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, 2006 follows. This discussion should be read in conjunction with the Company’s consolidated financial statements and related notes beginning on page 74 of this report.
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.
expected term based on contractual term and perceived future behavior relative to exercise
The Company’s consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). In addition, the Company regularly evaluates operating performance using non-GAAP financial measures which exclude or segregate derivative and realized investment gains and losses from operating revenues and earnings. Similar measures are commonly used in the insurance industry in order to assess profitability and results from ongoing operations. The Company believes that the presentation of these non-GAAP financial measures enhances the understanding of the Company’s results of operations by highlighting the results from ongoing operations and the underlying profitability factors of the Company’s business. The Company excludes or segregates derivative and realized investment gains and losses because such items are often the result of events which may or may not be at the Company’s discretion and the fluctuating effects of these items could distort trends in the underlying profitability of the Company’s business. Therefore, in the following sections discussing consolidated operations and segment operations, appropriate reconciliations have been included to report information management considers useful in enhancing an understanding of the Company’s operations to reportable GAAP balances reflected in the consolidated financial statements.
Universal life and annuity contract revenues - 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. The Company has experienced modest growth in its life block of businesses. This growth contributes to higher revenues in the form of cost of insurance charges which were $67.7 million in 2006 compared to $63.3 million in 2005, and $60.1 million in 2004. Administrative charges were $17.1 million, $15.0 million, and $13.0 million for the years ended December 31, 2006, 2005, and 2004, respectively. Surrender charges assessed against policyholder account balances upon withdrawal were $28.7 million in 2006 compared to $25.1 million in 2005 and $23.4 million in 2004.
Net investment income - A detail of net investment income is provided below.
The average invested asset decline in yield is due to the overall interest rate level decline and the Company obtaining lower yields on newly invested funds. In addition, prepayments, calls, and maturities of higher yielding debt securities have added to the yield decrease as these funds are reinvested at lower rates. Refer to the Derivatives discussion following this section for a more detailed explanation.
Derivatives income (loss) - Index options are derivative financial instruments used to fully hedge the equity return component of the Company’s equity-indexed products, which were first introduced for sale in 1997. In 2002, the Company began selling an equity-indexed universal life product in addition to its equity-indexed annuities. Any income or loss 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 credited to equity-indexed annuity and life policyholders.
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 2006 and 2004, the S&P 500 Index® increased and the Company recorded income from index options and likewise increased contract interest expenses. In 2005, the S&P 500 Index® decreased resulting in index option losses and a reduction in contract interest expenses.
Derivative components included in net investment income and the corresponding contract interest amounts are detailed below for each date presented.
Other income - Other income revenues consists primarily of gross income associated with nursing home operations of $11.2 million, $8.9 million, and $8.3 million in 2006, 2005, and 2004, respectively. In addition, the Company received $5.5 million related to lawsuit settlements during 2006. In 2004, a lawsuit settlement of $2.2 million was awarded to the Company relating to an investment previously owned and is also included in other income.
The mortgage loan valuation writedown in 2006 involves a New Orleans property whose value was negatively impacted by Hurricane Katrina.
Amortization of deferred policy acquisition costs increased to $90.4 million for the year ended December 31, 2006 compared to $88.0 million and $88.7 million reported in 2005 and 2004. Amortization for 2006 includes a true-up adjustment relative to partial surrenders, mortality assumptions, annuitizations, credited rates and earned rates which increased amortization in the current year by approximately $4.3 million. There were similar adjustments in 2005 and 2004 relative to amortization assumptions that resulted in increased amortization for those years.
The Company's U.S. operations have typically emphasized annuity product sales over life product sales but recent efforts have been made to attract new independent agents and to promote life products to improve domestic sales. It is the Company's goal to increase domestic life product sales through increased recruiting of new distribution and the development of new life insurance products. The Company had approximately 10,200 contracted agents as of December 31, 2006.
Policy benefits totaled $13.7 million, $14.9 million, and $15.1 million in 2006, 2005, and 2004, respectively, which are consistent with Company expectations. Net investment income remained consistent with $20.5 million, $20.0 million, and $20.3 million for 2006, 2005, and 2004, respectively. Other operating expenses increased significantly in 2006 due to an increase in compensation costs resulting from the change in liability classification for the Company’s stock option plan. Compensation costs totaled $3.0 million, $0.2 million, and $0.2 million in 2006, 2005, and 2004, respectively.
International sales during 2006 reflect Brazil, Taiwan, and Argentina as the top three international countries based on premiums and contract revenues recorded. As the international life insurance in force continues to grow, the Company anticipates operating earnings to similarly increase. The amount of international life insurance in force has grown from $11.3 billion at December 31, 2004 to $12.2 billion at December 31, 2005, and to $13.3 billion at December 31, 2006.
As previously noted, the Company's earnings are dependent upon annuity contracts persisting or remaining in force. While revenues decline with a reduction in surrender charges, the Company's earnings benefit. A mandated change in accounting for two-tier annuities in 2004 had the effect of eliminating payout annuity revenues pertaining to this product.
The Company experienced a substantial increase in sales relating to equity-indexed annuities as the stock market rebounded in 2003 and 2004. These indexed products are more attractive for consumers when interest rate levels remain low as has been the market environment the past few years. Equity-indexed annuity deposits as a percentage of total annuity deposits recorded were 62.5%, 53.5%, and 57.5% for the years ended December 31, 2006, 2005, and 2004, respectively. Since the Company does not offer variable products or mutual funds, equity-indexed products provide an important alternative to the Company's existing fixed interest rate annuity products.
The Company maintains a diversified portfolio which consists primarily of corporate, mortgage-backed, and public utility fixed income securities. Investments in mortgage-backed securities include primarily U.S. government agency pass-through securities and collateralized mortgage obligations ("CMO"). As of December 31, 2006 and 2005, the Company's debt securities portfolio consisted of the following:
National Western does not purchase below investment grade securities. Investments held in debt securities below investment grade are the result of subsequent downgrades of the securities. During 2006, the Company's percentage of below investment grade securities compared to total invested assets decreased from 3.1% to 2.5% as of December 31, 2005 and 2006, respectively. The decrease from year to year is primarily due to principal payments received and settlements from bankruptcy proceedings as well as sales, tenders and a maturity. Also, there were three upgraded and four downgraded securities. The Company's holdings of below investment grade securities as a percentage of total invested assets is relatively small compared to industry averages. These holdings are summarized below.
Holdings in below investment grade securities by category as of December 31, 2006 are summarized below, including 2005 fair values for comparison. The Company is continually monitoring developments in these industries that would affect security valuations.
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 2006. For the twelve months ended December 31, 2005, the Company transferred debt securities due to credit deterioration from the held to maturity portfolio to the available for sale portfolio in the amount of $7.0 million. The unrealized gains associated with the security transferred in 2005 totaled $0.2 million as recorded as a component of accumulated other comprehensive income, net of deferred acquisition costs and taxes. During 2005, two securities were sold from the held to maturity portfolio due to credit deterioration, with amortized cost of $10.0 million resulting in a realized gain of $0.9 million. No held to maturity sales were made during 2006.
The Company held net investments in mortgage loans totaling $103.3 million and $110.6 million at December 31, 2006 and 2005, respectively. The diversification of the portfolio by geographic region and by property type was as follows:
In the fourth quarter of 2006, a valuation loss of $2.1 million was recorded related to a mortgage loan based on information which indicated that the Company may not collect all amounts in accordance with the mortgage agreement. In the fourth quarter of 2004, an impairment loss of $0.6 million and an additional allowance of $0.4 million was recorded related to a mortgage loan based on information which indicated that the Company may not collect all amounts in accordance with the mortgage agreement. This allowance was reversed in the first quarter of 2005 upon the sale of the loan. 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 $12.1 million and $13.4 million at December 31, 2006 and 2005, 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 $0.8 million, $1.0 million, and $1.6 million for the years ended December 31, 2006, 2005, and 2004, 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 gains of $0.6 million, $6.7 million, and $2.2 million in 2006, 2005, and 2004, respectively associated with these properties.
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 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 $40 million on its bank line of credit for short-term cash needs.
Insurance reserves are the means by which life insurance companies determine the liabilities that must be established to assure that future policy benefits are provided for and can be paid. These reserves are required by law and based upon standard actuarial methodologies to ensure fulfillment of commitments guaranteed to policyholders and their beneficiaries, even though the obligations may not be due for many years. Refer to Note (1) in the Notes to Consolidated Financial Statements for a discussion of reserving methods.
(3) Other long-term liabilities includes obligations that are reported within the Company's reserve liabilities that reflect determinable payout patterns related to immediate annuities. The above amounts are undiscounted whereas the amounts included in future policy benefit liabilities are discounted in accordance with GAAP. Liabilities for future policy benefits and other policyholder liabilities of approximately $5.2 billion as of December 31, 2006 have been excluded from the contractual obligations table. These excluded liabilities include future policy benefits relating to life insurance products, deferred annuities, and universal life products. Amounts excluded from the table are comprised of policies or contracts where (a) the Company is not currently making payments and will not make payments in the future until the occurrence of a payment triggering event, such as death or (b) the occurrence of a payment triggering event, such as a surrender of a policy or contract, which is outside of the control of the Company. The timing of these payments is not reasonably fixed and determinable. These uncertainties are considered in the Company's asset-liability management program as previously noted.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and requires additional disclosures about fair value measurements. This Statement does not require any new fair value measurements, but the application of this Statement could change current practices in determining fair value. The Company plans to adopt this guidance effective January 1, 2008. The Company is currently assessing the impact of SFAS No. 157 on the Company's consolidated financial position and results of operations.