MANAGEMENT'S NARRATIVE ANALYSIS OF THE RESULTS OF OPERATIONS - ------ ------------------------------------------------------------
Management's discussion and analysis 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 the Company. 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) Nationwide Corporation's control of the Company through its beneficial ownership of approximately 97.8% of the combined voting power of all the outstanding common stock and approximately 81.5% of the economic interest in the Company; (ii) the Company's primary reliance, as a holding company, on dividends from its subsidiaries to meet debt payment obligations and the applicable regulatory restrictions on the ability of the Company's subsidiaries to pay such dividends; (iii) the potential impact on the Company's reported net income that could result from the adoption of certain accounting standards issued by the FASB; (iv) tax law changes impacting the tax treatment of life insurance and investment products; (v) 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; (vi) adverse state and federal legislation and regulation, including limitations on premium levels, increases in minimum capital and reserves, and other financial viability requirements; (vii) failure to expand distribution channels in order to obtain new customers or failure to retain existing customers; (viii) inability to carry out marketing and sales plans, including, among others, changes to certain products and acceptance of the revised products in the market; (ix) changes in interest rates and the capital markets causing a reduction of investment income or asset fees, reduction in the value of the Company's investment portfolio or a reduction in the demand for the Company's products; (x) general economic and business conditions which are less favorable than expected; (xi) unanticipated changes in industry trends and ratings assigned by nationally recognized statistical rating organizations or A.M. Best Company, Inc.; (xii) inaccuracies in assumptions regarding future persistency, mortality, morbidity and interest rates used in calculating reserve amounts and (xiii) failure of the Company or its significant business partners and vendors to identify and correct all non-Year 2000 compliant systems or to develop and execute adequate contingency plans.
The $20.3 million and $10.6 million increases in other income during 1998 and 1997, respectively, were primarily attributable to growth in the Company's mutual fund operations.
Amortization of deferred policy acquisition costs (DAC) increased $47.3 million in 1998 and $33.8 million in 1997 principally due to the Variable Annuities segment, which accounted for $36.1 and $30.4 million of the increases as a result of strong sales growth in each of the last two years.
Operating expenses were $419.7 million in 1998, a 9% increase from 1997 operating expenses of $384.9 million. Operating expenses were $342.4 million in 1996. The increase reflects the growth in the number of annuity and life insurance contracts in-force and the related increase in administrative processing costs. Increased operating expenses in 1997 also reflect the cost of certain technology initiatives.
Federal income tax expense was $190.4 million representing an effective tax rate of 34.2% for 1998. Federal income tax expense in 1997 and 1996 was $150.2 million and $110.9 million, respectively, representing effective rates of 34.9% and 35.2%.
Operating expenses in 1998 and 1997 include approximately $44.7 million and $45.4 million, respectively, for technology projects, including costs related to Year 2000. The company anticipates spending approximately $5 million on Year 2000 activities in 1999. Management does not anticipate that the completion of Year 2000 renovation and replacement activities will result in a reduction in operating expenses. Rather, personnel and resources currently allocated to Year 2000 issues will be assigned to other technology-related projects.
In June 1998, the FASB issued SFAS No. 133 - Accounting for Derivative Instruments and Hedging Activities (SFAS 133). SFAS 133 establishes accounting and reporting standards for derivative instruments and for hedging activities. Contracts that contain embedded derivatives, such as certain insurance contracts, are also addressed by the Statement. SFAS 133 requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. The Statement is effective for fiscal years beginning after June 15, 1999. It may be implemented earlier provided adoption occurs as of the beginning of any fiscal quarter after issuance. The Company plans to adopt this Statement in first quarter 2000 and is currently evaluating the impact on results of operations and financial condition.
In March 1998, The American Institute of Certified Public Accountant's Accounting Standards Executive Committee issued Statement of Position 98-1 - Accounting for the Costs of Computer Software Developed or Obtained for Internal Use (SOP 98-1). SOP 98-1 provides guidance intended to standardize accounting practices for costs incurred to develop or obtain computer software for internal use. Specifically, SOP 98-1 provides guidance for determining whether computer software is for internal use and when costs incurred for internal use software are to be capitalized. SOP 98-1 is effective for financial statements for fiscal years beginning after December 15, 1998. The Company does not expect the adoption of SOP 98-1, which occurred on January 1, 1999, to have a material impact on the Company's financial statements.
The Company sells its products through a broad distribution network comprised of wholesale and retail distribution channels. Wholesale distributors are unaffiliated entities that sell the Company's products to their own customer base and include independent broker/dealers, national and regional brokerage firms, pension plan administrators and financial institutions. Retail distributors are representatives of the Company who market products directly to a customer base identified by the Company and include exclusive sales representatives and Nationwide Insurance Enterprise insurance agents.
