The Westcap Corporation, a wholly owned subsidiary, owns the Company’s principal office location in Austin, Texas and two buildings adjacent to it, totaling approximately 93,000 square feet that are leased and utilized by the Company. The Company’s affiliate, Regent Care Building, LP, 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, LP, for use in its nursing home operations. The Company’s subsidiary, Regent Care San Marcos A-3 LP, completed construction of a 74,000 square foot building in San Marcos, Texas in 2009 which is used in 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 homes 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, 2011 follows. This discussion should be read in conjunction with the Company’s consolidated financial statements and related notes beginning on page 69 of this report.
In summary, no one's crystal ball provides enough foresight regarding the future to confidently predict the direction that the U.S. and global economies are headed. Strong economic expansion generally benefits the Company’s business. Alternatively, a tepid economic recovery consisting of higher unemployment, lower personal income, muted consumer spending and lackluster corporate earnings and business investment could adversely impact the demand for the Company’s products. Household financial income compression may also cause us to experience a higher incidence of claims, lapses or surrenders of policies. It is not possible to predict with certainty whether or when such activity may occur or what impact, if any, such actions could have on the Company’s business, results of operations, cash flows or financial condition.
Our operating strategy continues to be to maintain capital levels substantially above regulatory and rating agency requirements. The Company maintains resources more than adequate to fund future growth and absorb abnormal periods of cash outflows.
Universal life and annuity contract revenues - Revenues for universal life and annuity contract charges increased 4% in 2011 compared to 2010 primarily due to higher cost of insurance and administrative charges resulting from growth in the amount of business in force. 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, less reinsurance premiums as depicted in the following table.
Cost of insurance charges were $90.3 million in 2011 compared to $86.4 million in 2010 and $83.6 million in 2009. Cost of insurance charges typically trend with the size of the life insurance block in force. The increasing revenue from cost of insurance charges corresponds with the growth in life insurance in force primarily from international sales. At December 31, 2011 the volume of life insurance in force increased to $20.9 billion from $19.7 billion as of the end of 2010. Administrative charges were $26.9 million, $24.5 million and $25.4 million for the years ended December 31, 2011, 2010 and 2009, respectively, and correlate with new life insurance business sales both in number of policies placed as well as the volume of insurance issued. Surrender charges assessed against policyholder account balances upon withdrawal were $31.4 million in 2011 compared to $35.9 million in 2010 and $50.0 million in 2009. While the Company earns surrender charge income that is assessed upon policy terminations, the Company’s overall profitability is enhanced when policies remain in force and additional contract revenues are realized and the Company continues to make an interest rate spread equivalent to the difference it earns on its investment and the amounts that it credits to policyholders.
Traditional life and annuity premiums - Traditional life and annuity premiums increased 9.1% in 2011 compared to 2010. Traditional life insurance premiums for products such as whole life and term life are recognized as revenues over the premium-paying period. The Company’s life insurance sales focus has been primarily centered around universal life products. Universal life products, especially the Company’s equity indexed universal life products which offer the opportunity for consumers to acquire life insurance protection and receive credited interest linked in part to an outside market index such as the S&P 500 Index®, have been more popular product offerings in the Company’s markets. However, the 2008 to 2009 financial crisis generated renewed interest in the Company's term life insurance products particularly with residents outside of the United States.
The declination in average invested asset yield, excluding derivatives, from 2009 to 2010 and to 2011 is due to the Company obtaining lower yields on newly invested cash inflows. As described above, the Company invests substantially most of its net cash flows in debt securities whose yields have declined during this period. The pattern in average invested asset yield, including derivatives, incorporates increases and decreases in the fair value of index options purchased by the Company to support its fixed-indexed products. Fair values of the purchased call options increased markedly in 2009 due to the recovery in the equity markets. However fair values of options purchased the past two years have generally experienced unrealized losses due to intermittent declines in the S&P 500 Index during this period. Refer to the derivatives discussion following this section for a more detailed explanation.
Derivative gain (loss) - Index options are derivative financial instruments used to hedge the equity return component of the Company’s fixed-indexed products. Derivative gain or loss includes the amounts realized from the sale or expiration of the options. Since the the index options do not meet the requirements for hedge accounting under GAAP, they are marked to fair value on each reporting date and the resulting unrealized gain or loss is also reflected as a component of net investment income.
Debt security impairments in 2011 primarily include write-downs on asset-backed securities whose cash flows and fair values did not support the amortized cost basis at which the instruments were recorded in the financial statements. Debt security impairments in 2010 and 2009 included similar impairment write-downs on certain asset-backed securities in addition to impairment losses on several corporate debt securities.
The Company has been implementing new actuarial reserving systems the past several years that will enhance its ability to provide estimates used in establishing future policy liabilities, monitor the deferred acquisition costs and deferred sales inducement assets as well as support other actuarial processes within the Company. The Company has been installing a vendor software product for use in calculating the GAAP reserve liability for future policy benefits of its products. The vendor system provides actuarial formula calculations producing refined estimates of reserves in accordance with GAAP. The previous reserving system produced estimated liabilities on state regulated actuarial formulas which were supplemented with adjustments in order to produce GAAP reserve estimates. The Company elected to purchase and install the new reserving system as growth in its lines of businesses created a need for more refined and controlled actuarial reserve computations in accordance with GAAP. The implementation of these new reserving systems for specific blocks of business began in the second quarter of 2009 and the final blocks of business were completed in the fourth quarter of 2011. As the Company applied these new systems to a line of business, current reserving assumptions were reviewed and updated as appropriate.
The following table identifies the effects of unlocking and true-up adjustments on DPAC balances recorded through amortization expense for 2011, 2010 and 2009.
As noted previously in the discussion of the Company's net investment income, investment yields have been declining precipitously the past several years in tandem with intervention by the Federal Reserve and its policies to aid the economy in recovering from the financial crisis of 2008-2009. These policies have depressed interest rate levels to historical lows. In the fourth quarter of 2011, the Federal Reserve announced it's intention to maintain interest rates at current levels for at least the next couple of years in order to promote further economic recovery. As a result of this announced intention, the Company reevaluated it's assumptions concerning future investment portfolio yield rates and concluded that an unlocking of assumptions was required to incorporate the anticipated lowering of investment yields and its impact upon future investment spreads and profitability. The unlocking adjustment increased DPAC amortization expense by $9.1 million and reduced DPAC asset balances for deferred annuities and universal life by a like amount.
True-up adjustments are recorded quarterly and the adjustments in 2011, 2010 and 2009 relate to changes in expense ratios, partial surrender rates, mortality rates, credited interest rates and earned rates for the current year’s experience. The true-up adjustments by line of business were as shown in the following table.
With the growth in the Company's annuity block of business over the past few years, the dollar amount of true-up adjustments for this line are larger on a nominal basis.
The Company’s domestic life insurance in force has been declining since 2008 resulting in lower universal life contract revenue charges. The pace of new policies issued has lagged the number of policies terminating from death or surrender by roughly a six-to-one rate over the three years shown. The number of domestic life insurance policies has declined from 69,700 at December 31, 2009 to 66,000 at December 31, 2010 and to 62,900 at December 31, 2011.
Net investment income for this segment of business has been decreasing due to a lower level of investments needed to support active policies as a result of the decline in insurance in force. In addition, lower investment yields attained from debt security investment purchases has contributed to a lower level of investment income. The increase in policies issued during 2011 has served to arrest this declining trend after factoring out the gains and losses on index options purchased to back the obligations associated with equity-indexed universal life policies. A detail of net investment income for domestic life insurance operations is provided below.
The unlocking adjustment in 2011 came about as the Company reevaluated it assumptions concerning future investment portfolio yield rates and concluded that an unlocking of assumptions was required to incorporate the anticipated lowering of investment yields and its impact upon future investment spreads and profitability. The unlocking adjustment in 2009 was made to adjust future assumptions concerning per policy maintenance expenses and mortality and accordingly increased DPAC amortization expense by $2.7 million during the period.
As noted previously, the Company records true-up adjustments to DPAC balances each period to reflect current policy lapse or termination rates, expense levels and credited rates on policies as compared to anticipated experience as well as unlocking adjustments as necessary. The following table identifies the effects of unlocking and true-up adjustments on international life insurance DPAC balances recorded through amortization expense for 2011, 2010 and 2009.
As a selling inducement, many 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 $46.7 million, $51.1 million and $36.8 million for the years ended December 31, 2011, 2010 and 2009, respectively.
As previously described, derivatives are call options purchased to hedge the equity return component of the Company's fixed-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. Generally, a comparable impact for the derivative component in fixed-indexed annuity products is reflected in contract interest expense.
As previously noted the unlocking adjustment in 2011 came about as the Company reevaluated it assumptions concerning future investment portfolio yield rates and concluded that an unlocking of assumptions was required to incorporate the anticipated lowering of investment yields and its impact upon future investment spreads and profitability. During 2010 the Company unlocked for a change in projected surrender charge rates on certain fixed rate annuities that reduced DPAC (and increased amortization expense) by $2.7 million. Unlocking was not done during the year ended December 31, 2009.
The true-up adjustments in 2011, 2010 and 2009 relate to changes in policy lapse or termination rates, expense levels and credit rates compared to anticipated experience and are reflected in current period amortization expense.
Contract interest in 2010 includes an additional $16.7 million for policy credits as part of the settlement of a class action lawsuit. This amount had been provided for in 2009 financial results but as an operating expense accrual since the character of the settlement amount was not known at that time. Accordingly, a reclassification was made in the 2010 consolidated financial statements to report the amounts as contract interest with a corresponding reduction in other operating expenses.
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. Nursing home operations generated $0.8 million, $2.8 million and $0.8 million of operating earnings in 2011, 2010, and 2009, respectively. The increase in earnings from 2009 to 2010 reflects the commencement of operations of the San Marcos, TX facility in the middle of calendar year 2009. The decline in earnings in 2011 reflects reductions in Medicare and Medicaid reimbursement rates as governmental entities address their budget deficit conditions. Other operations revenue also includes gross income distributions from a life interest in a trust approximating $4 million per year which is included in a subsidiary company.
The Company's overall conservative investment philosophy is reflected in the allocation of its investments, which is detailed below as of December 31, 2011 and 2010. The Company emphasizes investment grade debt securities, with smaller holdings in mortgage loans and policy loans.
Holdings in below investment grade securities by category as of December 31, 2011 are summarized below, including 2011 and 2010 fair values for comparison. The Company is continually monitoring developments in these industries that may affect security valuation issues.
During the twelve months ended December 31, 2011 the Company recorded other-than-temporary impairment credit related write-downs on debt securities totaling $0.1 million and $0 million on equity securities. See Note 3, Investments Debt and Equity Securities, of the accompanying consolidated financial statements for further discussion.
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 on categorization 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, 2011, approximately 30% of the Company's total debt and equity securities, based on fair values, were classified as securities available for sale. These holdings in available for sale 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 holds one Alt-A security with a carrying value of $4.2 million. The Alt-A sector is a sub-sector of the jumbo prime MBS sector. The average FICO for an Alt-A borrower is approximately 715 compared to a score of 730 for a jumbo prime borrower. The Company’s exposure to the Alt-A and subprime sectors is limited to investments in the senior tranches of structured securities collateralized by Alt-A or subprime residential mortgage loans. The subprime sector is generally categorized under the asset-backed sector. This sector lends to borrowers who do not qualify for prime interest rates due to poor or insufficient credit history. Subprime borrowers generally have FICO scores of 660 or below. The slowing housing market, rising interest rates, and relaxed underwriting standards for loans originated after 2005 resulted in higher delinquency rates and losses beginning in 2007. These events caused illiquidity in the market and volatility in the market prices of subprime securities. With the government intervention initiatives in 2009, the housing market began to show signs of stabilizing. There was an improvement in the prices of subprime securities as the bond market also became more liquid. All of the loans classified as Alt-A or subprime in the Company’s portfolio as of December 31, 2011 were underwritten prior to 2005 as noted in the table below.
As of December 31, 2011, 5 of the subprime securities were rated AAA, 2 were rated AA, 1 was rated A, 1 was rated BBB+ and 3 were rated CC.
Loans in foreclosure, loans considered impaired or loans past due 90 days or more are placed on a non-accrual status. If a mortgage loan is determined to be on non-accrual status, the mortgage loan does not accrue any revenue into the Consolidated Statements of Income. The loan is independently monitored and evaluated as to potential impairment or foreclosure. If delinquent payments are made and the loan is brought current, then the Company returns the loan to active status and accrues income accordingly. The Company has no loans past due 90 days which are accruing interest.
The Company held net investments in mortgage loans totaling $157.5 million and $141.2 million at December 31, 2011 and 2010, respectively. The diversification of the portfolio by geographic region, property type, and loan-to-value ratio was as follows:
The Company does not recognize interest income on loans past due ninety days or more. The Company had one mortgage loan past due six months or more with a principal balance totaling $7.0 million at December 31, 2011 and 2010. There was no interest income not recognized in 2011, 2010 and 2009.
The Company's real estate investments total approximately $19.2 million at December 31, 2011 and $20.1 million at December 31, 2010, and consist primarily of income-producing properties which are being operated by a wholly-owned subsidiary of the Company. The Company recognized operating income on these properties of approximately $1.6 million, $1.6 million and $1.2 million for the years ended December 31, 2011, 2010 and 2009, respectively. The Company monitors the conditions and market values of these properties on a regular basis and makes repairs and capital improvements to keep the properties in good condition. The Company recorded net realized investment losses of $0.1 million in both 2011 and 2010 associated with these properties. There was no recorded gain or loss in 2009.
The correlation between fair values and interest rates for debt securities the past two years is reflected in the tables below.
The Company manages interest rate risk principally through ongoing cash flow testing required for insurance regulatory purposes. Business 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 risk through surrender charges that are imposed to discourage policy surrenders. 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.
The Company is exposed to credit risk through counterparties and within its investment portfolio. Credit risk relates to the uncertainty associated with an obligor’s continued ability to make timely payments of principal and interest in accordance with the contractual terms of an instrument or contract. As previously discussed, the Company manages credit risk through established investment credit policies and guidelines which address the quality of creditors and counterparties, concentration limits, diversification practices and acceptable risk levels. These policies and guidelines are regularly reviewed and approved by senior management and the Company’s Board of Directors.
The Company’s net exposure to loss due to credit risk if the option counterparties failed to completely perform according to the terms of the one-year contracts is as follows at December 31, 2011 and 2010.
The above contractual withdrawals, as well as the level of surrenders experienced, were generally consistent with the Company's assumptions in asset-liability management, and the associated cash outflows did not have an adverse impact on overall liquidity. The nominal increase in annuity dollar outflows coincides with a growing block of business which added $2.8 billion in deposits during the past two years. Individual life insurance policies are less susceptible to withdrawal than annuity reserves and deposit liabilities because policyholders may incur surrender charges and undergo a new underwriting process in order to obtain a new insurance policy. Cash flow projections and tests under various market interest rate scenarios are also performed to assist in evaluating liquidity needs and adequacy. The Company currently expects available liquidity sources and future cash flows to be more than adequate to meet the demand for funds.
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, 2011, the Company had no commitments beyond its normal operating and investment activities. The Company has declared and paid an annual dividend on its common shares since 2005 although its practice remains to substantially reinvest earnings internally to finance the development of new business. Despite the fact the Company's market price of its Class A common shares has been trading at a substantial discount to the book value for several years, there are no imminent plans for the Company to repurchase its shares as the Board of Directors has adopted a strategic policy of building a strong capital base to maintain high financial strength ratings and the ability to take competitive advantages as they arise. The capacity to pay dividends is limited by law in the state of Colorado to earned profits (statutory unassigned surplus). At December 31, 2011, the maximum amount legally available for distribution without further regulatory approval is $91.9 million.
In December 2007, the FASB issued new guidance establishing accounting and reporting standards for entities that have equity investments that are not attributable directly to the parent, called noncontrolling interests or minority interests. More specifically, the guidance addresses where and how to report noncontrolling interests in the consolidated statements of financial position and operations, how to account for changes in noncontrolling interests and provides disclosure requirements. The Company adopted this guidance effective January 1, 2009 and it did not have a material impact on the Company’s consolidated financial condition and results of operations.
In December 2007, the FASB issued new guidance establishing how an entity accounts for the identifiable assets acquired, liabilities assumed, and any noncontrolling interests acquired, how to account for goodwill acquired and determines what disclosures are required as part of a business combination, and it applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. The Company adopted this guidance effective January 1, 2009 and it did not have an impact on the Company’s consolidated financial condition or results of operations.
On April 9, 2009, the FASB issued new guidance for estimating fair value when the volume and level of activity for an asset or liability have significantly decreased and includes guidance on identifying circumstances that indicate a transaction is not orderly. This guidance emphasizes that even if there has been a significant decrease in the volume and level of activity for the asset or liability, and regardless of the valuation technique(s) used, the objective of a fair value measurement remains the same. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. This guidance is effective for interim and annual reporting periods ending after June 15, 2009. As further discussed in Note 14, Fair Values of Financial Instruments, of the accompanying consolidated financial statements, the adoption of this guidance did not have a material impact on the Company’s consolidated financial condition and results of operations.
On April 9, 2009, the FASB issued new guidance to require disclosures about fair value of financial instruments for interim reporting periods of publicly traded companies as well as in annual financial statements. It was effective for the Company as of June 30, 2009 and did not have a significant impact on the consolidated financial position or results of operations. See Note 14, Fair Values of Financial Instruments, of the accompanying consolidated financial statements for additional disclosures.
On June 12, 2009, the FASB issued new guidance that changes the way entities account for securitizations and special purpose entities. The guidance is effective as of the beginning of the Company’s first annual reporting period beginning after November 15, 2009 and did not have a significant impact on the consolidated financial position, results of operations or disclosures.