A summary of operating results, net of taxes, for the years ended December 31, 2002, 2001, and 2000 is provided below:
Net investable cash flow is primarily invested in investment grade debt securities. With the steady continued decline in interest rate levels during 2002, this was even more the case as the market for mortgage loans fell below the Company's required yield levels for this type of investment. Despite the drop in interest rate levels, the Company generated comparable higher net investment earnings. Increased earnings related to debt securities is due to the asset balance continuing to increase year to year. In addition, investment expenses have remained relatively low for 2002 and 2001.
The losses from index options in 2000-2002 were due to poor stock market conditions, specifically the performance of the S&P 500 Index®. Index options are intended to act as hedges to match closely the returns on the S&P 500 Index®. With the decline in this index, the index option values likewise declined. While income from index options was lower, the contract interest expense for the Company's equity-indexed annuities was also substantially lower.
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. Recognition of these deferred policy acquisition costs in the financial statements is to occur over future periods in relation to the 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 revisit 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 profits pattern is to be "unlocked" and reset based upon the actual experience. In 2001, the Company revisited its assumptions regarding the emergence of profits of its business and determined that unlocking was required to incorporate improved persistency with respect to its annuity block of business and to factor in the recent realized investment loss experience. The outcome of these revisions resulted in the amortization of deferred policy acquisition costs decreasing to $27.4 million in 2001. No assumption changes were made related to the amortization of these costs in 2002. While the Company is required to evaluate its emergence of profits continually, management believes that the current amortization patterns of deferred policy acquisition costs are reflective of actual experience.
Other operating expenses consist of general administrative expenses, licenses and fees, and commissions not subject to deferral. As noted with Other Revenues, the Company commenced its nursing home operations in 2000 and these expenses are included in other operating expenses in the amount of $5.4 million, $4.8 million, and $1.3 million in 2002, 2001, and 2000, respectively. The Company's operating expenses in 2002 include increases associated with its significant upturn in new business. Increases were also incurred with respect to the Company's employee benefit plans as a result of higher health plan utilization and underperforming investment experience supporting defined benefit pension plan obligations.
A summary of segment earnings from continuing operations for the years ended December 31, 2002, 2001, and 2000 is provided below. The segment earnings exclude realized gains and losses on investments, net of taxes.
The Company's U.S. operations have historically emphasized annuity product sales over life product sales. Consequently, domestic life revenues have been declining for several years. It is the Company's goal to increase domestic life product sales through increased recruiting of new distribution and the development of new life insurance products.
The Company's international life operations have been a significant part of the Company's operations as evidenced by the growth in collected premiums. International sales increased in 2002 due to new contracted distribution in several markets who were attracted to National Western given the Company's longstanding reputation for supporting its international life products and the instability of competing companies in international markets. In addition, the Company released its first equity-indexed universal life product for international life operations early in 2002 which was well received by its independent distribution with approximately $10 million in first year sales. Management expects continued growth internationally but at a steadier pace than the rapid increase experienced in 2002.
Revenues from annuity operations include primarily surrender charges and recognition of deferred revenues relating to immediate or payout annuities. A comparative detail of the components of premiums and annuity contract revenues is provided below.
As previously noted, the Company's earnings are dependent upon annuity contracts persisting or remaining inforce. While revenues decline with a reduction in surrender charges, the Company's earnings benefit.
Deposits collected on annuity contracts are not reflected as revenues in the Company's statements of earnings in accordance with generally accepted accounting principles. Actual annuity deposits collected are detailed below.
The Company unlocked its deferred policy acquisition cost amortization factors in 2001 for changes in persistency of the annuity block of business and for changes in investment earnings. As the unlocking of amortization factors is applied back to the inception of all policies, it had the affect of increasing 2001 operating earnings significantly. No changes were made in amortization factors in 2002. The Company is required to periodically adjust these factors for actual experience that varies from assumptions. While management does not currently anticipate any impact from unlocking in 2003, facts and circumstances may arise in the future which require that the factors be reexamined.
This emphasis is reflected in the high average credit rating of the Company's portfolio. In the table below, investments in debt securities are classified according to credit ratings by Standard and Poor's (S&P®), or other nationally recognized statistical rating organizations if securities were not rated by S&P®:
As part of its normal assessment of other than temporary impairments of investments, it was determined by the Company during 2002 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 is closely monitoring its other below investment grade holdings. While additional losses are not currently anticipated based on the existing status and condition of these securities, continued credit deterioration of some securities is possible, which may result in further writedowns.
The Company is required to classify its investments in debt and equity securities into one of three categories: (a) trading securities, (b) securities available for sale, or (c) securities held to maturity. The Company purchases securities with the intent to hold to maturity and accordingly does not maintain a portfolio of trading securities. Of the remaining two categories, available for sale and held to maturity, the Company makes a determination 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, 2002, approximately 31% of the Company's total debt and equity securities, based on fair values, were classified as securities available for sale. These holdings 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.
In conjunction with the required implementation of Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities, during 2001 the Company was permitted to reclassify securities previously included as held to maturity to available for sale with an aggregate amortized cost of $294 million. The net unrealized losses on the transferred securities totaled $5,148,000, after the effects of deferred taxes and deferred policy acquisition costs. This adjustment was reflected in the Company's consolidated financial statements in other comprehensive income as part of the cumulative effect of a change in accounting principle as of January 1, 2001.
During 2002, the Company transferred securities with an amortized cost of $29,109,000 from held to maturity to available for sale due to significant credit deterioration resulting in $1,358,000 net unrealized losses reported as a separate component in accumulated other comprehensive income.
The Company held net investments in mortgage loans totaling $168,634,000 and $185,057,000 at December 31, 2002 and 2001, respectively. The diversification of the portfolio by geographic region and by property type was as follows:
The Company does not recognize interest income on loans past due three months or more. At December 31, 2002 and 2001, the Company had mortgage loan principal balances past due three months or more of $6,949,000 and $3,014,000, respectively. Interest income not recognized for past due loans totaled approximately $276,000, $184,000 and $252,000 during 2002, 2001, and 2000, respectively.
The Company currently holds two mortgage loans on properties in which Kmart is the tenant totaling $16.8 million at December 31, 2002. Kmart Corporation filed for bankruptcy protection and intends to close over 300 stores. The loans held by the Company are current as to principal and interest payments and are therefore not considered impaired as of December 31, 2002. The appraised value of the underlying real estate on these loans is well in excess of the loan amount outstanding at year end.
Accounting policies discussed below are those considered critical to an understanding of the Company's financial statements.
Future Policy Benefits: Because of the long-term nature of insurance contracts, the Company is liable for policy benefit payments many years into the future. The liability for future policy benefits represents estimates of the present value of the Company's expected benefit payments, net of the related present value of future net premium collections. For traditional life insurance contracts, this is determined by standard actuarial procedures, using assumptions as to mortality (life expectancy), morbidity (health expectancy), persistency, and interest rates, which are based on the Company's experience with similar products. The assumptions used are those considered to be appropriate at the time the policies are issued. An additional provision is made on most products to allow for possible adverse deviation from the assumptions assumed. For universal life and investment annuity products, the Company's liability is the amount of the contract's account balance. Account balances are also subject to minimum liability calculations as a result of minimum guaranteed interest rates in the policies. While management and company actuaries have used their best judgment in determining the assumptions and in calculating the liability for future policy benefits, there is no assurance that the estimate of the liabilities reflected in the financial statements represents the Company's ultimate obligation. In addition, significantly different assumptions could result in materially different reported amounts. A discussion of the assumptions used to calculate the liability for future policy benefits is reported in Note 1, Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements.
See Attachment A, Index to Financial Statements and Schedules, on page ___.