The Company leases approximately 72,000 square feet of office space in Austin, Texas. This lease expires in 2010 and specifies lease payments that gradually increase over the term of the lease. Currently, lease payments are $487,500 per year plus taxes, insurance, maintenance, and other operating costs. Lease costs and related operating expenses for office facilities of the Company's subsidiaries are not significant in relation to the Company's consolidated financial statements.
In addition to the life insurance business, the Company had a brokerage operations segment through its wholly owned subsidiary, The Westcap Corporation (Westcap). However, during 1995 Westcap closed its sales offices and approved a plan to cease all brokerage operations. Subsequently on April 12, 1996, Westcap and its wholly owned subsidiary, Westcap Enterprises, Inc., separately filed voluntary petitions for reorganization under Chapter 11 of the U.S. Bankruptcy Code. The bankruptcy reorganization was completed in January, 1999, National Western retained 100% continuing ownership of the reorganized Westcap, and the subsidiary is now operating as a real estate management company. Accordingly, the brokerage segment is reported as discontinued operations throughout this report and in the accompanying financial statements.
The Company's overall conservative investment philosophy is reflected in the allocation of its investments, which is detailed below as of December 31, 1999 and 1998. The Company emphasizes investment grade debt securities, with smaller holdings in mortgage loans and policy loans.
The Company maintains a diversified debt securities portfolio which consists of various types of fixed income securities including primarily corporate, mortgage-backed securities, and public utilities. Investments in mortgage-backed securities include primarily U.S. government agency pass-through securities and collateralized mortgage obligations (CMOs). As of December 31, 1999, 1998, and 1997, the Company's debt securities portfolio consisted of the following mix of securities based on amortized cost:
An important aspect of the Company's investment philosophy 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. National Western continues to follow its conservative investment philosophy by minimizing its holdings of below investment grade debt securities, as these securities generally have greater default risk than higher rated corporate debt. These issuers usually are more sensitive to adverse industry or economic conditions than are investment grade issuers. The Company's small holdings of below investment grade debt securities are summarized below.
The Company's holdings of below investment grade debt securities have increased from $44,974,000 at December 31, 1998, to $70,900,000 at December 31, 1999. This increase is due to downgrades of investment grade debt securities as opposed to purchases of such holdings. Historically, the Company's strong credit risk management and commitment to quality has resulted in minimal defaults in the debt securities portfolio. At December 31, 1999, 1998, and 1997, no securities were in default and on nonaccrual status.
During 1999 the Company recorded permanent impairment writedowns totaling $4,403,000 related to two separate securities. The writedowns were reflected as realized losses in the accompanying financial statements. The Company is closely monitoring these securities as well as its other below investment grade holdings. While additional losses are not anticipated based on the current status and condition of these securities, continued credit deterioration of some securities is possible, which may result in further writedowns. Recently, credit deterioration of issuers has been due primarily to an increasing amount of acquisition activity and stock repurchase programs which cause companies to become more leveraged and less creditworthy.
Although there is some exposure to below investment grade debt securities, the Company is firmly committed to minimizing credit risks and maintaining a high quality portfolio. This commitment 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&P), a nationally recognized statistical rating organization (NRSRO). If securities were not rated by S&P, the equivalent rating of another NRSRO or the National Association of Insurance Commissioners was used.
Another important part of the Company's investment philosophy is managing the cash flow stability of the portfolio. Because expected maturities of securities may differ from contractual maturities due to prepayments, extensions, and calls, the Company takes steps to manage and minimize these risks. The Company continues to reduce its exposure to prepayment and extension risks by lowering its holdings of mortgage-backed securities. This strategy began in 1994 when mortgage-backed securities totaled 47.6% of the entire portfolio, but now total only 20.9% at December 31, 1999. The majority of this reduction has been achieved by shifting investments into corporate securities, as corporate holdings have increased from 32.5% in 1994 to 55.6% in 1999. Also, most of these additions have been noncallable corporates, which help reduce prepayment and call risks.
As of December 31, 1999, CMOs represent approximately 94% of the Company's mortgage-backed securities. The CMOs in the Company's portfolio have been modeled and subjected to detailed, comprehensive analysis by the Company's investment staff. The overall structure of the CMO as well as the individual tranche being considered for purchase have been evaluated to ensure that the security fits appropriately within the Company's investment philosophy and asset/liability management parameters. The Company's investment mix between mortgage-backed securities and other fixed income securities helps effectively balance prepayment, extension, and credit risks.
