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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

x

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2009

or

 

¨

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission File Number: 1-12785

 

 

LOGO

NATIONWIDE FINANCIAL SERVICES, INC.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   31-1486870
(State or other jurisdiction of incorporation or organization)   (IRS Employer Identification No.)

 

One Nationwide Plaza, Columbus, Ohio   43215
(Address of principal executive offices)   (Zip Code)

(614) 249-7111

(Registrant’s telephone number, including area code)

 

 

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 such filing requirements for the past 90 days.

Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes  ¨    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  x    Accelerated filer  ¨

Non-accelerated filer  ¨    (Do not check if a smaller reporting company)    Smaller reporting company  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes  ¨    No  x

No established published trading market exists for the registrant’s common stock, par value $0.01 per share. As of November 3, 2009, the registrant had 100 shares of its common stock outstanding.

 

 

 


Table of Contents

NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2009

TABLE OF CONTENTS

 

PART I – FINANCIAL INFORMATION

   1
    

ITEM 1 Condensed Consolidated Financial Statements

   1
    

ITEM 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations

   68
    

ITEM 3 Quantitative and Qualitative Disclosures About Market Risk

   113
    

ITEM 4 Controls and Procedures

   113

PART II – OTHER INFORMATION

   113
    

ITEM 1 Legal Proceedings

   113
    

ITEM 1A Risk Factors

   114
    

ITEM 2 Unregistered Sales of Equity Securities and Use of Proceeds

   114
    

ITEM 3 Defaults Upon Senior Securities

   114
    

ITEM 4 Submission of Matters to a Vote of Security Holders

   114
    

ITEM 5 Other Information

   114
    

ITEM 6 Exhibits

   114

SIGNATURE

   115


Table of Contents

PART I – FINANCIAL INFORMATION

ITEM 1 CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of (Loss) Income

(Unaudited)

(in millions)

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
     2009     2008     2009     2008  

Revenues:

        

Policy charges

   $ 310.7      $ 336.8      $ 916.4      $ 1,036.3   

Premiums

     119.6        89.8        365.5        304.1   

Net investment income

     513.3        480.8        1,512.5        1,511.8   

Net realized investment (losses) gains

     (138.4     (158.5     366.3        (207.4

Other-than-temporary impairment losses (consisting of $185.0 and $918.9 of total other-than-temporary impairment losses, net of $36.0 and $404.0 recognized in other comprehensive income, for the three and nine months ended September 30, 2009, respectively)

     (149.0     (396.6     (514.9     (580.5

Other income

     118.6        132.3        321.3        417.1   
                                

Total revenues

     774.8        484.6        2,967.1        2,481.4   
                                

Benefits and expenses:

        

Interest credited to policyholder accounts

     284.4        300.5        861.5        907.2   

Benefits and claims

     158.8        183.7        619.4        545.9   

Policyholder dividends

     22.4        23.7        67.3        72.0   

Amortization of deferred policy acquisition costs

     97.6        224.8        559.6        460.7   

Amortization of value of business acquired and other intangible assets

     12.0        9.6        40.3        22.9   

Interest expense

     25.7        26.1        77.5        79.7   

Other operating expenses

     261.3        254.3        759.8        798.5   
                                

Total benefits and expenses

     862.2        1,022.7        2,985.4        2,886.9   
                                

Loss from continuing operations before federal income tax benefit

     (87.4     (538.1     (18.3     (405.5

Federal income tax benefit

     (56.5     (191.7     (61.0     (166.1
                                

(Loss) income from continuing operations

     (30.9     (346.4     42.7        (239.4

Discontinued operations, net of taxes

     —          (9.2     —          (9.0
                                

Net (loss) income

     (30.9     (355.6     42.7        (248.4

Less: Net loss attributable to noncontrolling interest

     13.7        9.2        38.5        31.9   
                                

Net (loss) income attributable to NFS

   $ (17.2   $ (346.4   $ 81.2      $ (216.5
                                

See accompanying notes to condensed consolidated financial statements.

 

1


Table of Contents

NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

(in millions, except for share and per share amounts)

 

     September 30,
2009
    December 31,
2008
 
     (Unaudited)        

Assets

    

Investments:

    

Securities available-for-sale, at fair value:

    

Fixed maturity securities (amortized cost $27,439.4 and $25,825.7)

   $ 27,125.1      $ 23,069.7   

Equity securities (cost $56.2 and $68.7)

     60.5        60.7   

Mortgage loans on real estate, net

     7,294.1        7,888.2   

Short-term investments, including amounts managed by a related party

     1,780.7        3,055.0   

Other investments

     1,960.9        2,146.3   
                

Total investments

     38,221.3        36,219.9   

Cash and cash equivalents

     84.4        165.5   

Accrued investment income

     419.9        352.1   

Deferred policy acquisition costs

     3,766.9        4,523.8   

Value of business acquired

     289.9        334.0   

Goodwill

     246.5        246.5   

Other assets

     2,654.6        3,790.1   

Separate account assets

     56,471.8        48,840.7   
                

Total assets

   $ 102,155.3      $ 94,472.6   
                

Liabilities and Shareholder’s Equity

    

Liabilities:

    

Future policy benefits and claims

   $ 34,056.5      $ 35,720.0   

Short-term debt

     563.5        295.7   

Long-term debt

     1,726.9        1,725.9   

Other liabilities

     4,415.8        4,415.5   

Separate account liabilities

     56,471.8        48,840.7   
                

Total liabilities

     97,234.5        90,997.8   
                

Shareholder’s equity:

    

Common stock ($0.01 par value; authorized - 100 and 0 shares; issued - 100 and 0 shares; outstanding - 100 and 0 shares)

     —          —     

Class A common stock ($0.01 par value; authorized - 0 and 750,000,000 shares; issued - 0 and 72,100,000 shares; outstanding - 0 and 46,300,000 shares)

     —          0.7   

Class B common stock ($0.01 par value; authorized - 0 and 750,000,000 shares; issued and outstanding - 0 and 91,800,000 shares)

     —          1.0   

Additional paid-in capital

     1,824.7        1,807.1   

Retained earnings

     2,952.9        3,884.0   

Accumulated other comprehensive loss

     (233.4     (1,370.8

Treasury stock, at cost (0 and 25,800,000 shares)

     —          (1,262.5

Other, net

     —          (1.3
                

Total shareholder’s equity

     4,544.2        3,058.2   

Noncontrolling interest

     376.6        416.6   
                

Total equity

     4,920.8        3,474.8   
                

Total liabilities and equity

   $ 102,155.3      $ 94,472.6   
                

See accompanying notes to condensed consolidated financial statements.

 

2


Table of Contents

NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Changes in Equity

Nine Months Ended September 30, 2009 and 2008

(Unaudited)

(in millions)

 

     Common
stock
   Class A
common
stock
    Class B
common
stock
    Additional
paid-in
capital
   Retained
earnings
    Accumulated
other
comprehensive
income (loss)
    Treasury
stock
     Other,
net
     Total
shareholder’s
equity
     Non-controlling
interest
     Total
equity
 

Balance as of December 31, 2007

   $ —      $ 0.7      $ 1.0      $ 1,782.4    $ 4,853.0      $ (81.5   $ (1,229.6    $ (1.4    $ 5,324.6       $ 467.6       $ 5,792.2   

Cash dividends declared

     —        —          —          —        (120.0     —          —           —           (120.0      —           (120.0

Common shares repurchased under announced program

     —        —          —          —        —          —          (32.9      —           (32.9      —           (32.9

Stock options exercised

     —        —          —          10.8      —          —          —           —           10.8         —           10.8   

Member contributions to noncontrolling interest

     —        —          —          —        —          —          —           —           —           15.2         15.2   

Other, net

     —        —          —          8.4      —          —          —           0.1         8.5         (0.3      8.2   

Comprehensive loss:

                            

Net loss

     —        —          —          —        (216.5     —          —           —           (216.5      (31.9      (248.4

Other comprehensive loss, net of taxes

     —        —          —          —        —          (762.9     —           —           (762.9      —           (762.9
                                              

Total comprehensive loss

                         (979.4      (31.9      (1,011.3
                                                                                          

Balance as of September 30, 2008

   $ —      $ 0.7      $ 1.0      $ 1,801.6    $ 4,516.5      $ (844.4   $ (1,262.5    $ (1.3    $ 4,211.6       $ 450.6       $ 4,662.2   
                                                                                          

Balance as of December 31, 2008

   $ —      $ 0.7      $ 1.0      $ 1,807.1    $ 3,884.0      $ (1,370.8   $ (1,262.5    $ (1.3    $ 3,058.2       $ 416.6       $ 3,474.8   

Cumulative effect of change in accounting principle, net of taxes

     —        —          —          —        249.7        (249.7     —           —           —           —           —     

Retirement of shares (see Note 2)

     —        (0.7     (1.0     1.4      (1,262.2     —          1,262.5         —           —           —           —     

Other, net

     —        —          —          16.2      0.2        —          —           1.3         17.7         (1.5      16.2   

Comprehensive gain (loss):

                            

Net income (loss)

     —        —          —          —        81.2        —          —           —           81.2         (38.5      42.7   

Other comprehensive gain, net of taxes

     —        —          —          —        —          1,387.1        —           —           1,387.1         —           1,387.1   
                                              

Total comprehensive gain (loss)

                         1,468.3         (38.5      1,429.8   
                                                                                          

Balance as of September 30, 2009

   $ —      $ —        $ —        $ 1,824.7    $ 2,952.9      $ (233.4   $ —         $ —         $ 4,544.2       $ 376.6       $ 4,920.8   
                                                                                          

See accompanying notes to condensed consolidated financial statements.

 

3


Table of Contents

NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

(Unaudited)

(in millions)

 

     Nine months ended
September 30,
 
     2009     2008  

Cash flows from operating activities:

    

Net income (loss)

   $ 42.7      $ (248.4

Adjustments to reconcile net income (loss) to net cash provided by operating activities:

    

Net realized investment (gains) losses

     (366.3     207.4   

Other-than-temporary impairment losses

     514.9        580.5   

Interest credited to policyholder accounts

     861.5        907.2   

Capitalization of deferred policy acquisition costs

     (376.9     (441.2

Amortization of deferred policy acquisition costs

     559.6        460.7   

Amortization and depreciation

     42.2        39.9   

Increase in other assets

     (44.7     (259.4

Decrease in policy and other liabilities

     (1,392.9     (845.4

Decrease (increase) in derivative assets

     527.8        (19.9

Increase (decrease) in derivative liabilities

     37.4        (2.5

Other, net

     93.3        8.2   
                

Net cash provided by operating activities

     498.6        387.1   
                

Cash flows from investing activities:

    

Proceeds from maturity of securities available-for-sale

     3,364.0        3,367.0   

Proceeds from sale of securities available-for-sale

     4,282.3        3,735.9   

Proceeds from repayments or sales of mortgage loans on real estate

     568.9        746.1   

Cost of securities available-for-sale acquired

     (9,376.7     (6,676.0

Cost of mortgage loans on real estate originated or acquired

     (144.9     (388.3

Net decrease (increase) in short-term investments

     1,274.4        (22.0

Collateral paid, net

     (563.3     (221.6

Other, net

     133.2        (110.6
                

Net cash (used in) provided by investing activities

     (462.1     430.5   
                

Cash flows from financing activities:

    

Net increase in short-term debt

     267.8        27.3   

Net proceeds from issuance of long-term debt

     —          155.2   

Cash dividends paid

     —          (116.1

Investment and universal life insurance product deposits and other additions

     2,929.9        2,288.4   

Investment and universal life insurance product withdrawals and other deductions

     (3,683.7     (3,858.6

Common shares repurchased under announced program

     —          (32.9

Net increase in customer bank deposits

     359.8        583.5   

Other, net

     8.6        207.0   
                

Net cash used in financing activities

     (117.6     (746.2
                

Net (decrease) increase in cash and cash equivalents

     (81.1     71.4   

Cash and cash equivalents, beginning of period

     165.5        73.6   
                

Cash and cash equivalents, end of period

   $ 84.4      $ 145.0   
                

See accompanying notes to condensed consolidated financial statements.

 

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Table of Contents

NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2009 and 2008

 

(1)

Basis of Presentation

The accompanying condensed consolidated financial statements of Nationwide Financial Services, Inc. and subsidiaries (NFS, or collectively, the Company) have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all information and footnotes required by GAAP for complete financial statements. The financial information included herein reflects all adjustments (all of which are normal and recurring in nature) which are, in the opinion of management, necessary for a fair presentation of financial position and results of operations. Operating results for all periods presented are not necessarily indicative of the results that may be expected for the full year. All significant intercompany balances and transactions have been eliminated. The accompanying condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes for the year ended December 31, 2008 included in the Company’s 2008 Annual Report on Form 10-K.

The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements. Actual results could differ significantly from those estimates.

Certain items in the condensed consolidated financial statements and related notes have been reclassified to conform to the current presentation.

The Company evaluated subsequent events through November 3, 2009, the date the condensed consolidated financial statements were filed with the United States Securities and Exchange Commission (SEC).

 

(2)

Merger Transaction

On January 1, 2009, all of the outstanding Class A common stock of NFS not owned by Nationwide Corporation were acquired for $52.25 per share in cash by Nationwide Corporation through a merger of the Company with NWM Merger Sub., Inc., a wholly-owned subsidiary of Nationwide Corporation. On that date, all 100 shares of NWM Merger Sub’s issued and outstanding common stock became the issued and outstanding common stock of NFS and all such shares are held by Nationwide Corporation. The newly issued and outstanding shares of common stock of NFS were recorded as an addition to common stock at a par value of $0.01 per share.

Upon closing of the merger transaction, NFS retired its shares of Class A common stock, Class B common stock and treasury stock. In accordance with applicable accounting guidance, the previously existing balances of Class A common stock of $0.7 million and Class B common stock of $1.0 million were reclassified to additional-paid in capital. Additionally, the previously existing treasury stock balance of $1.26 billion was reclassified to retained earnings for the amount of excess of purchase price over par value and the par value was reclassified to additional-paid in capital.

 

(3)

Summary of Significant Accounting Policies

A complete summary of the Company’s significant accounting policies is included in Note 2 to the audited consolidated financial statements included in the Company’s 2008 Annual Report on Form 10-K. There have been no material changes to these policies since December 31, 2008 except as noted below.

 

  (a)

Valuation of Investments, Investment Income and Realized Gains and Losses

As a result of the Company’s adoption of guidance impacting Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 320-10, Investments – Debt and Equity Securities, in the first quarter of 2009, for all debt securities evaluated for other-than-temporary impairment (for which the Company does not have the intent to sell and it is not more likely than not that it will be required to sell the security before the recovery of its amortized cost basis), the Company considers the timing and amount of the cash flows. The Company evaluates its intent to sell on an individual security basis.

 

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NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

 

Additionally, debt securities that become other-than-temporarily impaired (where the Company does not intend to sell the security and it is not more likely than not that it will be required to sell the security prior to recovery of the security’s amortized cost) are bifurcated with the credit portion of the impairment loss being recognized in earnings and the non-credit loss portion of the impairment being recognized in a separate component of other comprehensive income, net of applicable taxes and other offsets.

The Company’s practice is to disclose as part of the separate component of accumulated other comprehensive income both the non-credit portion of the other-than-temporary impairment recognized in other comprehensive income and any subsequent changes in the fair value of those debt securities.

 

  (b)

Share-Based Payments

As part of the merger transaction, all outstanding stock options were cancelled on January 1, 2009 in exchange for $52.25 per option, less exercise price, for all options with an exercise price not in excess of $52.25. The total unrecognized share-based payment cost related to nonvested stock options of $2.5 million, net of taxes, was recognized on the merger date.

Deferred stock units (DSUs) were available through the Director Stock Retainer Plan for payment to non-management directors of all or a portion of their annual retainer. At the date of the merger transaction, there were approximately 41,000 DSUs outstanding. As part of the merger transaction, each DSU was cancelled and converted into the right to receive $52.25 in cash and credited to a deferral account for each director. The liability for the outstanding DSUs was transferred to Nationwide Mutual Insurance Company (NMIC) and treated as a capital contribution in the first quarter of 2009 and will be paid in cash to the non-management directors in a future period.

 

(4)

Recently Issued Accounting Standards

In September 2009, the FASB issued guidance under FASB ASC 820-10, Fair Value Measurements and Disclosures. This guidance applies to measuring the fair value of investments in investment companies that do not have a readily determinable fair value and calculate net asset values (NAV) consistent with the American Institute of Certified Public Accountants Audit and Accounting Guide, which generally requires these investments to be measured at fair value. For these investments, this update allows, as a practical expedient, the use of NAV as the basis to estimate fair value as long as it is not probable, as of the measurement date, that the investment will be sold and NAV is not the value that will be used in the sale. This guidance is effective for interim and annual periods ending after December 15, 2009 with early adoption permitted. The Company will adopt this guidance effective the period ending December 31, 2009 and is currently evaluating the impact of adoption.

In August 2009, the FASB issued guidance under FASB ASC 820-10, Fair Value Measurements and Disclosures. This guidance clarifies how the fair value of a liability should be determined. It reiterates that fair value is the price that would be paid to transfer the liability in an orderly transaction between market participants at the measurement date. It notes that the liability should reflect the company’s nonperformance and credit risk and should not reflect restrictions on the transfer of the liability. To determine the exit price, the guidance permits companies to look to the identical liability traded as an asset, similar liabilities traded as assets, or another valuation technique to measure the price the company would pay to transfer the liability. This guidance is effective for the first reporting period beginning after issuance. The Company will adopt this guidance effective the reporting period ending December 31, 2009 and is currently evaluating the impact of adoption.

 

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NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

 

In June 2009, the FASB issued guidance under FASB ASC 105, Generally Accepted Accounting Principles (Statement of Financial Accounting Standard (SFAS) No. 168, The FASB Accounting Standards CodificationTM and the Hierarchy of Generally Accepted Accounting Principles – a replacement of FASB Statement No. 162(SFAS 168)). This guidance establishes the FASB ASC as the single source of authoritative U.S. GAAP recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the SEC under authority of federal securities laws are also sources of authoritative U.S. GAAP for SEC registrants. SFAS 168 and the ASC are effective for financial statements issued for interim and annual periods ending after September 15, 2009. The ASC supersedes all existing non-SEC accounting and reporting standards. All other non-grandfathered, non-SEC accounting literature not included in the ASC have become non-authoritative. Following SFAS 168, the FASB will no longer issue new standards in the form of Statements, FSPs, or EITF Abstracts. Instead, the FASB will issue Accounting Standards Updates, which will serve only to update the ASC, provide background information about the guidance, and provide the bases for conclusions on the change(s) in the ASC. The Company adopted SFAS 168 effective September 30, 2009. The adoption of this guidance will not have an impact on the Company’s consolidated financial statements but will alter the references to accounting literature within the consolidated financial statements.

In June 2009, the FASB issued guidance under SFAS No. 167, Amendments to FASB Interpretation No. 46(R), (SFAS 167). This guidance changes the consolidation guidance applicable to a variable interest entity (VIE). It also amends the guidance governing the determination of whether an entity is the VIE’s primary beneficiary (the reporting entity that must consolidate the VIE) by requiring a qualitative analysis rather than a quantitative analysis. The qualitative analysis will include, among other things, consideration of who has the power to direct the activities of the entity that most significantly impact the entity’s economic performance and who has the obligation to absorb losses or the right to receive benefits of the VIE that could potentially be significant to the VIE. This guidance also requires continuous reassessment of whether an enterprise is the primary beneficiary of a VIE. Before this guidance, FASB Interpretation No. 46(R) required reconsideration of whether an enterprise was the primary beneficiary of a VIE only when specific events had occurred. SFAS 167 also requires enhanced disclosures about an enterprise’s involvement with a VIE. This guidance is effective for fiscal and interim reporting periods beginning after November 15, 2009. The Company will adopt this guidance effective January 1, 2010. The Company currently is evaluating the provisions of this guidance to determine the impact of adoption on its consolidated financial statements.

In June 2009, the FASB issued guidance under SFAS No. 166, Accounting for Transfers of Financial Assets – an amendment of FASB Statement No. 140 (SFAS 166). This guidance eliminates the concept of a qualifying special-purpose entity (QSPE) from SFAS No. 140 and clarifies and amends the derecognition criteria for a transfer to be accounted for as a sale and the unit of account eligible for sale accounting. Additionally, SFAS 166 requires a transferor to initially measure and recognize all assets obtained (including a transferor’s beneficial interest) and liabilities incurred as a result of a transfer of financial assets accounted for as a sale at fair value. Additionally, on and after the effective date, existing QSPEs (as defined under previous accounting standards) must be evaluated for consolidation in accordance with the applicable consolidation guidance. This guidance also establishes new requirements for reporting a transfer of a portion of a financial asset as a sale. This guidance requires enhanced disclosures about, among other things, a transferor’s continuing involvement with transfers of financial assets accounted for as sales, the risks inherent in the transferred financial assets that have been retained, and the nature and financial effect of restrictions on the transferor’s assets that continue to be reported in the consolidated balance sheets. This guidance is effective for fiscal and interim reporting periods beginning after November 15, 2009. The Company will adopt this guidance effective January 1, 2010. The Company currently is evaluating the provisions of the guidance to determine the impact of adoption on its consolidated financial statements.

In May 2009, the FASB issued guidance under FASB ASC 855, Subsequent Events, (SFAS No. 165, Subsequent Events). This guidance establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued. In particular, this guidance sets forth the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure, the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements, and the disclosures an entity should make about events or transactions that occurred after the balance sheet date. This guidance is effective for fiscal years and interim periods ending after June 15, 2009. The Company adopted this guidance effective June 30, 2009. The adoption of this guidance did not have a material impact on the consolidated financial statements of the Company. The Company evaluated subsequent events through November 3, 2009 the date that the condensed consolidated financial statements were issued. See Note 1 for required disclosure.

 

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NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

 

In April 2009, the FASB issued guidance under FASB ASC 320, Investments – Debt and Equity Securities, (FASB Staff Position (FSP) Financial Accounting Standard (FAS) 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments). This guidance is designed to create greater clarity and consistency in accounting for and presentation of impairment losses on debt and equity securities. This guidance is effective for interim and annual periods ending after June 15, 2009 with early adoption permitted. As of the beginning of the interim period of adoption, this guidance requires a cumulative-effect adjustment to reclassify the non-credit component of previously recognized other-than-temporary impairment losses from retained earnings to the beginning balance of accumulated other comprehensive income (AOCI). The Company adopted this guidance as of January 1, 2009. The adoption of FSP FAS 115-2 and FAS 124-2 resulted in a cumulative-effect adjustment of $249.7 million, net of taxes, as an adjustment to the opening balance of retained earnings with a corresponding adjustment to the opening balance of AOCI.

In April 2009, the FASB issued guidance under FASB ASC 820-10, Fair Value Measurements and Disclosures, (FSP FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly). This guidance provides guidelines for making fair value measurements more consistent with the principles presented in the previous standard SFAS No. 157, Fair Value Measurements, (SFAS 157). This guidance is effective for interim and annual periods ending after June 15, 2009 with early adoption permitted. The Company elected to early adopt FSP FAS 157-4 as of the period ending March 31, 2009.

In April 2009, the FASB issued guidance under FASB ASC 825-10, Financial Instruments (FSP FAS 107-1 and Accounting Principles Bulletin (APB) 28-1, Interim Disclosures about Fair Value of Financial Instruments). The guidance amended FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments (SFAS 107), to require disclosures about fair value of financial instruments within the scope of SFAS 107 for interim reporting periods of publicly traded companies as well as in annual financial statements. The guidance is effective for interim periods ending after June 15, 2009, with early adoption permitted for interim periods ending after March 15, 2009. The Company adopted this guidance for the period ending June 30, 2009 and included the required disclosures in Note 5.

In November 2008, the FASB issued guidance under FASB ASC 350-30, Intangibles – Goodwill and Other, General Intangibles Other than Goodwill (EITF 08-7, Accounting for Defensive Intangible Assets). This guidance requires defensive intangible assets acquired in a business combination or asset acquisition to be accounted for as a separate unit of accounting. In doing so, the asset should not be included as part of the cost of an entity’s existing intangible asset(s) because the defensive intangible asset is separately identifiable. This guidance is effective for intangible assets acquired on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. The Company adopted this guidance effective January 1, 2009. On the date of adoption, there was no impact to the Company’s financial position or results of operations. The Company will apply this guidance prospectively for intangible assets acquired on or after January 1, 2009.

In November 2008, the FASB issued guidance under FASB ASC 323-10, Investments – Equity Method and Joint Ventures (EITF 08-6, Equity Method Investment Accounting Considerations). This guidance clarifies how to account for certain transactions and impairment considerations involving equity method investments. Specifically, this guidance notes: 1) an entity shall measure its equity method investment initially at cost; 2) an equity method investor is required to recognize other-than-temporary impairments of an equity method investment in accordance with paragraph 35-32A and an equity method investor shall not separately test an investee’s underlying indefinite-lived intangible asset(s) for impairment; and 3) an equity method investor shall account for a share issuance by an investee as if the investor had sold a proportionate share of its investment and any gain or loss to the investor resulting from an investee’s share issuance shall be recognized in earnings. This guidance is effective on a prospective basis in fiscal years beginning on or after December 15, 2008, and interim periods within those fiscal years. The Company adopted this guidance prospectively beginning January 1, 2009. On the date of adoption, there was no impact to the Company’s financial position or results of operations.

 

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NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

 

In April 2008, the FASB issued guidance under FASB ASC 350-30, General Intangibles other than Goodwill, (FSP FAS 142-3, “Determination of the Useful Life of Intangible Assets”). This guidance amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under previous SFAS No. 142, Goodwill and Other Intangible Assets (SFAS 142). FASB ASC 350-30 is effective for financial statements issued for fiscal years and interim periods beginning after December 15, 2008. The amended factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS 142 are to be applied prospectively to intangible assets acquired after the effective date. The Company adopted this guidance effective January 1, 2009. On the date of adoption, there was no impact to the Company’s financial position or results of operations. The Company will apply this guidance prospectively to intangible assets acquired after January 1, 2009.

In March 2008, the FASB issued guidance under FASB ASC 815, Derivatives and Hedging, (SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133). This guidance amends and expands the disclosure requirements of previous SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133), with the intent to provide users of financial statements with an enhanced understanding of how and why an entity uses derivative instruments, how derivative instruments and related hedged items are accounted for under FASB ASC 815, and how derivative instruments and related hedged items affect an entity’s financial position, financial performance and cash flows. This guidance requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about derivative instrument fair values and related gains and losses, and disclosures about credit-risk-related contingent features in derivative agreements. This guidance is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. The Company adopted this guidance effective January 1, 2009.

In February 2008, the FASB issued guidance under FASB ASC 820, Fair Value Measurements and Disclosures, (FSP FAS 157-2, Effective Date of FASB Statement No. 157). This guidance delayed the effective date of SFAS 157 for nonfinancial assets and liabilities until fiscal years and interim periods beginning after November 15, 2008. FASB ASC 820 applies to nonfinancial assets and liabilities, except for items recognized or disclosed at fair value in the Company’s financial statements on a recurring basis (at least annually), and is effective upon issuance. The Company adopted this guidance effective January 1, 2009. On the date of adoption, there was no impact to the Company’s financial position or results of operations.

In December 2007, the FASB issued guidance under FASB ASC 805, Business Combinations, (SFAS No. 141 (revised 2007), Business Combinations, (SFAS 141R) which replaced SFAS No. 141, Business Combinations (SFAS 141)). The objective of this guidance is to improve the relevance, representational faithfulness, and comparability of the information a reporting entity provides in its financial reports about a business combination and its effects. Accordingly, this guidance establishes principles and requirements for how the acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree; recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. This guidance applies to all transactions or other events in which an entity obtains control of one or more businesses and retains the fundamental requirements in the previous SFAS 141 that the acquisition method of accounting be used for all business combinations and for an acquirer to be identified for each business combination. This guidance defines the acquirer as the entity that obtains control of one or more businesses in the business combination and establishes the acquisition date as the date the acquirer achieves control. This guidance is applicable prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Earlier application is prohibited. The Company adopted this guidance effective January 1, 2009. The Company will apply this guidance prospectively to any business combination on or after January 1, 2009.

 

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NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

 

In April 2009, the FASB issued guidance under FASB ASC 805-20, Business Combinations – Identifiable Assets and Liabilities, and Any Noncontrolling Interest, (FSP FAS 141R-1, Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies). This guidance amends the guidance of previous SFAS 141R related to contingencies. First, this guidance requires the acquirer to recognize the contingency at fair value, at the acquisition date, if the acquisition-date fair value of that asset or liability can be determined during the measurement period. Second, if the first criteria is not applicable as the fair value of the asset or liability cannot be determined during the measurement period, then the contingency shall be recognized if both (a) information available before the end of the measurement period indicates it is probable an asset existed or a liability had been incurred at the acquisition date and (b) the amount of the asset or liability can be reasonably estimated. If neither of these acquisition date recognition criterion apply, the acquirer shall not recognize an asset or liability as of the acquisition date. In periods after the acquisition date, the acquirer shall account for an asset or a liability arising from a contingency that does not meet the recognition criteria at the acquisition date in accordance with other applicable GAAP, including FASB ASC 450, Contingencies, as appropriate. The Company will apply this guidance prospectively to any business combination on or after January 1, 2009.

In December 2007, the FASB issued guidance under FASB ASC 810, Consolidation, (SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements, an Amendment of ARB No. 51). The objective of this guidance is to improve the relevance, comparability, and transparency of the financial information that a reporting entity provides in its consolidated financial statements by establishing accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. This guidance also amends certain consolidation procedures prescribed by previous Accounting Research Bulletin No. 51, Consolidated Financial Statements, for consistency with the requirements of previous SFAS No. 141 (revised 2007). This guidance is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. The Company adopted this guidance effective January 1, 2009. The required presentation of noncontrolling interests is reflected in the consolidated financial statements. As a result of the adoption of SFAS 160, the Company reclassified $416.6 million from other liabilities to equity as of December 31, 2008, representing the noncontrolling interest of low-income-housing tax credit funds (LIHTC Funds). See Note 15 for further discussion on the LIHTC Funds. The accounting requirements of SFAS 160 will be applied to any transactions involving noncontrolling interests on or after January 1, 2009.

 

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NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

 

(5)

Fair Value Measurements

Fair Value Option

Effective January 1, 2008, the Company elected fair value treatment for commercial mortgage loans held for sale. Accordingly, the Company now records in earnings all market fluctuations associated with this portfolio. The Company previously recorded such loans at the lower of cost or market value. Balances for these loans are measured at fair value with unrealized gains and losses included as a component of net realized investment gains and losses. The Company will assess the fair value option election for new financial assets or liabilities on a prospective basis.

Fair Value Hierarchy

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In determining fair value, the Company uses various methods including market, income and cost approaches. The Company utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs.

The Company categorizes its financial instruments into a three level hierarchy based on the priority of the inputs to the valuation technique. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure fair value fall within different levels of the hierarchy, the category level is based on the lowest priority level input that is significant to the fair value measurement of the instrument in its entirety.

The Company categorizes financial assets and liabilities recorded at fair value in the condensed consolidated balance sheets as follows:

 

   

Level 1 – Unadjusted quoted prices accessible in active markets for identical assets or liabilities at the measurement date.

 

   

Level 2 – Unadjusted quoted prices for similar assets or liabilities in active markets or inputs (other than quoted prices) that are observable or that are derived principally from or corroborated by observable market data through correlation or other means.

 

   

Level 3 – Prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. Inputs reflect management’s best estimate about the assumptions market participants would use at the measurement date in pricing the asset or liability. Consideration is given to the risk inherent in both the method of valuation and the valuation inputs.

For certain residential mortgage-backed securities backed by Prime, Sub-prime and Alt-A collateral, which are included in Level 3 financial assets, the Company utilizes internal pricing models to assist in determining the estimated fair values. As of December 31, 2008, these investments were priced solely with the assistance of independent pricing services. As a result of low levels of activity in these markets during the first three quarters of 2009, management believes that prices were no longer representative of the investments’ fair value, which is the price that would be received upon the sale of the investment in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date. The Company believes that a weighting of internal pricing models and independent pricing services represents a better estimate of the investments’ fair value and complies with FASB ASC 820, Fair Value Measurements and Disclosures.

Therefore, management determined that the use of multiple valuation techniques, considering both an income approach that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs and a market approach that observes quotes provided by independent pricing services produces a result more representative of an investment’s fair value.

 

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NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

 

The income approach incorporates cash flows for each investment adjusted for expected losses in different interest rate and housing scenarios. The adjusted cash flows are then discounted using a risk premium that market participants would demand because of the risk in the cash flows. The risk premium is reflective of an orderly transaction between market participants at the measurement date under current market conditions and includes items such as liquidity and structure risk. The income approach also includes a weighting of external third party values. As sufficient information is often not available to conclude whether such prices are based on orderly transactions, this weighting methodology is designed to incorporate external prices into the Company’s internal valuation process.

In addition to weighting external prices in developing the internal values, the Company further calibrates those values to market indications through pricing determined from two independent pricing services (the market approach). The Company calibrates the prices obtained from the independent pricing services and the price developed internally by utilizing the median value to determine the estimated fair value.

In addition, certain of the Company’s investments in corporate debt securities, mortgage-backed securities and other asset-backed securities were valued with the assistance of independent pricing services and non-binding broker quotes. The Company’s policy is to use the pricing obtained from our primary independent pricing service even in cases where a price is obtained from both an independent pricing service and a broker. In the event that pricing information is not available from an independent pricing service, non-binding broker quotes are used to assist in the valuation of the investments. In many cases, only one broker quote is available. The Company’s policy is generally not to adjust the values obtained from brokers.

Broker quotes are considered unobservable inputs as only one broker quote is ordinarily obtained, the investment is not traded on an exchange, the pricing is not available to other entities and the transaction volume in the same or similar investments has decreased such that generally only one quotation is available. As the brokers often do not provide the necessary transparency into their quotes and methodologies, the Company periodically performs reviews and tests to ensure that quotes are a reasonable estimate of the investments’ fair value.

For investments valued with the assistance of independent pricing services, the Company obtained the pricing services’ methodologies and classified these investments accordingly in the fair value hierarchy. The Company periodically reviews and tests the pricing and related methodologies obtained from these independent pricing services against secondary sources to ensure that management can validate the investment’s fair value and related categorization. If large variances are observed between the price obtained from the independent pricing services and secondary sources, the Company analyzes the causes driving the variance and resolves any differences.

As of September 30, 2009, 66% of the prices of fixed maturity securities were valued with the assistance of independent pricing services, 10% were valued with the assistance of the Company’s pricing matrices, 4% were valued with the assistance of broker quotes, 17% were valued with the assistance of the Company’s internal pricing processes and 3% were valued from other sources compared to 80%, 11%, 4%, 4% and 1%, respectively, as of December 31, 2008.

 

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NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

 

The following table summarizes assets and liabilities measured at fair value on a recurring basis as of September 30, 2009:

 

(in millions)

   Level 1     Level 2     Level 3     Total  

Assets

        

Investments:

        

Securities available-for-sale:

        

Fixed maturity securities:

        

U.S. Treasury securities and obligations of U.S. Government corporations and agencies

   $ 689.3      $ 4.5      $ 1.8      $ 695.6   

Obligations of states and political subdivisions

     —          388.7        —          388.7   

Debt securities issued by foreign governments

     —          77.5        —          77.5   

Corporate securities

     1.9        14,691.7        1,467.1        16,160.7   

Residential mortgage-backed securities

     1,981.6        2,875.4        2,998.6        7,855.6   

Commercial mortgage-backed securities

     —          821.5        334.3        1,155.8   

Collateralized debt obligations

     —          110.6        239.4        350.0   

Other asset-backed securities

     —          284.9        156.3        441.2   
                                

Total fixed maturity securities

     2,672.8        19,254.8        5,197.5        27,125.1   

Equity securities

     12.5        31.5        16.5        60.5   
                                

Total securities available-for-sale

     2,685.3        19,286.3        5,214.0        27,185.6   

Trading assets

     —          8.2        28.2        36.4   

Mortgage loans held for sale1

     —          —          53.3        53.3   

Short-term investments

     120.1        1,660.6        —          1,780.7   
                                

Total investments

     2,805.4        20,955.1        5,295.5        29,056.0   

Cash and cash equivalents

     84.4        —          —          84.4   

Derivative assets2

     —          477.8        391.9        869.7   

Separate account assets3,5

     11,496.1        43,587.8        1,387.9        56,471.8   
                                

Total assets

   $ 14,385.9      $ 65,020.7      $ 7,075.3      $ 86,481.9   
                                

Liabilities

        

Future policy benefits and claims4

   $ —        $ —        $ (521.8   $ (521.8

Derivative liabilities2

     (20.1     (397.5     (5.9     (423.5
                                

Total liabilities

   $ (20.1   $ (397.5   $ (527.7   $ (945.3
                                
 
  1

Elected to be carried at fair value.

 

  2

Comprised of interest rate swaps, cross-currency interest rate swaps, credit default swaps, other non-hedging derivative instruments, equity option contracts and interest rate futures contracts.

 

  3

Comprised of public, privately registered and non-registered mutual funds and investments in securities.

 

  4

Related to embedded derivatives associated with living benefit contracts. The Company’s guaranteed minimum accumulation benefits (GMABs), guaranteed lifetime withdrawal benefits (GLWBs) and hybrid GMABs/GLWBs are considered embedded derivatives requiring the related liabilities to be separated from the host insurance product and recognized at fair value, with changes in fair value reported in earnings. This balance also includes embedded derivatives associated with fixed equity-indexed annuities (EIA) of $44.6 million that provide for interest earnings that are linked to the performance of specified equity market indices.

 

  5

The fair value of separate account liabilities is set to equal the fair value of separate account assets.

 

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NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

 

The following table summarizes assets and liabilities measured at fair value on a recurring basis as of December 31, 2008:

 

(in millions)

   Level 1     Level 2     Level 3     Total  

Assets

        

Investments:

        

Securities available-for-sale:

        

Fixed maturity securities:

        

U.S. Treasury securities and obligations of U.S. Government corporations and agencies

   $ 627.3      $ 4.3      $ 1.9      $ 633.5   

Obligations of states and political subdivisions

     —          262.4        —          262.4   

Debt securities issued by foreign governments

     —          55.5        —          55.5   

Corporate securities

     2.0        11,263.6        1,330.1        12,595.7   

Residential mortgage-backed securities

     1,775.5        2,723.2        3,099.2        7,597.9   

Commercial mortgage-backed securities

     —          752.2        263.4        1,015.6   

Collateralized debt obligations

     —          73.0        250.4        323.4   

Other asset-backed securities

     —          473.9        111.8        585.7   
                                

Total fixed maturity securities

     2,404.8        15,608.1        5,056.8        23,069.7   

Equity securities

     1.4        34.9        24.4        60.7   
                                

Total securities available-for-sale

     2,406.2        15,643.0        5,081.2        23,130.4   

Trading assets

     0.2        21.7        44.2        66.1   

Mortgage loans held for sale1

     —          —          124.5        124.5   

Short-term investments

     165.4        2,889.6        —          3,055.0   
                                

Total investments

     2,571.8        18,554.3        5,249.9        26,376.0   

Cash and cash equivalents

     165.5        —          —          165.5   

Derivative assets2

     —          708.5        597.6        1,306.1   

Separate account assets3,5

     9,975.7        36,723.2        2,141.8        48,840.7   
                                

Total assets

   $ 12,713.0      $ 55,986.0      $ 7,989.3      $ 76,688.3   
                                

Liabilities

        

Future policy benefits and claims4

   $ —        $ —        $ (1,739.7   $ (1,739.7

Derivative liabilities2

     (6.0     (385.9     (4.2     (396.1
                                

Total liabilities

   $ (6.0   $ (385.9   $ (1,743.9   $ (2,135.8
                                
 
  1

Elected to be carried at fair value.

 

  2

Comprised of interest rate swaps, cross-currency interest rate swaps, credit default swaps, other non-hedging derivative instruments, equity option contracts and interest rate futures contracts.

 

  3

Comprised of public, privately registered and non-registered mutual funds and investments in securities.

 

  4

Related to embedded derivatives associated with living benefit contracts. The Company’s GMABs, GLWBs and hybrid GMABs/GMWBs are considered embedded derivatives requiring the related liabilities to be separated from the host insurance product and recognized at fair value, with changes in fair value reported in earnings. This balance also includes embedded derivatives associated with fixed EIAs of $41.7 million that provide for interest earnings that are linked to the performance of specified equity market indices.

 

  5

The fair value of separate account liabilities is set to equal the fair value of separate account assets.

 

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NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

 

The following tables summarize financial instruments for which the Company used significant unobservable inputs (Level 3) to determine fair value measurements for the three and nine months periods ended September 30, 2009:

 

(in millions)

  Balance
as of

June 30,
2009
    Net investment
gains (losses)
    Purchases,
issuances,
sales and
settlements
    Transfers
in to
Level 3
  Transfers
out of
Level 3
    Balance
as of
September 30,
2009
    Change in
unrealized

gains
(losses) in
earnings
due to
assets still
held
 
    In earnings
(realized
and
unrealized)1
    In OCI
(unrealized)2
           

Assets

               

Investments:

               

Securities available-for-sale3:

               

Fixed maturity securities

               

U.S. Treasury securities and obligations of U.S. Government corporations and agencies

  $ —        $ —        $ 0.1      $ —        $ 1.7   $ —        $ 1.8      $ —     

Corporate securities

    1,234.2        (18.5     197.9        (169.3     332.7     (109.9     1,467.1        —     

Residential mortgage-backed securities

    3,021.5        (61.2     257.5        (219.2     —       —          2,998.6        —     

Commercial mortgage-backed securities

    114.8        (13.3     78.6        (0.7     155.2     (0.3     334.3        —     

Collateralized debt obligations

    235.4        (9.0     26.9        1.6        —       (15.5     239.4        —     

Other asset-backed securities

    132.7        0.3        11.0        (9.9     22.2     —          156.3        —     
                                                             

Total fixed maturity securities

    4,738.6        (101.7     572.0        (397.5     511.8     (125.7     5,197.5        —     

Equity securities

    11.8        1.4        (0.1     3.4        —       —          16.5        —     
                                                             

Total securities available-for-sale

    4,750.4        (100.3     571.9        (394.1     511.8     (125.7     5,214.0        —     

Trading assets

    39.8        (2.6     —          (7.0     —       (2.0     28.2        3.2   

Mortgage loans held for sale

    63.0        4.6        —          (14.3     —       —          53.3        4.3   
                                                             

Total investments

    4,853.2        (98.3     571.9        (415.4     511.8     (127.7     5,295.5        7.5   

Derivative assets

    473.9        (109.6     —          27.6        —       —          391.9        (107.6

Separate account assets4,6

    2,179.5        (298.2     —          (9.1     0.4     (484.7     1,387.9        (294.6
                                                             

Total assets

  $ 7,506.6      $ (506.1   $ 571.9      $ (396.9   $ 512.2   $ (612.4   $ 7,075.3      $ (394.7
                                                             

Liabilities

               

Future policy benefits and claims5

  $ (780.1   $ 260.2      $ —        $ (1.9   $ —     $ —        $ (521.8   $ 260.2   

Derivative liabilities

    (9.5     3.6        —          —          —       —          (5.9     3.6   
                                                             

Total liabilities

  $ (789.6   $ 263.8      $ —        $ (1.9   $ —     $ —        $ (527.7   $ 263.8   
                                                             
 
  1

Includes gains and losses on sales of financial instruments, changes in market value of certain instruments and other-than-temporary impairments. The net unrealized loss on separate account assets is attributable to contractholders and, therefore, is not included in the Company’s earnings.

 

  2

Includes changes in market value of certain instruments.

 

  3

Includes certain collateralized mortgage obligations, residential mortgage-backed securities, commercial mortgage-backed securities, other ABSs, certain broker or internally priced securities and securities that are at or near default based on designations assigned by the National Association of Insurance Commissioners (NAIC) (see Note 7 for a discussion of NAIC designations). Equity securities represent holdings in non-registered mutual funds with significant unobservable inputs.

 

  4

Comprised of non-registered mutual funds with significant unobservable and/or liquidity restrictions. The net unrealized investment loss on these non-registered mutual funds is attributable to contractholders and, therefore, is not included in the Company’s earnings.

 

15


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NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

 

  5

Relates to GMAB, GLWB and hybrid GMAB/GLWB embedded derivatives associated with contracts with living benefit riders. This balance also includes embedded derivatives associated with EIAs. Related derivatives are internally valued. The valuation of guaranteed minimum benefit embedded derivatives is based on capital market and actuarial assumptions, including risk margin considerations reflecting policyholder behavior. The Company uses both observable and unobservable inputs, such as published swap rates and historical volatilities as well as implied volatilities, in its capital market assumptions. Actuarial assumptions, including lapse behavior and mortality rates, are either based on annuity experience or pricing assumptions if experience has not yet developed.

 

  6

The value of separate account liabilities is set to equal the fair value of separate account assets.

 

(in millions)

        Net investment
gains (losses)
    Purchases,
issuances,
sales and
settlements
    Transfers
in to
Level 3
  Transfers
out of
Level 3
    Balance
as of
September 30,
2009
    Change in
unrealized

gains
(losses) in
earnings
due to
assets still
held
 
  Balance
as of
December 31,
2008
    In earnings
(realized
and
unrealized)1
    In OCI
(unrealized)2
           

Assets

               

Investments:

               

Securities available-for-sale3:

               

Fixed maturity securities

               

U.S. Treasury securities and obligations of U.S.

               

Government corporations and agencies

  $ 1.9      $ —        $ —        $ (0.1   $ —     $ —        $ 1.8      $ —     

Corporate securities

    1,330.1        (65.1     247.1        (297.3     411.4     (159.1     1,467.1        —     

Residential mortgage-backed securities

    3,099.2        (108.3     450.5        (442.0     0.9     (1.7     2,998.6        —     

Commercial mortgage-backed securities

    263.4        (19.0     105.1        (1.7     89.0     (102.5     334.3        —     

Collateralized debt obligations

    250.4        (44.9     56.6        (6.9     —       (15.8     239.4        —     

Other asset-backed securities

    111.8        (14.5     24.2        (9.0     48.6     (4.8     156.3        —     
                                                             

Total fixed maturity securities

    5,056.8        (251.8 )      883.5        (757.0 )      549.9     (283.9 )      5,197.5        —     

Equity securities

    24.4        1.4        1.3        5.7        —       (16.3     16.5        —     
                                                             

Total securities available-for-sale

    5,081.2        (250.4     884.8        (751.3     549.9     (300.2     5,214.0        —     

Trading assets

    44.2        (2.3     —          (18.7     5.0     —          28.2        4.1   

Mortgage loans held for sale

    124.5        (4.5     —          (66.7     —       —          53.3        0.6   
                                                             

Total investments

    5,249.9        (257.2     884.8        (836.7     554.9     (300.2     5,295.5        4.7   

Derivative assets

    597.6        (252.3     (12.0     58.6        —       —          391.9        (250.2

Separate account assets4,6

    2,141.8        (189.1     —          (15.2     16.6     (566.2     1,387.9        (182.6
                                                             

Total assets

  $ 7,989.3      $ (698.6   $ 872.8      $ (793.3   $ 571.5   $ (866.4   $ 7,075.3      $ (428.1
                                                             

Liabilities

               

Future policy benefits and claims5

  $ (1,739.7   $ 1,224.6      $ —        $ (6.7   $ —     $ —        $ (521.8   $ 1,224.6   

Derivative liabilities

    (4.2     (1.7     —          —          —       —          (5.9     (1.7
                                                             

Total liabilities

  $ (1,743.9   $ 1,222.9      $ —        $ (6.7   $ —     $ —        $ (527.7   $ 1,222.9   
                                                             
 
  1

Includes gains and losses on sales of financial instruments, changes in market value of certain instruments and other-than-temporary impairments. The net unrealized gain on separate account assets is attributable to contractholders and, therefore, is not included in the Company’s earnings.

 

  2

Includes changes in market value of certain instruments.

 

16


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NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

 

  3

Includes certain collateralized mortgage obligations, residential mortgage-backed securities, commercial mortgage-backed securities, other ABSs, certain broker or internally priced securities and securities that are at or near default based on designations assigned by the National Association of Insurance Commissioners (NAIC) (see Note 7 for a discussion of NAIC designations). Equity securities represent holdings in non-registered mutual funds with significant unobservable inputs.

 

  4

Comprised of non-registered mutual funds with significant unobservable and/or liquidity restrictions. The net unrealized investment loss on these non-registered mutual funds is attributable to contractholders and, therefore, is not included in the Company’s earnings.

 

  5

Relates to GMAB, GLWB and hybrid GMAB/GLWB embedded derivatives associated with contracts with living benefit riders. This balance also includes embedded derivatives associated with EIAs. Related derivatives are internally valued. The valuation of guaranteed minimum benefit embedded derivatives is based on capital market and actuarial assumptions, including risk margin considerations reflecting policyholder behavior. The Company uses both observable and unobservable inputs, such as published swap rates and historical volatilities as well as implied volatilities, in its capital market assumptions. Actuarial assumptions, including lapse behavior and mortality rates, are either based on annuity experience or pricing assumptions if experience has not yet developed.

 

  6

The value of separate account liabilities is set to equal the fair value of separate account assets.

 

17


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NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

 

The following tables summarize financial instruments for which the Company used significant unobservable inputs (Level 3) to determine fair value measurements for the three and nine months periods ended September 30, 2008:

 

(in millions)

  Balance
as of

June 30,
2008
    Net investment
gains (losses)
    Purchases,
issuances,
sales and
settlements
    Transfers
in to
Level 3
  Transfers
out of
Level 3
    Balance as of
September 30,
2008
    Change in
unrealized

gains
(losses) in
earnings
due to
assets still
held
 
    In earnings
(realized
and
unrealized)1
    In OCI
(unrealized)2
           

Assets

               

Investments:

               

Securities available-for-sale3:

               

Fixed maturity securities

               

U.S. Treasury securities and obligations of U.S. Government corporations and agencies

  $ 1.5      $ —        $ 0.3      $ —        $ —     $ —        $ 1.8      $ —     

Corporate securities

    1,604.6        (73.5     (86.0     (56.8     404.4     (114.1     1,678.6        —     

Residential mortgage-backed securities

    223.2        (34.9     5.6        (8.0     65.0     (99.8     151.1        —     

Commercial mortgage-backed securities

    28.3        —          0.2        (1.2     —       (4.9     22.4        —     

Collateralized debt obligations

    563.7        (150.8     86.6        (40.9     6.7     (7.7     457.6        —     

Other asset-backed securities

    156.5        (0.5     (3.0     1.8        —       (31.4     123.4        —     
                                                             

Total fixed maturity securities

    2,577.8        (259.7     3.7        (105.1     476.1     (257.9     2,434.9        —     

Equity securities

    8.1        (51.5     2.3        23.3        50.7     —          32.9        —     
                                                             

Total securities available-for-sale

    2,585.9        (311.2     6.0        (81.8     526.8     (257.9     2,467.8        —     

Trading assets

    17.1        (1.2     —          7.4        13.6     —          36.9        (1.2

Mortgage loans held for sale

    90.7        (22.8     —          74.0        —       —          141.9        (22.8
                                                             

Total investments

    2,693.7        (335.2     6.0        (0.4     540.4     (257.9     2,646.6        (24.0

Derivative assets

    229.7        88.1        7.1        (21.0     —       —          303.9        76.5   

Separate account assets4,6

    572.8        (210.2     —          —          4.6     (3.3     363.9        (209.1
                                                             

Total assets

  $ 3,496.2      $ (457.3   $ 13.1      $ (21.4   $ 545.0   $ (261.2   $ 3,314.4      $ (156.6
                                                             

Liabilities

               

Future policy benefits and claims5

  $ (222.0   $ (285.5   $ —        $ (2.3   $ —     $ —        $ (509.8   $ (285.5

Derivative liabilities

    (25.3     13.5        —          —          —       —          (11.8     13.5   
                                                             

Total liabilities

  $ (247.3   $ (272.0   $ —        $ (2.3   $ —     $ —        $ (521.6   $ (272.0
                                                             
 
  1

Includes gains and losses on sales of financial instruments, changes in market value of certain instruments and other-than-temporary impairments. The net unrealized loss on separate account assets is attributable to contractholders and, therefore, is not included in the Company’s earnings.

 

  2

Includes changes in market value of certain instruments.

 

  3

Includes certain collateralized mortgage obligations, residential mortgage-backed securities, commercial mortgage-backed securities, other ABSs, certain broker or internally priced securities and securities that are at or near default based on designations assigned by the National Association of Insurance Commissioners (NAIC) (see Note 7 for a discussion of NAIC designations). Equity securities represent holdings in non-registered mutual funds with significant unobservable inputs.

 

  4

Comprised of non-registered mutual funds with significant unobservable and/or liquidity restrictions. The net unrealized investment loss on these non-registered mutual funds is attributable to contractholders and, therefore, is not included in the Company’s earnings.

 

18


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NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

 

  5

Relates to GMAB, GLWB and hybrid GMAB/GLWB embedded derivatives associated with contracts with living benefit riders. This balance also includes embedded derivatives associated with EIAs. Related derivatives are internally valued. The valuation of guaranteed minimum benefit embedded derivatives is based on capital market and actuarial assumptions, including risk margin considerations reflecting policyholder behavior. The Company uses both observable and unobservable inputs, such as published swap rates and historical volatilities as well as implied volatilities, in its capital market assumptions. Actuarial assumptions, including lapse behavior and mortality rates, are either based on annuity experience or pricing assumptions if experience has not yet developed.

 

  6

The value of separate account liabilities is set to equal the fair value of separate account assets.

 

(in millions)

  Balance
as of
December 31,
2007
    Net investment gains
(losses)
    Purchases,
issuances,
sales and
settlements
    Transfers
in to
Level 3
  Transfers
out of
Level 3
    Balance
as of
September 30,
2008
    Change in
unrealized

gains
(losses) in
earnings
due to
assets still
held
 
    In earnings
(realized
and
unrealized)1
    In OCI
(unrealized)2
           

Assets

               

Investments:

               

Securities available-for-sale3:

               

Fixed maturity securities

               

U.S. Treasury securities and obligations of U.S. Government corporations and agencies

  $ 1.6      $ —        $ 0.3      $ (0.1   $ —     $ —        $ 1.8      $ —     

Corporate securities

    1,520.2        (95.1     (170.1     (197.3     794.6     (173.7     1,678.6        —     

Residential mortgage-backed securities

    195.5        (89.1     (1.6     (6.3     120.3     (67.7     151.1        —     

Commercial mortgage-backed securities

    87.6        (0.4     0.2        (8.4     —       (56.6     22.4        —     

Collateralized debt obligations

    532.6        (203.7     (10.2     (9.2     189.1     (41.0     457.6        —     

Other asset-backed securities

    122.3        (1.0     (17.0     (41.8     82.2     (21.3     123.4        —     
                                                             

Total fixed maturity securities

    2,459.8        (389.3     (198.4     (263.1     1,186.2     (360.3     2,434.9        —     

Equity securities

    1.4        (50.6     (4.4     26.7        59.8     —          32.9        —     
                                                             

Total securities available-for-sale

    2,461.2        (439.9     (202.8     (236.4     1,246.0     (360.3     2,467.8        —     

Trading assets

    15.4        (4.5     —          26.0        —       —          36.9        (4.5

Mortgage loans held for sale

    86.1        (32.0     —          87.8        —       —          141.9        (32.0

Short-term investments

    476.7        —          —          —          —       (476.7     —          —     
                                                             

Total investments

    3,039.4        (476.4     (202.8     (122.6     1,246.0     (837.0     2,646.6        (36.5

Derivative assets

    166.6        99.0        8.3        30.0        —       —          303.9        96.6   

Separate account assets4,6

    2,258.6        (875.3     —          766.4        9.5     (1,795.3     363.9        (862.0
                                                             

Total assets

  $ 5,464.6      $ (1,252.7   $ (194.5   $ 673.8      $ 1,255.5   $ (2,632.3   $ 3,314.4      $ (801.9
                                                             

Liabilities

               

Future policy benefits and claims5

  $ (128.9   $ (374.9   $ —        $ (6.0   $ —     $ —        $ (509.8   $ (374.9

Derivative liabilities

    (16.3     5.4        —          (0.9     —       —          (11.8     4.3   
                                                             

Total liabilities

  $ (145.2   $ (369.5   $ —        $ (6.9   $ —     $ —        $ (521.6   $ (370.6
                                                             
 
  1

Includes gains and losses on sales of financial instruments, changes in market value of certain instruments and other-than-temporary impairments. The net unrealized loss on separate account assets is attributable to contractholders and, therefore, is not included in the Company’s earnings.

  2

Includes changes in market value of certain instruments.

 

19


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NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

 

  3

Includes certain collateralized mortgage obligations, residential mortgage-backed securities, commercial mortgage-backed securities, other ABSs, certain broker or internally priced securities and securities that are at or near default based on designations assigned by the National Association of Insurance Commissioners (NAIC) (see Note 7 for a discussion of NAIC designations). Equity securities represent holdings in non-registered mutual funds with significant unobservable inputs.

 

  4

Comprised of non-registered mutual funds with significant unobservable and/or liquidity restrictions. The net unrealized investment loss on these non-registered mutual funds is attributable to contractholders and, therefore, is not included in the Company’s earnings.

 

  5

Relates to GMAB, GLWB and hybrid GMAB/GLWB embedded derivatives associated with contracts with living benefit riders. This balance also includes embedded derivatives associated with EIAs. Related derivatives are internally valued. The valuation of guaranteed minimum benefit embedded derivatives is based on capital market and actuarial assumptions, including risk margin considerations reflecting policyholder behavior. The Company uses both observable and unobservable inputs, such as published swap rates and historical volatilities as well as implied volatilities, in its capital market assumptions. Actuarial assumptions, including lapse behavior and mortality rates, are either based on annuity experience or pricing assumptions if experience has not yet developed.

 

  6

The value of separate account liabilities is set to equal the fair value of separate account assets.

Transfers

The Company reviews its fair value hierarchy classifications quarterly. Changes in observability of significant valuation inputs identified during these reviews may trigger reclassification of fair value hierarchy levels of financial assets and liabilities. These reclassifications will be reported as transfers in/out of Level 3 in the beginning of the period in which the change occurs. During the first three quarters of 2009, transfers into Level 3 were driven by investments in corporate securities and commercial mortgage-backed securities, primarily due to ratings downgrades, as well as changes in pricing sources from corporate pricing matrix based to utilizing broker quotes or internal valuation techniques. During the first three quarters of 2009, additional observable inputs were obtained on assets previously considered Level 3, which led to transfers out of Level 3.

Fair Value on a Nonrecurring Basis

In the third quarter of 2009, certain mortgage loans on real estate held for investment were measured at the estimated fair value of the collateral on a non-recurring basis in periods subsequent to initial recognition due to these loans having specific reserves applied to them during the period. The application of these specific reserves adjusts the amortized cost basis of the loan to the estimated fair value of the collateral. The estimated fair value of the collateral was $23.4 million as of September 30, 2009.

Financial Instruments Not Carried at Fair Value

In estimating fair value for its disclosures for financial instruments not carried at fair value (and not included in the fair value disclosures above), the Company used the following methods and assumptions:

Mortgage loans on real estate held for investment, net: The fair values of mortgage loans held for investment on real estate are estimated using discounted cash flow analyses based on 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. As commercial mortgage loans held for sale are included in the above fair value disclosure, they are excluded from financial instruments not carried at fair value in the table below.

Policy loans: The carrying amount reported in the consolidated balance sheets approximates fair value.

Customer bank loans: The loan portfolio includes adjustable and fixed-rate loans. For fixed-rate loans, the fair value is estimated using discounted cash flow analyses and other valuation techniques. To calculate discounted cash flows, the loans are aggregated into pools of similar types and expected repayment terms. The expected cash flows of loans considers historical prepayment experience and are discounted based on an appropriate treasury yield curve plus an estimated spread for credit losses. The fair value of adjustable rate loans is assumed to be equal to their carrying value.

 

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NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

 

Customer bank deposits: The fair value of demand deposits, savings accounts and money market deposits is equal to the amount payable on demand. The fair value of fixed-rate certificates of deposit is estimated by discounting the contractual cash flows using current market rates of instruments with similar remaining maturities.

Investment contracts: The fair values of the Company’s liabilities under investment type contracts are based on one of two methods. For investment contracts without defined maturities, fair value is the amount payable on demand, net of certain surrender charges. For investment contracts with known or determined maturities, fair value is estimated using discounted cash flow analysis. Interest rates used in this analysis are similar to currently offered contracts with maturities consistent with those remaining for the contracts being valued.

Short-term debt: The carrying amount reported in the consolidated balance sheets approximates fair value.

Long-term debt: The fair values for senior notes are based on quoted market prices. The fair values of the junior subordinated debentures issued to a related party are based on quoted market prices of the capital securities of Nationwide Financial Services Capital Trust I, which approximate the fair value of this obligation.

The following table summarizes the carrying values and estimated fair values of financial instruments subject to disclosure requirements as of the dates indicated:

 

     September 30, 2009     December 31, 2008  

(in millions)

   Carrying
value
    Estimated
fair value
    Carrying
value
    Estimated
fair value
 

Assets:

        

Investments:

        

Mortgage loans on real estate, net

   $ 7,240.8      $ 6,188.8 1    $ 7,763.7      $ 6,845.6   

Policy loans

     1,040.5        1,040.5        1,095.6        1,095.6   

Customer bank loans

     659.6        668.1        470.4        483.5   

Liabilities:

        

Customer bank deposits

     (2,123.3     (2,134.6     (1,763.5     (1,779.8

Investment contracts

     (19,379.2     (19,412.5     (20,093.2     (19,621.5

Short-term debt

     (563.5     (563.5     (295.7     (295.7

Long-term debt

     (1,726.9     (1,565.2     (1,725.9     (1,336.5
 
  1

Includes $23.4 million of mortgage loans held for investment valued at fair value on a nonrecurring basis.

 

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NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

 

(6)

Derivative Financial Instruments

Qualitative Disclosures

The Company is required to recognize all of its derivative instruments as either assets or liabilities at fair value. The accounting for changes in the fair value (e.g., gains or losses) of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship, and further, on the type of hedging relationship.

For derivative instruments that are designated and qualify as a cash flow hedge (e.g., hedging the exposure to variability in expected future cash flows that is attributable to interest rate risk), the effective portion of the gain or loss on the derivative instrument is reported as a component of AOCI and reclassified into earnings in the same line item associated with the forecasted transaction and in the same period or periods during which the hedged transaction impacts earnings (e.g., interest income on a floating rate asset). The remaining gain or loss on the derivative instrument in excess of the cumulative change in the present value of future cash flows of the hedged item, if any (ineffectiveness), or components of fair value that are excluded from the assessment of effectiveness, are recognized in the condensed consolidated statements of income during the current period.

For derivative instruments that are designated and qualify as a fair value hedge (e.g., hedging the exposure to changes in the fair value of an asset or a liability or an identified portion thereof that is attributable to a particular risk), the gain or loss on the derivative instrument as well as the hedged item are both recognized in net realized investment gains and losses.

For derivative instruments that are not designated as a hedging instrument, the gain or loss on the derivative instrument is recognized in net realized investment gains and losses.

The Company periodically evaluates the risks within the derivative portfolios due to credit exposure. When evaluating this risk, the Company considers several factors which include, but are not limited to, the counterparty risk associated with derivative receivables, the Company’s own credit as it relates to derivative payables, the collateral thresholds associated with each counterparty, and changes in relevant market data in order to gain insight into the probability of default by the counterparty. In addition, the effect that the Company’s exposure to credit risk could have on the effectiveness of the Company’s hedging relationships is considered. As of September 30, 2009, the impact of the exposure to credit risk on both the fair value measurement of derivative assets and liabilities and the effectiveness of the Company’s hedging relationships was immaterial.

As of September 30, 2009 and December 31, 2008, the Company had received $582.3 million and $1.02 billion, respectively, of cash for derivative collateral, which is in turn invested in short-term investments. The Company also held $33.9 million and $35.4 million of securities as off-balance sheet collateral on derivative transactions as of September 30, 2009 and December 31, 2008, respectively. As of September 30, 2009 and December 31, 2008, the Company had pledged fixed maturity securities with a fair value of $47.6 million and $24.5 million, respectively, as collateral to various derivative counterparties. There are no contingent features associated with the Company’s derivative instruments which would require additional collateral to be pledged to counterparties.

The Company is exposed to certain other risks relating to its ongoing business operations. The primary risks managed by using derivative instruments are interest rate risk, foreign currency exchange risk, equity risk and credit risk.

Derivatives Qualifying for Hedge Accounting – Interest Rate Risk Management

The Company periodically purchases variable rate investments (e.g., commercial mortgage loans and corporate bonds). As a result, the Company is exposed to variability in cash flows and investment income due to changes in interest rates. Such variability poses risks to the Company when the assets are funded with fixed rate liabilities. In an effort to manage this risk, the Company may enter into receive fixed/pay variable interest rate swaps.

 

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NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

 

In using these interest rate swaps, the Company receives fixed interest rate payments and makes variable rate payments. The variable interest paid on the swap is intended to match the variable interest received on the investment, resulting in the Company receiving the fixed interest payments on the swap. The net receipt of a fixed rate will offset the fixed rate paid on the liability. These interest rate swaps are designated as hedging instruments in cash flow hedging relationships.

The Company periodically participates in a U.S. denominated medium-term note (MTN) program. Under this program, NLIC issues funding agreements to an unconsolidated third party trust to secure notes issued to investors by the trust. The proceeds from these funding agreements are generally used to purchase fixed rate assets (generally available-for-sale corporate bonds, available-for-sale private placement bonds or held for investment commercial mortgage loans). In a rising interest rate environment, the Company is exposed to narrowing margins as interest expense will increase while interest income remains constant. To manage this risk, the Company has entered into pay fixed/receive variable interest rate swaps. The interest rate swap agreement utilized by the Company effectively modifies its exposure to interest rate risk by converting the Company’s floating rate funding agreements associated with the MTN program to a fixed rate, thus reducing the impact of interest rate changes on future interest expense. These interest rate swaps are designated as hedging instruments in cash flow hedging relationships.

The Company also periodically enters into fixed rate commercial mortgage loan and private placement commitments or commitments to purchase fixed rate assets (generally available-for-sale corporate bonds, available-for-sale private placement bonds and held for investment commercial mortgage loans). The Company is exposed to declining values of the assets due to rising interest rates. In an effort to manage this risk, the Company enters into short U.S. Treasury futures and/or interest rate swaps. As interest rates change, the increase or decrease in the value of the derivative instrument will offset the changes in value of the asset (relative to interest rates). These futures and swaps are designated as hedging instruments in fair value hedging relationships.

Derivatives Qualifying for Hedge Accounting – Foreign Currency Risk Management

The Company purchases foreign-denominated fixed rate assets and the associated investment income is exposed to changes in the exchange rates of the foreign currencies. To manage this risk, the Company has entered into pay fixed foreign currency/receive fixed U.S. cross-currency swaps. As foreign exchange rates change, the increase or decrease in the cash flows of the derivative instrument will offset the changes in the functional-currency equivalent cash flows of the asset. These cross-currency swaps are designated as hedging instruments in cash flow hedging relationships.

The Company also purchases foreign-denominated fixed rate assets, funded with proceeds from funding agreements under a variable rate U.S.-denominated MTN program. The value of these investments is exposed to both changes in the exchange rates of the foreign currencies and changes in interest rates. To manage this risk, the Company has entered into pay fixed foreign currency/receive variable U.S. cross-currency interest rate swaps. As foreign exchange rates and interest rates change, the increase or decrease in the value of the derivative instrument will offset the changes in the asset’s value (relative to foreign currency and interest rate changes). These cross-currency interest rate swaps are designated as hedging instruments in fair value hedging relationships.

In addition, the Company periodically participates in a fixed rate foreign denominated MTN program. Under this program, NLIC issues funding agreements to an unconsolidated third party trust to secure notes issued to investors by the trust, and the value of these liabilities is exposed to both changes in the exchange rates of the foreign currencies and changes in interest rates. To manage this risk, the Company has entered into receive fixed foreign currency/pay variable U.S. cross-currency interest rate swaps. As foreign exchange rates and interest rates change, the increase or decrease in the value of the derivative instrument will offset the changes in the liability’s value (relative to foreign currency and interest rate changes). These cross-currency interest rate swaps are designated as hedging instruments in fair value hedging relationships.

Derivatives Not Qualifying for Hedge Accounting – Interest Rate Risk Management

The Company enters into commercial mortgage loan commitments that are held for sale, which exposes the Company to changes in the fair value of such commitments due to changes in interest rates during the commitment period prior to the loans being funded. In an effort to manage this risk, the Company enters into short U.S. Treasury futures and/or pay fixed interest rate swaps during the commitment period. If interest rates rise or fall, the gains or losses on short U.S. Treasury futures will offset the change in fair value of the commitment attributable to the change in interest rates.

 

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NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

 

The Company may use pay fixed/receive variable interest rate swaps to hedge the value of a portfolio of fixed-rate assets, relative to changes in interest rates. The interest rate swaps mitigate the risk of a loss of value due to increasing interest rates, with the fluctuations in the fair values of the derivatives offsetting changes in the fair values of the portfolios resulting from changes in interest rates.

The Company offers a variety of variable annuity programs with a guaranteed minimum balance or guaranteed withdrawal benefits, and options are utilized to economically hedge a portion of these products. See Derivatives Not Qualifying for Hedge Accounting – Equity Market Risk Management below for further explanation. As interest rates are a component of the option’s value, the effectiveness of economically hedging the annuity products may be adversely affected by changes in interest rates. The Company enters into interest rate swaps to mitigate this risk. The fluctuation in the fair values of the derivatives offsets the changes in the fair values of the options resulting from changes in interest rates.

The Company periodically enters into basis swaps (receive one variable rate/pay another variable rate) to better match the cash flows received from the specific variable-rate investments with the variable rate paid on a group of liabilities. While the pay-side terms of the basis swap will be consistent with the terms of the asset, the Company is not able to match the receive-side terms of the derivative to a specific liability. Therefore, basis swaps do not receive hedge accounting treatment.

Derivatives Not Qualifying for Hedge Accounting – Foreign Currency Risk Management

The Company periodically participates in a variable rate foreign denominated MTN program. Under this program, NLIC issues funding agreements to an unconsolidated third party trust to secure notes issued to investors by the trust. As such, the cash flows related to these MTNs are exposed to changes in the exchange rates of the foreign currencies. Because the Company desires to retain the variable interest rate, it has entered into receive variable foreign currency/pay variable U.S. dollar cross-currency basis swaps. The basis swap converts the debt instrument to a U.S. dollar variable rate, thereby eliminating foreign exchange risk. While the receive-side terms of the basis swap will be consistent with the terms of the liability, the Company is not able to match the pay-side terms of the derivative to a specific asset. Therefore, these basis swaps do not receive hedge accounting treatment.

Derivatives Not Qualifying for Hedge Accounting – Equity Market Risk Management

The Company offers a variety of variable annuity programs with a guaranteed minimum balance or guaranteed withdrawal benefits. The contractholders may elect to invest in equity funds. Adverse changes in the equity markets expose the Company to losses if the changes result in contractholder’s account balances falling below the guaranteed minimum. To mitigate a portion of the risk associated with these liabilities, the Company enters into equity index futures and options. The changes in value of the futures and options will offset a portion of the changes in the annuity accounts relative to changes in the equity market.

The Company offers a variety of variable annuity programs with a guaranteed minimum balance or guaranteed withdrawal benefits, where the contractholder elects to invest in funds with a foreign equity index. Adverse changes in the foreign equity index expose the Company to losses if the change results in contractholder’s account balances falling below the guaranteed minimum. To mitigate this risk, the Company enters into total return swaps, where the Company pays the total return on the foreign index and receives one-month U.S. London Interbank Offered Rate (LIBOR). The changes in cash flows of the total return swap will offset a portion of the changes in the annuity accounts relative to changes in the foreign index.

The Company’s living benefit riders represent an embedded derivative in a variable annuity contract that is required to be separated from, and valued apart from, the host variable annuity contract. The embedded derivatives are carried at fair value. Subsequent changes in the fair value of the embedded derivatives are recognized in earnings as a component of net realized investment gains and losses. The fair value of the embedded derivatives is calculated based on a combination of capital market and actuarial assumptions. Projections of cash flows inherent in the valuation of the embedded derivative incorporate numerous assumptions including, but not limited to, expectations of contractholder persistency, contractholder withdrawal patterns, risk neutral market returns, correlations of market returns and market return volatility. The Company does not expect any meaningful level of claims under the living benefit features for several years and believes the impact of claims is expected to be mitigated by its economic hedging program.

 

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NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

 

Derivatives Not Qualifying for Hedge Accounting – Credit Risk

The Company enters into two distinct types of credit derivative contracts (or credit default swaps) which allows the Company to either sell or buy credit protection on a specific creditor or credit index.

The Company sells credit default protection to counterparties on selected debt instruments with specific creditor or credit index exposure and combines the credit default swap with selected assets the Company owns to enhance spreads. These selected assets may have sufficient duration for the related liability, but do not earn a sufficient credit spread. When the Company sells these instruments, it receives periodic premium payments similar to the risk premium received on an equivalent maturity bond from the same creditor. In return, the Company agrees to provide for losses if a credit event occurs during the lifetime of the contract, by buying a pre-determined cash bond from the counterparty at face value. In such a contract, a credit event will be defined in the trade settlement documentation and may include, but is not limited to, creditor bankruptcy or restructuring. The combined credit default swap and investments provide cash flows with the duration and credit spread targeted by the Company.

The Company also has purchased credit default protection on selected debt instruments exposed to short-term credit concerns, or because the combination of the corporate bond and purchased default protection provides sufficient spread and duration targeted by the Company.

Quantitative Disclosures

The following table presents the fair value of derivative instruments, location of the related instruments in the condensed consolidated balance sheets and the related notional amounts of the derivative instruments as of September 30, 2009:

 

     Derivative assets    Derivative liabilities

(in millions)

   Balance sheet
location
   Fair value    Notional    Balance sheet
location
   Fair value    Notional

Derivatives designated as hedging instruments:

                 

Interest rate contracts

   Other assets    $ 4.5    $ 85.0    Other liabilities    $ 82.2    $ 1,331.2

Currency/interest rate swaps

   Other assets      36.7      94.5    Other liabilities      41.9      230.6

Total derivatives designated as hedging instruments

        41.2      179.5         124.1      1,561.8

Derivatives not designated as hedging instruments:

                 

Interest rate contracts

   Other assets      434.0      6,878.6    Other liabilities      261.1      5,133.1

Currency/interest rate swaps

   Other assets      0.2      1.4    Other liabilities      —        —  

Credit default swaps

   Other assets      0.9      54.2    Other liabilities      6.9      81.5

Total return swaps

   Other assets      1.5      60.0    Other liabilities      5.4      401.0

Equity contracts

   Other assets      391.9      2,473.2    Other liabilities      20.1      1,171.4

Embedded derivatives on guaranteed benefit annuity programs

   N/A      —        —      Future policy
benefits and claims
     521.8      N/A

Other embedded derivatives

   N/A      —        —      Other liabilities      5.9      N/A
                                 

Total derivatives not designated as hedging instruments

        828.5      9,467.4         821.2      6,787.0
                                 

Total derivatives

      $ 869.7    $ 9,646.9       $ 945.3    $ 8,348.8
                                 

 

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NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

 

The following table presents the gains (losses) for derivative instruments designated and qualifying as hedging instruments in fair value hedges and the location of these instruments in the condensed consolidated financial statements for the periods indicated:

 

(in millions)

  

Location of gain (loss) recognized on
derivatives

   Amount of
gain (loss)
recognized on
derivatives 1
 

Three months ended September 30, 2009:

     

Derivatives in fair value hedging relationships:

     

Interest rate contracts

   Net realized investment gains (losses)    $ (2.4

Currency/interest rate swap

   Net realized investment gains (losses)      0.5   
           

Total

      $ (1.9
           

Underlying hedged items in fair value hedge relationships:

     

Interest rate contracts

   Net realized investment gains (losses)    $ (2.2

Currency/interest rate swap

   Net realized investment gains (losses)      (0.5
           

Total

      $ (2.7
           

Nine months ended September 30, 2009:

     

Derivatives in fair value hedging relationships:

     

Interest rate contracts

   Net realized investment gains (losses)    $ 18.1   

Currency/interest rate swap

   Net realized investment gains (losses)      (3.6
           

Total

      $ 14.5   
           

Underlying hedged items in fair value hedge relationships:

     

Interest rate contracts

   Net realized investment gains (losses)    $ (27.0

Currency/interest rate swap

   Net realized investment gains (losses)      3.0   
           

Total

      $ (24.0
           
 
  1

Includes gains and losses recognized on terminating or unwinding fair value hedging relationships.

 

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NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

 

The following table presents the gains (losses) for derivative instruments designated and qualifying as hedging instruments in cash flow hedges and the location of these instruments in the condensed consolidated financial statements for the periods indicated:

 

(in millions)

   Amount of
gain (loss)
recognized
in OCI on
derivatives
   

Location of gain (loss) reclassified
from AOCI into income1

   Amount of
gain (loss)
reclassified
from
AOCI into
income3
   

Location of gain (loss) recognized in
income on derivatives2

   Amount of
realized gain
(loss)
recognized in
income on
derivatives2,3
 

Three months ended September 30, 2009:

            

Derivatives in cash flow hedging relationships:

            

Interest rate contracts

   $ 2.2     

Interest credited to policyholder accounts

   $ (1.2  

Net realized investment gains (losses)

   $ —     

Currency/interest rate swap

     (1.9  

Net realized investment gains (losses)

     —       

Net realized investment gains (losses)

     (0.3

Currency

     (6.7  

Net realized investment gains (losses)

     0.1     

Net realized investment gains (losses)

     —     
                              

Total

   $ (6.4      $ (1.1      $ (0.3
                              

Nine months ended September 30, 2009:

            

Derivatives in cash flow hedging relationships:

            

Interest rate contracts

   $ 8.5     

Interest credited to policyholder accounts

   $ (3.6  

Net realized investment gains (losses)

   $ —     

Currency/interest rate swap

     (4.1  

Net realized investment gains (losses)

     (10.9  

Net realized investment gains (losses)

     (1.2

Currency

     (16.9  

Net realized investment gains (losses)

     0.1     

Net realized investment gains (losses)

     (2.9

Other embedded derivatives

     (12.0   N/A      —        N/A      —     
                              

Total

   $ (24.5      $ (14.4      $ (4.1
                              
 
  1

Effective portion.

 

  2

Ineffective portion and amounts excluded from the measurement of ineffectiveness.

 

  3

Excludes periodic settlements in interest rate contracts.

 

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NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

 

The following table presents the gains (losses) for derivative instruments not designated and qualifying as hedging instruments and the location of these instruments in the condensed consolidated financial statements for the periods indicated:

 

(in millions)

  

Location of gain (loss) in income on
derivatives

   Amount of
realized gain
(loss) recognized
in income on
derivatives1
 

Three months ended September 30, 2009:

     

Derivatives not designated as hedging instruments:

     

Interest rate contracts

   Net realized investment gains (losses)    $ (2.0

Currency/interest rate swaps

   Net realized investment gains (losses)      (0.1

Credit default swaps

   Net realized investment gains (losses)      1.2   

Equity total return swaps

   Net realized investment gains (losses)      (6.0

Equity contracts

   Net realized investment gains (losses)      (325.0

Embedded derivatives on guaranteed benefit annuity programs

   Net realized investment gains (losses)      263.8   

Other embedded derivatives

   Net realized investment gains (losses)      4.0   
           

Total

      $ (64.1
           

Nine months ended September 30, 2009:

     

Derivatives not designated as hedging instruments:

     

Interest rate contracts

   Net realized investment gains (losses)    $ (193.9

Currency/interest rate swaps

   Net realized investment gains (losses)      3.3   

Credit default swaps

   Net realized investment gains (losses)      3.7   

Equity total return swaps

   Net realized investment gains (losses)      10.6   

Equity contracts

   Net realized investment gains (losses)      (592.6

Embedded derivatives on guaranteed benefit annuity programs

   Net realized investment gains (losses)      1,220.9   

Other embedded derivatives

   Net realized investment gains (losses)      (1.3
           

Total

      $ 450.7   
           
 
  1

Excludes net interest settlements in interest rate contracts and other revenue on embedded derivatives on guaranteed benefit annuity programs.

In addition to the net realized investment gains (losses) listed in the previous tables, $(89.6) million and $(132.3) million, respectively, of net interest settlements on all derivative instruments and $15.6 million and $41.7 million, respectively, of other revenue on embedded derivatives on guaranteed benefit annuity programs are also recorded in net realized investment gains (losses) for the three and nine months ended September 30, 2009.

 

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NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

 

Credit Derivatives

The Company had exposure to credit protection contracts for the periods ended September 30, 2009 and December 31, 2008. The Company had experienced no losses on credit protection contracts as of September 30, 2009 and 2008. The following table presents the Company’s outstanding exposure to credit protection contracts, all of which are related to corporate debt instruments, as of the dates indicated, by contract maturity and industry exposure:

 

    Less than or equal
to one year
    One
to three years
    Three
to five years
    Total  

(in millions)

  Maximum
potential
risk
  Estimated
fair value
    Maximum
potential
risk
  Estimated
fair

value
    Maximum
potential
risk
  Estimated
fair

value
    Maximum
potential
risk
  Estimated
fair

value
 

September 30, 2009:

               

Single sector exposure:

               

Consumer goods

  $ —     $ —        $ —     $ —        $ —     $ —        $ —     $ —     

Financial

    35.0     (5.9     9.0     (0.2     —       —          44.0     (6.1

Oil & gas pipelines

    15.0     —          —       —          —       —          15.0     —     

Services

    —       —          —       —          35.0     0.7        35.0     0.7   

Utilities

    —       —          —       —          —       —          —       —     
                                                       

Total single sector exposure

    50.0     (5.9     9.0     (0.2     35.0     0.7        94.0     (5.4

Index exposure:

               

Corporate bonds

    —       —          —       —          —       —          —       —     
                                                       

Total index exposure

    —       —          —       —          —       —          —       —     
                                                       

Total

  $ 50.0   $ (5.9   $ 9.0   $ (0.2   $ 35.0   $ 0.7      $ 94.0   $ (5.4
                                                       

December 31, 2008:

               

Single sector exposure:

               

Consumer goods

  $ —     $ —        $ 6.0   $ (0.8   $ —     $ —        $ 6.0   $ (0.8

Financial

    —       —          35.0     (5.8     13.0     (0.5     48.0     (6.3

Oil & gas pipelines

    10.0     —          15.0     (0.8     —       —          25.0     (0.8

Services

    —       —          —       —          35.0     (3.0     35.0     (3.0

Utilities

    4.5     —          —       —          —       —          4.5     —     
                                                       

Total single sector exposure

    14.5     —          56.0     (7.4     48.0     (3.5     118.5     (10.9

Index exposure:

               

Corporate bonds

    —       —          —       —          110.9     (0.3     110.9     (0.3
                                                       

Total index exposure

    —       —          —       —          110.9     (0.3     110.9     (0.3
                                                       

Total

  $ 14.5   $ —        $ 56.0   $ (7.4   $ 158.9   $ (3.8   $ 229.4   $ (11.2
                                                       

 

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NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

 

(7)

Investments

Fixed Maturity Securities and Equity Securities Available-for-Sale

The following table summarizes the amortized cost, gross unrealized gains and losses, and estimated fair values of securities available-for-sale as of the dates indicated:

 

(in millions)

   Amortized
cost
   Gross
unrealized
gains
   Gross
unrealized
losses
   Estimated
fair value

September 30, 2009:

           

Fixed maturity securities:

           

U.S. Treasury securities and obligations of U.S. Government corporations

   $ 182.3    $ 19.9    $ —      $ 202.2

U.S. Government agencies

     422.4      71.0      —        493.4

Obligations of states and political subdivisions

     382.2      14.1      7.6      388.7

Debt securities issued by foreign governments

     70.0      7.5      —        77.5

Corporate securities

           

Public

     10,890.7      669.1      205.8      11,354.0

Private

     4,707.3      209.6      110.2      4,806.7

Residential mortgage-backed securities

     8,379.8      183.3      707.5      7,855.6

Commercial mortgage-backed securities

     1,380.3      9.0      233.5      1,155.8

Collateralized debt obligations

     550.6      13.0      213.6      350.0

Other asset-backed securities

     473.8      10.4      43.0      441.2
                           

Total fixed maturity securities

     27,439.4      1,206.9      1,521.2      27,125.1

Equity securities

     56.2      5.7      1.4      60.5
                           

Total securities available-for-sale

   $ 27,495.6    $ 1,212.6    $ 1,522.6    $ 27,185.6
                           

December 31, 2008:

           

Fixed maturity securities:

           

U.S. Treasury securities and obligations of U.S. Government corporations

   $ 94.3    $ 25.4    $ —      $ 119.7

U.S. Government agencies

     420.5      93.3      —        513.8

Obligations of states and political subdivisions

     271.3      1.6      10.5      262.4

Debt securities issued by foreign governments

     50.1      5.4      —        55.5

Corporate securities

           

Public

     8,881.9      109.9      1,040.7      7,951.1

Private

     5,002.8      45.2      403.4      4,644.6

Residential mortgage-backed securities

     8,369.1      109.8      881.0      7,597.9

Commercial mortgage-backed securities

     1,488.9      0.6      473.9      1,015.6

Collateralized debt obligations

     557.7      6.4      240.7      323.4

Other asset-backed securities

     689.1      3.6      107.0      585.7
                           

Total fixed maturity securities

     25,825.7      401.2      3,157.2      23,069.7

Equity securities

     68.7      0.8      8.8      60.7
                           

Total securities available-for-sale

   $ 25,894.4    $ 402.0    $ 3,166.0    $ 23,130.4
                           

 

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NATIONWIDE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

 

The market value of the Company’s general account investments may fluctuate significantly in response to changes in interest rates, investment quality ratings and credit spreads. The Company does not have the intent to sell, nor is it more likely than not that the Company will be required to sell debt securities in unrealized loss positions that are not other-than-temporarily impaired before recovery. The Company may realize investment losses to the extent its liquidity needs require the disposition of general account fixed maturity securities in unfavorable interest rate, liquidity or credit spread environments.

For securities available-for-sale as of the dates indicated, the following table summarizes the Company’s gross unrealized losses based on the amount of time each type of security has been in an unrealized loss position:

 

    Less than or equal
to one year
  More than one year   Total

(in millions, except number of securities)

  Estimated
fair value
  Gross
unrealized
losses
  Number
of
securities
  Estimated
fair value
  Gross
unrealized
losses
  Number
of
securities
  Estimated
fair value
  Gross
unrealized
losses
  Number
of
securities

September 30, 2009:

                 

Fixed maturity securities:

                 

Obligations of states and political subdivisions

  $ 12.0   $ 0.4   3   $ 82.3   $ 7.2   13   $ 94.3   $ 7.6   16

Corporate securities

                 

Public

    707.1     26.2   153     1,363.4     179.6   237     2,070.5     205.8   390

Private

    248.4     15.4   48     1,123.9     94.8   89     1,372.3     110.2   137

Residential mortgage-backed securities

    438.4     86.2   63     2,704.8     621.3   386     3,143.2     707.5   449

Commercial mortgage-backed securities

    11.1     0.2   2     834.6     233.3   119     845.7     233.5   121

Collateralized debt obligations

    85.7     38.6   20     221.2     175.0   40     306.9     213.6   60

Other asset-backed securities

    5.5     0.7   11     241.4     42.3   34     246.9     43.0   45
                                               

Total fixed maturity securities

    1,508.2     167.7   300     6,571.6     1,353.5   918     8,079.8     1,521.2   1,218

Equity securities

    9.2     0.8   28     2.5     0.6   58     11.7     1.4   86
                                               

Total

  $ 1,517.4   $ 168.5   328   $ 6,574.1   $ 1,354.1   976   $ 8,091.5   $ 1,522.6