Management’s narrative analysis of the results of operations of NLIC and subsidiaries for the three years ended December 31, 2002 follows. This narrative analysis should be read in conjunction with the Company’s consolidated financial statements and related notes included in the F pages of this report.
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 and federal income taxes.
See note 2 to the consolidated financial statements included in the F pages of this report for a discussion of the Company’s significant accounting policies, including recently issued accounting pronouncements. In addition, the following discussion of modified coinsurance arrangements relates to tentative guidance that could affect the Company’s accounting, if finalized. Although disclosure of the impact of proposed guidance issued by standard-setting bodies is not appropriate in the footnotes to financial statements issued in accordance with accounting principles generally accepted in the United States of America, it is included herein as this tentative guidance is related solely to the Company’s industry and could change the accounting for such arrangements in the future.
On February 3, 2003 the FASB’s Derivatives Implementation Group issued tentative guidance related to the bifurcation of an embedded derivative within a reinsurer’s receivable and ceding company’s payable arising from a modified coinsurance arrangement (DIG B36). Paragraph 12.a. of FASB Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133) indicates that an embedded derivative must be separated from the host contract if the economic characteristics and risks of the embedded derivative instrument are not clearly and closely related to the economic characteristics and risks of the host contract. DIG B36 indicates that bifurcation is necessary in a modified coinsurance arrangement because the yield on the receivable and payable is based on a specified proportion of the ceding company’s return on either its general account assets or a specified block of those assets, rather than the overall creditworthiness of the ceding company. Status of the guidance provided in DIG B36 related to modified coinsurance arrangements will remain tentative until it is formally cleared by the FASB and incorporated in an FASB staff implementation guide, which is contingent upon an amendment of SFAS 133 being issued. As such, the Company is still evaluating the impact that this guidance will have on its financial results. The total amount of reserves that the Company holds under modified coinsurance arrangements is $734.0 million.
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) of the consolidated financial statements included in the F pages of this report.
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.
The valuation allowance account for mortgage loans on real estate is maintained at a level believed adequate by the Company to absorb estimated credit losses. The Company’s periodic evaluation of the adequacy of the allowance for losses is based on past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of the underlying collateral, composition of the loan portfolio, current economic conditions and other relevant factors.
The decline in asset fees reflect decreases in total average separate account assets of $6.78 billion (11%) and $9.13 billion (13%) in 2002 and 2001, respectively. The decrease in average separate account values over the past two years was 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 program and certain life insurance products as well as invested assets not allocated to product segments, net of related investment expenses. Net investment income totaled $1.84 billion in 2002 compared to $1.72 billion and $1.65 billion in 2001 and 2000, respectively. These increases were primarily due to increased invested assets supporting growth in individual fixed annuity, medium-term notes and fixed life insurance policy reserves, partially offset by lower yields due to declining market interest rates. General account assets supporting insurance products are closely correlated to the underlying reserves on these products. General account reserves supporting these products grew by $6.46 billion and $3.03 billion in 2002 and 2001, respectively, and totaled $31.68 billion as of December 31, 2002. The growth in general account reserves reflects increased customer preference for fixed products in light of declining and volatile equity markets. In addition, the growth reflects the Company’s commitment to strengthen its distribution and service capabilities for fixed products. The changes in net investment income were also impacted by average yields on investments, which decreased by 81 basis points and 52 basis points in 2002 in 2001, respectively, as a result of lower market interest rates.
Realized gains and losses on investments not related to securitizations, hedging instruments and hedged items are not considered by the Company to be recurring components of earnings. The Company makes decisions concerning the sale of invested assets based on a variety of market, business, tax and other factors. In addition, charges related to other-than-temporary impairments of available-for-sale securities and other investments and valuation allowances on mortgage loans on real estate are included in this caption. Also included are changes in the fair value of derivatives qualifying as fair value hedges and the change in the fair value of the hedged items, the ineffective portion of cash flow hedges and changes in the fair value of free-standing derivatives, all of which are considered non-recurring components of earnings.
