Management’s discussion and analysis of financial condition and results of operations (“MD&A”) of National Western Life Insurance Company for the three years ended December 31, 2010 follows. This discussion should be read in conjunction with the Company’s consolidated financial statements and related notes beginning on page 69 of this report.
The Company provides life insurance products on a global basis for the savings and protection needs of policyholders and annuity contracts for the asset accumulation and retirement needs of contract holders both domestically and internationally. The Company accepts funds from policyholders or contract holders 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 that follows in this Item 7 includes these indicators and presents information useful to an overall understanding of the Company’s business performance in 2010, incorporating required disclosures in accordance with the rules and regulations of the Securities and Exchange Commission.
The unprecedented low U.S. Treasury yields in 2009 and 2010 combined with tightening credit spreads (difference between bond yields and risk-free interest rates) on fixed maturity securities produced new challenges in managing Company profitability given the resulting “compression” on our interest spreads (difference between the yield on investments and the amounts required to credit on associated policy values). Industry analysts and observers generally agree that a sudden jump in interest rate levels would be harmful to life insurers with interest-sensitive products as it could provide an impetus for abnormal product surrenders and withdrawals at the same time fixed debt securities held by insurers declined in market value. The federal government’s burgeoning deficit and “quantitative easing” initiatives have served to put upward pressure on longer term interest rates. It is uncertain what direction and at what pace interest rate movements may occur in the future and what impact, if any, such movements would have on the Company’s business, results of operations, cash flows or financial condition.
Deferred Policy Acquisition Costs (“DPAC”). The Company is required to defer certain policy acquisition costs and amortize them over future periods. These costs include commissions and certain other expenses that vary with and are primarily associated with acquiring new business. The deferred costs are recorded as an asset commonly referred to as deferred policy acquisition costs. The DPAC asset balance is subsequently charged to income over the lives of the underlying contracts in relation to the anticipated emergence of revenue or profits. Actual revenue or profits can vary from Company estimates resulting in increases or decreases in the rate of amortization. The Company performs regular evaluations of its universal life and annuity contracts to determine if actual experience or other evidence suggests that earlier estimates should be revised. Assumptions considered significant include surrender and lapse rates, mortality, expense levels, investment performance, and estimated interest spread. Should actual experience dictate that the Company change its assumptions regarding the emergence of future revenues or profits (commonly referred to as “unlocking”), the Company would record a charge or credit to bring its DPAC balance to the level it would have been if using the new assumptions from the inception date of each policy.
These assumptions are continually reviewed by the Company and adjustments may be made based upon current facts and circumstances.
Universal life and annuity contract revenues - Revenues for universal life and annuity contract revenues decreased 12.7% in 2010 compared to 2009 primarily due to lower surrender charges collected as a result of improved persistency of its business in force. Revenues for these products consist of policy charges for the cost of insurance, administration charges, and surrender charges assessed against policyholder account balances, less reinsurance premiums.
Net investment income (with and without derivatives) - A detail of net investment income is provided below.
In the midst of the financial crisis during 2008 liquidity in the credit market was significantly affected. This illiquidity, along with a concern for accelerated withdrawals and surrenders by policyholders, prompted the Company to maintain higher levels of cash and short-term investments than is typical. By 2009, the fear caused by the financial meltdown began to abate resulting in improved conditions in credit markets and less of a concern for premature policyholder withdrawals and surrenders. However, the decrease in short-term investment income in 2009 is not the result of holding lower levels of cash and short-term investments as much as it is to the very low interest rates available on money market funds during all of 2009. During 2010, the Company employed a strategy of investing short-term funds in alternative investment vehicles which yielded incremental interest income.
Although there was more activity in mortgage loan lending in 2010, the Company’s mortgage loan and policy loan balances outstanding have remained relatively stable over the past few years. Interest income earned on other invested assets increased due to new investments in collateralized loans made during the second half of 2010.
The declination in average invested asset yield, excluding derivatives, from 2008 to 2009 and to 2010 is due to the Company obtaining lower yields on newly invested cash inflows. As described above, the Company invests substantially most of its net cash flows in debt securities whose yields have declined during this period. The pattern in average invested asset yield, including derivatives, reflects increases and decreases in the fair value of index options purchased by the Company to support its fixed-indexed products. Fair values of the purchased call options increased markedly in 2009 due to the recovery in the equity markets. Although not as dramatic, fair values of options purchased during 2010 generally experienced favorable increases. Refer to the derivatives discussion following this section for a more detailed explanation.
Other revenues - Other revenues primarily pertain to the Company’s two nursing home operations in Reno, Nevada and San Marcos, Texas. Revenues associated with these operations were $22.9 million, $15.7 million and $12.5 million in 2010, 2009 and 2008, respectively. The San Marcos nursing home began operations during the middle of calendar year 2009 contributing to the revenue growth incurred during the three year period. Other revenues also include $1.5 million received during 2010 in relation to investment security lawsuit settlements.
Net realized investment gains (losses) - Realized gains (losses) on investments include impairment write-downs on real estate and investments in debt securities as well as valuation allowances recorded on mortgage loans. The net investment gains reported in 2010 consisted of gross gains of $6.9 million, primarily from calls and sales of debt securities, offset by gross losses of $1.4 million, which includes other-than-temporary impairment losses.
Debt security impairments in 2010 primarily include write-downs on asset-backed securities whose cash flows and fair values did not support the amortized cost basis at which the instruments were recorded in the financial statements. Debt security impairments in 2009 and 2008 included similar impairment write-downs on certain asset-backed securities in addition to impairment losses on several corporate debt securities.
Equity impairments represent mark-to-market write-downs on various equity holdings. The Company’s practice is to impair equity security holdings whose market value declines more than 50% below their cost basis. The equity write-down in 2008 includes Fannie Mae and Freddie Mac preferred stock impairments of $4.6 million.
Life and other policy benefits - Life and other policy benefits include death claims of $32.9 million, $30.2 million and $29.6 million for 2010, 2009 and 2008, respectively. While death claim amounts are subject to variation from period to period, the Company’s mortality experience has generally been consistent with or better than its product pricing assumptions. In January 2010, the country of Haiti, where the Company is licensed to sell its products, sustained a severe earthquake in its major city of Port-au-Prince. Death claims received by the Company as a result of this incident approximated $3.1 million after reinsurance and are included in life and other policy benefits for 2010. In February 2010, an earthquake occurred in the country of Chile whose residents include policyholders of the Company. No death claims were received as a result of this incident.
The Company has been implementing new actuarial reserving systems the past several years that will enhance its ability to provide estimates used in establishing future policy liabilities, monitor the deferred acquisition costs and deferred sales inducement assets as well as support other actuarial processes within the Company. The Company has been installing a vendor software product for use in calculating the GAAP reserve liability for future policy benefits of its products. The vendor system provides actuarial formula calculations producing refined estimates of reserves in accordance with GAAP. The previous reserving system produced estimated liabilities on state regulated actuarial formulas which were supplemented with adjustments in order to produce GAAP reserve estimates. The Company elected to purchase and install the new reserving system as growth in its lines of businesses created a need for more refined and controlled actuarial reserve computations in accordance with GAAP. The implementation of these new reserving systems for specific blocks of business began in the second quarter of 2009 and is expected to be completed in 2011. As the Company applies these new systems to a line of business, current reserving assumptions are reviewed and updated as appropriate. During the year ended December 31, 2009, loss recognition testing was performed on certain products that were converted to the new reserving system. As a result of the loss recognition testing, unlocking of historical assumptions resulted in an increase of $11.6 million in reserves and policy benefit expenses. Specifically, the Company unlocked assumptions for discount interest rates which accounted for $7.8 million of the increase as well as mortality assumptions which accounted for the remaining $3.8 million.
The following table identifies the effects of unlocking and true-up adjustments on DPAC balances recorded through amortization expense for 2010, 2009 and 2008.
An unlocking adjustment was also recorded in 2008 which resulted in an increase of amortization by $6.3 million. This unlocking adjustment was based upon assumption changes to future annuitizations and full surrenders reflecting current experience studies. 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. The Company is required to periodically adjust for actual experience that varies from that assumed.
The Company has been involved in major information system initiatives to enhance actuarial, accounting, policy acquisition, and policy administration processes. Costs related to these systems are capitalized during the development process and then amortized once they are placed into service and used in operations. Amortization expense in association with these system implementations was $2.6 million in 2010 and $2.1 million in 2009.
Nursing home operation expenses were $20.1 million, $15.1 million and $11.4 million in 2010, 2009 and 2008, respectively. The increase in nursing home expenses reflects the commencement of operations for the San Marcos, Texas facility during the second quarter of 2009.
A summary of segment earnings from continuing operations for the years ended December 31, 2010, 2009 and 2008 is provided below. The segment earnings exclude realized gains and losses on investments, net of taxes.
A comparative analysis of results of operations for the Company's domestic life insurance segment is detailed below.
As noted previously in the discussion of results from consolidated operations, the Company records true-up adjustments to DPAC balances each period to reflect current policy lapse or termination rates, expense levels and credited rates on policies as compared to anticipated experience with the adjustment reflected in current period amortization expense. To the extent required, the Company may also record unlocking adjustments to DPAC balances. The following table identifies the effects of unlocking and true-up adjustments on domestic life insurance DPAC balances recorded through amortization expense for 2008, 2009 and 2010.
The unlocking adjustment in 2009 was made to adjust future assumptions concerning per policy maintenance expenses and mortality and accordingly increased DPAC amortization expense by $2.7 million during the period.
A comparative analysis of results of operations for the Company's international life insurance segment is detailed below.
The Company’s international life operations have been a significant factor in the Company’s overall earnings performance and represent a market niche where the Company believes it has a competitive advantage. A productive distribution force of independent broker agents and consultants has been developed given the Company’s longstanding reputation for supporting its international life products coupled with the instability of competing companies in international markets. In general, universal life revenues and operating earnings are anticipated to emerge with the amount of international life insurance in force. Over the past three years, the volume of insurance in force has grown from $15.9 billion at December 31, 2008 to $16.2 billion at December 31, 2009 and over $17.3 billion at December 31, 2010.
The Company’s most popular international products have been its fixed-indexed universal life products in which policyholders can elect to have the interest rate credited to their policy account values linked in part to the performance of the S&P 500 Index®. Included in the totals in the above table are collected related premiums of $90.2 million, $81.9 million and $78.5 million for the years ended 2010, 2009 and 2008, respectively, associated with these fixed-indexed products.
Life and policy benefits primarily consist of death claims on policies. The Company’s clientele for international products are wealthy individuals with access to U.S. dollars and quality medical care. Consequently, the amounts of coverage purchased tend to be larger amounts. In the year ended December 31, 2010, the average face amount of insurance purchased was approximately $339,000. Life and policy benefit expense for the international life segment reflects the larger policies purchased. In addition, the expense shown for 2010 includes death claims of approximately $3.1 million, after reinsurance, associated with the Haiti earthquake in January 2010.
As noted previously, 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 2010, 2009 and 2008.
In 2010, the Company did not record any additional amortization expense related to the unlocking of assumptions. In addition, true-up adjustments were recorded during the year which increased the DPAC balance (decreasing amortization expense) reflecting actual experience improvements over assumptions. In 2009, the Company recorded an unlocking adjustment of $2.5 million relative to changes in projected universal life per policy maintenance expenses and projected mortality assumptions that reduced the DPAC asset and increased amortization expense.
As a selling inducement, many annuity products include a first year premium or interest rate bonus in addition to the base first year deposit interest rate. These bonuses are credited to the policyholder account but are deferred by the Company and amortized over future periods. The amount deferred was approximately $51.1 million, $36.8 million and $19.5 million for the years ended December 31, 2010, 2009 and 2008, respectively.
Life and policy benefits for the annuity segment includes reserves established for contracts in a payout mode with or without life contingencies. The new actuarial reserving systems that the Company has been implementing included this block of policies and they were converted to the new reserving system during 2009. As a part of this process historical assumptions pertaining to interest rates and mortality assumptions were “unlocked” for the block of policies resulting in an increase of $11.6 million in reserves and policy benefit expenses in 2009. As the Company’s block of annuity business grows more contracts convert to a payout status and the 2010 amount reflects the reserves established for those policies.
Consistent with the domestic and international life segments, the Company records true-up adjustments to DPAC balances each period to reflect current policy lapse or termination rates, expense levels and credited rates on policies as compared to anticipated experience as well as unlocking adjustments as necessary.. The following table identifies the effects of unlocking and true-up adjustments on annuity DPAC balances recorded through amortization expense for 2008, 2009 and 2010.
True-up adjustments for year ended December 31, 2008 of $11.1 million were higher than historical levels. During this period, in addition to recurring true-up adjustments for contract surrenders and partial withdrawal activity, the Company made adjustments to reflect rapidly changing portfolio investment yields and crediting rates in the wake of the bottoming out of market interest rate levels.
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. Nursing home operations generated $2.8 million, $0.8 million and $1.1 million of operating earnings in 2010, 2009, and 2008, respectively, reflecting the commencement of operations of the San Marcos facility in the middle of calendar year 2009. Income from the Company's subsidiaries includes gross income distributions from a life interest in a trust approximating $4 million per year.
The Company’s investment portfolio increased 18% to $7.7 billion at December 31, 2010 compared to $6.5 billion at December 31, 2009 due to positive cash flows from operating and financing activities. The primary driver of the increase was the record annuity sales year in 2010 with over $1.4 billion in deposits collected. Although lesser in scope, the increase in investments includes improved security fair market values as a result of a decline in interest rates and, to a smaller extent, credit spread tightening. The unrealized gain position of the Company’s securities available for sale portfolio, which is reported at fair market value, increased from $82.7 million at December 31, 2009 to $168.5 million at December 31, 2010.
Substantially all of the Company’s investable cash flows are directed toward the purchase of 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 provides an appropriate strategy for managing cash flows. Debt securities purchased to fund insurance company operations are summarized below.
The effective annual yield shown is the yield calculated to the “worst-call date”. For callable bonds, the worst-call date is the call or maturity date that produces the lowest yield.
As National Western does not purchase below investment grade securities, the investments held in debt securities below investment grade are the result of subsequent downgrades of the securities. These holdings are summarized below.
Holdings in below investment grade securities by category as of December 31, 2010 are summarized below, including 2010 and 2009 fair values for comparison. The Company is continually monitoring developments in these industries that may affect security valuation issues.
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, 2010, approximately 31% 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.
As of April 1, 2009, the Company adopted the GAAP guidance on the recognition and accounting for other-than-temporary impairments due to credit loss versus non-credit losses. See Note 1, Summary of Significant Accounting Policies, and Note 3, Investments, in the accompanying consolidated financial statements for further discussion. Since adoption of this new guidance, the Company recognized $8.7 million of other-than-temporary impairments; of which $0.3 million was deemed credit related and recognized as realized investment losses in earnings, and $8.4 million was deemed a non credit related impairment and recognized in other comprehensive income.
The Company holds approximately $64.9 million in asset-backed securities as of December 31, 2010. This portfolio includes $30.1 million of manufactured housing bonds and $34.8 million of home equity loans (also referred to as subprime securities). The Company does not have any holdings in collaterized bond obligations (“CBO”s), collateralized debt obligations (“CDO”s), or collateralized loan obligations (“CLO”s). Principal risks in holding asset-backed securities are structural, credit, and capital market risks. Structural risks include the securities’ priority in the issuer’s capital structure, the adequacy of and ability to realize proceeds from collateral and the potential for prepayments. Credit risks include corporate credit risks or consumer credit risks for financing such as subprime mortgages. Capital market risks include the general level of interest rates and the liquidity for these securities in the marketplace.
The Company requires a minimum specified yield on mortgage loan investments. Until recently the low interest rate environment resulted in fewer loan opportunities being available which met the Company's required rate of return. This environment has recently started to change in 2010 and the Company increased its new mortgage loan activity which resulted in an increase of $68.5 million in total loans at the 2010 year-end.
The Company's direct investments in real estate are not a significant portion of its total investment portfolio as most of these investments were acquired through mortgage loan foreclosures. Due to the bankruptcy filing by Circuit City in 2009, the Company foreclosed on one mortgage loan each during 2010 and 2009. The Company also participates in several real estate joint ventures and limited partnerships that invest primarily in income-producing retail properties. These investments have enhanced the Company's overall investment portfolio returns.
The increase in the greater than 90% category in 2010 compared to 2009 is related to new loans made with a long standing borrower which are backed by the investment property, contracted leases and the guarantee of the borrower.
The Company does not recognize interest income on loans past due ninety days or more. The Company had one mortgage loan past due six months or more with a principal balance totaling $7.0 million at December 31, 2010 and two loans in 2009 with total principal balance of $7.0 million. There was no interest income not recognized in 2010 and 2009 for past due loans and approximately $0.4 million not recognized in 2008.
Derivative instruments totaling $80.3 million at December 31, 2010 and $89.9 million at December 31, 2009 consist of call options purchased to support the interest crediting mechanism on the Company’s fixed-indexed annuity and life products. The call options act as hedges to match closely the returns on the underlying index or indices that serve as the basis for the amounts which may be credited to policyholders. The index options are reported at fair value on the reporting date in the Company’s consolidated financial statements and are purchased from a select group of counterparties who maintain high credit ratings and who enter credit support agreements for option values in excess of specified limits. The Company has never incurred a loss on index options due to counterparty default.
A gradual increase in interest rates from current levels is generally 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 will 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.
During 2010, market interest rates of the ten-year U.S. Treasury bond decreased 54.4 basis points from year end 2009 which would generally be expected to produce unrealized gains in a fixed income debt security portfolio in and of itself. Additionally, the improved liquidity in the corporate bond market during 2010 resulted in the spread between corporate bonds and treasury securities narrowing which caused prices of the Company’s corporate bonds to further rise. These two factors combined to increase the unrealized gain balance by $212.1 million on a portfolio of approximately $7.4 billion at December 31, 2010. The Company would expect similar results in the future from a significant upward or downward movement in market rates. However, since the majority of the Company's debt securities are classified as held to maturity, which are recorded at amortized cost, changes in fair values have relatively small effects on the Company's financial results.
The Company has the ability to adjust interest rates, participation rates, and asset fees and caps, as applicable, in response to changes in investment portfolio yields for a substantial portion of its business in force. The ability to adjust these rates is subject to competitive forces in the market for the Company’s products. Surrender rates could increase and new sales could be negatively affected if crediting rates are not competitive with the rates offered on competing products offered by other insurance companies and financial service entities. The Company designs its products with features encouraging persistency. Interest sensitive life and annuity products have surrender and withdrawal penalty provisions. Depending on the products, surrender charge rates on annuity contracts sold or in force range up to 25% and surrender charge periods up to 15 years. Typically, surrender charge rates gradually decrease each year the contract is in force
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, 2010. 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.
In the past, cash flows from the Company's insurance operations have been sufficient to meet current needs. Cash flows from operating activities were $179 million, $138 million and $195 million in 2010, 2009 and 2008, respectively. The Company also has significant cash flows from both scheduled and unscheduled investment security maturities, redemptions, and prepayments. These cash flows totaled $911 million, $1,050 million and $727 million in 2010, 2009 and 2008, respectively. Cash flows from security maturities, redemptions, and prepayments were relatively higher over the last three years due to the decline in interest rates. These cash flow items could be reduced if interest rates rise in 2011. Net cash flows from the Company's universal life and annuity deposit product operations totaled $856 million, $337 million and $(118) million in 2010, 2009 and 2008, respectively.
The Company relies on stockholders' equity for its capital resources as there is no long-term debt outstanding and the Company does not anticipate the need for any long-term debt in the near future. As of December 31, 2010, the Company had no commitments beyond its normal operating and investment activities. The Company has declared and paid an annual dividend on its common shares since 2005 although its practice remains to reinvest earnings internally to finance the development of new business. The ability to pay dividends is limited by law in the state of Colorado to earned profits (statutory unassigned surplus). At December 31, 2010 the maximum amount legally available for distribution without further regulatory approval is $87.4 million.
On June 12, 2009 the FASB issued new guidance that changes the way entities account for securitizations and special purpose entities. The guidance is effective as of the beginning of the Company’s first annual reporting period beginning after November 15, 2009 and did not have a significant impact on the consolidated financial position, results of operations or disclosures.
During July 2010 the FASB issued new guidance that requires additional disclosures related to an entity’s financing receivables and the nature of its credit risks related to financing receivables. The effective date is for interim and annual periods ending after December 15, 2010. The adoption of this guidance was effective December 31, 2010. See Note 3 Investments, of the accompanying consolidated financial statements for additional disclosures.
For each security, the Company developed its best estimate of the net present value of the cash flows expected to be received. The credit component of the impairment for these securities was determined to be the difference between the amortized cost of the security and the projected net cash flows. The non-credit component was determined to be the difference between projected net cash flows and fair value. The Company also determined whether management had the intent to sell the security, or if it was more likely than not that it will be required to sell the security, prior to the recovery of the non-credit component.