The following five-year financial summary includes comparative amounts derived from the audited consolidated financial statements.
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, 2012 follows. This discussion should be read in conjunction with the Company’s consolidated financial statements and related notes beginning on page 81 of this report.
The Company's business generally is aided by economic expansion, whether moderate or vigorous. Conversely, a muted economic recovery could adversely impact the demand for the Company's products in the future. Economic data has shown conflicting signals of both improvement and retrenchment over recent quarters generating uncertainty about the direction of the economy at least in the near term. The European debt crisis continues to cause stress within the markets and recent predictions of further contraction of economic activity in the region during 2013 amplify the concerns. There exists ongoing uncertainty to actions the United States Congress will take to address the national debt situation given the inability to address the "fiscal cliff" crisis in recent months. Although unemployment remains high at nearly 8% in the United States, recent minutes of Federal Reserve meetings indicate a growing faction no longer supporting the supposed stimulus effects of the quantitative easing programs implemented to spur economic growth. Inflation has now emerged as a concern to be monitored. Personal income growth remains relatively modest as the cessation of the payroll tax holiday of the past two years begins to filter through various measures of sales and consumption. In summary, many economic challenges remain both globally and in the United States.
The fixed income markets, our primary investment source, have generally experienced an improvement in fundamental credit quality as stronger liquidity and positive trends in corporate profitability provided a more favorable backdrop. The Company experienced minimal impairment and degradation of quality in its fixed income holdings during the financial crisis and subsequent recovery. Fixed maturity investment yields declined during 2012 as both credit spreads and U.S. Treasury yields migrated lower. Although the yield curve was moderately upward sloping at the end of 2012, the low overall interest rate environment creates a challenging scenario for obtaining yields to support crediting rates on interest sensitive products. We intentionally managed annuity sales in 2012 to lesser levels given the interest rate environment and the Company's desire to avoid adding blocks of business to its in force at exceptionally low interest rate thresholds.
Traditional life and annuity premiums - Traditional life and annuity premiums increased 3% in 2012 compared to 2011. 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 recent financial crisis generated renewed interest in the Company's term life insurance products particularly with residents outside of the United States.
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 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.
The table below summarizes the derivative gain (loss) amounts and total contract interest by year.
Net realized investment gains (losses) - Realized gains (losses) on investments include impairment write-downs on real estate and investments in debt securities as well as valuation allowances recorded on mortgage loans. The net investment gains reported in 2012 consisted of gross gains of $15.8 million, primarily from calls and sales of debt securities and the sale of a foreclosed property, offset by gross losses of $2.6 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 impairment losses are included in other comprehensive income (loss). Impairment and valuation write-downs reflected in the consolidated statements of earnings are summarized in the following table.
Equity impairments 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 $50,000.
The Company had been implementing new actuarial reserving systems over 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 substantially completed its installation of 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. During the conversion process, current reserving assumptions were reviewed and updated as appropriate.
Amortization of deferred policy acquisition costs - Life insurance companies are required to defer certain expenses that vary with, and are directly 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 and sales inducements. The Company defers sales inducements in the form of first year interest bonuses on annuity and universal life products that are directly related to the production of new business. These charges are deferred and amortized using the same methodology and assumptions used to amortize other capitalized acquisition costs and the amortization is included in contract interest. 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 profit patterns 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, unearned revenue liabilities, and deferred sales inducement assets upon internal replacement of certain contracts as well as annuitizations of deferred annuities.
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 $7.9 million and reduced DPAC asset balances for deferred annuities and universal life by a like amount.
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.
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 in 2012 of $27.1 million, net realized and unrealized losses of $33.3 million in 2011, and net realized and unrealized gains of $16.6 million in 2010.
Contract interest in 2010 also includes $16.7 million of policy credits added in conjunction with the settlement of a class action lawsuit involving the Company's annuity products. See additional comments in “Other Operating Expenses” below.
Other operating expenses - Other operating expenses consist of general administrative expenses, licenses and fees, commissions not subject to deferral, nursing home expenses and compensation costs. These are summarized in the table that follows.
