The information included herein contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 with respect to the results of operations and businesses of Nationwide Financial Services, Inc. and subsidiaries (NFS, or collectively, the Company). Whenever used in this report, words such as “anticipate,” “estimate,” “expect,” “intend,” “plan,” “believe,” “project,” “target” and other words of similar meaning are intended to identify such forward-looking statements. These forward-looking statements involve certain risks and uncertainties. Factors that may cause actual results to differ materially from those contemplated or projected, forecast, estimated or budgeted in such forward-looking statements include, among others, the following possibilities:
(i) change in Nationwide Corporation’s control of the Company through its beneficial ownership of 94.4% of the combined voting power of all the outstanding common stock and 62.9% of the economic interest in the Company;
(ii) NFS’ primary reliance, as a holding company, on dividends from its subsidiaries to meet debt service obligations and the applicable regulatory restrictions on the ability of NFS’ subsidiaries to pay such dividends;
(vi) heightened competition, including specifically the intensification of price competition, the entry of new competitors and the development of new products by new and existing competitors;
(x) changes in interest rates and the equity markets causing a reduction of investment income and/or asset fees, an acceleration of the amortization of DAC and/or value of business acquired (VOBA), a reduction in separate account assets or a reduction in the demand for the Company’s products;
(xviii) 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, 2006. This discussion should be read in conjunction with the audited consolidated financial statements and related notes beginning on page of this report.
In particular, the Company’s profitability is driven by fee income on separate account products, general and separate account asset levels, and management’s ability to manage interest spread income. While asset fees are largely at guaranteed annual rates, amounts earned vary directly with the underlying performance of the separate accounts. Interest spread income is comprised of net investment income, excluding any applicable allocated charges for invested capital, 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.
During December 2006, the Company announced an agreement to sell The 401(k) Company for $115.0 million in cash, subject to a post-closing adjustment. The Company expects to record a gain on this transaction when it is finalized during the first quarter of 2007. During the year ended December 31, 2005, management decided to discontinue the following operations: (1) Cap Pro, a majority-owned subsidiary of NFS that provided broker/dealer, registered investment advisor and insurance agency services to producers of certain certified public accounting firms; (2) NFSB, a wholly-owned subsidiary of NFS that sold variable and fixed annuity products in offshore markets; and (3) TBG Lynch, a wholly-owned subsidiary of TBG Financial that distributed BOLI products. The results of operations of The 401(k) Company for 2006 and all prior years and for Cap Pro, NFSB and TBG Lynch for 2005 and all prior years are reflected as discontinued operations. However, the “Other Data” sections of the tables in the subsequent segment portions of MD&A include amounts applicable to the operations that were discontinued in 2006 and 2005. See Note 2(n) to the audited consolidated financial statements included in the F pages of this report for additional information on discontinued operations.
The most significant assumptions that are involved in the estimation of future gross profits include future net separate account performance, surrender/lapse rates, interest margins and mortality. The Company’s long-term assumption for net separate account performance is currently 8% growth per year. If actual net separate account performance varies from the 8% assumption, the Company assumes different performance levels over the next three years such that the mean return equals the long-term assumption. This process is referred to as a reversion to the mean. The assumed net separate account return assumptions used in the DAC models are 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 returns to 0-15% during the three-year reversion period.
Significant changes in the factors management 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.
The Company calculates its liability for future policy benefits and claims for investment products in the accumulation phase and universal life and variable universal life insurance policies as the policy account balance, which represents participants’ net premiums and deposits plus investment performance and interest credited less applicable contract charges.
The increase in net income primarily was driven by a tax benefit of $114.2 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, other income, and traditional life insurance and immediate annuity premiums. The comparison to the prior year also benefited from debt extinguishment costs incurred in 2005. Higher other operating expenses and life insurance and annuity benefits, combined with lower interest spread income, partially offset the overall increase in income from continuing operations before federal income tax expense.
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).
During the third quarter of 2006, the Company recorded $8.3 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.
Most of the increase in other operating expenses was attributable to the Retirement Plans segment due to increased trail commissions from higher average variable assets and investments in technology, sales processes and infrastructure.
Higher life insurance and annuity benefits primarily occurred within the Individual Investments segment due to increased immediate annuity benefit reserves, which were driven by growth in sales relative to a year ago and an increasing proportion of business with living benefit features. This increase is consistent with the corresponding increase in immediate annuity premiums and asset fees described above.
