1 Based on net operating income and excluding accumulated other comprehensive income.
NFS is the holding company for Nationwide Life Insurance Company (NLIC) and other companies that comprise the domestic life insurance and retirement savings operations of Nationwide, including Nationwide Life Insurance Company of America (NLICA, or Nationwide Provident together with its subsidiaries), effective October 1, 2002. The Company is a leading provider of long-term savings and retirement products in the United States of America. The Company develops and sells a diverse range of products including individual annuities, private and public sector pension plans and other investment products sold to institutions, and life insurance. As a result of its initial public offering in March 1997 and subsequent stock related transactions since that date, including the issuance of 31.8 million shares in connection with the acquisition of Nationwide Provident, NFS is 37.0% publicly owned, with the remainder owned by Nationwide Corporation (Nationwide Corp.), which is a majority-owned subsidiary of Nationwide Mutual Insurance Company (NMIC).
morbidity and interest rates used in calculating reserve amounts and in pricing the Company’s products; (xv) failure to successfully integrate Nationwide Provident into NFS; and (xvi) adverse litigation results or resolution of litigation and/or arbitration.
As part of the Company’s disclosure procedures, the Company has incorporated a business outlook section as a part of its quarterly earnings release, conference call and MD&A. As such, the following statements, which were published on February 3, 2003 as part of the Company’s earnings release, are forward-looking, based on business conditions that existed as of December 31, 2002. Due to the inherent difficulty in forecasting changes in interest rates, short-term performance of the equity markets, as measured by the S&P 500 Index, and the related performance of the Company’s separate account assets, the information provided below incorporates a range of possible results that are intended to illustrate the sensitivity of the Company’s revenue and earnings to the ultimate performance of the equity markets. To the extent that actual interest rates and equity market performance varies from that assumed in the illustration below, actual results will vary accordingly.
Utilizing the same equity market assumptions noted above, revenue growth should be within a range of 18 to 20 percent and return on equity should be within a range of 10 to 11 percent for the full year 2003.
The most critical estimates include those used in determining DAC for investment products and universal life insurance products, the value of business acquired (VOBA), 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
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 may have on its financial results. The total amount of reserves that the Company holds under modified coinsurance arrangements is $739.7 million.
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 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 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.
Management regularly reviews its fixed maturity and equity securities portfolio to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. A number of criteria are considered during this process including, but not limited to, the current fair value as compared to amortized cost or cost, as appropriate, of the security, the length of time the security’s fair value has been below amortized cost/cost, and by how much, specific credit issues related to the issuer and current economic conditions. Also, the Company estimates the cash flows over the life of purchased beneficial interests in securitized financial assets. Based on current information and events, if the Company estimates that the fair value of its beneficial interests is not greater than or equal to its carrying value and if there has been a decrease in the estimated cash flows since the last revised estimate, considering both timing and amount, then an other-than-temporary impairment is recognized and the purchased beneficial interest is written down to fair value. Other-than-temporary impairment losses result in a permanent reduction of the cost basis of the underlying investment.
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 the Company determines that a loan is impaired, a provision for loss is established equal to the difference between the carrying value and the estimated value of the mortgage loan. Estimated value is based on 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. Loans in foreclosure and loans considered impaired are placed on non-accrual status.
Surrender fees increased in 2002 compared to a year ago primarily due to higher lapse activity in individual variable annuities and investment life insurance products as a result of the sustained decline in the equity markets and the competitive environment in the marketplace. Lower surrender charges in 2001 compared to 2000 were the result of the successful implementation of customer retention programs in the individual variable annuity business during the year.
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 $1.92 billion in 2002 compared to $1.74 billion and $1.66 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 $10.78 billion and $3.25 billion in 2002 and 2001, respectively, and totaled $36.27 billion as of December 31, 2002. The growth in general account reserves reflects the addition of Nationwide Provident and 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 and 2001, respectively, as a result of lower market interest rates.
Other income includes management fees, commissions and other income earned by subsidiaries of the Company that provide administration, marketing and distribution services. The increase in other income in 2002 reflects an increase in the number of Private Sector pension plans sold through Nationwide Trust Company, FSB and the acquisition of Nationwide Provident. In addition, 2002 results include the results of TBG Insurance Services Corporation, d/b/a TBG Financial (TBG Financial) beginning May 31, 2002 resulting from an increased ownership position by the Company.
Interest credited to policyholder account values totaled $1.28 billion in 2002 compared to $1.25 billion in 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.
Operating expenses were $670.1 million in 2002, a 27% increase from 2001 operating expenses of $529.0 million. Operating expenses were $558.4 million in 2000. The increase in 2002 reflects the inclusion of TBG Financial and Nationwide Provident beginning May 31, 2002 and October 1, 2002, respectively, a growing customer base, increased employee benefit costs, increased litigation costs on existing cases and increased spending on projects focused on improving producer and customer support. The 5% decrease in 2001 compared to 2000 reflects the Company’s commitment to aggressive expense management in response to declining revenues and lower sales as a result of declining and volatile equity markets and a slowing economy throughout the year.
Income from discontinued operations, net of tax, in 2002 was $3.4 million compared to losses of $4.4 million and $0.2 million in 2001 and 2000, respectively.
The excluded items are important in understanding the Company’s overall results of operations. Pre-tax operating income or net operating income should not be viewed as substitutes for income from continuing operations before federal income taxes and cumulative effect of adoption of accounting principles or net income determined in accordance with GAAP, and it should be noted that the Company’s definition of these non-GAAP financial measures may differ from that used by other companies. The Company believes that the presentation of these non-GAAP financial measures as they are measured for management purposes enhances the understanding of the Company’s results of operations by highlighting the results from ongoing operations, on a pre- and post-tax basis, and the underlying profitability factors of the Company’s business. The Company excludes net realized gains and losses on investments not related to securitizations, hedging instruments and hedged items, net of tax, from these non-GAAP financial measures because such items are often the result of a single non-recurring event which may or may not be at the Company’s discretion. Including the fluctuating effects of these transactions could distort trends in the underlying profitability of the Company’s business. The Company also excludes discontinued operations and the cumulative effect of adoption of accounting principles from net operating income, as such adjustments are not reflective of the ongoing operations of the Company’s business.
The following table reconciles the Company’s reported income from continuing operations before federal income taxes and cumulative effect of adoption of accounting principles to pre-tax operating income for each of the last three years.
The Company regularly monitors and reports a non-GAAP financial measure titled sales. Sales or similar measures are commonly used in the insurance industry as a measure of business generated in the period. The Company has not provided a reconciliation of sales to a comparative GAAP financial measure because it does not believe there is a similar GAAP financial measure as it relates to its industry, as described below.
The Company sells its products through a diverse distribution network. Unaffiliated entities that sell the Company’s products to their own customer base include independent broker/dealers, wirehouse and regional firms, financial institutions, pension plan administrators and life insurance specialists. Representatives of the Company who market products directly to a customer base include Nationwide Retirement Solutions, The 401(k) Company and Nationwide Provident agents. The Company also distributes products through the agency distribution force of its ultimate parent, NMIC.
The 5% decrease in sales in the independent broker/dealer channel in 2002 reflects primarily lower demand for variable annuities and variable life insurance in light of depressed equity markets, partially offset by growth in sales of Private Sector pension plans. Total sales through this channel were down 24% in 2001, reflecting lower demand for variable annuities due to declining and volatile equity markets. Also contributing to the decline in 2001 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 through wirehouse and regional firms decreased 10% in 2002 to $2.20 billion compared to $2.45 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 67% 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.
The following table summarizes pre-tax operating income (loss) for the Company’s business segments for each of the last three years.
The Individual Annuity segment consists of individual The BEST of AMERICA and private label deferred variable annuity products, deferred fixed annuity products and income products. Also included in this segment are Nationwide Provident’s individual annuity products, reflecting business in-force on the date of acquisition, October 1, 2002. New business sold by Nationwide Provident agents is in the form of the Company’s individual The BEST of AMERICA products. 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, 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 fixed annuity contracts generate a return for the customer at a specified interest rate fixed for prescribed periods.
Pre-tax operating loss totaled $118.9 million in 2002, compared to earnings of $227.2 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 Discussion and Analysis of Financial Condition and Results of Operations-Benefits and Expenses. Excluding the accelerated DAC amortization, pre-tax operating income decreased 8% in 2002. In both years, the decline in the 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 comprised of 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.
Other benefits increased 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 $3.03 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 totaled $13.7 million and $11.4 million as of December 31, 2002 and 2001, respectively.
Sales results 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.
Pre-tax operating income totaled $207.0 million in 2002, down 1% compared to 2001 pre-tax operating income of $209.4 million, which was down 7% from 2000. Results for 2002 include $12.0 million of accelerated DAC amortization, as described in Part II, Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations-Benefits and Expenses. Excluding the accelerated DAC amortization, pre-tax operating income increased 5% 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. Declining equity markets throughout the past two years has driven average separate account balances, policy charges and earnings lower. In addition, an intensively
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, performance of the investment portfolio, including the rate of prepayments, changes in market interest rates, the competitive environment and other factors. Interest spread income was $31.0 million higher in 2002 compared to 2001, which was $20.0 million higher than 2000. The increases were driven by both higher average general account values and improved interest spread. The increase in average general account values was led by growth in the medium-term note program, where the Company issued $1.18 billion and $1.48 billion of notes in 2002 and 2001, respectively. The acquisition of Nationwide Provident and an increase in participants allocating assets to the fixed option of the Company’s retirement plan offerings also drove the increase in general account values in 2002.
Interest spread improved 5 basis points in 2002 compared to 2001 as the Company was able to lower crediting rates more quickly than the decrease in investment portfolio rates, which decreased due to lower market interest rates. Mortgage loan and bond prepayment income added 9 basis points to the 2002 interest spread, compared to 13 basis points and 4 basis points in 2001 and 2000, respectively. The additional prepayment income in 2001 offset the impact on spreads of higher than anticipated cash balances at times throughout 2001 and yields declining on new investments more quickly than crediting rates could be adjusted.
Other revenues include revenues from the Company’s administration-only products, including Private Sector pension plans offered by Nationwide Trust Company, FSB, and structured products transactions. The growth in 2002 reflects a shift in product mix to more administration-only contracts, as well as $7.9 million in fees from structured products transactions compared to $3.5 million in 2001.
Other operating expenses in 2002 increased 9%, compared to a 3% decrease in 2001. The increase in 2002 reflects the growth in the number of cases being administered and an increase in employee benefit costs. The decrease in 2001 reflects the Company’s commitment to aggressively manage expenses in
response to declining revenues and lower sales as a result of declining and volatile equity markets and a slowing economy throughout the year.
Account values ended 2002 at $49.80 billion, down $618.9 million from $50.42 billion at the end of 2001, which were up 7% compared to $47.15 billion at the end of 2000. 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, the acquisition of Nationwide Provident in 2002 which added $1.53 billion in account values, and new issues of medium-term notes in both years. Net flows, which consists of deposits less withdrawals, were $1.43 billion in 2002, compared to $1.76 billion and $1.95 billion in 2001 and 2000, respectively. Private Sector sales were up 11% in 2002 with new relationships and the addition of Nationwide Provident contributing to the growth. Private Sector sales were down 9% in 2001, reflecting a decrease in average takeover case size due to the depressed equity markets and an 11% decline in the number of new plans sold in light of the economic slowdown. Sales of Public Sector pension plans were flat compared to prior years as case terminations have stabilized and recurring deposits from new cases is becoming a more meaningful contributor to sales. 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.
The decrease in return on average allocated capital in 2002 is primarily driven by lower earnings on variable annuities resulting from depressed equity markets and the accelerated DAC amortization. The decline in average allocated capital in 2001 compared to 2000 reflects lower earnings from variable annuities and additional allocated capital to support 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, universal life insurance and the results of TBG Financial, a leading COLI producer. Effective May 31, 2002, the Company increased its ownership in TBG Financial to 63%. The results of TBG Financial are included in the consolidated results of the Company from that date forward. Also included in this segment, beginning October 1, 2002, are Nationwide Provident life insurance products. 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 2% to $186.7 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 Part II, Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations-Benefits and Expenses. Excluding the acceleration of DAC amortization, operating earnings increased $3.8 million or 2% compared to 2001. In 2002, the addition of Nationwide Provident and an increase in policy charges from a growing block of insurance in-force was
Policy charges increased 24% to $391.0 million in 2002, following a 19% increase to $316.2 million in 2001. Cost of insurance charges, which are assessed on the amount of insurance in-force in excess of the related policyholder account value, increased 32% and 29% in 2002 and 2001, respectively, and reflect a growing block of investment life business, as insurance in-force increased 50% to $105.79 billion at 2002 compared to $70.45 billion at 2001. Nationwide Provident contributed 45% of the 2002 growth. Insurance in-force increased 9% in 2001 from $64.39 billion at the end of 2000. The growth in insurance in-force reflects both the impact of new sales as well as high persistency of in-force contracts. Administrative fees remained flat in 2002 and 2001 compared to the respective prior years as 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.
The Corporate segment consists of net investment income not allocated to the three product segments, unallocated expenses, interest expense on debt, revenues and expenses of the Company’s broker/dealer subsidiaries and, through 2001, goodwill amortization.
