Pursuant to an arrangement between NMIC and certain of its subsidiaries, during 2005 the Company leased on average approximately 905,000 square feet of office space in the three building home office complex and in other offices in central Ohio. In addition, during 2005 NMIC announced plans to build and occupy a six-story, 130,000 square foot building in Columbus, Ohio. This building is still under construction. The Company expects to lease some of this space from NMIC. The Company believes that its present and planned facilities are adequate for the anticipated needs of the Company.
(vii) 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 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 narrative analysis of the results of operations of the Company for the three years ended December 31, 2006. This discussion should be read in conjunction with the audited consolidated financial statements and related notes beginning on page of this report.
Management makes decisions concerning the sale of invested assets based on a variety of market, business, tax and other factors. All realized gains and losses generated by these sales, charges related to other-than-temporary impairments of available-for-sale securities and other investments, and changes in valuation allowances on mortgage loans on real estate are reported in realized gains and losses on investments, hedging instruments and hedged items. Also included are changes in the fair values of derivatives qualifying as fair value hedges and the related changes in the fair values of hedged items; the ineffective, or excluded, portion of cash flow hedges; changes in the fair values of derivatives that do not qualify for hedge accounting treatment; and periodic net coupon settlements on non-qualifying derivatives.
The Company’s primary expenses include interest credited to policyholder account values, life insurance and annuity benefits, amortization of DAC and general business operating expenses. Interest credited principally relates to individual and group fixed annuities, funding agreements backing the Company’s MTN program and certain life insurance products. Life insurance and annuity benefits include policyholder benefits in excess of policyholder account values for universal life and individual deferred annuities and net claims and provisions for future policy benefits for traditional life insurance products and immediate annuities.
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 lapse rate and distribution of lapses affects surrender charges and impacts DAC amortization assumptions when lapse experience changes significantly.
Under the Company’s accounting policy for equity securities and debt securities that can be contractually prepaid or otherwise settled in a way that may limit the Company’s ability to fully recover cost, an impairment is deemed to be other-than-temporary unless the Company has both the ability and intent to hold the investment until the security’s forecasted recovery and evidence exists indicating that recovery will occur in a reasonable period of time. Also, for such debt securities management estimates cash flows over the life of purchased beneficial interests in securitized financial assets. If management estimates that the fair value of its beneficial interest is not greater than or equal to its carrying value based on current information and events, and if there has been an adverse change in estimated cash flows since the last revised estimate (considering both timing and amount), then the Company recognizes an other-than-temporary impairment and writes down the purchased beneficial interest to fair value.
The process of calculating reserve amounts for a life insurance organization involves the use of a number of assumptions, including those related to persistency, mortality, morbidity and interest rates.
The Company’s liability for funding agreements to an unrelated third party trust equals the balance that accrues to the benefit of the contractholder, including interest credited. The funding agreements constitute insurance obligations and are considered annuity contracts under Ohio insurance laws.
The Company’s federal income tax returns are routinely audited by the Internal Revenue Service (IRS). 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.
The increase in net income primarily was driven by a tax benefit of $110.9 million recorded during the second quarter of 2006 compared to tax benefits and recoverables totaling $48.2 million recorded during the third quarter of 2005. In addition, the Company recorded higher income from continuing operations before federal income tax expense primarily due to increases in policy charges and traditional life insurance and immediate annuity premiums. Higher life insurance and annuity benefits and lower interest spread income partially offset the overall increase in income from continuing operations before federal income tax expense.
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 reduction (DRD).
In July 2006, the Company reached substantial agreement with the IRS on all open issues for tax years 2000-2002, including issues related to the DRD. Accordingly, the Company revised its estimate of amounts that may be due in connection with certain tax positions, including the DRD, for all open tax years. As a result of the revised estimate, $110.9 million of tax reserves were released into earnings during the second quarter of 2006.
During the third quarter of 2006, the Company recorded $7.8 million of net federal income tax expense adjustments primarily related to differences between the 2005 estimated tax liability and the amounts reported on the Company’s 2005 tax returns. 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 tax years (2000 - 2005) that were open at that time. Also in the third quarter of 2005, the Company recorded $5.6 million of net benefit adjustments primarily related to differences between the 2004 estimated tax liability and the amounts reported on the Company’s 2004 tax returns. Because of the impact of this activity, along with the 2006 reserve release described above, the effective tax rates in 2006 and 2005 are not comparable.
Excluding additional federal income tax benefits recorded during the third and fourth quarters of 2005 as discussed below, the increase in net income primarily was driven by additional interest spread income; the recognition of net realized gains on investments, hedging instruments and hedged items in 2005 compared to net losses in 2004; lower other operating expenses; and higher assets fees. Increased amortization of DAC partially offset the overall improvement.
The decline in other operating expenses primarily was due to lower general sales and employee benefit costs.
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 tax years (2000 - 2005) that were open at that time. In addition, the Company recorded $5.6 million of net benefit adjustments primarily related to differences between the 2004 estimated tax liability and the amounts reported on the Company’s 2004 tax returns. 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.
Increased sales in the financial institutions, wirehouse and regional firms, and independent broker/dealers channels primarily were generated from strong variable annuity sales, specifically products offering the L.INC and CPPLI riders as mentioned above.
Sales generated by financial institutions declined primarily due to both planned reductions and intense competition in fixed annuity sales and the shift of pension business to the trust platform described above. Additionally, this channel has been impacted by wholesaler turnover.
The decrease in pre-tax operating earnings was driven by higher annuity benefits and claims, lower interest spread income, increased amortization of DAC and higher other operating expenses. Increased asset fees and premiums on income products partially offset the overall decrease.
Interest spread income decreased as interest spread margins declined during 2006 to 198 basis points compared to 200 basis points in 2005. Lower general account assets caused by fixed annuity net outflows drove $15.8 million of the total reduction in interest spread income. In addition, 2006 included only 15 basis points, or $20.3 million, of income from mortgage loan prepayment penalties and bond call premiums compared to 22 basis points, or $31.4 million, in 2005. For 2007, 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.
Approximately $31 million of the increase in asset fees was due to higher average separate account values. In addition, the average variable asset fee rate increased to 1.37% from 1.32% in the comparable prior year period as new business sold with living benefit riders and corresponding higher fee rates influenced the overall average rate. This factor contributed approximately $20 million of the overall increase.
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.
Higher amortization of DAC in 2005 compared to 2004 primarily was due to increased variable annuity gross profits driven by favorable market experience and business growth, which resulted in a $34.7 million true-up of amortization. In addition, increased fixed annuity gross profits, which were driven by higher income from mortgage loan prepayments and bond call premiums as well as increased surrender fees, resulted in a $5.0 million true-up of amortization. Unlocking within fixed annuities resulted in an additional $13.3 million of increased amortization in 2005 compared to 2004.
Amortization of DAC was lower in 2006 primarily due to unlocking in 2005 related to mutual fund revenue assumptions that resulted in higher amortization expense in 2005 compared to favorable true-ups in 2006.
Interest spread margins decreased to 188 basis points in 2005 compared to 196 basis points in 2004. Included in the current year were 20 basis points, or $21.2 million, of income from mortgage loan prepayment penalties and bond call premiums compared to 18 basis points, or $17.7 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 were below the portfolio rate. Overall interest spread income improved due to growth in general account values, offset in part by the lower interest margins described above.
Higher life insurance benefits were due to adverse mortality in both the fixed and investment life businesses, partially offset by a $3.3 million waiver of premium reserve release in fixed life during the first quarter of 2006. The overall increase in total policyholder benefits was partially offset by lower policyholder dividends on participating policies, primarily driven by a lower current dividend scale.
Sales improved primarily due to higher COLI sales, which were driven by several new large cases that closed during the year and a more favorable legislative environment.
Excluding periodic net coupon settlements on non-qualifying derivatives and net realized gains and losses related to securitizations.
Lower other operating expenses were driven by lower legal expenses in 2006 due to favorable developments on several cases.
Interest spread income declined primarily due to lower margins in the MTN program.
The following table summarizes net realized gains on investments, hedging instruments and hedged items from continuing operations by source for the years ended December 31:
Interest spread income rose due to increased invested asset levels as a result of higher excess capital and surplus retained in this segment and improved earnings from common stock and real estate investments. Lower margins on the MTN program offset some of these improvements.
The decline in other expenses primarily was due to a $7.3 million reclassification of activity related to variable interest entities (VIEs) between other expenses and other income.
The following table summarizes net realized gains (losses) on investments, hedging instruments and hedged items from continuing operations by source for the years ended December 31:
No other issuer had aggregate losses on sales and write-downs greater than 2.0% of the Company’s total gross losses on sales and write-downs on fixed maturity and equity securities.
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, 2006.
Contractual provisions exist which could adjust the amount and/or timing of those obligations reported. Key assumptions related to payments due by period include customer lapse and withdrawal rates (including timing of death), exchanges to and from the fixed and separate accounts of the variable annuities, claim experience with respect to guarantees, and future interest crediting level. Assumptions for future interest crediting levels have been made based on processes consistent with the Company’s past practices, which is at the discretion of the Company, subject to guaranteed minimum crediting rates in many cases and/or subject to contractually obligated increases for specified periods of time. Many of the contracts with potentially accelerated timing of payments are subject to surrender charges which are generally calculated as a percentage of deposits made and are assessed at declining rates during the first seven years after a deposit is made. Amounts disclosed herein include an estimate of those accelerated payments, net of applicable surrender charges. See Note 2(g) to the audited consolidated financial statements included in the F pages of this report for a description of the Company’s method for establishing life and annuity reserves in accordance with GAAP. Health reserves are immaterial and are reflected in the less than one-year column.
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, 2006.