Management’s discussion and analysis of financial condition and results of operations of NLIC and its subsidiaries for the three years ended December 31, 2003 follows. This discussion should be read in conjunction with the consolidated financial statements and related notes beginning on page of this report.
Management’s discussion and analysis 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 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) the potential impact on the Company’s reported consolidated net income that could result from the adoption of certain accounting standards issued by the Financial Accounting Standards Board (FASB) or other standard-setting bodies; (ii) tax law changes impacting the tax treatment of life insurance and investment products; (iii) repeal of the federal estate tax; (iv) 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; (v) adverse state and federal legislation and regulation, including limitations on premium levels, increases in minimum capital and reserves, and other financial viability requirements, restrictions on mutual fund distribution payment arrangements such as revenue sharing and 12b-1 payments and regulation changes resulting from industry practice investigations; (vi) failure to expand distribution channels in order to obtain new customers or failure to retain existing customers; (vii) inability to carry out marketing and sales plans, including, among others, development of new products and/or changes to certain existing products and acceptance of the new and/or revised products in the market; (viii) changes in interest rates and the stock markets causing a reduction of investment income and/or asset fees, an acceleration of the amortization of deferred policy acquisition costs (DAC), 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; (ix) general economic and business conditions which are less favorable than expected; (x) competitive, regulatory or tax changes that affect the cost of, or demand for the Company’s products; (xi) unanticipated changes in industry trends and ratings assigned by nationally recognized rating organizations; (xii) deviations from assumptions regarding future persistency, mortality, morbidity and interest rates used in calculating reserve amounts and in pricing the Company’s products; and (xiii) adverse litigation results or resolution of litigation and/or arbitration.
The most critical estimates include those used in determining DAC for investment products and universal life insurance products, impairment losses on investments, valuation allowances for mortgage loans on real estate, federal income taxes, pension and other postretirement employee benefits.
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 future 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 percent growth per year. If actual net separate account performance varies from the 8 percent 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 S&P 500 Index, the Company’s policy regarding the reversion to the mean process does not permit such returns to be below zero percent or in excess of 15 percent during the three-year reversion period.
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 federal income tax benefit, which has been reported in the following segments in the amounts indicated, net of tax: Individual Annuity-$213.4 million, Institutional Products-$7.8 million and Life Insurance-$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 guaranteed minimum death benefits (GMDB) on individual variable annuity contracts. These adjustments were primarily driven by the sustained downturn in the equity markets.
The 2003 pension expense for substantially all of the Company’s employees and certain agents totaled $13.2 million. This is an increase of $3.2 million over the 2002 pension expense of $10.0 million. This increase is primarily due to the impact of low interest rates and the decline in the equity market in 2002. For the Company’s primary pension plan, the discount rate used to value the cash flows was lowered to 6.00% for 2003 expenses from the discount rate of 6.50% for 2002 and the long-term expected return on plan assets assumption was lowered to 7.75% in 2003 from the assumption of 8.25% in 2002.
Total revenues, increased $99.2 million, or 3%, to $3.10 billion in 2003 compared to $3.00 billion in 2002. The growth in revenues in 2003 was primarily driven by an increase in net investment income as a result of continued growth in interest spread-based businesses, offset by lower policy charges due to depressed equity markets and an increase in net realized losses on investments, hedging instruments and hedged items of $16.4 million. In 2002, total revenues increased $13.6 million, or less than one percent. Growth in net investment income offset lower policy charges and an increase in net realized losses on investments, hedging instruments and hedged items of $66.1 million.
The $37.2 million decline in administrative fees in the year ended December 31, 2003 compared to 2002 is due to a decline in sales production in the Investment Life products which resulted in a decrease in sales loads collected, higher deferred revenue on premium and lower amortized revenue. In addition, there was a decrease in the number of individual annuity contracts that charge an annual administrative fee.
Interest credited to policyholder account values totaled $1.30 billion in 2003 and $1.24 billion in both 2002 and 2001 and principally relates to fixed annuities, both individual and institutional, funding agreements backing the Company’s medium-term note program and certain life insurance products. The increase in interest credited reflects an increase in account values for these products as a result of strong fixed annuity production and increased allocations of variable annuity funds to the guaranteed fixed option, partially offset by lower crediting rates in the Individual Annuity and Institutional Products segments, on products where crediting rates have not already reached guaranteed floors.
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 Annuity - $213.4 million, Institutional Products - $7.8 million and Life Insurance - $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 variable annuity contracts. These adjustments were primarily driven by the sustained downturn in the equity markets.
As a result of this transaction, the Company is no longer engaged in asset management operations and the underlying results of NSI have been reported as discontinued operations. Also, effective in second quarter 2002, the structured products transactions, previously reported in the Corporate segment, are reported in the Institutional Products segment. All periods presented have been revised to reflect these changes.
Income from discontinued operations, net of tax, for 2002 and 2001 was $0.7 million and $1.2 million, respectively.
As calculated and analyzed by the Company, statutory premiums and deposits on individual and group annuities and life insurance products calculated in accordance with accounting practices prescribed or permitted by regulatory authorities and deposits on administration-only group pension plans and the advisory services program are adjusted as described below to arrive at sales.
The Company’s flagship products are marketed under The BEST of AMERICA brand, and include individual variable and group annuities, group private sector pension plans and variable life insurance. The BEST of AMERICA products allow customers to choose from investment options managed by premier mutual fund managers. The Company has also developed private label variable and fixed annuity products in conjunction with other financial services providers that allow those providers to sell products to their own customer bases under their own brand name.
The 8% decrease in sales in the independent broker/dealer channel in 2003 reflects primarily lower demand for variable annuities and variable life insurance in light of depressed equity markets in early 2003. Total sales through this channel were down 16% in 2002, reflecting lower demand for variable annuities due to declining and volatile equity markets. Also contributing to the decline in 2002 were lower private sector group pension sales due to decreases in the average takeover case size reflecting the depressed equity markets and number of new plans sold in light of the economic slowdown.
Sales generated by wirehouse and regional firms decreased 18% in 2003 due to lower sales of individual annuity and private sector pension sales. Sales in this channel in 2002 decreased 12% in 2002 to $2.05 billion compared to $2.33 billion in 2001, primarily reflecting lower sales from the Waddell & Reed Financial, Inc. relationship, partially offset by growth from other firms
Sales generated by life insurance specialists declined 24% in 2003 compared to 2002 and were flat in 2002 compared to 2001 due to the current unfavorable environment for COLI and executive deferred compensation programs. The sluggish equity markets in 2002 and 2001, 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 generated by Nationwide Provident increased significantly in 2003. This increase is primarily due to the acquisition that NFS closed on October 1, 2002.
The following table summarizes pre-tax operating earnings (loss) for the Company’s business segments for each of the last three years.
Surrender fees decreased by $6.3 million to $54.1 million in 2003 compared to $60.4 million in 2002 and $55.7 million in 2001. The decrease in 2003 is due in part to positive equity market returns in the period, while the increase in 2002 was primarily due to the competitive market place and sustained downturn in the equity markets. Lower surrender fees in 2001 were the result of the successful implementation of customer retention programs in the individual variable annuity business during the year.
Premiums on immediate annuities increase by $20.3 million in 2003 over 2002, following an $8.5 million increase in 2002. The increase reflects increased sales efforts and growth in the number of firms and distributors selling income products.
Other benefits reflect increased GMDB and immediate annuity costs in 2003. GMDB exposure, as measured by the difference between the current contractual death benefit and account value, net of reinsurance, decreased to $0.98 billion at the end of 2003 from $2.96 billion at the end of 2002. As a result of first quarter 2003 increases in GMDB exposure and claims activity, the Company strengthened reserves by $11.9 million in first quarter 2003 to meet the current estimate of future net claims in excess of fees. During 2002, the Company strengthened its reserve for GMDB claims by $10.5 million to meet the then current estimate of future net GMDB claims in excess of fees. The Company’s reserve for GMDB claims was $21.8 million and $13.7 million as of December 31, 2003 and 2002, respectively. The growth in other benefits also reflects increased provision for future policy benefits for immediate annuities consistent with the growth in premium income.
The Company has taken actions to address the current low interest rate environment and the impact on interest spread margins. In 2003, the Company lowered commission rates for individual fixed annuities and the Company began invoking contractual provisions during second quarter 2003 that have limited the amount of variable annuity deposits allocated to the guaranteed fixed option. Furthermore, the Company introduced new products and has begun issuing contracts with lower floor guarantees.
Account values ended 2003 at $46.56 billion, up $7.92 billion from the end of 2002 of $38.63 billion, which was down $3.14 billion from the end of 2001. Net flows, which consists of deposits less withdrawals, of $1.62 billion and $1.98 billion in 2003 and 2002, respectively, were affected by market appreciation (depreciation) of variable annuities of $7.02 billion and $(4.48) billion in 2003 and 2002, respectively. The decrease in net flows is attributable to the decline in fixed annuity sales combined with an increase in variable annuity surrenders which we attribute primarily to continued losses in the equity markets.
In addition, a number of the Company’s competitors offer variable annuities with more robust living benefits (including income benefits and withdrawal benefits) than the Company offers. The Company has elected to offer more limited living benefit features that meet the Company’s risk/return profile. During 2003, the Company discontinued offering products with guaranteed minimum income benefits. Also in 2003, the Company began offering products with guaranteed minimum accumulation benefits. See note 5 to the consolidated financial statements included in the F pages of this report.
The decrease in pre-tax operating earnings to average account values, excluding the $328.3 million of accelerated DAC amortization in 2002, in 2003 compared to 2002 is primarily a result of lower interest spread margins and increased GMDB costs.
The following table provides selected information about the Company’s deferred individual fixed annuities as of December 31, 2003:
Institutional Products segment sales data presented on the following table do not include business generated through the Company’s medium-term note program, large case pension plan acquisitions and Nationwide employee and agent benefit plans, however the income statement data does reflect this business.
The following table summarizes selected financial data for the Company’s Institutional Products segment for the years indicated.
Excludes pre-tax operating earnings from structured products as there are no account values associated with structured products.
Pre-tax operating earnings totaled $209.0 million in 2003, up 3% compared to $203.4 million in 2002, which was down 4% from 2001. The increase in 2003 was the result of increased interest spread income driven primarily by prepayment income, and other income were partially offset by lower policy charges and higher operating expenses. Excluding the accelerated DAC amortization, pre-tax operating earnings increased 2% in 2002 compared to 2001. The increase is due to growth in interest spread income and other income, which more than offset lower policy charges as a result of depressed equity markets and a shift in product mix to non-annuity products.
Administrative fees declined by $6.3 million or 40% in 2003 compared to 2002, primarily due $3.6 million of fees related to a terminated case in the first quarter of 2002.
Other income increased 54% to $12.5 million in 2003 compared to $8.1 million in 2002. The increase was primarily due to an increase in fees from structured product transactions.
Interest spread income was $24.1 million higher in 2003 compared to 2002, which was $31.6 million higher than 2001 driven by higher prepayment income and higher average general account values. The increase in average general account values was led by the growth in the medium-term note program and an increase in participant allocations to the fixed option of the Company’s retirement plan offerings.
The following table depicts the interest spread on average general account values in the Institutional Products segment for the years ended December 31:
Account values ended 2003 at $33.52 billion, up $3.38 billion from $30.14 billion at the end of 2002, which were down $3.69 billion compared to $33.82 billion at the end of 2001. The 2003 increase is due in part to positive equity market returns in the period. In 2002, the impact of market depreciation resulting from depressed equity markets in both 2001 and 2002 was partially offset by the addition of the California Savings Plus Program in 2001 which added $4.77 billion in administration-only account values, and new issues of medium-term notes in both years. Net flows, which consists of deposits less withdrawals, were $935.0 million in 2003, compared to $1.06 billion and $1.95 billion in 2002 and 2001, respectively.
Public sector pension sales in 2003 totaled $1.44 billion, 5% higher compared to $1.38 billion in 2002, which was a decline of 10%, from the $1.52 billion reported in 2001. The increased sales reflect increased rollover activity from existing participants’ previous employer sponsored plans into existing accounts, as recent pension reform legislation implemented has expanded the portability of public plan assets and the addition of deposits into the newly acquired State of New York defined contribution plan.
Institutional Products segment deposits in 2003 of $4.54 billion offset by participant withdrawals and surrenders totaling $3.61 billion generated net flows from participant activity of $935.0 million, a 12% decrease over 2002, which reflected a 46% decrease from 2001 net flows. An increase in surrender activity, offset by deposits to Nationwide employee and agent benefit plans, deferrals into newly acquired plans, rollover activity into existing participant accounts drove the, 2003 decrease. The decline in 2002 was driven by an increase in withdrawals from public sector cases increased in early 2002, as participants took advantage of the new portability provisions and rolled over funds to other companies.
Policy charges decreased slightly to $346.2 million in 2003, following a 10% increase to $347.2 million in 2002. Cost of insurance charges, which are assessed on the amount of insurance in-force in excess of the related policyholder account value, increased 6% and 17% in 2003 and 2002, respectively, and reflect a growing block of investment life business, as insurance in-force increased 3% to $75.84 billion at 2003 compared to $73.78 billion at 2002. The growth in insurance in-force reflects both the impact of new sales as well as high persistency of in-force contracts. Administrative fees were $61.1 million or 24% lower in 2003 and 9% lower in 2002 compared to 2001. Growth in fees assessed on policies in-force offset lower fees assessed on premiums and deposits due to the decline in sale of investment life products.
