The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward-looking statements. Certain information contained herein or in other written or oral statements made by or on behalf of National Western Life Insurance Company or its subsidiaries are or may be viewed as forward-looking. Although the Company has taken appropriate care in developing any such information, forward-looking information involves risks and uncertainties that could significantly impact actual results. These risks and uncertainties include, but are not limited to, matters described in the Company's SEC filings such as exposure to market risks, anticipated cash flows or operating performance, future capital needs, and statutory or regulatory related issues. However, National Western, as a matter of policy, does not make any specific projections as to future earnings, nor does it endorse any projections regarding future performance that may be made by others. Whether or not actual results differ materially from forward-looking statements may depend on numerous foreseeable and unforeseeable events or developments. Also, the Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future developments, or otherwise.
Due to the business of accepting funds to pay future obligations in later years, the underlying economics and relevant factors affecting the life insurance industry include the following:
The Company monitors these factors continually as key business indicators. The discussion below includes these indicators and presents information useful to an overall understanding of the Company's business performance in 2004, incorporating required disclosures in accordance with the rules and regulations of the Securities and Exchange Commission.
The Company has experienced record sales both with its annuity products domestically and internationally with its life products over the past several years. The increase in sales has come at a challenging time for the insurance industry with low interest rate levels and increased regulatory requirements. Despite these obstacles, business levels have increased and the Company has effectively managed investment performance, not by taking on additional risks, but with improved overall credit quality of its portfolio of fixed income securities. The Company's financial performance is determined by the execution of its business model, which includes distribution and sale of its products through independent distributors, while maintaining invested values in order to meet future commitments to its policyholders and their beneficiaries.
Pension Plans and Other Postretirement Benefits. The Company sponsors a qualified defined benefit pension plan covering substantially all full-time employees and a nonqualified defined benefit plan primarily for senior officers. In addition, the Company also has postretirement health care benefits for certain senior officers. In accordance with prescribed accounting standards, the Company annually reviews plan asssumptions.
The Company annually reviews its pension benefit plan assumptions which include the discount rate, the expected long-term rate of return on plan assets, and the compensation increase rate. The assumed discount rate is set based on the rates of return on high quality long-term fixed income investments currently available and expected to be available during the period to maturity of the pension benefits. The assumed long-term rate of return on plan assets is generally set at the rate expected to be earned based on long-term investment policy of the plans and the various classes of the invested funds. The compensation rate increase assumption is generally set at a rate consistent with current and expected long-term compensation and salary policy, including inflation. These assumptions involve uncertainties and judgment and therefore actual performance may not be reflective of the assumptions.
The Company's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). In addition, the Company regularly evaluates operating performance using non-GAAP financial measures which exclude or segregate derivative and realized investment gains and losses from operating revenues and earnings. Similar measures are commonly used in the insurance industry in order to assess profitability and results from ongoing operations. The Company believes that the presentation of these non-GAAP financial measures enhances the understanding of the Company's results of operations by highlighting the results from ongoing operations and the underlying profitability factors of the Company's business. The Company excludes or segregates derivative and realized investment gains and losses because such items are often the result of events which may or may not be at the Company's discretion and the fluctuating effects of these items could distort trends in the underlying profitability of the Company's business. Therefore, in the following sections discussing consolidated operations and segment operations, appropriate reconciliations have been included to report information management considers useful in enhancing an understanding of the Company's operations to reportable GAAP balances reflected in the consolidated financial statements.
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. The Company has experienced strong sales growth with its universal life and annuity products, most notably in international universal life products. These sales contribute to higher revenues in the form of cost of insurance charges which were $60.1 million compared to $55.6 million in 2004 and 2003, respectively, and $49.7 million in 2002. Surrender charges assessed against policyholder account balances upon withdrawal were $23.4 million in 2004 compared to $21.6 million in 2003 and $23.1 million in 2002.
Traditional life insurance premiums for products such as whole life and term life are recognized as revenues over the premium-paying period. These are product lines that the Company has not put as much emphasis on relative to interest sensitive products, particularly in its international life insurance operations.
Derivatives. Index options are derivative financial instruments used to fully hedge the equity return component of the Company's equity-indexed products, which were first introduced for sale in 1997. In 2002, the Company began selling an equity-indexed universal life product in addition to its equity-indexed annuities. Any gains or losses from the sale or expiration of the options, as well as period-to-period changes in fair values, are reflected as a component of net investment income. However, increases or decreases in income from these options are substantially offset by corresponding increases or decreases in amounts credited to equity-indexed annuity and life policyholders.
