The Westcap Corporation, a wholly owned subsidiary, owns the Company’s principal office location in Austin, Texas and two buildings adjacent to it, totaling approximately 93,000 square feet that are leased and utilized by the Company. The Company’s affiliate, Regent Care Building, LP, owns a 65,000 square foot building in Reno, Nevada, which is leased and utilized by another of the Company’s affiliates, Regent Care Operations, LP, for use in its nursing home operations. The Company’s subsidiary, Regent Care San Marcos Holdings, LLC, completed construction of a 74,000 square foot building in San Marcos, Texas in 2009 used in nursing home operations. Lease costs and related operating expenses for facilities of the Company’s subsidiaries are currently not significant in relation to the Company’s consolidated financial statements. The intercompany lease costs related to The Westcap Corporation and the nursing homes have been eliminated for consolidated reporting purposes.
Management’s discussion and analysis of financial condition and results of operations (“MD&A”) of National Western Life Insurance Company for the three years ended December 31, 2009 follows. This discussion should be read in conjunction with the Company’s consolidated financial statements and related notes beginning on page 60 of this report.
changes in the fair value of derivative index options and embedded derivatives pertaining to fixed-index life and annuity products
The Company monitors these factors continually as key business indicators. The discussion that follows in this Item 7 includes these indicators and presents information useful to an overall understanding of the Company’s business performance in 2009, incorporating required disclosures in accordance with the rules and regulations of the Securities and Exchange Commission.
Deferred Policy Acquisition Costs (“DPAC”). The Company is required to defer certain policy acquisition costs and amortize them over future periods. These costs include commissions and certain other expenses that vary with and are primarily associated with acquiring new business. The deferred costs are recorded as an asset commonly referred to as deferred policy acquisition costs. The DPAC asset balance is subsequently charged to income over the lives of the underlying contracts in relation to the anticipated emergence of revenue or profits. Actual revenue or profits can vary from Company estimates resulting in increases or decreases in the rate of amortization. The Company does regular evaluations of its universal life and annuity contracts to determine if actual experience or other evidence suggests that earlier estimates should be revised. Assumptions considered significant include surrender and lapse rates, mortality, expense levels, investment performance, and estimated interest spread. Should actual experience dictate that the Company change its assumptions regarding the emergence of future revenues or profits (commonly referred to as “unlocking”), the Company would record a charge or credit to bring its DPAC balance to the level it would have been if using the new assumptions from the inception date of each policy.
DPAC is also subject to periodic recoverability and loss recognition testing. These tests ensure that the present value of future contract-related cash flows will support the capitalized DPAC balance to be amortized in the future. The present value of these cash flows, less the benefit reserve, is compared with the unamortized DPAC balance and if the DPAC balance is greater, the deficiency is charged to expense as a component of amortization and the asset balance is reduced to the recoverable amount. For more information about accounting for DPAC see Note 1, Summary of Significant Accounting Policies, of the consolidated financial statements.
Share-Based Payments. Liability awards under a share-based payment arrangement have been measured based on the awards’ fair value at the reporting date. The Black-Scholes valuation method is used to estimate the fair value of the options. This fair value calculation of the options include assumptions relative to the following:
The financial markets began experiencing stress during the second half of 2007 which significantly increased during 2008 and on into the first half of 2009. Volatility and disruption in the financial markets caused the availability and cost of credit to be materially affected. Consumer confidence declined in the face of depressed home prices, increasing foreclosures, and higher unemployment. Eventually, these factors precipitated a severe recession in many ways akin to the Great Depression.
This combination of economic conditions began to negatively impact our sales in 2008, particularly in the domestic life and international life segments. Although the financial markets and the economy began to show improvement in the latter half of 2009, international life insurance sales, as measured by placed annualized target premium, declined 15% from 2008 levels and domestic life insurance sales dropped 74%. Economic indicators are currently pointing toward the economy as having emerged from the trough of the recession and possibly toward a line of growth in the immediate future. However, high unemployment, massive Federal government budget deficits, instability in the European economic markets, and the threat of looming inflation make the prospects of future economic stability and prosperity anything but certain. Consequently, demand for our life insurance products may continue to be adversely impacted during this period of economic uncertainty. It is also uncertain what impact, if any, the current environment may have upon the incidence of claims, policy lapses, or surrenders of policies.
Our operating strategy is to maintain capital levels substantially above regulatory and rating agency requirements. While not significant, our capital levels incurred declinations for impairment losses on investments during 2008 and 2009. Despite these modest reductions in capital, the Company maintains resources more than adequate to fund future growth and absorb abnormal periods of cash outflows.
Investment grade debt securities generated approximately 95.4% of net investment income, excluding derivatives, in 2009. The decrease in short-term investment income in 2009 is attributable to the very low interest rates available on money market funds during all of 2009. Interest income earned on other investments increased due to new investments in collateralized loans made during the second half of 2009.
Net investment income performance is analyzed excluding derivative income (loss), which is a common practice in the insurance industry, in order to assess underlying profitability and results from ongoing operations. Net investment income performance is summarized as follows:
Income and losses from index options are due to market conditions. Index options are intended to act as hedges to match the returns on the product’s underlying reference index and the rise or decline in the index causes option values to likewise rise or decline. The Company does not elect hedge accounting relative to these derivative instruments. While income from index options fluctuates with the underlying index, the contract interest expense to policyholder accounts for the Company’s fixed-indexed products also fluctuates in a similar manner and direction. In 2009, the reference indices increased and the Company recorded income from index options and likewise increased contract interest expenses. In 2008 and 2007, the reference indices decreased resulting in index option losses and a reduction in contract interest expenses.
Net realized investment (losses) gains - Realized losses on investments have primarily resulted from impairment write-downs on investments in debt securities and valuation allowances recorded on mortgage loans. The net losses reported in 2009 of $5.2 million consisted of gross gains of $2.2 million primarily from calls and sales of debt securities, offset by gross losses of $7.4 million, which includes other-than-temporary impairment losses.
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. Impairment write-downs are summarized in the following table.
Due to events providing evidence of a significant deterioration in the issuers’ credit worthiness, one security was transferred from the held to maturity to the available for sale classification, and was ultimately sold.
The equity impairments represent mark-to-market write-downs on various equity holdings. In addition, the 2008 amount includes Fannie Mae and Freddie Mac preferred stock impairments of $4.6 million.
In accordance with GAAP guidance the Company writes off deferred acquisition costs, unearned revenue liabilities, and deferred sales inducement assets upon internal replacement of certain contracts as well as annuitizations of deferred annuities.
The Company is required to periodically adjust for actual experience that varies from that assumed. True-up adjustments were recorded in 2009, 2008 and 2007 relative to partial surrender rates, mortality rates, credited interest rates and earned rates for the current year’s experience resulting in $8.4 million, $16.2 million, and $1.0 million increases in amortization, respectively.
Universal life and annuity contract interest - The Company closely monitors credited interest rates on interest sensitive policies, 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". Raising policy credited rates can typically have an impact sooner than higher market rates on the Company's investment portfolio yield, making it more difficult to maintain the current interest spread.
Other operating expenses - Other operating expenses consist of general administrative expenses, legal costs, licenses and fees, commissions not subject to deferral, and expenses of nursing home operations. As discussed previously in Item 3. Legal Proceedings, and in reports on Form 8-K which the Company issued on February 9, 2010 and February 22, 2010, the Company is currently involved in various legal actions in the normal course of its business. In accordance with generally accepted accounting principles, the Company accrued $23.0 million during the year ended December 31, 2009 for potential future costs pertaining to these various matters.
During 2009, the Company started or accelerated major information system initiatives to enhance actuarial, accounting, policy acquisition, and policy administration processes. Non-capitalizable expenses associated with these various system development efforts were approximately $1.5 million higher than amounts incurred in 2008. Deprecation expense increased $0.9 million in association with new system implementations.
Guaranty fund assessment expenses increased to $0.5 million in 2009 from $0.3 million and $(0.2) million in 2008 and 2007, respectively.
Compensation costs related to stock options totaled $1.6 million in 2009, $(1.4) million in 2008 and $(1.1) million in 2007 as a result of marking the options to fair value under the liability method of accounting.
A summary of segment earnings from continuing operations for the years ended December 31, 2009, 2008 and 2007 is provided below. The segment earnings exclude realized gains and losses on investments, net of taxes.
Net investment income decreased slightly to $19.5 million in 2009 as compared to $20.3 million in 2008 and $18.9 million in 2007, due to lower investment yields from debt security investment purchases backing the obligations of the line of business.
Policy benefits in 2009, 2008 and 2007 were consistent with Company expectations. Other operating expenses were $2.9 million higher in 2009 reflecting the factors discussed in the other operating expense section of consolidated operations above.
During the current year, unlocking of the projected universal life per policy maintenance expense and projected mortality assumptions decreased the DPAC asset balance and increased life DPAC amortization by $2.7 million. Current year true-up adjustments increased amortization expense by $1.9 million. No unlocking adjustments were recorded in 2008. True-up adjustments increased DPAC amortization $1.4 million for the year. During 2007, the Company recorded an unlocking adjustment for changes in mortality assumptions which reduced the DPAC asset and increased DPAC amortization expense by $2.2 million. True-up adjustments increased DPAC amortization expense by $0.6 million.
In general, as the amount of international life insurance in force grows, the Company anticipates operating earnings to increase as well. The amount of international life insurance in force grew from $14.8 billion at December 31, 2007 to $15.9 billion at December 31, 2008. However, international life insurance in force declined slightly to $15.7 billion at December 31, 2009, in reaction to the U.S. financial market crisis.
The Company's international life operations historically have been a significant factor in the Company's overall earnings performance and represent a market niche where the Company believes it has a competitive advantage. A productive agency force has been developed given the Company's longstanding reputation for supporting its international life products coupled with the instability of competing companies in international markets. In particular, the Company has experienced growth with its fixed-indexed universal life products and has collected related premiums of $81.9 million, $78.5 million and $76.8 million for the years ended 2009, 2008 and 2007, respectively.
The appealing feature to a consumer purchasing a fixed-indexed universal life policy is the interest crediting component linked in part to an equity index. With the growth in this block of business, the period-to-period changes in fair values of the underlying options used to hedge this interest crediting feature have had an increasingly greater impact on net investment and contract interest. A detail of net investment income for international life insurance operations is provided below.
Contract interest expense includes fluctuations that are the result of underlying equity indices performance relative to the equity-indexed universal life products. The associated stock market gains (losses) increase (decrease) the amounts the Company credits to policyholders. With the recovery in the equity markets during 2009, the segment reported significant increases in net investment income and contract interest expense. For more details about the Company’s use of index options to hedge equity indices performance refer to the derivative income (loss) discussion in the Consolidated Operations section of Item 7.
Other operating expenses reported in 2009 were 15.4% higher compared to 2008, reflecting the factors discussed in the other operating expense section of Consolidated Operations previously.
Other deferred annuity deposits increased 169% in 2009 compared to 2008. These product sales had been trending lower over the past few years due to low interest rates and investor preferences. As a selling inducement, many annuity products include a first year premium or interest rate bonus in addition to the base first year deposit interest rate. These bonuses are credited to the policyholder account but are deferred by the Company and amortized over future periods. The amount deferred was approximately $36.8 million, $19.4 million and $20.8 million for the years ended December 31, 2009, 2008 and 2007, respectively.
As previously described, derivatives are used to hedge the equity return component of the Company's fixed-indexed annuity products with any gains or losses from the sale or expiration of the options, as well as period-to-period changes in fair values, reflected in net investment income. Derivative income and losses fluctuate from period to period based on the performance of the indices underlying fixed-indexed products.
With respect to deferred policy acquisition costs, the Company is required to periodically adjust for actual experience that varies from that assumed. A true-up of assumptions in 2009 resulted in increased amortization of deferred policy acquisition costs of $5.1 million. During 2008, the Company recorded an unlocking adjustment of $8.1 million and a true-up adjustment of $11.1 million that together increased amortization by $19.2 million. During 2007 the Company recorded an unlocking adjustment of $1.8 million and true-up adjustments of $3.3 million resulting in decreased amortization of deferred acquisition costs. While management does not currently anticipate any impact from unlocking in 2010, facts and circumstances may arise in the future which require that the factors be reexamined.
Other operating expenses in 2009 were $27.5 million higher compared to 2008 primarily due to various legal actions that arose in the normal course of business over the past several years. In accordance with generally accepted accounting principles, the Company accrued $23.0 million during 2009 pertaining to these various matters and for potential future costs. The balance of the increase in operating expenses reflects the other factors previously discussed in the Other Operating Expenses section of consolidated operations.
The Company's overall conservative investment philosophy is reflected in the allocation of its investments, which is detailed below as of December 31, 2009 and 2008. The Company emphasizes investment grade debt securities, with smaller holdings in mortgage loans and policy loans.
Because the Company's holdings of mortgage-backed securities are subject to prepayment and extension risk, the Company has substantially reduced these risks by investing in collateralized mortgage obligations, which have more predictable cash flow patterns than pass-through securities. These securities, known as planned amortization class I ("PAC I"), very accurately defined maturity ("VADM") and sequential tranches are designed to amortize in a more predictable manner than other CMO classes or pass-throughs. The Company does not purchase tranches, such as PAC II and support tranches, that subject the portfolio to greater than average prepayment risk. Using this strategy, the Company can more effectively manage and reduce prepayment and extension risks, thereby helping to maintain the appropriate matching of the Company's assets and liabilities.
As of December 31, 2009, 9 of the subprime securities were rated AAA, 1 was rated AA, 1 was rated A, 1 was rated BB and 1 was rated CC.
Holdings in below investment grade securities by category as of December 31, 2009 are summarized below, including 2009 and 2008 fair values for comparison. The Company is continually monitoring developments in these industries that may affect security valuation issues.
The Company is required to classify its investments in debt and equity securities into one of three categories: (a) trading securities; (b) securities available for sale; or (c) securities held to maturity. The Company purchases securities with the intent to hold to maturity and accordingly does not maintain a portfolio of trading securities. Of the remaining two categories, available for sale and held to maturity, the Company makes a determination on categorization based on various factors including the type and quality of the particular security and how it will be incorporated into the Company's overall asset/liability management strategy. As shown in the table below, at December 31, 2009, approximately 32% 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.
During the twelve months ended December 31, 2009 the Company recorded other-than-temporary impairment credit related write-downs on debt securities totaling $5.1 million and $0.4 million on equity securities. See Note 3, Investments Debt and Equity Securities, of the accompanying consolidated financial statements.
As of April 1, 2009, the Company adopted the GAAP guidance on the recognition and accounting for other-than-temporary impairments. See Note 1, Summary of Significant Accounting Policies, and Note 3, Investments, in the accompanying consolidated financial statements. Since adoption of this new guidance, the Company recognized $8.7 million of other-than-temporary impairments; of which $0.3 million was deemed credit related and recognized as realized investment losses in earnings, and $8.4 million was deemed a non credit related impairment and recognized in other comprehensive income.
The Company requires a minimum specified yield on mortgage loan investments. Until recently the low interest rate environment resulted in fewer loan opportunities being available which met the Company's required rate of return. This environment has recently started to change and the Company again made new mortgage loans which resulted in an increase in total loans at year-end.
The Company does not recognize interest income on loans past due ninety days or more. The Company had two mortgage loans past due six months or more with the principal balance totaling $7.0 million at December 31, 2009, 2008 and 2007. Interest income not recognized for past due loans totaled approximately $0.4 million in both 2008 and 2007. There was no interest income not recognized in 2009.
