Income Tax (Expense) Benefit - Non-operating-The non-operating income tax expense represents the income tax effect of non-operating adjustments and is computed by applying the appropriate jurisdiction’s tax rate to the non-operating adjustments that are subject to income tax.
Adjusted debt to capital ratio is a non-GAAP measure used to evaluate our capital structure excluding the impacts of AOCI and funds withheld and modco reinsurance unrealized gains and losses, net of DAC, DSI, rider reserve and tax offsets. Adjusted debt to capital ratio is calculated as total debt excluding consolidated Variable Interest Entities (VIEs) divided by adjusted shareholders’ equity. Adjusted debt to capital ratio should not be used as a substitute for the debt to capital ratio. However, we believe the adjustments to total debt and shareholders’ equity are significant to gaining an understanding of our capitalization, debt utilization, and debt capacity.
Premiums increased by $903 million to $3.4 billion in 2018 from $2.5 billion in 2017, driven by the Voya reinsurance inception premiums attributed to payout annuities with life contingencies, an increase in premiums from PRT transactions and an increase in premiums from flow reinsurance, partially offset by the deconsolidation of Germany.
Policy and other operating expenses decreased by $47 million to $625 million in 2018 from $672 million in 2017, primarily driven by $82 million related to the deconsolidation of Germany and lower stock compensation expense of $19 million as well as a decrease in restructuring and acquisition expenses mainly due to 2017 Germany restructuring and higher costs associated with acquisition and block reinsurance opportunities in 2017, partially offset by $41 million of interest expense related to our January 2018 debt issuance.
Adjusted operating income increased by $230 million, or 28%, to $1.0 billion in 2017, from $808 million in 2016. Adjusted operating ROE was 21.5%, an increase from 19.3% in the prior period. The increase in adjusted operating income was primarily driven by an increase in fixed and other investment income and lower other liability costs, partially offset by higher adjusted operating income tax expense attributed to the 2016 deferred tax valuation allowance release of $102 million, lower alternative investment income and higher cost of crediting.
Our invested assets, which are those that directly back our policyholder liabilities as well as surplus assets (as previously discussed in Key Operating and Non-GAAP Measures), were $111.0 billion and $82.3 billion as of December 31, 2018 and 2017, respectively. AAM managed, directly and indirectly, substantially all of our invested assets as of December 31, 2018, comprising a diversified portfolio of fixed maturity and other securities. AAM’s knowledge of our funding structure and regulatory requirements allows it to design customized strategies and investments for our portfolio.
We invest a portion of our investment portfolio in mortgage loans, which are generally comprised of high quality commercial first lien and mezzanine real estate loans. Our mortgage loan holdings were $10.6 billion and $6.2 billion as of December 31, 2018 and 2017, respectively. This included $2.1 billion and $1.8 billion of mezzanine mortgage loans as of December 31, 2018 and 2017, respectively. The increase in mortgage loans is mainly driven by an increase in RML purchases during 2018, purchases of triple net leases and the addition of mortgage loans from the Voya reinsurance transaction. We have acquired mortgage loans through acquisitions and reinsurance arrangements, as well as through an active program to invest in new mortgage loans. We invest in CMLs on income producing properties including hotels, apartments, retail and office buildings, and other commercial and industrial properties. Our RML portfolio primarily consists of first lien RMLs collateralized by properties located in the U.S. Loan-to-value ratios at the time of loan approval are generally 75% or less.
Through our relationship with Apollo and AAM, we have indirectly invested in companies that meet the key characteristics we look for in alternative investments. Two of our largest alternative investments are in asset originators, MidCap and AmeriHome, both of which, from time to time, provide us with access to assets for our investment portfolio.
While our business strategy does not involve the use of captives, as a result of the Aviva USA acquisition, we acquired a captive reinsurer that was formed in 2011 and domiciled in the state of Vermont and we ceded certain liabilities to this captive reinsurer. The statutory reserves of the affiliated captive reinsurer are supported by a combination of funds withheld receivable assets and letters of credit issued by an unaffiliated financial institution. The reinsurance activities within the captive reinsurer are eliminated in consolidation. As discussed in Note 16 - Statutory Requirements to the consolidated financial statements, a prescribed practice of the state of Vermont allows the captive to include the face amount of issued and outstanding letters of credit in the amount of $153 million as of each of December 31, 2018 and 2017 as admitted assets in its statutory financial statements.
For fixed maturity securities, we obtain the fair values, when available, based on quoted prices in active markets that are regularly and readily obtainable. Generally, these are liquid securities and the valuation does not require significant management judgment. When quoted prices in active markets are not available, fair value is based on market standard valuation techniques, giving priority to observable inputs. We obtain the fair value for most marketable bonds without an active market from several commercial pricing services. The pricing services incorporate a variety of market observable information in their valuation techniques, including benchmark yields, broker-dealer quotes, credit quality, issuer spreads, bids, offers, and other reference data. For certain fixed maturity securities without an active market, an internally-developed discounted cash flow or other approach is utilized to calculate the fair value. A discount rate is used, which adjusts a market comparable base rate for securities with similar characteristics for credit spread, market illiquidity or other adjustments. The fair value of privately placed fixed maturity securities are 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, which considers 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.
However, these estimated effects do not take into account potential changes in other variables, such as equity price levels and market volatility, which can also contribute significantly to changes in carrying values. Therefore, the quantitative impact presented in the table above does not necessarily correspond to the ultimate impact on the consolidated financial statements. In determining the ranges, we have considered current market conditions, as well as the market level of discount rates that can reasonably be anticipated over the near-term. For additional information regarding sensitivities to interest rate risk and public equity risk, see
Equity Securities - Equity securities includes common stock, mutual funds and non-redeemable preferred stock. Equity securities are carried at fair value with subsequent changes in fair value recognized in net income effective January 1, 2018. Prior to January 1, 2018, the accounting for subsequent changes in the fair value of an equity security was dependent on its classification as AFS or trading as discussed previously.
Other-Than-Temporary Impairment - We identify securities that could potentially have impairments that are other-than-temporary by monitoring market events for changes in market interest rates, credit issues, changes in business climate, management changes, litigation, government actions and other similar factors. Indicators of impairment may include changes in the issuers’ credit ratings and outlook, frequency of late payments, pricing levels, key financial ratios, financial statements, revenue forecasts and cash flow projections.
Deferred costs related to universal life-type policies and investment contracts with significant revenue streams from sources other than investment of the policyholder funds are amortized over the lives of the policies, based upon the proportion of current period gross profits to the present value of gross profits to be earned over the life of the policies. Gross profits include investment spread margins, surrender charge income, policy administration, changes in the guaranteed lifetime withdrawal benefit (GLWB) and guaranteed minimum death benefit (GMDB) reserves and realized gains and losses on investments. Current period gross profits for fixed indexed annuities also include the change in fair value of both freestanding and embedded derivatives. Estimates of the future gross profits and margins are based on assumptions using accepted actuarial methods related to policyholder behavior and mortality, yields on investments supporting the liabilities, future interest credited amounts (including indexed related credited amounts on fixed indexed annuity products), surrender and other policy changes as applicable, and the level of expenses necessary to maintain the policies over their expected lives. Each reporting period, we update estimated gross profits with actual gross profits as part of the amortization process and adjust the DAC and DSI balances due to the other comprehensive income (OCI) effects of unrealized investment gains and losses on AFS securities. We also periodically revise the key assumptions used in the amortization calculation, which results in revisions to the estimated future gross profits. The effects of changes in assumptions are recorded as unlocking in the period in which the changes are made.
The following represents the effects of the revisions on the consolidated statements of cash flows:
Net Investment Income-Net investment income by asset class consists of the following:
Our residential mortgage loan portfolio includes first lien residential mortgage loans collateralized by properties located in the U.S. As of December 31, 2018, California, Florida and New York represented 30.3%, 16.3% and 7.7%, respectively, of the portfolio, and the remaining 45.7% represented all other states, with each individual state comprising less than 5% of the portfolio. As of December 31, 2017, California, Florida and New York represented 34.3%, 15.6% and 6.0%, respectively, of the portfolio, and the remaining 44.1% represented all other states, with each individual state comprising less than 5% of the portfolio.
Commercial mortgage loans - As of December 31, 2018 and 2017, none of our commercial loans were 30 days or more past due.
Investment Funds-Our investment fund portfolio consists of funds that employ various strategies and include investments in real estate and other real assets, credit, equity, natural resources and hedge funds. Investment funds can meet the definition of VIEs, which are discussed further in Note 5 - Variable Interest Entities. Our investment funds do not specify timing of distributions on the funds’ underlying assets.
The following represents the hierarchy for our assets and liabilities measured at fair value on a recurring basis:
Class A shares collectively represent 55% of the total voting power of the Company. Class B shares collectively represent the remaining 45% of the total voting power of the Company, and are beneficially owned by shareholders who are members of the Apollo Group, as defined in our bye-laws. Class B shares can be converted to Class A shares on a one-to-one basis at any time upon notice to us. Class M shares are restricted, non-voting shares issued under equity incentive plans. Our bye-laws place certain restrictions on Class A shares such that (1) a holder of Class A shares, including its affiliates, cannot control greater than 9.9% of the total outstanding vote and if a holder of Class A shares were to control greater than 9.9%, then a holder’s voting power is automatically reduced to 9.9% and the other holders of Class A shares would vote the remainder on a prorated basis, (2) the total voting power held by members of our management and employees of the Apollo Group is limited to 3% and (3) Class A shares may be deemed non-voting when owned by a shareholder who owns Class B shares, has an equity interest in certain Apollo entities, or is a member of the Apollo Group.
MidCap - CoInvest VII holds a significant investment in MidCap, which is included in investment funds of consolidated VIEs on the consolidated balance sheets. We have also advanced amounts under a subordinated debt facility to Midcap and, as of December 31, 2018 and 2017, the principal balance was $245 million, which is included in other related party investments on the consolidated balance sheets. Our total investment in MidCap, including amounts advanced under credit facilities, totaled $791 million and $766 million as of December 31, 2018 and 2017, respectively. Additionally, we purchased ABS and CLO securities issued by MidCap affiliates during the years ended December 31, 2018, 2017, and 2016 of $142 million, $88 million, and $4 million, respectively, which are included in related party AFS securities on the consolidated balance sheets.
The tables below represent the effects of the revisions discussed in Note 2 - Financial Statement Revisions to the previously filed condensed consolidated statements of income, comprehensive income (loss), and cash flows in Quarterly Reports on Form 10-Q. The condensed consolidated statements of equity were adjusted only for the effects of net income and comprehensive income (loss) as shown below.