We lease commercial office space in one building in West Des Moines, Iowa, for our principal offices under an operating lease that expires on November 21, 2021. We also lease our office in Pell City, Alabama, pursuant to an operating lease that expires on December 31, 2011. We are fully utilizing these facilities and believe both locations to be sufficient to house our operations for the foreseeable future.
Management's discussion and analysis reviews our consolidated financial position at December 31, 2010 and 2009, and our consolidated results of operations for the three years in the period ended December 31, 2010, and where appropriate, factors that may affect future financial performance. This discussion should be read in conjunction with our audited consolidated financial statements, notes thereto and selected consolidated financial data appearing elsewhere in this report.
the risk factors or uncertainties listed from time to time in our filings with the SEC.
Since our formation in 1995, we have emphasized industry leading customer service to both our distribution force and our policyholders. We believe this to be a major part of our ability to attract production from our independent agent network as well as a low rate of policy surrenders. Excellent customer service teamed with our ability to design innovative insurance products that provide principal protection and tax deferred growth have continued to result in significant sales of our annuity products year over year. High sales levels has driven us to industry leading growth rates and to cash and investments in excess of $20 billion at December 31, 2010, in only 15 years of operations. We have applied a conservative investment strategy to the annuity deposits we continue to manage which has provided reliable returns on our invested assets. Our profitability has also been driven by maintaining an efficient operation.
In 2010, we issued $200 million principal amount of convertible senior notes. We used the proceeds from issuance of the convertible senior notes to fully repay the $150 million line of credit. Subsequent to the end of 2010, we obtained a new three year $160 million revolving line of credit and have terminated the $150 million line. We have $74.5 million principal amount of convertible notes that holders may require us to redeem in 2011 and at December 31, 2010, the parent company had cash and cash equivalents totaling $62.3 million available to extinguish this debt.
Results of Operations for the Three Years Ended December 31, 2010
Annuity deposits before coinsurance ceded increased 27% during 2010 compared to 2009 and 61% during 2009 compared to 2008. We attribute these increases to factors including the highly competitive rates of our products, our continued strong relationships with our national marketing organizations and field force of licensed, independent insurance agents the increased attractiveness of safe money products in volatile markets, lower interest rates on competing products such as bank certificates of deposit and product enhancements including a new generation of guaranteed income withdrawal benefit riders. In addition, we continue to benefit from the actions of several significant competitors who have been less aggressive in marketing their products than in prior periods. The extent to which this trend will be sustained in future periods is uncertain.
Operating income, a non-GAAP financial measure (see reconciliation to net income in Item 6 - Selected Consolidated Financial Data) increased 7% to $108.9 million in 2010 and increased 40% to $101.8 in 2009 from $72.5 million in 2008.
In addition to net income, we have consistently utilized operating income, a non-GAAP financial measure commonly used in the life insurance industry, as an economic measure to evaluate our financial performance. Operating income equals net income adjusted to eliminate the impact of net realized gains on investments, including net other than temporary impairment ("OTTI") losses recognized in operations and related deferred tax asset valuation allowance, (gain) loss on retirement of debt, fair value changes in derivatives and embedded derivatives, the Lehman counterparty default on expired call options and the cost to settle a class action lawsuit. Because these items fluctuate from year to year in a manner unrelated to core operations, we believe measures excluding their impact are useful in analyzing operating trends. We believe the combined presentation and evaluation of operating income together with net income, provides information that may enhance an investor's understanding of our underlying results and profitability.
Operating income is not a substitute for net income determined in accordance with GAAP. The adjustments made to derive adjusted operating income are important to understanding our overall results from operations and, if evaluated without proper context, operating income possesses material limitations. As an example, we could produce a low level of net income in a given period, despite strong operating performance, if in that period we generate significant net realized losses from our investment portfolio. We could also produce a high level of net income in a given period, despite poor operating performance, if in that period we generate significant net realized gains from our investment portfolio. As an example of another limitation of operating income, it does not include the decrease in cash flows expected to be collected as a result of credit loss OTTI. Therefore, our management and board of directors also separately review net realized investment gains (losses) and analyses of our net investment income, including impacts related to OTTI write-downs, in connection with their review of our investment portfolio. In addition, our management and board of directors examine net income as part of their review of our overall financial results.
Net realized gains on investments and net impairment losses recognized in operations fluctuate from year to year based upon changes in the interest rate and economic environment and the timing of the sale of investments or the recognition of other than temporary impairments. We adopted the FASB guidance for recognition and presentation of other than temporary impairments that was released in April 2009 on January 1, 2009, which amended the determination of the amount of other than temporary impairments recognized in the statement of operations resulting in the noncredit portion of other than temporary impairments being recognized in other comprehensive income for debt securities that we do not intend to sell and it is not more likely than not we will be required to sell but also do not expect to recover the entire amortized cost basis of the security. The amounts disclosed in the non-GAAP reconciliation in Item 6 - Selected Consolidated Financial Data are net of related reductions in amortization of deferred sales inducements and deferred policy acquisition costs and income taxes. Income tax benefits related to net realized
Amounts attributable to the fair value accounting for derivatives and embedded derivatives primarily fluctuate from year to year based upon changes in the fair values of call options purchased to fund the annual index credits for fixed index annuities and changes in the interest rates used to discount the embedded derivative liability. The amounts disclosed in the non-GAAP reconciliation in Item 6 - Selected Consolidated Financial Data are net of related adjustments to amortization of deferred sales inducements and deferred policy acquisition costs and income taxes. The significant changes in the impact from the item disclosed in the non-GAAP reconciliation in Item 6 - Selected Consolidated Financial Data relate primarily to changes in the interest rates used to discount the embedded derivative liabilities. Pursuant to fair value measurements accounting standards adopted prospectively on January 1, 2008, the discount rates are based on risk-free interest rates adjusted for our nonperformance risk. These rates decreased during the years ended December 31, 2010 and 2009 resulting in decreases in net income for those years. Prior to the adoption of the fair value measurements accounting standards, the discount rates used were risk-free interest rates without adjustment for our nonperformance risk. The change to discount rates including our nonperformance risk resulted in a decrease in policy benefit reserves on January 1, 2008 of $150.6 million. The net income impact of this decrease in reserves net of the related adjustments to amortization of deferred sales inducements and deferred policy acquisition costs and income taxes was $40.7 million.
Annuity product charges (surrender charges assessed against policy withdrawals and fees deducted from policyholder account balances for living income benefit riders) increased 9% to $69.1 million in 2010 and 20% to $63.4 million in 2009 from $52.7 million in 2008. These increases were principally attributable to increases in the amount of fees assessed for lifetime income benefit riders which were $13.5 million and $4.5 million for the years ended December 31, 2010 and 2009, respectively. Withdrawals from annuity and single premium universal life policies subject to surrender charges were $418.9 million, $432.1 million and $420.8 million for the years ended December 31, 2010, 2009 and 2008, respectively. The average surrender charge collected on withdrawals subject to a surrender charge was 13.2%, 13.5% and 12.4% for the year ended December 31, 2010, 2009 and 2008, respectively.
Net investment income increased 11% to $1,036.1 million in 2010 and 13% to $932.2 million in 2009 from $822.1 million in 2008. These increases were principally attributable to the growth in our annuity business and corresponding increases in our invested assets. Average invested assets excluding derivative instruments (on an amortized cost basis) increased 15% to $17.1 billion in 2010 and 12% to $14.8 billion in 2009 compared to $13.2 billion in 2008. The average yield earned on invested assets was 6.06%, 6.30% and 6.20% for 2010, 2009 and 2008, respectively. The decrease in yield earned on average invested assets in 2010 was attributable to a lag in reinvestment of proceeds from bonds called for redemption during 2010 into new assets causing excess liquidity. The 2010 decrease yield on invested assets was also effected by lower yields on investments purchased in 2010. Based on yields received for purchases of fixed maturity securities in 2010, we estimate that approximately $27.9 million in net investment income was foregone during 2010, as a result of the excess liquidity, and the average yield on invested assets would have been 6.23% for 2010 if such income had been earned. The increase in yield earned on average invested assets in 2009 was attributable to higher yields on investments purchased in 2009 and 2008.
Actual amounts credited to policyholder account balances may be less than the index appreciation due to contractual features in the fixed index annuity policies (caps, participation rates, and asset fees) which allow us to manage the cost of the options purchased to fund the annual index credits. The change in fair value of derivatives is also influenced by the aggregate costs of options purchased. The aggregate cost of options has increased primarily due to an increased amount of fixed index annuities in force. The aggregate cost of options is also influenced by the amount of policyholder funds allocated to the various indices and market volatility which affects option pricing. Costs for options purchased during the year ended December 31, 2010 and 2009 decreased compared to prior years due to lower volatility in equity markets and adjustments to caps, participation rates, and asset fees.
Gross realized gains have increased in 2010 due to tax planning strategies to generate taxable capital gains that will permit deduction of capital losses for income tax purposes. Gross realized losses in 2010 primarily relate to securities that experienced credit events during 2010 resulting in the decision to sell the securities at a loss. See Financial Condition-Investments for additional discussion of impairment losses recognized on mortgage loans on real estate.
Gain (loss) on extinguishment of debt includes a $0.3 million loss on an extinguishment of $6.7 million principal amount of our 5.25% convertible senior notes due in December 2024 (the "2024 notes") during the year ended December 31, 2010. The $0.7 million loss on extinguishment of debt in 2009 includes a $3.1 million gain on an exchange of five million shares of our common stock for $37.2 million principal amount of our 2024 notes and a $3.8 million loss on an exchange of $63.6 million principal amount of our 5.25% convertible senior notes due in December 2029 for the same principal amount of the 2024 notes. The fair value of the common stock issued was $31.3 million. The $9.7 million gain on extinguishment of debt in 2008 resulted from the purchase of $78.1 million principal amount of the 2024 notes for $61.4 million in cash, of which $0.4 million was assigned to the reacquisition of the equity component of the 2024 notes.
Interest sensitive and index product benefits increased 111% to $733.2 million in 2010 and 70% to $347.9 million in 2009 from $205.1 million in 2008. The components of interest credited to account balances are summarized as follows:
Change in fair value of embedded derivatives was an increase of $131.0 million during 2010 and $529.5 million in 2009 and a decrease of $210.8 million in 2008. The 2010 increase includes $29.6 million for the increase in the fair value of the 2015 notes embedded conversion derivative. As discussed previously, this amount was offset by an increase in the fair value of the 2015 notes hedges. The remainder of the 2010 increase and the 2009 and 2008 changes relate to the fixed index annuity embedded derivatives and resulted from (i) changes in the expected index credits on the next policy anniversary dates, which are related to the change in fair value of the call options acquired to fund these index credits discussed above in change in fair value of derivatives; (ii) changes in discount rates used in estimating our liability for policy growth; (iii) changes in estimates of expected costs of annual call options that will be purchased in the future to fund index credits beyond the next policy anniversary; and (iv) the growth in the host component of the policy liability. See Critical Accounting Policies - Policy Liabilities for Fixed Index Annuities. The primary reason for the increase in the change in fair value of fixed index annuity embedded derivatives in 2010 was decreases in the discount rates used in estimating our liability for policy growth offset in part by decreases in the expected index credits which correlated with the decrease in the change in fair value of derivatives for 2010 discussed above. The primary reasons for the significant increase
Interest expense on subordinated debentures decreased 6% to $14.9 million in 2010 and 19% to $15.8 million in 2009 from $19.4 million in 2008. These decreases were primarily due to decreases in the weighted average interest rates on the outstanding subordinated debentures which were 5.47%, 5.82% and 7.15% for 2010, 2009 and 2008, respectively. The weighted average interest rates have decreased because $149 million principal amount of the subordinated debentures have a floating rate of interest based upon the three month London Interbank Offered Rate plus an applicable margin. See Financial Condition-Liabilities.
Interest expense on amounts due under repurchase agreements decreased 93% $0.5 million in 2009 and $8.2 million in 2008. There were no amounts outstanding during the year ended December 31, 2010. Weighted average interest rates were 0.35% and 2.28% for 2009 and 2008, respectively, and average borrowings outstanding were $150.7 million and $359.9 million during 2009 and 2008, respectively. Repurchase agreements were not utilized during 2010 due to the high level of calls on investment securities during the year. See Financial Condition-Investments.
As discussed above, fair value accounting for derivatives and embedded derivatives utilized in our fixed index annuity business creates differences in the recognition of revenues and expenses from derivative instruments including the embedded derivative liabilities in our fixed index annuity contracts. The gross profit adjustments resulting from fair value accounting for derivatives and embedded derivatives utilized in our fixed index annuity business increased (decreased) amortization by ($48.3) million, ($60.6) million and $44.2 million in 2010, 2009 and 2008, respectively. The gross profit adjustments from net realized gains on investments and net OTTI losses recognized in operations decreased amortization by $0.0 million, $12.2 million and $61.6 million in 2010, 2009 and 2008, respectively. The gross profit adjustments from the litigation settlement decreased amortization in 2010 by $4.4 million. Excluding the amortization amounts attributable to fair value accounting for derivatives and embedded derivatives, realized gains on investments and net OTTI losses recognized in operations, and the litigation settlement, amortization would have been $189.1 million, $160.9 million and $144.2 million for 2010, 2009 and 2008, respectively.
Other operating costs and expenses increased 100% to $114.6 million in 2010 and 9% to $57.3 million in 2009 from $52.6 million in 2008. The increase in 2010 was principally attributable to the litigation settlement accrual of $48.0 million, a $6.8 million increase in salaries and benefits and a $2.2 million increase in legal costs. See note 13 in our audited consolidated financial statements for a discussion of the litigation settlement. The increase in salaries and benefits for 2010 was due to an increase in incentive bonuses incurred for employees including the implementation of a short-term incentive plan for senior management and an increase in the number of employees due to growth in our business. The increase in litigation expense during 2010 was related to the defense of a class action lawsuit which we entered into a settlement with the plaintiffs in February 2011. The increase in 2009 was principally attributable to an increase in salaries and benefits of $3.3 million, an increase in risk charges on reinsurance of $3.7 million, and an increase in general overhead of $1.0 million offset by a decrease in legal expense of $3.1 million. The increase in salaries and benefits for 2009 was primarily due to an increase in the number of employees due to the growth in our business. Also, we recorded post employment benefit expense of $1.2 million during the second quarter of 2009 related to a post employment benefit agreement with our Executive Chairman, David J. Noble which was approved by our board of directors on June 4, 2009. The increase in risk charges on reinsurance was due to a reinsurance treaty entered into on December 31, 2008 and the expansion of the in-force business covered under an existing reinsurance treaty during the second quarter of 2009. The increase in general overhead costs was due to the growth
in our business from increased sales. The decreases in legal expense were primarily related to a decrease in the cost of defense related to ongoing litigation.
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 mortgage loans on real estate.
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 and government-sponsored agency securities and corporate securities rated investment grade by established nationally recognized statistical rating organizations ("NRSRO's") or in securities of comparable investment quality, if not rated and commercial mortgage loans on real estate.
During 2010 and 2009, we received $5.2 billion and $4.2 billion, respectively, in net redemption proceeds related to calls of our callable United States Government sponsored agency securities, of which $1.6 billion and $2.1 billion, respectively, were classified as held for investment. We reinvested the proceeds from these redemptions primarily in United States Government sponsored agencies, corporate securities and United States municipalities, states, and territories classified as available for sale. At December 31, 2010, 36% of our fixed income securities have call features and 1% ($0.1 billion) of those securities were subject to call redemption. Another 21% ($3.4 billion) of our fixed income securities will become subject to call redemption during 2011.
Our fixed maturity security portfolio is managed to minimize risks such as interest rate changes and defaults or impairments while earning a sufficient and stable return on our investments. Historically, we have had a high percentage of our fixed maturity securities in U.S. Government sponsored agency securities (for the most part Federal Home Loan Mortgage Corporation and Federal National Mortgage Association). While U.S. Government sponsored agency securities are of high credit quality, the call features have resulted in our excess cash position in 2010. These calls resulted from the low interest rate and tight agency spread environment experienced in 2010. Since 2007, when we had almost 80% of our
The NAIC's Securities Valuation Office ("SVO") is responsible for the day-to-day 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 regulatory filings. The SVO conducts credit analysis on these securities for the purpose of assigning an NAIC designation and/or unit price. Typically, if a security has been rated by an NRSRO, the SVO utilizes that rating and assigns an NAIC designation based upon the following system:
A summary of our RMBS by collateral type and split by NAIC designation, as well as a separate summary of securities for which we have recognized OTTI and those which we have not yet recognized any OTTI is as follows as of December 31, 2010:
At December 31, 2010 and 2009, the amortized cost and fair value of fixed maturity securities and equity securities that were in an unrealized loss position were as follows:
Unrealized losses decreased $207.4 million from $550.1 million at December 31, 2009 to $342.7 million at December 31, 2010. We decreased unrealized losses by recognizing $23.9 million of credit OTTI losses on debt securities for the year ended December 31, 2010. The remaining decrease in unrealized losses was due to improving market and economic conditions and tightening of credit spreads resulting in higher fair values for many of our fixed maturity securities. The increase in fair value of RMBS is also due to an increased demand in the market for these types of securities.
The following table sets forth the composition by credit quality (NAIC designation) of fixed maturity securities with gross unrealized losses:
The following tables show our investments' gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities (consisting of 780 and 355 securities, respectively) have been in a continuous unrealized loss position, at December 31, 2010 and 2009:
United States municipalities, states and territories: These securities are relatively long in duration, making the value of such securities sensitive to changes in market interest rates. These securities carry yields less than those available at December 31, 2010 as the result of rising interest rates in 2010.
Corporate securities: The unrealized losses in these securities are due partially to the continuation of wider than historic credit spreads in certain sectors of the corporate bond market. While credit spreads have narrowed, several sectors remain at spreads wider than levels prior to the 2008 financial crisis, such as financials and select economic sensitive issuers. As the result of wider spreads, these issues carry yields less than those available in the market as of December 31, 2010.
Equity securities: The unrealized loss on equity securities, which are primarily investment grade perpetual preferred stocks with exposure to REITS, investment banks and finance companies, are due to the ongoing concerns relating to capital, asset quality and earnings stability due to the financial crisis. All of the equity securities in an unrealized loss position for 12 months or more are investment grade perpetual preferred stocks that are absent credit deterioration. A continued difficult housing market has raised concerns in regard to earnings and dividend stability in many companies which directly affect the values of these securities.
At December 31, 2010 and 2009, the amortized cost and fair value of fixed maturity securities (excluding United States Government and United States Government sponsored agency securities) segregated by investment grade (NRSRO rating of BBB/Baa or higher) and below investment grade and equity securities that had unrealized losses greater than 20% and the number of months in a continuous unrealized loss position greater than 20% were as follows:
The amortized cost and fair value of fixed maturity securities at December 31, 2010 and 2009, 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 residential mortgage backed securities provide for periodic payments throughout their lives, and are shown below as a separate line.
Our analysis of these securities that we have determined are temporarily impaired and their credit performance at December 31, 2010 is as follows:
Finance and Insurance: The decline in value of these securities is due to the continued wide spreads as a result of the ongoing concerns relating to capital, asset quality and earnings stability due to the financial events of the past two years. While these issuers have had their financial position and profitability weakened by the credit and liquidity crisis, we have determined that these securities were not other than temporarily impaired due to our evaluation of the operating performance and the credit worthiness of each individual issuer.
Retail: The decline in value of this bond relates to a debt-financed share repurchase combined with a weakening economy which has led to a decrease in sales. We have determined that this security was not other than temporarily impaired due to the issuer's very strong market position and a consistent history of strong operating performance, improving economic conditions and rising security prices.
Several factors led us to believe that full recovery of amortized cost will not be expected. These include, but are not limited to: (i) a significant change in the operating performance of a company; (ii) a material change in the expected contractual obligation of an issuer; (iii) a significant change in ratings as defined by the NRSRO; and (iv) the time frame in which a recovery to amortized cost may occur. We recognized OTTI of $2.4 million on two corporate fixed maturity securities during the year ended December 31, 2010, because we changed from a position of holding these securities until price recovery to intending to sell them prior to price recovery.
In the normal course of business, we commit to fund commercial mortgage loans up to 90 days in advance. At December 31, 2010, we had commitments to fund commercial mortgage loans totaling $96.2 million, with fixed interest rates ranging from 5.25% to 6.00%.
As of December 31, 2010 and 2009 we held $381.2 and $346.5 million, respectively, of cash and cash equivalents received from counterparties for derivative collateral, which is included in other liabilities on our consolidated balance sheets. This derivative collateral limits the maximum amount of economic loss due to credit risk that we would incur if parties to the call options failed completely to perform according to the terms of the contracts to $108.1 million and $149.6 million at December 31, 2010 and 2009, respectively.
We had unsecured counterparty exposure in connection with options purchased from affiliates of Lehman Brothers ("Lehman") which declared bankruptcy during the third quarter of 2008. All options purchased from affiliates of Lehman had expired as of June 30, 2010. The amount of option proceeds due on expired options purchased from affiliates of Lehman that we did not receive payment on was $12.0 million and $2.1 million for the years ended December 31, 2009 and 2008, respectively. No amount has been recognized for any recovery of these amounts that may result from our claim in Lehman's bankruptcy proceedings.
Our liability for policy benefit reserves increased to $23.7 billion at December 31, 2010 compared to $19.3 billion at December 31, 2009, primarily due to additional annuity sales as discussed above. Substantially all of our annuity products have a surrender charge feature designed to reduce the risk of early withdrawal or surrender of the policies and to compensate us for our costs if policies are withdrawn early. Notwithstanding these policy features, the withdrawal rates of policyholder funds may be affected by changes in interest rates and other factors.
In September 2010, we issued $200.0 million principal amount of the 2015 notes. The 2015 notes have a stated interest rate of 3.5%, mature on September 15, 2015, and are intended to be settled in cash; however, in certain limited circumstances we have the discretion to settle in shares of our common stock or a combination of cash and shares of our common stock. Contractual interest payable on the 2015 notes began accruing in September 2010 and is payable semi-annually in arrears on March 15 and September 15. We used $150 million of the proceeds to pay off our fully drawn bank line of credit.
Following is a summary of subordinated debt obligations to the trusts at December 31, 2010 and 2009:
The interest rate for Trust XI was fixed at 8.595% for 5 years until December 15, 2010.
At December 31, 2010, we had a $150 million revolving line of credit with eight banks. The applicable interest rate is floating at LIBOR plus 0.80% or the greater of prime rate or federal funds rate plus 0.50%, as elected by us. As noted above, we used $150 million of the 2015 notes proceeds to pay off the amount drawn on this revolving line of credit. No amount was outstanding at December 31, 2010. The amount outstanding under this revolving line of credit at December 31, 2009 was $150.0 million. Subsequent to December 31, 2010, we terminated the $150 million
We entered into interest rate swaps to manage interest rate risk associated with the floating rate component on certain of our subordinated debentures and our revolving line of credit. The terms of the interest rate swaps provide that we pay a fixed rate of interest and receive a floating rate of interest. The interest rate swaps are not effective hedges under accounting guidance for derivative instruments and hedging activities. 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 operations.
We, as the parent company, are a legal entity separate and distinct from our subsidiaries, and have no business operations. We need liquidity primarily to service our debt, including the convertible senior notes and subordinated debentures issued to subsidiary trusts, pay operating expenses and pay dividends to stockholders. Our assets consist primarily of the capital stock and surplus notes of our subsidiaries. Accordingly, our future cash flows depend upon the availability of dividends, surplus note interest payments and other statutorily permissible payments from our subsidiaries, such as payments under our investment advisory agreements and tax allocation agreement with our subsidiaries. These sources provide adequate cash flow to us to meet our current and reasonably foreseeable future obligations and we expect they will be adequate to fund our parent company cash flow requirements in 2011. During 2011, we may redeem and holders may require us to repurchase the $74.5 million principal amount outstanding of the 2024 notes. At December 31, 2010, we have cash and cash equivalents totaling $62.3 million on hand available to extinguish this debt.
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 addition, we manage the statutory capital and surplus in American Equity Life to maintain American Equity Life's current A.M. Best rating. As of December 31, 2010, we estimate American Equity Life has sufficient statutory capital and surplus, combined with capital available to the holding company, to meet this rating objective. However, this capital may not be sufficient if significant future losses are incurred or A.M. Best modifies its rating criteria and, given the current market conditions, access to additional capital could be limited.
The transfer of funds by American Equity Life is also restricted by a covenant in our revolving line of credit agreement which requires American Equity Life to maintain a minimum risk-based capital ratio of 275%. American Equity Life's risk-based capital ratio was 339% at December 31, 2010.
agreement with FPK. On August 4, 2010, we provided notice to Macquarie Capital and Sandler O'Neill that we were terminating the distribution agreements. During 2009, we sold 132,300 shares of our common stock pursuant to these distribution agreements, resulting in gross proceeds to us of $1.1 million, and we had no sales in 2010.
Amounts shown in this table are projected payments through the year 2030 which we are contractually obligated to pay to our annuity policyholders. The payments are derived from actuarial models which assume a level interest rate scenario and incorporate assumptions regarding mortality and persistency, when applicable. These assumptions are based on our historical experience.
Our fixed maturity securities (bonds and redeemable preferred stocks maturing more than one year after issuance) and equity securities (common and perpetual preferred stocks) classified as available for sale are reported at fair value. Unrealized gains and losses, if any, on these securities are included directly in stockholders' equity as a component of Accumulated Other Comprehensive Loss, net of income taxes and certain adjustments for assumed changes in amortization of deferred policy acquisition costs and deferred sales inducements. Unrealized gains and losses represent the difference between the amortized cost or cost basis and the fair value of these investments. We use significant judgment within the process used to determine fair value of these investments.
GAAP defines fair value as the price that would be received to sell an asset or paid to transfer a liability (exit price) in an orderly transaction between market participants at the measurement date. We categorize our investments into three levels of fair value hierarchy based on the priority for use of inputs in determining fair value. The hierarchy defines the highest priority inputs (Level 1) as quoted prices in active markets for identical assets. The lowest priority inputs (Level 3) are our own assumptions about what a market participant would use in determining fair value such as estimated future cash flows. We categorize financial assets and liabilities recorded at fair value in the consolidated balance sheets as follows:
Level 1 - Quoted prices are available in active markets for identical financial instruments as of the reporting date. We do not adjust the quoted price for these financial instruments, even in situations where we hold a large position and a sale could reasonably impact the quoted price.
The independent pricing services provide quoted market prices when available. Quoted prices are not always available due to market inactivity. Valuations and quotes obtained from third party commercial pricing services are non-binding and do not represent quotes on which one may execute the disposition of the assets.
In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, an investment's level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and considers factors specific to the investment.
changes in estimated cash flows of residential mortgage and asset backed securities.
The remaining amount of the other than temporary impairment is recognized in other comprehensive income.
Accounting for derivatives prescribes that the contractual obligations for future annual index credits are treated as a "series of embedded derivatives" over the expected life of the applicable contracts. Policy liabilities for fixed index annuities are equal to the sum of the "host" (or guaranteed) component and the embedded derivative component for each fixed index annuity policy. The host value is established at inception of the contract and accreted over the policy's life at a constant rate of interest. We estimate the fair value of the embedded derivative component at each valuation date by (i) projecting policy contract values and minimum guaranteed contract values over the expected lives of the contracts and (ii) discounting the excess of the projected contract value amounts at the applicable risk free interest rates adjusted for our nonperformance risk related to those liabilities. The projections of policy contract values are based on our best estimate assumptions for future policy growth and future policy decrements. Our best estimate assumptions for future policy growth include assumptions for the expected index credit on the next policy anniversary date which are derived from the fair values of the underlying call options purchased to fund such index credits and the expected costs of annual call options we will purchase in the future to fund index credits beyond the next policy anniversary. The projections of minimum guaranteed contract values include the same best estimate assumptions for policy decrements as were used to project policy contract values. The amounts reported in the consolidated statements of operations as "Interest sensitive and index product benefits" represent amounts credited to policy liabilities pursuant to accounting by insurance companies for certain long-duration contracts which include index credits through the most recent policy anniversary. The amounts reported in the consolidated statements of operations as "Changes in fair value of embedded derivatives" equal the change in the difference between policy benefit reserves for fixed index annuities computed under the derivative accounting standard and the long-duration contracts accounting standard at each balance sheet date.
The most sensitive assumption in determining policy liabilities for fixed index annuities is the rates used to discount the excess projected contract values. As indicated above, the discount rate reflects our nonperformance risk. If the discount rates used to discount the excess projected contract values at December 31, 2010 were to increase by100 basis points, our reserves for fixed index annuities would decrease by $131.6 million recorded through operations as a decrease in the change in fair value of embedded derivatives and there would be a corresponding decrease of $81.6 million to our combined balance for deferred policy acquisition costs and deferred sales inducements recorded through operations as an increase in amortization of deferred policy acquisition costs and deferred sales inducements. A decrease by 100 basis points in the discount rate used to discount the excess projected contract values would increase our reserves for fixed index annuities by $146.2 million recorded through operations as a increase in the change in fair value of embedded derivatives and increase our combined balance for deferred policy acquisition costs and deferred sales inducements by $91.7 million recorded through operations as a decrease in amortization of deferred policy acquisition costs and deferred sales inducements.
The impact of unlocking during 2010 was a $0.3 million increase in the amortization of deferred sales inducements and a $1.4 million increase in amortization of deferred policy acquisition costs. The impact of unlocking during 2010 was primarily due to adjustments made to future period assumptions for interest margins, surrenders, lifetime income benefit rider utilization and reinsurance costs. The impact of unlocking during 2008 was a $1.3 million increase in the amortization of deferred sales inducements and a $14.6 million increase in amortization of deferred policy acquisition costs. The impact of unlocking during 2008 was primarily due to actual index credits to policies being lower than what was estimated due to the lack of performance of the indices upon which the index credits are based. There were no changes in our estimated future gross profits in 2009 that resulted in unlocking adjustments to the deferred policy acquisition costs and deferred sales inducements balances.
Estimated future gross profits vary based on a number of sources including investment spread margins, surrender charge income, policy persistency, policy administrative expenses and realized gains and losses on investments including credit related other than temporary impairment losses. Estimated future gross profits are most sensitive to changes in investment spread margins which are the most significant component of gross profits. If estimated gross profits for all future years on business in force at December 31, 2010 were to increase by 10%, our combined balance for deferred policy acquisition costs and deferred sales inducements at December 31, 2010 would increase by $61.4 million recorded through operations as a decrease to amortization of deferred policy acquisition costs and deferred sales inducements. Correspondingly, a 10% decrease in estimated gross profits for all future years would result in a $69.2 million decrease in the combined December 31, 2010 balances recorded through operations as an increase to amortization of deferred policy acquisition costs and deferred sales inducements.
In July 2010, the FASB issued an accounting standards update that expands disclosures and provide users more transparency about allowances for credit losses and the credit quality of the financing receivables of an entity. This guidance requires additional disclosures about an entity's financing receivables, such as credit quality indicators, aging of past due financing receivables, and significant purchases and sales of financing receivables. In addition, disclosures must be disaggregated by portfolio segment or class based on how an entity develops its allowance for credit losses and how it manages its credit exposure. Most of the disclosure requirements were effective for the fourth quarter of 2010 with certain additional disclosures required for the first quarter of 2011.