The following is a reconciliation of adjusted operating common shares outstanding to its corresponding GAAP measure, Class A common shares outstanding:
In addition to our results presented in accordance with GAAP, we present certain financial information that includes non-GAAP measures. Management believes the use of these non-GAAP measures, together with the relevant GAAP measures, provides information that may enhance an investor’s understanding of our results of operations and the underlying profitability drivers of our business. The majority of these non-GAAP measures are intended to remove from the results of operations the impact of market volatility (other than with respect to alternative investments) as well as integration, restructuring and certain other expenses which are not part of our underlying profitability drivers, as such items fluctuate from period to period in a manner inconsistent with these drivers. These measures should be considered supplementary to our results in accordance with GAAP and should not be viewed as a substitute for the corresponding GAAP measures. See Non-GAAP Measure Reconciliations for the appropriate reconciliations to the corresponding GAAP measures.
Adjusted operating income is a non-GAAP measure used to evaluate our financial performance excluding market volatility and expenses related to integration, restructuring, stock compensation, and other expenses. Our adjusted operating income equals net income adjusted to eliminate the impact of the following (collectively, the “non-operating adjustments”):
Investment Gains (Losses), Net of Offsets-Investment gains (losses), net of offsets, consist of the realized gains and losses on the sale of AFS securities, the change in assumed modco and funds withheld reinsurance embedded derivatives, unrealized gains and losses, impairments, and other investment gains and losses. Unrealized, impairments and other investment gains and losses are comprised of the fair value adjustments of trading securities (other than CLOs) and investments held under the fair value option, derivative gains and losses not hedging FIA index credits, and the net other-than-temporary impairment (OTTI) impacts recognized in operations net of the change in AmerUs Closed Block fair value reserve related to the corresponding change in fair value of investments and the change in unit-linked reserves related to the corresponding trading securities. Investment gains and losses are net of offsets related to DAC, DSI, and VOBA amortization and changes to guaranteed lifetime withdrawal benefit (GLWB) and guaranteed minimum death benefit (GMDB) reserves (together, GLWB and GMDB reserves represent rider reserves) as well as the MVAs associated with surrenders or terminations of contracts.
We consider these non-operating adjustments to be meaningful adjustments to net income for the reasons discussed in greater detail above. Accordingly, we believe using a measure which excludes the impact of these items is useful in analyzing our business performance and the trends in our results of operations. Together with net income, we believe adjusted operating income, provides a meaningful financial metric that helps investors understand our underlying results and profitability. Adjusted operating income should not be used as a substitute for net income.
Adjusted operating earnings per share, weighted average shares outstanding - adjusted operating and adjusted book value per share are non-GAAP measures used to evaluate our financial performance and financial condition. The non-GAAP measures adjust the number of shares included in the corresponding GAAP measures to reflect the conversion or settlement of all shares and other stock-based awards outstanding. We believe using these measures represents an economic view of our share counts and provides a simplified and consistent view of our outstanding shares. Adjusted operating earnings per share is calculated as the adjusted operating income, over the weighted average shares outstanding - adjusted operating. Adjusted book value per share is calculated as the adjusted shareholders’ equity divided by the adjusted operating common shares outstanding. Our Class B common shares are economically equivalent to Class A common shares and can be converted to Class A common shares on a one-for-one basis at any time. Our Class M common shares are in the legal form of shares but economically function as options as they are convertible into Class A shares after vesting and payment of the conversion price. In calculating Class A diluted earnings per share on a GAAP basis, we are required to apply sequencing rules to determine the dilutive impacts, if any, of our Class B common shares, Class M common shares and any other stock-based awards. To the extent our Class B common shares, Class M common shares and/or any other stock-based awards are not dilutive, after considering the dilutive effects of the more dilutive securities in the sequence, they are excluded. Weighted average shares outstanding - adjusted operating and adjusted operating common shares outstanding assume conversion or settlement of all outstanding items that are able to be converted to or settled in Class A common shares, including the impacts of Class B common shares on a one-for-one basis, the impacts of all Class M common shares net of the conversion price and any other stock-based awards, but excluding any awards for which the exercise or conversion price exceeds the market value of our Class A common shares on the applicable measurement date. For certain historical periods, Class M shares were not included due to issuance restrictions which were contingent upon our IPO. Adjusted operating earnings per share, weighted average shares outstanding - adjusted operating and adjusted book value per share should not be used as a substitute for basic earnings per share - Class A common shares, basic weighted average shares outstanding - Class A or book value per share. However, we believe the adjustments to the shares and equity are significant to gaining an understanding of our overall results of operations and financial condition.
Cost of crediting is the interest credited to the policyholders on our fixed strategies as well as the option costs on the indexed annuity strategies. With respect to FIAs, the cost of providing index credits includes the expenses incurred to fund the annual index credits, and where applicable, minimum guaranteed interest credited. The interest credited on fixed strategies and option costs on indexed annuity strategies are divided by the average account value of our deferred annuities. Our average account values are averaged over the number of quarters in the relevant period to obtain our cost of crediting for such period. To enhance the ability to analyze these measures across periods, interim periods are annualized.
Net investment earned rate, cost of crediting and investment margin on deferred annuities are non-GAAP measures we use to evaluate the profitability of our core deferred annuities business. Deferred annuities include our fixed rate annuities and FIAs, which account for approximately 85% of our Retirement Services reserve liabilities as of December 31, 2018. We believe measures like net investment earned rate, cost of crediting and investment margin on deferred annuities are useful in analyzing the trends of our core business operations, profitability and pricing discipline. While we believe net investment earned rate, cost of crediting and investment margin on deferred annuities are meaningful financial metrics and enhance our understanding of the underlying profitability drivers of our business, they should not be used as a substitute for net investment income and interest sensitive contract benefits presented under GAAP.
Other liability costs include DAC, DSI and VOBA amortization, rider reserves, institutional costs, the cost of liabilities on products other than deferred annuities, premiums, product charges and other revenues. Along with our cost of crediting, other liability costs give a view of the total costs of our liabilities. We believe a measure like other liability costs is useful in analyzing the trends of our core business operations and profitability. While we believe other liability costs is a meaningful financial metric and enhances our understanding of the underlying profitability drivers of our business, it should not be used as a substitute for total benefits and expenses presented under GAAP.
In managing our business we analyze invested assets, which does not correspond to total investments, including investments in related parties, as disclosed in our consolidated financial statements and notes thereto. Invested assets represents the investments that directly back our reserve liabilities as well as surplus assets. Invested assets is used in the computation of net investment earned rate, which allows us to analyze the profitability of our investment portfolio. Invested assets includes (a) total investments on the consolidated balance sheets with AFS securities at cost or amortized cost, excluding derivatives, (b) cash and cash equivalents and restricted cash, (c) investments in related parties, (d) accrued investment income, (e) the consolidated VIE assets, liabilities and noncontrolling interest, (f) net investment payables and receivables and (g) policy loans ceded (which offset the direct policy loans in total investments). Invested assets also excludes assets associated with funds withheld liabilities related to business exited through reinsurance agreements and derivative collateral (offsetting the related cash positions). We include the underlying investments supporting our assumed funds withheld and modco agreements in our invested assets calculation in order to match the assets with the income received. We believe the adjustments for reinsurance provide a view of the assets for which we have economic exposure. Our invested assets are averaged over the number of quarters in the relevant period to compute our net investment earned rate for such period.
Sales statistics do not correspond to revenues under GAAP, but are used as relevant measures to understand our business performance as it relates to deposits generated during a specific period of time. Our sales statistics include deposits for fixed rate annuities and FIAs and align with the LIMRA definition of all money paid into an individual annuity, including money paid into new contracts with initial purchase occurring in the specified period and existing contracts with initial purchase occurring prior to the specified period (excluding internal transfers).
VIE investment related gains and losses decreased by $53 million to a loss of $18 million in 2018 from a gain of $35 million in 2017, primarily due to the decline in market value of public equity positions in one of our funds.
Product charges increased by $109 million to $449 million in 2018 from $340 million in the prior period, primarily driven by higher rider charges related to growth in the block of business and charges related to the addition of the Voya liabilities.
DAC, DSI and VOBA amortization decreased by $179 million to $228 million in 2018 from $407 million in 2017, primarily due to the change in investment related gains and losses, a favorable decrease to our annual unlocking of assumptions of $66 million, and the net change in FIA derivatives, partially offset by an increase in the DAC asset balance related to block growth. Unlocking in 2018 was favorable by $82 million related to changes in lapse assumptions, while 2017 unlocking was favorable by $16 million related to changes to the net investment earned rate and mortality assumptions.
Dividends to policyholders decreased by $81 million to $37 million in 2018 from $118 million in 2017, primarily attributed to the deconsolidation of our former German subsidiaries.
Future policy and other policy benefits increased by $987 million to $4.2 billion in 2018 from $3.2 billion in 2017, primarily attributable to the Voya reinsurance policyholder obligations at inception related to payout annuities with life contingencies, higher PRT obligations and an increase in rider reserves, partially offset by $247 million related to the deconsolidation of our former German subsidiaries and a decrease in the change in AmerUs Closed Block fair value liability. The increase in rider reserves of $251 million was primarily driven by an increase related to our annual unlocking of assumptions of $163 million, an increase related to the net change in FIA derivatives, growth in the block and unfavorable equity market performance compared to 2017, resulting in decreased index credits to policyholder accounts, which increased the amount needed to fund the rider reserve. Unlocking in 2018 was unfavorable by $212 million related to changes in lapse assumptions partially offset by utilization of certain rider benefits, while 2017 unlocking impacts were unfavorable by $49 million related to changes in the net investment earned rate and mortality assumptions. The favorable change in the AmerUs Closed Block fair value liability of $200 million was primarily driven by the increase in unrealized losses on the underlying investments related to credit spreads widening and the change in U.S. treasury rates compared to prior year.
Income tax expense increased by $16 million to $122 million in 2018 from $106 million in 2017. The income tax expense for 2018 reflects the restructuring of our internal modco arrangements and implementation of additional reinsurance arrangements common in the insurance industry.
Our effective tax rates were 10% in 2018 and 7% in 2017. The effective tax rate excludes the impacts of an excise tax benefit of $2 million in 2018 and expense of $50 million in 2017, which are included in policy and other operating expenses on the consolidated statements of income. Our effective tax rates may vary period to period depending upon the relationship of income and loss subject to tax compared to consolidated income and loss before income taxes.
The estimated future effective tax rate and overall tax rate presented above incorporates various assumptions and actual results may vary. See Item 1A. Risk Factors-Risks Relating to Taxation-The BEAT may significantly increase our tax liability.
Net income increased by $585 million, or 76%, to $1.4 billion in 2017 from $773 million in 2016. ROE and adjusted ROE increased to 16.9% and 18.0%, respectively, from 12.6% and 12.1% in 2016, respectively, benefiting from the increase in net income. The increase in net income was driven by an increase in revenues of $4.6 billion, partially offset by a $3.9 billion increase in benefits and expenses.
Total benefits and expenses increased by $3.9 billion to $7.3 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.
Dividends to policyholders increased by $81 million to $118 million in 2017 from $37 million in 2016, primarily attributed to higher Germany dividends to policyholders due to higher participation in realized gains in 2017 and unrealized gains related to foreign currency forwards.
Adjusted operating income increased by $85 million, or 8%, to $1.1 billion in 2018 from $1.1 billion in 2017. Adjusted operating ROE was 13.9%, down from 15.1% in 2017. The increase in adjusted operating income, was primarily driven by an increase in our Retirement Services segment of $163 million partially offset by a decrease in Corporate and Other of $76 million.
Non-operating adjustments decreased by $390 million to $(87) million in 2018 from $303 million in 2017. The decrease in non-operating adjustments was primarily driven by unfavorable assumed reinsurance embedded derivative impacts and a decrease in realized gains and losses on the sale of AFS securities, partially offset by lower non-operating expenses. Assumed reinsurance embedded derivative impacts were unfavorable by $554 million due to credit spreads widening compared to the prior year, which benefited from credit spreads tightening, and growth in the reinsurance block from the Voya and Lincoln transactions. Realized gains and losses decreased $124 million driven by gains on the sale of equity securities in 2017 and the redeployment of the investment portfolio received in the Voya transaction. Non-operating expenses were favorable compared to prior year as 2017 included higher acquisition and block reinsurance costs, Germany restructuring costs, and higher stock compensation expense due to 2017 vesting performance of shares.
Our consolidated net investment earned rate was 4.47% in 2017, an increase from 4.35% in 2016, primarily attributed to strong performance from our fixed and other investment portfolios and our alternative investment portfolio. Our alternative investment net investment earned rate was 8.72% in 2017, an increase from 7.64% in 2016, primarily attributed to the lower alternative returns in 2016 due to a decline in the market value of public equity positions in one of our funds, higher real estate income and higher AmeriHome income, partially offset by lower credit fund income, lower hedge fund income, as well as 2016 benefiting from an increase in the fair value of certain underlying investments of three funds which reflected the removal of liquidity discounts related to marketability assumptions used in the determination of the fair value.
Non-operating adjustments increased by $289 million to $303 million in 2017 from $14 million in 2016. The increase in non-operating adjustments was primarily driven by a favorable net change in FIA derivatives, favorable assumed reinsurance embedded derivative impacts and a $50 million gain on the sale of equity securities. The net change in FIA derivatives was primarily driven by the performance of the equity indices to which our FIA policies are linked, partially offset by an unfavorable decrease in discount rates. Assumed reinsurance embedded derivative impacts were favorable due to RMBS credit spreads tightening.
Retirement Services is comprised of our United States and Bermuda operations which issue and reinsure retirement savings products and institutional products. Retirement Services has retail operations, which provide annuity retirement solutions to our policyholders. Retirement Services also has reinsurance operations, which reinsure FIAs, MYGAs, traditional one year guarantee fixed deferred annuities, immediate annuities and institutional products from our reinsurance partners. In addition, our institutional operations, including funding agreements and PRT obligations, are included in our Retirement Services segment.
Net investment earned rate decreased by 2 basis points to 4.70% in 2017 from 4.72% in 2016. Although fixed and other net investment earned rates increased over the prior year, this was more than offset by lower alternative net investment earned rates. The alternative net investment earned rate decreased to 10.01% from 12.26% in the prior period, mainly due to 2016 benefiting from an increase in the fair value of MidCap and another fund which reflected the removal of liquidity discounts related to marketability assumptions used in the determination of the fair value, as well as lower hedge fund income, partially offset by 2017 reflecting higher real estate income and higher AmeriHome income. Fixed and other net investment earned rates increased in 2017 to 4.48% from 4.41% in the prior period, primarily attributed to higher short-term interest rates resulting in higher floating rate investment income and higher cash balances during the prior year, partially offset by lower bond call income.
Corporate and Other includes certain other operations related to our corporate activities and prior to January 1, 2018, included our former German operations, which were primarily comprised of participating long-duration savings products. Included in Corporate and Other are corporate allocated expenses, merger and acquisition costs, debt costs, certain integration and restructuring costs, certain stock-based compensation and intersegment eliminations. In Corporate and Other, we also hold capital in excess of the level of capital we hold in Retirement Services to support our operating strategy.
Adjusted operating income (loss) decreased by $78 million to $(61) million in 2018, from $17 million in 2017. The decrease in adjusted operating income (loss) was mainly driven by lower alternative investment income related to the decline in market value of public equity positions in two of our funds and debt costs from our debt issuance in January 2018. Our former German operations, which deconsolidated on January 1, 2018, had adjusted operating income of $2 million in 2017.
Adjusted operating income (loss) increased by $66 million to $17 million in 2017, from $(49) million in 2016. The increase in adjusted operating income (loss) was mainly driven by higher alternative investment income and higher allocation of fixed and other investment income, partially offset by higher Corporate operating expenses and lower Germany adjusted operating income of $2 million, a decrease of $14 million over 2016. Alternative investment income increased primarily due to losses in 2016 related to a decline in the market value of public equity positions in one of our funds, partially offset by lower credit fund income and 2016 benefiting from a $29 million increase in the fair value of certain underlying investments of one fund which reflected the removal of liquidity discounts related to marketability assumptions used in the determination of the fair value.
Our asset portfolio is managed within the limits and constraints set forth in our Investment and Credit Risk Policy. Under this policy, we set limits on investments in our portfolio by asset class, such as corporate bonds, emerging markets securities, municipal bonds, non-agency RMBS, CMBS, CLOs, commercial mortgage whole loans and mezzanine loans and investment funds. We also set credit risk limits for exposure to a single issuer that vary based on the issuer’s ratings. In addition, our investment portfolio is constrained by its scenario-based capital ratio limit and its stressed liquidity limit.
The increase in our total investments, including related party, as of December 31, 2018 of $23.3 billion compared to December 31, 2017 was mainly driven by significant growth in our inorganic and organic deposits, investment of the proceeds from our debt issuance in January and reinvestment of earnings. These were partially offset by the deconsolidation of our former German operations of $5.9 billion and the change in unrealized gains and losses on AFS securities. Inorganic growth as of December 31, 2018, reflects $17.2 billion of assets from the Voya reinsurance transactions and $7.2 billion of assets from the Lincoln reinsurance transaction, while organic deposits were $13.2 billion less liability outflows of $8.9 billion. Unrealized gains and losses on AFS securities decreased $3.3 billion attributed to credit spreads widening and an increase in U.S. treasury rates in 2018.
While the substantial majority of our investment portfolio has been allocated to corporate bonds and structured credit products, a key component of our investment strategy is the opportunistic acquisition of investment funds with attractive risk and return profiles. Our investment fund portfolio consists of funds that employ various strategies including real estate and other real asset funds, credit funds, private equity funds and hedge funds. We have a strong preference for assets that have some or all of the following characteristics, among others: (1) investments that constitute a direct investment or an investment in a fund with a high-degree of co-investment; (2) investments with credit- or debt-like characteristics (for example, a stipulated maturity and par value), or alternatively, investments with reduced volatility when compared to pure equity; or (3) investments that have less downside risk. We acquired certain investment funds from AAA Investor (which are classified as private equity investments and consolidated VIEs) as a one-time capital contribution by our largest shareholder in advance of the Aviva USA acquisition. With respect to investment fund portfolios that we received in these transactions, we actively reinvest these investments in our preferred credit-oriented strategies over time as we liquidate these holdings.
The fair value of our AFS securities, including related parties, was $60.7 billion and $61.4 billion as of December 31, 2018 and 2017, respectively. The decrease was mainly driven by the deconsolidation of our former German operations and the change in unrealized gains and losses on AFS securities. Unrealized gains and losses on AFS securities decreased attributed to credit spreads widening and an increase in U.S. treasury rates in 2018. These were partially offset by strong growth in deposits over liability outflows, assets from the Voya coinsurance transaction and the investment of the proceeds from our debt issuance in January 2018.
The Securities Valuation Office (SVO) of the NAIC is responsible for the credit quality assessment and valuation of securities owned by state regulated insurance companies. Insurance companies report ownership of securities to the SVO when such securities are eligible for filing on the relevant schedule of the NAIC Financial Statement Blank. The SVO conducts credit analysis on these securities for the purpose of assigning an NAIC designation and/or unit price. Subject to the important exceptions discussed below, if a security has been rated by a Nationally Recognized Statistical Rating Organization (NRSRO), the SVO utilizes that rating and assigns an NAIC designation based upon the following system (General Ratings Process):
The SVO has developed a ratings process and provides instruction on both modeled and non-modeled LBaSS. For modeled LBaSS, the process is specific to the non-agency RMBS and CMBS asset classes. In order to establish ratings at the individual security level, the SVO obtains loan-level analysis of each RMBS and CMBS using a selected vendor’s proprietary financial model. The SVO ensures that the vendor has extensive internal quality-control processes in place and the SVO conducts its own quality-control checks of the selected vendor’s valuation process. The SVO has retained the services of Blackrock, Inc. (Blackrock) to model non-agency RMBS and CMBS owned by U.S. insurers for all years presented herein. Blackrock provides five prices (breakpoints), based on each U.S. insurer’s statutory book value price, to utilize in determining the NAIC designation for each modeled LBaSS.
Prior to January 1, 2019, certain non-modeled LBaSS (including CLOs and ABS, other than RMBS and CMBS) underwent ratings evaluation by an NAIC credit rating provider (CRP). Such securities were subject to an exemption from the General Ratings Process (MFE Exemption) and received NAIC designations through a prescribed process (MFE Process). Pursuant to the MFE Process, CRP ratings were translated to an NAIC designation equivalent. If the translation process resulted in an NAIC designation equivalent of NAIC 1 or NAIC 6, then such designation was considered the final NAIC designation. If the translation process resulted in an NAIC designation equivalent of NAIC 2 through NAIC 5, then the NAIC designation equivalent was used to select the appropriate breakpoint from a pricing matrix and such breakpoint was applied to the amortized cost or fair value (in each instance, as a percentage of par), as applicable, to determine the final NAIC designation. Effective January 1, 2019, the MFE Exemption was eliminated, and as a result, NAIC designations for all non-modeled LBaSS are thereafter determined through the General Ratings Process.
A summary of our AFS securities, including related parties, by NAIC designation (with our former German operations applying NRSRO ratings to map to NAIC designations) is as follows:
A summary of our AFS securities, including related parties, by NRSRO ratings is set forth below:
As of December 31, 2018 and 2017, the non-rated securities shown above were comprised of 56% and 58%, respectively, of corporate private placement securities for which we have not sought individual ratings from the NRSRO, and 30% and 31%, respectively, of RMBS, many of which were acquired at a significant discount to par. We rely on internal analysis of credit risk and designations assigned by the NAIC. As of December 31, 2018 and 2017, 92% and 94%, respectively, of the non-rated securities were designated NAIC 1 or 2.
Asset-backed Securities - We invest in ABS which are securitized by pools of assets such as consumer loans, automobile loans, student loans, insurance-linked securities, operating cash flows of corporations and cash flows from various types of business equipment. Our AFS ABS holdings were $5.8 billion and $4.0 billion as of December 31, 2018 and 2017, respectively. The increase in our AFS ABS portfolio is mainly due to attractive investments made during the year as new deposits and the Voya and Lincoln investment portfolios are deployed. As of December 31, 2018 and 2017, our AFS ABS portfolio included $5.4 billion (92% of the total) and $3.8 billion (94% of the total), respectively, of securities that are considered investment grade based on NAIC designations, while $5.2 billion (89% of the total) and $3.6 billion (89% of the total), respectively, of securities were considered investment grade based on NRSRO ratings.
