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:
(i) the potential impact on the Company’s reported net income and related disclosures that could result from the adoption of certain accounting and/or financial reporting standards issued by the FASB, the SEC or other standard-setting bodies;
(iv) heightened competition, including specifically the intensification of price competition, the entry of new competitors and the development of new products by new and existing competitors;
(viii) 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; or a reduction in the demand for the Company’s products;
(xv) adverse litigation results and/or resolution of litigation and/or arbitration or investigation results.
Following is management’s narrative analysis of the 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.
The Company’s profitability largely depends on its ability to effectively price and manage risk on its various products, administer customer funds and control operating expenses. Lapse rates on existing contracts also impact profitability.
The Company adopted Statement of Position (SOP) 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts (SOP 03-1), effective January 1, 2004, which resulted in a $3.3 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 preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements. Actual results could differ significantly from those estimates.
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 (referred to as 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.
Management evaluates the appropriateness of the individual variable annuity DAC balance within pre-set parameters. These parameters are designed to appropriately reflect the Company’s long-term expectations with respect to individual variable annuity contracts while also evaluating the potential impact of short-term experience on the Company’s recorded individual variable annuity DAC balance. If the recorded balance of individual variable annuity DAC falls outside of these parameters for a prescribed period of time, or if the recorded balance falls outside of these parameters and management determines it is not reasonably possible to get back within the parameters during this period of time, assumptions are required to be unlocked and DAC is recalculated using revised best estimate assumptions. Otherwise, DAC is not unlocked to reflect updated assumptions. If DAC assumptions were unlocked and revised, the Company would continue to use the reversion to the mean process.
The Company’s federal income tax returns are routinely audited by the Internal Revenue Service (IRS), and the Company is currently under examination for the 2000-2002 tax years. Management has established tax reserves representing its best estimate of additional amounts it may be required to pay if certain tax positions it has taken are challenged and ultimately denied by the IRS. These reserves are reviewed regularly and are adjusted as events occur that management believes impact its liability for additional taxes, such as lapsing of applicable statutes of limitations, conclusion of tax audits or substantial agreement on the deductibility/non-deductibility of uncertain items, additional exposure based on current calculations, identification of new issues, release of administrative guidance or rendering of a court decision affecting a particular tax issue. Management believes its tax reserves reasonably provide for potential assessments that may result from IRS examinations and other tax-related matters for all open tax years.
A significant component of the tax reserve is related to the separate account dividends received deduction (DRD). The Company has not reached any final agreements with the IRS with respect to the DRD, and there can be no assurance that any such agreements will be reached. However, resolution of the separate account DRD and/or other identified issues could result in a potentially significant adjustment to the Company’s future results of operations.
The 2005 and 2004 OPEB (income) expense for substantially all of the Company’s employees and certain agents was $(0.1) million and $0.3 million, respectively. The discount rate used to value cash flows was lowered to 5.70% to determine 2005 OPEB expense from 6.10% 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.
During the third quarter of 2005, the Company refined its separate account DRD estimation process. As a result, the Company identified and recorded additional federal income tax benefits and recoverables in the amount of $42.6 million related to all open tax years (2000 - 2005). In addition, the Company recorded $5.6 million of net benefit adjustments in the third quarter of 2005, primarily related to differences between the estimated tax liability and the amounts reported on the Company’s tax returns and revised estimates of permanent income tax deductions expected to be generated in 2005. During the fourth quarter of 2005, the Company revised the estimate for the separate account DRD and recorded an additional federal income tax benefit of $8.0 million based on additional information available at year end. Therefore, the full year 2005 effective tax rate of 15.4% was lower than the 2004 rate of 22.4% primarily due to the additional DRD recorded in 2005 compared to 2004.
The increase in asset fees was due to changes in the market value of the investment options underlying the account values, which followed the general upward trends of the equity markets.
The increase in interest spread income primarily occurred in the Individual Investments segment and was due to higher income from mortgage loan prepayment penalties and bond call premiums along with increased average account values.
The increases in other operating expenses reflect higher advertising and promotion and employee compensation and benefits expenses.
Sales are not derived from any specific GAAP income statement accounts or line items and 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. Additionally, the Company’s definition of sales may 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 management believes 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 MTN program; asset transfers associated with large case BOLI and large case retirement plan acquisitions; and deposits into Nationwide employee and agent benefit plans. Although these products contribute to asset and earnings growth, their production flows potentially can mask trends in the underlying business and thus do not provide meaningful comparisons and analyses.
The Company’s flagship products are marketed under The BEST of AMERICA brand and include individual variable and group annuities, group private sector retirement plans, and variable life insurance. The BEST of AMERICA products allow customers to choose from investment options managed by premier mutual fund managers. The Company has also developed private label variable and fixed annuity products in conjunction with other financial services providers that allow those providers to sell products to their own customer bases under their own brand names.
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, The United States Conference of Mayors and The International Association of Firefighters when marketing IRC Section 457 products.
The decrease in total sales primarily was due to lower fixed annuity sales in the Individual Investments segment related to deliberate actions by the Company as described earlier. In addition, sales in the Retirement Plans segment continued to decline as a result of the movement of pension business to the NFS trust platform. In recent years, an increasing amount of business has been sold through NFS trust products rather than NLIC group annuity contracts due to NFS’ significant investment in the development of trust product capabilities not prevalent elsewhere in the market. The overall decline partially was offset by increased COLI sales in the Individual Protection segment.
