The following is a reconciliation of AHL shareholders’ equity to adjusted shareholders’ equity, which is used in calculating adjusted operating ROE and adjusted book value per share:
The following is a reconciliation of average AHL shareholders’ equity to average adjusted shareholders’ equity, which is used in calculating adjusted operating ROE:
The following is a reconciliation of adjusted book value per share to its corresponding GAAP measure, book value per share:
Change in Fair Values of Derivatives and Embedded Derivatives - FIAs, Net of Offsets-Impacts related to the fair value accounting for derivatives hedging the FIA index credits and the related embedded derivative liability fluctuations from period to period. The index reserve is measured at fair value for the current period and all periods beyond the current policyholder index term. However, the FIA hedging derivatives are purchased to hedge only the current index period. Upon policyholder renewal at the end of the period, new FIA hedging derivatives are purchased to align with the new term. The difference in duration between the FIA hedging derivatives and the index credit reserves creates a timing difference in earnings. This timing difference of the FIA hedging derivatives and index credit reserves is included as a non-operating adjustment, net of offsets related to DAC, DSI, and VOBA amortization and changes to rider reserves.
Integration, Restructuring, and Other Non-operating Expenses-Integration, restructuring, and other non-operating expenses consist of restructuring and integration expenses related to acquisitions and block reinsurance costs as well as certain other expenses which are not related to our underlying profitability drivers or likely to re-occur in the foreseeable future.
Stock Compensation Expense-Stock compensation expenses associated with our share incentive plans, excluding our long-term incentive plan, are not related to our underlying profitability drivers and fluctuate from time to time due to the structure of our plans.
Bargain Purchase Gain-Bargain purchase gains associated with acquisitions are adjustments to net income as they are not related to our underlying profitability drivers.
Adjusted ROE, adjusted operating ROE and adjusted net income are non-GAAP measures used to evaluate our financial performance excluding the impacts of AOCI and funds withheld and modco reinsurance unrealized gains and losses, in each case net of DAC, DSI, rider reserve and tax offsets. Adjusted ROE is calculated as adjusted net income, divided by average adjusted shareholders’ equity. Adjusted shareholders’ equity is calculated as the ending shareholders’ equity excluding AOCI and funds withheld and modco reinsurance unrealized gains and losses. Adjusted operating ROE is calculated as the adjusted operating income, divided by average adjusted shareholders’ equity. Adjusted net income is calculated as net income excluding funds withheld and modco reinsurance unrealized gains and losses, net of DAC, DSI, rider reserve and tax offsets. These adjustments fluctuate period to period in a manner inconsistent with our underlying profitability drivers as the majority of such fluctuation is related to the market volatility of the unrealized gains and losses associated with our AFS securities. Except with respect to reinvestment activity relating to acquired blocks of businesses, we typically buy and hold AFS investments to maturity throughout the duration of market fluctuations, therefore, the period-over-period impacts in unrealized gains and losses are not necessarily indicative of current operating fundamentals or future performance. Accordingly, we believe using measures which exclude AOCI and funds withheld and modco reinsurance unrealized gains and losses are useful in analyzing trends in our operating results. To enhance the ability to analyze these measures across periods, interim periods are annualized. Adjusted ROE, adjusted operating ROE and adjusted net income should not be used as a substitute for ROE and net income. However, we believe the adjustments to equity are significant to gaining an understanding of our overall financial performance.
Adjusted Operating Earnings Per Share, Weighted Average Shares Outstanding - Adjusted Operating and Adjusted Book Value Per Share
Retirement Services Net Investment Earned Rate, Cost of Crediting, Investment Margin on Deferred Annuities, Other Liability Costs and Operating Expenses
Net income decreased by $305 million, or 22%, to $1.1 billion in 2018 from $1.4 billion in 2017. ROE and adjusted ROE decreased to 12.1% and 15.7% in 2018, respectively, from 16.9% and 18.0% in 2017, respectively. The decrease in net income was driven by a $2.2 billion decrease in total revenues, partially offset by a decrease in benefits and expenses of $1.9 billion.
Total revenue decreased by $2.2 billion to $6.5 billion in 2018 from $8.7 billion in 2017. The decrease was driven by unfavorable changes in investment related gains and losses and VIE investment related gains and losses, partially offset by an increase in premiums, higher net investment income and an increase in product charges.
Investment related gains and losses decreased by $3.9 billion to a loss of $1.3 billion in 2018 from a gain of $2.6 billion in 2017, primarily due to the change in fair value of FIA hedging derivatives, the change in reinsurance embedded derivatives, an unfavorable change in gains and losses on trading securities and a $50 million gain on the sale of an equity security during 2017. The change in fair value of FIA hedging derivatives decreased by $2.8 billion driven by the weak performance of the indices upon which our call options are based. The majority of our call options are based on the S&P 500 index which experienced a 6.2% decrease in 2018, compared to a 19.4% increase in 2017. The reinsurance embedded derivatives decreased by $639 million primarily driven by a change in the value of the underlying assets related to credit spreads widening and the increase in U.S. treasury rates compared to the prior year, which benefited from credit spreads tightening. Both of these drivers were magnified by growth in the reinsurance block related to the Voya and Lincoln transactions. The unfavorable change in gains and losses on trading securities of $284 million was comprised primarily by a decrease in AmerUs Closed Block assets of $179 million related to higher losses resulting from credit spreads widening and the increase in U.S. treasury rates compared to prior year.
Interest sensitive contract benefits decreased by $2.6 billion to $290 million in 2018 from $2.9 billion in 2017, primarily due to the change in FIA fair value embedded derivatives, partially offset by growth in the block of business. The change in FIA fair value embedded derivatives decreased by $2.7 billion primarily driven by the weak performance of the equity indices to which our FIA policies are linked, primarily the S&P 500 index, which experienced a 6.2% decrease in 2018, compared to a 19.4% increase in 2017 as well as a favorable change in discount rates used in our embedded derivative calculations as the current period experienced an increase in discount rates compared to 2017, which experienced a decrease in discount rates. Additionally, the FIA fair value embedded derivatives were favorably impacted by $309 million during our annual unlocking of assumptions, which was mainly driven by updating lapse assumptions.
We currently expect that our effective tax rate and our overall tax rate, which includes the impacts of federal income tax, the BEAT and excise tax, will be between 9 and 10%, on average, over the near and medium term; however, we may experience significant fluctuations in these tax rates period-to-period, with certain periods falling outside of our expected range. Assuming that pre-tax income and adjusted operating income before tax are equal, the primary difference between our effective tax rate and our overall tax rate is the inclusion of excise taxes within the calculation of the overall tax rate. We currently expect excise taxes will be immaterial.
In this section, references to 2017 refer to the year ended December 31, 2017 and references to 2016 refer to the year ended December 31, 2016.
Premiums increased by $2.2 billion to $2.5 billion in 2017 from $240 million in 2016, driven by premiums from PRT transactions as we entered the PRT market in 2017.
Investment related gains and losses increased by $1.9 billion to $2.6 billion in 2017 from $652 million in 2016, primarily due to the change in fair value of FIA hedging derivatives, the change in assumed reinsurance embedded derivatives, and higher realized gains on AFS securities. The change in fair value of FIA hedging derivatives increased by $1.6 billion driven by the performance of the indices upon which our call options are based. The majority of our call options are based on the S&P 500 index, which experienced a 19.4% increase in 2017, compared to a 9.5% increase in 2016. The assumed reinsurance embedded derivatives increased by $145 million driven by unrealized gains due to credit spreads tightening primarily on RMBS, as well as a favorable change in FIA hedging derivatives backing the reinsurance block and growth in the reinsurance block. Realized gains on AFS securities increased primarily due to a $50 million gain on the sale of equity securities.
VIE investment related gains and losses increased by $88 million to a gain of $35 million in 2017 from a loss of $53 million in 2016, primarily driven by losses in 2016 resulting from a decline in market value of public equity positions in one of our funds, partially offset by 2016 benefiting from an increase of $82 million in the fair value of certain underlying investments in three of our consolidated VIEs, reflecting the removal of liquidity discounts related to marketability assumptions used in the determination of the fair value.
Interest sensitive contract benefits increased by $1.5 billion to $2.9 billion in 2017 from $1.3 billion in 2016, primarily due to the change in FIA fair value embedded derivatives and higher interest credited to policyholders related to strong growth in deposits. The change in FIA fair value embedded derivatives increased by $1.5 billion, primarily driven by the performance of the equity indices to which our FIA policies are linked, primarily the S&P 500 index, which experienced a 19.4% increase in 2017, compared to a 9.5% increase in 2016. Additionally, the FIA fair value embedded derivatives were impacted by a decrease in discount rates used in our embedded derivative calculations compared to 2016.
