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 Financial Services, Inc. and its subsidiaries (NFS, 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:
(i) Change in Nationwide Corporation’s control of the Company through its beneficial ownership of 94.4% of the combined voting power of all the outstanding common stock and 62.7% of the economic interest in the Company;
(iv) Tax law changes impacting the tax treatment of life insurance and investment products;
(vi) Heightened competition, including specifically the intensification of price competition, the entry of new competitors and the development of new products by new and existing competitors;
(viii) Failure to expand distribution channels in order to obtain new customers or failure to retain existing customers;
(ix) 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;
(x) Changes in interest rates and the equity markets causing a reduction of investment income and/or asset fees; an acceleration of the amortization of deferred policy acquisition costs (DAC) and/or value of business acquired (VOBA); reduction in the value of the Company’s investment portfolio or separate account assets, or a reduction in the demand for the Company’s products;
(xiv) Deviations from assumptions regarding future persistency, mortality, morbidity and interest rates used in calculating reserve amounts and in pricing the Company’s products; and
(xv) Adverse litigation results and/or resolution of litigation and/or arbitration or investigation results.
Following is management’s discussion and analysis of financial condition and results of operations of Nationwide Financial Services, Inc. and its subsidiaries for the three years ended December 31, 2004. This discussion should be read in conjunction with the consolidated financial statements and related notes beginning on page of this report.
NFS is the holding company for Nationwide Life Insurance Company (NLIC) and other companies that comprise the domestic life insurance and retirement savings operations of the Nationwide group of companies (Nationwide), including Nationwide Financial Network (NFN), which refers to Nationwide Life Insurance Company of America (NLICA) and subsidiaries, including the affiliated distribution network, and which was formerly referred to as Nationwide Provident. The Company is a leading provider of long-term savings and retirement products in the United States of America. The Company develops and sells a diverse range of products including individual annuities, private and public group retirement plans, other investment products sold to institutions, life insurance and advisory services. As a result of its initial public offering in March 1997 and subsequent stock related transactions since that date, including the issuance of 31.9 million shares in connection with the acquisition of NFN, 37.3% of the economic interest in NFS is publicly owned, with the remainder owned by Nationwide Corporation (Nationwide Corp.), which is a majority-owned subsidiary of Nationwide Mutual Insurance Company (NMIC).
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 and 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.
For investment products (principally individual and group annuities) and universal life insurance products, DAC is being amortized with interest over the lives of the policies in relation to the present value of estimated gross profits from projected interest margins, asset fees, cost of insurance, policy administration and surrender charges, less policy benefits and policy maintenance expenses. The DAC asset related to investment products and universal life insurance products is adjusted to reflect the impact of unrealized gains and losses on fixed maturity securities available-for-sale, as described in Note 2(b) to the consolidated financial statements included in the F pages of this report.
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 & 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.
In connection with acquisitions of operating entities, the Company recognizes the excess of the purchase price over the fair value of net assets acquired as goodwill. Goodwill is not amortized but is evaluated for impairment at the reporting unit level annually in the fourth quarter. Goodwill of a reporting unit also is tested for impairment on an interim basis in addition to the annual evaluation if an event occurs or circumstances change which would more likely than not reduce the fair value of a reporting unit below its carrying amount.
The process of evaluating goodwill for impairment requires several judgments and assumptions to be made to determine the fair value of the reporting units, including the method used to determine fair value; discount
Pension and other postretirement employee benefits (OPEB) assumptions are revised annually in conjunction with preparation of the Company’s Annual Report on Form 10-K. The 2004 pension expense for substantially all of the Company’s employees and certain agents totaled $14.3 million, an increase of $2.0 million over 2003 pension expense of $12.3 million. The increase primarily was due to decreasing interest rates at the plan level, reflected in a lower discount rate. For the Company’s primary pension plan, the discount rate used to value cash flows was lowered to 5.50% to determine 2004 pension expense from 6.00% used in 2003, and the long-term expected rate of return on plan assets was lowered to 7.25% for 2004 from 7.75% for 2003.