Realized Gains (Losses) on Investments. The net gains reported in 2004 consisted of gross gains of $7.9 million primarily from calls and sales of debt securities during the year and gross losses of $4.4 million resulting from most notably an impairment writedown on Delta Airline debt securities of $3.6 million. In past years, the losses on investments have primarily resulted from impairment writedowns on investments in debt securities. The Company records impairment writedowns when a decline in value is considered other-than-temporary and full recovery of the investment is not expected. Total impairment writedowns in 2004, 2003, and 2002 totaled $3.6 million, $7.2 million, and $17.4 million, respectively. In 2003, the Company recorded impairment writedowns on holdings of American Airlines ($3.1 million), Lukens ($0.8 million) and collaterialized bond obligation ("CBO") investments ($3.3 million). Writedowns in 2002 included WorldCom ($9.6 million), United Airlines ($4.0 million) and CBO investments ($3.8 million).
The Company's mortality experience over the past five years has generally been consistent with its product pricing assumptions. Life and other policy benefits reflect death claims of $24.7 million, $26.8 million, and $22.8 million for 2004, 2003, and 2002, respectively.
Life insurance companies are required to defer certain expenses associated with acquiring new business. The majority of these acquisition expenses consist of commissions paid to agents, underwriting costs, and certain marketing expenses and sales inducements. The Company defers sales inducements in the form of first year interest bonuses on annuity and universal life products that are directly related to the production of new business. These charges are deferred and amortized using the same methodology and assumptions used to amortize other capitalized acquisition costs and the amortization is included in contract interest. Recognition of these deferred policy acquisition costs in the consolidated financial statements is to occur 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 these 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 profit patterns is to be "unlocked" and reset based upon the actual experience.
Other operating expenses consist of general administrative expenses, licenses and fees, commissions not subject to deferral, and expenses of nursing home operations. Nursing home expenses amounted to $7.2 million, $6.0 million, and $5.4 million in 2004, 2003, and 2002, respectively. The Company's operating expenses for the years reported include increases associated with its significant upturn in business levels. In addition, a charge was recorded during 2003 in the amount of $9.7 million relating to a litigation claim where the Company had reached a settlement agreement that had been approved by the court. A reduction in expenses of $6.5 million due to the final accounting related to this lawsuit settlement is reflected in 2004 amounts. In addition, contractholder account balances were increased $2.3 million based on this final settlement.
A summary of segment earnings from continuing operations for the years ended December 31, 2004, 2003, and 2002 is provided below. The segment earnings exclude realized gains and losses on investments, net of taxes.
International operations have emphasized universal life policies over traditional life insurance products. In accordance with generally accepted accounting principles, premiums collected on universal life products are not reflected as revenues in the Company's consolidated statements of earnings. Actual international universal life premiums collected are detailed below.
The Company's international life operations have been a significant contributor to the Company's overall growth and represent a market niche where the Company feels it has a competitive advantage. A productive agency force has been developed given the Company's longstanding reputation for supporting its international life products coupled with the instability of competing companies in international markets. In particular, the Company has experienced sizable growth with its equity-indexed universal life products and has collected premiums of $37.2 million, $21.0 million, and $10.0 million for the years ended 2004, 2003, and 2002, respectively.
Life and other policy benefits totaled $16.6 million in 2004, $17.9 million in 2003, and $15.0 million in 2002, which are consistent with Company expectations. Amortization of deferred policy acquisition costs was $21.8 million, $12.1 million, and $10.5 million for 2004, 2003, and 2002, respectively. Increased amortization in 2004 is due to increased gross profits incurred from greater than expected capital gains, reduced credited rates, and higher costs of insurance charges in 2004 compared to 2003. In addition, the increase in amortization in 2003 over 2002 was a result of a change in expected emergence of profits given the increased sales related to equity-indexed universal life products. The increased sales of this product generated higher gross profits due to the stock market performance. The increase in universal life contract interest is the result of the increased sales of the equity-indexed universal life products and the associated stock market gains which increased the amounts the Company in turn credits to policyholders. Contract interest expense was $18.6 million, $17.8 million, and $16.5 million in 2004, 2003, and 2002, respectively.
International sales continued at a strong pace during 2004 with Brazil, Argentina, and Chile reflecting the top three international countries based on premiums and contract revenues recorded. Management expects sales growth internationally to trend at a steadier pace from the levels reported in recent years. As the international life insurance in force continues to grow, the Company anticipates operating earnings to similarly increase. The amount of international life insurance in force has grown from $8.8 billion at December 31, 2002 to $10.2 billion at December 31, 2003 and to $11.3 billion at December 31, 2004.
As previously noted, the Company's earnings are dependent upon annuity contracts persisting or remaining in force. While revenues decline with a reduction in surrender charges, the Company's earnings benefit. A mandated change in accounting for two-tier annuities in 2004 had the effect of eliminating payout annuity revenues pertaining to this product. This change explains the sharp reduction in these revenues in 2004 compared to 2003 and 2002.
Equity-indexed products sales typically follow the stock market in that sales are higher when confidence is high in the stock market and low if the stock market is performing poorly. The Company experienced a tremendous increase in sales relating to equity-indexed annuities as the stock market rebounded in 2003 and held steady in 2004. These indexed products are more attractive for consumers when interest rate levels remain low as has been the market environment the past few years. Equity-indexed annuity deposits as a percentage of total annuity deposits recorded were 57.5%, 40.1%, and 13.4% for the years ended December 31, 2004, 2003, and 2002, respectively. Since the Company does not offer variable products or mutual funds, equity-indexed products provide an important alternative to the Company's existing fixed interest rate annuity products.
As previously described, derivatives are used to hedge the equity return component of the Company's equity-indexed annuity products with any gains or losses from the sale or expiration of the options, as well as period-to-period changes in fair values, reflected in net investment income. The significant increase in net investment income, excluding derivatives from 2002 to 2004, is due to the increase in the overall size of the asset portfolio as a result of higher sales volume.
Increased amortization of deferred policy acquisition costs in 2003 and more notably in 2004 is due, in part, to the deferral of sales inducement costs. Also contributing to increased amortization is the increased sales of the equity-indexed products and the related increase in the stock market which resulted in higher current gross profits than expected. Consequently, the Company recognized a greater level of amortization expense corresponding with the higher profit level. In addition, higher capital gains in 2004 as compared to 2003, and reductions in credited rates over the same period, resulted in increased amortization. The Company unlocked its deferred policy acquisition costs amortization factors on other annuity products for assumption changes during 2003 and 2004 due to an anticipated decrease in future profit streams. The decrease in expected future profits results from the low interest rate environment which causes a tightening of expected future spreads. No changes were made in amortization factors in 2002. The Company is required to periodically adjust these factors for actual experience that varies from that assumed. While management does not currently anticipate any impact from unlocking in 2005, facts and circumstances may arise in the future which require that the factors be reexamined.
Annuity contract interest includes the equity component return associated with the Company's equity-indexed annuities. The detail of equity-indexed annuity contract interest compared to contract interest for all other annuities is as follows:
National Western's primary business encompasses its domestic and international life insurance operations and its annuity operations. However, the Company also has small real estate, nursing home, and other investment operations through its wholly owned subsidiaries. Most of the income from the Company's subsidiaries is from a life interest in a trust. Gross income distributions from the trust totaled $3.7 million, pre-tax, annually in 2004, 2003, and 2002.
The Company acquired a nursing home facility, which opened in late July, 2000 and is operated by an affiliated limited partnership, whose financial operating results are consolidated with those of the Company. Daily operations and management of the nursing home are performed by an experienced management company through a contract with the limited partnership. Nursing home operations generated $1.1 million, $0.9 million, and $0.7 million of operating earnings in 2004, 2003, and 2002, respectively.
National Western does not purchase below investment grade securities. Investments held in debt securities below investment grade are the result of subsequent downgrades of the securities. During 2004, the Company's percentage of below investment grade securities compared to total invested assets decreased from 3.6% to 2.6% as of December 31, 2003 and 2004, respectively. The decrease from year to year is primarily due to upgrades and reductions in issuer exposure through sales. Fair value of the below investment grade securities improved from December 31, 2003 to 2004 with over 89% of the fair values greater than 94% of amortized cost at December 31, 2004. The Company's holdings of below investment grade securities is a relatively small percentage of total invested assets. These holdings are summarized below.
