The Company is a leading provider of long-term savings and retirement products in the U.S. The Company develops and sells a diverse range of products including individual annuities, private and public sector pension plans, other investment products sold to institutions, life insurance and an advisory services program. The Company markets its products through a diverse distribution network, including independent broker/dealers, wirehouse and regional firms, financial institutions, pension plan administrators, life insurance specialists, certified public accounting firms and the following affiliated producers; NRS, TBG Financial, Nationwide Provident agents and Nationwide agents.
Changes in assumptions can have a significant impact on the amount of DAC reported for investment products and universal life insurance products and their related amortization patterns. In the event actual experience differs from assumptions or assumptions are revised, the Company is required to record an increase or decrease in DAC amortization expense (DAC unlocking), which could be significant. In general, increases in the estimated general and separate account returns result in increased expected future profitability and may lower the rate of DAC amortization, while increases in lapse/surrender and mortality assumptions reduce the expected future profitability of the underlying business and may increase the rate of DAC amortization.
Due to the magnitude of DAC balance related to the individual variable annuity business, the sensitivity of the calculation to minor changes in the underlying assumptions and the related volatility that could result in the reported DAC balance without meaningful improvement in its reasonableness, the Company evaluates the appropriateness of the individual variable annuity DAC balance within pre-set parameters. Should the recorded balance of individual variable annuity DAC fall outside of these parameters for a prescribed period of time, or should the recorded balance fall 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 the DAC is recalculated using revised best estimate assumptions. Otherwise, DAC is not unlocked to reflect updated assumptions. In the event DAC assumptions are unlocked and revised, the Company will continue to use the reversion to the mean process.
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 an adverse change 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.
Significant changes in the factors the Company considers in determining the valuation allowance on mortgage loans on real estate could result in a significant change in the provision for valuation allowance reported in the consolidated financial statements. During the third quarter of 2003, the Company refined its mortgage loan valuation allowance process by incorporating more detailed information in the analysis. This refined estimation process included an analysis by property type of the current composition of the portfolio, historical losses, current market cycles and trends and expected losses incurred at the balance sheet date, but not yet identified by specific loan. As a result, the valuation allowance was reduced by $12.1 million.
The 2003 postretirement benefit expense for substantially all of the Company’s employees, and in 2003, certain agents totaled $1.1 million, a decrease of $2.4 million from the 2002 postretirement benefit expense of $3.5 million. This decrease is primarily due to reductions in benefits provided by the plan. The discount rate used to value the cash flows was lowered to 6.60% for 2003 expenses from 7.25% in 2002 and the long-term expected return on plan assets assumption was lowered to 7.50% from the 2002 assumption of 7.75%.
To illustrate the impact of these assumptions on net periodic pension expense in 2003 and going forward, a 50 basis point increase in the pension plan discount rate (without changing any other assumption) would decrease annual expenses by approximately 10% and a 50 basis point increase in the pension plan long-term expected rate of return (without changing any other assumption) would decrease plan expenses by approximately 12%. For the retiree medical and death benefit plan, a 50 basis point increase in the discount rate would have decreased 2003 expense by approximately 14%, while a 50 basis point increase in the long-term expected rate of return would have decreased 2003 expense by approximately 3%.
Policy charges include asset fees, which are primarily earned from separate account values generated from sales of individual and group variable annuities and investment life insurance products; cost of insurance charges earned on universal life insurance products; administrative 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 of annuity and certain life insurance contracts.
The decline in asset fees reflect decreases in total average separate account assets of $2.71 billion or 5% and $6.78 billion or 11% in 2003 and 2002, 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.
Cost of insurance charges are assessed on the net amount at risk on universal life insurance policies. The net amount at risk is equal to a policy’s death benefit minus the related policyholder account value. The amount charged is based on the insured’s age and other underwriting factors. The increase in cost of insurance charges is due primarily to growth in the net amount at risk related to corporate and individual investment life insurance reflecting new sales, favorable persistency on policies sold in prior periods and equity market declines which lowered policyholder account values. The net amount at risk related to corporate and individual investment life insurance grew to $37.23 billion at the end of 2003 compared to $36.15 billion and $32.93 billion at the end of 2002 and 2001, respectively.
Surrender fees decreased by 6%, or $5.0 million, to $75.3 million in 2003 compared to 2002. The decrease is primarily due to improving equity markets in 2003. 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 downturn in the equity markets and the competitive environment in the marketplace.
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 2003 compared to a year ago reflects additional life insurance benefits reflecting growth in life insurance in-force, an increase in GMDB costs due to a higher level of claims and an increase in the provision for future policy benefits for immediate annuities due to growth in new premium in 2003 compared to 2002. An increase in other benefits and claims in 2002 compared to 2001 reflects higher levels of GMDB claims from individual variable annuity products and additional life insurance benefits reflecting growth in life insurance in-force.
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 Annuity and Life Insurance segments as a result of a growing book of business and the surrender of a large corporate-owned life insurance (COLI) contract in second quarter 2003.
Operating expenses were $533.7 million in 2003, a 5% increase from 2002 operating expenses of $508.6 million. Operating expenses were $439.3 million in 2001. The increase in 2003 reflects higher employee benefits, pension and insurance costs, partially offset by management’s efforts to manage expenses in response to the challenging market conditions. The increase in 2002 reflects a growing customer base, higher employee benefits, pension and insurance costs and increased spending on projects focused on improving producer and customer support.
Federal income tax expense from continuing operations was $96.2 million, representing an effective tax rate of 22.1% for 2003. Federal income tax expense in 2002 and 2001 was $8.7 million and $161.2 million, respectively, representing effective rates of 5.1% and 25.6%. The tax benefit of $121.5 million associated with the $347.1 million of accelerated DAC amortization in third quarter 2002 was calculated at the U.S. federal corporate income tax rate of 35%, which substantially impacts in what would normally be expected to be reported as an effective tax rate. The effective tax rate for 2002 was 25.2%, excluding the accelerated DAC amortization and related tax benefit. The decrease in effective rates in 2003, using this basis, is due to an increase in tax-exempt income and credits from affordable housing partnership investments. Using this same basis, the effective rate for 2002 was lower than 2001 due to an increase in tax credits from affordable housing partnership investments and the elimination of non-deductible goodwill amortization expense in 2002, partially offset by lower tax-exempt income.
The Company regularly monitors and reports a production volume metric titled sales. Sales or similar measures are commonly used in the insurance industry as a measure of the volume of new and renewal business generated in a period.
Sales should not be viewed as a substitute for any financial measure determined in accordance with GAAP, including “sales” as it relates to non-insurance companies, and the Company’s definition of sales might differ from that used by other companies. As used in the insurance industry, sales, or similarly titled measures, generate customer funds managed and administered, which ultimately drive revenues.
Sales, as reported by the Company, are stated net of internal replacements, which in the Company’s opinion provides a more meaningful disclosure of production in a given period. In addition, the Company’s definition of sales excludes: 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 also markets group deferred compensation retirement plans to employees of state and local governments for use under IRC Section 457. The Company utilizes its sponsorship by the National Association of Counties and The United States Conference of Mayors, and the International Association of Firefighters when marketing IRC Section 457 products.
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, life insurance specialists and representatives of certain CPA firms. Representatives of affiliates who market products directly to a customer base include NRS, TBG Financial and Nationwide Provident agents. The Company also distributes life and retirement savings products through the agency distribution force of its ultimate parent company, NMIC.
Sales generated by financial institutions declined 11% in 2003 as a result of efforts focused on pricing discipline and planned reduction in fixed annuity sales, while private sector pension plan and variable annuity sales were higher in 2003. Sales through financial institutions grew 7% in 2002, driven mainly by increased fixed annuity sales, partially offset by lower production of variable annuities.
The 3% increase in sales is due to ongoing sales activities relating to enrolling new employees and actively working with existing participants to increase their contributions and transfer in assets from other qualified plans.
Sales generated by Nationwide agents declined 9% in 2003 compared to 2002 due to lower fixed annuity sales resulting from an intentional slow down in sales and commission reductions.
Sales through TBG Financial increased 10% in 2003 compared to 2002, primarily due to the sale of a single large case. This increase was partially offset by a decline in sales due to the unfavorable environment for COLI and executive deferred compensation plans. Sales decreased 37% in 2002 compared to 2001, primarily due to the the sluggish equity markets in 2002 and 2001, the weak economy, unfavorable press regarding COLI and executive deferred compensation plans and proposed legislation which could adversely impact the tax benefits of COLI all negatively impacted sales and new business opportunities.
The following table summarizes selected financial data for the Company’s Individual Annuity segment for the years indicated.
Asset fees were $362.5 million in 2003 down 3% from $373.3 million in 2002 and totaled $420.8 million in 2001. Asset fees are calculated and assessed daily as a percentage of separate account values. The fluctuations in asset fees are primarily due to changes in the market value of the investment options underlying the account values, which have followed the general trends of the equity markets. Average separate account values decreased 5% in 2003 to $28.22 billion following a 11% decrease in 2002.
Amortization of DAC decreased by $299.8 million to $228.4 million in 2003, compared to $528.2 million in 2002. Excluding the $328.3 million of accelerated DAC amortization in 2002, amortization of DAC increased 14% to $228.4 million in 2003 reflecting higher estimated gross profits on the underlying business following a 9% decrease in 2002, reflecting lower estimated gross profits.
Operating expenses were $186.7 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. 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 benefits costs and projects focused on improving producer and customer support.
Interest spread income grew 16% in 2003 to $231.0 million from $198.9 million a year ago, while the growth was 37% during 2002 compared to the same period a year ago. The growth was driven by 36% and 33% increases in average general account assets for these same comparative periods, respectively, the result of growth in the individual fixed annuity business and increased customer allocations to the guaranteed fixed options on individual annuities. Allocations to the guaranteed fixed option related to new domestic individual variable annuity sales during 2003 and 2002 totaled 39% and 43%, respectively.
The following table depicts the interest spread on average general account values in the Individual Annuity segment for the years ended December 31:
Although interest spread income was higher, interest spread margins compressed to 167 basis points in 2003. A one year enhanced crediting rate special offered in the fourth quarter 2002 coupled with new crediting rates at or near contractual minimum rates and a jump in prepayments of higher yielding investments created pressure on interest spread on average general account values in 2003. Interest spread on average general account values increased 6 basis points in 2002 compared to 2001. 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. Included in the current year were 6 basis points, or $7.9 million of prepayment income on mortgage loans and bonds compared to 6 basis points, or $6.0 million, a year ago and 7 basis points, or $5.7 million in 2001. The current interest rate environment has limited the ability to adjust crediting rates to the extent of declines in investment yields due to the interest rate floors contained in annuity contracts.
Individual Annuity segment sales, which exclude internal replacements, during 2003 were $6.30 billion, down 10% from $6.96 billion a year ago. A sharp drop-off in fixed annuities, the result of actions described above, which were intended to reduce the level of new individual fixed annuity business, drove segment sales lower compared to 2002. Fixed annuity sales were $1.82 billion, down 31% compared to $2.66 billion in 2002. Fixed annuity sales were up 33% in 2002 from $2.00 billion in 2001. Variable annuity sales were $4.47 billion in 2003, up 4% compared to $4.30 million in 2002. Sales of variable annuities were down 19% in 2002 compared to 2001. In 2002, the sustained weakness in the equity markets reduced demand for variable products and drove consumer interest in fixed products. According to the Variable Annuity Research & Data Service (VARDS), the Company was ranked 9th in total variable annuity sales in 2003.
Asset fees declined 8% to $134.8 million in 2003 compared to $147.3 million in 2002 and totaled $176.7 million in 2001. The declines were driven by a 8% decrease in average separate account assets in 2003 following a decrease of 17% in 2002 as a result of experiencing in the equity markets and a shift in product mix from annuities to administration-only products.
Interest spread improved to 200 basis points in 2003 compared to 198 basis points in 2002. Included in 2003 were 20 basis points, or $27.1 million, of prepayment income on mortgage loans and bonds compared to 9 basis points, or $10.8 million in 2002 and 12 basis points, or $14.4 million in 2001, respectively.
Excluding the $12.0 million of accelerated DAC amortization in 2002, amortization of DAC increased 9% in 2003, following a comparative 12% decrease in 2002. The changes are reflection of fluctuations in the gross margins of the underlying business, which is driven in part by equity market activity.
Other operating expenses in 2003 increased 6% to $183.1 million, compared to a slight increase in 2002. The 2003 increase reflects increased costs related to an initiative aimed at expanding the sales and service capabilities in the Company’s private sector pension business, an increase in participants in public sector pension plans and increased employee benefit, pension and insurance costs. The increase in 2002 reflects the growth in the number of cases being administered and an increase in employee benefit costs.
Institutional Products segment sales during 2003 totaled $3.51 billion compared to $4.03 billion in 2002 and $4.65 in 2001. Private sector pension sales in 2003 totaled $2.07 billion, a decrease of 22% from 2002 compared to a decrease of 15% from 2001. The decrease reflects a strategy of writing new business with Nationwide Trust Company. In addition, during 2003 there was a trend of the existing block of business to convert to Nationwide Trust Company products at renewal.
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 segment products provide a death benefit and generally also allow the customer to build cash value on a tax-advantaged basis.
Life Insurance segment pre-tax operating earnings decreased 13% to $150.0 million in 2003, down from $171.5 million in 2002 while earnings in 2002 declined from $189.7 million in 2001. Excluding $6.8 million accelerated DAC amortization in third quarter 2002, pre-tax operating earnings totaled $178.3 million in 2002. Higher general operating expenses and DAC amortization on COLI, primarily the result of the surrender of a single large case, contributed to the decline in 2003. In both 2003 and 2002, increased cost of insurance charges were offset by higher policy benefits and operating expenses and DAC.
Amortization of DAC increased $13.7 million in 2003 following a $7.9 million increase in 2002, including $6.8 million of accelerated DAC amortization. Excluding the $6.8 million accelerated DAC amortization in third quarter 2002 resulted in increases in DAC amortization of $20.5 million in 2003 and a slight increase in 2002. The increase in 2003 primarily reflects the DAC amortization as a result of the surrender of a large COLI case and the near certain lapse of a second large COLI case. In addition, during 2003 morality experience was more favorable than expected and there was an increase in estimated gross profits on the in-force variable business. The slight increase in 2002 is due to an increase in estimated gross profits on the in-force variable business.
Other operating expenses increased to $157.3 million in 2003 a 6% increase compared to 2002, primarily due to higher employee benefit, pension and insurance costs.
Excludes net realized gains and losses on investments not related to securitizations, hedging instruments and hedged items, discontinued items and cumulative effect of adoption of accounting principles.
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 15 to the consolidated financial statements included in the F pages to this report and are hereby incorporated by reference.
Under the medium-term note program, NLIC issues funding agreements, which are insurance obligations, to an unrelated third-party trust to secure notes issued to investors by the trust. The funding agreements are recorded as a component of future policy benefits and claims on the consolidated balance sheets. Because the Company is not the primary beneficiary of, and has no ownership interest in, or control over, the third-party trust that issues the notes, the Company does not include the trust in its consolidated financial statements and therefore, such notes are not reflected in the consolidated financial statements of the Company. Because the notes issued by the trust have a secured interest in the funding agreements issued by the Company, Moody’s and S&P, assign the same ratings to the notes as the insurance financial strength ratings of NLIC.
To date, the Company has sold $290.1 million of credit enhanced equity interests in Tax Credit Funds to unrelated third parties. The Company has guaranteed cumulative after-tax yields to third party investors ranging from 5.10% to 5.25% and as of December 31, 2003 held guarantee reserves totaling $2.9 million on these transactions. These guarantees are in effect for periods of approximately 15 years each. The Tax Credit Funds provide a stream of tax benefits to the investors that will generate a yield and return of capital. To the extent that the tax benefits are not sufficient to provide these cumulative after-tax yields, then the Company must fund any shortfall, which is mitigated by stabilization collateral set aside by the Company at the inception of the transactions.
The maximum amount of undiscounted future payments that the Company could be required to pay the investors under the terms of the guarantees is $824.2 million. The Company does not anticipate making any payments related to the guarantees.
At the time of the sales, $4.3 million of net sale proceeds were set aside as collateral 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, but are not limited to, completion of construction and the leasing of each unit to a qualified tenant. Properties meeting the necessary criteria are considered to have “stabilized.” The properties are evaluated regularly and upon stabilizing, the collateral is released. During 2003 and 2002, $3.1 million and $0.5 million of stabilization collateral had been released into income, respectively.