Securities the Company purchases with the intent to hold to maturity are classified as securities held to maturity. Because the Company has strong cash flows and matches expected maturities of assets and liabilities, the Company has the ability to hold the securities, as it would be unlikely that forced sales of securities would be required prior to maturity to cover payments of liabilities. As a result, securities held to maturity are carried at amortized cost less declines in value that are other than temporary. However, certain situations may change the Company's intent to hold a particular security to maturity, the most notable of which is a deterioration in the issuer's creditworthiness. Accordingly, a security may be sold to avoid a further decline in realizable value when there has been a significant change in the credit risk of the issuer. Securities that are held for current resale are classified as trading securities, as the intent is to sell them, producing a trading profit. The Company does not maintain a portfolio of trading securities.
Additional review procedures are performed on those fair value declines which are caused by factors other than market expectations regarding inflation and general interest rates. Specific conditions of the issuer and its ability to comply with all terms of the instrument are considered in the evaluation of the realizable value of the investment. Information reviewed in making this evaluation would include the recent operational results and financial position of the issuer, information about its industry, recent press releases, and other available data. If evidence does not exist to support a realizable value equal to or greater than the carrying value of the investment, such decline in fair value is determined to be other than temporary, and the carrying amount is reduced to its net realizable value. The amount of the reduction is reported as a realized loss.
As described in the notes in the accompanying financial statements, on July 31, 1994, the Company transferred securities with fair values totaling $805 million from securities available for sale to securities held to maturity. On December 29, 1995, the Company made additional transfers totaling $156 million to the held to maturity category from securities available for sale. The lower holdings of securities available for sale significantly reduces the Company's exposure to equity volatility while still providing securities for liquidity and asset/liability management purposes. The transfers to held to maturity in 1994 and 1995 resulted in locking in net unrealized gains which require subsequent amortization and had the following effects on stockholders' equity:
The Company maintains a diversified debt securities portfolio which consists of various types of fixed income securities including primarily U.S. government, public utilities, corporate, and mortgage-backed securities. Investments in mortgage-backed securities include U.S. government and private issue mortgage-backed pass-through securities as well as collateralized mortgage obligations (CMOs). As of December 31, 1995 and 1994, the Company's debt securities portfolio consisted of the following mix of securities based on amortized cost:
The amortized cost and estimated fair values of investments in debt securities at December 31, 1995, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The Company's holdings of mortgage-backed securities are also subject to prepayment risk, as well as extension risk. Both of these risks are addressed by specific portfolio management strategies. The Company substantially reduced both prepayment and extension 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) CMOs, 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.
PAC I CMOs now account for approximately 90% of the total CMO portfolio as of December 31, 1995. The CMOs that the Company purchases are modeled and subjected to detailed, comprehensive analysis by the Company's investment staff before any investment decision is made. The overall structure of the entire CMO is evaluated, and an average life sensitivity analysis is performed on the individual tranche being considered for purchase under increasing and decreasing interest rate scenarios. This analysis provides information used in selecting securities that fit appropriately within the Company's investment philosophy and asset/liability management parameters. The Company's investment mix between mortgage-backed securities and other fixed income securities helps effectively balance prepayment, extension, and credit risks.
In general, the Company seeks loans on high quality, income producing properties such as shopping centers, freestanding retail stores, office buildings, industrial and sales or service facilities, selected apartment buildings, motels, and health care facilities. The location of these loans is typically in growth areas that offer a potential for property value appreciation. These growth areas are found primarily in major metropolitan areas, but occasionally in selected smaller communities. The Company currently seeks loans ranging from $500,000 to $11,000,000, with terms ranging from three to twenty-five years, at interest rates dictated by the marketplace.
The diversification of the mortgage loan portfolio by geographic region of the United States and by property type as of December 31, 1995 and 1994, was as follows:
The contractual maturities of mortgage loans at December 31, 1995, are as follows:
The Company monitors the conditions and market values of these properties on a regular basis. Realized losses recognized due to declines in values of properties totaled $882,000 and $318,000 for the years ended December 31, 1995 and 1994, respectively. The Company makes repairs and capital improvements to keep the properties in good condition and will continue this maintenance as needed.
Insurance Operations Net Earnings: Earnings from insurance operations for the year ended December 31, 1995, were $37,203,000 compared to $36,115,000 for 1994. However, 1995 earnings include a $5.7 million tax benefit resulting from the Company's subsidiary brokerage losses. Earnings for 1994 include a comparable $2.9 million tax benefit. The tax benefits were recognized in accordance with the Company's tax allocation agreement with its subsidiaries. Excluding the tax benefits, earnings from insurance operations for 1995 were down $1.7 million from 1994 due primarily to higher life insurance benefit claims and other policy and contract related expenses. The higher claims and policy related expenses were partially offset by lower insurance operating expenses relating to state guaranty association assessments.