Compensation expense includes share based compensation costs for the Company’s stock option plans related to outstanding vested and unvested stock options. As these costs vary in tandem with the Company's Class A common share price as a result of marking the stock options to fair value under the liability method of accounting, the related expense amount varies positive or negative in any given period. For the three years shown, share based compensation expense totaled $1.1 million in 2012, $(2.6) million in 2011 and $(0.1) million in 2010. The negative expense in 2011 and 2010 reflects the market price decline in the Company’s Class A common stock as of the reporting dates while the increase in 2012 reflects an increase in the Company's Class A common shares from $136.16 at December 31, 2011 to $157.74 at December 31, 2012.
At year-end 2012, the Company was informed by the California Life and Health Guaranty Fund Association that it would be assessing the Company approximately $1.8 million for its pro rata share as part of the finalization of the Executive Life Insurance Company insolvency of twenty years ago. The assessment will be forthcoming in the first half of 2013 and the entire amount was accrued at December 31, 2012 and included in taxes, licenses and fees expense.
Life and policy benefits for a smaller block of business are subject to variation from period to period. Claim activity during 2012 was consistent when compared to historical trends. The Company's overall mortality experience for this segment is in line with pricing assumptions.
As with domestic life operations, revenues from the international life insurance segment include both premiums on traditional type products and revenues from universal life insurance. A comparative detail of premiums and contract revenues is provided below.
As noted previously, premiums collected on universal life products are not reflected as revenues in the Company's consolidated statements of earnings in accordance with GAAP. Actual international universal life premiums collected are detailed below.
The Company’s most popular international products have been its fixed-index universal life products in which policyholders 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 $97.8 million, $98.1 million and $90.2 million for the years ended 2012, 2011 and 2010, respectively.
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. In the year ended December 31, 2012, the average face amount of insurance purchased was approximately $380,000, an increase of approximately 5% over the previous year. 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 expense shown for 2010 includes death claims of approximately $3.1 million, after reinsurance, associated with the Haiti earthquake in January 2010.
As indicated in the discussion concerning net investment income, contract interest expense includes fluctuations that are the result of the performance of underlying equity indices associated with fixed-index universal life products. The derivative gain (loss) realized on purchased call options is included in 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 Item 7.
The Company's annuity operations are almost exclusively in the United States. Although some of the Company's 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.
Deposits collected on annuity contracts are not reflected as revenues in the Company's consolidated statements of earnings in accordance with GAAP. Actual annuity deposits collected are detailed below.
Fixed-index products are more attractive for consumers when interest rate levels remain low and equity markets produce positive returns. Since the Company does not offer variable products or mutual funds, fixed-index products provide an important alternative to the Company's existing fixed interest rate annuity products. Fixed-index annuity deposits as a percentage of total annuity deposits were 79%, 65% and 63% for the years ended December 31, 2012, 2011 and 2010, respectively. The increasing percentage of fixed-index products to total annuity deposits reflects the low interest rate environment and the current bull market in equities.
Life and policy benefits for the annuity segment includes reserves established for contracts in a payout mode with or without life contingencies. The actuarial reserving systems that the Company implemented during the past several years included this particular block of policies. With the growth in the Company’s overall block of annuity business more contracts convert to a payout status and reserves are established for those policies. Additionally, during 2011, the Company added $19.2 million of reserves to a closed block of annuity business with higher minimum guaranteed interest rates as a result of extending the assumed benefit period beyond that previously used.
The fluctuation in reported contract interest amounts for fixed-indexed annuities is driven by sales levels, the level of the business in force and the positive or negative performance of equity markets on option values. The derivative gain (loss) information included in the net investment income discussion above is largely reflected in the amounts shown for contract interest for fixed-indexed annuities.
The Company's overall conservative investment philosophy is reflected in the allocation of its investments, which is detailed below as of December 31, 2012 and 2011. The Company emphasizes investment grade debt securities, with smaller holdings in mortgage loans and policy loans.
Substantially all of the Company’s investable cash flows are directed toward the purchase of 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. The percentage of mortgage-backed securities in the Company's investment portfolio declined during 2012 reflecting increased prepayment activity induced by the low interest rate environment. 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 theses states.
However, the Company does have exposure to the debt of non-financial companies in these countries. The following table shows bond holdings at December 31, 2012 of non-financial companies that are domiciled in Portugal, Ireland, Italy, Greece or Spain held in the available for sale and held to maturity debt security portfolios.
As of April 1, 2009, the Company adopted the GAAP guidance on the recognition and accounting for other-than-temporary impairments due to credit loss versus non-credit loss. See Note 1, Summary of Significant Accounting Policies, and Note 3, Investments, in the accompanying consolidated financial statements for further discussion. Since adoption of this new guidance, the Company recognized $7.4 million of other-than-temporary impairments; of which $2.3 million was deemed credit related and recognized as realized investment losses in earnings, and $5.1 million was deemed a non-credit related impairment and recognized in other comprehensive income.
The Company requires a minimum specified yield on mortgage loan investments. The historically low interest rate environment of the past couple of years has resulted in fewer loan opportunities being available which met the Company's required rate of return. Consequently, new mortgage loan origination activity has been less significant in this time frame with $21.5 million and $37.3 million in total loans for the years 2012 and 2011, respectively.
The Company's direct investments in real estate are not a significant portion of its total investment portfolio as most of these investments were acquired through mortgage loan foreclosures. For the year ended December 31, 2012, one property was acquired through mortgage loan foreclosure and for the year ended December 31, 2011, no real estate properties were acquired through mortgage loan foreclosure. The Company also participates in several real estate joint ventures and limited partnerships that invest primarily in income-producing retail properties. These investments have enhanced the Company's overall investment portfolio returns.
The Company held net investments in mortgage loans totaling $142.2 million and $157.5 million at December 31, 2012 and 2011, respectively. The diversification of the portfolio by geographic region, property type, and loan-to-value ratio was as follows:
The following table represents the mortgage loan allowance for the years ended December 31, 2012 and 2011:
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, 2012 and one mortgage loan past due six months or more at December 31, 2011, with principal balances totaling $0.0 million and $7.0 million, respectively. There was no interest income not recognized in 2012, 2011 and 2010.
The contractual maturities of mortgage loan principal balances at December 31, 2012 and 2011 were as follows:
The Company's real estate investments total approximately $18.8 million at December 31, 2012 and $19.2 million at December 31, 2011, 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 $1.6 million for the years ended December 31, 2012, 2011 and 2010, 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 gains and losses of $2.6 million, $(0.1) million and $(0.1) million associated with these properties in the years ended December 31, 2012, 2011 and 2010, respectively.
The Company offers fixed-indexed universal life and annuity products that guarantee the return of principal to policyholders and, at the policyholder’s election, credit interest based on a percentage gain in a specified market index, typically the S&P 500 Index® (policyholders may alternatively elect a fixed interest rate). Premiums and deposits received on these products are predominantly invested in investment grade fixed income securities with a portion used to purchase derivatives consisting of call options on the applicable market index to fund the index credits due to fixed-indexed policyholders. The call options purchased are one-year over-the-counter option contracts coinciding with the initial issuance of the policy and annual renewal periods in order to match the Company’s funding requirements for the underlying policies. On the respective anniversary dates of the index policies, the index used to compute the annual index credit is reset and a new one-year call option is purchased to fund the next annual index credit.
The fair value of derivative instruments presented in the Company’s consolidated financial statements totaling $57.9 million at December 31, 2012 and $30.8 million at December 31, 2011 pertain to notional policyholder account values of $2.02 billion and $1.95 billion at December 31, 2012 and 2011, respectively, electing interest credits based upon applicable market index performance.
Debt securities held to maturity are recorded at their amortized cost basis. Accordingly, the unrealized gain amounts shown in the table above are not incorporated into the Company's consolidated financial statements at December 31, 2012 and 2011, respectively.
