(vii) Adverse state and federal legislation and regulation, including limitations on premium levels, increases in minimum capital and reserves, and other financial viability requirements; restrictions on mutual fund distribution payment arrangements such as revenue sharing and 12b-1 payments; and regulation changes resulting from industry practice investigations;
(xii) Competitive, regulatory or tax changes that affect the cost of, or demand for, the Company’s products;
In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities as of the date of the audited consolidated financial statements and the reported amounts of revenues and expenses for the reporting period. Actual results could differ significantly from those estimates.
The most critical estimates include those used in determining DAC for investment products and universal life insurance products, VOBA, impairment losses on investments, valuation allowances for mortgage loans on real estate, federal income taxes, goodwill, and pension and other postretirement employee benefits.
As a result of the acquisition of NFN in 2002 and the application of purchase accounting, the Company reports an intangible asset representing the estimated fair value of the business in force and the portion of the purchase price that was allocated to the value of the right to receive future cash flows from the life insurance and annuity contracts existing as of the closing date of the NFN acquisition. The value assigned to VOBA in the purchase accounting for NFN was supported by an independent valuation study that was commissioned by the Company and executed by a team of qualified valuation experts, including actuarial consultants. The expected future cash flows used in determining such value were based on actuarially determined projections by major line of business of future policy and contract charges, premiums, mortality and morbidity, separate account performance, surrenders, changes in reserves, operating expenses, investment income and other factors. These projections considered all known or expected factors at the valuation date based on the judgment of management. The actual experience on purchased business, to some extent, has and may continue to vary from projections due to differences in renewal premiums, investment spreads, investment gains and losses, mortality and morbidity costs, or other factors.
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 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.
For other debt and equity securities, an other-than-temporary impairment charge is taken when the Company does not have the ability and intent to hold the security until the forecasted recovery or if it is no longer probable that the Company will recover all amounts due under the contractual terms of the security. Many criteria are considered during this process including, but not limited to, the current fair value as compared to amortized cost or cost, as appropriate, of the security; the amount and length of time a security’s fair value has been below amortized cost or cost; specific credit issues and financial prospects related to the issuer; the Company’s intent to hold or dispose of the security; and current economic conditions.
The valuation allowance account for mortgage loans on real estate is maintained at a level believed adequate by the Company and reflects the Company’s best estimate of probable credit losses, including losses incurred at the balance sheet date but not yet identified by specific loan. The Company’s periodic evaluation of the adequacy of the allowance for losses is based on past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of the underlying collateral, composition of the loan portfolio, current economic conditions and other relevant factors.
Significant changes in the factors the Company considers in determining the valuation allowance for mortgage loans on real estate could result in a significant change in the valuation allowance reported in the consolidated financial statements.
rates; expected levels of cash flows, revenues and earnings; and the selection of comparable companies used to develop market-based assumptions.
Management believes all judgments and assumptions made in connection with goodwill impairment testing are reasonable based on the underlying facts and circumstances evaluated. However, variances in actual results from expectations or changes in expectations for future cash flows, revenues and/or earnings could result in significant future goodwill impairment charges.
The following illustrates the impact of changes in individual assumptions (without changing any other assumption) on expenses in 2004: (1) a 50 basis point increase in the pension discount rate would have decreased 2004 pension expense by approximately 10%, and a 50 basis point increase in the pension long-term expected rate of return would have decreased 2004 pension expense by approximately 13%; and (2) a 50 basis point increase in the OPEB discount rate would have decreased 2004 OPEB expense by approximately 21%, and a 50 basis point increase in the OPEB long-term expected rate of return would have decreased 2004 OPEB expense by approximately 11%.
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 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 or account values during a specified period for annuity and certain life insurance contracts.
Asset fees totaled $631.1 million in 2004 compared to $552.9 million and $550.6 million in 2003 and 2002, respectively. The increases in 2004 and 2003 were due to changes in the market value of the investment options underlying the account values, which have followed the general upward trends of the equity markets. Asset fees were flat in 2003 compared to 2002, reflecting slight fluctuations in average separate account values.
