The Company leases approximately 72,000 square feet of office space in Austin, Texas, for $477,600 per year plus taxes, insurance, maintenance, and other operating costs. This lease expires in 2000. Lease costs and related operating expenses for office facilities of the Company's subsidiaries are not significant in relation to the Company's consolidated financial statements.
The following five-year financial summary includes comparative amounts taken from the audited financial statements.
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 30 IMOs contracted for sales of life and annuity products. Current marketing plans are to increase the number of IMOs under contract by adding qualified, select organizations each year that are able to meet minimum production standards.
The Company's International Division focuses marketing efforts on foreign nationals in upper socioeconomic classes with substantial financial resources. Insurance sales are primarily in countries in Central and South America, the Caribbean, and increasingly 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. The Company minimizes exposure to foreign currency risks, as almost all foreign policies require payment of premiums and claims in United States dollars.
Investments in debt and equity securities are classified and reported as either securities held to maturity or securities available for sale. The Company does not maintain a portfolio of trading securities. The reporting category chosen for the Company's securities investments depends 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. At December 31, 1997, approximately 25% 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.
Securities that are not classified as held to maturity are reported as securities available for sale. These securities may be sold if market or other measurement factors change unexpectedly after the securities were acquired. For example, opportunities arise that allow the Company to improve the performance and credit quality of the investment portfolio by replacing an existing security with an alternative security while still maintaining an appropriate matching of expected maturities of assets and liabilities. Examples of such improvements are as follows: improving the yield earned on invested assets, improving the credit quality, changing the duration of the portfolio, and selling securities in advance of anticipated calls or other prepayments. Securities available for sale are reported in the Company's financial statements at fair value. Any unrealized gains or losses resulting from changes in the fair value of the securities are reflected as a component of stockholders' equity.
The Company's overall conservative investment philosophy is reflected in the allocation of its investments which is detailed below as of December 31, 1997 and 1996. The Company emphasizes investment grade debt securities, with smaller holdings in mortgage loans and real estate.
The Company maintains a diversified debt securities portfolio which consists of various types of fixed income securities including primarily corporate, mortgage-backed securities, and public utilities. Investments in mortgage-backed securities include U.S. government agency and private issue pass-through securities and collateralized mortgage obligations (CMOs). As of December 31, 1997, 1996, and 1995, 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, 1997, 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.
In addition to managing prepayment, extension, and call risks, the Company closely manages 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. The Company continues to follow its conservative investment philosophy by minimizing its holdings of below investment grade debt securities, as these securities generally have greater default risk than higher rated corporate debt. These issuers usually are more sensitive to adverse industry or economic conditions than are investment grade issuers. The Company's small holdings of below investment grade debt securities are summarized below. The increase in below investment grade debt securities from 1995 is primarily due to investment grade issuers that were downgraded to below investment grade status.
The Company's strong credit risk management and commitment to quality has resulted in minimal defaults in the debt securities portfolio in recent years. In fact, at December 31, 1997, no securities were in default and on nonaccrual status, and at December 31, 1996, securities totaling only $2,945,000 were in such status.
The Company's commitment to high quality investments in debt securities is also reflected in the portfolio's high average credit rating. In the table below, investments in debt securities are classified according to credit ratings by Standard and Poor's Corporation (S&P), a nationally recognized statistical rating organization (NRSRO). If securities were not rated by S&P, the equivalent rating of another NRSRO or the National Association of Insurance Commissioners was used.
At December 31, 1997, gross unrealized gains in the Company's debt and equity securities portfolios were as follows:
As reflected above, changes in interest rates of 100 basis points or even less can have a significant impact on the market values of the Company's debt securities. The Company would expect similar results in the future from any significant upward or downward movement in market rates. However, because the majority of the Company's debt securities are classified as held to maturity, the changes in market values have had relatively small effects on the Company's financial statements. Also, the Company has the intent and ability to hold these securities to maturity, and it is unlikely that sales of such securities would be required which would realize the market gains or losses.
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'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 to date and increased investment income significantly in 1996 as several of these interests in real estate joint ventures were sold. The sales resulted in additional investment income totaling approximately $2,300,000 in 1996. No real estate joint ventures were sold in 1997.
The Company held net investments in mortgage loans totaling $181,878,000 and $193,311,000, or 6.3% and 7.0% of total invested assets, at December 31, 1997 and 1996. 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, 1997, the Company had no mortage loan principal balances on nonaccrual status, while at December 31, 1996, the Company had only $36,000 of mortgage loan principal balances on nonaccrual status. In addition to the nonaccrual loans, the Company had mortgage loan principal balances with restructured terms totaling approximately $12,463,000 and $12,719,000 at December 31, 1997 and 1996, respectively. For the years ended December 31, 1997 and 1996, the reductions in interest income due to nonaccrual and restructured mortgage loans were not significant.
The Company owns real estate that was acquired through foreclosure and through direct investment totaling approximately $15,027,000 and $15,209,000 at December 31, 1997 and 1996, 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 $716,000 and $638,000 for the years ended December 31, 1997 and 1996, respectively. The Company does not anticipate significant changes in these operating results in the near future.
The Company monitors the conditions and market values of these properties on a regular basis. The Company makes repairs and capital improvements to keep the properties in good condition and will continue this maintenance as needed. Realized losses recognized due to declines in values of properties totaled $46,000 and $526,000 for the years ended December 31, 1997 and 1996, respectively.
A summary of operating results, net of taxes, for the years ended December 31, 1997, 1996, and 1995 is provided below:
Significant changes and fluctuations in income and expense items between years are described in detail for insurance and brokerage operations as follows:
Life and Annuity Premiums: This revenue category represents the premiums on traditional type products. However, sales in most of the Company's markets continue to consist of nontraditional 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, as in past years no significant growth is anticipated for these premiums in the near future.
Universal Life and Investment Annuity Contract Revenues: These revenues are from the Company's nontraditional products, which are universal life and investment annuities. Revenues from these types of products consist primarily of policy charges for the cost of insurance, policy administration fees, and surrender charges assessed during the period. These revenues increased from $69.8 million in 1995 to $80.3 million in 1997. More specifically, cost of insurance, policy administration fees, and other related revenues have steadily increased each year due to continued sales of nontraditional products which continue to increase the Company's policies in force.
Annuities sold include flexible premium deferred annuities, single premium deferred annuities, and single premium immediate annuities. These products can be tax qualified or nonqualified annuities. In recent years the majority of annuities sold have been nonqualified single premium deferred annuities. The Company also continues to collect additional premiums on existing two-tier annuities, as a large portion of the two-tier block of business were flexible premium annuities on which renewal premiums continue to be collected.
Subsequent to discontinuing two-tier annuity sales in 1992, the Company developed new annuity products and diversified its distribution system by contracting new marketing organizations with extensive experience, financial resources, and success in marketing life and annuity products. The new products and new marketing organizations resulted in significant increases in annuity production in 1994 and 1995. However, annuity production slowed in 1996 and has continued to decrease in 1997, but sales still continue to be higher under this more diversified distribution system.
In efforts to increase annuity production again, the Company has further diversified its annuity products offered to customers by introducing an equity-indexed annuity in late 1997. This product is a flexible premium deferred annuity which combines the features associated with traditional fixed annuities, with the option to have interest rates that are linked in part to an equity index, the S&P 500 Composite Stock Price Index. This new annuity is a long-term contract designed as a planning vehicle for retirement security. The Company anticipates that this product will be attractive to customers, as it has guaranteed minimum interest rates, coupled with the potential for significantly higher returns based on an equity index component. Also, because the Company does not offer variable products or mutual funds, this new product provides a key equity-based alternative to the Company's existing fixed annuity products.
The international marketing and distribution strategy will include efforts to expand broker relationships and sales networks in countries that have higher growth potential than others. This will also include increased marketing efforts in the Pacific Rim. Marketing plans also include increased broker training on the Company's new and existing products.
Net investment income during 1997 increased only 1.5% from 1996, while invested assets increased 3.8%. The lower investment income growth is attributable to several factors. Market interest rates have continued to decline, which has affected yields on purchases of new debt securities. Mortgage loans continue to decline as a percentage of the investment portfolio and in actual amounts from previous years. Mortgage loans have typically had significantly higher yields than investments in debt securities. Additionally, investment income in 1996 included significantly higher returns from real estate joint ventures than in 1997.
Net investment income during 1996 increased 6.2% from 1995. The increase was from increases in invested assets and from gains from real estate joint ventures. NWL Investments I, L.P. sold several real estate joint venture interests during 1996, and the sales resulted in additional investment income totaling approximately $2,300,000. Excluding the income from the joint venture sales, net investment income was up 5.0% from 1995, which is consistent with the increase in total invested assets of 5.6% for the same period. Also, the yield on purchases in 1996 was similar to the yield of the 1995 portfolio.
Other Income: Other income for 1996 includes proceeds received from a lawsuit settlement totaling $850,000. The lawsuit related to the Company's previous investment in a mortgage loan. Also included in 1996 is other income totaling $1.3 million relating to litigation involving an independent marketing organization. The litigation is more fully described in Item 3, Legal Proceedings.
Universal Life and Investment Annuity Contract Interest: The Company closely monitors its credited interest rates, taking into consideration such factors as profitability goals, policyholder benefits, product marketability, and economic market conditions. Rates are established or adjusted after careful consideration and evaluation of these factors against established objectives. Average credited rates, calculated based on policy reserves for the Company's universal life and investment annuity business, have declined since 1995, which is consistent with declines in market interest rates. As market interest rates fluctuate, the Company's credited interest rates are often adjusted accordingly, while also taking into consideration other factors as described above. Average credited rates for 1997, 1996, and 1995 were 5.68%, 6.15%, and 6.19%, respectively. The declines in average credited rates over the past three years is also consistent with the Company's lower yields on average invested assets. The difference between yields earned over credited rates, often referred to as the interest spread, has remained relatively consistent at approximately 2% in 1997, 1996, and 1995.