Collateralized Loan Obligations - We also invest in CLOs which pay principal and interest from cash flows received from underlying corporate loans. These holdings were $5.9 billion and $5.4 billion as of December 31, 2018 and 2017, respectively.
Commercial Mortgage-backed Securities - A portion of our AFS portfolio is invested in CMBS. CMBS are constructed from pools of commercial mortgages. These holdings were $2.4 billion and $2.0 billion as of December 31, 2018 and 2017, respectively. As of December 31, 2018 and 2017, our AFS CMBS portfolio included $2.1 billion (91% of the total) and $1.9 billion (95% of the total), respectively, of securities that are considered investment grade based on NAIC designations, while $1.6 billion (66% of the total) and $1.4 billion (70% of the total), respectively, of securities were considered investment grade based on NRSRO ratings.
A significant majority of our AFS RMBS portfolio, 95.8% and 96.8% as of December 31, 2018 and 2017, respectively, was invested in assets considered to be investment grade based upon an application of the NAIC’s methodology to our holdings of RMBS. The NAIC’s methodology with respect to RMBS gives explicit effect to the amortized cost at which an insurance company carries each such investment. Because we invested in RMBS after the stresses related to U.S. housing had caused significant downward pressure on prices of RMBS, we carry most of our investments in RMBS at significant discounts to par value, which results in an investment grade NAIC designation. In contrast, our understanding is that in setting ratings, NRSROs focus on the likelihood of recovering all contractual payments, including principal at par value. As a result of a fundamental difference in approach, as of December 31, 2018 and 2017, NRSRO characterized 45.4% and 37.9%, respectively, of our AFS RMBS portfolio as investment grade.
The gross unrealized losses on AFS securities, including related parties, were $1.8 billion and $246 million as of December 31, 2018 and 2017, respectively. The increase in unrealized losses was driven by credit spreads widening and the increase in U.S. treasury rates during year ended December 31, 2018.
During the years ended December 31, 2018, 2017 and 2016, we recorded $18 million, $33 million and $30 million, respectively, of OTTI losses. OTTI losses in 2018 were primarily related to corporate fixed maturities, while OTTI losses in 2017 were primarily related to corporate fixed maturities, real estate and mortgage loans. OTTI losses in 2016 were primarily related to state, municipal and political subdivisions, corporate fixed maturities and ABS. The OTTI losses we have experienced for the years ended December 31, 2018, 2017 and 2016 translate into 2 basis points, 4 basis points and 4 basis points, respectively, of average invested assets.
Trading securities, including related parties, were $2.2 billion and $2.5 billion as of December 31, 2018 and 2017, respectively. Trading securities are primarily comprised of AmerUs Closed Block securities for which we have elected the fair value option valuation, CLO equity tranche securities, structured securities with embedded derivatives, and investments which support various reinsurance arrangements.
It is our policy to cease to accrue interest on loans that are over 90 days delinquent. For loans less than 90 days delinquent, interest is accrued unless it is determined that the accrued interest is not collectible. If a loan becomes over 90 days delinquent, it is our general policy to initiate foreclosure proceedings unless a workout arrangement to bring the loan current is in place. As of December 31, 2018 and 2017, we had $48 million and $28 million, respectively of mortgage loans that were 90 days past due, of which $15 million and $1 million, respectively, were in the process of foreclosure.
As of December 31, 2018 and 2017, we had not recorded any new specific loan valuation allowances. For the years ended December 31, 2018, 2017 and 2016, we recorded $0 million, $3 million and $0 million, respectively, of impairments through net income. We have established a general and specific loan valuation allowance in the aggregate amount of $2 million as of December 31, 2018 and 2017.
Our investment funds investment strategy primarily focuses on funds with core holdings of credit assets, real assets, real estate, preferred equity and income producing assets. Our investment strategy focuses on sourcing assets with some or all of the following characteristics, among others: (1) investments that constitute a direct investment or an investment in a fund with a high degree of co-investment; (2) investments with credit- or debt-like characteristics (for example, a stipulated maturity and par value), or alternatively, investments with reduced volatility when compared to pure equity; or (3) investments that have less downside risk.
Overall, the total investment funds, including related party and consolidated VIEs, were $3.6 billion and $2.6 billion as of December 31, 2018 and 2017, respectively. See Note 3 - Investments to the consolidated financial statements for further discussion regarding how we account for our investment funds. Our investment fund portfolio is subject to a number of market related risks including interest rate risk and equity market risk. Interest rate risk represents the potential for changes in the investment fund’s net asset values resulting from changes in the general level of interest rates. Equity market risk represents potential for changes in the investment fund’s net asset values resulting from changes in equity markets or from other external factors which influence equity markets. The interest rate risk and equity market risk to which our investment funds are subject expose us to potential volatility in our earnings period-over-period. We actively monitor our exposure to these risks.
The following summarizes the underlying investment composition of the funds withheld at interest, including related parties:
As of December 31, 2018 and 2017, we held $28.6 billion and $7.1 billion, respectively, of funds withheld at interest receivables, including related party. The increase in funds withheld at interest is mainly due to $14.0 billion of modco reinsurance agreements from the Voya reinsurance transaction and $7.2 billion from the Lincoln reinsurance transaction, both as of December 31, 2018. Approximately 96.6% and 94.2% of the fixed maturity securities within the funds withheld at interest are investment grade by NAIC designation as of December 31, 2018 and 2017, respectively.
A discussion regarding our derivative instruments and how such instruments are used to manage risk is included in Note 4 - Derivative Instruments to the consolidated financial statements.
Our alternative investment in A-A Mortgage was $568 million and $496 million as of December 31, 2018 and 2017, respectively. Our investment in A-A Mortgage represents our proportionate share of its net asset value, which largely reflects any contributions to and distributions from A-A Mortgage and the fair value of AmeriHome. A-A Mortgage returned a net investment earned rate of 13.15%, 12.01% and 11.62% for the years ended December 31, 2018, 2017, and 2016, respectively. Alternative investment income from A-A Mortgage was $72 million, $58 million and $41 million for the years ended December 31, 2018, 2017 and 2016, respectively. The increase in alternative investment income of $14 million, or 24%, for 2018 compared to 2017 was driven by strong originations and an increase in balance sheet size. The increase in alternative investment income for 2017 compared to 2016 was driven by increases in its overall balance sheet size, origination volumes and retained mortgage servicing rights.
The reconciliation of average shareholders’ equity to average adjusted shareholders’ equity, which is included in adjusted ROE and adjusted operating ROE is as follows:
The reconciliation of policy and other operating expenses to operating expenses is as follows:
minimum of 50% of any required AHL - Athene USA inter-company loan commitments to be held in cash and cash equivalents by AHL
AARe capital maintenance calls arising from AARe collateral calls from modco reinsurance contracts; and
Our policyholder obligations are generally long-term in nature. However, one liquidity risk is an extraordinary level of early policyholder withdrawals. We include provisions within our annuity policies, such as surrender charges and MVAs, which are intended to protect us from early withdrawals. As of December 31, 2018 and 2017, approximately 78% and 86%, respectively, of our deferred annuity liabilities were subject to penalty upon surrender. In addition, as of December 31, 2018 and 2017, approximately 65% and 72%, respectively, of policies contained MVAs that may also have the effect of limiting early withdrawals if interest rates increase. Our funding agreements, group annuities and payout annuities are generally non-surrenderable.
Through our membership in the FHLB, we are eligible to borrow under variable rate short-term federal funds arrangements to provide additional liquidity. The borrowings must be secured by eligible collateral such as mortgage loans, eligible CMBS or RMBS, government or agency securities and guaranteed loans. There were no outstanding borrowings under these arrangements as of December 31, 2018 or 2017.
The maximum FHLB indebtedness by a member is determined by the amount of collateral pledged, and cannot exceed a specified percentage of the member’s total statutory assets dependent on the internal credit rating assigned to the member by the FHLB. As of December 31, 2018, the total maximum borrowings under the FHLB facility were limited to $17.2 billion. However, our ability to borrow under the facility is constrained by the availability of assets that qualify as eligible collateral under the facility and by the Iowa Code requirement that we maintain funds equivalent to our legal reserve in certain permitted investments, from which we exclude pledged assets. Considering these limitations, we estimate that as of December 31, 2018 we had the ability to draw up to a total of approximately $1.5 billion, inclusive of borrowings then outstanding. This estimate is based on our internal analysis and assumptions, and may not accurately measure collateral which is ultimately acceptable to the FHLB. Drawing such amounts would have an adverse impact on AAIA’s RBC ratio, which may further restrict our ability or willingness to draw up to our estimated capacity.
The primary cash inflows from investing activities are the sales, maturities and repayments of investments. The primary cash outflows from investing activities are the purchases and acquisitions of new investments. Our investing activities used cash flows totaling $8.2 billion, $5.8 billion and $2.7 billion for the years ended December 31, 2018, 2017 and 2016, respectively. The change in cash used in investing activities for the year ended December 31, 2018 compared to 2017 was primarily attributed to the purchase of investments related to the increase in deposits over liability outflows, the investment of proceeds from our debt issuance, the deconsolidation of AGER Bermuda Holding Ltd. and its subsidiaries and the reinvestment of earnings. The increase in cash used from investing activities for the year ended December 31, 2017 compared to 2016, was primarily attributed to the purchase of investments related to the increase in deposits over liability outflows, as well as the reinvestment of earnings.
The primary cash inflows from financing activities are deposits on our investment-type policies, changes of cash collateral posted for derivative transactions, capital contributions and proceeds from borrowing activities. The primary cash outflows from financing activities are withdrawals on our investment-type policies, changes of cash collateral posted for derivative transactions and repayments of outstanding borrowings. Our financing activities provided cash flows totaling $3.7 billion, $5.0 billion and $1.2 billion for the years ended December 31, 2018, 2017 and 2016, respectively. The change in cash provided from financing activities for the year ended December 31, 2018 compared to 2017 was primarily attributed to the change in cash collateral posted for derivative transactions and lower funding agreement issuances in 2018, partially offset by proceeds from the issuance of debt. The change in cash provided from financing activities for the year ended December 31, 2017 compared to 2016 was primarily attributed to the increase in annuity and funding agreement deposits over liability outflows, the favorable change in cash collateral posted for derivative transactions and the settling of borrowings of our CMBS VIE funds in 2016.
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. AHL does not currently plan on having the U.S. subsidiaries pay any dividends to ALRe.
In the fourth quarter of 2018, our board of directors approved a share repurchase program, which authorizes us to repurchase up to $250 million of Class A shares. We repurchased 2.5 million Class A shares for $100 million under this authorization during the year ended December 31, 2018. Subsequent to December 31, 2018 and through February 22, 2019, we repurchased an additional 1.2 million Class A shares for $47 million.
We also have other obligations related to collateral on derivatives, investment fund commitments and funds withheld liabilities which have not been included in the above table as the timing and amount of each of the return on the collateral, the fulfillment of the commitments and the funds withheld liabilities are uncertain. See Note 18 - Commitments and Contingencies to the consolidated financial statements for further discussion on the investment fund commitments.
In the normal course of business, we invest in various investment funds which are considered VIEs, and we consolidate a VIE when we are considered the primary beneficiary of the entity. For further discussion of our involvement with VIEs, see Note 5 - Variable Interest Entities to the consolidated financial statements.
We are responsible for the fair value measurement of certain investments presented in our consolidated financial statements. We perform regular analysis and review of our valuation techniques, assumptions and inputs utilized in determining fair value to evaluate if the valuation approaches are appropriate and consistently applied, and the various assumptions are reasonable. We also perform quantitative and qualitative analysis and review of the information and prices received from commercial pricing services and broker-dealers, to verify it represents a reasonable estimate of the fair value of each investment. In addition, we utilize both internally-developed and commercially-available cash flow models to analyze the reasonableness of fair values utilizing credit spread and other market assumptions, where appropriate. For investment funds, we typically recognize our investment, including those for which we have elected the fair value option, based on net asset value information provided by the general partner or related asset manager. For a discussion of our investment funds for which we have elected the fair value option, see Note 6 - Fair Value to the consolidated financial statements.
The evaluation of securities for OTTIs is a quantitative and qualitative process done on a case-by-case basis, which is subject to risks and uncertainties and involves significant estimates and judgments by management. Changes in the estimates and judgments used in such analysis can have a significant impact on our consolidated results of operations.
We review and analyze our securities on an ongoing basis 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, the frequency of late payments, pricing levels, key financial ratios, financial statements, revenue forecasts and cash flow projections. We consider relevant facts and circumstances in evaluating whether a credit or interest rate-related impairment of a security is other-than-temporary. Relevant facts and circumstances include: (1) the extent and length of time the fair value has been below cost; (2) the reasons for the decline in fair value; (3) the issuer’s financial position and access to capital; and (4) for fixed maturity securities, our intent to sell a security or whether it is more-likely-than-not we will be required to sell the security before the recovery of its cost or amortized cost which, in some cases, may extend to maturity and for equity securities prior to the adoption of ASU 2016-01 on January 1, 2018, our ability and intent to hold the security for a period of time that allows for the recovery in value. An extended and severe unrealized loss position on a fixed maturity security may not have any impact on the ability of the issuer to service all scheduled principal and interest payments. Accordingly, such an unrealized loss position may not impact our evaluation of recoverability of all contractual cash flows or the ability to recover an amount at least equal to the security’s cost or amortized cost based on the present value of the expected future cash flows to be collected. To the extent we determine a security is deemed to be other-than-temporarily impaired, an impairment loss is recognized.
We issue and reinsure deferred annuity contracts which contain GLWB and GMDB riders. We establish future policy benefits for GLWB and GMDB by estimating the expected value of withdrawal and death benefits in excess of the projected account balance. We recognize the excess proportionally over the accumulation period based on total actual and expected assessments. The methods we use to estimate the liabilities have assumptions about policyholder behavior, which includes lapses, withdrawals and utilization of the benefit riders; mortality; and market conditions affecting the account balance growth.
The assessments used to accrue liabilities are based on interest margins, rider charges, surrender charges and realized gains (losses). As such, future reserve changes are sensitive to changes in investment results and the impacts of shadow adjustments, which represent the impact of assuming unrealized gains (losses) are realized in future periods. As of December 31, 2018, the GLWB and GMDB liability balance, including the impacts of shadow adjustments, totaled $3.3 billion. The increase (decrease) to the GLWB and GMDB liability balance, including the impacts of shadow adjustments from hypothetical changes in projected assessments, changes in the discount rate and annual equity growth is summarized as follows:
We issue and reinsure products, primarily FIA products, or purchase investments that contain embedded derivatives. If we determine the embedded derivative has economic characteristics not clearly and closely related to the economic characteristics of the host contract, and a separate instrument with the same terms would qualify as a derivative instrument, the embedded derivative is bifurcated from the host contract and accounted for separately, unless the fair value option is elected on the host contract. Under the fair value option, bifurcation of the embedded derivative is not necessary as the entire contract is carried at fair value with all related gains and losses recognized in investment related gains (losses) on the consolidated statements of income. Embedded derivatives are carried on the consolidated balance sheets at fair value in the same line item as the host contract.
In general, the change in the fair value of the embedded derivatives will not directly correspond to the change in fair value of the hedging derivative assets. The derivatives are intended to hedge the index credits expected to be granted at the end of the current term. The options valued in the embedded derivatives represent the rights of the policyholder to receive index credits over the entire period the FIAs are expected to be in force, which are typically much longer than the current term of the options. From an economic basis we believe it is suitable to hedge with options that align with index terms of our FIA products because policyholder accounts are credited with index performance at the end of each index term. However, because the value of an embedded derivative in an FIA contract is longer-dated, there is a duration mismatch which may lead to differences in the recognition of income and expense for accounting purposes.
A significant assumption in determining policy liabilities for FIAs is the vector of rates used to discount the excess projected contract values. The change in risk free rates is expected to drive most of the movement in the discount rates between periods. Changes to credit spreads for a given credit rating as well as any change to our credit rating requiring a revised level of nonperformance risk would also be factors in the changes to the discount rate. If the discount rates used to discount the excess projected contract values were to fluctuate, there would be a resulting change in reserves for FIAs recorded through the consolidated statements of income.
We have audited the accompanying consolidated balance sheets of Athene Holding Ltd. and its subsidiaries (the “Company”) as of December 31, 2018 and 2017, and the related consolidated statements of income, comprehensive income (loss), equity, and cash flows for each of the three years in the period ended December 31, 2018, including the related notes and financial statement schedules listed in the index appearing under Item 15(2) (collectively referred to as the “consolidated financial statements”). We also have audited the Company's internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2018 and 2017, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2018 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company did not maintain, in all material respects, effective internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the COSO because a material weakness in internal control over financial reporting existed as of that date related to ineffective controls over the process to value the host contracts within fixed indexed annuity liabilities.
We have prepared the consolidated financial statements in accordance with accounting principles generally accepted in the United States of America (GAAP), which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the period. Actual experience could materially differ from these estimates and assumptions. Our principal estimates impact:
Fixed Maturity Securities - Fixed maturity securities includes bonds, collateralized loan obligations (CLO), asset-backed securities (ABS), residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS) and redeemable preferred stock. We classify fixed maturity securities as available-for-sale (AFS) or trading at the time of purchase and subsequently carry them at fair value. Fair value hierarchy and valuation methodologies are discussed in Note 6 - Fair Value. Classification is dependent on a variety of factors including our expected holding period, election of the fair value option and asset and liability matching.
Trading Securities - We elected the fair value option for certain fixed maturity securities. These fixed maturity securities are classified as trading, with changes to fair value included in investment related gains (losses) on the consolidated statements of income. Although the securities are classified as trading, the trading activity related to these investments is primarily focused on asset and liability matching activities and is not intended to be an income strategy based on active trading. As such, the activity related to these investments on the consolidated statements of cash flows is classified as investing activities. Trading securities includes mutual funds supporting unit-linked investment contracts.
Policy Loans - Policy loans are funds provided to policyholders in return for a claim on the policy’s account value. The funds provided are limited to a specified percentage of the account balance. The majority of policy loans do not have a stated maturity and the balances and accrued interest are repaid with proceeds from the policy account balance. Policy loans are reported at the unpaid principal balance. Interest income is recorded as earned using the contract interest rate and is reported in net investment income on the consolidated statements of income.
Real estate investments for which we have committed to a plan to sell within one year and are actively marketing are classified as held for sale. Real estate held for sale is stated at the lower of depreciated cost as of the date we committed to a plan to sell or estimated fair value less expected disposition costs.
Short-term Investments - Short-term investments consists of financial instruments with maturities of greater than three months but less than twelve months when purchased. Short-term debt securities are accounted for as trading or AFS consistent with our policies for those investments. Short-term loans are carried at amortized cost. Fair values are determined consistent with methodologies described in Note 6 - Fair Value for the respective investment type.
The recognition of impairment losses on fixed maturity securities is dependent upon the facts and circumstances related to the specific security. If we intend to sell a security or it is more likely than not that we would be required to sell a security before the recovery of its cost or amortized cost, less any recorded credit loss, we recognize a loss in other-than-temporary impairment losses on the consolidated statements of income for the difference between cost or amortized cost and fair value. If neither of these two conditions exists, then the recognition of the loss is bifurcated and we recognize the credit loss portion in other-than-temporary impairment losses on the consolidated statements of income and the non-credit loss portion in AOCI on the consolidated balance sheets. Impairment losses on equity securities were recognized in investment related gains (losses) on the consolidated statements of income prior to January 1, 2018. Effective January 1, 2018, equity securities are no longer evaluated for impairment as all changes in fair value are recognized in net income.
the present value of expected future cash flows discounted at the loan’s original effective interest rate;
The cost of other invested assets is adjusted for impairments in value deemed to be other-than-temporary in the period in which the determination is made. These impairments are included within other-than-temporary impairment losses on the consolidated statements of income, and the cost basis of the investment securities is reduced accordingly. We do not change the revised cost basis for subsequent recoveries in value.
Derivative Instruments-We invest in derivatives to hedge the risks experienced in our ongoing operations, such as equity, interest rate and cash flow risks, or for other risk management purposes, which primarily involve managing liability risks associated with our indexed annuity products and reinsurance agreements. Derivatives are financial instruments whose values are derived from interest rates, foreign exchange rates, financial indices or other underlying notional amounts. Derivative assets and liabilities are carried at fair value on the consolidated balance sheets. We elect to present any derivatives subject to master netting provisions as a gross asset or liability and gross of collateral. Disclosures regarding balance sheet presentation of derivatives subject to master netting agreements are discussed in Note 4 - Derivative Instruments. We may designate derivatives as cash flow or fair value hedges.
For a cash flow hedge, all changes in the fair value of the hedging derivative are reported within AOCI beginning January 1, 2018, and the related gains or losses on the derivative are reclassified into the consolidated statements of income when the cash flows of the hedged item affect earnings. Prior to January 1, 2018, any portion deemed to be ineffective was reported in investment related gains (losses) on the consolidated statements of income each reporting period as effectiveness was assessed.
Fixed indexed annuity and indexed universal life insurance contracts allow the policyholder to elect a fixed interest rate return or an equity market component for which interest credited is based on the performance of certain stock market indices. The equity market option is an embedded derivative, similar to a call option. The benefit reserve is equal to the sum of the fair value of the embedded derivative and the host (or guaranteed) component of the contracts. The fair value of the embedded derivatives is computed as the present value of benefits attributable to the excess of the projected policy contract values over the projected minimum guaranteed contract values. The projections of policy contract values are based on assumptions for future policy growth, which include assumptions for expected index credits on the next policy anniversary date, future equity option costs, volatility, interest rates and policyholder behavior. The projections of minimum guaranteed contract values include the same assumptions for policyholder behavior as were used to project policy contract values. The embedded derivative cash flows are discounted using a rate that reflects our own credit rating. The host contract is established at contract inception as the initial account value less the initial fair value of the embedded derivative and accreted over the policy’s life. The host contract accretion rate is updated each quarter so that the present value of actual and expected guaranteed cash flows is equal to the initial host value. Changes in the fair value of embedded derivatives associated with fixed indexed annuities and indexed universal life insurance contracts are included in interest sensitive contract benefits on the consolidated statements of income.
We are required to consolidate a VIE if we are the primary beneficiary, defined as the variable interest holder with both the power to direct the activities that most significantly impact the VIE’s economic performance and rights to receive benefits or obligations to absorb losses that could be potentially significant to the VIE. We determine whether we are the primary beneficiary of an entity based on a qualitative assessment of the VIE’s capital structure, contractual terms, nature of the VIE’s operations and purpose and our relative exposure to the related risks of the VIE. Since affiliates of Apollo Global Management, LLC (AGM and, together with its subsidiaries, Apollo), a related party, are the decision makers in certain of the investment funds, we and a member of our related party group may together have the characteristics of the primary beneficiary of an investment fund. In this situation, we have concluded we are not under common control, as defined by GAAP, with the related party, and therefore consolidate in the circumstances when substantially all of the activities of the VIE are conducted on our behalf. We reassess the VIE and primary beneficiary determinations on an ongoing basis.
For entities that we do not consolidate but have significant influence over the entities’ operations, we record our investment under the equity method of accounting. If we do not consolidate and do not have significant influence, generally on investment funds in which we own a less than a 3% interest, we elect the fair value option.
Business Combinations and Goodwill-Business combination transactions are accounted for under the acquisition method. Accordingly, the purchase consideration is allocated to assets and liabilities based on their estimated fair value at the acquisition date. The consideration for the net assets acquired is determined prior to the assessment of the fair value of the net assets at the acquisition date. We have identified several intangible assets acquired in business combinations including VOBA, acquired distribution channels and state licenses. We value VOBA as described below under -Deferred Acquisition Costs, Deferred Sales Inducements and Value of Business Acquired. We value distribution channels using the multi-period excess earnings method under the income approach and the state licenses using the market approach. Intangible assets related to distribution channels and state licenses are included in other assets on the consolidated balance sheets.
Goodwill represents the excess of purchase consideration over the acquisition date fair value of net assets acquired and is included in the other assets on the consolidated balance sheets. Goodwill is not amortized but reviewed for impairment annually or more frequently if events occur or circumstances change indicating potential impairment has occurred. If the acquisition date fair value of the net assets acquired exceeds the purchase consideration in a business combination, a bargain purchase gain is recorded on the consolidated statements of income.
Reinsurance-We assume and cede insurance and investment contracts under coinsurance, funds withheld and modco. We follow reinsurance accounting for transactions that provide indemnification against loss or liability relating to insurance risk (risk transfer). To meet risk transfer requirements, a reinsurance agreement must transfer insurance risk arising from uncertainties about both underwriting and timing risks. Cessions under reinsurance do not discharge our obligations as the primary insurer, unless the requirements of assumption reinsurance have been met. We generally have the right of offset on reinsurance contracts, but have elected to present reinsurance settlement amounts due to and from the Company on a gross basis.
Interest Sensitive Contract Liabilities-Universal life-type policies and investment contracts include fixed indexed and traditional fixed annuities in the accumulation phase, funding agreements, universal life insurance, fixed indexed universal life insurance, unit-linked contracts and immediate annuities without significant mortality risk (which includes pension risk transfer (PRT) annuities without life contingencies). We carry liabilities for fixed annuities, universal life insurance, unit-linked contracts and funding agreements at the account balances without reduction for potential surrender or withdrawal charges, except for a block of universal life business ceded to Global Atlantic Financial Group Limited (together with its subsidiaries, Global Atlantic) which we carry at fair value. Liabilities for immediate annuities without significant mortality risk are calculated as the present value of future liability cash flows and policy maintenance expenses discounted at contractual interest rates. For a discussion regarding our indexed products, refer above to the embedded derivative discussion.
Future Policy Benefits-We issue contracts classified as long-duration, which includes endowments, term and whole life, accident and health, disability, and deferred and immediate annuities with life contingencies (which includes PRT annuities with life contingencies). Liabilities for non-participating long-duration contracts are established using accepted actuarial valuation methods which require the use of assumptions related to expenses, investment yields, mortality, morbidity and persistency, with a provision for adverse deviation, at the date of issue or acquisition. As of December 31, 2018, the reserve investment yield assumptions for non-participating contracts range from 3.31% to 5.44% and are specific to our expected earned rate on the asset portfolio supporting the reserves. Liabilities for participating long-duration contracts were established using accepted actuarial valuation methods, which required the use of guaranteed interest and mortality assumptions. Participating long-duration contracts resulted from our previously consolidated German subsidiaries. We base other key assumptions, such as mortality and morbidity, on industry standard data adjusted to align with actual company experience, if necessary.
Future policy benefits includes liabilities for no-lapse guarantees on universal life insurance and fixed indexed universal life insurance. We establish future policy benefits for no-lapse guarantees by estimating the expected value of death benefits paid after policyholder account balances have been exhausted. We recognize these benefits proportionally over the life of the contracts based on total expected assessments. The methods we use to estimate the liabilities have assumptions about policyholder behavior, mortality and market conditions affecting the account balance growth.
Changes in future policy benefits other than the adjustment for the OCI effects of unrealized investment gains and losses on AFS securities, are recorded in future policy and other policy benefits on the consolidated statements of income. Future policy benefits are not reduced for amounts ceded under reinsurance agreements which are reported as reinsurance recoverable on the consolidated balance sheets. See the reinsurance accounting policy discussed in -Reinsurance above and Note 7 - Reinsurance for more information on reinsurance.
Dividends Payable to Policyholders-Participating policies entitle the policyholders to receive dividends based on actual interest, mortality, morbidity and expense experience for the year. Dividends are distributed to the policyholders through annual or terminal dividends which the board of directors of the applicable insurance subsidiary approves. As of December 31, 2018 and 2017, 10% and 26%, respectively, of life policies, inclusive of ceded policies, were participating, and the related liability is recorded in dividends payable to policyholders on the consolidated balance sheets. Premiums related to participating policies represented 26%, 52% and 45% of total life insurance direct premiums and deposits for the years ended December 31, 2018, 2017 and 2016, respectively.
As of December 31, 2017, all of the non-separate account unit-linked policies were paying dividends, and the related liability was recorded in dividends payable to policyholders on the consolidated balance sheets for our previously consolidated German subsidiaries. There were no material deposits related to non-separate account unit-linked policies paying dividends for the years ended December 31, 2017 and 2016. Non-separate account unit-linked policies represented an insignificant percentage of our interest sensitive contracts in force as of December 31, 2017.
Stock-Based Compensation-We have compensation plans under which stock-based awards may be granted to our employees and directors and employees of Athene Asset Management, L.P. (AAM) as described in Note 12 - Stock-based Compensation. We recognize the fair value of stock-based compensation over a participant’s requisite service period through a charge to compensation expense and a corresponding entry to equity or a liability based on vesting criteria and other pertinent terms of the awards. Stock-based awards are accounted for as equity awards in instances where the awards’ vesting is linked to a market, performance or service condition. Equity awards are generally expensed based on the grant date fair value. Stock-based awards are accounted for as liabilities in instances where the awards’ vesting is linked to a factor other than a market, performance or service condition. Liability awards are remeasured each reporting period until settlement. In the event of an award modification, we recognize any additional value arising from the modification as compensation cost and determine whether the modified award should be accounted for prospectively as an equity or liability award.
Income Taxes-We compute income taxes using the asset and liability method, under which deferred income taxes are provided for the temporary differences between the financial statement carrying amounts and the tax basis of our assets and liabilities using estimated tax rates expected to be in effect for the year in which the differences are expected to reverse. Such temporary differences are primarily due to the tax basis of reserves, DAC, unrealized investment gains/losses, reinsurance related differences, embedded derivatives and net operating loss carryforwards. Changes in deferred income tax assets and liabilities associated with components of OCI are recorded directly to OCI. We evaluate the likelihood of realizing the benefit of our deferred tax assets and may record a valuation allowance if, based on all available evidence, we determine that it is more likely than not that some portion of the tax benefit will not be realized. We adjust the valuation allowance if, based on our evaluation, there is a change in the amount of deferred income tax assets that are deemed more-likely-than-not to be realized. Changes in deferred tax assets and liabilities attributable to changes in enacted income tax rates are recorded through net income in the period of enactment. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the relevant taxing authorities, based on the technical merits of our position. For those tax positions that meet the more-likely-than-not recognition threshold, we recognize the largest amount of tax benefit that is more than 50 percent likely to be realized upon ultimate settlement with the related tax authority. We recognize any income tax interest and penalties in income tax expense.
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 early adopted this update effective January 1, 2018, and the adoption did not have a material effect on our consolidated financial statements.
This update requires the immediate recognition of current and deferred income tax effects of intra-entity transfers of assets, other than inventory. Prior to adoption, recognition of the income tax consequence was not recognized until the asset was sold to an outside party. We adopted this update effective January 1, 2018. Upon adoption, we recognized a cumulative-effect decrease to beginning retained earnings of $3 million.
Leases (ASU 2018-20, ASU 2018-11, ASU 2018-10, ASU 2018-01, ASU 2017-13 and ASU 2016-02)
The updates are effective January 1, 2019. ASU 2016-02 required the adoption on a modified retrospective basis. However, with the issuance of ASU 2018-11, we have the option to recognize the cumulative effect as an adjustment to the opening balance of retained earnings in the year of adoption, while continuing to present all prior periods under the previous lease guidance. These updates provide optional practical expedients in transition.
This update is designed to reduce complexity by limiting the number of credit impairment models used for different assets. The model will result in accelerated credit loss recognition on assets held at amortized cost, which includes our commercial and residential mortgage investments. The identification of credit-deteriorated securities will include all assets that have experienced a more-than-insignificant deterioration in credit since origination. Additionally, any changes in the expected cash flows of credit-deteriorated securities will be recognized immediately in the income statement. AFS fixed maturity securities are not in scope of the new credit loss model, but will undergo targeted improvements to the current reporting model including the establishment of a valuation allowance for credit losses versus the current direct write down approach. We will be required to adopt this update effective January 1, 2020. We are currently evaluating the impact of this guidance on our consolidated financial statements.
The amendments in this update provide guidance on whether certain transactions between collaborative arrangement participants should be accounted for as revenue under Topic 606, providing comparability in the presentation of revenue for certain transactions. The update is effective January 1, 2020. Early adoption is permitted. We are currently evaluating the impact of this guidance on our consolidated financial statements.
The amendments in this update align the requirements for capitalizing implementation costs incurred in a cloud computing service arrangement with the requirements for capitalizing implementation costs incurred for internal-use software. We will be required to adopt this update on January 1, 2020, and we can elect to adopt this update either prospectively or retrospectively. Early adoption is permitted. We are currently evaluating the impact of this guidance on our consolidated financial statements.
The amendments in this update modify the disclosure requirements for fair value measurements by removing, modifying or adding certain disclosures. We will be required to adopt this update on January 1, 2020, and depending on the specific amendment will be required to adopt prospectively or retrospectively. We early adopted the removal and modification of certain disclosures as permitted. We are currently evaluating the impact of the remaining guidance on our consolidated financial statements.
Insurance - Targeted Improvements to the Accounting for Long-Duration Contracts (ASU 2018-12)
We will be required to adopt this update effective January 1, 2021. Certain provisions of the update are required to be adopted on a fully retrospective basis, while others may be adopted on a modified retrospective basis. Early adoption is permitted effective January 1, 2019. We are currently evaluating the impact of this guidance on our consolidated financial statements.
The amendments in this update simplify the subsequent measurement of goodwill by eliminating the comparison of the implied fair value of a reporting unit’s goodwill with the carrying amount of that goodwill to determine the goodwill impairment loss. With the adoption of this guidance, a goodwill impairment will be the amount by which a reporting unit’s carrying value exceeds its fair value, not to exceed the carrying amount of the goodwill allocated to that reporting unit. Entities will continue to have the option to perform a qualitative assessment to determine if a quantitative impairment test is necessary. We will be required to adopt this update prospectively effective January 1, 2020. Early adoption is permitted. We do not expect the adoption of this update will have a material effect on our consolidated financial statements.
The following represents the effects of the revisions on the consolidated balance sheet:
The following represents the effects of the revisions on the consolidated statements of comprehensive income:
As of December 31, 2018, we held 4,320 AFS securities that were in an unrealized loss position. Of this total, 860 were in an unrealized loss position 12 months or more. As of December 31, 2018, we held 40 related party AFS securities that were in an unrealized loss position. Of this total, seven were in an unrealized loss position 12 months or more. The unrealized losses on AFS securities can primarily be attributed to changes in market interest rates since acquisition. We did not recognize the unrealized losses in income as we intend to hold these securities and it is not more likely than not we will be required to sell a security before the recovery of its amortized cost.
Other-Than-Temporary Impairments-For the year ended December 31, 2018, we incurred $18 million of net OTTI, of which $13 million related to intent-to-sell impairments. These securities were impaired to fair value as of the impairment date. The remaining net OTTI of $5 million related to credit impairments where a portion was bifurcated in AOCI. Any credit loss impairments not bifurcated in AOCI are excluded from the rollforward below.
The distribution of commercial mortgage loans, including those under development, net of valuation allowances, by property type and geographic region, is as follows:
Mortgage Loan Valuation Allowance-The assessment of mortgage loan impairments and valuation allowances is substantially the same for residential and commercial mortgage loans. The valuation allowance was $2 million as of December 31, 2018 and 2017. We did not record any material activity in the valuation allowance during the years ended December 31, 2018, 2017 or 2016.
The loan-to-value ratio is expressed as a percentage of the amount of the loan relative to the value of the underlying property. A loan-to-value ratio in excess of 100% indicates the unpaid loan amount exceeds the underlying collateral. The following represents the loan-to-value ratio of the commercial mortgage loan portfolio, excluding those under development, net of valuation allowances:
The following table presents the carrying value by ownership percentage of equity method investment funds, including related party investment funds and investment funds owned by consolidated VIEs:
Fixed maturity securities - We invest in securitization entities as a debt holder or an investor in the residual interest of the securitization vehicle. 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.
Total return swaps - We purchase total rate of return swaps to gain exposure and benefit from a reference asset or index without ownership. Total rate of return swaps are contracts in which one party makes payments based on a set rate, either fixed or variable, while the other party makes payments based on the return of the underlying asset or index, which includes both the income it generates and any capital gains.
The estimated fair value of our net derivative and other financial assets and liabilities after the application of master netting agreements and collateral were as follows:
As of December 31, 2018 and 2017, no additional collateral would be required if a default or termination event were to occur.
CoInvest VI, CoInvest VII and CoInvest Other were formed to make investments, including co-investments alongside private equity funds sponsored by Apollo. Investments held by CoInvest VI, CoInvest VII and CoInvest Other are related party investments because Apollo affiliates exercise significant influence over the management or operations of the investees. We received our interests in CoInvest VI, CoInvest VII and CoInvest Other as part of a contribution agreement in 2012 with AAA Guarantor - Athene, L.P. (AAA Investor) and its subsidiary, Apollo Life Re Ltd., in order to provide a capital base to support future acquisitions.
During the fourth quarter of 2018, we dissolved NCL Athene LLC (NCL LLC) as we sold the investments held by NCL LLC. Previously a consolidated VIE, NCL LLC was formed to hold the investment in Norwegian Cruise Line Holdings Ltd. (NCLH) shares, which were originally held by CoInvest VI. NCL LLC was subject to the same management fees, selling restrictions with respect to shares of NCLH, and carried interest calculation as CoInvest VI. NCL LLC classified its NCLH shares as related party equity securities.
Observable inputs derived principally from market data through correlation or other means.
The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure fair value fall within different levels of the hierarchy, the category level is based on the lowest priority level input that is significant to the instrument’s fair value measurement.
Equity securities - Fair values of publicly traded equity securities are based on quoted market prices and classified as Level 1. Other equity securities, typically private equities or equity securities not traded on an exchange, we value based on other sources, such as commercial pricing services or brokers and are classified as Level 2 or 3.
Level 3 Financial Instruments-The following is a reconciliation for all Level 3 assets and liabilities measured at fair value on a recurring basis
AFS and trading securities - For certain fixed maturity securities, internal models are used to calculate the fair value. We use a discounted cash flow approach. The discount rate is the significant unobservable input due to the determined credit spread being internally developed, illiquid, or as a result of other adjustments made to the base rate. The base rate represents a market comparable rate for securities with similar characteristics. As of December 31, 2018, discounts ranged from 5% to 9%, and as of December 31, 2017, discounts ranged from 2% to 6%. This excludes assets for which significant unobservable inputs are not developed internally, primarily consisting of broker quotes.
Nonperformance risk - For contracts we issue, we use the credit spread, relative to the U.S. treasury curve based on our public credit rating as of the valuation date. This represents our credit risk for use in the estimate of the fair value of embedded derivatives.
Policyholder behavior - We regularly review the lapse and withdrawal assumptions (surrender rate). These are based on our initial pricing assumptions updated for actual experience. Actual experience may be limited for recently issued products.
We estimate the fair value for financial instruments not carried at fair value using the same methods and assumptions as those we carry at fair value. The financial instruments presented above are reported at carrying value on the consolidated balance sheets; however, in the case of policy loans and funds withheld at interest and liability, the carrying amount approximates fair value.
Reinsurance typically provides for recapture rights on the part of the ceding company for certain events of default. Additionally, some agreements require us to place assets in trust accounts for the benefit of the ceding entity. The required minimum assets are equal to or greater than statutory reserves, as defined by the agreement, and were $5,719 million and $1,123 million as of December 31, 2018 and 2017, respectively. Although we own the assets placed in trust, their use is restricted based on the trust agreement terms. If the statutory book value of the assets, or in certain cases fair value, in a trust declines because of impairments or other reasons, we may be required to contribute additional assets to the trust. In addition, the assets within a trust may be subject to a pledge in favor of the applicable reinsurance company.
We have novated certain open blocks of business ceded to Global Atlantic, in accordance with the terms of the coinsurance and assumption agreement. The below table summarizes the decreases in amounts on the consolidated balance sheets as a result of the novations. Novations during the year ended December 31, 2018 did not have a material effect on the consolidated balance sheets.
As of December 31, 2018 and 2017, Global Atlantic maintained a series of trust and custody accounts under the terms of these agreements with assets equal to or greater than a required aggregate statutory balance of $3,967 million and $3,350 million, respectively.
Senior Notes-In the first quarter of 2018, AHL issued $1 billion of unsecured senior notes due in January 2028. The senior notes have a 4.125% coupon rate, payable semi-annually. The senior notes are callable at any time prior to October 12, 2027 by AHL, at a price equal to the greater of (1) 100% of the principal and any accrued and unpaid interest and (2) an amount equal to the sum of the present values of remaining scheduled payments, discounted from the scheduled payment date to the redemption date at the Treasury Rate (as defined in the prospectus supplement relating to the senior notes, dated January 9, 2018) plus 25 basis points, and any accrued and unpaid interest. Interest expense on long-term debt was $41 million for the year ended December 31, 2018.
In the fourth quarter of 2018, our board of directors approved a share repurchase program, which authorizes us to repurchase up to $250 million of Class A shares. We may repurchase shares in open market transactions, in privately negotiated transactions or otherwise. The size and timing of repurchases will depend on legal requirements, market and economic conditions and other factors, and are solely at our discretion. The program has no expiration date, but may be modified, suspended or terminated by the board at any time. We repurchased 2.5 million Class A shares for $100 million under this authorization during the year ended December 31, 2018.
In the first quarter, a total of 21.9 million Class B shares were converted into Class A shares pursuant to a distribution of common shares from AP Alternative Assets, L.P. (AAA) to AAA unitholders.
In the fourth quarter, a total of 21.4 million Class B shares were converted into Class A shares pursuant to a distribution of common shares from AP Alternative Assets, L.P. (AAA) to AAA unitholders.
As a result of the lockup releases during the year, 1.3 million Class B shares were converted into Class A shares.
We issued 3.1 million Class A shares during the fourth quarter of 2016 from conversion of Class M-1, M-2, M-3 and M-4 shares and settlement of Class M-4 RSUs. All conversions were settled in shares net of the conversion price and, as a result, no proceeds were received from the conversions.
The purpose of our share incentive plans is to provide an incentive to achieve long-term company goals and align the interests of our employees, our directors and AAM employees with those of our shareholders. See Note 17 - Related Parties regarding our relationship with AAM. Under the share incentive plans, we may issue nonqualified stock options, incentive stock options, rights to purchase shares, restricted shares, RSUs and other awards which may be settled in, or based upon, our common shares. The aggregate number of shares authorized for issuance under the 2016 Plan is 3.5 million Class A shares. Shares issued upon settlement of an award are newly issued shares.
Through the share incentive plans, we have issued the following categories of stock-based compensation: long-term incentive plan (LTIP) awards and Class M awards.
The risk-free interest rate is derived from U.S. Constant Maturity Treasury yield at the valuation date, with maturity corresponding to weighted-average expected term. The expected dividend yield is based on our historical and expected dividend payments, which have been zero to date. Absent sufficient historical experience of our shares being traded on a public market, we have estimated volatility of our share price based on the published historical volatilities of comparable publicly-traded companies over a period consistent with the expected life of the award being valued. The expected term represents the weighted average period of time that awards granted are expected to be outstanding as determined at the grant date of the award.
RSUs - The following represents the activity of nonvested LTIP RSUs for the year ended December 31, 2018:
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 years ended December 31, 2017 and 2016 was $51.28 and $33.95, respectively. During the years ended December 31, 2018 and 2017, the total intrinsic value of LTIP RSUs converted was $3 million and $2 million, respectively. As of December 31, 2016, no LTIP RSUs were vested.
Class M share vesting - Tranche 1 shares generally vest in 20% increments on the first through fifth anniversaries of the earlier of the date of grant or vesting inception date. Tranche 1 shares also automatically vest upon the sale of the Company or change in control, prior to the participant’s termination or within six months following a qualifying termination. Unvested Tranche 1 shares are forfeited upon a participant’s termination.
