The Company leases approximately 25,000 square feet in an office building in Houston, Texas. The lease expires in 2000. The Company owns a five-story office building located in downtown Amarillo, Texas, which serves as the Company's annuity administration center. This building has approximately 50,000 square feet of net usable space. The Company believes that its existing facilities are adequate to meet its current and future anticipated needs.
The following discussion should be read in conjunction with "Item 6. Selected Financial Data" and "
To the Board of Directors and Shareholders of Western National Corporation:
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Western National Corporation and its subsidiaries as of December 31, 1996 and 1995, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles.
CONSOLIDATED STATEMENT OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994 (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
CONSOLIDATED STATEMENT OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994 (DOLLARS IN MILLIONS)
Western National Corporation (the "Company") is a Delaware corporation organized in October 1993 to serve as the holding company for Western National Life Insurance Company ("Western"), a Texas life insurance company founded in 1944. Unless the context otherwise requires, references to the "Company" are references to Western National Corporation and its consolidated subsidiaries. In a series of transactions consummated on February 15, 1994 (the "Reorganization"), the Company acquired all of the outstanding capital stock of Western from Conseco, Inc. ("Conseco") and issued to a Conseco subsidiary 60 million shares of common stock of the Company and a note in the amount of $150 million (the "Conseco Note"). Conseco thereupon sold approximately 35 million shares of common stock of the Company in a public offering, and the Company sold an additional 2.3 million shares of common stock in the same offering. On February 22, 1994, the Company issued $150 million 7 1/8% Senior Notes due 2004 ("the Senior Notes"), and repaid the Conseco Note. (The issuance and repayment of the Conseco Note were treated as a dividend in the accompanying consolidated financial statements.) Western was a subsidiary of Conseco between its acquisition in 1987 and the consummation of the Reorganization.
The accompanying consolidated financial statements include Western National Corporation and its subsidiaries. Intercompany balances and transactions have been eliminated. The consolidated statements of operations, changes in shareholders' equity and cash flows for the periods prior to the Reorganization are presented as if Western had been a part of the Company. As such, results of operations and cash flows of the Company and Western have been combined at historical values. Certain consolidated financial statement items have been reclassified to conform to the current year's presentation.
reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Fixed maturity investments ("fixed maturities") are debt securities that have original maturities greater than one year and comprise investments such as U.S. Treasury securities, mortgage-backed securities, asset-backed securities, corporate bonds and redeemable preferred stocks. Equity securities include common and non-redeemable preferred stocks. The Company follows the provisions of Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities ("SFAS 115"), and, accordingly, classifies its fixed maturities and equity securities into the following categories:
- Actively managed fixed maturities and equity securities are securities that may be sold prior to maturity due to changes that might occur in market interest rates, changes in prepayment risk, the Company's management of its income tax position, general liquidity needs, increase in loan demand, the need to increase regulatory capital or similar factors. Actively managed securities are carried at estimated fair value and the net unrealized gains (losses) are recorded as a component of shareholders' equity, net of tax and related adjustments described below. All of the Company's fixed maturities and equity securities were classified as actively managed as of December 31, 1996, compared to all but $1.1 million at December 31, 1995.
Anticipated returns, including realized gains and losses, from the investment of policyholder balances are considered in determining the amortization of the cost of policies purchased and the cost of policies produced. When actively managed fixed maturity and equity securities are stated at fair value, an adjustment is made to the cost of policies purchased and the cost of policies produced equal to the change in amortization that would have been recorded if such securities had been sold at their fair value and the proceeds reinvested at current yields. Furthermore, if future yields expected to be earned on such securities decline, it may be necessary to increase certain insurance liabilities. Adjustments to such liabilities are required when their balances, in addition to future net cash flows including investment income, are insufficient to cover future benefits and expenses.
other financial instruments with original maturities of typically ninety days or less, are carried at amortized cost.
Western occasionally uses derivative financial instruments to alter interest rate exposure arising from mismatches between assets and liabilities. Certain of Western's fixed maturities are floating-rate instruments. Western has entered into interest rate swap contracts that effectively convert the floating-rate securities to fixed-rate instruments. Specifically, Western contracts with counterparties to exchange, at specified intervals, the difference between fixed-rate and floating-rate interest amounts calculated by reference to an agreed notional amount. Western has contracted to pay a floating rate and receive a fixed rate, with the net difference charged or credited as an adjustment to investment income. Interest rate swaps are reported in the consolidated balance sheet at fair value, since they are hedged against investments reported at fair value. Gains or losses on early termination of interest rate swaps are recorded if the related hedged investments are sold. If the hedged investments are not sold, the gains or losses are deferred and amortized over the shorter of the remaining original terms of the interest rate swaps or hedged investments. Western's investment guidelines provide that all swap contracts must be either (i) with parties rated "A" or better by a nationally recognized statistical rating service, and/or (ii) secured by collateral approved by Western's Investment Committee.
Because both sides of the transaction are entered into on the basis of short-term, money-market rates, dollar rolls involve no duration risk while providing an enhancement to investment income. Western's dollar rolls are accounted for as short-term investment borrowings, with the proceeds included in short-term investments. The carrying values of Western's investment borrowings are assumed to approximate estimated fair value.
Costs of producing new business (primarily commissions and certain costs of policy issuance and underwriting), which vary with and are primarily related to the production of new business, are deferred to the extent recoverable from future profits. Such costs are amortized with interest as follows:
- For immediate annuities with mortality risks, in relation to the present value of benefits to be paid;
- For traditional life contracts, in relation to future anticipated premium revenue using the same assumptions that are used in calculating the insurance liabilities.
Recoverability of the unamortized balance of the cost of policies produced is evaluated regularly. For universal life-type contracts and investment-type contracts, the accumulated amortization is adjusted (whether an increase or a decrease) whenever there is a material change in the estimated gross profits expected over the life of a block of business in order to maintain a constant relationship between cumulative amortization and the present value (discounted at the rate of interest that accrues to the policies) of expected gross profits. For most other contracts, the unamortized asset balance is reduced by a charge to income only when the sum of the present value of future cash flows and the policy liabilities is not sufficient to cover such asset balance. Expected gross profits used in determining the amortization pattern and recoverability of cost of policies produced is based on historical gross profits and management's estimates and assumptions regarding future investment spreads, maintenance expenses, and persistency of the block of business. The accuracy of the estimates and assumptions is affected by several factors, including factors outside the control of management such as movements in interest rates and competition from other investment alternatives. It is reasonably possible that conditions affecting the estimates and assumptions will change and that such changes will result in future adjustments to cost of policies produced.
For investment contracts without mortality risk (such as deferred annuities and immediate annuities with benefits paid for a period certain) and for contracts that permit the Company or the insured to make changes in the contract terms (such as single premium whole life and universal life), premium deposits and benefit payments are recorded as increases or decreases in a liability account rather than as revenue and expense. Amounts charged against the liability account for the cost of insurance, policy administration and surrender penalties are recorded as revenues. Interest credited to the liability account and benefit payments made in excess of the contract liability account balance are charged to expense.
Reserves for traditional and limited-payment contracts are generally calculated using the net level premium method and assumptions as to investment yields, mortality, withdrawals and dividends. The assumptions are based on projections of past experience and include provisions for possible adverse deviation. These assumptions are made at the time the contract is issued or, in the case of contracts acquired by purchase, at the purchase date.
Pursuant to a tax sharing agreement, the Company was included in Conseco's consolidated tax return beginning January 1, 1993. Under the agreement, income taxes were allocated based upon separate return calculations with certain adjustments. Commencing with the income tax reporting period ended December 31, 1994, Western National Corporation and its non-life insurance subsidiaries file a consolidated tax return and Western files a separate life insurance company tax return.
Deferred income taxes are provided for the future tax effects of temporary differences between the tax bases of assets and liabilities and their financial reporting amounts, measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. The Company provides a valuation allowance, if necessary, to reduce deferred tax assets, if any, to their estimated realizable value.
The following table sets forth the amortized cost and estimated fair value of fixed maturities as of December 31, 1996, based upon the source of the estimated fair value:
The following table sets forth the quality of total fixed maturities as of December 31, 1996, classified in accordance with the highest rating by a nationally recognized statistical rating organization or, as to $159.1 million of fixed maturities not commercially rated, based on ratings assigned by the National Association of Insurance Commissioners ("NAIC") as follows (for purposes of the table, and only for fixed maturities (at fair value) not commercially rated: NAIC Class 1 securities are included in the "A" rating; Class 2, "BBB-"; Class 3, "BB-"; and Classes 4-6, "B" and below):
The amortized cost and estimated fair value of fixed maturities (all actively managed) by contractual maturity as of December 31, 1996, were as follows:
Net realized gains (losses) for the years indicated were as follows:
(a) The collateral coupon rates are not meaningful as they reset periodically in accordance with changes in market interest rates. In addition, such security coupons have been swapped for fixed rate payments.
