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 65,000 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 provides life insurance products on a global basis for the savings and protection needs of policyholders and annuity contracts for the asset accumulation and retirement needs of contractholders both domestically and internationally. The Company accepts funds from policyholders or contractholders and establishes a liability representing future obligations to pay the policy or contract-holders and their beneficiaries. To ensure the Company will be able to pay these future commitments, the funds received as premium payments and deposits are invested in high quality investments, primarily fixed income securities.
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 2006, incorporating required disclosures in accordance with the rules and regulations of the Securities and Exchange Commission.
Impairment of Investment Securities. The Company’s accounting policy requires that a decline in the value of a security below its amortized cost basis be evaluated to determine if the decline is other-than-temporary. The primary factors considered in evaluating whether a decline in value for fixed income and equity securities is other-than-temporary include: (a) the length of time and the extent to which the fair value has been less than cost, (b) the financial conditions and near-term prospects of the issuer, (c) whether the debtor is current on contractually obligated principal and interest payments, and (d) the intent and ability of the Company to retain the investment for a period of time sufficient to allow for any anticipated recovery. In addition, certain securitized financial assets with contractual cash flows are evaluated periodically by the Company to update the estimated cash flows over the life of the security. If the Company determines that the fair value of the securitized financial asset is less than its carrying amount and there has been a decrease in the present value of the estimated cash flows since the previous estimate, then an other-than-temporary impairment charge is recognized. When a security is deemed to be impaired a charge is recorded as net realized losses equal to the difference between the fair value and amortized cost basis of the security. Once an impairment charge has been recorded, the fair value of the impaired investment becomes its new cost basis and the Company continues to review the other-than-temporarily impaired security for appropriate valuation on an ongoing basis. Under U.S. generally accepted accounting principles, the Company is not permitted to increase the basis of impaired securities for subsequent recoveries in value.
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.
Share-Based Payments. Liability awards under a share-based payment arrangement have been measured based on the award's fair value at the reporting date. The Black-Scholes valuation method has been used to estimate the fair value of the options. This fair value calculation of the options include assumptions relative to the following:
Traditional life and annuity premiums - Traditional life insurance premiums for products such as whole life and term life are recognized as revenues over the premium-paying period. These are product lines that the Company has not put as much emphasis on relative to interest sensitive products, particularly in its international life insurance operations.
Investment grade debt securities generated approximately 91.0% of total investment income, excluding derivatives in 2006. The mortgage loan investment balance has been steadily declining over the past several years due to the low interest rate environment, which has resulted in loan pre-payments and a decrease of new loan fundings. Other investment income for 2006 includes $1.2 million related to income received on various profit participation arrangements compared to $2.8 million recorded in 2005 and $1.5 million recorded in 2004. In addition, proceeds of $4.3 million were received in 2006 from a class action settlement on a disposed debt security.
Realized gains on investments - The net gains reported in 2006 of $2.7 million consisted of gross gains of $5.3 million primarily from calls and sales of debt securities, sale of real estate during the year, offset by gross losses of $2.6 million, which includes the impairments highlighted in the table below, and from calls and sales of debt and equity securities.
In past years, the realized losses on investments have primarily resulted from impairment writedowns on investments in debt securities and valuation allowances recorded on mortgage loans. The Company records impairment writedowns when a decline in value is considered other-than-temporary and full recovery of the investment is not expected. Impairment writedowns are summarized in the following table.
Life and other policy benefits - Life and other policy benefits reflect death claims of $26.2 million, $30.0 million, and $24.7 million for 2006, 2005, and 2004, respectively. The Company's mortality experience over the past three years has generally been consistent with its product pricing assumptions.
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 in 2005, while also decreasing the Company's investment income given the hedge nature of the options. During 2006 and 2004, 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 - 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 $10.2 million, $7.6 million, and $7.2 million in 2006, 2005, and 2004, respectively. In 2006, $13.1 million was recorded related to increased compensation costs resulting from a change in liability classification for the Company’s stock option plan. Compensation costs reported in 2005 and 2004 totaled $0.9 million in both years. A reduction in expenses of $6.5 million due to the final accounting related to a lawsuit settlement is reflected in 2004 amounts. In addition, contractholder account balances were increased $2.3 million in 2004 based on this final settlement.
