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, 2013 follows. This discussion should be read in conjunction with the Company’s consolidated financial statements and related notes beginning on page 81 of this report.
Due to the business of accepting funds to pay future obligations in later years and the underlying economics, the relevant factors affecting the Company’s business and profitability include the following:
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 2013, incorporating required disclosures in accordance with the rules and regulations of the Securities and Exchange Commission.
The Company's business is generally aided by an economic environment undergoing expansion, whether moderate or vibrant. Conversely, a muted economic recovery could adversely impact the demand for the Company's products. Recent economic data has shown signs of improvement domestically as well as in the European markets. Conversely, there are concerns regarding the apparent slow down in the Chinese economy and the effect upon emerging markets as the fiscal stimulus of the past several years begins the process of unwinding. In the U.S. a rebound in the housing, energy, and car industries depicts an economy that has regained its footing and put a dent in the unemployment levels which spiked during the recent economic crisis. A smooth changeover in the leadership of the Federal Reserve and the removal of debt limit showdowns in Congress have eliminated other factors which have caused uncertainty to infiltrate the business environment. Taken all together, economists generally expect the U.S. economy to gain momentum over the next several years. The remaining outlier is the mounting federal debt position and its potential to cause rapid or sustained increases in both interest and inflation rates. The Federal Reserve's announced plan of tapering its long duration debt security purchases removes liquidity with the assumption that the emerging economic growth will be strong enough to absorb the reduced stimulus. The recent decrements in consumer confidence to start the 2014 year heighten the sensitivity of the economy to changes in the status quo of the past several years. A firmer economy would help to dispel some of the creeping negative sentiment.
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, in the Notes to Consolidated Financial Statements.
Traditional life and annuity premiums - Traditional life and annuity premiums increased 2.5% in 2013 compared to 2012. Traditional life insurance premiums for products such as whole life and term life are recognized as revenues over the premium-paying period. The Company’s life insurance sales focus has been primarily centered around universal life products. Universal life products, especially the Company’s equity indexed universal life products which offer the opportunity for consumers to acquire life insurance protection and receive credited interest linked in part to an outside market index such as the S&P 500 Index®, have been more popular product offerings in the Company’s markets. However, the global financial crisis generated renewed interest in the Company's term life insurance products particularly with residents outside of the United States leading to modest increases.
Debt securities generated approximately 94% of total investment income, excluding derivative gains and losses, in 2013, consistent with prior years. The Company’s strategy is to invest substantially all of its cash flows in fixed debt securities consistent with its guidelines for credit quality, duration, and diversification. In the wake of two record years in annuity sales in 2010 and 2011, and the substantial increases in single premium life insurance sales the past two years, the Company has experienced incremental cash flow for investing in debt securities which caused the portfolio to grow from $8.2 billion at December 31, 2011 to $8.8 billion at December 31, 2012 and to $9.2 billion at December 31, 2013. Despite the growth in the debt security portfolio, lower interest rate levels have persisted in accordance with Federal Reserve monetary policy which has depressed long-term U.S. Treasury rates. When combined with historically tight spreads of corporate securities over U.S. Treasury rate levels, this has resulted in lower yields on new investment purchases. The yield on debt security purchases to fund insurance operations rebounded somewhat to 3.53% in 2013 from 3.37% in 2012 but was still below the 4.18% yield attained in 2011. Also impacting bond portfolio returns has been the volume of higher yielding debt securities maturing or being called by borrowers with the proceeds being placed into lower yielding securities.
The Company’s new mortgage loan activity has been relatively low by historical standards in recent years given the low level of rates and the higher level of risk associated with commercial properties in the current economic environment. Policy loan and other invested asset balances outstanding have remained relatively stable declining modestly over the past few years. The increase in investment income for other invested assets during 2013 reflects a real estate profits participation loan held in a subsidiary company which paid off netting the Company $2.3 million.
