The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward-looking statements. Certain information contained herein or in other written or oral statements made by or on behalf of National Western Life Insurance Company or its subsidiaries are or may be viewed as forward-looking. Although the Company has used appropriate care in developing any such information, forward-looking information involves risks and uncertainties that could significantly impact actual results. These risks and uncertainties include, but are not limited to, matters described in the Company's SEC filings such as exposure to market risks, anticipated cash flows or operating performance, future capital needs, and statutory or regulatory related issues. However, National Western, as a matter of policy, does not make any specific projections as to future earnings, nor does it endorse any projections regarding future performance that may be made by others. Whether or not actual results differ materially from forward-looking statements may depend on numerous foreseeable and unforeseeable events or developments. Also, the Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future developments, or otherwise.
The Company provides life insurance products for the savings and protection needs of policyholders and annuity contracts for the asset accumulation and retirement needs of contractholders both domestically and internationally. The Company accepts funds from policyholders or contractholders and establishes a liability representing future obligations to pay the policy or contract holders and their beneficiaries. To ensure the Company will be able to pay these future commitments, the funds received as premium payments and deposits are invested in high quality investments, primarily fixed income securities.
The Company monitors these factors continually as key business indicators. The discussion below includes these indicators and presents information useful to an overall understanding of the Company's business performance in 2003, incorporating required disclosures in accordance with the rules and regulations of the Securities and Exchange Commission.
The Company's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). In addition, the Company regularly evaluates operating performance using non-GAAP financial measures which exclude or segregate index options and realized investment gains and losses from operating revenues and earnings. Similar measures are commonly used in the insurance industry in order to assess profitability and results from ongoing operations. The Company believes that the presentation of these non-GAAP financial measures enhances the understanding of the Company's results of operations by highlighting the results from ongoing operations and the underlying profitability factors of the Company's business. The Company excludes or segregates index options and realized investment gains and losses because such items are often the result of events which may or may not be at the Company's discretion and the fluctuating effects of these items could distort trends in the underlying profitability of the Company's business. Therefore, in the following sections discussing consolidated operations and segment operations, appropriate reconciliations have been included to report information management considers useful in enhancing an understanding of the Company's operations to reportable GAAP balances reflected in the consolidated financial statements.
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 not put as much emphasis on relative to 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.
The yield on average invested assets has declined from 7.47% in 2001 to 7.15% in 2002 and down to 6.85% in 2003, excluding index options. This decline in yield is due to the overall interest rate declines in the market and the Company obtaining lower yields on new invested funds. Net investment income performance is analyzed excluding the index option income which is a common practice in the insurance industry in order to assess underlying profitability and results from ongoing operations.
Index Options. Index options are derivative financial instruments used to fully 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.
Life insurance companies are required to defer certain expenses associated with acquiring new business. The majority of these acquisition expenses consist of commissions paid to agents, underwriting costs, and certain marketing expenses and sales inducements. 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 commonly deferred and amortized by insurers using the same methodology and assumptions used to amortize other capitalized acquisition costs and the amortization is included in annuity contract interest. Recognition of these deferred policy acquisition costs in the financial statements occurs over future periods in relation to the emergence of profits priced into the products sold. This emergence of profits is based upon assumptions regarding premium payment patterns, mortality, persistency, investment performance, and expense patterns. Companies are required to review these assumptions periodically to ascertain whether actual experience has deviated significantly from that assumed. If it is determined that a significant deviation has occurred, the emergence of profit patterns is to be "unlocked" and reset based upon the actual experience.
Amortization of deferred policy acquisition costs increased in 2003 to $53.8 million compared to $35.8 million and $27.4 million in 2002 and 2001, respectively. Increased amortization in the current year is due in part to the deferral of sales inducement costs, as noted above, which results in higher amortization of deferred acquisition costs. In addition to the deferral of sales inducements, an "unlocking" adjustment was made pertaining to the annuity line of business and the expected emergence of future profits which also resulted in increased deferred policy acquisition costs amortization during 2003. No expected changes were made related to the amortization of these costs in 2002. In 2001, the Company analyzed its assumptions regarding the emergence of profits of its business and determined that unlocking was required to incorporate improved persistency with respect to its annuity block of business and as well as to factor in the recent realized investment loss experience. The outcome of these revisions resulted in the amortization of deferred policy acquisition costs decreasing to $27.4 million in 2001. While the Company is required to evaluate its emergence of profits continually, management believes that the current amortization patterns of deferred policy acquisition costs are reflective of actual experience.
Contract interest also includes the performance of the equity-index component of the Company's equity-indexed products. As previously noted, the recent market performance of these equity-index features increased contract interest expenses while also increasing the Company's investment income given the hedge nature of the options purchased for these products. Excluding equity-indexed products, the Company's average credited rate on annuity products was approximately 4.3% in 2003. The average credited rate in 2003 for interest sensitive life products approximated 5.0%. With these credited rates, the Company generally realized its targeted interest spread on its products.
Other operating expenses consist of general administrative expenses, licenses and fees, and commissions not subject to deferral and expenses of nursing home operations. Nursing home expenses are included in the amount of $6.0 million, $5.4 million, and $4.8 million in 2003, 2002, and 2001, respectively. The Company's operating expenses in 2002 and 2003 include increases associated with its significant upturn in business. In addition, a charge was recorded during 2003 in the amount of $9.7 million relating to a litigation claim where the Company has reached a settlement agreement that has been approved by the court. The suit involves a class action lawsuit against the Company in the state of Michigan and filed on behalf of purchasers who challenged the bonus interest rate paid by the Company on certain annuity products. This settlement amount is included as a component of other operating expenses in 2003.
Policy benefits totaled $17.9 million in 2003 and $15.0 million in 2002 and 2001, which are consistent with Company expectations. Amortization of deferred policy acquisition costs was $12.1 million, $10.5 million, and $10.7 million for 2003, 2002, and 2001, respectively. The increase in amortization in 2003 is a result of a change in expected emergence of profits given the increased sales related to equity-indexed universal life products that are generating higher gross profits due to the surge in the stock market. Collected premiums related to the equity-indexed universal life product were $21.0 million and $10.0 million in 2003 and 2002, respectively. The increase in universal life contract interest is also the result of the increased sales of the equity-indexed universal life product and the associated stock market gains which increased the amounts the Company credits to policyholders on these products. Contract interest expense was $17.8 million, $16.5 million, and $15.9 million in 2003, 2002, and 2001, respectively.
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 performing poorly. The Company experienced a tremendous increase in sales relating to equity-indexed annuities as the stock market rebounded in 2003 and with low interest rates continuing these products became a more attractive product for contractholders. Since the Company does not offer variable products or mutual funds, equity-indexed products provide an important equity-based alternative to the Company's existing fixed interest rate annuity products.
Other deferred annuity sales also increased significantly in 2003 over 2002 with $674.4 million in collected deposits compared to $355.5 million, respectively. Fixed-rate annuity products became popular with consumers in the wake of the recent stock market decline and volatility as these products yield a stable and competitive interest rate. As a selling inducement, many of these products include a first year interest bonus in addition to the base interest rate. These bonus rates are currently credited to policyholders and are deferred by the Company with other capitalized policy acquisition costs and amortized over future periods. The amount deferred was approximately $43.9 million for the year ended December 31, 2003. No sales inducements were deferred in 2002 or 2001.
National Western'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. Most of the income from the Company's subsidiaries is from a life interest in a trust. Gross income distributions from the trust totaled $3.7 million in 2003 and 2002, and $3.8 million in 2001, respectively.
The Company acquired a nursing home facility, which opened in late July, 2000 and is operated by an affiliated limited partnership, whose 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 $0.9 million, $0.7 million, and $0.4 million of operating earnings in 2003, 2002, and 2001, respectively.
The Company's investment philosophy emphasizes the careful 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, 2003 and 2002. The Company emphasizes investment grade debt securities, with smaller holdings in mortgage loans and policy loans.
In addition to diversification, an important aspect of the Company's investment approach is managing the credit quality of its investments in debt securities. Thorough credit analysis is performed on potential corporate investments including examination of a company's credit and industry outlook, financial ratios and trends, and event risks.
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 2003, the Company's percentage of below investment grade securities decreased from 4.8% to 4.5% as of December 31, 2002 and 2003, respectively. Fair value of such securities improved significantly from $168.1 million up to $208.7 million as of December 31, 2002 and 2003. The Company's holdings of below investment grade securities is a relatively small percentage of total invested assets. These holdings are summarized below.
As part of its normal assessment of other than temporary impairments of investments, the Company determined during 2003 and 2002 that it held investments in several issuers whose decline in value was considered other than temporary and these holdings were written down to fair value and included as realized losses on investments as follows:
The decrease in impairment writedowns in 2003 compared to prior years reflects the improved standing of the Company's investment portfolio. The Company is closely monitoring its other below investment grade holdings by reviewing investment performance indicators including information such as issuer operating performance, debt ratings, analyst reports and other economic factors that may affect these specific investments. While additional losses are not currently anticipated based on the existing status and condition of these securities, continued credit deterioration of some securities is possible, which may result in further writedowns.
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 as to which category 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, 2003, approximately 32% of the Company's total debt and equity securities, based on fair values, were classified as securities available for sale. These holdings provide flexibility to the Company to react to market opportunities and conditions and to practice active management within the portfolio to provide adequate liquidity to meet policyholder obligations and other cash needs.
In conjunction with the required implementation of Statement of Financial Accounting Standards ("SFAS") No. 133, Accounting for Derivative Instruments and Hedging Activities, during 2001 the Company was permitted to reclassify securities previously included as held to maturity to available for sale with an aggregate amortized cost of $294 million. The net unrealized losses on the transferred securities totaled $5.1 million, after the effects of deferred taxes and deferred policy acquisition costs. This adjustment was reflected in the Company's consolidated financial statements in other comprehensive income as part of the cumulative effect of a change in accounting principle as of January 1, 2001.
The Company does not recognize interest income on loans past due six months or more. At December 31, 2002 the Company had mortgage loan principal balances past due six months or more of $6.9 million, and there were none as of December 31, 2003. Interest income not recognized for past due loans totaled approximately $0.3 million and $0.2 million during 2002 and 2001, respectively; there were none in 2003.
As of December 31, 2003 and 2002, the allowance for possible losses on mortgage loans was $0.7 million. 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 $20.2 million and $21.8 million at December 31, 2003 and 2002, 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 $1.8 million, $1.5 million, and $0.8 million for the years ended December 31, 2003, 2002, and 2001, 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 $72,000, $200,000, and $25,000 in 2003, 2002, and 2001, respectively, associated with these properties.
Changes in interest rates typically have a significant impact on the fair values of the Company's debt securities. Market interest rates of the ten-year U.S. Treasury bond increased approximately 40 basis points from year-end 2002 causing a slight change in unrealized gains of $4.9 million on a portfolio of approximately $4 billion. The Company would expect similar results in the future from any 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.
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, 2003. The potential impact on net earnings from these interest rate changes are summarized below.
In the past, cash flows from the Company's insurance operations have been sufficient to meet current needs. Cash flows from operating activities were $69 million, $127 million, and $142 million in 2003, 2002, and 2001, respectively. Operating cash flows are lower in 2003 due to increased commission payments on annuity deposits which are included in financing activities on the cash flow statement. The Company also has significant cash flows from both scheduled and unscheduled investment security maturities, redemptions, and prepayments. These cash flows totaled $668 million, $349 million, and $162 million in 2003, 2002, and 2001, respectively. Cash flows from security maturities, redemptions, and prepayments were significantly higher in 2003 and 2002 than reported in 2001 due to the continual decline in interest rates. These cash flow items could be reduced if interest rates rise in 2004. Net cash flows from the Company's universal life and annuity deposit product operations totaled inflows of $839 million and $142 million in 2003 and 2002 and a $53 million outflow for 2001, respectively. The net inflows are expected to continue in 2004.
It is not Company practice to enter into off-balance sheet arrangements nor is it Company policy to issue guarantees to third parties, other than in the normal course of issuing insurance contracts. Commitments related to insurance products sold are reflected as liabilities for future policy benefits. Insurance contracts guarantee certain performances by the Company.
(2) Other long-term liabilities includes obligations that are reported within the Company's reserve liabilities that reflect determinable pay out patterns related to immediate annuities. The above amounts are undiscounted whereas the amounts included in future policy benefit liabilities are discounted in accordance with GAAP.
Impairment of Investment Securities. The Company's accounting policy requires that a decline in the value of a security below its amortized cost basis be evaluated to determine if the decline is other than temporary. The primary factors considered in evaluating whether a decline in value for fixed income and equity securities is other than temporary include: (a) the length of time and the extent to which the fair value has been less than cost, (b) the financial conditions and near-term prospects of the issuer, (c) whether the debtor is current on contractually obligated principal and interest payments, and (d) the intent and ability of the Company to retain the investment for a period of time sufficient to allow for any anticipated recovery. In addition, certain securitized financial assets with contractual cash flows are evaluated periodically by the Company to update the estimated cash flows over the life of the security. If the Company determines that the fair value of the securitized financial asset is less than its carrying amount and there has been a decrease in the present value of the estimated cash flows since the previous estimate, then an other than temporary impairment charge is recognized. When a security is deemed to be impaired a charge is recorded as net realized losses equal to the difference between the fair value and amortized cost basis of the security. Once an impairment charge has been recorded, the fair value of the impaired investment becomes its new cost basis and the Company continues to review the other than temporarily impaired security for appropriate valuation on an ongoing basis. Under Generally Accepted Accounting Principles, the Company is not permitted to increase the basis of impaired securities for subsequent recoveries in value.
Future Policy Benefits. Because of the long-term nature of insurance contracts, the Company is liable for policy benefit payments many years into the future. The liability for future policy benefits represents estimates of the present value of the Company's expected benefit payments, net of the related present value of future net premium collections. For traditional life insurance contracts, this is determined by standard actuarial procedures, using assumptions as to mortality (life expectancy), morbidity (health expectancy), persistency, and interest rates, which are based on the Company's experience with similar products. The assumptions used are those considered to be appropriate at the time the policies are issued. An additional provision is made on most products to allow for possible adverse deviation from the assumptions assumed. For universal life and annuity products, the Company's liability is the amount of the contract's account balance. Account balances are also subject to minimum liability calculations as a result of minimum guaranteed interest rates in the policies. While management and company actuaries have used their best judgment in determining the assumptions and in calculating the liability for future policy benefits, there is no assurance that the estimate of the liabilities reflected in the financial statements represents the Company's ultimate obligation. In addition, significantly different assumptions could result in materially different reported amounts. A discussion of the assumptions used to calculate the liability for future policy benefits is reported in Note 1, Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements.
Pension Plans. The Company sponsors a qualified defined benefit pension plan covering substantially all full-time employees and a nonqualified defined benefit plan primarily for senior officers. In accordance with prescribed accounting standards, the Company annually reviews its pension benefit plan assumptions which include the discount rate, the expected long-term rate of return on plan assets, and the compensation increase rate.
In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. The statement amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133. The statement is generally effective for contracts entered into or modified after June 30, 2003 and is not expected to have a material impact on the Company's consolidated financial statements.
See Attachment A, Index to Financial Statements and Schedules, on page __.