National Western Life Insurance Company is a life insurance company, chartered in the State of Colorado in 1956, and doing business in forty-three states and the District of Columbia. It also accepts applications from and issues policies to residents of Central and South American countries. These policies are accepted and issued in the United States and accounted for approximately 16% of the Company's total premium revenues, universal life, and investment annuity contract deposits in 1996. The primary products marketed by the Company are its universal life and single and flexible premium annuity products.
Investments in debt and equity securities are classified and reported as either securities held to maturity or securities available for sale. The Company does not maintain a portfolio of trading securities. The reporting category chosen for the Company's securities investments depends 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. At December 31, 1996, approximately 22% 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.
The Company's overall conservative investment philosophy is reflected in the allocation of its investments which is detailed below as of December 31, 1996 and 1995. The Company emphasizes investment grade debt securities, with smaller holdings in mortgage loans and real estate.
The Company maintains a diversified debt securities portfolio which consists of various types of fixed income securities including primarily U.S. government, public utilities, corporate, and mortgage-backed securities. Investments in mortgage-backed securities include U.S. government and private issue mortgage-backed pass-through securities as well as collateralized mortgage obligations (CMOs). As of December 31, 1996, 1995, and 1994, the Company's debt securities portfolio consisted of the following mix of securities based on amortized cost:
The amortized cost and estimated fair values of investments in debt securities at December 31, 1996, 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.
An important aspect 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 has reduced its exposure to prepayment and extension risks by lowering its holdings of mortgage-backed securities over the past few years. Mortgage and asset-backed securities totaled 47.6% of the entire portfolio in 1994 and now total only 34.5% at December 31, 1996. The majority of this reduction has been offset by increases in corporate securities, as corporate holdings have increased from 32.5% in 1994 to 45.5% in 1996. However, most of these additions were non-callable corporates which help reduce prepayment and call risks.
As indicated above, the Company's holdings of mortgage-backed securities are also subject to prepayment risk, as well as extension risk. Both of these risks are addressed by specific portfolio management strategies. The Company substantially reduces both prepayment and extension 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) CMOs, are designed to amortize in a more predictable manner than other CMO classes or pass-throughs. 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.
The Company's commitment to high-quality investments in debt securities is also reflected by the portfolio average rating of "A," which is high quality. Allocation of investments in debt securities classified in accordance with the highest rating by a nationally recognized statistical rating organization as of December 31, 1996 and 1995, is provided below. If securities were not rated by one of these organizations, the equivalent classification as assigned by the National Association of Insurance Commissioners was used.
As reflected above, changes in interest rates of 100 basis points or more 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. However, because the majority of the Company's debt securities are classified as held to maturity, the changes in market values have had 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 the market gains or losses.
The diversification of the mortgage loan portfolio by geographic region of the United States and by property type as of December 31, 1996 and 1995, was as follows:
The contractual maturities of mortgage loans at December 31, 1996, are as follows:
The Company owns real estate that was acquired through foreclosure and through direct investment totaling approximately $15,209,000 and $19,066,000 at December 31, 1996 and 1995, respectively. This small concentration of properties represents less than one percent of the Company's entire investment portfolio. The real estate holdings consist primarily of income-producing properties which are being operated by the Company. The Company recognized operating income on these properties of approximately $638,000 and $404,000 for the years ended December 31, 1996 and 1995, respectively. The Company does not anticipate significant changes in these operating results in the near future.
The Company monitors the conditions and market values of these properties on a regular basis. Realized losses recognized due to declines in values of properties totaled $526,000 and $882,000 for the years ended December 31, 1996 and 1995, respectively. The Company makes repairs and capital improvements to keep the properties in good condition and will continue this maintenance as needed.
Insurance Operations Net Earnings: The Company recognized record earnings from insurance operations for the year totaling $45,167,000 in 1996, an increase of 21.4% over 1995 earnings. Increases in universal life and annuity revenues of 8.9% and net investment income of 6.2%, coupled with lower expenses, resulted in the record earnings. Lower expenses were primarily from decreases in life insurance benefit claims, policy acquisition costs, and state guaranty fund assessments. Also, 1995 earnings include a $5.7 million tax benefit resulting from the Company's subsidiary brokerage losses, and earnings for 1994 include a comparable $2.9 million tax benefit. The tax benefits were recognized in accordance with the Company's tax allocation agreement with its subsidiaries. Excluding the tax benefits, earnings from insurance operations for 1996 were actually up $13.7 million from 1995 due to the increases in revenues and lower expenses as previously described.
Subsequent to discontinuing the two-tier annuity sales, the Company set goals to not only develop new annuity products to replace the lost two-tier production, but to diversify and strengthen distribution channels to avoid dependence on its primary independent marketing organization. The Company achieved this by developing new annuity products in 1994 and by contracting new marketing organizations with extensive experience, financial resources, and success in marketing annuities. The combination of new products, primarily a single premium deferred annuity, and new marketing organizations started to produce results in the latter half of 1994 as annuity production began to increase significantly. This increased production continued throughout 1995. However, sales were lower in 1996, and the renewal premiums from the two-tier annuities also continued to decline. As the emphasis on new annuity sales is primarily single premium products, the Company does not anticipate a significant reversal of the decline in renewal premiums in the near future.
The majority of the Company's life insurance production is from the international market, primarily Central and South American countries. The Company continues to see increased competition in the Central and South American market, causing production growth to slow. However, the Company has been accepting policies from foreign nationals for over thirty years and has developed strong relationships with carefully selected brokers in the foreign countries. This experience and strong broker relations have enabled the Company to meet the increased competition with new product enhancements and marketing efforts. Such efforts resulted in increased life insurance production once again in 1995, although 1996 premiums declined somewhat from these levels.
Net Investment Income: Net investment income during 1996 increased 6.2% from 1995. The increase was from increases in invested assets and from gains from real estate joint ventures. NWL Investments I, L.P. sold several real estate joint venture interests during 1996, and the sales resulted in additional investment income totaling approximately $2,300,000. Excluding the income from the joint venture sales, net investment income was up 5.0% from 1995, which is consistent with the increase in total invested assets of 5.6% for the same period. Also, the yield on purchases in 1996 was similar to the yield of the 1995 portfolio.
During 1995, net investment income increased 6.2% from 1994 while total invested assets increased 12.0% for the same period. The increase in invested assets was primarily due to increased annuity production. The growth in net investment income lagged the growth in invested assets for several reasons. Interest rates declined significantly throughout 1995, resulting in investments in lower yielding securities. Also, net investment income was up significantly in 1994 due to yield and amortization adjustments on mortgage-backed securities. The adjustments were made to reflect changes in mortgage-backed securities prepayment levels, caused by changes in market interest rates, which affected average lives, yields, and amortization periods of the securities. There were no significant corresponding adjustments in 1995.
As previously described, market interest rates declined significantly during 1995 from 1994 levels. Interest rates were somewhat volatile during 1996, but overall were at levels comparable to 1995. Detailed below is the Company's investment performance for 1996, 1995, and 1994. The changes in the Company's yield reflect the changes in market interest rates. However, changes in market rates affect the Company's portfolio yield slowly because of the relative small volume of new investment purchases during a year in comparison to the size of the overall investment portfolio.
Other Income: Other income for 1996 includes proceeds received from a lawsuit settlement totaling $850,000. The lawsuit related to the Company's previous investment in a mortgage loan.
Realized Gains and Losses on Investments: The Company recorded realized gains totaling $1.6 million in both 1996 and 1994 compared to realized losses of $2.4 million in 1995. The gains in 1996 were primarily from sales of investments in debt securities and real estate. The losses in 1995 were also primarily from sales of investments in debt securities, the majority of which were from the Company's remaining investments in principal exchange rate linked securities. The Company made the decision to realize these losses to obtain tax benefits related to the losses which were scheduled to expire on December 31, 1995. The gains and losses in 1996, 1995, and 1994 are net of write-downs on real estate and mortgage loans totaling $1,026,000, $882,000, and $625,000, respectively.
Amortization of Deferred Policy Acquisition Costs: This expense item represents the amortization of the costs of acquiring or producing new business, which consists 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. Amortization for 1996, 1995, and 1994 has been relatively consistent at $30.4 million, $33.7 million, and $32.1 million, respectively. The lower amortization in 1996 is primarily due to changes in timing and increases in levels of anticipated future gross profits for certain blocks of business.
Universal Life and Investment Annuity Contract Interest: Prior to 1995, interest expense declined steadily as amounts totaled $129.1 million, $130.9 million, and $135.8 million for 1994, 1993, and 1992, respectively. This decline was primarily due to the lowering of credited interest rates on most universal life and investment annuity products throughout these years. The lowering of credited interest rates was largely in response to declining market interest rates. Additional interest costs related to increasing business was not significant, as the policy liabilities remained relatively constant over those years. However, in the latter part of 1994, annuity production began to increase significantly and it continued to increase into 1996. The increase in annuity deposits resulted in corresponding increases in policy liabilities and significantly higher interest costs in 1995 and 1996. Also, the Company's new annuity products typically credit significantly higher interest rates in the first policy year, again resulting in higher interest costs.
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 remained relatively consistent since 1994. Average credited rates for 1996, 1995, and 1994 were 6.15%, 6.19%, and 6.04%, respectively.
The Company is subject to state guaranty association assessments in all states in which it is licensed to do business. These associations generally guarantee certain levels of benefits payable to resident policyholders of insolvent insurance companies. Most states allow premium tax credits for all or a portion of such assessments, thereby allowing potential recovery of these payments over a period of years. However, several states do not allow such credits. The National Organization of Life and Health Insurance Guaranty Associations annually publishes assessment data on nationwide life and health insurance company insolvencies. Based on this information, the Company revises its estimates for assessment liabilities relating to such insolvencies. The Company will continue to monitor and revise its estimates for assessments as additional information becomes available. Other insurance operating expenses related to state guaranty association assessments totaled $1,146,000, $2,371,000, and $4,869,000 for the years ended December 31, 1996, 1995, and 1994, respectively.
Losses from the discontinued brokerage operations have been reflected separately from continuing operations of the Company in the accompanying consolidated financial statements. The 1995 losses disclosed above include estimated future operating losses as well as estimated costs to cease brokerage operations totaling $6,381,000 and resulted in the complete write-off of the Company's investment in Westcap on a consolidated basis. As a result, no losses were recognized in 1996. However, National Western, Westcap, and the Creditors' Committee agreed that National Western may make a $1,000,000 cash infusion to Westcap for operational expenses incurred during its bankruptcy and that such cash infusion will be credited against any future settlement or litigation recovery related to Westcap's alleged claims against National Western. Such funding was approved by the Bankruptcy Court on February 21, 1997, and the funds were transferred by National Western to Westcap on March 18, 1997. This contribution will be reflected as losses from discontinued operations in the first quarter of 1997. Any additional losses from discontinued operations will depend primarily on results of Westcap bankruptcy proceedings.
Federal Income Taxes: Federal income taxes for 1996 reflect an effective tax rate of 34.3%, which is consistent with the expected statutory rate of 35%. However, Federal income taxes for 1995 on earnings from continuing operations reflect an effective tax rate of only 23%. The 1995 taxes are lower than the expected statutory rate of 35% due to a $5.7 million tax benefit resulting from the Company's subsidiary brokerage losses. Correspondingly, losses on discontinued operations for 1995 totaling $16,350,000 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. However, on a consolidated basis, the Federal income taxes reflect the expected effective tax rate of 35% for 1995.
In the past, cash flows from the Company's insurance operations have been more than adequate to meet current needs. Cash flows from operating activities were $145 million, $99 million, and $117 million in 1996, 1995, and 1994, respectively. Lower earnings from brokerage operations was the primary reason for the lower cash flows in 1995 and 1994. Net cash flows from the Company's deposit product operations, which includes universal life and investment annuity products, totaled $16 million and $99 million in 1996 and 1995, respectively. These operations incurred net cash outflows in 1994 totaling $17 million. The increase in cash flows in 1995 was due to increased annuity production. However, the reduction in cash flows in 1996 was due to lower annuity production and higher policy surrenders than in 1995.
Stockholders' equity totaled $353 million at December 31, 1996, reflecting an increase of $41 million from 1995. The increase in capital is primarily from net earnings of $46 million, offset by the decrease in net unrealized gains on investment securities totaling $5 million in 1996. Slightly higher market interest rates at year-end 1996 compared to 1995 resulted in the decrease in unrealized gains. Book value per share at December 31, 1996, was $101.07, reflecting a 13.1% increase for the year.
The National Association of Insurance Commissioners (NAIC) has 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.