FORM 10-Q

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

(Mark One)

 

ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended March 31, 2005

 

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                    to                    

 

Commission File Number : 001-31911

 

American Equity Investment Life Holding Company

(Exact name of registrant as specified in its charter)

 

Iowa		42-1447959
(State of Incorporation)		(I.R.S. Employer Identification No.)
5000 Westown Parkway, Suite 440 West Des Moines, Iowa		50266
(Address of principal executive offices)		(Zip Code)
Registrant’s telephone number, including area code		(515) 221-0002
		(Telephone)
Securities registered pursuant to Section 12(b) of the Act:
Title of each class		Name of each exchange on which registered
Common Stock, par value $1		New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $1

 

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

 

Yes   ý     No   o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

 

Yes   ý     No   o

 

APPLICABLE TO CORPORATE ISSUERS:

 

Shares of common stock outstanding at April 30, 2005:  38,375,157

 

 

PART I. – FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

 

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except per share data)

(Unaudited)

 

		March 31, 2005			December 31, 2004
					(Restated)
Assets
Investments:
Fixed maturity securities:
Available for sale, at market (amortized cost: 2005 - $3,099,564; 2004 - $2,769,804)		$	3,035,187		$	2,705,323
Held for investment, at amortized cost (market: 2005 - $4,101,879; 2004 - $4,005,775)		4,223,362			4,098,493
Equity securities, available for sale, at market (cost: 2005 - $36,755; 2004 - $38,838)		35,313			38,303
Mortgage loans on real estate		1,070,532			959,779
Derivative instruments		122,100			148,006
Policy loans		365			362
Total investments		8,486,859			7,950,266
Cash and cash equivalents		30,804			66,542
Coinsurance deposits—related party		2,035,945			2,068,700
Accrued investment income		54,606			44,871
Deferred policy acquisition costs		774,130			713,021
Deferred sales inducements		190,794			159,467
Deferred income tax asset		64,591			56,142
Other assets		25,248			28,279
Total assets		$	11,662,977		$	11,087,288

 

2

 

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY

CONSOLIDATED BALANCE SHEETS (Continued)

(Dollars in thousands, except per share data)

(Unaudited)

 

		March 31, 2005			December 31, 2004
					(Restated)
Liabilities and Stockholders’ Equity
Liabilities:
Policy benefit reserves:
Traditional life and accident and health insurance products		$	65,330		$	62,073
Annuity and single premium universal life products		10,242,840			9,745,896
Other policy funds and contract claims		101,478			94,410
Other amounts due to related parties		28,865			31,955
Notes payable		282,409			283,375
Subordinated debentures		173,607			173,576
Amounts due under repurchase agreements		273,871			264,875
Federal income taxes payable		14,388			8,554
Other liabilities		162,905			117,031
Total liabilities		11,345,693			10,781,745
Stockholders’ equity:
Common Stock, par value $1 per share, 75,000,000 shares authorized; issued and outstanding: 2005 – 38,375,157 shares; 2004 – 38,360,343 shares		38,375			38,360
Additional paid-in capital		215,891			215,793
Accumulated other comprehensive loss		(20,169		)	(19,269		)
Retained earnings		83,187			70,659
Total stockholders’ equity		317,284			305,543
Total liabilities and stockholders’ equity		$	11,662,977		$	11,087,288

 

See accompanying notes.

 

3

 

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY

CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in thousands, except per share data)

(Unaudited)

 

		Three Months Ended March 31,
		2005			2004
					(Restated)
Revenues:
Traditional life and accident and health insurance premiums		$	3,756		$	4,386
Annuity and single premium universal life product charges		6,262			4,971
Net investment income		124,834			98,589
Realized gains on investments		232			379
Change in fair value of derivatives		(35,990		)	5,815
Total revenues		99,094			114,140
Benefits and expenses:
Insurance policy benefits and change in future policy benefits		3,632			3,075
Interest credited to account balances		61,482			85,081
Change in fair value of embedded derivatives		(18,591		)	(16,376		)
Interest expense on notes payable		4,139			505
Interest expense on subordinated debentures		3,046			2,118
Interest expense on amounts due under repurchase agreements		1,428			315
Amortization of deferred policy acquisition costs		16,666			14,966
Other operating costs and expenses		8,145			8,570
Total benefits and expenses		79,947			98,254
Income before income taxes and minority interest		19,147			15,886
Income tax expense		6,619			21,926
Income (loss) before minority interest		12,528			(6,040		)
Minority interest		—			(326		)
Net income (loss)		$	12,528		$	(5,714	)
Earnings (loss) per common share		$	0.33		$	(0.15	)
Earnings (loss) per common share - assuming dilution		$	0.29		$	(0.15	)

 

See accompanying notes.

