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, 2007 follows. This discussion should be read in conjunction with the Company’s consolidated financial statements and related notes beginning on page 76 of this report.
The Company monitors these factors continually as key business indicators. The discussion that follows in this Item includes these indicators and presents information useful to an overall understanding of the Company’s business performance in 2007, incorporating required disclosures in accordance with the rules and regulations of the Securities and Exchange Commission.
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.
Deferred Sales Inducements. Costs related to sales inducements offered on sales to new customers, principally on investment type contracts and primarily in the form of additional credits to the customer’s account value or enhancements to interest credited for a specified period, which are beyond amounts currently being credited to existing contracts, are deferred and recorded as other assets. All other sales inducements are expensed as incurred and included in interest credited to contract holders’ funds. Deferred sales inducements are amortized to income using the same methodology and assumptions as DAC, and are included in interest credited to contract holders’ funds. Deferred sales inducements are periodically reviewed for recoverability. See the discussion of the adoption of Statement of Position (“SOP”) 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts on page 44 of this report.
Investment activities of the Company are integral to its insurance operations. Since life insurance benefits may not be paid until many years into the future, the accumulation of cash flows from premium receipts are invested with income reported as revenue when earned. Anticipated yields on investments are reflected in premium rates, contract liabilities, and other product contract features. These anticipated yields are implied in the interest required on the Company’s net insurance liabilities (future policy benefits less deferred acquisition costs) and contractual interest obligations in its insurance and annuity products. The Company benefits to the extent actual net investment income exceeds the required interest on net insurance liabilities and manages the rates it credits on its products to maintain the targeted excess or “spread” of investment earnings over interest credited. The Company will continue to be required to provide for future contractual obligations in the event of a decline in investment yield. For more information concerning revenue recognition, investment accounting, and interest sensitivity, please refer to Note 1, Summary of Significant Accounting Policies, and Note 3, Investments, in the Notes to Consolidated Financial Statements and the discussions under Investments in Item 7 of this report.
Pension Plans and Other Postretirement Benefits. The Company sponsors a qualified defined benefit pension plan, which was frozen effective December 31, 2007, covering substantially all employees and three nonqualified defined benefit plans covering certain senior officers. In addition, the Company also has postretirement health care benefits for certain senior officers. In accordance with prescribed accounting standards, the Company annually reviews plan assumptions.
The Company annually reviews its pension benefit plan assumptions which include the discount rate, the expected long-term rate of return on plan assets, and the compensation increase rate. The assumed discount rate is set based on the rates of return on high quality long-term fixed income investments currently available and expected to be available during the period to maturity of the pension benefits. The assumed long-term rate of return on plan assets is generally set at the rate expected to be earned based on long-term investment policy of the plans and the various classes of the invested funds, based on the input of the plan’s investment advisors and consulting actuary and the plan’s historic rate of return. The compensation rate increase assumption is generally set at a rate consistent with current and expected long-term compensation and salary policy, including inflation. The freeze ceased future benefit accruals to all participants and closed the Plan to any new participants. In addition, all participants became immediately 100% vested in their accrued benefits as of that date.
Traditional life and annuity premiums - Traditional life and annuity premiums increased 23.5% in 2007 compared to 2006. Increasing life sales has been a strategic focus over the past several years. Traditional life insurance premiums for products such as whole life and term life are recognized as revenues over the premium-paying period.
Income and losses from index options are due to market conditions. Index options are intended to act as hedges to match the returns on the S&P 500 Index® and the rise or decline in this index causes index option values to likewise rise or decline. While income from index options fluctuates with the index, the contract interest expense to policyholder accounts for the Company’s equity-indexed products also fluctuates in a similar manner and direction. In 2007 and 2005, the S&P 500 Index® decreased resulting in index option losses and a reduction in contract interest expenses. In 2006, the S&P 500 Index® increased and the Company recorded income from index options and likewise increased contract interest expenses.
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 decreased contract interest expense in 2007 and 2005, while, also decreasing the Company's investment income given the hedge nature of the options. During 2006, the reverse was noted, as the S&P 500 Index® performance was up resulting in higher investment income and contract interest expense. With these credited rates, the Company generally realized its targeted interest spread on its products.
