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| AEL > SEC Filings for AEL > Form 10-Q on 10-Aug-2009 | All Recent SEC Filings |
10-Aug-2009
Quarterly Report
Management's discussion and analysis reviews our unaudited consolidated financial position at June 30, 2009, and the unaudited consolidated results of operations for the three and six month periods ended June 30, 2009 and 2008, and where appropriate, factors that may affect future financial performance. This analysis should be read in conjunction with our unaudited consolidated financial statements and notes thereto appearing elsewhere in this Form 10-Q, and the audited consolidated financial statements, notes thereto and selected consolidated financial data appearing in our Annual Report on Form 10-K for the year ended December 31, 2008. All prior period amounts are presented as adjusted due to the adoption of Financial Accounting Standards Board ("FASB") Staff Position ("FSP") No. APB 14-1, Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement) ("FSP APB 14-1").
All statements, trend analyses and other information contained in this report and elsewhere (such as in filings by us with the Securities and Exchange Commission ("SEC"), press releases, presentations by us or our management or oral statements) relative to markets for our products and trends in our operations or financial results, as well as other statements including words such as "anticipate," "believe," "plan," "estimate," "expect," "intend," and other similar expressions, constitute forward-looking statements. These forward-looking statements are subject to known and unknown risks, uncertainties and other factors which may cause actual results to be materially different from those contemplated by the forward-looking statements. Such factors include, among other things:
† general economic conditions and other factors, including prevailing interest rate levels and stock and credit market performance which may affect (among other things) our ability to sell our products, our ability to access capital resources and the costs associated therewith, the fair value of our investments, which could result in impairments and other than temporary impairments, and certain liabilities, and the lapse rate and profitability of policies;
† customer response to new products and marketing initiatives;
† changes in Federal income tax laws and regulations which may affect the relative income tax advantages of our products;
† increasing competition in the sale of annuities;
† regulatory changes or actions, including those relating to regulation of financial services affecting (among other things) bank sales and underwriting of insurance products and regulation of the sale, underwriting and pricing of products; and
† the risk factors or uncertainties listed from time to time in our private placement memorandums or filings with the SEC.
For a detailed discussion of these and other factors that might affect our performance, see "Risk Factors" in Part II, Item 1A and Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2008.
Overview
We specialize in the sale of individual annuities (primarily deferred annuities) and, to a lesser extent, we also sell life insurance policies. Under U.S. generally accepted accounting principles ("GAAP"), premium collections for deferred annuities are reported as deposit liabilities instead of as revenues. Similarly, cash payments to policyholders are reported as decreases in the liabilities for policyholder account balances and not as expenses. Sources of revenues for products accounted for as deposit liabilities are net investment income, surrender and other charges deducted from the account balances of policyholders in connection with withdrawals, realized gains and losses on investments and changes in fair value of derivatives. Components of expenses for products accounted for as deposit liabilities are interest credited to account balances, changes in fair value of embedded derivatives, amortization of deferred policy acquisition costs and deferred sales inducements, other operating costs and expenses and income taxes.
Annuity deposits by product type collected during the three months and six months ended June 30, 2009 and 2008, were as follows:
Three Months Ended Six Months Ended
June 30, June 30,
Product Type 2009 2008 2009 2008
(Dollars in thousands)
Fixed index annuities:
Index strategies $ 484,612 $ 391,783 $ 729,142 $ 724,619
Fixed strategy 626,146 248,397 980,892 421,930
1,110,758 640,180 1,710,034 1,146,549
Fixed rate annuities:
Single-year rate guaranteed 28,966 6,738 39,416 13,971
Multi-year rate guaranteed 4,774 1,085 48,181 2,643
33,740 7,823 87,597 16,614
Total before coinsurance ceded 1,144,498 648,003 1,797,631 1,163,163
Coinsurance ceded 289 434 589 971
Net after coinsurance ceded $ 1,144,209 $ 647,569 $ 1,797,042 $ 1,162,192
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Net annuity deposits after coinsurance ceded increased 77% during the three months ended June 30, 2009 compared to the same period in 2008, and increased 55% during the six months ended June 30, 2009, compared to the same period in 2008. We attribute these increases to several factors, including our continued strong relationships with our national marketing organizations and field force of licensed, independent insurance agents, the increased attractiveness of safe money products in volatile markets, lower interest rates on competing products such as bank certificates of deposit; and product enhancements including a new generation of guaranteed income withdrawal benefit riders. In addition, we have benefitted during the first six months of 2009 from the actions of several significant competitors who have restricted their capacity to accept new business. The extent to which this trend will be sustained for the balance of the year is uncertain. While we have the capital resources to accept more business than was sold in 2008, our capacity is not unlimited and sales growth must be matched with available capital resources to maintain desired financial strength ratings from credit rating agencies and in particular, A.M. Best Company. Toward this end, effective June 1, 2009, we restructured our payment of commissions to agents on new sales by reducing the amount of commission paid at the time of sale but providing for additional commission payments on the first and second anniversaries of the date a policy was issued. This change will initially increase our statutory earnings and capital and surplus and our capacity to accept new business. It is uncertain what impact the change will have on the agents' willingness to sell business for us. During the second quarter of 2009 we also amended one of our reinsurance agreements with Hannover Life Reassurance Company of America to include certain policy forms that were not in existence in 2005 when the agreement was executed. This amendment increased the statutory reinsurance reserve credit by approximately $37.4 million at June 30, 2009. Subsequent to June 30, 2009 we entered into two letters of intent with a newly formed reinsurance company to reinsure on a funds withheld coinsurance basis 20% of the annuity deposits received in 2009 from our two top selling index annuity products and 80% of the annuity deposits received after June 30, 2009 from a multi-year rate guaranteed fixed annuity product. Our objective with these agreements is to manage our new business growth to a maximum of $3 billion of net annuity deposits for 2009. We also have an additional $25 million available to us under our revolving line of credit with banks as a potential source of statutory capital should sales continue at an accelerated rate.
Earnings from products accounted for as deposit liabilities are primarily generated from the excess of net investment income earned over the interest credited or the cost of providing index credits to the policyholder, or the "investment spread". Our investment spread is summarized as follows:
Six Months Ended
June 30,
2009 2008
Average yield on invested assets 6.29 % 6.17 %
Cost of money:
Aggregate 3.31 % 3.49 %
Cost of money for index annuities 3.30 % 3.51 %
Average crediting rate for fixed rate annuities:
Annually adjustable 3.26 % 3.26 %
Multi-year rate guaranteed 3.89 % 3.92 %
Investment spread:
Aggregate 2.98 % 2.68 %
Index annuities 2.99 % 2.66 %
Fixed rate annuities:
Annually adjustable 3.03 % 2.91 %
Multi-year rate guaranteed 2.40 % 2.25 %
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The cost of money for index annuities and average crediting rates for fixed rate annuities are computed based upon policyholder account balances and do not include the impact of amortization of deferred sales inducements. See Critical Accounting Policies - Deferred Policy Acquisition Costs and Deferred Sales Inducements included in Management's Discussion and Analysis included in our Annual Report on Form 10-K for the year ended December 31, 2008. With respect to our index annuities, the cost of money includes the average crediting rate on amounts allocated to the fixed rate strategy, expenses we incur to fund the annual index credits and where applicable, minimum guaranteed interest credited. Proceeds received upon expiration or early termination of call options purchased to fund annual index credits are recorded as part of the change in fair value of derivatives, and are largely offset by an expense for interest credited to annuity policyholder account balances. See Critical Accounting Policies - Derivative Instruments - Index Products included in Management's Discussion and Analysis included in our Annual Report on Form 10-K for the year ended December 31, 2008.
Our profitability depends in large part upon the amount of assets under our management, investment spreads we earn on our policyholder account balances, our ability to manage our investment portfolio to maximize returns and minimize risks such as interest rate changes and defaults or impairments of assets, our ability to manage interest rates credited to policyholders and costs of the options purchased to fund the annual index credits on our index annuities, our ability to manage the costs of acquiring new business (principally commissions to agents and bonuses credited to policyholders) and our ability to manage our operating expenses.
Results of Operations
Three and Six Months Ended June 30, 2009 and 2008
Net income increased 147% to $9.0 million for the second quarter of 2009, and decreased 31% to $35.5 million for the six months ended June 30, 2009 compared to $3.7 million and $51.7 million for the same periods in 2008. Net income for the six months ended June 30, 2008 includes the impact of the adoption of Statement of Financial Accounting Standards ("SFAS") No. 157, Fair Value Measurements ("SFAS 157") as discussed below. Net income for the six months ended June 30, 2009 includes the impact of applying Financial Accounting Standards Board ("FASB") Staff Position ("FSP") No. FAS 115-2 and FAS 124-2, Recognition and Presentation of Other Than Temporary Impairments ("FSP FAS 115-2") as discussed below.
Net income has been positively impacted by the growth in the volume of business in force and the investment spread earned on this business. Average annuity account values outstanding increased 14% for the second quarter of 2009 and 13% for the six months ended June 30, 2009 compared to the same periods in 2008. Our investment spread measured on a percentage basis was 2.97% for the second quarter of 2009 and 2.98% for the six months ended June 30, 2009 compared to 2.76% and 2.68% for the same periods in 2008. The increase in investment spread resulted from a higher investment yield earned on average assets due to higher yield on investments purchased throughout 2008 and during the first six months of 2009 and a lower aggregate cost of money on our index annuities. The lower cost of money for index annuities during 2009 was due to adjustments we made throughout 2007 to caps, participation rates and asset fees to manage the cost of options purchased to fund the annual index credits. The benefit from these adjustments was not fully recognized until the fourth quarter of 2008.
The comparability of the amounts is significantly impacted by net realized gains on investments, net other than temporary impairment ("OTTI") losses recognized in operations, gain (loss) on extinguishment of debt and the impact of the application of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities ("SFAS 133") to our index annuity business. We estimate that these items increased (decreased) net income as follows:
Three Months Ended Six Months Ended
June 30, June 30,
2009 2008 2009 2008
(Dollars in thousands)
Net realized gains and net impairment
losses on investments recognized in
operations $ (141 ) $ (8,910 ) $ 537 $ (9,918 )
Gain (loss) on extinguishment of debt 1,812 263 1,812 107
Application of SFAS 133 to index annuity
business (12,541 ) (5,569 ) (8,845 ) 27,586
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Net realized gains on investments and net impairment losses recognized in operations fluctuate from period to period based upon changes in the interest rate and economic environment and the timing of the sale of investments or the recognition of other than temporary impairments. We adopted FSP FAS 115-2 effective January 1, 2009, which amended the determination of the amount of other than temporary impairments recognized in the statement of operations resulting in the noncredit portion of other than temporary impairments being recognized in accumulated other comprehensive loss for debt securities that we do not intend to sell and it is not more likely than not we will be required to sell but also do not expect to recover the entire amortized cost basis of the security. The amounts disclosed above are
net of related reductions in amortization of deferred sales inducements and deferred policy acquisition costs and income taxes. The net gain for the six months ended June 30, 2009 includes a benefit of $3.6 million for the reduction of the deferred tax valuation allowance related to other than temporary impairments.
Amounts attributable to the application of SFAS 133 to our index annuity business fluctuate based upon changes in the fair values of call options purchased to fund the annual index credits for index annuities and changes in the interest rates used to discount the embedded derivative liability. The significant increase in the impact from this item for the six months ended June 30, 2008 is primarily attributable to the adoption of SFAS 157 which requires that the discount rates used in the calculation of the fair value of embedded derivatives for index annuities include non performance risk related to those liabilities. The discount rates are based on risk-free interest rates adjusted for the our non performance risk. Prior to the adoption of SFAS 157, the discount rates used were risk-free interest rates. SFAS 157 was adopted prospectively on January 1, 2008 and the changes in the discount rates resulted in a decrease in policy benefit reserves on January 1, 2008 of $150.6 million. The net income impact of this decrease in reserves net of the related adjustments to amortization of deferred sales inducements and deferred policy acquisition costs and income taxes was $40.7 million.
We periodically revise assumptions used in the computations of amortization of deferred sales inducements and deferred policy acquisition costs, as applicable, through an "unlocking" process. Revisions are made based upon historical results and our best estimates of future experience. The impact of unlocking is recorded in the current period as an increase or decrease in amortization of the respective balances. The unlocking process can take place at any time as needs dictate. See Critical Accounting Policies - Deferred Policy Acquisition Costs and Deferred Sales Inducements included in Management's Discussion and Analysis included in our Annual Report on Form 10-K for the year ended December 31, 2008.
There was no unlocking necessary during the 2009 periods. The impact of unlocking for the three months and six months ended June 30, 2008 was a $2.2 million decrease in the amortization of deferred sales inducements and a $4.6 million increase in amortization of deferred policy acquisition costs for a net increase in amortization of $2.4 million. The impact of unlocking is primarily due to the impact of actual surrender experience on certain older business, offset in part by increases in the estimates of projected future interest margins and reductions in the estimates of projected future policy maintenance expenses.
Annuity product charges(surrender charges assessed against policy withdrawals) increased 40% to $16.6 million for the second quarter of 2009, and 32% to $31.7 million for the six months ended June 30, 2009 compared to $11.8 million and $23.9 million for the same periods in 2008. The increases were due to increases in withdrawals subject to surrender charges and increases in the average surrender charge assessed. Withdrawals from annuity and single premium universal life policies subject to surrender charges were $88.5 million and $76.4 million for the three months ended June 30, 2009 and 2008, respectively, and $181.7 million and $152.3 million for the six months ended June 30, 2009 and 2008, respectively. The average surrender charge collected on withdrawals subject to a surrender charge was 17.2% for the second quarter of 2009 and 16.6% for the six months ended June 30, 2009 compared to 15.3% and 15.5% for same periods in 2008.
Net investment income increased 12% to $226.8 million in the second quarter of 2009, and 15% to $447.5 million for the six months ended June 30, 2009 compared to $202.1 million and $397.6 million for the same periods in 2008. These increases were principally attributable to the growth in our annuity business and corresponding increases in our invested assets and the average yield earned on investments. Average invested assets excluding derivative instruments (on an amortized cost basis) increased 11% to $14.3 billion for the six months ended June 30, 2009 compared to $12.9 billion for the six months ended June 30, 2008, while the average yield earned on average invested assets was 6.29% for the six months ended June 30, 2009 compared to 6.17% for the same period in 2008. The increase in the yield earned on average invested assets was attributable to higher yields on investments purchased throughout 2008 and during the six months ended June 30, 2009.
Change in fair value of derivatives (principally call options purchased to fund annual index credits on index annuities) is affected by the performance of the indices upon which our options are based and the aggregate cost of options purchased. The components of change in fair value of derivatives are as follows:
Three Months Ended Six Months Ended
June 30, June 30,
2009 2008 2009 2008
(Dollars in thousands)
Call options:
Loss on option expiration $ (73,145 ) $ (74,700 ) $ (132,064 ) $ (121,203 )
Change in unrealized loss 103,316 625 118,962 (109,186 )
Interest rate swaps 323 762 (227 ) (289 )
$ 30,494 $ (73,313 ) $ (13,329 ) $ (230,678 )
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The differences between the change in fair value of derivatives between years are primarily due to the performance of the indices upon which our call options are based. A substantial portion of our call options are based upon the S&P 500 Index with the remainder based upon other equity and bond market indices. The range of index appreciation for options expiring during the three months and six months ended June 30, 2009 and 2008 is as follows:
Three Months Ended Six Months Ended
June 30, June 30,
2009 2008 2009 2008
S&P 500 Index
Point-to-point strategy 0.0% - 0.0% 0.0% - 0.0% 0.0% - 0.0% 0.0% - 2.6%
Monthly average strategy 0.0% - 0.0% 0.0% - 1.7% 0.0% - 0.0% 0.0% - 6.4%
Monthly point-to-point
strategy 0.0% - 0.0% 0.0% - 0.0% 0.0% - 0.0% 0.0% - 0.0%
Lehman Brothers U.S.
Aggregate and U.S. Treasury
indices 2.7% - 5.1% 4.5% - 12.6% 1.6% - 5.1% 4.5% - 12.6%
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Actual amounts credited to policyholder account balances may be less than the index appreciation due to contractual features in the index annuity policies (caps, participation rates and asset fees) which allow us to manage the cost of the options purchased to fund the annual index credits. The change in fair value of derivatives is also influenced by the aggregate cost of options purchased. The aggregate cost of options has increased primarily due to an increased amount of index annuities in force. The aggregate cost of options is also influenced by the amount of policyholder funds allocated to the various indices and market volatility which affects option pricing. Costs for options purchased during the six months ended June 30, 2009 decreased compared to the same period in 2008 due to adjustments to caps, participation rates and asset fees. See Critical Accounting Policies - Derivative Instruments - Index Products included in Management's Discussion and Analysis included in our Annual Report on Form 10-K for the year ended December 31, 2008.
We have unsecured counterparty exposure in connection with options purchased from affiliates of Lehman Brothers ("Lehman") which declared bankruptcy during the third quarter of 2008. We estimate our maximum exposure to the Lehman bankruptcy is $4.9 million at June 30, 2009. As of June 30, 2009, no fair value has been recorded for the unexpired options we own that were purchased from Lehman after taking into consideration counterparty risk. The amount of loss that we will realize upon expiration of these options will depend on the performance of the underlying indices upon which the options are based, the amount of related index credits we will make to policyholders and the amount, if any, that we will recover from Lehman through our claim in bankruptcy proceedings. The amount of option proceeds due on expired options purchased from Lehman that we did not receive payment on was $6.5 million for the second quarter of 2009 and $9.4 million for the six months ended June 30, 2009.
Net realized gains on investments, excluding OTTI losses include gains and losses on the sale of securities and impairment losses on mortgage loans on real estate and fluctuate from year to year due to changes in the interest rate and economic environment and the timing of the sale of investments. The components of net realized gains on investments for the three months and six months ended June 30, 2009 and 2008 are set forth in the table that follows.
Three Months Ended Six Months Ended
June 30, June 30,
2009 2008 2009 2008
(Dollars in thousands)
Available for sale fixed maturity
securities:
Gross realized gains $ 5,317 $ 200 $ 6,127 $ 1,143
Gross realized losses - - (53 ) (113 )
5,317 200 6,074 1,030
Equity securities:
Gross realized gains - 55 3 55
- 55 3 55
Mortgage loans on real estate:
Impairment losses (1,000 ) - (1,000 ) -
$ 4,317 $ 255 $ 5,077 $ 1,085
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Net OTTI losses recognized in operations decreased 81% to $5.6 million in the second quarter of 2009 and 43% to $19.1 million for the six months ended June 30, 2009 compared to $30.3 million and $33.5 million for the same periods in 2008. As discussed previously, we adopted FSP FAS 115-2 effective January 1, 2009. FSP FAS 115-2 requires that other than temporary impairments on debt securities be allocated between the credit related and noncredit related components with the credit loss portion included in operations and the noncredit portion included as a component of comprehensive income. See Financial Condition - Investments for additional discussion of write downs of the fair value of securities for other than temporary impairments.
Gain (loss) on extinguishment of debt includes a $3.1 million gain on an exchange of five million shares of our common stock for $37.2 million of our 5.25% contingent convertible senior notes in May 2009. The fair value of our common stock exchanged totaled $31.3 million and the notes extinguished carried unamortized debt issue costs and debt discount totaling $2.8 million. We used $11.0 million in cash to extinguish $12.0 million of our 5.25% contingent convertible senior notes that carried unamortized debt issue costs and debt discount totaling $1.2 million during the three months ended June 30, 2008. We used $30.8 million in cash, of which $0.4 million was assigned to reacquire the equity component of the debt, to extinguish $32.4 million of our 5.25% contingent convertible senior notes that carried unamortized debt discount and debt issue costs totaling $3.3 million during the six months ended June 30, 2008. The 2008 transactions resulted in losses on extinguishment of debt of $0.2 million and $1.3 million for the three months and six months ended June 30, 2008.
Interest sensitive and index product benefits increased 45% to $72.0 million in the second quarter of 2009, and 27% to $131.7 million for the six months ended . . .
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