The information included herein contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 with respect to the results of operations and businesses of the Company. Whenever used in this report, words such as “anticipate,” “estimate,” “expect,” “intend,” “plan,” “believe,” “project,” “target” and other words of similar meaning are intended to identify such forward-looking statements. These forward-looking statements involve certain risks and uncertainties. Factors that may cause actual results to differ materially from those contemplated or projected, forecast, estimated or budgeted in such forward-looking statements include, among others, the following possibilities:
(iv) tax law changes impacting the tax treatment of life insurance and investment products;
(x) changes in interest rates and the equity markets causing a reduction of investment income and/or asset fees; an acceleration of the amortization of DAC and/or value of business acquired (VOBA); or a reduction in the demand for the Company’s products;
Following is management’s discussion and analysis of financial condition and results of operations of the Company for the three years ended December 31, 2005. This discussion should be read in conjunction with the audited consolidated financial statements and related notes beginning on page of this report.
In particular, the Company’s profitability is driven by fee income on separate account products, general account asset levels and management’s ability to manage interest spread income. Interest spread income is comprised of net investment income, excluding any applicable allocated charges for invested capital, 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. In recent periods, management has taken actions to address low interest rate environments and the resulting impact on interest spread margins, including reducing commissions on fixed annuity sales, launching new products with new guaranteed rates, discontinuing the sale of its leading annual reset fixed annuities and invoking contractual provisions that limit the amount of variable annuity deposits allocated to the guaranteed fixed option. Also, the majority of new business now contains lower floor guarantees than were historically provided.
During the year ended December 31, 2005, management decided to discontinue the following operations: (1) Cap Pro, a majority-owned subsidiary of NFS that provided broker/dealer, registered investment advisor and insurance agency services to producers of certain certified public accounting firms; (2) NFSB, a wholly-owned subsidiary of NFS that sold variable and fixed annuity products; and (3) TBG Lynch, a wholly-owned subsidiary of TBG Financial that distributes BOLI products. The Company’s 2005 loss on discontinued operations of $24.5 million, net of taxes, includes the following: (1) Cap Pro-$4.5 million, primarily related to goodwill impairment; (2) NFSB-$8.3 million, primarily related to a loss on the sale of the business; and (3) TBG Lynch-$11.7 million, the loss expected to be realized from the planned sale of the business; this loss was recognized as a reduction in related goodwill as of December 31, 2005. The results of operations of Cap Pro, NFSB and TBG Lynch are reflected as discontinued operations for 2005 and all prior years. See Note 2(n) to the audited consolidated financial statements included in the F pages of the report for additional information on discontinued operations.
effective January 1, 2004, which resulted in a $3.4 million charge, net of taxes, as the cumulative effect of adoption of this accounting principle. See Note 3 to the audited consolidated financial statements included in the F pages of this report for a complete description of SOP 03-1.
The Company has deferred the costs of acquiring investment products and universal life insurance products business, principally commissions, certain expenses of the policy issue and underwriting department, and certain variable sales expenses that relate to and vary with the production of new and renewal business. Investment products primarily consist of individual and group variable and fixed deferred annuities. Universal life insurance products include universal life insurance, variable universal life insurance, COLI and other interest-sensitive life insurance policies. DAC is subject to recoverability testing at the time of policy issuance and loss recognition testing at the end of each reporting period.
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 gross profits from projected interest margins, asset fees, cost of insurance charges, administration fees, surrender charges, and net realized gains and losses 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) to the audited consolidated financial statements included in the F pages of this report.
For other investment products and universal life insurance products, DAC is adjusted each quarter to reflect revised best estimate assumptions, including the use of a reversion to the mean methodology over the next three years as it relates to net separate account performance. Any resulting DAC unlocking adjustments are reflected currently in the consolidated statements of income.
