The following analysis of consolidated results of operations and financial condition of the Company should be read in conjunction with Item 6 - Selected Consolidated Financial Data and the consolidated financial statements and related notes included elsewhere herein.
Policy Charges. Policy charges include asset fees, which are primarily earned from separate account assets generated from sales of variable annuities; administration fees, which include fees charged per contract on a variety of the Company's products and premium loads on universal life insurance products; surrender fees, which are charged as a percentage of assets withdrawn during a specified period (usually the first seven years) of annuity and certain life insurance contracts; and cost-of-insurance charges earned on universal life insurance products. For 1996, policy charges were $400.9 million, a 39.9% increase from $286.5 million in 1995. Policy charges increased 32.0% in 1995 from $217.2 million in 1994. Increases in policy charges have resulted primarily from increases in separate account assets and the resulting higher levels of asset fees, as well as a moderate increase in all of the fees discussed above due to the growth in customer accounts.
Benefits and Claims. Benefits and claims consist primarily of interest credited on fixed annuity products and life insurance benefits in the Life Insurance segment. Benefits and claims increased 4.0% to $1.16 billion in 1996 from 1995. Benefits and claims increased 12.4% to $1.12 billion in 1995 from $992.7 million in 1994. The changes in benefits and claims from year to year are primarily attributable to the changes in interest credited which are discussed in the Fixed Annuities segment results below. Life insurance benefits have remained consistent over the periods.
On February 24, 1997, NLIC paid a dividend to NFS, which subsequently made a dividend payment to Nationwide Corp., consisting of securities having an aggregate fair value of $850.0 million. On March 10, 1997 and March 11, 1997, NFS made cash capital contributions to NLIC totaling $836.8 million. These transactions resulted in a net decrease in invested assets of NLIC of $13.2 million, which is expected to result in a decrease in net investment income in the future.
The Company has three product segments: Variable Annuities, Fixed Annuities and Life Insurance. In addition, the Company reports corporate income and expenses and investments and related investment income supporting capital not specifically allocated to its product segments in a Corporate and Other segment. All information set forth below relating to the Company's Variable Annuities segment excludes the fixed option under the Company's variable annuity contracts. Such information is included in the Company's Fixed Annuities segment.
The table below presents summary financial data for the Company by segment.
Income from Continuing Operations Before Federal Income Tax Expense. Income from continuing operations before federal income tax expense was $90.3 million in 1996, a 77.8% increase from 1995. Income from continuing operations before federal income tax expense increased 106.5% to $50.8 million in 1995 from $24.6 million in 1994. Increases have primarily resulted from growth in variable annuity separate account assets and the corresponding increases in asset fees combined with expense levels which have decreased as a percentage of revenues. Total expenses were $189.7 million, $135.4 million and $105.8 million, or 66.7%, 71.6% and 79.7% of total revenues, for 1996, 1995 and 1994, respectively. During the period, the Company has controlled its operating expenses by taking advantage of economies of scale and by increasing productivity through investments in technology.
Revenues. Revenues in the Fixed Annuities segment consist mainly of net investment income, which is earned on invested assets allocated to support fixed annuity policy reserves and shareholders' equity allocated to such segment. Total revenues were $1.09 billion, $1.05 billion and $939.9 million in 1996, 1995 and 1994, respectively. Net investment income was $1.05 billion, $1.00 billion and $903.7 million, representing average pre-tax yields on the assets supporting this segment of 8.22%, 8.50% and 8.59%, in 1996, 1995 and 1994, respectively. The increase in net investment income for each period presented is the result of the increases in policy reserves discussed below and the corresponding increase in invested assets.
Interest Credited. Interest credited on account balances was $805.0 million, $775.7 million and $680.9 million, representing crediting rates of 6.30%, 6.58% and 6.47%, for 1996, 1995 and 1994, respectively. The differential between net investment income and interest credited on account balances resulted in spreads of $245.6 million, $227.1 million and $222.8 million, or 1.92%, 1.92% and 2.12%, in 1996, 1995 and 1994, respectively. Spreads vary depending on crediting rates offered by competitors, performance of the investment portfolio and other factors. The higher spread in 1994 is primarily the result of declining interest rates in late 1993 and early 1994 which resulted in lower crediting rates.
Revenues. Revenues in the Life Insurance segment consist of the life insurance premiums and policy charges, as well as net investment income. Total revenues were $435.6 million, $409.1 million and $383.1 million for 1996, 1995 and 1994, respectively. The increases are attributed to increases in life insurance in-force with the majority of the growth coming from the variable universal life product.
Income from Continuing Operations Before Federal Income Tax Expense. Income from continuing operations before federal income tax expense was $67.2 million in 1996, a 0.6% decrease from $67.6 million for 1995. The decrease is attributable to the increased amount of amortization of DAC due to increased volume and higher general expenses due to increased sales offset by an increase in revenues from the variable universal product. Income from continuing operations before federal income tax expense increased 27.5% to $67.6 million in 1995 from $53.0 million in 1994. The increase is due to growth in insurance in-force, particularly variable universal life, combined with only minimal increases in expenses.
Life Insurance In-Force. Life insurance in-force was $37.72 billion, $33.41 billion and $30.13 billion as of December 31, 1996, 1995 and 1994, respectively. Nearly two-thirds of the growth of life insurance in-force is in variable universal life and term insurance policies.
Revenues. Revenues in the Corporate and Other segment consist of net investment income on invested assets not allocated to the three product segments, all realized investment gains and losses, investment management fees and other revenues earned from Nationwide mutual funds other than the portion allocated to the Variable Annuities and Life Insurance segments and net investment income and policy charges from group annuity contracts issued to Enterprise employee and agent benefit plans. Total revenues excluding realized gains and losses were $180.3 million for 1996, a 20.0% increase from 1995. The increase in 1996 is the result of an increase in investment income and investment management fees earned. Total revenues excluding realized gains and losses were $150.3 million and $160.3 million in 1995 and 1994, respectively. The decrease is a result of a reduction of $155.0 million of invested assets. Effective December 31, 1994, the Company transferred $155.0 million of invested assets from the Corporate and Other segment for the purchase of ELICW. Realized losses on investments were $0.3 million, $1.7 million and $16.5 million in 1996, 1995 and 1994, respectively.
The Company leases approximately 465,000 square feet of office space at a current market rate of $19.53 per square foot, with limited exceptions, from NMIC and certain of its subsidiaries. For the years ended December 31, 1996, 1995 and 1994, the Company made lease payments to NMIC and its subsidiaries of $9.1 million, $9.0 million and $8.1 million, respectively. See Item 13 - Certain Relationships and Related Transactions-Existing Arrangements with the Enterprise-Lease.
The Company follows the customary industry practice of reinsuring (ceding) a portion of its life insurance and annuity risks with other companies in order to reduce net liability on individual risks, to provide protection against large losses and to obtain greater diversification of risks. The ceding of risk does not discharge the original insurer from its primary obligation to the policyholder. The Company has entered into a reinsurance contract to cede a portion of its general account individual annuity reserves to Franklin Life. Total recoveries due from Franklin Life were $240.5 million and $245.3 million as of December 31, 1996 and 1995, respectively. Under the terms of the contract, Franklin Life has established a trust as collateral for the recoveries. The trust assets are invested in investment grade securities, the market value of which must at all times be greater than or equal to 102% of the reinsured reserves. The Company has no other material reinsurance arrangements with unaffiliated reinsurers.
The only material reinsurance agreements which the Company has with affiliates are the modified coinsurance agreements pursuant to which NLIC reinsured all of its accident and health and group life insurance business to ELICW and NMIC. See Item 13 - Certain Relationships and Related Transactions-Existing Arrangements with the Enterprise-Modified Coinsurance Agreements. NLIC entered into these reinsurance agreements because its accident and health and group life insurance business was unrelated to NLIC's long-term savings and retirement products. Accordingly, all accident and health and group life insurance business is accounted for as discontinued operations. Under the modified coinsurance agreements, invested assets are retained by the ceding company and investment earnings are paid to the reinsurer. Under the terms of such agreements, the investment risk associated with changes in interest rates is borne by ELICW or NMIC, as the case may be. Risk of asset default is retained by the Company, although a fee is paid by ELICW or NMIC, as the case may be, to NLIC for NLIC's retention of such risk. The contracts will remain in force until all policy obligations are settled. However, with respect to the agreement between NLIC and NMIC, either party may terminate the contract on January 1 of any year with prior notice. NLIC believes that the terms of such modified coinsurance agreements are consistent in all material respects with what NLIC could have obtained with unaffiliated parties.
Total premiums ceded under the intercompany reinsurance agreements were $321.6 million during 1996. The effect of the reinsurance agreements was an increase in NLIC's income from discontinued operations before federal income tax expense of $4.5 million during 1996. NLIC does not expect the intercompany reinsurance agreements to have any material adverse effect on NLIC's future operations.
As a result of the $850.0 million dividend paid on February 24, 1997 and the dividend by NLIC of the stock of certain subsidiaries that do not operate in the long-term savings and retirement market, any dividend paid by NLIC during the 12-month period immediately following the $850.0 million dividend would be an extraordinary dividend under Ohio insurance laws. Accordingly, no such dividend could be paid without prior regulatory approval. NLIC has no reason to believe that any reasonably foreseeable dividend to be paid by NLIC would not receive the required approval.
A primary liquidity concern with respect to life insurance and annuity products is the risk of early policyholder and contractholder withdrawal. The Company closely evaluates and manages this risk. The following table summarizes the Company's annuity policy reserves as of December 31, 1996 and 1995 by the contractholder's ability to withdraw funds.
