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 National Western Life Insurance 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, National Western, 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.
Deferred Acquisition Costs (“DAC”). The Company is required to defer certain policy acquisition costs and amortize them over future periods. These costs include commissions and certain other expenses that vary with and are primarily associated with acquiring new business. The deferred costs are recorded as an asset commonly referred to as deferred policy acquisition costs. The DAC asset balance is subsequently charged to income over the lives of the underlying contracts in relation to the anticipated emergence of revenue or profits. Actual revenue or profits can vary from Company estimates resulting in increases or decreases in the rate of amortization. The Company regularly evaluates to determine if actual experience or other evidence suggests that earlier estimates should be revised. Assumptions considered significant include surrender and lapse rates, mortality, expense levels, investment performance, and estimated interest spread. Should actual experience dictate that the Company change its assumptions regarding the emergence of future revenues or profits (commonly referred to as “unlocking”), the Company would record a charge or credit to bring its DAC balance to the level it would have been if using the new assumptions from the inception date of each policy.
Other postretirement benefit assumptions include future events affecting retirement age, mortality, dependency status, per capita claims costs by age, health care trend rates, and discount rates. Per capita claims cost by age is the current cost of providing postretirement health care benefits for one year at each age from the youngest age to the oldest age at which plan participants are expected to receive benefits under the plan. Health care trend rates involve assumptions about the annual rate(s) of change in the cost of health care benefits currently provided by the plan, due to factors other than changes in the composition of the plan population by age and dependency status. These rates implicitly consider estimates of health care inflation, changes in utilization, technological advances and changes in health status of the participants. These assumptions involve uncertainties and judgment, and therefore actual performance may not be reflective of the assumptions.
Other significant accounting policies, although not involving the same level of measurement uncertainties as those discussed above but nonetheless important to an understanding of the financial statements, are described in Note 1, Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements.
The average invested asset decline in yield is due to the overall interest rate level decline and the Company obtaining lower yields on newly invested funds as well as prepayments, calls, and maturities of debt securities reinvested at lower rates. The additional income recognized from the other invested assets in 2006 and 2005, as previously discussed, also contributes to a higher yield for those years. Refer to the Derivatives discussion following this section for a more detailed explanation.
Derivative components included in net investment income and the corresponding contract interest amounts are detailed below.
The mortgage loan valuation writedown in 2007 and 2006 involves a New Orleans property whose value was negatively impacted by Hurricane Katrina.
Life and other policy benefits - Life and other policy benefits reflect death claims of $28.5 million, $26.2 million, and $30.0 million for 2007, 2006, and 2005, respectively.
Amortization of deferred policy acquisition costs decreased to $88.4 million for the year ended December 31, 2007 compared to $90.4 million and $88.0 million reported in 2006 and 2005. An unlocking adjustment was recorded in the current year which resulted in a decrease of amortization by $8.6 million. This unlocking adjustment was based upon changes to (1) future mortality assumptions reflecting current experience studies and (2) future cost of insurance rate assumptions based on company changes to future cost of insurance rate changes. In addition, a true-up adjustment was also recorded at December 2007 relative to partial surrender rates, mortality rates, credited interest rates and earned rates for the current year’s experience resulting in a $2.7 million decrease in amortization. Amortization for 2006 includes a true-up adjustment relative to partial surrenders, mortality assumptions, annuitizations, credited rates and earned rates which increased amortization in that year by approximately $4.3 million. There was a similar adjustment in 2005 relative to amortization assumptions that resulted in increased amortization for that year.
In accordance with the newly adopted SOP 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts, ("SOP 05-1") the Company’s amortization of these deferred policy acquisition costs is expected to increase in 2007 and in the future. Under this pronouncement, annuitizations and certain internal replacements of contracts result in the associated unamortized deferred acquisition costs, unearned revenue liabilities, and deferred sales inducement assets being written off.
Other operating expenses - Other operating expenses consist of general administrative expenses, licenses and fees, commissions not subject to deferral, and expenses of nursing home operations. Nursing home expenses amounted to $11.0 million, $10.2 million, and $7.6 million in 2007, 2006, and 2005, respectively. Compensation costs related to stock options totaled negative $1.1 million in 2007 as a result of marking the options to fair value under the liability method of accounting. In 2006, $13.1 million was recorded related to increase compensation costs resulting from a change to liability classification for the Company’s stock option plan. Compensation costs related to stock options reported in 2005 totaled $0.9 million.
A summary of segment earnings from continuing operations for the years ended December 31, 2007, 2006, and 2005 is provided below. The segment earnings exclude realized gains and losses on investments, net of taxes.
As the international life insurance in force continues to grow, the Company anticipates operating earnings to similarly increase. The amount of international life insurance in force has grown from $12.2 billion at December 31, 2005 to $13.3 billion at December 31, 2006 and to $14.8 billion at December 31, 2007.
Derivative income and losses fluctuate from period to period based on the S&P 500 Index® performance.
Annuity contract interest includes the equity component return associated with the Company's fixed indexed annuities. The detail of fixed indexed annuity contract interest compared to contract interest for all other annuities is as follows:
In comparison by year, the fluctuation in reported contract interest amounts for fixed indexed annuities is due to sales and the effect of the positive or negative performance of the stock market on option values as noted previously. As previously noted, contract interest reflects variations due to the S&P 500 Index® performance relative to the fair value of fixed indexed products.
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. Most of the income from the Company's subsidiaries is from a life interest in a trust. Gross income distributions from the trust totaled $4.1 million, pre-tax, in 2007 and $4.5 million and $3.9 million in 2006 and 2005, respectively.
