Management's discussion and analysis reviews our consolidated financial position at December 31, 1999 and 1998, and our consolidated results of operations for the three years ended December 31, 1999, and where appropriate, factors that may affect future financial performance. This analysis should be read in conjunction with the audited consolidated financial statements, notes thereto and selected consolidated financial data appearing elsewhere in this report.
o regulatory changes or actions, including those relating to regulation of financial services affecting (among other things) bank sales and underwriting of insurance products and regulation of the sale, underwriting and pricing of products
We specialize in the sale of individual annuities (primarily deferred annuities) and, to a lesser extent, we also sell life insurance. Under generally accepted accounting principles, premium collections for deferred annuities are reported as deposit liabilities instead of as revenues. Earnings from products accounted for as deposit liabilities are primarily generated from the excess of net investment income earned over the interest credited to the policyholder, or the "investment spread," as well as realized gains on investments. In the case of equity-index annuities, the investment spread consists of net investment income in excess of the amortization of the cost of the options purchased to fund the index-based component of the policyholder's return. Revenue is also recognized from surrender charges deducted from the policyholder's account balance.
Traditional life and accident and health insurance premiums decreased 2% to $10,294,000 in 1999 and 8% to $10,528,000 in 1998 from $11,425,000 in 1997. The majority of our traditional life and accident and health insurance premiums consist of group policies sold to a limited market. Because our primary focus is the sale of annuities, we have made no effort to expand sales of these products to other markets. As a result, sales of such products have declined slightly.
Annuity and single premium universal life product charges (surrender charges assessed against policy withdrawals and mortality and expense charges assessed against single premium universal life policyholder account balances) increased 437% to $3,452,000 in 1999, and 5,258% to $643,000 in 1998, from $12,000 in 1997. These increases are principally attributable to the growth in our annuity business
and correspondingly, increases in annuity policy withdrawals subject to surrender charges. Withdrawals from annuity and single premium universal life policies were $60,845,000, $23,637,000 and $2,419,000 for 1999, 1998 and 1997, respectively.
Realized gains on investments increased 241% to $1,454,000 in 1999 compared to $427,000 in 1998 and $0 in 1997. The increase in 1999 was primarily attributable to a gain realized on the termination of a total return swap contract. In 1998, realized gains consisted of a gain of $152,000 on the sale of fixed maturity securities and a gain of $275,000 on the sale of our office building in Alabama.
Other operating costs and expenses increased 39% to $12,058,000 in 1999 and 7% to $8,693,000 in 1998 from $8,161,000 in 1997. These increases are principally attributable to increases in employees and related salaries and costs of employment. The comparison of 1998 to 1997 is also favorably impacted by $1,864,000 of costs and expenses for two items in 1997. These items were: (i) $1,236,000
Income tax expense for 1999 was a benefit of $1,370,000 compared to an expense of $760,000 in 1998, and a benefit of $1,390,000 in 1997. The benefit in 1999 is attributable to: (i) the elimination of the December 31, 1998 valuation allowance on deferred income tax assets of $1,537,000 and (ii) tax benefits of $708,000 attributable to the redeemable preferred securities of subsidiaries. Excluding these two items, 1999 income tax expense would have been $815,000 for an effective income tax rate of 27%. The effective income tax rates for 1998 and 1997, excluding the impact of changes in the valuation allowance for deferred income tax assets were 36% and 44%, respectively. These effective income tax rates varied from the applicable statutory federal income tax rates of 35% for 1999 and 34% for 1998 and 1997 principally because: (i) in 1999, the December 31, 1998 net deferred tax asset was adjusted to the 35% rate; (ii) in 1998, we had certain nondeductible expenses; and (iii) in 1997, we qualified as a small life insurance company under provisions of the Internal Revenue Code and recognized the small company deduction only available to such companies. See Note 6 of the Notes to the Audited Consolidated Financial Statements included elsewhere in this report.
Liabilities. Our liability for policy benefit reserves increased $817,794,000 and $385,084,000 during 1999 and 1998, respectively, to $1,358,876,000 at December 31, 1999 and $541,082,000 at December 31, 1998, primarily due to annuity sales as discussed above. Substantially all of our annuity products have a surrender charge feature designed to reduce early withdrawal or surrender of the policies and to partially 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.
Stockholders' Equity. We were initially capitalized in December, 1995 and January, 1996 through the issuance of shares of Common Stock for cash of $4,000,000. Subsequent to our initial capitalization (400,000 shares of Common Stock after a May 29, 1996 100-for-1 stock split), we issued additional shares of Common Stock, warrants to purchase shares of Common Stock and shares of Series Preferred Stock convertible into shares of Common Stock in several private placement offerings as follows:
(1) issued to the placement agent in payment of a portion of the compensation due to the placement agent
(4) issued to the placement agent as part of placement agent compensation; expire on April 30, 2000
A portion of the 2,666,250 shares of Common Stock issued in 1997 at $16 per share were issued in a rights offering to existing stockholders and in connection therewith, certain of our officers and directors received management subscription rights to purchase one share of Common Stock for each share owned and one-half share of Common Stock for each stock option held on the offering date. An aggregate of 719,125 management subscription rights were issued to nine officers and directors at that time. The management subscription rights have an exercise price of $16.00 per share and expire on December 1, 2002. Farm Bureau Life Insurance Company purchased 1,562,500 shares of Common Stock in this offering and received a right of first refusal to maintain a 20% ownership interest in our capital stock.
In October, 1999, American Equity Capital Trust II ("Trust II"), our wholly-owned subsidiary, issued 97,000 shares of 5% Trust Preferred Securities (the "5% Trust Preferred Securities"). The 5% Trust Preferred Securities, which have a liquidation value of $100 per share ($97,000,000 in the aggregate) have been assigned a fair value of $72,490,000 (based upon an effective 7% yield-to-maturity). The consideration received by Trust II in connection with the issuance of the 5% Trust Preferred Securities consisted of fixed income trust preferred securities of equal value which were issued by the parent of Farm Bureau Life insurance Company. Farm Bureau beneficially owns 33.27% of our common stock.
We believe that the diversity of our investment portfolio and the concentration of investments in high-quality, liquid securities provides sufficient liquidity to meet foreseeable cash requirements. The investment portfolio at December 31, 1999 included $1,434,164,883 of publicly traded investment grade bonds. Although there is no present need or intent to dispose of such investments, our life subsidiary could readily liquidate portions of its investments, if such a need arose. In addition, investments could be used to facilitate borrowings under reverse-repurchase agreements or dollar-roll transactions. Such borrowings have been used by our life subsidiary from time to time to increase our return on investments and to improve liquidity.
The payment of dividends or the distributions, including surplus note payments, by our life subsidiary is subject to regulation by the Iowa Insurance Division. Currently, our life subsidiary may pay dividends or make other distributions without the prior approval of the Iowa Insurance Division, unless such payments, together with all other such payments within the preceding twelve months, exceed the greater of (1) our life subsidiary's net gain from operations (excluding net realized capital gains or losses) for the preceding calendar year, or (2) 10% of our statutory surplus at the preceding December 31. For 2000, up to $16,326,000 can be distributed as dividends or surplus note payments without prior approval of the Iowa Insurance Division. In addition, dividends and surplus note payments may be made only out of earned surplus, and all surplus note payments are subject to prior approval by regulatory authorities. Our life subsidiary had $29,259,000 of earned surplus at December 31, 1999.
The transfer of funds by our life subsidiary is also restricted by certain covenants in our loan agreement which, among other things, requires the life subsidiary to maintain statutory capital and surplus (including the asset valuation and interest maintenance reserves) of $120,000,000 plus 25% of statutory
Our life subsidiary has entered into a general agency commission and servicing agreement with American Equity Investment Service Company, an affiliated company wholly-owned by the Company's chairman and president, whereby the affiliate acts as a national supervisory agent with responsibility for paying commissions to the Company's agents. This agreement initially benefits the life subsidiary's statutory surplus by extending the payment of a portion of the first year commissions on new annuity business written by the life subsidiary over a longer period of time, and thereby enabling the life subsidiary to conduct a comparatively greater volume of business. In subsequent periods, the life subsidiary's statutory surplus is reduced through the payment of renewal commissions to the affiliate on this business based upon the account balances of the annuities remaining in force for a period of five years (see Note 11 of the Notes to the Audited Consolidated Financial Statements included elsewhere in this report).
The aggregate amount of first year commissions paid by the affiliate with funds obtained from sources other than the life subsidiary was $69,127,000 from the inception of the agreement through December 31, 1999, and the aggregate amount of renewal commissions paid by the life subsidiary to the affiliate for the same period was $22,708,000.
Inflation does not have a significant effect on our 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. Higher interest rates experienced in recent periods have decreased the value of our fixed maturity investments. It is likely that declining interest rates would have the opposite effect. It is not possible to calculate the effect such changes in interest rates have had on our operating results.
Many computer programs were originally written using two digits rather than four digits to identify a particular year. Such programs may recognize a date using "00" as the year 1900 rather than the year 2000. If not corrected, these computer programs could cause system failures or miscalculations in the year 2000, with possible adverse effects on our operations.
We experienced no disruptions or other problems with our computer systems on January 1, 2000 or thereafter in connection with date-sensitive processing. We experienced no disruptions in other services such electronic funds transfers, phone systems or utilities.
In June 1998, the Financial Accounting Standards Board issued Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities." Statement No. 133 requires companies to record derivatives on the balance sheet as assets or liabilities, measured at fair value. Accounting for gains or losses resulting from changes in the values of those derivatives is dependent on the use of the derivative and whether it qualifies for hedge accounting. The Statement is effective for us in the year 2001, with earlier adoption encouraged. We have not yet determined the effect that adoption of this new Statement will have on our operations or financial position.