In order to assess 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. Net investment income performance is summarized as follows:
The decline in average invested asset yield, excluding derivatives, from 2011 to 2012 and to 2013 is due to the Company obtaining progressively lower yields on newly invested cash inflows. As described above, the Company invests substantially most of its net cash flows in debt securities whose new money yields, as noted previously, have decreased during this period to levels below the weighted average portfolio yield. The pattern in average invested asset yield, including derivatives, incorporates increases and decreases in the fair value of index options purchased by the Company to support its fixed-index products. Fair values of the purchased call options have oscillated over the past few years with gains in 2013 and 2012 and losses in 2011 due to intermittent increases and decreases in the S&P 500 Index® during this period, the primary index the Company's fixed-index products employ. Refer to the derivatives discussion following this section for a more detailed explanation.
Other revenues - Other revenues primarily pertain to the Company’s two nursing home operations in Reno, Nevada and San Marcos, Texas. Revenues associated with these operations were $23.3 million, $22.8 million and $21.8 million in 2013, 2012 and 2011, respectively. Other revenues in 2011 also includes $2.9 million received as a net settlement of a lawsuit in which the Company was the plaintiff.
Derivative gain (loss) - Index options are derivative financial instruments used to hedge the equity return component of the Company’s fixed-index products. Derivative gain or loss includes the amounts realized from the sale or expiration of the options. Since the index options do not meet the requirements for hedge accounting under GAAP, they are marked to fair value on each reporting date and the resulting unrealized gain or loss is also reflected as a component of net investment income.
Net realized investment gains (losses) - Realized gains (losses) on investments include impairment write-downs on real estate and investments in debt securities. The net investment gains reported in 2013 consisted of gross gains of $9.0 million, primarily from calls of debt securities, offset by gross losses of $0.4 million, which include other-than-temporary impairment losses described below.
Equity impairments (common stocks) represent a mark-to-market write-down on securities in which the market discount to book value was significant and had been maintained for several reporting periods. Equity securities represent 0.1% of invested assets and individual holdings have an average cost basis of approximately $45,000.
The mortgage loan valuation write-down in 2012 of $637,000 represents a general valuation allowance established for the Company's mortgage loan portfolio based upon the Company's loss experience over the past ten years. It is not identified with a specific underlying asset. The mortgage loan valuation write-downs in 2011 principally involved a New Orleans, Louisiana property whose value was negatively impacted by Hurricane Katrina. The write-downs reflect an adjustment to a newly provided appraisal of the property. The property was subsequently acquired through foreclosure then sold during 2012 for a net gain on the sale of $2.7 million.
During 2013, annuity policy benefit obligations were increased $4.0 million pertaining to the market value adjustment feature on annuity contract surrenders and partial withdrawals transacted over a number of years. The amount of the market value adjustment for any single reporting period was not material given the length of time over which the transactions occurred.
As noted previously in the discussion of the Company's net investment income, investment yields have been declining precipitously the past several years in tandem with intervention by the Federal Reserve and its policies to aid the economy in recovering from the financial crisis of 2008-2009. These policies have depressed interest rate levels to historical lows. In the fourth quarter of 2011, the Federal Reserve announced it's intention to maintain interest rates at current levels for at least the next couple of years in order to promote further economic recovery. As a result of this announced intention, the Company reevaluated its assumptions in 2011 concerning future investment portfolio yield rates and concluded that an unlocking of assumptions was required to incorporate the anticipated lowering of investment yields and its impact upon future investment spreads and profitability. The unlocking adjustment increased DPAC amortization expense by $7.9 million and reduced DPAC asset balances for deferred annuities and universal life by a like amount. No unlocking adjustments were made by the Company in 2013 or 2012.
True-up adjustments are recorded quarterly and the adjustments in 2013, 2012 and 2011 relate to changes in expense ratios, partial surrender rates, mortality rates, credited interest rates and earned rates for the current year’s experience. the true-up adjustments for the life insurance lines of business were positive (decrease to amortization expenses) in 2013 and 2012, whereas the true-up adjustments for the annuity line of business were negative in these same periods incrementally adding to amortization expense. The true-up adjustments by line of business were as shown in the following table.
Contract interest including fixed-index products also encompasses the performance of the index options associated with the Company's fixed-index products. As previously noted, the market performance of these derivative features resulted in net realized and unrealized gains in 2013 and 2012 of $225.9 million and $27.1 million and net realized and unrealized losses of $33.3 million in 2011.
Similar to deferred policy acquisition costs the Company defers sales inducements in the form of first year interest bonuses on annuity products that are directly related to the production of new business. These charges are deferred and amortized using the same methodology and assumptions used to amortize other capitalized acquisition costs and the amortization is included in contract interest. In addition, deferred sales inducement balances are also reviewed periodically to ascertain whether actual experience has deviated significantly from that assumed (unlock) and are adjusted to reflect current policy lapse or termination rates, expense levels and credited rates on policies compared to anticipated experience (true-up). These adjustments, plus or minus, are included in contract interest expense. In the years ended December 31, 2013, 2012, and 2011 the Company recorded true-ups adjustments of its deferred sales inducement balances resulting in additional contract interest expense of $0.8 million, $5.5 million, and $0.9 million, respectively. For the year ended December 31, 2011, the Company also recorded an unlocking adjustment related to its deferred sales inducement balance increasing contract expense an additional $1.2 million.
In the fourth quarter of 2011, the Company evaluated its excess benefit reserve calculations for a closed block of two-tier annuity contracts using the computational tools available with the upgraded reserving system discussed previously. Changes in estimates for the block of business were implemented extending the benefit period and changing annuitization assumptions. As a result of these estimate changes, the Company recorded an additional contract reserve liability of $19.2 million which is included in contract interest for the year ended December 31, 2011.
Nursing home expenses include the Company's two facilities in Reno, Nevada and San Marcos, Texas. These two entities have operationally functioned at consistent levels of residents over the past several years.
The Company’s domestic life insurance in force policy count has been declining several years resulting in lower universal life contract revenue charges. The pace of new policies issued has lagged the number of policies terminating from death or surrender by roughly a five-to-one rate over the three years shown causing a declining level of insurance in force from which contract revenue is received. This ratio improved somewhat during 2012 to a three-to-one relationship and in 2013 to a two-to-one ratio. Nonetheless, the number of domestic life insurance policies has declined from 62,900 at December 31, 2011 to 60,000 at December 31, 2012 and to 57,700 at December 31, 2013. 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 2013 was 48% higher than in 2012 and the volume of insurance issued was 67% greater than that in 2012. As noted in the discussion of Consolidated Operations results, in 2013 the Company began deferring the premium load on its most popular product, single pay life insurance. This served to contain the level of universal life insurance revenues in comparison to prior year levels.
During the latter part of 2008, the Company’s internal checking and monitoring procedures detected potential instances of rebating in certain geographic markets and instituted commission caps and other preventive procedures to discourage this practice. Although not illegal in these markets, the practice of rebating is particularly prone to large face amount policies not renewing premium payments beyond the initial year of the policy. The level of life insurance volume subsequently lapsed at a rate in excess of 11.2% during 2010. However, this rate has subsequently declined to 6.6% in 2012 and further to 5.8% in 2013.
During the past couple of years the Company has achieved some success in growing its domestic life insurance business with the number of new policies issued increasing 76%, 56%, and 48% in 2011, 2012, and 2013, respectively, reversing a multi-year trend of declining activity. Sales the past several years have been substantially weighted toward single premium policies which do not have recurring premium payments. These products target wealth transfer strategies involving the movement of accumulated wealth in alternative investment vehicles, including annuities, into life insurance products.
Net investment income for this segment of business has been gradually increasing as well due to the increased new business activity described above and a higher level of investments needed to support this growth in policy obligations. The increase in net investment income has been partially muted by lower investment yields attained from debt security investment purchases during this time frame. Net investment income also includes the gains and losses on index options purchased to back the index crediting mechanism on fixed -index universal life products. A detail of net investment income for domestic life insurance operations is provided below.
