market rate. We also lease space for our office in Pell City, Alabama, pursuant to a written lease dated January 3, 2000, for approximately 3,380 square feet. This lease expires on December 31, 2004.
(c)Our GAAP net income and statutory net loss in 2001, were affected by a decision to maintain a significant liquid investment position after the September 11, 2001 terrorist attacks. See "Management's Discussion and Analysis of Financial Condition and Results of Operations-Results of Operations."
(d)Book value per share is calculated as total stockholders' equity less the liquidation preference of our series preferred stock dividend by the total number of shares of common stock outstanding.
significant increase in stockholders' equity that resulted from the receipt of the net proceeds from our initial public offering in December 2003.
The weighted average crediting rate and investment spread are computed without the impact of first year bonuses paid to policyholders which are deferred as policy acquisition costs and amortized in future periods. See "Critical Accounting Policies-Deferred Policy Acquisition Costs". The weighted average crediting rate and investment spread for multi-year rate guaranteed fixed rate annuities reflect the higher crediting rates on these policies for which the targeted investment spread is lower than the targeted investment spread for annually adjustable fixed rate annuities. With respect to our index annuities, index costs represent the expenses we incur to fund the annual income credits through the purchase of options and minimum guaranteed interest credited on the index business. Gains realized on such options 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.
Our fixed maturity securities (bonds and redeemable preferred stocks maturing more than one year after issuance) and equity securities (common and non-redeemable preferred stocks) classified as available for sale are reported at estimated fair value. Unrealized gains and losses, if any, on these securities are included directly in a separate component of stockholders' equity, net of income taxes and certain adjustments for assumed changes in amortization of deferred policy acquisition costs. Fair values for securities that are actively traded are determined using quoted market prices. For fixed
Our periodic assessment of our ability to recover the amortized cost basis of investments that have materially lower quoted market prices requires a high degree of management judgment and involves uncertainty. Factors considered in evaluating whether a decline in value is other than temporary include:
The amortized cost and estimated fair value of fixed maturity securities at December 31, 2003 and 2002, by contractual maturity, that were in an unrealized loss position are shown below. Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. All of our mortgage-backed and asset-backed securities provide for periodic payments throughout their lives, and are shown below as a separate line.
Approximately 69% and 79% of our total invested assets at December 31, 2003 and 2002, respectively, were in United States Government and agency fixed maturity securities. Mortgage and asset-backed securities including government and non-government issues represented approximately 11% and 4% of our total invested assets at December 31, 2003 and 2002, respectively. Corporate securities represented approximately 7% and 8% of our total invested assets at December 31, 2003 and 2002, respectively. Mortgage loans on real estate represented 10% and 6% of our total invested assets
at December 31, 2003 and 2002, respectively. There are no other significant concentrations in the portfolio by type of security or by industry.
We have reviewed these investments and concluded that there were no other than temporary impairments on these investments at December 31, 2003 and 2002.
Diversified Asset Securities II Class B-1 is a pool of asset-backed securities that entitle the holders thereof to receive payments that depend primarily on the cash flow from a specified pool of financial assets. We determined that an other than temporary impairment charge was not necessary for the following reasons: (i) as of December 31, 2003 the securities still had an investment grade rating by Moody's (Baa3); (ii) the securities were current on all scheduled interest payments and (iii) the securities were also passing applicable asset coverage covenants, which we believed should allow Diversified Asset Securities to continue to make interest payments.
Northwest Airlines Pass Thru Certificates 1999-1 Class C are backed by the general credit of Northwest Airlines as well as the collateral from a pool of airplanes. We determined that an other than temporary impairment charge was not necessary for the following reasons: (i) we believed that a bankruptcy was unlikely since Northwest had begun to see benefits from its attempts to return to profitability; (ii) we believed Northwest had adequate liquidity; (iii) we calculated Northwest to have unrestricted cach at the end of the third quarter of 2003 of approximately $2.8 billion; (iv) even if Northwest declared bankruptcy, these bonds would have remained current for at least 18 months due to a liquidity coverage feature and the bonds could remain current after 18 months if Northwest affirmed the leases on the planes in the collateral pool in the unlikely event of a bankruptcy and (v) based upon the liquidity of Northwest ($2.8 billion at September 30, 2003) and the improving conditions in the airline industry we believe the event of a default is remote.
Each of the six securities on the watch list is current in respect to payments of principal and interest. We have concluded for each of the six securities on the watch list that we have the intent and the ability to hold these securities for a period of time sufficient to allow for a recovery in fair value.
Pegasus Aviation 1999-1A Class C bonds are backed by leases on airplanes. We wrote down this security by $1.9 million to its fair value in the fourth quarter 2001. We determined that while a near term default was unlikely, it was probable that we would not receive a return of the entire principal on this security because of the downturn in the airline industry and significantly lower lease rates on renewing leases.
We owned the Class A3-A Tranche of the Juniper collateralized bond obligation. We wrote down this security by $2.0 million to its fair value in the first quarter of 2002. Due to the structure of payments from the collateralized bond obligation, it was likely that we would continue receiving interest payments for the foreseeable future, but it was unlikely that we would receive our entire principal at maturity. The fair value of this security continued to decline in subsequent months and we sold the bond at an additional loss of $0.5 million in the second quarter of 2003.
Jet Equipment Trust is an asset-backed security backed by collateral from a pool of planes and the general credit of United Airlines. We wrote down this security by $6.4 million in the third quarter of 2002. The downturn in the airline industry and the possibility of United Airlines declaring bankruptcy had caused this security to trade significantly below cost at the time of the original write down. United Airlines declared bankruptcy in the fourth quarter of 2002 and discontinued making lease payments on the planes that support this trust. Due to the fact that any further payments on this security were unlikely, we took an additional write down of $1.6 million in the fourth quarter of 2002 to reduce the book value to zero.
Calpine Canada was sold because it engaged in re-financing activities that threatened its long term profitability and exacerbated its reliance on leverage. The wholesale power market in which it was engaged was expected to be weak.
American Airlines pass thru certificates, which were collateralized by a pool of airplanes, were sold as a result of inadequate collateral coverage in a potential bankruptcy situation and recent changes regarding the airline's bank covenants regarding required minimum unrestricted cash balances.
Qwest was sold as the result of several factors, including its rapidly deteriorating operating environment, the sale of one of its business units for a value well below expectations and continuing government investigations.
Florida Gas Transmission (indirectly related to Enron) had a small unrealized gain at September 30, 2001. It was sold within a month after the security began trading below cost.
Enron was sold within two months after the security was acquired and within one month after the security began trading significantly below cost as a result of publicity regarding accounting abnormalities.
We offer a variety of index annuities with crediting strategies linked to several equity market indices, including the S&P 500, the Dow Jones Industrial Average and the NASDAQ 100. Several of these products also offer a bond strategy linked to the Lehman Aggregate Bond Index or the Lehman U.S. Treasury Bond Index. These products allow policyholders to earn returns linked to equity or bond index appreciation without the risk of loss of their principal. Most of these products allow policyholders to transfer funds once a year among several different crediting strategies, including one or more of the index based strategies and a traditional fixed rate strategy. Substantially all of our index products require annual crediting of interest and an annual reset of the applicable index on the contract anniversary date. The computation of the annual index credit is based upon either a one year point-to-point calculation (i.e., the gain in the applicable index from one anniversary date to the next anniversary date) or a monthly averaging of the index during the contract year.
Under SFAS No. 133, which became effective for us on January 1, 2001, all derivative instruments (including certain derivative instruments embedded in other contracts) are recognized in the balance sheet at their fair values and changes in fair value are recognized immediately in earnings. This impacts the items of revenue and expense we report on our index business in three ways.
•We must mark to market the purchased call options we use to fund the annual index credits on our index annuities based upon quoted market prices from related counterparties. We record the change in fair value of these options as a component of our revenues. Included within the change in fair value of the options is an element reflecting the time value of the options, which initially is their purchase cost declining to zero at the end of their one-year lives. In addition, change in fair value of derivatives also includes gains received at the expiration of the one year option terms and gains or losses upon early termination.
Commissions and certain other costs relating to the production of new business are not expensed when incurred but instead are capitalized as deferred policy acquisition costs. These costs for annuities are amortized into expense with the emergence of gross profits. Only costs which are expected to be recovered from future policy revenues and gross profits may be deferred. These costs consist principally of commissions, first-year premium and interest bonuses and certain costs of policy issuance. Deferred policy acquisition costs totaled $703.7 million and $595.5 million at December 31, 2003 and 2002, respectively. For annuity and single premium universal life products, these costs are being amortized generally in proportion to expected gross profits from investments and, to a lesser extent, from surrender charges and mortality and expense margins. Current period amortization must be adjusted retrospectively if changes occur in estimates of future gross profits/margins (including the impact of realized investment gains and losses). 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.
As of December 31, 2003 and 2002, we had $58.8 million and $50.7 million, respectively, of net deferred income tax assets related principally to book-to-tax temporary differences in the recording of policy benefit reserves and deferred policy acquisition costs. The realization of these assets is based upon estimates of future taxable income, which requires management judgement. Based upon future
Annuity deposits by product type collected in 2003, 2002 and 2001, were as follows:
The reduction in annuity deposits during the year ended December 31, 2003 resulted from actions taken by us during 2003 and the fourth quarter of 2002 to manage our capital position, including reductions in our interest crediting rates on both new and existing annuities, reductions in sales commissions and suspension of sales of one of our higher commission annuity products and our most popular multi-year rate guaranteed annuity product.
Interest credited to account balances increased 37% to $242.5 million in 2003 and 81% to $177.6 million in 2002 from $97.9 million in 2001. These increases were principally attributable to an increase in the average amount of annuity liabilities outstanding (net of annuity liabilities ceded under coinsurance agreements) during 2003 of 25% to $5,882.0 million from $4,693.9 million during 2002 and an increase of 55% from $3,024.0 million during 2001. In addition credits to index policies increased as a result of increases in underlying indices. For the year ended December 31, 2003, the S&P 500 Index (upon which the majority of our options are based) increased by 26.4% compared to a decrease of 23.4% during 2002 and a decrease of 13.0% during 2001. These increases were offset in part by the decrease in weighted average crediting rates, which we implemented in connection with our spread management process, of 67 basis points from December 31, 2002 to December 31, 2003, and 28 basis points from December 31, 2001 to December 31, 2002.
Change in fair value of embedded derivatives was an increase of $66.8 million during the year ended December 31, 2003 compared to a decrease of $5.0 million in 2002 and an increase of $12.9 million in 2001. Under SFAS No. 133, the liabilities on our index annuities are treated as a "series of embedded derivatives" over the life of the applicable contracts. We are required to estimate the fair value of the future index reserve liabilities by valuing the "host" (or guaranteed) component of the liabilities and projecting (i) the expected index credits on the next policy anniversary dates and (ii) the net cost of annual options we will purchase in the future to fund index credits. The change in the amount of expense recognized during 2003, 2002 and 2001 primarily resulted from the increase or decrease in expected index credits on the next policy anniversary dates, which are related to the change in the fair value of the options acquired to fund these index credits discussed above in the "Change in fair value of derivatives". In addition, the host value of the index reserve liabilities increased primarily as a result of increases in index annuity premium deposits. See "Critical Accounting Policies-Derivative Instruments-Index Products" and note 1 to our audited consolidated financial statements.
We have classified a substantial portion of our fixed maturity investments as available for sale. Available for sale securities are reported at market value and unrealized gains and losses, if any, on these securities (net of income taxes and certain adjustments for changes in amortization of deferred
The table below presents our total fixed maturity securities by NAIC designation and the equivalent ratings of a nationally recognized securities rating organization.
We have a credit agreement with Fleet National Bank, U.S. Bank National Association and West Des Moines State Bank. The amount outstanding under this agreement was $31.8 million at December 31, 2003 and $43.3 million at December 31, 2002. Principal and interest under this agreement are paid quarterly. The notes bear interest (3.57% at December 31, 2003) at prime or LIBOR plus a specified margin of up to 2.25%. Under this agreement, we are required to maintain minimum capital and surplus levels at American Equity Life and meet certain other financial and operating ratio requirements. We are also prohibited from incurring other indebtedness for borrowed money without obtaining a waiver from the lenders and from paying dividends on our capital stock in excess of 25% of our consolidated net income for the prior fiscal year. On August 14, 2003, we amended our credit agreement to provide that the financial strength ratings for American Equity Life issued by A.M. Best and Standard & Poor's may not be less than the current financial strength ratings of B++ and BBB+, respectively. On October 24, 2003, we amended our credit agreement to provide that we (and not our subsidiaries) must own cash equivalents (as defined in the credit agreement) having a market value of at least $30 million from the time of the consummation of our initial public offering (IPO) through and including the time of payment in full of the installments of the loans under the credit agreement due on June 30, 2004. The amendment also provides that subsequent to the IPO, quarterly principal payments for the quarters ending December 31, 2003 and March 31, 2004 will be deferred until June 30, 2004. On December 31, 2003, we amended our credit agreement to eliminate the requirement to hold cash equivalents of at least $30 million after the consumation of our IPO. See note 7 to our audited consolidated financial statements.
We were initially capitalized in December, 1995 and January, 1996 through the issuance of shares of common stock for cash. Subsequent to our initial capitalization, we issued additional shares of common stock, warrants to purchase shares of common stock and shares of preferred stock convertible into shares of common stock in several private placement offerings.
During 1998, we issued 625,000 shares of 1998 Series A Participating Preferred Stock. These shares have participating dividend rights with the shares of common stock, when and as such dividends are declared, are convertible into 1,875,000 shares of common stock, are non-voting and have an aggregate liquidation preference of $10.0 million.
During 1999, two subsidiary trusts issued preferred securities in private placement offerings. The trusts 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 net proceeds to the parent company from the issuance of its subordinated debentures to the subsidiary trusts were used to fund capital contributions to American Equity Life.
American Equity Capital Trust II ("Trust II") issued $97.0 million (97,000 shares) of 5% trust preferred securities and we issued $100.0 million principal amount of our 5% subordinated debentures due June 1, 2047 to Trust II. The consideration received by Trust II in connection with the issuance of its preferred securities consisted of fixed income trust preferred securities of equal value issued by the parent company of Farm Bureau.
The terms of the preferred securities issued by Trust I, Trust II and Trust IV 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. See note 9 to our audited consolidated financial statements for additional information concerning our subordinated debentures payable to and the preferred securities issued by the subsidiary trusts.
During 2003, we purchased 1,435,500 shares of our common stock at a total cost of $9.3 million ($6.49 per share). We issued these shares and 155,583 shares held as treasury stock to a rabbi trust established for the benefit of agents who have earned shares of our common stock under the American Equity Investment NMO Deferred Compensation Plan. See note 10 to our audited consolidated financial statements.
On December 9, 2003, we completed an initial public offering of 18,700,000 shares of our common stock at a price of $9.00 per share. Pursuant to the over-allotment option granted to the underwriters in this offering, the underwriters purchased an additional 2,000,000 shares on December 29, 2003 and an additional 805,000 shares on January 7, 2004, which fully exercised the over-allotment option. The proceeds from our initial public offering (including proceeds from shares issued pursuant to the over-allotment option), net of the underwriting discount and expenses, were approximately $178.0 million, of which $125.0 million was contributed to American Equity Life to fund the future growth of our business.
liabilities were subject to penalty upon surrender, with a weighted average remaining surrender charge period of 8.4 years and 8.7 years, respectively, and a weighted average surrender charge rate of 12%.
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 subordinated debentures issued to subsidiary trusts, pay operating expenses and pay dividends to stockholders. The primary sources of funds for these payments are: (i) principal and interest payments received on our note receivable from American Equity Investment Service Company (see discussion that follows); (ii) dividends on capital stock and surplus note interest payments from American Equity Life; and (iii) investment advisory fees from our life subsidiaries. These sources provide adequate cash flow to us to meet our current and reasonably foreseeable future obligations. We may also obtain cash by issuing debt or equity securities.
American Equity Life has entered into a general agency commission and servicing agreement with American Equity Investment Service Company, or the Service Company, an affiliated company wholly-owned by our chairman, chief executive officer, president and treasurer, whereby the affiliate acts as a national supervisory agent with responsibility for paying commissions to our agents. This agreement initially benefits American Equity Life's statutory surplus by extending the payment of a portion of the first year commissions on new annuity business written by American Equity Life over a longer period of time, and thereby enabling American Equity Life to conduct a comparatively greater volume of business. In subsequent periods, American Equity Life's statutory surplus is reduced through the payment of renewal commissions to the affiliate on this business based upon the account balances of the annuities remaining in force for a period of five years (see note 8 to our audited consolidated financial statements). During the years ended December 31, 2003 and 2002, the Service Company paid $14.4 million and $11.8 million, respectively, to agents of American Equity Life. The Service Company made no payments to the agents of American Equity Life during the year ended December 31, 2001. American Equity Life paid renewal commissions to the Service Company of $22.1 million, $21.7 million and $23.2 million, respectively, during the years ended December 31, 2003, 2002 and 2001.