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.
The Company's international operations focus marketing efforts on foreign nationals in upper socioeconomic classes with substantial financial resources. Insurance sales are from 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. Products sold in the international market are almost entirely universal life and traditional life insurance products. However, certain annuity and investment contracts are also available in this market.
International sales production is from broker-agents, many of whom have been selling National Western products for 20 or more years. The Company continues to expand its sales networks in specifically targeted South American and Pacific Rim countries which have higher growth potential than other countries.
At December 31, 1999, the Company's debt and equity securities were classified as follows:
Market risk-sensitive assets of the Company include debt securities, equity securities which are almost entirely preferred stocks, mortgage loans, policy loans, and index options. The Company does not maintain a securities trading portfolio. Market risk-sensitive liabilities include policy liabilities for deferred and immediate investment annuity contracts and supplemental contracts. Sensitivity analysis expresses the potential gain or loss in fair value, over a selected time period, from one or more selected hypothetical changes in interest rates which are reasonably possible in the near term. 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. The data is prepared 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.
Mortgage 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, 1999. 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. As a result, these assumptions incorporate both Company experience and mortality assumptions associated with such contracts.
In addition to the securities analyzed above, the Company invests in index options which are derivative financial instruments used to hedge the equity return component of the Company's equity-indexed annuities. The values of these options are primarily impacted by equity price risk, as the options' fair values are dependent on the performance of the S&P 500 Composite Stock Price Index (S&P 500 Index). However, increases or decreases in investment returns from these options are substantially offset by corresponding increases or decreases in amounts paid to equity-indexed annuity policyholders, subject to minimum guaranteed policy interest rates. An example of this equity price risk is reflected in the decline in the value of the Company's index options during the third quarter of 1999. The S&P 500 Index declined approximately 6.6%, which resulted in a net decrease in investment income totaling $13.1 million for the quarter ended September 30, 1999. Subsequently, during the fourth quarter of 1999, the S&P 500 Index increased significantly, which increased investment income from unrealized mark-to-market gains on the index options and reversed the declines of the previous quarter.
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.
The Company held net investments in mortgage loans totaling $183,902,000 and $174,921,000, or 5.7% and 5.6% of total invested assets, at December 31, 1999 and 1998, respectively. The loans are real estate mortgages, substantially all of which are related to commercial properties and developments and have fixed interest rates.
The Company currently places all loans past due three months or more on nonaccrual status, thus recognizing no interest income on the loans. At December 31, 1999, the Company had mortgage loan principal balances on nonaccrual status of $3,014,000. At December 31, 1998, the Company had no mortgage loans on nonaccrual status. The Company had mortgage loan principal balances with restructured terms totaling $8,572,000 and $12,096,000 at December 31, 1999 and 1998, respectively. For the year ended December 31, 1999, the reductions in interest income due to nonaccrual and restructured mortgage loans totaled approximately $192,000. For the year ended December 31, 1998, the reductions in interest income due to nonaccrual and restructured mortgage loans were not significant.
The contractual maturities of mortgage loan principal balances at December 31, 1999, are as follows:
The Company owns real estate that was acquired through foreclosure and through direct investment totaling approximately $11,388,000 and $13,553,000 at December 31, 1999 and 1998, respectively. This small concentration of properties represents less than one percent of the Company's entire investment portfolio. The real estate holdings consist primarily of income-producing properties which are being operated by the Company. The Company recognized operating income on these properties of approximately $1,037,000 and $740,000 for the years ended December 31, 1999 and 1998, respectively. The increase in operating income is primarily due to the sale of a property in 1999 that had been generating operating losses. While operating income could continue to improve again in 2000, the Company does not anticipate significant changes in overall operating results. Additionally, exclusive of the operating results, the sale of the property also produced a realized gain on investments totaling $1,419,000 in 1999.
Consolidated Operating Results: For the year ended December 31, 1999, the Company recorded net earnings of $59,225,000 compared to net earnings of $34,893,000 and $41,572,000 for 1998 and 1997, respectively. Earnings for 1999 include additional income totaling $5,513,000, net of taxes, from the resolution of pending litigation relating to a former general agency. Additionally, the Company recorded realized gains on investments, net of taxes, totaling $2,912,000 for 1999 compared to gains of $1,550,000 for 1998 and losses of $1,032,000 for 1997. The gains in 1999 were primarily from sales and calls of investments in debt securities and a sale of investment real estate. While earnings for 1999 were significantly higher than the previous years, earnings for 1998 were abnormally low due to several nonrecurring items, the most significant of which was the bankruptcy settlement of the Company's wholly owned subsidiary, The Westcap Corporation, totaling $14,125,000. This settlement was reflected as a loss from discontinued brokerage operations in 1998. Losses on discontinued brokerage operations totaled $1,000,000 in 1997.