Life and policy benefits for a smaller block of business are subject to variation from period to period. Claim activity during 2013 was consistent when compared to historical trends, although the Social Security Administration master database project mentioned in the Consolidated Operations section of this report has resulted in incremental claim activity. The Company's overall mortality experience for this segment is in line with pricing assumptions.
As noted previously in the discussion of results from consolidated operations, 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 with the adjustment reflected in current period amortization expense. To the extent required, the Company may also record unlocking adjustments to DPAC balances. The following table identifies the effects of unlocking and true-up adjustments on domestic life insurance DPAC balances recorded through amortization expense for 2013, 2012 and 2011.
The true-up adjustments recorded in 2013 and 2012 increased the DPAC balance which conversely reduced amortization expense by a like amount for each year. The unlocking adjustment in 2011 came about as the Company reevaluated it assumptions concerning future investment portfolio yield rates and concluded that an unlocking of assumptions was required to incorporate the anticipated lowering of investment yields and its impact upon future investment spreads and profitability.
In general, universal life revenues and operating earnings are anticipated to emerge with the amount of international life insurance in force and a steady growth in new sales. Over the past three years, the volume of insurance in force has grown from $18.6 billion at December 31, 2011 to $19.2 billion at December 31, 2012 and to $19.6 billion at December 31, 2013 promoting an increasing trend in revenues. 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 2013, the number of international life policies issued declined approximately 5% from the prior year while the volume of insurance issued was roughly 4% less than that in 2012.
The Company’s most popular international products have been its fixed-index universal life products in which the policyholder can elect to have the interest rate credited to their policy account values linked in part to the performance of the S&P 500 Index®. Included in the totals in the above table are collected premiums for fixed-index universal life products of $93.4 million, $97.8 million and $98.1 million for the years ended 2013, 2012 and 2011, respectively.
For liability purposes, the embedded option in the Company's policyholder obligations for this feature is bifurcated and separately reserved for. Accordingly, a comparable impact for the derivative component in the equity-index universal life product is reflected in the contract interest expense for each respective period.
Life and policy benefits primarily consist of death claims on policies. The Company’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 tend to be larger amounts. In the year ended December 31, 2013, the average face amount of insurance purchased was approximately $384,000, reflecting a slight increase over the previous year. While life and policy benefit expense for the international life segment reflects the larger policies purchased, mortality due to natural causes is comparable to that in the United States. During 2013, the Company incurred a higher than normal volume of international life claims which increased the related benefit expense during this period. The Company's maximum risk exposure per insured life is capped at $500,000.
Similar to domestic life results, the true-up adjustments recorded in 2013 and 2012 increased the DPAC balance which conversely reduced amortization expense by a like amount for the year. The unlocking adjustment in 2011 came about as the Company reevaluated it assumptions concerning future investment portfolio yield rates and concluded that an unlocking of assumptions was required to incorporate the anticipated lowering of investment yields and its impact upon future investment spreads and profitability.
As a selling inducement, some of the deferred products, as well as the fixed-index annuity products, include 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 bonus rates are deferred in conjunction with other capitalized policy acquisition costs. The amount deferred to be amortized over future periods amounted to approximately $26.2 million, $31.8 million and $46.7 million for the years ended December 31, 2013, 2012 and 2011, 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 and true-up adjustments on annuity DPAC balances recorded through amortization expense for 2013, 2012 and 2011.
As the true-up adjustments in each period decreased DPAC balances a corresponding increase in DPAC amortization expense was recorded. The true-up adjustments in 2013, 2012 and 2011 relate to changes in policy lapse or termination rates, expense levels and credit rates compared to anticipated experience. In addition to the true-up adjustments shown above, the Company decreased its DPAC balances (increased amortization expense) an additional $4.0 million during 2011 for adjustments determined in conjunction with the implementation of the new actuarial software platform which allowed the Company to perform an analysis of DPAC balances in finer detail.
