The Company's investment philosophy is to maintain a diversified portfolio of investment grade debt and equity securities that provide adequate liquidity to meet policyholder obligations and other cash needs. The prevailing strategy within this philosophy is the intent to hold investments in debt securities to maturity. However, the Company does manage its portfolio, which entails monitoring and reacting to all components which affect changes in the price or value of investments in debt and equity securities.
Effective January 1, 1994, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities," as more fully described in the notes to the financial statements. This statement addresses the accounting and reporting for investments in debt and equity securities and requires classification of such securities into the following categories: held to maturity, available for sale, and trading. At December 31, 1994, approximately 18% of the Company's total debt and equity securities 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. The reporting category chosen for the Company's securities investments depends 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.
Securities that are not classified as either held to maturity or trading securities are reported as securities available for sale. These securities may be sold if market or other measurement factors change unexpectedly after the securities were acquired. For example, opportunities arise when factors change that allow the Company to improve the performance and credit quality of the investment portfolio by replacing an existing security with an alternative security while still maintaining an appropriate matching of expected maturities of assets and liabilities. Examples of such improvements are as follows: improving the yield earned on invested assets, improving the credit quality, changing the duration of the portfolio, and selling securities in advance of anticipated calls or other prepayments. Securities available for sale are reported in the Company's financial statements at individual fair value. Any unrealized gains or losses resulting from changes in the fair value of the securities are reflected as a component of stockholders' equity.
Additional review procedures are performed on those fair value declines which are caused by factors other than market expectations regarding inflation and general interest rates. Specific conditions of the issuer and its ability to comply with all terms of the instrument are considered in the evaluation of the realizable value of the investment. Information reviewed in making this evaluation would include the recent operational results and financial position of the issuer, information about its industry, recent press releases and other available data. If evidence does not exist to support a realizable value equal to or greater than the carrying value of the investment, such decline in fair value is determined to be other than temporary, and the carrying amount is reduced to its net realizable value. The amount of the reduction is reported as a realized loss.
The Company's insurance operations do not maintain a trading securities portfolio. All trading securities reported in the accompanying financial statements are held by the Company's brokerage subsidiary, The Westcap Corporation. These securities totaled $69.7 million at December 31, 1994, or 2.7% of total invested assets. Net increases in the fair values of these securities totaled approximately $58,000 for the year ended December 31, 1994, and have been included in earnings.
The Company's insurance operations maintain a diversified debt securities portfolio which consists of various types of fixed income securities including primarily U.S. government, public utilities, corporate and mortgage-backed securities. Investments in mortgage-backed securities include U.S. government and private issue mortgage-backed pass-through securities as well as collateralized mortgage obligations (CMOs). As of December 31, 1994 and 1993, the Company's debt securities portfolio consisted of the following mix of securities:
The amortized cost and estimated fair values of investments in debt securities at December 31, 1994, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
PAC I CMOs account for over 85% of the total CMO portfolio as of December 31, 1994. The CMOs that the Company purchases are modeled and subjected to detailed, comprehensive analysis by the Company's investment staff before any investment decision is made. The overall structure of the entire CMO is evaluated, and an average life sensitivity analysis is performed on the individual tranche being considered for purchase under increasing and decreasing interest rate scenarios. This analysis provides information used in selecting securities that fit appropriately within the Company's investment philosophy and asset/liability management parameters. The Company's investment mix between mortgage-backed securities and other fixed income securities helps effectively balance prepayment, extension and credit risks.
The Company held net investments in mortgage loans totaling $189,632,000 and $188,920,000, or 7.4% of total invested assets, at December 31, 1994 and 1993. The loans are real estate mortgages, substantially all of which are related to commercial properties and developments and have fixed interest rates.
The Company currently places all loans past due three months or more on a non-accrual status, thus recognizing no interest income on the loans. At December 31, 1994 and 1993, the Company had approximately $2,292,000 and $4,191,000, respectively, of mortgage loan principal balances on a non-accrual status. For the years ended December 31, 1994 and 1993, the approximate reduction in interest income associated with non-accrual loans was as follows:
The contractual maturities of mortgage loans at December 31, 1994, are as follows:
Insurance Operations Net Earnings: Performance continues to improve as the Company recorded earnings from insurance operations for 1994 totaling $36,115,000 which represents an increase of $8,827,000, or 32%, over 1993 earnings. Increased net investment income, prudent interest and operating expense management, and favorable policy benefit expense experience all contributed to the positive results for 1994 as more fully described below.
Life and Annuity Premiums: This revenue category represents the premiums on traditional type products. However, sales in most of the Company's markets currently consist of non-traditional types such as universal life and investment annuities. Although 1994 reflects a small increase in these revenues, the Company will continue to focus the majority of its product development and marketing efforts on universal life and investment annuities.
As detailed above, the decline in deposits collected in 1993 is primarily related to investment annuities. Much of this decline is due to the discontinuance of the Company's two-tier annuity products in 1992 and increased competition due to market interest rate conditions. However, the Company has continued to develop new annuity and life products and has continued to contract new independent marketing organizations to further strengthen and diversify distribution channels for the sale of such products. The Company also significantly increased annuity marketing efforts in the second quarter of 1994 through personnel and agent additions and product developments. As a result of these efforts, annuity deposits have increased over $70 million, or 81%, from 1993.
Life and Other Policy Benefits: The decrease in these expenses is largely related to reductions in policy surrenders on traditional insurance products in 1994 and 1993 in comparison to 1992. Also, 1993 life insurance benefit claims were significantly higher than the Company's prior experience. However, the 1994 claims declined to a level more consistent with previous claims history.
Amortization of Deferred Policy Acquisition Costs: This expense item represents the amortization of the costs of acquiring or producing new business, which consists primarily of agents commissions. The majority of such costs are amortized in direct relation to the anticipated future gross profits of the applicable blocks of business. Amortization for 1994 was $32,131,000 compared to $33,159,000 and $25,085,000 for 1993 and 1992, respectively. The increase in amortization from 1992 correlates to increased earnings from insurance operations.
(b) National Western Life Insurance Company is subject to state guaranty association assessments in all states in which it is licensed to do business. These associations generally guarantee certain levels of benefits payable to resident policyholders of insolvent insurance companies. Most states allow premium tax credits for all or a portion of such assessments, thereby allowing potential recovery of these payments over a period of years. However, several states do not allow such credits. In December, 1994, the National Organization of Life and Health Insurance Guaranty Associations published revised assessment data on nationwide life and health insurance company insolvencies. Based on this information, the Company significantly increased its estimates in 1994 for assessment liabilities relating to such insolvencies. The Company will continue to monitor and revise its estimates for assessments as additional information becomes available which could result in additional expense charges. Other insurance operating expenses related to state guaranty association assessments totaled $4,869,000, $4,583,000 and $1,877,000 for the years ended December 31, 1994, 1993 and 1992, respectively.
Brokerage Revenues: Revenues for 1994, 1993 and 1992 were $40.2 million, $105.9 million and $123.1 million, respectively. The significant level of brokerage revenues in 1993 and 1992 is attributable to several factors. The steady decline in market interest rates in these years was very positive for brokerage firms. Also, The Westcap Corporation specializes in mortgage-backed securities, and many of their customers experienced significant prepayments within their portfolios. This contributed to increased sales for the brokerage firm as the investors reinvested the proceeds. Other contributing factors were the firm's ability to attract an experienced sales force and increases in the overall size of the force. While The Westcap Corporation experienced significantly increased revenues in 1993 and 1992, the entire brokerage industry, including Westcap, was impacted significantly by increasing interest rate conditions during 1994. The increase in market interest rates had a negative impact on sales for Westcap, and the bond brokerage industry in general, resulting in the significant decline in revenues in 1994.
Brokerage Expenses: Expenses for 1994, 1993 and 1992 were $40.2 million, $72.3 million and $82.6 million, respectively. The majority of these expenses relate to commission compensation and vary directly with brokerage revenues. Accordingly, the expenses directly correspond to the level of brokerage revenues for the same periods. However, as brokerage revenues decrease, the ratio of brokerage expenses to such revenues increases. This is because fixed and administrative costs are covered at certain levels of revenues, leaving only the variable cost of commissions. To adjust to the reduced volume of business due to the current adverse bond market conditions, Westcap has taken appropriate steps in 1995 to reduce administrative and operating costs.
Federal Income Tax Expense: The Federal corporate tax rate was increased from 34% to 35% beginning in 1993. The total increase in 1993 Federal income taxes resulting from the change in rates was approximately $1,018,000.
SFAS No. 112, "Employers' Accounting for Postemployment Benefits," was issued by the Financial Accounting Standards Board (FASB) in November, 1992. This statement establishes accounting standards for employers who provide benefits to former or inactive employees after employment but before retirement. Postemployment benefits include all types of benefits provided to former or inactive employees, their beneficiaries and covered dependents. The statement is effective for fiscal years beginning after December 15, 1993. As the Company provides insignificant postemployment benefits, implementation of this statement had no significant impact on the results of operations of the Company.
Both SFAS No. 114 and No. 118 apply to financial statements for fiscal years beginning after December 15, 1994. The Company will implement the statements in the first quarter of 1995. The Company is currently providing for impairment of loans through an allowance for possible losses, and the implementation of this statement is not expected to have a significant effect on the level of this allowance. As a result, there should be no significant net impact on the Company's results of operations stockholders' equity.
(b) Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings.
The Company has met the above scheduled difference for December 31, 1994. In fact, at December 31, 1994, the difference was less than that required, and it is anticipated that the Company will not require any additional statutory reserves in order to meet the above schedule of differences. This agreement does not affect the Company's policy reserves which are prepared under generally accepted accounting principles as reported in the accompanying consolidated financial statements.
In 1993, the National Association of Insurance Commissioners (NAIC) established new risk-based capital (RBC) requirements to help state regulators monitor the financial strength and stability of life insurers by identifying those companies that may be inadequately capitalized. Under the NAIC's requirements, each insurer must maintain its total capital above a calculated threshold or take corrective measures to achieve the threshold. The threshold of adequate capital is based on a formula that takes into account the amount of risk each company faces on its products and investments. The RBC formula takes into consideration four major areas of risk which are: (i) asset risk which primarily focuses on the quality of investments; (ii) insurance risk which encompasses mortality and morbidity risk; (iii) interest rate risk which involves asset/liability matching issues; and (iv) other business risks.
The information required by this item is shown on Attachment "A" on pages __ through __.