Management's narrative analysis of the results of operations of NLIC and subsidiaries for the three years ended December 31, 1999 follows. This discussion should be read in conjunction with the consolidated financial statements and related notes included elsewhere in this report.
The following table reconciles the Company's reported net income to net operating income for each of the last three years.
Total revenues for 1999, excluding realized gains and losses on investments, increased to $2.70 billion compared to $2.45 billion for 1998 and $2.21 billion for 1997. The growth in revenues over the past two years has primarily been driven by increases in policy charges and net investment income.
Policy charges include asset fees, which are primarily earned from separate account assets generated from sales of variable annuities and variable life insurance products; cost of insurance charges earned on universal life insurance products; administration fees, which include fees charged per contract on a variety of the Company's products and premium loads on universal life insurance products; and surrender fees, which are charged as a percentage of premiums withdrawn during a specified period of annuity and certain life insurance contracts. Policy charges for each of the last three years were as follows:
The growth in asset fees reflects increases in total separate account assets of $16.20 billion, or 32%, in 1999 and $13.2 billion, or 35%, in 1998. Record variable annuity sales and strong equity market performance in each of the last three years have resulted in separate account balances increasing 149% from $26.93 billion at the beginning of 1997 to $67.14 billion at the end of 1999.
Net investment income includes the gross investment income earned on investments supporting fixed annuities and certain life insurance products as well as the yield on the Company's general account invested assets which are not allocated to product segments. Net investment income grew from $1.41 billion and $1.48 billion in 1997 and 1998, respectively, to $1.52 billion in 1999 primarily due to increased invested assets to support growth in fixed annuity and life insurance policy reserves. Fixed annuity policy reserves, which include the fixed option of the Company's variable annuity products, increased $704.7 million in 1998 and $1.69 billion in 1999 and were $16.59 billion as of year end 1999. The growth in life insurance reserves was led by corporate-owned life insurance products, where fixed reserves increased $596.7 million in 1998 and $180.0 million in 1999. The increase in net investment income due to growth in invested assets was partially offset by declining investment yields in 1999 and 1998 due to lower market interest rates.
The Company does not consider realized gains and losses on investments to be recurring components of earnings. The Company makes decisions concerning the sale of invested assets based on a variety of market, business, tax and other factors.
Amortization of deferred policy acquisition costs (DAC) increased $58.1 million in 1999 and $47.3 million in 1998 principally due to the Variable Annuities segment, which accounted for $38.9 million and $36.1 million of the increases as a result of growth in the number of policies and related policy reserves in each of the last two years.
Operating expenses were $463.4 million in 1999, a 10% increase from 1998 operating expenses of $419.7 million. Operating expenses were $384.9 million in 1997. The increase reflects the growth in the number of annuity and life insurance contracts in force, particularly related to variable annuities and variable universal life insurance, and the related increase in administrative processing costs.
Federal income tax expense was $201.4 million representing an effective tax rate of 33.2% for 1999. Federal income tax expense in 1998 and 1997 was $190.4 million and $150.2 million, respectively, representing effective rates of 34.2% and 34.9%.
The Company developed and implemented a plan to address issues related to the Year 2000. The problem relates to many existing computer systems using only two digits to identify a year in a date field. These systems were designed and developed without considering the impact of the change in the century. If not corrected, many computer systems could fail or create erroneous results when processing information dated after December 31, 1999. Like many organizations, the Company was required to renovate or replace many computer systems so that the systems would function properly after December 31, 1999.
The Company completed an inventory and assessment of all computer systems. The Company renovated or replaced all applications that were not compliant. Testing of all systems included running each application in a Year 2000 environment was completed as planned during 1998. For applications being replaced, the Company had all replacement systems in place and functioning as planned by year-end 1998.
The Company's facilities in Columbus, Ohio were inventoried, assessed and tested as being Year 2000 compliant. Mission critical systems supporting the Company's infrastructure such as telecommunications, voice and networks were renovated and brought into compliance as planned during the second quarter of 1999.
Operating expenses in 1998 and 1997 include approximately $44.7 million and $45.4 million, respectively, for technology projects, including costs related to Year 2000. Year 2000 activities totaled $6.4 million during 1999. The cost associated with the completion of Year 2000 renovation and replacement efforts will not result in a reduction in operating expenses. Rather, personnel and resources that were allocated to the Year 2000 issues have been reassigned to other technology-related projects.
Sales, as measured by statutory premiums and deposits, by distribution channel for each of the last three years are summarized as follows:
(1) Prior to 1998, national and regional brokerage firms sales were included in independent broker/dealer sales.
The Company sells its products through a broad distribution network. Unaffiliated entities that sell the Company's products to their own customer base include independent broker/dealers, national and regional brokerage firms, pension plan administrators, life insurance specialists and financial institutions. Representatives of the Company or its affiliates who market products directly to a customer base identified by the Company include Nationwide Retirement Solutions sales representatives and Nationwide agents.
The competitive environment for individual annuity sales through the independent broker/dealer channel has become very challenging; however, total sales through this channel (including retirement plans and life insurance) were up 9% in 1999 reflecting the strength of the Company's multiple product strategy. Sales through financial institutions grew 16% during 1999 and 25% during 1998 driven mainly by proprietary individual annuity products sales.
The increase in sales through life insurance specialists reflects $409.2 million of corporate owned life insurance (COLI) sales in 1999 compared to $91.1 million in 1998. NFS entered the COLI market in 1998 and has quickly become a market leader through a focus on mid-sized cases.
Variable Annuities $290.3 $218.4 $150.9 Fixed Annuities 177.2 175.3 169.5 Life Insurance 120.8 88.8 66.7 Corporate and Other 29.8 46.2 31.7 ------ ------ ------ $618.1 $528.7 $418.8 ====== ====== ======
Efficiencies achieved through improved operating scale have enabled the Company to improve operating margins to 55 basis points of average policy reserves, up from 54 basis points in 1998 and 51 basis points n 1997.
The Fixed Annuities segment consists of annuity contracts that generate a return for the customer at a specified interest rate fixed for a prescribed period, tax-deferred accumulation of savings and flexible payout options including a lump sum, systematic withdrawal or a stream of payments for life. Such contracts consist of single premium deferred annuities, flexible premium deferred annuities and single premium immediate annuities. The Fixed Annuities segment includes the fixed option under the Company's variable annuity contracts.
---------- (1) Statutory data have been derived from the Annual Statements of the Company's life insurance subsidiaries, as filed with insurance regulatory authorities and prepared in accordance with statutory accounting practices.
Fixed Annuities segment results reflect an increase in interest spread income attributable to growth in fixed annuity policy reserves offset by narrower interest margins during 1999. Interest spread is the differential between net investment income and interest credited to policyholder account balances. Interest spreads vary depending on crediting rates offered by competitors, performance of the investment portfolio, including the rate of prepayments, changes in market interest rates and other factors. The following table depicts the interest margins on general account policy reserves in the Fixed Annuities segment for each of the last three years.
During 1998 and the first half of 1999 the Company experienced an increase in mortgage loan and bond prepayment fees and such income accounted for approximately 9 basis points of the interest spread in 1999 compared to 16 basis points and 8 basis points in 1998 and 1997, respectively. The recent increases in interest rates have slowed prepayment activity and the Company expects interest spreads to remain at 190 to 195 basis points, excluding the impact of mortgage loan and bond prepayment income.
Fixed annuity policy reserves increased to $16.59 billion as of year-end compared to $14.90 billion a year ago and $14.19 billion as of the end of 1997. The 1999 growth reflects increased sales levels as well as the acquisition of ELOW.
Life Insurance segment earnings in 1999 increased 36% to $120.8 million, up from $88.8 million a year ago and $66.7 million in 1997. Continued strong sales and reserve growth from both individual and corporate owned investment life insurance products contributed to the sharp earnings increases.
Driven primarily by increased policy charges, revenues from investment life products increased to $226.5 million in 1999 compared to $145.4 million in 1998 and $69.8 million 1997. The revenue growth reflects significantly increased policy reserve levels as individual investment life reserves increased 44% in 1999 to $1.83 billion compared to $1.27 billion a year ago and $895.6 million at the end of 1997. Corporate owned investment life reserves, which include both BOLI and corporate-owned (COLI) products reached $1.50 billion, up from $903.6 million and $221.9 million at the end of 1998 and 1997, respectively.
Traditional and universal life pre-tax earnings jumped 14% to $67.4 million in 1999 compared to $59.2 million in 1998 and were $52.0 million in 1997. The 1998 results reflect additional expenses related to the installation of a new policy administration system.
In addition to the operating revenues previously presented, the Company also reports realized gains and losses on investments in the Corporate and Other segment. The Company realized net investment (losses) gains of $(11.6) million, $28.4 million and $11.1 million during 1999, 1998 and 1997, respectively.