The 2004 and 2003 OPEB expense for substantially all of the Company’s employees and certain agents totaled $3.4 million and $3.3 million, respectively. The discount rate used to value cash flows was lowered to 6.10% to determine 2004 OPEB expense from 6.60% used 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 Company employs a prospective building block approach in establishing the discount rate and the expected long-term rate of return on plan assets. This process is integrated with the determination of other economic assumptions such as salary scale. For a given measurement date, the discount rate is set by reference to the yield on high-quality corporate bonds to approximate the rate at which plan benefits could effectively be settled. For pension benefits, a downward adjustment in the discount rate is included for plan administration and other expenses likely to be charged by an insurer. Since the OPEB liability includes both claims and administration expenses, a similar downward adjustment is not appropriate for the OPEB discount rate. The historical real rate of return for the reference bonds is subtracted from the yield on these bonds to generate an assumed inflation rate. The expected real rates of return on various asset sub-classes are developed based on historic risk premiums for those sub-classes. The expected real rates of return, reduced for investment expenses, are applied to the target allocation of each asset sub-class to produce an expected real rate of return for the target portfolio. This expected real rate of return varies by plan and changes when the plan’s target investment portfolio changes. The expected long-term rate of return on plan assets is the assumed inflation rate plus the expected real rate of return. This process effectively sets the expected return for the plan’s portfolio at the yield for the reference bond portfolio, adjusted for expected risk premiums of the target asset portfolio. Given the prospective nature of this calculation, short-term fluctuations in the market do not impact the expected risk premiums. However, as the yield for the reference bonds fluctuates, the assumed inflation rate and the expected long-term rate are adjusted in tandem.
Total revenues for 2004 increased to $4.18 billion compared to $3.94 billion in 2003. The growth in 2004 primarily was driven by higher policy charges, other income and net investment income, partially offset by a decline in life insurance premiums. Asset-based policy charges increased due to improved equity market returns. The increase in other income was primarily driven by increased sales of retirement plans and an increase in securitizations and structured products activity. Net investment income increased due primarily to additional prepayment income on mortgage loans and bond call premiums. The 20% growth in revenues in 2003 from $3.29 billion in 2002 was driven by the addition of NFN, which added $620.6 million in revenues in 2003.
related net realized gains on investments, hedging instruments and hedged items totaled $72.6 million in 2004 compared to $101.0 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.
Interest credited to policyholder account values totaled $1.35 billion in 2004 compared to $1.39 billion in 2003 and $1.28 billion in 2002, and principally relates to fixed annuities, both individual and institutional, funding agreements backing the Company’s MTN program and certain life insurance products. The decrease in interest credited reflects lower crediting rates in the Individual Investments segment and the private sector in the Retirement Plans segment in response to lower market interest rates, partially offset by increases in account values. Average crediting rates for the Individual Investments segment were 3.89% in 2004, compared to 4.31% a year ago and 4.93% in 2002. Average crediting rates for the Retirement Plans segment were 4.38% in 2004, compared to 4.69% a year ago and 5.26% in 2002. The increase in market interest rates in second quarter 2004 does not appear immediately in interest credited due to the timing of rate reset dates, which are typically annual or quarterly. The increase in interest credited in 2003 reflects an increase in account values for individual and institutional fixed annuities as a result of strong fixed annuity production during the first three quarters of 2003, and increased allocations of variable annuity deposits to the guaranteed fixed option through May. The increase was partially offset by lower crediting rates in the Individual Investments and Retirement Plans segments on products where crediting rates have not already reached guaranteed floors.
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 $563.5 million in 2003 to $526.9 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 significant increase in other benefits and claims for 2003 compared to 2002 reflect additional life insurance benefits related to NFN, growth in life insurance in force, an increase in the provision for future policy benefits for immediate annuities due to growth in new premium in 2003 compared to 2002, and an increase in guaranteed minimum death benefits (GMDB) costs due to a higher level of claims.
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.
of tax, in 2002 was $3.4 million. Also, the Company no longer reports an Asset Management segment, and structured products transactions previously reported in the Asset Management segment are now reported in the Corporate and Other segment. All periods presented have been revised to reflect these changes.
Life insurance premiums determined on a GAAP basis are significantly different than statutory premiums and deposits. Life insurance premiums determined on a GAAP basis are recognized as revenue when due, as calculated on an accrual basis in proportion to the service provided and performance rendered under the contract. In addition, many life insurance and annuity products involve an initial deposit or a series of deposits from customers. These deposits are accounted for as such on a GAAP basis and therefore are not reflected in the GAAP income statement. On a statutory basis, life insurance premiums collected (cash basis) and deposits received (cash basis) are aggregated and reported as revenues in the line item statutory premiums and annuity considerations.
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 retirement 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 also markets group deferred compensation retirement plans to employees of state and local governments for use under Internal Revenue Code (IRC) Section 457. The Company utilizes its sponsorship by the National Association of Counties, The United States Conference of Mayors and The International Association of Firefighters (IAFF) when marketing IRC Section 457 products.
Sales generated by financial institutions declined 30% 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 in 2003 declined 10%, as a result of efforts focused on pricing discipline and planned reductions in fixed annuity sales during the second half of 2003, which more than offset growth in variable annuity sales.
the unfavorable environment for COLI and executive deferred compensation programs affecting the creation of new plans and sales, partially offset by increased renewal premium from the funding of existing COLI cases. Increased renewal premium from COLI cases can be attributed to continued improvement in the market environment and increased participant deferrals in existing executive deferred compensation plans. Sales through this channel declined 24% in 2003 compared to 2002 due to the unfavorable environment for COLI and executive deferred compensation programs. The sluggish equity markets, the weak economy, unfavorable press regarding COLI and executive deferred compensation plans, and proposed legislation which could adversely impact the tax benefits of COLI, all negatively impacted sales and new business opportunities.
Sales through NRS increased 14% and 22%, respectively, in 2004 and 2003 primarily reflecting rollover activity from existing participants’ previous employer sponsored plans into existing accounts, as recent pension reform legislation has expanded the portability of public sector plan assets. In addition, participant contributions from the State of New York, New Mexico and IAFF cases acquired during 2003 and the addition of the City of Phoenix in 2004 contributed to the increases.
Sales generated by The 401(k) Company grew 31% and 44% in 2004 and 2003 compared to the prior year, respectively, as a result of employee salary deferrals on several new cases added in 2002 and at the beginning of 2003 and companies’ profit sharing contributions made in March and April of 2004.
Sales through TBG Financial increased 14% in 2004 compared to 2003 due to higher renewal premiums from the funding of existing executive deferred compensation plans. Sales increased in 2003 by 10% compared to 2002 due to the sale of a single large case.
The Individual Investments segment consists of individual The BEST of AMERICA and private label deferred variable annuity products, NFN individual annuity products, deferred fixed annuity products, income products, and advisory services program revenues and expenses. This segment differs from the former Individual Annuity segment due to the addition of the advisory services program results. Individual deferred annuity contracts provide the customer with tax-deferred accumulation of savings and flexible payout options including lump sum, systematic withdrawal or a stream of payments for life. In addition, individual variable annuity contracts provide the customer with access to a wide range of investment options and asset protection in the event of an untimely death, while individual fixed annuity contracts generate a return for the customer at a specified interest rate fixed for prescribed periods.
Asset fees of $445.9 million in 2004 were up 18% from $376.6 million in 2003, which was down 1% from $378.6 million reported 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% in 2004 to $34.2 billion following a 3% decrease in 2003.
Interest spread income grew $46.3 million, or 18%, in 2004 compared to a $46.4 million, or 22%, increase in 2003. The growth in 2004 was driven by an $11.3 million increase in prepayment income on mortgage loans and bond call premiums, net of SFAS 91 adjustments, relative to 2003 due to reductions in crediting rates over the last several quarters. Higher average general account values also contributed to the increase. These factors more than offset decreased customer allocations to the guaranteed fixed options of individual variable annuities. Allocations to the guaranteed fixed option related to new domestic individual variable annuity sales during 2004 totaled 22%, compared to 44% for the same period a year ago. The growth in 2003 was driven by a 42% increase in average general account assets for these same comparative periods, the result of growth in the individual fixed annuity business, the addition of NFN and increased customer allocations to the guaranteed fixed options of individual variable annuities. Allocations to the guaranteed fixed option related to new domestic individual variable annuity sales during 2003 totaled 42% compared to 49% in 2002.
In addition to higher general account assets, interest spread margins widened during 2004 to 185 basis points compared to 165 in 2003. The 2003 interest spread margin narrowed compared to the 191 basis points in 2002. Included in 2004 were 12 basis points, or $19.5 million, of prepayment income on mortgage loans and bond call premiums compared to 5 basis points, or $8.2 million, in 2003 and 6 basis points, or $6.8 million, in 2002, respectively. The higher interest rate environment in 2004 relative to a year ago has eased the pressure on margins due to the interest rate floors contained in annuity contracts.
Sales totaled $5.34 billion during 2004, down 21% from $6.74 billion in 2003, which was down 8% from $7.33 billion in 2002. Variable annuity production declined by 13% to $4.13 billion in 2004 compared to 2003, with 22% of new domestic sales allocated to the guaranteed fixed options. Sales of variable annuities were $4.74 billion in 2003, up 3% compared to $4.62 billion in 2002. Fixed annuity sales totaled $858.8 million in 2004, a 53% decline from levels reported a year ago. Fixed annuity sales were $1.82 billion in 2003 down 29% compared to $2.56 billion in 2002. Declines in 2004 and 2003 were attributable to a sharp drop-off in sales of fixed annuities, the result of the actions described above, which are intended to reduce the level of new individual fixed annuity business due to the challenging interest rate environment.
Deposits in 2004 of $5.08 billion offset by withdrawals and surrenders totaling $5.72 billion generated net outflows of $635.9 million compared to net inflows of $1.62 billion achieved in 2003 and $2.01 billion in 2002.
Surrender charges increased significantly to $12.1 million in 2004 from $5.7 million in 2003 primarily due to a 24% increase in withdrawals and surrenders as a higher percentage of plans surrendered within the surrender charge period. In addition, the trend of conversions from group annuity contracts to NTC products continued.
The slight decrease in surrender charges in 2003 compared to 2002 was not a significant driver in the decline in policy charges in 2003 versus 2002.
Interest spread declined to 198 basis points in 2004 compared to 208 basis points in 2003, which decreased slightly from 211 basis points in 2002. Included in 2004 were 18 basis points, or $17.9 million, of prepayment income on mortgage loans and bond call premiums compared to 21 basis points, or $20.3 million in 2003 and 11 basis points, or $10.2 million in 2002, respectively.
Other operating expenses increased 14% to $338.6 million in 2004 compared to $297.9 million in 2003. Other operating expenses increased 15% from $258.5 million in 2002. The increase in both years is reflective of the growth in plans and participants in both the public sector and private sector businesses, combined with investments in information technology to enhance the defined contribution record-keeping platform. Higher employee benefit and pension costs, and increased investments in sales, marketing, and advertising, also contributed to the annual increases.
Private sector retirement plan sales in 2004 increased 18% to $6.17 billion from $5.22 billion in the prior year, and $4.84 billion in 2002. The 2004 increase was due to an increased distribution force of approximately 25%, the acquisition of bigger than average cases in the small to mid-size market, and a 31% increase in sales at The 401(k) Company, which focuses on the large plan market. The 2003 increase compared to 2002 was driven by a 44% rise in sales at The 401(k) Company, and 31% additional sales on the NTC platform, slightly offset by a 22% decline in deposits of group annuities.
Public sector pension sales increased 14% to $3.64 billion in 2004 compared to $3.18 billion in 2003, and totaled $2.58 billion in 2002, an increase of 23%. The increases reflect the addition of deposits into the State of New York, State of New Mexico, City of Phoenix and IAFF defined contribution plans. In addition, recently implemented pension reform legislation has expanded the portability of public plan assets, leading to increased rollover activity from existing participants’ previous employer-sponsored plans into existing accounts.
Deposits in 2004 of $10.15 billion offset by participant withdrawals and surrenders of $7.45 billion generated net inflows from participant activity of $2.70 billion, a 12% increase from 2003. Deposits in 2003 of $8.69 billion offset by participant withdrawals and surrenders totaling $6.28 billion generated net flows from participant activity of $2.41 billion, a 68% increase over 2002. Deferrals into existing plans and the recently acquired State of New York, State of New Mexico and City of Phoenix defined contribution plans drove the increase in 2004. The year end account values included the April 2004 addition of the $529.0 million City of Phoenix defined contribution plan. An increase in deposits to Nationwide employee and agent benefit plans, deferrals into newly acquired plans, rollover activity into existing participant accounts and lower surrender activity drove the 2003 increase.
The ratio of pre-tax operating earnings to average account values declined slightly to 26 basis points in 2004 from 27 basis points in 2003. A 20% increase in pre-tax operating earnings, combined with an 24% increase in average account values due to the favorable equity market environment during 2004, drove the slight decrease in this ratio. The decreases in pre-tax operating earnings to average account values, which totaled 27 basis points in 2003, compared to 31 basis points in 2002, primarily was driven by changes in the mix of products including growth in administration-only products, which generally provide lower margins than group annuity contracts. The decrease also reflects more private sector pension business in the form of NTC products, which results in earlier recognition of selling and other acquisition costs than with annuity products.
The Individual Protection segment consists of investment life insurance products, including individual variable life, COLI and bank-owned life insurance (BOLI) products, traditional life insurance products, universal life insurance and the results of TBG Financial. This segment is unchanged from the former Life Insurance segment. Life insurance products provide a death benefit and generally allow the customer to build cash value on a tax-advantaged basis.
Policy charges increased 3% to $537.5 million in 2004 following a 33% increase to $520.1 million in 2003. Cost of insurance charges, which are assessed on the amount of insurance in force in excess of the related policyholder account value, increased 2% and 39% in 2004 and 2003, respectively. The increase reflects a growing block of investment life business, as insurance in force increased 1% to $109.23 billion at year-end 2004 compared to $107.82 billion at year-end 2003. Insurance in force increased slightly in 2003 over 2002.
Net investment income increased by 1% and 28% in 2004 and 2003, respectively, primarily reflecting the growth in traditional and universal life business in the past two years and the addition of NFN business.
The following table summarizes selected financial data for the Company’s Corporate and Other segment for the years ended December 31:
Net realized losses on investments, hedging instruments and hedged items excluding operating items (such as periodic net coupon settlements on non-qualifying derivatives, trading portfolio activity and trading valuation gains) totaled $39.5 million, $85.1 million and $88.3 million in 2004, 2003 and 2002, respectively, and included other-than-temporary impairments of $103.4 million, $170.4 million and $124.2 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 $16.5 million.
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 “Impairment Losses on Investments” in the “Critical Accounting Policies and Recently Issued Accounting Standards” section of Part II, Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) of this report for a complete discussion of this process.
In the normal course of business, the Company has entered into many related party transactions. Descriptions of these transactions are provided in Note 21 to the consolidated financial statements included in the F pages of this report and are incorporated herein by reference.
Additionally, the Company has reclassified its capital and preferred securities of subsidiary trusts into long-term debt for all prior periods presented. Consistent with their classification as debt, the Company recognizes distributions on the capital and preferred securities as interest expense in the consolidated statements of income. In connection with the adoption of FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities-an interpretation of ARB No. 51 (FIN 46R), the Company deconsolidated the trusts established in connection with the issuance of mandatorily redeemable capital and preferred securities effective December 31, 2003. FIN 46R did not require the restatement of any prior periods. As a result, at December 31, 2003, the Company reported as a component of long-term debt the junior subordinated debentures payable by NFS to the trusts. Previously, the junior subordinated debentures were eliminated in consolidation. Because the Company’s implementation of FIN 46R did not result in restating prior periods, the related trust preferred securities are still in the totals of long-term debt for 2002.
The terms of the senior notes contain various restrictive covenants, including limitations on the disposition of subsidiaries. As of December 31, 2004, the Company was in compliance with all such covenants.
The variable rate note payable is tied to 1-year U.S. LIBOR rates with annual resets and had an outstanding balance of $1.7 million and an interest rate of 4.35% as of December 31, 2004.
As an insurance holding company, the ability of NFS to meet debt service obligations and pay operating expenses and dividends depends primarily on the receipt of sufficient funds from its primary operating subsidiary, NLIC. The inability of NLIC to pay dividends to NFS in an amount sufficient to meet debt service obligations and pay operating expenses and dividends would have a material adverse effect on the Company. The payment of dividends by NLIC is subject to restrictions set forth in the insurance laws and regulations of the State of Ohio, its domiciliary state. The State of Ohio insurance laws require Ohio-domiciled life insurance companies to seek prior regulatory approval to pay a dividend or distribution of cash or other property if the fair market value thereof, together with that of other dividends or distributions made in the preceding 12 months, exceeds the greater of: (i) 10% of statutory-basis policyholders’ surplus as of the prior December 31; or (ii) the statutory-basis net income of the insurer for the 12-month period ending as of the prior December 31. NLIC’s statutory capital and surplus as of December 31, 2004 was $2.39 billion, and statutory net income for 2004 was $317.7 million. As of January 1, 2005, based on statutory financial results as of and for the year ended December 31, 2004, NLIC could pay dividends to NFS totaling $192.7 million without obtaining prior approval. On March 1, 2005, NLIC paid a $25.0 million dividend to NFS. The State of Ohio insurance laws also require insurers to seek prior regulatory approval for any dividend paid from other than earned surplus. The payment of dividends by NLIC may also be subject to restrictions set forth in the insurance laws of the State of New York that limit the amount of statutory profits on NLIC’s participating policies (measured before dividends to policyholders) that can inure to the benefit of NFS and its stockholders.
In addition, the Company has two majority-owned subsidiaries that each have available separate annually renewable, 364-day, $10.0 million line of credit agreements with a single financial institution. The lines of credit are guaranteed by NFS and are included in consolidation. One of the agreements was renewed in September 2004, and the majority-owned subsidiary had $6.8 million outstanding on that line of credit as of December 31, 2004 at a weighted average effective interest rate of 4.07% in 2004. The other agreement was established in August 2004, and the majority-owned subsidiary had $9.0 million outstanding on that line of credit as of December 31, 2004 at a weighted average effective interest rate of 2.34% in 2004. See also Note 13 to the consolidated financial statements included in the F pages of this report.
In addition to the agreement described above, NMIC has entered into an agreement with its custodial bank to borrow against the cash collateral that is posted in connection with its securities lending program. This is an uncommitted facility, which is contingent on the liquidity of the securities lending program. The borrowing
facility was established to fund commercial mortgage loans that were originated with the intent of sale through securitization. These loans are collateral for the facility. Because NLIC has a variable interest in the profits from the securitization of these loans, NLIC consolidates the assets and liabilities associated with these loans and the corresponding borrowings in accordance with FIN 46R. The maximum amount available under the agreement is $250.0 million. The borrowing rate on this program is equal to one-month U.S. LIBOR. NMIC had $32.6 million outstanding under this agreement as of December 31, 2004.
For individual annuity products ($50.38 billion of reserves as of December 31, 2004), the surrender charge is generally calculated as a percentage of the deposits made and is assessed at declining rates during the first seven years after a deposit is made.
For group annuity products ($25.85 billion of reserves as of December 31, 2004), the surrender charge amounts and periods can vary significantly, depending on the terms of each contract and the compensation structure for the producer. Generally, surrender charge percentages for group products are less than individual products because the Company incurs lower expenses at contract origination for group products. In addition, over ninety percent of the general account group annuity reserves are subject to a market value adjustment at withdrawal.
At the time of the sales, $5.1 million of net sale proceeds were set aside as collateral for certain properties owned by the Tax Credit Funds that had not met all of the criteria necessary to generate tax credits. Such criteria include completion of construction and the leasing of each unit to a qualified tenant, among others. Properties meeting the necessary criteria are considered to have “stabilized.” The properties are evaluated regularly, and the collateral is released when stabilized. During 2004 and 2003, $0.1 million and $3.1 million of stabilization collateral had been released into income, respectively.
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 and interest based on rates in effect at December 31, 2004.
Contractual provisions exist that could increase or accelerate those obligations presented. The amounts presented include contractual principal and interest based on stated rates in effect at December 31, 2004. See the “Liquidity and Capital Resources” section of MD&A for a detailed discussion of the Company’s long-term debt.
Contractual provisions exist that could increase or accelerate those obligations presented, including various leases with early buyouts and/or escalation clauses. However, the impact of any such transactions would not be material to the Company’s financial position or results of operations.
A significant portion of policy contract benefits to be paid do not have stated contractual maturity dates and may not result in any ultimate payment obligation. Amounts reported herein represent estimated undiscounted cash flows out of the Company’s general account related to death, surrender, annuity and other benefit payments under policy contracts in force at December 31, 2004. Separate account payments are not reflected herein due to the matched nature of these obligations and the fact that the contract owners maintain the investment risk of such deposits. Estimated payment amounts reported herein were developed based on review of historical results experienced by the Company and the related contractual provisions. Significant assumptions incorporated in the reported amounts include: future policy lapse rates (including the impact of customer decisions to make future premium payments to keep the related policies in force), coverage levels remaining unchanged from those provided under contracts in force at December 31, 2004, future interest crediting rates, and the estimated timing of payments. Actual amounts will vary, potentially in a significant manner, from the amounts indicated due to deviations between assumptions and actual results and the addition of new business in future periods.
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 (j) 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.
As of December 31, 2004 and 2003, the Company had received $1.01 billion 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 $194.7 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 $1.18 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.
The Company’s assets are divided between separate account and general account assets. As of December 31, 2004, $64.90 billion (55%) of the Company’s total assets were held in separate accounts and $52.05 billion (45%) were held in the Company’s general account, including $44.60 billion of general account investments.
During the fourth quarter of 2004, the Company began reporting separately amounts for agencies not backed by the full faith and credit of the U.S. Government.
The average duration and average maturity of the Company’s general account fixed maturity securities as of December 31, 2004 were approximately 4.0 and 5.3 years, respectively, compared to 4.0 years and 5.4 years, respectively, at December 31, 2003. The market value of the Company’s general account investments may fluctuate significantly in response to changes in interest rates. In addition, the Company may be likely to experience realized investment losses to the extent its liquidity needs require the disposition of general account fixed maturity securities in unfavorable interest rate environments.
The National Association of Insurance Commissioners (NAIC) assigns securities quality ratings and uniform valuations called “NAIC Designations” which are used by insurers when preparing their annual statements. The NAIC assigns designations to publicly traded and privately placed securities. The designations assigned by the NAIC range from class 1 (highest quality) to class 6. Of the Company’s general account fixed maturity securities, 94% were in the two highest NAIC Designations as of December 31, 2004.
NAIC Designations are assigned at least annually. Some designations for securities shown have been assigned to securities not yet assigned an NAIC Designation in a manner approximating equivalent public rating categories.
The Company believes that MBS investments add diversification, liquidity, credit quality and additional yield to its general account portfolio. The Company’s objective for its MBS portfolio is to provide reasonable cash flow stability and increased yield. The MBS portfolio includes collateralized mortgage obligations (CMOs), Real Estate Mortgage Investment Conduits (REMICs) and mortgage-backed pass-through securities. The Company’s general account MBS portfolio generally does not include interest-only securities, principal-only securities or other MBS investments which may exhibit extreme market volatility.
Prepayment/extension risk is an inherent risk of holding MBSs. However, the degree of prepayment/extension risk varies by the type of MBS held. The Company limits its exposure to prepayments/extensions by including less volatile types of MBSs. As of December 31, 2004, $2.39 billion (43%) of the carrying value of the general account MBS portfolio was invested in planned amortization class CMOs/REMICs (PACs). PACs are securities whose cash flows are designed to remain constant in a variety of mortgage prepayment environments. Most of the Company’s non-PAC MBSs possess varying degrees of cash flow structure and prepayment/extension risk. The MBS portfolio contains only 4% of pure pass-throughs.
The Company’s general account asset-backed securities (ABS) portfolio includes home equity and credit card-backed ABS investments, among others. As of December 31, 2004, ABS investments totaled $4.06 billion (13%) of the carrying value of the Company’s general account fixed maturity securities available-for-sale.
The following table summarizes the distribution by investment type of the Company’s general account ABS portfolio as of December 31:
business covenants available in private fixed maturity security loan agreements and stronger prepayment protection. Although private placement fixed maturity securities are not registered with the Securities and Exchange Commission (SEC) and generally are less liquid than public fixed maturity securities, restrictive financial and business covenants included in private placement fixed maturity security loan agreements generally are designed to compensate for the impact of increased liquidity risk. A significant portion of the private placement fixed maturity securities that the Company holds are participations in issues that are also owned by other investors. In addition, some of these securities are rated by nationally recognized rating agencies, and substantially all have been assigned a rating designation by the NAIC, as shown in the prior table which summarizes the credit quality, as determined by NAIC Designation, of the Company’s general account fixed maturity securities portfolio as of December 31, 2004.
As of December 31, 2004, general account mortgage loans were $9.27 billion (21%) of the carrying value of consolidated general account invested assets. Substantially all of these loans were commercial mortgage loans. Commitments to fund mortgage loans of $266.7 million were outstanding as of December 31, 2004.
The table below summarizes the carrying values of mortgage loans by regional exposure and type of collateral as of December 31, 2004:
As of December 31, 2004, the Company’s largest exposure to any single borrowing group was $834.3 million (9%) of the Company’s general account mortgage loan portfolio.
As of December 31, 2004, 0.05% of the Company’s mortgage loans were classified as delinquent compared to none as of December 31, 2003. Foreclosed and restructured loans totaled 0.13% and 0.27%, respectively, of the Company’s mortgage loans as of December 31, 2004 compared to 0.13% and 0.11%, respectively, as of December 31, 2003.