Changes in interest rates typically have a sizable effect on the fair values of the Company's debt securities. During 2012, market interest rates of the ten-year U.S. Treasury bond decreased roughly 12 basis points from year end 2011. In addition, there was an increase in demand for corporate bonds across the yield curve causing spreads between corporate bonds and treasury securities to tighten. Therefore, the increase in unrealized gains of $163.5 million was the result of the decline both in interest rates and corporate bond spreads. The Company would expect similar results in the future from a significant upward or downward movement in market rates. However, since the majority of the Company's debt securities are classified as held to maturity, which are recorded at amortized cost, changes in fair values have relatively small effects on the Company's financial results.
The following table profiles the Company’s insurance liabilities at December 31, 2012 for annuities, deposit-type contracts and supplementary contracts with life contingencies by surrender and discretionary withdrawal characteristics.
Mortgage and other loans were modeled by discounting scheduled cash flows through the scheduled maturities of the loans, starting with interest rates currently being offered for similar loans to borrowers with similar credit ratings. Policy loans were modeled by discounting estimated cash flows using U.S. Treasury Bill interest rates as the base rates at December 31, 2012. The estimated cash flows include assumptions as to whether such loans will be repaid by the policyholders or settled upon payment of death or surrender benefits on the underlying insurance contracts and incorporate both Company experience and mortality assumptions associated with such contracts.
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, 2012. The potential impact on net earnings from these interest rate changes are summarized below.
In connection with the Company’s use of call options to hedge the equity return component of its fixed-indexed annuity and life products, the Company is exposed to the risk that a counterparty fails to perform under terms of the option contract. The Company purchases one-year option contracts from multiple counterparties and evaluates the creditworthiness of all counterparties prior to the purchase of the contracts. For consideration in contracting with a counterparty the rating required by the Company is a Standard & Poor’s credit rating of “A” or higher and a Moody’s rating of “A2” or higher. Accordingly, all options are purchased from nationally recognized financial institutions with a demonstrated performance for honoring their financial obligations and possessing substantial financial capacity. In addition, each counterparty is required to execute a credit support agreement obligating the counterparty to provide collateral to the Company when the fair value of the Company’s exposure to the counterparty exceeds specified amounts. The amount of collateral to be provided is based upon a sliding scale tied to the credit rating of the counterparty (the higher the credit rating of the counterparty the higher the threshold of exposure before collateral is to be provided). At the highest credit rating level the maximum counterparty net exposure not subject to collateral support is $20 million. This net exposure level declines as the counterparty credit rating declines and ultimately is $0 at a rating of “BBB+”. Counterparty credit ratings and credit exposure are monitored continuously by the Company’s Investment department with adjustments to collateral levels managed as incurred under the credit support agreements.
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 approximately $3.6 billion in deposits over the past three 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.
In the past, cash flows from the Company's insurance operations have been sufficient to meet current needs. Cash flows from operating activities were $290.3 million, $244.8 million, and $178.9 million in 2012, 2011, and 2010, respectively. The Company also has significant cash flows from both scheduled and unscheduled investment security maturities, redemptions, and prepayments. These cash flows totaled $1,821.4 million, $812.5 million, and $911.3 million in 2012, 2011, and 2010, respectively. Cash flows from security maturities, redemptions, and prepayments were amplified over the last three years due to the decline in interest rates. These cash flow items could be reduced if interest rates rise in 2013. Net cash flows from the Company's universal life and annuity deposit product operations totaled $144.2 million, $662.9 million, and $855.9 million in 2012, 2011, and 2010, respectively.
During October 2010, the FASB issued new guidance affecting insurance companies that incur costs in the acquisition of new and renewal insurance contracts. The guidance addresses the diversity in practice regarding the interpretation for which costs relating to the acquisition of new or renewal business qualifies for deferral. The new guidance specifies the acquisition costs which are capitalizable and those which must be expensed. The effective date is for interim and annual periods ending after December 15, 2011. The adoption of this guidance was effective January 1, 2012. See Note 1, Summary of Significant Accounting Policies, of the accompanying consolidated financial statements for additional disclosures.