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, 2004 follows. This discussion should be read in conjunction with the Company's consolidated financial statements and related notes beginning on page __ of this report.
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 accounting principles generally accepted in the United States of America, the Company is not permitted to increase the basis of impaired securities for subsequent recoveries in value.
Deferred Acquisition Costs ("DAC"). 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 DAC 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 regularly evaluates 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 DAC balance to the level it would have been if using the new assumptions from the inception date of each policy.
Future Policy Benefits. Because of the long-term nature of insurance contracts, the Company is liable for policy benefit payments many years into the future. The liability for future policy benefits represents estimates of the present value of the Company's expected benefit payments, net of the related present value of future net premium collections. For traditional life insurance contracts, this is determined by standard actuarial procedures, using assumptions as to mortality (life expectancy), morbidity (health expectancy), persistency, and interest rates, which are based on the Company's experience with similar products. The assumptions used are those considered to be appropriate at the time the policies are issued. An additional provision is made on most products to allow for possible adverse deviation from the assumptions assumed. For universal life and annuity products, the Company's liability is the amount of the contract's account balance. Account balances are also subject to minimum liability calculations as a result of minimum guaranteed interest rates in the policies. While management and Company actuaries have used their best judgment in determining the assumptions and in calculating the liability for future policy benefits, there is no assurance that the estimate of the liabilities reflected in the financial statements represents the Company's ultimate obligation. In addition, significantly different assumptions could result in materially different reported amounts. A discussion of the assumptions used to calculate the liability for future policy benefits is reported in Note 1, Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements.
Net investable cash flow is primarily invested in investment grade debt securities generating approximately 90% of total investment income, excluding derivatives in 2004. With the decline in interest rate levels over the past several years, mortgage loan income has declined as prepayments of principal balances have continued and new loan funding opportunities with interest rates at or above the Company's required yield levels for this type of investment have decreased. Other investment income for 2004 includes $1.5 million related to income received on various profit participation arrangements compared to $3.3 million reported in 2003 and insignificant amounts recorded in 2002. Despite the drop in 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.
The yield on average invested assets declined from 7.41% in 2002 to 6.98% in 2003 and down to 6.47% in 2004, excluding derivatives. This decline in yield is due to the overall interest rate declines in the market and the Company obtaining lower yields on newly invested funds. In addition, prepayments, calls, and maturities of debt securities have added to the yield decrease as funds in higher yielding securities are reinvested at lower yields. Net investment income performance is analyzed excluding the derivative income which is a common practice in the insurance industry in order to assess underlying profitability and results from ongoing operations. Refer to the Derivatives discussion following this section for a more detailed explanation.
Other income consists primarily of revenues associated with nursing home operations which recorded revenues of $8.3 million, $6.9 million, and $6.1 million in 2004, 2003, and 2002, respectively. A lawsuit settlement of $2.2 million was awarded to the Company relating to an investment previously owned and is included in other income for 2004.
The gains and losses from index options are due to stock market conditions, specifically the performance of the S&P 500 Index®. Index options are intended to act as hedges to match the returns on the S&P 500 Index®. With the rise or decline in this index, the index option values likewise rose or declined. While income from index options fluctuates with the index, the contract interest expense for the Company's equity-indexed products also fluctuates in a similar manner and direction relative to policyholder accounts. In 2004 and 2003, the stock market increased and the Company recorded gains from index options and consequently increased contract interest expenses. However, in 2002, the S&P 500 Index® decreased resulting in index option losses and a reduction in contract interest expenses. Note the performance of the S&P 500 Index® relative to the index options gains and losses in the table below.
Contract interest also includes the performance of the derivative component of the Company's equity-indexed products. As previously noted, the recent market performance of these derivative features increased contract interest expense while also increasing the Company's investment income given the hedge nature of the options. During 2002, the reverse was noted, as the S&P 500 Index was down resulting in lower investment income and contract interest expense. With these credited rates, the Company generally realized its targeted interest spread on its products.
Federal Income Taxes. Federal income taxes on earnings from continuing operations for 2004, 2003, and 2002 reflect effective tax rates of 33.9%, 32.9%, and 33.1%, respectively, which are lower than the expected Federal rate of 35% primarily due to tax-exempt investment income related to investments in municipal securities and dividends-received deductions on income from stock investments.