 

4

 

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

(Dollars in thousands, except per share data)

(Unaudited)

 

		Preferred Stock			Common Stock			Additional Paid-in Capital			Accumulated Other Comprehensive Loss			Retained Earnings			Total Stockholders’ Equity
		(Restated)
Balance at January 1, 2004		$	625		$	35,294		$	208,436		$	(22,742	)	$	42,103		$	263,716
Comprehensive income:
Net loss for period		—			—			—			—			(5,714		)	(5,714		)
Change in net unrealized investment gains/losses		—			—			—			18,039			—			18,039
Total comprehensive income																	12,325
Issuance of 805,000 shares of common stock less issuance expenses of $507		—			805			5,933			—			—			6,738
Balance at March 31, 2004		$	625		$	36,099		$	214,369		$	(4,703	)	$	36,389		$	282,779
Balance at January 1, 2005, as previously reported		$	—		$	38,360		$	215,793		$	(19,269	)	$	86,620		$	321,504
Adjustment for the cumulative effect on prior years of applying retroactively the new method of accounting for a variable interest entity		—			—			—			—			(15,961		)	(15,961		)
Balance at January 1, 2005, as restated		—			38,360			215,793			(19,269		)	70,659			305,543
Comprehensive income:
Net income for period		—			—			—			—			12,528			12,528
Change in net unrealized investment gains/losses		—			—			—			(900		)	—			(900		)
Total comprehensive income																	11,628
Conversion of $120 of subordinated debentures		—			15			98			—			—			113
Balance at March 31, 2005		$	—		$	38,375		$	215,891		$	(20,169	)	$	83,187		$	317,284

 

See accompanying notes.

 

5

 

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)

 

		Three Months Ended March 31,
		2005			2004
					(Restated)
Operating activities
Net income (loss)		$	12,528		$	(5,714	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Adjustments related to interest sensitive products:
Interest credited to account balances		61,482			85,081
Annuity and single premium universal life product charges		(6,262		)	(4,971		)
Change in fair value of embedded derivatives		(18,591		)	(16,376		)
Increase in traditional life and accident and health insurance reserves		3,257			2,928
Policy acquisition costs deferred		(78,635		)	(29,522		)
Amortization of deferred policy acquisition costs		16,666			14,966
Provision for depreciation and other amortization		449			356
Amortization of discount and premiums on fixed maturity securities		(48,159		)	(29,480		)
Realized gains on investments		(232		)	(379		)
Change in fair value of derivatives		35,990			(5,815		)
Deferred income taxes		(7,965		)	10,213
Changes in other operating assets and liabilities:
Accrued investment income		(9,735		)	(3,327		)
Federal income taxes recoverable/payable		5,834			11,713
Other policy funds and contract claims		7,068			8,855
Other amounts due to related parties		5,300			6,477
Other liabilities		19,699			22,426
Other		(258		)	(498		)
Net cash provided by (used in) operating activities		(1,564		)	66,933
Investing Activities
Sales, maturities, or repayments of investments:
Fixed maturity securities - available for sale		118,249			848,565
Fixed maturity securities - held for investment		723,072			232,769
Equity securities, available for sale		7,166			16,066
Mortgage loans on real estate		22,870			9,612
Derivative instruments		13,276			31,640
		884,633			1,138,652
Acquisition of investments:
Fixed maturity securities - available for sale		(430,822		)	(339,815		)
Fixed maturity securities - held for investment		(786,971		)	(609,066		)
Equity securities, available for sale		(5,025		)	(16,537		)
Mortgage loans on real estate		(133,623		)	(44,600		)
Derivative instruments		(32,096		)	(20,284		)
Policy loans		(3		)	—
		(1,388,540		)	(1,030,302		)
Purchases of property, furniture and equipment		(291		)	(2,238		)
Net cash provided by (used in) investing activities		(504,198		)	106,112

 

6

 

		Three Months Ended March 31,
		2005			2004
					(Restated)
Financing activities
Receipts credited to annuity and single premium universal life policyholder account balances		$	676,286		$	366,869
Coinsurance deposits-related parties		(1,792		)	(71,594		)
Return of annuity and single premium universal life policyholder account balances		(212,344		)	(141,620		)
Financing fees incurred and deferred		(156		)	—
Repayments of notes payable		(966		)	(2,757		)
Increase (decrease) in amounts due under repurchase agreements		8,996			(108,790		)
Net proceeds from issuance of common stock		—			6,738
Net cash provided by financing activities		470,024			48,846
Increase (decrease) in cash and cash equivalents		(35,738		)	221,891
Cash and cash equivalents at beginning of period		66,542			33,752
Cash and cash equivalents at end of period		$	30,804		$	255,643
Supplemental disclosures of cash flow information:
Cash paid during period for:
Interest on notes payable and repurchase agreements		$	2,292		$	1,691
Interest on subordinated debentures		2,834			1,988
Income taxes		8,750			—
Non-cash financing and investing activities:
Premium and interest bonuses deferred as sales inducements		33,787			9,739
Conversion of subordinated debentures		113			—

 

See accompanying notes.

 

7

 

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2005

(Unaudited)

 

1. Significant Accounting Policies

 

Consolidation, Basis of Presentation and Restatement

 

The accompanying unaudited consolidated financial statements of American Equity Investment Life Holding Company  (the Company) have been prepared in accordance with accounting principles generally accepted in the United States (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 our financial position and results of operations on a basis consistent with the prior audited financial statements.  Operating results for the three months ended March 31, 2005, are not necessarily indicative of the results that may be expected for the year ended December 31, 2005.  For further information, refer to the audited consolidated financial statements and notes included in the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2004.

 

In the first quarter of 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. FIN 46(R)-5 (“FSP FIN 46(R)-5”), “Implicit Variable Interests under FASB Interpretation No. 46 (“FIN 46”), Consolidation of Variable Interest Entities.”  The Company has an implicit variable interest in American Equity Investment Service Company (“Service Company”) and as a result, under FSP FIN 46(R)-5, the Company must consolidate the Service Company.  As permitted by the FSP, the Company has applied FSP FIN 46(R)-5 retroactive to January 1, 2003, the date of the Company’s original adoption of FIN 46, and, accordingly, the financial statements for the three months ended March 31, 2004 and the balance sheet as of December 31, 2004 presented herein have been restated.  There was no cumulative effect on January 1, 2003 due to the adoption of FSP FIN 46(R)-5.  All intercompany transactions between the Company and the Service Company have been eliminated retroactively to January 1, 2003.

 

The effect on net income for the three months ended March 31, 2005 due to the consolidation of the Service Company is immaterial.  Previously reported net income, earnings per common share and earning per common share - assuming dilution for the three months ended March 31, 2004 decreased by $16.1 million, $0.43 and $0.40, respectively, due to the consolidation of the Service Company’s operations.  Prior to January 1, 2004, the Service Company was taxed as a Subchapter S Corporation.  Effective January 1, 2004, the Service Company revoked its Subchapter S election, which required the recognition of a deferred income tax liability on basis differences that existed at that date, all of which is reflected in income tax expense for the three months ended March 31, 2004.  The increase in income tax expense for the three months ended March 31, 2004 was approximately $16.3 million and is the principal reconciling item between the amount computed at the applicable statutory federal income tax rate (35%) and the amount reported in the consolidated statement of operations.  The primary impact on the restated consolidated balance sheet as of December 31, 2004 was a reduction of the deferred income tax asset, receivables from related parties, amounts due to related party under General Agency Commission and Service Agreement, and retained earnings of $14.4 million, $16.6 million, $35.8 million and $16.0 million, respectively, and an increase in notes payable of $23.4 million. For further information on the variable interest entity, see note 2 to our unaudited consolidated financial statements.

 

Reclassifications

 

Certain amounts in the unaudited consolidated financial statements for the period ended March 31, 2004 have been reclassified to conform to the financial statement presentation for March 31, 2005 and December 31, 2004.

 

Stock-Based Compensation

 

The Company has elected to follow Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) and related Interpretations in accounting for its employee stock options.  Under APB 25, because the exercise price of the company’s employee stock options equals the fair value of the underlying stock on the date of grant, no compensation expense is recognized.