Net investment income includes the investment income earned on investments supporting fixed annuities, the medium-term note (MTN) program, certain life insurance products and invested assets not allocated to product segments, net of related investment expenses. Net investment income totaled $2.27 billion in 2004 compared to $2.23 billion in 2003 and $1.91 billion in 2002. The increase in 2004 primarily was due to higher prepayment income on mortgage loans and higher bond call premium income. The increase in 2003 was primarily due to increased invested assets supporting growth in individual fixed annuities, allocations to the fixed option of variable annuities and the medium term note program, partially offset by lower yields due to declining market interest rates.
Other income includes management fees, commissions and other income earned by subsidiaries of the Company that provide administration, marketing and distribution services. Other income in 2004 increased to $307.6 million from $234.1 million and $126.6 million in 2003 and 2002, respectively. The increases in 2004 and 2003 reflect an increase in the number of private sector retirement plans sold through Nationwide Trust Company, FSB (NTC) and increased securitizations and structured products activity.
Policyholder dividends on participating policies decreased by 4% to $101.4 million in 2004 compared to $105.7 million in the same period a year ago. The decline was due to a reduction in dividend scale as a result of lower interest rates. Policyholder dividends on participating policies increased to $105.7 million in 2003 compared to $63.5 million in 2002 due to the addition of NFN, which had a significant amount of participating life insurance.
outside a pre-set parameter of acceptable results. 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 accelerated DAC amortization of $347.1 million in 2002, amortization of DAC increased $68.5 million to $399.5 million in 2003 compared to $331.0 million in 2002, primarily due to the addition of NFN and growth in the Individual Investments segment.
The increases in interest expense on debt for 2004 and 2003 were due to the issuance of $200.0 million of senior notes in February 2003, an increase in the utilization of commercial paper in 2004 and 2003, and interest on short-term borrowings related to a consolidated variable interest entity during 2004.
Other operating expenses increased 13% to $928.2 million in 2004 compared to $823.7 million 2003. Other operating expenses were $670.1 million in 2002. The increases reflect higher advertising and promotion and employee compensation and benefits expenses.
Federal income tax expense in 2004 and 2003 was $169.2 million and $119.4 million, respectively, representing an effective tax rate of 25.1% and 23.1%, respectively. Federal income tax benefit in 2002 was $7.3 million, representing an effective rate of (5.5)%. The effective tax rate for 2004 increased because permanent items grew at a lower rate than pre-tax earnings. Pre-tax earnings increased by 30% while the permanent tax deductions increased by 8%. The increase in the permanent tax deductions was due to the release of the Phase III tax liability due to changes in the tax law enacted in 2004, partially offset by an increase in valuation allowance for a consolidated subsidiary, while the separate account dividends received deduction remained fairly constant. 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 what would normally be expected to be reported as effective tax rates. Excluding the accelerated DAC amortization and related tax benefit, the effective tax rate for 2002 was 23.8%.
On June 28, 2002, NFS completed a transaction with Nationwide Corp. to exchange all of the shares of common stock of Gartmore Global Investments, Inc. (GGI), a majority-owned subsidiary, held by NFS for shares of NFS common stock held by Nationwide Corp. GGI comprised NFS’ asset management operations. NFS also exchanged all of the shares of common stock of Nationwide Securities, Inc. (NSI), an indirect wholly-owned broker/dealer subsidiary, for shares of NFS’ common stock held by Nationwide Corp.
As a result of these transactions, the Company is no longer engaged in asset management operations, and the results of GGI and NSI have been reported as discontinued operations. Income from discontinued operations, net
In July 2003, the American Institute of Certified Public Accountants issued Statement of Position 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts (SOP 03-1). SOP 03-1 addresses many topics. The most significant topic affecting the Company was the accounting for contracts with GMDB. SOP 03-1 requires companies to evaluate the significance of a GMDB to determine whether a contract should be accounted for as an investment or insurance contract. For contracts determined to be insurance contracts, companies are required to establish a reserve to recognize a portion of the assessment (revenue) that compensates the insurance company for benefits to be provided in future periods. SOP 03-1 also provides guidance on separate account presentation, interest in separate accounts, gains and losses on the transfer of assets from the general account to a separate account, liability valuation, return based on a contractually referenced pool of assets or index, annuitization options, and sales inducements to contract holders. The Company adopted SOP 03-1 effective January 1, 2004, which resulted in a $3.4 million charge, net of tax, as the cumulative effect of adoption of this accounting principle. Also, see Note 3 to the consolidated financials statements included in the F pages of this report.
