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.
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 (which may also be referred to as NFS, we, us, our, or collectively with its subsidiaries, 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:
(ii) 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;
(iii) 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;
(xii) competitive, regulatory or tax changes that affect the cost of, or demand for, the Company’s products;
(xiv) settlement of tax liabilities for amounts that differ significantly from those recorded on the balance sheets;
(xvii) the potential impact of industry developments relating to contract and fee transparency on the Retirement Plans segment; and
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 and changes in the valuation allowance not related to specific mortgage loans on real estate are reported in net realized investment gains and losses. Also included in net realized investment gains and losses 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; the mark-to-market of embedded derivatives, net of economic hedges; and periodic net amounts paid or received on interest rate swaps that do not qualify for hedge accounting treatment. All charges related to other-than-temporary impairments of available-for-sale securities and other investments are reported in other-than-temporary impairment losses.
The results of operations of TBG Financial and The 401(k) Company for 2008 and all prior periods are reflected as discontinued operations in the consolidated statements of income (loss). In addition, the sales tables and “Other Data” section of the Retirement Plans segment table in the subsequent portions of Part I, Item 7 - MD&A exclude amounts applicable to The 401(k) Company.
As of December 31, 2009, 71% of the prices of fixed maturity securities were valued with the assistance of independent pricing services, 12% were valued with the assistance of the Company’s internal pricing processes, 10% were valued with the assistance of the Company’s pricing matrices, 5% were valued with the assistance of broker quotes and 2% were valued from other sources compared to 80%, 4%, 11%, 4% and 1%, respectively, as of December 31, 2008.
Available-for-sale securities valued using significant Level 3 inputs include investments in markets which the Company considers inactive; the Company’s residential mortgage-backed securities backed by sub-prime and Alt-A collateral, certain commercial mortgage-backed securities, collateralized debt obligations and other asset-backed securities; certain broker-quoted or internally priced securities, and securities that are at or near default based on ratings assigned by the NAIC. As of December 31, 2009, Level 3 investments comprised 16% of total investments measured at fair value compared to 20% as of December 31, 2008.
As of December 31, 2009 and 2008, the Company had investments in markets that it considered inactive with an amortized cost of $3.24 billion and $4.87 billion, respectively, and an estimated fair value of $2.47 billion and $3.56 billion, respectively, which represents 9% and 15% 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, 78% were priced using a weighting of internal pricing models and independent pricing services, 14% 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 received $532.4 million and $1.02 billion, respectively, of cash for derivative collateral, which is in turn invested in short-term investments. The Company also held $32.3 million and $35.4 million of securities as off-balance sheet collateral on derivative transactions as of December 31, 2009 and 2008, respectively. 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. There are no contingent features associated with the Company’s derivative instruments which would require additional collateral to be pledged to counterparties.
The fair value measurements for future policy benefits and claims relate to embedded derivatives associated with contracts with living benefit riders (guaranteed minimum accumulation benefits (GMABs), guaranteed lifetime withdrawal benefits (GLWBs)) and equity-indexed annuities. Related derivatives are internally valued. The valuation of guaranteed minimum benefit embedded derivatives is based on capital market and actuarial risk assumptions, including risk margin considerations reflecting policyholder behavior. The Company uses observable inputs, such as published swap rates, in its capital market assumptions. Actuarial assumptions, including lapse behavior and mortality rates, are based on actual experience.
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, corporate-owned life insurance (COLI), bank-owned life insurance (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.
For variable annuity products, the DAC balance is sensitive to the effects of changes in the Company’s estimates of gross profits, primarily due to the significant portion of the Company’s gross profits that are dependent upon the rate of return on assets held in separate accounts. This rate of return influences fees earned by the Company from these products and costs incurred by the Company associated with minimum contractual guarantees, as well as other sources of future expected gross profits. As previously stated, the Company’s current long-term assumption for net separate account investment performance is approximately 7% growth per year. In its ongoing evaluation of this assumption, the Company monitors its historical experience, market information and other relevant trends. To demonstrate the sensitivity of both the Company’s variable annuity product DAC balance, which was approximately $1.77 billion in aggregate at December 31, 2009, and related amortization, a 1% increase (to 8%) or decrease (to 6%) in the long-term assumption for net separate account investment performance would result in an approximately $20.0 million net increase or net decrease, respectively, in DAC amortization over the following year. The information provided above considers only changes in the assumption for long-term net separate account investment performance and excludes changes in other assumptions used in the Company’s evaluation of DAC.
During the fourth quarter of 2009, the Company’s recorded balance of individual variable annuity DAC fell outside the Company’s preset parameters for the prescribed period, which primarily was driven by the continued market recovery and favorable market performance compared to assumed net separate account returns. Accordingly, the Company recalculated DAC using revised best estimate assumptions, which resulted in a increase in DAC and other related balances, including sales inducement assets, and a decrease in DAC amortization and other related balances of $218.5 million pre-tax in the Individual Investments segment. The Company used the reversion to the mean process with the anchor date that was reset during the second quarter 2007 unlocking as described below. The Company evaluated the assumed separate account performance level over the next three years and determined that the assumptions inherent in the reversion period were reasonable. The annual net separate account growth rate for the mean reversion period is 15%, the maximum rate under the Company’s parameters.
As a result of the Company’s adoption of guidance impacting FASB ASC 320-10, Investments - Debt and Equity Securities in the first quarter of 2009, for all debt securities evaluated for other-than-temporary impairment (for which the Company does not have the intent to sell and it is not more likely than not that it will be required to sell the security before the recovery of its amortized cost basis), the Company considers the timing and amount of the cash flows. The Company evaluates its intent to sell on an individual security basis.
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.
To the extent that the present value of the cash flows generated by a security is less than the amortized cost, an other-than-temporary impairment is recognized through earnings. It is reasonably possible that further declines in estimated fair values of such investments, or changes in assumptions or estimates of anticipated recoveries and/or cash flows, may cause further other-than-temporary impairments in the near term, which could be significant.
Equity securities may experience other-than-temporary impairment in the future based on the prospects for full recovery in value in a reasonable period of time and the Company’s ability and intent to hold the security to recovery.
During the year ended December 31, 2009, the Company recorded net realized investment gains on living benefit embedded derivatives, net of economic hedging losses, of $413.6 million, an increase of $914.3 million compared to the prior year. These gains were comprised of $1.50 billion of net realized investment gains on living benefit embedded derivatives and $1.08 billion of related economic hedging losses. The net realized investment gains on living benefit embedded derivatives primarily resulted from higher interest rates, lower volatility assumptions and an increase to the nonperformance component of the discount rate. The increase in net realized investment gains on embedded derivatives increased amortization of DAC by $389.6 million in 2009 compared to 2008, which is included in the Corporate and Other segment. Additionally, higher net realized gains on sales of investments of $160.8 million and higher mark-to-market gains on derivative activity of $66.8 million contributed to the increase. The overall increase was partially offset by losses on derivatives associated with the Company’s economic hedging program for GMDB contracts of $281.2 million.
Other-than-temporary impairment losses decreased $571.8 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.
The decline in asset fees primarily was due to lower average separate account values across all segments resulting from volatility in the equity markets as asset fees earned by the Company are driven by separate account values.
Lower other income primarily was driven by a decline in retail asset management revenues attributable to a decrease in average customer funds managed and administered and lower other asset fees and mutual fund revenues in the Retirement Plans segment due to lower average non-insurance assets due to volatility in the equity markets.
The Company recorded a net loss during 2008 compared to net income in 2007 primarily due to increases in other-than-temporary impairment losses, net realized investment losses and amortization of DAC. In addition, higher benefits and claims, lower interest spread income, lower other income and lower asset fees contributed to the overall decline. As previously discussed, the results of The 401(k) Company and TBG Financial are included as discontinued operations, contributing to the overall decline in net income. Lastly, the Company recorded a federal income tax benefit for the current year compared to federal income tax expense in 2007 primarily due to the aforementioned declines in net income.
Net realized investment 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 the structured products business related to impairments on the underlying mortgages and mortgage loan commitments and valuation losses on assets held for trading purposes increased $26.7 million. The overall decline was offset by higher realized gains of $228.0 million on derivatives associated with the Company’s economic hedging program related to contracts with death benefit guarantees.
Interest spread income declined primarily within the Corporate and Other segment due to a $94.5 million decline in income from alternative investments, lower income from mortgage loan prepayments and bond call premiums, and reduced earnings from the MTN program. See Part II, Item 7 - MD&A - Business Segments for a more detailed discussion of interest spread income.
The decline in other income occurred primarily in the Corporate and Other segment due to lower retail asset management and broker-dealer revenues ($31.9 million) and in the Retirement Plans segment due to lower average non-insurance assets ($22.1 million).
