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, 2002 follows. This discussion should be read in conjunction with the Company's consolidated financial statements and related notes beginning on page ___ of this report.
Revenues: The following details revenues excluding index options and realized losses on investments:
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. The Company's retention of inforce policies and contracts improved substantially in 2002 and 2001 contributing to higher operating earnings. However, revenues decreased from a lower incidence of surrender charges. Surrender charge revenue was $23.1 million in 2002 compared to $26.7 million in 2001, and $36.4 million in 2000.
Traditional life insurance premiums for products such as whole life and term life are recognized as revenues over the premium-paying period. These are product lines that the Company has been de-emphasizing in favor of interest sensitive products, particularly in its international life insurance operations. In addition, traditional life premiums are muted for increases in reinsurance premiums and exchange rate changes associated with policies in Haiti which is the only international country where premiums and benefits may be paid in other than U.S. dollars.
A detail of net investment income, excluding index options, is provided below:
Other revenue consists primarily of two sources. The first pertains to the Company's other operations involving a nursing home which commenced operations in 2000. Revenues associated with this operation were $6.1 million, $5.2 million and $0.6 million in 2002, 2001 and 2000, respectively. Also included in 2001 other revenue is nearly $0.7 million received from the favorable resolution of longstanding litigation against the Company and one of its wholly owned subsidiaries, The Westcap Corporation (Westcap). The United States Court of Appeals, 5th Circuit, ruled in favor of Westcap on the matter in 2001.
Index Options: Index options are derivative financial instruments used to hedge the equity return component of the Company's equity-indexed products, which were first introduced for sale in 1997. In 2002, the Company began selling an equity-indexed universal life product. Any gains or losses from the sale or expiration of the options, as well as period-to-period changes in fair values, are reflected as a component of net investment income. However, increases or decreases in income from these options are substantially offset by corresponding increases or decreases in amounts paid to equity-indexed annuity and life policyholders.
Realized Losses on Investments: The losses on investments consist primarily of impairment writedowns for investments in debt securities. The Company records impairment writedowns when a decline in value is considered other than temporary and full recovery of the investment is not expected. During 2002, two corporations filed for bankruptcy in whose debt securities the Company held positions. Impairment writedowns were recorded for these holdings including WorldCom ($9.6 million) and United Airlines ($4.0 million). The Company also recorded impairments on collateralized bond obligations (CBOs) of approximately $3.7 million in 2002. During 2001 CBO impairment writedowns totaled $4.6 million. Total impairment writedowns in 2002, 2001 and 2000 totaled $17.4 million, $32.3 million, and $14.7 million, respectively.
The Company benefited from improved mortality experience in 2002 resulting in lower policy benefits. Death claims decreased to $22.8 million in 2002 from $23.6 million in 2001 with domestic life recording more favorable results. The Company's mortality experience over the past five years has generally been consistent with its product pricing assumptions.
The Company closely monitors its credited interest rates on interest sensitive policies, taking into consideration such factors as profitability goals, policyholder benefits, product marketability, and economic market conditions. Average credited rates, calculated based on policy reserves for the Company's universal life and investment annuity business, have generally declined since 1997, which is consistent with declines in market interest rates. As market interest rates fluctuate, the Company's credited interest rates are often adjusted accordingly taking into consideration other factors as described above. 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. The difference between yields earned over policy credited rates is often referred to as the interest spread.
Contract interest also includes the performance of the equity-index component of the Company's equity-indexed annuities. As previously noted, the recent market performance of these equity-index features reduced contract interest expenses while also reducing the Company's investment income given the hedge nature of the options purchased for these products. Excluding equity-indexed annuities, the Company's average credited rate on annuity products was approximately 5.5% in 2002. The average credited rate in 2002 for interest sensitive life products approximated 5.4%. With these credited rates, the Company generally realized 95% to 100% of its required interest spread on its products.
Federal Income Taxes: Federal income taxes on earnings from continuing operations for 2002, 2001, and 2000 reflect effective tax rates of 33.1%, 34.2%, and 32.9%, respectively, which are lower than the expected Federal rate of 35%. The effective tax rate is lower than the Federal rate of 35% primarily due to tax-exempt investment income related to municipal securities and dividends-received deductions on income from stocks.
Segment earnings have declined as the block of business has contracted. The face amount of domestic life insurance inforce has declined from $3.0 billion at December 31, 2000, to $2.9 billion at December 31, 2001, and to $2.8 billion at December 31, 2002. Absent the growth rates targeted by management, the block of business will continue to contract due to the normal incidence of terminations from death or surrender with lower earnings resulting.
As the international life insurance inforce continues to grow, the Company anticipates operating earnings to similarly increase. The amount of international life insurance inforce has grown from $6.7 billion at December 31, 2000 to $7.1 billion at December 31, 2001, and to $8.8 billion at December 31, 2002.
The Company's annuity operations are almost exclusively in the United States. Although some of the Company's investment contracts are available to international residents, current sales are small relative to total annuity sales. A comparative analysis of results of operations for the Company's annuity segment is detailed below:
Equity indexed products sales typically follow the stock market in that sales are higher when confidence is high in the stock market and low if the stock market is showing poor performance. Sales of these products increased in 2002 over 2001 as consumers speculated as to a market bottom. Since the Company does not offer variable products or mutual funds, these equity indexed products provide a key equity-based alternative to the Company's existing fixed annuity products.
As previously described, index options are used to hedge the equity return component of the Company's equity-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. Excluding index option income or losses from investment income in the annuity segment results in net investment income totaling $197.1 million, $194.1 million, and $188.3 million for 2002, 2001, and 2000, respectively.
Other deferred annuity sales increased significantly in 2002 over 2001 with $355.5 million in collected deposits as compared to $232.3 million, respectively. Fixed-rate annuity products became very popular with consumers in the wake of the stock market decline and volatility as they are a stable investment yielding a competitive interest rate in the current market. Annuity earnings do not immediately reflect the significant increase in sales as most products sold include first year interest bonuses which are charged against earnings immediately.
The increase in contract interest for all other annuities is due to the increased sales of other deferred annuities and the interest bonuses as noted previously.
National Western's primary business encompasses its domestic and international life insurance operations and its annuity operations. However, National Western also has small real estate, nursing home, and other investment operations through its wholly owned subsidiaries. Most of the income from the Company's subsidiaries is from a life interest in a trust. Gross income distributions from the trust totaled $3,741,000, $3,753,000, and $3,643,000 in 2002, 2001, and 2000, respectively.
During the first quarter of 2000, the Company acquired a nursing home facility through an affiliated limited partnership. The acquisition, which totaled approximately $6.6 million, was made by a newly formed limited partnership, the partners of which are downstream subsidiaries of National Western. The nursing home facility, which opened in late July, 2000, is operated by an affiliated limited partnership, and the financial operating results are consolidated with those of the Company. Daily operations and management of the nursing home are performed by an experienced management company through a contract with the limited partnership. Nursing home operations generated $654,000 and $425,000 of operating earnings in 2002 and 2001, respectively, compared to operating losses of $748,000 in 2000.
The Company's investment philosophy emphasizes the prudent handling of policyowners' and stockholders' funds to achieve security of principal, to obtain the maximum possible yield while maintaining security of principal, and to maintain liquidity in a measure consistent with current and long-term requirements of the Company.
The Company's overall conservative investment philosophy is reflected in the allocation of its investments, which is detailed below as of December 31, 2002 and 2001. The Company emphasizes investment grade debt securities, with smaller holdings in mortgage loans and policy loans.
The Company maintains a diversified portfolio which consists primarily of corporate, mortgage-backed, and public utilities fixed income securities. Investments in mortgage-backed securities include primarily U.S. government agency pass-through securities and collateralized mortgage obligations (CMOs). As of December 31, 2002 and 2001, the Company's debt securities portfolio consisted of the following:
National Western does not purchase below investment grade securities. Investments held in debt securities below investment grade are the result of subsequent downgrades of the securities. During 2002, the Company's percentage of below investment grade securities increased due to continued effects of September 11th and accounting irregularities that plagued the energy and telecommunications industries. Despite these downgrades, the Company's holdings of below investment grade securities is lower than industry averages and is a small percentage of total invested assets. These holdings are summarized below.
The investment environment of 2002 continued with poor investor confidence and additional accounting irregularities reported by high profile companies. The telecommunications, energy and airlines industries all struggled during 2002 due to various factors that had significant impacts on theses industries. Economic conditions resulting from September 11th are continuing to impact the airline industry. The Company is closely monitoring developments in these industries that would affect security valuations. Holdings in below investment grade securities by category as of December 31, 2002 are summarized below.
Generally accepted accounting principles require that investments in debt securities be written down to fair value when declines in value are judged to be other than temporary. Since quoted market prices are readily available and understood by investors and creditors they are the mandated source for fair value estimation when available. In some instances, quoted market prices may not be available for securities that have limited buyer demand. When the quoted market price is not available other valuation techniques such as discounted cash flow analysis and fundamental analysis may be used. Although the Company is required to write down securities deemed to be impaired on an other than temporary basis to quoted market prices, the estimated ultimate recovery value of the impaired security is often anticipated to be an amount in excess of the quoted market price. This is due to the influence that "distressed bond" traders may have in depressing market prices in order to generate a yield commensurate with the investment risk of such securities. Consequently, financial results can significantly vary from period to period for securities written down to quoted market prices which may be subsequently redeemed at levels consistent with expected recovery value.
