We lease approximately 60,000 square feet for our principal offices in West Des Moines, Iowa, under an operating lease that expires in 2011. We also lease approximately 6,000 square feet for our office in Pell City, Alabama, pursuant to an operating lease that expires on December 31, 2008.
Management's discussion and analysis reviews our consolidated financial position at December 31, 2007 and 2006, and our consolidated results of operations for the three years in the period ended December 31, 2007, and where appropriate, factors that may affect future financial performance. This discussion should be read in conjunction with our audited consolidated financial statements, notes thereto and selected consolidated financial data appearing elsewhere in this report.
•general economic conditions and other factors, including prevailing interest rate levels and stock and credit market performance which may affect (among other things) our ability to sell our products, our ability to access capital resources and the costs associated therewith, the fair value of our investments and the lapse rate and profitability of our policies;
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 as a separate component of stockholders' equity, net of income taxes
and certain adjustments for assumed changes in amortization of deferred policy acquisition costs and deferred sales inducements. Fair values for primarily all of our securities are determined using quoted market prices from third parties. For fixed maturity securities that are not actively traded, fair values are estimated using yield data and other factors relating to instruments or securities with similar characteristics. The carrying amounts of all our investments are reviewed on an ongoing basis for changes in market interest rates and credit deterioration. If this review indicates a decline in fair value that is other than temporary, our carrying amount in the investment is reduced to its fair value and a specific write down is taken. Such reductions in carrying amount are recognized as realized losses and charged to earnings.
Our periodic assessment of our ability to recover the amortized cost basis of investments that have materially lower estimated fair values requires a high degree of management judgment and involves uncertainty. Factors considered in evaluating whether a decline in value is other than temporary include:
In addition, where our intent was to retain the investment to allow for recovery, but our intent changes due to changes or events that could not have been reasonably anticipated, an other-than-temporary impairment charge is recognized. Once an impairment charge has been recorded, we then continue to review the other than temporarily impaired securities for appropriate valuation on an ongoing basis. Unrealized losses may be recognized in future periods through a charge to earnings, should we later conclude that the decline in fair value below amortized cost is other than temporary pursuant to our accounting policy described above.
United States Government full faith and credit and United States Government sponsored agencies: These securities are relatively long in duration, making the value of such securities very sensitive to changes in market interest rates. The unrealized losses on these securities at December 31, 2007 are due to changes in the general level of interest rates from the date of purchase. The decrease in unrealized losses at December 31, 2007 compared to December 31, 2006 is due to a decrease in the general level of interest rates.
Equity securities: The unrealized loss on equity securities, which includes exposure to REITS, investment banks and finance companies, is primarily due to the decline in the housing market and subprime mortgage problems.
At December 31, 2007 and 2006, the fair value of investments we owned that were non-investment grade was $87.5 million and $105.5 million, respectively. Non-investment grade securities represented 1.0% and 1.2% at December 31, 2007 and 2006, respectively, of the fair value of our fixed maturity securities. The net unrealized losses on investments we owned that were non-investment grade at December 31, 2007 and 2006, were $10.9 million and $5.0 million, respectively. The unrealized losses on such securities at December 31, 2007 and 2006 represented 4.2% and 1.3%, respectively, of gross unrealized losses on fixed maturity securities.
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. We include these securities 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 have the ability and intent to hold these securities to maturity or until a market recovery is realized. At December 31, 2007, the amortized cost and estimated fair value of securities on the watch list are as follows (dollars in thousands):
Our analysis of these securities and their credit performance at December 31, 2007 is as follows:
The decline in market value of the finance, insurance and commercial real estate securities is related to concerns over their access to capital to enable them to execute their business plans. We have determined that other than temporary impairments were not necessary as recent market actions by the Federal Reserve signal an improving credit environment that will support their business plans.
The securities on the watch list are current with respect to payments of principal and interest. We concluded that we have the intent and ability to hold these securities for a period of time sufficient to allow for a recovery in fair value and that there were no other than temporary impairments on these securities at December 31, 2007.
During 2007, we wrote down one security in the media industry by $3.9 million which subsequent to the completion of a leveraged buyout had a significant increase in leverage combined with declining circulation and advertising revenues.
During 2006, we sold two asset-backed securities backed by leases on airplanes concurrent with our decision to write down these securities due to continuing problems in the airline industry and deterioration of the underlying collateral which resulted in decreases in the amount of expected principal and interest payments. The write down/realized loss on these securities was $2.5 million for the year ended December 31, 2006. We had previously written down these securities by $2.7 million during 2005 and $7.8 million during 2001 - 2003 due to deterioration in the underlying collateral.
During 2005, we wrote down an asset-backed security of a major U.S. airline by $5.8 million due to the uncertainty of recovery of all future principal and interest payments subsequent to the airline's bankruptcy filing. We sold this security in 2006 at a value in excess of its amortized cost.
Our mortgage loans on real estate are reported at cost, adjusted for amortization of premiums and accrual of discounts. If we determine that the value of any 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. The carrying value of impaired loans is reduced by the establishment of a valuation allowance, changes to which are recognized as realized gains or losses on investments. There were no valuation allowances at December 31, 2007 and 2006. Interest income on impaired loans is recorded on a cash basis.
We offer a variety of index annuities with crediting strategies linked to the S&P 500 Index and other equity and bond market indices. These products allow policyholders to earn index credits based upon an 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 annuity contract value is equal to the premiums paid plus any premium bonus, if applicable, plus annual index credits based upon a percentage, known as the "participation rate", of the annual appreciation (based in some instances on monthly averages or monthly point-to-point calculations) in the recognized index or benchmark. Some products apply an overall limit, or "cap", on the amount of annual interest the policyholder may earn in any one contract year. In addition, some of the products have an "asset fee" which is deducted from the annual interest to be credited. For products with asset fees, if the annual appreciation in the index does not exceed the asset fee, the policyholder's index
credit is zero. Participation rates, caps and asset fees may be adjusted annually subject to contractual limitations.
•We must mark to market the call options purchased 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. 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.
the fair value of embedded derivatives generally correspond to increases or decreases in the fair values of the call options purchased to fund the annual index credits and changes in the risk free interest rates used to discount the excess of the projected policy contract values over the projected minimum guaranteed contract values. The amounts reported in the consolidated statements of income as "Interest credited to account balances" represent amounts credited to policy liabilities pursuant to SFAS 97 which include index credits through the most recent policy anniversary. The amounts reported in the consolidated statements of income as "Changes in fair value of embedded derivatives" equal the change in the difference between policy benefit reserves for index annuities under SFAS 133 and SFAS 97 at each balance sheet date.
There were no changes in our estimated future gross profits in 2007 and 2005 that resulted in adjustments to the combined balance of deferred policy acquisition costs and deferred sales inducements. The impact of unlocking during 2006 was a $0.6 million decrease in amortization of deferred sales inducements and a $0.3 million increase in amortization of deferred policy acquisition costs. The impact of unlocking was primarily due to the impact of actual surrender experience on certain older business and changes in the estimates of future surrender experience on such business, offset in part by a reduction in the estimate of future projected policy maintenance expenses.
If estimated gross profits for all future years on business in force at December 31, 2007 were to increase by a reasonably likely amount of 10%, our combined balance for deferred policy acquisition costs and deferred sales inducements at December 31, 2007 would increase by $35.8 million. Correspondingly, a reasonably likely 10% decrease in estimated gross profits for all future years would results in a $40.2 million decrease in the combined December 31, 2007 balances.
Our A.M. Best Company financial strength rating is a key element of our competitive position in the index and fixed rate annuity market. The outlook for our current rating is stable. We believe this rating upgrade has enhanced our competitive position and improved our prospects for sales increases in future periods. However, the degree to which this rating upgrade will effect future sales is unknown.
Net income decreased 62% to $29.0 million in 2007, and increased 76% to $75.5 million in 2006, from $43.0 million in 2005. In general, net income has been increasing each year due to the growth in the volume of business in force and increases in the investment spread earned on our annuity liabilities. Our investment spread measured on a percentage basis declined in 2007 to 2.61% from 2.73% in 2006 due to a higher average cost of money for index annuities. This higher average cost of money generally resulted from increases in the cost of options purchased to fund the index credits on the index annuities which was attributable to increased equity market volatility throughout 2007. See Overview.
The comparability of the amounts is impacted by (i) realized gains (losses) on investments, (ii) the impact of the application of SFAS 133 to our index annuity business and contingent convertible senior notes, and (iii) the consolidation of the Service Company in 2005 prior to its acquisition on September 2, 2005 under FSP FIN 46(R)-5. We estimate that these items increased (decreased) net income as follows:
Realized gains and losses on investments fluctuate from year to year based upon changes in the interest rate and economic environment and the timing of the sale of investments or the recognition of other than temporary impairments. Amounts attributable to the application of SFAS 133 to our index annuity business fluctuate based upon changes in the fair values of call options purchased to fund the annual index credits for index annuities and changes in the risk-free interest rates used to discount the embedded derivative liability. The significant increase in the impact from this item for 2007 is attributable to the overall decline in the equity markets during 2007 and declines in the risk-free interest rates used to discount the embedded derivative liability. Changes in the amounts attributable to the application of SFAS 133 to our contingent convertible senior notes are discussed below under change in fair value of embedded derivatives and interest expense on notes payable. As discussed in note 1 to our audited consolidated financial statements, we acquired the Service Company on September 2, 2005 and consolidated it as a wholly-owned subsidiary effective as of that date. Prior to the acquisition, we had an implicit variable interest in the Service Company and consolidated it under FSP FIN 46(R)-5. The reduction in net income for 2005 was principally due to a $2.5 million distribution to the former shareholder of the Service Company prior to the September 2, 2005 acquisition and adjustments to the Service Company's income tax liabilities as a result of a change in its effective income tax rate upon becoming a wholly-owned subsidiary of us.
Realized gains (losses) on investments include gains and losses on the sale of securities as well as losses recognized when the fair value of a security is written down through earnings in recognition of an other than temporary impairment. Realized gains and losses on investments fluctuate from year to year due to changes in the interest rate and economic environment and the timing of the sale of investments or the recognition of other than temporary impairments. See note 3 to our audited consolidated financial statements for a summary of the components of realized gains (losses) on investments for the years ended December 31, 2007, 2006 and 2005. See Financial Condition-Investments for additional discussion of write downs of the fair values of securities for other than temporary impairments and securities sold at a material loss for the years ended December 31, 2007, 2006 and 2005.
The differences between the change in fair value of derivatives between years are primarily due to the performance of the indices upon which our call options are based. A substantial portion of our call options are based upon the S&P 500 Index with the remainder based upon other equity and bond market indices. The range of index appreciation for options expiring during the years ended December 31, 2007, 2006 and 2005 is as follows:
Interest credited to account balances increased 39% to $560.2 million in 2007 and 35% to $404.3 million in 2006 from $299.3 million in 2005. The components of interest credited to account balances are summarized as follows:
Amortization of deferred sales inducements decreased 53% to $11.7 million in 2007 and increased 103% to $24.8 million in 2006 from $12.2 million in 2005. 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 and interest bonus annuity products. Bonus products represented 86%, 77% and 68% of our total annuity deposits during 2007, 2006 and 2005, respectively. 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. 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 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 exceed 10 years. The gross profit adjustments resulting from the application of SFAS 133 to our index annuity business decreased amortization by $23.4 million,
Change in fair value of embedded derivatives was a decrease of $67.9 million during 2007 compared to increases of $151.1 million in 2006 and $31.1 million in 2005. The components of change in fair value of derivatives are summarized as follows:
The changes related to the embedded derivatives within our index annuities resulted from (i) changes in the expected index credits on the next policy anniversary dates, which are related to the change in fair value of the call options purchased to fund these index credits discussed above in change in fair value of derivatives; (ii) changes in discount rates used in estimating future option costs; and (iii) the growth in the host component of the embedded derivative. See Critical Accounting Policies-Derivative Instruments-Index Products.
Income tax expense decreased 67% to $13.9 million in 2007 and increased 63% to $41.4 million in 2006 from $25.4 million in 2005. The changes in income tax expense were principally due to the increase or decrease in income before income taxes. The effective tax rates were 32.4%, 35.4% and 35.8% for 2007, 2006 and 2005, respectively. The effective tax rate for 2007 was less than the applicable statutory federal income tax rate of 35% and the preceding years primarily due to state income tax benefits attributable to losses in the non-life subgroup.
Insurance statutes regulate the type of investments that our life subsidiaries are permitted to make and limit the amount of funds that may be used for any one type of investment. In light of these statutes and regulations and our business and investment strategy, we generally seek to invest in United States government and government-sponsored agency securities and corporate securities rated
investment grade by established nationally recognized rating organizations or in securities of comparable investment quality, if not rated.
The composition of our investment portfolio is summarized in the table below (dollars in thousands):
The table below presents our total fixed maturity securities by NAIC designation and the equivalent ratings of the nationally recognized securities rating organizations (dollars in thousands).
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 include limits on the amount that can be loaned to one borrower and other criteria to reduce our risk of default. As of December 31, 2007, there were no delinquencies or defaults in our commercial mortgage loan portfolio and no impaired loans requiring a valuation allowance. The commercial mortgage loan portfolio is summarized by geographic region and property type as follows (dollars in thousands):
Our derivative instruments primarily consist of call options purchased to provide the income needed to fund the annual index credits on our index annuity products. See Critical Accounting Policies-Derivative Instruments.
As part of our investment strategy, we enter into securities repurchase agreements (short-term collateralized borrowings). The amounts outstanding under repurchase agreements at December 31, 2007 and 2006 were $257.2 million and $386.0 million, respectively. These borrowings are collateralized by investment securities with fair values approximately equal to the amount due. 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 $301.9 million, $628.0 million and $318.8 million for the years ended December 31, 2007, 2006 and 2005, respectively. The weighted average interest rate on amounts due under repurchase agreements was 5.27%, 5.24% and 3.54% for the years ended December 31, 2007, 2006 and 2005, respectively.
In December 2004, we issued $260.0 million of contingent convertible senior notes due December 6, 2024. The 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, beginning June 6, 2005. In addition to regular interest on the 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 notes during a specified period. We repurchased $20.4 million of the notes in February 2008.
The 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 is $14.47 which represents a conversion rate of 69.1 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 will deliver 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 7 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 earnings per share calculation.
Following is a summary of subordinated debt obligations to the trusts at December 31, 2007 and 2006:
Details regarding the interest rate swaps are as follows (dollars in thousands):
At December 31, 2007, one of our subsidiaries had $8.2 million outstanding under a credit agreement with a third party. Quarterly payments in amounts ranging from $1.1 million to $1.3 million are payable over the next eight quarters with interest computed at a fixed rate of 11.2%. Cash and cash equivalents at December 31, 2007 include $1.7 million of restricted cash under the terms of the credit agreement. See note 7 to our audited consolidated financial statements for additional information concerning this credit agreement.
During 2007 and 2006, the NMO Deferred Compensation Trust (NMO Trust) purchased 359,489 and 1,052,065 shares of our common stock at a total cost of $4.4 million and $12.7 million, respectively. These shares are treated as treasury stock and are held by the NMO Trust 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.
Our life subsidiaries generally receive adequate cash flow from premium collections and investment income to meet their obligations. Annuity and life insurance liabilities are generally long-term in nature. Policyholders may, however, withdraw funds or surrender their policies, subject to surrender and withdrawal penalty provisions. At December 31, 2007, approximately 98% of our annuity liabilities were subject to penalty upon surrender, with a weighted average remaining surrender charge period of 10.2 years and a weighted average surrender charge rate of 13.7%.
The maximum distribution permitted by law or contract is not necessarily indicative of an insurer's actual ability to pay such distributions, which may be constrained by business and regulatory considerations, such as the impact of such distributions on surplus, which could affect the insurer's ratings or competitive position, the amount of premiums that can be written and the ability to pay future dividends or make other distributions. Further, state insurance laws and regulations require that the statutory surplus of our life subsidiaries following any dividend or distribution must be reasonable in relation to their outstanding liabilities and adequate for their financial needs.
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, 2007.
(1)Amounts shown in this table are projected payments through the year 2027 which we are contractually obligated to pay to our annuity policyholders. The payments are derived from actuarial models which assume a level interest rate scenario and incorporate assumptions regarding mortality and persistency, when applicable. These assumptions are based on our historical experience.
In February 2007, the Financial Accounting Standards Board ("FASB") issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, ("SFAS 159"). SFAS 159 permits entities to choose, at specified election dates, to measure eligible financial instruments and certain other items at fair value that are not currently required to be reported at fair value. Unrealized gains and losses on items for which the fair value option is elected shall be reported in net income. SFAS 159 also requires additional disclosures that are intended to facilitate comparisons between entities that choose different measurement attributes for similar assets and liabilities and between assets and liabilities in the financial statements of an entity that selects different measurement attributes for similar assets and liabilities. SFAS 159 is effective beginning on January 1, 2008. We are currently evaluating the impact SFAS 159 will have on our consolidated financial statements.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements ("SFAS 157"), which defines fair value, establishes a framework for measuring fair value and expands the required disclosures about fair value measurements. SFAS 157 also provides guidance regarding the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. For assets and liabilities that are measured at