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, 2008 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.
Impairment of Investment Securities. The Company’s accounting policy requires that a decline in the value of a security below its amortized cost basis be evaluated to determine if the decline is other-than-temporary. The primary factors considered in evaluating whether a decline in value for fixed income and equity securities is other-than-temporary include: (a) the length of time and the extent to which the fair value has been less than cost, (b) the reasons for the decline in value (credit event, interest rate related, credit spread widening), (c) the overall financial condition as well as the near-term prospects of the issuer, (d) whether the debtor is current on contractually obligated principal and interest payments, and (e) the intent and ability of the Company to retain the investment for a period of time sufficient to allow for any anticipated recovery. In addition, certain securitized financial assets with contractual cash flows are evaluated periodically by the Company to update the estimated cash flows over the life of the security. If the Company determines that the fair value of the securitized financial asset is less than its carrying amount and there has been a decrease in the present value of the estimated cash flows since the previous purchase or prior impairment, then an other-than-temporary impairment charge is recognized. The Company would recognize impairment of securities due to changing of interest rates or market dislocations only if the Company no longer had the ability to hold the securities until recovery or maturity. When a security is deemed to be impaired a charge is recorded as a realized loss equal to the difference between the fair value and amortized cost basis of the security. Once an impairment charge has been recorded, the fair value of the impaired investment becomes its new cost basis and the Company continues to review the other-than-temporarily impaired security for appropriate valuation on an ongoing basis. However, the new cost basis of an impaired security is not adjusted for subsequent increases in estimated fair value.
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 does regular evaluations 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.
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 DAC, and are included in interest credited to contract holders’ funds. Deferred sales inducements are periodically reviewed for recoverability. For more information about accounting for DAC including the discussion of the adoption of Statement of Position (“SOP”) 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts, see Note 1, Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements.
Credit spreads (difference between bond yields and risk-free interest rates) on fixed maturity securities increased markedly during 2008 given the market conditions. While the increase in credit spreads generated higher yields making our products more attractive to consumers, the higher rate levels also caused a reduction in the carrying value of our marked-to-market investments negatively impacting our financial condition and reported book value per share. It also caused us to hold a higher amount of cash and short-term investments in order to maintain a more liquid position during uncertain times.
Our operating strategy is to maintain capital levels substantially above regulatory and rating agency requirements. While not significant, our capital levels were nonetheless negatively impacted during 2008 as a result of impairment losses on our investments due to the downturn in economic activity, the increased level of credit spreads and limited liquidity conditions.
Universal life and annuity contract revenues - Revenues for universal life and annuity contract revenues increased 11.5% in 2008 compared to 2007. Revenues for these products consist of policy charges for the cost of insurance, administration charges, and surrender charges assessed against policyholder account balances, less reinsurance premiums. Cost of insurance charges were $82.9 million in 2008 compared to $74.3 million in 2007 and $67.7 million in 2006. Administrative charges were $25.0 million, $20.9 million, and $17.1 million for the years ended December 31, 2008, 2007, and 2006, respectively. Surrender charges assessed against policyholder account balances upon withdrawal were $39.1 million in 2008 compared to $33.4 million in 2007 and $28.7 million in 2006.
The average invested asset yield increase in 2008 is due to the Company obtaining higher yields on newly invested funds as well as re-investing prepayments, calls, and maturities of debt securities at higher rates. The additional income recognized from the other invested assets in 2006, as discussed below, contributes to a higher yield for that year. Refer to the Derivatives discussion following this section for a more detailed explanation.
Income and losses from index options are due to market conditions. Index options are intended to act as hedges to match the returns on the product’s underlying reference index and the rise or decline in the index causes option values to likewise rise or decline. While income from index options fluctuates with the underlying index, the contract interest expense to policyholder accounts for the Company’s fixed-indexed products also fluctuates in a similar manner and direction. In 2008 and 2007, the reference indices decreased resulting in index option losses and a reduction in contract interest expenses. In 2006, the reference indices increased and the Company recorded income from index options and likewise increased contract interest expenses.
Realized losses on investments have primarily resulted from impairment writedowns on investments in debt securities and valuation allowances recorded on mortgage loans. The Company records impairment writedowns when a decline in value is considered other-than-temporary and full recovery of the investment is not expected. Impairment writedowns are summarized in the following table.
For the year, the Company recorded other-than-temporary impairment writedowns on debt securities consisting of Washington Mutual ($9.3 million), Clear Channel Communications ($8.7 million), GMAC ($2.3 million), and Greentree ($1.5 million). Due to the events leading to the writedowns also providing evidence of a significant deterioration in the issuers’ credit worthiness, the Washington Mutual, Greentree Financial and two GMAC securities were transferred from held to maturity to available for sale.
The $5.4 million of equity impairments in 2008 include Fannie Mae and Freddie Mac preferred stock holdings ($4.6 million) and mark-to-market writedowns on various other equity holdings.
Life and other policy benefits - Life and other policy benefits include death claims of $29.6 million, $28.5 million, and $26.2 million for 2008, 2007, and 2006, respectively.
In accordance with the adoption of SOP 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts ("SOP 05-1"), beginning in 2007 the Company’s amortization of deferred policy acquisition costs is expected to increase. Under this pronouncement, annuitizations and certain internal replacements of contracts result in the associated contract’s unamortized deferred acquisition costs, unearned revenue liabilities, and deferred sales inducement assets being written off.
Contract interest includes the performance of the derivative component of the Company's equity-indexed products. As previously noted, the recent market performance of these derivative features decreased contract interest expense in 2008 and 2007, while also decreasing the Company's investment income given the hedge nature of the options. During 2006, the reverse was noted, as the underlying reference index performance was up resulting in higher investment income and contract interest expense. With these credited rates, the Company generally realized its targeted interest spread on its products.
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 $11.4 million, $11.0 million, and $10.2 million in 2008, 2007, and 2006, respectively. Compensation costs related to stock options totaled negative $1.4 million in 2008 and 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 of increased compensation costs resulted from a change to liability classification for the Company’s stock option plan.
During 2008, the Company was notified that its 2005 tax return amendment, which was filed September 2007, was being audited by the IRS. The audit is currently in progress. Adjustments to the amended return are not expected to have a material effect on the financial condition or operating results of the Company.
A summary of segment earnings from continuing operations for the years ended December 31, 2008, 2007, and 2006 is provided below. The segment earnings exclude realized gains and losses on investments, net of taxes.
The largest selling product in the international life insurance segment for the past five years has been a fixed-indexed universal life policy with the equity component linked in part to an equity index. With the growth in this block of business, the period-to-period changes in fair values of the underlying options have had an increasingly greater impact on net investment and contract interest. A detail of net investment income for international life insurance operations is provided below.
Derivative income and losses fluctuate from period to period based on the Company’s international equity-indexed universal life product and the applicable performance of the S&P 500 Index®.
As the international life insurance in force continues to grow, the Company anticipates operating earnings to increase as well. The amount of international life insurance in force has grown from $13.3 billion at December 31, 2006 to $14.8 billion at December 31, 2007 and $15.9 billion at December 31, 2008.
Derivative income and losses fluctuate from period to period based on the performance of the indices underlying the Company’s fixed-indexed products.
With respect to deferred policy acquisition costs, the Company recorded an unlocking adjustment of $6.3 million and a true-up adjustment of $11.1 million that together increased amortization by $17.4 million in 2008. During 2007 the Company recorded an unlocking adjustment of $1.8 million and true-up adjustments of $3.3 million resulting in decreased amortization of deferred acquisition costs. A true-up of assumptions in 2006 resulted in increased amortization of deferred policy acquisition costs of $3.1 million.
During the fourth quarter of 2008, during a detailed review of Deferred Acquisition Cost assets, the Company identified that it had over capitalized $ 2.4 million of cost during the first three quarters of 2008, and $3.5 million for periods prior to 2008. This immaterial error was corrected during the fourth quarter and resulted in a decrease in the deferred acquisition cost and an increase in amortization.
The Company is required to periodically adjust for actual experience that varies from that assumed. While management does not currently anticipate any impact from unlocking in 2009, facts and circumstances may arise in the future which require that the factors be reexamined.
In comparison by year, the fluctuation in reported contract interest amounts for fixed-indexed annuities is due to sales and the positive or negative performance of the stock market on option values as noted previously. In the fourth quarter of 2008, the Company increased its amortization of bonus interest (deferred sales inducements) by approximately $3.5 million for updates in future expected gross profit assumptions.
Other operating expenses in 2008 were level compared to 2007. The 2006 expense includes an additional $5.0 million due to increased compensation cost on stock options resulting from the change to liability classification for the Company’s plan. Compensation costs were $0.5 million in 2008.
The Company's overall conservative investment philosophy is reflected in the allocation of its investments, which is detailed below as of December 31, 2008 and 2007. The Company emphasizes investment grade debt securities, with smaller holdings in mortgage loans and policy loans.
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, 2008 and 2007. 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 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, 2008 in the debt securities portfolio. The Company holds approximately $88.3 million in asset-backed securities at December 31, 2008. This portfolio includes $41.3 million of manufactured housing bonds and $47.0 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.
In addition to diversification, an important aspect of the Company's investment approach is managing the credit quality of its investments in debt securities. Thorough credit analysis is performed on potential corporate investments including examination of a company's credit and industry outlook, financial ratios and trends, and event risks. This emphasis is reflected in the high average credit rating of the Company's portfolio with 98.7% held in investment grade securities. In the table below, investments in debt securities are classified according to credit ratings by Standard and Poor's ("S&P®"), or other nationally recognized statistical rating organizations if securities were not rated by S&P®.
As of December 31, 2008, the Company's percentage of below investment grade securities compared to total invested assets totaled 1.2%. The decrease from 2007 is primarily due to maturities, tenders, principal payments, and one issue being upgraded during the year. The Company's holdings of below investment grade securities as a percentage of total invested assets is relatively small compared to industry averages.
Generally accepted accounting principles require that investments in debt securities be written down to fair value when declines in value are judged to be other than temporary. As defined in SFAS No. 157, Fair Value Measurement, (“SFAS 157”) fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (an exit price methodology). SFAS 157 establishes a framework for measuring fair value that includes a hierarchy used to classify inputs used in measuring fair value. The hierarchy prioritizes inputs to valuation techniques used to measure fair value into three levels which are either observable or unobservable. Observable inputs reflect market data obtained from independent sources while unobservable inputs reflect an entity’s view of market assumptions in the absence of observable market information. The level in the fair value hierarchy within which the fair value measurement falls is determined based on the lowest level input that is significant to the fair value measurement. The three levels of the fair value hierarchy defined by SFAS 157 are as follows:
Level 1: Fair value is based on unadjusted quoted prices in active markets that are accessible to the Company for identical assets or liabilities. Active markets are those in which transactions for the asset or liability occur in sufficient frequency and volume to provide pricing information on an ongoing basis. These generally provide the most reliable evidence and are used to measure fair value whenever available. The Company’s Level 1 assets include equity securities that are traded in an active exchange market. Valuations are obtained from readily available pricing sources for market transactions involving identical assets.
Level 2: Fair value is based upon significant inputs other than quoted prices in active markets included in Level 1, which are either directly or indirectly observable for substantially the full term of the asset or liability through corroboration with observable market data as of the reporting date. Level 2 inputs include quoted market prices in active markets for similar assets and liabilities, quoted market prices in markets that are not active for identical or similar assets or liabilities, model-derived valuations whose inputs are observable or whose significant value drivers are observable and other observable inputs. The Company’s Level 2 assets include fixed maturity debt securities (corporate and private bonds, government or agency securities, asset-backed and mortgage-backed securities), preferred stock, certain equity securities, and over-the-counter derivative contracts. The Company’s Level 2 liabilities consist of certain product-related embedded derivatives. Valuations are generally obtained from third party pricing services for identical or comparable assets or determined through use of valuation methodologies using observable market inputs.
The following table provides additional information about fair value measurements for which significant unobservable (Level 3) inputs were utilized to determine fair value.
Realized gains (losses) on Level 3 assets and liabilities are reported in the consolidated statements of earnings as net investment gains (losses), while unrealized gain (losses) on debt and equity securities are reported as other comprehensive income (loss) within stockholders’ equity.
The Company does not recognize interest income on loans past due ninety days or more. The Company had two mortgage loans past due six months or more with the principal balance totaling $7.0 million at December 31, 2008, 2007 and 2006. Interest income not recognized for past due loans totaled approximately $0.4 million in 2008, 2007, and 2006.
The Company recognized valuation losses of $1.0 million, $1.5 million, and $2.1 million for the years ended December 31, 2008, 2007, and 2006 respectively, based on information which indicated that the Company may not collect all amounts in accordance with the mortgage agreement. While the Company closely manages its mortgage loan portfolio, future changes in economic conditions can result in impairments beyond those currently identified.
The contractual maturities of mortgage loan principal balances at December 31, 2008 are as follows:
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 annuity and supplemental contracts in force at December 31, 2008, and does not consider new product sales or the possible impact of interest rate changes on sales.
The actual amounts paid by product line in connection with surrenders and withdrawals for the years ended December 31 are noted in the table below.
In the past, cash flows from the Company's insurance operations have been sufficient to meet current needs. Cash flows from operating activities were $195 million, $260 million, and $224 million in 2008, 2007, and 2006, respectively. The Company also has significant cash flows from both scheduled and unscheduled investment security maturities, redemptions, and prepayments. These cash flows totaled $729 million, $517 million, and $399 million in 2008, 2007, and 2006, respectively. Cash flows from security maturities, redemptions, and prepayments were relatively higher over the last three years due to the decline in interest rates. These cash flow items could be reduced if interest rates rise in 2009. Net cash flows from the Company's universal life and annuity deposit product operations totaled inflows (outflows) of $(118) million, $(93) million, and $25 million in 2008, 2007, and 2006, respectively.
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, 2008, the Company had commitments of approximately $2.5 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.
In December 2007, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 141(R), Business Combinations. SFAS 141(R) establishes how an entity accounts for the identifiable assets acquired, liabilities assumed, and any noncontrolling interests acquired, how to account for goodwill acquired and determines what disclosures are required as part of a business combination. SFAS 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008, early adoption is prohibited. The Company is currently evaluating the impact that the adoption of this statement will have on the consolidated financial position, results of operations and disclosures.
In February 2008, the FASB issued FSP FAS 157-2, Effective Date of FASB Statement No. 157. This FSP delays the effective date of SFAS 157 for nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis, to fiscal years and interim periods beginning after November 15, 2008.
In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133. This statement requires enhanced disclosures regarding an entity’s derivative and hedging activity to enable investors to better understand the effects on an entity’s financial position, financial performance, and cash flows. SFAS No. 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. The adoption of SFAS No. 161 is not expected to have a material impact on the Company’s consolidated financial statements.
In September 2008, the FASB issued FSP No. FAS 133-1 and FIN 45-4, Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of FASB Statement No. 161. This FSP amends SFAS 133 to require disclosures by entities that assume credit risk through the sale of credit derivatives including credit derivatives embedded in a hybrid instrument to enable users of financial statements to assess the potential effect on its financial position, financial performance, and cash flows from these credit derivatives. This FSP also amends FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, to require additional disclosure about the current status of the payment/performance risk of a guarantee. FSP FAS 133-1 and FIN 45-4 are effective for financial statements issued for fiscal years and interim periods ending after November 15, 2008. The Company does not expect the adoption of FSP FAS 133-1 and FIN 45-4 to have an effect on the Company’s consolidated financial condition and results of operations.
In September 2005, the AICPA issued Statement of Position (“SOP”) 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts, which is effective for internal replacements occurring in fiscal years beginning after December 15, 2006. SOP 05-1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments. SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights, or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. The Company has an impact related to the adoption of SOP 05-1 for contracts which have annuitized and relative to reinstatements of contracts in that the unamortized deferred acquisition costs and deferred sales inducement assets must be written-off at the time of annuitization and may not be continued related to reinstatements. SOP 05-1 results in changes in assumptions relative to estimated gross profits which affects unamortized deferred acquisition costs, unearned revenue liabilities, and deferred sales inducement balances as of the beginning of the year. The effect of this SOP on beginning retained earnings as of January 1, 2007 was a decrease of $2.2 million, net of tax, as detailed below.