UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-Q/A

 

(Mark One)

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended June 30, 2007

 

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from              to              

 

Commission File Number : 001-31911

 

American Equity Investment Life Holding Company

(Exact name of registrant as specified in its charter)

 

 

Iowa

 

42-1447959

(State of Incorporation)

 

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

 

5000 Westown Parkway, Suite 440

 

 

West Des Moines, Iowa

 

50266

(Address of principal executive offices)

 

(Zip Code)

 

 

Registrant’s telephone number, including area code

 

(515) 221-0002

 

 

(Telephone)

 

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

 

Title of each class

 

Name of each exchange on which registered

Common Stock, par value $1

 

New York Stock Exchange

 

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

 

Indicate by check mark whether the registrant (1) has filed all documents and reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes  x     No  o

 

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

Large accelerated filer

 

o

 

Accelerated filer

 

x

 

Non-accelerated filer

 

o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act.)

Yes  o     No  x

 

APPLICABLE TO CORPORATE ISSUERS:

 

Shares of common stock outstanding at July 31, 2007: 56,880,720

 

 

 

 



 

EXPLANATORY NOTE

 

We are amending our Quarterly Report on Form 10-Q for the quarter ended June 30, 2007 as filed with the Securities and Exchange Commission on August 3, 2007 to restate our consolidated financial statements as of June 30, 2007 and for the three and six months ended June 30, 2007 and the related disclosures.  We identified an error in the calculation of the policy benefit reserves for our index annuities in accordance with Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities.  See Note 2, “Restatement of Unaudited Consolidated Financial Statements” of the notes to the unaudited consolidated financial statements for a discussion of the effect of the restatements.  We have also restated our unaudited consolidated financial statements as of September 30, 2007 and for the three and nine months ended September 30, 2007 and the related disclosures for this error.  This Form 10-Q/A does not reflect events that occurred after the August 3, 2007 filing date of the Quarterly Report on Form 10-Q that was originally filed or modify or update the disclosures presented in the original Form 10-Q, except to reflect the matters described above.  Other events occurring after the filing of the original Form 10-Q or other disclosures necessary to reflect subsequent events have been addressed in our reports filed with the Securities and Exchange Commission subsequent to the filing of the original Form 10-Q.

 

2



 

PART I - FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except per share data)

 

 

 

June 30, 2007
(Unaudited)

 

December 31, 2006

 

 

 

As restated

 

 

 

Assets

 

 

 

 

 

Investments:

 

 

 

 

 

Fixed maturity securities:

 

 

 

 

 

Available for sale, at fair value (amortized cost: 2007 - $4,833,524; 2006 - $4,297,182)

 

$

4,623,126

 

$

4,177,029

 

Held for investment, at amortized cost (fair value: 2007 - $4,798,026; 2006 - $4,871,237)

 

5,226,441

 

5,128,146

 

Equity securities, available for sale, at fair value (cost: 2007 - $81,763; 2006 - $46,000)

 

78,949

 

45,512

 

Mortgage loans on real estate

 

1,771,625

 

1,652,757

 

Derivative instruments

 

412,289

 

381,601

 

Policy loans

 

428

 

419

 

Total investments

 

12,112,858

 

11,385,464

 

 

 

 

 

 

 

Cash and cash equivalents

 

22,243

 

29,949

 

Coinsurance deposits - related party

 

1,772,761

 

1,841,720

 

Accrued investment income

 

73,384

 

68,323

 

Deferred policy acquisition costs

 

1,189,152

 

1,088,890

 

Deferred sales inducements

 

509,190

 

427,554

 

Deferred income taxes

 

85,719

 

73,831

 

Income taxes recoverable

 

3,040

 

4,526

 

Other assets

 

42,925

 

69,866

 

Total assets

 

$

15,811,272

 

$

14,990,123

 

 

3



 

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY

CONSOLIDATED BALANCE SHEETS (Continued)

(Dollars in thousands, except per share data)

 

 

 

 

June 30, 2007
(Unaudited)

 

December 31, 2006

 

 

 

As restated

 

 

 

Liabilities and Stockholders’ Equity

 

 

 

 

 

Liabilities:

 

 

 

 

 

Policy benefit reserves:

 

 

 

 

 

Traditional life and accident and health insurance products

 

$

102,489

 

$

93,632

 

Annuity and single premium universal life products

 

13,913,759

 

13,114,299

 

Other policy funds and contract claims

 

122,353

 

128,579

 

Other amounts due to related parties

 

45,077

 

45,504

 

Notes payable

 

264,848

 

266,383

 

Subordinated debentures

 

268,298

 

268,489

 

Amounts due under repurchase agreements

 

396,570

 

385,973

 

Other liabilities

 

100,160

 

92,198

 

Total liabilities

 

15,213,554

 

14,395,057

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Common stock, par value $1 per share, 125,000,000 shares authorized; issued and outstanding: 2007 - 53,862,051 shares (excluding 3,014,466 treasury shares); 2006 - 53,500,926 shares (excluding 2,664,448 treasury shares)

 

53,862

 

53,501

 

Additional paid-in capital

 

388,917

 

389,644

 

Accumulated other comprehensive loss

 

(66,282

)

(38,769

)

Retained earnings

 

221,221

 

190,690

 

Total stockholders’ equity

 

597,718

 

595,066

 

Total liabilities and stockholders’ equity

 

$

15,811,272

 

$

14,990,123

 

 

See accompanying notes to unaudited consolidated financial statements.

 

4



 

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY

CONSOLIDATED STATEMENTS OF INCOME

(Dollars in thousands, except per share data)

(Unaudited)

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2007

 

2006

 

2007

 

2006

 

 

 

Restated

 

 

 

Restated

 

 

 

Revenues:

 

 

 

 

 

 

 

 

 

Traditional life and accident and health insurance premiums

 

$

3,190

 

$

3,211

 

$

6,247

 

$

6,735

 

Annuity and single premium universal life product charges

 

11,453

 

10,740

 

20,447

 

18,340

 

Net investment income

 

175,719

 

169,182

 

345,077

 

331,567

 

Realized gains on investments

 

17

 

331

 

596

 

289

 

Change in fair value of derivatives

 

98,986

 

(61,582

)

90,464

 

(12,254

)

Total revenues

 

289,365

 

121,882

 

462,831

 

344,677

 

 

 

 

 

 

 

 

 

 

 

Benefits and expenses:

 

 

 

 

 

 

 

 

 

Insurance policy benefits and change in future policy benefits

 

2,097

 

2,269

 

4,030

 

4,667

 

Interest credited to account balances

 

168,141

 

101,845

 

284,094

 

185,453

 

Amortization of deferred sales inducements

 

11,602

 

6,737

 

15,963

 

15,675

 

Change in fair value of embedded derivatives

 

14,984

 

(111,321

)

8,353

 

(48,557

)

Interest expense on notes payable

 

4,057

 

6,528

 

8,139

 

13,814

 

Interest expense on subordinated debentures

 

5,614

 

5,402

 

11,203

 

10,320

 

Interest expense on amounts due under repurchase agreements

 

3,060

 

8,532

 

7,078

 

14,331

 

Amortization of deferred policy acquisition costs

 

34,366

 

25,363

 

51,935

 

56,118

 

Other operating costs and expenses

 

14,083

 

9,931

 

25,494

 

20,111

 

Total benefits and expenses

 

258,004

 

55,286

 

416,289

 

271,932

 

Income before income taxes

 

31,361

 

66,596

 

46,542

 

72,745

 

Income tax expense

 

10,757

 

23,685

 

16,011

 

25,861

 

Net income

 

$

20,604

 

$

42,911

 

$

30,531

 

$

46,884

 

 

 

 

 

 

 

 

 

 

 

Earnings per common share

 

$

0.36

 

$

0.77

 

$

0.54

 

$

0.84

 

Earnings per common share - assuming dilution

 

$

0.35

 

$

0.71

 

$

0.52

 

$

0.78

 

 

See accompanying notes to unaudited consolidated financial statements.

 

5



 

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

(Dollars in thousands)

(Unaudited)

 

 

 

 

Common
Stock

 

Additional
Paid-in
Capital

 

Accumulated
Other
Comprehensive
Loss

 

Retained
Earnings

 

Total
Stockholders’
Equity

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance at December 31, 2005

 

$

53,936

 

$

380,698

 

$

(27,306

)

$

112,030

 

$

519,358

 

Comprehensive loss:

 

 

 

 

 

 

 

 

 

 

 

Net income for period

 

 

 

 

46,884

 

46,884

 

Change in net unrealized investment gains/losses

 

 

 

(67,241

)

 

(67,241

)

Total comprehensive loss

 

 

 

 

 

 

 

 

 

(20,357

)

Share-based compensation

 

 

68

 

 

 

68

 

Issuance of 89,550 shares of common stock under compensation plans, including excess income tax benefits

 

90

 

682

 

 

 

772

 

Conversion of $360 of subordinated debentures

 

44

 

316

 

 

 

360

 

Balance at June 30, 2006

 

$

54,070

 

$

381,764

 

$

(94,547

)

$

158,914

 

$

500,201

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance at December 31, 2006

 

$

53,501

 

$

389,644

 

$

(38,769

)

$

190,690

 

$

595,066

 

Comprehensive income:

 

 

 

 

 

 

 

 

 

 

 

Net income for period, restated

 

 

 

 

30,531

 

30,531

 

Change in net unrealized investment gains/losses

 

 

 

(27,513

)

 

(27,513

)

Total comprehensive income, restated

 

 

 

 

 

 

 

 

 

3,018

 

Acquisition of 350,000 shares of common stock

 

(350

)

(3,886

)

 

 

(4,236

)

Share-based compensation

 

 

3,178

 

 

 

3,178

 

Issuance of 57,500 shares of common stock under compensation plans, including excess income tax benefits

 

57

 

385

 

 

 

442

 

Net issuance of 622,779 shares of common stock under stock option and warrant agreement

 

623

 

(623

)

 

 

 

Conversion of $250 of subordinated debentures

 

31

 

219

 

 

 

250

 

Balance at June 30, 2007, as restated

 

$

53,862

 

$

388,917

 

$

(66,282

)

$

221,221

 

$

597,718

 

 

Total comprehensive loss for the second quarter of 2007 was $6.8 million and was comprised of net income of $20.6 million and an increase in net unrealized depreciation of available for sale fixed maturity securities and equity securities of $27.4 million.

 

Total comprehensive income for the second quarter of 2006 was $10.6 million and was comprised of net income of $42.9 million and an increase in net unrealized depreciation of available for sale fixed maturity securities and equity securities of $32.3 million.

 

See accompanying notes to unaudited consolidated financial statements.

 

6



 

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)

 

 

 

 

Six Months Ended
June 30,

 

 

 

2007

 

2006

 

 

 

Restated

 

 

 

Operating activities

 

 

 

 

 

Net income

 

$

30,531

 

$

46,884

 

Adjustments to reconcile net income to net cash used in operating activities:

 

 

 

 

 

Adjustments related to interest sensitive products:

 

 

 

 

 

Interest credited to account balances

 

284,094

 

185,453

 

Amortization of deferred sales inducements

 

15,963

 

15,675

 

Annuity and single premium universal life product charges

 

(20,447

)

(18,340

)

Change in fair value of embedded derivatives

 

8,353

 

(48,557

)

Increase in traditional life and accident and health insurance reserves

 

4,904

 

5,982

 

Policy acquisition costs deferred

 

(117,939

)

(120,898

)

Amortization of discount on contingent convertible notes

 

526

 

5,970

 

Amortization of deferred policy acquisition costs

 

51,935

 

56,118

 

Provision for depreciation and other amortization

 

501

 

1,075

 

Amortization of discount and premiums on investments

 

(127,812

)

(119,536

)

Realized gains on investments

 

(596

)

(289

)

Change in fair value of derivatives

 

(90,464

)

12,254

 

Deferred income taxes

 

2,927

 

31,208

 

Share-based compensation

 

3,178

 

68

 

Changes in other operating assets and liabilities:

 

 

 

 

 

Accrued investment income

 

(5,061

)

(9,458

)

Income taxes recoverable

 

1,486

 

(22,490

)

Other assets

 

745

 

(1,653

)

Other policy funds and contract claims

 

(6,226

)

2,234

 

Other amounts due to related parties

 

(10,629

)

(1,483

)

Other liabilities

 

(43,810

)

(37,890

)

Net cash used in operating activities

 

(17,841

)

(17,673

)

 

 

 

 

 

 

Investing activities

 

 

 

 

 

Sales, maturities, or repayments of investments:

 

 

 

 

 

Fixed maturity securities - available for sale

 

71,739

 

106,129

 

Fixed maturity securities - held for investment

 

28,147

 

 

Equity securities, available for sale

 

15,968

 

17,878

 

Mortgage loans on real estate

 

87,967

 

48,920

 

Derivative instruments

 

224,636

 

98,900

 

Acquisition of investments:

 

 

 

 

 

Fixed maturity securities - available for sale

 

(551,709

)

(500,427

)

Fixed maturity securities - held for investment

 

 

(176,169

)

Equity securities, available for sale

 

(51,604

)

(5,980

)

Mortgage loans on real estate

 

(206,835

)

(300,484

)

Derivative instruments

 

(154,276

)

(110,077

)

Policy loans

 

(9

)

(29

)

Purchases of property, furniture and equipment

 

(568

)

(81

)

Net cash used in investing activities

 

(536,544

)

(821,420

)

 

7



 

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY

CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

(Dollars in thousands)

(Unaudited)

 

 

 

 

Six Months Ended
June 30,

 

 

 

2007

 

2006

 

 

 

Restated

 

 

 

Financing activities

 

 

 

 

 

Receipts credited to annuity and single premium universal life policyholder account balances

 

$

1,066,989

 

$

1,082,386

 

Coinsurance deposits - related party

 

92,734

 

88,149

 

Return of annuity and single premium universal life policyholder account balances

 

(640,946

)

(829,146

)

Financing fees incurred and deferred

 

 

(1,016

)

Repayments of notes payable

 

(2,061

)

(2,049

)

Increase in amounts due under repurchase agreements

 

10,597

 

393,229

 

Proceeds from issuance of subordinated debentures

 

 

30,000

 

Acquisition of common stock

 

(4,236

)

 

Excess tax benefits realized from exercise of stock options

 

148

 

226

 

Proceeds from issuance of common stock

 

294

 

546

 

Checks in excess of cash balance

 

23,160

 

 

Net cash provided by financing activities

 

546,679

 

762,325

 

Decrease in cash and cash equivalents

 

(7,706

)

(76,768

)

 

 

 

 

 

 

Cash and cash equivalents at beginning of period

 

29,949

 

112,395

 

Cash and cash equivalents at end of period

 

$

22,243

 

$

35,627

 

 

 

 

 

 

 

Supplemental disclosures of cash flow information:

 

 

 

 

 

Cash paid during period for:

 

 

 

 

 

Interest expense

 

$

25,711

 

$

31,322

 

Income taxes

 

10,600

 

17,138

 

 

 

 

 

 

 

Non-cash financing and investing activities:

 

 

 

 

 

Premium and interest bonuses deferred as sales inducements

 

81,612

 

74,186

 

Conversion of subordinated debentures

 

250

 

360

 

Subordinated debentures issued to subsidiary trusts for common equity securities of the subsidiary trust

 

 

928

 

 

See accompanying notes to unaudited consolidated financial statements.

 

8



 

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2007

(Unaudited)

 

1.  Organization and Significant Accounting Policies

 

Consolidation and Basis of Presentation

 

The accompanying unaudited consolidated financial statements of American Equity Investment Life Holding Company (the Company) have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all the information and notes required by GAAP for complete financial statements.  The unaudited consolidated financial statements reflect all adjustments, consisting only of normal recurring items, which are necessary to present fairly the Company’s financial position and results of operations on a basis consistent with the prior audited consolidated financial statements.  Operating results for the three-month and six-month periods ended June 30, 2007 are not necessarily indicative of the results that may be expected for the year ended December 31, 2007.  All significant intercompany accounts and transactions have been eliminated.  The preparation of financial statements requires the use of management estimates.  For further information related to a description of areas of judgment and estimates and other information necessary to understand the Company’s financial position and results of operations, refer to the audited consolidated financial statements and notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.

 

Reclassifications

 

Certain amounts in the unaudited consolidated financial statements for the periods ended June 30, 2006 have been reclassified to conform to the financial statement presentation for the periods ended June 30, 2007.

 

Adopted Accounting Pronouncements

 

In September 2005, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants  issued Statement of Position 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts (“SOP 05-1”).  SOP 05-1 provides guidance on accounting by insurance enterprises for deferred policy acquisition costs and deferred sales inducements on internal replacements of insurance contracts other than those specifically described in Statement of Financial Accounting Standards (“SFAS”) No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale on Investments.  SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights or coverages that occurs by exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract.  SOP 05-1 is effective for internal replacements occurring in fiscal years beginning January 1, 2007.  Retrospective application of SOP 05-1 to previously issued financial statements is not permitted.  There was no impact on the unaudited consolidated financial statements upon the adoption of SOP 05-1.

 

In June 2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”).  FIN 48 creates a single model to address uncertainty in tax positions and clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements.  Under FIN 48, a tax benefit can be recognized in the financial statements if it is more likely than not that the position will be sustained upon examination by taxing authorities who have full knowledge of all relevant information.  A tax position that meets the more-likely-than-not recognition threshold is measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon settlement.  FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.  FIN 48 is effective and was adopted by the Company on January 1, 2007.  The Company has no unrecognized tax benefits at January 1, 2007 or June 30, 2007.  The Company’s policy is to record the interest and penalties on tax obligations on the federal income tax expense line on the consolidated statements of income.  There was no impact on the unaudited consolidated financial statements upon the adoption of FIN 48.  As of June 30, 2007, the tax years that remain subject to examination for U.S. federal taxes and applicable state jurisdictions are tax years ended December 31, 2003 through December 31, 2006.

 

In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments (“SFAS 155”), which amends SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”) and SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (“SFAS 140”).  SFAS 155

 

9



 

simplifies the accounting for certain derivatives embedded in other financial instruments by allowing them to be accounted for as a whole if the holder elects to account for the whole instrument on a fair value basis.  SFAS 155 also clarifies and amends certain other provisions of SFAS 133 and SFAS 140.  SFAS 155 is effective for all financial instruments acquired, issued or subject to a remeasurement event beginning on January 1, 2007.  There was no impact on the unaudited consolidated financial statements upon adoption.

 

New Accounting Pronouncements

 

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value and expands the required disclosures about fair value measurements.  SFAS 157 is effective beginning on January 1, 2008.  The Company is continuing to evaluate SFAS 157 but does not believe that it will have a material impact on the consolidated financial statements.

 

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, Including an amendment of FASB Statement No. 115 (“SFAS 159”).  SFAS 159 permits entities to choose, at specified election dates, to measure eligible financial instruments and certain other items at fair value that are not currently required to be reported at fair value.  Unrealized gains and losses on items for which the fair value option is elected shall be reported in net income.  SFAS 159 also requires additional disclosures that are intended to facilitate comparisons between entities that choose different measurement attributes for similar assets and liabilities and between assets and liabilities in the financial statements of an entity that selects different measurement attributes for similar assets and liabilities.  SFAS 159 is effective beginning on January 1, 2008.  The Company is currently evaluating the impact SFAS 159 will have on the consolidated financial statements.

 

2.  Restatement of Unaudited Consolidated Financial Statements

 

The previously issued unaudited financial statements for the quarter ended June 30, 2007 have been restated.  The restatement reflects the correction of an error in the calculation of policy benefit reserves for index annuities in accordance with SFAS 133 that occurred during the quarter ended June 30, 2007.  The impact of this error was an understatement of annuity reserves by $14.6 million at June 30, 2007 which is reflected in the change in fair value of embedded derivatives.  For annuity products, deferred sales inducements and deferred policy acquisition costs are amortized  in proportion to expected gross profits.  This increase in reserves decreased gross profits and therefore the amortization of deferred sales inducements and deferred policy acquisition costs was adjusted.  The impact to net income was a decrease of $4.0 million for the three and six month periods ended June 30, 2007.  The impact of the restatement on the financial statements is as follows:

 

10



 

 

 

Three Months Ended June 30, 2007

 

Six Months Ended June 30, 2007

 

 

 

As previously
reported

 

Adjustments

 

As
restated

 

As previously
reported

 

Adjustments

 

As
restated

 

 

 

(Dollars in thousands, except per share data)

 

Revenues:

 

 

 

 

 

 

 

 

 

 

 

 

 

Traditional life and accident and health insurance premiums

 

$

3,190

 

$

 

$

3,190

 

$

6,247

 

$

 

$

6,247

 

Annuity and single premium universal life product charges

 

11,453

 

 

11,453

 

20,447

 

 

20,447

 

Net investment income

 

175,719

 

 

175,719

 

345,077

 

 

345,077

 

Realized gains on investments

 

17

 

 

17

 

596

 

 

596

 

Change in fair value of derivatives

 

98,986

 

 

98,986

 

90,464

 

 

90,464

 

Total revenues

 

289,365

 

 

289,365

 

462,831

 

 

462,831

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Benefits and expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

Insurance policy benefits and change in future policy benefits

 

2,097

 

 

2,097

 

4,030

 

 

4,030

 

Interest credited to account balances

 

168,141

 

 

168,141

 

284,094

 

 

284,094

 

Amortization of deferred sales inducements

 

14,184

 

2,582

 

11,602

 

18,545

 

2,582

 

15,963

 

Change in fair value of embedded derivatives

 

405

 

(14,579

)

14,984

 

(6,226

)

(14,579

)

8,353

 

Interest expense on notes payable

 

4,057

 

 

4,057

 

8,139

 

 

8,139

 

Interest expense on subordinated debentures

 

5,614

 

 

5,614

 

11,203

 

 

11,203

 

Interest expense on amounts due under repurchase agreements

 

3,060

 

 

3,060

 

7,078

 

 

7,078

 

Amortization of deferred policy acquisition costs

 

40,289

 

5,923

 

34,366

 

57,858

 

5,923

 

51,935

 

Other operating costs and expenses

 

14,083

 

 

14,083

 

25,494

 

 

25,494

 

Total benefits and expenses

 

251,930

 

(6,074

)

258,004

 

410,215

 

(6,074

)

416,289

 

Income before income taxes

 

37,435

 

(6,074

)

31,361

 

52,616

 

(6,074

)

46,542

 

Income tax expense

 

12,846

 

(2,089

)

10,757

 

18,100

 

(2,089

)

16,011

 

Net income

 

$

24,589

 

$

(3,985

)

$

20,604

 

$

34,516

 

$

(3,985

)

$

30,531

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Earnings per common share

 

$

0.43

 

$

(0.07

)

$

0.36

 

$

0.61

 

$

(0.07

)

$

0.54

 

Earnings per common share - assuming dilution

 

$

0.41

 

$

(0.06

)

$

0.35

 

$

0.58

 

$

(0.06

)

$

0.52

 

 

11



 

 

 

As of June 30, 2007

 

 

 

As previously
reported

 

Adjustments

 

As restated

 

 

 

(Dollars in thousands)

 

Assets

 

 

 

Investments:

 

 

 

 

 

 

 

Fixed maturity securities:

 

 

 

 

 

 

 

Available for sale, at fair value (amortized cost: 2007 - $4,833,524; 2006 - $4,297,182)

 

$

4,623,126

 

$

 

$

4,623,126

 

Held for investment, at amortized cost (fair value: 2007 - $4,798,026; 2006 - $4,871,237)

 

5,226,441

 

 

5,226,441

 

Equity securities, available for sale, at fair value (cost: 2007 - $81,763; 2006 - $46,000)

 

78,949

 

 

78,949

 

Mortgage loans on real estate

 

1,771,625

 

 

1,771,625

 

Derivative instruments

 

412,289

 

 

412,289

 

Policy loans

 

428

 

 

428

 

Total investments

 

12,112,858

 

 

12,112,858

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

22,243

 

 

22,243

 

Coinsurance deposits - related party

 

1,772,761

 

 

1,772,761

 

Accrued investment income

 

73,384

 

 

73,384

 

Deferred policy acquisition costs

 

1,183,229

 

5,923

 

1,189,152

 

Deferred sales inducements

 

506,608

 

2,582

 

509,190

 

Deferred income taxes

 

83,630

 

2,089

 

85,719

 

Income taxes recoverable

 

3,040

 

 

3,040

 

Other assets

 

42,925

 

 

42,925

 

Total assets

 

$

15,800,678

 

$

10,594

 

$

15,811,272

 

 

 

 

 

 

 

 

 

Liabilities:

 

 

 

 

 

 

 

Policy benefit reserves:

 

 

 

 

 

 

 

Traditional life and accident and health insurance products

 

$

102,489

 

$

 

$

102,489

 

Annuity and single premium universal life products

 

13,899,180

 

14,579

 

13,913,759

 

Other policy funds and contract claims

 

122,353

 

 

122,353

 

Other amounts due to related parties

 

45,077

 

 

45,077

 

Notes payable

 

264,848

 

 

264,848

 

Subordinated debentures

 

268,298

 

 

268,298

 

Amounts due under repurchase agreements

 

396,570

 

 

396,570

 

Other liabilities

 

100,160

 

 

100,160

 

Total liabilities

 

15,198,975

 

14,579

 

15,213,554

 

 

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

 

 

Common stock, par value $1 per share, 125,000,000 shares authorized; issued and outstanding: 2007 - 53,862,051 shares (excluding 3,014,466 treasury shares); 2006 - 53,500,926 shares (excluding 2,664,448 treasury shares)

 

53,862

 

 

53,862

 

Additional paid-in capital

 

388,917

 

 

388,917

 

Accumulated other comprehensive loss

 

(66,282

)

 

(66,282

)

Retained earnings

 

225,206

 

(3,985

)

221,221

 

Total stockholders’ equity

 

601,703

 

(3,985

)

597,718

 

Total liabilities and stockholders’ equity

 

$

15,800,678

 

$

10,594

 

$

15,811,272

 

 

12



 

 

 

Six Months Ended June 30, 2007

 

 

 

As previously
reported

 

Adjustments

 

As restated

 

 

 

(Dollars in thousands)

 

Operating activities

 

 

 

 

 

 

 

Net income

 

$

34,516

 

$

(3,985

)

$

30,531

 

Adjustments to reconcile net income to net cash used in operating activities:

 

 

 

 

 

 

 

Adjustments related to interest sensitive products:

 

 

 

 

 

 

 

Interest credited to account balances

 

284,094

 

 

284,094

 

Amortization of deferred sales inducements

 

18,545

 

(2,582

)

15,963

 

Annuity and single premium universal life product charges

 

(20,447

)

 

(20,447

)

Change in fair value of embedded derivatives

 

(6,226

)

14,579

 

8,353

 

Increase in traditional life and accident and health insurance reserves

 

4,904

 

 

4,904

 

Policy acquisition costs deferred

 

(117,939

)

 

(117,939

)

Amortization of discount on contingent convertible notes

 

526

 

 

526

 

Amortization of deferred policy acquisition costs

 

57,858

 

(5,923

)

51,935

 

Provision for depreciation and other amortization

 

501

 

 

501

 

Amortization of discount and premiums on investments

 

(127,812

)

 

(127,812

)

Realized gains on investments

 

(596

)

 

(596

)

Change in fair value of derivatives

 

(90,464

)

 

(90,464

)

Deferred income taxes

 

5,016

 

(2,089

)

2,927

 

Share-based compensation

 

3,178

 

 

3,178

 

Changes in other operating assets and liabilities:

 

 

 

 

 

 

 

Accrued investment income

 

(5,061

)

 

(5,061

)

Income taxes recoverable

 

1,486

 

 

1,486

 

Other assets

 

745

 

 

745

 

Other policy funds and contract claims

 

(6,226

)

 

(6,226

)

Other amounts due to related parties

 

(10,629

)

 

(10,629

)

Other liabilities

 

(43,810

)

 

(43,810

)

Net cash used in operating activities

 

(17,841

)

 

(17,841

)

 

 

 

 

 

 

 

 

Investing activities

 

 

 

 

 

 

 

Sales, maturities, or repayments of investments:

 

 

 

 

 

 

 

Fixed maturity securities - available for sale

 

71,739

 

 

71,739

 

Fixed maturity securities - held for investment

 

28,147

 

 

28,147

 

Equity securities, available for sale

 

15,968

 

 

15,968

 

Mortgage loans on real estate

 

87,967

 

 

87,967

 

Derivative instruments

 

224,636

 

 

224,636

 

Acquisition of investments:

 

 

 

 

 

 

 

Fixed maturity securities - available for sale

 

(551,709

)

 

(551,709

)

Equity securities, available for sale

 

(51,604

)

 

(51,604

)

Mortgage loans on real estate

 

(206,835

)

 

(206,835

)

Derivative instruments

 

(154,276

)

 

(154,276

)

Policy loans

 

(9

)

 

(9

)

Purchases of property, furniture and equipment

 

(568

)

 

(568

)

Net cash used in investing activities

 

(536,544

)

 

(536,544

)

 

13



 

 

 

Six Months Ended June 30, 2007

 

 

 

As previously
reported

 

Adjustments

 

As restated

 

 

 

(Dollars in thousands)

 

Financing activities

 

 

 

 

 

 

 

Receipts credited to annuity and single premium universal life policyholder account balances

 

$

1,066,989

 

$

 

$

1,066,989

 

Coinsurance deposits - related party

 

92,734

 

 

92,734

 

Return of annuity and single premium universal life policyholder account balances

 

(640,946

)

 

(640,946

)

Repayments of notes payable

 

(2,061

)

 

(2,061

)

Increase in amounts due under repurchase agreements

 

10,597

 

 

10,597

 

Acquisition of common stock

 

(4,236

)

 

(4,236

)

Excess tax benefits realized from exercise of stock options

 

148

 

 

148

 

Proceeds from issuance of common stock

 

294

 

 

294

 

Checks in excess of cash balance

 

23,160

 

 

23,160

 

Net cash provided by financing activities

 

546,679

 

 

546,679

 

Decrease in cash and cash equivalents

 

(7,706

)

 

(7,706

)

 

 

 

 

 

 

 

 

Cash and cash equivalents at beginning of period

 

29,949

 

 

29,949

 

Cash and cash equivalents at end of period

 

$

22,243

 

$

 

$

22,243

 

 

3.  Contingencies

 

In recent years, companies in the life insurance and annuity business have faced litigation, including class action lawsuits alleging improper product design, improper sales practices and similar claims.  The Company is currently a defendant in several purported class action lawsuits alleging improper sales practices.  In these lawsuits, the plaintiffs are seeking returns of premiums and other compensatory and punitive damages.  No class has been certified in any of the pending cases at this time.  Although the Company has denied all allegations in these lawsuits and intends to vigorously defend against them, the lawsuits are in the early stages of litigation and neither their outcomes nor a range of possible outcomes can be determined at this time.  However, the Company does not believe that these lawsuits will have a material adverse effect on its business, financial condition or results of operations.

 

In addition, the Company is from time to time subject to other legal proceedings and claims in the ordinary course of business, none of which management believes is likely to have a material adverse effect on the Company’s financial position, results of operations or cash flows.  There can be no assurance that such litigation, or any future litigation, will not have a material adverse effect on the Company’s financial position, results of operations or cash flows.

 

4. Share-based Compensation Plans

 

During the first quarter of 2007, the Company established the 2007 Independent Sales Agent Stock Option Plan (the “Plan”).  Under this Plan, agents of American Equity Investment Life Insurance Company may receive grants of options to acquire shares of the Company’s common stock based upon their individual sales during 2007.  The Plan authorizes grants of options to agents for up to 2,500,000 shares of the Company’s common stock.  As of June 30, 2007, there are no grants of options under the Plan.

 

14



 

5.  Earnings Per Share

 

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

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2007

 

2006

 

2007

 

2006

 

 

 

(Dollars in thousands, except per share data)

 

 

 

 

 

 

 

 

 

 

 

Numerator:

 

 

 

 

 

 

 

 

 

Net income - numerator for earnings per common share, restated

 

$

20,604

 

$

42,911

 

$

30,531

 

$

46,884

 

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

 

262

 

266

 

528

 

536

 

Numerator for earnings per common share - assuming dilution, restated

 

$

20,866

 

$

43,177

 

$

31,059

 

$

47,420

 

 

 

 

 

 

 

 

 

 

 

Denominator:

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding (1)

 

57,122,194

 

55,643,507

 

56,909,226

 

55,598,992

 

 

 

 

 

 

 

 

 

 

 

Effect of dilutive securities:

 

 

 

 

 

 

 

 

 

Convertible subordinated debentures

 

2,769,093

 

2,808,381

 

2,784,099

 

2,827,825

 

Stock options

 

417,725

 

1,018,371

 

648,175

 

1,066,945

 

Deferred compensation agreements

 

 

1,184,647

 

 

1,233,152

 

Denominator for earnings per common share - assuming dilution

 

60,309,012

 

60,654,906

 

60,341,500

 

60,726,914

 

 

 

 

 

 

 

 

 

 

 

Earnings per common share, as reported

 

$

0.43

 

$

0.77

 

$

0.61

 

$

0.84

 

Earnings per common share, restated

 

$

0.36

 

$

 

$

0.54

 

$

 

Earnings per common share - assuming dilution, as reported

 

$

0.41

 

$

0.71

 

$

0.58

 

$

0.78

 

Earnings per common share - assuming dilution, restated

 

$

0.35

 

$

 

$

0.52

 

$

 


(1) Weighted average common shares outstanding include shares vested under the NMO Deferred Compensation Plan.

 

Potentially dilutive common shares representing 15,000 shares and 5,500 shares of common stock for the three months ended June 30, 2007 and 2006, respectively, and 11,000 shares of common stock for the six months ended June 30, 2007, were excluded from the computation of diluted earnings per share for these periods because their effect would have been antidilutive.  For the six months ended June 30, 2006, all potentially dilutive common shares were included in the computation of diluted earnings per share because the exercise prices were less than the average market price of the common shares.

 

15



 

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

 

Management’s discussion and analysis reviews our unaudited consolidated financial position at June 30, 2007, and the unaudited consolidated results of operations for the periods ended June 30, 2007 and 2006, and where appropriate, factors that may affect future financial performance.  This analysis should be read in conjunction with the unaudited consolidated financial statements and notes thereto appearing elsewhere in this Form 10-Q/A, and the audited consolidated financial statements, notes thereto and selected consolidated financial data appearing in our Annual Report on Form 10-K for the year ended December 31, 2006.

 

All statements, trend analyses and other information contained in this report and elsewhere (such as in filings by us with the Securities and Exchange Commission (“SEC”), press releases, presentations by us or our management or oral statements) relative to markets for our products and trends in our operations or financial results, as well as other statements including words such as “anticipate,” “believe,” “plan,” “estimate,” “expect,” “intend,” and other similar expressions, constitute forward-looking statements under the Private Securities Litigation Reform Act of 1995.  These forward-looking statements are subject to known and unknown risks, uncertainties and other factors which may cause actual results to be materially different from those contemplated by the forward-looking statements. Such factors include, among other things:

 

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

 

·                          customer response to new products and marketing initiatives;

 

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

 

·                          increasing competition in the sale of annuities;

 

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

 

·                          the risk factors or uncertainties listed from time to time in our private placement memorandums or filings with the SEC

 

Overview

 

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

 

16



 

Annuity deposits by product type collected during the three months and six months ended June 30, 2007 and 2006, were as follows:

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

Product Type

 

2007

 

2006

 

2007

 

2006

 

 

 

(Dollars in thousands)

 

Index annuities:

 

 

 

 

 

 

 

 

 

Index strategies

 

$

455,060

 

$

332,581

 

$

756,851

 

$

695,019

 

Fixed strategy

 

149,402

 

163,316

 

278,372

 

340,622

 

 

 

604,462

 

495,897

 

1,035,223

 

1,035,641

 

Fixed rate annuities:

 

 

 

 

 

 

 

 

 

Single-year rate guaranteed

 

16,308

 

20,495

 

28,094

 

44,063

 

Multi-year rate guaranteed

 

1,740

 

1,327

 

3,672

 

2,682

 

 

 

18,048

 

21,822

 

31,766

 

46,745

 

Total before coinsurance ceded

 

622,510

 

517,719

 

1,066,989

 

1,082,386

 

Coinsurance ceded

 

484

 

884

 

1,075

 

1,834

 

Net after coinsurance ceded

 

$

622,026

 

$

516,835

 

$

1,065,914

 

$

1,080,552

 

 

Net annuity deposits after coinsurance ceded increased 20% during the three months ended June 30, 2007 compared to the same period in 2006, and decreased 1% during the six months ended June 30, 2007, compared to the same period in 2006.  We attribute  the increase for the three months ended June 30, 2007 to the reinstatement of our A.M. Best Company financial strength rating to A- (Excellent) from B++ (Very Good) on August 3, 2006, certain product initiatives and agent incentives introduced in 2007 and more rational pricing from certain competitors. Our A.M. Best Company financial strength rating is a key element of our competitive position in the index and fixed annuity market.  The outlook for our current rating is stable.  We believe the rating upgrade has enhanced our competitive position and improved our prospects for sales increases in future periods.  However, the degree to which this rating upgrade will effect future sales is unknown.

 

We attribute the slight decrease in net annuity deposits for the six months ended June 30, 2007 to a much smaller impact from the items effecting the second quarter comparison, the flat to inverted yield curve which made fixed income alternatives such as certificates of deposit more attractive and the impact of the NASD’s notice to members in August 2005 on the sale of index annuities which has created confusion and impediments to sales of index annuities by annuity sales agents who are dual licensed to sell both insurance and securities products and more competitive pricing from certain competitors in 2006.

 

Earnings from products accounted for as deposit liabilities are primarily generated from the excess of net investment income earned over the interest credited to the policyholder, or the “investment spread”.  In the case of index annuities, the investment spread consists of net investment income in excess of the cost of the options purchased to fund the index-based component of the policyholder’s return and amounts credited as a result of minimum guarantees.

 

Our investment spread is summarized as follows:

 

 

 

Six Months Ended
June 30,

 

 

 

2007

 

2006

 

 

 

 

 

 

 

Average yield on invested assets

 

6.09

%

6.13

%

Cost of money:

 

 

 

 

 

Aggregate

 

3.38

%

3.46

%

Average net cost of money for index annuities

 

3.34

%

3.27

%

Average crediting rate for fixed rate annuities:

 

 

 

 

 

Annually adjustable

 

3.27

%

3.25

%

Multi-year rate guaranteed

 

4.22

%

5.12

%

 

 

 

 

 

 

Investment spread:

 

 

 

 

 

Aggregate

 

2.71

%

2.67

%

Index annuities

 

2.75

%

2.86

%

Fixed rate annuities:

 

 

 

 

 

Annually adjustable

 

2.82

%

2.88

%

Multi-year rate guaranteed

 

1.87

%

1.01

%

 

17



 

The cost of money and average crediting rates are computed based upon policyholder account balances and do not include the impact of amortization of deferred sales inducements.  See Critical Accounting Policies - Deferred Policy Acquisition Costs and Deferred Sales Inducements included in Management’s Discussion and Analysis included in our Annual Report on Form 10-K for the year ended December 31, 2006.  With respect to our index annuities, the cost of money includes the average crediting rate on amounts allocated to the fixed rate strategy, expenses we incur to fund the annual index credits and where applicable, minimum guaranteed interest credited.  Proceeds received upon expiration or early termination of call options purchased to fund annual index credits are recorded as part of the change in fair value of derivatives, and are largely offset by an expense for interest credited to annuity policyholder account balances.  See Critical Accounting Policies - Derivative Instruments - Index Products included in Management’s Discussion and Analysis included in our Annual Report on Form 10-K for the year ended December 31, 2006.

 

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, defaults or impairment of assets, our ability to manage interest rates credited to policyholders and costs of the options purchased to fund the annual index credits on our index annuities, our ability to manage the costs of acquiring new business (principally commissions to agents and first year bonuses credited to policyholders) and our ability to manage our operating expenses.

 

Results of Operations

 

Three and Six Months Ended June 30, 2007 and 2006

 

Net income decreased 52% to $20.6 million for the second quarter of 2007, and 35% to $30.5 million for the six months ended June 30, 2007 compared to $42.9 million and $46.9 million for the same periods in 2006.  The comparability of the amounts is impacted by (i) the application of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”) to our index annuity business which we estimate increased net income by $3.9 million for the second quarter of 2007 and decreased net income by $1.3 million for the six months ended June 30, 2007 compared to increases of $0.5 million and $5.2 million for the same periods in 2006 and (ii) the application of SFAS 133 to our contingent convertible senior notes which we estimate decreased net income by $0.1 million for the second quarter of 2007 and $0.3 million for the six months ended June 30, 2007 compared to increases of  $22.2 million and $5.4 million for the same periods in 2006.  Excluding these amounts, net income for the second quarter of 2007 and the six months ended June 30, 2007 would have been $16.9 million and $31.7 million, respectively, compared to $20.1 million and $36.1 million for the same periods in 2006.  These decreases were principally due to higher amortization of deferred policy acquisition costs and deferred sales inducements and increased operating expenses as discussed below.

 

Annuity and single premium universal life product charges (surrender charges assessed against policy withdrawals and mortality and expense charges assessed against single premium universal life policyholder account balances) increased 7% to $11.5 million for the second quarter of 2007, and 11% to $20.4 million for the six months ended June 30, 2007 compared to $10.7 million and $18.3 million for the same periods in 2006.  The increases were principally due to increases in policy withdrawals subject to surrender charges due to growth in the volume and aging of the business in force.  Withdrawals from annuity and single premium universal life policies subject to surrender charges were $82.5 million and $73.6 million for the three months ended June 30, 2007 and 2006, respectively, and $144.5 million and $124.5 million for the six months ended June 30, 2007 and 2006, respectively.  The average surrender charge collected on withdrawals subject to a surrender charge was 13.8% for the second quarter of 2007 and 14.0% for the six months ended June 30, 2007 compared to 14.4% and 14.6% for same periods in 2006.

 

Net investment income increased 4% to $175.7 million in the second quarter of 2007, and 4% to $345.1 million for the six months ended June 30, 2007 compared to $169.2 million and $331.6 million for the same periods in 2006.  These increases were principally attributable to the growth in our annuity business and corresponding increases in our invested assets, offset by decreases in the average yield earned on investments.  Average invested assets (on an amortized cost basis) increased to $11.3 billion for the six months ended June 30, 2007 compared to $10.8 billion for the six months ended June 30, 2006, while the average yield earned on average invested assets was 6.09% for the six months ended June 30, 2007 compared to 6.13% for the same period in 2006.  The decline in the yield earned on average invested assets is attributable to an overall decline in yield on the mix of assets owned in the respective periods.

 

18



 

Realized gains on investments fluctuate from period to period due to changes in the interest rate and economic environment and the timing of the sale of investments.  Realized gains and losses on investments include gains and losses on the sale of securities as well as losses recognized when the fair value of a security is written down in recognition of an “other than temporary” impairment.  The components of realized gains on investments for the three months and six months ended June 30, 2007 and 2006 are set forth as follows:

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2007

 

2006

 

2007

 

2006

 

 

 

(Dollars in thousands)

 

Available for sale fixed maturity securities:

 

 

 

 

 

 

 

 

 

Gross realized gains

 

$

5

 

$

977

 

$

412

 

$

2,999

 

Gross realized losses

 

 

(546

)

 

(3,053

)

 

 

5

 

431

 

412

 

(54

)

Equity securities:

 

 

 

 

 

 

 

 

 

Gross realized gains

 

12

 

 

184

 

443

 

Gross realized losses

 

 

(100

)

 

(100

)

 

 

12

 

(100

)

184

 

343

 

 

 

$

17

 

$

331

 

$

596

 

$

289

 

 

Change in fair value of derivatives (principally call options purchased to fund annual index credits on index annuities) is affected by the performance of the indices upon which our options are based and the aggregate cost of options purchased.  The components of change in fair value of derivatives for the three months and six months ended June 30, 2007 and 2006 are set forth as follows:

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2007

 

2006

 

2007

 

2006

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

Call options:

 

 

 

 

 

 

 

 

 

Change in unrealized gain (loss)

 

$

24,563

 

$

(76,573

)

$

(14,949

)

$

(32,822

)

Gain on option expiration or early termination

 

73,593

 

14,991

 

104,829

 

20,568

 

Interest rate swaps

 

830

 

 

584

 

 

 

 

$

98,986

 

$

(61,582

)

$

90,464

 

$

(12,254

)

 

A substantial portion of our call options are based upon the S&P 500 Index with the remainder based upon other equity and bond market indices.  The range of index appreciation for options expiring during the three months and six months ended June 30, 2007 and 2006 is as follows:

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

2007

 

2006

 

2007

 

2006

 

S&P 500 Index

 

 

 

 

 

 

 

 

 

Point-to-point strategy

 

10.1% — 24.4

%

2.7% — 15.0

%

6.9% — 24.4

%

2.7% — 15.0

%

Monthly average strategy

 

3.4% — 14.1

%

3.4% — 9.1

%

1.2% — 14.1

%

0.0% — 9.1

%

Monthly point-to-point strategy

 

5.6% — 17.4

%

0.0% — 10.1

%

4.4% — 17.4

%

0.0% — 10.1

%

Lehman Brothers U.S. Aggregate and U.S. Treasury indices

 

4.9% — 7.2

%

0.7% — 3.3

%

2.6% — 7.2

%

0.7% — 3.8

%

 

Actual amounts credited to policyholder account balances may be less than the index appreciation due to contractual features in the index annuity policies (participation rates and caps) which allow us to manage the cost of the options purchased to fund the annual index credits. The change in fair value of derivatives is also influenced by the aggregate costs of options purchased.  The aggregate cost of options has increased due to market volatility causing variations in our weekly hedging results and an increased amount of index annuities in force.  The aggregate cost of options is also influenced by the amount of policyholder funds allocated to the various indices, market volatility which affects option pricing and the policy terms and historical experience which affects

 

19



 

the strikes and caps of the options we purchase.  See Critical Accounting Policies - Derivative Instruments - Index Products included in Management’s Discussion and Analysis included in our Annual Report on Form 10-K for the year ended December 31, 2006.

 

Interest credited to account balances increased 65% to $168.1 million in the second quarter of 2007, and 53% to $284.1 million for the six months ended June 30, 2007 compared to $101.8 million and $185.5 for the same periods in 2006.  The components of interest credited to account balances are summarized as follows:

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2007

 

2006

 

2007

 

2006

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

Index credits on index policies

 

$

128,425

 

$

55,389

 

$

205,546

 

$

86,551

 

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

 

39,716

 

46,456

 

78,548

 

98,902

 

 

 

$

168,141

 

$

101,845

 

$

284,094

 

$

185,453

 

 

The changes in index credits were attributable to changes in the appreciation of the underlying indices (see discussion above under change in fair value of derivatives) and the amount of funds allocated by policyholders to the respective index options.  Total proceeds received upon expiration or gains recognized upon early termination of the call options purchased to fund the annual index credits were $128.6 million and $201.6 million for the three months and six months ended June 30, 2007, respectively, compared to $51.6 million and $84.9 million for the same periods in 2006.  The decreases in interest credited were due to reductions in the account balances receiving a fixed rate of interest and decreases in interest crediting rates on several of our products.  A significant factor in the reductions in interest credited on fixed rate annuities is the reduced interest on multi-year rate guarantee annuities.  A significant amount of these annuities were sold in 2001 with an initial rate guaranteed for the first five policy years.  We experienced surrenders of these policies upon expiration of this initial guaranteed interest rate during 2006 and reduced the crediting rates on those policies that remained in force.  The average amount of annuity liabilities outstanding (net of annuity liabilities ceded under coinsurance agreements) increased 12% during the six months ended June 30, 2007 to $11.6 billion from $10.5 billion during the same period in 2006.

 

Amortization of deferred sales inducements increased 72% to $11.6 million in the second quarter of 2007 and 2% to $16.0 million for the six months ended June 30, 2007 compared to $6.7 million and $15.7 million for the same periods in 2006.  In general, amortization of deferred sales inducements has been increasing each period due to growth in our annuity business and the deferral of sales inducements incurred with respect to sales of premium and interest bonus annuity products.  Bonus products represented 85% and 74% of our total annuity deposits during the six months ended June 30, 2007 and 2006, respectively.  The anticipated increase in amortization from these factors has been affected by amortization associated with the application of SFAS 133 to our index annuity business.  The application of SFAS 133 to our index annuity business creates differences in the recognition of revenues and expenses from derivative instruments including the embedded derivative liabilities in our index annuity contracts.  The change in fair value of the embedded derivatives will not correspond to the change in fair value of the purchased options because the purchased options are one-year options while the options valued in the fair value of embedded derivatives cover the expected life of the contracts which typically exceed 10 years.  The gross profit adjustments resulting from the application of SFAS 133 to our index annuity business increased amortization by $2.5 million in the second quarter of 2007 and decreased amortization by $0.9 million for the six months ended June 30, 2007 compared to $0.2 million and $3.3 million for the same periods in 2006.  Excluding these amounts, amortization for the second quarter of 2007 would have been $9.1 million and $16.9 million for the six months ended June 30, 2007 compared to $6.6 million and $12.4 million for the same periods in 2006.  See Critical Accounting Policies - Deferred Policy Acquisition Costs and Deferred Sales Inducements included in Management’s Discussion and Analysis included in our Annual Report on Form 10-K for the year ended December 31, 2006.

 

20



 

Change in fair value of embedded derivatives was an increase of $15.0 million in the second quarter of 2007 and $8.4 million for the six months ended June 30, 2007 compared to decreases of $111.3 million and $48.6 million for the same periods in 2006.  The components of change in fair value of embedded derivatives are summarized as follows:

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2007

 

2006

 

2007