We do not own any real estate. We lease space for our principal offices in West Des Moines, Iowa, pursuant to written leases for approximately 45,000 square feet. The leases expire on June 30, 2006 and have a renewal option for an additional five year term at a rental rate equal to the prevailing fair market rate. We also lease space for our office in Pell City, Alabama, pursuant to a written lease dated January 3, 2000, for approximately 3,380 square feet. This lease expires on December 31, 2004.
Management's discussion and analysis reviews our consolidated financial position at December 31, 2002 and 2001, and our consolidated results of operations for the three years in the period ended December 31, 2002, and where appropriate, factors that may affect future financial performance. This analysis should be read in conjunction with the 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 market value of our investments and the lapse rate and profitability of our policies
Commissions and certain other costs relating to the production of new and renewal business are not expensed when incurred but instead are capitalized as deferred policy acquisition costs. Deferred policy acquisition costs for annuities are amortized into expense with the emergence of gross profits. Under certain circumstances, deferred policy acquisition costs will be expensed earlier than originally estimated, for example, when policy terminations are higher than originally estimated and when investments relating to the liabilities of such products are called or sold at a gain or loss prior to anticipated maturity.
The increasing complexity of the business environment and applicable authoritative accounting guidance require us to closely monitor our accounting policies. We have identified four 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 and changes in guidance.
Our periodic assessment of our ability to recover the amortized cost basis of investments that have materially lower quoted market prices requires a high degree of management judgment and uncertainty. Factors considered in evaluating whether a decline in value is other than temporary include: (a) the length of time and the extent to which the fair value has been less than cost; (b) the financial condition and near-term prospects of the issuer; (c) whether the investment is considered investment grade; (d) whether the issuer is current on all payments and that all contractual payments have been made as agreed; (e) our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery; (f) consideration of rating agency actions; and (g) change in cash flows of asset-backed and mortgage-backed securities. In addition, for securities expected to be sold, an other than temporary impairment charge is recognized if we do not expect the fair value of a security to recover to cost or amortized cost prior to the expected date of sale. 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. Realized losses through a charge to earnings may be recognized in future periods should management later conclude that the decline in market value below amortized cost is other than temporary pursuant to our accounting policy described above.
At December 31, 2002 and 2001, the amortized cost and estimated fair value of fixed maturity securities and equity securities that were in an unrealized loss position were as follows:
Approximately 80% and 69% of our total invested assets were in United States Government and agency fixed maturity
securities including government guaranteed mortgage-backed securities at December 31, 2002 and 2001, respectively. Corporate securities represented approximately 8% and 15% of our total invested assets at December 31, 2002 and 2001, respectively. There are no other significant concentrations in the portfolio by type of security or by industry.
At December 31, 2002 and 2001, the fair value of investments we owned that were non-investment grade or not rated was $51.9 million and $52.5 million, respectively. The unrealized losses on investments we owned that were non-investment grade or not rated at December 31, 2002 and 2001, were $19.8 million and $7.2 million, respectively.
We offer a variety of equity index annuities with income crediting strategies linked to several equity market indices, including the S&P 500, the Dow Jones Industrial Average, the NASDAQ 100 and the Russell 2000. Several of these products offer a bond strategy linked to the Lehman Aggregate Bond Index. These products allow purchasers to earn investment returns linked to equity or bond index appreciation without the risk of loss of their principal. Several of these products allow the purchaser to transfer funds once annually among several different income crediting strategies, including one or more of the index based strategies, a traditional fixed rate strategy and/or a multi-year rate guaranteed strategy. Substantially all of our equity index products require annual crediting of interest and an annual reset of the applicable index on the contract anniversary date. The computation of the annual index credit is based upon either a one year point-to-point calculation (i.e., the gain in the applicable index from the beginning of the applicable contract year to the next anniversary date) or a monthly averaging of the index during the contract year.
•We must mark to market the purchased call options we use to fund the annual index credits on our equity index annuities based upon quoted market prices from related counterparties. We record the
Commissions and certain other costs relating to the production of new business are not expensed when incurred but instead are capitalized as deferred policy acquisition costs. These costs are amortized into expense with the emergence of gross profits. Only costs which are expected to be recovered from future policy revenues and gross profits may be deferred. These costs consist principally of commissions, first-year bonus interest and certain costs of policy issuance. Deferred policy acquisition costs totaled $595.5 million and $492.8 million at December 31, 2002 and 2001, 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 period amortization must be adjusted retrospectively if changes occur in estimates of future gross profits/margins (including the impact of realized investment gains and losses). 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. We made no revisions to our estimates of future gross profits/margins.
As of December 31, 2002 and 2001, we had $50.7 million and $51.2 million, respectively, of net deferred income tax assets related principally to book-to-tax temporary differences in the recording of policy benefit reserves. The realization of these assets is based upon estimates of future taxable income, which requires management judgement. Based upon future projections of sufficient taxable income of our life subsidiaries, and the adoption of plans and policies related to our net (non-life) operating loss carryforwards, we have not recorded a valuation allowance against these assets.
