(a)Book value per share is calculated as total stockholders' equity less the liquidation preference of our series preferred stock divided by the total number of shares of common stock outstanding. Shares outstanding include shares held by rabbi trusts and exclude unallocated shares held by our employee stock ownership plan-see note 10 to our audited consolidated financial statements.
(b)We define return on equity as net income divided by average total stockholders' equity. Average total stockholders' equity is determined based upon the total stockholders' equity at the beginning and the end of the year. The computations of average stockholders' equity for 2005 and 2003 have been calculated on a weighted average basis to recognize the significant increases in stockholders' equity that resulted from the receipt of the net proceeds from our public offerings of common stock in December 2005 and 2003. Page 25 of 53
•our intent and ability to retain the investment for a period of time sufficient to allow for recovery;
At December 31, 2007 and 2006, the amortized cost and estimated fair value of fixed maturity securities and equity securities that were in an unrealized loss position were as follows:
The amortized cost and estimated fair value of fixed maturity securities at December 31, 2007 and 2006, 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.
The following is a description of the factors causing the unrealized losses by investment category as of December 31, 2007:
Corporate securities, public utilities, and redeemable preferred stocks: The unrealized losses in finance, insurance and real estate are due to a decline in the housing market and issues related to subprime mortgages. Securities that have significant exposure to subprime mortgages are experiencing larger price declines than other financial related securities. Securities that have more exposure to subprime include investment banks, mono-line insurers and reinsurance companies. Manufacturing, construction and mining is also suffering from the current distressed environment in the housing market related to issues surrounding subprime mortgages.
and asset-backed securities are primarily due to changes in interest rates and spread widening. While we do not have any exposure to subprime mortgage-backed securities, the subprime problem has caused spreads to widen across the mortgage-backed securities market.
Where the decline in market value is attributable to changes in market interest rates and not credit quality, we do not consider these investments to be other than temporarily impaired because we have the intent and ability to hold these investments until a recovery of amortized cost, which may be maturity. We do not consider securities to be other than temporarily impaired where the market decline is attributable to factors such as market volatility, liquidity, spread widening and credit quality where we anticipate a recovery of all amounts due under the contractual terms of the security and have the intent and ability to hold until recovery or maturity.
This reinsurance company announced a majority sale of the company in March 2007 and received a significant capital infusion. In August 2007, this company announced that subprime asset-backed securities represented 28% of its total investment portfolio. We have determined that an other than temporary impairment was not necessary as the company's capitalization and liquidity have significantly improved due to the capital infusion and the exposure to subprime asset-backed securities have limited loss exposure as they are mainly higher rated tranches.
This home builder has implemented several initiatives to respond to the current imbalance in housing supply and demand such as reductions in direct costs, overhead expenses and acquisition of land along with a focus on sales and marketing efforts to reduce unsold home inventory. We have determined an other than temporary impairment was not necessary as the company's liquidity has improved and unsold home inventory has decreased.
The mortgage-backed security consists of a pool of loans originated through the Federal Housing Authority ("FHA") and Department of Veteran Affairs ("VA"). The FHA insurance and VA guarantees cover a significant percent of any losses incurred as a result of borrower defaults which enhances the credit levels for this pool of loans comparable to prime-quality residential mortgage-backed securities. We have determined that an other than temporary impairment was not necessary as current credit support by the FHA and VA is adequate to sustain projected losses.
During 2006, we wrote down two securities in the automotive industry by $1.3 million due to deterioration in the issuer's operations and several downgrades of the issuer's credit rating. These securities were sold in 2006 subsequent to the write down at approximately their cost basis. During 2005, we wrote down the common stock of this issuer by $0.6 million based upon our assessment that this security would remain in an unrealized loss position for a significant period of time. We sold this security in 2006 at its cost basis.
During 2005, a security backed by the senior notes of a media company declined in value following an announcement of a change in future business strategy and the potential for share buybacks. We wrote this security down by $0.4 million during 2005 and sold it during 2006 at its cost basis.
During 2005, we sold two asset-backed securities backed by installment sales contracts secured by manufactured homes and liens on real estate concurrent with our decision to write down these securities due to continuing increases in the default rates and deterioration of the underlying collateral. The write down/realized loss on these securities was $2.7 million for the year ended December 31, 2005. We had previously written down these securities by $11.3 million during 2004 and $6.9 million during 2003 due to increases in default rates, deterioration of the underlying collateral and credit rating downgrades.
In making the decisions to write down the securities described above, we considered whether the factors leading to those write downs impacted any other securities held in our portfolio. In cases where we determined that a decline in value was related to an industry-wide concern, we considered the impact of such concern on all securities we held within that industry classification. For each of the securities discussed above that were sold at a loss, there were changes or events that could not have been reasonably anticipated resulting in a decline in credit quality which occurred shortly before the sale. This led to the decision to sell the securities at a loss concurrent with the decision that an additional impairment charge was required. Accordingly, in all cases, this did not contradict our previous assertion that we had the ability and intent to hold the securities until recovery in value.
We purchase one-year call options on the applicable indices as an investment to provide the income needed to fund the annual index credits on the index products. New one-year options are purchased at the outset of each contract year. We purchase call options weekly and daily based upon new and renewing index account values during the applicable week or day, and the purchases are made by category according to the particular products and indices applicable to the new or renewing account values. Any proceeds received at the expiration of the one-year option term fund the related index credits to the policyholders. If there is no gain in an index, the policyholder receives a zero index credit on the policy, and we incur no costs beyond the option cost, except in cases where the minimum guaranteed value of a contract exceeds its index value.
Under SFAS 133, all of our derivative instruments associated with our index products, including certain derivative instruments embedded in the index annuity contracts, are recognized in the balance sheet at their fair values and changes in fair value are recognized immediately in earnings. This impacts certain revenues and expenses we report for our index business as follows:
•Under SFAS 133, 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 index annuities are equal to the sum of the "host" (or guaranteed) component and the embedded derivative component for each 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. 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. Increases or decreases in
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 index annuities are expected to be in force, which typically exceeds 10 years.
Costs relating to the production of new business are not expensed when incurred but instead are capitalized as deferred policy acquisition costs or deferred sales inducements. Only costs which are expected to be recovered from future policy revenues and gross profits may be deferred. Deferred policy acquisition costs consist principally of commissions and certain costs of policy issuance. Deferred sales inducements consist of first-year premium and interest bonuses credited to policyholder account balances.
Deferred policy acquisition costs and deferred sales inducements totaled $1.9 billion and $1.5 billion at December 31, 2007 and 2006, respectively. For annuity products, these costs are being amortized generally in proportion to expected gross profits from investments and, to a lesser extent, from surrender charges. Current and future period gross profits/margins for 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.
As of December 31, 2007 and 2006, we had $75.8 million and $73.8 million, respectively, of net deferred income tax assets. The realization of these assets is primarily based upon estimates of future taxable income, which requires management judgment. The realization of deferred income tax assets related to unrealized losses on available for sale fixed maturity and equity securities is also based upon management's intent to hold these securities for a period of time sufficient to allow for a recovery in fair value and not realize the unrealized loss. Based upon expectations of future taxable income, and considering all other available evidence, management believes the realization of these assets is more likely than not and we have not recorded a valuation allowance against these assets.
Results of Operations for the Three Years Ended December 31, 2007
Annuity deposits by product type collected during 2007, 2006 and 2005, were as follows:
Net annuity deposits after coinsurance increased 15% during 2007 compared to 2006, and decreased 35% during 2006 compared to 2005. We attribute the increase in 2007 to the reinstatement of our A.M. Best Company financial strength rating to A- (Excellent) from B++ (Very Good) on August 3, 2006, certain product initiatives and agent incentives introduced in 2007 and more rational pricing from certain competitors. We attribute the decrease in 2006 to the flat to inverted yield curve interest rate environment that existed throughout the year which made fixed income alternatives such as certificates of deposit more attractive, the impact of FINRA's notice to members on the sale of index annuities which has created confusion and impediments to sales of index annuities by annuity sales agents who are dual licensed to sell both insurance and securities products and highly competitive pricing from certain competitors.
Annuity product charges (surrender charges assessed against policy withdrawals) increased 16% to $45.8 million in 2007, and 54% to $39.5 million in 2006, from $25.7 million in 2005. These increases were principally due to increases in policy withdrawals subject to surrender charges due to growth in the volume and aging of the business in force. The increase for 2006 was also due in part to the flat to inverted yield curve interest rate environment that existed throughout the year. Withdrawals from annuity and single premium universal life policies subject to surrender charges were $325.5 million, $270.3 million and $179.3 million for 2007, 2006 and 2005, respectively. The average surrender charge collected on withdrawals subject to a surrender charge was 14.0%, 14.5% and 14.2% for 2007, 2006 and 2005, respectively.
business and corresponding increases in our invested assets, offset by decreases in the average yield earned on investments. Average invested assets excluding derivative instruments (on an amortized cost basis) increased 13% to $12.5 billion at December 31, 2007 and 31% to $11.1 billion at December 31, 2006 compared to $10.5 billion at December 31, 2005, while the average yield earned on average invested assets was 6.11%, 6.14% and 6.18% for 2007, 2006 and 2005, respectively. The declines in the yield earned on average invested assets are attributable to an overall decline in yield on the mix of assets owned in the respective periods. See Quantitative and Qualitative Disclosures About Market Risk.
Actual amounts credited to policyholder account balances may be less than the index appreciation due to contractual features in the index annuity policies (participation rates, caps 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 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. The increases in market volatility experienced during 2007 have resulted in increased option costs. We have partially mitigated these increases through adjustments to participation rates, caps and asset fees. See Critical Accounting Policies-Derivative Instruments-Index Products.
The changes 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 strategies. Total proceeds received upon expiration or gains recognized upon early termination of the call options purchased to fund the annual index credits were $392.1 million, $214.3 million and $88.6 million for the years ended December 31, 2007, 2006 and 2005, respectively. The decreases in interest credited were due to reductions in the account balances receiving a fixed rate of interest and decreases in interest crediting rates on several of our products. A significant factor in the reductions in interest credited on fixed rate annuities is the reduced interest on multi-year rate guarantee annuities. A significant amount of these annuities were sold in 2001 with an initial rate guaranteed for the first five policy years. We experienced surrenders of these policies upon expiration of this initial guaranteed interest during 2006 and reduced the crediting rates on those policies that remained in force. The average amount of annuity liabilities outstanding (net of annuity liabilities ceded under coinsurance agreements) increased 12% to $11.9 billion in 2007 and 19% to $10.6 billion in 2006 from $8.9 billion in 2005.
Interest expense on notes payable decreased 20% to $16.2 million in 2007 and increased 25% to $20.4 million in 2006 from $16.3 million in 2005. These changes were primarily due to a decrease in the amortization of the discount on our contingent convertible senior notes to $1.1 million in 2007 and an increase to $4.7 million in 2006 from $0.6 million in 2005. This discount was created in the fourth quarter of 2005 when the conversion option embedded in our contingent convertible senior notes was bifurcated from the host instrument, and adjusted when the derivative was unbifurcated from the host instrument on June 8, 2006. See note 7 to our audited consolidated financial statements.
Interest expense on subordinated debentures increased 5% to $22.5 million in 2007 and 51% to $21.4 million in 2006 from $14.1 million in 2005. These increases were primarily due to the issuance of additional subordinated debentures of $41.2 million and $56.7 million during 2006 and 2005, respectively. The increase for 2006 was also due to an increases in the weighted average interest rate on the outstanding subordinated debentures which were 8.32%, 8.35% and 7.38% for 2007, 2006 and 2005, respectively. The weighted average interest rates for 2007 and 2006 have increased from 2005 because substantially all of the subordinated debentures issued during 2004 - 2006 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 52% to $15.9 million in 2007 and increased 192% to $32.9 million in 2006 from $11.3 million in 2005. The decrease in 2007 was principally due to a decrease in the borrowings outstanding, offset by changes in the weighted average interest rates on amounts borrowed. The increase in 2006 was principally due to an increase in the borrowings outstanding and in the weighted average interest rates on amounts borrowed. Average borrowings outstanding were $301.9 million, $628.0 million and $318.8 million during 2007, 2006 and 2005, respectively and weighted average interest rates were 5.27%, 5.24% and 3.54% for 2007, 2006 and 2005, respectively.
Amortization of deferred policy acquisition costs decreased 41% to $56.3 million in 2007 and increased 39% to $94.9 million in 2006 from $68.1 million in 2005. In general, amortization has been increasing each year due to the growth in our annuity business and the deferral of policy acquisition costs incurred with respect to sales of annuity products. The anticipated increase in amortization from these factors has been affected by amortization associated with the application of SFAS 133 to our index annuity business. As discussed above, the application of SFAS 133 to our index annuity business creates differences in the recognition of revenues and expenses from derivative instruments including the embedded derivative liabilities in our index annuity contracts. The gross profit adjustments resulting from the application of SFAS 133 to our index annuity business decreased amortization by $52.3 million, $6.7 million, and $9.1 million in 2007, 2006 and 2005, respectively. Excluding these amounts, amortization of deferred policy acquisition costs would have been $108.6 million, $101.6 million and $77.2 million for 2007, 2006 and 2005, respectively. The comparisons between years are also affected by amortization associated with realized gains (losses) on investments. The gross profit adjustments from net realized gains (losses) on investments decreased amortization by $0.9 million and $2.7 million in 2007 and 2005, respectively, and increased amortization by $0.5 million in 2006.
Our investment strategy is to maintain a predominantly investment grade fixed income portfolio, provide adequate liquidity to meet our cash obligations to policyholders and others and maximize current income and total investment return through active investment management. Consistent with this strategy, our investments principally consist of fixed maturity securities and short-term investments.
We have classified a portion of our fixed maturity investments as available for sale. Available for sale securities are reported at fair value and unrealized gains and losses, if any, on these securities (net of income taxes and certain adjustments for changes in amortization of deferred policy acquisition costs and deferred sales inducements) are included directly in a separate component of stockholders' equity, thereby exposing stockholders' equity to volatility due to changes in market interest rates and the accompanying changes in the reported value of securities classified as available for sale, with stockholders' equity increasing as interest rates decline and, conversely, decreasing as interest rates rise.
The carrying value of investments increased to $12.6 billion at December 31, 2007 compared to $11.4 billion at December 31, 2006 as a result of the growth in our annuity business discussed above. At December 31, 2007, the fair value of our available for sale fixed maturity and equity securities was $129.2 million less than the amortized cost of those investments, compared to $120.6 million at December 31, 2006. At December 31, 2007, the amortized cost of our fixed maturity securities held for investment exceeded the fair value by $142.9 million, compared to $256.9 million at December 31, 2006. The decrease in net unrealized investment losses at December 31, 2007 compared to December 31, 2006 was principally related to a decrease in the general level of interest rates.
Our liability for policy benefit reserves increased to $14.7 billion at December 31, 2007 compared to $13.2 billion at December 31, 2006, 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. In accordance with FIN 46, 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 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.
American Equity Capital Trust I issued 865,671 shares of trust preferred securities, of which 2,000 shares are held by one of our subsidiaries. During 2007, 2006 and 2005, 9,333 shares, 14,000 shares and 5,667 shares of these trust preferred securities converted into 34,567 shares, 51,849 shares and 20,988 shares, respectively, of our common stock. The remaining 746,671 shares of these trust preferred securities not held by a subsidiary are convertible into 2,765,390 shares of our common stock.
