UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997 COMMISSION FILE NO. 1-12785 NATIONWIDE FINANCIAL SERVICES, INC. (Exact name of registrant as specified in its charter) DELAWARE (State or other jurisdiction of incorporation or organization) 31-1486870 (I.R.S. Employer Identification No.) ONE NATIONWIDE PLAZA, COLUMBUS, OHIO 43215 (Address of principal executive offices) (614) 249-7111 (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: CLASS A COMMON STOCK (PAR VALUE $.01 PER SHARE) (Title of Class) NEW YORK STOCK EXCHANGE (Name of each exchange on which registered) Securities registered pursuant to Section 12(g) of the Act: NONE Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to the filing requirements for at least the past 90 days. YES X NO ----- ---- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] The aggregate market value of voting stock held by non-affiliates on March 20, 1998 was $1,046,844,894. The number of shares outstanding of each of the registrant's classes of common stock on March 20, 1998 was as follows: CLASS A COMMON STOCK (PAR VALUE $.01 PER SHARE) 23,783,136 shares issued and outstanding CLASS B COMMON STOCK (PAR VALUE $.01 PER SHARE) 104,745,000 shares issued and outstanding (Title of Class) DOCUMENTS INCORPORATED BY REFERENCE Parts I and II of this Form 10-K incorporate by reference certain information from the registrant's 1997 Annual Report to Shareholders. Part III of this Form 10-K incorporates by reference certain information from the registrant's definitive Proxy Statement for the 1998 Annual Shareholders' Meeting.
Nationwide Insurance (NFS) NYSE
INDEXED 10-K FOR THE FISCAL YEAR ENDED December 31, 1997
Return to Corporate Window PART I ITEM 1 BUSINESS OVERVIEW Nationwide Financial Services, Inc. (NFS) was formed in November 1996 as a holding company for Nationwide Life Insurance Company (NLIC) and the other companies within the Nationwide Insurance Enterprise that offer or distribute long-term savings and retirement products. NFS is incorporated in Delaware and maintains its principal executive offices in Columbus, Ohio. On March 11, 1997, NFS sold, in an initial public offering, 23.6 million shares of its newly-issued Class A common stock for net proceeds of $524.2 million (the Equity Offering). In March 1997, NFS also sold, in companion public offerings, $300.0 million of 8% Senior Notes (the Notes) and, through a wholly owned subsidiary trust, $100.0 million of 7.899% Capital Securities (the Capital Securities). Aggregate net proceeds from the Equity Offering, the offering of the Notes and the sale of the Capital Securities totaled $917.0 million. NFS contributed $836.8 million of the proceeds to the capital of NLIC and retained $80.2 million of the proceeds for general corporate purposes. Prior to the initial public offering, NFS was a wholly owned subsidiary of Nationwide Corporation (Nationwide Corp.). Nationwide Corp. continues to own all of the outstanding shares of Class B common stock, which represents approximately 81% of the total number of common shares outstanding and approximately 98% of the combined voting power of the stockholders of NFS. During the first quarter of 1997, NFS's Board of Directors approved a 104,745 for one split of the Company's Class B common stock, which became effective February 10, 1997. Share information for all periods presented has been restated to reflect the split. During 1996 and 1997, Nationwide Corp. and NFS completed transactions in anticipation of the initial public offering that focused the business of NFS on long-term savings and retirement products. On September 24, 1996, NLIC declared a dividend payable to Nationwide Corp. on January 1, 1997 consisting of the outstanding shares of common stock of certain subsidiaries that do not offer or distribute long-term savings or retirement products. In addition, during 1996, NLIC entered into two reinsurance agreements whereby all of NLIC's accident and health and group life insurance business was ceded to two affiliates effective January 1, 1996. These subsidiaries and all accident and health and group life insurance business have been accounted for as discontinued operations for all periods presented. See notes 14 and 19 to the consolidated financial statements. On January 27, 1997, Nationwide Corp. contributed the common stock of NLIC and three marketing and distribution companies to NFS. Accordingly, the consolidated financial statements include the results of NLIC and its subsidiaries and the three marketing and distribution companies as if they were consolidated with NFS for all periods presented. NFS and its subsidiaries are collectively referred to as "the Company." In addition to the transactions discussed previously, the Company paid $900.0 million of dividends to Nationwide Corp., $50.0 million on December 31, 1996 and $850.0 million on February 24, 1997, as part of the restructuring. The Company is a leading provider of long-term savings and retirement products. The Company offers variable annuities, fixed annuities and life insurance as well as mutual funds and pension products and administrative services. By developing and offering a wide variety of products, the Company believes that it has positioned itself to compete effectively in various stock market and interest rate environments. The Company markets its products through a broad spectrum of wholesale and retail distribution channels, including financial planners, pension plan administrators, securities firms, banks and Nationwide Insurance Enterprise insurance agents. The Company has grown substantially in recent years as a result of its long-term investments in developing the distribution channels necessary to reach its target customers and the products required to meet the demands of these customers. The Company believes its growth has been enhanced further by favorable demographic trends, the growing tendency of Americans to supplement traditional sources of retirement income with self-directed investments, such as products offered by the Company, and the performance of the financial markets, particularly the United States (U.S.) stock markets, in recent years. From 1993 to 1997, the Company's assets grew from $24.70 billion to $59.90 billion, a compound annual growth rate of 24.8%. Asset growth during this period 2 resulted from sales of the Company's products as well as market appreciation of assets in the Company's separate accounts and in its general account investment portfolio. The Company's sales of variable annuities grew from $2.41 billion in 1993 to $7.54 billion in 1997, a compound annual growth rate of 33.0%. The Company's separate account assets, which are generated by the sale of variable annuities and variable universal life insurance, grew from 36.5% of total assets as of December 31, 1993 to 63.0% of total assets as of December 31, 1997. During this period of substantial growth, the Company controlled its operating expenses by taking advantage of economies of scale and by increasing productivity through investments in technology. From 1993 to 1997, the Company's total assets increased by 142% while operating expenses increased by only 68%. BUSINESS SEGMENTS The Company has three product segments: Variable Annuities, Fixed Annuities and Life Insurance. In addition, the Company reports corporate revenues and expenses, investments and related investment income supporting capital not specifically allocated to its product segments, revenues and expenses of its distribution companies, revenues and expenses of its investment advisor subsidiary (other than the portion allocated to the Variable Annuities and Life Insurance segments), revenues and expenses related to group annuity contracts sold to Nationwide Insurance Enterprise employee benefit plans and interest expense on debt in a Corporate and Other segment. All information set forth below relating to the Company's Variable Annuities segment excludes the fixed option under the Company's variable annuity contracts. Such information is included in the Company's Fixed Annuities segment. Variable Annuities The Variable Annuities segment consists of annuity contracts that provide the customer with the opportunity to invest in mutual funds managed by independent investment managers and the Company, with investment returns accumulating on a tax-deferred basis. Variable Annuity segment revenues, operating income before federal income tax expense and policy reserves are summarized in the following table. 1997 1996 1995 ---- ---- ---- (IN MILLIONS OF DOLLARS) Total revenues........................... $ 404.0 $ 284.6 $ 189.0 Operating income before federal income tax expense............................ 150.9 90.3 50.8 Policy reserves as of year end........... $34,486.7 $24,278.1 $16,761.8 The Company is one of the leaders in the development and sale of variable annuities. For the year ended December 31, 1997, the Company was the third largest writer of individual variable annuity contracts in the U.S. based on sales, according to The Variable Annuity Research & Data Service. The Company believes that demographic trends and shifts in attitudes toward retirement savings will continue to support increased consumer demand for its products. The Company believes that it possesses distinct competitive advantages in the market for variable annuities. Some of the Company's most important advantages include its innovative product offerings and strong relationships with independent, well-known fund managers. Its principal annuity series, The BEST of AMERICA, allows the customer to choose from up to 39 investment options managed by premier mutual fund managers. In the aggregate, the Company's group variable annuity products offer over 100 underlying investment options. A recent example of product innovation was the Company's November 1997 launch of a new individual variable annuity product, America's FUTURE Annuity, a breakthrough product that combines the flexibility and dozens of investment choices of The BEST of AMERICA brand products with insurance charges that are lower than comparable products sold through the financial planning community. The Company markets its variable annuity products through a broad spectrum of distribution channels, including broker/dealers, financial planners, banks and Nationwide Insurance Enterprise insurance agents. The Company seeks to capture a growing share of variable annuity sales in these channels by working closely with its investment managers and product distributors to adapt the Company's products and services to changes in the retail and institutional marketplace in order to enhance its leading position in the market for variable annuities. 3 The Company is following a strategy of extending The BEST of AMERICA brand name to more of its products and distribution channels in an effort to build upon its brand name recognition. The Company believes that the variable annuity business is attractive because it generates fee income. In addition, because the investment risk on variable annuities is borne principally by the customer and not the Company, the variable annuity business requires significantly less capital support than fixed annuity and traditional life insurance products. The Company receives income from variable annuity contracts primarily in the form of asset and administration fees. In addition, most of the Company's variable annuity products provide for a contingent deferred sales charge, also known as a "surrender charge" or "back-end load," that is assessed against premium withdrawals in excess of specified amounts made during a specified period, usually the first seven years of the contract. Surrender charges are intended to protect the Company from withdrawals early in the contract period, before the Company has had the opportunity to recover its sales expenses. Generally, surrender charges on individual variable annuity products are 7% of premiums withdrawn during the first year, scaling ratably to 0% for the eighth year and each year thereafter. For group annuity products, the surrender charge amounts and periods can vary significantly, depending on the terms of each contract. The Company's variable annuity products consist almost entirely of flexible premium deferred variable annuity (FPVA) contracts. FPVA contracts are distributed through broker/dealers, financial planners, banks, pension plan administrators and Nationwide Insurance Enterprise insurance agents. Such contracts are savings vehicles in which the customer makes a single deposit or series of deposits. The customer has the flexibility to invest in mutual funds managed by independent investment managers and the Company. Deposits may be at regular or irregular intervals and in regular or irregular amounts. The value of the annuity fluctuates in accordance with the investment experience of the mutual funds chosen by the customer. The customer is permitted to withdraw all or part of the accumulated value of the annuity, less any applicable surrender charges. As specified in the FPVA contract, the customer generally can elect from a number of payment options that provide either fixed or variable benefit payments. The Company offers individual variable annuities under The BEST of AMERICA brand name. In addition to The BEST of AMERICA individual variable annuities, the Company markets employer-sponsored variable annuities to both public sector employees and teachers for use in connection with plans described under Sections 457 and 403(b) of the Internal Revenue Code (IRC), and to private sector employees for use in connection with IRC Section 401(k) plans. These employer-sponsored variable annuities are marketed under several brand names, including Group BEST of AMERICA. The Company also markets variable annuities as "private label" products. Such products are offered through banks and are also offered to members of The National Education Association of the United States (NEA) under The NEA Valuebuilder brand name. The BEST of AMERICA. The Company's principal individual FPVA contracts are sold under the brand names The BEST of AMERICA-America's Vision, The BEST of AMERICA IV and The BEST of AMERICA-America's FUTURE Annuity. The BEST of AMERICA brand name individual variable annuities accounted for $3.66 billion (or 49%) of the Company's variable annuity sales in 1997, and $19.30 billion (or 56%) of the Company's variable annuity policy reserves as of year end. The Company's The BEST of AMERICA-America's Vision and The BEST of AMERICA-America's FUTURE Annuity products are intended to appeal to distributors in the market for large initial deposits. The contracts require initial minimum deposits of $15,000. The Company's The BEST of AMERICA IV product is intended primarily for the tax-qualified, payroll deduction market, where initial deposits are often smaller. The BEST of AMERICA IV generally pays a lower up-front commission to distributors but requires only $1,500 as an initial deposit. All three products generate an annual asset fee and may also generate annual administration fees for the Company. Group BEST of AMERICA. These group variable annuity products accounted for $1.99 billion (or 26%) of the Company's variable annuity sales in 1997, and $6.40 billion (or 19%) of the Company's variable annuity policy reserves as of year end. Group BEST of AMERICA products are typically offered only on a tax-qualified basis. These products may be structured with a variety of features which may be arranged in over 600 combinations of front-end loads, back-end loads and asset-based fees. Section 457 Contracts. These products accounted for $1.11 billion (or 15%) of the Company's variable annuity sales in 1997, and $5.88 billion (or 17%) of the Company's variable annuity policy reserves as of year 4 end. The Company offers a variety of group variable annuity contracts that are designed primarily for use in conjunction with plans described under IRC Section 457. Section 457 permits employees of state and local governments to defer a certain portion of their yearly income and invest such income on a tax-deferred basis. These contracts typically generate an annual asset fee and may also generate annual administration fees for the Company. Private Label Variable Annuities. These products accounted for $637.2 million (or 8%) of the Company's variable annuity sales in 1997, and $2.54 billion (or 7%) of the Company's variable annuity policy reserves as of year end. The Company has developed several private label variable annuity products in conjunction with other financial intermediaries. The products allow financial intermediaries to market products with substantially the same features as the Company's brand name products to their own customer bases under their own brand names. The Company believes these private label products strengthen the Company's ties to certain significant distributors of the Company's products. These contracts generate an annual asset fee and may also generate annual administration fees for the Company. The NEA Valuebuilder. This product accounted for $135.9 million (or 2%) of the Company's variable annuity sales in 1997, and $369.5 million (or 1%) of the Company's variable annuity policy reserves as of year end. The Company offers individual variable annuity contracts to the Teacher Market under Section 403(b) of the IRC. Section 403(b) permits teachers and other employees of educational organizations to defer a certain portion of their yearly income and invest such income on a tax-deferred basis. These contracts generate an annual asset fee and may also generate annual administration fees for the Company. Fixed Annuities The Company has sought to maintain its ability to grow profitably in a variety of market environments. The Company believes that periods of rising interest rates, that tend to cause lower sales growth in its Variable Annuities segment, make its fixed annuity products more attractive to consumers. In addition to providing balance to the Company's variable annuity business, its fixed annuity business allows the Company to offer a comprehensive portfolio of savings alternatives to its customers and distributors as the Company seeks to capture a growing share of sales in all distribution channels. The Fixed Annuities segment includes the fixed option under the Company's variable annuity products. Customers who purchase variable annuities are able to designate some or all of their deposits to fixed options which, like the Company's fixed annuity contracts, offer a guarantee of principal and a guaranteed interest rate for a specified period of time. The fixed option under the Company's variable annuity products accounted for $1.67 billion (or 78%) of the Company's fixed annuity sales in 1997, and $10.39 billion (73%) of the Company's fixed annuity policy reserves as of year end. Fixed Annuity segment revenues, operating income before federal income tax expense and policy reserves are summarized in the following table. 1997 1996 1995 ---- ---- ---- (IN MILLIONS OF DOLLARS) Total revenues........................... $ 1,141.4 $ 1,092.6 $ 1,052.0 Operating income before federal income tax expense............................ 169.5 135.4 137.0 Policy reserves as of year end........... $14,194.2 $13,511.8 $12,784.0 Fixed annuity products are marketed to individuals who choose to allocate long-term savings to products that provide a guarantee of principal, a stable net asset value and a guarantee of the interest rate to be credited to the principal amount for some period of time. The Company's fixed annuity products are offered both to individuals and as group products to employers for use in employee benefit programs. The Company's individual fixed annuity products are distributed through its wholesale and retail channels and include single premium deferred annuity contracts, flexible premium deferred annuity contracts and single premium immediate annuity contracts. The Company's group fixed annuity contracts are also distributed through its wholesale and retail channels. The Company invests fixed annuity customer deposits in its general account investment portfolio. Unlike variable annuity assets that are held in the Company's separate account, the Company bears the 5 investment risk on assets held in its general account. The Company attempts to earn a spread by investing a customer's deposits for higher yields than the interest rate it credits to the customer's fixed annuity contract. During 1997, the average crediting rate on contracts (including the fixed option under the Company's variable contracts) in the Fixed Annuities segment was 6.12%. Substantially all of the Company's crediting rates its fixed annuity contracts are guaranteed for a period not exceeding 15 months. Fixed Option Under Variable Annuity Contracts. Fixed options are available to customers who purchase certain of the Company's variable annuities by designation of some or all of their deposits to such options. A fixed option offers the customer a guarantee of principal and a guaranteed interest rate for a specified period of time. Such contracts have no maturity date and remain in force until the customer elects to take the proceeds of the annuity as a single payment or as a specified income for life or for a fixed number of years. The Company reports its fixed option business in its Fixed Annuities segment because the characteristics of such business are similar to those of its fixed annuity business. Although the customer may elect, subject to limitations for certain products, to transfer balances from the fixed option to other investment options, it is the Company's experience that historically few have made such election. Single Premium Deferred Annuity (SPDA) Contracts. SPDA contracts accounted for $373.7 million (or 17%) of the Company's fixed annuity sales in 1997, and $2.03 billion (or 14%) of the Company's fixed annuity policy reserves as of year end. SPDA contracts are distributed through broker/dealers, financial planners, banks and Nationwide Insurance Enterprise insurance agents. An SPDA contract is a savings vehicle in which the customer makes a single deposit with the Company. The Company guarantees the customer's principal and credits the customer's account with earnings at an interest rate that is stated and fixed for an initial period, typically at least one year. Thereafter, the Company resets, typically annually, the interest rate credited to the contract based upon market and other conditions. SPDA contracts have no maturity date and remain in force until the customer elects to take the proceeds of the annuity as a single payment or as a specified income for life or for a fixed number of years. No front-end sales charges are imposed for the Company's SPDA contracts. All such contracts, however, provide for the imposition of certain surrender charges, which are assessed against premium withdrawals in excess of specified amounts and which occur during the surrender charge period. The surrender charges are typically set within the range of 7% and 0% and typically decline from year to year, disappearing after seven contract years. Flexible Premium Deferred Annuity (FPDA) Contracts. FPDA contracts accounted for $33.9 million (or 2%) of the Company's fixed annuity sales in 1997, and $708.4 million (or 5%) of the Company's fixed annuity policy reserves as of year end. FPDA contracts are distributed through broker/dealers, financial planners, banks and Nationwide Insurance Enterprise insurance agents. FPDA contracts are typically marketed to teachers and employees of tax-exempt organizations as tax-qualified retirement programs. Under these contracts, the Company accepts a single deposit or a series of deposits. Deposits may be paid at intervals which are either regular or irregular. FPDA contracts contain substantially the same guarantee of principal and interest rate terms included in the Company's SPDA contracts. Surrender charges are typically set within the range of 7% and 0% and typically decline from year to year, disappearing after seven contract years. Single Premium Immediate Annuity (SPIA) Contracts. SPIA contracts accounted for $59.6 million (or 3%) of the Company's fixed annuity sales for 1997, and $1.06 billion (or 7%) of the Company's fixed annuity policy reserves as of year end. The Company's SPIA contracts are offered through its retail and wholesale distribution channels and are offered as either direct purchases or as fixed annuity options under the Company's various individual and group annuity contracts. An SPIA is an annuity that requires a one-time deposit in exchange for guaranteed, periodic annuity benefit payments, often for the contract holder's lifetime. SPIA contracts are often purchased by persons at or near retirement age who desire a steady stream of future income. Life Insurance The Company's life insurance segment is composed of a wide range of variable universal life insurance, whole life insurance, universal life insurance, term life insurance and corporate-owned life insurance products. In recent years, the Company has placed particular emphasis within this segment on the sale of variable life insurance products that offer multiple investment options. The Company distributes its variable universal life 6 insurance products through its wholesale distribution channels as well as through Nationwide Insurance Enterprise insurance agents. The Company's target markets for its life insurance products include the holders of personal automobile and homeowners' insurance policies issued by members of the Nationwide Insurance Enterprise and select customers to whom the accumulation of cash values is important. Life Insurance segment revenues, operating income before federal income tax expense, policy reserves and life insurance in force are summarized in the following table. 1997 1996 1995 ---- ---- ---- (IN MILLIONS OF DOLLARS) Total revenues........................... $ 473.1 $ 435.6 $ 409.1 Operating income before federal income tax expense............................ 70.9 67.2 67.6 Life insurance policy reserves as of year end.................................... 3,487.0 2,938.9 2,660.5 Life insurance in force as of year end... $39,259.4 $36,274.6 $32,543.4 Universal Life and Variable Universal Life Insurance Products. The Company offers universal life insurance and variable universal life insurance products including both flexible premium and single premium designs. These products provide life insurance under which the benefits payable upon death or surrender depend upon the policyholder's account value. Universal life insurance provides whole life insurance with flexible premiums and adjustable death benefits. For universal life insurance, the policyholder's account value is credited based on an adjustable rate of return set by the Company relating to current interest rates. For variable universal life insurance, the policyholder's account value is credited with the investment experience of the mutual funds chosen by the customer. The variable universal life insurance products also typically include a general account guaranteed interest investment option. All of the Company's variable universal life insurance products are marketed under the Company's The BEST of AMERICA brand name and have the same wide range of investment options as the Company's variable annuity products. These products are distributed on a retail basis by Nationwide Insurance Enterprise insurance agents as well as through wholesale distribution channels by broker/dealers, financial planners and banks. Traditional Life Insurance Products. The Company offers whole life and term life insurance. Whole life insurance combines a death benefit with a savings plan that increases gradually in amount over a period of years. The customer pays a level premium over the customer's expected lifetime. The customer may borrow against the savings and also has the option of surrendering the policy and receiving the accumulated cash value rather than the death benefit. Term life insurance provides only a death benefit without any savings component. These traditional life insurance products are distributed on a retail basis by Nationwide Insurance Enterprise insurance agents. Corporate-owned Life Insurance Products: The Company offers corporate-owned life insurance (COLI). Corporations purchase COLI to provide protection against the death of selected employees and to fund non-qualified benefit plans. Corporations may make a single premium payment or a series of premium payments. Premium payments made are credited with a guaranteed interest rate which is fixed for a specified period of time. MARKETING AND DISTRIBUTION The Company sells its products through a broad distribution network comprised of wholesale and retail distribution channels. The Company defines wholesale channels of distribution as channels in which an unaffiliated company, such as a securities broker/dealer, pension plan administrator, bank or other financial institution, sells the Company's products to its own customer base. The Company defines retail channels as those in which the Company's representatives, such as Nationwide Insurance Enterprise insurance agents and representatives of the Company's sales subsidiaries market products directly to a customer base identified by the Company. The Company provides, through both its retail and wholesale channels, the means for employers sponsoring tax-favored retirement plans (such as those described in IRC Sections 401(k), 403(b) and 457) to allow their employees to make contributions to such plans through payroll deductions. Typically, the Company receives the right from an employer to market products to employees and arrange to deduct periodic deposits 7 from the employees' regular paychecks. The Company believes that the payroll deduction market is characterized by more predictable levels of sales than other markets because these customers are less likely, even in times of market volatility, to stop making annuity deposits than customers in other markets. In addition, the Company believes that payroll deduction access to customers provides significant insulation from competition by providing the customer with a convenient, planned method of periodic saving. In both the Pension Market, where the Company's products are distributed primarily on a wholesale basis, and in the Public Sector and Teachers Markets, where the Company's products are distributed primarily on a retail basis, payroll deduction is the primary method used for collecting premiums and deposits. A table showing statutory premiums and deposits by distribution channel for each of the last three years is presented in Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) on page 21 of the Company's 1997 Annual Report to Shareholders. Wholesale Channels Investment Dealers. The Company sells individual and group variable annuities, fixed annuities and variable life insurance through broker/dealers in all 50 states and the District of Columbia. The Company has access to over 1,000 broker/dealers and over 30,000 registered representatives. The Company historically has focused on distributing through mid-sized regional broker/dealers and financial planning firms, but recently has added national "wirehouse" firms to this channel. The Company believes that it has strong broker/dealer relationships based on its diverse product mix, large selection of fund options and administrative technology. In addition to such relationships, the Company believes its financial strength and The BEST of AMERICA brand name are competitive advantages in this distribution channel. The Company regularly seeks to add new broker/ dealers to its distribution network. Pension Market. The Company defines the Pension Market as defined contribution plans pursuant to Section 401 of the IRC sponsored by employers as part of employee retirement programs. The Company markets group variable annuities, group fixed annuities and record-keeping services to these plan sponsors primarily through over 250 regional pension plan administrators located in 45 states. The Company has also linked pension plan administrators with the financial planning community to sell group pension products. In 1997, over $1.2 billion in pension sales came from financial planners who use the Company's pension plan administrators to perform back-office processing and record-keeping functions. The Company targets employers having between 25 and 2,000 employees because it believes that these plan sponsors tend to require more extensive record-keeping services from pension plan administrators and therefore tend to become long-term customers. The Company believes, based on industry survey data, that it is the third largest administrator of 401(k) plans based on total number of plans. Financial Institutions. The Company markets individual variable and fixed annuities (under its brand names and on a private-label basis), and variable universal life insurance through financial institutions, consisting primarily of banks and their subsidiaries. The Company currently distributes products through over 180 financial institutions and is actively seeking to increase the number of financial institutions with which it has distribution arrangements. The Company believes that its expertise in training financial institution personnel to sell annuities, its breadth of product offerings, its financial strength, the Nationwide and The BEST of AMERICA brand names, and the ability to offer private label products are competitive advantages in this distribution channel. Retail Channels Public Sector and Teacher Markets. The Company markets various products and services on a retail basis through several subsidiary sales organizations to both the Public Sector and Teachers Markets. With respect to the Public Sector Market, the Company markets group variable annuities and fixed annuities to state and local governments for use in their IRC Section 457 retirement programs. The Company services the Public Sector market through a sales force of more than 500 exclusive retail sales representatives. The Company believes that its existing relationships with state and local government entities and the Company's sponsorship by such entities as the National Association of Counties (NACO) and The United States Conference of Mayors (USCM) provide it with distinct competitive advantages in this market. NACO sponsorship, which began in 1980 and has been 8 renewed three times, expires December 31, 2005, and USCM sponsorship, which began in 1979 and has been renewed twice, expires on December 31, 2004. With respect to the Teacher Market, the Company has an exclusive contractual arrangement with the NEA to offer and sell certain products to its 2.2 million members. Under The NEA Valuebuilder brand name, the Company markets both qualified and non-qualified (under IRC Section 403(b)) individual variable annuity contracts. The Company also offers IRAs in this market. As of December 31,1997, the Company administers plans for over 1,800 school districts in 48 states. The NEA exclusive contractual arrangement, which began in 1990, automatically renewed on July 26, 1995 for an additional 5-year period. Nationwide Insurance Enterprise Insurance Agents. The Company sells traditional life insurance, universal life insurance and variable universal life insurance products and individual annuities through approximately 4,300 licensed Nationwide Insurance Enterprise insurance agents who primarily target the holders of personal automobile and homeowners' insurance policies issued by the Nationwide Insurance Enterprise. The Nationwide Insurance Enterprise insurance agents sell exclusively Nationwide Insurance Enterprise products and may not offer products which compete with those of the Company. CORPORATE AND OTHER SEGMENT The Corporate and Other segment includes corporate revenue and expenses, investments and related investment income supporting capital not specifically allocated to the three product segments, revenues and expenses of the distribution companies, revenues and expenses of its investment advisor subsidiary (other than the portion allocated to the Variable Annuities and Life Insurance segments), revenues and expenses related to group annuity contracts sold to Nationwide Insurance Enterprise employee benefit plans and interest expense on debt. Realized gains and losses on investments are also reported in the Corporate and Other segment. Corporate and Other segment revenues, operating income before federal income tax expense (which excludes realized gains and losses on investments and results of discontinued operations) and policy reserves are summarized in the following table. 1997 1996 1995 ---- ---- ---- (IN MILLIONS OF DOLLARS) Total revenues.............................. $ 219.9 $ 203.8 $ 186.9 Operating income before federal income tax expense................................... 4.6 35.4 27.5 Policy reserves as of year end.............. $3,791.9 $3,302.5 $2,644.3 The decrease in operating income in 1997 primarily relates to interest expense on the senior notes and capital securities issued in March 1997. REINSURANCE The Company follows the customary industry practice of reinsuring a portion of its life insurance and annuity risks with other companies in order to reduce net liability on individual risks, to provide protection against large losses and to obtain greater diversification of risks. The maximum amount of individual ordinary life insurance retained by the Company on any one life is $1.0 million. The Company cedes insurance primarily on an automatic basis, under which risks are ceded to a reinsurer on specific blocks of business where the underlying risks meet certain predetermined criteria, and on a facultative basis, under which the reinsurer's prior approval is required for each risk reinsured. The Company also cedes insurance on a case-by-case basis particularly where the Company may be writing new risks or is unwilling to retain the full costs associated with new lines of business. The ceding of risk does not discharge the original insurer from its primary obligation to the policyholder. The Company has entered into a reinsurance contract to cede a portion of its general account individual annuity reserves to Franklin Life Insurance Company (Franklin). Total recoveries due from Franklin were $220.2 million and $240.5 million as of December 31, 1997 and 1996, respectively. Under the terms of the contract, Franklin has established a trust as collateral for the recoveries. The trust assets are invested in investment grade securities, the market value of which must at all times be greater than or equal to 102% of the 9 reinsured reserves. The Company has no other material reinsurance arrangements with unaffiliated reinsurers. The only material reinsurance agreements the Company has with affiliates are the modified coinsurance agreements pursuant to which NLIC reinsured all of its accident and health and group life insurance business to other members of the Nationwide Insurance Enterprise as described in note 14 to the Company's consolidated financial statements. RATINGS Ratings with respect to claims-paying ability and financial strength have become an increasingly important factor in establishing the competitive position of insurance companies. Ratings are important to maintaining public confidence in the Company and its ability to market its annuity and life insurance products. Rating organizations continually review the financial performance and condition of insurers, including the Company. Any lowering of the Company's ratings could have a material adverse effect on the Company's ability to market its products and could increase the surrender of the Company's annuity products. Both of these consequences could, depending upon the extent thereof, have a material adverse effect on the Company's liquidity and, under certain circumstances, net income. NLIC is rated "A+" (Superior) by A.M. Best Company, Inc. and its claims-paying ability is rated "Aa2" (Excellent) by Moody's Investor Services, Inc. (Moody's) and "AA+" (Excellent) by Standard & Poor's Corporation (S&P). The foregoing ratings reflect each rating agency's opinion of NLIC's financial strength, operating performance and ability to meet its obligations to policyholders and are not evaluations directed toward the protection of investors. Such factors are of concern to policyholders, agents and intermediaries. The Company's financial strength is also reflected in the ratings of the senior notes and capital securities of subsidiary trust. The senior notes are rated "A+" by S&P and "A1" by Moody's. The capital securities of subsidiary trust are rated "A" by S&P and "a1" by Moody's. COMPETITION The Company competes with a large number of other insurers as well as non-insurance financial services companies, such as banks, broker/dealers and mutual funds, some of whom have greater financial resources, offer alternative products and, with respect to other insurers, have higher ratings than the Company. The Company believes that competition in the Company's lines of business is based on price, product features, commission structure, perceived financial strength, claims-paying ratings, service and name recognition. National banks, with their preexisting customer bases for financial services products, may pose increasing competition in the future to insurers who sell annuities, including the Company, as a result of the U.S. Supreme Court's 1994 decision in NationsBank of North Carolina v. Variable Annuity Life Insurance Company, which permits national banks to sell annuity products of life insurance companies in certain circumstances. Several proposals to repeal or modify the Glass-Steagall Act of 1933, as amended, and the Bank Holding Company Act of 1956, as amended, have been made by members of Congress and the Clinton Administration. Currently, the Bank Holding Company Act restricts banks from being affiliated with insurance companies. None of these proposals has yet been enacted, and it is not possible to predict whether any of these proposals will be enacted, or if enacted, their potential effect on the Company. REGULATION General Regulation at State Level As an insurance holding company, the Company is subject to regulation by the states in which its insurance subsidiaries are domiciled and/or transact business. Most states have enacted legislation that requires each insurance holding company and each insurance company in an insurance holding company system to register with the insurance regulatory authority of the insurance company's state of domicile and, annually, to furnish financial and other information concerning the operations of companies within the holding company system that materially affect the operations, management or financial condition of the insurers within such system. The Company is subject to the insurance holding company laws in Ohio. Under such laws, all transactions within an 10 insurance holding company system affecting insurers must be fair and equitable and each insurer's policyholder surplus following any such transaction must be both reasonable in relation to its outstanding liabilities and adequate for its needs. The Ohio insurance holding company laws also require prior notice or regulatory approval of the change of control of an insurer or its holding company and of material intercorporate transfers of assets within the holding company structure. Generally, under such laws, a state insurance authority must approve in advance the direct or indirect acquisition of 10% or more of the voting securities of an insurance company domiciled in its state. In addition, the laws of the various states establish regulatory agencies with broad administrative powers to approve policy forms, grant and revoke licenses to transact business, regulate trade practices, license agents, require statutory financial statements and prescribe the type and amount of investments permitted. In recent years, a number of life and annuity insurers have been the subject of regulatory proceedings and litigation relating to alleged improper life insurance pricing and sales practices. Some of these insurers have incurred or paid substantial amounts in connection with the resolution of such matters. In addition, state insurance regulatory authorities regularly make inquiries, hold investigations and administer market conduct examinations with respect to insurers' compliance with applicable insurance laws and regulations. None of the Company's insurance subsidiaries is the subject of any such investigation by any regulatory authority or any such market conduct examination in any state at this time. The Company's subsidiaries continuously monitor sales, marketing and advertising practices and related activities of their agents and personnel and provide continuing education and training in an effort to ensure compliance with applicable insurance laws and regulations. There can be no assurance that any non-compliance with such applicable laws and regulations would not have a material adverse effect on the Company. Insurance companies are required to file detailed annual and quarterly financial statements with state insurance regulators in each of the states in which they do business, and their business and accounts are subject to examination by such agencies at any time. In addition, insurance regulators periodically examine an insurer's financial condition, adherence to statutory accounting practices and compliance with insurance department rules and regulations. Applicable state insurance laws, rather than federal bankruptcy laws, apply to the liquidation or the restructuring of insurance companies. As part of their routine regulatory oversight process, state insurance departments conduct detailed examinations periodically (generally once every three to four years) of the books, records and accounts of insurance companies domiciled in their states. Such examinations are generally conducted in cooperation with the departments of two or three other states under guidelines promulgated by the National Association of Insurance Commissioners (NAIC). The insurance subsidiaries are currently under examination by the Ohio and Delaware insurance departments for the four-year period ended December 31, 1996. While final reports of these examinations have not yet been issued, management does not expect such reports to raise any significant issues or adjustments. Regulation of Dividends and Other Payments from Insurance Subsidiaries As an insurance holding company, the Company's ability to meet debt service obligations and pay operating expenses and dividends depends primarily on the receipt of sufficient funds from its primary operating subsidiary, NLIC. The inability of NLIC to pay dividends to the Company in an amount sufficient to meet debt service obligations and pay operating expenses and dividends would have a material adverse effect on the Company. The payment of dividends by NLIC is subject to restrictions set forth in the insurance laws and regulations of Ohio, its domiciliary state. The Ohio insurance laws require Ohio-domiciled life insurance companies to seek prior regulatory approval to pay a dividend or distribution of cash or other property if the fair market value thereof, together with that of other dividends or distributions made in the preceding 12 months, exceeds the greater of (i) 10% of statutory-basis policyholders' surplus as of the prior December 31 or (ii) the statutory-basis net income of the insurer for the 12-month period ending as of the prior December 31. The Ohio insurance laws also require insurers to seek prior regulatory approval for any dividend paid from other than earned surplus. Earned surplus is defined under the Ohio insurance laws as the amount equal to the Company's unassigned funds as set forth in its most recent statutory financial statements, including net unrealized capital gains and losses or revaluation of assets. Additionally, following any dividend, an insurer's policyholder surplus must be reasonable in relation to 11 the insurer's outstanding liabilities and adequate for its financial needs. As a result of the $850.0 million dividend paid on February 24, 1997, any dividend paid by NLIC during the 12-month period immediately following the dividend would be an extraordinary dividend under Ohio insurance laws. Accordingly, no such dividend could be paid without prior regulatory approval. The payment of dividends by NLIC may also be subject to restrictions set forth in the insurance laws of New York that limit the amount of statutory profits on NLIC's participating policies (measured before dividends to policyholders) that can inure to the benefit of the Company and its stockholders. The Company currently does not expect such regulatory requirements to impair its ability to pay operating expenses and dividends in the future. NAIC IRIS Ratios In the 1970's, the NAIC developed a set of relationships or "tests" known as the Insurance Regulatory Information System (IRIS) that was designed for early identification of companies which may require special attention by insurance regulatory authorities. There are separate but similar tests for property/casualty companies and life and health companies. Insurance companies submit data annually to the NAIC, which in turn analyzes the data by utilizing, in the case of life insurance companies, 13 ratios, each with defined "usual ranges." An insurance company may fall out of the usual range for one or more ratios because of specific transactions that are in themselves immaterial or eliminated at the consolidated level. Generally, an insurance company will become subject to regulatory scrutiny if it falls outside the usual ranges of four or more of the ratios, and regulators may then act, if the company has insufficient capital, to constrain the company's underwriting capacity. At December 31, 1997, NLIC reported three ratios and Nationwide Life and Annuity Insurance Company reported one ratio that fell outside the usual range. Management does not believe the ratios that fell outside the usual range will have any adverse impact on the Company's underwriting capacity. Risk-Based Capital Requirements In order to enhance the regulation of insurer solvency, the NAIC has adopted a model law to implement risk-based capital (RBC) requirements for life insurance companies. The requirements are designed to monitor capital adequacy and to raise the level of protection that statutory surplus provides for policyholders. The model law measures four major areas of risk facing life insurers: (i) the risk of loss from asset defaults and asset value fluctuation; (ii) the risk of loss from adverse mortality and morbidity experience; (iii) the risk of loss from mismatching of asset and liability cash flow due to changing interest rates and (iv) business risks. Insurers having less statutory surplus than required by the RBC model formula will be subject to varying degrees of regulatory action depending on the level of capital inadequacy. Based on the formula adopted by the NAIC, NLIC's adjusted capital exceeded the level at which the Company would be required to take corrective action by a substantial amount as of December 31, 1997. Assessments Against Insurers Insurance guaranty association laws exist in all states, the District of Columbia and Puerto Rico. Insurers doing business in any of these jurisdictions can be assessed for policyholder losses incurred by insolvent insurance companies. The amount and timing of any future assessment on the Company's insurance subsidiaries under these laws cannot be reasonably estimated and are beyond the control of the Company and its insurance subsidiaries. A large part of the assessments paid by the Company's insurance subsidiaries pursuant to these laws may be used as credits for a portion of the Company's insurance subsidiaries' premium taxes. For the years ended December 31, 1997, 1996 and 1995, the Company paid $7.2 million, $4.5 million and $7.5 million, respectively, in assessments pursuant to state insurance guaranty association laws. General Regulation at Federal Level Although the federal government generally does not directly regulate the insurance business, federal initiatives often have an impact on the business in a variety of ways. Current and proposed federal measures that may significantly affect the insurance business include limitations on antitrust immunity, minimum solvency 12 requirements and the removal of barriers restricting banks from engaging in the insurance and mutual fund business. Securities Laws Certain of the Company's insurance subsidiaries and certain policies and contracts offered by them are subject to regulation under the federal securities laws administered by the Securities and Exchange Commission (the Commission) and under certain state securities laws. Certain separate accounts of the Company's insurance subsidiaries are registered as investment companies under the Investment Company Act of 1940, as amended (Investment Company Act). Separate account interests under certain variable annuity contracts and variable insurance policies issued by the Company's insurance subsidiaries are also registered under the Securities Act of 1933, as amended. Certain other subsidiaries of the Company are registered as broker/dealers under the Securities Exchange Act of 1934, as amended and are members of, and subject to regulation by, the National Association of Securities Dealers. Certain of the Company's subsidiaries are investment advisors registered under the Investment Advisors Act of 1940, as amended. The investment companies managed by such subsidiaries are registered with the Commission under the Investment Company Act and the shares of certain of these entities are qualified for sale in certain states in the U.S. and the District of Columbia. A subsidiary of the Company is registered with the Commission as a transfer agent. Certain subsidiaries of the Company are also subject to the Commission's net capital rules. All aspects of the Company's subsidiaries' investment advisory activities are subject to various federal and state laws and regulations in jurisdictions in which they conduct business. These laws and regulations are primarily intended to benefit investment advisory clients and investment company shareholders and generally grant supervisory agencies broad administrative powers, including the power to limit or restrict the carrying on of business for failure to comply with such laws and regulations. In such event, the possible sanctions which may be imposed include the suspension of individual employees, limitations on the activities in which the investment advisor may engage, suspension or revocation of the investment advisor's registration as an advisor, censure and fines. ERISA Considerations On December 31, 1993, the United States Supreme Court issued its opinion in John Hancock Mutual Life Insurance Company v. Harris Trust and Savings Bank holding that certain assets in excess of amounts necessary to satisfy guaranteed obligations held by John Hancock in its general account under a participating group annuity contact are "plan assets" and therefore subject to certain fiduciary obligations under the Employee Retirement Income Security Act of 1974, as amended (ERISA), which specify that fiduciaries must perform their duties solely in the interest of ERISA plan participants and beneficiaries. The Court limited the imposition of ERISA fiduciary obligations in these instances to assets in the insurer's general account that were not reserved to pay benefits of guaranteed benefit policies (i.e. benefits whose value would not fluctuate in accordance with the insurer's investment experience). The Secretary of Labor issued proposed regulations in December 1997, providing guidance for the purpose of determining, in cases where an insurer issues one or more policies backed by the insurer's general account to or for the benefit of an employee benefit plan, which assets of the insurer constitute plan assets for purposes of ERISA and the IRC. The regulations, once final, will apply only with respect to a policy issued by an insurer on or before December 31, 1998. In the case of such a policy, the regulations will take effect at the end of the 18-month period following the date such regulations become final, or perhaps sooner in some cases if necessary to prevent avoidance of the regulations. Generally, no person will be liable under ERISA or the IRC for conduct occurring prior to the end of such 18-month period, where the basis of a claim is that insurance company general account assets constitute plan assets. New policies issued after December 31, 1998, which are not guaranteed benefit policies will be subject to the fiduciary obligations under ERISA. 13 Potential Tax Legislation Congress has, from time to time, considered possible legislation that would eliminate many of the tax benefits currently afforded to annuity products. A discussion on proposed tax legislation is included in MD&A on page 33 of the Company's 1997 Annual Report to Shareholders. EMPLOYEES As of December 31, 1997, the Company had approximately 3,460 employees. None of the employees of the Company are covered by a collective bargaining agreement and the Company believes that its employee relations are satisfactory. ITEM 2 PROPERTIES The Company's principal executive offices are located in Columbus, Ohio. The Company leases its home office complex, consisting of approximately 468,000 square feet, from Nationwide Mutual Insurance Company (NMIC) and its subsidiaries at One Nationwide Plaza, Two Nationwide Plaza and Three Nationwide Plaza, Columbus, Ohio. The Company believes that its present facilities are adequate for the anticipated needs of the Company. ITEM 3 LEGAL PROCEEDINGS The Company is a party to litigation and arbitration proceedings in the ordinary course of its business, none of which is expected to have a material adverse effect on the Company. In recent years, life insurance companies have been named as defendants in lawsuits, including class action lawsuits, relating to life insurance pricing and sales practices. A number of these lawsuits have resulted in substantial jury awards or settlements. In October 1996, a policyholder of NLIC filed a complaint in Alabama state court against NLIC and an agent of NLIC (Wayne M. King v. Nationwide Life Insurance Company and Danny Nix) related to the sale of a whole life policy on a "vanishing premium" basis and seeking unspecified compensatory and punitive damages. The King case was dismissed with prejudice on June 25, 1997 pursuant to an agreement between the parties. In February 1997, NLIC was named as a defendant in a lawsuit filed in New York Supreme Court related to the sale of whole life policies on a "vanishing premium" basis (John H. Snyder v. Nationwide Life Insurance Co.). The plaintiff in such lawsuit seeks to represent a national class of NLIC's policyholders and claims unspecified compensatory and punitive damages. This lawsuit has not been certified as a class action. On April 22, 1997, a motion to dismiss the Snyder complaint in its entirety was filed by the defendants, and the plaintiff has opposed such motion. In November 1997, two plaintiffs, one who was the owner of a variable life insurance contract and the other who was the owner of a variable annuity contract, commenced an action against NLIC and the American Century group of defendants (Robert Young and David D. Distad v. Nationwide Life Insurance Company et al.). In this action, plaintiffs seek to represent a class of variable life insurance contract owners and variable annuity contract owners whom they claim were allegedly misled when purchasing these variable contracts into believing that some portion of their premiums were invested in a publicly traded mutual fund when, in fact, the premium monies were invested in a mutual fund whose shares may only be purchased by insurance companies. The complaint seeks unspecified compensatory, treble and punitive damages. In January 1998, both NLIC and American Century filed motions to dismiss the entire complaint. Plaintiffs' counsel have opposed these motions and the federal court in Texas will hear arguments on the motions to dismiss on April 1, 1998. This lawsuit is in an early stage and has not been certified as a class action. NLIC intends to defend this case vigorously. There can be no assurance that any litigation relating to pricing and sales practices will not have a material adverse effect on the Company in the future. 14 ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of 1997 no matters were submitted to a vote of security holders, through the solicitation of proxies or otherwise. EXECUTIVE OFFICERS OF THE REGISTRANT NAME AGE POSITION WITH THE COMPANY ---- --- ------------------------- Dimon Richard McFerson............. 61 Chairman and Chief Executive Officer--Nationwide Insurance Enterprise Joseph J. Gasper................... 54 President and Chief Operating Officer Galen R. Barnes.................... 50 Executive Vice President Richard D. Crabtree................ 57 Executive Vice President Robert A. Oakley................... 51 Executive Vice President--Chief Financial Officer Robert J. Woodward, Jr............. 56 Executive Vice President--Chief Investment Officer James E. Brock..................... 50 Senior Vice President--Corporate Development John R. Cook....................... 54 Senior Vice President--Chief Communications Officer W. Sidney Druen.................... 55 Senior Vice President and General Counsel Harvey S. Galloway, Jr............. 64 Senior Vice President--Chief Actuary Richard D. Headley................. 49 Senior Vice President--Chief Information Technology Officer Donna A. James..................... 40 Senior Vice President--Human Resources Richard A. Karas................... 55 Senior Vice President--Sales--Financial Services Susan A. Wolken.................... 47 Senior Vice President--Operations Bruce C. Barnes.................... 50 Vice President--Information Systems Dennis W. Click.................... 59 Vice President and Secretary David A. Diamond................... 42 Vice President--Controller Matthew S. Easley.................. 41 Vice President--Marketing and Administrative Services Joseph P. Rath..................... 48 Vice President--Chief Compliance Officer Mark R. Thresher................... 41 Vice President--Finance and Treasurer Business experience for each of the individuals listed in the above table is set forth below. DIMON RICHARD MCFERSON has been Chief Executive Officer of the Nationwide Insurance Enterprise since December 1992. He has been Chairman and Chief Executive Officer--Nationwide Insurance Enterprise of the Company since December 1996 and a director of the Company since November 1996. Mr. McFerson has been a director of NLIC and NMIC since April 1988 and Chairman and Chief Executive Officer--Nationwide Insurance Enterprise of NLIC and NMIC since April 1996. Previously he was elected Chief Executive Officer of NLIC in December 1992, and President and Chief Executive Officer -Nationwide Insurance Enterprise of NLIC in December 1993. He was President and General Manager of NMIC from April 1988 to April 1991; President and Chief Operating Officer of NMIC from April 1991 to December 1992; and President and Chief Executive Officer of NMIC from December 1992 to April 1996. Mr. McFerson has been with the Nationwide Insurance Enterprise for 18 years. JOSEPH J. GASPER has been President and Chief Operating Officer of the Company since December 1996 and a director of the Company since November 1996. Mr. Gasper has been President and Chief Operating Officer of NLIC and director since April 1996. Previously, he was Executive Vice President--Property/Casualty Operations of NMIC from April 1995 to April 1996. He was Senior Vice President--Property/Casualty Operations of NMIC from September 1993 to April 1995. Prior to that time, Mr. Gasper held numerous positions within the Nationwide Insurance Enterprise. Mr. Gasper has been with the Nationwide Insurance Enterprise for 31 years. GALEN R. BARNES has been Executive Vice President of the Company since December 1996. Mr. Barnes has been President of the Nationwide Insurance Enterprise since April 1996. Previously, he was President and Chief Operating Officer of the Wausau Insurance Companies, members of the Nationwide Insurance Enterprise, from May 1993 to September 1996 and was Senior Vice President of the Nationwide Insurance Enterprise from 15 May 1993 to April 1996. Prior to that time, Mr. Barnes held several positions within the Nationwide Insurance Enterprise. Mr. Barnes has been with the Nationwide Insurance Enterprise for 22 years. RICHARD D. CRABTREE has been Executive Vice President of the Company since December 1996. Mr. Crabtree has been a director and President and Chief Operating Officer of NMIC, Nationwide Mutual Fire Insurance Company and Nationwide Property and Casualty Insurance Company since April 1996. Previously, he was Executive Vice President--Property/Casualty Operations of the Nationwide Insurance Enterprise from April 1995 to April 1996. Prior to that time, Mr. Crabtree held various positions within the Nationwide Insurance Enterprise. Mr. Crabtree has been with the Nationwide Insurance Enterprise for 32 years. ROBERT A. OAKLEY has been Executive Vice President--Chief Financial Officer of the Company since December 1996. Mr. Oakley has been Executive Vice President--Chief Financial Officer of the Nationwide Insurance Enterprise since April 1995. Previously, he was Senior Vice President--Chief Financial Officer of the Nationwide Insurance Enterprise from October 1993 to April 1995. Prior to that time, Mr. Oakley held several positions within the Nationwide Insurance Enterprise. Mr. Oakley has been with the Nationwide Insurance Enterprise for 22 years. ROBERT J. WOODWARD, JR. has been Executive Vice President--Chief Investment Officer of the Company since December 1996. Mr. Woodward has been Executive Vice President--Chief Investment Officer of the Nationwide Insurance Enterprise since August 1995. Previously, he was Senior Vice President--Fixed Income Investments of the Nationwide Insurance Enterprise from March 1991 to August 1995. Prior to that time, Mr. Woodward held several positions within the Nationwide Insurance Enterprise. Mr. Woodward has been with the Nationwide Insurance Enterprise for 33 years. JAMES E. BROCK has been Senior Vice President--Corporate Development of the Company since July 1997. Mr. Brock has been Senior Vice President--Corporate Development of the Nationwide Insurance Enterprise since July 1997. Previously, he was Senior Vice President--Company Operations from December 1996 to July 1997 and was also Senior Vice President--Life Company Operations of NLIC from April 1996 to July 1997. Mr. Brock was Senior Vice President--Investment Product Operations of NLIC from November 1990 to April 1996. Prior to that time, Mr. Brock held several positions within the Nationwide Insurance Enterprise. Mr. Brock has been with the Nationwide Insurance Enterprise for 28 years. JOHN R. COOK has been Senior Vice President--Chief Communications Officer of the Company since October 1997. Mr. Cook has been Senior Vice President--Chief Communications Officer of the Nationwide Insurance Enterprise since May 1997. Previously, Mr. Cook was Senior Vice President--Chief Communications Officer of USAA from July 1989 to May 1997. W. SIDNEY DRUEN has been Senior Vice President and General Counsel of the Company since December 1996. Mr. Druen has been Senior Vice President and General Counsel and Assistant Secretary of the Nationwide Insurance Enterprise since September 1994. Previously, he was Vice President, Deputy General Counsel and Assistant Secretary of the Nationwide Insurance Enterprise from October 1989 to September 1994. Prior to that time, Mr. Druen held several positions within the Nationwide Insurance Enterprise. Mr. Druen has been with the Nationwide Insurance Enterprise for 28 years. HARVEY S. GALLOWAY, JR. has been Senior Vice President--Chief Actuary of the Company since December 1996. Mr. Galloway has been Senior Vice President--Chief Actuary--Life, Health and Annuities of the Nationwide Insurance Enterprise since April 1993. Previously, he was Senior Vice President and Chief Actuary of the Nationwide Insurance Enterprise from January 1993 to April 1993. Prior to that time, Mr. Galloway held several positions within the Nationwide Insurance Enterprise. Mr. Galloway has been with the Nationwide Insurance Enterprise for 28 years. RICHARD D. HEADLEY has been Senior Vice President--Chief Information Technology Officer of the Company since October 1997. Mr. Headley has been Senior Vice President--Chief Information Technology Officer of the Nationwide Insurance Enterprise since October 1997. Previously, Mr. Headley was Chairman and Chief Executive Officer of Banc One Services Corporation from 1992 to October 1997. From January 1975 until 1992 Mr. Headley held several positions with Banc One Corporation. 16 DONNA A. JAMES has been Senior Vice President--Human Resources of the Company since December 1997. Ms. James has been Senior Vice President--Human Resources of the Nationwide Insurance Enterprise since December 1997. Previously, she was Vice President--Human Resources of the Nationwide Insurance Enterprise from July 1996 to December 1997. Prior to that time Ms. James was Vice President--Assistant to the CEO of the Nationwide Insurance Enterprise from March 1996 to July 1996. From May 1994 to March 1996 she was Associate Vice President--Assistant to the CEO for the Nationwide Insurance Enterprise. Prior to that time Ms. James held several positions within the Nationwide Insurance Enterprise. Ms. James has been with the Nationwide Insurance Enterprise for 16 years. RICHARD A. KARAS has been Senior Vice President--Sales--Financial Services of the Company since December 1996. Mr. Karas has been Senior Vice President--Sales--Financial Services of the Nationwide Insurance Enterprise since March 1993. Previously, he was Vice President--Sales--Financial Services of the Nationwide Insurance Enterprise from February 1989 to March 1993. Prior to that time, Mr. Karas held several positions within the Nationwide Insurance Enterprise. Mr. Karas has been with the Nationwide Insurance Enterprise for 33 years. SUSAN A. WOLKEN has been Senior Vice President--Life Company Operations of the Company since July 1997. Ms. Wolken has been Senior Vice President--Life Company Operations of the Nationwide Insurance Enterprise since June 1997. Previously, she was Senior Vice President--Enterprise Administration of the Nationwide Insurance Enterprise from July 1996 to June 1997. Prior to that time, she was Senior Vice President--Human Resources of the Nationwide Insurance Enterprise from April 1995 to July 1996. From September 1993 to April 1995 Ms. Wolken was Vice President--Human Resources of the Nationwide Insurance Enterprise. From October 1989 to September 1993 she was Vice President--Individual Life and Health Operations of the Nationwide Insurance Enterprise. Ms. Wolken has been with the Nationwide Insurance Enterprise for 23 years. BRUCE C. BARNES has been Vice President--Information Systems of the Company since February 1997. Mr. Barnes has been Vice President--Life Systems of the Nationwide Insurance Enterprise since May 1996. Previously, he was Vice President--Investment Product Systems of Nationwide Insurance Enterprise from April 1995 to May 1996. Prior to that time, Mr. Barnes was Vice President--Individual Investment Products/ Common Systems of the Nationwide Insurance Enterprise from May 1994 to April 1995 and Associate Vice President--Individual Investment Products/Common Systems of NLIC from May 1992 to May 1994. Mr. Barnes was Vice President--Information Services of PHP Benefits Systems, Inc. from January 1987 to January 1992. Mr. Barnes has been with the Nationwide Insurance Enterprise for 6 years. DENNIS W. CLICK has been Vice President--Secretary of the Company since December 1997. Mr. Click has been Vice President--Secretary of the Nationwide Insurance Enterprise since December 1997. Previously, he was Vice President--Assistant Secretary of the Company from December 1996 to December 1997. Mr. Click was Vice President--Assistant Secretary of the Nationwide Insurance Enterprise from August 1994 to December 1997. Mr. Click was Associate Vice President and Assistant Secretary of the Nationwide Insurance Enterprise from August 1989 to August 1994. Prior to that time, he held several positions within the Nationwide Insurance Enterprise. Mr. Click has been with the Nationwide Insurance Enterprise for 37 years. DAVID A. DIAMOND has been Vice President--Controller of the Company since December 1996. Mr. Diamond has been Vice President--Enterprise Controller of Nationwide Insurance Enterprise since August 1996. Previously, he was Vice President--Controller of NLIC from October 1993 to August 1996. Prior to that time, Mr. Diamond held several positions within the Nationwide Insurance Enterprise. Mr. Diamond has been with the Nationwide Insurance Enterprise for 9 years. MATTHEW S. EASLEY has been Vice President--Marketing and Administrative Services of the Company since December 1996. Mr. Easley has been Vice President--Life Marketing and Administrative Services of the Nationwide Insurance Enterprise since May 1996. Mr. Easley was Vice President--Annuity and Pension Actuarial of the Nationwide Insurance Enterprise from August 1989 to May 1996. Prior to that time, Mr. Easley held several positions within the Nationwide Insurance Enterprise. Mr. Easley has been with the Nationwide Insurance Enterprise for 15 years. 17 JOSEPH P. RATH has been Vice President--Chief Compliance Officer of the Company since April 1997. Mr. Rath has been Vice President--Compliance for Nationwide Advisory Services, Inc. and Nationwide Investment Services Corp. since April 1997. He has also been Vice President--Product and Market Compliance for the Nationwide Insurance Enterprise since April 1997. Previously, he was Vice President--Associate General Counsel of the Nationwide Insurance Enterprise from October 1988 to April 1997. Prior to that time, Mr. Rath held several positions within the Nationwide Insurance Enterprise. Mr. Rath has been with the Nationwide Insurance Enterprise for 21 years. MARK R. THRESHER has been Vice President--Finance and Treasurer of the Company since February 1997. Mr. Thresher has been Vice President--Controller of NLIC since August 1996. He was Vice President and Treasurer of the Company from November 1996 to February 1997. Previously, he was Vice President and Treasurer of the Nationwide Insurance Enterprise from June 1996 to August 1996. Prior to joining the Nationwide Insurance Enterprise, Mr. Thresher served as a partner with KPMG Peat Marwick LLP since July 1988. 18 PART II ITEM 5 MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS The Class A Common Stock of NFS is traded on the New York Stock Exchange under the symbol "NFS". As of March 1, 1998, NFS had 827 registered shareholders of Class A Common Stock. There is no established public trading market for the Company's Class B Common Stock. All 104,745,000 shares of Class B Common Stock are owned by Nationwide Corp. Information regarding the high and low sales prices of NFS Class A Common Stock and cash dividends declared on such shares, as required by this item, is set forth in the following table: QUARTER QUARTER ENDED HIGH LOW CLOSE DIVIDENDS --------------------------------------- ------ ------ ------- --------- March 31, 1997......................... $28.50 $25.75 $25.75 -- June 30, 1997.......................... $29.75 $23.38 $26.75 $0.06 September 30, 1997..................... $31.94 $25.75 $27.88 $0.06 December 31, 1997...................... $38.25 $27.00 $36.16 $0.06 Information regarding restrictions on the ability of NFS's insurance subsidiaries to pay dividends to NFS, as required by this item, is set forth under "Item 1: Business-Regulation-Regulation of Dividends and Other Payments from Insurance Subsidiaries" above and in note 13 of the consolidated financial statements on page 53 of the 1997 Annual Report to Shareholders, and is incorporated herein by reference. ITEM 6 SELECTED CONSOLIDATED FINANCIAL DATA Information required by this item is set forth in the table titled "Five Year Summary" on pages 34 and 35 of the Company's 1997 Annual Report to Shareholders, and is incorporated herein by reference. ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Information required by this item is set forth on pages 19 through 33 of the Company's 1997 Annual Report to Shareholders, and is incorporated herein by reference. ITEM 8 CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Information required by this item is set forth on pages 36 through 57 (consolidated financial statements) and page 58 (independent auditors' report) of the Company's 1997 Annual Report to Shareholders, and is incorporated herein by reference. Reference is made to the index to consolidated financial statements included in Item 14. Financial statement schedules are included on pages 25 through 33 herein. Reference is made to the index to financial statement schedules included on page 24 herein. ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES None. 19 PART III ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information set forth under the caption "Election of Directors" on pages 3 through 6 of the Company's 1998 Proxy Statement is incorporated herein by reference. Refer to Part I of the Form 10-K for information as to the executive officers of NFS. ITEM 11 EXECUTIVE COMPENSATION Information required by this item is set forth from the heading "Executive Compensation and Other Information" on pages 7 through 18 of the Company's 1998 Proxy Statement, and is incorporated herein by reference. ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information required by this item is set forth under the caption "Beneficial Ownership of Common Stock" on pages 2 and 3 of the Company's 1998 Proxy Statement, and is incorporated herein by reference. ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information required by this item is set forth under the caption "CERTAIN TRANSACTIONS" on pages 19 through 22 of the Company's 1998 Proxy Statement, and is incorporated herein by reference. 20 PART IV ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-KPART I
Item 1. BusinessItem 4. Submission of Matters to a Vote of Security Holders
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder MattersItem 6. Selected Financial Data
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Item 8. Consolidated Financial Statements and Supplementary Data
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
PART III
Item 10. Directors and Executive Officers of RegistrantItem 11. Executive Compensation
Item 12. Security Ownership of Certain Beneficial Owners and Management
Item 13. Certain Relationships and Related Transactions
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-KFORM 10-K PAGE ---- INDEX TO FINANCIAL STATEMENT SCHEDULES...................... 24 EXHIBIT INDEX............................................... 34-35 REPORTS ON FORM 8-K: On October 8, 1997, the Company filed a Current Report on Form 8-K concerning the announcement of the planned introduction of a new individual variable annuity product. 21 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. NATIONWIDE FINANCIAL SERVICES, INC. (Registrant) By: /s/ DIMON R. MCFERSON ------------------------------------ Dimon R. McFerson Chairman and Chief Executive Officer-- Nationwide Insurance Enterprise Date: March 4, 1998 22 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. /s/ DIMON R. MCFERSON March 4, 1998 /s/ JOSEPH J. GASPER March 4, 1998 --------------------------------- Date --------------------------------- Date Dimon R. McFerson Chairman and Joseph J. Gasper, President and Chief Executive Chief Operating Officer and Officer--Nationwide Insurance Director Enterprise /s/ JAMES G. BROCKSMITH, JR. March 10, 1998 /s/ CHARLES L. FUELLGRAF, JR. March 4, 1998 --------------------------------- Date --------------------------------- Date James G. Brocksmith, Jr., Charles L. Fuellgraf, Jr., Director Director /s/ HENRY S. HOLLOWAY March 4, 1998 /s/ LYDIA MICHEAUX MARSHALL March 9, 1998 --------------------------------- Date --------------------------------- Date Henry S. Holloway, Director Lydia Micheaux Marshall, Director /s/ DONALD L. MCWHORTER March 10, 1998 /s/ DAVID O. MILLER March 4, 1998 --------------------------------- Date --------------------------------- Date Donald L. McWhorter, Director David O. Miller, Director /s/ JAMES F. PATTERSON March 4, 1998 /s/ GERALD D. PROTHRO March 17, 1998 --------------------------------- Date --------------------------------- Date James F. Patterson, Director Gerald D. Prothro, Director /s/ ARDEN L. SHISLER March 4, 1998 /s/ ROBERT A. OAKLEY March 4, 1998 --------------------------------- Date --------------------------------- Date Arden L. Shisler, Director Robert A. Oakley, Executive Vice President--Chief Financial Officer /s/ MARK R. THRESHER March 4,1998 --------------------------------- Date Mark R. Thresher, Vice President--Finance and Treasurer (Chief Accounting Officer) 23 NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES INDEX TO FINANCIAL STATEMENT SCHEDULES PAGE ---- Independent Auditors' Report on Financial Statement Schedules................... 25 Schedule I Consolidated Summary of Investments--Other Than Investments in Related Parties as of December 31, 1997................ 26 Schedule II Condensed Financial Information of Registrant............... 30 Schedule III Supplementary Insurance Information as of December 31, 1997, 1996 and 1995 and for each of the years then ended........ 31 Schedule IV Reinsurance as of December 31, 1997, 1996 and 1995 and for each of the years then ended.............................. 32 Schedule V Valuation and Qualifying Accounts for the years ended December 31, 1997, 1996 and 1995.......................... 33 All other schedules are omitted because they are not applicable or not required, or because the required information has been included in the audited consolidated financial statements or notes thereto. 24CONSOLIDATED FINANCIAL STATEMENTS:
- Consolidated Balance Sheets
- Consolidated Statements of Income
- Consolidated Statements of Shareholders' Equity
- Consolidated Statements of Cash Flows
- Notes to Consolidated Financial Statements
- Report of Independent Auditors
Back to Table of Contents Return to financial index INDEPENDENT AUDITORS' REPORT ON FINANCIAL STATEMENT SCHEDULES The Board of Directors Nationwide Financial Services, Inc.: Under date of January 30, 1998, we reported on the consolidated balance sheets of Nationwide Financial Services, Inc. and Subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1997, as contained in the 1997 annual report to shareholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1997. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG Peat Marwick LLP Columbus, Ohio January 30, 1998 25 SCHEDULE I NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED SUMMARY OF INVESTMENTS -- OTHER THAN INVESTMENTS IN RELATED PARTIES (IN MILLIONS OF DOLLARS) AS OF DECEMBER 31, 1997 ----------------------------------------------------------- --------- --------- -------------- COLUMN A COLUMN B COLUMN C COLUMN D ----------------------------------------------------------- --------- --------- -------------- AMOUNT AT WHICH SHOWN IN THE MARKET CONSOLIDATED TYPE OF INVESTMENT COST VALUE BALANCE SHEET ----------------------------------------------------------- --------- --------- -------------- Fixed maturity securities available-for-sale: Bonds: U.S. Government and government agencies and authorities......................................... $ 3,859.7 $ 3,981.7 $ 3,981.7 States, municipalities and political subdivisions..... 1.6 1.6 1.6 Foreign governments................................... 93.3 95.8 95.8 Public utilities...................................... 1,555.3 1,609.8 1,609.8 All other corporate................................... 7,223.0 7,515.2 7,515.2 --------- --------- --------- Total fixed maturity securities available-for-sale............................... 12,732.9 13,204.1 13,204.1 --------- --------- --------- Equity securities available-for-sale: Common stocks: Industrial, miscellaneous and all other............... 67.8 78.0 78.0 Non-redeemable preferred stock........................... -- 2.4 2.4 --------- --------- --------- Total equity securities available-for-sale.......... 67.8 80.4 80.4 --------- --------- --------- Fixed maturity securities held-to-maturity: Bonds U.S. Government and government agencies and authorities......................................... 6.0 6.0 6.0 --------- --------- --------- Total fixed maturity securities held-to-maturity.... 6.0 6.0 6.0 --------- --------- --------- Mortgage loans on real estate, net......................... 5,228.1 5,181.6(1) Real estate, net: Investment properties.................................... 254.9 235.7(1) Acquired in satisfaction of debt......................... 82.6 75.7(1) Policy loans............................................... 415.3 415.3 Other long-term investments................................ 27.9 25.2(2) Short-term investments..................................... 449.2 449.2 --------- --------- Total investments................................... $19,264.7 $19,673.2 ========= ========= ------------ (1) Difference from Column B is primarily due to valuation allowances due to impairments on mortgage loans on real estate and due to accumulated depreciation and valuation allowances due to impairments on real estate. See note 3 to the consolidated financial statements. (2) Difference from Column B is primarily due to operating gains (losses) of investments in limited partnerships. See accompanying independent auditors' report. 26 SCHEDULE II NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT (IN THOUSANDS OF DOLLARS) CONDENSED BALANCE SHEETS DECEMBER 31, --------------------- 1997 1996 ---- ---- ASSETS Investment in subsidiaries.................................. $2,474,386 $ -- Short-term investments...................................... 67,534 -- Cash........................................................ -- 1 Accrued investment income................................... 762 -- Other assets................................................ 8,704 803 ---------- ---- $2,551,386 $804 ========== ==== LIABILITIES AND SHAREHOLDERS' EQUITY Long-term debt.............................................. $ 401,469 $ -- Other liabilities........................................... 25,754 803 ---------- ---- 427,223 803 ---------- ---- Shareholders' equity........................................ 2,124,163 1 ---------- ---- $2,551,386 $804 ========== ==== CONDENSED STATEMENT OF INCOME YEAR ENDED DECEMBER 31, 1997 ----------------- Revenues: Dividends received from subsidiaries...................... $ 850,000 Investment income......................................... 3,965 --------- 853,965 --------- Expenses: Interest expense on long-term debt........................ 26,111 Other operating expenses.................................. 510 --------- 26,621 --------- Income before federal income tax benefit............... 827,344 Federal income tax benefit.................................. 7,930 --------- Income before equity in net income of subsidiaries..... 835,274 Equity in net income of subsidiaries........................ (570,093) --------- Net income............................................. $ 265,181 ========= See accompanying notes to condensed financial statements and independent auditors' report. 27 NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES SCHEDULE II--CONDENSED FINANCIAL INFORMATION OF REGISTRANT, CONTINUED (IN THOUSANDS OF DOLLARS) CONDENSED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, ------------ 1997 1996 ---- ---- Cash flows from operating activities: Net income................................................ $ 265,181 $-- Adjustments to reconcile net income to net cash provided by operating activities: Equity in net income of subsidiaries................... (279,907) -- Other, net............................................. 17,502 -- --------- --- Net cash provided by operating activities............ 2,776 -- --------- --- Cash flows from investing activities: Contributions of capital paid to subsidiaries............. (839,873) -- Short-term investments, net............................... (67,534) -- --------- --- Net cash used in investing activities................ (907,407) -- --------- --- Cash flows from financing activities: Net proceeds from issuance of common stock................ 524,191 1 Net proceeds from issuance of long-term debt.............. 395,862 -- Cash dividends paid....................................... (15,423) -- --------- --- Net cash provided by financing activities............ 904,630 -- --------- --- Net decrease in cash........................................ (1) -- Cash, beginning of year..................................... 1 -- --------- --- Cash, end of year........................................... $ -- $ 1 ========= === See accompanying notes to condensed financial statements and independent auditors' report. 28 NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES SCHEDULE II--CONDENSED FINANCIAL INFORMATION OF REGISTRANT, CONTINUED (IN THOUSANDS OF DOLLARS) NOTES TO CONDENSED FINANCIAL STATEMENTS (1) ORGANIZATION AND PRESENTATION Nationwide Financial Services, Inc. (NFS) was formed in November 1996 as a holding company for Nationwide Life Insurance Company (NLIC) and the other companies within the Nationwide Insurance Enterprise that offer or distribute long-term savings and retirement products. On March 11 1997, NFS sold, in an initial public offering, 23.6 million shares of its newly-issued Class A common stock for net proceeds of $524,191 (the Equity Offering). In March 1997, NFS also sold, in companion public offerings, $300,000 of 8% Senior Notes (the Notes) and, Nationwide Financial Services Capital Trust (NFSCT), a wholly owned subsidiary of NFS, issued $100,000 of 7.899% Capital Securities (the Capital Securities). Concurrent with the sale of the Capital Securities by NFSCT, NFS sold to NFSCT $103,093 in principal amount of its 7.899% Junior Subordinated Deferrable Interest Debentures (Junior Subordinated Debentures). Aggregate net proceeds from the Equity Offering, the offering of the Notes and the sale of the Junior Subordinated Debentures totaled $920,053. NFS contributed $836,780 and $3,093 of the proceeds to the capital of NLIC and NFSCT, respectively, and retained $80,180 of the proceeds for general corporate purposes. Prior to the initial public offering , NFS was a wholly owned subsidiary of Nationwide Corporation (Nationwide Corp.). Nationwide Corp. continues to own all of the outstanding shares of Class B common stock, which represents approximately 98% of the combined voting power of the shareholders of NFS. During the first quarter of 1997, NFS's Board of Directors approved a 104,745 for one split of the NFS Class B common stock, which became effective February 10, 1997. During 1996 and 1997, Nationwide Corp. and NFS completed certain transactions in anticipation of the initial public offering that focused the business of NFS on long-term savings and retirement products. On September 24, 1996, NLIC declared a dividend payable to Nationwide Corp. on January 1, 1997 consisting of the outstanding shares of common stock of certain subsidiaries that do not offer or distribute long-term savings or retirement products. In addition, during 1996, NLIC entered into two reinsurance agreements whereby all of NLIC's accident and health and group life insurance business was ceded to two affiliates effective January 1, 1996. On January 27, 1997, Nationwide Corp. contributed the common stock of NLIC and three marketing and distribution companies to NFS. Additionally, NFS received a dividend from NLIC on February 24, 1997 and immediately thereafter paid a dividend to Nationwide Corp. consisting of securities with a fair value of $850,000. NFS conducted no operations during 1996, except for the deferral of certain costs associated with the public offerings, and accordingly, has not presented a condensed statement of income for the year ended December 31, 1996. See accompanying independent auditors' report. 29 NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES SCHEDULE II--CONDENSED FINANCIAL INFORMATION OF REGISTRANT, CONTINUED (IN THOUSANDS OF DOLLARS) NOTES TO CONDENSED FINANCIAL STATEMENTS, CONTINUED (2) LONG-TERM DEBT AND GUARANTEES Long-term debt outstanding as of December 31, 1997 consists of the following: 8% Senior Notes due March 1, 2027 (net of unamortized discount of $1,624)....................................... $298,376 7.899% Junior Subordinated Deferrable Interest Debentures due March 1, 2037......................................... 103,093 -------- $401,469 ======== The Notes 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 Notes are not subject to any sinking fund payments. The terms of the Notes contain various restrictive covenants including limitations on the disposition of subsidiaries. As of December 31, 1997, NFS was in compliance with all such covenants. NFS made interest payments on the Notes in 1997 of $11,400. The Junior Subordinated Debentures are redeemable by NFS in whole at any time or in part from time to time at par plus an applicable make-whole premium. The Junior Subordinated Debentures will mature or be called simultaneously with the Capital Securities. The Capital Securities, through obligations of NFS under the Junior Subordinated Debentures, the Capital Securities Guarantee Agreement and the related Declaration of Trust and Indenture, are fully and unconditionally guaranteed by NFS. NFS made interest payments on the Junior Subordinated Debentures in 1997 of $3,845. See accompanying independent auditors' report. 30 SCHEDULE III NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES SUPPLEMENTARY INSURANCE INFORMATION (IN MILLIONS OF DOLLARS) As of December 31, 1997, 1996 and 1995 and for each of the years then ended ----------------------- --------------- -------------------- ------------------ ------------------- ---------- COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F ----------------------- --------------- -------------------- ------------------ ------------------- ---------- DEFERRED FUTURE POLICY OTHER POLICY POLICY BENEFITS, LOSSES, CLAIMS AND ACQUISITION CLAIMS AND UNEARNED BENEFITS PAYABLE PREMIUM SEGMENT COSTS LOSS EXPENSES PREMIUMS (1) (1) REVENUE ----------------------- --------------- -------------------- ------------------ ------------------- ---------- 1997: Variable Annuities $1,018.4 $ -- $ -- Fixed Annuities 277.9 14,103.1 27.3 Life Insurance 472.9 2,683.4 178.1 Corporate and Other (103.8) 1,916.3 -- -------- --------- ------ Total $1,665.4 $18,702.8 $205.4 ======== ========= ====== 1996: Variable Annuities $ 792.1 $ -- $ -- Fixed Annuities 242.0 13,388.9 24.0 Life Insurance 414.4 2,391.5 174.6 Corporate and Other (82.0) 1,820.2 -- -------- --------- ------ Total $1,366.5 $17,600.6 $198.6 ======== ========= ====== 1995: Variable Annuities $ 569.8 $ -- $ -- Fixed Annuities 220.7 12,759.3 32.8 Life Insurance 366.9 2,282.6 166.3 Corporate and Other (136.9) 1,730.0 -- -------- --------- ------ Total $1,020.5 $16,771.9 $199.1 ======== ========= ====== ----------------------- --------------- -------------------- ------------------ ------------------- ---------- COLUMN A COLUMN G COLUMN H COLUMN I COLUMN J COLUMN K ----------------------- --------------- -------------------- ------------------ ------------------- ---------- NET INVESTMENT BENEFITS, CLAIMS, AMORTIZATION OTHER INCOME LOSSES AND OF DEFERRED POLICY OPERATING EXPENSES PREMIUMS SEGMENT (2) SETTLEMENT EXPENSES ACQUISITION COSTS (2) WRITTEN ----------------------- --------------- -------------------- ------------------ ------------------- ---------- 1997: Variable Annuities $ (26.8) $ 5.9 $ 87.8 $159.4 Fixed Annuities 1,098.2 846.7 39.8 85.4 Life Insurance 189.1 227.5 39.6 94.5 Corporate and Other 153.4 114.7 -- 63.4 -------- --------- ------ ------ Total $1,413.9 $ 1,194.8 $167.2 $402.7 ======== ========= ====== ====== 1996: Variable Annuities $ (21.4) $ 4.6 $ 57.4 $132.3 Fixed Annuities 1,050.6 838.5 38.6 79.7 Life Insurance 174.0 211.4 37.4 79.0 Corporate and Other 154.6 106.1 -- 62.5 -------- --------- ------ ------ Total $1,357.8 $ 1,160.6 $133.4 $353.5 ======== ========= ====== ====== 1995: Variable Annuities $ (17.6) $ 2.9 $ 26.3 $109.1 Fixed Annuities 1,002.7 805.0 29.5 80.3 Life Insurance 171.2 202.0 31.0 68.8 Corporate and Other 137.7 105.6 (4.1) 59.5 -------- --------- ------ ------ Total $1,294.0 $ 1,115.5 $ 82.7 $317.7 ======== ========= ====== ====== ------------ (1) Unearned premiums and other policy claims and benefits payable are included in Column C amounts. See accompanying independent auditors' report. 31 (2) Allocations of net investment income and certain operating expenses are based on a number of assumptions and estimates, and reported operating results would change by segment if different methods were applied. See accompanying independent auditors' report. 31.1 SCHEDULE IV NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES REINSURANCE (IN MILLIONS OF DOLLARS) AS OF DECEMBER 31, 1997, 1996 AND 1995 AND FOR EACH OF THE YEARS THEN ENDED ----------------------------------------- --------- --------- ---------- --------- ---------- COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F ----------------------------------------- --------- --------- ---------- --------- ---------- PERCENTAGE CEDED TO ASSUMED OF AMOUNT GROSS OTHER FROM OTHER NET ASSUMED AMOUNT COMPANIES COMPANIES AMOUNT TO NET --------- --------- ---------- --------- ---------- 1997: Life insurance in force................ $52,648.4 $13,678.7 $289.7 $39,259.4 0.7% ========= ========= ====== ========= === Premiums: Life insurance...................... $ 235.9 $ 32.7 $ 2.2 $ 205.4 1.1% Accident and health insurance....... 261.2 272.6 11.4 -- N/A --------- --------- ------ --------- --- Total............................. $ 497.1 $ 305.3 $ 13.6 $ 205.4 6.6% ========= ========= ====== ========= === 1996: Life insurance in force................ $47,150.6 $11,164.6 $288.6 $36,274.6 0.8% ========= ========= ====== ========= === Premiums: Life insurance...................... $ 225.6 $ 29.3 $ 2.3 $ 198.6 1.2% Accident and health insurance....... 291.9 305.8 13.9 -- N/A --------- --------- ------ --------- --- Total............................. $ 517.5 $ 335.1 $ 16.2 $ 198.6 8.2% ========= ========= ====== ========= === 1995: Life Insurance in force................ $41,087.9 $ 8,935.7 $391.2 $32,543.4 1.2% ========= ========= ====== ========= === Premiums: Life insurance...................... $ 221.3 $ 24.4 $ 2.2 $ 199.1 1.1% Accident and health insurance....... 298.0 313.0 15.0 -- N/A --------- --------- ------ --------- --- Total............................. $ 519.3 $ 337.4 $ 17.2 $ 199.1 8.6% ========= ========= ====== ========= === ------------ Note: The life insurance caption represents principally premiums from traditional life insurance and life-contingent immediate annuities and excludes deposits on investment products and universal life insurance products. See accompanying independent auditors' report. 32 SCHEDULE V NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS (IN MILLIONS OF DOLLARS) YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995 ----------------------------------------- ----------- ----------------------- ---------- ---------- COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E ----------------------------------------- ----------- ----------------------- ---------- ---------- BALANCE AT CHARGED TO CHARGED TO BALANCE AT BEGINNING COSTS AND OTHER DEDUCTIONS END OF DESCRIPTION OF PERIOD EXPENSES ACCOUNTS (1) PERIOD ----------------------------------------- ----------- ---------- ---------- ---------- ---------- 1997: Valuation allowances - fixed maturity securities.......................... $ -- $ 16.2 $ -- $ 16.2 $ -- Valuation allowances - mortgage loans on real estate...................... 51.0 (1.2) -- 7.3 42.5 Valuation allowances - real estate..... 15.2 (4.1) -- -- 11.1 --------- -------- ----- -------- ----- Total............................. $ 66.2 $ 10.9 $ -- $ 23.5 $53.6 ========= ======== ===== ======== ===== 1996: Valuation allowances - mortgage loans on real estate...................... $ 49.1 $ 4.5 $ -- $ 2.6 $51.0 Valuation allowances - real estate..... 25.8 (10.6) -- -- 15.2 --------- -------- ----- -------- ----- Total............................. $ 74.9 $ (6.1) $ -- $ 2.6 $66.2 ========= ======== ===== ======== ===== 1995: Valuation allowances - fixed maturity securities.......................... $ -- $ 8.9 $ -- $ 8.9 $ -- Valuation allowances - mortgage loans on real estate...................... 46.4 7.4 -- 4.7 49.1 Valuation allowances - real estate..... 27.3 (1.5) -- -- 25.8 --------- -------- ----- -------- ----- Total............................. $ 73.7 $ 14.8 $ -- $ 13.6 $74.9 ========= ======== ===== ======== ===== ------------ (1) Amounts represent direct write-downs charged against the valuation allowance. See accompanying independent auditors' report. 33 EXHIBIT INDEX EXHIBIT ------- 3.1 Form of Restated Certificate of Incorporation of Nationwide Financial Services, Inc. (previously filed as Exhibit 3.1 to Form S-1, Registration Number 333-18527, filed March 5, 1997, and incorporated herein by reference) 3.2 Form of Restated Bylaws of Nationwide Financial Services, Inc. (previously filed as Exhibit 3.2 to Form S-1, Registration Number 333-18527, filed March 5, 1997, and incorporated herein by reference) 4.1 Form of Indenture relating to the Notes, including the form of Global Note and the form of Definitive Note (previously filed as Exhibit 4.1 to Form S-1, Registration Number 333-18527, filed March 5, 1997, and incorporated herein by reference) 4.2 Form of Indenture relating to the Junior Subordinated Deferrable Interest Debentures due 2037 of Nationwide Financial Services, Inc. (previously filed as Exhibit 4.1 to Form S-1, Registration Number 333-18533, filed March 5, 1997, and incorporated herein by reference) 10.1 Form of Intercompany Agreement among Nationwide Mutual Insurance Company, Nationwide Corporation and Nationwide Financial Services, Inc. (previously filed as Exhibit 10.1 to Form S-1, Registration Number 333-18527, filed March 5, 1997, and incorporated herein by reference) 10.2 Form of Tax Sharing Agreement among Nationwide Mutual Insurance Company and any corporation that may hereafter be a subsidiary of Nationwide Mutual Insurance Company (previously filed as Exhibit 10.2 to Form S-1, Registration Number 333-18527, filed March 5, 1997,and incorporated herein by reference) 10.2.1 First Amendment to the Tax Sharing Agreement among Nationwide Mutual Insurance Company and any corporation that may hereafter be a subsidiary of Nationwide Mutual Insurance Company 10.3 Form of First Amendment to Cost Sharing Agreement among parties named therein (previously filed as Exhibit 10.3 to Form S-1, Registration Number 333-18527, filed March 5, 1997, and incorporated herein by reference) 10.4 Modified Coinsurance Agreement between Nationwide Life Insurance Company and Nationwide Mutual Insurance Company (previously filed as Exhibit 10.4 to Form S-1, Registration Number 333-18527, filed March 5, 1997, and incorporated herein by reference) 10.5 Modified Coinsurance Agreement between Employers Life Insurance Company of Wausau and Nationwide Life Insurance Company (previously filed as Exhibit 10.5 to Form S-1, Registration Number 333-18527, filed March 5, 1997, and incorporated herein by reference) 10.6 Credit Facility, dated August 12, 1996, among Nationwide Life Insurance Company, Nationwide Mutual Insurance Company, the banks named therein and Morgan Guaranty Trust Company of New York, the administrative agent (previously filed as Exhibit 10.6 to Form S-1, Registration Number 333-18527, filed March 5, 1997, and incorporated herein by reference) 10.6.1 Amendment dated as of September 8, 1997 to the Credit Agreement dated as of August 12, 1996 among Nationwide Mutual Insurance Company, Nationwide Life Insurance Company, the Banks party thereto and Morgan Guaranty Trust Company of New York, as administrative agent (previously filed as Exhibit 10(a) to Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1997, and incorporated herein by reference) 10.7 Form of Lease Agreement between Nationwide Mutual Insurance Company, Nationwide Life Insurance Company, Nationwide Life and Annuity Insurance Company and Nationwide Financial Services, Inc. (previously filed as Exhibit 10.7 to Form S-1, Registration Number 333-18527, filed March 5, 1997, and incorporated herein by reference) 10.8 Form of Nationwide Financial Services, Inc. 1996 Long-Term Equity Compensation Plan (previously filed as Exhibit 10.8 to Form S-1, Registration Number 333-18527, filed March 5, 1997, and incorporated herein by reference) 34 EXHIBIT ------- 10.9 General Description of Nationwide Insurance Enterprise Executive Incentive Plan (previously filed as Exhibit 10.9 to Form S-1, Registration Number 333-18527, filed March 5, 1997, and incorporated herein by reference) 10.10 General Description of Nationwide Insurance Enterprise Management Incentive Plan (previously filed as Exhibit 10.10 to Form S-1, Registration Number 333-18527, filed March 5, 1997, and incorporated herein by reference) 10.11 Nationwide Insurance Enterprise Excess Benefit Plan effective as of December 31, 1996 (previously filed as Exhibit 10.11 to Form S-1, Registration Number 333-18527, filed March 5, 1997, and incorporated herein by reference) 10.12 Nationwide Insurance Enterprise Supplemental Retirement Plan effective as of December 31, 1996 (previously filed as Exhibit 10.12 to Form S-1, Registration Number 333-18527, filed March 5, 1997, and incorporated herein by reference) 10.13 Nationwide Salaried Employees Severance Pay Plan (previously filed as Exhibit 10.13 to Form S-1, Registration Number 333-18527, filed March 5, 1997, and incorporated herein by reference) 10.14 Nationwide Insurance Enterprise Supplemental Defined Contribution Plan effective as of January 1, 1996 (previously filed as Exhibit 10.14 to Form S-1, Registration Number 333-18527, filed March 5, 1997, and incorporated herein by reference) 10.15 General Description of Nationwide Insurance Enterprise Individual Deferred Compensation Program (previously filed as Exhibit 10.15 to Form S-1, Registration Number 333-18527, filed March 5, 1997, and incorporated herein by reference) 10.16 General Description of Nationwide Mutual Insurance Company Directors Deferred Compensation Program (previously filed as Exhibit 10.16 to Form S-1, Registration Number 333-18527, filed March 5, 1997, and incorporated herein by reference) 10.17 Deferred Compensation Agreement, dated as of September 3, 1979, between Nationwide Mutual Insurance Company and D. Richard McFerson (previously filed as Exhibit 10.17 to Form S-1, Registration Number 333-18527, filed March 5, 1997, and incorporated herein by reference) 10.18 Nationwide Financial Services, Inc. Stock Retainer Plan for Non-Employee Directors (previously filed as Exhibit 10.18 to Form S-1, Registration Number 333-18527, filed March 5, 1997, and incorporated herein by reference) 11 Statement Regarding Computation of Earnings Per Share 13 Pages 19-58 of the Company's 1997 Annual Report to Shareholders 21 Subsidiaries of the Registrant 23 Consent of KPMG Peat Marwick LLP, Independent Auditors 27 Financial Data Schedule ------------ All other exhibits referenced by Item 601 of Regulation S-K are not required under the related instructions or are inapplicable and therefore have been omitted. 35 Exhibit 10.2.1 FIRST AMENDMENT TO THE TAX SHARING AGREEMENT The First Amendment of the Tax Sharing Agreement dated March 4, 1997 (the "Agreement") is entered into by and between Nationwide Mutual Insurance Company, an Ohio mutual company ("Nationwide") and any corporation that is, or may hereafter be, a subsidiary of Nationwide and become a party hereto as contemplated by Section 8 of the Agreement (collectively, the "Subsidiaries"). WHEREAS, Nationwide and the Subsidiaries did enter into the Agreement on March 4, 1997, with the intent to define the method for allocating the tax liability of the Group, as that term is defined in the Agreement; and WHEREAS, Nationwide and the Subsidiaries wish to amend the Agreement to more accurately and clearly reflect their intent, effective as of the effective date of the Agreement; NOW, THEREFORE, the Agreement is amended as follows: 1. The last paragraph of Section 1 of the Agreement is hereby amended and restated to read: In addition, for purposes of this Agreement, the "federal income tax liability" or "federal income tax refund" for any Tax Year shall be an amount equal to the decrease or increase, respectively, in the earnings and profits of Nationwide or any Subsidiary, as calculated under Section 1552(a)(2) and Regulation 1.1502-33(d)(3) (the Percentage Method, using 100%), but without regard to the provisions of Section 55 of the Code. 2. Section 6 is amended and restated to read: Section 6. Refunds. If, on the basis of the computation made by Nationwide in accordance with Section 4 hereof, any Subsidiary is entitled to a federal income tax refund taking into account all facts in existence at the time of such determination, but excluding any tax attributes of the Subsidiary which have been utilized by the Group and for which the Subsidiary has been previously compensated, Nationwide shall pay such Subsidiary the amount of the federal income tax refund. In all other respects, the Agreement is hereby ratified and affirmed by the parties hereto. This Amendment may be executed in any number of counterparts all of which shall be considered one original. IN WITNESS WHEREOF, the parties hereto have caused this Tax Sharing Agreement to be duly executed and delivered as of December 15, 1997. NATIONWIDE MUTUAL INSURANCE COMPANY AFFILIATE AGENCY, INC. By: /s/ ROBERT A. OAKLEY By: /s/ W. SIDNEY DRUEN ------------------------------------------------ ----------------------------------------- Robert A. Oakley W. Sidney Druen Executive Vice President-Chief Financial Officer Senior Vice President and General Counsel AFFILIATE AGENCY OF OHIO, INC. BEAK AND WIRE CORPORATION (THE). By: /s/ W. SIDNEY DRUEN By: /s/ W. SIDNEY DRUEN ------------------------------------------------ ----------------------------------------- W. Sidney Druen W. Sidney Druen Senior Vice President and General Counsel Senior Vice President and General Counsel COLONIAL INSURANCE COMPANY CALIFORNIA CASH MANAGEMENT COMPANY OF WISCONSIN By: /s/ W. SIDNEY DRUEN By: /s/ W. SIDNEY DRUEN ------------------------------------------------ ----------------------------------------- W. Sidney Druen W. Sidney Druen Senior Vice President and General Counsel Senior Vice President and General Counsel FINANCIAL HORIZONS DISTRIBUTORS AGENCY FINANCIAL HORIZONS DISTRIBUTORS AGENCY OF ALABAMA, INC. OF OHIO, INC. By: /s/ W. SIDNEY DRUEN By: /s/ W. SIDNEY DRUEN ------------------------------------------------ ----------------------------------------- W. Sidney Druen W. Sidney Druen Senior Vice President and General Counsel Senior Vice President and General Counsel FINANCIAL HORIZONS DISTRIBUTORS AGENCY FINANCIAL HORIZONS DISTRIBUTORS AGENCY OF OKLAHOMA, INC. OF TEXAS, INC. By: /s/ W. SIDNEY DRUEN By: /s/ W. SIDNEY DRUEN ------------------------------------------------ ----------------------------------------- W. Sidney Druen W. Sidney Druen Senior Vice President and General Counsel Senior Vice President and General Counsel FINANCIAL HORIZONS SECURITIES CORP. GATES, MCDONALD & COMPANY By: /s/ W. SIDNEY DRUEN By: /s/ W. SIDNEY Druen ------------------------------------------------ ----------------------------------------- W. Sidney Druen W. Sidney Druen Senior Vice President and General Counsel Senior Vice President and General Counsel GATES, MCDONALD & COMPANY OF NEW GATES, MCDONALD & COMPANY OF NEVADA YORK, INC. By: /s/ W. SIDNEY DRUEN By: /s/ W. SIDNEY DRUEN ------------------------------------------------ ----------------------------------------- W. Sidney Druen W. Sidney Druen Senior Vice President and General Counsel Senior Vice President and General Counsel GATESMCDONALD HEALTH PLUS, INC. INSURANCE INTERMEDIARIES, INC. By: /s/ W. SIDNEY DRUEN By: /s/ R. LEE AYOTTE ------------------------------------------------ ----------------------------------------- W. Sidney Druen R. Lee Ayotte Senior Vice President and General Counsel President LANDMARK FINANCIAL SERVICES OF NEW YORK, INC. LONE STAR GENERAL AGENCY, INC. By: /s/ W. SIDNEY DRUEN By: /s/ W. SIDNEY DRUEN ------------------------------------------------ ----------------------------------------- W. Sidney Druen W. Sidney Druen Senior Vice President and General Counsel Senior Vice President and General Counsel MRM INVESTMENTS, INC. NEW, INC. By: /s/ W. SIDNEY DRUEN By: /s/ W. SIDNEY DRUEN ------------------------------------------------ ----------------------------------------- W. Sidney Druen W. Sidney Druen Senior Vice President and General Counsel Senior Vice President and General Counsel NATIONAL PREMIUM & BENEFIT NATIONAL CASUALTY COMPANY ADMINISTRATION COMPANY By: /s/ W. SIDNEY DRUEN By: /s/ GORDON E. MCCUTCHAN ------------------------------------------------ ----------------------------------------- W. Sidney Druen Gordon E. McCutchan Senior Vice President and General Counsel Executive Vice President-Law and Corporate Services and Secretary NATIONWIDE ADVISORY SERVICES, INC. NATIONWIDE AGENCY, INC. By: /s/ W. SIDNEY DRUEN By: /s/ GORDON E. MCCUTCHAN ------------------------------------------------ ----------------------------------------- W. Sidney Druen Gordon E. McCutchan Senior Vice President and General Counsel Secretary NATIONWIDE AGRIBUSINESS INSURANCE COMPANY NATIONWIDE CASH MANAGEMENT COMPANY By: /s/ W. SIDNEY DRUEN By: /s/ W. SIDNEY DRUEN ------------------------------------------------ ----------------------------------------- W. Sidney Druen W. Sidney Druen Senior Vice President and General Counsel Senior Vice President and General Counsel NATIONWIDE COMMUNITY URBAN NATIONWIDE COMMUNICATIONS INC. REDEVELOPMENT CORPORATION By: /s/ W. SIDNEY DRUEN By: /s/ W. SIDNEY DRUEN ------------------------------------------------ ----------------------------------------- W. Sidney Druen W. Sidney Druen Senior Vice President and General Counsel Senior Vice President and General Counsel NATIONWIDE FINANCIAL INSTITUTIONS NATIONWIDE CORPORATION DISTRIBUTORS AGENCY, INC. By: /s/ W. SIDNEY DRUEN By: /s/ W. SIDNEY DRUEN ------------------------------------------------ ----------------------------------------- W. Sidney Druen W. Sidney Druen Senior Vice President and General Counsel Senior Vice President and General Counsel NATIONWIDE FINANCIAL SERVICES, INC. NATIONWIDE GENERAL INSURANCE COMPANY By: /s/ W. SIDNEY DRUEN By: /s/ W. SIDNEY DRUEN ------------------------------------------------ ----------------------------------------- W. Sidney Druen W. Sidney Druen Senior Vice President and General Counsel Senior Vice President and General Counsel NATIONWIDE HMO, INC. NATIONWIDE INDEMNITY COMPANY By: /s/ GORDON E. MCCUTCHAN By: /s/ W. SIDNEY DRUEN ------------------------------------------------ ----------------------------------------- Gordon E. McCutchan W. Sidney Druen Secretary Senior Vice President and General Counsel NATIONWIDE INVESTMENT SERVICES CORPORATION NATIONWIDE INVESTORS SERVICES, INC. By: /s/ W. SIDNEY DRUEN By: /s/ W. SIDNEY DRUEN ------------------------------------------------ ----------------------------------------- W. Sidney Druen W. Sidney Druen Senior Vice President and General Counsel Senior Vice President and General Counsel NATIONWIDE LIFE AND ANNUITY INSURANCE NATIONWIDE LIFE INSURANCE COMPANY COMPANY By: /s/ W. SIDNEY DRUEN By: /s/ W. SIDNEY DRUEN ------------------------------------------------ ----------------------------------------- W. Sidney Druen W. Sidney Druen Senior Vice President and General Counsel Senior Vice President and General Counsel NATIONWIDE PROPERTY AND CASUALTY NATIONWIDE MANAGEMENT SYSTEMS, INC. INSURANCE COMPANY By: /s/ GORDON E. MCCUTCHAN By: /s/ W. SIDNEY DRUEN ------------------------------------------------ ----------------------------------------- Gordon E. McCutchan W. Sidney Druen Secretary Senior Vice President and General Counsel NEA VALUEBUILDER INVESTOR SERVICES OF NEA VALUEBUILDER INVESTOR SERVICES, INC. ALABAMA, INC. By: /s/ W. SIDNEY DRUEN By: /s/ W. SIDNEY DRUEN ------------------------------------------------ ----------------------------------------- W. Sidney Druen W. Sidney Druen Senior Vice President and General Counsel Senior Vice President and General Counsel NEA VALUEBUILDER INVESTOR SERVICES OF NEA VALUEBUILDER INVESTOR SERVICES OF ARIZONA, INC. MONTANA, INC. By: /s/ W. SIDNEY DRUEN By: /s/ W. SIDNEY DRUEN ------------------------------------------------ ----------------------------------------- W. Sidney Druen W. Sidney Druen Senior Vice President and General Counsel Senior Vice President and General Counsel NEA VALUEBUILDER INVESTOR SERVICES OF NEA VALUEBUILDER INVESTOR SERVICES OF NEVADAA, INC. OHIO, INC. By: /s/ W. SIDNEY DRUEN By: /s/ W. SIDNEY DRUEN ------------------------------------------------ ----------------------------------------- W. Sidney Druen W. Sidney Druen Senior Vice President and General Counsel Senior Vice President and General Counsel NEA VALUEBUILDER INVESTOR SERVICES OF NEA VALUEBUILDER INVESTOR SERVICES OF OKLAHOMA, INC. TEXAS, INC. By: /s/ W. SIDNEY DRUEN By: /s/ ROBERT W. WENDEL ------------------------------------------------ ----------------------------------------- W. Sidney Druen Robert W. Wendel Senior Vice President and General Counsel President NEA VALUEBUILDER INVESTOR SERVICES OF NEA VALUEBUILDER SERVICES INSURANCE WYOMING, INC. AGENCY, INC. By: /s/ W. SIDNEY DRUEN By: /s/ W. SIDNEY DRUEN ------------------------------------------------ ----------------------------------------- W. Sidney Druen W. Sidney Druen Senior Vice President and General Counsel Senior Vice President and General Counsel PEBSCO OF MASSACHUSSETTS INSURANCE AGENCY, INC. PEBSCO OF TEXAS, INC. By: /s/ W. SIDNEY DRUEN By: /s/ ROBERT W. WENDEL ------------------------------------------------ ----------------------------------------- W. Sidney Druen Robert W. Wendel Senior Vice President and General Counsel President PUBLIC EMPLOYEES BENEFIT SERVICES PUBLIC EMPLOYEES BENEFIT SERVICES CORPORATION CORPORATION OF ALABAMA By: /s/ W. SIDNEY DRUEN By: /s/ W. SIDNEY DRUEN ------------------------------------------------ ----------------------------------------- W. Sidney Druen W. Sidney Druen Senior Vice President and General Counsel Senior Vice President and General Counsel PUBLIC EMPLOYEES BENEFIT SERVICES PUBLIC EMPLOYEES BENEFIT SERVICES CORPORATION OF ARKANSAS CORPORATION OF MONTANA By: /s/ W. SIDNEY DRUEN By: /s/ W. SIDNEY DRUEN ------------------------------------------------ ----------------------------------------- W. Sidney Druen W. Sidney Druen Senior Vice President and General Counsel Senior Vice President and General Counsel PUBLIC EMPLOYEES BENEFIT SERVICES CORPORATION OF NEW MEXICO SCOTTSDALE INDEMNITY COMPANY By: /s/ W. SIDNEY DRUEN By: /s/ W. SIDNEY DRUEN ------------------------------------------------ ----------------------------------------- W. Sidney Druen W. Sidney Druen Senior Vice President and General Counsel Senior Vice President and General Counsel SCOTTSDALE INSURANCE COMPANY TIG COUNTRYWIDE INSURANCE COMPANY By: /s/ W. SIDNEY DRUEN By: /s/ W. SIDNEY DRUEN ------------------------------------------------ ----------------------------------------- W. Sidney Druen W. Sidney Druen Senior Vice President and General Counsel Senior Vice President and General Counsel Exhibit 11 NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES Computation of Earnings Per Share Years Ended December 31, 1997, 1996 and 1995 (in millions of dollars, except per share amounts) 1997 1996 1995 ---- ---- ---- Net income $ 265.2 $ 223.6 $ 209.6 ============ ============ ============ Diluted net income $ 265.2 $ 223.6 $ 209.6 ============ ============ ============ Weighted average common shares outstanding 124,031,688 104,745,000 104,745,000 Dilutive effect of stock options 34,550 -- -- ------------ ------------ ------------ Diluted common shares outstanding 124,066,238 104,745,000 104,745,000 ============ ============ ============ Earnings per common share: Basic $ 2.14 Diluted $ 2.14 Exhibit 13 Nationwide Financial Services, Inc. and Subsidiaries -------------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ================================================================================ INTRODUCTION Management's discussion and analysis of financial condition and results of operations of Nationwide Financial Services, Inc. and subsidiaries (NFS or collectively the Company) for the three years ended December 31, 1997 follows. This discussion should be read in conjunction with the Company's consolidated financial statements and related notes included elsewhere in this report. NFS is a holding company for Nationwide Life Insurance Company (NLIC) and the other companies within the Nationwide Insurance Enterprise that offer or distribute long-term savings and retirement products. In March 1997, NFS sold 23.6 million shares of its newly-issued Class A common stock in an initial public offering (the IPO), receiving net proceeds of $524.2 million. Concurrent with the IPO, NFS sold $300.0 million of senior notes and $100.0 million of capital securities of subsidiary trust in companion public offerings. In addition to actual results, the Company presents pro forma results adjusted for the public offerings and for special dividends paid in anticipation of the IPO as if they had occurred at the beginning of each year presented. See note 1 to the consolidated financial statements for additional information regarding the public offerings and special dividends. Management's discussion and analysis contains forward-looking statements that are intended to enhance the reader's ability to assess the future financial performance of the Company. These forward-looking statements are not based on historical information and are being made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include, but are not limited to, statements which represent the Company's beliefs concerning future levels of sales and redemptions of the Company's products, investment yields and interest spread, or the earnings or profitability of the Company's activities. Because these statements are subject to numerous assumptions, risks, and uncertainties, actual results could be materially different. The following factors, among others, may have such an impact: changes in economic conditions; movements in interest rates and the stock markets; competitive pressures on product pricing and services; success and timing of business strategies; and the nature and extent of legislation and regulatory actions and reforms. Readers are directed to consider these and the other risks and uncertainties described in more detail elsewhere in documents filed by the Company with the Securities and Exchange Commission. The Company undertakes no obligation to update or revise any forward-looking information, whether as a result of new information, future events, or otherwise. ============================================================================== RESULTS OF OPERATIONS In addition to net income, the Company reports net operating income, which excludes realized investment gains and losses and results of discontinued operations. Net operating income is commonly used in the insurance industry as a measure of on-going earnings performance. The following table reconciles the Company's reported net income to net operating income for each of the last three years. In addition, net operating income reflecting pro forma adjustments for the IPO, companion senior notes and capital securities public offerings and special dividends as discussed previously is also presented. This pro forma information is not necessarily indicative of what the Company's results would have been had the above transactions actually occurred at the beginning of each year presented, or of future results of the Company. (in millions of dollars, except per share amounts) 1997 1996 1995 ======================================================= Net income $265.2 $223.6 $209.6 Realized gains on investments, net of tax (7.9) (1.0) (0.1) Income from discontinued operations, net of tax -- (11.3) (24.7) ------------------------------------------------------- Net operating income 257.3 211.3 184.8 Pro forma adjustments, net of tax (2.9) (26.2) (26.2) ------------------------------------------------------- Pro forma net operating income $254.4 $185.1 $158.6 ======================================================= Basic and diluted pro forma net operating income per share $ 1.98 $ 1.44 $ 1.24 ======================================================= Earnings per share amounts reflect the Company's adoption of Statement of Financial Accounting Standards No. 128 -- Earnings Per Share during 1997. The earnings per share amounts presented represent both basic and diluted earnings per share as the dilutive effects of stock options do 19 -------------------------------------------------------------------------------- not result in dilutive amounts different from basic earnings per share. Revenues Total revenues for 1997, excluding realized gains and losses on investments, increased to $2.23 billion compared to $2.02 billion for 1996 and $1.84 billion for 1995. Increases in policy charges and net investment income accounted for most of the growth. Policy charges include asset fees, which are primarily earned from separate account assets generated from sales of variable annuities; administration fees, which include fees charged per contract on a variety of the Company's products and premium loads on universal life insurance products; surrender fees, which are charged as a percentage of premiums withdrawn during a specified period of annuity and certain life insurance contracts; and cost of insurance charges earned on universal life insurance products. Policy charges for each of the last three years were as follows: (in millions of dollars) 1997 1996 1995 ======================================================== Asset fees $384.8 $275.5 $184.8 Administrative fees 59.5 50.1 40.7 Surrender fees 32.4 22.1 17.3 Cost of insurance charges 68.5 53.2 43.8 -------------------------------------------------------- Total policy charges $545.2 $400.9 $286.6 ======================================================== The growth in asset fees reflects increases in total separate account assets of 40% in 1997 and 45% in 1996. As of year end, total separate account assets were $37.72 billion. Separate Account Assets (in billions) 1993 $ 9.0 1994 $12.1 1995 $18.6 1996 $26.9 1997 $37.7 Net investment income includes the gross investment income earned on investments supporting fixed annuities and certain life insurance products as well as the yield on the Company's general account invested assets which are not allocated to product segments. Net investment income grew from $1.29 billion and $1.36 billion in 1995 and 1996, respectively, to $1.41 billion in 1997 primarily due to increased invested assets to support growth in fixed annuity policy reserves. Fixed annuity policy reserves, which include the fixed option of the Company's variable annuity products, increased $727.8 million in 1996 and $682.4 million in 1997 and were $14.19 billion as of year end 1997. The increase in net investment income due to growth in invested assets was partially offset by declining investment yields in 1997 and 1996 due to lower market interest rates. Realized gains and losses on investments are not considered by the Company to be recurring components of earnings and are reported in the Corporate and Other segment. The Company makes decisions concerning the sale of invested assets based on a variety of market, business, tax and other factors. Net realized gains on investments were $11.1 million in 1997 compared to realized losses of $0.2 million and $1.7 million in 1996 and 1995, respectively. Realized gains in 1997 include $14.4 million recognized when securities of $850.0 million were paid to Nationwide Corporation (Nationwide Corp.), the 100% owner of NFS prior to the IPO, as a dividend on February 24, 1997 as a part of certain transactions that were completed in anticipation of the IPO. Also, during 1997, the Company recorded a realized loss of $16.2 million related to the sale of a single corporate bond investment that had deteriorated due to the credit quality of the issuer. Benefits and Expenses Interest credited to policyholder account balances totaled $1.02 billion in 1997 compared to $982.3 million in 1996 and $950.3 million in 1995 and principally relates to fixed annuity products. The growth in interest credited reflects the increase in fixed annuity policy reserves previously discussed partially offset by reduced average crediting rates. The average crediting rate on fixed annuity policy reserves was 6.12% in 1997 compared to 6.30% and 6.58% in 1996 and 1995, respectively. Amortization of deferred policy acquisition costs (DAC) increased to $167.2 million in 1997 compared to $133.4 million in 1996 and $82.7 million in 1995. The increase is principally related to increased business in the Variable Annuities segment. Operating expenses were $402.7 million in 1997, a 14% increase from 1996 operating expenses of $353.5 million. Operating expenses were $317.7 million in 1995. 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. The Company has developed a plan to address issues related to the Year 2000. The problem relates to many existing computer programs using only two digits to identify a year in the date field. These programs were designed and developed without considering the impact of the upcoming change in the century. If not corrected, many computer applications could fail or create erroneous results by or at the Year 2000. The Company has been evaluating its exposure to the Year 2000 issue through a review of all of its operating systems as well as dependencies on the systems of others 20 -------------------------------------------------------------------------------- since 1996. The Company expects all system changes and replacements needed to achieve Year 2000 compliance to be completed by the end of 1998. Compliance testing will be completed in the first quarter of 1999. The Company charges to expense all costs associated with these system changes as the costs are incurred. Operating expenses in 1997 include approximately $45 million on technology projects, which includes costs related to Year 2000 and the development of a new policy administration system for traditional life insurance products and other system enhancements. The Company anticipates spending a comparable amount in 1998 on technology projects, including Year 2000 initiatives. The Company recorded interest expense of $26.1 million in 1997 on the senior notes and the capital securities issued in March 1997 concurrent with the Company's IPO. Federal income tax expense was $141.8 million representing an effective tax rate of 34.8% for 1997. Federal income tax expense in 1996 and 1995 was $115.8 million and $96.3 million, respectively, representing effective rates of 35.3% and 34.3%. Discontinued Operations Discontinued operations include the results of (i) the three NLIC subsidiaries whose outstanding common stock, on September 24, 1996, was declared as a dividend payable to Nationwide Corp. on January 1, 1997 and (ii) NLIC's accident and health and group life insurance business which was ceded to affiliates effective January 1, 1996. The Company entered into these transactions in 1996 in order to focus its business on long-term savings and retirement products. The transactions are described in note 19 of the consolidated financial statements. The Company did not recognize any gain or loss on the disposal of these subsidiaries or discontinuance of the accident and health and group life insurance business. Income from discontinued operations was $11.3 million in 1996 and $24.7 million in 1995. There was no income from discontinued operations in 1997. Statutory Premiums and Deposits 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 investment broker/dealers, pension plan administrators and financial institutions. The Company has access to over 1,000 broker/dealers and over 30,000 registered representatives who sell individual and group variable annuities, fixed annuities and variable life insurance in all 50 states and the District of Columbia. Over 250 regional pension plan administrators market the Company's group variable and fixed annuities to employers sponsoring employee retirement programs. The Company currently has relationships with over 180 banks selling individual variable annuities (under the Company's brand name and on a private-label basis), individual fixed annuities, variable universal life insurance and group pension products. Retail distributors are representatives of the Company who market products directly to a customer base identified by the Company and include employees of the Company's sales subsidiaries and Nationwide Insurance Enterprise insurance agents. The Company markets products on a retail basis to state and local governments and to teachers through its subsidiary sales organizations. Approximately 4,300 licensed Nationwide Insurance Enterprise insurance agents sell life insurance and individual annuities primarily targeting holders of personal automobile and homeowners' insurance policies issued by the Nationwide Insurance Enterprise. Statutory premiums and deposits by distribution channel for each of the last three years are summarized as follows: 1997 1996 1995 ------------------ ----------------- ----------------- (in millions of dollars) AMOUNT % Amount % Amount % ============================================================================================================ WHOLESALE CHANNELS Investment dealers $ 3,894.1 37.7% $3,627.8 42.5% $2,835.4 42.8% Pension market 2,325.0 22.5 1,911.6 22.4 1,573.7 23.8 Financial institutions 1,653.2 16.0 947.2 11.1 515.4 7.8 ------------------------------------------------------------------------------------------------------------ Total wholesale channels 7,872.3 76.2 6,486.6 76.0 4,924.5 74.4 ------------------------------------------------------------------------------------------------------------ RETAIL CHANNELS Public sector and teachers market 1,862.1 18.0 1,528.0 17.9 1,244.9 18.8 Nationwide agents 602.7 5.8 525.5 6.1 446.5 6.8 ------------------------------------------------------------------------------------------------------------ Total retail channels 2,464.8 23.8 2,053.5 24.0 1,691.4 25.6 ------------------------------------------------------------------------------------------------------------ Total external premiums and deposits 10,337.1 100.0% 8,540.1 100.0% 6,615.9 100.0% ============================================================================================================ Nationwide Insurance Enterprise employee and agent benefit plans 174.9 502.5 182.1 ------------------------------------------------------------------------------------------------------------ Total statutory premiums and deposits $10,512.0 $9,042.6 $6,798.0 ============================================================================================================ 21 -------------------------------------------------------------------------------- Excluding Nationwide Insurance Enterprise benefit plan sales, the Company achieved annual sales growth of 21%, 29%, and 21% in 1997, 1996 and 1995, respectively. The Company's goal is 20% annual growth in external sales and management believes the Company is well positioned to achieve that goal in 1998. The Company's flagship products are marketed under The BEST of AMERICA brand, and include individual and group variable annuities and variable life insurance. The BEST of AMERICA products allow customers to choose from among investment options managed by premier mutual fund managers. The Company has also developed private label variable and fixed annuity products in conjunction with other financial services providers which allow those providers to sell individual variable and fixed annuities with substantially the same features as the Company's brand name products to their own customer bases under their own brand name. 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. External statutory premiums and deposits by product are as follows: (in millions of dollars) 1997 1996 1995 =============================================================== The BEST of AMERICA products: Individual variable annuities $ 4,269.7 $3,801.5 $2,740.6 Group variable annuities 2,220.5 1,807.1 1,457.6 Variable universal life 220.3 165.4 101.3 Private label annuities 1,006.3 625.9 389.7 IRC Section 457 annuities 1,715.7 1,425.8 1,191.1 The NEA Valuebuilder annuities 145.5 102.2 53.8 Other 759.1 612.2 681.8 --------------------------------------------------------------- $10,337.1 $8,540.1 $6,615.9 =============================================================== Business Segments The Company has three product segments: Variable Annuities, Fixed Annuities and Life Insurance. In addition, the Company reports corporate income and expenses, investments and related investment income supporting capital not specifically allocated to its product segments, revenues and expenses of its distribution companies, revenues and expenses of its investment advisor subsidiary, revenues and expenses related to group annuity contracts sold to Nationwide Insurance Enterprise employee benefit plans and interest expense on long-term debt and capital securities in a Corporate and Other segment. All information set forth below relating to the Company's Variable Annuities segment excludes the fixed option under the Company's variable annuity contracts. Such information is included in the Company's Fixed Annuities segment. The following table summarizes operating income before federal income tax expense for the Company's business segments for each of the last three years. (in millions of dollars) 1997 1996 1995 ======================================================== Variable annuity $150.9 $ 90.3 $ 50.8 Fixed annuity 169.5 135.4 137.0 Life insurance 70.9 67.2 67.6 Corporate and other 4.6 35.4 27.5 -------------------------------------------------------- $395.9 $328.3 $282.9 ======================================================== Variable Annuities The Variable Annuities segment consists of annuity contracts that provide the customer with the opportunity to invest in mutual funds managed by independent investment managers and the Company, with investment returns accumulating on a tax-deferred basis. The Company's variable annuity products consist almost entirely of flexible premium deferred variable annuity contracts. The following table summarizes certain selected financial data for the Company's Variable Annuities segment for the years indicated. (in millions of dollars) 1997 1996 1995 =========================================================== INCOME STATEMENT DATA (1) Revenues: Asset fees $ 370.2 $ 261.8 $ 172.8 Administrative fees 21.8 18.1 14.0 Surrender fees 21.9 13.6 10.0 ----------------------------------------------------------- Total policy charges 413.9 293.5 196.8 Net investment income and other (2) (9.9) (8.9) (7.8) ----------------------------------------------------------- 404.0 284.6 189.0 ----------------------------------------------------------- Benefits and expenses: Benefits and claims 5.9 4.6 2.9 Amortization of DAC 87.8 57.4 26.3 Other operating expenses 159.4 132.3 109.0 ----------------------------------------------------------- 253.1 194.3 138.2 ----------------------------------------------------------- Operating income before federal income tax expense $ 150.9 $ 90.3 $ 50.8 =========================================================== 22 -------------------------------------------------------------------------------- (in millions of dollars) 1997 1996 1995 =========================================================== OTHER DATA (1) Statutory premiums and deposits (3) $ 7,535.8 $ 6,500.3 $ 4,399.3 Withdrawals 2,683.3 1,697.4 1,071.6 Policy reserves as of year end $34,486.7 $24,278.1 $16,761.8 Ratio of policy charges to average policy reserves 1.41% 1.43% 1.44% Pre-tax operating income to average policy reserves 0.51% 0.44% 0.37% =========================================================== (1) Excludes the fixed option under the Company's variable annuity contracts which is reported in the Company's Fixed Annuities segment. (2) The Company's method of allocating net investment income results in a charge (negative net investment income) to this segment which is recognized in the Corporate and Other segment. The charge relates to non-invested assets which support this segment on a statutory basis. (3) Statutory data have been derived from the Annual Statements of the Company's life insurance subsidiaries, as filed with insurance regulatory authorities and prepared in accordance with statutory accounting practices. Variable annuity segment results reflect a sharp increase in policy charge revenues partially offset by increases in amortization of DAC and other operating expenses. The increase in policy charge revenues is attributable to growth in asset fees. Asset fees were $370.2 million in 1997 up 41% from $261.8 million in 1996 and totaled $172.8 million in 1995. The increase in assets fees reflects substantial growth in policy reserve levels as a result of steady premium growth and through market appreciation on investments underlying reserves. Variable Annuity Policy Reserves (in billions) 1993 $ 7.9 1994 $10.8 1995 $16.8 1996 $24.3 1997 $34.5 Variable annuity policy reserves grew $10.21 billion during 1997 reaching $34.49 billion as of year end 1997 compared to growth in 1996 of $7.52 billion and year end 1996 reserves of $24.28 billion. Total policy charges as a percentage of policy reserves remained relatively stable between 141 and 144 basis points during the last three years presented, reflecting no or minimal changes in the levels of policy charges for most variable annuity products. The Company has sustained high sales growth over the recent three year period through deeper penetration of existing distribution channels and the addition of new sales outlets. In addition, variable annuity sales reflect growing consumer demand for equity-based retirement savings investments, coupled with a robust stock market and lower interest rates. Significant increases in production through financial institutions, pension plan administrators and public sector markets have contributed strongly to the growth in variable annuity sales in 1997, when sales increased 16% to a record $7.54 billion compared to $6.50 billion in 1996. Variable annuity sales in 1996 represented a 48% increase over 1995 sales of $4.40 billion. Favorable equity market conditions over the past three years have also contributed significantly to the growth in variable annuity policy reserves. Variable annuity policy reserves reflect market appreciation of $5.21 billion, $2.72 billion and $2.93 billion in 1997, 1996 and 1995, respectively. The increase in amortization of DAC in 1997 compared to 1996 and 1995 is due to overall growth in the variable annuity business. The growth in operating expenses also reflects the overall growth in the variable annuity business. Operating expenses were 54 basis points of average variable annuity policy reserves for 1997 comparing favorably to 64 basis points and 80 basis points for 1996 and 1995, respectively. The Company has controlled operating expense growth by increasing productivity through investments in technology and economies of scale. Fixed Annuities 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. 23 -------------------------------------------------------------------------------- The following table summarizes certain selected financial data for the Company's Fixed Annuities segment for the years indicated. (in millions of dollars) 1997 1996 1995 =========================================================== INCOME STATEMENT DATA (1) Revenues: Policy charges $ 15.9 $ 18.0 $ 16.4 Life insurance premiums 27.3 24.0 32.8 Net investment income 1,098.2 1,050.6 1,002.8 ----------------------------------------------------------- 1,141.4 1,092.6 1,052.0 ----------------------------------------------------------- Benefits and expenses: Interest credited to policyholder account balances 823.4 805.0 775.7 Other benefits and claims 23.3 33.8 29.5 Amortization of DAC 39.8 38.6 29.5 Other operating expenses 85.4 79.8 80.3 ----------------------------------------------------------- 971.9 957.2 915.0 ----------------------------------------------------------- Operating income before federal income tax expense $ 169.5 $ 135.4 $ 137.0 =========================================================== OTHER DATA (1) Statutory premiums and deposits (2) $ 2,137.9 $ 1,600.5 $ 1,864.2 Withdrawals and benefits 1,710.0 1,375.5 1,151.6 Policy reserves as of year end $14,194.2 $13,511.8 $12,784.0 Net interest margin on general account policy reserves 2.04% 1.92% 1.92% Pre-tax operating income to average policy reserves 1.22% 1.03% 1.14% =========================================================== (1) Includes the fixed option under the Company's variable annuity contracts. (2) Statutory data have been derived from the Annual Statements of the Company's life insurance subsidiaries, as filed with insurance regulatory authorities and prepared in accordance with statutory accounting practices. Fixed annuity 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. 1997 1996 1995 ------------------------------------------------------- Net investment income 8.16% 8.22% 8.50% Interest credited 6.12 6.30 6.58 ------------------------------------------------------- 2.04% 1.92% 1.92% ======================================================= The Company expects interest margins to compress during 1998 reflecting the lower interest rate environment available for new invested assets. 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, 1997, $6.85 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 $4.88 billion are in contracts that adjust the crediting rate on an annual basis with portions resetting in each calendar quarter. The Company also has $1.40 billion of fixed annuity policy reserves that call for the crediting rate to be reset annually on each January 1. The remaining $1.06 billion of fixed annuity policy reserves are in payout status where the Company has guaranteed periodic, typically monthly, payments. Fixed annuity policy reserves increased to $14.19 billion as of year-end compared to $13.51 billion a year ago and $12.78 billion as of the end of 1995. The growth reflects increased fixed annuity sales in 1997 through the financial institutions and investment dealer channels. Sales for 1997 were up 34% to $2.14 billion compared to $1.60 billion in 1996. Sales in 1995 totaled $1.86 billion. Most of the Company's fixed annuity sales are premiums allocated to the guaranteed fixed option of variable annuity contracts. Fixed annuity sales for 1997 include $1.67 billion in premiums allocated to the fixed option under a variable annuity contract, compared to $1.24 billion in 1996. Sales growth in 1997 reflects the success of proprietary fixed product sales through financial institutions, as well as the impact of a 1.00% first-year bonus crediting rate offered on The BEST of AMERICA-America's Vision product during the second half of 1997. Fixed Annuity Policy Reserves (in billions) 1993 $10.2 1994 $11.2 1995 $12.8 1996 $13.5 1997 $14.2 The decrease in other benefits and claims reflects a $13.0 million charge in 1996 related to reserve strengthening in the immediate annuity line due to changes in estimated profitability based on revised assumptions for mortality and 24 -------------------------------------------------------------------------------- reinvestment rates. Amortization of DAC reflects a reduction in 1996 of $6.0 million due to changes in estimates of expected future profits as a result of favorable investment spread and persistency experience. Life Insurance The Life Insurance segment consists of insurance products, including variable universal life insurance and corporate-owned insurance products, that provide a death benefit and may also allow the customer to build cash value on a tax- deferred basis. The following table summarizes certain selected financial data for the Company's Life Insurance segment for the years indicated. (in millions of dollars) 1997 1996 1995 ----------------------------------------------------------- INCOME STATEMENT DATA Revenues: Cost of insurance charges $ 68.5 $ 53.2 $ 43.8 Other policy charges 36.8 33.4 27.5 ----------------------------------------------------------- Total policy charges 105.3 86.6 71.3 Life insurance premiums 178.1 174.6 166.3 Net investment income 189.1 174.0 171.3 Other 0.6 0.4 0.2 ----------------------------------------------------------- 473.1 435.6 409.1 ----------------------------------------------------------- Benefits and expenses: Interest credited to policyholder account balances 78.5 70.2 69.0 Other benefits and claims 149.0 141.2 133.0 Policyholder dividends 40.6 40.7 39.7 Amortization of DAC 39.6 37.4 31.0 Other operating expenses 94.5 78.9 68.8 ----------------------------------------------------------- 402.2 368.4 341.5 ----------------------------------------------------------- Operating income before federal income tax expense $ 70.9 $ 67.2 $ 67.6 =========================================================== OTHER DATA Statutory premiums(1): Traditional and universal life $ 248.4 $ 253.9 $ 248.3 Variable universal life 220.0 165.4 104.1 Corporate-owned life 195.0 20.0 -- Policy reserves as of year end: Traditional and universal life 2,369.5 2,295.5 2,213.7 Variable universal life 892.1 622.6 446.8 Corporate-owned life 225.4 20.8 -- Life insurance in force: Traditional and universal life 27,495.7 28,107.0 27,616.9 Variable universal life 11,337.4 8,094.6 4,926.5 Corporate-owned life $ 426.3 $ 73.0 $ -- =========================================================== (1) Statutory data have been derived from the Annual Statements of the Company's life insurance subsidiaries, as filed with insurance regulatory authorities and prepared in accordance with statutory accounting practices. Life Insurance segment results reflect revenue growth in the variable universal life insurance line driven by a steady increase in insurance in-force and policy reserves partially offset by higher operating expenses associated with technology-related costs in the traditional life insurance lines. Life Insurance Policy Reserves (in billions) 1993 $2.3 1994 $2.4 1995 $2.7 1996 $2.9 1997 $3.5 Variable universal life insurance policy charges were $57.1 million in 1997, an increase of $18.5 million, or 48%, compared to $38.6 million in 1996. For 1995, variable universal life insurance policy charges were $26.7 million. The growth in variable universal life policy charges is attributable to the growth in insurance in-force and policy reserves, which increased 40% and 43%, respectively, in 1997. During 1996, variable universal life insurance in-force and policy reserves increased 64% and 39%, respectively. Growth in insurance in-force and policy reserves is due to strong sales from both investment dealers and Nationwide Insurance Enterprise insurance agents, combined with high persistency. In February, 1998, the Company introduced a new variable universal life insurance product called Next Generation, which offers an innovative, tiered-pricing structure that maximizes cash value. The Company anticipates continued sales growth in 1998 for variable universal life insurance as well as its recent entry into corporate-owned insurance products. The growth in operating expenses is due to technology-related costs combined with the increase in variable life insurance policies in-force. Technology-related expenses in 1997 were $16.5 million, compared to $3.2 million in 1996. The majority of the expenses are for a new policy administration system to support traditional life insurance products and for activities to make systems Year 2000 compliant. 25 -------------------------------------------------------------------------------- Corporate and Other The following table summarizes certain selected financial data for the Company's Corporate and Other segment for the years indicated. (in millions of dollars) 1997 1996 1995 =========================================================== INCOME STATEMENT DATA Revenues: Net investment income $ 153.5 $ 154.7 $ 137.6 Other 55.3 49.3 51.0 ----------------------------------------------------------- 208.8 204.0 188.6 ----------------------------------------------------------- Benefits and expenses: Interest credited to policy reserves 114.7 106.1 105.6 Interest expense on debt and capital securities of subsidiary trust 26.1 -- -- Other operating expenses 63.4 62.5 55.5 ----------------------------------------------------------- 204.2 168.6 161.1 ----------------------------------------------------------- Operating income before federal income tax expense(1) $ 4.6 $ 35.4 $ 27.5 =========================================================== OTHER DATA Statutory premiums and deposits(2) $ 174.9 $ 502.6 $ 182.1 Withdrawals and benefits 205.4 140.3 144.4 Policy reserves as of year end 3,791.9 3,302.5 2,644.3 Nationwide retail mutual fund assets(3) $2,555.0 $2,136.2 $2,113.9 =========================================================== (1) Excludes realized gains (losses) on investments and discontinued operations. (2) Statutory data have been derived from the Annual Statements of the Company's life insurance subsidiaries, as filed with insurance regulatory authorities and prepared in accordance with statutory accounting practices. (3) Excludes mutual funds selected as investment options under the Company's variable annuity and variable universal life insurance contracts and mutual funds selected as investment options under Nationwide Insurance Enterprise employee and agent benefit plans. Revenues in the Corporate and Other segment consist of net investment income on invested assets not allocated to the three product segments, investment management fees and other revenues earned from Nationwide mutual funds other than the portion allocated to the Variable Annuities and Life Insurance segments, commissions and other income earned by the marketing and distribution subsidiaries of the Company and net investment income and policy charges from group annuity contracts issued to Nationwide Insurance Enterprise employee and agent benefit plans. The decreases in operating income for the period to period comparisons primarily relate to interest expense on the senior notes and capital securities issued in March 1997 concurrent with the IPO and the impact on net investment income related to the special dividends paid in anticipation of the IPO. On a pro forma basis, net operating income (loss) before federal income tax expense was $0.2 million, $(4.9) million and $(12.8) million for 1997, 1996 and 1995, respectively. In addition to the operating revenues previously presented, the Company also reports realized gains and losses on investments in the Corporate and Other segment. Net realized gains on investments were $11.1 million in 1997 compared to realized losses of $0.2 million and $1.7 million in 1996 and 1995, respectively. Realized gains in 1997 include $14.4 million recognized when securities of $850.0 million were paid to Nationwide Corp. as a dividend on February 24, 1997. Also, during 1997, the Company recorded realized losses of $16.2 million related to the sale of a single corporate bond investment due to deterioration in the credit quality of the issuer. =============================================================================== LIQUIDITY AND CAPITAL RESOURCES Liquidity and capital resources demonstrate the overall financial strength of the Company and its ability to generate strong cash flows from its operations and borrow funds at competitive rates to meet operating and growth needs. The Company's capital structure consists of debt, capital securities of subsidiary trust and equity, summarized in the following table. 26 -------------------------------------------------------------------------------- December 31, ---------------------------------- 1996 (in millions of dollars) 1997 Pro forma(1) 1996 ============================================================= Long-term debt $ 298.4 $ 298.4 $ -- Capital securities of subsidiary trust 100.0 100.0 -- ------------------------------------------------------------- Total long-term debt and capital securities 398.4 398.4 -- ------------------------------------------------------------- Shareholders' equity, excluding unrealized gains on securities available-for-sale, net 1,877.1 1,632.3 1,958.1 Unrealized gains on securities available-for-sale, net 247.1 173.6 173.6 ------------------------------------------------------------- Total shareholders' equity 2,124.2 1,805.9 2,131.7 ------------------------------------------------------------- Total capital $2,522.6 $2,204.3 $2,131.7 ============================================================= Total capital excluding unrealized gains on securities available-for-sale, net $2,275.5 $2,030.7 $1,958.1 ============================================================= Long-term debt and capital securities to total capital 15.8% 18.1% -- Long-term debt and capital securities to total capital excluding unrealized gains on securities available-for-sale, net 17.5% 19.6% -- ============================================================= (1) Adjusts 1996 shareholders' equity for the net proceeds of the IPO and for the special dividends paid in anticipation of the IPO. The Company's long-term debt bears interest at 8% per annum and matures March 1, 2027. The capital securities of subsidiary trust are due March 1, 2037. There are no sinking fund requirements related to the debt or capital securities. NFS is a holding company whose principal asset is 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. State insurance laws generally restrict the ability of insurance companies to pay cash dividends in excess of certain prescribed limitations without prior approval. The ability of NLIC to pay dividends is subject to restrictions set forth in the insurance laws and regulations of Ohio, its domiciliary state. The Ohio insurance laws require life insurance companies to seek prior regulatory approval to pay a dividend if the fair market value of the dividend, together with that of other dividends made within the preceding 12 months, exceeds the greater of (i) 10% of policyholders' surplus as of the prior December 31 or (ii) the net income of the insurer for the prior year. NLIC's statutory-basis policyholders' surplus as of December 31, 1997 was $1.13 billion and statutory-basis net income for 1997 was $111.7 million. The Ohio insurance laws also require insurers to seek prior regulatory approval for any dividend paid from other than earned surplus. The payment of dividends by NLIC may also be subject to restrictions set forth in the insurance laws of New York that limit the amount of statutory profits on NLIC's participating policies (measured before dividends to policyholders) that can inure to the benefit of NFS and its stockholders. NFS currently does not expect such regulatory requirements to impair its ability to pay interest, dividends, operating expenses, and principal in the future. As a result of the $850.0 million dividend paid on February 24, 1997, any dividend paid by NLIC during the twelve-month period immediately following the $850.0 million dividend would be an extraordinary dividend under Ohio insurance laws. Accordingly, no such dividend could be paid without prior regulatory approval. The Company's principal sources of funds are premiums and deposits paid, contract charges earned, net investment income received and proceeds from investments called, redeemed or sold. The principal uses of these funds are the payment of benefits on annuity contracts and life insurance policies, operating expenses, commissions, and the purchase of investments. Net cash provided by operating activities (reflecting principally (i) premiums and contract charges collected, less (ii) benefits paid on life insurance products, plus (iii) income collected on invested assets, less (iv) commissions and other operating expenses paid) was $1.17 billion, $853.7 million and $1.12 billion in 1997, 1996 and 1995, respectively. Net cash used in investing activities (principally reflecting investments purchased less investments called, redeemed or sold) was $2.05 billion, $765.9 million and $1.73 billion in 1997, 1996 and 1995, respectively. Net cash provided by (used in) financing activities (principally reflecting net proceeds from the IPO and the companion offerings in 1997 only and deposits to investment product and universal life insurance product account balances less withdrawals from such account balances, and dividends to shareholders) was $1.01 billion, $(54.7) million and $616.5 million in, 1997, 1996 and 1995, respectively. Also available as a source of funds to the Company is a $600.0 million revolving credit facility entered into by NLIC and Nationwide Mutual Insurance Company in August 1996 with a five year term with a group of national financial institutions. In September 1997, the credit agreement was amended to include NFS as a party to and borrower under the agreement. The facility provides for several and not joint liability with respect to any amount drawn by any party. To date, no amounts have been drawn down on the facility. The facility provides covenants, including, but not limited to, requirements that the Company maintain consolidated tangi- 27 -------------------------------------------------------------------------------- ble net worth, as defined, in excess of $1.23 billion and NLIC maintain statutory surplus in excess of $875 million. A primary liquidity concern with respect to annuity and life insurance products is the risk of early policyholder withdrawal. The Company mitigates 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 individual annuity products ($27.1 billion of reserves as of December 31, 1997) the surrender charge is calculated as a percentage of the lesser of deposits made or the amount surrendered and is assessed at declining rates during the first seven years after a deposit is made. For group annuity products ($20.5 billion of reserves as of December 31, 1997), the 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. Life insurance policies are also subject to withdrawal. However, they are less susceptible to withdrawal than are annuity products because policyholders generally must undergo a new underwriting process and may incur a surrender fee in order to obtain a new insurance policy. The short-term and long-term liquidity requirements of the Company are monitored regularly to match cash inflows with cash requirements. The Company periodically reviews its short-term and long-term projected sources and uses of funds and the asset/liability, investment and cash flow assumptions underlying these projections. Adjustments are made periodically with respect to the Company's investment policies to reflect changes in the Company's short-term and long-term cash needs and changing business and economic conditions. The Company employs an asset/liability management approach tailored to the specific requirements of each of its products. The Company's general account investments are primarily managed in a number of pools that are segregated by weighted average maturity of the assets required by the pools. On fixed maturity securities and mortgages, the weighted average maturity is based on repayments which are scheduled to occur under the terms of the asset. For mortgage backed securities, repayments are determined using the current rate of repayment of the underlying pool of mortgages and the terms of the securities. Each product line has an investment strategy based on the specific characteristics of such product line. The strategy establishes asset duration, quality and other guidelines. The Company's actuaries determine the amount of new investments needed for each line to arrive at the amount of new investments needed for each pool by month. The investments acquired for each pool are shared on a proportional basis by each of the lines requesting investments in the pool based on their actual investment needs. For all business having future benefits which cannot be changed at the option of the policyholder, the underlying assets are managed in a separate pool. The duration of assets and liabilities in this pool are kept as close together as possible. For assets, the repayment cash flows, plus anticipated coupon payments, are used in calculating asset duration. Future benefits and expenses are used for liabilities. On December 31, 1997, the average duration of assets in this pool was 7.39 years and the average duration of the liabilities was 7.90 years. Policy reserves on this business were $1.06 billion as of December 31, 1997. Because the timing of the payment of future benefits on the majority of the Company's business can be changed by the policyholder, the Company employs cash flow testing techniques in its asset/liability management process. Annually, the Company's annuity and insurance business is analyzed to determine the adequacy of the reserves supporting such business. This analysis is accomplished by projecting under a number of possible future interest rate scenarios the anticipated cash flows from such business and the assets required to support such business. The first seven of these scenarios are required by the state insurance laws. Projections are also made using 13 additional scenarios which involve more extreme fluctuations in future interest rates. Finally, to get a statistical analysis of possible results and to minimize any bias in the 20 predetermined scenarios, additional projections are made using 200 randomly generated interest rate scenarios. For the Company's 1997 cash flow testing process, interest rates for 90-day treasury bills ranged from 0.5% to 12.4% under the 20 predetermined scenarios and 0.9% to 29.4% under the 200 random scenarios. Interest rates for longer maturity treasury securities had comparable ranges. The values produced by each projection are used to determine future gains or losses from the Company's annuity and insurance business, which, in turn, are used to quantify the adequacy of the Company's reserves over the entire projection period. The results of the Company's cash flow testing for year end 1997 indicated that the Company's reserves were adequate as of December 31, 1997. The Company manages its investment portfolio in part to reduce its exposure to interest rate fluctuations. In general, the market value of the Company's fixed maturity portfolio increases or decreases in inverse relationship with fluctuations in interest rates. For example, if interest rates rise, the Company's fixed maturity investments will generally decrease in value. Additionally, the Company's net investment income may be affected by interest rate changes. If interest rates decline, net investment income will decrease if high-yielding fixed maturity investments mature or are sold and the 28 -------------------------------------------------------------------------------- proceeds therefrom are reinvested in securities yielding a lower rate. Given the Company's historic cash flow and current financial results, management of the Company believes that the cash flow from the operating activities of the Company over the next year will provide sufficient liquidity for the operations of the Company, as well as provide sufficient funds to enable the Company to make dividend payments. ================================================================================ INVESTMENTS General The Company's assets are divided between separate account and general account assets. As of December 31, 1997, $37.72 billion (or 63%) of the Company's total assets were held in separate accounts and $22.18 billion (or 37%) were held in the Company's general account, including $19.67 billion of general account investments. IP graph here 1997 Investment Portfolio 19.7 Billion Fixed Maturity $13.2 Mortgage $ 5.2 Real Estate, Policy Loans Equites and other $ 1.3 Separate account assets consist primarily of deposits from the Company's variable annuity business. Most separate account assets are invested in various mutual funds. All of the investment risk in the Company's separate account assets is borne by the Company's customers, with the exception of $365.5 million of policy reserves as of December 31, 1997 ($280.2 million as of December 31, 1996) for which the Company bears the investment risk. In addition to the information presented herein, see note 3 to the consolidated financial statements for information regarding the Company's investments. The following table summarizes the Company's consolidated general account invested assets by asset category. DECEMBER 31, 1997 December 31, 1996 ------------------ ------------------ (in millions CARRYING % OF Carrying % of of dollars) VALUE TOTAL Value Total =============================================================== Fixed maturity securities $13,210.1 67.2% $12,310.5 67.2% Mortgage loans, net 5,181.6 26.3 5,272.1 28.8 Real estate, net 311.4 1.6 265.8 1.5 Policy loans 415.3 2.1 371.8 2.0 Equity securities 80.4 0.4 59.1 0.3 Other long-term investments 25.2 0.1 28.7 0.2 Short-term investments 449.2 2.3 9.3 -- --------------------------------------------------------------- Total $19,673.2 100.0% $18,317.3 100.0% =============================================================== Fixed Maturity Securities The following table summarizes the composition of the Company's general account fixed maturity securities by category. DECEMBER 31, 1997 December 31, 1996 ------------------ ------------------ (in millions CARRYING % OF Carrying % of of dollars) VALUE TOTAL Value Total =============================================================== U.S. government/ agencies $ 319.7 2.4% $ 285.1 2.3% Foreign governments 95.8 0.7 101.9 0.9 State and political subdivisions 1.6 -- 6.7 -- Mortgage-backed securities: U.S. government/ agencies 3,750.3 28.4 3,665.3 29.8 Corporate: Public 4,597.3 34.8 4,339.7 35.3 Private 4,445.4 33.7 3,911.8 31.7 --------------------------------------------------------------- Total $13,210.1 100.0% $12,310.5 100.0% =============================================================== The average duration and average maturity of the Company's general account fixed maturity securities as of December 31, 1997 were approximately 3.44 and 7.77 years, respectively. As a result, 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 also be likely to experience investment losses to the extent its liquidity needs require the disposition of general account fixed maturity securities in unfavorable interest rate environments. The National Association of Insurance Commissioners (NAIC) assigns securities quality ratings and uniform 29 -------------------------------------------------------------------------------- valuations called "NAIC Designations" which are used by insurers when preparing their annual statements. The NAIC assigns designations to publicly traded as well as privately placed securities. The designations assigned by the NAIC range from class 1 to class 6, with a designation in class 1 being of the highest quality. Of the Company's general account fixed maturity securities, 98% were in the highest two NAIC Designations as of December 31, 1997. The following table sets forth an analysis of credit quality, as determined by NAIC Designation, of the Company's general account fixed maturity securities portfolio. DECEMBER 31, 1997 December 31, 1996 NAIC RATING AGENCY ---------------------------- ---------------------------- DESIGNATION(1) EQUIVALENT DESIGNATION(2) CARRYING VALUE % OF TOTAL Carrying Value % of Total ===================================================================================================================== (in millions of dollars) 1 Aaa/Aa/A $ 8,815.3 66.7% $ 8,453.4 68.7% 2 Baa 4,116.6 31.2 3,629.9 29.5 3 Ba 220.9 1.7 166.6 1.3 4 B 53.7 0.4 49.7 0.4 5 Caa and lower 3.6 -- 10.9 0.1 6 In or near default -- -- -- -- --------------------------------------------------------------------------------------------------------------------- $ 13,210.1 100.0% $ 12,310.5 100.0% ===================================================================================================================== (1) NAIC Designations are assigned no less frequently than annually. Some designations for securities shown have been assigned to securities not yet assigned an NAIC Designation in a manner approximating equivalent public rating categories. (2) Comparison's between NAIC and Moody's designations are published by the NAIC. In the event no Moody's rating is available, the Company has assigned internal ratings corresponding to the public rating. The Company's general account mortgage-backed security (MBS) investments include residential MBSs and multi-family mortgage pass-through certificates. As of December 31, 1997, MBSs were $3.75 billion (or 28%) of the carrying value of the general account fixed maturity securities available-for-sale, all of which were guaranteed by the U.S. government or an agency of the U.S. government. The Company believes that general account MBS investments add diversification, liquidity, credit quality and additional yield to its general account fixed maturity securities portfolio. The objective of the Company's general account MBS investments is to provide reasonable cash flow stability and increased yield. General account MBS investments include collateralized mortgage obligations (CMOs), Real Estate Mortgage Investment Conduits (REMICs) and mortgage-backed pass-through securities. The Company's general account MBS investments do not include interest-only securities or principal-only securities or other MBSs which may exhibit extreme market volatility. Prepayment risk is an inherent risk of holding MBSs. However, the degree of prepayment risk is particular to the type of MBS held. The Company limits its exposure to prepayments by purchasing less volatile types of MBSs. As of December 31, 1997, $2.65 billion (or 71%) of the carrying value of the general account MBS portfolio was invested in planned amortization class CMOs/REMICs (PACs). PACs are securities whose cash flows are designed to remain constant over a variety of mortgage prepayment environments. Other classes in the CMO/REMIC security are structured to accept the volatility of mortgage prepayment changes, thereby insulating the PAC class. The following table sets forth the distribution by investment type of the Company's general account MBS portfolio. DECEMBER 31, December 31, 1997 1996 ----------------- ----------------- (in millions CARRYING % OF Carrying % of of dollars) VALUE TOTAL Value Total ============================================================= Accrual $ 48.5 1.3% $ 41.4 1.1% Planned Amortization Class 2,645.3 70.5 2,970.6 81.0 Sequential 19.8 0.5 2.5 0.1 Scheduled 160.6 4.3 167.2 4.6 Targeted Amortization Class 90.8 2.4 87.7 2.4 Very Accurately Defined Maturity 550.1 14.7 395.9 10.8 Multi-family Mortgage Pass-through Certificates 235.2 6.3 -- -- ------------------------------------------------------------- $3,750.3 100.0% $3,665.3 100.0% ============================================================= The Company invests in private fixed maturity securities because of the (i) generally higher nominal yield available compared to comparably rated public fixed maturity securities, (ii) more restrictive financial and business cove- 30 -------------------------------------------------------------------------------- nants available in private fixed maturity security loan agreements and (iii) stronger prepayment protection. Although private fixed maturity securities are not registered with the Securities and Exchange Commission and generally are less liquid than public fixed maturity securities, restrictive financial and business covenants included in private fixed maturity security loan agreements generally are designed to compensate for the impact of increased liquidity risk. A significant majority of the private fixed maturity securities that the Company holds are participations in issues that are also owned by other investors. In addition, some of the private fixed maturity securities are rated by nationally recognized rating agencies and substantially all have been assigned a rating designation by the NAIC. The Company has not invested in derivative securities other than MBSs. Mortgage Loans As of December 31, 1997, general account mortgage loans were $5.18 billion (or 26%) of the carrying value of consolidated general account invested assets. As of such date, commercial mortgage loans constituted substantially all (99.9%) of total general account mortgage loans. Commitments to fund mortgage loans of $341.4 million extending into 1998 were outstanding as of December 31, 1997. In June 1997, the Company exchanged $359.7 million of multi-family mortgage loans with the Federal Home Loan Mortgage Corporation (FHLMC) for FHLMC multi-family mortgage pass-through certificates supported by the exchanged loans. The transaction resulted in the reclassification of the exchanged amount from mortgage loans on real estate to fixed maturity securities available-for-sale on the consolidated balance sheet. No gain or loss was recognized as a result of the exchange. The summary below depicts loans by remaining principal balance as of December 31, 1997: (in millions APARTMENT of dollars) OFFICE WAREHOUSE RETAIL & OTHER TOTAL ========================================================================== East North Central $131.7 $135.3 $ 627.7 $154.3 $1,049.0 East South Central 33.9 25.4 155.4 72.9 287.6 Mountain 25.6 28.5 110.4 103.6 268.1 Middle Atlantic 120.6 93.7 166.0 15.3 395.6 New England 53.7 42.6 145.3 -- 241.6 Pacific 216.6 338.1 426.2 89.7 1,070.6 South Atlantic 113.3 145.5 491.0 317.9 1,067.7 West North Central 134.0 8.7 73.2 52.9 268.8 West South Central 116.6 114.1 188.2 162.4 581.3 -------------------------------------------------------------------------- $946.0 $931.9 $2,383.4 $969.0 5,230.3 =============================================================== Less valuation allowances and unamortized discount 48.7 -------------------------------------------------------------------------- Total mortgage loans on real estate, net $5,181.6 ========================================================================== As of December 31, 1997, the Company's largest exposure to any single borrowing group was $98.5 million, or 2% of the Company's general account mortgage portfolio. The following table sets forth the maturity and principal repayment schedule for the Company's general account mortgage loan portfolio. DECEMBER 31, December 31, 1997 1996 ---------------------- ---------------------- AGGREGATE Aggregate PRINCIPAL Principal BALANCE OF % OF Balance of % of MORTGAGE TOTAL Mortgage Total LOANS PRINCIPAL Loans Principal MATURING BALANCE Maturing Balance ====================================================================== 1997 $ -- 0.0% $ 162.0 3.0% 1998 197.8 3.8 210.2 3.9 1999 294.8 5.6 349.3 6.6 2000 451.5 8.6 519.5 9.7 2001 267.2 5.1 357.1 6.7 2002 362.4 6.9 429.8 8.1 Thereafter 3,656.6 70.0 3,302.6 62.0 ---------------------------------------------------------------------- $5,230.3 100.0% $5,330.5 100.0% ====================================================================== 31 -------------------------------------------------------------------------------- The following table sets forth the delinquency, foreclosure and restructured commercial mortgage loan experience for the Company and for the life insurers reporting to the American Council of Life Insurance (ACLI) for the years indicated. 1997 1996 1995 ------------------ ------------------ ------------------ COMPANY ACLI(1) COMPANY ACLI(2) COMPANY ACLI(2) ================================================================================================================= Delinquent(3) 0.19% --% 0.79% 1.79% 0.63% 2.35% In foreclosure(4) 0.19 -- 0.79 1.10 0.63 1.45 Restructured(5) 0.77 -- 1.11 6.81 1.48 8.27 ------- ------- ------- ------- ------- ------- Subtotal 0.96 -- 1.90 8.60 2.11 10.62 Foreclosed -- year to date 1.07 -- 0.35 1.01 0.74 1.75 ----------------------------------------------------------------------------------------------------------------- Total 2.03% --% 2.25% 9.61% 2.85% 12.37% ================================================================================================================= (1) ACLI data for the year ended December 31, 1997 are not yet available. (2) Source: ACLI Investment Bulletins entitled "Quarterly Survey of Mortgage Loan Delinquencies and Foreclosures," numbers 1367 and 1289, dated March 6, 1997 and February 28, 1996, respectively. (3) Commercial mortgage loans are classified by the Company and the ACLI as delinquent when they are 60 days or more past due. (4) Delinquent includes loans in foreclosure; therefore, subtotal and total lines exclude "In foreclosure" amounts. (5) Commercial mortgage loans are classified by the Company and the ACLI as restructured when they are in good standing, but the basic terms have been modified as a result of an actual or anticipated delinquency. 32 -------------------------------------------------------------------------------- INFLATION Many of the Company's assets and liabilities are monetary in nature and sensitive to the interest rate environment which can be affected by inflation. The Company is exposed to the risk of a reduction in interest spread or profit margins when interest rates fluctuate. Bond calls, mortgage prepayments, contract surrenders and withdrawals of annuity contracts and life insurance policies, and sales of contracts are influenced by the interest rate environment. In general, the fair value of the Company's fixed maturity securities portfolio increases or decreases inversely with fluctuations in interest rates. For example, if interest rates rise, the Company's fixed maturity investments will generally decrease in value. Additionally, the Company's net investment income may be affected by the interest rate changes. If interest rates decline, net investment income will decrease if high-yielding fixed maturity investments mature or are sold and the proceeds therefrom are reinvested in securities yielding a lower rate. Management attempts to mitigate the negative impact of interest rate changes through asset/liability management, product design, management of crediting rates, surrender charges and market value adjustments at withdrawal for certain products and management of mortality charges and dividend scales with respect to its in-force life insurance policies. ================================================================================ PROPOSED LEGISLATION The Clinton Administration's 1999 budget proposal contains provisions which, if enacted, would eliminate many tax benefits currently afforded to annuity products and certain life insurance products. These provisions appear to be inconsistent with what the Company believes to be the Administration's desire to encourage private sector long-term savings. Currently, policyholders are permitted to exchange life insurance, endowment or annuity contracts for similar contracts without being required to pay tax on the accretion of value within the contracts being transferred in the exchange. In addition, policyholders who hold variable annuity or life insurance contracts are currently permitted to transfer funds between various investment options offered under such contracts on a tax-free basis. The 1999 budget proposal, if enacted in its current form, would make all exchanges involving insurance contracts immediately taxable. In addition, under the budget proposal each investment option offered under a single variable contract would be treated as a separate variable contract, and thus transfers of funds between different investment options would cause the amounts transferred to be subject to tax, to the extent there has been accretion in value. The budget proposal would also reduce policyholders' tax basis in annuity and life insurance contracts by the mortality and expense charges paid, increasing future taxable gains. Most of the tax benefits of corporate-owned life insurance products would also be eliminated by the budget proposal. The Company supports social policy that encourages private sector savings, and believes that the provisions contained in the budget proposal clearly run counter to that goal. Annuity products are specifically designed for long-term and retirement savings and play an important role in millions of individuals' financial protection plans. However, there can be no assurance as to whether legislation will be enacted which would contain provisions with possible adverse effects on the Company's ability to sell its annuity and life insurance products. 33 -------------------------------------------------------------------------------- FIVE-YEAR SUMMARY Years ended December 31, --------------------------------------------------------- (in millions of dollars, except per share amounts) 1997 1996 1995 1994 1993 ============================================================================================================= RESULTS OF OPERATIONS (1) Total policy charges $ 545.2 $ 400.9 $ 286.6 $ 217.2 $ 165.5 Traditional life insurance premiums 205.4 198.6 199.1 176.7 188.3 Net investment income 1,413.9 1,357.8 1,294.0 1,210.8 1,131.3 Realized gains (losses) on investments 11.1 (0.2) (1.7) (16.5) 106.2 Other 62.8 59.5 59.0 45.9 48.0 ------------------------------------------------------------------------------------------------------------- Total revenues 2,238.4 2,016.6 1,837.0 1,634.1 1,639.3 ------------------------------------------------------------------------------------------------------------- Interest credited and other benefits 1,235.4 1,201.6 1,155.4 1,031.5 1,025.2 Interest expense on debt and capital securities 26.1 -- -- -- -- Other operating expenses 569.9 486.9 400.4 362.2 338.3 ------------------------------------------------------------------------------------------------------------- Total benefits and expenses 1,831.4 1,688.5 1,555.8 1,393.7 1,363.5 ------------------------------------------------------------------------------------------------------------- Income from continuing operations before federal income tax expense and cumulative effect of changes in accounting principles 407.0 328.1 281.2 240.4 275.8 Federal income tax expense 141.8 115.8 96.3 82.5 96.7 ------------------------------------------------------------------------------------------------------------- Income from continuing operations before cumulative effect of changes in accounting principles $ 265.2 $ 212.3 $ 184.9 $ 157.9 $ 179.1 ============================================================================================================= Net income $ 265.2 $ 223.6 $ 209.6 $ 178.4 $ 207.6 ============================================================================================================= Basic and diluted earnings per common share amounts: (2) Income from continuing operations $ 2.14 Net income $ 2.14 Cash dividends declared $ 0.18 RECONCILIATION OF NET OPERATING INCOME (1) Net income $ 265.2 $ 223.6 $ 209.6 $ 178.4 $ 207.6 Less: Realized (gains) losses on investments, net of tax (7.9) (1.0) (0.1) 10.3 (69.3) Less: Income from discontinued operations, net of tax -- (11.3) (24.7) (20.5) (28.6) ------------------------------------------------------------------------------------------------------------- Net operating income 257.3 211.3 184.8 $ 168.2 $ 109.7 ========= ========= Pro forma adjustments (2.9) (26.2) (26.2) --------- --------- --------- Pro forma net operating income $ 254.4 $ 185.1 $ 158.6 ===================================================================================== Pro forma net operating income per common share $ 1.98 $ 1.44 $ 1.24 ===================================================================================== (1) Comparisons between 1997 results of operations and those of prior years are affected by the Company's initial public offering in March 1997 and companion offerings of senior notes and capital securities as well as the payment of certain special dividends. Pro forma amounts adjust for these transactions. See note 1 to the consolidated financial statements for further description of these transactions and the related pro forma adjustments. (2) Actual earnings per common share amounts have not been presented for periods prior to 1997, because such amounts are not meaningful due to the effects of the initial public offering and the $900.0 million of dividends paid prior to the initial public offering as described in note 1 to the consolidated financial statements. 34 -------------------------------------------------------------------------------- FIVE-YEAR SUMMARY As of December 31, --------------------------------------------------------- (in millions of dollars) 1997 1996 1995 1994 1993 ============================================================================================================= SUMMARY OF FINANCIAL POSITION (1) Total investments $19,673.2 $18,317.3 $17,837.0 $15,239.1 $14,237.7 Deferred policy acquisition costs 1,665.4 1,366.5 1,020.4 995.6 763.8 Separate account assets 37,724.4 26,926.7 18,591.1 12,087.1 9,006.4 Other assets 829.9 1,159.7 1,057.6 921.5 696.0 ------------------------------------------------------------------------------------------------------------- Total assets $59,892.9 $47,770.2 $38,506.1 $29,243.3 $24,703.9 ============================================================================================================= Policy reserves $18,702.8 $17,600.6 $16,771.9 $15,072.7 $13,803.7 Separate account liabilities 37,724.4 26,926.7 18,591.1 12,087.1 9,006.4 Other liabilities 943.1 1,111.2 526.4 222.9 284.2 Long-term debt 298.4 -- -- -- -- ------------------------------------------------------------------------------------------------------------- Total liabilities 57,668.7 45,638.5 35,889.4 27,382.7 23,094.3 NFS-obligated mandatorily redeemable capital securities of subsidiary trust 100.0 -- -- -- -- Shareholders' equity 2,124.2 2,131.7 2,616.7 1,860.6 1,609.6 ------------------------------------------------------------------------------------------------------------- Total liabilities and shareholders' equity $59,892.9 $47,770.2 $38,506.1 $29,243.3 $24,703.9 ============================================================================================================= POLICY RESERVES BY BUSINESS SEGMENT Variable annuity $34,486.7 $24,278.1 $16,761.8 $10,751.1 $ 7,854.7 Fixed annuity 14,194.2 13,511.8 12,784.0 11,247.0 10,154.1 Life insurance 3,487.0 2,938.9 2,660.5 2,425.2 2,254.9 Corporate and other 3,791.9 3,302.5 2,644.3 2,252.7 2,103.9 Reserves ceded 467.4 496.0 512.4 483.8 442.5 ------------------------------------------------------------------------------------------------------------- $56,427.2 $44,527.3 $35,363.0 $27,159.8 $22,810.1 ============================================================================================================= Years ended December 31, --------------------------------------------------------- (in millions of dollars, except per share amounts) 1997 1996 1995 1994 1993 ============================================================================================================= OPERATING INCOME BEFORE FEDERAL INCOME TAX EXPENSE BY BUSINESS SEGMENT (1) Variable annuity $ 150.9 $ 90.3 $ 50.8 $ 24.6 $ 10.4 Fixed annuity 169.5 135.4 137.0 139.0 105.9 Life insurance 70.9 67.2 67.6 53.0 49.7 Corporate and other 4.6 35.4 27.5 40.3 3.6 ------------------------------------------------------------------------------------------------------------- $ 395.9 $ 328.3 $ 282.9 $ 256.9 $ 169.6 ============================================================================================================= EXTERNAL SALES BY BUSINESS SEGMENT Variable annuity $ 7,535.8 $ 6,500.3 $ 4,399.3 $ 3,821.2 $ 2,414.2 Fixed annuity 2,137.9 1,600.5 1,864.2 1,308.6 1,300.9 Life insurance 663.4 439.3 352.4 320.8 279.4 ------------------------------------------------------------------------------------------------------------- $10,337.1 $ 8,540.1 $ 6,615.9 $ 5,450.6 $ 3,994.5 ============================================================================================================= 35 Nationwide Financial Services, Inc. and Subsidiaries --------------------------------------------------------------------------------Return to financial index CONSOLIDATED STATEMENTS OF INCOME (in millions of dollars, except per share amounts) YEARS ENDED DECEMBER 31, 1997 1996 1995 ======================================================================================================== REVENUES Investment product and universal life insurance product policy charges $ 545.2 $ 400.9 $ 286.6 Traditional life insurance premiums 205.4 198.6 199.1 Net investment income 1,413.9 1,357.8 1,294.0 Realized gains (losses) on investments 11.1 (0.2) (1.7) Other 62.8 59.5 59.0 -------------------------------------------------------------------------------------------------------- 2,238.4 2,016.6 1,837.0 -------------------------------------------------------------------------------------------------------- BENEFITS AND EXPENSES Interest credited to policyholder account balances 1,016.6 982.3 950.3 Other benefits and claims 178.2 178.3 165.2 Policyholder dividends on participating policies 40.6 41.0 39.9 Amortization of deferred policy acquisition costs 167.2 133.4 82.7 Interest expense on debt and capital securities of subsidiary trust 26.1 -- -- Other operating expenses 402.7 353.5 317.7 -------------------------------------------------------------------------------------------------------- 1,831.4 1,688.5 1,555.8 -------------------------------------------------------------------------------------------------------- Income from continuing operations before federal income tax expense 407.0 328.1 281.2 Federal income tax expense 141.8 115.8 96.3 -------------------------------------------------------------------------------------------------------- Income from continuing operations 265.2 212.3 184.9 Income from discontinued operations (less federal income tax expense of $4.5 and $7.4 in 1996 and 1995, respectively) -- 11.3 24.7 -------------------------------------------------------------------------------------------------------- Net income $ 265.2 $ 223.6 $ 209.6 ======================================================================================================== BASIC AND DILUTED EARNINGS PER COMMON SHARE Income from continuing operations $ 2.14 Net income $ 2.14 Weighted average number of shares of common stock outstanding (in millions) 124.0 ======================================================================================================== See accompanying notes to consolidated financial statements. 36 Nationwide Financial Services, Inc. and Subsidiaries --------------------------------------------------------------------------------Return to financial index CONSOLIDATED BALANCE SHEETS (in millions of dollars, except per share amounts) December 31, 1997 1996 ========================================================================================= ASSETS Investments: Securities available-for-sale, at fair value: Fixed maturity securities $13,204.1 $12,304.6 Equity securities 80.4 59.1 Fixed maturity securities held-to-maturity, at amortized cost (fair value $6.0 in 1997; $5.9 in 1996) 6.0 5.9 Mortgage loans on real estate, net 5,181.6 5,272.1 Real estate, net 311.4 265.8 Policy loans 415.3 371.8 Other long-term investments 25.2 28.7 Short-term investments 449.2 9.3 ----------------------------------------------------------------------------------------- 19,673.2 18,317.3 ----------------------------------------------------------------------------------------- Cash 180.9 43.2 Accrued investment income 211.2 210.2 Deferred policy acquisition costs 1,665.4 1,366.5 Investment in subsidiaries classified as discontinued operations -- 485.7 Other assets 437.8 420.6 Assets held in Separate Accounts 37,724.4 26,926.7 ----------------------------------------------------------------------------------------- $59,892.9 $47,770.2 ========================================================================================= LIABILITIES AND SHAREHOLDERS' EQUITY Future policy benefits and claims $18,702.8 $17,600.6 Long-term debt 298.4 -- Other liabilities 943.1 1,111.2 Liabilities related to Separate Accounts 37,724.4 26,926.7 ----------------------------------------------------------------------------------------- 57,668.7 45,638.5 ----------------------------------------------------------------------------------------- Commitments and contingencies (notes 9 and 16) NFS-obligated mandatorily redeemable capital securities of subsidiary trust holding solely junior subordinated debentures of NFS 100.0 -- ----------------------------------------------------------------------------------------- Shareholders' equity: Preferred stock, $.01 par value Authorized 50.0 million shares; no shares issued and outstanding -- -- Class A common stock, $.01 par value Authorized 750.0 million shares; 23.8 million shares issued and outstanding in 1997 (none in 1996) 0.2 -- Class B common stock, $.01 par value Authorized 750.0 million shares; 104.7 million shares issued and outstanding 1.0 1.0 Additional paid-in capital 629.2 551.4 Retained earnings 1,247.8 1,405.7 Unearned compensation (1.1) -- Unrealized gains on securities available-for-sale, net 247.1 173.6 ----------------------------------------------------------------------------------------- 2,124.2 2,131.7 ----------------------------------------------------------------------------------------- $59,892.9 $47,770.2 ========================================================================================= See accompanying notes to consolidated financial statements. 37 Nationwide Financial Services, Inc. and Subsidiaries --------------------------------------------------------------------------------Return to financial index CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (in millions of dollars) UNREALIZED GAINS (LOSSES) CLASS A CLASS B ADDITIONAL ON SECURITIES TOTAL COMMON COMMON PAID-IN RETAINED UNEARNED AVAILABLE- SHAREHOLDERS' STOCK STOCK CAPITAL EARNINGS COMPENSATION FOR-SALE, NET EQUITY ======================================================================================================================= DECEMBER 31, 1994 $ -- $ 1.0 $ 629.7 $ 1,349.6 $ -- $ (119.7) $1,860.6 Capital contribution -- -- 51.0 -- -- (4.1) 46.9 Net income -- -- -- 209.6 -- -- 209.6 Dividends to shareholder -- -- -- (8.5) -- -- (8.5) Unrealized gains on securities available-for-sale, net -- -- -- -- -- 508.1 508.1 ----------------------------------------------------------------------------------------------------------------------- DECEMBER 31, 1995 -- 1.0 680.7 1,550.7 -- 384.3 2,616.7 Net income -- -- -- 223.6 -- -- 223.6 Dividends to shareholder -- -- (129.3) (368.6) -- (39.8) (537.7) Unrealized losses on securities available-for-sale, net -- -- -- -- -- (170.9) (170.9) ----------------------------------------------------------------------------------------------------------------------- DECEMBER 31, 1996 -- 1.0 551.4 1,405.7 -- 173.6 2,131.7 Issuance of Class A common stock 0.2 -- 524.0 -- -- -- 524.2 Net income -- -- -- 265.2 -- -- 265.2 Dividends to shareholders -- -- (450.0) (423.1) -- -- (873.1) Unrealized gains on securities available-for-sale, net -- -- -- -- -- 73.5 73.5 Other, net -- -- 3.8 -- (1.1) -- 2.7 ----------------------------------------------------------------------------------------------------------------------- DECEMBER 31, 1997 $ 0.2 $ 1.0 $ 629.2 $ 1,247.8 $ (1.1) $ 247.1 $2,124.2 ======================================================================================================================= See accompanying notes to consolidated financial statements. 38 Nationwide Financial Services, Inc. and Subsidiaries --------------------------------------------------------------------------------Return to financial index CONSOLIDATED STATEMENTS OF CASH FLOWS (in millions of dollars) Years Ended December 31, 1997 1996 1995 =========================================================================================================== CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 265.2 $ 223.6 $ 209.6 Adjustments to reconcile net income to net cash provided by operating activities: Interest credited to policyholder account balances 1,016.6 982.3 950.3 Capitalization of deferred policy acquisition costs (487.9) (422.6) (321.3) Amortization of deferred policy acquisition costs 167.2 133.4 82.7 Amortization and depreciation (0.6) 7.3 13.2 Realized (gains) losses on invested assets, net (11.1) (0.6) 3.3 (Increase) decrease in accrued investment income (1.0) 2.8 (16.9) (Increase) decrease in other assets (16.5) (93.6) 25.8 (Decrease) increase in policy liabilities (23.1) (151.0) 123.9 Increase in other liabilities 270.3 177.4 69.9 Other, net (5.7) (5.3) (22.0) ----------------------------------------------------------------------------------------------------------- Net cash provided by operating activities 1,173.4 853.7 1,118.5 ----------------------------------------------------------------------------------------------------------- CASH FLOWS FROM INVESTING ACTIVITIES Proceeds from maturity of securities available-for-sale 993.4 1,162.8 634.6 Proceeds from sale of securities available-for-sale 574.5 299.6 150.5 Proceeds from maturity of fixed maturity securities held-to-maturity -- -- 564.4 Proceeds from repayments of mortgage loans on real estate 437.3 309.0 207.8 Proceeds from sale of real estate 34.8 18.5 48.3 Proceeds from repayments of policy loans and sale of other invested assets 22.7 22.8 53.6 Cost of securities available-for-sale acquired (2,828.1) (1,573.6) (1,998.2) Cost of fixed maturity securities held-to-maturity acquired -- -- (599.4) Cost of mortgage loans on real estate acquired (752.2) (972.8) (796.0) Cost of real estate acquired (24.9) (7.9) (10.9) Policy loans issued and other invested assets acquired (62.5) (57.7) (75.9) Short-term investments, net (441.0) 33.4 91.7 ----------------------------------------------------------------------------------------------------------- Net cash used in investing activities (2,046.0) (765.9) (1,729.5) ----------------------------------------------------------------------------------------------------------- CASH FLOWS FROM FINANCING ACTIVITIES Net proceeds from issuance of Class A common stock 524.2 -- -- Net proceeds from issuance of NFS-obligated mandatorily redeemable capital securities of subsidiary trust 98.3 -- -- Net proceeds from issuance of long-term debt 294.5 -- -- Cash dividends paid (15.4) (52.0) (8.5) Increase in investment product and universal life insurance product account balances 2,488.5 1,781.8 1,883.7 Decrease in investment product and universal life insurance product account balances (2,379.8) (1,784.5) (1,258.7) ----------------------------------------------------------------------------------------------------------- Net cash provided by (used in) financing activities 1,010.3 (54.7) 616.5 ----------------------------------------------------------------------------------------------------------- Net increase in cash 137.7 33.1 5.5 Cash, beginning of year 43.2 10.1 4.6 ----------------------------------------------------------------------------------------------------------- Cash, end of year $ 180.9 $ 43.2 $ 10.1 =========================================================================================================== See accompanying notes to consolidated financial statements. 39 Nationwide Financial Services, Inc. and Subsidiaries --------------------------------------------------------------------------------Return to financial index NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1997, 1996 and 1995 ================================================================================ 1 ORGANIZATION AND DESCRIPTION OF BUSINESS Nationwide Financial Services, Inc. (NFS) was formed in November 1996 as a holding company for Nationwide Life Insurance Company (NLIC) and the other companies within the Nationwide Insurance Enterprise that offer or distribute long-term savings and retirement products. NFS and its subsidiaries are collectively referred to as "the Company." On March 11 1997, NFS sold, in an initial public offering, 23.6 million shares of its newly-issued Class A common stock for net proceeds of $524.2 million (the Equity Offering). In March 1997, NFS also sold, in companion public offerings, $300.0 million of 8% Senior Notes (the Notes) and, through a wholly owned subsidiary trust, $100.0 million of 7.899% Capital Securities (the Capital Securities). Aggregate net proceeds from the Equity Offering, the offering of the Notes and the sale of the Capital Securities totaled $917.0 million. NFS contributed $836.8 million of the proceeds to the capital of NLIC and retained $80.2 million of the proceeds for general corporate purposes. Prior to the initial public offering , NFS was a wholly owned subsidiary of Nationwide Corporation (Nationwide Corp.). Nationwide Corp. continues to own all of the outstanding shares of Class B common stock, which represents approximately 98% of the combined voting power of the shareholders of NFS. During the first quarter of 1997, NFS's Board of Directors approved a 104,745 for one split of the NFS Class B common stock, which became effective February 10, 1997. Share information for all periods presented has been restated to reflect the split. During 1996 and 1997, Nationwide Corp. and NFS completed certain transactions in anticipation of the initial public offering that focused the business of NFS on long-term savings and retirement products. On September 24, 1996, NLIC declared a dividend payable to Nationwide Corp. on January 1, 1997 consisting of the outstanding shares of common stock of certain subsidiaries that do not offer or distribute long-term savings or retirement products. In addition, during 1996, NLIC entered into two reinsurance agreements whereby all of NLIC's accident and health and group life insurance business was ceded to two affiliates effective January 1, 1996. These subsidiaries, through December 31, 1996, and all accident and health and group life insurance business have been accounted for as discontinued operations for all periods presented. See notes 14 and 19. On January 27, 1997, Nationwide Corp. contributed the common stock of NLIC and three marketing and distribution companies to NFS. Accordingly, the 1996 and 1995 consolidated financial statements include the results of NLIC and its subsidiaries and the three marketing and distribution companies as if they were consolidated with NFS for all periods presented. Additionally, the Company paid $900.0 million of dividends to Nationwide Corp., $50.0 million on December 31, 1996 and $850.0 million on February 24, 1997. The Company is a leading provider of long-term savings and retirement products. The Company is subject to regulation by the Insurance Departments of states in which it is licensed, and undergoes periodic examinations by those departments. The following unaudited pro forma information presents the results of operations of the Company for the years ended December 31, 1997, 1996 and 1995, with pro forma adjustments to net investment income and interest expense giving effect to (i) the Equity Offering and companion offerings of the Notes and the Capital Securities, (ii) the $850.0 million dividend paid by the Company on February 24, 1997 and (iii) for 1996 and 1995 only, the $50.0 million dividend paid by the Company on December 31, 1996, as if each had been consummated at the beginning of the year indicated. This pro forma information is not necessarily indicative of what would have occurred had the above transactions been made on the dates indicated, or of future results of the Company.Return to financial index 40 -------------------------------------------------------------------------------- (Unaudited) ----------------------------------------------------------- (in millions of dollars, except per share amounts) 1997 1996 1995 =========================================================== Revenues $2,240.1 $2,008.4 $1,828.8 Benefits and expenses 1,837.5 1,720.6 1,587.9 ----------------------------------------------------------- Income from continuing operations before federal income tax expense 402.6 287.8 240.9 Federal income tax expense 140.3 101.7 82.2 ----------------------------------------------------------- Income from continuing operations 262.3 186.1 158.7 Income from discontinued operations, net of federal income tax expense -- 11.3 24.7 ----------------------------------------------------------- Net income $ 262.3 $ 197.4 $ 183.4 =========================================================== Basic and diluted earnings per common share: Income from continuing operations $ 2.04 $ 1.45 $ 1.24 Net income $ 2.04 $ 1.54 $ 1.43 Weighted average number of shares of common stock outstanding (in millions) 128.5 128.4 128.4 =========================================================== The impact on the above per common share amounts of realized gains on investments, net of tax, was $0.06 in 1997, $0.01 in 1996 and none in 1995. =============================================================================== 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The significant accounting policies followed by the Company that materially affect financial reporting are summarized below. The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles which differ from statutory accounting practices prescribed or permitted by regulatory authorities. Annual Statements for the Company's insurance subsidiaries, filed with the department of insurance of each insurance company's state of domicile, are prepared on the basis of accounting practices prescribed or permitted by each department. Prescribed statutory accounting practices include a variety of publications of the National Association of Insurance Commissioners (NAIC), as well as state laws, regulations and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed. The Company's insurance subsidiaries have no material permitted statutory accounting practices. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenues and expenses for the reporting period. Actual results could differ significantly from those estimates. The most significant estimates include those used in determining deferred policy acquisition costs, valuation allowances for mortgage loans on real estate and real estate investments and the liability for future policy benefits and claims. Although some variability is inherent in these estimates, management believes the amounts provided are adequate.Return to financial index a. Consolidation Policy The consolidated financial statements include the accounts of NFS and its wholly owned subsidiaries. Subsidiaries that are classified and reported as discontinued operations are not consolidated but rather are reported as "Investment in subsidiaries classified as discontinued operations" in the accompanying consolidated balance sheets and "Income from discontinued operations" in the accompanying consolidated statements of income. All significant intercompany balances and transactions have been eliminated. b. Valuation of Investments and Related Gains and Losses The Company is required to classify its fixed maturity securities and equity securities as either held-to-maturity, available-for-sale or trading. Fixed maturity securities are classified as held-to-maturity when the Company has the positive intent and ability to hold the securities to maturity and are stated at amortized cost. Fixed maturity securities not classified as held-to-maturity and all equity securities are classified as available-for-sale and are stated at fair value, with the unrealized gains and losses, net of adjustments to deferred policy acquisition costs and deferred federal income tax, reported as a separate component of shareholders' equity. The adjustment to deferred policy acquisition costs represents the change in amortization of deferred policy acquisition costs that would have been required as a charge or credit to operations had such unrealized amounts been realized. The Company has no fixed maturity securities classified as trading as of December 31, 1997 or 1996. Mortgage loans on real estate are carried at the unpaid principal balance less valuation allowances. The Company provides valuation allowances for impairments of mortgage loans on real estate based on a review by portfolio managers. The measurement of impaired loans is based on the present value of expected future cash flows discounted at the loan's effective interest rate or, as a practical expedient, at the fair value of the collateral, if the loan is collateral dependent. Loans in foreclosure and loans considered to be impaired are placed on non-accrual status. Interest received 41 -------------------------------------------------------------------------------- on non-accrual status mortgage loans on real estate is included in interest income in the period received. Real estate is carried at cost less accumulated depreciation and valuation allowances. Other long-term investments are carried on the equity basis, adjusted for valuation allowances. Impairment losses are recorded on long-lived assets used in operations when indicators of impairment are present and the undiscounted cash flows estimated to be generated by those assets are less than the assets' carrying amount. Realized gains and losses on the sale of investments are determined on the basis of specific security identification. Estimates for valuation allowances and other than temporary declines are included in realized gains and losses on investments. c. Revenues and Benefits Investment Products and Universal Life Insurance Products: Investment products consist primarily of individual and group variable and fixed annuities. Universal life insurance products include universal life insurance, variable universal life insurance and other interest-sensitive life insurance policies. Revenues for investment products and universal life insurance products consist of net investment income, asset fees, cost of insurance, policy administration and surrender charges that have been earned and assessed against policy account balances during the period. Policy benefits and claims that are charged to expense include interest credited to policy account balances and benefits and claims incurred in the period in excess of related policy account balances. Traditional Life Insurance Products: Traditional life insurance products include those products with fixed and guaranteed premiums and benefits and consist primarily of whole life insurance, limited-payment life insurance, term life insurance and certain annuities with life contingencies. Premiums for traditional life insurance products are recognized as revenue when due. Benefits and expenses are associated with earned premiums so as to result in recognition of profits over the life of the contract. This association is accomplished by the provision for future policy benefits and the deferral and amortization of policy acquisition costs. d. Deferred Policy Acquisition Costs The costs of acquiring new business, principally commissions, certain expenses of the policy issue and underwriting department and certain variable sales expenses have been deferred. For investment products and universal life insurance products, deferred policy acquisition costs are being amortized with interest over the lives of the policies in relation to the present value of estimated future gross profits from projected interest margins, asset fees, cost of insurance, policy administration and surrender charges. For years in which gross profits are negative, deferred policy acquisition costs are amortized based on the present value of gross revenues. For traditional life insurance products, these deferred policy acquisition costs are predominantly being amortized with interest over the premium paying period of the related policies in proportion to the ratio of actual annual premium revenue to the anticipated total premium revenue. Such anticipated premium revenue was estimated using the same assumptions as were used for computing liabilities for future policy benefits. Deferred policy acquisition costs are adjusted to reflect the impact of unrealized gains and losses on fixed maturity securities available-for-sale as described in note 2(b).Return to financial index e. Separate Accounts Separate Account assets and liabilities represent contractholders' funds which have been segregated into accounts with specific investment objectives. For all but $365.5 million of separate account assets, the investment income and gains or losses of these accounts accrue directly to the contractholders. The activity of the Separate Accounts is not reflected in the consolidated statements of income and cash flows except for the fees the Company receives. f. Future Policy Benefits Future policy benefits for investment products in the accumulation phase, universal life insurance and variable universal life insurance policies have been calculated based on participants' contributions plus interest credited less applicable contract charges. Future policy benefits for traditional life insurance policies have been calculated using a net level premium method based on estimates of mortality, morbidity, investment yields and withdrawals which were used or which were being experienced at the time the policies were issued, rather than the assumptions prescribed by state regulatory authorities. See note 4. g. Participating Business Participating business represents approximately 50% in 1997 (52% in 1996 and 54% in 1995) of the Company's life insurance in force, 77% in 1997 (78% in 1996 and 79% in 1995) of the number of life insurance policies in force, and 27% in 1997 (40% in 1996 and 47% in 1995) of life insurance statutory premiums. The provision for policyholder dividends is based on current dividend scales and is included in "Future policy benefits and claims" in the accompanying consolidated balance sheets. 42 -------------------------------------------------------------------------------- h. Federal Income Tax The Company files a consolidated federal income tax return with Nationwide Mutual Insurance Company (NMIC), the majority shareholder of Nationwide Corp. The members of the consolidated tax return group have a tax sharing arrangement which provides, in effect, for each member to bear essentially the same federal income tax liability as if separate tax returns were filed. The Company utilizes the asset and liability method of accounting for income tax. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under this method, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances are established when necessary to reduce the deferred tax assets to the amounts expected to be realized. i. Reinsurance Ceded Reinsurance premiums ceded and reinsurance recoveries on benefits and claims incurred are deducted from the respective income and expense accounts. Assets and liabilities related to reinsurance ceded are reported on a gross basis. All of the Company's accident and health and group life insurance business is ceded to affiliates and is accounted for as discontinued operations. See notes 14 and 19.Return to financial index j. Earnings Per Common Share The Company adopted Statement of Financial Accounting Standards (SFAS) No. 128 -- Earnings Per Share during the fourth quarter of 1997. The statement requires dual presentation of basic and diluted earnings per share on the face of the income statement. The effects of common stock equivalents do not result in diluted earnings per share different from basic earnings per share. Earnings per common share amounts are adjusted for the stock split described in note 1. Actual earnings per common share amounts have not been presented for periods prior to 1997, because such amounts are not meaningful due to the effects of the initial public offering and the $900 million of dividends paid prior to the initial public offering as described in note 1. k. Recently Issued Accounting Pronouncements SFAS No. 130 -- Reporting Comprehensive Income was issued in June 1997 and is effective for fiscal years beginning after December 15, 1997. The statement establishes standards for reporting and display of comprehensive income and its components in a full set of financial statements. Comprehensive income includes all changes in equity during a period except those resulting from investments by shareholders and distributions to shareholders and includes net income. Comprehensive income would be reported in addition to earnings amounts currently presented. The Company will adopt the statement and begin reporting comprehensive income in the first quarter of 1998. l. Reclassification Certain items in the 1996 and 1995 consolidated financial statements have been reclassified to conform to the 1997 presentation. 43 -------------------------------------------------------------------------------- 3 INVESTMENTS The amortized cost, gross unrealized gains and losses and estimated fair value of securities available-for-sale as of December 31, 1997 and 1996 were: GROSS GROSS AMORTIZED UNREALIZED UNREALIZED ESTIMATED (in millions of dollars) COST GAINS LOSSES FAIR VALUE ============================================================================================================== DECEMBER 31, 1997 Fixed maturity securities: U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 305.1 $ 8.6 $ -- $ 313.7 Obligations of states and political subdivisions 1.6 -- -- 1.6 Debt securities issued by foreign governments 93.3 2.7 (0.2) 95.8 Corporate securities 8,698.7 355.5 (11.5) 9,042.7 Mortgage-backed securities 3,634.2 118.6 (2.5) 3,750.3 ============================================================================================================== Total fixed maturity securities 12,732.9 485.4 (14.2) 13,204.1 Equity securities 67.8 12.9 (0.3) 80.4 -------------------------------------------------------------------------------------------------------------- $12,800.7 $498.3 $(14.5) $13,284.5 ============================================================================================================== DECEMBER 31, 1996 Fixed maturity securities: U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 275.7 $ 4.8 $ (1.3) $ 279.2 Obligations of states and political subdivisions 6.2 0.5 -- 6.7 Debt securities issued by foreign governments 100.7 2.1 (0.9) 101.9 Corporate securities 7,999.3 285.9 (33.7) 8,251.5 Mortgage-backed securities 3,589.0 91.4 (15.1) 3,665.3 -------------------------------------------------------------------------------------------------------------- Total fixed maturity securities 11,970.9 384.7 (51.0) 12,304.6 Equity securities 43.9 15.6 (0.4) 59.1 -------------------------------------------------------------------------------------------------------------- $12,014.8 $400.3 $(51.4) $12,363.7 ==============================================================================================================Return to financial index The amortized cost and estimated fair value of the U.S. Treasury security classified as held-to-maturity were $6.0 million as of December 31, 1997 and were $5.9 million as of December 31, 1996. The security has a contractual maturity date of March 31, 1998. The amortized cost and estimated fair value of fixed maturity securities available-for-sale as of December 31, 1997, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. AMORTIZED ESTIMATED (in millions of dollars) COST FAIR VALUE ========================================================== Fixed maturity securities available for sale: Due in one year or less $ 419.2 $ 422.1 Due after one year through five years 4,573.5 4,708.4 Due after five years through ten years 2,772.6 2,879.7 Due after ten years 1,333.4 1,443.6 ---------------------------------------------------------- 9,098.7 9,453.8 Mortgage-backed securities 3,634.2 3,750.3 ---------------------------------------------------------- $12,732.9 $13,204.1 ========================================================== 44 -------------------------------------------------------------------------------- The components of unrealized gains on securities available-for-sale, net, were as follows as of December 31: (in millions of dollars) 1997 1996 ======================================================== Gross unrealized gains $ 483.8 $349.0 Adjustment to deferred policy acquisition costs (103.7) (81.9) Deferred federal income tax (133.0) (93.5) -------------------------------------------------------- $ 247.1 $173.6 ======================================================== An analysis of the change in gross unrealized gains (losses) on securities available-for-sale and fixed maturity securities held-to-maturity follows for the years ended December 31: (in millions of dollars) 1997 1996 1995 ======================================================== Securities available-for-sale: Fixed maturity securities $137.5 $(289.2) $876.3 Equity securities (2.7) 8.9 -- Fixed maturity securities held-to-maturity -- (0.2) 75.9 -------------------------------------------------------- $134.8 $(280.5) $952.2 ======================================================== Proceeds from the sale of securities available-for-sale during 1997, 1996 and 1995 were $574.5 million, $299.6 million and $150.5 million, respectively. During 1997, gross gains of $9.9 million ($6.4 million and $4.8 million in 1996 and 1995, respectively) and gross losses of $18.0 million ($13.7 million and $2.1 million in 1996 and 1995, respectively) were realized on those sales. In addition, gross gains of $15.1 million and gross losses of $0.7 million were realized in 1997 when the Company paid a dividend to Nationwide Corp. consisting of securities having an aggregate fair value of $850.0 million. During 1995, the Company transferred fixed maturity securities classified as held-to-maturity with amortized cost of $25.4 million to available-for-sale securities due to evidence of a significant deterioration in the issuer's creditworthiness. The transfer of those fixed maturity securities resulted in a gross unrealized loss of $3.5 million. As permitted by the Financial Accounting Standards Board's Special Report, A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities, issued in November 1995, the Company transferred nearly all of its fixed maturity securities previously classified as held-to-maturity to available-for-sale. As of December 14, 1995, the date of transfer, the fixed maturity securities had amortized cost of $3.32 billion, resulting in a gross unrealized gain of $155.9 million. Investments that were non-income producing for the twelve month period preceding December 31, 1997 amounted to $19.4 million ($26.8 million for 1996) and consisted of $3.0 million ($0.2 million in 1996) in securities available-for-sale, $16.4 million ($20.6 million in 1996) in real estate and none ($5.9 million in 1996) in other long-term investments. Real estate is presented at cost less accumulated depreciation of $45.1 million as of December 31, 1997 ($30.3 million as of December 31, 1996) and valuation allowances of $11.1 million as of December 31, 1997 ($15.2 million as of December 31, 1996). The recorded investment of mortgage loans on real estate considered to be impaired as of December 31, 1997 was $19.9 million ($51.8 million as of December 31, 1996), which includes $3.9 million ($41.7 million as of December 31, 1996) of impaired mortgage loans on real estate for which the related valuation allowance was $0.1 million ($8.5 million as of December 31, 1996) and $16.0 million ($10.1 million as of December 31, 1996) of impaired mortgage loans on real estate for which there was no valuation allowance. During 1997, the average recorded investment in impaired mortgage loans on real estate was approximately $31.8 million ($39.7 million in 1996) and interest income recognized on those loans was $1.0 million ($2.1 million in 1996), which is equal to interest income recognized using a cash-basis method of income recognition. Activity in the valuation allowance account for mortgage loans on real estate is summarized for the years ended December 31: (in millions of dollars) 1997 1996 ======================================================= Allowance, beginning of year $51.0 $49.1 (Reductions) additions charged to operations (1.2) 4.5 Direct write-downs charged against the allowance (7.3) (2.6) ------------------------------------------------------- Allowance, end of year $42.5 $51.0 =======================================================Return to financial index 45 -------------------------------------------------------------------------------- An analysis of investment income by investment type follows for the years ended December 31: (in millions of dollars) 1997 1996 1995 ========================================================== Gross investment income: Securities available-for-sale: Fixed maturity securities $ 911.6 $ 917.1 $ 685.8 Equity securities 0.8 1.3 1.3 Fixed maturity securities held-to-maturity 0.4 0.4 201.8 Mortgage loans on real estate 457.7 432.8 395.5 Real estate 42.9 44.3 38.3 Short-term investments 26.9 4.2 10.6 Other 21.1 3.6 7.2 ---------------------------------------------------------- Total investment income 1,461.4 1,403.7 1,340.5 Less investment expenses 47.5 45.9 46.5 ---------------------------------------------------------- Net investment income $1,413.9 $1,357.8 $1,294.0 ========================================================== An analysis of realized gains (losses) on investments, net of valuation allowances, by investment type follows for the years ended December 31: (in millions of dollars) 1997 1996 1995 ======================================================== Securities available-for-sale: Fixed maturity securities $ 3.6 $(3.5) $ 4.2 Equity securities 2.7 3.2 3.4 Mortgage loans on real estate 1.6 (4.1) (7.1) Real estate and other 3.2 4.2 (2.2) -------------------------------------------------------- $11.1 $(0.2) $(1.7) ======================================================== Fixed maturity securities with an amortized cost of $6.2 million as of December 31, 1997 and 1996 were on deposit with various regulatory agencies as required by law. =============================================================================== 4 FUTURE POLICY BENEFITS AND CLAIMS The liability for future policy benefits for investment contracts represents approximately 86% and 87% of the total liability for future policy benefits as of December 31, 1997 and 1996, respectively. The average interest rate credited on investment product policies was approximately 6.1%, 6.3% and 6.6% for the years ended December 31, 1997, 1996 and 1995, respectively. The liability for future policy benefits for traditional life insurance policies has been established based upon the following assumptions: Interest rates: Interest rates vary by issue year and were 6.9% and 6.6% in 1997 and 1996, respectively. Interest rates have generally ranged from 6.0% to 10.5% for previous issue years. Withdrawals: Rates, which vary by issue age, type of coverage and policy duration, are based on Company experience. Mortality: Mortality and morbidity rates are based on published tables, modified for the Company's actual experience. The Company has entered into a reinsurance contract to cede a portion of its general account individual annuity business to The Franklin Life Insurance Company (Franklin). Total recoveries due from Franklin were $220.2 million and $240.5 million as of December 31, 1997 and 1996, respectively. The contract is immaterial to the Company's results of operations. The ceding of risk does not discharge the original insurer from its primary obligation to the policyholder. Under the terms of the contract, Franklin has established a trust as collateral for the recoveries. The trust assets are invested in investment grade securities, the market value of which must at all times be greater than or equal to 102% of the reinsured reserves. The Company has reinsurance agreements with certain affiliates as described in note 14. All other reinsurance agreements are not material to either premiums or reinsurance recoverable. =============================================================== 5 LONG-TERM DEBT On March 10, 1997, NFS sold the Notes in a public offering generating net proceeds of $294.5 million. The Notes bear interest at the rate of 8% per annum and mature on March 1, 2027. The Notes 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 Notes are not subject to any sinking fund payments. The terms of the Notes contain various restrictive covenants including limitations on the disposition of subsidiaries. As of December 31, 1997, NFS was in compliance with all such covenants. The Company made interest payments on the Notes in 1997 of $11.4 million.Return to financial index 46 -------------------------------------------------------------------------------- 6 MANDATORILY REDEEMABLE CAPITAL SECURITIES OF SUBSIDIARY TRUST Nationwide Financial Services Capital Trust (the Trust), a wholly owned subsidiary of NFS, was formed under the laws of the state of Delaware. The Trust exists for the exclusive purposes of (i) issuing Capital Securities representing undivided beneficial interests in the assets of the Trust; (ii) investing the gross proceeds from the sale of the Capital Securities in Junior Subordinated Deferrable Interest Debentures (Junior Subordinated Debentures) of NFS; and (iii) engaging in only those activities necessary or incidental thereto. These Junior Subordinated Debentures and the related income effects are eliminated in the consolidated financial statements. On March 11, 1997, the Trust sold, in a public offering, $100.0 million of 7.899% Capital Securities, representing preferred undivided beneficial interests in the assets of the Trust generating net proceeds of $98.3 million. Concurrent with the sale of the Trust's Capital Securities, NFS sold to the Trust $103.1 million in principal amount of its 7.899% Junior Subordinated Debentures due March 1, 2037. The Junior Subordinated Debentures are the sole assets of the Trust and are redeemable by NFS in whole at any time or in part from time to time at par plus an applicable make-whole premium. The Capital Securities will mature or be called simultaneously with the Junior Subordinated Debentures and have a liquidation value of $1,000 per Capital Security. The Capital Securities, through obligations of NFS under the Junior Subordinated Debentures, the Capital Securities Guarantee Agreement and the related Declaration of Trust and Indenture, are fully and unconditionally guaranteed by NFS. Distributions on the Capital Securities are cumulative and payable semi-annually in arrears. Distributions on the Capital Securities have been classified as interest expense in the consolidated statements of income. The Company made distributions on the Capital Securities in 1997 of $3.8 million. 7 FEDERAL INCOME TAX The Company's current federal income tax liability was $59.4 million and $29.2 million as of December 31, 1997 and 1996, respectively. The tax effects of temporary differences that give rise to significant components of the net deferred tax liability as of December 31, 1997 and 1996 are as follows: (in millions of dollars) 1997 1996 ======================================================= DEFERRED TAX ASSETS Future policy benefits $200.1 $183.0 Liabilities in Separate Accounts 242.0 188.4 Mortgage loans on real estate and real estate 19.0 23.4 Other assets and other liabilities 63.1 57.8 ------------------------------------------------------- Total gross deferred tax assets 524.2 452.6 Less valuation allowance (7.0) (7.8) ------------------------------------------------------- Net deferred tax assets 517.2 444.8 ------------------------------------------------------- DEFERRED TAX LIABILITIES Deferred policy acquisition costs 480.5 399.3 Fixed maturity securities 193.3 133.2 Deferred tax on realized investment gains 40.1 37.6 Equity securities and other long-term investments 7.5 8.2 Other 22.2 25.4 ------------------------------------------------------- Total gross deferred tax liabilities 743.6 603.7 ------------------------------------------------------- Net deferred tax liability $226.4 $158.9 ======================================================= In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion of the total gross deferred tax assets will not be realized. Nearly all future deductible amounts can be offset by future taxable amounts or recovery of federal income tax paid within the statutory carryback period. The valuation allowance decreased $0.8 million for the year ended December 31, 1997 (no change during 1996 and decreased $0.8 million during 1995). Federal income tax expense attributable to income from continuing operations for the years ended December 31 was as follows: (in millions of dollars) 1997 1996 1995 ======================================================== Currently payable $114.4 $116.0 $89.4 Deferred tax expense (benefit) 27.4 (0.2) 6.9 -------------------------------------------------------- $141.8 $115.8 $96.3 ========================================================Return to financial index 47 -------------------------------------------------------------------------------- Total federal income tax expense for the years ended December 31, 1997, 1996 and 1995 differs from the amount computed by applying the U.S. federal income tax rate to income before tax as follows: 1997 1996 1995 (in millions ------------- ------------- ------------- of dollars) AMOUNT % Amount % Amount % ==================================================================== Computed (expected) tax expense $142.5 35.0 $114.8 35.0 $98.4 35.0 Tax exempt interest and dividends received deduction -- 0.0 (0.2) (0.1) -- 0.0 Other, net (0.7) (0.2) 1.2 0.4 (2.1) (0.7) -------------------------------------------------------------------- Total (effective rate of each year) $141.8 34.8 $115.8 35.3 $96.3 34.3 ==================================================================== Total federal income tax paid was $84.2 million, $117.3 million and $58.1 million during the years ended December 31, 1997, 1996 and 1995, respectively. =============================================================== 8 FAIR VALUE OF FINANCIAL INSTRUMENTS The following disclosures summarize the carrying amount and estimated fair value of the Company's financial instruments. Certain assets and liabilities are specifically excluded from the disclosure requirements of financial instruments. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company. The fair value of a financial instrument is defined as the amount at which the financial instrument could be exchanged in a current transaction between willing parties. In cases where quoted market prices are not available, fair value is to be based on estimates using present value or other valuation techniques. Many of the Company's assets and liabilities subject to the disclosure requirements are not actively traded, requiring fair values to be estimated by management using present value or other valuation techniques. These techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Although fair value estimates are calculated using assumptions that management believes are appropriate, changes in assumptions could cause these estimates to vary materially. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in the immediate settlement of the instruments. Although insurance contracts, other than policies such as annuities that are classified as investment contracts, are specifically exempted from the disclosure requirements, estimated fair value of policy reserves on life insurance contracts is provided to make the fair value disclosures more meaningful. The tax ramifications of the related unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates. The following methods and assumptions were used by the Company in estimating its fair value disclosures: Fixed maturity and equity securities: The fair value for fixed maturity securities is based on quoted market prices, where available. For fixed maturity securities not actively traded, fair value is estimated using values obtained from independent pricing services or, in the case of private placements, is estimated by discounting expected future cash flows using a current market rate applicable to the yield, credit quality and maturity of the investments. The fair value for equity securities is based on quoted market prices. Mortgage loans on real estate, net: The fair value for mortgage loans on real estate is estimated using discounted cash flow analyses, using interest rates currently being offered for similar loans to borrowers with similar credit ratings. Loans with similar characteristics are aggregated for purposes of the calculations. Fair value for mortgage loans in default is the estimated fair value of the underlying collateral. Policy loans, short-term investments and cash: The carrying amount reported in the consolidated balance sheets for these instruments approximates their fair value. Separate Account assets and liabilities: The fair value of assets held in Separate Accounts is based on quoted market prices. The fair value of liabilities related to Separate Accounts is the amount payable on demand, which includes certain surrender charges. Investment contracts: The fair value for the Company's liabilities under investment type contracts is disclosed using two methods. For investment contracts without defined maturities, fair value is the amount payable on demand. For investment contracts with known or determined maturities, fair value is estimated using discounted cash flow analysis. Interest rates used are similar to currently offered contracts with maturities consistent with those remaining for the contracts being valued. Policy reserves on life insurance contracts: Included are disclosures for individual life insurance, universal life insurance and supplementary contracts with life contingencies for which the estimated fair value is the amount payable on demand. Also included are disclosures for the Company's limited payment policies, which the Company has used discounted cash flow analyses similar to those used for investment contracts with known maturities to estimate fair value. Long-term Debt: The fair value for long-term debt is based on quoted market prices.Return to financial index 48 -------------------------------------------------------------------------------- Capital securities of subsidiary trust: The fair value for capital securities of subsidiary trust is based on quoted market prices. Commitments to extend credit: Commitments to extend credit have nominal fair value because of the short-term nature of such commitments. See note 9. Carrying amount and estimated fair value of financial instruments subject to disclosure requirements and policy reserves on life insurance contracts were as follows as of December 31: 1997 1996 ----------------------- ----------------------- CARRYING ESTIMATED Carrying Estimated (in millions of dollars) AMOUNT FAIR VALUE amount fair value ================================================================================================================== ASSETS Investments: Securities available-for-sale: Fixed maturity securities $13,204.1 $13,204.1 $12,304.6 $12,304.6 Equity securities 80.4 80.4 59.1 59.1 Fixed maturity securities held-to-maturity 6.0 6.0 5.9 5.9 Mortgage loans on real estate, net 5,181.6 5,509.7 5,272.1 5,397.9 Policy loans 415.3 415.3 371.8 371.8 Short-term investments 449.2 449.2 9.3 9.3 Cash 180.9 180.9 43.2 43.2 Assets held in Separate Accounts 37,724.4 37,724.4 26,926.7 26,926.7 LIABILITIES Investment contracts 14,708.2 14,322.1 13,914.4 13,484.5 Policy reserves on life insurance contracts 3,345.4 3,182.4 3,392.8 3,197.5 Long-term debt 298.4 327.0 -- -- Liabilities related to Separate Accounts 37,724.4 36,747.0 26,926.7 26,164.2 Capital securities of subsidiary trust 100.0 109.4 -- -- ================================================================================================================== ================================================================================ 9 RISK DISCLOSURES The following is a description of the most significant risks facing life insurers and how the Company mitigates those risks: Legal/Regulatory Risk: The risk that changes in the legal or regulatory environment in which an insurer operates will result in increased competition, reduce demand for a company's products, or create additional expenses not anticipated by the insurer in pricing its products. The Company mitigates this risk by offering a wide range of products and by operating throughout the United States, thus reducing its exposure to any single product or jurisdiction, and also by employing underwriting practices which identify and minimize the adverse impact of this risk. Credit Risk: The risk that issuers of securities owned by the Company or mortgagors on mortgage loans on real estate owned by the Company will default or that other parties, including reinsurers, which owe the Company money, will not pay. The Company minimizes this risk by adhering to a conservative investment strategy, by maintaining reinsurance and credit and collection policies and by providing for any amounts deemed uncollectible. Interest Rate Risk: The risk that interest rates will change and cause a decrease in the value of an insurer's investments. This change in rates may cause certain interest-sensitive products to become uncompetitive or may cause disintermediation. The Company mitigates this risk by charging fees for non-conformance with certain policy provisions, by offering products that transfer this risk to the purchaser, and/or by attempting to match the maturity schedule of its assets with the expected payouts of its liabilities. To the extent that liabilities come due more quickly than assets mature, an insurer would have to borrow funds or sell assets prior to maturity and potentially recognize a gain or loss. Financial Instruments with Off-Balance-Sheet Risk: The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business through management of its investment portfolio. These financial instruments include commitments to extend credit in the form of loans. These instruments involve, to varying degrees, elements of credit risk in excess of amounts recognized on the consolidated balance sheets. Commitments to fund fixed rate mortgage loans on real estate are agreements to lend to a borrower, and are subject to conditions established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a deposit. Commitments extended by the Company are based on management's case-by-case credit evaluation of the borrower and the borrower's loan collateral. The underlying mortgageReturn to financial index 49 -------------------------------------------------------------------------------- property represents the collateral if the commitment is funded. The Company's policy for new mortgage loans on real estate is to lend no more than 75% of collateral value. Should the commitment be funded, the Company's exposure to credit loss in the event of nonperformance by the borrower is represented by the contractual amounts of these commitments less the net realizable value of the collateral. The contractual amounts also represent the cash requirements for all unfunded commitments. Commitments on mortgage loans on real estate of $341.4 million extending into 1998 were outstanding as of December 31, 1997. The Company also had $63.9 million of commitments to purchase fixed maturity securities outstanding as of December 31, 1997. Significant Concentrations of Credit Risk: The Company grants mainly commercial mortgage loans on real estate to customers throughout the United States. The Company has a diversified portfolio with no more than 20% (21% in 1996) in any geographic area and no more than 2% (2% in 1996) with any one borrower as of December 31, 1997. As of December 31, 1997, 46% (44% in 1996) of the remaining principal balance of the Company's commercial mortgage loan portfolio financed retail properties. The Company had a significant reinsurance recoverable balance from one reinsurer as of December 31, 1997 and 1996. See note 4. =============================================================================== 10 PENSION PLAN The Company is a participant, together with other affiliated companies, in a pension plan covering all employees who have completed at least one year of service. Benefits are based upon the highest average annual salary of a specified number of consecutive years of the last ten years of service. The Company funds pension costs accrued for direct employees plus an allocation of pension costs accrued for employees of affiliates whose work efforts benefit the Company. Effective January 1, 1995, the plan was amended to provide enhanced benefits for participants who met certain eligibility requirements and elected early retirement no later than March 15, 1995. The entire cost of the enhanced benefit was borne by NMIC and certain of its property and casualty insurance company affiliates. Effective December 31, 1995, the Nationwide Insurance Companies and Affiliates Retirement Plan was merged with the Farmland Mutual Insurance Company Employees' Retirement Plan and the Wausau Insurance Companies Pension Plan to form the Nationwide Insurance Enterprise Retirement Plan (the Retirement Plan). Immediately prior to the merger, the plans were amended to provide consistent benefits for service after January 1, 1996. These amendments had no significant impact on the accumulated benefit obligation or projected benefit obligation as of December 31, 1995. Pension costs charged to operations by the Company during the years ended December 31, 1997, 1996 and 1995 were $8.3 million, $8.2 million and $11.4 million, respectively. The Company's net accrued pension expense as of December 31, 1997 and 1996 was $0.2 million and $1.2 million, respectively. The net periodic pension cost for the Retirement Plan as a whole for the years ended December 31, 1997 and 1996 and for the Nationwide Insurance Companies and Affiliates Retirement Plan as a whole for the year ended December 31, 1995 follows: (in millions of dollars) 1997 1996 1995 ========================================================== Service cost (benefits earned during the period) $ 77.3 $ 75.5 $ 64.5 Interest cost on projected benefit obligation 118.6 105.5 95.3 Actual return on plan assets (328.0) (210.6) (249.3) Net amortization and deferral 196.4 101.8 143.4 ---------------------------------------------------------- $ 64.3 $ 72.2 $ 53.9 ========================================================== Basis for measurements, net periodic pension cost: (in millions of dollars) 1997 1996 1995 ======================================================= Weighted average discount rate 6.50% 6.00% 7.50% Rate of increase in future compensation levels 4.75% 4.25% 6.25% Expected long-term rate of return on plan assets 7.25% 6.75% 8.75% =======================================================Return to financial index 50 -------------------------------------------------------------------------------- Information regarding the funded status of the Retirement Plan as a whole as of December 31, 1997 and 1996 follows: (in millions of dollars) 1997 1996 ====================================================== Accumulated benefit obligation: Vested $1,547.5 $1,338.6 Nonvested 13.5 11.1 ------------------------------------------------------ $1,561.0 $1,349.7 ====================================================== Net accrued pension expense: Projected benefit obligation for services rendered to date $2,033.8 $1,847.8 Plan assets at fair value 2,212.9 1,947.9 ------------------------------------------------------ Plan assets in excess of projected benefit obligation 179.1 100.1 Unrecognized prior service cost 34.7 37.9 Unrecognized net gains (330.7) (202.0) Unrecognized net asset at transition 33.3 37.2 ------------------------------------------------------ $ (83.6) $ (26.8) ====================================================== Basis for measurements, funded status of plan: 1997 1996 ====================================================== Weighted average discount rate 6.00% 6.50% Rate of increase in future compensation levels 4.25% 4.75% ====================================================== Assets of the Retirement Plan are invested in group annuity contracts of NLIC and Employers Life Insurance Company of Wausau (ELICW). ============================================================================= 11 POSTRETIREMENT BENEFITS OTHER THAN PENSIONS In addition to the defined benefit pension plan, the Company, together with other affiliated companies, participates in life and health care defined benefit plans for qualifying retirees. Postretirement life and health care benefits are contributory and generally available to full time employees who have attained age 55 and have accumulated 15 years of service with the Company after reaching age 40. Postretirement health care benefit contributions are adjusted annually and contain cost-sharing features such as deductibles and coinsurance. In addition, there are caps on the Company's portion of the per-participant cost of the postretirement health care benefits. These caps can increase annually, but not more than three percent. The Company's policy is to fund the cost of health care benefits in amounts determined at the discretion of management. Plan assets are invested primarily in group annuity contracts of NLIC. The Company elected to immediately recognize its estimated accumulated postretirement benefit obligation (APBO), however, certain affiliated companies elected to amortize their initial transition obligation over periods ranging from 10 to 20 years. The Company's accrued postretirement benefit expense as of December 31, 1997 and 1996 was $36.5 million and $34.9 million, respectively, and the net periodic postretirement benefit cost (NPPBC) for 1997, 1996 and 1995 was $3.0 million, $3.4 million and $3.2 million, respectively. Information regarding the funded status of the plan as a whole as of December 31, 1997 and 1996 follows: (in millions of dollars) 1997 1996 ======================================================== Accrued postretirement benefit expense: Retirees $ 93.3 $ 93.0 Fully eligible, active plan participants 31.6 23.7 Other active plan participants 113.0 84.0 -------------------------------------------------------- Accumulated postretirement benefit obligation 237.9 200.7 Plan assets at fair value 69.2 63.0 -------------------------------------------------------- Plan assets less than accumulated postretirement benefit obligation (168.7) (137.7) Unrecognized transition obligation of affiliates 1.5 1.7 Unrecognized net losses (gains) 1.6 (23.2) -------------------------------------------------------- $(165.6) $(159.2) ======================================================== The amount of NPPBC for the plan as a whole for the years ended December 31, 1997, 1996 and 1995 was as follows: (in millions of dollars) 1997 1996 1995 ======================================================== Service cost (benefits attributed to employee service during the year) $ 7.0 $ 6.5 $ 6.2 Interest cost on accumulated postretirement benefit obligation 14.0 13.7 14.2 Actual return on plan assets (3.6) (4.3) (2.7) Amortization of unrecognized transition obligation of affiliates 0.2 0.2 3.0 Net amortization and deferral (0.5) 1.8 (1.6) -------------------------------------------------------- $17.1 $17.9 $19.1 ======================================================== 51 -------------------------------------------------------------------------------- Actuarial assumptions used for the measurement of the APBO and the NPPBC for 1997, 1996 and 1995 were as follows: 1997 1996 1995 ======================================================== APBO: Discount rate 6.70% 7.25% 6.75% Assumed health care cost trend rate: Initial rate 12.13% 11.00% 11.00% Ultimate rate 6.12% 6.00% 6.00% Uniform declining period 12 YEARS 12 Years 12 Years NPPBC: Discount rate 7.25% 6.65% 8.00% Long term rate of return on plan assets, net of tax 5.89% 4.80% 8.00% Assumed health care cost trend rate: Initial rate 11.00% 11.00% 10.00% Ultimate rate 6.00% 6.00% 6.00% Uniform declining period 12 YEARS 12 Years 12 Years ======================================================== For the plan as a whole, a one percentage point increase in the assumed health care cost trend rate would increase the APBO as of December 31, 1997 by $0.4 million and have no impact on the NPPBC for the year ended December 31, 1997. ============================================================================== 12 STOCK COMPENSATION The Company sponsors the Nationwide Financial Services, Inc. 1996 Long-Term Equity Compensation Plan (LTEP) covering selected officers, directors and employees of the Company and certain of its affiliates. The LTEP provides for the grant of any or all of the following types of awards: (i) stock options for shares of Class A common stock; (ii) stock appreciation rights (SARs); (iii) restricted stock; and (iv) performance awards. The LTEP was effective December 11, 1996 and no awards may be granted under the LTEP after December 11, 2006. The number of shares of Class A common stock which may be issued under the LTEP, or as to which SARs or other awards may be granted, may not exceed 2.6 million. The Company has elected to continue to follow Accounting Principles Board Opinion No. 25 -- Accounting for Stock Issued to Employees (APB 25) and related interpretations in accounting for its employee stock options as permitted by SFAS No. 123 -- Accounting for Stock-Based Compensation (SFAS 123). Under APB 25, because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized. Pro forma disclosures as if the Company adopted the expense recognition provisions of SFAS 123, which require the fair value of the options granted to be recorded as expense over the vesting period, are required and are presented below. Stock options granted under the LTEP in 1997 have ten year terms. One third of the options vest and become fully exercisable at the end of each of three years of continued employment, or upon retirement. No stock options were granted in years prior to 1997. The Company's stock option activity and related information is summarized for the year ended December 31, 1997: Options on Weighted Class A average common exercise stock price ========================================================= Outstanding, beginning of period -- -- Granted 242,500 $23.72 Exercised -- -- Forfeited/Expired -- -- --------------------------------------------------------- Outstanding, end of period 242,500 $23.72 --------------------------------------------------------- Exercisable, end of period 2,500 $23.50 ========================================================= The weighted average fair value at date of grant for options granted during 1997 was $9.79 per option. Fair value was estimated using a Black-Scholes option pricing model with the following assumptions: ======================================================== Risk free interest rate 6.00% Dividend yield 0.80% Volatility factor 0.347 Weighted average expected option life 6 Years ======================================================== Had the compensation cost for the employee stock options been determined in accordance with the fair value based accounting method provided by SFAS 123, net income and net income per common share for the year ended December 31, 1997 would have been as follows: As Pro forma presented ========================================================= Net income $264.1 $265.2 Basic and diluted earnings per common share $ 2.13 $ 2.14 ========================================================= Pro forma information has not been presented for the years ended December 31, 1996 and 1995 as no stock awards were made prior to 1997. 52 -------------------------------------------------------------------------------- 13 SHAREHOLDERS' EQUITY, REGULATORY RISK-BASED CAPITAL, RETAINED EARNINGS AND DIVIDEND RESTRICTIONS The Board of Directors of the Company has the authority to issue 50.0 million shares of preferred stock without further action of the shareholders. Preferred stock may be issued in one or more classes with full, special, limited or no voting powers, and designations, preferences and relative, participating, optional or other special rights, and qualifications and limitations or restrictions as stated in any resolution adopted by the Board of Directors of the Company issuing any class of preferred stock. No shares of preferred stock have been issued or are outstanding. The holders of Class A common stock are entitled to one vote per share. The holders of Class B common stock are entitled to ten votes per share. Class A common stock has no conversion rights. Class B common stock is convertible into Class A common stock, in whole or in part, at any time and from time to time at the option of the holder, on the basis of one share of Class A common stock for each share of Class B common stock converted. If at any time after the initial issuance of shares of Class A common stock the number of outstanding shares of Class B common stock falls below 5% of the aggregate number of issued and outstanding shares of common stock, then each outstanding share of Class B common stock shall automatically convert into one share of Class A common stock. In the event of any sale or transfer of shares of Class B common stock to any person or persons other than NMIC or its affiliates, such shares of Class B common stock so transferred shall be automatically converted into an equal number of shares of Class A common stock. Cash dividends of $0.18 per common share were declared during 1997. Each insurance company's state of domicile imposes minimum risk-based capital requirements that were developed by the NAIC. The formulas for determining the amount of risk-based capital specify various weighting factors that are applied to financial balances or various levels of activity based on the perceived degree of risk. Regulatory compliance is determined by a ratio of the company's regulatory total adjusted capital, as defined by the NAIC, to its authorized control level risk-based capital, as defined by the NAIC. Companies below specific trigger points or ratios are classified within certain levels, each of which requires specified corrective action. NLIC and each of its insurance company subsidiaries exceed the minimum risk-based capital requirements. The statutory capital and surplus of NLIC as of December 31, 1997, 1996 and 1995 was $1.13 billion, $1.00 billion and $1.36 billion, respectively. The statutory net income of NLIC for the years ended December 31, 1997, 1996 and 1995 was $111.7 million, $73.2 million and $86.5 million, respectively. As a result of the $850.0 million dividend paid on February 24, 1997, any dividend paid by NLIC during the twelve-month period immediately following the $850.0 million dividend would be an extraordinary dividend under Ohio insurance laws. Accordingly, no such dividend could be paid without prior regulatory approval. The Company has no reason to believe that any reasonably foreseeable dividend to be paid by NLIC would not receive the required approval. In addition, the payment of dividends by NLIC may also be subject to restrictions set forth in the insurance laws of New York that limit the amount of statutory profits on NLIC's participating policies (measured before dividends to policyholders) that can inure to the benefit of the Company and its shareholders. The Company currently does not expect such regulatory requirements to impair its ability to pay operating expenses and shareholder dividends in the future. ============================================================================== 14 TRANSACTIONS WITH AFFILIATES As part of the restructuring described in note 1, NLIC paid a dividend valued at $485.7 million to Nationwide Corp. on January 1, 1997 consisting of the outstanding shares of common stock of ELICW, National Casualty Company (NCC) and West Coast Life Insurance Company (WCLIC). Also, on February 24, 1997, NLIC paid a dividend to NFS, and NFS paid an equivalent dividend to Nationwide Corp., consisting of securities having an aggregate fair value of $850.0 million. The Company recognized a gain of $14.4 million on the transfer of securities. The Company leases office space from NMIC and certain of its subsidiaries. For the years ended December 31, 1997, 1996 and 1995, the Company made lease payments to NMIC and its subsidiaries of $9.1 million, $10.0 million and $9.9 million, respectively. Pursuant to a cost sharing agreement among NMIC and certain of its direct and indirect subsidiaries, including the Company, NMIC provides certain operational and administrative services, such as sales support, advertising, personnel and general management services, to those subsidiaries. Expenses covered by this agreement are subject to allocation among NMIC, the Company and other affiliates. Amounts allocated to the Company were $85.8 million, $101.6 million and $107.1 million in 1997, 1996 and 1995, respectively. The allocations are based on techniques and procedures in accordance with insurance regulatory guidelines. Measures used to allocate expenses among companies include individual employee estimates of time spent, special cost studies, 53 -------------------------------------------------------------------------------- salary expense, commissions expense and other methods agreed to by the participating companies that are within industry guidelines and practices. The Company believes these allocation methods are reasonable. In addition, the Company does not believe that expenses recognized under the inter-company agreements are materially different than expenses that would have been recognized had the Company operated on a stand alone basis. Amounts payable to NMIC from the Company under the cost sharing agreement were $20.5 million and $15.1 million as of December 31, 1997 and 1996, respectively. The Company also participates in intercompany repurchase agreements with affiliates whereby the seller will transfer securities to the buyer at a stated value. Upon demand or a stated period, the securities will be repurchased by the seller at the original sales price plus a price differential. Transactions under the agreements during 1997 and 1996 were not material. The Company believes that the terms of the repurchase agreements are materially consistent with what the Company could have obtained with unaffiliated parties. Intercompany reinsurance agreements exist between NLIC and, respectively, NMIC and ELICW whereby all of NLIC's accident and health and group life insurance business is ceded on a modified coinsurance basis. NLIC entered into the reinsurance agreements during 1996 because the accident and health and group life insurance business was unrelated to the Company's long-term savings and retirement products. Accordingly, the accident and health and group life insurance business has been accounted for as discontinued operations for all periods presented. Under modified coinsurance agreements, invested assets are retained by the ceding company and investment earnings are paid to the reinsurer. Under the terms of the Company's agreements, the investment risk associated with changes in interest rates is borne by ELICW or NMIC, as the case may be. Risk of asset default is retained by the Company, although a fee is paid by ELICW or NMIC, as the case may be, to the Company for the Company's retention of such risk. The agreements will remain in force until all policy obligations are settled. However, with respect to the agreement between NLIC and NMIC, either party may terminate the contract on January 1 of any year with prior notice. The ceding of risk does not discharge the original insurer from its primary obligation to the policyholder. The Company believes that the terms of the modified coinsurance agreements are consistent in all material respects with what the Company could have obtained with unaffiliated parties. Amounts ceded to NMIC and ELICW for the years ended December 31, 1997 and 1996 were: 1997 1996 --------------- --------------- (in millions of dollars) NMIC ELICW NMIC ELICW =========================================================== Premiums $ 91.4 $199.8 $ 97.3 $224.2 Net investment income and other revenue $ 10.7 $ 13.4 $ 10.9 $ 14.8 Benefits, claims and other expenses $100.7 $225.9 $100.5 $246.6 =========================================================== The Company and various affiliates entered into agreements with Nationwide Cash Management Company (NCMC), an affiliate, under which NCMC acts as a common agent in handling the purchase and sale of short-term securities for the respective accounts of the participants. Amounts on deposit with NCMC were $286 million and $9.3 million as of December 31, 1997 and 1996, respectively, and are included in short-term investments on the accompanying consolidated balance sheets. On March 1, 1995, Nationwide Corp. contributed all of the outstanding shares of common stock of Farmland Life Insurance Company (Farmland) to NLIC. Farmland merged into WCLIC effective June 30, 1995. The contribution resulted in a direct increase to consolidated shareholder's equity of $46.9 million. As discussed in note 19, WCLIC is accounted for as discontinued operations. =============================================================== 15 BANK LINES OF CREDIT In August 1996, NLIC, along with NMIC, entered into a $600.0 million revolving credit facility which provides for a $600.0 million loan over a five year term on a fully revolving basis with a group of national financial institutions. The credit facility provides for several and not joint liability with respect to any amount drawn by either NLIC or NMIC. NLIC and NMIC pay facility and usage fees to the financial institutions to maintain the revolving credit facility. All previously existing line of credit agreements were canceled. In September 1997, the credit agreement was amended to include NFS as a party to and borrower under the agreement. 54 -------------------------------------------------------------------------------- 16 CONTINGENCIES The Company is a defendant in various lawsuits. In the opinion of management, the effects, if any, of such lawsuits are not expected to be material to the Company's financial position or results of operations. ============================================================================== 17 SEGMENT INFORMATION The Company has three product segments: Variable Annuities, Fixed Annuities and Life Insurance. The Variable Annuities segment consists of annuity contracts that provide the customer with the opportunity to invest in mutual funds managed by the Company and independent investment managers, with the investment returns accumulating on a tax-deferred basis. 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. The Fixed Annuities segment also includes the fixed option under the Company's variable annuity contracts. The Life Insurance segment consists of insurance products that provide a death benefit and may also allow the customer to build cash value on a tax-deferred basis. In addition, the Company reports corporate expenses and investments, and the related investment income supporting capital not specifically allocated to its product segments in a Corporate and Other segment. In addition, all realized gains and losses, investment management fees and other revenue earned from mutual funds other than the portion allocated to the variable annuities and life insurance segments, and income and expenses of the marketing and distribution companies are reported in the Corporate and Other segment. The following table summarizes revenues and income from continuing operations before federal income tax expense for the years ended December 31, 1997, 1996 and 1995 and assets as of December 31, 1997, 1996 and 1995, by segment. (in millions of dollars) 1997 1996 1995 ============================================================= REVENUES Variable Annuities $ 404.0 $ 284.6 $ 189.1 Fixed Annuities 1,141.4 1,092.6 1,052.0 Life Insurance 473.1 435.6 409.1 Corporate and Other 219.9 203.8 186.8 ------------------------------------------------------------- $ 2,238.4 $ 2,016.6 $ 1,837.0 ============================================================= INCOME FROM CONTINUING OPERATIONS BEFORE FEDERAL INCOME TAX EXPENSE Variable Annuities $ 150.9 $ 90.3 $ 50.8 Fixed Annuities 169.5 135.4 137.0 Life Insurance 70.9 67.2 67.6 Corporate and Other 15.7 35.2 25.8 ------------------------------------------------------------- $ 407.0 $ 328.1 $ 281.2 ============================================================= ASSETS Variable Annuities $35,278.7 $25,069.7 $17,333.0 Fixed Annuities 14,436.3 13,994.7 13,250.4 Life Insurance 3,901.4 3,353.3 3,027.4 Corporate and Other 6,276.5 5,352.5 4,895.3 ------------------------------------------------------------- $59,892.9 $47,770.2 $38,506.1 ============================================================= 55 -------------------------------------------------------------------------------- 18 QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) The following is a summary of the unaudited quarterly results of operations for the years ended December 31, 1997 and 1996. (in millions of dollars) 1Q 2Q 3Q 4Q =========================================================== 1997 Revenues other than investment gains (losses) $531.7 $551.4 $566.7 $577.5 Realized gains (losses) on investments 21.1 (11.9) (4.8) 6.7 ----------------------------------------------------------- Total revenues 552.8 539.5 561.9 584.2 Benefits and expenses 446.7 454.6 461.6 468.5 ----------------------------------------------------------- Income before federal income tax expense 106.1 84.9 100.3 115.7 Federal income tax expense 37.2 29.7 34.9 40.0 ----------------------------------------------------------- Net income $ 68.9 $ 55.2 $ 65.4 $ 75.7 =========================================================== Basic and diluted earnings per common share: Net income $ 0.63 $ 0.43 $ 0.51 $ 0.59 =========================================================== 1996 Revenues other than investment gains (losses) $490.2 $508.8 $502.4 $515.4 Realized gains (losses) on investments 3.6 5.8 (5.1) (4.5) ----------------------------------------------------------- Total revenues 493.8 514.6 497.3 510.9 Benefits and expenses 415.9 423.2 413.7 435.7 ----------------------------------------------------------- Income from continuing operations before federal income tax expense 77.9 91.4 83.6 75.2 Federal income tax expense 26.6 32.6 29.5 27.1 ----------------------------------------------------------- Income from continuing operations 51.3 58.8 54.1 48.1 Income from discontinued operations, net of federal income tax expense 4.2 3.1 2.3 1.7 ----------------------------------------------------------- Net income $ 55.5 $ 61.9 $ 56.4 $ 49.8 =========================================================== 19 DISCONTINUED OPERATIONS As discussed in note 1, NFS is a holding company for NLIC and certain other companies within the Nationwide Insurance Enterprise that offer or distribute long-term savings and retirement products. Prior to the contribution by Nationwide Corp. to NFS of the outstanding common stock of NLIC and other companies, NLIC effected certain transactions with respect to certain subsidiaries and lines of business that were unrelated to long-term savings and retirement products. On September 24, 1996, NLIC's Board of Directors declared a dividend payable to Nationwide Corp. on January 1, 1997 consisting of the outstanding shares of common stock of three subsidiaries: ELICW, NCC and WCLIC. ELICW writes group accident and health and group life insurance business and maintains it offices in Wausau, Wisconsin. NCC is a property and casualty company with offices in Scottsdale, Arizona that serves as a fronting company for a property and casualty subsidiary of NMIC. WCLIC writes high dollar term life insurance policies and is located in San Francisco, California. ELICW, NCC and WCLIC have been accounted for as discontinued operations in the accompanying consolidated financial statements through December 31, 1996. The Company did not recognize any gain or loss on the disposal of these subsidiaries. Also, during 1996, NLIC entered into two reinsurance agreements whereby all of NLIC's accident and health and group life insurance business was ceded to ELICW and NMIC, effective January 1, 1996. See note 14 for a complete discussion of the reinsurance agreements. The Company has discontinued its accident and health and group life insurance business and in connection therewith has entered into reinsurance agreements to cede all existing and any future writings to other affiliated companies. NLIC's accident and health and group life insurance business is accounted for as discontinued operations for all periods presented. The Company did not recognize any gain or loss on the disposal of the accident and health and group life insurance business. The assets, liabilities, results of operations and activities of discontinued operations are distinguished physically, operationally and for financial reporting purposes from the remaining assets, liabilities, results of operations and activities of the Company. 56 -------------------------------------------------------------------------------- A summary of the results of operations of discontinued operations for the years ended December 31, 1997, 1996 and 1995 is as follows: (in millions of dollars, except per share amounts) 1997 1996 1995 =============================================================== Revenues $ -- $668.9 $776.9 Net income $ -- $ 11.3 $ 24.7 Contribution to basic and diluted earnings per common share $ -- $ 0.10 $ 0.24 =============================================================== A summary of the assets and liabilities of discontinued operations as of December 31, 1997, 1996 and 1995 is as follows: (in millions of dollars) 1997 1996 1995 ========================================================= Assets, consisting primarily of investments $247.3 $3,288.5 $3,206.7 Liabilities, consisting primarily of policy benefits and claims $247.3 $2,802.8 $2,700.0 ========================================================= 57 -------------------------------------------------------------------------------- INDEPENDENT AUDITORS' REPORT The Board of Directors Nationwide Financial Services, Inc.: We have audited the accompanying consolidated balance sheets of Nationwide Financial Services, Inc. and subsidiaries (collectively the Company) as of December 31, 1997 and 1996, and the related consolidated statements of income, shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 1997. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Nationwide Financial Services, Inc. and subsidiaries as of December 31, 1997 and 1996, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1997, in conformity with generally accepted accounting principles. As discussed in note 1 to the consolidated financial statements, the Company was formed in November 1996 as a holding company for Nationwide Life Insurance Company and the other companies within the Nationwide Insurance Enterprise that offer or distribute long-term savings and retirement products. The consolidated financial statements are presented as if these companies were consolidated for all periods presented. /s/ KPMG PEAT MARWICK LLP ------------------------- Columbus, Ohio January 30, 1998 58 Exhibit 21 NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES Subsidiaries of the Registrant As of December 31, 1997 The following are wholly owned (unless otherwise noted) subsidiaries of Nationwide Financial Services, Inc. and their state of incorporation: State of Subsidiary Incorporation ------------------------------------------------------------------ ----------------- Nationwide Life Insurance Company Ohio Nationwide Financial Services Capital Trust Delaware Public Employees Benefit Services Corporation Ohio NEA Valuebuilder Investor Services, Inc. Ohio Nationwide Financial Institution Distributors Agency, Inc. Ohio Irvin L. Schwartz & Associates, Inc. (60% owned) Ohio The following are wholly owned subsidiaries of Nationwide Life Insurance Company and their state of incorporation: State of Subsidiary Incorporation ------------------------------------------------------------------ ----------------- Nationwide Life and Annuity Insurance Company Ohio Nationwide Advisory Services, Inc. Ohio Nationwide Investment Services Corporation. Ohio NWE, Inc. Ohio The following are wholly owned subsidiaries of Public Employees Benefit Services Corporation and their state of incorporation: State of Subsidiary Incorporation ------------------------------------------------------------------ ----------------- Public Employees Benefit Services Corporation of Alabama Alabama Public Employees Benefit Services Corporation of Arkansas Arkansas PEBSCO of Massachusetts Insurance Agency, Inc. Massachussetts Public Employees Benefit Services Corporation of Montana Montana Public Employees Benefit Services Corporation of New Mexico New Mexico The following are wholly owned subsidiaries of NEA Valuebuilder Investor Services, Inc. and their state of incorporation: State of Subsidiary Incorporation ------------------------------------------------------------------ ----------------- NEA Valuebuilder Investor Services of Alabama, Inc. Alabama NEA Valuebuilder Investor Services of Arizona, Inc Arizona NEA Valuebuilder Investor Services of Montana, Inc. Montana NEA Valuebuilder Investor Services of Nevada, Inc. Nevada NEA Valuebuilder Investor Services of Ohio, Inc. Ohio NEA Valuebuilder Investor Services of Oklahoma, Inc. Oklahoma NEA Valuebuilder Investor Services of Wyoming, Inc. Wyoming NEA Valuebuilder Investor Services of Texas, Inc. Texas NEA Valuebuilder Investor Services of Agency, Inc. Ohio The following are wholly owned subsidiaries of Nationwide Financial Institution Distributors Agency, Inc. and their state of incorporation: State of Subsidiary Incorporation ------------------------------------------------------------------ ----------------- Affiliate Agency, Inc. Ohio Financial Horizons Distributors Agency of Alabama, Inc. Alabama Landmark Financial Services of New York, Inc. New York Financial Horizons Securities Corp. Ohio The following is a wholly owned subsidiary of Nationwide Advisory Services, Inc. and its state of incorporation: State of Subsidiary Incorporation ------------------------------------------------------------------ ----------------- Nationwide Investor Services, Inc. Ohio All business operations of Nationwide Financial Services, Inc. and all of its subsidiaries are conducted using each company's legally registered name. Exhibit 23 CONSENT OF INDEPENDENT AUDITORS The Board of Directors Nationwide Financial Services, Inc.: We consent to the incorporation by reference in this Annual Report on Form 10-K of Nationwide Financial Services, Inc. of our report dated January 30, 1998, relating to the consolidated balance sheets of Nationwide Financial Services, Inc. and Subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of income, shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 1997, which report appears in the 1997 Annual Report to Shareholders of Nationwide Financial Services, Inc. /s/ KPMG Peat Marwick LLP Columbus, Ohio March 27, 1998 This schedule contains summary financial information extracted from Nationwide Financial Services Inc.'s Annual Report on Form 10-K for the Year ended December 31, 1997, and is qualified in its entirety by reference to such consolidated financial statements.