UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-Q

 

(Mark One)

 

x		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2007
o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from             to               

 

Commission File Number : 001-31911

 

American Equity Investment Life Holding Company

(Exact name of registrant as specified in its charter)

 

 

 

 

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

 

 

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

Yes  x      No   o

 

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

 

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

 

APPLICABLE TO CORPORATE ISSUERS:

 

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

 

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except per share data)

		June 30,  2007			December 31,  2006
		(Unaudited)
Assets
Investments:
Fixed maturity securities:
Available for sale, at fair value (amortized cost: 2007 - $4,833,524; 2006 - $4,297,182)		$	4,623,126		$	4,177,029
Held for investment, at amortized cost (fair value: 2007 - $4,798,026; 2006 - $4,871,237)		5,226,441			5,128,146
Equity securities, available for sale, at fair value (cost: 2007 - $81,763; 2006 - $46,000)		78,949			45,512
Mortgage loans on real estate		1,771,625			1,652,757
Derivative instruments		412,289			381,601
Policy loans		428			419
Total investments		12,112,858			11,385,464
Cash and cash equivalents		22,243			29,949
Coinsurance deposits - related party		1,772,761			1,841,720
Accrued investment income		73,384			68,323
Deferred policy acquisition costs		1,183,229			1,088,890
Deferred sales inducements		506,608			427,554
Deferred income taxes		83,630			73,831
Income taxes recoverable		3,040			4,526
Other assets		42,925			69,866
Total assets		$	15,800,678		$	14,990,123

 

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AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY
CONSOLIDATED BALANCE SHEETS (Continued)
(Dollars in thousands, except per share data)

 

		June 30, 2007			December 31, 2006
		(Unaudited)
Liabilities and Stockholders’ Equity
Liabilities:
Policy benefit reserves:
Traditional life and accident and health insurance products		$	102,489		$	93,632
Annuity and single premium universal life products		13,899,180			13,114,299
Other policy funds and contract claims		122,353			128,579
Other amounts due to related parties		45,077			45,504
Notes payable		264,848			266,383
Subordinated debentures		268,298			268,489
Amounts due under repurchase agreements		396,570			385,973
Other liabilities		100,160			92,198
Total liabilities		15,198,975			14,395,057
Stockholders’ equity:
Common stock, par value $1 per share, 125,000,000 shares authorized; issued and outstanding: 2007 - 53,862,051 shares (excluding 3,014,466 treasury shares); 2006 - 53,500,926 shares (excluding 2,664,448 treasury shares)		53,862			53,501
Additional paid-in capital		388,917			389,644
Accumulated other comprehensive loss		(66,282		)	(38,769		)
Retained earnings		225,206			190,690
Total stockholders’ equity		601,703			595,066
Total liabilities and stockholders’ equity		$	15,800,678		$	14,990,123

 

See accompanying notes to unaudited consolidated financial statements.

3

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY

CONSOLIDATED STATEMENTS OF INCOME

(Dollars in thousands, except per share data)

(Unaudited)

 

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2007			2006			2007			2006
Revenues:
Traditional life and accident and health insurance premiums		$	3,190		$	3,211		$	6,247		$	6,735
Annuity and single premium universal life product charges		11,453			10,740			20,447			18,340
Net investment income		175,719			169,182			345,077			331,567
Realized gains on investments		17			331			596			289
Change in fair value of derivatives		98,986			(61,582		)	90,464			(12,254		)
Total revenues		289,365			121,882			462,831			344,677
Benefits and expenses:
Insurance policy benefits and change in future policy benefits		2,097			2,269			4,030			4,667
Interest credited to account balances		168,141			101,845			284,094			185,453
Amortization of deferred sales inducements		14,184			6,737			18,545			15,675
Change in fair value of embedded derivatives		405			(111,321		)	(6,226		)	(48,557		)
Interest expense on notes payable		4,057			6,528			8,139			13,814
Interest expense on subordinated debentures		5,614			5,402			11,203			10,320
Interest expense on amounts due under repurchase agreements		3,060			8,532			7,078			14,331
Amortization of deferred policy acquisition costs		40,289			25,363			57,858			56,118
Other operating costs and expenses		14,083			9,931			25,494			20,111
Total benefits and expenses		251,930			55,286			410,215			271,932
Income before income taxes		37,435			66,596			52,616			72,745
Income tax expense		12,846			23,685			18,100			25,861
Net income		$	24,589		$	42,911		$	34,516		$	46,884
Earnings per common share		$	0.43		$	0.77		$	0.61		$	0.84
Earnings per common share - assuming dilution		$	0.41		$	0.71		$	0.58		$	0.78

 

See accompanying notes to unaudited consolidated financial statements.

 

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AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

(Dollars in thousands)

(Unaudited)

 

		Common Stock			Additional Paid-in Capital			Accumulated Other Comprehensive Loss			Retained Earnings			Total Stockholders’ Equity
Balance at December 31, 2005		$	53,936		$	380,698		$	(27,306	)	$	112,030		$	519,358
Comprehensive loss:
Net income for period		—			—			—			46,884			46,884
Change in net unrealized investment gains/losses		—			—			(67,241		)	—			(67,241		)
Total comprehensive loss														(20,357		)
Share-based compensation		—			68			—			—			68
Issuance of 89,550 shares of common stock under compensation plans, including excess income tax benefits		90			682			—			—			772
Conversion of $360 of subordinated debentures		44			316			—			—			360
Balance at June 30, 2006		$	54,070		$	381,764		$	(94,547	)	$	158,914		$	500,201
Balance at December 31, 2006		$	53,501		$	389,644		$	(38,769	)	$	190,690		$	595,066
Comprehensive income:
Net income for period		—			—			—			34,516			34,516
Change in net unrealized investment gains/losses		—			—			(27,513		)	—			(27,513		)
Total comprehensive income														7,003
Acquisition of 350,000 shares of common stock		(350		)	(3,886		)	—			—			(4,236		)
Share-based compensation		—			3,178			—			—			3,178
Issuance of 57,500 shares of common stock under compensation plans, including excess income tax benefits		57			385			—			—			442
Net issuance of 622,779 shares of common stock under stock option and warrant agreement		623			(623		)	—			—			—
Conversion of $250 of subordinated debentures		31			219			—			—			250
Balance at June 30, 2007		$	53,862		$	388,917		$	(66,282	)	$	225,206		$	601,703

 

Total comprehensive loss for the second quarter of 2007 was $2.8 million and was comprised of net income of $24.6 million and an increase in net unrealized depreciation of available for sale fixed maturity securities and equity securities of $27.4 million.

 

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

 

See accompanying notes to unaudited consolidated financial statements.

5

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)

 

		Six Months Ended June 30,
		2007			2006
Operating activities
Net income		$	34,516		$	46,884
Adjustments to reconcile net income to net cash used in operating activities:
Adjustments related to interest sensitive products:
Interest credited to account balances		284,094			185,453
Amortization of deferred sales inducements		18,545			15,675
Annuity and single premium universal life product charges		(20,447		)	(18,340		)
Change in fair value of embedded derivatives		(6,226		)	(48,557		)
Increase in traditional life and accident and health insurance reserves		4,904			5,982
Policy acquisition costs deferred		(117,939		)	(120,898		)
Amortization of discount on contingent convertible notes		526			5,970
Amortization of deferred policy acquisition costs		57,858			56,118
Provision for depreciation and other amortization		501			1,075
Amortization of discount and premiums on investments		(127,812		)	(119,536		)
Realized gains on investments		(596		)	(289		)
Change in fair value of derivatives		(90,464		)	12,254
Deferred income taxes		5,016			31,208
Share-based compensation		3,178			68
Changes in other operating assets and liabilities:
Accrued investment income		(5,061		)	(9,458		)
Income taxes recoverable		1,486			(22,490		)
Other assets		745			(1,653		)
Other policy funds and contract claims		(6,226		)	2,234
Other amounts due to related parties		(10,629		)	(1,483		)
Other liabilities		(43,810		)	(37,890		)
Net cash used in operating activities		(17,841		)	(17,673		)
Investing Activities
Sales, maturities, or repayments of investments:
Fixed maturity securities - available for sale		71,739			106,129
Fixed maturity securities - held for investment		28,147			—
Equity securities, available for sale		15,968			17,878
Mortgage loans on real estate		87,967			48,920
Derivative instruments		224,636			98,900
Acquisition of investments:
Fixed maturity securities - available for sale		(551,709		)	(500,427		)
Fixed maturity securities - held for investment		—			(176,169		)
Equity securities, available for sale		(51,604		)	(5,980		)
Mortgage loans on real estate		(206,835		)	(300,484		)
Derivative instruments		(154,276		)	(110,077		)
Policy loans		(9		)	(29		)
Purchases of property, furniture and equipment		(568		)	(81		)
Net cash used in investing activities		(536,544		)	(821,420		)

 

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AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY

CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

(Dollars in thousands)

(Unaudited)

 

		Six Months Ended June 30,
		2007			2006
Financing activities
Receipts credited to annuity and single premium universal life policyholder account balances		$	1,066,989		$	1,082,386
Coinsurance deposits - related party		92,734			88,149
Return of annuity and single premium universal life policyholder account balances		(640,946		)	(829,146		)
Financing fees incurred and deferred		—			(1,016		)
Repayments of notes payable		(2,061		)	(2,049		)
Increase in amounts due under repurchase agreements		10,597			393,229
Proceeds from issuance of subordinated debentures		—			30,000
Acquisition of common stock		(4,236		)	—
Excess tax benefits realized from exercise of stock options		148			226
Proceeds from issuance of common stock		294			546
Checks in excess of cash balance		23,160			—
Net cash provided by financing activities		546,679			762,325
Decrease in cash and cash equivalents		(7,706		)	(76,768		)
Cash and cash equivalents at beginning of period		29,949			112,395
Cash and cash equivalents at end of period		$	22,243		$	35,627
Supplemental disclosures of cash flow information:
Cash paid during period for:
Interest expense		$	25,711		$	31,322
Income taxes		10,600			17,138
Non-cash financing and investing activities:
Premium and interest bonuses deferred as sales inducements		81,612			74,186
Conversion of subordinated debentures		250			360
Subordinated debentures issued to subsidiary trusts for common equity securities of the subsidiary trust		—			928

 

See accompanying notes to unaudited consolidated financial statements.

7

 

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2007
(Unaudited)

1.   Organization and Significant Accounting Policies

Consolidation and Basis of Presentation

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

Reclassifications

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

Adopted Accounting Pronouncements

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

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

In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments (“SFAS 155”), which amends SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”) and SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (“SFAS 140”).  SFAS 155 simplifies the accounting for certain derivatives embedded in other financial instruments by allowing them to be accounted for

 

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

New Accounting Pronouncements

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

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

2.   Contingencies

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

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

3. Share-based Compensation Plans

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

 

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4.   Earnings Per Share

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

		Three Months Ended June 30,						Six Months Ended June 30,
		2007			2006			2007			2006
		(Dollars in thousands, except per share data)
Numerator:
Net income—numerator for earnings per common share		$	24,589		$	42,911		$	34,516		$	46,884
Interest on convertible subordinated debentures (net of income tax benefit)		262			266			528			536
Numerator for earnings per common share— assuming dilution		$	24,851		$	43,177		$	35,044		$	47,420
Denominator:
Weighted average common shares outstanding(1)		57,122,194			55,643,507			56,909,226			55,598,992
Effect of dilutive securities:
Convertible subordinated debentures		2,769,093			2,808,381			2,784,099			2,827,825
Stock options		417,725			1,018,371			648,175			1,066,945
Deferred compensation agreements		—			1,184,647			—			1,233,152
Denominator for earnings per common share— assuming dilution		60,309,012			60,654,906			60,341,500			60,726,914
Earnings per common share		$	0.43		$	0.77		$	0.61		$	0.84
Earnings per common share—assuming dilution		$	0.41		$	0.71		$	0.58		$	0.78

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

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

 

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

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

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

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

·                          customer response to new products and marketing initiatives;

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

·                          increasing competition in the sale of annuities;

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

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

Overview

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

 

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

 

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

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

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

Our investment spread is summarized as follows:

 

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

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

Results of Operations

Three and Six Months Ended June 30, 2007 and 2006

Net income decreased 43% to $24.6 million for the second quarter of 2007, and 26% to $34.5 million for the six months ended June 30, 2007 compared to $42.9 million and $46.9 million for the same periods in 2006.  The comparability of the amounts is impacted by (i) the application of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”) to our index annuity business which we estimate increased net income by $7.8 million for the second quarter of 2007 and $2.6 million for the six months ended June 30, 2007 compared to increases of $0.5 million and $5.2 million for the same periods in 2006 and (ii) the application of SFAS 133 to our contingent convertible senior notes which we estimate decreased net income by $0.1 million for the second quarter of 2007 and $0.3 million for the six months ended June 30, 2007 compared to increases of  $22.2 million and $5.4 million for the same periods in 2006.  Excluding these amounts, net income for the second quarter of 2007 and the six months ended June 30, 2007 would have been $17.0 million and $31.8 million, respectively, compared to $20.1 million and $36.1 million for the same periods in 2006.  These decreases were principally due to higher amortization of deferred policy acquisition costs and deferred sales inducements and increased operating expenses as discussed below.

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

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

 

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

 

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

 

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

		Three Months Ended June 30,				Six Months Ended June 30,
		2007		2006		2007		2006
S&P 500 Index
Point-to-point strategy		10.1% – 24.	4%	2.7% – 15.	0%	6.9% – 24.	4%	2.7% – 15.	0%
Monthly average strategy		3.4% – 14.	1%	3.4% – 9.	1%	1.2% – 14.	1%	0.0% – 9.	1%
Monthly point-to-point strategy		5.6% – 17.	4%	0.0% – 10.	1%	4.4% – 17.	4%	0.0% – 10.	1%
Lehman Brothers U.S. Aggregate and U.S. Treasury indices		4.9% – 7.	2%	0.7% – 3.	3%	2.6% – 7.	2%	0.7% – 3.	8%

 

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

 

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

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

 

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

Amortization of deferred sales inducements increased 112% to $14.2 million in the first quarter of 2007 and 18% to $18.5 million for the six months ended June 30, 2007 compared to $6.7 million and $15.7 million for the same periods in 2006.  In general, amortization of deferred sales inducements has been increasing each period due to growth in our annuity business and the deferral of sales inducements incurred with respect to sales of premium and interest bonus annuity products.  Bonus products represented 85% and 74% of our total annuity deposits during the six months ended June 30, 2007 and 2006, respectively.  The anticipated increase in amortization from these factors has been affected by amortization associated with the application of SFAS 133 to our index annuity business.  The application of SFAS 133 to our index annuity business creates differences in the recognition of revenues and expenses from derivative instruments including the embedded derivative liabilities in our index annuity contracts.  The change in fair value of the embedded derivatives will not correspond to the change in fair value of the purchased options because the purchased options are one-year options while the options valued in the fair value of embedded derivatives cover the expected life of the contracts which typically exceed 10 years.  The gross profit adjustments resulting from the application of SFAS 133 to our index annuity business increased amortization by $5.1 million in the second quarter of 2007 and $1.7 million for the six months ended June 30, 2007 compared to $0.2 million and $3.3 million for the same periods in 2006.  Excluding these amounts, amortization for the second quarter of 2007 would have been $9.1 million and $16.9 million for the six months ended June 30, 2007 compared to $6.6 million and $12.4 million for the same periods in 2006.  See Critical Accounting Policies—Deferred Policy Acquisition Costs and Deferred Sales Inducements included in Management’s Discussion and Analysis included in our Annual Report on Form 10-K for the year ended December 31, 2006.

 

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Change in fair value of embedded derivatives was an increase of $0.4 million in the second quarter of 2007 and a decrease of $6.2 million for the six months ended June 30, 2007 compared to decreases of $111.3 million and $48.6 million for the same periods in 2006.  The components of change in fair value of embedded derivatives are summarized as follows:

 

The changes related to the embedded derivatives within our index annuities resulted primarily from changes in the expected index credits on the next policy anniversary dates, which are related to the change in fair value of the call options acquired to fund these index credits discussed above in “change in fair value of derivatives”.  The value of the embedded derivative is also impacted by changes in discount rates used in estimating future option costs and the growth in the host component of the embedded derivative.  See Critical Accounting Policies—Derivative Instruments—Index Products included in Management’s Discussion and Analysis included in our Annual Report on Form 10-K for the year ended December 31, 2006.

The conversion option embedded within our contingent convertible senior notes was required to be bifurcated and recorded at fair value in accordance with SFAS 133 beginning December 15, 2005 due to an insufficient number of authorized shares.  See notes 1 and 7 to our audited consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2006.  Effective June 8, 2006, this conversion option was no longer required to be bifurcated and recorded at fair value upon shareholder approval of an increase of authorized shares.  The changes in the fair value of the conversion option embedded within these notes for the three months and six months ended June 30, 2006 coincides with the change in the per share price of our common stock during that period.

Interest expense on notes payable decreased 38% to $4.1 million in the second quarter of 2007 and 41% to $8.1 million for the six months ended June 30, 2007 compared to $6.5 million and $13.8 million for the same periods in 2006.  These decreases were primarily due to a decrease in the amortization of the discount on our contingent convertible senior notes to $0.3 million for the second quarter of 2007 and $0.5 million for the six months ended June 30, 2007 compared to $2.6 million and $6.0 million for the same periods in 2006.  This discount was created in the fourth quarter of 2005 when the conversion option embedded in our contingent convertible senior notes was bifurcated from the host instrument, and adjusted when the derivative was unbifurcated from the host instrument on June 8, 2006.  See note 7 to our audited consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2006.

Interest expense on subordinated debentures increased 4% to $5.6 million in the second quarter of 2007 and 9% to $11.2 million for the six months ended June 30, 2007 compared to $5.4 million and $10.3 million for the same periods in 2006.  These increases were primarily due to the issuance of additional subordinated debentures of $41.2 million during 2006.  These increases were also due to increases in weighted average interest rates on the outstanding subordinated debentures which were 8.35% and 8.13% for the six months ended June 30, 2007 and 2006, respectively.  The weighted average interest rates have increased because substantially all of the subordinated debentures issued during 2004 – 2006 have a floating rate of interest based upon the three month London Interbank Offered Rate plus an applicable margin.  See Financial Condition—Liabilities in Management’s Discussion and Analysis included in our Annual Report on Form 10-K for the year ended December 31, 2006.

Interest expense on amounts due under repurchase agreements decreased to $3.1 million in the second quarter of 2007 and to $7.1 million for the six months ended June 30, 2007 compared to $8.5 million and $14.3 million for the same periods in 2006.  These decreases were principally due to decreases in the borrowings outstanding which averaged $226.3 million for the second quarter of 2007 and $261.0 million for the six months ended June 30, 2007 compared to $664.4 million and $587.1 million for the same periods in 2006, offset by changes in the weighted average interest rates on amounts borrowed which were 5.42% for the second quarter of 2007 and 5.47% for the six months ended June 30, 2007 compared to 5.15% and 4.92% for the same periods in 2006.

Amortization of deferred policy acquisition costs increased 59% to $40.3 million in the second quarter of 2007, and 3% to $57.9 million for the six months ended June 30, 2007 compared to $25.4 million and $56.1 million for the same periods in 2006.  In general, amortization of deferred policy acquisition costs has been increasing each period due to the growth in our annuity

 

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business and the deferral of policy acquisition costs incurred with respect to sales of annuity products.  The anticipated increase in amortization from these factors has been affected by amortization associated with the application of SFAS 133 to our index annuity business.  As discussed above, the application of SFAS 133 to our index annuity business creates differences in the recognition of revenues and expenses from derivative instruments including the embedded derivative liabilities in our index annuity contracts.  The gross profit adjustments resulting from the application of SFAS 133 to our index annuity business increased amortization by $11.9 million in the second quarter of 2007 and $3.8 million for the six months ended June 30, 2007 compared to $0.9 million and $8.8 million for the same periods in 2006.  Excluding these amounts, amortization for the second quarter of 2007 would have been $28.4 million and $54.1 million for the six months ended June 30, 2007 compared to $24.5 million and $47.3 million for the same periods in 2006.

Other operating costs and expenses increased 42% to $14.1 million in the second quarter of 2007 and 27% to $25.5 million for the six months ended June 30, 2007 compared to $9.9 million and $20.1 million for the same periods in 2006.  These increases were attributable to increases of $3.3 million in legal fees and $0.6 million in costs related to the development of an electronic document database that occurred in the second quarter of 2007.

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 short-term investments.

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

We have classified a portion of our fixed maturity investments as available for sale.  Available for sale securities are reported at fair value and unrealized gains and losses, if any, on these securities (net of income taxes and certain adjustments for changes in amortization of deferred policy acquisition costs and deferred sales inducements) are included directly in a separate component of stockholders’ equity, thereby exposing stockholders’ equity to volatility due to changes in market interest rates and the accompanying changes in the reported value of securities classified as available for sale, with stockholders’ equity increasing as interest rates decline and, conversely, decreasing as interest rates rise.

Investments increased to $12.1 billion at June 30, 2007 compared to $11.4 billion at December 31, 2006 as a result of the growth in our annuity business discussed above.  At June 30, 2007, the fair value of our available for sale fixed maturity and equity securities was $213.2 million less than the amortized cost of those investments, compared to $120.6 million at December 31, 2006.  At June 30, 2007, the amortized cost of our fixed maturity securities held for investment exceeded the fair value by $428.4 million, compared to $256.9 million at December 31, 2006.  The increase in the net unrealized investment losses at June 30, 2007 compared to December 31, 2006 is principally related to an increase in market interest rates and an increase in invested assets.

 

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