AMERICAN EQUITY INVE

AEL
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AMERICAN EQUITY INVESTMENT LIFE : Management's Discussion and Analysis of Financial Condition and Results of Operations (form 10-Q)

11/06/2020 | 04:42pm


Management's discussion and analysis reviews our unaudited consolidated
financial position at September 30, 2020, and the unaudited consolidated results
of operations for the three and nine month periods ended September 30, 2020 and
2019, and where appropriate, factors that may affect future financial
performance. This analysis should be read in conjunction with our unaudited
consolidated financial statements and notes thereto appearing elsewhere in this
Form 10-Q, and the audited consolidated financial statements, notes thereto and
selected consolidated financial data appearing in our Annual Report on Form 10-K
for the year ended December 31, 2019. Interim operating results for the three
and nine month periods ended September 30, 2020 are not necessarily indicative
of the results expected for the entire year, particularly in light of the
material risks and uncertainties surrounding the spread of COVID-19 and the
impact it may have on our business, results of operations and financial
condition. Preparation of financial statements requires use of management
estimates and assumptions. Our estimates and assumptions could change in the
future as more information becomes known about the impact of COVID-19.
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 the SEC, press releases,
presentations by us or management or oral statements) may contain
forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933 and Section 21E of the Securities Exchange Act of 1934.
Forward-looking statements 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, and are subject to assumptions, risks and uncertainties.
Statements such as "guidance", "expect", "anticipate", "strong", "believe",
"intend", "goal", "objective", "target", "position", "potential", "will", "may",
"would", "should", "can", "deliver", "accelerate", "enable", "estimate",
"projects", "outlook", "opportunity" or similar words, as well as specific
projections of future events or results qualify as forward-looking statements.
Forward-looking statements, by their nature, are subject to a variety of
inherent 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
the SEC.
A detailed discussion of these and other factors that might affect our
performance, can be found in the Company's Annual Report on Form 10-K for the
year ended December 31, 2019 and in our Quarterly Report on Form 10-Q for the
quarterly periods ended March 31, 2020 and June 30, 2020 filed with the SEC.
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.
The outbreak of the novel coronavirus (COVID-19), recognized as a pandemic by
the World Health Organization, has created significant economic and financial
turmoil both in the U.S. and around the world which has had a material effect on
the global economy and financial markets and raised concerns of a global
recession. At this time, it is not possible to predict how COVID-19 will impact
the Company, our results of operations or our financial condition and liquidity.
See Item 1A. Risk Factors of our Quarterly Report on Form 10-Q for the quarterly
period ended March 31, 2020 for a discussion of risk factors related to major
public health issues, specifically the COVID-19 pandemic.
At the outbreak of COVID-19, we moved decisively to first protect our employees
and business partners and then to pivot our operating platform to continue to
provide industry leading levels of service to clients and producers, in a
prolonged work from home environment. In addition, we increased our liquidity
position and held $2.2 billion of unencumbered cash as of September 30, 2020.
Currently, most of our employees are working remotely with only operationally
critical employees working at our offices in West Des Moines, Iowa.
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COVID-19 has caused significant economic effects where we operate, including
closures of many businesses deemed non-essential due to shelter-in-place,
stay-at-home, travel limitations and other governmental regulations or self
imposed social distancing practices. These actions have caused disruption to the
distribution channels through which we sell our products, including independent
agents, and their clients. It is currently unclear how long such COVID-19
related actions will last.
Under U.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.
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 have begun to implement an updated strategy after undertaking a thorough
review of our current business, market dynamics and the current interest rate
environment. Our updated strategy focuses on four key pillars: Go-to-Market,
Investment Management, Capital Structure and Foundational Capabilities.
Go-to-Market focuses on how we generate policyholder funds under management
through annuity product sales. We consider our marketing capabilities and
franchise to be one of our core competitive strengths. We have 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 with
one million dollars or greater of annuity product sales each year. We want to
increase our share of annuity product sales generated by IMOs and accelerate our
expansion into bank and broker dealer 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 financial objectives of our go to market
strategy are to accelerate growth of new business and annuity funding
origination in normal economic environments and to reduce cost of funds, the
total cost of originating an annuity funding.
Investment Management enables the return on assets to generate adequate spread
income. In an environment where risk free rates are between zero and one
percent, 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 with
contractually strong cash flows like real estate and infrastructure. 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 investment alternatives to traditional fixed
income securities. The future partnerships with asset managers may include us
taking an equity interest in the asset manager to create greater alignment and
allow us to participate in the economics from scaling investment platforms.
Our capital structure plan is to make greater use of reinsurance to enable us to
free up capital. We announced on September 28, 2020 an agreement in principle to
enter into a strategic partnership with Värde Partners and Agam Capital
Management
which includes a proposed reinsurance agreement and an asset
management joint venture with Värde Partners under which we will cede $5 billion
of existing annuity liabilities and free up capital of approximately $350
million
. Under the terms of the agreement in principle, Värde Partners will
establish a Bermuda reinsurance company that would reinsure $5 billion of our
fixed index annuity liabilities. We and Värde Partners will jointly establish an
asset management entity to provide insurance asset management services to the
reinsurance company. We intend to have a significant minority interest in the
new reinsurer and a 35% interest in the newly formed asset management entity. We
announced on October 18, 2020 an agreement in principle to enter into a
strategic partnership with Brookfield Asset Management ("Brookfield") under
which we will cede $5 billion of existing annuity liabilities and up to an
incremental $5 billion of new annuity sales; gain access to Brookfield
investments in targeted asset classes; and receive a cornerstone investment by
Brookfield in which it will acquire up to a 19.9% ownership interest in the
Company. The proposed reinsurance agreement with Brookfield will free up
approximately $320 to $350 million of capital. We expect to close both
transactions in the first half of 2021.
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The equity investment by Brookfield will take place in two stages: an initial
purchase of a 9.9% equity interest at $37.00 per share promptly following
approval under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, and a
second purchase of up to an incremental 10.0% equity interest, at the greater
value of $37.00 per share or adjusted book value per share (excluding AOCI and
the net impact of fair value accounting for derivatives and embedded
derivatives). The second equity investment is subject to finalization of certain
reinsurance agreement terms, receipt of applicable regulatory approvals and
other closing conditions. In addition, Brookfield has agreed not to transfer any
common shares purchased in the equity investment for a period of two years after
the applicable closing of the investment, as well as to customary standstill
restrictions until the five-year anniversary of the initial equity investment,
in each case, subject to certain exceptions. Brookfield will also receive one
seat on the Company's Board of Directors following the initial equity
investment.
On October 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 and to institute a
regular cash return program for shareholders. We started the buyback program on
October 30, 2020 and expect an accelerated share repurchase program to launch in
the fourth quarter.
We plan in the future to establish our own wholly-owned offshore reinsurance
company and will seek 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. Based on our updated business strategy, we expect to annually return
$250 million to $300 million of capital to shareholders starting in 2021.
Foundational Capabilities is focused on upgrading our operating platform to
enhance the digital customer experience, create differentiation through data
analytics, enhance core technology, and align talent.
Based on our updated strategy, we are targeting operating return on equity in
the 11-14% range over the next few years, and above 15%, on average, over the
long term.
Life insurance companies are subject to the NAIC risk-based capital ("RBC")
requirements and rating agencies utilize a form of RBC to partially determine
capital strength of insurance companies. Our RBC ratio at December 31, 2019 was
372%, and our estimated RBC ratio at September 30, 2020 was 382%.
We intend to manage our capitalization in normal economic conditions at a level
that is consistent with a 400% RBC ratio; and allow it to drift downwards if
necessary to approximately 320% RBC for reasons including, but not limited to,
realized credit losses or temporary increases in required risk capital for
ratings migrations. This level is intended to reflect a level that is consistent
with the rating agencies expectations for capital adequacy ratios at different
points in an economic cycle. This implies operating with a peak to trough swing
whereby capital is absorbing risk at the low point of the economic cycle. As
economic activity recovers, we would expect to grow capital adequacy back to or
near the 400% RBC ratio level through a combination of earnings and balance
sheet optimization actions while continuing to execute on our core business
strategy.
During June of 2020, we strengthened our balance sheet by raising $300 million
in preferred equity through the issuance of 12,000 shares of 6.625% Fixed-Rate
Reset Non-Cumulative Preferred Stock with a liquidation preference of $25,000
per share, for aggregate net proceeds of approximately $290.3 million which is
currently held at American Equity Investment Life Holding Company. This provides
us a strong capital cushion to weather turbulence from potential ratings
migration and credit losses and would provide an additional 27 points of RBC if
such proceeds were contributed to American Equity Investment Life Insurance
Company
.
On August 21, 2020 S&P affirmed its "A-" financial strength rating on American
Equity Investment Life Insurance Company
and its "BBB-" long-term issuer credit
rating on American Equity Investment Life Holding Company, and revised its
outlook to "stable" from "negative" primarily due to capital management actions
taken throughout the year, including a $200 million contribution from American
Equity Investment Life Holding Company
to American Equity Investment Life
Insurance Company
and the issuance of Fixed-Rate Reset Non-Cumulative Stock,
Series B for aggregate net proceeds of $290.3 million.
On June 26, 2020, A.M. Best affirmed its "A-" financial strength rating of
American Equity Investment Life Insurance Company and its subsidiaries, American
Equity Investment Life Insurance Company of New York
and Eagle Life Insurance
Company
, its "bbb-" long-term issuer credit rating of American 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 by A.M. Best on June 26, 2020.
On April 24, 2020, Fitch affirmed its "A-" financial strength rating on American
Equity Investment Life Insurance Company
and its life insurance subsidiaries,
its "BBB" issuer default rating on American Equity Investment Life Holding
Company
and its "BBB-" senior unsecured debt ratings, but revised its outlook to
"negative" from "stable" on its financial strength, issuer default and senior
unsecured debt ratings due to disruption to economic activity and the financial
markets from the COVID-19 pandemic.
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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,
2020 2019 2020 2019
Average yield on invested assets 4.10% 4.59% 4.20% 4.53%
Aggregate cost of money 1.66% 1.84% 1.71% 1.87%
Aggregate investment spread 2.44% 2.75% 2.49% 2.66%

Impact of:
Investment yield - additional prepayment
income 0.10% 0.11% 0.06% 0.06%
Cost of money benefit from over (under)
hedging 0.03% 0.02% 0.03% 0.04%


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 ended December 31, 2019. 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 ended December 31, 2019.
The current environment of low interest rates and low yields for investments
with the credit quality we prefer presents a strong headwind to achieving our
target rate for investment spread. Active management of policyholder crediting
rates has continued to lower the aggregate cost of money. The most recent
actions include reductions to caps and crediting rates on $29.7 billion of
policyholder funds in January of 2020 and reductions to participation rates on
$4.3 billion of policyholder funds in June 2020. We continue to have flexibility
to reduce our crediting rates if necessary and could decrease our cost of money
by approximately 63 basis points if we reduce current rates to guaranteed
minimums. Investment yields on fixed income securities purchased and mortgage
loans funded during most of 2020 and 2019 were at average rates below the
overall portfolio yield which has resulted in a decrease in the average yield on
invested assets. In addition, the decline in yields on our floating rate
investment portfolio, mark to market losses on investment partnerships and our
decision to hold higher levels of cash and cash equivalents since March of 2020
contributed to the decrease in the average yield on invested assets for the
three and nine month periods ended September 30, 2020 compared to the same
periods in 2019.
Results of Operations for the Three and Nine Months Ended September 30, 2020 and
2019
Annuity deposits by product type collected during the three and nine months
ended September 30, 2020 and 2019, were as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
2020 2019 2020 2019
(Dollars in thousands)
American Equity Investment Life Insurance
Company
:
Fixed index annuities $ 432,602 $ 1,054,100% $ 1,491,564 $ 3,293,458
Annual reset fixed rate annuities 1,817 2,340 6,464 9,402
Multi-year fixed rate annuities 531 593 983 1,307
Single premium immediate annuities 10,205 3,314 25,687 7,129
445,155 1,061,043 1,524,698 3,311,296
Eagle Life Insurance Company:
Fixed index annuities 60,476 166,081 239,349 579,119
Annual reset fixed rate annuities 39 - 97 193
Multi-year fixed rate annuities 68,206 79,000 73,386 151,572
128,721 245,081 312,832 730,884
Consolidated:
Fixed index annuities 493,078 1,220,877 1,730,913 3,872,577
Annual reset fixed rate annuities 1,856 2,340 6,561 9,595
Multi-year fixed rate annuities 68,737 79,593 74,369 152,879
Single premium immediate annuities 10,205 3,314 25,687 7,129
Total before coinsurance ceded 573,876 1,306,124 1,837,530 4,042,180
Coinsurance ceded 5,996 86,090 29,390 212,641
Net after coinsurance ceded $ 567,880 $ 1,220,034 $ 1,808,140 $ 3,829,539


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Annuity deposits before and after coinsurance ceded decreased 56% and 53%,
respectively, during the third quarter of 2020 compared to the same period in
2019 and decreased 55% and 53%, respectively, during the nine months ended
September 30, 2020 compared to the same period in 2019. The decrease in sales
for the three and nine months ended September 30, 2020 compared to the same
periods in 2019 was primarily due to the impact of the COVID-19 pandemic on
limitations of face to face meetings and increased social distancing
requirements as well as competitive pressures within each of our distribution
channels. We continue to face a challenging environment for sales of fixed index
annuities due to a highly competitive market, and until social distancing needs
abate or producers find new ways to engage with clients, we would expect sales
to remain subdued.
We coinsure 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. The decrease in coinsurance ceded premiums was
attributable to a decrease in certain multi-year rate guaranteed annuities and
fixed index annuities sold by Eagle Life for the three and nine months ended
September 30, 2020 compared to the same periods in 2019.
Net income available to common stockholders increased to $661.3 million in the
third quarter of 2020 and to $644.2 million for the nine months ended
September 30, 2020 compared to $37.4 million and $25.9 million for the same
periods in 2019. The increases in net income available to common stockholders
for the three and nine months ended September 30, 2020 were driven primarily by
the impact of assumption updates during the third quarter of 2020 compared to
the impact of assumption updates during the third quarter of 2019 as further
described below.
Net income is impacted by the change in 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 ended
September 30, 2020 was negatively impacted by a net decrease 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. Net income for the
three and nine months ended September 30, 2019 was also negatively impacted by
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
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.
Net income, in general, is impacted by the volume of business in force and the
investment spread earned on this business. Our investment spread measured in
dollars was $318.2 million for the third quarter of 2020 and $966.3 million for
the nine months ended September 30, 2020 compared to $344.0 million and $975.3
million
for the same periods in 2019. Our investment spread has been negatively
impacted by the extended low interest rate environment and by holding higher
levels of cash and cash equivalents due to current economic conditions caused by
COVID-19 (see Net investment income). 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.
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 2020 and 2019 periods
includes effects from updates to assumptions as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
2020 2019 2020 2019
(Dollars in thousands)
Increase (decrease) in amortization of
deferred sales inducements $ 391,428 $


(104,707) $ 428,101 $ (104,707)
Increase (decrease) in amortization of
deferred policy acquisition costs


589,209 (192,982) 646,785 (192,982)
Increase in interest sensitive and index
product benefits 285,825 315,383 285,825 315,383
Increase (decrease) in change in fair
value of embedded derivatives (2,111,140) 28,208 (2,341,279) 28,208
Effect on net income available to common
stockholders 663,073 (35,987) 769,611 (35,987)


We review these assumptions quarterly and as a result of these reviews, we made
updates to assumptions in the second and third quarters of 2020 and the third
quarter of 2019. In addition, we implemented an enhanced actuarial valuation
system during the third quarter of 2019, and as a result, our third quarter 2019
assumption updates include model refinements resulting from the implementation.
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.
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Due to the current 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.
The most significant assumption updates made during the third quarter of 2019
were to lapse and utilization assumptions. We had credible lapse and utilization
data based upon a comprehensive experience study spanning over 10 years on our
products with lifetime income benefit riders and have experienced lapse rates
that are lower than previously estimated.
Lower lapse assumptions resulted in an expectation that more policyholders will
turn on their lifetime income benefit than previously anticipated which results
in a greater amount of benefit payments in excess of account value and the need
for a greater liability for lifetime income benefit riders. The decrease in
lapse rate assumptions also resulted in policies being in force for a longer
period of time and an increase in expected gross profits as compared to previous
estimates. The higher level of expected future gross profits resulted in an
increase in the balances of deferred policy acquisition costs and deferred sales
inducements.
Our historical experience also indicated that the ultimate utilization of
certain lifetime income benefit riders was expected to be less than our prior
assumptions and the timing of utilization of lifetime income benefit riders is
later than in our prior assumptions. We reduced our ultimate utilization
assumptions for fee riders from 75% to 60% and for no-fee riders from 37.5% to
30%, for policies issued in 2014 and prior years. The net effect of the
utilization assumption revisions resulted in a decrease in the liability for
lifetime income benefit riders and partially offset the increase in the reserve
for lifetime income benefit riders from the change in lapse assumptions.
In addition, we revised our assumptions regarding future crediting/discount
rates. We assumed a 3.80% U.S. Treasury rate with a 20 year mean revision
period. Our assumption for aggregate investment spread was 2.60% which
translated to an ultimate discount rate of 2.90%. While the aggregate spread of
2.60% did not change from prior estimates, our estimates of the profitability of
individual cohorts changed with the use of an aggregate portfolio yield across
all cohorts. This assumption revision resulted in a change in the allocation of
profitability by cohort, which caused a reduction in the deferred policy
acquisition costs and deferred sales inducements assets and partially offset the
increase in the deferred policy acquisition costs and deferred sales inducements
assets from the change in lapse assumptions.
The most significant updates 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 2019 were to decrease lapse rate assumptions as noted
above. The impact of the lapse rate assumption changes was partially offset by a
decrease in the option budget from 3.10% to 2.90% as a result of a revised
estimate of the cost of options over the 20 year mean reversion period.
Net income available to common stockholders for the three and nine months ended
September 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 available to common stockholders for the nine months ended
September 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 allows 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.
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Non-GAAP operating income (loss) available to common stockholders, a non-GAAP
financial measure, decreased to $(249.8) million in the third quarter of 2020
and decreased to $(2.6) million for the nine months ended September 30, 2020
compared to $233.4 million and $422.3 million for the same periods in 2019.
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 ended September 30, 2020 and 2019 are set forth in the table
that follows:
Three Months Ended Nine Months Ended
September 30, September 30,
2020 2019 2020 2019
(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 $ 661,250 $ 37,360 $ 644,207 $ 25,940
Adjustments to arrive at non-GAAP operating
income (loss) available to common
stockholders:
Net realized gains/losses on financial
assets, including credit losses 15,145 (3,175) 49,986 (245)
Change in fair value of derivatives and
embedded derivatives - fixed index annuities (1,176,909) 250,186 (873,773) 500,998
Change in fair value of derivatives -
interest rate caps and swap - (76) (848) 1,414

Income taxes 250,701 (50,940) 177,804 (105,759)
Non-GAAP operating income (loss) available
to common stockholders $ (249,813) $ 233,355


$ (2,624) $ 422,348





The amounts disclosed in the reconciliation above are presented net of related
adjustments to amortization of deferred sales inducements and deferred policy
acquisition costs where applicable.
Non-GAAP operating income (loss) available to common stockholders for
the 2020 and 2019 periods includes effects from updates to assumptions as
follows:
Three and Nine Months
Ended
September 30,
2020
2019



(Dollars in thousands)
Increase (decrease) in amortization of deferred sales
inducements


$ 57,467 $ (184,882)


Increase (decrease) in amortization of deferred policy
acquisition costs


90,970 (288,332)
Increase in interest sensitive and index product benefits 285,825 315,383
Effect on non-GAAP operating income (loss) available to common
stockholders (340,895) 123,739


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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 2020 and 2019 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.
The changes in non-GAAP operating income (loss) available to common stockholders
for the three and nine months ended September 30, 2020 compared to the same
periods in 2019 were primarily a result of the impact of assumption updates as
previously noted. Non-GAAP operating income available to common stockholders
adjusted for the impact of updates to assumptions for the three and nine months
ended September 30, 2020 decreased compared to the same periods in 2019 due to
lower investment income and a greater increase in the liability for lifetime
income benefit riders partially offset by a decline in deferred policy
acquisition cost and deferred sales inducement amortization. The increase in the
liability for lifetime income benefit riders and the decline in deferred policy
acquisition cost and deferred sales inducement amortization were primarily a
result of actuarial updates made in the third quarters of 2020 and 2019 and the
impact such updates had on the pattern of the increase in the liability for
lifetime income benefit riders and the pattern of deferred policy acquisition
cost and deferred sales inducement amortization. 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 2% to $62.3 million in the third quarter of 2020 and increased
4% to $185.3 million for the nine months ended September 30, 2020 compared to
$63.6 million and $177.3 million for the same periods in 2019. The components of
annuity product charges are set forth in the table that follows:
Three Months Ended Nine Months Ended
September 30, September 30,
2020 2019 2020 2019
(Dollars in thousands)
Surrender charges $ 16, $ 20,537 $ 55,542 $ 56,473
Lifetime income benefit riders (LIBR)
fees 45,830 43,110 129,722 120,840
$ 62,277 $ 63,647 $ 185,264 $ 177,313

Withdrawals from annuity policies subject
to surrender charges $ 176,442 $ 201,392 $ 573,419 $ 511,236
Average surrender charge collected on
withdrawals subject to surrender charges 9.3 % 10.2 % 9.7 % 11.0 %

