Pursuant to an arrangement between NMIC and certain of its subsidiaries, during 2002 the Company leased on average approximately 767,000 square feet of office space in the three building home office complex and in other offices in Columbus, Ohio. The Company believes that its present facilities are adequate for the anticipated needs of the Company.
The Company is a leading provider of long-term savings and retirement products in the U.S. The Company develops and sells a diverse range of products including individual annuities, Private and Public Sector pension plans and other investment products sold to institutions, and life insurance. The Company sells its products through a diverse distribution network, including independent broker/dealers, wirehouse and regional firms, financial institutions, pension plan administrators, life insurance specialists, Nationwide Retirement Solutions, Nationwide Provident agents and Nationwide agents.
Management’s discussion and analysis contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 with respect to the results of operations and businesses of the Company. These forward-looking statements involve certain risks and uncertainties. Factors that may cause actual results to differ materially from those contemplated or projected, forecast, estimated or budgeted in such forward-looking statements include, among others, the following possibilities: (i) the potential impact on the Company’s reported consolidated net income that could result from the adoption of certain accounting standards issued by the Financial Accounting Standards Board (FASB) or other standard-setting bodies; (ii) tax law changes impacting the tax treatment of life insurance and investment products; (iii) repeal of the federal estate tax; (iv) heightened competition, including specifically the intensification of price competition, the entry of new competitors and the development of new products by new and existing competitors; (v) adverse state and federal legislation and regulation, including limitations on premium levels, increases in minimum capital and reserves, and other financial viability requirements; (vi) failure to expand distribution channels in order to obtain new customers or failure to retain existing customers; (vii) inability to carry out marketing and sales plans, including, among others, development of new products and/or changes to certain existing products and acceptance of the new and/or revised products in the market; (viii) changes in interest rates and the stock markets causing a reduction of investment income and/or asset fees, an acceleration of the amortization of deferred policy acquisition costs (DAC), reduction in the value of the Company’s investment portfolio or separate account assets, or a reduction in the demand for the Company’s products; (ix) general economic and business conditions which are less favorable than expected; (x) competitive, regulatory or tax changes that affect the cost of, or demand for the Company’s products; (xi) unanticipated changes in industry trends and ratings assigned by nationally recognized rating organizations; (xii) deviations from assumptions regarding future persistency, mortality, morbidity and interest rates used in calculating reserve amounts and in pricing the Company’s products; and (xiii) adverse litigation results or resolution of litigation and/or arbitration.
The most significant assumptions that are involved in the estimation of future gross profits include future net separate account performance, surrender/lapse rates, interest margins and mortality. The Company’s long-term assumption for net separate account performance is 8 percent. If actual net separate account performance varies from the 8 percent assumption, the Company assumes different performance levels over the next three years, such that the mean return equals the long-term assumption. This process is referred to as a reversion to the mean. The assumed net separate account return assumptions used in the DAC models are intended to reflect what is anticipated. However, based on historical returns of the S&P 500 Index, the Company’s policy regarding the reversion to the mean process does not permit such returns to be below zero percent or in excess of 15 percent during the three-year reversion period.
The Company provides valuation allowances for impairments of mortgage loans on real estate based on a review by portfolio managers. Mortgage loans on real estate are considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. When the Company determines that a loan is impaired, a provision for loss is established equal to the difference between the carrying value and the estimated value of the mortgage loan. Estimated value is based on the present value of expected future cash flows discounted at the loan’s effective interest rate, or the fair value of the collateral, if the loan is collateral dependent. Loans in foreclosure and loans considered impaired are placed on non-accrual status. Interest received on non-accrual status mortgage loans on real estate is included in net investment income in the period received.
Total operating revenues, which exclude net realized gains and losses on investments not related to securitizations, hedging instruments and hedged items, increased $79.7 million, or 3%, to $3.08 billion in 2002 compared to $3.00 billion in 2001. The growth in operating revenues in 2002 was primarily driven by an increase in net investment income as a result of continued growth in interest spread-based businesses, which offset lower policy charges due to depressed equity markets. Operating revenues in 2001 increased by less than 1% from $3.00 billion reported in 2000, with growth in net investment income offsetting lower policy charges.
Cost of insurance charges are assessed on the net amount at risk on universal life insurance policies. The net amount at risk is equal to a policy’s death benefit minus the related policyholder account value. The amount charged is based on the insured’s age and other underwriting factors. The increase in cost of insurance charges is due primarily to growth in the net amount at risk related to corporate and individual investment life insurance reflecting new sales, favorable persistency on policies sold in prior periods and equity market declines which lowered policyholder account values. The net amount at risk related to corporate and individual investment life insurance grew to $36.15 billion at the end of 2002 compared to $32.93 billion and $28.28 billion at the end of 2001 and 2000, respectively.
Surrender fees increased in 2002 compared to a year ago, primarily due to higher lapse activity in individual variable annuities and investment life insurance products as a result of the sustained downturn in the equity markets and the competitive environment in the marketplace. Lower surrender charges in 2001 compared to 2000 were the result of the successful implementation of customer retention programs in the individual variable annuity business during the year.
Losses from other-than-temporary impairments were $120.3 million in 2002, compared to $80.6 million in 2001 and $15.4 million in 2000. Included in the 2002 losses were $22.5 million, pre-tax, related to WorldCom, Inc., and 2001 losses included $25.9 million related to fixed maturity securities issued by Enron and affiliated entities. Non-impairment related net realized gains on investments, hedging instruments and hedged items totaled $35.9 million in 2002 compared to $62.3 million of net gains in 2001 and net losses of $4.0 million in 2000, including gains of $23.2 million and $44.4 million in 2002 and 2001, respectively, related to the two-step sale of a real estate limited partnership to related parties, as described in note 14 to the consolidated financial statements included in the F pages of this report.
The substantial increase in DAC amortization in 2002 compared to a year ago reflects an acceleration of DAC amortization recorded in the third quarter of 2002. As part of the regular quarterly analysis of DAC, at the end of the third quarter of 2002, the Company determined that using actual experience to date and assumptions consistent with those used in the second quarter of 2002, its individual variable annuity DAC balance would be outside a pre-set parameter of acceptable results. The Company also determined that it was not reasonably possible that the DAC would return to an amount within the acceptable parameter within a prescribed period of time. Accordingly, the Company unlocked its DAC assumptions for individual variable annuities and reduced the DAC asset to the amount calculated using the revised assumptions. Because the Company unlocked the net separate account growth rate assumption for individual variable annuities for the three-year reversion period, the Company unlocked that assumption for all investment products and variable universal life insurance products to be consistent across product lines.
The increase in interest expense in 2002 relates to the issuance of $300 million of surplus notes to NFS in both December 2001 and June 2002, partially offset by lower utilization of commercial paper.
Operating expenses were $508.6 million in 2002, a 16% increase from 2001 operating expenses of $439.3 million. Operating expenses were $472.0 million in 2000. The increase in 2002 reflects a growing customer base, increased employee benefit costs and increased spending on projects focused on improving producer and customer support. The 7% decrease in 2001 compared to 2000 reflects the Company’s commitment to aggressive expense management in response to declining revenues and lower sales as a result of declining and volatile equity markets and a slowing economy throughout the year.
Federal income tax expense was $8.7 million representing an effective tax rate of 5.1% for 2002. Federal income tax expense in 2001 and 2000 was $161.2 million and $207.3 million, respectively, representing effective rates of 25.6% and 30.3%. The tax benefit of $121.5 million associated with the $347.1 million of accelerated DAC amortization in third quarter 2002 was calculated at the U.S. federal corporate income tax rate of 35%, which causes a distortion in what would normally be expected to be reported as an effective tax rate. Excluding the accelerated DAC amortization and related tax benefit, the effective tax rate for 2002 was 25.2%, which is lower than 2001 due to an increase in tax credits from affordable housing partnership investments and the elimination of non-deductible goodwill amortization expense in 2002, partially offset by lower tax-exempt income. An increase in tax-exempt income and tax credits, including credits from affordable housing partnership investments, resulted in the decrease in 2001.
On June 27, 2002, NLIC paid a dividend to NFS consisting of its shares of common stock of Nationwide Securities, Inc. (NSI), a wholly owned broker/dealer subsidiary. This is a transaction between related parties and therefore was recorded at carrying value, $10.0 million, of the underlying components of the transaction rather than fair value.
Income (loss) from discontinued operations, net of tax, for 2002, 2001 and 2000 was $0.7 million, $1.2 million and $(0.5) million, respectively.
The excluded items are important in understanding the Company’s overall results of operations. Pre-tax operating income or net operating income should not be viewed as substitutes for income from continuing operations before federal income taxes and cumulative effect of adoption of accounting principles or net income, respectively, determined in accordance with GAAP, and it should be noted that the Company’s definition of these non-GAAP financial measures may differ from those used by other companies. The Company believes that the presentation of these non-GAAP financial measures as they are measured for management purposes enhances the understanding of the Company’s results of operations by highlighting the results from ongoing operations, on a pre- and post-tax basis, and the underlying profitability factors of the Company’s business. The Company excludes net realized gains and losses on investments not related to securitizations, hedging instruments and hedged items from these non-GAAP financial measures because such items are often the result of a single non-recurring event which may or may not be at the Company’s discretion. Including the fluctuating effects of these transactions could distort trends in the underlying profitability of the Company’s business. The Company also excludes discontinued operations and the cumulative effect of adoption of accounting principles from net operating income, as such adjustments are not reflective of the ongoing operations of the Company’s business.
The Company regularly monitors and reports a non-GAAP financial measure titled sales. Sales or similar measures are commonly used in the insurance industry as a measure of business generated in the period. The Company has not provided a reconciliation of sales to a comparative GAAP financial measures because it does not believe there is a similar GAAP measure as it relates to its industry, as described below.
Sales should not be viewed as a substitute for revenues determined in accordance with GAAP, and the Company’s definition of sales might differ from that used by other companies. Sales generate customer funds managed and administered, which ultimately drive revenues. Sales are primarily comprised of statutory premiums and deposits on individual and group annuities and life insurance products sold to a diverse customer base. Statutory premiums and deposits are calculated in accordance with accounting practices prescribed or permitted by regulatory authorities and then adjusted to arrive at sales. Revenues are generated from both current and previous sales that are in-force during part of the reporting period and are reported as policy charges, life insurance premiums, net investment income and other revenues. Because revenues are generated primarily based on charges against the in-force or surrendering contracts based on a fraction of the value of the contract and sales relate primarily to the amount of premiums and deposits received in a period, the Company does not believe a reconciliation of these amounts would be meaningful.
Sales by product and segment for each of the last three years are as follows:
Sales through financial institutions grew 7% in 2002, driven mainly by increased fixed annuity sales, partially offset by lower production of variable annuities. Sales in 2001 grew 12% due primarily to the appointment of new distributors in the bank channel who sell fixed annuity products and a shift in customer preference in 2001 to fixed annuity products in light of the declining and volatile equity markets.
The 16% decrease in sales in the independent broker/dealer channel in 2002 reflects primarily lower demand for variable annuities and variable life insurance in light of depressed equity markets. Total sales through this channel were down 30% in 2001, reflecting lower demand for variable annuities due to declining and volatile equity markets. Also contributing to the decline in 2001 were lower Private Sector group pension sales due to decreases in the average takeover case size reflecting the depressed equity markets and number of new plans sold in light of the economic slowdown.
The 11% decrease in sales through life insurance specialists in 2002 reflects a weakness in COLI sales being negatively impacted by the sluggish equity markets, the weak economy, unfavorable press regarding COLI and executive deferred compensation plans and proposed legislation which would adversely impact the tax benefits of COLI. Sales for 2001 grew 4% over 2000 and reflect continued growth in renewal premiums, offset by a sharp decline in first-year premiums, as the depressed economic conditions reduced demand for new executive benefit plans.
Asset fees were $373.3 million in 2002 down 11% from $420.8 million in 2001 and totaled $478.5 million in 2000. Asset fees are calculated daily and charged as a percentage of separate account values. The fluctuations in asset fees are primarily due to changes in the market value of the investment options underlying the account values, which have followed the general trends of the equity markets. Average separate account values decreased 11% in 2002 to $29.75 billion following a 12% decrease in 2001.
The Institutional Products segment is comprised of the Company’s Private and Public Sector group retirement plans, medium-term note program and structured products initiatives. The Private Sector includes the 401(k) business generated through variable and fixed group annuities. The Public Sector includes the IRC Section 457 business in the form of fixed and variable annuities.
Pre-tax operating income totaled $203.4 million in 2002, down 4% compared to $211.3 million in 2001, which was down 4% from 2000. Results in 2002 include $12.0 million of accelerated DAC amortization, as described in Part II, Item 7 - Management’s Narrative Analysis of the Results of Operations - Benefits and Expenses. Excluding the accelerated DAC amortization, pre-tax operating income increased 2% due to growth in interest spread income and other income, which more than offset lower policy charges as a result of depressed equity markets and a shift in product mix to non-annuity products. Declining equity markets throughout the past two years has driven average separate account balances, policy charges and earnings lower. In addition an intensively competitive environment in the Public Sector market and a shift in product mix to more administration-only cases have resulted in reduced revenues and earnings.
Asset fees declined 17% to $147.3 million in 2002 compared to $176.7 million in 2001 and totaled $220.2 million in 2000. The declines were driven by back-to-back 17% decreases in average separate account assets in 2002 and 2001 as a result of sustained downturn in the equity markets and a shift in product mix from annuities to administrative-only products. The 2001 decline in other policy charges was a result of additional administration fees in 2000 from case terminations.
Interest spread income is net investment income less interest credited to policyholder account values. Interest spread income can vary depending on crediting rates offered by the Company, performance of the investment portfolio, including the rate of prepayments, changes in market interest rates, the competitive environment and other factors. Interest spread income was $31.6 million higher in 2002 compared to 2001, which was $21.1 million higher than 2000. The increases were driven by both higher average general account values and improved interest spread. The increase in average general account values was led by growth in the medium-term note program, where the Company issued $1.18 billion and $1.48 billion of notes in 2002 and 2001, respectively. An increase in participants allocating assets to the fixed option of the Company’s retirement plan offerings also drove the increase in general account values in 2002.
Interest spread improved 7 basis points in 2002 compared to 2001, as the Company was able to lower crediting rates more quickly than the decrease in investment portfolio rates, which decreased due to lower market interest rates. Mortgage loan and bond prepayment income added 9 basis points to the 2002 interest spread, compared to 13 basis points and 4 basis points in 2001 and 2000, respectively. The additional prepayment income in 2001 offset the impact on spreads of higher than anticipated cash balances at times throughout 2001 and yields declining on new investments more quickly than crediting rates could be adjusted.
The growth in other revenue in 2002 reflects additional structured products transactions.
Excluding the $12.0 million of accelerated DAC amortization in 2002, amortization of DAC decreased 12% in 2002, following a 3% decrease in 2001, reflecting lower revenue and earnings from group annuity contracts.
The decrease in return on average allocated capital in 2002 is primarily driven by lower earnings on variable annuities resulting from depressed equity markets and the accelerated DAC amortization. The decline in average allocated capital in 2001 compared to 2002 reflects lower earnings from variable annuities due to depressed equity markets and additional allocated capital to support growth in the medium-term note program.
Policy charges increased 10% to $347.2 million in 2002, following a 19% increase to $316.2 million in 2001. Cost of insurance charges, which are assessed on the amount of insurance in-force in excess of the related policyholder account value, increased 17% and 29% in 2002 and 2001, respectively, and reflect a growing block of investment life business, as insurance in-force increased 5% to $73.78 billion at 2002 compared to $70.45 billion at 2001. The growth in insurance in-force reflects both the impact of new sales as well as high persistency of in-force contracts. Administrative fees were $80.3 million or 9% lower in 2002 and flat in 2001 compared to 2000. Growth in fees assessed on policies in-force offset lower fees assessed on premiums and deposits due to the decline in sale of investment life products.
Return on average allocated capital increased slightly to 11.8% in 2002 compared to 11.6% and 12.1% in 2001 and 2000, respectively.
The increase in revenues in 2002 reflects an increase in net investment income primarily attributable to income earned on the proceeds from the surplus note offerings completed in December 2001 and June 2002, less the impact of lower investment income as a result of dividends paid to NFS and lower yields. The additional interest expense in 2002 reflects the surplus note offerings mentioned above, offset by lower utilization of commercial paper borrowings. The decline in revenues in 2001 reflects a decrease in net investment income on real estate investments, higher passive losses from affordable housing partnership investments, lower investment yields from declining interest rates and fewer investments retained in the Corporate segment as more capital and the related investment earnings were allocated to the product segments to support growth.
In addition to these operating revenues and expenses, the Company also reports net realized gains and losses on investments not related to securitizations, hedging instruments and hedged items in the Corporate segment. Losses from other-than-temporary impairments were $120.3 million in 2002, compared to $80.6 million in 2001 and $15.4 million in 2000. Included in the 2002 losses were $22.5 million related to WorldCom, Inc., and losses included $25.9 million related to fixed maturity securities issued by Enron and affiliated entities. Non-impairment related net realized gains on investments, hedging instruments and hedged items totaled $35.9 million in 2002 compared to $62.3 of net gains in 2001 and net losses of $4.0 million in 2000, including gains of $23.2 million and $44.4 million in 2002 and 2001, respectively, related to the two-step sale of a real estate partnership to related parties, as described in note 14 to the audited consolidated financial statements included in the F pages of this report.
During the 2002, NLIC paid a dividend of $35.0 million and dividends in the form of return of capital of $475.0 million to NFS.
In addition, in June 2002, NLIC paid a dividend to NFS in the form of all of the shares of common stock of NSI, a wholly owned broker/dealer subsidiary. Therefore, the results of the operations of NSI have been reflected as discontinued operations for all periods presented. This was a transaction between related parties and therefore was recorded at carrying value, $10.0 million, of the underlying components of the transaction rather than fair value.
In December 2001 NLIC sold NFS a 7.50%, $300.0 million surplus note maturing on December 17, 2031. In June 2002, NLIC sold NFS an 8.15%, $300.0 million surplus note maturing June 27, 2032. The Company made interest payments on surplus notes to NFS totaling $30.1 million in 2002 and none in 2001. In addition, the Company made interest payments on unsecured notes to NFS totaling $0.5 million in 2002.
Under the medium-term note program, NLIC issues funding agreements, which are insurance obligations, to an unrelated third-party trust to secure notes issued to investors by the trust. The funding agreements are recorded as a component of future policy benefits and claims on the Company’s consolidated balance sheets. Because the Company has no ownership interest in, or control over, the third-party trust that issues the notes, the Company does not include the trust in its consolidated financial statements and therefore, such notes are not reflected in the consolidated financial statements of the Company. As the notes issued by the trust have a secured interest in the funding agreement issued by the Company, Moody’s and S&P assign the same ratings to the notes as the insurance financial strength ratings of NLIC.
During 2002, the Company sold credit enhanced equity interests in Low Income Housing Tax Credit Funds (Tax Credit Funds) to unrelated third parties for $125.3 million and recognized $6.8 million of income. The Company guaranteed cumulative after-tax yields to third party investors ranging from 5.15% to 5.25%. These guarantees are in effect for approximately 15 years. The Tax Credit Funds will provide a stream of tax benefits to the investors that will generate a yield and return of capital. To the extent that the tax benefits are not sufficient to provide these cumulative after-tax yields, then the Company must fund any shortfall, which is mitigated by cash reserves established by the Company at the inception of the transactions.
To the extent there are cash deficits in any specific property owned by the Tax Credit Funds, property reserves, property operating guaranties and reserves held by the Tax Credit Funds are exhausted before the Company is required to perform under its guarantees. To the extent the Company is ever required to perform under its guarantees, it can recover any such funding out of the residual value generated upon the sale of any and/or all of the underlying properties of the Tax Credit Funds.