Pursuant to an arrangement between NMIC and certain of its subsidiaries, during 2005 the Company leased on average approximately 903,000 square feet of office space in the three-building home office complex and in other offices in central Ohio. In addition, the Company leases approximately 120,000 square feet of office space in Berwyn, Pennsylvania (of which approximately 90,000 square feet are subleased) and owns approximately 160,000 square feet of office space in Newark, Delaware (of which approximately 14,000 square feet are subleased to an affiliate). Also, during 2005 NMIC announced plans to build and occupy a six-story, 130,000 square foot building in Columbus, Ohio. The Company expects to lease some of this space from NMIC. The Company believes that its present and planned facilities are adequate for the anticipated needs of the Company.
(i) change in Nationwide Corp.’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;
(iii) the potential impact on the Company’s reported net income and related disclosures that could result from the adoption of certain accounting and/or financial reporting standards issued by the FASB, the SEC or other standard-setting bodies;
(xiv) unanticipated changes in industry trends and ratings assigned by nationally recognized rating organizations;
(xv) settlement of tax liabilities for amounts that differ significantly from those recorded on the balance sheet;
(xvi) deviations from assumptions regarding future persistency, mortality, morbidity and interest rates used in calculating reserve amounts and in pricing the Company’s products; and
(xvii) adverse litigation results and/or resolution of litigation and/or arbitration or investigation results.
Management of the Company views its business primarily based on the underlying products, and this is the basis used for defining its reportable segments. The Company reports four segments: Individual Investments, Retirement Plans, Individual Protection, and Corporate and Other.
The primary segment profitability measure that management uses is pre-tax operating earnings, which is calculated by adjusting income from continuing operations before federal income taxes, discontinued operations and the cumulative effect of adoption of accounting principles to exclude: (1) net realized gains and losses on investments, hedging instruments and hedged items, except for operating items (periodic net coupon settlements on non-qualifying derivatives, trading portfolio realized gains and losses, and trading portfolio valuation changes); (2) net realized gains and losses related to securitizations; and (3) the adjustment to amortization of DAC related to net realized gains and losses.
In addition, life insurance profits are significantly impacted by mortality, morbidity and persistency experience.
The Company adopted Statement of Position (SOP) 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts (SOP 03-1),
The most critical estimates include those used to determine the following: the balance, recoverability and amortization of DAC for investment products and universal life insurance products; the balance and amortization of VOBA; impairment losses on investments; valuation allowances for mortgage loans on real estate; federal income tax provisions; goodwill impairment; the liability for future policy benefits; and pension and other postretirement employee benefits.
Changes in assumptions can have a significant impact on the amount of DAC reported for investment products and universal life insurance products and their related amortization patterns. In the event actual experience differs from assumptions or assumptions are revised, the Company is required to record an increase or decrease in DAC amortization expense (referred to as DAC unlocking), which could be significant. In general,
As a result of the acquisition of NFN in 2002 and the application of purchase accounting, the Company reports an intangible asset representing the estimated fair value of the business in force and the portion of the purchase price that was allocated to the value of the right to receive future cash flows from the life insurance and annuity contracts existing as of the closing date of the NFN acquisition. The value assigned to VOBA was supported by an independent valuation study commissioned by the Company and executed by a team of qualified valuation experts, including actuarial consultants. The expected future cash flows used in determining such value were based on actuarially determined projections by major lines of business of future policy and contract charges, premiums, mortality and morbidity, separate account performance, surrenders, changes in reserves, operating expenses, investment income and other factors. These projections considered all known or expected factors at the valuation date based on the judgment of management. The actual experience on purchased business, to some extent, has and may continue to vary from projections due to differences in renewal premiums, investment spreads, investment gains and losses, mortality and morbidity costs, or other factors.
For those products amortized in relation to estimated gross profits, the most significant assumptions 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%. 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. The assumed net separate account return assumptions used in the VOBA models are intended to reflect what is anticipated. However, based on historical returns of the S&P 500 Index, the Company’s reversion to the mean process generally limits returns to 0-15% during the three-year reversion period.
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
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 rates; expected levels of cash flows, revenues and earnings; and the selection of comparable companies used to develop market-based assumptions.
Management believes that all judgments and assumptions made in connection with goodwill impairment testing are reasonable based on the underlying facts and circumstances evaluated. However, variances in actual results from expectations or changes in expectations for future cash flows, revenues and/or earnings could result in significant future goodwill impairment charges. Strategic restructurings also could result in the write-off of goodwill.
The Company’s liability for funding agreements to an unrelated third party trust equals the balance that accrues to the benefit of the contractholder, including interest credited. The funding agreements constitute insurance obligations considered annuity contracts under Ohio insurance laws.
Pension and other postretirement employee benefits (OPEB) assumptions are revised at least annually in conjunction with preparation of the Company’s Annual Report on Form 10-K. The 2005 pension expense for substantially all of the Company’s employees and certain agents totaled $16.5 million, an increase of $2.2 million over 2004 pension expense of $14.3 million. Expenses increased at the plan level primarily due to decreasing interest rates, reflected in a lower discount rate. The discount rate used to value cash flows was lowered to 5.00% to determine 2005 pension expense from 5.50% for 2004, and the long-term expected rate of return on plan assets was lowered to 6.75% for 2005 from 7.25% for 2004.
The increase in other benefits and claims primarily was driven by an increase in immediate annuity business and growth in contracts containing guaranteed living benefits within the Individual Investments segment. Additionally, Individual Protection benefits and claims increased primarily as a result of increased insurance in force and a corresponding net amount at risk.
Also during the third quarter of 2005, the Company refined its separate account DRD estimation process. As a result, the Company identified and recorded additional federal income tax benefits and recoverables in the amount of $42.6 million related to all open tax years (2000 - 2005). In addition, the Company recorded $5.6 million of net benefit adjustments in the third quarter of 2005, primarily related to differences between the estimated tax liability and the amounts reported on the Company’s tax returns and revised estimates of permanent income tax deductions expected to be generated in 2005. During the fourth quarter of 2005, the Company revised the estimate for the separate account DRD and recorded an additional federal income tax benefit of $8.0 million based on additional information available at year end. Therefore, the full year 2005 effective tax rate of 17.5% was lower than the 2004 rate of 24.8% primarily due to the additional DRD recorded in 2005 compared to 2004.
Other income increased due to more private sector retirement plans being sold through NTC and increased activity related to securitizations and structured products.
Higher amortization of DAC primarily was attributable to the Individual Investments segment due to higher gross margins on the underlying business.
The effective tax rate for 2004 was 24.8% compared to 23.0% in 2003. The increase was due to permanent items that grew at a lower rate (8%) than pre-tax earnings (31%). The increase in the permanent tax deductions was due to the release of the Phase III tax liability driven by changes in the tax law enacted in 2004, partially offset by an increase in valuation allowance for a consolidated subsidiary, while the separate account DRD remained fairly constant.
Management believes that the presentation of sales as measured for management purposes enhances the understanding of the Company’s business and helps depict longer-term trends that may not be apparent in the results of operations due to differences between the timing of sales and revenue recognition.
See Part I, Item 1 - Business-Overview for a description of the Company’s sales distribution network.
The following table summarizes sales by product and segment for the years ended December 31:
The following table summarizes sales by distribution channel for the years ended December 31:
The slight increase in total sales primarily was driven by strong sales in the Retirement Plans segment, led by The 401(k) Company and NRS. These gains were almost entirely offset by lower sales in the Individual Investments segment, especially in fixed annuities.
Sales through the independent broker/dealer channel increased due to growth in group annuity and private sector retirement plan sales.
Sales generated by financial institutions declined primarily due to planned reductions in fixed annuity sales and the effects of changes made to the fixed option of variable annuity products.
Other operating expenses improved primarily due to lower sales incentives and reduced technology expenses.
The decrease in other benefits and claims primarily reflects lower GMDB costs in 2004. GMDB exposure declined from the average levels experienced in 2003. This exposure moderated due to the general upward trends of the equity markets in 2004 and resulted in reduced benefit payments and lower provisions for future benefits.
Sales declines primarily were attributable to lower sales of fixed annuities as described previously.
The following table summarizes selected information about the Company’s deferred individual fixed annuities, including the fixed option of variable annuities, as of December 31, 2004:
In recent years, an increasing amount of business has been sold through the Company’s trust products rather than group annuity contracts due to the Company’s significant investment in NTC to develop trust product capabilities not prevalent elsewhere in the market.
The increase in other income, which includes fees for administration-only cases and NTC business, was due to higher average variable assets, increased equity returns, NTC business growth, small case 401(k) asset growth and RIA revenue.
The decline in policy charges was driven by nearly all new contract sales coming from NTC non-annuity contracts, whose fees are recorded as other income versus policy charges, and continued surrenders of group annuity contracts.
Private sector sales increases continue to be driven by additional production through the independent broker/dealers and financial institutions channels and growth at The 401(k) Company primarily due to flows associated with the addition of four large plans during the fourth quarter of 2004.
The increase in public sector sales was due to growth in large cases, including the State of New York, the State of California, the State of Maryland, the State of Florida and the City of Phoenix plans. Growth in the State of New York plan occurred due to increased participation at the state level, along with increased adoption of the state’s plan by smaller entities, which added large numbers of eligible participants. The increased sales in the State of California and the City of Phoenix plans primarily were due to higher plan transfers. The majority of the increases related to the State of Maryland and the State of Florida plans were associated with the re-introduction of the state funded 401(a) plan.
The increase in pre-tax operating earnings primarily was due to growth in other income and policy charges, partially offset by higher other operating expenses.
The increase in other operating expenses 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, marketing and advertising expenses also contributed to the increase.
Interest spread declined to 198 basis points in 2004 compared to 208 basis points in 2003. 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. Excluding the effects of prepayment income, the decrease primarily was due to spread compression associated with prepayment activity and lower reinvestment rates on prepaying assets.
The increase in private sector retirement plan sales was due to an increased distribution force, the acquisition of larger than average cases in the small to mid-size market, and higher sales at The 401(k) Company, which focuses on the large plan market. The increase in public sector sales reflects the addition of deposits into the State of New York, the State of New Mexico, the City of Phoenix and the IAFF plans. In addition, recently implemented pension reform legislation expanded the portability of public plan assets, leading to increased rollover activity from existing participants’ previous employer-sponsored plans into existing accounts.
Lower other operating expenses primarily resulted from a decline in commissions due to a shift in mix to products with lower commission rates. Also contributing to the increase were higher capitalization of certain software charges related to a systems consolidation project with an increase in the amounts eligible to be capitalized and additional mutual fund expense reimbursements from increased separate account values.
The increase in cost of insurance charges reflects a growing block of investment and universal life business with increased insurance in force. The aging of the block generally tends to increase the cost of insurance charged.
The other benefits and claims increase was due to adverse mortality experience compared to 2004. In addition, benefit charges increased in the fixed and variable universal life and traditional life businesses due to increased insurance in force.
Pre-tax operating earnings increased primarily due to higher policy charges, lower other benefits and claims and decreased amortization of DAC, partially offset by lower life insurance premiums.
The increase in policy charges primarily was due to higher cost of insurance charges, reflecting a growing block of investment life business with increased insurance in force, along with higher asset fees and administrative fees due to increased average separate account balances.
Amortization of DAC decreased due to the implementation of investment life business DAC model enhancements, which provide a more refined calculation and more timely reflections of observed trends in the underlying assumptions. However, DAC amortization increased in the fixed life business, consistent with higher earnings.
Other income and other expenses declined due to a reclassification of activity related to variable interest entities (VIEs) between other expenses and other income. In addition, other income was impacted by a decrease in the number of structured products transactions as margins on these deals compressed.
Interest spread income rose due to increased invested asset levels a result of higher excess capital and surplus retained in this segment and improved earnings from common stock and real estate investments. Lower margins on the MTN program offset some of these improvements.
The following table summarizes net realized gains (losses) on investments, hedging instruments and hedged items from continuing operations by source for the periods indicated:
Pre-tax operating earnings increased slightly due to higher interest spread income, somewhat offset by higher other expenses.
The following table summarizes net realized losses on investments, hedging instruments and hedged items from continuing operations by source for the years ended December 31:
Liquidity and capital resources demonstrate the overall financial strength of the Company and its ability to generate cash flows from its operations and borrow funds at competitive rates to meet operating and growth needs.
For individual annuity products ($50.29 billion of reserves as of December 31, 2005), 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.
The Company has available as a source of funds a $1.00 billion revolving credit facility entered into by NFS, NLIC and NMIC with a group of national financial institutions. Previously, the facility consisted of a 364-day agreement and a five-year agreement. In May 2005, the 364-day agreement was terminated, and the five-year agreement was amended and restated for a new five-year term. The facility provides for several and not joint liability with respect to any amount drawn by any party. The facility provides covenants, including, but not limited to, requirements that the Company maintain consolidated tangible net worth, as defined, in excess of $2.60 billion and that NLIC maintain statutory surplus, as defined, in excess of $1.67 billion. As of December 31, 2005, the Company and NLIC were in compliance with all covenants. The Company had no amounts outstanding under this agreement as of December 31, 2005 and 2004. NLIC also has an $800.0 million commercial paper program and is required to maintain an available credit facility equal to 50% of any amounts outstanding under
the commercial paper program. Therefore, borrowing capacity under the aggregate $1.00 billion revolving credit facility is reduced by 50% of any amounts outstanding under the commercial paper program. NLIC had $134.7 million in commercial paper outstanding at December 31, 2005 and 2004 at a weighted average effective interest rate of 4.22% in 2005 and 2.14% in 2004.
NLIC 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. The maximum amount available under the agreement is $350.0 million. The borrowing rate on this program is equal to one-month U.S. London Interbank Offered Rate (LIBOR). NLIC had $75.0 million and $47.7 million outstanding under this agreement as of December 31, 2005 and 2004, respectively. As of December 31, 2005, the Company has not provided any guarantees on such borrowings, either directly or indirectly.
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. Because NLIC has a variable interest in the profits from the securitization of these loans and is the primary beneficiary of this arrangement, NLIC consolidates the assets and liabilities associated with these loans and the corresponding borrowings in accordance with current accounting guidance. 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, 2005 and 2004. As of December 31, 2005, the Company has not provided any guarantees on such borrowings, either directly or indirectly.
Long-term debt is comprised of the following: (1) three separate issuances of $300.0 million principal of senior notes and two separate issuances of $200.0 million principal of senior notes, none of which are subject to any sinking fund payments; (2) a single issuance of $100.0 million of junior subordinated debentures that are due March 1, 2037 and pay a distribution rate of 7.899%, issued to an unconsolidated subsidiary trust; and (3) other miscellaneous notes payable.
On September 26, 2005, NFS issued $200.0 million of 5.10% senior notes due October 1, 2015. These senior notes are redeemable, in whole or in part, at the option of NFS at any time or from time to time at a redemption price equal to the greater of: (1) 100% of the aggregate principal amount of the notes to be redeemed; or (2) the sum of the present value of the remaining scheduled payments of principal and interest on the notes, discounted to the redemption date on a semi-annual basis at a prevailing U.S. Treasury rate plus 15 basis points, together in each case with accrued interest payments to the redemption date.
2011 were issued in November 2001 and are not redeemable prior to their maturity date. The $300.0 million principal of 5.90% senior notes due July 1, 2012, issued in June 2002, and the $200.0 million principal of 5.625% senior notes due February 13, 2015, issued in February 2003, are redeemable, in whole or in part, at the option of NFS at any time or from time to time at a redemption price equal to the greater of: (1) 100% of the aggregate principal amount of the notes to be redeemed; or (2) the sum of the present value of the remaining scheduled payments of principal and interest on the notes, discounted to the redemption date on a semi-annual basis at a prevailing U.S. Treasury rate plus 20 basis points, together in each case with accrued interest payments to the redemption date.
The terms of each series of senior notes contain various restrictive business and financial covenants, including limitations on the disposition of subsidiaries. As of December 31, 2005 and 2004, the Company was in compliance with all such covenants.
On March 11, 1997, Nationwide Financial Services Capital Trust I (Trust I) sold, in a public offering, $100.0 million principal of 7.899% capital securities, representing preferred undivided beneficial interests in the assets of Trust I. This sale generated net proceeds of $98.3 million. Concurrent with the sale of the capital securities, NFS sold to Trust I $103.1 million principal of its 7.899% junior subordinated debentures due March 1, 2037. The junior subordinated debentures are the sole assets of Trust I and are redeemable by NFS in whole at any time or in part from time to time at par plus an applicable make-whole premium. The related capital securities will mature or be called simultaneously with the junior subordinated debentures and have a liquidation value of $1,000 per capital security. The capital securities are fully and unconditionally guaranteed by NFS, and there are no related sinking fund requirements. Distributions on the capital securities are cumulative and payable semi-annually in arrears.
To the extent there are cash deficits in any specific property owned by the Tax Credit Funds, property reserves, property operating guarantees and reserves held by the Tax Credit Funds are exhausted before the Company is required to perform under its guarantees. To the extent the Company is ever required to perform under its guarantees, it may recover any such funding out of the cash flow distributed from the sale of the underlying properties of the Tax Credit Funds. This cash flow distribution would be paid to the Company prior to any cash flow distributions to unrelated third party investors.
The following table summarizes the Company’s contractual obligations and commitments as of December 31, 2005 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.
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, 2005.
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 and withdrawal rates (including timing of death), exchanges to and from the fixed and separate accounts of the variable annuities, claims experience with respect to variable annuity guarantees, 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 audited 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.
Since the timing of the return of collateral is uncertain, these obligations have been reflected in payments due in less than one year. See Part II, Item 7 - MD&A-Off-Balance Sheet Transactions for a detailed discussion of the impact of collateral on the Company’s consolidated balance sheets.
Separate account assets consist primarily of deposits from the Company’s variable annuity and variable life insurance business. Most separate account assets are invested in various mutual funds. All of the investment performance in the Company’s separate account assets is passed through to the Company’s customers. See Note 7 to the audited consolidated financial statements included in the F pages of this report for further information regarding the Company’s investments.
The following table summarizes the amortized cost, gross unrealized gains and losses, and estimated fair values of securities available-for-sale as of the dates indicated:
The average duration and average maturity of the Company’s general account fixed maturity securities as of December 31, 2005 were approximately 4.5 years and 6.1 years, respectively, compared to 4.0 years and 5.3 years, respectively, at December 31, 2004. 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 following table summarizes the credit quality, as determined by NAIC Designation, of the Company’s general account fixed maturity securities portfolio as of December 31:
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, 2005, $2.43 billion (36%) of the carrying value of the general account MBS portfolio was invested in planned amortization class CMOs/REMICs (PACs) compared to $2.39 billion (43%) as of December 31, 2004. 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 contained only 4% of pure pass-throughs as of December 31, 2005 and 2004.
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, 2005, ABS investments totaled $3.64 billion (12%) of the carrying value of the Company’s general account fixed maturity securities available-for-sale compared to $4.06 billion (13%) as of December 31, 2004.
The Company believes that general account ABS investments add diversification, liquidity, credit quality and additional yield to its general account portfolio. Like the MBS portfolio, the Company’s objective for its ABS portfolio is to provide reasonable cash flow stability and increased yield. The Company’s general account ABS portfolio generally does not include interest-only securities, principal-only securities or other ABS investments which may exhibit extreme market volatility.
As of December 31, 2005, general account mortgage loans were $9.15 billion (21%) of the carrying value of consolidated general account invested assets compared to $9.27 billion (21%) as of December 31, 2004. Substantially all of these loans were commercial mortgage loans. Commitments to fund mortgage loans of $293.7 million were outstanding as of December 31, 2005 compared to $266.7 million as of December 31, 2004.
As of December 31, 2005, the Company’s largest exposure to any single borrowing group was $844.3 million (9%) of the Company’s general account mortgage loan portfolio compared to $834.3 million (9%) as of December 31, 2004.