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 $487,500 per year plus taxes, insurance, maintenance, and other operating costs. Additionally, the Company's wholly owned subsidiary, The Westcap Corporation, owns two buildings in Austin, Texas, that total 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. Additionally, the intercompany lease costs related to The Westcap Corporation and the nursing home have been eliminated for consolidated reporting purposes.
National Western Life Insurance Company is a life insurance company, chartered in the State of Colorado in 1956, and doing business in forty-three states, the District of Columbia, and four U.S. territories or possessions. It is also licensed in Haiti, and although not otherwise licensed, the Company accepts applications from and issues policies to residents of various Central and South American, Caribbean, and Pacific Rim countries. Such policies are underwritten, accepted, and issued in the United States. A distribution of the Company's direct premium revenues and deposits by domestic and international products is provided below:
The Company's international operations focus on foreign nationals in upper socioeconomic classes with substantial financial resources. 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.
Although National Western purchases only investment grade debt securities, a growing number of companies have become more leveraged due to an environment of heightened acquisition activity and large share repurchase programs. Therefore, continued monitoring of credit quality after the purchase of a company's debt securities is crucial in order for National Western to maintain a high quality portfolio with a low percentage of below investment grade debt securities. While the Company's holdings of below investment grade debt securities remain low, these holdings have increased from $44,974,000 at December 31, 1998, to $82,764,000 at December 31, 2000. This increase is due to downgrades of investment grade debt securities as opposed to purchases of such holdings. Historically, the Company's strong credit risk management and commitment to quality has resulted in minimal defaults in the debt securities portfolio.
The Company records other than temporary impairment writedowns typically based on estimated recovery values which are often significantly in excess of current market values. Quoted market prices are often significantly lower due to limited buyer demand for the securities and due to uncertainty as to the timing of possible bankruptcy proceedings. Realized losses on investments related to writedowns of debt securities totaled $14,671,000 for the year ended December 31, 2000. During 2000, the Company also sold several debt securities primarily for tax planning purposes. Realized losses incurred during 2000 related to these sales totaled $4,394,000. Additionally, only two of the Company's securities were in default at December 31, 2000. Reductions to investment income due to these securities totaled $990,000 for the year ended December 31, 2000.
Another important part of the Company's investment philosophy is managing the cash flow stability of the portfolio. Because expected maturities of securities may differ from contractual maturities due to prepayments, extensions, and calls, the Company takes steps to manage and minimize these risks. The Company reduced its exposure to prepayment and extension risks by lowering its holdings of mortgage-backed securities. This strategy began in 1994 when mortgage-backed securities totaled 47.6% of the entire portfolio, but now total only 21.0% at December 31, 2000, which is comparable to the life insurance industry average. The majority of this reduction was achieved by shifting investments into corporate securities and public utilities, as these holdings have increased from 47.0% in 1994 to 68.1% in 2000. Also, most of these additions have been noncallable corporates, which help reduce prepayment and call risks. The Company has recently begun to buy mortgage-backed securities again, with small purchases in 2000. However, there are no current plans to significantly increase mortgage-backed security holdings as a percentage of the total portfolio.
At December 31, 2000, the Company's debt and equity securities were classified as follows:
As detailed above, debt securities classified as held to maturity comprise the majority of the Company's securities portfolio, while equity securities continue to be a small component of the portfolio. Unrealized losses totaling $45,955,000 on the securities portfolio at December 31, 2000, are a reflection of market interest rates at year-end. The fair values, or market values, of fixed income debt securities correlate to external market interest rate conditions. Because the interest rates are fixed on almost all of the Company's debt securities, market values typically increase when market interest rates decline, and decrease when market interest rates rise. However, market values may fluctuate for other reasons, such as changing economic conditions or increasing event-risk concerns. The correlation between market values and interest rates is reflected in the tables below.
Changes in fair values of securities due to changes in market interest rates is an example of market risk. Market risk is the risk of change in market values of financial instruments due to changes in interest rates, currency exchange rates, commodity prices, or equity prices. The most significant market risk exposure for National Western is interest rate risk. 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. Management strives to closely match the durations of its assets and liabilities. Sensitivity analysis allows the Company to measure the potential gain or loss in fair value of its interest-sensitive instruments and to seek 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 and risk may be limited due to management actions regarding asset and liability instruments. However, potential changes in the values of financial instruments indicated by hypothetical interest changes will likely be different from actual changes experienced, and the differences may be material.
Market risk-sensitive assets of the Company include debt securities, equity securities which are almost entirely preferred stocks, mortgage and other loans, policy loans, and index options. The Company does not maintain a securities trading portfolio. Market risk-sensitive liabilities include policy liabilities for deferred and immediate investment annuity contracts and supplemental contracts. Sensitivity analysis expresses the potential gain or loss in fair value, over a selected time period, from one or more selected hypothetical changes in interest rates which are reasonably possible in the near term. The following table illustrates the market risk sensitivity of the Company's interest rate-sensitive assets. The table shows the effect of a change in interest rates on the fair value of the portfolio. The data is prepared using models that measure the change in fair value arising from an immediate and sustained change in interest rates in increments of 100 basis points.
The debt securities portfolio includes primarily noncallable corporate and public utility bonds, mortgage-backed securities, and asset-backed securities. Expected maturities of debt securities may differ from contractual maturities due to call or prepayment provisions. The model assumes that prepayments on mortgage-backed securities are influenced by agency and pool types, the level of interest rates, loan age, refinancing incentive, month of the year, and underlying coupon. During periods of declining interest rates, principal payments on mortgage-backed securities and collateralized mortgage obligations increase as the underlying mortgages are prepaid. Conversely, during periods of rising interest rates, the rate of prepayment slows. Both of these situations can expose the Company to the possibility of asset/liability cash flow and yield mismatch. The model uses a proprietary method of sampling interest rate paths along with a mortgage prepayment model to derive future cash flows. The initial interest rates used are based on the current U.S. Treasury yield curve as well as current mortgage rates for the various types of collateral in the portfolio.
The Company has modeled these scenarios, as a change in market interest rates could pose potential risks to the current profitability levels of this business. These movements in interest rates are also reasonably possible near-term scenarios given the current interest rate environment. The risks from such changes are primarily due to changes in interest rate spreads, which are the differences between investment income earned and credited interest paid to policyholders. Also, the changes in interest rates can effect the level of surrenders and timing of cash flows related to policy liabilities.
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 investment annuity and supplemental contracts in force at December 31, 2000, and does not consider new product sales or the possible impact of interest rate changes on sales.
In general, the Company seeks 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 growth areas that offer a potential for property value appreciation. These growth areas are found primarily in major metropolitan areas, but occasionally in selected smaller communities.
As of December 31, 2000, the allowance for possible losses on mortgage loans was $4,215,000. This balance reflects a net addition of $111,000 during 2000 which was recognized as a realized loss on investments. The allowance was adjusted as a result of general increases of $402,000, offset by a reduction in the allowance of $291,000 due to the complete repayment of an impaired mortgage loan. Net reductions to the allowance totaling $536,000 were recognized as realized gains on investments in the Company's 1999 financial statements. The allowance was adjusted primarily as a result of the complete repayment of an impaired mortgage loan resulting in an allowance reduction totaling $895,000, partially offset by an unrelated general increase totaling $359,000. Management believes that the allowance for possible losses is adequate. However, while management uses available information to recognize losses, future additions to the allowance may be necessary based on changes in economic conditions, particularly in the West South Central region which includes Texas, Louisiana, Oklahoma, and Arkansas, as this area contains the highest concentrations of the Company's mortgage loans.
A summary of operating results, net of taxes, for the years ended December 31, 2000, 1999, and 1998 is provided below:
An analysis of net investment income also involves a review of market interest rates. Interest rates continued to decline in 1998 from 1997 and 1996 rates. In 1999, interest rates reversed this trend by increasing significantly, and in 2000 interest rates have again declined. However, changes in market rates affect the Company's portfolio yield slowly because of the relatively small volume of new investment purchases during a year in comparison to the size of the overall investment portfolio. As a result, although yields on new investment purchases did increase during 1999, the Company's overall yield on average invested assets declined from 1998. Also, because of lower premium production and higher policy surrenders during 2000, purchases of new debt securities were substantially lower in 2000 than 1999 and 1998. As a result, changes in market rates during 2000 had less impact on the Company's investment yield than in prior years, producing relatively comparable yields between 2000 and 1999. Yields were also somewhat affected by the change in the mix of the investment portfolio. Mortgage loans have typically had significantly higher yields than the Company's investments in debt securities, and average mortgage loan holdings increased in 2000, which helped enhance yields.
The gains in 1999 consist primarily of gains from sales and calls of debt securities totaling $6,250,000, offset by other than temporary impairment writedowns of $4,403,000. The Company also recognized gains totaling $1,963,000 on real estate, the majority of which was from the sale of a real estate property owned by the Company's subsidiary, NWL 806 Main, Inc. The gains in 1998 were primarily from gains on debt securities totaling $1.3 million, substantially all of which related to securities that were called. Realized gains in 1998 also include $300,000 related to a deficiency settlement agreement on a mortgage loan that was foreclosed in 1994.
Other Operating Expenses: Other operating expenses totaled $29,427,000, $27,764,000, and $35,504,000 for the years ended December 31, 2000, 1999, and 1998, respectively. However, when including investment related expenses, which are netted against investment income for reporting purposes, operating and investment expenses totaled $32,467,000, $31,792,000, and $39,120,000 for 2000, 1999, and 1998, respectively. This reflects an increase of only 2.1% in 2000 over 1999 levels due primarily to higher agency convention expenses. The higher expenses in 1998 are due to the nonrecurring costs related to a lawsuit settlement and transfer of the Company's nonqualified defined benefit plan to a pension administration firm as previously described. The relationships between other operating expenses and investment expenses were impacted in 2000 by a new cost allocation study between insurance segments and investment related activities. The study has resulted in lower investment expenses compared to operating expenses than in previous years.
A summary of segment earnings from continuing operations for the years ended December 31, 2000, 1999, and 1998 is provided below. The segment earnings exclude realized gains and losses on investments, net of taxes, and discontinued brokerage operations.
Earnings for the domestic life insurance operating segment were $6,124,000, $8,209,000, and $6,395,000 for 2000, 1999, and 1998, respectively. The higher 1999 earnings were primarily a result of higher universal life insurance revenues, lower other operating expenses, and lower policy benefits, which consists substantially of life insurance death claims. Earnings for 2000 were more comparable to 1998 earnings, primarily due to policy benefits increasing from the lower 1999 levels to an amount more consistent with 1998 benefits. Also, although results for 2000 include lower other operating expenses than 1998, this decrease was offset by higher amortization of deferred policy acquisition costs.
As reflected above, the Company is experiencing declines in first year and single premium production. This is partially due to the intense competition within the U.S. life insurance market. However, the Company's life insurance in force for universal life products continues small and steady increases, resulting in higher cost of insurance revenues as detailed earlier.
Policy benefits were significantly lower in 1999, totaling $15.5 million compared to $17.3 million and $17.9 million for 2000 and 1998, respectively. These benefits consist primarily of life insurance death claims which are subject to fluctuations from period to period. The benefits in 1999 were lower than recent historical experience.
As with domestic operations, revenues from the international life insurance segment include both premiums on traditional type products and revenues from universal life insurance. The international operations' efforts are also focused more on universal life insurance, and, as a result, revenues from these products continue to increase, while premiums from traditional products decline. Cost of insurance revenues continue to increase as the international block of business grows, reflecting increases of 5.6% and 6.9% in 2000 and 1999 over the respective prior years. Additionally, surrender charge revenues were 27.0% higher in 1999 compared to 1998, which corresponds directly to an unusually high increase in universal life insurance policy surrenders of 27.5%. Surrender charge revenues declined somewhat in 2000 from the higher level in 1999.
Actual universal life insurance deposits collected for the years ended December 31, 2000, 1999, and 1998 are detailed below. Deposits collected on these nontraditional products are not reflected as revenues in the Company's statements of earnings, as they are recorded directly to policyholder liabilities upon receipt, in accordance with generally accepted accounting principles. Deposits and universal life insurance in force continue to grow, which corresponds to the previously described increases in cost of insurance revenues.
Amortization of deferred policy acquisition costs were higher in 1998, totaling $15.8 million compared to $15.4 million and $14.6 million in 2000 and 1999, respectively. Changes in anticipated future gross profits resulted in retrospective adjustments to deferred policy acquisition costs, which produced higher amortization in 1998 relative to 2000 and 1999.
Universal life insurance contract interest has risen steadily from $13.4 million in 1998 to $13.9 million and $15.1 million in 1999 and 2000, respectively. The increases in contract interest are consistent with growth in the universal life insurance business. Interest is also higher in 2000 due to increasing policyholder persistency bonuses credited to specific international products. Certain products are credited with bonus interest if the policies remain in force for specified time periods.
The Company's annuity operations are almost exclusively in the United States. Like the Company's domestic life insurance operations, annuities are marketed in 43 states and the District of Columbia using independent agents, brokers, and independent marketing organizations (IMOs). For most of these organizations, annuity sales are much more significant than life insurance sales and are the primary focus of their business operations. Although some of the Company's annuities and investment contracts are available to the international market, current sales are small relative to total annuity sales.
Annuities sold include single and flexible premium deferred annuities, single premium immediate annuities, and equity-indexed annuities. These products can be tax qualified or nonqualified annuities. In recent years the majority of annuities sold have been nonqualified deferred annuities. The Company also continues to collect additional premiums on existing two-tier annuities, as a large portion of the two-tier block of business are flexible premium annuities on which renewal premiums continue to be collected. However, the Company has not sold two-tier annuities since 1992.
Revenues from annuity operations include primarily surrender charges and recognition of deferred revenues relating to immediate or payout annuities. Annuitizations result in transfers of policies from deferred to immediate or payout status. The deferred revenues related to these annuities are amortized into income during the payout period. Total surrender charge revenues were up 26% in 2000 compared to 1999 due to increases in surrender charges from single-tier annuities. While actual policy surrenders for two-tier annuities decreased slightly in 2000, policy surrenders for single-tier annuities were abnormally high, increasing 54% in 2000 from the previous year, resulting in the significant increase in related revenues. Much of the increased surrender activity was in the second and third quarters of 2000, and the activity returned to more normal levels in the fourth quarter. Although single-tier annuity surrenders have been higher, the decline in two-tier annuity surrenders and related income is not unexpected and could continue, since this is a closed block of business. The Company has not sold two-tier annuities since 1992. A comparative detail of the components of premiums and annuity contract revenues is provided below.
Actual annuity deposits collected for the years ended December 31, 2000, 1999, and 1998 are detailed below. Deposits collected on these nontraditional products are not reflected as revenues in the Company's statements of earnings, as they are recorded directly to policyholder liabilities upon receipt, in accordance with generally accepted accounting principles.
Although annuity sales were significantly higher in 1998 than in prior years, sales in 2000 and 1999 decreased 15.5% and 9.6%, respectively. However, premium production in 2000 and 1999 totaling $329.0 million and $389.6 million is still significantly higher than 1997 and 1996 sales, which totaled $241.0 million and $273.2 million, respectively. The strong growth in 1998 was primarily attributable to the Company's new equity-indexed annuity product, as it was first introduced in late 1997. Sales continue to be strong in the Company's other deferred annuity products, as deposits collected have increased from $187.8 million in 1998 to $204.7 million in 2000.
Sales of equity-indexed annuities began declining during the year ended December 31, 1999, primarily due to volatility in the stock market. This volatility affects both the immediate demand for these annuities and the pricing of these products. Increased product costs from stock market volatility, including costs of index options used to hedge the equity return component of these annuities and lower policyholder asset fees, can reduce potential credited interest to policyholders. The lower production level continued throughout 2000, which is consistent with the poor performance of the stock market. Depressed stock market conditions made the equity-indexed annuities less appealing, as the potential for higher credited interest for policyholders was significantly diminished.
Net investment income for 2000, 1999, and 1998 totaled $156,014,000, $191,328,000, and $182,347,000, respectively. The increase in investment income of 4.9% in 1999 is consistent with the growth in annuity segment assets of 5.7% for the same period. The large decrease in net investment income in 2000 is due to declines in fair values of index options totaling $32,268,000. As previously described, index options are derivative financial instruments used to hedge the equity return component of the Company's equity-indexed annuity products. 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 net investment income. The reduction to investment income from index options was due to the decline in the performance of the stock market during 2000, more specifically the S&P 500 Index. Excluding index option income or losses from investment income in the annuity segment results in net investment income totaling $188,282,000, $180,609,000, and $174,290,000 for 2000, 1999, and 1998, respectively. These amounts reflect the growth in investment income which is more consistent with the growth in the annuity segment business. Although investment income in 2000 was substantially lower due to index options, the contract interest expense for the Company's equity-indexed annuities was significantly lower also as described in more detail below.
As a result of the settlement, accrued bonus commissions relating to the NAP contract totaling $8,482,000 were released, as they are no longer considered a liability to NAP and will not be paid. Accordingly, the release of these accrued commissions from liabilities in 1999 resulted in additional income of $8,482,000, before taxes. Any future renewal premiums received by the Company on currently issued and in force annuity policies written by NAP sub-agents under the contract could generate additional commissions for such sub-agents. The payment of such future commissions is subject to and conditioned upon receipt of such renewal premiums by the Company and compliance by the sub- agents with the terms of the agents' contracts with the Company and NAP.
The relationship of contract interest for equity-indexed annuities and the income from index options used as hedges are important factors in analyzing the results of this product. Differences between income from index options and contract interest credited to policyholders will occur for several reasons, some of which may only be timing differences between the recognition of income and expenses. One reason is that the costs of the index options are essentially amortized against net investment income, as the options are marked to fair value each reporting period. The costs of options are covered by additional income earned on debt securities purchased with equity-indexed annuity premiums. Other differences are due to asset fees charged against policyholder contract interest, surrenders, and death benefits on annuities within the annual hedging period and inherent differences between index option fair values and policy liability reserves related to minimum guaranteed interest rates. Another important factor regarding these products is that during periods of poor stock market performance, asset fees charged against policyholder contract interest may be significantly lower. This can reduce the current profitability of these annuities.
Other operating expenses totaled $10,593,000, $9,772,000, and $15,145,000 for 2000, 1999, for 1998, respectively. Expenses for 2000 were somewhat higher than the 1999 level. As previously described for international operations, 2000 expenses were impacted partially due to a new cost allocation study between segments and investment related activities. Expenses for 1998 were unusually high primarily due to two nonrecurring items as previously described in the summary of consolidated operating results. Additional pension expenses were incurred in 1998 related to the Company's transfer of its nonqualified defined benefit plan to a pension administration firm. Also included in 1998 expenses is a $5,000,000 lawsuit settlement for the Diffie, et al vs. National Western Life Insurance Company and National Annuity Programs, Inc. class action litigation. The litigation involved various issues regarding sales of the Company's annuities.
Most of the income from the Company's subsidiaries is from a life interest in the Libbie Shearn Moody Trust. This asset was owned by National Western Life Insurance Company prior to 1997 but was transferred to NWL Services, Inc., in 1997. Gross income distributions from the Trust totaled $3,643,000, $3,595,000, and $3,451,000 in 2000, 1999, and 1998, respectively.
The Company also has significant cash flows from both scheduled and unscheduled investment security maturities, redemptions, and prepayments. These cash flows totaled $113 million, $187 million, and $159 million in 2000, 1999, and 1998, respectively. The Company again expects significant cash flows from these sources in 2001 at levels consistent with the past year.
The Company currently sells equity-indexed annuities that contain an equity return component for policyholders which is an embedded derivative instrument. The Company purchases index options, which are also derivative instruments, to hedge this equity return component. The index options are reported at fair value in the Company's financial statements, which is in accordance with SFAS No. 133 requirements. The Company also uses a fair value approach in recording policy liabilities for the equity-indexed annuities. However, one of the more complex and challenging aspects of interpreting and implementing SFAS No. 133 is how the insurance industry is 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 only recently in December, 2000, released guidance for the liability calculation. The DIG guidance was approved by FASB at its meeting on March 14, 2001. Because of the lack of guidance and delayed approval by FASB, companies are allowed additional time to implement the new policy liability method for equity-indexed annuities. National Western will implement the new method effective April 1, 2001, as provided by changes to the implementation guidance. The Company is continuing its review of the final guidance and is in the process of making system programming changes to calculate policy liabilities under the new method. This method requires that the option portion of the contract be identified and accounted for as an embedded derivative, while the insurance portion of the contract is recorded independently as an annuity contract. Preliminary calculations indicate that if the new method were to be implemented on January 1, 2001, policy liabilities may be reduced. However, the final impact of the change has yet to be determined. The difference in policy liability calculations is not anticipated to be material to the Company's financial position, although it could be significant to net income for the year ended December 31, 2001. Any finally determined adjustment will be reported in net income as a cumulative effect of a change in accounting principle in the second quarter of 2001.
Regulations that affect the Company and the insurance industry are often the result of efforts by the National Association of Insurance Commissioners (NAIC). The NAIC is an association of state insurance commissioners, regulators, and support staff that acts as a coordinating body for the state insurance regulatory process. The NAIC has recently completed a comprehensive process of codifying statutory accounting practices and procedures. Other than specific individual state laws, the codification results will be the only source of prescribed statutory accounting practices. The Company's state of domicile, Colorado, has adopted the new codified statutory accounting practices and procedures. Insurance companies must adopt these new statutory accounting practices in 2001, which will result in significant changes to existing practices used in the preparation of statutory financial statements. The Company is currently in the process of finalizing the implementation of the new accounting practices, as the first statutory financial statements filed under the new rules will be for the quarter ended March 31, 2001. National Western currently anticipates the financial effects of implementation will be to increase statutory capital and surplus by approximately $3 million as of January 1, 2001. The Company's statutory capital and surplus as of December 31, 2000, before the effects of the rule changes was $396 million.