The amortized cost and estimated fair values of investments in debt securities at December 31, 1999, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
As detailed above, debt securities classified as held to maturity comprise the majority of the Company's securities portfolio, while equity securities continue to be a small component of the portfolio. Unrealized losses totaling $91,090,000 on the securities portfolio at December 31, 1999, is a reflection of market interest rates at year-end. The fair values, or market values, of fixed income debt securities correlate to external market interest rate conditions. Because the 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. This correlation between market values and interest rates is reflected in the tables below.
As reflected above, changes in interest rates typically have a significant impact on the market values of the Company's debt securities. The Company would expect similar results in the future from any significant upward or downward movement in market rates. The substantial increase in unrealized losses during 1999 is due to a significant increase in interest rates. Market interest rates of the ten-year U.S. Treasury bond rose approximately 180 basis points from year-end 1998. However, because the majority of the Company's debt securities are classified as held to maturity, which are recorded at amortized cost, changes in market values have relatively small effects on the Company's financial statements. Also, the Company has the intent and ability to hold these securities to maturity, and it is unlikely that sales of such securities would be required, which would realize market gains or losses.
The Company's market risk liabilities, which include policy liabilities for investment 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 both a 100 basis point increase and decrease in the U.S. Treasury yield curve as of December 31, 1999. A 100 basis point interest rate decline would decrease net earnings for 2000 by approximately $300,000, based on the Company's projections. A 100 basis point increase in interest rates would increase net earnings by approximately $200,000, based on the Company's projections. These estimated impacts to earnings are net of tax effects determined at a tax rate of 35% and are also net of the estimated effects of deferred policy acquisition costs.
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, 1999, and does not consider new product sales or the possible impact of interest rate changes on sales.
As of December 31, 1999, the allowance for possible losses on mortgage loans was $4,104,000. This balance reflects a net reduction of $536,000 during 1999 which was recognized as a realized gain on investments. The allowance was adjusted primarily as a result of the complete repayment of an impaired mortgage loan resulting in an allowance reduction totaling $895,000, partially offset by an unrelated general increase totaling $359,000. No additions were made to the allowance during 1998. Management believes that the allowance for possible losses is adequate. However, while management uses available information to recognize losses, future additions to the allowance may be necessary based on changes in economic conditions, particularly in the West South Central region which includes Texas, Louisiana, Oklahoma, and Arkansas, as this area contains the highest concentrations of the Company's mortgage loans.
The Company monitors the conditions and market values of these properties on a regular basis. The Company makes repairs and capital improvements to keep the properties in good condition and will continue this maintenance as needed. No realized losses were recognized due to declines in values of properties during 1999 or 1998.
A summary of operating results, net of taxes, for the years ended December 31, 1999, 1998, and 1997 is provided below:
Excluding the nonrecurring items and related tax effects described above, 1999 earnings grew by over 9% compared to 1998. The growth in earnings is primarily due to increases in investment income over policy contract interest and higher realized gains on investments. Earnings for 1998, excluding the nonrecurring items, also exceeded comparable 1997 earnings by over 17%. The higher earnings are due primarily to increases in universal life and annuity contract revenues, increases in investment income over policy contract interest, and higher realized gains on investments.
As indicated by the table above, net investment income increased substantially in both 1998 and 1999. Much of this increase is attributable to growth in invested assets from continued strong premium production. The net cash flow from operations continued to be invested primarily in high quality debt securities. However, increases in net investment income from index options has also been significant, as this income has grown from $18,000 in 1997 to $8,057,000 and $10,719,000 in 1998 and 1999, respectively.
Index options are derivative financial instruments used to hedge the equity return component of the Company's equity-indexed annuity products, which were first introduced for sale in 1997. Any gains or losses from the sale or expiration of the options, as well as period-to-period changes in fair values, are reflected as net investment income. Increases or decreases in income from these options are substantially offset by corresponding increases or decreases in amounts paid to equity-indexed annuity policyholders, subject to minimum guaranteed policy interest rates.
While net investment income for debt securities and index options continues to grow, income for mortgage loans and policy loans continues to steadily decline. This correlates directly to lower holdings in these investments as the Company has placed less emphasis on these investments, particularly mortgage loan originations, than in prior years. Much of this decline is due to current competitive market conditions for mortgage loans.
Detailed below is the Company's investment performance for 1999, 1998, and 1997. This analysis excludes index options, as these derivative financial instruments are used solely for hedging purposes for the Company's equity- indexed annuity products. Income from the options offsets interest credited to policyholders for the equity return component on these products.
Universal Life and Investment Annuity Contract Interest: The Company closely monitors its credited interest rates, taking into consideration such factors as profitability goals, policyholder benefits, product marketability, and economic market conditions. Rates are established or adjusted after careful consideration and evaluation of these factors against established objectives. Average credited rates, calculated based on policy reserves for the Company's universal life and investment annuity business, have generally declined since 1996, which is consistent with declines in market interest rates. However, as previously described for net investment income, market interest rates rose in 1999. As market interest rates fluctuate, the Company's credited interest rates are often adjusted accordingly, while also taking into consideration other factors as described above. Raising policy credited rates can typically have an impact sooner than higher market rates have on the Company's investment portfolio yield, making it more difficult to maintain the current interest spread. The difference between yields earned over policy credited rates is often referred to as the interest spread.
Federal Income Taxes: Federal income taxes on earnings from continuing operations for 1999, 1998, and 1997 reflect effective tax rates of 34.1%, 26.1%, and 33.8%, respectively, which are lower than the expected Federal rate of 35%. The 1998 and 1997 effective tax rates are significantly lower due to tax benefits totaling $4,944,000 and $350,000, respectively, resulting from the Company's subsidiary brokerage losses. Correspondingly, losses on discontinued operations for 1998 and 1997 totaling $14,125,000 and $1,000,000 do not include any tax benefits relating to the brokerage subsidiary. This tax reporting treatment is in accordance with the Company's tax allocation agreement with its subsidiaries. On a consolidated basis, Federal income taxes reflect consistent effective tax rates of 34.1%, 33.2%, and 34.3% for 1999, 1998, and 1997, respectively.
Discontinued Brokerage Operations: On April 12, 1996, The Westcap Corporation and its wholly owned subsidiary, Westcap Enterprises, Inc., separately filed voluntary petitions for reorganization under Chapter 11 of the U.S. Bankruptcy Code in the United States Bankruptcy Court, Southern District of Texas, Houston Division. As a result of brokerage losses and the resulting bankruptcy, National Western's investment in Westcap was completely written off during 1995. However, a $1,000,000 cash infusion was made to Westcap on March 18, 1997, for operational expenses incurred during its bankruptcy. This contribution was reflected as a loss from discontinued operations in 1997. Losses from the discontinued brokerage operations have been reflected separately from continuing operations of the Company in the accompanying consolidated financial statements.
By order dated August 28, 1998, the United States Bankruptcy Court, Southern District of Texas, Houston Division, confirmed and approved the Third Amended Joint Consensual Plan of Reorganization (the Plan) of The Westcap Corporation and Westcap Enterprises, Inc. Pursuant to the Plan, National Western received credit for the $1,000,000 previously contributed to Westcap in bankruptcy in March, 1997, and paid an additional $14,125,000 to compromise and settle (i) all claims of Westcap against National Western, and (ii) all claims and litigation of certain settling creditors of Westcap who have alleged federal or state securities law "control person" violations by National Western relating to Westcap's brokerage business, in exchange for full and complete releases from all of such claims, litigation, and alleged violations. The bankruptcy reorganization was completed in January, 1999, National Western retained 100% continuing ownership of the reorganized Westcap, and the subsidiary is now operating as a real estate management company.
Although the $14,125,000 settlement was paid by National Western on January 13, 1999, the settlement payment was reflected in the accompanying financial statements as a loss from discontinued operations in 1998. Any additional losses will depend on the results of The City Colleges lawsuit filed against National Western on March 28, 1994, for alleged federal or state securities law "control person" violations relating to Westcap, and which is pending in the United States District Court, Western District of Texas, as more fully described in Item 3, Legal Proceedings. National Western believes it has reasonable and adequate defenses to this suit and, accordingly, no amounts have been accrued in National Western's financial statements for potential losses relating to such suit.
A summary of segment earnings from continuing operations for the years ended December 31, 1999, 1998, and 1997 is provided below. The segment earnings exclude realized gains and losses on investments, net of taxes, and discontinued brokerage operations.
Earnings for the domestic life insurance operating segment were $8,209,000, $6,395,000, and $5,901,000 for 1999, 1998, and 1997, respectively. The increase in 1999 earnings is primarily a result of higher universal life insurance revenues, lower other operating expenses, and lower policy benefits, which consists substantially of life insurance death claims. The slight increase in earnings in 1998 is due to increases in revenues and other income and lower amortization of deferred policy acquisition costs. However, these items were offset substantially by increases in other operating expenses and policy benefits.
Actual universal life insurance deposits collected for the years ended December 31, 1999, 1998, and 1997 are detailed below. Deposits collected on these nontraditional products are not reflected as revenues in the Company's statements of earnings, as they are recorded directly to policyholder liabilities upon receipt, in accordance with generally accepted accounting principles.
Amortization of deferred policy acquisition costs has decreased from $5.1 million in 1997 to $3.0 million and $3.4 million in 1998 and 1999, respectively. These expenses represent the amortization of the costs of acquiring or producing new business, which consist primarily of agents' commissions. The majority of such costs are amortized in direct relation to the anticipated future gross profits of the applicable blocks of business. Amortization is also impacted by the level of policy surrenders.
Universal life insurance contract interest has remained relatively constant at $9.8 million, $10.0 million, and $9.7 million in 1999, 1998, and 1997, respectively. This is consistent with the relative stable size of this block of business along with minimal adjustments of policy credited rates.
Earnings for the international life insurance operating segment were $6,798,000, $6,397,000, and $7,143,000 for 1999, 1998, and 1997, respectively. Higher 1999 earnings are due to increases in universal life insurance contract revenues, primarily cost of insurance and surrender charge revenues. The higher revenues were tempered by higher policy benefits and universal life insurance contract interest. Earnings in 1998 were lower than 1999 and 1997 primarily due to higher operating expenses, reinsurance costs, and amortization of deferred policy acquisition costs, offset significantly by lower policy benefits. A comparative analysis of results of operations for the Company's international life insurance segment is detailed below:
Policy benefits, which consist primarily of life insurance death claims, were abnormally high in 1997 at $17.1 million compared to $16.5 million and $14.1 million for 1999 and 1998, respectively. As previously described for domestic life insurance operations, mortality claims fluctuate from period to period. These deviations, which can at times be significant, are not uncommon in the life insurance industry. Additionally, the Company utilizes reinsurance to help minimize its exposure to adverse mortality experience. The Company's general policy is to reinsure amounts in excess of $200,000 on the life of any one individual.
Earnings for the annuity operating segment were $38,068,000, $27,508,000, and $28,389,000 for 1999, 1998, and 1997, respectively. Earnings for 1999 were up significantly from 1998 and 1997 primarily due to income resulting from a lawsuit settlement totaling $5,513,000, net of taxes. Earnings were also enhanced from increases in net investment income over annuity contract interest. Additionally, 1998 earnings were negatively impacted by a class action lawsuit settlement totaling $3,250,000, net of taxes. A comparative analysis of results of operations for the Company's annuity segment is detailed below:
Although annuity sales increased significantly in 1998 from prior years, sales in 1999 totaling $389.6 million were down 9.6%. However, this level of production is still significantly higher than 1997 and 1996 sales. The strong growth in 1998 was primarily attributable to the Company's new equity-indexed annuity product, as it was first introduced in late 1997. Sales continue to be strong in the Company's other deferred annuity products, as deposits collected have increased from $187.8 million in 1998 to $205.6 million in 1999. Additionally, immediate annuities continue to grow, as 1999 and 1998 reflected increases of 47.5% and 65.0%, respectively.
Although sales were lower in 1999, equity-indexed annuities are a major portion of the Company's total annuity production. The Company's equity- indexed annuities are flexible premium deferred annuities which combine the features associated with traditional fixed annuities, with the option to have interest rates that are linked in part to an equity index, the S&P 500 Index. These annuities are long-term contracts designed as planning vehicles for retirement security. These annuities are attractive to customers, as they have guaranteed minimum interest rates, coupled with the potential for significantly higher returns based on an equity index component. Also, because the Company does not offer variable products or mutual funds, these products provide a key equity-based alternative to the Company's existing fixed annuity products. In conjunction with the sale of these annuities, the Company uses an investment hedging program to offset the potential higher returns that could be paid on these products. Specifically, the Company purchases index options from highly rated banks and brokerage firms. These index options act as hedges to match closely the returns based on the S&P 500 Index which may be paid to policyholders.
Other income was relatively insignificant in 1998 and 1997, totaling $270,000 and $277,000, respectively. However, other income for 1999 totaled $8,863,000, which includes $8.5 million in income relating to litigation involving an independent marketing organization. As more fully described in Item 3, Legal Proceedings, National Western Life Insurance Company, National Annuity Programs, Inc. (NAP), and others executed a settlement agreement for a pending declaratory judgment lawsuit. NAP was an independent marketing general agency under contract with the Company that hired and supervised agents marketing annuity products on behalf of the Company. The contract was entered into in 1983 and amended in 1994. The Company alleged that during the course of the contract NAP violated its terms and conditions, among other things. By the settlement, each party dismisses with prejudice all claims asserted by them in the lawsuit. The Company was also released from any claims for any funds and other rights arising under the contract. Additionally, the Company paid in 1999 all valid claims for unpaid commissions to sub-agents of NAP who wrote business for the Company under the contract.
The impact of these equity-indexed annuity issues on earnings from annuity operations was experienced by the Company in the third and fourth quarters of 1999. Because of the volatility and large declines in the S&P 500 Index during the third quarter of 1999, the Company recorded significant decreases in investment income resulting from unrealized mark-to-market losses on the options. The S&P 500 Index decline also resulted in lower interest credited to equity-indexed annuity contracts. However, primarily because of policy liability reserving treatments related to minimum guaranteed interest rates, the reduction in annuity contract interest expense was much less than the decline in investment income, which significantly reduced third quarter 1999 earnings. The Company's fourth quarter 1999 earnings were significantly higher, largely a result of improvement in stock market conditions from the 1999 third quarter. The increased earnings in the fourth quarter essentially offset the lower earnings performance of the third quarter, which coincides with the fluctuations of the S&P 500 Index. For the fourth quarter of 1999, the S&P 500 Index reversed its poor performance of the previous quarter. The S&P 500 Index increased significantly, which increased the Company's investment income from unrealized mark-to-market gains on index options and produced the improved earnings performance.
Most of the income from the Company's subsidiaries is from a life interest in the Libbie Shearn Moody Trust. This asset was owned by National Western Life Insurance Company prior to 1997 but was transferred to NWL Services, Inc. in 1997. Gross income distributions from the Trust totaled $3,595,000, $3,451,000, and $3,335,000 in 1999, 1998, and 1997, respectively.
The Company also has significant cash flows from both scheduled and unscheduled investment security maturities, redemptions, and prepayments. These cash flows totaled $187 million, $159 million, and $144 million in 1999, 1998, and 1997, respectively. The Company again expects significant cash flows from these sources in 2000 at levels consistent with the past two years.
In October, 1998, the American Institute of Certified Public Accountants (AICPA) issued Statement of Position (SOP) 98-7, "Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk." The SOP specifies classifications for insurance and reinsurance contracts for which deposit accounting is appropriate and specifies accounting methods for each. For each insurance and reinsurance contract accounted for under deposit accounting, a deposit asset or liability should be recognized at inception and should be measured based on consideration paid or received, less any premiums or fees to be retained by the insurer or reinsurer, irrespective of the experience of the contract. The Company anticipates that this SOP will not have a significant effect on its financial statements, as the Company's current insurance and reinsurance contracts all transfer insurance risk. SOP 98-7 is effective for all fiscal years beginning after June 15, 1999. The Company currently plans to implement the SOP in the first quarter of 2000.
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.
The Year 2000 problem, also known as Y2K, was the result of concerns that many computer software systems would not be able to distinguish the year 2000 from the year 1900. The Y2K problem arose because many existing computer programs use only the last two digits to refer to a year, resulting in these programs' inability to recognize "00" in the date field as the year 2000. If not corrected, many computer systems may not have been able to process date- sensitive data accurately beyond the year 1999, resulting in possible system failures or generation of erroneous results. National Western was cognizant of these problems for many years, as life insurance and annuity products can have very long life spans. Thus, many of our systems were originally developed to process and administer our insurance products into the next century. National Western worked to alleviate or eliminate Year 2000 problems for many years. The Company's Year 2000 plan included staff review and analysis of internal systems, embedded chip technology, and external vendor interfaces.
National Western incurred no significant Y2K related issues and did not experience any disruptions in its operations during the transition into 2000. The Company did not encounter any significant problems with respect to its systems, and it was not necessary to implement any contingency or business continuity plans. Likewise, with respect to external vendors, service providers, and other third parties, National Western did not experience any significant Y2K related problems. Total costs incurred related to the Company's Year 2000 plan did not exceed $250,000. Although no problems are anticipated, the Company will continue to monitor its systems as the year progresses.