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 its subsidiaries (NLIC, or collectively, 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:
(ii) Tax law changes impacting the tax treatment of life insurance and investment products;
(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;
(xi) Unanticipated changes in industry trends and ratings assigned by nationally recognized rating organizations;
Note 2 to the audited consolidated financial statements included in the F pages of this report provides a summary of significant accounting policies. Note 3 to the consolidated financial statements included in F pages of this report provides a discussion of recently issued accounting standards.
Deferred Policy Acquisition Costs for Investment Products and Universal Life Insurance Products
The Company has deferred the costs of acquiring investment products and universal life insurance products business, principally commissions, certain expenses of the policy issue and underwriting department, and certain variable sales expenses that relate to and vary with the production of new or renewal business. Investment products consist primarily of individual and group variable and fixed deferred annuities. Universal life insurance products include universal life insurance, variable universal life insurance, corporate-owned life insurance (COLI) and other interest-sensitive life insurance policies. DAC is subject to recoverability testing at the time of policy issuance and loss recognition testing at the end of each reporting period.
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 currently 8% growth per year. If actual net separate account performance varies from the 8% 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 Standard and Poor’s (S&P) 500 Index, the Company’s policy regarding the reversion to the mean process does not permit such returns to be negative or in excess of 15% during the three-year reversion period.
Significant changes in the factors the Company 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 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 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. In addition to the valuation allowance on specific loans, the Company maintains an unallocated allowance for probable losses inherent in the loan portfolio as of the balance sheet date, but not yet specifically identified by loan. Changes in the valuation allowance are recorded in net realized gains and losses on investments, hedging instruments and hedged items. Loans in foreclosure 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.
The 2004 and 2003 OPEB expense for substantially all of the Company’s employees and certain agents totaled $1.1 million. The discount rate used to value cash flows was lowered to 6.10% to determine 2004 OPEB expense from 6.60% in 2003, and the long-term expected rate of return on plan assets was lowered to 7.00% for 2004 from 7.50% for 2003.
The following table summarizes policy charges for the years ended December 31:
Net realized losses on investments, hedging instruments and hedged items totaled $36.4 million, $85.2 million and $75.5 million in 2004, 2003 and 2002, respectively, and included other-than-temporary impairments of $90.6 million, $156.5 million and $120.3 million in 2004, 2003 and 2002, respectively. Non-impairment related net realized gains on investments, hedging instruments and hedged items totaled $54.2 million in 2004 compared to $71.3 million and $44.8 million in 2003 and 2002, respectively. Realized gains on sales, net of hedging losses were driven by an improving market and credit environment. Realized losses on sales, net of hedging gains were lessened by the impact of market pricing and portfolio alignment. Other-than-temporary and other investment impairments were positively impacted by the improving credit environment.
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. Other benefits and claims decreased from $361.8 million in 2003 to $347.2 million in 2004. The decline primarily was due to a decrease in GMDB benefits driven by improved equity market levels and reduced life insurance benefits as a result of favorable mortality. The increase in other benefits and claims in 2003 compared to 2002 reflects additional life insurance benefits reflecting growth in life insurance in force, an increase in Guaranteed Minimum Death Benefits (GMDB) costs due to a higher level of claims and an increase in the provision for future policy benefits for immediate annuities due to growth in new premium in 2003 compared to 2002.
Policyholder dividends on participating policies decreased by 12% to $36.2 million in 2004 compared to $41.2 million and $45.2 million in 2003 and 2002, respectively. The declines were due to a reduction in dividend scale as a result of lower interest rates.
Therefore, in 2002, the Company recorded an acceleration of DAC amortization totaling $347.1 million, before tax, or $225.6 million, net of $121.5 million of tax benefit, which has been reported in the following segments in the amounts indicated, net of tax: Individual Investments - $213.4 million, Retirement Plans - $7.8 million and Individual Protection - $4.4 million. The acceleration of DAC amortization was the result of unlocking certain assumptions underlying the calculation of DAC for investment products and variable universal life insurance products. The most significant assumption changes were the resetting of the Company’s anchor date for reversion to the mean calculations to September 30, 2002, resetting the assumption for annual net separate account growth to 8 percent during the three-year reversion period for all investment products and variable life insurance products, and increasing future lapses and costs related to GMDB on individual variable annuity contracts. These adjustments were primarily driven by the sustained downturn in the equity markets.