American Equity Capital Trust II issued $97.0 million (97,000 shares) of 5% trust preferred securities and we issued $100 million of our 5% subordinated debentures. The consideration received by American Equity Capital Trust II in connection with the issue of its trust preferred securities consisted of fixed income trust preferred securities of equal value issued by Farm Bureau Life Insurance Company.
During the fourth quarter of 2006, we entered into four interest rate swaps to manage interest rate risk associated with the floating rate component on certain of our subordinated debentures. The terms of the interest rate swaps provide that we pay a fixed rate of interest and receive a floating rate of interest on a notional amount totaling $80.0 million. The interest rate swaps are not effective hedges under SFAS 133. 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 income.
During the fourth quarter of 2006, we entered into a $150 million revolving line of credit with eight banks. The amount outstanding under this revolving line of credit at December 31, 2007 was $5.0 million. See note 7 to our audited consolidated financial statements for additional details concerning the terms of the revolving line of credit.
During 2007, we purchased 299,552 shares of our common stock under a share repurchase program approved by our board of directors in November 2007. Under the program, we are authorized to repurchase up to 10,000,000 shares of our common stock.
During 2006 and 2005, we issued 19,500 shares of our common stock in each year to an agent's beneficiaries in settlement of the agent's deferred compensation arrangement.
During 2005, certain officers and directors exercised subscription rights to purchase shares of our common stock with respect to 2,151,375 shares. The subscription rights had an exercise price of $5.33 per share and the tax benefit realized for the tax deduction from the exercise of the subscription rights was $4.7 million.
On December 20, 2005, we completed an offering of 13,000,000 shares of our common stock at a price of $11.60 per share. Pursuant to the over-allotment option granted to the underwriters in this offering, the underwriters purchased an additional 1,950,000 shares on December 30, 2005. The proceeds from this offering (including proceeds from shares issued pursuant to the over-allotment option), net of the underwriting discount and expenses, were approximately $163.5 million.
The payment of dividends or distributions, including surplus note payments, by our life subsidiaries is subject to regulation by each subsidiary's state of domicile's insurance department. Currently, American Equity Life may pay dividends or make other distributions without the prior approval of its state of domicile's insurance department, unless such payments, together with all other such payments within the preceding twelve months, exceed the greater of (1) American Equity Life's net gain from operations for the preceding calendar year, or (2) 10% of American Equity Life's statutory capital and surplus at the preceding December 31. For 2008, up to approximately $99.1 million can be distributed as dividends by American Equity Life without prior approval of the Iowa Insurance Division. In addition, dividends and surplus note payments may be made only out of statutory earned surplus, and all surplus note payments are subject to prior approval by regulatory authorities in the life subsidiary's state of domicile. American Equity Life had approximately $159.6 million of statutory earned surplus at December 31, 2007.
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 200%. American Equity Life's risk-based capital ratio was 426% at December 31, 2007.
Statutory accounting practices prescribed or permitted for our life subsidiaries differ in many respects from those governing the preparation of financial statements under GAAP. Accordingly, statutory operating results and statutory capital and surplus may differ substantially from amounts reported in the GAAP basis financial statements for comparable items. Information as to statutory capital and surplus and statutory net income for our life subsidiaries as of December 31, 2007 and 2006 and for the years ended December 31, 2007, 2006 and 2005 is included in note 11 to our audited consolidated financial statements.
(2)Amount shown is net of equity investments in the capital trusts due to the contractual right of offset upon repayment of the notes. New Accounting Pronouncements
fair value on a recurring basis in periods subsequent to initial recognition, the reporting entity shall disclose information that enables financial statement users to assess the inputs used to develop those measurements. For recurring fair value measurements using significant unobservable inputs, the reporting entity shall disclose the effect of the measurements on earnings for the period. SFAS 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. SFAS 157 is effective beginning on January 1, 2008. We are continuing to evaluate SFAS 157 but do not believe it will have a material impact on our consolidated financial statements.