(xv) adverse litigation results and/or resolution of litigation and/or arbitration or investigation results that could result in monetary damages or impact the manner in which the Company conducts its operations; and
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 to exclude: (1) net realized gains and losses on investments, hedging instruments and hedged items, except for periodic net coupon settlements on non-qualifying derivatives and net realized gains and losses related to securitizations; and (2) the adjustment to amortization of DAC related to net realized gains and losses.
The Company has deferred certain costs of acquiring investment 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 primarily consist of individual and group variable and fixed deferred annuities. Universal life insurance products include universal life insurance, variable universal life insurance, COLI and other interest-sensitive life insurance policies. DAC is subject to recoverability testing in the year of policy issuance and loss recognition testing at the end of each reporting period.
For investment 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 charges, administration fees, surrender charges, and net realized gains and losses 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 audited consolidated financial statements included in the F pages of this report.
Management evaluates the appropriateness of the individual variable annuity DAC balance within pre-set parameters. These parameters are designed to appropriately reflect the Company’s long-term expectations with respect to individual variable annuity contracts while also evaluating the potential impact of short-term experience on the Company’s recorded individual variable annuity DAC balance. If the recorded balance of individual variable annuity DAC falls outside of these parameters for a prescribed period of time, or if the recorded balance falls outside of these parameters and management determines it is not reasonably possible to get back within the parameters during this period of time, assumptions are required to be unlocked and DAC is recalculated using revised best estimate assumptions. If DAC assumptions were unlocked and revised, the Company would continue to use the reversion to the mean process.
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 management 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.
Higher policy charges were driven by increases in asset fees and administrative fees. Asset fees rose due to increases in both average separate account values and the average asset fee rate charged within the Individual Investments segment. The average variable asset fee rate increased as new business sold with living benefit riders and corresponding higher fee rates influenced the overall average rate. Administrative fees increased primarily in the Retirement Plans segment due to a policy adjustment related to the surrender of a group fixed annuity contract. See Part II - Item 7 - Management’s Narrative Analysis of the Results of Operations (MD&A) - Business Segments - Retirement Plans for additional information.
Interest spread income decreased primarily within the Individual Investments and Corporate and Other segments. The decline in Individual Investments was due to a decline in general account assets caused by fixed annuity net outflows and lower income from mortgage loan prepayment penalties and bond call premiums. Shrinking margins in the MTN program drove the decrease in the Corporate and Other segment.
The Company also markets group deferred compensation retirement plans to employees of state and local governments for use under IRC Section 457. The Company utilizes its endorsement by the National Association of Counties, The United States Conference of Mayors and The International Association of Firefighters when marketing IRC Section 457 products.
Higher sales in the NFN producers channel were driven by variable annuity and income products.
Lower sales through Mullin TBG reflected the addition of two large COLI cases in the prior year.
Other operating expenses increased primarily due to higher sales incentives and employee compensation and benefits.
Higher sales occurred in the variable annuity business driven by the recently introduced L.INC and CPPLI product riders and a more targeted sales process. Sales of products with the L.INC and CPPLI riders accounted for $886.3 million and $451.9 million, respectively, of the increase in sales compared to 2005.
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, 2006:
The slight increase in pre-tax operating earnings primarily was driven by higher asset fees, lower other operating expenses, additional interest spread income and increased premiums on income products, offset by increases in amortization of DAC and annuity benefits and claims.
Asset fees rose due to both higher average separate account values and a higher average asset fee rate charged, representing approximately $20 million and $8 million, respectively, of the overall increase. The increase in average separate account values primarily was due to the general upward trend in the equity and fixed income markets offset in part by withdrawals that exceeded new deposits. The average variable asset fee rate increased from 1.29% to 1.32% as new business sold with living benefit riders influenced the overall average rate.
The increase in annuity benefits and claims primarily was driven by increased premiums from immediate annuity products and growth in contracts containing guaranteed living benefits.
The increase in pre-tax operating earnings primarily was driven by higher administrative fees and lower amortization of DAC.
Higher administrative fees were attributable to the surrender of a group fixed annuity contract in the second quarter of 2006, which resulted in an $18.6 million policy adjustment.
Interest spread margins decreased to 182 basis points in 2006 compared to 188 basis points in 2005. Included in the current year were 9 basis points, or $9.9 million, of income from mortgage loan prepayment penalties and bond call premiums compared to 20 basis points, or $21.2 million, in 2005. For the full year 2007, the Company expects interest spread margins to remain relatively stable in this segment and projects full year spreads of 180 to 185 basis points, including a nominal level of prepayment activity.
Private sector sales decreased due to the declining issuance of group annuity contracts described earlier and the related decrease in recurring flows.
The decline in asset fees was driven by the shift in sales from group annuity to trust products and continued surrenders of existing group annuity contracts.
The increase in pre-tax operating earnings primarily was driven by decreased amortization of DAC, increased cost of insurance charges and lower policyholder dividends on participating policies, partially offset by higher life insurance benefits.
Amortization of DAC declined primarily due to unlocking related to mortality assumptions within the fixed life line of business resulting in $17.4 million of lower DAC amortization.
Higher cost of insurance charges were due to increased business in force combined with the aging of the individual life business block. The aging of a block generally increases cost of insurance charges.
The increase in sales primarily was attributable to significant COLI production during 2006.
Pre-tax operating earnings increased due to lower other operating expenses and higher cost of insurance charges, partially offset by lower life insurance premiums.
Life insurance premiums decreased due to lower fixed life sales and the impact of changes in reinsurance coverage from yearly renewable term to coinsurance in the traditional life portfolio.
Pre-tax operating earnings were virtually flat as lower other operating expenses were offset by lower interest spread income.
The Company recorded lower net realized gains on investments, hedging instruments and hedged items during 2006 compared to 2005 primarily due to an increase in gross losses on sales of fixed maturity securities, partially offset by lower current year impairments as 2005 included significant losses on airline industry holdings.
Pre-tax operating earnings increased due to higher interest spread income and lower other expenses, partially offset by a decline in other income.
Primarily related to investments in low-income-housing tax credit partnerships. Call dates for the obligations presented are either date or event specific. The date specific requirement mandates the Company fund a specified amount on a stated date provided there are no defaults under the agreement. The event specific requirement is such that the Company is obligated to fund a specified amount of its capital commitment when all of the properties in a fund become fully stabilized. The ultimate call date of these commitments may extend beyond one year but have been reflected in payments due in less than one year due to the call features. The Company’s capital typically is called within one to four years, depending on when the events contemplated in the documents transpire.
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 notes, 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 and S&P assign the same ratings to the notes and the insurance financial strength of the Company.