Other operating expenses increased 13% to $604.5 million in 2004 compared to $533.7 million and $508.5 million in 2003 and 2002, respectively. The increases reflect higher advertising and promotion and employee compensation and benefits expenses.
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 was a related party transaction and therefore was recorded at the $10.0 million carrying value of the underlying components of the transaction rather than at fair value.
As a result of this transaction, the Company is no longer engaged in asset management operations, and the underlying results of NSI have been reported as discontinued operations. Income from discontinued operations, net of tax, for 2002 was $0.7 million.
The Company regularly monitors and reports a production volume metric titled “sales.” Sales or similar measures are commonly used in the insurance industry as a measure of the volume of new and renewal business generated in a period.
Sales, as reported by the Company, are stated net of internal replacements, which the Company believes provides a more meaningful disclosure of production in a given period. In addition, the Company’s definition of sales excludes funding agreements issued under the Company’s MTN program; large case bank-owned life insurance (BOLI); large case pension plan acquisitions; and deposits into Nationwide employee and agent benefit plans. Although these products contribute to asset and earnings growth, they do not produce steady production flow that lends itself to meaningful comparisons and, therefore, are excluded from sales.
The Company’s flagship products are marketed under The BEST of AMERICA® brand and include individual variable and group annuities, group private sector retirement plans, and variable life insurance. The BEST of AMERICA products allow customers to choose from investment options managed by premier mutual fund managers. The Company has also developed private label variable and fixed annuity products in conjunction with other financial services providers that allow those providers to sell products to their own customer bases under their own brand names.
Sales generated by financial institutions declined 40% to $1.84 billion in 2004 compared to 2003 primarily due to planned reductions in fixed annuity sales and the effects of changes made to the fixed option of variable annuity products. Sales generated by financial institutions declined 11% in 2003 as a result of efforts focused on pricing discipline and planned reduction in fixed annuity sales during the second half of 2003, while private sector pension plan and variable annuity sales were higher in 2003.
As the Company’s private sector retirement plan business model continues to evolve, direct production through the pension plan administrators channel is expected to decline, as more new business opportunities are being created in conjunction or partnership with the independent broker/dealers, wirehouse and regional firms and financial institutions relationships. This was evidenced by the 21% and 28% declines in 2004 and 2003, respectively.
Sales generated by the CPA channel increased significantly to $96.1 million in 2004 compared to $14.4 million in 2003. The increase was due to the reclassification of certain CPA channel sales, which prior to 2004 were reported with independent broker/dealer sales and were not reclassified to conform to the current year presentation.
Sales generated by Nationwide agents increased 2% in 2004 compared to 2003, due to an increase in individual variable annuity sales related to new products, partially offset by an intentional reduction in fixed annuity production. Sales declined 9% in 2003 compared to 2002, due to lower fixed annuity sales resulting from an intentional slow down in sales and commission reductions.
NFN sales decreased by 5% compared to 2003, as individual investment life sales continue to be adversely impacted by the consumer preference for fixed products. Sales increased significantly in 2003 primarily due to the acquisition that NFS closed on October 1, 2002.
Policy charges totaled $503.7 million in 2004, up 18% from $427.9 million in 2003, which was down 6% from $456.5 million in 2002. The increase was due to higher variable asset fees as average separate account values increased and higher surrender charges.
Asset fees increased to $427.8 million in 2004, up 18% from $362.5 million in 2003, and totaled $373.3 million in 2002. Asset fees are calculated daily and charged as a percentage of separate account values. The fluctuations in asset fees were 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 increased 17% to $33.03 billion for 2004 compared to $28.22 billion in 2003 following a 5% decrease in 2002.
Surrender fees increased by 12% to $60.6 million in 2004 compared to $54.1 million in 2003 and $60.4 million in 2002. The increase in 2004 primarily was due to the competitive market place, volatile equity markets and larger in force levels. The decrease in 2003 primarily was due to positive equity market returns in the period.