Life insurance policies are also subject to withdrawal. However, they are less susceptible to withdrawal than are annuity contracts because policyholders may incur surrender charges and undergo a new underwriting process in order to obtain a new insurance policy.
The Company employs an asset/liability management approach tailored to the specific requirements of each of its product lines. The Company's general account invested assets are primarily managed in a number of pools that are separated by weighted average maturity of the assets acquired by the pools. On bonds and mortgages, the weighted average maturity is based on repayments which are scheduled to occur under the terms of the asset. For mortgage backed securities, repayments are determined using the current rate of repayment of the underlying pool of mortgages and the terms of the securities. Each product line has an investment strategy based on the specific characteristics of such product line. The strategy establishes asset duration, quality and other guidelines. The Company's actuaries determine the amount of new investments needed for each line to arrive at the amount of new investments needed for each pool by month. The investments acquired for each pool are shared on a proportional basis by each of the lines requesting investments in the pool based on their actual investment needs.
For all business having future benefits which cannot be changed at the option of the policyholder, the underlying assets are managed in a separate pool. The duration of assets and liabilities in this pool are kept as close together as possible. For assets, the repayment cash flows, plus anticipated coupon payments, are used in calculating asset duration. Future benefits and expenses are used for liabilities. On December 31, 1996, the average duration of assets in this pool was 6.80 years and the average duration of the liabilities was 7.44 years. Policy reserves on this business were $1.11 billion as of December 31, 1996.
Because the timing of the payment of future benefits on the majority of the Company's business can be changed by the policyholder, the Company employs cash flow testing techniques as a final step in its asset/liability management process. Annually, the Company's annuity and insurance business is analyzed to determine the adequacy of the reserves supporting such business. This analysis is accomplished by projecting under a number of possible future interest rate scenarios the anticipated cash flows from such business and the assets required to support such business. The first seven of these scenarios are required by state insurance laws. Projections are also made using 13 additional scenarios which involve more extreme fluctuations in future interest rates. Finally, to get a statistical analysis of possible results and to minimize any bias in the 20 predetermined scenarios, additional projections are made using 200 randomly generated interest rate scenarios. For the Company's 1996 cash flow testing process, interest rates for 90-day treasury bills ranged from 0.4% to 11.5% under the 20 predetermined scenarios and 0.8% to 25.3% under the 200 random scenarios. Interest rates for longer maturity treasury securities had comparable ranges. The values produced by each projection are used to determine future gains or losses from the Company's annuity and insurance business, which, in turn, are used to quantify the adequacy of the Company's reserves over the entire projection period. The results of the Company's cash flow testing for year end 1996 indicated that the Company's reserves were adequate as of December 31, 1996.
The Company manages its investment portfolio in part to reduce its exposure to interest rate fluctuations. In general, the fair value of the Company's fixed maturity portfolio increases or decreases in inverse relationship with fluctuations in interest rates. For example, if interest rates rise, the Company's fixed maturity investments will generally decrease in value. Additionally, the Company's net investment income may be affected by interest rate changes. If interest rates decline, net investment income will decrease if high-yielding fixed maturity investments mature or are sold and the proceeds therefrom are reinvested in securities yielding a lower rate.
Given the Company's historic cash flow and current financial results, management of the Company believes that the cash flow from the operating activities of the Company over the next year will provide sufficient liquidity for the operations of the Company, as well as provide sufficient funds to enable the Company to make dividend payments.
The following table sets forth an analysis of credit quality, as determined by NAIC Designation, of the Company's general account fixed maturity securities portfolio as of December 31, 1996 and 1995.
The Company believes that general account MBS investments add diversification, liquidity, credit quality and additional yield to its general account fixed maturity securities portfolio. The objective of the Company's general account MBS investments is to provide reasonable cash flow stability and increased yield. General account MBS investments include collateralized mortgage obligations (CMOs) and mortgage-backed pass-through securities. The Company's general account MBS investments do not include interest-only securities or principal-only securities or other MBSs which may exhibit extreme market volatility.
As of December 31, 1996, general account mortgage loans were $5.27 billion (or 28.8%) of the carrying value of consolidated general account invested assets. As of such date, commercial mortgage loans constituted substantially all (99.9%) of total general account mortgage loans with the remainder being 76 residual residential loans originated prior to 1981 with a principal balance of $2.7 million. These mortgages, substantially all of which are made on a non-recourse basis, consist primarily of fixed rate mortgages on existing income-producing properties. As of December 31, 1996, there were two second mortgages totaling $2.6 million and no construction loans, participating or convertible mortgages or land development loans. Commitments to fund mortgage loans of $327.5 million extending into 1997 were outstanding as of December 31, 1996.
The consolidated financial statements of Nationwide Life Insurance Company and Subsidiaries are included in a separate section of this report which is indexed in Item 14 - Exhibits, Financial Statement Schedules, and Reports on Form 8-K.