The decrease in total sales primarily was driven by lower fixed annuity sales in the Individual Investments segment due to deliberate actions by the Company as described earlier and lower private sector sales in Retirement Plans. These declines were offset slightly by increased sales of both traditional/universal life insurance and COLI products in the Individual Protection segment.
Sales generated by financial institutions declined due to reductions in fixed annuity sales as described previously.
Sales through the independent broker/dealer channel decreased due to lower demand for variable annuities and the aforementioned reduction in fixed annuity production.
Other operating expenses decreased primarily due to lower sales incentives driven by reduced fixed annuity production.
Interest spread margins widened during 2005 to 200 basis points compared to 188 basis points in 2004. Included in 2005 were 22 basis points, or $31.4 million, of income from mortgage loan prepayment penalties and bond call premiums compared to 13 basis points, or $18.4 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 increase in premiums on income products was driven by improving the competitiveness of the Company’s immediate annuity products by increasing the fixed purchase rate offered.
The decrease in fixed annuity sales was due to the competitive interest rate environment and the Company’s exit from the offshore business in the second quarter of 2005. 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 the interest spread on Individual Investments segment average general account values for the years ended December 31:
The decrease in other benefits and claims primarily reflects lower guaranteed minimum death benefit (GMDB) costs in 2004. GMDB exposure declined from the average levels experienced in 2003. This exposure moderated due to the general upward trends of the equity markets in 2004 and resulted in reduced benefit payments and lower provisions for future benefits.
In recent years, an increasing amount of business has been sold through NFS trust products rather than NLIC group annuity contracts due to NFS’ significant investment in the development of trust product capabilities not prevalent elsewhere in the market.
The decline in asset fees was driven by the shift in sales mentioned above and continued surrenders of group annuity contracts.
The following table summarizes the interest spread on Retirement Plans segment average general account values for the years ended December 31:
Private sector sales decreased due to the declining issuance of group annuity contracts described above and the related decrease in recurring flows.
Other benefits and claims increased despite the decrease in life insurance premiums due to less favorable mortality in 2004 compared to 2003.
The increase in sales was due to continued strength in sales of traditional/universal life insurance and COLI products. The traditional/universal life sales increase was driven by a re-tooled universal life insurance product portfolio and expanding distribution relationships in the non-affiliated distribution channels. The increase in COLI sales was driven by higher renewal premiums from the funding of existing COLI cases due to continued improvement in the equity market environment and increased participant deferrals in existing executive deferred compensation plans. Slow growth in new COLI sales, due to the unfavorable environment for COLI and executive deferred compensation programs affecting the creation of new plans and sales, partially offset the overall increase.
The decline in other expenses primarily was due to a reclassification of activity related to variable interest entities (VIEs) between other expenses and other income.
The Company recorded net realized gains on investments, hedging instruments and hedged items during 2005 compared to net realized losses in 2004 primarily due to a significant decline in impairment charges due to a generally improved credit environment.
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.
No contractual provisions exist that could create, increase or accelerate those obligations presented. The amount presented includes contractual principal payments and interest based on rates in effect at December 31, 2005.
A significant portion of policy contract benefits and claims to be paid do not have stated contractual maturity dates and may not result in any ultimate payment obligation. Amounts reported herein represent estimated undiscounted cash flows out of the Company’s general account related to death, surrender, annuity and other benefit payments under policy contracts in force at December 31, 2005. Separate account payments are not reflected herein due to the matched nature of these obligations and the fact that the contract owners maintain the investment risk of such deposits. Estimated payment amounts reported herein were developed based on review of historical results experienced by the Company and the related contractual provisions. Significant assumptions incorporated in the reported amounts include: future policy lapse rates (including the impact of customer decisions to make future premium payments to keep the related policies in force), coverage levels remaining unchanged from those provided under contracts in force at December 31, 2005, future interest crediting rates, and the estimated timing of payments. Actual amounts will vary, potentially in a significant manner, from the amounts indicated due to deviations between assumptions and actual results and the addition of new business in future periods.
Contractual provisions exist that could increase those obligations presented. In developing the estimates of payments due by period, the Company followed the process for determining future interest crediting rates as described in note 5 above.
Since the timing of the return of collateral is uncertain, these obligations have been reflected in payments due in less than one year. See Part II, Item 7 - MD&A - Off-Balance Sheet Transactions for a detailed discussion of the impact of collateral on the Company’s balance sheets.
As of December 31, 2005 and 2004, the Company had received $1.10 billion and $874.2 million, respectively, of cash collateral on securities lending and $203.3 million and $415.7 million, respectively, of cash for derivative collateral. As of December 31, 2005, the Company had not received any non-cash collateral on securities lending compared to $191.8 million received at December 31, 2004. Both the cash and non-cash collateral amounts are included in short-term investments with a corresponding liability recorded in other liabilities. As of December 31, 2005 and 2004, the Company had loaned securities with a fair value of $1.07 billion and $1.04 billion, respectively. The Company also held $53.2 million and $222.5 million of securities as off-balance sheet collateral on derivative transactions as of December 31, 2005 and 2004, respectively.