The correct answer is Option 3: Both 1 and 2.

1. The National School of Drama (NSD) was indeed set up by the Sangeet Natak Akademi in 1959. The Sangeet Natak Akademi, established in 1952, is the national academy of music, dance, and drama in India. The idea behind establishing the NSD was to create a school that would provide systematic training in various aspects of theater and produce well-trained theater artists. The NSD has since become a premier institution for theater education and has made significant contributions to the Indian theater scene.

2. The Sahitya Akademi, established in 1954, is the national academy of letters in India. It recognizes and promotes literary excellence in various Indian languages. The highest honor conferred by the Sahitya Akademi on a writer is by electing him or her as its Fellow. This prestigious recognition is given to eminent writers who have made exceptional contributions to literature and have a substantial body of work to their credit. Being elected as a Fellow of the Sahitya Akademi is considered a significant achievement and acknowledgment of a writer`s literary prowess.

In summary, both statements are correct. The National School of Drama was established by the Sangeet Natak Akademi, and the highest honor bestowed by the Sahitya Akademi on a writer is through their election as a Fellow.