As part of an evaluation of its entire portfolio in 2001, the Company made the determination to transfer debt securities with fair values totaling $112 million from securities available for sale to securities held to maturity as of January 1, 2001. In accordance with the provisions of SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, the transfers were recorded at fair values, and the unrealized holding loss totaling $647,000 at the date of transfer, net of the effects of deferred taxes and deferred policy acquisition costs, was reported in accumulated other comprehensive income and is being amortized over the remaining lives of the securities. The transfer of securities from available for sale to held to maturity had no effect on the net earnings of the Company in 2001.
As of December 31, 2002, the allowance for possible losses on mortgage loans was $660,000 representing a reduction of $1,455,000 from December 31, 2001 due to payoffs of two loans with allowances during 2002. Management believes that the allowance for possible losses is adequate. While the Company closely manages its mortgage loan portfolio, future changes in economic conditions can result in impairments beyond those currently identified.
The Company's real estate investments totaled approximately $21,798,000 and $15,220,000 at December 31, 2002 and 2001, respectively, and consist primarily of income-producing properties which are being operated by a wholly owned subsidiary of the Company. The Company recognized operating income on these properties of approximately $1,475,000, $845,000, and $1,063,000 for the years ended December 31, 2002, 2001, and 2000, 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 losses of $200,000, $25,000, and $420,000 in 2002, 2001 and 2000, respectively, associated with these properties.
In addition to the securities analyzed above, the Company invests in index options which are derivative financial instruments used to hedge the equity return component of the Company's equity-indexed annuity and life products. The values of these options are primarily impacted by equity price risk, as the options' fair values are dependent on the performance of the S&P 500® Composite Stock Price Index (S&P 500 Index®). However, increases or decreases in investment returns from these options are substantially offset by corresponding increases or decreases in amounts paid to equity-indexed policyholders, subject to minimum guaranteed policy interest rates.
The Company's market risk liabilities, which include policy liabilities for investment annuity and supplemental contracts, are managed for interest rate risk through cash flow testing as previously described. As part of this cash flow testing, the Company has analyzed the potential impact on net earnings of both a 100 basis point increase and decrease in the U.S. Treasury yield curve as of December 31, 2002. A 100 basis point interest rate decline would decrease net earnings for 2003 by approximately $445,000, based on the Company's projections. A 100 basis point increase in interest rates would increase net earnings by approximately $210,000, based on the Company's projections. These estimated impacts to earnings are net of tax effects and the estimated effects of deferred policy acquisition costs.
The above-described scenarios produce estimated changes in cash flows as well as cash flow reinvestment projections. Estimated cash flows in the Company's model assume cash flow reinvestments which are representative of the Company's current investment strategy. Calls and prepayments include scheduled maturities and those expected to occur which would benefit the security issuers. Assumed policy surrenders consider differences and relationships between credited interest rates and market interest rates as well as surrender charges on individual policies. The impact to earnings also includes the expected effects on amortization of deferred policy acquisition costs. The model considers only investment annuity and supplemental contracts in force at December 31, 2002, and does not consider new product sales or the possible impact of interest rate changes on sales.
A primary liquidity concern is the risk of an extraordinary level of early policyholder withdrawals. The Company includes provisions within its annuity and universal life insurance policies, such as surrender charges, that help limit and discourage early withdrawals. Cash flow projections and cash flow tests under various market interest rate scenarios are also performed to assist in evaluating liquidity needs and adequacy. The Company currently expects available liquidity sources and future cash flows to be more than adequate to meet the demand for funds.
In the past, cash flows from the Company's insurance operations have been sufficient to meet current needs. Cash flows from operating activities were $127 million, $142 million, and $139 million in 2002, 2001, and 2000, respectively. The Company also has significant cash flows from both scheduled and unscheduled investment security maturities, redemptions, and prepayments. These cash flows totaled $349 million, $162 million, and $113 million in 2002, 2001, and 2000, respectively. Cash flows from security maturities, redemptions, and prepayments were significantly higher in 2002 than 2001 due to the continual decline in interest rates from 2001 to 2002. These cash flow items could be reduced if interest rates rise in 2003. Net cash flows from the Company's universal life and investment annuity deposit product operations, totaled $142 million inflow in 2002 and $53 and $98 million outflow for 2001 and 2000 respectively. The net inflows are expected to continue in 2003.
DAC 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 DAC balance. The present value of these cash flows, less the benefit reserve, is compared with the unamortized DAC balance and if the asset 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 DAC see Note 1, Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements.
Revenue Recognition: Premium income for the Company's traditional life insurance contracts is generally recognized as the premium becomes due from policyholders. For investment annuity and universal life contracts, the amounts collected from policyholders are considered deposits and are not included in revenue. For these contracts, fee income consists of policy charges for policy administration, cost of insurance charges and surrender charges assessed against policyholders' account balances which are recognized in the period the services are provided.
For a discussion of recently issued accounting pronouncements, see Note 1, Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements.