The Company leases approximately 72,000 square feet of office space in Austin, Texas. This lease expires in 2010 and specifies lease payments that gradually increase over the term of the lease. Currently, lease payments are $550,800 per year plus taxes, insurance, maintenance, and other operating costs. Additionally, the Company
=s wholly owned subsidiary, The Westcap Corporation, owns two buildings adjacent to the Company's principal office space totaling approximately 21,000 square feet that are leased and utilized by the Company. The Company=s affiliate, Regent Care Building, Limited Partnership, owns a 46,000 square foot building in Reno, Nevada, which is leased and utilized by another of the Company=s affiliates, Regent Care Operations, Limited Partnership, for use in its nursing home operations. Lease costs and related operating expenses for facilities of the Company=s subsidiaries are currently not significant in relation to the Company=s consolidated financial statements. The intercompany lease costs related to The Westcap Corporation and the nursing home have been eliminated for consolidated reporting purposes.
The Company is currently licensed to do business in all states except for New York, Delaware, New Hampshire, and Connecticut. Products marketed are annuities, universal life insurance, and traditional life insurance, which includes both term and whole life products. The majority of domestic sales are the Company=s annuities, which include single and flexible premium deferred annuities, single premium immediate annuities, and equity-indexed annuities. Most of these annuities can be sold as tax qualified or nonqualified products. At December 31, 2001, the Company maintained over 101,000 annuity policies inforce.
The Company=s international operations focus on foreign nationals in upper socioeconomic classes. Insurance products are issued primarily to residents of countries in Central and South America, the Caribbean, and the Pacific Rim. Issuing policies to residents in countries in these different regions provides diversification that helps to minimize large fluctuations that could arise due to various economic, political, and competitive pressures that may occur from one country to another. Products issued to international residents are almost entirely universal life and traditional life insurance products. However, certain annuity and investment contracts are also available. At December 31, 2001, the Company had nearly 48,000 international life insurance policies inforce representing approximately $7.1 billion in face amount of coverage.
International applications are submitted by independent contractor broker-agents, many of whom have been submitting policy applications to National Western for 20 or more years. The Company has approximately 2,600 independent international agents currently contracted, over 40% of which have submitted policy applications to the Company in the past twelve months.
There are some inherent risks of accepting international applications which are not present within the domestic market that are reduced substantially by the Company in several ways. As previously described, the Company accepts applications from foreign nationals in upper socioeconomic classes who have substantial financial resources. This targeted customer base coupled with National Western=s conservative underwriting practices have historically resulted in claims experience similar to that in the United States. The Company minimizes exposure to foreign currency risks by requiring payment of premiums and claims in United States dollars. Finally, the Company=s thirty-five years of experience with the international products and its longstanding independent broker-agent relationships further serve to minimize risks.
The Company's overall conservative investment philosophy is reflected in the allocation of its investments, which is detailed below as of December 31, 2001 and 2000. The Company emphasizes investment grade debt securities, with smaller holdings in mortgage loans and policy loans.
=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.
National Western held investments in several issuers whose decline in value was considered other than temporary during 2001 and these holdings were written down to fair value and included as realized losses on investments as follows:
With the exception of Enron, whose deterioration was much more precipitous and unexpected, the Company had been concerned about these securities prior to the end of 2001. However, the events of September 11th and the resulting economic recession eventually caused their outlook to become overwhelmingly negative and the securities were adjusted down to the quoted market values in 2001.
As part of an evaluation of its entire investment portfolio, the Company made the determination to transfer debt securities with fair values totaling $112 million from securities available for sale to securities held to maturity as of January 1, 2001. In accordance with the provisions of Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities," the transfers were recorded at fair values, and the unrealized holding loss totaling $647,000 at the date of transfer, net of the effects of deferred taxes and deferred policy acquisition costs, has been reported in accumulated other comprehensive income and will be amortized over the remaining lives of the securities. The transfer of securities from available for sale to held to maturity had no effect on the net earnings of the Company.
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 loans 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 lessee. This approach has proven to result in higher quality mortgage loans with fewer defaults.
The Company's direct investments in real estate are not a significant portion of its total investment portfolio as many of these investments were acquired through mortgage loan foreclosures. The Company also participates in several real estate joint ventures and limited partnerships that invest primarily in income-producing retail properties. These investments have enhanced the Company
The contractual maturities of mortgage loan principal balances at December 31, 2001, are as follows:
As of December 31, 2001, the allowance for possible losses on mortgage loans was $2,115,000 representing a reduction of $2,100,000 from December 31, 2000. The allowance was adjusted as a result of an analysis of specific loans and management believes that the allowance for possible losses is adequate. While the Company closely manages its mortgage loan portfolio, future changes in economic conditions can result in impairments beyond those currently identified.