Interest credited to policyholder account values totaled $1.24 billion in both 2002 and 2001 and $1.18 billion in 2000 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 growth in interest credited over the past two years reflects the increase in policy reserves for these products, partially offset by lower crediting rates in response to lower market interest rates. Crediting rates in the Individual Annuity segment have declined in 2002 and new crediting rates for most products are at, or near, contractual minimums, while in 2001, crediting rates remained flat despite declining market interest rates, reflecting competitive market conditions.
Other benefits and claims include policyholder benefits in excess of policyholder account values for universal life and individual deferred annuities and net claims and provisions for future policy benefits for traditional life insurance products and immediate annuities. An increase in other benefits and claims in 2002 compared to a year ago reflects higher levels of GMDB claims from individual variable annuity products and additional life insurance benefits reflecting growth in life insurance in-force. The growth in 2001 reflects additional life insurance claims primarily as a result of growth in life insurance in-force.
Therefore, 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 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.
The Company analyzes operating performance using non-GAAP financial measures called pre-tax operating income and net operating income. The Company calculates pre-tax operating income by adjusting income from continuing operations before federal income taxes and cumulative effect of adoption of accounting principles to exclude net realized gains and losses on investments not related to securitizations, hedging instruments and hedged items. The Company calculates net operating income by adjusting net income to exclude net realized gains and losses on investments not related to securitizations, hedging instruments and hedged items, discontinued operations and cumulative effect of adoption of accounting principles, all net of tax. Pre-tax operating income, net operating income, or similar measures are commonly used in the insurance industry as measures of ongoing earnings performance.
Sales are stated net of internal replacements, which in the Company’s opinion provides a more meaningful disclosure of sales. In addition, sales exclude: funding agreements issued under the Company’s medium-term note program; large case bank-owned life insurance (BOLI); large case pension plan acquisitions; and deposits into Nationwide employee and agent benefit plans. Although these products contribute to asset and earnings growth, they do not produce steady production flow that lends itself to meaningful comparisons and are therefore excluded from sales.
The Company’s flagship products are marketed under The BEST of AMERICA® brand, and include individual variable and group annuities 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.
Sales through wirehouse and regional firms 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 in this channel in 2001 increased 65% over 2000, due primarily to higher sales following the launch of the Waddell & Reed Financial, Inc. relationship, which generated $1.04 billion of sales in 2001.
Sales through pension plan administrators dropped 26% and 8% in 2002 and 2001, respectively. As the Company’s Private Sector pension business model continues to evolve, direct production through this channel is not expected to grow, as more new business opportunities are being created in conjunction or partnership with the independent broker/dealers, wirehouse and regional firms and financial institutions relationships.
Pre-tax operating loss totaled $122.8 million in 2002 compared to earnings of $231.4 million in 2001, which were down 18% from 2000. The loss in 2002 was primarily due to the acceleration of DAC amortization recorded in third quarter 2002, which totaled $328.3 million, as described in Part II, Item 7 - Management’s Narrative Analysis of the Results of Operations-Benefits and Expenses. Excluding the accelerated DAC amortization, pre-tax operating income decreased 11% in 2002. In both years, the decline in equity markets pushed average separate account balances lower, thereby reducing policy charges and earnings. The decline in policy charges was partially offset by additional interest spread income generated by rapid growth in fixed annuities.
Interest spread income is net investment income less interest credited to policyholder account values. Interest spread income can vary depending on crediting rates offered by the Company, performance of the investment portfolio, including the rate of prepayments, changes in market interest rates, the competitive environment and other factors.