Amortization of VOBA occurs with interest over the anticipated lives of the major lines of business to which it relates (initially ranging from 13 to 30 years) in relation to estimated gross profits, gross margins or premiums, as appropriate. If estimated gross profits, gross margins or premiums differ from expectations, the amortization of VOBA is adjusted on a retrospective or prospective basis, as appropriate. The VOBA asset related to investment products and universal life insurance products is adjusted annually for the impact of net unrealized gains and losses on securities available-for-sale had such gains and losses been realized and allocated to the product lines, as described in Note 2(b) to the audited consolidated financial statements included in the F pages of this report. The recoverability of VOBA is evaluated annually. If the evaluation indicates that the existing insurance liabilities, together with the present value of future net cash flows from the blocks of business acquired, is insufficient to recover VOBA, the difference, if any, is charged to expense as accelerated amortization of VOBA.
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 management determines that a loan is impaired, a provision for loss is established equal to the difference between the carrying value and 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. In addition to the valuation allowance on specific loans, the Company maintains an unallocated allowance for probable losses inherent in the loan portfolio as of the balance sheet date, but not yet specifically identified by loan. Changes in the valuation allowance are recorded in net realized gains and losses on investments, hedging instruments and hedged items. Loans in foreclosure are placed on non-accrual status. Interest received on non-accrual status mortgage loans on real estate is included in net investment income in the period received.
In connection with acquisitions of operating entities, the Company recognizes the excess of the purchase price over the fair value of net assets acquired as goodwill. Goodwill is not amortized, but is evaluated for
The Company calculates its liability for future policy benefits for investment products in the accumulation phase and universal life and variable universal life insurance policies as the policy account balance, which represents participants’ net premiums and deposits plus investment performance and interest credited less applicable contract charges.
The 2005 and 2004 OPEB expense for substantially all of the Company’s employees and certain agents totaled $1.0 million and $2.5 million, respectively. The discount rate used to value cash flows was lowered to 5.70% to determine 2005 OPEB expense from 6.10% used in 2004, and the long-term expected rate of return on plan assets was lowered to 6.50% for 2005 from 7.00% for 2004.
The following illustrates the impact of changes in individual assumptions (without changing any other assumption) on expenses in 2005: (1) a 50 basis point increase in the pension discount rate would have decreased 2005 pension expense by approximately 13%, while a 50 basis point decrease in the pension discount rate would have increased 2005 pension expense by approximately 29%; (2) a 50 basis point increase in the pension long-term expected rate of return would have decreased 2005 pension expense by approximately 12%, while a 50 basis point decrease in the pension long-term expected rate of return would have increased 2005 pension expense by approximately 12%; (3) a 50 basis point increase in the OPEB discount rate would have decreased 2005 OPEB expense by approximately 31%, while a 50 basis point decrease in the OPEB discount rate would have increased 2005 OPEB expense by approximately 31%; and (4) a 50 basis point increase in the OPEB long-term expected rate of return would have decreased 2005 OPEB expense by approximately 19%, while a 50 basis point decrease in the OPEB long-term expected rate of return would have increased 2005 OPEB expense by approximately 19%.
The increase in other income primarily was attributable to the Retirement Plans segment due to higher asset-based fees from improving equity markets; revenue earned by RIA, which was acquired during the first quarter of 2005; and growth in trust and administration-only products.
Asset fees rose primarily due to increases in both average separate account values and the average asset fee rate charged in the Individual Investments segment.
Higher amortization of DAC primarily occurred within the Individual Investments segment due to increased variable annuity revenues. Fixed annuity true-ups and unlocking also contributed to the increase.
During the third quarter of 2005, the Company paid $206.2 million to redeem all of its outstanding 7.10% junior subordinated debentures due October 1, 2028, which in turn caused the redemption by Nationwide Financial Services Capital Trust II of its outstanding 7.10% Trust Preferred Securities and 7.10% Trust Common Securities. As a result of this transaction, the Company incurred debt extinguishment costs of $21.7 million for accelerated amortization of unamortized debt issuance costs, including a deferred loss on previous hedging transactions. These amounts otherwise would have been recognized through 2028.
The increase in net income primarily was driven by higher asset fees, interest spread income and other income and declines in net realized losses on investments, hedging instruments and hedged items and other benefits and claims. Higher other operating expenses and amortization of DAC partially offset the overall increase.
The decline in net realized losses on investments, hedging instruments and hedged items was driven by an improving market and credit environment and the impact of market pricing and portfolio alignment. Other-than-temporary and other investment impairments were positively impacted by the improved credit environment.
Other benefits and claims decreased primarily due to lower GMDB benefits driven by improved equity markets and favorable mortality in the Individual Protection segment.
The increase in other operating expenses reflects higher advertising and promotion and employee compensation and benefits expenses.
As calculated and analyzed by management, statutory premiums and deposits on individual and group annuities and life insurance products calculated in accordance with accounting practices prescribed or permitted by regulatory authorities and deposits on administration-only group retirement plans and the advisory services program are adjusted as described below to arrive at sales.
The slight decrease in total sales primarily was driven by continued challenges within the Individual Investments segment, which was negatively impacted by the Company’s announced exit from the offshore fixed annuity business in the second quarter of 2005 due to a challenging rate environment that depressed margins on this business. In addition, the variable annuity line experienced lower sales of The BEST of AMERICA products, especially the MarketFLEX product. The overall decline in sales partially was offset by strong sales in the Retirement Plans segment, led by small 401(k) plan sales at The 401(k) Company.
Sales generated by financial institutions declined primarily due to intense competition in fixed annuity sales and the impact of the exit from the offshore fixed annuity market mentioned above. The overall decline was partially offset by increases in sales in both the Individual Protection and Retirement Plans segments.
Sales generated by The 401(k) Company continued to grow primarily due to recurring flows from the addition of four large plans during the fourth quarter of 2004.
See Part II, Item 7 - MD&A-Business Segments for an analysis of sales by product and segment.
NRS sales growth was driven by rollover activity from existing participants’ previous employer sponsored plans into existing accounts due to pension reform legislation that expanded the portability of public sector plan assets. Also contributing to the increase were participant contributions from the State of New York, the State of New Mexico and the IAFF cases acquired during 2003 and the addition of the City of Phoenix plan in 2004.
Sales generated by The 401(k) Company continued to grow as a result of employee salary deferrals on several new cases and companies’ profit sharing contributions made in March and April of 2004.
Asset fees rose due to increases in both average separate account values and the average asset fee rate charged. The average variable asset fee rate increased from 1.27% to 1.30% as new business sold with higher-risk features influenced the overall average rate. The increase in average separate account values primarily was due to the general upward trend in the equity and fixed income markets offset in part by withdrawals that exceeded new deposits.
Interest spread margins widened during 2005 to 191 basis points compared to 178 basis points in 2004. Included in 2005 were 20 basis points, or $33.0 million, of income from mortgage loan prepayment penalties and bond call premiums compared to 12 basis points, or $19.5 million, in 2004. The higher interest rate environment in 2005 relative to 2004 eased the pressure on margins due to the interest rate floors contained in certain annuity contracts and contributed to increased margins. For 2006, the Company expects interest spread margins to tighten in this segment and projects full year spreads of 185 to 190 basis points, including a nominal level of prepayment activity.
The decrease in fixed annuity sales was due to the competitive interest rate environment and the Company’s exit from the offshore fixed annuity business in the second quarter of 2005 as discussed earlier. In addition, the variable annuity line experienced lower sales of The BEST of AMERICA products, especially the MarketFLEX product, consistent with industry-wide declines.
The following table summarizes selected information about the Company’s deferred individual fixed annuities, including the fixed option of variable annuities, as of December 31, 2005:
The increase in pre-tax operating earnings was driven by higher other income, partially offset by higher other operating expenses, lower policy charges and higher amortization of DAC.
The increase in other operating expenses reflects higher trail commissions from increased average variable assets, higher NTC deposit commissions associated with business growth and inclusion of expenses related to the newly acquired RIA business early in 2005.
The increase in amortization of DAC was related to changes in private sector amortization assumptions driven by actual experience for the declining block of group annuity business.
The following table summarizes the interest spread on Retirement Plans segment average general account values for the periods indicated:
Interest spread margins declined to 190 basis points in 2005 compared to 198 basis points for 2004. Included in 2005 were 20 basis points, or $22.2 million, of income from mortgage loan prepayment penalties and bond call premiums compared to 18 basis points, or $17.9 million, in 2004. Excluding the impact from prepayment activity, the decrease in margins was driven by the combination of long-duration higher yielding assets rolling over into lower yielding assets as yields on new cash flows are below the portfolio rate. For 2006, the Company expects interest spread margins to continue to tighten in this segment and projects full year spreads of 180 to 185 basis points, including a nominal level of prepayment activity.
Other income increased due to growth in private sector retirement plans being sold through NTC and continued growth in administration-only business in public sector.
Higher policy charges were due to increased surrender fees as a greater percentage of plans surrendered within the surrender charge period. In addition, asset fees rose due to higher average separate account values.
The decrease in amortization of DAC was attributable to a true-up in the universal life business related to favorable mortality experience.
Life insurance premiums decreased due to the expected decline of the NFN closed block, lower fixed life sales and the impact of changes in reinsurance coverage from yearly renewable term to coinsurance in the traditional life portfolio.
Higher sales were driven by improved COLI sales, partially offset by declines in variable life production. The increase in COLI sales was driven by several large cases that closed during 2005 and a more favorable legislative environment.
The decline in other benefits and claims primarily was due to favorable mortality in the fixed life insurance business.
The Company has a comprehensive portfolio monitoring process for fixed maturity and equity securities to identify and evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. See Part II, Item 7 - MD&A-Critical Accounting Policies and Recently Issued Accounting Standards-Impairment Losses on Investments for a complete discussion of this process.
Excluding operating items (periodic net coupon settlements on non-qualifying derivatives, trading portfolio realized gains and losses, and trading portfolio valuation changes).
Other expenses increased due to higher advertising and promotion and employee compensation and benefit expenses.
The following table summarizes for the year ended December 31, 2005 the Company’s largest aggregate losses on sales and write-downs by issuer (including affiliates), the related circumstances giving rise to the losses and the circumstances that may have affected other material investments held:
In the normal course of business, the Company has entered into many related party transactions. See Note 19 to the audited consolidated financial statements included in the F pages of this report for descriptions of these transactions.
A primary liquidity concern with respect to annuity and life insurance products is the risk of early policyholder withdrawal. The Company attempts to mitigate this risk by offering variable products where the
investment risk is transferred to the policyholder, charging surrender fees at the time of withdrawal for certain products, applying a market value adjustment to withdrawals for certain products in the Company’s general account, and monitoring and matching anticipated cash inflows and outflows.
For group annuity products ($25.57 billion of reserves as of December 31, 2005), 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.
The Company has an available financing capacity of $1.10 billion under a shelf registration statement dated February 4, 2003. Under the shelf registration statement, the Company can issue various security instruments including, but not limited to, unsecured senior or subordinated debt securities, preferred stock, Class A common stock, stock purchase contracts or stock purchase units. In conjunction with an owned trust, capital securities guaranteed by NFS may be issued.
See Part II, Item 5 - Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities for a description of the Company’s stock repurchase program and its impact on liquidity.
In addition, the Company has a majority-owned subsidiary that has available an annually renewable, 364-day, $10.0 million line of credit agreement with a single financial institution. The line of credit is guaranteed by NFS and is included in the consolidated balance sheets. The agreement was amended in August 2005, and the majority-owned subsidiary had $10.0 million and $9.0 million outstanding on that line of credit as of December 31, 2005 and 2004, respectively, at a weighted average effective interest rate of 4.35% in 2005 and 2.34% in 2004.
The $300.0 million principal of 8.00% senior notes due March 1, 2027 were issued in March 1997 and 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,
Since 2001, the Company has sold $626.1 million of credit enhanced equity interests in Low-Income-Housing Tax Credit Funds (Tax Credit Funds) to unrelated third parties. The Company has guaranteed cumulative after-tax yields to the third party investors ranging from 3.75% to 5.25% over periods ending between 2002 and 2022. As of December 31, 2005, the Company held guarantee reserves totaling $6.3 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. If 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 $1.54 billion. The Company does not anticipate making any payments related to the guarantees.
No contractual provisions exist that could create, increase or accelerate those obligations presented. The amount presented includes contractual principal and interest based on rates in effect at December 31, 2005.
