In addition to net income, we have consistently utilized operating income, operating income per common share and operating income per common share-assuming dilution, non-GAAP financial measures commonly used in the life insurance industry, as economic measures to evaluate our financial performance. Operating income equals net income adjusted to eliminate the impact of net realized gains on investments including net OTTI losses recognized in operations and related deferred tax asset valuation allowance, (gain) loss on extinguishment of convertible debt, fair value changes in derivatives and embedded derivatives, the Lehman counterparty default on expired call options and the net charge to settle a class action lawsuit. Because these items fluctuate from year to year in a manner unrelated to core operations, we believe measures excluding their impact are useful in analyzing operating trends. We believe the combined presentation and evaluation of operating income together with net income, provides information that may enhance an investor's understanding of our underlying results and profitability.
Book value per share and book value per share excluding AOCI is calculated as total stockholders' equity and total stockholders' equity excluding AOCI divided by the total number of shares of common stock outstanding. AOCI fluctuates from year to year due to unrealized changes in the fair value of available for sale investments. Shares outstanding include shares held by the NMO Deferred Compensation Trust and exclude unallocated shares held by our employee stock ownership plan-see note 11 to our audited consolidated financial statements.
changes in the Federal income tax laws and regulations which may affect the relative income tax advantages of our products;
For a detailed discussion of these and other factors that might affect our performance, see Item 1A of this report.
Over the past several years we have steadily grown our invested assets, investment spread and operating income (a non-GAAP financial measurement - see Item 6. Selected Consolidated Financial Data) despite the challenging economic conditions and interest rate environment. Our business model contemplates continued growth in invested assets and operating income while maintaining a high quality investment portfolio that will not experience significant losses from impairments of invested assets. Growth in invested assets is predicated on a continuation of our high sales achievements of the last two years while at the same time maintaining a high level of retention of the funds received. The economic and personal investing environments continue to be conducive for high sales levels as retirees and others look to put their money in instruments that will protect their principal and provide them with consistent cash flow sources in their retirement years. We expect to continue to grow our operating income by maintaining a reliable investment spread of 2.90% or more through effective management of our investment portfolio and the cost of money for our annuity business. We are committed to maintaining a high quality investment portfolio with limited exposure to below investment grade securities and other riskier assets.
We specialize in the sale of individual annuities (primarily deferred annuities) and, to a lesser extent, we also sell life insurance policies. Under U.S. generally accepted accounting principles ("GAAP"), premium collections for deferred annuities are reported as deposit liabilities instead of as revenues. Similarly, cash payments to policyholders are reported as decreases in the liabilities for policyholder account balances and not as expenses. Sources of revenues for products accounted for as deposit liabilities are net investment income, surrender and other charges deducted from the account balances of policyholders, net realized gains (losses) on investments and changes in fair value of derivatives. Components of expenses for products accounted for as deposit liabilities are interest sensitive and index product benefits (primarily interest credited to account balances), changes in fair value of embedded derivatives, amortization of deferred sales inducements and deferred policy acquisition costs, other operating costs and expenses, and income taxes.
As reported in our 2009 filings, we undertook several actions in 2009 to manage our statutory capital position to facilitate growth. These actions included a restructuring of commission payments to agents, an amendment to a reinsurance agreement to expand such agreement to cover certain policy forms that were not in existence when the agreement was executed and the entry into two funds withheld coinsurance agreements to reinsure a portion of our 2009 sales. Under the 2009 coinsurance agreements, we ceded to the reinsurer 20% of annuity deposits received in 2009 and the first quarter of 2010 from our two top selling fixed index annuity products and 80% of the annuity deposits received after June 30, 2009 from a multi-year rate guaranteed fixed annuity product. The agreement to cede 80% of the annuity deposits from the multi-year rate guaranteed fixed annuity product is ongoing. Effective April 1, 2010, we are retaining 100% of our fixed index annuity deposits and are no longer ceding any portion of those annuity deposits to the reinsurer. We believe our existing statutory capital and surplus and the statutory surplus we expect to generate internally through statutory earnings will support a higher level of new business growth than in previous years. However, while we have the capital resources to accept more business than was sold in 2009, our capacity is not unlimited and sales growth must be matched with available resources to maintain desired financial strength ratings from credit rating agencies and in particular, A.M. Best Company. Should sales growth accelerate to levels that cannot be supported by internal capital generation, we would intend to obtain capital from external sources to facilitate such growth. Given the prospects for higher levels of new business in 2011, in February 2011 we entered into a binding letter of intent to complete an additional surplus relief reinsurance transaction on or before March 31, 2011 that will provide an initial pretax statutory surplus benefit of $49.2 million.
