The Company leases approximately 72,000 square feet of office space in Austin, Texas, for $477,600 per year plus taxes, insurance, maintenance, and other operating costs. This lease expires in 2000. National Western is currently negotiating to extend this existing lease. Lease costs and related operating expenses for office facilities of the Company's subsidiaries are not significant in relation to the Company's consolidated financial statements.
There are inherent risks of conducting international business that are not present within the domestic market. The risks involved with international business are reduced substantially by the Company in several ways. As previously described, the Company focuses its marketing efforts on a specific niche group, which is foreign nationals in upper socioeconomic classes who have substantial financial resources. This targeted customer base coupled with National Western's conservative, yet competitive, underwriting practices have historically resulted in claims experience similar to that in the United States. The Company also minimizes exposure to foreign currency risks, as almost all foreign policies require payment of premiums and claims in United States dollars. Finally, the Company's experience in the international market and its strong broker-agent relationships, which in many cases exceed 20 years, help minimize risks and problems when selling products to foreign nationals.
Investments in debt and equity securities are classified and reported as either securities held to maturity or securities available for sale. The Company does not maintain a portfolio of trading securities. The reporting category chosen for the Company's securities investments depends 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. At December 31, 1998, approximately 26% of the Company's total debt and equity securities, based on fair values, were classified as securities available for sale. These holdings provide flexibility to the Company to react to market opportunities and conditions and to practice active management within the portfolio to provide adequate liquidity to meet policyholder obligations and other cash needs.
The amortized cost and estimated fair values of investments in debt securities at December 31, 1998, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
As of December 31, 1998, CMOs represent approximately 92% of the Company's mortgage-backed securities. The CMOs in the Company's portfolio have been modeled and subjected to detailed, comprehensive analysis by the Company's investment staff. The overall structure of the CMO as well as the individual tranche being considered for purchase have been evaluated to ensure that the security fits appropriately within the Company's investment philosophy and asset/liability management parameters. The Company's investment mix between mortgage-backed securities and other fixed income securities helps effectively balance prepayment, extension, and credit risks.
In addition to managing prepayment, extension, and call risks, the Company closely manages 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. The Company continues to follow its conservative investment philosophy by minimizing its holdings of below investment grade debt securities, as these securities generally have greater default risk than higher rated corporate debt. These issuers usually are more sensitive to adverse industry or economic conditions than are investment grade issuers. The Company's small holdings of below investment grade debt securities are summarized below.
The Company's strong credit risk management and commitment to quality has resulted in minimal defaults in the debt securities portfolio in recent years. In fact, at December 31, 1998 and 1997, no securities were in default and on nonaccrual status, and at December 31, 1996, securities totaling only $2,945,000 were in such status.
At December 31, 1998, unrealized gains in the Company's debt and equity securities portfolios were as follows:
As detailed above, debt securities classified as held to maturity comprise the majority of the Company's securities portfolio, while equity securities continue to be a small component of the portfolio. Unrealized gains totaling $134,241,000 on the securities portfolio at December 31, 1998, is a reflection of market interest rates at year-end. The fair values, or market values, of fixed income debt securities correlate to external market interest rate conditions. Because the interest rates are fixed on almost all of the Company's debt securities, market values typically increase when market interest rates decline, and decrease when market interest rates rise. This correlation between market values and interest rates is reflected in the tables below.
Changes in fair values of securities due to changes in market interest rates is an example of market risk. Market risk is the risk of change in market values of financial instruments due to changes in interest rates, currency exchange rates, commodity prices, or equity prices. The most significant market risk exposure for National Western is interest rate risk. The Company manages interest rate risk through on-going cash flow testing required for insurance regulatory purposes. Computer models are used to perform cash flow testing under various commonly used stress test interest rate scenarios to determine if existing assets would be sufficient to meet projected liability outflows. Management strives to closely match the durations of its assets and liabilities. Sensitivity analysis allows the Company to measure the potential gain or loss in fair value of its interest-sensitive instruments and to seek to protect its economic value and achieve apredictable spread between what is earned on invested assets and what is paid on liabilities. The Company seeks to minimize the impact of interest risk through surrender charges that are imposed to discourage policy surrenders. Interest rate changes can be anticipated and risk may be limited due to management actions regarding asset and liability instruments. However, potential changes in the values of financial instruments indicated by hypothetical interest changes will likely be different from actual changes experienced, and the differences may be material.
Market risk-sensitive assets include debt securities, equity securities which are almost entirely preferred stocks, mortgage loans, policy loans, and index options. The Company does not maintain a securities trading portfolio. Market risk-sensitive liabilities include policy liabilities for deferred and immediate investment annuity contracts and supplemental contracts. Sensitivity analysis expresses the potential gain or loss in fair value, over a selected time period, from one or more selected hypothetical changes in interest rates which are reasonably possible in the near term. The following table illustrates the market risk sensitivity of the Company's interest rate- sensitive assets. The table measures the effect of a change in interest rates on the fair value of the portfolio. The data is prepared using models that measure the change in fair value arising from an immediate and sustained change in interest rates in increments of 100 basis points.
The debt securities portfolio includes primarily noncallable corporate bonds, mortgage-backed securities, and asset-backed securities. Expected maturities of debt securities may differ from contractual maturities due to call or prepayment provisions. The model assumes that prepayments on mortgage-backed securities are influenced by agency and pool types, the level of interest rates, loan age, refinancing incentive, month of the year, and underlying coupon. During periods of declining interest rates, principal payments on mortgage-backed securities and collateralized mortgage obligations increase as the underlying mortgages are prepaid. Conversely, during periods of rising interest rates, the rate of prepayment slows. Both of these situations can expose the Company to the possibility of asset/liability cash flow and yield mismatch. The model uses a proprietary method of sampling interest rate paths along with a mortgage prepayment model to derive future cash flows. The initial interest rates used are based on the current U.S. Treasury yield curve as well as current mortgage rates for the various types of collateral in the portfolio.
Mortgage 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, 1998. 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. As a result, these assumptions incorporate both Company experience and mortality assumptions associated with such contracts.
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 annuities. 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 Composite Stock Price Index (S&P 500 Index). However, increases or decreases in investment returns from these options are directly offset by corresponding increases or decreases in amounts paid to equity-indexed annuity policyholders.
The Company has modeled this scenario, as a decline in market interest rates could pose potential risks to the current profitability levels of this business. A downward movement in interest rates is also a reasonably possible near-term scenario. The risks from such a change are primarily due to possible lower interest rate spreads which are the differences between investment income earned and credited interest paid to policyholders. However, the relatively small projected impact to earnings of the interest rate change is a reflection on the effectiveness of the Company's asset/liability and interest risk management.
The Company currently places all loans past due three months or more on nonaccrual status, thus recognizing no interest income on the loans. At December 31, 1998 and 1997, the Company had no mortage loan principal balances on nonaccrual status. The Company had mortgage loan principal balances with restructured terms totaling approximately $12,096,000 and $12,463,000 at December 31, 1998 and 1997, respectively. For the years ended December 31, 1998 and 1997, the reductions in interest income due to nonaccrual and restructured mortgage loans were not significant.
The Company owns real estate that was acquired through foreclosure and through direct investment totaling approximately $13,553,000 and $15,027,000 at December 31, 1998 and 1997, respectively. This small concentration of properties represents less than one percent of the Company's entire investment portfolio. The real estate holdings consist primarily of income-producing properties which are being operated by the Company. The Company recognized operating income on these properties of approximately $740,000 and $716,000 for the years ended December 31, 1998 and 1997, respectively. The Company does not anticipate significant changes in these operating results in the near future.
A summary of operating results, net of taxes, for the years ended December 31, 1998, 1997, and 1996 is provided below:
1998 Consolidated Operating Results: For the year ended December 31, 1998, the Company recorded net earnings of $34,893,000 compared to net earnings of $41,572,000 for 1997. Earnings were lower due to nonrecurring items, the most significant of which was the bankruptcy settlement of the Company's wholly owned subsidiary, The Westcap Corporation, totaling $14,125,000. This settlement was reflected as a loss from discontinued brokerage operations in 1998. Losses on discontinued brokerage operations totaled $1,000,000 in 1997.
