During 2016, National Western created a new operating entity, Braker P III, LLC ("BP III"), to own and manage the operations of a 196,000 square foot commercial office building in Austin, Texas, which BP III acquired. The purchase price of the property was $49.25 million, exclusive of closing costs and fees. The Company intends to relocate its principal office to this facility during the second half of 2017. The space not occupied by the Company will be leased by BP III to third party tenants.
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 2016, incorporating required disclosures in accordance with the rules and regulations of the SEC.
Investment activities of the Company are integral to its insurance operations. Since life insurance benefits may not be paid until many years into the future, the accumulation of cash flows from premium receipts are invested with income reported as revenue when earned. Anticipated yields on investments are reflected in premium rates, contract liabilities, and other product contract features. These anticipated yields are implied in the interest required on the Company’s net insurance liabilities (future policy benefits less deferred acquisition costs) and contractual interest obligations in its insurance and annuity products. The Company benefits to the extent actual net investment income exceeds the required interest on net insurance liabilities and manages the rates it credits on its products to maintain the targeted excess or “spread” of investment earnings over interest credited. The Company will continue to be required to provide for future contractual obligations in the event of a decline in investment yield. For more information concerning revenue recognition, investment accounting, and interest sensitivity, please refer to Note 1, Summary of Significant Accounting Policies; Note 3, Investments, in the Notes to Consolidated Financial Statements; and the discussions under Investments in Item 7 of this report.
Other postretirement benefit assumptions include future events affecting retirement age, mortality, dependency status, per capita claims costs by age, health care trend rates, and discount rates. Per capita claims cost by age is the current cost of providing postretirement health care benefits for one year at each age from the youngest age to the oldest age at which plan participants are expected to receive benefits under the plan. Health care trend rates involve assumptions about the annual rate(s) of change in the cost of health care benefits currently provided by the plan, due to factors other than changes in the composition of the plan population by age and dependency status. These rates implicitly consider estimates of health care inflation, changes in utilization, technological advances, and changes in health status of the participants.
Cost of insurance charges were $106.2 million in 2016 compared to $105.2 million in 2015 and $101.7 million in 2014. Cost of insurance charges typically trend with the size of the universal life insurance block in force and the amount of new business issued during the period. At December 31, 2016, the volume of universal life insurance in force decreased to $19.6 billion from $20.5 billion as of the end of 2015. However, during 2016 the Company increased its cost of insurance charges in accordance with its policy provisions on certain blocks of international life insurance policies. Administrative charges were $27.8 million, $28.6 million, and $27.4 million for the years ended December 31, 2016, 2015 and 2014, respectively, and correlate with new universal life insurance business sales by the number of policies placed, the amount of premiums received and the volume of insurance issued.
Debt and equity securities generated approximately 95% of total investment income, excluding derivative gains and losses, in 2016 consistent with prior years. The Company’s strategy is to invest substantially all of its cash flows in fixed debt securities within its guidelines for credit quality, duration, and diversification. The Company has experienced incremental cash flow from new business and investment income from its portfolio to be used for investing in debt securities which has caused the debt securities portfolio to grow from $9.6 billion at December 31, 2014 to $10.0 billion at December 31, 2015 and to $10.2 billion at December 31, 2016. Investment yields on new bond purchases in 2016 remained below the portfolio's weighted average yield of approximately 4.13% at December 31, 2016. The yield on debt security purchases to fund insurance operations decreased to 3.38% in 2016 from 3.51% in 2015. Also impacting bond portfolio returns has been the volume of higher yielding debt securities maturing or being called by borrowers with the proceeds being reinvested into lower yielding securities.
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 $18.2 million, $20.6 million and $21.1 million in 2016, 2015 and 2014, respectively. The 2015 amount also includes additional revenue recorded associated with the life interest in the Libbie Shearn Moody Trust.
The Company records impairment write-downs when a decline in value is considered to be other-than-temporary and full recovery of the investment is not expected. Impairments due to credit factors are recorded in the Company’s Consolidated Statement of Earnings while non-credit (liquidity) impairment losses are included in other specific statement comprehensive income (loss). Impairment and valuation write-downs reflected in the Consolidated Statements of Earnings are summarized in the following table.
