Management's discussion and analysis reviews our unaudited consolidated financial position atSeptember 30, 2020 , and the unaudited consolidated results of operations for the three and nine month periods endedSeptember 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 endedDecember 31, 2019 . Interim operating results for the three and nine month periods endedSeptember 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 theSEC , 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 theSEC . 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 endedDecember 31, 2019 and in our Quarterly Report on Form 10-Q for the quarterly periods endedMarch 31, 2020 andJune 30, 2020 filed with theSEC . 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 theWorld Health Organization , has created significant economic and financial turmoil both in theU.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 endedMarch 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 ofSeptember 30, 2020 . Currently, most of our employees are working remotely with only operationally critical employees working at our offices inWest Des Moines, Iowa . 28 -------------------------------------------------------------------------------- Table of Contents 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. UnderU.S. GAAP, premium collections for deferred annuities are reported as deposit liabilities instead of as revenues. Similarly, cash payments to policyholders are reported as decreases in the liabilities for policyholder account balances and not as expenses. Sources of revenues for products accounted for as deposit liabilities are net investment income, surrender charges assessed against policy withdrawals and fees deducted from policyholder account balances for lifetime income benefit riders, net realized gains (losses) on investments and changes in fair value of derivatives. Components of expenses for products accounted for as deposit liabilities are interest sensitive and index product benefits (primarily interest credited to account balances and changes in the liability for lifetime income benefit riders), changes in fair value of embedded derivatives, amortization of deferred sales inducements and deferred policy acquisition costs, other operating costs and expenses and income taxes. 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 withone 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 onSeptember 28, 2020 an agreement in principle to enter into a strategic partnership with Värde Partners andAgam 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 aBermuda 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 onOctober 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. 29 -------------------------------------------------------------------------------- Table of Contents 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. OnOctober 18, 2020 , the Company's Board of Directors approved a$500 million share repurchase program. The purpose of the share repurchase program is to both offset dilution from the issuance of shares to Brookfield and to institute a regular cash return program for shareholders. We started the buyback program onOctober 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 atDecember 31, 2019 was 372%, and our estimated RBC ratio atSeptember 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 atAmerican 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 toAmerican Equity Investment Life Insurance Company . OnAugust 21, 2020 S&P affirmed its "A-" financial strength rating onAmerican Equity Investment Life Insurance Company and its "BBB-" long-term issuer credit rating onAmerican 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 fromAmerican Equity Investment Life Holding Company toAmerican 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 . OnJune 26, 2020 ,A.M. Best affirmed its "A-" financial strength rating ofAmerican Equity Investment Life Insurance Company and its subsidiaries,American Equity Investment Life Insurance Company of New York andEagle Life Insurance Company , its "bbb-" long-term issuer credit rating ofAmerican Equity Investment Life Holding Company , its "bbb-" senior unsecured debt ratings, and its "bb" perpetual, non-cumulative preferred stock ratings. The outlook for these credit ratings of "stable" was also affirmed byA.M. Best onJune 26, 2020 . OnApril 24, 2020 , Fitch affirmed its "A-" financial strength rating onAmerican Equity Investment Life Insurance Company and its life insurance subsidiaries, its "BBB" issuer default rating onAmerican Equity Investment Life Holding Company and its "BBB-" senior unsecured debt ratings, 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. 30
--------------------------------------------------------------------------------
Table of Contents 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 endedDecember 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 endedDecember 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$4.3 billion of policyholder funds inJune 2020 . We continue to have flexibility to reduce our crediting rates if necessary and could decrease our cost of money by approximately 63 basis points if we reduce current rates to guaranteed minimums. Investment yields on fixed income securities purchased and mortgage loans funded during most of 2020 and 2019 were at average rates below the overall portfolio yield which has resulted in a decrease in the average yield on invested assets. In addition, the decline in yields on our floating rate investment portfolio, mark to market losses on investment partnerships and our decision to hold higher levels of cash and cash equivalents since March of 2020 contributed to the decrease in the average yield on invested assets for the three and nine month periods endedSeptember 30, 2020 compared to the same periods in 2019. Results of Operations for the Three and Nine Months EndedSeptember 30, 2020 and 2019 Annuity deposits by product type collected during the three and nine months endedSeptember 30, 2020 and 2019, were as follows: Three Months Ended Nine Months Ended September 30, September 30, 2020 2019 2020 2019 (Dollars in thousands)American Equity Investment Life Insurance Company : Fixed index annuities$ 432,602 $ 1,054,796 $ 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 3,311,296Eagle 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 31
-------------------------------------------------------------------------------- Table of Contents 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 endedSeptember 30, 2020 compared to the same period in 2019. The decrease in sales for the three and nine months endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 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)
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. 32 -------------------------------------------------------------------------------- Table of Contents 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 endedSeptember 30, 2020 was negatively impacted by net realized losses on investments primarily as a result of credit losses on available for sale fixed maturity securities (see Net realized gains on investments). Net income available to common stockholders for the nine months endedSeptember 30, 2020 was impacted by a discrete tax item that provided a tax benefit of$30.1 million related to the provision of the Coronavirus Aid, Relief, and Economic Security Act that allows net operating losses for 2018 through 2020 to be carried back to previous tax years in which a 35% statutory tax rate was in effect. 33 -------------------------------------------------------------------------------- Table of Contents Non-GAAP operating income (loss) available to common stockholders, a non-GAAP financial measure, decreased to$(249.8) million in the third quarter of 2020 and decreased to$(2.6) million for the nine months endedSeptember 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 endedSeptember 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
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 EndedSeptember 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 34
-------------------------------------------------------------------------------- Table of Contents 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 endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 30, 2020 compared to$63.6 million and$177.3 million for the same periods in 2019. The components of annuity product charges are set forth in the table that follows: Three Months Ended Nine Months Ended September 30, September 30, 2020 2019 2020 2019 (Dollars in thousands) Surrender charges$ 16,447 $ 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 endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 30, 2020 compared to the same periods in 2019, partially offset by increases in our average invested assets during the three and nine months endedSeptember 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 endedSeptember 30, 2020 compared to$51.5 billion and$50.7 billion for the same periods in 2019. 35 -------------------------------------------------------------------------------- Table of Contents The average yield earned on average invested assets was 4.10% for the third quarter of 2020 and 4.20% for the nine months endedSeptember 30, 2020 compared to 4.59% and 4.53% for the same periods in 2019. The decrease in average yield earned for the three and nine months endedSeptember 30, 2020 compared to the same periods in 2019 was primarily attributable to investment of new premiums and portfolio cash flows during most of 2020 and 2019 at average rates below the overall portfolio yield, a decline in yields on our floating rate investment portfolio due to decreases in the average benchmark rates associated with these investments, an increase in the level of cash and cash equivalent holdings due to our decision to hold higher levels of cash and cash equivalents sinceMarch 2020 and mark to market losses on investment partnerships during the nine months endedSeptember 30, 2020 due to changes in fair market valuations. The average yield on fixed income securities purchased and mortgage loans funded during the three and nine months endedSeptember 30, 2020 was 3.59% and 3.75%, compared to 3.30% and 3.95% for the same periods in 2019. During the second and third quarter of 2020 we began to purchase residential mortgage loans which provided a meaningful increase in purchase yields for the three and nine months endedSeptember 30, 2020 . Change in fair value of derivatives consists of call options purchased to fund annual index credits on fixed index annuities, and an interest rate swap and interest rate caps that hedge our floating rate subordinated debentures. The components of change in fair value of derivatives are as follows: Three Months Ended Nine Months Ended September 30, September 30, 2020 2019 2020 2019 (Dollars in thousands) Call options: Loss on option expiration$ (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 endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 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 endedDecember 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 endedSeptember 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. 36 -------------------------------------------------------------------------------- Table of Contents 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 endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 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$1.3 billion atSeptember 30, 2020 andDecember 31, 2019 , respectively. Amortization of deferred sales inducements before gross profit adjustments increased for the three and nine months endedSeptember 30, 2020 compared to the same periods in 2019 primarily due to the impact of assumption updates made during the third quarter of 2020 as compared to the impact of assumption updates made during the third quarter of 2019. Bonus products represented 76% and 78% of our net annuity account values atSeptember 30, 2020 andSeptember 30, 2019 , respectively. The amount of amortization is affected by amortization associated with fair value accounting for derivatives and embedded derivatives utilized in our fixed index annuity business and amortization associated with net realized gains (losses) on investments including credit losses on fixed maturity securities. Fair value accounting for derivatives and embedded derivatives utilized in our fixed index annuity business creates differences in the recognition of revenues and expenses from derivative instruments including the embedded derivative liabilities in our fixed index annuity contracts. The change in fair value of the embedded derivatives will not correspond to the change in fair value of the derivatives (purchased call options), because the purchased call options are one-year options while the options valued in the fair value of embedded derivatives cover the expected lives of the contracts which typically exceed ten years. Amortization of deferred sales inducements is summarized as follows: Three Months Ended Nine Months Ended September 30, September 30, 2020 2019 2020 2019 (Dollars in thousands) Amortization of deferred sales inducements before gross profit adjustments$ 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)
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 endedSeptember 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 endedDecember 31, 2019 . 37 -------------------------------------------------------------------------------- Table of Contents 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 endedDecember 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 endedSeptember 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 endedSeptember 30, 2020 . SeeNet 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 endedSeptember 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 endedSeptember 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 endedSeptember 30, 2019 resulted in a decrease in the change in fair value of the fixed annuity embedded derivatives for the nine-months endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 30, 2020 were partially offset by a larger decrease in the net discount rate during the nine months endedSeptember 30, 2020 compared to the same period of 2019. The decrease in the net discount rate for the nine months endedSeptember 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 endedSeptember 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) 38
-------------------------------------------------------------------------------- Table of Contents 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 endedSeptember 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 endedDecember 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 endedSeptember 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
Salary and benefits for the three and nine months endedSeptember 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 endedSeptember 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 endedSeptember 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 atSeptember 30, 2020 and 2019 were$1,332.2 million and$1,132.2 million , respectively. Other expenses decreased for the three months endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 30, 2020 was impacted by a discrete tax item that provided a tax benefit of$30.1 million related to the provision of the Coronavirus Aid, Relief, and Economic Security Act that 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 endedSeptember 30, 2020 compared to$1.3 million for the nine months endedSeptember 30, 2019 . Income tax expense for the three and nine months endedSeptember 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 endedSeptember 30, 2020 and 21.50% and 21.53% for the same periods in 2019, respectively. 39 -------------------------------------------------------------------------------- Table of Contents 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 inUnited States government and government-sponsored agency securities, corporate securities, residential and commercial mortgage backed securities, other asset backed securities andUnited 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 % 40
-------------------------------------------------------------------------------- Table of Contents 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. 41 -------------------------------------------------------------------------------- Table of Contents 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
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
6 374,961 (4,785) - 370,176United 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) - 796,722 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 atSeptember 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 forSeptember 30, 2020 andDecember 31, 2019 , respectively, are on securities that are rated investment grade, defined as being the highest two NAIC designations. The increase in unrealized losses fromDecember 31, 2019 toSeptember 30, 2020 was primarily related to the impacts the COVID-19 pandemic had on credit markets. While treasury yields declined during the nine months endedSeptember 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-yearU.S. Treasury yields atSeptember 30, 2020 andDecember 31, 2019 were 0.69% and 1.92%, respectively. The 30-yearU.S. Treasury yields atSeptember 30, 2020 andDecember 31, 2019 were 1.46% and 2.39%, respectively. 42
--------------------------------------------------------------------------------
Table of Contents 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 ofSeptember 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 atSeptember 30, 2020 andDecember 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. 43 -------------------------------------------------------------------------------- Table of Contents 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
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
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
44 -------------------------------------------------------------------------------- Table of Contents 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 $ 447,291 $ (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
45 -------------------------------------------------------------------------------- Table of Contents 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
810,505 796,722 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 ofSeptember 30, 2020 , 24% of the carrying value of our fixed maturity securities was comprised of corporate debt securities of issuers based outside ofthe United States and debt securities of foreign governments. All of our fixed maturity securities with international exposure are denominated inU.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 andSpain ("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. 46 -------------------------------------------------------------------------------- Table of Contents 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. AtSeptember 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 atSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 30, 2020 . 47 -------------------------------------------------------------------------------- Table of Contents 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 endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 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 withinthe 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. AtSeptember 30, 2020 andDecember 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% atSeptember 30, 2020 andDecember 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. AtSeptember 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 endedSeptember 30, 2020 , we received$126.4 million in cash for loans being paid in full compared to$127.5 million for the nine months endedSeptember 30, 2019 . Some of the loans being paid off have either reached their maturity or are nearing maturity; however, some borrowers are paying the prepayment fee and refinancing at a lower rate. See Note 4 to our unaudited consolidated financial statements, incorporated by reference, for a presentation of our valuation allowance, foreclosure activity and troubled debt restructure analysis. We have a process by which we evaluate the credit quality of each of our commercial mortgage loans. This process utilizes each loan's loan-to-value and debt service coverage ratios as primary metrics. See Note 4 to our unaudited consolidated financial statements, incorporated by reference, for a summary of our portfolio by loan-to-value and debt service coverage ratios. 48
--------------------------------------------------------------------------------
Table of Contents We closely monitor loan performance for both our commercial and residential mortgage loan portfolios. Commercial and residential loans are considered nonperforming when they are 90 days or more past due. Aging of financing receivables is summarized in the following table:
30-59
days 60-89 days Over 90 days
Current past due past due past due Total As of September 30, 2020: (Dollars in thousands) Commercial mortgage loans$ 3,776,490 $ -
$ - $ -
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 endedSeptember 30, 2020 compared to$1.5 billion for the nine months endedSeptember 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 endedSeptember 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% ofAmerican Equity Life's statutory capital and surplus at the precedingDecember 31 . For 2020, up to$349.0 million can be distributed as dividends byAmerican Equity Life without prior approval of theIowa 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 atSeptember 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 ofSeptember 30, 2020 , we estimateAmerican 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. 49 -------------------------------------------------------------------------------- Table of Contents The transfer of funds byAmerican Equity Life is also restricted by a covenant in our line of credit agreement which requiresAmerican 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 atJune 30, 2016 , 2) 50% of the statutory net income for each fiscal quarter ending afterJune 30, 2016 , and 3) 50% of all capital contributed toAmerican Equity Life afterJune 30, 2016 .American Equity Life's RBC ratio was 372% atDecember 31, 2019 . Under this agreement, we are also required to maintain a maximum ratio of adjusted debt to total adjusted capital of 0.35. OnJune 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 . OnNovember 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 toAmerican Equity Life during May of 2020. Cash and cash equivalents of the parent holding company atSeptember 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 throughSeptember 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. 50 -------------------------------------------------------------------------------- Table of Contents If interest rates were to increase 10% (15 basis points) from levels atSeptember 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 endedDecember 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 ofSeptember 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$4.9 billion of floating rate fixed maturity securities as ofSeptember 30, 2020 . Generally, interest rates on these floating rate fixed maturity securities are based on the 3 month LIBOR rate and are reset quarterly. Should rates decline to levels which tighten the spread between our average portfolio yield and average cost of interest credited on annuity liabilities, we have the ability to reduce crediting rates (caps, participation rates or asset fees for fixed index annuities) on most of our annuity liabilities to maintain the spread at our targeted level. AtSeptember 30, 2020 , approximately 99% of our annuity liabilities were subject to annual adjustment of the applicable crediting rates at our discretion, limited by minimum guaranteed crediting rates specified in the policies. AtSeptember 30, 2020 , approximately 19% of our annuity liabilities were at minimum guaranteed crediting rates. We purchase call options on the applicable indices to fund the annual index credits on our fixed index annuities. These options are primarily one-year instruments purchased to match the funding requirements of the underlying policies. Fair value changes associated with those investments are substantially offset by an increase or decrease in the amounts added to policyholder account balances for fixed index products. The difference between proceeds received at expiration of these options and index credits, as shown in the following table, is primarily due to under or over-hedging as a result of policyholder behavior being different than our expectations. Three Months Ended Nine Months Ended September 30, September 30, 2020 2019 2020 2019 (Dollars in thousands) Proceeds received at expiration of options related to such credits$ 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 ofSeptember 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 endedSeptember 30, 2020 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
© Edgar Online, source