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AMERICAN EQUITY INVESTMENT LIFE HOLDING CO - Quarter Report: 2015 September (Form 10-Q)

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 September 30, 2015
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 or a smaller reporting company. See the definitions of “large accelerated filer," “accelerated filer” and “smaller reporting 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
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 November 2, 2015, there were 81,548,649 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)
 
September 30, 2015
 
December 31, 2014
 
(Unaudited)
 
 
Assets
 
 
 
Investments:
 
 
 
Fixed maturity securities:
 
 
 
Available for sale, at fair value (amortized cost: 2015 - $34,058,330; 2014 - $30,205,046)
$
35,389,842

 
$
32,445,202

Held for investment, at amortized cost (fair value: 2015 - $62,000; 2014 - $75,838)
76,574

 
76,432

Equity securities, available for sale, at fair value (cost: 2015 - $7,514; 2014 - $7,509)
7,833

 
7,805

Mortgage loans on real estate
2,452,402

 
2,434,580

Derivative instruments
180,649

 
731,113

Other investments
284,994

 
286,726

Total investments
38,392,294

 
35,981,858

 
 
 
 
Cash and cash equivalents
523,614

 
701,514

Coinsurance deposits
3,062,924

 
3,044,342

Accrued investment income
375,522

 
326,559

Deferred policy acquisition costs
2,591,327

 
2,058,556

Deferred sales inducements
1,981,209

 
1,587,257

Deferred income taxes
129,948

 

Income taxes recoverable
4,693

 
9,252

Other assets
66,890

 
280,396

Total assets
$
47,128,421

 
$
43,989,734

 
 
 
 
Liabilities and Stockholders' Equity
 
 
 
Liabilities:
 
 
 
Policy benefit reserves
$
43,582,521

 
$
39,802,861

Other policy funds and contract claims
335,185

 
365,819

Notes payable
400,000

 
421,679

Subordinated debentures
246,397

 
246,243

Deferred income taxes

 
3,895

Other liabilities
414,409

 
1,009,361

Total liabilities
44,978,512

 
41,849,858

 
 
 
 
Stockholders' equity:
 
 
 
Preferred stock, par value $1 per share, 2,000,000 shares authorized,
  2015 and 2014 - no shares issued and outstanding

 

Common stock, par value $1 per share, 200,000,000 shares authorized; issued and outstanding:
   2015 - 81,190,936 shares (excluding 3,536,875 treasury shares);
   2014 - 76,062,407 shares (excluding 4,126,167 treasury shares)
81,191

 
76,062

Additional paid-in capital
626,914

 
513,218

Accumulated other comprehensive income
426,555

 
721,401

Retained earnings
1,015,249

 
829,195

Total stockholders' equity
2,149,909

 
2,139,876

Total liabilities and stockholders' equity
$
47,128,421

 
$
43,989,734

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
September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
Revenues:
 
 
 
 
 
 
 
Premiums and other considerations
$
8,335

 
$
6,043

 
$
25,369

 
$
22,497

Annuity product charges
37,975

 
31,958

 
99,066

 
86,477

Net investment income
436,085

 
386,931

 
1,253,930

 
1,127,818

Change in fair value of derivatives
(351,360
)
 
39,218

 
(405,484
)
 
358,594

Net realized gains (losses) on investments, excluding other than temporary impairment ("OTTI") losses
1,159

 
(3,190
)
 
10,362

 
(6,134
)
OTTI losses on investments:
 
 
 
 
 
 
 
Total OTTI losses
(10,000
)
 

 
(10,132
)
 

Portion of OTTI losses recognized in (from) other comprehensive income
4,771

 
(564
)
 
3,943

 
(2,063
)
Net OTTI losses recognized in operations
(5,229
)
 
(564
)
 
(6,189
)
 
(2,063
)
Loss on extinguishment of debt

 

 

 
(10,551
)
Total revenues
126,965

 
460,396

 
977,054

 
1,576,638

 
 
 
 
 
 
 
 
Benefits and expenses:
 
 
 
 
 
 
 
Insurance policy benefits and change in future policy benefits
10,959

 
9,109

 
32,629

 
30,191

Interest sensitive and index product benefits
213,465

 
429,415

 
802,431

 
1,114,381

Amortization of deferred sales inducements
65,807

 
40,661

 
152,278

 
96,676

Change in fair value of embedded derivatives
(414,724
)
 
(195,206
)
 
(583,112
)
 
(21,652
)
Interest expense on notes payable
7,283

 
8,741

 
21,976

 
28,126

Interest expense on subordinated debentures
3,075

 
3,044

 
9,138

 
9,076

Amortization of deferred policy acquisition costs
67,885

 
39,671

 
186,871

 
113,949

Other operating costs and expenses
24,497

 
20,616

 
70,487

 
60,588

Total benefits and expenses
(21,753
)
 
356,051

 
692,698

 
1,431,335

Income before income taxes
148,718

 
104,345

 
284,356

 
145,303

Income tax expense
51,412

 
36,530

 
98,302

 
50,497

Net income
$
97,306

 
$
67,815

 
$
186,054

 
$
94,806

 
 
 
 
 
 
 
 
Earnings per common share
$
1.22

 
$
0.90

 
$
2.39

 
$
1.28

Earnings per common share - assuming dilution
$
1.19

 
$
0.85

 
$
2.33

 
$
1.19

Weighted average common shares outstanding (in thousands):
 
 
 
 
 
 
 
Earnings per common share
79,676

 
75,083

 
77,995

 
74,030

Earnings per common share - assuming dilution
81,559

 
79,467

 
79,977

 
79,477

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
September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
 
 
 
 
 
 
 
 
Net income
$
97,306

 
$
67,815

 
$
186,054

 
$
94,806

Other comprehensive income (loss):
 
 
 
 
 
 
 
Change in net unrealized investment gains/losses (1)
60,402

 
(15,590
)
 
(453,582
)
 
768,414

Noncredit component of OTTI losses (1)
(2,381
)
 
9

 
(1,968
)
 
703

Reclassification of unrealized investment gains/losses to net income (1)
96

 
(18
)
 
1,940

 
(294
)
Other comprehensive income (loss) before income tax
58,117

 
(15,599
)
 
(453,610
)
 
768,823

Income tax effect related to other comprehensive income (loss)
(20,341
)
 
5,459

 
158,764

 
(269,088
)
Other comprehensive income (loss)
37,776

 
(10,140
)
 
(294,846
)
 
499,735

Comprehensive income (loss)
$
135,082

 
$
57,675

 
$
(108,792
)
 
$
594,541

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

4

Table of Contents

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
 
Unallocated
Common
Stock Held
by ESOP
 
Accumulated
Other
Comprehensive
Income
 
Retained
Earnings
 
Total
Stockholders'
Equity
 
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2014
$
76,062

 
$
513,218

 
$

 
$
721,401

 
$
829,195

 
$
2,139,876

Net income for period

 

 

 

 
186,054

 
186,054

Other comprehensive loss

 

 

 
(294,846
)
 

 
(294,846
)
Share-based compensation, including excess income tax benefits

 
7,567

 

 

 

 
7,567

Issuance of common stock via public offering
4,300

 
100,179

 



 

 
104,479

Issuance of 828,529 shares of common stock under compensation plans, including excess income tax benefits
829

 
5,950

 

 

 

 
6,779

Balance at September 30, 2015
$
81,191

 
$
626,914

 
$

 
$
426,555

 
$
1,015,249

 
$
2,149,909

 
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2013
$
70,535

 
$
550,400

 
$
(631
)
 
$
46,196

 
$
718,187

 
$
1,384,687

Net income for period

 

 

 

 
94,806

 
94,806

Other comprehensive income

 

 

 
499,735

 

 
499,735

Allocation of 58,618 shares of common stock by ESOP, including excess income tax benefits

 
721

 
631

 

 

 
1,352

Share-based compensation, including excess income tax benefits

 
4,548

 

 

 

 
4,548

Issuance of 1,290,732 shares of common stock under compensation plans, including excess income tax benefits
1,291

 
9,653

 

 

 

 
10,944

Extinguishment of convertible senior notes, net of tax, including 2,443,457 shares of common stock issued upon conversion
2,444

 
7,015

 

 

 

 
9,459

Warrants reclassified to embedded derivative liability to be settled in cash

 
(30,455
)
 

 

 

 
(30,455
)
Balance at September 30, 2014
$
74,270

 
$
541,882

 
$

 
$
545,931

 
$
812,993

 
$
1,975,076

See accompanying notes to unaudited consolidated financial statements.

5

Table of Contents

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

 
Nine Months Ended
September 30,
 
2015
 
2014
Operating activities
 
 
 
Net income
$
186,054

 
$
94,806

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Interest sensitive and index product benefits
802,431

 
1,114,381

Amortization of deferred sales inducements
152,278

 
96,676

Annuity product charges
(99,066
)
 
(86,477
)
Change in fair value of embedded derivatives
(583,112
)
 
(21,652
)
Increase in traditional life and accident and health insurance reserves
3,024

 
396

Policy acquisition costs deferred
(464,451
)
 
(312,070
)
Amortization of deferred policy acquisition costs
186,871

 
113,949

Provision for depreciation and other amortization
3,733

 
7,578

Amortization of discounts and premiums on investments
(10,730
)
 
(12,500
)
Realized gains/losses on investments and net OTTI losses recognized in operations
(4,173
)
 
8,197

Change in fair value of derivatives
404,085

 
(359,626
)
Deferred income taxes
23,640

 
(39,823
)
Loss on extinguishment of debt

 
10,551

Share-based compensation
5,332

 
1,142

Change in accrued investment income
(48,963
)
 
(38,574
)
Change in income taxes recoverable/payable
4,794

 
(6,384
)
Change in other assets
1,053

 
(2,359
)
Change in other policy funds and contract claims
(36,876
)
 
(47,257
)
Change in collateral held for derivatives
(469,752
)
 
10,048

Change in other liabilities
24,766

 
(40,310
)
Other
(9,843
)
 
(3,339
)
Net cash provided by operating activities
71,095

 
487,353

 
 
 
 
Investing activities
 
 
 
Sales, maturities, or repayments of investments:
 
 
 
Fixed maturity securities - available for sale
1,280,927

 
1,233,408

Mortgage loans on real estate
354,391

 
316,841

Derivative instruments
563,125

 
886,556

Other investments
11,716

 
16,515

Acquisition of investments:
 
 
 
Fixed maturity securities - available for sale
(5,041,263
)
 
(3,998,902
)
Mortgage loans on real estate
(362,123
)
 
(227,244
)
Derivative instruments
(427,763
)
 
(355,473
)
Other investments
(5,206
)
 
(68,891
)
Purchases of property, furniture and equipment
(913
)
 
(777
)
Net cash used in investing activities
(3,627,109
)
 
(2,197,967
)

6

Table of Contents

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

 
Nine Months Ended
September 30,
 
2015
 
2014
Financing activities
 
 
 
Receipts credited to annuity and single premium universal life policyholder account balances
$
4,913,473

 
$
3,016,856

Coinsurance deposits
21,623

 
41,740

Return of annuity policyholder account balances
(1,638,598
)
 
(1,410,682
)
Financing fees incurred and deferred

 
(100
)
Repayment of notes payable
(48,152
)
 
(119,677
)
Net proceeds from settlement of notes hedges and warrants
25,775

 
10,401

Proceeds from amounts due under repurchase agreements

 
81,189

Acquisition of common stock
(16
)
 

Excess tax benefits realized from share-based compensation plans
3,281

 
4,312

Proceeds from issuance of common stock
111,274

 
10,038

Change in checks in excess of cash balance
(10,546
)
 
(32,192
)
Net cash provided by financing activities
3,378,114

 
1,601,885

Decrease in cash and cash equivalents
(177,900
)
 
(108,729
)
Cash and cash equivalents at beginning of period
701,514

 
897,529

Cash and cash equivalents at end of period
$
523,614

 
$
788,800

 
 
 
 
Supplemental disclosures of cash flow information
 
 
 
Cash paid during period for:
 
 
 
Interest expense
$
36,136

 
$
39,090

Income taxes
66,541

 
91,675

Non-cash operating activity:
 
 
 
Deferral of sales inducements
346,410

 
241,277

Non-cash investing activity:
 
 
 
Real estate acquired in satisfaction of mortgage loans

 
11,755

Non-cash financing activities:
 
 
 
Common stock issued in extinguishment of debt

 
56,292

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
September 30, 2015
(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 and nine month periods ended September 30, 2015 are not necessarily indicative of the results that may be expected for the year ended December 31, 2015. 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, 2014.
Adopted Accounting Pronouncements
There were no accounting pronouncements that were adopted during the current period.
New Accounting Pronouncements
In April 2015, the Financial Accounting Standards Board ("FASB") issued an accounting standards update ("ASU") which requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. This ASU will be effective for us on January 1, 2016, and retroactive application is required. It is not expected to have a material impact on our consolidated financial statements. Subsequently, in August 2015, the FASB issued an ASU that states that the Securities and Exchange Commission staff would not object to an entity deferring and presenting debt issuance costs related to line-of-credit arrangements as an asset and expensing those costs ratably over the term of the line of credit arrangement.
In June 2014, the FASB issued an ASU that requires that a performance target in a share-based payment arrangement that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. The requisite service period ends when the employee can cease rendering service and still be eligible to vest in the award if the performance target is achieved. This ASU will be effective for us on January 1, 2016, and early adoption is permitted, but it is not expected to have a material impact on our consolidated financial statements.

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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:
 
September 30, 2015
 
December 31, 2014
 
Carrying
Amount
 
Fair Value
 
Carrying
Amount
 
Fair Value
 
(Dollars in thousands)
Assets
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
Available for sale
$
35,389,842

 
$
35,389,842

 
$
32,445,202

 
$
32,445,202

Held for investment
76,574

 
62,000

 
76,432

 
75,838

Equity securities, available for sale
7,833

 
7,833

 
7,805

 
7,805

Mortgage loans on real estate
2,452,402

 
2,492,283

 
2,434,580

 
2,493,901

Derivative instruments
180,649

 
180,649

 
731,113

 
731,113

Other investments
275,300

 
282,277

 
266,488

 
273,004

Cash and cash equivalents
523,614

 
523,614

 
701,514

 
701,514

Coinsurance deposits
3,062,924

 
2,750,361

 
3,044,342

 
2,698,552

Interest rate caps
1,492

 
1,492

 
2,778

 
2,778

2015 notes hedges

 

 
30,291

 
30,291

Counterparty collateral
30,880

 
30,880

 
206,096

 
206,096

 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
Policy benefit reserves
43,240,623

 
36,871,234

 
39,463,987

 
33,078,978

Single premium immediate annuity (SPIA) benefit reserves
334,921

 
346,930

 
365,440

 
377,654

Notes payable
400,000

 
421,500

 
421,679

 
503,349

Subordinated debentures
246,397

 
204,817

 
246,243

 
244,437

2015 notes embedded conversion derivative

 

 
30,291

 
30,291

Interest rate swap
4,528

 
4,528

 
2,644

 
2,644

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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Table of Contents

Our assets and liabilities which are measured at fair value on a recurring basis as of September 30, 2015 and December 31, 2014 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)
September 30, 2015
 
 
 
 
 
 
 
Assets
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
Available for sale:
 
 
 
 
 
 
 
United States Government full faith and credit
$
37,681

 
$
5,549

 
$
32,132

 
$

United States Government sponsored agencies
1,314,748

 

 
1,314,748

 

United States municipalities, states and territories
3,760,888

 

 
3,760,888

 

Foreign government obligations
216,987

 

 
216,987

 

Corporate securities
23,459,748

 
20

 
23,459,728

 

Residential mortgage backed securities
1,556,308

 

 
1,556,308

 

Commercial mortgage backed securities
3,941,863

 

 
3,941,863

 

Other asset backed securities
1,101,619

 

 
1,101,619

 

Equity securities, available for sale: finance, insurance and real estate
7,833

 

 
7,833

 

Derivative instruments
180,649

 

 
180,649

 

Cash and cash equivalents
523,614

 
523,614

 

 

Interest rate caps
1,492

 

 
1,492

 

Counterparty collateral
30,880

 

 
30,880

 

 
$
36,134,310

 
$
529,183

 
$
35,605,127

 
$

Liabilities
 
 
 
 
 
 
 
Interest rate swap
$
4,528

 
$

 
$
4,528

 
$

Fixed index annuities - embedded derivatives
5,731,117

 

 

 
5,731,117

 
$
5,735,645

 
$

 
$
4,528

 
$
5,731,117

 
 
 
 
 
 
 
 
December 31, 2014
 
 
 
 
 
 
 
Assets
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
Available for sale:
 
 
 
 
 
 
 
United States Government full faith and credit
$
138,460

 
$
4,255

 
$
134,205

 
$

United States Government sponsored agencies
1,393,890

 

 
1,393,890

 

United States municipalities, states and territories
3,723,309

 

 
3,723,309

 

Foreign government obligations
193,803

 

 
193,803

 

Corporate securities
21,490,292

 
11

 
21,490,281

 

Residential mortgage backed securities
1,751,345

 

 
1,750,970

 
375

Commercial mortgage backed securities
2,807,620

 

 
2,807,620

 

Other asset backed securities
946,483

 

 
946,483

 

Equity securities, available for sale: finance, insurance and real estate
7,805

 

 
7,805

 

Derivative instruments
731,113

 

 
731,113

 

Cash and cash equivalents
701,514

 
701,514

 

 

Interest rate caps
2,778

 

 
2,778

 

2015 notes hedges
30,291

 

 
30,291

 

Counterparty collateral
206,096

 

 
206,096

 

 
$
34,124,799

 
$
705,780

 
$
33,418,644

 
$
375

Liabilities
 
 
 
 
 
 
 
2015 notes embedded conversion derivative
$
30,291

 
$

 
$
30,291

 
$

Interest rate swap
2,644

 

 
2,644

 

Fixed index annuities - embedded derivatives
5,574,653

 

 

 
5,574,653

 
$
5,607,588

 
$

 
$
32,935

 
$
5,574,653


10

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 further quotes or prices from additional parties as needed. In addition, for our callable United States Government sponsored agencies, we obtain multiple broker quotes and take the average of the broker prices received. 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 September 30, 2015 and December 31, 2014.
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 current 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 and appraised property values); 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
None of the financial instruments included in other investments are measured at fair value on a recurring basis. Financial instruments included in other investments 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 value 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 value of our equity method investments qualify as Level 3 fair values and were determined by calculating the present value of future cash flows discounted by a risk free rate, a risk spread and a liquidity discount. The risk spread and liquidity discount are rates determined by our investment professionals and are unobservable market inputs. The fair value of our COLI approximates the cash surrender value of the policies and whose fair values fall within Level 2 of the fair value hierarchy.

11

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 projected LIBOR rates for the term of the swap and caps.
2015 notes hedges
The fair value of these call options was determined by a third party who applies market observable data such as our common stock price, its dividend yield and its volatility, as well as the time to expiration of the call options to determine a fair value of the buy side of these options.
Counterparty collateral
Amounts reported in other assets on 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 purchased 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 and convertible senior 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.
2015 notes embedded conversion derivative
The fair value of this embedded derivative was determined by pricing the call options that hedge this potential liability. The terms of the conversion option are identical to the 2015 notes hedges and the method of determining fair value of the call options is based upon observable market data.
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.

12

Table of Contents

The following tables provide a reconciliation of the beginning and ending balances for our Level 3 assets and liabilities, which are measured at fair value on a recurring basis using significant unobservable inputs for the three and nine months ended September 30, 2015 and 2014:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
 
(Dollars in thousands)
Available for sale securities
 
 
 
 
 
 
 
Beginning balance
$
26

 
$
668

 
$
375

 
$
1,376

Principal returned
(2
)
 
(68
)
 
(23
)
 
(260
)
Amortization of premium/accretion of discount
(28
)
 
1

 
(494
)
 
(164
)
Total gains (losses) (realized/unrealized):
 
 
 
 
 
 
 
Included in other comprehensive income (loss)
4

 
127

 
280

 
(19
)
Included in operations

 
(202
)
 
(138
)
 
(407
)
Ending balance
$

 
$
526

 
$

 
$
526

The Level 3 assets included in the table above are not material to our financial position, results of operations or cash flows, and it is management's opinion that the sensitivity of the inputs used in determining the fair value of these assets is not material as well.
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
 
(Dollars in thousands)
Fixed index annuities - embedded derivatives
 
 
 
 
 
 
 
Beginning balance
$
5,984,007

 
$
5,119,823

 
$
5,574,653

 
$
4,406,163

Premiums less benefits
207,141

 
496,295

 
1,020,853

 
1,294,024

Change in fair value, net
(460,031
)
 
(354,564
)
 
(864,389
)
 
(438,633
)
Ending balance
$
5,731,117

 
$
5,261,554

 
$
5,731,117

 
$
5,261,554

Change in fair value, net for each period in our embedded derivatives are 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 September 30, 2015, were to increase by 100 basis points, the fair value of the embedded derivatives would decrease by $383.9 million recorded through operations as a decrease in the change in fair value of embedded derivatives and there would be a corresponding decrease of $269.2 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 $429.3 million recorded through operations as an increase in the change in fair value of embedded derivatives and there would be a corresponding increase of $223.8 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.

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Table of Contents

3. Investments
At September 30, 2015 and December 31, 2014, the amortized cost and fair value of fixed maturity securities and equity securities were as follows:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair Value
 
(Dollars in thousands)
September 30, 2015
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
Available for sale:
 
 
 
 
 
 
 
United States Government full faith and credit
$
36,355

 
$
1,437

 
$
(111
)
 
$
37,681

United States Government sponsored agencies
1,286,586

 
35,864

 
(7,702
)
 
1,314,748

United States municipalities, states and territories
3,405,519

 
363,590

 
(8,221
)
 
3,760,888

Foreign government obligations
210,941

 
16,199

 
(10,153
)
 
216,987

Corporate securities
22,738,792

 
1,135,974

 
(415,018
)
 
23,459,748

Residential mortgage backed securities
1,431,656

 
126,485

 
(1,833
)
 
1,556,308

Commercial mortgage backed securities
3,881,487

 
90,536

 
(30,160
)
 
3,941,863

Other asset backed securities
1,066,994

 
45,295

 
(10,670
)
 
1,101,619

 
$
34,058,330

 
$
1,815,380

 
$
(483,868
)
 
$
35,389,842

Held for investment:
 
 
 
 
 
 
 
Corporate security
$
76,574

 
$

 
$
(14,574
)
 
$
62,000

 
 
 
 
 
 
 
 
Equity securities, available for sale:
 
 
 
 
 
 
 
Finance, insurance, and real estate
$
7,514

 
$
319

 
$

 
$
7,833

 
 
 
 
 
 
 
 
December 31, 2014
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
Available for sale:
 
 
 
 
 
 
 
United States Government full faith and credit
$
137,710

 
$
765

 
$
(15
)
 
$
138,460

United States Government sponsored agencies
1,364,424

 
43,399

 
(13,933
)
 
1,393,890

United States municipalities, states and territories
3,293,551

 
430,469

 
(711
)
 
3,723,309

Foreign government obligations
181,128

 
16,628

 
(3,953
)
 
193,803

Corporate securities
19,984,747

 
1,628,941

 
(123,396
)
 
21,490,292

Residential mortgage backed securities
1,616,846

 
136,704

 
(2,205
)
 
1,751,345

Commercial mortgage backed securities
2,720,294

 
90,649

 
(3,323
)
 
2,807,620

Other asset backed securities
906,346

 
48,022

 
(7,885
)
 
946,483

 
$
30,205,046

 
$
2,395,577

 
$
(155,421
)
 
$
32,445,202

Held for investment:
 
 
 
 
 
 
 
Corporate security
$
76,432

 
$

 
$
(594
)
 
$
75,838

 
 
 
 
 
 
 
 
Equity securities, available for sale:
 
 
 
 
 
 
 
Finance, insurance, and real estate
$
7,509

 
$
296

 
$

 
$
7,805

At September 30, 2015, 33% of our fixed income securities have call features, of which 2.0% ($0.7 billion) were subject to call redemption and another 0.4% ($0.1 billion) will become subject to call redemption during the next twelve months. Approximately 66% of our fixed income securities that have call features are not callable until within six months of their stated maturities.

14

Table of Contents

The amortized cost and fair value of fixed maturity securities at September 30, 2015, 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
$
134,699

 
$
138,612

 
$

 
$

Due after one year through five years
1,818,945

 
1,969,759

 

 

Due after five years through ten years
9,951,489

 
10,005,018

 

 

Due after ten years through twenty years
8,419,743

 
8,976,207

 

 

Due after twenty years
7,353,317

 
7,700,456

 
76,574

 
62,000

 
27,678,193

 
28,790,052

 
76,574

 
62,000

Residential mortgage backed securities
1,431,656

 
1,556,308

 

 

Commercial mortgage backed securities
3,881,487

 
3,941,863

 

 

Other asset backed securities
1,066,994

 
1,101,619

 

 

 
$
34,058,330

 
$
35,389,842

 
$
76,574

 
$
62,000

Net unrealized gains on available for sale fixed maturity securities and equity securities reported as a separate component of stockholders' equity were comprised of the following:
 
September 30, 2015
 
December 31, 2014
 
(Dollars in thousands)
Net unrealized gains on available for sale fixed maturity securities and equity securities
$
1,331,831

 
$
2,240,452

Adjustments for assumed changes in amortization of deferred policy acquisition costs and deferred sales inducements
(710,260
)
 
(1,165,271
)
Deferred income tax valuation allowance reversal
22,534

 
22,534

Deferred income tax expense
(217,550
)
 
(376,314
)
Net unrealized gains reported as accumulated other comprehensive income
$
426,555

 
$
721,401

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 98% of our fixed maturity portfolio rated investment grade at both September 30, 2015 and December 31, 2014.
The following table summarizes the credit quality, as determined by NAIC designation, of our fixed maturity portfolio as of the dates indicated:
 
 
September 30, 2015
 
December 31, 2014
NAIC
Designation
 
Amortized Cost
 
Fair Value
 
Amortized Cost
 
Fair Value
 
 
(Dollars in thousands)
1
 
$
21,918,272

 
$
23,171,086

 
$
19,223,151

 
$
20,941,634

2
 
11,432,147

 
11,581,162

 
10,432,593

 
10,981,618

3
 
745,289

 
679,289

 
602,191

 
583,313

4
 
31,042

 
17,256

 
22,888

 
14,089

5
 

 

 

 

6
 
8,154

 
3,049

 
655

 
386

 
 
$
34,134,904

 
$
35,451,842

 
$
30,281,478

 
$
32,521,040


15

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 855 and 402 securities, respectively) have been in a continuous unrealized loss position, at September 30, 2015 and December 31, 2014:
 
Less than 12 months
 
12 months or more
 
Total
 
Fair Value
 
Unrealized
Losses
 
Fair Value
 
Unrealized
Losses
 
Fair Value
 
Unrealized
Losses
 
(Dollars in thousands)
September 30, 2015
 
 
 
 
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
 
 
 
 
Available for sale:
 
 
 
 
 
 
 
 
 
 
 
United States Government full faith and credit
$
7,431

 
$
(111
)
 
$

 
$

 
$
7,431

 
$
(111
)
United States Government sponsored agencies
589,545

 
(7,702
)
 

 

 
589,545

 
(7,702
)
United States municipalities, states and territories
217,954

 
(8,115
)
 
2,894

 
(106
)
 
220,848

 
(8,221
)
Foreign government obligations
43,821

 
(898
)
 
15,400

 
(9,255
)
 
59,221

 
(10,153
)
Corporate securities:
 
 
 
 
 
 
 
 
 
 
 
Finance, insurance and real estate
1,552,033

 
(38,683
)
 
51,196

 
(13,569
)
 
1,603,229

 
(52,252
)
Manufacturing, construction and mining
2,735,903

 
(155,795
)
 
319,447

 
(77,062
)
 
3,055,350

 
(232,857
)
Utilities and related sectors
1,681,159

 
(74,879
)
 
67,812

 
(9,995
)
 
1,748,971

 
(84,874
)
Wholesale/retail trade
335,950

 
(13,414
)
 
41,296

 
(6,234
)
 
377,246

 
(19,648
)
Services, media and other
692,146

 
(24,241
)
 
33,986

 
(1,146
)
 
726,132

 
(25,387
)
Residential mortgage backed securities
51,190

 
(1,180
)
 
7,110

 
(653
)
 
58,300

 
(1,833
)
Commercial mortgage backed securities
1,283,393

 
(30,043
)
 
4,768

 
(117
)
 
1,288,161

 
(30,160
)
Other asset backed securities
166,719

 
(3,140
)
 
48,641

 
(7,530
)
 
215,360

 
(10,670
)
 
$
9,357,244

 
$
(358,201
)
 
$
592,550

 
$
(125,667
)
 
$
9,949,794

 
$
(483,868
)
Held for investment:
 
 
 
 
 
 
 
 
 
 
 
Corporate security:
 
 
 
 
 
 
 
 
 
 
 
Insurance
$
62,000

 
$
(14,574
)
 
$

 
$

 
$
62,000

 
$
(14,574
)
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2014
 
 
 
 
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
 
 
 
 
Available for sale:
 
 
 
 
 
 
 
 
 
 
 
United States Government full faith and credit
$

 
$

 
$
498

 
$
(15
)
 
$
498

 
$
(15
)
United States Government sponsored agencies

 

 
610,339

 
(13,933
)
 
610,339

 
(13,933
)
United States municipalities, states and territories

 

 
27,947

 
(711
)
 
27,947

 
(711
)
Foreign government obligations
14,194

 
(1,068
)
 
11,542

 
(2,885
)
 
25,736

 
(3,953
)
Corporate securities:
 
 
 
 
 
 
 
 
 
 
 
Finance, insurance and real estate
253,439

 
(2,586
)
 
399,874

 
(16,277
)
 
653,313

 
(18,863
)
Manufacturing, construction and mining
1,078,089

 
(35,151
)
 
694,088

 
(35,926
)
 
1,772,177

 
(71,077
)
Utilities and related sectors
373,952

 
(8,185
)
 
344,313

 
(10,153
)
 
718,265

 
(18,338
)
Wholesale/retail trade
88,766

 
(2,290
)
 
99,427

 
(3,122
)
 
188,193

 
(5,412
)
Services, media and other
131,940

 
(1,567
)
 
277,296

 
(8,139
)
 
409,236

 
(9,706
)
Residential mortgage backed securities
22,115

 
(1,219
)
 
20,427

 
(986
)
 
42,542

 
(2,205
)
Commercial mortgage backed securities
241,637

 
(1,344
)
 
187,241

 
(1,979
)
 
428,878

 
(3,323
)
Other asset backed securities
142,094

 
(3,519
)
 
58,958

 
(4,366
)
 
201,052

 
(7,885
)
 
$
2,346,226

 
$
(56,929
)
 
$
2,731,950

 
$
(98,492
)
 
$
5,078,176

 
$
(155,421
)
Held for investment:
 
 
 
 
 
 
 
 
 
 
 
Corporate security:
 
 
 
 
 
 
 
 
 
 
 
Insurance
$

 
$

 
$
75,838

 
$
(594
)
 
$
75,838

 
$
(594
)
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 September 30, 2015 are principally related to timing of the purchases of these securities, which carry less yield than those available at September 30, 2015. In addition, a general widening of credit spreads has occurred in risk asset classes and some financial and industrial sector credit spreads remain wide due to continued economic uncertainty and concerns of prolonged economic weakness.

16

Table of Contents

At September 30, 2015, we had no exposure to sub-prime residential mortgage backed securities. All of our residential mortgage backed securities are pools of first-lien residential mortgage loans. Substantially all of the securities that we own are in the most senior tranche of the securitization in which they are structured and are not subordinated to any other tranche. Our "Alt-A" residential mortgage backed securities are comprised of 34 securities with a total amortized cost basis of $215.4 million and a fair value of $238.8 million.
Approximately 82% and 78% of the unrealized losses on fixed maturity securities shown in the above table for September 30, 2015 and December 31, 2014, 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 and nine months ended September 30, 2015 and 2014 are as follows:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
 
(Dollars in thousands)
Fixed maturity securities held for investment carried at amortized cost
$
(3,753
)
 
$
4,883

 
$
(13,980
)
 
$
10,527

Investments carried at fair value:
 
 
 
 
 
 
 
Fixed maturity securities, available for sale
$
118,345

 
$
(54,291
)
 
$
(908,644
)
 
$
1,639,619

Equity securities, available for sale
(30
)
 
(7
)
 
23

 
(26
)
 
118,315

 
(54,298
)
 
(908,621
)
 
1,639,593

Adjustment for effect on other balance sheet accounts:
 
 
 
 
 
 
 
Deferred policy acquisition costs and deferred sales inducements
(60,198
)
 
38,699

 
455,011

 
(870,770
)
Deferred income tax asset/liability
(20,341
)
 
5,459

 
158,764

 
(269,088
)
 
(80,539
)
 
44,158

 
613,775

 
(1,139,858
)
Change in net unrealized gains on investments carried at fair value
$
37,776

 
$
(10,140
)
 
$
(294,846
)
 
$
499,735

Proceeds from sales of available for sale securities for the nine months ended September 30, 2015 and 2014 were $269.7 million and $141.8 million, respectively. Scheduled principal repayments, calls and tenders for available for sale securities for the nine months ended September 30, 2015 and 2014 were $1.0 billion and $1.1 billion, 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 (losses) on investments, excluding net OTTI losses for the three and nine months ended September 30, 2015 and 2014, are as follows:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
 
(Dollars in thousands)
Available for sale fixed maturity securities:
 
 
 
 
 
 
 
Gross realized gains
$
283

 
$
179

 
$
4,783

 
$
1,536

Gross realized losses
(97
)
 
(148
)
 
(897
)
 
(910
)
 
186

 
31

 
3,886

 
626

Other investments:
 
 
 
 
 
 
 
Gain on sale of real estate
2,245

 
455

 
3,278

 
1,493

Loss on sale of real estate

 

 
(575
)
 
(231
)
Impairment losses on real estate
(570
)
 
(1,436
)
 
(1,199
)
 
(2,235
)
 
1,675

 
(981
)
 
1,504

 
(973
)
Mortgage loans on real estate:
 
 
 
 
 
 
 
Decrease (increase) in allowance for credit losses
(702
)
 
(2,240
)
 
597

 
(5,787
)
Recovery of specific allowance

 

 
4,375

 

 
(702
)
 
(2,240
)
 
4,972

 
(5,787
)
 
$
1,159

 
$
(3,190
)
 
$
10,362

 
$
(6,134
)
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, 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.

17

Table of Contents

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;
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;
our assessment in the case of equity securities including perpetual preferred stocks with credit deterioration that the security cannot recover to cost in a reasonable period of time;
our intent and ability to retain equity securities for a period of time sufficient to allow for recovery;
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 and equity 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. For equity securities, we recognize an impairment charge in the period in which we do not have the intent and ability to hold the securities until recovery of cost or we determine that the security will not recover to book value within a reasonable period of time. We determine what constitutes a reasonable period of time on a security-by-security basis by considering all the evidence available to us, including the magnitude of any unrealized loss and its duration.
Other than temporary impairment losses on equity securities are recognized in operations. 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 or asset 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.

18

Table of Contents

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 nine months ended September 30, 2015 and 2014, 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
Nine months ended September 30, 2015
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Prime
 
2006
 
6.5
%
 
6.5
%
 
14
%
 
14
%
 
40
%
 
40
%
 
 
2007
 
5.8
%
 
7.0
%
 
15
%
 
21
%
 
45
%
 
55
%
Alt-A
 
2005
 
5.6
%
 
5.6
%
 
99
%
 
99
%
 
2
%
 
2
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Nine months ended September 30, 2014
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Prime
 
2005
 
7.5
%
 
7.5
%
 
15
%
 
15
%
 
50
%
 
50
%
 
 
2006
 
6.5
%
 
7.4
%
 
11
%
 
12
%
 
50
%
 
50
%
 
 
2007
 
7.0
%
 
7.0
%
 
14
%
 
14
%
 
55
%
 
55
%
Alt-A
 
2005
 
5.6
%
 
6.4
%
 
87
%
 
89
%
 
2
%
 
2
%
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.
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 in net income and amortized cost is written down to fair value. 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.

19

Table of Contents

The following table summarizes other than temporary impairments for the three and nine months ended September 30, 2015 and 2014, 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 September 30, 2015
 
 
 
 
 
 
 
Fixed maturity securities, available for sale:
 
 
 
 
 
 
 
Residential mortgage backed securities
3
 
$

 
$
(354
)
 
$
(354
)
Other asset backed securities
1
 
(10,000
)
 
5,125

 
(4,875
)
 
4
 
$
(10,000
)
 
$
4,771

 
$
(5,229
)
 
 
 
 
 
 
 
 
Three months ended September 30, 2014
 
 
 
 
 
 
 
Fixed maturity securities, available for sale:
 
 
 
 
 
 
 
Residential mortgage backed securities
3
 
$

 
$
(564
)
 
$
(564
)
 
 
 
 
 
 
 
 
Nine months ended September 30, 2015
 
 
 
 
 
 
 
Fixed maturity securities, available for sale:
 
 
 
 
 
 
 
Residential mortgage backed securities
7
 
$
(132
)
 
$
(1,182
)
 
$
(1,314
)
Other asset backed securities
1
 
(10,000
)
 
5,125

 
(4,875
)
 
8
 
$
(10,132
)
 
$
3,943

 
$
(6,189
)
 
 
 
 
 
 
 
 
Nine months ended September 30, 2014
 
 
 
 
 
 
 
Fixed maturity securities, available for sale:
 
 
 
 
 
 
 
Residential mortgage backed securities
6
 
$

 
$
(2,063
)
 
$
(2,063
)
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
September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
 
(Dollars in thousands)
Cumulative credit loss at beginning of period
$
(128,010
)
 
$
(127,459
)
 
$
(127,050
)
 
$
(125,960
)
Credit losses on securities for which OTTI has not previously been recognized
(4,876
)
 

 
(5,008
)
 

Additional credit losses on securities for which OTTI has previously been recognized
(353
)
 
(564
)
 
(1,181
)
 
(2,063
)
Accumulated losses on securities that were disposed of during the period
761

 

 
761

 

Cumulative credit loss at end of period
$
(132,478
)
 
$
(128,023
)
 
$
(132,478
)
 
$
(128,023
)

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Table of Contents

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 (loss), by major type of security, for securities that are part of our investment portfolio at September 30, 2015 and December 31, 2014:
 
Amortized Cost
 
OTTI
Recognized in
Other
Comprehensive
Income
 
Change in Fair
Value Since
OTTI was
Recognized
 
Fair Value
 
(Dollars in thousands)
September 30, 2015
 
 
 
 
 
 
 
Fixed maturity securities, available for sale:
 
 
 
 
 
 
 
Corporate securities
$

 
$

 
$
20

 
$
20

Residential mortgage backed securities
495,278

 
(171,632
)
 
205,140

 
528,786

Other asset backed securities
8,154

 
(5,125
)
 

 
3,029

 
$
503,432

 
$
(176,757
)
 
$
205,160

 
$
531,835

December 31, 2014
 
 
 
 
 
 
 
Fixed maturity securities, available for sale:
 
 
 
 
 
 
 
Corporate securities
$

 
$

 
$
11

 
$
11

Residential mortgage backed securities
569,508

 
(173,494
)
 
215,625

 
611,639

 
$
569,508

 
$
(173,494
)
 
$
215,636

 
$
611,650

4. Mortgage Loans on Real Estate
Our mortgage loan portfolio, summarized in the following table, totaled $2.5 billion at September 30, 2015 and $2.4 billion December 31, 2014, respectively, with commitments outstanding of $64.3 million at September 30, 2015.
 
September 30, 2015
 
December 31, 2014
 
(Dollars in thousands)
Principal outstanding
$
2,470,456

 
$
2,457,721

Loan loss allowance
(17,518
)
 
(22,633
)
Deferred prepayment fees
(536
)
 
(508
)
Carrying value
$
2,452,402

 
$
2,434,580


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Table of Contents

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:
 
September 30, 2015
 
December 31, 2014
 
Principal
 
Percent
 
Principal
 
Percent
 
(Dollars in thousands)
Geographic distribution
 
 
 
 
 
 
 
East
$
720,522

 
29.2
%
 
$
701,638

 
28.5
%
Middle Atlantic
160,946

 
6.5
%
 
166,249

 
6.8
%
Mountain
255,454

 
10.3
%
 
279,075

 
11.4
%
New England
13,267

 
0.5
%
 
12,280

 
0.5
%
Pacific
359,231

 
14.6
%
 
302,307

 
12.3
%
South Atlantic
451,123

 
18.3
%
 
471,849

 
19.2
%
West North Central
311,774

 
12.6
%
 
349,028

 
14.2
%
West South Central
198,139

 
8.0
%
 
175,295

 
7.1
%
 
$
2,470,456

 
100.0
%
 
$
2,457,721

 
100.0
%
Property type distribution
 
 
 
 
 
 
 
Office
$
417,122

 
16.9
%
 
$
484,585

 
19.7
%
Medical Office
84,843

 
3.4
%
 
88,275

 
3.6
%
Retail
768,210

 
31.1
%
 
711,775

 
29.0
%
Industrial/Warehouse
688,336

 
27.9
%
 
649,425

 
26.4
%
Hotel
3,412

 
0.1
%
 
30,640

 
1.3
%
Apartment
362,809

 
14.7
%
 
335,087

 
13.6
%
Mixed use/other
145,724

 
5.9
%
 
157,934

 
6.4
%
 
$
2,470,456

 
100.0
%
 
$
2,457,721

 
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
September 30, 2015
 
Three Months Ended
September 30, 2014
 
Specific
Allowance
 
General Allowance
 
Specific
Allowance
 
General Allowance
 
(Dollars in thousands)
Beginning allowance balance
$
(9,316
)
 
$
(7,500
)
 
$
(17,282
)
 
$
(9,300
)
Charge-offs

 

 
958

 

Change in provision for credit losses
(1,302
)
 
600

 
(1,040
)
 
(1,200
)
Ending allowance balance
$
(10,618
)
 
$
(6,900
)
 
$
(17,364
)
 
$
(10,500
)
 
 
 
 
 
 
 
 
 
Nine Months Ended
September 30, 2015
 
Nine Months Ended
September 30, 2014
 
Specific
Allowance
 
General Allowance
 
Specific
Allowance
 
General Allowance
 
(Dollars in thousands)
Beginning allowance balance
$
(12,333
)
 
$
(10,300
)
 
$
(16,847
)
 
$
(9,200
)
Charge-offs
143

 

 
3,715

 

Recoveries
4,375

 

 
255

 

Change in provision for credit losses
(2,803
)
 
3,400

 
(4,487
)
 
(1,300
)
Ending allowance balance
$
(10,618
)
 
$
(6,900
)
 
$
(17,364
)
 
$
(10,500
)
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:
 
September 30, 2015
 
December 31, 2014
 
(Dollars in thousands)
Individually evaluated for impairment
$
27,244

 
$
29,116

Collectively evaluated for impairment
2,443,212

 
2,428,605

Total loans evaluated for impairment
$
2,470,456

 
$
2,457,721

Charge-offs include allowances that have been established on loans that were satisfied by taking ownership of the collateral. 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).
During the three and nine months ended September 30, 2015, no mortgage loans were satisfied by taking ownership of any real estate serving as collateral compared to one and six mortgage loans for the same periods in 2014. The following table summarizes the activity in the real estate owned, included in Other investments, which was obtained in satisfaction of mortgage loans on real estate:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
 
(Dollars in thousands)
Real estate owned at beginning of period
$
12,958

 
$
24,606

 
$
20,238

 
$
22,844

Real estate acquired in satisfaction of mortgage loans

 
1,748

 

 
11,755

Additions
120

 

 
120

 

Sales
(2,761
)
 
(2,431
)
 
(9,241
)
 
(9,579
)
Impairments
(570
)
 
(1,436
)
 
(1,199
)
 
(2,235
)
Depreciation
(53
)
 
(153
)
 
(224
)
 
(451
)
Real estate owned at end of period
$
9,694

 
$
22,334

 
$
9,694

 
$
22,334


23

Table of Contents

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.
 
September 30, 2015
 
December 31, 2014
 
(Dollars in thousands)
Credit Exposure--By Payment Activity
 
 
 
Performing
$
2,443,679

 
$
2,451,760

In workout
10,739

 

Delinquent

 

Collateral dependent
16,038

 
5,961

 
$
2,470,456

 
$
2,457,721

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. Outstanding principal of loans in a non-accrual status at September 30, 2015 and December 31, 2014 totaled $16.0 million and $6.0 million, respectively.
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.
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
 
 
 
 
 
 
 
 
 
 
 
 
 
September 30, 2015
$

 
$

 
$

 
$

 
$
2,454,418

 
$
16,038

 
$
2,470,456

December 31, 2014
$

 
$

 
$

 
$

 
$
2,451,760

 
$
5,961

 
$
2,457,721


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Table of Contents

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)
September 30, 2015
 
 
 
 
 
Mortgage loans with an allowance
$
16,626

 
$
27,244

 
$
(10,618
)
Mortgage loans with no related allowance
13,396

 
13,396

 

 
$
30,022

 
$
40,640

 
$
(10,618
)
December 31, 2014
 
 
 
 
 
Mortgage loans with an allowance
$
16,783

 
$
29,116

 
$
(12,333
)
Mortgage loans with no related allowance
2,656

 
2,656

 

 
$
19,439

 
$
31,772

 
$
(12,333
)
 
Average Recorded Investment
 
Interest Income Recognized
 
(Dollars in thousands)
Three months ended September 30, 2015
 
 
 
Mortgage loans with an allowance
$
17,336

 
$
44

Mortgage loans with no related allowance
13,414

 
176

 
$
30,750

 
$
220

Three months ended September 30, 2014
 
 
 
Mortgage loans with an allowance
$
22,157

 
$
539

Mortgage loans with no related allowance
2,656

 

 
$
24,813

 
$
539

Nine months ended September 30, 2015
 
 
 
Mortgage loans with an allowance
$
17,649

 
$
866

Mortgage loans with no related allowance
13,432

 
595

 
$
31,081

 
$
1,461

Nine months ended September 30, 2014
 
 
 
Mortgage loans with an allowance
$
23,580

 
$
1,696

Mortgage loans with no related allowance
2,656

 

 
$
26,236

 
$
1,696

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.

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If the borrower is determined to be in financial difficulty, we consider the following conditions to determine if the borrower was 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 September 30, 2015 and December 31, 2014 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)
September 30, 2015
 
 
 
 
 
 
 
 
South Atlantic
 
6
 
$
10,878

 
$
(2,992
)
 
$
7,886

East North Central
 
2
 
3,345

 
(467
)
 
2,878

West North Central
 
2
 
7,790

 
(1,046
)
 
6,744

 
 
10
 
$
22,013

 
$
(4,505
)
 
$
17,508

December 31, 2014
 
 
 
 
 
 
 
 
South Atlantic
 
7
 
$
14,475

 
$
(4,244
)
 
$
10,231

East North Central
 
1
 
2,177

 
(467
)
 
1,710

West North Central
 
1
 
1,881

 
(1,047
)
 
834

 
 
9
 
$
18,533

 
$
(5,758
)
 
$
12,775

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 and derivative instruments embedded in a convertible debt issue, presented in the consolidated balance sheets are as follows:
 
September 30, 2015
 
December 31, 2014
 
(Dollars in thousands)
Assets
 
 
 
Derivative instruments
 
 
 
Call options
$
180,649

 
$
731,113

Other assets
 
 
 
2015 notes hedges

 
30,291

Interest rate caps
1,492

 
2,778

 
$
182,141

 
$
764,182

Liabilities
 
 
 
Policy benefit reserves - annuity products
 
 
 
Fixed index annuities - embedded derivatives
$
5,731,117

 
$
5,574,653

Other liabilities
 
 
 
2015 notes embedded conversion derivative

 
30,291

Interest rate swap
4,528

 
2,644

 
$
5,735,645

 
$
5,607,588


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The changes in fair value of derivatives included in the unaudited consolidated statements of operations are as follows:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
 
(Dollars in thousands)
Change in fair value of derivatives:
 
 
 
 
 
 
 
Call options
$
(347,038
)
 
$
45,931

 
$
(396,399
)
 
$
391,173

2015 notes hedges
(1,141
)
 
(6,823
)
 
(4,516
)
 
(27,124
)
Interest rate swap
(2,349
)
 
254

 
(3,283
)
 
(2,996
)
Interest rate caps
(832
)
 
(144
)
 
(1,286
)
 
(2,459
)
 
$
(351,360
)
 
$
39,218

 
$
(405,484
)
 
$
358,594

Change in fair value of embedded derivatives:
 
 
 
 
 
 
 
Fixed index annuities—embedded derivatives
$
(413,583
)
 
$
(188,383
)
 
$
(578,596
)
 
$
9,704

2015 notes embedded conversion derivative
(1,141
)
 
(6,823
)
 
(4,516
)
 
(31,356
)
 
$
(414,724
)
 
$
(195,206
)
 
$
(583,112
)
 
$
(21,652
)
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.
Our strategy attempts to mitigate any potential risk of loss under these agreements 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:
 
 
 
 
 
 
September 30, 2015
 
December 31, 2014
Counterparty
 
Credit Rating
(S&P)
 
Credit Rating (Moody's)
 
Notional
Amount
 
Fair Value
 
Notional
Amount
 
Fair Value
 
 
 
 
 
 
(Dollars in thousands)
Bank of America
 
A
 
A1
 
$
5,415,765

 
$
33,313

 
$
2,114,812

 
$
62,932

Barclays
 
A-
 
A2
 
2,816,999

 
30,954

 
4,083,259

 
135,609

BNP Paribas
 
A+
 
A1
 
1,749,912

 
15,409

 
1,321,136

 
42,644

Citibank, N.A.
 
A
 
A1
 
3,314,018

 
6,834

 
3,190,204

 
96,759

Credit Suisse
 
A
 
A1
 
1,517,315

 
8,875

 
2,354,811

 
75,381

Deutsche Bank
 
BBB+
 
A3
 
1,733,406

 
1,537

 
2,682,960

 
64,028

HSBC
 
AA-
 
Aa3
 

 

 
38,599

 
1,767

J.P. Morgan
 
A+
 
Aa3
 
703,532

 
2,309

 
401,804

 
13,488

Morgan Stanley
 
A-
 
A3
 
3,622,471

 
19,178

 
2,605,687

 
77,106

Royal Bank of Canada
 
AA-
 
Aa3
 
2,265,389

 
22,342

 
1,364,362

 
41,717

SunTrust
 
A-
 
Baa1
 
836,304

 
4,096

 
248,622

 
5,405

Wells Fargo
 
AA-
 
Aa2
 
4,043,630

 
35,802

 
3,550,188

 
114,277

 
 
 
 
 
 
$
28,018,741

 
$
180,649

 
$
23,956,444

 
$
731,113


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As of September 30, 2015 and December 31, 2014, we held $98.0 million and $743.0 million, 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 $82.8 million and $47.4 million at September 30, 2015 and December 31, 2014, 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. During the nine months ended September 30, 2014, we revised future period assumptions for lapse rates and the expected costs of annual call options used in determining fixed index annuity embedded derivatives. These revisions decreased the change in fair value of embedded derivatives for the nine months ended September 30, 2014 by $62.6 million, which after related adjustments to deferred sales inducements and deferred policy acquisition costs and income taxes, increased net income and earnings per common share - assuming dilution by $14.8 million and $0.19, respectively.
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, 2014 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 London Interbank Offered Rate ("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
 
 
 
September 30, 2015
 
December 31, 2014
Maturity Date
 
Amount
 
Receive Rate
 
Rate
 
Counterparty
 
Fair Value
 
Fair Value
 
 
 
 
 
 
 
 
 
 
(Dollars in thousands)
March 15, 2021
 
$
85,500

 
LIBOR
 
2.415
%
 
SunTrust
 
$
(4,528
)
 
$
(2,644
)
Details regarding the interest rate caps are as follows:
 
 
Notional
 
 
 
Cap
 
 
 
September 30, 2015
 
December 31, 2014
Maturity Date
 
Amount
 
Floating Rate
 
Rate
 
Counterparty
 
Fair Value
 
Fair Value
 
 
 
 
 
 
 
 
 
 
(Dollars in thousands)
July 7, 2021
 
$
40,000

 
LIBOR
 
2.50
%
 
SunTrust
 
$
748

 
$
1,398

July 8, 2021
 
12,000

 
LIBOR
 
2.50
%
 
SunTrust
 
225

 
420

July 29, 2021
 
27,000

 
LIBOR
 
2.50
%
 
SunTrust
 
519

 
960

 
 
$
79,000

 
 
 
 
 
 
 
$
1,492

 
$
2,778

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. As of September 30, 2015, we deposited $2.8 million of collateral with the counterparty to the swap and caps.
In September 2010, concurrently with the issuance of $200.0 million principal amount of 3.50% Convertible Senior Notes due September 15, 2015 (the "2015 notes"), we entered into hedge transactions (the "2015 notes hedges") with two counterparties whereby we would receive the cash equivalent of the conversion spread on 16.0 million shares of our common stock based upon a strike price of $12.50 per share, subject to certain conversion rate adjustments in the 2015 notes. The number of shares and strike price of the 2015 notes hedges are subject to adjustment based on dividends we pay subsequent to their purchase. At December 31, 2014, as a result of partial unwind transactions executed in 2013 and 2014 and cash dividend adjustments, we had 2015 notes hedges outstanding on 1.8 million shares of our common stock at a strike price of $12.25 per share. The 2015 notes hedges expired on September 15, 2015, and we received $25.8 million in cash. The 2015 notes hedges were accounted for as derivative assets and were included in other assets in our consolidated balance sheets. The 2015 notes embedded conversion derivative liability was settled with the extinguishment of the 2015 notes (see Note 6) whereby we paid holders of the notes a total of $25.8 million in cash to settle the conversion premium. The 2015 notes hedges and 2015 notes embedded conversion derivative were adjusted to fair value each reporting period and unrealized gains and losses are reflected in our consolidated statements of operations.
In separate transactions, we sold warrants (the "2015 warrants") to the 2015 notes hedges counterparties for the purchase of up to 16.0 million shares of our common stock at a price of $16.00 per share. We received $15.6 million in cash proceeds from the sale of the 2015 warrants, which was recorded as an increase in additional paid-in capital. The number of shares and strike price of the warrants are subject to adjustment based on dividends we pay subsequent to selling the warrants. The warrants expire on various dates from December 2015 through March 2016 and are intended to be settled in net shares. Changes in the fair value of these warrants will not be recognized in our consolidated financial statements as long as the instruments remain classified as equity. At September 30, 2015 and December 31, 2014, as a result of partial unwind transactions executed in 2013 and 2014 and cash dividend adjustments, we had 2015 warrants outstanding on 1.8 million shares of our common stock at a strike price of $15.68 per share.

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At September 30, 2015 and 2014, the remaining 2015 warrants were dilutive as the average price of our common stock exceeded the strike price of the 2015 warrants and the effect has been included in diluted earnings per share for the three and nine months ended September 30, 2015 and 2014.
6. Notes Payable
The carrying amount of the 2015 notes and the amount by which the if-converted value exceeds the outstanding principal for the 2015 notes is as follows:
 
September 30, 2015
 
December 31, 2014
 
(Dollars in thousands)
Principal amount of liability component
$

 
$
22,377

Unamortized discount

 
(698
)
Net carrying amount of liability component
$

 
$
21,679

 
 
 
 
Amount by which the if-converted value exceeds principal
$

 
$
30,497

The discount was amortized over the expected life of the 2015 notes, which was the maturity date of September 15, 2015. The effective interest rate for the 2015 notes was 8.9%. The interest cost recognized in operations for the convertible notes, inclusive of the coupon and amortization of the discount and debt issue costs, was $0.4 million and $1.4 million for the three and nine months ended September 30, 2015, compared to $1.9 million and $7.6 million for the same periods in 2014. The 2015 notes were excluded from the dilutive effect in our diluted earnings per share calculation as they were intended to be, and were, settled only in cash.
The 2015 notes matured and were extinguished on September 15, 2015. Total consideration paid to holders of the 2015 notes at maturity was $48.2 million in cash, which included $22.4 million principal amount and $25.8 million conversion premium. See Note 5 for a discussion of the settlement of the 2015 notes embedded derivative liability.
During the nine months ended September 30, 2014, we extinguished $36.2 million principal amount of our 2029 notes and $46.5 million principal amount of our 2015 notes. Total consideration paid to holders of the 2029 notes consisted of $66.8 million in cash and and $23.2 million in shares of our common stock (946,793 shares). The carrying value of the 2029 notes at extinguishment was $34.6 million which resulted in a loss of $2.5 million on extinguishment of debt, net of income taxes. Total consideration paid to holders of the 2015 notes consisted of $52.9 million in cash and $33.1 million in shares of our common stock (1,496,664 shares). The carrying value of the 2015 notes at extinguishment was $43.8 million which resulted in a loss of $5.4 million, net of income taxes.
We have a $140 million unsecured revolving line of credit agreement with five banks that terminates on November 22, 2017. The interest rate is floating at a rate based on our election that will be equal to the alternate base rate (as defined in the credit agreement) plus the applicable margin or the adjusted LIBOR rate (as defined in the credit agreement) plus the applicable margin. We also pay a commitment fee based on the available unused portion of the credit facility. The applicable margin and commitment fee rate are based on our credit rating and can change throughout the period of the credit facility. Based upon our current credit rating, the applicable margin is 0.75% for alternate base rate borrowings and 1.75% for adjusted LIBOR rate borrowings, and the commitment fee is 0.30%. Under this agreement, we are required to maintain a minimum risk-based capital ratio at our subsidiary, American Equity Investment Life Insurance Company ("American Equity Life"), of 275%, a maximum ratio of adjusted debt to total adjusted capital of 0.35, and a minimum level of statutory surplus at American Equity Life equal to the sum of 1) 80% of statutory surplus at September 30, 2013, 2) 50% of the statutory net income for each fiscal quarter ending after September 30, 2013, and 3) 50% of all capital contributed to American Equity Life after September 30, 2013. The agreement contains an accordion feature that allows us, on up to three occasions and subject to credit availability, to increase the credit facility by an additional $50 million in the aggregate. We also have the ability to extend the maturity date by an additional one year past the initial maturity date of November 22, 2017 with the consent of the extending banks. There are currently no guarantors of the credit facility, but certain of our subsidiaries must guarantee our obligations under the credit agreement if such subsidiaries guarantee other material amounts of our debt. No amounts were outstanding at September 30, 2015 and December 31, 2014. As of September 30, 2015, $577.5 million is unrestricted and could be distributed to shareholders and still be in compliance with all covenants under this credit agreement.
As part of our investment strategy, we enter into securities repurchase agreements (short-term collateralized borrowings). The maximum amount borrowed was $40.6 million and $138.7 million during the nine months ended September 30, 2015 and 2014, respectively. 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 $0.6 million for the nine months ended September 30, 2015 compared to $0.9 million and $9.4 million for the three and nine months ended September 30, 2014. We had no borrowings under repurchase agreements during the three months ended September 30, 2015. The weighted average interest rate on amounts due under repurchase agreements was 0.39% for the nine months ended September 30, 2015 compared to 0.35% and 0.15% for the three and nine months ended September 30, 2014.

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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 SEC, FINRA, the Department of Labor, 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.
Companies in the life insurance and annuity business have faced litigation, including class action lawsuits, alleging improper product design, improper sales practices and similar claims. We were a defendant in a purported class action, McCormack, et al. v. American Equity Investment Life Insurance Company, et al., in the United States District Court for the Central District of California, Western Division and Anagnostis v. American Equity, et al., coordinated in the Central District, entitled, In Re: American Equity Annuity Practices and Sales Litigation (complaint filed September 7, 2005) (the "Los Angeles Case"), involving allegations of improper sales practices and similar claims.
The Los Angeles Case was a consolidated action involving several lawsuits filed by putative class members seeking class action status for a national class of purchasers of annuities issued by us. On July 30, 2013, the parties entered into a settlement agreement and stipulated to certification of the case as a class action for settlement purposes only. Notice of the terms of the settlement was mailed to the members of the class on October 7, 2013 and settlement claim forms were due from members of the class on or before December 6, 2013. On January 27, 2014, a hearing was held regarding the fairness of the settlement. On January 29, 2014, the District Court signed a final order approving the settlement and finding the settlement is fair and represents a complete resolution of all claims asserted on behalf of the class. On January 30, 2014, a final judgment was entered dismissing the case on the merits and with prejudice. On February 28, 2014, a member of the class filed an appeal of the District Court's approval of the terms of the settlement agreement with the United States Court of Appeals for the Ninth Circuit.
We recorded an estimated litigation liability of $17.5 million during the third quarter of 2012 related to the Los Angeles Case. We increased our estimated litigation liability for this matter to $21.2 million during the fourth quarter of 2013 following the passage of the deadline for submission of claims by class members in the lawsuit and based upon information available at that time. However, we decreased the liability by $2.3 million in the first quarter of 2014 as additional information became available concerning the nature and magnitude of the claims received. In addition, during the first quarter of 2014, we paid $7.8 million in legal fees to the plaintiffs' counsel. The estimated litigation liability at September 30, 2015 is $11.1 million. While review of the claim forms has been stayed due to the appeal and it is difficult to predict the amount of the liabilities that will ultimately result from the completion of the claims process, the $11.1 million litigation liability represents our best estimate of probable loss with respect to this litigation. In light of the inherent uncertainties involved in the matter described above, there can be no assurance that such litigation, or any other 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 September 30, 2015 to limited partnerships of $28.5 million and to secured bank loans of $13.9 million.

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8. Earnings Per Share and Stockholders' Equity
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
September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
 
(Dollars in thousands, except per share data)
Numerator:
 
 
 
 
 
 
 
Net income - numerator for earnings per common share
$
97,306

 
$
67,815

 
$
186,054

 
$
94,806

 
 
 
 
 
 
 
 
Denominator:
 
 
 
 
 
 
 
Weighted average common shares outstanding (1)
79,675,955

 
75,082,852

 
77,994,602

 
74,030,290

Effect of dilutive securities:
 
 
 
 
 
 
 
Convertible senior notes

 
1,982,089

 

 
2,485,974

2015 warrants and equity forward sale agreements
714,980

 
1,230,020

 
766,795

 
1,730,077

Stock options and deferred compensation agreements
981,271

 
1,115,927

 
1,076,166

 
1,185,973

Restricted stock and restricted stock units
186,430

 
56,222

 
139,747

 
44,944

Denominator for earnings per common share - assuming dilution
81,558,636

 
79,467,110

 
79,977,310

 
79,477,258

 
 
 
 
 
 
 
 
Earnings per common share
$
1.22

 
$
0.90

 
$
2.39

 
$
1.28

Earnings per common share - assuming dilution
$
1.19

 
$
0.85

 
$
2.33

 
$
1.19


(1)
Weighted average common shares outstanding include shares vested under the NMO Deferred Compensation Plan and exclude unallocated shares held by the ESOP.
Options to purchase shares of our common stock that were outstanding during the respective periods indicated but were not included in the computation of diluted earnings per share because the options' exercise price was greater than the average market price of the common shares are as follows:
Period
 
Number of
Shares
 
Range of
Exercise Prices
 
 
 
 
Minimum
 
Maximum
Three months ended September 30, 2015
 
 
$—
 
$—
Three months ended September 30, 2014
 
1,275,050
 
$24.79
 
$24.79
Nine months ended September 30, 2015
 
 
$—
 
$—
Nine months ended September 30, 2014
 
1,275,050
 
$24.79
 
$24.79
Stockholders' Equity
In August 2015, we completed an underwritten public offering of 8,600,000 shares of our common stock at a public offering price of $25.25 per share, of which 4,300,000 shares are subject to a forward sale agreement described below. The offering of 4,300,000 shares of our common stock (shares not subject to the forward sale agreement) resulted in initial net proceeds of approximately $104.5 million (after deducting fees and expenses related to the offering). The underwriters exercised in full their option to purchase 1,290,000 additional shares of common stock, which is subject to a separate forward sale agreement. Settlement of the forward sale agreements will occur on one or more dates occurring no later than 12 months after August 12, 2015, the closing date of the offering. We used the net proceeds from the offering for a capital contribution to the capital and surplus of our primary life insurance subsidiary. If we elect to exercise our rights to physically settle the forward sales agreements, we intend to use the net proceeds from the settlement for general corporate purposes, including contributions to the capital and surplus of our life insurance subsidiaries to support their continued growth and maintain desired financial strength ratings.
The forward sale agreements had no initial fair value since they were entered into at the then market price of the common stock. The forward sale agreements are equity instruments and they qualify for an exception from derivative and fair value accounting.

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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
Management's discussion and analysis reviews our unaudited consolidated financial position at September 30, 2015, and the unaudited consolidated results of operations for the three and nine month periods ended September 30, 2015 and 2014, 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, 2014.
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 Securities and Exchange Commission ("SEC"), press releases, presentations by us or our management or oral statements) relative to markets for our products and trends in our operations or financial results, as well as other statements including words such as "anticipate", "believe", "plan", "estimate", "expect", "intend", and other similar expressions, constitute forward-looking statements. 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, 2014 and Item 1A of our Quarterly Report on Form 10-Q for the three months ended March 31, 2015.
Overview
We specialize in the sale of individual annuities (primarily deferred annuities) and, to a lesser extent, we also sell life insurance policies. Under U.S. generally accepted accounting principles ("GAAP"), premium collections for deferred annuities are reported as deposit liabilities instead of as revenues. Similarly, cash payments to policyholders are reported as decreases in the liabilities for policyholder account balances and not as expenses. Sources of revenues for products accounted for as deposit liabilities are net investment income, surrender and other charges deducted from the account balances of policyholders, 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), 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 operating income while maintaining a high quality investment portfolio that will not experience significant losses from impairments of invested assets. Growth in invested assets is predicated on a continuation of attaining a high level of sales while at the same time maintaining a high level of retention of the funds received. The economic and personal investing environments continue 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. We are committed to maintaining a high quality investment portfolio with limited exposure to below investment grade securities and other riskier assets.
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
September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
Average yield on invested assets
4.79%
 
4.89%
 
4.77%
 
4.89%
Aggregate cost of money
1.96%
 
2.07%
 
1.96%
 
2.12%
Aggregate investment spread
2.83%
 
2.82%
 
2.81%
 
2.77%
 
 
 
 
 
 
 
 
Impact of:
 
 
 
 
 
 
 
Investment yield - additional prepayment income
0.14%
 
0.07%
 
0.08%
 
0.05%
Cost of money benefit of over hedging
0.02%
 
0.05%
 
0.05%
 
0.03%

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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, 2014. 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 (primarily costs to purchase call options) 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, 2014.
As reported in previous filings, in response to the persistent low interest rate environment, we have been reducing policyholder crediting rates for new annuities and existing annuities since the fourth quarter of 2011. Spread results for the 2015 and 2014 periods reflect the benefit from these reductions; however, the reductions in cost of money were offset by continued lower yields available on investments. We reduced new money crediting rates in early March of 2015 by approximately 0.20%. In addition, during the first quarter of 2015, we began to initiate additional renewal crediting rate reductions on existing policies. A portion of the 2015 renewal rate reductions occurred in the first three quarters of 2015 and the remaining will occur on policy anniversary dates over the next nine months. Our active management of renewal crediting rates will continue should the low investment yields currently available to us persist.
The current interest rate environment with low yields for investments with the credit quality we prefer presents a strong headwind to restoring our investment spread to the 3.00% target rate. With our portfolio yield still under pressure from lower rates on benchmark U.S. Treasury securities and narrower credit spreads, further adjustments to new and renewal crediting rates will be considered. We have on average 0.56% of room to reduce rates before we would reach guaranteed rates on the entire September 30, 2015 in force book of business.
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 to agents and bonuses credited to policyholders) and our ability to manage our operating expenses.
Results of Operations for the Three and Nine Months Ended September 30, 2015 and 2014
Annuity deposits by product type collected during the three and nine months ended September 30, 2015 and 2014, were as follows:
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
Product Type
 
2015
 
2014
 
2015
 
2014
 
 
(Dollars in thousands)
Fixed index annuities
 
$
1,764,179

 
$
1,041,449

 
$
4,748,612

 
$
2,883,106

Annual reset fixed rate annuities
 
8,425

 
10,959

 
32,612

 
43,359

Multi-year fixed rate annuities
 
45,032

 
13,741

 
132,249

 
90,391

Single premium immediate annuities
 
8,921

 
5,633

 
27,085

 
18,059

Total before coinsurance ceded
 
1,826,557

 
1,071,782

 
4,940,558

 
3,034,915

Coinsurance ceded
 
98,881

 
36,308

 
272,827

 
118,699

Net after coinsurance ceded
 
$
1,727,676

 
$
1,035,474

 
$
4,667,731

 
$
2,916,216

Annuity deposits before coinsurance ceded increased 70% during the third quarter of 2015 and 63% during the nine months ended September 30, 2015 compared to the same periods in 2014. We attribute these increases in sales to our attractive product offerings, our consistent presence in the fixed index annuity market, our continued strong relationships with and excellent service provided to our distribution partners, the withdrawal in the first quarter of 2015 of a competitor's guaranteed income product that had been the source of significant competition, the increased attractiveness of safe money products in volatile markets and lower interest rates on competing products such as bank certificates of deposit.
In August 2015, we completed an underwritten public offering of 9,890,000 shares of our common stock at a public offering price of $25.25 per share, of which 5,590,000 shares are subject to forward sale agreements. The forward sale agreements provide us with flexibility in managing our capital based upon sales levels. The net proceeds available to us through physical settlement of the forward sale agreements based on the forward sale price would be approximately $135.8 million. See Note 8 to our unaudited consolidated financial statements in this Form 10-Q for more information on this offering. We believe our existing statutory capital and surplus, the statutory surplus we expect to generate internally through statutory earnings and the capital raised through the public offering will be sufficient to support the level of sales we are currently experiencing.
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 liabilities outstanding (net of annuity liabilities ceded under coinsurance agreements) increased 15% to $38.9 billion for the third quarter of 2015 and 14% to $37.4 billion for the nine months ended September 30, 2015 compared to $33.8 billion and $32.9 billion for the same periods in 2014. Our investment spread measured in dollars was $239.5 million for the third quarter of 2015 and $688.9 million for the nine months ended September 30, 2015 compared to $206.8 million and $587.9 million for the same periods in 2014. As previously mentioned, our investment spread has been negatively impacted by the extended low interest rate environment (see Net investment income).

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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 and nine months ended September 30, 2015 was positively impacted by increases in the discount rates used to estimate the fair value of our embedded derivative liabilities. Net income for the three months ended September 30, 2014 was positively impacted by increases in the discount rates used to estimate our embedded derivative liabilities, while net income for the nine months ended September 30, 2014 was negatively impacted by decreases in the discount rates used to estimate our embedded derivative liabilities. The negative effect on net income for the nine months ended September 30, 2014 due to the decrease in discount rates was offset by revisions of assumptions used in determining fixed index annuity embedded derivatives that were made in the second quarter of 2014. These revisions, which consisted of changes in the lapse and expected costs of annual call options assumptions, decreased the change in fair value of embedded derivatives for the nine months ended September 30, 2014 by $62.6 million, which after related adjustments to deferred sales inducements and deferred policy acquisition costs and income taxes, increased net income for the nine months ended September 30, 2014 by $14.8 million. See Change in fair value of embedded derivatives.
We periodically revise the key assumptions used in the calculation of amortization of deferred policy acquisition costs and deferred sales inducements retrospectively through an unlocking process when estimates of current or future gross profits/margins (including the impact of realized investment gains and losses) to be realized from a group of products are revised. The impact of unlocking during the three and nine months ended September 30, 2015 was a $5.6 million decrease in amortization of deferred sales inducements and a $11.0 million decrease in amortization of deferred policy acquisition costs and included the impact of account balance true ups as of September 30, 2015 and adjustment to future period assumptions for investment spread and lapses. The unlocking process increased net income for the three and nine months ended September 30, 2015 by $10.7 million. The impact of unlocking during the three and nine months ended September 30, 2014 was a $12.6 million decrease in amortization of deferred sales inducements and a $35.5 million decrease in amortization of deferred policy acquisition costs and included the impact of account balance true ups as of September 30, 2014 and adjustment to future period assumptions for investment spread, lapses and certain expenses. The unlocking process increased net income for the three and nine months ended September 30, 2014 by $31.0 million.
Net income for the 2015 periods was negatively impacted by a revision of assumptions used in determining reserves held for living income benefit riders. The impact increased interest sensitive and index product benefits for the three and nine months ended September 30, 2015 by $18.3 million and decreased net income for the three and nine months ended September 30, 2015 by $11.8 million and included the impact of account balance true ups as of September 30, 2015 and adjustment to future period assumptions for the ages at which people elect to exercise the benefit and lapses. For the three and nine months ended September 30, 2014, the impact from the revision of these assumptions, which were consistent with unlocking for deferred policy acquisition costs and deferred sales inducements, increased interest sensitive and index product benefits by $12.4 million and decreased net income for the three and nine months ended September 30, 2014 by $8.0 million.
During the nine months ended September 30, 2015, we extinguished the remaining $22.4 million principal amount of our convertible notes. No gain or loss was recognized related to this extinguishment. During the nine months ended September 30, 2014, we extinguished $82.7 million principal amount of two issues of convertible notes. The loss on extinguishment of debt recognized was $10.6 million ($7.9 million after income taxes).
Operating income (a non-GAAP financial measure) decreased 28% to $45.9 million in the third quarter of 2015 and increased 4% to $145.7 million for the nine months ended September 30, 2015 compared to $64.0 million and $139.9 million for the same periods in 2014.
In addition to net income, we have consistently utilized operating income, a non-GAAP financial measure commonly used in the life insurance industry, as an economic measure to evaluate our financial performance. Operating income equals net income adjusted to eliminate the impact of net realized gains and losses on investments including net OTTI losses recognized in operations, fair value changes in derivatives and embedded derivatives, losses on extinguishment of debt and changes in litigation reserves. Because these items fluctuate from year to year in a manner unrelated to core operations, we believe measures excluding their impact are useful in analyzing operating trends. We believe the combined presentation and evaluation of operating income together with net income provides information that may enhance an investor's understanding of our underlying results and profitability.
Operating income is not a substitute for net income determined in accordance with GAAP. The adjustments made to derive operating income are important to understanding our overall results from operations and, if evaluated without proper context, 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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The adjustments made to net income to arrive at operating income for the three and nine months ended September 30, 2015 and 2014 are set forth in the table that follows:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
 
(Dollars in thousands)
Reconciliation of net income to operating income:
 
 
 
 
 
 
 
Net income
$
97,306

 
$
67,815

 
$
186,054

 
$
94,806

Adjustments to arrive at operating income:
 
 
 
 
 
 
 
Net realized (gains) losses and net OTTI losses on investments, net of offsets
1,639

 
1,551

 
(1,829
)
 
3,476

Change in fair value of derivatives and embedded derivatives - index annuities, net of offsets
(54,535
)
 
(4,957
)
 
(40,152
)
 
34,636

Change in fair value of derivatives and embedded derivatives - debt, net of income taxes
1,506

 
(427
)
 
1,606

 
29

Extinguishment of debt, net of income taxes

 

 

 
7,912

Litigation reserve, net of offsets

 

 

 
(916
)
Operating income
$
45,916

 
$
63,982

 
$
145,679

 
$
139,943

The amounts disclosed in the reconciliation above are net of income taxes and where applicable, are net of related adjustments to amortization of deferred sales inducements and deferred policy acquisition costs.
Operating income for the 2015 periods includes benefit from unlocking which decreased amortization of deferred sales inducements by $0.5 million and amortization of deferred acquisition costs by $4.3 million and increased operating income by $3.1 million for the three and nine months ended September 30, 2015. The three and nine months ended September 30, 2014 includes benefit from unlocking which decreased amortization of deferred sales inducements by $10.7 million and amortization of deferred acquisition costs by $33.0 million and increased operating income by $28.2 million.
Operating income for the 2015 periods also includes expense from a revision of assumptions used in determining reserves held for living income benefit riders which increased interest sensitive and index product benefits for the three and nine months ended September 30, 2015 by $18.3 million and decreased operating income for the three and nine months ended September 30, 2015 by $11.8 million. For the three and nine months ended September 30, 2014, the impact increased interest sensitive and index product benefits by $12.4 million and decreased operating income by $8.0 million.
Annuity product charges (surrender charges assessed against policy withdrawals and fees deducted from policyholder account balances for lifetime income benefit riders) increased 19% to $38.0 million in the third quarter of 2015 and 15% to $99.1 million for the nine months ended September 30, 2015 compared to $32.0 million and $86.5 million for the same periods in 2014. The components of annuity product charges are set forth in the table that follows:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
 
(Dollars in thousands)
Surrender charges
$
13,104

 
$
11,717

 
$
36,071

 
$
37,082

Lifetime income benefit riders (LIBR) fees
24,871

 
20,241

 
62,995

 
49,395

 
$
37,975

 
$
31,958

 
$
99,066

 
$
86,477

 
 
 
 
 
 
 
 
Withdrawals from annuity policies subject to surrender charges
$
106,939

 
$
66,476

 
$
288,135

 
$
252,993

Average surrender charge collected on withdrawals subject to surrender charges
12.3
%
 
17.6
%
 
12.5
%
 
14.7
%
 
 
 
 
 
 
 
 
Fund values on policies subject to LIBR fees
$
3,816,764

 
$
3,301,219

 
$
10,295,527

 
$
8,733,843

Weighted average per policy LIBR fee
0.65
%
 
0.61
%
 
0.61
%
 
0.57
%
The increases in annuity product charges were primarily attributable to increases in fees assessed for lifetime income benefit riders due to a larger volume of business in force subject to the fee. See Interest sensitive and index product benefits below for corresponding expense recognized on lifetime income benefit riders.

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Net investment income increased 13% to $436.1 million in the third quarter of 2015 and 11% to $1.3 billion for the nine months ended September 30, 2015 compared to $386.9 million and $1.1 billion for the same periods in 2014. These increases were principally attributable to the growth in our annuity business and a corresponding increase in our invested assets. Average invested assets excluding derivative instruments (on an amortized cost basis) increased 15% to $36.5 billion for the third quarter of 2015 and 14% to $35.1 billion for the nine months ended September 30, 2015 compared to $31.7 billion and $30.8 billion for the same periods in 2014. The average yield earned on average invested assets was 4.79% for the third quarter of 2015 and 4.77% for the nine months ended September 30, 2015 compared to 4.89% for both of the same periods in 2014.
The decreases in yield earned on average invested assets were attributable to yields on investments purchased in the first nine months of 2015 and in 2014 being lower than the overall portfolio yield. Additionally, net investment income and average yield were positively impacted by prepayment and fee income received resulting in additional net investment income of $13.1 million and $20.0 million for the three and nine months ended September 30, 2015 and $5.4 million and $10.5 million for the same periods in 2014, respectively.
Change in fair value of derivatives consists of call options purchased to fund annual index credits on fixed index annuities, the 2015 notes hedges related to our 2015 notes 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
September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
 
(Dollars in thousands)
Call options:
 
 
 
 
 
 
 
Gain (loss) on option expiration
$
(17,336
)
 
$
223,504

 
$
193,957

 
$
550,935

Change in unrealized gains/losses
(329,702
)
 
(177,573
)
 
(590,356
)
 
(159,762
)
2015 notes hedges
(1,141
)
 
(6,823
)
 
(4,516
)
 
(27,124
)
Interest rate swap
(2,349
)
 
254

 
(3,283
)
 
(2,996
)
Interest rate caps
(832
)
 
(144
)
 
(1,286
)
 
(2,459
)
 
$
(351,360
)
 
$
39,218

 
$
(405,484
)
 
$
358,594

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. A substantial portion of our call options are based upon the S&P 500 Index with the remainder based upon other equity and bond market indices. The range of index appreciation (after applicable caps, participation rates and asset fees) for options expiring during the three and nine months ended September 30, 2015 and 2014 is as follows:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
S&P 500 Index
 
 
 
 
 
 
 
Point-to-point strategy
0.0 - 8.0%
 
1.0 - 11.5%
 
0.0 - 8.9%
 
1.0 - 11.5%
Monthly average strategy
0.0 - 7.4%
 
0.8 - 9.0%
 
0.0 - 9.0%
 
0.8 - 11.1%
Monthly point-to-point strategy
0.0 - 6.5%
 
0.0 - 17.9%
 
0.0 - 12.1%
 
0.0 - 19.9%
Fixed income (bond index) strategies
0.0 - 7.0%
 
0.0 - 8.0%
 
0.0 - 10.0%
 
0.0 - 8.0%
The change in fair value of derivatives is also influenced by the aggregate costs of options purchased. The aggregate cost of options has increased primarily due to an increased amount of fixed index annuities in force. 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, 2014.
The fair value of the 2015 notes hedges changes based upon changes in the price of our common stock, interest rates, stock price volatility, dividend yield and the time to expiration of the 2015 notes hedges. Similarly, the fair value of the conversion option obligation to the holders of the 2015 notes changes based upon these same factors and the conversion option obligation is accounted for as an embedded derivative liability with changes in fair value reported in the Change in fair value of embedded derivatives. The amount of the change in fair value of the 2015 notes hedges has historically been equal to the amount of the change in the related embedded derivative liability and there has been an offsetting expense in the change in fair value of embedded derivatives. Due to the partial unwind agreements we entered into in the second quarter of 2014, the decrease in the change in fair value of 2015 notes embedded conversion derivative liability exceeded the decrease in the change in fair value of the 2015 notes hedges by $4.2 million for the nine months ended September 30, 2014. See Note 5 to our unaudited consolidated financial statements for a discussion of 2015 notes hedges and the 2015 warrants.

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Net realized gains (losses) 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. The components of net realized gains (losses) on investments are set forth in the table that follows:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
 
(Dollars in thousands)
Available for sale fixed maturity securities:
 
 
 
 
 
 
 
Gross realized gains
$
283

 
$
179

 
$
4,783

 
$
1,536

Gross realized losses
(97
)
 
(148
)
 
(897
)
 
(910
)
 
186

 
31

 
3,886

 
626

Other investments:
 
 
 
 
 
 
 
Gain on sale of real estate
2,245

 
455

 
3,278

 
1,493

Loss on sale of real estate

 

 
(575
)
 
(231
)
Impairment losses on real estate
(570
)
 
(1,436
)
 
(1,199
)
 
(2,235
)
 
1,675

 
(981
)
 
1,504

 
(973
)
Mortgage loans on real estate:
 
 
 
 
 
 
 
Decrease (increase) in allowance for credit losses
(702
)
 
(2,240
)
 
597

 
(5,787
)
Recovery of specific allowance

 

 
4,375

 

 
(702
)
 
(2,240
)
 
4,972

 
(5,787
)
 
$
1,159

 
$
(3,190
)
 
$
10,362

 
$
(6,134
)
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, 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 $5.2 million in the third quarter of 2015 and increased to $6.2 million for the nine months ended September 30, 2015 compared to $0.6 million and $2.1 million for the same periods in 2014. See Financial Condition - Investments and Note 3 to our unaudited consolidated financial statements for additional discussion of write downs of securities for other than temporary impairments.
Interest sensitive and index product benefits decreased 50% to $213.5 million in the third quarter of 2015 and 28% to $802.4 million for the nine months ended September 30, 2015 compared to $429.4 million and $1.1 billion for the same periods in 2014. The components of interest sensitive and index product benefits are summarized as follows:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
 
(Dollars in thousands)
Index credits on index policies
$
101,170

 
$
323,682

 
$
515,675

 
$
831,524

Interest credited (including changes in minimum guaranteed interest for fixed index annuities)
64,680

 
71,113

 
194,476

 
215,213

Lifetime income benefit riders
47,615

 
34,620

 
92,280

 
67,644

 
$
213,465

 
$
429,415

 
$
802,431

 
$
1,114,381

The decreases in index credits were attributable to changes in the appreciation of the underlying indices (see discussion above under Change in fair value of derivatives) and the amount of funds allocated by policyholders to the respective index options. Total proceeds received upon expiration of the call options purchased to fund the annual index credits were $103.8 million and $529.2 million for the three and nine months ended September 30, 2015, compared to $327.8 million and $834.5 million for the same periods in 2014. The decreases in interest credited were primarily due to decreases in the average rate credited to the annuity liabilities outstanding receiving a fixed rate of interest. The average amount of annuity liabilities outstanding (net of annuity liabilities ceded under coinsurance agreements) increased 15% to $38.9 billion during the third quarter of 2015 and 14% to $37.4 billion for the nine months ended September 30, 2015 compared $33.8 billion and $32.9 billion for the same periods in 2014. The increase in benefits recognized for living income benefit rider was due to an increase in the number of policies with lifetime income benefit riders and correlates to the increase in fees discussed in Annuity product charges.
See Net income above for discussion of the impact of revisions of assumptions used in determining reserves held for living income benefit riders and interest sensitive and index product benefits for the three and nine months ended September 31, 2015 and 2014.

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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 87% of our net annuity deposits during both the three and nine months ended September 30, 2015, respectively, compared to 95% and 96% during the same periods in 2014. The increase in amortization from these factors has been affected by amortization associated with fair value accounting for derivatives and embedded derivatives utilized in our fixed index annuity business, amortization associated with net realized gains (losses) on investments and net OTTI losses recognized in operations and, for the nine months ended September 30, 2014, amortization associated with changes in litigation liabilities. 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
September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
 
(Dollars in thousands)
Amortization of deferred sales inducements before gross profit adjustments
$
53,163

 
$
36,774

 
$
155,014

 
$
125,476

Gross profit adjustments:
 
 
 
 
 
 
 
Fair value accounting for derivatives and embedded derivatives
13,334

 
4,456

 
(3,279
)
 
(28,003
)
Net realized gains (losses) on investments, net OTTI losses recognized in operations and changes in litigation liabilities
(690
)
 
(569
)
 
543

 
(797
)
Amortization of deferred sales inducements after gross profit adjustments
$
65,807

 
$
40,661

 
$
152,278

 
$
96,676

See Net income above for discussion of the impact of unlocking on amortization of deferred sales inducements for the three and nine months ended September 31, 2015 and 2014. 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, 2014.
Change in fair value of embedded derivatives includes changes in the fair value of our fixed index annuity embedded derivatives and changes in the fair value of the embedded derivative related to the conversion option of our 2015 notes (see Note 5 to our unaudited consolidated financial statements and Note 9 to our audited consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2014). The components of change in fair value of embedded derivatives are as follows:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
Fixed index annuities - embedded derivatives
$
(413,583
)
 
$
(188,383
)
 
$
(578,596
)
 
$
9,704

2015 notes embedded conversion derivative
(1,141
)
 
(6,823
)
 
(4,516
)
 
(31,356
)
 
$
(414,724
)
 
$
(195,206
)
 
$
(583,112
)
 
$
(21,652
)
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. 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, 2014. The primary reasons for the decreases in the change in fair value of the fixed index annuity embedded derivatives during the three and nine months ended September 30, 2015 were increases in the discount rates used in estimating the fair value of our liability and 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 first nine months of 2015 as compared to the first nine months of 2014.
See Note 5 to our unaudited consolidated financial statements in this Form 10-Q, incorporated by reference, and Net income above for discussion of the impact of assumption changes on the fixed index annuity embedded derivatives for the nine month period ended September 30, 2014. 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, 2014.
As discussed above under Change in fair value of derivatives, the fair value of the 2015 notes embedded conversion derivative changes based upon the same factors effecting the changes in the 2015 notes hedges. The changes in the fair value of the 2015 notes embedded conversion derivative were offset by a comparable increase or decrease in the change in fair value of the 2015 notes hedges.
Interest expense on notes payable decreased 17% to $7.3 million in the third quarter of 2015 and 22% to $22.0 million for the nine months ended September 30, 2015 compared to $8.7 million and $28.1 million for the same periods in 2014. The decreases in interest expense are primarily attributable to the extinguishment of $137.9 million principal amount of our convertible senior notes in 2014.

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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 increase in amortization from these factors has been affected by amortization associated with fair value accounting for derivatives and embedded derivatives utilized in our fixed index annuity business, amortization associated with net realized gains (losses) on investments and net OTTI losses recognized in operations and, for the nine months ended September 30, 2014, amortization associated with changes in litigation liabilities. 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
September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
 
(Dollars in thousands)
Amortization of deferred policy acquisition costs before gross profit adjustments
$
71,715

 
$
36,322

 
$
216,608

 
$
167,677

Gross profit adjustments:
 
 
 
 
 
 
 
Fair value accounting for derivatives and embedded derivatives
(2,992
)
 
4,134

 
(30,532
)
 
(52,500
)
Net realized gains (losses) on investments, net OTTI losses recognized in operations and changes in litigation liabilities
(838
)
 
(785
)
 
795

 
(1,228
)
Amortization of deferred policy acquisition costs after gross profit adjustments
$
67,885

 
$
39,671

 
$
186,871

 
$
113,949

See Net income above for discussion of the impact of unlocking on amortization of deferred sales inducements for the three and nine months ended September 31, 2015 and 2014. 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, 2014.
Other operating costs and expenses increased 19% to $24.5 million in the third quarter of 2015 and increased 16% to $70.5 million for the nine months ended September 30, 2015 compared to $20.6 million and $60.6 million for the same periods in 2014. The three and nine months ended September 30, 2015 reflect increases in salaries and benefits related to an increased number of employees, cost of overtime and increased incentive compensation. In addition, the three and nine months ended September 30, 2015 reflect an increase in expense for reinsurance risk charges due to growth in our policyholder liabilities and an increase in printing and postage expenses due to the increase in sales as compared to the same periods in 2014. For the nine months ended September 30, 2015, these increases were offset by certain non-recurring items related to the recovery of funds from a reinsurer related to a previously paid guaranty fund assessment, the recovery of a state tax refund and the reduction of a liability associated with certain employee benefits which totaled approximately $1.6 million. The nine months ended September 30, 2014, reflect a decrease in an estimated litigation liability of $2.3 million (see Note 7 to our unaudited consolidated financial statements).
Income tax expense increased to $51.4 million in the third quarter of 2015 and increased to $98.3 million for the nine months ended September 30, 2015 compared to $36.5 million and $50.5 million for the same periods in 2014. The change in income tax expense was primarily due to changes in income before income taxes.
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 35.5% reflecting the absence of state income taxes for substantially all of the states that the life insurance subsidiaries do business in. The income (loss) for the parent company and other non-life insurance subsidiaries is generally taxed at an effective tax rate of 41.5% reflecting the combined federal / state income tax rates. The effective tax rates resulting from the combination of the income tax provisions for the life / non-life sources of income vary from period to period based primarily on the relative size of pretax income from the two sources. The effective tax rate was 34.6% for both the three and nine months ended September 30, 2015, respectively, and 35.0% and 34.8% for the same periods in 2014, 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 nationally recognized statistical rating organizations ("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:
 
September 30, 2015
 
December 31, 2014
 
Carrying
Amount
 
Percent
 
Carrying
Amount
 
Percent
 
(Dollars in thousands)
Fixed maturity securities:
 
 
 
 
 
 
 
United States Government full faith and credit
$
37,681

 
0.1
%
 
$
138,460

 
0.4
%
United States Government sponsored agencies
1,314,748

 
3.4
%
 
1,393,890

 
3.9
%
United States municipalities, states and territories
3,760,888

 
9.8
%
 
3,723,309

 
10.4
%
Foreign government obligations
216,987

 
0.6
%
 
193,803

 
0.5
%
Corporate securities
23,536,322

 
61.3
%
 
21,566,724

 
59.9
%
Residential mortgage backed securities
1,556,308

 
4.0
%
 
1,751,345

 
4.9
%
Commercial mortgage backed securities
3,941,863

 
10.3
%
 
2,807,620

 
7.8
%
Other asset backed securities
1,101,619

 
2.9
%
 
946,483

 
2.6
%
Total fixed maturity securities
35,466,416

 
92.4
%
 
32,521,634

 
90.4
%
Equity securities
7,833

 
%
 
7,805

 
%
Mortgage loans on real estate
2,452,402

 
6.4
%
 
2,434,580

 
6.8
%
Derivative instruments
180,649

 
0.5
%
 
731,113

 
2.0
%
Other investments
284,994

 
0.7
%
 
286,726

 
0.8
%
 
$
38,392,294

 
100.0
%
 
$
35,981,858

 
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 investment grade (NAIC designation 1 or 2) publicly traded or privately placed corporate securities.
A summary of our fixed maturity securities by NRSRO ratings is as follows:
 
 
September 30, 2015
 
December 31, 2014
Rating Agency Rating
 
Carrying
Amount
 
Percent of
Fixed Maturity
Securities
 
Carrying
Amount
 
Percent of
Fixed Maturity
Securities
 
 
(Dollars in thousands)
Aaa/Aa/A
 
$
22,808,058

 
64.3
%
 
$
20,672,331

 
63.6
%
Baa
 
11,300,580

 
31.9
%
 
10,516,834

 
32.3
%
Total investment grade
 
34,108,638

 
96.2
%
 
31,189,165

 
95.9
%
Ba
 
704,655

 
2.0
%
 
548,681

 
1.7
%
B
 
56,943

 
0.1
%
 
87,272

 
0.3
%
Caa and lower
 
421,999

 
1.2
%
 
497,477

 
1.5
%
In or near default
 
174,181

 
0.5
%
 
199,039

 
0.6
%
Total below investment grade
 
1,357,778

 
3.8
%
 
1,332,469

 
4.1
%
 
 
$
35,466,416

 
100.0
%
 
$
32,521,634

 
100.0
%

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The National Association of Insurance Commissioner's ("NAIC") Securities Valuation Office ("SVO") is responsible for the 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 and lower
6
 
In or near default
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 revised NAIC rating methodologies is performed on an annual basis.
As stated previously, our fixed maturity security portfolio is managed to minimize risks such as defaults or impairments while earning a sufficient and stable return on our investments. Our strategy has been to invest primarily in investment grade fixed maturity securities. Investment grade is NAIC 1 and 2 securities and Baa3/BBB- and better securities on the NRSRO scale. This strategy meets the objective of minimizing risk while also managing asset capital charges on a regulatory capital basis.
A summary of our fixed maturity securities by NAIC designation is as follows:
 
 
September 30, 2015
 
December 31, 2014
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
 
$
21,918,272

 
$
23,171,086

 
$
23,171,086

 
65.3
%
 
$
19,223,151

 
$
20,941,634

 
$
20,941,634

 
64.4
%
2
 
11,432,147

 
11,581,162

 
11,581,162

 
32.7
%
 
10,432,593

 
10,981,618

 
10,981,618

 
33.8
%
3
 
745,289

 
679,289

 
693,863

 
2.0
%
 
602,191

 
583,313

 
583,907

 
1.8
%
4
 
31,042

 
17,256

 
17,256

 
%
 
22,888

 
14,089

 
14,089

 
%
5
 

 

 

 
%
 

 

 

 
%
6
 
8,154

 
3,049

 
3,049

 
%
 
655

 
386

 
386

 
%
 
 
$
34,134,904

 
$
35,451,842

 
$
35,466,416

 
100.0
%
 
$
30,281,478

 
$
32,521,040

 
$
32,521,634

 
100.0
%
The amortized cost and fair value of fixed maturity securities at September 30, 2015, 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)
September 30, 2015
 
 
 
 
 
 
 
Fixed maturity securities, available for sale:
 
 
 
 
 
 
 
United States Government full faith and credit
2

 
$
7,542

 
$
(111
)
 
$
7,431

United States Government sponsored agencies
8

 
597,247

 
(7,702
)
 
589,545

United States municipalities, states and territories
59

 
229,069

 
(8,221
)
 
220,848

Foreign government obligations
6

 
69,374

 
(10,153
)
 
59,221

Corporate securities:
 
 
 
 
 
 
 
Finance, insurance and real estate
112

 
1,655,481

 
(52,252
)
 
1,603,229

Manufacturing, construction and mining
251

 
3,288,207

 
(232,857
)
 
3,055,350

Utilities and related sectors
164

 
1,833,845

 
(84,874
)
 
1,748,971

Wholesale/retail trade
31

 
396,894

 
(19,648
)
 
377,246

Services, media and other
68

 
751,519

 
(25,387
)
 
726,132

Residential mortgage backed securities
20

 
60,133

 
(1,833
)
 
58,300

Commercial mortgage backed securities
113

 
1,318,321

 
(30,160
)
 
1,288,161

Other asset backed securities
20

 
226,030

 
(10,670
)
 
215,360

 
854

 
$
10,433,662

 
$
(483,868
)
 
$
9,949,794

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

 
$
76,574

 
$
(14,574
)
 
$
62,000

 
 
 
 
 
 
 
 
December 31, 2014
 
 
 
 
 
 
 
Fixed maturity securities, available for sale:
 
 
 
 
 
 
 
United States Government full faith and credit
1

 
$
513

 
$
(15
)
 
$
498

United States Government sponsored agencies
7

 
624,272

 
(13,933
)
 
610,339

United States municipalities, states and territories
17

 
28,658

 
(711
)
 
27,947

Foreign government obligations
3

 
29,689

 
(3,953
)
 
25,736

Corporate securities:
 
 
 
 
 
 
 
Finance, insurance and real estate
40

 
672,176

 
(18,863
)
 
653,313

Manufacturing, construction and mining
138

 
1,843,254

 
(71,077
)
 
1,772,177

Utilities and related sectors
77

 
736,603

 
(18,338
)
 
718,265

Wholesale/retail trade
17

 
193,605

 
(5,412
)
 
188,193

Services, media and other
39

 
418,942

 
(9,706
)
 
409,236

Residential mortgage backed securities
12

 
44,747

 
(2,205
)
 
42,542

Commercial mortgage backed securities
33

 
432,201

 
(3,323
)
 
428,878

Other asset backed securities
17

 
208,937

 
(7,885
)
 
201,052

 
401

 
$
5,233,597

 
$
(155,421
)
 
$
5,078,176

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

 
$
76,432

 
$
(594
)
 
$
75,838

Unrealized losses increased $342.4 million from $156.0 million at December 31, 2014 to $498.4 million at September 30, 2015. The increase in unrealized losses was primarily due to a general widening in credit spreads in select industries and credits during the nine months ended September 30, 2015. The 10-year treasury yield curve rates at September 30, 2015 and December 31, 2014 were 2.03% and 2.17%, 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)
September 30, 2015
 
 
 
 
 
 
 
 
1
 
$
5,006,728

 
49.9
%
 
$
(128,511
)
 
25.8
%
2
 
4,475,823

 
44.7
%
 
(281,640
)
 
56.5
%
3
 
523,532

 
5.2
%
 
(69,382
)
 
13.9
%
4
 
17,256

 
0.2
%
 
(13,784
)
 
2.8
%
5
 

 
%
 

 
%
6
 
3,029

 
%
 
(5,125
)
 
1.0
%
 
 
$
10,026,368

 
100.0
%
 
$
(498,442
)
 
100.0
%
December 31, 2014
 
 
 
 
 
 
 
 
1
 
$
2,366,939

 
45.9
%
 
$
(44,380
)
 
28.5
%
2
 
2,381,413

 
46.2
%
 
(77,681
)
 
49.8
%
3
 
391,792

 
7.6
%
 
(24,876
)
 
15.9
%
4
 
14,089

 
0.3
%
 
(8,799
)
 
5.6
%
5
 

 
%
 

 
%
6
 
375

 
%
 
(279
)
 
0.2
%
 
 
$
5,154,608

 
100.0
%
 
$
(156,015
)
 
100.0
%
Our investments' gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities (consisting of 855 and 402 securities, respectively) have been in a continuous unrealized loss position at September 30, 2015 and December 31, 2014, 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 the 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)
September 30, 2015
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
Investment grade:
 
 
 
 
 
 
 
Less than six months
617

 
$
7,621,554

 
$
7,386,385

 
$
(235,169
)
Six months or more and less than twelve months
97

 
1,757,803

 
1,656,232

 
(101,571
)
Twelve months or greater
40

 
484,057

 
417,759

 
(66,298
)
Total investment grade
754

 
9,863,414

 
9,460,376

 
(403,038
)
Below investment grade:
 
 
 
 
 
 
 
Less than six months
69

 
321,367

 
297,616

 
(23,751
)
Six months or more and less than twelve months
11

 
91,295

 
79,011

 
(12,284
)
Twelve months or greater
21

 
234,160

 
174,791

 
(59,369
)
Total below investment grade
101

 
646,822

 
551,418

 
(95,404
)
 
855

 
$
10,510,236

 
$
10,011,794

 
$
(498,442
)
 
 
 
 
 
 
 
 
December 31, 2014
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
Investment grade:
 
 
 
 
 
 
 
Less than six months
154

 
$
2,114,497

 
$
2,065,474

 
$
(49,023
)
Six months or more and less than twelve months
6

 
85,951

 
82,264

 
(3,687
)
Twelve months or greater
155

 
2,664,255

 
2,595,916

 
(68,339
)
Total investment grade
315

 
4,864,703

 
4,743,654

 
(121,049
)
Below investment grade:
 
 
 
 
 
 
 
Less than six months
55

 
153,861

 
151,532

 
(2,329
)
Six months or more and less than twelve months
12

 
48,846

 
46,956

 
(1,890
)
Twelve months or greater
20

 
242,619

 
211,872

 
(30,747
)
Total below investment grade
87

 
445,326

 
410,360

 
(34,966
)
 
402

 
$
5,310,029

 
$
5,154,014

 
$
(156,015
)

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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)
September 30, 2015
 
 
 
 
 
 
 
Investment grade:
 
 
 
 
 
 
 
Less than six months
22

 
$
211,075

 
$
147,683

 
$
(63,392
)
Six months or more and less than twelve months
1

 
3,218

 
2,253

 
(965
)
Twelve months or greater

 

 

 

Total investment grade
23

 
214,293

 
149,936

 
(64,357
)
Below investment grade:
 
 
 
 
 
 
 
Less than six months
9

 
104,204

 
72,539

 
(31,665
)
Six months or more and less than twelve months

 

 

 

Twelve months or greater
1

 
12,281

 
3,750

 
(8,531
)
Total below investment grade
10

 
116,485

 
76,289

 
(40,196
)
 
33

 
$
330,778

 
$
226,225

 
$
(104,553
)
 
 
 
 
 
 
 
 
December 31, 2014
 
 
 
 
 
 
 
Investment grade:
 
 
 
 
 
 
 
Less than six months

 
$

 
$

 
$

Six months or more and less than twelve months

 

 

 

Twelve months or greater

 

 

 

Total investment grade

 

 

 

Below investment grade:
 
 
 
 
 
 
 
Less than six months

 

 

 

Six months or more and less than twelve months
3

 
43,881

 
28,651

 
(15,230
)
Twelve months or greater
1

 
655

 
375

 
(280
)
Total below investment grade
4

 
44,536

 
29,026

 
(15,510
)
 
4

 
$
44,536

 
$
29,026

 
$
(15,510
)

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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)
September 30, 2015
 
 
 
 
 
 
 
Due in one year or less
$
20,667

 
$
20,256

 
$

 
$

Due after one year through five years
154,607

 
149,899

 

 

Due after five years through ten years
4,449,940

 
4,281,618

 

 

Due after ten years through twenty years
1,896,624

 
1,828,692

 

 

Due after twenty years
2,307,340

 
2,107,508

 
76,574

 
62,000

 
8,829,178

 
8,387,973

 
76,574

 
62,000

Residential mortgage backed securities
60,133

 
58,300

 

 

Commercial mortgage backed securities
1,318,321

 
1,288,161

 

 

Other asset backed securities
226,030

 
215,360

 

 

 
$
10,433,662

 
$
9,949,794

 
$
76,574

 
$
62,000

 
 
 
 
 
 
 
 
December 31, 2014
 
 
 
 
 
 
 
Due in one year or less
$

 
$

 
$

 
$

Due after one year through five years
74,447

 
73,594

 

 

Due after five years through ten years
2,753,526

 
2,692,393

 

 

Due after ten years through twenty years
1,091,955

 
1,061,437

 

 

Due after twenty years
627,784

 
578,280

 
76,432

 
75,838

 
4,547,712

 
4,405,704

 
76,432

 
75,838

Residential mortgage backed securities
44,747

 
42,542

 

 

Commercial mortgage backed securities
432,201

 
428,878

 

 

Other asset backed securities
208,937

 
201,052

 

 

 
$
5,233,597

 
$
5,078,176

 
$
76,432

 
$
75,838


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International Exposure
We hold fixed maturity securities with international exposure. As of September 30, 2015, 16% of the carrying value of our fixed maturity securities was comprised of corporate debt securities of issuers based outside of the United States and debt securities of foreign governments. All of these securities are denominated in U.S. dollars and all are investment grade (NAIC designation of either 1 or 2), except for 20 securities with a total fair value of $117.9 million which have a NAIC 3 designation and one security with a fair value of $3.0 million which has an NAIC 6 designation. Our investment professionals analyze each holding for credit risk by economic and other factors of each country and industry. The following table presents our international exposure in our fixed maturity portfolio by country or region:
 
September 30, 2015
 
Amortized Cost
 
Carrying
Amount/Fair Value
 
Percent
of Total
Carrying
Amount
 
(Dollars in thousands)
 
 
GIIPS (1)
$
231,761

 
$
249,974

 
0.7%
Asia/Pacific
364,013

 
374,208

 
1.1%
Non-GIIPS Europe
2,471,399

 
2,544,977

 
7.2%
Latin America
240,278

 
208,981

 
0.6%
Non-U.S. North America
1,176,395

 
1,147,498

 
3.2%
Australia & New Zealand
531,928

 
541,671

 
1.5%
Other
378,356

 
413,988

 
1.2%
 
$
5,394,130

 
$
5,481,297

 
15.5%
(1)
Greece, Ireland, Italy, Portugal and Spain continue to cause credit risk as economic conditions in these countries continue to be volatile, especially within the financial and banking sectors. 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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Table of Contents

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 RMBS as we monitor all of our RMBS 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 September 30, 2015, the amortized cost and fair value of securities on the watch list 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)
 
 
 
 
Investment grade
 
 
 
 
 
 
 
 
 
 
 
 
Corporate fixed maturity securities:
 
 
 
 
 
 
 
 
 
 
 
 
Finance
 
1
 
$
20,000

 
$
(3,618
)
 
$
16,382

 
49
 
Industrial
 
2
 
24,656

 
(9,256
)
 
15,400

 
13 - 29
 
1 - 4
 
 
3
 
44,656

 
(12,874
)
 
31,782

 
 
 
 
Other asset backed securities
 
1
 
3,218

 
(965
)
 
2,253

 
54
 
5
 
 
4
 
47,874

 
(13,839
)
 
34,035

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Below investment grade
 
 
 
 
 
 
 
 
 
 
 
 
Corporate fixed maturity securities:
 
 
 
 
 
 
 
 
 
 
 
 
Industrial
 
6
 
39,291

 
(21,179
)
 
18,112

 
13 - 31
 
4 - 13
Telecommunications
 
1
 
6,000

 
(3,090
)
 
2,910

 
15
 
3
 
 
7
 
45,291

 
(24,269
)
 
21,022

 
 
 
 
Other asset backed securities
 
1
 
8,154

 
(5,125
)
 
3,029

 
28
 
9
 
 
8
 
53,445

 
(29,394
)
 
24,051

 
 
 
 
 
 
12
 
$
101,319

 
$
(43,233
)
 
$
58,086

 
 
 
 
One of the securities on the watch list have Eurozone exposure that has contributed to their depressed fair values. Our analysis of all of the securities on the watch list that we have determined are temporarily impaired and their credit performance at September 30, 2015 is as follows:
Finance: The decline in value of this security is due to the continued wide spreads as a result of the ongoing concerns relating to capital, asset quality and earnings stability due to the financial events of the past four years and the ongoing events in the Eurozone. While this issuer has had its financial position and profitability weakened by the credit and liquidity crisis, we have determined that this security was not other than temporarily impaired due to our evaluation of the operating performance and the credit worthiness of the issuer.
Industrial: The decline in the value of these securities relates to ongoing operational issues related to the decline in certain commodity prices specific to their business. The decline in these commodity prices creates financial challenges as the industry realigns 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 chain of supply. While these issuers have seen the financial and profitability profile weakened, we have determined that the 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: The decline in value of the investment grade other asset backed security 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 the guarantee is in good standing and all required payments have been made, including hyper-amortization payments triggered by the performance of the student loan portfolio. The decline in value of the below investment grade 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 declined the operator of the deep water vessel has experienced financial pressure on its balance sheet. While the issuer has filed for what is equivalent to Chapter 11 bankruptcy, our asset has not been included in the bankruptcy, and is 100% secured by the deep water drilling asset providing a level of safety in principal recovery.

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Telecommunications: The decline in the value of this security is the result of regional economic recessionary pressure and an increase in competition in the markets it operates. There is potential for merger and acquisition activity in this market and an increase in price volatility is expected. While this issuer has seen weakened performance and heightened risk of merger activity, we have determined that this security was not other than temporarily impaired due to our evaluation of the operating performance and the credit worthiness of the issuer.
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 and, as such, there were no other than temporary impairments on these securities at September 30, 2015 other than the other than temporary impairment recognized on the below investment grade other asset backed security noted above.
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, 2014. During the periods presented, we recognized other than temporary impairment and additional credit losses on residential mortgage backed securities and on one other asset backed security for which we had not previously recognized OTTI. Several factors led us to believe that full recovery of amortized cost will not be 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, adjusted for amortization of premiums and accrual of discounts net of valuation allowances. At September 30, 2015 and December 31, 2014 the largest principal amount outstanding for any single mortgage loan was $18.0 million and $15.8 million, respectively, and the average loan size was $2.8 million and $2.7 million at September 30, 2015 and December 31, 2014, respectively. We have the contractual ability to pursue full personal recourse on 6.2% of the loans and partial personal recourse on 18.1% of the loans. In addition, the average loan to value ratio for the overall portfolio was 53.8% and 53.7% at September 30, 2015 and December 31, 2014, 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 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, incorporated by reference in this Item 2.
In the normal course of business, we commit to fund commercial mortgage loans up to 90 days in advance. At September 30, 2015, we had commitments to fund commercial mortgage loans totaling $64.3 million, with fixed interest rates ranging from 4.05% to 4.60%. During 2015 and 2014, due to historically low interest rates, the commercial mortgage loan industry has been very competitive. This competition has resulted in a number of borrowers refinancing with other lenders. For the nine months ended September 30, 2015, we received $282.9 million in cash for loans being paid in full compared to $244.5 million for the nine months ended September 30, 2014. Some of the loans being paid off have either reached their maturity or are nearing maturity; however, some borrowers are paying the prepayment fee and refinancing at a lower rate.
See Note 4 to our unaudited consolidated financial statements, incorporated by reference for a presentation of our 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:
 
September 30, 2015
 
December 31, 2014
 
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
$
1,712,952

 
69.3
%
 
$
1,599,817

 
65.1
%
Greater than or equal to 1.2 and less than 1.5
510,716

 
20.7
%
 
537,828

 
21.9
%
Greater than or equal to 1.0 and less than 1.2
130,266

 
5.3
%
 
155,004

 
6.3
%
Less than 1.0
116,522

 
4.7
%
 
165,072

 
6.7
%
 
$
2,470,456

 
100.0
%
 
$
2,457,721

 
100.0
%
Approximately 84% (based on principal outstanding) of our mortgage loans that have a debt service coverage ratio of less than 1.0 are performing and current with contractual principal and interest payments at September 30, 2015.

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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).
 
September 30, 2015
 
December 31, 2014
 
(Dollars in thousands)
Impaired mortgage loans with an allowance
$
27,244

 
$
29,116

Impaired mortgage loans with no related allowance
13,396

 
2,656

Allowance for probable loan losses
(10,618
)
 
(12,333
)
Net carrying value of impaired mortgage loans
$
30,022

 
$
19,439

At September 30, 2015, 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.
We recognize all derivative instruments as assets or liabilities in the consolidated balance sheets at fair value. None of our derivatives qualify for hedge accounting, thus, any change in the fair value of the derivatives is recognized immediately in the consolidated statements of operations. A presentation of our derivative instruments along with a discussion of the business strategy involved with our derivatives is included in Note 5 to our unaudited consolidated financial statements in this Form 10-Q, which is incorporated by reference in this Item 2.
Liquidity and Capital Resources
Our insurance subsidiaries 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 $3.3 billion for the nine months ended September 30, 2015 compared to $1.6 billion for the nine months ended September 30, 2014, with the increase primarily attributable to a $1.7 billion increase in net annuity deposits after coinsurance which was partially offset by a $93.9 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, including the 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.
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 2015, up to $343.3 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 $1.3 billion of statutory earned surplus at September 30, 2015.
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.

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Table of Contents

In August 2015, we completed an underwritten public offering of 9,890,000 shares of our common stock at a public offering price of $25.25 per share, of which 5,590,000 shares are subject to forward sale agreements. During the third quarter of 2015, we contributed $120 million to the capital and surplus of American Equity Life which included $104.5 million of initial net proceeds from the issuance of 4.3 million shares of common stock in our August 2015 public stock offering. If we elect to exercise our rights to physically settle the forward sales agreements, we intend to use the net proceeds from the settlement of approximately $135.8 million, based on the current forward price, for general corporate purposes, including contributions to the capital and surplus of our life insurance subsidiaries to support their continued growth and maintain desired financial strength ratings.
On August 5, 2015, Standard & Poor's raised its counterparty credit rating on American Equity Investment Life Holding Company to BBB- from BB+ and its financial strength rating on American Equity Life to A- from BBB+. On August 7, 2015, Fitch Ratings upgraded the issuer default rating of American Equity Investment Life Holding Company to BBB- from BB+.
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 risk-based capital ratio of 275% and a minimum level of statutory surplus equal to the sum of 1) 80% of statutory surplus at September 30, 2013, 2) 50% of the statutory net income for each fiscal quarter ending after September 30, 2013, and 3) 50% of all capital contributed to American Equity Life after September 30, 2013. American Equity Life's risk-based capital ratio was 372% at December 31, 2014. 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 September 30, 2015, were $36.7 million. In addition, we have a $140 million revolving line of credit, with no borrowings outstanding, available through November 2017 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, which is incorporated by reference in this Item 2, for new accounting pronouncement disclosures that supplement the disclosures in Note 1 to our audited consolidated financial statements in our 2014 Annual Report on Form 10-K.
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. An OTTI shall be considered to have occurred when we have an intention to sell available for sale securities in an unrealized loss position. If we do not intend to sell a debt security, we consider all available evidence to make an assessment of whether it is more likely than not that we will be required to sell the security before the recovery of its amortized cost basis. If it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis, an OTTI will be considered to have occurred.
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 September 30, 2015, of which $85.5 million has been swapped to a fixed rate which began in March 2014 and $79.0 million has been capped for a term of seven years which began in July 2014 (see Note 5 to our unaudited consolidated financial statements). 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 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.
A major component of our interest rate risk management program is structuring the investment portfolio with cash flow characteristics consistent with the cash flow characteristics of our insurance liabilities. We use models to simulate cash flows expected from our existing business under various interest rate scenarios. These simulations enable us to measure the potential gain or loss in fair value of our interest rate-sensitive financial instruments, to evaluate the adequacy of expected cash flows from our assets to meet the expected cash requirements of our liabilities and to determine if it is necessary to lengthen or shorten the average life and duration of our investment portfolio. The "duration" of a security is the time weighted present value of the security's expected cash flows and is used to measure a security's sensitivity to changes in interest rates. When the durations of assets and liabilities are similar, exposure to interest rate risk is minimized because a change in value of assets should be largely offset by a change in the value of liabilities.

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If interest rates were to increase 10% (29 basis points) from levels at September 30, 2015, we estimate that the fair value of our fixed maturity securities would decrease by approximately $859.9 million. The impact on stockholders' equity of such decrease (net of income taxes and certain adjustments for changes in amortization of deferred policy acquisition costs and deferred sales inducements) would be a decrease of $283.4 million in accumulated other comprehensive income and a decrease in stockholders' equity. The computer 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, 2014.
At September 30, 2015, 33% of our fixed income securities have call features, of which 2% ($0.7 billion) were subject to call redemption. Another 0.4% ($0.1 billion) will become subject to call redemption during the next twelve months. We have reinvestment risk related to these potential 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 index annuities) on most of our annuity liabilities to maintain the spread at our targeted level. At September 30, 2015, 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.
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. For the nine months ended September 30, 2015 and 2014, the annual index credits to policyholders on their anniversaries were $515.7 million and $831.5 million, respectively. Proceeds received at expiration of these options related to such credits were $529.2 million and $834.5 million for the nine months ended September 30, 2015 and 2014, respectively.
Within our hedging process we purchase options out of the money to the extent of anticipated minimum guaranteed interest on index policies. 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.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
In accordance with the Securities Exchange Act Rules 13a-15 and 15d-15, 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 September 30, 2015 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 during the quarter ended September 30, 2015 that have materially affected, or are reasonably likely to materially affect, internal control over financial reporting.

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PART II. OTHER INFORMATION
Item 1. Legal Proceedings
See Note 7 - Commitments and Contingencies to the unaudited consolidated financial statements, which is incorporated by reference in this Item 1, for litigation and regulatory disclosures that supplements the disclosure in Note 13 - Commitments and Contingencies to the audited consolidated financial statements of our 2014 Annual Report on Form 10-K.
Item 1A. Risk Factors
Our 2014 Annual Report on Form 10-K described our Risk Factors. In light of recent activity by the U.S. Department of Labor, we modified the Risk Factor titled Changes in state and federal regulation may affect our profitabilty in our Form 10-Q for the quarterly period ended March 31, 2015. There have been no other material changes to the Risk Factors during the nine months ended September 30, 2015.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
There were no issuer purchases of equity securities for the quarter ended September 30, 2015.

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Item 6. Exhibits
Exhibit No.
 
Description
 
Method of Filing
12.1
 
Ratio of Earnings to Fixed Charges
 
Filed herewith
31.1
 
Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
Filed herewith
31.2
 
Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
Filed herewith
32.1
 
Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
Filed herewith
32.2
 
Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
Filed herewith
101.INS
 
XBRL Instance Document
 
*
101.SCH
 
XBRL Taxonomy Extension Schema Document
 
*
101.CAL
 
XBRL Taxonomy Extension Calculation Linkbase Document
 
*
101.DEF
 
XBRL Taxonomy Extension Definition Linkbase Document
 
*
101.LAB
 
XBRL Taxonomy Extension Label Linkbase Document
 
*
101.PRE
 
XBRL Taxonomy Extension Presentation Linkbase Document
 
*
*
 
Pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, or Section 18 of the Securities and Exchange Act of 1934, as amended and otherwise are not subject to liability under those sections.

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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:
November 9, 2015
 
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 - Controller
 
 
 
 
 
(Principal Accounting Officer)
 



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