The summary consolidated financial and other data should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and our consolidated financial statements and related notes appearing elsewhere in this report. The results for past periods are not necessarily indicative of results that may be expected for future periods.
Management’s discussion and analysis reviews our consolidated financial position at December 31, 2006 and 2005, and our consolidated results of operations for the three years in the period ended December 31, 2006, 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.
· the risk factors or uncertainties listed from time to time in our private placement memorandums or filings with the SEC.
We specialize in the sale of individual annuities (primarily deferred annuities) and, to a lesser extent, we also sell life insurance policies. Under 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 charges deducted from the account balances of policyholders in connection with withdrawals, realized gains and losses on investments and changes in fair value of derivatives. Components of expenses for products accounted for as deposit liabilities are interest credited to account balances, changes in fair value of embedded derivatives, amortization of deferred policy acquisition costs and deferred sales inducements, other operating costs and expenses and income taxes.
Our profitability depends in large part upon the amount of assets under our management, investment spreads we earn on our policyholder account balances, our ability to manage our investment portfolio to maximize returns and minimize risks such as interest rate changes, defaults or impairment of assets, our ability to manage costs of the options purchased to fund the annual index credits on our index annuities, our ability to manage the costs of acquiring new business (principally commissions to agents and first year bonuses credited to policyholders) and our ability to manage our operating expenses.
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
· our intent and ability to retain the investment for a period of time sufficient to allow for recovery;
At December 31, 2006 and 2005, the amortized cost and estimated fair value of fixed maturity securities and equity securities that were in an unrealized loss position were as follows:
At December 31, 2006 and 2005, the fair value of investments we owned that were non-investment grade was $105.5 million and $115.2 million, respectively. Non-investment grade securities represented 1.0% and 0.9% at December 31, 2006 and 2005, 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, 2006 and 2005 were $5.0 million and $5.8 million, respectively. The unrealized losses on such securities at December 31, 2006 and 2005 represented 1.3% and 2.8%, 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 book value 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. There were no securities on our watch list at December 31, 2006.
We took write downs on certain investments that we concluded had an other than temporary impairment during 2006, 2005 and 2004 of $1.3 million, $9.5 million and $12.8 million, respectively. We also realized losses on the sale of certain investments during 2006, 2005 and 2004 of $3.2 million, $3.6 million and $0.2 million, respectively. The following is a discussion of each security for which we have
taken write downs or sold at a material loss during the years ended December 31, 2006, 2005 and 2004. The discussion excludes securities sold at a loss which were deemed immaterial. There were no material losses on sales of securities during 2004.
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, 2006 and 2005. Interest income on impaired loans is recorded on a cash basis.
The annuity contract value is equal to the premiums paid 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. The participation rate, which we may reset annually, generally varies among the index products from 50% to 100%. Some products apply an overall limit, or “cap”, ranging from 5% to 13%, on the amount of annual interest the policyholder may earn in any one contract year, and the applicable cap may also be adjusted annually subject to stated minimums. In addition, some of the products have an “asset fee” ranging from 1.5 to 5.0%, 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. The minimum guaranteed contract values range from 80% to 100% of the premium collected plus interest credited on the minimum guaranteed contract value at an annual rate of 2.0% to 3.5%.
The amounts reported with respect to our index business for SFAS 133 are summarized as follows:
Deferred policy acquisition costs and deferred sales inducements totaled $1.5 billion and $1.3 billion at December 31, 2006 and 2005, respectively. For annuity and single premium universal life products, these costs are being amortized generally in proportion to expected gross profits from investments and, to a lesser extent, from surrender charges and mortality and expense margins. Current 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.
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 is 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. There were no changes in our estimated gross profits in 2005 and 2004 that resulted in significant adjustments to the combined balance of deferred policy acquisition costs and deferred sales inducements.
If estimated gross profits for all future years on business in force at December 31, 2006 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, 2006 would increase by $31.5 million. Correspondingly, a
As of December 31, 2006 and 2005, we had $73.8 million and $92.5 million, respectively, of net deferred income tax assets. The realization of these assets is based upon estimates of future taxable income, which requires management judgment. 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, 2006
A key element of our competitive position in the index and fixed annuity market throughout the past several years has been the financial strength rating we received from A.M. Best Company. On August 3, 2006, A.M. Best Company upgraded our financial strength rating to A- (Excellent) from B++ (Very Good). The rating outlook is stable. We believe this rating upgrade will enhance our competitive position and improve our prospects for sales increases in future periods. However, the degree to which this rating upgrade will effect future sales and persistency is unknown.
Net investment income increased 22% to $677.6 million in 2006 and 29% to $554.1 million in 2005 from $428.4 million in 2004. These increases are principally attributable to the growth in our annuity business and corresponding increases in our invested assets, offset by decreases in the average yield earned on investments. Invested assets (on an amortized cost basis) increased 6% to $11.1 billion at December 31, 2006 and 31% to $10.5 billion at December 31, 2005 compared to $8.0 billion at December 31, 2004, while the average yield earned on average invested assets was 6.14%, 6.18% and 6.28% for 2006, 2005 and 2004, respectively. The declines in the yield earned on average invested assets is attributable to a general decline in interest rates and the reinvestment of net redemption proceeds from called securities at lower yields. See Quantitative and Qualitative Disclosures About Market Risk.
The increases in amortization of deferred sales inducements during 2006, 2005 and 2004 were principally attributable to growth in account balances attributable to premium and interest bonus products. Bonus products represented 77%, 68% and 64% of our total annuity deposits during 2006, 2005 and 2004, respectively. The comparisons between periods are also affected by amortization associated with net realized gains (losses) on investments and amortization associated with the application of SFAS 133 to our index annuity business. The gross profit adjustments from net realized gains (losses) on investments increased amortization by $0.2 million in 2006, decreased amortization by $0.8 million in 2005 and had no impact in 2004. 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 change in fair value of the embedded derivatives will not correspond to the change in fair value of the purchased options because the purchased 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 $2.9 million in 2006 and $3.2 million in 2005 and increased amortization by $1.4 million in 2004. See Critical Accounting Policies-Deferred Policy Acquisition Costs and Deferred Sales Inducements.
Change in fair value of embedded derivatives was an increase of $151.1 million during 2006 compared to an increase of $31.1 million in 2005 and a decrease of $8.6 million in 2004. The components of change in fair value of derivatives are summarized as follows:
Interest expense on notes payable increased 25% to $20.4 million in 2006 compared to $16.3 million in 2005 and $2.4 million in 2004. The increase in 2006 was primarily due to $4.7 million of amortization of the discount created in the fourth quarter of 2005 when the conversion option embedded in our contingent convertible senior notes was bifurcated from the host instrument. This discount was reduced from $76.9 million to $6.5 million during the second quarter of 2006 when the conversion option embedded within our contingent convertible senior notes was no longer required to be bifurcated. The increase in 2005 was primarily due to the issuance of $260.0 million of convertible senior notes at a fixed rate of 5.25% per annum during December 2004. See note 7 to our audited consolidated financial statements.
Interest expense on subordinated debentures increased 51% to $21.4 million in 2006 and 47% to $14.1 million in 2005 from $9.6 million in 2004. These increases were primarily due to the issuance of additional subordinated debentures of $41.2 million, $56.7 million and $59.3 million during 2006, 2005 and 2004, respectively. The increases were also due to increases in the weighted average interest rates on the outstanding subordinated debentures which were 8.35%, 7.38% and 7.01% for 2006, 2005 and 2004, respectively. The weighted average interest rates have increased 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.
Other operating costs and expenses increased 13% to $40.4 million in 2006 and 10% to $35.9 million in 2005 from $32.5 million in 2004. The increase in 2006 was principally attributable to an increase of $2.5 million in risk charges related to our reinsurance agreements with Hannover Life Reassurance
Company of America and an increase of $1.9 million in salaries and related cost of employment due to growth in our annuity business, offset by a decrease of $1.7 million in legal fees. The increase in 2005 was principally attributable to an increase of $2.9 million in salaries and related costs of employment due to the growth in our annuity business and an increase of $1.8 million in legal fees. These increases were offset in part by a decrease of $1.2 million in insurance taxes and guaranty fund assessments.
Investments increased to $11.4 billion at December 31, 2006 compared to $10.5 billion at December 31, 2005 as a result of the growth in our annuity business discussed above. At December 31, 2006, the fair value of our available for sale fixed maturity and equity securities was $120.6 million less than the amortized cost of those investments, compared to $88.7 million at December 31, 2005. At December 31, 2006, the amortized cost of our fixed maturity securities held for investment exceeded the fair value by $256.9 million, compared to $112.8 million at December 31, 2005. The increases in net unrealized investment losses at December 31, 2006 compared to December 31, 2005 was principally related to an increase in market interest rates and an increase in invested assets.
We have derivative instruments carried at fair market value of $381.5 million at December 31, 2006 and $185.4 million at December 31, 2005. These derivative instruments consist primarily of call options purchased to provide the income needed to fund the annual index credits on our index products. See Critical Accounting Policies-Derivative Instruments.
Our liability for policy benefit reserves increased to $13.2 billion at December 31, 2006 compared to $12.2 billion at December 31, 2005, 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.
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, 2006 and 2005 were $386.0 million and $396.7 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 $628.0 million, $318.8 million and $196.3 million for the years ended December 31, 2006, 2005 and 2004, respectively. The weighted average interest rate on amounts due under repurchase agreements was 5.24%, 3.54% and 1.60% for the years ended December 31, 2006, 2005 and 2004, 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.
Details regarding the interest rate swaps at December 31, 2006 are as follows (dollars in thousands):
During the fourth quarter of 2006, we entered into a $150 million revolving line of credit with eight banks. There is no amount outstanding under this revolving line of credit at December 31, 2006. See note 7 to our audited consolidated financial statements for additional details concerning the terms of the revolving line of credit.
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 and 2004, certain officers and directors exercised subscription rights to purchase shares of our common stock with respect to 2,151,375 shares and 6,000 shares, respectively. 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 for 2005 and immaterial for 2004.
our life subsidiaries could readily liquidate portions of their investments, if such a need arose. See Quantitative and Qualitative Disclosures about Market Risk for further discussion of the related interest rate risk exposure. In addition, investments could be used to facilitate borrowings under repurchase agreements . As indicated above, such borrowings have been used by American Equity Life from time to time to increase our return on investments.
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 452% at December 31, 2006.
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, 2006 and 2005 and for the years ended December 31, 2006, 2005 and 2004 is included in note 11 to our audited consolidated financial statements.
(1) Amounts shown in this table are projected payments through the year 2026 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 June 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections (“SFAS 154”), which is a replacement of Accounting Principals Board Opinion No. 20, Accounting Changes and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements. SFAS 154 requires retrospective application of prior periods’ financial statements for all voluntary changes in accounting principle, unless impracticable. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 31, 2005. SFAS 154 has no immediate impact on our consolidated financial statements, though it will impact the presentation of future voluntary accounting changes, if any such changes occur.
In September 2005, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts (“SOP 05-1”). SOP 05-1 provides guidance on accounting by insurance enterprises for deferred policy acquisition costs and deferred sales inducements on internal replacements of insurance contracts other than those specifically described in SFAS 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments. SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights or coverages that occurs by exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. SOP 05-1 is effective for internal replacements occurring in fiscal years beginning after December 31, 2006. Retrospective application of SOP 05-1 to previously issued financial statements is not permitted. We have evaluated SOP 05-1 and do not believe that it will have a material impact on our consolidated financial statements.
In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments (“SFAS 155”), which amends SFAS 133 and SFAS No. 140, Accounting for Transfers and Servicing of