 

Pro forma information regarding net income is required by SFAS No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure, and has been determined as if the Company had accounted for its employee stock options under the fair value method of these statements.  The fair value for these options was estimated at the date of grant using a Black-Scholes option valuation model with the following weighted-average assumptions:

 

		2005		2004
Risk-free interest rate		3.85	%	1.46	%
Dividend yield		0	%	0	%
Weighted-average expected life		10 years		10 years
Expected volatility		17.8	%	31.2	%

 

8

 

For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting period.  The Company’s pro forma net earnings and earnings per common share were as follows (dollars in thousands, except per share data):

 

		Three Months Ended March 31,
		2005			2004
Net income (loss), as reported – numerator for earnings per common share		$	12,528		$	(5,714	)
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effect		(430		)	(121		)
Net income (loss), pro forma – numerator for earnings (loss) per common share, pro forma		12,098			(5,835		)
Interest on convertible subordinated debentures (net of income tax benefit)		301			337
Numerator for earnings (loss) per common share - assuming dilution, pro forma		$	12,399		$	(5,498	)
Earnings (loss) per common share, as reported		$	0.33		$	(0.15	)
Earnings (loss) per common share, pro forma		$	0.32		$	(0.15	)
Earnings (loss) per common share - assuming dilution, as reported		$	0.29		$	(0.15	)
Earnings (loss) per common share - assuming dilution, pro forma		$	0.28		$	(0.15	)

 

Pending Accounting Changes

 

In March 2004, the FASB’s Emerging Issues Task Force (EITF) reached a consensus on EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (EITF 03-1).  EITF 03-1 provides guidance regarding the meaning of other-than-temporary impairment and its application to investments classified as either available for sale or held to maturity under FASB Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and to equity securities accounted for under the cost method.  Included in EITF 03-1 is guidance on how to account for impairments that are solely due to interest rate changes, including changes resulting from increases in sector credit spreads.  This guidance was to become effective for reporting periods beginning after June 15, 2004.  However, on September 30, 2004, the FASB issued a Staff Position that delays the effective date for the recognition and measurement guidance of EITF 03-1 until additional clarifying guidance is issued.  The issuance of this guidance was delayed during the fourth quarter of 2004, with additional discussion of this issue by the FASB planned for 2005.  We are not able to assess the impact of the adoption of EITF 03-1 until final guidance is issued.

 

In December 2004, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 123 (Revised 2004), “Share-Based Payment” (“SFAS 123R”).  SFAS 123R requires expensing stock options and other share-based payments and supersedes SFAS No. 123, which had allowed companies to choose between expensing stock or showing pro forma disclosure only.  SFAS 123R is effective for the Company as of January 1, 2006 and will apply to all awards granted, modified, cancelled or purchased after that date as well as the unvested portion of prior awards.  The Company will adopt SFAS 123R as of the effective date and does not believe it will have a material effect on the financial statements.

 

2.  Variable Interest Entity

 

The Company has a General Agency Commission and Servicing Agreement with the Service Company, which is wholly-owned by the Company's Chairman, whereby the Service Company acts as a national supervisory agent with responsibility for paying commissions to agents of the Company.  This Agreement is more fully described in note 8 to the audited consolidated financial statements included in the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2004.  As described in note 1, the Company has an implicit variable interest in the Service Company and is required to include the Service Company in its consolidated financial statements.  The Service Company was consolidated in the first quarter of 2005, retroactive to January 1, 2003.  Cash and cash equivalents at March 31, 2005 and December 31, 2004 include $2.5 million of restricted cash under terms of a credit agreement between the Service Company and a third party.  The Company's Chairman has guaranteed indebtedness of the Service Company to the third party under this credit agreement with a principal balance of $19.4 million and $20.4 million at March 31, 2005 and December 31, 2004, respectively.

 

9

 

3. Earnings Per Share

 

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

 

		Three Months Ended March 31,
		2005			2004
		(Dollars in thousands, except per share data)
Numerator:
Net income (loss) - numerator for earnings per common share		$	12,528		$	(5,714	)
Interest on convertible subordinated debentures (net of income tax benefit)		301			337
Numerator for earnings (loss) per common share - assuming dilution		$	12,829		$	(5,377	)
Denominator:
Weighted average common shares outstanding		38,372,359			36,037,112
Participating preferred stock		—			1,875,000
Denominator for earnings (loss) per common share		38,372,359			37,912,112
Effect of dilutive securities:
Convertible subordinated debentures		2,860,778			—
Stock options and management subscription rights		1,596,597			—
Deferred compensation agreements		835,268			—
Denominator for earnings (loss) per common share - assuming dilution		43,665,002			37,912,112
Earnings (loss) per common share		$	0.33		$	(0.15	)
Earnings (loss) per common share - assuming dilution		$	0.29		$	(0.15	)

 

There were no dilutive securities during the three months ended March 31, 2004 because of the net loss realized by the Company during that period.