The increase in revenues in 2002 reflects an increase in net investment income primarily attributable to income earned on the proceeds from the $300.0 million senior note offerings completed in November 2001 and June 2002 and $7.6 million of revenue from Nationwide Provident’s broker-dealer, partially offset by lower yields on investments. 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 are allocated to the product segments to support growth.
The increase in other operating expenses in 2002 is primarily related to the inclusion of Nationwide Provident non-insurance subsidiaries beginning October 1, 2002, and increased litigation costs on existing cases. The decrease in other operating expenses in 2001 was primarily the result of expense management activities.
In addition, the Company realized an after tax loss of $4.8 million related to the adoption of SFAS 133 in first quarter 2001 and an after tax loss of $2.3 million related to the adoption of Emerging Issues Task Force Issue No. 99-20 in second quarter 2001.
Company recorded a realized gain of $23.2 million and related tax expense of $8.1 million. The sales prices for each transaction, which were paid in cash, represented the fair value of the portions of limited partnership interests that were sold and were based on valuations of the limited partnership and its underlying investments as of the effective dates of the transactions. The valuations were completed by qualified management of the limited partnership and utilized a combination of internal and independent valuations of the underlying investments of the limited partnership. Additionally, senior financial officers and the Boards of Directors of the Company and NMIC separately reviewed, through their respective Finance Committees, and approved the process and methodology of the valuations prior to the execution of these transactions. The Company no longer holds an economic or voting interest in the limited partnership.
On May 31, 2002, NFS purchased an additional interest in TBG Financial for $40.7 million from existing shareholders. The shareholders primarily consisted of management and employees of TBG Financial. This additional investment increased NFS’ ownership of TBG Financial to 63%. The results of TBG Financial are included in the consolidated financial statements of the Company beginning May 31, 2002. As a result of the increase in ownership and the consolidation of TBG Financial, the Company recorded an increase in goodwill in the Life Insurance segment totaling $62.6 million.
The Company 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 $4.73 billion and $4.72 billion as of December 31, 2002 and 2001, respectively. Total revenues from these contracts were $148.7 million, $154.0 million and $160.2 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 $115.7 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.
The 401(k) Companies, Inc., a wholly owned subsidiary, serves as the administrator of certain defined contribution plans sponsored by NMIC and its affiliates. Total revenues reported by The 401(k) Companies, Inc. related to these administration services totaled $2.9 million, $2.0 million and $2.4 million during 2002, 2001 and 2000, respectively, which are included in the total revenue amounts reported in the paragraph above.
NLIC has a reinsurance agreement with NMIC whereby all of NLIC’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 NLIC’s agreements, the investment risk associated with changes in interest rates is borne by the reinsurer. Risk of asset default is retained by NLIC, although a fee is paid to NLIC 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.
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 for the benefit of the Company were $236.1 million and $85.6 million as of December 31, 2002 and 2001, respectively, and are included in short-term investments on the accompanying consolidated balance sheets. For each of the years in the three-year period ending December 31, 2002, the Company paid NCMC fees and expenses totaling $0.4 million under this agreement.
Liquidity and capital resources demonstrate the overall financial strength of the Company and its ability to generate strong cash flows from its operations and borrow funds at competitive rates to meet operating and growth needs. The Company’s capital structure consists of long-term debt, capital and preferred securities of subsidiary trusts and equity, as of each December 31 is summarized in the following table.
Long-term debt is comprised of senior issues, none of which is subject to any sinking fund payments, and a variable rate note payable. The terms of the senior notes contain various restrictive covenants including limitations on the disposition of subsidiaries. As of December 31, 2002, the Company was in compliance with all such covenants. The $300.0 million principal of 8.00% senior notes, due March 1, 2027, are redeemable in whole or in part, at the option of NFS, at any time on or after March 1, 2007 at scheduled redemption premiums through March 1, 2016, and, thereafter, at 100% of the principal amount thereof plus, in each case, accrued and unpaid interest. The $300.0 million principal of 6.25% senior notes, due November 15, 2011, were issued in November 2001 and are not redeemable prior to their maturity
NFS is a holding company whose principal asset is the common stock of NLIC. The principal sources of funds for NFS to pay interest, dividends and operating expenses are existing cash and investments, and dividends from NLIC and other subsidiaries.
