We do not own any real estate. We lease space for our principal offices in West Des Moines, Iowa, pursuant to written leases for approximately 26,550 square feet at an annual rental of $480,588. The leases expire on June 30, 2004 and have a renewal option of an additional five year term at a rental rate equal to the prevailing fair market value. We also lease space for our office in Pell City, Alabama, pursuant to a written lease dated January 3, 2000, for approximately 3,380 square feet at an annual rental of $43,095. This lease expires on December 31, 2004.
The following selected consolidated financial data as of and for the periods indicated should be read in conjunction with our consolidated financial statements and related notes and Management's Discussion and Analysis of Financial Condition and Results of Operations appearing elsewhere in this report.
Management's discussion and Analysis of Financial Condition and Results of Operations
o general economic conditions and other factors, including prevailing interest rate levels and stock and credit market performance which may affect (among other things) our ability to sell our products, our ability to access capital resources and the costs associated therewith, the market value of our investments and the lapse rate and profitability of policies
o mortality and other factors which may affect the profitability of our products
o changes in the Federal income tax laws and regulations which may affect the relative income tax advantages of our products
Business Overview. We effectively commenced business on January 1, 1996, shortly after our formation and incorporation. As a foundation for beginning our business, we acquired two blocks of in-force insurance from another insurance company, of which several of our executive officers were previously employees. Later in 1996, we acquired another life insurance company with no in-force insurance which expanded our licensing authority to sell insurance and annuities to 23 states and the District of Columbia. Since then, we have expanded our licensing to 42 states and the District of Columbia.
The growth in our annuity business resulted in a sizeable increase in our investment spread for 1999 and 1998. While certain expenses also increased as a result of the growth in our annuity business, the incremental profits from a larger deposit base allowed us to offset a greater portion of our fixed operating costs and expenses. Our 1999 results also benefitted from a gain of $1,542,000 on the termination of a total return swap contract. Our 1998 results also benefitted from a gain of $275,000 on the sale of an office building in Birmingham, Alabama, from which our operations in that location were previously conducted. The comparison of 1998 to 1997 was also favorably impacted by certain costs and expenses recognized in 1997 as discussed below under Other operating costs and expenses.
Net investment income increased 145% to $64,610,000 in 1999 and 556% to $26,356,000 in 1998 from $4,019,000 in 1997. These increases are principally attributable to the growth in our annuity business and correspondingly, increases in our invested assets. Invested assets (amortized cost basis) increased 147% to $1,499,730,000 at December 31, 1999 and 199% to $607,764,000 at December 31, 1998 compared to $203,034,000 at December 31, 1997, while the effective yield earned on average invested assets was 7.34%, 7.46% and 7.80% for 1999, 1998, and 1997, respectively.
Traditional life and accident and health insurance benefits increased 19% to $7,232,000 in 1999 and decreased 18% to $6,085,000 in 1998 compared to $7,440,000 in 1997. The increase in 1999 was attributable to an increase in death benefits and surrenders, and the decrease in 1998 was attributable to a decrease in those items for that year.
Interest credited to annuity policyholder account balances increased 163% to $41,727,000 in 1999 and 644% to $15,838,000 in 1998 from $2,130,000 in 1997. These increases are principally attributable to increases in annuity liabilities. The amounts are also impacted by changes in the weighted average crediting rate for our fixed rate annuity liabilities, which, excluding interest rate bonuses guaranteed for the first year of the annuity contract, was 5.11%, 5.20% and 5.43% at December 31, 1999, 1998 and 1997, respectively. The weighted average crediting rate, including interest rate bonuses guaranteed for the first year of the annuity contract, was 6.51%, 7.05%, and 7.25% at December 31, 1999, 1998 and 1997, respectively.
Interest expense on notes payable increased 14% to $896,000 in 1999 and decreased 19% to $789,000 in 1998 from $980,000 in 1997. The 1999 increase is attributable to increases in the outstanding borrowings in the third and fourth quarters of 1999, offset in part by a decrease in the average applicable interest rate. The 1998 decrease is attributable to lower interest rates. The applicable interest rate declined from 8.41% for 1997 to 7.96% for 1998, and 7.52% for 1999.
Interest expense on amounts due under repurchase agreements increased 128% to $3,491,000 in 1999 and 424% to $1,529,000 in 1998 from $292,000 in 1997. These increases were principally attributable to larger average balances of funds borrowed, offset in part by a lower cost of funds in 1999. See Note 7 of the Notes to the Audited Consolidated Financial Statements included elsewhere in this report.
Amortization of deferred policy acquisition costs and value of insurance in force acquired increased 185% to $11,240,000 in 1999 and 245% to $3,946,000 in 1998 from $1,143,000 in 1997. These increases are primarily due to the growth in our annuity business as discussed above.
for agency and product development costs that were expensed in 1997 in the year incurred rather than being capitalized and amortized to expense in subsequent years and (ii) $628,000 for compensation expense as a result of an amendment to the stock option agreement with our chairman and president. See Note 9 of the Notes to the Audited Consolidated Financial Statements included elsewhere in this report.
Minority interest in earnings of subsidiaries includes amounts for distributions and the accretion of the issue discount on company-obligated mandatorily redeemable preferred stocks of subsidiary trusts issued in 1999. Tax benefits attributable to these amounts are reported as a reduction of income tax expense. See Note 8 of the Notes to the Audited Consolidated Financial Statements included elsewhere in this report.
Investments. Our investment strategy is to maintain a predominantly investment grade fixed income portfolio, provide adequate liquidity to meet our cash obligations to policyholders and others and maximize current income and total investment return through active investment management. Consistent with this strategy, our investments principally consist of fixed maturity securities and short-term investments. We also have approximately 3% of our invested assets at December 31, 1999 in derivative instruments (equity market index call options) purchased in connection with the issuance of equity-index annuities.
On October 18, 1996, we borrowed $10,000,000 from two banks under a variable rate revolving credit agreement. Proceeds from the borrowing were contributed to the capital and surplus of our life subsidiary ($6,000,000) and used to refinance indebtedness we incurred to capitalize our life subsidiary at the time of its formation ($4,000,000). During 1999, this line of credit was increased to permit maximum borrowings of $25,000,000, and we borrowed an additional $10,600,000, bringing our liability for notes payable to $20,600,000 at December 31, 1999. We loaned the proceeds of the 1999 borrowings to American Equity Investment Service Company (see discussion that follows under Liquidity of Parent Company). The loan matures on March 31, 2001 with an option for a four year extension as a term loan. Under this agreement, we are required to maintain minimum capital and surplus levels at our life subsidiary and meet certain other financial and operating ratio requirements. We are also prohibited from incurring other indebtedness for borrowed money without obtaining a waiver from the lenders and from paying dividends on our capital stock in excess of 10% of our consolidated net income for the prior fiscal year (except that in 1999 we were permitted to make a dividend payment equal to 44% of our consolidated net income for 1998).
The aggregate net proceeds from these offerings, including proceeds received from the exercise of warrants, was $65,699,000, substantially all of which were contributed to the capital and surplus of our life subsidiary or used to fund the acquisition of the life insurance company acquired in 1996.
Liquidity for Insurance Operations. Our life subsidiary generally receives adequate cash flow from premium collections and investment income to meet its 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, 1999, approximately 98% of our annuity liabilities were subject to penalty upon surrender.
Liquidity of Parent Company. The parent company is a legal entity separate and distinct from its subsidiaries, and has no business operations. The parent company needs liquidity primarily to service its debt, including the subordinated debentures issued to subsidiary trusts, pay operating expenses and pay dividends to stockholders. The primary sources of funds for these payments are: (i) interest received on trust preferred securities received in connection with the issuance of the 5% Trust Preferred Securities; (ii) principal and interest payments received on the parent company's note receivable from American Equity Investment Service Company (see discussion that follows); (iii) dividends on capital stock and surplus note interest payments from our life subsidiary; (iv) cash on hand ($683,000 at December 31, 1999); and (v) cash ($835,000 at December 31, 1999) that may be distributed by the American Equity Investment Properties, L.C. which holds the remaining cash proceeds from the sale of the office building in Birmingham, Alabama that was sold in 1998. The parent company may also obtain cash by issuing debt or equity securities.
net income for periods subsequent to December 31, 1999. Under the most restrictive of these limitations, $21,450,000 of earned surplus at December 31, 1999 would be available for distribution by our life subsidiary to the parent company in the form of dividends or other distributions.
Statutory accounting practices prescribed or permitted for our life subsidiary differ in many respects from those governing the preparation of financial statements under generally accepted accounting principles ("GAAP"). Accordingly, statutory operating results and statutory capital and surplus may differ substantially from amounts reported in the GAAP basis financial statements for comparable items. Information as to statutory capital and surplus and statutory net income for our life subsidiary as of December 31, 1999 and 1998 and for the years ended December 31, 1999, 1998 and 1997 is included in Note 10 of the Notes to Audited Consolidated Financial Statements included elsewhere in this report.
During 1999, the parent company agreed to loan the affiliate up to $50,000,000 as the source of funds for the affiliate portion of first year commissions and had advanced $18,175,000 through December 31, 1999 pursuant to the promissory note evidencing this agreement. Principal and interest are payable quarterly over five years from the date of the advance. The principal source of funds for us to advance funds to the affiliate is our bank line of credit, of which $4,400,000 was available for borrowing at December 31, 1999. We anticipate increasing the maximum borrowing level under our bank line of credit in 2000 in order to be able to continue to make funds available to the affiliate to fund its portion of first year commissions.
Future payments by the life subsidiary on business in force at December 31, 1999 are dependent upon the account balances of the annuities remaining in force on each remaining quarterly renewal commission payment date. Assuming that the account balances remain constant over such remaining renewal commission payments dates, future renewal commission payments by the life subsidiary would be $4,756,556 per quarterly payment until December, 2002 and $3,685,274 per quarterly payment from January, 2003 until June, 2005. All such payments would be capitalized as deferred policy acquisition costs and amortized to expense pursuant to the Company's stated accounting policy.
During the first quarter of 1998, we developed a strategy to identify and then test our internal computer programs which are date sensitive. Our systems for administering our group life policies were identified as having two-digit date codes. Conversion to four-digit codes and testing of such converted systems commenced in the second quarter of 1998 and was completed prior to December 31, 1998. These systems are now year 2000 compliant. The costs of testing and conversion charged to expense during 1998 were approximately $25,000.
The policy issue and administration system for our individual annuity and life insurance business is a system developed from the outset using four digits for the year. This system was purchased from a third party vendor in the fourth quarter of 1996. At that time, the vendor provided us with a letter of year 2000 compliance for this system. However, we did not rely solely on the compliance letter and began a comprehensive systems test in the third quarter of 1998. Testing included processing daily, monthly, quarterly and annual business cycles through February 29, 2000. Internal testing was completed during the fourth quarter of 1998. This system was determined to be year 2000 compliant. The costs of testing of this system charged to expense during 1998 were approximately $10,000.
External testing with third party providers of computer dependent services was completed during the first quarter of 1999. The most critical of these providers to our ongoing business operations is the financial institution with which we electronically interface each business day for the processing of premium collections and commission payments. Integrated testing between us and this financial institution was successfully completed in February 1999. Testing included all types of ACH (Automated Clearing House) transactions. The cost of such testing charged to expense in 1999 was approximately $5,000.
Additionally, we instituted a corporate wide disaster recovery plan for our data systems which included our Iowa and Alabama locations. Both locations were prepared to serve the other in the event of a prolonged business outage. The plan incorporated contingencies for year 2000 interruptions caused by certain third party providers and other outside elements for which adequate testing cannot be conducted. These would include, for example, utility companies that supply electricity and water.
The financial statements are included as a part of this report on form 10-K on pages through.