As calculated and analyzed by the Company, 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 Company’s flagship products are marketed under The BEST of AMERICA® brand and include individual variable and group annuities, group private sector retirement plans sold through NTC 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 sells its products through a diverse distribution network. Unaffiliated entities that sell the Company’s products to their own customer bases include independent broker/dealers, financial institutions, wirehouse and regional firms, pension plan administrators, life insurance specialists and representatives of certain certified public accounting (CPA) firms. Representatives of the Company who market products directly to a customer base include Nationwide Retirement Solutions, Inc. (NRS), NFN producers, The 401(k) Company and TBG Insurance Services Corporation (TBG Financial). The Company also distributes products through the agency distribution force of its ultimate parent, NMIC (Nationwide agents).
Sales through the independent broker/dealer channel increased 10% in 2004 compared to 2003 reflecting growth in group annuity and private sector retirement plan sales. Sales through this channel in 2003 increased by 3% compared to 2002 reflecting the distribution of NFN pension products through the independent broker/dealer channel.
Sales generated by wirehouse and regional firms decreased slightly in 2004 compared to 2003 and decreased 10% in 2003 from $2.20 billion in 2002. The declines were due to lower individual annuity sales, offset by higher private sector retirement plan sales as a result of the new business model.
As the Company’s private sector retirement plan business model continues to evolve, direct production through the pension plan administrators channel is expected to decline, as more new business opportunities are being created in conjunction or in partnership with the independent broker/dealers, wirehouse and regional firms and financial institutions relationships. This was evidenced by the 17% and 23% decline in 2004 and 2003 sales, respectively, compared to the prior year.
Sales generated by life insurance specialists decreased 1% in 2004 compared to 2003. The decline in sales during 2004 was driven largely by the slow growth in new corporate-owned life insurance (COLI) sales due to
Sales generated by the CPA channel increased significantly to $223.2 million in 2004 compared to $73.3 million in 2003. The increases were due to the reclassification of certain CPA channel sales, which prior to 2004 were reported with independent broker/dealer sales and were not reclassified to conform to the current year presentation.
NFN sales declined 4% in 2004 compared to 2003. The decrease was primarily due to a reduction in distribution personnel. NFN sales grew significantly in 2003 due to the acquisition that closed on October 1, 2002.
Sales generated by Nationwide agents increased 4% in 2004 compared to 2003 due to an increase in individual variable annuity sales related to new products, partially offset by an intentional reduction in fixed annuity production. Sales through this channel declined 7% in 2003 due to lower fixed annuity sales resulting from an intentional slow down in sales and commission reductions.
Pre-tax operating earnings totaled $239.4 million in 2004, up 29% compared to $185.5 million in 2003 and a loss of $121.1 million in 2002. The higher earnings in 2004 were primarily driven by higher asset fees and interest spread income, somewhat offset by higher other operating expenses and DAC amortization. Excluding $328.3 million of accelerated DAC amortization in 2002, pre-tax operating earnings totaled $207.2 million. Excluding the accelerated DAC amortization, the lower 2003 earnings were primarily driven by lower policy charges and higher policy benefits primarily related to GMDB expenses, partially offset by an increase in interest spread income.
Surrender fees increased by $7.4 million to $63.9 million in 2004 relative to a year ago, primarily due to a higher level of surrender activity and higher contract values relative to a year ago. Surrender fees decreased $4.7 million in 2003 from $61.2 million in 2002 in part due to the positive equity market returns in the period.
Premiums on immediate annuities totaled $90.8 million, down 3% from $93.4 million in 2003, which increased $24.0 million, or 35%, from 2002. Results for 2004 reflect an increasingly competitive sales environment, though higher interest rates in late second and early third quarter helped immediate annuity sales in third quarter. The increase in 2003 reflected increased sales efforts and growth in the number of firms and distributors selling income products.
The 17% decrease in other benefits during 2004 compared to the prior year primarily reflects lower GMDB costs in 2004. GMDB exposure, as measured by the difference between the current contractual death benefit and account value, net of reinsurance, fell over 50% from the average levels experienced in 2003. Moderation in this exposure directly resulted in reduced benefit payments and lesser reserve provisions for future benefits. Gross GMDB death claims expense fell 44% from $56.7 million in 2003 to $31.5 million in 2004. Reinsurance recoveries covered a greater proportion of actual claims during 2004 (84% versus 61%), due to favorable experience and the addition of a new reinsurance treaty in April covering base mortality exposure, but not equity market exposure. Benefit reserve expenses of $8.1 million in 2003 were affected by a $11.9 million strengthening, while 2004 reserves increased only $1.9 million. In contrast, strong equity performance in the fourth quarter of 2004, together with expanded hedging of GMDB benefits, led to hedge losses of $7.0 million in 2004 compared to $2.3 million in losses in 2003. Benefit expenses for guaranteed living benefits, including GMIB and GMAB, improved by $2.1 million in 2004. The Company’s reserves for all variable annuity guarantees, calculated in accordance with SOP 03-01 and SFAS 133, totaled $47.6 million and $26.1 million as of December 31, 2004 and 2003, respectively.
Other operating expenses were $242.0 million in 2004, an increase of 22% compared to $198.8 million in 2003, which was a 5% increase over 2002. The increase in 2004 was driven by two primary factors. First, asset-based trail compensation increased due to growth in account values. Asset-based trail commissions increased by $16.8 million to $65.6 million in 2004 compared to $48.8 in 2003. Trail commissions are paid to the Company’s producing firms and are based on the level of assets under management rather than on the new deposits made in that time period. Instead of paying a one-time amount at the point of sale, a smaller payment is made each year the business remains in force. In some cases, a combination of both types of compensation is paid. The second factor was increased expenses primarily related to advertising and promotion as well as employee compensation
and benefits. The increase in 2003 reflects the addition of NFN, growth in the number of contracts in force, increases in employee benefit, pension and insurance costs, all of which are partially offset by expense management efforts in response to the challenging equity markets and interest rate environments.
Interest spread income is comprised of net investment income, excluding capital charges, 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.
The increase in the ratio of pre-tax operating earnings to average account values of 5 basis points to 47 basis points in 2004 compared to 42 basis points in 2003 was primarily due to higher policy charges and interest spreads on average general account values and decreased variable annuity guaranteed benefit costs. Pre-tax operating earnings to average account values was 42 basis points and 51 basis points (excluding the accelerated DAC amortization) in 2003 and 2002, respectively. The declines reflect lower policy charges, higher policy benefits, and in 2003, lower interest spread margins.
The Retirement Plans segment is comprised of the Company’s private- and public-sector retirement plans business. This segment differs from the former Institutional Products segment because it no longer includes the results of the structured products and MTN businesses. The private sector includes IRC Section 401(k) business generated through fixed and variable annuities, NTC and The 401(k) Company. The public sector includes IRC Section 457 and Section 401(a) business in the form of fixed and variable annuities and administration-only business. Retirement Plans sales do not include large case retirement plan acquisitions and Nationwide employee and agent benefit plans. However, the statements of income data in the following table does reflect this business.
Pre-tax operating earnings increased 20% to $178.6 million in 2004 compared to $148.8 million in 2003. This increase primarily was due to growth in other income from NTC and administration-only products, partially offset by higher general operating expenses, increased commission expense and lower interest spread income. Pre-tax operating earnings increased 7% in 2003 compared to 2002 due to higher interest spread income and other income, partly offset by increased operating expenses and lower policy charges.
Asset fees increased 3% to $150.8 million in 2004 compared to $146.9 million in 2003. This increase was driven by 8% higher average separate account values compared to 2003, reflecting improved equity markets in 2004 and more than offsetting the shift in new business mix from group annuities to non-annuity products. Fluctuations in asset fees do not always vary with average separate account values due to periodic re-pricing of various products. Asset fees declined 3% in 2003 compared to 2002 due to a 4% decrease in average separate account values due to the shift in product mix from annuities to NTC and administration-only products, coupled with a less favorable equity market environment.
