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
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.
(b)Effective December 31, 2003, we adopted Financial Accounting Standards Board Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51. See note 1 to our audited financial statements.
(e)We define return on equity as net income divided by average total stockholders' equity. Average total stockholders' equity is determined based upon the total stockholders' equity at the beginning and the end of the year. The computation of average stockholders' equity for 2003 has been modified to recognize the Page 16 of 42
(f)Our statutory net loss in 2001, was also affected by (i) an increase in reserves related to sales of certain multi-year rate guaranteed products, which have reserve requirements that are higher in earlier years and (ii) income tax expense of $6.0 million caused by a difference between statutory and tax basis reserves and other timing differences.
(g)See note 1 to our audited financial statements for a discussion of a change in balance sheet presentation in 2003. Page 17 of 42
Management's discussion and analysis reviews our consolidated financial position at December 31, 2003 and 2002, and our consolidated results of operations for the three years in the period ended December 31, 2003, and where appropriate, factors that may affect future financial performance. This discussion should be read in conjunction with our consolidated financial statements, notes thereto and selected consolidated financial data appearing elsewhere in this report.
•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;
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". In the case of index annuities, the investment spread consists of net investment income in
Our profitability depends in large part upon the amount of assets under our management, investment spreads we earn on our policyholders' 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 interest 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.
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.
maturity securities that are not actively traded, fair values are estimated using price matrices developed 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 credit deterioration. If this review indicates a decline in market value that is other than temporary, our carrying amount in the investment is reduced to its fair value and a specific writedown is taken. Such reductions in carrying amount are recognized as realized losses and charged to income.
At December 31, 2003 and 2002, the fair value of investments we owned that were non-investment grade or not rated was $91.5 million and $51.9 million, respectively. Non-investment grade or not rated securities represented 1.7% and 1.1% at December 31, 2003 and 2002, respectively, of the fair value of our fixed maturity securities. The unrealized losses on investments we owned that were non-investment grade or not rated at December 31, 2003 and 2002, were $10.8 million and $19.8 million, respectively. The unrealized losses on such securities at December 31, 2003 and 2002 represented 4.9% and 27.6%, respectively, of gross unrealized losses on fixed maturity securities
At December 31, 2003 and 2002, we identified certain 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 other than temporary impairments which are listed below by length of time these invested assets have been in an unrealized loss position. This list is referred to as our watch list. We have excluded 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.
At December 31, 2003, the amortized cost and estimated fair value of each fixed maturity security on the watch list are as follows:
Our analysis of these securities and their credit performance at December 31, 2003 is as follows:
Continental Airlines Pass Thru Certificates 2001-001 Class B are backed by the general credit of Continental Airlines as well as the collateral from a pool of airplanes. We determined that an
other than temporary impairment charge was not necessary for the following reasons: (i) we believed that Continental Airlines' improving liquidity reduced the likelihood of bankruptcy and (ii) even if Continental Airlines were to declare bankruptcy, the chance of full recovery on this security was high due to the excess collateral coverage supplied by the aircraft collateral.
Oakwood Mortgage 2000-C Class M1 is backed by installment sales contracts secured by manufactured homes and liens on real estate. We determined that an other than temporary impairment charge was not necessary for the following reasons: (i) the security still had investment grade ratings from both Moody's and S&P (A3/BBB+) and (ii) the security was current on all scheduled interest payments. We performed stress tests with above average default rates and above average loss severity per default and the M1 Tranche still received all of its scheduled principal and interest payments.
We took writedowns on certain other investments that we concluded did have an other than temporary impairments during 2003, 2002 and 2001 of $9.8 million, $13.0 million and $7.8 million, respectively. Following is a discussion of each security for which we have taken write downs on during the years ended December 31, 2003, 2002 and 2001.
AIG Global Investment is a trust that consists of the equity tranche of a collateralized bond obligation wrapped by a U.S. Treasury strip. The security is rated AAA due to the principal being backed by U.S. Treasury strip. We took an impairment charge of $2.8 million on this security in the fourth quarter of 2001. This adjustment reflected our belief that the only future cash flow likely to be received on this security was upon the maturity of the U.S. Treasury Strip.
South Street is a trust that consists of the equity tranche of a collateralized bond obligation wrapped by a U.S. Treasury Strip. The security is rated AAA due to the principal being backed by U.S. Treasury Strip. We took an impairment charge of $1.4 million on this security in the fourth quarter of 2001. This adjustment reflected our belief that the only future cash likely to be received on this security was upon the maturity of the U.S. Treasury strip.
Knight Funding is a trust that consists of the equity tranche of a collateralized bond obligation wrapped by a U.S. Treasury strip. The security is rated AAA due to the principal being backed by U.S. Treasury strip. We took an impairment charge of $1.7 million on this security in the fourth quarter of 2001. We determined that while payments on the equity tranche would continue to be paid, it was likely that these payments would be less than previously estimated.
Following is a list of securities which we have sold at a loss excluding losses arising from interest rate changes and losses deemed immaterial:
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) in a recognized index or benchmark. The participation rate, which we may reset annually, generally varies among the index products from 50% to 100%. Some of the products have an "asset fee" ranging from 1% to 4%, which is deducted from the interest to be credited. The asset fees may be adjusted annually by us, subject to stated limits. In addition, some products apply an overall limit, or "cap", ranging from 7% to 13%, on the amount of annual interest the policyholder may earn in any one contract year, and the applicable cap also may be adjusted annually subject to stated minimums. 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 3%.
We purchase one-year call options on the applicable indices as an investment to provide the income needed to fund the amount of the annual index credits on the index products. New one-year options are purchased at the outset of each contract year. We budget a specific amount to the purchase price of the specific options needed to fund the annual credits, and the cost of the options represents our cost of providing the credits. The amount we budget to the purchase of index call options is based on our interest spread targets and is comparable to the credited rates of interest we offer on fixed rate annuities. For example, if the yield on our invested assets is 6.50% and our targeted spread is 2.50%, we allocate up to 4.00% of the premium in the first year or account balance after the first year to the purchase of one-year call options on the index products. Participation rates, which define the
policyholder's level of participation in index gains each year, are determined by option costs. For example, if, based on current market conditions, the amount allocated to the purchase of options is sufficient to purchase an option that will provide a return equal to 70% of the annual gain in the applicable index, we will set the policyholder's participation rate at 70%. We have the ability to modify participation rates each year when a new option is purchased. In general, if option costs increase, participation rates may be decreased, and if option costs decrease, participation rates may be increased. We purchase call options weekly based upon new and renewing index account values during the applicable week, and the purchases are made by category according to the particular products and indices applicable to the new or renewing account values. Any gains on the options at the expiration of the one-year term fund the related index credits to the policyholders. If there is no gain in an index, the policyholder receives a zero index credit on the policy, and we incur no costs beyond the option cost, except in cases where the minimum guaranteed value of a contract exceeds its index value.
Market value changes associated with those investments are reported as an increase or decrease in revenues in our consolidated statements of income in accordance with Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities". The risk associated with prospective purchases of future one-year options is the uncertainty of the cost, which will determine whether we are able to earn our spread on our index business. All our index products permit us to modify participation rates, asset fees or annual income caps at least once a year. This feature is comparable to our fixed rate annuities, which allow us to adjust crediting rates annually. By modifying our participation rates or other features, we can limit our costs of purchasing the related one-year call options, except in cases where contractual features would prevent further modifications. Based upon actuarial testing which we conduct as a part of the design of our index products and on an ongoing basis, we believe the risk that contractual features would prevent us from controlling option costs is not material.
value of these embedded derivatives are based on assumptions related to underlying policy terms (including annual participation rates, asset fees, cap rates and minimum guarantees), index values, notional amounts, strike prices and expected lives of the policies. The change in fair value of embedded derivatives increases with increases in volatility in the indices and interest rates. 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 contract which typically exceeds 10 years.
•We adjust the amortization of deferred policy acquisition costs to reflect the impact of the items discussed above.
Net income was $25.4 million in 2003, $14.2 million in 2002 and $0.9 million in 2001. The growth in net income was directly tied to: (i) an increase in our invested assets (on an amortized cost basis) of 18% from December 31, 2002 to December 31, 2003 and 42% from December 31, 2001 to December 31, 2002; (ii) decreases in weighted average interest crediting rates of 67 basis points and 28 basis points during 2003 and during 2002, respectively; and (iii) realized gains on sales of investments of $6.9 million for the year ended December 31, 2003. 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.
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 33% to $20.5 million in 2003, and 23% to $15.4 million in 2002, from $12.5 million in 2001. These increases are principally attributable to the growth and aging of our annuity business and correspondingly, increases in annuity policy withdrawals subject to surrender charges. Withdrawals from annuity and single premium universal life policies were $472.2 million, $332.0 million and $223.2 million for 2003, 2002 and 2001, respectively.
Net investment income increased 16% to $358.5 million in 2003 and 48% to $308.5 million in 2002 from $209.1 million in 2001. These increases are principally attributable to the growth in our annuity business and corresponding increases in our invested assets. Invested assets (on an amortized cost basis) increased 18% to $6,161.5 million at December 31, 2003 and 42% to $5,229.1 million at
Realized gains on investments were $6.9 million in 2003 compared to realized losses of $0.1 million in 2002 and realized gains of $0.8 million in 2001. 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. Realized gains and 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 in recognition of an "other than temporary" impairment. The components of realized gains and losses on investments are set forth in note 3 to our audited consolidated financial statements. See "Critical Accounting Policies-Valuation of Investments" for additional discussion of losses recognized on the sale of securities and write downs of the fair value of securities for "other than temporary" impairments.
Change in fair value of derivatives was an increase of $52.5 million in 2003, a decrease of $57.8 million in 2002 and a decrease of $55.2 million in 2001. These fluctuations were primarily related to the performance of the underlying market indices on which our options are based. A substantial portion of our options are based upon equity market indices which had significant appreciation in 2003 and significant depreciation in 2002 and 2001. Accordingly, our options had much higher gains at expiration in 2003 compared to 2002 and 2001 and the unrealized gains in these options at December 31, 2003 were significantly greater than at December 31, 2002 and 2001. See "Critical Accounting Policies-Derivative Instruments-Index Products" for the components of the change in fair value of derivatives.
Insurance policy benefits and change in future policy benefits increased 27% to $11.8 million in 2003 compared to $9.3 million in 2002 and $9.8 million in 2001. The increase during 2003 was primarily due to an increase in interest credited and payments on supplemental contracts involving life contingencies of $1.5 million compared to 2002.
Interest expense on subordinated debentures for 2003 was $7.7 million. The comparable amounts for 2002 and 2001 were $7.4 million and are reported as minority interests in subsidiaries.
Amortization of deferred policy acquisition costs increased 33% to $53.0 million in 2003 and 73% to $39.9 million in 2002 from $23.0 million in 2001. These increases are primarily due to: (i) additional annuity deposits as discussed above; and (ii) the introduction of multi-year rate guaranteed products with shorter expected lives. Additional amortization associated with net realized gains on investments for the year ended December 31, 2003 was $3.1 million. The application of SFAS No. 133 resulted in a $1.7 million reduction in amortization in 2003 and increased amortization by $1.4 million and $0.8 million in 2002 and 2001, respectively. See notes 1 and 4 to our audited consolidated financial statements.
Other operating costs and expenses increased 18% to $25.6 million in 2003 and 26% to $21.6 million in 2002 from $17.2 million in 2001. The increase during 2003 compared to 2002 was principally attributable to an increase of $0.8 million in professional fees related to litigation, $1.5 million in salaries and related costs of employment due to growth in our annuity business and $1.7 million in risk charges related to the reinsurance agreement entered into with Hannover Life Reassurance Company of America on November 1, 2002. This agreement is more fully described in note 5 to our audited consolidated financial statements. The increase during 2002 compared to 2001 was principally attributable to an increase of $1.0 million in professional fees, $1.6 million in marketing expenses and $0.8 million in salaries and related cost of employment due to growth in our annuity business.
Income tax expense increased 85% to $13.5 million in 2003 from $7.3 million in 2002. Income tax expense increased $7.0 million in 2002 from $0.3 million in 2001. These increases were principally due to an increase in pre-tax income. Our effective tax rates for 2003, 2002 and 2001 were 35%, 34% and 17%, respectively, after taking into consideration the impact of earnings attributable to company-obligated mandatorily redeemable preferred securities of subsidiary trusts. The effective income tax rates for 2002 and 2001 varied from the applicable statutory federal income tax rates of 35% principally due to (i) the impact of state taxes on the federal income tax expense and (ii) the dividends received deduction. See note 6 to our audited consolidated financial statements.
Our investment strategy is to maintain a predominantly investment grade fixed income portfolio, provide adequate liquidity to meet our cash obligations to policyholders and others and maximize current income and total investment return through active investment management. Consistent with this strategy, our investments principally consist of fixed maturity securities and short-term investments. We also had approximately 1.9% and 0.9% of our invested assets at December 31, 2003 and 2002 in derivative instruments (primarily equity market index call options) purchased in connection with the issuance of index annuities.
policy acquisition costs) are included directly in a separate component of stockholders' equity, thereby exposing stockholders' equity to volatility due to changes in market interest rates and the accompanying changes in the reported value of securities classified as available-for-sale, with stockholders' equity increasing as interest rates decline and, conversely, decreasing as interest rates rise.
Cash and investments increased to $6.23 billion at December 31, 2003 compared to $5.33 billion at December 31, 2002 as a result of the growth in our annuity business discussed above. At December 31, 2003, the fair value of our available for sale fixed maturity and equity securities was $86.1 million less than the amortized cost of those investments, compared to $44.8 million at December 31, 2002. At December 31, 2003, the amortized cost of our fixed maturity securities held for investment exceeded the market value by $110.1 million, compared to $1.8 million at December 31, 2002. The increase in net unrealized investment losses at December 31, 2003 compared to December 31, 2002 was related to an increase in market interest rates.
During 2001, we began a commercial mortgage loan program. At December 31, 2003 and 2002, we held $608.7 million and $334.3 million, respectively, of mortgage loans with commitments outstanding of $48.3 million at December 31, 2003. These mortgage loans are diversified as to property type, location, and loan size, and are collateralized by the related properties. Our mortgage lending policies establish limits on the amount that can be loaned to one borrower and require diversification by geographic location and collateral type. As of December 31, 2003, there were no delinquencies in our mortgage portfolio. The commercial mortgage loan portfolio is diversified by geographic region and specific collateral property type as follows:
Our liability for policy benefit reserves increased to $8.32 billion at December 31, 2003 compared to $6.74 billion at December 31, 2002, 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.
American Equity Capital Trust I ("Trust I") issued $26.0 million of 8% trust preferred securities and we issued $26.8 million principal amount of our 8% subordinated debentures due September 30, 2029 to Trust I. The preferred securities issued by Trust I are convertible into 3,198,717 shares of common stock. There are 865,671 shares of the 8% trust preferred securities issued, of which 2,000 shares are held by one of our subsidiaries.
During December 2003, American Equity Capital Trust IV ("Trust IV"), a subsidiary trust, issued $12.0 million of floating rate trust preferred securities and we issued $12.4 million principal amount of floating rate subordinated debentures due January 8, 2034 to Trust IV. The floating rate for the trust preferred securities and the subordinated debentures is based on the three month London Interbank Offered Rate plus 4.00%.
Prior to the adoption of Financial Accounting Standards Board Interpretation No. 46, "Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51" in December 2003, the subsidiary trusts were included in our consolidated financial statements. The subsidiary trusts are no longer consolidated upon adoption of the Interpretation and the effect of such deconsolidation is that the obligations of the trusts to the preferred security holders have been replaced with our subordinated debt obligations to the trusts and our equity investments in the trusts. See notes 1 and 9 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, 2003 and 2002, approximately 99% of our annuity
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, 2003 and 2002 included $3,401.1 million and $3,503.7 million (amortized cost basis), respectively, of publicly traded available for sale investment grade bonds. Although there is no present need or intent to dispose of such investments, our life subsidiaries could readily liquidate portions of their investments, if such a need arose. See "Management's Discussion and Analysis of Financial Condition and Results of Operations-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 reverse-repurchase agreements or dollar-roll transactions. Such borrowings have been used by American Equity Life from time to time to increase our return on investments.
The payment of dividends or the 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 its state of domicile's insurance department, 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 surplus at the preceding December 31. For 2004, up to approximately $37.5 million can be distributed as dividends by American Equity Life 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 in the life subsidiary's state of domicile. American Equity Life had approximately $69.8 million of earned surplus at December 31, 2003.
The transfer of funds by American Equity Life is also restricted by certain covenants in our loan agreement which, among other things, requires American Equity Life to maintain statutory capital and surplus (including the asset valuation and interest maintenance reserves) of $140 million plus 25% of statutory net income and 75% of the capital contributions to American Equity Life for periods subsequent to December 31,1999. Under the most restrictive of these limitations, $37.5 million of our
earned surplus at December 31, 2003 would be available for distribution by American Equity Life to the parent company in the form of dividends or other distributions. As disclosed in our audited consolidated financial statements, our loan agreement has been amended from time to time to maintain our continuing compliance with these and other restrictive covenants.
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, 2003 and 2002 and for the years ended December 31, 2003, 2002 and 2001 is included in note 11 to our audited consolidated financial statements.
From time to time the Service Company has borrowed money from us as a source of funds for the commissions it paid to American Equity Life's agents. During 2003, the Service Company borrowed $14.5 million from us. At December 31, 2003 and 2002, the amount receivable from the Service Company was $27.9 million and $20.5 million, respectively. Principal and interest are payable quarterly over five years from the date of the advance.
Future payments by American Equity Life on business in force at December 31, 2003 are dependent upon the account balances of the annuities remaining in force on each remaining quarterly renewal commission payment date.
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, 2003.
In June 2003, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position (SOP) 03-1, "Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for the Separate Accounts". The SOP provides guidance on the presentation of sales inducements ("premium bonus and bonus interest"). We expect to adopt this SOP when it becomes effective in the first quarter of 2004 and will change our presentation of deferred expenses relating to sales inducements at that time. The SOP requires that sales inducements be recognized as an asset and amortized with the amortization being included as a component of interest credited to account balances. We currently include sales inducements as a component of deferred policy acquisition costs and the related amortization expense. The amount of sales inducements included as a component of deferred policy acquisition costs at December 31, 2003 and December 31, 2002 was $88.4 million and $62.9 million, respectively. The adoption of this SOP will have no impact on net income or earnings per common share.