The summary consolidated financial data shown below as of September 30, 2002 and 2001 and for the years ended September 30, 2002, 2001 and 2000, other than the ratio of earnings to fixed charges and preferred stock dividends, have been derived from, and should be read in conjunction with, the Western Holding’s consolidated financial statements and related notes, and Management’s Discussion and Analysis of Financial Condition and Results of Operations appearing elsewhere herein. The consolidated financial data shown below as of September 30, 2000, 1999 and 1998 and for the years ended September 30, 1999 and 1998, other than the ratio of earnings to fixed charges and preferred stock dividends, have been derived from audited consolidated financial statements not included herein. In May 2002, Western Holding was formed and subsequently was transferred 100% of the outstanding common stock of Western Life. In accordance with SFAS No. 141, the exchange of shares has been accounted for similar to that of a pooling of interests. As a result of a pooling of interests, the Summary Consolidated Financial data shown below has been restated as of the earliest period presented as though the ownership exchange had occurred at that date. See Note 1 to the consolidated financial statements.
credit losses related to certain loans should be determined. According to SFAS No. 114, a loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. Probable is defined as “future events are likely to occur.” When a loan has been identified as impaired, the Consolidated Group determines the allowance for loss based on the estimated fair market value, less estimated liquidation expenses, of the collateral compared to the carrying value of the Receivable. The estimated fair market value is based on the most recent appraisal of the collateral. If the most recent appraisal is more than one year old, a new appraisal is ordered. In the interim, estimated fair market value is established through a review of the appraisal in addition to a review of other relevant market information. When reviewing the most recent appraisal, the Consolidated Group considers the type of property, changes in the economic factors of the region and the underlying appraisal assumptions. If the estimated fair market value of the collateral is less than the carrying value, an allowance for loss is recognized.
Allowances for losses on real estate contracts and mortgage notes receivable are based on the carrying value of the Receivable, including accrued interest. Accordingly, the Consolidated Group accrues interest on delinquent Receivables until foreclosure.
The following table presents the components of the results of operations for the years ended September 30, 2002, 2001 and 2000:
Net investment spread consists of interest and earned discounts on Receivables and other investments, net of interest expense, insurance policy and annuity benefits, and salaries, commissions and other expenses incurred as a result of owning the investments.
The following table presents the net average yields realized by the Consolidated Group on interest sensitive assets and liabilities during the three years ended September 30, 2002, 2001 and 2000 based on average monthly ending asset/liability balances:
The increase in gross investment income from 2000 to 2002 was primarily due to an increase in annuity products sold by Western Life, which resulted in an increase in the commercial lending activities of Western Life. Commercial Loans, which have higher stated yields than Western Life’s residential portfolio, accounted for 58.1% of the outstanding principal balance of real estate contracts and mortgage notes receivable at September 30, 2002, compared to 1.4% at September 30, 2000. Additionally, for commercial development loans, the Consolidated Group occasionally negotiates exit fee agreements with the borrower. If the transaction meets the requirements to be accounted for as a loan, the exit fee is amortized into income over the estimated life of the loan using the level yield method. The amortization of exit fees accounted for 2.45% of the increase in yield on real estate contracts and mortgage notes receivable in 2002.
The increase in yields on the real estate contracts and mortgage notes receivable portfolio were partially offset by lower yields on the investment portfolio as the 5-year constant maturity Treasury rate, which is similar to the average maturity of the Consolidated Group’s fixed income portfolio, decreased from 5.95% on September 30, 2000 to 2.65% on September 30, 2002. During the fiscal year ended September 30, 2002, Western Life sold approximately $320.2 million in available-for-sale investments for gains of approximately $6.7 million. As proceeds from the sales and maturities were reinvested back into a lower interest rate market, the overall portfolio yield was reduced. Additionally, the Consolidated Group’s recent focus on improving the average credit rating of the investment portfolio has also contributed to a reduction in the investment yields. At September 30, 2002, approximately 81.1% of the Consolidated Group’s fixed income portfolio was rated either AAA or AA compared to approximately 46.8% at September 30, 2001. Generally, the higher the credit rating, the lower the effective yield.
The components of net investment securities losses for the fiscal years ended September 30, 2002, 2001 and 2000 are as follows:
Western Life holds interest only securities created out of Receivable securitization transactions that were entered into in conjunction with Metropolitan and other affiliates. The fair market value of these securities, which do not have established market prices, are estimated using expected discounted future cash flows. When determining expected future cash flows, management considers interest rates, estimated prepayment rates, and historical default rates. During the last two fiscal years, the 10-year constant maturity Treasury rate, which is a widely accepted benchmark for mortgage prepayments and pricing, decreased from approximately 5.9% at September 30, 2000 to approximately 3.6% at September 30, 2002. The reduction in the interest rate environment has resulted in higher than expected prepayment rates as borrowers refinanced their mortgages at lower interest rates. In response to the sustained prepayment rates, Western Life revised its assumptions of future prepayment rates during the fiscal year ended September 30, 2002. As a result, the carrying values of the investments were decreased by approximately $2.6 million, representing the amount impaired.
In 2002 and as a result of the impairment experience of the Consolidated Group’s portfolio, management changed the investment strategy to move away from lower credit rating exposure. At September 30, 2002, 81.1% of the Consolidated Group’s fixed income portfolio was rated either AAA or AA compared to 46.8% at September 30, 2001.
During the year ended September 30, 2001, the Consolidated Group sold portfolios of real estate Receivables through both direct sales and the fulfillment of a September 30, 2000 securitization pre-funding balance for proceeds of approximately $89.3 million and gains of $0.9 million. During that same period, the Consolidated Group sold other Receivables through direct sales for proceeds of approximately $3.8 million and gains of $0.3 million.
Capitalized deferred costs, net of amortization is comprised of the capitalization of expenses incurred to sell and underwrite life and annuity policies, offset by the amortization of previously capitalized expenses. The following table reflects the components of the net change in deferred acquisition costs reported by the Consolidated Group for fiscal years ended September 30, 2002, 2001 and 2000:
While the capitalization of current year costs is dependent upon actual expenses (commissions and other) incurred, the amortization of capitalized costs is dependent upon the net investment yields (after default costs and related investment expenses) obtained by Western Life, policy crediting rates, and the policy termination experience, which is actuarially determined. DPAC is also impacted by the assumptions for these variables expected in future years.
During the fiscal years ended September 30, 2002 and 2001, Western Life revised its amortization assumptions on the DPAC related to its deferred annuity business (92% of the total DPAC as of September 30, 2002) to reflect the higher yields it expected to be earned on its commercial real estate loan portfolio and the expected future crediting rates on the annuity business which the investments support. The earnings rate for 2003 assumes that Western Life will generate, on a monthly basis, approximately $37.0 million in Commercial Loans with an average yield of 15.0%. The monthly average production for Western Life during the last quarter of fiscal 2002 was $38.2 million in Commercial Loans with an average yield of 16.1%. The expected future crediting rates are based primarily on Western Life’s current policy for re-pricing its existing annuity products assuming a level interest rate environment. Since the amortization of deferred acquisition costs is based on the estimated gross profits of the underlying life and annuity products using current effective crediting rates, increases in the crediting rate environment may accelerate the amortization of these costs in the future.
During the years ended September 30, 2002 and 2001, these revised assumptions resulted in an increase of approximately $11.7 million and $4.3 million, respectively, in deferred costs with a corresponding decrease in the amortization of deferred acquisition costs. There were no significant adjustments to the gross profit
estimates in 2000. The following table reflects the future assumptions about and actual earnings rates, crediting rates and lapse rates for the deferred annuity business line at September 30:
The Consolidated Group’s $8.4 million tax benefit recorded during the fiscal year ended September 30, 2001, includes an $11.2 million tax benefit relating to an investment that was entered into in conjunction with Metropolitan in 1999. In total, the investment resulted in Western Life recording a $22.4 million tax benefit, of which $11.2 million was also recorded as an income tax benefit during the fiscal year ended September 30, 1999. The objectives for the investment were to produce economic gains combined with favorable tax benefits. Similar investments were presented throughout the United States to numerous individuals and companies (the “Participants”) as an investment and tax strategy. Prior to, and in conjunction with the investment, Metropolitan received two independent tax opinions relating to the investment. Additionally, Western Life and Metropolitan executed a supplement to their Federal Tax Sharing Agreement allowing Western Life to recover from Metropolitan up to $11.2 million, plus applicable interest on the $11.2 million, in federal income tax benefits derived from this investment that are not otherwise utilized by Western Life. The non-utilization of the income tax benefits could result from the expiration of the net operating loss carry forward limit of 20 years, disallowance on audit, or any enactment of law that may affect the utilization of the benefits.
The following depicts the distribution of the Consolidated Group’s assets as a percentage of total assets as of September 30, 2002:
The Consolidated Group’s investments in Receivables include Receivables collateralized primarily by first position single-family residential property and commercial properties. At September 30, 2002, all of the Consolidated Group’s Receivables were held with first priority real estate liens.
During the fiscal years ended September 30, 2002 and 2001, the Consolidated Group expanded the origination of Commercial Loans. The expansion was due to the Consolidated Group’s current perception that this market may be inadequately served by current lenders, who it believes are inflexible in their underwriting and pricing policies and who are not able to quickly underwrite and close these loans, particularly in the temporary, bridge and development Commercial Loan markets.
Management continually monitors economic and demographic conditions throughout the country in an effort to avoid a concentration of its acquired real estate Receivables in those areas experiencing economic decline, which could result in higher than anticipated default rates and subsequent investment losses.
The following charts present information regarding type of real estate collateral, lien priority and geographical distribution of the Consolidated Group’s portfolio of outstanding real estate Receivables as of September 30, 2002.
At September 30, 2002, the Consolidated Group held contracts and mortgage notes Receivables with face values as follows:
At September 30, 2001, the Consolidated Group held contracts and mortgage notes Receivables with face values as follows:
The commercial real estate Receivables are defined as those generated through the Consolidated Group’s commercial lending source.
The future maturities of the aggregate amounts of Commercial Loans (face amount) at September 30, 2001 are as follows:
The following table outlines the nature and carrying value of securities investments held by the Consolidated Group at September 30, 2002:
Temporary declines in the fair market value of investments that are “available-for-sale” are excluded from earnings and presented as accumulated other comprehensive income or loss, net of related income taxes. The Consolidated Group continually monitors its investment portfolio for other than temporary impairments of its securities. When an other than temporary decline in value below cost or amortized cost is identified, the investment is reduced to its fair market value, which becomes the new cost basis of the investment. The amount of reduction is reported as a realized loss in the statement of operations. In determining whether the losses are temporary or other than temporary, the Consolidated Group considers (1) the length of time and extent to which the fair market value has been less than cost, (2) the circumstances contributing to the decline in fair market value (including a change in interest rates or spreads to benchmarks), (3) recent performance of the security, (4) the financial strength of the issuer, and (5) the intent and ability of the Consolidated Group to retain the investment for a period of time sufficient to allow for anticipated recovery. Additionally, for asset-backed investments, the Consolidated Group also considers the credit rating and determines the amount of credit support available for the security. At September 30, 2002, the Consolidated Group’s investment portfolio had approximately $3.4 million in unrealized losses that were deemed to be temporary. To the extent that any losses currently deemed as temporary are determined to be other than temporary in the future, the unrealized losses will be reported as realized losses in future statements of operations.
The following table stratifies the unrealized losses as of September 30, 2002 by investment category:
The following table stratifies the unrealized losses as of September 30, 2002 by credit rating:
On behalf of the Consolidated Group, Metropolitan also negotiates the purchase of Receivables that are not collateralized by real estate, such as structured settlements, annuities and lottery prizes. The lottery prizes generally arise out of state operated lottery games that are typically paid in annual installments to the prizewinner. The structured settlements generally arise out of the settlement of legal disputes whereby the prevailing party is awarded a sum of money, payable over a period of time, generally through the creation of an annuity. Other annuities generally consist of investments that cannot be immediately converted to cash directly with the issuing insurance company.
From time to time, Western Life may acquire development properties through a purchase from Metropolitan or other third parties. The development or improvement of properties is undertaken for the purpose of enhancing values to increase marketability and to maximize profit potential.
The following development properties exceeded 5% of the Consolidated Group’s stockholder’s equity at September 30, 2002.
The principal amount of the Consolidated Group’s Commercial Loans (as a percentage of total outstanding Commercial Loans) that were in arrears for more than 90 days as of the following dates were as follows:
The principal amount of the Consolidated Group’s residential and other Receivables collateralized by real estate (as a percentage of total residential and other Receivables collateralized by real estate) that were in arrears for more than 90 days as of the following dates were as follows:
The carrying amount of the Consolidated Group’s other Receivable investments not collateralized by real estate (as a percentage of total other Receivable investments) that were in arrears for more than 90 days as of the following dates were as follows:
An analysis of the allowance for losses on Receivables was as follows:
The allowance for losses on Receivables represents management’s estimate of credit losses inherent in the portfolios as of the balance sheet dates. Management performs regular reviews in order to identify these inherent losses and to assess the overall collection probability of the portfolios. This process provides an allowance that consists of two components: allocated and unallocated. To arrive at the allocated component, the Consolidated Group combines estimates of the allowance needed for loans that are evaluated collectively and those that are evaluated individually.
Real estate held for sale is periodically evaluated for impairment. Loss provisions for real estate held for sale are calculated as the difference between the estimated net realizable value and the carrying value at the measurement date. Any loss on liquidation or subsequent reduction in the carrying value is charged to operations through provision for losses.
Market risk is defined as the sensitivity of income and capital to changes in interest rates, equity prices and other market variables. Market risk is managed within an overall asset/ liability management framework. The Consolidated Group’s Asset/ Liability Committee is responsible for reviewing and administering its asset/ liability management positions.
Interest rates. Management continually monitors the interest sensitive income and expense of the Consolidated Group. Interest sensitive expense is predominantly related to annuity benefits, and the interest costs of collateralized borrowings, while interest sensitive income includes interest, earned discounts and other income from the Receivable and investment portfolio. Substantially all of the Consolidated Group’s interest rate risk arises from instruments, positions and transactions entered into for purposes other than trading, which includes loans, securities, annuity deposits and long-term debt. Increases or decreases in interest rates can cause changes in net income and fluctuations in the fair market value of interest sensitive assets and liabilities.
Gap analysis. A conventional view of interest rate sensitivity for financial institutions is the gap report, which indicates the difference between assets maturing or re-pricing within a period and total liabilities maturing or re-pricing within the same period. In assigning assets to maturity and re-pricing categories, the Consolidated Group takes into consideration expected prepayment speeds and contractual maturities. The balances reflect expected amortization of principal and do not take into consideration reinvestment of cash. Principal prepayments are the amounts of principal reduction over and above normal amortization. The Consolidated Group has used prepayment assumptions based on market estimates and past experience with its current portfolio. In assigning liabilities to maturity and re-pricing categories, the Consolidated Group takes into consideration expected annuity policy lapse rates based on past experience. Non-rate sensitive items such as the allowance for loan losses and deferred loan fees/costs are not included in the table.
In the next 12 months, the Consolidated Group’s Gap Analysis indicates a positive gap, meaning that its interest-sensitive assets are expected to reprice before its interest sensitive liabilities. In a rising interest rate environment, the net interest income will tend to increase which will have a positive impact on results of operations. Conversely, in a falling interest rate environment, the net interest income will tend to decrease which will have a negative impact on results of operations.
In January 2001, the Consolidated Group changed the focus of its investment strategy away from acquiring residential real estate loans for securitization purposes as it does not intend to participate in any real estate-backed securitizations in the near future, and began focusing its investment activity on acquiring and holding both residential real estate loans and Commercial Loans. Historically, proceeds from securitizations were primarily reinvested in additional securitizable products. Because securitization proceeds were not primarily used to acquire and hold residential or Commercial Loans, the Consolidated Group does not anticipate that the change in investment strategy away from securitizations will have a negative effect on its ability to acquire and hold residential and Commercial Loans.
Western Life paid no dividends on its common stock during the three fiscal years ended September 30, 2002, 2001 and 2000:
Western Life has entered into a reinsurance agreement with Old Standard, which became effective July 1, 1998. Under this agreement, Western Life can reinsure with Old Standard 75% of the risk on various annuity products. The reinsurance agreement is an ongoing arrangement with no stated expiration or termination date, although either party may stop and restart at their discretion by providing a 30-day advance written notice.
