The Westcap Corporation, a wholly owned subsidiary of National Western, owned the Company’s former office location in Austin, Texas and two buildings adjacent to it. During 2018, the two adjacent buildings were sold for in excess of $2.9 million. During 2019, the former 72,000 square foot office building was sold for $8.5 million.
The Company’s affiliate, Regent Care Building, LP, owned an approximately 63,000 square foot building in Reno, Nevada, which was leased and utilized by another of the Company’s affiliates, Regent Care Operations, LP, for use in its nursing home operations. The Company sold the Reno nursing home operation in the first quarter of 2019.
Lease costs and related operating expenses for facilities of the Company’s subsidiaries are not significant in relation to the Company’s Consolidated Financial Statements. The intercompany lease costs have been eliminated for consolidated reporting purposes.
(1) See Note (1) Summary of Significant Accounting Policies to the Consolidated Financial Statement for reorganization effective October 1, 2015.
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 Group, Inc. and its subsidiaries (the "Company") 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 filings such as exposure to market risks, anticipated cash flows or operating performance, future capital needs, and statutory or regulatory related issues. However, as a matter of policy, the Company 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.
Management’s discussion and analysis of the financial condition and results of operations (“MD&A”) of National Western Life Group, Inc. ("NWLGI") for the three years ended December 31, 2019 follows. Where appropriate, discussion specific to the insurance operations of National Western Life Insurance Company is denoted by "National Western" or "NWLIC". This discussion should be read in conjunction with the Company’s Consolidated Financial Statements and related notes beginning on page 89 of this report.
Effective January 31, 2019, the Company completed its previously announced acquisition of Ozark National Life Insurance Company ("Ozark National") and N.I.S. Financial Services, Inc. ("NIS") following the receipt of regulatory approvals. NWLGI and National Western paid cash in an aggregate amount of approximately $205.4 million in exchange for all of the outstanding stock of Ozark National (wholly owned by National Western) and NIS (wholly owned by NWLGI). The eleven month results of Ozark National and NIS are included in the Company's Consolidated Financial Statements as of and for the year ended December 31, 2019 and reference to each is made in this MD&A where appropriate.
National Western has historically provided life insurance products on a global basis for the savings and protection needs of policyholders and issued annuity contracts for the asset accumulation and retirement needs of contract holders, both domestic and international residents. As disclosed in the Company's filings during 2018, the Company discontinued accepting applications for its international life insurance products from all foreign residents in other countries in May 2018.
The Company's business is generally aided by an economic environment experiencing growth, whether moderate or vibrant, characterized by metrics which indicate improving employment data and increases in personal income growth.
Investment activities of the Company are integral to its insurance operations. Since life insurance benefits may not be paid until many years into the future, the accumulation of cash flows from premium receipts are invested with income reported as revenue when earned. Anticipated yields on investments are reflected in premium rates, contract liabilities, and other product contract features. These anticipated yields are implied in the interest required on the Company’s net insurance liabilities (future policy benefits less deferred acquisition costs) and contractual interest obligations in its insurance and annuity products. The Company benefits to the extent actual net investment income exceeds the required interest on net insurance liabilities and manages the rates it credits on its products to maintain the targeted excess or “spread” of investment earnings over interest credited. The Company will continue to be required to provide for future contractual obligations in the event of a decline in investment yield. For more information concerning revenue recognition, investment accounting, and interest sensitivity, please refer to Note (1), Summary of Significant Accounting Policies; Note (3), Investments, in the Notes to Consolidated Financial Statements; and the discussions under Investments in Item 7 of this report.
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.
Universal life and annuity contract revenues - Revenues for universal life and annuity contract charges decreased in 2019 compared to 2018 due to lower surrender charge revenue from terminated policies and lower cost of insurance and administrative charges as shown below. Revenues for universal life and annuity products consist of policy charges for the cost of insurance, administration charges, and surrender charges assessed against policyholder account balances, less reinsurance premiums as depicted in the following table.
The growth in domestic life insurance sales for the past several years has been driven principally by the sale of single premium life insurance products. In 2013, the Company began deferring the premium load associated with these products and spreading it over future income periods. The amount shown above as "Other charges" represents the net of previously capitalized amounts being amortized into revenue over current year deferrals of premium loads. Sales of single premium life insurance products have been a substantial portion of the Company's new business over the past several years and has generated a higher balance of premium loads being amortized as revenue.
Debt and equity securities generated approximately 93% of total investment income, excluding derivative gains and losses, in 2019 compared to 93% in 2018. The Company’s strategy is to invest substantially all of its cash flows in fixed debt securities within its guidelines for credit quality, duration, and diversification. The higher level of investment income from debt and equity securities in 2019 versus 2018, reflects the addition of Ozark National which added $22.2 million to the total amount. National Western's debt and equity securities investment income continues to experience higher yielding debt securities maturing or being called by borrowers and being replaced with lower yielding securities in the current interest rate environment. In addition, the excess of annuity outflows over inflows has caused the debt security portfolio to contract during 2019. With the acquisition of Ozark National and NIS in the first quarter of 2019, a substantial portion of National Western's investable cash resources was applied toward the purchase of the two companies and then subsequently to pay back line of credit borrowings of $75 million used to fund a part of the acquisition price.
Effective January 1, 2018, new accounting guidance required changes in fair values of equity securities to be included in the Consolidated Statements of Earnings rather than as a component of Accumulated Other Comprehensive Income in Stockholders' Equity. For the years ended December 31, 2019 and 2018, an unrealized gain of $3.5 million and an unrealized loss of $(1.8) million, respectively, are included in net investment income reflecting the change in fair value of equity securities during the periods. The carrying value of the Company’s portfolio of equity securities was $23.6 million at December 31, 2019.
The Company’s new mortgage loan activity has been impacted by the low level of rates and the highly competitive underwriting of commercial properties in the current economic environment. Due to a concerted effort, the volume of new mortgage loan originations during 2019 increased from prior year levels, although aggressive interest rates offered by competitors served to hold down new loan originations in 2018. Mortgage loan investment income benefits from incremental contributions from loan prepayment fees and profit participation receipts.
Policy loan and other invested asset balances outstanding have remained relatively stable over the past few years. As noted above, the Company maintained elevated short-term investment balances during the latter part of 2018 in anticipation of closing the acquisition of target companies in early 2019.
In order to evaluate underlying profitability and results from ongoing operations, net investment income performance is analyzed excluding derivative gain (loss), which is a common practice in the insurance industry. Although this is considered a non-GAAP financial measure, Company management believes this financial measure provides useful supplemental information by removing the swings associated with fair value changes on derivative instruments. Net investment income and average invested assets shown below includes cash and cash equivalents. Net investment income performance is summarized as follows:
The decline in average invested asset yield, excluding derivatives, from 2017 to 2018 and to 2019 is due to the Company continuing to obtain low yields on newly invested cash inflows as higher yielding assets mature or are called. The pattern in average invested asset yield, including derivatives, incorporates increases and decreases in the fair value of index options purchased by National Western to support its fixed-index products. Fair values of the purchased call options recorded net gains in 2017 and 2019 while recording a loss in 2018 corresponding to the movement in the S&P 500 Index® during these periods (the primary index the fixed-index products employ). Refer to the derivatives discussion following this section for a more detailed explanation.
Other revenues - Other revenues have historically pertained to the Company’s two nursing home operations in Reno, Nevada and San Marcos, Texas. Beginning in 2017, other revenues also includes the operations of Braker P III ("BP III"), a new subsidiary created at the end of 2016 to own and manage a commercial office building it acquired (Refer to Item 2. Properties in Part I of this filing for further discussion). Beginning in 2019, other revenues also include NIS, the broker-dealer affiliate of Ozark National acquired effective January 31, 2019.
The financial statement investment spread, the difference between investment income and interest credited to contractholders, is subject to variations from option performance during any given period. For example, many of the Company's equity-index annuity products provide for the collection of asset management fees. These asset management fees are assessed when returns on expiring options are positive, and they are collected prior to passing any additional returns above the assessed management fees to the policy contractholders. During periods of positive returns, the collected asset management fees serve to increase the financial statement spread by increasing option realized gains reported as investment income in an amount greater than interest credited to policy contractholders which is reported as contract interest expense. Asset management fees collected in 2019, 2018, and 2017 were $15.9 million, $24.3 million, and $31.8 million, respectively.
The Company records impairment write-downs when a decline in value is considered to be other-than-temporary and full recovery of the investment is not expected. Impairments due to credit factors are recorded in the Company’s Consolidated Statements of Earnings while non-credit (liquidity) impairment losses are included in the Consolidated Statements of Comprehensive Income (Loss).
Life and other policy benefits also includes policy liabilities held associated with the Company's traditional life products, including riders such as the guaranteed minimum withdrawal benefit rider ("WBR"), a popular rider to National Western's equity-indexed annuity products. The increases in these liabilities for National Western were $24.4 million, $7.3 million, and $17.9 million in 2019, 2018, and 2017, respectively. In 2019 and 2018, National Western unlocked its policy benefit reserves associated with the WBR which resulted in an increase to the policy benefit liability of $0.7 million in 2019 and a decrease to the policy benefit liability during in 2018 of $15.7 million. The primary unlocking adjustment included within the 2018 amount was an adjustment of the assumed rate of election by policyholders taking withdrawal payments to a rate consistent with actual experience (which was lower than the conservative assumption previously used).
Life and other policy benefits in the year ended December 31, 2019 includes changes in traditional life reserves and miscellaneous benefit payments associated with Ozark National's operations of $30.5 million reflecting normal business conditions.
The amortization amount for the year ended December 31, 2019 was comprised of DPAC amortization by National Western of $108.4 million and by Ozark National of $0.7 million. Ozark National's deferred policy acquisition cost balance was initiated February 1, 2019 following its acquisition by National Western.
In 2019, the Company unlocked its DPAC balances for: (1) mortality rates, lapse rates, portfolio yield rates and spreads, and maintenance expense on its International life business which collectively increased DPAC balances (and reduced amortization expense) on its Life segment by $11.2 million; and (2) surrender rates, annuitization rates, portfolio yield rates and spreads, and utilization of the Company's withdrawal benefit rider which collectively decreased DPAC balances (and increased amortization expense) on its Annuity segment by $2.6 million.
As the DPAC balance is an asset on the Company's Consolidated Balance Sheets, GAAP provides for an earned interest return on the unamortized balance each period. The earned interest serves to increase the DPAC balance and reduce other amortization component expense. The rate at which the DPAC balance earns interest is the average credited interest rate on universal life and annuity policies in force, including credited interest on equity-indexed policies. The amount of earned interest on DPAC balances recorded was $12.0 million, $29.1 million, and $33.5 million in 2019, 2018, and 2017, respectively, decreasing other amortization component expense. The reduced interest amount in 2019 reflects lower realized returns on equity-index products.
As part of the purchase accounting required with the acquisition of Ozark National effective January 31, 2019, the Company recorded an intangible asset of $145.8 million referred to as the value of business acquired ("VOBA"). VOBA represents the difference between the acquired assets and liabilities of Ozark National measured in accordance with the Company's accounting policies and the fair value of these same assets and liabilities. The VOBA balance sheet amount is amortized following a methodology similar to that used for amortizing deferred policy acquisition costs. In the year ended December 31, 2019, the Company's VOBA amortization was $7.7 million.
Universal life and annuity contract interest - The Company closely monitors credited interest rates on interest sensitive policies (National Western products), taking into consideration such factors as profitability goals, policyholder benefits, product marketability, and economic market conditions. As long-term interest rates change, the Company's credited interest rates are often adjusted accordingly, taking into consideration the factors described above. The difference between yields earned on investments over policy credited rates is often referred to as the "interest spread."
Contract interest reported in financial statements also encompasses the performance of the index options associated with the Company's fixed-index products. As previously noted, the market value changes of these derivative features resulted in net realized and unrealized gains (losses) in 2019, 2018 and 2017 of $123.2 million, $(80.0) million and $222.9 million, respectively. In 2019, this figure was comprised of unrealized gains totaling $153.0 million offset by realized losses of $(29.8) million. These returns similarly increased/(decreased) the computed average credited rates for the periods shown above. Policyholders of equity-indexed products cannot receive an interest credit below 0% according to the policy contract terms.
Accounting rules require the embedded derivative liability to include a projection of asset management fees estimated to be collected in the succeeding fiscal year. This projection is based upon the most recent performance of the reference equity index. Increases in projected asset management fees collected reduce contract interest expense while decreases in projected asset management fees collected increase contract interest expense. During the years ended December 31, 2019, 2018, and 2017, contract interest was increased/(decreased) by $(33.6) million, $17.6 million, and $6.9 million, respectively, for these projection changes. The increases to contract interest expense reflect lower estimated asset management fees to be collected while the decrease to contract interest expense represents an increase to the amount of asset management fees estimated to be collected. Refer to Note (3) Derivative Investments in the accompanying Notes to Consolidated Financial Statements for further information.
Contract interest expense also includes reserve changes for immediate annuities, two tier annuities, excess death benefit reserves, excess annuitizations, and amortization of deferred sales inducement balances. These items are offset by policy charges assessed for policies having the withdrawal benefit rider (WBR). As changes in these items collectively impact contract interest expense, financial statement interest spread is also affected. For the years ended December 31, 2019, 2018, and 2017 the changes in these items increased contract interest expense by $26.9 million, $22.8 million, and $38.1 million, respectively.
As previously discussed in the amortization of deferred policy acquisition costs section, the Company unlocked its life insurance DPAC balance for mortality experience and its annuity DPAC for annuitization reserves. These prospective unlockings impacted the excess benefit reserves and excess annuitization reserves, respectively. The impact of these unlockings increased these reserves, and contract interest expense, by $9.6 million in 2019. Similarly, the unlocking adjustments in 2018 increased these same reserves by $14.2 million and contract interest by a like amount. The unlockings of excess benefit reserves and two-tier annuity reserves increased contract interest expense by $13.7 million in 2017.
Other operating expenses - Other operating expenses consist of general administrative expenses, licenses and fees, commissions not subject to deferral, nursing home expenses, real estate expenses, brokerage expenses, and compensation costs. These are summarized in the table that follows.
Nursing home expenses reflect the operations of the Company's two facilities in Reno, Nevada and San Marcos, Texas. As noted previously, these operations were sold during 2019: the Reno operation effective February 1, 2019, and the San Marcos operation effective May 1, 2019. Expenses shown for 2019 reflect operations up to the date of sale for each facility.
Compensation expenses include share-based compensation costs related to outstanding vested and nonvested stock options and stock appreciation rights ("SARs"), restricted stock units ("RSUs"), and performance share units ("PSUs"). The related share-based compensation costs move in tandem not only with the number of awards outstanding but also with the movement in the market price of the Company's Class A common stock as a result of marking the stock options, SARs, and RSUs to fair value under the liability method of accounting. Consequently, the related expense amount varies positive or negative in any given period. In the amounts shown above, share-based compensation expense totaled $2.4 million in 2019, $1.4 million in 2018 and $5.0 million in 2017. These expense levels reflect a change in the Company's Class A common share price from $310.80 at December 31, 2016 to $331.02 at December 31, 2017 to $300.70 at December 31, 2018 and to $290.88 at December 31, 2019. In addition to the changes in price of the Company's Class A common shares, there were 20,380, 12,590, and 22,184 SARs granted to officers in 2019, 2018 and 2017, respectively.
Commission expenses in 2019 include Ozark National non-deferrable commissions of $3.2 million.
Universal life insurance revenues are also generated with the issuance of new business based upon amounts per application and percentages of the face amount (volume) of insurance issued. The number of domestic policies issued during 2019 was 8% lower than in 2018 and the volume of insurance issued was 3% more than that in 2018.
In 2013 the Company began deferring the premium load on its highest selling domestic product, single pay life insurance. Amounts deferred are amortized into revenues over future periods corresponding with the duration of the policies. Initially, the premium load amounts deferred exceeded the amounts amortized back into revenues. However, the cumulative amounts deferred have reached a level such that the current year revenue amortization now exceeds the current period deferral resulting in net increasing revenue from this accounting method. Net revenue associated with this activity was $8.2 million, $6.0 million, and $(0.2) million in 2019, 2018, and 2017, respectively.
Life and policy benefits for a smaller block of business are subject to variation from period to period. Claim count activity during 2019 decreased 5% compared to 2018 while the average net claim amount increased to $34,400 from $31,800. The low face amount per claim relative to the current issued amounts of insurance per policy reflects the older block of domestic life insurance policies sold which were final expense type products (i.e. purchased to cover funeral costs). The increase in the average net claim amount reflects claims from more recent policy sales (single premium wealth transfer products) which have higher face amounts of insurance coverage per policy. GAAP reporting requires that claims be recorded after any cash value amounts that have been accumulated in the policies. While the average domestic claim increased in 2019 compared to 2018, the accumulated cash values on the claims incurred was higher in 2019 (which reduces the net amount at risk on policies). The overall mortality experience for this segment has been better than pricing assumptions.
As noted previously in the discussion of results from Consolidated Operations, true-up adjustments are recorded to DPAC balances each period to reflect current policy lapse or termination rates, expense levels and credited rates on policies as compared to anticipated experience with the adjustment reflected in current period amortization expense. To the extent required, unlocking adjustments may also be recorded to DPAC balances. The following table identifies the effects of unlocking adjustments on domestic life insurance DPAC balances recorded through amortization expense separate from recurring amortization expense components for 2019, 2018 and 2017.
In 2019, DPAC balances were unlocked for this segment for mortality rates, lapse rates, and portfolio yield rates (investment spread margin) which cumulatively had the effect of slightly increasing DPAC balances (and reducing amortization expense). In 2018, the Company unlocked DPAC balances associated with the Domestic Life segment for favorable mortality, extended death benefit reserves, and the investment portfolio yield supporting universal life policy liabilities, the effect of which was to decrease DPAC balances by $1.0 million (and increase amortization expense). During 2017, the Company unlocked the interest crediting rate spread on certain equity-indexed universal life products which also increased amortization expense by $0.8 million.
Contract interest expense includes the fluctuations that are the result of the effect upon the embedded derivative for the performance of the underlying equity indices associated with fixed-indexed universal life products. For liability purposes, the embedded option in the Company's policyholder obligations for this feature is bifurcated and reserved for separately. Accordingly, the impact for the embedded derivative component in the equity-index universal life product is reflected in the contract interest expense for approximately the same amounts as in net investment income for each respective period.
Operating expenses are allocated to lines of business based upon a functional cost analysis of the business activity giving rise to incurred expenses. With the Company's decision to cease accepting applications from international residents and the decline in annuity sales volumes, a higher proportion of operating expenses were allocated to the Domestic Life segment in 2019 and 2018 given the increase in activity in this segment and its greater share of the overall operational resources.
As with Domestic Life operations, revenues from the International Life insurance segment include both premiums on traditional type products and revenues from universal life insurance. A comparative detail of premiums and contract revenues is provided below.
Universal life revenues and operating earnings are largely generated from the amount of life insurance in force. Over the past three years, the volume of insurance in force for this segment has contracted from $16.6 billion at December 31, 2017 to $15.4 billion at December 31, 2018 and to $13.7 billion at December 31, 2019. The decline in volume of in force reflects the decision at the end of 2015 to begin disengaging from certain countries. During 2018 the Company made the decision to cease accepting international policy applications from residents from all remaining countries. Universal life insurance revenues are also generated with the issuance of new business based upon amounts per application and percentages of the face amount (volume) of insurance issued. During 2018, the number of international life policies decreased 48% from the prior year while the volume of insurance issued decreased approximately 50% from the level in 2017. No policies have been issued since September 2018.
National Western’s most popular international products were its fixed-index universal life products in which the policyholder could elect to have the interest rate credited to their policy account values linked in part to the performance of an outside equity index. These products issued were not generally available in the local markets when sold. Included in the totals in the above table are collected premiums for fixed-index universal life products of approximately $41.3 million, $57.8 million and $65.6 million for the years ended 2019, 2018 and 2017, respectively. The declining trend in renewal premiums during these periods corresponds with the decline in policies in force due to reduced sales activity and increased termination activity as discussed above.
The gain or loss on index options follows the movement of the reference indice with realized gains or losses being recognized on the anniversary of each index option based upon the reference indice level at the expiration date relative to the index level at the time the index option was purchased. Unrealized gains and losses are recorded for index options outstanding based upon their fair values, largely determined by the reference indice level, at the balance sheet reporting date as compared to the original purchase cost of each respective option.
For liability purposes, the embedded option in the Company's policyholder obligations for this feature is bifurcated and reserved for separately. Accordingly, the impact for the embedded derivative component in the equity-index universal life product is reflected in the contract interest expenses for each respective period.
Life and policy benefits primarily consist of death claims on policies. National Western’s clientele for international products are generally wealthy individuals with access to U.S. dollars and quality medical care. Consequently, the amounts of coverage purchased historically tended to be larger amounts. Life and policy benefit expense for the international life segment reflects the larger policies historically purchased, however mortality due to natural causes is comparable to that in the United States. The Company's maximum risk exposure per insured life is capped at $500,000 through reinsurance. The average international life net claim amount (after reinsurance) in 2019 decreased to $175,000 from $205,200 while the number of claims incurred declined 6% from the amount incurred in 2018. Measured over a period of years, the Company's international life mortality experience has generally been better than product pricing assumptions.
During 2019, DPAC balances were unlocked for mortality rates, lapse rates, maintenance expenses, and investment spread which increased DPAC balances and reduced amortization expense. Favorable mortality experience on the block of business was the primary cause behind the DPAC balance increase.
Annuity operations are exclusively in the United States. A comparative analysis of results of operations for the Company's annuity segment is detailed below.
Fixed-index products are more attractive for consumers when interest rate levels remain low and equity markets produce positive returns. Since National Western does not offer variable products or mutual funds, fixed-index products provide an important alternative to the Company's existing fixed interest rate annuity products. Fixed-index annuity deposits as a percentage of total annuity deposits were 91%, 93% and 95% for the years ended December 31, 2019, 2018 and 2017, respectively. The percentage of fixed-index products to total annuity sales reflects the low interest rate environment and the ongoing bull market in equities.
Some of the Company's deferred products, including fixed-index annuity products, contain a first year interest bonus ranging from 1% to 7% depending upon the product, in addition to the base first year interest rate. Other products include a premium bonus ranging from 2% to 10% which is credited to the account balance when premiums are applied. These sales inducements are deferred in conjunction with other capitalized policy acquisition costs. The amount deferred to be amortized over future periods amounted to approximately $3.2 million, $7.5 million and $17.9 million for the years ended December 31, 2019, 2018 and 2017, respectively. Amortization of deferred sales inducements is included as a component of annuity contract interest as described later in this discussion of Annuity Operations.
Consistent with the domestic and international life segments, the Company records true-up adjustments to DPAC balances each period to reflect current policy lapse or termination rates, expense levels and credited rates on policies as compared to anticipated experience as well as unlocking adjustments as necessary. The following table identifies the effects of unlocking adjustments on annuity DPAC balances recorded through amortization expense separate from recurring amortization expense components for 2019, 2018 and 2017.
DPAC balances associated with the Annuity segment were unlocked in 2019 for assumptions pertaining to lapse rates, annuitization rates, investment spreads, and utilization of the Company's withdrawal benefit rider. The effect of the prospective unlocking was to decrease DPAC balances and to increase amortization expense.
Amortization of DPAC balances is proportional to estimated expected gross profits ("EGPs") for a line of business. Experience which deviates from the EGPs assumed similarly increases or decreases the amortization of DPAC. With the decline in collected asset management fees in 2019 as compared to 2018 due to lower index option returns, EGPs for the annuity line of business have been less than previously estimated which has produced a slowdown in core amortization of DPAC. This is the underlying factor causing amortization to be lower than that experienced in 2018 and 2017. In addition, the EGPs of the non-index block of annuity policies have been steadily decreasing with the declining amount of policies in force as well as DPAC unlockings in recent years for unfavorable experience.
Annuity contract interest includes the equity component return associated with the call options purchased to hedge National Western's fixed-index annuities. The detail of fixed-index annuity contract interest as compared to contract interest for all other annuities is as follows:
As previously noted, accounting rules require the embedded derivative liability to include a projection of asset management fees estimated to be collected in the succeeding fiscal year as an offset to projected policyholder interest credits. The projections are based upon the recent performance of options as of balance sheet reporting dates. The change in this projection, plus or minus, is included in contract interest expense for the period being reported on. During the years ended December 31, 2019, 2018, and 2017, contract interest was increased/(decreased) by $(33.6) million, $17.6 million, and $6.9 million, respectively, for this occurrence. The increases to contract interest expense reflect lower estimated asset management fees to be collected while the decrease to contract interest expense represents an increase to the amount of asset management fees estimated to be collected. The Annuity segment contains the products which charge asset management fees.
As noted in the Domestic Life insurance and International Life insurance segments, the Company's overall operating expenses are allocated based upon functional business activity and volumes. Although annuity sales activity decreased in 2019 and 2018 relative to the life insurance segments, the Annuity segment maintains a high level of maintenance expenses for the in force block of business which kept operating expenses at a relatively level amount. The 2018 annuity operating expense also benefited by the $1.9 million lawsuit accrual reduction for the Puerto Rico matter discussed in Part I Item 3. Legal Proceedings of this annual report.
Ozark National's traditional life block of business at December 31, 2019 included approximately 183,400 policies in force representing $6.25 billion of life insurance coverage. The repetitive pay nature of Ozark National's business promotes a higher level of persistency with an annualized lapse rate of 4.6% through December 31, 2019. Traditional life premiums by first year and renewal are detailed below.
Other revenues consists primarily of brokerage revenue of NIS. Brokerage revenues of $8.2 million for the eleven months subsequent to their acquisition had associated brokerage expense of $4.4 million which is included in Other operating expenses.
As discussed in the Consolidated Operations section, the Company closed on the sales of its two nursing home facilities during 2019. The Reno, Nevada nursing home operations were sold effective February 1, 2019 and the San Marcos, Texas nursing home operations were sold effective May 1, 2019. Nursing home operations generated $0.8 million, $1.3 million and $1.4 million of pre-tax earnings in 2019, 2018, and 2017, respectively.
The remaining pre-tax earnings in Other Operations of $25.2 million, $26.8 million, and $27.8 million for the years ended December 31, 2019, 2018, and 2017, respectively, includes investment income from real estate, municipal bonds, and common and preferred equities held in subsidiary company portfolios principally for tax-advantage purposes. Included in these amounts are semi-annual distributions from a life interest in the Libbie Shearn Moody Trust which is held in NWLSM, Inc. Pretax distributions from this trust were $6.7 million, $7.5 million, and $6.1 million in 2019, 2018, and 2017, respectively. In addition to pretax distributions, these amounts also include additional revenue recorded for annually revaluing the actuarial life interest in the Libbie Shearn Moody Trust which had a value of $9.2 million and $8.7 million at December 31, 2019 and 2018, respectively. Pre-tax earnings in 2019 also include expenses of $3.3 million related to the purchase of Ozark National and NIS.
The Company’s investment portfolio increased 5% to $11.1 billion at December 31, 2019 compared to $10.6 billion at December 31, 2018 due primarily to the addition of Ozark National and NIS invested assets as well as unrealized gain increases associated with investments reported at fair value (debt securities available for sale, index options and equity securities). These increases offset the decline in National Western's bond portfolio caused by annuity policy benefit outflows exceeding new premium cash inflows.
A portion of the Company’s debt securities are designated in the available for sale portfolio, which is reported at fair market value. Unrealized losses associated with this part of the portfolio were $(62.6) million at December 31, 2018 but shifted to an unrealized gain position of $150.8 million at December 31, 2019 incrementally increasing the total portfolio balance. The increase in the unrealized gain position of the portfolio is largely a consequence of market interest rate levels decreasing during 2019.
Derivatives are call options purchased to hedge the interest crediting mechanism associated with the Company's fixed-index universal life and annuity policies. These options are reported on the Consolidated Balance Sheets at fair value in accordance with GAAP. The unrealized gain position of options held at December 31, 2019 was $80.7 million which was $153.0 million higher than the unrealized loss position at December 31, 2018 of $72.3 million. The increase is due to the higher equity index level at the end of 2019 relative to the market indice levels at the time outstanding options were purchased while the converse was true at the end of 2018.
The Company maintains a diversified portfolio which consists mostly 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"). The Company's investment guidelines prescribe limitations by type of security as a percent of the total investment portfolio and all holdings were within these threshold limits. As of December 31, the Company's debt securities portfolio consisted of the following for 2019 and 2018:
Rating agencies generally view mortgage-backed securities as having additional risk for insurers holding interest sensitive liabilities given the potential for asset/liability disintermediation. Consequently, the Company holds predominantly agency mortgage-backed securities. Because mortgage-backed securities are subject to prepayment and extension risk, the Company has substantially reduced these risks by investing in CMOs, 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.
The Company closely monitors its below investment grade holdings by reviewing investment performance indicators, including information such as issuer operating performance, debt ratings, analyst reports and other economic factors that may affect these specific investments. While additional losses are not currently anticipated, based on the existing status and condition of these securities, continued credit deterioration of some securities or the markets in general is possible, which may result in future write-downs.
During the year ended December 31, 2019, the Company recorded an other-than-temporary impairment ("OTTI") credit related write-down on one debt security. See Note (2) Investments of the accompanying Consolidated Financial Statements for further discussion. In accordance with GAAP guidance for reporting other-than-temporary impairments due to credit loss versus non-credit loss, the Company recognized on its securities held at December 31, 2019 a total of $8.5 million of other-than-temporary impairments of which $8.5 million were deemed credit related and recognized as realized investment losses in earnings, and $0.0 million that was deemed non-credit related impairments and recognized in other comprehensive income.
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, hotels, 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 lease payments and also by the borrower. This approach has proved over time to result in quality mortgage loans with few defaults. Mortgage loan interest income is recognized on an accrual basis with any premium or discount amortized over the life of the loan. Prepayment and late fees are recorded on the date of collection.
Loans in foreclosure, loans considered impaired or loans past due 90 days or more are placed on a non-accrual status. If a mortgage loan is determined to be on non-accrual status, the mortgage loan does not accrue any income into the Consolidated Statements of Earnings. The loan is independently monitored and evaluated as to potential impairment or foreclosure. If delinquent payments are made and the loan is brought current, then the Company returns the loan to active status and accrues income accordingly. The Company currently has no loans past due 90 days which are accruing interest.
The Company held net investments in mortgage loans, after allowances for possible losses, totaling $272.4 million and $203.2 million at December 31, 2019 and 2018, respectively. The diversification of the portfolio by geographic region, property type, and loan-to-value ratio was as follows:
All mortgage loans are analyzed quarterly in order to monitor the financial quality of these assets. Based on ongoing monitoring, mortgage loans with a likelihood of becoming delinquent are identified and placed on an internal “watch list”. Among the criteria that would indicate a potential problem are: major tenant vacancies or bankruptcies, late payments, and loan relief/restructuring requests. The mortgage loan portfolio is analyzed for the need for a valuation allowance on any loan that is on the internal watch list, in the process of foreclosure or that currently has a valuation allowance.
The following table represents the mortgage loan allowance for the years ended December 31, 2019 and 2018:
The contractual maturities of mortgage loan principal balances at December 31, 2019 and 2018 were as follows:
The Company's direct investments in real estate total approximately $34.6 million at December 31, 2019 and $35.7 million at December 31, 2018, and consist primarily of income-producing properties which are being operated by a wholly owned subsidiary of National Western. Included in the amount at December 31, 2019 is a surface parking property owned by Ozark National which it contracts. The value of this real estate investment was appraised at $4.3 million at January 31, 2019 as part of the purchase accounting done as of that date. The Company recognized operating income on these properties of approximately $2.9 million, $2.2 million and $2.9 million for the years ended December 31, 2019, 2018 and 2017, 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 $6.9 million, $1.8 million and $2.7 million associated with real estate investments in the years ended December 31, 2019, 2018 and 2017, respectively. Included in net realized gains during 2019 are the sale of the Company's former home office facility in Austin, Texas at a gain of $3.2 million and the sale of the Company's two nursing home facilities at a net gain of $3.7 million.
Market risk is the risk of change in market values of financial instruments due to changes in interest rates, currency exchange rates, commodity prices, or equity prices. The most significant market risk exposure for the Company is interest rate risk. Substantial and sustained increases and decreases in market interest rates can affect the profitability of insurance products and the fair value of investments. The yield realized on new investments generally increases or decreases in direct relationship with interest rate changes. The fair values of fixed income debt securities correlate to external market interest rate conditions as market values typically increase when market interest rates decline and decrease when market interest rates rise. However, market values may fluctuate for other reasons, such as changing economic conditions, market dislocations or increasing event-risk concerns.
A decline in interest rates could cause certain mortgage-backed securities in the Company’s portfolio to be more likely to pay down or prepay. In this situation, the Company typically will be unable to reinvest the proceeds at comparable yields. Lower interest rates will likely also cause lower net investment income, subject the Company to reinvestment rates risks, and possibly reduce profitability through reduced interest rate margins associated with products having minimum guaranteed crediting rates. Alternatively, the fair value of the Company’s investment portfolio will increase when interest rates decline.
The Company's unrealized gain (loss) balance for debt securities held at December 31, 2019 and 2018 is shown in the following table.
Debt securities held to maturity are recorded at their amortized cost basis. Accordingly, the unrealized amounts shown in the table above for Debt securities held to maturity are not incorporated into the Company's Consolidated Financial Statements at December 31, 2019 and 2018, respectively.
Changes in interest rates typically have a sizable effect on the fair values of the Company's debt securities. During 2019, the market interest rate of the ten-year U.S. Treasury bond decreased roughly 77 basis points from 2.69% at year-end 2018 to 1.92% at year-end 2019. Therefore, the change from an unrealized loss position to an unrealized gain position was primarily the result of the decrease in interest rate levels. However, since the majority of the Company's debt securities are classified as held to maturity, which are recorded at amortized cost, changes in fair values have a lesser effect on the Company's financial results.
Mortgage and other loans were modeled by discounting scheduled cash flows through the scheduled maturities of the loans, starting with interest rates currently being offered for similar loans to borrowers with similar credit ratings. Policy loans were modeled by discounting estimated cash flows using U.S. Treasury Bill interest rates as base rates at December 31, 2019. The estimated cash flows include assumptions as to whether such loans will be repaid by the policyholders or settled upon payment of death or surrender benefits on the underlying insurance contracts and incorporate both Company experience and mortality assumptions associated with such contracts.
The Company's market risk liabilities, which include policy liabilities for annuity and supplemental contracts, are managed for interest rate risk through cash flow testing as previously described. As part of this cash flow testing, the Company has analyzed the potential impact on net earnings of a 100 basis point decrease and increases in increments of 100 basis points in the U.S. Treasury yield curve as of December 31, 2019. The potential impact on net earnings from these interest rate changes are summarized below.
These estimated impacts on earnings are net of tax effects and the estimated effects of deferred policy acquisition costs.
The Company’s net exposure to loss due to credit risk if option counterparties failed to completely perform according to the terms of their one-year contracts is as follows at December 31, 2019 and 2018.
The Company is also exposed to credit spread risk related to market prices of investment securities and cash flows associated with changes in credit spreads. Credit spread tightening will reduce net investment income associated with new purchases of fixed debt securities and will increase the fair value of the investment portfolio. Credit spread widening will reduce the fair value of the investment portfolio and will increase net investment income on new purchases.
Liquidity requirements are met primarily by funds provided from operations. Premium deposits and annuity considerations, investment income, and investment maturities and prepayments are the primary sources of funds while investment purchases, policy benefits in the form of claims, and payments to policyholders and contract holders in connection with surrenders and withdrawals as well as operating expenses are the primary uses of funds. To ensure the Company will be able to pay future commitments, the funds received as premium payments and deposits are invested in high quality investments, primarily fixed income securities. Funds are invested with the intent that the income from investments, plus proceeds from maturities, will meet the ongoing cash flow needs of the Company. The approach of matching asset and liability durations and yields requires an appropriate mix of investments. Although the Company historically has not been put in the position of having to liquidate invested assets to provide cash flow, its investments consist primarily of marketable debt securities that could be readily converted to cash for liquidity needs. Effective October 1, 2018, the Company (National Western) increased its line of credit facility up to $75 million which it may access for short-term cash needs. As part of the acquisition of Ozark National and NIS effective January 31, 2019, National Western borrowed $75 million to partly fund the closing cash purchase price of $205.4 million. The amounts borrowed were subsequently repaid during the first quarter of 2019 and there were no borrowings outstanding under the line of credit at December 31, 2019.
Cash flows from the Company's insurance operations have historically been sufficient to meet current needs. Cash flows from operating activities were $329.0 million, $326.6 million, and $276.1 million in 2019, 2018, and 2017, respectively. The Company also has significant cash flows from both scheduled and unscheduled investment security maturities, redemptions, and prepayments. These cash flows totaled $995.8 million, $633.2 million, and $779.0 million in 2019, 2018, and 2017, respectively. Cash flows from security maturities, redemptions, and prepayments coincide primarily with scheduled maturity dates of securities given the Company's buy and hold investment philosophy but may become amplified during periods of significant declines in interest rates due to prepayments and bond calls. Conversely, these cash flow items could experience reduced levels of activity if interest rates rise in the future. Net cash inflows/(outflows) from the Company's universal life and annuity product operations totaled $(584.7) million, $(440.6) million, and $(163.3) million in 2019, 2018, and 2017, respectively reflecting the trend in declining annuity sales during the period and in a higher incidence of annuity cash surrenders and withdrawals.
The Company relies on stockholders 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, 2019, the Company maintained commitments for its normal operating and investment activities. In addition, the Company had pending an acquisition under a Stock Purchase Agreement executed October 3, 2018, which was subject to receiving the requisite regulatory approvals at December 31, 2018. As disclosed in Note (7) Business Combinations in the Notes to Consolidated Financial Statements in Attachment A of Part IV Item 15. Exhibits and Financial Statement Schedules of this filing, the Company subsequently completed the announced acquisition on January 31, 2019 paying $205.4 million for the targeted companies.
Insurance reserves are the means by which life insurance companies determine the liabilities that must be established to assure that future policy benefits are provided for and can be paid. These reserves are required by law and based upon standard actuarial methodologies to ensure fulfillment of commitments guaranteed to policyholders and their beneficiaries, even though the obligations may not be due for many years. Refer to Note (1) Summary of Significant Accounting Policies in the Notes to Consolidated Financial Statements for a discussion of reserving methods.