National Western markets and distributes its domestic products primarily through independent marketing organizations (IMOs). These IMOs assist the Company in recruiting, contracting, and managing independent agents. The Company currently has over 85 IMOs contracted who in turn have contracted over 6,000 independent agents with the Company. Roughly 20% of these contracted agents have submitted policy applications to the Company in the past twelve months.
The Company maintains a diversified portfolio which consists primarily of corporate, mortgage-backed, and public utilities fixed income securities. Investments in mortgage-backed securities include primarily U.S. government agency pass-through securities and collateralized mortgage obligations (CMOs). As of December 31, 2001, 2000, and 1999, the Company's debt securities portfolio consisted of the following:
This emphasis is reflected in the high average credit rating of the Company=s portfolio. In the table below, investments in debt securities are classified according to credit ratings by Standard and Poor=s (S&P7), or other nationally recognized statistical rating organizations if securities were not rated by S&P7 :
National Western does not purchase below investment grade securities. Investments held in debt securities below investment grade are the result of subsequent downgrades of the securities. During 2001, the Company's percentage of below investment grade securities increased primarily after the events of September 11th as Company holdings in certain industries (i.e. airlines) were downgraded across the board. Despite these downgrades, the Company's holdings of below investment grades securities is much lower than industry averages and is a small percentage of total invested assets. These holdings are summarized below.
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 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, 2001, approximately 30% 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.
In conjunction with the required implementation of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," during 2001 the Company was permitted to reclassify securities previously included as held to maturity to available for sale with an aggregate amortized cost of $294 million. The net unrealized losses on the transferred securities totaled $5,148,000, after the effects of deferred taxes and deferred policy acquisition costs. This adjustment was reflected in the Company's consolidated financial statements in other comprehensive income as part of the cumulative effect of a change in accounting principle as of January 1, 2001.
The Company does not recognize interest income on loans past due three months or more. At December 31, 2001 and 2000, the Company had mortgage loan principal balances past due three months or more of $3,014,000 and $2,983,000, respectively. The Company will at times restructure mortgage loans under certain conditions, which may involve changes in interest rates, payment terms, or other modifications. The Company had mortgage loan principal balances with restructured terms totaling $7,486,000 and $7,749,000 at December 31, 2001 and 2000, respectively. Interest income not recognized for past due and restructured loans totaled approximately $236,000 and $309,000 in 2001 and 2000, respectively.
Market risk is the risk of change in market values of financial instruments due to changes in interest rates, currency exchange rates, commodity prices, or equity prices. The most significant market risk exposure for National Western is interest rate risk. The fair values of fixed income debt securities correlate to external market interest rate conditions. Because interest rates are fixed on almost all of the Company
=s debt securities, market values typically increase when market interest rates decline, and decrease when market interest rates rise. However, market values may fluctuate for other reasons, such as changing economic conditions or increasing event-risk concerns.
In addition to the securities analyzed above, the Company invests in index options which are derivative financial instruments used to hedge the equity return component of the Company's equity-indexed annuities. The values of these options are primarily impacted by equity price risk, as the options' fair values are dependent on the performance of the S&P 500
The above-described scenarios produce estimated changes in cash flows as well as cash flow reinvestment projections. Estimated cash flows in the Company's model assume cash flow reinvestments which are representative of the Company's current investment strategy. Calls and prepayments include scheduled maturities and those expected to occur which would benefit the security issuers. Assumed policy surrenders consider differences and relationships between credited interest rates and market interest rates as well as surrender charges on individual policies. The impact to earnings also includes the expected effects on amortization of deferred policy acquisition costs. The model considers only investment annuity and supplemental contracts in force at December 31, 2001, and does not consider new product sales or the possible impact of interest rate changes on sales.
A summary of operating results, net of taxes, for the years ended December 31, 2001, 2000, and 1999 is provided below:
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. During 2000, the Company's revenues associated with surrender charges increased substantially due to higher than normal terminations of annuity contracts. Although generating revenue for financial reporting purposes, the increase in annuity terminations negatively impacted 2000 earnings as the Company lost the profits associated with maintaining the contracts inforce. In 2001, the Company's retention of inforce policies and contracts improved substantially contributing to higher operating earnings. However, revenues decreased from a lower incidence of surrender charges. Surrender charge revenue was $26.7 million in 2001 compared to $36.4 million and $31.2 million in 2000 and 1999, respectively.