The Company also markets group deferred compensation retirement plans to employees of state and local governments for use under Internal Revenue Code (IRC) Section 457. The Company utilizes its sponsorship by the National Association of Counties and The United States Conference of Mayors when marketing IRC Section 457 products. In addition, the Company utilizes an exclusive arrangement with the National Education Association (NEA) to market tax-qualified annuities under IRC 403(b) to NEA members. Variable annuities developed for the NEA members are sold under the NEA Valuebuilder brand.
Variable Annuities segment revenues reflect a significant increase in policy charges, primarily asset fees, consistent with the growth in variable annuity policy reserves. Asset fees were $479.1 million in 1998 up 29% from $370.2 million in 1997 and totaled $261.8 million in 1996. Asset fees are charged as a percentage of policy reserves which have increased substantially in the past three years as a result of steady premium growth and through market appreciation on investments underlying reserves. Variable annuity policy reserves grew $11.93 billion during 1998 reaching $46.42 billion as of year end 1998 compared to growth in 1997 of $10.21 billion and year end 1997 reserves of $34.49 billion. During 1996, policy reserves increased $7.52 billion.
An example of the Company's ability to develop innovative products and to leverage its strong distributor relationships to maintain its competitive position is America's FUTURE Annuity. This individual variable annuity product was developed in late 1997 in partnership with distributors and offers the customer greater flexibility and investment choice with insurance charges lower than comparable products sold through the financial planning community. Sales of this product reached $2.4 billion during 1998, its first full year of availability.
Although the equity markets were more volatile in 1998 than in the previous two years, equity market conditions over each of the past three years have contributed significantly to the growth in variable annuity policy reserves. Variable annuity policy reserves reflect market appreciation of $6.80 billion, $5.21 billion and $2.72 billion in 1998, 1997 and 1996, respectively.
The Fixed Annuities segment consists of annuity contracts that generate a return for the customer at a specified interest rate, fixed for a prescribed period, with returns accumulating on a tax-deferred basis. Such contracts consist of single premium deferred annuities, flexible premium deferred annuities and single premium immediate annuities. The Fixed Annuities segment includes the fixed option under the Company's variable annuity contracts.
Fixed Annuities segment results reflect an increase in interest spread income attributable to growth in fixed annuity policy reserves and wider interest margins. Interest spread is the differential between net investment income and interest credited to policyholder account balances. Interest spreads vary depending on crediting rates offered by competitors, performance of the investment portfolio, changes in market interest rates and other factors. The following table depicts the interest margins on general account policy reserves in the Fixed Annuities segment for each of the last three years.
The declining interest rate environment has put pressure on interest margins when fixed income investments mature or prepay and are reinvested at lower rates; however, mortgage loan and bond prepayment income actually increased interest margins in 1998. Prepayment income added 8 additional basis points to the 1998 interest margin compared to 1997. The Company expects 1999 interest margins excluding prepayment income to return to historically normal levels of 190 to 195 basis points.
The Company is able to mitigate the effects of lower investment yields by periodically resetting the rates credited on fixed annuity contracts. As of December 31, 1998, $7.17 billion, or 48% of fixed annuity policy reserves, were in contracts where the guaranteed interest rate is reestablished each quarter. Fixed annuity policy reserves of $5.29 billion are in contracts that adjust the crediting rate on an annual basis with portions resetting in each calendar quarter. The Company also has $1.36 billion of fixed annuity policy reserves that call for the crediting rate to be reset annually on each January 1. The remaining $1.08 billion of fixed annuity policy reserves are in payout status where the Company has guaranteed periodic, typically monthly, payments.
The Life Insurance segment consists of insurance products, including variable universal life insurance and corporate-owned life insurance products, that provide a death benefit and also allow the customer to build cash value on a tax-deferred basis.
The increase in Life Insurance segment earnings is attributable to strong growth in investment life insurance products, which include individual variable universal life insurance and corporate-owned life insurance, where the Company has aggressively expanded its distribution capabilities. Investment life premiums and deposits increased from $185.4 million in 1996 to $415.0 million in 1997 to $961.8 million in 1998. As a result of the sales growth and high persistency, revenues from investment life products increased to $150.4 million in 1998 from $71.9 million in 1997 and $45.5 million in 1996. The Company believes there are growth opportunities for investment life products and in 1999 will be introducing new products and expanding distribution to new outlets to better penetrate these markets.
The increase in benefits and expenses is composed primarily of increased interest credited to policyholders and increased operating expenses. Death claims and other policyholder benefits reflected modest growth during 1997 and 1998. Interest credited to policyholders increased $36.9 million in 1998 reaching $115.4 million compared to $78.5 million a year ago. Interest credited to policyholders totaled $70.2 million in 1996. The increased corporate-owned life insurance business discussed previously accounted for most of the increases. Operating expenses grew to $101.7 million in 1998 compared to $94.5 million and $78.9 million in 1997 and 1996, respectively, reflecting the increased number of policies in-force as well as technology related expenditures.