Life benefits and policyholder dividends decreased slightly to $451.3 million in 2003 following a 6% increase in 2002. The growth in 2002 reflects the growth in insurance in-force and higher mortality experience.
Total Life Insurance segment sales in 2003 decreased 10% to $1.28 billion compared to $1.42 billion in 2002. Variable life sales in 2003 declined 16% as individual variable life production continues to be adversely impacted by consumer preference for fixed products. COLI sales in 2003 declined 17% from the prior year due to the current unfavorable environment for COLI and executive deferred compensation programs.
Strong fixed life growth was substantially offset as individual variable life sales continue to be adversely impacted by the sluggish equity markets, concern over the potential for adverse tax legislation and consumer preference for fixed products. According to the December 31, 2003 Tillinghast-Towers Perrin Value Variable Life Survey, the Company was ranked 4th in total variable life sales in 2003, compared to 3rd in 2002 and 6th in 2001. In 2002, our efforts to expand sales to new channels drove sales through the wirehouse and regional firms and financial institutions up 37% and 30%, respectively, from 2001. COLI sales were negatively impacted throughout 2002 by the sluggish economy, depressed equity markets, unfavorable press regarding COLI and executive deferred compensation plans and proposed legislation which could adversely impact the tax benefits of COLI. First year premiums for fixed life were up from a year ago due to increased universal life and term life sales. Total life insurance sales of $1.42 billion in 2002 declined 8% compared to 2001 sales of $1.54 billion. Individual variable universal life sales were adversely impacted by the phase out of the estate tax, uncertainty surrounding the taxation of split dollar plans and the volatile stock market. Sales of new COLI cases in 2002 were down given the depressed economic conditions where corporations were not forming new executive benefit plans and existing plans were being funded at lower levels.
The increase in operating revenues in 2003 reflects an increase in net investment income primarily attributable to income earned on the proceeds from the $200.0 million capital contribution from NFS in February 2003. The increase in revenues in 2002 reflects an increase in net investment income primarily attributable to income earned on the proceeds from the surplus note offerings completed in December 2001 and June 2002, less the impact of lower investment income as a result of dividends paid to NFS and lower yields. The 34% increase in interest expense in 2003 compared to 2002 is due to the surplus notes issued in 2002 and the increased utilization of commercial paper in 2003. The additional interest expense in 2002 reflects the surplus note offerings mentioned above, offset by lower utilization of commercial paper borrowings. The decline in revenues in 2001 reflects a decrease in net investment income on real estate investments, higher passive losses from affordable housing partnership investments, lower investment yields from declining interest rates and fewer investments retained in the Corporate segment as more capital and the related investment earnings were allocated to the product segments to support growth.
In addition to these operating revenues and expenses, the Company also reports net realized gains and losses on investments, hedging instruments and hedged items in the Corporate segment. Net realized losses on investments, hedging instruments and hedged items totaled $100.8 million in 2003, compared to net realized losses of $84.4 million in 2002 and $18.3 million in 2001, respectively, and included other-than-temporary impairments of $156.5 million, $120.3 million and $80.6 million in 2003, 2002 and 2001, respectively. Included in 2003 net realized losses are $13.0 million, net of tax of other than temporarily impairments related to Parmalat, leaving $5.0 million of gross exposure. Also, in third quarter 2003, the Company refined its mortgage loan valuation allowance process by incorporating more detailed information in the analysis. As a result, the valuations allowance was reduced by $12.1 million. The table below provides a detailed summary of the components of net realized gains and losses on investments, hedging instruments and hedged items.
An analysis of net realized (losses) gains on investments, hedging instruments and hedged items, by source and investment type follows:
The following table summarizes the Company’s contractual obligations and commitments as of December 31, 2003 due in each period presented.
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 any and/or all 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.
As of December 31, 2003, NLIC had received $976.6 million of cash collateral on securities lending and invested the proceeds in short-term investments, which are reflected on the balance sheet, and a corresponding liability is established to reflect the return of the collateral. Also, NLIC has received $544.5 million of cash for derivative collateral, which has been invested in short-term investments and a corresponding liability has been recorded in other liabilities. The Company also held $163.0 million and $25.9 million of securities as off-balance sheet collateral on derivative transactions as of December 31, 2003 and 2002, respectively.
The consolidated financial statements of Nationwide Life Insurance Company and Subsidiaries are indexed in Part IV, Item 5 - Exhibits, Financial Statement Schedule, and Reports on Form 8-K, and included in the F pages to this report.