Primarily related to investments in low-income-housing tax credit partnerships. Call dates for the obligations presented are either date or event specific. The date specific requirement mandates the Company fund a specified amount on a stated date provided there are no defaults under the agreement. The event specific requirement is such that the Company is obligated to fund a specified amount of its capital commitment when all the properties in a fund become fully stabilized. The ultimate call date of these commitments may extend beyond one year but have been reflected in payments due in less than one year due to the call features. The Company’s capital typically is called within one to four years, depending on when the events contemplated in the documents transpire.
See Part II, Item 7 - MD&A-Off-Balance Sheet Transactions for a detailed discussion of the Company’s MTN program. The amounts presented include contractual principal and interest based on rates in effect at December 31, 2005.
Under the MTN program, NLIC issues funding agreements to an unconsolidated third party trust to secure notes issued to investors by the trust. The funding agreements rank pari passu with all other insurance claims of the issuing company in the event of liquidation and should be treated as “annuities” under applicable Ohio insurance law. Therefore, the funding agreement obligations are classified 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 MTNs, the Company does not include the trust in its consolidated financial statements. Since 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 and the insurance financial strength of NLIC.
The Company’s assets are divided between separate account and general account assets. As of December 31, 2005, $65.96 billion (57%) of the Company’s total assets were held in separate accounts ($64.90 billion, or 55%, as of December 31, 2004) and $50.20 billion (43%) were held in the Company’s general account ($52.05 billion, or 45%, as of December 31, 2004), including $43.17 billion of general account investments ($44.60 billion as of December 31, 2004).
The following table lists the ten largest fixed maturity investment holdings by amortized cost for both investment grade and non-investment grade securities included in the general account as of December 31, 2005 (excluding U.S. Treasury securities, obligations of U.S. Government corporations, and agency bonds not backed by the full faith and credit of the U.S. Government):
The 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 and privately placed securities. The designations assigned by the NAIC range from class 1 (highest quality) to class 6 (lowest quality). Of the Company’s general account fixed maturity securities, 94% were in the two highest NAIC Designations as of December 31, 2005 compared to 94% as of December 31, 2004.
Comparisons between NAIC and Moody’s designations are published by the NAIC. If no Moody’s rating is available, the Company assigns internal ratings corresponding to public ratings.
The Company’s general account MBS portfolio is comprised of residential MBS investments. As of December 31, 2005, MBS investments totaled $6.73 billion (22%) of the carrying value of the Company’s general account fixed maturity securities available-for-sale compared to $5.52 billion (18%) as of December 31, 2004.
The Company believes that MBS investments add diversification, liquidity, credit quality and additional yield to its general account portfolio. The Company’s objective for its MBS portfolio is to provide reasonable cash flow stability and increased yield. The MBS portfolio includes CMOs, Real Estate Mortgage Investment Conduits (REMICs) and mortgage-backed pass-through securities. The Company’s general account MBS portfolio generally does not include interest-only securities, principal-only securities or other MBS investments which may exhibit extreme market volatility.
The Company invests in private placement 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 placement fixed maturity securities are not registered with the SEC and generally are less liquid than public fixed maturity securities, restrictive financial and business covenants included in private placement fixed maturity security loan agreements generally are designed to compensate for the impact of increased liquidity risk. A significant portion of the private placement fixed maturity securities that the Company holds are participations in issues that are also owned by other investors. In addition, some of these securities are rated by nationally recognized rating agencies, and substantially all have been assigned a rating designation by the NAIC, as shown in the earlier table which summarizes the credit quality, as determined by NAIC Designation, of the Company’s general account fixed maturity securities portfolio as of December 31, 2005.
The table below summarizes the carrying values of mortgage loans by regional exposure and type of collateral as of December 31, 2005:
As of December 31, 2005 and 2004, 0.05% of the Company’s mortgage loans were classified as delinquent. Foreclosed loans totaled 0.11% of the Company’s mortgage loans as of December 31, 2005 compared to 0.13% as of December 31, 2004. Restructured loans totaled 0.28% and 0.27% of the Company’s mortgage loans as of December 31, 2005 and 2004, respectively.