New annuity deposits (net of reinsurance) for the years ended December 31, 2002 totaled $1,597.3 million, compared to $2,006.9 million for 2001 and $843.3 million for 2000. New annuity deposits before reinsurance totaled $2,435.2 million and $2,425.2 million for the years ended December 31, 2002 and 2001, respectively. Our annuity reserves continued to show strong growth throughout 2002, primarily as a result of the growth in our agency force. Annuity reserves and the number of our appointed agents have grown as follows during the last three years:
The growth in our annuity business resulted in a sizeable increase in our earnings from invested assets for 2002 and 2001. While certain expenses also increased as a result of the growth in our annuity business, the incremental profits from a larger deposit base allowed us to offset a greater portion of our fixed operating costs and expenses. Production decreased in the last two months of 2002 due to actions (i.e. crediting rate reductions and withdrawal of certain products) taken by us throughout the year to manage our capital position. We will continue to manage our levels of production throughout 2003 at levels the statutory capital and surplus of our life subsidiaries will support.
Net income was $14.2 million in 2002, $0.9 million in 2001 and $4.8 million in 2000. The strong growth in net income is directly tied to the growth of our assets from the sales of annuities. In addition, net income in 2001 was lower than expected due to our decision after September 11th to maintain approximately 25% of our assets in cash equivalents. We estimate that the decline in net income for 2001 attributable to our high level of liquidity was approximately $5.7 million, net of income taxes.
Net investment income increased 48% to $308.5 million in 2002 and 109% to $209.1million in 2001 from $100.1 million in 2000. These increases are principally attributable to the growth in our annuity business and correspondingly, increases in our invested assets. Invested assets (amortized cost basis) increased 44% to $5,299.1 million at December 31, 2002 and 88% to $3,682.7 million at December 31, 2001 compared to $1,960.3 million at December 31, 2000, while the weighted average yield earned on average invested assets was 6.91%, 7.08% and 7.78% for 2002, 2001, and 2000, respectively. Prior to the adoption of SFAS No. 133 on January 1, 2001, net investment income for 2000 included amounts related to the options we hold to fund the annual index credits on our equity index annuities. This included gains received on such options, which were passed on to the equity index policyholders and the amortization of such options. Gains received on options held for equity index policies were $13.2 million for 2000. Costs of amortization of such options were $55.9 million for 2000.
Realized gains (losses) on investments were losses of $0.1 million in 2002 compared to realized gains of $0.8 million in 2001 and losses of $1.4 million in 2000. In 2002, net realized losses of $0.1 million consisted of gains of $19.9 million, offset by losses of $7.0 million on the sale of securities and write downs of approximately $13.0 million in the fair value of certain securities in recognition of other than temporary impairments. In 2001, net realized gains of $0.8 million consisted of gains of $13.0 million, offset by losses of $4.4 million on the sale of securities and write downs of approximately $7.8 million in the fair value of certain securities in recognition of other than temporary impairments. In 2000, net realized losses of $1.4 million were entirely comprised of losses related to the sale of certain corporate fixed maturity and equity securities.
Change in fair value of derivatives was $(57.8) million for the year ended December 31, 2002 compared to $(55.2) million in 2001 and $(3.4) million in 2000. The change in fair value of derivatives in 2001 arises from the adoption of SFAS No. 133. We adopted SFAS No. 133 on January 1, 2001, which requires that we mark to market the purchased call options we use to fund the annual index credits on our equity index annuities. We include this as a component of our revenues (see Critical Accounting Policies-Derivative Instruments-Equity Index Products). The change in fair value of derivatives of $(3.4) million in 2000 is related to the change in fair value of total return exchange agreements that we
Interest credited to annuity policyholder account balances increased 81% to $177.6 million in 2002 and 73% to $97.9 million in 2001 from $56.5 million in 2000. These increases are principally attributable to increases in annuity liabilities. The amounts are also impacted by changes in the weighted average crediting rates for our annuity liabilities. The weighted average crediting rates for our annuity liabilities at December 31, 2002, 2001 and 2000 are summarized as follows:
Interest expense on notes payable decreased 34% to $1.9 million in 2002 and increased 26% to $2.9 in 2001 from $2.3 million in 2000. The decrease from 2001 to 2002 is due to a decrease in the balance outstanding under the notes, and a decrease in the average applicable interest rate. The increase from 2000 to 2001 was due to increases in the outstanding borrowings, offset in part by a decrease in the average applicable interest rate. The applicable interest rate was 4.36%, 6.28% and 7.99% for 2002, 2001 and 2000, respectively.
Interest expense on amounts due under repurchase agreements decreased 36% to $0.7 million in 2002 and 67% to $1.1 million in 2001 from $3.3 million in 2000. These changes are principally attributable to a decrease in the average balances outstanding. See Note 7 of the Notes to the Consolidated Financial Statements included elsewhere in this report.
Other interest expense increased $0.6 million to $1.0 million in 2002 from $0.4 million in 2001, and arises from the financial reinsurance transactions we entered into with Swiss Re effective January 1, 2001 and net interest expense on a short-bond transaction. See Notes 3 and 5 of the Notes to Consolidated Financial Statements included elsewhere in this report.
Amortization of deferred policy acquisition costs increased 73% to $39.9 million in 2002 and 167% to $23.0 million
Minority interest in earnings of subsidiaries includes amounts for distributions and the accretion of the issue discount on company-obligated mandatorily redeemable preferred stocks of subsidiary trusts issued in 1999. Tax benefits attributable to these amounts are reported as a reduction of income tax expense. See Notes 6 and 9 of the Notes to Consolidated Financial Statements included elsewhere in this report.
We were initially capitalized in December, 1995 and January, 1996 through the issuance of shares of Common Stock for cash of $4.0 million. 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:
(4)issued to the placement agent as part of placement agent compensation; 170,625 exercised in 2000, and the remaining 34,125 exercised in 2002.
In September, 1999, American Equity Capital Trust I ("Trust I"), our wholly-owned subsidiary, issued $26.0 million of 8% Convertible Trust Preferred Securities (the "8% Trust Preferred Securities"). In connection with Trust I's issuance of the 8% Trust Preferred Securities and the related purchase by us of all of Trust I's common securities, we issued $26.8 million in principal amount of our 8% Convertible Junior Subordinated Debentures, due September 30, 2029 (the "8% Debentures") to Trust I. The sole assets of Trust I are the 8% Debentures and any interest accrued thereon. Each 8% Trust Preferred Security is convertible into three shares of our common stock at a conversion price equal to the lesser of (i) $10 per share or (ii) 90% of the initial price per share to the public of common stock sold in connection with our initial public offering of such common stock (the "IPO"), upon the earlier of the 91st day following the IPO or September 30, 2002. The interest payment dates on the 8% Debentures correspond to the distribution dates on the 8% Trust Preferred Securities.
The 8% Trust Preferred Securities, which have a liquidation value of $30 per share plus accrued and unpaid distributions, mature simultaneously with the 8% Debentures. As of December 31, 2002, 863,671 shares of 8% Trust Preferred Securities were outstanding, all of which are unconditionally guaranteed by us to the extent of the assets of Trust I.
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 ($97.0 million in the aggregate) have been assigned a fair value of $78.6 million (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. Farm Bureau beneficially owns 32.47% of our common stock.
In connection with Trust II's issuance of the 5% Preferred Securities and the related purchase by us of all of Trust II's common securities, we issued $100 million in principal amount of our 5% Subordinated Debentures, due June 1, 2047 (the "5% Debentures") to Trust II. The sole assets of Trust II are the 5% Debentures and any interest accrued thereon. The interest payment dates on the 5% Debentures correspond to the distribution dates on the 5% Trust Preferred Securities. The 5% Trust Preferred Securities mature simultaneously with the 5% Debentures. All of the 5% Trust Preferred Securities are unconditionally guaranteed by us to the extent of the assets of Trust II.
We believe that the diversity of our investment portfolio and the concentration of investments in high-quality securities provides sufficient liquidity to meet foreseeable cash requirements. The investment portfolio at December 31, 2002 included $3,503.7 million (amortized cost basis) of publicly traded investment grade bonds. Although there is no present need or intent to dispose of such investments, our life subsidiaries 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 parent company is a legal entity separate and distinct from its subsidiaries, and has no business operations. The parent company needs liquidity primarily to service its debt, including the subordinated debentures issued to subsidiary trusts, pay operating expenses and pay dividends to stockholders. The primary sources of funds for these payments are: (i) principal and interest payments received on the parent company's note receivable from American Equity Investment Service Company (see discussion that follows); (ii) dividends on capital stock and surplus note interest payments from American Equity Life; (iii) investment advisory fees from our life subsidiaries; (iv) cash on hand ($0.8 million at December 31, 2002); and (v) cash ($0.2 million at December 31, 2002) that may be distributed by American Equity Investment Properties, L.C. which invests and re-invests the remaining proceeds from the sale of the office building in Birmingham, Alabama that was sold in 1998. The parent company may also obtain cash by issuing debt or equity securities.
Statutory accounting practices prescribed or permitted for our life subsidiaries differ in many respects from those governing the preparation of financial statements under accounting principles generally accepted in the United States ("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, 2002 and 2001 and for the years ended December 31, 2002, 2001 and 2000 is included in Note 11 of the Notes to Consolidated Financial Statements included elsewhere in this report.
American Equity Life 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 American Equity Life's statutory surplus by extending the payment of a portion of the first year commissions on new annuity business written by American Equity Life over a longer period of time, and thereby enabling American Equity Life to conduct a comparatively greater volume of business. In subsequent periods, American Equity Life'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 8 of the Notes to Consolidated Financial Statements included elsewhere in this report). During the years ended December 31,
2002 and 2000, the Service Company paid $11.8 million and $28.4 million, respectively, to agents of American Equity Life. American Equity Life paid renewal commissions to the Service Company of $21.7 million, $23.2 million and $20.4 million, respectively, during the years ended December 31, 2002, 2001 and 2000.
As a source of funds the Service Company borrowed money from the parent company. At December 31, 2002 and 2001, the amounts receivable from the Service Company totaled $20.5 million and $29.1 million, respectively. Principal and interest are payable quarterly over five years from the date of the advance.