The Company leases approximately 72,000 square feet of office space in Austin, Texas. This lease expires in 2010 and specifies lease payments that gradually increase over the term of the lease. Currently, lease payments are $0.6 million per year plus taxes, insurance, maintenance, and other operating costs. Additionally, the Company's wholly owned subsidiary, The Westcap Corporation, owns two buildings adjacent to the Company's principal office space totaling approximately 21,000 square feet that are leased and utilized by the Company. The Company's affiliate, Regent Care Building, Limited Partnership, owns a 46,000 square foot building in Reno, Nevada, which is leased and utilized by another of the Company's affiliates, Regent Care Operations, Limited Partnership, for use in its nursing home operations. Lease costs and related operating expenses for facilities of the Company's subsidiaries are currently not significant in relation to the Company's consolidated financial statements. The intercompany lease costs related to The Westcap Corporation and the nursing home have been eliminated for consolidated reporting purposes.
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 2005, incorporating required disclosures in accordance with the rules and regulations of the Securities and Exchange Commission.
Revenue Recognition. Premium income for the Company's traditional life insurance contracts is generally recognized as the premium becomes due from policyholders. For annuity and universal life contracts, the amounts collected from policyholders are considered deposits and are not included in revenue. For these contracts, fee income consists of policy charges for policy administration, cost of insurance charges and surrender charges assessed against policyholders' account balances which are recognized in the period the services are provided.
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 Notes to Consolidated Financial Statements and the discussions under Investments in Item 7 of this report.
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, based on the input of the plan's investment advisors and consulting actuary and the plan's historic rate of return. 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.
Other income consists primarily of revenues associated with nursing home operations of $8.9 million, $8.3 million, and $6.9 million in 2005, 2004, and 2003, respectively. A lawsuit settlement of $2.2 million was awarded to the Company relating to an investment previously owned and is included in other income for 2004.
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 $30.0 million, $24.7 million, and $26.8 million for 2005, 2004, and 2003, respectively.
Amortization of deferred policy acquisition costs reported were $88.0 million, $88.7 million, and $53.8 million in 2005, 2004, and 2003, respectively. Deferred amortization in 2005 includes an "unlocking" adjustment relative to future spreads, surrender charges and ultimate valuation rates on certain annuity products resulting in an increase in amortization of $1.3 million. Unlocking adjustments were also made during 2003 and 2004 pertaining to the annuity line of business and the expected emergence of future profits which also resulted in increased deferred policy acquisition costs amortization. While the Company is required to continually evaluate its emergence of profits, management believes that the current amortization patterns of deferred policy acquisition costs are reflective of actual experience. See additional discussions of amortization relative to the Company's lines of business included in the segment discussion following this section.
Contract interest also includes the performance of the derivative component of the Company's equity-indexed products. As previously noted, the recent market performance of these derivative features decreased contract interest expense while also decreasing the Company's investment income given the hedge nature of the options. During 2004 and 2003, the reverse was noted, as the S&P 500 Index
® performance was up resulting in higher investment income and contract interest expense. With these credited rates, the Company generally realized its targeted interest spread on its products.
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 $7.6 million, $7.2 million, and $6.0 million in 2005, 2004, and 2003, 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.
Life and other policy benefits totaled $21.2 million in 2005, $16.6 million in 2004, and $17.9 million in 2003, which are consistent with Company expectations. Amortization of deferred policy acquisition costs was $20.4 million, $21.8 million, and $12.1 million for 2005, 2004, and 2003, 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 and 2005. The decrease in universal life contract interest is primarily the result of the decrease in the S&P 500 Index® performance relative to the equity-indexed universal life products and the associated stock market losses in 2005 which decreased the amounts the Company in turn credited to policyholders. Contract interest expense was $18.1 million, $18.6 million, and $17.8 million in 2005, 2004, and 2003, respectively.
The Company experienced a tremendous increase in sales relating to equity-indexed annuities as the stock market rebounded in 2003 and 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 53.5%, 57.5%, and 40.1% for the years ended December 31, 2005, 2004, and 2003, 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 increase in net investment income, excluding derivatives from 2003 to 2005, is due to the increase in the overall size of the asset portfolio as a result of higher sales volume.
Amortization of deferred policy acquisition costs in 2005 of $61.8 million includes an unlocking adjustment of $1.3 million. Adjustments were made in the assumptions relative to the future spreads on certain equity-index annuity products; modified surrender charges on certain annuities to reflect continuing lower new money rates; and reduced ultimate valuation rates for pay out on annuitization under all annuities. These adjustments resulted in a decrease to the deferred asset balance and an increase in amortization.
Contributing to amortization in 2003 and 2004 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. 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 2006, facts and circumstances may arise in the future which require that the factors be reexamined.
In comparison to 2005, the 2004 and 2003 higher reported contract interest amount for equity-indexed annuities is due to increased sales and the effect of the positive performance of the stock market on option values as noted previously. In addition, the 2004 contract interest figures include an increase of $2.3 million for certain contractholder account balances as part of a lawsuit settlement.
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 $3.9 million, pre-tax, annually in 2005 and $3.7 million in 2004 and 2003.
In addition to diversification, an important aspect of the Company's investment approach is managing the credit quality of its investments in debt securities. Thorough credit analysis is performed on potential corporate investments including examination of a company's credit and industry outlook, financial ratios and trends, and event risks. This emphasis is reflected in the high average credit rating of the Company's portfolio with 96.8% held in investment grade securities. 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®.
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 2005, the Company's percentage of below investment grade securities compared to total invested assets increased from 2.6% to 3.1% as of December 31, 2004 and 2005, respectively. The increase from year to year is primarily due to downgrades on several issues. The Company's holdings of below investment grade securities as a percentage of total invested assets is relatively small compared to industry averages. These holdings are summarized below.
As part of the Company's review for other-than-temporary impairments of investments, the Company determined during 2005 and 2004 that it held investments in several issuers whose decline in value was considered other-than-temporary and these holdings were written down and included as realized losses on investments as follows:
In accordance with the provisions of SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, the Company may under certain conditions transfer a debt security from held to maturity to available for sale. For the twelve months ended December 31, 2005 and 2004, the Company transferred debt securities due to credit deterioration from the held to maturity portfolio to the available for sale portfolio in the amount of $7.0 million and $35.9 million, respectively. The unrealized gains associated with the security transferred in 2005 and the two securities transferred in 2004 totaled $0.2 million for both periods and were recorded as a component of accumulated other comprehensive income, net of deferred acquisition costs and taxes. During 2005, two securities were sold from the held to maturity portfolio due to credit deterioration, with amortized cost of $10.0 million resulting in a realized gain of $0.9 million. During 2004, bonds were sold from the held to maturity portfolio due to credit deterioration with amortized book value of $8.1 million with the sales resulting in realized gains of $0.6 million.
The Company's direct investments in real estate are not a significant portion of its total investment portfolio as many of these investments were acquired through mortgage loan foreclosures. The Company also participates in several real estate joint ventures and limited partnerships that invest primarily in income-producing retail properties. These investments have enhanced the Company's overall investment portfolio returns.
The Company does not recognize interest income on loans past due six months or more. At December 31, 2005 and 2004 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 2005 or 2003.
Changes in interest rates typically have a significant impact on the fair values of the Company's debt securities. During 2005 market interest rates of the ten-year U.S. Treasury bond increased 17 basis points from year end 2004 resulting in an unrealized loss of $142.9 million on a portfolio of approximately $5.2 billion. The Company would expect similar 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.
The following table illustrates the market risk sensitivity of the Company's interest rate-sensitive assets. The table shows the effect of a change in interest rates on the fair value of the portfolio using models that measure the change in fair value arising from an immediate and sustained change in interest rates in increments of 100 basis points.
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, 2005, and does not consider new product sales or the possible impact of interest rate changes on sales.
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 adopted SOP 03-3 as of the beginning of fiscal year 2005. This SOP did not have a material impact on the consolidated financial statements.
As of December 31, 2005, the Company held debt securities with an outstanding balance of $17.6 million and a carrying value of $17.3 million accounted for in accordance with Statement of Position 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer ("SOP 03-3"). For the year ended December 31, 2005, an impairment of $0.2 million was recorded related to one debt security. The Company does not acquire securities meeting the requirements of this SOP 03-3 at the time of purchase; however, securities that have credit deterioration subsequent to purchase may require reporting under this accounting standard.
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 original effective date set by the FASB was to begin with the first fiscal quarter after June 15, 2005. The Securities and Exchange Commission announced on April 14, 2005 a six month postponement of FAS 123(R) which requires companies to apply the accounting standard beginning with the first fiscal year after June 15, 2005. The adoption of Statement No. 123(R) is not expected to have a material impact on the consolidated financial statements of the Company.
In September 2005, the AICPA issued Statement of Position 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts ("SOP 05-1"). The SOP 05-1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in FASB No. 97. The SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights, or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. The SOP 05-1 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006, with earlier adoption encouraged. The adoption of SOP 05-1 is not expected to have a material impact on the consolidated financials statements of the Company.
In July 2003, the American Institute of Certified Public Accountants issued Statement of Position 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts ("SOP 03-1"). SOP 03-1 provides guidance relating to the reporting by insurance enterprises for certain contracts and insurance specific accounting issues and is effective for financial statements for fiscal years beginning after December 15, 2003. In the first quarter of 2004, the Company adopted the reserving method for its two-tier annuity products, which were issued from 1984 until 1992, in accordance with the SOP 03-1 guidance. The new reserving method under SOP 03-1 requires that the Company hold a reserve equal to the cash surrender value and establish an additional liability for expected annuitizations. The Company previously maintained reserves for two-tier annuities at the account balance value which is substantially higher than the cash value reserve. This reserving change resulted in an adjustment decreasing reserves, less deferred acquisition costs written off, by $54.7 million, net of taxes. The amount is reflected as a change in accounting principle as of January 1, 2004. Components of the accounting change are detailed below.
At December 31, 2005, the Company held a reserve relating to two-tier annuities in the amount of $20.9 million as an additional liability relating to annuitization benefits. The expected annuitizations were determined based upon actual experience relating to this block of business, which is relatively seasoned and the policies are no longer issued by the Company. The issuance of this SOP did not impact the Company's accounting relating to sales inducements.