The Company maintains a diversified debt securities portfolio which consists of various types of fixed income securities including primarily corporate, mortgage-backed securities, and public utilities. Investments in mortgage-backed securities include primarily U.S. government agency pass-through securities and collateralized mortgage obligations (CMOs). As of December 31, 1998, 1997, and 1996, the Company's debt securities portfolio consisted of the following mix of securities based on amortized cost:
An important aspect 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 continues to reduce 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 22.5% at December 31, 1998. The majority of this reduction has been achieved by shifting investments into corporate securities, as corporate holdings have increased from 32.5% in 1994 to 53.9% in 1998. Also, most of these additions have been noncallable corporates which help reduce prepayment and call risks.
As indicated above, the Company's holdings of mortgage-backed securities are also subject to prepayment risk, as well as extension risk. Both of these risks are addressed by specific portfolio management strategies. The Company has substantially reduced both prepayment and extension risks by investing primarily in collateralized mortgage obligations which have more predictable cash flow patterns than pass-through securities. These securities, known as planned amortization class I (PAC I) CMOs, are designed to amortize in a more predictable manner than other CMO classes or pass-throughs. Using this strategy, the Company can more effectively manage and reduce prepayment and extension risks, thereby helping to maintain the appropriate matching of the Company's assets and liabilities.
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 a 100 basis point decline in the U.S. Treasury yield curve as of December 31, 1998. This interest rate decline would reduce net earnings for 1999 by less than $200,000 based on the Company's projections. This estimated earnings decline is net of tax benefits determined at a tax rate of 35%.
Net earnings for 1998 also include a lawsuit settlement as previously reported by the Company on September 28, 1998. Parties involved in the Diffie, et al vs. National Western Life Insurance Company and National Annuity Programs, Inc. class action litigation filed a joint motion in District Court for preliminary approval of a settlement agreement among the parties. This settlement was approved by the Court in January, 1999, and, as a result, the Company will pay $5,000,000 to settle the litigation. This amount was accrued in the Company's financial statements in 1998, thereby reducing earnings $3,250,000, after taxes.
The Company's domestic life insurance operations concentrate marketing efforts on federal employees, seniors, and specific employee groups in private industry, as well as individual sales. The products marketed are universal life insurance and traditional life insurance, which includes both term and whole life products. National Western markets and distributes its domestic products primarily through independent agents and brokers and independent marketing organizations (IMOs). The IMOs also assist the Company in recruiting, contracting, and managing agents as well as providing additional financial resources for product marketing. Geographically, the domestic life insurance operations market products in most of the United States, which encompasses 43 states and the District of Columbia. The states in which the Company does not conduct business are primarily in the northeast and include Connecticut, Delaware, Massachusetts, New Hampshire, New Jersey, New York, and Vermont.
The Company has implemented an investment hedging program to offset the potential higher returns required to be paid on these products. Specifically, the Company purchases index options from highly rated banks and brokerage firms. These index options act as hedges to match closely the returns based on the S&P 500 Composite Stock Price Index which may be paid to policyholders.
National Western does have some exposure to date-sensitive embedded technology such as microcontrollers, but the Company views this exposure as minimal. Unlike other industries that may be equipment intensive, such as manufacturing, National Western is a financial services company providing insurance and annuities to its customers. As such, the primary equipment and electronic devices used are computers and telephone-related equipment. This type of hardware can have date-sensitive embedded technology which could be subject to Year 2000 problems. Because of this exposure, National Western has reviewed its computer hardware and telephone systems, with assistance from the applicable vendors, and has replaced or is in the process of replacing any items that will not properly process date-sensitive data in the Year 2000 or beyond. This project was substantially completed as of December 31, 1998.