Net investable cash flow is primarily invested in investment grade debt securities. With the steady decline in interest rate levels during 2001, this was even more the case as the market for mortgage loans fell below the Company's required yield levels for this type of investment. Despite the drop in interest rate levels, the Company still generated higher net investment earnings. A significant contributor was increased profit participation earnings related to other equity-type loans on income producing real estate properties. Although the Company has minimal holdings in these type loans, these investments have been profitable, are related to high quality properties, and are supported by strong borrower guarantees. In addition, investment expenses were reduced substantially as legal fees associated with an investment related lawsuit subsided with the favorable resolution of this matter to the Company.
The loss from index options in 2001 and 2000 was due to poor stock market conditions, specifically the performance of the S&P 500 Index®. Index options are intended to act as hedges to match closely the returns on the S&P 500 Index®. With the decline in this index, the index option values likewise declined. While income from index options was lower, the contract interest expense for the Company's equity-indexed annuities was also substantially lower.
Realized Gains and Losses on Investments: The losses in 2001 and 2000 consist primarily of impairment writedowns for investments in debt securities. The Company records impairment writedowns when a decline in value is considered other than temporary and full recovery of the investment is not expected. During 2001, several noteworthy corporations filed for bankruptcy in whose debt securities the Company held positions. Impairment writedowns were recorded for these holdings including Enron Corporation ($9.0 million), Lukens, Inc. ($14.4 million) and Federal Mogul Corporation ($4.4 million). Impairment writedowns in 2000 totaled $14.7 million. The gains in 1999 consist primarily of gains from sales and calls of debt securities totaling $6.3 million, offset by other than temporary impairment writedowns of $4.4 million. The Company also recognized gains totaling $2.0 million on real estate in 1999.
Life insurance companies are required to defer certain expenses associated with 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 in the financial statements is to occur over future periods in relation to the 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 revisit these 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. In 2000, the Company determined that the persistency of annuity contracts had deviated from assumptions such that an unlocking was required to accelerate the amortization of deferred policy acquisition costs. As a result, amortization expense increased from $39.1 million in 1999 to $47.9 million 2000. In 2001, the Company revisited its assumptions regarding the emergence of profits of its business and determined that unlocking was again required to incorporate improved persistency with respect to its annuity block of business and to factor in the recent realized investment loss experience. The outcome of these revisions resulted in the amortization of deferred policy acquisition costs decreasing to $27.4 million in 2001. While the Company is required to evaluate its emergence of profits continually, management believes that the current amortization patterns of deferred policy acquisition costs are reflective of actual experience.
The Company closely monitors its credited interest rates on interest sensitive policies, taking into consideration such factors as profitability goals, policyholder benefits, product marketability, and economic market conditions. Average credited rates, calculated based on policy reserves for the Company
Federal Income Taxes: Federal income taxes on earnings from continuing operations for 2001, 2000, and 1999 reflect effective tax rates of 34.2%, 32.9%, and 34.1%, respectively, which are lower than the expected Federal rate of 35%. The effective tax rate is lower than the Federal rate of 35% primarily due to tax-exempt investment income related to municipal securities and dividends-received deductions on income from stocks.
The Company's U.S. operations have historically emphasized annuity product sales over life product sales. Consequently, domestic life revenues have been declining for several years. However, a refocus on domestic life business was identified as a focal point of the Company in 2001 which resulted in increased recruiting of new distribution and the development of new life insurance products. It is the Company's goal to more than double domestic life product sales in 2002 and to continue to attract new sources of distribution.
The Company's international life operations has been a steady performer as evidenced by the growth in collected premiums. Management expects this growth to accelerate in 2002 with the addition of new contracted distribution which began to occur in the fourth quarter of 2001. This distribution was attracted to National Western given the Company's longstanding reputation for supporting its international life products and the instability of competing companies in this area. In addition, the Company released its first equity-indexed universal life product for international life operations early in 2002 which has been well received by its independent distribution.
After an unusually high amount of death claims in 2000, international life mortality returned to expected levels. As the international life insurance inforce continues to grow, the Company anticipates operating earnings to similarly increase. The amount of international life insurance inforce has grown from $6.6 billion at December 31, 1999, to $6.7 billion at December 2000 and $7.1 billion at December 31, 2001.
=s annuity operations are almost exclusively in the United States. Although some of the Company=s annuities and investment contracts are available to international residents, current sales are small relative to total annuity sales. A comparative analysis of results of operations for the Company=s annuity segment is detailed below:
As previously noted, the Company's earnings are dependent upon annuity contracts persisting or remaining in force. While revenues decline with a reduction in surrender charges, the Company's earnings benefit.
Deposits collected on annuity contracts are not reflected as revenues in the Company's statements of earnings in accordance with generally accepted accounting principles. Actual annuity deposits collected for the years ended December 31, 2001, 2000, and 1999 are detailed below.
Sales of equity-indexed annuities began declining during the year ended December 31, 1999, primarily due to volatility in the stock market. This volatility affects both the demand for these annuities and the pricing of these products. Increased product costs from stock market volatility, including costs of index options used to hedge the equity return component of these annuities and lower policyholder asset fees can reduce potential credited interest to policyholders. The lower production level continued throughout 2001, which is consistent with the poor performance of the stock market and the negative outlook that persisted during 2001. However, because the Company does not offer variable products or mutual funds, these products provide a key equity-based alternative to the Company
As previously described, index options are used to hedge the equity return component of the Company=s equity-indexed annuity products with any gains or losses from the sale or expiration of the options, as well as period-to-period changes in fair values, reflected in net investment income. Excluding index option income or losses from investment income in the annuity segment results in net investment income totaling $194.1 million, $188.3 million, and $180.6 million for 2001, 2000, and 1999, respectively.
Other income for 1999 includes $8.5 million in income pertaining to litigation involving an independent marketing organization. The amount related to accrued bonus commissions which were not owed as a result of the settlement of the Company's lawsuit against the former marketing organization.
As previously described the Company unlocked its deferred policy acquisition cost amortization factors for changes in persistency of the annuity block of business in both 2000 and 2001 and for changes in investment earnings in 2001. The changes in 2000 accelerated the amortization of deferred policy acquisition costs while the 2001 unlocking adjusted the amortization stream back. The Company is required to periodically adjust these factors for actual experience that varies from assumptions. While management does not currently anticipate any impact from unlocking in 2002, facts and circumstances may arise in the future which require that the factors be reexamined.
Annuity contract interest includes the equity component return associated with the Company's equity-indexed annuities. The detail of equity-index annuity contract interest compared to contract interest for all other annuities is as follows:
The decrease in contract interest for all other annuities reflects managed reductions in credited interest rates necessary for the Company to maintain its required spread.
A primary liquidity concern is the risk of an extraordinary level of early policyholder withdrawals. The Company includes provisions within its annuity and universal life insurance policies, such as surrender charges, that help limit and discourage early withdrawals. Cash flow projections and cash flow 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 adequate to meet the demand for funds.
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 $142 million, $139 million, and $118 million in 2001, 2000, and 1999, respectively. The Company also has significant cash flows from both scheduled and unscheduled investment security maturities, redemptions, and prepayments. These cash flows totaled $162 million, $113 million, and $187 million in 2001, 2000, and 1999, respectively. The Company expects cash flows from these sources in 2002 at levels consistent with the past year.
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. There are also no current or anticipated material commitments for capital expenditures in 2002.
Revenue Recognition: Premium income for the Company's traditional life insurance contracts is generally recognized as the premium becomes due. Revenue on universal life and annuity contracts (deposit balance products) are recognized differently. Premiums on deposit balance products are added to the policy account value as the Company's liability. This deposit balance is then charged a fee for the cost of insurance, administration, surrender, and certain other charges which are recognized as revenue in the period the fees are charged to the policyholder. Benefits and expenses are matched against revenues in a manner by which they are incurred as the revenues are earned.
As discussed in Item 1.(a), regulations that affect the Company and the insurance industry are often the result of efforts by the National Association of Insurance Commissioners (NAIC). Insurance companies were required to adopt new statutory accounting practices promulgated by the NAIC in 2001 which resulted in changes to existing practices used in the preparation of statutory financial statements, and in the case of National Western increased statutory capital and surplus by approximately $3.9 million as of January 1, 2001. The NAIC routinely publishes new regulations as model acts or laws which states subsequently adopt as part of their insurance regulations. Currently, the Company is not aware of any other NAIC regulatory matter material to its operations or reporting of financial results.
The 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. Statutory laws prohibit public dissemination of certain RBC information. However, the Company's current statutory capital and surplus is significantly in excess of the threshold RBC requirements.