Interest spread on average general account values increased 6 basis points in 2002 compared a year ago. The improvement was due to the Company’s ability to lower renewal crediting rates more quickly than investment portfolio rates have declined as a result of lower market interest rates. However, a one-year enhanced crediting rate special offered in the fourth quarter of 2002 coupled with new crediting rates at or near contractual minimum rates and a jump in prepayments of higher yielding investments will put pressure on interest spread on average general account values in 2003. A combination of a competitive environment, a sharp decline in interest rates and a by-product of the Company’s investment strategy contributed to the reduction in interest spreads in 2001 compared to 2000. As a strategic move to maintain market share, the Company did not lower crediting rates in the third quarter of 2001 as quickly as earned rates declined. In addition, throughout 2001, the Company had a significant increase in cash flows in the general account due to strong fixed annuity sales. As a result, at certain times throughout the year, cash positions were greater than targeted as the Company acquired appropriate long-term investments, putting pressure on spreads, especially given a declining interest rate environment. Declining interest rates in 2002 and 2001 resulted in a significant increase in mortgage loan and bond prepayment income, which added 6 and 8 basis points to the 2002 and 2001 interest spread, respectively, compared to 4 basis points in 2000.
Other benefits increased in 2002 primarily due to higher levels of GMDB claims. GMDB exposure, as measured by the difference between the aggregate account value and death benefit due to the contract holder net of any reinsurance coverage, increased to $2.96 billion at the end of 2002 from $1.29 billion at the end of 2001. During 2002, the Company strengthened its reserve for GMDB claims by $10.5 million to meet the current estimate of future net GMDB claims in excess of fees. The Company’s reserve for GMDB claims was $13.7 million and $11.4 million as of December 31, 2002 and 2001, respectively.
Operating expenses were $183.9 million in 2002, an increase of 34% over 2001. The increase reflects growth in the number of contracts in-force, an increase in employee benefit costs and projects focused on improving producer and customer support.
Account values ended 2002 at $38.63 billion, down $3.15 billion from the end of 2001 of $41.78 billion, which was down $1.79 billion from the end of 2000. Net flows, which consists of deposits less withdrawals, of $1.98 billion and $3.09 billion in 2002 and 2001, respectively, were offset by market depreciation of variable annuities of $4.88 billion and $4.51 billion in 2002 and 2001, respectively. The decrease in net flows is attributable to the decline in sales combined with an increase in variable annuity surrenders due to continued losses in the equity markets. Individual annuity sales, which exclude internal replacements, during 2002 were $6.96 billion, down 5% from $7.33 billion a year ago. The decline in sales is driven by sustained weakness in the equity markets, which had a negative impact on variable annuity demand. Variable annuity sales were $4.30 billion in 2002, down 19% compared to 2001. Sales of variable annuities were down 19% in 2001 compared to 2000. According to the Variable Annuity Research & Data Service (VARDS), the Company was ranked 8th in total variable annuity sales in 2002. Partially offsetting a decline in variable annuity sales was the strong appeal of fixed products to consumers, as fixed annuities sales reached a record $2.66 billion in 2002, a 33% increase from the $2.00 billion reported in 2001. Fixed annuity sales were up 202% in 2001 from 2000. The decline in the equity markets has fueled interest in fixed annuity sales across the industry. In addition, the Company has expanded the number of banks that sell the Company’s fixed products.
The decrease in return on average allocated capital in 2002 is a result of lower earnings on individual variable annuities, primarily due to the accelerated DAC amortization charge resulting from depressed equity markets. Excluding the $328.3 million of accelerated DAC amortization, return on average allocated capital in 2002 was 10.2%. The lower returns in 2002 and 2001 were driven by lower earnings from variable annuities due to the depressed equity markets and additional allocated capital to support growth in fixed annuities during 2002 and 2001.
Excluding the $328.3 million of accelerated DAC amortization in 2002, pre-tax operating income to average account values was 51 basis points. The lower returns in 2002 and 2001 were driven by lower earnings from variable annuities and lower interest spreads on average general account values in 2001. Also contributing to this decline was the Company’s inability to reduce its operating expenses as quickly as and in proportion to the decrease in policy charges due to declining equity markets.
Account values ended 2002 at $30.14 billion, down $3.68 billion from $33.82 billion at the end of 2001, which were down 8% compared to $36.92 billion at the end of 2000. The decreases reflect market depreciation due to depressed equity markets. Net flows, which consist of deposits less withdrawals, were $(118.1) million in 2002, compared to $473.1 million and $738.9 million in 2001 and 2000, respectively. Private Sector sales have decreased by 15% in 2002, as an increasing percentage of pension sales are sold as trust products offered by an affiliate, Nationwide Trust Company, FSB. Private Sector sales were down 21% in 2001 reflecting lower sales due to decreases in the average takeover case size reflecting the depressed equity markets and an 11% decline in the number of new plans sold in light of the economic slow down. Sales in the Public Sector declined from a year ago reflecting the impact of case terminations in 2001 and 2002 on recurring deposits. In addition, an increasing number of new plan sales are administration-only products offered by Nationwide Retirement Solutions, an affiliate of the Company, rather than annuities offered by the Company. Sales of Public Sector pension plans in 2001 decreased 29% compared to 2000 reflecting the impact of earlier case terminations.
Pre-tax operating income to average account balances of 0.64% in 2002 increased compared to 0.61% in 2001 and 0.57% in 2000, and reflects the growth in the medium-term note program.
The Life Insurance segment consists of investment life products, including individual variable life and COLI products, traditional life insurance products and universal life insurance. Life insurance products provide a death benefit and generally also allow the customer to build cash value on a tax-advantaged basis.
Life Insurance segment earnings in 2002 decreased 10% to $171.5 million from $189.7 million a year ago, while earnings in 2000 were $161.1 million. Earnings in 2002 include $6.8 million of expense from the acceleration of DAC amortization, as described in Item 7 - Management’s Narrative Analysis of the Results of Operations - Benefits and Expenses. Excluding the acceleration of DAC amortization, operating earnings decreased $11.4 million or 6% compared to 2001. In 2002, an increase in policy charges from a growing block of insurance in-force was offset by an increase in operating expenses and lower earnings from the Company’s COLI business as a result of a slowdown in the COLI and deferred compensation markets due to the economic downturn, depressed equity markets and proposed legislation which would adversely impact the tax advantages of COLI. In 2001 the increase in Life Insurance segment earnings was attributable to revenue growth generated from new sales and high persistency of both individual and corporate investment life insurance products.
Net investment income increased in both 2002 and 2001 reflecting growth in general account corporate-owned life insurance in-force.
Policy benefits increased 6% to $458.2 million in 2002 following an 11% increase in 2001. The growth in 2002 reflects the growth in insurance in-force and higher mortality experience. In 2001, favorable mortality experience allowed the Company to renegotiate and lower certain reinsurance premiums.
Amortization of DAC increased $7.9 million in 2002 following a $16.1 million increase in 2001. The increase in 2002 reflects $6.8 million of accelerated DAC amortization and the increase in 2001 reflects the growth in investment life insurance earnings.
Operating expenses were $148.4 million in 2002, up 11% from 2001, due to growth in insurance in-force and higher employee benefit costs. Operating expenses for 2001 were $133.7 million, a 2% decrease from 2000. Operating expenses for 2002 and 2001 also reflect the operational efficiencies and scale advantage being developed in the investment life operation. Technology and process improvement investments intended to streamline and improve the underwriting and policy-issue process made in 2000 are helping to develop these efficiencies.
Total life insurance sales in 2002 of $1.42 billion were down 8% from sales of $1.54 billion in 2001, 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. 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 would 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 $1.54 billion in 2001 were essentially flat compared to $1.53 billion in 2000. 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 2001 were down given the depressed economic conditions where corporations are not forming new executive benefit plans and existing plans are being funded at lower levels.
The Corporate segment consists of net investment income not allocated to the three product segments, interest expense on debt and unallocated expenses.
NLIC has issued group annuity and life insurance contracts and performs administrative services for various employee benefit plans sponsored by NMIC or its affiliates. Total account values of these contracts were $4.50 billion and $4.68 billion as of December 31, 2002 and 2001, respectively. Total revenues from these contracts were $143.3 million, $150.7 million and $156.8 million for the years ended December 31, 2002, 2001 and 2000, respectively, and include policy charges, net investment income from investments backing the contracts and administrative fees. Total interest credited to the account balances were $114.8 million, $122.5 million and $135.8 million for the years ended December 31, 2002, 2001 and 2000, respectively. The terms of these contracts are consistent in all material respects with what the Company offers to unaffiliated parties who are similarly situated.
Through September 30, 2002, the Company filed a consolidated federal income tax return with NMIC, as discussed in more detail in note 2(i) to the Company’s consolidated financial statements included in the F pages of this report, and beginning October 1, 2002, will file a consolidated federal income tax return with NLAIC. Total payments to (from) NMIC were $71.0 million, $(45.4) million and $74.6 million for the years ended December 31, 2002, 2001 and 2000, respectively.
The Company has a reinsurance agreement with NMIC whereby all of the Company’s accident and health business not ceded to unaffiliated reinsurers is ceded to NMIC on a modified coinsurance basis. Either party may terminate the agreement on January 1 of any year with prior notice. Under a modified coinsurance agreement, the ceding company retains invested assets and investment earnings are paid to the reinsurer. Under the terms of the Company’s agreements, the investment risk associated with changes in interest rates is borne by the reinsurer. The Company retains risk of asset default, although a fee is paid to the Company for the retention of such risk. The ceding of risk does not discharge the original insurer from its primary obligation to the policyholder. The Company believes that the terms of the modified coinsurance agreements are consistent in all material respects with what the Company could have obtained with unaffiliated parties. Revenues ceded to NMIC for the years ended December 31, 2002, 2001 and 2000 were $325.0 million, $200.7 million and $170.1 million, respectively, while benefits, claims and expenses ceded were $328.4 million, $210.1 million and $171.0 million, respectively.
Under a marketing agreement with NMIC, NLIC makes payments to cover a portion of the agent marketing allowance that is paid to Nationwide agents. These costs cover product development and promotion, sales literature, rent and similar items. Payments under this agreement totaled $24.9 million, $26.4 million and $31.4 million for the years ended December 31, 2002, 2001 and 2000, respectively.
The Company leases office space from NMIC and certain of its subsidiaries. For the years ended December 31, 2002, 2001 and 2000, the Company made lease payments to NMIC and its subsidiaries of $20.2 million, $18.7 million and $14.1 million, respectively.
The Company and various affiliates entered into agreements with Nationwide Cash Management Company (NCMC), an affiliate, under which NCMC acts as a common agent in handling the purchase and sale of short-term securities for the respective accounts of the participants. Amounts on deposit with NCMC were $87.0 million and $54.8 million as of December 31, 2002 and 2001, respectively, and are included in short-term investments on the accompanying consolidated balance sheets. For the years ending December 31, 2002, 2001 and 2000 the Company paid NCMC fees and expenses totaling $0.3 million, $0.4 million and $0.3 million, respectively.
Certain annuity products are sold through affiliated companies, which are also subsidiaries of NFS. Total commissions and fees paid to these affiliates for the three years ended December 31, 2002 were $50.3 million, $52.9 million and $65.0 million, respectively.
The maximum amount of undiscounted future payments that the Company could be required to pay the investors under the terms of the guarantees is $368.7 million. The Company does not anticipate making any payments related to the guarantees.
The consolidated financial statements of Nationwide Life Insurance Company and Subsidiaries are indexed in Part IV, Item 15 - Exhibits, Financial Statement Schedules, and Reports on Form 8-K, and included in the F pages to this report.