Pursuant to an arrangement between NMIC and certain of its subsidiaries, during 2008 the Company leased on average approximately 890,000 square feet of office space in the three building home office complex and in other offices in central Ohio. The Company believes that its present and planned facilities are adequate for the anticipated needs of the Company.
(xii) unanticipated changes in industry trends and ratings assigned by nationally recognized rating organizations;
The primary segment profitability measure that management uses is pre-tax operating (loss) earnings, which is calculated by adjusting (loss) income from continuing operations before federal income tax (benefit) expense to exclude: (1) net realized investment gains and losses, except for periodic net amounts paid or received on interest rate swaps that do not qualify for hedge accounting treatment and net realized gains and losses related to GMDB contracts and securitizations; and (2) the adjustment to amortization of DAC related to net realized investment gains and losses.
The Company’s profitability largely depends on its ability to effectively price and manage risk on its various products, administer customer funds and control operating expenses. Lapse rates on existing contracts also impact profitability. The lapse rate and distribution of lapses affect surrender charges and impact DAC amortization assumptions when lapse experience changes significantly.
In addition, life insurance profits are significantly impacted by mortality, morbidity and persistency experience. Asset impairments and the tax position of the Company also impact profitability.
The Company periodically evaluates the risks within the derivative portfolios due to credit exposure. When evaluating this risk, the Company considers several factors which include, but are not limited to, the counterparty risk associated with derivative receivables, the Company’s own credit as it relates to derivative payables, the collateral thresholds associated with each counterparty, and changes in relevant market data in order to gain insight into the probability of default by the counterparty. In addition, the effect that the Company’s exposure to credit risk could have on the effectiveness of our hedging relationships is considered. As of December 31, 2008, the impact of the exposure to credit risk on both the fair value measurement of derivative assets and liabilities and the effectiveness of our hedging relationships was immaterial.
As of December 31, 2008, the Company had investments in markets that it considered inactive with an amortized cost of $4.42 billion and an estimated fair value of $3.20 billion, which represents 17% of the estimated fair value of all fixed maturity securities available-for-sale. Of these amounts, 93% were valued with the assistance of independent pricing services.
The fair value measurements for future policy benefits and claims relate to embedded derivatives associated with contracts with living benefit riders (guaranteed minimum accumulation benefits, guaranteed minimum withdrawal benefits and equity-indexed annuities). Related derivatives are internally valued. The valuation of guaranteed minimum benefit embedded derivatives is based on capital market and actuarial risk assumptions, including risk margin considerations reflecting policyholder behavior. The Company uses observable inputs, such as published swap rates, in its capital market assumptions. Actuarial assumptions, including lapse behavior and mortality rates, are based on actual experience.
During the second quarter of 2007, the Company added a new feature to its existing guaranteed minimum withdrawal benefit rider, Lifetime Income (L.inc). This new feature results in a substantial change in the existing contracts and, therefore, an extinguishment of the DAC associated with those contracts pursuant to the American Institute of Certified Public Accountants’ Statement of Position 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts. As a result, the Company eliminated existing DAC and other related balances resulting in a $135.0 million pre-tax charge.
Generally, DAC related to traditional life insurance products is amortized with interest over the premium-paying period of the related policies in proportion to the ratio of actual annual premium revenue to the anticipated total premium revenue. Such anticipated premium revenue is estimated using the same assumptions as those used for computing liabilities for future policy benefits at issuance. Under existing accounting guidance, the concept of DAC unlocking does not apply to traditional life insurance products, although evaluations of DAC for recoverability at the time of policy issuance and loss recognition testing at each reporting period are required.
For debt securities not subject to EITF 99-20, an other-than-temporary impairment charge is taken when the Company does not have the ability and intent to hold the security until the forecasted recovery or if it is no longer probable that the Company will recover all contractual amounts when due. Furthermore, equity securities may experience other-than-temporary impairments based on prospects of recovery in a reasonable period of time. Many criteria are considered during this process including, but not limited to, specific credit issues and financial prospects related to the issuer, the quality of the underlying collateral, management’s intent and ability to hold the security until recovery, current economic conditions that could affect the creditworthiness of the issuer in the future, the current fair value as compared to the amortized cost of the security, the extent and duration of the unrealized loss, and the rating of the affected security. Other-than-temporary impairment losses result in a reduction to the cost basis of the underlying investment.
A significant change in impairment losses reported in the consolidated financial statements may result if one of the factors that management considers when evaluating investments for impairment changes significantly, such as the deterioration in the credit worthiness of individual issuers, market liquidity or performance of underlying collateral.
The Company recorded a net loss during 2008 compared to net income in the prior year primarily due to lower income from continuing operations before federal income tax expense. The major drivers were increases in net realized investment losses and amortization of DAC. In addition, higher benefits and claims, lower interest spread income partially and lower asset fees contributed to the overall decrease. Lastly, the Company recorded a federal income tax benefit for the current year compared to federal income tax expense in 2007 primarily due to the aforementioned declines in net income.
Net realized investment losses increased primarily due to a $935.0 million increase in impairment charges due to challenging conditions in the credit markets. In addition, the Company recorded a $474.0 million increase in losses on living benefit embedded derivatives, net of economic hedging activity. Finally, the Company recorded $49.6 million in losses in its structured products business related to impairments on mortgages and mortgage loan commitments. The overall decline was offset by higher realized gains of $215.8 million on derivatives associated with the Company’s economic hedging program related to contracts with death benefit guarantees.
Higher amortization of DAC was due to several factors. First, the aforementioned DAC unlocking in 2007 lowered amortization of DAC by $235.8 million in the prior year. Next, the previously discussed DAC unlockings in 2008 increased amortization of DAC by $426.7 million in the current year. However, the Company modified the features of its L.inc product within the Individual Investments segment during 2007. This modification required the Company to extinguish existing DAC and other balances related to L.inc, resulting in a $124.0 million increase in amortization of DAC and increased annuity benefits of $11.0 million in the prior year. In addition, net realized losses on embedded derivatives in annuity products offering living benefits decreased amortization of DAC by $93.1 million in 2008. Finally, lower gross profits in the current year and a lower rate of DAC amortization due to the impact of 2007 unlocking further offset the increases described above by approximately $141.8 million.