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 30, 2026. We also lease our office in Pell City, Alabama, pursuant to an operating lease that expires on December 31, 2014. 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, 2013 and 2012, and our consolidated results of operations for the three years in the period ended December 31, 2013, and where appropriate, factors that may affect future financial performance. This analysis should be read in conjunction with our audited consolidated financial statements, notes thereto and selected consolidated financial data appearing elsewhere in this report.
In 2013, we issued $400 million of senior unsecured notes due 2021 (the "2021 Notes") and retired $184 million aggregate principal amount of three convertible note issues. The total consideration paid to retire the convertible notes included $219 million of cash and 5.5 million shares of our common stock. In the short-term, these convertible debt retirements reduced net income and book value per share. However, these retirements are expected to provide long-term benefit by eliminating potential additional dilution from further increases in our stock price. At December 31, 2013, we had $206 million of net proceeds remaining from the 2021 Notes offering which we intend to use to retire the $160 million aggregate principal amount of convertible notes that were outstanding at December 31, 2013. The form and timing of additional convertible debt retirements will be dependent upon market conditions and other factors and there can be no assurance that any such transactions will be completed prior to the December 2014 call date for our 5.25% Contingent Convertible Senior Notes due 2029 (the "2029 notes") or the September 2015 maturity date for our 3.50% Convertible Senior Notes due 2015 (the "2015 notes").
Earnings from products accounted for as deposit liabilities are primarily generated from the excess of net investment income earned over the interest credited or the cost of providing index credits to the policyholder, or the "investment spread." Our investment spread is summarized as follows:
Annuity deposits by product type collected during 2013, 2012 and 2011, were as follows:
Net income for 2012 was negatively affected by the prospective adoption on January 1, 2012, of an accounting standards update that defines the types of costs that are deferrable with policy acquisition. This resulted in $9.1 million of costs that were expensed as incurred during the year ended December 31, 2013, which under the accounting method in effect for the years ended December 31, 2011, would have been capitalized as deferred policy acquisition costs and amortized in future periods. This change in accounting, including the impact on related amortization expense, resulted in a $5.8 million decrease in net income for the year ended December 31, 2012.
We periodically revise the key assumptions used in the calculation of amortization of deferred policy acquisition costs and deferred sales inducements 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. The impact of unlocking on our results of operations, including the impact of account balance true ups and adjustments to future period assumptions for interest margins and surrenders, was as follows:
Net income for 2013 and 2012 was positively impacted by a revision of assumptions used in determining liabilities for living income benefit riders. This revision was consistent with unlocking for deferred policy acquisition costs and deferred sales inducements. The impact decreased interest sensitive and index product benefits by $1.8 million and $2.2 million and increased net income by $1.1 million and $1.4 million for the years ended December 31, 2013 and 2012, respectively.
Operating income, a non-GAAP financial measure (see reconciliation to net income in Item 6. Selected Consolidated Financial Data) increased 48% to $163.4 million in 2013 and decreased 18% to $110.2 million in 2012 from $133.7 million in 2011.
Operating income is not a substitute for net income determined in accordance with GAAP. The adjustments made to derive 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 experience 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.
Premiums and other considerations decreased 41% to $45.3 million in 2013 and 36% to $76.7 million in 2012 from $118.9 million in 2011. These revenues are comprised of life insurance premiums and premiums from life contingent single premium immediate annuities including life contingent supplemental contracts issued upon annuitization of deferred annuities. Life insurance premiums have remained consistent throughout the periods presented while premiums from life contingent single premium immediate annuities ($34.8 million, $63.8 million and $106.8 million in 2013, 2012 and 2011, respectively) have decreased over the periods because we have adjusted the rates offered on these products to be less competitive in the low interest rate environment.
Change in fair value of derivatives consists primarily of call options purchased to fund annual index credits on fixed index annuities, the 2015 notes hedges and 2015 warrants related to our 2015 notes and an interest rate swap and interest rate caps that hedge our floating rate subordinated debentures. The components of change in fair value of derivatives are as follows:
Insurance policy benefits and changes in future policy benefits decreased 35% to $53.1 million in 2013 and 29% to $81.5 million in 2012 from $115.3 million in 2011. 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 ($46.1 million, $73.4 million and $107.4 million in 2013, 2012 and 2011, respectively) have decreased over the periods primarily because the related premiums have decreased as discussed above under Premiums and other considerations.
The amount of 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 $910.4 million, $447.2 million and $454.2 million for the years ended December 31, 2013, 2012 and 2011, respectively. The decrease in interest credited for 2013 was due to a decrease in the average rate credited to the annuity liabilities outstanding receiving a fixed rate of interest. The increase in interest credited for 2012 was due to an increase in the average amount of 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 14% to $29.5 billion in 2013 and 16% to $26.0 billion in 2012 from $22.4 billion in 2011. 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.
Amortization of deferred sales inducements increased 190% to $253.1 million in 2013 and 21% to $87.2 million in 2012 from $71.8 million in 2011. 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 97%, 97% and 95% of our total net annuity deposits during 2013, 2012 and 2011, 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, in 2013 and 2012, 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 policy acquisition costs for the years ended December 31, 2013, 2012 and 2011. See Critical Accounting Policies-Deferred Policy Acquisition Costs and Deferred Sales Inducements.
Other operating costs and expenses decreased 4% to $91.9 million in 2013 and increased 41% to $95.5 million in 2012 from $67.6 million in 2011. The decrease in 2013 is due to a decrease in litigation expense of $16.5 million 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 increase in 2012 includes the $17.5 million estimated litigation liability that was recorded in the third quarter of 2012. Other operating expenses also increased $9.1 million during 2012 due to a change in accounting which we adopted prospectively effective January 1, 2012 for the types of costs that may be capitalized as acquisition costs of new and renewal insurance contracts (see Note 1 to our audited consolidated financial statements).
In 2013, other operating costs and expenses net of changes in litigation liabilities and guaranty fund assessments are primarily affected by increases in salaries and benefits, increased risk charges for our financing reinsurance agreement with Hannover (2013 Hannover Transaction) as well as the fluctuation in legal expense for the cost of defense of on-going litigation. Other operating costs and expenses excluding litigation expense and guaranty fund assessments discussed previously increased 7% to $82.4 million in 2013 from $77.1 million in 2012.
In 2012, other operating costs and expenses net of litigation settlements and the change in accounting were primarily affected by increases in salaries and benefits, marketing expenses and general operating expenses due to the growth of our business as well as the fluctuation in legal expense for the cost of defense of on-going litigation. Other operating costs and expense excluding the litigations settlement and the change in accounting discussed previously increased 2% to 68.9 million in 2012 from $67.5 million in 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 resulted in our excess cash position during 2011, 2012 and the first nine months of 2013. These calls resulted from the low interest rate and tight agency spread environment. Since 2007, when we had almost 80% of our fixed maturity portfolio invested in callable agencies, we have reallocated a significant portion of our fixed maturities from the callable agency securities to other highly rated, long-term securities. The largest portion of our fixed maturity securities are now in investment grade (NAIC designation 1 or 2) publicly traded or privately placed corporate securities. We have also built a portfolio of residential mortgage backed securities ("RMBS") that provide our investment portfolio a source of regular cash flow and higher yielding assets than our agency securities. In addition, we have acquired a portfolio of taxable bonds issued by municipalities, states and territories of the United States that provide us with attractive yields while being consistent with our credit risk parameters. Beginning in 2012, we have increased our position in other asset backed securities as well as establishing a position in commercial mortgage backed securities ("CMBS").
For most of the bonds held in our portfolio the NAIC designation matches the NRSRO equivalent rating. However, for certain loan-backed and structured securities, as defined by the NAIC, the NAIC rating is not always equivalent to the NRSRO rating presented in the previous table. The NAIC has adopted revised rating methodologies for certain loan-backed and structured securities comprised of non-agency RMBS and CMBS. The NAIC’s objective with the revised rating methodologies for these structured securities is to increase the accuracy in assessing expected losses and use the improved assessment to determine a more appropriate capital requirement for such structured securities. The revised methodologies reduce regulatory reliance on rating agencies and allow for greater regulatory input into the assumptions used to estimate expected losses from structured securities.
The amortized cost and fair value of fixed maturity securities at December 31, 2013, 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 increased $777.5 million from $83.9 million at December 31, 2012 to $861.4 million at December 31, 2013. The increase in unrealized losses was primarily due to an increase in interest rates during 2013.
Four of the securities, including the investment grade security, 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, 2013 is as follows:
Finance: The decline in value of this security which is rated investment grade 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 three years and the ongoing events in the Eurozone. While this issuer has had its financial position and profitability weakened by the credit and liquidity crisis, we have determined that this security was not other than temporarily impaired due to our evaluation of the operating performance and the credit worthiness of the issuer.
We do not intend to sell these securities and it is more likely than not we will not have to sell these securities before recovery of their amortized cost and, as such, there were no other than temporary impairments on these securities at December 31, 2013.
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, 2013 and 2012, the largest principal amount outstanding for any single mortgage loan was $14.6 million and $15.0 million, respectively, and the average loan size was $2.5 million for 2013 and $2.4 million for 2012. We have the contractual ability to pursue full personal recourse on 9.7% of the loans and partial personal recourse on 26.7% of the loans. In addition, the average loan to value ratio for the overall portfolio was 54.3% and 53.5% at December 31, 2013 and 2012, 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, 2013, we had commitments to fund commercial mortgage loans totaling $79.6 million, with fixed interest rates ranging from 4.50% to 5.09%. During 2013 and 2012, 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, 2013, we received $441.7 million in cash for loans being paid in full compared to $439.7 million for the year ended December 31, 2012. 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.
We increased the specific allowance for loan losses by $7.5 million on thirteen mortgage loans with outstanding principal due totaling $32.7 million, by $15.0 million on 23 mortgage loans with outstanding principal due totaling $67.2 million, and by $24.5 million on 32 mortgage loans with outstanding principal due totaling $99.4 million during the years ended December 31, 2013, 2012 and 2011, respectively.
Our liability for policy benefit reserves increased to $35.8 billion at December 31, 2013 compared to $31.8 billion at December 31, 2012, 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.
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, 2013, approximately 95% of our annuity liabilities were subject to penalty upon surrender, with a weighted average remaining surrender charge period of 9.6 years and a weighted average surrender charge percentage of 15.1%.
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 $2.4 billion for the year ended December 31, 2013 compared to $2.2 billion for the year ended December 31, 2012 with the increase primarily attributable to a $399.2 million increase in net annuity deposits after coinsurance and a $188.7 million (after coinsurance) increase in funds returned to policyholders. 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. As reported above under Financial Condition-Investments, during 2012 and 2011 we experienced a significant amount of calls of United States Government sponsored agency securities. As a result we had elevated levels of short-term investments and cash and cash equivalents during 2012 and 2011 and into the third quarter of 2013. At December 31, 2013, 31% of our fixed income securities have call features, of which 0.5% ($0.1 billion) were subject to call redemption. Another 5% ($1.2 billion) will become subject to call redemption during 2014.
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 2014.
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, 2013, 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.
The transfer of funds by American Equity Life is also restricted by a covenant in our line of credit agreement which requires American Equity Life to maintain a minimum risk-based capital ratio of 275% and a minimum level of statutory surplus equal to the sum of 1) 80% of statutory surplus at September 30, 2013, 2) 50% of the statutory net income for each fiscal quarter ending after December 31, 2013, and 3) 50% of all capital contributed to American Equity Life after September 30, 2013. American Equity Life's risk-based capital ratio was 344% at December 31, 2013. Under this agreement we are also required to maintain a maximum ratio of adjusted debt to total adjusted capital of 0.35.
Inflation does not have a significant effect on our consolidated balance sheet. We have minimal investments in property, equipment or inventories. To the extent that interest rates may change to reflect inflation or inflation expectations, there would be an effect on our balance sheet and operations. Higher interest rates and widening spreads experienced in 2013 have decreased the value of our fixed maturity investments. It is likely that lower interest rates and tighter spreads would have the opposite effect. It is not possible to calculate the effect such changes in interest rates, if any, have had on our operating results.
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 of inputs used in determining fair value. The hierarchy defines the highest priority inputs (Level 1) as quoted prices in active markets for identical assets or liabilities. 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. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, a financial instrument's level within the fair value hierarchy is based on the lowest level of input that is significant to
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, 2013 and 2012, respectively:
We utilize the models from a leading structured product software specialist serving institutional investors. These models incorporate each security's seniority and cash flow structure. In circumstances where the analysis implies a potential for principal loss at some point in the future, we use our "best estimate" cash flow projection discounted at the security's effective yield at acquisition to determine the amount of our potential credit loss associated with this security. The discounted expected future cash flows equates to our expected recovery value. Any shortfall of the expected recovery when compared to the amortized cost of the security will be recorded as the credit loss component of the other than temporary impairment.
In addition, for debt securities which we do not intend to sell and it is not more likely than not we will be required to sell, but our intent changes due to changes or events that could not have been reasonably anticipated, an other than temporary impairment charge is recognized. Once an impairment charge has been recorded, we then continue to review the other than temporarily impaired securities for appropriate valuation on an ongoing basis. Unrealized losses may be recognized in future periods through a charge to earnings, should we later conclude that the decline in fair value below amortized cost is other than temporary pursuant to our accounting policy described above. The use of different methodologies and assumptions to determine the fair value of investments and the timing and amount of impairments may have a material effect on the amounts presented in our audited consolidated financial statements.
We evaluate our mortgage loan portfolio for the establishment of a loan loss reserve by specific identification of impaired loans and the measurement of an estimated loss for each individual loan identified. A mortgage loan is impaired when it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. If we determine that the value of any specific mortgage loan is impaired, the carrying amount of the mortgage loan will be reduced to its fair value, based upon the present value of expected future cash flows from the loan discounted at the loan's effective interest rate, or the fair value of the underlying collateral less estimated costs to sell. In addition, we analyze the mortgage loan portfolio for the need of a general loan allowance for probable losses on all other loans. The amount of the general loan allowance is based upon management's evaluation of the collectability of the loan portfolio, historical loss experience, delinquencies, credit concentrations, underwriting standards and national and local economic conditions.