The Company’s subsidiary, Regent Care San Marcos A-3 LP, owned an approximately 79,000 square foot building in San Marcos, Texas, which was also used in nursing home operations. The Company sold the San Marcos nursing home operation in the second quarter of 2019.
Ozark National owns an approximately 63,000 square foot building located in Kansas City, Missouri which is utilized as commercial office space by Ozark, is leased and utilized as commercial office space by its affiliate NIS, and the remainder historically has been leased by Ozark to a third party tenant. The intercompany lease costs related to NIS have been eliminated for consolidated reporting purposes. Additionally, Ozark owns two parcels of land located in Kansas City, Missouri. The first parcel contains 0.3 acres of land and an unused single-story parking garage. The second parcel contains 2.3 acres of land and operates as a surface parking lot contracted on a monthly basis to a parking lot operator.
Management’s discussion and analysis of the financial condition and results of operations (“MD&A”) of National Western Life Group, Inc. ("NWLGI") for the three years ended December 31, 2020 follows. Where appropriate, discussion specific to the insurance operations of National Western Life Insurance Company is denoted by "National Western" or "NWLIC". This discussion should be read in conjunction with the Company’s Consolidated Financial Statements and related notes beginning on page 96 of this report.
The Company monitors these factors continually as key business indicators. The discussion that follows in this Item 7 includes these indicators and presents information useful to an overall understanding of the Company’s business performance in 2020, incorporating required disclosures in accordance with the rules and regulations of the Securities Exchange Commission ("SEC").
The Company's business is generally aided by an economic environment experiencing growth, whether moderate or vibrant, characterized by improving employment data and increases in personal income. Important metrics indicating sustained economic growth over the longer term principally revolve around employment and confidence, both consumer and business sentiment.
In recent years, in an attempt to acquire additional investment yield in the low rate environment, life insurers substantially increased allocations to BBB- rated bonds. In a recession, many of these investment grade corporate credits are at risk for downgrades, as well as the potential to default. Risk-based capital (RBC) formulas assess higher required capital charges as investment quality declines. A meaningful shift of BBB- rated debt securities to non-investment grade categories could have significant implications in terms of required capital levels which would depress RBC ratios of impacted insurers. Life insurance companies also have a large exposure to real estate in its investment portfolios through commercial mortgage, direct real estate investment, alternative investment funds, and mortgage-backed securities. These investments are highly dependent upon occupancy and payment of rent and lease obligations. The quarantine and shelter-at-home lockdown affect the ability to meet these payment obligations.
Life insurance revenues are driven more by renewal premiums than sales. Most state insurance departments have issued directives instructing insurers to allow premium payments to fall into arrears. New life insurance sales face the challenge of having to forego face-to-face consultation with agents and distributors. In addition, full medical underwriting, which is a cornerstone of evaluating risk when an insurer makes the decision to offer coverage and at what level of coverage, will likely be unavailable or difficult to complete as a medical test for life insurance applications will not be considered as "essential" in a pandemic environment.
With regard to the credit market, although not probable in the current environment, industry analysts and observers generally agree that a sudden jump in interest rate levels would be harmful to life insurers with interest-sensitive products as it could provide an impetus for abnormal levels of product surrenders and withdrawals at the same time fixed debt securities held by insurers declined in market value. Ultimately, a mix of monetary policy adjustments, fiscal policy, and economic fundamentals will determine the future direction of interest rate movements and the speed of such shifts. It is uncertain at what pace interest rate movements may occur in the future and what impact, if any, such movements would have on the Company’s business, results of operations, cash flows or financial condition.
Impairment of Investment Securities. The Company’s accounting policy requires that a decline in the value of a security below its amortized cost basis be evaluated to determine if the decline is a result of credit loss. The primary factors considered in evaluating whether a decline in value for fixed income and equity securities without readily determinable fair values is a result of credit loss are: (a) the length of time and the extent to which the fair value has been less than cost, (b) the reasons for the decline in value (credit event, interest rate related, credit spread widening), (c) the overall financial condition as well as the near-term prospects of the issuer, (d) whether the debtor is current on contractually obligated principal and interest payments, and (e) that the Company does not intend or be required to sell the investment prior to recovery. In addition, certain securitized financial assets with contractual cash flows are evaluated periodically by the Company to update the estimated cash flows over the life of the security. If the Company determines that the fair value of the securitized financial asset is less than its carrying amount and there has been a decrease in the present value of the estimated cash flows since the previous purchase or prior impairment, then a credit loss charge is recognized. The Company would recognize impairment of securities due to changing interest rates or market dislocations only if the Company intended to sell the securities prior to recovery. When a security is deemed to be impaired, a charge is recorded equal to the difference between the fair value and amortized cost basis of the security. In compliance with GAAP guidance the estimated credit loss is recorded as an allowance with changes in the allowance recorded to Net investment income in the Consolidated Statements of Earnings.
Deferred Policy Acquisition Costs (“DPAC”). The Company is required to defer certain policy acquisition costs and amortize them over future periods. These costs include commissions and certain other expenses that vary with and are directly associated with acquiring new business. The deferred costs are recorded as an asset commonly referred to as deferred policy acquisition costs. The DPAC asset balance is subsequently charged to income over the lives of the underlying contracts in relation to the anticipated emergence of revenue or profits. Actual revenue or profits can vary from Company estimates resulting in increases or decreases in the rate of amortization. The Company performs regular evaluations of its universal life and annuity contracts to determine if actual experience or other evidence suggests that earlier estimates should be revised. Assumptions considered significant include surrender and lapse rates, mortality, expense levels, investment performance, and estimated interest spread. Should actual experience dictate that the Company change its assumptions regarding the emergence of future revenues or profits (commonly referred to as “unlocking”), the Company would record a charge or addition to bring its DPAC balance to the level it would have been if using the new assumptions from the inception date of each policy.
DPAC is also subject to periodic recoverability and loss recognition testing. These tests ensure that the present value of future contract-related cash flows will support the capitalized DPAC balance to be amortized in the future. The present value of these cash flows, less the benefit reserve, is compared with the unamortized DPAC balance and if the DPAC balance is greater, the deficiency is charged to expense as a component of amortization and the asset balance is reduced to the recoverable amount. For more information about accounting for DPAC see Note (1), Summary of Significant Accounting Policies, in the accompanying Notes to Consolidated Financial Statements in this report.
Investment activities of the Company are integral to its insurance operations. Since life insurance benefits may not be paid until many years into the future, the accumulation of cash flows from premium receipts are invested with income reported as revenue when earned. Anticipated yields on investments are reflected in premium rates, contract liabilities, and other product contract features. These anticipated yields are implied in the interest required on the Company’s net insurance liabilities (future policy benefits less deferred acquisition costs) and contractual interest obligations in its insurance and annuity products. The Company benefits to the extent actual net investment income exceeds the required interest on net insurance liabilities and manages the rates it credits on its products to maintain the targeted excess or “spread” of investment earnings over interest credited. The Company will continue to be required to provide for future contractual obligations in the event of a decline in investment yield. For more information concerning revenue recognition, investment accounting, and interest sensitivity, please refer to Note (1), Summary of Significant Accounting Policies, and Note (3), Investments, in the accompanying Notes to Consolidated Financial Statements in this report, and the discussions under Investments in Item 7 of this report.
Other significant accounting policies, although not involving the same level of measurement uncertainties as those discussed above, but nonetheless important to an understanding of the financial statements, are described in Note (1), Summary of Significant Accounting Policies, in the accompanying Notes to Consolidated Financial Statements in this report.
Universal life and annuity contract revenues - Revenues for universal life and annuity contract charges decreased in 2020 compared to 2019 due to lower surrender charge revenue from terminated policies and lower cost of insurance and administrative charges. Revenues for universal life and annuity products consist of policy charges for the cost of insurance, administration charges, and surrender charges assessed against policyholder account balances, less reinsurance premiums as depicted in the following table.
Cost of insurance charges were $98.9 million in 2020 compared to $102.0 million in 2019 and $105.9 million in 2018. Cost of insurance charges typically trend with the size of the universal life insurance block in force and the amount of new business issued during the period. The volume of universal life insurance in force during 2020 decreased to $13.5 billion from $14.4 billion at year-end 2019 and $15.6 billion at year-end 2018. Administrative charges were $25.9 million, $24.1 million, and $23.7 million for the years ended December 31, 2020, 2019 and 2018, respectively, and correlate with new universal life insurance business sales by the number of policies placed, the amount of premiums received and the volume of insurance issued. While National Western's decision in the second quarter of 2018 to cease accepting international policy applications from residents of other countries significantly decreased the level of universal life insurance sales, the Company's increasing domestic life sales have served to offset a substantial portion of this decline.
Surrender charges assessed against policyholder account balances upon withdrawal were $26.6 million in 2020 compared to $33.1 million in 2019 and $37.1 million in 2018. The Company earns surrender charge income that is assessed upon policy terminations, however, the Company’s overall profitability is enhanced when policies remain in force and additional contract revenues are realized and the Company continues to make an interest rate spread equivalent to the difference it earns on its investment and the amounts that it credits to policyholders. While policy lapse rates in 2020 for the domestic life insurance and international life insurance segments were somewhat lower than those experienced in 2019, the annuities segment exhibited a higher lapse rate due to liquidity demands prompted by the pandemic crisis. Surrender charge income recognized is also dependent upon the duration of policies at the time of surrender (i.e. later duration policy surrenders have lower surrender charges assessed and earlier policy surrenders have a higher surrender charge assessed). The declining trend in assessed surrender charges is indicative of policy surrenders later in the surrender charge period.
Other charges include the net amortization into income of the premium load on single premium life insurance products which is deferred at the inception of the policy. As these products have become a substantial portion of the Company's new business the amortization of accumulated deferrals has surpassed current premium loads being deferred. As part of the Company's annual unlocking analysis, a prospective unlocking of the unearned revenue reserve was done for each year shown. The effect of the unlocking was an increase in other charges revenue of $5.9 million, $0.5 million, and $0.5 million in the years ended December 31, 2020, 2019, and 2018, respectively.
Effective January 1, 2018, new accounting guidance required changes in fair values of equity securities to be included in the Consolidated Statements of Earnings rather than as a component of Accumulated Other Comprehensive Income in Stockholders' Equity. For the years ended December 31, 2020, 2019, and 2018 an unrealized gain(loss) of $(1.0) million, $3.5 million, and ($1.8) million, respectively, has been included in net investment income reflecting the change in fair value of equity securities during the periods. The carrying value of the Company’s portfolio of equity securities was $17.7 million at December 31, 2020.
Prior to 2020, the Company’s new mortgage loan activity had been impacted by the low level of rates and the highly competitive underwriting of commercial properties. The pandemic COVID-19 crisis further slowed down the underwriting of new loan applications early in 2020 until clarity regarding the impacts of closing down the economy upon commercial real estate became discernible. Eventually the volume of new mortgage loan originations during the latter half of 2020 approached the pace of that in 2019. The Company originated new mortgage loans in the amount of $80.2 million in 2020 as compared to $121.4 in 2019. Mortgage loan investment income also benefits from incremental contributions from loan prepayment fees and profit participation receipts.
The Company adopted new accounting guidance pertaining to current expected credit losses on financial instruments ("CECL") in 2020. The adoption as of January 1, 2020 was reported as a change in accounting with initial balances recorded and charged to retained earnings. Remeasurement of the CECL allowance during 2020 resulted in a decrease in the allowance of $2.0 million for the year ended December 31, 2020 which is netted in gross investment income.
Other revenues - Other revenues pertain to NIS, the broker-dealer affiliate of Ozark National; the operations of Braker P III ("BP III"), a new subsidiary created at the end of 2016 to own and manage a commercial office building BP III acquired; and the Company’s previously owned two nursing home operations in Reno, Nevada and San Marcos, Texas.
NIS revenues were $9.9 million and $8.2 million for the years ended December 31, 2020 and 2019, respectively. NIS revenues in 2019 were for the period subsequent to its acquisition effective January 31, 2019.
The Company's acquisition of Ozark National (by National Western) included a contingent payment provision that was dependent upon the subsequent persistency of Ozark National's in force block of business that was acquired. The Company had been progressively accruing for this potential obligation in its financial statements. During 2020, the Company executed an agreement with the seller under which both parties agreed that the Company had fulfilled its payment obligation under the Stock Purchase Agreement executed October 3, 2018. Consequently, the Company reversed the contingent payment amounts previously accrued and recognized as Other revenues $4.1 million in the year ended December 31, 2020.
Gains and losses from index options are substantially due to changes in equity market conditions. Index options are intended to act as hedges to match the returns on the product’s underlying reference index and the rise or decline in the index relative to the index level at the time of the option purchase which causes option values to likewise rise or decline. As income from index options fluctuates with the underlying index, the contract interest expense to policyholder accounts for the Company’s fixed-index products also fluctuates in a similar manner and direction. The Company recorded derivative gain (loss) and contract interest amounts as shown below.
The economic impact of option performance in the Company's financial statements is not generally determined solely by the option gain or loss included in net investment income as there is a corresponding amount recorded in the contract interest expense line. The Company's profitability with respect to these options is largely dependent upon the purchase cost of the option remaining within the financial budget for acquiring options embedded in the product pricing. Option prices vary with interest rates, volatility, and dividend yields among other things. As option prices vary, the Company manages for the variability by making offsetting adjustments to product caps, participation rates, and management fees. For the periods shown, the Company's option costs have generally been within the product pricing budgets.
Prior to January 1, 2020 and the adoption of the new accounting guidance on current expected credit losses, the Company recorded impairment write-downs when a decline in value was considered to be other-than-temporary and full recovery of the investment is not expected. Impairments due to credit factors were recorded in the Company’s Consolidated Statements of Earnings while non-credit (liquidity) impairment losses were included in the Consolidated Statements of Comprehensive Income (Loss). Under the new accounting guidance, credit loss allowances for available-for-sale debt securities are recorded following the same process previously applied for impairment accounting. Credit loss allowances are recorded through net investment income in the Consolidated Statement of Earnings. Impairment or valuation write-downs recorded prior to January 1, 2020 were completed under accounting guidance prior to adoption of the accounting standard update 2016-13, Financial Instruments-Credit Losses and totaled $7.8 million and $0.0 million in the years ended December 31, 2019 and 2018, respectively.
Amortization of deferred policy acquisition costs and value of business acquired - Life insurance companies are required to defer certain expenses that vary with, and are directly related to, the cost of acquiring new business. The majority of these acquisition expenses consist of commissions paid to agents, underwriting costs, and certain marketing expenses. Recognition of these deferred policy acquisition costs (“DPAC”) as an expense in the Consolidated Financial Statements occurs over future periods in relation to the expected emergence of profits priced into the products sold. This emergence of profits is based upon assumptions regarding premium payment patterns, mortality, persistency, investment performance, and expense patterns. Companies are required to review universal life and annuity contract assumptions periodically to ascertain whether actual experience has deviated significantly from that assumed. If it is determined that a significant deviation has occurred, the emergence of profits pattern is to be "unlocked" and reset based upon the actual experience. DPAC balances are also adjusted each period to reflect current policy lapse or termination rates, expense levels and credited rates on policies as compared to anticipated experience (“true-up”) with the adjustment reflected in current period amortization expense. In accordance with GAAP guidance, the Company must also write off deferred acquisition costs and unearned revenue liabilities upon internal replacement of certain contracts as well as annuitizations of deferred annuities.
The following table identifies the effects of unlocking adjustments on DPAC balances recorded through amortization expense separate from recurring amortization expense components for 2020, 2019 and 2018.
National Western's approximated average credited rates, excluding and including equity-indexed products, were as follows:
Contract interest reported in financial statements also encompasses the performance of the index options associated with the Company's fixed-index products. As previously noted, the market value changes of these derivative features resulted in net realized and unrealized gains/(losses) in 2020, 2019, and 2018 of $14.8 million, $123.2 million, and $(80.0) million, respectively. In 2020, this figure was comprised of unrealized losses totaling $(9.7) million offset by realized gains of $24.5 million. In 2019, the amount consisted of unrealized gains of $153.0 million offset by realized losses of $(29.8) million. These returns similarly increased/(decreased) the computed average credited rates for the periods shown above. Policyholders of equity-indexed products cannot receive an interest credit below 0% according to the policy contract terms.
Accounting rules require the embedded derivative liability to include a projection of asset management fees estimated to be collected in the succeeding fiscal year due to the Company's historical practice of purchasing options priced to incorporate an expected probability of collecting asset management fees (referred to as "at the money hedging"). This projection for the embedded derivative liability is based upon the most recent performance of the reference equity index. Increases in projected asset management fees to be collected reduce contract interest expense while decreases in projected asset management fees to be collected increase contract interest expense. During the years ended December 31, 2020, 2019, and 2018, contract interest was increased/(decreased) by $34.4 million, $(33.6) million, and $17.6 million, respectively, for the projected change in asset management fees to be collected. During 2020, the Company changed its embedded derivative hedging process to incorporate "out of the money" hedging which reduces option costs and eliminates probability projections of collected asset management fees going forward. As the current inventory of annual hedges under the prior method continue to roll over during 2021, the embedded derivative liability component for projected asset management fees to be collected will be phased out. Refer to Note (3) Derivative Investments in the accompanying Notes to Consolidated Financial Statements in this report for further information.
Other embedded derivative components include changes pertaining to other modeling differences, changes in future interest adjustments, and the change in the host contract component of the embedded derivative products. In the first quarter of 2020, the Company incurred an additional charge to contract interest of $12.1 million pertaining to an assumption regarding the embedded derivative option budget which was made several years ago when the Company's investment portfolio yield was higher. The combination of the embedded derivative option budget being out of date relative to the Company's current investment portfolio yield and the historically low interest rate levels introduced an embedded derivative floor which prevented the Company's contract interest expense from declining in tandem with the option value decreases recorded in net investment income. The Company subsequently unlocked for this out of date embedded derivative option budget assumption to reflect the Company's current investment portfolio yield. The effect of the unlocking was to remove the embedded derivative floor and reverse the contract interest charge recorded in the first quarter of 2020 so that there was no effect for this occurrence for the year ended December 31, 2020.
General insurance expenses include software amortization of previously capitalized information technology expenditures including National Western's proprietary policy administration system which was phased into production over the past several years. Software costs, including amortization expense, for 2020, 2019, and 2018 were $12.6 million, $12.7 million, and $11.3 million, respectively. This category of expenses also includes employee benefit plan expenses for the various health and retirement plans the Company sponsors. Related expenses for these items were $13.0 million, $8.1 million, and $6.6 million in 2020, 2019, and 2018, respectively. The increasing trend reflects actuarial expenses of an unfunded non-qualified defined benefit plan. Refer to Note (14) Pension and Other Postretirement Plans in the accompanying Notes to Consolidated Financial Statements in this report for a discussion of financial statement expenses of the Company's defined benefit pension plans. General insurance expenses also include payments and provisions made relating to potential or contingent legal liabilities and legal fees. Expenses in this category were $2.8 million, $3.8 million, and $1.4 million in 2020, 2019, and 2018, respectively. The 2018 amount reflects settlement of an annuity contract matter in Puerto Rico and the release of the excess provision of $1.9 million previously recorded. General insurance expenses for the year ended December 31, 2019 include a $3.3 million broker fee paid in connection with the acquisition of Ozark National and NIS which closed early in 2019. GAAP precludes this fee from being part of the purchase price for acquiring these businesses. General insurance expenses in the years ended December 31, 2020 and 2019 include Ozark National expenses in the amount of $4.4 million and $4.2 million, respectively.
Commission expenses in 2020 and 2019 include Ozark National non-deferrable commissions of $3.1 million and $3.2 million, respectively.
Real estate expenses pertain to the commercial building operated by Braker P III. The building was acquired at year-end 2016 and National Western relocated to this facility during the fourth quarter of 2017. The trending increase in the level of operating expenses reflects the addition of new tenants and associated operating expenses. At December 31, 2020, the facility was fully occupied.
Universal life insurance revenues are also generated with the issuance of new business based upon amounts per application and percentages of the face amount (volume) of insurance issued. The number of domestic policies issued during 2020 was level with that in 2019 and the volume of insurance issued increased less than 1% from that in 2019.
Universal life insurance revenues also include surrender charge income realized on terminating policies and, in the case of domestic universal life, amortization into income of the premium load on single premium policies which is deferred. Amounts deferred are amortized into revenues over future periods corresponding with the duration of the policies. The net premium load amortization associated with this activity was $11.4 million, $8.2 million, and $6.0 million in 2020, 2019, and 2018, respectively. The net amortization amount in 2020 includes $5.8 million from the Company's annual unlocking of actuarial assumptions.
Premiums collected on universal life products are not reflected as revenues in the Company's Consolidated Statements of Earnings in accordance with GAAP. Actual domestic universal life premiums collected are detailed below.
Net investment income for this segment of business, excluding derivative gain/(loss), has been gradually increasing due to the increased new business activity described above (single premium policies) and a higher level of investments needed to support the corresponding growth in policy obligations, especially those for single premium policies. The increase in net investment income has been partially muted by lower investment yields from debt security investment purchases during this time frame. Net investment income also includes the gains and losses on index options purchased to back the index crediting mechanism on fixed-index universal life products. A detail of net investment income for domestic life insurance operations is provided below.
Life and policy benefits for a smaller block of business are subject to variation from period to period. Claim count activity during 2020 increased 12% compared to 2019 while the average net claim amount decreased to $30,600 from $34,400. Of the increase in claim count in 2020 over 2019, approximately half was due to COVID-19 death claims. National Western's domestic life insurance segment incurred 70 COVID-19 claims with a net benefit amount (after reinsurance) of $2.4 million, roughly 6% of the total net claims for this segment. The low face amount per claim relative to the current issued amounts of insurance per policy reflects the older block of domestic life insurance policies sold which were final expense type products (i.e. purchased to cover funeral costs). The overall mortality experience for this segment has been consistent with pricing assumptions.
As noted previously in the discussion of results from Consolidated Operations, true-up adjustments are recorded to DPAC balances each period to reflect current policy lapse or termination rates, expense levels and credited rates on policies as compared to anticipated experience with the adjustment reflected in current period amortization expense. To the extent required, unlocking adjustments may also be recorded to DPAC balances. The following table identifies the effects of unlocking adjustments on domestic life insurance DPAC balances recorded through amortization expense separate from recurring amortization expense components for 2020, 2019 and 2018.
In 2020, DPAC balances were unlocked for this segment for mortality, lapse rates, and investment spread increasing amortization expense. In 2019, DPAC balances were unlocked for this segment for mortality rates, lapse rates, and portfolio yield rates (investment spread margin) which cumulatively had the effect of slightly increasing DPAC balances (and reducing amortization expense). In 2018, the Company unlocked DPAC balances associated with the Domestic Life segment for favorable mortality, extended death benefit reserves, and the investment portfolio yield supporting universal life policy liabilities.
Contract interest expense includes the fluctuations that are the result of the effect upon the embedded derivative for the performance of the underlying equity indices associated with fixed-indexed universal life products. For liability purposes, the embedded option in the Company's policyholder obligations for this feature is bifurcated and reserved for separately. Accordingly, the impact for the embedded derivative component in the equity-index universal life product is reflected in contract interest expense for approximately the same amounts as in net investment income for each respective period.
Contract interest also includes certain policy reserve balance changes which are also subject to unlocking adjustments in conjunction with DPAC. As part of the 2020 and 2019 unlockings discussed above, the Company increased/(decreased) its domestic life insurance excess benefit reserve balance by $1.4 million in 2020 (increasing contract interest expense) and increased its excess benefit reserve balance by $0.3 million in 2019 (increasing contract interest expense).
Universal life revenues and operating earnings are largely generated from the amount of life insurance in force. Over the past three years, the volume of insurance in force for this segment has contracted from $15.4 billion at December 31, 2018 to $13.7 billion at December 31, 2019 and to $12.4 billion at December 31, 2020. The decline in volume of in force reflects the decision at the end of 2015 to begin disengaging from certain countries and ultimately making the decision in 2018 to cease accepting international policy applications from residents from all remaining countries. Universal life insurance revenues are also generated with the issuance of new business based upon amounts per application and percentages of the face amount (volume) of insurance issued. No policies have been issued since September 2018.
National Western’s most popular international products were its fixed-index universal life products in which the policyholder could elect to have the interest rate credited to their policy account values linked in part to the performance of an outside equity index. These products issued were not generally available in the local markets when sold. Included in the totals in the above table are collected premiums for fixed-index universal life products of approximately $32.4 million, $41.3 million and $57.8 million for the years ended 2020, 2019 and 2018, respectively. The declining trend in renewal premiums during these periods corresponds with the decline in policies in force due to the elimination of new sales and the termination activity as discussed above.
The Company records true-up adjustments to DPAC balances each period to reflect current policy lapse or termination rates, expense levels, and credited rates on policies as compared to anticipated experience as well as unlocking adjustments as necessary. The following table identifies the effects of unlocking adjustments on international life insurance DPAC balances recorded through amortization expense separate from recurring amortization components for 2020, 2019 and 2018.
In 2018, the Company unlocked DPAC balances associated with its International Life segment for extended death benefit reserves and the investment portfolio yield supporting universal life policy liabilities. The effect of the prospective unlocking was to decrease DPAC balances by $0.3 million (and increase amortization expense).
Although not an unlocking, during 2018 the Company successfully converted its reserve modeling for excess death benefit reserves on UL riders over to its existing actuarial software platform. The implementation refined the actuarial estimate increasing these reserves and included an adjustment increasing the International Life DPAC balance (decreasing amortization expense). The amount of the core amortization expense decrease was $3.6 million.
As part of the unlockings performed in 2019 and 2018, the Company also unlocked its policy benefits reserves associated with the assumption regarding policyholder utilization of the GMWB rider. The assumptions were updated for actual utilization experience versus that which was previously assumed. The effect of this prospective unlocking was to increase policy reserves by $0.7 million (and increase policy benefits expense) in 2019 and to decrease policy reserves by $15.7 million (and decrease life and policy benefits expense) in 2018. The adjustment in 2018 was the first instance of unlocking for utilization of the GMWB rider and the adjustment reflects an overly conservative utilization assumption that was previously in place.
Consistent with the domestic and international life segments, the Company records true-up adjustments to DPAC balances each period to reflect current policy lapse or termination rates, expense levels and credited rates on policies as compared to anticipated experience as well as unlocking adjustments as necessary. The following table identifies the effects of unlocking adjustments on annuity DPAC balances recorded through amortization expense separate from recurring amortization expense components for 2020, 2019 and 2018.
In 2020, the Company unlocked Annuity segment DPAC balances for assumptions pertaining to lapse rates, annuitization rates, and portfolio investment yield rates supporting the block of business which increased amortization expense approximately $15.0 million. DPAC balances associated with the Annuity segment were unlocked in 2019 for assumptions pertaining to lapse rates, annuitization rates, investment spreads, and utilization of the Company's withdrawal benefit rider. The effect of the prospective unlocking was to increase amortization expense $2.6 million. In 2018, the Company unlocked the DPAC balances associated with its Annuity segment for assumptions concerning mortality, the election rate of the Company's withdrawal benefit rider, and for the investment portfolio yield supporting annuity contract accounts. The effect of the prospective unlocking was to decrease amortization expense by $2.2 million.
The fluctuation in reported contract interest amounts for fixed-index annuities is driven by sales levels, the level of the business in force, and the effect of positive or negative market returns of option values on projected interest credits. As noted in the net investment income discussion, the amounts shown for contract interest for fixed-index annuities generally align with the derivative gains/(losses) included in net investment income due to the market change of index options aligning closely with the movement of the embedded derivative liability held for these products.
In addition to the effects of the unlocking adjustments on Life and other policy benefits and amortization of DPAC expenses, the unlocking assumption changes impacted certain annuity benefit reserves. As noted above, the Company unlocked the mortality assumption with regards to payout annuities (contracts paying systematic benefits). The effect of the prospective unlocking was to increase annuity benefit reserves by $22.8 million which increased contract interest expense by a like amount. For other deferred fixed rate annuities, the unlocking assumption changes pertaining to lapse rates, annuitization rates and portfolio yields supporting the block of business increased annuitization and excess death benefit reserves by $11.3 million which similarly increased contract interest expense.
Annuity contract interest includes true-up adjustments for the deferred sales inducement balance which are done each period similar to that done with respect to DPAC balances with the adjustment reflected in current period contract interest expense. To the extent required, the Company may also record unlocking adjustments to deferred sales inducement balances in conjunction with DPAC balance unlockings. For the years ended December 31, 2020, 2019, and 2018 bonus interest amortization was increased/(decreased) by $4.4 million, $0.6 million, and $(1.3) million, respectively, for unlocking adjustments.
The average face value of Ozark National's policies in force at December 31, 2020 was approximately $33,700. Consequently, life and policy benefits for smaller face amounts are subject to variation from quarter to quarter. Incurred death claims in 2020 were $37.0 million representing an average net claim of $14,800 while for the eleven months of operations in 2019 incurred death claims were $29.3 million representing an average net claim of $15,300. Included in 2020 death claims were 191 claims with a cause of death identified as COVID-19 which aggregated to $2.8 million in net claims. Ozark National's maximum retention on any single insured life is $200,000 with limited exceptions related to the conversation of child protection and guaranteed insurability riders. The balance of life and policy benefits during 2020 and 2019 consists of increases in insurance reserves and payments of other policy benefits.
As part of the purchase accounting required with the acquisition of Ozark National effective January 31, 2019, the Company recorded an intangible asset of $145.8 million referred to as the value of business acquired ("VOBA"). VOBA represents the difference between the acquired assets and liabilities of Ozark National measured in accordance with the Company's accounting policies and the fair value of these same assets and liabilities. The VOBA balance sheet amount is amortized following a methodology similar to that used for amortizing deferred policy acquisition costs. During the year ended December 31, 2020, the cash value of certain acquired reserves was increased which resulted in a commensurate increase in both the traditional life reserve liability and the related VOBA balance reported on the Consolidated Balance Sheets.
The Company's primary business encompasses its domestic and international life insurance operations, its annuity operations, and its acquired businesses. However, the Company also has small real estate and other investment operations through its wholly owned subsidiaries, and owned nursing home operations through the early part of 2019.
As discussed in the Consolidated Operations section, the Company closed on the sales of its two nursing home facilities during 2019. The Reno, Nevada nursing home operations were sold during the first quarter of 2019 and the San Marcos, Texas nursing home operations were in the second quarter of 2019. Operating results for each entity are included to the date of their respective sales. Nursing home operations generated $(0.7) million, $0.8 million and $1.3 million of pre-tax earnings in 2020, 2019, and 2018, respectively. The results for 2019 include net gains of $1.4 million from the sale of Reno personal property and equipment.
Pre-tax operating amounts include the results of BP III, the entity owning and operating the Company's home office facility in Austin, Texas. BP III commenced operations at the beginning of 2017 and National Western relocated to this facility in the fourth quarter of 2017 leasing approximately 40% of the facility. BP III incurred pre-tax losses of $(0.9) million, $(1.4) million and $(1.9) million in 2020, 2019 and 2018, respectively. Lease and operating expense payments made by National Western to BP III have been eliminated in consolidation.
The remaining pre-tax earnings in Other Operations of $22.6 million, $25.2 million, and $26.8 million for the years ended December 31, 2020, 2019, and 2018, respectively, includes investment income from real estate, municipal bonds, and common and preferred equities held in subsidiary company portfolios principally for tax-advantage purposes. Included in these amounts are semi-annual distributions from a life interest in the Libbie Shearn Moody Trust which is held in NWLSM, Inc. Pretax distributions from this trust were $5.3 million, $6.7 million, and $7.5 million in 2020, 2019, and 2018, respectively. In addition, the Company holds a modest portfolio of equity securities, primarily in NWL Financial, Inc., whose fair value changes are recorded in net investment income. For the years ended December 31, 2020, 2019 and 2018, the market value changes for these securities were $(1.0) million, $3.5 million, and $(2.4) million, respectively.
The Company's overall investment philosophy is reflected in the allocation of its investments, which is detailed below as of December 31, 2020 and 2019. The Company has historically emphasized investment grade debt securities.
Invested assets at December 31, 2020 include Ozark National amounts as follows: Debt securities of $811.6 million; Policy loans of $25.5 million; and Real estate of $4.6 million. These amounts as of December 31, 2019 consisted of: Debt securities of $722.9 million; Policy loans of $27.1 million; and Real estate of $4.6 million.
The Company’s investment portfolio increased 3% to $11.4 billion at December 31, 2020 compared to $11.1 billion at December 31, 2019 reflecting adjustments made to record certain debt securities at fair value that were previously reported at amortized cost.
Effective December 31, 2020, National Western entered into a Funds Withheld Coinsurance Agreement ("Agreement") with Prosperity Life Assurance Limited ("Prosperity") under which it ceded a 100% quota share of contractual statutory annuity reserve liabilities approximating $1.7 billion. Under terms of the Agreement, National Western, on behalf of Prosperity, transferred debt securities to a funds withheld account on its Consolidated Balance Sheet. These securities had previously been classified as held-to-maturity with an amortized cost value of $964.8 million and as available-for-sale at a fair market value of $712.5 million. Prosperity, as investment manager of the funds withheld account, intends to actively trade these securities in an effort to secure higher yields. Since Prosperity's intent is to not hold the funds withheld debt securities to maturity, the Company was required to reclassify the transferred holdings in the held-to-maturity category to the available-for-sale portfolio category for financial statement purposes. An unrealized gain of $67.1 million was recorded as a result of this transfer and resulted in all funds withheld debt securities recorded at fair market value as of December 31, 2020.
The Company has historically designated approximately 70% of its debt securities in the held-to-maturity portfolio category, which is reported at amortized cost, with the remainder designated in the available-for-sale portfolio, which is reported at fair market value. As an outcome of the accounting for the securities involved in the Agreement with Prosperity, the Company's remaining held-to-maturity securities not included in the Agreement were also precluded from retaining the held-to-maturity classification. Accordingly, the Company reclassified debt securities with a $5.7 billion amortized cost to the available-for-sale category and recognized an unrealized gain of $523.8 million in reporting the securities at their fair market values. Consequently, the increase in the investment portfolio is primarily due to reporting balances at fair market value.
Derivatives are call options purchased to hedge the interest crediting mechanism associated with the Company's fixed-index universal life and annuity policies. These options are reported on the Consolidated Balance Sheets at fair value in accordance with GAAP. The unrealized gain position of options held at December 31, 2020 was $71.0 million which was $9.7 million lower than the unrealized gain position at December 31, 2019 of $80.7 million. The decrease is due to the Company moving to an "out-of-the-money" option approach during 2020 which reduces the cost of options by not hedging for potential collection of asset management fees on the associated equity-indexed annuity contracts. The purchase cost of options outstanding at December 31, 2020 was $61.8 million and at December 31, 2019 was $76.9 million.
The growth in the Other investment category in 2020 is due to investments in alternative investment opportunities which have the potential for higher yields than that available with other investment securities. The typical structure involves a fund under the management of an investment management firm with direct lending expertise in a particular market niche which seeks to construct portfolios comprised of senior secured debt. The Company participates through capital funding commitments approved by its Board of Directors based upon the recommendation of the Company's senior investment management team. The funds have targeted dollar sizes and targeted internal rates of return.
The majority of the Company’s investable cash flows are directed toward the purchase of long-term debt securities. The Company’s investment policy calls for investing in debt securities that are investment grade, meet quality and yield objectives, and provide adequate liquidity for obligations to policyholders. Debt securities with intermediate maturities are targeted by the Company as they more closely match the intermediate nature of the Company’s policy liabilities and provide an appropriate strategy for managing cash flows. In the past two years, the Company has purchased a higher level of longer maturity debt securities to match the increased duration of its growing life insurance policy liabilities. The Company holds minimal levels of U.S. Treasury securities due to their low yields and deposits most of these holdings with various state insurance departments in order to meet security deposit on hand requirements in these jurisdictions.
The Company has deemphasized mortgage-backed securities for a number of years given the low interest rate environment and the lack of incremental yield relative to other classes of debt securities. Rating agencies generally view mortgage-backed securities as having additional risk for insurers holding interest sensitive liabilities given the potential for asset/liability disintermediation. Consequently, the Company holds predominantly agency mortgage-backed securities. Because mortgage-backed securities are subject to prepayment and extension risk, the Company has substantially reduced these risks by investing in collateralized mortgage obligations ("CMO"), which have more predictable cash flow patterns than pass-through securities. These securities, known as planned amortization class I ("PAC I"), very accurately defined maturity ("VADM"), and sequential tranches, are designed to amortize in a more predictable manner than other CMO classes or pass-throughs. The Company does not purchase tranches, such as PAC II and support tranches, that subject the portfolio to greater than average prepayment risk. Using this strategy, the Company can more effectively manage and reduce prepayment and extension risks, thereby helping to maintain the appropriate matching of the Company's assets and liabilities.
Generally accepted accounting principles through the end of 2019 required that investments in debt securities be written down to fair value when declines in value were judged to be other-than-temporary. Fair value is 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 (an exit price methodology). Refer to Note (4), Fair Values of Financial Instruments, of the accompanying Notes to Consolidated Financial Statements for further discussion.
During 2019, the Company recorded a $7.8 million other-than-temporary impairment on a single debt security issuer. Under prior GAAP guidance pertaining to the recognition and accounting for other-than-temporary impairments and their classification as either a credit loss or non-credit loss, the Company recognized a cumulative total of $8.5 million of other-than-temporary impairments of which $8.5 million was deemed credit related and recognized as realized investment losses in earnings, and $0.0 million, net of amortization, which was deemed non-credit related and recognized in other comprehensive income.
The Company is required to classify its investments in debt securities into one of three categories: (a) trading securities; (b) securities available-for-sale; or (c) securities held-to-maturity. The Company's investment philosophy calls for purchases of securities with the intent to hold to maturity. Historically, a determination was made on categorization based on various factors including the type and quality of the particular security and how it will be incorporated into the Company's overall asset/liability management strategy. As shown in the table below, at December 31, 2020, 100.0% of the Company's total debt securities were classified as securities available-for-sale, including the debt securities in the funds withheld account. These holdings in available-for-sale provide flexibility to the Company to react to market opportunities and conditions and to practice active management within the portfolio to provide adequate liquidity to meet policyholder obligations and other cash needs.
As noted previously, the Company transferred approximately $1.7 billion of its debt securities into the available-for-sale category effective December 31, 2020 as a result of a reinsurance agreement with Prosperity that resulted in an unrealized investment gain of $67.1 million.
The Company originates loans on high quality, income-producing properties such as shopping centers, freestanding retail stores, office buildings, industrial and sales or service facilities, selected apartment buildings, hotels, and health care facilities. The location of these properties is typically in major metropolitan areas that offer a potential for property value appreciation. Credit and default risk is minimized through strict underwriting guidelines and diversification of underlying property types and geographic locations. In addition to being secured by the property, mortgage loans with leases on the underlying property are often guaranteed by the lease payments. This approach has proved over time to result in quality mortgage loans with few defaults. Mortgage loan interest income is recognized on an accrual basis with any premium or discount amortized over the life of the loan. Prepayment and late fees are recorded on the date of collection.
Loans in foreclosure, loans considered impaired or loans past due 90 days or more are placed on a non-accrual status. If a mortgage loan is determined to be on non-accrual status, the mortgage loan does not accrue any revenue into the Consolidated Statements of Earnings. The loan is independently monitored and evaluated as to potential impairment or foreclosure. If delinquent payments are made and the loan is brought current, then the Company returns the loan to active status and accrues income accordingly. The Company currently has no loans past due 90 days which are accruing interest. As a result of the economic climate change induced by the COVID-19 virus, various mortgage loan borrowers of the Company requested a temporary forbearance of principal payments on loans in the range of three to nine months. During 2020, there were eight loans representing an aggregate principal balance of $29.2 million with borrowers meeting specified criteria of the Company that forbearance terms were agreed to. At December 31, 2020, only one of these loans with a principal balance of $4.7 million remained in forbearance.
The Company had no mortgage loans past due six months or more at December 31, 2020 or 2019. There was no interest income that was not recognized in 2020, 2019 or 2018.
The Company's direct investments in real estate total approximately $33.8 million at December 31, 2020 and $34.6 million at December 31, 2019, and consist primarily of income-producing properties which are being operated by a wholly owned subsidiary of National Western. Included in the amounts at December 31, 2020 and 2019 is a surface parking property owned by Ozark National which it contracts out for rent. The value of this real estate investment was appraised at $4.3 million at January 31, 2019 as part of the purchase accounting done as of that date. The Company recognized operating income on these properties of approximately $2.9 million, $2.9 million and $2.2 million for the years ended December 31, 2020, 2019 and 2018, respectively. The Company monitors the conditions and market values of these properties on a regular basis and makes repairs and capital improvements to keep the properties in good condition. The Company recorded net realized investment gains of $2.7 million, $6.9 million and $1.8 million associated with real estate investments in the years ended December 31, 2020, 2019 and 2018, respectively. Net realized investment gains for the year ended December 31, 2020 pertain to property located in Travis County, Texas which was sold. Included in net realized investment gains during 2019 are the sale of the Company's former home office facility in Austin, Texas at a gain of $3.2 million and the sale of the Company's two nursing home facilities at a net gain of $3.7 million.
Although the call options are employed to be effective hedges against the Company’s policyholder obligations from an economic standpoint, they do not meet the requirements for hedge accounting under GAAP. Accordingly, the call options are marked to fair value on each reporting date with the change in fair value, plus or minus, included as a component of net investment income. The change in fair value of the call options includes the realized gains or losses recognized at the expiration of the option term and the unrealized gain or loss changes in fair value for open contracts.
A gradual increase in interest rates from current levels would generally be a positive development for the Company. Rate increases would be expected to provide incremental net investment income, produce increased sales of fixed rate products, and limit the potential erosion of the Company’s interest rate spread on products due to minimum guaranteed crediting rates in products. Alternatively, a rise in interest rates would reduce the fair value of the Company’s investment portfolio and if long-term rates rise dramatically within a relatively short time period the Company could be exposed to disintermediation risk. Disintermediation risk is the risk that policyholders will surrender their policies in a rising interest rate environment forcing the Company to liquidate assets when they are in an unrealized loss position.
Changes in interest rates typically have a sizable effect on the fair values of the Company's debt securities. During 2020, the market interest rate of the ten-year U.S. Treasury bond decreased roughly 100 basis points from 1.92% at year-end 2019 to 0.92% at year-end 2020. Therefore, the dollar increase in the unrealized gain position was primarily the result of the decrease in interest rate levels.