Additionally, to increase liquidity, the Consolidated Group may occasionally sell securities to a broker-dealer under the provision that the Consolidated Group will buy them back by a predetermined date for a specific price, often called a reverse repurchase agreement. At September 30, 2002, the Consolidated Group did not have any reverse repurchase agreements outstanding.
Western Life’s ability to sell available-for-sale investments for liquidity purposes is partially affected by the laws of the state of Washington that limit its investments in real estate related assets to 65% of its statutory assets. Western Life is restricted from selling non-real estate related assets if, after the sale, its real estate assets would exceed 65% of its statutory assets. However, occasionally Western Life may acquire real estate related Receivables that qualify as mortgage-related securities under the Secondary Mortgage Market Enhancement Act, or SMMEA. SMMEA generally provides that qualifying loans may be acquired to the same extent that obligations that are issued by or guaranteed as to principal and interest by the United States Government, its agencies and the instrumentalities can be acquired. As a result, Western Life can acquire qualifying real estate loans in amounts in excess of the 65% limitation. At September 30, 2002, Western Life had 46% of its statutory admitted assets invested in real estate related assets that did not qualify as SMMEA investments.
For statutory purposes, Western Life performs cash flow testing using seven different rate scenarios. An annual opinion regarding the adequacy of the cash flow testing is filed with the insurance departments in the states where Western Life is licensed as an insurance company. At the end of calendar year 2001, the results of this cash flow testing process were satisfactory.
The following table summarizes, as of September 30, 2002, the Consolidated Group’s anticipated annual cash principal and interest obligations on secured credit lines and the anticipated annual cash dividend requirements on the Consolidated Group’s outstanding preferred stock for the indicated periods:
During 2001, $636.7 million in funds provided by the Consolidated Group’s various liquidity sources were used to (1) invest $459.4 million primarily in Receivables and investments and (2) fund $124.4 million in debt maturities, annuity product surrenders and the payment of dividends.
In June 1998, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (SFAS) No. 133, “Accounting for Derivative Instruments and Hedging Activities”. SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives), and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. In June 1999 and 2000, SFAS No. 137, “Accounting for Derivative Instruments and Hedging Activities-Deferral of Effective Date of SFAS 133” and SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities, an Amendment of SFAS 133,” were issued. SFAS No. 137 amended SFAS No. 133 to become effective for all quarters of fiscal years beginning after June 15, 2000. The implementation of SFAS No. 133, as amended, did not have a material effect on the Consolidated Group’s financial statements. As part of implementing SFAS No. 133 on October 1, 2000, the Consolidated Group reclassified approximately $58.5 million of investments from held-to-maturity to available-for-sale. The unrealized gain on the date of transfer was $0.4 million.
In December 1999, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 101, “Revenue Recognition in Financial Statements.” SAB No. 101 summarizes some of the SEC’s views on applying generally accepted accounting principles to revenue recognition in financial
statements. The implementation of SAB No. 101 on July 1, 2001 did not have a material impact on the Consolidated Group’s financial statements.
In September 2000, the FASB issued SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities-A Replacement of FASB Statement No. 125.” This statement essentially further restricts the rules as to when a transfer of financial assets should be accounted for as a sale rather than a financing. The implementation of SFAS No. 140 on April 1, 2001 did not have a material impact on the Consolidated Group’s financial statements.
In July 2001, the FASB issued SFAS No. 142, “Goodwill and Other Intangible Assets.” The statement will require discontinuing the amortization of goodwill and other intangible assets with indefinite useful lives. Instead, these assets will be tested periodically for impairment and written down to their fair market values as necessary. This statement is effective for fiscal years beginning after December 15, 2001. The implementation of this statement on October 1, 2002 did not have a material impact on the Consolidated Group’s financial statements.
In October 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which is effective for fiscal years beginning after December 15, 2001. This statement addresses accounting and reporting of long-lived assets, except goodwill, that are either held and used or disposed of through sale or other means. Implementation of this new standard on October 1,2002 did not have a material impact on the Consolidated Group’s financial statements.
The consolidated financial statements and related financial information required to be filed are attached to this Report. Reference is made to page of this Annual Report for an index to the consolidated financial statements.