Pursuant to an arrangement between NMIC and certain of its subsidiaries, during 2009 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. The Company believes that its present and planned facilities are adequate for the anticipated needs of the Company.
(i) the potential impact on the Company’s reported net income (loss) and related disclosures that could result from the adoption of certain accounting and/or financial reporting standards issued by the Financial Accounting Standards Board, the United States Securities and Exchange Commission (SEC) or other standard-setting bodies;
(xv) adverse litigation results and/or resolution of litigation and/or arbitration, investigation and/or inquiry results that could result in monetary damages or impact the manner in which the Company conducts its operations;
Following is management’s narrative analysis of the results of operations of the Company for the three years ended December 31, 2009. This discussion should be read in conjunction with the audited consolidated financial statements and related notes beginning on page of this report.
See Part I, Item 1 - Business - Overview for a description of the Company and its ownership structure.
The following table summarizes pre-tax operating earnings (loss) by segment for the years ended December 31:
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premium loads on universal life insurance products; and surrender fees, which are charged as a percentage of premiums withdrawn during a specified period for annuity and certain life insurance contracts.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 medium-term notes (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 and distribution services.
The Company categorized its financial instruments based on the priority of the inputs to the valuation technique. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure fair value fall within different levels of the hierarchy, the category level is based on the lowest priority level input that is significant to the fair value measurement of the instrument in its entirety.
As of December 31, 2009 and 2008, the Company had investments in markets that it considered inactive with an amortized cost of $3.18 billion and $4.78 billion, respectively, and an estimated fair value of $2.42 billion and $3.49 billion, respectively, which represents 10% and 16% of the estimated fair value of all fixed maturity securities available-for-sale as of December 31, 2009 and 2008, respectively. Of these investments in markets that are considered inactive, 80% were priced using a weighting of internal pricing models and independent pricing services, 12% were valued with the assistance of independent pricing services, and 8% were priced using a weighting of broker quotes and internal pricing models to determine the estimated fair values as of December 31, 2009, in comparison to 0%, 94%, and 6%, respectively, as of December 31, 2008.
As of December 31, 2009 and 2008, the Company had pledged fixed maturity securities with a fair value of $55.6 million and $24.5 million, respectively, as collateral to various derivative counterparties.
Investment and universal life insurance products. The Company has deferred certain costs of acquiring investment and universal life insurance products business, principally commissions, certain expenses of the policy issue and underwriting department, and certain variable sales expenses that relate to and vary with the production of new and renewal business. In addition, the Company defers sales inducements, such as interest credit bonuses and jumbo deposit bonuses. Investment products primarily consist of individual and group variable and fixed deferred annuities in the Individual Investments and Retirement Plans segments. Universal life insurance products include universal life insurance, variable universal life insurance, COLI, BOLI and other interest-sensitive life insurance policies in the Individual Protection segment. DAC is subject to recoverability testing in the year of policy issuance and loss recognition testing at the end of each reporting period.
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.
Valuation of Investments, Investment Income, Realized Gains and Losses and Other-than-temporary Impairment Evaluations
In assessing corporate debt securities for other-than-temporary impairment, the Company evaluates the ability of the issuer to meet its debt obligations, the value of the company or specific collateral securing the debt position , the Company’s intent to sell the security and whether it is more likely than not it will be required to sell the security before the recovery of its amortized cost basis. A similar analysis is performed to evaluate U.S. Treasury securities and obligations of U.S. Government corporations, U.S. Government agencies, obligations of states and political subdivisions, and debt securities issued by foreign governments.
The Company’s practice is to disclose as part of the separate component of accumulated other comprehensive income both the non-credit portion of the other-than-temporary impairment recognized in other comprehensive income and any subsequent changes in the fair value of those debt securities.
The Company uses derivative instruments in efforts to manage exposures and mitigate risks associated with interest rates, equities, foreign currency and credit. These derivative instruments primarily include interest rate swaps, futures contracts, credit default swaps, cross-currency swaps and other traditional swap agreements. Certain features embedded in the Company’s investment portfolio, equity-indexed life and annuity contracts and certain variable life and annuity contracts are derivatives requiring separate accounting under the provisions of FASB ASC 815-15 Embedded Derivatives. All derivative instruments are carried at fair value and are reflected as an asset or liability.
See Note 2(d) and Note 5 of the audited consolidated financial statements included in the F pages of this report for additional information regarding the Company’s use of derivatives instruments to manage interest rate and equity market risk.
Other-than-temporary impairment losses decreased $556.1 million during 2009, primarily due to lower fixed maturity and equity security impairments driven by stabilizing market conditions and changes in accounting literature pertaining to other-than-temporary impairments of investment securities.
Lower losses from hedge fund and private equity investments of $80.4 million and higher interest spread income for the Retirement Plans segment $31.6 million drove the increase in interest spread income during 2009. The overall increase was partially offset by lower MTN interest spread income of $41.9 million.
Lower other operating expenses primarily were driven by expense saving initiatives and a decline in retail asset management operating expenses attributable to a decrease in average customer funds managed and administered during 2009. Additionally, the Company exited its NFN professional consulting group sales channel in 2008, which resulted in a pre-tax charge of $24.7 million during 2008.
Net realized losses increased primarily due to a $474.0 million increase in losses on living benefit embedded derivatives, net of economic hedging activity and $49.6 million in losses in its structured products business related to impairments on the underlying mortgages and mortgage loan commitments. The overall decline was offset by higher realized gains of $215.8 million on derivatives associated with the Company’s economic hedging program related to contracts with death benefit guarantees.
Higher amortization of DAC was due to several factors. First, the DAC unlocks in 2007 lowered amortization of DAC by $235.8 million in 2007. Next, the DAC unlocks in 2008 increased amortization of DAC by $434.2 million in 2008. However, the Company modified the features of its L.inc product within the Individual Investments segment during 2007. This modification required the Company to extinguish existing DAC and other balances related to L.inc, resulting in a $124.0 million increase in amortization of DAC and increased annuity benefits of $11.0 million in 2007. In addition, net realized losses on embedded derivatives in annuity products offering living benefits decreased amortization of DAC by $93.1 million in 2008. Finally, lower gross profits in 2008 and a lower rate of DAC amortization due to the impact of 2007 unlocking further offset the increases described above by approximately $141.4 million.
New and renewal production premiums and deposits, 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 new and renewal production premiums and deposits excludes funding agreements issued under the 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 recorded pre-tax operating earnings during the year ended December 31, 2009 compared to a loss in 2008 due to lower amortization of DAC, lower benefits and claims, higher premiums and higher interest spread income, partially offset by losses in other income and lower asset fees.
Lower amortization of DAC primarily was driven by DAC unlocks in 2009, which lowered amortization of DAC by $191.9 million in the current year. Additionally, DAC unlocks in 2008, which increased amortization in the prior year by $429.1 million, and lower variable annuity gross profits in the current year contributed to the overall decline in amortization. Refer to Part II, Item 7 - MD&A - Critical Accounting Policies and Recently Issued Accounting Standards - Deferred Policy Acquisition Costs for Investment and Universal Life Insurance Products for a description of the current and prior year DAC unlocks.
Other income resulted in a net loss due to realized losses of $281.2 million on derivatives associated with the Company’s economic hedging program for GMDB contracts.
See Note 11 to the audited consolidated financial statements included in the F pages of this report for further discussion of guarantee types offered on non-traditional variable annuity contacts offered by the Company, which are consistent with the fixed annuity descriptions above.
The following table summarizes selected financial data for the Company’s Individual Investments segment for the years ended December 31:
Interest spread income declined primarily due to lower general account assets caused by variable and fixed annuity net outflows (average account values fell 10%), which reduced interest spread income by approximately $17.7 million. In addition, interest spread margins declined to 154 basis points in 2008 compared to 193 basis points in 2007, reducing interest spread income by approximately $16.0 million. The 2008 margins included a $13.6 million decrease in income from mortgage loan prepayments and bond call premiums compared to 2007, which contributed 11 basis points to the margin decline discussed above.
Public sector sales drove the overall increase due to increased contributions into the Company’s fixed return products. Private sector sales declined primarily due to the shift in pension business to NFS.
Amortization of DAC increased due to the DAC unlock in the second quarter of 2009, which increased amortization of DAC by $43.9 million in 2009, compared to the DAC unlock in the second quarter of 2008, which increased amortization by $2.8 million. Refer to Part II, Item 7 - MD&A - Critical Accounting Policies and Recently Issued Accounting Standards - Deferred Policy Acquisition Costs for Investment and Universal Life Insurance Products for a description of the 2009 and 2008 DAC unlocks. The increase was partially offset by lower amortization due to lower gross profits during 2009.
Other operating expenses decreased due to the Company exiting its NFN professional consulting group sales channel in 2008 and selling arrangement changes for the NFN independent agency force. The Individual Protection segment recorded a pre-tax charge of $24.7 million during the fourth quarter of 2008. Lower mutual fund expense reimbursements driven by lower average separate account values partially offset the decrease.
Lower sales of COLI and variable life insurance products decreased new and renewal production premiums and deposits in the current year. The decline was attributable to the economic slowdown, which has reduced corporations’ and individuals’ demand for life insurance products. Additionally, corporations’ earnings and the corresponding deferred compensation plan contributions declined from 2008, leading to lower first year production and renewals. The launch of a new single premium universal life insurance product boosted sales of universal life insurance products by $79.3 million during 2009.
Lower amortization of VOBA and other intangible assets primarily was due to the unlocking during the second quarter of 2008 of the long-term lapse rate assumption and higher estimated gross profits in the investment life insurance business. These factors lowered amortization of VOBA by $7.5 million in 2008. In addition, unlocking of assumptions in the second quarter of 2007 increased VOBA amortization by $5.1 million.
The Company recorded a lower pre-tax operating loss during 2009 compared to 2008 primarily due to higher interest spread income and higher other income.
Non-operating other-than-temporary impairments decreased $556.1 million during 2009, primarily due to lower fixed maturity and equity security impairments driven by volatile market conditions and changes in accounting literature pertaining to other-than-temporary impairments of investment securities.
The following table summarizes net realized investment gains (losses) from continuing operations by source for the years ended December 31:
Includes losses of $171.8 million and gains of $109.4 million on derivatives associated with death benefit contracts for the years ended December 31, 2009 and 2008, respectively.
The following tables summarize other-than-temporary impairment losses for the years ended December 31:
Declines in the creditworthiness of the issuer of hybrid securities with both debt and equity-like features requires the use of the equity model in analyzing the security for other-than-temporary impairment. For the year ended December 31, 2009, the Company recognized $167.6 million in other-than-temporary impairments related to these securities compared to $89.5 million for the year ended December 31, 2008.
The decrease in interest spread income primarily was driven by lower income from hedge fund and private equity investments of $94.5 million. Lower income from mortgage loan prepayments and bond call premiums of $12.5 million, reduced earnings from the MTN program of $9.0 million primarily due to lower prepayment income, and approximately a 10% decline in average asset levels further contributed to the shortfall.
Other-than-temporary investment losses were driven by a $1.01 billion increase in impairment charges compared to the prior year due to challenging conditions in the credit markets.
The increase in losses on living benefit embedded derivatives, net of economic hedging activity, gave rise to the increase in the adjustment to amortization related to net realized investment gains and losses.
The following table summarizes net realized investment losses from continuing operations by source for the years ended December 31:
Includes gains of $109.4 million on derivatives associated with death benefit contracts for the years ended December 31, 2008. There were no material gains or losses during 2007.
Holdings represent amortized cost of fixed maturity securities and cost of equity securities as of the date indicated for issuer and issuer sponsored vehicles.
Contractual provisions exist that could increase those obligations presented. The process for determining future interest crediting rates as described in note 5 above was used to develop the estimates of payments due by period.
Since the timing of the return of collateral is uncertain, these obligations have been reflected in payments due in less than one year.