The Company acquired a nursing home facility, which opened in late July, 2000 and is operated by an affiliated limited partnership, whose financial operating results are consolidated with those of the Company. Daily operations and management of the nursing home are performed by an experienced management company through a contract with the limited partnership. Nursing home operations generated $1.6 million, $1.0 million, and $1.3 million of operating earnings in 2007, 2006, and 2005, respectively.
The Company maintains a diversified portfolio which consists primarily of corporate, mortgage-backed, and public utility fixed income securities. Investments in mortgage-backed securities primarily include U.S. government agency pass-through securities and collateralized mortgage obligations ("CMO"). As of December 31, 2007 and 2006, the Company's debt securities portfolio consisted of the following:
The Company's investment guidelines prescribe limitations as a percent of the total investment portfolio by type of security and all holdings were within these threshold limits at December 31, 2007 and 2006. Because the Company's holdings of mortgage-backed securities are subject to prepayment and extension risk, the Company has substantially reduced these risks by investing primarily in collateralized mortgage obligations, which have more predictable cash flow patterns than pass-through securities. These securities, known as planned amortization class I ("PAC I"), very accurately defined maturity ("VADM") and sequential tranches are designed to amortize in a more predictable manner than other CMO classes or pass-throughs. The Company does not purchase tranches, such as PAC II and support tranches, that subject the portfolio to greater than average prepayment risk. Using this strategy, the Company can more effectively manage and reduce prepayment and extension risks, thereby helping to maintain the appropriate matching of the Company's assets and liabilities.
Due to recent negative news relative to the mortgage industry and in particular subprime mortgages the Company has included detailed information below related to the exposure at December 31, 2007 in the debt securities portfolio. The Company holds approximately $107.0 million in asset-backed securities at December 31, 2007. This portfolio includes $52.7 million of manufactured housing bonds and $54.3 million of home equity loans (also referred to as subprime securities). The Company does not have any holdings in collaterized bond obligations (CBOs), collateralized debt obligations (CDOs), or collateralized loan obligations (CLOs). 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 mortgage-backed portfolio includes one Alt-A security with a carrying value of $4.7 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 asset-backed portfolio includes thirteen subprime securities, totaling $54.7 million. 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 in 2007. These events caused illiquidity in the market and volatility in the market prices of subprime securities. All of the loans classified as Alt-A or subprime in the Company’s portfolio as of December 31, 2007 were underwritten prior to 2005 as noted in the table below.
As of December 31, 2007, all of the subprime securities were rated AAA. Seven of the thirteen subprime securities owned by the Company were wrapped by bond insurers in order to provide additional credit enhancement. These insurers were AMBAC Assurance Corporation, MBIA Insurance Corporation, and Financial Guaranty Insurance Company (FGIC). Subsequent to December 31, 2007, FGIC’s rating was downgraded by Moody’s Rating Service, which also caused the two subprime bonds that were insured by FGIC to be downgraded. Both of the securities insured by FGIC retained investment grade ratings and the rest of the subprime and Alt-A securities remained AAA-rated.
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 as to which category 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, 2007, approximately 33.5% 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 general, the Company originates loans on high quality, income-producing properties such as shopping centers, freestanding retail stores, office buildings, industrial and sales or service facilities, selected apartment buildings, motels, and health care facilities. The location of these properties is typically in major metropolitan areas that offer a potential for property value appreciation. Credit and default risk is minimized through strict underwriting guidelines and diversification of underlying property types and geographic locations. In addition to being secured by the property, mortgage loans with leases on the underlying property are often guaranteed by the lessee. This approach has proven to result in higher quality mortgage loans with fewer defaults.
The Company requires a minimum specified yield on mortgage loan investments. In the loan interest rate environment of the past few years, fewer loan opportunities have been available which met the Company's required rate of return. As a result, the Company's portfolio has declined.
The Company does not recognize interest income on loans past due ninety days or more. At December 31, 2007 and 2006, the Company had two mortgage loans past due six months or more with the principal balance totaling $7.0 million for both years. Interest income not recognized for past due loans totaled approximately $0.4 million in 2007 and 2006.
The contractual maturities of mortgage loan principal balances at December 31, 2007 are as follows:
The Company's real estate investments totaled approximately $12.0 million and $12.1 million at December 31, 2007 and 2006, respectively, 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 $1.0 million, $0.8 million, and $1.0 million for the years ended December 31, 2007, 2006, and 2005, 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 of $0.2 million, $0.6 million, and $6.7 million in 2007, 2006, and 2005, respectively associated with these properties.
Expected maturities of debt securities may differ from contractual maturities due to call or prepayment provisions. The models assume that prepayments on mortgage-backed securities are influenced by agency and pool types, the level of interest rates, loan age, refinancing incentive, month of the year, and underlying coupon. During periods of declining interest rates, principal payments on mortgage-backed securities and collateralized mortgage obligations increase as the underlying mortgages are prepaid. Conversely, during periods of rising interest rates, the rate of prepayment slows. Both of these situations can expose the Company to the possibility of asset-liability cash flow and yield mismatch. The model uses a proprietary method of sampling interest rate paths along with a mortgage prepayment model to derive future cash flows. The initial interest rates used are based on the current U.S. Treasury yield curve as well as current mortgage rates for the various types of collateral in the portfolio.
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, 2007, the Company had commitments of approximately $8.1 million which were approved by the Company's Board of Directors for the construction of a nursing home facility in Central Texas. The construction of the new facility began in 2007.
It is Company practice to not enter into off-balance sheet arrangements or to issue guarantees to third parties, other than in the normal course of issuing insurance contracts. Commitments related to insurance products sold are reflected as liabilities for future policy benefits. Insurance contracts guarantee certain performances by the Company.
(1) Refer to Note 9 in the Notes to Consolidated Financial Statements relating to Company leases.