Fund values on policies subject to LIBR
fees $ 5,789,502 $ 5,674,545 $ 16,821,767 $ 16,365,077
Weighted average per policy LIBR fee 0.79 % 0.76 % 0.77 % 0.74 %


The decrease in annuity product charges for the three months ended September 30,
2020
compared to the same period in 2019 was attributable to a decrease in
withdrawals from annuity policies subject to surrender charges and lower average
surrender charges collected on those withdrawals partially offset by an increase
in fees assessed for lifetime income benefit riders due to a larger volume of
business subject to the fee and an increase in the average fees being charged.
The increase in annuity product charges for the nine months ended September 30,
2020
compared to the same period in 2019 was attributable to an increase in fees
assessed for lifetime income benefit riders due to a larger volume of business
in force subject to the fee and increases in the average fees being charged
partially offset by lower average surrender charges collected on withdrawals
from annuity policies subject to surrender charges. See Interest sensitive and
index product benefits below for corresponding expense recognized on lifetime
income benefit riders.
Net investment income decreased 8% to $543.3 million in the third quarter of
2020 and 3% to $1,660.4 million for the nine months ended September 30, 2020
compared to $590.4 million and $1,719.4 million for the same periods in 2019.
The decreases were attributable to a decrease in average yield earned on average
invested assets during the three and nine months ended September 30, 2020
compared to the same periods in 2019, partially offset by increases in our
average invested assets during the three and nine months ended September 30,
2020
compared to the same periods in 2019. Average invested assets excluding
derivative instruments (on an amortized cost basis) increased 3% to $53.0
billion
for the third quarter of 2020 and 4% to $52.8 billion for the nine
months ended September 30, 2020 compared to $51.5 billion and $50.7 billion for
the same periods in 2019.
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The average yield earned on average invested assets was 4.10% for the third
quarter of 2020 and 4.20% for the nine months ended September 30, 2020 compared
to 4.59% and 4.53% for the same periods in 2019. The decrease in average yield
earned for the three and nine months ended September 30, 2020 compared to the
same periods in 2019 was primarily attributable to investment of new premiums
and portfolio cash flows during most of 2020 and 2019 at average rates below the
overall portfolio yield, a decline in yields on our floating rate investment
portfolio due to decreases in the average benchmark rates associated with these
investments, an increase in the level of cash and cash equivalent holdings due
to our decision to hold higher levels of cash and cash equivalents since March
2020
and mark to market losses on investment partnerships during the nine months
ended September 30, 2020 due to changes in fair market valuations. The average
yield on fixed income securities purchased and mortgage loans funded during the
three and nine months ended September 30, 2020 was 3.59% and 3.75%, compared to
3.30% and 3.95% for the same periods in 2019. During the second and third
quarter of 2020 we began to purchase residential mortgage loans which provided a
meaningful increase in purchase yields for the three and nine months ended
September 30, 2020.
Change in fair value of derivatives consists of call options purchased to fund
annual index credits on fixed index annuities, and an interest rate swap and
interest rate caps that hedge our floating rate subordinated debentures. The
components of change in fair value of derivatives are as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
2020 2019 2020 2019
(Dollars in thousands)
Call options:
Loss on option expiration $ (3,228) $ (106,440) $ (2,492) $ (272,603)
Change in unrealized gains/losses 208,239 86,443 (406,771) 714,714
Interest rate swap - (3) - (1,059)
Interest rate caps - (42) 62 (580)
$ 205,011 $ (20,042) $ (409,201) $ 440,472


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 fair values and changes in the fair
values of those call options between periods. The change in unrealized
gains/losses on call options for the three and nine months ended September 30,
2020
as compared to the same periods in 2019 reflect the impact from equity
market volatility throughout 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, 2020 and 2019 is as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
2020 2019 2020 2019
S&P 500 Index
Point-to-point strategy 0.6% - 11.6% 0.0% - 7.0% 0.0% - 17.4% 0.0% - 7.0%
Monthly average strategy 0.0% - 8.0% 0.0% - 3.5% 0.0% - 11.9% 0.0% - 6.9%
Monthly point-to-point strategy 0.0% - 0.2% 0.0% - 2.1% 0.0% - 14.0% 0.0% - 4.3%
Fixed income (bond index) strategies 0.0% - 11.1% 0.0% - 10.0% 0.0% - 13.6% 0.0% - 10.0%


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, 2020 were lower than for the same periods in 2019 as
option costs generally decreased during 2019 and into 2020. The decrease in
aggregate option costs was partially offset by an increase in the amount of
fixed index annuities in force during the three and nine months ended
September 30, 2020 compared to the same periods in 2019. 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, 2019.
Net realized gains (losses) on investments includes gains and losses on the sale
of securities and other investments and 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 3 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 4 to our unaudited consolidated financial statements
for discussion of credit losses recognized on mortgage loans on real estate.
During the nine months ended September 30, 2020, securities were sold at gains
as we looked to increase our cash and cash equivalent holdings in response to
the COVID-19 pandemic. 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.
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Interest sensitive and index product benefits increased 15% to $576.1 million in
the third quarter of 2020 and 37% to $1.2 billion for the nine months ended
September 30, 2020 compared to $500.3 million and $888.1 million for the same
periods in 2019. The components of interest sensitive and index product benefits
are summarized as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
2020 2019 2020 2019
(Dollars in thousands)
Index credits on index policies $ 174,747 $ 92,343 $ 551,562 $ 310,020
Interest credited (including changes in
minimum guaranteed interest for fixed
index annuities) 48,042 51,706 148,078 153,110
Lifetime income benefit riders 353,358 356,236 517,718 424,932
$ 576,147 $ 500,285 $ 1,217,358 $ 888,062


The increase in index credits for the three and nine months ended September 30,
2020
compared to the same periods in 2019 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 $178.4 million and
$560.7 million for the three and nine months ended September 30, 2020, compared
to $95.5 million and $320.4 million for the same periods in 2019. The changes in
benefits recognized for lifetime income benefit riders for the three and nine
months ended September 30, 2020 compared to the same periods in 2019 were
primarily due to the impact that assumption updates made during the third
quarter of 2020 and 2019 had on the lifetime income benefit riders liability and
the pattern of growth of the liability due to those assumption updates. The
assumption updates used in determining the liability for lifetime income benefit
riders resulted in an increase in the liability for lifetime income benefit
riders in both 2020 and 2019. (See Net income above for a discussion of the
impact of assumption updates). Benefits recognized for lifetime income benefit
riders increased for the three and nine months ended September 30, 2020 as
compared to the same periods in 2019 due to an increase in fund value of
policies with lifetime income benefit riders, which correlates to the increase
in fees discussed in Annuity product charges.
The liability (net of coinsurance ceded) for lifetime income benefit riders was
$1.8 billion and $1.3 billion at September 30, 2020 and December 31, 2019,
respectively.
Amortization of deferred sales inducements before gross profit adjustments
increased for the three and nine months ended September 30, 2020 compared to the
same periods in 2019 primarily due to the impact of assumption updates made
during the third quarter of 2020 as compared to the impact of assumption updates
made during the third quarter of 2019. Bonus products represented 76% and 78% of
our net annuity account values at September 30, 2020 and September 30, 2019,
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 including credit losses on fixed maturity
securities. 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,
2020 2019 2020 2019
(Dollars in thousands)
Amortization of deferred sales inducements
before gross profit adjustments $ 113,273 $ (113,177) $ 197,514 $ 24,512
Gross profit adjustments:
Fair value accounting for derivatives and
embedded derivatives 305,981 57,102 224,938 (26,319)
Net realized gains (losses) on investments (2,271) 306 (7,056) (868)
Amortization of deferred sales inducements
after gross profit adjustments $ 416,983 $ (55,769)


$ 415,396 $ (2,675)





See Net income and Non-GAAP operating income (loss) above for discussion of the
impact of assumption updates on amortization of deferred sales inducements for
the three and nine months ended September 30, 2020 and 2019. 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 ended December 31, 2019.
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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 5 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,
2020 2019 2020 2019
(Dollars in thousands)
Fixed index annuities - embedded
derivatives $ (2,021,513) $ 24,998 $ (2,392,600) $ 882,230
Other changes in difference between policy
benefit reserves computed using derivative
accounting vs. long-duration contracts
accounting 289,016 187,280 536,977 423,933
$ (1,732,497) $ 212,278 $ (1,855,623) $ 1,306,163


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, 2019.
The primary reason for the decreases in the change in fair value of the fixed
index annuity embedded derivatives during the three and nine months ended
September 30, 2020 compared to the same periods of 2019 was a decrease in the
expected cost of annual call options we will purchase in the future to fund
index credits beyond the next policy anniversary date as a result of updates to
assumptions made during the three months ended September 30, 2020. See Net
Income
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, 2020 and 2019. In addition, a decrease in the
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 nine months ended September 30, 2020 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 nine months ended
September 30, 2019 resulted in a decrease in the change in fair value of the
fixed annuity embedded derivatives for the nine-months ended September 30, 2020
compared to the same period of 2019 while an increase in such expected index
credits due to a larger increase in the fair value of the call options acquired
to fund such index credits for the three months ended September 30, 2020
compared to the same period of 2019 resulted in an increase in the fair value of
the fixed index annuity embedded derivatives for the three months ended
September 30, 2020 compared to the same period of 2019. These decreases in the
fair value of the fixed index annuity embedded derivatives for the nine months
ended September 30, 2020 were partially offset by a larger decrease in the net
discount rate during the nine months ended September 30, 2020 compared to the
same period of 2019. The decrease in the net discount rate for the nine months
ended September 30, 2020 consists of a decrease in treasury rates partially
offset by a widening of credit spreads. 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 increased for the three and nine months ended September 30, 2020
compared to the same periods in 2019 primarily due to the impact of assumption
updates made during the third quarter of 2020 as compared to the impact of
assumption updates made during the third quarter of 2019. 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 including credit losses on fixed maturity securities. 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.
Amortization of deferred policy acquisition costs is summarized as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
2020 2019 2020 2019
(Dollars in thousands)
Amortization of deferred policy
acquisition costs before gross profit
adjustments $ 173,508 $ (182,353) $ 301,004 $ 19,162
Gross profit adjustments:
Fair value accounting for derivatives and
embedded derivatives 452,694 60,674 333,319 (64,259)
Net realized gains (losses) on investments (3,606) 745 (10,914) (759)
Amortization of deferred policy
acquisition costs after gross profit
adjustments $ 622,596 $ (120,934) $ 623,409 $ (45,856)


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See Net income and Non-GAAP operating income (loss) above for discussion of the
impact of assumption updates on amortization of deferred policy acquisition
costs for the three and nine months ended September 30, 2020 and 2019. 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 ended December 31, 2019.
Other operating costs and expenses increased 11% to $42.7 million in the third
quarter of 2020 and 12% to $128.3 million for the nine months ended
September 30, 2020 compared to $38.6 million and $115.0 million for the same
periods in 2019 and are summarized as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
2020 2019 2020 2019
(Dollars in thousands)
Salary and benefits $ 24,966 $ 20,170 $ 68,953 $ 61,263
Risk charges 11,387 10,031 33,334 28,062
Other 6,385 8,353



26,028 25,634
Total other operating costs and expenses $ 42,738 $ 38,554 $ 128,315 $ 114,959





Salary and benefits for the three and nine months ended September 30, 2020
reflect increases of $6.0 million and $2.6 million, respectively, due to an
increased number of employees related to our growth and increases of $2.2
million
and $2.4 million, respectively, for expense recognized under our equity
and cash incentive compensation programs ("incentive compensation programs")
compared to the same periods in the prior year. The increases in expenses
related to our incentive compensation programs for the three and nine months
ended September 30, 2020 were primarily due to an increase in the percentage of
performance-based restricted stock units expected to be earned and an increase
in expected payouts due to a larger number of employees participating in
incentive compensation programs in 2020 as compared to 2019.
The increase in risk charges expense for the three and nine months ended
September 30, 2020 compared to the same periods in 2019 was due to an increase
in the amount of excess regulatory reserves ceded to an unaffiliated reinsurer.
The excess regulatory reserves ceded at September 30, 2020 and 2019 were
$1,332.2 million and $1,132.2 million, respectively.
Other expenses decreased for the three months ended September 30, 2020 compared
to the same period in 2019 primarily as a result of decreases in expenses
related to lower sales production activity due to the COVID-19 pandemic offset
by increases in consulting fees. Other expenses increased for the nine months
ended September 30, 2020 compared to the same period in 2019 primarily as a
result of increases in consulting fees, depreciation and maintenance expense
related to software and hardware assets, licensing fees which are based on the
level of policyholder funds under management allocated to index strategies and
non-deferrable commission expenses. These increases were offset by decreases in
expenses related to lower sales promotion activity due to the COVID-19 pandemic.
Income tax expense was $184.6 million in the third quarter of 2020 and $143.3
million
for the nine months ended September 30, 2020 compared to $13.6 million
and $8.8 million for the same periods in 2019. The change in income tax expense
was primarily due to changes in income before income taxes. The effective income
tax rates for the three and nine months ended September 30, 2020 were 21.7% and
17.8%, respectively, and 26.8% and 25.3% for the same periods in 2019,
respectively.
Income tax expense and the resulting effective tax rate are based upon two
components of income before income taxes ("pretax income") that are taxed at
different tax rates. Life insurance income is generally taxed at an effective
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 for the parent company and other non-life insurance subsidiaries
(the "non-life insurance group") is generally taxed at an effective tax rate of
29.5% reflecting the combined federal / state income tax rates. The effective
income tax rates resulting from the combination of the income tax provisions for
the life / non-life sources of income vary from period to period based primarily
on the relative size of pretax income from the two sources.
The effective tax rate for the nine months ended September 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
allows 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. In addition, the
effective income tax rate was impacted by a discrete tax item related to
share-based compensation that provided a tax benefit (expense) of approximately
$0.4 million for the nine months ended September 30, 2020 compared to $1.3
million
for the nine months ended September 30, 2019. Income tax expense for the
three and nine months ended September 30, 2019 reflects an increase in income
tax expense of approximately $2.5 million related to the reversal of the impact
of capital losses expected to be carried back to periods in which a 35%
statutory rate was in effect. The effective income tax rates excluding the
impact of discrete items were 21.57% and 21.55%, respectively, for the three and
nine months ended September 30, 2020 and 21.50% and 21.53% for the same periods
in 2019, respectively.
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Financial Condition
Investments
Our investment strategy is to maintain a predominantly investment grade fixed
income portfolio, provide adequate liquidity to meet our cash obligations to
policyholders and others and maximize current income and total investment return
through active investment management. Consistent with this strategy, our
investments principally consist of fixed maturity securities and mortgage loans
on real estate.
Insurance statutes regulate the type of investments that our life subsidiaries
are permitted to make and limit the amount of funds that may be used for any one
type of investment. In light of these statutes and regulations and our business
and investment strategy, we generally seek to invest in United States government
and government-sponsored agency securities, corporate securities, residential
and commercial mortgage backed securities, other asset backed securities and
United States municipalities, states and territories securities rated investment
grade by established NRSRO's or in securities of comparable investment quality,
if not rated and mortgage loans on real estate.
The composition of our investment portfolio is summarized as follows:
September 30, 2020 December 31, 2019
Carrying Carrying
Amount Percent Amount Percent
(Dollars in thousands)
Fixed maturity securities:
United States Government full faith and
credit $ 38,739 0.1 % $ 161,765 0.3 %
United States Government sponsored
agencies 1,074,978 1.9 % 625,020 1.1 %
United States municipalities, states and
territories 3,805,086 6.7 % 4,527,671 7.9 %
Foreign government obligations 209,233 0.4 % 205,096 0.3 %
Corporate securities 33,457,290 58.7 % 32,536,839 57.2 %
Residential mortgage backed securities 1,623,073 2.8 % 1,575,664 2.8 %
Commercial mortgage backed securities 5,478,783 9.6 % 5,786,279 10.2 %
Other asset backed securities 6,013,561 10.5 % 6,162,156 10.8 %
Total fixed maturity securities 51,700,743 90.7 % 51,580,490 90.6 %

Mortgage loans on real estate 3,926,699 6.9 % 3,448,793 6.1 %
Derivative instruments 874,741 1.5 % 1,355,989 2.4 %
Other investments 495,740 0.9 % 492,301 0.9 %
$ 56,997,923 100.0 % $ 56,877,573 100.0 %


Fixed Maturity Securities
Our fixed maturity security portfolio is managed to minimize risks such as
interest rate changes and defaults or impairments while earning a sufficient and
stable return on our investments. The largest portion of our fixed maturity
securities are in investment grade (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, 2020 December 31, 2019
Carrying Percent of Fixed Carrying Percent of Fixed
Rating Agency Rating Amount Maturity Securities Amount Maturity Securities
(Dollars in thousands)
Aaa/Aa/A $ 29,855,053 57.8 % $ 30,662,644 59.4 %
Baa 19,893,094 38.5 % 19,833,309 38.4 %
Total investment grade 49,748,147 96.3 % 50,495,953 97.8 %
Ba 1,573,650 3.0 % 821,902 1.6 %
B 224,170 0.4 % 81,407 0.2 %
Caa 65,386 0.1 % 95,676 0.2 %
Ca and lower 89,390 0.2 % 85,552 0.2 %
Total below investment grade 1,952,596 3.7 % 1,084,537 2.2 %
$ 51,700,743 100.0 % $ 51,580,490 100.0 %


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The NAIC's Securities Valuation Office ("SVO") is responsible for the day-to-day
credit quality assessment and the valuation of fixed maturity 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 higher 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.
As stated previously, 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 has been to invest primarily in
investment grade fixed maturity 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, 2020 December 31, 2019
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 $ 25,857,683 $ 28,981,733 $ 28,981,733 56.1 % $ 27,781,525 $ 30,122,657 $ 30,122,657 58.4 %
2 18,973,077 20,682,645 20,682,645 40.0 % 19,278,355 20,316,911 20,316,911 39.4 %
3 1,844,263 1,684,689 1,684,689 3.3 % 1,001,087 977,191 977,191 1.9 %
4 300,794 248,133 248,133 0.5 % 114,497 112,534 112,534 0.2 %
5 81,869 80,048 80,048 0.1 % 57,952 45,205 45,205 0.1 %
6 74,929 23,495 23,495 - % 5,530 5,992 5,992 - %
$ 47,132,615 $ 51,700,743 $ 51,700,743 100.0 % $ 48,238,946 $ 51,580,490 $ 51,580,490 100.0 %


The amortized cost and fair value of fixed maturity securities at September 30,
2020, by contractual maturity, are presented in Note 3 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, 2020
Fixed maturity securities, available
for sale:

United States Government sponsored
agencies 6 $ 800,682


$ (672) $ - $ 800,010
United States municipalities, states
and territories


15 46,036 (5,866) - 40,170
Foreign government obligations 1 14,190 (408) - 13,782
Corporate securities:
Finance, insurance and real estate 30 337,874 (12,818) - 325,056
Manufacturing, construction and
mining 19 160,490 (9,919) - 150,571
Utilities and related sectors 61 512,293 (62,235) (1,615) 448,443
Wholesale/retail trade 31 284,112 (34,233) - 249,879
Services, media and other 82 749,435 (62,422) (51,430) 635,583
Residential mortgage backed
securities 51 225,825 (3,767) (1,221) 220,837
Commercial mortgage backed securities 309 2,232,993 (202,723) (7,353) 2,022,917
Other asset backed securities 739 4,771,176 (348,848) - 4,422,328
1,344 $ 10,135,106 $ (743,911) $ (61,619) $ 9,329,576

December 31, 2019
Fixed maturity securities, available
for sale:
United States Government full faith
and credit 5 $ 144,678


$ (96) $ - $ 144,582
United States Government sponsored
agencies


6 374,961 (4,785) - 370,176
United States municipalities, states
and territories 42 296,812 (8,250) - 288,562

Corporate securities:
Finance, insurance and real estate 38 399,043 (9,529) - 389,514
Manufacturing, construction and
mining 20 216,229 (9,990) - 206,239
Utilities and related sectors 32 397,116 (11,212) - 385,904
Wholesale/retail trade 12 194,815 (11,162) - 183,653
Services, media and other 65 631,587 (40,366) - 591,221
Residential mortgage backed
securities 34 227,427 (3,691) - 223,736
Commercial mortgage backed securities 127 810,505 (13,783) - 100%,722
Other asset backed securities 652 4,306,620 (179,191) - 4,127,429
1,033 $ 7,999,793 $ (292,055) $ - $ 7,707,738


The unrealized losses at September 30, 2020 are principally related to the
impacts the COVID-19 pandemic has had on credit markets. Approximately 67% and
79% of the unrealized losses on fixed maturity securities shown in the above
table for September 30, 2020 and December 31, 2019, respectively, are on
securities that are rated investment grade, defined as being the highest two
NAIC designations.
The increase in unrealized losses from December 31, 2019 to September 30, 2020
was primarily related to the impacts the COVID-19 pandemic had on credit
markets. While treasury yields declined during the nine months ended
September 30, 2020, credit spreads have widened. The widening of credit spreads
in most cases was driven by a flight to quality into treasury securities due to
illiquidity and uncertainty of the impact of the COVID-19 pandemic on the
economy. The 10-year U.S. Treasury yields at September 30, 2020 and December 31,
2019
were 0.69% and 1.92%, respectively. The 30-year U.S. Treasury yields at
September 30, 2020 and December 31, 2019 were 1.46% and 2.39%, respectively.
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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, 2020
1 $ 4,491,450 48.2 % $ (216,558) 29.1 %
2 3,283,029 35.2 % (280,939) 37.8 %
3 1,260,783 13.5 % (181,374) 24.4 %
4 243,452 2.6 % (52,509) 7.0 %
5 28,289 0.3 % (4,495) 0.6 %
6 22,573 0.2 % (8,036) 1.1 %
$ 9,329,576 100.0 % $ (743,911) 100.0 %
December 31, 2019
1 $ 3,580,578 46.4 % $ (79,638) 27.3 %
2 3,412,695 44.3 % (151,826) 52.0 %
3 613,240 8.0 % (38,216) 13.1 %
4 74,027 1.0 % (8,575) 2.9 %
5 26,998 0.3 % (13,437) 4.6 %
6 200 - % (363) 0.1 %
$ 7,707,738 100.0 % $ (292,055) 100.0 %


(1) Gross unrealized losses have been adjusted to reflect the allowance for
credit loss as of September 30, 2020 of $61.6 million.
Our investments' gross unrealized losses and fair value, aggregated by
investment category and length of time that individual securities (consisting of
1,344 and 1,033 securities, respectively) have been in a continuous unrealized
loss position at September 30, 2020 and December 31, 2019, along with a
description of the factors causing the unrealized losses is presented in Note
3 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, 2020
Fixed maturity securities, available for
sale:
Investment grade:
Less than six months 148 $


1,754,169 $ 1,725,012 $ (29,157)
Six months or more and less than twelve
months


567 3,982,278 3,713,531 (268,747)
Twelve months or greater 361 2,602,800 2,389,680 (213,120)
Total investment grade 1,076 8,339,247 7,828,223 (511,024)
Below investment grade:
Less than six months 34 225,537 200,433 (25,104)
Six months or more and less than twelve
months 80 526,071 461,852 (64,219)
Twelve months or greater 154 982,632 839,068 (143,564)
Total below investment grade 268



1,734,240 1,501,353 (232,887)

1,344 $ 10,073,487 $ 9,329,576 $ (743,911)

December 31, 2019
Fixed maturity securities, available for
sale:
Investment grade:
Less than six months 352 $


2,960,557 $ 2,911,909 $ (48,648)
Six months or more and less than twelve
months


46 290,674 282,347 (8,327)
Twelve months or greater 513 4,003,478 3,829,474 (174,004)
Total investment grade 911 7,254,709 7,023,730 (230,979)
Below investment grade:
Less than six months 11 32,607 31,695 (912)
Six months or more and less than twelve
months 8 35,080 33,268 (1,812)
Twelve months or greater 103 677,397 619,045 (58,352)
Total below investment grade 122 745,084 684,008 (61,076)

1,033 $ 7,999,793 $ 7,707,738 $ (292,055)



(1) Amortized cost and gross unrealized losses have been adjusted to reflect the
allowance for credit loss as of September 30, 2020 of $61.6 million.



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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, 2020
Investment grade:
Less than six months 11 $ 100,733 $ 71,823 $ (28,910)
Six months or more and less than twelve
months 24 186,115 134,412 (51,703)
Twelve months or greater - - - -
Total investment grade 35 286,848 206,235 (80,613)
Below investment grade:
Less than six months 33 148,666 109,890 (38,776)
Six months or more and less than twelve
months 23 173,162 124,873 (48,289)
Twelve months or greater 3 10,320 6,293 (4,027)
Total below investment grade 59 332,148 241,056 (91,092)
94 $ 618,996 $ ,291 $ (171,705)

December 31, 2019
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 1 2,640 1,755 (885)
Twelve months or greater 4 53,800 35,541 (18,259)
Total below investment grade 5 56,440 37,296 (19,144)
5 $ 56,440 $ 37,296 $ (19,144)



(1) Amortized cost and gross unrealized losses have been adjusted to reflect the
allowance for credit loss as of September 30, 2020 of $61.6 million.



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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, 2020
Due in one year or less $ 3,108 $ 2,228



Due after one year through five years 1,166,223 1,125,636
Due after five years through ten years 871,939 771,026
Due after ten years through twenty years 449,485 409,951
Due after twenty years


414,357 354,653
2,905,112 2,663,494
Residential mortgage backed securities 225,825 220,837
Commercial mortgage backed securities 2,232,993 2,022,917
Other asset backed securities 4,771,176 4,422,328
$ 10,135,106 $ 9,329,576

December 31, 2019
Due in one year or less $ 5,073 $ 5,071
Due after one year through five years 278,165 273,869


Due after five years through ten years 555,200 544,687
Due after ten years through twenty years 1,041,474 1,008,487
Due after twenty years


775,329 727,737
2,655,241 2,559,851


Residential mortgage backed securities 227,427 223,736
Commercial mortgage backed securities


810,505 100%,722
Other asset backed securities 4,306,620 4,127,429
$ 7,999,793 $ 7,707,738


International Exposure
We hold fixed maturity securities with international exposure. As of
September 30, 2020, 24% 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, 2020
Percent
of Total
Amortized Carrying Amount/ Carrying
Cost Fair Value Amount
(Dollars in thousands)
GIIPS (1) $ 251,563 $ 281,301 0.5 %
Asia/Pacific 436,613 499,825 1.0 %
Non-GIIPS Europe 2,960,710 3,292,311 6.4 %
Latin America 254,541 286,902 0.5 %
Non-U.S. North America 1,403,319 1,566,323 3.0 %
Australia & New Zealand 1,047,547 1,130,250 2.2 %
Other 5,543,900 5,318,443 10.3 %
$ 11,898,193 $ 12,375,355 23.9 %


(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, 2020
Carrying Amount/
Amortized Cost Fair Value
(Dollars in thousands)
GIIPS $ 14,547 $ 17,248
Asia/Pacific 11,000 10,951
Non-GIIPS Europe 223,929 197,189
Latin America 74,579 76,354
Non-U.S. North America 112,518 101,765
Other 814,196 709,817
$ 1,250,769 $ 1,113,324


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 issues, we evaluate the financial stability and quality
of asset coverage for the securities relative to the term to maturity for the
issues we own. For asset-backed securities, we evaluate changes in factors such
as collateral performance, default rates, loss severities and expected cash
flows. At September 30, 2020, the amortized cost and fair value of securities on
the watch list (all fixed maturity securities) are as follows:
Net Unrealized
Amortized Cost, Losses,
Number of Amortized Allowance for Net of Net of
General Description Securities Cost Credit Losses Allowance Allowance Fair Value
(Dollars in thousands)
Corporate securities - Public
securities 17 $ 202,148 $ (51,430) $ 150,718 $ (23,736) $ 126,982
Corporate securities - Private
placement securities 35 350,537 (1,615) 348,922 (22,957) 325,965
Residential mortgage backed
securities 21 59,491 (1,221) 58,270 (501) 57,769
Commercial mortgage backed
securities 24 250,545 (7,353) 243,192 (47,711) 195,481
Other asset backed securities 2 69,738 - 69,738 (8,780)


60,958



Collateralized loan obligations 8 74,805 - 74,805 (14,081) 60,724
107 $ 1,007,264 $ (61,619) $ 945,645 $ (117,766) $ 827,879


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, 2020 is as follows:
Corporate securities - public securities: The public corporate securities
included on the watch list are primarily domestic oil drillers or securities
with exposure to the travel industry. The decline in value of the securities of
domestic oil drillers is due to the continuing low level of oil prices, which
has caused credit metrics to continue to be under pressure. The decline in value
and the heightened credit risk on the securities with exposure to the travel
industry is primarily due to the impact COVID-19 has had on the travel industry
As a result of our process for identifying securities that could potentially
have credit losses, we recognized credit losses of $4.8 million and $51.5
million
, respectively, on these securities during the three and nine months
ended September 30, 2020.
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. While there is a heightened level of credit risk for the
private placement securities included on the watch list, we expect minimal
credit losses on these securities based on our current analyses. Based on these
analyses, we recognized credit losses of $1.5 million and $1.6 million,
respectively, on these securities during the three and nine months ended
September 30, 2020.
Residential mortgage backed securities: The residential mortgage backed
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 residential mortgage backed securities
included on the watch list, we expect minimal credit losses on these securities
based on our current analyses. Based on these analyses, we recognized credit
losses of $0.4 million and $1.2 million, respectively, on these securities
during the three and nine months ended September 30, 2020.
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Commercial mortgage backed securities: The commercial mortgage backed securities
included on the watch list have generally experienced higher levels of stress
due to the impact COVID-19 is having on the economy. As a result of our process
for identifying securities that could potentially have credit losses and our
intent to sell certain commercial mortgage backed securities, we recognized
credit losses of $19.2 million and $27.5 million, respectively, on these
securities during the three and nine months ended September 30, 2020.
Other asset backed securities: The decline in value of these securities, which
are primarily related to the auto rental industry, is primarily a result of the
impact COVID-19 has had on the travel industry. We did not take any credit
losses on these securities during the three or nine months ended September 30,
2020
as we do not expect any credit losses on the securities based on our
current analyses. We recognized a credit loss of $0.5 million on an other asset
backed security during the nine months ended September 30, 2020 due to our
intent to sell the security.
Collateralized loan obligations: The collateralized loan obligations 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 collateralized loan obligations included on the watch list,
we do not expect credit losses on these securities based on our current
analyses.
Credit Losses
We have a policy and process to identify securities in our investment portfolio
for which we recognize credit loss. See Note 3 to our unaudited consolidated
financial statements.
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 as discussed above 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 3 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 two mortgage loan portfolio segments:
commercial mortgage loans and residential mortgage loans. Our commercial
mortgage loan portfolio consists of mortgage loans collateralized by the related
properties and diversified as to property type, location and loan size. Our
mortgage lending policies establish limits on the amount that can be loaned to
one borrower and other criteria to attempt to reduce the risk of default. Our
residential mortgage loan portfolio consists of loans with an outstanding
principal balance of $171.9 million that have been purchased throughout 2020.
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, 2020 and December 31, 2019, the largest principal amount
outstanding for any single commercial mortgage loan was $34.7 million and $28.5
million
, respectively, and the average loan size was $4.7 million and $4.4
million
, respectively. In addition, the average loan to value ratio for
commercial mortgage loans was 53.9% and 54.3% at September 30, 2020 and
December 31, 2019, respectively, based upon the underwriting and appraisal at
the time the loan was made. This loan to value is indicative of our conservative
underwriting policies and practices for making commercial 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 4


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, 2020, we had commitments to fund
commercial mortgage loans totaling $106.1 million, with interest rates ranging
from 3.00% to 5.65%. During 2020 and 2019, 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, 2020, we received $126.4
million
in cash for loans being paid in full compared to $127.5 million for the
nine months ended September 30, 2019. 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 4 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 commercial mortgage loans. This
process utilizes each loan's loan-to-value and debt service coverage ratios as
primary metrics. See Note 4 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 both our commercial and residential
mortgage loan portfolios. Commercial 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, 2020: (Dollars in thousands)
Commercial mortgage loans $ 3,776,490 $ -


$ - $ - $ 3,776,490
Residential mortgage loans


166,171 2,546 771 - 169,488
Total mortgage loans $ 3,942,661 $ 2,546 $ 771 $ - $ 3,945,978


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 5 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 $(806) million for the nine months
ended September 30, 2020 compared to $1.5 billion for the nine months ended
September 30, 2019, with the decrease attributable to a $2.0 billion decrease in
net annuity deposits after coinsurance and a $243 million (after coinsurance)
increase in funds returned to policyholders. As a result of funds returned to
policyholders being in excess of cash flows from annuity deposits for the nine
months ended September 30, 2020, we experienced a net cash outflow related to
policyholder activity which was funded primarily by cash flows from investment
income. We may continue to experience net cash outflows related to policyholder
activity due to lower sales as a result of social distancing due to COVID-19. We
continue to invest the net proceeds from policyholder transactions and
investment activities in high quality fixed maturity securities and mortgage
loans.
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. 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 Investment Life Insurance Company ("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 2020, up to $349.0 million can 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, 2020.
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, 2020, we estimate American Equity Life has sufficient statutory
capital and surplus, combined with capital available to the holding company, to
maintain this rating objective. 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.
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The transfer of funds by American Equity Life is also restricted by a covenant
in our line of credit agreement which requires American Equity Life to maintain
a minimum RBC ratio of 275% and a minimum level of statutory surplus equal to
the sum of 1) 80% of statutory surplus at June 30, 2016, 2) 50% of the statutory
net income for each fiscal quarter ending after June 30, 2016, and 3) 50% of all
capital contributed to American Equity Life after June 30, 2016. American Equity
Life's
RBC ratio was 372% at December 31, 2019. Under this agreement, we are
also required to maintain a maximum ratio of adjusted debt to total adjusted
capital of 0.35.
On June 10, 2020, we issued 12,000 shares of 6.625% Fixed-Rate Reset
Non-Cumulative Preferred Stock, Series B ("Series B") with a $1.00 par value per
share and a liquidation preference of $25,000 per share, for aggregate net
proceeds of $290.3 million.
On November 21, 2019 we issued $400 million of 5.95% fixed-rate reset
non-cumulative preferred stock and received net proceeds of $388.9 million. We
used a portion of the proceeds to redeem $165 million of our floating rate
subordinated debentures in the fourth quarter of 2019 and the first quarter of
2020 and contributed $200 million to American Equity Life during May of 2020.
Cash and cash equivalents of the parent holding company at September 30, 2020,
were $353.4 million which includes the $290.3 million of net proceeds from the
Series B preferred issuance described above. In addition, we have a $150 million
revolving line of credit, with no borrowings outstanding, available through
September 2021 for general corporate purposes of the parent company and its
subsidiaries. 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.
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% (15 basis points) from levels at
September 30, 2020, we estimate that the fair value of our fixed maturity
securities would decrease by approximately $545.5 million. The impact on
stockholders' equity of such decrease (net of income taxes and certain
adjustments for changes in amortization of deferred policy acquisition costs and
deferred sales inducements) would be a decrease of $258.9 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, 2019
for a further discussion of 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 $7.2
billion
as of September 30, 2020. 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 $4.9 billion of floating rate fixed maturity securities as of
September 30, 2020. 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, 2020, approximately 99% 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, 2020, approximately 19% 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,
2020 2019 2020 2019
(Dollars in thousands)
Proceeds received at expiration of options
related to such credits $ 178,405 $ 95,491 $ 560,683 $ 320,381
Annual index credits to policyholders on
their anniversaries 174,747 92,343 551,562 310,020


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,
2020
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, 2020 that have materially
affected, or are reasonably likely to materially affect, our internal control
over financial reporting.

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