Pursuant to an arrangement between NMIC and certain of its subsidiaries, during 2008 the Company leased on average approximately 890,000 square feet of office space in the three-building home office complex and in other offices in central Ohio. In addition, the Company leases approximately 120,000 square feet of office space in Berwyn, Pennsylvania (of which approximately 90,000 square feet are subleased). The Company believes that its present and planned facilities are adequate for the anticipated needs of the Company.
(ii) the potential impact on the Company’s reported net (loss) 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;
(vii) failure to expand distribution channels in order to obtain new customers or failure to retain existing customers;
(viii) inability to carry out marketing and sales plans, including, among others, development of new products and/or changes to certain existing products and acceptance of the new and/or revised products in the market;
(xvi) adverse litigation results and/or resolution of litigation and/or arbitration or investigation results that could result in monetary damages or impact the manner in which the Company conducts its operations; and
(xvii) adverse consequences, including financial and reputation costs, regulatory problems and potential loss of customers resulting from failure to meet privacy regulations and/or protect the Company’s customers’ confidential information.
Following is management’s discussion and analysis of financial condition and results of operations of the Company for the three years ended December 31, 2008. This discussion should be read in conjunction with the audited consolidated financial statements and related notes beginning on page of this report.
The primary segment profitability measure that management uses is pre-tax operating (loss) earnings, which is calculated by adjusting (loss) income from continuing operations before federal income tax (benefit) expense and discontinued operations to exclude: (1) net realized investment gains and losses, except for operating items (periodic net amounts paid or received on interest rate swaps that do not qualify for hedge accounting treatment, trading portfolio realized gains and losses, trading portfolio valuation changes, and net realized gains and losses related to hedges on GMDB contracts and securitizations); and (2) the adjustment to amortization of DAC and VOBA related to net realized investment gains and losses.
The Company earns revenues and generates cash primarily from policy charges, life insurance premiums and net investment income. Policy charges include asset fees, which are earned primarily from separate account values generated from the sale of individual and group variable annuities and investment life insurance products; cost of insurance charges earned on all life insurance products except traditional, which are assessed on the amount of insurance in force in excess of the related policyholder account value; 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 for annuity and certain life insurance contracts. Net investment income includes earnings on investments supporting fixed annuities, the MTN program and certain life insurance products, and earnings on invested assets not allocated to product segments, all net of related investment expenses. Other income includes asset fees, administrative fees, commissions and other income earned by subsidiaries of the Company that provide administrative, marketing, distribution and retail asset management services.
The Company regularly evaluates and adjusts the DAC balance when actual gross profits in a given reporting period vary from management’s initial estimates, with a corresponding charge or credit to current period earnings. This process is referred to by the Company as a “true-up”, which generally is performed, and the resulting impact recognized, on a quarterly basis. Additionally, the Company regularly evaluates its assumptions regarding the future estimated gross profits used as a basis for amortization of DAC and adjusts the total amortization recorded to date by a charge or credit to earnings if evidence suggests that these future assumptions and estimates should be revised. The Company refers to this process as “unlocking”, which generally is performed on an annual basis with any corresponding charge or credit reflected in the second quarter. In addition, the Company regularly monitors its actual experience and evaluates relevant internal and external information impacting its assumptions and may unlock more frequently than annually if such information and analysis warrants.
Effective March 31, 2007, the Company completed the sale of The 401(k) Company for $115.4 million in cash and recorded a $45.5 million gain, net of taxes.
In September 2005, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position (SOP) 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts (SOP 05-1). The Company adopted SOP 05-1 effective January 1, 2007, which resulted in a $6.0 million charge, net of taxes, as the cumulative effect of adoption of this accounting principle.
Nationwide Bank and Nationwide Federal Credit Union (NFCU) entered into an Agreement and Plan of Merger, dated as of June 16, 2006, pursuant to which Nationwide Bank would acquire 100% of the ownership interests in NFCU for $79.0 million in cash. The merger was effective January 1, 2007, with payment of merger consideration to the NFCU membership on January 8, 2007, on a pro rata basis according to the members’ deposit account balances as of March 31, 2006.
On February 2, 2007, NFS entered into a stock purchase agreement with Nationwide Corporation to acquire the Philadelphia-based retail asset management operations of NWD Investment Management, Inc. The transaction closed on April 30, 2007 with a final purchase price of $244.2 million. The acquired operations are known as NFG. The purchase was accounted for during the second quarter of 2007 at historical cost in a manner similar to a pooling of interests because the involved entities are under common control. NFG is reflected in the Company’s current and prior period consolidated financial statements at the historical cost of the transferred net assets to provide comparative information as though the companies were combined for all periods presented. The excess purchase price over the historical cost of the acquired net assets was accounted for as a $202.5 million equity transaction, including a $4.0 million true-up recorded during the fourth quarter of 2007.
For fixed maturity and marketable equity securities for which market quotations generally are available, the Company generally uses independent pricing services to assist in determining the fair value measurement. For certain fixed maturity securities not priced by independent services (generally private placement securities without quoted market prices), an internally developed pricing model or “corporate pricing matrix” is most often used. The corporate pricing matrix is developed by obtaining private spreads versus the U.S. Treasury yield for corporate securities with varying weighted average lives and bond ratings. The weighted average life and bond rating of a particular fixed maturity security to be priced using the corporate matrix are important inputs into the model and are used to determine a corresponding spread that is added to the U.S. Treasury yield to create an estimated market yield for that bond. The estimated market yield and other relevant factors are then used to estimate the fair value of the particular fixed maturity security. The Company also utilized broker quotes to assist in pricing securities or to validate modeled prices.
As of December 31, 2008, 80% of the prices of fixed maturity securities were valued with assistance of independent pricing services, 11% were valued with assistance of the Company’s pricing matrices, 4% were valued with assistance of broker quotes and 5% were valued from other sources (compared to 74%, 16%, 7% and 3%, respectively, as of December 31, 2007).
Available-for-sale securities valued using significant Level 3 inputs includes investments in markets which the Company considers inactive, the Company’s non-investment grade holdings in collateralized mortgage obligations, certain MBSs, ABSs and ABS trust preferred notes, certain broker-quoted or internally priced securities and securities that are at or near default based on designations assigned by the NAIC. As of December 31, 2008, Level 3 investments comprised 20% of total investments measured at fair value.
As of December 31, 2008 and 2007, the Company had received $1,022.5 million and $245.4 million, respectively, of cash for derivative collateral, which is in turn invested in short-term investments. The Company also held $35.4 million and $18.5 million of securities as off-balance sheet collateral on derivative transactions as of December 31, 2008 and 2007, respectively. As of December 31, 2008 and 2007, the Company had pledged fixed maturity securities with a fair value of $24.5 million and $18.8 million, respectively, as collateral to various derivative counterparties.
The Company’s most critical estimates include, but are not limited to, those used to determine the following: the balance, recoverability and amortization of DAC; whether an available-for-sale security is other-than-temporarily impaired, valuation allowances for mortgage loans on real estate; derivative instruments; the liability for future policy benefits and claims; and federal income tax provision.
The assumptions used in the estimation of future gross profits are based on the Company’s current best estimates of future events and are reviewed as part of an annual process during the second quarter. During the annual process, the Company performs a comprehensive study of assumptions, including mortality and persistency studies, maintenance expense studies, and an evaluation of projected general and separate account investment returns. The most significant assumptions that are involved in the estimation of future gross profits include future net separate account investment performance, surrender/lapse rates, interest margins and mortality. Currently, the Company’s long-term assumption for net separate account investment performance is approximately 7% growth per year and varies by product. The Company reviews this assumption, like others, as part of its annual process. If this assumption were unlocked, the date of the unlocking could become the anchor date used in the reversion to the mean process (defined below). Variances from the long-term assumption are expected since the majority of the investments in the underlying separate accounts are in equity securities, which strongly correlate in the aggregate with the S&P 500 Index. The Company bases its reversion to the mean process on actual net separate account investment performance from the anchor date to the valuation date. The Company then assumes different performance levels over the next three years such that the separate account mean return measured from the anchor date to the end of the life of the product equals the long-term assumption. The assumed net separate account investment performance used in the DAC models is intended to reflect what is anticipated. However, based on historical returns of the S&P 500 Index, and as part of its pre-set parameters, the Company’s reversion to the mean process generally limits net separate account investment performance to 0-15% during the three-year reversion period. See below for a discussion of 2008 and 2007 assumption changes that impacted DAC amortization and related balances.
At the end of the second quarter of 2008, the Company determined as part of its comprehensive annual study of assumptions that certain assumptions should be unlocked. The unlocked assumptions primarily related to lapse and spread assumptions in the Individual Investments segment, the assumed growth rate on deposits per contract in the Retirement Plans segment, and mortality and lapse assumptions in the Individual Protection segment. Therefore, in the second quarter of 2008, the Company recorded the following pre-tax adjustments: 1) a decrease in DAC and additional DAC amortization of $13.9 million; 2) a decrease in other assets and additional benefits and claims of $0.6 million; 3) an increase in VOBA and a benefit to VOBA amortization of $4.9 million; and 4) a decrease in unearned revenue liability and additional administrative fees of $3.2 million. The net impact of this activity was a $6.4 million unfavorable pre-tax adjustment to net income in the second quarter of 2008, which was reported in the following segments in the pre-tax amounts indicated: Individual Investments - $12.0 million unfavorable; Retirement Plans - $2.3 million unfavorable; and Individual Protection - $7.9 million favorable.
During the third quarter of 2008, the Company’s recorded balance of individual variable annuity DAC fell outside the Company’s preset parameters for the prescribed period, which primarily was driven by unfavorable market performance compared to the assumed net separate account returns. Accordingly, the Company recalculated DAC using revised best estimate assumptions, which resulted in a decrease in DAC and an increase in DAC amortization and other related balances totaling $177.2 million pretax in the Individual Investments segment. During the fourth quarter of 2008, the Company’s recorded balance of individual variable annuity DAC fell outside the Company’s preset parameters, which primarily was driven by continued unfavorable market performance compared to assumed net separate account returns. Management made a determination that it was not reasonably possible to get back within the preset parameters during the remaining prescribed period. Accordingly, the Company recalculated DAC using revised best estimate assumptions, which resulted in a decrease in DAC and an increase in DAC amortization and other related balances of $243.1 million pre-tax in the Individual Investments segment. The Company continues to use the reversion to the mean process with the anchor date that was reset during the second quarter 2007 unlocking as described above. The Company evaluated the assumed separate account performance level over the next three years and determined that the assumptions inherent in the reversion period were reasonable. The annual net separate account growth rate for the mean reversion period is 15%, the maximum rate under the Company’s parameters. Accordingly, future periods may incur additional amortization of DAC if the Company’s actual returns are less than assumed.
Management regularly reviews investments in its fixed maturity and equity securities portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments.
The liability for future policy benefits and claims for traditional life insurance policies was determined using the net level premium method using interest rates varying from 2.0% to 10.5% and estimates of mortality, morbidity, investment yields and withdrawals that were used or being experienced at the time the policies were issued.
Management has established tax reserves in accordance with the requirements of FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109, Accounting for Income Taxes (FIN 48). See Note 3 to the audited consolidated financial statements included in the F pages of this report for a summary of FIN 48. 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/nondeductibility 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 Internal Revenue Service (IRS) examinations and other tax-related matters for all open tax years.
Net realized investment losses increased primarily due to a $1.03 billion increase in impairment charges due to challenging conditions in the credit markets. In addition, the Company recorded a $474.0 million increase in losses on living benefit embedded derivatives, net of economic hedging activity. Finally, the Company recorded $49.6 million in losses in its structured products business related to impairments on mortgages and mortgage loan commitments, and valuation losses on assets held for trading purposes increased $26.7 million. The overall decline was offset by higher realized gains of $228.0 million on derivatives associated with the Company’s economic hedging program related to contracts with death benefit guarantees.
The decrease in net income compared to 2006 was impacted by several events. First, $114.2 million of tax reserves were released into earnings during the second quarter of 2006. Second, 2007 results include the $45.5 million gain on the sale of The 401(k) Company, partially offset by a $23.3 million loss related to TBG Financial (both reported in discontinued operations as described previously). Lastly, the Company recorded higher income from continuing operations before federal income tax expense largely due to lower amortization of DAC and related adjustments as discussed previously and below, along with higher other income and asset fees. Partially offsetting these factors were net realized investment losses; higher other operating expenses; lower administrative fees; increased amortization of DAC and annuity benefits related to modifications of features in the Company’s L.inc product; and debt extinguishment costs.
Through June 2006, the Company’s federal income tax returns for tax years 2000-2002 were under IRS examination pursuant to a routine audit. In accordance with its regular practice, management established tax reserves representing its best estimate of additional amounts the Company could be required to pay if certain positions it had taken were challenged and ultimately denied by the IRS with respect to these tax years. These reserves are reviewed regularly and are adjusted as events occur that management believes impacts the Company’s 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. A significant component of the Company’s tax reserve as of December 31, 2005 was related to the separate account dividends received deduction (DRD).
Other income increased primarily in the Retirement Plans segment due to higher average assets driven by strong market performance in the private sector business. The Corporate and Other segment also contributed to the increase with higher revenues from retail broker/dealer operations, partially offset by lower income in the structured products business that resulted from an unfavorable environment for mortgage loan securitizations.
The Company recorded net realized investment losses in 2007 compared to net gains in 2006 primarily due to a $100.1 million increase in impairment charges driven by challenging conditions in the credit markets. In addition, the Company recorded higher losses on living benefit embedded derivatives, net of economic hedging activity, primarily as a result of increased volatility in market returns. See Part II,