Life and Annuity Premiums: This revenue category represents the premiums on traditional type products. However, sales in most of the Company's markets currently consist of non-traditional types such as universal life and investment annuities. The Company's current plans are to continue to focus the majority of its product development and marketing efforts on universal life and investment annuities. As a result, no significant growth is anticipated for these premiums in the near future.
Actual universal life and investment annuity deposits collected for the years ended December 31, 1995, 1994, and 1993 are detailed below. Deposits collected on these non-traditional 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.
Prior to 1993, most of the Company's investment annuity production was from the sale of two-tier annuity products. However, in the third quarter of 1992, the Company discontinued sales of all two-tier annuities due to declines in sales and certain regulatory issues concerning two-tier products. The Company has continued to collect additional premiums on existing two-tier annuities, which accounts for the majority of the deposits for investment annuities in 1993. The vast majority of the two-tier annuities were sold by a single independent marketing organization.
Subsequent to discontinuing the two-tier annuity sales, the Company set goals to not only develop new annuity products to replace the lost two-tier production, but to diversify and strengthen distribution channels to avoid dependence on its primary independent marketing organization. The Company achieved this by developing new annuity products in 1994 and by contracting new marketing organizations with extensive experience, financial resources, and success in marketing annuities. The combination of new products, primarily a single premium deferred annuity, and new marketing organizations started to produce results in the latter half of 1994 as annuity production began to increase significantly. This increased production has continued into 1995 with annuity deposits increasing from $158 million in 1994 to $310 million in 1995, reflecting a 97% increase.
The majority of the Company's universal life insurance production is from the international market, primarily Central and South American countries. The Company has seen increased competition in the Central and South American market in recent years causing production growth to slow. However, the Company has been accepting policies from foreign nationals for almost thirty years and has developed strong relationships with carefully selected brokers in the foreign countries. This experience and strong broker relations have enabled the Company to meet the increased competition with new product enhancements and marketing efforts. Such efforts have resulted in increased universal life production once again in 1995. Deposits for universal life for both international and domestic markets are up 5.7% in 1995 from $64.8 million in 1994 to $68.5 million in 1995.
Net investment income increased 5.4% from $180.3 million in 1993 to $190.0 million in 1994. Net investment income was up primarily due to yield and amortization adjustments on mortgage-backed securities and increases in invested assets. The yield and amortization adjustments were made in accordance with Statement of Financial Accounting Standards No. 91, "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases." The adjustments are made to reflect changes in mortgage-backed securities prepayment levels, caused by changes in market interest rates, which affect average lives, yields, and amortization periods of the securities.
Other Insurance Operating Expenses: These expenses totaled $27.1 million, $29.4 million, and $29.0 million for 1995, 1994, and 1993, respectively. Although these expenses are relatively comparable between years, these amounts include significant expenses for guaranty association assessments.
National Western Life Insurance Company is subject to state guaranty association assessments in all states in which it is licensed to do business. These associations generally guarantee certain levels of benefits payable to resident policyholders of insolvent insurance companies. Most states allow premium tax credits for all or a portion of such assessments, thereby allowing potential recovery of these payments over a period of years. However, several states do not allow such credits. In December, 1995 and 1994, the National Organization of Life and Health Insurance Guaranty Associations published revised assessment data on nationwide life and health insurance company insolvencies. Based on this information, the Company revised its estimates for assessment liabilities relating to such insolvencies. The Company will continue to monitor and revise its estimates for assessments as additional information becomes available, which could result in additional expense charges. Other insurance operating expenses related to state guaranty association assessments totaled $2,371,000, $4,869,000, and $4,583,000 for the years ended December 31, 1995, 1994, and 1993, respectively. The lower assessment expenses in 1995 are the primary reason for the lower overall insurance operating expenses for the same period.
In previous years, Westcap has contributed significantly to the consolidated earnings of National Western Life Insurance Company. However, more recently, brokerage operations have produced losses due to the reasons cited above. A summary of net earnings and losses from brokerage operations since 1992 is provided below.
Federal Income Taxes: Federal income taxes for 1995 on earnings from continuing operations reflect an effective tax rate of 23%. The 1995 taxes are lower than the expected statutory rate of 35% due to a $5.7 million tax benefit resulting from the Company's subsidiary brokerage losses. Correspondingly, losses on discontinued operations for 1995 totaling $16,350,000 do not include any tax benefits relating to the brokerage subsidiary. This tax reporting treatment is in accordance with the Company's tax allocation agreement with its subsidiaries. However, on a consolidated basis, the Federal income taxes reflect the expected effective tax rate of 35% for 1995.
