We lease approximately 60,000 square feet for our principal offices in West Des Moines, Iowa, under an operating lease that expires in 2011. We also lease approximately 6,000 square feet for our office in Pell City, Alabama, pursuant to an operating lease that expires on December 31, 2007.
(a) On December 31, 2003, retroactive to January 1, 2003, we adopted Financial Accounting Standards Board Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51 (“FIN 46”). During the first quarter of 2005, retroactive to January 1, 2003, we adopted FASB Staff Position No. FIN 46(R)-5, Implicit Variable Interests under FIN 46. See note 1 to our audited consolidated financial statements.
(b) Book value per share is calculated as total stockholders’ equity less the liquidation preference of our series preferred stock divided by the total number of shares of common stock outstanding. Shares outstanding include shares held by rabbi trusts-see note 10 to our audited consolidated financial statements.
(c) We define return on equity as net income divided by average total stockholders’ equity. Average total stockholders’ equity is determined based upon the total stockholders’ equity at the beginning and the end of the year. The computations of average stockholders’ equity for 2005 and 2003 have been calculated on a weighted average basis to recognize the significant increases in stockholders’ equity that resulted from the receipt of the net proceeds from our public offerings of common stock in December 2005 and 2003.
· regulatory changes or actions, including those relating to regulation of financial services affecting (among other things) bank sales and underwriting of insurance products and regulation of the sale, underwriting and pricing of products; and
Earnings from products accounted for as deposit liabilities are primarily generated from the excess of net investment income earned over the interest credited to the policyholder, or the “investment spread”. In
the case of index annuities, the investment spread consists of net investment income in excess of the cost of the options purchased to fund the index-based component of the policyholder’s return and amounts credited as a result of minimum guarantees.
The cost of money and average crediting rates are computed based upon policyholder account balances and do not include the impact of amortization of deferred sales inducements. See Critical Accounting Policies-Deferred Policy Acquisition Costs and Deferred Sales Inducements. With respect to our index annuities, the cost of money includes the average crediting rate on amounts allocated to the fixed rate options, expenses we incur to fund the annual index credits and where applicable, minimum guaranteed interest credited. Proceeds received upon expiration or early termination of call options purchased to fund annual index credits are recorded as part of the change in fair value of derivatives, and are largely offset by an expense for interest credited to annuity policyholder account balances. See Critical Accounting Policies-Derivative Instruments-Index Products.
included directly as a separate component of stockholders’ equity, net of income taxes and certain adjustments for assumed changes in amortization of deferred policy acquisition costs and deferred sales inducements. Fair values for securities that are actively traded are determined using quoted market prices. For fixed maturity securities that are not actively traded, fair values are estimated using price matrices developed using yield data and other factors relating to instruments or securities with similar characteristics. The carrying amounts of all our investments are reviewed on an ongoing basis for changes in market interest rates and credit deterioration. If this review indicates a decline in fair value that is other than temporary, our carrying amount in the investment is reduced to its fair value and a specific write down is taken. Such reductions in carrying amount are recognized as realized losses and charged to earnings.
In addition, where our intent was to retain the investment to allow for recovery, but our intent changes, an other than temporary impairment charge is recognized. Once an impairment charge has been recorded, we then continue to review the other than temporarily impaired securities for appropriate valuation on an ongoing basis. Unrealized losses may be recognized in future periods through a charge to earnings, should we later conclude that the decline in fair value below amortized cost is other than temporary pursuant to our accounting policy described above.
The amortized cost and estimated fair value of fixed maturity securities at December 31, 2006 and 2005, by contractual maturity, that were in an unrealized loss position are shown below. Actual maturities
will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. All of our mortgage-backed and asset-backed securities provide for periodic payments throughout their lives, and are shown below as a separate line.
The increase in unrealized losses at December 31, 2006 compared to December 31, 2005 is primarily due to the impact of increases in market interest rates in 2006. Because we have the ability and intent to hold these investments until a recovery of amortized cost, which may be maturity, we do not consider these investments to be other than temporarily impaired at December 31, 2006.
During 2005, a security backed by the senior notes of a media company declined in value following an announcement of a change in future business strategy and the potential for share buybacks. We wrote this security down by $0.4 million during 2005 and sold it during 2006, at its cost basis.
During 2005, we sold two asset-backed securities backed by installment sales contracts secured by manufactured homes and liens on real estate concurrent with our decision to write down these securities due to continuing increases in the default rates and deterioration of the underlying collateral. The write down/realized loss on these securities was $2.7 million for the year ended December 31, 2005. We had previously written down these securities by $6.9 million during 2003 and $11.3 million during 2004 due to increases in default rates, deterioration of the underlying collateral and credit rating downgrades.
During 2004, we wrote down an asset-backed security backed by cash flows from a specified pool of financial assets by $1.5 million due to deterioration of the underlying collateral and a downgrade of the issuer’s credit rating to below investment grade. This security was sold in 2004 subsequent to the write down.
In making the decisions to write down the securities described above, we considered whether the factors leading to those write downs impacted any other securities held in our portfolio. In cases where we determined that a decline in value was related to an industry-wide concern, we considered the impact of such concern on all securities we held within that industry classification. For each of the securities discussed above that were sold at a loss, there was an unexpected event resulting in a decline in credit quality which occurred shortly before the sale. This led to the decision to sell the securities at a loss concurrent with the decision that an additional impairment charge was required. Accordingly, in all cases, this did not contradict our previous assertion that we had the ability and intent to hold the securities until recovery in value.
We offer a variety of index annuities with crediting strategies linked to several market indices, including the S&P 500, the Dow Jones Industrial Average, NASDAQ 100, the Lehman Aggregate Bond Index and the Lehman U.S. Treasury Bond Index. These products allow policyholders to earn returns linked to equity or bond index appreciation without the risk of loss of their principal. Most of these products allow policyholders to transfer funds once a year among several different crediting strategies, including one or more of the index based strategies and a traditional fixed rate strategy. Substantially all of our index products require annual crediting of interest and an annual reset of the applicable index on the contract anniversary date. The computation of the annual index credit is based upon either a one year annual point-to-point calculation (i.e., the gain in the applicable index from one anniversary date to the next anniversary date), a monthly averaging of the index during the contract year, or a one year monthly point-to-point calculation (the net gain determined by adding the twelve monthly gains and losses in the applicable index within the one year period from one anniversary date to the next anniversary date).
We purchase one-year call options on the applicable indices as an investment to provide the income needed to fund the annual index credits on the index products. New one-year options are purchased at the outset of each contract year. We budget an amount to purchase the specific options needed to fund the annual index credits, and the cost of the options represents our cost of providing the credits. The amount we budget for the purchase of index call options is based on our interest spread targets and is comparable to the credited rates of interest we offer on fixed rate annuities. For example, if the yield on our invested assets is 6.00% and our targeted spread is 2.50%, we allocate up to 3.50% of the premium in the first year or account balance after the first year to the purchase of one-year call options. Participation rates, which define the policyholder’s level of participation in index gains each year, are determined by option costs. For example, if, based on current market conditions, the amount allocated to the purchase of options is sufficient to purchase an option that will provide a return equal to 70% of the annual gain in the applicable index, we will set the policyholder’s participation rate at 70%. We have the ability to modify participation rates each year when a new option is purchased. In general, if option costs increase, participation rates may be decreased, and if option costs decrease, participation rates may be increased. We purchase call options weekly and daily based upon new and renewing index account values during the applicable week or day, and the purchases are made by category according to the particular products and indices applicable to the new or renewing account values. Any proceeds received on the options at the expiration of the one-year term fund the related index credits to the policyholders. If there is no gain in an index, the policyholder receives a zero index credit on the policy, and we incur no costs beyond the option cost, except in cases where the minimum guaranteed value of a contract exceeds its index value.
Fair value changes associated with the call options are reported as an increase or decrease in revenues in our consolidated statements of income in accordance with Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”). The risk associated with prospective purchases of future one-year options is the uncertainty of the cost, which will determine
whether we are able to earn our spread on our index business. All our index products permit us to modify participation rates, annual income caps or asset fees at least once a year. This feature is comparable to our fixed rate annuities, which allow us to adjust crediting rates annually. By modifying our participation rates or other features, we can limit our costs of purchasing the related one-year call options, except in cases where contractual features would prevent further modifications. Based upon actuarial testing which we conduct as a part of the design of our index products and on an ongoing basis, we believe the risk that contractual features would prevent us from controlling option costs is not material.
Under SFAS 133, all of our derivative instruments (including certain derivative instruments embedded in other contracts) associated with our index products are recognized in the balance sheet at their fair values and changes in fair value are recognized immediately in earnings. This impacts the items of revenue and expense we report on our index business as follows:
· Under SFAS 133, the future annual index credits on our index annuities are treated as a “series of embedded derivatives” over the expected life of the applicable contracts. We are required to estimate the fair value of policy liabilities for index annuities, including the embedded derivatives, by valuing the “host” (or guaranteed) component of the liabilities and projecting (i) the expected index credits on the next policy anniversary dates and (ii) the net cost of annual options we will purchase in the future to fund index credits. Our estimates of the fair value of these embedded derivatives are based on assumptions related to underlying policy terms (including annual participation rates, cap rates, asset fees, and minimum guarantees), index values, notional amounts, strike prices and expected lives of the policies. The change in fair value of embedded derivatives increases with increases in volatility in the indices and interest rates. The change in fair value of the embedded derivatives will not correspond to the change in fair value of the purchased options because the purchased options are one-year options while the options valued in the fair value of embedded derivatives cover the expected life of the contracts which typically exceed 10 years.
reasonably likely 10% decrease in estimated gross profits for all future years would results in a $35.4 million decrease in the combined December 31, 2006 balances.
Annuity deposits by product type collected during 2006, 2005 and 2004, were as follows:
Net annuity deposits after coinsurance decreased 35% during 2006 compared to 2005, and increased 63% during 2005 compared to 2004. We attribute the decrease in 2006 to the flat to inverted yield curve interest rate environment that existed throughout the year which made fixed income alternatives such as certificates of deposit more attractive, the impact of the NASD’s notice to members on the sale of index annuities which has created confusion and impediments to sales of index annuities by annuity sales agents who are dual licensed to sell both insurance and securities products and highly competitive pricing from certain competitors. We attribute the increase in 2005 to increased marketing efforts following the completion of our initial public offering in December 2003 and the reduction in deposits ceded to EquiTrust Life Insurance Company, following the suspension of our coinsurance agreement with EquiTrust. See note 5 to our audited consolidated financial statements.
Net income increased 76% to $75.5 million in 2006, and 47% to $43.0 million in 2005, from $29.3 million in 2004. The increases in net income were principally due to growth in the volume of business in force and increases in the investment spread earned on our annuity liabilities. Our net annuity liabilities (after coinsurance ceded) increased from $6.4 billion at the beginning of 2004 to $11.3 billion at the end of 2006. As set forth in a table included earlier in this item, we increased our aggregate investment spread to 2.73% in 2006 compared to 2.48% in 2005 and 2.38% in 2004. Net income in 2006 and 2005 included $6.1 million and ($2.7) million for the change in fair value of embedded derivatives in our contingent convertible notes. Net income was also impacted by the application of SFAS 133 to our index annuity business which we estimate decreased net income in 2006 and 2005 by $4.4 million and $5.1 million, respectively, and increased net income in 2004 by $1.7 million. Net income also included amounts for realized gains (losses) on investments which we estimate increased net income in 2006 and 2004 by $0.4 million and $0.6 million, respectively, and decreased net income in 2005 by $2.7 million.
The comparisons of net income also reflect the impact of the consolidation of the Service Company. As discussed in note 1 to our audited consolidated financial statements, we acquired the Service Company on September 2, 2006, resulting in the consolidation of the Service Company as a wholly-owned subsidiary of us, rather than an “implicit variable interest” under FSP FIN 46(R)-5. Prior to the acquisition, we had an implicit variable interest in the Service Company and we consolidated the Service Company under FSP FIN 46(R)-5 upon its adoption by us in the first quarter of 2005. As permitted by the FSP, we applied FSP FIN 46(R)-5 retroactive to January 1, 2003, the date of our original adoption of FIN 46. The Service Company had net income in 2006 of $0.4 million as a wholly-owned subsidiary for the entire year. Substantially all of the Service Company’s revenue is renewal commissions received from American Equity Life (see note 8 to our audited consolidated financial statements) which are eliminated in consolidation. The consolidation of the Service Company reduced net income by $3.2 million for the year ended December 31, 2005. This amount was principally due to a $2.5 million distribution to the former shareholder of the Service Company prior to the September 2, 2005 acquisition and adjustments to the Service Company’s income tax liabilities as a result of a change in its effective income tax rate upon becoming a wholly-owned subsidiary of us. The adoption of FSP FIN 46(R)-5 and consolidation of the Service Company as an “implicit variable interest” resulted in an increase in income tax expense of $16.3 million during 2004 due to a change in the federal income tax status of the Service Company.
Annuity and single premium universal life product charges (surrender charges assessed against policy withdrawals and mortality and expense charges assessed against single premium universal life policyholder account balances) increased 54% to $39.5 million in 2006, and 14% to $25.7 million in 2005, from $22.5 million in 2004. These increases were principally due to increases in policy withdrawals subject to surrender charges due to growth in the volume and aging of the business in force. The increase in surrender charges and policy withdrawals for 2006 was also due in part to the flat to inverted yield curve interest rate environment that existed throughout the year. Withdrawals from annuity and single premium universal life policies subject to surrender charges were $259.2 million, $179.3 million and $147.0 million for 2006, 2005 and 2004, respectively. The average surrender charge collected on withdrawals subject to a surrender charge was 15.1%, 14.2% and 15.2% for 2006, 2005 and 2004, respectively.
Realized gains (losses) on investments fluctuate from year to year due to changes in the interest rate and economic environment and the timing of the sale of investments. Realized gains and losses on investments include gains and losses on the sale of securities as well as losses recognized when the fair value of a security is written down in recognition of an “other than temporary” impairment. See note 3 to our audited consolidated financial statements for a summary of the components of realized gains (losses) on investments for the years ended December 31, 2006, 2005 and 2004. See Financial Condition-Investments for additional discussion of write downs of the fair values of securities for other than temporary impairments and securities sold at a material loss for the years ended December 31, 2006, 2005 and 2004.
Interest credited to account balances increased 38% to $429.1 million in 2006 and 1% to $311.5 million in 2005 from $309.0 million in 2004. The components of interest credited to account balances are summarized as follows:
The changes in index credits were attributable to changes in the appreciation of the underlying indices (see discussion above under change in fair value of derivatives) and the amounts allocated by policyholders to the respective index options. Total proceeds received upon expiration of the call options purchased to fund the annual index credits were $216.8 million, $89.9 million and $87.6 million for the years ended December 31, 2006, 2005 and 2004, respectively. The decrease in interest credited including changes in minimum guaranteed interest for index annuities for the year ended December 31, 2006 was due to reductions in interest credited on fixed rate annuities as a result of declines in the account balances of such annuities and decreases in interest crediting rates on several products, offset in part by increases in interest credited on amounts allocated to the fixed rate option and minimum guaranteed interest for index annuities as a result of the growth in amounts allocated to the fixed rate option in the index annuity liabilities. A significant factor in the reductions in interest credited on fixed rate annuities is the reduced interest on multi-year rate guarantee annuities. A significant amount of these annuities were sold in 2001 with an initial rate guaranteed for the first five policy years. We experienced surrenders of these policies upon expiration of this initial guaranteed interest during 2006 and reduced the crediting rates on those policies that remained in force as of December 31, 2006. The increase in interest credited including changes in minimum guaranteed interest for index annuities for the year ended December 31, 2005 was due to the growth in the annuity liabilities outstanding. The average amount of annuity liabilities outstanding (net of annuity liabilities ceded under coinsurance agreements) increased 20% to $10.8 billion in 2006 and 27% to $8.9 billion in 2005 from $7.0 billion in 2004.
The conversion option embedded within our contingent convertible senior notes was required to be bifurcated and marked to market in accordance with SFAS 133 beginning December 15, 2005 due to an insufficient number of authorized shares. See notes 1 and 7 to our audited consolidated financial statements. Effective June 8, 2006, this conversion option is no longer required to be bifurcated and marked to market upon shareholder approval of an increase of authorized shares. The changes in the fair value of the conversion option embedded within these notes for the years ended December 31, 2006 and 2005 coincide with the changes in the per share price of our common stock during the periods of time during 2006 and 2005 that the conversion option was required to be bifurcated.
Income tax expense increased 63% to $41.4 million in 2006 and decreased 37% to $25.4 million in 2005 from $40.6 million in 2004. As discussed above and in note 1 to our audited consolidated financial statements, income tax expense for 2004 included $16.3 million for the change in the Service Company’s federal income tax status. Excluding the impact of this item, income tax expense would have increased in 2005 and the increases in income tax expense for 2006 and 2005 were principally due to increases in income before income taxes. Excluding the impact of the change in the Service Company’s federal income tax status in 2004, our effective income tax rates for 2006, 2005 and 2004 were 35.4%, 35.8% and 35.1%, respectively. See note 6 to our audited consolidated financial statements.
Insurance statutes regulate the type of investments that our life subsidiaries are permitted to make and limit the amount of funds that may be used for any one type of investment. In light of these statutes and regulations and our business and investment strategy, we generally seek to invest in United States government agency securities and corporate securities rated investment grade by established nationally recognized rating organizations or in securities of comparable investment quality, if not rated.
The table below presents our total fixed maturity securities by NAIC designation and the equivalent ratings of a nationally recognized securities rating organization (dollars in thousands).
At December 31, 2006 and 2005, we held $1.7 billion and $1.3 billion, respectively, of mortgage loans with commitments outstanding of $30.9 million at December 31, 2006. The portfolio consists of commercial mortgage loans diversified as to property type, location, and loan size. The loans are collateralized by the related properties. Our mortgage lending policies establish limits on the amount that can be loaned to one borrower and require diversification by geographic location and collateral type. As of December 31, 2006, there were no delinquencies or defaults in our mortgage loan portfolio. The commercial mortgage loan portfolio is diversified by geographic region and specific collateral property type as follows (dollars in thousands):
The notes are convertible at the holders’ option prior to the maturity date into cash and shares of our common stock under certain conditions. The conversion price per share is $14.47 which represents a conversion rate of 69.1 shares of our common stock per $1,000 in principal amount of notes. Upon conversion, we will deliver to the holder cash equal to the aggregate principal amount of the notes to be converted and will deliver shares of our common stock for the amount by which the conversion value exceeds the aggregate principal amount of the notes to be converted (commonly referred to as “net share settlement”). See note 7 to the consolidated financial statements for additional details concerning the conversion features of the notes and the dilutive effect of the notes in our diluted earnings per share calculation.
Following is a summary of subordinated debt obligations to the trusts at December 31, 2006 and 2005:
The interest rate for Trust XI is fixed at 8.595% for 5 years and then is floating based upon the three month London Interbank Offered Rate plus 3.65%.
During the fourth quarter of 2006, we entered into four interest rate swaps to manage interest rate risk associated with the floating rate component on certain of our subordinated debentures. The terms of the interest rate swaps provide that we pay a fixed rate of interest and receive a floating rate of interest on a notional amount totaling $80.0 million. The interest rate swaps are not effective hedges under SFAS 133. Therefore, we record the interest rate swaps at fair value with the changes in fair value and any net cash payments received or paid included in the change in fair value of derivatives in our consolidated statements of income.
American Equity Capital Trust I issued 865,671 shares of trust preferred securities, of which 2,000 shares are held by one of our subsidiaries. During 2006, 2005 and 2004, 14,000 shares, 5,667 shares and 88,000 shares of these trust preferred securities converted into 51,849 shares, 20,988 shares and 325,923 shares, respectively, of our common stock. The remaining 756,004 shares of these trust preferred securities not held by a subsidiary are convertible into 2,799,957 shares of our common stock.
American Equity Capital Trust II issued $97.0 million (97,000 shares) of 5% trust preferred securities and we issued $100 million of our 5% subordinated debentures. The consideration received by American Equity Capital Trust II in connection with the issue of its trust preferred securities consisted of fixed income trust preferred securities of equal value issued by FBL.
During 2006, the NMO Deferred Compensation Trust (NMO Trust) purchased 1,052,065 shares of our common stock at a total cost of $12.7 million. These shares are treated as treasury stock and are held by the NMO Trust for the benefit of agents who have earned shares of our common stock under the American Equity Investment NMO Deferred Compensation Plan. See note 10 to our audited consolidated financial statements.
During 2004, 625,000 shares of 1998 Series A Participating Preferred Stock (aggregate liquidation preference of $10.0 million) converted into 1,875,000 shares of our common stock. Prior to conversion, these shares had participating dividend rights with the shares of our common stock, when and as such dividends were declared.
Our life subsidiaries generally receive adequate cash flow from premium collections and investment income to meet their obligations. Annuity and life insurance liabilities are generally long-term in nature. Policyholders may, however, withdraw funds or surrender their policies, subject to surrender and withdrawal penalty provisions. At December 31, 2006, approximately 97% of our annuity liabilities were subject to penalty upon surrender, with a weighted average remaining surrender charge period of 10 years and a weighted average surrender charge rate of 13%.
The payment of dividends or distributions, including surplus note payments, by our life subsidiaries is subject to regulation by each subsidiary’s state of domicile’s insurance department. Currently, American Equity Life may pay dividends or make other distributions without the prior approval of its state of domicile’s insurance department, unless such payments, together with all other such payments within the preceding twelve months, exceed the greater of (1) American Equity Life’s net gain from operations for the preceding calendar year, or (2) 10% of American Equity Life’s statutory surplus at the preceding December 31. For 2007, up to approximately $99.2 million can be distributed as dividends by American Equity Life without prior approval of the Iowa Insurance Division. In addition, dividends and surplus note payments may be made only out of statutory earned surplus, and all surplus note payments are subject to prior approval by regulatory authorities in the life subsidiary’s state of domicile. American Equity Life had approximately $161.0 million of statutory earned surplus at December 31, 2006.
The maximum distribution permitted by law or contract is not necessarily indicative of an insurer’s actual ability to pay such distributions, which may be constrained by business and regulatory considerations, such as the impact of such distributions on surplus, which could affect the insurer’s ratings or competitive position, the amount of premiums that can be written and the ability to pay future dividends or make other distributions. Further, state insurance laws and regulations require that the statutory surplus of our life subsidiaries following any dividend or distribution must be reasonable in relation to their outstanding liabilities and adequate for their financial needs.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value and expands the required disclosures about fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007. We are continuing to evaluate SFAS 157 but do not believe that it will have a material impact on our consolidated financial statements.