Federal Income Taxes. Federal income taxes on earnings from continuing operations for 2006, 2005, and 2004 reflect effective tax rates of 34.6%, 33.9%, and 33.9%, respectively, which are lower than the expected Federal rate of 35% primarily due to tax-exempt investment income related to investments in municipal securities and dividends-received deductions on income from stock investments.
A summary of segment earnings from continuing operations for the years ended December 31, 2006, 2005, and 2004 is provided below. The segment earnings exclude realized gains and losses on investments, net of taxes.
The Company's international life operations have been a significant contributor to the Company's overall growth and represent a market niche where the Company believes it has a competitive advantage. A productive agency force has been developed given the Company's longstanding reputation for supporting its international life products coupled with the instability of competing companies in international markets. In particular, the Company has experienced sizable growth with its equity-indexed universal life products and has collected premiums of $60.5 million, $48.2 million, and $37.2 million for the years ended 2006, 2005, and 2004, respectively.
Life and other policy benefits totaled $18.2 million in 2006, $21.2 million in 2005, and $16.6 million in 2004, which are consistent with Company expectations. Amortization of deferred policy acquisition costs was $23.1 million, $20.4 million, and $21.8 million for 2006, 2005, and 2004, respectively. In the first quarter of 2006, a true-up of amortization assumptions resulted in increased amortization of $1.0 million. Contract interest expense was $25.7 million, $18.1 million, and $18.6 million, in 2006, 2005, and 2004, respectively. The universal life contract interest fluctuations are primarily the result of the S&P 500 Index® performance relative to the equity-indexed universal life products and the associated stock market gains and losses which increased or decreased the amounts the Company credited to policyholders.
Other operating expenses reported in 2006 were $21.1 million compared to $13.4 million and $12.4 million in 2005 and 2004. The significant increase in 2006 is due to an increase in compensation costs resulting from the change in liability classification for the Company’s stock option plan. Compensation costs totaled $5.1 million, $0.4 million, and $0.4 million in 2006, 2005, and 2004, respectively.
Other deferred annuity deposits decreased in 2006 compared to 2005 with $171.6 million recorded in collected deposits compared to $236.3 million, respectively. As a selling inducement, many fixed-rate annuity products include a first year premium or interest rate bonus in addition to the base first year deposit interest rate. These bonuses are credited to the policyholder account but are deferred by the Company and amortized over future periods. The amount deferred was approximately $19.7 million, $21.2 million, and $27.5 million for the years ended December 31, 2006, 2005, and 2004, respectively.
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 2004 to 2006, is due to the increase in the overall size of the asset portfolio as a result of higher sales volume.
A true-up of assumptions in the first quarter of 2006 resulted in increased amortization of deferred policy acquisition costs of $3.1 million. 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.
The Company is required to periodically adjust for actual experience that varies from that assumed. While management does not currently anticipate any impact from unlocking in 2007, facts and circumstances may arise in the future which require that the factors be reexamined.
In comparison by year, the fluctuation in reported contract interest amounts for equity-indexed annuities is due to sales and the effect of the positive or negative 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 $4.5 million, pre-tax, in 2006 and $3.9 million and $3.7 million in 2005 and 2004, respectively.
The Company acquired a nursing home facility, which opened in late July, 2000 and is operated by an affiliated limited partnership, whose financial operating results are consolidated with those of the Company. Daily operations and management of the nursing home are performed by an experienced management company through a contract with the limited partnership. Nursing home operations generated $1.0 million, $1.3 million, and $1.1 million of operating earnings in 2006, 2005, and 2004, respectively.
