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, 2005 follows. This discussion should be read in conjunction with the Company's consolidated financial statements and related notes beginning on page 59 of this report.
The Company provides life insurance products for the savings and protection needs of policyholders and annuity contracts for the asset accumulation and retirement needs of contractholders both domestically and internationally. The Company accepts funds from policyholders or contractholders and establishes a liability representing future obligations to pay the policy or contract-holders and their beneficiaries. To ensure the Company will be able to pay these future commitments, the funds received as premium payments and deposits are invested in high quality investments, primarily fixed income securities.
Impairment of Investment Securities. The Company's accounting policy requires that a decline in the value of a security below its amortized cost basis be evaluated to determine if the decline is other-than-temporary. The primary factors considered in evaluating whether a decline in value for fixed income and equity securities is other-than-temporary include: (a) the length of time and the extent to which the fair value has been less than cost, (b) the financial conditions and near-term prospects of the issuer, (c) whether the debtor is current on contractually obligated principal and interest payments, and (d) the intent and ability of the Company to retain the investment for a period of time sufficient to allow for any anticipated recovery. In addition, certain securitized financial assets with contractual cash flows are evaluated periodically by the Company to update the estimated cash flows over the life of the security. If the Company determines that the fair value of the securitized financial asset is less than its carrying amount and there has been a decrease in the present value of the estimated cash flows since the previous estimate, then an other-than-temporary impairment charge is recognized. When a security is deemed to be impaired a charge is recorded as net realized losses equal to the difference between the fair value and amortized cost basis of the security. Once an impairment charge has been recorded, the fair value of the impaired investment becomes its new cost basis and the Company continues to review the other-than-temporarily impaired security for appropriate valuation on an ongoing basis. Under U.S. generally accepted accounting principles, the Company is not permitted to increase the basis of impaired securities for subsequent recoveries in value.
The Company's consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles ("GAAP"). In addition, the Company regularly evaluates operating performance using non-GAAP financial measures which exclude or segregate derivative and realized investment gains and losses from operating revenues and earnings. Similar measures are commonly used in the insurance industry in order to assess profitability and results from ongoing operations. The Company believes that the presentation of these non-GAAP financial measures enhances the understanding of the Company's results of operations by highlighting the results from ongoing operations and the underlying profitability factors of the Company's business. The Company excludes or segregates derivative and realized investment gains and losses because such items are often the result of events which may or may not be at the Company's discretion and the fluctuating effects of these items could distort trends in the underlying profitability of the Company's business. Therefore, in the following sections discussing consolidated operations and segment operations, appropriate reconciliations have been included to report information management considers useful in enhancing an understanding of the Company's operations to reportable GAAP balances reflected in the consolidated financial statements.
Revenues for universal life and annuity products consist of policy charges for the cost of insurance, administration charges, and surrender charges assessed against policyholder account balances, less reinsurance premiums. The Company has experienced modest growth in its block of business, most notably in international universal life products. This growth contributes to higher revenues in the form of cost of insurance charges which were $63.3 million compared to $60.1 million in 2004, and $55.6 million in 2003. Administrative charges were $15.0 million, $13.0 million, and $9.3 million for the years ended December 31, 2005, 2004, and 2003, respectively. Surrender charges assessed against policyholder account balances upon withdrawal were $25.1 million in 2005 compared to $23.4 million in 2004 and $21.6 million in 2003.
Net investable cash flow is primarily invested in investment grade debt securities generating approximately 91.4% of total investment income, excluding derivatives in 2005. The mortgage loan investment balance has been steadily declining over the past several years due to the low interest rate environment, which has resulted in loan pre-payments and a decrease of new loan fundings. As a result, investment income from mortgage loans has declined from $15.1 million in 2003 to $12.5 million in 2004 and down to $9.7 million in 2005. Other investment income for 2005 includes $2.8 million related to income received on various profit participation arrangements compared to $1.5 million reported in 2004 and $3.3 million recorded in 2003. Despite the low interest rate levels, the Company generated comparable higher net investment earnings due to increasing invested asset balances. In addition, investment expenses have remained relatively level during this time frame.
Realized Gains (Losses) on Investments. The net gains reported in 2005 consisted of gross gains of $12.2 million primarily from calls and sales of debt securities, sale of real estate during the year, and gross losses of $2.3 million resulting from, most notably, an additional impairment writedown on Delta Airline debt securities of $1.6 million. Other impairments include an asset-backed security ($0.2 million) due to underlying cash flow deteoriation and an investment in a New Orleans utility ($0.2 million). In past years, the losses on investments have primarily resulted from impairment writedowns on investments in debt securities. The Company records impairment writedowns when a decline in value is considered other-than-temporary and full recovery of the investment is not expected. Total impairment writedowns in 2005, 2004, and 2003 totaled $2.0 million, $3.6 million, and $7.2 million, respectively. In 2004, the Company recorded an impairment writedown on Delta Airline debt securities of $3.6 million. Writedowns in 2003 included holdings of American Airlines ($3.1 million), Lukens ($0.8 million) and collaterialized bond obligation ("CBO") investments ($3.3 million).
A summary of segment earnings from continuing operations for the years ended December 31, 2005, 2004, and 2003 is provided below. The segment earnings exclude realized gains and losses on investments, net of taxes.
Policy benefits totaled $14.9 million, $15.1 million, and $16.0 million in 2005, 2004, and 2003, respectively, which are consistent with Company expectations. The face amount of domestic life insurance in force has declined from $2.7 billion at December 31, 2003 to $2.5 billion at December 31, 2004 and 2005. Absent the growth rates targeted by management, the block of business will continue to contract due to the normal incidence of terminations from death or surrender with lower earnings resulting. Net investment income declined reporting $20.0 million, $20.3 million, and $21.7 million for 2005, 2004, and 2003, respectively, as investment assets for the block of business decrease as the amount of business in force decreases.
A detail of net investment income for international life insurance operations is provided below.
International sales during 2005 reflect Brazil, Argentina, and Taiwan as the top three international countries based on premiums and contract revenues recorded. Management expects sales growth internationally to trend at a steadier pace from the levels reported in recent years. As the international life insurance in force continues to grow, the Company anticipates operating earnings to similarly increase. The amount of international life insurance in force has grown from $10.2 billion at December 31, 2003 to $11.3 billion at December 31, 2004 and to $12.2 billion at December 31, 2005.
Other deferred annuity deposits decreased in 2005 compared to 2004 with $236.3 million recorded in collected deposits compared to $350.7 million, respectively. Fixed-rate annuity products became popular with consumers during 2003 as these products yielded a stable and competitive interest rate. As a selling inducement, many of these products include a first year interest bonus in addition to the base interest rate. These bonus rates are credited to the policyholder account but are deferred by the Company and amortized over future periods. The amount deferred was approximately $21.2 million, $27.5 million, and $43.9 million for the years ended December 31, 2005, 2004, and 2003, respectively.
Other operating expenses for 2004 reflect a reduction of $6.5 million for a charge recorded in the prior year. A $9.7 million charge was initially recorded in 2003 relating to a litigation claim which involved certain annuity products, and actual settlement payments made were $3.2 million during 2004.
The Company acquired a nursing home facility, which opened in late July, 2000 and is operated by an affiliated limited partnership, whose financial operating results are consolidated with those of the Company. Daily operations and management of the nursing home are performed by an experienced management company through a contract with the limited partnership. Nursing home operations generated $1.3 million, $1.1 million, and $0.9 million of operating earnings in 2005, 2004, and 2003, respectively.
The Company's overall conservative investment philosophy is reflected in the allocation of its investments, which is detailed below as of December 31, 2005 and 2004. The Company emphasizes investment grade debt securities, with smaller holdings in mortgage loans and policy loans.
The Company maintains a diversified portfolio which consists primarily of corporate, mortgage-backed, and public utilities fixed income securities. Investments in mortgage-backed securities include primarily U.S. government agency pass-through securities and collateralized mortgage obligations ("CMO"). As of December 31, 2005 and 2004, the Company's debt securities portfolio consisted of the following:
The Company's investment guidelines prescribe limitations as a percent of the total investment portfolio by type of security and all holdings were within these threshold limits at December 31, 2005 and 2004. During 2004 and continuing into 2005, the Company expanded its holdings of U.S. government and private mortgage-backed securities given attractive yields and spreads. Because the Company's holdings of mortgage-backed securities are subject to prepayment and extension risk, the Company has substantially reduced these risks by investing primarily in collateralized mortgage obligations, 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. 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.
Holdings in below investment grade securities by category as of December 31, 2005 are summarized below, including 2004 fair values for comparison. The Company is continually monitoring developments in these industries that would affect security valuations.
The Company held net investments in mortgage loans totaling $110.6 million and $124.7 million at December 31, 2005 and 2004, respectively. The diversification of the portfolio by geographic region and by property type was as follows:
In the fourth quarter of 2004, an impairment loss of $0.6 million and an additional allowance of $0.4 million was recorded related to a mortgage loan based on information which indicated that the Company may not collect all amounts in accordance with the mortgage agreement. This allowance was reversed in the first quarter of 2005 upon the sale of the loan. As of December 31, 2003, an allowance for possible losses on mortgage loans was $0.7 million. During the first quarter of 2004, this allowance was released due to a review of anticipated cash flows showing that all principal would be recovered. Management believes that the allowance for possible losses is adequate. While the Company closely manages its mortgage loan portfolio, future changes in economic conditions can result in impairments beyond those currently identified.
The Company's real estate investments totaled approximately $13.4 million and $17.2 million at December 31, 2005 and 2004, respectively, and consist primarily of income-producing properties which are being operated by a wholly-owned subsidiary of the Company. The Company recognized operating income on these properties of approximately $1.0 million, $1.6 million, and $1.8 million for the years ended December 31, 2005, 2004, and 2003, 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 $6.7 million, $2.2 million, and $0.9 million in 2005, 2004, and 2003, respectively associated with these properties.
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, 2005. 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 above contractual withdrawals, as well as the level of surrenders experienced, were generally consistent with the Company's assumptions in asset-liability management, and the associated cash outflows did not have an adverse impact on overall liquidity. Individual life insurance policies are less susceptible to withdrawal than annuity reserves and deposit liabilities because policyholders may incur surrender charges and undergo a new underwriting process in order to obtain a new insurance policy. Cash flow projections and tests under various market interest rate scenarios are also performed to assist in evaluating liquidity needs and adequacy. The Company currently expects available liquidity sources and future cash flows to be more than adequate to meet the demand for funds.
The Company relies on the accumulated earnings in stockholders' equity for its capital resources as it has no long-term debt outstanding and does not anticipate the need for any long-term debt in the near future. There are also no current or anticipated material commitments for capital expenditures in 2006. At December 31, 2005, the Company had commitments of approximately $1.0 million for the purchase of land for the future construction of a nursing home facility. The land acquisition is expected to be completed in the first quarter of 2006. Construction costs are expected to begin during 2006.
In March 2004, the Emerging Issues Task Force ("EITF") reached a final consensus on Issue 03-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments. This Issue establishes impairment models for determining whether to record impairment losses associated with investments in certain equity and debt securities and requires expanded disclosures related to securities with unrealized losses. It also requires income to be accrued on a level-yield basis following an impairment of debt securities, where reasonable estimates of the timing and amount of future cash flows can be made. The Company's current policy has generally been to record income only as cash is received following an impairment of a debt security. The application of this Issue was required for reporting periods beginning after June 15, 2004. In September 2004, the FASB approved FASB Staff Position EITF 03-1-1, which deferred the effective date for the recognition and measurement guidance contained in EITF 03-1 until certain issues were resolved. On November 3, 2005 the FASB issued FASB Staff Position ("FSP") Nos. FAS 115-1 and FAS 124-1 titled The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. This FSP nullifies certain requirements of EITF 03-1 and carries forward certain requirements and disclosures. The guidance in this FSP shall be applied to reporting periods beginning after December 15, 2005. The Company has adopted the disclosure provisions and has included the required disclosures for 2005 and 2004. The Company will adopt FSP Nos. FAS 115-1 and FAS 124-1 as of the beginning of fiscal year 2006 and does not expect this FSP to have a material impact on the consolidated financial statements.
EITF No. 99-20 Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets requires the Company to periodically review changes in future cash flow expectations and account for interest income using the prospective effective yield-method. EITF 99-20 includes specific guidance regarding impairment of asset backed securities that do not fall under the SOP 03-3 guidance noted above.