Class M-4 (excluding M-4 Prime) - The vesting performance hurdles for Class M-4 shares have been met and were based on the rate of return and realized cash received by certain holders of our shares (Relevant Investors), as defined in the incentive plan, upon sale of their shares or based on deemed sales by Relevant Investors.
Although the Class M shares function similar to options, they are equity shares, and have dividend rights upon satisfaction of certain conditions and no expiration date once vested. Prior to vesting, if Class M shares are eligible for dividends, any dividends paid would accrue on the unvested M shares; however, if the M share is forfeited, the accrued dividend would also be forfeited.
As a result of the modifications, we recorded an $83 million increase to additional paid-in capital, due to the reclassification of the Tranche 2 shares from liability awards to equity awards. We also recorded a $42 million charge to stock-based compensation expense and additional paid-in capital for the vesting of Tranche 2 shares, primarily related to the acceleration of previously unrecognized compensation expense.
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, 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.
Award activity for Class M Shares-A rollforward of award activity for the year ended December 31, 2018 of the Class M shares is as follows:
The following represents the activity of nonvested Class M shares for the year ended December 31, 2018:
The total fair value of vested Tranche 1 Class M shares was $5 million, $16 million and $92 million during the years ended December 31, 2018, 2017 and 2016, respectively. The total fair value of vested Tranche 2 Class M shares was $3 million, $40 million and $122 million during the years ended December 31, 2018, 2017 and 2016, respectively.
Employee Stock Purchase Plan-Eligible employees may participate in our 2017 Employee Stock Purchase Plan (ESPP), which provides the opportunity to purchase our Class A shares at a discount from the market price through payroll deductions. Pursuant to the ESPP, employees are permitted to purchase shares at a price equal to 85% of the fair value of such shares as determined by reference to the closing price of our Class A shares on the New York Stock Exchange on the last day of the relevant purchase period. Under the ESPP we may make available for sale up to 3.8 million Class A shares over the term of the ESPP, which may extend for up to 10 years. The number of shares sold under the ESPP during the years ended December 31, 2018 and 2017 were not material.
Compensation expense-Compensation expense is recognized based on the number of awards expected to vest, which represents the awards granted less actual forfeitures when they occur, if any.
As of December 31, 2018, the Class M shares had unrecognized compensation cost of $5 million for Tranche 1 and $4 million for Tranche 2 and the cost is expected to be recognized over a weighted-average period of 1.0 years and 0.6 years, respectively. Unrecognized compensation cost of $16 million for LTIP awards is expected to be recognized over a weighted-average period of 1.0 years.
Dilutive shares are calculated using the treasury stock method. For Class A shares, this method takes into account shares that can be settled into Class A shares, net of a conversion price. The diluted EPS calculations for Class A shares excluded the following shares, RSUs and options:
The expected tax provision computed on pre-tax income at the weighted average tax rate has been calculated as the sum of the pre-tax income in each jurisdiction multiplied by that jurisdiction’s applicable statutory tax rate. Statutory tax rates of 0% and 21% have been used for Bermuda and the United States, respectively, for the year ended December 31, 2018. Statutory tax rates of 0%, 31% and 35% have been used for Bermuda, Germany and the United States, respectively, for the years ended December 31, 2017 and 2016. A reconciliation of the difference between the expected tax provision at the weighted average tax rate and income tax expense (benefit) is as follows:
During the third quarter of 2016, we identified a tax plan that allows us to use a significant portion of the U.S. non-life insurance companies’ net operating losses and other deductible temporary differences. As a result, we released the corresponding deferred tax valuation allowance of $102 million, as it is more likely than not that these attributes will be realized.
Withholding taxes have not been provided on undistributed earnings of AHL’s U.S. subsidiaries as of December 31, 2018. Although withholding taxes may apply in the event a dividend is paid by AHL’s U.S. subsidiaries, we have not accrued withholding taxes as we do not intend to remit these earnings. The cumulative amount potentially subject to withholding tax, if distributed, as well as the determination of the potential associated tax liability, is not practicable to compute. Any dividends remitted to AHL from ALRe are not subject to withholding tax.
Under the Bermuda Insurance Act, long-term insurers are required to maintain minimum statutory capital and surplus to meet the minimum margin of solvency (MMS) and the Enhanced Capital Requirement (ECR). For our Class C reinsurer, ACRA, MMS is equal to the greater of $500,000 or 1.5% of the total statutory assets. For our Class E reinsurers, ALRe and AARe, MMS is equal to the greater of $8 million or 2% of the first $500 million of statutory assets plus 1.5% of statutory assets above $500 million. For each class, the ECR is calculated based on a risk-based capital model where risk factor charges are applied to the EBS. As of December 31, 2018, our Bermuda subsidiaries were in excess of the minimum levels required. As of December 31, 2018 and 2017, ALRe’s EBS capital and surplus was $12.0 billion and $7.7 billion, respectively, resulting in a BSCR ratio of 340% and 354%, respectively.
Under the Bermuda Insurance Act, our Bermuda subsidiaries are 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 the companies’ respective 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 the subsidiary to fail to meet its relevant margins. In certain instances, the Bermuda subsidiary 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, and further subject to meeting the MMS and ECR requirements, a Bermuda subsidiary is permitted to distribute up to the sum of 100% of statutory surplus and an amount less than 15% of statutory capital. Distributions in excess of this amount require the approval of the BMA. The following represents the maximum distribution our Bermuda subsidiaries would be permitted to remit to its parent without the need for prior approval:
The maximum dividend these subsidiaries can pay to shareholders, without prior approval of the respective state insurance department, is subject to restrictions relating to statutory surplus or net gain from operations. The maximum dividend payment over a twelve-month period may not, without prior approval, be paid from a source other than earned surplus and may not exceed the greater of (1) the prior year’s net gain from operations or (2) 10% of policyholders’ surplus. Based on these restrictions, the maximum dividend AADE could pay to Athene USA absent regulatory approval was $154 million and $135 million as of December 31, 2018 and 2017, respectively. Other requirements limit the amount that could be withdrawn from AADE and the maximum AADE could dividend while staying in compliance with these state regulations, which was $310 million and $103 million as of December 31, 2018 and 2017, respectively. Any dividends from AHL’s other U.S. statutory entities in excess of the amounts allowed for AADE would not be able to be remitted to Athene USA without regulatory approval from the Delaware Department of Insurance.
AAIA - Among the products issued by AAIA are indexed universal life insurance and fixed indexed annuities. These products allow a portion of the premium to earn interest based on certain indices, primarily the S&P 500. We purchase call options, futures and variance swaps to hedge the growth in interest credited to the customer as a direct result of increases in the related index. The Iowa Insurance Division allows an insurer to elect (1) to use an amortized cost method to account for certain derivative instruments, such as call options, purchased to hedge the growth in interest credited to the customer on indexed insurance products and (2) to use an indexed annuity reserve calculation methodology under which call options associated with the current index interest crediting term are valued at zero. AAIA has elected to apply this option to its over-the-counter call options and reserve liabilities. As a result, AAIA’s statutory surplus increased by $39 million and decreased by $66 million as of December 31, 2018 and 2017, respectively.
Athene Re USA IV - AAIA has ceded the AmerUs Closed Block to Athene Re USA IV on a 100% funds withheld basis. A permitted practice in the State of Vermont allows Athene Re USA IV to include as admitted assets the face amount of all issued and outstanding letters of credit used to fund its reinsurance obligations to AAIA in its statutory financial statements. If Athene Re USA IV had not followed this permitted practice, then it would not have exceeded authorized control level risk based capital requirements. As of December 31, 2018 and 2017, the face amount of the letters of credit was $153 million.
For the services it renders, AAM earns a fee on all assets managed in accounts owned by or related to us, including sub-advised assets, subject to certain limited exceptions. Additionally, AAM recharges the sub-advisory fees it incurs with respect to our sub-advised assets to us. Historically, AAM generally earned an annual fee of 0.40% of assets under management. In the second quarter of 2017, following shareholder approval of an amendment to our bye-laws, we entered into the Fifth Amended and Restated Fee Agreement (Revised Fee Agreement), retroactive to January 1, 2017. The Revised Fee Agreement amended certain fee arrangements we previously had in place with AAM to provide for, among other things, an annual fee of 0.30% (reduced from 0.40%) on all assets that Apollo manages in accounts owned by us in the U.S. and Bermuda or in accounts supporting reinsurance ceded to our U.S. and Bermuda subsidiaries by third-party insurers (North American Accounts) in excess of $65,846 million (the level of assets in the North American Accounts as of December 31, 2016). The fee to be paid by us to AAM on the first $65,846 million of assets in the North American Accounts remains 0.40% per year, subject to certain discounts and exceptions.
For certain assets which require specialized sourcing and underwriting capabilities, AAM has chosen to mandate sub-advisors rather than building out in-house capabilities. AAM has entered into Master Sub-Advisory Agreements (MSAAs) with certain Apollo affiliates to sub-advise AAM with respect to a portion of our assets, with the fees recharged to us, in addition to the gross fee paid to AAM as described above. The MSAAs cover services rendered by Apollo-affiliated sub-advisors relating to the following investments:
AAM and certain other Apollo affiliates entered into addendums to the MSAAs in 2017, retroactive to January 1, 2017, pursuant to which, with limited exceptions, Apollo will earn 0.40% per year on all assets in the North American Accounts explicitly sub-advised by Apollo up to $10,000 million, 0.35% per year on all assets in such accounts explicitly sub-advised by Apollo in excess of $10,000 million up to $12,441 million (the level of fee-paying sub-advised assets in the North American Accounts at December 31, 2016), 0.40% per year on all assets in such accounts explicitly sub-advised by Apollo in excess of $12,441 million up to $16,000 million, and 0.35% per year on all assets in such accounts explicitly sub-advised by Apollo in excess of $16,000 million.
We had an investment advisory agreement with Apollo Asset Management Europe (together with certain of its affiliates, AAME), also a subsidiary of AGM, for advisory services for all of Athora’s investment portfolio, with certain exceptions. Primarily excluded were assets held in German special investment funds managed or advised by Apollo or its affiliates, to the extent the entity received a management or advisory fee in connection with the fund. As compensation for the investment advisory services rendered, AAME received a fee of 0.10% per year on the assets it sub-advised. As of December 31, 2017, the total assets sub-advised by AAME were $4,153 million. Affiliates of AAME received an advisory fee of 0.35% per year on certain German special investment funds and our investment in a sub-fund of Apollo Capital Efficient Fund I (ACE fund), as well as a pro rata share of operating expenses up to 0.30% on the ACE fund. As of December 31, 2017, the German special investment funds totaled $1,190 million, and the ACE fund totaled $97 million. The fees incurred for management of these funds are included in sub-advisory fees in the table below.
Our bye-laws currently provide that we may not, and will cause our subsidiaries not to, terminate any IMA among us or any of our subsidiaries, on the one hand, and AAM, on the other hand, before any annual anniversary of October 31 (each such date, an IMA Termination Election Date) and any termination on an IMA Termination Election Date requires (i) the approval of two-thirds of our Independent Directors (as defined in the bye-laws) and (ii) prior written notice to AAM of such termination at least 30 days’ prior to an IMA Termination Election Date. If our Independent Directors make such election to terminate and notice of such termination is delivered, the termination will be effective on the second anniversary of the applicable IMA Termination Election Date (IMA Termination Effective Date). Notwithstanding the foregoing, (A) except as set forth in (B) below, our Independent Directors may only elect to terminate an IMA on an IMA Termination Election Date if two-thirds of our Independent Directors determine, in their sole discretion and acting in good faith, that either (i) there has been unsatisfactory long-term performance materially detrimental to us by AAM or (ii) the fees being charged by AAM are unfair and excessive compared to a comparable asset manager (provided, that in either case such Independent Directors must deliver notice of any such determination to AAM and AAM will have until the applicable IMA Termination Effective Date to address such concerns, and provided, further, that in the case of such a determination that the fees being charged by Apollo are unfair and excessive, Apollo has the right to lower its fees to match the fees of such comparable asset manager) and (B) upon the determination by two-thirds of our Independent Directors, we or our subsidiaries may also terminate an IMA with AAM as a result of either (i) a material violation of law relating to AAM’s advisory business, or (ii) AAM’s gross negligence, willful misconduct or reckless disregard of its obligations under the relevant agreement, and in either case, the delivery of written notice at least 30 days’ prior to such termination and such termination will be effective at the end of such 30-day period (the events described in the foregoing clauses (A) and (B) are referred to in more detail in our bye-laws as “AHL Cause”).
A significant voting interest in the Company is held by shareholders who are members of the Apollo Group, as defined in our bye-laws. Also, James Belardi, our Chief Executive Officer, is also an employee of AAM, receives substantial remuneration from acting as Chief Executive Officer of AAM, and owns a 5% profits interest in AAM. Additionally, six of the fifteen members of our board of directors are employees of or consultants to Apollo (including Mr. Belardi). In order to protect against potential conflicts of interest resulting from transactions into which we have entered and will continue to enter into with the Apollo Group, our bye-laws require us to maintain a conflicts committee comprised solely of three of our directors who are not officers or employees of any member of the Apollo Group. The conflicts committee reviews and approves material transactions between us and the Apollo Group, subject to certain exceptions.
Athora - On January 1, 2018, in order to align our interests with those of Athora, in connection with the closing of the Athora Offering, we entered into a cooperation agreement with Athora, pursuant to which, among other things, (1) we have the right to reinsure approximately 20% of the spread business written or reinsured by any insurance or reinsurance company owned or acquired by Athora, (2) Athora’s insurance subsidiaries are required to purchase certain funding agreements and/or other spread instruments issued by our insurance subsidiaries, (3) we provide Athora with a right of first refusal to pursue acquisition and reinsurance transactions in Europe (other than the United Kingdom (UK)) and (4) Athora provides us and our subsidiaries with a right of first refusal to pursue acquisition and reinsurance transactions in North America and the UK. Our investment in Athora, which is included in related party investment funds on the consolidated balance sheets, was $105 million as of December 31, 2018. During the fourth quarter of 2018, Athora called capital and we remitted $20 million to Athora as a result. However, as the capital call was not yet fully funded by other parties, Athora has not issued shares to us and other shareholders; therefore, we have recorded a receivable in other assets on the consolidated balance sheets for the capital funding. Additionally, as of December 31, 2018, we had $166 million of funding agreements outstanding to Athora, which were issued to Athora prior to Closing. We also have commitments to make additional equity investments in Athora of $307 million as of December 31, 2018.
VA Capital and Venerable Holdings, Inc. (Venerable) - In connection with the Voya reinsurance transactions, we made a $75 million minority equity investment in VA Capital, which is included in investments in related parties - investment funds on the consolidated balance sheets and accounted for as an equity method investment. VA Capital is owned by a consortium of investors, led by affiliates of AGM, Crestview Partners and Reverence Capital Partners, and is the holding company of Venerable. Additionally, we provided Venerable with a $150 million, 15-year term loan, which is held at amortized cost and included in investment in related parties - other investments on the consolidated balance sheets. While management views the overall transactions with Voya and Venerable as favorable to us, the stated interest rate of 6.257% on the term loan to Venerable represents a below-market interest rate, and management considered such rate as part of its evaluation and pricing of the Voya reinsurance transactions. Venerable is the holding company of VIAC.
Contingent Commitments-We had commitments to make investments, primarily capital contributions to investment funds, inclusive of related party commitments discussed previously, of $3,036 million and $2,358 million as of December 31, 2018 and 2017, respectively. We expect most of our current commitments will be invested over the next five years; however, these commitments could become due any time upon counterparty request.
We have a funding agreement backed notes (FABN) program, which allows Athene Global Funding, a special-purpose, unaffiliated statutory trust, to offer up to $10 billion of its senior secured medium-term notes. Athene Global Funding uses the net proceeds from each sale to purchase one or more funding agreements from us. As of December 31, 2018 and 2017, we had $2,700 million and $2,996 million, respectively, of FABN funding agreements outstanding.
Griffiths Matter - On July 27, 2015, John Griffiths, on behalf of himself and others similarly situated, filed a putative class action complaint against us in the United States District Court for the District of Massachusetts. An amended complaint was filed on December 18, 2015. The complaint asserted claims against AHL, AAIA and Athene London Assignment Corporation (Athene London), in addition to an Aviva defendant. AHL is a named defendant due to its purchase of Aviva USA, and AAIA and Athene London are named as successors to Aviva Life Insurance Company and Aviva London Assignment Corporation, respectively. The complaint alleged a putative class of all persons who are the beneficial owners of assets which were used to purchase structured settlement annuities that Aviva Life Insurance Company, Aviva London Assignment Corporation, and Aviva International Insurance Limited (collectively, the Aviva Entities) or their predecessors, as applicable, delivered to purchasers on or after April 1, 2003 that were backed by a capital maintenance agreement issued by Aviva International Insurance Limited or its predecessor (the CMA). The complaint alleged that the Aviva Entities sold structured settlement annuities to the public on the basis that such products were backed by the CMA, which was alleged to be a source of great financial strength. The complaint further alleged that the Aviva Entities used the CMA to enhance the sales volume and raise the price of the annuities. The complaint claimed that, as a result of Aviva USA’s sale to AHL, the CMA terminated. According to the complaint, no notice of this termination was provided to the owners of the structured settlement annuities. The complaint alleged that the termination of the CMA gave rise to claims for breach of contract, breach of fiduciary duty, promissory estoppel, and unjust enrichment. AHL and plaintiff agreed to a term sheet settlement on a class-wide basis. On November 8, 2018, the court dismissed the action pursuant to the settlement approval which required AHL to: (1) enter into a capital maintenance agreement with Athene London requiring AHL to provide capital to Athene London upon a missed structured settlement payment that is not timely cured and (2) pay a monetary amount that is immaterial to us. We have complied with the settlement.
Internal Revenue Service (IRS) Matters - The IRS completed its examinations of the 2006 through 2010 and 2011 through 2012 Aviva USA tax years with Aviva USA agreeing to all proposed adjustments with two exceptions: (1) AAIA’s treatment of call options used to hedge fixed indexed annuity (FIA) liabilities and (2) the disallowance of offsetting tax deductions taken by AAIA and taxable income reported by the non-life subgroup with respect to unpaid independent marketing organization commissions. Athene USA filed suit in federal court contesting the IRS’s position after negotiations proved unsuccessful. We resolved this matter with the IRS through a Closing Agreement on Final Determination Covering Specific Matters (Form 906). The resolution did not have a material impact on our financial position or results of operations. The court dismissed the matter on December 17, 2018.
Corporate-owned Life Insurance (COLI) Matter - In 2000 and 2001, two insurance companies which were subsequently merged into AAIA purchased from American General Life Insurance Company (American General) broad based variable COLI policies that, as of December 31, 2018, had an asset value of $362 million, and is included in other assets on the consolidated balance sheets. In January 2012, the COLI policy administrator delivered to AAIA a supplement to the existing COLI policies and advised that American General and ZC Resource Investment Trust (ZC Trust) had unilaterally implemented changes set forth in the supplement that if effective, would: (1) potentially negatively impact the crediting rate for the policies and (2) change the exit and surrender protocols set forth in the policies. In March 2013, AAIA filed suit against American General, ZC Trust, and ZC Resource LLC in Chancery Court in Delaware, seeking, among other relief, a declaration that the changes set forth in the supplement were ineffectual and in breach of the parties’ agreement. The parties filed cross motions for judgment as a matter of law, and the court granted defendants’ motion and dismissed without prejudice on ripeness grounds. The issue that negatively impacts the crediting rate for one of the COLI policies has subsequently been triggered and on April 3, 2018, we filed suit against the same defendants in Chancery Court in Delaware seeking substantially similar relief, which the defendants have moved to dismiss. The Court heard oral arguments on February 13, 2019 and has taken the matter under advisement. If the supplement is ultimately deemed to be effective, the purported changes to the policies could impair AAIA’s ability to access the value of guarantees associated with the policies. The value of the guarantees included within the asset value reflected above is $187 million as of December 31, 2018.
Holzer Matter - On September 12, 2016, Jack Holzer and Mary Bruesh-Holzer filed suit in Jackson County, Missouri against several defendants, including AADE, as successor-in-interest to Business Men’s Assurance Company of America. Mr. Holzer allegedly sustained injuries due to asbestos exposure from 1966-1973 while working in an office building in Kansas City, Missouri, then owned by Business Men’s Assurance Company of America. Plaintiffs asserted strict liability and negligence claims against AADE. On February 26, 2018, an agreement was reached that resulted in the settlement of this matter. The settlement had no impact on our financial condition, results of operations or cash flows.
On January 23, 2019, we received a letter from the NYSDFS, with respect to a recent PRT transaction, which expressed concerns with our interpretation and reliance upon certain exemptions from licensing in New York in connection with certain activities performed by employees in our PRT channel, including specific activities performed within New York. We are currently in discussions with the NYSDFS to identify approaches to resolve its concerns. Reasonably possible losses, if any, cannot be estimated at this time.
On May 3, 2018, following AHL’s filing of the writ in Bermuda described above, Caldera, Caldera Life Reinsurance Company, and Caldera Shareholder, L.P., commenced an action in the Supreme Court of the State of New York, County of New York, by filing a Summons with Notice against AHL, Apollo, certain affiliates of Apollo and Leon Black, a founder of Apollo. On July 12, 2018, plaintiffs filed a complaint alleging claims for tortious interference with prospective business relations, defamation, and unfair competition related to plaintiffs’ attempt to purchase Company A and seeking alleged damages of “no less than $1.5 billion.” AHL has moved to dismiss the complaint. On January 21, 2019, plaintiffs filed an amended complaint, which revised certain allegations about jurisdiction, venue and the merits of the plaintiffs’ claims. We intend to renew our motion to dismiss. We believe we have meritorious defenses to the claims and intend to vigorously defend the litigation. In light of the inherent uncertainties involved in this matter, reasonably possible losses, if any, cannot be estimated at this time.
We operate our core business strategies out of one reportable segment, Retirement Services. In addition to Retirement Services, we report certain other operations in Corporate and Other.
Adjusted operating revenue is a component of adjusted operating income and excludes market volatility and adjustments for other non-operating activity. Our adjusted operating revenue equals our total revenue, adjusted to eliminate the impact of the following non-operating adjustments:
The following represents the effects of the revisions on the condensed consolidated statements of cash flows: