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 $550,800 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.
Management's discussion and analysis of financial condition and results of operations ("MD&A") of National Western Life Insurance Company for the three years ended December 31, 2003 follows. This discussion should be read in conjunction with the Company's consolidated financial statements and related notes beginning on page __ of this report.
- effect of interest rate changes on revenues and investments including asset and liability matching
The Company has experienced record sales both with its annuity products domestically and internationally with its life products over the past several years. The increase in sales has come at a challenging time for the insurance industry with the sluggish economy, low interest rate levels, deterioration in corporate credit quality, and increased regulatory requirements. Despite these obstacles, business levels have increased and the Company has improved investment performance, not by taking on additional risks in the investment portfolio, but with improved overall credit quality of its portfolio of fixed income securities. The Company's financial performance is determined by the execution of its business model, which includes distribution and sale of its products, while maintaining invested values in order to meet future commitments of its policyholders and their beneficiaries.
Revenues for universal life and annuity products consist of policy charges for the cost of insurance, administration charges, and surrender charges assessed against policyholder account balances. The Company's retention of inforce policies and contracts, referred to as persistency, improved substantially year over year from 2001 to 2003 contributing to higher operating earnings. However, revenues decreased from a lower incidence of surrender charges. Surrender charges promote persistency and protect the Company during times of increasing interest rates as these charges discourage policy and contract holders from withdrawing part or all of their funds held by the Company. Surrender charge revenue was $21.6 million in 2003 compared to $23.1 million in 2002 and $26.7 million in 2001.
Net investable cash flow is primarily invested in investment grade debt securities generating nearly 87% of total investment income in 2003. With the decline in interest rate levels over the past several years, mortgage loan income has declined as prepayments have continued and new loan funding opportunities with interest rates below the Company's required yield levels for this type of investment opportunities have decreased. Other investment income for 2003 includes $3.3 million related to income received on various profit participation arrangements. Despite the drop in interest rate levels, the Company generated comparable higher net investment earnings due to the invested asset balance continuing to increase year to year. In addition, investment expenses have remained relatively level from 2001, 2002, and 2003.
Other revenue consists primarily of revenues associated with nursing home operations which recorded revenues of $6.9 million, $6.1 million, and $5.2 million in 2003, 2002, and 2001, respectively. In 2001, other revenue included nearly $0.7 million received from the favorable resolution of longstanding litigation against the Company and one of its wholly owned subsidiaries, The Westcap Corporation ("Westcap").
Realized Losses on Investments. The losses on investments consist primarily of impairment writedowns for investments in debt securities. The Company records impairment writedowns when a decline in value is considered other than temporary and full recovery of the investment is not expected. In 2003, the Company recorded impairment writedowns totaling $7.2 million on holdings of American Airlines ($3.1 million), Lukens ($0.8 million) and collaterialized bond obligation ("CBO") investments ($3.3 million). Writedowns in 2002 included WorldCom ($9.6 million), United Airlines ($4.0 million) and CBO investments ($3.8 million). Writedowns in 2001 related to Enron ($9.0 million), Lukens ($14.4 million), Federal Mogul ($4.4 million) and CBOs ($4.5 million). Total impairment writedowns in 2003, 2002, and 2001 totaled $7.2 million, $17.4 million, and $32.3 million, respectively.
The Company's mortality experience over the past five years has generally been consistent with its product pricing assumptions. Policy benefits reflect death claims of $26.8 million, $22.8 million, and $23.6 million for 2003, 2002, and 2001, respectively. The increase in death claims in 2003 is consistent with the Company's substantial increase in business inforce.
Federal Income Taxes. Federal income taxes on earnings from continuing operations for 2003, 2002, and 2001 reflect effective tax rates of 32.9%, 33.1%, and 34.2%, respectively, which are lower than the expected Federal rate of 35% primarily due to tax-exempt investment income related to municipal securities and dividends-received deductions on income from stocks.
A summary of segment earnings from continuing operations for the years ended December 31, 2003, 2002, and 2001 is provided below. The segment earnings exclude realized gains and losses on investments, net of taxes.
The Company's U.S. operations have recently emphasized annuity product sales over life product sales. Consequently, domestic life revenues have been declining for several years. It is the Company's goal to increase domestic life product sales through increased recruiting of new distribution and the development of new life insurance products. To that end, the Company increased its level of contracted agents from 5,200 at the end of 2002 to 11,100 at the end of 2003.
Segment earnings have declined as the block of business has contracted reporting earnings of $1.4 million, $2.6 million, and $5.2 million for the years ended December 31, 2003, 2002, and 2001, respectively. The face amount of domestic life insurance inforce has declined from $2.9 billion at December 31, 2001 to $2.8 billion at December 31, 2002 and to $2.7 billion at December 31, 2003. Absent the growth rates targeted by management, the block of business will continue to contract due to the normal incidence of terminations from death or surrender with lower earnings resulting. Lack of critical mass in this block of business also impacted the expected emergence of future profits which can serve to increase the amortization of deferred policy acquisition costs.
International operations have emphasized universal life policies over traditional life insurance products. In accordance with generally accepted accounting principles premiums collected on universal life products are not reflected as revenues in the Company's statements of earnings. Actual universal life premiums collected are detailed below.
The Company's international life operations have been a significant part of the Company's overall business as evidenced by the growth in collected premiums. International sales increased in 2003 and 2002 due to the addition of new agents in several markets who were attracted to National Western given the Company's longstanding reputation for supporting its international life products and the instability of competing companies in international markets.
While the Company experienced a rapid move to a higher sales level in 2002 due to the added markets, the Company did not expect 2003 sales activity to replicate that of 2002. However, 2003 international sales surpassed the Company's expectations and approximated those of 2002. Management expects sales growth internationally to trend at a steadier pace from the level of 2002 and 2003 sales. As the international life insurance inforce continues to grow, the Company anticipates operating earnings to similarly increase. The amount of international life insurance inforce has grown from $7.1 billion at December 31, 2001 to $8.8 billion at December 31, 2002 and to $10.2 billion at December 31, 2003.
In accordance with generally accepted accounting principles deposits collected on annuity contracts are not reflected as revenues in the Company's statements of earnings. Actual annuity deposits collected are detailed below.
As previously described, index options 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. Investment income in the annuity segment includes index option income of $24.9 million, and losses of $13.0 million and $13.5 million for December 31, 2003, 2002, and 2001, respectively. Net investment income, excluding index options totaled $221.9 million, $197.1 million, and $194.1 million, respectively, related to the annuity segment. The significant increase in net investment income, excluding index options from 2002 to 2003 is due to the increase in the overall size of the asset portfolio as a result of sales volume.
Increased amortization of deferred policy acquisition costs in 2003 is due, in part, to the deferral of sales inducement costs. Also contributing to increased amortization is the increased sales of the equity-indexed products and the related increase in the stock market which resulted in higher gross profits then expected. Consequently, the Company recognized a greater level of amortization expense corresponding with the higher profit level. The Company conversely unlocked its deferred policy acquisition costs amortization factors on other annuity products for assumption changes during 2003 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 spreads.
The Company unlocked its deferred policy acquisition cost amortization factors in 2001 for changes in persistency of the annuity block of business at that time and for changes in investment earnings. As unlocking of amortization factors is applied retroactively back to the inception of all policies, it had the affect of increasing 2001 operating earnings. No changes were made in amortization factors in 2002. 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 2004, facts and circumstances may arise in the future which require that the factors be reexamined.
The 2003 increase in contract interest 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. All other annuity contract interest includes sales inducement expenses not deferred of approximately $12 million and $5 million for 2002 and 2001, respectively. The Company currently defers these sales costs.
Other operating expenses include a $9.7 million charge in 2003 relating to a litigation claim which involved certain annuity products. The increase in other operating expenses, excluding this litigation claim, is due to the overall increase in annuity business and the allocation of corporate expenses to this line of business due to the increased sales.
The Company maintains a diversified portfolio which consists primarily of corporate, mortgage-backed, and public utilities fixed income securities. Investments in mortgage-backed securities include primarily U.S. government agency pass-through securities and collateralized mortgage obligations ("CMOs"). As of December 31, 2003 and 2002, the Company's debt securities portfolio consisted of the following:
This emphasis is reflected in the high average credit rating of the Company's portfolio. In the table below, investments in debt securities are classified according to credit ratings by Standard and Poor's ("S&P®"), or other nationally recognized statistical rating organizations if securities were not rated by S&P®.
The investment environment improved during 2003 compared to 2002. The market showed signs of improvement which was reflected in several industries that were experiencing problems during 2002, such as the airline, energy and telecommunications industries. These industries all showed marked improvement in fair values from 2002 to 2003. The Company is closely monitoring developments in these industries that would affect security valuations. Holdings in below investment grade securities by category as of December 31, 2003 are summarized below, including 2002 fair values for comparison.
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 an evaluation of its entire portfolio in 2001, the Company made the determination to transfer debt securities with fair values totaling $112 million from securities available for sale to securities held to maturity as of January 1, 2001. In accordance with the provisions of SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, the transfers were recorded at fair value, and the unrealized holding loss totaling $0.6 million at the date of transfer, net of the effects of deferred taxes and deferred policy acquisition costs, was reported in accumulated other comprehensive income and is being amortized over the remaining lives of the securities. The transfer of securities from available for sale to held to maturity had no effect on the net earnings of the Company in 2001.
During 2003, the Company transferred securities with an amortized cost of $12.8 million from held to maturity to available for sale due to credit deterioration resulting in $96,000 of net unrealized gains reported as a separate component in accumulated other comprehensive income.
The Company manages interest rate risk through on-going cash flow testing required for insurance regulatory purposes. Computer models are used to perform cash flow testing under various commonly used stress test interest rate scenarios to determine if existing assets would be sufficient to meet projected liability outflows. Sensitivity analysis allows the Company to measure the potential gain or loss in fair value of its interest-sensitive instruments and to protect its economic value and achieve a predictable spread between what is earned on invested assets and what is paid on liabilities. The Company seeks to minimize the impact of interest rate risk through surrender charges that are imposed to discourage policy surrenders and to offset unamortized acquisition costs. Interest rate changes can be anticipated in the computer models and the corresponding risk addressed by management actions affecting asset and liability instruments. However, potential changes in the values of financial instruments indicated by hypothetical interest rate changes will likely be different from actual changes experienced, and the differences could be significant.
Expected maturities of debt securities may differ from contractual maturities due to call or prepayment provisions. The models assume that prepayments on mortgage-backed securities are influenced by agency and pool types, the level of interest rates, loan age, refinancing incentive, month of the year, and underlying coupon. During periods of declining interest rates, principal payments on mortgage-backed securities and collateralized mortgage obligations increase as the underlying mortgages are prepaid. Conversely, during periods of rising interest rates, the rate of prepayment slows. Both of these situations can expose the Company to the possibility of asset/liability cash flow and yield mismatch. The model uses a proprietary method of sampling interest rate paths along with a mortgage prepayment model to derive future cash flows. The initial interest rates used are based on the current U.S. Treasury yield curve as well as current mortgage rates for the various types of collateral in the portfolio.
Liquidity requirements are met primarily by funds provided from operations. Premium deposits and revenues, investment income, and investment maturities are the primary sources of funds while investment purchases, policy benefits, and operating expenses are the primary uses of funds. Although the Company historically has not been put in the position of liquidating invested assets to provide cash flow, its investments consist primarily of marketable debt securities that could be readily converted to cash for liquidity needs. The Company may also borrow up to $40 million on its bank line of credit for short-term cash needs.
The Company relies on the accumulated earnings in stockholders' equity for its capital resources as it has no long-term debt outstanding and 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 2004.
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. 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.
SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure was issued December 2002 and is effective for fiscal years ending after December 15, 2002. This Statement amends SFAS No. 123 to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. This Statement also amends the disclosure requirements of Statement 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company did implement the accounting provisions of SFAS No. 148 in the first quarter of 2003 and did not report a material effect on the Company's consolidated financial statements.
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. This SOP is effective for financial statements for fiscal years beginning after December 15, 2003. One aspect of this SOP relates to sales inducements for investment or universal life-type contracts which are to be recognized as part of the liability for future policy benefits and deferred and amortized using the same methodology and assumptions used to amortize other capitalized acquisition costs. The Company currently defers these sales inducement costs in a manner consistent with the requirements of the SOP 03-1. Another aspect of this SOP relates to the reserving method for two-tier annuity products which the Company issued from 1984 until 1992. The Company plans to adopt this new reserving method in the first quarter of 2004. The implementation of this SOP relating to the Company's two-tier block of business is expected to have a material and positive impact on the Company's net earnings by an amount ranging between $40 million and $80 million, net of taxes. For a discussion of recently issued accounting pronouncements, see Note 1, Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements.