FIAs are one of the fastest growing annuity products having grown from $27.3 billion in 2005 to $60.9 billion in sales for the year ended December 31, 2016. According to LIMRA, for the nine months ended September 30, 2017 (the most recent period for which specific market share data is available), we were the 2nd largest provider of FIAs in terms of sales, and our market share for the same period was 8.6% with sales of $3.7 billion. For the nine months ended September 30, 2016, we were the 3rd largest provider of FIAs in terms of sales, and our market share was 6.9% with sales of $3.2 billion.
Total benefits and expenses increased by $3.8 billion to $7.2 billion in 2017 from $3.4 billion in 2016. The increase was driven by an increase in interest sensitive contract benefits, an increase in future policy and other policy benefits, an increase in DAC, DSI and VOBA amortization, an increase in dividends payable to policyholders and higher policy and other operating expenses.
Adjusted operating income decreased by $10 million, or 1%, to $728 million in 2016 from $738 million in 2015. Adjusted operating ROE excluding AOCI was 12.1%, down from 15.6% in the prior period, as we drew the remaining $1.1 billion of capital raise proceeds in April 2015, catalyzing a ratings upgrade and providing us with significant excess capital to reinvest into market opportunities. The decrease in adjusted operating income was primarily driven by an unfavorable change of $182 million attributed to our annual unlocking of assumptions in our rider reserves and our DAC, DSI and VOBA assets, combining for an expense of $158 million in 2016 compared to a benefit of $24 million in 2015. A higher cost of crediting due to higher option costs and a change in the mix of business related to MYGA growth, an increase in DAC and VOBA amortization related to growth in our FIA block of business, an unfavorable change in rider reserves primarily due to higher than expected persistency as well as higher operating expenses attributed to growing our business and expanding our distribution channels, also contributed to the decrease in adjusted operating income.
DAC, DSI and VOBA amortization increased by $130 million to $357 million in 2016 from $227 million in 2015, primarily attributable to growth in the FIA block increasing our DAC asset, an increase in gross profits in 2016 and the $3 million unfavorable change in unlocking of assumptions of our DAC, DSI and VOBA assets. The unlocking impacts in 2016 of $38 million primarily related to a decrease in projected net investment earned rates partially offset by lower projected lapse rate assumptions while the 2015 unlocking impacts were unfavorable by $35 million.
The change in rider reserves increased by $225 million driven by the unfavorable change of $178 million attributed to our annual unlocking of assumptions. The unlocking impact in 2016 of $126 million related to a decrease in projected net investment earned rates and lower projected lapse rate assumptions while the 2015 unlocking impacts were favorable by $52 million. Additionally, the change in rider reserves increased due to an increase in gross profits in 2016 and higher than expected persistency increasing the projected excess benefits, partially offset by favorable equity market performance in 2016 compared to 2015.
Collateralized Loan Obligations - We also invest in CLOs which pay principal and interest from cash flows received from underlying corporate loans. These holdings were $5.4 billion and $5.1 billion as of December 31, 2017 and 2016, respectively. As of December 31, 2017 and 2016, our CLO portfolio included approximately $4.6 billion (85% of the total) and $4.2 billion (83% of the total), respectively, of securities that are considered investment grade based on NAIC designations while approximately $4.8 billion (88% of the total) and $4.2 billion (82% of the total), respectively, of securities were considered investment grade based on NRSRO ratings.
The following table presents our international exposure in our fixed maturity securities portfolio, including related parties, by country or region:
Our alternative investment in CoInvest VII is substantially comprised of its investment in MidCap, which was $528 million and $524 million as of December 31, 2017 and 2016, respectively. Our investment in CoInvest VII largely reflects any contributions to and distributions from CoInvest VII and the fair value of MidCap. CoInvest VII returned a net investment earned rate of 8.93%, 15.15% and 15.98% for the years ended December 31, 2017, 2016 and 2015, respectively. Alternative investment income from CoInvest VII was $50 million, $79 million and $78 million for the years ended December 31, 2017, 2016 and 2015, respectively. The decrease in alternative investment income of $29 million, or 37%, for 2017 compared to 2016, was due to 2016 benefiting from a $37 million increase in the fair value of MidCap related to the removal of liquidity discounts related to marketability assumptions used in the determination of MidCap’s fair value. Alternative investment income increased $1 million, or 1%, for 2016 compared to 2015.
The reconciliations to the nearest GAAP measure for adjusted operating income is included in the Consolidated Results of Operations section.
for purposes of administering this test, liquid limit assets are discounted by 25% and include public corporate bonds rated A- or above, liquid ABS (defined as prime auto, auto floorplan, Tier 1 subprime auto, auto lease, prime credit cards, equipment lease or utility stranded assets) and RMBS with weighted average lives less than three years rated A- or above; or CMBS with weighted average lives less than three years rated AAA- or above
Subject to these limitations and prior notification to the appropriate regulatory agency, the U.S. insurance subsidiaries are permitted to pay ordinary dividends based on calculations specified under insurance laws of the relevant state of domicile. Any distributions above the amount permitted by statute in any twelve month period are considered to be extraordinary dividends, and the approval of the appropriate regulator is required prior to payment. In addition, dividends from U.S. insurance subsidiaries to AHL would result in a 30% withholding tax. AHL does not currently plan on having the U.S. subsidiaries pay any dividends to AHL. As a result, dividends from ALRe are projected to be the primary source of AHL’s liquidity.
Under the Bermuda Insurance Act, ALRe is prohibited from paying a dividend in an amount exceeding 25% of the prior year’s statutory capital and surplus, unless at least two members of ALRe’s board of directors and its principal representative in Bermuda sign and submit to the BMA an affidavit attesting that a dividend in excess of this amount would not cause ALRe to fail to meet its relevant margins. In certain instances, ALRe would also be required to provide prior notice to the BMA in advance of the payment of dividends. In the event that such an affidavit is submitted to the BMA in accordance with the Bermuda Insurance Act, and further subject to ALRe meeting its relevant margins, ALRe is permitted to distribute up to the sum of 100% of statutory surplus and an amount less than 15% of its total statutory capital. Distributions in excess of this amount require the approval of the BMA.
The following table summarizes the dividends and other distributions our insurance subsidiaries were permitted to pay to AHL without the need for insurance regulatory approval and without regard to any withholding tax, subject to meeting solvency requirements when applicable:
On January 3, 2018, we filed our Shelf Registration Statement with the SEC, which became effective upon filing. Under our Shelf Registration Statement, we have the ability to issue, in indeterminate amounts, debt securities, preferred shares, depositary shares, Class A common shares, warrants and units. On January 12, 2018 we issued $1.0 billion in aggregate principal amount of 4.125% Senior Notes due January 2028 under our Shelf Registration Statement.
We measure the fair value of our investments based on assumptions used by market participants in pricing the assets, which may include inherent risk, restrictions on the sale or use of an asset, or nonperformance risk. The estimate of fair value is the price that would be received to sell an investment in an orderly transaction between market participants in the principal market, or the most advantageous market in the absence of a principal market, for that investment. Market participants are assumed to be independent, knowledgeable, able and willing to transact an exchange while not under duress. The valuation of investments involves considerable judgment, is subject to considerable variability and is revised as additional information becomes available. As such, changes in, or deviations from, the assumptions used in such valuations can significantly affect our consolidated financial statements. Financial markets are susceptible to severe events evidenced by rapid depreciation in investment values accompanied by a reduction in asset liquidity. Our ability to sell investments, or the price ultimately realized upon the sale of investments, depends upon the demand and liquidity in the market and increases the use of judgment in determining the estimated fair value of certain investments. Accordingly, estimates of fair value are not necessarily indicative of the amounts that could be realized in a current or future market exchange.
Other-Than-Temporary Impairment - We identify fixed maturity and equity securities that could potentially have impairments that are other-than-temporary by monitoring market events for changes in market interest rates, credit issues, changes in business climate, management changes, litigation, government actions and other similar factors. Indicators of impairment may include changes in the issuers’ credit ratings and outlook, frequency of late payments, pricing levels, key financial ratios, financial statements, revenue forecasts and cash flow projections.
Business Combinations - Clarifying the Definition of a Business (ASU 2017-01)
Derivatives and Hedging - Contingent Put and Call Options (ASU 2016-06)
The amendments in this update contain improvements to the financial reporting of hedging relationships that more closely reflect the economic results of an entity’s risk management activities in its financial statements. Additionally, the amendments in this update make certain targeted improvements to simplify the application of hedge accounting. We will be required to adopt this update effective January 1, 2019. Early adoption is permitted. We are currently evaluating the impact of this update on our consolidated financial statements.
During the respective year, we acquired PCI investments with the following amounts at the time of purchase:
Fixed Maturity Securities - We invest in securitization entities as a debt holder or an investor in the residual interest of the securitization vehicle, which are included in fixed maturity securities on the consolidated balance sheets. These entities are deemed VIEs due to insufficient equity within the structure and lack of control by the equity investors over the activities that significantly impact the economics of the entity. In general, we are a debt investor within these entities and, as such, hold a variable interest; however, due to the debt holders’ lack of ability to control the decisions within the trust that significantly impact the entity, and the fact the debt holders are protected from losses due to the subordination by the equity tranche, the debt holders are not deemed the primary beneficiary. Securitization vehicles in which we hold the residual tranche are not consolidated because we do not unilaterally have substantive rights to remove the general partner, or when assessing related party interests, we are not under common control, as defined by GAAP, with the related party, nor are substantially all of the activities conducted on our behalf; therefore, we are not deemed the primary beneficiary. Debt investments and investments in the residual tranche of securitization entities are considered debt instruments and are held at fair value on the balance sheet and classified as AFS or trading.
See Note 4 - Variable Interest Entities for fair value disclosures associated with consolidated VIEs.
AmerUs Closed Block - We elected the fair value option for the future policy benefits liability in the AmerUs Closed Block. Our valuation technique is to set the fair value of policyholder liabilities equal to the fair value of assets. There is an additional component which captures the fair value of the open block’s obligations to the closed block business. This component is the present value of the projected release of required capital and future after tax earnings on required capital supporting the AmerUs Closed Block, discounted at a rate which represents a market participant’s required rate of return, less the initial required capital. Unobservable inputs include estimates for these items. The AmerUs Closed Block policyholder liabilities and any corresponding reinsurance recoverable are classified as Level 3.
The fair value of the award is determined based on the fair value of our Class A shares on the grant date. The weighted average grant date fair value of LTIP RSUs granted during the year ended December 31, 2016 was $33.95. During the year ended December 31, 2017, the total intrinsic value of LTIP RSUs converted was $2 million. As of December 31, 2016, no LTIP RSUs were vested.
The fair value of the Class A shares subsequent to our IPO is determined based on the publicly traded closing price on the New York Stock Exchange. During 2016 and 2015, prior to our IPO, the fair value was determined based on a GAAP book value multiple approach. Under this approach, we used a comparable peer set of public companies and their share price to book value ratio, less applicable discounts for lack of marketability of AHL, in order to determine the AHL Class A share price.
The total fair value of vested Tranche 1 Class M shares was $16 million, $92 million and $98 million during the years ended December 31, 2017, 2016 and 2015, respectively. The total fair value of vested Tranche 2 Class M shares was $40 million, $122 million and $28 million during the years ended December 31, 2017, 2016 and 2015, respectively.
Income tax expense was calculated based on the following components of income before income taxes:
During the three months ended June 30, September 30, and December 31, 2017, we recorded out-of-period adjustments primarily related to DAC and VOBA amortization and actuarial reserves, which increased consolidated net income by $16 million, $16 million, and $21 million, respectively. The three months ended September 30 and December 31, 2017 include income tax adjustments which decreased income tax expense by $3 million and $14 million, respectively. These adjustments were primarily attributed to the consolidated statements of income for the years ended December 31, 2016 and 2015. We evaluated these out-of-period adjustments and determined they were not material to the consolidated financial statements for the current period, or any other previously reported period.