The unlocking adjustment in 2011 came about as the Company re-evaluated its assumptions concerning future investment portfolio yield rates and concluded that an unlocking of assumptions was required to incorporate the anticipated lowering of investment yields and its impact upon future investment spreads and profitability. Unlocking was not done during the years ended December 31, 2013 and 2012.
True-up adjustments for the deferred sales inducement balance are done each period similar to that done with respect to DPAC balances. For the years ended December 31, 2013, 2012, and 2011 deferred sales inducement balances were reduced by $0.8 million, $5.5 million, and $0.9 million, respectively, with a corresponding increase to bonus interest amortization. For the year ended December 31, 2012, deferred sales inducement balances were reduced by $5.5 million in true-up adjustments. For the year ended December 31, 2011, deferred sales inducement balances were further reduced by $1.2 million for unlocking and by $1.6 million pertaining to the Company's implementation of new actuarial system technology. These adjustments, also reflected above as additional bonus interest amortization, were incremental to true-up adjustment recognized during the period.
The Company's primary business encompasses its domestic and international life insurance operations and its annuity operations. However, the Company also has small real estate, nursing home, and other investment operations through its wholly-owned subsidiaries. Nursing home operations generated $2.1 million, $1.2 million and $0.8 million of operating earnings in 2013, 2012, and 2011, respectively. The lower level of earnings in 2011 reflects reductions in Medicare and Medicaid reimbursement rates as state governmental entities addressed their budget deficit conditions. The remaining earnings in Other Operations of $13.0 million, $12.8 million, and $12.5 million for the years ended December 31, 2013, 2012, 2011, respectively, represent 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 Libby Shearn Moody Trust which is an asset held in NWLSM, Inc. Pretax distributions from this trust were $5.4 million, $4.9 million, and $4.5 million in 2013, 2012, and 2011, respectively.
The Company’s investment portfolio increased 5% to $9.6 billion at December 31, 2013 compared to $9.1 billion at December 31, 2012 due to positive cash flows from operating and financing activities. The primary driver of the increase was a strong single premium life insurance and annuity sales year. Although annuity production was intentionally managed to a constant level, approximately $0.8 billion in annuity deposits were again collected in 2013. Somewhat mitigating the increase in the portfolio balance was the unrealized gain position of the Company’s securities available for sale portfolio, which is reported at fair market value, as it decreased from $257.5 million at December 31, 2012 to $116.3 million at December 31, 2013 due to the increase in interest rates during 2013 (which serves to decrease market values).
Debt securities purchased to fund insurance company operations are summarized below.
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, 2013, approximately 28.5% of the Company's total debt and equity securities, based on fair values, were classified as securities available for sale. These holdings in available for sale provide flexibility to the Company to react to market opportunities and conditions and to practice active management within the portfolio to provide adequate liquidity to meet policyholder obligations and other cash needs.
The Company holds approximately $43.6 million in asset-backed securities as of December 31, 2013. This portfolio includes $11.1 million of manufactured housing bonds and $32.5 million of home equity loans (also referred to as subprime securities). The Company does not have any holdings in collaterized bond obligations (“CBO”s), collateralized debt obligations (“CDO”s), or collateralized loan obligations (“CLO”s). Principal risks in holding asset-backed securities are structural, credit, and capital market risks. Structural risks include the securities’ priority in the issuer’s capital structure, the adequacy of and ability to realize proceeds from collateral and the potential for prepayments. Credit risks include corporate credit risks or consumer credit risks for financing such as subprime mortgages. Capital market risks include the general level of interest rates and the liquidity for these securities in the marketplace.
The Company holds one Alt-A security with a carrying value of $3.5 million. The Alt-A sector is a sub-sector of the jumbo prime MBS sector. The average FICO for an Alt-A borrower is approximately 715 compared to a score of 730 for a jumbo prime borrower. The Company’s exposure to the Alt-A and subprime sectors is limited to investments in the senior tranches of structured securities collateralized by Alt-A or subprime residential mortgage loans. The subprime sector is generally categorized under the asset-backed sector. This sector lends to borrowers who do not qualify for prime interest rates due to poor or insufficient credit history. Subprime borrowers generally have FICO scores of 660 or below. The slowing housing market, rising interest rates, and relaxed underwriting standards for loans originated after 2005 resulted in higher delinquency rates and losses beginning in 2007. These events caused illiquidity in the market and volatility in the market prices of subprime securities. With the government intervention initiatives in 2009, the housing market began to show signs of stabilizing. There was an improvement in the prices of subprime securities as the bond market also became more liquid. All of the loans classified as Alt-A or subprime in the Company’s portfolio as of December 31, 2013 were underwritten prior to 2005 as noted in the table below.
The Company requires a minimum specified yield on mortgage loan investments. During the past several years, the low interest rate environment has resulted in fewer loan opportunities being available that meet the Company's required rate of return. Mortgage loans originated by the Company totaled $34.1 million and $21.5 million for the years 2013 and 2012, respectively.
The Company recognized valuation losses of $0 million, $0.65 million and $0.61 million for the years ended December 31, 2013, 2012 and 2011, respectively. The mortgage loan valuation write-down in 2012 represents a general valuation allowance established for the Company's mortgage loan portfolio based upon the Company's loss experience over the past ten years and is not specifically identified to individual loans. The valuation write-downs in 2011 pertained to specifically impaired loans. The specific principle balances requiring a valuation allowance were $0.0 million, $0.0 million and $7.0 million in 2013, 2012, and 2011, respectively. The amount of interest recorded while these loans were impaired was $0 million, $0 million and $0.3 million in 2013, 2012, and 2011, respectively. The impairments in 2011 were based on information which indicated that the Company may not collect all amounts in accordance with the mortgage agreement. While the Company closely monitors its mortgage loan portfolio, future changes in economic conditions can result in impairments beyond those currently identified.
The mortgage loan allowance released during 2012 pertained to a property forced into bankruptcy which the Company subsequently acquired in a bankruptcy auction. The mortgage loan was foreclosed and the Company incurred a write-down of $0.6 million and the property reclassified as a real estate investment included in other long-term investments on the Company's balance sheet. The property was subsequently sold for a net gain of $2.7 million.
The Company offers fixed-index universal life and annuity products that guarantee the return of principal to policyholders and, at the policyholder’s election, credit interest based on a percentage gain in a specified market index, typically the S&P 500 Index® (policyholders may alternatively elect a fixed interest rate). Premiums and deposits received on these products are predominantly invested in investment grade fixed income securities with a portion used to purchase derivatives consisting of call options on the applicable market index to fund the index credits due to fixed-index policyholders. The call options purchased are one-year over-the-counter option contracts coinciding with the initial issuance of the policy and annual renewal periods in order to match the Company’s funding requirements for the underlying policies. On the respective anniversary dates of the index policies, the index used to compute the annual index credit is reset and a new one-year call option is purchased to fund the next annual index credit.
Although the call options are employed to be effective hedges against the Company’s policyholder obligations from an economic standpoint, they do not meet the requirements for hedge accounting under GAAP. Accordingly, the call options are marked to fair value on each reporting date with the change in fair value, plus or minus, included as a component of net investment income. The change in fair value of the call options includes the gains or losses recognized at the expiration of the option term and the changes in fair value for open contracts.
The fair value of derivative instruments presented in the Company’s consolidated financial statements totaling $169.3 million at December 31, 2013 and $57.9 million at December 31, 2012 pertain to notional policyholder account values of $2.6 billion and $2.0 billion at December 31, 2013 and 2012, respectively, electing interest credits based upon applicable market index performance.