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 $40,000.
The following table identifies the effects of unlocking and true-up adjustments on DPAC balances recorded through amortization expense for 2016, 2015 and 2014.
In 2015, the Company unlocked the DPAC balance associated with its International Life segment for favorable mortality experience on one of its universal life products. The effect of the prospective unlocking was to increase DPAC balances by $7.1 million (and decrease amortization expense). In addition, the Company unlocked the DPAC balance associated with its annuity segment for future expense assumptions pertaining to product development override costs (trailer commissions) which it is obligated to pay certain contracted National Marketing Organizations. The effect of the prospective unlocking was to decrease DPAC balances by $5.3 million (and increase amortization expense). During 2014, the Company unlocked the DPAC balance associated with its International Life segment for premium load increases implemented on several international universal life products. The effect of the prospective unlocking was to increase DPAC balances by $1.4 million (and decrease amortization expense).
realized and unrealized gains/(losses) included in net investment income approximate the change in contract interest associated with the corresponding embedded derivative liability change). However, during periods of equity market movements (gains or losses), in tandem with Company changes in asset management fees assessed on these products (increases or decreases), deviations can occur between index option asset values and the embedded derivative liability. During the years ended December 31, 2016, 2015, and 2014, contract interest was increased/(decreased) by ($15.9 million), $2.0 million, and ($6.5 million), respectively, for this occurrence. Refer to Note 15 Derivative Investments in the accompanying Notes to Consolidated Financial Statements for further information.
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 bonus interest 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, 2016, 2015, and 2014 the Company recorded true-up adjustments of its deferred sales inducement balances resulting in additional contract interest expense of $6.2 million, $3.9 million and $1.6 million, respectively.
expenditures. In 2016, the Company began processing new policy applications for certain lines of business on a proprietary policy
administration system that had been under development for a number of years. Amortization of the costs capitalized in development
Given the Company's strategic commitment to upgrading its information technology, consulting expenditures have similarly increased approximating $3.2 million during 2016 from $1.6 million in the prior year.
In addition, general insurance expenses include provisions for litigation and other settlement payments made in lieu of litigation. As discussed in the Legal Proceedings narrative included in Part I, Item 3 of this Form 10-K, the Company charged $2.9 million against earnings in 2016 related to litigation involving an annuity contract matter in Puerto Rico and an additional amount approximating $1.3 million (including interest and expenses) for payment to insurance authorities in Brazil pertaining to administrative proceedings in that country.
In addition to share-based compensation costs, other compensation costs decreased to $20.2 million in 2016 from $20.9 million in 2015. Included in this decline was a $1.0 million reduction in officer incentive bonus amounts due to sales and expense results not achieving target goals.
A summary of segment earnings from continuing operations for the years ended December 31, 2016, 2015 and 2014 is provided below. The segment earnings exclude realized gains and losses on investments, net of taxes.
The Company’s domestic life insurance in force in terms of policy counts has been declining for several years resulting in lower universal life contract revenue charges from the in force block. The pace of new policies issued has lagged the number of policies terminating from death or surrender over the three years shown causing a declining level of insurance in force from which contract revenue is received. In 2016, the Company issued 1,540 new domestic life policies while 4,170 terminated. The ratio of terminated policies to new issues was slightly higher than in preceding years. The number of domestic life insurance policies in force has declined from 55,750 at December 31, 2014 to 54,270 at December 31, 2015 and to 51,640 at December 31, 2016. Policy lapse rates in 2016 increased to 7.5% from 5.9% and 6.2% in 2015 and 2014, respectively. Increased policy lapses also serve to increase universal life insurance revenues through a greater amount of assessed surrender charge fees.
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 2016 was 20% lower than in 2015 and the volume of insurance issued was 10% less than that in 2015. The decline in the amount of policies in force and new issues each contribute to lower universal life insurance revenues. However, as noted in the discussion of Consolidated Operations results, in 2013 the Company began deferring the premium load on its highest selling domestic product, single pay life insurance. Amounts deferred are amortized into revenues over future periods corresponding with the duration of the policies. The premium load amounts deferred during 2013 through 2015 exceeded the amounts amortized back into revenues in each of those years. In 2016, the cumulative amounts deferred reached a level such that the current year revenue amortization exceeded the current period deferral resulting in net increasing revenue from this accounting method.