The 16% decrease in other benefits in 2004 compared to the prior year primarily reflects lower GMDB costs in 2004. GMDB exposure, as measured by the difference between the current contractual death benefit and account value, net of reinsurance, fell over 50% from the average levels experienced in 2003. Moderation in this exposure directly resulted in reduced benefit payments and lesser reserve provisions for future benefits. Gross GMDB death claims expense decreased significantly from $56.7 million in 2003 to $31.5 million in 2004. Reinsurance recoveries covered a greater proportion of actual claims during 2004 (84% versus 61%), due to favorable experience and the addition of a new reinsurance treaty in April. Benefit reserve expenses of $8.1 million in 2003 were affected by a $11.9 million strengthening, while 2004 reserves increased only $1.9 million. In contrast, strong equity performance in the fourth quarter of 2004, together with expanded hedging of GMDB benefits, led to hedge losses of $7.0 million in 2004 compared to $2.3 million in losses in 2003. Benefit expenses for guaranteed living benefits, including GMIB and GMAB, improved by $2.0 million in 2004. The Company’s reserves for all variable annuity guarantees, calculated in accordance with SOP 03-01 and SFAS 133, totaled $45.0 million and $26.1 million as of December 31, 2004 and 2003, respectively.
In addition to higher general account assets, interest spread margins widened during 2004 to 188 basis points compared to 167 basis points in 2003 and 195 basis points in 2002. 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 and 7 basis points, or $6.8 million, in 2002. The higher interest rate environment relative to a year ago has eased the pressure on margins due to the interest rate floors contained in annuity contracts. Although interest spread income was higher, interest spread margins compressed to 167 basis points in 2003. A one year enhanced crediting rate special offered in the fourth quarter 2002 coupled with new crediting rates at or near contractual minimum rates and a jump in prepayments of higher yielding investments created pressure on interest spread on average general account values in 2003.
The Company has taken actions to address low interest rate environments and the resulting impact on interest spread margins. In 2003 the Company lowered commission rates for individual fixed annuities, and the Company began invoking contractual provisions during second quarter 2003 that limited the amount of variable annuity deposits allocated to the guaranteed fixed option. In addition, the Company re-filed its products with lower floor guarantees in 2003, and the majority of new business is now written in these lower floor guarantee products.
The Retirement Plans segment is comprised of the Company’s private- and public-sector retirement plans business. This segment differs from the former Institutional Products segment because it no longer includes the results of the structured products and MTN businesses. The private sector includes IRC Section 401(k) business and the public sector includes IRC Section 457 and Section 401(a) business, both in the form of fixed and variable annuities. Retirement Plans sales do not include large case retirement plan acquisitions and Nationwide employee and agent benefit plans. However, the statements of income data in the following table does reflect this business.
Pre-tax operating earnings increased 2% to $125.3 million in 2004 compared to $122.5 million in 2003 and $136.1 million in 2002. The increase in 2004 was due to higher policy charges and lower DAC amortization, partially offset by increased general operating expenses and lower interest spread income. The decline in 2003 from 2002 was due to lower policy charges and increased general operating expenses, slightly offset by higher interest spread income.
Asset fees increased 2% to $137.6 million in 2004 compared to $134.8 million in 2003. This increase was driven by 8% higher average separate account values compared to 2003, reflecting an improved equity market in 2004 and more than offsetting the shift in new business mix from group annuities to non-annuity products. Fluctuations in asset fees do not always vary with average seperate account values due to periodic re-pricing of various products. Asset fees declined 8% in 2003 compared to 2002 due to a 9% decrease in average separate account values due to the shift in product mix from annuities to administration-only products, coupled with a less favorable equity market environment.
Interest spread income was $4.6 million lower in 2004 compared to 2003, which was $9.2 million higher than 2002. The decrease in 2004 primarily was due to spread compression in both the public sector and private sector business associated with lower prepayment payment penalty income on mortgage loans and bond call premiums. The 2003 increase over 2002 was driven by significantly higher prepayment income.
Other operating expenses increased 3% to $184.5 million for 2004 versus $178.9 million in 2003 and $167.8 million in 2002. The increase in both years reflected higher employee benefit and pension costs, investments in information technology to enhance the defined contribution record-keeping platform, and increases in marketing and advertising.
Pre-tax operating earnings increased 14% to $170.6 million in 2004 compared to $150.0 million in 2003, which decreased 13% from $171.5 million in 2002. Excluding $6.8 million of accelerated DAC amortization in third quarter 2002, pre-tax operating earnings totaled $178.3 million in 2002. Improved results from investment life products, both individual and corporate-owned, drove the growth in 2004. The combination of higher policy charges and lower DAC amortization contributed to the earnings improvement. In 2003, higher general operating expenses and DAC amortization on COLI, primarily the result of the surrender of a single large case, drove the decline.
Policy charges increased to $364.6 million in 2004 compared to $346.2 million in 2003, which was a slight decrease from $347.2 million in 2002. Cost of insurance charges, which are assessed on the amount of insurance in force in excess of the related policyholder account value, increased 4% and 6% in 2004 and 2003, respectively. Growth in universal life and individual investment life products were the primary contributors to this improvement.
Amortization of DAC decreased $7.5 million, or 7%, in 2004 following an increase of $13.7 million, or 16%, in 2003. The implementation of DAC model enhancements, which provide a more refined calculation and more timely reflections of observed trends in the underlying assumptions, reduced amortization in the investment life business by $8.5 million in 2004. However, DAC amortization increased in the fixed life business, consistent with higher earnings. Excluding the $6.8 million accelerated DAC amortization in third quarter 2002, DAC amortization increased $20.5 million in 2003. This increase primarily was due to the surrender of a large COLI case. In addition, during 2003 mortality experience was more favorable than expected, and estimated gross profits on the in force variable business increased.
Other operating expenses were $159.7 million in 2004, up 2% from 2003, which were up 6% from 2002. The increases in operating expenses primarily were driven by higher compensation and employee benefits expenses.
Pre-tax operating earnings decreased 36% in 2004 compared to 2003. The decrease was primarily attributable to an increase in general expenses related to advertising and promotion and employee compensation and benefits, partially offset by other income from structured products activity and higher interest spread income. Pre-tax earnings increased 35% in 2003 compared to 2002 primarily due to higher interest spread income due to income earned on the proceeds from the $200.0 million capital contribution from NFS in February 2003.
Net realized losses on investments, hedging instruments and hedged items excluding periodic net coupon settlements on non-qualifying derivatives totaled $43.0 million, $100.8 million and $84.4 million in 2004, 2003 and 2002, respectively, and included other-than-temporary impairments of $90.6 million, $156.5 million and $120.3 million in 2004, 2003 and 2002, respectively. Realized gains on sales, net of hedging losses were driven by an improving market and credit environment. Realized losses on sales, net of hedging gains were lessened by the impact of market pricing and portfolio alignment. Other-than-temporary and other investment impairments were positively impacted by the improving credit environment. During the third quarter 2003, the Company refined the calculation of its mortgage loan valuation allowance by incorporating more detailed information. As a result, the valuation allowance was reduced by $12.1 million.
The following table summarizes for the year ended December 31, 2004 the Company’s largest aggregate losses on sales and write-downs by issuer (including affiliates), the related circumstances giving rise to the losses and the circumstances that may have affected other material investments held:
The following table summarizes the Company’s contractual obligations and commitments as of December 31, 2004 expected to be paid in the periods presented. Payment amounts reflect the Company’s estimate of undiscounted cash flows related to these obligations and commitments. Balance sheet amounts were determined in accordance with GAAP and in many cases differ significantly from the summation of undiscounted cash flows. The most significant difference relates to future policy benefits related to life and health insurance which include discounting.
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, 2004.
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 rates (including timing of death) 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 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 retirement patterns in the amounts reported. Actual retirements may differ significantly from those projected and may result in early withdrawal of contract funds, 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 decrease and/or accelerate those obligations presented. Most 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. Furthermore, in developing the estimates of payments due by period, the Company followed the process for determining future interest crediting rates as described in note 5 above.
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 MTNs, 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 assign the same ratings to the notes and the insurance financial strength of the Company.
As of December 31, 2004 and 2003, the Company had received $874.2 million and $976.6 million, respectively, of cash collateral on securities lending and $415.7 million and $544.5 million, respectively, of cash for derivative collateral. As of December 31, 2004, the Company had received $191.8 million of non-cash collateral on securities lending. Both the cash and non-cash collateral amounts are included in short-term investments with a corresponding liability recorded in other liabilities. As of December 31, 2004 and 2003, the Company had loaned securities with a fair value of $1.04 billion and 958.1 million, respectively. The Company also held $222.5 million and $163.0 million of securities as off-balance sheet collateral on derivative transactions as of December 31, 2004 and 2003, respectively.