As previously reported, National Western Life Insurance Company's brokerage subsidiary, The Westcap Corporation, is currently in reorganization under Chapter 11 bankruptcy. Declines in both sales revenues and earnings were principal reasons for ceasing brokerage operations in 1995. Increasing market interest rates and resulting adverse bond market conditions during 1994 and 1995 compared to previous years had a negative impact on the entire bond brokerage industry. These conditions, coupled with adverse publicity about litigation related to sales of collateralized mortgage obligation (CMO) products, led to the declines in sales and earnings. The publicity surrounding these claims made it extremely difficult to keep Westcap's customer base and sales force in place. Additionally, because much publicity characterized CMOs as derivatives, adverse publicity about derivatives impacted the market for CMOs and decreased Westcap's prospects for future sales.
On April 12, 1996, The Westcap Corporation and its wholly owned subsidiary, Westcap Enterprises, Inc., separately filed voluntary petitions for reorganization under Chapter 11 of the U.S. Bankruptcy Code in the United States Bankruptcy Court, Southern District of Texas, Houston Division. As a result of the discontinued operations and subsequent bankruptcy filing, Westcap's assets are being carried at their estimated fair value, and its liabilities include estimated costs related to ceasing operations. In accordance with generally accepted accounting principles, the assets and liabilities of Westcap have been reclassified in the accompanying consolidated balance sheets to separately identify them as assets and liabilities of the discontinued operations.
As a result of brokerage losses and the resulting bankruptcy, National Western's investment in Westcap was completely written off during 1995. However, a $1,000,000 cash infusion was made to Westcap on March 18, 1997, for operational expenses incurred during its bankruptcy. This contribution was reflected as a loss from discontinued operations in the first quarter of 1997. Losses from the discontinued brokerage operations have been reflected separately from continuing operations of the Company in the accompanying consolidated financial statements. Any additional losses from discontinued operations will depend primarily on results of Westcap bankruptcy proceedings and settlement discussions. A summary of net earnings and losses from brokerage operations since 1993 is provided below.
Federal Income Taxes: Federal income taxes for 1997 and 1996 reflect effective tax rates of 33.8% and 34.3%, respectively, which are consistent with the expected federal rate of 35%. However, Federal income taxes for 1995 on earnings from continuing operations reflect an effective tax rate of only 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.
The Company also has significant cash flows from both scheduled and unscheduled investment security maturities, redemptions, and prepayments. These cash flows totaled $144 million, $117 million, and $69 million in 1997, 1996, and 1995, respectively. The Company again expects significant cash flows from these sources in 1998 at levels similar to the past two years.
The Company relies on stockholders' equity for its capital resources, as there has been no long-term debt outstanding in 1997 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 1998.
Prior to issuance of SFAS No. 130, some changes in equity were displayed in the income statement, which reports the results of operations, while other changes were included directly in balances within a separate component of equity in the statement of financial position. SFAS No. 130 will affect the Company's reporting presentation of certain items such as foreign currency translation adjustments and unrealized gains and losses on investment securities. These items will now be a component of other comprehensive income. SFAS No. 130 is effective for fiscal years beginning after December 15, 1997, and reclassification of financial statements for earlier periods provided for comparative purposes is required. The Company will implement this statement in the first quarter of 1998.
SFAS No. 131 requires that a public business enterprise report financial and descriptive information about its reportable operating segments, such as segment profit or loss, certain specific revenue and expense items, and segment assets. Operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance.
Although the Company currently reports certain information about its operating segments, products, geographical distribution of business, and major customers, this new standard will require expanded disclosures related to these items. The Company anticipates that the expanded disclosures will include additional information about its life insurance and annuity products as well as its domestic and international operations. SFAS No. 131 is effective for financial statements for periods beginning after December 15, 1997. The Company will implement this statement in its December 31, 1998, financial statements.
The new statement will require changes and enhancements to certain pension related disclosures of the Company, primarily related to changes in plan assets. Other aspects of the statement will have no effect as the Company provides no significant other postretirement benefits to retirees. SFAS No. 132 is effective for fiscal years beginning after December 15, 1997. The Company will implement this statement in its December 31, 1998, financial statements.
The National Association of Insurance Commissioners (NAIC) established risk-based capital (RBC) requirements to help state regulators monitor the financial strength and stability of life insurers by identifying those companies that may be inadequately capitalized. Under the NAIC's requirements, each insurer must maintain its total capital above a calculated threshold or take corrective measures to achieve the threshold. The threshold of adequate capital is based on a formula that takes into account the amount of risk each company faces on its products and investments. The RBC formula takes into consideration four major areas of risk which are: (i) asset risk which primarily focuses on the quality of investments; (ii) insurance risk which encompasses mortality and morbidity risk; (iii) interest rate risk which involves asset/liability matching issues; and (iv) other business risks.