Operating expenses are allocated to lines of business based upon a functional cost analysis of the business activity giving rise to incurred expenses. As discussed in the Consolidated Operations section, the Company's overall operating expense levels increased in 2016 from the prior year, which resulted in operating expenses for this segment being higher.
The Company's international life operations have been a steady contributor to the Company's overall earnings performance and represents a niche where the Company believes it has had a competitive advantage historically. A stable population of distribution relationships has been developed over decades of operations providing the Company with a consistent foundation for development of the block of business.
A third component of international universal life revenues include surrender charges assessed upon surrender of contracts by policyholders. At the height of the financial crisis in 2008 through 2010, the Company’s international policyholders exhibited concern regarding the developments in U.S. financial markets. This evidenced itself in the Company's termination activity in its international life policies in force. The Company incurred higher termination experience than is typical which resulted in recognition of increased surrender charge fee income. This level of termination activity subsequently subsided in 2011 with the termination activity over the following years remaining relatively level. In 2015, termination activity revisited the levels last seen during the 2008 through 2010 period resulting in additional surrender charge fee income, and this activity continued into 2016. The following table illustrates the Company’s international life termination experience over the past five years.
The higher incidence of terminations primarily is occurring with policies to residents of the countries from which the Company discontinued accepting applications in late 2015. As a result of the higher termination incidence, the Company unlocked its DPAC balances for this segment of the business during 2016 to incorporate a greater lapse assumption, among other things.
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 an outside equity index. Included in the totals in the above table are collected premiums for fixed-index universal life products of approximately $74.9 million, $84.5 million and $94.9 million for the years ended 2016, 2015 and 2014, respectively. The decline in renewal premiums during these periods corresponds with the increased termination activity discussed above.
As noted previously, net investment income and contract interest include period-to-period changes in fair values pertaining to call options purchased to hedge the interest crediting feature on the fixed-index universal life products. With the growth in the fixed-index universal life block of business, the period-to-period changes in fair values of the underlying options have had an increasingly greater impact on net investment income and universal life contract interest. A detail of net investment income for international life insurance operations is provided below.
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 international life insurance DPAC balances recorded through amortization expense for 2016, 2015 and 2014.
True-up adjustments during the periods shown above were favorable and increased the DPAC balance on the Consolidated Balance Sheet and decreased amortization expense by a like amount.
Similar to the Domestic Life segment, operating expenses are allocated to lines of business based upon a functional cost analysis of the business activity giving rise to incurred expenses. As discussed in the Consolidated Operations section, the Company's overall operating expense levels increased in 2016 from the prior year, which resulted in operating expenses for this segment being higher.
Premiums and contract charges primarily consist of surrender charge income recognized on terminated policies. The amount of surrender charge income recognized is determined by the volume of surrendered contracts as well as the duration of each contract at the time of surrender given the pattern of declining surrender charge rates over time that is common to most annuity contracts. The Company's lapse rate for annuity contracts during 2016 was 6.5%, a slight increase from a rate of 6.2% in 2015 and marginally lower than the 6.6% rate experienced in 2014.
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 $19.3 million, $17.7 million and $18.4 million for the years ended December 31, 2016, 2015 and 2014, respectively. Amortization of deferred sales inducements is included as a component of annuity contract interest as described later in this discussion of annuity operations.
As previously described, derivatives are call options purchased to hedge the equity return component of the Company's fixed-index annuity products with any gains or losses from the sale or expiration of the options, as well as period-to-period changes in fair values, reflected in net investment income. Since the embedded derivative option in the policies is bifurcated when determining the contract reserve liability, the impact of the market value change of index options on asset values generally aligns closely with the movement of the embedded derivative liability such that the net effect upon pretax earnings is negligible (i.e. net realized and unrealized gains/(losses) included in net investment income approximate the change in contract interest associated with the corresponding embedded derivative liability change). See further discussion below regarding contract interest activity.
The Company unlocked the DPAC balance associated with its annuity segment during 2016 for surrender and annuitization rates. The effect of this prospective unlocking was to decrease DPAC balances by $3.7 million (and increase amortization expense). The Company also unlocked in 2015 for future expense assumptions pertaining to product development override costs (trailer commissions) which it is obligated to pay certain contracted National Marketing Organizations. The effect of the prospective unlocking was to decrease DPAC balances by $5.3 million (and increase amortization expense). No unlocking adjustments were recorded in 2014.
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 2016, 2015 and 2014 relate to policy lapse or termination rates, renewal trail commissions, expense levels, investment yields and interest credited rates compared to anticipated experience. The increasing amount of the negative true-up adjustment for the period shown is substantially due to the impact of spread compression on the Company's interest rate margin. The effect of spread compression is to reduce the estimated gross profits for the product line and result in higher (accelerated) amortization of DPAC balances than expected.
Annuity contract interest includes true-up adjustments for the deferred sales inducement balance which are done each period similar to that done with respect to DPAC balances. For the years ended December 31, 2016, 2015, and 2014 deferred sales inducement balances on the Consolidated Balance Sheet were reduced by $6.2 million, $3.9 million and $1.6 million, respectively, for true-up adjustments. These adjustments are included in the above table as an addition to bonus interest amortization.
The majority of litigation and legal matters the Company is involved with emanate from annuity products. The $2.9 million litigation provision discussed in the Consolidated Operations section of this report was allocated to the Annuity Operations segment and is included in other operating expenses in 2016. Similar to the Domestic Life insurance and International Life insurance segments, the Company's overall increase in operating expenses has been allocated to the Annuity segment based upon functional business activity and volumes.
Substantially all of the Company’s investable cash flows are directed toward the purchase of long-term debt securities. The Company’s investment policy calls for investing in debt securities that are investment grade, meet quality and yield objectives, and provide adequate liquidity for obligations to policyholders. Debt securities with intermediate maturities are targeted by the Company as they more closely match the intermediate nature of the Company’s policy liabilities and provide an appropriate strategy for managing cash flows. The Company holds minimal levels of U.S. Treasury securities due to their low yields and deposits most of these holdings with various state insurance departments in order to meet security deposit on hand requirements in these states.
Rating agencies generally view mortgage-backed securities as having additional risk for insurers holding interest sensitive liabilities given the potential for asset/liability disintermediation. Consequently, the Company holds predominantly agency mortgage-backed securities. Because mortgage-backed securities are subject to prepayment and extension risk, the Company has substantially reduced these risks by investing in collateralized mortgage obligations ("CMO"), which have more predictable cash flow patterns than pass-through securities. These securities, known as planned amortization class I ("PAC I"), very accurately defined maturity ("VADM") and sequential tranches are designed to amortize in a more predictable manner than other CMO classes or pass-throughs. The Company does not purchase tranches, such as PAC II and support tranches, that subject the portfolio to greater than average prepayment risk. Using this strategy, the Company can more effectively manage and reduce prepayment and extension risks, thereby helping to maintain the appropriate matching of the Company's assets and liabilities.
However, the Company does have exposure to the debt of non-financial companies in certain of these countries. The following table shows bond holdings at December 31, 2016 of non-financial companies that are domiciled in Portugal, Ireland, Italy or Spain held in the available for sale and held to maturity debt security portfolios.
During the year ended December 31, 2016, the Company recorded no other-than-temporary impairment ("OTTI") credit related write-downs on debt securities or equity securities. There was one debt security impairment during 2014 which pertained to an asset-backed security whose fair value and present value of future cash flows fell below the amortized cost of the security. See Note 3, Investments Debt and Equity Securities, of the accompanying Consolidated Financial Statements for further discussion.
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, 2016, approximately 29.4% 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 $20.0 million in asset-backed securities as of December 31, 2016. This portfolio includes $1.6 million of manufactured housing bonds and $18.4 million of home equity loans (also referred to as subprime securities). These holdings are down from the levels held at December 31, 2015 of $3.4 million and $32.0 million, respectively. 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’s exposure to the subprime sector is limited to investments in the senior tranches of 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. The housing market subsequently stabilized and an improvement in the prices of subprime securities occurred as the bond market regained more liquidity. All of the loans classified as subprime in the Company’s portfolio as of December 31, 2016 were underwritten prior to 2005 as noted in the table below.
The Company held net investments in mortgage loans, after allowances for possible losses, totaling $174.5 million and $108.3 million at December 31, 2016 and 2015, respectively. The diversification of the portfolio by geographic region, property type, and loan-to-value ratio was as follows:
The Company does not recognize interest income on loans past due ninety days or more. The Company had no mortgage loans past due six months or more at December 31, 2016 and 2015. There was no interest income that was not recognized in 2016, 2015 and 2014.
The Company's direct investments in real estate are not a significant portion of its total investment portfolio. These investments total approximately $31.8 million at December 31, 2016 and $16.3 million at December 31, 2015, and consist primarily of income-producing properties which are being operated by a wholly-owned subsidiary of National Western. The Company recognized operating income on these properties of approximately $2.6 million, $1.8 million and $1.7 million for the years ended December 31, 2016, 2015 and 2014, 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 gains of $2.9 million, $0.0 million and $1.0 million associated with real estate investments in the years ended December 31, 2016, 2015 and 2014, respectively.
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 equity market 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.
A gradual increase in interest rates from current levels would generally be a positive development for the Company. Rate increases would be expected to provide incremental net investment income, produce increased sales of fixed rate products, and limit the potential erosion of the Company’s interest rate spread on products due to minimum guaranteed crediting rates in products. Alternatively, a rise in interest rates would reduce the fair value of the Company’s investment portfolio and if long-term rates rise dramatically within a relatively short time period could expose the Company to disintermediation risk. Disintermediation risk is the risk that policyholders will surrender their policies in a rising interest rate environment forcing the Company to liquidate assets when they are in an unrealized loss position.
A decline in interest rates could cause certain mortgage-backed securities in the Company’s portfolio to be more likely to pay down or prepay. In this situation, the Company typically will be unable to reinvest the proceeds at comparable yields. Lower interest rates will likely also cause lower net investment income, subject the Company to reinvestment rates risks, and possibly reduce profitability through reduced interest rate margins associated with products with minimum guaranteed crediting rates. Alternatively, the fair value of the Company’s investment portfolio will increase when interest rates decline.
The Company's unrealized gains balance for debt securities held at December 31, 2016 and 2015 is shown in the following table.
Debt securities held to maturity are recorded at their amortized cost basis. Accordingly, the unrealized gain amounts shown in the table above are not incorporated into the Company's Consolidated Financial Statements at December 31, 2016 and 2015, respectively.
Changes in interest rates typically have a sizable effect on the fair values of the Company's debt securities. During 2016, the market interest rate of the ten-year U.S. Treasury bond increased roughly 18 basis points from 2.27% at year-end 2015 to 2.45% at year-end 2016. Therefore, the increase in unrealized gains was not the result of the change in interest rates. While interest rate levels increased during 2016, the Company's unrealized gain position improved from the prior year-end due to price recoveries of corporate debt securities in certain industry sectors (i.e. oil and gas). In addition, corporate debt security spreads narrowed sharply concurrent with the rise in treasury rates, primarily during the fourth quarter of 2016, further serving to offset the expected drop in unrealized gains on the debt security portfolio. 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.
Mortgage and other loans were modeled by discounting scheduled cash flows through the scheduled maturities of the loans, starting with interest rates currently being offered for similar loans to borrowers with similar credit ratings. Policy loans were modeled by discounting estimated cash flows using U.S. Treasury Bill interest rates as the base rates at December 31, 2016. The estimated cash flows include assumptions as to whether such loans will be repaid by the policyholders or settled upon payment of death or surrender benefits on the underlying insurance contracts and incorporate both Company experience and mortality assumptions associated with such contracts.
The following table sets forth withdrawal characteristics of National Western's annuity reserves and deposit liabilities (based on statutory liability values) as of the dates indicated.