Net income decreased 37% to $42.9 million in 2010 and increased 330% to $68.5 million in 2009 from $15.9 million in 2008. Net income for 2008 does not include the impact of applying the FASB guidance for recognition and presentation of other than temporary impairments that was released in April 2009 as discussed below. Net income for 2008 includes the impact of the adoption of fair value measurement accounting standards as discussed below.
Net income has been positively impacted by the growth in the volume of business in force and the investment spread earned on this business. Average annuity account values outstanding increased 18% for the year ended December 31, 2010 compared to 2009 and 14% for the year ended December 31, 2009 compared to 2008. Our investment spread measured on a percentage basis was 3.15%, 3.04% and 2.77% for the years ended December 31, 2010, 2009 and 2008, respectively. The increase in investment spread in 2010 resulted from a lower aggregate cost of money on our fixed index annuities, offset in part, by a smaller decline in the yield on invested assets. The lower cost of money for fixed index annuities during 2010 was due to lower costs of options purchased to fund the annual index credits on fixed index annuities and lower rates for the fixed rate strategy in fixed index annuities. The 2010 decrease in the average yield on invested assets was primarily attributable to a lag in reinvestment of proceeds from bonds called for redemption during the year into new assets resulting in high levels of low yielding short-term investments and interest earning cash and cash equivalents. The 2010 decrease in average yield on invested assets was also effected by lower yields on investments purchased in 2010. The increase in investment spread in 2009 resulted from a higher investment yield earned in 2009 on average assets due to higher yields on investments purchased subsequent to 2007 and a lower aggregate cost of money on our fixed index annuities for 2010 and 2009. The lower cost of money for fixed index annuities during 2009 was due to adjustments we made throughout 2007 to caps, participation rates and asset fees to manage the cost of options purchased to fund the annual index credits. The benefit from these adjustments was not fully recognized until the fourth quarter of 2008.
See note 13 in our audited consolidated financial statements for further discussion of the litigation settlement.
Concurrently with the issuance of the 2015 notes, we entered into hedge transactions (the “2015 notes hedges”) to provide the cash needed to meet our cash obligations in excess of the principal amount of the 2015 notes upon conversion of the 2015 notes. The fair value of the 2015 notes hedges changes based upon changes in the price of our common stock which increased in 2010 subsequent to the date of origination. Similarly, the fair value of the conversion option obligation to the holders of the 2015 notes changes based upon changes in the price of our common stock 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 for the change in fair value of the 2015 notes hedges equals the amount for the change in the related embedded derivative liabilities and there is an offsetting expense in the change in fair value of embedded derivatives. See note 9 to our audited consolidated financial statements for a discussion of the 2015 notes hedges.
Net realized gains on investments, excluding OTTI losses include gains and losses on the sale of securities and impairment losses on mortgage loans on real estate which fluctuate from year to year due to changes in the interest rate and economic environment and the timing of the sale of investments. The components of net realized gains on investments for the years ended December 31, 2010, 2009 and 2008 are set forth in the table that follows:
Net OTTI losses recognized in operations decreased to $23.9 million in 2010 and decreased to $86.8 million in 2009 from $192.6 million in 2008. See Financial Condition-Investments for additional discussion of write downs of securities for other than temporary impairments.
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 options. Total proceeds received upon expiration of the call options purchased to fund the annual index credits were $438.4 million, $70.6 million and $26.2 million for the years ended December 31, 2010, 2009 and 2008, respectively. Proceeds for 2009 and 2008 were adversely affected by the Lehman defaults as discussed above. The increases in interest credited for 2010 and 2009 were 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 18% to $18.1 billion in 2010 and 14% to $15.4 billion in 2009 from $13.5 billion in 2008.
Amortization of deferred sales inducements increased 50% to $59.9 million in 2010 and 30% to $40.0 million in 2009 from $30.7 million in 2008. The 2010 increase includes the $0.3 million impact of unlocking in 2010 and the 2009 decrease includes the $1.3 million impact of unlocking in 2008. See Critical Accounting Policies - Deferred Acquisition Costs and Deferred Sales Inducements. 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%, 94% and 93% of our total annuity deposits during 2010, 2009 and 2008, respectively. The anticipated 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 on investments and net OTTI losses recognized in operations and, in 2010, amortization associated with the litigation settlement.
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 life of the contracts which typically exceeds ten years. The gross profit adjustments resulting from fair value accounting for derivatives and embedded derivatives utilized in our fixed index annuity business increased (decreased) amortization by ($39.2) million, ($29.2) million and $13.9 million in 2010, 2009 and 2008, respectively. The gross profit adjustments from net realized gains on investments and net OTTI losses recognized in operations increased (decreased) amortization by $0.5 million, ($6.8) million and ($35.6) million in 2010, 2009 and 2008, respectively. The gross profit adjustments from the litigation settlement decreased amortization in 2010 by $1.3 million. Excluding the amortization amounts attributable to fair value accounting for derivatives and embedded derivatives, realized gains on investments and net OTTI losses recognized in operations, and the litigation settlement, amortization would have been $99.9 million, $76.0 million and $52.4 million for 2010, 2009 and 2008, respectively. See Critical Accounting Policies - Deferred Policy Acquisition Costs and Deferred Sales Inducements.
in the change in fair value of fixed index annuity embedded derivatives in 2009 were decreases in the discount rates used in estimating our liability for policy growth and increases in the expected index credits which correlated with the increase in the change in fair value of derivatives for 2009 discussed above. The primary reasons for the significant decrease in the change in fair value of fixed index annuity embedded derivatives in 2008 were increases in the discount rates used in estimating our liability for policy growth, a decrease in the expected index credits which correlated with a decrease in the change in fair value of derivatives for 2008 and a decrease in our estimate of the expected future cost of annual call options. The increase in the discount rates to reflect our nonperformance risk upon the adoption of the fair value measurements accounting requirements on January 1, 2008 as discussed previously decreased the fair value of embedded derivatives by $150.6 million and the decrease in the estimate of future option costs decreased the fair value of the embedded derivatives for 2008 by $51.6 million.
Interest expense on notes payable increased 49% to $22.1 million in 2010 and decreased 25% to $14.9 million in 2009 from $19.8 million in 2008. The 2010 increase was primarily due to the December 2009 issuance of an additional $52.2 million of 5.25% convertible senior notes and a higher effective rate of interest on $63.6 million principal amount of 5.25% convertible senior notes that were issued in December 2009 in exchange for the same principal amount of another issue of 5.25% convertible senior notes. The 2010 increase was also due to additional interest associated with the September 2010 issuance of $200 million principal amount of 3.50% convertible senior notes. The decrease in 2009 was primarily attributable to the extinguishment of $78.1 million principal amount of our 2024 notes during 2008 and extinguishment of $37.2 million principal amount of our 2024 notes through the exchange of five million shares of our common stock in the second quarter of 2009. The 2010 increase and 2009 decrease in interest expense on the convertible notes were partially offset by a decrease in 2010 and an increase in 2009 in interest expense on borrowings under our revolving line of credit with banks. The weighted average interest rates were 1.10%, 1.49% and 4.15% and the average borrowings outstanding were $108.5 million, $113.3 million and $35.9 million for the years ended December 31, 2010, 2009 and 2008, respectively. Interest expense on notes payable is expected to increase in 2011 due to the September 2010 issuance of the 2015 notes that carry an effective interest rate of 8.9%. See note 9 to our audited consolidated financial statements.
Amortization of deferred policy acquisition costs increased 55% to $136.4 million in 2010 and decreased 31% to $88.0 million in 2009 from $126.7 million in 2008. The 2010 increase includes the $1.4 million impact of unlocking in 2010 and the 2009 decrease includes the $14.6 million impact of unlocking in 2008. See Critical Accounting Policies - Deferred Acquisition Costs and Deferred Sales Inducements. In general, amortization of deferred policy acquisition costs 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 fair value accounting for derivatives and embedded derivatives utilized in our fixed index annuity business, amortization associated with net realized gains on investments and net OTTI losses recognized in operations and, in 2010, the amortization associated with the litigation settlement.
Income tax expense increased 27% to $22.3 million in 2010 and decreased 71% to $17.6 million in 2009 from $61.1 million in 2008. These changes were primarily related to changes in income before income taxes and the impact of changes in the valuation allowance for deferred income tax assets related to capital loss carryforwards and other than temporary impairments on investment securities. The effective tax rates were 34.2%, 20.5% and 79.3% for 2010, 2009 and 2008, respectively. The effective tax rate for 2010 was less than the applicable statutory federal income tax rate of 35% primarily due to state income tax benefits attributable to losses in the non-life subgroup. The effective tax rate for 2009 was less than the applicable statutory federal income tax rate of 35% primarily due to a decrease in the deferred income tax asset valuation allowance established in 2008 for capital loss carryforwards and other than temporary impairments which decreased income tax expense in 2009 by $11.9 million. This decrease was primarily due to current year taxable income from capital gain sources which resulted from the recognition of net realized gains on available for sale fixed maturity and equity securities that were sold as part of a tax planning strategy to generate capital gains to offset capital losses as discussed above. The effective tax rate for 2008 was more than the applicable statutory federal income tax rate of 35% primarily due to the establishment of a valuation allowance for deferred income tax assets related to capital loss carryforwards and other than temporary impairments on investment securities. See note 8 to our consolidated financial statements.
In November 2010, the NAIC membership approved continuation of a process developed in 2009 to assess non-agency RMBS for the 2010 filing year that does not rely on NRSRO ratings. The NAIC retained the services of PIMCO Advisory to model each non-agency RMBS owned by U.S. insurers at year-end 2010 and 2009. PIMCO Advisory has provided 5 prices for each security for life insurance companies to utilize in determining the NAIC designation for each RMBS based on each insurer's statutory book value price. This process is used to determine the level of RBC requirements for non-agency RMBS.
The amortized cost and fair value of fixed maturity securities at December 31, 2010, by contractual maturity are shown below. Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. All of our residential mortgage backed securities provide for periodic payments throughout their lives and are shown below as a separate line.
The following is a description of the factors causing the unrealized losses by investment category as of December 31, 2010:
Residential mortgage backed securities: At December 31, 2010, we had no exposure to sub-prime residential mortgage backed securities. All of our residential mortgage backed securities are pools of first-lien residential mortgage loans. Substantially all of the securities that we own are in the most senior tranche of the securitization in which they are structured and are not subordinated to any other tranche. Our "Alt-A" residential mortgage backed securities are comprised of 36 securities with a total amortized cost basis of $478.0 million and a fair value of $441.1 million. Despite recent improvements in the capital markets, the fair values of RMBS continue at prices below amortized cost. RMBS prices will likely remain below our cost basis until the housing market is able to absorb current and future foreclosures.
Where the decline in market value of debt securities is attributable to changes in market interest rates or to factors such as market volatility, liquidity and spread widening, and we anticipate recovery of all contractual or expected cash flows, we do not consider these investments to be other than temporarily impaired because we do not intend to sell these investments and it is not more likely than not we will be required to sell these securities before a recovery of amortized cost, which may be maturity. For equity securities, we recognize an impairment charge in the period in which we do not have the intent and ability to hold the securities until a recovery of cost or we determine that the security will not recover to book value within a reasonable period of time. We determine what constitutes a reasonable period of time on a security-by-security basis based upon consideration of all the evidence available to us, including the magnitude of an unrealized loss and its duration. In any event, this period does not exceed 18 months from the date of impairment for perpetual preferred securities for which there is evidence of deterioration in credit of the issuer and common equity securities. For perpetual preferred securities absent evidence of a deterioration in credit of the issuer we apply an impairment model, including an anticipated recovery period, similar to a debt security. For equity securities we measure other than temporary impairment charges based upon the difference between the book value of a security and its fair value.
Approximately 85% and 81% of the unrealized losses on fixed maturity securities shown in the above table for December 31, 2010 and 2009, respectively, are on securities that are rated investment grade, defined as being the highest two NAIC designations. All of the fixed maturity securities with unrealized losses are current with respect to the payment of principal and interest.
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, 2010, the amortized cost and fair value of securities on the watch list are as follows:
We have a policy and process in place 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 as set forth in the following table:
The presentation for the year ended December 31, 2008, is prior to the adoption of FASB guidance issued in April 2009 which separates OTTI for debt securities into credit component that is recognized in operations and a non-credit component that is recognized in other comprehensive income.
Deterioration of the issuers’ credit worthiness and liquidity profile were major factors in leading us to make the determination that other than temporary impairments were present in our corporate bonds and preferred stocks. Our analysis demonstrated that we could not expect a recovery of our cost basis within our expected holding period for debt securities or within a reasonable period of time for equity securities.
In the case of residential mortgage backed securities, we considered the ratings downgrades, increased default and loss severity projections, actual defaults, and expected cash flow projections to determine that other than temporary impairments were present. We continue to monitor the cash flows and economics surrounding these securities to determine changes in expected future cash flows.
The following table presents the range of significant assumptions used to determine the credit loss component of other than temporary impairments we have recognized on residential mortgage backed securities which are all senior level tranches within the structure of the securities:
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 allowances for loan loss. At December 31, 2010 and 2009, the largest principal amount outstanding for any single mortgage loan was $10.7 million and $11.2 million, respectively, and the average loan size was $2.4 million for both 2010 and 2009. We have the contractual ability to pursue full personal recourse on 13.3% of the loans and partial personal recourse on 32.5% of the loans, and master leases provide us recourse against the principals of the borrowing entity on 5.6% of the loans. In addition, the average loan to value ratio for the overall portfolio was 54.7% and 56.3% at December 31, 2010 and 2009, 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 may obtain a current appraisal of the underlying collateral. The commercial mortgage loan portfolio is summarized by geographic region and property type as follows:
During 2010, five mortgage loans were satisfied by taking ownership of the real estate serving as collateral the loans. These loans had an aggregate principal amount outstanding of $11.7 million, for which specific loan loss allowances totaling $4.3 million were established and recognized in 2010. Additional impairment of $0.6 million was recognized on two properties after ownership of the real estate was taken in 2010 as the fair value of each property was revalued by a third party appraiser and the fair value less the estimated costs to sell was lower due to new facts discovered after ownership was obtained.
At December 31, 2010, we have seven mortgage loans that are in the process of being satisfied by taking ownership of the real estate serving as collateral on the loan. These seven loans have a total outstanding principal balance of $24.1 million for which we have recorded specific loan loss allowances totaling $11.1 million in 2010. We also have 23 commercial mortgage loans at December 31, 2010 with a total outstanding principal balance of $68.5 million that have been given "workout" terms which generally allow for interest only payments or the capitalization of interest for a specified period of time. We have recorded a specific loan loss allowance on one of the "workout" loans (principal balance of
$5.7 million) of $1.9 million ($0.9 million in 2010 and $1.0 million in 2009). At December 31, 2010, we have six commercial mortgage loans with a total outstanding principal balance of $20.5 million that were delinquent (60 days or more at the reporting date) in their principal and interest payments and we recorded a specific loan loss allowance on one of these loans (principal balance of $1.3 million) of $0.2 million in 2010. The total outstanding principal balance of these 36 loans is $113.0 million, which represents less than 5% of our total mortgage loan portfolio.
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 and an analysis of the mortgage loan portfolio for the need for a general loan allowance for probable losses on all other loans. 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 that collateral. 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. Based upon this process and analysis, we established a general loan loss allowance of $3.0 million during the year ended December 31, 2010. No general loan loss allowance was considered necessary at December 31, 2009, and the 2010 activity reflects our ongoing evaluation of historical experience and current market conditions.
We have fixed index annuity products that guarantee the return of principal to the policyholder and credit interest based on a percentage of the gain in a specified market index. When fixed index annuity deposits are received, a portion of the deposit is used to purchase derivatives consisting of call options on the applicable market indices to fund the index credits due to fixed index annuity policyholders. Substantially all such call options are one year options purchased to match the funding requirements of the underlying policies. The call options are marked to fair value with the change in fair value included as a component of revenues. The change in fair value of derivatives includes the gains or losses recognized at the expiration of the option term or upon early termination and the changes in fair value for open positions. On the respective anniversary dates of the index policies, the index used to compute the annual index credit is reset and we purchase new one-year call options to fund the next annual index credit. We manage the cost of these purchases through the terms of our fixed index annuities, which permit us to change caps, participation rates, and/or asset fees, subject to guaranteed minimums on each policy's anniversary date. By adjusting caps, participation rates, or asset fees, we can generally manage option costs except in cases where the contractual features would prevent further modifications.
Our strategy attempts to mitigate any potential risk of loss under these agreements through a regular monitoring process which evaluates the program's effectiveness. We do not purchase call options that would require payment or collateral to another institution and our call options do not contain counterparty credit-risk-related contingent features. We are exposed to risk of loss in the event of nonperformance by the counterparties and, accordingly, we purchase our option contracts from multiple counterparties and evaluate the creditworthiness of all counterparties prior to purchase of the contracts. All of these options have been purchased from nationally recognized financial institutions with a Standard and Poor's credit rating of A- or higher at the time of purchase and the maximum credit exposure to any single counterparty is subject to concentration limits. We also have credit support agreements that allow us to request the counterparty to provide collateral to us when the fair value of our exposure to the counterparty exceeds specified amounts.
Concurrently with the issuance of our 3.5% Convertible Senior Notes due in 2015 (the "2015 notes"), we entered into hedge transactions (the "2015 notes hedges") with various parties whereby we have the option to receive the cash equivalent of the conversion spread on approximately 16.0 million shares of our common stock based upon a strike price of $12.50 per share, subject to certain conversion rate adjustments in the 2015 notes. These options expire on September 15, 2015 and must be settled in cash. The aggregate cost of the 2015 notes hedges was $37.0 million. The 2015 notes hedges are accounted for as derivative assets, and are included in Other assets in our Consolidated Balance Sheets. The estimated fair value of the 2015 notes hedges was $66.6 million as of December 31, 2010.
The conversion option of the 2015 notes (the "2015 notes embedded conversion derivative") is an embedded derivative that requires bifurcation from the 2015 notes and is accounted for as a derivative liability, which is included in Other liabilities in our Consolidated Balance Sheets. The fair value of the 2015 notes embedded conversion derivative at the time of issuance of the 2015 notes was $37.0 million, and was recorded as the original debt discount for purposes of accounting for the debt component of the 2015 notes. This discount will be recognized as interest expense using the effective interest method over the term of the 2015 notes. The estimated fair value of the 2015 notes embedded conversion derivative was $66.6 million as of December 31, 2010.
As part of our investment strategy, we enter into securities repurchase agreements (short-term collateralized borrowings). We had no borrowings under repurchase agreements during 2010. The maximum amount borrowed during 2009 and 2008 was $440.0 million and $641.1 million, respectively. When we do borrow cash on these repurchase agreements, we pledge collateral in the form of debt securities with fair values approximately equal to the amount due and we use the cash to purchase debt securities ahead of the time we collect the cash from selling annuity policies to avoid a lag between the investment of funds and the obligation to credit interest to policyholders. We earn investment income on the securities purchased with these borrowings at a rate in excess of the cost of these borrowings. Such borrowings averaged $150.7 million and $359.9 million for the years ended December 31, 2009 and 2008, respectively. The weighted average interest rate on amounts due under repurchase agreements was 0.35% and 2.28% for the years ended December 31, 2009 and 2008, respectively.
In December 2004, we issued $260.0 million principal amount of convertible senior notes due December 6, 2024 (the "2024 notes"). The 2024 notes are unsecured and bear interest at a fixed rate of 5.25% per annum. Interest is payable semi-annually in arrears on June 6 and December 6 of each year. In addition to regular interest on the 2024 notes, beginning with the six-month interest period ending June 6, 2012, we will also pay contingent interest under certain conditions at a rate of 0.5% per annum based on the average trading price of the 2024 notes during a specified period.
We extinguished $78.1 million principal amount of the 2024 notes during 2008 at a discount and recognized a gain of $9.7 million. In 2009, we issued five million shares of our common stock with a fair value of $31.3 million in exchange for $37.2 million principal amount of the 2024 notes and recognized a gain of $3.1 million. In 2010, we extinguished $6.7 million principal amount of the outstanding 2024 notes for $6.6 million in cash and recognized a loss of $0.3 million.
In December 2009, we issued $115.8 million principal amount of convertible senior notes due December 6, 2029 (the "2029 notes"). The 2029 notes are unsecured and bear interest at a fixed rate of 5.25% per annum. Interest is payable semi-annually in arrears on June 6 and December 6 of each year. In addition to regular interest on the 2029 notes, beginning with the six-month interest period ending June 6, 2015, we will also pay contingent interest under certain conditions at a rate of 0.5% per annum based on the average trading price of the 2029 notes during a specified period. $52.2 million of these notes were issued for cash. The remaining $63.6 million were issued in exchange for the same amount of the 2024 notes, for which a loss of $3.8 million was recognized.
The 2024 notes and 2029 notes are convertible at the holders' option prior to the maturity date into cash and shares of our common stock under certain conditions. The conversion price per share of the 2024 notes is $14.03, which represents a conversion rate of 71.3 shares of our common stock per $1,000 in principal amount of notes. The conversion price per share of the 2029 notes is $9.69, which represents a conversion rate of 103.2 shares of our common stock per $1,000 in principal amount of notes. Upon conversion, we will deliver to the holder cash equal to the aggregate principal amount of the notes to be converted and shares of our common stock for the amount by which the conversion value exceeds the aggregate principal amount of the notes to be converted (commonly referred to as "net share settlement"). See note 9 to the audited consolidated financial statements for additional details concerning the conversion features of the notes and the dilutive effect of the notes in our diluted
The initial conversion rate for the 2015 notes is 80 shares of our common stock per $1,000 principal amount of 2015 notes, equivalent to a conversion price of approximately $12.50 per share of our common stock, with the amount due on conversion. Upon conversion, a holder will receive a cash payment equal to the sum of the daily settlement amounts, calculated on a proportionate basis for each day, during a specified observation period following the conversion date.
At December 31, 2010, $74.5 million principal amount of the 2024 notes remains outstanding which we may redeem at any time on or after December 15, 2011. The holders of the 2024 notes may require us to repurchase their notes on December 15, 2011, 2014, and 2019 and for a certain period of time following a change in control. We may redeem the 2029 notes at any time on or after December 15, 2014. The holders of the 2029 notes may require us to repurchase their notes on December 15, 2014, 2019 and 2024 and for a certain period of time following a change in control. The redemption price or the repurchase price shall be payable in cash and equal to 100% of the principal amount of the notes, plus accrued and unpaid interest (including contingent interest and liquidated damages, if any) up to but not including the date of redemption or repurchase.
American Equity Capital Trust I issued 865,671 shares of 8% trust preferred securities, of which 2,000 shares are held by one of our subsidiaries, and we issued $26.8 million of our 8% subordinated debentures. During 2010 and 2008, 2,010 and 8,333 shares of these trust preferred securities converted into 7,444 and 30,862 shares of our common stock, respectively. There were no conversions during 2009. The remaining 736,328 shares of these trust preferred securities not held by a subsidiary are convertible into 2,727,084 shares of our common stock.
revolving line of credit agreement and entered into a $160 million revolving line of credit agreement with seven banks. The revolving period of the $160 million facility will be three years. The interest rate will be floating at a rate based on our election that will be equal to the applicable base rate (highest of the rate of interest publicly announced by JPMorgan Chase Bank as its prime rate in effect at its principal office in New York City, the federal funds effective rate from time to time plus 0.50% and the adjusted LIBOR for a one month interest period on such day plus 1.00%) plus the applicable margin or the adjusted LIBOR plus the applicable margin. The applicable margin and commitment fee rate are based on our credit rating and can change throughout the period of the credit facility. Based on our current credit rating the applicable margin is 2.00% and the commitment fee is 0.50% on the unused portion of credit available. Under this agreement, we are required to maintain a minimum risk-based capital ratio at American Equity Life, a maximum ratio of debt to total capital, a minimum cash coverage ratio, and a minimum level of statutory surplus at American Equity Life.
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, that help limit and discourage early withdrawals. At December 31, 2010, approximately 97% of our annuity liabilities were subject to penalty upon surrender, with a weighted average remaining surrender charge period of 10.3 years and a weighted average surrender charge rate of 15.2%.
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 $2.8 billion for the year ended December 31, 2010 compared to $1.7 billion for the year ended December 31, 2009 with the increase primarily attributable to a $1.3 billion increase in net annuity deposits after coinsurance and a $200.7 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 2010 we experienced a significant amount of calls of United States Government sponsored agency securities. As a result we have had elevated levels of short-term investments and cash and cash equivalents during 2010. We have been reinvesting the proceeds from the called securities in United States Government sponsored agency securities, investment grade corporate fixed maturity securities and United States municipalities, states and territories securities with yields that meet our investment spread objectives. The accelerated pace of these calls may continue in 2011. At December 31, 2010, 36% of our fixed income securities have call features and 1% ($0.1 billion) of those securities were subject to call redemption. Another 21% ($3.4 billion) of our fixed income securities will become subject to call redemption during 2011. If interest rates remain unchanged from December 31, 2010 levels we expect many of the securities callable in 2011 to be called. Our ability to continue to reinvest the proceeds from called securities in assets with acceptable credit quality and yield characteristics similar to the called securities will be dependent on future
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 the Iowa Insurance Commissioner, 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 2011, up to $187.5 million can be distributed as dividends by American Equity Life without prior approval of the Iowa Insurance Commissioner. 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 $493.6 million of statutory earned surplus at December 31, 2010.
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, 2010 and 2009 and for the years ended December 31, 2010, 2009 and 2008 is included in note 12 to our audited consolidated financial statements.
During the third quarter 2010, we issued $200.0 million principal amount of the 2015 notes. Concurrently with the issuance of the 2015 notes, we entered into hedge transactions (the "2015 notes hedges") with various parties whereby we have the option to receive the cash equivalent of approximately 16.0 million shares of our common stock based upon a strike price of $12.50 per share, subject to certain conversion rate adjustments in the 2015 notes. In separate transactions, we also sold warrants (the "2015 warrants") to two counterparties for the purchase of up to approximately 16.0 million shares of our common stock at a price of $16.00 per share. The 2015 notes, 2015 notes hedges and 2015 warrants produced net cash proceeds of $171.9 million. We used $150.0 million of these proceeds to pay off the amount drawn on our now terminated revolving line of credit.
As discussed above, subsequent to December 31, 2010, we terminated the $150 million line of credit and entered into a $160 million revolving line of credit agreement (see note 9 to our audited consolidated financial statements). The new revolving line of credit terminates on January 28, 2014, and borrowings are available for general corporate purposes of the parent company and its subsidiaries. During 2009, we borrowed $75.0 million under our now terminated revolving line of credit and used the proceeds to make $75.0 million in capital contributions to American Equity Life.
During 2008, we purchased $78.1 million principal amount of the 2024 notes at a discount and recognized a gain of $9.7 million related to the retirement of these notes. The cash required to retire these notes totaled $61.4 million. We also repurchased 3,545,744 shares of our common stock as part of our share repurchase program during 2008. We suspended the repurchase of our common stock under this program in August 2008. The cash used to purchase our common stock during 2008 was $30.7 million. The sources of cash to fund the debt retirements and the common stock repurchases primarily came from draws on our $150 million revolving line of credit and sales of investments including sales to American Equity Life.
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, 2010.
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. Lower interest rates and tighter spreads experienced in recent periods have increased the value of our fixed maturity investments. It is likely that rising interest rates and wider 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.
The increasing complexity of the business environment and applicable authoritative accounting guidance require us to closely monitor our accounting policies. We have identified five critical accounting policies that are complex and require significant judgment. The following summary of our critical accounting policies is intended to enhance your ability to assess our financial condition and results of operations and the potential volatility due to changes in estimates.
Level 2 - Quoted prices in active markets for similar financial instruments, quoted prices for identical or similar financial instruments in markets that are not active; and models and other valuation methodologies using inputs other than quoted prices that are observable.
Level 3 - Models and other valuation methodologies using significant inputs that are unobservable for financial instruments and include situations where there is little, if any, market activity for the financial instrument. The inputs into the determination of fair value require significant management judgment or estimation. Financial instruments that are included in Level 3 are securities for which no market activity or data exists and for which we used discounted expected future cash flows with our own assumptions about what a market participant would use in determining fair value.
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, 2010 and 2009, respectively:
We utilize independent pricing services in estimating the fair values of investment securities. The independent pricing services incorporate a variety of observable market data in their valuation techniques, including:
The independent pricing services also take into account perceived market movements and sector news, as well as a security's terms and conditions, including any features specific to that issue that may influence risk and marketability. Depending on the security, the priority of the use of observable market inputs may change as some observable market inputs may not be relevant or additional inputs may be necessary. 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, we obtain prices from a broker for our callable United States Government sponsored agencies. 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.
the length of time and the extent to which the fair value has been less than amortized cost or cost;
Deferred policy acquisition costs and deferred sales inducements are subject to loss recognition testing on a quarterly basis or when an event occurs that may warrant loss recognition. Deferred policy acquisition costs consist principally of commissions and certain costs of policy issuance. Deferred sales inducements consist of premium and interest bonuses credited to policyholder account balances.
For annuity products, these costs are being amortized generally in proportion to expected gross profits from interest margins and, to a lesser extent, from surrender 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.
In January 2010, the FASB issued an accounting standards update that expands the disclosure requirements related to fair value measurements. A reporting entity is now required to disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurement categories and describe the reasons for the transfers. Additionally, a reporting entity will be required to present on a gross basis rather than as one net number information about the purchases, sales, issuances and settlements of financial instruments that are categorized as Level 3 for fair value measurements. Clarification on existing disclosure requirements is also provided in this update relating to the level of disaggregation of information as to determining appropriate classes of assets and liabilities as well as disclosure requirements regarding valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements. This standard was effective for us on January 1, 2010. The disclosures about purchases, sales, issuances and settlements in the roll forward of activity in Level 3 fair value measurements will become effective for fiscal years beginning after December 15, 2010.
In October 2010, as a result of a consensus of the FASB Emerging Issues Task Force, the FASB issued an accounting standards update that modifies the definition of the types of costs incurred that can be capitalized in the acquisition of new and renewal insurance contracts. This guidance defines the costs that qualify for deferral as incremental direct costs that result directly from and are essential to successful contract transactions and would not have been incurred by the insurance entity had the contract transactions not occurred. In addition, it lists certain costs as deferrable as those that are directly related to underwriting, policy issuance and processing, medical and inspection, and sales force contract selling as deferrable, as well as the portion of an employee's total compensation related directly to time spent performing those activities for actual acquired contracts and other costs related directly to those activities that would not have been incurred if the contract had not been acquired. This amendment to current GAAP should be applied prospectively and is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011, with retrospective application permitted. We are currently evaluating the impact of the guidance on our consolidated financial statements. See note 6 to our audited consolidated financial statements for the policy issue costs that could be subject to non-deferral.