The following five-year financial summary includes comparative amounts derived from the audited consolidated financial statements. (1)
The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for forward-looking statements. Certain information contained herein or in other written or oral statements made by or on behalf of the Company or its subsidiaries are or may be viewed as forward-looking. Although the Company has taken appropriate care in developing any such information, forward-looking information involves risks and uncertainties that could significantly impact actual results. These risks and uncertainties include, but are not limited to, matters described in the Company’s SEC filings such as exposure to market risks, anticipated cash flows or operating performance, future capital needs, and statutory or regulatory related issues. However, the Company, as a matter of policy, does not make any specific projections as to future earnings, nor does it endorse any projections regarding future performance that may be made by others. Whether or not actual results differ materially from forward-looking statements may depend on numerous foreseeable and unforeseeable events or developments. Also, the Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future developments, or otherwise.
Beginning with its December meeting, the Federal Reserve began to move interest rates off zero with the expectation that future moves would be in calibrated increments. The rise in rates would be of benefit to industry sales, particularly fixed annuity sales, while having a much slower effect on (increasing) insurer portfolio yields. Subsequent to this move, a high level of uncertainty has emerged regarding the "if" and "when" of future increases. The fear is that the Federal Reserve will not follow through on its desire to gradually raise interest rates this year because of concerns about global economic growth. This fear is evidenced by the ten-year treasury rate having fallen as much as fifty basis points since the December Federal Reserve action and whispers of "negative" interest rates becoming more prevalent.
There are estimates that the U.S. life insurance industry holds about 10% of its corporate bond investments in the energy sector. Downgrades of debt securities in this sector will require additional allocations of capital and increase risk-based capital requirements.
Regulatory change will demand the attention of the industry. The Department of Labor ("DOL") fiduciary proposal will be an intensely debated issue and the outcome remains uncertain. As currently drafted, the DOL fiduciary rule may impose onerous or unworkable conditions limiting interactions of insurers and their contracted agents with existing or prospective customers who might otherwise be interested in life insurance and annuity products as solutions for their financial needs.
Deferred Sales Inducements. Costs related to sales inducements offered on sales to new customers, principally on investment type contracts and primarily in the form of additional credits to the customer’s account value or enhancements to interest credited for a specified period, which are beyond amounts currently being credited to existing contracts, are deferred and recorded as other assets. All other sales inducements are expensed as incurred and included in interest credited to contract holders’ funds. Deferred sales inducements are amortized to income using the same methodology and assumptions as DPAC, and are included in interest credited to contract holders’ funds. Deferred sales inducements are periodically reviewed for recoverability. For more information about accounting for DPAC see Note 1, Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements.
Pension Plans and Other Postretirement Benefits. The Company sponsors a qualified defined benefit pension plan, which was frozen effective December 31, 2007, covering substantially all employees, and three non-qualified defined benefit plans covering certain senior officers. In addition, the Company has postretirement health care benefits for certain senior officers. The freeze of the qualified benefit pension plan ceased future benefit accruals to all participants and closed the Plan to any new participants. In addition, all participants became immediately 100% vested in their accrued benefits as of that date. In accordance with prescribed accounting standards, the Company annually reviews plan assumptions.
Surrender charges assessed against policyholder account balances upon withdrawal were $41.3 million in 2015 compared to $39.1 million in 2014 and $37.0 million in 2013. 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. Policy lapse rates by line of business in 2015 were generally consistent with those experienced in 2014, the annuity lapse rate decreased while the universal life lapse rate increased, and the overall lapse rate was slightly lower. The higher surrender charge income recognized in 2015 over 2014 reflects a slight change in the duration of policies at the time of surrender with earlier policy surrenders having a higher surrender charge assessed.
The growth in domestic life insurance sales the past several years have been driven principally by the sale of single premium life insurance products. In 2013, the Company began deferring the premium load associated with these products and spreading it over future income periods. The amounts shown above as "Other charges" represent current year deferrals of premium loads in excess of previously capitalized amounts amortized into revenue.
Debt securities generated approximately 94.1% of total investment income, excluding derivative gains and losses, in 2015, consistent with prior years. The Company’s strategy is to invest substantially all of its cash flows in fixed debt securities consistent with its guidelines for credit quality, duration, and diversification. The Company has experienced incremental cash flow from new business for investing in debt securities which has caused the portfolio to grow from $9.2 billion at December 31, 2013 to $9.6 billion at December 31, 2014 and to $10.0 billion at December 31, 2015. Investment yields on new bond purchases in 2015 remained below the portfolio's weighted average yield of approximately 4.25% at December 31, 2015. The yield on debt security purchases to fund insurance operations decreased to 3.51% in 2015 from 3.68% in 2014. Also impacting bond portfolio returns has been the volume of higher yielding debt securities maturing or being called by borrowers with the proceeds being reinvested into lower yielding securities.
The Company’s new mortgage loan activity has been relatively low in recent years given the low level of rates and the higher level of risk associated with commercial properties in this economic environment. Mortgage loan investment income in 2015 received incremental contributions from loan prepayment fees and profit participation receipts during the year. Policy loan and other invested asset balances outstanding have remained relatively stable declining modestly over the past few years. The higher level of investment income for other invested assets during 2014 reflects real estate profits participation loans held in a subsidiary company which received payments of approximately $3.0 million in that period.
Other revenues - Other revenues primarily pertain to the Company’s two nursing home operations in Reno, Nevada and San Marcos, Texas. Revenues associated with these operations were $20.6 million, $21.1 million and $23.3 million in 2015, 2014 and 2013, respectively. The 2015 amount also includes additional revenue recorded associated with the life interest in the Libbie Shearn Moody Trust.
The economic impact of option performance in the Company's financial statements is not generally determined solely by the option gain or loss included in net investment income as there is a corresponding amount recorded in the contract interest expense line. Rather, the Company's profitability with respect to these options is dependent upon the purchase cost of the option remaining within the financial budget for acquiring options embedded in the product pricing. Option prices vary with interest rates, volatility, and dividend yields among other things. As option prices vary, the Company manages for the variability by making offsetting adjustments to product caps, participation rates, and management fees. For the periods shown, the Company's option costs have been within the product pricing budgets.
Net realized investment gains (losses) - Realized gains (losses) on investments include proceeds on bond calls and sales as well as impairment write-downs on investments in debt and equity securities and real estate. The net investment gains reported in 2015 consisted of gross gains of $7.6 million, primarily from calls of debt securities, offset by gross losses of $0.4 million, which include other-than-temporary impairment losses described below.
The Company records impairment write-downs when a decline in value is considered to be other-than-temporary and full recovery of the investment is not expected. Impairments due to credit factors are recorded in the Company’s consolidated statement of earnings while non-credit (liquidity) impairment losses are included in other specific statement comprehensive income (loss). Impairment and valuation write-downs reflected in the consolidated statements of earnings are summarized in the following table.
Debt security impairments in 2014 and 2013 primarily pertain to 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 consolidated financial statements.
Equity impairments (common stocks) represent a mark-to-market write-down on securities in which the market discount to book value was significant and had been maintained for several reporting periods. Equity securities represent 0.1% of invested assets and individual holdings have an average cost basis of approximately $39,000.
Life and other policy benefits - Life and other policy benefits include death claims of $38.2 million, $31.7 million and $36.9 million for 2015, 2014 and 2013, respectively. While death claim amounts are subject to variation from period to period, the Company’s mortality experience has generally been consistent with or better than its product pricing assumptions. Mortality exposure is managed through reinsurance treaties under which the Company's retained maximum net amount at risk on any one life is capped at $500,000.
During 2013, annuity policy benefit obligations were increased $4.0 million pertaining to the market value adjustment feature on annuity contract surrenders and partial withdrawals transacted over a number of years. The amount of the market value adjustment for any single reporting period was not material given the length of time over which the transactions occurred. These incremental obligations were paid out during 2014.
Amortization of deferred policy acquisition costs - Life insurance companies are required to defer certain expenses that vary with, and are primarily related to, the cost of acquiring new business. The majority of these acquisition expenses consist of commissions paid to agents, underwriting costs, and certain marketing expenses. Recognition of these deferred policy acquisition costs (“DPAC”) as an expense in the consolidated financial statements occurs over future periods in relation to the expected emergence of profits priced into the products sold. This emergence of profits is based upon assumptions regarding premium payment patterns, mortality, persistency, investment performance, and expense patterns. Companies are required to review universal life and annuity contract assumptions periodically to ascertain whether actual experience has deviated significantly from that assumed. If it is determined that a significant deviation has occurred, the emergence of profits pattern is to be "unlocked" and reset based upon the actual experience. DPAC balances are also adjusted each period to reflect current policy lapse or termination rates, expense levels and credited rates on policies as compared to anticipated experience (“true-up”) with the adjustment reflected in current period amortization expense. In accordance with GAAP guidance, the Company must also write off deferred acquisition costs and unearned revenue liabilities upon internal replacement of certain contracts as well as annuitizations of deferred annuities.
True-up adjustments are recorded quarterly and the adjustments in 2015, 2014 and 2013 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 for the life insurance lines of business were positive (decrease to amortization expenses) during these periods, whereas the true-up adjustments for the annuity line of business were negative in these same periods incrementally adding to amortization expense.
Contract interest including fixed-index products also encompasses the performance of the index options associated with the Company's fixed-index products. As previously noted, the market performance of these derivative features resulted in net realized and unrealized gains (losses) in 2015, 2014 and 2013 of $(61.8) million, $68.6 million and $225.9 million, respectively.
Nursing home expenses include the Company's two facilities in Reno, Nevada and San Marcos, Texas. These two entities have operationally functioned at consistent levels of residents over the past several years. Certain higher acuity resident services were discontinued at the Reno facility in 2014 resulting in lower expenses.
Compensation expenses include share-based compensation costs for the Company's stock option plans related to outstanding vested and nonvested stock options and stock appreciation rights (SARs). These costs move in tandem with the number of stock options and SARs outstanding as well as the market price of the Company's Class A common share as a result of marking the stock options and SARs to fair value under the liability method of accounting. Consequently, the related expense amount varies positive or negative in any given period. For the three years shown, share-based compensation expense totaled $(0.9) million in 2015, $4.4 million in 2014 and $5.7 million in 2013. The expense increases in 2013 and 2014 reflect an increase in the Company's Class A common share price from $223.55 at December 31, 2013 to $269.25 at December 31, 2014, while the expense decrease in 2015 is indicative of a price decline to $251.94 at December 31, 2015. No awards of stock options or SARs were granted in 2015 and 2014.
In addition to share-based compensation costs, other compensation costs decreased to $20.9 million in 2015 from $23.8 million in 2014. Of the decline, $1.0 million of the reduction pertained to lower officer bonus amounts primarily due to international life and annuity sales results below target goals.
The Company’s domestic life insurance in force in terms of policy counts has been declining for several years resulting in lower universal life contract revenue charges from the in force block. The pace of new policies issued has lagged the number of policies terminating from death or surrender over the three years shown causing a declining level of insurance in force from which contract revenue is received. In 2015, the Company issued 1,920 new domestic life policies while 3,400 terminated. This was a slightly better ratio than in preceding years. Nonetheless, the number of domestic life insurance policies has declined from 57,740 at December 31, 2013 to 55,750 at December 31, 2014 and to 54,270 at December 31, 2015. Policy lapse rates in 2015 improved to 5.9% from 6.2% and 6.7% in 2014 and 2013, respectively.
During the past several years the Company has achieved some success in growing its domestic life insurance business with the number of new policies issued trending higher. Sales have been substantially weighted toward single premium policies which do not have much in the way of recurring premium payments. These products target wealth transfer strategies involving the movement of accumulated wealth in alternative investment vehicles, including annuities, into life insurance products. The Company launched a series of recurring premium payment whole life and term policies during 2014 which have added marginally to premiums levels thus far.
Net investment income for this segment of business has been gradually increasing due to the increased new business activity described above (single premium policies) and a higher level of investments needed to support the corresponding growth in policy obligations. The increase in net investment income has been partially muted by lower investment yields from debt security investment purchases during this time frame. Net investment income also includes the gains and losses on index options purchased to back the index crediting mechanism on fixed-index universal life products. A detail of net investment income for domestic life insurance operations is provided below.
As noted previously in the discussion of results from consolidated operations, 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 with the adjustment reflected in current period amortization expense. To the extent required, the Company may also record unlocking adjustments to DPAC balances. The following table identifies the effects of unlocking and true-up adjustments on domestic life insurance DPAC balances recorded through amortization expense for 2015, 2014 and 2013.
A third component of international universal life revenues include surrender charges assessed upon surrender of contracts by policyholders. In the midst of the financial crisis during 2008 through 2010, the Company’s international policyholders in particular exhibited concern regarding the developments in U.S. financial markets. This level of termination activity subsequently subsided in 2011 with the termination activity over the following years remaining relatively level. In 2015, termination activity revisited the levels last seen during the 2008 through 2010 period. The following table illustrates the Company’s international life termination experience over the past five years.
The Company’s most popular international products have been its fixed-index universal life products in which the policyholder can elect to have the interest rate credited to their policy account values linked in part to the performance of the S&P 500 Index®. Included in the totals in the above table are collected premiums for fixed-index universal life products of $84.5 million, $94.9 million and $93.4 million for the years ended 2015, 2014 and 2013, respectively. The decline in renewal premiums during 2015 corresponds with the increased termination activity discussed above.
Life and policy benefits primarily consist of death claims on policies. The Company’s clientele for international products are generally wealthy individuals with access to U.S. dollars and quality medical care. Consequently, the amounts of coverage purchased tend to be larger amounts than those for domestic life insurance. In the year ended December 31, 2015, the average face amount of insurance purchased was approximately $342,500, reflecting a level somewhat lower than that of immediately prior years. While life and policy benefit expense for the international life segment reflects the larger policies purchased, mortality due to natural causes is comparable to that in the United States. The Company's maximum risk exposure per insured life, after reinsurance, is capped at $500,000. The number of claims reported during 2015 was approximately 4% less than the prior year. However, the average net claim (after reinsurance) increased from $142,500 to $168,700. Measured over a period of years, the Company's international life mortality experience has generally been better than product pricing assumptions.
As indicated in the discussion concerning net investment income, contract interest expense includes fluctuations that are the result of the effect upon the embedded derivative for the performance of underlying equity indices associated with fixed-index universal life products. The amounts realized on purchased call options approximate the amounts the Company credits to policyholders. For more details about the Company’s use of index options to hedge the performance of equity indices refer to the derivative gain (loss) discussion in the Consolidated Operations section of this Item 7.
As a selling inducement, some of the deferred products, as well as the fixed-index annuity products, include a first year interest bonus ranging from 1% to 7% depending upon the product, in addition to the base first year interest rate. Other products include a premium bonus ranging from 2% to 10% which is credited to the account balance when premiums are applied. These bonus rates are deferred in conjunction with other capitalized policy acquisition costs. The amount deferred to be amortized over future periods amounted to approximately $17.7 million, $18.4 million and $26.2 million for the years ended December 31, 2015, 2014 and 2013, respectively. Amortization of deferred sales inducements is included as a component of annuity contract interest as described later in this discussion of annuity operations.
True-up adjustments for the deferred sales inducement balance are done each period similar to that done with respect to DPAC balances. For the years ended December 31, 2015, 2014, and 2013 deferred sales inducement balances on the consolidated balance sheet were reduced by $3.9 million, $1.6 million and $0.8 million, respectively, for true-up adjustments. These adjustments are included in the above table as an addition to bonus interest amortization. The Company also unlocked its deferred sales inducement balance in 2015 for future expense assumptions pertaining to product development override costs as previously discussed in the Consolidated Operations section of this report. The effect of the prospective unlocking was to decrease the deferred sales inducement balance by $1.8 million which increased contract interest expense by the same amount. No unlocking adjustments were made in 2014 and 2013.
The majority of litigation and legal matters the Company is involved with emanate from annuity products. Accordingly, the $6.5 million addition to the liability for legal matters during 2013 discussed in the Consolidated Operations section of this report was allocated to the Annuity Operations segment and is included in other operating expenses in that period.
Substantially all of the Company’s investable cash flows are directed toward the purchase of long-term debt securities. The Company’s investment policy calls for investing in debt securities that are investment grade, meet quality and yield objectives, and provide adequate liquidity for obligations to policyholders. Debt securities with intermediate maturities are targeted by the Company as they more closely match the intermediate nature of the Company’s policy liabilities and provide an appropriate strategy for managing cash flows. With the advent of the Federal Reserve's low interest rate environment, the percentage of mortgage-backed securities in the Company's investment portfolio has declined over the past few years reflecting fewer new purchases of these instruments as well as increased prepayment activity. This percentage has been over 35% of the portfolio in previous years. The Company holds minimal levels of U.S. Treasury securities due to their low yields and deposits most of these holdings with various state insurance departments in order to meet security deposit on hand requirements in these states.
The Company's percentage of below investment grade securities compared to total invested assets at December 31, 2015 increased from year-end 2014 due mostly to downgrades of several securities to below investment grade, primarily energy-related entities. The Company's holdings of below investment grade securities are relatively small and as a percentage of total invested assets low compared to industry averages.
Since the Company's adoption of the GAAP guidance and accounting for other-than-temporary impairments due to credit loss versus non-credit loss, the Company has recognized a total of $3.0 million of other-than-temporary impairments of which $2.3 million were deemed credit related and recognized as realized investment losses in earnings, and $0.7 million that was deemed non-credit related impairments and recognized in other comprehensive income.
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, 2015, approximately 28.2% 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 approximately $35.4 million in asset-backed securities as of December 31, 2015. This portfolio includes $3.4 million of manufactured housing bonds and $32.0 million of home equity loans (also referred to as subprime securities). The Company does not have any holdings in collaterized bond obligations (“CBO”s), collateralized debt obligations (“CDO”s), or collateralized loan obligations (“CLO”s). Principal risks in holding asset-backed securities are structural, credit, and capital market risks. Structural risks include the securities’ priority in the issuer’s capital structure, the adequacy of and ability to realize proceeds from collateral and the potential for prepayments. Credit risks include corporate credit risks or consumer credit risks for financing such as subprime mortgages. Capital market risks include the general level of interest rates and the liquidity for these securities in the marketplace.
The Company’s exposure to the subprime sector is limited to investments in the senior tranches of 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. The housing market subsequently stabilized and an improvement in the prices of subprime securities occurred as the bond market regained more liquidity. All of the loans classified as subprime in the Company’s portfolio as of December 31, 2015 were underwritten prior to 2005 as noted in the table below.
As of December 31, 2015, 3 of the subprime securities were rated AA, 2 were rated BBB, 2 were rated CC, 2 were rated CCC and 1was not rated.
The Company recognized no valuation losses for the years ended December 31, 2015, 2014 and 2013, respectively. The mortgage loan valuation allowance currently held represents a general valuation allowance established for the Company's mortgage loan portfolio based upon the Company's loss experience for more than ten years and is not specifically identified to individual loans.
The following table represents the mortgage loan allowance for the years ended December 31, 2015 and 2014:
The Company does not recognize interest income on loans past due ninety days or more. The Company had no mortgage loans past due six months or more at December 31, 2015 and 2014. There was no interest income that was not recognized in 2015, 2014 and 2013.
The contractual maturities of mortgage loan principal balances at December 31, 2015 and 2014 were as follows:
The Company's market risk liabilities, which include policy liabilities for annuity and supplemental contracts, are managed for interest rate risk through cash flow testing as previously described. As part of this cash flow testing, the Company has analyzed the potential impact on net earnings of a 100 basis point decrease and increases in increments of 100 basis points in the U.S. Treasury yield curve as of December 31, 2015. The potential impact on net earnings from these interest rate changes are summarized below.
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, 2015 and 2014.
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, 2015, 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 discount to the book value per share 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 its high financial strength ratings and the ability to take competitive advantages as they arise. The capacity of National Western to pay dividends to NWLGI is limited by law in the state of Colorado to earned profits (statutory unassigned surplus). At December 31, 2015, the maximum amount legally available for distribution without further regulatory approval is $117.1 million.