Future policy and other policy benefits increased by $2.2 billion to $3.2 billion in 2017 from $1.0 billion in 2016, primarily attributable to $2.3 billion of policyholder obligations from our PRT transactions, partially offset by a favorable change in the rider reserves. The favorable change in rider reserves of $89 million was primarily driven by a decrease related to our annual unlocking of assumptions of $84 million, and favorable equity market performance compared to 2016 resulting in increased index credits to policyholder accounts, which lowered the amount needed to fund the rider reserve. The favorable change in rider reserves was partially offset by growth in the block of business and an increase related to the net change in FIA derivatives. Unlocking in 2017 was unfavorable $49 million related to impacts of the net investment earned rate and mortality assumptions, while 2016 unlocking impacts were unfavorable by $133 million.
DAC, DSI and VOBA amortization increased by $64 million to $407 million in 2017 from $343 million in 2016, primarily due to an increase related to the net change in FIA derivatives and growth in the DAC asset balance related to block growth, partially offset by $54 million favorable change in unlocking of assumptions, as well as favorable equity market performance. Unlocking in 2017 was favorable $16 million, primarily related to impacts of the net investment earned rate and mortality assumptions, while the 2016 unlocking impacts were unfavorable $38 million.
Income tax expense increased by $167 million to $106 million in 2017 from a benefit of $61 million in 2016. The increase was primarily driven by the release of a deferred tax valuation allowance in 2016 of $102 million related to a tax plan that allows us to use a significant portion of the U.S. non-life insurance companies’ net operating losses. Additionally, the increase in income tax expense was attributed to an increase in income subject to U.S. income taxes of $140 million, or approximately a $49 million increase of tax based on a 35% U.S. statutory rate, primarily driven by higher investment realized gains, higher net change in FIA derivatives and lower DAC, DSI, VOBA amortization and rider reserves attributed to unlocking of assumptions and favorable equity market performance. The impact from U.S. tax reform enacted in December of 2017 was a benefit to net income of $7 million due to the lower U.S. tax rate impacts on our net deferred tax liabilities at the date of enactment.
Our effective tax rates were 7% in 2017 and (9)% in 2016. Our effective tax rates may vary year to year depending upon the relationship of income and loss subject to tax compared to consolidated income and loss before income taxes.
Adjusted operating income increased by $296 million, or 39%, to $1.1 billion in 2017 from $759 million in 2016. Adjusted operating ROE was 15.1%, up from 12.6% in the prior period. The increase in adjusted operating income was primarily driven by an increase in our Retirement Services segment of $230 million and an increase of $66 million in Corporate and Other.
Adjusted operating income increased by $163 million, or 16%, to $1.2 billion in 2018, from $1.0 billion in 2017. Adjusted operating ROE was 18.4%, down from 21.5% in the prior period. The increase in adjusted operating income was driven by $35.8 billion of growth in our invested assets delivering attractive spread accretion over prior year primarily attributed to inorganic deposits from the Voya and Lincoln reinsurance transactions as well as strong organic deposits over the prior twelve months. Net investment earnings also benefited from higher floating rate income of $113 million related to higher short-term interest rates and higher alternative investment income attributed to the strong performance from MidCap and Amerihome and higher income in one of our hedge funds. Partially offsetting this increase were higher rider reserves and DAC amortization related to unfavorable equity market performance resulting in an unfavorable $21 million impact in 2018 compared to a favorable $152 million impact in 2017. Unlocking in 2018 was unfavorable by $13 million compared to a favorable $20 million impact in the prior year. Unlocking in 2018 reflected changes in lapse assumptions partially offset by utilization of certain rider benefits, while 2017 reflected changes in the net investment earned rate and mortality assumptions.
Net investment earned rate decreased due to the decline in fixed and other net investment earned rate, partially offset by the increase in alternative net investment earned rate. The fixed and other net investment earned rate decreased in 2018, to 4.36% from 4.48% in 2017 primarily attributed to lower returns on the assets from the Voya and Lincoln reinsurance transactions, lower new money rates on purchases compared to maturities over the past year and higher levels of cash during 2018, partially offset by higher floating rate investment income. The alternative net investments earned rate increased in 2018 to 11.15% from 10.01% in 2017, reflecting strong MidCap and AmeriHome performance and higher income in one of our hedge funds.
Cost of crediting on deferred annuities increased by 7 basis points to 1.95% in 2018, from 1.88% in 2017, driven by an increase in option costs due to higher volatility and short-term interest rates as well as a higher cost of crediting rate on the Voya reinsurance liabilities. We continue to focus on pricing discipline, managing interest rates credited to policyholders and managing the cost of options to fund the annual index credits on our FIA products.
Other liability costs decreased $132 million driven by lower unlocking of assumptions and $100 million lower rider reserves and DAC amortization related to favorable equity market performance impacts, partially offset by growth in the block of business. Our annual unlocking of assumptions resulted in an increase to other liability costs of $20 million compared to an increase of $158 million in the prior year.
Cost of crediting increased $47 million driven by growth in our deferred annuity block of business, which was partially offset by rate actions and lower option costs.
Cost of crediting on deferred annuities decreased by 8 basis points to 1.88% in 2017, from 1.96% in 2016. The decrease in cost of crediting was driven by rate actions and lower option costs.
We had consolidated investments, including related parties, of $107.6 billion and $84.4 billion as of December 31, 2018 and 2017, respectively. Our investment strategy seeks to achieve sustainable risk-adjusted returns through the disciplined management of our investment portfolio against our long-duration liabilities, coupled with the diversification of risk. The investment strategies utilized by our investment managers focus primarily on a buy and hold asset allocation strategy that may be adjusted periodically in response to changing market conditions and the nature of our liability profile. Substantially all of our investment portfolio is managed by AAM, an indirect subsidiary of Apollo founded for the express purpose of managing our portfolio. AAM provides a full suite of services for our investment portfolio, including direct investment management, asset allocation, mergers and acquisition asset diligence, and certain operational support services, including investment compliance, tax, legal and risk management support. Our relationship with AAM and Apollo allows us to take advantage of our generally illiquid liability profile by identifying investment opportunities with an emphasis on earning incremental yield by taking liquidity and complexity risk rather than assuming solely credit risk. The deep experience of the AAM investment team and Apollo’s credit portfolio managers assists us in sourcing and underwriting complex asset classes. AAM has selected a diverse array of corporate bonds and more structured, but highly rated asset classes. We also maintain holdings in floating rate and less rate-sensitive instruments, including CLOs, non-agency RMBS and various types of structured products. In addition to our fixed income portfolio, we opportunistically allocate 5-10% of our portfolio to alternative investments where we primarily focus on fixed income-like, cash flow-based investments.
We hold derivatives for economic hedging purposes to reduce our exposure to the cash flow variability of assets and liabilities, equity market risk, interest rate risk, credit risk, and to a lesser extent, foreign exchange risk. Our primary use of derivative instruments relates to providing the income needed to fund the annual indexed credits on our FIA products. We primarily use fixed indexed options to economically hedge FIA products that guarantee the return of principal to the policyholder and credit interest based on a percentage of the gain in a specific market index.
The distribution of our AFS securities, including related parties, by type is as follows:
We maintain a diversified AFS portfolio of corporate fixed maturity securities across industries and issuers, and a diversified portfolio of structured securities. The composition of our AFS securities, including related parties, is as follows:
The NRSRO ratings methodology is focused on the likelihood of recovery of all contractual payments, including principal at par, regardless of an investor’s carrying value. In effect, the NRSRO rating assumes that the holder is the original purchaser at par. In contrast, the SVO’s loan-backed and structured securities (LBaSS) methodology is focused on determining the risk associated with the recovery of the amortized cost of each security. Because the NAIC’s methodology explicitly considers amortized cost and the likelihood of recovery of such amount, we view the NAIC’s methodology as the most appropriate way to view our fixed maturity portfolio for purposes of evaluating credit quality since a large portion of our holdings were purchased and are carried at significant discounts to par.
The NAIC designation determines the associated level of RBC that an insurer is required to hold for modeled LBaSS owned by the insurer. In general, under the modeled LBass process and, prior to January 1, 2019, the non-modeled LBaSS processes, the larger the discount to par value at the time of determination, the higher the NAIC designation the LBaSS will have.
Substantially all of our AFS portfolio, 94.2% and 93.7% as of December 31, 2018 and 2017, respectively, was invested in assets considered investment grade with a NAIC designation of 1 or 2.
The portion of our AFS portfolio that was considered below investment grade based on NRSRO ratings was 13.3% and 16.0% as of December 31, 2018 and 2017, respectively. The primary driver of the difference in the percentage of securities considered below investment grade by NRSROs as compared to the securities considered below investment grade by the NAIC is the difference in methodologies between the NRSRO and NAIC for RMBS due to investments acquired and/or carried at a discount to par value, as discussed above.
As of December 31, 2018 and 2017, a majority of our AFS CLO portfolio, 92.9% and 85.1%, respectively, was invested in assets considered to be investment grade based upon an application of the NAIC’s methodology. As of December 31, 2018 and 2017, 97.1% and 88.3%, respectively, of of our AFS CLO portfolio was considered investment grade based on NRSRO ratings.
Residential Mortgage-backed Securities - As part of our core investment strategy, a portion of our AFS portfolio is invested in RMBS. RMBS are securities constructed from pools of residential mortgages and backed by payments from those pools. These holdings were $8.0 billion and $9.4 billion as of December 31, 2018 and 2017, respectively.
A summary of our AFS RMBS portfolio by NAIC designations and NRSRO quality ratings is as follows:
The following tables reflect the unrealized losses on the AFS portfolio, including related parties, by NAIC designations:
For our OTTI policy and the identification of securities that could potentially have impairments, see Note 1 - Business, Basis of Presentation and Significant Accounting Policies and Note 3 - Investments to the consolidated financial statements, as well as Critical Accounting Estimates and Judgments.
A portion of our AFS securities are invested in securities with international exposure. As of December 31, 2018 and 2017, 30% and 33%, respectively, of the carrying value of our AFS securities, including related parties, was comprised of securities of issuers based outside of the United States and debt securities of foreign governments. These securities are either denominated in U.S. dollars or do not expose us to significant foreign currency risk as a result of foreign currency swap arrangements.
The following table presents our international exposure in our AFS portfolio, including related parties, by country or region:
Approximately 93.9% and 90.9% of these securities are investment grade by NAIC designation as of December 31, 2018 and 2017, respectively. As of December 31, 2018, 9% of our AFS securities, including related parties, were invested in CLOs of Cayman Islands issuers (for which underlying investments are largely loans to U.S. issuers) and 21% were invested in securities of non-U.S. issuers.
Portugal, Ireland, Italy, Greece and Spain continue to represent credit risk as economic conditions in these countries continue to be volatile, especially within the financial and banking sectors. We had $649 million and $801 million as of December 31, 2018 and 2017, respectively, of exposure in these countries.
As of December 31, 2018, we held UK and Channel Islands AFS securities of $2.3 billion, or 4% of our AFS securities, including related parties. As of December 31, 2018, these securities were in a net unrealized loss position of $122 million. Our investment managers analyze each holding for credit risk by economic and other factors of each country and industry.
See Note 3 - Investments to the consolidated financial statements for information regarding valuation allowance for collection loss, impairments, loan-to-value, and debt service coverage.
Our investment funds generally meet the definition of a variable interest entity (VIE), and in certain cases these investment funds are consolidated in our financial statements because we meet the criteria of the primary beneficiary. See Note 5 - Variable Interest Entities to the consolidated financial statements for further discussion on our investment funds that meet the criteria for consolidation and the accounting treatment for them.
The funds withheld at interest is comprised of the host contract and an embedded derivative. We are subject to the investment performance on the withheld assets with the total return directly impacting the host contract and the embedded derivative. Interest accrues at a risk free rate on the host receivable and is recorded as net investment income in the consolidated statements of income. The embedded derivative in our reinsurance agreements is similar to a total return swap on the income generated by the underlying assets held by the ceding companies. The change in the embedded derivative is recorded in investment related gains (losses). Although we do not directly control the underlying investments in the funds withheld at interest, in each instance the ceding company has hired AAM to manage the withheld assets in accordance with our investment guidelines.
Our total invested assets were $111.0 billion and $82.3 billion as of December 31, 2018 and 2017, respectively. As of December 31, 2018, our total invested assets were mainly comprised of 50.2% of corporate securities, 26.0% of structured securities, 13.0% of mortgage loans and 4.1% of alternative investments. Corporate securities included $14.8 billion of private placements, which represented 13% of our total invested assets. The increase in total invested assets as of December 31, 2018 from 2017 was primarily driven by $17.0 billion of invested assets from the Voya reinsurance transaction and $7.5 billion of invested assets from the Lincoln reinsurance transaction, strong organic growth in deposits exceeding liability outflows, investment of the proceeds of our debt issuance in January 2018 and reinvestment of earnings, partially offset by the deconsolidation of our former Germany operations.
In managing our business we utilize invested assets as presented in the above table. Invested assets do not correspond to the total investments, including related parties, on our consolidated balance sheets, as discussed previously in Key Operating and Non-GAAP Measures. Invested assets represent the investments that directly back our reserve liabilities and surplus assets. We believe this view of our portfolio provides a view of the assets for which we have economic exposure. We adjust the presentation for funds withheld and modco transactions to include or exclude the underlying investments based upon the contractual transfer of economic exposure to such underlying investments. We also deconsolidate any VIEs in order to show the net investment in the funds, which are included in the alternative investments line above.
Alternative investments were $4.5 billion and $3.8 billion as of December 31, 2018 and 2017, respectively, representing 4.1% and 4.6% of our total invested assets portfolio as of December 31, 2018 and 2017, respectively.
Alternative investments do not correspond to the total investment funds, including related parties and VIEs, on our consolidated balance sheets. As discussed above in the invested assets section, we adjust the GAAP presentation for funds withheld and modco and de-consolidate VIEs. We also include CLO equity tranche securities in alternative investments due to their underlying characteristics and equity-like features.
We indirectly hold public equity positions through our equity investments in a few alternative investments. Although the carrying value of these securities is minor, such securities have resulted in volatility in our statements of income in recent periods. As of December 31, 2018 and 2017, we indirectly held public equity positions of $100 million and $171 million, respectively. As of December 31, 2018, the most significant equity positions were investments in Caesars Entertainment Corporation (Caesars) and OneMain Holdings, Inc. (OneMain). Caesars is held indirectly through our investment in AAA Investment (Co Invest VI), L.P. (CoInvest VI). As of each of December 31, 2018 and 2017, we held approximately 5.5 million shares of Caesars, with a market value of $37 million and $69 million, respectively. As of December 31, 2018 and 2017, we held approximately 2.8 million and no shares, respectively, of OneMain, with a market value of $63 million and $0 million, respectively.
The reconciliation of shareholders’ equity to adjusted shareholders’ equity, which is included in adjusted book value per share, adjusted debt to capital ratio, adjusted ROE and adjusted operating ROE, is as follows:
The reconciliation of net income to adjusted net income, which is included in adjusted ROE is as follows:
The reconciliation of interest sensitive contract benefits to Retirement Services’ cost of crediting on deferred annuities, and the respective rates, is as follows:
The reconciliation of GAAP benefits and expenses to other liability costs is as follows:
Our investment portfolio is structured to ensure a strong liquidity position over time in order to permit timely payment of policy and contract benefits without requiring asset sales at inopportune times or at depressed prices. In general, liquid assets include cash and cash equivalents, highly rated corporate bonds, unaffiliated preferred stock and unaffiliated public common stock, all of which generally have liquid markets with a large number of buyers. The carrying value of these assets as of December 31, 2018 was $52.8 billion. Although our investment portfolio does contain assets that are generally considered illiquid for liquidity monitoring purposes (primarily mortgage loans, policy loans, real estate, investment funds, and affiliated common stock), there is some ability to raise cash from these assets if needed. In periods of economic downturn we may maintain higher cash balances than required to manage our liquidity risk and to take advantage of market dislocations as they arise. We have access to additional liquidity through our $1.0 billion revolving credit facility, which was undrawn as of December 31, 2018 and has a remaining term of approximately two years. On January 3, 2018, we filed a registration statement on Form S-3 ASR (Shelf Registration Statement), which, subject to market conditions and other factors, provides us with access to the capital markets and on January 12, 2018, we issued $1.0 billion of senior unsecured notes under our Shelf Registration Statement. In addition, through our membership in the FHLB, we are eligible to borrow under variable rate short-term federal funds arrangements to provide additional liquidity.
We proactively manage our liquidity position to meet cash needs while minimizing adverse impacts on investment returns. We analyze our cash-flow liquidity over the upcoming 12 months by modeling potential demands on liquidity under a variety of scenarios, taking into account the provisions of our policies and contracts in force, our cash flow position, and the volume of cash and readily marketable securities in our portfolio. We also monitor our liquidity profile under more severe scenarios.
we hold enough cash, cash equivalents and other discounted liquid limit assets to cover 12 months of AHL’s and Athene USA’s projected obligations, including debt servicing costs
for purposes of administering this test, liquid limit assets are discounted by 25% and include public corporate bonds rated A- or above, liquid ABS (defined as prime auto, auto floorplan, Tier 1 subprime auto, auto lease, prime credit cards, equipment lease or utility stranded assets; RMBS with weighted average lives less than three years rated A- or above and CMBS with weighted average lives less than three years rated AAA- or above
we seek to maintain sufficient capital and surplus at ALRe to meet the following collateral and capital maintenance calls under a substantial stress event, such as the failure of a major financial institution (Lehman event):
The primary cash flow sources for our insurance subsidiaries include retirement services product inflows (premiums), investment income, principal repayments on our investments, and net transfers from separate accounts and financial product deposits. Uses of cash include investment purchases, payments to policyholders for surrenders and withdrawals, maturity payments on funding agreements, policy acquisition costs, and general operating costs.
We have issued funding agreements to the FHLB in exchange for cash advances. These funding agreements were issued in an investment spread strategy, consistent with other investment spread operations. As of December 31, 2018 and 2017, we had funding agreements outstanding with the FHLB in the aggregate principal amount of $926 million and $573 million, respectively.
The primary cash inflows from operating activities include net investment income, annuity considerations and insurance premiums. The primary cash outflows from operating activities are comprised of benefit payments and operating expenses. Our operating activities generated cash flows totaling $2.9 billion, $3.2 billion and $1.2 billion for the years ended December 31, 2018, 2017 and 2016, respectively. The decrease in cash provided by operating activities for the year ended December 31, 2018 compared to 2017 was primarily driven by the ceding commissions related to the Voya and Lincoln reinsurance transactions, higher tax refunds in 2017 and higher commissions due to strong retail sales, partially offset by an increase in net investment income reflecting an increase in our investment portfolio and an increase in PRT premiums. The increase in cash provided by operating activities for the year ended December 31, 2017 compared to 2016 was primarily driven by an increase in PRT premiums and due to an increase in net investment income reflecting an increase in our investment portfolio attributed to the strong growth in deposits.
AHL is a holding company whose primary liquidity needs include the cash-flow requirements relating to its corporate activities, including its day-to-day operations, debt servicing and strategic transactions, such as acquisitions. The primary source of AHL’s cash flow is dividends from its subsidiaries, which are expected to be adequate to fund cash flow requirements based on current estimates of future obligations.
Dividends from ALRe are projected to be the primary source of AHL’s liquidity. Under the Bermuda Insurance Act, ALRe is prohibited from paying a dividend in an amount exceeding 25% of the prior year’s statutory capital and surplus, unless at least two members of ALRe’s board of directors and its principal representative in Bermuda sign and submit to the BMA an affidavit attesting that a dividend in excess of this amount would not cause ALRe to fail to meet its relevant margins. In certain instances, ALRe would also be required to provide prior notice to the BMA in advance of the payment of dividends. In the event that such an affidavit is submitted to the BMA in accordance with the Bermuda Insurance Act, and further subject to ALRe meeting its relevant margins, ALRe is permitted to distribute up to the sum of 100% of statutory surplus and an amount less than 15% of its total statutory capital. Distributions in excess of this amount require the approval of the BMA.
As of December 31, 2018, the maximum dividend that AADE could pay absent regulatory approval from the Delaware Department of Insurance was $154 million. However, other regulations requiring AADE to hold surplus outside of surplus in subsidiaries could effectively limit the amount that AADE can dividend while staying in compliance with such state regulations. Pursuant to these other regulations and requirements, the limit that AADE could dividend, as of December 31, 2018, would be $310 million. Any dividends from AHL’s other U.S. statutory entities in excess of the amounts allowed for AADE would not be able to be remitted to AHL without regulatory approval from the Delaware Department of Insurance.
The maximum distribution permitted by law or contract is not necessarily indicative of our actual ability to pay such distributions, which may be further restricted by business and other considerations, such as the potential imposition of withholding tax and the impact of such distributions on surplus, which could affect our ratings or competitive position and the amount of premiums that can be written. Specifically, the level of capital needed to maintain desired financial strength ratings from rating agencies, including S&P, A.M. Best and Fitch, is of particular concern when determining the amount of capital available for distributions. AHL believes its insurance subsidiaries have sufficient statutory capital and surplus, combined with additional capital available to be provided by AHL, to meet their financial strength ratings objectives. Finally state insurance laws and regulations require that the statutory surplus of our insurance subsidiaries following any dividend or distribution must be reasonable in relation to their outstanding liabilities and adequate for the insurance subsidiaries’ financial needs.
If needed, we may seek to secure additional funding at the holding company level by means other than dividends from subsidiaries, such as by drawing on our undrawn $1.0 billion credit facility or by pursuing future issuances of debt or equity securities to third-party investors. See Note 10 - Debt to the consolidated financial statements for more information regarding our $1.0 billion credit facility. However, such additional funding may not be available on terms favorable to us or at all, depending on our financial condition, results of operations or prevailing market conditions. In addition, certain covenants in our credit facility prohibit us from incurring any debt not expressly permitted thereby, which may limit our ability to pursue future issuances of debt. Specifically, our credit facility prohibits us from incurring any debt if, on a pro-forma basis, the debt would cause us to exceed a Consolidated Debt to Capitalization Ratio (as such term is defined in the credit facility) of 35%. Certain other sources of liquidity potentially available at the holding company level are discussed below.
Under our Shelf Registration Statement, subject to market conditions, we have the ability to issue, in indeterminate amounts, debt securities, preferred shares, depositary shares, Class A common shares, warrants and units. On January 12, 2018 we issued $1.0 billion in aggregate principal amount of 4.125% Senior Notes due January 2028 under our Shelf Registration Statement.
AHL has an unsecured revolving note payable with ALRe, which permits AHL to borrow up to $250 million with a fixed interest rate of 1.25% and a maturity date of June 1, 2020. As of December 31, 2018 and 2017, the revolving note payable had an outstanding balance of $105 million and $0 million, respectively. In February 2019, the revolving note payable agreement was amended to increase the borrowing capacity to $1 billion and to extend the maturity date to March 31, 2024.
As of December 31, 2018 and 2017, our U.S. insurance companies’ TAC, as defined by the NAIC, was $2.2 billion and $1.9 billion, respectively, and our U.S. RBC ratio was 421% and 490%. Each U.S. domestic insurance subsidiary’s state of domicile imposes minimum RBC requirements that were developed by the NAIC. The formulas for determining the amount of RBC specify various weighting factors that are applied to financial balances or various levels of activity based on the perceived degree of risk. Regulatory compliance is determined by a ratio of TAC to its authorized control level RBC (ACL). Our TAC was significantly in excess of all regulatory standards as of December 31, 2018 and 2017, respectively.
ALRe statutory capital was $9.7 billion and $7.0 billion as of December 31, 2018 and 2017, respectively. During 2018, AHL contributed its wholly owned subsidiary, Athene USA, to ALRe. ALRe adheres to BMA regulatory capital requirements to maintain statutory capital and surplus to meet the MMS and maintain minimum EBS capital and surplus to meet the enhanced capital requirement. Under the EBS framework, ALRe’s assets are recorded at market value and its insurance reserves are determined by reference to nine prescribed scenarios, with the scenario resulting in the highest reserve balance being ultimately required to be selected. ALRe’s EBS capital and surplus was $12.0 billion and $7.7 billion, resulting in a BSCR ratio of 340% and 354% as of December 31, 2018 and 2017, respectively. An insurer must have a BSCR ratio of 100% or greater to be considered solvent by the BMA. As of December 31, 2018 and 2017, ALRe held the appropriate capital to adhere to these regulatory standards. In evaluating our capital position and the amount of capital needed to support our Retirement Services segment, we review our ALRe capital by applying the NAIC RBC factors. As of December 31, 2018 and 2017, our ALRe RBC was 405% and 562%, respectively. The decrease in ALRe RBC was driven by the capital charges related to the Voya and Lincoln reinsurance agreements, alternative investment deployment, the increase in deposits and impacts resulting from the Tax Act. Although the updates to the RBC factors to reflect the reduction in the corporate income tax rate from 35% to 21% lowered our ALRe RBC ratio, we do not believe this materially impacted the level of capital that we deem appropriate to run our business. We believe that we enjoy a strong capital position in light of our risks and that we are well positioned to meet policyholder and other obligations. We also believe that our strong capital position, as well as our excess capital position, provides us the opportunity to take advantage of market dislocations as they arise.
The following table summarizes estimated future payments on our contractual obligations as of December 31, 2018:
For equity securities, we obtain the fair value, when available, based on quoted market prices. Other equity securities, typically private equities or equity securities not traded on an exchange, are valued based on other sources, such as commercial pricing services or brokers. Effective with the adoption of Financial Instruments - Recognition and Measurement (ASU 2016-01) on January 1, 2018, subsequent changes in fair value are recognized in net income.
The recognition of impairment losses on fixed maturity securities is dependent on the facts and circumstances related to the specific security. If we intend to sell a security or it is more-likely-than-not that we would be required to sell a security before the recovery of its cost or amortized cost, less any recorded credit loss, we recognize a loss in other-than-temporary impairment losses on the consolidated statements of income for the difference between cost or amortized cost and fair value. If neither of these two conditions exists, then the recognition of the loss is bifurcated and we recognize the credit loss portion in other-than-temporary impairment losses on the consolidated statements of income and the non-credit loss portion in AOCI on the consolidated balance sheets. Impairment losses on equity securities are recognized in investment related gains (losses) on the consolidated statements of income prior to the adoption of ASU 2016-01. Effective January 1, 2018, equity securities are no longer evaluated for impairment as all changes in fair value are recognized in net income.
The future policy benefit liabilities associated with long duration contracts include endowment contracts, term and whole-life products, accident and health, disability, and deferred and immediate annuities with life contingencies. Liabilities for non-participating long duration contracts are established using accepted actuarial valuation methods which require us to make certain assumptions regarding expenses, investment yields, mortality, morbidity, and persistency, with a provision for adverse deviation, at the date of issue or acquisition. As of December 31, 2018, the reserve investment yield assumptions for non-participating contracts range from 3.31% to 5.44% and are specific to our expected earned rate on the asset portfolio supporting the reserves. Liabilities for participating long-duration contracts were established using acceptable actuarial valuation methods, which required the use of guaranteed interest and mortality assumptions. Participating long-duration contracts resulted from our previously consolidated German subsidiaries. We base other key assumptions, such as mortality and morbidity, on industry standard data adjusted to align with actual company experience, if necessary. Premium deficiency tests are performed periodically using current assumptions, without provisions for adverse deviation, in order to test the appropriateness of the established reserves. If the reserves using current assumptions are greater than the existing reserves, the excess is recorded and the initial assumptions are revised.
As of December 31, 2018, we had embedded derivative liabilities classified as Level 3 in the fair value hierarchy of $8.0 billion. The increase (decrease) to the embedded derivatives on FIA products from hypothetical changes in discount rates is summarized as follows:
A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis. The material weakness referred to above is described in Management’s Annual Report on Internal Control over Financial Reporting appearing under Item 9A. We considered this material weakness in determining the nature, timing, and extent of audit tests applied in our audit of the 2018 consolidated financial statements, and our opinion regarding the effectiveness of the Company’s internal control over financial reporting does not affect our opinion on those consolidated financial statements.
The Company's management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in management's report referred to above. Our responsibility is to express opinions on the Company’s consolidated financial statements and on the Company's internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
Athene Holding Ltd. (AHL), a Bermuda exempted company, together with its subsidiaries (collectively, Athene, we, our, us, or the Company), is a leading retirement services company that issues, reinsures and acquires retirement savings products in all U.S. states and the District of Columbia.
Our non-U.S. reinsurance subsidiaries, to which AHL’s other insurance subsidiaries and third party ceding companies directly and indirectly reinsure a portion of their liabilities, including Athene Life Re Ltd. (ALRe), a Bermuda exempted company; and
Athene USA Corporation, an Iowa corporation (together with its subsidiaries, Athene USA).
We report investments in related parties and assets and liabilities of consolidated VIEs separately, as further described in the accounting policies that follow.
We generally record security transactions on a trade date basis, with any unsettled trades recorded in other assets or other liabilities on the consolidated balance sheets.
We review securities on a case-by-case basis to determine whether an other-than-temporary decline in value exists and whether losses should be recognized. We consider relevant facts and circumstances in evaluating whether a credit or interest rate-related impairment of a security is other-than-temporary. Relevant facts and circumstances include: (1) the extent and length of time the fair value has been below cost; (2) the reasons for the decline in fair value; (3) the issuer’s financial position and access to capital; and (4) for fixed maturity securities, our intent to sell a security or whether it is more likely than not that we will be required to sell the security before the recovery of its cost or amortized cost which, in some cases, may extend to maturity and for equity securities prior to January 1, 2018, our ability and intent to hold the security for a period of time that allows for the recovery in value. To the extent we determine that a security is other-than-temporarily impaired, an impairment loss is recognized.
the value of the loan’s collateral if it is in the process of foreclosure or otherwise collateral dependent; or
Hedge Documentation and Hedge Effectiveness - To qualify for hedge accounting, at the inception of the hedging relationship, we formally document our designation of the hedge as a cash flow or fair value hedge and our risk management objective and strategy for undertaking the hedging transaction. In this documentation, we identify how the hedging instrument is expected to hedge the designated risks related to the hedged item, the method that will be used to retrospectively and prospectively assess the hedging instrument’s effectiveness and the method which will be used to measure ineffectiveness. A derivative designated as a hedging instrument must be assessed as being highly effective in offsetting the designated risk of the hedged item. Hedge effectiveness is formally assessed at inception and periodically throughout the life of the designated hedging relationship.
Embedded Derivatives - We issue and reinsure products, primarily fixed indexed annuity products, or purchase investments that contain embedded derivatives. If we determine the embedded derivative has economic characteristics not clearly and closely related to the economic characteristics of the host contract, and a separate instrument with the same terms would qualify as a derivative instrument, the embedded derivative is bifurcated from the host contract and accounted for separately, unless the fair value option is elected on the host contract. Under the fair value option, bifurcation of the embedded derivative is not necessary as the entire contract is carried at fair value with all related gains and losses recognized in investment related gains (losses) on the consolidated statements of income. Embedded derivatives are carried on the consolidated balance sheets at fair value in the same line item as the host contract.
Additionally, reinsurance agreements written on a funds withheld or modco basis contain embedded derivatives. The right to receive or obligation to pay the total return on the assets supporting the funds withheld at interest or funds withheld liability, respectively, represents a total return swap with a floating rate leg. The fair value of embedded derivatives on funds withheld and modco agreements is computed as the unrealized gain (loss) on the underlying assets and is included in the funds withheld at interest and funds withheld liability lines on the consolidated balance sheets for assumed and ceded agreements, respectively. The change in the fair value of the embedded derivatives is recorded in investment related gains (losses) on the consolidated statements of income. Assumed and ceded earnings from funds withheld at interest, funds withheld liability and changes in the fair value of embedded derivatives are reported in operating activities on the consolidated statements of cash flows. Contributions to and withdrawals from funds withheld at interest and funds withheld liability are reported in operating activities on the consolidated statements of cash flows.
See Note 5 - Variable Interest Entities for discussion of our interest in entities that meet the definition of a VIE.
Cash and Cash Equivalents-Cash and cash equivalents include deposits and short-term highly liquid investments with a maturity of less than 90 days from the date of acquisition. Amounts included are readily convertible to known amounts of cash and are subject to an insignificant risk of change in value.
See Note 8 - Deferred Acquisition Costs, Deferred Sales Inducements and Value of Business Acquired for further discussion.
Changes in the interest sensitive contract liabilities, excluding deposits and withdrawals, are recorded in interest sensitive contract benefits or product charges on the consolidated statements of income. Interest sensitive contract liabilities are not reduced for amounts ceded under reinsurance agreements which are reported as reinsurance recoverable on the consolidated balance sheets. See the reinsurance accounting policy discussed in -Reinsurance above and Note 7 - Reinsurance for more information on reinsurance.
We issue and reinsure deferred annuity contracts which contain GLWB and GMDB riders. We establish future policy benefits for GLWB and GMDB by estimating the expected value of withdrawal and death benefits in excess of the projected account balance. We recognize the excess proportionally over the accumulation period based on total actual and expected assessments. The methods we use to estimate the liabilities have assumptions about policyholder behavior, which includes lapses, withdrawals and use of benefit riders; mortality; and market conditions affecting the account balance growth.
Policyholder dividend liabilities are recorded in dividends payable to policyholders on the consolidated balance sheets and policyholder dividends are recorded in dividends to policyholders on the consolidated statements of income. For participating policies issued by our previously consolidated German subsidiaries, dividends payable to policyholders includes an adjustment to recognize timing differences between GAAP and local statutory earnings that reverse and enter into future calculations of dividends to policyholders. Except for changes due to unrealized gains or losses on AFS securities, the change in this adjustment is recorded in dividends to policyholders on the consolidated statements of income. Changes in this adjustment due to unrealized gains or losses on AFS securities are recorded in OCI.
Premiums for long-duration contracts, including products with fixed and guaranteed premiums and benefits, are recognized as revenue when due from policyholders. When premiums are due over a significantly shorter period than the period over which benefits are provided, such as immediate annuities with life contingencies (which includes PRT annuities), any gross premium in excess of the net premium (i.e., the portion of the gross premium required to provide for all expected future benefits and expenses) is generally deferred and recognized into revenue in a constant relationship to the benefit reserves.
Revenue Recognition (ASU 2017-13, ASU 2016-20, ASU 2016-12, ASU 2016-11, ASU 2016-10, ASU 2016-08, ASU 2015-14 and ASU 2014-09)
These updates are based on the core principle that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. These updates replace all general and most industry-specific revenue recognition guidance, excluding insurance contracts, leases, financial instruments and guarantees, which have been scoped out of these updates. Since the guidance does not apply to revenue on contracts accounted for under the financial instruments or insurance contracts standards, only a portion of our revenues are impacted by this guidance. We adopted these updates on a modified retrospective basis effective January 1, 2018. The adoptions did not have a material effect on our consolidated financial statements.
The amendments in this update clarify the scope of asset derecognition guidance and accounting for partial sales of nonfinancial assets. We adopted this update on a modified retrospective basis effective January 1, 2018. The adoption did not have a material effect on our consolidated financial statements.
This update requires amounts generally described as restricted cash or restricted cash equivalents be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period amounts shown on the consolidated statements of cash flows. We adopted this update effective January 1, 2018, and have changed the presentation on the consolidated statements of cash flows as required by this update.
This update provides specific guidance to clarify how entities should classify certain cash receipts and cash payments on the statement of cash flows. The update also clarifies the application of the predominance principle when cash receipts and cash payments have aspects of more than one class of cash flows. We adopted this update effective January 1, 2018, and the adoption did not have a material effect on our consolidated financial statements.
This update changes the accounting for certain equity investments, the presentation of changes in the fair value of liabilities measured under the fair value option due to instrument-specific credit risk, and certain disclosures. For liabilities measured under the fair value option, changes in fair value attributable to instrument-specific credit risk will no longer affect net income, but will be recognized separately in OCI. Additionally, this update requires equity investments to be measured at fair value with subsequent changes recognized in net income, except for those accounted for under the equity method or requiring consolidation. Prior to the effective date of this update, changes in fair value related to AFS equity securities were recognized in OCI. We adopted this update effective January 1, 2018. Upon adoption, we recognized a cumulative-effect increase to beginning retained earnings of $42 million and a corresponding decrease to AOCI. Additionally, we combined the presentation of AFS and trading equity securities on the consolidated balance sheets for all periods presented.
These updates are intended to increase transparency and comparability for lease transactions. ASU 2016-02 requires a lessee to recognize a right-of-use asset and lease liability on the balance sheet for all leases with an original term longer than twelve months and disclose key information about leasing arrangements. Lessor accounting is largely unchanged.
We have reviewed our existing lease contracts and determined that on January 1, 2019, we will record a lease liability and right-of-use asset related to office space, copiers, reserved areas and equipment at data centers, and other agreements. We will continue to present all prior periods under the previous lease guidance. We will elect the “package of practical expedients,” which permits us to maintain our prior conclusions about lease identification, classification and initial direct costs. We will also elect the short-term lease exception, which allows us to exclude contracts with a lease term of 12 months or less, including any reasonably certain renewal options, from consideration under the new guidance. This update will not have a material effect on our consolidated financial statements.
The amendments in this update expand certain discussions in the VIE guidance, including considerations necessary for determining when a decision-making fee is a variable interest. We will be required to adopt this update retrospectively with a cumulative-effect adjustment to retained earnings at the beginning of the earliest period presented. The update is effective January 1, 2020. Early adoption is permitted. We are currently evaluating the impact of this guidance on our consolidated financial statements.
The amendments in this update allow entities to use the Overnight Index Swap rate based on the Secured Overnight Financing Rate as a U.S. benchmark interest rate for hedge accounting purposes, in addition to the previously acceptable rates. We will be required to adopt this update prospectively for qualifying new or redesignated hedging relationships entered into on or after the date of adoption. This update is effective January 1, 2019. We do not expect the adoption of this update will have a material effect on our consolidated financial statements.
This update amends four key areas pertaining to the accounting and disclosures for long-duration insurance and investment contracts.
The update requires certain contract features meeting the definition of market risk benefits to be measured at fair value. Among the features included in this definition are the guaranteed lifetime withdrawal benefits (GLWB) and guaranteed minimum death benefit (GMDB) riders attached to the Company’s annuity products. The change in fair value of the market risk benefits is to be recognized in net income, excluding the portion attributable to changes in instrument-specific credit risk which is recognized in other comprehensive income.
The update also introduces disclosure requirements around the liability for future policy benefits, policyholder account balances, market risk benefits, separate account liabilities, and deferred acquisition costs. This includes disaggregated rollforwards of these balances and information about significant inputs, judgments, assumptions and methods used in their measurement.
The amendments in this update simplify the accounting for share-based payments to nonemployees by aligning with the accounting for share-based payments to employees, with certain exceptions. We will be required to adopt this update on a modified retrospective basis effective January 1, 2019. This update will not have a material effect on our consolidated financial statements.
Our year end controls identified an understatement of our fixed index annuity liabilities for $140 million, with offsets of $62 million for DAC, rider reserves and taxes, for a net effect of $78 million. Recording this error in the fourth quarter of 2018 would have had a material effect on our results of operations for 2018. We have revised our consolidated financial statements, notes, and schedules for the years ended December 31, 2017 and 2016, as a result of correcting this error and other unrelated immaterial errors. We assessed the materiality of these errors individually and in the aggregate, and concluded these errors are not material to the previously reported consolidated financial statements as a whole. See Note 20 - Quarterly Results of Operations (Unaudited) for summarized quarterly effects of these revisions.
The following represents the effects of the revisions on the consolidated statements of income:
We revised the consolidated statements of equity for the years ended December 31, 2017 and 2016, for the changes to net income and comprehensive income, as presented above. In addition, the balance of retained earnings was revised from $2,308 million to $2,327 million as of December 31, 2015, and the balance of accumulated other comprehensive loss was revised from $237 million to $241 million, as a result of revisions to periods prior to 2016.
AFS Securities-The following table represents the amortized cost, gross unrealized gains and losses, fair value and OTTI in AOCI of our AFS investments by asset type:
The amortized cost and fair value of AFS securities, including related party, are shown by contractual maturity below:
Proceeds from sales of AFS securities were $7,831 million, $6,023 million and $4,662 million for the years ended December 31, 2018, 2017 and 2016, respectively.
The following table summarizes the change in unrealized gains (losses) on trading and equity securities, including related party and consolidated VIEs, we still held as of the respective period end:
Residential mortgage loans - The primary credit quality indicator of residential mortgage loans is loan performance. Nonperforming residential mortgage loans are 90 days or more past due and/or are in non-accrual status. As of December 31, 2018 and 2017, $48 million and $28 million, respectively, of our residential mortgage loans were nonperforming.
The following summarizes our investment funds, including related party and those owned by consolidated VIEs:
Equity securities - We invest in preferred equity securities issued by entities deemed to be VIEs due to insufficient equity within the structure.
We use a variety of derivative instruments to manage risks, primarily equity, interest rate, credit, foreign currency and market volatility. See Note 1 - Business, Basis of Presentation and Significant Accounting Policies for a description of our accounting policies for derivatives and Note 6 - Fair Value for information about the fair value hierarchy for derivatives.
Foreign currency swaps - We use foreign currency swaps to convert foreign currency denominated cash flows of an investment to U.S. dollars to reduce cash flow fluctuations due to changes in currency exchange rates. Certain of these swaps are designated and accounted for as cash flow hedges, which will expire by December 2045. During the years ended December 31, 2018, 2017 and 2016, we had foreign currency swap gains of $146 million and losses of $105 million and $5 million, respectively, recorded in AOCI. There were no amounts reclassified to income and no amounts deemed ineffective for the years ended December 31, 2018, 2017 or 2016. As of December 31, 2018, no amounts are expected to be reclassified to income within the next 12 months.
Foreign currency forwards - We use foreign currency forward contracts to hedge certain exposures to foreign currency risk. The price is agreed upon at the time of the contract and payment is made at a specified future date. Certain of these forwards entered into during 2018 are designated and accounted for as fair value hedges. As of December 31, 2018, the carrying amount of the hedged AFS securities - CLOs was $88 million, and the cumulative amount of fair value hedging adjustments included in the hedged AFS securities - CLOs included gains of $1 million. The gains and losses on derivatives and the related hedged items in fair value hedge relationships are recorded in investment related gains (losses) on the consolidated statements of income. The derivatives had losses of $1 million during the year ended December 31, 2018, and the related hedged items had gains of $1 million during the year ended December 31, 2018.
Interest rate swaps - We use interest rate swaps to reduce market risks from interest rate changes and to alter interest rate exposure arising from duration mismatches between assets and liabilities. With an interest rate swap, we agree with another party to exchange the difference between fixed-rate and floating-rate interest amounts tied to an agreed-upon notional principal amount at specified intervals. Certain of these swaps entered into during the fourth quarter of 2016 were designated as fair value hedges. These fair value hedges were dedesignated during the second quarter of 2018 and there was no material impact as a result.
Credit Risk-We may be exposed to credit-related losses in the event of counterparty nonperformance on derivative financial instruments. Generally, the current credit exposure of our derivative contracts is the fair value at the reporting date less any collateral received from the counterparty.
Entities included under our agreement to purchase funds managed by Apollo entities (Strategic Partnership). See Note 17 - Related Parties for further discussion on the Strategic Partnership.
During the first quarter of 2018, we invested in profit participating notes of ALR. ALR was formed to invest in a joint venture that provides airplane lease financing to a major commercial airline. We are the only investor in the profit participating notes and, as substantially all of the activities of ALR are conducted on our behalf, we are the primary beneficiary and consolidate ALR.
We also have fixed maturity securities priced based on indicative broker quotes or by employing market accepted valuation models. For certain fixed maturity securities, the valuation model uses significant unobservable inputs and are included in Level 3 in our fair value hierarchy. Significant unobservable inputs used include: issue specific credit adjustments, material non-public financial information, estimation of future earnings and cash flows, default rate assumptions, liquidity assumptions and indicative quotes from market makers. These inputs are usually considered unobservable, as not all market participants have access to this data.
We value privately placed fixed maturity securities based on the credit quality and duration of comparable marketable securities, which may be securities of another issuer with similar characteristics. In some instances, we use a matrix-based pricing model. These models consider the current level of risk-free interest rates, corporate spreads, credit quality of the issuer and cash flow characteristics of the security. We also consider additional factors such as net worth of the borrower, value of collateral, capital structure of the borrower, presence of guarantees and our evaluation of the borrower’s ability to compete in its relevant market. Privately placed fixed maturity securities are classified as Level 2 or 3.
Investment funds - Certain investment funds for which we elected the fair value option are included in Level 3 and are priced based on market accepted valuation models. The valuation models use significant unobservable inputs, which include material non-public financial information, estimation of future distributable earnings and demographic assumptions. These inputs are usually considered unobservable, as not all market participants have access to this data.
Universal life liabilities and other life benefits - We elected the fair value option for certain blocks of universal and other life business ceded to Global Atlantic. We use a present value of liability cash flows. Unobservable inputs include estimates of mortality, persistency, expenses, premium payments and a risk margin used in the discount rates that reflects the riskiness of the business. These universal life policyholder liabilities and corresponding reinsurance recoverable are classified as Level 3.
Fair Value Option-The following represents the gains (losses) recorded for instruments for which we have elected the fair value option, including related parties and consolidated VIEs:
There were no fair value option mortgage loans 90 days or more past due as of December 31, 2018 and 2017.
Voya Financial, Inc. (Voya) - On June 1, 2018, we entered into coinsurance and modco agreements with Voya Insurance and Annuity Company (VIAC) to reinsure a block of fixed and fixed indexed annuities. VIAC is a related party pursuant to GAAP due to our minority equity investment in its holding company’s parent, VA Capital Company LLC (VA Capital), as discussed further in Note 17 - Related Parties. Additionally, we entered into modco agreements with ReliaStar Life Insurance Company (RLI), a subsidiary of Voya, to reinsure a block of fixed and fixed indexed annuities. The following summarizes these reinsurance transactions (collectively, Voya reinsurance transactions):
The Lincoln National Life Insurance Company (Lincoln) - On December 7, 2018, we entered into a modco agreement with Lincoln, effective as of October 1, 2018, to reinsure an 80% quota share block of fixed deferred and fixed indexed annuities. The following summarizes this reinsurance transaction:
Athora - During the fourth quarter of 2018, we entered into a coinsurance agreement with Athora Lebensversicherung AG (ALV) to reinsure endowment contracts and annuities. We then retroceded these endowment contracts and annuities through a modco agreement to Athora Life Re Ltd. (ARE). These transactions will serve as a model for future transactions for Athora within the European market. We will earn a commission of 0.2% of reserves on the retrocession to ARE. See Note 17 - Related Parties for further information on other Athora transactions. The following summarizes these reinsurance transactions:
Protective Life Insurance Company (Protective) - We reinsured substantially all of the existing life and health business of Athene Annuity & Life Assurance Company (AADE) to Protective under a coinsurance agreement in 2011. As of December 31, 2018 and 2017, Protective maintained a trust for our benefit with assets having a fair value of $1,525 million and $1,688 million, respectively.
8. Deferred Acquisition Costs, Deferred Sales Inducements and Value of Business Acquired
Credit Facility-In 2016, we entered into a five-year revolving credit agreement (Credit Facility) with Citibank, N.A., as administrative agent. The borrowing capacity under the Credit Facility is $1 billion. In connection with the Credit Facility, AHL and Athene USA guaranteed all of the obligations of AHL, ALRe, Athene Annuity Re Ltd. (AARe) and Athene USA under this facility, and ALRe and AARe guaranteed certain of the obligations of AHL and Athene USA under this facility. The Credit Facility contains various standard covenants with which we must comply, including the following:
As of December 31, 2018 and 2017, we had no amounts outstanding under the Credit Facility and were in compliance with all covenants under this facility.
Interest accrues on outstanding borrowings at the London Interbank Offered Rate (LIBOR) plus a margin or a base rate plus a margin, with the applicable margin varying based on AHL’s issuer credit rating. The Credit Facility has a commitment fee that is determined by reference to AHL’s issuer credit rating, and ranges from 0.15% to 0.50% of the unused commitment. As of December 31, 2018 and 2017, the commitment fee was 0.225% of the unused commitment.
On December 14, 2016, we completed the initial public offering (IPO) of our Class A common shares. Shareholders sold 31.1 million existing Class A shares through the offering. We did not sell any shares in the IPO. A total of 24.2 million Class B shares were converted into Class A shares on a one-for-one basis in order to participate in the IPO.
As of December 31, 2018, we had 150 million shares of capital stock authorized which remain undesignated.
Stock Options - A rollforward of activity for the year ended December 31, 2018 for stock options is as follows:
The weighted average grant date fair value of stock options granted during the years ended December 31, 2018, 2017 and 2016 was $9.43, $9.44 and $5.83, respectively. The total intrinsic value of stock options exercised during the years ended December 31, 2018 and 2017 was not material. No options were exercised or exercisable during the year ended December 31, 2016.
Class M awards-We have issued Class M shares and RSUs concurrently with the timing of capital raises, in order to align management incentives with shareholder investments.
Class M shares function similar to options in that they are exchangeable into Class A shares upon payment of a conversion price and other conditions being met. The settlement value of the RSUs is based upon the value of the Class A shares at the time of settlement after deducting the conversion price of the RSUs. RSUs may be settled either in cash or Class A shares at our election. A portion of the Class M shares and RSUs are subject to time vesting conditions (Tranche 1), and the remainder are subject to certain performance-based vesting conditions (Tranche 2). Vesting conditions are further described below.
Conversion to Class A shares - Vested Class M shares are eligible for conversion to Class A shares subject to payment of the conversion price for each Class M share converted. A holder of vested Class M shares may elect to exchange vested shares for an equivalent number of Class A shares upon payment, in cash or shares, of the conversion price less the amount of any dividends paid by the Company on Class A shares subsequent to the granting of Class M shares. Following a conversion to Class A shares, shares can be sold subject to contractual transfer or legal restrictions, such as lockups, blackout periods or affiliate sale volume caps.
Valuation Assumptions for Class M Shares-The fair value of the Class M shares is determined using the Black-Scholes option pricing model, with application of a Monte-Carlo simulation to determine the value of the Tranche 2 Class M shares. No Tranche 2 Class M shares were granted during the years ended December 31, 2018 and 2017. Grant date assumptions used for valuation of Class M share awards for the year ended December 31, 2016 were:
In addition, the Tranche 2 Class M share assumptions include an estimate of the probability of the vesting conditions being met. This assumption is developed by using a Monte-Carlo simulation to generate the possible future value of the Company’s equity at a liquidity event to determine the percentage of Tranche 2 Class M shares that vest for each simulated path. The fair value of the Tranche 2 Class M shares is then estimated by averaging the value for all simulated paths and discounting the results at the risk-free interest rate to the valuation date.
The weighted average grant date fair value of Class M share awards granted during the year ended December 31, 2016 was $10.43.
The total intrinsic value of M shares converted during the years ended December 31, 2018, 2017 and 2016 was $11 million, $29 million and $117 million, respectively.
LTIP awards are accounted for as equity awards. Expense for time-based RSUs and options is recognized ratably over the vesting period based on the number of shares expected to vest. Expense for performance-based RSUs is further adjusted by the performance factor most likely to be achieved, as estimated by management at the end of the performance period.
We use the two-class method for allocating net income to each class of our common stock. Our Class M shares did not become eligible to participate in dividends until a return of investment (ROI) condition had been met for each class. Once eligible, each class of our common stock has equal dividend rights. In conjunction with our IPO in the fourth quarter of 2016, the ROI condition for Class M-1 was met. The ROI condition was met for Class M-2 on March 28, 2017, and for Class M-3 and Class M-4 on April 20, 2017. For purposes of calculating basic weighted average shares outstanding and the allocation of basic income, shares are deemed to be participating in earnings for only the portion of the period after the condition is met. For purposes of calculating diluted weighted average shares outstanding, shares are deemed dilutive as of the beginning of the period.
The following is a detail of AOCI and changes in AOCI. Prior period balances include equity securities that were classified as AFS securities prior to the adoption of ASU 2016-01.
Current income tax recoverable and deferred tax assets are included in other assets on the consolidated balance sheets, and current income tax payable and deferred tax liabilities are included in other liabilities on the consolidated balance sheets. Current and deferred income tax assets and liabilities were as follows:
As of December 31, 2018, we have gross deferred tax assets associated with U.S. federal and state net operating losses of $308 million, which will begin to expire in 2022.
AHL and its Bermuda subsidiaries file protective U.S. income tax returns and its U.S. subsidiaries file income tax returns with the U.S. federal government and various U.S. state governments. AADE is not subject to U.S. federal and state examinations by tax authorities for years prior to 2011, while Athene Annuity & Life Assurance Company of New York (AANY) is not subject to examinations for years prior to 2015. The Internal Revenue Service is currently auditing the 2013 consolidated tax return filed by Athene USA Corporation, and is conducting a limited scope audit of the 2015 consolidated tax return filed by AADE. No material adverse proposed adjustments have been issued with respect to either exam. See discussion of tax examinations relating to Aviva USA and subsidiaries in Note 18 - Commitments and Contingencies.
Bermuda statutory requirements-ALRe, AARe, and Acra Re II Ltd. (ACRA) are each licensed by the Bermuda Monetary Authority (BMA) as long-term insurers and are subject to the Insurance Act 1978, as amended (Bermuda Insurance Act) and regulations promulgated thereunder. The BMA implemented the Economic Balance Sheet (EBS) framework into the Bermuda Solvency Capital Requirement (BSCR), which was granted equivalence to the European Union’s Directive (2009/138/EC) (Solvency II).
As of December 31, 2018, our U.S. subsidiaries’ solvency, liquidity and risk-based capital amounts were significantly in excess of the minimum levels required.
Statutory capital and surplus and net income (loss)-The following table presents, for each of our insurance subsidiaries, the statutory capital and surplus and the statutory net income (loss), based on the most recently filed statutory financial statements filed with insurance regulators:
Investment related expenses - Substantially all of our investments are managed by AAM, a subsidiary of AGM. AAM provides direct investment management, asset allocation, mergers and acquisition asset diligence and certain operational support services for our investment portfolio, including investment compliance, tax, legal and risk management support. As of December 31, 2018, AAM directly managed $88,356 million of our investment portfolio assets, of which 84% are designated one or two (the two highest designations) by the NAIC.
Asset management and sub-advisory fees-The following summarizes the asset management fees and sub-advisory fees we have incurred related to AAM, AAME and other Apollo affiliates:
Strategic Partnership - On October 24, 2018, we entered into an agreement pursuant to which we may invest up to $2.5 billion over three years in funds managed by Apollo entities. This arrangement is intended to permit us to invest across the Apollo alternatives platform into credit-oriented, strategic and other alternative investments in a manner and size that is consistent with our existing investment strategy. Fees for such investments payable by us to Apollo would be more favorable to us than market rates, and consistent with our existing alternative investments, investments made under the Strategic Partnership require approval of AAM and remain subject to our existing governance processes, including approval by our conflicts committee where applicable. During the fourth quarter of 2018, we invested $16 million under the Strategic Partnership and these investments are classified as investment funds of consolidated VIEs.
Funding Agreements-We are a member of the Federal Home Loan Bank (FHLB) and, through membership, we have issued funding agreements to the FHLB in exchange for cash advances. As of December 31, 2018 and 2017, we had $926 million and $573 million, respectively, of funding agreements outstanding with the FHLB. We are required to provide collateral in excess of the funding agreement amounts outstanding, considering any discounts to the securities posted and prepayment penalties.
As a result of the difficulties experienced with respect to the administration of such policies, we have received notifications from several state regulators, including but not limited to the New York State Department of Financial Services (NYSDFS), the California Department of Insurance (CDI) and the Texas Department of Insurance, indicating, in each case, that the respective regulator planned to undertake a market conduct examination or enforcement proceeding of the applicable U.S. insurance subsidiary relating to the treatment of policyholders subject to our reinsurance agreements with affiliates of Global Atlantic and the conversion of such annuity policies, including the administration of such blocks by AllianceOne. On June 28, 2018 we entered into a consent order with the NYSDFS resolving that matter in a manner that, when considering the indemnification received from affiliates of Global Atlantic, did not have a material impact on our financial condition, results of operations or cash flows.
Caldera Matters - On May 3, 2018, AHL filed a writ commencing litigation in the Supreme Court of Bermuda against a former officer of AHL, a former director of AHL (who is also considered a former officer pursuant to Bermuda law), and Caldera Holdings, Ltd. (Caldera). AHL alleges in the writ, among other things, that the defendants breached various duties owed to AHL under Bermuda law by using AHL’s confidential information in their attempted acquisition of a company referred to in the litigation as Company A. AHL is seeking injunctive relief and damages.
Corporate and Other-Corporate and Other includes certain other operations related to our corporate activities and prior to January 1, 2018, included our former German operations, which were primarily comprised of participating long-duration savings products. Included in Corporate and Other are corporate allocated expenses, merger and acquisition costs, debt costs, certain integration and restructuring costs, certain stock-based compensation and intersegment eliminations. In Corporate and Other, we also hold capital in excess of the level of capital we hold in Retirement Services to support our operating strategy. See Note 1 - Business, Basis of Presentation and Significant Accounting Policies for discussion on the deconsolidation of our German operations in 2018.
The table below reconciles segment adjusted operating revenues to total revenues presented on the consolidated statements of income:
Adjusted operating income is an internal measure used to evaluate our financial performance excluding market volatility and expenses related to integration, restructuring, stock compensation and certain other expenses. Our adjusted operating income equals net income adjusted to eliminate the impact of the following non-operating adjustments:
The table below reconciles segment adjusted operating income to net income presented on the consolidated statements of income:
Adjusted operating income excludes the income tax impact of the taxable non-operating adjustments presented above. The income tax expense of non-operating income adjustments is comprised of the appropriate jurisdiction’s tax rate applied to the non-operating adjustments subject to income tax, as well as the amount recorded for the change in the U.S. statutory rate resulting from the recently enacted Tax Act. The table below reconciles segment provision for income taxes - operating to income tax expense presented on the consolidated statements of income:
The unaudited quarterly results of operations for the years ended December 31, 2018 and 2017 are summarized in the table below, as adjusted for revisions discussed further in Note 2 - Financial Statement Revisions:
The following represents the effects of the revisions on the condensed consolidated statements of income: