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 2012, incorporating required disclosures in accordance with the rules and regulations of the Securities and Exchange Commission.
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 the Federal Reserve's “quantitative easing” initiatives threaten to push longer term interest rates higher by creating greater borrowing demand and fueling inflationary conditions, respectfully. Observers of credit markets increasingly refer to "frothy" conditions with respect to bonds and their low yields and speculate as to what may be the impetus to reverse the course on lower 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.
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 reasons for the decline in value (credit event, interest rate related, credit spread widening), (c) the overall financial condition as well as the near-term prospects of the issuer, (d) whether the debtor is current on contractually obligated principal and interest payments, and (e) that the Company does not intend to sell the investment prior to 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 purchase or prior impairment, then an other-than-temporary impairment charge is recognized. The Company would recognize impairment of securities due to changing interest rates or market dislocations only if the Company intended to sell the securities prior to recovery. When a security is deemed to be impaired a charge is recorded equal to the difference between the fair value and amortized cost basis of the security. In compliance with GAAP guidance the estimated credit versus the non-credit components are bifurcated, and the non-credit component is reclassified as unrealized losses in other comprehensive income. 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. However, the new cost basis of an impaired security is not adjusted for subsequent increases in estimated fair value.
Universal life and annuity contract revenues - Revenues for universal life and annuity contract charges increased 13.0% in 2012 compared to 2011 primarily due to higher cost of insurance and administrative charges resulting from growth in the amount of business in force. 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 as depicted in the following table.
Cost of insurance charges were $95.3 million in 2012 compared to $90.3 million in 2011 and $86.4 million in 2010. Cost of insurance charges typically trend with the size of the life insurance block in force. The increasing revenue from cost of insurance charges corresponds with the growth in life insurance in force. At December 31, 2012, the volume of life insurance in force increased to $21.6 billion from $20.9 billion as of the end of 2011. Administrative charges were $32.6 million, $26.9 million and $24.5 million for the years ended December 31, 2012, 2011 and 2010, respectively, and correlate with new life insurance business sales both in number of policies placed as well as the volume of insurance issued. Surrender charges assessed against policyholder account balances upon withdrawal were $39.2 million in 2012 compared to $31.4 million in 2011 and $35.9 million in 2010. While the Company earns surrender charge income that is assessed upon policy terminations, the Company’s overall profitability is enhanced when policies remain in force and additional contract revenues are realized and the Company continues to make an interest rate spread equivalent to the difference it earns on its investment and the amounts that it credits to policyholders.
Debt securities generated approximately 94% of total investment income, excluding derivative gains and losses, in 2012, consistent with prior years. The Company’s strategy is to invest substantially all of its cash flows in fixed debt securities consistent with its guidelines for credit quality, duration, and diversification. In the wake of two record years in annuity sales in 2010 and 2011, the Company experienced substantial cash flow for investing in debt securities which caused the portfolio to grow from $7.4 billion at December 31, 2010 to $8.2 billion at December 31, 2011 and to $8.8 billion at December 31, 2012. Despite the growth in the debt security portfolio, lower interest rate levels have persisted in accordance with Federal Reserve monetary policy which has depressed long-term U.S. Treasury rates. When combined with historically tight spreads of corporate securities over U.S. Treasury rate levels, this has resulted in lower yields on new investment purchases. The yield on debt security purchases to fund insurance operations declined to 3.37% in 2012 and 4.18% in 2011 from 4.45% in 2010.
The Company’s new mortgage loan activity has been relatively low by historical standards in recent years given the low level of rates and the higher level of risk associated with commercial properties in the current economic environment. Policy loan and other invested asset balances outstanding have remained relatively stable over the past few years.
The decline in average invested asset yield, excluding derivatives, from 2010 to 2011 and to 2012 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, incorporates 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 have oscillated over the past few years with gains in 2012 and 2010 and losses in 2011 due to intermittent increases and decreases in the S&P 500 Index® during this period. 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 $22.8 million, $21.8 million and $22.9 million in 2012, 2011 and 2010, respectively. Other revenues in 2011 also includes $2.9 million received as net settlement of a lawsuit in which the Company was plaintiff.
Gains and losses from index options are due to equity market conditions. Index options are intended to act as hedges to match the returns on the product’s underlying reference index and the rise or decline in the index relative to the index level at the time of the option purchase causes option values to likewise rise or decline. As income from index options fluctuates with the underlying index, the contract interest expense to policyholder accounts for the Company’s fixed-indexed products also fluctuates in a similar manner and direction. In 2012, the Company incurred unrealized gains on unexpired options in excess of the realized losses on expiring options thus resulting in an overall derivative gain for the period. In 2011, the opposite situation occurred as unrealized losses on unexpired options exceeded the realized gains on expiring options. In 2010, the reference indices increased and the Company recorded an overall gain from index options with a corresponding increase in contract interest expenses.
Debt security impairments in 2012 and 2011 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 2010 included similar impairment write-downs on certain asset-backed securities as well as impairment losses on corporate debt securities.
The mortgage loan valuation write-down in 2012 of $0.7 million represents a general valuation allowance established for the Company's mortgage loan portfolio based upon the Company's loss experience over the past ten years. It is not identified with a specific underlying asset. The mortgage loan valuation write-downs in 2011 and 2010 principally involved a New Orleans, Louisiana property whose value was negatively impacted by Hurricane Katrina. The write-downs reflect an adjustment to a newly provided appraisal of the property. The property was subsequently acquired through foreclosure then sold during 2012 for a net gain on the sale of $2.7 million. The real estate valuation write-down in 2010 principally pertains to property located in Fort Smith, Arkansas. The Company had a letter of intent to sell the property at December 31, 2010 and adjusted the carrying value associated with the offer. The Company subsequently sold the property in January 2011.
Life and other policy benefits - Life and other policy benefits include death claims of $31.8 million, $29.8 million and $32.9 million for 2012, 2011 and 2010, 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. Although not utilized previously, the Company initiated a project during 2012 to identify unreported death claims by researching the Social Security Administration master data base for deceased individuals matching with insureds under in force policies of the Company. The Company identified death claims of $2.5 million in 2012 through this initiative for deaths incurred over the past decade and prior in some cases. Going forward, the Company will continue the program annually in order to identify unreported death claims although the amounts will be lesser in scope as the search will be more current. 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.
The following table identifies the effects of unlocking and true-up adjustments on DPAC balances recorded through amortization expense for 2012, 2011 and 2010.
During 2010 a correction was made to a surrender charge assumption for future years on one deferred annuity product line. This change resulted in an unlocking adjustment that increased the current period’s DPAC amortization expense (decreased DPAC balance) by $2.7 million. As the amount of the correction was determined to have occurred over the course of multiple previously reported periods, it was concluded that the amount of the correction was immaterial to the financial results reported in any of these periods, as well as the current period.
True-up adjustments are recorded quarterly and the adjustments in 2012, 2011 and 2010 relate to changes in expense ratios, partial surrender rates, mortality rates, credited interest rates and earned rates for the current year’s experience. The true-up adjustments by line of business were as shown in the following table.
During 2010, the Company settled a lawsuit which previously had been entirely accrued and expensed as a general insurance expense. The settlement defined the components of the amount previously accrued between policyholder benefits and operating expenses. This resulted in the Company decreasing operating expense by $16.7 million during 2010 and reclassifying the amount as annuity contract interest. As the amount had been entirely accrued, there was no net effect on pretax earnings but it did produce a reduction in other operating expense in the 2010 results.
In addition to legal expense activity, general insurance expense includes amortization expense associated with capitalized system costs. 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 $3.5 million, $3.3 million, and $2.6 million in 2012, 2011, and 2010, respectively. The increasing trend in amortization expense is attributable to additional functionality being placed into operation during the period.
A summary of segment earnings from continuing operations for the years ended December 31, 2012, 2011 and 2010 is provided below. The segment earnings exclude realized gains and losses on investments, net of taxes.
The Company’s domestic life insurance in force policy count has been declining since 2008 resulting in lower universal life contract revenue charges. The pace of new policies issued has lagged the number of policies terminating from death or surrender by roughly a five-to-one rate over the three years shown causing a declining level of insurance in force from which contract revenue is received. This ratio improved somewhat during 2012 to a three-to-one relationship. Nonetheless, the number of domestic life insurance policies has declined from 66,000 at December 31, 2010 to 62,900 at December 31, 2011 and to 60,000 at December 31, 2012. Universal life insurance revenues are also generated with the issuance of new business based upon amounts per application and percentages of the face amount (volume) of insurance issued. The number of domestic policies issued during 2012 was 56% higher than in 2011 and the volume of insurance issued was 123% greater than that in 2011. Contract revenues associated with this increased new business activity account for the overall increase in domestic life premiums and contract charges.
During the latter part of 2008, the Company’s internal checking and monitoring procedures detected potential instances of rebating in certain geographic markets and instituted commission caps and other preventive procedures to discourage this practice. Although not illegal in these markets, the practice of rebating is particularly prone to large face amount policies not renewing premium payments beyond the initial year of the policy. The level of life insurance volume subsequently lapsed at a rate in excess of 11.2% during 2010. However, this rate declined to 7.1% in 2011 and further to 6.6% in 2012.
The Company’s efforts over the past several years have been to attract new independent agents and to promote life products to improve domestic life sales. During the past couple of years the Company has achieved some success in this regard with the number of new policies issued increasing 76% in 2011, reversing a multi-year trend of declining activity, and trending higher still in 2012 as noted above. Sales the past two years have been substantially weighted toward single premium policies which do not have recurring premium payments. These products are targeting wealth transfer strategies involving the movement of accumulated wealth in alternative investment vehicles, including annuities, into life insurance products.
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 2010, 2011 and 2012.
The true-up adjustments recorded in 2012 increased the DPAC balance which conversely reduced amortization expense by a like amount for the year.The unlocking adjustment in 2011 came about as the Company reevaluated it assumptions concerning future investment portfolio yield rates and concluded that an unlocking of assumptions was required to incorporate the anticipated lowering of investment yields and its impact upon future investment spreads and profitability.
The Company's international life operations have been a steady contributor to the Company's overall earnings performance and represents a niche where the Company believes it has a competitive advantage. A stable population of distribution relationships has been developed given the Company's longstanding reputation for supporting its international life products coupled with the instability of competing insurers.
In general, universal life revenues and operating earnings are anticipated to emerge with the amount of international life insurance in force and a steady growth in new sales. Over the past three years, the volume of insurance in force has grown from $17.3 billion at December 31, 2010 to $18.6 billion at December 31, 2011 and to $19.2 billion at December 31, 2012 promoting an increasing trend in revenues. Universal life insurance revenues are also generated with the issuance of new business based upon amounts per application and percentages of the face amount (volume) of insurance issued. During 2012, the number of international life policies issued declined approximately 19% from the prior year while the volume of insurance issued was roughly 15% less than that in 2011.
International universal life revenues also include surrender charges assessed upon surrender of contracts by policyholders. In the midst of the financial crisis the past few years, the Company’s international policyholders in particular exhibited concern regarding the developments in U.S. financial markets. This evidenced itself in the Company’s termination activity in its international life in force. During 2009, the Company incurred higher termination experience than is typical which resulted in recognition of increased surrender charge fee income. This level of termination activity subsequently subsided although the termination activity in 2012 increased over the pace incurred in 2011. The following table illustrates the Company’s international life termination experience over the past five years.
As noted previously, net investment income and contract interest include period-to-period changes in fair value pertaining to call options purchased to hedge the interest crediting feature on the fixed-index universal life products. To support the index crediting rate feature on its fixed-index universal life products the Company purchases S&P 500 Index® call options. With the growth in the block of business of these policies, the period-to-period changes in fair values of the underlying options used to hedge this interest crediting feature have had an increasingly greater impact on net investment income and universal life contract interest. A detail of net investment income for international life insurance operations is provided below.
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 2012, 2011 and 2010.
Similar to domestic life results, the true-up adjustments recorded in 2012 increased the DPAC balance which conversely reduced amortization expense by a like amount for the year. The unlocking adjustment in 2011 came about as the Company reevaluated it assumptions concerning future investment portfolio yield rates and concluded that an unlocking of assumptions was required to incorporate the anticipated lowering of investment yields and its impact upon future investment spreads and profitability.
As a selling inducement, some of the deferred products, as well as the fixed-index annuity products, include a first year interest rate bonus ranging from 1% to 7% depending upon the product, in addition to the base first year interest rate. Other products include a premium bonus ranging from 2% to 10% which is credited to the account balance when premiums are applied. These bonus rates are deferred in conjunction with other capitalized policy acquisition costs. The amount deferred to be amortized over future periods amounted to approximately $31.8 million, $46.7 million and $51.1 million for the years ended December 31, 2012, 2011 and 2010, respectively. Amortization of deferred sales inducements is included as a component of annuity contract interest as described later in this discussion of annuity operations.
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 2010, 2011 and 2012.
As the true-up adjustments in each period decreased DPAC balances a corresponding increase in DPAC amortization expense was recorded. The true-up adjustments in 2012, 2011 and 2010 relate to changes in policy lapse or termination rates, expense levels and credit rates compared to anticipated experience. In addition to the true-up adjustments shown above, during the second quarter of 2011 the Company decreased its DPAC balances (increased amortization expense) an additional $4.0 million for adjustments determined in conjunction with the implementation of the new actuarial software platform which allowed the Company to perform an analysis of DPAC balances in finer detail.
The unlocking adjustment in 2011 came about as the Company reevaluated it assumptions concerning future investment portfolio yield rates and concluded that an unlocking of assumptions was required to incorporate the anticipated lowering of investment yields and its impact upon future investment spreads and profitability. During 2010, the Company unlocked for a change in projected surrender charge rates on certain fixed rate annuities that reduced DPAC (and increased amortization expense) by $2.7 million. Unlocking was not done during the year ended December 31, 2012.
Annuity contract interest includes the equity component return associated with the call options purchased to hedge the Company's fixed-index annuities. The detail of fixed-index annuity contract interest as compared to contract interest for all other annuities is as follows:
True-up adjustments for the deferred sales inducement balance are done each period similar to that done with respect to DPAC balances. For the year ended December 31, 2012, deferred sales inducement balances were reduced by $5.5 million in true-up adjustments. This decrease is included in the above table as an addition to bonus interest amortization. For the year ended December 31, 2011, deferred sales inducement balances were reduced by $1.2 million for unlocking and by $1.6 million pertaining to the Company's implementation of new actuarial system technology. These adjustments, reflected above as additional bonus interest amortization, were incremental to true-up adjustment recognized during the period.
Gross contract interest in 2010 includes an additional $16.7 million for policy credits as part of the settlement of a class action lawsuit. This amount had been provided for in prior year financial results as an operating expense accrual since the character of the settlement amount was not known at that time. Accordingly, a reclassification was made in the 2010 consolidated financial statements to report the amounts as contract interest with a corresponding reduction in other operating expenses.
The Company'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 $1.2 million, $0.8 million and $2.8 million of operating earnings in 2012, 2011, and 2010, respectively. The decline in earnings in 2011 reflects reductions in Medicare and Medicaid reimbursement rates as state governmental entities addressed their budget deficit conditions. The remaining earnings in Other Operations of $12.8 million, $12.5 million, and $11.7 million for the years ended December 31, 2012, 2011, 2010, respectively, represent investment income from real estate, municipal bonds, and common and preferred equities held in subsidiary company portfolios principally for tax-advantage purposes. Included in these amounts are semi-annual distributions from a life interest in the Libby Shearn Moody Trust which is an asset held in NWLSM, Inc. Pretax distributions from this trust were $4.9 million, $4.5 million, and $4.4 million in 2012, 2011, and 2010, respectively.
The Company’s investment portfolio increased 6% to $9.1 billion at December 31, 2012 compared to $8.6 billion at December 31, 2011 due to positive cash flows from operating and financing activities. The primary driver of the increase was another strong annuity sales year. Although intentionally managed to a lower level, approximately $0.8 billion in annuity deposits were collected in 2012. The increase in investments also includes improved security fair market values (for debt securities categorized as "available for sale" and reported at fair value on the consolidated balance sheet) as a result of a decline in interest rates and, to a lesser 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 $202.3 million at December 31, 2011 to $257.5 million at December 31, 2012.
Derivatives, index options are call options purchased to hedge the interest crediting mechanism associated with the Company's fixed-index universal life and annuity policies. These options are reported on the balance sheet at fair value in accordance with GAAP. As previously discussed in the Results of Operations section of this Item 7, the unrealized gain position of options held at December 31, 2012 of $36.6 million was approximately $97.9 million larger than the unrealized loss position at December 31, 2011 ($61.3 million).
Rating agencies generally view mortgage-backed securities as having additional risk for insurers holding interest sensitive product liabilities given a potential asset/liability disintermediation. Consequently, the Company holds predominantly agency mortgage-backed securities. Because mortgage-backed securities are subject to prepayment and extension risk, the Company has substantially reduced these risks by investing 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. The Company does not purchase tranches, such as PAC II and support tranches, that subject the portfolio to greater than average prepayment risk. 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 debt securities portfolio with 98.1% 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®.
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 further summarized below.
Holdings in below investment grade securities by category as of December 31, 2012 are summarized below, including 2012 and 2011 fair values for comparison. The Company is continually monitoring developments in these industries that may affect security valuation issues.
Certain European countries have experienced varying degrees of financial stress. Risks from the continued debt crisis in Europe could continue to disrupt financial markets and have a detrimental impact on global conditions as well as on sovereign and non-sovereign obligations.The Company has no exposure to the sovereign debt of Portugal, Ireland, Italy, Greece or Spain. These countries in particular are experiencing significant economic, fiscal and political strains that increase the likelihood of default for these countries. Additionally, the Company has no exposure to the debt of financial institutions domiciled in these countries.
During the year ended December 31, 2012, the Company recorded other-than-temporary impairment ("OTTI") credit related write-downs on debt securities totaling $1.2 million and $0.1 million on equity securities, respectively. The debt security impairments all pertained to asset-backed securities whose discounted future cash flows fell below the Company's amortized cost basis in such securities in conjunction with fair value declines. See Note 3, Investments Debt and Equity Securities, of the accompanying consolidated financial statements for further discussion.
The Company holds approximately $48.2 million in asset-backed securities as of December 31, 2012. This portfolio includes $15.9 million of manufactured housing bonds and $32.3 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 holds one Alt-A security with a carrying value of $3.8 million. The Alt-A sector is a sub-sector of the jumbo prime MBS sector. The average FICO for an Alt-A borrower is approximately 715 compared to a score of 730 for a jumbo prime borrower. The Company’s exposure to the Alt-A and subprime sectors is limited to investments in the senior tranches of structured securities collateralized by Alt-A or subprime residential mortgage loans. The subprime sector is generally categorized under the asset-backed sector. This sector lends to borrowers who do not qualify for prime interest rates due to poor or insufficient credit history. Subprime borrowers generally have FICO scores of 660 or below. The slowing housing market, rising interest rates, and relaxed underwriting standards for loans originated after 2005 resulted in higher delinquency rates and losses beginning in 2007. These events caused illiquidity in the market and volatility in the market prices of subprime securities. With government intervention through the quantitative easing initiatives over the past few years, the housing market has begun to show signs of stabilizing. There has also been an improvement in the prices of subprime securities as the bond market became more liquid. All of the loans classified as Alt-A or subprime in the Company’s portfolio as of December 31, 2012 were underwritten prior to 2005 as noted in the table below.
As of December 31, 2012, 2 of the subprime securities were rated AAA, 3 were rated AA, 4 were rated BBB and 2 were rated CC.
In general, the Company originates loans on high quality, income-producing properties such as shopping centers, freestanding retail stores, office buildings, industrial and sales or service facilities, selected apartment buildings, motels, and health care facilities. The location of these properties is typically in major metropolitan areas that offer a potential for property value appreciation. Credit and default risk is minimized through strict underwriting guidelines and diversification of underlying property types and geographic locations. In addition to being secured by the property, mortgage loans with leases on the underlying property are often guaranteed by the lease payments and also by the borrower. This approach has proven to result in quality mortgage loans with few defaults. Mortgage loan interest income is recognized on an accrual basis with any premium or discount amortized over the life of the loan. Prepayment and late fees are recorded on the date of collection.
The mortgage loan allowance released during 2012 pertained to a property forced into bankruptcy which the Company subsequently acquired in a bankruptcy auction. The mortgage loan was foreclosed and the Company incurred a write-down of $0.6 million and the property reclassified as a real estate investment included in other long-term investments on the Company's balance sheet. The property was subsequently sold in the third quarter of 2012 for a net gain of $2.7 million. The mortgage loan provision at December 31, 2012 represents a general allowance based upon the Company's mortgage loan portfolio loss experience over the past ten years.
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.
The above described scenarios produce estimated changes in cash flows as well as cash flow reinvestment projections. Estimated cash flows in the Company's model assume cash flow reinvestments, which are representative of the Company's current investment strategy. Calls and prepayments include scheduled maturities and those expected to occur which would benefit the security issuers. Assumed policy surrenders consider differences and relationships between credited interest rates and market interest rates as well as surrender charges on individual policies. The impact to earnings also includes the expected effects on amortization of deferred policy acquisition costs. The model considers only annuity and supplemental contracts in force at December 31, 2012, and does not consider new product sales or the possible impact of interest rate changes on sales.
Liquidity requirements are met primarily by funds provided from operations. Premium deposits and annuity considerations, investment income, and investment maturities and prepayments are the primary sources of funds while investment purchases, policy benefits in the form of claims, and payments to policyholders and contract holders in connection with surrenders and withdrawals as well as operating expenses are the primary uses of funds. To ensure the Company will be able to pay future commitments, the funds received as premium payments and deposits are invested in high quality investments, primarily fixed income securities. Funds are invested with the intent that the income from investments, plus proceeds from maturities, will meet the ongoing cash flow needs of the Company. The approach of matching asset and liability durations and yields requires an appropriate mix of investments. Although the Company historically has not been put in the position of having to liquidate invested assets to provide cash flow, its investments consist primarily of marketable debt securities that could be readily converted to cash for liquidity needs. The Company may also borrow up to $40 million on its bank line of credit for short-term cash needs. There were no borrowings outstanding under the line of credit at December 31, 2012.
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, 2012, 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 substantially reinvest earnings internally to finance the development of new business. Despite the fact the Company's market price of its Class A common shares has been trading at a substantial discount to the book value for several years, there are no imminent plans for the Company to repurchase its shares as the Board of Directors has adopted a strategic policy of building a strong capital base to maintain high financial strength ratings and the ability to take competitive advantages as they arise. The capacity to pay dividends is limited by law in the state of Colorado to earned profits (statutory unassigned surplus). At December 31, 2012, the maximum amount legally available for distribution without further regulatory approval is $100 million.
It is not Company practice to enter into off-balance sheet arrangements or to issue guarantees to third parties, other than in the normal course of issuing insurance contracts. Commitments related to insurance products sold are reflected as liabilities for future policy benefits. Insurance contracts guarantee certain performances by the Company.