Document
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 March 31, 2018
OR
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 or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
6000 Westown Parkway
West Des Moines, Iowa 50266
(Address of principal executive offices, including zip code)
(515) 221-0002
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for 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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of "large accelerated filer," "accelerated filer," "smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer x
Accelerated filer o
Non-accelerated filer o
Smaller reporting company o
Emerging growth company o
 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
APPLICABLE TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date:
As of May 2, 2018, there were 90,095,990 shares of the registrant's common stock, $1 par value, outstanding.



TABLE OF CONTENTS
 
Page
 
 
 
 
 
 




Table of Contents

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except share and per share data)
 
March 31, 2018
 
December 31, 2017
 
(Unaudited)
 
 
Assets
 
 
 
Investments:
 
 
 
Fixed maturity securities:
 
 
 
Available for sale, at fair value (amortized cost: 2018 - $44,510,813; 2017 - $43,116,759)
$
45,551,348

 
$
45,372,989

Held for investment, at amortized cost (fair value: 2018 - $69,441; 2017 - $76,460)
77,043

 
77,041

Mortgage loans on real estate
2,699,637

 
2,665,531

Derivative instruments
847,741

 
1,568,380

Other investments
481,825

 
616,764

Total investments
49,657,594

 
50,300,705

 
 
 
 
Cash and cash equivalents
723,784

 
1,434,045

Coinsurance deposits
4,871,912

 
4,858,289

Accrued investment income
454,519

 
429,008

Deferred policy acquisition costs
3,039,311

 
2,714,523

Deferred sales inducements
2,219,597

 
2,001,892

Deferred income taxes
159,601

 
38,147

Other assets
175,006

 
254,127

Total assets
$
61,301,324

 
$
62,030,736

 
 
 
 
Liabilities and Stockholders' Equity
 
 
 
Liabilities:
 
 
 
Policy benefit reserves
$
56,072,140

 
$
56,142,673

Other policy funds and contract claims
280,072

 
282,884

Notes payable
494,215

 
494,093

Subordinated debentures
242,667

 
242,565

Amounts due under repurchase agreements
137,223

 

Income taxes payable
72,191

 
34,285

Other liabilities
1,455,826

 
1,984,079

Total liabilities
58,754,334

 
59,180,579

 
 
 
 
Stockholders' equity:
 
 
 
Preferred stock, par value $1 per share, 2,000,000 shares authorized,
  2018 and 2017 - no shares issued and outstanding

 

Common stock, par value $1 per share, 200,000,000 shares authorized; issued and outstanding:
   2018 - 89,983,823 shares (excluding 1,814,460 treasury shares);
   2017 - 89,331,087 shares (excluding 2,064,727 treasury shares)
89,984

 
89,331

Additional paid-in capital
798,835

 
791,446

Accumulated other comprehensive income
399,982

 
724,599

Retained earnings
1,258,189

 
1,244,781

Total stockholders' equity
2,546,990

 
2,850,157

Total liabilities and stockholders' equity
$
61,301,324

 
$
62,030,736

See accompanying notes to unaudited consolidated financial statements.

2

Table of Contents

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in thousands, except per share data)
(Unaudited)

 
Three Months Ended 
 March 31,
 
2018
 
2017
Revenues:
 
 
 
Premiums and other considerations
$
9,053

 
$
9,402

Annuity product charges
50,723

 
43,572

Net investment income
510,784

 
485,597

Change in fair value of derivatives
(451,083
)
 
386,533

Net realized gains on investments, excluding other than temporary impairment ("OTTI") losses
302

 
2,338

OTTI losses on investments:
 
 
 
Total OTTI losses
(907
)
 

Portion of OTTI losses recognized in (from) other comprehensive income

 
(141
)
Net OTTI losses recognized in operations
(907
)
 
(141
)
Total revenues
118,872

 
927,301

 
 
 
 
Benefits and expenses:
 
 
 
Insurance policy benefits and change in future policy benefits
12,094

 
11,875

Interest sensitive and index product benefits
514,095

 
419,139

Amortization of deferred sales inducements
100,423

 
62,325

Change in fair value of embedded derivatives
(867,232
)
 
224,170

Interest expense on notes and loan payable
6,372

 
7,722

Interest expense on subordinated debentures
3,630

 
3,336

Amortization of deferred policy acquisition costs
140,639

 
89,678

Other operating costs and expenses
31,240

 
27,579

Total benefits and expenses
(58,739
)
 
845,824

Income before income taxes
177,611

 
81,477

Income tax expense
36,649

 
27,538

Net income
$
140,962

 
$
53,939

 
 
 
 
Earnings per common share
$
1.57

 
$
0.61

Earnings per common share - assuming dilution
$
1.55

 
$
0.60

 
 
 
 
Weighted average common shares outstanding (in thousands):
 
 
 
Earnings per common share
90,017

 
88,647

Earnings per common share - assuming dilution
91,139

 
89,976

See accompanying notes to unaudited consolidated financial statements.

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Table of Contents

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(Dollars in thousands)
(Unaudited)

 
Three Months Ended 
 March 31,
 
2018
 
2017
 
 
 
 
Net income
$
140,962

 
$
53,939

Other comprehensive income (loss):
 
 
 
Change in net unrealized investment gains/losses (1)
(572,033
)
 
129,124

Noncredit component of OTTI losses (1)

 
65

Reclassification of unrealized investment gains/losses to net income (1)
(339
)
 
930

Other comprehensive income (loss) before income tax
(572,372
)
 
130,119

Income tax effect related to other comprehensive income (loss)
120,201

 
(45,542
)
Other comprehensive income (loss)
(452,171
)
 
84,577

Comprehensive income (loss)
$
(311,209
)
 
$
138,516

(1)
Net of related adjustments to amortization of deferred sales inducements and deferred policy acquisition costs.
See accompanying notes to unaudited consolidated financial statements.

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AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(Dollars in thousands, except share data)
(Unaudited)

 
Common
Stock
 
Additional
Paid-in
Capital
 
Accumulated
Other
Comprehensive
Income
 
Retained
Earnings
 
Total
Stockholders'
Equity
Balance at December 31, 2016
$
88,001

 
$
770,344

 
$
339,966

 
$
1,093,284

 
$
2,291,595

Net income for period

 

 

 
53,939

 
53,939

Other comprehensive income

 

 
84,577

 

 
84,577

Share-based compensation

 
2,403

 

 

 
2,403

Issuance of 629,553 shares of common stock under compensation plans
630

 
3,087

 

 

 
3,717

Balance at March 31, 2017
$
88,631

 
$
775,834

 
$
424,543

 
$
1,147,223

 
$
2,436,231

 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2017
$
89,331

 
$
791,446

 
$
724,599

 
$
1,244,781

 
$
2,850,157

Net income for period

 

 

 
140,962

 
140,962

Other comprehensive loss

 

 
(452,171
)
 

 
(452,171
)
Implementation of accounting standard related to the reclassification of certain tax effects

 

 
127,554

 
(127,554
)
 

Share-based compensation

 
3,526

 

 

 
3,526

Issuance of 652,736 shares of common stock under compensation plans
653

 
3,863

 

 

 
4,516

Balance at March 31, 2018
$
89,984

 
$
798,835

 
$
399,982

 
$
1,258,189

 
$
2,546,990

See accompanying notes to unaudited consolidated financial statements.

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Table of Contents

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
(Unaudited)

 
Three Months Ended 
 March 31,
 
2018
 
2017
Operating activities
 
 
 
Net income
$
140,962

 
$
53,939

Adjustments to reconcile net income to net cash provided by (used in) operating activities:
 
 
 
Interest sensitive and index product benefits
514,095

 
419,139

Amortization of deferred sales inducements
100,423

 
62,325

Annuity product charges
(50,723
)
 
(43,572
)
Change in fair value of embedded derivatives
(867,232
)
 
224,170

Change in traditional life and accident and health insurance reserves
2,049

 
726

Policy acquisition costs deferred
(96,562
)
 
(110,574
)
Amortization of deferred policy acquisition costs
140,639

 
89,678

Provision for depreciation and other amortization
900

 
957

Amortization of discounts and premiums on investments
6,002

 
2,800

Realized gains (losses) on investments and net OTTI losses recognized in operations
605

 
(2,197
)
Distributions from equity method investments
66

 
122

Change in fair value of derivatives
450,906

 
(386,842
)
Deferred income taxes
(1,253
)
 
(3,670
)
Share-based compensation
3,526

 
2,403

Change in accrued investment income
(25,511
)
 
(26,371
)
Change in income taxes recoverable/payable
37,906

 
31,161

Change in other assets
(470
)
 
33

Change in other policy funds and contract claims
(4,343
)
 
(6,985
)
Change in collateral held for derivatives
(784,932
)
 
233,992

Change in other liabilities
(6,472
)
 
(38,754
)
Other
(3,757
)
 
(4,431
)
Net cash provided by (used in) operating activities
(443,176
)
 
498,049

 
 
 
 
Investing activities
 
 
 
Sales, maturities, or repayments of investments:
 
 
 
Fixed maturity securities - available for sale
265,837

 
517,301

Mortgage loans on real estate
68,017

 
75,110

Derivative instruments
479,675

 
349,732

Other investments
153,936

 
4,868

Acquisitions of investments:
 
 
 
Fixed maturity securities - available for sale
(1,310,985
)
 
(1,216,014
)
Mortgage loans on real estate
(101,037
)
 
(100,797
)
Derivative instruments
(200,542
)
 
(147,283
)
Other investments
(15,131
)
 
(1,550
)
Purchases of property, furniture and equipment
(1,099
)
 
(1,402
)
Net cash used in investing activities
(661,329
)
 
(520,035
)

6

Table of Contents

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
(Dollars in thousands)
(Unaudited)

 
Three Months Ended 
 March 31,
 
2018
 
2017
Financing activities
 
 
 
Receipts credited to annuity and single premium universal life policyholder account balances
$
1,020,429

 
$
1,073,583

Coinsurance deposits
(6,867
)
 
63,746

Return of annuity policyholder account balances
(738,219
)
 
(727,494
)
Net proceeds from amounts due under repurchase agreements
137,223

 

Proceeds from issuance of common stock
4,516

 
3,717

Change in checks in excess of cash balance
(22,838
)
 
(10,084
)
Net cash provided by financing activities
394,244

 
403,468

Increase (decrease) in cash and cash equivalents
(710,261
)
 
381,482

Cash and cash equivalents at beginning of period
1,434,045

 
791,266

Cash and cash equivalents at end of period
$
723,784

 
$
1,172,748

 
 
 
 
Supplemental disclosures of cash flow information
 
 
 
Cash paid during period for:
 
 
 
Interest expense
$
3,488

 
$
18,682

Income taxes

 
47

Non-cash operating activity:
 
 
 
Deferral of sales inducements
43,670

 
65,245

See accompanying notes to unaudited consolidated financial statements.




 

7

Table of Contents

AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2018
(Unaudited)


1. Significant Accounting Policies
Consolidation and Basis of Presentation
The accompanying consolidated financial statements of American Equity Investment Life Holding Company ("we", "us" or "our") 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 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 consolidated financial statements. Operating results for the three month period ended March 31, 2018 are not necessarily indicative of the results that may be expected for the year ended December 31, 2018. 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 our financial position and results of operations, refer to the audited consolidated financial statements and notes included in our Annual Report on Form 10-K for the year ended December 31, 2017.
Adopted Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board ("FASB") issued an accounting standards update ("ASU") related to revenue arising from contracts with customers. This ASU, which replaces most current revenue recognition guidance, including industry specific guidance, prescribes that an entity should recognize revenue to reflect the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. We adopted this ASU on January 1, 2018. The adoption of this ASU had no impact on our consolidated financial statements as revenues related to insurance contracts and investment contracts are excluded from its scope.
In January 2016, the FASB issued an ASU that, among other aspects of recognition, measurement, presentation and disclosure of financial instruments, primarily requires equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. However, an entity may choose to measure equity investments that do not have readily determinable fair values at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. Additionally, it changes the accounting for financial liabilities measured at fair value under the fair value option and eliminates some disclosures regarding fair value of financial assets and liabilities measured at amortized cost. We adopted this ASU on January 1, 2018. The adoption of this ASU had no impact on our consolidated financial statements.
In August 2016, the FASB issued an ASU that clarifies how certain cash receipts and cash payments are to be presented and classified in the statement of cash flows. We adopted this ASU on January 1, 2018. The adoption of this ASU resulted in a reclassification of certain cash flows related to equity method investment distributions from investing activities to operating activities within our consolidated statements of cash flows.
In February 2018, the FASB issued an ASU that allows a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act of 2017 ("Tax Reform"). We adopted this ASU on January 1, 2018. The adoption of this ASU resulted in a reclassification of $128 million between accumulated other comprehensive income and retained earnings within our consolidated balance sheet.
New Accounting Pronouncements
In February 2016, the FASB issued an ASU that will require recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. This ASU affects accounting and disclosure more dramatically for lessees as accounting for lessors is mainly unchanged. This ASU will be effective for us on January 1, 2019, with early adoption permitted. We are in the process of evaluating the impact this guidance may have on our consolidated financial statements.
In June 2016, the FASB issued an ASU that significantly changes the impairment model for most financial assets that are measured at amortized cost and certain other instruments from an incurred loss model to an expected loss model that requires these assets be presented at the net amount expected to be collected. In addition, credit losses on available for sale debt securities should be recorded through an allowance account.  This ASU will be effective for us on January 1, 2020, with early adoption permitted. While we are still in the process of evaluating the impact this guidance will have on our consolidated financial statements, we believe the new impairment model will lead to earlier recognition of credit losses for our commercial mortgage loans.

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Table of Contents

In March 2017, the FASB issued an ASU that applies to certain callable debt securities where the amortized cost basis is at a premium to the price repayable by the issuer at the earliest call date. Under this guidance, the premium will be amortized to the first call date. This ASU will be effective for us on January 1, 2019, with early adoption permitted. We are in the process of evaluating the impact this guidance may have on our consolidated financial statements.
Income Tax Reform
As a result of Tax Reform, the federal corporate tax rate was reduced from 35% to 21% effective January 1, 2018.

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Table of Contents

2. Fair Values of Financial Instruments
The following sets forth a comparison of the carrying amounts and fair values of our financial instruments:
 
March 31, 2018
 
December 31, 2017
 
Carrying
Amount
 
Fair Value
 
Carrying
Amount
 
Fair Value
 
(Dollars in thousands)
Assets
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
Available for sale
$
45,551,348

 
$
45,551,348

 
$
45,372,989

 
$
45,372,989

Held for investment
77,043

 
69,441

 
77,041

 
76,460

Mortgage loans on real estate
2,699,637

 
2,684,976

 
2,665,531

 
2,670,037

Derivative instruments
847,741

 
847,741

 
1,568,380

 
1,568,380

Other investments
481,825

 
472,642

 
616,764

 
605,894

Cash and cash equivalents
723,784

 
723,784

 
1,434,045

 
1,434,045

Coinsurance deposits
4,871,912

 
4,402,849

 
4,858,289

 
4,347,990

Interest rate caps
890

 
890

 
415

 
415

Interest rate swap
427

 
427

 

 

Counterparty collateral
124,778

 
124,778

 
186,108

 
186,108

 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
Policy benefit reserves
55,713,429

 
47,137,678

 
55,786,011

 
46,344,931

Single premium immediate annuity (SPIA) benefit reserves
279,678

 
288,991

 
282,563

 
292,153

Notes payable
494,215

 
506,345

 
494,093

 
521,800

Subordinated debentures
242,667

 
229,588

 
242,565

 
244,117

Amounts due under repurchase agreements
137,223

 
137,223

 

 

Interest rate swap

 

 
789

 
789

Fair value is the price that would be received to sell an asset or paid to transfer a liability (exit price) in an orderly transaction between market participants at the measurement date. The objective of a fair value measurement is to determine that price for each financial instrument at each measurement date. We meet this objective using various methods of valuation that include market, income and cost approaches.
We categorize our financial instruments into three levels of fair value hierarchy based on the priority of inputs used in determining fair value. The hierarchy defines the highest priority inputs (Level 1) as quoted prices in active markets for identical assets or liabilities. The lowest priority inputs (Level 3) are our own assumptions about what a market participant would use in determining fair value such as estimated future cash flows. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, a financial instrument's level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and considers factors specific to the financial instrument. We categorize financial assets and liabilities recorded at fair value in the consolidated balance sheets as follows:
Level 1—
Quoted prices are available in active markets for identical financial instruments as of the reporting date. We do not adjust the quoted price for these financial instruments, even in situations where we hold a large position and a sale could reasonably impact the quoted price.
Level 2—
Quoted prices in active markets for similar financial instruments, quoted prices for identical or similar financial instruments in markets that are not active; and models and other valuation methodologies using inputs other than quoted prices that are observable.
Level 3—
Models and other valuation methodologies using significant inputs that are unobservable for financial instruments and include situations where there is little, if any, market activity for the financial instrument. The inputs into the determination of fair value require significant management judgment or estimation. Financial instruments that are included in Level 3 are securities for which no market activity or data exists and for which we used discounted expected future cash flows with our own assumptions about what a market participant would use in determining fair value.
Transfers of securities among the levels occur at times and depend on the type of inputs used to determine fair value of each security. There were no transfers between levels during any period presented.

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Our assets and liabilities which are measured at fair value on a recurring basis as of March 31, 2018 and December 31, 2017 are presented below based on the fair value hierarchy levels:
 
Total
Fair Value
 
Quoted
Prices in
Active
Markets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
 
(Dollars in thousands)
March 31, 2018
 
 
 
 
 
 
 
Assets
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
Available for sale:
 
 
 
 
 
 
 
United States Government full faith and credit
$
11,433

 
$
5,541

 
$
5,892

 
$

United States Government sponsored agencies
1,270,106

 

 
1,270,106

 

United States municipalities, states and territories
4,137,005

 

 
4,137,005

 

Foreign government obligations
231,671

 

 
231,671

 

Corporate securities
29,584,128

 
375

 
29,583,753

 

Residential mortgage backed securities
1,102,609

 

 
1,102,609

 

Commercial mortgage backed securities
5,596,882

 

 
5,596,882

 

Other asset backed securities
3,617,514

 

 
3,617,514

 

Other investments: equity securities
157,431

 
150,000

 
7,431

 

Derivative instruments
847,741

 

 
847,741

 

Cash and cash equivalents
723,784

 
723,784

 

 

Interest rate caps
890

 

 
890

 

Interest rate swap
427

 

 
427

 

Counterparty collateral
124,778

 

 
124,778

 

 
$
47,406,399

 
$
879,700

 
$
46,526,699

 
$

Liabilities
 
 
 
 
 
 
 
Fixed index annuities - embedded derivatives
$
8,233,557

 
$

 
$

 
$
8,233,557

 
$
8,233,557

 
$

 
$

 
$
8,233,557

 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
 
Assets
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
Available for sale:
 
 
 
 
 
 
 
United States Government full faith and credit
$
11,876

 
$
5,640

 
$
6,236

 
$

United States Government sponsored agencies
1,305,017

 

 
1,305,017

 

United States municipalities, states and territories
4,166,812

 

 
4,166,812

 

Foreign government obligations
239,360

 

 
239,360

 

Corporate securities
29,878,971

 
5

 
29,878,966

 

Residential mortgage backed securities
1,105,567

 

 
1,105,567

 

Commercial mortgage backed securities
5,544,850

 

 
5,544,850

 

Other asset backed securities
3,120,536

 

 
3,120,536

 

Other investments: equity securities, available for sale
292,429

 
285,000

 
7,429

 

Derivative instruments
1,568,380

 

 
1,568,380

 

Cash and cash equivalents
1,434,045

 
1,434,045

 

 

Interest rate caps
415

 

 
415

 

Counterparty collateral
186,108

 

 
186,108

 

 
$
48,854,366

 
$
1,724,690

 
$
47,129,676

 
$

Liabilities
 
 
 
 
 
 
 
Interest rate swap
$
789

 
$

 
$
789

 
$

Fixed index annuities - embedded derivatives
8,790,427

 

 

 
8,790,427

 
$
8,791,216

 
$

 
$
789

 
$
8,790,427


11

Table of Contents

The following methods and assumptions were used in estimating the fair values of financial instruments during the periods presented in these consolidated financial statements.
Fixed maturity securities and equity securities
The fair values of fixed maturity securities and equity securities in an active and orderly market are determined by utilizing independent pricing services. The independent pricing services incorporate a variety of observable market data in their valuation techniques, including:
reported trading prices,
benchmark yields,
broker-dealer quotes,
benchmark securities,
bids and offers,
credit ratings,
relative credit information, and
other reference data.
The independent pricing services also take into account perceived market movements and sector news, as well as a security's terms and conditions, including any features specific to that issue that may influence risk and marketability. Depending on the security, the priority of the use of observable market inputs may change as some observable market inputs may not be relevant or additional inputs may be necessary.
The independent pricing services provide quoted market prices when available. Quoted prices are not always available due to market inactivity. When quoted market prices are not available, the third parties use yield data and other factors relating to instruments or securities with similar characteristics to determine fair value for securities that are not actively traded. We generally obtain one value from our primary external pricing service. In situations where a price is not available from this service, we may obtain quotes or prices from additional parties as needed. Market indices of similar rated asset class spreads are considered for valuations and broker indications of similar securities are compared. Inputs used by the broker include market information, such as yield data and other factors relating to instruments or securities with similar characteristics. Valuations and quotes obtained from third party commercial pricing services are non-binding and do not represent quotes on which one may execute the disposition of the assets.
We validate external valuations at least quarterly through a combination of procedures that include the evaluation of methodologies used by the pricing services, analytical reviews and performance analysis of the prices against trends, and maintenance of a securities watch list. Additionally, as needed we utilize discounted cash flow models or perform independent valuations on a case-by-case basis using inputs and assumptions similar to those used by the pricing services. Although we do identify differences from time to time as a result of these validation procedures, we did not make any significant adjustments as of March 31, 2018 and December 31, 2017.
Mortgage loans on real estate
Mortgage loans on real estate are not measured at fair value on a recurring basis. The fair values of mortgage loans on real estate are calculated using discounted expected cash flows using competitive market interest rates currently being offered for similar loans. The fair values of impaired mortgage loans on real estate that we have considered to be collateral dependent are based on the fair value of the real estate collateral (based on appraised values) less estimated costs to sell. The inputs utilized to determine fair value of all mortgage loans are unobservable market data (competitive market interest rates); therefore, fair value of mortgage loans falls into Level 3 in the fair value hierarchy.
Derivative instruments
The fair values of derivative instruments, primarily call options, are based upon the amount of cash that we will receive to settle each derivative instrument on the reporting date. These amounts are determined by our investment team using industry accepted valuation models and are adjusted for the nonperformance risk of each counterparty net of any collateral held. Inputs include market volatility and risk free interest rates and are used in income valuation techniques in arriving at a fair value for each option contract. The nonperformance risk for each counterparty is based upon its credit default swap rate. We have no performance obligations related to the call options purchased to fund our fixed index annuity policy liabilities.
Other investments
Equity securities are the only financial instruments included in other investments that are measured at fair value on a recurring basis (see determination of fair value above). Financial instruments included in other investments that are not measured at fair value on a recurring basis are policy loans, equity method investments and company owned life insurance ("COLI"). We have not attempted to determine the fair values associated with our policy loans, as we believe any differences between carrying values and the fair values afforded these instruments are immaterial to our consolidated financial position and, accordingly, the cost to provide such disclosure does not justify the benefit to be derived. The fair values of our equity method investments are obtained from third parties and determined by calculating the present value of future cash flows discounted by a risk free rate, a risk spread and a liquidity discount. As the risk spread and liquidity discount are unobservable market inputs, the fair value of our equity method investments falls within Level 3 of the fair value hierarchy. The fair value of our COLI approximates the cash surrender value of the policies and falls within Level 2 of the fair value hierarchy.

12

Table of Contents

Cash and cash equivalents
Amounts reported in the consolidated balance sheets for these instruments are reported at their historical cost which approximates fair value due to the nature of the assets assigned to this category.
Interest rate swap and caps
The fair values of our pay fixed/receive variable interest rate swap and our interest rate caps are obtained from third parties and are determined by discounting expected future cash flows using a projected London Interbank Offered Rate ("LIBOR") for the term of the swap and caps.
Counterparty collateral
Amounts reported in other assets in the consolidated balance sheets for these instruments are reported at their historical cost which approximates fair value due to the nature of the assets assigned to this category.
Policy benefit reserves, coinsurance deposits and SPIA benefit reserves
The fair values of the liabilities under contracts not involving significant mortality or morbidity risks (principally deferred annuities), are stated at the cost we would incur to extinguish the liability (i.e., the cash surrender value) as these contracts are generally issued without an annuitization date. The coinsurance deposits related to the annuity benefit reserves have fair values determined in a similar fashion. For period-certain annuity benefit contracts, the fair value is determined by discounting the benefits at the interest rates currently in effect for newly issued immediate annuity contracts. We are not required to and have not estimated the fair value of the liabilities under contracts that involve significant mortality or morbidity risks, as these liabilities fall within the definition of insurance contracts that are exceptions from financial instruments that require disclosures of fair value. Policy benefit reserves, coinsurance deposits and SPIA benefit reserves are not measured at fair value on a recurring basis. All of the fair values presented within these categories fall within Level 3 of the fair value hierarchy as most of the inputs are unobservable market data.
Notes payable
The fair values of our senior unsecured notes are based upon pricing matrices developed by a third party pricing service when quoted market prices are not available and are categorized as Level 2 within the fair value hierarchy. Notes payable are not remeasured at fair value on a recurring basis.
Subordinated debentures
Fair values for subordinated debentures are estimated using discounted cash flow calculations based principally on observable inputs including our incremental borrowing rates, which reflect our credit rating, for similar types of borrowings with maturities consistent with those remaining for the debt being valued. These fair values are categorized as Level 2 within the fair value hierarchy. Subordinated debentures are not measured at fair value on a recurring basis.
Amounts due under repurchase agreements
The amounts reported in the consolidated balance sheets for short term indebtedness under repurchase agreements with variable interest rates approximate their fair values.
Fixed index annuities - embedded derivatives
We estimate the fair value of the embedded derivative component of our fixed index annuity policy benefit reserves at each valuation date by (i) projecting policy contract values and minimum guaranteed contract values over the expected lives of the contracts and (ii) discounting the excess of the projected contract value amounts at the applicable risk free interest rates adjusted for our nonperformance risk related to those liabilities. The projections of policy contract values are based on our best estimate assumptions for future policy growth and future policy decrements. Our best estimate assumptions for future policy growth include assumptions for the expected index credit on the next policy anniversary date which are derived from the fair values of the underlying call options purchased to fund such index credits and the expected costs of annual call options we will purchase in the future to fund index credits beyond the next policy anniversary. The projections of minimum guaranteed contract values include the same best estimate assumptions for policy decrements as were used to project policy contract values.
Within this determination we have the following significant unobservable inputs: 1) the expected cost of annual call options we will purchase in the future to fund index credits beyond the next policy anniversary and 2) our best estimates for future policy decrements, primarily lapse, partial withdrawal and mortality rates. As of March 31, 2018 and December 31, 2017, we utilized an estimate of 3.10% for the expected cost of annual call options, which is based on estimated long-term account value growth and a historical review of our actual option costs.

13

Table of Contents

Our best estimate assumptions for lapse, partial withdrawal and mortality rates are based on our actual experience and our outlook as to future expectations for such assumptions. These assumptions, which are consistent with the assumptions used in calculating deferred policy acquisition costs and deferred sales inducements, are reviewed on a quarterly basis and are revised as our experience develops and/or as future expectations change. Our mortality rate assumptions are based on 65% of the 1983 Basic Annuity Mortality Tables. The following table presents average lapse rate and partial withdrawal rate assumptions, by contract duration, used in estimating the fair value of the embedded derivative component of our fixed index annuity policy benefit reserves at each reporting date:
 
 
Average Lapse Rates
 
Average Partial Withdrawal Rates
Contract Duration (Years)
 
March 31, 2018
 
December 31, 2017
 
March 31, 2018
 
December 31, 2017
1 - 5
 
2.11%
 
1.83%
 
3.33%
 
3.32%
6 - 10
 
7.30%
 
7.01%
 
3.33%
 
3.32%
11 - 15
 
11.33%
 
11.31%
 
3.34%
 
3.34%
16 - 20
 
11.91%
 
11.96%
 
3.24%
 
3.20%
20+
 
11.58%
 
11.62%
 
3.21%
 
3.20%
Lapse rates are generally expected to increase as surrender charge percentages decrease. Lapse expectations reflect a significant increase in the year in which the surrender charge period on a contract ends.
The following table provides a reconciliation of the beginning and ending balances for our Level 3 liabilities, which are measured at fair value on a recurring basis using significant unobservable inputs for the three months ended March 31, 2018 and 2017:
 
Three Months Ended 
 March 31,
 
2018
 
2017
 
(Dollars in thousands)
Fixed index annuities - embedded derivatives
 
 
 
Beginning balance
$
8,790,427

 
$
6,563,288

Premiums less benefits
549,153

 
411,502

Change in fair value, net
(1,106,023
)
 
76,210

Ending balance
$
8,233,557

 
$
7,051,000

The fair value of our fixed index annuities embedded derivatives is net of coinsurance ceded of $529.6 million and $539.7 million as of March 31, 2018 and December 31, 2017, respectively. Change in fair value, net for each period in our embedded derivatives is included in change in fair value of embedded derivatives in the unaudited consolidated statements of operations.
Certain derivatives embedded in our fixed index annuity contracts are our most significant financial instrument measured at fair value that are categorized as Level 3 in the fair value hierarchy. The contractual obligations for future annual index credits within our fixed index annuity contracts are treated as a "series of embedded derivatives" over the expected life of the applicable contracts. We estimate the fair value of these embedded derivatives at each valuation date by the method described above under fixed index annuities - embedded derivatives. The projections of minimum guaranteed contract values include the same best estimate assumptions for policy decrements as were used to project policy contract values.
The most sensitive assumption in determining policy liabilities for fixed index annuities is the rates used to discount the excess projected contract values. As indicated above, the discount rate reflects our nonperformance risk. If the discount rates used to discount the excess projected contract values at March 31, 2018, were to increase by 100 basis points, the fair value of the embedded derivatives would decrease by $529.0 million recorded through operations as a decrease in the change in fair value of embedded derivatives and there would be a corresponding decrease of $321.0 million to our combined balance for deferred policy acquisition costs and deferred sales inducements recorded through operations as an increase in amortization of deferred policy acquisition costs and deferred sales inducements. A decrease by 100 basis points in the discount rate used to discount the excess projected contract values would increase the fair value of the embedded derivatives by $588.5 million recorded through operations as an increase in the change in fair value of embedded derivatives and there would be a corresponding increase of $340.9 million to our combined balance for deferred policy acquisition costs and deferred sales inducements recorded through operations as a decrease in amortization of deferred policy acquisition costs and deferred sales inducements.

14

Table of Contents

3. Investments
At March 31, 2018 and December 31, 2017, the amortized cost and fair value of fixed maturity securities were as follows:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair Value
 
(Dollars in thousands)
March 31, 2018
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
Available for sale:
 
 
 
 
 
 
 
United States Government full faith and credit
$
11,696

 
$
110

 
$
(373
)
 
$
11,433

United States Government sponsored agencies
1,308,312

 
21,134

 
(59,340
)
 
1,270,106

United States municipalities, states and territories
3,853,098

 
296,762

 
(12,855
)
 
4,137,005

Foreign government obligations
227,617

 
8,502

 
(4,448
)
 
231,671

Corporate securities
28,801,351

 
1,186,607

 
(403,830
)
 
29,584,128

Residential mortgage backed securities
1,044,032

 
65,581

 
(7,004
)
 
1,102,609

Commercial mortgage backed securities
5,685,290

 
33,098

 
(121,506
)
 
5,596,882

Other asset backed securities
3,579,417

 
52,730

 
(14,633
)
 
3,617,514

 
$
44,510,813

 
$
1,664,524

 
$
(623,989
)
 
$
45,551,348

Held for investment:
 
 
 
 
 
 
 
Corporate security
$
77,043

 
$

 
$
(7,602
)
 
$
69,441

 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
Available for sale:
 
 
 
 
 
 
 
United States Government full faith and credit
$
11,861

 
$
162

 
$
(147
)
 
$
11,876

United States Government sponsored agencies
1,308,290

 
28,457

 
(31,730
)
 
1,305,017

United States municipalities, states and territories
3,804,360

 
366,048

 
(3,596
)
 
4,166,812

Foreign government obligations
228,214

 
13,171

 
(2,025
)
 
239,360

Corporate securities
28,127,653

 
1,897,005

 
(145,687
)
 
29,878,971

Residential mortgage backed securities
1,028,484

 
79,554

 
(2,471
)
 
1,105,567

Commercial mortgage backed securities
5,531,922

 
82,768

 
(69,840
)
 
5,544,850

Other asset backed securities
3,075,975

 
57,966

 
(13,405
)
 
3,120,536

 
$
43,116,759

 
$
2,525,131

 
$
(268,901
)
 
$
45,372,989

Held for investment:
 
 
 
 
 
 
 
Corporate security
$
77,041

 
$

 
$
(581
)
 
$
76,460

 
 
 
 
 
 
 
 
Other investments: equity securities, available for sale:
 
 
 
 
 
 
 
Finance, insurance, and real estate
$
292,429

 
$

 
$

 
$
292,429

At March 31, 2018, 37% of our fixed income securities have call features, of which 2.7% ($1.2 billion) were subject to call redemption and another 0.2% ($111.2 million) will become subject to call redemption during the next twelve months. Approximately 74% of our fixed income securities that have call features are not callable until within six months of their stated maturities.

15

Table of Contents

The amortized cost and fair value of fixed maturity securities at March 31, 2018, by contractual maturity, are shown below. Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. All of our mortgage and other asset backed securities provide for periodic payments throughout their lives and are shown below as separate lines.
 
Available for sale
 
Held for investment
 
Amortized
Cost
 
Fair Value
 
Amortized
Cost
 
Fair Value
 
(Dollars in thousands)
Due in one year or less
$
218,825

 
$
223,487

 
$

 
$

Due after one year through five years
5,615,360

 
5,673,765

 

 

Due after five years through ten years
10,439,109

 
10,428,466

 

 

Due after ten years through twenty years
9,188,746

 
9,774,966

 

 

Due after twenty years
8,740,034

 
9,133,659

 
77,043

 
69,441

 
34,202,074

 
35,234,343

 
77,043

 
69,441

Residential mortgage backed securities
1,044,032

 
1,102,609

 

 

Commercial mortgage backed securities
5,685,290

 
5,596,882

 

 

Other asset backed securities
3,579,417

 
3,617,514

 

 

 
$
44,510,813

 
$
45,551,348

 
$
77,043

 
$
69,441

Net unrealized gains on available for sale fixed maturity securities reported as a separate component of stockholders' equity were comprised of the following:
 
March 31, 2018
 
December 31, 2017
 
(Dollars in thousands)
Net unrealized gains on available for sale fixed maturity securities
$
1,040,535

 
$
2,256,230

Adjustments for assumed changes in amortization of deferred policy acquisition costs and deferred sales inducements
(562,755
)
 
(1,206,078
)
Deferred income tax valuation allowance reversal
22,534

 
22,534

Deferred income tax expense (a)
(100,332
)
 
(348,087
)
Net unrealized gains reported as accumulated other comprehensive income
$
399,982

 
$
724,599

(a)
December 31, 2017 includes $128 million related to the impact of Tax Reform that was reclassified between accumulated other comprehensive income and retained earnings within our consolidated balance sheet during the first quarter of 2018. For more information regarding the reclassification, see Note 1 to our unaudited consolidated financial statements.
The National Association of Insurance Commissioners ("NAIC") assigns designations to fixed maturity securities. These designations range from Class 1 (highest quality) to Class 6 (lowest quality). In general, securities are assigned a designation based upon the ratings they are given by the Nationally Recognized Statistical Rating Organizations ("NRSRO’s"). The NAIC designations are utilized by insurers in preparing their annual statutory statements. NAIC Class 1 and 2 designations are considered "investment grade" while NAIC Class 3 through 6 designations are considered "non-investment grade." Based on the NAIC designations, we had 97% of our fixed maturity portfolio rated investment grade at both March 31, 2018 and December 31, 2017, respectively.
The following table summarizes the credit quality, as determined by NAIC designation, of our fixed maturity portfolio as of the dates indicated:
 
 
March 31, 2018
 
December 31, 2017
NAIC
Designation
 
Amortized Cost
 
Fair Value
 
Amortized Cost
 
Fair Value
 
 
(Dollars in thousands)
1
 
$
27,142,276

 
$
27,984,297

 
$
26,669,427

 
$
28,274,379

2
 
15,897,296

 
16,147,267

 
15,198,551

 
15,869,219

3
 
1,350,395

 
1,316,146

 
1,161,737

 
1,157,420

4
 
170,754

 
145,085

 
134,838

 
117,542

5
 
17,108

 
19,926

 
17,015

 
20,927

6
 
10,027

 
8,068

 
12,232

 
9,962

 
 
$
44,587,856

 
$
45,620,789

 
$
43,193,800

 
$
45,449,449


16

Table of Contents

The following table shows our investments' gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities (consisting of 1,902 and 955 securities, respectively) have been in a continuous unrealized loss position, at March 31, 2018 and December 31, 2017:
 
Less than 12 months
 
12 months or more
 
Total
 
Fair Value
 
Unrealized
Losses
 
Fair Value
 
Unrealized
Losses
 
Fair Value
 
Unrealized
Losses
 
(Dollars in thousands)
March 31, 2018
 
 
 
 
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
 
 
 
 
Available for sale:
 
 
 
 
 
 
 
 
 
 
 
United States Government full faith and credit
$
3,193

 
$
(50
)
 
$
6,380

 
$
(323
)
 
$
9,573

 
$
(373
)
United States Government sponsored agencies
74,632

 
(1,513
)
 
932,691

 
(57,827
)
 
1,007,323

 
(59,340
)
United States municipalities, states and territories
224,928

 
(5,000
)
 
124,097

 
(7,855
)
 
349,025

 
(12,855
)
Foreign government obligations
127,620

 
(2,442
)
 
12,297

 
(2,006
)
 
139,917

 
(4,448
)
Corporate securities:
 
 
 
 
 
 
 
 
 
 
 
Finance, insurance and real estate
1,980,979

 
(46,008
)
 
599,683

 
(48,915
)
 
2,580,662

 
(94,923
)
Manufacturing, construction and mining
1,378,585

 
(29,518
)
 
229,805

 
(17,840
)
 
1,608,390

 
(47,358
)
Utilities and related sectors
1,830,012

 
(41,549
)
 
239,209

 
(18,121
)
 
2,069,221

 
(59,670
)
Wholesale/retail trade
755,307

 
(16,446
)
 
173,229

 
(16,809
)
 
928,536

 
(33,255
)
Services, media and other
3,498,221

 
(85,932
)
 
855,680

 
(82,692
)
 
4,353,901

 
(168,624
)
Residential mortgage backed securities
286,561

 
(4,535
)
 
24,870

 
(2,469
)
 
311,431

 
(7,004
)
Commercial mortgage backed securities
2,495,283

 
(43,167
)
 
1,310,142

 
(78,339
)
 
3,805,425

 
(121,506
)
Other asset backed securities
797,174

 
(6,376
)
 
187,857

 
(8,257
)
 
985,031

 
(14,633
)
 
$
13,452,495

 
$
(282,536
)
 
$
4,695,940

 
$
(341,453
)
 
$
18,148,435

 
$
(623,989
)
Held for investment:
 
 
 
 
 
 
 
 
 
 
 
Corporate security:
 
 
 
 
 
 
 
 
 
 
 
Insurance
$

 
$

 
$
69,441

 
$
(7,602
)
 
$
69,441

 
$
(7,602
)
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
 
 
 
 
Available for sale:
 
 
 
 
 
 
 
 
 
 
 
United States Government full faith and credit
$
1,565

 
$
(10
)
 
$
6,731

 
$
(137
)
 
$
8,296

 
$
(147
)
United States Government sponsored agencies
44,794

 
(180
)
 
958,965

 
(31,550
)
 
1,003,759

 
(31,730
)
United States municipalities, states and territories
44,736

 
(128
)
 
128,499

 
(3,468
)
 
173,235

 
(3,596
)
Foreign government obligations
49,663

 
(337
)
 
12,625

 
(1,688
)
 
62,288

 
(2,025
)
Corporate securities:
 
 
 
 
 
 
 
 
 
 
 
Finance, insurance and real estate
456,244

 
(5,135
)
 
600,655

 
(28,043
)
 
1,056,899

 
(33,178
)
Manufacturing, construction and mining
222,985

 
(3,475
)
 
231,196

 
(10,849
)
 
454,181

 
(14,324
)
Utilities and related sectors
395,183

 
(4,099
)
 
249,416

 
(8,901
)
 
644,599

 
(13,000
)
Wholesale/retail trade
152,941

 
(1,249
)
 
178,635

 
(11,371
)
 
331,576

 
(12,620
)
Services, media and other
729,124

 
(19,000
)
 
891,654

 
(53,565
)
 
1,620,778

 
(72,565
)
Residential mortgage backed securities
39,771

 
(387
)
 
32,917

 
(2,084
)
 
72,688

 
(2,471
)
Commercial mortgage backed securities
1,096,757

 
(10,385
)
 
1,306,437

 
(59,455
)
 
2,403,194

 
(69,840
)
Other asset backed securities
765,531

 
(3,499
)
 
217,595

 
(9,906
)
 
983,126

 
(13,405
)
 
$
3,999,294

 
$
(47,884
)
 
$
4,815,325

 
$
(221,017
)
 
$
8,814,619

 
$
(268,901
)
Held for investment:
 
 
 
 
 
 
 
 
 
 
 
Corporate security:
 
 
 
 
 
 
 
 
 
 
 
Insurance
$

 
$

 
$
76,460

 
$
(581
)
 
$
76,460

 
$
(581
)
Based on the results of our process for evaluating available for sale securities in unrealized loss positions for other than temporary impairments, which is discussed in detail later in this footnote, we have determined that the unrealized losses on the securities in the preceding table are temporary. The unrealized losses at March 31, 2018 are principally related to timing of the purchases of these securities, which carry less yield than those available at March 31, 2018.

17

Table of Contents

Approximately 88% and 83% of the unrealized losses on fixed maturity securities shown in the above table for March 31, 2018 and December 31, 2017, respectively, are on securities that are rated investment grade, defined as being the highest two NAIC designations. All of the fixed maturity securities with unrealized losses are current with respect to the payment of principal and interest.
Changes in net unrealized gains on investments for the three months ended March 31, 2018 and 2017 are as follows:
 
Three Months Ended 
 March 31,
 
2018
 
2017
 
(Dollars in thousands)
Fixed maturity securities held for investment carried at amortized cost
$
(7,021
)
 
$
(1,976
)
Investments carried at fair value:
 
 
 
Fixed maturity securities, available for sale
$
(1,215,695
)
 
$
281,094

Equity securities, available for sale

 
(13
)
 
(1,215,695
)
 
281,081

Adjustment for effect on other balance sheet accounts:
 
 
 
Deferred policy acquisition costs and deferred sales inducements
643,323

 
(150,962
)
Deferred income tax asset/liability
120,201

 
(45,542
)
 
763,524

 
(196,504
)
Change in net unrealized gains on investments carried at fair value
$
(452,171
)
 
$
84,577

Proceeds from sales of available for sale securities for the three months ended March 31, 2018 and 2017 were $85.5 million and $186.5 million, respectively. Scheduled principal repayments, calls and tenders for available for sale fixed maturity securities for the three months ended March 31, 2018 and 2017 were $180.4 million and $330.8 million, respectively.
Realized gains and losses on sales are determined on the basis of specific identification of investments based on the trade date. Net realized gains on investments, excluding net OTTI losses for the three months ended March 31, 2018 and 2017, are as follows:
 
Three Months Ended 
 March 31,
 
2018
 
2017
 
(Dollars in thousands)
Available for sale fixed maturity securities:
 
 
 
Gross realized gains
$
1,382

 
$
5,572

Gross realized losses
(2,102
)
 
(3,563
)
 
(720
)
 
2,009

 
 
 
 
Other investments:
 
 
 
Gain on sale of real estate

 
29

 
 
 
 
Mortgage loans on real estate:
 
 
 
Decrease in allowance for credit losses
300

 
300

Recovery of specific allowance
722

 

 
1,022

 
300

 
$
302

 
$
2,338

Losses on available for sale fixed maturity securities were realized primarily due to strategies to reposition the fixed maturity security portfolio that result in improved net investment income, credit risk or duration profiles as they pertain to our asset liability management.
We review and analyze all investments on an ongoing basis for changes in market interest rates and credit deterioration. This review process includes analyzing our ability to recover the amortized cost basis of each investment that has a fair value that is materially lower than its amortized cost and requires a high degree of management judgment and involves uncertainty. The evaluation of securities for other than temporary impairments is a quantitative and qualitative process, which is subject to risks and uncertainties.
We have a policy and process to identify securities that could potentially have impairments that are other than temporary. This process involves monitoring market events and other items that could impact issuers. The evaluation includes but is not limited to such factors as:
the length of time and the extent to which the fair value has been less than amortized cost or cost;
whether the issuer is current on all payments and all contractual payments have been made as agreed;
the remaining payment terms and the financial condition and near-term prospects of the issuer;

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Table of Contents

the lack of ability to refinance due to liquidity problems in the credit market;
the fair value of any underlying collateral;
the existence of any credit protection available;
our intent to sell and whether it is more likely than not we would be required to sell prior to recovery for debt securities;
consideration of rating agency actions; and
changes in estimated cash flows of mortgage and asset backed securities.
We determine whether other than temporary impairment losses should be recognized for debt securities by assessing all facts and circumstances surrounding each security. Where the decline in fair value of debt securities is attributable to changes in market interest rates or to factors such as market volatility, liquidity and spread widening, and we anticipate recovery of all contractual or expected cash flows, we do not consider these investments to be other than temporarily impaired because we do not intend to sell these investments and it is not more likely than not we will be required to sell these investments before a recovery of amortized cost, which may be maturity.
If we intend to sell a debt security or if it is more likely than not that we will be required to sell a debt security before recovery of its amortized cost basis, other than temporary impairment has occurred and the difference between amortized cost and fair value will be recognized as a loss in operations.
If we do not intend to sell and it is not more likely than not we will be required to sell the debt security but also do not expect to recover the entire amortized cost basis of the security, an impairment loss would be recognized in operations in the amount of the expected credit loss. We determine the amount of expected credit loss by calculating the present value of the cash flows expected to be collected discounted at each security's acquisition yield based on our consideration of whether the security was of high credit quality at the time of acquisition. The difference between the present value of expected future cash flows and the amortized cost basis of the security is the amount of credit loss recognized in operations. The remaining amount of the other than temporary impairment is recognized in other comprehensive income (loss).
The determination of the credit loss component of a mortgage backed security is based on a number of factors. The primary consideration in this evaluation process is the issuer's ability to meet current and future interest and principal payments as contractually stated at time of purchase. Our review of these securities includes an analysis of the cash flow modeling under various default scenarios considering independent third party benchmarks, the seniority of the specific tranche within the structure of the security, the composition of the collateral and the actual default, loss severity and prepayment experience exhibited. With the input of third party assumptions for default projections, loss severity and prepayment expectations, we evaluate the cash flow projections to determine whether the security is performing in accordance with its contractual obligation.
We utilize the models from a leading structured product software specialist serving institutional investors. These models incorporate each security's seniority and cash flow structure. In circumstances where the analysis implies a potential for principal loss at some point in the future, we use the "best estimate" cash flow projection discounted at the security's effective yield at acquisition to determine the amount of our potential credit loss associated with this security. The discounted expected future cash flows equates to our expected recovery value. Any shortfall of the expected recovery when compared to the amortized cost of the security will be recorded as the credit loss component of other than temporary impairment.
The cash flow modeling is performed on a security-by-security basis and incorporates actual cash flows on the residential mortgage backed securities through the current period, as well as the projection of remaining cash flows using a number of assumptions including default rates, prepayment rates and loss severity rates. The default curves we use are tailored to the Prime or Alt-A residential mortgage backed securities that we own, which assume lower default rates and loss severity for Prime securities versus Alt-A securities. These default curves are scaled higher or lower depending on factors such as current underlying mortgage loan performance, rating agency loss projections, loan to value ratios, geographic diversity, as well as other appropriate considerations.
The following table presents the range of significant assumptions used to determine the credit loss component of other than temporary impairments we have recognized on residential mortgage backed securities for the three months ended March 31, 2017, which are all senior level tranches within the structure of the securities:
 
 
 
 
Discount Rate
 
Default Rate
 
Loss Severity
Sector
 
Vintage
 
Min
 
Max
 
Min
 
Max
 
Min
 
Max
Three months ended March 31, 2017
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Prime
 
2005
 
7.7
%
 
7.7
%
 
8
%
 
8
%
 
50
%
 
50
%
 
 
2007
 
6.2
%
 
6.3
%
 
15
%
 
18
%
 
50
%
 
60
%
The determination of the credit loss component of a corporate bond (including redeemable preferred stocks) is based on the underlying financial performance of the issuer and their ability to meet their contractual obligations. Considerations in our evaluation include, but are not limited to, credit rating changes, financial statement and ratio analysis, changes in management, significant changes in credit spreads, breaches of financial covenants and a review of the economic outlook for the industry and markets in which they trade. In circumstances where an issuer appears unlikely to meet its future obligation, or the security's price decline is deemed other than temporary, an estimate of credit loss is determined. Credit loss is calculated using default probabilities as derived from the credit default swaps markets in conjunction with recovery rates derived from independent third party analysis or a best estimate of credit loss. This credit loss rate is then incorporated into a present value calculation based on an expected principal loss in the future discounted at the yield at the date of purchase and compared to amortized cost to determine the amount of credit loss associated with the security.

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Table of Contents

In addition, for debt securities which we do not intend to sell and it is not more likely than not we will be required to sell, but our intent changes due to changes or events that could not have been reasonably anticipated, an other than temporary impairment charge is recognized. Once an impairment charge has been recorded, we then continue to review the other than temporarily impaired securities for appropriate valuation on an ongoing basis. Unrealized losses may be recognized in future periods through a charge to earnings should we later conclude that the decline in fair value below amortized cost is other than temporary pursuant to our accounting policy described above. The use of different methodologies and assumptions to determine the fair value of investments and the timing and amount of impairments may have a material effect on the amounts presented in our consolidated financial statements.
The following table summarizes other than temporary impairments for the three months ended March 31, 2018 and 2017, by asset type:
 
Number
of
Securities
 
Total OTTI
Losses
 
Portion of OTTI
Losses
Recognized
in (from) Other
Comprehensive
Income
 
Net OTTI
Losses
Recognized in
Operations
 
 
 
(Dollars in thousands)
Three months ended March 31, 2018
 
 
 
 
 
 
 
Fixed maturity securities, available for sale:
 
 
 
 
 
 
 
Corporate securities:
 
 
 
 
 
 
 
Consumer discretionary
1

 
$
(907
)
 
$

 
$
(907
)
 
 
 
 
 
 
 
 
Three months ended March 31, 2017
 
 
 
 
 
 
 
Fixed maturity securities, available for sale:
 
 
 
 
 
 
 
Residential mortgage backed securities
3

 
$

 
$
(141
)
 
$
(141
)
The cumulative portion of other than temporary impairments determined to be credit losses which have been recognized in operations for debt securities are summarized as follows:
 
Three Months Ended 
 March 31,
 
2018
 
2017
 
(Dollars in thousands)
Cumulative credit loss at beginning of period
$
(157,066
)
 
$
(166,375
)
Credit losses on securities for which OTTI has not previously been recognized
(907
)
 

Additional credit losses on securities for which OTTI has previously been recognized

 
(141
)
Accumulated losses on securities that were disposed of during the period
3,900

 
13,939

Cumulative credit loss at end of period
$
(154,073
)
 
$
(152,577
)
The following table summarizes the cumulative noncredit portion of OTTI and the change in fair value since recognition of OTTI, both of which were recognized in other comprehensive income, by major type of security, for securities that are part of our investment portfolio at March 31, 2018 and December 31, 2017:
 
Amortized Cost
 
OTTI
Recognized in
Other
Comprehensive
Income
 
Change in Fair
Value Since
OTTI was
Recognized
 
Fair Value
 
(Dollars in thousands)
March 31, 2018
 
 
 
 
 
 
 
Fixed maturity securities, available for sale:
 
 
 
 
 
 
 
Corporate securities
$
17,947

 
$
(3,700
)
 
$
10,012

 
$
24,259

Residential mortgage backed securities
282,835

 
(168,355
)
 
198,719

 
313,199

Other asset backed securities
4,567

 
(1,356
)
 
(1,631
)
 
1,580

 
$
305,349

 
$
(173,411
)
 
$
207,100

 
$
339,038

December 31, 2017
 
 
 
 
 
 
 
Fixed maturity securities, available for sale:
 
 
 
 
 
 
 
Corporate securities
$
13,015

 
$
(4,263
)
 
$
10,739

 
$
19,491

Residential mortgage backed securities
297,582

 
(168,355
)
 
201,620

 
330,847

Other asset backed securities
4,567

 
(1,356
)
 
(1,875
)
 
1,336

 
$
315,164

 
$
(173,974
)
 
$
210,484

 
$
351,674


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Table of Contents

4. Mortgage Loans on Real Estate
Our mortgage loan portfolio is summarized in the following table. There were commitments outstanding of $51.7 million at March 31, 2018.
 
March 31, 2018
 
December 31, 2017
 
(Dollars in thousands)
Principal outstanding
$
2,707,352

 
$
2,674,315

Loan loss allowance
(6,496
)
 
(7,518
)
Deferred prepayment fees
(1,219
)
 
(1,266
)
Carrying value
$
2,699,637

 
$
2,665,531

The portfolio consists of commercial mortgage loans collateralized by the related properties and diversified as to property type, location and loan size. Our mortgage lending policies establish limits on the amount that can be loaned to one borrower and other criteria to attempt to reduce the risk of default. The mortgage loan portfolio is summarized by geographic region and property type as follows:
 
March 31, 2018
 
December 31, 2017
 
Principal
 
Percent
 
Principal
 
Percent
 
(Dollars in thousands)
Geographic distribution
 
 
 
 
 
 
 
East
$
563,593

 
20.8
%
 
$
548,067

 
20.5
%
Middle Atlantic
166,782

 
6.2
%
 
163,485

 
6.1
%
Mountain
317,872

 
11.7
%
 
308,486

 
11.5
%
New England
12,146

 
0.5
%
 
12,265

 
0.5
%
Pacific
482,593

 
17.8
%
 
466,030

 
17.4
%
South Atlantic
613,999

 
22.7
%
 
609,736

 
22.8
%
West North Central
315,339

 
11.6
%
 
324,808

 
12.2
%
West South Central
235,028

 
8.7
%
 
241,438

 
9.0
%
 
$
2,707,352

 
100.0
%
 
$
2,674,315

 
100.0
%
Property type distribution
 
 
 
 
 
 
 
Office
$
270,066

 
10.0
%
 
$
283,926

 
10.6
%
Medical Office
32,902

 
1.2
%
 
34,338

 
1.3
%
Retail
1,051,749

 
38.8
%
 
1,040,028

 
38.9
%
Industrial/Warehouse
703,892

 
26.0
%
 
677,770

 
25.3
%
Apartment
471,097

 
17.4
%
 
462,897

 
17.3
%
Mixed use/other
177,646

 
6.6
%
 
175,356

 
6.6
%
 
$
2,707,352

 
100.0
%
 
$
2,674,315

 
100.0
%
Our financing receivables currently consist of one portfolio segment which is our commercial mortgage loan portfolio. These are mortgage loans with collateral consisting of commercial real estate and borrowers consisting mostly of limited liability partnerships or limited liability corporations.
We evaluate our mortgage loan portfolio for the establishment of a loan loss allowance by specific identification of impaired loans and the measurement of an estimated loss for each individual loan identified. A mortgage loan is impaired when it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. If we determine that the value of any specific mortgage loan is impaired, the carrying amount of the mortgage loan will be reduced to its fair value, based upon the present value of expected future cash flows from the loan discounted at the loan's effective interest rate, or the fair value of the underlying collateral less estimated costs to sell.
In addition, we analyze the mortgage loan portfolio for the need of a general loan allowance for probable losses on all other loans on a quantitative and qualitative basis. The amount of the general loan allowance is based upon management's evaluation of the collectability of the loan portfolio, historical loss experience, delinquencies, credit concentrations, underwriting standards and national and local economic conditions.
We rate each of the mortgage loans in our portfolio based on factors such as historical operating performance, loan to value ratio and economic outlook, among others. We calculate a loss factor to apply to each rating based on historical losses we have recognized in our mortgage loan portfolio. We apply the loss factors to the total principal outstanding within each rating category to determine an appropriate estimate of the general loan loss allowance. We also assess the portfolio qualitatively and apply a loss rate to all loans without a specific allowance based on management's assessment of economic conditions, and we apply an additional amount of loss allowance to a group of loans that we have identified as having higher risk of loss.

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Table of Contents

The following table presents a rollforward of our specific and general valuation allowances for mortgage loans on real estate:
 
Three Months Ended 
 March 31, 2018
 
Three Months Ended 
 March 31, 2017
 
Specific
Allowance
 
General Allowance
 
Specific
Allowance
 
General Allowance
 
(Dollars in thousands)
Beginning allowance balance
$
(1,418
)
 
$
(6,100
)
 
$
(1,327
)
 
$
(7,100
)
Charge-offs

 

 

 

Recoveries
722

 

 

 

Change in provision for credit losses

 
300

 

 
300

Ending allowance balance
$
(696
)
 
$
(5,800
)
 
$
(1,327
)
 
$
(6,800
)
The specific allowance represents the total credit loss allowances on loans which are individually evaluated for impairment. The general allowance is for the group of loans discussed above which are collectively evaluated for impairment. The following table presents the total outstanding principal of loans evaluated for impairment by basis of impairment method:
 
March 31, 2018
 
December 31, 2017
 
(Dollars in thousands)
Individually evaluated for impairment
$
3,186

 
$
5,445

Collectively evaluated for impairment
2,704,166

 
2,668,870

Total loans evaluated for impairment
$
2,707,352

 
$
2,674,315

Charge-offs include allowances that have been established on loans that were satisfied either by taking ownership of the collateral or by some other means such as discounted pay-off or loan sale. When ownership of the property is taken it is recorded at the lower of the mortgage loan's carrying value or the property's fair value (based on appraised values) less estimated costs to sell. The real estate owned is recorded as a component of Other investments and the mortgage loan is recorded as fully paid, with any allowance for credit loss that has been established charged off. Fair value of the real estate is determined by third party appraisal. Recoveries are situations where we have received a payment from the borrower in an amount greater than the carrying value of the loan (principal outstanding less specific allowance). We did not own any real estate during the three months ended March 31, 2018 and 2017.
We analyze credit risk of our mortgage loans by analyzing all available evidence on loans that are delinquent and loans that are in a workout period.
 
March 31, 2018
 
December 31, 2017
 
(Dollars in thousands)
Credit Exposure--By Payment Activity
 
 
 
Performing
$
2,705,957

 
$
2,670,657

In workout
1,395

 
1,436

Collateral dependent

 
2,222

 
$
2,707,352

 
$
2,674,315

The loans that are categorized as "in workout" consist of loans that we have agreed to lower or no mortgage payments for a period of time while the borrowers address cash flow and/or operational issues. The key features of these workouts have been determined on a loan-by-loan basis. Most of these loans are in a period of low cash flow due to tenants vacating their space or tenants requesting rent relief during difficult economic periods. Generally, we have allowed the borrower a six month interest only period and in some cases a twelve month period of interest only. Interest only workout loans are expected to return to their regular debt service payments after the interest only period. Interest only loans that are not fully amortizing will have a larger balance at their balloon date than originally contracted. Fully amortizing loans that are in interest only periods will have larger debt service payments for their remaining term due to lost principal payments during the interest only period. In limited circumstances we have allowed borrowers to pay the principal portion of their loan payment into an escrow account that can be used for capital and tenant improvements for a period of not more than twelve months. In these situations new loan amortization schedules are calculated based on the principal not collected during this twelve month workout period and larger payments are collected for the remaining term of each loan. In all cases, the original interest rate and maturity date have not been modified, and we have not forgiven any principal amounts.
Mortgage loans are considered delinquent when they become 60 days or more past due. In general, when loans become 90 days past due, become collateral dependent or enter a period with no debt service payments required we place them on non-accrual status and discontinue recognizing interest income. If payments are received on a delinquent loan, interest income is recognized to the extent it would have been recognized if normal principal and interest would have been received timely. If payments are received to bring a delinquent loan back to current we will resume accruing interest income on that loan. There were no loans in non-accrual status at March 31, 2018. There were $2.2 million loans in non-accrual status at December 31, 2017.
We define collateral dependent loans as those mortgage loans for which we will depend on the value of the collateral real estate to satisfy the outstanding principal of the loan.

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Table of Contents

All of our commercial mortgage loans depend on the cash flow of the borrower to be at a sufficient level to service the principal and interest payments as they come due. In general, cash inflows of the borrowers are generated by collecting monthly rent from tenants occupying space within the borrowers' properties. Our borrowers face collateral risks such as tenants going out of business, tenants struggling to make rent payments as they become due, and tenants canceling leases and moving to other locations. We have a number of loans where the real estate is occupied by a single tenant. Our borrowers sometimes face both a reduction in cash flow on their mortgage property as well as a reduction in the fair value of the real estate collateral. If borrowers are unable to replace lost rent revenue and increases in the fair value of their property do not materialize, we could potentially incur more losses than what we have allowed for in our specific and general loan loss allowances.
Aging of financing receivables is summarized in the following table, with loans in a "workout" period as of the reporting date considered current if payments are current in accordance with agreed upon terms:
 
30 - 59 Days
 
60 - 89 Days
 
90 Days
and Over
 
Total
Past Due
 
Current
 
Collateral Dependent Receivables
 
Total Financing Receivables
 
(Dollars in thousands)
Commercial Mortgage Loans
 
 
 
 
 
 
 
 
 
 
 
 
 
March 31, 2018
$

 
$

 
$

 
$

 
$
2,707,352

 
$

 
$
2,707,352

December 31, 2017
$

 
$

 
$

 
$

 
$
2,672,093

 
$
2,222

 
$
2,674,315

Financing receivables summarized in the following two tables represent all loans that we are either not currently collecting, or those we feel it is probable we will not collect all amounts due according to the contractual terms of the loan agreements (all loans that we have worked with the borrower to alleviate short-term cash flow issues, loans delinquent for 60 days or more at the reporting date, loans we have determined to be collateral dependent and loans that we have recorded specific impairments on that we feel may continue to have performance issues).
 
Recorded
Investment
 
Unpaid Principal Balance
 
Related
Allowance
 
(Dollars in thousands)
March 31, 2018
 
 
 
 
 
Mortgage loans with an allowance
$
2,490

 
$
3,186

 
$
(696
)
Mortgage loans with no related allowance
1,395

 
1,395

 

 
$
3,885

 
$
4,581

 
$
(696
)
December 31, 2017
 
 
 
 
 
Mortgage loans with an allowance
$
4,027

 
$
5,445

 
$
(1,418
)
Mortgage loans with no related allowance
1,436

 
1,436

 

 
$
5,463

 
$
6,881

 
$
(1,418
)
 
Average Recorded Investment
 
Interest Income Recognized
 
(Dollars in thousands)
Three months ended March 31, 2018
 
 
 
Mortgage loans with an allowance
$
2,509

 
$
50

Mortgage loans with no related allowance
1,415

 
21

 
$
3,924

 
$
71

Three months ended March 31, 2017
 
 
 
Mortgage loans with an allowance
$
3,291

 
$
72

Mortgage loans with no related allowance
1,572

 
23

 
$
4,863

 
$
95


23

Table of Contents

A Troubled Debt Restructuring ("TDR") is a situation where we have granted a concession to a borrower for economic or legal reasons related to the borrower's financial difficulties that we would not otherwise consider. A mortgage loan that has been granted new terms, including workout terms as described previously, would be considered a TDR if it meets conditions that would indicate a borrower is experiencing financial difficulty and the new terms constitute a concession on our part. We analyze all loans where we have agreed to workout terms and all loans that we have refinanced to determine if they meet the definition of a TDR. We consider the following factors in determining whether or not a borrower is experiencing financial difficulty:
borrower is in default,
borrower has declared bankruptcy,
there is growing concern about the borrower's ability to continue as a going concern,
borrower has insufficient cash flows to service debt,
borrower's inability to obtain funds from other sources, and
there is a breach of financial covenants by the borrower.
If the borrower is determined to be in financial difficulty, we consider the following conditions to determine if the borrower is granted a concession:
assets used to satisfy debt are less than our recorded investment,
interest rate is modified,
maturity date extension at an interest rate less than market rate,
capitalization of interest,
delaying principal and/or interest for a period of three months or more, and
partial forgiveness of the balance or charge-off.
Mortgage loan workouts, refinances or restructures that are classified as TDRs are individually evaluated and measured for impairment. A summary of mortgage loans on commercial real estate with outstanding principal at March 31, 2018 and December 31, 2017 that we determined to be TDRs are as follows:
Geographic Region
 
Number
of TDRs
 
Principal
Balance
Outstanding
 
Specific Loan Loss Allowance
 
Net
Carrying
Amount
 
 
 
 
(Dollars in thousands)
March 31, 2018
 
 
 
 
 
 
 
 
South Atlantic
 
1
 
$
2,930

 
$

 
$
2,930

East North Central
 
1
 
1,910

 
(467
)
 
1,443

 
 
2
 
$
4,840

 
$
(467
)
 
$
4,373

December 31, 2017
 
 
 
 
 
 
 
 
South Atlantic
 
1
 
$
2,947

 
$

 
$
2,947

East North Central
 
1
 
1,933

 
(467
)
 
1,466

 
 
2
 
$
4,880

 
$
(467
)
 
$
4,413


24

Table of Contents

5. Derivative Instruments
None of our derivatives qualify for hedge accounting, thus, any change in the fair value of the derivatives is recognized immediately in the consolidated statements of operations. The fair value of our derivative instruments, including derivative instruments embedded in fixed index annuity contracts, presented in the consolidated balance sheets are as follows:
 
March 31, 2018
 
December 31, 2017
 
(Dollars in thousands)
Assets
 
 
 
Derivative instruments
 
 
 
Call options
$
847,741

 
$
1,568,380

Other assets
 
 
 
Interest rate caps
890

 
415

Interest rate swap
427

 

 
$
849,058

 
$
1,568,795

Liabilities
 
 
 
Policy benefit reserves - annuity products
 
 
 
Fixed index annuities - embedded derivatives
$
8,233,557

 
$
8,790,427

Other liabilities
 
 
 
Interest rate swap

 
789

 
$
8,233,557

 
$
8,791,216

The changes in fair value of derivatives included in the unaudited consolidated statements of operations are as follows:
 
Three Months Ended 
 March 31,
 
2018
 
2017
 
(Dollars in thousands)
Change in fair value of derivatives:
 
 
 
Call options
$
(452,598
)
 
$
386,736

Interest rate swap
1,040

 
75

Interest rate caps
475

 
(278
)
 
$
(451,083
)
 
$
386,533

Change in fair value of embedded derivatives:
 
 
 
Fixed index annuities—embedded derivatives
$
(1,106,023
)
 
$
76,210

Other changes in difference between policy benefit reserves computed using derivative accounting vs. long-duration contracts accounting
238,791

 
147,960

 
$
(867,232
)
 
$
224,170

The amounts presented as "Other changes in difference between policy benefit reserves computed using derivative accounting vs. long-duration contracts accounting" represents the total change in the difference between policy benefit reserves for fixed index annuities computed under the derivative accounting standard and the long-duration contracts accounting standard at each balance sheet date, less the change in fair value of our fixed index annuities embedded derivatives that is presented as Level 3 liabilities in Note 2.
We have fixed index annuity products that guarantee the return of principal to the policyholder and credit interest based on a percentage of the gain in a specified market index. When fixed index annuity deposits are received, a portion of the deposit is used to purchase derivatives consisting of call options on the applicable market indices to fund the index credits due to fixed index annuity policyholders. Substantially all such call options are one year options purchased to match the funding requirements of the underlying policies. The call options are marked to fair value with the change in fair value included as a component of revenues. The change in fair value of derivatives includes the gains or losses recognized at the expiration of the option term or upon early termination and the changes in fair value for open positions. On the respective anniversary dates of the index policies, the index used to compute the annual index credit is reset and we purchase new one-year call options to fund the next annual index credit. We manage the cost of these purchases through the terms of our fixed index annuities, which permit us to change caps, participation rates, and/or asset fees, subject to guaranteed minimums on each policy's anniversary date. By adjusting caps, participation rates, or asset fees, we can generally manage option costs except in cases where the contractual features would prevent further modifications.

25

Table of Contents

Our strategy attempts to mitigate any potential risk of loss due to the nonperformance of the counterparties to these call options through a regular monitoring process which evaluates the program's effectiveness. We do not purchase call options that would require payment or collateral to another institution and our call options do not contain counterparty credit-risk-related contingent features. We are exposed to risk of loss in the event of nonperformance by the counterparties and, accordingly, we purchase our option contracts from multiple counterparties and evaluate the creditworthiness of all counterparties prior to purchase of the contracts. All of these options have been purchased from nationally recognized financial institutions with a Standard and Poor's credit rating of A- or higher at the time of purchase and the maximum credit exposure to any single counterparty is subject to concentration limits. We also have credit support agreements that allow us to request the counterparty to provide collateral to us when the fair value of our exposure to the counterparty exceeds specified amounts.
The notional amount and fair value of our call options by counterparty and each counterparty's current credit rating are as follows:
 
 
 
 
 
 
March 31, 2018
 
December 31, 2017
Counterparty
 
Credit Rating
(S&P)
 
Credit Rating (Moody's)
 
Notional
Amount
 
Fair Value
 
Notional
Amount
 
Fair Value
 
 
 
 
 
 
(Dollars in thousands)
Bank of America
 
A+
 
Aa3
 
$
5,522,691

 
$
91,549

 
$
4,645,366

 
$
237,955

Barclays
 
A
 
A1
 
3,784,024

 
89,471

 
4,135,537

 
154,127

BNP Paribas
 
A
 
Aa3
 
935,091

 
21,769

 
1,411,989

 
73,650

Canadian Imperial Bank of Commerce

 
A+
 
A1
 
4,179,179

 
101,280

 
2,808,030

 
84,268

Citibank, N.A.
 
A+
 
A1
 
4,422,448

 
77,256

 
4,104,666

 
219,900

Credit Suisse
 
A
 
A1
 
3,020,434

 
52,130

 
3,538,855

 
137,384

J.P. Morgan
 
A+
 
Aa3
 
2,118,331

 
85,080

 
1,753,649

 
109,689

Morgan Stanley
 
A+
 
A1
 
3,244,428

 
40,096

 
3,408,179

 
184,323

Royal Bank of Canada
 
AA-
 
A1
 
3,158,242

 
96,854

 
3,027,469

 
104,141

Societe Generale

 
A
 
A2
 
71,401

 
1,689

 

 

SunTrust
 
A-
 
Baa1
 
2,080,242

 
65,445

 
2,331,168

 
90,399

Wells Fargo
 
A+
 
Aa2
 
4,065,628

 
118,295

 
4,036,255

 
162,781

Exchange traded
 
 
 
 
 
260,283

 
6,827

 
296,840

 
9,763

 
 
 
 
 
 
$
36,862,422

 
$
847,741

 
$
35,498,003

 
$
1,568,380

As of March 31, 2018 and December 31, 2017, we held $0.8 billion and $1.6 billion, respectively, of cash and cash equivalents and other securities from counterparties for derivative collateral, which is included in Other liabilities on our consolidated balance sheets. This derivative collateral limits the maximum amount of economic loss due to credit risk that we would incur if parties to the call options failed completely to perform according to the terms of the contracts to $60.2 million and $11.9 million at March 31, 2018 and December 31, 2017, respectively.
The future annual index credits on our fixed index annuities are treated as a "series of embedded derivatives" over the expected life of the applicable contract. We do not purchase call options to fund the index liabilities which may arise after the next policy anniversary date. We must value both the call options and the related forward embedded options in the policies at fair value.
We entered into an interest rate swap and interest rate caps to manage interest rate risk associated with the floating rate component on certain of our subordinated debentures. See Note 10 in our Annual Report on Form 10-K for the year ended December 31, 2017 for more information on our subordinated debentures. The terms of the interest rate swap provide that we pay a fixed rate of interest and receive a floating rate of interest. The terms of the interest rate caps limit the three month LIBOR to 2.50%. The interest rate swap and caps are not effective hedges under accounting guidance for derivative instruments and hedging activities. Therefore, we record the interest rate swap and caps at fair value and any net cash payments received or paid are included in the change in fair value of derivatives in the unaudited consolidated statements of operations.
Details regarding the interest rate swap are as follows:
 
 
Notional
 
 
 
Pay
 
 
 
March 31, 2018
 
December 31, 2017
Maturity Date
 
Amount
 
Receive Rate
 
Rate
 
Counterparty
 
Fair Value
 
Fair Value
 
 
 
 
 
 
 
 
 
 
(Dollars in thousands)
March 15, 2021
 
$
85,500

 
LIBOR
 
2.415
%
 
SunTrust
 
$
427

 
$
(789
)

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Table of Contents

Details regarding the interest rate caps are as follows:
 
 
Notional
 
 
 
Cap
 
 
 
March 31, 2018
 
December 31, 2017
Maturity Date
 
Amount
 
Floating Rate
 
Rate
 
Counterparty
 
Fair Value
 
Fair Value
 
 
 
 
 
 
 
 
 
 
(Dollars in thousands)
July 7, 2021
 
$
40,000

 
LIBOR
 
2.50
%
 
SunTrust
 
$
445

 
$
207

July 8, 2021
 
12,000

 
LIBOR
 
2.50
%
 
SunTrust
 
134

 
62

July 29, 2021
 
27,000

 
LIBOR
 
2.50
%
 
SunTrust
 
311

 
146

 
 
$
79,000

 
 
 
 
 
 
 
$
890

 
$
415

The interest rate swap converts floating rates to fixed rates for seven years which began in March 2014. The interest rate caps cap our interest rates for seven years which began in July 2014.
6. Notes Payable and Amounts Due Under Repurchase Agreements
Notes payable includes the following:
 
March 31, 2018
 
December 31, 2017
 
(Dollars in thousands)
Senior notes due 2027
 
 
 
Principal
$
500,000

 
$
500,000

Unamortized debt issue costs
(5,457
)
 
(5,572
)
Unamortized discount
(328
)
 
(335
)
 
$
494,215

 
$
494,093

On June 16, 2017, we issued $500 million aggregate principal amount of senior unsecured notes due 2027 which bear interest at 5.0% per year and will mature on June 15, 2027 (the "2027 Notes"). The 2027 Notes were issued at a $0.3 million discount, which is being amortized over the term of the 2027 Notes using the effective interest method. Contractual interest is payable semi-annually in arrears each June 15th and December 15th. The initial transaction fees and costs totaling $5.8 million were capitalized as deferred financing costs and are being amortized over the term of the 2027 Notes using the effective interest method.
As part of our investment strategy, we enter into securities repurchase agreements (short-term collateralized borrowings). When we do borrow cash on these repurchase agreements, we pledge collateral in the form of debt securities with fair values approximately equal to the amount due and we use the cash to purchase debt securities ahead of the time we collect the cash from selling annuity policies to avoid a lag between the investment of funds and the obligation to credit interest to policyholders. We earn investment income on the securities purchased with these borrowings at a rate in excess of the cost of these borrowings. Such borrowings averaged $7.6 million and $102.8 million and the maximum amount borrowed was $137.3 million and $274.5 million during the three months ended March 31, 2018 and March 31, 2017, respectively. The weighted average interest rate on amounts due under repurchase agreements was 1.63% and 0.64% for the three months ended March 31, 2018 and March 31, 2017, respectively.
7. Commitments and Contingencies
We are occasionally involved in litigation, both as a defendant and as a plaintiff. In addition, state regulatory bodies, such as state insurance departments, the Securities and Exchange Commission ("SEC"), Financial Industry Regulatory Authority, the Department of Labor ("DOL"), and other regulatory bodies regularly make inquiries and conduct examinations or investigations concerning our compliance with, among other things, insurance laws, securities laws, the Employee Retirement Income Security Act of 1974, as amended, and laws governing the activities of broker/dealers.
In accordance with applicable accounting guidelines, we establish an accrued liability for litigation and regulatory matters when those matters present loss contingencies that are both probable and estimable. As a litigation or regulatory matter is developing we, in conjunction with outside counsel, evaluate on an ongoing basis whether the matter presents a loss contingency that meets conditions indicating the need for accrual and/or disclosure, and if not the matter will continue to be monitored for further developments. If and when the loss contingency related to litigation or regulatory matters is deemed to be both probable and estimable, we will establish an accrued liability with respect to that matter and will continue to monitor the matter for further developments that may affect the amount of the accrued liability.
There can be no assurance that any pending or future litigation will not have a material adverse effect on our business, financial condition, or results of operations.
In addition to our commitments to fund mortgage loans, we have unfunded commitments at March 31, 2018 to limited partnerships of $48.4 million and to secured bank loans of $6.2 million.

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Table of Contents

8. Earnings Per Share
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 
 March 31,
 
2018
 
2017
 
(Dollars in thousands, except per share data)
Numerator:
 
 
 
Net income - numerator for earnings per common share
$
140,962

 
$
53,939

 
 
 
 
Denominator:
 
 
 
Weighted average common shares outstanding
90,017,166

 
88,647,078

Effect of dilutive securities:
 
 
 
Stock options and deferred compensation agreements
850,292

 
948,317

Restricted stock and restricted stock units
271,890

 
380,217

Denominator for earnings per common share - assuming dilution
91,139,348

 
89,975,612

 
 
 
 
Earnings per common share
$
1.57

 
$
0.61

Earnings per common share - assuming dilution
$
1.55

 
$
0.60

There were no options to purchase shares of our common stock outstanding excluded from the computation of diluted earnings per share during the three months ended March 31, 2018 or 2017, as the exercise price of all options outstanding was less than the average market price of our common shares for those periods.

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Table of Contents

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 March 31, 2018, and the unaudited consolidated results of operations for the three month periods ended March 31, 2018 and 2017, and where appropriate, factors that may affect future financial performance. This analysis should be read in conjunction with our unaudited consolidated financial statements and notes thereto appearing elsewhere in this Form 10-Q, and the audited consolidated financial statements, notes thereto and selected consolidated financial data appearing in our Annual Report on Form 10-K for the year ended December 31, 2017.
Cautionary Statement Regarding Forward-Looking Information
All statements, trend analyses and other information contained in this report and elsewhere (such as in filings by us with the 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. We caution that these statements may and often do vary from actual results and the differences between these statements and actual results can be material. Accordingly, we cannot assure you that actual results will not differ materially from those expressed or implied by the forward-looking statements. Factors that could contribute to these differences include, among other things:
general economic conditions and other factors, including prevailing interest rate levels and stock and credit market performance which may affect (among other things) our ability to sell our products, our ability to access capital resources and the costs associated therewith, the fair value of our investments, which could result in impairments and other than temporary impairments, and certain liabilities, 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 filings with the SEC.
For a detailed discussion of these and other factors that might affect our performance, see Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2017.
Our Business and Profitability
We specialize in the sale of individual annuities (primarily fixed index deferred annuities). Under U.S. GAAP, premium collections for deferred annuities are reported as deposit liabilities instead of as revenues. Similarly, cash payments to policyholders are reported as decreases in the liabilities for policyholder account balances and not as expenses. Sources of revenues for products accounted for as deposit liabilities are net investment income, surrender charges assessed against policy withdrawals and fees deducted from policyholder account balances for lifetime income benefit riders, net realized gains (losses) on investments and changes in fair value of derivatives. Components of expenses for products accounted for as deposit liabilities are interest sensitive and index product benefits (primarily interest credited to account balances and changes in lifetime income benefit rider reserves), changes in fair value of embedded derivatives, amortization of deferred sales inducements and deferred policy acquisition costs, other operating costs and expenses and income taxes.
Our business model contemplates continued growth in invested assets and non-GAAP operating income while maintaining a high quality investment portfolio that will not experience significant losses from impairments of invested assets. We are committed to maintaining a high quality investment portfolio with limited exposure to below investment grade securities and other riskier assets. Growth in invested assets is predicated on a continuation of our high sales achievements of the last five years while at the same time maintaining a high level of retention of the funds received. The economic and personal investing environments continued to be conducive for high sales levels as retirees and others look to put their money in instruments that will protect their principal and provide them with consistent cash flow sources in their retirement years. However, our sales have slowed since the first half of 2016 as competition in our distribution channels escalated, rates from several of our competitors were appreciably above prior levels, and uncertainty regarding the DOL conflict of interest fiduciary rule persisted. The uncertainty regarding the DOL conflict of interest fiduciary rule was abated in the second half of 2017 following the delay of the final applicability date of the regulation and the related exemptions.
On April 6, 2016, the DOL released a final regulation which substantially expands the range of activities that will be considered to be fiduciary advice under the Employee Retirement Income Security Act of 1974 and the Internal Revenue Code of 1986. On June 9, 2017 certain provisions of the fiduciary regulation became applicable with the remainder to become effective July 1, 2019. On March 15, 2018, the United States Fifth Circuit Court of Appeals ("Fifth Circuit") issued a decision vacating the DOL fiduciary regulation. Subject to certain appeal rights, the Fifth Circuit's decision is expected to become effective on or about May 8, 2018. At that time the law regarding fiduciary status will revert back to the law in effect prior to the issuance of the DOL fiduciary regulation.

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Table of Contents

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

Earnings from products accounted for as deposit liabilities are primarily generated from the excess of net investment income earned over the interest credited or the cost of providing index credits to the policyholder, or the "investment spread." Our investment spread is summarized as follows:
 
Three Months Ended 
 March 31,
 
2018
 
2017
Average yield on invested assets
4.36%
 
4.48%
Aggregate cost of money
1.82%
 
1.77%
Aggregate investment spread
2.54%
 
2.71%
 
 
 
 
Impact of:
 
 
 
Investment yield - additional prepayment income
0.03%
 
0.07%
Cost of money benefit of over hedging
0.02%
 
0.05%
The cost of money for fixed index annuities and average crediting rates for fixed rate annuities are computed based upon policyholder account balances and do not include the impact of amortization of deferred sales inducements. See Critical Accounting Policies - Deferred Policy Acquisition Costs and Deferred Sales Inducements included in Management's Discussion and Analysis in our Annual Report on Form 10-K for the year ended December 31, 2017. With respect to our fixed 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 of call options purchased to fund annual index credits are recorded as part of the change in fair value of derivatives, and are largely offset by an expense for interest credited to annuity policyholder account balances. See Critical Accounting Policies - Policy Liabilities for Fixed Index Annuities and Financial Condition - Derivative Instruments included in Management's Discussion and Analysis in our Annual Report on Form 10-K for the year ended December 31, 2017.
We continue to be in the midst of an unprecedented period of low interest rates and low yields for investments with the credit quality we prefer which presents a strong headwind to achieving our target rate for investment spread. In response to this, we have been reducing policyholder crediting rates for new annuities and existing annuities since the fourth quarter of 2011. We continue to have flexibility to reduce our crediting rates if necessary and could decrease our cost of money by approximately 54 basis points if we reduce current rates to guaranteed minimums. In addition, starting in 2017 we began to invest in asset classes that were not traditionally in our portfolio, focusing on investments with less liquidity that provide higher yields and have a track record of positive credit performance over time. Investment yields available to us in the first quarter of 2018 increased compared to 2017 due to an increase in interest rates on the asset classes we targeted for purchase and investment in new asset classes as noted above.
Life insurance companies are subject to the NAIC risk-based capital ("RBC") requirements which are intended to be used by insurance regulators as an early warning tool to identify deteriorating or weakly capitalized insurance companies for the purpose of initiating regulatory action. Rating agencies utilize a form of RBC to partially determine capital strength of insurance companies. Our RBC ratio at December 31, 2017 was 378%, and our estimated RBC ratio at March 31, 2018 was 383%.

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Table of Contents

Results of Operations for the Three Months Ended March 31, 2018 and 2017
Annuity deposits by product type collected during the three months ended March 31, 2018 and 2017, were as follows:
 
 
Three Months Ended 
 March 31,
Product Type
 
2018
 
2017
 
 
(Dollars in thousands)
Fixed index annuities
 
$
993,914

 
$
1,028,839

Annual reset fixed rate annuities
 
16,490

 
14,843

Multi-year fixed rate annuities
 
10,025

 
29,901

Single premium immediate annuities
 
10,630

 
5,551

Total before coinsurance ceded
 
1,031,059

 
1,079,134

Coinsurance ceded
 
89,695

 
71,074

Net after coinsurance ceded
 
$
941,364

 
$
1,008,060

Annuity deposits before and after coinsurance ceded decreased 4% and 7%, respectively, during the first quarter of 2018 compared to the same period in 2017. The decrease in sales for the three months ended March 31, 2018 as compared to the same period in 2017 primarily reflects continued competitive pressures within each of our distribution channels. In addition, we continued to face a challenging environment for sales of fixed index annuities during the first quarter of 2018 due to low interest rates and strong equity markets. The relatively larger decline in net sales compared to gross sales is due to an increase in coinsurance ceded premiums as a result of an increase in Eagle Life Insurance Company's ("Eagle Life") fixed index annuity sales during the first quarter of 2018 as compared to the same period in 2017.
We coinsure 80% of the annuity deposits received from MYGA fixed annuity products and 50% of the fixed index annuities sold by Eagle Life through broker/dealers and banks. The changes in coinsurance ceded premiums are attributable to changes in premiums from these sources.
Net income increased to $141.0 million in the first quarter of 2018 compared to $53.9 million for the same period in 2017.
Net income, in general, has been positively impacted by the growth in the volume of business in force and the investment spread earned on this business. The average amount of annuity account balances outstanding (net of annuity liabilities ceded under coinsurance agreements) increased 7% to $48.8 billion for the first quarter of 2018 compared to $45.6 billion for the same period in 2017. Our investment spread measured in dollars was $283.6 million for the first quarter of 2018 compared to $278.6 million for the same period in 2017. As previously mentioned, our investment spread has been negatively impacted by the extended low interest rate environment (see Net investment income).
Net income is also impacted by the change in fair value of derivatives and embedded derivatives which fluctuates from period to period based upon changes in fair values of call options purchased to fund the annual index credits for fixed index annuities and changes in interest rates used to discount the embedded derivative liability. Net income for the three months ended March 31, 2018 was positively impacted by increases in the discount rates used to estimate the fair value of our embedded derivative liability while net income for the three months ended March 31, 2017 was negatively impacted by decreases in those same discount rates (see Change in fair value of derivatives and Change in fair value of embedded derivatives). 
Net income for the three months ended March 31, 2018 was also positively impacted by a decrease in the tax rate as a result of Tax Reform (see Income taxes).
Non-GAAP operating income, a non-GAAP financial measure, increased to $77.7 million in the first quarter of 2018 compared to $59.6 million for the same period in 2017.
In addition to net income, we have consistently utilized non-GAAP operating income, a non-GAAP financial measure commonly used in the life insurance industry, as an economic measure to evaluate our financial performance. Non-GAAP operating income equals net income adjusted to eliminate the impact of items that fluctuate from quarter to quarter in a manner unrelated to core operations, and we believe measures excluding their impact are useful in analyzing operating trends. The most significant adjustments to arrive at non-GAAP operating income eliminate the impact of fair value accounting for our fixed index annuity business and are not economic in nature but rather impact the timing of reported results. We believe the combined presentation and evaluation of non-GAAP operating income together with net income provides information that may enhance an investor's understanding of our underlying results and profitability.
Non-GAAP operating income is not a substitute for net income determined in accordance with GAAP. The adjustments made to derive non-GAAP operating income are important to understand our overall results from operations and, if evaluated without proper context, non-GAAP operating income possesses material limitations. As an example, we could produce a low level of net income in a given period, despite strong operating performance, if in that period we experience significant net realized losses from our investment portfolio. We could also produce a high level of net income in a given period, despite poor operating performance, if in that period we generate significant net realized gains from our investment portfolio. As an example of another limitation of operating income, it does not include the decrease in cash flows expected to be collected as a result of credit loss OTTI. Therefore, our management reviews net realized investment gains (losses) and analyses of our net investment income, including impacts related to OTTI write-downs, in connection with their review of our investment portfolio. In addition, our management examines net income as part of their review of our overall financial results.

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Table of Contents

The adjustments made to net income to arrive at non-GAAP operating income for the three months ended March 31, 2018 and 2017 are set forth in the table that follows:
 
Three Months Ended 
 March 31,
 
2018
 
2017
 
(Dollars in thousands)
Reconciliation from net income to non-GAAP operating income:
 
 
 
Net income
$
140,962

 
$
53,939

Adjustments to arrive at non-GAAP operating income:
 
 
 
Net realized investment (gains) losses, including OTTI
23

 
(1,942
)
Change in fair value of derivatives and embedded derivatives - fixed index annuities
(78,818
)
 
10,977

Change in fair value of derivatives - debt
(1,832
)
 
(247
)
Income taxes
17,359

 
(3,105
)
Non-GAAP operating income
$
77,694

 
$
59,622

The amounts disclosed in the reconciliation above are presented net of related adjustments to amortization of deferred sales inducements and deferred policy acquisition costs where applicable.
Annuity product charges (surrender charges assessed against policy withdrawals and fees deducted from policyholder account balances for lifetime income benefit riders) increased 16% to $50.7 million in the first quarter of 2018 compared to $43.6 million for the same period in 2017. The components of annuity product charges are set forth in the table that follows:
 
Three Months Ended 
 March 31,
 
2018
 
2017
 
(Dollars in thousands)
Surrender charges
$
16,282

 
$
13,634

Lifetime income benefit riders (LIBR) fees
34,441

 
29,938

 
$
50,723

 
$
43,572

 
 
 
 
Withdrawals from annuity policies subject to surrender charges
$
129,996

 
$
107,219

Average surrender charge collected on withdrawals subject to surrender charges
12.5
%
 
12.7
%
 
 
 
 
Fund values on policies subject to LIBR fees
$
4,782,117

 
$
4,296,670

Weighted average per policy LIBR fee
0.72
%
 
0.70
%
The increase in annuity product charges was primarily attributable to an increase in fees assessed for lifetime income benefit riders due to a larger volume of business in force subject to the fee and an increase in the average fees being charged due to higher fees on new products as compared to prior periods. See Interest sensitive and index product benefits below for corresponding expense recognized on lifetime income benefit riders. Surrender charges increased in the first quarter of 2018 as compared to the same period in 2017 due to an increase in withdrawals from annuity policies subject to surrender charges during the first quarter of 2018 as compared to the same period in 2017.
Net investment income increased 5% to $510.8 million in the first quarter of 2018 compared to $485.6 million for the same period in 2017. The increase was principally attributable to the growth in our annuity business and corresponding increases in our invested assets. Average invested assets excluding derivative instruments (on an amortized cost basis) increased 8% to $46.9 billion for the first quarter of 2018 compared to $43.6 billion for the same period in 2017.
The average yield earned on average invested assets was 4.36% for the first quarter of 2018 compared to 4.48% for the same period in 2017. The decrease in yield earned on average invested assets was attributable to investment of new premiums and portfolio cash flows during 2017 at rates below the overall portfolio yield. The average yield on fixed income securities purchased and commercial mortgage loans funded during the three months ended March 31, 2018 was 4.43%, compared to 4.13% for the same period in 2017. The unfavorable impact from lower new money investment yields was offset by non-trendable investment income items which added three and seven basis points to the average yield on invested assets for the first quarter of 2018 and 2017.

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Table of Contents

Change in fair value of derivatives consists of call options purchased to fund annual index credits on fixed index annuities, and an interest rate swap and interest rate caps that hedge our floating rate subordinated debentures. The components of change in fair value of derivatives are as follows:
 
Three Months Ended 
 March 31,
 
2018
 
2017
 
(Dollars in thousands)
Call options:
 
 
 
Gain (loss) on option expiration
$
291,976

 
$
205,400

Change in unrealized gains/losses
(744,574
)
 
181,336

Interest rate swap
1,040

 
75

Interest rate caps
475

 
(278
)
 
$
(451,083
)
 
$
386,533

The differences between the change in fair value of derivatives between periods for call options are primarily due to the performance of the indices upon which our call options are based which impacts the market values and changes in the market values of those call options between periods. A substantial portion of our call options are based upon the S&P 500 Index with the remainder based upon other equity and bond market indices. The range of index appreciation (after applicable caps, participation rates and asset fees) for options expiring during the three months ended March 31, 2018 and 2017 is as follows:
 
Three Months Ended 
 March 31,
 
2018
 
2017
S&P 500 Index
 
 
 
Point-to-point strategy
1.0% - 12.6%
 
1.0% - 13.3%
Monthly average strategy
0.6% - 8.0%
 
0.1% - 10.6%
Monthly point-to-point strategy
0.0% - 17.5%
 
0.0% - 15.2%
Fixed income (bond index) strategies
0.0% - 2.5%
 
0.0% - 4.1%
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 fixed index annuities in force as well as an increase in the cost of options for certain index strategies which began during the second half of 2017. The aggregate cost of options is also influenced by the amount of policyholder funds allocated to the various indices and market volatility which affects option pricing. See Critical Accounting Policies - Policy Liabilities for Fixed Index Annuities included in Management's Discussion and Analysis in our Annual Report on Form 10-K for the year ended December 31, 2017.
Net realized gains on investments, excluding OTTI losses include gains and losses on the sale of securities and impairment losses on mortgage loans on real estate which fluctuate from year to year due to changes in the interest rate and economic environment and the timing of the sale of investments, as well as gains (losses) recognized on real estate owned due to any sales and impairments on long-lived assets. See Note 3 to our unaudited consolidated financial statements for a detailed presentation of the types of investments that generated the gains (losses).
Losses on available for sale fixed maturity securities were realized primarily due to strategies to reposition the fixed maturity security portfolio that resulted in improved net investment income, risk or duration profiles as they pertain to our asset liability management. See Financial Condition - Investments and Note 4 to our unaudited consolidated financial statements for additional discussion of allowance for credit losses recognized on mortgage loans on real estate.
Net OTTI losses recognized in operations increased to $0.9 million in the first quarter of 2018 compared to $0.1 million for the same period in 2017. See Financial Condition - Other Than Temporary Impairments for additional discussion of other than temporary impairments recognized during the periods presented.
Interest sensitive and index product benefits increased 23% to $514.1 million in the first quarter of 2018 compared to $419.1 million for the same period in 2017. The components of interest sensitive and index product benefits are summarized as follows:
 
Three Months Ended 
 March 31,
 
2018
 
2017
 
(Dollars in thousands)
Index credits on index policies
$
423,940

 
$
321,880

Interest credited (including changes in minimum guaranteed interest for fixed index annuities)
56,770

 
67,006

Lifetime income benefit riders
33,385

 
30,253

 
$
514,095

 
$
419,139


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Table of Contents

The increase in index credits was attributable to changes in the level of appreciation of the underlying indices (see discussion above under Change in fair value of derivatives) and the amount of funds allocated by policyholders to the respective index options. Total proceeds received upon expiration of the call options purchased to fund the annual index credits were $425.6 million for the three months ended March 31, 2018, compared to $326.6 million for the same period in 2017. The decrease in interest credited was due to decreases in the average rate credited to the annuity liabilities outstanding receiving a fixed rate of interest and the amount of annuity liabilities outstanding receiving a fixed rate of interest. The increase in benefits recognized for lifetime income benefit riders was due to an increase in the number of policies with lifetime income benefit riders which correlates to the increase in fees discussed in Annuity product charges.
The reserve (net of coinsurance ceded) held for lifetime income benefit riders was $737.8 million and $704.4 million at March 31, 2018 and December 31, 2017, respectively.
Amortization of deferred sales inducements, in general, 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 bonus annuity products. Bonus products represented 86% and 88% of our net annuity account values at March 31, 2018 and March 31, 2017, respectively. The increases in amortization from these factors have been affected by amortization associated with fair value accounting for derivatives and embedded derivatives utilized in our fixed index annuity business and amortization associated with net realized gains (losses) on investments and net OTTI losses recognized in operations. Fair value accounting for derivatives and embedded derivatives utilized in our fixed index annuity business creates differences in the recognition of revenues and expenses from derivative instruments including the embedded derivative liabilities in our fixed index annuity contracts. The change in fair value of the embedded derivatives will not correspond to the change in fair value of the derivatives (purchased call options), because the purchased call options are one-year options while the options valued in the fair value of embedded derivatives cover the expected lives of the contracts which typically exceed ten years. Amortization of deferred sales inducements is summarized as follows:
 
Three Months Ended 
 March 31,
 
2018
 
2017
 
(Dollars in thousands)
Amortization of deferred sales inducements before gross profit adjustments
$
67,211

 
$
67,784

Gross profit adjustments:
 
 
 
Fair value accounting for derivatives and embedded derivatives
33,456

 
(5,588
)
Net realized gains (losses) on investments and net OTTI losses recognized in operations
(244
)
 
129

Amortization of deferred sales inducements after gross profit adjustments
$
100,423

 
$
62,325

Change in fair value of embedded derivatives includes changes in the fair value of our fixed index annuity embedded derivatives (see Note 5 to our unaudited consolidated financial statements). The components of change in fair value of embedded derivatives are as follows:
 
Three Months Ended 
 March 31,
 
2018
 
2017
 
(Dollars in thousands)
 
 
 
 
Fixed index annuities - embedded derivatives
$
(1,106,023
)
 
$
76,210

Other changes in difference between policy benefit reserves computed using derivative accounting vs. long-duration contracts accounting
238,791

 
147,960

 
$
(867,232
)
 
$
224,170

The change in fair value of the fixed index annuity embedded derivatives resulted from (i) changes in the expected index credits on the next policy anniversary dates, which are related to the change in fair value of the call options acquired to fund those index credits discussed above in Change in fair value of derivatives; (ii) changes in discount rates used in estimating our embedded derivative liabilities; and (iii) the growth in the host component of the policy liability. The amounts presented as "Other changes in difference between policy benefit reserves computed using derivative accounting vs. long-duration contracts accounting" represents the total change in the difference between policy benefit reserves for fixed index annuities computed under the derivative accounting standard and the long-duration contracts accounting standard at each balance sheet date, less the change in fair value of our fixed index annuities embedded derivative. See Critical Accounting Policies - Policy Liabilities for Fixed Index Annuities included in Management's Discussion and Analysis in our Annual Report on Form 10-K for the year ended December 31, 2017. The primary reasons for the decrease in the change in fair value of the fixed index annuity embedded derivatives during the three months ended March 31, 2018 were decreases in the expected index credits on the next policy anniversary dates resulting from decreases in the fair value of the call options acquired to fund these index credits during the three months ended March 31, 2018 as compared to the increases in the expected index credits due to increases in the fair value of the call options for the same period of 2017 and increases in the discount rates used in estimating the fair value of our embedded derivative liabilities during the three months ended March 31, 2018 as compared to decreases in those same discount rates for the same period of 2017. The discount rates used in estimating our embedded derivative liabilities fluctuate based on changes in the general level of interest rates and credit spreads both of which increased during the three months ended March 31, 2018.
Interest expense on notes and loan payable decreased 17% to $6.4 million in the first quarter of 2018 compared to $7.7 million for the same period in 2017. Interest expense by debt instrument is as follows:

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Three Months Ended 
 March 31,
 
2018
 
2017
 
(Dollars in thousands)
2027 Notes
$
6,372

 
$

2021 Notes

 
6,896

Term loan due 2019

 
826

 
$
6,372

 
$
7,722

The decrease in interest expense for the three months ended March 31, 2018 was due to the repayment of our outstanding $100 million term loan and the refinancing of our $400 million 6.625% notes due 2021 with the issuance of the 2027 Notes. This lowered our senior notes costs to 5% from 6.625%.
Amortization of deferred policy acquisition costs, in general, has been increasing each period due to the growth in our annuity business and the deferral of policy acquisition costs incurred with respect to sales of annuity products. The increases in amortization from these factors have been affected by amortization associated with fair value accounting for derivatives and embedded derivatives utilized in our fixed index annuity business and amortization associated with net realized gains (losses) on investments and net OTTI losses recognized in operations. As discussed above, fair value accounting for derivatives and embedded derivatives utilized in our fixed index annuity business creates differences in the recognition of revenues and expenses from derivative instruments including the embedded derivative liabilities in our fixed index annuity contracts. Amortization of deferred policy acquisition costs is summarized as follows:
 
Three Months Ended 
 March 31,
 
2018
 
2017
 
(Dollars in thousands)
Amortization of deferred policy acquisition costs before gross profit adjustments
$
95,440

 
$
95,431

Gross profit adjustments:
 
 
 
Fair value accounting for derivatives and embedded derivatives
45,537

 
(5,878
)
Net realized gains (losses) on investments and net OTTI losses recognized in operations
(338
)
 
125

Amortization of deferred policy acquisition costs after gross profit adjustments
$
140,639

 
$
89,678

Other operating costs and expenses increased 13.3% to $31.2 million in the first quarter of 2018 compared to $27.6 million for the same period in 2017 and are summarized as follows:
 
Three Months Ended 
 March 31,
 
2018
 
2017
 
(Dollars in thousands)
Salary and benefits
$
16,387

 
$
13,777

Risk charges
7,679

 
7,055

Other
7,174

 
6,747

Total other operating costs and expenses
$
31,240

 
$
27,579

The three months ended March 31, 2018 reflect an increase in salary and benefits of $0.9 million due to an increased number of employees related to our growth and an increase of $1.9 million related to expense recognized under our incentive compensation program and other bonus programs as compared to the same period in 2017. The increase in expenses related to our incentive compensation program and other bonus programs during the three months ended March 31, 2018 as compared to the same period in 2017 was primarily due to an increase in the percentage of restricted stock units granted that were earned or are expected to be earned and an increase in expected payouts under various company bonus plans due to an increased number of employees participating in certain plans and a higher potential payout for certain employees participating in certain plans.
The increase in reinsurance risk charges expense for the three months ended March 31, 2018 as compared to the same period in 2017 was due to growth in our policyholder liabilities subject to the reinsurance agreement pursuant to which we cede excess regulatory reserves to an unaffiliated reinsurer. The regulatory reserves ceded at March 31, 2018 and 2017 were $754.0 million and $690.9 million, respectively.
Income tax expense was $36.6 million in the first quarter of 2018 compared to $27.5 million for the same period in 2017. The change in income tax expense was primarily due to changes in income before income taxes as well as changes in the tax rate as a result of Tax Reform. The effective income tax rates were 20.6% and 33.8% for the three months ended March 31, 2018 and 2017, respectively.

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Income tax expense and the resulting effective tax rate are based upon two components of income before income taxes ("pretax income") that are taxed at different tax rates. Life insurance income is generally taxed at an effective rate of approximately 21.6% reflecting the absence of state income taxes for substantially all of the states that the life insurance subsidiaries do business in. The income for the parent company and other non-life insurance subsidiaries (the "non-life insurance group") is generally taxed at an effective tax rate of 29.5% reflecting the combined federal / state income tax rates. Prior to Tax Reform, life insurance income was generally taxed at an effective rate of approximately 35.6% while income for the non-life insurance group was generally taxed at an effective tax rate of 41.5% reflecting the combined federal / state income tax rates. The effective income tax rates resulting from the combination of the income tax provisions for the life / non-life sources of income vary from period to period based primarily on the relative size of pretax income from the two sources.
The effective income tax rate was impacted by a discrete tax item related to share-based compensation that reduced income tax expense for the three months ended March 31, 2018 and 2017 by approximately $1.6 million and $1.3 million, respectively.

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Table of Contents

Financial Condition
Investments
Our investment strategy is to maintain a predominantly investment grade fixed income portfolio, provide adequate liquidity to meet our cash obligations to policyholders and others and maximize current income and total investment return through active investment management. Consistent with this strategy, our investments principally consist of fixed maturity securities and mortgage loans on real estate.
Insurance statutes regulate the type of investments that our life subsidiaries are permitted to make and limit the amount of funds that may be used for any one type of investment. In light of these statutes and regulations and our business and investment strategy, we generally seek to invest in United States government and government-sponsored agency securities, corporate securities, residential and commercial mortgage backed securities, other asset backed securities and United States municipalities, states and territories securities rated investment grade by established NRSRO's or in securities of comparable investment quality, if not rated, and commercial mortgage loans on real estate.
The composition of our investment portfolio is summarized as follows:
 
March 31, 2018
 
December 31, 2017
 
Carrying
Amount
 
Percent
 
Carrying
Amount
 
Percent
 
(Dollars in thousands)
Fixed maturity securities:
 
 
 
 
 
 
 
United States Government full faith and credit
$
11,433

 
%
 
$
11,876

 
%
United States Government sponsored agencies
1,270,106

 
2.6
%
 
1,305,017

 
2.6
%
United States municipalities, states and territories
4,137,005

 
8.3
%
 
4,166,812

 
8.3
%
Foreign government obligations
231,671

 
0.5
%
 
239,360

 
0.5
%
Corporate securities
29,661,171

 
59.7
%
 
29,956,012

 
59.6
%
Residential mortgage backed securities
1,102,609

 
2.2
%
 
1,105,567

 
2.2
%
Commercial mortgage backed securities
5,596,882

 
11.3
%
 
5,544,850

 
11.0
%
Other asset backed securities
3,617,514

 
7.3
%
 
3,120,536

 
6.2
%
Total fixed maturity securities
45,628,391

 
91.9
%
 
45,450,030

 
90.4
%
Mortgage loans on real estate
2,699,637

 
5.4
%
 
2,665,531

 
5.3
%
Derivative instruments
847,741

 
1.7
%
 
1,568,380

 
3.1
%
Other investments
481,825

 
1.0
%
 
616,764

 
1.2
%
 
$
49,657,594

 
100.0
%
 
$
50,300,705

 
100.0
%
Fixed Maturity Securities
Our fixed maturity security portfolio is managed to minimize risks such as interest rate changes and defaults or impairments while earning a sufficient and stable return on our investments. The largest portion of our fixed maturity securities are in investment grade (NAIC designation 1 or 2) publicly traded or privately placed corporate securities.
A summary of our fixed maturity securities by NRSRO ratings is as follows:
 
 
March 31, 2018
 
December 31, 2017
Rating Agency Rating
 
Carrying
Amount
 
Percent of
Fixed Maturity
Securities
 
Carrying
Amount
 
Percent of
Fixed Maturity
Securities
 
 
(Dollars in thousands)
Aaa/Aa/A
 
$
27,823,308

 
61.0
%
 
$
27,909,879

 
61.4
%
Baa
 
16,267,301

 
35.7
%
 
16,048,610

 
35.3
%
Total investment grade
 
44,090,609

 
96.7
%
 
43,958,489

 
96.7
%
Ba
 
1,097,231

 
2.4
%
 
1,035,676

 
2.3
%
B
 
156,922

 
0.3
%
 
130,857

 
0.3
%
Caa
 
152,903

 
0.3
%
 
134,586

 
0.3
%
Ca and lower
 
130,726

 
0.3
%
 
190,422

 
0.4
%
Total below investment grade
 
1,537,782

 
3.3
%
 
1,491,541

 
3.3
%
 
 
$
45,628,391

 
100.0
%
 
$
45,450,030

 
100.0
%

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Table of Contents

The NAIC's Securities Valuation Office ("SVO") is responsible for the day-to-day credit quality assessment and the valuation of fixed maturity securities owned by state regulated insurance companies. The purpose of such assessment and valuation is for determining regulatory capital requirements and regulatory reporting. Insurance companies report ownership to the SVO when such securities are eligible for regulatory filings. The SVO conducts credit analysis on these securities for the purpose of assigning a NAIC designation and/or unit price. Typically, if a security has been rated by a NRSRO, the SVO utilizes that rating and assigns a NAIC designation based upon the following system:
NAIC Designation
 
NRSRO Equivalent Rating
1
 
Aaa/Aa/A
2
 
Baa
3
 
Ba
4
 
B
5
 
Caa
6
 
Ca and lower
For most of the bonds held in our portfolio the NAIC designation matches the NRSRO equivalent rating. However, for certain loan-backed and structured securities, as defined by the NAIC, the NAIC rating is not always equivalent to the NRSRO rating presented in the previous table. The NAIC has adopted revised rating methodologies for certain loan-backed and structured securities comprised of non-agency residential mortgage backed securities ("RMBS") and commercial mortgage backed securities ("CMBS"). The NAIC’s objective with the revised rating methodologies for these structured securities is to increase the accuracy in assessing expected losses and use the improved assessment to determine a more appropriate capital requirement for such structured securities. The revised methodologies reduce regulatory reliance on rating agencies and allow for greater regulatory input into the assumptions used to estimate expected losses from structured securities.
The use of this process by the SVO may result in certain non-agency RMBS and CMBS being assigned a NAIC designation that is higher than the equivalent NRSRO rating. The NAIC designations for non-agency RMBS and CMBS are based on security level expected losses as modeled by an independent third party (engaged by the NAIC) and the statutory carrying value of the security, including any purchase discounts or impairment charges previously recognized. Evaluation of non-agency RMBS and CMBS held by insurers using the NAIC rating methodologies is performed on an annual basis.
As stated previously, our fixed maturity security portfolio is managed to minimize risks such as defaults or impairments while earning a sufficient and stable return on our investments. Our strategy has been to invest primarily in investment grade fixed maturity securities. Investment grade is NAIC 1 and 2 securities and Baa3/BBB- and better securities on the NRSRO scale. This strategy meets the objective of minimizing risk while also managing asset capital charges on a regulatory capital basis.
A summary of our fixed maturity securities by NAIC designation is as follows:
 
 
March 31, 2018
 
December 31, 2017
NAIC Designation
 
Amortized
Cost
 
Fair Value
 
Carrying
Amount
 
Percent
of Total
Carrying
Amount
 
Amortized
Cost
 
Fair Value
 
Carrying
Amount
 
Percent
of Total
Carrying
Amount
 
 
(Dollars in thousands)
 
 
 
(Dollars in thousands)
 
 
1
 
$
27,142,276

 
$
27,984,297

 
$
27,984,297

 
61.3
%
 
$
26,669,427

 
$
28,274,379

 
$
28,274,379

 
62.2
%
2
 
15,897,296

 
16,147,267

 
16,147,267

 
35.4
%
 
15,198,551

 
15,869,219

 
15,869,219

 
34.9
%
3
 
1,350,395

 
1,316,146

 
1,323,748

 
2.9
%
 
1,161,737

 
1,157,420

 
1,158,001

 
2.5
%
4
 
170,754

 
145,085

 
145,085

 
0.3
%
 
134,838

 
117,542

 
117,542

 
0.3
%
5
 
17,108

 
19,926

 
19,926

 
0.1
%
 
17,015

 
20,927

 
20,927

 
0.1
%
6
 
10,027

 
8,068

 
8,068

 
%
 
12,232

 
9,962

 
9,962

 
%
 
 
$
44,587,856

 
$
45,620,789

 
$
45,628,391

 
100.0
%
 
$
43,193,800

 
$
45,449,449

 
$
45,450,030

 
100.0
%
The amortized cost and fair value of fixed maturity securities at March 31, 2018, by contractual maturity, are presented in Note 3 to our unaudited consolidated financial statements in this form 10-Q, which is incorporated by reference in this Item 2.

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Table of Contents

Unrealized Losses
The amortized cost and fair value of fixed maturity securities that were in an unrealized loss position were as follows:
 
Number of
Securities
 
Amortized
Cost
 
Unrealized
Losses
 
Fair Value
 
 
 
(Dollars in thousands)
March 31, 2018
 
 
 
 
 
 
 
Fixed maturity securities, available for sale:
 
 
 
 
 
 
 
United States Government full faith and credit
7

 
$
9,946

 
$
(373
)
 
$
9,573

United States Government sponsored agencies
23

 
1,066,663

 
(59,340
)
 
1,007,323

United States municipalities, states and territories
109

 
361,880

 
(12,855
)
 
349,025

Foreign government obligations
5

 
144,365

 
(4,448
)
 
139,917

Corporate securities:
 
 


 
 
 
 
Finance, insurance and real estate
233

 
2,675,585

 
(94,923
)
 
2,580,662

Manufacturing, construction and mining
160

 
1,655,748

 
(47,358
)
 
1,608,390

Utilities and related sectors
201

 
2,128,891

 
(59,670
)
 
2,069,221

Wholesale/retail trade
85

 
961,791

 
(33,255
)
 
928,536

Services, media and other
420

 
4,522,525

 
(168,624
)
 
4,353,901

Residential mortgage backed securities
44

 
318,435

 
(7,004
)
 
311,431

Commercial mortgage backed securities
470

 
3,926,931

 
(121,506
)
 
3,805,425

Other asset backed securities
144

 
999,664

 
(14,633
)
 
985,031

 
1,901

 
$
18,772,424

 
$
(623,989
)
 
$
18,148,435

Fixed maturity securities, held for investment:
 
 
 
 
 
 
 
Corporate security:
 
 
 
 
 
 
 
Insurance
1

 
$
77,043

 
$
(7,602
)
 
$
69,441

 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
 
Fixed maturity securities, available for sale:
 
 
 
 
 
 
 
United States Government full faith and credit
4

 
$
8,443

 
$
(147
)
 
$
8,296

United States Government sponsored agencies
18

 
1,035,489

 
(31,730
)
 
1,003,759

United States municipalities, states and territories
48

 
176,831

 
(3,596
)
 
173,235

Foreign government obligations
2

 
64,313

 
(2,025
)
 
62,288

Corporate securities:
 
 

 
 
 
 
Finance, insurance and real estate
92

 
1,090,077

 
(33,178
)
 
1,056,899

Manufacturing, construction and mining
55

 
468,505

 
(14,324
)
 
454,181

Utilities and related sectors
63

 
657,599

 
(13,000
)
 
644,599

Wholesale/retail trade
31

 
344,196

 
(12,620
)
 
331,576

Services, media and other
165

 
1,693,343

 
(72,565
)
 
1,620,778

Residential mortgage backed securities
20

 
75,159

 
(2,471
)
 
72,688

Commercial mortgage backed securities
310

 
2,473,034

 
(69,840
)
 
2,403,194

Other asset backed securities
146

 
996,531

 
(13,405
)
 
983,126

 
954

 
$
9,083,520

 
$
(268,901
)
 
$
8,814,619

Fixed maturity securities, held for investment:
 
 
 
 
 
 
 
Corporate security:
 
 
 
 
 
 
 
Insurance
1

 
$
77,041

 
$
(581
)
 
$
76,460

The increase in unrealized losses from December 31, 2017 to March 31, 2018 was primarily due to an increase in interest rates in addition to price deterioration due to wider credit spreads as of March 31, 2018. The 10-year U.S. Treasury yields at March 31, 2018 and December 31, 2017 were 2.74% and 2.40%, respectively. The 30-year U.S. Treasury yields at March 31, 2018 and December 31, 2017 were 2.97% and 2.74%, respectively.

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Table of Contents

The following table sets forth the composition by credit quality (NAIC designation) of fixed maturity securities with gross unrealized losses:
NAIC Designation
 
Carrying Value of
Securities with
Gross Unrealized
Losses
 
Percent of
Total
 
Gross
Unrealized
Losses
 
Percent of
Total
 
 
(Dollars in thousands)
March 31, 2018
 
 
 
 
 
 
 
 
1
 
$
10,959,521

 
60.1
%
 
$
(366,296
)
 
58.0
%
2
 
6,387,958

 
35.1
%
 
(188,558
)
 
29.8
%
3
 
737,227

 
4.0
%
 
(44,604
)
 
7.1
%
4
 
128,328

 
0.7
%
 
(25,864
)
 
4.1
%
5
 
9,551

 
0.1
%
 
(3,126
)
 
0.5
%
6
 
2,893

 
%
 
(3,143
)
 
0.5
%
 
 
$
18,225,478

 
100.0
%
 
$
(631,591
)
 
100.0
%
December 31, 2017
 
 
 
 
 
 
 
 
1
 
$
5,433,608

 
61.1
%
 
$
(158,991
)
 
59.0
%
2
 
2,809,981

 
31.6
%
 
(64,369
)
 
23.9
%
3
 
540,320

 
6.1
%
 
(23,166
)
 
8.6
%
4
 
94,004

 
1.1
%
 
(17,972
)
 
6.7
%
5
 
11,130

 
0.1
%
 
(1,460
)
 
0.5
%
6
 
2,617

 
%
 
(3,524
)
 
1.3
%
 
 
$
8,891,660

 
100.0
%
 
$
(269,482
)
 
100.0
%
Our investments' gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities (consisting of 1,902 and 955 securities, respectively) have been in a continuous unrealized loss position at March 31, 2018 and December 31, 2017, along with a description of the factors causing the unrealized losses is presented in Note 3 to our unaudited consolidated financial statements in this Form 10-Q, which is incorporated by reference in this Item 2.

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Table of Contents

The amortized cost and fair value of fixed maturity securities in an unrealized loss position and the number of months in a continuous unrealized loss position (fixed maturity securities that carry an NRSRO rating of BBB/Baa or higher are considered investment grade) were as follows:
 
Number of
Securities
 
Amortized
Cost
 
Fair Value
 
Gross
Unrealized
Losses
 
 
 
(Dollars in thousands)
March 31, 2018
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
Investment grade:
 
 
 
 
 
 
 
Less than six months
1,215

 
$
11,893,032

 
$
11,684,032

 
$
(209,000
)
Six months or more and less than twelve months
165

 
1,484,739

 
1,425,452

 
(59,287
)
Twelve months or greater
427

 
4,646,882

 
4,354,841

 
(292,041
)
Total investment grade
1,807

 
18,024,653

 
17,464,325

 
(560,328
)
Below investment grade:
 
 
 
 
 
 
 
Less than six months
35

 
284,001

 
277,609

 
(6,392
)
Six months or more and less than twelve months
15

 
73,259

 
65,402

 
(7,857
)
Twelve months or greater
45

 
467,554

 
410,540

 
(57,014
)
Total below investment grade
95

 
824,814

 
753,551

 
(71,263
)
 
1,902

 
$
18,849,467

 
$
18,217,876

 
$
(631,591
)
 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
Investment grade:
 
 
 
 
 
 
 
Less than six months
409

 
$
3,550,774

 
$
3,520,164

 
$
(30,610
)
Six months or more and less than twelve months
27

 
257,924

 
249,690

 
(8,234
)
Twelve months or greater
430

 
4,668,838

 
4,486,239

 
(182,599
)
Total investment grade
866

 
8,477,536

 
8,256,093

 
(221,443
)
Below investment grade:
 
 
 
 
 
 
 
Less than six months
32

 
201,885

 
194,821

 
(7,064
)
Six months or more and less than twelve months
12

 
36,595

 
34,619

 
(1,976
)
Twelve months or greater
45

 
444,545

 
405,546

 
(38,999
)
Total below investment grade
89

 
683,025

 
634,986

 
(48,039
)
 
955

 
$
9,160,561

 
$
8,891,079

 
$
(269,482
)

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Table of Contents

The amortized cost and fair value of fixed maturity securities (excluding United States Government and United States Government sponsored agency securities) segregated by investment grade (NRSRO rating of BBB/Baa or higher) and below investment grade that had unrealized losses greater than 20% and the number of months in a continuous unrealized loss position were as follows:
 
Number of
Securities
 
Amortized
Cost
 
Fair
Value
 
Gross
Unrealized
Losses
 
 
 
(Dollars in thousands)
March 31, 2018
 
 
 
 
 
 
 
Investment grade:
 
 
 
 
 
 
 
Less than six months

 
$

 
$

 
$

Six months or more and less than twelve months

 

 

 

Twelve months or greater

 

 

 

Total investment grade

 

 

 

Below investment grade:
 
 
 
 
 
 
 
Less than six months
3

 
50,156

 
39,169

 
(10,987
)
Six months or more and less than twelve months
1

 
3,521

 
2,297

 
(1,224
)
Twelve months or greater
3

 
39,191

 
24,477

 
(14,714
)
Total below investment grade
7

 
92,868

 
65,943

 
(26,925
)
 
7

 
$
92,868

 
$
65,943

 
$
(26,925
)
 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
 
Investment grade:
 
 
 
 
 
 
 
Less than six months
3

 
$
8,597

 
$
6,931

 
$
(1,666
)
Six months or more and less than twelve months

 

 

 

Twelve months or greater

 

 

 

Total investment grade
3

 
8,597

 
6,931

 
(1,666
)
Below investment grade:
 
 
 
 
 
 
 
Less than six months
1

 
11,021

 
8,275

 
(2,746
)
Six months or more and less than twelve months
1

 
3,523

 
2,674

 
(849
)
Twelve months or greater
4

 
55,647

 
37,591

 
(18,056
)
Total below investment grade
6

 
70,191

 
48,540

 
(21,651
)
 
9

 
$
78,788

 
$
55,471

 
$
(23,317
)

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The amortized cost and fair value of fixed maturity securities, by contractual maturity, that were in an unrealized loss position are shown below. Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. All of our mortgage and other asset backed securities provide for periodic payments throughout their lives, and are shown below as a separate line.
 
Available for sale
 
Held for investment
 
Amortized
Cost
 
Fair Value
 
Amortized
Cost
 
Fair Value
 
(Dollars in thousands)
March 31, 2018
 
 
 
 
 
 
 
Due in one year or less
$

 
$

 
$

 
$

Due after one year through five years
2,167,775

 
2,130,293

 

 

Due after five years through ten years
6,063,714

 
5,891,646

 

 

Due after ten years through twenty years
2,490,238

 
2,369,431

 

 

Due after twenty years
2,805,667

 
2,655,178

 
77,043

 
69,441

 
13,527,394

 
13,046,548

 
77,043

 
69,441

Residential mortgage backed securities
318,435

 
311,431

 

 

Commercial mortgage backed securities
3,926,931

 
3,805,425

 

 

Other asset backed securities
999,664

 
985,031

 

 

 
$
18,772,424

 
$
18,148,435

 
$
77,043

 
$
69,441

 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
 
Due in one year or less
$

 
$

 
$

 
$

Due after one year through five years
463,667

 
454,062

 

 

Due after five years through ten years
1,996,166

 
1,945,474

 

 

Due after ten years through twenty years
1,937,009

 
1,881,162

 

 

Due after twenty years
1,141,954

 
1,074,913

 
77,041

 
76,460

 
5,538,796

 
5,355,611

 
77,041

 
76,460

Residential mortgage backed securities
75,159

 
72,688

 

 

Commercial mortgage backed securities
2,473,034

 
2,403,194

 

 

Other asset backed securities
996,531

 
983,126

 

 

 
$
9,083,520

 
$
8,814,619

 
$
77,041

 
$
76,460

International Exposure
We hold fixed maturity securities with international exposure. As of March 31, 2018, 19% of the carrying value of our fixed maturity securities was comprised of corporate debt securities of issuers based outside of the United States and debt securities of foreign governments. Our investment professionals analyze each holding for credit risk by economic and other factors of each country and industry. The following table presents our international exposure in our fixed maturity portfolio by country or region:
 
March 31, 2018
 
Amortized
Cost
 
Carrying Amount/
Fair Value
 
Percent
of Total
Carrying
Amount
 
(Dollars in thousands)
 
 
GIIPS (1)
$
265,668

 
$
280,715

 
0.6%
Asia/Pacific
433,877

 
441,770

 
1.0%
Non-GIIPS Europe
3,100,441

 
3,157,021

 
6.9%
Latin America
291,117

 
298,767

 
0.7%
Non-U.S. North America
1,346,732

 
1,387,196

 
3.0%
Australia & New Zealand
767,242

 
757,598

 
1.7%
Other
2,475,918

 
2,488,042

 
5.4%
 
$
8,680,995

 
$
8,811,109

 
19.3%
(1)
Greece, Ireland, Italy, Portugal and Spain ("GIIPS"). All of our exposure in GIIPS are corporate securities with issuers domiciled in these countries. None of our foreign government obligations were held in any of these countries.

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All of the securities presented in the table above are denominated in U.S. dollars and all are investment grade (NAIC designation of either 1 or 2), except for the following:
 
March 31, 2018
 
Amortized Cost
 
Carrying Amount/
Fair Value
 
(Dollars in thousands)
GIIPS
$
19,515

 
$
21,013

Asia/Pacific
11,000

 
9,500

Non-GIIPS Europe
194,558

 
191,198

Latin America
59,577

 
55,507

Non-U.S. North America
76,725

 
76,584

 
$
361,375

 
$
353,802

Watch List
At each balance sheet date, we identify invested assets which have characteristics (i.e. significant unrealized losses compared to amortized cost and industry trends) creating uncertainty as to our future assessment of an other than temporary impairment. As part of this assessment, we review not only a change in current price relative to its amortized cost but the issuer's current credit rating and the probability of full recovery of principal based upon the issuer's financial strength. Specifically for corporate issues we evaluate the financial stability and quality of asset coverage for the securities relative to the term to maturity for the issues we own. A security which has a 25% or greater change in market price relative to its amortized cost and a possibility of a loss of principal will be included on a list which is referred to as our watch list. We exclude from this list securities with unrealized losses which are related to market movements in interest rates and which have no factors indicating that such unrealized losses may be other than temporary as we do not intend to sell these securities and it is more likely than not we will not have to sell these securities before a recovery is realized. In addition, we exclude our residential and commercial mortgage backed securities as we monitor all of our residential and commercial mortgage backed securities on a quarterly basis for changes in default rates, loss severities and expected cash flows for the purpose of assessing potential other than temporary impairments and related credit losses to be recognized in operations. At March 31, 2018, the amortized cost and fair value of securities on the watch list (all fixed maturity securities) are as follows:
General Description
 
Number of
Securities
 
Amortized
Cost
 
Unrealized
Gains (Losses)
 
Fair Value
 
Months in
Continuous
Unrealized
Loss Position
 
Months
Unrealized
Losses
Greater
Than 20%
 
 
 
 
(Dollars in thousands)
 
 
 
 
Below investment grade
 
 
 
 
 
 
 
 
 
 
 
 
Corporate securities:
 
 
 
 
 
 
 
 
 
 
 
 
Consumer discretionary
 
2
 
$
25,974

 
$
(5,061
)
 
$
20,913

 
4 - 38
 
0 - 1
Energy
 
4
 
29,054

 
(6,538
)
 
22,516

 
2 - 43
 
0 - 8
Industrials
 
1
 
2,585

 
(785
)
 
1,800

 
41
 
1
Materials
 
1
 
3,990

 
1,172

 
5,162

 
 
Other asset backed securities:
 
 
 
 
 
 
 
 
 
 
 
 
Financials
 
2
 
6,036

 
(3,143
)
 
2,893

 
58 - 84
 
0 - 39
 
 
10
 
$
67,639

 
$
(14,355
)
 
$
53,284

 
 
 
 

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Table of Contents

We have determined that the unrealized losses of the securities on the watch list are temporary as we do not intend to sell these securities and it is more likely than not we will not have to sell these securities before recovery of their amortized cost. Our analysis of these securities and their credit performance at March 31, 2018 is as follows:
Corporate securities:
Consumer discretionary: The decline in the value of these securities, issued by a United States based toy manufacturer, relates to weak operating performance and sales trends and downgrades from all three main rating agencies. A portion of the decrease in sales is attributable to the liquidation of a major toy retailer during the fourth quarter of 2017. While the issuer has seen a decrease in operating performance, it has implemented a plan to reduce costs and stabilize its revenue and is in the early phase of executing on that plan. We have determined that these securities were not other than temporarily impaired due to our evaluation of the operating performance and the creditworthiness of the issuer and the fact that all required payments have been made.
Energy, Industrials and Materials: The decline in the value of these securities relates to continued operational pressure due to a decline in certain commodity prices specific to their businesses. The decline in these commodity prices creates financial challenges as the companies realign to accommodate the lower prices. These issuers will be stressed greater than the average company due to their price sensitivity and the specific position they hold in the supply chain. While values have declined, improving commodity prices have provided better financial performance for these companies. We recognized an other than temporary impairment on one security during the fourth quarter of 2017 and one security during the third quarter of 2016 due to our evaluation of the operating performance and the credit worthiness of the issuers. While the remaining issuers have seen their financial and profitability profile weakened, we have determined that the remaining securities were not other than temporarily impaired due to our evaluation of the operating performance and the credit worthiness of the issuer.
Other asset backed securities:
Financials:  The decline in value of one of the asset backed securities is due to poor performance in the underlying pool of student loans. The investment is backed by a guarantee from the for-profit education services provider. We have determined that this security was not other than temporarily impaired, because all required payments have been made. The decline in value of the other asset backed security is related directly to the decline in oil prices and the financial stability of its operator. The issuer has direct exposure to the oil market as its primary business is deep water drilling. As oil prices have remained low, the operator of the deep water vessel has experienced financial pressure on its balance sheet. We recognized other than temporary impairments on this security during the second quarter of 2017, the second quarter of 2016 and the third quarter of 2015.
Other Than Temporary Impairments
We have a policy and process to identify securities in our investment portfolio for which we should recognize impairments. See Critical Accounting Policies—Evaluation of Other Than Temporary Impairments included in Management's Discussion and Analysis in our Annual Report on Form 10-K for the year ended December 31, 2017. During the three months ended March 31, 2018, we recognized an OTTI of $0.9 million on a corporate security issued by a Brazilian food company due to our intent to sell the security, which was in an unrealized loss position at the reporting date. During the three months ended March 31, 2017, we recognized additional credit losses on residential mortgage backed securities on which we have previously recognized OTTI.
Several factors led us to believe that full recovery of amortized cost is not expected on the securities for which we recognized credit losses and reclassified OTTI from accumulated other comprehensive income to net income. A discussion of these factors, our policy and process to identify securities that could potentially have impairment that is other than temporary and a summary of OTTI is presented in Note 3 to our unaudited consolidated financial statements in this Form 10-Q, which is incorporated by reference in this Item 2.
Mortgage Loans on Real Estate
Our commercial mortgage loan portfolio consists of mortgage loans collateralized by the related properties and diversified as to property type, location and loan size. Our mortgage lending policies establish limits on the amount that can be loaned to one borrower and other criteria to attempt to reduce the risk of default. Our commercial mortgage loans on real estate are reported at cost, net of loan loss allowances and deferred prepayment fees. At March 31, 2018 and December 31, 2017, the largest principal amount outstanding for any single mortgage loan was $23.9 million and $21.2 million, respectively, and the average loan size was $3.6 million and $3.5 million, respectively. In addition, the average loan to value ratio for the overall portfolio was 53.6% at both March 31, 2018 and December 31, 2017, respectively, based upon the underwriting and appraisal at the time the loan was made. This loan to value is indicative of our conservative underwriting policies and practices for making commercial mortgage loans and may not be indicative of collateral values at the current reporting date. Our current practice is to only obtain market value appraisals of the underlying collateral at the inception of the loan unless we identify indicators of impairment in our ongoing analysis of the portfolio, in which case, we either calculate a value of the collateral using a capitalization method or obtain a third party appraisal of the underlying collateral. The commercial mortgage loan portfolio is summarized by geographic region and property type in Note 4 to our unaudited consolidated financial statements in this Form 10-Q, incorporated by reference in this Item 2.
In the normal course of business, we commit to fund commercial mortgage loans up to 90 days in advance. At March 31, 2018, we had commitments to fund commercial mortgage loans totaling $51.7 million, with interest rates ranging from 4.41% to 6.64%. During 2018 and 2017, due to historically low interest rates, the commercial mortgage loan industry has been very competitive. This competition has resulted in a number of borrowers refinancing with other lenders. For the three months ended March 31, 2018, we received $42.4 million in cash for loans being paid in full compared to $49.8 million for the three months ended March 31, 2017. Some of the loans being paid off have either reached their maturity or are nearing maturity; however, some borrowers are paying the prepayment fee and refinancing at a lower rate.

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See Note 4 to our unaudited consolidated financial statements, incorporated by reference for a presentation of our specific and general loan loss allowances, impaired loans, foreclosure activity and troubled debt restructure analysis.
We have a process by which we evaluate the credit quality of each of our commercial mortgage loans. This process utilizes each loan's debt service coverage ratio as a primary metric. A summary of our portfolio by debt service coverage ratio (based on most recent information collected) follows:
 
March 31, 2018
 
December 31, 2017
 
Principal Outstanding
 
Percent of Total Principal Outstanding
 
Principal Outstanding
 
Percent of Total Principal Outstanding
 
(Dollars in thousands)
Debt Service Coverage Ratio:
 
 
 
 
 
 
 
Greater than or equal to 1.5
$
1,854,662

 
68.5
%
 
$
1,826,596

 
68.3
%
Greater than or equal to 1.2 and less than 1.5
647,165

 
23.9
%
 
638,299

 
23.9
%
Greater than or equal to 1.0 and less than 1.2
155,268

 
5.7
%
 
148,881

 
5.6
%
Less than 1.0
50,257

 
1.9
%
 
60,539

 
2.2
%
 
$
2,707,352

 
100.0
%
 
$
2,674,315

 
100.0
%
Approximately 97% of our mortgage loans (based on principal outstanding) that have a debt service coverage ratio of less than 1.0 are performing under the original contractual loan terms at March 31, 2018.
Mortgage loans summarized in the following table represent all loans that we are either not currently collecting or those we feel it is probable we will not collect all amounts due according to the contractual terms of the loan agreements (all loans that we have worked with the borrower to alleviate short-term cash flow issues, loans delinquent for 60 days or more at the reporting date, loans we have determined to be collateral dependent and loans that we have recorded specific impairments on that we feel may continue to have performance issues).
 
March 31, 2018
 
December 31, 2017
 
(Dollars in thousands)
Impaired mortgage loans with an allowance
$
3,186

 
$
5,445

Impaired mortgage loans with no related allowance
1,395

 
1,436

Allowance for probable loan losses
(696
)
 
(1,418
)
Net carrying value of impaired mortgage loans
$
3,885

 
$
5,463

At March 31, 2018, we had no commercial mortgage loans that were delinquent (60 days or more past due at the reporting date) in their principal and interest payments.
Derivative Instruments
Our derivative instruments primarily consist of call options purchased to provide the income needed to fund the annual index credits on our fixed index annuity products. The fair value of the call options is based upon the amount of cash that would be required to settle the call options obtained from the counterparties adjusted for the nonperformance risk of the counterparty. The nonperformance risk for each counterparty is based upon its credit default swap rate. We have no performance obligations related to the call options.
None of our derivatives qualify for hedge accounting, thus, any change in the fair value of the derivatives that are not classified as equity is recognized immediately in the consolidated statements of operations. A presentation of our derivative instruments along with a discussion of the business strategy involved with our derivatives is included in Note 5 to our unaudited consolidated financial statements in this Form 10-Q, which is incorporated by reference in this Item 2.
Liquidity and Capital Resources
Our insurance subsidiaries continue to have adequate cash flows from annuity deposits and investment income to meet their policyholder and other obligations. Net cash flows from annuity deposits and funds returned to policyholders as surrenders, withdrawals and death claims were $275.3 million for the three months ended March 31, 2018 compared to $409.8 million for the three months ended March 31, 2017, with the decrease attributable to a $71.8 million decrease in net annuity deposits after coinsurance and a $62.7 million (after coinsurance) increase in funds returned to policyholders. We continue to invest the net proceeds from policyholder transactions and investment activities in high quality fixed maturity securities and fixed rate commercial mortgage loans.
We, as the parent company, are a legal entity separate and distinct from our subsidiaries, and have no business operations. We need liquidity primarily to service our debt (senior notes and subordinated debentures issued to subsidiary trusts), pay operating expenses and pay dividends to stockholders. Our assets consist primarily of the capital stock and surplus notes of our subsidiaries. Accordingly, our future cash flows depend upon the availability of dividends, surplus note interest payments and other statutorily permissible payments from our subsidiaries, such as payments under our investment advisory agreements and tax allocation agreement with our subsidiaries. These sources provide adequate cash flow for us to meet our current and reasonably foreseeable future obligations.

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Table of Contents

The ability of our life insurance subsidiaries to pay dividends or distributions, including surplus note payments, will be limited by applicable laws and regulations of the states in which our life insurance subsidiaries are domiciled, which subject our life insurance subsidiaries to significant regulatory restrictions. These laws and regulations require, among other things, our insurance subsidiaries to maintain minimum solvency requirements and limit the amount of dividends these subsidiaries can pay.
Currently, American Equity Life may pay dividends or make other distributions without the prior approval of the Iowa Insurance Commissioner, unless such payments, together with all other such payments within the preceding twelve months, exceed the greater of (1) American Equity Life's net gain from operations for the preceding calendar year, or (2) 10% of American Equity Life's statutory capital and surplus at the preceding December 31. For 2018, up to $377.1 million can be distributed as dividends by American Equity Life without prior approval of the Iowa Insurance Commissioner. In addition, dividends and surplus note payments may be made only out of statutory earned surplus, and all surplus note payments are subject to prior approval by regulatory authorities in the life subsidiary's state of domicile. American Equity Life had $1.8 billion of statutory earned surplus at March 31, 2018.
The maximum distribution permitted by law or contract is not necessarily indicative of an insurer's actual ability to pay such distributions, which may be constrained by business and regulatory considerations, such as the impact of such distributions on surplus, which could affect the insurer's ratings or competitive position, the amount of premiums that can be written and the ability to pay future dividends or make other distributions. Further, state insurance laws and regulations require that the statutory surplus of our life subsidiaries following any dividend or distribution must be reasonable in relation to their outstanding liabilities and adequate for their financial needs. Along with solvency regulations, the primary driver in determining the amount of capital used for dividends is the level of capital needed to maintain desired financial strength ratings from rating agencies. Both regulators and rating agencies could become more conservative in their methodology and criteria, including increasing capital requirements for our insurance subsidiaries which, in turn, could negatively affect the cash available to us from insurance subsidiaries. As of March 31, 2018, we estimate American Equity Life has sufficient statutory capital and surplus, combined with capital available to the holding company, to maintain this rating objective. However, this capital may not be sufficient if significant future losses are incurred or a rating agency modifies its rating criteria and access to additional capital could be limited.
The transfer of funds by American Equity Life is also restricted by a covenant in our line of credit agreement which requires American Equity Life to maintain a minimum RBC ratio of 275% and a minimum level of statutory surplus equal to the sum of 1) 80% of statutory surplus at June 30, 2016, 2) 50% of the statutory net income for each fiscal quarter ending after June 30, 2016, and 3) 50% of all capital contributed to American Equity Life after June 30, 2016. American Equity Life's RBC ratio was 378% at December 31, 2017. Under this agreement, we are also required to maintain a maximum ratio of adjusted debt to total adjusted capital of 0.35.
Cash and cash equivalents of the parent holding company at March 31, 2018, were $22.9 million. In addition, we have a $150 million revolving line of credit, with no borrowings outstanding, available through September 2021 for general corporate purposes of the parent company and its subsidiaries. We also have the ability to issue equity, debt or other types of securities through one or more methods of distribution under a currently effective shelf registration statement on Form S-3. The terms of any offering would be established at the time of the offering, subject to market conditions.
New Accounting Pronouncements
See Note 1 to our unaudited consolidated financial statements in this Form 10-Q, which is incorporated by reference in this Item 2.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
We seek to invest our available funds in a manner that will maximize shareholder value and fund future obligations to policyholders and debtors, subject to appropriate risk considerations. We seek to meet this objective through investments that: (i) consist substantially of investment grade fixed maturity securities, (ii) have projected returns which satisfy our spread targets, and (iii) have characteristics which support the underlying liabilities. Many of our products incorporate surrender charges, market interest rate adjustments or other features to encourage persistency.
We seek to maximize the total return on our available for sale investments through active investment management. Accordingly, we have determined that our available for sale portfolio of fixed maturity securities is available to be sold in response to: (i) changes in market interest rates, (ii) changes in relative values of individual securities and asset sectors, (iii) changes in prepayment risks, (iv) changes in credit quality outlook for certain securities, (v) liquidity needs, and (vi) other factors.
Interest rate risk is our primary market risk exposure. Substantial and sustained increases and decreases in market interest rates can affect the profitability of our products, the fair value of our investments, and the amount of interest we pay on our floating rate subordinated debentures. Our floating rate trust preferred securities bear interest at the three month LIBOR plus 3.50% - 4.00%. Our outstanding balance of floating rate trust preferred securities was $164.5 million at March 31, 2018, of which $85.5 million has been swapped to a fixed rate for seven years which began in March 2014 and $79.0 million has been capped for seven years which began in July 2014 (see Note 5 to our unaudited consolidated financial statements in this Form 10-Q). The profitability of most of our products depends on the spreads between interest yield on investments and rates credited on insurance liabilities. We have the ability to adjust crediting rates (caps, participation rates or asset fee rates for fixed index annuities) on substantially all of our annuity liabilities at least annually (subject to minimum guaranteed values). In addition, substantially all of our annuity products have surrender and withdrawal penalty provisions designed to encourage persistency and to help ensure targeted spreads are earned. However, competitive factors, including the impact of the level of surrenders and withdrawals, may limit our ability to adjust or maintain crediting rates at levels necessary to avoid narrowing of spreads under certain market conditions.

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Table of Contents

A major component of our interest rate risk management program is structuring the investment portfolio with cash flow characteristics consistent with the cash flow characteristics of our insurance liabilities. We use models to simulate cash flows expected from our existing business under various interest rate scenarios. These simulations enable us to measure the potential gain or loss in fair value of our interest rate-sensitive financial instruments, to evaluate the adequacy of expected cash flows from our assets to meet the expected cash requirements of our liabilities and to determine if it is necessary to lengthen or shorten the average life and duration of our investment portfolio. The "duration" of a security is the time weighted present value of the security's expected cash flows and is used to measure a security's sensitivity to changes in interest rates. When the durations of assets and liabilities are similar, exposure to interest rate risk is minimized because a change in value of assets should be largely offset by a change in the value of liabilities.
If interest rates were to increase 10% (30 basis points) from levels at March 31, 2018, we estimate that the fair value of our fixed maturity securities would decrease by approximately $1.1 billion. The impact on stockholders' equity of such decrease (net of income taxes and certain adjustments for changes in amortization of deferred policy acquisition costs and deferred sales inducements) would be a decrease of $380.3 million in accumulated other comprehensive income and a decrease in stockholders' equity. The models used to estimate the impact of a 10% change in market interest rates incorporate numerous assumptions, require significant estimates and assume an immediate and parallel change in interest rates without any management of the investment portfolio in reaction to such change. Consequently, potential changes in value of our financial instruments indicated by the simulations will likely be different from the actual changes experienced under given interest rate scenarios, and the differences may be material. Because we actively manage our investments and liabilities, our net exposure to interest rates can vary over time. However, any such decreases in the fair value of our fixed maturity securities (unless related to credit concerns of the issuer requiring recognition of an other than temporary impairment) would generally be realized only if we were required to sell such securities at losses prior to their maturity to meet our liquidity needs, which we manage using the surrender and withdrawal provisions of our annuity contracts and through other means. See Financial Condition - Liquidity for Insurance Operations included in Management's Discussion and Analysis in our Annual Report on Form 10-K for the year ended December 31, 2017 for a further discussion of liquidity risk.
At March 31, 2018, 37% of our fixed income securities have call features, of which 2.7% ($1.2 billion) were subject to call redemption. Another 0.2% ($111.2 million) will become subject to call redemption during the next twelve months. Approximately 74% of our fixed income securities that have call features are not callable until within six months of their stated maturities. We have reinvestment risk related to these redemptions to the extent we cannot reinvest the net proceeds in assets with credit quality and yield characteristics similar to the redeemed bonds. Such reinvestment risk typically occurs in a declining rate environment. Should rates decline to levels which tighten the spread between our average portfolio yield and average cost of interest credited on annuity liabilities, we have the ability to reduce crediting rates (caps, participation rates or asset fees for fixed index annuities) on most of our annuity liabilities to maintain the spread at our targeted level. At March 31, 2018, approximately 99% of our annuity liabilities were subject to annual adjustment of the applicable crediting rates at our discretion, limited by minimum guaranteed crediting rates specified in the policies. At March 31, 2018, approximately 13% of our annuity liabilities were at minimum guaranteed crediting rates.
We purchase call options on the applicable indices to fund the annual index credits on our fixed index annuities. These options are primarily one-year instruments purchased to match the funding requirements of the underlying policies. Fair value changes associated with those investments are substantially offset by an increase or decrease in the amounts added to policyholder account balances for fixed index products. The difference between proceeds received at expiration of these options and index credits, as shown in the following table, is primarily due to over-hedging as a result of policyholder behavior being different than our expectations.
 
Three Months Ended 
 March 31,
 
2018
 
2017
 
(Dollars in thousands)
Annual index credits to policyholders on their anniversaries
$
423,940

 
$
321,880

Proceeds received at expiration of options related to such credits
425,557

 
326,552

On the anniversary dates of the index policies, we purchase new one-year call options to fund the next annual index credits. The risk associated with these prospective purchases is the uncertainty of the cost, which will determine whether we are able to earn our spread on our index business. We manage this risk through the terms of our fixed index annuities, which permit us to change caps, participation rates and asset fees, subject to contractual features. By modifying caps, participation rates or asset fees, we can limit option costs to budgeted amounts, except in cases where the contractual features would prevent further modifications. Based upon actuarial testing which we conduct as a part of the design of our index products and on an ongoing basis, we believe the risk that contractual features would prevent us from controlling option costs is not material.

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Table of Contents

Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
In accordance with the Securities Exchange Act Rules 13a-15(e) and 15d-15(e), our management, under the supervision of our Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report on Form 10-Q. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the design and operation of our disclosure controls and procedures were effective as of March 31, 2018 in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by us in the reports that we file or submit under the Exchange Act.
There were no changes in our internal control over financial reporting that occurred during the quarter ended March 31, 2018 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
See Note 7 - Commitments and Contingencies to the unaudited consolidated financial statements in this Form 10-Q, which is incorporated by reference in this Item 1, for litigation and regulatory disclosures.
Item 1A. Risk Factors
Our 2017 Annual Report on Form 10-K described our Risk Factors. There have been no material changes to the Risk Factors during the three months ended March 31, 2018.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Issuer Purchases of Securities
The following table presents the amount of our share purchase activity for the periods indicated:
Period
 
Total Number of
Shares Purchased (a)
 
Average Price
Paid Per Share
January 1, 2018 - January 31, 2018
 

 
$

February 1, 2018 - February 28, 2018
 
913

 
$
31.92

March 1, 2018 - March 31, 2018
 
8,759

 
$
31.82

Total
 
9,672

 
 
(a)
Includes the number of shares of common stock utilized to execute certain stock incentive awards.


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Table of Contents

Item 6. Exhibits
Exhibit No.
 
Description
 
Method of Filing
10.1
 
 
Filed herewith
10.2
 
 
Filed herewith
10.3
 
 
Filed herewith
10.4
 
 
Filed herewith
10.5
 
 
Filed herewith
12.1
 
 
Filed herewith
31.1
 
 
Filed herewith
31.2
 
 
Filed herewith
32.1
 
 
Filed herewith
32.2
 
 
Filed herewith
101.INS
 
XBRL Instance Document
 
Filed herewith
101.SCH
 
XBRL Taxonomy Extension Schema Document
 
Filed herewith
101.CAL
 
XBRL Taxonomy Extension Calculation Linkbase Document
 
Filed herewith
101.DEF
 
XBRL Taxonomy Extension Definition Linkbase Document
 
Filed herewith
101.LAB
 
XBRL Taxonomy Extension Label Linkbase Document
 
Filed herewith
101.PRE
 
XBRL Taxonomy Extension Presentation Linkbase Document
 
Filed herewith


50

Table of Contents

SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Date:
May 8, 2018
 
AMERICAN EQUITY INVESTMENT LIFE
 
 
 
 
HOLDING COMPANY
 
 
 
 
 
 
 
 
 
By:
/s/ John M. Matovina
 
 
 
 
 
John M. Matovina, Chief Executive Officer and President
 
 
 
 
 
(Principal Executive Officer)
 
 
 
 
 
 
 
 
 
By:
/s/ Ted M. Johnson
 
 
 
 
 
Ted M. Johnson, Chief Financial Officer and Treasurer
 
 
 
 
 
(Principal Financial Officer)
 
 
 
 
 
 
 
 
 
By:
/s/ Scott A. Samuelson
 
 
 
 
 
Scott A. Samuelson, Vice President and Chief Accounting Officer
 
 
 
 
 
(Principal Accounting Officer)
 



51