FORM 10-Q

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

(Mark One)

 

x      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2009

 

o         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                           to                         

 

Commission File Number : 001-31911

 

American Equity Investment Life Holding Company

(Exact name of registrant as specified in its charter)

 

Iowa

 

42-1447959

(State of Incorporation)

 

(I.R.S. Employer Identification No.)

 

 

 

5000 Westown Parkway, Suite 440

 

 

West Des Moines, Iowa

 

50266

(Address of principal executive offices)

 

(Zip Code)

 

Registrant’s telephone number, including area code

 

(515) 221-0002

 

 

(Telephone)

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class

 

Name of each exchange on which registered

Common Stock, par value $1

 

New York Stock Exchange

 

Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $1

 

Indicate by check mark whether the registrant (1) has filed all documents and reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 504 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definition of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer o

 

Accelerated filer x

 

 

 

Non-accelerated filer o
 (Do not check if a smaller reporting company)

 

Smaller reporting company o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act.)  Yes o No x

 

Shares of common stock outstanding at October 30, 2009: 58,294,559

 

 

 



 

PART I — FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except per share data)

 

 

 

September 30,
2009

 

December 31,
2008

 

 

 

(Unaudited)

 

(As Adjusted)

 

 

 

 

 

 

 

Assets

 

 

 

 

 

Investments:

 

 

 

 

 

Fixed maturity securities:

 

 

 

 

 

Available for sale, at fair value (amortized cost: 2009 - $11,147,379; 2008 - $7,159,286)

 

$

11,082,957

 

$

6,629,046

 

Held for investment, at amortized cost (fair value: 2009 - $1,746,033; 2008 - $3,588,114)

 

1,758,747

 

3,604,149

 

Equity securities, available for sale, at fair value (cost: 2009 - $84,512; 2008 - $125,157)

 

94,076

 

99,552

 

Trading securities

 

371,338

 

 

Mortgage loans on real estate

 

2,375,833

 

2,329,824

 

Derivative instruments

 

364,041

 

56,588

 

Other investments

 

9,332

 

446

 

Total investments

 

16,056,324

 

12,719,605

 

 

 

 

 

 

 

Cash and cash equivalents

 

249,862

 

214,862

 

Restricted cash and short-term investments

 

177,149

 

 

Coinsurance deposits

 

2,010,084

 

1,528,981

 

Accrued investment income

 

132,621

 

91,756

 

Deferred policy acquisition costs

 

1,553,709

 

1,579,871

 

Deferred sales inducements

 

936,512

 

843,377

 

Deferred income taxes

 

143,773

 

82,409

 

Other assets

 

36,445

 

20,879

 

Total assets

 

$

21,296,479

 

$

17,081,740

 

 

2



 

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY

CONSOLIDATED BALANCE SHEETS (Continued)

(Dollars in thousands, except per share data)

 

 

 

September 30,
2009

 

December 31,
2008

 

 

 

(Unaudited)

 

(As Adjusted)

 

Liabilities and Stockholders’ Equity

 

 

 

 

 

Liabilities:

 

 

 

 

 

Policy benefit reserves:

 

 

 

 

 

Traditional life and accident and health insurance products

 

$

134,490

 

$

121,914

 

Annuity products

 

18,331,332

 

15,687,625

 

Other policy funds and contract claims

 

110,690

 

111,205

 

Notes payable

 

287,697

 

247,750

 

Subordinated debentures

 

268,312

 

268,209

 

Amounts due under repurchase agreements

 

410,254

 

 

Funds withheld reinsurance liability

 

463,100

 

 

Income taxes payable

 

25,631

 

14,133

 

Other liabilities

 

513,689

 

134,060

 

Total liabilities

 

20,545,195

 

16,584,896

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Common stock, par value $1 per share, 125,000,000 shares authorized; issued and outstanding: 2009 - 56,203,159 shares (excluding 5,936,696 treasury shares); 2008 - 50,739,355 shares (excluding 6,263,700 treasury shares)

 

56,203

 

50,739

 

Additional paid-in capital

 

406,234

 

376,782

 

Unallocated common stock held by ESOP: 2009 - 563,265 shares; 2008 - 588,312 shares

 

(5,930

)

(6,336

)

Accumulated other comprehensive income (loss)

 

14,011

 

(147,376

)

Retained earnings

 

280,766

 

223,035

 

Total stockholders’ equity

 

751,284

 

496,844

 

Total liabilities and stockholders’ equity

 

$

21,296,479

 

$

17,081,740

 

 

See accompanying notes to unaudited consolidated financial statements.

 

3



 

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY

CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in thousands, except per share data)

(Unaudited)

 

 

 

Three Months Ended
September 30
,

 

Nine Months Ended
September 30
,

 

 

 

2009

 

2008

 

2009

 

2008

 

 

 

 

 

(As Adjusted)

 

 

 

(As Adjusted)

 

Revenues:

 

 

 

 

 

 

 

 

 

Traditional life and accident and health insurance premiums

 

$

3,166

 

$

3,223

 

$

9,519

 

$

9,419

 

Annuity product charges

 

15,835

 

13,328

 

47,501

 

37,271

 

Net investment income

 

241,471

 

209,978

 

688,928

 

607,546

 

Change in fair value of derivatives

 

121,507

 

(83,753

)

108,178

 

(314,431

)

Net realized gains on investments, excluding other than temporary impairment (“OTTI”) losses

 

5,510

 

2,258

 

10,587

 

3,343

 

OTTI losses on investments:

 

 

 

 

 

 

 

 

 

Total OTTI losses

 

(94,216

)

(61,232

)

(171,668

)

(94,755

)

Portion of OTTI losses recognized in other comprehensive income

 

49,641

 

 

108,012

 

 

Net OTTI losses recognized in operations

 

(44,575

)

(61,232

)

(63,656

)

(94,755

)

Gain (loss) on extinguishment of debt

 

 

(28

)

3,098

 

(1,356

)

Total revenues

 

342,914

 

83,774

 

804,155

 

247,037

 

 

 

 

 

 

 

 

 

 

 

Benefits and expenses:

 

 

 

 

 

 

 

 

 

Insurance policy benefits and change in future policy benefits

 

2,737

 

2,126

 

6,910

 

7,056

 

Interest sensitive and index product benefits

 

75,288

 

50,387

 

207,028

 

154,032

 

Amortization of deferred sales inducements

 

(8,081

)

6,760

 

17,814

 

34,193

 

Change in fair value of embedded derivatives

 

259,737

 

(37,100

)

414,636

 

(237,969

)

Interest expense on notes payable

 

3,370

 

5,014

 

11,288

 

15,127

 

Interest expense on subordinated debentures

 

3,841

 

4,669

 

12,078

 

14,549

 

Interest expense on amounts due under repurchase agreements

 

100

 

2,698

 

344

 

7,694

 

Amortization of deferred policy acquisition costs

 

(2,972

)

19,285

 

44,938

 

118,595

 

Other operating costs and expenses

 

13,961

 

13,549

 

45,305

 

38,550

 

Total benefits and expenses

 

347,981

 

67,388

 

760,341

 

151,827

 

Income (loss) before income taxes

 

(5,067

)

16,386

 

43,814

 

95,210

 

Income tax expense (benefit)

 

(2,089

)

28,102

 

11,305

 

55,214

 

Net income (loss)

 

$

(2,978

)

$

(11,716

)

$

32,509

 

$

39,996

 

 

 

 

 

 

 

 

 

 

 

Earnings (loss) per common share

 

$

(0.05

)

$

(0.22

)

$

0.59

 

$

0.74

 

Earnings (loss) per common share - assuming dilution

 

$

(0.05

)

$

(0.22

)

$

0.57

 

$

0.72

 

 

See accompanying notes to unaudited consolidated financial statements.

 

4



 

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

(Dollars in thousands)

(Unaudited)

 

 

 

Common
Stock

 

Additional
Paid-in
Capital

 

Unallocated
Common
Stock Held
by ESOP

 

Accumulated
Other
Comprehensive
Income/(Loss)

 

Retained
Earnings

 

Total
Stockholders’
Equity

 

Balance at December 31, 2008, as adjusted

 

$

50,739

 

$

376,782

 

$

(6,336

)

$

(147,376

)

$

223,035

 

$

496,844

 

Cumulative effect of noncredit OTTI, net

 

 

 

 

(20,094

)

25,240

 

5,146

 

Other comprehensive income:

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income for period

 

 

 

 

 

32,509

 

32,509

 

Change in net unrealized investment gains/losses

 

 

 

 

251,689

 

 

251,689

 

Noncredit component of OTTI losses, available for sale securities, net

 

 

 

 

(70,208

)

 

(70,208

)

Other comprehensive income

 

 

 

 

 

 

 

 

 

 

 

213,990

 

Issuance of treasury stock

 

5

 

50

 

 

 

(18

)

37

 

Acquisition of 12,362 shares of common stock

 

(12

)

(40

)

 

 

 

(52

)

Allocation of 37,667 shares of common stock by ESOP, including excess income tax benefits

 

 

(114

)

406

 

 

 

292

 

Share-based compensation, including excess income tax benefits

 

 

2,814

 

 

 

 

2,814

 

Issuance of 5,000,000 shares of common stock in exchange for notes payable

 

5,000

 

26,226

 

 

 

 

31,226

 

Issuance of 132,300 shares of common stock

 

132

 

855

 

 

 

 

987

 

Issuance of 339,015 shares of common stock under compensation plans

 

339

 

(339

)

 

 

 

 

Balance at September 30, 2009

 

$

56,203

 

$

406,234

 

$

(5,930

)

$

14,011

 

$

280,766

 

$

751,284

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance at December 31, 2007

 

$

53,556

 

$

387,302

 

$

(6,781

)

$

(38,929

)

$

216,487

 

$

611,635

 

Retrospective application of accounting for convertible debt

 

 

15,355

 

 

 

(5,888

)

9,467

 

Other comprehensive loss:

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income for period, as adjusted

 

 

 

 

 

39,996

 

39,996

 

Change in net unrealized investment gains/losses

 

 

 

 

(104,227

)

 

(104,227

)

Other comprehensive loss, as adjusted

 

 

 

 

 

 

 

 

 

 

 

(64,231

)

Acquisition of 3,734,938 shares of common stock

 

(3,735

)

(28,875

)

 

 

 

(32,610

)

Allocation of 29,337 shares of common stock by ESOP, including excess income tax benefits

 

 

(26

)

309

 

 

 

283

 

Share-based compensation, including excess income tax benefits

 

 

2,063

 

 

 

 

2,063

 

Issuance of 889,729 shares of common stock under compensation plans, including excess income tax benefits

 

890

 

(626

)

 

 

 

264

 

Conversion of $250 of subordinated debentures

 

31

 

182

 

 

 

 

213

 

Balance at September 30, 2008, as adjusted

 

$

50,742

 

$

375,375

 

$

(6,472

)

$

(143,156

)

$

250,595

 

$

527,084

 

 

See accompanying notes to unaudited consolidated financial statements.

 

5



 

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

 (Unaudited)

 

 

 

Nine Months Ended
September 30,

 

 

 

2009

 

2008

 

 

 

 

 

(As Adjusted)

 

Operating activities

 

 

 

 

 

Net income

 

$

32,509

 

$

39,996

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

Interest sensitive and index product benefits

 

207,028

 

154,032

 

Amortization of deferred sales inducements

 

17,814

 

34,193

 

Annuity product charges

 

(47,501

)

(37,271

)

Change in fair value of embedded derivatives

 

414,636

 

(237,969

)

Increase in traditional life and accident and health insurance reserves

 

6,331

 

2,724

 

Policy acquisition costs deferred

 

(244,164

)

(200,267

)

Amortization of deferred policy acquisition costs

 

44,938

 

118,595

 

Provision for depreciation and other amortization

 

4,323

 

5,250

 

Amortization of discount and premium on investments

 

(160,338

)

(195,443

)

Trading securities purchases, sales and maturities, net

 

(360,418

)

 

Change in restricted cash and short-term investments

 

(177,149

)

 

Net realized gains on investments, excluding OTTI losses

 

(10,587

)

(3,343

)

Net OTTI losses recognized in operations

 

63,656

 

94,755

 

Change in fair value of derivatives

 

(109,563

)

313,853

 

Deferred income taxes

 

(114,669

)

57,891

 

Loss (gain) on extinguishment of debt

 

(3,098

)

1,356

 

Share-based compensation

 

3,183

 

1,920

 

Change in accrued investment income

 

(40,865

)

(16,724

)

Change in income taxes payable

 

11,498

 

10,721

 

Change in other assets

 

(4,111

)

50

 

Change in other policy funds and contract claims

 

(515

)

(6,296

)

Change in funds withheld reinsurance liability

 

452,180

 

 

Change in other liabilities

 

276,056

 

12,200

 

Other

 

(2,010

)

(309

)

Net cash provided by operating activities

 

259,164

 

149,914

 

 

 

 

 

 

 

Investing activities

 

 

 

 

 

Sales, maturities, or repayments of investments:

 

 

 

 

 

Fixed maturity securities - available for sale

 

2,236,834

 

1,094,762

 

Fixed maturity securities - held for investment

 

1,918,418

 

955,560

 

Equity securities - available for sale

 

11,778

 

12,211

 

Mortgage loans on real estate

 

87,898

 

91,446

 

Derivative instruments

 

6,534

 

29,323

 

Acquisition of investments:

 

 

 

 

 

Fixed maturity securities - available for sale

 

(5,987,086

)

(2,575,652

)

Equity securities - available for sale

 

 

(102,881

)

Mortgage loans on real estate

 

(149,624

)

(418,293

)

Derivative instruments

 

(189,424

)

(221,702

)

Policy loans

 

(28

)

(10

)

Purchases of property, furniture and equipment

 

(1,001

)

(176

)

Net cash used in investing activities

 

(2,065,701

)

(1,135,412

)

 

6



 

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY

CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

(Dollars in thousands)

(Unaudited)

 

 

 

Nine Months Ended
September 30,

 

 

 

2009

 

2008

 

 

 

 

 

(As Adjusted)

 

Financing activities

 

 

 

 

 

Receipts credited to annuity policyholder account balances

 

$

2,777,615

 

$

1,735,001

 

Coinsurance deposits

 

(371,897

)

132,761

 

Return of annuity policyholder account balances

 

(1,038,657

)

(975,384

)

Financing fees incurred and deferred

 

(320

)

 

Proceeds from notes payable

 

75,000

 

40,000

 

Repayments of notes payable

 

(3,082

)

(35,353

)

Increase in amounts due under repurchase agreements

 

410,254

 

115,914

 

Acquisition of common stock

 

(34

)

(27,051

)

Excess tax benefits realized from share-based compensation plans

 

63

 

197

 

Proceeds from issuance of common stock

 

987

 

219

 

Change in checks in excess of cash balance

 

(8,404

)

(2,302

)

Other

 

12

 

 

Net cash provided by financing activities

 

1,841,537

 

984,002

 

Increase (decrease) in cash and cash equivalents

 

35,000

 

(1,496

)

 

 

 

 

 

 

Cash and cash equivalents at beginning of period

 

214,862

 

18,888

 

Cash and cash equivalents at end of period

 

$

249,862

 

$

17,392

 

 

 

 

 

 

 

Supplemental disclosures of cash flow information

 

 

 

 

 

Cash paid during period for:

 

 

 

 

 

Interest expense

 

$

19,669

 

$

30,228

 

Income taxes

 

117,850

 

 

Non-cash operating activity:

 

 

 

 

 

Deferral of sales inducements

 

229,739

 

145,595

 

Non-cash investing activity:

 

 

 

 

 

Real estate acquired in satisfaction of mortgage loans

 

8,949

 

 

Non-cash financing activities:

 

 

 

 

 

Conversion of subordinated debentures

 

 

213

 

Stock acquired in satisfaction of obligations

 

 

5,559

 

Stock issued in extinguishment of debt

 

31,250

 

 

 

See accompanying notes to unaudited consolidated financial statements.

 

7



 

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2009

(Unaudited)

 

1.  Organization and Significant Accounting Policies

 

Consolidation and Basis of Presentation

 

The accompanying consolidated financial statements of American Equity Investment Life Holding Company (“we”, “us” or “our”) have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all the information and notes required by GAAP for complete financial statements.  The consolidated financial statements reflect all adjustments, consisting only of normal recurring items, which are necessary to present fairly our financial position and results of operations on a basis consistent with the prior audited consolidated financial statements.  Operating results for the three month and nine month periods ended September 30, 2009 are not necessarily indicative of the results that may be expected for the year ended December 31, 2009.  All significant intercompany accounts and transactions have been eliminated.  The preparation of financial statements requires the use of management estimates.  For further information related to a description of areas of judgment and estimates and other information necessary to understand our financial position and results of operations, refer to the audited consolidated financial statements and notes included in our Annual Report on Form 10-K for the year ended December 31, 2008.

 

Reclassifications have been made to prior period financial statements to conform with the September 30, 2009 presentation.  See Adopted Accounting Pronouncements for impact of new accounting guidance on prior period financial statements.

 

Restricted Cash and Short-Term Investments

 

We consider all cash and short term investments held that we are legally restricted from using in our normal operations and investing activities as restricted cash.  The restricted cash at September 30, 2009 is cash and short term investments held in trust as funds withheld in connection with coinsurance agreements.

 

Adopted Accounting Pronouncements

 

On January 1, 2009, we adopted accounting standards that enhance the required disclosures regarding derivatives and hedging activities, including enhanced disclosures regarding how an entity uses derivative instruments and how derivative instruments and related hedged items are accounted for and affect an entity’s financial position, financial performance and cash flows.  The adoption of these disclosure requirements did not have a material impact on our financial position or results of operations as it impacts financial statement disclosure only.

 

In April 2009, the Financial Accounting Standards Board (“FASB”) issued further guidance on the recognition and presentation of other than temporary impairments.  This guidance amends the other than temporary impairment guidance for debt securities only to make the guidance more operational and to expand the presentation and disclosure of other than temporary impairments on debt and equity securities in the financial statements.  This guidance requires management to determine cash flows expected to be collected on each debt security for which an other than temporary impairment is being recognized.  In accordance with this guidance, the reporting entity shall allocate its other than temporary impairments on debt securities between credit and noncredit components with the noncredit portion of the other than temporary impairments recognized as a component of other comprehensive income (loss) and the credit loss portion included in operations.  Credit loss is defined as the amount that the amortized cost basis of the impaired security exceeds the present value of cash flows

 

8



 

expected to be collected.  This guidance also requires a cumulative effect adjustment to the opening balance of retained earnings and accumulated other comprehensive income (loss) in the period of adoption for other than temporary impairments on debt securities recognized in prior periods which are still held as investments at the date of adoption.  This guidance was effective for interim and annual reporting periods ending after June 15, 2009; however, early application was permitted.  We elected to adopt these accounting standards effective January 1, 2009.  The cumulative effect adjustment as of January 1, 2009 increased retained earnings by $25.2 million and decreased accumulated other comprehensive income by $20.1 million.

 

In April 2009, the FASB issued additional guidance for estimating fair value of financial instruments including investment securities when the volume and level of activity for the asset or liability have significantly decreased, as well as guidance on identifying circumstances that indicate a transaction is not orderly.  This guidance was effective for interim and annual reporting periods ending after June 15, 2009, and shall be applied prospectively, with early adoption permitted.  We elected to adopt this guidance as of January 1, 2009, and it did not have a material impact on our consolidated financial statements.

 

On January 1, 2009, we adopted and applied retrospectively to all periods presented an accounting standard for convertible debt instruments that may be settled in whole or in part with cash.  This standard specifies that issuers of such instruments should separately account for the liability component and the equity component represented by the embedded conversion option in a manner that will reflect the issuer’s nonconvertible debt borrowing rate when interest cost is recognized in subsequent periods.  Upon settlement, the issuer shall allocate consideration transferred and transaction costs incurred to the extinguishment of the liability component and the reacquisition of the equity component.

 

In December 2004, we issued $260 million of contingent convertible senior notes with a fixed rate of 5.25% and a maturity date of December 6, 2024.  On the date of issuance bifurcation of these notes into a debt component and an equity component is required.  The difference between the fair value of the debt component at the date of issuance and the initial proceeds at the date of issuance is recorded as a component of equity.  The fair value of the notes without the embedded conversion option (liability component) at the date of issuance was $221.4 million.  The fair value of the embedded conversion option (equity component) at the date of issuance was $39.1 million.  The fair value of the equity component at issuance has been recorded as a debt discount to the notes, with a corresponding increase to additional paid-in capital, net of income tax.  The debt discount is being amortized over the expected life of the debt.

 

The following summarizes the effects of the retrospective adoption of the accounting for convertible debt on the balance sheet, statements of operations and earnings per share:

 

 

 

December 31, 2008

 

 

 

As Originally
Reported

 

Adjustments

 

As Adjusted

 

 

 

(Dollars in thousands)

 

Deferred income taxes

 

$

85,700

 

$

(3,291

)

$

82,409

 

Other assets

 

23,661

 

(2,782

)

20,879

 

Total assets

 

17,087,813

 

(6,073

)

17,081,740

 

 

 

 

 

 

 

 

 

Notes payable

 

258,462

 

(10,712

)

247,750

 

Total liabilities

 

16,595,608

 

(10,712

)

16,584,896

 

 

 

 

 

 

 

 

 

Additional paid-in capital

 

361,427

 

15,355

 

376,782

 

Retained earnings

 

233,751

 

(10,716

)

223,035

 

Total stockholders’ equity

 

492,205

 

4,639

 

496,844

 

 

9



 

 

 

Three Months Ended September 30, 2008

 

Nine Months Ended September 30, 2008

 

 

 

As Originally
Reported

 

Adjustments

 

As
Adjusted

 

As Originally
Reported

 

Adjustments

 

As Adjusted

 

 

 

(Dollars in thousands, except per share data)

 

Gain (loss) on extinguishment of debt (1)

 

$

59

 

$

(87

)

$

(28

)

$

242

 

$

(1,598

)

$

(1,356

)

Interest expense on notes payable

 

3,881

 

1,133

 

5,014

 

11,732

 

3,395

 

15,127

 

Income tax expense

 

28,608

 

(506

)

28,102

 

57,286

 

(2,072

)

55,214

 

Net income (loss)

 

(11,002

)

(714

)

(11,716

)

42,917

 

(2,921

)

39,996

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Earnings per common share

 

$

(0.21

)

$

(0.01

)

$

(0.22

)

$

0.79

 

$

(0.05

)

$

0.74

 

Earnings per common share - assuming dilution

 

$

(0.21

)

$

(0.01

)

$

(0.22

)

$

0.77

 

$

(0.05

)

$

0.72

 

 


(1)             the gain on extinguishment of debt was originally reported as part of other operating costs and expenses in the consolidated statements of operations for the three and nine months ended September 30, 2008.

 

In May 2009, the FASB issued an accounting standard that requires reporting entities to recognize in their financial statements the effects of all subsequent events that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing those financial statements.  In addition, a reporting entity shall disclose the date through which subsequent events have been evaluated, as well as whether that date is the date the financial statements were issued or the date the financial statements were available to be issued.  These requirements were effective for periods ending after June 15, 2009.  Accordingly, we adopted the subsequent event reporting requirements effective June 30, 2009 and it did not have a material effect on our consolidated financial statements.

 

In April 2009, the FASB issued disclosure guidance that requires disclosures about fair value of financial instruments within the scope of existing standards for interim reporting periods as well as in annual financial statements.  This guidance also requires entities to disclose the methods and significant assumptions used to estimate the fair value of financial instruments in financial statements on an interim and annual basis and to highlight any changes from prior periods and was effective for financial statements issued for interim and annual periods ending after June 15, 2009.  We adopted these disclosure requirements as of and for the periods ended June 30, 2009.

 

New Accounting Pronouncements

 

In June 2009, the FASB amended accounting standards for transfers and servicing of financial assets and extinguishments of liabilities.  The new standards removes the concept of a qualifying special-purpose entity (“QSPE”) from existing standards and removes the exception of QSPE’s from consolidation requirements.  Additionally, more stringent conditions for reporting a transfer of a portion of a financial asset as a sale were created, derecognition criteria was clarified, how retained interests are initially measured was revised, the guaranteed mortgage securitization recharacterization provisions were removed and disclosure requirements were added.  This standard must be applied as of the beginning of our first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period and for interim and annual reporting periods thereafter.  Earlier application is prohibited.  We are currently assessing the impact of this standard.

 

In June 2009, the FASB issued amendments to the accounting standards for consolidation of variable interest entities.  The new standard replaces the quantitative-based risks and rewards calculation of existing standards for determining which enterprise, if any, has a controlling financial interest in a variable interest entity with a primarily qualitative approach focused on identifying which enterprise has the power to direct the activities of a variable interest entity that most significantly impacts the entity’s economic performance and (1) the obligation to absorb losses of the entity or (2) the right to receive benefits from the entity.  This amendment is effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period and for interim and annual reporting periods thereafter.  Earlier application is prohibited.  We are currently assessing the impact of this standard.

 

In September 2009, the FASB issued an accounting standards update that allows for net asset value per share to be used as a means to estimate fair value for an investment if the fair value of that investment is not readily determinable.  Investments that qualify are those that calculate a net asset value per share or its equivalent as of the investor’s measurement date.  This standard is effective for interim and annual periods ending after December 15, 2009, with early application permitted.  We are currently assessing the impact of this accounting standards update.

 

In August 2009, the FASB issued an accounting standards update that amends the fair value measurement of liabilities.  The update provides clarification that in circumstances in which a quoted price in an active market for

 

10



 

the identical liability is not available, a reporting entity is required to measure fair value using the quoted price of the identical liability when traded as an asset, quoted prices for similar liabilities or similar liabilities when traded as assets, or another valuation technique that is consistent with the principles of fair value.  This guidance is effective for the first reporting period beginning after issuance, which will be our three months and year ending December 31, 2009.  We are currently assessing the impact of this accounting standards update.

 

2.  Other Comprehensive Income (Loss)

 

Other comprehensive income (loss) is as follows:

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2009

 

2008

 

2009

 

2008

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

(2,978

)

$

(11,716

)

$

32,509

 

$

39,996

 

Change in net unrealized investment gains/losses

 

171,044

 

(54,731

)

251,689

 

(104,227

)

Noncredit component of OTTI losses, available for sale securities, net

 

(32,267

)

 

(70,208

)

 

 

 

$

 135,799

 

$

(66,447

)

$

213,990

 

$

(64,231

)

 

3.  Fair Values of Financial Instruments

 

Fair value is the price that would be received to sell an asset or paid to transfer a liability (exit price) in an orderly transaction between market participants at the measurement date.  The objective of a fair value measurement is to determine that price for each financial instrument at each measurement date.  We meet this objective using various methods of valuation that include market, income and cost approaches.

 

We categorize our financial instruments into three levels of fair value hierarchy based on the priority for use of inputs in determining fair value.  The hierarchy defines the highest priority inputs (Level 1) as quoted prices in active markets for identical assets.  The lowest priority inputs (Level 3) are our own assumptions about what a market participant would use in determining fair value such as estimated future cash flows.  We categorize financial assets and liabilities recorded at fair value in the consolidated balance sheets as follows:

 

Level 1 -   Quoted prices are available in active markets for identical financial instruments as of the reporting date.  The types of financial instruments included in Level 1 are listed equities, United States treasuries and non-interest bearing cash.  We do not adjust the quoted price for these financial instruments, even in situations where we hold a large position and a sale could reasonably impact the quoted price.

 

Level 2 -   Quoted prices in active markets for similar financial instruments, quoted prices for identical or similar financial instruments in markets that are not active; and models and other valuation methodologies using inputs other than quoted prices that are observable.  The types of financial instruments included in Level 2 are U.S. Government sponsored agency securities, corporate preferred securities, corporate bonds and mortgage and asset backed securities.

 

Level 3 -   Models and other valuation methodologies using significant inputs that are unobservable for financial instruments and include situations where there is little, if any, market activity for the financial instrument.  The inputs into the determination of fair value require significant management judgment or estimation.  Financial instruments that are included in Level 3 are securities for which no market activity or data exists and for which we used discounted expected future cash flows with our own assumptions about what a market participant would use in determining fair value.

 

We used the following valuation techniques in estimating the fair values of financial instruments:

 

I.                                               Fair values of fixed maturity securities are obtained primarily from a broker who starts by obtaining a price from an independent pricing source and adjusts for observable data.  These prices from the independent broker undergo

 

11



 

evaluation by our internal investment professionals.  We generally obtain one price per security, which is compared to relevant credit information, perceived market movements and sector news.  Market indices of similar rated asset class spreads are considered for valuations and broker indications of similar securities are compared.  Inputs used by both the broker and the pricing service include market information, such as yield data and other factors relating to instruments or securities with similar characteristics.  If the issuer has had trades in similar debt outstanding but not necessarily the same rank in the capital structure, spread information is used to support fair value.  If discrepancies are identified, additional quotes are obtained and the quote that best reflects a fair value exit price at the reporting date is selected.  In the case of private placement bonds, the broker typically starts with a price of a publicly traded bond of an entity that is comparable to size and financial position of the issuer of the private bond.  The broker adjusts the price for factors such as marketability and risk factors specific to each security.

 

II.                                           Amounts reported as fair value of embedded derivatives are estimated by projecting policy contract values and minimum guaranteed contract values over the expected lives of the contracts and discounting the excess of the projected contract value amounts.  The projections of the policy contract values are based on best estimate assumptions for future policy growth and future policy decrements.  Best estimate assumptions for future policy growth include assumptions for the expected index credit on the next policy anniversary date which are derived from the fair values of the underlying call options purchased to fund such index credits and the expected costs of annual call options that will be purchased in the future to fund index credits beyond the next policy anniversary.  The projections of minimum guaranteed contract values include the same best estimate assumptions for policy decrements as were used to project policy contract values.  Increases or decreases in the fair value of embedded derivatives generally correspond to increases or decreases in the fair values of call options purchased to fund the annual index credits and changes in the discount rates used to discount the excess of the projected policy contract values over the projected minimum guaranteed contract values.  The fair value of the embedded derivatives includes an adjustment through the discount rate for our non performance risk.

 

In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy.  In such cases, a financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.  Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and considers factors specific to the financial instrument.

 

We review the prices received from the independent brokers to ensure that the prices represent a reasonable estimate of fair value.  This process involves quantitative and qualitative analysis and is administered by our investment department.  This review process includes, but is not limited to, initial and on-going review of methodologies used by the independent broker, review of pricing statistics and trends, back testing recent trades, comparing prices to those obtained from other third party pricing services, reviewing cash flow activity in the subsequent period, monitoring credit rating upgrades and downgrades and monitoring of trading volumes.  Most all of the information used by the pricing service and the independent broker can be corroborated by our procedures of investigating market data and tying that data to the facts utilized by the broker.

 

The fixed income markets in 2008 and early 2009 experienced a period of extreme volatility and limited market liquidity conditions, which affected a broad range of asset classes and sectors.  In addition, there were credit downgrade events and an increased probability of default for many fixed income instruments.  These volatile market conditions increased the difficulty of valuing certain instruments as trading was less frequent and/or market data was less observable.  There were certain instruments that were in active markets with significant observable data that became illiquid due to the current financial environment or market conditions.  As a result, certain valuations require greater estimation and judgment as well as valuation methods which are more complex.  These values may not ultimately be realizable in a market transaction, and such values may change very rapidly as market conditions change and valuation assumptions are modified.

 

The following methods and assumptions were used in estimating the fair values of financial instruments during the periods presented in these consolidated financial statements.

 

Fixed maturity securities and trading securities: The fair values of fixed maturity securities and trading securities are obtained from third parties and are based on quoted market prices when available.  The third parties use yield data and other factors relating to instruments or securities with similar characteristics to determine fair value for securities that are not actively traded.

 

Equity securities: The fair values of equity securities are based on quoted market prices.

 

12



 

Mortgage loans on real estate: The fair values of mortgage loans on real estate are calculated using discounted expected cash flows using current competitive market interest rates currently being offered for similar loans.

 

Derivative instruments: The fair values of our derivative instruments are based upon the amount of cash that we will receive to settle each derivative instrument on the reporting date.  These amounts are obtained from each of the counterparties and are adjusted for the non-performance risk of each counterparty net of any collateral held.   The non-performance risk for each counterparty is based upon its credit default swap rate.  We have no performance obligations related to the call options purchased to fund our index annuity policy liabilities.

 

Other investments: Other investments is comprised of policy loans and real estate held for sale.  We have not attempted to determine the fair values associated with our policy loans, as management believes any differences between carrying value and the fair values afforded these instruments are immaterial to our financial position and, accordingly, the cost to provide such disclosure is not worth the benefit to be derived.  The fair value of our real estate held for sale was determined by estimating the net operating income of the commercial rental property and dividing that by a current market capitalization rate.

 

Cash and cash equivalents and restricted cash: Amounts reported in the consolidated balance sheets for these instruments are reported at their historical cost which approximates fair value due to the nature of the assets assigned to this category.

 

Annuity policy benefit reserves and coinsurance deposits: The fair values of the liabilities under contracts not involving significant mortality or morbidity risks (principally deferred annuities), are stated at the cost we would incur to extinguish the liability (i.e., the cash surrender value).  The coinsurance deposits related to the annuity benefit reserves have fair values determined in a similar fashion.  We are not required to and have not estimated the fair value of the liabilities under contracts that involve significant mortality or morbidity risks, as these liabilities fall within the definition of insurance contracts that are exceptions from financial instruments that require disclosures of fair value.

 

Notes payable and amounts due under repurchase agreements: The fair value of the contingent convertible senior notes is based upon quoted market prices.  Fair values for other notes payable with fixed interest rates are estimated by discounting expected cash flows using current market interest rates currently being offered for similar securities.  The amounts reported in the consolidated balance sheets for short term indebtedness under repurchase agreements with variable interest rates approximate their fair values.

 

Subordinated debentures: The carrying amount of subordinated debentures with variable interest rates reported in the consolidated balance sheets approximates fair value.  Fair values for subordinated debentures with fixed interest rates are estimated by discounting expected cash flows using current market interest rates currently being offered for similar securities.

 

The following sets forth a comparison of the fair values and carrying amounts of our financial instruments:

 

 

 

September 30, 2009

 

December 31, 2008

 

 

 

Carrying
Amount

 

Fair Value

 

Carrying
Amount

 


Fair Value

 

 

 

 

 

(Dollars in thousands)

 

 

 

Assets

 

 

 

 

 

 

 

 

 

Fixed maturity securities:

 

 

 

 

 

 

 

 

 

Available for sale

 

$

11,082,957

 

$

11,082,957

 

$

6,629,046

 

$

6,629,046

 

Held for investment

 

1,758,747

 

1,746,033

 

3,604,149

 

3,588,114

 

Equity securities, available for sale

 

94,076

 

94,076

 

99,552

 

99,552

 

Mortgage loans on real estate

 

2,375,833

 

2,338,065

 

2,329,824

 

2,284,583

 

Derivative instruments

 

364,041

 

364,041

 

56,588

 

56,588

 

Trading securities

 

371,338

 

371,338

 

 

 

Other investments

 

9,332

 

9,332

 

446

 

446

 

Cash and cash equivalents

 

249,862

 

249,862

 

214,862

 

214,862

 

Restricted cash and short-term investments

 

177,149

 

177,149

 

 

 

Coinsurance deposits

 

2,010,084

 

1,726,909

 

1,528,981

 

1,366,149

 

 

 

 

 

 

 

 

 

 

 

Liabilities

 

 

 

 

 

 

 

 

 

Annuity benefit reserves

 

18,331,332

 

15,539,193

 

15,687,625

 

13,391,244

 

Notes payable

 

287,697

 

285,661

 

247,750

 

193,267

 

Subordinated debentures

 

268,312

 

208,256

 

268,209

 

248,283

 

Amounts due under repurchase agreements

 

410,254

 

410,254

 

 

 

Interest rate swaps

 

2,227

 

2,227

 

 

 

 

13



 

Our assets and liabilities which are measured at fair value on a recurring basis as of September 30, 2009 and December 31, 2008 are presented below based on the fair value hierarchy levels:

 

 

 

Total
Fair Value

 

Quoted
Prices in
Active
Markets
(Level 1)

 

Significant
Other
Observable
Inputs
(Level 2)

 

Significant
Unobservable
Inputs
(Level 3)

 

 

 

(Dollars in thousands)

 

September 30, 2009

 

 

 

 

 

 

 

 

 

Assets

 

 

 

 

 

 

 

 

 

Fixed maturity securities:

 

 

 

 

 

 

 

 

 

Available for sale:

 

 

 

 

 

 

 

 

 

United States Government full faith and credit

 

$

3,292

 

$

2,585

 

$

707

 

$

 

United States Government sponsored agencies

 

4,224,437

 

 

4,224,437

 

 

U.S. states, territories and political subdivisions

 

305,128

 

 

305,128

 

 

Corporate securities

 

3,966,748

 

69,502

 

3,879,464

 

17,782

 

Mortgage and asset backed securities

 

2,583,351

 

 

2,580,704

 

2,647

 

Equity securities, available for sale: finance, insurance and real estate

 

94,073

 

85,665

 

8,408

 

 

Trading securities

 

371,338

 

 

371,338

 

 

Derivative instruments

 

364,041

 

 

364,041

 

 

Cash and cash equivalents

 

249,862

 

249,862

 

 

 

Restricted cash and short-term investments

 

177,149

 

177,149

 

 

 

 

 

$

12,339,419

 

$

584,763

 

$

11,734,227

 

$

20,429

 

Liabilities

 

 

 

 

 

 

 

 

 

Interest rate swaps

 

$

2,227

 

$

 

$

2,227

 

$

 

Index annuities-embedded derivatives

 

1,248,912

 

 

 

1,248,912

 

 

 

$

 1,251,139

 

$

 

$

2,227

 

$

1,248,912

 

 

 

 

 

 

 

 

 

 

 

December 31, 2008

 

 

 

 

 

 

 

 

 

Assets

 

 

 

 

 

 

 

 

 

Fixed maturity securities:

 

 

 

 

 

 

 

 

 

Available for sale:

 

 

 

 

 

 

 

 

 

United States Government full faith and credit

 

$

22,050

 

$

3,404

 

$

18,646

 

$

 

United States Government sponsored agencies

 

3,104,853

 

 

3,104,853

 

 

Corporate securities

 

1,688,869

 

84,946

 

1,586,174

 

17,749

 

Mortgage and asset backed securities

 

1,813,274

 

 

1,810,941

 

2,333

 

Equity securities, available for sale: finance, insurance and real estate

 

99,552

 

84,554

 

14,998

 

 

Derivative instruments

 

56,588

 

 

56,588

 

 

Cash and cash equivalents

 

214,862

 

214,862

 

 

 

 

 

$

 7,000,048

 

$

387,766

 

$

6,592,200

 

$

20,082

 

Liabilities

 

 

 

 

 

 

 

 

 

Index annuities-embedded derivatives

 

$

 998,015

 

$

 

$

 

$

998,015

 

 

14



 

The following tables provide a reconciliation of the beginning and ending balances for our Level 3 assets and liabilities, which are measured at fair value on a recurring basis using significant unobservable inputs for the three and nine months ended September 30, 2009 and 2008:

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2009

 

2008

 

2009

 

2008

 

 

 

(Dollars in thousands)

 

Available for sale securities

 

 

 

 

 

 

 

 

 

Beginning balance

 

$

19,140

 

$

19,099

 

$

20,082

 

$

 

Transfers in to or out of Level 3

 

 

2,364

 

 

29,398

 

Disposals

 

(52

)

 

(126

)

 

Total gains (losses) (unrealized/realized):

 

 

 

 

 

 

 

 

 

Included in other comprehensive income

 

1,628

 

(4,664

)

1,586

 

(4,664

)

Net OTTI losses recognized in operations

 

(287

)

 

(1,113

)

(7,935

)

 

 

$

 20,429

 

$

16,799

 

$

20,429

 

$

16,799

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2009

 

2008

 

2009

 

2008

 

 

 

(Dollars in thousands)

 

Index annuities-embedded derivatives

 

 

 

 

 

 

 

 

 

Beginning balance

 

$

1,050,769

 

$

1,168,050

 

$

998,015

 

$

1,432,746

 

Reinsurance adjustment

 

(14,567

)

 

(14,567

)

 

Premiums less benefits

 

2,377

 

2,478

 

(2,464

)

71,463

 

Change in unrealized losses (gains), net

 

210,333

 

(102,533

)

267,928

 

(436,214

)

 

 

$

 1,248,912

 

$

1,067,995

 

$

1,248,912

 

$

1,067,995

 

 

Change in unrealized losses (gains), net for each period in our embedded derivatives are included in change in fair value of embedded derivatives in the consolidated statements of operations.

 

15



 

4.  Investments

 

At September 30, 2009 and December 31, 2008, the amortized cost and fair value of fixed maturity securities and equity securities were as follows:

 

 

 

Amortized
Cost

 

Gross
Unrealized
Gains

 

Gross
Unrealized
Losses

 

Fair Value

 

 

 

(Dollars in thousands)

 

September 30, 2009

 

 

 

 

 

 

 

 

 

Fixed maturity securities:

 

 

 

 

 

 

 

 

 

Available for sale:

 

 

 

 

 

 

 

 

 

United States Government full faith and credit

 

$

3,000

 

$

292

 

$

 

$

3,292

 

United States Government sponsored agencies

 

4,233,286

 

13,345

 

(22,195

)

4,224,436

 

U.S. states, territories and political subdivisions

 

287,926

 

17,245

 

(42

)

305,129

 

Corporate securities

 

3,737,905

 

314,766

 

(85,923

)

3,966,748

 

Mortgage and asset backed securities

 

2,885,262

 

58,010

 

(359,920

)

2,583,352

 

 

 

$

 11,147,379

 

$

403,658

 

$

(468,080

)

$

11,082,957

 

 

 

 

 

 

 

 

 

 

 

Held for investment:

 

 

 

 

 

 

 

 

 

United States Government sponsored agencies

 

$

1,683,131

 

$

5,682

 

$

(136

)

$

1,688,677

 

Corporate security

 

75,616

 

 

(18,260

)

57,356

 

 

 

$

 1,758,747

 

$

5,682

 

$

(18,396

)

$

1,746,033

 

 

 

 

 

 

 

 

 

 

 

Equity securities, available for sale:

 

 

 

 

 

 

 

 

 

Finance, insurance and real estate

 

$

84,512

 

$

13,411

 

$

(3,847

)

$

94,076

 

 

 

 

 

 

 

 

 

 

 

December 31, 2008

 

 

 

 

 

 

 

 

 

Fixed maturity securities:

 

 

 

 

 

 

 

 

 

Available for sale:

 

 

 

 

 

 

 

 

 

United States Government full faith and credit

 

$

21,664

 

$

515

 

$

(129

)

$

22,050

 

United States Government sponsored agencies

 

3,090,458

 

15,528

 

(1,133

)

3,104,853

 

Corporate securities

 

1,951,308

 

14,939

 

(277,378

)

1,688,869

 

Mortgage and asset backed securities

 

2,095,856

 

6,055

 

(288,637

)

1,813,274

 

 

 

$

 7,159,286

 

$

37,037

 

$

(567,277

)

$

6,629,046

 

 

 

 

 

 

 

 

 

 

 

Held for investment:

 

 

 

 

 

 

 

 

 

United States Government sponsored agencies

 

$

3,528,628

 

$

6,421

 

$

(4,984

)

$

3,530,065

 

Corporate security

 

75,521

 

 

(17,472

)

58,049

 

 

 

$

 3,604,149

 

$

6,421

 

$

(22,456

)

$

3,588,114

 

 

 

 

 

 

 

 

 

 

 

Equity securities, available for sale:

 

 

 

 

 

 

 

 

 

Finance, insurance and real estate

 

$

125,157

 

$

373

 

$

(25,978

)

$

99,552

 

 

During the nine months ended September 30, 2009 and 2008, we received $3.6 billion and $1.5 billion, respectively, in net redemption proceeds related to calls of our callable United States Government sponsored agency securities, of which $1.9 billion and $1.0 billion, respectively, were classified as held for investment.  We reinvested the proceeds from these redemptions primarily in United States Government sponsored agency securities, corporate securities and mortgage backed securities classified as available for sale.  At September 30, 2009, 50% of our fixed income securities have call features and 8% were subject to call redemption.  Another 9% will become subject to call redemption through December 31, 2009.

 

16



 

The amortized cost and fair value of fixed maturity securities at September 30, 2009, by contractual maturity, are shown below.  Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.  All of our mortgage and asset backed securities provide for periodic payments throughout their lives and are shown below as a separate line.

 

 

 

Available for sale

 

Held for investment

 

 

 

Amortized
Cost

 

Fair Value

 

Amortized
Cost

 

Fair Value

 

 

 

(Dollars in thousands)

 

Due in one year or less

 

$

26,586

 

$

25,896

 

$

 

$

 

Due after one year through five years

 

399,912

 

417,416

 

 

 

Due after five years through ten years

 

1,445,204

 

1,573,290

 

 

 

Due after ten years through twenty years

 

1,831,095

 

1,852,315

 

555,000

 

555,981

 

Due after twenty years

 

4,559,320

 

4,630,688

 

1,203,747

 

1,190,052

 

 

 

8,262,117

 

8,499,605

 

1,758,747

 

1,746,033

 

Mortgage and asset backed securities

 

2,885,262

 

2,583,352

 

 

 

 

 

$

 11,147,379

 

$

11,082,957

 

$

1,758,747

 

$

1,746,033

 

 

Net unrealized losses on available for sale fixed maturity securities and equity securities reported as a separate component of stockholders’ equity were comprised of the following:

 

 

 

September 30,
2009

 

December 31,
2008

 

 

 

(Dollars in thousands)

 

Net unrealized losses on available for sale fixed maturity securities and equity securities

 

$

(54,859

)

$

(555,845

)

Adjustments for assumed changes in amortization of deferred policy acquisition costs and deferred sales inducements

 

28,965

 

329,113

 

Deferred tax valuation allowance reversal

 

30,842

 

 

Deferred income tax asset

 

9,063

 

79,356

 

Net unrealized losses reported as accumulated other comprehensive income (loss)

 

$

14,011

 

$

(147,376

)

 

The National Association of Insurance Commissioners (“NAIC”) assigns designations to fixed maturity securities.  These designations range from Class 1 (highest quality) to Class 6 (lowest quality).  In general, securities are assigned a designation based upon the ratings they are given by the Nationally Recognized Statistical Rating Organizations (“NRSRO’s”).  The NAIC designations are utilized by insurers in preparing their annual statutory statements.  NAIC Class 1 and 2 designations are considered “investment grade” while NAIC Class 3 through 6 designations are considered “non-investment grade”.  We had 90% and 96% of our fixed maturity portfolio rated investment grade at September 30, 2009 and December 31, 2008, respectively.

 

The following table summarizes the credit quality, as determined by NAIC designation, of our fixed maturity portfolio and displays the equivalent NRSRO rating as of the dates indicated:

 

 

 

 

 

September 30, 2009

 

December 31, 2008

 

NAIC
Designation

 

NRSRO Equivalent
Credit Rating

 

Amortized
Cost

 

Fair
Value

 

Amortized
Cost

 

Fair
Value

 

 

 

 

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

1

 

Aaa/Aa/A

 

$

9,104,618

 

$

9,226,240

 

$

8,764,338

 

$

8,512,209

 

2

 

Baa

 

2,221,614

 

2,325,360

 

1,509,399

 

1,292,303

 

3

 

Ba

 

343,704

 

293,539

 

276,519

 

208,122

 

4

 

B

 

210,541

 

185,126

 

140,754

 

135,989

 

5

 

Caa and lower

 

689,830

 

548,962

 

35,391

 

31,375

 

6

 

In or near default

 

335,819

 

249,763

 

37,034

 

37,162

 

 

 

 

 

$

 12,906,126

 

$

12,828,990

 

$

10,763,435

 

$

10,217,160

 

 

17



 

The following tables show our investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities (consisting of 280 and 394 securities, respectively) have been in a continuous unrealized loss position, at September 30, 2009 and December 31, 2008:

 

 

 

Less than 12 months

 

12 months or more

 

Total

 

 

 

Fair Value

 

Unrealized
Losses

 

Fair Value

 

Unrealized
Losses

 

Fair Value

 

Unrealized
Losses

 

 

 

(Dollars in thousands)

 

September 30, 2009

 

 

 

 

 

 

 

 

 

 

 

 

 

Fixed maturity securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

Available for sale:

 

 

 

 

 

 

 

 

 

 

 

 

 

United States Government sponsored agencies

 

$

1,451,941

 

$

(22,195

)

$

 

$

 

$

1,451,941

 

$

(22,195

)

U.S. states, territories and political subdivisions

 

8,433

 

(42

)

 

 

8,433

 

(42

)

Corporate securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

Finance, insurance and real estate

 

58,283

 

(6,729

)

265,006

 

(40,040

)

323,289

 

(46,769

)

Manufacturing, construction and mining

 

68,579

 

(4,263

)

97,692

 

(10,943

)

166,271

 

(15,206

)

Utilities and related sectors

 

36,888

 

(1,933

)

83,243

 

(9,383

)

120,131

 

(11,316

)

Wholesale/retail trade

 

35,258

 

(1,090

)

52,812

 

(6,162

)

88,070

 

(7,252

)

Services, media and other

 

 

 

71,535

 

(5,380

)

71,535

 

(5,380

)

Mortgage and asset backed securities

 

256,466

 

(27,243

)

1,164,958

 

(332,677

)

1,421,424

 

(359,920

)

 

 

$

 1,915,848

 

$

(63,495

)

$

1,735,246

 

$

(404,585

)

$

3,651,094

 

$

(468,080

)

Held for investment:

 

 

 

 

 

 

 

 

 

 

 

 

 

United States Government sponsored agencies

 

$

 

$

 

$

149,864

 

$

(136

)

$

149,864

 

$

(136

)

Corporate security:

 

 

 

 

 

 

 

 

 

 

 

 

 

Finance, insurance and real estate

 

 

 

57,356

 

(18,260

)

57,356

 

(18,260

)

 

 

$

 —

 

$

 

$

207,220

 

$

(18,396

)

$

207,220

 

$

(18,396

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Equity securities, available for sale:

 

 

 

 

 

 

 

 

 

 

 

 

 

Finance, insurance and real estate

 

$

3,050

 

$

(118

)

$

35,271

 

$

(3,729

)

$

38,321

 

$

(3,847

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2008

 

 

 

 

 

 

 

 

 

 

 

 

 

Fixed maturity securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

Available for sale:

 

 

 

 

 

 

 

 

 

 

 

 

 

United States Government full faith and credit

 

$

 

$

 

$

18,645

 

$

(129

)

$

18,645

 

$

(129

)

United States Government sponsored agencies

 

60,475

 

(57

)

298,925

 

(1,076

)

359,400

 

(1,133

)

Corporate securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

Finance, insurance and real estate

 

205,148

 

(44,478

)

146,226

 

(46,761

)

351,374

 

(91,239

)

Manufacturing, construction and mining

 

294,428

 

(37,589

)

65,578

 

(27,978

)

360,006

 

(65,567

)

Utilities and related sectors

 

192,110

 

(22,816

)

116,173

 

(32,307

)

308,283

 

(55,123

)

Wholesale/retail trade

 

120,056

 

(16,557

)

11,825

 

(9,680

)

131,881

 

(26,237

)

Services, media and other

 

119,297

 

(22,425

)

79,664

 

(16,787

)

198,961

 

(39,212

)

Mortgage and asset backed securities

 

1,117,973

 

(221,480

)

297,442

 

(67,157

)

1,415,415

 

(288,637

)

 

 

$

 2,109,487

 

$

(365,402

)

$

1,034,478

 

$

(201,875

)

$

3,143,965

 

$

(567,277

)

Held for investment:

 

 

 

 

 

 

 

 

 

 

 

 

 

United States Government sponsored agencies

 

$

 

$

 

$

360,016

 

$

(4,984

)

$

360,016

 

$

(4,984

)

Corporate security:

 

 

 

 

 

 

 

 

 

 

 

 

 

Finance, insurance and real estate

 

 

 

58,049

 

(17,472

)

58,049

 

(17,472

)

 

 

$

 —

 

$

 

$

418,065

 

$

(22,456

)

$

418,065

 

$

(22,456

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Equity securities, available for sale:

 

 

 

 

 

 

 

 

 

 

 

 

 

Finance, insurance and real estate

 

$

30,093

 

$

(14,360

)

$

20,358

 

$

(11,618

)

$

50,451

 

$

(25,978

)

 

18



 

The following is a description of the factors causing the temporary unrealized losses by investment category as of September 30, 2009:

 

United States Government sponsored agencies and U.S. states, territories and political subdivisions: These securities are relatively long in duration, making the value of such securities sensitive to changes in market interest rates.  During the last nine months spreads on agency securities have improved; however, long term interest rates have risen by a greater amount.  These securities carry yields less than those available at September 30, 2009 as the result of these rising interest rates.

 

Corporate securities:  The unrealized losses in these securities are due partially to a rise in interest rates in 2009 as well as the continuation in wider than historic credit spreads. While credit spreads have improved on a recovering economy, several industries remain at much wider spreads, such as financials and economic sensitive issuers. As the result of wider spreads, these issues carry yields less than those available in the market as of September 30, 2009.

 

Mortgage and asset backed securities: At September 30, 2009, we had no exposure to subprime mortgage-backed securities.  All of our mortgage-backed securities are pools of residential mortgage loans.  Substantially all of the securities that we own are in the highest rated tranche of the pool in which they are structured and are not subordinated to any other tranche. Our “Alt-A” mortgage-backed securities are comprised of 36 securities with a total amortized cost basis of $536.4 million and a fair value of $402.5 million.  Fair values of residential mortgage-backed securities have continued at prices significantly less than amortized cost as spreads in this sector have not improved like other sectors of the fixed income market.  With the uncertainty of future foreclosures and high delinquencies on residential mortgages, these security prices will likely remain below our cost basis until the housing market conditions improve.

 

Equity securities: The unrealized losses on equity securities, which are primarily investment grade perpetual preferred stocks with exposure to REITS, investment banks and finance companies, are due to the instability in the financial markets and a further deterioration in the economy.  All of the equity securities in an unrealized loss position for 12 months or more are investment grade perpetual preferred stocks that are absent credit deterioration.  A deepening recession due to tight credit markets and a difficult housing market have raised concerns in regard to earnings and dividend stability in many companies which directly affect the values of these securities.

 

Where the decline in market value of debt securities is attributable to changes in market interest rates or to factors such as market volatility, liquidity and spread widening, and we anticipate recovery of all contractual or expected cash flows, we do not consider these investments to be other than temporarily impaired because we do not intend to sell these investments and it is not more likely than not we will be required to sell these investments before a recovery of amortized cost, which may be maturity. For equity securities, we recognize an impairment charge in the period in which we do not have the intent and ability to hold the securities until recovery of cost or we determine that the security will not recover to book value within a reasonable period of time. We determine what constitutes a reasonable period of time on a security-by-security basis based upon consideration of all the evidence available to us, including the magnitude of an unrealized loss and its duration. In any event, this period does not exceed 18 months from the date of impairment for perpetual preferred securities for which there is evidence of deterioration in credit of the issuer and common equity securities. For perpetual preferred securities absent evidence of a deterioration in credit of the issuer we apply an impairment model, including an anticipated recovery period, similar to a debt security. For equity securities we measure impairment charges based upon the difference between the book value of a security and its fair value.

 

Approximately 36% of the unrealized losses on fixed maturity securities shown in the above table for September 30, 2009 are on securities that are rated investment grade, defined as being the highest two NAIC designations.  Approximately 64% of the unrealized losses on fixed maturity securities shown in the above table for September 30, 2009 are on securities rated below investment grade.  All of the fixed maturity securities with unrealized losses are current with respect to the payment of principal and interest.

 

19



 

Changes in net unrealized losses on investments for the nine months ended September 30, 2009 and 2008 are as follows:

 

 

 

September 30,

 

 

 

2009

 

2008

 

 

 

(Dollars in thousands)

 

Fixed maturity securities held for investment carried at amortized cost

 

$

3,321

 

$

44,389

 

Investments carried at fair value:

 

 

 

 

 

Fixed maturity securities, available for sale

 

$

465,818

 

$

(346,486

)

Equity securities, available for sale

 

35,169

 

(8,427

)

 

 

500,987

 

(354,913

)

Adjustment for effect on other balance sheet accounts:

 

 

 

 

 

Deferred policy acquisition costs and deferred sales inducements

 

(300,148

)

202,376

 

Change in deferred tax valuation allowance

 

30,842

 

(5,078

)

Deferred income tax asset

 

(70,294

)

53,388

 

 

 

(339,600

)

250,686

 

Decrease (increase) in net unrealized losses on investments carried at fair value

 

$

161,387

 

$

(104,227

)

 

Realized gains and losses on sales are determined on the basis of specific identification of investments based on the trade date.  Net realized gains on investments, excluding other than temporary impairment losses for the three and nine months ended September 30, 2009 and 2008 are as follows:

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2009

 

2008

 

2009

 

2008

 

 

 

(Dollars in thousands)

 

Available for sale fixed maturity securities:

 

 

 

 

 

 

 

 

 

Gross realized gains

 

$

10,334

 

$

2,228

 

$

16,461

 

$

3,371

 

Gross realized losses

 

(2,619

)

(170

)

(2,672

)

(283

)

 

 

7,715

 

2,058

 

13,789

 

3,088

 

Equity securities:

 

 

 

 

 

 

 

 

 

Gross realized gains

 

3,279

 

200

 

3,282

 

255

 

 

 

3,279

 

200

 

3,282

 

255

 

Mortgage loans on real estate:

 

 

 

 

 

 

 

 

 

Impairment losses

 

(5,484

)

 

(6,484

)

 

 

 

$

 5,510

 

$

2,258

 

$

10,587

 

$

3,343

 

 

We review and analyze all investments on an ongoing basis for changes in market interest rates and credit deterioration.  This review process includes analyzing our ability to recover the amortized cost or cost basis of each investment that has a fair value that is materially lower than its amortized cost or cost and requires a high degree of management judgment and involves uncertainty.  The evaluation of securities for other than temporary impairments is a quantitative and qualitative process, which is subject to risks and uncertainties.

 

We have a policy and process in place to identify securities that could potentially have an impairment that is other than temporary.  This process involves monitoring market events and other items that could impact issuers.  The evaluation includes but is not limited to such factors as:

 

·            our assessment in the case of equity securities including perpetual preferred stocks with credit deterioration that the security cannot recover to cost in a reasonable period of time;

·            the length of time and the extent to which the fair value has been less than amortized cost or cost;

·            whether the issuer is current on all payments and all contractual payments have been made as agreed;

 

20



 

·            the remaining payment terms and the financial condition and near-term prospects of the issuer;

·            the lack of ability to refinance due to liquidity problems in the credit market;

·            the fair value of any underlying collateral;

·            the existence of any credit protection available;

·            our intent to sell and whether it is more likely than not we would be required to sell prior to recovery for debt securities;

·            our intent and ability to retain equity securities for a period of time sufficient to allow for recovery;

·            consideration of rating agency actions; and

·            changes in estimated cash flows of and mortgage and asset backed securities.

 

We determine whether other than temporary impairment losses should be recognized for debt and equity securities by assessing all facts and circumstances surrounding the security.  Other than temporary impairment losses on equity securities are recognized in operations.  If we intend to sell a debt security or if it is more likely than not that we will be required to sell a debt security before recovery of its amortized cost basis, other than temporary impairment has occurred and the difference between amortized cost and fair value will be recognized as a loss in operations.

 

If we do not intend to sell and it is not more likely than not we will be required to sell the debt security but also do not expect to recover the entire amortized cost basis of the security, an impairment loss would be recognized in operations in the amount of the expected credit loss.  We calculate the present value of the cash flows expected to be collected.  The difference between the present value of expected future cash flows and the amortized cost basis of the security is the amount of credit loss recognized in operations.  The remaining amount of the other than temporary impairment is recognized in other comprehensive income.

 

The determination of the credit loss component of a mortgage-backed security is based on a number of factors.  The primary consideration in this evaluation process is the issuer’s ability to meet current and future interest and principal payments as contractually stated at time of purchase.  Our review of these securities includes an analysis of the cash flow modeling under various default scenarios considering independent third party benchmarks, the seniority of the specific tranche within the structure of the security, the composition of the collateral and the actual default, loss severity and prepayment experience exhibited.  With the input of third party assumptions for default projections, loss severity and prepayment expectations, we evaluate the cash flow projections to determine whether the security is performing in accordance with its contractual obligation.

 

We utilize the models from a leading structured product software specialist serving institutional investors.  These models incorporate each security’s seniority and cash flow structure.  In circumstances where the analysis implies a potential for principal loss at some point in the future, we use the “best estimate” cash flow projection discounted at the security’s effective yield at acquisition to determine the amount of our potential credit loss associated with this security.  The discounted expected future cash flows equates to our expected recovery value.  Any shortfall of the expected recovery when compared to the amortized cost of the security will be recorded as the credit loss component of other than temporary impairment.

 

The cash flow modeling is performed on a security-by-security basis and incorporates actual cash flows on the mortgage-backed securities through the current period, as well as the projection of remaining cash flows using a number of assumptions including default rates, prepayment rates and loss severity rates.  The default curves we use are tailored to the Prime or Alt-A mortgage-backed securities that we own, which assume lower default rates and loss severity for Prime securities versus Alt-A securities.  These default curves are scaled higher or lower depending on factors such as current underlying mortgage loan performance, rating agency loss projections, loan to value ratios, geographic diversity, as well as other appropriate considerations.  The default curves generally assume lower loss levels for older vintage securities versus more recent vintage securities, which reflects the decline in underwriting standards over the years.

 

The following table presents the range of significant assumptions used to determine the credit loss component of other than temporary impairments we have recognized on mortgage-backed securities which are all senior level tranches  within the structure of the securities:

 

 

 

 

 

Discount Rate

 

Default Rate

 

Loss Severity

 

Sector

 

Vintage

 

Min

 

Max

 

Min

 

Max

 

Min

 

Max

 

Prime

 

2005

 

7.7

%

7.7

%

7

%

7

%

50

%

50

%

 

 

2006

 

6.5

%

9.2

%

8

%

14

%

35

%

55

%

 

 

2007

 

5.8

%

7.9

%

10

%

31

%

40

%

50

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Alt-A

 

2005

 

5.6

%

8.7

%

10

%

16

%

10

%

55

%

 

 

2006

 

6.0

%

7.3

%

18

%

27

%

50

%

60

%

 

 

2007

 

6.2

%

7.4

%

15

%

52

%

45

%

70

%

 

21



 

The determination of the credit loss component of a corporate bond (including redeemable preferred stocks) is based on the underlying financial performance of the issuer and their ability to meet their contractual obligations.  Considerations in our evaluation include, but are not limited to, credit rating changes, financial statement and ratio analysis, changes in management, large changes in credit spreads, breaches of financial covenants and a review of the economic outlook for the industry and markets in which they trade.  In circumstances where an issuer appears unlikely to meet its future obligation, or the security’s price decline is deemed other than temporary, an estimate of credit loss is determined.  Credit loss is calculated using default probabilities as derived from the credit default swaps markets in conjunction with recovery rates derived from independent third party analysis or a best estimate of credit loss.  This credit loss rate is then incorporated into a present value calculation based on an expected principal loss in the future discounted at the yield at the date of purchase and compared to amortized cost to determine the amount of credit loss associated with the security.

 

The following table summarizes other than temporary impairments by asset type:

 

 

 

 

 

 

 

 

 

Three Months

 

 

 

 

 

 

 

 

 

Ended

 

 

 

Three Months Ended September 30, 2009

 

September 30,
2008

 

 

 

Total Other

 

Included in

 

Net

 

 

 

 

 

Than

 

Other

 

Impairment

 

Impairment

 

 

 

Temporary

 

Comprehensive

 

Losses

 

Losses

 

 

 

Losses

 

Income

 

in Operations

 

in Operations

 

 

 

(Dollars in thousands)

 

Fixed maturity securities:

 

 

 

 

 

 

 

 

 

Available for sale:

 

 

 

 

 

 

 

 

 

Corporate securities

 

$

(3,830

)

$

(2,953

)

$

(6,783

)

$

(15,848

)

Residential mortgage-backed securities

 

(78,712

)

52,594

 

(26,118

)

 

Equity securities, available for sale

 

(11,674

)

 

(11,674

)

(45,384

)

 

 

$

 (94,216

)

$

49,641

 

$

(44,575

)

$

(61,232

)

 

 

 

 

 

 

 

 

 

Nine Months

 

 

 

 

 

 

 

 

 

Ended

 

 

 

Nine Months Ended September 30, 2009

 

September 30,
2008

 

 

 

Total Other

 

Included in

 

Net

 

 

 

 

 

Than

 

Other

 

Impairment

 

Impairment

 

 

 

Temporary

 

Comprehensive

 

Losses

 

Losses

 

 

 

Losses

 

Income

 

in Operations

 

in Operations

 

 

 

(Dollars in thousands)

 

Fixed maturity securities:

 

 

 

 

 

 

 

 

 

Available for sale:

 

 

 

 

 

 

 

 

 

United States Government full faith and credit

 

$

(245

)

$

 

$

(245

)

$

 

Corporate securities

 

(9,785

)

(2,756

)

(12,541

)

(33,673

)

Residential mortgage-backed securities

 

(140,454

)

110,768

 

(29,686

)

(3,249

)

Equity securities, available for sale

 

(21,184

)

 

(21,184

)

(57,833

)

 

 

$

 (171,668

)

$

108,012

 

$

(63,656

)

$

(94,755

)

 

The cumulative portion of other than temporary impairments determined to be credit losses which have been recognized in operations for debt securities are summarized as follows:

 

 

 

Three Months
Ended

September 30,
2009

 

Nine Months
Ended
September 30,
2009

 

 

 

(Dollars in thousands)

 

Cumulative credit loss at beginning of period

 

$

(43,554

)

$

(34,229

)

Credit losses on securities for which an other than temporary impairment was not previously recognized

 

(6,015

)

(13,083

)

Additional credit losses on securities for which an other than temporary impairment was previously recognized

 

(26,887

)

(29,389

)

Losses included in beginning balance on securities sold during the period

 

5,210

 

5,455

 

 

 

$

 (71,246

)

$

(71,246

)

 

22



 

The following table summarizes the cumulative noncredit portion of OTTI and the change in fair value since recognition of OTTI, both of which were recognized in other comprehensive income, by major type of security for securities that are part of our investment portfolio at September 30, 2009:

 

 

 

September 30,
2009

Amortized Cost

 

OTTI
Recognized
in Other
Comprehensive
Income

 

Change in Fair
Value
Since OTTI
was
Recognized

 

September 30,
2009

Fair Value

 

 

 

(Dollars in thousands)

 

Corporate securities

 

$

35,725

 

$

(12,982

)

$

7,426

 

$

30,169

 

Residential mortgage-backed securities

 

701,034

 

(180,224

)

8,353

 

529,163

 

Equity securities:

 

 

 

 

 

 

 

 

 

Finance, insurance and real estate

 

37,227

 

 

13,168

 

50,395

 

 

 

$

 773,986

 

$

(193,206

)

$

28,947

 

$

609,727

 

 

Trading securities consist of fixed maturity and equity securities in designated portfolios, which support funds withheld reinsurance arrangements.  Investment results for these portfolios, including gains and losses from sales, are passed directly to the reinsurer pursuant to contractual terms of the reinsurance arrangements.  Trading securities are carried at fair value and changes in fair value are recorded as changes in the funds withheld reinsurance liability, as the funds withheld are being held on deposit to support the amount of reinsurance recoverable.  The fair value of our trading securities is determined in the same manner as our securities classified as available for sale.

 

Trading securities at fair value retained in connection with reinsurance arrangements consisted of the following:

 

 

 

September 30, 2009

 

December 31,
2008

 

 

 

(Dollars in thousands)

 

United States Government sponsored agencies

 

$

3,517

 

$

 

U.S. states, territories and political subdivisions

 

24,763

 

 

Corporate securities

 

66,841

 

 

Mortgage-backed securities

 

229,334

 

 

Equity securities

 

46,883

 

 

Total trading securities

 

$

371,338

 

$

 

 

23



 

5.  Mortgage Loans on Real Estate

 

Our mortgage loan portfolio totaled $2.4 billion and $2.3 billion at September 30, 2009 and December 31, 2008, respectively, with commitments outstanding of $31.5 million at September 30, 2009.  The portfolio consists of commercial mortgage loans collateralized by the related properties and diversified as to property type, location and loan size.  Our mortgage lending policies establish limits on the amount that can be loaned to one borrower and other criteria to reduce the risk of default. The mortgage loan portfolio is summarized by geographic region and property type as follows:

 

 

 

September 30, 2009

 

December 31, 2008

 

 

 

Carrying
Amount

 

Percent

 

Carrying
Amount

 

Percent

 

 

 

(Dollars in thousands)

 

Geographic distribution

 

 

 

 

 

 

 

 

 

East

 

$

541,057

 

22.7

%

$

537,303

 

23.1

%

Middle Atlantic

 

165,905

 

7.0

%

161,222

 

6.9

%

Mountain

 

379,368

 

16.0

%

386,988

 

16.6

%

New England

 

44,953

 

1.9

%

44,517

 

1.9

%

Pacific

 

208,349

 

8.8

%

194,301

 

8.3

%

South Atlantic

 

443,566

 

18.6

%

421,507

 

18.1

%

West North Central

 

410,342

 

17.3

%

397,375

 

17.1

%

West South Central

 

182,293

 

7.7

%

186,611

 

8.0

%

 

 

$

2,375,833

 

100.0

%

$

2,329,824

 

100.0

%

Property type distribution

 

 

 

 

 

 

 

 

 

Office

 

$

651,572

 

27.4

%

$

655,278

 

28.1

%

Medical Office

 

141,016

 

5.9

%

142,409

 

6.1

%

Retail

 

546,014

 

23.0

%

551,172

 

23.7

%

Industrial/Warehouse

 

583,588

 

24.6

%

552,012

 

23.7

%

Hotel

 

156,146

 

6.6

%

154,671

 

6.6

%

Apartment

 

119,163

 

5.0

%

111,933

 

4.8

%

Mixed use/other

 

178,334

 

7.5

%

162,349

 

7.0

%

 

 

$

2,375,833

 

100.0

%

$

2,329,824

 

100.0

%

 

As of September 30, 2009, we have two mortgage loans that we completed foreclosure proceedings and obtained the underlying collateral which we are accounting for as real estate held for sale.  The principal balance outstanding on the loans at the dates of foreclosure was $8.9 million and no loss was recognized since the fair value of the properties acquired less the estimated costs to sell exceeds the amounts outstanding on the loan.  We have five mortgage loans with a total outstanding balance of $14.6 million that were in default and we have commenced foreclosure proceedings.

 

We evaluate our mortgage loan portfolio for the purpose of determining the need to establish a loan loss reserve.  We accomplish this by specific identification of impaired loans and the measurement of an estimated loss for each individual loan identified.  In addition, we analyze the mortgage loan portfolio for the need of a general loan allowance for probable losses on all other loans.  The amount of the general loan allowance is based upon management’s evaluation of the collectability of the loan portfolio, historical loss experience, delinquencies, credit concentrations, underwriting standards and national and local economic conditions.  Based upon this process and analysis, we have determined that no general loan loss allowance was necessary.  A mortgage loan is impaired when it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement.  We recorded impairment losses of $5.5 million and $6.5 million during the three and nine months ended September 30, 2009, respectively, on specific mortgage loans with a total outstanding balance of $12.5 million and $18.4 million during the three and nine months ended September 30, 2009, respectively, for which  principal amounts outstanding exceed the fair value of the collateral real estate less projected costs to sell the properties.

 

24



 

A summary of impaired commercial mortgage loans as of September 30, 2009 and December 31, 2008 is as follows:

 

 

 

September 30,
2009

 

December 31,
2008

 

 

 

(Dollars in thousands)

 

Impaired mortgage loans with allowances for losses

 

$

18,384

 

$

 

Impaired mortgage loans with no allowance for losses

 

58,862

 

20,983

 

Allowance for probable loan losses

 

(6,484

)

 

Net carrying value of impaired mortgage loans

 

$

70,762

 

$

20,983

 

 

Mortgage loans summarized in the preceding table represent all loans that we are either not currently collecting, or those we feel it is probable we will not be able to collect, all amounts due according to the contractual terms of the loan agreements. We have not recognized an allowance on any of our impaired mortgage loans for which the present value of our expected future cash flows have not decreased. Should the delinquency rate or loss performance of our commercial mortgage loan portfolio increase significantly, the increase could have an adverse effect on our results.

 

6.  Derivative Instruments

 

We recognize all derivative instruments as assets or liabilities in the consolidated balance sheets at fair value.  None of our derivatives qualify for hedge accounting, thus, any change in the fair value of the derivatives is recognized immediately in the  consolidated statements of operations.

 

The fair value of our derivative instruments, including derivative instruments embedded in index annuity contracts, presented in the  consolidated balance sheets are as follows:

 

 

 

September 30,
2009

 

December 31,
2008

 

 

 

(Dollars in thousands)

 

ASSETS

 

 

 

 

 

Derivative instruments

 

 

 

 

 

Call options

 

$

364,041

 

$

58,358

 

Interest rate swaps

 

 

(1,770

)

 

 

$

 364,041

 

$

56,588

 

LIABILITIES

 

 

 

 

 

Policy benefit reserves - annuity products

 

 

 

 

 

Index annuities-embedded derivatives

 

$

1,248,912

 

$

998,015

 

Other liabilities

 

 

 

 

 

Interest rate swaps

 

2,227

 

 

 

 

$

 1,251,139

 

$

998,015

 

 

The change in fair value of derivatives included in the consolidated statements of operations are as follows:

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

 

 

2009

 

2008

 

2009

 

2008

 

 

 

(Dollars in thousands)

 

Change in fair value of derivatives:

 

 

 

 

 

 

 

 

 

Call options

 

$

123,121

 

$

(83,598

)

$

110,019

 

$

(313,987

)

Interest rate swaps

 

(1,614

)

(155

)

(1,841

)

(444

)

 

 

$

 121,507

 

$

(83,753

)

$

108,178

 

$

(314,431

)

Change in fair value of embedded derivatives:

 

 

 

 

 

 

 

 

 

Index annuities

 

$

259,737

 

$

(37,100

)

$

414,636

 

$

(237,969

)

 

We have index annuity products that guarantee the return of principal to the policyholder and credit interest based on a percentage of the gain in a specified market index.  When index annuity premiums are received, a portion of

 

25



 

the premium is used to purchase derivatives consisting of call options on the applicable market indices to fund the index credits due to index annuity policyholders.  Substantially all such call options are one year options purchased to match the funding requirements of the underlying policies.  The call options are marked to fair value with the change in fair value included as a component of revenues.  The change in fair value of derivatives includes the gains or losses recognized at the expiration of the option term or upon early termination and the changes in fair value for open positions.  On the respective anniversary dates of the index policies, the index used to compute the annual index credit is reset and we purchase new one-year call options to fund the next annual index credit.  We manage the cost of these purchases through the terms of our index annuities, which permit us to change caps, participation rates, and/or asset fees, subject to guaranteed minimums on each policy’s anniversary date.  By adjusting caps, participation rates, or asset fees, we can generally manage option costs except in cases where the contractual features would prevent further modifications.

 

Our strategy attempts to mitigate any potential risk of loss under these agreements through a regular monitoring process which evaluates the program’s effectiveness.  We do not bear derivative related risk with our call options that would require payment or collateral to another institution and our call options do not contain counterparty credit-risk-related contingent features.  We are exposed to risk of loss in the event of nonperformance by the counterparties and, accordingly, we purchase our option contracts from multiple counterparties and evaluate the creditworthiness of all counterparties prior to purchase of the contracts.  All of these options had been purchased from nationally recognized financial institutions with a Standard and Poor’s credit rating of A- or higher at the time of purchase and the maximum credit exposure to any single counterparty is subject to concentration limits.  We also have credit support agreements with several counterparties that allow us to request the counterparty to provide collateral to us when the fair value of our exposure to the counterparty exceeds specified amounts.

 

The notional amount and maximum amount of loss due to credit risk that we would incur if parties to the call options failed completely to perform according to the terms of the contracts are as follows:

 

 

 

September 30, 2009

 

December 31, 2008

 

Counterparty

 

Credit
Rating

 

Notional
Amount

 

Fair Value

 

Notional
Amount

 

Fair Value

 

 

 

(Dollars in thousands)

 

Bank of America

 

A+

 

$

218,490

 

$

4,360

 

$

2,184,932

 

$

4,593

 

BNP Paribas

 

AA

 

1,729,500

 

92,316

 

1,410,092

 

16,533

 

Lehman

 

NR

 

1,437

 

 

1,353,837

 

 

Bank of New York

 

AA-

 

152,150

 

7,820

 

641,405

 

3,541

 

Credit Suisse

 

A+

 

2,875,154

 

106,778

 

613,333

 

9,380

 

Barclays

 

AA-

 

254,793

 

10,599

 

694,967

 

13,618

 

SunTrust

 

A-

 

498,375

 

26,534

 

484,101

 

4,263

 

Wells Fargo (Wachovia)

 

AA

 

664,702

 

41,460

 

338,790

 

16

 

J.P. Morgan

 

AA-

 

1,234,280

 

74,174

 

312,943

 

6,296

 

Citi

 

NA

 

 

 

83,315

 

118

 

Others

 

NR

 

51

 

 

73,679

 

 

 

 

 

 

$

 7,628,932

 

$

364,041

 

$

8,191,394

 

$

58,358

 

 

As of September 30, 2009 we are holding $228.1 million of cash and cash equivalents received from counterparties for derivative collateral.

 

We had unsecured counterparty exposure in connection with options purchased from affiliates of Lehman Brothers (“Lehman”) which declared bankruptcy during the third quarter of 2008.  Except for a few options involving immaterial amounts, all options purchased from affiliates of Lehman have expired as of September 30, 2009.  The amount of option proceeds due on expired options purchased from Lehman that we did not receive payment on was $2.6 million for the third quarter of 2009 and $12.0 million for the nine months ended September 30, 2009.  No amount has been recognized for any recovery of these amounts that may result from our claim in Lehman’s bankruptcy proceedings.

 

The future annual index credits on our index annuities are treated as a “series of embedded derivatives” over the expected life of the applicable contract.  We do not purchase call options to fund the index liabilities which may

 

26



 

arise after the next policy anniversary date.  We must value both the call options and the related forward embedded options in the policies at fair value.

 

We have entered into interest rate swaps to manage interest rate risk associated with the floating rate component on certain of our subordinated debentures and amounts outstanding under our revolving line of credit.  See notes 8 and 9 in our Annual Report on Form 10-K for the year ended December 31, 2008  for more information on our revolving line of credit and subordinated debentures.  The terms of the interest rate swaps provide that we pay a fixed rate of interest and receive a floating rate of interest.  The interest rate swaps are not effective hedges.  Therefore, we record the interest rate swaps at fair value and any net cash payments received or paid are included in the change in fair value of derivatives in the consolidated statements of operations.

 

27



 

Details regarding the interest rate swaps are as follows:

 

Maturity

 

Notional

 

Receive

 

Pay

 

 

 

September 30,
2009

 

December 31,
2008

 

Date

 

Amount

 

Rate

 

Rate

 

Counterparty

 

Fair Value

 

Fair Value

 

 

 

 

 

 

 

 

 

 

 

(Dollars in thousands)

 

April 29, 2009

 

$

20,000

 

*LIBOR

 

4.94

%

Bank of America

 

$

 

$

(257

)

December 15, 2009

 

20,000

 

*LIBOR

 

4.93

%

Bank of America

 

(234

)

(719

)

September 15, 2010

 

20,000

 

*LIBOR (a)

 

5.19

%

Bank of America

 

(189

)

(325

)

April 7, 2011

 

20,000

 

*LIBOR (a)

 

5.23

%

Bank of America

 

(331

)

(469

)

October 15, 2011

 

15,000

 

**LIBOR

 

1.54

%

SunTrust

 

(141

)

 

October 31, 2011

 

30,000

 

**LIBOR

 

1.51

%

SunTrust

 

(231

)

 

October 31, 2011

 

30,000

 

**LIBOR

 

1.61

%

SunTrust

 

(299

)

 

October 31, 2011

 

30,000

 

**LIBOR

 

1.77

%

SunTrust

 

(802

)

 

 

 

$

 185,000

 

 

 

 

 

 

 

$

(2,227

)

$

(1,770

)

 


* - three month London Interbank Offered Rate

** - one month London Interbank Offered Rate

(a) - subject to a floor of 4.25%

 

7. Reinsurance

 

Effective July 1, 2009, we entered into two funds withheld coinsurance agreements with Athene Life Re Ltd. (“Athene”), a Bermuda life reinsurer.  One agreement cedes 20% of certain of our index annuities issued from January 1, 2009, through December 31, 2009.  The other agreement cedes 80% of our multi-year rate guaranteed annuities issued on or after July 1, 2009.

 

Coinsurance deposits (aggregate policy benefit reserves transferred to Athene under these agreements) were $577.3 million at September 30, 2009.  We remain liable to policyholders with respect to the policy liabilities ceded to Athene should Athene fail to meet the obligations it has coinsured.  The annuity deposits that have been ceded to Athene are being held by us on a funds withheld basis.  The funds withheld are presented in our consolidated balance sheet as trading securities and restricted cash with a corresponding funds withheld reinsurance liability that represents the fair value of the funds withheld.  The balance due under these agreements with Athene was $9.8 million at September 30, 2009 and represents the fair value of call options held by the Company to fund index credits related to the ceded business net of cash due from Athene related to monthly settlements of policy activity.

 

8.  Income Taxes

 

In 2008, we recorded a valuation allowance of $34.5 million on deferred income tax assets related to capital loss carryforwards and other than temporary impairments on investment securities, as utilization of the income tax benefits from a portion of these items was not more likely than not due to the fact that we had insufficient future taxable income from capital gain sources.  The valuation allowance was eliminated in 2009 due to an increase in anticipated future taxable income from capital gain sources, which resulted from an increase in unrealized gains on securities in our available for sale investment portfolio which may be sold as part of a tax planning strategy to generate capital gains to offset capital losses.

 

The effective tax rate for the third quarter of 2009 was more than the applicable statutory federal income tax rate of 35% primarily due to state income tax benefits attributable to losses in the non-life subgroup.  The effective tax rate for the nine months ended September 30, 2009 was less than the applicable statutory federal income tax rate of 35% primarily due to a decrease in the deferred tax valuation allowance for capital loss carryforwards and other than temporary impairments on investment securities which decreased income tax expense for the first quarter of 2009 by $3.6 million.  The remainder of the deferred tax valuation allowance of $30.9 million was eliminated in the second quarter of 2009 and was recognized in accumulated other comprehensive income.  The effective tax rates for the 2008 periods were more than the applicable statutory federal income tax rate of 35% primarily due to the establishment of a deferred tax valuation allowance for deferred income tax assets related to capital loss carryforwards and other than temporary impairments on investment securities which increased income tax expense in the 2008 periods by $22.5 million.

 

28



 

9.  Contingent Convertible Senior Notes

 

In December 2004, we issued $260.0 million of contingent convertible senior notes due December 6, 2024.  The notes are unsecured and bear interest at a fixed rate of 5.25% per annum.  Interest is payable semi-annually in arrears on June 6 and December 6 of each year, beginning June 6, 2005.  In addition to regular interest on the notes, beginning with the six-month interest period ending June 6, 2012, we will also pay contingent interest under certain conditions at a rate of 0.5% per annum based on the average trading price of the notes during a specified period.

 

The notes are accounted for separately as a liability component and an equity component in the consolidated balance sheets.  The liability component and equity component are as follows:

 

 

 

September 30,
2009

 

December 31,
2008

 

 

 

 

 

(As Adjusted)

 

 

 

(Dollars in thousands)

 

Notes payable:

 

 

 

 

 

Principal amount of liability component

 

$

144,766

 

$

181,924

 

Unamortized discount

 

(8,097

)

(13,284

)

Net carrying amount of liability component

 

$

136,669

 

$

168,640

 

 

 

 

 

 

 

Additional paid-in capital:

 

 

 

 

 

Carrying amount of equity component

 

$

22,637

 

$

22,637

 

 

The discount is being amortized over the expected life of the notes, which is December 15, 2011, the date at which we may redeem the notes or the holders may require us to repurchase the notes.  The effective interest rate on the notes is 8.5%.  The interest cost recognized in operations, inclusive of the 5.25% coupon and amortization of the discount and debt issue costs, recognized for the three months and nine months ended September 30, 2009 was $2.9 million and $9.7 million, respectively and $1.2 million and $10.5 million for the same periods in 2008.

 

The notes are convertible at the holders’ option prior to the maturity date into cash and shares of our common stock under the following conditions:

 

 

·

during any fiscal quarter, if the closing sale price of our common stock for at least 20 trading days in the period of 30 consecutive trading days ending on the last trading day of the fiscal quarter preceding the quarter in which the conversion occurs is more than 120% of the conversion price of the notes in effect on that 30th trading day;

 

·

we have called the notes for redemption and the redemption has not yet occurred; or

 

·

upon the occurrence of specified corporate transactions.

 

Holders may convert any outstanding notes into cash and shares of our common stock at a conversion price per share of $14.24.  This represents a conversion rate of approximately 70.2 shares of common stock per $1,000 in principal amount of notes (the “conversion rate”).  Subject to certain exceptions described in the indenture covering these notes, at the time the notes are tendered for conversion, the value (the “conversion value”) of the cash and shares of our common stock, if any, to be received by a holder converting $1,000 principal amount of the notes will be determined by multiplying the conversion rate by the “ten day average closing stock price”, which equals the average of the closing per share prices of our common stock on the New York Stock Exchange on the ten consecutive trading days beginning on the second trading day following the day the notes are submitted for conversion.  We will deliver the conversion value to holders as follows: (1) an amount in cash (the “principal return”) equal to the lesser of (a) the aggregate conversion value of the notes to be converted and (b) the aggregate principal amount of the notes to be converted, and (2) if the aggregate conversion value of the notes to be converted is greater than the principal return, an amount in shares (the “net shares”) equal to such aggregate conversion value less the principal return (the “net share amount”) and (3) an amount in cash in lieu of fractional shares of common stock.  The number of net shares to be paid will be determined by dividing the net share amount by the ten day average closing stock price.

 

29



 

We may redeem some or all of the notes at any time on or after December 15, 2011.  In addition, the holders may require us to repurchase all or a portion of their notes on December 15, 2011, 2014 and 2019 and upon a change in control, as defined in the indenture governing the notes, holders may require us to repurchase all or a portion of their notes for a period of time after the change in control.  The redemption price or repurchase price shall be payable in cash and equal to 100% of the principal amount of the notes plus accrued and unpaid interest (contingent interest and liquidated damages, if any) up to but not including the date of redemption or repurchase.  We reacquired $34.0 million of the notes during the nine months ended September 30, 2008.  In connection with those debt extinguishments, we recognized losses of $1.4 million for the nine months ended September 30, 2008.

 

In May 2009, we exchanged five million shares of our common stock for $37.2 million of the 5.25% contingent convertible senior notes.  The transaction was settled with the fair value of the common stock exchanged at $6.25 per share totaling $31.3 million.  The notes that were extinguished carried an unamortized debt issue costs of $0.4 million and an unamortized debt discount of $2.4 million.  No value of the consideration was allocated to the reacquisition of the equity component.  Therefore, a $3.1 million gain on extinguishment of debt was recorded for the amount that the carrying value of the notes extinguished exceeded the fair value of the consideration transferred to the holder of the notes.

 

The notes are senior unsecured obligations and rank equally in right of payment with all existing and future senior indebtedness and senior to any existing and future subordinated indebtedness.  The notes effectively rank junior in right of payment to any existing and future secured indebtedness to the extent of the value of the assets securing such secured indebtedness.  The notes are structurally subordinated to all liabilities of our subsidiaries.

 

We are required to include the dilutive effect of the contingent convertible senior notes in our diluted earnings per share calculation. Because the notes include a mandatory cash settlement feature for the principal amount, incremental dilutive shares will only exist when the average fair value of our common stock for a reporting period exceeds the conversion price per share of $14.24.

 

10.  Contingencies

 

We are occasionally involved in litigation, both as a defendant and as a plaintiff.  In addition, state regulatory bodies, such as state insurance departments, the Securities and Exchange Commission (“SEC”), the Financial Industry Regulatory Authority (“FINRA”), the Department of Labor, and other regulatory bodies regularly make inquiries and conduct examinations or investigations concerning our compliance with, among other things, insurance laws, securities laws, the Employee Retirement Income Security Act of 1974, as amended, and laws governing the activities of broker-dealers.

 

During the fourth quarter of 2007 we received a formal request for information from the staff of the Division of Enforcement (the “Staff”) of the SEC concerning certain transactions between American Equity and American Equity Investment Service Company (“Service Company”) in 2003, 2004 and 2005. We have cooperated fully in providing information and documentation to the Staff throughout the course of its investigation.  On May 4, 2009, American Equity, our Chairman and our Chief Executive Officer and President received a Wells Notice from the Staff in connection with this investigation.  The Wells Notice provides notification that the Staff intends to recommend to the SEC that it bring a civil action against the recipients for possible violations of the federal securities laws and related rules.  A Wells Notice does not itself initiate litigation, nor is it a finding of wrongdoing by us or any individual.  According to discussions with the SEC Staff and our understanding of the scope of the investigation, the Wells Notice relates to disclosures in our 2004, 2005 and 2006 proxy statements and statements made during our third quarter 2005 earnings conference call concerning the effects of transactions involving the Service Company, the last of which was completed almost four years ago.  Beginning in 1999, our public securities filings contained extensive disclosures related to Service Company transactions, including the effect of each such transaction on our consolidated financial statements.  Based on our own investigation and the facts disclosed to us during the course of the SEC investigation, we believe these proxy statements accurately disclosed all material information, and strongly disagree with the Staff’s recommendation on this matter.  We will continue to pursue a potential resolution of this matter before the Staff makes its formal recommendation to the SEC and will vigorously defend any action brought by the SEC, but we cannot predict the outcome or timing of this matter.

 

In recent years, companies in the life insurance and annuity business have faced litigation, including class action lawsuits, alleging improper product design, improper sales practices and similar claims.  We are currently a

 

30



 

defendant in two purported class action lawsuits alleging improper sales practices and similar claims as described below.  It is often not possible to determine the ultimate outcome of pending legal proceedings or to provide reasonable ranges of potential losses with any degree of certainty.  The lawsuits referred to below are in very preliminary stages and we do not have sufficient information to make an assessment of the plaintiffs’ claims for liability or damages.  The plaintiffs are seeking undefined amounts of damages or other relief, including punitive damages, which are difficult to quantify and cannot be estimated based on the information currently available.  We do not believe that these lawsuits, including those discussed below, will have a material adverse effect on our financial position, results of operations or cash flows.  However, there can be no assurance that such litigation, or any future litigation, will not have a material adverse effect on our business, financial condition, or results of operations.

 

We are a defendant in two cases seeking class action status, including (i) Stephens v. American Equity Investment Life Insurance Company, et. al., in the San Luis Obispo Superior Court, San Francisco, California (complaint filed November 29, 2004) (the “SLO Case”) and (ii) McCormack, et al. v. American Equity Investment Life Insurance Company, et al.,  in the United States District Court for the Central District of California, Western Division and Anagnostis v. American Equity, et al., coordinated in the Central District, entitled, In re American Equity Annuity Practices and Sales Litigation (complaint filed September 7, 2005) (the “Los Angeles Case”).

 

The plaintiffs in the SLO Case seek to represent a class of individuals who are California residents and who either purchased their annuity from us through a co-defendant marketing organization or who purchased one of a defined set of particular annuities issued by us.  The named plaintiffs in this case are:  Chalys M. Stephens and John P. Stephens.  Plaintiffs seek injunctive relief and restitution on behalf of all class members under California Business & Professions Code section 17200 et seq.; compensatory damages for breach of contract and breach of fiduciary duty; other pecuniary damages under California Civil Code section 1750 and California Welfare & Institutions Codes section 15600 et seq.; and punitive damages under common law causes of action for fraud and breach of the covenant of good faith and fair dealing.  On November 3, 2008, the court issued an order certifying the class.  We are vigorously defending the underlying allegations and are seeking to decertify a portion of the class and may seek to decertify the entire class after further discovery into the merits of the case.

 

The Los Angeles Case is a consolidated action involving several lawsuits filed by individuals,  and the individuals are seeking class action status for a national class of purchasers of annuities issued by us.  The named plaintiffs in this consolidated case are Bernard McCormack, Gust Anagnostis by and through Gary S. Anagnostis and Robert C. Anagnostis, Regina Bush by and through Sharon Schipiour, Lenice Mathews by and through Mary Ann Maclean and George Miller.  The allegations generally attack the suitability of sales of deferred annuity products to persons over the age of 65.  The plaintiffs seek recessionary and injunctive relief including restitution and disgorgement of profits on behalf of all class members under California Business & Professions Code section 17200 et seq. and Racketeer Influenced and Corrupt Organizations Act; compensatory damages for breach of fiduciary duty and aiding and abetting of breach of fiduciary duty; unjust enrichment and constructive trust; and other pecuniary damages under California Civil Code section 1750 and California Welfare & Institutions Codes section 15600 et seq. We are vigorously defending against both class action status as well as the underlying claims.

 

11.  Sale of Our Common Stock

 

On August 20, 2009, we entered into distribution agreements with Fox-Pitt Kelton Cochran Caronia Waller (USA) LLC (“FPK”) and Sandler O’Neill & Partners, L.P. Under the distribution agreements, we can offer and sell shares of our common stock up to an aggregate offering price of $50,000,000. From August 20, 2009 through September 30, 2009, we sold 132,300 shares of our common stock at an average price of $8.26 per share, resulting in gross proceeds to us of $1.09 million. The aggregate net proceeds from such sales were $0.99 million after deducting related expenses, including $30,036 in gross sales commissions paid to FPK.

 

31



 

12.  Earnings Per Share

 

The following table sets forth the computation of earnings (loss) per common share and earnings (loss) per common share - assuming dilution:

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2009

 

2008

 

2009

 

2008

 

 

 

(Dollars in thousands, except per share data)

 

Numerator:

 

 

 

 

 

 

 

 

 

Net income (loss) - numerator for earnings (loss) per common share

 

$

(2,978

)

$

(11,716

)

$

32,509

 

$

39,996

 

Interest on convertible subordinated debentures (net of income tax benefit)

 

259

 

259

 

777

 

783

 

Numerator for earnings (loss) per common share - assuming dilution

 

$

(2,719

)

$

(11,457

)

$

33,286

 

$

40,779

 

 

 

 

 

 

 

 

 

 

 

Denominator:

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding (1)

 

58,029,697

 

52,916,026

 

55,462,097

 

54,075,275

 

Effect of dilutive securities:

 

 

 

 

 

 

 

 

 

Convertible subordinated debentures

 

2,734,528

 

2,761,318

 

2,734,528

 

2,763,899

 

Stock options and deferred compensation agreements

 

68,410

 

158,028

 

34,501

 

113,662

 

Denominator for earnings (loss) per common share - assuming dilution

 

60,832,635

 

55,835,372

 

58,231,126

 

56,952,836

 

 

 

 

 

 

 

 

 

 

 

Earnings (loss) per common share

 

$

(0.05

)

$

(0.22

)

$

0.59

 

$

0.74

 

Earnings (loss) per common share - assuming dilution

 

$

(0.05

)

$

(0.22

)

$

0.57

 

$

0.72

 

 


(1) Weighted average common shares outstanding include shares vested under the NMO Deferred Compensation Plan and exclude unallocated shares held by the ESOP.

 

Options to purchase shares of our common stock that were outstanding during the respective periods indicated but were not included in the computation of diluted earnings (loss) per share because the options’ exercise price was greater than the average market price of the common shares are as follows:

 

Period

 

Number of
Shares

 

Range of
Exercise Prices

 

Three months ended September 30, 2009

 

1,769,489

 

$8.67 - $14.34

 

Nine months ended September 30, 2009

 

2,389,289

 

$6.96 - $14.34

 

Three months ended September 30, 2008

 

1,207,239

 

$9.00 - $14.34

 

Nine months ended September 30, 2008

 

1,224,739

 

$8.67 - $14.34

 

 

13. Subsequent Events

 

We evaluated subsequent events through November 9, 2009, which is the date the consolidated financial statements were issued.

 

32



 

Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Management’s discussion and analysis reviews our unaudited consolidated financial position at September 30, 2009, and the unaudited consolidated results of operations for the three and nine month periods ended September 30, 2009 and 2008, and where appropriate, factors that may affect future financial performance.  This analysis should be read in conjunction with our unaudited consolidated financial statements and notes thereto appearing elsewhere in this Form 10-Q, and the audited consolidated financial statements, notes thereto and selected consolidated financial data appearing in our Annual Report on Form 10-K for the year ended December 31, 2008.  All prior period amounts are presented as adjusted due to the adoption of Financial Accounting Standards Board (“FASB”) guidance for accounting for convertible debt instruments that may be settled partially or totally in cash upon conversion.

 

All statements, trend analyses and other information contained in this report and elsewhere (such as in filings by us with the Securities and Exchange Commission (“SEC”), press releases, presentations by us or our management or oral statements) relative to markets for our products and trends in our operations or financial results, as well as other statements including words such as “anticipate,” “believe,” “plan,” “estimate,” “expect,” “intend,” and other similar expressions, constitute forward-looking statements.  These forward-looking statements are subject to known and unknown risks, uncertainties and other factors which may cause actual results to be materially different from those contemplated by the forward-looking statements. Such factors include, among other things:

 

·                  general economic conditions and other factors, including prevailing interest rate levels and stock and credit market performance which may affect (among other things) our ability to sell our products, our ability to access capital resources and the costs associated therewith, the fair value of our investments, which could result in impairments and other than temporary impairments, and certain liabilities, and the lapse rate and profitability of policies;

·                  customer response to new products and marketing initiatives;

·                  changes in Federal income tax laws and regulations which may affect the relative income tax advantages of our products;

·                  increasing competition in the sale of annuities;

·                  regulatory changes or actions, including those relating to regulation of financial services affecting (among other things) bank sales and underwriting of insurance products and regulation of the sale, underwriting and pricing of products; and

·                  the risk factors or uncertainties listed from time to time in our filings with the SEC.

 

For a detailed discussion of these and other factors that might affect our performance, see “Risk Factors” in Part II, Item 1A and Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2008.

 

Overview

 

We specialize in the sale of individual annuities (primarily deferred annuities) and, to a lesser extent, we also sell life insurance policies.  Under U.S. generally accepted accounting principles (“GAAP”), premium collections for deferred annuities are reported as deposit liabilities instead of as revenues.  Similarly, cash payments to policyholders are reported as decreases in the liabilities for policyholder account balances and not as expenses.  Sources of revenues for products accounted for as deposit liabilities are net investment income, surrender and other charges deducted from the account balances of policyholders in connection with withdrawals, realized gains and losses on investments and changes in fair value of derivatives.  Components of expenses for products accounted for as deposit liabilities are interest credited to account balances, changes in fair value of embedded derivatives, amortization of deferred policy acquisition costs and deferred sales inducements, other operating costs and expenses and income taxes.

 

33



 

Annuity deposits by product type collected during the three months and nine months ended September 30, 2009 and 2008, were as follows:

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

Product Type

 

2009

 

2008

 

2009

 

2008

 

 

 

(Dollars in thousands)

 

Fixed index annuities:

 

 

 

 

 

 

 

 

 

Index strategies

 

$

434,233

 

$

315,915

 

$

1,163,375

 

$

1,040,534

 

Fixed strategy

 

482,034

 

247,122

 

1,462,926

 

669,052

 

 

 

916,267

 

563,037

 

2,626,301

 

1,709,586

 

Fixed rate annuities:

 

 

 

 

 

 

 

 

 

Single-year rate guaranteed

 

37,462

 

7,379

 

76,878

 

21,350

 

Multi-year rate guaranteed

 

26,255

 

1,422

 

74,436

 

4,065

 

 

 

63,717

 

8,801

 

151,314

 

25,415

 

Total before coinsurance ceded

 

979,984

 

571,838

 

2,777,615

 

1,735,001

 

Coinsurance ceded

 

514,031

 

178

 

514,620

 

1,149

 

Net after coinsurance ceded

 

$

465,953

 

$

571,660

 

$

2,262,995

 

$

1,733,852

 

 

Annuity deposits before coinsurance ceded increased 71% during the three months ended September 30, 2009 compared to the same period in 2008, and 60% during the nine months ended September 30, 2009 compared to the same period in 2008.  We attribute these increases to several factors, including our continued strong relationships with our national marketing organizations and field force of licensed, independent insurance agents, the increased attractiveness of safe money products in volatile markets, lower interest rates on competing products such as bank certificates of deposit and product enhancements including a new generation of guaranteed income withdrawal benefit riders.  In addition, we have benefitted during the first nine months of 2009 from the actions of several significant competitors who have restricted their capacity to accept new business.  The extent to which this trend will be sustained in future periods is uncertain.  While we have the capital resources to accept more business than was sold in 2008, our capacity is not unlimited and sales growth must be matched with available capital resources to maintain desired financial strength ratings from credit rating agencies and in particular, A.M. Best Company.  Toward this end, effective June 1, 2009, we restructured our payment of commissions to agents on new sales by reducing the amount of commission paid at the time of sale but providing for additional commission payments on the first and second anniversaries of the date a policy was issued.  This change will initially increase our statutory earnings and capital and surplus and our capacity to accept new business.  It is uncertain what impact the change will have on the agents’ willingness to sell business for us.  During the second quarter of 2009 we also amended one of our reinsurance agreements with Hannover Life Reassurance Company of America to include certain policy forms that were not in existence in 2005 when the agreement was executed.  This amendment increased the statutory reinsurance reserve credit by approximately $37.4 million at June 30, 2009.  Effective July 1, 2009 we entered into two reinsurance arrangements with a newly formed reinsurance company to reinsure on a funds withheld coinsurance basis 20% of the annuity deposits received in 2009 from our two top selling index annuity products and 80% of the annuity deposits received after June 30, 2009 from a multi-year rate guaranteed fixed annuity product.  Our objective with these agreements is to manage our new business growth to a maximum of $3 billion of net annuity deposits for 2009.  These reinsurance arrangements resulted in the significant increases in coinsurance ceded annuity deposits for the 2009 periods in the table above.

 

34



 

Earnings from products accounted for as deposit liabilities are primarily generated from the excess of net investment income earned over the interest credited or the cost of providing index credits to the policyholder, or the “investment spread”.  Our investment spread is summarized as follows:

 

 

 

Nine Months Ended
September 30,

 

 

 

2009

 

2008

 

 

 

 

 

 

 

Average yield on invested assets

 

6.32

%

6.18

%

Cost of money:

 

 

 

 

 

Aggregate

 

3.29

%

3.45

%

Cost of money for index annuities

 

3.27

%

3.46

%

Average crediting rate for fixed rate annuities:

 

 

 

 

 

Annually adjustable

 

3.26

%

3.26

%

Multi-year rate guaranteed

 

3.90

%

3.90

%

Investment spread:

 

 

 

 

 

Aggregate

 

3.03

%

2.73

%

Index annuities

 

3.05

%

2.72

%

Fixed rate annuities:

 

 

 

 

 

Annually adjustable

 

3.06

%

2.92

%

Multi-year rate guaranteed

 

2.42

%

2.28

%

 

The cost of money for index annuities and average crediting rates for fixed rate annuities are computed based upon policyholder account balances and do not include the impact of amortization of deferred sales inducements.  See Critical Accounting Policies - Deferred Policy Acquisition Costs and Deferred Sales Inducements included in Management’s Discussion and Analysis included in our Annual Report on Form 10-K for the year ended December 31, 2008.  With respect to our index annuities, the cost of money includes the average crediting rate on amounts allocated to the fixed rate strategy, expenses we incur to fund the annual index credits and where applicable, minimum guaranteed interest credited.  Proceeds received upon expiration or early termination of call options purchased to fund annual index credits are recorded as part of the change in fair value of derivatives, and are largely offset by an expense for interest credited to annuity policyholder account balances.  See Critical Accounting Policies - Derivative Instruments - Index Products included in Management’s Discussion and Analysis included in our Annual Report on Form 10-K for the year ended December 31, 2008.

 

Our profitability depends in large part upon the amount of assets under our management, investment spreads we earn on our policyholder account balances, our ability to manage our investment portfolio to maximize returns and minimize risks such as interest rate changes and defaults or impairment of assets, our ability to manage interest rates credited to policyholders and costs of the options purchased to fund the annual index credits on our index annuities, our ability to manage the costs of acquiring new business (principally commissions to agents and bonuses credited to policyholders) and our ability to manage our operating expenses.

 

Results of Operations

 

Three and Nine Months Ended September 30, 2009 and 2008

 

Net income (loss) decreased 75% to $(3.0) million for the third quarter of 2009 and decreased 19% to $32.5 million for the nine months ended September 30, 2009 compared to $(11.7) million and $40.0 million for the same periods in 2008.  Net income for the nine months ended September 30, 2008 includes the impact of the adoption of the fair value measurement accounting standards as discussed below.  Net income for the nine months ended September 30, 2009 includes the impact of applying the FASB guidance for recognition and presentation of other than temporary impairments that was released in April 2009 as discussed below.

 

Net income has been positively impacted by the growth in the volume of business in force and the investment spread earned on this business.  Average annuity account values outstanding increased 14% for the third quarter of 2009 and 13% for the nine months ended September 30, 2009 compared to the same periods in 2008.  Our investment spread measured on a percentage basis was 3.13% for the third quarter of 2009 and 3.03% for the nine months ended September 30, 2009 compared to 2.83% and 2.73% for the same periods in 2008.  The increase in

 

35



 

investment spread resulted from a higher investment yield earned on average assets due to higher yield on investments purchased throughout 2008 and during the first nine months of 2009 and a lower aggregate cost of money on our index annuities.  The lower cost of money for index annuities during 2009 was due to adjustments we made throughout 2007 to caps, participation rates and asset fees to manage the cost of options purchased to fund the annual index credits.  The benefit from these adjustments was not fully recognized until the fourth quarter of 2008.

 

The comparability of the amounts is significantly impacted by net realized gains on investments, net other than temporary impairment (“OTTI”) losses recognized in operations, gain (loss) on extinguishment of debt and the impact of fair value accounting for index annuity derivatives and embedded derivatives.  We estimate that these items increased (decreased) net income as follows:

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2009

 

2008

 

2009

 

2008

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

Net realized gains and net impairment losses on investments recognized in operations

 

$

(11,491

)

$

(39,222

)

$

(10,954

)

$

(49,140

)

Gain (loss) on extinguishment of debt

 

 

(16

)

1,812

 

(793

)

Change in fair value of index annuity derivatives and embedded derivatives

 

(18,162

)

5,507

 

(27,007

)

33,093

 

 

Net realized gains on investments and net impairment losses recognized in operations fluctuate from period to period based upon changes in the interest rate and economic environment and the timing of the sale of investments or the recognition of other than temporary impairments.  We adopted the FASB guidance for recognition and presentation of other than temporary impairments that was released in April 2009 on January 1, 2009, which amended the determination of the amount of other than temporary impairments recognized in the statement of operations resulting in the noncredit portion of other than temporary impairments being recognized in accumulated other comprehensive income for debt securities that we do not intend to sell and it is not more likely than not we will be required to sell but also do not expect to recover the entire amortized cost basis of the security.  The amounts disclosed above are net of related reductions in amortization of deferred sales inducements and deferred policy acquisition costs and income taxes.  The net loss for the nine months ended September 30, 2009 includes a benefit of $3.6 million for the reduction of the deferred tax valuation allowance related to other than temporary impairments.

 

Amounts attributable to fair value accounting for index annuity derivatives and embedded derivatives fluctuate from period to period based upon changes in fair values of call options purchased to fund annual index credits for index annuities and changes in the interest rates used to discount the embedded derivative liabilities. The amounts disclosed above are net of related adjustments to amortization of deferred sales inducements and deferred policy acquisition costs and income taxes. The significant changes in the impact from this item disclosed above relate primarily to changes in the interest rates used to discount the embedded derivative liabilities. Pursuant to fair value measurements accounting standards adopted prospectively on January 1, 2008, the discount rates are based on risk-free interest rates adjusted for our non performance risk. These rates decreased materially in the three months and nine months ended September 30, 2009 resulting in decreases in net income for those periods. Prior to the adoption of the fair value measurements accounting standards, the discount rates used were risk-free interest rates without adjustment for our non performance risk. The change to discount rates including our non performance risk resulted in a decrease in policy benefit reserves on January 1, 2008 of $150.6 million. The net income impact of this decrease in reserves net of related adjustments to amortization of deferred sales inducements and deferred policy acquisition costs and income taxes was $40.7 million.

 

We periodically revise assumptions used in the computations of amortization of deferred sales inducements and deferred policy acquisition costs, as applicable, through an “unlocking” process.  Revisions are made based upon historical results and our best estimates of future experience.  The impact of unlocking is recorded in the current period as an increase or decrease in amortization of the respective balances.  The unlocking process can take place at any time as needs dictate.  See Critical Accounting Policies - Deferred Policy Acquisition Costs and Deferred Sales Inducements included in Management’s Discussion and Analysis included in our Annual Report on Form 10-K for the year ended December 31, 2008.

 

There was no unlocking necessary during the 2009 periods and the three months ended September 30, 2008.  The impact of unlocking for the nine months ended September 30, 2008 was a $2.2 million decrease in the amortization of deferred sales inducements and a $4.6 million increase in amortization of deferred policy acquisition costs for a net

 

36



 

increase in amortization of $2.4 million.  The impact of unlocking is primarily due to the impact of actual surrender experience on certain older business, offset in part by increases in the estimates of projected future interest margins and reductions in the estimates of projected future policy maintenance expenses.

 

Annuity product charges (surrender charges assessed against policy withdrawals and fees deducted from policyholder account balances for living income benefit riders) increased 19% to $15.8 million for the third quarter of 2009 and 27% to $47.5 million for the nine months ended September 30, 2009 compared to $13.3 million and $37.3 million for the same periods in 2008.  Product charges for the three months and nine months ended September 30, 2009 include $1.7 million and $3.0 million, respectively, of fees deducted from policyholder account balances for living income benefit riders. Surrender charges fluctuate from period to period based upon policyholder behavior and have generally increased during the 2009 periods consistent with growth in the volume of business in force.

 

Net investment income increased 15% to $241.5 million in the third quarter of 2009 and 13% to $688.9 million for the nine months ended September 30, 2009 compared to $210.0 million and $607.5 million for the same periods in 2008.  These increases were principally attributable to the growth in our annuity business and corresponding increases in our invested assets and the average yield earned on investments.  Average invested assets (on an amortized cost basis) excluding derivative instruments increased 12% to $15.1 billion in the third quarter of 2009 and 11% to $14.5 billion for the nine months ended September 30, 2009 compared to $13.6 billions and $13.1 billion for the same periods in 2008.  The average yield earned on average invested assets was 6.38% in the third quarter of 2009 and 6.32% for the nine months ended September 30, 2009 compared to 6.20% and 6.18% for the same periods in 2008.  The increase in the yield earned on average invested assets was attributable to higher yields on investments purchased throughout 2008 and during the nine months ended September 30, 2009.

 

Change in fair value of derivatives (principally call options purchased to fund annual index credits on index annuities) is affected by the performance of the indices upon which our options are based and the aggregate cost of options purchased.  The components of change in fair value of derivatives are as follows:

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2009

 

2008

 

2009

 

2008

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

Call options:

 

 

 

 

 

 

 

 

 

Loss on option expiration

 

$

(65,118

)

$

(75,062

)

$

(197,182

)

$

(196,265

)

Change in unrealized gain (loss)

 

188,239

 

(8,536

)

307,201

 

(117,722

)

Interest rate swaps

 

(1,614

)

(155

)

(1,841

)

(444

)

 

 

$

121,507

 

$

(83,753

)

$

108,178

 

$

(314,431

)

 

The differences between the change in fair value of derivatives between years are primarily due to the performance of the indices upon which our call options are based.  A substantial portion of our call options are based upon the S&P 500 Index with the remainder based upon other equity and bond market indices.  The range of index appreciation for options expiring during the three months and nine months ended September 30, 2009 and 2008 is as follows:

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2009

 

2008

 

2009

 

2008

 

S&P 500 Index

 

 

 

 

 

 

 

 

 

Point-to-point strategy

 

0.0% - 0.0%

 

0.0% - 0.0%

 

0.0% - 0.0%

 

0.0% - 2.6%

 

Monthly average strategy

 

0.0% - 0.0%

 

0.0% - 0.0%

 

0.0% - 0.0%

 

0.0% - 6.4%

 

Monthly point-to-point strategy

 

0.0% - 0.0%

 

0.0% - 0.0%

 

0.0% - 0.0%

 

0.0% - 0.0%

 

Lehman Brothers U.S. Aggregate and U.S. Treasury indices 4.2% - 6.3%

 

6.0% - 6.4%

 

4.5% - 10.8%

 

1.6% - 6.4%

 

4.5% - 12.6%

 

 

37



 

Actual amounts credited to policyholder account balances may be less than the index appreciation due to contractual features in the index annuity policies (caps, participation rates and asset fees) which allow us to manage the cost of the options purchased to fund the annual index credits.  The change in fair value of derivatives is also influenced by the aggregate cost of options purchased.  The aggregate cost of options has increased primarily due to an increased amount of index annuities in force.  The aggregate cost of options is also influenced by the amount of policyholder funds allocated to the various indices and market volatility which affects option pricing.  Costs for options purchased during the nine months ended September 30, 2009 decreased compared to the same period in 2008 due to adjustments to caps, participation rates and asset fees.  See Critical Accounting Policies - Derivative Instruments - Index Products included in Management’s Discussion and Analysis included in our Annual Report on Form 10-K for the year ended December 31, 2008.

 

We had unsecured counterparty exposure in connection with options purchased from affiliates of Lehman Brothers (“Lehman”) which declared bankruptcy during the third quarter of 2008.  Except for a few options involving immaterial amounts, all options purchased from affiliates of Lehman have expired as of September 30, 2009.  The amount of option proceeds due on expired options purchased from Lehman that we did not receive payment on was $2.6 million for the third quarter of 2009 and $12.0 million for the nine months ended September 30, 2009.  No amount has been recognized for any recovery of these amounts that may result from our claim in Lehman’s bankruptcy proceedings.

 

Net realized gains on investments, excluding OTTI losses include gains and losses on the sale of securities and impairment losses on mortgage loans on real estate and fluctuate from year to year due to changes in the interest rate and economic environment and the timing of the sale of investments.  The components of net realized gains on investments for the three months and nine months ended September 30, 2009 and 2008 are set forth in the table that follows.

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2009

 

2008

 

2009

 

2008

 

 

 

(Dollars in thousands)

 

Available for sale fixed maturity securities:

 

 

 

 

 

 

 

 

 

Gross realized gains

 

$

9,340

 

$

2,228

 

$

15,467

 

$

3,371

 

Gross realized losses

 

(1,625

)

(170

)

(1,678

)

(283

)

 

 

7,715

 

2,058

 

13,789

 

3,088

 

Equity securities:

 

 

 

 

 

 

 

 

 

Gross realized gains

 

3,279

 

200

 

3,282

 

255

 

 

 

3,279

 

200

 

3,282

 

255

 

Mortgage loans on real estate:

 

 

 

 

 

 

 

 

 

Impairment losses

 

(5,484

)

 

(6,484

)

 

 

 

$

5,510

 

$

2,258

 

$

10,587

 

$

3,343

 

 

Gross realized gains have increased in the 2009 periods due to tax planning strategies to generate taxable capital gains that will permit deduction of capital losses for income tax purposes. Gross realized losses in the 2009 periods primarily relate to two securities that experienced credit events in the three months ended September 30, 2009 resulting in the decision to sell the securities at a loss. See Financial Condition — Investments for additional discussion of impairment losses recognized on mortgage loans on real estate.

 

Net OTTI losses recognized in operations decreased 27% to $44.6 million in the third quarter of 2009 and 33% to $63.7 million for the nine months ended September 30, 2009 compared to $61.2 million and $94.8 million for the same periods in 2008.  See Financial Condition - Investments for additional discussion of write downs of securities for other than temporary impairments.

 

Gain (loss) on extinguishment of debt includes a $3.1 million gain on an exchange of five million shares of our common stock for $37.2 million of our 5.25% contingent convertible senior notes in May 2009.  The fair value of our common stock exchanged totaled $31.3 million and the notes extinguished carried unamortized debt issue costs and debt discount totaling $2.8 million.  We used $32.3 million in cash, of which $0.4 million was assigned to reacquire the equity component of the debt, to extinguish $34.0 million of our 5.25% contingent convertible senior notes that carried unamortized debt discount and debt issue costs totaling $3.5 million during the nine months ended September 30, 2008.  The 2008 transactions resulted in losses on extinguishment of debt of $1.4 million for nine months ended September 30, 2008.

 

Interest sensitive and index product benefits increased 49% to $75.3 million in the third quarter of 2009 and 34%

 

38



 

to $207.0 million for the nine months ended September 30, 2009 compared to $50.4 million and $154.0 million for the same periods in 2008.  The components of interest credited to account balances are summarized as follows:

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2009

 

2008

 

2009

 

2008

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

Index credits on index policies

 

$

7,740

 

$

5,047

 

$

25,259

 

$

29,264

 

Interest credited (including changes in minimum guaranteed interest for index annuities)

 

65,897

 

45,340

 

178,794

 

124,768

 

Living income benefit rider

 

1,651

 

 

2,975

 

 

 

 

$

75,288

 

$

50,387

 

$

207,028

 

$

154,032

 

 

The changes in index credits were attributable to changes in the appreciation of the underlying indices (see discussion above under change in fair value of derivatives) and the amount of funds allocated by policyholders to the respective index options.  Total proceeds received upon expiration of the call options purchased to fund the annual index credits were $0.7 million and $5.7 million for the three months and nine months ended September 30, 2009, respectively, compared to $4.4 million and $25.6 million for the same periods in 2008.  Proceeds for the 2009 periods were adversely affected by the Lehman defaults as discussed above.  The increase in interest credited was due to an increase in the average amount of annuity liabilities outstanding receiving a fixed rate of interest and an increase in minimum guaranteed interest for index annuities.  The increase in minimum guaranteed interest for index annuities is directly attributable to the weak equity market performance during prior periods which resulted in smaller index credits.  The average amount of annuity liabilities outstanding (net of annuity liabilities ceded under coinsurance agreements) increased 13% during the nine months ended September 30, 2009 to $15.1 billion from $13.3 billion during the same period in 2008.

 

Amortization of deferred sales inducements decreased to $(8.1) million in the third quarter of 2009 and 48% to $17.8 million for the nine months ended September 30, 2009 compared to $6.8 million and $34.2 million for the same periods in 2008.  The 2008 periods include the impact of unlocking discussed above.  In general, amortization of deferred sales inducements has been increasing each period due to growth in our annuity business and the deferral of sales inducements incurred with respect to sales of premium bonus annuity products.  Bonus products represented 94% and 92% of our total annuity deposits during the nine months ended September 30, 2009 and 2008, respectively.  The anticipated increase in amortization from these factors has been affected by amortization associated with fair value accounting for derivatives and embedded derivatives utilized in our index annuity business and amortization associated with the net realized gains on investments and net OTTI losses recognized in operations.

 

Fair value accounting for derivatives and embedded derivatives utilized in our index annuity business creates differences in the recognition of revenues and expenses from derivative instruments including the embedded derivative liabilities in our index annuity contracts.  The change in fair value of the embedded derivatives will not correspond to the change in fair value of derivatives (purchased call options) because the purchased call options are one-year options while the options valued in the fair value of embedded derivatives cover the expected life of the contracts which typically exceed ten years.  The gross profit adjustments resulting from fair value accounting for derivatives and embedded derivatives utilized in our index annuity business decreased amortization by $19.7 million in the third quarter of 2009 and $25.1 million for the nine months ended September 30, 2009 compared to increases of $6.9 million and $20.1 million for the same periods in 2008.  The gross profit adjustments from net realized gains on investments and net OTTI losses recognized in operations decreased amortization by $8.6 million in the third quarter of 2009 and $12.4 million for the nine months ended September 30, 2009 compared to decreases of $13.5 million and $19.8 million for the same periods in 2008.  Excluding the amortization amounts attributable to fair value accounting for derivatives and embedded derivatives and net realized gains on investments and net OTTI losses recognized in operations, amortization would have been $20.2 million and $55.3 million for the three months and nine months ended September 30, 2009, respectively, compared to $13.4 million and $33.9 million for the same periods in 2008.  See Critical Accounting Policies - Deferred Policy Acquisition Costs and Deferred Sales Inducements included in Management’s Discussion and Analysis included in our Annual Report on Form 10-K for the year ended December 31, 2008.

 

Change in fair value of embedded derivatives was an increase of $259.7 million in the third quarter of 2009 and $414.6 million for the nine months ended September 30, 2009 compared to decreases of $37.1 million and $238.0

 

39



 

million for the same periods in 2008.  These changes resulted from (i) changes in the expected index credits on the next policy anniversary dates, which are related to the change in fair value of the call options acquired to fund these index credits discussed above in change in fair value of derivatives; (ii) changes in discount rates used in estimating our liability for policy growth; (iii) changes in estimates of expected costs of annual call options that will be purchased in the future to fund index credits beyond the next policy anniversary; and (iv) the growth in the host component of the policy liability.  See Critical Accounting Policies - Derivative Instruments - Index Products included in Management’s Discussion and Analysis included in our Annual Report on Form 10-K for the year ended December 31, 2008.  The primary reasons for the significant increases in the fair values of embedded derivatives for the three months and nine months ended September 30, 2009 were decreases in the discount rates used in estimating our liability for policy growth and increases in the expected index credits on the next policy anniversary dates which correlated with the change in fair value of derivatives discussed above.  The primary reasons for the significant decrease in the fair value of the embedded derivatives for the nine months ended September 30, 2008 were increases in the discount rates used in estimating our liability for policy growth and a decrease in our estimate of the expected future cost of annual call options.  The increase in the discount rates to reflect our non performance risk upon the adoption of the fair value measurements accounting requirements on January 1, 2008 as discussed above decreased the fair value of embedded derivatives by $150.6 million and the decrease in the estimate of future option costs decreased the fair value of the embedded derivatives for 2008 by $51.6 million.

 

Interest expense on notes payable decreased 33% to $3.4 million in the third quarter of 2009 and 25% to $11.3 million for the nine months ended September 30, 2009 compared to $5.0 million and $15.1 million for the same periods in 2008.  These decreases were primarily attributable to the retirement of $78.1 million principal amount of our 5.25% contingent convertible notes during 2008 and extinguishment of $37.2 million principal amount of our 5.25% contingent convertible senior notes through the exchange of five million shares of our common stock in the second quarter of 2009.  This decrease in interest expense on notes payable was offset in part by interest on borrowings under our revolving line of credit, which had a weighted average interest rate of 1.70% and 4.07% for the nine months ended September 30, 2009 and 2008, respectively.  The average borrowings outstanding under the line of credit were $100.9 million and $24.5 million for the nine months ended September 30, 2009 and 2008, respectively.

 

Interest expense on subordinated debentures decreased 18% to $3.8 million in the third quarter of 2009 and 17% to $12.1 million for the nine months ended September 30, 2009 compared to $4.7 million and $14.5 million for the same periods in 2008.  These decreases were primarily due to decreases in the weighted average interest rates on the outstanding subordinated debentures which were 5.92% and 7.16% for the nine months ended September 30, 2009 and 2008, respectively.  The weighted average interest rates have decreased because $149.0 million principal amount of the subordinated debentures have a floating rate of interest based upon the three month London Interbank Offered Rate.  See Financial Condition - Liabilities in Management’s Discussion and Analysis included in our Annual Report on Form 10-K for the year ended December 31, 2008.

 

Interest expense on amounts due under repurchase agreements decreased 96% to $0.1 million in the third quarter of 2009 and 96% to $0.3 million for the nine months ended September 30, 2009 compared to $2.7 million and $7.7 million for the same periods in 2008.  These decreases were principally due to decreases in the borrowings outstanding and decreases in the weighted average interest rates on amounts borrowed.  Weighted average interest rates were 0.31% for the third quarter of 2009 and 0.41% for the nine months ended September 30, 2009 compared to 2.26% and 2.58% for the same periods in 2008, and average borrowings outstanding were $128.7 million for the third quarter of 2009 and $112.4 million for the nine months ended September 30, 2009 compared to $472.9 million and $397.3 million for the same periods in 2008.

 

Amortization of deferred policy acquisition costs decreased 115% to $(3.0) million in the third quarter of 2009 and 62% to $44.9 million for the nine months ended September 30, 2009 compared to $19.3 million and $118.6 million for the same periods in 2008.  The 2008 periods include the impact of unlocking discussed above.  In general, amortization of deferred policy acquisition costs has been increasing each period due to the growth in our annuity business and the deferral of policy acquisition costs incurred with respect to sales of annuity products.  The anticipated increase in amortization from these factors has been affected by amortization associated with fair value accounting for derivatives and embedded derivatives utilized in our index annuity business and amortization associated with net realized gains on investments and net OTTI losses recognized in operations.

 

As discussed above, fair value accounting for derivatives and embedded derivatives utilized in our index annuity business creates differences in the recognition of revenues and expenses from derivative instruments including the embedded derivative liabilities in our index annuity contracts.  The gross profit adjustments resulting from fair value accounting for derivatives and embedded derivatives utilized in our index annuity business decreased amortization by $31.8 million in the third quarter of 2009 and $56.1 million for the nine months ended September 30, 2009 compared to increases of $5.7 million and $49.9 million for the same periods in 2008.  The gross profit adjustments from net realized gains on investments and net OTTI losses recognized in operations decreased amortization by $12.7 million

 

40



 

in the third quarter of 2009 and $18.1 million for the nine months ended September 30, 2009 compared to decreases of $19.6 million and $30.3 million for the same periods in 2008.  Excluding the amortization amounts attributable to fair value accounting for derivatives and embedded derivatives and net realized gains on investments and net OTTI losses recognized in operations, amortization for the third quarter of 2009 would have been $41.5 million and $119.1 million for the nine months ended September 30, 2009 compared to $33.1 million and $99.0 million for the same periods in 2008.

 

Other operating costs and expenses increased 3% to $14.0 million in the third quarter of 2009 and 18% to $45.3 million for the nine months ended September 30, 2009 compared to $13.5 million and $38.6 million for the same periods in 2008.  These increases were principally attributable to increases in salaries and benefits of $0.6 million for the third quarter of 2009 and $3.1 million for the nine months ended September 30, 2009, increases in risk charges on reinsurance of $0.9 million for the third quarter of 2009 and $2.9 million for the nine months ended September 30, 2009, increases in general overhead costs of $0.9 million for the third quarter of 2009 and $1.6 million for the 9 months ended September 30, 2009 offset by decreases in legal costs of $2.2 million for the third quarter of 2009 and $1.8 million for the nine months ended September 30, 2009.  The increase in salaries and benefits for the third quarter of 2009 and the nine months ended September 30, 2009 was primarily due to an increase in the number of employees due to the growth in our business.  Also, we recorded post employment benefit expense of $1.2 million during the second quarter of 2009 related to a post employment benefit agreement with our Chairman, David J. Noble which was approved by our board of directors on June 4, 2009.  The increases in risk charges on reinsurance were due to a reinsurance treaty entered into on December 31, 2008 and the expansion of the inforce business covered under an existing reinsurance treaty during the second quarter of 2009.  The increases in general overhead costs were due to the growth in our business from increased sales.  The decreases in legal expense are primarily related to a decrease in the cost of defense related to ongoing litigation.

 

Income tax expense decreased 107% to $(2.1) million in the third quarter of 2009 and 80% to $11.3 million for the nine months ended September 30, 2009 compared to $28.1 million and $55.2 million for the same periods in 2008. These changes were primarily related to changes in income before income taxes and the impact of changes in the valuation allowance for deferred income tax assets related to capital loss carryforwards and other than temporary impairments on investment securities. The effective tax rates were 41.2% for the third quarter of 2009 and 25.8% for the nine months ended September 30, 2009 compared to 171.5% and 58.0% for the same periods in 2008. The effective tax rate for the third quarter of 2009 was more than the applicable statutory federal income tax rate of 35% primarily due to state income tax benefits attributable to losses in the non-life subgroup. The effective tax rate for the nine months ended September 30, 2009 was less than the applicable statutory federal income tax rate of 35% primarily due to a decrease in the deferred tax valuation allowance established in 2008 for capital loss carryforwards and other than temporary impairments which decreased income tax expense for the first quarter of 2009 by $3.6 million. This decrease was primarily due to an increase in anticipated future taxable income from capital gain sources which resulted from an increase in unrealized gains on available for sale investment securities which may be sold as part of a tax planning strategy to generate capital gains to offset capital losses. The effective tax rates for the 2008 periods were more than the applicable statutory federal income tax rate of 35% primarily due to the establishment of a deferred tax valuation allowance for deferred income tax assets related to capital loss carryforwards and other than temporary impairments on investment securities which increased income tax expense in the 2008 periods by $22.5 million.

 

41



 

Financial Condition

 

Investments

 

Our investment strategy is to maintain a predominantly investment grade fixed income portfolio, provide adequate liquidity to meet our cash obligations to policyholders and others and maximize current income and total investment return through active investment management.  Consistent with this strategy, our investments principally consist of fixed maturity securities, mortgage loans on real estate and short-term investments.

 

Insurance statutes regulate the type of investments that our life subsidiaries are permitted to make and limit the amount of funds that may be used for any one type of investment.  In light of these statutes and regulations and our business and investment strategy, we generally seek to invest in United States government and government-sponsored agency securities and corporate securities rated investment grade by established nationally recognized rating organizations or in securities of comparable investment quality, if not rated and mortgage loans on real estate.

 

The composition of our investment portfolio is summarized as follows:

 

 

 

September 30, 2009

 

December 31, 2008

 

 

 

Carrying
Amount

 

Percent

 

Carrying
Amount

 

Percent

 

 

 

(Dollars in thousands)

 

Fixed maturity securities:

 

 

 

 

 

 

 

 

 

United States Government full faith and credit

 

$

3,292

 

 

$

22,050

 

0.2

%

United States Government sponsored agencies

 

5,907,567

 

36.8

%

6,633,481

 

52.1

%

U.S. states, territories and political subdivisions

 

305,129

 

1.9

%

 

 

Corporate securities

 

4,042,364

 

25.2

%

1,764,390

 

13.9

%

Mortgage and asset backed securities

 

2,583,352

 

16.1

%

1,813,274

 

14.3

%

Total fixed maturity securities

 

12,841,704

 

80.0

%

10,233,195

 

80.5

%

Equity securities

 

94,076

 

0.6

%

99,552

 

0.8

%

Trading securities

 

371,338

 

2.3

%

 

 

Mortgage loans on real estate

 

2,375,833

 

14.7

%

2,329,824

 

18.3

%

Derivative instruments

 

364,041

 

2.3

%

56,588

 

0.4

%

Other investments

 

9,332

 

0.1

%

446

 

 

 

 

$

16,056,324

 

100.0

%

$

12,719,605

 

100.0

%

 

During the nine months ended September 30, 2009 and 2008, we received $3.6 billion and $1.5 billion, respectively, in net redemption proceeds related to calls of our callable United States Government sponsored agency securities, of which $1.9 billion and $1.0 billion, respectively, were classified as held for investment.  We reinvested the proceeds from these redemptions primarily in United States Government sponsored agency securities, corporate fixed maturity securities and mortgage-backed securities classified as available for sale.  At September 30, 2009, 50% of our fixed income securities have call features and 8% were subject to call redemption.  Another 9% will become subject to call redemption through December 31, 2009.

 

Trading securities consist of fixed maturity and equity securities in designated portfolios, which support funds withheld reinsurance arrangements.  Investment results for these portfolios, including gains and losses from sales, are passed directly to the reinsurer pursuant to contractual terms of the reinsurance arrangements.  Trading securities are carried at fair value and changes in fair value are recorded as changes in the funds withheld reinsurance liability, as the funds withheld are being held on deposit to support the amount of reinsurance recoverable.  The fair value of our trading securities is determined in the same manner as our securities classified as available for sale.

 

42



 

A summary of our mortgage and asset backed portfolios by collateral type split by those that are rated investment grade and and those that are rated below investment grade based upon NRSRO designation, as well as summarized information on securities for which we have recognized OTTI:

 

 

 

September 30, 2009

 

December 31, 2008

 

 

 

 

 

 

 

Percent of

 

 

 

 

 

Percent of

 

 

 

 

 

 

 

Fixed

 

 

 

 

 

Fixed

 

 

 

Amortized

 

 

 

Maturity

 

Amortized

 

 

 

Maturity

 

 

 

Cost

 

Fair Value

 

Securities

 

Cost

 

Fair Value

 

Securities

 

 

 

(Dollars in thousands)

 

(Dollars in thousands)

 

Investment grade

 

 

 

 

 

 

 

 

 

 

 

 

 

Government agency

 

69,740

 

73,882

 

0.6

%

72,959

 

74,923

 

0.7

%

Prime

 

1,423,232

 

1,400,202

 

10.9

%

1,382,684

 

1,198,272

 

11.7

%

Alt-A

 

129,687

 

99,906

 

0.8

%

357,059

 

280,182

 

2.7

%

Non-mortgage

 

14,400

 

13,283

 

0.1

%

16,841

 

15,764

 

0.2

%

 

 

1,637,059

 

1,587,273

 

12.4

%

1,829,543

 

1,569,141

 

15.3

%

Below investment grade

 

 

 

 

 

 

 

 

 

 

 

 

 

Prime

 

514,938

 

441,717

 

3.4

%

67,945

 

53,189

 

0.5

%

Prime (OTTI has been recognized)

 

326,505

 

251,771

 

2.0

%

12,519

 

12,519

 

0.1

%

Alt-A

 

32,231

 

25,199

 

0.2

%

32,524

 

25,100

 

0.2

%

Alt-A (OTTI has been recognized)

 

374,529

 

277,392

 

2.2

%

153,325

 

153,325

 

1.5

%

 

 

1,248,203

 

996,079

 

7.8

%

266,313

 

244,133

 

2.4

%

 

 

2,885,262

 

2,583,352

 

20.1

%

2,095,856

 

1,813,274

 

17.7

%

 

43



 

The table below presents our fixed maturity securities by NAIC designation and the equivalent ratings of the nationally recognized securities rating organizations.

 

 

 

 

 

September 30, 2009

 

December 31, 2008

 

NAIC
Designation

 

Rating Agency

 

Carrying
Amount

 

Percent

 

Carrying
Amount

 

Percent

 

 

 

 

 

(Dollars in thousands)

 

1

 

Aaa/Aa/A

 

$

9,220,694

 

71.8

%

$

8,510,772

 

83.2

%

2

 

Baa

 

2,325,360

 

18.1

%

1,292,303

 

12.6

%

Total investment grade

 

11,546,054

 

89.9

%

9,803,075

 

95.8

%

3

 

Ba

 

311,799

 

2.4

%

225,594

 

2.2

%

4

 

B

 

185,126

 

1.4

%

135,989

 

1.3

%

5

 

Caa and lower

 

548,962

 

4.4

%

31,375

 

0.3

%

6

 

In or near default

 

249,763

 

1.9

%

37,162

 

0.4

%

Total below investment grade

 

1,295,650

 

10.1

%

430,120

 

4.2

%

 

 

 

 

$

12,841,704

 

100.0

%

$

10,233,195

 

100.0

%

 

We have experienced credit deterioration in our fixed maturity portfolio which primarily occurred during the first nine months of 2009 and the fourth quarter of 2008 on mortgage-backed securities and financial sector securities due to the global financial crisis.

 

The amortized cost and fair value of fixed maturity securities by contractual maturity are shown below.  Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.  All of our mortgage and asset backed securities provide for periodic payments throughout their lives and are shown below as a separate line.

 

 

 

Available for sale

 

Held for investment

 

 

 

Amortized
Cost

 

Fair Value

 

Amortized
Cost

 

Fair Value

 

 

 

(Dollars in thousands)

 

September 30, 2009

 

 

 

 

 

 

 

 

 

Due in one year or less

 

$

26,586

 

$

25,896

 

$

 

$

 

Due after one year through five years

 

399,912

 

417,416

 

 

 

Due after five years through ten years

 

1,445,204

 

1,573,290

 

 

 

Due after ten years through twenty years

 

1,831,095

 

1,852,315

 

555,000

 

555,981

 

Due after twenty years

 

4,559,320

 

4,630,688

 

1,203,747

 

1,190,052

 

 

 

8,262,117

 

8,499,605

 

1,758,747

 

1,746,033

 

Mortgage and asset backed securities

 

2,885,262

 

2,583,352

 

 

 

 

 

$

11,147,379

 

$

11,082,957

 

$

1,758,747

 

$

1,746,033

 

December 31, 2008

 

 

 

 

 

 

 

 

 

Due after one year through five years

 

$

313,611

 

$

282,869

 

$

 

$

 

Due after five years through ten years

 

797,903

 

728,597

 

 

 

Due after ten years through twenty years

 

2,259,873

 

2,211,963

 

805,170

 

801,384

 

Due after twenty years

 

1,692,043

 

1,592,343

 

2,798,979

 

2,786,730

 

 

 

5,063,430

 

4,815,772

 

3,604,149

 

3,588,114

 

Mortgage and asset backed securities

 

2,095,856

 

1,813,274

 

 

 

 

 

$

7,159,286

 

$

6,629,046

 

$

3,604,149

 

$

3,588,114

 

 

44



 

At September 30, 2009 and December 31, 2008, the amortized cost and fair value of fixed maturity securities and equity securities that were in an unrealized loss position were as follows:

 

 

 

Number of
Securities

 

Amortized
Cost

 

Unrealized
Losses

 

Fair Value

 

 

 

(Dollars in thousands)

 

September 30, 2009

 

 

 

 

 

 

 

 

 

Fixed maturity securities, available for sale:

 

 

 

 

 

 

 

 

 

United States Government sponsored agencies

 

10

 

$

1,474,136

 

$

(22,195

)

$

1,451,941

 

U.S. states, territories and political subdivisions

 

1

 

8,475

 

(42

)

8,433

 

Corporate securities:

 

 

 

 

 

 

 

 

 

Finance, insurance and real estate

 

60

 

370,058

 

(46,769

)

323,289

 

Manufacturing, construction and mining

 

25

 

181,477

 

(15,206

)

166,271

 

Utilities and related sectors

 

17

 

131,447

 

(11,316

)

120,131

 

Wholesale/retail trade

 

19

 

95,322

 

(7,252

)

88,070

 

Services, media and other

 

15

 

76,915

 

(5,380

)

71,535

 

Mortgage and asset backed securities

 

115

 

1,781,344

 

(359,920

)

1,421,424

 

 

 

262

 

$

4,119,174

 

$

(468,080

)

$

3,651,094

 

 

 

 

 

 

 

 

 

 

 

Fixed maturity securities, held for investment:

 

 

 

 

 

 

 

 

 

United States Government sponsored agencies

 

1

 

$

150,000

 

$

(136

)

$

149,864

 

Corporate security:

 

 

 

 

 

 

 

 

 

Finance, insurance and real estate

 

1

 

75,616

 

(18,260

)

57,356

 

 

 

2

 

$

225,616

 

$

(18,396

)

$

207,220

 

 

 

 

 

 

 

 

 

 

 

Equity securities, available for sale:

 

 

 

 

 

 

 

 

 

Finance, insurance and real estate

 

16

 

$

42,168

 

$

(3,847

)

$

38,321

 

 

 

 

 

 

 

 

 

 

 

December 31, 2008

 

 

 

 

 

 

 

 

 

Fixed maturity securities, available for sale:

 

 

 

 

 

 

 

 

 

United States Government full faith and credit

 

1

 

$

18,774

 

$

(129

)

$

18,645

 

United States Government sponsored agencies

 

9

 

360,533

 

(1,133

)

359,400

 

Corporate securities:

 

 

 

 

 

 

 

 

 

Finance, insurance and real estate

 

67

 

442,613

 

(91,239

)

351,374

 

Manufacturing, construction and mining

 

57

 

425,573

 

(65,567

)

360,006

 

Utilities and related sectors

 

61

 

363,406

 

(55,123

)

308,283

 

Wholesale/retail trade

 

26

 

158,118

 

(26,237

)

131,881

 

Services, media and other

 

41

 

238,173

 

(39,212

)

198,961

 

Mortgage and asset backed securities

 

101

 

1,704,052

 

(288,637

)

1,415,415

 

 

 

363

 

$

3,711,242

 

$

(567,277

)

$

3,143,965

 

 

 

 

 

 

 

 

 

 

 

Fixed maturity securities, held for investment:

 

 

 

 

 

 

 

 

 

United States Government sponsored agencies

 

4

 

$

365,000

 

$

(4,984

)

$

360,016

 

Corporate security:

 

 

 

 

 

 

 

 

 

Finance, insurance and real estate

 

1

 

75,521

 

(17,472

)

58,049

 

 

 

5

 

$

440,521

 

$

(22,456

)

$

418,065

 

 

 

 

 

 

 

 

 

 

 

Equity securities, available for sale:

 

 

 

 

 

 

 

 

 

Finance, insurance and real estate

 

26

 

$

76,429

 

$

(25,978

)

$

50,451

 

 

Unrealized losses decreased $125.4 million from $615.7 million at December 31, 2008 to $490.3 million at September 30, 2009.  On January 1, 2009, we increased unrealized losses by $83.9 million due to the cumulative adjustment to reclassify the noncredit portion of OTTI recognized at December 31, 2008, by adopting the FASB’s guidance issued in April 2009 for bifurcating credit and noncredit portions of OTTI between earnings and other comprehensive income/loss. We have decreased unrealized losses by $63.7 million by recognizing OTTI losses on equity securities totaling $21.2 million and by recognizing $42.5 million of credit OTTI losses on debt securities for the nine months ended September 30, 2009. The remaining decrease in unrealized losses was due to improving market conditions that resulted in higher fair values of many of our corporate securities.

 

The following table sets forth the composition by credit quality (NAIC designation and the equivalent ratings of a nationally recognized securities rating organization) of fixed maturity securities with gross unrealized losses:

 

45



 

NAIC
Designation

 

Rating Agency

 

Carrying Value of
Securities with
Gross Unrealized

Losses

 

Percent of
Total

 

Gross
Unrealized
Losses

 

Percent of
Total

 

 

 

 

 

(Dollars in thousands)

 

September 30, 2009

 

 

 

 

 

 

 

 

 

 

 

1

 

Aaa/Aa/A

 

$

2,240,667

 

57.8

%

$

(112,686

)

23.2

%

2

 

Baa

 

513,149

 

13.2

%

(63,069

)

13.0

%

Total investment grade

 

2,753,816

 

71.0

%

(175,755

)

36.2

%

3

 

Ba

 

252,455

 

6.5

%

(51,744

)

10.6

%

4

 

B

 

143,032

 

3.7

%

(29,170

)

6.0

%

5

 

Caa and lower

 

482,275

 

12.5

%

(142,623

)

29.3

%

6

 

In or near default

 

245,132

 

6.3

%

(87,184

)

17.9

%

Total below investment grade

 

1,122,894

 

29.0

%

(310,721

)

63.8

%

 

 

 

 

$

3,876,710

 

100.0

%

$

(486,476

)

100.0

%

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2008

 

 

 

 

 

 

 

 

 

 

 

1

 

Aaa/Aa/A

 

$

2,235,159

 

62.3

%

$

(289,300

)

49.1

%

2

 

Baa

 

1,110,279

 

31.0

%

(223,225

)

37.9

%

Total investment grade

 

3,345,438

 

93.3

%

(512,525

)

86.9

%

3

 

Ba

 

224,003

 

6.2

%

(68,397

)

11.6

%

4

 

B

 

7,953

 

0.2

%

(4,765

)

0.8

%

5

 

Caa and lower

 

5,472

 

0.2

%

(4,016

)

0.7

%

6

 

In or near default

 

1,620

 

––

 

(30

)

––

 

Total below investment grade

 

239,048

 

6.7

%

(77,208

)

13.1

%

 

 

 

 

$

3,584,486

 

100.0

%

$

(589,733

)

100.0

%

 

46



 

The following tables show our investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities (consisting of 280 and 394 securities, respectively) have been in a continuous unrealized loss position, at September 30, 2009 and December 31, 2008:

 

 

 

Less than 12 months

 

12 months or more

 

Total

 

 

 

Fair Value

 

Unrealized
Losses

 

Fair Value

 

Unrealized
Losses

 

Fair Value

 

Unrealized
Losses

 

 

 

(Dollars in thousands)

 

September 30, 2009

 

 

 

 

 

 

 

 

 

 

 

 

 

Fixed maturity securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

Available for sale:

 

 

 

 

 

 

 

 

 

 

 

 

 

United States Government sponsored agencies

 

$

1,451,941

 

$

(22,195

)

$

 

$

 

$

1,451,941

 

$

(22,195

)

U.S. states, territories and political subdivisions

 

8,433

 

(42

)

 

 

8,433

 

(42

)

Corporate securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

Finance, insurance and real estate

 

58,283

 

(6,729

)

265,006

 

(40,040

)

323,289

 

(46,769

)

Manufacturing, construction and mining

 

68,579

 

(4,263

)

97,692

 

(10,943

)

166,271

 

(15,206

)

Utilities and related sectors

 

36,888

 

(1,933

)

83,243

 

(9,383

)

120,131

 

(11,316

)

Wholesale/retail trade

 

35,258

 

(1,090

)

52,812

 

(6,162

)

88,070

 

(7,252

)

Services, media and other

 

 

 

71,535

 

(5,380

)

71,535

 

(5,380

)

Mortgage and asset backed securities

 

256,466

 

(27,243

)

1,164,958

 

(332,677

)

1,421,424

 

(359,920

)

 

 

$

1,915,848

 

$

(63,495

)

$

1,735,246

 

$

(404,585

)

$

3,651,094

 

$

(468,080

)

Held for investment:

 

 

 

 

 

 

 

 

 

 

 

 

 

United States Government sponsored agencies

 

$

 

$

 

$

149,864

 

$

(136

)

$

149,864

 

$

(136

)

Corporate security:

 

 

 

 

 

 

 

 

 

 

 

 

 

Finance, insurance and real estate

 

 

 

57,356

 

(18,260

)

57,356

 

(18,260

)

 

 

$

 

$

 

$

207,220

 

$

(18,396

)

$

207,220

 

$

(18,396

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Equity securities, available for sale:

 

 

 

 

 

 

 

 

 

 

 

 

 

Finance, insurance and real estate

 

$

3,050

 

$

(118

)

$

35,271

 

$

(3,729

)

$

38,321

 

$

(3,847

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2008

 

 

 

 

 

 

 

 

 

 

 

 

 

Fixed maturity securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

Available for sale:

 

 

 

 

 

 

 

 

 

 

 

 

 

United States Government full faith and credit

 

$

 

$

 

$

18,645

 

$

(129

)

$

18,645

 

$

(129

)

United States Government sponsored agencies

 

60,475

 

(57

)

298,925

 

(1,076

)

359,400

 

(1,133

)

Corporate securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

Finance, insurance and real estate

 

205,148

 

(44,478

)

146,226

 

(46,761

)

351,374

 

(91,239

)

Manufacturing, construction and mining

 

294,428

 

(37,589

)

65,578

 

(27,978

)

360,006

 

(65,567

)

Utilities and related sectors

 

192,110

 

(22,816

)

116,173

 

(32,307

)

308,283

 

(55,123

)

Wholesale/retail trade

 

120,056

 

(16,557

)

11,825

 

(9,680

)

131,881

 

(26,237

)

Services, media and other

 

119,297

 

(22,425

)

79,664

 

(16,787

)

198,961

 

(39,212

)

Mortgage and asset backed securities

 

1,117,973

 

(221,480

)

297,442

 

(67,157

)

1,415,415

 

(288,637

)

 

 

$

2,109,487

 

$

(365,402

)

$

1,034,478

 

$

(201,875

)

$

3,143,965

 

$

(567,277

)

Held for investment:

 

 

 

 

 

 

 

 

 

 

 

 

 

United States Government sponsored agencies

 

$

 

$

 

$

360,016

 

$

(4,984

)

$

360,016

 

$

(4,984

)

Corporate security:

 

 

 

 

 

 

 

 

 

 

 

 

 

Finance, insurance and real estate

 

 

 

58,049

 

(17,472

)

58,049

 

(17,472

)

 

 

$

 

$

 

$

418,065

 

$

(22,456

)

$

418,065

 

$

(22,456

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Equity securities, available for sale:

 

 

 

 

 

 

 

 

 

 

 

 

 

Finance, insurance and real estate

 

$

30,093

 

$

(14,360

)

$

20,358

 

$

(11,618

)

$

50,451

 

$

(25,978

)

 

47



 

The following is a description of the factors causing the unrealized losses by investment category as of September 30, 2009:

 

United States Government sponsored agencies and U.S. states, territories and political subdivisions: These securities are relatively long in duration, making the value of such securities sensitive to changes in market interest rates.  During the last six months spreads on agency securities have improved; however, long term interest rates have risen by a greater amount.  These securities carry yields less than those available at September 30, 2009 as the result of these rising interest rates.

 

Corporate securities:  The unrealized losses in these securities are due partially to a rise in interest rates in 2009 as well as the continuation in wider than historic credit spreads. While credit spreads have improved on a recovering economy, several industries remain at much wider spreads, such as financials and economic sensitive issuers. As the result of wider spreads, these issues carry yields less than those available in the market as of September 30, 2009.

 

Mortgage and asset backed securities: At September 30, 2009, we had no exposure to subprime mortgage-backed securities.  All of our mortgage-backed securities are pools of residential mortgage loans.   Substantially all of the securities that we own are in the most senior tranche of the pool in which they are structured and are not subordinated to any other tranche. Our “Alt-A” mortgage-backed securities are comprised of 36 securities with a total amortized cost basis of $536.4  million and a fair value of $402.5 million.  Fair values of residential mortgage-backed securities have continued at prices significantly less than amortized cost as spreads in this sector have not improved like other sectors of the fixed income market.  With the uncertainty of future foreclosures and high delinquencies on residential mortgages, these security prices will likely remain below our cost basis until the housing market conditions improve.

 

Equity securities: The unrealized losses on equity securities, which are primarily investment grade perpetual preferred stocks with exposure to RElTS, investment banks and finance companies, are due to the instability in the financial markets and a further deterioration in the economy. All of the equity securities in an unrealized loss position for 12 months or more are investment grade perpetual preferred stocks that are absent credit deterioration.  A deepening recession due to tight credit markets and a difficult housing market have raised concerns in regard to earnings and dividend stability in many companies which directly affect the values of these securities.

 

Where the decline in market value of debt securities is attributable to changes in market interest rates or to factors such as market volatility, liquidity and spread widening, and we anticipate recovery of all contractual or expected cash flows, we do not consider these investments to be other than temporarily impaired because we do not intend to sell these investments and it is not more likely than not we will be required to sell these securities before a recovery of amortized cost, which may be maturity. For equity securities, we recognize an impairment charge in the period in which we do not have the intent or ability to hold the securities until a recovery of cost or we determine that the security will not recover to book value within a reasonable period of time. We determine what constitutes a reasonable period of time on a security-by-security basis based upon consideration of all the evidence available to us, including the magnitude of an unrealized loss and its duration. In any event, this period does not exceed 18 months from the date of impairment for perpetual preferred securities for which there is evidence of deterioration in credit of the issuer and common equity securities. For perpetual preferred securities absent evidence of a deterioration in credit of the issuer we apply an impairment model, including an anticipated recovery period, similar to a debt security. For equity securities we measure impairment charges based upon the difference between the book value of a security and its fair value.

 

48



 

At September 30, 2009 and December 31, 2008, the amortized cost and fair value of fixed maturity securities and equity securities in an unrealized loss position and the number of months in an unrealized loss position were as follows:

 

 

 

Number of Securities

 

Amortized
Cost

 

Fair
Value

 

Gross
Unrealized
Losses

 

 

 

(Dollars in thousands)

 

September 30, 2009

 

 

 

 

 

 

 

 

 

Fixed maturity securities:

 

 

 

 

 

 

 

 

 

Investment grade:

 

 

 

 

 

 

 

 

 

Less than six months

 

16

 

$

158,901

 

$

152,552

 

$

(6,349

)

Six months or more and less than twelve months

 

35

 

1,688,168

 

1,656,041

 

(32,127

)

Twelve months or greater

 

101

 

1,082,365

 

945,087

 

(137,278

)

Total investment grade

 

152

 

2,929,434

 

2,753,680

 

(175,754

)

Below investment grade:

 

 

 

 

 

 

 

 

 

Less than six months

 

2

 

28,296

 

25,740

 

(2,556

)

Six months or more and less than twelve months

 

15

 

103,978

 

81,515

 

(22,463

)

Twelve months or greater

 

95

 

1,283,082

 

997,379

 

(285,703

)

Total below investment grade

 

112

 

1,415,356

 

1,104,634

 

(310,722

)

Equity securities:

 

 

 

 

 

 

 

 

 

Less than six months

 

3

 

2,962

 

2,851

 

(111

)

Six months or more and less than twelve months

 

1

 

206

 

199

 

(7

)

Twelve months or greater

 

12

 

39,000

 

35,271

 

(3,729

)

Total equity securities

 

16

 

42,168

 

38,321

 

(3,847

)

 

 

280

 

$

4,386,958

 

$

3,896,635

 

$

(490,323

)

December 31, 2008

 

 

 

 

 

 

 

 

 

Fixed maturity securities

 

 

 

 

 

 

 

 

 

Investment grade:

 

 

 

 

 

 

 

 

 

Less than six months

 

101

 

$

923,551

 

$

856,068

 

$

(67,483

)

Six months or more and less than twelve months

 

135

 

1,397,316

 

1,132,870

 

(264,446

)

Twelve months or greater

 

104

 

1,532,112

 

1,351,515

 

(180,597

)

Total investment grade

 

340

 

3,852,979

 

3,340,453

 

(512,526

)

Below investment grade:

 

 

 

 

 

 

 

 

 

Less than six months

 

4

 

27,862

 

23,378

 

(4,484

)

Six months or more and less than twelve months

 

13

 

126,163

 

97,172

 

(28,991

)

Twelve months or greater

 

11

 

144,759

 

101,027

 

(43,732

)

Total below investment grade

 

28

 

298,784

 

221,577

 

(77,207

)

Equity securities:

 

 

 

 

 

 

 

 

 

Less than six months

 

10

 

23,454

 

17,635

 

(5,819

)

Six months or more and less than twelve months

 

8

 

21,000

 

12,459

 

(8,541

)

Twelve months or greater

 

8

 

31,975

 

20,357

 

(11,618

)

Total equity securities

 

26

 

76,429

 

50,451

 

(25,978

)

 

 

394

 

$

4,228,192

 

$

3,612,481

 

$

(615,711

)

 

49



 

At September 30, 2009 and December 31, 2008, the amortized cost and estimated fair value of fixed maturity securities (excluding United States Government and United States Government sponsored agency securities) and equity securities that had unrealized losses greater than 20% and the number of months in an unrealized loss position greater than 20% were as follows:

 

 

 

Number of Securities

 

Amortized
Cost

 

Carrying
Value

 

Gross
Unrealized
Losses

 

 

 

(Dollars in thousands)

 

September 30, 2009

 

 

 

 

 

 

 

 

 

Investment grade:

 

 

 

 

 

 

 

 

 

Less than six months

 

2

 

$

76,040

 

$

59,212

 

$

(16,828

)

Six months or more and less than twelve months

 

11

 

153,436

 

114,027

 

(39,409

)

Twelve months or greater

 

3

 

10,471

 

7,344

 

(3,127

)

Total investment grade

 

16

 

239,947

 

180,583

 

(59,364

)

Below investment grade:

 

 

 

 

 

 

 

 

 

Less than six months

 

2

 

40,220

 

30,593

 

(9,627

)

Six months or more and less than twelve months

 

36

 

521,178

 

375,652

 

(145,526

)

Twelve months or greater

 

25

 

307,820

 

223,433

 

(84,387

)

Total below investment grade

 

63

 

869,218

 

629,678

 

(239,540

)

Equity securities:

 

 

 

 

 

 

 

 

 

Less than six months

 

 

 

 

 

Six months or more and less than twelve months

 

 

 

 

 

Twelve months or greater

 

 

 

 

 

Total equity securities

 

 

 

 

 

 

 

79

 

$

1,109,165

 

$

810,261

 

$

(298,904

)

December 31, 2008

 

 

 

 

 

 

 

 

 

Investment grade:

 

 

 

 

 

 

 

 

 

Less than six months

 

98

 

$

840,309

 

$

614,000

 

$

(226,309

)

Six months or more and less than twelve months

 

18

 

99,216

 

65,679

 

(33,537

)

Twelve months or greater

 

 

 

 

 

Total investment grade

 

116

 

939,525

 

679,679

 

(259,846

)

Below investment grade:

 

 

 

 

 

 

 

 

 

Less than six months

 

17

 

152,936

 

104,729

 

(48,207

)

Six months or more and less than twelve months

 

2

 

10,497

 

4,159

 

(6,338

)

Twelve months or greater

 

 

 

 

 

Total below investment grade

 

19

 

163,433

 

108,888

 

(54,545

)

Equity securities:

 

 

 

 

 

 

 

 

 

Less than six months

 

17

 

44,321

 

27,562

 

(16,759

)

Six months or more and less than twelve months

 

3

 

8,000

 

4,642

 

(3,358

)

Twelve months or greater

 

 

 

 

 

Total equity securities

 

20

 

52,321

 

32,204

 

(20,117

)

 

 

155

 

$

1,155,279

 

$

820,771

 

$

(334,508

)

 

50



 

The amortized cost and fair value of fixed maturity securities at September 30, 2009 and December 31, 2008, by contractual maturity, that were in an unrealized loss position are shown below.  Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.  All of our mortgage and asset backed securities provide for periodic payments throughout their lives, and are shown below as a separate line.

 

 

 

Available for sale

 

Held for investment

 

 

 

Amortized
Cost

 

Fair Value

 

Amortized
Cost

 

Fair Value

 

 

 

(Dollars in thousands)

 

September 30, 2009

 

 

 

 

 

 

 

 

 

Due in one year or less

 

$

16,227

 

$

15,522

 

$

 

$

 

Due after one year through five years

 

100,009

 

91,469

 

 

 

Due after five years through ten years

 

138,555

 

128,270

 

 

 

Due after ten years through twenty years

 

233,814

 

212,154

 

150,000

 

149,864

 

Due after twenty years

 

1,849,225

 

1,782,255

 

75,616

 

57,356

 

 

 

2,337,830

 

2,229,670

 

225,616

 

207,220

 

Mortgage and asset backed securities

 

1,781,344

 

1,421,424

 

 

 

 

 

$

 4,119,174

 

$

3,651,094

 

$

225,616

 

$

207,220

 

 

 

 

 

 

 

 

 

 

 

December 31, 2008

 

 

 

 

 

 

 

 

 

Due after one year through five years

 

$

270,261

 

$

237,628

 

$

 

$

 

Due after five years through ten years

 

616,498

 

540,629

 

 

 

Due after ten years through twenty years

 

559,594

 

501,542

 

365,000

 

360,016

 

Due after twenty years

 

560,837

 

448,751

 

75,521

 

58,049

 

 

 

2,007,190

 

1,728,550

 

440,521

 

418,065

 

Mortgage and asset backed securities

 

1,704,052

 

1,415,415

 

 

 

 

 

$

 3,711,242

 

$

3,143,965

 

$

440,521

 

$

418,065

 

 

51



 

At each balance sheet date, we identify invested assets which have characteristics (i.e. significant unrealized losses compared to amortized cost and industry trends) creating uncertainty as to our future assessment of an other than temporary impairment.  As part of this assessment we review not only a change in current price relative to its amortized cost but the issuer’s/security’s current credit rating and the probability of full recovery of principal based upon the issuer’s financial strength and/or collateral performance. Specifically for corporate issues we evaluate the financial stability and quality of asset coverage for the securities relative to the term to maturity for the issues we own. For residential mortgage backed securities we evaluate the current delinquencies relative to credit enhancements, credit loss severity and trends in mortgage default rates. Securities which have a 25% or greater change in market price relative to its amortized cost and/or has a possibility of a loss of principal will be included on a list which is referred to as our watch list.  We exclude from this list securities with unrealized losses which are related to market movements in interest rates and which have no factors indicating that such unrealized losses may be other than temporary as we do not intend to sell these securities and it is more likely than not we will not have to sell these securities before a recovery is realized.  At September 30, 2009, the amortized cost and fair value of securities on the watch list are as follows:

 

General Description

 

Number of
Securities

 

Amortized
Cost

 

Unrealized
Gains/

(Losses)

 

Fair Value

 

Months in
Continuous
Unrealized
Loss Position

 

Months
Unrealized
Losses Greater
Than 20%

 

 

 

(Dollars in thousands)

 

Investment grade

 

 

 

 

 

 

 

 

 

 

 

 

 

Corporate bonds:

 

 

 

 

 

 

 

 

 

 

 

 

 

Finance

 

1

 

$

9,984

 

$

(734

)

$

9,250

 

17

 

 

Insurance

 

2

 

9,537

 

(2,134

)

7,403

 

28 - 31

 

16

 

Perpetual preferred stocks:

 

 

 

 

 

 

 

 

 

 

 

 

 

Insurance

 

1

 

3,000

 

(780

)

2,220

 

 

 

 

 

4

 

22,521

 

(3,648

)

18,873

 

 

 

 

 

Below investment grade

 

 

 

 

 

 

 

 

 

 

 

 

 

Corporate bonds:

 

 

 

 

 

 

 

 

 

 

 

 

 

Finance

 

4

 

22,181

 

(3,505

)

18,676

 

17 - 30

 

0 - 20

 

Insurance

 

3

 

19,664

 

(4,519

)

15,145

 

 

 

Retail

 

1

 

10,490

 

(2,990

)

7,500

 

50 - 52

 

20

 

Consumer staple

 

1

 

9,274

 

(1,591

)

7,683

 

40

 

 

Home building

 

1

 

4,970

 

(195

)

4,775

 

49

 

 

Mining

 

1

 

7,248

 

(806

)

6,442

 

29

 

 

Mortgage-backed securities

 

31

 

569,035

 

(111,250

)

457,785

 

3 - 51

 

0 - 12

 

Redeemable preferred stocks:

 

 

 

 

 

 

 

 

 

 

 

 

 

Finance

 

4

 

17,000

 

(3,567

)

13,433

 

16 - 49

 

0 - 16

 

 

 

46

 

659,862

 

(128,423

)

531,439

 

 

 

 

 

 

 

50

 

$

682,383

 

$

(132,071

)

$

550,312

 

 

 

 

 

 

Our analysis of these securities that we have determined are temporarily impaired and their credit performance at September 30, 2009 is as follows:

 

Finance and Insurance: The decline in value of these corporate bonds and preferred stocks is due to the continued wide spreads as a result of the ongoing concerns relating to capital, asset quality and earnings stability due to the recent financial crisis.  While these issuers have had their financial position and profitability weakened by the credit and liquidity crisis, we have determined that these securities were not other than temporarily impaired due to our evaluation of the operating performance and the credit worthiness of each individual issuer.

 

Retail: We own a bond issued by a U.S. retail company.  The decline in value of this bond relates to a recent debt-financed share repurchase combined with a weakening economy which has led to a decrease in sales.  We have determined that this security was not other than temporarily impaired due to the issuer’s very strong market position and a consistent history of strong operating performance.

 

Consumer Staple: The decline in value of this bond was due to a reduction in the company’s capital position during 2007 due to non-recurring write-offs related to the refinancing of debt and the correction of improper accounting practices.  We have determined that this security was not other than temporarily impaired due to the issuer’s strong operating performance, decreased outstanding debt through the sale of assets and improved access to liquidity through new credit facilities.

 

52



 

Home Building: This bond has been affected by the deterioration in demand for new homes, decreases in new and existing home prices, mortgage credit availability and excessive housing inventory.  We have determined that this security was not other than temporarily impaired based upon the issuer’s cash position and access to liquidity through existing credit facilities which will allow them to operate effectively through these economic conditions.

 

Mining: The decline in fair value of this bond is related to increased debt levels during 2008 due to several acquisitions during the year combined with the lower coal prices due to lower global demand. We have determined that this security was not other than temporarily impaired due to implemented work force reductions, capital expenditure reductions and elimination of its dividend to reduce its debt level.

 

Mortgage-backed securities: The decline in fair value of these mortgage-backed securities is due to imbalances in supply and demand for mortgage-backed securities, increased foreclosures and bankruptcies and projections of potential future losses.  We have determined that these securities were not other than temporarily impaired due to our analysis of future cash flows.

 

The securities on the watch list are current with respect to payments of principal and interest.  We do not intend to sell these securities and it is more likely than not we will not have to sell these securities before recovery of their amortized cost and, as such, there were no other than temporary impairments on these securities at September 30, 2009.

 

53



 

We recognized other than temporary impairments and additional credit losses on a number of securities for which we have previously recognized OTTI as follows:

 

 

 

Three Months Ended September 30, 2009

 

Three Months Ended
September 30, 2008

 

General Description

 

Number of
Securities

 

Other Than
Temporary
Impairments

 

Portion
Recognized in
Comprehensive
Income

 

Net
Impairment
Losses
Recognized in
Operations

 

Number of
Securities

 

Other Than
Temporary
Impairments

 

 

 

(Dollars in thousands)

 

Corporate bonds:

 

 

 

 

 

 

 

 

 

 

 

 

 

Finance

 

1

 

$

(3,619

)

$

(2,257

)

$

(5,876

)

3

 

$

(8,283

)

Insurance

 

1

 

(211

)

(696

)

(907

)

2

 

(4,415

)

Media

 

 

 

 

 

1

 

(3,150

)

Mortgage-backed securities

 

47

 

(78,712

)

52,594

 

(26,118

)

 

 

Common & preferred stocks:

 

 

 

 

 

 

 

 

 

 

 

 

 

Finance

 

1

 

(10,182

)

 

(10,182

)

4

 

(41,339

)

Insurance

 

2

 

(1,492

)

 

(1,492

)

 

 

Real estate

 

 

 

 

 

3

 

(4,045

)

 

 

52

 

$

(94,216

)

$

49,641

 

$

(44,575

)

13

 

$

(61,232

)

 

 

 

Nine Months Ended September 30, 2009

 

Nine Months Ended
September 30, 2008

 

General Description

 

Number of
Securities

 

Other Than
Temporary
Impairments

 

Portion
Recognized in
Comprehensive
Income

 

Net Impairment
Losses
Recognized in
Operations

 

Number of
Securities

 

Other Than
Temporary
Impairments

 

 

 

(Dollars in thousands)

 

United States Government full faith and credit

 

1

 

$

(245

)

$

 

$

(245

)

 

$

 

Corporate bonds:

 

 

 

 

 

 

 

 

 

 

 

 

 

Finance

 

3

 

(8,388

)

(1,521

)

(9,909

)

4

 

(9,267

)

Insurance

 

2

 

(641

)

(1,165

)

(1,806

)

3

 

(10,397

)

Home building

 

3

 

(756

)

(70

)

(826

)

4

 

(9,352

)

Media

 

 

 

 

0

 

1

 

(3,150

)

Mortgage-backed securities

 

49

 

(140,454

)

110,768

 

(29,686

)

2

 

(3,249

)

Common & preferred stocks:

 

 

 

 

 

 

 

 

 

 

 

 

 

Finance

 

7

 

(18,292

)

 

(18,292

)

6

 

(43,467

)

Insurance

 

2

 

(1,492

)

 

(1,492

)

1

 

(1,507

)

Real estate

 

2

 

(1,400

)

 

(1,400

)

8

 

(14,366

)

 

 

69

 

$

(171,668

)

$

108,012

 

$

(63,656

)

29

 

$

(94,755

)

 

Several factors have led us to believe that full recovery of amortized cost will not be expected.  These include, but are not limited to: (i) a significant change in the operating performance of a company; (ii) a material change in the expected contractual obligation of an issuer; (iii) a significant change in ratings as defined by the NRSRO; and (iv) the time frame in which a recovery to amortized cost may occur.

 

Deterioration of the issuers’ credit worthiness and liquidity profile were major factors in leading us to make the determination that other than temporary impairments were present in our corporate bonds and common and preferred stocks.  Our analysis demonstrated that we could not expect a recovery of our cost basis within our expected holding period for debt securities or within a reasonable period of time for equity securities.

 

In the case of mortgage-backed securities, we considered the ratings downgrades, increased default projections, actual defaults, and expected cash flow projections to determine that other than temporary impairments were present.  We continue to monitor the cash flows and economics surrounding these securities to determine changes in expected future cash flows.

 

In making the decisions to write down the securities described above, we considered whether the factors leading to those write downs impacted any other securities held in our portfolio.  In cases where we determined that a decline in value was related to an industry-wide concern, we considered the impact of such concern on all securities we held within that industry classification.

 

The following table is a summary of securities that are a part of our investment portfolio at September 30, 2009 and for which at any time during our holding period we have recognized OTTI and the activity since recognizing OTTI:

 

54



 

 

 

Number of
Securities

 

Amortized Cost
Prior to OTTI

 

OTTI
Recognized

in Operations

 

Return of
Principal Since
OTTI was
Recognized

 

Premium
Amortization/
Discount
Accretion Since
OTTI was
Recognized

 

September 30, 2009
Amortized

Cost

 

 

 

(Dollars in thousands)

 

Corporate securities

 

10

 

$

60,610

 

$

(24,609

)

$

(35

)

$

(241

)

$

35,725

 

Residential mortgage-backed securities

 

53

 

750,622

 

(36,956

)

(12,847

)

215

 

701,034

 

Equity securities: finance, insurance and real estate

 

23

 

120,974

 

(83,398

)

(350

)

 

37,227

 

 

 

86

 

$

932,206

 

$

(144,963

)

$

(13,232

)

$

(26

)

$

773,986

 

 

The following table summarizes the cumulative noncredit portion of OTTI and the change in fair value since recognition of OTTI, both of which were recognized in other comprehensive income, by major type of security for securities that are part of our investment portfolio at September 30, 2009:

 

 

 

September 30,
2009
Amortized Cost

 

OTTI
Recognized in
Other
Comprehensive
Income

 

Change in Fair
Value

Since OTTI
was
Recognized

 

September 30,
2009
Fair Value

 

 

 

(Dollars in thousands)

 

Corporate securities

 

$

35,725

 

$

(12,982

)

$

7,426

 

$

30,169

 

Residential mortgage-backed securities

 

701,034

 

(180,224

)

8,353

 

529,163

 

Equity securities: Finance, insurance and real estate

 

37,227

 

 

13,168

 

50,395

 

 

 

$

 773,986

 

$

(193,206

)

$

28,947

 

$

609,727

 

 

Our commercial mortgage loan portfolio consists of mortgage loans collateralized by the related properties and diversified as to property type, location, and loan size.  Our mortgage lending policies establish limits on the amount that can be loaned to one borrower and other criteria to reduce the risk of default.  The commercial mortgage loan portfolio is summarized by geographic region and property type as follows:

 

 

 

September 30, 2009

 

December 31, 2008

 

 

 

Carrying
Amount

 

Percent

 

Carrying
Amount

 

Percent

 

Geographic distribution

 

 

 

 

 

 

 

 

 

East

 

$

541,057

 

22.7

%

$

537,303

 

23.1

%

Middle Atlantic

 

165,905

 

7.0

%

161,222

 

6.9

%

Mountain

 

379,368

 

16.0

%

386,988

 

16.6

%

New England

 

44,953

 

1.9

%

44,517

 

1.9

%

Pacific

 

208,349

 

8.8

%

194,301

 

8.3

%

South Atlantic

 

443,566

 

18.6

%

421,507

 

18.1

%

West North Central

 

410,342

 

17.3

%

397,375

 

17.1

%

West South Central

 

182,293

 

7.7

%

186,611

 

8.0

%

 

 

$

2,375,833

 

100.0

%

$

2,329,824

 

100.0

%

 

 

 

 

 

 

 

 

 

 

Property type distribution

 

 

 

 

 

 

 

 

 

Office

 

$

651,572

 

27.4

%

$

655,278

 

28.1

%

Medical Office

 

141,016

 

5.9

%

142,409

 

6.1

%

Retail

 

546,014

 

23.0

%

551,172

 

23.7

%

Industrial/Warehouse

 

583,588

 

24.6

%

552,012

 

23.7

%

Hotel

 

156,146

 

6.6

%

154,671

 

6.6

%

Apartment

 

119,163

 

5.0

%

111,933

 

4.8

%

Mixed use/other

 

178,334

 

7.5

%

162,349

 

7.0

%

 

 

$

2,375,833

 

100.0

%

$

2,329,824

 

100.0

%

 

Our commercial mortgage loans on real estate are reported at cost, adjusted for amortization of premiums and accrual of discounts.  The average loan to value ratio for the overall portfolio was 56.7% and 58.6% and the average loan size was $2.4 million (987 loans) and $2.6 million (912 loans) at September 30, 2009 and December 31, 2008, respectively.  The loan to value ratio is calculated using the underwriting and appraisal at the time the loan was made.  We have the contractual ability to pursue full personal recourse on 12.7% of the loans and partial personal recourse on 34.8% of the loans, and master leases provide us recourse against the principals of the borrowing entity on 11.4% of the loans.  In the normal course of business, we commit to fund commercial mortgage loans up to 90 days in advance.  At September 30, 2009, we had commitments to fund commercial mortgage loans totaling $31.5 million, with fixed interest rates ranging from 7.0% to 7.3%.

 

During 2009 we completed the foreclosure of two loans with a total principal balance at the time of foreclosure of $8.9 million. No impairments were recognized upon foreclosure as the fair values of the properties less the estimated costs to sell exceeded the outstanding mortgage loan balances and accordingly, the real estate was assigned a value equal to the outstanding loan balance. The foreclosed properties are being accounted for as “real estate held for sale” as we are committed to a plan of marketing and selling the properties within twelve months of acquisition. Real estate held for sale is carried at the lower of cost or fair value, less projected costs to sell. We would establish a valuation allowance for the amount that our carrying value exceeds the property’s fair value, less projected selling costs, if such an occurrence would ever arise.

 

At September 30, 2009, we have foreclosure proceedings in process on five commercial mortgage loans with a total outstanding balance of $14.6 million that were in default and twenty commercial mortgage loans with an outstanding principal balance of $58.9 million (2% of the commercial mortgage loan portfolio) have been given “workout” terms which generally allow for interest only payments or the capitalization of interest for a specified period of time.

 

We evaluate our mortgage loan portfolio for the establishment of a loan loss reserve by specific identification of impaired loans and the measurement of an estimated loss for each individual loan identified and an analysis of the mortgage loan portfolio for the need for a general loan allowance for probable losses on all other loans.  If we determine that the value of any specific mortgage loan is impaired, the carrying amount of the mortgage loan will be reduced to its fair value, based upon the present value of expected future cash flows from the loan discounted at the loan’s effective interest rate, or the fair value of the underlying collateral.  The amount of the general loan allowance is based upon management’s evaluation of the collectability of the loan portfolio, historical loss experience, delinquencies, credit concentrations, underwriting standards and national and local economic conditions.  Based upon this process and analysis, no general loan loss allowance, was necessary.  A mortgage loan is impaired when it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement.  We recorded impairment losses of $5.5 million and $6.5 million during the three and nine months ended September 30, 2009 on specific mortgage loans with a total outstanding balance of $12.5 and $18.4 million for which principal amounts outstanding exceed the fair value of the real estate collateral less projected costs to sell the properties.  A summary of impaired commercial mortgage loans as of September 30, 2009 and December 31, 2008 is as follows:

 

55



 

 

 

September 30,
2009

 

December 31,
2008

 

 

 

(Dollars in thousands)

 

Impaired mortgage loans with allowances for losses

 

$

18,384

 

 

Impaired mortgage loans with no allowance for losses

 

58,862

 

20,983

 

Allowance for probable loan losses

 

(6,484

)

 

Net carrying value of impaired mortgage loans

 

$

70,762

 

$

20,983

 

 

Mortgage loans summarized in the preceding table represent all loans that we are either not currently collecting, or those we feel it is probable we will not be able to collect, all amounts due according to the contractual terms of the loan agreement. We have not recognized an allowance on any of our impaired mortgage loans for which the present value of our expected future cash flows have not decreased.

 

Liquidity and Capital Resources

 

Our insurance subsidiaries continue to have adequate cash flows from annuity deposits and investment income to meet their policyholder and other obligations.  Net cash flows from annuity deposits and funds returned to policyholders as surrenders, withdrawals and death claims were $1.4 billion in the nine months ended September 30, 2009 compared to $0.9 billion for the nine months ended September 30, 2008 with the increase primarily attributable to the $0.5 billion increase in net annuity deposits collected reported above under Overview.  We continue to invest the net proceeds from policyholder transactions and investment activities in high quality fixed maturity securities and fixed rate commercial mortgage loans.  As reported above under Financial Condition - Investment, during the nine months ended September 30, 2009 we experienced a significant amount of calls of United States Government sponsored agency securities.  We have been reinvesting the proceeds from the called securities in investment grade fixed maturity securities and mortgage-backed securities with yields that meet our investment spread objectives.  Our ability to continue to reinvest the proceeds from called securities in assets with acceptable credit quality and yield characteristics similar to the called securities will be dependent on future market conditions.

 

We, as the parent company, are a legal entity separate and distinct from our subsidiaries, and have no direct business operations of our own.  Our parent company assets consist primarily of the capital stock and surplus notes of our subsidiaries.  Accordingly, our future cash flows depend upon the availability of dividends, surplus note interest payments and other statutorily permissible payments from our subsidiaries, such as payments under our investment advisory agreements and tax allocation agreement with our subsidiaries.  The ability to pay such dividends and to make such other payments will be limited by applicable laws and regulations of the states in which our subsidiaries are domiciled, which subject our subsidiaries to significant regulatory restrictions.  These laws and regulations require, among other things, our insurance subsidiaries to maintain minimum solvency requirements and limit the amount of dividends these subsidiaries can pay.  Along with solvency regulations, the primary driver in determining the amount of capital used for dividends is the level of capital needed to maintain desired financial strength ratings from A.M. Best Company.  Given recent economic events that have affected the insurance industry, both regulators and rating agencies could become more conservative in their methodology and criteria, including increasing capital requirements for our insurance subsidiaries which, in turn, could negatively affect the cash available to us from insurance subsidiaries.

 

The statutory capital and surplus of our life insurance subsidiaries at September 30, 2009 was $1.1 billion.  American Equity Investment Life Insurance Company (“American Equity Life”) made surplus note interest payments to us of $3.1 million during the nine months ended September 30, 2009.  For the remainder of 2009, up to $98.3 million can be distributed by American Equity Life as dividends under applicable laws and regulations without prior regulatory approval.  Dividends may be made only out of earned surplus, and all surplus note payments are subject to prior approval by regulatory authorities.  American Equity Life had $168.4 million of statutory earned surplus at September 30, 2009.

 

During the second quarter of 2009, we extinguished $37.2 million of our 5.25% contingent convertible senior notes by issuing five million shares of our common stock to the holder of these notes.  This transaction resulted in increasing our equity by $33.1 million and reducing our liabilities by $32.7 million.

 

During 2009, we have borrowed $75.0 million under our revolving line of credit and used the proceeds to make $75.0 million in capital contributions to American Equity Life.  The capital contributions will assist this subsidiary in maintaining adequate statutory capital and surplus should new annuity sales continue at an accelerated pace in subsequent periods.  We also have the ability to issue equity, debt or other types of securities through one or more methods of distribution under a currently effective shelf registration statement on Form S-3.  The terms of any offering

 

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would be established at the time of the offering, subject to market conditions.

 

On August 20, 2009, we entered into distribution agreements with Fox-Pitt Kelton Cochran Caronia Waller (USA) LLC (“FPK”) and Sandler O’Neill & Partners, L.P. Under the distribution agreements, we can offer and sell shares of our common stock up to an aggregate offering price of $50,000,000. From August 20, 2009 through September 30, 2009, we sold 132,300 shares of our common stock at an average price of $8.26 per share, resulting in gross proceeds to us of $l.09 million. The aggregate net proceeds from such sales were $0.99 million after deducting related expenses, including $30,036 in gross sales commissions paid to FPK.

 

The transfer of funds by American Equity Life is also restricted by a covenant in our revolving line of credit which requires American Equity Life to maintain a minimum risk-based capital ratio of 200%.

 

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New Accounting Pronouncements

 

In June 2009, the FASB amended accounting standards for transfers and servicing of financial assets and extinguishments of liabilities. The new standards removes the concept of a qualifying special-purpose entity (“QSPE”) from existing standards and removes the exception of QSPE’s from consolidation requirements. Additionally, more stringent conditions for reporting a transfer of a portion of a financial asset as a sale were created, derecognition criteria was clarified, how retained interests are initially measured was revised, the guaranteed mortgage securitization recharacterization provisions were removed and disclosure requirements were added. This standard must be applied as of the beginning of our first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period and for interim and annual reporting periods thereafter. Earlier application is prohibited. We are currently assessing the impact of this standard.

 

In June 2009, the FASB issued amendments to the accounting standards for consolidation of variable interest entities. The new standard replaces the quantitative-based risks and rewards calculation of existing standards for determining which enterprise, if any, has a controlling financial interest in a variable interest entity with a primarily qualitative approach focused on identifying which enterprise has the power to direct the activities of a variable interest entity that most significantly impacts the entity’s economic performance and (1) the obligation to absorb losses of the entity or (2) the right to receive benefits from the entity. This amendment is effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period and for interim and annual reporting periods thereafter. Earlier application is prohibited. We are currently assessing the impact of this standard.

 

In September 2009, the FASB issued an accounting standards update that allows for net asset value per share to be used as a means to estimate fair value for an investment if the fair value of that investment is not readily determinable. Investments that qualify are those that calculate a net asset value per share or its equivalent as of the investor’s measurement date. This standard is effective for interim and annual periods ending after December 15, 2009, with early application permitted. We are currently assessing the impact of this accounting standards update.

 

In August 2009, the FASB issued an accounting standards update that amends the fair value measurement of liabilities. The update provides clarification that in circumstances in which a quoted price in an active market for the identical liability is not available, a reporting entity is required to measure fair value using the quoted price of the identical liability when traded as an asset, quoted prices for similar liabilities or similar liabilities when traded as assets, or another valuation technique that is consistent with the principles of fair value. This guidance is effective for the first reporting period beginning after issuance, which will be our three months and year ending December 31, 2009. We are currently assessing the impact of this accounting standards update.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

 

We seek to invest our available funds in a manner that will maximize shareholder value and fund future obligations to policyholders and debtors, subject to appropriate risk considerations.  We seek to meet this objective through investments that: (i) consist predominately of investment grade fixed maturity securities; (ii) have projected returns which satisfy our spread targets; and (iii) have characteristics which support the underlying liabilities.  Many of our products incorporate surrender charges, market interest rate adjustments or other features to encourage persistency.

 

We seek to maximize the total return on our available for sale investments through active investment management.  Accordingly, we have determined that our available for sale portfolio of fixed maturity securities is available to be sold in response to: (i) changes in market interest rates; (ii) changes in relative values of individual securities and asset sectors; (iii) changes in prepayment risks; (iv) changes in credit quality outlook for certain securities; (v) liquidity needs; and (vi) other factors.  An OTTI shall be considered to have occurred when we sell, or have an intention to sell, available for sale securities in an unrealized loss position.  If we do not intend to sell a debt security, we consider all available evidence to make an assessment of whether it is more likely than not that we will be required to sell the security before the recovery of its amortized cost basis.  If it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis, an OTTI will be considered to have occurred.  We have a portfolio of held for investment securities which principally consists of long duration bonds issued by U.S. government agencies.  These securities are purchased to secure long-term yields which meet our spread targets and support the underlying liabilities.

 

Interest rate risk is our primary market risk exposure.  Substantial and sustained increases and decreases in market interest rates can affect the profitability of our products, the fair value of our investments, and the amount of interest we pay on our floating rate subordinated debentures.  Our floating rate trust preferred securities issued by Trust III, IV, VII, VIII, IX, X, XI (beginning on December 31, 2010) and XII bear interest at the three month LIBOR plus 3.50% - 4.00%.  Our outstanding balance of floating rate trust preferred securities was $144.5 million at September 30, 2009, of which $60 million had been swapped to fixed rates (see note 9 to our audited consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2008).  The applicable interest rate on our borrowings under our revolving line of credit is floating at LIBOR plus 0.80% or the greater of prime rate or federal funds rate plus 0.50%, as elected by us.  In 2009, we swapped the floating interest rate to fixed rates of $150.0 million of the borrowings outstanding on our revolving line of credit (see note 8 to our audited consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2008.)  The profitability of most of our products depends on the spreads between interest yield on investments and rates credited on insurance

 

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liabilities.  We have the ability to adjust crediting rates (caps, participation rates or asset fee rates for index annuities) on substantially all of our annuity liabilities at least annually (subject to minimum guaranteed values).  In addition, substantially all of our annuity products have surrender and withdrawal penalty provisions designed to encourage persistency and to help ensure targeted spreads are earned.  However, competitive factors, including the impact of the level of surrenders and withdrawals, may limit our ability to adjust or maintain crediting rates at levels necessary to avoid narrowing of spreads under certain market conditions.

 

A major component of our interest rate risk management program is structuring the investment portfolio with cash flow characteristics consistent with the cash flow characteristics of our insurance liabilities.  We use computer models to simulate cash flows expected from our existing business under various interest rate scenarios.  These simulations enable us to measure the potential gain or loss in fair value of our interest rate-sensitive financial instruments, to evaluate the adequacy of expected cash flows from our assets to meet the expected cash requirements of our liabilities and to determine if it is necessary to lengthen or shorten the average life and duration of our investment portfolio.  The “duration” of a security is the time weighted present value of the security’s expected cash flows and is used to measure a security’s sensitivity to changes in interest rates.  When the durations of assets and liabilities are similar, exposure to interest rate risk is minimized because a change in value of assets should be largely offset by a change in the value of liabilities.

 

If interest rates were to increase 10% (41 basis points) from levels at September 30, 2009, we estimate that the fair value of our fixed maturity securities would decrease by approximately $408.7 million.  The impact on stockholders’ equity of such decrease (net of income taxes and certain adjustments for changes in amortization of deferred policy acquisition costs and deferred sales inducements) would be a decrease of $103.9 million in the accumulated other comprehensive income and a decrease to stockholders’ equity.  The computer models used to estimate the impact of a 10% change in market interest rates incorporate numerous assumptions, require significant estimates and assume an immediate and parallel change in interest rates without any management of the investment portfolio in reaction to such change.  Consequently, potential changes in value of our financial instruments indicated by the simulations will likely be different from the actual changes experienced under given interest rate scenarios, and the differences may be material.  Because we actively manage our investments and liabilities, our net exposure to interest rates can vary over time.  However, any such decreases in the fair value of our fixed maturity securities (unless related to credit concerns of the issuer requiring recognition of an other than temporary impairment) would generally be realized only if we were required to sell such securities at losses prior to their maturity to meet our liquidity needs, which we manage using the surrender and withdrawal provisions of our annuity contracts and through other means.  See Financial Condition - Liquidity for Insurance Operations included in Management’s Discussion and Analysis in our Annual Report on Form 10-K for the year ended December 31, 2008.

 

At September 30, 2009, 50% of our fixed income securities have call features and 8% were subject to call redemption.  Another 9% will become subject to call redemption through December 31, 2009.  During the nine months ended September 30, 2009 and 2008, we received $3.6 billion and $1.5 billion, respectively, in net redemption proceeds related to the exercise of such call options.  We have reinvestment risk related to these redemptions to the extent we cannot reinvest the net proceeds in assets with credit quality and yield characteristics similar to the redeemed bonds.  Such reinvestment risk typically occurs in a declining rate environment.  Should rates decline to levels which tighten the spread between our average portfolio yield and average cost of interest credited on our annuity liabilities, we have the ability to reduce crediting rates (caps, participation rates or asset fees for index annuities) on most of our annuity liabilities to maintain the spread at our targeted level.  At September 30, 2009, approximately 98% of our annuity liabilities were subject to annual adjustment of the applicable crediting rates at our discretion, limited by minimum guaranteed crediting rates specified in the policies

 

With respect to our index annuities, we purchase call options on the applicable indices to fund the annual index credits on such annuities.  These options are primarily one-year instruments purchased to match the funding requirements of the underlying policies.  Fair value changes associated with those investments are substantially offset by an increase or decrease in the amounts added to policyholder account balances for index products.  For the nine months ended September 30, 2009 and 2008, the annual index credits to policyholders on their anniversaries were $25.3 million and $29.3 million, respectively.  Proceeds received at expiration of these options were $5.7 million and $25.6 million for the nine months ended September 30, 2009 and 2008, respectively.  Proceeds for 2009 were adversely affected by $12.0 million in proceeds not received from affiliates of Lehman Brothers which declared bankruptcy in the third quarter of 2008.  The difference between proceeds received at expiration or gains recognized upon early termination of these options and index credits is primarily due to credits attributable to minimum guaranteed interest self funded by us.

 

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Within our hedging process we purchase options out of the money to the extent of anticipated minimum guaranteed interest on index policies.  On the anniversary dates of the index policies, we purchase new one-year call options to fund the next annual index credits.  The risk associated with these prospective purchases is the uncertainty of the cost, which will determine whether we are able to earn our spread on our index business.  We manage this risk through the terms of our index annuities, which permit us to change caps, participation rates and asset fees, subject to contractual features.  By modifying caps, participation rates or asset fees, we can limit option costs to budgeted amounts, except in cases where the contractual features would prevent further modifications.  Based upon actuarial testing which we conduct as a part of the design of our index products and on an ongoing basis, we believe the risk that contractual features would prevent us from controlling option costs is not material.

 

Item 4.  Controls and Procedures

 

Evaluation of Disclosure Controls and Procedures

 

In accordance with the Securities Exchange Act Rules 13a-15 and 15d-15, our management, under the supervision of our Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report on Form 10-Q.  Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the design and operation of our disclosure controls and procedures were effective as of September 30, 2009 in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports the Company files or submits under the Exchange Act.

 

There were no changes in our internal control over financial reporting during the quarter ended September 30, 2009 that have materially affected, or are reasonably likely to materially affect, internal control over financial reporting.

 

PART II.  OTHER INFORMATION

 

Item 1.  Legal Proceedings

 

We are occasionally involved in litigation, both as a defendant and as a plaintiff.  In addition, state regulatory bodies, such as state insurance departments, the Securities and Exchange Commission (“SEC”), the Financial Industry Regulatory Authority (“FINRA”), the Department of Labor, and other regulatory bodies regularly make inquiries and conduct examinations or investigations concerning our compliance with, among other things, insurance laws, securities laws, the Employee Retirement Income Security Act of 1974, as amended, and laws governing the activities of broker-dealers.

 

During the fourth quarter of 2007 we received a formal request for information from the staff of the Division of Enforcement (the “Staff”) of the SEC concerning certain transactions between American Equity and American Equity Investment Service Company (“Service Company”) in 2003, 2004 and 2005. We have cooperated fully in providing information and documentation to the Staff throughout the course of its investigation.  On May 4, 2009, American Equity, our Chairman and our Chief Executive Officer and President received a Wells Notice from the Staff in connection with this investigation.  The Wells Notice provides notification that the Staff intends to recommend to the SEC that it bring a civil action against the recipients for possible violations of the federal securities laws and related rules.  A Wells Notice does not itself initiate litigation, nor is it a finding of wrongdoing by us or any individual.  According to discussions with the SEC Staff and our understanding of the scope of the investigation, the Wells Notice relates to disclosures in our 2004, 2005 and 2006 proxy statements and statements made during our third quarter 2005 earnings conference call concerning the effects of transactions involving the Service Company, the last of which was completed almost four years ago.  Beginning in 1999, our public securities filings contained extensive disclosures related to Service Company transactions, including the effect of each such transaction on our consolidated financial statements.  Based on our own investigation and the facts disclosed to us during the course of the SEC investigation, we believe these proxy statements accurately disclosed all material information, and strongly disagree with the Staff’s recommendation on this matter.  We will continue to pursue a potential resolution of this matter before the Staff makes its formal recommendation to the SEC and will vigorously defend any action brought by the SEC, but we cannot predict the outcome or timing of this matter.

 

In recent years, companies in the life insurance and annuity business have faced litigation, including class action lawsuits, alleging improper product design, improper sales practices and similar claims.  We are currently a defendant in two purported class action lawsuits alleging improper sales practices and similar claims as described below.  It is often not possible to determine the ultimate outcome of pending legal proceedings or to provide reasonable ranges of

 

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potential losses with any degree of certainty.  The lawsuits referred to below are in very preliminary stages and we do not have sufficient information to make an assessment of the plaintiffs’ claims for liability or damages.  The plaintiffs are seeking undefined amounts of damages or other relief, including punitive damages, which are difficult to quantify and cannot be estimated based on the information currently available.  We do not believe that these lawsuits, including those discussed below, will have a material adverse effect on our financial position, results of operations or cash flows.  However, there can be no assurance that such litigation, or any future litigation, will not have a material adverse effect on our business, financial condition, or results of operations.

 

We are a defendant in two cases seeking class action status, including (i) Stephens v. American Equity Investment Life Insurance Company, et. al., in the San Luis Obispo Superior Court, San Francisco, California (complaint filed November 29, 2004) (the “SLO Case”) and (ii) McCormack, et al. v. American Equity Investment Life Insurance Company, et al., in the United States District Court for the Central District of California, Western Division and Anagnostis v. American Equity, et al., coordinated in the Central District, entitled, In re American Equity Annuity Practices and Sales Litigation (complaint filed September 7, 2005) (the “Los Angeles Case”).

 

The plaintiffs in the SLO Case seeks to represent a class of individuals who are California residents and who either purchased their annuity from us through a co-defendant marketing organization or who purchased one of a defined set of particular annuities issued by us.  The named plaintiffs in this case are:  Chalys M. Stephens and John P. Stephens.  Plaintiffs seek injunctive relief and restitution on behalf of all class members under California Business & Professions Code section 17200 et seq.; compensatory damages for breach of contract and breach of fiduciary duty; other pecuniary damages under California Civil Code section 1750 and California Welfare & Institutions Codes section 15600 et seq.; and punitive damages under common law causes of action for fraud and breach of the covenant of good faith and fair dealing.  On November 3, 2008, the court issued an order certifying the class.  We are vigorously defending the underlying allegations and are seeking to decertify a portion of the class and may seek to decertify the entire class after further discovery into the merits of the case.

 

The Los Angeles Case is a consolidated action involving several lawsuits filed by individuals, and the individuals are seeking class action status for a national class of purchasers of annuities issued by us.  The named plaintiffs in this consolidated case are Bernard McCormack, Gust Anagnostis by and through Gary S. Anagnostis and Robert C. Anagnostis, Regina Bush by and through Sharon Schipiour, Lenice Mathews by and through Mary Ann Maclean and George Miller.  The allegations generally attack the suitability of sales of deferred annuity products to persons over the age of 65.  The plaintiffs seek recessionary and injunctive relief including restitution and disgorgement of profits on behalf of all class members under California Business & Professions Code section 17200 et seq. and Racketeer Influenced and Corrupt Organizations Act; compensatory damages for breach of fiduciary duty and aiding and abetting of breach of fiduciary duty; unjust enrichment and constructive trust; and other pecuniary damages under California Civil Code section 1750 and California Welfare & Institutions Codes section 15600 et seq. We are vigorously defending against both class action status as well as the underlying claims.

 

Item 1A.  Risk Factors

 

The following risk factors represent material updates and additions to the risk factors previously disclosed in Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2008.  The risk factors below should be read in conjunction with the Risk Factors and other information disclosed in our Annual Report on Form 10-K for the year ended December 31, 2008.

 

We continue to be adversely affected by the overall deterioration in debt and equity markets caused by the recessionary economic environment.  These adverse conditions could continue to have a negative impact on our financial position and operations.

 

Current conditions in the financial markets and credit system in the United States and throughout the world have resulted in deteriorated asset values and illiquid and inactive markets for certain types of securities and commercial mortgage loans on real estate.  We have experienced uncommon levels of other than temporary impairments and rating downgrades of securities in our investment portfolio for the last four quarters of operations.  At the same time we are experiencing record production in annuity sales.  The combination of ratings downgrades on some of our investment portfolio and record production has resulted in pressure on our capital position.

 

If market conditions continue to deteriorate, it may result in additional ratings downgrades and other than temporary

 

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impairments on our fixed maturity and equity securities and impairments on our commercial mortgage loans.  This may result in us needing to raise additional capital to sustain our current business in force and new sales of our annuity products, which may be difficult under current market conditions.  If capital is available, it may be at terms that are not favorable to us.  If we are unable to raise adequate capital, we may be required to limit growth in sales of our annuity products.

 

Changes in state and federal regulation may affect our profitability.

 

We are subject to regulation under applicable insurance statutes, including insurance holding company statutes, in the various states in which our life insurance subsidiaries transact business.  Our life insurance subsidiaries are domiciled in New York and Iowa.  We are currently licensed to sell our products in 50 states and the District of Columbia.  Insurance regulation is intended to provide safeguards for policyholders rather than to protect shareholders of insurance companies or their holding companies.

 

Regulators oversee matters relating to trade practices, policy forms, claims practices, guaranty funds, types and amounts of investments, reserve adequacy, insurer solvency, minimum amounts of capital and surplus, transactions with related parties, changes in control and payment of dividends.  As increased scrutiny has been placed upon the insurance regulatory framework, a number of state legislatures have considered or enacted legislative proposals that alter, and in many cases increase, state authority to regulate insurance companies and holding company systems.

 

State insurance regulators and the NAIC continually reexamine existing laws and regulations and may impose changes in the future.  Currently, there are proposed statutory accounting pronouncements that could potentially have a significant impact on our level of statutory capital and surplus.

 

Our life insurance subsidiaries are subject to the NAIC’s RBC requirements which are intended to be used by insurance regulators as an early warning tool to identify deteriorating or weakly capitalized insurance companies for the purpose of initiating regulatory action.  Our life insurance subsidiaries also may be required, under solvency or guaranty laws of most states in which they do business, to pay assessments up to certain prescribed limits to fund policyholder losses or liabilities for insolvent insurance companies.

 

Although the federal government does not directly regulate the insurance business, federal legislation and administrative policies in several areas, including pension regulation, age and sex discrimination, financial services regulation, securities regulation and federal taxation, can significantly affect the insurance business.  In addition, legislation has been introduced in Congress which could result in the federal government assuming some role in the regulation of the insurance industry.

 

On December 17, 2008, the SEC voted to approve Rule 151A, which would apply federal securities oversight to index annuities issued on or after January 12, 2011.  Along with several other parties, we filed a petition for judicial review of this rule seeking to have it overturned.  The court issued its decision in this case on July 21, 2009 and remanded Rule 151A to the SEC for further consideration of the effect of the Rule on efficiency, capital formation and competition.  However, the court upheld the SEC’s authority under the Securities Act of 1933 to regulate our fixed index products if the SEC properly adopts the Rule after consideration of such effects.  Further steps in this litigation are uncertain at this time.  In addition, legislation has been introduced in the U.S. House of Representatives and the U.S. Senate that would negate Rule 151A.  Whether and when such bills may be enacted into law is also uncertain.  Should these efforts to defeat Rule 151A be unsuccessful, costs of compliance with Rule 151A will be substantial and will include, among other things: (i) the costs of registering one or more index annuities; (ii) the annual costs of printing and mailing prospectuses to policyholders; (iii) the costs of expanding the operations of our broker dealer subsidiary; (iv) the costs of establishing relationships with other broker dealers; and (v) the costs of compensating broker dealers in connection with product sales.  In addition, we believe a portion of our sales agents would choose not to become licensed to sell SEC registered products, which could lead to a substantial decline in new annuity deposits unless we are successful in developing new insurance products they want to sell.

 

The regulatory framework at the state and federal level applicable to our insurance products is evolving.  The changing regulatory framework could affect the design of such products and our ability to sell certain products.  Any changes in these laws and regulations could materially and adversely affect our business, financial condition or results of operations.

 

The ongoing SEC investigation regarding our disclosure of certain transactions between American Equity and the Service Company in 2003, 2004 and 2005 could adversely affect us.

 

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During the fourth quarter of 2007 we received a formal request for information from the staff of the Division of Enforcement (the “Staff”) of the SEC concerning certain transactions between American Equity and the Service Company in 2003, 2004 and 2005, and we cooperated fully in providing information and documentation to the Staff throughout the course of its investigation.  On May 4, 2009, American Equity, our Chairman and our Chief Executive Officer and President received a Wells Notice from the Staff in connection with this investigation.  The Wells Notice provides notification that the Staff intends to recommend to the SEC that it bring a civil action against the recipients for possible violations of the federal securities laws and related rules.  A Wells Notice does not itself initiate litigation, nor is it a finding of wrongdoing by us or any individual.  According to discussions with the SEC Staff and our understanding of the scope of the investigation, the Wells Notice relates to disclosures in our 2004, 2005 and 2006 proxy statements and statements made during our third quarter 2005 earnings conference call concerning the transactions involving the Service Company, the last of which was completed almost four years ago.  Based on our own investigation and the facts disclosed to us during the course of the SEC investigation, we believe these proxy statements accurately disclosed all material information, and strongly disagree with the Staff’s recommendation on this matter.  We will continue to pursue a potential resolution of this matter before the Staff makes its formal recommendation to the SEC and will vigorously defend any action brought by the SEC, but we cannot predict the outcome or timing of this matter and an adverse resolution could have a material adverse effect on our business, financial condition and results of operations.

 

Item 2.  Unregistered Sales of Securities and Use of Proceeds

 

There were no issuer purchases of equity securities for the quarter ended September 30, 2009.

 

We have a Rabbi Trust, the NMO Deferred Compensation Trust, which purchases our common shares to fund the amount of shares earned by our agents under the NMO Deferred Compensation Plan.  At September 30, 2009, agents had earned 83,351 shares which had vested but had not yet been purchased and contributed to the Rabbi Trust.

 

In addition, we have a share repurchase program under which we are authorized to purchase up to 10,000,000 shares of our common stock.  As of September 30, 2009, we have repurchased 3,845,296 shares of our common stock under this program.  We suspended the repurchase of our common stock under this program in August of 2008.

 

The maximum number of shares that may yet be purchased under these plans is 6,238,055 at September 30, 2009.

 

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Item 6. Exhibits

 

10.29

 

Coinsurance Agreement effective July 1, 2009, between American Equity Investment Life Insurance Company and Athene Life Re Ltd (Treaty #070109)

 

 

 

10.30

 

Coinsurance Agreement effective July 1, 2009, between American Equity Investment Life Insurance Company and Athene Life Re Ltd (Treaty #08042009)

 

 

 

12.1

 

Ratio of Earnings to Fixed Charges

 

 

 

31.1

 

Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 

 

 

31.2

 

Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 

 

 

32.1

 

Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

 

 

32.2

 

Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

Date: November 9, 2009

 

AMERICAN EQUITY INVESTMENT LIFE

 

HOLDING COMPANY

 

 

 

 

 

By:

/s/ Wendy L. Carlson

 

 

Wendy L. Carlson, President and Chief Executive Officer

 

 

(Principal Executive Officer)

 

 

 

By:

/s/ John M. Matovina

 

 

John M. Matovina, Vice Chairman,

 

 

Chief Financial Officer and Treasurer

 

 

(Principal Financial Officer)

 

 

 

By:

/s/ Ted M. Johnson

 

 

Ted M. Johnson, Vice President - Controller

 

 

(Principal Accounting Officer)

 

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