The information included herein 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 Nationwide Life Insurance Company and subsidiaries (NLIC, or collectively, the Company). Whenever used in this report, words such as “anticipate,” “estimate,” “expect,” “intend,” “plan,” “believe,” “project,” “target,” and other words of similar meaning are intended to identify such forward-looking statements. 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:
(vi) failure to expand distribution channels in order to obtain new customers or failure to retain existing customers;
(xvi) the potential impact of industry developments relating to contract and fee transparency on the Retirement Plans segment; and
The primary segment profitability measure that management uses is pre-tax operating earnings (loss), which is calculated by adjusting income (loss) from continuing operations before federal income tax expense (benefit) to exclude: (1) net realized investment gains and losses, except for operating items (periodic net amounts paid or received on interest rate swaps that do not qualify for hedge accounting treatment and net realized gains and losses related to hedges on guaranteed minimum death benefit (GMDB) contracts and securitizations); (2) other-than-temporary impairment losses; (3) the adjustment to amortization of DAC and VOBA related to net realized investment gains and losses; and (4) net loss attributable to noncontrolling interest.
See Part I, Item 1 - Business - Business Segments for a description of the components of each segment.
Management makes decisions concerning the sale of invested assets based on a variety of market, business, tax and other factors. All realized gains and losses generated by these sales, and changes in the valuation allowance not related to specific mortgage loans on real estate are reported in net realized investment gains and losses. Also included in net realized investment gains and losses are changes in the fair values of derivatives qualifying as fair value hedges and the related changes in the fair values of hedged items; the ineffective, or excluded, portion of cash flow hedges; changes in the fair values of derivatives that do not qualify for hedge accounting treatment; the mark-to-market of embedded derivatives, net of economic hedges; and periodic net amounts paid or received on interest rate swaps that do not qualify for hedge accounting treatment. All charges related to other-than-temporary impairments of available-for-sale securities and other investments are reported in other-than-temporary impairment losses.
In April 2009, the Financial Accounting Standards Board (FASB) issued guidance under FASB Accounting Standards Codification (ASC) 320, Investments - Debt and Equity Securities (FASB Staff Position, FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments). The Company adopted this guidance as of January 1, 2009. The adoption of this guidance resulted in a cumulative-effect adjustment of $249.7 million, net of taxes, as an adjustment to the opening balance of retained earnings with a corresponding adjustment to the opening balance of accumulated other comprehensive income.
In September 2005, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position (SOP) 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts. The Company adopted this guidance effective January 1, 2007, which resulted in a $6.0 million charge, net of taxes, as the cumulative effect of adoption of this accounting principle.
As described in Note 4 to the audited consolidated financial statements included in the F pages of this report, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In determining fair value, the Company uses various methods including market, income and cost approaches. The Company utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs.
As of December 31, 2009, 68% of the prices of fixed maturity securities were valued with the assistance of independent pricing services, 13% were valued with the assistance of the Company’s internal pricing processes, 11% were valued with the assistance of the Company’s pricing matrices, 5% were valued with the assistance of broker quotes and 2% were valued from other sources compared to 78%, 4%, 12%, 5% and 1%, respectively, as of December 31, 2008.
Available-for-sale securities valued using significant Level 3 inputs include investments in markets which the Company considers inactive; the Company’s residential mortgage-backed securities backed by sub-prime and Alt-A collateral, certain commercial mortgage-backed securities, collateralized debt obligations and other asset-backed securities; certain broker-quoted or internally priced securities; and securities that are at or near default based on ratings assigned by the NAIC. As of December 31, 2009, Level 3 investments comprised 17% of total investments measured at fair value compared to 21% as of December 31, 2008.
Therefore, management determined that the use of multiple valuation techniques, considering both an income approach that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs and a market approach that observes quotes provided by independent pricing services produces a result more representative of an investment’s fair value.
The income approach incorporates cash flows for each investment adjusted for expected losses in different interest rate and housing scenarios. The adjusted cash flows are then discounted using a risk premium that market participants would demand because of the risk in the cash flows. The risk premium is reflective of an orderly transaction between market participants at the measurement date under current market conditions and includes items such as liquidity and structure risk. The income approach also includes a weighting of external third party values. As sufficient information is often not available to conclude whether such prices are based on orderly transactions, this weighting methodology is designed to incorporate external prices into the Company’s internal valuation process.
In addition, certain of the Company’s investments in corporate debt securities, mortgage-backed securities and other asset-backed securities were valued with the assistance of independent pricing services and non-binding broker quotes. The Company’s policy is to use the pricing obtained from our primary independent pricing service even in cases where a price is obtained from both an independent pricing service and a broker. In the event that pricing information is not available from an independent pricing service, non-binding broker quotes are used to assist in the valuation of the investments. In many cases, only one broker quote is available. The Company generally does not adjust the values obtained from brokers.
The Company’s derivative activities primarily are with financial institutions and corporations. To attempt to minimize credit risk, the Company enters into master netting agreements, which reduce risk by permitting the closeout and netting of transactions with the same counterparty upon occurrence of certain events. In addition, the Company attempts to reduce credit risk by obtaining collateral from counterparties. The determination of the need for and the levels of collateral vary based on an assessment of the credit risk of the counterparty. Generally, the Company accepts collateral in the form of cash, U.S. Treasury securities and other marketable securities.
As of December 31, 2009 and 2008, the Company had received $532.4 million and $1.02 billion, respectively, of cash for derivative collateral, which is in turn invested in short-term investments. The Company also held $32.3 million and $35.4 million of securities as off-balance sheet collateral on derivative transactions as of December 31, 2009 and 2008, respectively.
See Note 11 to the audited consolidated financial statements included in the F pages of this report for a discussion of the net realized gains recognized on living benefit embedded derivatives.
The preparation of financial statements in accordance with United States generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect the amounts reported in the financial statements. Actual results could differ significantly from those estimates.
In addition to the comprehensive annual study of assumptions, management evaluates the appropriateness of the individual variable annuity DAC balance quarterly within pre-set parameters. These parameters are designed to appropriately reflect the Company’s long-term expectations with respect to individual variable annuity contracts while also evaluating the potential impact of short-term experience on the Company’s recorded individual variable annuity DAC balance. If the recorded balance of individual variable annuity DAC falls outside of these parameters for a prescribed period, or if the recorded balance falls outside of these parameters and management determines it is not reasonably possible to get back within the parameters during a given period, assumptions are required to be unlocked, and DAC is recalculated using revised best estimate assumptions. When DAC assumptions are unlocked and revised, the Company continues to use the reversion to the mean process. See below for a discussion of 2009, 2008 and 2007 assumption changes that impacted DAC amortization and related balances.
The pre-tax positive (negative) impact on the Company’s assets and liabilities as a result of the unlocking of assumptions during 2009 was as follows:
The pre-tax positive (negative) impact on the Company’s assets and liabilities as a result of the unlocking of assumptions during the year ended December 31, 2008 was as follows:
Accordingly, the second quarter 2007 unlocking process included changes in several assumptions, including assumptions affecting net separate account investment performance. This unlocking resulted in a net increase in DAC and a benefit to DAC amortization and other related balances totaling $216.5 million pre-tax. First, the Company reset the anchor date for its reversion to the mean calculations, which increased the annual net separate account growth rate to 7% during the first three years of the projection period from 0% (which was the rate of return for the three-year reversion period required from the previous anchor date). Second, as a result of its current analysis, including its evaluation of ongoing trends and expectations regarding financial market performance, the Company unlocked and reset its long-term assumption for net separate account growth rates to 7% from 8%. This decreased the net separate account growth rate by 1% to 7% for all years subsequent to the three-year reversion period. The combination of resetting these two factors resulted in a $161.9 million increase in DAC and benefit to DAC amortization and other related balances. The impact of changing the annual net separate account growth rate from 0% to 7% during the three-year reversion period had a much larger effect on the DAC balance when compared to the 1% incremental change in the long-term assumption for net separate account investment performance. The remainder of the increase in DAC and benefit to DAC amortization and other related balances resulting from the DAC unlocking process primarily was related to the recorded balance of individual variable annuity DAC falling outside the Company’s preset parameters for the prescribed period, which was driven by favorable market performance in excess of the assumed net separate account returns. Accordingly, the Company recalculated DAC using revised best estimate assumptions, which resulted in a $78.8 million increase in DAC and benefit to DAC amortization and other related balances. This was partially offset by a $24.2 million decrease in DAC and increase in DAC amortization and other related balances due to increasing estimated lapse rates for fixed annuity and BOLI products.
During the second quarter of 2007, the Company added a new feature to its existing GLWB rider, L.inc. This new feature resulted in a substantial change in the existing contracts and, therefore, an extinguishment of the DAC associated with those contracts pursuant to the American Institute of Certified Public Accountants’ Statement of Position 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts. As a result, the Company eliminated existing DAC and other related balances resulting in a $135.0 million pre-tax charge.
The pre-tax positive (negative) impact on the Company’s assets and liabilities as a result of the unlocking of these assumptions during the second quarter of 2007 was as follows:
Traditional life insurance products. Generally, DAC related to traditional life insurance products is amortized with interest over the premium-paying period of the related policies in proportion to the ratio of actual annual premium revenue to the anticipated total premium revenue. Such anticipated premium revenue is estimated using the same assumptions as those used for computing liabilities for future policy benefits at issuance. Under existing accounting guidance, the concept of DAC unlocking does not apply to traditional life insurance products, although evaluations of DAC for recoverability at the time of policy issuance and loss recognition testing at each reporting period are required.
Management regularly reviews investments in its fixed maturity and equity security portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments.
When evaluating whether a residential mortgage-backed security, commercial mortgage-backed security, collateralized debt obligation and other asset-backed securities are other-than-temporarily impaired, the Company examines characteristics of the underlying collateral, such as delinquency, prepayments and default rates, the quality of the underlying borrower, the type of collateral in the pool, the vintage year of the collateral, subordination levels within the structure of the collateral pool, the quality of any credit guarantors, the Company’s intent to sell the security and whether it is more likely than not it will be required to sell the security before the recovery of its amortized cost basis.
The Company’s liability for funding agreements to an unrelated third party trust related to the MTN program equals the balance that accrues to the benefit of the contractholder, including interest credited. The funding agreements constitute insurance obligations and are considered annuity contracts under Ohio insurance laws.
Management provides for federal income taxes based on amounts it believes it ultimately will owe. Inherent in the provision for federal income taxes are estimates regarding the deductibility of certain items and the realization of certain tax credits. In the event the ultimate deductibility of certain items or the realization of certain tax credits differs from estimates, management may be required to significantly change the provision for federal income taxes recorded in the consolidated financial statements. Any such change could significantly affect the amounts reported in the consolidated statements of income (loss).
The Company recorded net income for the year ended December 31, 2009 compared to a net loss in the prior year, primarily due to net realized investment gains, lower other than-temporary impairment losses and lower amortization of DAC. In addition, higher interest spread income, lower other operating expenses and higher premiums contributed to the overall increase, partially offset by lower asset fees. Lastly, the Company recorded federal income tax expense for 2009 compared to a tax benefit in 2008 primarily due to the aforementioned increases in net income.
During the year ended December 31, 2009, the Company recorded net realized investment gains on living benefit embedded derivatives, net of economic hedging losses of $413.6 million, an increase of $914.3 million compared to the prior year. These gains were comprised of $1.50 billion of net realized investment gains on living benefit embedded derivatives and $1.08 billion of related economic hedging losses. The net realized investment gains on living benefit embedded derivatives primarily resulted from higher interest rates, lower volatility assumptions and an increase to the nonperformance component of the discount rate. The increase in net realized investment gains on embedded derivatives increased amortization of DAC by $389.6 million in 2009 compared to 2008, which is included in the Corporate and Other segment. Additionally, higher net realized gains on sales of investments of $160.8 million and higher mark-to-market gains on derivative activity of $66.8 million contributed to the increase. The overall increase was partially offset by losses on derivatives associated with the Company’s economic hedging program for GMDB contracts of $281.2 million.
Lower amortization of DAC was driven by favorable DAC unlocks in 2009, which lowered amortization of DAC by $139.8 million in 2009. Additionally, DAC unlocks in 2008, which increased amortization in the prior year by $434.2 million, and lower gross profits in 2009 contributed to the decline in amortization. Refer to Part II, Item 7 - MD&A - Critical Accounting Policies and Recently Issued Accounting Standards - Deferred Policy Acquisition Costs for Investment and Universal Life Insurance Products for a description of the current and prior year DAC unlocks. The overall decrease was partially offset by higher net realized gains on living benefit embedded derivatives, which increased amortization of DAC by $389.6 million in 2009.
A 44% increase in sales of income products in 2009 generated higher premiums as customer demand shifted toward fixed income products.
Benefits and claims increased in the Individual Investments segment primarily due to higher exposure on GMDB contracts driven by unfavorable market conditions which increased benefits and claims by $134.3 million. In addition, adverse mortality in 2008 in the variable universal life and universal life insurance businesses in the Individual Protection segment contributed to the increase. The average net claim size and the number of claims in these products increased compared to 2007.
New and renewal production premiums and deposits, previously referred to as “sales”, are not derived from any specific GAAP income statement accounts or line items and should not be viewed as a substitute for any financial measure determined in accordance with GAAP, including sales as it relates to non-insurance companies. Management believes that the presentation of new and renewal production premiums and deposits enhances the understanding of the Company’s business and helps depict longer-term trends that may not be apparent in the results of operations due to differences between the timing of sales and revenue recognition.
See Part I, Item 1 - Business - Overview for a description of the Company’s sales distribution network.
The following table summarizes new and renewal production premiums and deposits by product and segment for the years ended December 31:
Improvements in market conditions reduced the Company’s exposure on GMDB contracts and lowered benefits and claims by $187.3 million in the year ended December 31, 2009. Additionally, the favorable unlock of sales inducement assets in the fourth quarter of 2009, lowered benefits and claims by $12.0 million. The decrease was offset by higher sales of income products (see premiums discussion above), which resulted in higher reserve accruals. These higher reserve accruals increased benefits and claims by $62.0 million in the current year.
Interest spread income increased primarily due to higher average general assets (up 6%) caused by improved net flows in both variable and fixed annuities and favorable investment performance. The improvement in net flows was driven by lower withdrawals and surrenders in the current year across all product lines. Withdrawals and surrenders declined by 33% in variable annuities and 43% in fixed annuities. In addition, interest spread margins improved to 176 basis points in the current year compared to 154 basis points in 2008.
The Individual Investments segment recorded a pre-tax operating loss for 2008 compared to pre-tax operating earnings in the prior year primarily due to higher amortization of DAC. In addition, lower interest spread income, asset fees and benefits and claims partially were offset by an increase in other income.
The decrease in asset fees primarily was driven by lower average separate account values driven by unfavorable market performance which decreased asset fees by $74.4 million. However, the average variable asset fee rate increased to 1.45% from 1.42% in the prior year as new business with living benefit riders and corresponding higher fee rates influenced the overall average rate, increasing asset fees by $12.5 million.
Lower overall new and renewal production premiums and deposits primarily were attributable to the individual variable annuity business due to volatile market conditions and the economic slowdown, partially offset by improved fixed annuity sales. In addition, the decline in advisory services program sales was due to the Company exiting this business during 2008.
Pre-tax operating earnings declined primarily due to lower assets fee and higher amortization of VOBA and other intangible assets, partially offset by higher interest spread income.
Asset fees decreased primarily due to lower average separate account values (down 20%) driven by volatility in the equity markets.
The decrease in new and renewal production premiums and deposits was primarily due to reduced employer discretionary contributions, employee deferrals and plan transfers on private sector products. Additionally, sales of public sector products declined primarily due to lower transfers and payroll deposits resulting from volatile market conditions.
The following table summarizes selected financial data for the Company’s Retirement Plans segment for the years ended December 31:
The decrease in pre-tax operating earnings was driven by lower asset fees, higher amortization of DAC and lower other income, partially offset by reduced other operating expenses and higher interest spread income.
Asset fees decreased due to lower average separate account values driven by unfavorable market performance.
Higher amortization of DAC primarily was due to the DAC unlock in the second quarter of 2007, which lowered amortization of DAC in 2007 by $10.5 million. In addition, the DAC unlock in the second quarter of 2008 increased amortization of DAC by $2.3 million in 2008.
The decrease in other operating expenses primarily was due to the aforementioned movement of pension business to NFS trust product offerings and lower employee incentives and benefits.
Higher benefits and claims reflect an aging of the individual life business block and adverse mortality in the universal life insurance and COLI businesses during the year ended December 31, 2009. Both total claims counts and average net claim size increased significantly in these businesses compared to the prior year. Additionally, updates to benefit ratio assumptions in 2009 increased benefits and claims by $11.6 million.
Asset fees declined due to lower average separate account values (down 10%) driven by volatility in the equity markets.
Cost of insurance charges rose by $19.2 million in the universal life insurance business due to increased fixed life business in force combined with the aging of the individual life business block. The aging of a block generally increases cost of insurance charges as the Company’s related mortality risk also rises.
Higher benefits primarily were due to adverse mortality in 2008 in the variable life and universal life insurance businesses. The average net claim size and the number of claims in these products increased 22% and 16%, respectively, compared to 2007.
Policyholder dividends increased due to a higher dividend scale in 2008.
Interest spread income increased primarily due to growth in the universal life business block driven by sales of the ULtimate product.
Lower losses from hedge fund and private equity investments of $80.4 million drove the increase in interest spread income during the year ended December 31, 2009. The overall increase was partially offset by lower MTN earnings of $41.9 million during 2009 primarily due to a decrease in MTN assets as a result of note maturities and repurchases of $1.56 billion.
The increase in other income was driven by lower losses of $41.9 million in the structured products business related to impairments on the underlying mortgages and mortgage loan commitments, and a $29.2 million increase due to hedging gains on mortgage loan sales in 2009 compared to losses in 2008.
Includes gains of $413.6 million and losses of $500.7 million on derivatives and embedded derivatives associated with living benefit contracts for the years ended December 31, 2009, and 2008, respectively.
Lower other income primarily was driven by losses in the Company’s structured products business related to impairments on the underlying mortgages and mortgage loan commitments.
Higher non-operating net realized investment losses primarily were driven by a $474.0 million increase in losses on living benefit embedded derivatives, net of economic hedging activity.
Includes valuation of trading securities, mark-to-market valuation of mortgage loans held for sale, and changes in the valuation allowance not related to specific mortgage loans on real estate.
The following table summarizes other-than-temporary impairment losses for the years ended December 31:
The Company has a comprehensive portfolio monitoring process for fixed maturity and equity securities to identify and evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. See Part II, Item 7 - MD&A - Critical Accounting Policies and Recently Issued Accounting Standards - Valuation of Investments, Investment Income , Realized Gains and Losses and Other-than-temporary Impairment Evaluations for a complete discussion of this process.
The following table summarizes for the year ended December 31, 2009 the Company’s largest aggregate losses on sales and write-downs by issuer, the related circumstances giving rise to the losses and the circumstances that may have affected other material investments held:
No contractual provisions exist that could create, increase or accelerate those obligations presented. The amount presented includes contractual principal payments and interest based on rates in effect at December 31, 2009.