The Company's investment guidelines prescribe limitations as a percent of the total investment portfolio by type of security and all holdings were within these threshold limits at December 31, 2006 and 2005. During 2005 and continuing into 2006, the Company expanded its holdings of U.S. government and private mortgage-backed securities given attractive yields and spreads. Because the Company's holdings of mortgage-backed securities are subject to prepayment and extension risk, the Company has substantially reduced these risks by investing primarily in collateralized mortgage obligations, which have more predictable cash flow patterns than pass-through securities. These securities, known as planned amortization class I ("PAC I"), very accurately defined maturity ("VADM") and sequential tranches are designed to amortize in a more predictable manner than other CMO classes or pass-throughs. Using this strategy, the Company can more effectively manage and reduce prepayment and extension risks, thereby helping to maintain the appropriate matching of the Company's assets and liabilities.
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 97% 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®.
Generally accepted accounting principles require that investments in debt securities be written down to fair value when declines in value are judged to be other-than-temporary. Since quoted market prices are readily available and understood by investors and creditors, they are the mandated source for fair value estimation when available. In some instances, quoted market prices may not be available for securities that have limited buyer demand. When the quoted market price is not available other valuation techniques such as discounted cash flow analysis and fundamental analysis may be used. Although the Company is required to write down securities deemed to be impaired on an other-than-temporary basis to quoted market prices, the estimated ultimate recovery value of the impaired security is often anticipated to be an amount in excess of the quoted market price. This is due to the influence that "distressed bond" traders may have in depressing market prices in order to generate a yield commensurate with the investment risk of such securities. Consequently, financial results can significantly vary from period to period for securities written down to quoted market prices which may be subsequently redeemed at levels consistent with expected recovery value.
As part of the Company's review for other-than-temporary impairments of investments, the Company determined during 2006 and 2005 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:
The Company is closely monitoring its other below investment grade holdings by reviewing investment performance indicators including information such as issuer operating performance, debt ratings, analyst reports and other economic factors that may affect these specific investments. 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 as to which category 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, 2006, approximately 35% 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.
The Company does not recognize interest income on loans past due ninety days or more. At December 31, 2006, the Company had two mortgage loans past due six months or more with the principal balance totaling $7.0 million. At December 31, 2005 and 2004, the Company had no mortgage loan principal balances past due three months or more. Interest income not recognized for past due loans totaled approximately $0.4 million in 2006.
The contractual maturities of mortgage loan principal balances at December 31, are as follows:
Changes in interest rates typically have a significant impact on the fair values of the Company's debt securities. During 2006, market interest rates of the ten-year U.S. Treasury bond increased 31 basis points from year end 2005 resulting in an unrealized loss change of $59.8 million on a portfolio of approximately $5.5 billion. This amount is reasonable based upon the current market factors and the current investment portfolio characteristics. 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 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, 2006, and does not consider new product sales or the possible impact of interest rate changes on sales.
In the past, cash flows from the Company's insurance operations have been sufficient to meet current needs. Cash flows from operating activities were $224 million, $201 million, and $146 million in 2006, 2005, and 2004, respectively. The Company also has significant cash flows from both scheduled and unscheduled investment security maturities, redemptions, and prepayments. These cash flows totaled $399 million, $485 million, and $440 million in 2006, 2005, and 2004, respectively. Cash flows from security maturities, redemptions, and prepayments were relatively higher over the last three years due to the decline in interest rates. These cash flow items could be reduced if interest rates rise in 2007. Net cash flows from the Company's universal life and annuity deposit product operations totaled inflows of $25 million, $153 million, and $497 million in 2006, 2005, and 2004, respectively.
The Company relies on stockholders' equity for its capital resources as there is no long-term debt outstanding and the Company does not anticipate the need for any long-term debt in the near future. As of December 31, 2006, the Company had commitments of approximately $8.0 million which were approved by the Company's Board of Directors for the construction of a nursing home facility in Central Texas. The construction of the new facility is expected to begin in 2007.
In May of 2005, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard ("SFAS") No. 154, Accounting Changes and Error Correction. This standard is a replacement of Accounting Policy Board Opinion No. 20, Accounting Changes, and FASB Standard No. 3, Reporting Accounting Changes in Interim Financial Statements. Under the new standard, any voluntary changes in accounting principles are to be adopted via a retrospective application of the accounting principle in the financial statements presented and an opinion obtained from the auditors that the new principle is preferred. In addition, adoption of a change in accounting principle required by the issuance of a new accounting standard will also require retroactive restatement, unless the new standard includes explicit transition guidelines. This standard was effective for fiscal years beginning after December 15, 2005. Adoption of this standard did not have an 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"). 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. 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. SOP 05-1 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006, with earlier adoption encouraged. The Company will have an impact related to the adoption of SOP 05-1 related to contracts which have annuitized and relative to reinstatements of contracts in that the unamortized deferred acquisition costs and deferred sales inducement assets must be released at the time of annuitization and may not be continued related to reinstatements. The effect of this SOP on beginning retained earnings as of January 1, 2007 is expected to be a decrease of $2.2 million, net of tax.
The FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109 ("FIN 48"), dated June, 2006. The interpretation requires public companies to recognize the tax benefits of uncertain tax positions only where the position is "more likely than not" to be sustained assuming examination by tax authorities. The amount recognized would be the amount that represents the largest amount of tax benefit that is greater than 50% likely of being ultimately realized. A liability would be recognized for any benefit claimed, or expected to be claimed, in a tax return in excess of the benefit recorded in the financial statements, along with any interest and penalty (if applicable) on the excess. FIN 48 will require a tabular reconciliation of the change in the aggregate unrecognized tax benefits claimed, or expected to be claimed, in tax returns and disclosure relating to accrued interest and penalties for unrecognized tax benefits. Discussion will also be required for those uncertain tax positions where it is reasonably possible that the estimate of the tax benefit will change significantly in the next 12 months. FIN 48 is effective for fiscal years beginning after December 15, 2006. Adoption of FIN 48 is not expected to have a material impact on the Company's consolidated financial statements.
On February 16, 2006, the FASB issued SFAS 155, Accounting for Certain Hybrid Financial Instruments, which amends SFAS No. 133, Accounting for Derivatives and Hedging Activities, and SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. Hybrid financial instruments are single financial instruments that contain an embedded derivative. Under SFAS No. 155, entities can elect to record certain hybrid financial instruments at fair value as individual financial instruments. Prior to this amendment, certain hybrid financial instruments were required to be separated into two instruments - a derivative and host - and generally only the derivative was recorded at fair value. SFAS No. 155 also requires that beneficial interests in securitized assets be evaluated for either freestanding or embedded derivatives. SFAS No. 155 is effective for all financial instruments acquired or issued after January 1, 2007. SFAS No. 155 is not expected to have a material effect on the Company's consolidated financial statements on the date of adoption.
In September 2006, the FASB issued SFAS No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans an amendment of FASB Statements No. 87, 88, 106 and 132(R). This statement requires an employer on a prospective basis to recognize the overfunded or underfunded status of its defined benefit pension and postretirement plans as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. This requirement, along with the required disclosures, is effective for fiscal years ending after December 15, 2006. SFAS No. 158 also requires an employer on a prospective basis to measure the funded status of its plans as of its fiscal year-end, and is effective for fiscal years ending after December 15, 2008. The incremental effect of the adoption of SFAS No. 158 was to increase other liabilities $8.8 million, decrease deferred Federal income taxes $3.1 million and increase accumulated other comprehensive loss $5.7 million.
In September 2006, the staff of the SEC issued Staff Accounting Bulletin ("SAB") No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. The interpretations in this SAB express the staff's views regarding the process of quantifying financial statement misstatements. Specifically, the SEC staff believes that registrants must quantify the impact on current period financial statements of correcting all misstatements, including both those occurring in the current period and the effect of reversing those that have accumulated from prior periods. This SAB should be applied beginning with the first fiscal year ending after November 15, 2006, with early adoption encouraged. The adoption of SAB No. 108 did not impact the financial position and results of operations of the Company.
See Attachment A, Index to Financial Statements and Schedules, on page 74.