• 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 filings with the SEC.

For a detailed discussion of these and other factors that might affect our performance, see Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2011.
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, net realized gains (losses) on investments and changes in fair value of derivatives. Components of expenses for products accounted for as deposit liabilities are interest sensitive and index product benefits (primarily interest credited to account balances), changes in fair value of embedded derivatives, amortization of deferred sales inducements and deferred policy acquisition costs, other operating costs and expenses and income taxes. Annuity deposits by product type collected during the three and nine months ended September 30, 2012 and 2011, were as follows:

                                        Three Months Ended            Nine Months Ended
                                           September 30,                September 30,
Product Type                            2012          2011           2012           2011
                                                     (Dollars in thousands)
Fixed index annuities:
Index strategies                     $ 547,230    $   701,796    $ 1,568,989    $ 2,075,800
Fixed strategy                         315,029        317,091        885,589        986,724
                                       862,259      1,018,887      2,454,578      3,062,524
Fixed rate annuities:
Single-year rate guaranteed             22,413         37,195         78,041        118,084
Multi-year rate guaranteed              45,037        116,768        205,934        279,407
Single premium immediate annuities      52,315         94,514        140,265        257,995
                                       119,765        248,477        424,240        655,486
Total before coinsurance ceded         982,024      1,267,364      2,878,818      3,718,010
Coinsurance ceded                       36,539         94,412        167,986        230,620
Net after coinsurance ceded          $ 945,485    $ 1,172,952    $ 2,710,832    $ 3,487,390

Annuity deposits before coinsurance ceded decreased 23% during the third quarter of 2012 and the nine months ended September 30, 2012 compared to the same periods in 2011. We attribute this in part to the low interest rate environment which appears to have made prospective policyholders less willing to commit funds to fixed index annuities. We also attribute the decreases in annuity deposits to certain competitors

who were more aggressive in their product pricing in the first half of 2012. The extent to which this will affect our annuity deposits is uncertain. In addition, sales for the first nine months of 2011 benefited from higher demand in advance of a rate decrease implemented during that period.
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:

                                      Three Months Ended         Nine Months Ended
                                        September 30,              September 30,
                                      2012          2011         2012          2011
Reported Amounts
Average yield on invested assets     5.17%         5.70%        5.36%         5.81%
Aggregate cost of money              2.55%         2.75%        2.60%         2.77%
Aggregate investment spread          2.62%         2.95%        2.76%         3.04%

Adjustments
Investment yield - temporary
cash investments                     0.29%         0.11%        0.23%         0.09%
Investment yield - additional
prepayment income                   (0.04)%          -%        (0.04)%          -%
Cost of money effect of over
hedging                              0.01%         0.05%        0.01%         0.07%

Adjusted Amounts
Average yield on invested assets     5.42%         5.81%        5.55%         5.90%
Aggregate cost of money              2.56%         2.80%        2.61%         2.84%
Aggregate investment spread          2.86%         3.01%        2.94%         3.06%

The decreases in investment spread for the three and nine months ended September 30, 2012 resulted from a decline in the average yield on investments, offset in part by a smaller decline in the average cost of money on our fixed index annuities. The lower cost of money for fixed index annuities during 2012 was due to lower costs of options purchased to fund the annual index credits on fixed index annuities and lower rates for the fixed rate strategy in fixed index annuities. The lower option costs and lower fixed rates are primarily due to the reductions in policyholder crediting rates discussed below. The decrease in the average yield on invested assets was attributable to lower yields on investments purchased in 2011 and the nine months ended September 30, 2012. Our investment spread has been impacted by shortfalls in investment income from excess liquidity resulting from a lag in the reinvestment of proceeds of government agency bonds called for redemption, benefits from additional prepayment and fee income on certain investments and the impact of hedging experience of the annual index credits for index annuities.
The callable government agency securities have been a cornerstone of our investment portfolio since our formation. Through the years they have provided very acceptable yields that met our spread requirements without any risk-based capital charges. We have been through several cycles of calls on these securities and each time we have reinvested a portion of the call redemption proceeds into new callable government agency securities. This kept cash balances low but perpetuated the call risk. In 2011, we had $3.1 billion in such securities called and purchased $3.7 billion for a $600 million net purchase of callable government agency securities. However, in the current interest rate environment, we have been unwilling to reinvest any of the call redemption proceeds in the government agency securities with yields under 4% and have only purchased $1.2 billion in 2012 compared to $3.6 billion in calls. Consequently, excess cash persists and more securities are expected to be called in the next 3 quarters. The impact of excess liquidity and additional prepayment and fee income on net investment income and average yield on invested assets is quantified in Results of Operations - Net investment income.
The cost of money for fixed 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 in our Annual Report on Form 10-K for the year ended December 31, 2011. With respect to our fixed 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 - Policy Liabilities for Fixed Index Annuities and Financial Condition - Derivative Instruments included in Management's Discussion and Analysis in our Annual Report on Form 10-K for the year ended December 31, 2011.
As reported in our previous filings, in response to the continuing low interest rate environment, we implemented reductions of policyholder crediting rates for new annuities and existing annuities in the fourth quarter of 2011. Rates on new sales were reduced 0.40% - 0.50% beginning with applications received after October 7, 2011. Renewal rate adjustments began taking effect on November 15, 2011 and will continue to take effect on the policy anniversary dates through July 20, 2013. Accordingly, the benefit from the renewal rate reductions did not have a material impact on 2011 spread results. We expect spread results to further benefit from rate adjustments already implemented by a 0.20% to 0.25% decline in the aggregate cost of money over the next twelve months, and we intend to make further adjustments in 2013. However, the anticipated reductions in cost of money may be offset by continued lower yields available on investments including reinvestment of proceeds from calls of the callable bonds in our investment portfolio.

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 impairment of investments, our ability to manage interest rates credited to policyholders and costs of the options purchased to fund the annual index credits on our fixed 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 Nine Months Ended September 30, 2012 and 2011 Net income (loss) was $(7.8) million in the third quarter of 2012 and $21.4 million for the nine months ended September 30, 2012 compared to $(13.1) million and $36.5 million for the same periods in 2011. The comparability of net income from period to period is primarily impacted by fair value accounting for derivative instruments as presented below in Operating income (a non-GAAP financial measure). Amounts attributable to the fair value accounting for fixed index annuity derivatives and embedded derivatives fluctuate from period to period primarily based upon changes in the fair values of call options purchased to fund the annual index credits for fixed index annuities and changes in the interest rates used to discount the embedded derivative liability. The significant changes in the impact from this item relate primarily to changes in the interest rates used to discount the embedded derivative liabilities. In general, net income (loss) has been positively impacted by the growth in the volume of business in force and the investment spread earned on this business. The average amount of annuity liabilities outstanding (net of annuity liabilities ceded under coinsurance agreements) increased 15% to $26.3 billion during the third quarter of 2012 and increased 17% to $25.7 billion for the nine months ended September 30, 2012 compared to $22.8 billion and $21.8 billion for the same periods in 2011. Our investment spread measured in dollars was $146.0 million during the third quarter of 2012 and $447.5 million for the nine months ended September 30, 2012 compared to $143.8 million and $433.5 million during the same periods in 2011. As previously mentioned, our investment spread has been negatively impacted by both the extended low interest rate environment and our excess liquidity due to calls of our United States government agency securities (see Net investment income).
Net income (loss) was negatively affected by the prospective adoption on January 1, 2012, of an accounting standards update that defines the types of costs that are deferrable with policy acquisition. This resulted in $2.2 million and $7.2 million of costs to be expensed as incurred in the three and nine months ended September 30, 2012, which under the accounting method in effect for the three and nine months ended September 30, 2011, would have been capitalized as deferred policy acquisition costs and amortized in future periods. This change in accounting, including the impact on related amortization expense, resulted in a $1.5 million after tax increase in net loss for the three months ended September 30, 2012 and a $4.6 million after tax decrease in net income for the nine months ended September 30, 2012
We periodically revise the key assumptions used in the calculation of amortization of deferred policy acquisition costs and deferred sales inducements retrospectively through an unlocking process when estimates of current or future gross profits/margins (including the impact of realized investment gains and losses) to be realized from a group of products are revised. The impact of unlocking during the three and nine months ended September 30, 2012 was a $0.2 million decrease in the amortization of deferred sales inducements and a $3.7 million increase in amortization of deferred policy acquisition costs and included the impact of account balance true ups as of September 30, 2012 and adjustment to future period assumptions for interest margins and surrenders. The unlocking process increased net loss for the three months ended September 30, 2012 and decreased net income for the nine months ended September 30, 2012 by $2.2 million. The impact of unlocking during the three and nine months ended September 30, 2011 was a $5.0 million decrease in the amortization of deferred sales inducements and a $9.1 million decrease in amortization of deferred policy acquisition costs, which reduced net loss for the three moths ended September 30, 2011 and increased net income for the nine months ended September 30, 2011 by $9.1 million.
Net income (loss) for the 2012 periods was positively impacted by a revision of assumptions used in determining reserves held for living income benefit riders. This revision was consistent with unlocking for deferred policy acquisition costs and deferred sales inducements. The impact decreased interest sensitive and index product benefits for the three and nine months ended September 30, 2012 by $2.2 million and reduced the net loss for the three months ended September 30, 2012 and increased net income for the nine months ended September 30, 2012 by $1.4 million.
Based upon developments in mediation discussions concerning potential settlement terms of a purported class action lawsuit, we established an estimated litigation liability of $17.5 million during the third quarter of 2012 ($9.6 million after offsets for income taxes and adjustments to deferred policy acquisition costs and deferred sales inducements). See note 8 to our consolidated financial statements.
As discussed in our prior filings and in Note 1 to our unaudited consolidated financial statements in this Form 10-Q, net income for the nine months ended September 30, 2011 increased $2.7 million resulting from the correction of a prior period error.
Operating income (a non-GAAP financial measure) decreased 47% to $22.2 million in the third quarter of 2012 and decreased 22% to $79.3 million for the nine months ended September 30, 2012 compared to $41.5 million and $101.1 million for the same periods in 2011.
In addition to net income, we have consistently utilized operating income, a non-GAAP financial measure commonly used in the life insurance industry, as an economic measure to evaluate our financial performance. Operating income equals net income adjusted to eliminate the impact of net realized gains (losses) on investments, including net other than temporary impairment ("OTTI") losses recognized in operations, litigation reserve and fair value changes in derivatives and embedded derivatives. Because these items fluctuate from period to period in a manner unrelated to core operations, we believe measures excluding their impact are useful in analyzing operating trends. We believe the combined presentation and evaluation of operating income together with net income, provides information that may enhance an investor's understanding of our underlying results and profitability.

Operating income is not a substitute for net income determined in accordance with GAAP. The adjustments made to derive operating income are important to understanding our overall results from operations and, if evaluated without proper context, operating income possesses material limitations. As an example, we could produce a low level of net income in a given period, despite strong operating performance, if in that period we generate significant net realized losses from our investment portfolio. We could also produce a high level of net income in a given period, despite poor operating performance, if in that period we generate significant net realized gains from our investment portfolio. As an example of another limitation of operating income, it does not include the decrease in cash flows expected to be collected as a result of credit loss OTTI. Therefore, our management and board of directors also separately review net realized investment gains (losses) and analyses of our net investment income, including impacts related to OTTI write-downs, in connection with their review of our investment portfolio. In addition, our management and board of directors examine net income as part of their review of our overall financial results. The adjustments made to net income to arrive at operating income for the three and nine months ended September 30, 2012 and 2011 are set forth in the table that follows:

                                             Three Months Ended           Nine Months Ended
                                                September 30,               September 30,
                                             2012          2011           2012          2011
                                                          (Dollars in thousands)
Reconciliation of net income (loss) to
operating income:
Net income (loss)                         $  (7,829 )   $ (13,068 )   $   21,401     $  36,549
Net realized losses and net OTTI losses
on investments, net of offsets                1,415         8,988          5,823        12,738
Net effect of derivatives and embedded
derivatives, net of offsets                  19,000        45,544         42,478        51,764
Litigation reserve, net of offsets            9,580             -          9,580             -
Operating income                          $  22,166     $  41,464     $   79,282     $ 101,051

The amounts disclosed in this table as reconciling items are net of related adjustments to amortization of deferred sales inducements and deferred policy acquisition costs and income taxes. Net realized losses 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. Operating income for the 2012 periods includes expense from unlocking which increased amortization of deferred sales inducements by $2.4 million and amortization of deferred acquisition costs by $7.3 million and decreased operating income by $6.3 million for the three and nine months ended September 30, 2012. The three and nine months ended September 30, 2011 includes benefit from unlocking which reduced amortization of deferred sales inducements by $7.3 million and amortization of deferred acquisition costs by $12.1 million and increased operating income by $12.5 million.
Annuity product charges (surrender charges assessed against policy withdrawals and fees deducted from policyholder account balances for lifetime income benefit riders) increased 17% to $23.9 million in the third quarter of 2012 and increased 14% to $65.2 million for the nine months ended September 30, 2012 compared to $20.4 million and $57.3 million for the same periods in 2011. These increases were primarily attributable to increases in the amounts of fees assessed for lifetime income benefit riders which were $12.6 million in the third quarter of 2012 and $30.1 million for the nine months ended September 30, 2012 compared to $7.4 million and $17.8 million for the same periods in 2011. The increases in these fees are attributable to a larger volume of business in force subject to the fee. See Interest sensitive and index product benefits below for corresponding expense recognized on lifetime income benefit riders. Surrender charges decreased by $1.8 million for the third quarter of 2012 and $4.4 million for the nine months ended September 30, 2012. These decreases were primarily attributable to reductions in withdrawals subject to a surrender charge. Withdrawals from annuity and single premium universal life policies subject to surrender charges were $83.4 million in the third quarter of 2012 and $261.2 million for the nine months ended September 30, 2012 compared to $101.6 million and $304.4 million for the same periods in 2011. The average surrender charge collected on withdrawals subject to a surrender charge was 13.4% in the third quarter of 2012 and 13.3% for the nine months ended September 30, 2012 compared to 13.3% and 13.1% for the same periods in 2011.
Net investment income increased 4% to $318.6 million in the third quarter of 2012 and 8% to $965.8 million compared to $305.5 million and $894.5 million for the same periods in 2011. These increases were principally attributable to the growth in our annuity business and a corresponding increase in our invested assets. Average invested assets excluding derivative instruments (on an amortized cost basis) increased 15% to $24.7 billion for the the third quarter of 2012 and 17% to $24.0 billion for the nine months ended September 30, 2012 compared to $21.5 billion and $20.5 billion for the same periods in 2011. The average yield earned on average invested assets was 5.17% for the third quarter of 2012 and 5.36% for the nine months ended September 30, 2012 compared to 5.70% and 5.81% for the same periods in 2011.
The decrease in yield earned on average invested assets was attributable to lower yields on investments purchased in 2011 and the nine months ended September 30, 2012. In addition, net investment income and average yield for the periods ended September 30, 2012 and 2011 were negatively impacted by a lag in reinvestment of proceeds from bonds called for redemption during the periods into new assets causing excess liquidity. Based on yields received for purchases of fixed maturity securities during the three and nine months ended September 30, 2012 and 2011, we estimate that approximately $17.7 million and $42.0 million in net investment income was foregone during the three and nine months ended September 30, 2012 compared to $6.2 million and $14.0 million for the same periods in 2011. Additionally, net investment income and average yield for the three and nine months ended September 30, 2012 was positively impacted by prepayment and fee income received resulting in additional net investment income of $2.2 million and $7.8 million, respectively. There was no prepayment and fee income impact for the

three and nine months ended September 30, 2011. Average yield on invested assets would have been 5.42% and 5.55% for the three and nine months ended September 30, 2012 compared to 5.81% and 5.90% for the same periods in 2011 taking into account these factors.
The high level of excess cash may persist for several more quarters as we hold $932 million of U.S. Government agency securities at interest rates of 4.00% or higher that are likely to be called during the last quarter of 2012 and another $949 million of such securities that are callable in the first four months of 2013.
Change in fair value of derivatives (principally call options purchased to fund annual index credits on fixed 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           Nine Months Ended
                                       September 30,                September 30,
                                    2012           2011          2012           2011
                                                 (Dollars in thousands)
Call options:
Gain (loss) on option expiration $  57,637     $   62,695     $ (17,663 )   $  169,156
Change in unrealized gain/loss     103,098       (354,862 )     297,677       (331,109 )
2015 notes hedges                    1,839        (41,446 )      (5,573 )      (44,900 )
Interest rate swaps                 (1,171 )           (8 )      (4,319 )         (144 )
Interest rate caps                    (313 )            -          (718 )            -
                                 $ 161,090     $ (333,621 )   $ 269,404     $ (206,997 )

. . .