Also during 1998, the Company transferred pension obligations and administrative responsibilities of its nonqualified defined benefit plan to a pension administration firm. The financial effects of the transaction resulted in additional pension expense in 1998 totaling $1,653,000, net of taxes, as the amount paid upon transfer exceeded the recorded pension liabilities as required for financial reporting purposes. However, as a result of the transfer, substantially all future pension and administrative liabilities and expenses under the plan are now the responsibility of the new firm.
1997 and 1996 Consolidated Operating Results: For the year ended December 31, 1997, the Company recognized net earnings totaling $41,572,000, a decrease of 10.0% from 1996 earnings. The lower earnings in 1997 compared to 1996 were primarily due to higher life insurance benefit claims and amortization of deferred policy acquisition costs. Deferred policy acquisition costs, which are primarily capitalized agents' commissions, are amortized in direct relation to anticipated future gross profits on applicable life and annuity business. Increases in anticipated future gross profits resulted in retrospective adjustments to deferred policy acquisition costs, which lowered the amortization in 1996 relative to 1997 amounts. Additionally, other income in 1997 declined $1.5 million, net of taxes, as 1996 included nonrecurring income primarily due to litigation-related recoveries. Net earnings for 1997 also included losses from discontinued brokerage operations totaling $1,000,000 and realized losses on investments, net of taxes, totaling $1,032,000. No losses from discontinued brokerage operations were reported in 1996, but realized gains on investments totaling $1,048,000, net of taxes, were recorded.
As indicated by the table above, net investment income increased substantially in 1998 from the prior two years. However, excluding index options, net investment income during 1998 actually increased only 3.8% from 1997, while invested assets rose 8.2%. The lower investment income growth is attributable to several factors. As in previous years, market interest rates have continued to decline, which has affected yields on purchases of new debt securities. Mortgage loans have typically had significantly higher yields than the Company's investments in debt securities. However, mortgage loans continue to decline as a percentage of the investment portfolio and in actual amounts from previous years. Also, matured or prepaid mortgage loans are typically replaced with loans with lower interest rates.
As the Company is now selling equity-indexed annuities, net investment income for 1998 includes income from index options which totaled $8,057,000. The index options are derivative financial instruments used to hedge the equity return component of the Company's equity-indexed annuity products. Any gains or losses from the sale or expiration of the options, as well as period-to- period changes in fair values, are reflected as net investment income. The income from these options substantially offset the change in the related policyholder liabilities for the equity-indexed annuity products during 1998. Investment income from index options totaled only $18,000 in 1997, as the Company introduced the new equity-indexed products in the fourth quarter of 1997 and sales were minimal.
Realized Gains and Losses on Investments: The Company realized gains of $2.4 million in 1998 compared to realized losses of $1.6 million in 1997 and gains of $1.6 million in 1996. The gains in 1998 were primarily from gains on debt securities totaling $1.3 million, substantially all of which related to securities that were called. Realized gains in 1998 also include a gain of $300,000 related to a deficiency settlement agreement on a mortgage loan that was foreclosed in 1994. The losses in 1997 were primarily from net losses on debt securities totaling $1.2 million and writedowns on real estate and mortgage loans totaling $1.2 million, primarily related to a single foreclosure. The gains in 1996 were primarily from sales of investments in debt securities and real estate. The 1996 gains are also net of writedowns on real estate and mortgage loans totaling $1,026,000.
