Pursuant to an arrangement between NMIC and certain of its subsidiaries, during 2005 the Company leased on average approximately 903,000 square feet of office space in the three building home office complex and in other offices in central Ohio. In addition, during 2005 NMIC announced plans to build and occupy a six-story, 130,000 square foot building in Columbus, Ohio. The Company expects to lease some of this space from NMIC. The Company believes that its present and planned facilities are adequate for the anticipated needs of the Company.
(v) adverse state and federal legislation and regulation, including limitations on premium levels, increases in minimum capital and reserves, and other financial viability requirements; restrictions on mutual fund distribution payment arrangements such as revenue sharing and 12b-1 payments; and regulation changes resulting from industry practice investigations;
(xiii) settlement of tax liabilities for amounts that differ significantly from those recorded on the balance sheet;
The Company’s primary expenses include interest credited to policyholder account values, other benefits and claims, amortization of DAC and general business operating expenses. Interest credited principally relates to individual and group fixed annuities, funding agreements backing the Company’s MTN program and certain life insurance products. Other benefits and claims include policyholder benefits in excess of policyholder account values for universal life and individual deferred annuities and net claims and provisions for future policy benefits for traditional life insurance products and immediate annuities.
The most critical estimates include those used to determine the following: the balance, recoverability and amortization of DAC for investment products and universal life insurance products; impairment losses on investments; valuation allowances for mortgage loans on real estate; federal income tax provisions; the liability for future policy benefits; and pension and other postretirement employee benefits.
Note 2 and Note 3 to the audited consolidated financial statements included in the F pages of this report provide a summary of significant accounting policies and a discussion of recently issued accounting standards, respectively.
Significant changes in the factors management considers when evaluating investments for impairment losses, including significant deterioration in the credit worthiness of individual issuers, could result in a significant change in impairment losses reported in the consolidated financial statements.
The liability for future policy benefits for traditional life insurance policies has been calculated by the net level premium method using interest rates varying from 5.4% to 6.0% and estimates of mortality, morbidity, investment yields and withdrawals that were used or being experienced at the time the policies were issued.
The liability for future policy benefits for payout annuities has been calculated using the present value of future benefits and maintenance costs discounted using interest rates varying from 3.0% to 13.0%. Also, as of December 31, 2005 and 2004, the calculated reserve was adjusted to reflect the incremental reserve that would be required if unrealized gains and losses had been realized and the proceeds reinvested at lower interest rates, which would have resulted in the use of a lower discount rate.
Pension and other postretirement employee benefits (OPEB) assumptions are revised at least annually in conjunction with preparation of the Company’s Annual Report on Form 10-K. The 2005 pension expense for substantially all of the Company’s employees and certain agents totaled $16.6 million, an increase of $2.9 million over 2004 pension expense of $13.7 million. Expenses increased at the plan level primarily due to decreasing interest rates, reflected in a lower discount rate. The discount rate used to value cash flows was lowered to 5.00% to determine 2005 pension expense from 5.50% for 2004, and the long-term expected rate of return on plan assets was lowered to 6.75% for 2005 from 7.25% for 2004.
The Company recorded net realized gains on investments, hedging instruments and hedged items during 2005 compared to net realized losses in 2004 primarily due to a significant decline in impairment charges.
Asset fees rose primarily due to increases in both average separate account values and the average asset fee rate charged within the Individual Investments segment.
The increase in amortization of DAC primarily was attributable to the Individual Investments segment due to higher gross margins on the underlying business.
The effective tax rate for 2004 was flat compared to 2003 as permanent tax deductions increased at approximately the same rate as pre-tax earnings. The increase in permanent tax deductions in 2004 primarily was due to the release of the Phase III tax liability driven by 2004 tax law changes and the release of tax reserves as a result of a current valuation of tax exposure items.
See Part II, Item 7 - Management’s Narrative Analysis of the Results of Operations (MD&A) - Business Segments for an analysis of sales by product and segment.
The decline in sales through independent broker/dealers and wirehouse and regional firms were driven by lower variable annuity sales and the movement of pension business as mentioned above. However, partially offsetting these declines were advisory services sales that have begun to grow through the independent broker/dealers channel and higher sales of immediate annuities and fixed life insurance products through the wirehouse and regional firms channel.
Sales generated by wirehouse and regional firms declined due to lower sales of individual fixed and variable annuities and private sector retirement plans.
Asset fees rose due to increases in both average separate account values and the average asset fee rate charged. The average variable asset fee rate increased from 1.29% to 1.32% as new business sold with higher-risk features influenced the overall average rate. The increase in average separate account values primarily was due to the general upward trend in the equity and fixed income markets offset in part by withdrawals that exceeded new deposits.
The increase in pre-tax operating earnings primarily was driven by higher asset fees, additional interest spread income and lower other benefits and claims, partially offset by increases in amortization of DAC and other operating expenses.
The increase in asset fees were primarily due to changes in the market value of the investment options underlying the account values, which followed the general trends of the equity markets.
In addition to higher general account assets, interest spread margins widened during 2004 to 188 basis points compared to 167 basis points in 2003. Included in 2004 were 13 basis points, or $18.4 million, of prepayment income on mortgage loans and bond call premiums compared to 6 basis points, or $7.8 million, in 2003. The higher interest rate environment in 2004 relative to 2003 eased the pressure on margins due to the interest rate floors contained in certain annuity contracts and contributed to increased margins.
The increase in other operating expenses was driven by two primary factors. First, asset-based trail compensation increased due to growth in account values. The second factor was increased expenses primarily related to advertising and promotion as well as employee compensation and benefits.
The decrease in pre-tax operating earnings primarily was driven by lower asset fees and higher amortization of DAC, partially offset by additional interest spread income.
Interest spread margins decreased to 188 basis points in 2005 compared to 196 basis points in 2004. Included in the current year were 27 basis points, or $21.1 million, of income from mortgage loan prepayment penalties and bond call premiums compared to 18 basis points, or $17.7 million, in 2004. Excluding the impact from prepayment activity, the decrease in margins was driven by the combination of long-duration higher yielding assets rolling over into lower yielding assets as yields on new cash flows are below the portfolio rate. Overall interest spread income improved due to growth in general account values, offset in part by the lower interest margins described above. For 2006, the Company expects interest spread margins to continue to tighten in this segment and projects full year spreads of 180 to 185 basis points, including a nominal level of prepayment activity.
Pre-tax operating earnings increased slightly primarily due to higher surrender charges, partially offset by higher other operating expenses and lower interest spread income.
Higher surrender charges were due to increased surrender fees as a greater percentage of plans surrendered within the surrender charge period. In addition, the trend of conversions from group annuity contracts to trust contracts continued.
Interest spread margins declined to 196 basis points in 2004 compared to 211 basis points in 2003. Included in 2004 were 18 basis points, or $17.7 million, of prepayment income on mortgage loans and bond call premiums compared to 22 basis points, or $20.1 million, in 2003. Excluding the effects of prepayment income, the decrease primarily was due to spread compression associated with prepayment activity and lower reinvestment rates on prepaying assets.
Private sector sales decreased due to the declining issuance of group annuity contracts described above and the related decrease in recurring flows. The increase in public sector retirement plan sales was driven by a combination of strong flows, primarily from existing plans, and increased rollover activity associated with pension reform legislation, which expanded the portability of public plan assets.
The increase in policy charges primarily resulted from higher cost of insurance charges, administrative fees and asset fees, reflecting a growing block of investment life business with increased insurance in force, account values and policy counts.
The decrease in life insurance premiums primarily was driven by higher reinsurance premiums due to a change in the mix of traditional life reinsurance from yearly renewable term to coinsurance.
Other income declined due to the reclassification described above and a decrease in the number of structured products transactions as margins on these deals compressed.
Pre-tax operating earnings declined primarily due to higher other expenses, lower other income and increased interest expense on debt, somewhat offset by higher interest spread income.
Lower other income primarily was due to declines in structured products earnings and trading portfolio gains.
Interest expense on debt increased primarily due to the issuance of a $100.0 million surplus note to NFS in December 2003 and increased utilization of commercial paper.
The decline in net realized losses on investments, hedging instruments and hedged items was driven by an improving market and credit environment.
In the normal course of business, the Company has entered into many related party transactions. See Note 15 to the audited consolidated financial statements included in the F pages of this report for descriptions of these transactions.
Contractual provisions exist which could adjust the amount and/or timing of those obligations reported. Key assumptions related to payments due by period include customer lapse and withdrawal rates (including timing of death), exchanges to and from the fixed and separate accounts of the variable annuities, claim experience with respect to guarantees, and future interest crediting level. Assumptions for future interest crediting levels have been made based on processes consistent with the Company’s past practices, which is at the discretion of the Company, subject to guaranteed minimum crediting rates in many cases and/or subject to contractually obligated increases for specified periods of time. Many of the contracts with potentially accelerated timing of payments are subject to surrender charges which are generally calculated as a percentage of deposits made and are assessed at declining rates during the first seven years after a deposit is made. Amounts disclosed herein include an estimate of those accelerated payments, net of applicable surrender charges. See Note 2 (g) to the audited consolidated financial statements included in the F pages of this report for a description of the Company’s method for establishing life and annuity reserves in accordance with GAAP. Health reserves represent less than $0.5 million of the amounts reflected in the table and are reflected in the less than one-year column.
Certain assumptions have been made about mortality experience and retirement patterns in the amounts reported. Actual deaths and retirements may differ significantly from those projected, which could cause the timing of the obligations reported to vary significantly. In addition, contractual surrender provisions exist on an immaterial portion of these contracts that could accelerate those obligations presented. The amounts disclosed herein do not include an estimate of those accelerated payments. Most of the contracts with potentially accelerated timing of payments are subject to surrender charges which are generally calculated as a percentage of the commuted value of the remaining term certain benefit payments and are assessed at declining rates during the first seven policy years.
See Part II, Item 7 - MD&A - Off-Balance Sheet Transactions for a detailed discussion of the Company’s MTN program. The amounts presented include contractual principal and interest based on rates in effect at December 31, 2005.
In addition, the Company makes discretionary pension plan and other postretirement benefit plan contributions. See Note 14 to the audited consolidated financial statements included in the F pages of this report for a detailed discussion of plan contributions.
Under the MTN program, NLIC issues funding agreements to an unconsolidated third party trust to secure notes issued to investors by the trust. The funding agreements rank pari passu with all other insurance claims of the issuing company in the event of liquidation and should be treated as “annuities” under applicable Ohio insurance law. Therefore, the funding agreement obligations are classified as a component of future policy benefits and claims on the consolidated balance sheets. Because the Company is not the primary beneficiary of, and 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. Since the notes issued by the trust have a secured interest in the funding agreements issued by the Company, Moody’s Investors Service, Inc. and Standard & Poor’s Ratings Services, a division of The McGraw-Hill Companies, Inc., assign the same ratings to the notes and the insurance financial strength of the Company.
Semi-annual and annual reports are sent to contract owners of the variable annuity and life insurance contracts issued through registered separate accounts of the Company.