The Westcap Corporation, a wholly owned subsidiary, owns the Company’s principal office location in Austin, Texas and two buildings adjacent to it, totaling approximately 93,000 square feet that are leased and utilized by the Company. The Company’s affiliate, Regent Care Building, Limited Partnership, owns a 65,000 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. The Company’s subsidiary Regent Care San Marcos Holdings, LLC completed construction of a 74,000 square foot building in San Marcos, Texas that will be utilized in nursing home operations beginning in 2009. 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.
effect of interest rate changes on revenues and investments including asset and liability matching
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 2008, incorporating required disclosures in accordance with the rules and regulations of the Securities and Exchange Commission.
DAC is also 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 DAC balance to be amortized in the future. The present value of these cash flows, less the benefit reserve, is compared with the unamortized DAC balance and if the DAC 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 DAC including 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, see Note 1, Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements.
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, Note 3, Investments, in the Notes to Consolidated Financial Statements and the discussions under Investments in Item 7 of this report.
The Company annually reviews its pension benefit plans 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 the long-term investment policy of the plans, 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. These assumptions involve uncertainties and judgment, and therefore actual performance may not be reflective of the assumptions.
Other postretirement benefit assumptions include future events affecting retirement age, mortality, dependency status, per capita claims costs by age, health care trend rates, and discount rates. Per capita claims cost by age is the current cost of providing postretirement health care benefits for one year at each age from the youngest age to the oldest age at which plan participants are expected to receive benefits under the plan. Health care trend rates involve assumptions about the annual rate(s) of change in the cost of health care benefits currently provided by the plan, due to factors other than changes in the composition of the plan population by age and dependency status. These rates implicitly consider estimates of health care inflation, changes in utilization, technological advances and changes in health status of the participants.
The fixed income markets, our primary investment source, are experiencing a high level of volatility and limited market liquidity conditions. Credit downgrade events have begun and there is an increased probability of default for many fixed income instruments. These volatile market conditions have also increased the difficulty of valuing certain securities as trading is less frequent and/or market data is less observable. Certain securities that were in active markets with significant observable data became illiquid due to the current financial environment resulting in valuations that require greater estimation and judgment as well as valuation methods which are more complex. Such valuations may not ultimately be realizable in a market transaction and may change very rapidly as market conditions change and valuation assumptions need to be modified.
Traditional life and annuity premiums - Traditional life and annuity premiums decreased 9.0% in 2008 compared to 2007. Traditional life insurance premiums for products such as whole life and term life are recognized as revenues over the premium-paying period. The Company’s life insurance sales focus has been primarily centered around universal life products.
Investment grade debt securities generated approximately 94.5% of total investment income, excluding derivatives in 2008. The decrease in short-term investment income in 2008 is attributable to fewer asset holdings on these investments compared to prior years when the yield curve was flat or slightly inverted and the Company did not sacrifice yield holding shorter term securities and lower short-term yields. There was no other investment income from profit participation agreements in 2008. Other investment income received on various profit participation arrangements of $0.9 million and $1.2 million were recorded in 2007 and 2006, respectively. In addition, proceeds of $0.9 million and $4.3 million were received in 2008 and 2006, respectively from a class action settlement on a disposed debt security.
Other income - Other income consists primarily of gross income associated with nursing home operations of $12.5 million, $12.6 million, and $11.2 million in 2008, 2007, and 2006, respectively. In addition, the Company received $0.5 million and $5.5 million related to lawsuit settlements during 2007 and 2006, respectively.
Realized gains (losses) on investments - The net losses reported in 2008 of $26.2 million consisted of gross gains of $2.2 million primarily from calls and sales of debt securities, offset by gross losses of $28.4 million, which includes the other-than-temporary impairment losses highlighted in the table below.
The mortgage loan valuation writedown in 2008 principally involves one property located in Ft. Smith, Arkansas. The 2007 and 2006 mortgage loan valuation write downs involve a New Orleans property whose value was negatively impacted by Hurricane Katrina.
Amortization of deferred policy acquisition costs - Life insurance companies are required to defer certain expenses associated with acquiring new business. The majority of these acquisition expenses consist of commissions paid to agents, underwriting costs, and certain marketing expenses and sales inducements. The Company defers sales inducements in the form of first year interest bonuses on annuity and universal life products that are directly related to the production of new business. These charges are deferred and amortized using the same methodology and assumptions used to amortize other capitalized acquisition costs and the amortization is included in contract interest. Recognition of these deferred policy acquisition costs in the consolidated financial statements is to occur over future periods in relation to the expected emergence of profits priced into the products sold. This emergence of profits is based upon assumptions regarding premium payment patterns, mortality, persistency, investment performance, and expense patterns. Companies are required to review these assumptions periodically to ascertain whether actual experience has deviated significantly from that assumed. If it is determined that a significant deviation has occurred, the emergence of profit patterns is to be "unlocked" and reset based upon the actual experience.
Amortization of deferred policy acquisition costs increased to $127.1 million for the year ended December 31, 2008 compared to $88.4 million and $90.4 million reported in 2007 and 2006. An unlocking adjustment was recorded in the current year which resulted in an increase of amortization by $6.3 million. This unlocking adjustment was based upon changes to future annuitizations and full surrenders reflecting current experience studies. An unlocking adjustment was recorded in 2007 which resulted in a decrease in amortization of $10.4 million. This unlocking adjustment was based upon changes to (1) future mortality assumptions reflecting current experience studies and (2) assumption changes to future cost of insurance rates. There were no unlocking adjustments recognized during 2006. True-up adjustments were also recorded in 2008 and 2007 relative to partial surrender rates, mortality rates, credited interest rates and earned rates for the current year’s experience resulting in a $16.2 million and $1.0 million increase in amortization, respectively. Amortization for 2006 includes a true-up adjustment relative to partial surrenders, mortality assumptions, annuitizations, credited rates and earned rates which increased amortization in that year by approximately $5.4 million.
During the fourth quarter of 2008, during a detailed review of Deferred Acquisition Cost assets, the Company identified that it a had over capitalized $2.4 million of deferred acquisition costs during the first three quarters of 2008, and an additional $3.5 million for periods prior to 2008. This immaterial error was corrected during the fourth quarter and resulted in a decrease in the deferred acquisition cost asset and an increase in amortization.
Federal Income Taxes - Federal income taxes on earnings from continuing operations for 2008, 2007, and 2006 reflect effective tax rates of 32.1%, 31.8%, and 34.6%, respectively, which are lower than the expected Federal rate of 35% primarily due to tax-exempt investment income related to investments in municipal securities and dividends-received deductions on income from stock investments.
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.
The Company’s premiums and contract revenues have increased 8% from 2007 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 4,300 contracted agents as of December 31, 2008.
Policy benefits in 2006 through 2008 were consistent with Company expectations. Net investment income increased to $20.3 million in 2008 as compared to $18.9 million in 2007, consistent with the growth of the volume of insurance in force. Other operating expenses 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 in both 2008 and 2007 and $3.0 million 2006.
The Company's international life operations historically 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 growth with its fixed-indexed universal life products and has collected premiums of $78.5 million, $76.8 million, and $60.5 million for the years ended 2008, 2007, and 2006, respectively.
Life and other policy benefits in 2006 through 2008 were generally consistent with Company expectations. Amortization of deferred policy acquisition costs in 2008, were impacted as the Company recorded true-up adjustments that reduced the DAC asset and increased amortization by $3.7 million. The Company recorded an unlocking adjustment benefit in 2007 totaling $9.0 million relative to improved mortality assumptions that resulted 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 2007 amortization for the unlocking and true-up adjustments was 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. 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 includes fluctuations primarily the result of the S&P 500 Index® performance relative to the equity-indexed universal life products. The associated stock market gains and losses increase or decrease the amounts the Company credited to policyholders.
Other operating expenses reported in 2008 were 8% higher compared to 2007. The lower level in 2007 resulted from negative compensation costs related to stock options recorded under liability accounting. Compensation costs totaled $0.6 million, $0.4 million, and $5.1 million in 2008, 2007, and 2006, respectively.
Fixed-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 68.7%, 72.4%, and 62.5% for the years ended December 31, 2008, 2007, and 2006, 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. The performance of equity markets in 2008 had a dampening effect on sales of these products.
Other deferred annuity deposits increased 4.3% in 2008 compared to 2007. These product sales had 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 $19.4 million, $20.8 million, and $19.8 million for the years ended December 31, 2008, 2007, and 2006, respectively.
National Western'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. Most of the income from the Company's subsidiaries is from a life interest in a trust. Gross income distributions from the trust totaled $4.1 million, pre-tax, in both 2008 and 2007, and $4.5 million in 2006.
The Company owns a nursing home facility which is operated by an affiliated limited partnership, whose 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 $1.1 million, $1.6 million, and $1.0 million of operating earnings in 2008, 2007, and 2006, respectively.
The Company maintains a diversified portfolio which consists primarily of corporate, mortgage-backed, and public utility fixed income securities. Investments in mortgage-backed securities primarily include U.S. government agency pass-through securities and collateralized mortgage obligations ("CMO"). As of December 31, 2008 and 2007, the Company's debt securities portfolio consisted of the following:
The mortgage-backed portfolio includes 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 asset-backed portfolio includes thirteen subprime securities, totaling $47.0 million. 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. All of the loans classified as Alt-A or subprime in the Company’s portfolio as of December 31, 2008 were underwritten prior to 2005 as noted in the table below.
As of December 31, 2008, nine of the subprime securities were rated AAA, two were rated AA, one was rated A, and one was rated BBB.
The Company closely monitors its 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 or the markets in general is possible, which may result in further writedowns.
Level 3: Fair value is based on significant unobservable inputs which reflect the entity’s or third party pricing service assumptions about the assumptions market participants would use in pricing an asset or liability. The Company’s Level 3 assets include certain equity securities and certain less liquid or private fixed maturity debt securities where significant valuation inputs cannot be corroborated with market observable data. The Company’s Level 3 liabilities consist of share-based compensation obligations. Valuations are estimated based on non-binding broker prices or internally developed valuation models or methodologies, discounted cash flow models and other similar techniques.
The following table sets forth the Company’s assets and liabilities that are measured at fair value on a recurring basis as of the date indicated:
The fair value hierarchy classifications are reviewed each reporting period. Reclassification of certain financial assets and liabilities may result based on changes in the observability of valuation attributes. Reclassifications are reported as transfers into and out of Level 3 at the beginning fair value for the reporting period in which the changes occur.
The Company is required to classify its investments in debt and equity securities into one of three categories: (a) trading securities, (b) securities available for sale, or (c) securities held to maturity. The Company purchases securities with the intent to hold to maturity and accordingly does not maintain a portfolio of trading securities. Of the remaining two categories, available for sale and held to maturity, the Company makes a determination as to which category based on various factors including the type and quality of the particular security and how it will be incorporated into the Company's overall asset/liability management strategy. As shown in the table below, at December 31, 2008, approximately 31.9% of the Company's total debt and equity securities, based on fair values, were classified as securities available for sale. These holdings provide flexibility to the Company to react to market opportunities and conditions and to practice active management within the portfolio to provide adequate liquidity to meet policyholder obligations and other cash needs.
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. For the year 2008, the Company recorded other-than-temporary impairment writedowns on debt securities consisting of Washington Mutual ($9.3 million), Clear Channel Communications ($8.7 million), GMAC ($2.3 million), and Greentree Financial ($1.5 million) and on equity securities totaling $5.4 million including Freddie Mac and Fannie Mae preferred stock ($4.6 million). Due to the events leading to the writedowns also providing evidence of a significant deterioration in the issuers’ credit worthiness, the Washington Mutual, Greentree Financial and two GMAC securities were transferred 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.
Changes in interest rates typically have a significant impact on the fair values of the Company's debt securities. During 2008, market interest rates of the ten-year U.S. Treasury bond decreased 181 basis points from year end 2007 while there was a substantial increase in corporate spreads over the treasury yield. This increase in spread contributed to the increase in the unrealized loss balance of $253.8 million on a portfolio of approximately $5.6 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.
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, 2008. 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.
The Company's market risk liabilities, which include policy liabilities for annuity and supplemental contracts, are managed for interest rate risk through cash flow testing as previously described. As part of this cash flow testing, the Company has analyzed the potential impact on net earnings of a 100 basis point decrease and increases in increments of 100 basis points in the U.S. Treasury yield curve as of December 31, 2008. The potential impact on net earnings from these interest rate changes are summarized below.
It is Company practice not 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.
In December 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 160, Noncontrolling Interests in Consolidated Financial Statements. SFAS 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 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 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 April 2008, the FASB issued FSP No. FAS 142-3, Determination of the Useful Life of Intangible Assets. FSP FAS 142-3 amends the factors to be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS 142. The provisions of FSP FAS 142-3 are to be applied prospectively to intangible assets acquired after January 1, 2009 although the disclosure provisions are required for all intangible assets as of or subsequent to January 1, 2009. The adoption of FSP FAS 142-3 is not expected to impact the Company’s consolidated financial condition and results of operations.
Other recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force), the AICPA, and the SEC did not, or are not believed by management to, have a material impact on the Company's present or future consolidated financial statements.
See Attachment A, Index to Financial Statements and Schedules, on page 81.