation......... 10,787 35,166
Campbell Soup Company........ 16,193 380,050
Capital One Financial
Corporation................ 7,932 235,739
Cardinal Health, Inc. ....... 16,637 984,744
Carnival Corporation......... 23,173 578,166
Caterpillar Inc. ............ 12,742 582,564
+Cendant Corporation......... 42,528 445,693
</Table>
192
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--INDEX 500 V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES
COMMON STOCKS HELD VALUE
- -------------------------------------------------------
CenterPoint Energy, Inc. .... 12,683 $ 107,806
Centex Corporation........... 1,986 99,697
CenturyTel, Inc. ............ 6,202 182,215
The Charles Schwab
Corporation................ 53,765 583,350
Charter One Financial,
Inc. ...................... 9,986 286,898
ChevronTexaco Corporation.... 41,311 2,746,355
+Chiron Corporation.......... 7,021 263,990
The Chubb Corporation........ 6,298 328,756
Cincinnati Financial
Corporation................ 7,036 264,202
Cinergy Corp. ............... 6,973 235,130
Cintas Corporation........... 6,236 285,297
Circuit City
Stores -- Circuit City
Group...................... 5,665 42,034
+Cisco Systems, Inc. ........ 278,515 3,648,547
Citigroup Inc. .............. 199,151 7,008,124
+Citizens Communications
Company.................... 12,503 131,907
+Citrix Systems, Inc. ....... 4,329 53,333
+Clear Channel
Communications, Inc. ...... 24,645 919,012
The Clorox Company........... 8,768 361,680
The Coca-Cola Company........ 95,996 4,206,545
Coca-Cola Enterprises
Inc. ...................... 18,937 411,312
Colgate-Palmolive Company.... 20,085 1,053,057
+Comcast Corporation (Class
A)......................... 59,891 1,411,631
+Comcast Corporation (Special
Class A)................... 29,611 668,912
Comerica Incorporated........ 6,326 273,536
Computer Associates
International, Inc. ....... 23,010 310,635
+Computer Sciences
Corporation................ 7,108 244,871
+Compuware Corporation....... 16,118 77,366
+Comverse Technology,
Inc. ...................... 5,776 57,876
ConAgra, Inc. ............... 19,632 490,996
+Concord EFS, Inc. .......... 19,108 300,760
ConocoPhillips............... 25,576 1,237,623
Consolidated Edison, Inc. ... 7,358 315,070
Constellation Energy Group... 7,152 198,969
+Convergys Corporation....... 7,534 114,140
Cooper Industries, Ltd.
(Class A).................. 4,615 168,217
Cooper Tire & Rubber
Company.................... 3,206 49,180
+Corning Incorporated........ 40,758 134,909
+Costco Wholesale
Corporation................ 17,105 479,966
Countrywide Credit
Industries, Inc. .......... 5,190 268,064
Crane Co. ................... 2,627 52,356
Cummins Engine Company,
Inc. ...................... 895 25,176
DTE Energy Company........... 5,723 265,547
Dana Corporation............. 6,498 76,416
Danaher Corporation.......... 6,033 396,368
Darden Restaurants, Inc. .... 7,261 148,487
Deere & Company.............. 8,688 398,345
+Del Monte Foods Company..... 2,038 15,695
+Dell Computer Corporation... 99,976 2,673,358
Delphi Automotive Systems
Corporation................ 24,585 197,909
</Table>
<Table>
<Caption>
SHARES
COMMON STOCKS HELD VALUE
- -------------------------------------------------------
Delta Air Lines, Inc. ....... 5,399 $ 65,328
Deluxe Corporation........... 3,097 130,384
Devon Energy Corporation..... 6,929 318,041
Dillard's, Inc. (Class A).... 3,726 59,094
Dollar General Corporation... 14,488 173,132
Dominion Resources, Inc. .... 11,761 645,679
Dover Corporation............ 8,934 260,515
The Dow Chemical Company..... 34,436 1,022,749
Dow Jones & Company, Inc. ... 3,785 163,626
Duke Energy Corporation...... 35,426 692,224
Dynegy Inc. (Class A)........ 12,846 15,158
E.I. du Pont de Nemours and
Company.................... 38,396 1,627,990
+EMC Corporation............. 88,604 544,029
EOG Resources, Inc. ......... 3,816 152,335
Eastman Chemical Company..... 3,358 123,474
Eastman Kodak Company........ 10,711 375,313
Eaton Corporation............ 2,989 233,471
+eBay Inc. .................. 12,200 827,404
Ecolab Inc. ................. 5,638 279,081
+Edison International........ 14,096 167,038
El Paso Corporation.......... 21,312 148,332
+Electronic Arts Inc. ....... 5,200 258,804
Electronic Data Systems
Corporation................ 18,238 336,126
Eli Lilly and Company........ 43,448 2,758,948
Emerson Electric Co. ........ 15,475 786,904
Engelhard Corporation........ 5,730 128,066
Entergy Corporation.......... 8,472 386,238
Equifax Inc. ................ 6,279 145,296
Equity Office Properties
Trust...................... 16,080 401,678
Equity Residential Properties
Trust...................... 11,200 275,296
Exelon Corporation........... 12,739 672,237
Exxon Mobil Corporation++.... 260,546 9,103,477
FPL Group, Inc. ............. 6,407 385,253
Family Dollar Stores,
Inc. ...................... 7,527 234,918
Fannie Mae................... 38,934 2,504,624
+Federated Department Stores,
Inc. ...................... 7,230 207,935
FedEx Corp. ................. 11,155 604,824
Fifth Third Bancorp.......... 22,219 1,300,922
First Data Corporation....... 29,034 1,028,094
First Tennessee National
Corporation................ 4,100 147,354
FirstEnergy Corp. ........... 12,888 424,917
+Fiserv, Inc. ............... 6,955 236,122
FleetBoston Financial
Corporation................ 39,560 961,308
Fluor Corporation............ 3,474 97,272
Ford Motor Company........... 70,671 657,240
+Forest Laboratories,
Inc. ...................... 6,809 668,780
Fortune Brands, Inc. ........ 5,499 255,758
Franklin Resources, Inc. .... 11,122 379,038
Freddie Mac.................. 27,350 1,615,018
+Freeport-McMoRan Copper &
Gold, Inc. (Class B)....... 6,008 100,814
Gannett Co., Inc. ........... 9,947 714,195
The Gap, Inc. ............... 34,263 531,762
+Gateway Inc. ............... 14,179 44,522
General Dynamics
Corporation................ 7,564 600,355
General Electric Company++... 386,465 9,410,423
</Table>
193
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--INDEX 500 V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES
COMMON STOCKS HELD VALUE
- -------------------------------------------------------
General Mills, Inc. ......... 13,508 $ 634,201
General Motors Corporation... 21,483 791,863
Genuine Parts Company........ 7,538 232,170
+Genzyme Corporation......... 7,800 230,646
Georgia-Pacific Group........ 9,904 160,049
The Gillette Company......... 39,558 1,200,981
Golden West Financial
Corporation................ 6,099 437,969
The Goldman Sachs Group,
Inc. ...................... 18,100 1,232,610
The Goodyear Tire & Rubber
Company.................... 5,034 34,282
Great Lakes Chemical
Corporation................ 2,211 52,799
+Guidant Corporation......... 11,691 360,667
H & R Block, Inc. ........... 6,581 264,556
HCA Inc. .................... 19,555 811,533
+HEALTHSOUTH Corporation..... 17,076 71,719
H.J. Heinz Company........... 12,849 422,347
Halliburton Company.......... 16,702 312,494
Harley-Davidson, Inc. ....... 11,252 519,842
+Harrah's Entertainment,
Inc. ...................... 3,955 156,618
The Hartford Financial
Services Group, Inc. ...... 10,377 471,427
Hasbro, Inc. ................ 7,545 87,145
Health Management Associates,
Inc. (Class A)............. 10,100 180,790
+Hercules Incorporated....... 4,776 42,029
Hershey Foods Corporation.... 5,574 375,911
Hewlett-Packard Company...... 118,643 2,059,642
Hilton Hotels Corporation.... 16,163 205,432
The Home Depot, Inc. ........ 89,559 2,145,834
Honeywell International
Inc. ...................... 30,363 728,712
Household International,
Inc. ...................... 17,325 481,808
+Humana Inc. ................ 7,457 74,570
Huntington Bancshares
Incorporated............... 11,005 205,904
IMS Health Incorporated...... 12,948 207,168
ITT Industries, Inc. ........ 3,578 217,149
Illinois Tool Works Inc. .... 11,466 743,685
Ingersoll-Rand Company (Class
A)......................... 6,279 270,374
Intel Corporation............ 257,088 4,002,860
International Business
Machines Corporation....... 65,634 5,086,635
International Flavors &
Fragrances Inc. ........... 4,199 147,385
+International Game
Technology................. 2,977 226,014
International Paper Company.. 18,124 633,796
The Interpublic Group of
Companies, Inc. ........... 16,433 231,377
+Intuit Inc. ................ 8,193 384,416
J.C. Penney Company, Inc. ... 10,035 230,905
+JDS Uniphase Corporation.... 50,977 125,913
J.P. Morgan Chase & Co. ..... 78,191 1,876,584
+Jabil Circuit, Inc. ........ 8,415 150,797
Jefferson -- Pilot
Corporation................ 6,666 254,041
John Hancock Financial
Services, Inc. ............ 12,599 351,512
Johnson & Johnson............ 114,753 6,163,384
Johnson Controls, Inc. ...... 3,823 306,490
+Jones Apparel Group,
Inc. ...................... 5,300 187,832
KB HOME...................... 1,489 63,804
</Table>
<Table>
<Caption>
SHARES
COMMON STOCKS HELD VALUE
- -------------------------------------------------------
+KLA-Tencor Corporation...... 7,200 $ 254,664
+Kadant Inc. ................ 1 15
Kellogg Company.............. 14,989 513,673
Kerr-McGee Corporation....... 4,421 195,850
KeyCorp...................... 16,203 407,343
KeySpan Corporation.......... 6,017 212,039
Kimberly-Clark Corporation... 19,021 902,927
Kinder Morgan, Inc. ......... 5,048 213,379
+King Pharmaceuticals,
Inc. ...................... 10,716 184,208
Knight Ridder, Inc. ......... 3,235 204,614
+Kohl's Corporation.......... 12,725 711,964
+The Kroger Co. ............. 29,826 460,812
+LSI Logic Corporation....... 15,796 91,143
Leggett & Platt,
Incorporated............... 8,655 194,218
Lehman Brothers Holdings,
Inc. ...................... 8,601 458,347
+Lexmark International Group,
Inc. (Class A)............. 4,807 290,824
The Limited, Inc. ........... 21,765 303,186
Lincoln National
Corporation................ 7,831 247,303
Linear Technology
Corporation................ 13,064 336,006
Liz Claiborne, Inc. ......... 4,508 133,662
Lockheed Martin Corporation.. 17,133 989,431
Loews Corporation............ 6,976 310,153
+Louisiana-Pacific
Corporation................ 4,587 36,971
Lowe's Companies, Inc. ...... 29,911 1,121,663
+Lucent Technologies Inc. ... 126,842 159,821
MBIA, Inc. .................. 4,588 201,230
MBNA Corporation............. 48,539 923,212
MGIC Investment Corporation.. 3,567 147,317
+Manor Care, Inc. ........... 4,549 84,657
Marathon Oil Corporation..... 12,123 258,099
Marriott International, Inc.
(Class A).................. 10,683 351,150
Marsh & McLennan Companies,
Inc. ...................... 20,060 926,973
Marshall & Ilsley
Corporation................ 9,200 251,896
Masco Corporation............ 20,151 424,179
Mattel, Inc. ................ 18,280 350,062
Maxim Integrated Products,
Inc. ...................... 13,187 435,698
The May Department Stores
Company.................... 12,347 283,734
Maytag Corporation........... 3,336 95,076
+McDermott International,
Inc. ...................... 2,676 11,721
McDonald's Corporation....... 46,972 755,310
The McGraw-Hill Companies,
Inc. ...................... 7,152 432,267
McKesson HBOC, Inc. ......... 12,007 324,549
MeadWestvaco Corporation..... 8,642 213,544
+MedImmune, Inc. ............ 8,858 240,672
Medtronic, Inc. ............. 47,662 2,173,387
Mellon Financial
Corporation................ 15,911 415,436
Merck & Co., Inc. ........... 86,679 4,906,898
+Mercury Interactive
Corp. ..................... 2,766 82,012
Meredith Corporation......... 2,232 91,758
Merrill Lynch & Co., Inc.*... 34,179 1,297,093
MetLife, Inc. ............... 25,553 690,953
+Micron Technology, Inc. .... 24,326 236,935
+Microsoft Corporation++..... 206,643 10,683,443
Millipore Corporation........ 2,031 69,054
+Mirant Corporation.......... 15,770 29,805
</Table>
194
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--INDEX 500 V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES
COMMON STOCKS HELD VALUE
- -------------------------------------------------------
Molex Incorporated........... 7,063 $ 162,732
Monsanto Company............. 10,667 205,340
Moody's Corporation.......... 6,502 268,468
Morgan Stanley............... 41,863 1,671,171
Motorola, Inc. .............. 90,636 784,001
+NCR Corporation............. 4,270 101,370
NICOR, Inc. ................. 2,029 69,047
+NVIDIA Corporation.......... 5,500 63,305
+Nabors Industries, Ltd. .... 4,746 167,391
National City Corporation.... 25,125 686,415
+National Semiconductor
Corporation................ 7,454 111,885
+Navistar International
Corporation................ 2,617 63,619
+Network Appliance, Inc. .... 11,665 116,650
The New York Times Company
(Class A).................. 6,077 277,901
Newell Rubbermaid Inc. ...... 10,185 308,911
Newmont Mining Corporation... 14,803 429,731
+Nextel Communications, Inc.
(Class A).................. 36,224 418,387
Nike, Inc. (Class B)......... 9,917 441,009
NiSource Inc. ............... 9,011 180,220
+Noble Corporation........... 4,387 154,203
Nordstrom, Inc. ............. 5,884 111,619
Norfolk Southern
Corporation................ 16,886 337,551
North Fork Bancorporation.... 5,400 182,196
Northern Trust Corporation... 8,101 283,940
Northrop Grumman
Corporation................ 6,120 593,640
+Novell, Inc. ............... 15,782 52,712
+Novellus Systems, Inc. ..... 5,242 147,195
Nucor Corporation............ 2,735 112,956
Occidental Petroleum
Corporation................ 13,279 377,788
+Office Depot, Inc. ......... 13,040 192,470
Omnicom Group Inc. .......... 7,217 466,218
+Oracle Corporation.......... 207,485 2,240,838
PACCAR Inc. ................. 3,964 182,859
+PG&E Corporation............ 16,981 236,036
+PMC -- Sierra, Inc. ........ 4,833 26,871
PNC Bank Corp. .............. 10,164 425,872
PPG Industries, Inc. ........ 6,243 313,086
PPL Corporation.............. 6,379 221,224
+Pactiv Corporation.......... 6,967 152,299
Pall Corporation............. 5,410 90,239
+Parametric Technology
Corporation................ 11,577 29,174
Parker-Hannifin Corporation.. 3,835 176,909
Paychex, Inc. ............... 14,260 397,854
Peoples Energy Corporation... 985 38,070
+PeopleSoft, Inc. ........... 11,482 210,121
The Pepsi Bottling Group,
Inc. ...................... 11,104 285,373
PepsiCo, Inc. ............... 66,439 2,805,055
PerkinElmer, Inc. ........... 4,409 36,374
Pfizer Inc. ................. 239,028 7,307,086
Pharmacia Corporation........ 50,009 2,090,376
+Phelps Dodge Corporation.... 2,944 93,178
Philip Morris Companies
Inc.++..................... 79,589 3,225,742
Pinnacle West Capital
Corporation................ 3,724 126,951
</Table>
<Table>
<Caption>
SHARES
COMMON STOCKS HELD VALUE
- -------------------------------------------------------
Pitney Bowes Inc. ........... 10,315 $ 336,888
Plum Creek Timber Company
Inc. ...................... 8,000 188,800
+Power-One, Inc. ............ 3,461 19,624
Praxair, Inc. ............... 5,877 339,514
The Principal Financial
Group, Inc. ............... 13,000 391,690
The Procter & Gamble
Company.................... 50,153 4,310,149
Progress Energy, Inc. ....... 9,529 413,082
The Progressive Corporation.. 9,194 456,298
+Providian Financial
Corporation................ 12,579 81,638
Prudential Financial,
Inc. ...................... 20,800 660,192
Public Service Enterprise
Group Incorporated......... 9,114 292,559
Pulte Corporation............ 1,821 87,171
+QLogic Corporation.......... 3,343 115,367
+QUALCOMM Incorporated....... 30,784 1,120,230
+Quest Diagnostics
Incorporated............... 3,800 216,220
+Quintiles Transnational
Corp. ..................... 5,108 61,807
+Qwest Communications
International Inc. ........ 62,996 314,980
R.J. Reynolds Tobacco
Holdings, Inc. ............ 3,000 126,330
R.R. Donnelley & Sons
Company.................... 5,144 111,985
RadioShack Corporation....... 7,283 136,483
+Rational Software
Corporation................ 5,700 59,223
Raytheon Company............. 16,446 505,715
+Reebok International
Ltd. ...................... 1,524 44,806
Regions Financial
Corporation................ 8,770 292,567
+Robert Half International
Inc. ...................... 7,686 123,821
Rockwell Collins............. 7,983 185,685
Rockwell International
Corporation................ 7,983 165,328
Rohm and Haas Company........ 9,588 311,418
Rowan Companies, Inc. ....... 3,935 89,325
Ryder System, Inc. .......... 2,684 60,229
SAFECO Corporation........... 4,044 140,205
SBC Communications Inc. ..... 128,284 3,477,779
SLM Corporation.............. 5,941 617,032
SUPERVALU Inc. .............. 5,792 95,626
SYSCO Corporation............ 24,571 731,970
+Sabre Holdings
Corporation................ 5,823 105,455
+Safeway Inc. ............... 15,547 363,178
+Sanmina Corporation......... 20,209 90,738
Sara Lee Corporation......... 31,817 716,201
Schering-Plough Corporation.. 56,511 1,254,544
Schlumberger Limited......... 22,045 927,874
Scientific-Atlanta, Inc. .... 5,680 67,365
+Sealed Air Corporation...... 2,660 99,218
Sears, Roebuck & Co. ........ 11,795 282,490
Sempra Energy................ 9,017 213,252
The Sherwin-Williams
Company.................... 6,866 193,965
+Siebel Systems, Inc. ....... 20,257 151,522
Sigma-Aldrich Corporation.... 2,117 103,098
Simon Property Group,
Inc. ...................... 6,300 214,641
Snap-On Incorporated......... 2,541 71,428
+Solectron Corporation....... 35,435 125,794
The Southern Company......... 28,118 798,270
</Table>
195
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--INDEX 500 V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES
COMMON STOCKS HELD VALUE
- -------------------------------------------------------
SouthTrust Corporation....... 14,938 $ 371,209
Southwest Airlines Co. ...... 31,675 440,283
+Sprint Corp. (PCS Group).... 43,259 189,474
Sprint Corporation........... 34,634 501,500
+St. Jude Medical, Inc. ..... 6,294 249,998
The St. Paul Companies,
Inc. ...................... 7,597 258,678
The Stanley Works............ 3,741 129,364
+Staples, Inc. .............. 17,495 320,159
+Starbucks Corporation....... 14,622 297,996
Starwood Hotels & Resorts
Worldwide, Inc. ........... 7,309 173,516
State Street Corporation..... 11,893 463,827
+Stilwell Financial, Inc. ... 9,611 125,616
Stryker Corporation.......... 8,348 560,318
+Sun Microsystems, Inc. ..... 113,212 352,089
+Sungard Data Systems
Inc. ...................... 12,000 282,720
Sunoco, Inc. ................ 3,578 118,718
SunTrust Banks, Inc. ........ 10,696 608,816
Symbol Technologies, Inc. ... 11,628 95,582
Synovus Financial Corp. ..... 12,710 246,574
T. Rowe Price Group Inc. .... 5,393 147,121
TECO Energy, Inc. ........... 4,415 68,300
The TJX Companies, Inc. ..... 20,356 397,349
+TMP Worldwide Inc. ......... 3,471 39,257
TXU Corp. ................... 11,258 210,299
Target Corporation........... 34,834 1,045,020
+Tektronix, Inc. ............ 4,131 75,143
+Tellabs, Inc. .............. 14,333 104,201
Temple-Inland, Inc. ......... 1,554 69,635
+Tenet Healthcare
Corporation................ 18,612 305,237
+Teradyne, Inc. ............. 7,638 99,370
Texas Instruments
Incorporated............... 68,971 1,035,255
Textron, Inc. ............... 6,180 265,678
+Thermo Electron
Corporation................ 7,936 159,672
+Thomas & Betts Corporation.. 2,565 43,349
Tiffany & Co. ............... 6,447 154,148
Torchmark Corporation........ 5,497 200,805
+Toys 'R' Us, Inc. .......... 8,668 86,680
Transocean Inc. ............. 13,911 322,735
+Travelers Property Casualty
Corp. (Class B)............ 41,748 611,608
Tribune Company.............. 12,577 571,750
Tupperware Corporation....... 2,512 37,881
Tyco International Ltd. ..... 78,463 1,340,148
U.S. Bancorp................. 75,004 1,591,585
UST Inc. .................... 5,399 180,489
Union Pacific Corporation.... 9,307 557,210
Union Planters Corporation... 9,012 253,598
+Unisys Corporation.......... 13,869 137,303
United Parcel Service, Inc.
(Class B).................. 43,200 2,725,056
United States Steel
Corporation................ 3,889 51,024
United Technologies
Corporation................ 18,082 1,119,999
UnitedHealth Group
Incorporated............... 12,099 1,010,267
</Table>
<Table>
<Caption>
SHARES
COMMON STOCKS HELD VALUE
- -------------------------------------------------------
+Univision Communications
Inc. (Class A)............. 9,098 $ 222,901
Unocal Corporation........... 10,710 327,512
UnumProvident Corporation.... 10,589 185,731
+VERITAS Software
Corporation................ 15,715 245,468
V. F. Corporation............ 4,908 176,933
Verizon Communications....... 107,018 4,146,948
+Viacom, Inc. (Class B)...... 68,907 2,808,649
Visteon Corporation.......... 5,774 40,187
Vulcan Materials Company..... 4,450 166,875
W. W. Grainger, Inc. ........ 4,121 212,438
Wachovia Corporation......... 52,522 1,913,902
Walgreen Co. ................ 39,344 1,148,451
Wal-Mart Stores, Inc. ....... 171,116 8,643,069
The Walt Disney Company...... 78,282 1,276,779
Washington Mutual, Inc. ..... 37,115 1,281,581
Waste Management, Inc. ...... 24,310 557,185
+Waters Corporation.......... 6,400 139,392
+Watson Pharmaceuticals,
Inc. ...................... 4,640 131,173
+WellPoint Health Networks
Inc. ...................... 5,384 383,125
Wells Fargo & Co. ........... 65,303 3,060,752
Wendy's International,
Inc. ...................... 3,919 106,087
Weyerhaeuser Company......... 8,129 400,028
Whirlpool Corporation........ 2,834 147,991
The Williams Companies,
Inc. ...................... 18,007 48,619
Winn-Dixie Stores, Inc. ..... 6,123 93,559
Wm. Wrigley Jr. Company...... 8,916 489,310
Worthington Industries,
Inc. ...................... 3,772 57,485
Wyeth........................ 51,251 1,916,787
XL Capital Ltd. (Class A).... 5,255 405,949
Xcel Energy, Inc. ........... 13,884 152,724
+Xerox Corporation........... 30,423 244,905
+Xilinx, Inc. ............... 12,413 255,708
+YUM! Brands, Inc. .......... 12,442 301,345
+Yahoo! Inc. ................ 24,842 406,167
+Zimmer Holdings, Inc. ...... 7,216 299,608
Zions Bancorporation......... 4,124 162,275
- -------------------------------------------------------
TOTAL COMMON STOCKS
(COST--$327,051,786)--98.4% 314,505,010
- -------------------------------------------------------
</Table>
<Table>
PARTNERSHIP
SHORT-TERM OBLIGATIONS INTEREST
- ------------------------------------------------------
Merrill Lynch Liquidity
Series, LLC Cash Sweep
Series II*............... $ 4,615,056 4,615,056
- ------------------------------------------------------
TOTAL SHORT-TERM OBLIGATIONS
(COST--$4,615,056)--1.4% 4,615,056
- ------------------------------------------------------
TOTAL INVESTMENTS
(COST--$331,666,842)--99.8%.. 319,120,066
VARIATION MARGIN ON
FINANCIAL FUTURES
CONTRACTS**--0.0%.......... 8,400
OTHER ASSETS LESS
LIABILITIES--0.2%.......... 611,907
------------
NET ASSETS--100.0%......... $319,740,373
============
</Table>
- --------------------------------------------------------------------------------
196
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--INDEX 500 V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONCLUDED)
- --------------------------------------------------------------------------------
+ Non-income producing security.
++ Portions of holdings pledged as collateral for financial futures contracts.
* Investments in companies considered to be an affiliate of the Fund (such
companies are defined as "Affiliated Companies" in Section 2(a)(3) of the
Investment Company Act of 1940) are as follows:
<Table>
<Caption>
- ---------------------------------------------------------------------------------------------------
INTEREST/
NET DIVIDEND
AFFILIATE ACTIVITY NET COST INCOME
- ---------------------------------------------------------------------------------------------------
Merrill Lynch & Co., Inc. .................................. (2,600) $(148,379) $22,675
Merrill Lynch Liquidity Series, LLC Cash Sweep Series II.... $4,615,056 4,615,056 3,277
- ---------------------------------------------------------------------------------------------------
</Table>
** Financial futures contracts purchased as of December 31, 2002 were as
follows:
<Table>
<Caption>
- -----------------------------------------------------------------------
NUMBER OF EXPIRATION
CONTRACTS ISSUE DATE VALUE
- -----------------------------------------------------------------------
24 S&P 500 Financial Futures Index March 2003 $5,273,400
- -----------------------------------------------------------------------
TOTAL FINANCIAL FUTURES CONTRACTS PURCHASED (TOTAL CONTRACT
PRICE--$5,354,460).................... .................... $5,273,400
==========
- -----------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
197
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--INDEX 500 V.I. FUND
STATEMENT OF ASSETS AND LIABILITIES AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
<Caption>
ASSETS:
Investments, at value (including securities loaned of
$36,324,317) (identified cost--$331,666,842).............. $319,120,066
Investments held as collateral for loaned securities, at
value..................................................... 37,614,151
Receivables:
Capital shares sold....................................... $ 564,255
Dividends................................................. 498,101
Variation margin.......................................... 8,400
Loaned securities income.................................. 3,114
Interest.................................................. 2,160
Securities sold........................................... 780 1,076,810
------------
Prepaid expenses............................................ 2,267
------------
Total assets................................................ 357,813,294
------------
- -----------------------------------------------------------------------------------------
LIABILITIES:
Collateral on securities loaned, at value................... 37,614,151
Payables:
Capital shares redeemed................................... 329,200
Investment adviser........................................ 86,354 415,554
------------
Accrued expenses............................................ 43,216
------------
Total liabilities........................................... 38,072,921
------------
- -----------------------------------------------------------------------------------------
NET ASSETS.................................................. $319,740,373
============
- -----------------------------------------------------------------------------------------
NET ASSETS CONSIST OF:
Class A Shares of Common Stock, $.10 par value, 100,000,000
shares authorized+........................................ $ 2,866,653
Paid-in capital in excess of par............................ 385,494,562
Accumulated distributions in excess of investment
income--net............................................... $ (33,306)
Accumulated realized capital losses on investments--net..... (55,959,700)
Unrealized depreciation on investments--net................. (12,627,836)
------------
Total accumulated losses--net............................... (68,620,842)
------------
NET ASSETS.................................................. $319,740,373
============
- -----------------------------------------------------------------------------------------
NET ASSET VALUE:
Class A--Based on net assets of $319,740,373 and 28,666,529
shares outstanding........................................ $ 11.15
============
- -----------------------------------------------------------------------------------------
</Table>
+ The Fund is also authorized to issue 100,000,000 Class B Shares.
See Notes to Financial Statements.
198
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--INDEX 500 V.I. FUND
STATEMENT OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
INVESTMENT INCOME:
Dividends (net of $37,267 foreign withholding tax).......... $ 6,073,839
Interest.................................................... 149,950
Securities lending--net..................................... 43,049
-------------
Total income................................................ 6,266,838
-------------
- ----------------------------------------------------------------------------------------
EXPENSES:
Investment advisory fees.................................... $1,171,795
Accounting services......................................... 139,922
Professional fees........................................... 53,955
Custodian fees.............................................. 43,362
Printing and shareholder reports............................ 39,096
Transfer agent fees......................................... 32,679
Directors' fees and expenses................................ 18,121
Registration fees........................................... 820
Pricing services............................................ 185
Other....................................................... 66,279
----------
Total expenses.............................................. 1,566,214
-------------
Investment income--net...................................... 4,700,624
-------------
- ----------------------------------------------------------------------------------------
REALIZED & UNREALIZED LOSS ON INVESTMENTS--NET:
Realized loss on investments--net........................... (31,775,446)
Change in unrealized appreciation/depreciation on
investments--net.......................................... (73,853,572)
-------------
Total realized and unrealized loss on investments--net...... (105,629,018)
-------------
NET DECREASE IN NET ASSETS RESULTING FROM OPERATIONS........ $(100,928,394)
=============
- ----------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
199
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--INDEX 500 V.I. FUND
STATEMENTS OF CHANGES IN NET ASSETS
- --------------------------------------------------------------------------------
<Table>
<Caption>
FOR THE YEAR ENDED
DECEMBER 31,
-----------------------------
INCREASE (DECREASE) IN NET ASSETS: 2002 2001
- ---------------------------------------------------------------------------------------------
OPERATIONS:
Investment income--net...................................... $ 4,700,624 $ 4,676,279
Realized loss on investments--net........................... (31,775,446) (13,275,102)
Change in unrealized appreciation/depreciation on
investments--net.......................................... (73,853,572) (59,817,774)
------------- ------------
Net decrease in net assets resulting from operations........ (100,928,394) (68,416,597)
------------- ------------
- ---------------------------------------------------------------------------------------------
DIVIDENDS TO SHAREHOLDERS:
Investment income--net:
Class A................................................... (4,700,013) (4,675,024)
------------- ------------
Net decrease in net assets resulting from dividends to
shareholders.............................................. (4,700,013) (4,675,024)
------------- ------------
- ---------------------------------------------------------------------------------------------
CAPITAL SHARE TRANSACTIONS:
Net increase (decrease) in net assets derived from capital
share transactions........................................ (57,005,669) 10,299,404
------------- ------------
- ---------------------------------------------------------------------------------------------
NET ASSETS:
Total decrease in net assets................................ (162,634,076) (62,792,217)
Beginning of year........................................... 482,374,449 545,166,666
------------- ------------
End of year*................................................ $ 319,740,373 $482,374,449
============= ============
- ---------------------------------------------------------------------------------------------
* Accumulated distributions in excess of investment
income--net............................................... $ (33,306) $ (33,917)
============= ============
- ---------------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
200
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--INDEX 500 V.I. FUND
FINANCIAL HIGHLIGHTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
THE FOLLOWING PER SHARE DATA AND RATIOS HAVE BEEN DERIVED CLASS A
FROM INFORMATION PROVIDED IN THE FINANCIAL STATEMENTS. --------------------------------------------------------
FOR THE YEAR ENDED DECEMBER 31,
--------------------------------------------------------
INCREASE (DECREASE) IN NET ASSET VALUE: 2002 2001 2000 1999 1998
- ------------------------------------------------------------------------------------------------------------------------
PER SHARE OPERATING PERFORMANCE:
Net asset value, beginning of year.......................... $ 14.58 $ 16.79 $ 18.73 $ 16.23 $ 13.48
-------- -------- -------- -------- --------
Investment income--net...................................... .15+ .15 .16 .19 .18
Realized and unrealized gain (loss) on investments--net..... (3.41) (2.21) (1.91) 3.05 3.40
-------- -------- -------- -------- --------
Total from investment operations............................ (3.26) (2.06) (1.75) 3.24 3.58
-------- -------- -------- -------- --------
Less dividends and distributions:
Investment income--net.................................... (.17) (.15) (.16) (.37) (.17)
In excess of investment income--net....................... -- -- --++ -- --
Realized gain on investments--net......................... -- -- -- (.18) (.66)
In excess of realized gain on investments--net............ -- -- (.03) (.19) --
-------- -------- -------- -------- --------
Total dividends and distributions........................... (.17) (.15) (.19) (.74) (.83)
-------- -------- -------- -------- --------
Net asset value, end of year................................ $ 11.15 $ 14.58 $ 16.79 $ 18.73 $ 16.23
======== ======== ======== ======== ========
- ------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENT RETURN:*
Based on net asset value per share.......................... (22.40%) (12.28%) (9.37%) 20.50% 28.28%
======== ======== ======== ======== ========
- ------------------------------------------------------------------------------------------------------------------------
RATIOS TO AVERAGE NET ASSETS:
Expenses.................................................... .40% .40% .35% .35% .36%
======== ======== ======== ======== ========
Investment income--net...................................... 1.20% .94% .88% 1.13% 1.36%
======== ======== ======== ======== ========
- ------------------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL DATA:
Net assets, end of year (in thousands)...................... $319,740 $482,374 $545,167 $586,394 $403,217
======== ======== ======== ======== ========
Portfolio turnover.......................................... 7.79% 3.46% 7.31% 26.35% 11.92%
======== ======== ======== ======== ========
- ------------------------------------------------------------------------------------------------------------------------
</Table>
*Total investment returns exclude insurance-related fees and expenses.
+Based on average shares outstanding.
++Amount is less than $.01 per share.
See Notes to Financial Statements.
201
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--INDEX 500 V.I. FUND
NOTES TO FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
1. SIGNIFICANT ACCOUNTING POLICIES:
Merrill Lynch Variable Series Funds, Inc. (the "Company") is an open-end
management investment company that is comprised of 17 separate funds. Each fund
offers two classes of shares to the Merrill Lynch Life Insurance Company, ML
Life Insurance Company of New York (indirect, wholly-owned subsidiaries of
Merrill Lynch & Co., Inc. ("ML & Co.")), and other insurance companies that are
not affiliated with ML & Co., for their separate accounts to fund benefits under
certain variable annuity and variable life insurance contracts. Index 500 V.I.
Fund (the "Fund") (formerly Index 500 Fund) is classified as "non-diversified,"
as defined in the Investment Company Act of 1940. Class A and Class B Shares
have equal voting, dividend, liquidation and other rights, except that only
shares of the respective classes are entitled to vote on matters concerning only
that class and Class B Shares bear certain expenses related to the distribution
of such shares. The Fund's financial statements are prepared in conformity with
accounting principles generally accepted in the United States of America, which
may require the use of management accruals and estimates. The following is a
summary of significant accounting policies followed by the Fund.
(a) Valuation of investments--Portfolio securities that are traded on stock
exchanges are valued at the last sale price as of the close of business on the
day the securities are being valued or, lacking any sales, at the closing bid
price. Securities traded in the over-the-counter market are valued at the last
sale price prior to the time of valuation. Securities traded in the NASDAQ
National Market System are valued at the last sale price prior to the time of
valuation. In cases where securities are traded on more than one exchange, the
securities are valued on the exchange designated by or under the authority of
the Board of Directors as the primary market. Portfolio securities that are
traded both in the over-the-counter market and on a stock exchange are valued
according to the broadest and most representative market. Options written or
purchased are valued at the last sale price in the case of exchange-traded
options. In the case of options traded in the over-the-counter market, valuation
is the last asked price (options written) or the last bid price (options
purchased). Futures contracts are valued at the settlement price at the close of
the applicable exchange. Short-term securities are valued at amortized cost,
which approximates market value. 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.
(b) Derivative financial instruments--The Fund may engage in various portfolio
investment strategies to increase or decrease the level of risk to which the
Fund is exposed more quickly and efficiently than transactions in other types of
instruments. Losses may arise due to changes in the value of the contract or if
the counterparty does not perform under the contract.
- - Financial futures contracts--The Fund may purchase or sell financial futures
contracts and options on such futures contracts for the purpose of hedging the
market risk on existing securities or the intended purchase of securities.
Futures contracts are contracts for delayed delivery of securities at a specific
future date and at a specific price or yield. Upon entering into a contract, the
Fund deposits and maintains as collateral such initial margin as required by the
exchange on which the transaction is effected. Pursuant to the contract, the
Fund agrees to receive from or pay to the broker an amount of cash equal to the
daily fluctuation in value of the contract. Such receipts or payments are known
as variation margin and are recorded by the Fund as unrealized gains or losses.
When the contract is closed, the Fund records a realized gain or loss equal to
the difference between the value of the contract at the time it was opened and
the value at the time it was closed.
- - Options--The Fund is authorized to purchase and write covered call and put
options. When the Fund writes an option, an amount equal to the premium received
by the Fund is reflected as an asset and an equivalent liability. The amount of
the liability is subsequently marked to market to reflect the current market
value of the option written. When a security is purchased or sold through an
exercise of an option, the related premium paid (or received) is added to (or
deducted from) the basis of the security acquired or deducted from (or added to)
the proceeds of the security sold. When an option expires (or the Fund enters
into a closing transaction), the Fund realizes a gain or loss on the option to
the extent of the premiums received or paid (or gain or loss to the extent the
cost of the closing transaction exceeds the premium paid or received). Written
and purchased options are non-income producing investments.
202
- --------------------------------------------------------------------------------
(c) Foreign currency transactions--Transactions denominated in foreign
currencies are recorded at the exchange rate prevailing when recognized. Assets
and liabilities denominated in foreign currencies are valued at the exchange
rate at the end of the period. Foreign currency transactions are the result of
settling (realized) or valuing (unrealized) assets and liabilities expressed in
foreign currencies into U.S. dollars. Realized and unrealized gains or losses
from investments include the effects of foreign exchange rates on investments.
(d) Income taxes--It is the Fund's policy to comply with the requirements of
the Internal Revenue Code applicable to regulated investment companies and to
distribute substantially all of its taxable income to its shareholders.
Therefore, no Federal income tax provision is required. Under the applicable
foreign tax law, a withholding tax may be imposed on interest, dividends and
capital gains at various rates.
(e) Security transactions and investment income--Security transactions are
recorded on the dates the transactions are entered into (the trade dates).
Realized gains and losses on security transactions are determined on the
identified cost basis. Dividend income is recorded on the ex-dividend dates.
Interest income is recognized on the accrual basis.
(f) Dividends and distributions--Dividends and distributions paid by the Fund
are recorded on the ex-dividend dates.
(g) Expenses--Certain expenses have been allocated to the individual funds in
the Company on a pro rata basis based upon the respective aggregate net asset
value of each fund included in the Company.
(h) Securities lending--The Fund may lend securities to financial institutions
that provide cash or securities issued or guaranteed by the U.S. government as
collateral, which will be maintained at all times in an amount equal to at least
100% of the current market value of the loaned securities. Where the Fund
receives securities as collateral for the loaned securities, it collects a fee
from the borrower. The Fund typically receives the income on the loaned
securities but does not receive the income on the collateral. Where the Fund
receives cash collateral, it may invest such collateral and retain the amount
earned on such investment, net of any amount rebated to the borrower. Loans of
securities are terminable at any time and the borrower, after notice, is
required to return borrowed securities within five business days. The Fund may
pay reasonable finder's, lending agent, administrative and custodial fees in
connection with its loans. In the event that the borrower defaults on its
obligation to return borrowed securities because of insolvency or for any other
reason, the Fund could experience delays and costs in gaining access to the
collateral. The Fund also could suffer a loss where the value of the collateral
falls below the market value of the borrowed securities, in the event of
borrower default or in the event of losses on investments made with cash
collateral.
2. INVESTMENT ADVISORY AGREEMENT AND TRANSACTIONS WITH AFFILIATES:
The Company has entered into an Investment Advisory Agreement with Merrill Lynch
Investment Managers, L.P. ("MLIM"). The general partner of MLIM is Princeton
Services, Inc. ("PSI"), an indirect, wholly-owned subsidiary of ML & Co., which
is the limited partner.
MLIM is responsible for the management of the Company's funds and provides the
necessary personnel, facilities, equipment and certain other services necessary
to the operations of the Fund. For such services, the Fund pays a monthly fee at
the annual rate of .30% of the average daily value of the Fund's net assets.
MLIM and Merrill Lynch Life Agency, Inc. ("MLLA") have entered into an
agreement which limits the operating expenses paid by the Fund, exclusive of any
distribution fees imposed on Class B Shares, to 1.25% of its average daily net
assets. Any such expenses in excess of 1.25% of average daily net assets will be
reimbursed to the Fund by MLIM which, in turn, will be reimbursed by MLLA.
The Company has received an exemptive order from the Securities and Exchange
Commission permitting it to lend portfolio securities to Merrill Lynch, Pierce,
Fenner & Smith Incorporated ("MLPF&S"), a subsidiary of ML & Co., or its
affiliates. Pursuant to that order, the Company also has retained Merrill Lynch
Investment Managers, LLC ("MLIM, LLC"), an affiliate of MLIM, as the securities
lending agent for a fee based on a share of the returns on investment of cash
collateral. MLIM, LLC may, on behalf of the Company and the Fund, invest cash
collateral received by the Fund for such loans, among other things, in a private
investment company managed by MLIM, LLC or in registered money market funds
advised by MLIM or its affiliates. As of December 31, 2002, cash collateral of
$19,935,501 was invested in the Money Market Series of the Merrill Lynch
Liquidity Series, LLC and $17,678,650 was invested in the Merrill Lynch Premier
Institutional Fund. As of December 31, 2002, the Fund lent securities with a
value of $16,357,018 to MLPF&S or its affiliates. For the year ended
203
- --------------------------------------------------------------------------------
December 31, 2002, MLIM, LLC received $16,423 in securities lending agent fees
from the Fund.
Financial Data Services, Inc. ("FDS"), a wholly-owned subsidiary of ML & Co.,
is the Company's transfer agent.
FAM Distributors, Inc. ("FAMD"), which is a wholly-owned subsidiary of Merrill
Lynch Group, Inc., is the Fund's distributor.
For the year ended December 31, 2002, the Fund reimbursed MLIM $14,922 for
certain accounting services.
Certain officers and/or directors of the Company are officers and/or directors
of MLIM, PSI, FDS, FAMD, and/or ML & Co.
3. INVESTMENTS:
Purchases and sales of investments, excluding short-term securities, for the
year ended December 31, 2002 were $29,878,272 and $70,012,297, respectively.
Net realized losses for the year ended December 31, 2002 and net unrealized
losses as of December 31, 2002 were as follows:
<Table>
<Caption>
- ------------------------------------------------------------------
Realized Unrealized
Losses Losses
- ------------------------------------------------------------------
Long-term investments................ $(30,448,036) $(12,546,776)
Financial futures contracts.......... (1,327,410) (81,060)
------------ ------------
Total................................ $(31,775,446) $(12,627,836)
============ ============
- ------------------------------------------------------------------
</Table>
At December 31, 2002, net unrealized depreciation for Federal income tax
purposes aggregated $21,323,259, of which $52,897,309 related to appreciated
securities and $74,220,568 related to depreciated securities. At December 31,
2002, the aggregate cost of investments for Federal income tax purposes was
$340,443,325.
4. CAPITAL SHARE TRANSACTIONS:
Transactions in capital shares were as follows:
<Table>
<Caption>
- ------------------------------------------------------------------
Class A Shares for the Year Dollar
Ended December 31, 2002 Shares Amount
- ------------------------------------------------------------------
Shares sold............................ 2,855,921 $ 36,516,950
Shares issued to shareholders in
reinvestment of dividends............. 421,526 4,700,013
---------- ------------
Total issued........................... 3,277,447 41,216,963
Shares redeemed........................ (7,688,014) (98,222,632)
---------- ------------
Net decrease........................... (4,410,567) $(57,005,669)
========== ============
- ------------------------------------------------------------------
</Table>
<Table>
<Caption>
- ------------------------------------------------------------------
Class A Shares for the Year Dollar
Ended December 31, 2001 Shares Amount
- ------------------------------------------------------------------
Shares sold............................ 4,773,093 $ 71,922,215
Shares issued to shareholders in
reinvestment of dividends............. 317,043 4,675,024
---------- ------------
Total issued........................... 5,090,136 76,597,239
Shares redeemed........................ (4,483,632) (66,297,835)
---------- ------------
Net increase........................... 606,504 $ 10,299,404
========== ============
- ------------------------------------------------------------------
</Table>
5. SHORT-TERM BORROWINGS:
The Fund, along with certain other funds managed by MLIM and its affiliates, is
a party to a credit agreement with Bank One, N.A. and certain other lenders.
Effective November 29, 2002, in conjunction with the renewal for one year at the
same terms, the total commitment was reduced from $1,000,000,000 to
$500,000,000. The Fund may borrow under the credit agreement to fund shareholder
redemptions and for other lawful purposes other than for leverage. The Fund may
borrow up to the maximum amount allowable under the Fund's current prospectus
and statement of additional information, subject to various other legal,
regulatory or contractual limits. The Fund pays a commitment fee of .09% per
annum based on the Fund's pro rata share of the unused portion of the credit
agreement. Amounts borrowed under the credit agreement bear interest at a rate
equal to, at each fund's election, the Federal Funds rate plus .50% or a base
rate as determined by Bank One, N.A. The Fund did not borrow under the credit
agreement during the year ended December 31, 2002.
6. DISTRIBUTIONS TO SHAREHOLDERS:
The tax character of distributions paid during the fiscal years ended December
31, 2002 and December 31, 2001 was as follows:
<Table>
<Caption>
- ------------------------------------------------------------------
12/31/2002 12/31/2001
- ------------------------------------------------------------------
Distributions paid from:
Ordinary income......................... $4,700,013 $4,675,024
---------- ----------
Total taxable distributions.............. $4,700,013 $4,675,024
========== ==========
- ------------------------------------------------------------------
</Table>
As of December 31, 2002, the components of accumulated losses on a tax basis
were as follows:
<Table>
<Caption>
- ---------------------------------------------------------------
Undistributed ordinary income--net............... $ --
Undistributed long-term capital gains--net....... --
------------
Total undistributed earnings--net................ --
Capital loss carryforward........................ (45,671,148)*
Unrealized losses--net........................... (22,949,694)**
------------
Total accumulated losses--net.................... $(68,620,842)
============
- ---------------------------------------------------------------
</Table>
* On December 31, 2002, the Fund had a net capital loss carryforward of
$45,671,148, of which $3,261,712 expires in 2008, $14,759,870 expires in 2009
and $27,649,566 expires in 2010. This amount will be available to offset like
amounts of any future taxable gains.
** The difference between book-basis and tax-basis net unrealized losses is
attributable primarily to the tax deferral of losses on wash sales, the
realization for tax purposes of unrealized gains (losses) on certain futures
contracts, the deferral of post-October capital losses for tax purposes and
other book/tax temporary differences.
204
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--INDEX 500 V.I. FUND
INDEPENDENT AUDITORS' REPORT
- --------------------------------------------------------------------------------
THE BOARD OF DIRECTORS AND SHAREHOLDERS, INDEX 500 V.I. FUND OF MERRILL LYNCH
VARIABLE SERIES FUNDS, INC.:
We have audited the accompanying statement of assets and liabilities,
including the schedule of investments, of Index 500 V.I. Fund (formerly, Index
500 Fund) of Merrill Lynch Variable Series Funds, Inc. as of December 31, 2002,
the related statements of operations for the year then ended and changes in net
assets for each of the years in the two-year period then ended and the financial
highlights for each of the years presented. These financial statements and the
financial highlights are the responsibility of the Fund's management. Our
responsibility is to express an opinion on these financial statements and the
financial highlights based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements and the financial highlights are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. Our procedures included confirmation of
securities owned at December 31, 2002 by correspondence with the custodian and
brokers; where replies were not received from brokers, we performed other
auditing procedures. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such financial statements and financial highlights present
fairly, in all material respects, the financial position of Index 500 V.I. Fund
of Merrill Lynch Variable Series Funds, Inc. as of December 31, 2002, the
results of its operations, the changes in its net assets, and the financial
highlights for the respective stated periods in conformity with accounting
principles generally accepted in the United States of America.
Deloitte & Touche LLP
Princeton, New Jersey
February 14, 2003
205
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--LARGE CAP CORE V.I. FUND
DECEMBER 31, 2002--ANNUAL REPORT
- --------------------------------------------------------------------------------
DEAR SHAREHOLDER:
The Fund invests primarily in a diversified portfolio of equity securities of
large cap companies that Fund Management selects from among those included in
the Russell 1000 Index. Our investment process attempts to add value through
both security selection and portfolio construction. The Fund's security
selection involves the use of quantitative selection criteria--including
earnings momentum, earnings surprise and valuation--and certain fundamental
overrides. Portfolio construction consists of an optimization process with risk
management controlling style, capitalization, sector and individual security
selection.
FISCAL YEAR IN REVIEW
For the 12-month period ended December 31, 2002, the Fund's Class A Shares had
a total return of -16.98%. On a relative basis, this was ahead of its benchmark,
the Russell 1000 Index, which returned -21.65% for the same period. The Fund's
relative outperformance resulted primarily from stock selection, particularly in
consumer discretionary and financials. The Fund also benefited from an
overweighted position in consumer staples and an underweighted position in
telecommunication services.
2002 turned out to be an erratic year for the economy as its fits and starts
confused investors. Our belief is that the resilient U.S. consumer, supported by
modest job growth and real wage gains, is likely to support--but perhaps not
lead--the U.S. economy. As such, we increased our relative weightings in
financials, health care and materials, and reduced our relative weightings in
industrials, consumer staples and information technology. Largest purchases
included Allstate Corporation, Bear Stearns Companies, Fannie Mae, International
Paper Company, Merck & Co., Inc. and QUALCOMM Incorporated. Largest sales
included Apple Computer, Inc., Intuit, Inc., Philip Morris Companies Inc.,
Raytheon Company, The TJX Companies and Union Pacific Corporation. We continue
to concentrate on sectors and stocks with near-term earnings deliverability and
reasonable valuations. As a result, we are above benchmark weights in consumer
discretionary and health care and below benchmark weights in telecommunication
services, utilities, energy, industrials and information technology. We remain
tilted toward the lower end of the permissible capitalization range,
anticipating continued outperformance of mid and large cap securities relative
to mega cap securities.
MARKET OUTLOOK
We believe that after a third consecutive annual decline in equity markets,
equity investors could experience positive returns in 2003. With the end of the
recession, a decline in interest rates, and a nice improvement in profitability
supported by stunning productivity improvement, 2002 could have been a good year
for financial markets. However, issues surrounding economic uncertainty,
corporate governance and geopolitics (including Iraq) caused investors to sell
stocks again as the equity market decline surpassed that of the 1970s in both
duration and magnitude. Only the 1930s decline during the Great Depression was
worse. After three years of decline, stocks should benefit from stimulative
fiscal and monetary policy and somewhat more reasonable valuations, especially
when compared to cash and Treasury bonds. This same stimulative activity is
likely to cause a backup in interest rates in the second half of the year at
both the short and long ends of the interest rate curve. In the early months of
the 2003, the significant uncertainty surrounding Iraq is likely to be
resolved--we hope--in a positive way.
We believe that October 2002 marked the low for equity prices for this cycle.
An accommodative monetary policy, low inflation, improving profitability,
improved valuation levels, and a stimulative fiscal policy support higher equity
prices. However, the magnitude of any rise is likely to be limited by high debt
levels, absolute valuation levels, and sub-par economic and earnings growth. Our
belief is that interest rates have seen their trough and will experience modest
upward pressure during the second half of 2003. While volatility is likely to
continue, we believe that over the next five--ten years, we will experience an
"8-5-2 world": 8% return for stocks, 5% for bonds, and 2% for cash. If this
forecast is realized, then equity market averages will not experience new highs
until the next decade. Inside the markets, we expect that the phrase "a stock
picker's market" will be more true than usual. Again, it is likely that
intelligent trading and tactical asset allocation will be rewarded.
206
- --------------------------------------------------------------------------------
IN CONCLUSION
We appreciate your investment in Large Cap Core V.I. Fund of Merrill Lynch
Variable Series Funds, Inc., and we look forward to serving your investment
needs in the months and years ahead.
Sincerely,
/s/ Terry K. Glenn
Terry K. Glenn
President and Director
/s/ Robert C. Doll
Robert C. Doll, Jr.
Senior Vice President and Portfolio Manager
January 17, 2003
207
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--LARGE CAP CORE V.I. FUND
TOTAL RETURN BASED ON A $10,000 INVESTMENT--CLASS A SHARES
- --------------------------------------------------------------------------------
<Table>
<Caption>
LARGE CAP CORE V.I. FUND+-CLASS
A SHARES* RUSSELL 1000 INDEX++
------------------------------- --------------------
12/92 10000 10000
12/93 11457 11018
12/94 11320 11061
12/95 13879 15238
12/96 16363 18658
12/97 20241 24787
12/98 23395 31485
12/99 30748 38069
12/00 27719 35104
12/01 25671 30734
12/02 21312 24079
</Table>
* Assuming transaction costs and other operating expenses, including advisory
fees. Does not include insurance-related fees and expenses.
+ The Fund, under normal circumstances, invests at least 80% of its net assets
in a diversified portfolio of equity securities, primarily common stocks, of
large cap companies included at the time of purchase in the Russell 1000
Index.
++ This unmanaged Index measures the performance of the 1,000 largest companies
in the Russell 3000 Index, which represents approximately 92% of the total
market capitalization of the Russell 3000 Index.
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--LARGE CAP CORE V.I. FUND
AVERAGE ANNUAL TOTAL RETURN--CLASS A SHARES*
- --------------------------------------------------------------------------------
PERIOD COVERED % RETURN
- --------------------------------------------------------------------------------
One Year Ended 12/31/02 -16.98%
- --------------------------------------------------------------------------------
Five Years Ended 12/31/02 + 1.03
- --------------------------------------------------------------------------------
Ten Years Ended 12/31/02 + 7.86
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--LARGE CAP CORE V.I. FUND
RECENT PERFORMANCE RESULTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
6-MONTH 12-MONTH
AS OF DECEMBER 31, 2002 TOTAL RETURN TOTAL RETURN
- -----------------------------------------------------------------------------------------
Class A Shares* -13.79% -16.98%
- -----------------------------------------------------------------------------------------
Russell 1000 Index** -10.13 -21.65
- -----------------------------------------------------------------------------------------
</Table>
*
Total investment returns are based on changes in net asset values for the
periods shown, and assume reinvestment of all dividends and capital gains
distributions at net asset value on the ex-dividend date. Insurance-related fees
and expenses are not reflected in these returns.
**
This unmanaged Index measures the performance of the 1,000 largest companies in
the Russell 3000 Index, which represents approximately 92% of the total market
capitalization of the Russell 3000 Index.
Past results shown should not be considered a representation of future
performance.
208
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--LARGE CAP CORE V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
INDUSTRY++ HELD COMMON STOCKS VALUE NET ASSETS
- ---------------------------------------------------------------------------------------------------------------------
AUTO COMPONENTS 39,000 +Lear Corporation....................................... $ 1,297,920 0.3%
- ---------------------------------------------------------------------------------------------------------------------
BANKS 194,000 AmSouth Bancorporation.................................. 3,724,800 0.9
150,000 Astoria Financial Corporation........................... 4,072,500 0.9
155,000 Bank of America Corporation............................. 10,783,350 2.5
53,000 Commerce Bancorp, Inc. ................................. 2,289,070 0.5
68,000 Golden West Financial Corporation....................... 4,883,080 1.1
104,000 GreenPoint Financial Corp. ............................. 4,698,720 1.1
240,000 Hibernia Corporation (Class A).......................... 4,622,400 1.1
157,000 New York Community Bancorp, Inc. ....................... 4,534,160 1.0
113,000 North Fork Bancorporation............................... 3,812,620 0.9
325,000 Sovereign Bancorp, Inc. ................................ 4,566,250 1.1
304,000 U.S. Bancorp............................................ 6,450,880 1.5
181,000 Washington Mutual, Inc. ................................ 6,249,930 1.4
------------ -----
60,687,760 14.0
- ---------------------------------------------------------------------------------------------------------------------
BEVERAGES 74,000 Adolph Coors Company (Class B).......................... 4,532,500 1.1
12,000 The Coca-Cola Company................................... 525,840 0.1
223,000 Coca-Cola Enterprises Inc. ............................. 4,843,560 1.1
176,000 +Constellation Brands, Inc. (Class A)................... 4,172,960 1.0
24,000 The Pepsi Bottling Group, Inc. ......................... 616,800 0.1
------------ -----
14,691,660 3.4
- ---------------------------------------------------------------------------------------------------------------------
BIOTECHNOLOGY 127,000 +Charles River Laboratories International, Inc. ........ 4,886,960 1.1
- ---------------------------------------------------------------------------------------------------------------------
CHEMICALS 109,000 Eastman Chemical Company................................ 4,007,930 0.9
- ---------------------------------------------------------------------------------------------------------------------
COMMERCIAL 109,000 +Apollo Group, Inc. (Class A)........................... 4,796,000 1.1
SERVICES &
SUPPLIES 96,000 +Career Education Corporation........................... 3,840,000 0.9
96,000 Deluxe Corporation...................................... 4,041,600 0.9
127,000 H & R Block, Inc. ...................................... 5,105,400 1.2
------------ -----
17,783,000 4.1
- ---------------------------------------------------------------------------------------------------------------------
COMMUNICATIONS 69,000 +Advanced Fibre Communications, Inc. ................... 1,150,230 0.3
EQUIPMENT 51,000 +Cisco Systems, Inc. ................................... 667,590 0.1
158,000 +QUALCOMM Incorporated.................................. 5,740,140 1.3
------------ -----
7,557,960 1.7
- ---------------------------------------------------------------------------------------------------------------------
COMPUTERS & 282,000 +Dell Computer Corporation.............................. 7,546,320 1.7
PERIPHERALS 35,000 International Business Machines Corporation............. 2,712,500 0.6
78,000 +Storage Technology Corporation......................... 1,670,760 0.4
------------ -----
11,929,580 2.7
- ---------------------------------------------------------------------------------------------------------------------
CONTAINERS & 94,000 Ball Corporation........................................ 4,811,860 1.1
PACKAGING 207,000 +Pactiv Corporation..................................... 4,525,020 1.0
------------ -----
9,336,880 2.1
- ---------------------------------------------------------------------------------------------------------------------
DIVERSIFIED 155,000 Citigroup Inc. ......................................... 5,454,450 1.3
FINANCIALS
90,000 Countrywide Credit Industries, Inc. .................... 4,648,500 1.1
117,000 Fannie Mae.............................................. 7,526,610 1.7
------------ -----
17,629,560 4.1
- ---------------------------------------------------------------------------------------------------------------------
DIVERSIFIED 16,000 SBC Communications Inc. ................................ 433,760 0.1
TELECOMMUNICATION 31,000 Verizon Communications.................................. 1,201,250 0.3
------------ -----
1,635,010 0.4
SERVICES
- ---------------------------------------------------------------------------------------------------------------------
FOOD & DRUG 89,000 +Whole Foods Market, Inc. .............................. 4,691,190 1.1
RETAILING
- ---------------------------------------------------------------------------------------------------------------------
FOOD PRODUCTS 130,000 +Dean Foods Company..................................... 4,823,000 1.1
237,000 Sara Lee Corporation.................................... 5,334,870 1.3
123,000 Tyson Foods, Inc. (Class A)............................. 1,380,060 0.3
------------ -----
11,537,930 2.7
- ---------------------------------------------------------------------------------------------------------------------
</Table>
209
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--LARGE CAP CORE V.I. FUND
SCHEDULE OF INVESTMENTS DECEMBER 31, 2002 (CONTINUED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
INDUSTRY++ HELD COMMON STOCKS VALUE NET ASSETS
- ---------------------------------------------------------------------------------------------------------------------
HEALTH CARE 127,000 Bausch & Lomb Incorporated.............................. $ 4,572,000 1.1%
EQUIPMENT & 55,000 C.R. Bard, Inc. ........................................ 3,190,000 0.7
SUPPLIES 47,000 DENTSPLY International Inc. ............................ 1,744,170 0.4
157,000 +Guidant Corporation.................................... 4,843,450 1.1
98,000 +Varian Medical Systems, Inc. .......................... 4,860,800 1.1
------------ -----
19,210,420 4.4
- ---------------------------------------------------------------------------------------------------------------------
HEALTH CARE 115,500 +Accredo Health, Incorporated........................... 4,071,375 0.9
PROVIDERS & 114,000 Aetna Inc. (New Shares)................................. 4,687,680 1.1
SERVICES 257,000 +Caremark Rx, Inc. ..................................... 4,176,250 1.0
189,000 +DaVita, Inc. .......................................... 4,662,630 1.1
87,000 +Express Scripts, Inc. (Class A)........................ 4,182,960 1.0
373,000 +Humana Inc. ........................................... 3,730,000 0.8
125,000 +Lincare Holdings Inc. ................................. 3,932,500 0.9
126,000 +Oxford Health Plans, Inc. ............................. 4,592,700 1.1
698,000 +Service Corporation International...................... 2,317,360 0.5
63,000 UnitedHealth Group Incorporated......................... 5,260,500 1.2
99,000 +Universal Health Services, Inc. (Class B).............. 4,464,900 1.0
76,000 +WellPoint Health Networks Inc. ........................ 5,408,160 1.2
------------ -----
51,487,015 11.8
- ---------------------------------------------------------------------------------------------------------------------
HOTELS, 117,000 +GTECH Holdings Corporation............................. 3,259,620 0.8
RESTAURANTS & 114,000 +Harrah's Entertainment, Inc. .......................... 4,514,400 1.0
LEISURE 28,000 +International Game Technology.......................... 2,125,760 0.5
158,000 +Mandalay Resort Group.................................. 4,836,380 1.1
------------ -----
14,736,160 3.4
- ---------------------------------------------------------------------------------------------------------------------
HOUSEHOLD DURABLES 233,000 +American Greetings Corporation (Class A)............... 3,681,400 0.9
156,000 D.R. Horton, Inc. ...................................... 2,706,600 0.6
97,000 Fortune Brands, Inc. ................................... 4,511,470 1.0
82,000 Lennar Corporation...................................... 4,231,200 1.0
76,000 +Mohawk Industries, Inc. ............................... 4,328,200 1.0
59,000 Newell Rubbermaid Inc. ................................. 1,789,470 0.4
49,000 Pulte Corporation....................................... 2,345,630 0.5
68,000 The Ryland Group, Inc. ................................. 2,267,800 0.5
83,000 Whirlpool Corporation................................... 4,334,260 1.0
------------ -----
30,196,030 6.9
- ---------------------------------------------------------------------------------------------------------------------
HOUSEHOLD PRODUCTS 130,000 The Procter & Gamble Company............................ 11,172,200 2.6
- ---------------------------------------------------------------------------------------------------------------------
INDUSTRIAL 345,000 General Electric Company................................ 8,400,750 1.9
CONGLOMERATES
- ---------------------------------------------------------------------------------------------------------------------
INSURANCE 152,000 The Allstate Corporation................................ 5,622,480 1.3
47,000 American International Group, Inc. ..................... 2,718,950 0.6
74,000 MetLife, Inc. .......................................... 2,000,960 0.5
152,000 Old Republic International Corporation.................. 4,256,000 1.0
39,000 SAFECO Corporation...................................... 1,346,670 0.3
------------ -----
15,945,060 3.7
- ---------------------------------------------------------------------------------------------------------------------
LEISURE EQUIPMENT & 137,000 Eastman Kodak Company................................... 4,800,480 1.1
PRODUCTS 189,000 Mattel, Inc. ........................................... 3,619,350 0.8
73,000 Polaris Industries, Inc. ............................... 4,277,800 1.0
------------ -----
12,697,630 2.9
- ---------------------------------------------------------------------------------------------------------------------
METALS & MINING 103,000 United States Steel Corporation......................... 1,351,360 0.3
- ---------------------------------------------------------------------------------------------------------------------
MULTILINE RETAIL 202,000 Dillard's, Inc. (Class A)............................... 3,203,720 0.8
211,000 J.C. Penney Company, Inc. .............................. 4,855,110 1.1
54,000 Wal-Mart Stores, Inc. .................................. 2,727,540 0.6
------------ -----
10,786,370 2.5
- ---------------------------------------------------------------------------------------------------------------------
OIL & GAS 230,000 ExxonMobil Corporation.................................. 8,036,200 1.9
- ---------------------------------------------------------------------------------------------------------------------
</Table>
210
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--LARGE CAP CORE V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONCLUDED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
INDUSTRY++ HELD COMMON STOCKS VALUE NET ASSETS
- ---------------------------------------------------------------------------------------------------------------------
PHARMACEUTICALS 94,000 Johnson & Johnson....................................... $ 5,048,740 1.2%
195,000 Merck & Co., Inc. ...................................... 11,038,950 2.5
205,000 Pfizer Inc. ............................................ 6,266,850 1.4
123,000 +SICOR Inc. ............................................ 1,949,550 0.5
27,000 +Watson Pharmaceuticals, Inc. .......................... 763,290 0.2
------------ -----
25,067,380 5.8
- ---------------------------------------------------------------------------------------------------------------------
ROAD & RAIL 243,000 Norfolk Southern Corporation............................ 4,857,570 1.1
- ---------------------------------------------------------------------------------------------------------------------
SEMICONDUCTOR 87,000 Intel Corporation....................................... 1,353,720 0.3
EQUIPMENT &
PRODUCTS
- ---------------------------------------------------------------------------------------------------------------------
SOFTWARE 73,000 +Electronic Arts Inc. .................................. 3,628,830 0.8
27,000 Fair, Isaac and Company, Incorporated................... 1,152,900 0.3
66,000 +Intuit Inc. ........................................... 3,097,380 0.7
163,000 +Microsoft Corporation.................................. 8,428,730 1.9
116,000 +Symantec Corporation................................... 4,698,000 1.1
------------ -----
21,005,840 4.8
- ---------------------------------------------------------------------------------------------------------------------
SPECIALTY RETAIL 364,000 +AutoNation, Inc. ...................................... 4,571,840 1.1
65,000 +AutoZone, Inc. ........................................ 4,592,250 1.1
51,000 Lowe's Companies, Inc. ................................. 1,912,500 0.4
19,000 +Michael's Stores....................................... 594,700 0.1
180,000 Pier 1 Imports, Inc. ................................... 3,407,400 0.8
112,000 Ross Stores, Inc. ...................................... 4,744,320 1.1
------------ -----
19,823,010 4.6
- ---------------------------------------------------------------------------------------------------------------------
TEXTILES, APPAREL & 69,000 +Jones Apparel Group, Inc. ............................. 2,445,360 0.5
LUXURY GOODS 147,000 Liz Claiborne, Inc. .................................... 4,358,550 1.0
160,000 +Reebok International Ltd. ............................. 4,704,000 1.1
------------ -----
11,507,910 2.6
- ---------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS (COST--$443,012,921).................. 435,307,965 100.1
LIABILITIES IN EXCESS OF OTHER ASSETS................... (381,818) (0.1)
------------ -----
NET ASSETS.............................................. $434,926,147 100.0%
============ =====
- ---------------------------------------------------------------------------------------------------------------------
</Table>
+ Non-income producing security.
++For Fund compliance purposes, "Industry" means any one or more of the industry
sub-classifications used by one or more widely recognized market indexes or
ratings group indexes, and/or as defined by Fund management. This definition
may not apply for purposes of this report, which may combine such industry
sub-classifications for reporting ease. These industry classifications are
unaudited.
See Notes to Financial Statements.
211
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--LARGE CAP CORE V.I. FUND
STATEMENT OF ASSETS AND LIABILITIES AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
ASSETS:
Investments, at value (including securities loaned of
$82,654,269)
(identified cost--$443,012,921)........................... $ 435,307,965
Investments held as collateral for loaned securities, at
value..................................................... 85,031,401
Foreign cash (cost--$367)................................... 341
Receivables:
Securities sold........................................... $ 13,248,901
Dividends................................................. 388,232
Loaned securities income.................................. 5,467 13,642,600
-------------
Prepaid expenses............................................ 3,000
-------------
Total assets................................................ 533,985,307
-------------
- -------------------------------------------------------------------------------------------
LIABILITIES:
Collateral on securities loaned, at value................... 85,031,401
Payables:
Securities purchased...................................... 12,383,033
Custodian bank............................................ 1,076,027
Capital shares redeemed................................... 323,742
Investment adviser........................................ 181,602 13,964,404
-------------
Accrued expenses............................................ 63,355
-------------
Total liabilities........................................... 99,059,160
-------------
- -------------------------------------------------------------------------------------------
NET ASSETS.................................................. $ 434,926,147
=============
- -------------------------------------------------------------------------------------------
NET ASSETS CONSIST OF:
Class A Shares of Common Stock, $.10 par value, 200,000,000
shares authorized+........................................ $ 2,247,667
Paid-in capital in excess of par............................ 588,284,068
Accumulated distributions in excess of investment
income--net............................................... $ (23,244)
Accumulated realized capital losses on investments and
foreign currency transactions--net........................ (147,877,362)
Unrealized depreciation on investments and foreign currency
transactions--net......................................... (7,704,982)
-------------
Total accumulated losses--net............................... (155,605,588)
-------------
NET ASSETS.................................................. $ 434,926,147
=============
- -------------------------------------------------------------------------------------------
NET ASSET VALUE:
Class A--Based on net assets of $434,926,147 and 22,476,670
shares outstanding........................................ $ 19.35
=============
- -------------------------------------------------------------------------------------------
</Table>
+ The Fund is also authorized to issue 100,000,000 Class B Shares.
See Notes to Financial Statements.
212
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--LARGE CAP CORE V.I. FUND
STATEMENT OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
INVESTMENT INCOME:
Dividends................................................... $ 6,720,328
Securities lending--net..................................... 140,431
Interest.................................................... 4,603
------------
Total income................................................ 6,865,362
------------
- -----------------------------------------------------------------------------------------
EXPENSES:
Investment advisory fees.................................... $ 2,405,646
Accounting services......................................... 187,909
Custodian fees.............................................. 166,454
Professional fees........................................... 69,451
Printing and shareholder reports............................ 51,204
Transfer agent fees......................................... 34,308
Directors' fees and expenses................................ 23,415
Pricing services............................................ 6,682
Registration fees........................................... 867
Other....................................................... 20,948
------------
Total expenses.............................................. 2,966,884
------------
Investment income--net...................................... 3,898,478
------------
- -----------------------------------------------------------------------------------------
REALIZED & UNREALIZED GAIN (LOSS) ON INVESTMENTS & FOREIGN
CURRENCY
TRANSACTIONS--NET:
Realized loss on investments--net........................... (49,708,825)
Change in unrealized appreciation/depreciation on:
Investments--net.......................................... (50,241,924)
Foreign currency transactions--net........................ 2 (50,241,922)
------------ ------------
Total realized and unrealized loss on investments and
foreign currency transactions--net........................ (99,950,747)
------------
NET DECREASE IN NET ASSETS RESULTING FROM OPERATIONS........ $(96,052,269)
============
- -----------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
213
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--LARGE CAP CORE V.I. FUND
STATEMENTS OF CHANGES IN NET ASSETS
- --------------------------------------------------------------------------------
<Table>
<Caption>
FOR THE YEAR ENDED
DECEMBER 31,
------------------------------
DECREASE IN NET ASSETS: 2002 2001
- ----------------------------------------------------------------------------------------------
OPERATIONS:
Investment income--net...................................... $ 3,898,478 $ 5,552,308
Realized loss on investments and foreign currency
transactions--net......................................... (49,708,825) (65,288,549)
Change in unrealized appreciation/depreciation on
investments and foreign currency transactions--net........ (50,241,922) 1,966,163
------------- -------------
Net decrease in net assets resulting from operations........ (96,052,269) (57,770,078)
------------- -------------
- ----------------------------------------------------------------------------------------------
DIVIDENDS & DISTRIBUTIONS TO SHAREHOLDERS:
Investment income--net:
Class A................................................... (3,925,945) (4,957,348)
Realized gain on investments--net:
Class A................................................... -- (60,007)
------------- -------------
Net decrease in net assets resulting from dividends and
distributions to shareholders............................. (3,925,945) (5,017,355)
------------- -------------
- ----------------------------------------------------------------------------------------------
CAPITAL SHARE TRANSACTIONS:
Net decrease in net assets derived from capital share
transactions.............................................. (61,833,163) (102,033,531)
------------- -------------
- ----------------------------------------------------------------------------------------------
NET ASSETS:
Total decrease in net assets................................ (161,811,377) (164,820,964)
Beginning of year........................................... 596,737,524 761,558,488
------------- -------------
End of year*................................................ $ 434,926,147 $ 596,737,524
============= =============
- ----------------------------------------------------------------------------------------------
* Undistributed(accumulated distributions in excess of)
investment income--net.................................... $ (23,244) $ 4,223
============= =============
- ----------------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements
214
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--LARGE CAP CORE V.I. FUND
FINANCIAL HIGHLIGHTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
THE FOLLOWING PER SHARE DATA AND RATIOS HAVE
BEEN DERIVED FROM INFORMATION PROVIDED IN THE CLASS A
FINANCIAL STATEMENTS. --------------------------------------------------------
FOR THE YEAR ENDED DECEMBER 31,
--------------------------------------------------------
INCREASE (DECREASE) IN NET ASSET VALUE: 2002 2001 2000 1999 1998
- --------------------------------------------------------------------------------------------------------------------
PER SHARE OPERATING PERFORMANCE:
Net asset value, beginning of year........................ $ 23.52 $ 25.61 $ 39.93 $ 38.12 $ 38.42
-------- -------- -------- -------- --------
Investment income--net+................................... .16 .20 .44 .19 .34
Realized and unrealized gain (loss) on investments and
foreign currency transactions--net...................... (4.15) (2.09) (4.16) 10.46 4.80
-------- -------- -------- -------- --------
Total from investment operations.......................... (3.99) (1.89) (3.72) 10.65 5.14
-------- -------- -------- -------- --------
Less dividends and distributions:
Investment income--net.................................. (.18) (.20) (.48) (.56) (.35)
In excess of investment income--net..................... -- -- (.16) (.02) --
Realized gain on investments--net....................... -- --++ (8.58) (8.26) (5.09)
In excess of realized gain on investments--net.......... -- -- (1.38) -- --
-------- -------- -------- -------- --------
Total dividends and distributions......................... (.18) (.20) (10.60) (8.84) (5.44)
-------- -------- -------- -------- --------
Net asset value, end of year.............................. $ 19.35 $ 23.52 $ 25.61 $ 39.93 $ 38.12
======== ======== ======== ======== ========
- --------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENT RETURN:*
Based on net asset value per share........................ (16.98%) (7.39%) (9.85%) 31.43% 15.58%
======== ======== ======== ======== ========
- --------------------------------------------------------------------------------------------------------------------
RATIOS TO AVERAGE NET ASSETS:
Expenses.................................................. .56% .53% .49% .49% .49%
======== ======== ======== ======== ========
Investment income--net.................................... .74% .86% 1.14% .52% .95%
======== ======== ======== ======== ========
- --------------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL DATA:
Net assets, end of year (in thousands).................... $434,926 $596,738 $761,558 $958,313 $862,897
======== ======== ======== ======== ========
Portfolio turnover........................................ 115.39% 170.43% 102.12% 77.73% 100.29%
======== ======== ======== ======== ========
- --------------------------------------------------------------------------------------------------------------------
</Table>
* Total investment returns exclude insurance-related fees and expenses.
+ Based on average shares outstanding.
++ Amount is less than $.01 per share.
See Notes to Financial Statements.
215
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--LARGE CAP CORE V.I. FUND
NOTES TO FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
1. SIGNIFICANT ACCOUNTING POLICIES:
Merrill Lynch Variable Series Funds, Inc. (the "Company") is an open-end
management investment company that is comprised of 17 separate funds. Each fund
offers two classes of shares to the Merrill Lynch Life Insurance Company, ML
Life Insurance Company of New York (indirect, wholly-owned subsidiaries of
Merrill Lynch & Co., Inc. ("ML & Co.")), and other insurance companies that are
not affiliated with ML & Co., for their separate accounts to fund benefits under
certain variable annuity and variable life insurance contracts. Large Cap Core
V.I. Fund (the "Fund") (formerly Large Cap Core Focus Fund) is classified as
"diversified," as defined in the Investment Company Act of 1940. Class A and
Class B Shares have equal voting, dividend, liquidation and other rights, except
that only shares of the respective classes are entitled to vote on matters
concerning only that class and Class B Shares bear certain expenses related to
the distribution of such shares. The Fund's financial statements are prepared in
conformity with accounting principles generally accepted in the United States of
America, which may require the use of management accruals and estimates. The
following is a summary of significant accounting policies followed by the Fund.
(a) Valuation of investments--Portfolio securities that are traded on stock
exchanges are valued at the last sale price as of the close of business on the
day the securities are being valued, or lacking any sales, at the closing bid
price. Securities traded in the over-the-counter market are valued at the last
available bid price prior to the time of valuation. In cases where securities
are traded on more than one exchange, the securities are valued on the exchange
designated by or under the authority of the Board of Directors as the primary
market. Portfolio securities that are traded both in the over-the-counter 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. Options written are valued at
the last sale price in the case of exchange-traded options. In the case of
options traded in the over-the-counter market, valuation is the last asked
price. Short-term securities are valued at amortized cost, which approximates
market value. 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.
(b) Derivative financial instruments--The Fund may engage in various portfolio
investment strategies to increase or decrease the level of risk to which the
Fund is exposed more quickly and efficiently than transactions in other types of
instruments. Losses may arise due to changes in the value of the contract or if
the counterparty does not perform under the contract.
- - Forward foreign exchange contracts--The Fund is authorized to enter into
forward foreign exchange contracts as a hedge against either specific
transactions or portfolio positions. The contract is marked to market daily and
the change in market value is recorded by the Fund as an unrealized gain or
loss. When the contract is closed, the Fund records a realized gain or loss
equal to the difference between the value at the time it was opened and the
value at the time it was closed.
- - Options--The Fund may write covered call options. When the Fund writes an
option, an amount equal to the premium received by the Fund is reflected as an
asset and an equivalent liability. The amount of the liability is subsequently
marked to market to reflect the current market value of the option written. When
a security is purchased or sold through an exercise of an option, the related
premium received is added to (or deducted from) the basis of the security
acquired or deducted from (or added to) the proceeds of the security sold. When
an option expires (or the Fund enters into a closing transaction), the Fund
realizes a gain or loss on the option to the extent of the premiums received (or
gain or loss to the extent the cost of the closing transaction exceeds the
premium paid or received).
Written options are non-income producing investments.
(c) Foreign currency transactions--Transactions denominated in foreign
currencies are recorded at the exchange rate prevailing when recognized. Assets
and liabilities denominated in foreign currencies are valued at the exchange
rate at the end of the period. Foreign currency transactions are the result of
settling (realized) or valuing (unrealized) assets and liabilities expressed in
foreign currencies into U.S. dollars. Realized and unrealized gains or losses
from investments include the effects of foreign exchange rates on investments.
(d) Income taxes--It is the Fund's policy to comply with the requirements of
the Internal Revenue Code applicable to regulated investment companies and to
distribute substantially all of its taxable income to its shareholders.
216
- --------------------------------------------------------------------------------
Therefore, no Federal income tax provision is required. Under the applicable
foreign tax law, a withholding tax may be imposed on interest, dividends and
capital gains at various rates.
(e) Security transactions and investment income--Security transactions are
recorded on the dates the transactions are entered into (the trade dates).
Realized gains and losses on security transactions are determined on the
identified cost basis. Dividend income is recorded on the ex-dividend dates.
Dividends from foreign securities where the ex-dividend date may have passed are
subsequently recorded when the Fund has determined the ex-dividend date.
Interest income is recognized on the accrual basis.
(f) Dividends and distributions--Dividends and distributions paid by the Fund
are recorded on the ex-dividend dates.
(g) Expenses--Certain expenses have been allocated to the individual funds in
the Company on a pro rata basis based upon the respective aggregate net asset
value of each fund included in the Company.
(h) Securities lending--The Fund may lend securities to financial institutions
that provide cash or securities issued or guaranteed by the U.S. government as
collateral, which will be maintained at all times in an amount equal to at least
100% of the current market value of the loaned securities. Where the Fund
receives securities as collateral for the loaned securities, it collects a fee
from the borrower. The Fund typically receives the income on the loaned
securities but does not receive the income on the collateral. Where the Fund
receives cash collateral, it may invest such collateral and retain the amount
earned on such investment, net of any amount rebated to the borrower. Loans of
securities are terminable at any time and the borrower, after notice, is
required to return borrowed securities within five business days. The Fund may
pay reasonable finder's, lending agent, administrative and custodial fees in
connection with its loans. In the event that the borrower defaults on its
obligation to return borrowed securities because of insolvency or for any other
reason, the Fund could experience delays and costs in gaining access to the
collateral. The Fund also could suffer a loss where the value of the collateral
falls below the market value of the borrowed securities, in the event of
borrower default or in the event of losses on investments made with cash
collateral.
(i) Custodian bank--The Fund recorded an amount payable to the custodian bank
reflecting an overnight overdraft resulting from management estimates of
available cash.
2. INVESTMENT ADVISORY AGREEMENT AND
TRANSACTIONS WITH AFFILIATES:
The Company has entered into an Investment Advisory Agreement with Merrill Lynch
Investment Managers, L.P. ("MLIM"). The general partner of MLIM is Princeton
Services, Inc. ("PSI"), an indirect, wholly-owned subsidiary of ML & Co., which
is the limited partner. MLIM is responsible for the management of the Company's
funds and provides the necessary personnel, facilities, equipment and certain
other services necessary to the operations of the Fund.
For such services, the Fund pays a monthly fee at the following annual rates:
..500% of the Fund's average daily net assets not exceeding $250 million; .450%
of average daily net assets in excess of $250 million but not exceeding $300
million; .425% of average daily net assets in excess of $300 million but not
exceeding $400 million; and .400% of average daily net assets in excess of $400
million.
MLIM and Merrill Lynch Life Agency, Inc. ("MLLA") have entered into an
agreement which limits the operating expenses paid by the Fund, exclusive of any
distribution fees imposed on Class B Shares, to 1.25% of its average daily net
assets. Any such expenses in excess of 1.25% of average daily net assets will be
reimbursed to the Fund by MLIM which, in turn, will be reimbursed by MLLA.
The Company has received an exemptive order from the Securities and Exchange
Commission permitting it to lend portfolio securities to Merrill Lynch, Pierce,
Fenner & Smith Incorporated ("MLPF&S"), a subsidiary of ML & Co., or its
affiliates. Pursuant to that order, the Company also has retained Merrill Lynch
Investment Managers, LLC ("MLIM, LLC"), an affiliate of MLIM, as the securities
lending agent for a fee based on a share of the returns on investment of cash
collateral. MLIM, LLC may, on behalf of the Company and the Fund, invest cash
collateral received by the Fund for such loans, among other things, in a private
investment company managed by MLIM, LLC or in registered money market funds
advised by MLIM or its affiliates. As of December 31, 2002, cash collateral of
$45,066,643 was invested in the Money Market Series of the Merrill Lynch
Liquidity Series, LLC and $39,964,758 was invested in the Merrill Lynch Premier
Institutional Fund. As of December 31, 2002, the Fund lent securities with a
value of $3,417,000 to MLPF&S or its affiliates. For the year ended December 31,
2002, MLIM, LLC received $58,488 in securities lending agent fees from the Fund.
217
- --------------------------------------------------------------------------------
Financial Data Services, Inc. ("FDS"), a wholly-owned subsidiary of ML & Co.,
is the Company's transfer agent.
FAM Distributors, Inc. ("FAMD"), which is a wholly-owned subsidiary of Merrill
Lynch Group, Inc., is the Fund's distributor.
For the year ended December 31, 2002, the Fund reimbursed MLIM $19,404 for
certain accounting services.
Certain officers and/or directors of the Company are officers and/or directors
of MLIM, PSI, FDS, FAMD, and/or ML & Co.
3. INVESTMENTS:
Purchases and sales of investments, excluding short-term securities, for the
year ended December 31, 2002 were $609,509,401 and $667,308,105, respectively.
Net realized losses for the year ended December 31, 2002 and net unrealized
losses as of December 31, 2002 were as follows:
<Table>
<Caption>
- -------------------------------------------------------------------
Realized Unrealized
Losses Losses
- -------------------------------------------------------------------
Long-term investments.................. $(49,708,825) $(7,704,956)
Foreign currency transactions.......... -- (26)
------------ -----------
Total.................................. $(49,708,825) $(7,704,982)
============ ===========
- -------------------------------------------------------------------
</Table>
At December 31, 2002, net unrealized depreciation for Federal income tax
purposes aggregated $17,789,151, of which $22,740,148 related to appreciated
securities and $40,529,299 related to depreciated securities. At December 31,
2002, the aggregate cost of investments for Federal income tax purposes was
$453,097,116.
4. CAPITAL SHARE TRANSACTIONS:
Transactions in capital shares were as follows:
- ---------------------------------------------------------
<Table>
<Caption>
Class A Shares for the Year Ended Dollar
December 31, 2002 Shares Amount
- -----------------------------------------------------------------
Shares sold........................... 756,815 $ 17,586,545
Shares issued to shareholders in
reinvestment of dividends............ 202,743 3,925,945
---------- ------------
Total issued.......................... 959,558 21,512,490
Shares redeemed....................... (3,855,197) (83,345,653)
---------- ------------
Net decrease.......................... (2,895,639) $(61,833,163)
========== ============
- -----------------------------------------------------------------
</Table>
- ---------------------------------------------------------
<Table>
<Caption>
Class A Shares for the Year Ended Dollar
December 31, 2001 Shares Amount
- -----------------------------------------------------------------
Shares sold.......................... 228,928 $ 5,393,178
Shares issued to shareholders in
reinvestment of dividends and
distributions....................... 211,707 5,017,355
---------- -------------
Total issued......................... 440,635 10,410,533
Shares redeemed...................... (4,799,984) (112,444,064)
---------- -------------
Net decrease......................... (4,359,349) $(102,033,531)
========== =============
- -----------------------------------------------------------------
</Table>
5. SHORT-TERM BORROWINGS:
The Fund, along with certain other funds managed by MLIM and its affiliates, is
a party to a credit agreement with Bank One, N.A. and certain other lenders.
Effective November 29, 2002, in conjunction with the renewal for one year at the
same terms, the total commitment was reduced from $1,000,000,000 to
$500,000,000. The Fund may borrow under the credit agreement to fund shareholder
redemptions and for other lawful purposes other than for leverage. The Fund may
borrow up to the maximum amount allowable under the Fund's current prospectus
and statement of additional information, subject to various other legal,
regulatory or contractual limits. The Fund pays a commitment fee of .09% per
annum based on the Fund's pro rata share of the unused portion of the credit
agreement. Amounts borrowed under the credit agreement bear interest at a rate
equal to, at each fund's election, the Federal Funds rate plus .50% or a base
rate as determined by Bank One, N.A. The Fund did not borrow under the credit
agreement during the year ended December 31, 2002.
6. DISTRIBUTIONS TO SHAREHOLDERS:
The tax character of distributions paid during the fiscal years ended December
31, 2002 and December 31, 2001 was as follows:
<Table>
<Caption>
- ------------------------------------------------------------------
12/31/2002 12/31/2001
- ------------------------------------------------------------------
Distributions paid from:
Ordinary income......................... $3,925,945 $4,957,348
Net long-term capital gains............. -- 60,007
---------- ----------
Total taxable distributions.............. $3,925,945 $5,017,355
========== ==========
- ------------------------------------------------------------------
</Table>
As of December 31, 2002, the components of accumulated losses on a tax basis
were as follows:
<Table>
- -----------------------------------------------------------------
Undistributed ordinary income--net............... $ --
Undistributed long-term capital gains--net....... --
-------------
Total undistributed earnings--net................ --
Capital loss carryforward........................ (119,865,601)*
Unrealized losses--net........................... (35,739,987)**
-------------
Total accumulated losses--net.................... $(155,605,588)
=============
- -----------------------------------------------------------------
</Table>
* On December 31, 2002, the Fund had a net capital loss carryforward of
$119,865,601, of which $73,889,758 expires in 2009 and $45,975,843 expires in
2010. This amount will be available to offset like amounts of any future
taxable gains.
** The difference between book-basis and tax-basis net unrealized losses is
attributable primarily to the tax deferral of losses on wash sales and the
deferral of post-October capital losses for tax purposes.
218
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--LARGE CAP CORE V.I. FUND
INDEPENDENT AUDITORS' REPORT
- --------------------------------------------------------------------------------
THE BOARD OF DIRECTORS AND SHAREHOLDERS,
LARGE CAP CORE V.I. FUND OF
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.:
We have audited the accompanying statement of assets and liabilities,
including the schedule of investments, of Large Cap Core V.I. Fund (formerly,
Large Cap Core Focus Fund) of Merrill Lynch Variable Series Funds, Inc. as of
December 31, 2002, the related statements of operations for the year then ended
and changes in net assets for each of the years in the two-year period then
ended, and the financial highlights for each of the years presented. These
financial statements and the financial highlights are the responsibility of the
Fund's management. Our responsibility is to express an opinion on these
financial statements and the financial highlights based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements and the financial highlights are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. Our procedures included confirmation of
securities owned at December 31, 2002 by correspondence with the custodian and
brokers; where replies were not received from brokers, we performed other
auditing procedures. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such financial statements and financial highlights present
fairly, in all material respects, the financial position of Large Cap Core V.I.
Fund of Merrill Lynch Variable Series Funds, Inc. as of December 31, 2002, the
results of its operations, the changes in its net assets, and the financial
highlights for the respective stated periods in conformity with accounting
principles generally accepted in the United States of America.
Deloitte & Touche LLP
Princeton, New Jersey
February 14, 2003
219
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--LARGE CAP VALUE V.I. FUND
DECEMBER 31, 2002--ANNUAL REPORT
- --------------------------------------------------------------------------------
DEAR SHAREHOLDER:
The Fund invests primarily in a diversified portfolio of equity securities of
large cap companies that Fund management selects from among those included in
the Russell 1000 Index. Our investment process attempts to add value through
both security selection and portfolio construction. The Fund's security
selection involves the use of quantitative selection criteria--including
earnings momentum, earnings surprise and valuation--and certain fundamental
overrides. Portfolio construction consists of an optimization process with risk
management controlling style, capitalization, sector and individual security
selection.
FISCAL YEAR IN REVIEW
For the 12-month period ended December 31, 2002, the Fund's Class A Shares had
a total return of -12.62%. On a relative basis, the Fund outperformed its
benchmark, the Russell 1000 Value Index, which returned -15.52% for the same
period. The Fund's relative outperformance resulted primarily from stock
selection, particularly in consumer discretionary, financials and industrials.
The Fund also benefited from an underweighted position in telecommunication
services.
2002 turned out to be an erratic year for the economy as its fits and starts
confused investors. Our belief is that the resilient U.S. consumer, supported by
modest job growth and real wage gains, is likely to support--but perhaps not
lead--the U.S. economy. As such, we increased our relative weightings in
financials, health care and materials, and reduced our relative weightings in
industrials and information technology. Largest purchases included Allstate
Corporation, Bank of America Corp., Exxon Mobil Corporation, Merck & Co., Inc.
and Wells Fargo & Co. Largest sales included General Dynamics Corporation,
International Paper Company, Raytheon Company, Union Pacific Corporation and
United Technologies Corp. We continue to concentrate on sectors and stocks with
near-term earnings deliverability and reasonable valuations. As a result, we are
above benchmark weights in consumer staples, consumer discretionary and health
care and below benchmark weights in telecommunication services, utilities,
energy, industrials and information technology. We remain tilted toward the
lower end of the capitalization range, anticipating continued outperformance of
mid and large cap securities relative to mega cap securities.
MARKET OUTLOOK
We believe that after a third consecutive annual decline in equity markets,
equity investors are likely to experience positive returns in 2003. With the end
of the recession, a decline in interest rates, and a nice improvement in
profitability supported by stunning productivity improvement, 2002 could have
been a good year for financial markets. However, issues surrounding economic
uncertainty, corporate governance and geopolitics (including Iraq) caused
investors to sell stocks again as the equity market decline surpassed that of
the 1970s in both duration and magnitude. Only the 1930s decline during the
Great Depression was worse. After three years of decline, stocks should benefit
from stimulative fiscal and monetary policy and somewhat more reasonable
valuations, especially when compared to cash and Treasury bonds. This same
stimulative activity is likely to cause a backup in interest rates in the second
half of the year at both the short and long ends of the interest rate curve. In
the early months of the 2003, the significant uncertainty surrounding Iraq is
likely to be resolved--we hope--in a positive way.
October 2002 marked the low for equity prices for this cycle, in our opinion.
An accommodative monetary policy, low inflation, improving profitability,
improved valuation levels, and a stimulative fiscal policy support higher equity
prices. However, the magnitude of any rise is likely to be limited by high debt
levels, absolute valuation levels, and sub-par economic and earnings growth. Our
belief is that interest rates have seen their trough and will experience modest
upward pressure during the second half of 2003. While volatility is likely to
continue, we believe that over the next five--ten years, we will experience an
"8-5-2 world": 8% return for stocks, 5% for bonds, and 2% for cash. If this
forecast is realized, then equity market averages will not experience new highs
until the next decade. Inside the markets, we expect that the phrase "a stock
picker's market" will be more true than usual. Again, it is likely that
intelligent trading and tactical asset allocation will be rewarded.
220
- --------------------------------------------------------------------------------
IN CONCLUSION
We appreciate your investment in Large Cap Value V.I. Fund of Merrill Lynch
Variable Series Funds, Inc., and we look forward to serving your investment
needs in the months and years ahead.
Sincerely,
/s/ Terry K. Glenn
Terry K. Glenn
President and Director
/s/ Robert C. Doll
Robert C. Doll, Jr.
Senior Vice President and Portfolio Manager
January 17, 2003
221
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--LARGE CAP VALUE V.I. FUND
TOTAL RETURN BASED ON A $10,000 INVESTMENT--CLASS A SHARES
- --------------------------------------------------------------------------------
<Table>
<Caption>
LARGE CAP VALUE V.I. FUND+--
CLASS A SHARES* RUSSELL 1000 VALUE INDEX++
---------------------------- --------------------------
4/23/01** 10000.00 10000.00
12/01 10299.00 9559.00
12/02 8999.00 8075.00
</Table>
* Assuming transaction costs and other operating expenses, including advisory
fees. Does not include insurance-related fees and expenses.
** The Fund commenced operations on 4/23/01.
+ The Fund invests primarily in equity securities of large cap companies that
Fund management selects from among those included in the unmanaged Russell
1000 Value Index.
++ This unmanaged broad-based index is a subset of the Russell 1000 Index
consisting of those Russell 1000 securities with lower price-to-book ratios
and lower forecasted growth values. The starting date for the Index in the
graph is from 4/30/01.
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--LARGE CAP VALUE V.I. FUND
AVERAGE ANNUAL TOTAL RETURN--CLASS A SHARES*
- --------------------------------------------------------------------------------
<Table>
<Caption>
PERIOD COVERED % RETURN
- ----------------------------------------------------------------------
One Year Ended 12/31/02 -12.62%
- ----------------------------------------------------------------------
Inception (4/23/01) to 12/31/02 - 6.05%
- ----------------------------------------------------------------------
</Table>
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--LARGE CAP VALUE V.I. FUND
RECENT PERFORMANCE RESULTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
6-MONTH 12-MONTH
AS OF DECEMBER 31, 2002 TOTAL RETURN TOTAL RETURN
- -----------------------------------------------------------------------------------------
Class A Shares* -14.86% -12.62%
- -----------------------------------------------------------------------------------------
Russell 1000 Value Index** -11.29% -15.52%
- -----------------------------------------------------------------------------------------
</Table>
*Total investment returns are based on changes in net asset value for the period
shown, and assume reinvestment of all dividends and capital gains distributions
at net asset value on the ex-dividend date. Insurance-related fees and expenses
are not reflected in these returns.
** This unmanaged broad-based Index is a subset of the Russell 1000 Index
consisting of those Russell 1000 securities with lower price-to-book ratios
and have lower forecasted growth values.
Past results shown should not be considered a representation of future
performance.
222
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--LARGE CAP VALUE V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
INDUSTRY++ HELD STOCKS VALUE NET ASSETS
- -------------------------------------------------------------------------------------------------------------------
AUTO COMPONENTS
14,900 +Lear Corporation $ 495,872 0.7%
- -------------------------------------------------------------------------------------------------------------------
BANKS
37,600 AmSouth Bancorporation...................................... 721,920 1.1
26,500 Astoria Financial Corporation............................... 719,475 1.0
34,500 Bank of America Corporation................................. 2,400,165 3.5
27,600 Banknorth Group, Inc. ...................................... 623,760 0.9
6,300 Charter One Financial, Inc. ................................ 180,999 0.3
3,700 City National Corporation................................... 162,763 0.2
6,500 Commerce Bancorp, Inc. ..................................... 280,735 0.4
12,200 Golden West Financial Corporation........................... 876,082 1.3
18,000 GreenPoint Financial Corp. ................................. 813,240 1.2
39,300 Hibernia Corporation (Class A).............................. 756,918 1.1
27,700 Independence Community Bank Corp. .......................... 703,026 1.0
29,800 National City Corporation................................... 814,136 1.2
25,100 New York Community Bancorp, Inc. ........................... 724,888 1.1
19,000 North Fork Bancorporation................................... 641,060 0.9
31,800 SouthTrust Corporation...................................... 788,322 1.1
49,500 Sovereign Bancorp, Inc. .................................... 695,475 1.0
65,300 U.S. Bancorp................................................ 1,385,666 2.0
36,700 Washington Mutual, Inc. .................................... 1,267,251 1.8
36,200 Wells Fargo & Co............................................ 1,696,694 2.5
----------- -----
16,252,575 23.6
- -------------------------------------------------------------------------------------------------------------------
BEVERAGES
11,900 Adolph Coors Company (Class B).............................. 728,875 1.1
18,200 Anheuser-Busch Companies, Inc. ............................. 880,880 1.3
33,200 Coca-Cola Enterprises Inc. ................................. 721,104 1.0
24,400 +Constellation Brands, Inc. (Class A)....................... 578,524 0.8
10,100 The Pepsi Bottling Group, Inc. ............................. 259,570 0.4
----------- -----
3,168,953 4.6
- -------------------------------------------------------------------------------------------------------------------
CHEMICALS
17,500 Eastman Chemical Company.................................... 643,475 0.9
10,500 International Flavors & Fragrances Inc. .................... 368,550 0.5
24,400 RPM, Inc. .................................................. 372,832 0.6
7,000 +The Scotts Company (Class A)............................... 343,280 0.5
----------- -----
1,728,137 2.5
- -------------------------------------------------------------------------------------------------------------------
COMMERCIAL
SERVICES &
SUPPLIES
35,900 +CheckFree Corp. ........................................... 571,887 0.8
7,300 Deluxe Corporation.......................................... 307,330 0.5
6,200 H & R Block, Inc. .......................................... 249,240 0.4
7,200 Pitney Bowes Inc. .......................................... 235,152 0.3
----------- -----
1,363,609 2.0
- -------------------------------------------------------------------------------------------------------------------
COMMUNICATIONS
EQUIPMENT
8,400 +Advanced Fibre Communications, Inc. ....................... 140,028 0.2
- -------------------------------------------------------------------------------------------------------------------
CONTAINERS &
PACKAGING
14,900 Ball Corporation............................................ 762,731 1.1
14,600 Bemis Company, Inc. ........................................ 724,598 1.0
34,000 +Pactiv Corporation......................................... 743,240 1.1
----------- -----
2,230,569 3.2
- -------------------------------------------------------------------------------------------------------------------
DIVERSIFIED
FINANCIALS
33,900 Citigroup Inc. ............................................. 1,192,941 1.7
15,800 Countrywide Credit Industries, Inc. ........................ 816,070 1.2
12,800 Freddie Mac................................................. 755,840 1.1
----------- -----
2,764,851 4.0
- -------------------------------------------------------------------------------------------------------------------
DIVERSIFIED
TELECOMMUNICATION
SERVICES
5,900 SBC Communications Inc. .................................... 159,949 0.2
10,400 Verizon Communications...................................... 403,000 0.6
----------- -----
562,949 0.8
- -------------------------------------------------------------------------------------------------------------------
ELECTRIC UTILITIES
10,500 Exelon Corporation.......................................... 554,085 0.8
- -------------------------------------------------------------------------------------------------------------------
FOOD PRODUCTS
35,300 ConAgra, Inc. .............................................. 882,853 1.4
20,800 +Dean Foods Company......................................... 771,680 1.1
16,500 General Mills, Inc.......................................... 774,675 1.1
22,500 Kellogg Company............................................. 771,075 1.1
37,500 Sara Lee Corporation........................................ 844,125 1.2
----------- -----
4,044,408 5.9
- -------------------------------------------------------------------------------------------------------------------
</Table>
223
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--LARGE CAP VALUE V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
INDUSTRY++ HELD STOCKS VALUE NET ASSETS
- -------------------------------------------------------------------------------------------------------------------
HEALTH CARE
EQUIPMENT &
SUPPLIES
20,400 Bausch & Lomb Incorporated.................................. $ 734,400 1.1%
13,300 C.R. Bard, Inc.............................................. 771,400 1.1
----------- -----
1,505,800 2.2
- -------------------------------------------------------------------------------------------------------------------
HEALTH CARE
PROVIDERS &
SERVICES
19,200 Aetna Inc. (New Shares)..................................... 789,504 1.2
13,100 +DaVita, Inc. .............................................. 323,177 0.5
15,500 +Henry Schein, Inc.......................................... 697,500 1.0
70,400 +Humana Inc. ............................................... 704,000 1.0
6,800 Omnicare, Inc. ............................................. 162,044 0.2
3,100 UnitedHealth Group Incorporated............................. 258,850 0.4
3,700 +WellPoint Health Networks Inc. ............................ 263,292 0.4
----------- -----
3,198,367 4.7
- -------------------------------------------------------------------------------------------------------------------
HOTELS,
RESTAURANTS &
LEISURE
25,900 +GTECH Holdings Corporation................................. 721,574 1.1
15,700 +Harrah's Entertainment, Inc. .............................. 621,720 0.9
13,100 +MGM Mirage Inc. ........................................... 431,907 0.6
24,400 +Mandalay Resort Group...................................... 746,884 1.1
----------- -----
2,522,085 3.7
- -------------------------------------------------------------------------------------------------------------------
HOUSEHOLD
DURABLES
38,900 +American Greetings Corporation (Class A)................... 614,620 0.9
16,300 Fortune Brands, Inc. ....................................... 758,113 1.1
8,700 KB HOME..................................................... 372,795 0.5
6,100 Lennar Corporation.......................................... 314,760 0.5
5,200 +Mohawk Industries, Inc. ................................... 296,140 0.4
25,900 Newell Rubbermaid Inc. ..................................... 785,547 1.1
14,500 Pulte Corporation........................................... 694,115 1.0
20,100 The Ryland Group, Inc. ..................................... 670,335 1.0
3,800 Whirlpool Corporation....................................... 198,436 0.3
----------- -----
4,704,861 6.8
- -------------------------------------------------------------------------------------------------------------------
HOUSEHOLD
PRODUCTS
16,900 The Clorox Company.......................................... 697,125 1.0
16,600 The Procter & Gamble Company................................ 1,426,604 2.1
----------- -----
2,123,729 3.1
- -------------------------------------------------------------------------------------------------------------------
INSURANCE
3,300 AFLAC Incorporated.......................................... 99,396 0.2
29,800 The Allstate Corporation.................................... 1,102,302 1.6
30,200 MetLife, Inc. .............................................. 816,608 1.2
22,800 Old Republic International Corporation...................... 638,400 0.9
21,800 SAFECO Corporation.......................................... 752,754 1.1
----------- -----
3,409,460 5.0
- -------------------------------------------------------------------------------------------------------------------
LEISURE
EQUIPMENT &
PRODUCTS
24,800 Eastman Kodak Company....................................... 868,992 1.3
6,200 Mattel, Inc................................................. 118,730 0.2
----------- -----
987,722 1.5
- -------------------------------------------------------------------------------------------------------------------
MACHINERY
32,100 +AGCO Corporation........................................... 709,410 1.0
- -------------------------------------------------------------------------------------------------------------------
MEDIA
7,200 Gannett Co., Inc. .......................................... 516,960 0.8
- -------------------------------------------------------------------------------------------------------------------
METALS & MINING
49,400 United States Steel Corporation............................. 648,128 0.9
- -------------------------------------------------------------------------------------------------------------------
MULTILINE RETAIL
37,000 Dillard's, Inc. (Class A)................................... 586,820 0.8
35,500 J.C. Penney Company, Inc.................................... 816,855 1.2
----------- -----
1,403,675 2.0
- -------------------------------------------------------------------------------------------------------------------
OIL & GAS
74,600 Exxon Mobil Corporation..................................... 2,606,524 3.8
14,200 Ocean Energy Inc............................................ 283,574 0.4
19,500 Pogo Producing Company...................................... 726,375 1.1
----------- -----
3,616,473 5.3
- -------------------------------------------------------------------------------------------------------------------
PHARMACEUTICALS
10,700 +Medicis Pharmaceutical (Class A)........................... 531,469 0.8
28,100 Merck & Co., Inc. .......................................... 1,590,741 2.3
40,700 +SICOR Inc. ................................................ 645,095 0.9
26,000 +Watson Pharmaceuticals, Inc................................ 735,020 1.1
----------- -----
3,502,325 5.1
- -------------------------------------------------------------------------------------------------------------------
ROAD & RAIL
41,600 Norfolk Southern Corporation................................ 831,584 1.2
- -------------------------------------------------------------------------------------------------------------------
</Table>
224
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--LARGE CAP VALUE V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONCLUDED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
INDUSTRY++ HELD STOCKS VALUE NET ASSETS
- ---------------------------------------------------------------------------------------------------------------------
SOFTWARE
3,600 +Intuit Inc. ............................................... $ 168,948 0.2%
14,600 +Sybase, Inc. .............................................. 195,640 0.3
----------- -----
364,588 0.5
- ---------------------------------------------------------------------------------------------------------------------
SPECIALTY RETAIL
58,900 +AutoNation, Inc. .......................................... 739,784 1.1
3,500 +AutoZone, Inc. ............................................ 247,275 0.4
10,200 Foot Locker, Inc. .......................................... 107,100 0.2
37,000 Pier 1 Imports, Inc. ....................................... 700,410 1.0
7,300 Ross Stores, Inc. .......................................... 309,228 0.4
----------- -----
2,103,797 3.1
- ---------------------------------------------------------------------------------------------------------------------
TEXTILES,
APPAREL &
LUXURY GOODS
22,000 +Jones Apparel Group, Inc. ................................. 779,680 1.1
25,300 Liz Claiborne, Inc.......................................... 750,145 1.1
25,700 +Reebok International Ltd................................... 755,580 1.1
----------- -----
2,285,405 3.3
- ---------------------------------------------------------------------------------------------------------------------
TOBACCO
29,100 Philip Morris Companies Inc. ............................... 1,179,423 1.7
- ---------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN STOCKS
(COST--$70,676,634) 68,919,828 100.2
- ---------------------------------------------------------------------------------------------------------------------
<Caption>
PARTNERSHIP
INTEREST SHORT-TERM SECURITIES
- ---------------------------------------------------------------------------------------------------------------------
$164,563 Merrill Lynch Liquidity Series, LLC Cash Sweep Series II*... 164,563 0.3
- ---------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN SHORT-TERM SECURITIES
(COST--$164,563) 164,563 0.3
- ---------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS (COST--$70,841,197)....................... 69,084,391 100.5
LIABILITIES IN EXCESS OF OTHER ASSETS....................... (309,849) (0.5)
----------- -----
NET ASSETS.................................................. $68,774,542 100.0%
=========== =====
- ---------------------------------------------------------------------------------------------------------------------
</Table>
+ Non-income producing security.
++ For Fund compliance purposes, "Industry" means any one or more of the
industry sub-classifications used by one or more widely recognized market
indexes or ratings group indexes, and/or as defined by Fund management.
This definition may not apply for purposes of this report, which may
combine such industry sub-classifications for reporting ease. These
industry classifications are unaudited.
* Investments in companies considered to be an affiliate of the Fund (such
companies are defined as "Affiliated Companies" in Section 2(a)(3) of the
Investment Company Act of 1940) are as follows:
<Table>
<Caption>
- --------------------------------------------------------------------------------------------
NET INTEREST
AFFILIATE ACTIVITY NET COST INCOME
- --------------------------------------------------------------------------------------------
Merrill Lynch Liquidity Series, LLC Cash Sweep Series II.... $164,563 $164,563 $461
- --------------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
225
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--LARGE CAP VALUE V.I. FUND
STATEMENT OF ASSETS AND LIABILITIES AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
ASSETS:
Investments, at value (identified cost--$70,841,197)........ $69,084,391
Receivables:
Securities sold........................................... $ 1,627,995
Capital shares sold....................................... 90,666
Dividends................................................. 81,584
Interest.................................................. 200 1,800,445
-----------
Prepaid expenses............................................ 136
-----------
Total assets................................................ 70,884,972
-----------
- ---------------------------------------------------------------------------------------
LIABILITIES:
Payables:
Securities purchased...................................... 2,051,635
Investment adviser........................................ 45,255
Capital shares redeemed................................... 580 2,097,470
-----------
Accrued expenses............................................ 12,960
-----------
Total liabilities........................................... 2,110,430
-----------
- ---------------------------------------------------------------------------------------
NET ASSETS.................................................. $68,774,542
===========
- ---------------------------------------------------------------------------------------
NET ASSETS CONSIST OF:
Class A Shares of Common Stock, $.10 par value, 100,000,000
shares authorized+........................................ $ 770,889
Paid-in capital in excess of par............................ 75,923,439
Accumulated distributions in excess of investment
income--net............................................... $ (15,106)
Accumulated realized capital losses on investments--net..... (6,147,874)
Unrealized depreciation on investments--net................. (1,756,806)
-----------
Total accumulated losses--net............................... (7,919,786)
-----------
NET ASSETS.................................................. $68,774,542
===========
- ---------------------------------------------------------------------------------------
NET ASSET VALUE:
Class A--Based on net assets of $68,774,542 and 7,708,892
shares outstanding........................................ $ 8.92
===========
- ---------------------------------------------------------------------------------------
</Table>
+ The Fund is also authorized to issue 100,000,000 Class B Shares.
See Notes to Financial Statements.
226
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--LARGE CAP VALUE V.I. FUND
STATEMENT OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
INVESTMENT INCOME:
Dividends................................................... $ 689,733
Interest.................................................... 20,247
-----------
Total income................................................ 709,980
-----------
- ------------------------------------------------------------------------------------
EXPENSES:
Investment advisory fees.................................... $302,442
Custodian fees.............................................. 29,563
Accounting services......................................... 13,206
Offering costs.............................................. 12,882
Professional fees........................................... 9,729
Transfer agent fees......................................... 6,074
Printing and shareholder reports............................ 2,025
Directors' fees and expenses................................ 1,052
Pricing services............................................ 835
Other....................................................... 5,190
--------
Total expenses before reimbursement......................... 382,998
Reimbursement of expenses................................... (291)
--------
Total expenses after reimbursement.......................... 382,707
-----------
Investment income--net...................................... 327,273
-----------
- ------------------------------------------------------------------------------------
REALIZED & UNREALIZED LOSS ON INVESTMENTS--NET:
Realized loss on investments--net........................... (5,753,158)
Change in unrealized appreciation/depreciation on
investments--net.......................................... (2,390,363)
-----------
Total realized and unrealized loss on investments--net...... (8,143,521)
-----------
NET DECREASE IN NET ASSETS RESULTING FROM OPERATIONS........ $(7,816,248)
===========
- ------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
227
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--LARGE CAP VALUE V.I. FUND
STATEMENTS OF CHANGES IN NET ASSETS
- --------------------------------------------------------------------------------
<Table>
<Caption>
FOR THE YEAR FOR THE PERIOD
ENDED APRIL 23, 2001+
DECEMBER 31, TO DECEMBER 31,
INCREASE (DECREASE) IN NET ASSETS: 2002 2001
- ---------------------------------------------------------------------------------------------
OPERATIONS:
Investment income--net...................................... $ 327,273 $ 28,982
Realized loss on investments--net........................... (5,753,158) (394,716)
Change in unrealized appreciation/depreciation on
investments--net.......................................... (2,390,363) 633,557
------------ ------------
Net increase (decrease) in net assets resulting from
operations................................................ (7,816,248) 267,823
------------ ------------
- ---------------------------------------------------------------------------------------------
DIVIDENDS TO SHAREHOLDERS:
Dividends to Class A shareholders from investment
income--net............................................... (350,005) (60,001)
------------ ------------
- ---------------------------------------------------------------------------------------------
CAPITAL SHARE TRANSACTIONS:
Net increase in net assets derived from capital share
transactions.............................................. 60,838,128 14,894,845
------------ ------------
- ---------------------------------------------------------------------------------------------
NET ASSETS:
Total increase in net assets................................ 52,671,875 15,102,667
Beginning of period......................................... 16,102,667 1,000,000
------------ ------------
End of period*.............................................. $68,774,542 $ 16,102,667
============ ============
- ---------------------------------------------------------------------------------------------
* Accumulated distributions in excess of investment
income--net............................................... $ (15,106) $ (5,256)
============ ============
- ---------------------------------------------------------------------------------------------
</Table>
+Commencement of operations.
See Notes to Financial Statements.
228
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--LARGE CAP VALUE V.I. FUND
FINANCIAL HIGHLIGHTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
CLASS A
THE FOLLOWING PER SHARE DATA AND RATIOS HAVE BEEN DERIVED FROM INFORMATION PROVIDED --------------------------------
IN THE FINANCIAL STATEMENTS. FOR THE YEAR FOR THE PERIOD
ENDED APRIL 23, 2001+
DECEMBER 31, TO DECEMBER 31,
INCREASE (DECREASE) IN NET ASSET VALUE: 2002 2001
- ---------------------------------------------------------------------------------------------------------------------
PER SHARE OPERATING PERFORMANCE:
Net asset value, beginning of period................................... $ 10.26 $ 10.00
-------- -------
Investment income--net................................................. .08** .02
Realized and unrealized gain (loss) on investments--net................ (1.37) .28
-------- -------
Total from investment operations....................................... (1.29) .30
-------- -------
Less dividends from investment income--net............................. (.05) (.04)
-------- -------
Net asset value, end of period......................................... $ 8.92 $ 10.26
======== =======
- ---------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENT RETURN:***
Based on net asset value per share..................................... (12.62%) 2.99%++
======== =======
- ---------------------------------------------------------------------------------------------------------------------
RATIOS TO AVERAGE NET ASSETS:
Expenses, net of reimbursement......................................... .95% 1.25%*
======== =======
Expenses............................................................... .95% 1.65%*
======== =======
Investment income--net................................................. .81% .64%*
======== =======
- ---------------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL DATA:
Net assets, end of period (in thousands)............................... $ 68,775 $16,103
======== =======
Portfolio turnover..................................................... 101.99% 64.52%
======== =======
- ---------------------------------------------------------------------------------------------------------------------
</Table>
*Annualized.
**Based on average shares outstanding.
***Total investment returns exclude insurance-related fees and expenses. The
Company's Investment Adviser waived a portion of its management fee. Without
such waiver, the Fund's performance would have been lower.
+Commencement of operations.
++Aggregate total investment return.
See Notes to Financial Statements.
229
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--LARGE CAP VALUE V.I. FUND
NOTES TO FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
1. SIGNIFICANT ACCOUNTING POLICIES:
Merrill Lynch Variable Series Funds, Inc. (the "Company") is an open-end
management investment company that is comprised of 17 separate funds. Each fund
offers two classes of shares to the Merrill Lynch Life Insurance Company
("MLLIC"), ML Life Insurance Company of New York (indirect, wholly-owned
subsidiaries of Merrill Lynch & Co., Inc. ("ML & Co.")), and other insurance
companies, that are not affiliated with ML & Co., for their separate accounts to
fund benefits under certain variable annuity and variable life insurance
contracts. Large Cap Value V.I. Fund (the "Fund") (formerly Large Cap Value
Focus Fund) is classified as "non-diversified," as defined in the Investment
Company Act of 1940. Class A and Class B Shares have equal voting, dividend,
liquidation and other rights, except that only shares of the respective classes
are entitled to vote on matters concerning only that class and Class B Shares
bear certain expenses related to the distribution of such shares. The Fund's
financial statements are prepared in conformity with accounting principles
generally accepted in the United States of America, which may require the use of
management accruals and estimates. The following is a summary of significant
accounting policies followed by the Fund.
(a) Valuation of investments--Portfolio securities that are traded on stock
exchanges are valued at the last sale price as of the close of business on the
day the securities are being valued or, lacking any sales, at the closing bid
price. Securities that are traded in the over-the-counter market are valued at
the last available bid price prior to the time of valuation. In cases where
securities are traded on more than one exchange, the securities are valued on
the exchange designated by or under the authority of the Board of Directors as
the primary market. Portfolio securities that are traded both in the
over-the-counter market and on a stock exchange are valued according to the
broadest and most representative market. Options written or purchased are valued
at the last sale price in the case of exchange-traded options. In the case of
options traded in the over-the-counter market, valuation is the last asked price
(options written) or the last bid price (options purchased). Futures contracts
are valued at the settlement price at the close of the applicable exchange.
Short-term securities are valued at amortized cost, which approximates market
value. 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.
(b) Derivative financial instruments--The Fund may engage in various portfolio
investment strategies to increase or decrease the level of risk to which the
Fund is exposed more quickly and efficiently than transactions in other types of
instruments. Losses may arise due to changes in the value of the contract or if
the counterparty does not perform under the contract.
- - Forward foreign exchange contracts--The Fund is authorized to enter into
forward foreign exchange contracts as a hedge against either specific
transactions or portfolio positions. The contract is marked to market daily and
the change in market value is recorded by the Fund as an unrealized gain or
loss. When the contract is closed, the Fund records a realized gain or loss
equal to the difference between the value at the time it was opened and the
value at the time it was closed.
- - Options--The Fund may write and purchase call and put options. When the Fund
writes an option, an amount equal to the premium received by the Fund is
reflected as an asset and an equivalent liability. The amount of the liability
is subsequently marked to market to reflect the current market value of the
option written. When a security is purchased or sold through an exercise of an
option, the related premium paid or received is added to (or deducted from) the
basis of the security acquired or deducted from (or added to) the proceeds of
the security sold. When an option expires (or the Fund enters into a closing
transaction), the Fund realizes a gain or loss on the option to the extent of
the premiums received or paid (or gain or loss to the extent the cost of the
closing transaction exceeds the premium paid or received).
Written and purchased options are non-income producing investments.
- - Financial futures contracts--The Fund may purchase or sell financial futures
contracts and options on such futures contracts for the purpose of hedging the
market risk on existing securities or the intended purchase of securities.
Futures contracts are contracts for delayed delivery of securities at a specific
future date and at a specific price or yield. Upon entering into a contract, the
Fund deposits and maintains as collateral such initial margin as required by the
exchange on which the transaction is effected. Pursuant to the contract, the
Fund agrees to receive from or pay to the broker an amount of cash equal to the
daily fluctuation in
230
- --------------------------------------------------------------------------------
value of the contract. Such receipts or payments are known as variation margin
and are recorded by the Fund as unrealized gains or losses. When the contract is
closed, the Fund records a realized gain or loss equal to the difference between
the value of the contract at the time it was opened and the value at the time it
was closed.
- - Foreign currency options and futures--The Fund may also purchase or sell
listed or over-the-counter foreign currency options, foreign currency futures
and related options on foreign currency futures as a short or long hedge against
possible variations in foreign exchange rates. Such transactions may be effected
with respect to hedges on non-U.S. dollar denominated securities owned by the
Fund, sold by the Fund but not yet delivered, or committed or anticipated to be
purchased by the Fund.
(c) Foreign currency transactions--Transactions denominated in foreign
currencies are recorded at the exchange rate prevailing when recognized. Assets
and liabilities denominated in foreign currencies are valued at the exchange
rate at the end of the period. Foreign currency transactions are the result of
settling (realized) or valuing (unrealized) assets and liabilities expressed in
foreign currencies into U.S. dollars. Realized and unrealized gains or losses
from investments include the effects of foreign exchange rates on investments.
(d) Income taxes--It is the Fund's policy to comply with the requirements of
the Internal Revenue Code applicable to regulated investment companies and to
distribute substantially all of its taxable income to its shareholders.
Therefore, no Federal income tax provision is required. Under the applicable
foreign tax law, a withholding tax may be imposed on interest, dividends and
capital gains at various rates.
(e) Security transactions and investment income--Security transactions are
recorded on the dates the transactions are entered into (the trade dates).
Realized gains and losses on security transactions are determined on the
identified cost basis. Dividend income is recorded on the ex-dividend dates.
Dividends from foreign securities where the ex-dividend date may have passed are
subsequently recorded when the Fund has determined the ex-dividend date.
Interest income is recognized on the accrual basis.
(f) Dividends and distributions--Dividends and distributions paid by the Fund
are recorded on the ex-dividend dates.
(g) Expenses--Certain expenses have been allocated to the individual funds in
the Company on a pro rata basis based upon the respective aggregate net asset
value of each fund included in the Company.
(h) Reclassification--Accounting principles generally accepted in the United
States of America require that certain components of net assets be adjusted to
reflect permanent differences between financial and tax reporting. Accordingly,
the current year's permanent book/ tax difference of $12,882 has been
reclassified between paid-in capital in excess of par and accumulated
distributions in excess of net investment income. This reclassification has no
effect on net assets or net asset values per share.
2. INVESTMENT ADVISORY AGREEMENT AND TRANSACTIONS WITH AFFILIATES:
The Company has entered into an Investment Advisory Agreement with Merrill Lynch
Investment Managers, L.P. ("MLIM"). The general partner of MLIM is Princeton
Services, Inc. ("PSI"), an indirect, wholly-owned subsidiary of ML & Co., which
is the limited partner.
MLIM is responsible for the management of the Company's funds and provides the
necessary personnel, facilities, equipment and certain other services necessary
to the operations of the Fund. For such services, the Fund pays a monthly fee at
the annual rate of .75% of the average daily value of the Fund's net assets. For
the year ended December 31, 2002, MLIM earned fees of $302,442, of which $291
was waived.
MLIM and Merrill Lynch Life Agency, Inc. ("MLLA") have entered into an
agreement which limits the operating expenses paid by the Fund, exclusive of any
distribution fees imposed on Class B Shares, to 1.25% of its average daily net
assets. Any expenses in excess of 1.25% of average daily net assets will be
reimbursed to the Fund by MLIM which, in turn, will be reimbursed by MLLA.
Financial Data Services, Inc. ("FDS"), a wholly-owned subsidiary of ML & Co.,
is the Company's transfer agent.
FAM Distributors, Inc. ("FAMD"), which is a wholly-owned subsidiary of Merrill
Lynch Group, Inc., is the Fund's distributor.
For the year ended December 31, 2002, the Fund reimbursed MLIM $1,142 for
certain accounting services.
Certain officers and/or directors of the Company are officers and/or directors
of MLIM, PSI, FDS, FAMD, and/or ML & Co.
3. INVESTMENTS:
Purchases and sales of investments, excluding short-term securities, for the
year ended
231
- --------------------------------------------------------------------------------
December 31, 2002 were $102,070,960 and $40,908,181, respectively.
Net realized losses for the year ended December 31, 2002 and net unrealized
losses as of December 31, 2002 were as follows:
<Table>
<Caption>
- ------------------------------------------------------------------
Realized Unrealized
Losses Losses
- ------------------------------------------------------------------
Long-term investments.................. $(5,753,158) $(1,756,806)
----------- -----------
Total.................................. $(5,753,158) $(1,756,806)
=========== ===========
- ------------------------------------------------------------------
</Table>
At December 31, 2002, net unrealized depreciation for Federal income tax
purposes aggregated $2,040,895, of which $1,698,058 related to appreciated
securities and $3,738,953 related to depreciated securities. At December 31,
2002, the aggregate cost of investments for Federal income tax purposes was
$71,125,286.
4. CAPITAL SHARE TRANSACTIONS:
Transactions in capital shares were as follows:
<Table>
<Caption>
- ------------------------------------------------------------------
Class A Shares for the Year ended Dollar
December 31, 2002 Shares Amount
- ------------------------------------------------------------------
Shares sold.............................. 7,056,874 $69,816,160
Shares issued to shareholders in
reinvestment of dividends............... 39,194 350,005
--------- -----------
Total issued............................. 7,096,068 70,166,165
Shares redeemed.......................... (956,787) (9,328,037)
--------- -----------
Net increase............................. 6,139,281 $60,838,128
========= ===========
- ------------------------------------------------------------------
</Table>
<Table>
<Caption>
- -------------------------------------------------------------------------
Class A Shares for the Period April 23, 2001+ to Dollar
December 31, 2001 Shares Amount
- -------------------------------------------------------------------------
Shares sold................................. 1,700,336 $17,194,842
Shares issued to shareholders in reinvestment of
dividends.................................. 5,814 60,001
--------- -----------
Total issued................................ 1,706,150 17,254,843
Shares redeemed............................. (236,539) (2,359,998)
--------- -----------
Net increase................................ 1,469,611 $14,894,845
========= ===========
- -------------------------------------------------------------------------
</Table>
+ Prior to April 23, 2001 (commencement of operations), the Fund issued 100,000
shares to MLLIC for $1,000,000.
5. SHORT-TERM BORROWINGS:
The Fund, along with certain other funds managed by MLIM and its affiliates, is
a party to a credit agreement with Bank One, N.A. and certain other lenders.
Effective November 29, 2002, in conjunction with the renewal for one year at the
same terms, the total commitment was reduced from $1,000,000,000 to
$500,000,000. The Fund may borrow under the credit agreement to fund shareholder
redemptions and for other lawful purposes other than for leverage. The Fund may
borrow up to the maximum amount allowable under the Fund's current prospectus
and statement of additional information, subject to various other legal,
regulatory or contractual limits. The Fund pays a commitment fee of .09% per
annum based on the Fund's pro rata share of the unused portion of the credit
agreement. Amounts borrowed under the credit agreement bear interest at a rate
equal to, at each fund's election, the Federal Funds rate plus .50% or a base
rate as determined by Bank One, N.A. The Fund did not borrow under the credit
agreement during the year ended December 31, 2002.
6. DISTRIBUTIONS TO SHAREHOLDERS:
The tax character of distributions paid during the fiscal years ended December
31, 2002 and December 31, 2001 was as follows:
<Table>
<Caption>
- ------------------------------------------------------------------
12/31/2002 12/31/2001
- ------------------------------------------------------------------
Distributions paid from:
Ordinary income......................... $350,005 $60,001
-------- -------
Total taxable distributions.............. $350,005 $60,001
======== =======
- ------------------------------------------------------------------
</Table>
As of December 31, 2002, the components of accumulated losses on a tax basis
were as follows:
<Table>
<Caption>
- ---------------------------------------------------------------
Undistributed ordinary income--net................ $ --
Undistributed long-term capital gains--net........ --
-----------
Total undistributed earnings--net................. --
Capital loss carryforward......................... (3,568,704)*
Unrealized losses--net............................ (4,351,082)**
-----------
Total accumulated losses--net..................... $(7,919,786)
===========
</Table>
- ---------------------------------------------------------
* On December 31, 2002, the Fund had a net capital loss carryforward of
$3,568,704, of which $217,611 expires in 2009 and $3,351,093 expires in 2010.
This amount will be available to offset like amounts of any future taxable
gains.
** The difference between book-basis and tax-basis net unrealized losses is
attributable primarily to the tax deferral of losses on wash sales, the
deferral of post-October capital losses for tax purposes and other book/tax
temporary differences.
232
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--LARGE CAP VALUE V.I. FUND
INDEPENDENT AUDITORS' REPORT
- --------------------------------------------------------------------------------
THE BOARD OF DIRECTORS AND SHAREHOLDERS,
LARGE CAP VALUE V.I. FUND OF
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.:
We have audited the accompanying statement of assets and liabilities,
including the schedule of investments, of Large Cap Value V.I. Fund (formerly,
Large Cap Value Focus Fund) of Merrill Lynch Variable Series Funds, Inc. as of
December 31, 2002, the related statements of operations for the year then ended
and changes in net assets and the financial highlights for the year then ended
and for the period April 23, 2001 (commencement of operations) to December 31,
2001. These financial statements and the financial highlights are the
responsibility of the Fund's management. Our responsibility is to express an
opinion on these financial statements and the financial highlights based on our
audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements and the financial highlights are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. Our procedures included confirmation of
securities owned at December 31, 2002 by correspondence with the custodian and
brokers; where replies were not received from brokers, we performed other
auditing procedures. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such financial statements and financial highlights present
fairly, in all material respects, the financial position of Large Cap Value V.I.
Fund of Merrill Lynch Variable Series Funds, Inc. as of December 31, 2002, the
results of its operations, the changes in its net assets, and the financial
highlights for the respective stated periods in conformity with accounting
principles generally accepted in the United States of America.
Deloitte & Touche LLP
Princeton, New Jersey
February 14, 2003
233
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--RESERVE ASSETS V.I. FUND
DECEMBER 31, 2002--ANNUAL REPORT
- --------------------------------------------------------------------------------
DEAR SHAREHOLDER:
For the 12 months ended December 31, 2002, Reserve Assets V.I. Fund's Class A
Shares had a net annualized yield of 1.23%. For the six-month period ended
December 31, 2002, the Fund's Class A Shares had a net annualized yield of
1.03%. The Fund's 7-day yield as of December 31, 2002 was .68%. The Fund's
average portfolio maturity was 50 days at December 31, 2002, compared to 54 days
at June 30, 2002.
ECONOMIC ENVIRONMENT
By December 31, 2002, the U.S. economy appeared to be on track for annual
growth of roughly 2.5%, with growth in the fourth quarter of 2002 declining to
an estimated 1% from a relatively strong 4% in the third quarter. Most analysts
do not expect consumers to continue to support economic growth in 2003 as they
had in 2002. Large-scale layoff announcements in the fourth quarter and
uncertainty over Iraq led to a decline in consumer confidence. Industry surveys
indicated that consumers were still uneasy about the employment situation. These
factors contributed to the anemic holiday season, with modest gains in overall
sales limited by heavy discounting needed to bring buyers into the stores. The
strength in the housing market and mortgage refinancing activity provided
household well-being during the six-month period ended December 31, 2002, but
there are signs this trend is tapering off as mortgage rates have stopped
dropping. After more than two years of retrenchment, corporate balance sheets
improved during the six-month period. It remains unclear if this will lead to an
increase in capital expenditures unless revenues show signs of growth. However,
the combination of low interest rates and proposed fiscal stimulus may yet bring
improvement to the economic outlook.
The impact of economic data continued to be muted in light of other events
that have brought increased volatility to the markets. The short end of the U.S.
Treasury market (two years and under) was subject to a safe-haven trade during
the last few months, with U.S. Treasury yields approaching historical lows. The
equity and corporate bond markets continued to slide from the disclosure of
questionable accounting and business practices. The threat of a U.S. military
conflict with Iraq cast a pall on financial markets, with volatility increasing
along with the rhetoric. Increasingly, the decline in the U.S. dollar compared
to other major currencies and recent highs in oil and gold prices added another
element to the uncertainties facing the markets. We believe that fiscal stimulus
will lead to increased borrowing by the U.S. Treasury, and changes in the
borrowings mix are likely to produce structural changes to the yield curve.
These factors influenced the markets during the fourth quarter of 2002, and we
believe are likely to continue, to varying degrees, into the first quarter of
2003.
PORTFOLIO MATTERS
Our desired portfolio mix and average duration remained relatively unchanged
during the six-month period ended December 31, 2002. To target a 50-day-60-day
average life, we favored an overweighted position in variable rate notes, and
for fixed rate exposure, we preferred callable agency structures. The universe
of available first-tier corporate credits declined throughout the year, thus
collapsing spreads because of scarcity value. Somewhat surprisingly, spreads on
agency issues remained unchanged. We added floating rate agency securities on a
one-month London Interbank Offered Rate (LIBOR) less an eight basis point (.08%)
equivalent, which represented a similar level to that of first-tier commercial
paper. As we expect higher interest rates to eventually produce a steeper curve,
sufficient exposure in variable rate product should provide adequate protection
against higher interest rates and allow us greater flexibility with our fixed
rate purchases. Amid the flat-to-inverted yield curve that existed within the
one-year sector, we became increasingly involved in callable agency paper. We
believed the premiums we received by selling these imbedded call options created
valuable investment opportunities, especially given the inversion of the LIBOR
curve in the front end. This scenario enabled us to generate yields that were
otherwise unavailable for the higher-quality credits, which we were primarily
focused on. At these volatility levels, callable bonds offered superior
option-adjusted spreads in addition to their higher coupons.
Recently we have become increasingly cautious about adding any new longer
fixed rate exposure as volatility has declined, quality spreads have collapsed
and U.S. Treasury yields have re-tested their lows. Hence, we currently do not
see value in callable structures, as their option-adjusted spreads are far less
compelling. We remain content to allow our duration target to passively drift
lower, awaiting better buying opportunities, which we believe may arise if
sustained economic growth
234
- --------------------------------------------------------------------------------
becomes more apparent and the safe-haven trade diminishes.
The Fund's composition at the end of December and as of our last report to
shareholders is detailed below:
<Table>
<Caption>
- -----------------------------------------------------------------
12/31/02 6/30/02
- -----------------------------------------------------------------
Certificates of Deposit...................... 1.7% --
Certificates of Deposit--Yankee.............. 5.0 3.0%
Commercial Paper............................. 66.2 66.9
Corporate Notes.............................. 7.9 9.3
Funding Agreements........................... 4.1 3.7
Municipal Bonds.............................. 0.8 --
U.S. Government, Agency & Instrumentality
Obligations--Discount....................... 0.3 0.3
U.S. Government, Agency & Instrumentality
Obligations--Non-Discount................... 17.2 17.3
Liabilities in Excess of Other Assets........ (3.2) (0.5)
----- -----
Total........................................ 100.0% 100.0%
===== =====
- -----------------------------------------------------------------
</Table>
IN CONCLUSION
We appreciate your investment in Reserve Assets V.I. Fund of Merrill Lynch
Variable Series Funds, Inc., and we look forward to discussing our investment
outlook and strategy with you in our next report to shareholders.
Sincerely,
/s/ Terry K. Glenn
Terry K. Glenn
President and Director
/s/ Jacqueline Rogers
Jacqueline Rogers
Vice President and Portfolio Manager
January 17, 2003
235
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--RESERVE ASSETS V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
<Caption>
FACE INTEREST MATURITY
AMOUNT ISSUE RATE* DATE VALUE
- ------------------------------------------------------------------------------------------------------------------------
CERTIFICATES OF $200,000 State Street Bank & Trust............... 2.30 % 6/17/2003 $ 200,911
DEPOSIT--1.7%
- ------------------------------------------------------------------------------------------------------------------------
TOTAL CERTIFICATES OF DEPOSIT (COST--$200,489) 200,911
- ------------------------------------------------------------------------------------------------------------------------
CERTIFICATES OF 100,000 Bank of Nova Scotia..................... 2.98 3/27/2003 100,393
DEPOSIT--YANKEE--5.0%
150,000 Canadian Imperial Bank of Commerce...... 2.425 1/10/2003 150,036
100,000 Canadian Imperial Bank of Commerce...... 2.17 7/14/2003 100,461
250,000 Nordea Bank PLC+........................ 1.379 9/09/2003 249,974
- ------------------------------------------------------------------------------------------------------------------------
TOTAL CERTIFICATES OF DEPOSIT--YANKEE (COST--$600,015) 600,864
- ------------------------------------------------------------------------------------------------------------------------
COMMERCIAL PAPER--66.2% 400,000 Apreco, Inc............................. 1.36 1/21/2003 399,713
250,000 Bavaria TRR Corp........................ 1.75 1/15/2003 249,880
334,000 Clipper Receivables Corp................ 1.25 1/02/2003 334,000
302,000 Corporate Asset Funding Co., Inc........ 1.35 1/08/2003 301,932
350,000 Dorada Finance Inc...................... 1.35 2/28/2003 349,269
318,000 Edison Asset Securitization, LLC........ 1.36 1/09/2003 317,916
203,000 FCAR Owner Trust........................ 1.78 1/16/2003 202,895
493,000 Fleet Funding Corporation............... 1.35 1/10/2003 492,852
250,000 Goldman Sachs Group, Inc.+.............. 1.76 10/09/2003 249,975
326,000 Greyhawk Funding, LLC................... 1.36 1/13/2003 325,865
300,000 International Lease Finance
Corporation........................... 1.35 1/27/2003 299,719
600,000 Kitty Hawk Funding Corp................. 1.35 1/14/2003 599,730
287,000 Mont Blanc Capital Corp................. 1.33 1/07/2003 286,947
150,000 Morgan Stanley+......................... 1.393 4/15/2003 150,000
429,000 Newport Funding Corp.................... 1.35 1/24/2003 428,648
500,000 PB Finance (Delaware)................... 1.38 2/13/2003 499,230
480,000 Park Avenue Receivables Corp............ 1.34 2/13/2003 479,261
399,000 Rio Tinto Limited....................... 1.35 1/15/2003 398,805
506,000 Sheffield Receivables Corporation....... 1.35 1/23/2003 505,602
530,000 Societe Generale NA..................... 1.36 2/21/2003 528,999
338,000 Spintab AB.............................. 1.33 2/06/2003 337,559
250,000 Svenska Handelsbanken AB................ 1.34 1/30/2003 249,737
- ------------------------------------------------------------------------------------------------------------------------
TOTAL COMMERCIAL PAPER (COST--$7,988,425) 7,988,534
- ------------------------------------------------------------------------------------------------------------------------
CORPORATE NOTES--7.9% 250,000 General Electric Capital Corp.+......... 1.756 11/03/2003 250,118
195,000 General Electric Capital Corp.+......... 1.45 1/16/2004 195,000
100,000 Goldman Sachs Group, Inc.+.............. 2.025 1/13/2004 100,000
250,000 Morgan Stanley+......................... 1.52 1/16/2004 250,000
150,000 Wal-Mart Stores, Inc.................... 4.878 6/01/2003 151,982
- ------------------------------------------------------------------------------------------------------------------------
TOTAL CORPORATE NOTES (COST--$946,552) 947,100
- ------------------------------------------------------------------------------------------------------------------------
FUNDING AGREEMENTS--4.1% 500,000 Monumental Life Insurance Company+...... 1.54 11/24/2003 500,000
- ------------------------------------------------------------------------------------------------------------------------
TOTAL FUNDING AGREEMENTS (COST--$500,000) 500,000
- ------------------------------------------------------------------------------------------------------------------------
MUNICIPAL BONDS--0.8% 100,000 California State, Revenue Anticipation
Note+................................. 1.42 6/20/2003 100,000
- ------------------------------------------------------------------------------------------------------------------------
TOTAL MUNICIPAL BONDS (COST--$100,000) 100,000
- ------------------------------------------------------------------------------------------------------------------------
U.S. GOVERNMENT, AGENCY & 40,000 Federal Home Loan Mortgage
INSTRUMENTALITY OBLIGATIONS-- Corporation........................... 2.35 1/30/2003 39,963
DISCOUNT--0.3%
- ------------------------------------------------------------------------------------------------------------------------
TOTAL U.S. GOVERNMENT, AGENCY & INSTRUMENTALITY
OBLIGATIONS--DISCOUNT (COST--$39,927) 39,963
- ------------------------------------------------------------------------------------------------------------------------
U.S. GOVERNMENT, AGENCY & 75,000 Federal Home Loan Bank.................. 4.50 4/25/2003 75,755
INSTRUMENTALITY OBLIGATIONS-- NON-
DISCOUNT--17.2%
200,000 Federal Home Loan Bank+................. 1.44 11/07/2003 200,047
100,000 Federal Home Loan Bank+................. 1.253 12/04/2003 100,072
100,000 Federal Home Loan Bank+................. 1.695 1/02/2004 99,975
400,000 Federal Home Loan Bank+................. 1.303 1/06/2004 399,847
250,000 Federal Home Loan Mortgage
Corporation........................... 2.45 1/16/2003 250,102
75,000 Federal Home Loan Mortgage
Corporation........................... 3.25 1/15/2004 76,474
</Table>
236
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--RESERVE ASSETS V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONCLUDED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
FACE INTEREST MATURITY
AMOUNT ISSUE RATE* DATE VALUE
- ------------------------------------------------------------------------------------------------------------------------
U.S. GOVERNMENT, AGENCY & $ 25,000 Federal Home Loan Mortgage
INSTRUMENTALITY Corporation........................... 3.75 % 4/15/2004 $ 25,743
OBLIGATIONS--NON-DISCOUNT
(CONCLUDED)
100,000 Federal National Mortgage Association... 4.00 8/15/2003 101,685
300,000 Federal National Mortgage
Association+.......................... 1.447 1/14/2004 300,131
50,000 Federal National Mortgage Association... 2.46 8/19/2004 50,364
50,000 Federal National Mortgage Association... 2.70 8/19/2004 50,094
50,000 Federal National Mortgage Association... 2.72 8/27/2004 50,109
50,000 Federal National Mortgage Association... 2.80 9/03/2004 50,124
40,000 Federal National Mortgage Association... 2.50 10/01/2004 40,370
35,000 Federal National Mortgage Association... 2.60 10/29/2004 35,142
150,000 Student Loan Marketing Association+..... 1.427 2/12/2004 149,967
25,000 U.S. Treasury Notes..................... 2.125 8/31/2004 25,278
- ------------------------------------------------------------------------------------------------------------------------
TOTAL U.S. GOVERNMENT, AGENCY & INSTRUMENTALITY
OBLIGATIONS--NON-DISCOUNT (COST--$2,076,894) 2,081,279
- ------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS
(COST--$12,452,302)--103.2%............. 12,458,651
LIABILITIES IN EXCESS OF OTHER
ASSETS--(3.2%).......................... (381,661)
-----------
NET ASSETS--100.0%...................... $12,076,990
===========
- ------------------------------------------------------------------------------------------------------------------------
</Table>
* Commercial Paper and certain U.S. Government, Agency & Instrumentality
Obligations are traded on a discount basis; the interest rates shown reflect the
discount rates paid at the time of purchase by the Fund. Other securities bear
interest at the rates shown, payable at fixed dates or upon maturity. The
interest rates on variable rate securities are adjusted periodically based upon
appropriate indexes; the interest rates shown are the rates in effect at
December 31, 2002.
+ Variable rate notes.
See Notes to Financial Statements.
237
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--RESERVE ASSETS V.I. FUND
STATEMENT OF ASSETS AND LIABILITIES AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
ASSETS:
Investments, at value (identified cost--$12,452,302*)....... $12,458,651
Cash........................................................ 832
Interest receivable......................................... 28,952
Prepaid expenses............................................ 70
-----------
Total assets................................................ 12,488,505
-----------
- -------------------------------------------------------------------------------------
LIABILITIES:
Payables:
Securities purchased...................................... $399,847
Investment adviser........................................ 5,126
Capital shares redeemed................................... 950 405,923
--------
Accrued expenses............................................ 5,592
-----------
Total liabilities........................................... 411,515
-----------
- -------------------------------------------------------------------------------------
NET ASSETS.................................................. $12,076,990
===========
- -------------------------------------------------------------------------------------
NET ASSETS CONSIST OF:
Class A Shares of Common Stock, $.10 par value, 500,000,000
shares authorized+........................................ $ 1,207,064
Paid-in capital in excess of par............................ 10,863,577
Unrealized appreciation on investments--net................. 6,349
-----------
NET ASSETS.................................................. $12,076,990
===========
- -------------------------------------------------------------------------------------
NET ASSET VALUE:
Class A--Based on net assets of $12,076,990 and 12,070,641
shares outstanding........................................ $ 1.00
===========
- -------------------------------------------------------------------------------------
</Table>
* Cost for Federal income tax purposes. At December 31, 2002, net unrealized
appreciation for Federal income tax purposes amounted to $6,349, of which
$6,410 related to appreciated securities and $61 related to depreciated
securities.
+ The Fund is also authorized to issue 500,000,000 Class B Shares.
See Notes to Financial Statements.
238
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--RESERVE ASSETS V.I. FUND
STATEMENT OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
INVESTMENT INCOME:
Interest and discount earned................................ $273,736
- ---------------------------------------------------------------------------------
EXPENSES:
Investment advisory fees.................................... $67,330
Transfer agent fees......................................... 9,912
Professional fees........................................... 9,807
Custodian fees.............................................. 8,339
Accounting services......................................... 4,753
Printing and shareholder reports............................ 1,487
Registration fees........................................... 867
Directors' fees and expenses................................ 604
Pricing services............................................ 473
Other....................................................... 4,533
-------
Total expenses.............................................. 108,105
--------
Investment income--net...................................... 165,631
--------
- ---------------------------------------------------------------------------------
REALIZED & UNREALIZED GAIN (LOSS) ON INVESTMENTS--NET:
Realized gain on investments--net........................... 795
Change in unrealized appreciation on investments--net....... (9,827)
--------
Total realized and unrealized loss on investments--net...... (9,032)
--------
NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS........ $156,599
========
- ---------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
239
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--RESERVE ASSETS V.I. FUND
STATEMENTS OF CHANGES IN NET ASSETS
- --------------------------------------------------------------------------------
<Table>
<Caption>
FOR THE YEAR ENDED
DECEMBER 31,
--------------------------
INCREASE (DECREASE) IN NET ASSETS: 2002 2001
- ------------------------------------------------------------------------------------------
OPERATIONS:
Investment income--net...................................... $ 165,631 $ 612,812
Realized gain on investments--net........................... 795 3,112
Change in unrealized appreciation on investments--net....... (9,827) 14,503
----------- -----------
Net increase in net assets resulting from operations........ 156,599 630,427
----------- -----------
- ------------------------------------------------------------------------------------------
DIVIDENDS & DISTRIBUTIONS TO SHAREHOLDERS:
Investment income--net:
Class A................................................... (165,631) (612,812)
Realized gain on investments--net:
Class A................................................... (795) (3,112)
----------- -----------
Net decrease in net assets resulting from dividends and
distributions to shareholders............................. (166,426) (615,924)
----------- -----------
- ------------------------------------------------------------------------------------------
CLASS A CAPITAL SHARE TRANSACTIONS:
Net proceeds from sale of shares............................ 2,072,526 2,901,953
Net asset value of shares issued to shareholders in
reinvestment of dividends and distributions............... 166,431 615,918
----------- -----------
2,238,957 3,517,871
Cost of shares redeemed..................................... (5,043,133) (6,463,243)
----------- -----------
Net decrease in net assets derived from capital share
transactions.............................................. (2,804,176) (2,945,372)
----------- -----------
- ------------------------------------------------------------------------------------------
NET ASSETS:
Total decrease in net assets................................ (2,814,003) (2,930,869)
Beginning of year........................................... 14,890,993 17,821,862
----------- -----------
End of year................................................. $12,076,990 $14,890,993
=========== ===========
- ------------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
240
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--RESERVE ASSETS V.I. FUND
FINANCIAL HIGHLIGHTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
THE FOLLOWING PER SHARE DATA AND RATIOS HAVE BEEN DERIVED FROM
INFORMATION PROVIDED IN THE FINANCIAL STATEMENTS. CLASS A
---------------------------------------------------
FOR THE YEAR ENDED DECEMBER 31,
---------------------------------------------------
INCREASE (DECREASE) IN NET ASSET VALUE: 2002 2001 2000 1999 1998
- -------------------------------------------------------------------------------------------------------------------
PER SHARE OPERATING PERFORMANCE:
Net asset value, beginning of year........................... $ 1.00 $ 1.00 $ 1.00 $ 1.00 $ 1.00
------- ------- ------- ------- -------
Investment income--net....................................... .0122 .0371 .0574 .0464 .0496
Realized and unrealized gain (loss) on investments--net...... (.0006) .0011 .0008 (.0006) .0003
------- ------- ------- ------- -------
Total from investment operations............................. .0116 .0382 .0582 .0458 .0499
------- ------- ------- ------- -------
Less dividends and distributions:
Investment income--net..................................... (.0122) (.0371) (.0574) (.0464) (.0496)
Realized gain on investments--net.......................... (.0001) (.0002) -- (.0001) (.0003)
------- ------- ------- ------- -------
Total dividends and distributions............................ (.0123) (.0373) (.0574) (.0465) (.0499)
------- ------- ------- ------- -------
Net asset value, end of year................................. $ 1.00 $ 1.00 $ 1.00 $ 1.00 $ 1.00
======= ======= ======= ======= =======
- -------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENT RETURN:*
Based on net asset value per share........................... 1.23% 3.79% 5.86% 4.76% 5.10%
======= ======= ======= ======= =======
- -------------------------------------------------------------------------------------------------------------------
RATIOS TO AVERAGE NET ASSETS:
Expenses..................................................... .80% .78% .68% .65% .68%
======= ======= ======= ======= =======
Investment income and realized gain on investments--net...... 1.24% 3.79% 5.73% 4.66% 4.96%
======= ======= ======= ======= =======
- -------------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL DATA:
Net assets, end of year (in thousands)....................... $12,077 $14,891 $17,822 $20,933 $21,338
======= ======= ======= ======= =======
- -------------------------------------------------------------------------------------------------------------------
</Table>
*Total investment returns exclude insurance-related fees and expenses.
See Notes to Financial Statements.
241
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--RESERVE ASSETS V.I. FUND
NOTES TO FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
1. SIGNIFICANT ACCOUNTING POLICIES:
Merrill Lynch Variable Series Funds, Inc. (the "Company") is an open-end
management investment company that is comprised of 17 separate funds. Each fund
offers two classes of shares to the Merrill Lynch Life Insurance Company, ML
Life Insurance Company of New York (indirect, wholly-owned subsidiaries of
Merrill Lynch & Co., Inc. ("ML & Co.")), and other insurance companies that are
not affiliated with ML & Co., for their separate accounts to fund benefits under
certain variable annuity and variable life insurance contracts. Reserve Assets
V.I. Fund (the "Fund") (formerly Reserve Assets Fund) is classified as
"diversified," as defined in the Investment Company Act of 1940. Class A and
Class B Shares have equal voting, dividend, liquidation and other rights, except
that only shares of the respective classes are entitled to vote on matters
concerning only that class and Class B Shares bear certain expenses related to
the distribution of such shares. The Fund's financial statements are prepared in
conformity with accounting principles generally accepted in the United States of
America, which may require the use of management accruals and estimates. The
following is a summary of significant accounting policies followed by the Fund.
(a) Valuation of investments--Portfolio securities with remaining maturities
of greater than sixty days, for which market quotations are readily available,
are valued at market value. As securities transition from sixty-one to sixty
days to maturity, the difference between the valuation existing on the
sixty-first day before maturity and maturity value is amortized on a
straight-line basis to maturity. Securities maturing sixty days or less from
their date of acquisition are valued at amortized cost, which approximates
market value. For the purposes of valuation, the maturity of a variable rate
security is deemed to be the next coupon date on which the interest rate is to
be adjusted. Other investments for which market quotations are not available are
valued at their fair value as determined in good faith by or under the direction
of the Company's Board of Directors.
(b) Repurchase agreements--The Fund invests in U.S. government securities
pursuant to repurchase agreements. Under such agreements, the counterparty
agrees to repurchase the security at a mutually agreed upon time and price. The
Fund takes possession of the underlying securities, marks to market such
securities and, if necessary, receives additions to such securities daily to
ensure that the contract is fully collateralized. If the counterparty defaults
and the fair value of the collateral declines, liquidation of the collateral by
the Fund may be delayed or limited.
(c) Income taxes--It is the Fund's policy to comply with the requirements of
the Internal Revenue Code applicable to regulated investment companies and to
distribute all of its taxable income to its shareholders. Therefore, no Federal
income tax provision is required.
(d) Security transactions and investment income--Security transactions are
recorded on the dates the transactions are entered into (the trade dates).
Realized gains and losses on security transactions are determined on the
identified cost basis. Interest income is recognized on the accrual basis.
(e) Dividends and distributions--The Fund declares dividends daily and
reinvests monthly such dividends (net of non-resident alien tax and backup
withholding tax) in additional shares of beneficial interest at net asset value.
Dividends and distributions are declared from the total of net investment income
and net realized gain or loss on investments.
(f) Expenses--Certain expenses have been allocated to the individual funds in
the Company on a pro rata basis based upon the respective aggregate net asset
value of each fund included in the Company.
2. INVESTMENT ADVISORY AGREEMENT AND TRANSACTIONS WITH AFFILIATES:
The Company has entered into an Investment Advisory Agreement with Merrill Lynch
Investment Managers, L.P. ("MLIM"). The general partner of MLIM is Princeton
Services, Inc. ("PSI"), an indirect, wholly-owned subsidiary of ML & Co., which
is the limited partner.
MLIM is responsible for the management of the Company's funds and provides the
necessary personnel, facilities, equipment and certain other services necessary
to the operations of the Fund. For such services, the Fund pays a monthly fee at
the following annual rates: .500% of the Fund's average daily net assets not
exceeding $500 million; .425% of average daily net assets in excess of $500
million but not exceeding $750 million; .375% of average daily net assets in
excess of $750 million but not exceeding $1 billion; .350% of average daily net
assets in excess of $1 billion but not exceeding $1.5 billion; .325% of average
daily net assets in excess of $1.5 billion but not exceeding $2 bil-
242
- --------------------------------------------------------------------------------
lion; .300% of average daily net assets in excess of $2 billion but not
exceeding $2.5 billion and .275% of average daily net assets in excess of $2.5
billion.
MLIM and Merrill Lynch Life Agency, Inc. ("MLLA") have entered into an
agreement which limits the operating expenses paid by the Fund, exclusive of any
distribution fees imposed on Class B Shares, to 1.25% of its average daily net
assets. Any such expenses in excess of 1.25% of average daily net assets will be
reimbursed to the Fund by MLIM which, in turn, will be reimbursed by MLLA.
Financial Data Services, Inc. ("FDS"), a wholly-owned subsidiary of ML & Co.,
is the Company's transfer agent.
FAM Distributors, Inc. ("FAMD"), which is a wholly-owned subsidiary of Merrill
Lynch Group, Inc., is the Fund's distributor.
For the year ended December 31, 2002, the Fund reimbursed MLIM $461 for
certain accounting services.
Certain officers and/or directors of the Company are officers and/or directors
of MLIM, PSI, FDS, FAMD, and/or ML & Co.
3. CAPITAL SHARE TRANSACTIONS:
The number of shares sold, reinvested and redeemed during the years corresponds
to the amounts included in the Statements of Changes in Net Assets for net
proceeds from sale of shares, value of shares reinvested and cost of shares
redeemed, respectively, since shares are recorded at $1.00 per share.
4. DISTRIBUTIONS TO SHAREHOLDERS:
The tax character of distributions paid during the fiscal years ended December
31, 2002 and December 31, 2001 was as follows:
<Table>
<Caption>
- -------------------------------------------------------------------
12/31/2002 12/31/2001
- -------------------------------------------------------------------
Distributions paid from:
Ordinary income.......................... $166,426 $615,924
-------- --------
Total taxable distributions............... $166,426 $615,924
======== ========
- -------------------------------------------------------------------
</Table>
As of December 31, 2002, there were no significant differences between the book
and tax components of net assets.
243
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--RESERVE ASSETS V.I. FUND
INDEPENDENT AUDITORS' REPORT
- --------------------------------------------------------------------------------
THE BOARD OF DIRECTORS AND SHAREHOLDERS,
RESERVE ASSETS V.I. FUND OF
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.:
We have audited the accompanying statement of assets and liabilities,
including the schedule of investments, of Reserve Assets V.I. Fund (formerly,
Reserve Assets Fund) of Merrill Lynch Variable Series Funds, Inc. as of December
31, 2002, the related statements of operations for the year then ended and
changes in net assets for each of the years in the two-year period then ended,
and the financial highlights for each of the years presented. These financial
statements and the financial highlights are the responsibility of the Fund's
management. Our responsibility is to express an opinion on these financial
statements and the financial highlights based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements and the financial highlights are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. Our procedures included confirmation of
securities owned at December 31, 2002 by correspondence with the custodian and
brokers; where replies were not received from brokers, we performed other
auditing procedures. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such financial statements and financial highlights present
fairly, in all material respects, the financial position of Reserve Assets V.I.
Fund of Merrill Lynch Variable Series Funds, Inc. as of December 31, 2002, the
results of its operations, the changes in its net assets, and the financial
highlights for the respective stated periods in conformity with accounting
principles generally accepted in the United States of America.
Deloitte & Touche LLP
Princeton, New Jersey
February 14, 2003
244
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--SMALL CAP VALUE V.I. FUND
DECEMBER 31, 2002--ANNUAL REPORT
- --------------------------------------------------------------------------------
DEAR SHAREHOLDER:
FISCAL YEAR IN REVIEW
For the year ended December 31, 2002, Small Cap Value V.I. Fund slightly
underperformed the unmanaged benchmark Russell 2000 Index. The Fund's Class A
and Class B Shares had total returns of -23.76% and -23.86%, respectively,
compared to a return of -20.48% for the Russell 2000 Index.
The downward trend in equity markets gained momentum during the year as the
Russell 2000 Index posted its worst performance since the Index was created in
1979. After outperforming during the first half of the year ended December 31,
2002, small-capitalization stocks declined sharply and underperformed
large-capitalization stocks in the second half of the year. For the 12-month
period, the Russell 2000 Index surpassed the Standard & Poor's 500 Index by 162
basis points (1.62%). The differential between value and growth was even more
extreme with small cap value significantly outperforming small cap growth. The
growth-oriented stocks in the Russell 2000 Index did stage an impressive fourth
quarter rally as interest rate cuts by the Federal Reserve Board and optimism
regarding an economic stimulus package fueled a rebound that lost steam in
December 2002.
During 2002, only the financial services sector posted positive absolute
performance within the Russell 2000 Index, the other nine sectors all delivered
losses. Information technology and health care posted the steepest declines
within the Index, down 46% and 38%, respectively, while the financial and energy
sectors performed the best, with returns of +5% and -8%, respectively. The Fund
slightly underperformed the Russell 2000 Index as a result of poor sector
positioning. The Fund was overweighted in the poor-performing technology sector
and underweighted in the better-performing financial sector. Specific stock
selection had a negligible impact on performance and individual stocks performed
approximately in line with comparable companies in the benchmark Index.
Individual stocks that most benefited the Fund's annual results included
shares of XTO Energy, Inc., The Men's Wearhouse, Inc. and WebMD Corporation.
Shares of XTO Energy, a producer of natural gas, performed favorably as energy
prices surged on fears regarding a military conflict with Iraq. The Men's
Wearhouse, Inc., a retailer of men's tailored clothing, rallied from depressed
levels as spending on men's apparel surpassed analysts' estimates. We
significantly reduced the Fund's position in The Men's Wearhouse on stock price
strength given our belief that spending levels would prove unsustainable. Shares
of WebMD gained 21% during the year as revenue growth accelerated and the
company attained profitability. We realized capital gains in WebMD and
substantially reduced the size of the Fund's investment position toward the end
of the year.
Stocks that most detracted from the Fund's performance during the year were
all in the technology sector. They included shares of Vignette Corporation,
Parametric Technology Corporation and Liberate Technologies, Inc. We are
committed to the Fund's investments in Vignette Corporation and Parametric
Technology. Both companies have a sizeable base of corporate customers, generate
significant revenues, have net cash on the balance sheet and are expected to
return to profitability even without help from a rebound in corporate spending
on information technology. When the economy eventually rebounds, we believe
these companies should experience an even greater boost. Liberate Technologies,
a software platform provider for cable and interactive television customers,
experienced an abrupt slowdown in its end markets. We continue to hold a small
position in the stock based on the company's strong balance sheet.
The Fund began the year 2002 significantly overweighted in the technology
sector compared to the Russell 2000 Index. Performance of the Fund's technology
holdings was approximately in line with comparable companies in the Russell 2000
Index. However, being overweighted in an underperforming sector detracted from
the Fund's performance. The Fund began the year underweighted in the financial
services, utilities and telecommunication sectors. Financial stocks were the
best-performing sector within the Russell 2000 Index and the Fund's
underweighting in this area had an adverse effect on relative performance for
the year ended December 31, 2002. The downward movement in interest rates in
2002 supported the sector's favorable relative results. We remain underweighted
in the financial sector because there are few financial stocks that meet our
out-of-favor valuation criteria.
IN CONCLUSION
The Fund produced negative returns in 2002, performing slightly below the
Russell 2000 Index. Although we are disappointed with the
245
- --------------------------------------------------------------------------------
Fund's annual results, we remain committed to our research-intensive process of
investing in out-of-favor small cap stocks. Over three-year and five-year time
periods, this process has generated above-market returns, and we believe that
short-term volatility in the markets can provide attractive longer-term
opportunities.
We thank you for your continued investment in Small Cap Value V.I. Fund, and
we look forward to reviewing our outlook and strategy with you again in our next
report to shareholders.
Sincerely,
/s/ Terry K. Glenn
Terry K. Glenn
President and Director
/s/ R. Elise Baum
R. Elise Baum
Senior Vice President and Portfolio Manager
January 17, 2003
246
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--SMALL CAP VALUE V.I. FUND
TOTAL RETURN BASED ON A $10,000 INVESTMENT--CLASS A AND CLASS B SHARES
- --------------------------------------------------------------------------------
<Table>
<Caption>
SMALL CAP VALUE V.I. FUND+--
CLASS A SHARES* RUSSELL 2000 INDEX++
---------------------------- --------------------
12/92 10000.00 10000.00
12/93 11778.00 11888.00
12/94 10922.00 11671.00
12/95 15935.00 14991.00
12/96 17227.00 17464.00
12/97 19246.00 21369.00
12/98 17995.00 20825.00
12/99 24140.00 25252.00
12/00 27701.00 24489.00
12/01 35995.00 25098.00
12/02 27443.00 19957.00
</Table>
<Table>
<Caption>
SMALL CAP VALUE V.I. FUND+--
CLASS B SHARES* RUSSELL 2000 INDEX++
---------------------------- --------------------
10/23/97** 10000.00 10000.00
12/97 8882.00 10109.00
12/98 8303.00 9852.00
12/99 11125.00 11946.00
12/00 12746.00 11585.00
12/01 16534.00 11873.00
12/02 12589.00 9441.00
</Table>
* Assuming transaction costs and other operating expenses, including advisory
fees. Does not include insurance-related fees and expenses.
** Commencement of operations.
+ The Fund invests primarily in common stocks of small companies and emerging
growth companies that Fund management believes have special investment value.
++ This unmanaged Index is comprised of approximately 2,000
smaller-capitalization common stocks from various industrial sectors. The
starting date for the Index in the Class B Shares' graph is from 10/31/97.
Past results shown should not be considered a representation of future
performance.
]
247
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--SMALL CAP VALUE V.I. FUND
AVERAGE ANNUAL TOTAL RETURN--CLASS A SHARES*
- --------------------------------------------------------------------------------
PERIOD COVERED % RETURN
- --------------------------------------------------------------------------------
One Year Ended 12/31/02 -23.76%
- --------------------------------------------------------------------------------
Five Years Ended 12/31/02 + 7.34
- --------------------------------------------------------------------------------
Ten Years Ended 12/31/02 +10.62
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--SMALL CAP VALUE V.I. FUND
AVERAGE ANNUAL TOTAL RETURN--CLASS B SHARES*
- --------------------------------------------------------------------------------
PERIOD COVERED % RETURN
- --------------------------------------------------------------------------------
One Year Ended 12/31/02 -23.86%
- --------------------------------------------------------------------------------
Five Years Ended 12/31/02 + 7.22
- --------------------------------------------------------------------------------
Inception (10/23/97) through 12/31/02 + 4.53
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--SMALL CAP VALUE V.I. FUND
RECENT PERFORMANCE RESULTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
6-MONTH 12-MONTH
AS OF DECEMBER 31, 2002 TOTAL RETURN TOTAL RETURN
- -----------------------------------------------------------------------------------------
Class A Shares* -16.10% -23.76%
- -----------------------------------------------------------------------------------------
Class B Shares* -16.13 -23.86
- -----------------------------------------------------------------------------------------
Russell 2000 Index** -16.56 -20.48
- -----------------------------------------------------------------------------------------
</Table>
* Total investment returns are based on changes in net asset values for the
periods shown, and assume reinvestment of all dividends and capital gains
distributions at net asset value on the ex-dividend date. Insurance-related fees
and expenses are not reflected in these returns.
** This unmanaged Index is comprised of approximately 2,000
smaller-capitalization common stocks from various industrial sectors.
Past results shown should not be considered a representation of future
performance.
248
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--SMALL CAP VALUE V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
INDUSTRY++ HELD COMMON STOCKS VALUE NET ASSETS
- ----------------------------------------------------------------------------------------------------------------------
AEROSPACE & DEFENSE 142,300 Precision Castparts Corp.................. $ 3,450,775 0.7%
251,500 +Triumph Group, Inc....................... 8,032,910 1.7
------------ -----
11,483,685 2.4
- ----------------------------------------------------------------------------------------------------------------------
AIR FREIGHT & LOGISTICS 330,500 CNF Transportation Inc. .................. 10,985,820 2.3
46,300 UTI Worldwide, Inc........................ 1,203,800 0.3
------------ -----
12,189,620 2.6
- ----------------------------------------------------------------------------------------------------------------------
AUTO COMPONENTS 359,700 Intermet Corporation...................... 1,456,785 0.3
58,200 +Keystone Automotive Industries, Inc. .... 874,164 0.2
218,200 +Shiloh Industries, Inc. ................. 464,766 0.1
------------ -----
2,795,715 0.6
- ----------------------------------------------------------------------------------------------------------------------
BANKS 199,700 Bank of Hawaii Corporation................ 6,068,883 1.3
367,100 Banknorth Group, Inc. .................... 8,296,460 1.7
268,551 Charter One Financial, Inc. .............. 7,715,470 1.6
181,400 The Colonial BancGroup, Inc. ............. 2,164,102 0.5
247,400 Compass Bancshares, Inc. ................. 7,713,932 1.6
282,000 First Midwest Bancorp, Inc. .............. 7,501,200 1.6
445,400 Sovereign Bancorp, Inc. .................. 6,257,870 1.3
------------ -----
45,717,917 9.6
- ----------------------------------------------------------------------------------------------------------------------
BIOTECHNOLOGY 170,000 +Applera Corporation--Celera Genomics
Group................................... 1,623,500 0.3
274,700 +Diversa Corporation...................... 2,475,047 0.5
367,500 +Incyte Genomics, Inc. ................... 1,653,750 0.4
155,000 +Isis Pharmaceuticals, Inc. .............. 1,016,800 0.2
261,800 +Maxygen Inc. ............................ 1,987,062 0.4
392,800 +Medarex, Inc. ........................... 1,551,560 0.3
106,900 +Vertex Pharmaceuticals Incorporated...... 1,693,296 0.4
441,400 +Vical Incorporated....................... 1,522,830 0.3
------------ -----
13,523,845 2.8
- ----------------------------------------------------------------------------------------------------------------------
BUILDING PRODUCTS 146,500 ElkCorp................................... 2,534,450 0.5
- ----------------------------------------------------------------------------------------------------------------------
COMMERCIAL SERVICES & 192,800 +Ambassadors International, Inc. ......... 1,733,272 0.4
SUPPLIES
390,100 +Convergys Corporation.................... 5,910,015 1.2
875,800 +EXE Technologies, Inc. .................. 455,416 0.1
63,100 G & K Services, Inc. (Class A)............ 2,233,740 0.5
118,055 +On Assignment, Inc. ..................... 1,007,009 0.2
51,800 +PRG-Schultz International, Inc. ......... 458,948 0.1
90,800 +Sabre Holdings Corporation............... 1,644,388 0.3
193,600 +Valassis Communications, Inc. ........... 5,697,648 1.2
------------ -----
19,140,436 4.0
- ----------------------------------------------------------------------------------------------------------------------
COMMUNICATIONS EQUIPMENT 319,398 +Arris Group Inc. ........................ 1,124,281 0.3
898,400 +Aspect Communications Corporation........ 2,533,488 0.5
165,400 +Com21, Inc. ............................. 34,734 0.0
569,007 +Proxim Corporation (Class A)............. 495,036 0.1
------------ -----
4,187,539 0.9
- ----------------------------------------------------------------------------------------------------------------------
COMPUTERS & PERIPHERALS 87,700 +Electronics for Imaging, Inc. ........... 1,426,002 0.3
520,200 +Maxtor Corporation....................... 2,632,212 0.6
------------ -----
4,058,214 0.9
- ----------------------------------------------------------------------------------------------------------------------
CONSTRUCTION & ENGINEERING 61,600 Fluor Corporation......................... 1,724,800 0.4
- ----------------------------------------------------------------------------------------------------------------------
CONSTRUCTION MATERIALS 169,500 Martin Marietta Materials, Inc. .......... 5,196,870 1.1
- ----------------------------------------------------------------------------------------------------------------------
CONTAINERS & PACKAGING 46,500 Rock-Tenn Company (Class A)............... 626,820 0.1
346,100 +Smurfit-Stone Container Corporation...... 5,323,018 1.1
------------ -----
5,949,838 1.2
- ----------------------------------------------------------------------------------------------------------------------
DIVERSIFIED FINANCIALS 6,600 Chicago Mercantile Exchange............... 288,156 0.0
95,200 iShares Russell 2000 Index Fund........... 7,225,680 1.5
2,739,800 +Knight Trading Group, Inc. .............. 13,315,428 2.8
</Table>
249
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--SMALL CAP VALUE V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
INDUSTRY++ HELD COMMON STOCKS VALUE NET ASSETS
- ----------------------------------------------------------------------------------------------------------------------
DIVERSIFIED FINANCIALS 68,600 S&P 500 Depositary Receipts(a)............ $ 6,056,694 1.3%
(CONCLUDED)
88,700 S&P Mid Cap 400 Depositary Receipts(b).... 6,976,255 1.5
------------ -----
33,862,213 7.1
- ----------------------------------------------------------------------------------------------------------------------
ELECTRICAL EQUIPMENT 449,200 +Global Power Equipment Group Inc. ....... 2,214,556 0.5
397,900 +Paxar Corporation........................ 5,869,025 1.2
------------ -----
8,083,581 1.7
- ----------------------------------------------------------------------------------------------------------------------
ELECTRONIC EQUIPMENT & 268,700 +Nu Horizons Electronics Corp. ........... 1,531,590 0.3
INSTRUMENTS
1,783,400 Symbol Technologies, Inc. ................ 14,659,548 3.1
132,600 +Tech Data Corporation.................... 3,573,570 0.8
------------ -----
19,764,708 4.2
- ----------------------------------------------------------------------------------------------------------------------
ENERGY EQUIPMENT & SERVICES 162,500 +BJ Services Company...................... 5,250,375 1.1
129,200 Diamond Offshore Drilling, Inc. .......... 2,823,020 0.6
210,700 +FMC Technologies, Inc. .................. 4,304,601 0.9
21,700 Halliburton Company....................... 406,007 0.1
337,400 +Key Energy Services, Inc. ............... 3,026,478 0.6
130,800 +National-Oilwell, Inc. .................. 2,856,672 0.6
------------ -----
18,667,153 3.9
- ----------------------------------------------------------------------------------------------------------------------
FOOD PRODUCTS 133,200 +Chiquita Brands International, Inc. ..... 1,766,232 0.4
261,300 Corn Products International, Inc. ........ 7,872,969 1.7
133,096 +Dean Foods Company....................... 4,937,862 1.0
410,600 +Smithfield Foods, Inc. .................. 8,146,304 1.7
------------ -----
22,723,367 4.8
- ----------------------------------------------------------------------------------------------------------------------
HEALTH CARE EQUIPMENT & 148,600 Bausch & Lomb Incorporated................ 5,349,600 1.1
SUPPLIES
67,900 C.R. Bard, Inc. .......................... 3,938,200 0.8
12,600 +Closure Medical Corporation.............. 132,678 0.0
334,300 +Intuitive Surgical, Inc. ................ 2,045,916 0.5
25,800 Mentor Corporation........................ 990,720 0.2
------------ -----
12,457,114 2.6
- ----------------------------------------------------------------------------------------------------------------------
HEALTH CARE PROVIDERS & 40,900 +Caremark Rx, Inc. ....................... 664,625 0.1
SERVICES
571,600 Hooper Holmes, Inc. ...................... 3,509,624 0.7
174,500 IMS Health Incorporated................... 2,792,000 0.6
84,300 +MAXIMUS, Inc............................. 2,200,230 0.5
54,800 Owens & Minor, Inc. ...................... 899,816 0.2
675,000 +Quintiles Transnational Corp. ........... 8,160,750 1.7
537,800 +WebMD Corporation........................ 4,598,190 1.0
------------ -----
22,825,235 4.8
- ----------------------------------------------------------------------------------------------------------------------
HOTELS, RESTAURANTS & 183,900 +Ambassadors Group, Inc. ................. 2,372,310 0.5
LEISURE
201,000 Dover Downs Gaming & Entertainment,
Inc. ................................... 1,827,090 0.4
300,400 Dover Motorsports, Inc. .................. 1,396,860 0.3
96,900 +Jack in the Box Inc. .................... 1,675,401 0.3
348,800 Outback Steakhouse, Inc. ................. 12,012,672 2.5
------------ -----
19,284,333 4.0
- ----------------------------------------------------------------------------------------------------------------------
HOUSEHOLD DURABLES 221,200 +Furniture Brands International, Inc. .... 5,275,620 1.1
- ----------------------------------------------------------------------------------------------------------------------
IT CONSULTING & SERVICES 225,400 +American Management Systems,
Incorporated............................ 2,682,260 0.6
185,100 +Sykes Enterprises, Incorporated.......... 607,128 0.1
------------ -----
3,289,388 0.7
- ----------------------------------------------------------------------------------------------------------------------
INSURANCE 17,000 American National Insurance Company....... 1,388,900 0.3
346,400 Protective Life Corporation............... 9,532,928 2.0
------------ -----
10,921,828 2.3
- ----------------------------------------------------------------------------------------------------------------------
INTERNET & CATALOG RETAIL 30,700 +Coldwater Creek Inc. .................... 589,440 0.1
198,600 +Insight Enterprises, Inc. ............... 1,650,366 0.4
------------ -----
2,239,806 0.5
- ----------------------------------------------------------------------------------------------------------------------
</Table>
250
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--SMALL CAP VALUE V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONTINUED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
INDUSTRY++ HELD COMMON STOCKS VALUE NET ASSETS
- ----------------------------------------------------------------------------------------------------------------------
INTERNET SOFTWARE & SERVICES 326,400 +Commerce One, Inc. ...................... $ 881,280 0.2%
820,900 +DoubleClick Inc. ........................ 4,646,294 1.0
1,060,600 +EarthLink, Inc. ......................... 5,748,452 1.2
3,696,400 +Vignette Corporation..................... 4,472,644 0.9
446,000 +Vitria Technology, Inc. ................. 325,580 0.1
------------ -----
16,074,250 3.4
- ----------------------------------------------------------------------------------------------------------------------
MACHINERY 89,200 +BHA Group Holdings, Inc. ................ 1,517,292 0.3
208,100 Kaydon Corp. ............................. 4,413,801 0.9
239,400 Reliance Steel & Aluminum Co. ............ 4,989,096 1.1
305,800 +Wolverine Tube, Inc. .................... 1,746,118 0.4
------------ -----
12,666,307 2.7
- ----------------------------------------------------------------------------------------------------------------------
MEDIA 262,100 +APAC Customer Services Inc. ............. 602,830 0.1
145,900 Harte-Hanks, Inc. ........................ 2,723,953 0.6
894,900 +Paxson Communications Corporation........ 1,843,494 0.4
194,800 The Reader's Digest Association, Inc.
(Class A)............................... 2,941,480 0.6
------------ -----
8,111,757 1.7
- ----------------------------------------------------------------------------------------------------------------------
METALS & MINING 135,400 +A.M. Castle & Company.................... 616,070 0.1
140,700 Gibraltar Steel Corporation............... 2,678,928 0.6
129,000 Quanex Corporation........................ 4,321,500 0.9
279,376 Ryerson Tull, Inc. ....................... 1,704,194 0.3
155,300 +Zemex Corporation........................ 782,712 0.2
------------ -----
10,103,404 2.1
- ----------------------------------------------------------------------------------------------------------------------
OIL & GAS 84,800 Burlington Resources Inc. ................ 3,616,720 0.8
16,700 +Evergreen Resources, Inc. ............... 748,995 0.1
201,600 Noble Energy, Inc. ....................... 7,570,080 1.6
165,000 +Plains Exploration & Production
Company................................. 1,608,750 0.3
165,000 +Plains Resources Inc. ................... 1,955,250 0.4
69,007 +Stone Energy Corporation................. 2,302,074 0.5
131,800 +Tom Brown, Inc. ......................... 3,308,180 0.7
65,000 Vintage Petroleum, Inc. .................. 685,750 0.1
166,600 XTO Energy, Inc. ......................... 4,115,020 0.9
------------ -----
25,910,819 5.4
- ----------------------------------------------------------------------------------------------------------------------
PAPER & FOREST PRODUCTS 303,800 Boise Cascade Corporation................. 7,661,836 1.6
257,100 +Mercer International, Inc. .............. 1,360,059 0.3
------------ -----
9,021,895 1.9
- ----------------------------------------------------------------------------------------------------------------------
REAL ESTATE 129,800 Brandywine Reality Trust.................. 2,830,938 0.6
68,800 Camden Property Trust..................... 2,270,400 0.5
74,100 Crescent Real Estate Equities Company..... 1,233,024 0.2
726,800 +La Quinta Corporation.................... 3,197,920 0.7
263,600 Trizec Properties, Inc. .................. 2,475,204 0.5
------------ -----
12,007,486 2.5
- ----------------------------------------------------------------------------------------------------------------------
SEMICONDUCTOR EQUIPMENT & 122,300 +ATMI, Inc. .............................. 2,246,651 0.4
PRODUCTS
213,500 +AXT, Inc. ............................... 384,300 0.1
172,400 +Actel Corp. ............................. 2,789,432 0.6
207,774 +IXYS Corporation......................... 1,460,651 0.3
------------ -----
6,881,034 1.4
- ----------------------------------------------------------------------------------------------------------------------
SOFTWARE 234,200 +Agile Software Corporation............... 1,812,708 0.4
886,300 +Ascential Software Corporation........... 2,127,120 0.4
151,700 +Aspen Technology, Inc. .................. 424,760 0.1
198,900 +Clarus Corporation....................... 1,115,829 0.2
1,558,250 +E.piphany, Inc. ......................... 6,419,990 1.3
512,600 +Entrust Technologies Inc. ............... 1,722,336 0.4
372,300 +FileNET Corporation...................... 4,530,891 1.0
602,800 +i2 Technologies, Inc. ................... 687,192 0.1
172,644 +InterVoice-Brite, Inc. .................. 366,005 0.1
</Table>
251
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--SMALL CAP VALUE V.I. FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONCLUDED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
INDUSTRY++ HELD COMMON STOCKS VALUE NET ASSETS
- ----------------------------------------------------------------------------------------------------------------------
SOFTWARE (CONCLUDED) 285,500 +Legato Systems, Inc. .................... $ 1,421,790 0.3%
1,535,500 +Liberate Technologies, Inc. ............. 2,211,120 0.5
545,800 +Nuance Communications Inc. .............. 1,337,210 0.3
3,098,700 +Parametric Technology Corporation........ 7,777,737 1.6
175,300 +QRS Corporation.......................... 1,125,426 0.2
77,700 +RSA Security Inc. ....................... 461,538 0.1
130,100 +Transaction Systems Architects, Inc.
(Class A)............................... 845,650 0.2
------------ -----
34,387,302 7.2
- ----------------------------------------------------------------------------------------------------------------------
SPECIALTY RETAIL 285,300 +American Eagle Outfitters, Inc. ......... 3,914,316 0.8
153,000 +Charlotte Russe Holding Inc. ............ 1,623,330 0.3
551,300 Foot Locker, Inc. ........................ 5,788,650 1.2
93,900 +Linens 'n Things, Inc. .................. 2,122,140 0.4
215,000 +The Men's Wearhouse, Inc. ............... 3,687,250 0.8
198,600 The Talbots, Inc. ........................ 5,467,458 1.2
267,400 +United Rentals, Inc. .................... 2,877,224 0.6
------------ -----
25,480,368 5.3
- ----------------------------------------------------------------------------------------------------------------------
TEXTILES, APPAREL & LUXURY 496,900 +Unifi, Inc. ............................. 2,608,725 0.6
GOODS
- ----------------------------------------------------------------------------------------------------------------------
TRADING COMPANIES & 172,350 Applied Industrial Technologies, Inc. .... 3,257,415 0.7
DISTRIBUTORS
503,200 +Watsco, Inc. ............................ 8,242,416 1.7
------------ -----
11,499,831 2.4
- ----------------------------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS (COST--$577,970,483) 482,650,453 101.3
- ----------------------------------------------------------------------------------------------------------------------
<Caption>
PARTNERSHIP
INTEREST SHORT-TERM SECURITIES
- ----------------------------------------------------------------------------------------------------------------------
$27,637,071 Merrill Lynch Liquidity Series, LLC Cash
Sweep Series II(c)...................... 27,637,071 5.8
- ----------------------------------------------------------------------------------------------------------------------
TOTAL SHORT-TERM SECURITIES
(COST--$27,637,071) 27,637,071 5.8
- ----------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS (COST--$605,607,554).... 510,287,524 107.1
LIABILITIES IN EXCESS OF OTHER ASSETS..... (33,836,063) (7.1)
------------ -----
NET ASSETS................................ $476,451,461 100.0%
============ =====
- ----------------------------------------------------------------------------------------------------------------------
</Table>
+ Non-income producing security.
++ For Fund compliance purposes, "Industry" means any one or more of the
industry sub-classifications used by one or more widely recognized market
indexes or ratings group indexes, and/or as defined by Fund management. This
definition may not apply for purposes of this report, which may combine such
industry sub-classifications for reporting ease. These industry classifications
are unaudited.
(a) Represents ownership in S&P 500 SPDR Trust, a registered unit investment
trust. The investment objective of S&P 500 SPDR Trust is to provide investment
results that generally correspond to the price and yield performance of the
component stocks of the S&P 500 Index.
(b) Represents ownership in Mid Cap S&P 500 SPDR Trust, a registered unit
investment trust. The investment objective of the Mid Cap SPDR Trust is to
provide investment results that generally correspond to the price performance
and dividend yield of the component stocks of the S&P Mid Cap 400 Index.
(c) Investments in companies considered to be an affiliate of the Fund (such
companies are defined as "Affiliated Companies" in Section 2(a)(3) of the
Investment Company Act of 1940) are as follows:
<Table>
<Caption>
- ---------------------------------------------------------------------------------------------------
INTEREST
AFFILIATE NET ACTIVITY NET COST INCOME
- ---------------------------------------------------------------------------------------------------
Merrill Lynch Liquidity Series, LLC Cash Sweep Series II.... $27,637,071 $27,637,071 $44,781
- ---------------------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
252
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--SMALL CAP VALUE V.I. FUND
STATEMENT OF ASSETS AND LIABILITIES AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
ASSETS:
Investments, at value (including securities loaned of
$81,789,867) (identified cost--$605,607,554).............. $ 510,287,524
Investments held as collateral for loaned securities, at
value..................................................... 85,056,251
Cash........................................................ 12,457
Receivables:
Securities sold........................................... $ 1,903,944
Dividends................................................. 445,682
Capital shares sold....................................... 136,873
Interest.................................................. 33,403
Loaned securities income.................................. 6,161 2,526,063
------------
Prepaid expenses............................................ 4,060
-------------
Total assets................................................ 597,886,355
-------------
- ------------------------------------------------------------------------------------------
LIABILITIES:
Collateral on securities loaned, at value................... 85,056,251
Payables:
Capital shares redeemed................................... 35,978,402
Investment adviser........................................ 345,364
Distributor............................................... 2,173 36,325,939
------------
Accrued expenses............................................ 52,704
-------------
Total liabilities........................................... 121,434,894
-------------
- ------------------------------------------------------------------------------------------
NET ASSETS.................................................. $ 476,451,461
=============
- ------------------------------------------------------------------------------------------
NET ASSETS CONSIST OF:
Class A Shares of Common Stock, $.10 par value, 100,000,000
shares authorized......................................... $ 2,544,246
Class B Shares of Common Stock, $.10 par value, 100,000,000
shares authorized......................................... 89,462
Paid-in capital in excess of par............................ 577,965,974
Accumulated distributions in excess of realized capital
gains on investments--net................................. $ (8,828,191)
Unrealized depreciation on investments--net................. (95,320,030)
------------
Total accumulated losses--net............................... (104,148,221)
-------------
NET ASSETS.................................................. $ 476,451,461
=============
- ------------------------------------------------------------------------------------------
NET ASSET VALUE:
Class A--Based on net assets of $460,279,541 and 25,442,463
shares outstanding........................................ $ 18.09
=============
Class B--Based on net assets of $16,171,920 and 894,622
shares outstanding........................................ $ 18.08
=============
- ------------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
253
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--SMALL CAP VALUE V.I. FUND
STATEMENT OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
INVESTMENT INCOME:
Dividends................................................... $ 3,717,314
Interest.................................................... 898,259
Securities lending--net..................................... 155,482
-------------
Total income................................................ 4,771,055
-------------
- ----------------------------------------------------------------------------------------
EXPENSES:
Investment advisory fees.................................... $4,871,394
Accounting services......................................... 227,064
Transfer agent fees......................................... 103,354
Professional fees........................................... 84,379
Custodian fees.............................................. 73,466
Printing and shareholder reports............................ 66,560
Distribution fees--Class B.................................. 31,646
Directors' fees and expenses................................ 28,649
Registration fees........................................... 867
Pricing services............................................ 835
Other....................................................... 23,404
----------
Total expenses.............................................. 5,511,618
-------------
Investment loss--net........................................ (740,563)
-------------
- ----------------------------------------------------------------------------------------
REALIZED & UNREALIZED GAIN (LOSS) ON INVESTMENTS--NET:
Realized gain on investments--net........................... 16,091,975
Change in unrealized appreciation/depreciation on
investments--net.......................................... (196,782,654)
-------------
Total realized and unrealized loss on investments--net...... (180,690,679)
-------------
NET DECREASE IN NET ASSETS RESULTING FROM OPERATIONS........ $(181,431,242)
=============
- ----------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
254
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--SMALL CAP VALUE V.I. FUND
STATEMENTS OF CHANGES IN NET ASSETS
- --------------------------------------------------------------------------------
<Table>
<Caption>
FOR THE YEAR ENDED
DECEMBER 31,
-----------------------------
INCREASE (DECREASE) IN NET ASSETS: 2002 2001
- ---------------------------------------------------------------------------------------------
OPERATIONS:
Investment income (loss)--net............................... $ (740,563) $ 1,799,991
Realized gain on investments--net........................... 16,091,975 41,875,522
Change in unrealized appreciation/depreciation on
investments--net.......................................... (196,782,654) 137,654,589
------------- ------------
Net increase (decrease) in net assets resulting from
operations................................................ (181,431,242) 181,330,102
------------- ------------
- ---------------------------------------------------------------------------------------------
DIVIDENDS & DISTRIBUTIONS TO SHAREHOLDERS:
Investment income--net:
Class A................................................... -- (1,778,118)
Class B................................................... -- (34,932)
Realized gain on investments--net:
Class A................................................... (31,491,346) (49,047,754)
Class B................................................... (1,010,341) (1,363,993)
------------- ------------
Net decrease in net assets resulting from dividends and
distributions to shareholders............................. (32,501,687) (52,224,797)
------------- ------------
- ---------------------------------------------------------------------------------------------
CAPITAL SHARE TRANSACTIONS:
Net increase (decrease) in net assets derived from capital
share transactions........................................ (82,203,834) 42,248,953
------------- ------------
- ---------------------------------------------------------------------------------------------
NET ASSETS:
Total increase (decrease) in net assets..................... (296,136,763) 171,354,258
Beginning of year........................................... 772,588,224 601,233,966
------------- ------------
End of year................................................. $ 476,451,461 $772,588,224
============= ============
- ---------------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
255
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--SMALL CAP VALUE V.I. FUND
FINANCIAL HIGHLIGHTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
THE FOLLOWING PER SHARE DATA AND RATIOS HAVE
BEEN DERIVED FROM INFORMATION PROVIDED IN THE CLASS A
FINANCIAL STATEMENTS. ----------------------------------------------------------
FOR THE YEAR ENDED DECEMBER 31,
----------------------------------------------------------
INCREASE (DECREASE) IN NET ASSET VALUE: 2002 2001 2000 1999 1998
- -------------------------------------------------------------------------------------------------------------------------
PER SHARE OPERATING PERFORMANCE:
Net asset value, beginning of year......................... $ 25.08 $ 20.78 $ 23.35 $ 19.95 $ 27.75
-------- -------- -------- -------- --------
Investment income (loss)--net+............................. (.02) .06 .07 .06 .03
Realized and unrealized gain (loss) on investments--net.... (5.84) 6.01 3.30 6.03 (1.41)
-------- -------- -------- -------- --------
Total from investment operations........................... (5.86) 6.07 3.37 6.09 (1.38)
-------- -------- -------- -------- --------
Less dividends and distributions:
Investment income--net................................... -- (.06) (.07) (.09) (.09)
In excess of investment income--net...................... -- -- --++ (.01) --
Realized gain on investments--net........................ (1.13) (1.71) (5.87) (2.59) (6.33)
-------- -------- -------- -------- --------
Total dividends and distributions.......................... (1.13) (1.77) (5.94) (2.69) (6.42)
-------- -------- -------- -------- --------
Net asset value, end of year............................... $ 18.09 $ 25.08 $ 20.78 $ 23.35 $ 19.95
======== ======== ======== ======== ========
- -------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENT RETURN:*
Based on net asset value per share......................... (23.76%) 29.94% 14.75% 34.15% (6.50%)
======== ======== ======== ======== ========
- -------------------------------------------------------------------------------------------------------------------------
RATIOS TO AVERAGE NET ASSETS:
Expenses................................................... .84% .83% .81% .81% .81%
======== ======== ======== ======== ========
Investment income (loss)--net.............................. (.11%) .26% .28% .32% .13%
======== ======== ======== ======== ========
- -------------------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL DATA:
Net assets, end of year (in thousands)..................... $460,279 $746,874 $591,631 $528,571 $446,510
======== ======== ======== ======== ========
Portfolio turnover......................................... 76.33% 64.99% 83.78% 89.90% 56.29%
======== ======== ======== ======== ========
- -------------------------------------------------------------------------------------------------------------------------
</Table>
* Total investment returns exclude insurance-related fees and expenses.
+ Based on average shares outstanding.
++ Amount is less than $.01 per share.
See Notes to Financial Statements.
256
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--SMALL CAP VALUE V.I. FUND
FINANCIAL HIGHLIGHTS (CONCLUDED)
- --------------------------------------------------------------------------------
<Table>
<Caption>
THE FOLLOWING PER SHARE DATA AND RATIOS HAVE
BEEN DERIVED FROM INFORMATION PROVIDED IN THE CLASS B
FINANCIAL STATEMENTS. ------------------------------------------------------------
FOR THE YEAR ENDED DECEMBER 31,
------------------------------------------------------------
INCREASE (DECREASE) IN NET ASSET VALUE: 2002 2001 2000 1999 1998
- --------------------------------------------------------------------------------------------------------------------------
PER SHARE OPERATING PERFORMANCE:
Net asset value, beginning of year........................ $ 25.05 $ 20.77 $ 23.35 $ 19.94 $ 27.74
------- ------- ------- ------- --------
Investment income (loss)--net+............................ (.06) .02 .04 .03 --++
Realized and unrealized gain (loss) on investments--net... (5.82) 6.01 3.29 6.03 (1.39)
------- ------- ------- ------- --------
Total from investment operations.......................... (5.88) 6.03 3.33 6.06 (1.39)
------- ------- ------- ------- --------
Less dividends and distributions:
Investment income--net.................................. -- (.04) (.04) (.06) (.08)
In excess of investment income--net..................... -- -- --++ --++ --
Realized gain on investments--net....................... (1.09) (1.71) (5.87) (2.59) (6.33)
------- ------- ------- ------- --------
Total dividends and distributions......................... (1.09) (1.75) (5.91) (2.65) (6.41)
------- ------- ------- ------- --------
Net asset value, end of year.............................. $ 18.08 $ 25.05 $ 20.77 $ 23.35 $ 19.94
======= ======= ======= ======= ========
- --------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENT RETURN:*
Based on net asset value per share........................ (23.86%) 29.72% 14.57% 33.99% (6.52%)
======= ======= ======= ======= ========
- --------------------------------------------------------------------------------------------------------------------------
RATIOS TO AVERAGE NET ASSETS:
Expenses.................................................. .99% .98% .96% .96% .97%
======= ======= ======= ======= ========
Investment income (loss)--net............................. (.26%) .09% .15% .17% .02%
======= ======= ======= ======= ========
- --------------------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL DATA:
Net assets, end of year (in thousands).................... $16,172 $25,714 $ 9,603 $ 4,618 $ 1,275
======= ======= ======= ======= ========
Portfolio turnover........................................ 76.33% 64.99% 83.78% 89.90% 56.29%
======= ======= ======= ======= ========
- --------------------------------------------------------------------------------------------------------------------------
</Table>
* Total investment returns exclude insurance-related fees and expenses.
+ Based on average shares outstanding.
++ Amount is less than $.01 per share.
See Notes to Financial Statements.
257
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--SMALL CAP VALUE V.I. FUND
NOTES TO FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
1. SIGNIFICANT ACCOUNTING POLICIES:
Merrill Lynch Variable Series Funds, Inc. (the "Company") is an open-end
management investment company that is comprised of 17 separate funds. Each fund
offers two classes of shares to the Merrill Lynch Life Insurance Company, ML
Life Insurance Company of New York (indirect, wholly-owned subsidiaries of
Merrill Lynch & Co., Inc. ("ML & Co.")), and other insurance companies, that are
not affiliated with ML & Co., for their separate accounts to fund benefits under
certain variable annuity and variable life insurance contracts. Small Cap Value
V.I. Fund (the "Fund") (formerly Small Cap Value Focus Fund) is classified as
"diversified," as defined in the Investment Company Act of 1940. Class A and
Class B Shares have equal voting, dividend, liquidation and other rights, except
that only shares of the respective classes are entitled to vote on matters
concerning only that class and Class B Shares bear certain expenses related to
the distribution of such shares. The Fund's financial statements are prepared in
conformity with accounting principles generally accepted in the United States of
America, which may require the use of management accruals and estimates. Income,
expenses (other than expenses attributable to a specific class) and realized and
unrealized gains and losses on investments are allocated daily to each class
based on its relative net assets. The following is a summary of significant
accounting policies followed by the Fund.
(a) Valuation of investments--Portfolio securities that are traded on stock
exchanges are valued at the last sale price as of the close of business on the
day the securities are being valued, or lacking any sales, at the closing bid
price. Securities traded in the over-the-counter market are valued at the last
available bid price prior to the time of valuation. In cases where securities
are traded on more than one exchange, the securities are valued on the exchange
designated by or under the authority of the Board of Directors as the primary
market. Portfolio securities that are traded both in the over-the-counter 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. Options written are valued at
the last sale price in the case of exchange-traded options. In the case of
options traded in the over-the-counter market, valuation is the last asked
price. Short-term securities are valued at amortized cost, which approximates
market value. 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.
(b) Derivative financial instruments--The Fund may engage in various portfolio
investment strategies to increase or decrease the level of risk to which the
Fund is exposed more quickly and efficiently than transactions in other types of
instruments. Losses may arise due to changes in the value of the contract or if
the counterparty does not perform under the contract.
- - Options--The Fund may write covered call options. When the Fund writes an
option, an amount equal to the premium received by the Fund is reflected as an
asset and an equivalent liability. The amount of the liability is subsequently
marked to market to reflect the current market value of the option written. When
a security is purchased or sold through an exercise of an option, the related
premium received is added to (or deducted from) the basis of the security
acquired or deducted from (or added to) the proceeds of the security sold. When
an option expires (or the Fund enters into a closing transaction), the Fund
realizes a gain or loss on the option to the extent of the premiums received (or
gain or loss to the extent the cost of the closing transaction exceeds the
premium received).
Written options are non-income producing investments.
(c) Income taxes--It is the Fund's policy to comply with the requirements of the
Internal Revenue Code applicable to regulated investment companies and to
distribute substantially all of its taxable income to its shareholders.
Therefore, no Federal income tax provision is required. Under the applicable
foreign tax law, a withholding tax may be imposed on interest, dividends and
capital gains at various rates.
(d) Security transactions and investment income--Security transactions are
recorded on the dates the transactions are entered into (the trade dates).
Realized gains and losses on security transactions are determined on the
identified cost basis. Dividend income is recorded on the ex-dividend dates.
Interest income is recognized on the accrual basis.
(e) Dividends and distributions--Dividends and distributions paid by the Fund
are recorded on the ex-dividend dates.
258
- --------------------------------------------------------------------------------
(f) Securities lending--The Fund may lend securities to financial institutions
that provide cash or securities issued or guaranteed by the U.S. government as
collateral, which will be maintained at all times in an amount equal to at least
100% of the current market value of the loaned securities. Where the Fund
receives securities as collateral for the loaned securities, it collects a fee
from the borrower. The Fund typically receives the income on the loaned
securities but does not receive the income on the collateral. Where the Fund
receives cash collateral, it may invest such collateral and retain the amount
earned on such investment, net of any amount rebated to the borrower. Loans of
securities are terminable at any time and the borrower, after notice, is
required to return borrowed securities within five business days. The Fund may
pay reasonable finder's, lending agent, administrative and custodial fees in
connection with its loans. In the event that the borrower defaults on its
obligation to return borrowed securities because of insolvency or for any other
reason, the Fund could experience delays and costs in gaining access to the
collateral. The Fund also could suffer a loss where the value of the collateral
falls below the market value of the borrowed securities, in the event of
borrower default or in the event of losses on investments made with cash
collateral.
(g) Expenses--Certain expenses have been allocated to the individual Funds in
the Company on a pro rata basis based upon the respective aggregate net asset
value of each Fund included in the Company.
(h) Reclassification--Accounting principles generally accepted in the United
States of America require that certain components of net assets be adjusted to
reflect permanent differences between financial and tax reporting. Accordingly,
the current year's permanent book/tax difference of $740,563 has been
reclassified between accumulated distributions in excess of net realized capital
gains and accumulated net investment loss. This reclassification has no effect
on net assets or net asset values per share.
