National Western markets and distributes its domestic products primarily through independent marketing organizations (IMOs). These IMOs assist the Company in recruiting, contracting, and managing agents. The Company currently has over 80 IMOs contracted for sales of life and annuity products. This represents a significant increase from 1997, as numerous organizations were added in 1998 that should be able to meet the Company's minimum production standards.
In addition to the life insurance business, the Company had a brokerage operations segment through its wholly owned subsidiary, The Westcap Corporation (Westcap). However, during 1995 Westcap closed its sales offices and approved a plan to cease all brokerage operations. Subsequently on April 12, 1996, Westcap and its wholly owned subsidiary, Westcap Enterprises, Inc., separately filed voluntary petitions for reorganization under Chapter 11 of the U.S. Bankruptcy Code. The bankruptcy reorganization was completed in January, 1999, National Western retained 100% continuing ownership of the reorganized Westcap, and the subsidiary is now operating as a real estate management company. However, the brokerage segment is reported as discontinued operations throughout this report and in the accompanying financial statements.
Securities that are not classified as held to maturity are reported as securities available for sale. These securities may be sold if market or other measurement factors change unexpectedly after the securities were acquired. For example, opportunities arise that allow the Company to improve the performance and credit quality of the investment portfolio by replacing an existing security with an alternative security while still maintaining an appropriate matching of expected maturities of assets and liabilities. Examples of such improvements are as follows: improving the yield earned on invested assets, improving the credit quality, changing the duration of the portfolio, and selling securities in advance of anticipated calls or other prepayments. Securities available for sale are reported in the Company's financial statements at fair value. Any unrealized gains or losses resulting from changes in the fair value of the securities are reflected in accumulated other comprehensive income.
As an integral part of its investment philosophy, the Company performs an ongoing process of monitoring the creditworthiness of issuers within the investment portfolio. Review procedures are also performed on securities that have had significant declines in fair value. The Company's objective in these circumstances is to determine if the decline in fair value is due to changing market expectations regarding inflation and general interest rates or other factors. Additionally, the Company closely monitors financial, economic, and interest rate conditions to manage prepayment and extension risks in its mortgage-backed securities portfolio.
The Company's overall conservative investment philosophy is reflected in the allocation of its investments which is detailed below as of December 31, 1998 and 1997. The Company emphasizes investment grade debt securities, with smaller holdings in mortgage loans and real estate.
The Company's commitment to high quality investments in debt securities is also reflected in the portfolio's high average credit rating. In the table below, investments in debt securities are classified according to credit ratings by Standard and Poor's (S&P), a nationally recognized statistical rating organization (NRSRO). If securities were not rated by S&P, the equivalent rating of another NRSRO or the National Association of Insurance Commissioners was used.
As reflected above, changes in interest rates of 100 basis points or even less can have a significant impact on the market values of the Company's debt securities. The Company would expect similar results in the future from any significant upward or downward movement in market rates. However, because the majority of the Company's debt securities are classified as held to maturity, the changes in market values have had relatively small effects on the Company's financial statements.
The above-described scenario produces 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 investment annuity and supplemental contracts in force at December 31, 1998, and does not consider new product sales or the possible impact of interest rate changes on sales.
The Company's direct investments in real estate are not a significant portion of its total investment portfolio, and the majority of real estate owned was acquired through mortgage loan foreclosures. However, the Company also participates in several real estate joint ventures and limited partnerships. The joint ventures and partnerships invest primarily in income-producing retail properties. While not a significant portion of the Company's investment portfolio, these investments have produced favorable returns and significantly increased investment income in 1996 as several of these interests in real estate joint ventures were sold. The sales resulted in additional investment income totaling approximately $2,300,000 in 1996. No real estate joint ventures were sold in 1997 or 1998.
The Company held net investments in mortgage loans totaling $174,921,000 and $181,878,000, or 5.6% and 6.3% of total invested assets, at December 31, 1998 and 1997, respectively. The loans are real estate mortgages, substantially all of which are related to commercial properties and developments and have fixed interest rates.
The diversification of the mortgage loan portfolio by geographic region of the United States and by property type as of December 31, 1998 and 1997, was as follows:
As of December 31, 1998, the allowance for possible losses on mortgage loans was $4,640,000. No additions were made to the allowance during 1998. Additions to the allowance totaling $1,133,000 were recognized as realized losses on investments in the Company's 1997 financial statements. Management believes that the allowance for possible losses is adequate. However, while management uses available information to recognize losses, future additions to the allowance may be necessary based on changes in economic conditions, particularly in the West South Central region which includes Texas, Louisiana, Oklahoma, and Arkansas, as this area contains the highest concentrations of the Company's mortgage loans.
The contractual maturities of mortgage loan principal balances at December 31, 1998, are as follows:
The Company monitors the conditions and market values of these properties on a regular basis. The Company makes repairs and capital improvements to keep the properties in good condition and will continue this maintenance as needed. No realized losses were recognized due to declines in values of properties during 1998. However, realized losses recognized due to declines in values of properties totaled $46,000 for the year ended December 31, 1997.
Excluding the nonrecurring items and related tax effects described above, 1998 earnings actually exceeded comparable 1997 earnings by over 17%. The higher earnings are due primarily to increases in universal life and annuity contract revenues, increases in investment income over policy contract interest, and decreases in life insurance benefit claims. Universal life and annuity contract revenues increased almost $3,000,000 from $80,250,000 in 1997 to $83,169,000 in 1998. This increase is almost entirely from increases in cost of insurance revenues. Life insurance benefit claims were lower in 1998, decreasing $2,480,000, or 10.2%, from 1997. The Company also recorded realized gains on investments of $1,550,000 in 1998 compared to realized losses of $1,032,000 in 1997, net of taxes.
Net Investment Income: A detail of net investment income is provided below:
Net investment income from 1996 reflects higher other investment income than 1997 and 1998. The higher income is primarily from gains from real estate joint ventures. NWL Investments I, L.P. sold several real estate joint venture interests during 1996, and the sales resulted in additional investment income totaling $2,300,000.
An analysis of net investment income also involves a review of market interest rates. Interest rates continued to decline in 1998 and 1997 from 1996 rates. Detailed below is the Company's investment performance for 1998, 1997, and 1996, and the changes in the Company's yields reflect the changes in market interest rates. However, changes in market rates affect the Company's portfolio yield slowly because of the relatively small volume of new investment purchases during a year in comparison to the size of the overall investment portfolio. Yields in 1998 and 1997 were also somewhat affected by the change in the mix of the investment portfolio and by lower returns from real estate joint ventures as previously described above. The analysis below excludes index options, as these derivative financial instruments are used solely for hedging purposes for the Company's equity-indexed annuity products. Income from the options directly offset interest credited to policyholders for the equity return component on these products.
Universal Life and Investment Annuity Contract Interest: The Company closely monitors its credited interest rates, taking into consideration such factors as profitability goals, policyholder benefits, product marketability, and economic market conditions. Rates are established or adjusted after careful consideration and evaluation of these factors against established objectives. Average credited rates, calculated based on policy reserves for the Company's universal life and investment annuity business, have declined since 1996, which is consistent with declines in market interest rates. As market interest rates fluctuate, the Company's credited interest rates are often adjusted accordingly, while also taking into consideration other factors as described above. Although credited rates are lower, contract interest increased significantly during 1998. Contract interest totaled $158.9 million, $145.2 million, and $151.5 million in 1998, 1997, and 1996, respectively. The increase is primarily attributable to interest totaling $12,980,000 for the Company's new equity-indexed annuity products. As previously described, the Company purchases index options to provide the potential higher interest to be credited on these products. The income provided by the index options substantially offsets the interest credited to the policyholders. Because of this hedging program, the Company separately analyzes average credited rates on its other products. Excluding the Company's equity-indexed annuity products, average credited rates for 1998, 1997, and 1996 were 5.67%, 5.68%, and 6.15%, respectively. The declines in average credited rates over the past three years is also consistent with the Company's lower yields on average invested assets. The difference between yields earned over credited rates, often referred to as the interest spread, has remained relatively consistent at approximately 2% in 1998, 1997, and 1996.
Although the $14,125,000 settlement was paid by National Western on January 13, 1999, the settlement payment has been reflected in the accompanying 1998 financial statements as a loss from discontinued operations. Any additional losses will depend on the results of The City Colleges lawsuit filed against National Western on March 28, 1994, for alleged federal or state securities law "control person" violations relating to Westcap, and which is pending in the United States District Court, Western District of Texas. National Western believes it has reasonable and adequate defenses to this suit and, accordingly, no amounts have been accrued in National Western's financial statements for potential losses relating to such suit.
Revenues from domestic life insurance operations include life insurance premiums on traditional type products and revenues from universal life insurance. The Company's current marketing efforts focus more on universal life insurance, and, as a result, revenues from these products continue to increase over traditional products. Revenues from traditional products are simply premiums collected, while revenues from universal life insurance consist of policy charges for the cost of insurance, policy administration fees, and surrender charges assessed during the period. A comparative detail of premiums and contract revenues is provided below:
Other income for 1998, 1997, and 1996 totaled $750,000, $43,000, and $375,000, respectively. The significant increase in 1998 was primarily due to proceeds totaling $444,000 received from the U.S. government in 1998 related to previous litigation involving a failed savings and loan institution. The litigation involved the Company's previous investment in bonds of the financial institution and subsequent losses incurred upon its failure. The financial institution had also purchased life insurance from National Western, the cash values of which served as collateral for the bonds.
Other operating expenses increased significantly in 1998, totaling $10.8 million compared to $8.6 million and $6.9 million in 1997 and 1996, respectively. The increase in expenses is due to higher pension expenses from the transfer of the Company's nonqualified defined benefit plan as previously described and other increases primarily in salaries, agent conventions, and marketing related expenses such as travel and printing costs.
The Company's international life insurance operations focus marketing efforts on foreign nationals in upper socioeconomic classes with substantial financial resources. Insurance sales are primarily in countries in Central and South America, the Caribbean, and the Pacific Rim. Marketing to numerous countries in these different regions provides diversification that helps to minimize large fluctuations in sales that can occur due to various economic, political, and competitive pressures that may occur from one country to another. Historically, the top three countries in insurance sales have often been Argentina, Chile, and Peru. Products sold in the international market include both universal life and traditional life insurance products. The Company minimizes exposure to foreign currency risks, as almost all foreign policies require payment of premiums and claims in United States dollars. Sales production from the international market is from independent broker-agents, many of whom have been selling National Western products for 20 or more years.
As with domestic operations, revenues from the international life insurance segment include both premiums on traditional type products and revenues from universal life insurance. The international operations' marketing efforts are also focused more on universal life insurance, and, as a result, revenues from these products continue to increase over traditional products. A comparative detail of premiums and contract revenues is provided below:
Universal life insurance contract interest has increased steadily from $11.9 million in 1996 to $12.6 million and $13.4 million in 1997 and 1998, respectively. The increases in contract interest are consistent with growth in the universal life insurance business. The increases have been tempered somewhat by declines in policyholder credited rates due to declines in market interest rates, which also lower the Company's net investment income.
Amortization of deferred policy acquisition costs were significantly lower in 1996, totaling $10.3 million compared to $13.6 million and $15.8 million in 1997 and 1998, respectively. Increases in anticipated future gross profits resulted in retrospective adjustments to deferred policy acquisition costs which lowered amortization in 1996 relative to 1997 and 1998.
The Company's annuity operations are almost exclusively in the United States. Like the Company's domestic life insurance operations, annuities are marketed in 43 states and the District of Columbia using independent agents, brokers, and independent marketing organizations (IMOs). In fact, many of the agents, brokers, and IMOs that sell life insurance also sell annuities for National Western. For most of these organizations, annuity sales are much more significant and are the primary focus of their business operations. Although some of the Company's annuities are available in the international market, current sales are insignificant to total annuity sales.
Annuities sold include flexible premium deferred annuities, single premium deferred annuities, and single premium immediate annuities. These products can be tax qualified or nonqualified annuities. In recent years the majority of annuities sold have been nonqualified deferred annuities. The Company also continues to collect additional premiums on existing two-tier annuities, as a large portion of the two-tier block of business are flexible premium annuities on which renewal premiums continue to be collected. However, the Company has not sold two-tier annuities since 1992.
Revenues from annuity operations include primarily surrender charges and recognition of deferred revenues relating to immediate or payout annuities. Annuitizations result in transfers of policies from deferred to immediate or payout status. The deferred revenues related to these annuities are amortized into income during the payout period. A comparative detail of the components of premiums and annuity contract revenues is provided below.
Although annuity sales declined in 1996 and 1997 from previous levels, the Company is again experiencing significant growth in annuity production in 1998. The growth is primarily attributable to the Company's new equity- indexed annuities. In fact, the growth has been dramatic, as annuity production increased 79% from $240,987,000 in 1997 to $431,003,000 in 1998.
Net investment income for 1998, 1997, and 1996 totaled $182,347,000, $166,348,000, and $165,943,000, respectively. Amounts for 1997 and 1996 were consistent, as premiums were lower in 1997, impacting invested asset growth. Market interest rates as well as investment yields have also decreased since 1996, tempering investment income increases. The large increase in net investment income in 1998 is due to the substantial increase in premium production, primarily from sales of the Company's new equity-indexed annuities, which resulted in increases in invested assets. Net investment income also includes $8,057,000 of income from index options. Investment income from index options totaled only $18,000 in 1997, as sales of equity- indexed annuities were minimal in 1997.
Annuity contract interest was $129.9 million in 1996 compared to $122.9 million in 1997. As previously described for consolidated operations, the decrease is due to lower average credited rates on policies, which is consistent with declines in market interest rates. While the lower market and credited rates have continued into 1998, annuity contract interest has increased substantially, totaling $135.5 million in 1998. The increase is largely due to increases in annuities in force from sales of equity-indexed annuities and higher credited rates that can be paid on these policies. Contract interest on equity-indexed annuities totaled $12,980,000 in 1998. Amounts for 1997 were insignificant, as sales of these annuities were minimal in 1997. Although contract interest is higher due to equity-indexed annuities, net investment income also includes an additional $8,057,000 from index options which are used to hedge the equity return component of these products. Differences between income from index options and contract interest credited to policyholders will occur for several reasons. The most significant reason is the costs of the index options are essentially amortized against net investment income as the options are marked to fair value each reporting period. The costs of options are covered by additional income earned on debt securities purchased with equity-indexed annuity premiums. Other differences are due to asset fees charged against policyholder contract interest, surrenders and death benefits on annuities within the annual hedging period, and inherent differences between index option fair values and policy liability reserving requirements such as minimum guaranteed interest rates.
Amortization of deferred policy acquisition costs represents the amortization of the costs of acquiring or producing new business, primarily agents' commissions, the majority of which are amortized in direct relation to the anticipated future gross profits of the applicable blocks of business. Amortization is also impacted by the level of policy surrenders. Amortization for 1998, 1997, and 1996 was $21.6 million, $21.3 million, and $14.6 million, respectively. Increases in anticipated future gross profits resulted in retrospective adjustments to deferred policy acquisition costs which lowered the amortization in 1996 relative to 1997 and 1998 amounts. Additionally, increases in policy surrenders since 1996 contributed to higher amortization in 1997 and 1998.
Other operating expenses totaled $15,145,000, $11,223,000, and $11,261,000 for 1998, 1997, and 1996, respectively. Expenses for 1998 were unusually high primarily due to two nonrecurring items as previously described in the summary of consolidated operating results. Additional pension expenses were incurred in 1998 related to the Company's transfer of its nonqualified defined benefit plan to a pension administration firm. Also included in 1998 expenses is a $5,000,000 lawsuit settlement for the Diffie, et al vs. National Western Life Insurance Company and National Annuity Programs, Inc. class action litigation. The litigation involved various issues regarding sales of the Company's annuities.
National Western's primary business encompasses its domestic and international life insurance operations and its annuity operations. However, National Western also has small real estate and other investment operations through the following wholly owned subsidiaries: NWL Investments, Inc., NWL Properties, Inc., NWL 806 Main, Inc., NWL Services, Inc., and NWL Financial, Inc. Earnings for these operations totaled $2,224,000 and $1,821,000 for 1998 and 1997, respectively. Operating results for 1996 reflected losses totaling $425,000. The increase in earnings since 1996 is due to the transfer of an asset from National Western to one of the subsidiaries as described in detail below.
Most of the income from the Company's subsidiaries is from a life interest in the Libbie Shearn Moody Trust. This asset was owned by National Western Life Insurance Company during 1996 but was transferred to NWL Services, Inc., in 1997. Gross income distributions from the Trust totaled $3,451,000, $3,335,000, and $3,252,000 in 1998, 1997, and 1996, respectively. The distributions for 1998 and 1997 were paid to NWL Services, Inc., and, therefore, are included in other operations for these periods. The 1996 distribution was paid to National Western Life Insurance Company. As a result, this income was allocated among the insurance segments, domestic life insurance, international life insurance, and annuity operations, for 1996.
The Company also has significant cash flows from both scheduled and unscheduled investment security maturities, redemptions, and prepayments. These cash flows totaled $159 million, $144 million, and $117 million in 1998, 1997, and 1996, respectively. The Company again expects significant cash flows from these sources in 1999 at levels similar to the past two years.
In October, 1998, the AICPA issued SOP 98-7, "Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk." The SOP specifies classifications for insurance and reinsurance contracts for which deposit accounting is appropriate and specifies accounting methods for each. For each insurance and reinsurance contract accounted for under deposit accounting, a deposit asset or liability should be recognized at inception and should be measured based on consideration paid or received, less any premiums or fees to be retained by the insurer or reinsurer, irrespective of the experience of the contract. The Company anticipates that this SOP will not have a significant effect on its financial statements, as the Company's current insurance and reinsurance contracts all transfer insurance risk. SOP 98-7 is effective for all fiscal years beginning after June 15, 1999. The Company currently plans to implement the SOP in the first quarter of 2000.
The Company currently sells equity-indexed annuities that contain an equity return component for policyholders which is an embedded derivative instrument. The Company purchases index options, which are also derivative instruments, to hedge this equity return component. The index options are reported at fair value in the Company's financial statements, which is in accordance with SFAS No. 133 requirements. The Company also uses a fair value approach in recording policy liabilities for the equity-indexed annuities. However, there is currently no specific, authoritative interpretation of SFAS No. 133 with respect to accounting for equity-indexed annuity liabilities. Additional guidance in 1999 regarding this issue may result in a definitive method significantly different from that currently used by the Company. As a result, the ultimate implementation of SFAS No. 133 could have a significant effect on the Company's results of operations. The Company expects to implement the new statement in the first quarter of 2000.
Regulations that affect the Company and the insurance industry are often the result of efforts by the National Association of Insurance Commissioners (NAIC). The NAIC is an association of state insurance commissioners, regulators, and support staff that acts as a coordinating body for the state insurance regulatory process. The NAIC has recently completed a comprehensive process of codifying statutory accounting practices and procedures. Other than specific individual state laws, the codification results will be the only source of prescribed statutory accounting practices. Insurance companies must adopt these new statutory accounting practices in 2001, which may result in significant changes to existing practices used in the preparation of statutory financial statements. Based on a preliminary review, National Western does not currently anticipate a material impact to its capital and surplus position as a result of implementation of the new prescribed statutory accounting procedures.
The Year 2000 problem, also known as Y2K, is the result of concerns that many computer software systems today cannot distinguish the year 2000 from the year 1900. The Year 2000 problem arose because many existing computer programs use only the last two digits to refer to a year, resulting in these programs' inability to recognize "00" in the date field as the year 2000. If not corrected, many computer systems may be unable to process date-sensitive data accurately beyond the year 1999, resulting in possible system failures or generation of erroneous results. National Western has been cognizant of these problems for many years, as life insurance and annuity products can have very long life spans. Thus, many of our systems have been developed to process and administer our insurance products into the next century. National Western has been working to alleviate or eliminate Year 2000 problems for many years and has assigned the responsibility for the analysis of the problem to its Senior Vice President-Information Services, who deemed the most complete and cost- effective approach to the problem was to use existing staff and facilities. Accordingly, the Company's Year 2000 plan includes staff review and analysis of internal systems, embedded chip technology, and external vendor interfaces as described below.
National Western's primary internal software systems include its policy administration system and investment accounting system. The policy administration system is an important software system for National Western, as it is a comprehensive system involving the following functions: policy issuance, maintenance, and accounting, cash receipts, cash disbursements, general ledger, agent commissions, and various other accounting functions. While this policy administration system was not developed by National Western, several key employees of the National Western Information Services department were involved in the system's original development process. As a result, National Western does not maintain a service agreement with the original developer but, rather, maintains and services the system internally. National Western has performed an assessment of this system regarding Year 2000 issues, which revealed that there is some exposure to insufficient date processing that must be corrected. However, the assessment also revealed that much of the date-sensitive data is already in four-digit format, which avoids the Year 2000 processing problems. Accordingly, National Western commenced a project to perform a comprehensive review of the entire policy administration system. This project has been substantially completed and changes are currently being made to correct any software coding problems. All changes that were made as of December 31, 1998, have been tested and implemented. Testing will continue throughout 1999. Final implementation of any additional necessary system changes is currently planned for mid-year 1999 based on anticipated favorable results of testing.
The Company's investment accounting system is also a critical system, as it provides accounting, analysis, and transaction processing for the Company's bond and stock securities which comprise most of its investments. Like the Company's policy administration system, this system was developed by a third- party software vendor. However, National Western does maintain a product support agreement with the original vendor. Maintenance and changes to this investment system are the responsibility of the vendor in accordance with this support agreement. National Western has addressed Year 2000 issues with the vendor, and the vendor has provided assurance that their system has been subjected to significant review for any problems. The review included assessment, correction, and testing of date-sensitive problems, and the vendor has provided us written acknowledgment that we should encounter no significant Year 2000 related problems. The Company is using the vendor's Year 2000 modified software release for current processing and has not encountered any problems.
The final area of concern is the Company's use of third-party systems or interfaces with vendor systems. National Western's most significant interfaces and uses of third-party vendor systems are in the bank and trust services area. The Company utilizes various banks to handle numerous types of financial transactions. Several of these banks also provide trustee and custodial services for National Western's investment holdings and transactions. These services are critical to a financial service company such as National Western, as its business centers around cash receipts and disbursements to policyholders and the investment of policyholder funds. As a result, National Western has received written confirmation from its vendor banks regarding their status on Year 2000 issues. The banks indicate their dedication to resolving any Year 2000 issues related to their systems and services prior to the critical date. These banks have completed assessments of their exposure to Year 2000 issues and are in problem resolution and testing phases of their Y2K projects.
Based on its analysis, the Company believes it is on schedule with its Year 2000 plan so that any disruptions by Year 2000 will be minimal. National Western recognizes, however, that it is virtually impossible to assure that the Company will be 100% compliant until Year 2000 is here. We anticipate there will be problems that will have to be resolved in the ordinary course of business on and after Year 2000. However, the Company does not believe that the problems will have a material effect on the Company's operations or financial condition. Under a worst case scenario, where systems do not function adequately on or after Year 2000, the Company intends to place all available resources it can to remedy any problems as soon as possible. The resources include National Western staff as well as outside consulting services.
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 used 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, future capital needs, and Year 2000 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.