Interest spread income was $2.5 million, or 1%, lower in 2004 compared to 2003, which was $16.5 million, or 9%, higher than 2002. The decrease in 2004 primarily was due to spread compression in both the public sector and private sector businesses associated with lower prepayment penalty income on mortgage loans and bond call premiums and lower reinvestment rates on prepaying assets. The 2003 increase was driven by higher prepayment income and higher average general account values. The increase in average general account values was led by the acquisition of NFN and an increase in participant allocations to the fixed option of the Company’s retirement plan offerings.
Sales during 2004 increased 17% to $9.81 billion compared to $8.40 billion in 2003 and $7.42 billion in 2002. The increase in 2004 was driven by flows from three recently acquired large cases in public sector, coupled with acquisitions of larger than average cases in private sector during 2004. The 2003 sales exceeded prior year primarily due to the addition of NFN.
Pre-tax operating earnings increased 13% to $243.0 million in 2004 from $215.2 million in 2003, which increased 15% from $186.7 million in 2002. Excluding $6.8 million of accelerated DAC amortization in third quarter 2002, pre-tax operating earnings totaled $193.5 million in 2002. Improved results from investment life products, both individual and corporate-owned, drove the growth in 2004. Higher policy charges, combined with lower operating expenses and DAC amortization, pushed investment life 18% higher than a year ago. Strong earnings growth in 2003 was driven by the acquisition of NFN in 2002, which contributed $68.0 million in 2003 pre-tax operating earnings. A $5.2 million reduction in second quarter 2003 pre-tax operating earnings due to the surrender of a large COLI case partially offset the overall increase. In both 2003 and 2002, increased cost of insurance charges and fee income from TBG Financial were offset by higher policy benefits, operating expenses, and DAC and VOBA amortization.
Life benefits and policyholder dividends decreased 3% to $700.2 million in 2004, following a 37% increase in 2003. Favorable mortality in the fixed life insurance business was partially offset by unfavorable mortality in the individual investment life business. The decline in policyholder dividends on participating policies was due to a reduction in the dividend scale to reflect of the current lower interest rate environment. The increase in 2003 was due to growth in insurance in force, unfavorable mortality and the addition of NFN business.
Amortization of DAC and VOBA decreased $4.2 million, or 3%, in 2004 following an increase of $53.8 million, or 51%, in 2003. The implementation of DAC and VOBA model enhancements, which provide a more refined calculation and more timely reflections of observed trends in the underlying assumptions, reduced DAC amortization and VOBA amortization in the investment life business by $7.0 million and $5.0 million in 2004, respectively. However, DAC and VOBA amortization increased in the fixed life business, consistent with higher earnings and an expected decrease in future investment income. The 2003 increase primarily reflects the addition of VOBA amortization related to NFN business acquired and higher DAC amortization due to the surrender of a large COLI case. In addition, during 2003 mortality experience was more favorable than expected, and estimated gross profits on the in force variable business increased.
Other operating expenses were flat in 2004 compared to 2003. Other operating expenses were $257.8 million in 2003, up 39% from 2002, primarily due to the addition of operating expenses related to TBG Financial and NFN in 2003. Excluding TBG Financial and NFN, operating expenses increased 4% driven by higher employee benefit, pension and insurance costs.
Sales in 2004 increased 3% to $1.77 billion compared to $1.72 billion in 2003. Continued strength in sales of traditional/universal life insurance and COLI products drove the improvement. Traditional/universal life sales of $506.9 million increased 6% from 2003, driven by a re-tooled universal life insurance product portfolio and expanding distribution relationships in the non-affiliated distribution channels. COLI sales of $564.5 million increased 4% compared to a year ago. This increase was driven by higher renewal premium 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. Sales in 2003 increased 12% compared to $1.54 billion in 2002. Growth attributable to NFN was substantially offset as individual variable life sales were negatively impacted by sluggish equity markets, concern over the potential for adverse tax legislation and consumer preference for fixed products. COLI sales in 2003 declined 17% from the prior year due to the unfavorable environment for COLI and executive deferred compensation programs.