2. INVESTMENT ADVISORY AGREEMENT AND TRANSACTIONS WITH AFFILIATES:
The Company has entered into an Investment Advisory Agreement with Merrill Lynch
Investment Managers, L.P. ("MLIM"). The general partner of MLIM is Princeton
Services, Inc. ("PSI"), an indirect, wholly-owned subsidiary of ML & Co., which
is the limited partner. The Company has also entered into a Distribution
Agreement and Distribution Plan with FAM Distributors, Inc. ("FAMD" or the
"Distributor"), which is a wholly-owned subsidiary of Merrill Lynch Group, Inc.
MLIM is responsible for the management of the Company's funds and provides the
necessary personnel, facilities, equipment and certain other services necessary
to the operations of the Fund. For such services, the Fund pays a monthly fee at
the annual rate of .75% of the average daily value of the Fund's net assets.
Pursuant to the Distribution Plan adopted by the Company, in accordance with
Rule 12b-1 under the Investment Company Act of 1940, the Fund pays the
Distributor an ongoing distribution fee each month at the annual rate of .15% of
the average daily value of the Fund's Class B net assets.
MLIM and Merrill Lynch Life Agency, Inc. ("MLLA") have entered into an
agreement that limits the operating expenses paid by the Fund, exclusive of any
distribution fees imposed on Class B Shares, to 1.25% of its average daily net
assets. Any such expenses in excess of 1.25% of average daily net assets will be
reimbursed to the Fund by MLIM which, in turn, will be reimbursed by MLLA.
The Company has received an exemptive order from the Securities and Exchange
Commission permitting it to lend portfolio securities to Merrill Lynch, Pierce,
Fenner & Smith Incorporated ("MLPF&S"), a subsidiary of ML & Co., or its
affiliates. Pursuant to that order, the Fund also has retained Merrill Lynch
Investment Managers, LLC ("MLIM, LLC"), an affiliate of MLIM, as the securities
lending agent for a fee based on a share of the returns on investment of cash
collateral. MLIM, LLC may, on behalf of the Company and the Fund, invest cash
collateral received by the Fund for such loans, among other things, in a private
investment company managed by MLIM, LLC or in registered money market funds
advised by MLIM or its affiliates. As of December 31, 2002 cash collateral of
$45,079,813 was invested in the Money Market Series of the Merrill Lynch
Liquidity Series, LLC and $39,976,438 was invested in the Merrill Lynch Premier
Institutional Fund. As of December 31, 2002, the Fund lent securities with a
value of $39,736,861 to MLPF&S or its affiliates. For the year ended December
31, 2002, MLIM, LLC received $65,472 in securities lending agent fees from the
Fund.
For the year ended December 31, 2002, MLPF&S, a subsidiary of ML & Co., earned
$165,991 in commissions on the execution of portfolio security transactions.
259
- --------------------------------------------------------------------------------
Financial Data Services, Inc. ("FDS"), a wholly-owned subsidiary of ML & Co.,
is the Company's transfer agent.
For the year ended December 31, 2002, the Fund reimbursed MLIM $19,798 for
certain accounting services.
Certain officers and/or directors of the Company are officers and/or directors
of MLIM, PSI, FDS, FAMD, and/or ML & Co.
3. INVESTMENTS:
Purchases and sales of investments, excluding short-term securities, for the
year ended December 31, 2002 were $462,327,441 and $458,096,888, respectively.
Net realized gains (losses) for the year ended December 31, 2002 and net
unrealized losses as of December 31, 2002 were as follows:
<Table>
<Caption>
- --------------------------------------------------------------
Realized Unrealized
Gains (Losses) Losses
- --------------------------------------------------------------
Long-term investments.......... $16,093,405 $(95,320,030)
Short-term investments......... (1,430) --
----------- ------------
Total.......................... $16,091,975 $(95,320,030)
=========== ============
- --------------------------------------------------------------
</Table>
At December 31, 2002, net unrealized depreciation for Federal income tax
purposes aggregated $108,176,947, of which $30,799,318 related to appreciated
securities and $138,976,265 related to depreciated securities. At December 31,
2002, the aggregate cost of investments for Federal income tax purposes was
$618,464,471.
4. CAPITAL SHARE TRANSACTIONS:
Net increase (decrease) in net assets derived from capital share transactions
was $(82,203,834) and $42,248,953 for the years ended December 31, 2002 and
December 31, 2001, respectively.
Transactions in capital shares were as follows:
<Table>
<Caption>
- -----------------------------------------------------------------
Class A Shares for the Year Ended Dollar
December 31, 2002 Shares Amount
- -----------------------------------------------------------------
Shares sold........................ 4,162,502 $ 85,676,843
Shares issued to shareholders in
reinvestment of distributions..... 1,544,980 31,491,346
----------- -------------
Total issued....................... 5,707,482 117,168,189
Shares redeemed.................... (10,050,544) (196,709,897)
----------- -------------
Net decrease....................... (4,343,062) $ (79,541,708)
=========== =============
- -----------------------------------------------------------------
</Table>
<Table>
<Caption>
- -----------------------------------------------------------------
Class A Shares for the Year Ended Dollar
December 31, 2001 Shares Amount
- -----------------------------------------------------------------
Shares sold......................... 3,360,518 $ 77,137,714
Shares issued to shareholders in
reinvestment of dividends and
distributions...................... 2,158,059 50,825,871
---------- -------------
Total issued........................ 5,518,577 127,963,585
Shares redeemed..................... (4,202,562) (98,215,509)
---------- -------------
Net increase........................ 1,316,015 $ 29,748,076
========== =============
- -----------------------------------------------------------------
</Table>
<Table>
<Caption>
- -----------------------------------------------------------------
Class B Shares for the Year Ended
December 31, 2002 Shares Dollar Amount
- -----------------------------------------------------------------
Shares sold........................... 97,213 $ 2,278,308
Shares issued to shareholders in
reinvestment of distributions........ 49,263 1,010,341
-------- -------------
Total issued.......................... 146,476 3,288,649
Shares redeemed....................... (278,574) (5,950,775)
-------- -------------
Net decrease.......................... (132,098) $ (2,662,126)
======== =============
- -----------------------------------------------------------------
</Table>
<Table>
<Caption>
- -----------------------------------------------------------------
Class B Shares for the Year Ended Dollar
December 31, 2001 Shares Amount
- -----------------------------------------------------------------
Shares sold............................. 615,213 $13,650,800
Shares issued to shareholders in
reinvestment of dividends and
distributions.......................... 58,134 1,398,925
-------- -----------
Total issued............................ 673,347 15,049,725
Shares redeemed......................... (109,006) (2,548,848)
-------- -----------
Net increase............................ 564,341 $12,500,877
======== ===========
- -----------------------------------------------------------------
</Table>
5. SHORT-TERM BORROWINGS:
The Fund, along with certain other funds managed by MLIM and its affiliates, is
a party to a credit agreement with Bank One, N.A. and certain other lenders.
Effective November 29, 2002, in conjunction with the renewal for one year at the
same terms, the total commitment was reduced from $1,000,000,000 to
$500,000,000. The Fund may borrow under the credit agreement to fund shareholder
redemptions and for other lawful purposes other than for leverage. The Fund may
borrow up to the maximum amount allowable under the Fund's current prospectus
and statement of additional information, subject to various other legal,
regulatory or contractual limits. The Fund pays a commitment fee of .09% per
annum based on the Fund's pro rata share of the unused portion of the credit
agreement. Amounts borrowed under the credit agreement bear interest at a rate
equal to, at each fund's election, the Federal Funds rate plus .50% or a base
rate as determined by Bank One, N.A. The Fund did not borrow under the credit
agreement during the year ended December 31, 2002.
6. DISTRIBUTIONS TO SHAREHOLDERS:
The tax character of distributions paid during the fiscal years ended December
31, 2002 and December 31, 2001 was as follows:
<Table>
<Caption>
- ------------------------------------------------------------------
12/31/2002 12/31/2001
- ------------------------------------------------------------------
Distributions paid from:
Ordinary income...................... $ 8,181,320 $ 33,377,403
Net long-term capital gains.......... 24,320,367 18,847,394
----------- ------------
Total taxable distributions........... $32,501,687 $ 52,224,797
=========== ============
- ------------------------------------------------------------------
</Table>
260
- --------------------------------------------------------------------------------
As of December 31, 2002, the components of accumulated losses on a tax basis
were as follows:
<Table>
- ---------------------------------------------------------------
Undistributed ordinary income--net.............. $ 1,573,013
Undistributed long-term capital gains--net...... 2,455,713
-------------
Total undistributed earnings--net............... 4,028,726
Unrealized losses--net.......................... (108,176,947)*
-------------
Total accumulated losses--net................... $(104,148,221)
=============
- ---------------------------------------------------------------
</Table>
* The difference between book-basis and tax-basis net unrealized losses is
attributable primarily to the tax deferral of losses on wash sales.
261
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--SMALL CAP VALUE V.I. FUND
INDEPENDENT AUDITORS' REPORT
- --------------------------------------------------------------------------------
THE BOARD OF DIRECTORS AND SHAREHOLDERS,
SMALL CAP VALUE V.I. FUND OF
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.:
We have audited the accompanying statement of assets and liabilities,
including the schedule of investments, of Small Cap Value V.I. Fund (formerly,
Small Cap Value Focus Fund) of Merrill Lynch Variable Series Funds, Inc. as of
December 31, 2002, the related statements of operations for the year then ended
and changes in net assets for each of the years in the two-year period then
ended, and the financial highlights for each of the years presented. These
financial statements and the financial highlights are the responsibility of the
Fund's management. Our responsibility is to express an opinion on these
financial statements and the financial highlights based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements and the financial highlights are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the
financial statements. Our procedures included confirmation of securities owned
at December 31, 2002 by correspondence with the custodian and brokers; where
replies were not received from brokers, we performed other auditing procedures.
An audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, such financial statements and financial highlights present
fairly, in all material respects, the financial position of Small Cap Value V.I.
Fund of Merrill Lynch Variable Series Funds, Inc. as of December 31, 2002, the
results of its operations, the changes in its net assets, and the financial
highlights for the respective stated periods in conformity with accounting
principles generally accepted in the United States of America.
Deloitte & Touche LLP
Princeton, New Jersey
February 14, 2003
262
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--UTILITIES AND TELECOMMUNICATIONS V.I.
FUND
DECEMBER 31, 2002--ANNUAL REPORT
- --------------------------------------------------------------------------------
DEAR SHAREHOLDER:
FISCAL YEAR IN REVIEW
For the year ended December 31, 2002, Utilities and Telecommunications V.I.
Fund's Class A Shares had a total return of -18.77%. This compared to the
unmanaged benchmark Standard & Poor's (S&P) Utility Index's -29.99% total return
for the same period. The broader market, as measured by the S&P 500 Index, had a
total return of -22.10%.
Portfolio diversification was absolutely critical in fiscal year 2002. There
was significant disparity among company performance within the domestic electric
sector. Premium valuation levels were placed on the perceived safer transmission
and distribution companies as well as some of the integrated companies. Dividend
yield and dividend safety became more critical throughout the year ended
December 31, 2002. Several long-term, highly regarded companies ran into
company-specific problems during the year. To name just a few, TXU Corp. had
diversification problems abroad, Allegheny Energy, Inc. had too much reliance on
power marketing and trading, and Teco Energy suffered with its financial
position. The Fund ended fiscal year 2002 with over 60 holdings.
At the start of fiscal year 2002, we retained the Fund's defensive position
that contributed outperforming relative results in fiscal year 2001. Low
interest rates, a weak economy, investor concerns about accounting issues and
the direction of the broad equity market made for an attractive bond market and
a more relative positive view toward dividend-paying electric utility stocks. By
June 30, 2002, rating agencies became concerned about the financial health of
many companies and sectors. There was particular attention given to the utility
sector following the problems at Enron Corporation. The net result was that many
companies within the electric sector had to raise capital to reduce overall debt
levels and the broad market staged a rally. These two events resulted in bonds
looking less attractive than equities in the utility sector and we shifted
gradually out of our utility bonds and into similar yielding utility stocks.
Moreover, the telecommunications sector, in which we have had a relative
underweight position for some time, was trading at what we believe were very
attractive valuation levels. The net result was that we added to our weighting
in the telecommunications sector in both the integrated companies as well as in
the wireless companies. To put some of these changes into perspective, at the
end of fiscal year 2001 there was only one telecommunications stock in the
Fund's ten largest holdings compared to three at December 31, 2002.
MARKET OUTLOOK
Several factors should be considered as we look to the new year. Current
discussions in Washington, D.C. about the relaxation of the double taxation of
dividends may benefit shareholders. Rating agency activity has resulted in
companies within the utility sector, and in particular on the electric side,
focusing on having maximum financial flexibility, which implies a high equity
ratio compared to debt. Companies within the domestic utility sector indicated
that they have no appetite for acquisitions in the current environment.
Cost-cutting opportunities remain whether it is on the operating or capital
expenditure side of the ledger. We believe that when growth in the overall
economy improves, these companies should benefit, particularly as it relates to
employment.
The electric utility sector, with its above-market dividend yields, should be
the greatest beneficiary of a change in the taxation rules of dividends. Most
companies have gone "back to basics," which is to provide electricity at
reasonable prices to the customer base in the franchise market(s) that they
serve. A significant amount of new electric generation that was planned for the
next few years was either put on hold or cancelled outright. The supply/demand
will therefore become tighter, which should help prices for generation.
The telecommunications sector, for the most part, also has above-market yields
and, therefore, should also benefit from dividend taxation rule changes.
However, on a fundamental basis, it is our view that this sector would benefit
the most from an improving economy, which results in higher employment levels.
We believe the companies we favor offer particular advantages. For example,
Verizon Communications has the ability to provide local, long distance, wireless
and broadband services to its customers at a reasonable price. Competition has
already been rampant in their service territory, and we believe the company's
management has shown that they know how to handle a very competitive market
place. Management has become an even more critical variable in the current
environment than ever before. We believe that the management of Verizon
Communications understands this and has the ability and desire to express this
factor to investors.
In our view, Nextel Communications, a wireless service provider, is also in a
positive position. The company has a patent-protected
263
- --------------------------------------------------------------------------------
technology that serves a niche market. The "push to talk" market is very
attractive. Nextel has won over the business market with its product. Other
wireless carriers have talked about having a similar product in this market and
have hinted at near-term execution of plans. The only problem is that their
products prove inferior to Nextel with respect to call setup times. The
financial health of Nextel continues to improve. The net result is that the
competition is focused on the markets that Nextel has not exploited, such as the
teen market, which finds the direct connect feature "to be cool."
The natural gas industry continued to be dominated by oil prices, demand from
new gas generation electricity plants and weather factors. Since two of these
three factors are difficult to determine, we continue to remain cautious about
the sector. Thus, we have an investment presence but it is a cautious position.
However, we do have a greater exposure to natural gas utilities, which benefit
from conversions of other fuel sources to natural gas (such as KeySpan) and from
customer growth (such as New Jersey Resources Corporation).
The water business is a highly fragmented business in the United States with
most companies in private hands. The focus is on producing a high-quality
product. The net result is tariff increases to provide funding for necessary
quality improvements. Moreover, water is a relatively inexpensive utility to the
majority of consumers. Foreign companies have historically been buyers of water
assets.
Looking toward fiscal year 2003, we will continue to closely monitor current
portfolio positions in terms of both valuation and fundamental considerations.
We believe that at the current time we have a balanced position. We bought the
telecommunications sector when valuations became inexpensive and plan to hold
them until the economy starts to improve. The domestic electric sector is a
beneficiary of low interest rates, balance sheet improvement, lack of
merger/acquisition activity and cancellation of new electric generating plants.
Diversification remains critical in terms of the risk/reward equation.
IN CONCLUSION
We appreciate your investment in Utilities and Telecommunications V.I. Fund of
Merrill Lynch Variable Series Funds, Inc., and we look forward to serving your
investment needs in the months and years ahead.
Sincerely,
/s/ Terry K. Glenn
Terry K. Glenn
President and Director
/s/ Kathleen M. Anderson
Kathleen M. Anderson
Vice President and Senior Portfolio Manager
January 17, 2003
264
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--UTILITIES AND TELECOMMUNICATIONS V.I.
FUND
TOTAL RETURN BASED ON A $10,000 INVESTMENT--CLASS A SHARES
- --------------------------------------------------------------------------------
[PERFORMANCE GRAPH]
<Table>
<Caption>
UTILITIES &
TELECOMMUNICATIONS V.I.
FUND+-CLASS A SHARES* S&P UTILITIES INDEX++ S&P 500 INDEX+++
----------------------- --------------------- ----------------
7/01/93** 10000.00 10000.00 10000.00
12/93 10685.00 9674.00 10539.00
12/94 9776.00 8534.00 10678.00
12/95 12155.00 11329.00 14691.00
12/96 13730.00 11972.00 18064.00
12/97 17286.00 14924.00 24091.00
12/98 21445.00 17138.00 30976.00
12/99 24154.00 15565.00 37494.00
12/00 23499.00 24466.00 34080.00
12/01 20204.00 17019.00 30029.00
12/02 16412.00 11915.00 23392.00
</Table>
* Assuming transaction costs and other operating expenses, including advisory
fees. Does not include insurance-related fees and expenses.
** Commencement of operations.
+ The Fund invests at least 80% of its net assets in a diversified portfolio of
equity and debt securities issued by utility companies.
++ The S&P Utilities Index is a capitalization index of all stocks designed to
measure the performance of the utility sector of the S&P 500 Index. The starting
date for the Index in the graph is from 7/30/93.
+++ This unmanaged Index covers 500 industrial, utility, transportation and
financial companies of the U.S. markets (mostly NYSE issues), representing about
75% of NYSE market capitalization and 30% of NYSE issues.
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--UTILITIES AND TELECOMMUNICATIONS V.I.
FUND
AVERAGE ANNUAL TOTAL RETURN--CLASS A SHARES*
- --------------------------------------------------------------------------------
PERIOD COVERED % RETURN
- --------------------------------------------------------------------------------
One Year Ended 12/31/02 -18.77%
- --------------------------------------------------------------------------------
Five Years Ended 12/31/02 - 1.03
- --------------------------------------------------------------------------------
Inception (7/01/93) through 12/31/02 + 5.35
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--UTILITIES AND TELECOMMUNICATIONS V.I.
FUND
RECENT PERFORMANCE RESULTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
6-MONTH 12-MONTH
AS OF DECEMBER 31, 2002 TOTAL RETURN TOTAL RETURN
- -----------------------------------------------------------------------------------------
Class A Shares* -11.28% -18.77%
- -----------------------------------------------------------------------------------------
S&P Utilities Index** -18.49 -29.99
- -----------------------------------------------------------------------------------------
S&P 500 Index*** -10.30 -22.10
- -----------------------------------------------------------------------------------------
</Table>
* Total investment returns are based on changes in net asset values for the
periods shown, and assume reinvestment of all dividends and capital gains
distributions at net asset value on the ex-dividend date. Insurance-related fees
and expenses are not reflected in these returns.
** This unmanaged capitalization index is comprised of all stocks designed to
measure the performance of the utility sector of the S&P 500 Index.
*** This unmanaged Index covers 500 industrial, utility, transportation and
financial companies of the U.S. markets (mostly NYSE issues), representing about
75% of NYSE market capitalization and 30% of NYSE issues.
Past results shown should not be considered a representation of future
performance.
265
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--UTILITIES AND TELECOMMUNICATIONS V.I.
FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
COUNTRY INDUSTRY++ HELD STOCKS VALUE NET ASSETS
- ----------------------------------------------------------------------------------------------------------------------------
CANADA DIVERSIFIED 54,500 BCE Inc. ....................... $ 981,545 2.1%
TELECOMMUNICATION SERVICES
---------------------------------------------------------------------------------------------------
OIL & GAS 7,700 EnCana Corp. ................... 237,756 0.5
---------------------------------------------------------------------------------------------------
TOTAL STOCKS IN CANADA 1,219,301 2.6
- ----------------------------------------------------------------------------------------------------------------------------
FRANCE MULTI-UTILITIES & 8,700 Suez SA......................... 151,007 0.3
UNREGULATED POWER
---------------------------------------------------------------------------------------------------
TOTAL STOCKS IN FRANCE 151,007 0.3
- ----------------------------------------------------------------------------------------------------------------------------
GERMANY ELECTRIC UTILITIES 4,900 E.On AG......................... 197,455 0.4
---------------------------------------------------------------------------------------------------
MULTI-UTILITIES & 4,400 RWE AG.......................... 113,818 0.3
UNREGULATED POWER
---------------------------------------------------------------------------------------------------
TOTAL STOCKS IN GERMANY 311,273 0.7
- ----------------------------------------------------------------------------------------------------------------------------
GREECE ELECTRIC UTILITIES 23,600 +Public Power Corporation
(GDR)(b)...................... 326,414 0.7
---------------------------------------------------------------------------------------------------
TOTAL STOCKS IN GREECE 326,414 0.7
- ----------------------------------------------------------------------------------------------------------------------------
ITALY DIVERSIFIED 49,500 Telecom Italia SpA (Registered
TELECOMMUNICATION SERVICES Shares)....................... 249,857 0.5
---------------------------------------------------------------------------------------------------
TOTAL STOCKS IN ITALY 249,857 0.5
- ----------------------------------------------------------------------------------------------------------------------------
MEXICO DIVERSIFIED 12,000 Telefonos de Mexico SA
TELECOMMUNICATION SERVICES (ADR)(a)...................... 383,760 0.8
---------------------------------------------------------------------------------------------------
TOTAL STOCKS IN MEXICO 383,760 0.8
- ----------------------------------------------------------------------------------------------------------------------------
SPAIN ELECTRIC UTILITIES 23,500 Endesa SA....................... 274,969 0.6
97,000 Iberdrola SA.................... 1,358,921 3.0
---------------------------------------------------------------------------------------------------
TOTAL STOCKS IN SPAIN 1,633,890 3.6
- ----------------------------------------------------------------------------------------------------------------------------
UNITED KINGDOM ELECTRIC UTILITIES 24,600 Scottish and Southern Energy
PLC........................... 269,304 0.6
---------------------------------------------------------------------------------------------------
MULTI-UTILITIES & 37,762 National Grid Group PLC......... 277,520 0.6
UNREGULATED
POWER 19,800 United Utilities PLC............ 198,906 0.4
----------- -----
476,426 1.0
---------------------------------------------------------------------------------------------------
WIRELESS TELECOMMUNICATION 8,500 Vodafone Group PLC (ADR)(a)..... 154,020 0.4
SERVICES
---------------------------------------------------------------------------------------------------
TOTAL STOCKS IN THE UNITED
KINGDOM 899,750 2.0
- ----------------------------------------------------------------------------------------------------------------------------
UNITED STATES DIVERSIFIED 18,000 ALLTEL Corporation.............. 918,000 2.0
TELECOMMUNICATION SERVICES
13,420 AT&T Corp. ..................... 350,396 0.8
58,000 BellSouth Corporation........... 1,500,460 3.2
12,200 CenturyTel, Inc. ............... 358,436 0.8
61,400 SBC Communications Inc. ........ 1,664,554 3.6
23,300 Sprint Corporation.............. 337,384 0.7
45,900 Verizon Communications.......... 1,778,625 3.9
----------- -----
6,907,855 15.0
---------------------------------------------------------------------------------------------------
</Table>
266
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--UTILITIES AND TELECOMMUNICATIONS V.I.
FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
<Table>
<Caption>
SHARES PERCENT OF
COUNTRY INDUSTRY++ HELD STOCKS VALUE NET ASSETS
- ----------------------------------------------------------------------------------------------------------------------------
UNITED STATES ELECTRIC UTILITIES 12,000 Ameren Corporation.............. $ 498,840 1.1%
(CONCLUDED) 34,200
American Electric Power Company,
Inc. ......................... 934,686 2.0
12,100 CMS Energy Corporation 114,224 0.3
38,192 Cinergy Corp. .................. 1,287,834 2.8
34,000 Cleco Corporation............... 476,000 1.0
14,300 Consolidated Edison, Inc. ...... 612,326 1.3
31,300 Constellation Energy Group...... 870,766 1.9
54,000 DPL Inc. ....................... 828,360 1.8
31,500 DTE Energy Company.............. 1,461,600 3.2
34,000 Dominion Resources, Inc. ....... 1,866,600 4.1
23,300 +Edison International........... 276,105 0.6
24,900 Entergy Corporation............. 1,135,191 2.5
20,600 Exelon Corporation.............. 1,087,062 2.4
25,100 FPL Group, Inc. ................ 1,509,263 3.3
36,700 FirstEnergy Corp. .............. 1,209,999 2.6
28,500 NSTAR........................... 1,265,115 2.7
39,000 PPL Corporation................. 1,352,520 2.9
12,200 Pepco Holdings, Inc. ,.......... 236,558 0.5
20,700 Pinnacle West Capital
Corporation................... 705,663 1.5
24,100 Progress Energy, Inc. .......... 1,044,735 2.3
35,500 Public Service Enterprise Group
Incorporated.................. 1,139,550 2.5
23,800 The Southern Company............ 675,682 1.5
32,500 TXU Corp. ...................... 607,100 1.3
9,900 Wisconsin Energy Corporation.... 249,480 0.5
----------- -----
21,445,259 46.6
---------------------------------------------------------------------------------------------------
GAS UTILITIES 25,900 KeySpan Corporation............. 912,716 2.0
37,500 New Jersey Resources
Corporation................... 1,184,625 2.6
26,000 NiSource Inc. .................. 520,000 1.1
----------- -----
2,617,341 5.7
---------------------------------------------------------------------------------------------------
MEDIA 9,806 +Comcast Corporation (Class A).. 231,029 0.5
14,900 +Comcast Corporation (Special
Class A)...................... 335,995 0.7
----------- -----
567,024 1.2
---------------------------------------------------------------------------------------------------
MULTI-UTILITIES & 55,900 Duke Energy Corporation......... 1,092,286 2.4
UNREGULATED POWER
63,000 Energy East Corporation......... 1,391,670 3.0
43,500 National Fuel Gas Company....... 901,755 2.0
34,700 SCANA Corporation............... 1,074,312 2.3
24,000 Vectren Corporation............. 552,000 1.2
----------- -----
5,012,023 10.9
---------------------------------------------------------------------------------------------------
OIL & GAS 4,600 Devon Energy Corporation........ 211,140 0.5
15,400 EOG Resources, Inc. ............ 614,768 1.3
----------- -----
825,908 1.8
---------------------------------------------------------------------------------------------------
WATER UTILITIES 16,700 American Water Works Company,
Inc. ......................... 759,516 1.6
33,000 Philadelphia Suburban
Corporation................... 679,800 1.5
----------- -----
1,439,316 3.1
---------------------------------------------------------------------------------------------------
WIRELESS TELECOMMUNICATION 73,636 +AT&T Wireless Services Inc. ... 416,043 0.9
SERVICES
34,700 +Nextel Communications, Inc.
(Class A)..................... 394,886 0.9
----------- -----
810,929 1.8
---------------------------------------------------------------------------------------------------
TOTAL STOCKS IN THE UNITED
STATES 39,625,655 86.1
- ----------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN STOCKS
(COST--$44,607,194) 44,800,907 97.3
- ----------------------------------------------------------------------------------------------------------------------------
</Table>
267
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--UTILITIES AND TELECOMMUNICATIONS V.I.
FUND
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2002 (CONCLUDED) (IN U.S. DOLLARS)
- --------------------------------------------------------------------------------
<Table>
PARTNERSHIP PERCENT OF
INTEREST SHORT-TERM SECURITIES VALUE NET ASSETS
- -----------------------------------------------------------------------------------------------------------------------------
$1,201,194 Merrill Lynch Liquidity Series, LLC
Cash Sweep Series II(c).......... $ 1,201,194 2.6%
- -----------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS IN SHORT-TERM
SECURITIES (COST--$1,201,194) 1,201,194 2.6
- -----------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS
(COST--$45,808,388)................ 46,002,101 99.9
OTHER ASSETS LESS LIABILITIES...... 37,064 0.1
----------- -----
NET ASSETS......................... $46,039,165 100.0%
=========== =====
- -----------------------------------------------------------------------------------------------------------------------------
</Table>
(a) American Depositary Receipts (ADR).
(b) Global Depositary Receipts (GDR).
(c) Investments in companies considered to be an affiliate of the Fund (such
companies are defined as "Affiliated Companies" in Section 2(a)(3) of the
Investment Company Act of 1940) are as follows:
<Table>
<Caption>
- ------------------------------------------------------------------------------------------------
NET NET INTEREST
AFFILIATE ACTIVITY COST INCOME
- ------------------------------------------------------------------------------------------------
Merrill Lynch Liquidity Series, LLC Cash Sweep Series II.... $1,201,194 $1,201,194 $1,938
- ------------------------------------------------------------------------------------------------
</Table>
+ Non-income producing security.
++ For Fund compliance purposes, "Industry" means any one or more of the
industry sub-classifications used by one or more widely recognized market
indexes or ratings group indexes, and/or as defined by Fund management. This
definition may not apply for purposes of this report, which may combine such
industry sub-classifications for reporting ease. These industry classifications
are unaudited.
See Notes to Financial Statements.
268
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--UTILITIES AND TELECOMMUNICATIONS V.I.
FUND
STATEMENT OF ASSETS AND LIABILITIES AS OF DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
ASSETS:
Investments, at value (including securities loaned of
$1,118,165) (identified cost--$45,808,388)................ $ 46,002,101
Investments held as collateral for loaned securities, at
value..................................................... 1,139,252
Cash........................................................ 124
Receivables:
Dividends................................................. $ 115,875
Interest.................................................. 1,389
Loaned securities income.................................. 124 117,388
------------
Prepaid expenses............................................ 345
------------
Total assets................................................ 47,259,210
------------
- -----------------------------------------------------------------------------------------
LIABILITIES:
Collateral on securities loaned, at value................... 1,139,252
Payables:
Capital shares redeemed................................... 44,319
Investment adviser........................................ 24,107 68,426
------------
Accrued expenses............................................ 12,367
------------
Total liabilities........................................... 1,220,045
------------
- -----------------------------------------------------------------------------------------
NET ASSETS.................................................. $ 46,039,165
============
- -----------------------------------------------------------------------------------------
NET ASSETS CONSIST OF:
Class A Shares of Common Stock, $.10 par value, 100,000,000
shares authorized+........................................ $ 728,735
Paid-in capital in excess of par............................ 58,116,150
Accumulated distributions in excess of investment
income--net............................................... $ (5,794)
Accumulated realized capital losses on investments and
foreign currency transactions--net........................ (12,994,447)
Unrealized appreciation on investments and foreign currency
transactions--net......................................... 194,521
------------
Total accumulated losses--net............................... (12,805,720)
------------
NET ASSETS.................................................. $ 46,039,165
============
- -----------------------------------------------------------------------------------------
NET ASSET VALUE:
Class A--Based on net assets of $46,039,165 and 7,287,347
shares outstanding........................................ $ 6.32
============
- -----------------------------------------------------------------------------------------
</Table>
+ The Fund is also authorized to issue 100,000,000 Class B Shares.
See Notes to Financial Statements.
269
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--UTILITIES AND TELECOMMUNICATIONS V.I.
FUND
STATEMENT OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 2002
- --------------------------------------------------------------------------------
<Table>
INVESTMENT INCOME:
Dividends (net of $22,530 foreign withholding tax).......... $ 1,861,704
Interest.................................................... 571,384
Securities lending--net..................................... 5,576
------------
Total income................................................ 2,438,664
------------
- -----------------------------------------------------------------------------------------
EXPENSES:
Investment advisory fees.................................... $ 344,128
Custodian fees.............................................. 21,717
Accounting services......................................... 20,810
Professional fees........................................... 16,112
Transfer agent fees......................................... 11,120
Printing and shareholder reports............................ 6,049
Directors' fees and expenses................................ 2,699
Pricing services............................................ 2,565
Registration fees........................................... 867
Other....................................................... 6,848
------------
Total expenses.............................................. 432,915
------------
Investment income--net...................................... 2,005,749
------------
- -----------------------------------------------------------------------------------------
REALIZED & UNREALIZED GAIN (LOSS) ON INVESTMENTS & FOREIGN
CURRENCY TRANSACTIONS--NET:
Realized loss from:
Investments--net.......................................... (12,994,447)
Foreign currency transactions--net........................ (8,198) (13,002,645)
------------
Change in unrealized appreciation/depreciation on:
Investments--net.......................................... (1,618,092)
Foreign currency transactions--net........................ 1,052 (1,617,040)
------------ ------------
Total realized and unrealized loss on investments and
foreign currency transactions--net........................ (14,619,685)
------------
NET DECREASE IN NET ASSETS RESULTING FROM OPERATIONS........ $(12,613,936)
============
- -----------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
270
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--UTILITIES AND TELECOMMUNICATIONS V.I.
