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AEL > SEC Filings for AEL > Form 10-Q on 8-Aug-2014All Recent SEC Filings

Show all filings for AMERICAN EQUITY INVESTMENT LIFE HOLDING CO

Form 10-Q for AMERICAN EQUITY INVESTMENT LIFE HOLDING CO


8-Aug-2014

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Management's discussion and analysis reviews our unaudited consolidated financial position at June 30, 2014, and the unaudited consolidated results of operations for the three and six month periods ended June 30, 2014 and 2013, 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, 2013.
Cautionary Statement Regarding Forward-Looking Information 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. We caution that these statements may and often do vary from actual results and the differences between these statements and actual results can be material. Accordingly, we cannot assure you that actual results will not differ materially from those expressed or implied by the forward-looking statements. Factors that could contribute to these differences 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 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, 2013.
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. Our business model contemplates continued growth in invested assets and operating income while maintaining a high quality investment portfolio that will not experience significant losses from impairments of invested assets. Growth in invested assets is predicated on a continuation of our high sales while at the same time maintaining a high level of retention of the funds received. The economic and personal investing environments continue to be conducive for high sales levels as retirees and others look to put their money in instruments that will protect their principal and provide them with consistent cash flow sources in their retirement years. We are committed to maintaining a high quality investment portfolio with limited exposure to below investment grade securities and other riskier assets.
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        Six Months Ended
                                               June 30,                 June 30,
                                          2014         2013        2014         2013
Average yield on invested assets          4.83%        4.94%       4.89%        4.98%
Aggregate cost of money                   2.13%        2.24%       2.15%        2.28%
Aggregate investment spread               2.70%        2.70%       2.74%        2.70%

Impact of:
Investment yield - additional
prepayment income                         0.01%        0.05%       0.03%        0.06%
Cost of money benefit of over hedging     0.03%        0.06%       0.01%        0.04%


Table of Contents

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. See Results of Operations - Net investment income for additional information regarding our excess liquidity. 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, 2013. With respect to our fixed index annuities, the cost of money includes the average crediting rate on amounts allocated to the fixed rate strategy, costs we incur to fund the annual index credits (primarily costs to purchase call options) 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, 2013.
As reported in previous filings, in response to the persistent low interest rate environment, we have been reducing policyholder crediting rates for new annuities and existing annuities since the fourth quarter of 2011. Spread results for the 2014 and 2013 periods reflect the benefit from these reductions; however, the reductions in cost of money were offset by continued lower yields available on investments including those purchased with the reinvestment of proceeds from calls of callable bonds in our investment portfolio. In 2014, we have initiated additional renewal crediting rate reductions for policies issued prior to July 20, 2010. These rate reductions will occur on policy anniversary dates over a fifteen month period that began on April 14, 2014, with the majority of the rate reductions completed by May 15, 2015. When fully implemented, we estimate that the cost of money for approximately $15 billion of policyholder funds will be reduced by 0.20%.
The current interest rate environment with low yields for investments with the credit quality we prefer presents a strong headwind to restoring our investment spread to the 3.00% target rate. With our portfolio yield still under pressure from lower rates on benchmark U.S. Treasury securities and narrower credit spreads, further adjustments to new and renewal crediting rates will be considered. We have on average 0.59% of room to reduce rates before we would reach guaranteed rates on the entire June 30, 2014 in force book of business. Our most recent new money rates adjustments were a year ago in the third quarter of 2013 when we increased rates in response to rising investment yields at that time. However, investment yields no longer support those rates. While we have been reluctant to reduce new money rates so far this year for competitive reasons, we remain aware of our spread and return on average equity objectives. Reductions in new money rates are likely should current interest rate conditions continue.
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 for the Three and Six Months Ended June 30, 2014 and 2013 Annuity deposits by product type collected during the three and six months ended June 30, 2014 and 2013, were as follows:

                                         Three Months Ended             Six Months Ended
                                              June 30,                      June 30,
Product Type                             2014           2013           2014           2013
                                                      (Dollars in thousands)
Fixed index annuities:
Index strategies                     $   781,238    $   764,437    $ 1,423,504    $ 1,369,078
Fixed strategy                           214,615        285,416        418,153        528,545
                                         995,853      1,049,853      1,841,657      1,897,623
Fixed rate annuities:
Single-year rate guaranteed               17,160         20,404         32,400         40,314
Multi-year rate guaranteed                22,063         48,291         76,650         95,547
Single premium immediate annuities         7,140         16,824         12,426         31,804
                                          46,363         85,519        121,476        167,665
Total before coinsurance ceded         1,042,216      1,135,372      1,963,133      2,065,288
Coinsurance ceded                         32,165         44,572         82,391         87,179
Net after coinsurance ceded          $ 1,010,051    $ 1,090,800    $ 1,880,742    $ 1,978,109

Annuity deposits before coinsurance ceded decreased 8% during the second quarter of 2014 and 5% during the six months ended June 30, 2014 compared to the same periods in 2013. We attribute these decreases to certain competitive factors in the market. In August 2014, we will launch three initiatives intended to enhance our competitive position: a new index crediting strategy, revisions to the payouts under our lifetime income benefit rider and a new option for payment of commissions to independent agents. These three initiatives should enhance our competitiveness in the fixed index annuity market, and we are optimistic that they will result in stronger sales in the second half of 2014.


Table of Contents

Net income, in general, 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 13% to $32.8 billion for the second quarter of 2014 and increased 13% to $32.4 billion for the six months ended June 30, 2014 compared to $29.0 billion and $28.5 billion for the same periods in 2013. Our investment spread measured in dollars was $190.9 million for the second quarter of 2014 and $381.1 million for the six months ended June 30, 2014 compared to $168.0 million and $329.1 million for the same periods in 2013. As previously mentioned, our investment spread has been negatively impacted by the extended low interest rate environment (see Net investment income).
Net income is also impacted by the change in fair value of derivatives and embedded derivatives which fluctuates from period to period based upon changes in fair values of call options purchased to fund the annual index credits for fixed index annuities and changes in interest rates used to discount the embedded derivative liability. Net income for the three and six months ended June 30, 2014 was negatively impacted by decreases in the discount rates used to estimate our embedded derivative liabilities. Net income for the three and six months ended June 30, 2013 was positively impacted by increases in the discount rates used to estimate our embedded derivative liabilities. The negative effect on net income for the 2014 periods due to the decrease in discount rates was offset by revisions of assumptions used in determining fixed index annuity embedded derivatives that were made in the second quarter of 2014. These revisions, which consisted of changes in the lapse and expected costs of annual call options assumptions, decreased the change in fair value of embedded derivatives for the three and six months ended June 30, 2014 by $62.6 million, which after related adjustments to deferred sales inducements and deferred policy acquisition costs and income taxes, increased net income for the three and six months ended June 30, 2014 by $14.8 million. See Change in fair value of embedded derivatives.
Operating income (a non-GAAP financial measure) increased 27% to $38.5 million in the second quarter of 2014 and increased 19% to $76.0 million for the six months ended June 30, 2014 compared to $30.3 million and $63.7 million for the same periods in 2013. In the 2013 periods, we incurred $8.5 million of guaranty fund assessments related to the insolvency of Executive Life Insurance Company of New York, which had a $5.6 million negative after tax effect on operating income and net income.
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 OTTI losses recognized in operations, fair value changes in derivatives and embedded derivatives, losses on extinguishment of debt and changes in litigation reserves. Because these items fluctuate from year to year 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 experience 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 reviews 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 examines 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 six months ended June 30, 2014 and 2013 are set forth in the table that follows:

                                           Three Months Ended             Six Months Ended
                                                June 30,                      June 30,
                                           2014           2013           2014           2013
                                                        (Dollars in thousands)
Reconciliation of net income to
operating income:
Net income                             $   36,744     $  120,113     $   26,991     $  146,144
Net realized (gains) losses and net
OTTI losses on investments, net of
offsets                                     1,361         (3,574 )        1,925         (6,378 )
Change in fair value of derivatives
and embedded derivatives - index
annuities, net of offsets                  (4,115 )      (81,351 )       39,593        (70,378 )
Change in fair value of derivatives
and embedded derivatives - debt, net
of income taxes                            (1,053 )       (3,302 )          456         (4,038 )
Extinguishment of debt, net of income
taxes                                       5,518            345          7,912            345
Litigation reserve, net of offsets              -         (1,969 )         (916 )       (1,969 )
Operating income                       $   38,455     $   30,262     $   75,961     $   63,726

The amounts disclosed in the reconciliation above are net of related adjustments to amortization of deferred sales inducements and deferred policy acquisition costs and income taxes.


Table of Contents

Premiums and other considerations decreased 21% to $9.1 million in the second quarter of 2014 and decreased 33% to $16.5 million for the six months ended June 30, 2014 compared to $11.6 million and $24.6 million for the same periods in 2013. These revenues are comprised of life insurance premiums and premiums from life contingent single premium immediate annuities including life contingent supplemental contracts issued upon annuitization of deferred annuities. Life insurance premiums have remained consistent while premiums from life contingent single premium immediate annuities ($6.3 million and $8.6 million for the second quarter of 2014 and 2013, respectively, and $10.8 million and $19.0 million for the six months ended June 30, 2014 and 2013, respectively) have decreased because we have adjusted the rates offered on these products to be less competitive in the low interest rate environment.
Annuity product charges (surrender charges assessed against policy withdrawals and fees deducted from policyholder account balances for lifetime income benefit riders) increased 24% to $29.2 million in the second quarter of 2014 and increased 21% to $54.5 million for the six months ended June 30, 2014 compared to $23.5 million and $45.0 million for the same periods in 2013. The components of annuity product charges are set forth in the table that follows:

                                            Three Months Ended               Six Months Ended
                                                 June 30,                        June 30,
                                           2014            2013            2014            2013
                                                          (Dollars in thousands)
Surrender charges                      $    12,942     $    11,292     $    25,365     $    22,794
Lifetime income benefit riders (LIBR)
fees                                        16,305          12,219          29,154          22,198
                                       $    29,247     $    23,511     $    54,519     $    44,992

Withdrawals from annuity policies
subject to surrender charges           $   104,159     $    81,305     $   186,517     $   159,310
Average surrender charge collected on
withdrawals subject to
surrender charges                             12.4 %          13.9 %          13.6 %          14.3 %

Fund values on policies subject to
LIBR fees                              $ 3,054,530     $ 2,423,891     $ 5,428,046     $ 4,311,461
Weighted average per policy LIBR fee          0.53 %          0.50 %          0.54 %          0.52 %

The increases in fees assessed for lifetime income benefit riders were primarily due 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.
Net investment income increased 10% to $370.9 million in the second quarter of 2014 and increased 11% to $740.9 million for the six months ended June 30, 2014 compared to $336.1 million and $665.8 million for the same periods in 2013. 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 13% to $30.8 billion for the second quarter of 2014 and increased 13% to $30.4 billion for the six months ended June 30, 2014 compared to $27.3 billion and $26.8 billion for the same periods in 2013. The average yield earned on average invested assets was 4.83% for second quarter of 2014 and 4.89% for the six months ended June 30, 2014 compared to 4.94% and 4.98% for the same periods in 2013.
The decrease in yield earned on average invested assets was attributable to yields on investments purchased in 2014 and 2013 being lower than the overall portfolio yield. In addition, net investment income and average yield in the second quarter of 2014 and the first two quarters of 2013 were negatively impacted by a lag in reinvestment of proceeds from bonds called for redemption during the period and earlier periods into new assets causing excess liquidity held in low yielding cash and other short-term investments. The average balance held in cash and short-term investments was $0.6 billion for the three months ended June 30, 2014, and $1.7 billion and $1.8 billion for the three and six months ended June 30, 2013. The average yield on our cash and short-term investments for the three months ended June 30, 2014 was 0.07% and for the three and six months ended June 30, 2013 was 0.47% and 0.40%. Additionally, net investment income and average yield was positively impacted by prepayment and fee income received resulting in additional net investment income of $1.1 million and $5.0 million for the three and six months ended June 30, 2014 and $3.1 million and $8.0 million for the same periods in 2013, respectively.


Table of Contents

Change in fair value of derivatives consists primarily of call options purchased to fund annual index credits on fixed index annuities, the 2015 notes hedges related to our 2015 notes and an interest rate swap and interest rate caps that hedge our floating rate subordinated debentures. The components of change in fair value of derivatives are as follows:

                                     Three Months Ended           Six Months Ended
                                          June 30,                    June 30,
                                     2014          2013          2014          2013
                                                 (Dollars in thousands)
Call options:
Gain on option expiration         $ 176,184     $ 150,874     $ 327,431     $ 209,700
Change in unrealized gains/losses    97,585       (92,674 )      17,811       193,154
2015 notes hedges                       100           197       (20,301 )      28,295
Interest rate swap                   (1,848 )       3,802        (3,250 )       4,535
Interest rate caps                   (1,138 )       1,841        (2,315 )       2,318
                                  $ 270,883     $  64,040     $ 319,376     $ 438,002

The differences between the change in fair value of derivatives between periods for call options 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 (after applicable caps, participation rates and asset fees) for options expiring during the three and six months ended June 30, 2014 and 2013 is as follows:

                                            Three Months Ended             Six Months Ended
                                                 June 30,                      June 30,
                                            2014           2013           2014           2013
S&P 500 Index
Point-to-point strategy                 1.0% - 11.5%   1.5% - 11.5%   1.0% - 11.5%   1.5% - 11.5%
Monthly average strategy                0.9% - 10.9%   0.0% - 11.7%   0.9% - 11.1%   0.0% - 11.7%
Monthly point-to-point strategy         0.0% - 16.8%   0.0% - 19.0%   0.0% - 19.9%   0.0% - 19.0%
Fixed income (bond index) strategies     0.0% - 3.7%    0.0% - 8.0%    0.0% - 3.7%    0.0% - 8.0%

The change in fair value of derivatives is also influenced by the aggregate costs of options purchased. The aggregate cost of options has increased primarily due to an increased amount of fixed 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. See Critical Accounting Policies - Policy Liabilities for Fixed Index Annuities included in Management's Discussion and Analysis in our Annual Report on Form 10-K for the year ended December 31, 2013.
The fair value of the 2015 notes hedges changes based upon changes in the price of our common stock, interest rates, stock price volatility, dividend yield and the time to expiration of the 2015 notes hedges. Similarly, the fair value of the conversion option obligation to the holders of the 2015 notes changes based upon these same factors and the conversion option obligation is accounted for as an embedded derivative liability with changes in fair value reported in the Change in fair value of embedded derivatives. The amount of the change in fair value of the 2015 notes hedges has historically been equal to the amount of the change in the related embedded derivative liability and there has been an offsetting expense in the change in fair value of embedded derivatives. Due to the partial unwind agreements we entered into in the second quarter of 2014, the decrease in the change in fair value of 2015 notes embedded conversion derivative liability exceeded the decrease in the change in fair value of the 2015 notes hedges by $4.2 million for the three and six months ended June 30, . . .

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