The other nonrecurring items affecting earnings for 1998 include a lawsuit settlement and a pension plan related transaction. Parties involved in the Diffie, et al vs. National Western Life Insurance Company and National Annuity Programs, Inc. class action litigation filed a joint motion in District Court for preliminary approval of a settlement agreement among the parties. This settlement was approved by the Court in January, 1999, and, as a result, the Company paid $5,000,000 to settle the litigation. This amount was accrued in the Company's financial statements in 1998, thereby reducing earnings $3,250,000, after taxes. Also during 1998, the Company transferred pension obligations and administrative responsibilities of its nonqualified defined benefit plan to a pension administration firm. The financial effects of the transaction resulted in additional pension expense in 1998 totaling $1,653,000, net of taxes, as the amount paid upon transfer exceeded the recorded pension liabilities as required for financial reporting purposes. However, as a result of the transfer, substantially all future pension and administrative liabilities and expenses under the plan are now the responsibility of the new firm.
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. In 1999, interest rates reversed this trend by increasing significantly. 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. As a result, although yields on new investment purchases did increase during 1999, the Company's overall yield on average invested assets declined from 1998. Yields were also somewhat affected by the change in the mix of the investment portfolio. Mortgage loans have typically had significantly higher yields than the Company's investments in debt securities. However, average mortgage loan holdings in 1997 and 1998 have declined. Also, matured or prepaid mortgage loans are typically replaced with loans with lower interest rates.
Realized Gains and Losses on Investments: The Company realized gains of $4.5 million in 1999 compared to realized gains of $2.4 million in 1998 and losses of $1.6 million in 1997. The gains in 1999 consist primarily of gains from sales and calls of debt securities totaling $6,250,000, offset by permanent impairment writedowns of $4,403,000. The Company also recognized gains totaling $1,963,000 on real estate, the majority of which was from the sale of a real estate property owned by the Company's subsidiary, NWL 806 Main, Inc. The gains in 1998 were primarily from gains on debt securities totaling $1.3 million, substantially all of which related to securities that were called. Realized gains in 1998 also include $300,000 related to a deficiency settlement agreement on a mortgage loan that was foreclosed in 1994. The losses in 1997 were primarily from net losses on debt securities totaling $1.2 million and writedowns on real estate and mortgage loans totaling $1.2 million, primarily related to a single foreclosure.
Contract interest totaled $162.3 million, $158.9 million, and $145.2 million in 1999, 1998, and 1997, respectively. The increase is primarily attributable to interest totaling $20,480,000 and $12,980,000 in 1999 and 1998, respectively, for the Company's 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, subject to minimum guaranteed policy interest rates. 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 1999, 1998, and 1997 were 5.51%, 5.67%, and 5.68%, respectively. The Company's interest rate spread has been approximately 2% in recent years, although this spread has declined slightly in 1999 and 1998 for the reasons previously described above.
Other income for 1999, 1998, and 1997 totaled $40,000, $750,000, and $43,000, 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.
Policy benefits were significantly lower in 1999 totaling $15.5 million compared to $17.9 million and $18.2 million for 1998 and 1997, respectively. These benefits consist primarily of life insurance death claims which are subject to fluctuations from period to period.
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 from 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 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. Cost of insurance revenues continue to increase as the international block of business grows. Additionally, surrender charge revenues were 27.0% higher in 1999 compared to 1998, which corresponds directly to an unusually high increase in universal life insurance policy surrenders of 27.5%. A comparative detail of premiums and contract revenues is provided below:
Actual universal life insurance deposits collected for the years ended December 31, 1999, 1998, and 1997 are detailed below. Deposits collected on these nontraditional products are not reflected as revenues in the Company's statements of earnings, as they are recorded directly to policyholder liabilities upon receipt, in accordance with generally accepted accounting principles. Deposits continue to grow, which corresponds to the previously described increases in cost of insurance revenues.
Other operating expenses totaled $9.4 million, $9.6 million, and $7.7 million in 1999, 1998, and 1997, respectively. The increase in expenses is attributable to the same reasons as previously described for domestic life insurance operations.
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). For most of these organizations, annuity sales are much more significant than life insurance sales 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.
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. Surrender charge revenues were down 13.6% in 1999 compared to 1998 primarily due to reductions in surrender charges from two-tier annuities. Although total annuity policy surrenders were actually up 4.0% from 1998 to 1999, the mix of surrender types was significantly different. While single-tier annuity policy surrenders increased in 1999, two-tier annuity policy surrenders, which typically have much higher surrender charges, declined over 21%. This decline in surrenders and related income from two-tier annuities is not unexpected and could continue, since this is a closed block of business. The Company has not sold two-tier annuities since 1992. A comparative detail of the components of premiums and annuity contract revenues is provided below.
Although sales of these annuities continue to be strong, production declined in 1999 primarily due to volatility in the stock market. This volatility affects both the immediate demand for these annuities and the pricing of these products. Increased product costs from stock market volatility, particularly costs of index options used to hedge the equity return component of these annuities, can reduce potential credited interest to policyholders.
Net investment income for 1999, 1998, and 1997 totaled $191,328,000, $182,347,000, and $166,348,000, respectively. The increases in investment income of 4.9% and 9.6% in 1999 and 1998, respectively, are consistent with the growth in annuity segment assets of 5.7% and 10.8% for the same periods. The large increases in net investment income in 1999 and 1998 over 1997 are due to the substantial increase in premium production, primarily from sales of the Company's equity-indexed annuities, which resulted in increases in invested assets. Net investment income also includes $10,719,000 and $8,057,000 of income from index options for 1999 and 1998, respectively. Income from index options totaled only $18,000 in 1997, as sales of equity- indexed annuities were minimal in 1997.
As a result of the settlement, accrued bonus commissions relating to the NAP contract totaling $8,482,000 were released, as they are no longer considered a liability to NAP and will not be paid. Accordingly, the release of these accrued commissions from liabilities in 1999 resulted in additional income of $8,482,000, before taxes. It is anticipated that any future renewal premiums received by the Company on currently issued and in force annuity policies written by NAP sub-agents under the Contract could generate additional commissions for such sub-agents. The payment of such future commissions is subject to and conditioned upon receipt of such renewal premiums by the Company and compliance by the sub-agents with the terms of the agents' contracts with the Company and NAP.
Annuity contract interest for 1999, 1998, and 1997 totaled $138.6 million, $135.5 million, and $122.9 million, respectively. While general increases in contract interest are expected due to the growth in the size of the annuity block of business, higher interest is also due to increases in equity-indexed annuities in force and the higher credited rates that may be paid on these policies. The increases in 1999 and 1998 are largely due to increases in annuities in force from sales of equity-indexed annuities and higher credited interest that were paid on these policies. Contract interest on equity- indexed annuities totaled $20,480,000 and $12,980,000 in 1999 and 1998, respectively. 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 $10,719,000 and $8,057,000 in 1999 and 1998 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, some of which may only be timing differences between the recognition of income and expenses. One reason is that 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 treatments related to minimum guaranteed interest rates.
In summary, the Company's equity-indexed annuity products are long-term policies with contractual periods of either nine or fifteen years. The Company routinely analyzes the profitability of its equity-indexed annuity products under numerous economic scenarios, including both positive and negative equity market conditions. Although earnings may not be level or constant from period to period for this product due to timing of market conditions and policy liability reserving methods, the Company anticipates the equity-indexed annuities will be profitable over the long-term contractual periods of the policies.
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 1999, 1998, and 1997 was relatively consistent totaling $21.1 million, $21.6 million, and $21.3 million, respectively.
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. Also, during January, 1999, the Company's wholly owned subsidiary, The Westcap Corporation, completed its Chapter 11 bankruptcy reorganization. With the reorganization complete, National Western transferred its investment real estate holdings to Westcap, and the subsidiary is now operating as a real estate management company. Earnings for these other operations totaled $3,238,000, $2,224,000, and $1,821,000 for 1999, 1998, and 1997, respectively. Earnings were higher in 1999 primarily due to income from the real estate properties that were transferred from National Western to Westcap.
In the past, cash flows from the Company's insurance operations have been more than adequate to meet current needs. Cash flows from operating activities were $118 million, $131 million, and $144 million in 1999, 1998, and 1997, respectively. The lower cash flow in 1999 is largely a result of lawsuit and bankruptcy settlement payments as described in detail in Item 3, Legal Proceedings. Net cash flows from the Company's deposit product operations, which include universal life and investment annuity products, totaled $47 million in 1999 and $113 million in 1998. However, these operations incurred net cash outflows in 1997 totaling $51 million. The cash outflows in 1997 were due to low annuity production along with increased policy surrenders. Although surrenders have increased, significant annuity production generated strong positive cash flow in 1999 and 1998.
The Company relies on stockholders' equity for its capital resources, as there has been no long-term debt outstanding in 1999 or recent years. The Company 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 2000.
Stockholders' equity totaled $475.5 million at December 31, 1999, reflecting an increase of $37 million from 1998. The increase in capital is primarily from net earnings of $59 million, reduced by net unrealized losses on investment securities totaling $22 million. The significant decline in values of investment securities is a direct result of increased interest rates at December 31, 1999, which lowered the market values of the Company's holdings in its securities available for sale portfolio. Book value per share at December 31, 1999, was $135.84, reflecting an 8.4% increase for the year.
In June, 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative Instruments and Hedging Activities." In June, 1999, SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133," was issued deferring SFAS No. 133, which will now be effective for all fiscal quarters of all fiscal years beginning after June 15, 2000. SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. The statement defines several designations of derivatives based on the instrument's intended use and specifies the appropriate accounting treatment for changes in the fair value of the derivative based on its resulting designation.
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. The Company's state of domicile, Colorado, is currently in the process of adopting the new codified statutory accounting practices and procedures. 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. The Company will perform a review of the entire newly codified statutory accounting practices and procedures during 2000. This review process may not be fully completed until the latter portion of the year. Based on a preliminary review, National Western does not anticipate a material impact to its capital and surplus position as a result of implementation of the new prescribed statutory accounting procedures.
Due to statutory laws prohibiting public dissemination of certain RBC information, the Company has chosen not to publish its RBC ratios or levels. However, the Company's current statutory capital and surplus is significantly in excess of the threshold RBC requirements.
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 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.