State insurance laws generally restrict the ability of insurance companies to pay cash dividends in excess of certain prescribed limitations without prior approval. The ability of NLIC to pay dividends is subject to restrictions set forth in the insurance laws and regulations of the State of Ohio, its domiciliary state. State of Ohio insurance laws require life insurance companies to seek prior regulatory approval to pay a dividend if the fair market value of the dividend, together with that of other dividends made within the preceding 12 months, exceeds the greater of (i) 10% of statutory-basis policyholders’ surplus as of the prior December 31 or (ii) the statutory-basis net income of the insurer for the prior year. NLIC’s statutory-basis policyholders’ surplus as of December 31, 2002 was $1.61 billion and statutory-basis net income for 2002 was $92.5 million. Dividends of $35.0 million and dividends in the form of return of capital of $475.0 million were paid in the preceding twelve months as of December 31, 2002.
The State of Ohio insurance laws also require insurers to seek prior regulatory approval for any dividend paid from other than earned surplus. NLIC sought and obtained prior regulatory approval from the Ohio Department of Insurance to return this $475.0 million of capital to NFS during 2002. The payment of dividends by NLIC may also be subject to restrictions set forth in the insurance laws of the State of New York that limit the amount of statutory profits on NLIC’s participating policies (measured before dividends to policyholders) that can inure to the benefit of NFS and its stockholders.
NFS currently does not expect such regulatory requirements to impair its ability to pay interest, dividends, operating expenses and principal in the future.
Also available as a source of funds to the Company is a $1 billion revolving credit facility entered into by NFS, NLIC and NMIC with a group of national financial institutions. The facility provides for several and not joint liability with respect to any amount drawn by any party. The facility provides covenants, including, but not limited to, requirements that the Company maintain consolidated tangible net worth, as defined, in excess of $1.69 billion and NLIC maintain statutory surplus in excess of $935 million. The Company had no amounts outstanding under this agreement as of December 31, 2002. NLIC also has a $500 million commercial paper program and is required to maintain an available credit facility equal to 50% of any amounts outstanding under the commercial paper program. Therefore borrowing capacity under the $1 billion revolving credit facility is reduced by 50% of any amounts outstanding under the commercial paper program. There was no commercial paper outstanding as of December 31, 2002.
For individual annuity products ($39.22 billion of reserves as of December 31, 2002) the surrender charge is generally calculated as a percentage of the deposits made and is assessed at declining rates during the first seven years after a deposit is made.
For group annuity products ($23.40 billion of reserves as of December 31, 2002), the surrender charge amounts and periods can vary significantly, depending on the terms of each contract and the compensation structure for the producer. Generally, surrender charge percentages for group products are less than individual products because the Company incurs lower expenses at contract origination for group products. In addition, over ninety percent of the general account group annuity reserves are subject to a market value adjustment at withdrawal.
Life insurance policies, while subject to withdrawal, are less susceptible to withdrawal than annuity products because policyholders generally must undergo a new underwriting process and may incur a surrender fee in order to obtain a new insurance policy.
The short-term and long-term liquidity requirements of the Company are monitored regularly to match cash inflows with cash requirements. The Company periodically reviews its short-term and long-term projected sources and uses of funds and the asset/liability, investment and cash flow assumptions underlying these projections. Adjustments are made periodically with respect to the Company’s investment policies to reflect changes in the Company’s short-term and long-term cash needs and changing business and economic conditions.
Given the Company’s historic cash flow and current financial results, management of the Company believes that the cash flow from the operating activities of the Company over the next year will provide sufficient liquidity for the operations of the Company, as well as provide sufficient funds to enable the Company to make dividend and interest payments.
As described in note 3 to the consolidated financial statements included in the F pages of this report, the Company acquired Nationwide Provident effective October 1, 2002. The aggregate purchase price was $1.12 billion, which was funded through a combination of the issuance of 31.8 million shares of NFS Class A common stock valued at $841.7 million, the payment of $223.0 million in cash and the issuance of $48.0 million of policy credits. Of the total consideration, $62.3 million was funded by Provident and the remainder was funded with existing resources, including funds raised by the Company in the form of senior debt issued in June 2002. The shares of the Class A common stock issued in this transaction were valued using an average stock price covering the period extending two days before and after the date the consideration elections were closed.
At the time of the sales, $4.9 million of net sale proceeds were set aside as reserves for certain properties owned by the Tax Credit Funds that had not met all of the criteria necessary to generate tax credits. Such criteria include completion of construction and the leasing of each unit to a qualified tenant among other criteria. Properties meeting the necessary criteria are considered to have “stabilized.” The properties are evaluated regularly and upon stabilizing, the reserve is released. During 2002, $0.5 million of stabilization reserves were released into income.
Separate account assets consist primarily of deposits from the Company’s variable annuity and variable life insurance business. Most separate account assets are invested in various mutual funds. All of the investment risk in the Company’s separate account assets is borne by the Company’s customers, with the exception of $1.78 billion of policy reserves as of December 31, 2002 ($1.39 billion as of December 31, 2001) for which the Company bears the investment risk. In addition to the information presented herein, see note 4 to the consolidated financial statements included in the F pages of this report for further information regarding the Company’s investments.
The average duration and average maturity of the Company’s general account fixed maturity securities as of December 31, 2002 were approximately 3.72 and 5.69 years, respectively, compared to 4.31 years and 5.15 years, respectively, at December 31, 2001. The market value of the Company’s general account investments may fluctuate significantly in response to changes in interest rates. In addition, the Company may also be likely to experience realized investment losses to the extent its liquidity needs require the disposition of general account fixed maturity securities in unfavorable interest rate environments.
As of December 31, 2002, the Company had unrealized losses on fixed maturity securities available-for-sale of $311.8 million, including $7.3 million related to securities that had a fair value that was less than 80% of amortized cost as of December 31, 2002 and 2001. As part of the Company’s normal assessment of other-than-temporary impairments of investments, as described in -Impairment losses on Investments in this section, each of these securities were evaluated and no further impairments were deemed necessary as of December 31, 2002.
The National Association of Insurance Commissioners (NAIC) assigns securities quality ratings and uniform valuations called “NAIC Designations” which are used by insurers when preparing their annual statements. The NAIC assigns designations to publicly traded as well as privately placed securities. The designations assigned by the NAIC range from class 1 to class 6, with a designation in class 1 being of the highest quality. Of the Company’s general account fixed maturity securities, 93% were in the highest two NAIC Designations as of December 31, 2002.
Comparison’s between NAIC and Moody’s designations are published by the NAIC. In the event no Moody’s rating is available, the Company has assigned internal ratings corresponding to the public rating.
As of December 31, 2002 the fair value of the Company’s general account mortgage-backed security (MBS) investments totaled $4.82 billion (17%) of the carrying value of the general account fixed maturity securities available-for-sale. During 2002 the Company has increased its allocation of new investment purchases to MBS investments as the supply of commercial mortgage loans has decreased and to diversify away from the credit risk of corporate fixed income securities.
Prepayment/extension risk is an inherent risk of holding MBSs. However, the degree of prepayment/extension risk is particular to the type of MBS held. The Company limits its exposure to prepayments/ extension by purchasing less volatile types of MBSs. As of December 31, 2002, $2.55 billion (53%) of the carrying value of the general account MBS portfolio was invested in planned amortization class CMOs/REMICs (PACs). PACs are securities whose cash flows are designed to remain constant over a variety of mortgage prepayment environments. The majority of the Company’s non-PAC mortgage-securities posses varying degrees of cash flow structure. Only 3% of the MBS portfolio consists of pure pass-throughs.
The Company invests in private fixed maturity securities because of the generally higher nominal yield available compared to comparably rated public fixed maturity securities, more restrictive financial and business covenants available in private fixed maturity security loan agreements and stronger prepayment protection. Although private fixed maturity securities are not registered with the Securities and Exchange Commission and generally are less liquid than public fixed maturity securities, restrictive financial and business covenants included in private fixed maturity security loan agreements generally are designed to compensate for the impact of increased liquidity risk. A significant majority of the private fixed maturity securities that the Company holds are participations in issues that are also owned by other investors. In addition, some of the private fixed maturity securities are rated by nationally recognized rating agencies and substantially all have been assigned a rating designation by the NAIC.
As of December 31, 2002, general account mortgage loans were $8.49 billion (22%) of the carrying value of consolidated general account invested assets. As of such date, commercial mortgage loans constituted substantially all of total general account mortgage loans. Commitments to fund mortgage loans of $266.1 million extending into 2003 were outstanding as of December 31, 2002.
The summary below depicts loans by carrying value as of December 31, 2002:
As of December 31, 2002, the Company’s largest exposure to any single borrowing group was $112.2 million, or 1.32% of the Company’s general account mortgage loan portfolio.
As of December 31, 2002, 0.11% of the Company’s mortgage loans were classified as delinquent, including loans in foreclosure, compared to 0.42% a year ago. Foreclosed and restructured loans totaled only 0.63% and 0.36% of the Company’s mortgage loans for the years ended December 31, 2002 and 2001, respectively.