As part of the Company's review for other-than-temporary impairments of investments, the Company determined during 2004 and 2003 that it held investments in several issuers whose decline in value was considered other-than-temporary and these holdings were written down to fair value and included as realized losses on investments as follows:
The Company does not recognize interest income on loans past due six months or more. At December 31, 2004 and 2003 the Company had no mortgage loan principal balances past due six months or more. Interest income not recognized for past due loans totaled approximately $54,000 in 2004; there was none in 2003.
In the fourth quarter of 2004, an impairment loss of $0.6 million and an additional allowance of $0.4 million was recorded related to a mortgage loan based on information which indicates that the Company may not collect all amounts in accordance with the mortgage agreement. As of December 31, 2003, an allowance for possible losses on mortgage loans was $0.7 million. During the first quarter of 2004, this allowance was released due to a review of anticipated cash flows showing that all principal would be recovered. Management believes that the allowance for possible losses is adequate. While the Company closely manages its mortgage loan portfolio, future changes in economic conditions can result in impairments beyond those currently identified.
The Company's real estate investments totaled approximately $17.2 million and $20.2 million at December 31, 2004 and 2003, respectively, and consist primarily of income-producing properties which are being operated by a wholly owned subsidiary of the Company. The Company recognized operating income on these properties of approximately $1.6 million, $1.8 million, and $1.5 million for the years ended December 31, 2004, 2003, and 2002, 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 $2.2 million and $0.9 million in 2004 and 2003, respectively and net losses of $0.1 million in 2002 associated with these properties.
Changes in interest rates typically have a significant impact on the fair values of the Company's debt securities. However, during 2004 market interest rates of the ten-year U.S. Treasury bond decreased only 3 basis points from year end 2003 causing an insignificant change in the market value. The change in value was an unrealized loss of only $7.9 million on a portfolio of approximately $5 billion. The Company would expect more dramatic results in the future from a significant upward or downward movement in market rates. However, since the majority of the Company's debt securities are classified as held to maturity, which are recorded at amortized cost, changes in fair values have relatively small effects on the Company's financial results.
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 the base rates at December 31, 2004. 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, 2004, and does not consider new product sales or the possible impact of interest rate changes on sales.
In the past, cash flows from the Company's insurance operations have been sufficient to meet current needs. Cash flows from operating activities were $146 million, $69 million, and $127 million in 2004, 2003, and 2002, respectively. Operating cash flows are lower in 2003 due to increased commission payments on annuity deposits which are included in financing activities on the consolidated statements of cash flows. The Company also has significant cash flows from both scheduled and unscheduled investment security maturities, redemptions, and prepayments. These cash flows totaled $440 million, $668 million, and $349 million in 2004, 2003, and 2002, respectively. Cash flows from security maturities, redemptions, and prepayments were relatively higher over the last three years due to the decline in interest rates. These cash flow items could be reduced if interest rates rise in 2005. Net cash flows from the Company's universal life and annuity deposit product operations totaled inflows of $497 million, $839 million and $142 million in 2004, 2003, and 2002, respectively. The net inflows are expected to continue in 2005.
The Company relies on the accumulated earnings in stockholders' equity for its capital resources as it has no long-term debt outstanding and does not anticipate the need for any long-term debt in the near future. There are also no current or anticipated material commitments for capital expenditures in 2005.
In December of 2003, the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer ("SOP 03-3"). SOP 03-3 addresses revenue recognition and impairment assessments for certain loans and debt securities that were purchased at a discount that was at least in part due to credit quality. SOP 03-3 states that where expected cash flows from the loan or debt security can be reasonably estimated, the difference between the purchase price and the expected cash flows (i.e., the "accretable yield") should be accreted into income. In addition, the SOP prohibits the recognition of a reserve for impairment on the purchase date. Further, the SOP requires that the allowance for loan losses be supported through a cash flow analysis, on either an individual or on a pooled basis, for all loans that fall within the scope of the guidance. This SOP is effective for loans acquired in fiscal years beginning after December 15, 2004. The Company will adopt SOP 03-3 as of the beginning of fiscal year 2005 but does not expect this SOP to have a material impact on the consolidated financial statements.
In December 2004, the FASB issued Statement No. 123(R), Share-Based Payment which is a revision of Statement No. 123. Statement No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. We currently use the Black-Scholes-Merton option pricing model to estimate the value of employee stock options and expect to continue to use this acceptable option pricing model upon adoption of Statement No. 123(R). Statement No. 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow rather than as an operating cash flow, as currently required. The adoption of Statement No. 123(R) is not expected to have a material impact on the consolidated financial statements of the Company.