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AMERICAN EQUITY INVESTMENT LIFE HOLDING CO – 10-Q – Management's Discussion and Analysis of Financial Condition and Results of Operations
Management's discussion and analysis reviews our unaudited consolidated financial position atSeptember 30, 2021 , and the unaudited consolidated results of operations for the three and nine month periods endedSeptember 30, 2021 and 2020, 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 endedDecember 31, 2020 . Interim operating results for the three and nine months endedSeptember 30, 2021 are not necessarily indicative of the results expected for the entire year. Preparation of financial statements requires use of management estimates and assumptions. Cautionary Statement Regarding Forward-Looking Information All statements, trend analysis and other information contained in this report and elsewhere (such as in filings by us with theSEC , press releases, presentations by us or management or oral statements) may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended. Forward-looking statements give expectations or forecasts of future events and do not relate strictly to historical or current facts. They may relate to markets for our products, trends in our operations or financial results, strategic alternatives, future operations, strategies, plans, partnerships, investments, share buybacks and other financial developments. They use words and terms such as accelerate, anticipate, assumption, believe, can, could, enable, estimate, evolve, expect, foreseeable, improve, intend, likely, may, migrating, model, objective, opportunity, outlook, plan, potential, project, seek, should, strategy, sustainable, target, will, would, and other words and terms of similar meaning or that are otherwise tied to future periods or future performance, in each case in all forms of speech and derivative forms, or similar words, as well as any projections of future events or results. Forward-looking statements, by their nature, are subject to a variety of assumptions, risks, and uncertainties that could cause actual results to differ materially from the results projected. Many of these risks and uncertainties cannot be controlled by the Company. Factors that may cause our actual decisions or results to differ materially from those contemplated by these forward-looking statements 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 credit losses, and certain liabilities, and the lapse rate and profitability of policies; •major public health issues, and specifically the COVID-19 pandemic and the resulting impacts on economic conditions and financial markets; •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 fixed 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 theSEC . For a detailed discussion of these and other factors that might affect our performance, see Item 1A of our Annual Report on Form 10-K for the year endedDecember 31, 2020 and Item 1A of our Quarterly Report on Form 10-Q for the quarterly period endedSeptember 30, 2021 . Forward-looking statements speak only as of the date the statement was made and the Company undertakes no obligation to update such forward-looking statements. There can be no assurance that other factors not currently disclosed or anticipated by the Company will not materially adversely affect our results of operations or plans. Investors are cautioned not to place undue reliance on any forward-looking statements made by us or on our behalf. Our Business and Profitability We specialize in the sale of individual annuities (primarily fixed and fixed index deferred annuities) through independent marketing organizations ("IMOs"), agents, banks and broker-dealers. Fixed and fixed index annuities are an important product for Americans looking to fund their retirement needs as annuities have the ability to provide retirees a paycheck for life. UnderU.S. 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 charges assessed against policy withdrawals and fees deducted from policyholder account balances for lifetime income benefit riders, net realized gains (losses) on investments and changes in fair value of derivatives. Components of expenses for products accounted for as deposit liabilities are interest sensitive and index product benefits (primarily interest credited to account balances and changes in the liability for lifetime income benefit riders), changes in fair value of embedded derivatives, amortization of deferred sales inducements and deferred policy acquisition costs, other operating costs and expenses and income taxes. 34 -------------------------------------------------------------------------------- Table of Contents 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 credit losses, •our ability to appropriately price for lifetime income benefit riders offered on certain of our fixed rate and fixed index annuity policies, •our ability to manage interest rates credited to policyholders and costs of the options purchased to fund the annual index credits on our fixed index annuities, •our ability to manage the costs of acquiring new business (principally commissions paid to agents and distribution partners and bonuses credited to policyholders), •our ability to manage our operating expenses, and •income taxes. We are implementing an updated strategy, referred to as AEL 2.0, after having undertaken a thorough review of our business in 2020. AEL 2.0 is designed to capitalize on the scarcity value of our annuity origination platform and couple it with an "open architecture" investment management platform for investing the annuity assets. Our approach to investment management is to partner with best in class investment management firms across a wide array of asset classes and capture part of the asset management value chain economics for our shareholders. This will enable us to operate at the intersection of both asset management and insurance. Our updated strategy focuses on four key pillars: Go-to-Market, Investment Management, Capital Structure and Foundational Capabilities. The Go-to-Market pillar focuses on how we generate long-term client assets, referred to as policyholder funds under management, through annuity product sales. We consider our marketing capabilities and franchise to be one of our core competitive strengths. The liabilities we expect to originate will result in stable, long-term attractive funding, which we will invest to earn a spread and return over the prudent level of risk capital.American Equity Life has become one of the leading insurance companies in the IMO distribution channel over our 25-year history and can tap into a core set of loyal independent producers to originate new annuity product sales. We are focused on growing our loyal producers withone million dollars or greater of annuity product sales each year. We plan to increase our share of annuity product sales generated by IMOs and accelerate our expansion into bank, broker dealer and registered investment advisor distribution through our subsidiary,Eagle Life Insurance Company ("Eagle Life"). Our strategy is to improve sales execution and enhance producer loyalty with product solutions, focused marketing campaigns, distribution analytics to enhance both sales productivity and producer engagement and new client engagement models that complement traditional physical face-to-face interactions.The Investment Management pillar will enable the return on assets to generate adequate spread income. In an environment where risk free rates remain low, insurers need to invest for better risk-adjusted yields than what are available in traditional fixed income securities. Our investment strategy is to look for opportunities to invest in alpha-producing specialty sub-sectors like middle market credit and sectors with contractually strong cash flows like commercial and residential real estate and infrastructure debt and equity. Our investment management strategy includes forming partnerships with certain asset managers that will provide access to specific asset sectors, resulting in a sustainable supply of quality private investments, in addition to traditional fixed income securities. The partnerships with asset managers may include us taking an equity interest in the asset manager to create greater alignment or forming an alternate economic sharing arrangement so we benefit as our partners scale their platforms with third party assets under management. The Capital Structure pillar is focused on greater use of reinsurance structuring to both optimize asset allocation for our balance sheet and enableAmerican Equity Life to free up capital and become a capital-light company over time. OnOctober 8, 2021 , we completed the previously announced reinsurance transaction with North End Re (Cayman) SPC ("North End Re"), a wholly owned subsidiary of Brookfield Asset Management Reinsurance Partners Ltd. In addition, we continue to work diligently on the formation of our own reinsurance platform, as well as working on other potential reinsurance arrangements. These transactions will enable us to achieve three business outcomes over time: first, free up capital to potentially return to shareholders, second, redeploy capital into higher yielding alpha generating assets to grow investment income relative to new money yields in a traditional core fixed income portfolio and third, successfully demonstrating the first two outcomes will allow us to raise third-party capital into reinsurance vehicles ("side-cars") to provide risk capital to back a portion of our existing liabilities and future sales of annuity products. This will enable us to convert from an investment spread business with our own capital at risk into a combination spread based and fee based business with externally sourced risk capital. In combination, we expect these three outcomes to generate sustained, deployable capital for shareholders and significant accretion in return on equity ("ROE") over time. The Foundational Capabilities pillar is focused on upgrading our operating platform to enhance the digital customer experience, create differentiation through data analytics to support the first three pillars, enhance core technology and align talent. We have maintained high quality personal service as one of our highest priorities since our inception and continue to strive for an unprecedented level of timely and accurate service to both our agents and policyholders. Examples of our high quality service include a live person answering phone calls and issuing policies within 24 hours of receiving the application if the paperwork is in good order. We believe high quality service is one of our strongest competitive advantages and the foundational capabilities pillar will look to continue to enhance our high quality service. The combination of differentiated investment strategies and increased capital efficiency will improve annuity product competitiveness, thereby enhancing new business growth potential and further strengthening the operating platform. This will complete the virtuous cycle of the AEL 2.0 business model, having started with a strong, at scale annuity originator, that is even further strengthened by the power of the investments and capital structure pillars. 35 -------------------------------------------------------------------------------- Table of Contents The migration towards the AEL 2.0 business model will result in 2021 being a transitionary year for our financial results. We are migrating a fairly large balance sheet from a legacy core fixed income asset strategy with relatively higher asset leverage to a new asset allocation approach encompassing lower asset leverage, capital structure optimization through reinsurance and third-party capital, and utilization of alpha-producing assets to both improve sustainability of investment results in a low-interest rate environment and deliver superior, loss adjusted net yield over time. The scaling of alpha-producing assets is expected to be a multi-year journey. We have added in excess of$2 billion in private assets during 2021 and expect to grow such assets at a pace of 5% or greater of the portfolio in each subsequent year to evolve into our new asset allocation of 30% to 40% in private assets. During 2021, we have made progress in the execution of the AEL 2.0 strategy. Key areas of progress include the following: •we continued revitalization of our Go-to-Market strategy pillar. We delivered a complete refresh of our general account product suite, regained relevance and growth in the IMO distribution channel and built additional distribution with Eagle Life. Go-to-Market has been trending upward since the fourth quarter of last year. Our fixed index annuity sales were driven by the new competitive indices we introduced to the AssetShield product in February. At Eagle Life, the increase in fixed index annuity sales was driven by new relationships, a new income product, and an increase in our employee wholesaler team; •we continued to build out our investment management pillar capabilities. We began to leverage our asset management partnerships to invest in single-family rental homes, middle market loans and agricultural and residential loans consistent with ramping towards the AEL 2.0 asset allocation strategy. Year-to-date, including residential mortgage loans, single family rental homes, commercial mortgage and agricultural loans and middle market loans, we have invested in approximately$2.5 billion in privately sourced assets. We are in process of transitioning the management of our core fixed income and private placement investments toBlackRock Financial Management, Inc. andConning, Inc. •we finalized a reinsurance treaty with North End Re, a wholly owned subsidiary of Brookfield Asset Management Reinsurance Partners Ltd. that covers both a portion of our in-force and new business flow which will provide attractive fee-like revenues that will start to drive our evolution to a higher return on equity business through building a capital efficient, return on assets fee-like earnings model. See Note 8 - Reinsurance and Policy Provisions for more information. OnOctober 18, 2020 , the Company's Board of Directors approved a$500 million share repurchase program. The purpose of the share repurchase program is to both offset dilution from the issuance of shares to Brookfield Asset Management (including its affiliates "Brookfield"), and to institute a regular capital return program for shareholders. OnJuly 1, 2021 , we completed our share-repurchase of 9.1 million shares since starting our buyback in the fourth quarter of last year, which fully offset the impact of shares issued to Brookfield. As ofSeptember 30, 2021 , we have repurchased approximately 9.1 million shares of our common stock at an average price of$29.04 per common share since the beginning of the share repurchase program inOctober 2020 . OnApril 14, 2021 , Fitch affirmed its "A-" financial strength rating onAmerican Equity Investment Life Insurance Company and its life insurance subsidiaries, its "BBB" issuer default rating onAmerican Equity Investment Life Holding Company and its "BBB-" senior unsecured debt ratings, and revised its outlook to "stable" from "negative" on its financial strength, issuer default and senior unsecured debt ratings. OnJuly 29, 2021 ,A.M. Best affirmed its "A-" financial strength rating onAmerican Equity Investment Life Insurance Company and its subsidiaries,American Equity Investment Life Insurance Company of New York andEagle Life Insurance Company , its "bbb-" long-term issuer credit rating ofAmerican Equity Investment Life Holding Company , its "bbb-" senior unsecured debt ratings, and its "bb" perpetual, non-cumulative preferred stock ratings. The outlook for these credit ratings of "stable" was also affirmed byA.M. Best onJuly 29, 2021 . 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: Three Months Ended Nine Months Ended September 30, September 30, 2021 2020 2021 2020 Average yield on invested assets 3.91% 4.10% 3.71% 4.20% Aggregate cost of money 1.51% 1.66% 1.55% 1.71% Aggregate investment spread 2.40% 2.44% 2.16% 2.49% Impact of: Investment yield - additional prepayment income 0.12% 0.10% 0.11% 0.06% Cost of money benefit from over hedging 0.08% 0.03% 0.05% 0.03% 36 -------------------------------------------------------------------------------- Table of Contents The cost of money for fixed 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 in our Annual Report on Form 10-K for the year endedDecember 31, 2020 . With respect to our fixed index annuities, the cost of money includes the average crediting rate on amounts allocated to the fixed rate strategy and expenses we incur to fund the annual index credits. Proceeds received upon expiration 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 - Policy Liabilities for Fixed Index Annuities and Financial Condition - Derivative Instruments included in Management's Discussion and Analysis in our Annual Report on Form 10-K for the year endedDecember 31, 2020 . Average yield on invested assets decreased primarily as a result of a higher level of cash and cash equivalent holdings during the three and nine months endedSeptember 30, 2021 compared to the same periods in 2020. The higher level of cash and cash equivalent holdings was a result of our decision to execute a series of trades in the fourth quarter of 2020 designed to raise liquidity to fund block reinsurance transactions and de-risk the investment portfolio. See Net investment income. Active management of policyholder crediting rates has continued to lower the aggregate cost of money. We expect to have flexibility to reduce our crediting rates if necessary and could decrease our cost of money by approximately 58 basis points if we reduce current rates to guaranteed minimums. Results of Operations for the Three and Nine Months EndedSeptember 30, 2021 and 2020 Annuity deposits by product type collected during the three and nine months endedSeptember 30, 2021 and 2020, were as follows: Three Months Ended Nine Months Ended September 30, September 30, 2021 2020 2021 2020 (Dollars in thousands)American Equity Investment Life Insurance Company : Fixed index annuities$ 727,641 $ 432,602 $ 1,947,241 $ 1,491,564 Annual reset fixed rate annuities 1,462 1,817 5,285 6,464 Multi-year fixed rate annuities 14,196 531 849,062 983 Single premium immediate annuities 16,282 10,205 45,671 25,687 759,581 445,155 2,847,259 1,524,698Eagle Life Insurance Company : Fixed index annuities 187,611 60,476 520,967 239,349 Annual reset fixed rate annuities - 39 337 97 Multi-year fixed rate annuities 362,769 68,206 1,556,391 73,386 550,380 128,721 2,077,695 312,832 Consolidated: Fixed index annuities 915,252 493,078 2,468,208 1,730,913 Annual reset fixed rate annuities 1,462 1,856 5,622 6,561 Multi-year fixed rate annuities 376,965 68,737 2,405,453 74,369 Single premium immediate annuities 16,282 10,205 45,671 25,687 Total before coinsurance ceded 1,309,961 573,876 4,924,954 1,837,530 Coinsurance ceded 203,218 5,996 209,968 29,390 Net after coinsurance ceded$ 1,106,743 $ 567,880
Annuity deposits before and after coinsurance ceded increased 128% and 95%, respectively, during the third quarter of 2021 compared to the same period in 2020 and increased 168% and 161%, respectively, during the nine months endedSeptember 30, 2021 compared to the same period in 2020. The increases in sales in for the three and nine months endedSeptember 30, 2021 compared to the same periods in 2020 were driven by the sales of multi-year fixed rate annuity products introduced in late 2020 at bothAmerican Equity Life and Eagle Life and increased sales of fixed index annuities at bothAmerican Equity Life and Eagle Life. We are focused on our fixed index annuity products with recent product refreshes and the new EstateShield product atAmerican Equity Life and the addition of a guaranteed retirement income product at Eagle Life. We are targeting total sales of$5 billion to$6 billion in 2021. Prior toJanuary 1, 2021 , we had been ceding 80% of the annuity deposits received from certain multi-year rate guaranteed annuities and 20% of certain fixed index annuities sold by Eagle Life through broker/dealers and banks to an unaffiliated reinsurer. BeginningJanuary 1, 2021 , no new business is being ceded to the unaffiliated reinsurer. EffectiveJuly 1, 2021 , we ceded 100% of an in-force block of fixed index annuities and began ceding 75% of certain fixed index annuities issued afterJuly 1, 2021 to Brookfield which caused the increases in coinsurance ceded premiums for the three and nine months endedSeptember 30, 2021 compared to the same periods in 2020. Net income available to common stockholders decreased to$141.9 million in the third quarter of 2021 and$348.1 million for the nine months endedSeptember 30, 2021 compared to$661.3 million and$644.2 million for the same periods in 2020. The decreases in net income available to common stockholders for the three and nine months endedSeptember 30, 2021 were driven primarily by the impact of assumption updates during the third quarter of 2021 compared to the impact of assumption updates during the third quarter of 2020 as further described below. 37 -------------------------------------------------------------------------------- Table of Contents Net income available to common stockholders for the three and nine months endedSeptember 30, 2021 was negatively impacted by a decrease in the aggregate investment spread as previously noted. Net income, in general, is impacted by the volume of business in force and the investment spread earned on this business. The average amount of annuity account balances outstanding (net of annuity liabilities ceded under coinsurance agreements) decreased 1% to$52.6 billion for the third quarter of 2021 and increased 3% to$54.6 billion for the nine months endedSeptember 30, 2021 compared to$53.1 billion and$53.2 billion for the same periods in 2020. Our investment spread measured in dollars was$323.2 million for the third quarter of 2021 and$876.0 million for the nine months endedSeptember 30, 2021 compared to$318.2 million and$966.3 million for the same periods in 2020. Our investment spread has been negatively impacted by the extended low interest rate environment and by holding higher levels of cash and cash equivalents (see Net investment income). The higher levels of cash and cash equivalent holdings will decrease in the fourth quarter of 2021 with the execution of the reinsurance treaty with North End Re which closed onOctober 8, 2021 . We expect to invest most of the cash balances above our target cash levels into traditional fixed income securities and privately sourced assets during the rest of 2021. The impact of the extended low interest rate environment and higher cash and cash equivalent holdings has been partially offset by a lower aggregate cost of money due to our continued active management of new business and renewal rates. Net income available to common stockholders for the three and nine months endedSeptember 30, 2021 was negatively impacted by an increase in other operating costs and expenses (see Other operating costs and expenses). We expect operating costs to trend higher in the near term, as we will build out the necessary infrastructure to continue execution of the AEL 2.0 strategy. We expect the level of other operating costs and expenses to settle into the high$40 million range each quarter beginning during 2022, post refinancing our existing redundant reserve financing facilities. Net income was also impacted by the change in the fair value of derivatives and embedded derivatives, which fluctuates from period to period based upon changes in fair values of call options purchased to fund the annual index credits for fixed index annuities and changes in interest rates used to discount the embedded derivative liability. Net income for the three and nine months endedSeptember 30, 2021 was positively impacted by decreases in expected index credits on the next policy anniversary dates resulting from decreases in the fair value of the call options acquired to fund these index credits and net increases in the discount rates use to estimate the fair value of our embedded derivative liabilities, the impact of which was partially offset by increases in amortization of deferred policy acquisition costs and deferred sales inducements related to the change in fair value of derivatives and embedded derivatives. Net income (loss) for the three and nine months endedSeptember 30, 2020 was negatively impacted by net decreases in the discount rates used to estimate the fair value of our embedded derivative liabilities, the impact of which was partially offset by decreases in amortization of deferred policy acquisition costs and deferred sales inducements related to the change in fair value of derivatives and embedded derivatives. See discussion below for the drivers of changes in net income as a result of actuarial assumption updates. See Change in fair value of derivatives, Change in fair value of embedded derivatives, Amortization of deferred sales inducements and Amortization of deferred policy acquisition costs. We periodically update the key assumptions used in the calculation of amortization of deferred policy acquisition costs and deferred sales inducements retrospectively through an unlocking process when estimates of current or future gross profits/margins (including the impact of realized investment gains and losses) to be realized from a group of products are revised. In addition, we periodically update the assumptions used in determining the liability for lifetime income benefit riders and the embedded derivative component of our fixed index annuity policy benefit reserves as experience develops that is different from our assumptions. Net income available to common stockholders for the 2021 and 2020 periods includes effects from updates to assumptions as follows: Three Months Ended Nine Months Ended September 30, September 30, 2021 2020 2021 2020 (Dollars in thousands) (Decrease) increase in amortization of deferred sales inducements$ (51,412) $ 391,428 $ (51,412) $ 428,101 (Decrease) increase in amortization of deferred policy acquisition costs (52,602) 589,209 (52,602) 646,785 Increase in interest sensitive and index product benefits 233,178 285,825 233,178 285,825 Decrease in change in fair value of embedded derivatives (125,752) (2,111,140) (125,752) (2,341,279) Effect on net income available to common stockholders (2,678) 663,073 (2,678) 769,611 We review these assumptions quarterly and as a result of these reviews, we made updates to assumptions in the third quarter of 2021 and the second and third quarters of 2020. The most significant assumption updates made in the third quarter of 2021 were to investment spread assumptions, including the net investment earned rate and crediting rate on policies, lifetime income benefit rider utilization assumptions, mortality assumptions, and lapse rate assumptions as discussed below. Due to the continued low interest rate environment, we updated our assumption for investment spread forAmerican Equity Life to 2.25% in the near term and increasing to 2.50% over an eight-year reversion period and our assumption for crediting/discount rate to 1.55% increasing to 2.10% over an eight-year reversion period. Prior to these assumption updates, our long-term assumption for aggregate investment spread was at 2.60% at then end of an eight-year reversion period, with a near term crediting/discount rate of 1.90% increasing to 2.10% over an eight-year reversion period. The assumption change to decrease aggregate investment spread resulted in lower expected future gross profits as compared to previous estimates and a decrease in the balances of deferred policy acquisition costs and deferred sales inducements. We updated lapse rate and mortality assumptions based on historical experience. For certain annuity products without a lifetime income benefit rider, the lapse rate assumption was increased in more recent cohorts to reflect higher lapses on polices with a market value adjustment 38 -------------------------------------------------------------------------------- Table of Contents ("MVA") feature. For other annuity products with a lifetime income benefit rider, the population was bifurcated based on whether policies had utilized the rider. For those policies which had utilized the rider, the lapse rate assumption was decreased in later durations. The overall mortality assumption was lowered to reflect historical experience. The net impact of the updates to the lapse rate and mortality assumptions resulted in higher expected future gross profits as compared to previous estimates and an increase in the balances of deferred policy acquisition costs and deferred sales inducements. The net impact of the updates to lapse rate and mortality assumptions resulted in an increase in the liability for lifetime income benefit riders due to a greater amount of expected benefit payments in excess of account values. We updated the lifetime income benefit rider utilization assumption based on historical experience. The ultimate utilization assumption was lowered for policies with a fee rider and certain policies with a no-fee rider. In addition, the utilization assumption was changed to reflect seasonality with higher utilization rates during the first quarter of each year. The net impact of the updates to the utilization assumption resulted in a decrease in the liability for lifetime income benefit riders due to a lower amount of expected benefits payments due to lower expected utilization. The net impact of the updates to the utilization assumption resulted in higher expected future gross profits as compared to previous estimates and an increase in the balances of deferred policy acquisition costs and deferred sales inducements. The most significant assumption update to the calculation of the fair value of the embedded derivative component of our fixed index annuity policy benefit reserve in the third quarter of 2021 was the change in lapse rate assumptions discussed above. The net impact of the updates to the lapse rate assumption resulted in a decrease in the embedded derivative component of our fixed index annuity policy benefit reserves as less funds ultimately qualify for excess benefits. The most significant assumption updates made in the third quarter of 2020 were to investment spread assumptions, including the net investment earned rate and crediting rates on policies, as well as updates to lapse rate and partial withdrawal assumptions as discussed below. Due to the economic and low interest rate environments, we updated our assumption for aggregate investment spread to 2.40% in the near-term increasing to 2.60% over an eight-year reversion period and our assumption for crediting/discount rate to 1.60% increasing to 2.10% over an eight-year reversion period. Prior to these assumption updates, our long-term assumption for aggregate investment spread was steady at 2.60%, with a near term crediting/discount rate of 1.90% increasing to 2.90% over a 20-year reversion period. The assumption update to decrease aggregate investment spread resulted in lower expected future gross profits as compared to previous estimates and a decrease in the balances of deferred policy acquisition costs and deferred sales inducements. The decrease in the crediting rate, which is used as the discount rate in the calculation of the liability for lifetime income benefit riders, resulted in an increase in the liability for lifetime income benefit riders. We updated lapse rate and partial withdrawal assumptions based on actual historical experience. For certain annuity products without a lifetime income benefit rider, lapse rate and partial withdrawal assumptions were increased while for certain annuity products with a lifetime income benefit rider, lapse rate and partial withdrawal assumptions were decreased. The net impact of the updates to lapse rate and partial withdrawal assumptions resulted in lower expected future gross profits as compared to previous estimates and a decrease in the balances of deferred policy acquisition costs and deferred sales inducements. The net impact of the updates to lapse rate and partial withdrawal assumptions resulted in an increase in the liability for lifetime income benefit riders due to a greater amount of expected benefit payments in excess of account values. The most significant assumption update to the calculation of the fair value of the embedded derivative component of our fixed index annuity policy benefit reserves in the third quarter of 2020 was a decrease in the crediting rate/option budget to 2.10% from 2.90% as a result of a revised estimate of the cost of options. This assumption change resulted in a decrease in the fair value of the embedded derivative component of our fixed index annuity policy benefit reserves due to a reduction in the projected policy contract values over the expected lives of the contracts. The net impact of the the updates to lapse and partial withdrawal assumptions noted above resulted in an increase in the embedded derivative component of our fixed index annuity policy benefit reserves as more funds ultimately qualify for excess benefits. During the second quarter of 2020, we updated assumptions used in determining the embedded derivative component of our fixed index annuity policy benefit reserves. The revision consisted of a refinement in the derivation of the discount rate used in calculating the fair value of embedded derivatives which increased the discount rate and resulted in a decrease in the change in fair value of embedded derivatives offset by increases in amortization of deferred sales inducements and deferred policy acquisition costs. Net income available to common stockholders for the three and nine months endedSeptember 30, 2020 was negatively impacted by net realized losses on investments primarily as a result of credit losses on available for sale fixed maturity securities (see Net realized gains on investments). Net income for the nine months endedSeptember 30, 2020 was impacted by a discrete tax item that provided a tax benefit of$30.1 million related to the provision of the Coronavirus Aid, Relief, and Economic Security Act that allowed net operating losses for 2018 through 2020 to be carried back to previous tax years in which a 35% statutory tax rate was in effect. Non-GAAP operating income (loss) available to common stockholders, a non-GAAP financial measure, increased to$79.5 million in the third quarter of 2021 and$214.7 million for the nine months endedSeptember 30, 2021 compared to$(249.8) million and$(2.6) million for the same periods in 2020. 39 -------------------------------------------------------------------------------- Table of Contents In addition to net income available to common stockholders, we have consistently utilized non-GAAP operating income (loss) available to common stockholders, a non-GAAP financial measure commonly used in the life insurance industry, as an economic measure to evaluate our financial performance. Non-GAAP operating income (loss) available to common stockholders equals net income available to common stockholders adjusted to eliminate the impact of items that fluctuate from quarter to quarter in a manner unrelated to core operations, and we believe measures excluding their impact are useful in analyzing operating trends. The most significant adjustments to arrive at non-GAAP operating income (loss) available to common stockholders eliminate the impact of fair value accounting for our fixed index annuity business and are not economic in nature but rather impact the timing of reported results. We believe the combined presentation and evaluation of non-GAAP operating income (loss) available to common stockholders together with net income available to common stockholders provides information that may enhance an investor's understanding of our underlying results and profitability. Non-GAAP operating income (loss) available to common stockholders is not a substitute for net income available to common stockholders determined in accordance with GAAP. The adjustments made to derive non-GAAP operating income (loss) available to common stockholders are important to understand our overall results from operations and, if evaluated without proper context, non-GAAP operating income (loss) available to common stockholders possesses material limitations. As an example, we could produce a low level of net income available to common stockholders or a net loss available to common stockholders in a given period, despite strong operating performance, if in that period we experience significant net realized losses from our investment portfolio. We could also produce a high level of net income available to common stockholders in a given period, despite poor operating performance, if in that period we generate significant net realized gains from our investment portfolio. As an example of another limitation of non-GAAP operating income (loss) available to common stockholders, it does not include the decrease in cash flows expected to be collected as a result of credit losses on financial assets. Therefore, our management reviews net realized investment gains (losses) and analyses of our net investment income, including impacts related to credit losses, in connection with their review of our investment portfolio. In addition, our management examines net income available to common stockholders as part of their review of our overall financial results. The adjustments made to net income available to common stockholders to arrive at non-GAAP operating income (loss) available to common stockholders for the three and nine months endedSeptember 30, 2021 and 2020 are set forth in the table that follows: Three Months Ended Nine Months Ended September 30, September 30, 2021 2020 2021 2020 (Dollars in thousands) Reconciliation from net income available to common stockholders to non-GAAP operating income (loss) available to common stockholders: Net income available to common stockholders$ 141,947 $ 661,250 $ 348,099 $ 644,207 Adjustments to arrive at non-GAAP operating income (loss) available to common stockholders: Net realized (gains) losses on financial assets, including credit losses (3,900) 15,145 2,528 49,986 Change in fair value of derivatives and embedded derivatives - fixed index annuities (75,879) (1,176,909) (172,746) (873,773) Change in fair value of derivatives - interest rate caps and swap - - - (848) Income taxes 17,285 250,701 36,801 177,804 Non-GAAP operating income (loss) available to common stockholders$ 79,453 $
(249,813)
The amounts disclosed in the reconciliation above are presented net of related
adjustments to amortization of deferred sales inducements and deferred policy
acquisition costs and accretion of lifetime income benefit rider reserves where
applicable.
Non-GAAP operating income (loss) available to common stockholders for
the 2021 and 2020 periods includes effects from updates to assumptions as
follows:
Three and Nine Months
Ended
September 30,
2021 2020
(Dollars in thousands)
(Decrease) increase in amortization of deferred sales
inducements
$ (73,791) $ 57,467
(Decrease) increase in amortization of deferred policy
acquisition costs
(87,029) 90,970 Increase in interest sensitive and index product benefits 233,178 285,825
Effect on non-GAAP operating income (loss) available to common
stockholders
(56,801) (340,895)
The impact to net income available to common stockholders and non-GAAP operating
income (loss) available to common stockholders from assumption updates varies
due to the impact of fair value accounting for our fixed index annuity business
as non-GAAP operating income (loss) available to common stockholders eliminates
the impact of fair value accounting for our fixed index annuity business. While
the assumption updates made during 2021 and 2020 were consistently applied, the
impact to net income available to common stockholders and non-GAAP operating
income (loss) available to common stockholders varies due to different
amortization rates being applied to gross profit adjustments included in the
valuation.
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The changes in non-GAAP operating income (loss) available to common stockholders
for the three and nine months ended September 30, 2021 compared to the same
periods in 2020 were primarily a result of the impact of assumption updates as
previously noted. Non-GAAP operating income (loss) available to common
stockholders adjusted for the impact of updates to assumptions for the three
months ended September 30, 2021 increased compared to the same period in 2020.
The increase is primarily due to a smaller increase in the liability for
lifetime income benefit riders and less amortization of deferred policy
acquisition costs and deferred sales inducements partially offset by lower
investment income and higher other operating costs and expenses. Non-GAAP
operating income (loss) available to common stockholders adjusted for the impact
of updates to assumptions for the nine months ended September 30, 2021 decreased
compared to the same period in 2020. The decrease is primarily due to lower
investment income and higher other operating costs and expenses partially offset
by a smaller increase in the liability for lifetime income benefit riders and
less amortization of deferred policy acquisition costs and deferred sales
inducements. In addition, non-GAAP operating income (loss) available to common
stockholders for the nine months ended September 30, 2020 was impacted by a
$30.1 million tax benefit from a discrete tax item related to the Coronavirus
Aid, Relief, and Economic Security Act. See Net income available to common
stockholders.