The contractual maturities of mortgage loan principal balances at December 31, 2009 are as follows:
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 National Western is interest rate risk. The fair values of fixed income debt securities correlate to external market interest rate conditions. Because 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. However, market values may fluctuate for other reasons, such as changing economic conditions, market dislocations or increasing event-risk concerns.
The Company manages interest rate risk through ongoing cash flow testing required for insurance regulatory purposes. Business models are used to perform cash flow testing under various commonly used stress test interest rate scenarios to determine if existing assets would be sufficient to meet projected liability outflows. Sensitivity analysis allows the Company to measure the potential gain or loss in fair value of its interest-sensitive instruments and to protect its economic value and achieve a predictable spread between what is earned on invested assets and what is paid on liabilities. The Company seeks to minimize the impact of interest rate risk through surrender charges that are imposed to discourage policy surrenders and to offset unamortized acquisition costs. Interest rate changes can be anticipated in the computer models and the corresponding risk addressed by management actions affecting asset and liability instruments. However, potential changes in the values of financial instruments indicated by hypothetical interest rate changes will likely be different from actual changes experienced, and the differences could be significant.
Expected maturities of debt securities may differ from contractual maturities due to call or prepayment provisions. The models assume that prepayments on mortgage-backed securities are influenced by agency and pool types, the level of interest rates, loan age, refinancing incentive, month of the year, and underlying coupon. During periods of declining interest rates, principal payments on mortgage-backed securities and collateralized mortgage obligations tend to increase as the underlying mortgages are prepaid. Conversely, during periods of rising interest rates, the rate of prepayment slows. Both of these situations can expose the Company to the possibility of asset-liability cash flow and yield mismatch. The model uses a proprietary method of sampling interest rate paths along with a mortgage prepayment model to derive future cash flows. The initial interest rates used are based on the current U.S. Treasury yield curve as well as current mortgage rates for the various types of collateral in the portfolio.
In the past, cash flows from the Company's insurance operations have been sufficient to meet current needs. Cash flows from operating activities were $138 million, $195 million and $260 million in 2009, 2008 and 2007, respectively. The Company also has significant cash flows from both scheduled and unscheduled investment security maturities, redemptions, and prepayments. These cash flows totaled $1,050 million, $727 million and $477 million in 2009, 2008 and 2007, respectively. Cash flows from security maturities, redemptions, and prepayments were relatively higher over the last three years due to the decline in interest rates. These cash flow items could be reduced if interest rates rise in 2010. Net cash flows from the Company's universal life and annuity deposit product operations totaled $337 million, $(118) million and $(93) million in 2009, 2008 and 2007, respectively.
(1) Refer to Note 9, Commitments and Contingencies, of the accompanying consolidated financial statements relating to Company leases.
On June 12, 2009 the FASB issued new guidance that changes the way entities account for securitizations and special purpose entities. The guidance is effective as of the beginning of the Company’s first annual reporting period beginning after November 15, 2009 and is not expected to have a significant impact on the consolidated financial position, results of operations or disclosures.
Other recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force), the AICPA, and the SEC did not, or are not believed by management to, have a material impact on the Company’s present or future consolidated financial statements.
During the second quarter of 2009, the Company reviewed all previously recorded other-than-temporary impairments of securities, in compliance with newly issued FASB GAAP guidance, and estimated the credit versus the non-credit component of prior impairments consistent with the methodology used in the current period to analyze and bifurcate impairments into credit and non-credit components. As a result, the Company determined that $0.8 million in previously recorded other-than-temporary impairments had been due to non-credit impairments.
For each security the Company developed its best estimate of the net present value of the cash flows expected to be received. The credit component of the impairment for these securities was determined to be the difference between the amortized cost of the security and the projected net cash flows. The non-credit component was determined to be the difference between projected net cash flows and fair value. The Company also determined whether management had the intent to sell the security, or if it was more likely than not that it will be required to sell the security, prior to the recovery of the non-credit component.
See Attachment A, Index to Financial Statements and Schedules, on page 60.