Federal income taxes for 1994 on earnings from continuing operations also reflect a low effective tax rate, as such taxes also include a tax benefit totaling $2.9 million resulting from the Company's subsidiary brokerage losses. Losses on discontinued operations for 1994 totaling $2,936,000 include Federal income taxes of $2,983,000. Again, the tax reporting treatment is in accordance with the tax allocation agreement previously described, and on a consolidated basis, Federal income taxes reflect an effective tax rate of 35% for 1994.
The Federal corporate tax rate was increased from 34% to 35% beginning in 1993. The total increase in 1993 Federal income taxes resulting from the change in rates was approximately $1,018,000.
The Company adopted SFAS No. 109 effective January 1, 1993. The cumulative effect of this change in accounting for income taxes of $5,520,000 was determined as of January 1, 1993, and is reported separately in the statement of earnings for the year ended December 31, 1993.
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 $99 million, $117 million, and $136 million in 1995, 1994, and 1993, respectively. Lower earnings from brokerage operations is the primary reason for the decrease in cash flows in 1995 and 1994. Additionally, net cash flows from the Company's deposit product operations, which includes universal life and investment annuity products, totaled $99 million in 1995. These operations incurred net cash outflows in 1994 and 1993 totaling $17 million and $99 million, respectively. The increase in cash flows in 1995 is due to increased annuity production as previously described in "Results of Operations." The Company expects this increased annuity production will continue through 1996, thereby enhancing cash flows.
In January, 1995, the FASB issued SFAS No. 120, "Accounting and Reporting by Mutual Life Insurance Enterprises and by Insurance Enterprises for Certain Long-Duration Participating Contracts." Also, the AICPA has established accounting for certain participating life insurance contracts of mutual life insurance enterprises in its Statement of Position (SOP) 95-1, "Accounting for Certain Insurance Activities of Mutual Life Insurance Enterprises," that should be applied to those contracts that meet the conditions in this statement. This statement also permits stock life insurance enterprises to apply the provisions of the SOP to participating life insurance contracts that meet certain conditions. SFAS No. 120 is effective for financial statements issued for fiscal years beginning after December 15, 1995. Due to the Company's small level of participating life insurance contracts, this statement will have no significant effects on the Company's financial statements.
The FASB issued SFAS No. 121, "Accounting for Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of," in March, 1995. The statement requires that long-lived assets and certain identifiable intangibles to be held and used by an entity be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Measurement of an impairment loss for long-lived assets and identifiable intangibles that an entity expects to hold and use should be based on the fair value of the asset. The statement also requires that long-lived assets and certain identifiable intangibles to be disposed of be reported at the lower of carrying amount or fair value less costs to sell.
The Company's real estate investments are the only significant assets that will be subject to this statement. As the Company already records foreclosed real estate at the lower of cost or fair value less estimated costs to sell, the implementation of this statement will not have a significant effect on the Company's financial statements. The statement will be implemented in the first quarter of 1996.
In October, 1995, the FASB issued SFAS No. 123, "Accounting for Stock-Based Compensation." This statement establishes financial accounting and reporting standards for stock-based employee compensation plans. It defines a fair value based method of accounting for employee stock options or similar equity instruments. However, it also allows an entity to continue to measure compensation cost for plans using the intrinsic value based method of accounting prescribed by APB Opinion No. 25, "Accounting for Stock Issued to Employees." Entities electing to continue applying the accounting methods in Opinion 25 must make pro forma disclosures of net income and earnings per share as if the fair value based method of accounting defined in SFAS No. 123 had been applied.
The Company anticipates that it will continue to apply the accounting methods prescribed by Opinion 25 for its existing stock and incentive plan. Therefore, the implementation of this statement will not affect the Company's results of operations. However, as required by this statement, disclosure information will be provided in the Company' financial statements reflecting costs that would have been recorded under the fair value based method. The statement will be implemented in 1996.
The Company has met the above scheduled difference for December 31, 1995. However, in 1995, the Company entered into discussions with the Colorado Division of Insurance (the Division) to implement Actuarial Guideline 33 and to phase it in over a three-year period as allowed by the guideline. In January, 1996, the Division approved the proposal for this three-year phase-in. The effect on the Company's statutory financial statements will not be significant, since the previous agreement with the Division was similar to the final guideline. Also, the guideline does not affect the Company's policy reserves which are prepared under generally accepted accounting principles as reported in the accompanying consolidated financial statements.
There continues to be some public pressure for insurance companies to publish their RBC ratios or levels. However, the legality of publishing such information is uncertain. The American Institute of Certified Public Accountants (AICPA) released an exposure draft of a Statement of Position (SOP) which included requirements that insurance companies disclose certain information about their RBC levels. This requirement was deleted from the final SOP version due to questions raised about the legality of such disclosures. Instead, the AICPA decided to consider a separate SOP at a later date on RBC disclosures, after the legal issues are resolved. Due to these unanswered legal issues, 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.