Annuity product charges (surrender charges assessed against policy withdrawals
and fees deducted from policyholder account balances for lifetime income benefit
riders) decreased 6% to $58.5 million in the third quarter of 2021 and 2% to
$182.3 million for the nine months ended September 30, 2021 compared to $62.3
million and $185.3 million for the same periods in 2020. The components of
annuity product charges are set forth in the table that follows:
Three Months Ended Nine Months Ended
September 30, September 30,
2021 2020 2021 2020
(Dollars in thousands)
Surrender charges $ 16,481 $ 16,447 $ 54,019 $ 55,542
Lifetime income benefit riders (LIBR)
fees 41,999 45,830 128,302 129,722
$ 58,480 $ 62,277 $ 182,321 $ 185,264
Withdrawals from annuity policies subject
to surrender charges $ 313,557 $ 176,442 $ 875,046 $ 573,419
Average surrender charge collected on
withdrawals subject to surrender charges 5.3 % 9.3 % 6.2 % 9.7 %
Fund values on policies subject to LIBR
fees $ 5,260,739 $ 5,789,502 $ 16,563,433 $ 16,821,767
Weighted average per policy LIBR fee 0.80 % 0.79 % 0.77 % 0.77 %
The decreases in annuity product charges for the three and nine month periods
ended September 30, 2021 compared to the same periods in 2020 were primarily
attributable to decreases in fees assessed for lifetime income benefit riders
due to lower volumes of business in force subject to the fee compared to the
prior periods post the execution of the North End Re reinsurance treaty
effective on July 1, 2021 . In addition, surrender charges decreased for the nine
month period ended September 30, 2021 as the increases in withdrawals from
annuity policies subject to surrender charges were more than offset by lower
average surrender charges collected on those withdrawals due to changes in the
surrender charge levels and offsetting market value adjustments on policies that
were surrendered compared to the same period in 2020. See Interest sensitive and
index product benefits below for corresponding expense recognized on lifetime
income benefit riders.
Net investment income decreased 3% to $526.4 million in the third quarter of
2021 and 8% to $1,522.9 million for the nine months ended September 30, 2021
compared to $543.3 million and $1,660.4 million for the same periods in 2020.
The decreases were principally attributable to decreases in average yield earned
on average invested assets during the three and nine months ended September 30,
2021 compared to the same periods in 2020, partially offset by increases in our
average invested assets during the three and nine months ended September 30,
2021 compared to the same periods in 2020. Average invested assets excluding
derivative instruments (on an amortized cost basis) increased 1% to $53.8
billion for the third quarter of 2021 and 4% to $54.9 billion for the nine
months ended September 30, 2021 compared to $53.0 billion and $52.8 billion for
the same periods in 2020.
The average yield earned on average invested assets was 3.91% for the third
quarter of 2021 and 3.71% for the nine months ended September 30, 2021 compared
to 4.10% and 4.20% for the same periods in 2020. The decreases in average yield
earned for the three and nine months ended September 30, 2021 compared to the
same periods in 2020 were primarily attributable to increases in our level of
cash and cash equivalent holdings as previously described and investment of new
premiums and portfolio cash flows during the first half of 2021 and most of 2020
at average rates below the overall portfolio yield, excluding the impact of cash
and cash equivalent holdings on the overall portfolio yield. Cash and cash
equivalents holdings averaged $6.9 billion during the three months ended
September 30, 2021 , after adjusting for the cash impact to average cash holdings
of the North End Re reinsurance treaty, compared to $1.4 billion during the
three months ended September 30, 2020 . As of September 30, 2021 , we held
approximately $7.6 billion of cash and cash equivalents, after adjusting for the
cash impact to cash holdings of the North End Re reinsurance treaty. We intend
to hold approximately 1% to 2% of our investment portfolio in cash and cash
equivalents once we are fully invested.
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The expected return on investments purchased during the three and nine months
ended September 30, 2021 was 4.63% and 4.07%, net of third-party investment
management expenses. Purchases for the three months ended September 30, 2021
included $23.9 million of fixed maturity securities with an expected return of
3.47% and $375 million of privately sourced assets with an expected return of
4.70%. The privately sourced assets include investments in investment real
estate, middle market loans, mortgage loans and strategic investments in limited
partnerships. The expected return on investments purchased during the three and
nine months ended September 30, 2020 was 4.54% and 4.06%.
Change in fair value of derivatives primarily consists of call options purchased
to fund annual index credits on fixed index annuities. The components of change
in fair value of derivatives are as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
2021 2020 2021 2020
(Dollars in thousands)
Call options:
Gain on option expiration $ 346,674 $ (3,228) $ 1,058,152 $ (2,492)
Change in unrealized gains/losses (418,362) 208,239 (232,771) (406,771)
Warrants 987 - 1,103 -
Interest rate caps - - - 62
$ (70,701) $ 205,011 $ 826,484 $ (409,201)
The differences between the change in fair value of derivatives between periods
for call options are primarily due to the performance of the indices upon which
our call options are based which impacts the level of gains on call option
expirations, the fair values of those call options and changes in the fair
values of those call options between periods. The changes in gain on option
expiration and unrealized gains/losses on call options for the three and nine
months ended September 30, 2021 compared to the same periods in 2020 reflect the
impact of the recovery of the equity markets subsequent to the equity markets
decline in March of 2020 related to the economic uncertainty caused by the
COVID-19 pandemic. 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 (after applicable caps, participation
rates and asset fees) for options expiring during the three and nine months
ended September 30, 2021 and 2020 is as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
2021 2020 2021 2020
S&P 500 Index
Point-to-point strategy 1.0% - 17.6% 0.6% - 11.6% 0.0% - 42.6% 0.0% - 17.4%
Monthly average strategy 1.0% - 12.2% 0.0% - 8.0% 0.0% - 29.4% 0.0% - 11.9%
Monthly point-to-point strategy 0.4% - 20.2% 0.0% - 0.2% 0.0% - 21.7% 0.0% - 14.0%
Volatility control index point-to-point
strategy 0.0% - 8.3% 0.0% - 1.4% 0.0% - 9.7% 0.0% - 9.3%
Fixed income (bond index) strategies 0.0% - 4.7% 0.0% - 11.1% 0.0% - 10.0% 0.0% - 13.6%
The change in fair value of derivatives is also influenced by the aggregate cost
of options purchased. The aggregate cost of options for the three and nine
months ended September 30, 2021 were lower than for the same periods in 2020 as
option costs generally decreased during 2020 and into 2021. 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. See
Critical Accounting Policies - Policy Liabilities for Fixed Index Annuities
included in Management's Discussion and Analysis in our Annual Report on Form
10-K for the year ended December 31, 2020 .
Net realized gains (losses) on investments includes gains and losses on the sale
of securities and other investments and changes in allowances for credit losses
on our securities and mortgage loans on real estate. Net realized gains (losses)
on investments fluctuate from year to year primarily due to changes in the
interest rate and economic environment and the timing of the sale of
investments. See Note 4 and Note 5 to our unaudited consolidated financial
statements and Financial Condition - Credit Losses for a detailed presentation
of the types of investments that generated the gains (losses) as well as
discussion of credit losses on our securities recognized during the periods
presented and Financial Condition - Investments and Note 5 to our unaudited
consolidated financial statements for discussion of credit losses recognized on
mortgage loans on real estate.
Securities sold at losses are generally due to our long-term fundamental concern
with the issuers' ability to meet their future financial obligations or to
improve our risk or duration profiles as they pertain to our asset liability
management.
Other revenue was $7.6 million for the three and nine months ended September 30,
2021 and primarily consists of $2.7 million related to asset liability
management fees and $4.5 million of amortization related to the deferred gain
associated with the cost of reinsurance. Both of these items are associated with
the North End Re reinsurance treaty which was effective July 1, 2021 . See Note 8
- Reinsurance and Policy Provisions for more information.
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Interest sensitive and index product benefits increased 42% to $817.0 million in
the third quarter of 2021 and 73% to $2.1 billion for the nine months ended
September 30, 2021 compared to $576.1 million and $1.2 billion for the same
periods in 2020. The components of interest sensitive and index product benefits
are summarized as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
2021 2020 2021 2020
(Dollars in thousands)
Index credits on index policies $ 475,292 $ 174,747 $ 1,535,320 $ 551,562
Interest credited (including changes in
minimum guaranteed interest for fixed
index annuities) 65,637 48,042 188,279 148,078
Lifetime income benefit riders 276,085 353,358 382,991 517,718
$ 817,014 $ 576,147 $ 2,106,590 $ 1,217,358
The increases in index credits for the three and nine months ended September 30,
2021 compared to the same periods in 2020 were due to changes in the level of
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 $489.9 million and
$1,559.5 million for the three and nine months ended September 30, 2021 ,
compared to $178.4 million and $560.7 million for the same periods in 2020. The
increases in interest credited for the three and nine months ended September 30,
2021 compared to the same periods in 2020 were due to increases in sales of
single premium deferred annuity products that receive a fixed rate of interest
partially offset by a reduction in interest credited to funds allocated to the
fixed option within our fixed index annuities due to a decrease in the average
balance allocated to the fixed option. The decreases in benefits recognized for
lifetime income benefit riders for the three and nine months ended September 30,
2021 compared to the same periods in 2020 were primarily due to the impact of
assumption updates made during the third quarter of 2021 compared to the impact
of assumption updates made during the third quarter of 2020 and the level of
index credits on index policies for the three and nine months ended September
30, 2021 compared to the same periods in 2020. In addition, fund value of
policies with lifetime income benefit riders decreased as a result of the North
End Re reinsurance treaty, which correlates to the decrease in fees discussed in
Annuity product charges.
The liability (net of coinsurance ceded) for lifetime income benefit riders was
$2.7 billion and $2.5 billion at September 30, 2021 and December 31, 2020 ,
respectively which includes the impact of unrealized gains and losses on
available for sale securities on the liability for lifetime income benefit
riders of $461.9 million and $584.6 million at September 30, 2021 and
December 31, 2020 , respectively.
Amortization of deferred sales inducements before gross profit adjustments
decreased for the three and nine months ended September 30, 2021 compared to the
same periods in 2020. Amortization of deferred sales inducements is based on
historical, current and future expected gross profits. The changes in
amortization from period to period are the result of differences in actual gross
profits compared to expected or modeled gross profits and changes to the
underlying business. The decreases in amortization before and after gross profit
adjustments for the three and nine months ended September 30, 2021 compared to
the same periods in 2020 were primarily due to the impact of assumption updates
made during the third quarter of 2021 as compared to the impact of assumption
updates made during the third quarter of 2020. See Net Income available to
common stockholders and Non-GAAP operating income (loss) available to common
stockholders above for discussion of the impact of assumption updates for the
three and nine months ended September 30, 2021 and 2020. In addition,
amortization of deferred sales inducements for the three and nine months ended
September 30, 2021 decreased as index credits on index policies for the three
and nine months ended September 30, 2021 were in excess of index credits on
index policies for the same periods of 2020. Bonus products represented 67% and
76% of our net annuity account values at September 30, 2021 and September 30,
2020 , respectively. The amount of amortization is affected by amortization
associated with fair value accounting for derivatives and embedded derivatives
utilized in our fixed index annuity business and amortization associated with
net realized gains (losses) on investments. Fair value accounting for
derivatives and embedded derivatives utilized in our fixed index annuity
business creates differences in the recognition of revenues and expenses from
derivative instruments including the embedded derivative liabilities in our
fixed index annuity contracts. The change in fair value of the embedded
derivatives will not correspond to the change in fair value of the 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 lives of the contracts which typically exceed ten years.
Amortization of deferred sales inducements is summarized as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
2021 2020 2021 2020
(Dollars in thousands)
Amortization of deferred sales inducements
before gross profit adjustments $ (34,854) $ 113,273 $ 57,887 $ 197,514
Gross profit adjustments:
Fair value accounting for derivatives and
embedded derivatives 17,613 305,981 35,752 224,938
Net realized losses on investments 69 (2,271) (356) (7,056)
Amortization of deferred sales inducements
after gross profit adjustments $ (17,172) $ 416,983
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Change in fair value of embedded derivatives includes changes in the fair value
of our fixed index annuity embedded derivatives (see Note 7 to our unaudited
consolidated financial statements). The components of change in fair value of
embedded derivatives are as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
2021 2020 2021 2020
(Dollars in thousands)
Fixed index annuities - embedded
derivatives $ (681,509) $ (2,021,513) $ (932,546) $ (2,392,600)
Other changes in difference between policy
benefit reserves computed using derivative
accounting vs. long-duration contracts
accounting 145,105 289,016 387,442 536,977
$ (536,404) $ (1,732,497) $ (545,104) $ (1,855,623)
The change in fair value of the fixed index annuity embedded derivatives
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 those index credits discussed above in Change in fair
value of derivatives; (ii) changes in the expected annual cost of options we
will purchase in the future to fund index credits beyond the next policy
anniversary; (iii) changes in the discount rates used in estimating our embedded
derivative liabilities; and (iv) the growth in the host component of the policy
liability. The amounts presented as "Other changes in difference between policy
benefit reserves computed using derivative accounting vs. long-duration
contracts accounting" represent the total change in the difference between
policy benefit reserves for fixed index annuities computed under the derivative
accounting standard and the long-duration contracts accounting standard at each
balance sheet date, less the change in fair value of our fixed index annuities
embedded derivative. See Critical Accounting Policies - Policy Liabilities for
Fixed Index Annuities included in Management's Discussion and Analysis in our
Annual Report on Form 10-K for the year ended December 31, 2020 .
The primary reason for the increases in the change in fair value of the fixed
index annuity embedded derivatives during the three and nine months nine months
ended September 30, 2021 compared to the same periods of 2020 was the impact of
assumption updates made during the third quarter of 2021 compared to the impact
of assumption updates made during the third quarter of 2020. See Net Income
available to common stockholders above for discussion of the impact of
assumption updates on the fair value of the fixed index annuity embedded
derivative for the three and nine months ended September 30, 2021 and 2020.
In addition, the increase in the change in fair value of the fixed index annuity
embedded derivatives during the three months ended September 30, 2021 compared
to the same period of 2020 was due to a decrease in expected index credits on
the next policy anniversary dates resulting from decreases in the fair value of
the call options acquired to fund these index credits during the three months
ended September 30, 2021 compared to increases in the expected index credits
resulting from increases in the fair value of the call options acquired to fund
these index credits during the three months ended September 30, 2020 and an
increase in the net discount rate during the three months ended September 20,
2021 compared to a decrease in the net discount rate during the same period of
2020. The increase in change in fair value of the fixed index annuity embedded
derivatives for the nine months ended September 30, 2021 was also due to an
increase in the net discount rate during the nine months ended September 20,
2021 compared to a decrease in the net discount rate during the same period of
2020. The discount rates used in estimating our embedded derivative liabilities
fluctuate based on the changes in the general level of risk free interest rates
and our own credit spread.
Amortization of deferred policy acquisition costs before gross profit
adjustments decreased for the three and nine months ended September 30, 2021
compared to the same periods in 2020. Amortization of deferred policy
acquisition costs is based on historical, current and future expected gross
profits. The changes in amortization from period to period are the result of
differences in actual gross profits compared to expected or modeled gross
profits and changes to the underlying business. The decreases in amortization
before and after gross profit adjustments for the three and nine months ended
September 30, 2021 compared to the same periods in 2020 were primarily due to
the impact of assumption updates made during the third quarter of 2021 as
compared to the impact of assumption updates made during the third quarter of
2020. See Net Income available to common stockholders and Non-GAAP operating
income (loss) available to common stockholders above for discussion of the
impact of assumption updates for the three and nine months ended September 30,
2021 and 2020. In addition, amortization of deferred sales inducements for the
three and nine months ended September 30, 2021 decreased as index credits on
index policies for the three and nine months ended September 30, 2021 were in
excess of index credits on index policies for the same periods of 2020. The
amount of amortization is affected by amortization associated with fair value
accounting for derivatives and embedded derivatives utilized in our fixed index
annuity business and amortization associated with net realized gains (losses) on
investments. As discussed above, fair value accounting for derivatives and
embedded derivatives utilized in our fixed index annuity business creates
differences in the recognition of revenues and expenses from derivative
instruments including the embedded derivative liabilities in our fixed index
annuity contracts.
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Amortization of deferred policy acquisition costs is summarized as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
2021 2020 2021 2020
(Dollars in thousands)
Amortization of deferred policy
acquisition costs before gross profit
adjustments $ (33,190) $ 173,508 $ 106,963 $ 301,004
Gross profit adjustments:
Fair value accounting for derivatives and
embedded derivatives 31,582 452,694 79,107 333,319
Net realized losses on investments 20 (3,606) (741) (10,914)
Amortization of deferred policy
acquisition costs after gross profit
adjustments $ (1,588) $ 622,596
Other operating costs and expenses increased 32% to$56.5 million in the third quarter of 2021 and 38% to$177.4 million for the nine months endedSeptember 30, 2021 compared to$42.7 million and$128.3 million for the same periods in 2020 and are summarized as follows: Three Months Ended Nine Months Ended September 30, September 30, 2021 2020 2021 2020 (Dollars in thousands) Salary and benefits$ 33,733 $ 24,966 $ 97,441 $ 68,953 Risk charges 9,608 11,387 33,404 33,334 Other 13,177 6,385
46,588 26,028
Total other operating costs and expenses
Salary and benefits for the three and nine months endedSeptember 30, 2021 increased$8.8 million and$28.5 million , respectively, compared to the same periods in 2020. These increases are primarily a result of an increase in salary and benefits of$5.6 million and an increase of$2.2 million related to expense recognized under our equity and cash incentive compensation programs ("incentive compensation programs") for the three months endedSeptember 30, 2021 compared to the same period in 2020 and an increase in salary and benefits of$12.7 million and an increase of$13.6 million related to incentive compensation programs for the nine months endedSeptember 30, 2021 compared to the same period in 2020. The increases in salary and benefits were primarily due to an increased number of employees related to our continued growth and implementation of AEL 2.0. The increases in expenses related to our incentive compensation programs were primarily due to an increase in the expected payouts due to a larger number of employees participating in the programs and higher potential payouts for certain employees participating in the programs. The increases in salary and benefits for the nine months endedSeptember 30, 2021 include$5.1 million of expenses associated with talent transition as we implement the AEL 2.0 strategy. Risk charges decreased for the three months endedSeptember 30, 2021 and increased slightly for the nine months endedSeptember 30, 2021 compared to the same periods in 2020. The decrease in risk charge expense for the three months endedSeptember 30, 2021 is due to a reduction in the excess regulatory reserves ceded as ofSeptember 31, 2021 compared toSeptember 30, 2020 as a result of the recapture of certain excess regulatory reserves ceded as ofSeptember 30, 2021 . These expenses are based on the amount of excess regulatory reserves ceded to an unaffiliated reinsurer. The excess regulatory reserves ceded atSeptember 30, 2021 and 2020 were$1,226.6 million and$1,332.2 million , respectively. Other expenses increased for the three and nine months endedSeptember 30, 2021 compared to the same periods in 2020 primarily as a result of increases in legal and consulting fees related to the implementation of AEL 2.0, increases in depreciation and maintenance expense related to software and hardware assets and increases in agent conference related expenses as a result of conferences being planned as we emerge from the COVID-19 pandemic. Income tax expense was$44.7 million in the third quarter of 2021 and$107.5 million for the nine months endedSeptember 30, 2021 compared to$184.6 million and$143.3 million for the same periods in 2020. The changes in income tax expense were primarily due to changes in income before income taxes as well as changes in the effective income tax rates. The effective income tax rates for the three and nine months endedSeptember 30, 2021 were 22.6% and 22.0%, respectively, and 21.7% and 17.8% for the same periods in 2020, respectively. Income tax expense and the resulting effective tax rate are based upon two components of income (loss) before income taxes ("pretax income") that are taxed at different tax rates. Life insurance income is generally taxed at a statutory rate of approximately 21.5% reflecting the absence of state income taxes for substantially all of the states that the life insurance subsidiaries do business in. The income (loss) for the parent company and other nonlife insurance subsidiaries (the "nonlife insurance group") is generally taxed at a statutory tax rate of 28.7% reflecting the combined federal and state income tax rates. The effective income tax rates resulting from the combination of the income tax provisions for the life and nonlife sources of income (loss) vary from period to period based primarily on the relative size of pretax income from the two sources. 45 -------------------------------------------------------------------------------- Table of Contents The effective tax rates for the three and nine months endedSeptember 30, 2021 and the three months endedSeptember 30, 2020 were not significantly impacted by discrete tax items. The effective tax rate for the nine months endedSeptember 30, 2020 was impacted by a discrete tax item that provided a tax benefit of$30.8 million related to the provision of the Coronavirus Aid, Relief, and Economic Security Act that allowed net operating losses for 2018 through 2020 to be carried back to previous tax years in which a 35% statutory tax rate was in effect. The effective income tax rates excluding the impact of discrete items were 21.62% and 21.63%, respectively, for the three and nine months endedSeptember 30, 2021 and 21.57% and 21.55% for the same periods in 2020, respectively. 46 -------------------------------------------------------------------------------- Table of Contents Financial Condition Investments Our investment strategy is to maximize current income and total investment return through active management while maintaining a responsible asset allocation strategy containing high credit quality investments and providing adequate liquidity to meet our cash obligations to policyholders and others. Our investment strategy is also reflective of insurance statutes, which regulate the type of investments that our life subsidiaries are permitted to make and which limit the amount of funds that may be used for any one type of investment. As previously noted, as part of our AEL 2.0 investment pillar, we intend to ramp up our allocation to private assets in part by partnering with proven asset managers in our focus expansion sectors of commercial real estate, residential real estate including mortgages and single family rental homes, infrastructure debt and equity, middle market lending and lending to revenue, technology and software sector companies. The composition of our investment portfolio is summarized as follows: September 30, 2021 December 31, 2020 Carrying Carrying Amount Percent Amount Percent (Dollars in thousands) Fixed maturity securities: United States Government full faith and credit $ 38,486 0.1 % $ 39,771 0.1 % United States Government sponsored agencies 1,043,351 2.0 % 1,039,551 1.9 %United States municipalities, states and territories 3,596,256 6.9 % 3,776,131 7.0 % Foreign government obligations 195,341 0.4 % 202,706 0.4 % Corporate securities 31,021,887 59.3 % 31,156,827 58.1 % Residential mortgage backed securities 1,053,983 2.0 % 1,512,831 2.8 % Commercial mortgage backed securities 4,138,078 7.9 % 4,261,227 8.0 % Other asset backed securities 4,650,715 8.9 % 5,549,849 10.4 % Total fixed maturity securities 45,738,097 87.5 % 47,538,893 88.7 % Mortgage loans on real estate 4,288,742 8.2 % 4,165,489 7.8 % Real estate 259,262 0.5 % - - % Derivative instruments 990,033 1.9 % 1,310,954 2.4 % Other investments 1,021,226 1.9 % 590,078 1.1 %$ 52,297,360 100.0 %$ 53,605,414 100.0 %Fixed Maturity Securities Our fixed maturity security portfolio is managed to minimize risks such as interest rate changes and defaults or credit losses while earning a sufficient and stable return on our investments. The largest portion of our fixed maturity securities are in investment grade (typically NAIC designation 1 or 2) publicly traded or privately placed corporate securities. A summary of our fixed maturity securities by NRSRO ratings is as follows: September 30, 2021 December 31, 2020 Carrying Percent of Fixed Carrying Percent of Fixed Rating Agency Rating Amount Maturity Securities Amount Maturity Securities (Dollars in thousands) Aaa/Aa/A$ 26,662,952 58.3 %$ 27,883,428 58.7 % Baa 18,109,280 39.6 % 18,408,954 38.7 % Total investment grade 44,772,232 97.9 % 46,292,382 97.4 % Ba 786,584 1.7 % 973,581 2.0 % B 79,414 0.2 % 122,553 0.3 % Caa 40,126 0.1 % 61,037 0.1 % Ca and lower 59,741 0.1 % 89,340 0.2 % Total below investment grade 965,865 2.1 % 1,246,511 2.6 %$ 45,738,097 100.0 %$ 47,538,893 100.0 % 47
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The NAIC's Securities Valuation Office ("SVO") is responsible for the day-to-day
credit quality assessment of securities owned by state regulated insurance
companies. The purpose of such assessment and valuation is for determining
regulatory capital requirements and regulatory reporting. Insurance companies
report ownership to the SVO when such securities are eligible for regulatory
filings. The SVO conducts credit analysis on these securities for the purpose of
assigning a NAIC designation and/or unit price. Typically, if a security has
been rated by an NRSRO, the SVO utilizes that rating and assigns an NAIC
designation based upon the following system:
NAIC Designation NRSRO Equivalent Rating
1 Aaa/Aa/A
2 Baa
3 Ba
4 B
5 Caa
6 Ca and lower
For most of the bonds held in our portfolio the NAIC designation matches the
NRSRO equivalent rating. However, for certain loan-backed and structured
securities, as defined by the NAIC, the NAIC rating is not always equivalent to
the NRSRO rating presented in the previous table. The NAIC has adopted revised
rating methodologies for certain loan-backed and structured securities comprised
of non-agency residential mortgage backed securities ("RMBS") and commercial
mortgage backed securities ("CMBS"). The NAIC's objective with the revised
rating methodologies for these structured securities is to increase the accuracy
in assessing expected losses and use the improved assessment to determine a more
appropriate capital requirement for such structured securities. The revised
methodologies reduce regulatory reliance on rating agencies and allow for
greater regulatory input into the assumptions used to estimate expected losses
from structured securities.
The use of this process by the SVO may result in certain non-agency RMBS and
CMBS being assigned an NAIC designation that is different than the equivalent
NRSRO rating. The NAIC designations for non-agency RMBS and CMBS are based on
security level expected losses as modeled by an independent third party (engaged
by the NAIC) and the statutory carrying value of the security, including any
purchase discounts or impairment charges previously recognized. Evaluation of
non-agency RMBS and CMBS held by insurers using the NAIC rating methodologies is
performed on an annual basis.
Our fixed maturity security portfolio is managed to minimize risks such as
defaults or impairments while earning a sufficient and stable return on our
investments. Our strategy with respect to our fixed maturity securities
portfolio has been to invest primarily in investment grade securities.
Investment grade is NAIC 1 and 2 securities and Baa3/BBB- and better securities
on the NRSRO scale. This strategy meets the objective of minimizing risk while
also managing asset capital charges on a regulatory capital basis.
A summary of our fixed maturity securities by NAIC designation is as follows:
September 30, 2021 December 31, 2020
Percent Percent
of Total of Total
Amortized Carrying Carrying Amortized Carrying Carrying
NAIC Designation Cost Fair Value Amount Amount Cost Fair Value Amount Amount
(Dollars in thousands) (Dollars in thousands)
1 $ 22,823,664 $ 25,508,437 $ 25,508,437 55.8 % $ 23,330,149 $ 26,564,542 $ 26,564,542 55.9 %
2 17,170,505 18,928,256 18,928,256 41.4 % 17,312,485 19,377,013 19,377,013 40.8 %
3 1,066,599 1,107,418 1,107,418 2.4 % 1,292,124 1,299,455 1,299,455 2.7 %
4 145,455 157,196 157,196 0.3 % 282,049 256,651 256,651 0.5 %
5 17,226 15,860 15,860 - % 29,396 16,288 16,288 - %
6 24,091 20,930 20,930 0.1 % 58,533 24,944 24,944 0.1 %
$ 41,247,540 $ 45,738,097 $ 45,738,097 100.0 % $ 42,304,736 $ 47,538,893 $ 47,538,893 100.0 %
The amortized cost and fair value of fixed maturity securities at September 30,
2021, by contractual maturity, are presented in Note 4 to our unaudited
consolidated financial statements in this Form 10-Q, which is incorporated by
reference in this Item 2.
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Unrealized Losses
The amortized cost and fair value of fixed maturity securities that were in an
unrealized loss position were as follows:
Unrealized
Number of Amortized Losses, Net of Allowance for
Securities Cost Allowance Credit Losses Fair Value
(Dollars in thousands)
September 30, 2021
Fixed maturity securities, available
for sale:
United States Government full faith
and credit 1 $ 1,043
United States municipalities, states and territories 20 67,964 (1,188) (2,772) 64,004 Corporate securities 69 599,505 (14,518) (1,006) 583,981 Residential mortgage backed securities 51 126,692 (2,158) (296) 124,238 Commercial mortgage backed securities 62 429,719 (23,405) - 406,314 Other asset backed securities 364 2,467,702 (46,678) - 2,421,024 567$ 3,692,625 $ (87,971) $ (4,074) $ 3,600,580 December 31, 2020 Fixed maturity securities, available for sale: United States Government sponsored agencies 3$ 250,521 $ (46) $ -$ 250,475 United States municipalities, states and territories 14 36,558 (1,044) (2,844) 32,670 Corporate securities 103 856,995 (35,892) (60,193) 760,910 Residential mortgage backed securities 43 173,875 (2,526) (1,734) 169,615 Commercial mortgage backed securities 122 1,034,424 (64,678) - 969,746 Other asset backed securities 558 3,728,144 (146,640) - 3,581,504 843$ 6,080,517 $ (250,826) $ (64,771) $ 5,764,920 The unrealized losses atSeptember 30, 2021 are principally related to the timing of the purchases of certain securities, which carry less yield than those available atSeptember 30, 2021 , and the continued impact the COVID-19 pandemic had on credit markets. Approximately 81% and 75% of the unrealized losses on fixed maturity securities shown in the above table forSeptember 30, 2021 andDecember 31, 2020 , respectively, are on securities that are rated investment grade, defined as being the highest two NAIC designations. The decrease in unrealized losses fromDecember 31, 2020 toSeptember 30, 2021 was primarily related to pricing improvements due to improved credit quality for certain fixed maturity securities during the nine months endedSeptember 30, 2021 and strategies to reposition the fixed maturity security portfolio that resulted in the sales of certain securities that were in an unrealized loss position atDecember 31, 2020 . This decrease was partially offset by an increase in treasury yields during the nine months endedSeptember 30, 2021 . The 10-yearU.S. Treasury yields atSeptember 30, 2021 andDecember 31, 2020 were 1.52% and 0.93%, respectively. The 30-yearU.S. Treasury yields atSeptember 30, 2021 andDecember 31, 2020 were 2.08% and 1.65%, respectively. 49
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The following table sets forth the composition by credit quality (NAIC
designation) of fixed maturity securities with gross unrealized losses:
Carrying Value of
Securities with Gross
Gross Unrealized Percent of Unrealized Percent of
NAIC Designation Losses Total Losses (1) Total
(Dollars in thousands)
September 30, 2021
1 $ 1,340,009 37.2 % $ (30,840) 35.0 %
2 1,785,151 49.6 % (40,816) 46.4 %
3 388,245 10.8 % (12,900) 14.7 %
4 54,940 1.5 % (1,995) 2.3 %
5 15,860 0.4 % (467) 0.5 %
6 16,375 0.5 % (953) 1.1 %
$ 3,600,580 100.0 % $ (87,971) 100.0 %
December 31, 2020
1 $ 2,625,341 45.5 % $ (82,045) 32.7 %
2 2,286,377 39.7 % (106,700) 42.5 %
3 650,364 11.3 % (42,040) 16.8 %
4 178,669 3.1 % (16,274) 6.5 %
5 4,991 0.1 % (1,640) 0.7 %
6 19,178 0.3 % (2,127) 0.8 %
$ 5,764,920 100.0 % $ (250,826) 100.0 %
(1)Gross unrealized losses have been adjusted to reflect the allowance for
credit loss of $4.1 million and $64.8 million as of September 30, 2021 and
December 31, 2020 , respectively.
Our investments' gross unrealized losses and fair value, aggregated by
investment category and length of time that individual securities (consisting of
567 and 843 securities, respectively) have been in a continuous unrealized loss
position at September 30, 2021 and December 31, 2020 , along with a description
of the factors causing the unrealized losses is presented in Note 4 to our
unaudited consolidated financial statements in this Form 10-Q, which is
incorporated by reference in this Item 2.
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The amortized cost and fair value of fixed maturity securities in an unrealized
loss position and the number of months in a continuous unrealized loss position
(fixed maturity securities that carry an NRSRO rating of BBB/Baa or higher are
considered investment grade) were as follows:
Gross
Amortized Unrealized
Number of Cost, Net of Losses, Net of
Securities Allowance (1) Fair Value Allowance (1)
(Dollars in thousands)
September 30, 2021
Fixed maturity securities, available for
sale:
Investment grade:
Less than six months 114 $
754,630
Six months or more and less than twelve
months
42 182,807 180,785 (2,022)
Twelve months or greater 330 2,309,934 2,245,622 (64,312)
Total investment grade 486 3,247,371 3,174,644 (72,727)
Below investment grade:
Less than six months 7 25,379 25,156 (223)
Six months or more and less than twelve
months 4 12,687 11,868 (819)
Twelve months or greater 70 403,114 388,912 (14,202)
Total below investment grade 81 441,180 425,936 (15,244)
567 $ 3,688,551 $ 3,600,580 $ (87,971)
December 31, 2020
Fixed maturity securities, available for
sale:
Investment grade:
Less than six months 54 $
686,711
Six months or more and less than twelve
months
310 2,201,769 2,118,844 (82,925)
Twelve months or greater 338 2,400,833 2,288,755 (112,078)
Total investment grade 702 5,289,313 5,086,936 (202,377)
Below investment grade:
Less than six months 9 48,355 47,984 (371)
Six months or more and less than twelve
months 37 155,451 146,779 (8,672)
Twelve months or greater 95 522,627 483,221 (39,406)
Total below investment grade 141 726,433 677,984 (48,449)
843 $ 6,015,746 $ 5,764,920 $ (250,826)
(1)Amortized cost and gross unrealized losses have been adjusted to reflect the
allowance for credit loss of $4.1 million and $64.8 million as of September 30,
2021 and December 31, 2020 , respectively.
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The amortized cost and fair value of fixed maturity securities (excluding United
States Government and United States Government sponsored agency securities)
segregated by investment grade (NRSRO rating of BBB/Baa or higher) and below
investment grade that had unrealized losses greater than 20% and the number of
months in a continuous unrealized loss position were as follows:
Gross
Amortized Unrealized
Number of Cost, Net of Fair Losses, Net of
Securities Allowance (1) Value Allowance (1)
(Dollars in thousands)
September 30, 2021
Investment grade:
Less than six months - $ - $ - $ -
Six months or more and less than twelve
months - - - -
Twelve months or greater - - - -
Total investment grade - - - -
Below investment grade:
Less than six months - - - -
Six months or more and less than twelve
months - - - -
Twelve months or greater - - - -
Total below investment grade - - - -
- $ - $ - $ -
December 31, 2020
Investment grade:
Less than six months 1 $ 2,453 $ 1,909 $ (544)
Six months or more and less than twelve
months 4 21,368 15,589 (5,779)
Twelve months or greater - - - -
Total investment grade 5 23,821 17,498 (6,323)
Below investment grade:
Less than six months 1 5,963 4,323 (1,640)
Six months or more and less than twelve
months 8 38,046 38,046 -
Twelve months or greater 5 3,875 3,062 (813)
Total below investment grade 14 47,884 45,431 (2,453)
19 $ 71,705 $ 62,929 $ (8,776)
(1) Amortized cost and gross unrealized losses have been adjusted to reflect the
allowance for credit loss of $4.1 million and $64.8 million as of September 30,
2021 and December 31, 2020 , respectively.
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The amortized cost and fair value of fixed maturity securities, 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 other asset backed securities provide for
periodic payments throughout their lives, and are shown below as a separate
line.
Available for sale
Amortized
Cost Fair Value
(Dollars in thousands)
September 30, 2021
Due in one year or less $ 31,570 $ 31,143
Due after one year through five years 41,118 38,332
Due after five years through ten years 200,680 194,093
Due after ten years through twenty years 184,145 180,742
Due after twenty years
210,999 204,694
668,512 649,004
Residential mortgage backed securities 126,692 124,238
Commercial mortgage backed securities 429,719 406,314
Other asset backed securities 2,467,702 2,421,024
$ 3,692,625 $ 3,600,580
December 31, 2020
Due in one year or less $ 2,324 $ 1,864
Due after one year through five years 382,843 360,761
Due after five years through ten years 396,842 355,188
Due after ten years through twenty years 216,725 203,282
Due after twenty years
145,340 122,960
1,144,074 1,044,055
Residential mortgage backed securities 173,875 169,615
Commercial mortgage backed securities 1,034,424 969,746
Other asset backed securities
3,728,144 3,581,504
$ 6,080,517 $ 5,764,920
International Exposure
We hold fixed maturity securities with international exposure. As of
September 30, 2021 , 16.1% of the carrying value of our fixed maturity securities
was comprised of corporate debt securities of issuers based outside of the
United States and debt securities of foreign governments. All of our fixed
maturity securities with international exposure are denominated in U.S. dollars.
Our investment professionals analyze each holding for credit risk by economic
and other factors of each country and industry. The following table presents our
international exposure in our fixed maturity portfolio by country or region:
September 30, 2021
Percent
of Total
Amortized Carrying Amount/ Carrying
Cost Fair Value Amount
(Dollars in thousands)
GIIPS (1) $ 227,691 $ 253,570 0.6 %
Asia/Pacific 425,035 477,989 1.0 %
Non-GIIPS Europe 2,592,188 2,899,194 6.3 %
Latin America 228,392 255,981 0.6 %
Non-U.S. North America 1,376,418 1,545,320 3.4 %
Australia & New Zealand 952,105 1,023,260 2.2 %
Other 846,302 933,980 2.0 %
$ 6,648,131 $ 7,389,294 16.1 %
(1)Greece , Ireland , Italy , Portugal and Spain ("GIIPS"). All of our exposure in
GIIPS are corporate securities with issuers domiciled in these countries. None
of our foreign government obligations were held in any of these countries.
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All of the securities presented in the table above are investment grade (NAIC
designation of either 1 or 2), except for the following:
September 30, 2021
Carrying Amount/
Amortized Cost Fair Value
(Dollars in thousands)
GIIPS $ 14,873 $ 17,139
Asia/Pacific 196 189
Non-GIIPS Europe 97,569 102,371
Latin America 50,142 53,417
Non-U.S. North America 79,586 81,337
Australia & New Zealand 545 545
Other 89,575 94,610
$ 332,486 $ 349,608
Watch List
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 credit
losses. As part of this assessment, we review not only a change in current price
relative to its amortized cost but the issuer's current credit rating and the
probability of full recovery of principal based upon the issuer's financial
strength. For corporate issuers, 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 asset-backed securities, we evaluate changes in factors such
as collateral performance, default rates, loss severities and expected cash
flows. At September 30, 2021 , the amortized cost and fair value of securities on
the watch list (all fixed maturity securities) are as follows:
Amortized Cost, Net Unrealized
Number of Amortized Allowance for Net of Losses, Fair
General Description Securities Cost Credit Losses Allowance Net of Allowance Value
(Dollars in thousands)
Corporate securities - Public
securities 1 $ 6,351 $ (209) $ 6,142 $ - $ 6,142
Corporate securities - Private
placement securities 5 36,589 (797) 35,792 (742) 35,050
Residential mortgage backed
securities 10 21,470 (296) 21,174 (284) 20,890
Commercial mortgage backed
securities 5 68,232 - 68,232 (2,989) 65,243
United States municipalities,
states and territories 5 19,044 (2,772) 16,272 (575) 15,697
26 $ 151,686 $ (4,074) $ 147,612 $ (4,590) $ 143,022
We expect to recover the unrealized losses, net of allowances, as we did not
have the intent to sell and it was not more likely than not that we would be
required to sell these securities prior to recovery of the amortized cost basis,
net of allowances. Our analysis of these securities and their credit performance
at September 30, 2021 is as follows:
Corporate securities - public securities: The public corporate security included
on the watch list has exposure to the offshore drilling industry. The decline in
value of this security is due the low level of oil prices over a long period of
time. While oil prices have drifted up in recent periods, the company's credit
metrics remain under pressure.
Corporate securities - private placement securities: The private placement
securities included on the watch list are spread across numerous industries, the
most significant of which is the airlines industry. The heightened credit risk
on these securities is primarily due to the impact COVID-19 has had on the
travel industry.
Structured securities: The structured securities included on the watch list have
generally experienced higher levels of stress due to the impact COVID-19 is
having on the economy. While there is a heightened level of credit risk for the
structured securities on the watch list, we expect minimal credit losses on
these securities based on our current analyses.
United States municipalities, states and territories: The decline in value of
these securities, which are related to senior living facilities in the
Southeastern region of the United States , is primarily due to the financial
strain COVID-19 is having on this industry.
Credit Losses
We have a policy and process to identify securities in our investment portfolio
for which we recognize credit loss. See Note 4 to our unaudited consolidated
financial statements.
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During the three months ended September 30, 2021 , we recognized a benefit
related to a reduction in the allowance for credit losses for our fixed maturity
securities of $0.1 million which included recoveries on municipal securities
partially offset by additional credit losses realized on corporate securities
and residential mortgage backed securities. During the nine months ended
September 30, 2021 , we recognized credit losses of $0.1 million which included
net credit losses realized on corporate securities partially offset by net
recoveries on municipal securities and residential mortgage backed securities.
During the three and nine months ended September 30, 2020 , we recognized credit
losses of $4.8 million and $51.5 million , respectively, on corporate securities
with exposure to the offshore drilling industry and $19.2 million and $27.5
million , respectively, on commercial mortgage backed securities due to the
impact of COVID-19 on the performance of the underlying collateral or our intent
to sell the securities. In addition, during the three and nine months ended
September 30, 2020 , we recognized credit losses of $0.4 million and $1.2
million , respectively, on residential mortgage backed securities due to the
performance of the underlying collateral and $1.5 million and $1.6 million ,
respectively, on private placement securities with exposure primarily to the
airlines industry. During the nine months ended September 30, 2020 we recognized
a credit loss of $0.5 million on an asset backed security due to our intent to
sell such security.
Several factors led us to believe that full recovery of amortized cost is not
expected on the securities for which we recognized credit losses. A discussion
of these factors, our policy and process to identify securities that could
potentially have credit loss is presented in Note 4 to our unaudited
consolidated financial statements in this Form 10-Q, which is incorporated by
reference in this Item 2.
Mortgage Loans on Real Estate
Our financing receivables consist of three mortgage loan portfolio segments:
commercial mortgage loans, agricultural mortgage loans and residential mortgage
loans. Our commercial mortgage loan portfolio consists of loans with an
outstanding principal balance of $3.3 billion and $3.6 billion as of
September 30, 2021 and December 31, 2020 , respectively. This 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
attempt to reduce the risk of default. Our agricultural mortgage loan portfolio
consists of loans with an outstanding principal balance of $354.7 million and
$245.8 million as of September 30, 2021 and December 31, 2020 , respectively.
These loans are collateralized by agricultural land and are diversified as to
location within the United States . Our residential mortgage loan portfolio
consists of loans with an outstanding principal balance of $610.6 million and
$366.3 million as of September 30, 2021 and December 31, 2020 , respectively.
These loans are collateralized by the related properties and diversified as to
location within the United States . Mortgage loans on real estate are generally
reported at cost adjusted for amortization of premiums and accrual of discounts,
computed using the interest method and net of valuation allowances.
At September 30, 2021 and December 31, 2020 , the largest principal amount
outstanding for any single commercial mortgage loan was $28.2 million and $34.7
million , respectively, and the average loan size was $4.7 million and $4.8
million , respectively. In addition, the average loan-to-value ratio for
commercial and agricultural mortgage loans combined was 53.2% and 53.6% at
September 30, 2021 and December 31, 2020 , respectively, based upon the
underwriting and appraisal at the time the loan was made. This loan-to-value
ratio is indicative of our conservative underwriting policies and practices for
originating mortgage loans and may not be indicative of collateral values at the
current reporting date. Our current practice is to only obtain market value
appraisals of the underlying collateral at the inception of the loan unless we
identify indicators of impairment in our ongoing analysis of the portfolio, in
which case, we either calculate a value of the collateral using a capitalization
method or obtain a third party appraisal of the underlying collateral. The
commercial mortgage loan portfolio is summarized by geographic region and
property type in Note 5 to our unaudited consolidated financial statements in
this Form 10-Q, incorporated by reference in this Item 2.
In the normal course of business, we commit to fund commercial mortgage loans up
to 90 days in advance. At September 30, 2021 , we had commitments to fund
mortgage loans totaling $44.0 million , with interest rates ranging from 3.55% to
6.03%. During 2021 and 2020, due to historically low interest rates, the
commercial mortgage loan industry has been very competitive. This competition
has resulted in a number of borrowers refinancing with other lenders. For the
nine months ended September 30, 2021 , we received $250.3 million in cash for
loans being paid in full compared to $126.4 million for the nine months ended
September 30, 2020 . Some of the loans being paid off have either reached their
maturity or are nearing maturity; however, some borrowers are paying the
prepayment fee and refinancing at a lower rate.
See Note 5 to our unaudited consolidated financial statements, incorporated by
reference, for a presentation of our valuation allowance, foreclosure activity
and troubled debt restructure analysis. We have a process by which we evaluate
the credit quality of each of our mortgage loans. This process utilizes each
loan's loan-to-value and debt service coverage ratios as primary metrics. See
Note 5 to our unaudited consolidated financial statements, incorporated by
reference, for a summary of our portfolio by loan-to-value and debt service
coverage ratios.
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We closely monitor loan performance for our commercial, agricultural and
residential mortgage loan portfolios. Commercial, agricultural and residential
loans are considered nonperforming when they are 90 days or more past due. Aging
of financing receivables is summarized in the following table:
30-59 days 60-89 days Over 90 days
Current past due past due past due Total
As of September 30, 2021: (Dollars in thousands)
Commercial mortgage loans $ 3,323,984 $ - $ - $ - $ 3,323,984
Agricultural mortgage loans 353,741 - - - 353,741
Residential mortgage loans 565,085 55,416 5,160 6,914 632,575
Total mortgage loans $ 4,242,810 $ 55,416 $ 5,160 $ 6,914 $ 4,310,300
As of December 31, 2020 :
Commercial mortgage loans $ 3,578,888 $ - $ - $ - $ 3,578,888
Agricultural mortgage loans 245,173 - - - 245,173
Residential mortgage loans 346,730 25,449 111 167 372,457
Total mortgage loans $ 4,170,791 $ 25,449 $ 111 $ 167 $ 4,196,518
Derivative Instruments
Our derivative instruments primarily consist of call options purchased to
provide the income needed to fund the annual index credits on our fixed index
annuity products. The fair value of the call options is based upon the amount of
cash that would be required to settle the call options obtained from the
counterparties adjusted for the nonperformance risk of the counterparty. The
nonperformance risk for each counterparty is based upon its credit default swap
rate. We have no performance obligations related to the call options.
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. A presentation of our derivative instruments along
with a discussion of the business strategy involved with our derivatives is
included in Note 7 to our unaudited consolidated financial statements in this
Form 10-Q, which is incorporated by reference in this Item 2.
Liquidity and Capital Resources
Our insurance subsidiaries generally 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 $1,567.7 million for the nine
months ended September 30, 2021 compared to $(806.2) million for the nine months
ended September 30, 2020 , with the increase attributable to a $2,886.9 million
increase in net annuity deposits after coinsurance and a $513.0 million (after
coinsurance) increase in funds returned to policyholders. We continue to invest
the net proceeds from policyholder transactions and investment activities in
high quality fixed maturity securities and mortgage loans. We have a highly
liquid investment portfolio that can be used to meet policyholder and other
obligations as needed. In addition, we intend to hold approximately 1% to 2% of
our investment portfolio in cash and cash equivalents.
We, as the parent company, are a legal entity separate and distinct from our
subsidiaries, and have no business operations. We need liquidity primarily to
service our debt (senior notes and subordinated debentures issued to subsidiary
trusts), pay operating expenses, and pay dividends to common and preferred
stockholders. Our 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. We expect these sources provide adequate cash flow for us to meet
our current and reasonably foreseeable future obligations.
The ability of our life insurance subsidiaries to pay dividends or
distributions, including surplus note payments, will be limited by applicable
laws and regulations of the states in which our life insurance subsidiaries are
domiciled, which subject our life insurance 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.
Currently, American Equity Life may pay dividends or make other distributions
without the prior approval of the Iowa Insurance Commissioner, unless such
payments, together with all other such payments within the preceding twelve
months, exceed the greater of (1) American Equity Life's net gain from
operations for the preceding calendar year, or (2) 10% of American Equity Life's
statutory capital and surplus at the preceding December 31 . For 2021, up to
$372.9 million can yet be distributed as dividends by American Equity Life
without prior approval of the Iowa Insurance Commissioner. In addition,
dividends and surplus note payments may be made only out of statutory earned
surplus, and all surplus note payments are subject to prior approval by
regulatory authorities in the life subsidiary's state of domicile. American
Equity Life had $2.1 billion of statutory earned surplus at September 30, 2021 .
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The maximum distribution permitted by law or contract is not necessarily
indicative of an insurer's actual ability to pay such distributions, which may
be constrained by business and regulatory considerations, such as the impact of
such distributions on surplus, which could affect the insurer's ratings or
competitive position, the amount of premiums that can be written and the ability
to pay future dividends or make other distributions. Further, state insurance
laws and regulations require that the statutory surplus of our life subsidiaries
following any dividend or distribution must be reasonable in relation to their
outstanding liabilities and adequate for their financial needs. 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 rating agencies. 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. As of
September 30, 2021 , we estimate American Equity Life has sufficient statutory
capital and surplus, combined with capital available to the holding company, to
maintain its insurer financial strength rating. However, this capital may not be
sufficient if significant future losses are incurred or a rating agency modifies
its rating criteria and access to additional capital could be limited.
Cash and cash equivalents of the parent holding company at September 30, 2021 ,
were $397.0 million . We also have the ability to issue equity, debt or other
types of securities through one or more methods of distribution. The terms of
any offering would be established at the time of the offering, subject to market
conditions.
New Accounting Pronouncements
See Note 1 to our unaudited consolidated financial statements in this Form
10-Q, which is incorporated by reference in this Item 2.
Regulatory Developments
The U.S. Department of Labor (the "DOL") issued new guidance during the first
quarter of 2021 broadening the criteria for when an advisor on ERISA or
Individual Retirement Account products has a fiduciary duty to the client.
Advisors who sell our products who may be fiduciaries will have more complex
compliance and disclosure obligations, and as a result higher costs. In
addition, to the extent the DOL requires a fiduciary institution to oversee such
an advisor, we or the IMO's with whom we partner may have more complex
compliance and disclosure obligations, and as a result higher costs and greater
risk. The DOL has also indicated it intends to make further changes to the
existing regulatory framework for providing fiduciary advice. While the scope
and content of any such changes remain uncertain, they may include new rules and
amending or revoking exemptions financial institutions rely on in providing
services.
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 substantially 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, including lifetime income benefit riders, to encourage
persistency.
We seek to maximize the total return on our fixed maturity securities 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.
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 and the fair value of our investments. The
profitability of most of our products depends on the spreads between interest
yield on investments and rates credited on insurance liabilities. We have the
ability to adjust crediting rates (caps, participation rates or asset fee rates
for fixed index annuities) on substantially all of our annuity liabilities at
least annually (subject to minimum guaranteed values). Substantially all of our
annuity products have surrender and withdrawal penalty provisions designed to
encourage persistency and to help ensure targeted spreads are earned. In
addition, a significant amount of our fixed index annuity policies and many of
our annual reset fixed rate deferred annuities were issued with a lifetime
income benefit rider which we believe improves the persistency of such annuity
products. 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 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.
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If interest rates were to increase 10% (20 basis points) from levels at
September 30, 2021 , we estimate that the fair value of our fixed maturity
securities would decrease by approximately $701.4 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 and policy benefit reserves) would be a decrease of
$316.1 million in accumulated other comprehensive income and a decrease in
stockholders' equity. The 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 a credit loss) 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, 2020 for a further discussion of the liquidity risk.
The amortized cost of fixed maturity securities that are callable at the option
of the issuer, excluding securities with a make-whole provision, was $5.4
billion as of September 30, 2021 . 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. In addition,
we have $3.5 billion of floating rate fixed maturity securities as of
September 30, 2021 . Generally, interest rates on these floating rate fixed
maturity securities are based on the 3 month LIBOR rate and are reset quarterly.
Should rates decline to levels which tighten the spread between our average
portfolio yield and average cost of interest credited on annuity liabilities, we
have the ability to reduce crediting rates (caps, participation rates or asset
fees for fixed index annuities) on most of our annuity liabilities to maintain
the spread at our targeted level. At September 30, 2021 , approximately 92% 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. At September 30, 2021 , approximately 18% of our
annuity liabilities were at minimum guaranteed crediting rates.
We purchase call options on the applicable indices to fund the annual index
credits on our fixed index 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 fixed index products. The difference between proceeds received at
expiration of these options and index credits, as shown in the following table,
is primarily due to under or over-hedging as a result of policyholder behavior
being different than our expectations.
Three Months Ended Nine Months Ended
September 30, September 30,
2021 2020 2021 2020
(Dollars in thousands)
Proceeds received at expiration of options
related to such credits $ 489,902 $ 178,405 $ 1,559,495 $ 560,683
Annual index credits to policyholders on
their anniversaries 475,292 174,747 1,535,320 551,562
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 fixed index business. We manage
this risk through the terms of our fixed 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 fixed 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(e) and 15d-15(e),
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 the design and operation
of our disclosure controls and procedures were effective as of September 30,
2021 in recording, processing, summarizing and reporting, on a timely basis,
information required to be disclosed by us in the reports that we file or submit
under the Exchange Act.
There were no changes in our internal control over financial reporting that
occurred during the quarter ended September 30, 2021 that have materially
affected, or are reasonably likely to materially affect, our internal control
over financial reporting.
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ELECTROMED, INC. – 10-Q – Management's Discussion and Analysis of Financial Condition and Results of Operations.
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