The Company's U.S. operations have typically emphasized annuity product sales over life product sales but recent efforts have been made to attract new independent agents and to promote life products to improve domestic sales. It is the Company's goal to increase domestic life product sales through increased recruiting of new distribution and the development of new life insurance products. The Company had nearly 10,000 contracted agents as of December 31, 2004.
Policy benefits totaled $15.1 million, $16.0 million, and $14.6 million in 2004, 2003, and 2002, respectively, which are consistent with Company expectations. The face amount of domestic life insurance in force has declined from $2.8 billion at December 31, 2002 to $2.7 billion at December 31, 2003 and to $2.5 billion at December 31, 2004. 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 $20.3 million, $21.7 million, and $23.1 million for 2004, 2003, and 2002, respectively, as investment assets for the block of business decrease as the amount of business in force decreases.
As with domestic operations, revenues from the international life insurance segment include both premiums on traditional type products and revenues from universal life insurance. A comparative detail of premiums and contract revenues is provided below.
Derivative gains and losses fluctuate from period to period based on the S&P 500 Index® performance.
Other deferred annuity deposits decreased significantly in 2004 compared to 2003 with $350.7 million recorded in collected deposits compared to $674.4 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 $28.2 million and $43.9 million for the years ended December 31, 2004 and 2003, respectively. No sales inducements were deferred in 2002.
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 increase in other operating expenses, excluding this litigation claim, is due to the overall increase in annuity business and the allocation of corporate expenses to this line of business due to annuity operations becoming a greater portion of the Company's overall business volumes.
The Company's overall conservative investment philosophy is reflected in the allocation of its investments, which is detailed below as of December 31, 2004 and 2003. 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, 2004 and 2003, 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, 2004 and 2003. During 2003 and continuing into 2004, 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.
In addition to diversification, an important aspect of the Company's investment approach is managing the credit quality of its investments in debt securities. Thorough credit analysis is performed on potential corporate investments including examination of a company's credit and industry outlook, financial ratios and trends, and event risks. This emphasis is reflected in the high average credit rating of the Company's portfolio with 97.2% held in investment grade securities. In the table below, investments in debt securities are classified according to credit ratings by Standard and Poor's ("S&P®"), or other nationally recognized statistical rating organizations if securities were not rated by S&P®.
The Company is closely monitoring its other below investment grade holdings by reviewing investment performance indicators including information such as issuer operating performance, debt ratings, analyst reports and other economic factors that may affect these specific investments. While additional losses are not currently anticipated based on the existing status and condition of these securities, continued credit deterioration of some securities is possible, which may result in further writedowns. In addition, the future adoption of pending guidance from EITF Issue No. 03-1 could result in the recognition of additional other-than-temporary impairments based upon the ultimate guidance in this standard. No estimates or judgements can be made at his time; however, the Company is monitoring the progress relative to this proposed accounting standard.
During 2004 and 2003, the Company transferred securities with an amortized cost of $35.9 million and $12.8 million from held to maturity to available for sale due to credit deterioration resulting in $0.2 million and $0.1 million, respectively, of net unrealized gains reported as a separate component in accumulated other comprehensive income. No transfers were made in 2002 from the held to maturity category.
The contractual maturities of mortgage loan principal balances at December 31, 2004 are as follows:
In addition to the securities analyzed above, the Company invests in index options which are derivative financial instruments used to hedge the equity return component of the Company's equity-indexed annuity and life products. The values of these options are primarily impacted by equity price risk, as the options' fair values are dependent on the performance of the S&P 500 Index®. However, increases or decreases in investment returns from these options are substantially offset by corresponding increases or decreases in amounts paid to equity-indexed policyholders, subject to minimum guaranteed policy interest rates.
The Company's market risk liabilities, which include policy liabilities for annuity and supplemental contracts, are managed for interest rate risk through cash flow testing as previously described. As part of this cash flow testing, the Company has analyzed the potential impact on net earnings of a 100 basis point decrease and increases in increments of 100 basis points in the U.S. Treasury yield curve as of December 31, 2004. The potential impact on net earnings from these interest rate changes are summarized below.
The above contractual withdrawals, as well as the level of surrenders experienced, were 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.