 

4. Contingencies

 

Assessments are, from time to time, levied on the Company by life and health guaranty associations in most states in which the Company is licensed to cover losses to policyholders of insolvent or rehabilitated companies.  The Company has a reserve established for future assessments related to the insolvency of London Pacific Life and Annuity Company  of $1.1 million at March 31, 2005.  The Company believes the reserve for guaranty fund assessments is sufficient to provide for future assessments based upon known insolvencies.

 

10

 

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 filed in state courts alleging improper sales practices.  In these lawsuits, the plaintiffs are seeking returns of premiums and other compensatory and punitive damages.  We have reached a final settlement in one of these cases, the impact of which is expected to be immaterial.  The class was certified as such incident to the settlement in that case.  No class has been certified in any of the other 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 believe are 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.

 

11

 

ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS  OF OPERATIONS

 

Management’s discussion and analysis reviews our consolidated financial position at March 31, 2005, and the consolidated results of operations for the three month periods ended March 31, 2005 and 2004, 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/A for the year ended December 31, 2004.

 

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, 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 market 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

 

•                                          the risk factors or uncertainties listed from time to time in our private placement memorandums or filings with the Securities and Exchange Commission

 

12

 

Results of Operations

 

Three Months Ended March 31, 2005 and 2004

 

Annuity deposits by product type collected during the three months ended March 31, 2005 and 2004, were as follows:

 

		Three months ended March 31,
Product Type		2005			2004
		(Dollars in thousands)
Index annuities:
Index strategies		$	418,677		$	209,797
Fixed strategy		201,585			61,459
		620,262			271,256
Fixed rate annuities:
Single-year rate guaranteed		52,116			88,765
Multi-year rate guaranteed		3,908			6,848
		56,024			95,613
Total before coinsurance ceded		$	676,286		$	366,869
Coinsurance ceded		1,792			71,594
Net after coinsurance ceded		$	674,494		$	295,275

 

For information related to our coinsurance agreements, see note 5 to our audited consolidated financial statements included in our Annual Report on Form 10-K/A for the year ended December 31, 2004.

 

Gross annuity deposits for the first quarter of 2005 increased 84% compared to the same period in 2004 resulting from increased marketing efforts following the completion of our initial public offering (“IPO”).  The gross annuity deposits for the first quarter of 2005 are benefitting from the marketing efforts that occurred throughout 2004.

 

Net annuity deposits after coinsurance ceded increased 128% during the first quarter of 2005 compared to the same period in 2004 because we suspended our coinsurance agreement with EquiTrust Life Insurance Company (“EquiTrust”), a subsidiary of FBL Financial Group, Inc., effective August 1, 2004.  During the first quarter of 2004, the amount ceded under the coinsurance agreement with EquiTrust was 20%.

 

Net income was $12.5 million for the first quarter of 2005 compared to a restated net loss of $5.7 million for the same period in 2004.  As discussed in notes 1 and 2 to our unaudited consolidated financial statements, we adopted FSP FIN 46(R)-5 in the first quarter of 2005 with respect to an implicit variable interest we have in a related party and, as permitted by the FSP, applied it retroactively to January 1, 2003, the date of our original adoption of FIN 46.  Accordingly, the financial statements for the three months ended March 31, 2004 have been restated.  The adoption of FSP FIN 46(R)-5 did not have a material effect on net income for the three months ended March 31, 2005.  The principal difference between net income of $10.4 million as previously reported for the three months ended March 31, 2004 and the restated amount was the recognition of a deferred income tax liability that arose from a change in the federal income tax status of the related party entity in that period.  Income tax expense as previously reported was $16.3 million less than the restated amount.

 

The increase in net income attributable to factors other than income taxes is principally due to growth in the volume of business in force and an increase in the investment spread earned on our annuity liabilities.  Our net annuity liabilities (after coinsurance ceded) increased from $6.46 billion at March 31, 2004 to $7.94 billion at March 31, 2005.  As set forth in a table following, we increased our aggregate investment spread to 2.52% for the three months ended March 31, 2005 compared to 2.30% for the same period in 2004.  The increase in net income also benefitted from the spread earned on the investment of the net proceeds from the issuance of $260.0 million of convertible senior debt during December 2004.  Net income in each period was also impacted by the application of SFAS No. 133 to our index annuity business which we estimate decreased net income for the three months ended March 31, 2005 by $1.0 million compared to an increase of $0.9 million for the same period in 2004.

 

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 25% to $6.3 million for the first quarter of 2005, compared to $5.0 million for the same period in 2004.  The increase in  surrender charges collected during the first quarter of 2005 compared to the same period in 2004 was principally due to a higher amount of surrenders subject to surrender charges in 2005.  Withdrawals from annuity and single premium universal life policies subject to surrender charges were $43.2 million and $30.9 million for the three months ended March 31, 2005 and 2004, respectively.

 

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Net investment income increased 27% to $124.8 million in the first quarter of 2005, compared to $98.6 million for the same period in 2004.  This increase is principally attributable to the growth in our annuity business and a corresponding increase in our invested assets, offset by a decrease in the average yield earned on investments.  Invested assets (on an amortized cost basis) increased 28% to $8.4 billion at March 31, 2005 compared to $6.6 billion at March 31, 2004, while the  average yield earned on average invested assets was 6.22% and 6.33% for the three months ended March 31, 2005 and 2004, respectively.  The decline in the yield earned on average invested assets is attributable to a general decline in interest rates and the reinvestment of net redemption proceeds from called securities at lower yields.  See Quantitative and Qualitative Disclosures About Market Risk.

 

Realized gains on investments were $0.2 million in the first quarter of 2005 compared to $0.4 million for the same period in 2004.  Realized gains and losses 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 ended March 31, 2005 and 2004 are set forth as follows:

 

		Three Months Ended March 31,
		2005			2004
		(Dollars in thousands)
Available for sale fixed maturity securities:
Gross realized gains		$	261		$	8,026
Gross realized losses		(62		)	(137		)
Writedowns (other than temporary impairments)		—			(7,639		)
		199			250
Equity securities		33			129
		$	232		$	379

 

See “Financial Condition - - Investments” for additional discussion of write downs of the fair value of securities for “other than temporary” impairments.

 

Change in fair value of derivatives (call options purchased to fund annual index credits on index annuities) was a decrease of $36.0 million in the first quarter of 2005, compared to an increase of $5.8 million for the same period in 2004.  The components of the change in fair value of derivatives are summarized as follows:

 

		Three Months Ended March 31,
		2005			2004
		(Dollars in thousands)
Change in fair value of derivatives:
Proceeds received at expiration		$	8,743		$	30,650
Cost of money for index annuities		(22,286		)	(10,901		)
Change in difference between fair value and remaining option cost at beginning and end of period		(22,447		)	(13,934		)
		$	(35,990	)	$	5,815

 

The difference between the change in fair value of derivatives between the periods is primarily due the performance of the indices upon which our options are based.  A substantial portion of our 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 ended March 31, 2005 and 2004 is as follows:

 

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		Three Months Ended March 31,
		2005		2004
S&P 500 Index
Point-to-point strategy		1.71%-7.62%		22.54%-40.21%
Monthly average strategy		0.00%-4.82%		6.79%-29.17%
Lehman Brothers U.S. Aggregate and U.S. Treasury indices		1.19%-4.39%		2.94% - 5.40%

 

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 cost of options purchased.  The aggregate cost of options has increased primarily due to 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 the strikes and caps of the options we purchase.  See Critical Accounting Policies—Derivatives Instruments—Index Products included in Management’s Discussion and Analysis included in our Annual Report on Form 10-K/A for the year ended December 31, 2004.

 

Interest credited to account balances decreased 28% to $61.5 million in the first quarter of 2005, compared to $85.1 million for the same period in 2004.  This decrease was principally attributable to index credits on index policies which decreased to $9.4 million during the first quarter of 2005 from $36.6 million during the same period in 2004 as a result of decreases in the appreciation of the underlying indices (see discussion above under change in fair value of derivatives).  A decrease in average crediting rates also contributed to the overall decrease, which we implemented in connection with our spread management process, of 33 basis points from March 31, 2004 to March 31, 2005.  The decrease was  offset by an increase in the average amount of annuity liabilities outstanding (net of annuity liabilities ceded under coinsurance agreements) during the first quarter of 2005 of 23% to $7.94 billion from $6.46 billion during the same period in 2004 and an increase in amortization of deferred sales inducements.

 

Our investment spread is summarized as follows:

 

		Three Months Ended March 31,
		2005		2004
Average yield on investment assets		6.22	%	6.33	%
Cost of money:
Aggregate		3.70	%	4.03	%
Average net cost of money for index annuities		3.32	%	3.43	%
Average crediting rate for fixed rate annuities:
Annually adjustable		3.34	%	3.53	%
Multi-year rate guaranteed		5.49	%	5.64	%
Investment spread:
Aggregate		2.52	%	2.30	%
Index annuities		2.90	%	2.90	%
Fixed rate annuities:
Annually adjustable		2.88	%	2.80	%
Multi-year rate guaranteed		0.73	%	0.69	%

 

The average crediting rate and investment spread are computed without the impact of amortization of deferred sales inducements.  With respect to our index annuities, index costs represent the expenses we incur to fund the annual income credits and minimum guaranteed interest credited on the index business.  Gains realized on such options 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.

 

A component of interest credited to account balances is the amortization of deferred sales inducements.  The

 

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amortization of deferred sales inducements was $2.9 million and $2.0 million for the three months ended March 31, 2005 and 2004, respectively.  The increase in amortization during the first quarter of 2005 compared to the same period in 2004 was principally attributable to growth in the sales of our premium and interest bonus products.  The application of SFAS No. 133 to the amortization of deferred sales inducements resulted in a $0.4 million decrease in amortization during the first quarter of 2005 and an increase in amortization of $0.1 million for the same period in 2004.  Bonus products made up 69.7% and 65.5% of our total annuity deposits during the three months ended March 31, 2005 and 2004, respectively.  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/A for the year ended December 31, 2004.

 

Change in fair value of embedded derivatives was a decrease of $18.6 million in the first quarter of 2005 compared to a decrease of $16.4 million for the first quarter of 2004.  The change in the amount of expense recognized during the first quarter of 2005 and 2004 primarily resulted from the decrease in expected index credits on the next policy anniversary dates, which are related to the change in the fair value of the options acquired to fund these index credits discussed above in the “Change in fair value of derivatives”.  In addition, the host value of the index reserve liabilities increased primarily as a result of increases in index annuity premium deposits.  See Critical Accounting Policies - Derivative Instruments - Index Products included in Management’s Discussion included  in our Annual Report on Form 10-K/A for the year ended December 31, 2004.

 

Interest expense on notes payable increased  to $4.1 million in the first quarter of 2005 compared to $0.5 million for the same period in 2004.  This increase was primarily due to the issuance of $260.0 million of convertible senior notes at a fixed rate of 5.25% per annum during December 2004.  See note 7 to our audited consolidated financial statements included in our Annual Report on Form 10-K/A for the year ended December 31, 2004.

 

Interest expense on subordinated debentures increased to $3.0 million in the first quarter of 2005 compared to $2.1 million for the same period in 2004.  This increase was due to the issuance of additional floating rate subordinated debentures during 2004 of $59.3 million.  The amount of subordinated debentures outstanding at March 31, 2004 was $116.6 million compared to $173.6 million at March 31, 2005.  See Financial Condition—Liabilities included in Management’s Discussion and Analysis included in our Annual Report on Form 10-K/A for the year ended December 31, 2004.

 

Interest expense on amounts due under repurchase agreements increased to $1.4 million in the first quarter of 2005 compared to $0.3 million to for the same period in 2004.  This increase is principally due to increases in the borrowings outstanding which averaged $211.6 million and $99.2 million for the first quarter 2005 and 2004, respectively and changes in the weighted average interest rates on amounts borrowed which were 2.74% and 1.27%, respectively.

 

Amortization of deferred policy acquisition costs increased 11% to $16.7 million in the first quarter of 2005, compared to $15.0 million for the same period in 2004.  This increase is primarily due to additional annuity deposits as discussed  above.  The application of SFAS No. 133 resulted in a $1.8 million decrease in amortization in the first quarter of 2005  and an increase in amortization of $1.0 million in the first quarter of 2004.

 

Other operating costs and expenses decreased 5% to $8.1 million in the first quarter of 2005, compared to $8.6 million for the same period in 2004.  The decrease during the first quarter of 2005 compared to the same period in 2004 was principally attributable to a decrease in marketing expenses of $0.6 million offset by an increase in salaries of $0.2 million.

 

Income tax expense decreased 70% to $6.6 million in the first quarter of 2005, compared to $21.9 million for the same period in 2004.  Income tax expense for the first quarter of 2004 was increased by $16.3 million due to the consolidation of a variable interest entity under FIN 46.  (See note 1 to our unaudited consolidated financial statements.) Excluding the impact of this item, income tax expense would have increased by $1.0 million principally due to an increase in pretax income.

 

Financial Condition

 

Investments

 

Our investment strategy is to maintain a predominantly investment grade fixed income portfolio, provide adequate

 

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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 market 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 $8.49 billion at March 31, 2005 compared to $7.95 billion at December 31, 2004 as a result of the growth in our annuity business discussed above.  At March 31, 2005, the fair value of our available for sale fixed maturity and equity securities was $64.8 million less than the amortized cost of those investments, compared to $65.0  million at December 31, 2004.  At March 31, 2005, the amortized cost of our fixed maturity securities held for investment exceeded the market value by $121.5 million, compared to $92.7 million at December 31, 2004.  The increase in the net unrealized investment losses at March 31, 2005 compared to December 31, 2004 is principally related to an increase in invested assets and an increase in market interest rates.

 

The composition of our investment portfolio is summarized as follows:

 

		March 31, 2005					December 31, 2004
		Carrying Amount			Percent		Carrying Amount			Percent
		(Dollars in thousands)
Fixed maturity securities:
United States Government and agencies		$	6,107,579		72.1	%	$	5,730,894		72.1	%
Public utilities		44,254			0.5	%	44,849			0.6	%
Corporate securities		419,851			4.9	%	338,407			4.3	%
Redeemable preferred stocks		45,761			0.5	%	35,369			0.4	%
Mortgage and asset-backed securities:
Government		249,005			2.9	%	257,004			3.2	%
Non-government		392,099			4.6	%	397,293			5.0	%
Total fixed maturity securities		7,258,549			85.5	%	6,803,816			85.6	%
Equity securities		35,313			0.4	%	38,303			0.5	%
Mortgage loans on real estate		1,070,532			12.7	%	959,779			12.0	%
Derivative instruments		122,100			1.4	%	148,006			1.9	%
Policy loans		365			—		362			—
Total investments		$	8,486,859		100.0	%	$	7,950,266		100.0	%

 

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At March 31, 2005 and December 31, 2004, the amortized cost and estimated fair value of fixed maturity securities and equity securities that were in an unrealized loss position were as follows:

 

		Number of Positions		Amortized Cost			Unrealized Losses			Estimated Fair Value
		(Dollars in thousands)
March 31, 2005
Fixed maturity securities:
Available for sale:
United States Government and agencies		40		$	1,972,338		$	(59,537	)	$	1,912,801
Public utilities		1		8,946			(107		)	8,839
Corporate securities		26		159,385			(9,315		)	150,070
Redeemable preferred stocks		9		33,183			(1,981		)	31,202
Mortgage and asset-backed securities:
United States Government and agencies		3		6,625			(150		)	6,475
Non-government		11		231,153			(12,757		)	218,396
		90		$	2,411,630		$	(83,847	)	$	2,327,783
Held for investment:
United States Government and agencies		63		$	3,699,035		$	(121,723	)	$	3,577,312
		63		$	3,699,035		$	(121,723	)	$	3,577,312
Equity securities, available for sale:
Non-redeemable preferred stocks		7		$	20,290		$	(1,109	)	$	19,181
Common stocks		3		5,020			(805		)	4,215
		10		$	25,310		$	(1,914	)	$	23,396
December 31, 2004
Fixed maturity securities:
Available for sale:
United States Government and agencies		32		$	1,705,737		$	(58,759	)	$	1,646,978
Corporate securities		11		65,488			(6,916		)	58,572
Redeemable preferred stocks		4		20,000			(584		)	19,416
Mortgage and asset-backed securities:
United States Government and agencies		2		5,873			(72		)	5,801
Non-government		12		278,393			(15,279		)	263,114
		61		$	2,075,491		$	(81,610	)	$	1,993,881
Held for investment:
United States Government and agencies		56		$	3,213,468		$	(94,958	)	$	3,118,510
		56		$	3,213,468		$	(94,958	)	$	3,118,510
Equity securities, available for sale:
Non-redeemable preferred stocks		3		$	14,784		$	(294	)	$	14,490
Common stocks		3		2,945			(572		)	2,373
		6		$	17,729		$	(866	)	$	16,863

 

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