Interest spread income decreased primarily within the Individual Investments segment due to a decline in general account assets caused by fixed annuity net outflows and lower income from mortgage loan prepayment penalties and bond call premiums.
Excluding additional federal income tax benefits recorded during the third and fourth quarters of 2005 as discussed below and the impact of discontinued operations described previously, the increase in net income primarily was driven by higher interest spread income and other income; the recognition of net realized gains on investments, hedging instruments and hedged items in 2005 compared to net losses in 2004; and increased asset fees. Higher amortization of DAC, increased other benefits and claims and debt extinguishment costs partially offset the overall improvement.
The increase in interest spread income was driven by the Corporate and Other and Individual Investments segments. Within Corporate and Other, higher interest spread income was due to increased invested asset levels primarily as a result of higher excess capital and surplus retained in the Corporate and Other segment and improved earnings from common stock and real estate investments. The increase in interest spread income within the Individual Investments segment primarily resulted from a higher level of invested assets and lower crediting rates.
The increase in total sales primarily was driven by higher variable annuity sales in the Individual Investments segment as a result of the strong performance of the recently introduced L.INC and CPPLI product riders. Also contributing to the overall increase were improved private sector sales in the Retirement Plans segment, led by trust products and The 401(k) Company, and higher COLI sales in the Individual Protection segment from the addition of a large case during 2006.
Higher sales in the independent broker/dealers, financial institutions, and wirehouse and regional firms channels primarily were due to increased variable annuity sales, specifically products offering the L.INC and CPPLI riders as mentioned above.
Sales generated by The 401(k) Company continued to grow as a result of larger annual employer discretionary contributions compared to the prior year and the addition of several large plans during 2006.
Interest spread income declined even though interest spread margins widened during 2006 to 198 basis points compared to 192 basis points in 2005. Lower general account assets caused by fixed annuity net outflows drove a $16.0 million of the total reduction in interest spread income. In addition, 2006 included only 15 basis points, or $21.0 million, of income from mortgage loan prepayment penalties and bond call premiums compared to 20 basis points, or $33.0 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.
Other operating expenses increased primarily due to higher sales incentives and employee compensation and benefits. In addition, in 2006 the Company began expensing at fair value the costs resulting from share-based payment transactions in accordance with SFAS 123R, resulting in $3.7 million in expense for this segment.
Asset fees rose due to both a higher average asset fee rate charged and higher average separate account values, representing approximately $28 million and $22 million, respectively, of the overall increase. The average variable asset fee rate increased to 1.37% from 1.30% in the prior year as new business sold with living benefit riders and corresponding higher fee rates influenced the overall average rate.
The increase in premiums on income products was due to higher interest rates relative to a year ago, which created a favorable environment for immediate annuity product sales. The Federal Funds rate was 5.25% at December 31, 2006 compared to 4.25% at December 31, 2005.
Asset fees rose due to both higher average separate account values and a higher average asset fee rate charged, representing approximately $18 million and $8 million, respectively, of the overall increase. The increase in average separate account values primarily was due to the general upward trend in the equity and fixed income markets offset in part by withdrawals that exceeded new deposits. The average variable asset fee rate increased from 1.27% to 1.30% as new business sold with living benefit riders influenced the overall average rate.
Interest spread margins widened during 2005 to 192 basis points compared to 178 basis points in 2004. Included in 2005 were 20 basis points, or $33.0 million, of income from mortgage loan prepayment penalties and bond call premiums compared to 12 basis points, or $19.5 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 $34.9 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.
The increase in pre-tax operating earnings primarily was driven by higher other income and administrative fees and lower amortization of DAC, partially offset by higher other operating expenses.
The increase in other income, which includes administrative fees from non-insurance retirement and deferred compensation plans and asset-based fees from the NTC small-plan 401(k) platform, primarily was driven by higher other asset fees and mutual fund revenue of $34.3 million and $19.8 million, respectively, resulting from higher average variable assets.
The increase in administrative fees primarily was due to the surrender of a group fixed annuity contract, which resulted in an $18.6 million policy adjustment in the second quarter of 2006. In addition, the surrender of a group retirement plan in the third quarter of 2006 resulted in the recognition of $5.1 million of previously deferred revenue and $3.5 million of related VOBA amortization.
The increase in other operating expenses reflects higher trail commissions of $18.6 million from increased average variable assets and higher asset-based variable expenses. Trail commissions represent compensation paid to the Company’s producing firms that is based on the level of assets under management rather than new deposits made in a given time period. Instead of paying a one-time amount at the point of sale, a smaller payment is made each period that the business remains in force. In some cases, a combination of both types of compensation is paid. In addition, the current year included $7.1 million of amortization related to an internally developed software application that did not exist in the same period a year ago.
Interest spread margins declined to 181 basis points in 2006 compared to 190 basis points for 2005. Included in 2006 were 9 basis points, or $9.9 million, of income from mortgage loan prepayment penalties and bond call premiums compared to 20 basis points, or $22.1 million, in 2005. For 2007, the Company expects interest spread margins to continue to remain relatively stable in this segment and projects full year spreads of 180 to 185 basis points, including a nominal level of prepayment activity.
Private sector sales rose due to sales generated by The 401(k) Company as a result of larger annual employer discretionary contributions compared to the prior year and the addition of several large plans during 2006.
Public sector sales increased due to increased flows from existing cases and higher rates of plan transfers, especially IAFF cases. These increases were partially offset by the fixed annuity contract withdrawal mentioned previously.
Higher other operating expenses reflects a $17.1 million increase in trail commissions from increased average variable assets, $4.8 million higher deposit commissions associated with business growth and inclusion of $4.2 million of expenses related to the newly acquired RIA business early in 2005.
Interest spread margins declined to 190 basis points in 2005 compared to 198 basis points for 2004. Included in 2005 were 20 basis points, or $22.1 million, of income from mortgage loan prepayment penalties and bond call premiums compared to 18 basis points, or $17.9 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.
Private sector sales increases were driven by additional production through the independent broker/dealers and financial institutions channels and growth at The 401(k) Company primarily due to flows associated with the addition of four large plans during the fourth quarter of 2004.
The increase in pre-tax operating earnings primarily was driven by decreased amortization of DAC, lower policyholder dividends on participating policies and increased cost of insurance charges. Higher life insurance benefits, lower net investment income and lower administrative fees partially offset the overall increase.
Despite the slight growth in fixed account assets, net investment income declined primarily due to a $7.0 million decrease in mortgage loan prepayment and bond call premium income compared to the prior year.
Administrative fees decreased primarily due to a change in business mix in the current year.
Higher pre-tax operating earnings were driven by lower other operating expenses and amortization of DAC and higher cost of insurance charges. A decline in life insurance premiums and increased life insurance benefits partially offset the overall increase.
The decrease in amortization of DAC resulted from lower amortization in the universal life business primarily related to mortality experience.
Other income and other expenses declined due to a $7.3 million reclassification of activity related to variable interest entities (VIEs) between other expenses and other income. In addition, other income was impacted by a decrease in the number of structured products transactions as margins on these deals compressed.
The Company recorded net realized gains on investments, hedging instruments and hedged items during 2005 compared to net realized losses in 2004 primarily due to a significant decline in impairment charges driven by a generally improved credit environment.
NFS is a holding company whose principal assets are the common stock of NLIC and NLICA. The principal sources of funds for NFS to pay interest, dividends and operating expenses are existing cash and investments and dividends from NLIC, NLICA and other subsidiaries. See Part I, Item 1 - Business-Regulation-Regulation of Dividends and Other Payments from Insurance Companies for a description of NLIC and NLICA dividend limitations. NFS currently does not expect such regulatory requirements to impair the ability of its insurance subsidiaries to pay sufficient dividends in order for NFS to have the necessary funds available to meet its obligations.
For individual annuity products ($50.34 billion and $48.84 billion of reserves as of December 31, 2006 and 2005, respectively), the surrender charge is generally calculated as a percentage of the deposits made and is assessed at declining rates during the first seven years after a deposit is made.
In addition, the Company has a majority-owned subsidiary that has available an annually renewable, 364-day, $10.0 million variable rate line of credit agreement with a single financial institution. The line of credit is guaranteed by NFS and is included in the consolidated balance sheets. The majority-owned subsidiary had $10.0 million outstanding on that line of credit as of December 31, 2006 and 2005 at a weighted average effective interest rate of 5.29% in 2006 and 4.35% in 2005.
The $300.0 million principal of 8.00% senior notes due March 1, 2027 were issued in March 1997 and 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 (1) 100% of the aggregate principal amount of the notes to be redeemed or (2) the sum of the present value of the remaining scheduled payments of principal and interest on the notes, discounted to the redemption date on a semi-annual basis at a prevailing U.S. Treasury rate plus 20 basis points, together in each case with accrued interest payments to the redemption date. The $200.0 million principal of 5.10% senior notes due October 1, 2015 were issued in September 2005 and 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 (1) 100% of the aggregate principal amount of the notes to be redeemed or (2) the sum of the present value of the remaining scheduled payments of principal and interest on the notes, discounted to the redemption date on a semi-annual basis at a prevailing U.S. Treasury rate plus 15 basis points, together in each case with accrued interest payments to the redemption date.
See Note 19 to the audited consolidated financial statements included in the F pages of this report for a description of the potential impact on liquidity of the Company’s guarantees.
The following table summarizes the Company’s contractual obligations and commitments as of December 31, 2006 expected to be paid in the periods presented. Payment amounts reflect the Company’s estimate of undiscounted cash flows related to these obligations and commitments. Balance sheet amounts were determined in accordance with GAAP and in many cases differ significantly from the summation of undiscounted cash flows. The most significant difference relates to future policy benefits related to life and health insurance, which include discounting.
No contractual provisions exist that could create, increase or accelerate those obligations presented. The amount presented includes contractual principal and interest based on rates in effect at December 31, 2006.
Contractual provisions exist that could increase or accelerate those obligations presented. The amounts presented include contractual principal and interest based on stated 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, claims experience with respect to variable annuity 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(j) 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.
Contractual provisions exist that could increase those obligations presented. In developing the estimates of payments due by period, the process for determining future interest crediting rates as described in note 7 above was followed.
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 6 to the audited consolidated financial statements included in the F pages of this report for further information regarding the Company’s investments.
As of December 31, 2006 and 2005, the Company had received $886.7 million and $1.17 billion, respectively, of cash collateral on securities lending and $171.0 million and $203.3 million, respectively, of cash for derivative collateral. As of December 31, 2006, the Company had not received any non-cash collateral on securities lending compared to $5.9 million as of December 31, 2005. Both the cash and non-cash collateral amounts are included in short-term investments with a corresponding liability recorded in other liabilities. As of December 31, 2006 and 2005, the Company had loaned securities with a fair value of $859.9 million and $1.14 billion, respectively. The Company also held $12.8 million and $53.2 million of securities as off-balance sheet collateral on derivative transactions as of December 31, 2006 and 2005, respectively.
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, 2006 (excluding U.S. Treasury securities, obligations of U.S. Government corporations, and agency bonds not backed by the full faith and credit of the U.S. Government):
The average duration and average maturity of the Company’s general account fixed maturity securities at December 31, 2006 were approximately 4.4 years and 5.9 years, respectively, compared to 4.5 years and 6.1 years, respectively, at December 31, 2005. The market value of the Company’s general account investments may fluctuate significantly in response to changes in interest rates. In addition, the Company may be likely to experience realized investment losses to the extent its liquidity needs require the disposition of general account fixed maturity securities in unfavorable interest rate environments.
The NAIC assigns securities quality ratings and uniform valuations (called NAIC Designations), which are used by insurers when preparing their annual statements. The NAIC assigns designations to publicly traded and privately placed securities. The designations assigned by the NAIC range from class 1 (highest quality) to class 6 (lowest quality). Of the Company’s general account fixed maturity securities, 94% were in the two highest NAIC Designations as of December 31, 2006 compared to 94% as of December 31, 2005.
Prepayment/extension risk is an inherent risk of holding MBSs. However, the degree of prepayment/extension risk varies by the type of MBS held. The Company limits its exposure to prepayments/extensions by holding less volatile types of MBSs. As of December 31, 2006, $2.36 billion (34%) of the carrying value of the general account MBS portfolio was invested in planned amortization class CMOs/REMICs (PACs) compared to $2.43 billion (36%) as of December 31, 2005. PACs are securities whose cash flows are designed to remain constant in a variety of mortgage prepayment environments. Most of the Company’s non-PAC MBSs possess varying degrees of cash flow structure and prepayment/extension risk. The MBS portfolio contained 5% and 4% of pure pass-throughs as of December 31, 2006 and 2005, respectively.