(i) 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 Financial Accounting Standards Board (FASB), Public Company Accounting Oversight Board or other standard-setting bodies;
(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;
(viii) 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); 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;
(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
Following is management’s narrative analysis of the results of operations of Nationwide Life Insurance Company 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.
The Company is a leading provider of long-term savings and retirement products in the United States of America and is a wholly-owned subsidiary of Nationwide Financial Services, Inc. (NFS). 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.
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, and pension and other postretirement employee benefits.
The Company 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 the Company determines it is not reasonably possible to get back within this period of time, assumptions are required to be unlocked and DAC is recalculated using revised best estimate assumptions. Otherwise, DAC is not unlocked to reflect updated assumptions. If DAC assumptions were unlocked and revised, the Company would continue to use the reversion to the mean process.
Under the Company’s accounting policy for equity securities and debt securities that can be contractually prepaid or otherwise settled in a way that may limit the Company’s ability to fully recover cost, an impairment is deemed to be other-than-temporary unless the Company has both the ability and intent to hold the investment for a reasonable period until the security’s forecasted recovery and evidence exists indicating that recovery will occur in a reasonable period of time. Also, for such debt securities the Company estimates cash flows over the life of purchased beneficial interests in securitized financial assets. If the Company estimates that the fair value of its beneficial interests is not greater than or equal to its carrying value based on current information and events, and if there has been an adverse change in estimated cash flows since the last revised estimate, considering both timing and amount, then the Company recognizes an other-than-temporary impairment and writes down the purchased beneficial interest to fair value.
Impairment losses are recorded on investments in long-lived assets used in operations when indicators of impairment are present and the undiscounted cash flows estimated to be generated by those assets are less than the assets’ carrying amounts.
Total revenues for 2004 increased to $3.27 million compared to $3.10 billion in 2003 and $3.00 million in 2002, respectively. The growth in 2004 primarily was driven by higher policy charges and net investment income, partially offset by a decline in life insurance premiums. Asset-based policy charges increased due to improved equity market returns and net investment income increased due to additional prepayment income on mortgage loans and bond call premiums. 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.
Policy charges include asset fees, which are earned primarily from separate account values generated from the sale of individual and group variable annuities and investment life insurance products; cost of insurance charges earned on universal life insurance products; administration fees, which include fees charged per contract on a variety of the Company’s products and premium loads on universal life insurance products; and surrender fees, which are charged as a percentage of premiums withdrawn during a specified period for annuity and certain life insurance contracts.
Asset fees totaled $588.4 million in 2004 compared to $516.8 million and $538.8 million in 2003 and 2002, respectively. The increase in 2004 was due to changes in the market value of the investment options underlying the account values, which have followed the general upward trends of the equity markets. The decline in asset fees in 2003 reflect decreases in total average separate account values fueled by market depreciation on investment options underlying variable annuity and investment life insurance products as a result of the sharp declines in the equity markets.
Net investment income includes the investment income earned on investments supporting fixed annuities, the medium-term note (MTN) program, certain life insurance products and invested assets not allocated to product segments, net of related investment expenses. Net investment income totaled $2.00 billion in 2004 compared to $1.97 billion and $1.83 billion in 2003 and 2002, respectively. The increase in 2004 primarily was due to higher prepayment income on mortgage loans and higher bond call premium income. The increase in 2003 was primarily due to increased invested assets supporting growth in individual fixed annuity, allocations to the fixed option of variable annuities, MTNs and fixed life insurance policy reserves, partially offset by lower yields due to declining market interest rates.
Interest credited to policyholder account values totaled $1.28 billion in 2004 compared to $1.31 billion and $1.24 billion in 2003 and 2002, respectively, 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 decrease in interest credited in 2004 reflects lower crediting rates in the Individual Investments segment and the private sector segment 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 for 2004 were 3.93%, compared to 4.36% in 2003 and 4.98% in 2002. Average crediting rates for the Retirement Plans segment for 2004 were 4.46%, compared to 4.75% in 2003 and 4.95% in 2002. The increase in market interest rates in 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.
Amortization of DAC increased by $34.2 million to $410.1 million in 2004 compared to $375.9 million and $670.1 million in 2003 and 2002, respectively. The increase in DAC amortization expense primarily was attributable to the Individual Investments segment due to higher estimated gross profits on the underlying business. Amortization of DAC decreased by $294.2 million in 2003 from $670.1 million in 2002. The substantial decrease in DAC amortization in 2003 reflects an acceleration of DAC amortization recorded in the third quarter of 2002. As part of the regular quarterly analysis of DAC, at the end of the third quarter of 2002, the Company determined that using actual experience to date and assumptions consistent with those used in the second quarter of 2002, its individual variable annuity DAC balance would be outside a pre-set parameter of acceptable results. The Company also determined that it was not reasonably possible that the DAC would return to an amount within the acceptable parameter within a prescribed period of time. Accordingly, the Company unlocked its DAC assumptions for individual variable annuities and reduced the DAC asset to the amount calculated using the revised assumptions. Because the Company unlocked the net separate account growth rate assumption for individual variable annuities for the three-year reversion period, the Company unlocked that assumption for all investment products and variable universal life insurance products to be consistent across product lines.
Excluding the accelerated DAC amortization in 2002, amortization of DAC increased 16% in 2003 compared to 2002. The increase in DAC amortization expense, excluding the accelerated DAC amortization, was attributable to the Individual Investments and Individual Protection segments as a result of a growing book of business and the surrender of a large COLI contract in second quarter 2003.
In July 2003, the American Institute of Certified Public Accountants issued Statement of Position 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts (SOP 03-1). SOP 03-1 addresses many topics. The most significant topic affecting the Company was the accounting for contracts with GMDB. SOP 03-1 requires companies to evaluate the significance of a GMDB to determine whether a contract should be accounted for as an investment or insurance contract. For contracts determined to be insurance contracts, companies are required to establish a reserve to recognize a portion of the assessment (revenue) that compensates the insurance company for benefits to be provided in future periods. SOP 03-1 also provides guidance on separate account presentation, interest in separate accounts, gains and losses on the transfer of assets from the general account to a separate account, liability valuation, return based on a contractually referenced pool of assets or index, annuitization options, and sales inducements to contract holders. The Company adopted SOP 03-1 effective January 1, 2004, which resulted in a $3.3 million charge, net of tax, as the cumulative effect of adoption of this accounting principle. Also, see Note 3 to the consolidated financials statements included in the F pages of this report.
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 when marketing IRC Section 457 products.
Sales through the independent broker/dealer channel in the year ended December 31, 2004 declined 8% compared to 2003 reflecting continued lower demand for variable annuities and an intentional reduction in fixed annuity production. The 8% decrease in sales in the independent broker/dealer channel in 2003 compared to 2002 reflects primarily lower demand for variable annuities and variable life insurance in light of depressed equity markets in early 2003.
Sales generated by wirehouse and regional firms declined 13% in 2004 to $1.46 billion compared to $1.67 billion in 2003, due to lower sales of individual fixed and variable annuities and private sector retirement plans. Sales generated by wirehouse and regional firms decreased 18% in 2003 due to lower sales of individual annuity and private sector retirement plans.
Sales through NRS increased in both 2004 and 2003 by 5% and 3%, respectively. Increased 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.
The Individual Investments segment consists of individual The BEST of AMERICA and private label deferred variable 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.
Premiums on immediate annuities decreased by 2% to $87.6 million in 2004, compared to $89.7 million in 2003 and $69.8 million in 2002. Despite a generally more competitive sales environment, an increase in interest rates in late second and early third quarter 2004 helped immediate annuity sales. The increase in 2003 reflects increased sales efforts and growth in the number of firms and distributors selling income products.
Other operating expenses were $231.9 million in 2004, an increase of 21% compared to 2003. The increase was driven by two primary factors. First, asset-based trail compensation increased due to growth in account values. Asset-based trail commissions increased by $16.3 million to $64.9 million in 2004 compared to $48.6 million in 2003. Trail commissions are paid to the Company’s producing firms and are based on the level of assets under management rather than on the new deposits made in that time period. Instead of paying a one-time amount at the point of sale, a smaller payment is made each year the business remains in force. In some cases, a combination of both types of compensation is paid. The second factor was increased expenses primarily related to advertising and promotion and employee compensation and benefits. Other operating expenses were $191.0 million in 2003, a slight increase over 2002. The increase reflects growth in the number of contracts in force, an increase in employee benefit, pension and insurance costs, partially offset by expense management efforts in response to the challenging equity markets and interest rate environments.
Sales totaled $4.95 billion during 2004, down 22% from $6.32 billion in 2003 and $6.96 billion in 2002. Variable annuity production declined by 14% to $3.84 billion in 2004 compared to 2003, with 22% of new domestic sales allocated to the guaranteed fixed options. Sales of variable annuities were $4.46 billion in 2003, up 4% compared to $4.30 billion in 2002. The sustained weakness in the equity markets in 2002 reduced demand for variable products and drove consumer interest in fixed products. Fixed annuity sales totaled $780.2 million in 2004, a 54% decrease from levels reported in 2003 and a 69% decrease form levels reported in 2002. Fixed annuity sales were $1.69 billion in 2003, down 33% compared to $2.52 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 $5.06 billion offset by withdrawals and surrenders totaling $5.44 billion generated net outflows of $386.9 million compared to net inflows of $1.64 billion achieved in 2003 and 1.98 billion in 2002.