FUND
STATEMENTS OF CHANGES IN NET ASSETS
- --------------------------------------------------------------------------------
<Table>
<Caption>
FOR THE YEAR ENDED
DECEMBER 31,
----------------------------
DECREASE IN NET ASSETS: 2002 2001
- --------------------------------------------------------------------------------------------
OPERATIONS:
Investment income--net...................................... $ 2,005,749 $ 2,920,821
Realized gain (loss) on investments and foreign currency
transactions--net......................................... (13,002,645) 3,284,913
Change in unrealized appreciation/depreciation on
investments and foreign currency transactions--net........ (1,617,040) (19,588,742)
------------ ------------
Net decrease in net assets resulting from operations........ (12,613,936) (13,383,008)
------------ ------------
- --------------------------------------------------------------------------------------------
DIVIDENDS & DISTRIBUTIONS TO SHAREHOLDERS:
Investment income--net:
Class A................................................... (2,001,428) (2,920,253)
Realized gain on investments--net:
Class A................................................... (1,340,095) (2,929,945)
------------ ------------
Net decrease in net assets resulting from dividends and
distributions to shareholders............................. (3,341,523) (5,850,198)
------------ ------------
- --------------------------------------------------------------------------------------------
CAPITAL SHARE TRANSACTIONS:
Net decrease in net assets derived from capital share
transactions.............................................. (11,188,568) (13,913,650)
------------ ------------
- --------------------------------------------------------------------------------------------
NET ASSETS:
Total decrease in net assets................................ (27,144,027) (33,146,856)
Beginning of year........................................... 73,183,192 106,330,048
------------ ------------
End of year*................................................ $ 46,039,165 $ 73,183,192
============ ============
- --------------------------------------------------------------------------------------------
* Accumulated distributions in excess of investment
income--net............................................... $ (5,794) $ (1,908)
============ ============
- --------------------------------------------------------------------------------------------
</Table>
See Notes to Financial Statements.
271
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--UTILITIES AND TELECOMMUNICATIONS V.I.
FUND
FINANCIAL HIGHLIGHTS
- --------------------------------------------------------------------------------
<Table>
<Caption>
THE FOLLOWING PER SHARE DATA AND RATIOS HAVE
BEEN DERIVED FROM INFORMATION PROVIDED IN THE CLASS A
FINANCIAL STATEMENTS. -------------------------------------------------------
FOR THE YEAR ENDED DECEMBER 31,
-------------------------------------------------------
INCREASE (DECREASE) IN NET ASSET VALUE: 2002 2001 2000 1999 1998
- -----------------------------------------------------------------------------------------------------------------------
PER SHARE OPERATING PERFORMANCE:
Net asset value, beginning of year.......................... $ 8.25 $ 10.31 $ 16.85 $ 17.08 $ 14.84
-------- ------- -------- -------- --------
Investment income--net+..................................... .25 .31 .47 .30 .36
Realized and unrealized gain (loss) on investments and
foreign currency transactions--net........................ (1.76) (1.71) (.92) 1.75 2.99
-------- ------- -------- -------- --------
Total from investment operations............................ (1.51) (1.40) (.45) 2.05 3.35
-------- ------- -------- -------- --------
Less dividends and distributions:
Investment income--net.................................... (.26) (.33) (.50) (.37) (.40)
In excess of investment income--net....................... -- -- (.01) -- --
Realized gain on investments--net......................... (.16) (.33) (5.58) (1.91) (.71)
-------- ------- -------- -------- --------
Total dividends and distributions........................... (.42) (.66) (6.09) (2.28) (1.11)
-------- ------- -------- -------- --------
Net asset value, end of year................................ $ 6.32 $ 8.25 $ 10.31 $ 16.85 $ 17.08
======== ======= ======== ======== ========
- -----------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENT RETURN:*
Based on net asset value per share.......................... (18.77%) (14.02%) (2.71%) 12.63% 24.06%
======== ======= ======== ======== ========
- -----------------------------------------------------------------------------------------------------------------------
RATIOS TO AVERAGE NET ASSETS:
Expenses.................................................... .75% .71% .69% .69% .68%
======== ======= ======== ======== ========
Investment income--net...................................... 3.50% 3.27% 3.00% 1.83% 2.39%
======== ======= ======== ======== ========
- -----------------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL DATA:
Net assets, end of year (in thousands)...................... $ 46,039 $73,183 $106,330 $133,087 $144,978
======== ======= ======== ======== ========
Portfolio turnover.......................................... 30.32% 34.59% 64.95% 4.20% 5.20%
======== ======= ======== ======== ========
- -----------------------------------------------------------------------------------------------------------------------
</Table>
*Total investment returns exclude insurance-related fees and expenses.
+ Based on average shares outstanding.
See Notes to Financial Statements.
272
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--UTILITIES AND TELECOMMUNICATIONS V.I.
FUND
NOTES TO FINANCIALS STATEMENTS
- --------------------------------------------------------------------------------
1. SIGNIFICANT ACCOUNTING POLICIES:
Merrill Lynch Variable Series Funds, Inc. (the "Company") is an open-end
management investment company that is comprised of 17 separate funds. Each fund
offers two classes of shares to the Merrill Lynch Life Insurance Company, ML
Life Insurance Company of New York (indirect, wholly-owned subsidiaries of
Merrill Lynch & Co., Inc. ("ML & Co.")), and other insurance companies that are
not affiliated with ML & Co., for their separate accounts to fund benefits under
certain variable annuity and variable life insurance contracts. Utilities and
Telecommunications V.I. Fund (the "Fund") (formerly Utilities and
Telecommunications Focus Fund) is classified as "diversified," as defined in the
Investment Company Act of 1940. Class A and Class B Shares have equal voting,
dividend, liquidation and other rights, except that only shares of the
respective classes are entitled to vote on matters concerning only that class
and Class B Shares bear certain expenses related to the distribution of such
shares. The Fund's financial statements are prepared in conformity with
accounting principles generally accepted in the United States of America, which
may require the use of management accruals and estimates. The following is a
summary of significant accounting policies followed by the Fund.
(a) Valuation of investments--Portfolio securities that are traded on stock
exchanges are valued at the last sale price as of the close of business on the
day the securities are being valued, or lacking any sales, at the closing bid
price. Securities traded in the over-the-counter market are valued at the last
available bid price prior to the time of valuation. In cases where securities
are traded on more than one exchange, the securities are valued on the exchange
designated by or under the authority of the Board of Directors as the primary
market. Portfolio securities that are traded both in the over-the-counter 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. Options written or purchased are
valued at the last sale price in the case of exchange-traded options. In the
case of options traded in the over-the-counter market, valuation is the last
asked price (options written) or the last bid price (options purchased). Futures
contracts are valued at the settlement price at the close of the applicable
exchange. Short-term securities are valued at amortized cost, which approximates
market value. 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.
(b) Derivative financial instruments--The Fund may engage in various portfolio
investment strategies to increase or decrease the level of risk to which the
Fund is exposed more quickly and efficiently than transactions in other types of
instruments. Losses may arise due to changes in the value of the contract or if
the counterparty does not perform under the contract.
- - Forward foreign exchange contracts--The Fund is authorized to enter into
forward foreign exchange contracts as a hedge against either specific
transactions or portfolio positions. The contract is marked to market daily and
the change in market value is recorded by the Fund as an unrealized gain or
loss. When the contract is closed, the Fund records a realized gain or loss
equal to the difference between the value at the time it was opened and the
value at the time it was closed.
- - Options--The Fund may write call and put options and purchase put options.
When the Fund writes an option, an amount equal to the premium received by the
Fund is reflected as an asset and an equivalent liability. The amount of the
liability is subsequently marked to market to reflect the current market value
of the option written. When a security is purchased or sold through an exercise
of an option, the related premium paid (or received) is added to (or deducted
from) the basis of the security acquired or deducted from (or added to) the
proceeds of the security sold. When an option expires (or the Fund enters into a
closing transaction), the Fund realizes a gain or loss on the option to the
extent of the premiums received or paid (or gain or loss to the extent the cost
of the closing transaction exceeds the premium paid or received).
Written and purchased options are non-income producing investments.
- - Financial futures contracts--The Fund may purchase or sell financial futures
contracts and options on such futures contracts for the purpose of hedging the
market risk on existing securities or the intended purchase of securities.
Futures contracts are contracts for delayed delivery of securities at a specific
future date and at a specific price or yield. Upon entering into a contract, the
Fund deposits and maintains as collateral such initial margin as required by the
exchange on which the transaction is
273
- --------------------------------------------------------------------------------
effected. Pursuant to the contract, the Fund agrees to receive from or pay to
the broker an amount of cash equal to the daily fluctuation in value of the
contract. Such receipts or payments are known as variation margin and are
recorded by the Fund as unrealized gains or losses. When the contract is closed,
the Fund records a realized gain or loss equal to the difference between the
value of the contract at the time it was opened and the value at the time it was
closed.
- - Foreign currency options and futures--The Fund may also purchase or sell
listed or over-the-counter foreign currency options, foreign currency futures
and related options on foreign currency futures as a short or long hedge against
possible variations in foreign exchange rates. Such transactions may be effected
with respect to hedges on non-U.S. dollar denominated securities owned by the
Fund, sold by the Fund but not yet delivered, or committed or anticipated to be
purchased by the Fund.
(c) Foreign currency transactions--Transactions denominated in foreign
currencies are recorded at the exchange rate prevailing when recognized. Assets
and liabilities denominated in foreign currencies are valued at the exchange
rate at the end of the period. Foreign currency transactions are the result of
settling (realized) or valuing (unrealized) assets and liabilities expressed in
foreign currencies into U.S. dollars. Realized and unrealized gains or losses
from investments include the effects of foreign exchange rates on investments.
(d) Income taxes--It is the Fund's policy to comply with the requirements of
the Internal Revenue Code applicable to regulated investment companies and to
distribute substantially all of its taxable income to its shareholders.
Therefore, no Federal income tax provision is required. Under the applicable
foreign tax law, a withholding tax may be imposed on interest, dividends and
capital gains at various rates.
(e) Security transactions and investment income--Security transactions are
recorded on the dates the transactions are entered into (the trade dates).
Realized gains and losses on security transactions are determined on the
identified cost basis. Dividend income is recorded on the ex-dividend dates.
Dividends from foreign securities where the ex-dividend date may have passed are
subsequently recorded when the Fund has determined the ex-dividend date.
Interest income is recognized on the accrual basis.
(f) Dividends and distributions--Dividends from net investment income are
declared and paid quarterly. Distributions of capital gains are recorded on the
ex-dividend date.
(g) Expenses--Certain expenses have been allocated to the individual funds in
the Company on a pro rata basis based upon the respective aggregate net asset
value of each fund included in the Company.
(h) Securities lending--The Fund may lend securities to financial institutions
that provide cash or securities issued or guaranteed by the U.S. government as
collateral, which will be maintained at all times in an amount equal to at least
100% of the current market value of the loaned securities. Where the Fund
receives securities as collateral for the loaned securities, it receives a fee
from the borrower. The Fund typically receives the income on the loaned
securities, but does not receive the income on the collateral. Where the Fund
receives cash collateral, it may invest such collateral and retain the amount
earned on such investment, net of any amount rebated to the borrower. Loans of
securities are terminable at any time and the borrower, after notice, is
required to return borrowed securities within five business days. The Fund may
pay reasonable finder's, lending agent, administrative and custodial fees in
connection with its loans. In the event that the borrower defaults on its
obligation to return borrowed securities because of insolvency or for any other
reason, the Fund could experience delays and costs in gaining access to the
collateral. The Fund also could suffer a loss where the value of the collateral
falls below the market value of the borrowed securities, in the event of
borrower default or in the event of losses on investments made with cash
collateral.
(i) Reclassification--Accounting principles generally accepted in the United
States of America require that certain components of net assets be adjusted to
reflect permanent differences between financial and tax reporting. Accordingly,
the current year's permanent book/tax difference of $8,207 has been reclassified
between accumulated distributions in excess of net investment income and
accumulated net realized capital losses. This reclassification has no effect on
net assets or net asset value per share.
2. INVESTMENT ADVISORY AGREEMENT AND
TRANSACTIONS WITH AFFILIATES:
The Company has entered into an Investment Advisory Agreement with Merrill Lynch
Investment Managers, L.P. ("MLIM"). The general partner of MLIM is Princeton
Services, Inc. ("PSI"), an indirect, wholly-owned subsidiary of ML & Co., which
is the limited partner.
MLIM is responsible for the management of the Company's funds and provides the
necessary personnel, facilities, equipment and certain
274
- --------------------------------------------------------------------------------
other services necessary to the operations of the Fund. For such services, the
Fund pays a monthly fee at the annual rate of .60% of the average daily value of
the Fund's net assets.
MLIM and Merrill Lynch Life Agency, Inc. ("MLLA") have entered into an
agreement that limits the operating expenses paid by the Fund, exclusive of any
distribution fees imposed on Class B Shares, to 1.25% of its average daily net
assets. Any such expenses in excess of 1.25% of average daily net assets will be
reimbursed to the Fund by MLIM which, in turn, will be reimbursed by MLLA.
The Company has received an exemptive order from the Securities and Exchange
Commission permitting it to lend portfolio securities to Merrill Lynch, Pierce,
Fenner & Smith Incorporated ("MLPF&S"), a subsidiary of ML & Co., or its
affiliates. Pursuant to that order, the Fund also has retained Merrill Lynch
Investment Managers, LLC ("MLIM, LLC"), an affiliate of MLIM, as the securities
lending agent for a fee based on a share of the returns on investment of cash
collateral. MLIM, LLC may, on behalf of the Company and the Fund, invest cash
collateral received by the Fund for such loans, among other things, in a private
investment company managed by MLIM, LLC or in registered money market funds
advised by MLIM or its affiliates. As of December 31, 2002, cash collateral of
$603,803 was invested in the Money Market Series of the Merrill Lynch Liquidity
Series, LLC and $535,449 was invested in the Merrill Lynch Premier Institutional
Fund. As of December 31, 2002, the Fund lent securities with a value of
$1,104,500 to MLPF&S or its affiliates. For the year ended December 31, 2002,
MLIM, LLC received $2,058 in securities lending agent fees from the Fund.
For the year ended December 31, 2002, MLPF&S earned $3,983 in commissions on
the execution of portfolio security transactions.
For the year ended December 31, 2002, the Fund paid Merrill Lynch Securities
Pricing Service, an affiliate of MLPF&S, $255 for providing security price
quotations to compute the Fund's net asset value.
Financial Data Services, Inc. ("FDS"), a wholly-owned subsidiary of ML & Co.,
is the Company's transfer agent.
FAM Distributors, Inc. ("FAMD"), which is a wholly-owned subsidiary of Merrill
Lynch Group, Inc., is the Fund's distributor.
For the year ended December 31, 2002, the Fund reimbursed MLIM $2,276 for
certain accounting services.
Certain officers and/or directors of the Company are officers and/or directors
of MLIM, PSI, FDS, FAMD, and/or ML & Co.
3. INVESTMENTS:
Purchases and sales of investments, excluding short-term securities, for the
year ended December 31, 2002 were $16,464,324 and $27,312,697, respectively.
Net realized losses for the year ended December 31, 2002 and net unrealized
gains as of December 31, 2002 were as follows:
<Table>
<Caption>
- -------------------------------------------------------------------
Realized Unrealized
Losses Gains
- -------------------------------------------------------------------
Long-term investments................... $(12,994,382) $193,713
Short-term investments.................. (65) --
Foreign currency transactions........... (8,198) 808
------------ --------
Total................................... $(13,002,645) $194,521
============ ========
- -------------------------------------------------------------------
</Table>
At December 31, 2002, net unrealized appreciation for Federal income tax
purposes aggregated $168,276, of which $5,759,913 related to appreciated
securities and $5,591,637 related to depreciated securities. At December 31,
2002, the aggregate cost of investments for Federal income tax purposes was
$45,833,825.
4. CAPITAL SHARE TRANSACTIONS:
Transactions in capital shares were as follows:
<Table>
<Caption>
- -----------------------------------------------------------------
Class A Shares for the Year Ended Dollar
December 31, 2002 Shares Amount
- -----------------------------------------------------------------
Shares sold.......................... 144,278 $ 973,644
Shares issued to shareholders in
reinvestment of dividends and
distributions....................... 470,261 3,341,523
---------- ------------
Total issued......................... 614,539 4,315,167
Shares redeemed...................... (2,193,856) (15,503,735)
---------- ------------
Net decrease......................... (1,579,317) $(11,188,568)
========== ============
- -----------------------------------------------------------------
</Table>
<Table>
<Caption>
- -----------------------------------------------------------------
Class A Shares for the Year Ended Dollar
December 31, 2001 Shares Amount
- -----------------------------------------------------------------
Shares sold.......................... 601,810 $ 5,679,794
Shares issued to shareholders in
reinvestment of dividends and
distributions....................... 656,007 5,850,198
---------- ------------
Total issued......................... 1,257,817 11,529,992
Shares redeemed...................... (2,701,523) (25,443,642)
---------- ------------
Net decrease......................... (1,443,706) $(13,913,650)
========== ============
- -----------------------------------------------------------------
</Table>
5. SHORT-TERM BORROWINGS:
The Fund, along with certain other funds managed by MLIM and its affiliates, is
a party to a credit agreement with Bank One, N.A. and certain other lenders.
Effective November 29, 2002, in conjunction with the renewal for one year at the
same terms, the total commitment was reduced from $1,000,000,000 to
$500,000,000. The Fund may borrow under the credit agreement to fund shareholder
redemptions and for other lawful purposes other than for leverage. The Fund may
borrow up to the
275
- --------------------------------------------------------------------------------
maximum amount allowable under the Fund's current prospectus and statement of
additional information, subject to various other legal, regulatory or
contractual limits. The Fund pays a commitment fee of .09% per annum based on
the Fund's pro rata share of the unused portion of the credit agreement. Amounts
borrowed under the credit agreement bear interest at a rate equal to, at each
fund's election, the Federal Funds rate plus .50% or a base rate as determined
by Bank One, N.A. The Fund did not borrow under the credit agreement during the
year ended December 31, 2002.
6. DISTRIBUTIONS TO SHAREHOLDERS:
The tax character of distributions paid during the fiscal years ended December
31, 2002 and December 31, 2001 was as follows:
<Table>
<Caption>
- ------------------------------------------------------------------
12/31/2002 12/31/2001
- ------------------------------------------------------------------
Distributions paid from:
Ordinary income......................... $2,001,428 $3,987,537
Net long-term capital gains............. 1,340,095 1,862,661
---------- ----------
Total taxable distributions.............. $3,341,523 $5,850,198
========== ==========
- ------------------------------------------------------------------
</Table>
As of December 31, 2002, the components of accumulated losses on a tax basis
were as follows:
- ---------------------------------------------------------
<Table>
Undistributed ordinary income--net................ $ --
Undistributed long-term capital gains--net........ --
------------
Total undistributed earnings--net................. --
Capital loss carryforward......................... (12,650,732)*
Unrealized losses--net............................ (154,988)**
------------
Total accumulated losses--net..................... $(12,805,720)
============
- -----------------------------------------------------------------
</Table>
* On December 31, 2002, the Fund had a net capital loss carryforward of
$12,650,732, all of which expires in 2010. This amount will be available to
offset like amounts of any future taxable gains.
** The difference between book-basis and tax-basis net unrealized losses is
attributable primarily to the tax deferral of losses on wash sales and the
deferral of post-October currency and capital losses for tax purposes.
276
- --------------------------------------------------------------------------------
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.--UTILITIES AND TELECOMMUNICATIONS V.I.
FUND
INDEPENDENT AUDITORS' REPORT
- --------------------------------------------------------------------------------
THE BOARD OF DIRECTORS AND SHAREHOLDERS,
UTILITIES AND TELECOMMUNICATIONS V.I. FUND OF
MERRILL LYNCH VARIABLE SERIES FUNDS, INC.:
We have audited the accompanying statement of assets and liabilities,
including the schedule of investments, of Utilities and Telecommunications V.I.
Fund (formerly, Utilities and Telecommunications Focus Fund) of Merrill Lynch
Variable Series Funds, Inc. as of December 31, 2002, the related statements of
operations for the year then ended and changes in net assets for each of the
years in the two-year period then ended, and the financial highlights for each
of the years presented. These financial statements and the financial highlights
are the responsibility of the Fund's management. Our responsibility is to
express an opinion on these financial statements and the financial highlights
based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements and the financial highlights are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. Our procedures included confirmation of
securities owned at December 31, 2002 by correspondence with the custodian. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, such financial statements and financial highlights present
fairly, in all material respects, the financial position of Utilities and
Telecommunications V.I. Fund of Merrill Lynch Variable Series Funds, Inc. as of
December 31, 2002, the results of its operations, the changes in its net assets,
and the financial highlights for the respective stated periods in conformity
with accounting principles generally accepted in the United States of America.
Deloitte & Touche LLP
Princeton, New Jersey
February 14, 2003
277
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MERRILL LYNCH VARIABLE SERIES FUNDS, INC.
OFFICERS AND DIRECTORS
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INTERESTED DIRECTOR
<Table>
<Caption>
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NUMBER OF
PORTFOLIOS IN
FUND COMPLEX
POSITION(S) HELD LENGTH OF PRINCIPAL OCCUPATION(S) OVERSEEN OTHER DIRECTORSHIPS
NAME, ADDRESS & AGE WITH FUND TIME SERVED DURING PAST 5 YEARS BY DIRECTOR HELD BY DIRECTOR
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Terry K. Glenn* President and 1999 to present and Chairman, Americas Region 117 Funds 162 None
P.O. Box 9011 Director 1985 to present since 2001 and Executive Portfolios
Princeton, NJ 08543-9011 Vice President since 1983
Age: 62 of Fund Asset Management
("FAM") and Merrill Lynch
Investment Managers, L.P.
("MLIM"); President of
Merrill Lynch Mutual Funds
since 1999; President of
FAM Distributors, Inc.
("FAMD") since 1986 and
Director thereof since
1991; Executive Vice
President and Director of
Princeton Services, Inc.
("Princeton Services")
since 1993; President of
Princeton Administrators,
L.P. since 1988; Director
of Financial Data Services,
Inc. since 1985.
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* Mr. Glenn is a director, trustee or member of an advisory board of certain other investment companies for which FAM or MLIM acts
as investment adviser. Mr. Glenn is an "interested person," as described in the Investment Company Act, of each Fund based on his
positions as Chairman (Americas Region) and Executive Vice President of FAM and MLIM; President of FAMD; Executive Vice President
of Princeton Services; and President of Princeton Administrators, L.P. The Director's term is unlimited. Directors serve until
their resignation, removal or death, or until December 31, of the year which they turn 72. As Fund President, Mr. Glenn serves at
the pleasure of the Board of Directors.
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</Table>
INDEPENDENT DIRECTORS
<Table>
<Caption>
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NUMBER OF
PORTFOLIOS IN
FUND COMPLEX
POSITION(S) HELD LENGTH OF PRINCIPAL OCCUPATION(S) OVERSEEN OTHER DIRECTORSHIPS
NAME, ADDRESS & AGE WITH FUND TIME SERVED* DURING PAST 5 YEARS BY DIRECTOR HELD BY DIRECTOR
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James H. Bodurtha Director 2002 to present Director and Executive 42 Funds None
P.O. Box 9095 Vice President, The 61 Portfolios
Princeton, NJ 08543-9095 China Business Group,
Age: 58 Inc. since 1995;
Chairman, Berkshire
Holding Corporation
since 1980.
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</Table>
278
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<Table>
<Caption>
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NUMBER OF
PORTFOLIOS IN
FUND COMPLEX
POSITION(S) HELD LENGTH OF PRINCIPAL OCCUPATION(S) OVERSEEN OTHER DIRECTORSHIPS
NAME, ADDRESS & AGE WITH FUND TIME SERVED* DURING PAST 5 YEARS BY DIRECTOR HELD BY DIRECTOR
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Joe Grills Director 1994 to present Member of the Committee 42 Funds Kimco Realty Corporation
P.O. Box 9095 of Investment of 61 Portfolios
Princeton, NJ 08543-9095 Employee Benefit Assets
Age: 67 of the Association of
Financial Professionals
("CIEBA") since 1986;
Member of CIEBA's
Executive Committee
since 1988; Member of
the Investment Advisory
Committees of the State
of New York Common
Retirement Fund since
1989; Member of the
Investment Advisory
Committee of the Howard
Hughes Medical
Institute from 1997 to
2000; Director, Duke
Management Company
since 1992 and Vice
Chairman thereof since
1998; Director, LaSalle
Street Fund from 1995
to 2001; Member of the
Investment Advisory
Committee of the
Virginia Retirement
System since 1998;
Director, Montpelier
Foundation since 2000;
Member of the
Investment Committee of
the Woodberry Forest
School since 2000;
Member of the
Investment Committee of
the National Trust for
Historic Preservation
since 2000.
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Herbert I. London Director 2002 to present John M. Olin Professor 42 Funds None
P.O. Box 9095 of Humanities, New York 61 Portfolios
Princeton, NJ 08543-9095 University since 1993
Age: 63 and Professor thereof
since 1980; President
of Hudson Institute
since 1997 and Trustee
thereof since 1980.
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Andre F. Perold Director 2002 to present George Gund Professor 42 Funds None
P.O. Box 9095 of Finance and Banking, 61 Portfolios
Princeton, NJ 08543-9095 Harvard Business School
Age: 50 since 2000 and a member
of the faculty since
1979; Director,
Stockback.com since
2002.
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</Table>
279
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<Table>
<Caption>
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NUMBER OF
PORTFOLIOS IN
FUND COMPLEX
POSITION(S) HELD LENGTH OF PRINCIPAL OCCUPATION(S) OVERSEEN OTHER DIRECTORSHIPS
NAME, ADDRESS & AGE WITH FUND TIME SERVED* DURING PAST 5 YEARS BY DIRECTOR HELD BY DIRECTOR
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Roberta Cooper Ramo Director 2002 to present Shareholder, Modral, 42 Funds Coopers, Inc.;
P.O. Box 9095 Sperling, Roehl, Harris 61 Portfolios ECMC, Inc.
Princeton, NJ 08543-9095 & Sisk, P.A. since
Age: 60 1993.
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Robert S. Salomon, Jr. Director 1997 to present Principal of STI 42 Funds None
P.O. Box 9095 Management since its 61 Portfolios
Princeton, NJ 08543-9095 founding in 1994;
Age: 66 Trustee of Commonfund
from 1980 to 2002;
Trustee and Chairman of
the Investment
Management Workshop
from 1978 to 2000;
Director of Rye Country
Day School since 2001.
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Melvin R. Seiden Director 1982 to present Director, Silbanc 42 Funds None
P.O. Box 9095 Properties, Ltd. (real 61 Portfolios
Princeton, NJ 08543-9095 estate, investment and
Age: 72 consulting) since 1987.
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Stephen B. Swensrud Director 1984 to present Chairman, Fernwood 42 Funds International Mobile
P.O. Box 9095 Advisors (investment 61 Portfolios Communications, Inc.
Princeton, NJ 08543-9095 adviser) since 1996;
Age: 69 Principal of Fernwood
Associates (financial
consultant) since 1975;
Chairman of RPP
Corporation since 1978.
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* The Director's term is unlimited. Directors serve until their resignation, removal or death, or until December 31, of the year
which they turn 72.
</Table>
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Effective January 1, 2003, Melvin R. Seiden, Director of Merrill Lynch Variable
Series Funds, Inc., retired.
The Fund's Board of Directors wishes Mr. Seiden well in his retirement.
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280
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FUND OFFICERS
<Table>
<Caption>
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POSITION(S) HELD
NAME, ADDRESS & AGE WITH FUND LENGTH OF TIME SERVED* PRINCIPAL OCCUPATION(S) DURING PAST 5 YEARS
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Donald C. Burke Vice President & 1993 to present First Vice President of FAM and MLIM since 1997
P.O. Box 9011 Treasurer and 1999 to present and Treasurer thereof since 1999; Senior Vice
Princeton, NJ 08543-9011 President and Treasurer of Princeton Services
Age: 42 since 1999; Vice President of FAMD since 1999;
Director of MLIM Taxation since 1990.
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Kathleen M. Anderson Senior Vice 2002 to present Director (Equities) of MLIM since 2000;
P.O. Box 9011 President Associate Portfolio Manager of MLIM since 1998.
Princeton, NJ 08543-9011
Age: 44
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Robin Elise Baum Senior Vice 1999 to present Managing Director (Equities) of MLIM since 2000;
P.O. Box 9011 President First Vice President from 1999 to 2000; Director
Princeton, NJ 08543-9011 (Equities) of MLIM from 1997 to 1999.
Age: 42
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Walter Cuje Senior Vice 2001 to present Director (Equities) of MLIM since 2000 and First
P.O. Box 9011 President Vice President from 1997 to 2000.
Princeton, NJ 08543-9011
Age: 43
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Robert C. Doll, Jr. Senior Vice 2000 to present President and Global Chief Investment Officer of
P.O. Box 9011 President MLIM and member of the Executive Management
Princeton, NJ 08543-9011 Committee of ML & Co., Inc. since 2001; Chief
Age: 49 Investment Officer, Senior Vice President and
Co-Head of MLIM Americas from 1999 to 2001;
Chief Investment Officer of Oppenheimer Funds,
Inc. from 1987 to 1999 and Executive Vice
President from 1991 to 1999.
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Gareth Fielding Senior Vice 2001 to present Director (Global Fixed Income) of MLIM since
P.O. Box 9011 President 1998; Senior Portfolio Manager with J.P. Morgan
Princeton, NJ 08543-9011 from 1991 to 1998.
Age: 39
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Lawrence R. Fuller Senior Vice 1997 to present Managing Director (Equities) of MLIM since 2000
P.O. Box 9011 President and First Vice President from 1997 to 2000.
Princeton, NJ 08543-9011
Age: 61
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Michael S. Hahn Senior Vice 2002 to present Director (Equities) of MLIM since 2000;
P.O. Box 9011 President Associate Portfolio Manager of MLIM from 1999 to
Princeton, NJ 08543-9011 2000; Portfolio Manager and Analyst for the PBHG
Age: 35 family of mutual funds from 1996 to 1999.
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Patrick Maldari Senior Vice 2002 to present Managing Director (Global Fixed Income) of MLIM
P.O. Box 9011 President since 2000 and First Vice President from 1997 to
Princeton, NJ 08543-9011 2000.
Age: 40
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Robert J. Martorelli Senior Vice 2000 to present Managing Director (Equities) of MLIM since 2000
P.O. Box 9011 President and First Vice President from 1997 to 2000.
Princeton, NJ 08543-9011
Age: 45
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Kevin J. McKenna Senior Vice 1998 to present Managing Director of MLIM and Head of MLIM
P.O. Box 9011 President Americas Fixed Income since 2000; First Vice
Princeton, NJ 08543-9011 President of MLIM from 1997 to 2001.
Age: 45
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Nicholas Moakes Senior Vice 2002 to present Director of MLIM UK (Equities) since 2000;
P.O. Box 9011 President Member of the Global Emerging Markets team since
Princeton, NJ 08543-9011 1997.
Age: 37
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Robert F. Murray Senior Vice 2001 to present Director (Global Fixed Income) of MLIM since
P.O. Box 9011 President 2001; Vice President of MLIM from 1993 to 2001.
Princeton, NJ 08543-9011
Age: 45
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James J. Pagano Senior Vice 2002 to present Vice President (Global Fixed Income) of MLIM
P.O. Box 9011 President since 1996.
Princeton, NJ 08543-9011
Age: 40
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Josephine Ragni Senior Vice 2002 to present Co-Portfolio Manager of MLIM (Developing Capital
P.O. Box 9011 President Markets and Latin American family of funds)
Princeton, NJ 08543-9011 since 2002 and Latin American fund manager from
Age: 34 1998 to 2002;
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</Table>
281
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FUND OFFICERS (CONCLUDED)
<Table>
<Caption>
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POSITION(S) HELD
NAME, ADDRESS & AGE WITH FUND LENGTH OF TIME SERVED* PRINCIPAL OCCUPATION(S) DURING PAST 5 YEARS
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Kevin M. Rendino Senior Vice 1998 to present Managing Director (Equities) of MLIM since 2000
P.O. Box 9011 President and First Vice President from 1997 to 2000.
Princeton, NJ 08543-9011
Age: 36
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Jacqueline Rogers-Ayoub Senior Vice 2001 to present Vice President of MLIM since 1986.
P.O. Box 9011 President
Princeton, NJ 08543-9011
Age: 45
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Kurt Schansinger Senior Vice 1999 to present Managing Director (Equities) of MLIM since 2000
P.O. Box 9011 President and First Vice President from 1997 to 2000.
Princeton, NJ 08543-9011
Age: 42
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Robert Shearer Senior Vice 1998 to present Managing Director (Equities) of MLIM since 2000
P.O. Box 9011 President and First Vice President from 1998 to 2000.
Princeton, NJ 08543-9011
Age: 47
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Dennis W. Stattman Senior Vice 2001 to present Managing Director of MLIM since 2000 and First
P.O. Box 9011 President Vice President from 1997 to 2000.
Princeton, NJ 08543-9011
Age: 51
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Stephen M. Benham Secretary 2002 to present Vice President (Legal Advisory) of MLIM since
P.O. Box 9011 2000; Associate with Kirkpatrick & Lockhart LLP
Princeton, NJ 08543-9011 from 1997 to 2000.
Age: 43
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</Table>
* Officers of the Fund serve at the pleasure of the Board of Directors.
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PRINCIPAL OFFICE OF THE FUNDS
Box 9011
Princeton, NJ 08543-9011
TRANSFER AGENT
Financial Data Services, Inc.
4800 Deer Lake Drive East
Jacksonville, FL 32246-6484
CUSTODIAN
For all Funds except Developing Capital
Markets Focus Fund:
The Bank of New York
110 Washington Street
New York, NY 10286
For Developing Capital Markets Focus Fund:
Brown Brothers Harriman & Co.
40 Water Street
Boston, MA 02109
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Further information about the Fund's directors/trustees is available in the
Fund's Statement of Additional Information, which can be obtained without charge
by calling 1-800-MER-FUND.
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282
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