Asset-backed securities ("ABS") are securitized pools of assets, such as manufactured housing loans and credit card receivables, that are collateralized by the underlying loans. ABS are typically structured similarly to CMOs or MBS pass-throughs, but are usually not subject to as much prepayment risk as MBS. Senior-tranche ABS contain credit enhancement features that raise the quality of the ABS above that of the underlying loans. At December 31,1996, the aggregate carrying value of Western's ABS portfolio was $351.9 million, or 3.8% of total invested assets. The following table sets forth the carrying value of Western's ABS portfolio by collateral type as of December 31,1996:
During 1996, Western recognized $0.2 million of realized losses on mortgage loans, compared with none in 1995 and 1994. At December 31, 1996, Western had no nonperforming mortgage loans.
At December 31, 1996, Western held $208.5 million, or 2.2% of total invested assets, of credit-tenant loans ("CTLs"), compared to $249.7 million at year-end 1995. CTLs are mortgage loans for commercial properties which require, as stipulated by Western's underwriting guidelines, (i) the lease of the principal tenant to be assigned to Western (including the direct receipt by Western of the tenant's lease payments) and to produce adequate cash flow to fund the requirements of the loan and (ii) the principal tenant (or the guarantor of such tenant's obligations) to have a credit rating of generally at least "BBB" or its equivalent. The underwriting guidelines take into account such factors as the lease terms on the subject property; the borrower's management ability, including business experience, property management capabilities and financial soundness; and such economic, demographic or other factors that may affect the income generated by the property or its value. The underwriting guidelines also require a loan-to-value ratio of 75% or less. Because CTLs are principally underwritten on the basis of the creditworthiness of the tenant rather than on the value of the underlying property, they are classified as a separate class of securities for financial reporting purposes. As with commercial mortgage loans, CTLs are additionally secured by liens on the underlying property.
(e) Various, ranging from 3% to 6% in 1996 and 1995.
In the normal course of business, the Company seeks to limit its exposure to loss on any single policy and to recover a portion of benefits paid by ceding reinsurance to other insurance enterprises or reinsurers under excess coverage contracts. The Company has set its retention limit for acceptance of risk on life insurance policies at various levels up to $0.8 million. To the extent that reinsuring companies are unable to meet obligations under these agreements, the Company remains contingently liable. The Company evaluates the financial condition of its reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. Assets and liabilities relating to reinsurance contracts are reported gross of the effects of reinsurance. Reinsurance receivables and prepaid reinsurance premiums, including amounts related to insurance liabilities, are reported as assets.
Effective October 1, 1995, the Company recaptured certain annuity business with assets approximately equal to insurance liabilities of $72.8 million that had previously been ceded.
In October 1995, Western and AGLIC entered into a modified coinsurance agreement. Under the agreement, AGLIC issues the SPIAs, and 50% of each risk is reinsured to Western. Under this arrangement, Western reports its pro rata share of premiums and shares in its pro rata portion of the gain or loss on policies sold. Pursuant to this arrangement in 1996, Western assumed $90.9 million of premiums. The arrangement resulted in $91.3 million of revenues and expenses for Western in 1996. As of December 31, 1996, the funds held by reinsurer and the insurance liabilities resulting from this agreement were $96.6 million.
Additionally, included in other liabilities is $50.0 million and $57.6 million at December 31, 1996 and 1995, respectively, of outstanding borrowings under an unsecured credit agreement with a syndicate of banks, which matures in 2000 (the "Credit Agreement"). Under the Credit Agreement, the Company could borrow on a revolving basis an aggregate principal amount of up to $100.0 million as of December 31, 1996. Subsequent to year end, the borrowing base was increased to $150.0 million. At December 31, 1996, the interest rate under the Credit Agreement was either the agent bank's prime rate or LIBOR plus .375% (5.975% at December 31, 1996). The Credit Agreement contained certain provisions that required the Company to maintain specified levels of financial solvency during the term of the agreement, including provisions concerning its consolidated net worth, adjusted statutory capital and surplus, market capitalization, A.M. Best rating, and risk based capital levels.
The components of income tax included in the consolidated balance sheet are as follows:
Income tax expense differed from that computed at the applicable federal statutory rate (35% during 1996, 1995, and 1994) for the following reasons:
Notes payable: The estimated fair value is determined by discounting future cash flows based on the Company's current incremental borrowing rate for similar types of borrowing arrangements.
Generally, the net assets of Western available for transfer to the Company are limited to the amounts by which Western's net assets, as determined in accordance with statutory accounting practices, exceed minimum statutory capital requirements. Under Texas law, dividends that can be paid by Western to the Company during any twelve-month period without prior regulatory approval cannot exceed the greater of statutory net gain from operations (excluding realized gains on investments) for the preceding year or 10% of statutory surplus at the end of the preceding year. In 1997, Western can transfer up to $57.0 million in the form of dividends to the Company without seeking prior regulatory approval.
The components of the balance sheet caption "unrealized appreciation of investments, net" in shareholders' equity are summarized as follows:
The shares exercisable for vested options and the corresponding weighted average exercise price was 971,110 shares and $12.08, and 458,330 shares and $12.07 at December 31, 1996 and 1995, respectively.
The following table summarizes the information about stock options outstanding in December 31, 1996:
related Interpretations ("APB 25") in accounting for the measurement and recognition of the Plan's cost. However, pro forma disclosures as if the Company adopted the cost recognition provisions of SFAS 123 effective with awards granted since January 1, 1995, are required.
Under SFAS 123, compensation cost is measured at the grant date based on the fair value of the awards and is recognized over the service period, which is usually the vesting period. The fair value of options granted during 1996 and 1995 is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions used to calculate fair values of options awarded in both 1996 and 1995: (i) average dividend yield of .2%, (ii) expected volatility of 25.3%, (iii) expected life of five years, and (iv) an estimated risk-free interest rate, which is different for grants awarded on different grant dates, ranging from 5.3% to 7.7%.
The weighted average fair value of options granted was $5.08 and $3.80 during the years ended December 31, 1996 and 1995, respectively. The weighted average fair value of restricted stock awards granted was $17.14 and $12.38 during the years ended December 31, 1996 and 1995, respectively.
The Company leases office space and equipment under noncancellable operating leases. The approximate future minimum lease rental commitments under such leases as of December 31, 1996 are as follows (dollars in thousands):
Assessments are levied on Western from time to time by guaranty fund associations of states in which it is licensed to provide for payment of covered claims or to meet other insurance obligations, subject to prescribed limits, of insolvent insurance enterprises. Assessments are allocated to an insurer based on the ratio of premiums written by an insurer to total premiums written in the state. The terms of the assessments depend on how each guaranty fund association elects to fund its obligations. Assessments levied by certain states may be recoverable through a reduction in future premium taxes. Western provides a liability, net of discount and estimated premium tax offsets, for estimated future assessments of known insolvencies. Included in other liabilities is a reserve for guaranty fund assessments of $22.1 million, $29.2 million and $7.4 million, at December 31, 1996, 1995, and 1994, respectively. Western determines guaranty fund liabilities by utilizing a report prepared annually by the National Organization of Life and Health Insurance Guaranty Associations which provides estimates of assessments by insolvency. Management believes the provision for guaranty fund assessments is adequate for all known insolvencies, and does not currently anticipate the need for any material additions to the reserve for known insolvencies. However, it is reasonably possible that the estimates on which the provision is based will change and that such changes will result in future adjustments.
Based on current conditions and assumptions as to future events on all policies in force, approximately 6% to 7% of the cost of policies purchased as of December 31, 1996, excluding the effect of fair value adjustments for actively managed fixed maturities, is expected to be amortized in each of the next five years. The average discount rate for the cost of policies purchased was approximately 19% for the year ended December 31, 1996.
Earnings per common share for each quarter are computed independently of earnings per share for the year. Due to transactions affecting the number of shares outstanding during each quarter and due to the uneven distribution of earnings during the year, the sum of the quarterly earnings per share may not equal the earnings per share for the year.
Quarterly results of operations are based on numerous estimates, principally related to policy reserves, the amortization of cost of policies purchased, the amortization of cost of policies produced, and income taxes. Such estimates are revised quarterly and are ultimately adjusted to year-end amounts. When such revisions are determined, they are reported as part of operations of the current quarter. The Company recorded a provision for guaranty fund assessments of $24.5 million and amortization of cost of policies purchased and produced of $8.0 million from retrospective adjustments in the fourth quarter of 1995.
To the Board of Directors and Shareholders of Western National Corporation
CONDENSED FINANCIAL INFORMATION OF REGISTRANT FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994 (DOLLARS IN THOUSANDS)
In February 1994, the Company loaned approximately $1.1 million to an officer for the purchase of 100,000 shares of the Company's common stock under the terms of a promissory note bearing interest at the prime rate plus 1% with principal and accrued interest payable in February 1999. The note receivable is collateralized by the 100,000 shares purchased by the officer and has been recorded as a reduction to common stock and additional paid-in capital. The accompanying balance sheet as of December 31, 1995 has been restated to reflect the reclassification of the note receivable from other assets to common stock and additional paid-in capital. During 1996, the promissory note was contributed to a subsidiary of the Company.