The increase in the ratio of pre-tax operating earnings to average account values in 2004 compared to 2003 was primarily due to higher policy charges and interest spreads on average general account values and decreased variable annuity guaranteed benefit costs. The decrease in pre-tax operating earnings to average account values (excluding the accelerated DAC amortization) in 2003 compared to 2002 primarily was due to lower interest spread margins and increased GMDB costs.
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:
Surrender charges increased significantly to $11.1 million in 2004 from $5.6 million in 2003 primarily due to a 4% 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 trust contracts 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 income is comprised of net investment income less interest credited to policyholder account values. Interest spreads vary depending on crediting rates offered by the Company, the performance of the investment portfolio, including the rate of prepayments, changes in market interest rates, the competitive environment and other factors.
Interest spread margins declined to 196 basis points in 2004 compared to 211 basis points in 2003 and 202 basis points in 2002. Included in 2004 were 18 basis points, or $17.7 million, of prepayment income on mortgage loans and bond call premiums compared to 22 basis points, or $20.1 million in 2003 and 11 basis points, or $10.2 million in 2002.
Private sector retirement plan sales decreased 17% to $1.71 billion in 2004 from $2.07 billion in 2003 and $2.66 billion in 2002. The decline in 2004 compared to 2003 and 2002 was due to the declining issuance of group annuity products in the private sector retirement plans business in favor of products on the Nationwide Trust Company, FSB (NTC) platform. The increased sales in 2003 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.
Deposits in 2004 of $3.56 billion offset by participant withdrawals and surrenders of $3.76 billion generated net outflows from participant activity of $197.0 million, down from $210.0 million of inflows in 2003 and down from $118.1 million of outflows in 2002. The decreases reflect the lower issuance of group annuity products in favor of products on the NTC platform as well as the affects of the conversion activity from insurance contacts to non-insurance contracts in NTC.
The Individual Protection segment consists of investment life insurance products, including individual variable, COLI and BOLI products, traditional life insurance products and universal life insurance. 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.
Sales in 2004 increased 5% to $1.35 billion compared to $1.28 billion in 2003. Continued strength in sales of traditional/universal life insurance and COLI products drove the improvement. Traditional/universal life sales of $342.2 million increased 14% from 2003, driven by a re-tooled universal life insurance product portfolio and expanding distribution relationships in the non-affiliated distribution channels. COLI sales of $564.5 million increased 4% compared to a year ago. This increase was driven by higher renewal premium from the funding of existing COLI cases due to continued improvement in the equity market environment and increased participant deferrals in existing executive deferred compensation plans. Slow growth in new COLI sales, due to the unfavorable environment for COLI and executive deferred compensation programs affecting the creation of new plans and sales, partially offset the overall increase. Sales in 2003 declined 10% from $1.42 billion in 2002. Variable life sales declined 16% from 2002 as individual variable life production was negatively impacted by sluggish equity markets, concern over the potential for adverse tax legislation and consumer preference for fixed products. COLI sales in 2003 declined 17% from the prior year due to the unfavorable environment for COLI and executive deferred compensation programs.
In the normal course of business, the Company has entered into a number of related party transactions. Descriptions of these transactions are provided in Note 16 to the consolidated financial statements included in the F pages of this report and are incorporated herein by reference.
See the “Off-Balance Sheet Transactions” section of MD&A for a detailed discussion of the Company’s MTN program. The amounts presented include contractual principal and interest based on rates in effect at December 31, 2004.
Since the timing of the return of collateral is uncertain, these obligations have been reflected in payments due in less than one year. See the “Off-Balance Sheet Transactions” section of MD&A for a detailed discussion of the impact of collateral on the Company’s balance sheets.
Estimated future cash flows related to an immaterial amount of group accident and health insurance reserves have not been reflected in the table above due to significant uncertainty about the amount and timing of such cash flows.
In addition, the Company makes discretionary pension plan and other postretirement benefit plan contributions. See Note 15 to the consolidated financial statements included in the F pages of this report for a detailed discussion of plan contributions.
The consolidated financial statements of Nationwide Life Insurance Company and subsidiaries are indexed in Part IV, Item 15 - Exhibits, Financial Statement Schedules and included in the F pages of this report.