Changes in interest rates typically have a sizable effect on the fair values of the Company's debt securities. During 2013, market interest rates of the ten-year U.S. Treasury bond increased roughly 127 basis points from year end 2012. Therefore, the decrease in unrealized gains of $537.8 million was the result of the increase in interest rates. The Company would expect similar results in the future from a significant upward or downward movement in market rates. 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 relatively small effects on the Company's financial results.
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 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 underlying reference index. However, increases or decreases in investment returns from these options are substantially offset by corresponding increases or decreases in amounts paid to indexed policyholders, subject to minimum guaranteed policy interest rates.
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, 2013. The potential impact on net earnings from these interest rate changes are summarized below.
In connection with the Company’s use of call options to hedge the equity return component of its fixed-indexed annuity and life products, the Company is exposed to the risk that a counterparty fails to perform under terms of the option contract. The Company purchases one-year option contracts from multiple counterparties and evaluates the creditworthiness of all counterparties prior to the purchase of the contracts. For consideration in contracting with a counterparty the rating required by the Company is a Standard & Poor’s credit rating of “A” or higher and a Moody’s rating of “A2” or higher. Accordingly, all options are purchased from nationally recognized financial institutions with a demonstrated performance for honoring their financial obligations and possessing substantial financial capacity. In addition, each counterparty is required to execute a credit support agreement obligating the counterparty to provide collateral to the Company when the fair value of the Company’s exposure to the counterparty exceeds specified amounts. The amount of collateral to be provided is based upon a sliding scale tied to the credit rating of the counterparty (the higher the credit rating of the counterparty the higher the threshold of exposure before collateral is to be provided). At the highest credit rating level the maximum counterparty net exposure not subject to collateral support is $20 million. This net exposure level declines as the counterparty credit rating declines and ultimately is $0 at a rating of “BBB+”. Counterparty credit ratings and credit exposure are monitored continuously by the Company’s Investment department with adjustments to collateral levels managed as per the credit support agreements.
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. The Company may also borrow up to $40 million on its bank line of credit for short-term cash needs. There were no borrowings outstanding under the line of credit at December 31, 2013.
A primary liquidity concern for life insurers 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 and market value adjustments, that help limit and discourage early withdrawals. The following table sets forth withdrawal characteristics of the Company's annuity reserves and deposit liabilities (based on statutory liability values) as of the dates indicated.
The above contractual withdrawals, as well as the level of surrenders experienced, were generally consistent with the Company's assumptions in asset-liability management, and the associated cash outflows did not have an adverse impact on overall liquidity. The nominal increase in annuity dollar outflows coincides with a growing block of business which added approximately $3.1 billion in deposits over the past three years. Individual life insurance policies are less susceptible to withdrawal than annuity reserves and deposit liabilities because policyholders may incur surrender charges and undergo a new underwriting process in order to obtain a new insurance policy. Cash flow projections and 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.
The Company relies on stockholders' equity 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, 2013, the Company had no commitments beyond its normal operating and investment activities. The Company has declared and paid an annual dividend on its common shares since 2005 although its practice remains to substantially reinvest earnings internally to finance the development of new business. Despite the fact the Company's market price of its Class A common shares has been trading at a discount to the book value for several years, there are no imminent plans for the Company to repurchase its shares as the Board of Directors has adopted a strategic policy of building a strong capital base to maintain high financial strength ratings and the ability to take competitive advantages as they arise. The capacity to pay dividends is limited by law in the state of Colorado to earned profits (statutory unassigned surplus). At December 31, 2013, the maximum amount legally available for distribution without further regulatory approval is $112.3 million.
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, of the accompanying consolidated financial statements for a discussion of reserving methods.
During 2011, it was discovered that compensation costs associated with the exercise of stock options under the Company's stock and incentive plans had been recorded incorrectly during 2010 and 2009. The associated cumulative amount of $239,000 was not material to either 2010 or 2009 and the Company recorded the amount as an adjustment to retained earnings as of December 31, 2011.