Mortgage and other loans were modeled by discounting scheduled cash flows through the scheduled maturities of the loans, starting with interest rates currently being offered for similar loans to borrowers with similar credit ratings. Policy loans were modeled by discounting estimated cash flows using U.S. Treasury Bill interest rates as base rates at December 31, 2020. The estimated cash flows include assumptions as to whether such loans will be repaid by the policyholders or settled upon payment of death or surrender benefits on the underlying insurance contracts and incorporate both Company experience and mortality assumptions associated with such contracts.
The above described scenarios produce estimated changes in cash flows as well as cash flow reinvestment projections. Estimated cash flows in the Company's model assume cash flow reinvestments, which are representative of the Company's current investment strategy. Calls and prepayments include scheduled maturities and those expected to occur which would benefit the security issuers. Assumed policy surrenders consider differences and relationships between credited interest rates and market interest rates as well as surrender charges on individual policies. The impact to earnings also includes the expected effects on amortization of deferred policy acquisition costs. The model considers only annuity and supplemental contracts in force at December 31, 2020, and does not consider new product sales or the possible impact of interest rate changes on sales.
In connection with the Company’s use of call options to hedge the equity return component of its fixed-indexed annuity and life products, the Company is exposed to the risk that a counterparty fails to perform under terms of the option contract. The Company purchases one-year option contracts from multiple counterparties and evaluates the creditworthiness of all counterparties prior to the purchase of the contracts. For consideration in contracting with a counterparty the rating required by the Company is a credit rating of “A” or higher. Accordingly, all options are purchased from nationally recognized financial institutions with a demonstrated performance for honoring their financial obligations and possessing substantial financial capacity. In addition, each counterparty is required to execute a credit support agreement obligating the counterparty to provide collateral to the Company when the fair value of the Company’s exposure to the counterparty exceeds specified amounts. Counterparty credit ratings and credit exposure are monitored continuously by National Western’s Investment department with adjustments to collateral levels managed as incurred under the credit support agreements.
Liquidity requirements are met primarily by funds provided from operations. Premium deposits and annuity considerations, investment income, and investment maturities and prepayments are the primary sources of funds while investment purchases, policy benefits in the form of claims, and payments to policyholders and contract holders in connection with surrenders and withdrawals as well as operating expenses are the primary uses of funds. To ensure the Company will be able to pay future commitments, the funds received as premium payments and deposits are invested in high quality investments, primarily fixed income securities. Funds are invested with the intent that the income from investments, plus proceeds from maturities, will meet the ongoing cash flow needs of the Company. The approach of matching asset and liability durations and yields requires an appropriate mix of investments. Although the Company historically has not been put in the position of having to liquidate invested assets to provide cash flow, its investments consist primarily of marketable debt securities that could be readily converted to cash for liquidity needs. National Western maintains a line of credit facility of $75 million which it may access for short-term cash needs. As part of the acquisition of Ozark National and NIS effective January 31, 2019, National Western borrowed $75 million to partly fund the closing cash purchase price of $205.4 million. The amounts borrowed were subsequently repaid during the first quarter of 2019 and there have been no borrowings under the line of credit since that time including as at December 31, 2020.
The above contractual withdrawals, as well as the level of surrenders experienced, and the associated cash outflows did not have an adverse impact on overall liquidity. The amount shown for traditional life in 2020 and 2019 includes Ozark National cash outflows (subsequent to their acquisition on January 31, 2019). Individual life insurance policies are typically less susceptible to withdrawal than annuity reserves and deposit liabilities because policyholders may need to undergo a new underwriting process in order to obtain a new insurance policy elsewhere. Annuity dollar outflows are generally more sensitive to economic conditions, interest rate levels, and the level of surrender charges assessed upon withdrawal or termination. Cash flow projections and tests under various market interest rate scenarios and assumptions are performed to assist in evaluating liquidity needs and adequacy. With economic decline precipitated by the COVID-19 pandemic, Company management conducted additional liquidity scenario testing during 2020 using more severe assumptions and concluded that liquid assets were more than adequate under these scenarios. Accordingly, the Company currently expects available liquidity sources and future cash flows to be more than adequate to meet the demand for funds.
The Company relies on stockholders for its capital resources as there is no long-term debt outstanding and the Company does not anticipate the need for any long-term debt in the near future. As of December 31, 2020, the Company maintained commitments for its normal operating and investment activities. During the first quarter of 2020, National Western became a member of the Federal Home Loan Bank of Dallas (FHLB) through an initial minimum required stock investment of $4.3 million. Through this membership, National Western will have a specified borrowing capacity based upon the amount of collateral it establishes.
The National Association of Insurance Commissioners ("NAIC") has established risk-based capital ("RBC") standards for U.S. life insurers as well as a risk-based capital model act ("RBC Model Act"). The RBC Model Act requires that life insurers annually submit a report to state regulators regarding their RBC amounts based upon four categories of risk (asset risk, insurance risk, interest rate risk, and business risk). The capital requirement for each is determined by applying factors that vary based upon the degree of risk to various asset, premium and policy benefit reserve items. The formula is an early warning tool to identify potential weakly capitalized companies for purposes of initiating further regulatory action. Independent rating agencies utilize proprietary versions similar to the NAIC RBC model incorporating additional risk factors identified in their respective rating methodology. At December 31, 2020, National Western and Ozark National each maintained statutory capital substantially in excess of applicable statutory requirements.
Insurance reserves are the means by which life insurance companies determine the liabilities that must be established to assure that future policy benefits are provided for and can be paid. These reserves are required by law and based upon standard actuarial methodologies to ensure fulfillment of commitments guaranteed to policyholders and their beneficiaries, even though the obligations may not be due for many years. Refer to Note (1) Summary of Significant Accounting Policies in the accompanying Notes to Consolidated Financial Statements in this report for a discussion of reserving methods.
(1) Refer to Note (17) Commitments and Contingencies in the accompanying Notes to Consolidated Financial Statements in this report relating to Company leases.
Refer to Note (1), Summary of Significant Accounting Policies in the accompanying Notes to Consolidated Financial Statements in this report.