The Corporate and Other segment includes structured products business, the MTN program, net investment income not allocated to product segments, periodic net coupon settlements on non-qualifying derivatives, unallocated expenses, interest expense on debt, revenues and expenses of the Company’s non-insurance subsidiaries not reported in other segments, and realized gains and losses related to securitizations. This segment differs from the former Corporate segment as it now includes results from the structured products and MTN businesses, but no longer includes results from the advisory services program.
Pre-tax operating earnings in 2004 were flat compared to 2003. Higher interest spread income and other income from securitizations and structured products activity were offset by increases in general expenses, related to advertising and promotion and employee compensation and benefits. In addition, higher commissions during 2004 created an adverse impact on pre-tax operating earnings. Pre-tax operating earnings increased significantly in 2003 compared to 2002. The increase primarily was attributable to other income from structured products activity and higher interest spread income from income earned on the proceeds from the $200.0 million senior note offering completed in February 2003 and the $300.0 million senior note offering completed in June 2002, partially offset by an increase in commissions and general expenses.
The following table summarizes the Company’s capital structure as of December 31:
Long-term debt is comprised of the following: (1) three separate issuances of $300.0 million principal of senior notes and a single issuance of $200.0 million principal of senior notes, none of which are subject to any sinking fund payments; (2) a variable rate note payable; and (3) issuances of $100.0 million of junior subordinated debentures that are due March 1, 2037 and pay a distribution rate of 7.899%, and $200.0 million of junior subordinated debentures that are due October 31, 2028 and pay a distribution rate of 7.100%, each issued to unconsolidated subsidiary trusts.
The $300.0 million principal of 8.00% senior notes, due March 1, 2027, are redeemable, in whole or in part, at the option of NFS at any time on or after March 1, 2007 at scheduled redemption premiums through March 1, 2016, and, thereafter, at 100% of the principal amount thereof plus, in each case, accrued and unpaid interest. The $300.0 million principal of 6.25% senior notes, due November 15, 2011, were issued in November 2001 and are not redeemable prior to their maturity date. The $300.0 million principal of 5.90% senior notes, due July 1, 2012, issued in June 2002, and the $200.0 million principal of 5.625% senior notes due February 13, 2015, issued in February 2003, are redeemable, in whole or in part, at the option of NFS at any time or from time to time at a redemption price equal to the greater of: (i) 100% of the aggregate principal amount of the notes to be redeemed;
The 7.899% junior subordinated debentures are the sole assets of Nationwide Financial Services Capital Trust (Trust I) and are redeemable by NFS, in whole at any time or in part from time to time, at par plus an applicable make-whole premium. The capital securities have a liquidation value of $1,000 per security and must be redeemed by Trust I when the 7.899% junior subordinated debentures mature or are redeemed by NFS. The 7.10% junior subordinated debentures are the sole assets of Nationwide Financial Services Capital Trust II (Trust II) and became redeemable, in whole or in part, on or after October 19, 2003 at a redemption price equal to the principal amount to be redeemed plus any accrued and unpaid interest. The preferred securities have a liquidation value of $25 per security and must be redeemed by Trust II when the 7.10% junior subordinated debentures mature or are redeemed by NFS. The related capital and preferred securities are fully and unconditionally guaranteed by NFS. There are no sinking fund requirements related to the capital and preferred securities of subsidiary trusts.
The ability of NLICA to pay dividends to NFS is subject to regulation under Pennsylvania insurance law. Under Pennsylvania insurance laws, unless the Pennsylvania Insurance Department (PID) either approves or fails to disapprove payment within 30 days after being notified, NLICA may not pay any cash dividends or other non-stock distributions to NFS during any 12-month period if the total payments exceed the greater of: (i) 10% of statutory-basis policyholders’ surplus as of the prior December 31; or (ii) the statutory-basis net income of the insurer for the prior year. In connection with the acquisition of NLICA, the PID ordered that no dividends could
be paid out of NLICA before October 1, 2005 without prior approval. The statutory capital and surplus of NLICA as of December 31, 2004 was $576.5 million, while statutory net income for the year ended December 31, 2004 was $126.4 million. NLICA sought and received permission from the PID to pay $50.0 million of dividends to NFS during 2004. Effective October 1, 2005, based on statutory financial results as of and for the year ended December 31, 2004, and based on dividends paid through March 1, 2005, NLICA will be able to pay dividends to NFS totaling $76.4 million without obtaining prior approval.
Also available as a source of funds to the Company is a $1.00 billion revolving credit facility entered into by NFS, NLIC and NMIC with a group of national financial institutions. The facility provides for several and not joint liability with respect to any amount drawn by any party. The facility provides covenants, including, but not limited to, requirements that the Company maintain consolidated tangible net worth, as defined, in excess of $2.29 billion and NLIC maintain statutory surplus in excess of $1.56 billion. The Company had no amounts outstanding under this agreement as of December 31, 2004. NLIC also has an $800.0 million commercial paper program and is required to maintain an available credit facility equal to 50% of any amounts outstanding under the commercial paper program. Therefore, borrowing capacity under the $1.00 billion revolving credit facility is reduced by 50% of any amounts outstanding under the commercial paper program. NLIC had $134.7 million in commercial paper outstanding as of December 31, 2004.
The Company has an available financing capacity of $1.30 billion under a shelf registration statement dated February 4, 2003. Under the shelf registration statement, the Company can issue many 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. The Company may also, in conjunction with owned trusts, issue trust preferred securities guaranteed by NFS.
Also, as a result of consolidating certain variable interest entities where the Company was identified as the primary beneficiary, the Company reported $80.3 million of short-term debt as of December 31, 2004 related to borrowings under a securities lending agreement. As of December 31, 2004, the Company has not provided any guarantees on such borrowings, either directly or indirectly.
As described in Note 20 to the consolidated financial statements included in the F pages of this report, the Company acquired NFN effective October 1, 2002. The aggregate purchase price was $1.13 billion, which was funded through a combination of the issuance of 31.9 million shares of NFS Class A common stock valued at $843.2 million, the payment of $235.1 million in cash and the issuance of $48.0 million of policy credits. Of the total consideration, $62.4 million was funded by Provident Mutual Insurance Company (the name of the insurer before it was acquired by the Company), and the remainder was funded with existing resources, including funds raised by the Company in the form of senior debt issued in June 2002. The shares of the Class A common stock issued in this transaction were valued using an average stock price covering the period extending two days before and after the date the consideration elections were closed.
The Company has sold $469.3 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 third party investors ranging from 4.60% to 5.25% over periods ending between 2004 and 2021 and as
of December 31, 2004 held guarantee reserves totaling $4.7 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 $1.27 billion. The Company does not anticipate making any payments related to the guarantees.
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 Investors Service, Inc. (Moody’s) and Standard & Poor’s Ratings Services assign the same ratings to the notes and the insurance financial strength of NLIC.
Separate account assets consist primarily of deposits from the Company’s variable annuity and variable life insurance business. Most separate account assets are invested in various mutual funds. All of the investment performance in the Company’s separate account assets is passed through to the Company’s customers. See Note 7 to the consolidated financial statements included in the F pages of this report for further information regarding the Company’s investments.
The following table summarizes the Company’s consolidated general account investments by asset category as of December 31:
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, 2004:
The following table summarizes by time the gross unrealized losses on securities available-for-sale in an unrealized loss position as of the dates indicated:
The Company’s general account mortgage-backed securities (MBS) portfolio is comprised of residential MBS investments. As of December 31, 2004, MBS investments totaled $5.52 billion (18%) of the carrying value of the Company’s general account fixed maturity securities available-for-sale.
The following table summarizes the distribution by investment type of the Company’s general account MBS portfolio as of December 31:
The consolidated financial statements of Nationwide Financial Services, Inc. and subsidiaries are indexed in Part IV, Item 15 - Exhibits, Financial Statement Schedules and included in the F pages of this report.