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 endorsement by the National Association of Counties, The United States Conference of Mayors and The International Association of Fire Fighters when marketing IRC Section 457 products.
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, higher premiums, lower benefits and claims, and higher interest spread income, partially offset by losses in other income and lower asset fees.
Improvements in market conditions reduced the Company’s exposure on GMDB contracts and lowered benefits and claims by $187.3 million in the year ended December 31, 2009. Additionally, the favorable unlock of sales inducement assets during 2009, lowered benefits and claims by $10.9 million. The decrease was offset by higher sales of income products (see premiums discussion above), which resulted in higher reserve accruals. These higher reserve accruals increased benefits and claims by $62.0 million in 2009.
Individual variable annuities decreased new and renewal production premiums and deposits, primarily due to volatile market conditions. Fixed annuities declined due to actions implemented by the Company to reduce sales and conserve capital during the year. Income products production improved due to greater marketing emphasis by the Company. In addition, the decline in the advisory services program was due to the Company exiting this business during 2008.
The following table summarizes selected information about the Company’s deferred individual fixed annuities, including the fixed option of variable annuities, as of December 31, 2009:
Lower overall new and renewal production premiums and deposits primarily were attributable to the individual variable annuity business due to volatile market conditions and the current economic slowdown, partially offset by improved fixed annuity sales. In addition, the decline in advisory services program sales was due to the Company exiting this business during 2008.
The following table summarizes selected information about the Company’s deferred individual fixed annuities, including the fixed option of variable annuities, as of December 31, 2008:
The decrease in other income, which includes administrative fees from administration-only plans and asset fees from non-insurance deferred compensation plans and the NTC platform, primarily was driven by decreases in mutual fund revenues and other asset fees of $9.3 million and $7.3 million, respectively, resulting from lower average non-insurance assets.
Higher amortization of VOBA and other intangible assets was driven by Company’s plans to exit the NFN retirement services distribution channel in 2009. As a result, the Retirement Plans segment recorded a pre-tax charge of $8.1 million during the fourth quarter of 2009 related to VOBA and other intangible assets.
The increase in interest spread income primarily was due to higher general account assets (a 4% increase) caused by a shift in customer demand from equity investment funds to fixed investment funds and lower crediting rates.
Interest spread income increased primarily due to lower crediting rates on both private and public sector products.
Private sector sales drove down overall new and renewal production premiums and deposits due to fewer discretionary employer contributions, employee deferrals and plan transfers as a result of volatile market conditions and the current economic slowdown. The increase in public sector sales was driven by additional deposits from two large administration-only agreements and increased contributions into the Company’s fixed return products.
Higher benefits and claims reflect an aging of the individual life business block and adverse mortality in the universal life insurance and COLI businesses during the year ended December 31, 2009. Both total claim counts and average net claim size increased significantly in these businesses compared to the prior year. Additionally, updates to benefit ratio assumptions in 2009 increased benefits and claims by $11.6 million.
Amortization of VOBA increased by $13.2 million due to the VOBA unlock in 2009. Lower amortization of VOBA of $7.5 million during 2008, primarily due to the unlocking of the long-term lapse rate assumption and higher gross profits in the investment life insurance business, further contributed to the change in comparison to the prior year.
Amortization of DAC increased primarily due to the DAC unlock in the second quarter of 2007, which lowered amortization of DAC by $18.1 million in 2007. In addition, the DAC unlock in the second quarter of 2008 increased amortization of DAC by $2.8 million in 2008. The remainder of the increase was due to higher gross profits in 2008.
The Company recorded a lower pre-tax operating loss during 2009 compared to 2008 primarily due to lower operating expenses, higher interest spread income and higher other income.
The increase in other income was driven by a $47.0 million increase due to valuation gains on the Company’s trading portfolio in 2009 compared to losses in 2008, lower losses of $41.9 million in the structured products business related to impairments on the underlying mortgages and mortgage loan commitments, and a $29.2 million increase due to hedging gains on mortgage loan sales in 2009 compared to losses in 2008. These increases were partially offset by the aforementioned decline in income on the retail asset management business of $49.8 million.
Higher non-operating net realized investment gains and losses primarily were driven by a $914.3 million increase in realized gains on living benefits embedded derivatives, net of economic hedging activity. Higher net gains on sales of fixed maturity securities further contributed to the increase.
Non-operating other-than-temporary impairments decreased $571.8 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.
Higher gains on living benefit embedded derivatives, net of economic hedging activity, and gains on sales inducements impacted the adjustment to amortization related to net realized investment gains and losses.
Includes valuation of trading securities, mark-to-market valuation of mortgage loans held for sale and changes in the valuation allowance not related to specific mortgage loans on real estate.
Lower other income primarily was driven by a $49.6 million increase in losses in the Company’s structured products business in 2008 related to impairments on the underlying mortgages and mortgage loan commitments, a $26.7 million increase in valuation losses on assets held for trading purposes, a $19.8 million decline in retail asset management revenues (pre-tax operating earnings declined $6.6 million) and a $12.1 million decline in broker-dealer revenues (pre-tax operating earnings declined $7.4 million).
Includes gains of $109.4 million on derivatives associated with death benefit contracts for the year ended December 31, 2008. There were no material gains or losses during 2007.
NFS is a holding company whose principal assets are the common stock of NLIC. The principal sources of funds for NFS to pay interest, dividends and operating expenses are existing cash and investments and dividends from NLIC and other subsidiaries. See Part I, Item 1 - Business - Regulation - Regulation of Dividends and Other Payments from Insurance Companies for a description of NLIC 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.
A primary liquidity concern with respect to annuity and life insurance products is the risk of early policyholder withdrawal. The Company attempts to mitigate this risk by offering variable products where the investment risk is transferred to the policyholder, charging surrender fees at the time of withdrawal for certain products, applying a market value adjustment to withdrawals for certain products in the Company’s general account, and monitoring and matching anticipated cash inflows and outflows.
For group annuity products ($3.20 billion and $3.18 billion of reserves as of December 31, 2009 and 2008, respectively), surrender charge amounts and periods can vary significantly depending on the terms of each contract and the compensation structure for the producer. Generally, surrender charge percentages for group products are less than individual products because the Company incurs lower expenses at contract origination for group products. In addition, over ninety percent of the general account group annuity reserves are subject to a market value adjustment at withdrawal.
The Company has available as a source of funds a $1.00 billion revolving credit facility entered into by NFS, NLIC and NMIC with a maturity of May 13, 2010. The facility provides for several and not joint liability with respect to any amount drawn by any party. The facility contains covenants, including, but not limited to, requirements that NMIC maintain statutory surplus in excess of $5.30 billion, the Company’s debt not exceed 40% of tangible net worth, as defined, and that NLIC maintain statutory surplus in excess of $1.67 billion. A breach by any borrower of the financial covenants will impact the availability of the line for the other borrowers and may accelerate payment. NMIC had no amounts outstanding under this agreement as of December 31, 2009. NLIC also has an $800.0 million commercial paper program, and rating agency guidelines recommend that NLIC maintain minimum liquidity backup, which includes cash and liquid assets as well as committed bank lines, equal to 50% of any amounts outstanding under the commercial paper program. Therefore, availability under the aggregate $1.00 billion credit facility is reduced by the amount outstanding in excess of available cash and liquid assets. NLIC had $150.0 million of commercial paper outstanding at December 31, 2009 at a weighted average interest rate of 0.29% and $149.9 million outstanding at December 31, 2008 at a weighted average interest rate of 2.07%.
Long-term debt primarily is comprised of (1) two separate issuances of $300.0 million in principal amount of senior notes and two separate issuances of $200.0 million in principal amount of senior notes, none of which is subject to any sinking fund payments; (2) a single issuance of $400.0 million in principal amount of fixed-to-floating rate junior subordinated notes; and (3) a single issuance of $100.0 million in principal amount of junior subordinated debentures that are due March 1, 2037 and pay a distribution rate of 7.899%, issued to an unconsolidated subsidiary trust.
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.
The terms of each series of senior notes contain various restrictive business and financial covenants, including limitations on the disposition of subsidiaries. As of December 31, 2009, the Company was in compliance with all such covenants.
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, 2009.
No contractual provisions exist that could create, accelerate or materially increase those obligations presented.
See Part II, Item 7 - MD&A - Off-Balance Sheet Transactions for a detailed discussion of the MTN program. Amounts presented include contractual principal and interest based on rates in effect at December 31, 2009.
Since the timing of the return of collateral is uncertain, these obligations have been reflected in payments due in less than one year. See Part II, Item 7 - MD&A - Overview - Fair Value Measurements - Counterparty Risk Associated with Derivatives and Note 5 to the audited consolidated financial statements included in the F pages of this report for a detailed discussion of the impact of collateral on the Company’s consolidated balance sheets.
The table above excludes certain derivative liabilities, for more information on these instruments see