During the second quarter of 2007, upon the completion of a detailed review of the deferred tax items, the Company identified a $2.3 million error in the net deferred tax liability. The error, which occurred during various periods prior to 2005, was corrected in the second quarter of 2007 and resulted in a decrease in the net deferred tax liability and deferred tax expense. The adjustment was not material to the current period or any prior period financial statements.
The Company’s premiums and contract revenues have increased 13.8% from 2006 as efforts have been made to promote domestic life products. It is the Company's marketing plan to increase domestic life product sales through increased recruiting of new distribution and the development of new life insurance products. The Company had approximately 5,600 contracted agents as of December 31, 2007.
Policy benefits totaled $14.9 million, $13.7 million, and $14.9 million in 2007, 2006, and 2005, respectively, which are consistent with Company expectations. Net investment income decreased to $18.9 million in 2007 as compared to $20.5 million and $20.0 million in 2006 and 2005, respectively. Other operating expense decreased in 2007 resulting from negative stock option compensation costs recorded under liability accounting. The costs increased significantly in 2006 due to an increase in compensation costs resulting from the change to liability classification for the Company’s stock option plan. Compensation costs totaled $0.3 million, $3.0 million, and $0.2 million in 2007, 2006, and 2005, respectively.
The Company's international life operations have been a significant contributor to the Company's overall growth and represent a market niche where the Company believes it has a competitive advantage. A productive agency force has been developed given the Company's longstanding reputation for supporting its international life products coupled with the instability of competing companies in international markets. In particular, the Company has experienced sizable growth with its equity-indexed universal life products and has collected premiums of $76.8 million, $60.5 million, and $48.2 million for the years ended 2007, 2006, and 2005, respectively.
Life and other policy benefits totaled $22.8 million in 2007, $18.2 million in 2006, and $21.2 million in 2005, which are consistent with Company expectations. Amortization of deferred policy acquisition costs were $25.0 million, $23.1 million, and $20.4 million for 2007, 2006, and 2005, respectively. The Company recorded an unlocking adjustment in 2007 totaling $9.0 million relative to improved mortality assumptions that results in an increase to the deferred asset balance and a decrease in amortization expense. In addition, a true-up adjustment of $1.7 million was also recorded in 2007 resulting in a decrease to amortization. Offsetting the decrease to amortization by the unlocking and true-up adjustments is an increase in amortization due primarily to the application of SOP 05-1 which requires the write-off of deferred balances on contracts that are considered substantially changed under this new guidance. These balances were previously carried and amortized over the projected life of the contract. In 2006, a true-up of amortization assumptions resulted in increased amortization of $1.0 million. Contract interest expense was $20.1 million, $25.7 million, and $18.1 million, in 2007, 2006, and 2005, respectively. The universal life contract interest fluctuations are primarily the result of the S&P 500 Index® performance relative to the equity-indexed universal life products and the associated stock market gains and losses which increased or decreased the amounts the Company credited to policyholders.
Other operating expenses reported in 2007 were $15.3 million compared to $21.1 million and $13.4 million in 2006 and 2005. The decrease in 2007 results from negative compensation costs related to stock options recorded under liability accounting. The significant increase in 2006 is due to an increase in compensation costs resulting from the change to liability classification for the Company’s stock option plan. Compensation costs totaled $0.4 million, $5.1 million, and $0.4 million in 2007, 2006, and 2005, respectively.
Revenues from annuity operations primarily include surrender charges and recognition of deferred revenues relating to immediate or payout annuities. A comparative detail of the components of premiums and annuity contract revenues is provided below.
Indexed products are more attractive for consumers when interest rate levels remain low as has been the market environment the past few years. Fixed indexed annuity deposits as a percentage of total annuity deposits recorded were 72.4%, 62.5%, and 53.5% for the years ended December 31, 2007, 2006, and 2005, respectively. Since the Company does not offer variable products or mutual funds, fixed indexed products provide an important alternative to the Company's existing fixed interest rate annuity products.
Other deferred annuity deposits decreased in 2007 compared to 2006 with $116.3 million recorded in collected deposits compared to $171.6 million, respectively. These product sales have been trending lower over the past few years due to low interest rates and investor preferences. As a selling inducement, many fixed-rate annuity products include a first year premium or interest rate bonus in addition to the base first year deposit interest rate. These bonuses are credited to the policyholder account but are deferred by the Company and amortized over future periods. The amount deferred was approximately $20.8 million, $19.8 million, and $21.4 million for the years ended December 31, 2007, 2006, and 2005, respectively.
The Company recorded an unlocking adjustment of $1.8 million and true-up adjustments of $3.3 million in 2007 resulting in decreased amortization of deferred acquisition costs. A true-up of assumptions in 2006 resulted in increased amortization of deferred policy acquisition costs of $3.1 million. Amortization of deferred policy acquisition costs in 2005 of $61.8 million includes an unlocking adjustment of $1.3 million relative to the future spreads on certain fixed indexed annuity products; modified surrender charges on certain annuities to reflect continuing lower new money rates; and reduced ultimate valuation rates for pay out on annuitization under all annuities. These adjustments in 2005 resulted in a decrease to the deferred asset balance and an increase in amortization in that year.
The Company is required to periodically adjust for actual experience that varies from that assumed. While management does not currently anticipate any impact from unlocking in 2008, facts and circumstances may arise in the future which require that the factors be reexamined.
Other operating expenses totaled $16.9 million in 2007 compared to $21.8 million in 2006. The decrease in 2007 results from negative compensation costs recorded under liability accounting in the current year. The 2006 expense reflects an increase of $5.0 million due to increased compensation costs on stock options resulting from the change to liability classification for the Company’s plan. Compensation costs were $0.4 million in 2007 and 2005.
The Company's overall conservative investment philosophy is reflected in the allocation of its investments, which is detailed below as of December 31, 2007 and 2006. The Company emphasizes investment grade debt securities, with smaller holdings in mortgage loans and policy loans.
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 98.2% 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®.
As of December 31, 2007, the Company's percentage of below investment grade securities compared to total invested assets totaled 1.7%. The decrease from 2006 is primarily due to principal payments received and settlements from bankruptcy proceedings as well as sales, tenders and a maturity. The Company's holdings of below investment grade securities as a percentage of total invested assets is relatively small compared to industry averages.
Holdings in below investment grade securities by category as of December 31, 2007 are summarized below, including 2006 fair values for comparison. The Company is continually monitoring developments in these industries that may affect security valuation issues.
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 accordance with the provisions of SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, the Company may under certain conditions transfer a debt security from held to maturity to available for sale. No transfers were made in 2007 or 2006. During 2007, one security was sold from the held to maturity portfolio due to credit deterioration, with an amortized cost of $5.2 million, resulting in a minimal realized gain. No held to maturity sales were made during 2006. During 2005, two securities were sold from the held to maturity portfolio due to credit deterioration with an amortized cost of $10.0 million resulting in a realized gain of $0.9 million.
In the fourth quarter of 2006, a valuation loss of $2.1 million was recorded and in 2007, an additional allowance of $1.5 million was recorded related to one mortgage loan based on information which indicated that the Company may not collect all amounts in accordance with the mortgage agreement. While the Company closely manages its mortgage loan portfolio, future changes in economic conditions can result in impairments beyond those currently identified.
Changes in interest rates typically have a significant impact on the fair values of the Company's debt securities. During 2007, market interest rates of the ten-year U.S. Treasury bond decreased 68 basis points from year end 2006 resulting in a decrease in the unrealized loss balance of $33.8 million on a portfolio of approximately $5.7 billion. This amount is reasonable based upon the current market factors and the current investment portfolio characteristics. The Company would expect similar results in the future from a significant upward or downward movement in market rates. However, since the majority of the Company's debt securities are classified as held to maturity, which are recorded at amortized cost, changes in fair values have relatively small effects on the Company's financial results.
The Company analyzes interest rate risk through ongoing 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. Sensitivity analysis allows the Company to measure the potential gain or loss in fair value of its interest-sensitive instruments and to protect its economic value and achieve a predictable spread between what is earned on invested assets and what is paid on liabilities. The Company seeks to minimize the impact of interest rate risk through surrender charges that are imposed to discourage policy surrenders and to offset unamortized acquisition costs. Interest rate changes can be anticipated in the computer models and the corresponding risk addressed by management actions affecting asset and liability instruments. However, potential changes in the values of financial instruments indicated by hypothetical interest rate changes will likely be different from actual changes experienced, and the differences could be significant.
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, 2007. The estimated cash flows include assumptions as to whether such loans will be repaid by the policyholders or settled upon payment of death or surrender benefits on the underlying insurance contracts and incorporate both Company experience and mortality assumptions associated with such contracts.
In 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 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 indexed policyholders, subject to minimum guaranteed policy interest rates.
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, 2007, and does not consider new product sales or the possible impact of interest rate changes on sales.
In the past, cash flows from the Company's insurance operations have been sufficient to meet current needs. Cash flows from operating activities were $258 million, $224 million, and $201 million in 2007, 2006, and 2005, respectively. The Company also has significant cash flows from both scheduled and unscheduled investment security maturities, redemptions, and prepayments. These cash flows totaled $518 million, $399 million, and $485 million in 2007, 2006, and 2005, respectively. Cash flows from security maturities, redemptions, and prepayments were relatively higher over the last three years due to the decline in interest rates. These cash flow items could be reduced if interest rates rise in 2008. Net cash flows from the Company's universal life and annuity deposit product operations totaled inflows (outflows) of $(93) million, $25 million, and $153 million in 2007, 2006, and 2005, respectively.
(3) Other long-term liabilities include estimated life and annuity obligations related to death claims, policy surrenders, policy withdrawals, maturities and annuity payments based on mortality, lapse, annuitization, and withdrawal assumptions consistent with the Company’s historical experience. These estimated life and annuity obligations are undiscounted projected cash outflows that assume interest crediting and market growth consistent with assumptions used in amortizing deferred acquisition costs. They do not include any offsets for future premiums or deposits. Other long-term liabilities also include determinable payout patterns related to immediate annuities. In contrast to this table, the majority of the Company’s liabilities for future obligations recorded on the consolidated balance sheet do not incorporate future credited interest and market growth. Therefore, the estimated life and annuity obligations presented in this table significantly exceed the life and annuity liabilities recorded in the reserves for future life and annuity obligations. Due to the significance of the assumptions used, the actual cash outflows will differ both in amount and timing, possibly materially, from these estimates.
In February of 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. This Statement permits entities to choose to measure many financial instruments and certain other items at fair value. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. The Company does not currently anticipate an impact from adopting SFAS No. 159.
In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements. SFAS No. 160 establishes accounting and reporting standards for entities that have equity investments that are not attributable directly to the parent, called noncontrolling interests or minority interests. Specifically, SFAS No. 160 states where and how to report noncontrolling interests in the consolidated statements of financial position and operations, how to account for changes in noncontrolling interests and provides disclosure requirements. The provisions of SFAS No. 160 are effective beginning January 1, 2009. The Company is currently evaluating the impact that the adoption of this statement will have on the consolidated financial position, results of operations and disclosures.
In December 2007, the FASB issued SFAS No. 141(R), Business Combinations. SFAS No. 141(R) establishes how an entity accounts for the identifiable assets acquired, liabilities assumed, and any noncontrolling interests acquired, how to account for goodwill acquired and determines what disclosures are required as part of a business combination. SFAS No. 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008, early adoption is prohibited. The Company is currently evaluating the impact that the adoption of this statement will have on the consolidated financial position, results of operations and disclosures.
In September 2005, the AICPA issued Statement of Position (“SOP”) 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts, which is effective for internal replacements occurring in fiscal years beginning after December 15, 2006. SOP 05-1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97. SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights, or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. The Company has an impact related to the adoption of SOP 05-1 for contracts which have annuitized and relative to reinstatements of contracts in that the unamortized deferred acquisition costs and deferred sales inducement assets must be written-off at the time of annuitization and may not be continued related to reinstatements. SOP 05-1 results in changes in assumptions relative to estimated gross profits which affects unamortized deferred acquisition costs, unearned revenue liabilities, and deferred sales inducement balances as of the beginning of the year. The effect of this SOP on beginning retained earnings as of January 1, 2007 was a decrease of $2.2 million, net of tax, as detailed below.
See Attachment A, Index to Financial Statements and Schedules, on page 76.