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 maintain 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. In 2014, our sales decreased 1% to $4.2 billion which has resulted in cash and investments in excess of $36 billion at December 31, 2014. Our sales for the last five years have ranged from $3.9 billion to $5.1 billion and we have exceeded $4 billion in sales in four of those years. 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.
Our investment spread in 2014, 2013 and 2012 (see Our Business and Profitability) was impacted by shortfalls in investment income from excess liquidity resulting from a lag in the reinvestment of proceeds of government agency bonds called for redemption. The callable government agency securities have been a cornerstone of our investment portfolio since our formation. Through the years they have provided acceptable yields that met our spread requirements without any risk-based capital charges. We went through several cycles of calls on these securities and each time we have reinvested a portion of the call redemption proceeds into new callable government agency securities. This kept cash balances low but perpetuated the call risk. However, beginning in 2012, we substantially curtailed purchases of callable government agency securities and experienced several periods during the last three years where we held excess cash and other short-term investments due to lags in the reinvestment of proceeds from bonds called for redemption during those years. See Results of Operations-Net investment income for additional information regarding our excess liquidity.
The cost of money for fixed index annuities and average crediting rates for fixed rate annuities 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 fixed index annuities, the cost of money includes the average crediting rate on amounts allocated to the fixed rate strategy, 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-Policy Liabilities for Fixed Index Annuities and Financial Condition-Derivative Instruments.
Net income is also impacted by the change in fair value of derivatives and embedded derivatives which fluctuates from year to year based upon changes in fair values of call options purchased to fund the annual index credits for fixed index annuities and changes in interest rates used to discount the embedded derivative liability. Net income for the years ended December 31, 2014 and 2012 was negatively impacted by decreases in the discount rates used to estimate our embedded derivative liabilities while net income for the year ended December 31, 2013 was positively impacted by increases in the discount rates used to estimate our embedded derivative liabilities. Net income for the year ended December 31, 2014 was also positively impacted by revisions of assumptions used in determining fixed index annuity embedded derivatives that were made in the second quarter of 2014. These revisions, which consisted of changes in the lapse and expected costs of annual call options assumptions, decreased the change in the fair value of embedded derivatives for the year ended December 31, 2014 by $62.6 million, which after related adjustments to deferred sales inducements and deferred policy acquisition costs and income taxes, increased net income for the year ended December 31, 2014 by $14.8 million (see Change in fair value of embedded derivatives).
Operating income, a non-GAAP financial measure (see reconciliation to net income in Item 6. Selected Consolidated Financial Data) increased 17% to $190.6 million in 2014 and increased 48% to $163.4 million in 2013 from $110.2 million in 2012.
The revision of assumptions in 2014, 2013 and 2012 used in determining liabilities for lifetime income benefit riders had the same effect on operating income as it had on net income as discussed previously.
Annuity product charges (surrender charges assessed against policy withdrawals and fees deducted from policyholder account balances for lifetime income benefit riders) increased 15% to $119.0 million in 2014 and 16% to $103.6 million in 2013 from $89.0 million in 2012. The components of annuity product charges are set forth in the table that follows:
The decrease in yield earned on average invested assets in 2014 and 2013 was attributable to yields on investments purchased in those periods and 2012 being lower than the overall portfolio yield. In addition, net investment income and average yield were negatively impacted by a lag in reinvestment of proceeds from bonds called for redemption during 2014, 2013 and 2012 into new assets causing excess liquidity held in low yielding cash and other short-term investments. The average balance held in cash and short-term investments was $0.4 billion, $1.0 billion and $1.7 billion in 2014, 2013 and 2012, respectively. The average yield on our cash and short-term investments was 0.07% in 2014, 0.38% in 2013, and 0.25% in 2012. Additionally, net investment income and average yield was positively impacted by prepayment and fee income received resulting in additional net investment income of $22.3 million, $15.7 million and $14.8 million, in 2014, 2013 and 2012, respectively.
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. See Critical Accounting Policies - Policy Liabilities for Fixed Index Annuities.
The fair value of the 2015 notes hedges changes based upon changes in the price of our common stock, interest rates, stock price volatility, dividend yield and the time to expiration of the 2015 notes hedges. Similarly, the fair value of the conversion option obligation to the holders of the 2015 notes changes based upon these same factors and the conversion option obligation is accounted for as an embedded derivative liability with changes in fair value reported in the Change in fair value of embedded derivatives. The amount of the change in fair value of the 2015 notes hedges has historically been equal to the amount of the change in the related embedded derivative liability and there has been an offsetting expense in the change in fair value of embedded derivatives. Due to the partial unwind agreements we entered into in 2014, the decrease in the change in the fair value of the 2015 notes embedded derivative conversion liability exceeded the decrease in the fair value of the 2015 notes hedges by $10.1 million for the year ended December 31, 2014. Due to the partial unwind agreements we entered into in 2013, the amount of the change in fair value of the 2015 notes hedges was $3.8 million more than the amount of the change in the related embedded conversion derivative liability for the year ended December 31, 2013. See Note 5 to our audited consolidated financial statements for a discussion of the unwind agreements, the 2015 notes hedges and the 2015 notes embedded derivative conversion liability.
Losses on available for sale fixed maturity securities were realized primarily due to strategies to reposition the fixed maturity security portfolio that resulted in improved net investment income, risk or duration profiles as they pertain to our asset liability management. Two corporate issues were sold at a loss in 2013 due to our fundamental, long-term concern with the issuer's ability to meet its future financial obligations. See Note 4 to our audited consolidated financial statements for additional discussion of allowance for credit losses recognized on mortgage loans on real estate.
Insurance policy benefits and changes in future policy benefits decreased 21% to $41.8 million in 2014 and 35% to $53.1 million in 2013 from $81.5 million in 2012. These expenses include amounts for life insurance policies and life contingent single premium immediate annuities including life contingent supplemental contracts issued upon annuitization of deferred annuities. Amounts for life insurance policies have remained consistent throughout the periods presented while amounts related to life contingent single premium immediate annuities ($34.1 million, $46.1 million and $73.4 million in 2014, 2013 and 2012, respectively) have decreased over the periods primarily because the related premiums have decreased as discussed above under Premiums and other considerations.
Interest sensitive and index product benefits increased 16% to $1.5 billion in 2014 and 57% to $1.3 billion in 2013 from $808.5 million in 2012. The components of interest sensitive and index product benefits are summarized as follows:
The increases 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 amount of funds 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 $1.1 billion, $910.4 million and $447.2 million for the years ended December 31, 2014, 2013 and 2012, respectively. The decreases in interest credited were primarily due to decreases in the average rate credited to the annuity liabilities outstanding receiving a fixed rate of interest. The average amount of annuity liabilities outstanding (net of annuity liabilities ceded under coinsurance agreements) increased 13% to $33.4 billion in 2014 and 14% to $29.5 billion in 2013 from $26.0 billion in 2012. The increases in benefits recognized for lifetime income benefit riders were due to increases in the number of policies with lifetime income benefit riders and correlates to the increase in fees discussed in Annuity product charges and in 2014, the impact of revisions to assumptions used in determining reserves held for lifetime income benefit riders. For 2013 and 2012, the impact of revisions to assumptions used in determining reserves held for lifetime income benefit riders partially offset the increase in expense attributable to a larger volume of policies with the rider. See Net income above for discussion of the impact of changes in the assumptions used in determining reserves for lifetime income benefit riders for the years ended December 31, 2014, 2013 and 2012.
Amortization of deferred sales inducements decreased 48% to $131.4 million in 2014 and increased 190% to $253.1 million in 2013 from $87.2 million in 2012. In general, amortization of deferred sales inducements has been increasing each year due to growth in our annuity business and the deferral of sales inducements incurred with respect to sales of premium bonus annuity products. Bonus products represented 95%, 97% and 97% of our net annuity deposits during 2014, 2013 and 2012, respectively. The increase in amortization from these factors has been affected by amortization associated with fair value accounting for derivatives and embedded derivatives utilized in our fixed index annuity business, amortization associated with the net realized gains (losses) on investments and net OTTI losses recognized in operations and amortization associated with litigation reserves. 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 change in fair value of the embedded derivatives will not correspond to the change in fair value of the derivatives (purchased call options), because the purchased call options are one-year options while the options valued in the fair value of embedded derivatives cover the expected lives of the contracts which typically exceed ten years. Amortization of deferred sales inducements is summarized as follows:
See Net income and Operating income (a non-GAAP financial measure) above for discussion of the impact of unlocking on amortization of deferred sales inducements for the years ended December 31, 2014, 2013 and 2012. See Critical Accounting Policies-Deferred Policy Acquisition Costs and Deferred Sales Inducements.
See Net income and Operating income (a non-GAAP financial measure) above for discussion of the impact of unlocking on amortization of deferred policy acquisition costs for the years ended December 31, 2014, 2013 and 2012. See Critical Accounting Policies-Deferred Policy Acquisition Costs and Deferred Sales Inducements.
Other operating costs and expenses decreased 11% to $81.6 million in 2014 and decreased 4% to $91.9 million in 2013 from $95.5 million in 2012. The decrease in 2014 is due to a decrease in expense for guaranty fund assessments of $10.0 million and a decrease of $3.2 million in litigation expense (See Note 13 to our consolidated financial statements) offset by increases in risk charges for our financing reinsurance agreement with Hannover (2013 Hannover Transaction) of $2.7 million and $0.9 in compensation costs. The decrease in 2013 is due to a decrease in litigation expense of $16.5 million (a $17.5 million estimated litigation liability was recorded in 2012) offset by an increase in expense for guaranty fund assessments of $7.6 million related to the insolvency of Executive Life Insurance Company of New York and compensation costs of $3.3 million that vary based on the Company's stock price.
The use of this process by the SVO may result in certain non-agency RMBS and CMBS being assigned a NAIC designation that is higher than the equivalent NRSRO rating. The NAIC designations for non-agency RMBS and CMBS are based on security level expected losses as modeled by an independent third party (engaged by the NAIC) and the statutory carrying value of the security, including any purchase discounts or impairment charges previously recognized. Evaluation of non-agency RMBS and CMBS held by insurers using the revised NAIC rating methodologies is performed on an annual basis.
The amortized cost and fair value of fixed maturity securities at December 31, 2014, by contractual maturity are presented in Note 3 to our audited consolidated financial statements in this Form 10-K, which is incorporated by reference in this Item 7.
Unrealized losses decreased $705.4 million from $861.4 million at December 31, 2013 to $156.0 million at December 31, 2014. The decrease in unrealized losses was primarily due to a decrease in interest rates during 2014.
Our investments' gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities (consisting of 402 and 1,047 securities, respectively) have been in a continuous unrealized loss position at December 31, 2014 and 2013, along with a description of the factors causing the unrealized losses is presented in Note 3 to our audited consolidated financial statements in this Form 10-K, which is incorporated by reference in this Item 7.
The amortized cost and fair value of fixed maturity securities and equity securities in an unrealized loss position and the number of months in a continuous unrealized loss position (fixed maturity securities that carry an NRSRO rating of BBB/Baa or higher are considered investment grade) were as follows:
We hold fixed maturity securities with international exposure. As of December 31, 2014, 16% of the carrying value of our fixed maturity securities was comprised of corporate debt securities of issuers based outside of the United States and debt securities of foreign governments. All of these securities are denominated in U.S. dollars and all are investment grade (NAIC designation of either 1 or 2), except for 21 securities with a total fair value of $128.6 million which have a NAIC 3 designation. Our investment professionals analyze each holding for credit risk by economic and other factors of each country and industry. The following table presents our international exposure in our fixed maturity portfolio by country or region:
At each balance sheet date, we identify invested assets which have characteristics (i.e. significant unrealized losses compared to amortized cost and industry trends) creating uncertainty as to our future assessment of an other than temporary impairment. As part of this assessment we review not only a change in current price relative to its amortized cost but the issuer's current credit rating and the probability of full recovery of principal based upon the issuer's financial strength. Specifically for corporate issues we evaluate the financial stability and quality of asset coverage for the securities relative to the term to maturity for the issues we own. A security which has a 25% or greater change in market price relative to its amortized cost and a possibility of a loss of principal will be included on a list which is referred to as our watch list. We exclude from this list securities with unrealized losses which are related to market movements in interest rates and which have no factors indicating that such unrealized losses may be other than temporary as we do not intend to sell these securities and it is more likely than not we will not have to sell these securities before a recovery is realized. In addition, we exclude our RMBS as we monitor all of our RMBS on a quarterly basis for changes in default rates, loss severities and expected cash flows for the purpose of assessing potential other than temporary impairments and related credit losses to be recognized in operations. At December 31, 2014, the amortized cost and fair value of securities on the watch list are as follows:
Two of the securities on the watch list have Eurozone exposure that has contributed to their depressed fair values. Our analysis of all of the securities on the watch list that we have determined are temporarily impaired and their credit performance at December 31, 2014 is as follows:
Industrial: The decline in the value of these securities relates to ongoing operational issues related to the decline in certain commodity prices specific to their business. The decline in these commodity prices creates financial challenges as the industry realigns to accommodate the lower prices. These issuers will be stressed greater than the average company due to their price sensitivity and the specific position they hold in the chain of supply. While these issuers have seen the financial and profitability profile weakened, we have determined that the securities were not other than temporarily impaired due to our evaluation of the operating performance and the credit worthiness of the issuer.
We have a policy and process to identify securities in our investment portfolio for which we should recognize impairments. See Critical Accounting Policies-Evaluation of Other Than Temporary Impairments. We recognized other than temporary impairments and additional credit losses on a number of securities for which we have previously recognized OTTI. A summary of OTTI is presented in Note 3 to our audited consolidated financial statements in this Form 10-K, which is incorporated by reference in this Item 7.
Several factors led us to believe that full recovery of amortized cost will not be expected. A discussion of these factors and our policy and process to identify securities that could potentially have impairment that is other than temporary is in Note 3 to our audited consolidated financial statements in this Form 10-K, which is incorporated by reference in this Item 7.
Our commercial mortgage loan portfolio consists of mortgage loans collateralized by the related properties and diversified as to property type, location and loan size. Our mortgage lending policies establish limits on the amount that can be loaned to one borrower and other criteria to attempt to reduce the risk of default. Our commercial mortgage loans on real estate are reported at cost, adjusted for amortization of premiums and accrual of discounts net of valuation allowances. At December 31, 2014 and 2013, the largest principal amount outstanding for any single mortgage loan was $15.8 million and $14.6 million, respectively, and the average loan size was $2.7 million and $2.5 million at December 31, 2014 and 2013, respectively. We have the contractual ability to pursue full personal recourse on 7.4% of the loans and partial personal recourse on 21.6% of the loans. In addition, the average loan to value ratio for the overall portfolio was 53.7% and 54.3% at December 31, 2014 and 2013, respectively, based upon the underwriting and appraisal at the time the loan was made. This loan to value is indicative of our conservative underwriting policies and practices for making commercial mortgage loans and may not be indicative of collateral values at the current reporting date. Our current practice is to only obtain market value appraisals of the underlying collateral at the inception of the loan unless we identify indicators of impairment in our ongoing analysis of the portfolio, in which case, we either calculate a value of the collateral using a capitalization method or obtain a current appraisal of the underlying collateral. The commercial mortgage loan portfolio is summarized by geographic region and property type in Note 4 of our audited consolidated financial statements of this Form 10-K, which is incorporated by reference in this Item 7.
In the normal course of business, we commit to fund commercial mortgage loans up to 90 days in advance. At December 31, 2014, we had commitments to fund commercial mortgage loans totaling $61.3 million, with fixed interest rates ranging from 3.90% to 4.23%. During 2014 and 2013, due to historically low interest rates, the commercial mortgage loan industry has been very competitive. This competition has resulted in a number of borrowers refinancing with other lenders. For the year ended December 31, 2014, we received $361.1 million in cash for loans being paid in full compared to $441.7 million for the year ended December 31, 2013. Some of the loans being paid off have either reached their maturity or are nearing maturity; however, some borrowers are paying the prepayment fee and refinancing at a lower rate.
At December 31, 2014, we had no commercial mortgage loans that were delinquent (60 days or more past due at the reporting date) in their principal and interest payments.
Our liability for policy benefit reserves increased to $39.8 billion at December 31, 2014 compared to $35.8 billion at December 31, 2013, 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.
Our subsidiary trusts have issued fixed rate and floating rate trust preferred securities and the trusts have used the proceeds from these offerings to purchase subordinated debentures from us. We also issued subordinated debentures to the trusts in exchange for all of the common securities of each trust. The sole assets of the trusts are the subordinated debentures and any interest accrued thereon. The terms of the preferred securities issued by each trust parallel the terms of the subordinated debentures. Our obligations under the subordinated debentures and related agreements provide a full and unconditional guarantee of payments due under the trust preferred securities. Accounting standards for consolidation of variable interest entities, specifically exempts qualifying special purpose entities from consolidation; therefore, we do not consolidate our subsidiary trusts and record our subordinated debt obligations to the trusts and our equity investments in the trusts. See Note 10 to our audited consolidated financial statements for additional information concerning our subordinated debentures payable to, and the preferred securities issued by, the subsidiary trusts.
Liquidity requirements are met primarily by funds provided from operations. Our life subsidiaries generally receive adequate cash flow from annuity deposits and investment income to meet their obligations. Annuity and life insurance liabilities are generally long-term in nature. However, a primary liquidity concern is the risk of an extraordinary level of early policyholder withdrawals. We include provisions within our annuity policies, such as surrender charges and bonus vesting, that help limit and discourage early withdrawals. At December 31, 2014, approximately 95% of our annuity liabilities were subject to penalty upon surrender, with a weighted average remaining surrender charge period of 9.2 years and a weighted average surrender charge percentage of 14.7%.
Our insurance subsidiaries continue to have adequate cash flows from annuity deposits and investment income to meet their policyholder and other obligations. Net cash flows from annuity deposits and funds returned to policyholders as surrenders, withdrawals and death claims were $2.2 billion for the year ended December 31, 2014 compared to $2.4 billion for the year ended December 31, 2013 with the decrease primarily attributable to a $189.3 million (after coinsurance) increase in funds returned to policyholders offset by a $11.1 million increase in net annuity deposits after coinsurance. We continue to invest the net proceeds from policyholder transactions and investment activities in high quality fixed maturity securities and fixed rate commercial mortgage loans.
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 senior notes, 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 2015.
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. Along with solvency regulations, the primary driver in determining the amount of capital used for dividends is the level of capital needed to maintain desired financial strength ratings from A.M. Best. Given recent economic events that have affected the insurance industry, both regulators and rating agencies could become more conservative in their methodology and criteria, including increasing capital requirements for our insurance subsidiaries which, in turn, could negatively affect the cash available to us from insurance subsidiaries. As of December 31, 2014, 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 access to additional capital could be limited.
Cash and cash equivalents of the parent holding company at December 31, 2014, were $61.1 million. In addition, as discussed in Note 9 to our audited consolidated financial statements we have a $140 million revolving line of credit agreement. This revolving line of credit terminates on November 22, 2017, and borrowings are available for general corporate purposes of the parent company and its subsidiaries. We also have the ability to issue equity, debt or other types of securities through one or more methods of distribution under a currently effective shelf registration statement on Form S-3. The terms of any offering would be established at the time of the offering, subject to market conditions.
In the normal course of business, we enter into financing transactions, lease agreements, or other commitments. These commitments may obligate us to certain cash flows during future periods. The following table summarizes such obligations as of December 31, 2014.
The following table presents the fair value of fixed maturity and equity securities, available for sale, by pricing source and hierarchy level as of December 31, 2014 and 2013, respectively:
The independent pricing services provide quoted market prices when available. Quoted prices are not always available due to market inactivity. When quoted market prices are not available, the third parties use yield data and other factors relating to instruments or securities with similar characteristics to determine fair value for securities that are not actively traded. We generally obtain one value from our primary external pricing service. In situations where a price is not available from this service, we may obtain further quotes or prices from additional parties as needed. In addition, for our callable United States Government sponsored agencies we obtain two broker quotes and take the average of two broker prices received. Market indices of similar rated asset class spreads are considered for valuations and broker indications of similar securities are compared. Inputs used by the broker include market information, such as yield data and other factors relating to instruments or securities with similar characteristics. 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.
Other than temporary impairment losses on equity securities are recognized in operations. If we intend to sell a debt security or if it is more likely than not that we will be required to sell a debt security before recovery of its amortized cost basis, other than temporary impairment has occurred and the difference between amortized cost and fair value will be recognized as a loss in operations.
In general, the change in the fair value of the embedded derivatives will not correspond to the change in fair value of the purchased call options because the purchased call options are one year options while the options valued in the embedded derivatives represent the rights of the contract holder to receive index credits over the entire period the fixed index annuities are expected to be in force, which typically exceeds 10 years.
For annuity products, these costs are being amortized generally in proportion to expected gross profits from interest margins and, to a lesser extent, from product charges. Current and future period gross profits/margins for fixed index annuities also include the impact of amounts recorded for the change in fair value of derivatives and the change in fair value of embedded derivatives. Current period amortization is adjusted retrospectively through an unlocking process when estimates of current or future gross profits/margins (including the impact of realized investment gains and losses) to be realized from a group of products are revised. Our estimates of future gross profits/margins are based on actuarial assumptions related to the underlying policies terms, lives of the policies, yield on investments supporting the liabilities and level of expenses necessary to maintain the polices over their entire lives. Revisions are made based on historical results and our best estimates of future experience. See Results of Operations for the Three Years Ended December 31, 2014 in this Item 7. for a discussion and presentation of the actual effects of unlocking.