The Company's real estate investments totaled approximately $15,220,000 and $14,683,000 at December 31, 2001 and 2000, respectively, and consist primarily of income-producing properties which are being operated by a wholly owned subsidiary of the Company. The Company recognized operating income on these properties of approximately $845,000 and $1,063,000 for the years ended December 31, 2001 and 2000, respectively. The Company monitors the conditions and market values of these properties on a regular basis and makes repairs and capital improvements to keep the properties in good condition. The Company recorded net realized investment losses of $25,000 and $420,000 in 2001 and 2000, respectively, associated with these properties.
Changes in interest rates typically have a significant impact on the fair values of the Company's debt securities. Market interest rates of the ten-year U.S. Treasury bond declined approximately 60 basis points from year-end 2000 causing an unrealized gain of $112.6 million on a portfolio of approximately $3 billion. The Company would expect similar results in the future from any 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 operating results.
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. 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 risk through surrender charges that are imposed to discourage policy surrenders. 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, 2001. 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.
7 Composite Stock Price Index (S&P 500 Index7). However, increases or decreases in investment returns from these options are substantially offset by corresponding increases or decreases in amounts paid to equity-indexed annuity policyholders, subject to minimum guaranteed policy interest rates.
The Company's market risk liabilities, which include policy liabilities for investment annuity and supplemental contracts, are managed for interest rate risk through cash flow testing as previously described. As part of this cash flow testing, the Company has analyzed the potential impact on net earnings of both a 100 basis point increase and decrease in the U.S. Treasury yield curve as of December 31, 2001. A 100 basis point interest rate decline would decrease net earnings for 2002 by approximately $95,000, based on the Company's projections. A 100 basis point increase in interest rates would increase net earnings by approximately $115,000, based on the Company's projections. These estimated impacts to earnings are net of tax effects and the estimated effects of deferred policy acquisition costs.
Revenues: The following details revenues excluding index options and realized gains (losses) on investments:
Traditional life insurance premiums for products such as whole life and term life are recognized as revenues over the premium-paying period. These are product lines that the Company has been de-emphasizing in favor of interest sensitive products, particularly in its international life insurance operations. In addition, 2001 traditional life premiums were muted for increases in reinsurance premiums and translation losses associated with policies in Haiti which is the only international country where premiums and benefits may be paid in other than U.S. dollars.
Other revenue in 2001 consists primarily of two sources. Approximately $5.2 million pertains to the Company's other operations involving a nursing home which commenced operations in 2000. Revenues in 2000 associated with this operation were $0.6 million. Also included in 2001 other revenue is nearly $0.7 million received from the favorable resolution of longstanding litigation against the Company and one of its wholly owned subsidiaries, The Westcap Corporation (Westcap). The United States Court of Appeals, 5th Circuit, ruled in favor of Westcap on the matter in 2001.
Index Options: Index options are derivative financial instruments used to hedge the equity return component of the Company's equity-indexed annuity products, which were first introduced for sale in 1997. 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 a component of net investment income. However, increases or decreases in income from these options are substantially offset by corresponding increases or decreases in amounts paid to equity-indexed annuity policyholders.
The Company benefited from improved mortality experience in 2001 resulting in lower policy benefits. Death claims decreased to $23.6 million in 2001 from $26.2 million with both domestic life and international life recording more favorable results. The Company's mortality experience over the past five years has generally been consistent with its product pricing assumptions.
=s universal life and investment annuity business, have generally declined since 1997, which is consistent with declines in market interest rates. As market interest rates fluctuate, the Company=s credited interest rates are often adjusted accordingly taking into consideration other factors as described above. Raising policy credited rates can typically have an impact sooner than higher market rates on the Company=s investment portfolio yield, making it more difficult to maintain the current interest spread. The difference between yields earned over policy credited rates is often referred to as the interest spread.
Contract interest also includes the performance of the equity-index component of the Company's equity-indexed annuities. As previously noted, the recent market performance of these equity-index features reduced contract interest expenses while also reducing the Company's investment income given the hedge nature of the options purchased for these products. Excluding equity-indexed annuities, the Company's average credited rate on annuity products was approximately 5.4% in 2001. The average credited rate in 2001 for interest sensitive life products approximated 5.5%. With these credited rates, the Company generally realized 95% to 100% of its required interest spread on its products.
Other operating expenses consist of general administrative expenses, licenses and fees, and commissions not subject to deferral. As noted with Other Revenues, the Company commenced its nursing home operations in 2000 and these expenses are included in other operating expenses in the amount of $4.8 million in 2001 and $1.3 million in 2000. Excluding nursing home operations expenses, the Company has been able to leverage its operations to keep expenses relatively stable.
A summary of segment earnings from continuing operations for the years ended December 31, 2001, 2000, and 1999 is provided below. The segment earnings exclude realized gains and losses on investments, net of taxes.
A comparative analysis of results of operations for the Company=s domestic life insurance segment is detailed below:
Revenues from domestic life insurance operations include life insurance premiums on traditional type products and revenues from universal life insurance. Revenues from traditional products are simply premiums collected, while revenues from universal life insurance consist of policy charges for the cost of insurance, policy administration fees, and surrender charges assessed during the period. A comparative detail of premiums and contract revenues is provided below:
Segment earnings have declined as the block of business has contracted. The face amount of domestic life insurance inforce has declined from $3.2 billion at December 31, 1999, to $3.0 billion at December 31, 2000 and $2.9 billion at December 31, 2001. Absent the growth rates targeted by management, the block of business will continue to contract due to the normal incidence of terminations from death or surrender with lower earnings resulting.
International operations have emphasized universal life policies over traditional life insurance products. Premiums collected on universal life products are not reflected as revenues in the Company's statements of earnings in accordance with generally accepted accounting principles. Actual universal life premiums collected are detailed below:
=s primary business encompasses its domestic and international life insurance operations and its annuity operations. However, National Western also has small real estate, nursing home, and other investment operations through its wholly owned subsidiaries. Most of the income from the Company=s subsidiaries is from a life interest in a trust. Gross income distributions from the trust totaled $3,753,000, $3,643,000, and $3,595,000, in 2001, 2000, and 1999, respectively.
During the first quarter of 2000, the Company acquired a nursing home facility through an affiliated limited partnership. The acquisition, which totaled approximately $6.6 million, was made by a newly formed limited partnership, the partners of which are downstream subsidiaries of National Western. The nursing home facility, which opened in late July, 2000, is operated by an affiliated limited partnership, and the financial operating results are consolidated with those of the Company. Daily operations and management of the nursing home are performed by an experienced management company through a contract with the limited partnership. Nursing home operations generated $425,000 of operating earnings in 2001 compared to operating losses of $850,000 in 2000.
Liquidity requirements are met primarily by funds provided from operations. Premium deposits and revenues, investment income, and investment maturities are the primary sources of funds while investment purchases, policy benefits, and operating expenses are the primary uses of funds. Although the Company historically has not been put in the position of liquidating 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 $60 million on its bank line of credit for short-term cash needs.
Derivative Instruments: In June, 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative Instruments and Hedging Activities." . In June, 2000, the FASB issued SFAS No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities," which amended SFAS No. 133 for certain specifically identified derivative instruments and hedging activities. Both pronouncements were required to be implemented effective January 1, 2001. They establish accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. Derivatives must be recognized as either assets or liabilities in the statement of financial position and be measured at fair value.
The Company offers for sale equity-indexed annuities that contain an equity return component for policyholders which is an embedded derivative instrument under the FASB pronouncements. Equity-indexed annuities combine features associated with traditional fixed annuities with the option to have interest rates linked entirely or in part to an index, such as the S&P 500 Index®. The equity return component of such policy contracts must be separately identified and accounted for at fair value as embedded derivatives reflected in the balance sheet as a component of future policy benefits with changes in fair value included in earnings. The remaining portions of these policy contracts are considered the host contracts and are recorded separately as fixed annuity contracts. The host contracts are accounted for as investment contracts under provisions of SFAS No. 97, which requires the host contracts to be recorded as discounted debt instruments that are accreted, using the effective yield method, to their guaranteed account values at the projected maturity or termination dates. The cumulative effect adjustment for the implementation of the change in accounting for equity-indexed annuities resulted in an increase to net earnings totaling $2,134,000, net of taxes of $1,149,000 as of January 1, 2001.
One of the more complex and challenging aspects of interpreting and implementing SFAS No. 133 and No. 138 was how the insurance industry was to apply the statement's provisions to policy liabilities for equity-indexed products. The Derivatives Implementation Group (DIG) of the FASB addressed this policy liability issue, and released guidance for the liability calculation which was not approved by FASB until an effective date of April 1, 2001. The Company implemented this additional guidance on the policy liability valuation method for equity-indexed annuities as of April 1, 2001, which produced an additional reduction in policy liabilities contributing over $1.8 million, net of taxes, to operating earnings.
In conjunction with the sale of equity-indexed annuities, the Company purchases index options to hedge or offset the equity return component of the annuities. Although the Company uses index options to hedge the equity return component of the equity-indexed annuities, these options do not qualify as hedging instruments or for hedge accounting treatment pursuant to SFAS No. 133. Accordingly, the index options are carried at fair value in the balance sheet based upon quoted market prices and mark-to-market gains or losses to record the options at fair value are recognized as net investment income in earnings in the period of change, which has been the Company's practice. Consequently, there was no change in accounting principle for these options upon implementation of SFAS No. 133.
Future Policy Benefits: Because of the long-term nature of insurance contracts, the Company is liable for policy benefit payments many years into the future. The liability for future policy benefits represents estimates of the present value of the Company's expected benefit payments, net of the related present value of future net premium collections. For traditional life insurance contracts, this is determined by standard actuarial procedures, using assumptions as to mortality (life expectancy), morbidity (health expectancy), persistency, and interest rates, which are based on the Company's experience with similar products. The assumptions used are those considered to be appropriate at the time the policies are issued. An additional provision is made on most products to allow for possible adverse deviation from the assumptions assumed. For universal life, investment annuity and equity-indexed annuity products, the Company's liability is the amount of the contract's account balance. Account balances are also subject to minimum liability calculations as a result of minimum guaranteed interest rates in the policies. While management and company actuaries have used their best judgment in determining the assumptions and in calculating the liability for future policy benefits, there is no assurance that the estimate of the liabilities reflected in the financial statements represents the Company's ultimate obligation. Additionally, significantly different assumptions could result in materially different reported amounts. A discussion of the assumptions used to calculate the liability for future policy benefits is reported in Note 1 Summary of Significant Accounting Policies in the Notes to Consolidated Financial Statements found on page __ of this report.
Deferred Acquisition Costs: As previously noted in the discussion of the Company's benefits and expenses on page __ of this report, the Company is required to defer certain policy acquisition costs and amortize them over future periods. Deferred acquisition costs are subject to periodic recoverability and loss recognition testing. These tests ensure that the present value of future contract-related cash flows will support the capitalized deferred acquisition cost balance. The present value of these cash flows, less the benefit reserve, is compared with the unamortized deferred acquisition cost balance and if the asset balance is greater, the deficiency is charged to expense as a component of amortization and the asset balance is reduced to the recoverable amount. For more information about accounting for deferred acquisition costs see Note 1 Summary of Significant Accounting Policies in the Notes to Consolidated Financial Statements found on page __ 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 beginning on page __, Note 3, Investments beginning on page __ in the Notes to Consolidated Financial Statements and discussions under the captions Investments on page __ and Market Risk on page __ of this report.
The events of 2001 have called into question company activities and transactions which are not regularly disclosed in an SEC registrant's Annual Report and are not readily apparent from the financial statements. These include the use of unconsolidated entities, off-balance sheet arrangements and other transactions not conducted at arm's-length. The Company's consolidated financial statements include all subsidiaries and related operations and the Company does not utilize relationships with unconsolidated entities that facilitate the transfer of or access to assets such as "structured finance" or "special purpose" entities. Accordingly, the Company does not rely on off-balance sheet arrangements for financing, liquidity, or market or credit risk support which would expose the Company to liabilities not reflected on the face of its consolidated financial statements. All related party transactions and relationships have been fully disclosed in Items 10 and 13, and Note 16, Related Party Transactions, on page 88 of this report.
The Private Securities Litigation Reform Act of 1995 provides a Asafe harbor@ for forward-looking statements. Certain information contained herein or in other written or oral statements made by or on behalf of National Western Life Insurance Company or its subsidiaries are or may be viewed as forward-looking. Although the Company has used appropriate care in developing any such information, forward-looking information involves risks and uncertainties that could significantly impact actual results. These risks and uncertainties include, but are not limited to, matters described in the Company=s SEC filings such as exposure to market risks, anticipated cash flows or operating performance, future capital needs, and statutory or regulatory related issues. However, National Western, as a matter of policy, does not make any specific projections as to future earnings, nor does it endorse any projections regarding future performance that may be made by others. Whether or not actual results differ materially from forward-looking statements may depend on numerous foreseeable and unforeseeable events or developments. Also, the Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future developments, or otherwise.
The information required by this item is reported in Attachment A beginning on page __. See Index to Financial Statements and Schedules on page __ for a list of financial information included in Attachment A.