Federal Income Taxes: Federal income taxes on earnings from continuing operations for 1998, 1997, and 1996 reflect effective tax rates of 26.1%, 33.8%, and 34.3%, respectively, which are lower than the expected Federal rate of 35%. The 1998 and 1997 effective tax rates are significantly lower due to tax benefits totaling $4,944,000 and $350,000, respectively, resulting from the Company's subsidiary brokerage losses. Correspondingly, losses on discontinued operations for 1998 and 1997 totaling $14,125,000 and $1,000,000 do not include any tax benefits relating to the brokerage subsidiary. This tax reporting treatment is in accordance with the Company's tax allocation agreement with its subsidiaries. On a consolidated basis, Federal income taxes reflect consistent effective tax rates of 33.2%, 34.3%, and 34.3% for 1998, 1997, and 1996, respectively.
As more fully described in Item 3, Legal Proceedings, of this Form 10-K, by order dated August 28, 1998, the United States Bankruptcy Court, Southern District of Texas, Houston Division, confirmed and approved the Third Amended Joint Consensual Plan of Reorganization (the Plan) of The Westcap Corporation and Westcap Enterprises, Inc. Pursuant to the Plan, National Western received credit for the $1,000,000 previously contributed to Westcap in bankruptcy in March, 1997, and paid an additional $14,125,000 to compromise and settle (i) all claims of Westcap against National Western, and (ii) all claims and litigation of certain settling creditors of Westcap who have alleged federal or state securities law "control person" violations by National Western relating to Westcap's brokerage business, in exchange for full and complete releases from all of such claims, litigation, and alleged violations. The bankruptcy reorganization was completed in January, 1999, National Western retained 100% continuing ownership of the reorganized Westcap, and the subsidiary is now operating as a real estate management company.
A summary of segment earnings from continuing operations for the years ended December 31, 1998, 1997, and 1996 is provided below. The segment earnings exclude realized gains and losses on investments, net of taxes, and discontinued brokerage operations.
Earnings for the domestic life insurance operating segment were $6,395,000, $5,901,000, and $8,710,000 for 1998, 1997, and 1996, respectively. The decline in 1997 earnings is primarily attributable to higher other operating expenses. The slight increase in earnings in 1998 is due to increases in revenues and other income and lower amortization of deferred policy acquistion costs. However, these items were offset substantially by increases in other operating expenses and life insurance benefit claims. A detailed analysis of significant revenues and expenses for this segment is provided below.
Life insurance benefit claims were significantly higher in 1998 at $15.3 million compared to $14.4 million in 1997 and 1996. Mortality claims experience fluctuates from period to period, and such deviations are not uncommon in the life insurance industry. Over extended periods of time, higher claims experience tends to be offset by periods of lower claims experience. Additionally, the Company utilizes reinsurance to help minimize its exposure to adverse mortality experience. The Company's general policy is to reinsure amounts in excess of $200,000 on the life of any one individual.
Universal life insurance contract interest has remained relatively constant at $9.7 million in 1996 and 1997 and $10.0 million in 1998. Although credited rates have declined somewhat over this time period, which is consistent with declines in market interest rates, the small growth in this block of business has resulted in relatively stable overall interest.
Amortization of deferred policy acquisition costs has decreased from $5.5 million in 1996 to $5.1 million and $3.0 million in 1997 and 1998, respectively. These expenses represent the amortization of the costs of acquiring or producing new business, which consists primarily of agents' commissions. The majority of such costs are amortized in direct relation to the anticipated future gross profits of the applicable blocks of business. Amortization is also impacted by the level of policy surrenders.
Earnings for the international life insurance operating segment were $6,397,000, $7,143,000, and $7,150,000 for 1998, 1997, and 1996, respectively. Earnings in 1998 were lower primarily due to higher operating expenses, reinsurance costs, and amortization of deferred policy acquisition costs offset significantly by lower life insurance benefit claims. A detailed analysis of significant revenues and expenses for this segment is provided below.
Actual universal life insurance deposits collected for the years ended December 31, 1998, 1997, and 1996 are detailed below. Deposits collected on these nontraditional products are not reflected as revenues in the Company's statements of earnings, as they are recorded directly to policyholder liabilities upon receipt, in accordance with generally accepted accounting principles.
Other operating expenses totaled $9.6 million, $7.7 million, and $7.5 million in 1998, 1997, and 1996, respectively, which reflects a significant increase in 1998. The increase in expenses is attributable to the same reasons as previously described for domestic life insurance operations.
Earnings for the annuity operating segment were $27,508,000, $28,389,000, and $29,550,000 for 1998, 1997, and 1996, respectively. Earnings for 1998 were down significantly from 1997 and 1996 primarily due to nonrecurring items, which increased other operating expenses as more fully described below. Also, over the past several years, sales in the annuity business have been declining. However, during 1998 annuity deposits have increased substantially primarily due to sales of the Company's equity-indexed annuity products. A detailed analysis of significant revenues and expenses for this segment is provided below.
Actual annuity deposits collected for the years ended December 31, 1998, 1997, and 1996 are detailed below. Deposits collected on these nontraditional products are not reflected as revenues in the Company's statements of earnings, as they are recorded directly to policyholder liabilities upon receipt, in accordance with generally accepted accounting principles.
Other income was relatively insignificant in 1998 and 1997, totaling $270,000 and $277,000, respectively. However, other income for 1996 totaled $2,087,000, which includes $1.3 million in income relating to litigation involving an independent marketing organization. The litigation is more fully described in Item 3, Legal Proceedings.
In the past, cash flows from the Company's insurance operations have been more than adequate to meet current needs. Cash flows from operating activities were $131 million, $144 million, and $145 million in 1998, 1997, and 1996, respectively. Net cash flows from the Company's deposit product operations, which include universal life and investment annuity products, totaled $113 million in 1998 and $16 million in 1996. However, these operations incurred net cash outflows in 1997 totaling $51 million. The cash outflows in 1997 were due to low annuity production along with increased policy surrenders. Although surrenders increased again in 1998, strong equity-indexed annuity production generated the strong positive cash flow in 1998.
The Company relies on stockholders' equity for its capital resources, as there has been no long-term debt outstanding in 1998 or recent years. The Company 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 1999.
Stockholders' equity totaled $438 million at December 31, 1998, reflecting an increase of $38 million from 1997. The increase in capital is primarily from net earnings of $35 million. Net unrealized gains on investment securities totaling $2.2 million also contributed to the rise in stockholders' equity. Book value per share at December 31, 1998, was $125.31, reflecting a 9.2% increase for the year.
In December, 1997, the American Institute of Certified Public Accountants issued Statement of Position (SOP) 97-3, which provides guidance on accounting by insurance and other enterprises for assessments related to insurance activities. The SOP provides: (1) guidance for determining when an entity should recognize a liability for guaranty fund and other insurance related assessments, (2) guidance on how to measure the liability, including discounting of the liability if the amount and timing of the cash payments are fixed or reliably determinable, (3) guidance on when an asset may be recognized for a portion or all of the assessment liability or paid assessment that can be recovered through premium tax offsets or policy surcharges, and (4) requirements for disclosure of certain information. The Company anticipates that this SOP will not have a significant effect on its reporting of liabilities for guaranty fund assessments, as the Company is currently applying accounting procedures similar to those in the new statement. SOP 97- 3 is effective for financial statements for fiscal years beginning after December 15, 1998. The Company currently expects to implement the SOP in the first quarter of 1999.
In reviewing the Year 2000 issue, National Western has identified various risks to the Company that could impact daily operations and its ability to satisfactorily transact business with its primary customers and vendors. Risks related to servicing our customers are inabilities to process policyholder and agent commission-related transactions timely, which could lead to some loss of business. The accuracy of policyholder transactions should not be affected, as the Company's policy administration system already uses four-digit year data for policy calculations. Risks in the investment accounting area center around accuracy of accounting for investments but should not actually impact cash receipt and disbursement transactions. However, the Company has various controls which should identify and enable correction of such issues should they arise. Risks in interfaces with third-party systems, which are primarily banking systems for National Western, include the inability to timely and accurately receive and disburse cash and process investment-related transactions. This could affect the Company's service to its policyholders if cash flow issues arise due to delays in bank processing. Based on information from the Company's banks, National Western does not anticipate significant Year 2000 issues relating to bank processing.