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AMERICAN EQUITY INVESTMENT LIFE HOLDING CO - Quarter Report: 2017 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, 2017
OR
o 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ________ to ________
Commission File Number : 001-31911
American Equity Investment Life Holding Company
(Exact name of registrant as specified in its charter)
Iowa
 
42-1447959
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
6000 Westown Parkway
West Des Moines, Iowa 50266
(Address of principal executive offices, including zip code)
(515) 221-0002
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer," “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer x
Accelerated filer o
Non-accelerated filer o
Smaller reporting company o
Emerging growth company o
 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
APPLICABLE TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date:
As of November 3, 2017, there were 89,121,559 shares of the registrant's common stock, $1 par value, outstanding.



TABLE OF CONTENTS
 
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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, 2017
 
December 31, 2016
 
(Unaudited)
 
 
Assets
 
 
 
Investments:
 
 
 
Fixed maturity securities:
 
 
 
Available for sale, at fair value (amortized cost: 2017 - $42,486,275; 2016 - $39,953,955)
$
44,601,297

 
$
41,060,494

Held for investment, at amortized cost (fair value: 2017 - $75,046; 2016 - $68,766)
76,986

 
76,825

Mortgage loans on real estate
2,611,426

 
2,480,956

Derivative instruments
1,235,125

 
830,519

Other investments
328,299

 
308,774

Total investments
48,853,133

 
44,757,568

 
 
 
 
Cash and cash equivalents
1,285,662

 
791,266

Coinsurance deposits
4,758,417

 
4,639,492

Accrued investment income
439,182

 
397,773

Deferred policy acquisition costs
2,757,130

 
2,905,377

Deferred sales inducements
2,054,494

 
2,208,218

Deferred income taxes
35,524

 
168,578

Income taxes recoverable
11,067

 
11,474

Other assets
185,106

 
173,726

Total assets
$
60,379,715

 
$
56,053,472

 
 
 
 
Liabilities and Stockholders' Equity
 
 
 
Liabilities:
 
 
 
Policy benefit reserves
$
54,935,694

 
$
51,637,026

Other policy funds and contract claims
284,149

 
298,347

Notes and loan payable
493,972

 
493,755

Subordinated debentures
242,145

 
241,853

Amounts due under repurchase agreements
23,542

 

Other liabilities
1,637,546

 
1,090,896

Total liabilities
57,617,048

 
53,761,877

 
 
 
 
Stockholders' equity:
 
 
 
Preferred stock, par value $1 per share, 2,000,000 shares authorized,
  2017 and 2016 - no shares issued and outstanding

 

Common stock, par value $1 per share, 200,000,000 shares authorized; issued and outstanding:
   2017 - 88,933,928 shares (excluding 2,407,786 treasury shares);
   2016 - 88,001,130 shares (excluding 2,887,082 treasury shares)
88,934

 
88,001

Additional paid-in capital
783,116

 
770,344

Accumulated other comprehensive income
659,491

 
339,966

Retained earnings
1,231,126

 
1,093,284

Total stockholders' equity
2,762,667

 
2,291,595

Total liabilities and stockholders' equity
$
60,379,715

 
$
56,053,472

See accompanying notes to unaudited consolidated financial statements.

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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,
 
2017
 
2016
 
2017
 
2016
Revenues:
 
 
 
 
 
 
 
Premiums and other considerations
$
8,569

 
$
12,731

 
$
25,691

 
$
31,534

Annuity product charges
51,931

 
47,675

 
144,106

 
125,304

Net investment income
500,202

 
463,583

 
1,479,288

 
1,374,239

Change in fair value of derivatives
362,525

 
103,794

 
1,015,878

 
68,828

Net realized gains on investments, excluding other than temporary impairment ("OTTI") losses
1,579

 
5,256

 
7,790

 
10,680

OTTI losses on investments:
 
 
 
 
 
 
 
Total OTTI losses
(273
)
 
(4,554
)
 
(273
)
 
(11,334
)
Portion of OTTI losses recognized in (from) other comprehensive income
(191
)
 
1,575

 
(1,281
)
 
(1,785
)
Net OTTI losses recognized in operations
(464
)
 
(2,979
)
 
(1,554
)
 
(13,119
)
Loss on extinguishment of debt
(18,389
)
 

 
(18,817
)
 

Total revenues
905,953

 
630,060

 
2,652,382

 
1,597,466

 
 
 
 
 
 
 
 
Benefits and expenses:
 
 
 
 
 
 
 
Insurance policy benefits and change in future policy benefits
10,823

 
15,065

 
32,684

 
37,567

Interest sensitive and index product benefits
501,028

 
278,943

 
1,392,763

 
487,735

Amortization of deferred sales inducements
14,707

 
69,245

 
110,727

 
127,396

Change in fair value of embedded derivatives
229,702

 
144,404

 
628,845

 
694,564

Interest expense on notes and loan payable
7,597

 
6,887

 
23,997

 
20,649

Interest expense on subordinated debentures
3,502

 
3,253

 
10,260

 
9,627

Amortization of deferred policy acquisition costs
23,023

 
98,108

 
162,248

 
198,486

Other operating costs and expenses
28,782

 
25,133

 
82,325

 
78,786

Total benefits and expenses
819,164

 
641,038

 
2,443,849

 
1,654,810

Income (loss) before income taxes
86,789

 
(10,978
)
 
208,533

 
(57,344
)
Income tax expense (benefit)
29,832

 
(3,558
)
 
70,691

 
(19,791
)
Net income (loss)
$
56,957

 
$
(7,420
)
 
$
137,842

 
$
(37,553
)
 
 
 
 
 
 
 
 
Earnings (loss) per common share
$
0.64

 
$
(0.09
)
 
$
1.55

 
$
(0.45
)
Earnings (loss) per common share - assuming dilution
$
0.63

 
$
(0.09
)
 
$
1.53

 
$
(0.45
)
 
 
 
 
 
 
 
 
Weighted average common shares outstanding (in thousands):
 
 
 
 
 
 
 
Earnings (loss) per common share
89,069

 
86,262

 
88,873

 
83,645

Earnings (loss) per common share - assuming dilution
90,421

 
87,044

 
90,171

 
84,413

See accompanying notes to unaudited consolidated financial statements.

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

 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2017
 
2016
 
2017
 
2016
 
 
 
 
 
 
 
 
Net income (loss)
$
56,957

 
$
(7,420
)
 
$
137,842

 
$
(37,553
)
Other comprehensive income:
 
 
 
 
 
 
 
Change in net unrealized investment gains/losses (1)
75,017

 
107,003

 
487,486

 
1,167,763

Noncredit component of OTTI losses (1)
110

 
(731
)
 
625

 
835

Reclassification of unrealized investment gains/losses to net income (loss) (1)
825

 
2,287

 
3,466

 
3,914

Other comprehensive income before income tax
75,952

 
108,559

 
491,577

 
1,172,512

Income tax effect related to other comprehensive income
(26,583
)
 
(37,995
)
 
(172,052
)
 
(410,379
)
Other comprehensive income
49,369

 
70,564

 
319,525

 
762,133

Comprehensive income
$
106,326

 
$
63,144

 
$
457,367

 
$
724,580

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

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

 
Common
Stock
 
Additional
Paid-in
Capital
 
Accumulated
Other
Comprehensive
Income
 
Retained
Earnings
 
Total
Stockholders'
Equity
Balance at December 31, 2015
$
81,354

 
$
630,367

 
$
201,663

 
$
1,031,151

 
$
1,944,535

Net loss for period

 

 

 
(37,553
)
 
(37,553
)
Other comprehensive income

 

 
762,133

 

 
762,133

Share-based compensation, including excess income tax benefits

 
5,335

 

 

 
5,335

Issuance of common stock via settlement of forward sale agreements
5,590

 
129,072

 

 

 
134,662

Issuance of 861,375 shares of common stock under compensation plans, including excess income tax benefits
861

 
2,890

 

 

 
3,751

Issuance of 92,998 shares of common stock to settle warrants that have reached their expiration
93

 
(94
)
 

 

 
(1
)
Balance at September 30, 2016
$
87,898

 
$
767,570

 
$
963,796

 
$
993,598

 
$
2,812,862

 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2016
$
88,001

 
$
770,344

 
$
339,966

 
$
1,093,284

 
$
2,291,595

Net income for period

 

 

 
137,842

 
137,842

Other comprehensive income

 

 
319,525

 

 
319,525

Share-based compensation

 
5,414

 

 

 
5,414

Issuance of 932,798 shares of common stock under compensation plans
933

 
7,358

 

 

 
8,291

Balance at September 30, 2017
$
88,934

 
$
783,116

 
$
659,491

 
$
1,231,126

 
$
2,762,667

See accompanying notes to unaudited consolidated financial statements.

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

 
Nine Months Ended 
 September 30,
 
2017
 
2016
Operating activities
 
 
 
Net income (loss)
$
137,842

 
$
(37,553
)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
 
 
 
Interest sensitive and index product benefits
1,392,763

 
487,735

Amortization of deferred sales inducements
110,727

 
127,396

Annuity product charges
(144,106
)
 
(125,304
)
Change in fair value of embedded derivatives
628,845

 
694,564

Change in traditional life and accident and health insurance reserves
170

 
8,977

Policy acquisition costs deferred
(312,355
)
 
(423,525
)
Amortization of deferred policy acquisition costs
162,248

 
198,486

Provision for depreciation and other amortization
2,793

 
3,000

Amortization of discounts and premiums on investments
11,079

 
(2,258
)
Realized gains (losses) on investments and net OTTI losses recognized in operations
(6,236
)
 
2,439

Change in fair value of derivatives
(1,016,714
)
 
(70,002
)
Deferred income taxes
(38,998
)
 
(66,895
)
Loss on extinguishment of debt
18,817

 

Share-based compensation
5,414

 
4,849

Change in accrued investment income
(41,409
)
 
(43,892
)
Change in income taxes recoverable/payable
407

 
16,947

Change in other assets
31

 
1,930

Change in other policy funds and contract claims
(19,941
)
 
(27,627
)
Change in collateral held for derivatives
446,920

 
254,210

Change in other liabilities
(62,487
)
 
(48,608
)
Other
(11,016
)
 
(10,363
)
Net cash provided by operating activities
1,264,794

 
944,506

 
 
 
 
Investing activities
 
 
 
Sales, maturities, or repayments of investments:
 
 
 
Fixed maturity securities - available for sale
1,333,829

 
1,853,281

Mortgage loans on real estate
240,245

 
302,262

Derivative instruments
1,150,793

 
147,887

Other investments
9,373

 
12,928

Acquisitions of investments:
 
 
 
Fixed maturity securities - available for sale
(3,755,011
)
 
(5,065,873
)
Mortgage loans on real estate
(370,229
)
 
(284,186
)
Derivative instruments
(494,226
)
 
(444,360
)
Other investments
(18,654
)
 
(9,778
)
Purchases of property, furniture and equipment
(3,894
)
 
(872
)
Net cash used in investing activities
(1,907,774
)
 
(3,488,711
)

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

 
Nine Months Ended 
 September 30,
 
2017
 
2016
Financing activities
 
 
 
Receipts credited to annuity and single premium universal life policyholder account balances
$
3,151,516

 
$
5,712,759

Coinsurance deposits
30,892

 
(1,180,827
)
Return of annuity policyholder account balances
(2,048,967
)
 
(1,806,895
)
Financing fees incurred and deferred
(5,609
)
 
(1,456
)
Proceeds from issuance of notes payable
499,650

 

Repayment of notes payable
(413,252
)
 

Repayment of loan payable
(100,000
)
 

Proceeds from issuance of loan payable

 
100,000

Net proceeds from amounts due under repurchase agreements
23,542

 

Excess tax benefits realized from share-based compensation plans

 
487

Proceeds from issuance of common stock
8,291

 
138,660

Change in checks in excess of cash balance
(8,687
)
 
(3,458
)
Net cash provided by financing activities
1,137,376

 
2,959,270

Increase in cash and cash equivalents
494,396

 
415,065

Cash and cash equivalents at beginning of period
791,266

 
397,749

Cash and cash equivalents at end of period
$
1,285,662

 
$
812,814

 
 
 
 
Supplemental disclosures of cash flow information
 
 
 
Cash paid during period for:
 
 
 
Interest expense
$
39,583

 
$
35,764

Income taxes
109,581

 
29,961

Non-cash operating activity:
 
 
 
Deferral of sales inducements
175,076

 
270,991

Non-cash financing activity:
 
 
 
Common stock issued to settle warrants that have expired

 
93

See accompanying notes to unaudited consolidated financial statements.




 

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AMERICAN EQUITY INVESTMENT LIFE HOLDING COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2017
(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, 2017 are not necessarily indicative of the results that may be expected for the year ended December 31, 2017. 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, 2016.
Adopted Accounting Pronouncements
In March 2016, the Financial Accounting Standards Board ("FASB") issued an accounting standards update ("ASU") related to the accounting for share-based payment transactions. The aspects of accounting guidance affected by this ASU are income taxes, classification of awards as either equity or liabilities, and classification on the statement of cash flows. We adopted this ASU on January 1, 2017. The adoption of this ASU resulted in an income tax benefit of $0.2 million and $1.8 million being recognized in operations during the three and nine month periods ended September 30, 2017 due to the requirement under this standard to recognize excess tax benefits related to share-based payment awards in income tax expense.
New Accounting Pronouncements
In May 2014, the FASB issued an ASU related to revenue arising from contracts with customers. This ASU, which replaces most current revenue recognition guidance, including industry specific guidance, prescribes that an entity should recognize revenue to reflect the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. This ASU will be effective for us on January 1, 2018 and may be adopted using either a full retrospective or a modified retrospective approach. While we are still evaluating the effect this ASU will have on our consolidated financial statements, we expect the impact will be insignificant as revenues related to insurance contracts and investment contracts are excluded from its scope.
In January 2016, the FASB issued an ASU that, among other aspects of recognition, measurement, presentation and disclosure of financial instruments, primarily requires equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. However, an entity may choose to measure equity investments that do not have readily determinable fair values at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. Additionally, it changes the accounting for financial liabilities measured at fair value under the fair value option and eliminates some disclosures regarding fair value of financial assets and liabilities measured at amortized cost. This ASU will be effective for us on January 1, 2018. While we are still in process of evaluating the full impact this guidance will have on our consolidated financial statements, we do not currently expect it to have a significant impact.
In February 2016, the FASB issued an ASU that will require recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. This ASU affects accounting and disclosure more dramatically for lessees as accounting for lessors is mainly unchanged. This ASU will be effective for us on January 1, 2019, with early adoption permitted. We are in process of evaluating the impact this guidance may have on our consolidated financial statements.
In June 2016, the FASB issued an ASU that significantly changes the impairment model for most financial assets that are measured at amortized cost and certain other instruments from an incurred loss model to an expected loss model that requires these assets be presented at the net amount expected to be collected. In addition, credit losses on available for sale debt securities should be recorded through an allowance account.  This ASU will be effective for us on January 1, 2020, with early adoption permitted. While we are still in process of evaluating the full impact this guidance will have on our consolidated financial statements, we believe the new impairment model will lead to earlier recognition of credit losses for our commercial mortgage loans.

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In August 2016, the FASB issued an ASU that clarifies how certain cash receipts and cash payments are to be presented and classified in the statement of cash flows. This ASU will be effective for us on January 1, 2018, with early adoption permitted. While we are still in process of evaluating the full impact this guidance will have on our consolidated financial statements, we do not currently expect it to have a significant impact.
In March 2017, the FASB issued an ASU that applies to certain callable debt securities where the amortized cost basis is at a premium to the price repayable by the issuer at the earliest call date. Under this guidance, the premium will be amortized to the first call date. This ASU will be effective for us on January 1, 2019, with early adoption permitted. We are in process of evaluating the impact this guidance may have on our consolidated financial statements.

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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, 2017
 
December 31, 2016
 
Carrying
Amount
 
Fair Value
 
Carrying
Amount
 
Fair Value
 
(Dollars in thousands)
Assets
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
Available for sale
$
44,601,297

 
$
44,601,297

 
$
41,060,494

 
$
41,060,494

Held for investment
76,986

 
75,046

 
76,825

 
68,766

Mortgage loans on real estate
2,611,426

 
2,625,709

 
2,480,956

 
2,522,035

Derivative instruments
1,235,125

 
1,235,125

 
830,519

 
830,519

Other investments
328,299

 
318,802

 
308,774

 
300,918

Cash and cash equivalents
1,285,662

 
1,285,662

 
791,266

 
791,266

Coinsurance deposits
4,758,417

 
4,262,511

 
4,639,492

 
4,150,792

Interest rate caps
370

 
370

 
1,082

 
1,082

Counterparty collateral
125,940

 
125,940

 
145,693

 
145,693

 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
Policy benefit reserves
54,578,829

 
45,513,913

 
51,280,331

 
43,104,183

Single premium immediate annuity (SPIA) benefit reserves
283,503

 
293,282

 
297,724

 
308,028

Notes and loan payable
493,972

 
533,800

 
493,755

 
519,440

Subordinated debentures
242,145

 
240,752

 
241,853

 
225,106

Amounts due under repurchase agreements
23,542

 
23,542

 

 

Interest rate swap
1,687

 
1,687

 
2,113

 
2,113

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

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Our assets and liabilities which are measured at fair value on a recurring basis as of September 30, 2017 and December 31, 2016 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, 2017
 
 
 
 
 
 
 
Assets
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
Available for sale:
 
 
 
 
 
 
 
United States Government full faith and credit
$
11,935

 
$
5,704

 
$
6,231

 
$

United States Government sponsored agencies
1,302,075

 

 
1,302,075

 

United States municipalities, states and territories
4,093,632

 

 
4,093,632

 

Foreign government obligations
240,400

 

 
240,400

 

Corporate securities
29,675,924

 
7

 
29,675,917

 

Residential mortgage backed securities
1,146,822

 

 
1,146,822

 

Commercial mortgage backed securities
5,532,483

 

 
5,532,483

 

Other asset backed securities
2,598,026

 

 
2,598,026

 

Other investments: equity securities, available for sale
7,427

 

 
7,427

 

Derivative instruments
1,235,125

 

 
1,235,125

 

Cash and cash equivalents
1,285,662

 
1,285,662

 

 

Interest rate caps
370

 

 
370

 

Counterparty collateral
125,940

 

 
125,940

 

 
$
47,255,821

 
$
1,291,373

 
$
45,964,448

 
$

Liabilities
 
 
 
 
 
 
 
Interest rate swap
$
1,687

 
$

 
$
1,687

 
$

Fixed index annuities - embedded derivatives
8,069,105

 

 

 
8,069,105

 
$
8,070,792

 
$

 
$
1,687

 
$
8,069,105

 
 
 
 
 
 
 
 
December 31, 2016
 
 
 
 
 
 
 
Assets
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
Available for sale:
 
 
 
 
 
 
 
United States Government full faith and credit
$
11,805

 
$
5,381

 
$
6,424

 
$

United States Government sponsored agencies
1,344,787

 

 
1,344,787

 

United States municipalities, states and territories
3,926,950

 

 
3,926,950

 

Foreign government obligations
236,341

 

 
236,341

 

Corporate securities
27,114,418

 
6

 
27,114,412

 

Residential mortgage backed securities
1,254,835

 

 
1,254,835

 

Commercial mortgage backed securities
5,365,235

 

 
5,365,235

 

Other asset backed securities
1,806,123

 

 
1,806,123

 

Other investments: equity securities, available for sale
8,000

 

 
8,000

 

Derivative instruments
830,519

 

 
830,519

 

Cash and cash equivalents
791,266

 
791,266

 

 

Interest rate caps
1,082

 

 
1,082

 

Counterparty collateral
145,693

 

 
145,693

 

 
$
42,837,054

 
$
796,653

 
$
42,040,401

 
$

Liabilities
 
 
 
 
 
 
 
Interest rate swap
$
2,113

 
$

 
$
2,113

 
$

Fixed index annuities - embedded derivatives
6,563,288

 

 

 
6,563,288

 
$
6,565,401

 
$

 
$
2,113

 
$
6,563,288


11

Table of Contents

The following methods and assumptions were used in estimating the fair values of financial instruments during the periods presented in these consolidated financial statements.
Fixed maturity securities and equity securities
The fair values of fixed maturity securities and equity securities in an active and orderly market are determined by utilizing independent pricing services. The independent pricing services incorporate a variety of observable market data in their valuation techniques, including:
reported trading prices,
benchmark yields,
broker-dealer quotes,
benchmark securities,
bids and offers,
credit ratings,
relative credit information, and
other reference data.
The independent pricing services also take into account perceived market movements and sector news, as well as a security's terms and conditions, including any features specific to that issue that may influence risk and marketability. Depending on the security, the priority of the use of observable market inputs may change as some observable market inputs may not be relevant or additional inputs may be necessary.
The independent pricing services provide quoted market prices when available. Quoted prices are not always available due to market inactivity. When quoted market prices are not available, the third parties use yield data and other factors relating to instruments or securities with similar characteristics to determine fair value for securities that are not actively traded. We generally obtain one value from our primary external pricing service. In situations where a price is not available from this service, we may obtain quotes or prices from additional parties as needed. Market indices of similar rated asset class spreads are considered for valuations and broker indications of similar securities are compared. Inputs used by the broker include market information, such as yield data and other factors relating to instruments or securities with similar characteristics. Valuations and quotes obtained from third party commercial pricing services are non-binding and do not represent quotes on which one may execute the disposition of the assets.
We validate external valuations at least quarterly through a combination of procedures that include the evaluation of methodologies used by the pricing services, analytical reviews and performance analysis of the prices against trends, and maintenance of a securities watch list. Additionally, as needed we utilize discounted cash flow models or perform independent valuations on a case-by-case basis using inputs and assumptions similar to those used by the pricing services. Although we do identify differences from time to time as a result of these validation procedures, we did not make any significant adjustments as of September 30, 2017 and December 31, 2016.
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); 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
Available for sale equity securities are the only financial instruments included in other investments that are measured at fair value on a recurring basis (see determination of fair value above). Financial instruments included in other investments that are not measured at fair value on a recurring basis are policy loans, equity method investments and company owned life insurance (COLI). We have not attempted to determine the fair values associated with our policy loans, as we believe any differences between carrying 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.

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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.
Counterparty collateral
Amounts reported in other assets in the consolidated balance sheets for these instruments are reported at their historical cost which approximates fair value due to the nature of the assets assigned to this category.
Policy benefit reserves, coinsurance deposits and SPIA benefit reserves
The fair values of the liabilities under contracts not involving significant mortality or morbidity risks (principally deferred annuities), are stated at the cost we would incur to extinguish the liability (i.e., the cash surrender value) as these contracts are generally issued without an annuitization date. The coinsurance deposits related to the annuity benefit reserves have fair values determined in a similar fashion. For period-certain annuity benefit contracts, the fair value is determined by discounting the benefits at the interest rates currently in effect for newly issued immediate annuity contracts. We are not required to and have not estimated the fair value of the liabilities under contracts that involve significant mortality or morbidity risks, as these liabilities fall within the definition of insurance contracts that are exceptions from financial instruments that require disclosures of fair value. Policy benefit reserves, coinsurance deposits and SPIA benefit reserves are not measured at fair value on a recurring basis. All of the fair values presented within these categories fall within Level 3 of the fair value hierarchy as most of the inputs are unobservable market data.
Notes and loan payable
The fair values of our senior unsecured notes are based upon pricing matrices developed by a third party pricing service when quoted market prices are not available and are categorized as Level 2 within the fair value hierarchy. The fair value of our term loan is estimated using discounted cash flow calculations based principally on observable inputs including our incremental borrowing rate, which reflects our credit rating, for a similar type of borrowing with a maturity consistent with that remaining for the term loan. Notes and loan payable are not remeasured at fair value on a recurring basis.
Subordinated debentures
Fair values for subordinated debentures are estimated using discounted cash flow calculations based principally on observable inputs including our incremental borrowing rates, which reflect our credit rating, for similar types of borrowings with maturities consistent with those remaining for the debt being valued. These fair values are categorized as Level 2 within the fair value hierarchy. Subordinated debentures are not measured at fair value on a recurring basis.
Amounts due under repurchase agreements
The amounts reported in the consolidated balance sheets for short term indebtedness under repurchase agreements with variable interest rates approximate their fair values.
Fixed index annuities - embedded derivatives
We estimate the fair value of the embedded derivative component of our fixed index annuity policy benefit reserves at each valuation date by (i) projecting policy contract values and minimum guaranteed contract values over the expected lives of the contracts and (ii) discounting the excess of the projected contract value amounts at the applicable risk free interest rates adjusted for our nonperformance risk related to those liabilities. The projections of policy contract values are based on our best estimate assumptions for future policy growth and future policy decrements. Our best estimate assumptions for future policy growth include assumptions for the expected index credit on the next policy anniversary date which are derived from the fair values of the underlying call options purchased to fund such index credits and the expected costs of annual call options we will purchase in the future to fund index credits beyond the next policy anniversary. The projections of minimum guaranteed contract values include the same best estimate assumptions for policy decrements as were used to project policy contract values.
Within this determination we have the following significant unobservable inputs: 1) the expected cost of annual call options we will purchase in the future to fund index credits beyond the next policy anniversary and 2) our best estimates for future policy decrements, primarily lapse, partial withdrawal and mortality rates. As of September 30, 2017 and December 31, 2016, we utilized an estimate of 3.10% for the expected cost of annual call options, which are based on estimated long-term account value growth and a historical review of our actual option costs.

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Table of Contents

Our best estimate assumptions for lapse, partial withdrawal and mortality rates are based on our actual experience and our outlook as to future expectations for such assumptions. These assumptions, which are consistent with the assumptions used in calculating deferred policy acquisition costs and deferred sales inducements, are reviewed on a quarterly basis and are revised as our experience develops and/or as future expectations change. Our mortality rate assumptions are based on 65% of the 1983 Basic Annuity Mortality Tables. The following table presents average lapse rate and partial withdrawal rate assumptions, by contract duration, used in estimating the fair value of the embedded derivative component of our fixed index annuity policy benefit reserves at each reporting date:
 
 
Average Lapse Rates
 
Average Partial Withdrawal Rates
Contract Duration (Years)
 
September 30, 2017
 
December 31, 2016
 
September 30, 2017
 
December 31, 2016
1 - 5
 
1.83%
 
1.76%
 
3.32%
 
3.30%
6 - 10
 
7.03%
 
6.58%
 
3.32%
 
3.30%
11 - 15
 
11.29%
 
11.25%
 
3.34%
 
3.32%
16 - 20
 
11.97%
 
12.04%
 
3.20%
 
3.18%
20+
 
11.63%
 
11.68%
 
3.20%
 
3.18%
Lapse rates are generally expected to increase as surrender charge percentages decrease. Lapse expectations reflect a significant increase in the year in which the surrender charge period on a contract ends.
The following table provides a reconciliation of the beginning and ending balances for our Level 3 liabilities, which are measured at fair value on a recurring basis using significant unobservable inputs for the three and nine months ended September 30, 2017 and 2016:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2017
 
2016
 
2017
 
2016
 
(Dollars in thousands)
Fixed index annuities - embedded derivatives
 
 
 
 
 
 
 
Beginning balance
$
7,552,365

 
$
6,499,015

 
$
6,563,288

 
$
5,983,622

Premiums less benefits
475,600

 
137,526

 
1,384,791

 
273,287

Change in fair value, net
41,140

 
41,561

 
121,026

 
421,193

Ending balance
$
8,069,105

 
$
6,678,102

 
$
8,069,105

 
$
6,678,102

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, 2017, were to increase by 100 basis points, the fair value of the embedded derivatives would decrease by $542.4 million recorded through operations as a decrease in the change in fair value of embedded derivatives and there would be a corresponding decrease of $318.9 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 $604.9 million recorded through operations as an increase in the change in fair value of embedded derivatives and there would be a corresponding increase of $351.5 million to our combined balance for deferred policy acquisition costs and deferred sales inducements recorded through operations as a decrease in amortization of deferred policy acquisition costs and deferred sales inducements.

14

Table of Contents

3. Investments
At September 30, 2017 and December 31, 2016, the amortized cost and fair value of fixed maturity securities were as follows:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair Value
 
(Dollars in thousands)
September 30, 2017
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
Available for sale:
 
 
 
 
 
 
 
United States Government full faith and credit
$
11,864

 
$
210

 
$
(139
)
 
$
11,935

United States Government sponsored agencies
1,306,423

 
29,350

 
(33,698
)
 
1,302,075

United States municipalities, states and territories
3,737,212

 
362,914

 
(6,494
)
 
4,093,632

Foreign government obligations
228,291

 
13,821

 
(1,712
)
 
240,400

Corporate securities
28,071,650

 
1,755,592

 
(151,318
)
 
29,675,924

Residential mortgage backed securities
1,060,247

 
88,841

 
(2,266
)
 
1,146,822

Commercial mortgage backed securities
5,510,057

 
90,743

 
(68,317
)
 
5,532,483

Other asset backed securities
2,560,531

 
52,145

 
(14,650
)
 
2,598,026

 
$
42,486,275

 
$
2,393,616

 
$
(278,594
)
 
$
44,601,297

Held for investment:
 
 
 
 
 
 
 
Corporate security
$
76,986

 
$

 
$
(1,940
)
 
$
75,046

 
 
 
 
 
 
 
 
Other investments: equity securities, available for sale:
 
 
 
 
 
 
 
Finance, insurance, and real estate
$
7,427

 
$

 
$

 
$
7,427

 
 
 
 
 
 
 
 
December 31, 2016
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
Available for sale:
 
 
 
 
 
 
 
United States Government full faith and credit
$
11,864

 
$
229

 
$
(288
)
 
$
11,805

United States Government sponsored agencies
1,368,340

 
23,360

 
(46,913
)
 
1,344,787

United States municipalities, states and territories
3,626,395

 
322,948

 
(22,393
)
 
3,926,950

Foreign government obligations
229,589

 
11,832

 
(5,080
)
 
236,341

Corporate securities
26,333,213

 
1,149,978

 
(368,773
)
 
27,114,418

Residential mortgage backed securities
1,166,944

 
91,445

 
(3,554
)
 
1,254,835

Commercial mortgage backed securities
5,422,255

 
59,994

 
(117,014
)
 
5,365,235

Other asset backed securities
1,795,355

 
31,471

 
(20,703
)
 
1,806,123

 
$
39,953,955

 
$
1,691,257

 
$
(584,718
)
 
$
41,060,494

Held for investment:
 
 
 
 
 
 
 
Corporate security
$
76,825

 
$

 
$
(8,059
)
 
$
68,766

 
 
 
 
 
 
 
 
Other investments: equity securities, available for sale:
 
 
 
 
 
 
 
Finance, insurance, and real estate
$
7,521

 
$
479

 
$

 
$
8,000

At September 30, 2017, 37% of our fixed income securities have call features, of which 2.7% ($1.2 billion) were subject to call redemption and another 0.3% ($125.6 million) will become subject to call redemption during the next twelve months. Approximately 73% of our fixed income securities that have call features are not callable until within six months of their stated maturities.

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Table of Contents

The amortized cost and fair value of fixed maturity securities at September 30, 2017, 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
$
254,328

 
$
259,418

 
$

 
$

Due after one year through five years
4,036,883

 
4,220,686

 

 

Due after five years through ten years
11,479,300

 
11,803,130

 

 

Due after ten years through twenty years
8,941,769

 
9,725,828

 

 

Due after twenty years
8,643,160

 
9,314,904

 
76,986

 
75,046

 
33,355,440

 
35,323,966

 
76,986

 
75,046

Residential mortgage backed securities
1,060,247

 
1,146,822

 

 

Commercial mortgage backed securities
5,510,057

 
5,532,483

 

 

Other asset backed securities
2,560,531

 
2,598,026

 

 

 
$
42,486,275

 
$
44,601,297

 
$
76,986

 
$
75,046

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, 2017
 
December 31, 2016
 
(Dollars in thousands)
Net unrealized gains on available for sale fixed maturity securities and equity securities
$
2,115,022

 
$
1,107,018

Adjustments for assumed changes in amortization of deferred policy acquisition costs and deferred sales inducements
(1,135,088
)
 
(618,661
)
Deferred income tax valuation allowance reversal
22,534

 
22,534

Deferred income tax expense
(342,977
)
 
(170,925
)
Net unrealized gains reported as accumulated other comprehensive income
$
659,491

 
$
339,966

The National Association of Insurance Commissioners (“NAIC”) assigns designations to fixed maturity securities. These designations range from Class 1 (highest quality) to Class 6 (lowest quality). In general, securities are assigned a designation based upon the ratings they are given by the Nationally Recognized Statistical Rating Organizations (“NRSRO’s”). The NAIC designations are utilized by insurers in preparing their annual statutory statements. NAIC Class 1 and 2 designations are considered “investment grade” while NAIC Class 3 through 6 designations are considered “non-investment grade.” Based on the NAIC designations, we had 97% of our fixed maturity portfolio rated investment grade at both September 30, 2017 and December 31, 2016, respectively.
The following table summarizes the credit quality, as determined by NAIC designation, of our fixed maturity portfolio as of the dates indicated:
 
 
September 30, 2017
 
December 31, 2016
NAIC
Designation
 
Amortized Cost
 
Fair Value
 
Amortized Cost
 
Fair Value
 
 
(Dollars in thousands)
1
 
$
26,653,735

 
$
28,133,264

 
$
25,607,268

 
$
26,507,798

2
 
14,618,128

 
15,264,374

 
13,037,592

 
13,295,648

3
 
1,156,976

 
1,149,258

 
1,201,059

 
1,155,702

4
 
102,604

 
98,308

 
154,226

 
137,188

5
 
19,492

 
22,271

 
17,475

 
24,664

6
 
12,326

 
8,868

 
13,160

 
8,260

 
 
$
42,563,261

 
$
44,676,343

 
$
40,030,780

 
$
41,129,260


16

Table of Contents

The following table shows our investments' gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities (consisting of 906 and 1,514 securities, respectively) have been in a continuous unrealized loss position, at September 30, 2017 and December 31, 2016:
 
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, 2017
 
 
 
 
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
 
 
 
 
Available for sale:
 
 
 
 
 
 
 
 
 
 
 
United States Government full faith and credit
$
6,731

 
$
(139
)
 
$

 
$

 
$
6,731

 
$
(139
)
United States Government sponsored agencies
914,762

 
(28,722
)
 
72,024

 
(4,976
)
 
986,786

 
(33,698
)
United States municipalities, states and territories
206,787

 
(6,467
)
 
473

 
(27
)
 
207,260

 
(6,494
)
Foreign government obligations
49,971

 
(30
)
 
12,641

 
(1,682
)
 
62,612

 
(1,712
)
Corporate securities:
 
 
 
 
 
 
 
 
 
 
 
Finance, insurance and real estate
691,425

 
(22,211
)
 
270,612

 
(12,683
)
 
962,037

 
(34,894
)
Manufacturing, construction and mining
387,180

 
(7,752
)
 
161,727

 
(9,802
)
 
548,907

 
(17,554
)
Utilities and related sectors
446,845

 
(8,962
)
 
94,224

 
(5,477
)
 
541,069

 
(14,439
)
Wholesale/retail trade
244,317

 
(6,418
)
 
72,601

 
(4,356
)
 
316,918

 
(10,774
)
Services, media and other
923,719

 
(24,079
)
 
663,689

 
(49,578
)
 
1,587,408

 
(73,657
)
Residential mortgage backed securities
31,390

 
(607
)
 
19,849

 
(1,659
)
 
51,239

 
(2,266
)
Commercial mortgage backed securities
1,508,005

 
(27,249
)
 
731,738

 
(41,068
)
 
2,239,743

 
(68,317
)
Other asset backed securities
633,600

 
(3,588
)
 
147,538

 
(11,062
)
 
781,138

 
(14,650
)
 
$
6,044,732

 
$
(136,224
)
 
$
2,247,116

 
$
(142,370
)
 
$
8,291,848

 
$
(278,594
)
Held for investment:
 
 
 
 
 
 
 
 
 
 
 
Corporate security:
 
 
 
 
 
 
 
 
 
 
 
Insurance
$

 
$

 
$
75,046

 
$
(1,940
)
 
$
75,046

 
$
(1,940
)
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2016
 
 
 
 
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
 
 
 
 
Available for sale:
 
 
 
 
 
 
 
 
 
 
 
United States Government full faith and credit
$
7,405

 
$
(288
)
 
$

 
$

 
$
7,405

 
$
(288
)
United States Government sponsored agencies
995,548

 
(46,913
)
 

 

 
995,548

 
(46,913
)
United States municipalities, states and territories
463,409

 
(22,393
)
 

 

 
463,409

 
(22,393
)
Foreign government obligations
29,158

 
(913
)
 
20,388

 
(4,167
)
 
49,546

 
(5,080
)
Corporate securities:
 
 
 
 
 
 
 
 
 
 
 
Finance, insurance and real estate
1,940,107

 
(70,421
)
 
82,907

 
(7,723
)
 
2,023,014

 
(78,144
)
Manufacturing, construction and mining
1,199,420

 
(34,304
)
 
311,591

 
(23,273
)
 
1,511,011

 
(57,577
)
Utilities and related sectors
1,401,650

 
(45,015
)
 
58,597

 
(5,820
)
 
1,460,247

 
(50,835
)
Wholesale/retail trade
637,121

 
(18,880
)
 
29,719

 
(1,930
)
 
666,840

 
(20,810
)
Services, media and other
2,539,519

 
(82,196
)
 
716,857

 
(79,211
)
 
3,256,376

 
(161,407
)
Residential mortgage backed securities
81,762

 
(3,463
)
 
1,853

 
(91
)
 
83,615

 
(3,554
)
Commercial mortgage backed securities
3,148,395

 
(116,938
)
 
895

 
(76
)
 
3,149,290

 
(117,014
)
Other asset backed securities
751,533

 
(12,289
)
 
146,167

 
(8,414
)
 
897,700

 
(20,703
)
 
$
13,195,027

 
$
(454,013
)
 
$
1,368,974

 
$
(130,705
)
 
$
14,564,001

 
$
(584,718
)
Held for investment:
 
 
 
 
 
 
 
 
 
 
 
Corporate security:
 
 
 
 
 
 
 
 
 
 
 
Insurance
$

 
$

 
$
68,766

 
$
(8,059
)
 
$
68,766

 
$
(8,059
)
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, 2017 are principally related to timing of the purchases of these securities, which carry less yield than those available at September 30, 2017.

17

Table of Contents

Approximately 85% and 86% of the unrealized losses on fixed maturity securities shown in the above table for September 30, 2017 and December 31, 2016, 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, 2017 and 2016 are as follows:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2017
 
2016
 
2017
 
2016
 
(Dollars in thousands)
Fixed maturity securities held for investment carried at amortized cost
$
(1,711
)
 
$
6,954

 
$
6,119

 
$
10,019

Investments carried at fair value:
 
 
 
 
 
 
 
Fixed maturity securities, available for sale
$
128,981

 
$
224,258

 
$
1,008,483

 
$
2,507,204

Equity securities, available for sale
(457
)
 
28

 
(479
)
 
10

 
128,524

 
224,286

 
1,008,004

 
2,507,214

Adjustment for effect on other balance sheet accounts:
 
 
 
 
 
 
 
Deferred policy acquisition costs and deferred sales inducements
(52,572
)
 
(115,727
)
 
(516,427
)
 
(1,334,702
)
Deferred income tax asset/liability
(26,583
)
 
(37,995
)
 
(172,052
)
 
(410,379
)
 
(79,155
)
 
(153,722
)
 
(688,479
)
 
(1,745,081
)
Change in net unrealized gains on investments carried at fair value
$
49,369

 
$
70,564

 
$
319,525

 
$
762,133

Proceeds from sales of available for sale securities for the nine months ended September 30, 2017 and 2016 were $496.1 million and $364.0 million, respectively. Scheduled principal repayments, calls and tenders for available for sale securities for the nine months ended September 30, 2017 and 2016 were $837.7 million and $1.5 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 on investments, excluding net OTTI losses for the three and nine months ended September 30, 2017 and 2016, are as follows:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2017
 
2016
 
2017
 
2016
 
(Dollars in thousands)
Available for sale fixed maturity securities:
 
 
 
 
 
 
 
Gross realized gains
$
1,520

 
$
4,956

 
$
11,571

 
$
11,047

Gross realized losses
(1
)
 
(79
)
 
(4,463
)
 
(2,678
)
 
1,519

 
4,877

 
7,108

 
8,369

Available for sale equity securities:
 
 
 
 
 
 
 
Gross realized gains
348

 

 
348

 

 
 
 
 
 
 
 
 
Other investments:
 
 
 
 
 
 
 
Gain on sale of real estate
12

 
31

 
56

 
867

Loss on sale of real estate

 

 

 
(93
)
 
12

 
31

 
56

 
774

Mortgage loans on real estate:
 
 
 
 
 
 
 
Decrease (increase) in allowance for credit losses
(300
)
 
(113
)
 
278

 
(3,946
)
Recovery of specific allowance

 
461

 

 
5,483

 
(300
)
 
348

 
278

 
1,537

 
$
1,579

 
$
5,256

 
$
7,790

 
$
10,680

Losses on available for sale fixed maturity securities were realized primarily due to strategies to reposition the fixed maturity security portfolio that result in improved net investment income, credit risk or duration profiles as they pertain to our asset liability management. Securities were sold at losses in 2017 and 2016 due to our long-term fundamental concern with the issuers' ability to meet their future financial obligations.
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.

18

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 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.

19

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, 2017 and 2016, 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, 2017
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Prime
 
2005
 
7.0
%
 
7.7
%
 
8
%
 
22
%
 
40
%
 
50
%
 
 
2006
 
7.3
%
 
7.3
%
 
14
%
 
14
%
 
40
%
 
40
%
 
 
2007
 
6.2
%
 
6.6
%
 
15
%
 
19
%
 
50
%
 
60
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Nine months ended September 30, 2016
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Prime
 
2005
 
7.7
%
 
7.7
%
 
14
%
 
14
%
 
50
%
 
50
%
 
 
2006
 
7.3
%
 
7.3
%
 
13
%
 
13
%
 
50
%
 
50
%
 
 
2007
 
6.2
%
 
6.4
%
 
18
%
 
31
%
 
50
%
 
55
%
Alt-A
 
2005
 
7.4
%
 
7.4
%
 
11
%
 
11
%
 
60
%
 
60
%
The determination of the credit loss component of a corporate bond (including redeemable preferred stocks) is based on the underlying financial performance of the issuer and their ability to meet their contractual obligations. Considerations in our evaluation include, but are not limited to, credit rating changes, financial statement and ratio analysis, changes in management, significant changes in credit spreads, breaches of financial covenants and a review of the economic outlook for the industry and markets in which they trade. In circumstances where an issuer appears unlikely to meet its future obligation, or the security's price decline is deemed other than temporary, an estimate of credit loss is determined. Credit loss is calculated using default probabilities as derived from the credit default swaps markets in conjunction with recovery rates derived from independent third party analysis or a best estimate of credit loss. This credit loss rate is then incorporated into a present value calculation based on an expected principal loss in the future discounted at the yield at the date of purchase and compared to amortized cost to determine the amount of credit loss associated with the security.
In addition, for debt securities which we do not intend to sell and it is not more likely than not we will be required to sell, but our intent changes due to changes or events that could not have been reasonably anticipated, an other than temporary impairment charge is recognized. Once an impairment charge has been recorded, we then continue to review the other than temporarily impaired securities for appropriate valuation on an ongoing basis. Unrealized losses may be recognized in future periods through a charge to earnings should we later conclude that the decline in fair value below amortized cost is other than temporary pursuant to our accounting policy described above. The use of different methodologies and assumptions to determine the fair value of investments and the timing and amount of impairments may have a material effect on the amounts presented in our consolidated financial statements.

20

Table of Contents

The following table summarizes other than temporary impairments for the three and nine months ended September 30, 2017 and 2016, 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, 2017
 
 
 
 
 
 
 
Fixed maturity securities, available for sale:
 
 
 
 
 
 
 
Residential mortgage backed securities
3

 
$
(273
)
 
$
(191
)
 
$
(464
)
 
 
 
 
 
 
 
 
Three months ended September 30, 2016
 
 
 
 
 
 
 
Fixed maturity securities, available for sale:
 
 
 
 
 
 
 
Corporate securities:
 
 
 
 
 
 
 
Materials
1

 
$
(4,554
)
 
$
1,575

 
$
(2,979
)
 
 
 
 
 
 
 
 
Nine months ended September 30, 2017
 
 
 
 
 
 
 
Fixed maturity securities, available for sale:
 
 
 
 
 
 
 
Residential mortgage backed securities
8

 
$
(273
)
 
$
(994
)
 
$
(1,267
)
Other asset backed securities
1

 

 
(287
)
 
(287
)
 
9

 
$
(273
)
 
$
(1,281
)
 
$
(1,554
)
 
 
 
 
 
 
 
 
Nine months ended September 30, 2016
 
 
 
 
 
 
 
Fixed maturity securities, available for sale:
 
 
 
 
 
 
 
Corporate securities:
 
 
 
 
 
 
 
Energy
2

 
$
(642
)
 
$

 
$
(642
)
Materials
1

 
(4,554
)
 
1,575

 
(2,979
)
Telecommunications
1

 
(4,462
)
 
562

 
(3,900
)
Utilities
1

 
(136
)
 

 
(136
)
Residential mortgage backed securities
6

 

 
(440
)
 
(440
)
Commercial mortgage backed securities
5

 
(1,540
)
 

 
(1,540
)
Other asset backed securities
1

 

 
(3,482
)
 
(3,482
)
 
17

 
$
(11,334
)
 
$
(1,785
)
 
$
(13,119
)
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,
 
2017
 
2016
 
2017
 
2016
 
(Dollars in thousands)
Cumulative credit loss at beginning of period
$
(153,526
)
 
$
(154,408
)
 
$
(166,375
)
 
$
(145,824
)
Credit losses on securities for which OTTI has not previously been recognized
(273
)
 
(2,979
)
 
(273
)
 
(9,197
)
Additional credit losses on securities for which OTTI has previously been recognized
(191
)
 

 
(1,281
)
 
(3,922
)
Accumulated losses on securities that were disposed of during the period

 
573

 
13,939

 
2,129

Cumulative credit loss at end of period
$
(153,990
)
 
$
(156,814
)
 
$
(153,990
)
 
$
(156,814
)

21

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, by major type of security, for securities that are part of our investment portfolio at September 30, 2017 and December 31, 2016:
 
Amortized Cost
 
OTTI
Recognized in
Other
Comprehensive
Income
 
Change in Fair
Value Since
OTTI was
Recognized
 
Fair Value
 
(Dollars in thousands)
September 30, 2017
 
 
 
 
 
 
 
Fixed maturity securities, available for sale:
 
 
 
 
 
 
 
Corporate securities
$
10,508

 
$
(4,263
)
 
$
10,432

 
$
16,677

Residential mortgage backed securities
313,966

 
(168,946
)
 
204,207

 
349,227

Other asset backed securities
4,567

 
(1,356
)
 
(1,924
)
 
1,287

 
$
329,041

 
$
(174,565
)
 
$
212,715

 
$
367,191

December 31, 2016
 
 
 
 
 
 
 
Fixed maturity securities, available for sale:
 
 
 
 
 
 
 
Corporate securities
$
17,549

 
$
(5,910
)
 
$
13,566

 
$
25,205

Residential mortgage backed securities
368,862

 
(169,941
)
 
205,854

 
404,775

Commercial mortgage backed securities
6,596

 

 
(107
)
 
6,489

Other asset backed securities
6,683

 
(1,643
)
 
(1,566
)
 
3,474

 
$
399,690

 
$
(177,494
)
 
$
217,747

 
$
439,943

4. Mortgage Loans on Real Estate
Our mortgage loan portfolio is summarized in the following table. There were commitments outstanding of $113.9 million at September 30, 2017.
 
September 30, 2017
 
December 31, 2016
 
(Dollars in thousands)
Principal outstanding
$
2,620,756

 
$
2,490,619

Loan loss allowance
(8,149
)
 
(8,427
)
Deferred prepayment fees
(1,181
)
 
(1,236
)
Carrying value
$
2,611,426

 
$
2,480,956


22

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, 2017
 
December 31, 2016
 
Principal
 
Percent
 
Principal
 
Percent
 
(Dollars in thousands)
Geographic distribution
 
 
 
 
 
 
 
East
$
586,379

 
22.4
%
 
$
635,434

 
25.5
%
Middle Atlantic
173,873

 
6.6
%
 
151,640

 
6.1
%
Mountain
303,314

 
11.6
%
 
235,932

 
9.5
%
New England
12,381

 
0.5
%
 
12,724

 
0.5
%
Pacific
446,512

 
17.0
%
 
385,683

 
15.5
%
South Atlantic
555,184

 
21.2
%
 
519,065

 
20.8
%
West North Central
316,294

 
12.1
%
 
325,447

 
13.1
%
West South Central
226,819

 
8.6
%
 
224,694

 
9.0
%
 
$
2,620,756

 
100.0
%
 
$
2,490,619

 
100.0
%
Property type distribution
 
 
 
 
 
 
 
Office
$
282,595

 
10.8
%
 
$
308,578

 
12.4
%
Medical Office
34,795

 
1.3
%
 
50,780

 
2.1
%
Retail
1,018,501

 
38.9
%
 
886,942

 
35.6
%
Industrial/Warehouse
690,808

 
26.4
%
 
700,644

 
28.1
%
Apartment
420,454

 
16.0
%
 
375,837

 
15.1
%
Mixed use/other
173,603

 
6.6
%
 
167,838

 
6.7
%
 
$
2,620,756

 
100.0
%
 
$
2,490,619

 
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.

23

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, 2017
 
Three Months Ended 
 September 30, 2016
 
Specific
Allowance
 
General Allowance
 
Specific
Allowance
 
General Allowance
 
(Dollars in thousands)
Beginning allowance balance
$
(2,049
)
 
$
(5,800
)
 
$
(4,552
)
 
$
(6,300
)
Charge-offs

 

 
2,977

 

Recoveries

 

 
461

 

Change in provision for credit losses

 
(300
)
 
(213
)
 
100

Ending allowance balance
$
(2,049
)
 
$
(6,100
)
 
$
(1,327
)
 
$
(6,200
)
 
 
 
 
 
 
 
 
 
Nine Months Ended 
 September 30, 2017
 
Nine Months Ended 
 September 30, 2016
 
Specific
Allowance
 
General Allowance
 
Specific
Allowance
 
General Allowance
 
(Dollars in thousands)
Beginning allowance balance
$
(1,327
)
 
$
(7,100
)
 
$
(7,842
)
 
$
(6,300
)
Charge-offs

 

 
5,078

 

Recoveries

 

 
5,483

 

Change in provision for credit losses
(722
)
 
1,000

 
(4,046
)
 
100

Ending allowance balance
$
(2,049
)
 
$
(6,100
)
 
$
(1,327
)
 
$
(6,200
)
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, 2017
 
December 31, 2016
 
(Dollars in thousands)
Individually evaluated for impairment
$
6,728

 
$
4,640

Collectively evaluated for impairment
2,614,028

 
2,485,979

Total loans evaluated for impairment
$
2,620,756

 
$
2,490,619

Charge-offs include allowances that have been established on loans that were satisfied either by taking ownership of the collateral or by some other means such as discounted pay-off or loan sale. When ownership of the property is taken it is recorded at the lower of the mortgage loan's carrying value or the property's fair value (based on appraised values) less estimated costs to sell. The real estate owned is recorded as a component of other investments and the mortgage loan is recorded as fully paid, with any allowance for credit loss that has been established charged off. Fair value of the real estate is determined by third party appraisal. Recoveries are situations where we have received a payment from the borrower in an amount greater than the carrying value of the loan (principal outstanding less specific allowance).
We did not own any real estate during the three and nine months ended September 30, 2017. The following table summarizes the activity in real estate owned, included in Other investments, which was obtained in satisfaction of mortgage loans on real estate during the three and nine months ended September 30, 2016:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2016
 
2016
 
(Dollars in thousands)
Real estate owned at beginning of period
$

 
$
6,485

Real estate acquired in satisfaction of mortgage loans

 

Additions

 

Sales

 
(6,444
)
Impairments

 

Depreciation

 
(41
)
Real estate owned at end of period
$

 
$


24

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, 2017
 
December 31, 2016
 
(Dollars in thousands)
Credit Exposure--By Payment Activity
 
 
 
Performing
$
2,617,058

 
$
2,489,028

In workout
1,476

 
1,591

Delinquent

 

Collateral dependent
2,222

 

 
$
2,620,756

 
$
2,490,619

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 non-accrual status at September 30, 2017 totaled $2.2 million. There were no loans in non-accrual status at December 31, 2016.
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, 2017
$

 
$

 
$

 
$

 
$
2,618,534

 
$
2,222

 
$
2,620,756

December 31, 2016
$
2,737

 
$

 
$

 
$
2,737

 
$
2,487,882

 
$

 
$
2,490,619


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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, 2017
 
 
 
 
 
Mortgage loans with an allowance
$
4,679

 
$
6,728

 
$
(2,049
)
Mortgage loans with no related allowance
1,476

 
1,476

 

 
$
6,155

 
$
8,204

 
$
(2,049
)
December 31, 2016
 
 
 
 
 
Mortgage loans with an allowance
$
3,313

 
$
4,640

 
$
(1,327
)
Mortgage loans with no related allowance
1,591

 
1,591

 

 
$
4,904

 
$
6,231

 
$
(1,327
)
 
Average Recorded Investment
 
Interest Income Recognized
 
(Dollars in thousands)
Three months ended September 30, 2017
 
 
 
Mortgage loans with an allowance
$
4,702

 
$
21

Mortgage loans with no related allowance
1,496

 
22

 
$
6,198

 
$
43

Three months ended September 30, 2016
 
 
 
Mortgage loans with an allowance
$
3,378

 
$
75

Mortgage loans with no related allowance
1,634

 
25

 
$
5,012

 
$
100

Nine months ended September 30, 2017
 
 
 
Mortgage loans with an allowance
$
5,112

 
$
228

Mortgage loans with no related allowance
1,533

 
69

 
$
6,645

 
$
297

Nine months ended September 30, 2016
 
 
 
Mortgage loans with an allowance
$
3,420

 
$
226

Mortgage loans with no related allowance
1,680

 
75

 
$
5,100

 
$
301

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, 2017 and December 31, 2016 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, 2017
 
 
 
 
 
 
 
 
South Atlantic
 
1
 
$
2,962

 
$

 
$
2,962

East North Central
 
1
 
1,956

 
(467
)
 
1,489

 
 
2
 
$
4,918

 
$
(467
)
 
$
4,451

December 31, 2016
 
 
 
 
 
 
 
 
South Atlantic
 
1
 
$
3,004

 
$

 
$
3,004

East North Central
 
1
 
2,020

 
(467
)
 
1,553

 
 
2
 
$
5,024

 
$
(467
)
 
$
4,557

5. Derivative Instruments
None of our derivatives qualify for hedge accounting, thus, any change in the fair value of the derivatives is recognized immediately in the consolidated statements of operations. The fair value of our derivative instruments, including derivative instruments embedded in fixed index annuity contracts, presented in the consolidated balance sheets are as follows:
 
September 30, 2017
 
December 31, 2016
 
(Dollars in thousands)
Assets
 
 
 
Derivative instruments
 
 
 
Call options
$
1,235,125

 
$
830,519

Other assets
 
 
 
Interest rate caps
370

 
1,082

 
$
1,235,495

 
$
831,601

Liabilities
 
 
 
Policy benefit reserves - annuity products
 
 
 
Fixed index annuities - embedded derivatives
$
8,069,105

 
$
6,563,288

Other liabilities
 
 
 
Interest rate swap
1,687

 
2,113

 
$
8,070,792

 
$
6,565,401


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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,
 
2017
 
2016
 
2017
 
2016
 
(Dollars in thousands)
Change in fair value of derivatives:
 
 
 
 
 
 
 
Call options
$
362,560

 
$
103,267

 
$
1,017,001

 
$
72,910

Interest rate swap
63

 
647

 
(411
)
 
(2,979
)
Interest rate caps
(98
)
 
(120
)
 
(712
)
 
(1,103
)
 
$
362,525

 
$
103,794

 
$
1,015,878

 
$
68,828

Change in fair value of embedded derivatives:
 
 
 
 
 
 
 
Fixed index annuities—embedded derivatives
$
41,140

 
$
41,561

 
$
121,026

 
$
421,193

Other changes in difference between policy benefit reserves computed using derivative accounting vs. long-duration contracts accounting
188,562

 
102,843

 
507,819

 
273,371

 
$
229,702

 
$
144,404

 
$
628,845

 
$
694,564

The amounts presented as "Other changes in difference between policy benefit reserves computed using derivative accounting vs. long-duration contracts accounting" represents the total change in the difference between policy benefit reserves for fixed index annuities computed under the derivative accounting standard and the long-duration contracts accounting standard at each balance sheet date, less the change in fair value of our fixed index annuities embedded derivatives that is presented as Level 3 liabilities in Note 2.
We have fixed index annuity products that guarantee the return of principal to the policyholder and credit interest based on a percentage of the gain in a specified market index. When fixed index annuity deposits are received, a portion of the deposit is used to purchase derivatives consisting of call options on the applicable market indices to fund the index credits due to fixed index annuity policyholders. Substantially all such call options are one year options purchased to match the funding requirements of the underlying policies. The call options are marked to fair value with the change in fair value included as a component of revenues. The change in fair value of derivatives includes the gains or losses recognized at the expiration of the option term or upon early termination and the changes in fair value for open positions. On the respective anniversary dates of the index policies, the index used to compute the annual index credit is reset and we purchase new one-year call options to fund the next annual index credit. We manage the cost of these purchases through the terms of our fixed index annuities, which permit us to change caps, participation rates, and/or asset fees, subject to guaranteed minimums on each policy's anniversary date. By adjusting caps, participation rates, or asset fees, we can generally manage option costs except in cases where the contractual features would prevent further modifications.
Our strategy attempts to mitigate any potential risk of loss due to the nonperformance of the counterparties to these call options through a regular monitoring process which evaluates the program's effectiveness. We do not purchase call options that would require payment or collateral to another institution and our call options do not contain counterparty credit-risk-related contingent features. We are exposed to risk of loss in the event of nonperformance by the counterparties and, accordingly, we purchase our option contracts from multiple counterparties and evaluate the creditworthiness of all counterparties prior to purchase of the contracts. All of these options have been purchased from nationally recognized financial institutions with a Standard and Poor's credit rating of A- or higher at the time of purchase and the maximum credit exposure to any single counterparty is subject to concentration limits. We also have credit support agreements that allow us to request the counterparty to provide collateral to us when the fair value of our exposure to the counterparty exceeds specified amounts.

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Table of Contents

The notional amount and fair value of our call options by counterparty and each counterparty's current credit rating are as follows:
 
 
 
 
 
 
September 30, 2017
 
December 31, 2016
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
 
$
4,295,908

 
$
187,930

 
$
5,958,884

 
$
178,477

Barclays
 
A-
 
A1
 
4,628,936

 
138,249

 
3,441,832

 
89,721

BNP Paribas
 
A
 
Aa3
 
1,938,070

 
65,535

 
1,199,265

 
19,598

Canadian Imperial Bank of Commerce

 
A+
 
A1
 
1,235,942

 
28,451

 

 

Citibank, N.A.
 
A+
 
A1
 
4,111,559

 
190,027

 
4,038,528

 
97,094

Credit Suisse
 
A
 
A1
 
3,463,619

 
111,405

 
2,130,710

 
44,242

Deutsche Bank
 
A-
 
Baa2
 

 

 
25,935

 
892

J.P. Morgan
 
A+
 
Aa3
 
1,571,624

 
64,112

 
1,785,583

 
19,645

Morgan Stanley
 
A+
 
A1
 
3,195,620

 
134,302

 
2,543,421

 
64,425

Royal Bank of Canada
 
AA-
 
A1
 
3,139,561

 
97,472

 
3,384,310

 
103,510

SunTrust
 
A-
 
Baa1
 
2,763,926

 
94,439

 
2,375,418

 
72,990

Wells Fargo
 
AA-
 
Aa2
 
3,521,620

 
112,389

 
3,850,842

 
130,545

Exchange traded
 
 
 
 
 
346,742

 
10,814

 
313,354

 
9,380

 
 
 
 
 
 
$
34,213,127

 
$
1,235,125

 
$
31,048,082

 
$
830,519

As of September 30, 2017 and December 31, 2016, we held $1.3 billion and $0.8 billion, respectively, of cash and cash equivalents and other securities from counterparties for derivative collateral, which is included in other liabilities on our consolidated balance sheets. This derivative collateral limits the maximum amount of economic loss due to credit risk that we would incur if parties to the call options failed completely to perform according to the terms of the contracts to $15.1 million and $55.5 million at September 30, 2017 and December 31, 2016, respectively.
The future annual index credits on our fixed index annuities are treated as a "series of embedded derivatives" over the expected life of the applicable contract. We do not purchase call options to fund the index liabilities which may arise after the next policy anniversary date. We must value both the call options and the related forward embedded options in the policies at fair value.
We entered into an interest rate swap and interest rate caps to manage interest rate risk associated with the floating rate component on certain of our subordinated debentures. See Note 10 in our Annual Report on Form 10-K for the year ended December 31, 2016 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, 2017
 
December 31, 2016
Maturity Date
 
Amount
 
Receive Rate
 
Rate
 
Counterparty
 
Fair Value
 
Fair Value
 
 
 
 
 
 
 
 
 
 
(Dollars in thousands)
March 15, 2021
 
$
85,500

 
LIBOR
 
2.415
%
 
SunTrust
 
$
(1,687
)
 
$
(2,113
)
Details regarding the interest rate caps are as follows:
 
 
Notional
 
 
 
Cap
 
 
 
September 30, 2017
 
December 31, 2016
Maturity Date
 
Amount
 
Floating Rate
 
Rate
 
Counterparty
 
Fair Value
 
Fair Value
 
 
 
 
 
 
 
 
 
 
(Dollars in thousands)
July 7, 2021
 
$
40,000

 
LIBOR
 
2.50
%
 
SunTrust
 
$
184

 
$
542

July 8, 2021
 
12,000

 
LIBOR
 
2.50
%
 
SunTrust
 
55

 
163

July 29, 2021
 
27,000

 
LIBOR
 
2.50
%
 
SunTrust
 
131

 
377

 
 
$
79,000

 
 
 
 
 
 
 
$
370

 
$
1,082

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, 2017, we deposited $1.4 million of collateral with the counterparty to the swap.

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Table of Contents

6. Notes and Loan Payable and Amounts Due Under Repurchase Agreements
Notes and loan payable includes the following:
 
September 30, 2017
 
December 31, 2016
 
(Dollars in thousands)
Senior notes due 2027
 
 
 
Principal
$
500,000

 
$

Unamortized debt issue costs
(5,686
)
 

Unamortized discount
(342
)
 

Senior notes due 2021
 
 
 
Principal

 
400,000

Unamortized debt issue costs

 
(5,733
)
Term loan due 2019
 
 
 
Principal

 
100,000

Unamortized debt issue costs

 
(512
)
 
$
493,972

 
$
493,755

On June 16, 2017, we issued $500 million aggregate principal amount of senior unsecured notes due 2027 which bear interest at 5.0% per year and will mature on June 15, 2027 (the “2027 Notes”). The 2027 Notes were issued at a $0.3 million discount, which is being amortized over the term of the 2027 Notes using the effective interest method. Contractual interest is payable semi-annually in arrears each June 15th and December 15th. The initial transaction fees and costs totaling $5.8 million were capitalized as deferred financing costs and are being amortized over the term of the 2027 Notes using the effective interest method. We used the net proceeds from the issuance of the 2027 Notes to prepay our $100 million term loan that was scheduled to mature in 2019 on June 16, 2017, and to redeem our $400 million notes due 2021 (the “2021 Notes”) on July 17, 2017. We paid $413.3 million to redeem the 2021 Notes which included a redemption premium equal to 3.313% of the $400 million principal amount of the 2021 Notes. We incurred a loss of $18.4 million on the redemption of the 2021 Notes.
As part of our investment strategy, we enter into securities repurchase agreements (short-term collateralized borrowings). When we do borrow cash on these repurchase agreements, we pledge collateral in the form of debt securities with fair values approximately equal to the amount due and we use the cash to purchase debt securities ahead of the time we collect the cash from selling annuity policies to avoid a lag between the investment of funds and the obligation to credit interest to policyholders. We earn investment income on the securities purchased with these borrowings at a rate in excess of the cost of these borrowings. Such borrowings averaged $22.4 million and $53.3 million during the three and nine months ended September 30, 2017, respectively, and the maximum amount borrowed was $274.5 million during the nine months ended September 30, 2017. We had no borrowings under repurchase agreements during the three and nine months ended September 30, 2016. The weighted average interest rate on amounts due under repurchase agreements was 1.35% and 0.83% for the three and nine months ended September 30, 2017.
7. Commitments and Contingencies
We are occasionally involved in litigation, both as a defendant and as a plaintiff. In addition, state regulatory bodies, such as state insurance departments, the Securities and Exchange Commission, Financial Industry Regulatory Authority, 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.
There can be no assurance that any pending or future litigation will not have a material adverse effect on our business, financial condition, or results of operations.
In addition to our commitments to fund mortgage loans, we have unfunded commitments at September 30, 2017 to limited partnerships of $46.5 million and to secured bank loans of $8.2 million.

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8. Earnings (Loss) Per Share
Earnings (Loss) Per Share
The following table sets forth the computation of earnings (loss) per common share and earnings (loss) per common share - assuming dilution:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2017
 
2016
 
2017
 
2016
 
(Dollars in thousands, except per share data)
Numerator:
 
 
 
 
 
 
 
Net income (loss) - numerator for earnings (loss) per common share
$
56,957

 
$
(7,420
)
 
$
137,842

 
$
(37,553
)
 
 
 
 
 
 
 
 
Denominator:
 
 
 
 
 
 
 
Weighted average common shares outstanding (1)
89,068,770

 
86,261,692

 
88,872,562

 
83,645,427

Effect of dilutive securities:
 
 
 
 
 
 
 
2015 warrants

 

 

 
20,219

Stock options and deferred compensation agreements
974,208

 
424,875

 
924,465

 
423,498

Restricted stock and restricted stock units
377,552

 
357,359

 
373,993

 
323,409

Denominator for earnings (loss) per common share - assuming dilution
90,420,530

 
87,043,926

 
90,171,020

 
84,412,553

 
 
 
 
 
 
 
 
Earnings (loss) per common share
$
0.64

 
$
(0.09
)
 
$
1.55

 
$
(0.45
)
Earnings (loss) per common share - assuming dilution
$
0.63

 
$
(0.09
)
 
$
1.53

 
$
(0.45
)

(1)
Weighted average common shares outstanding include shares vested under the NMO Deferred Compensation Plan.
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 (loss) 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, 2017
 
 
$—
 
$—
Three months ended September 30, 2016
 
1,058,491
 
$24.79
 
$24.79
Nine months ended September 30, 2017
 
 
$—
 
$—
Nine months ended September 30, 2016
 
1,058,491
 
$24.79
 
$24.79


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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, 2017, and the unaudited consolidated results of operations for the three and nine month periods ended September 30, 2017 and 2016, 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, 2016.
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, 2016 and Item 1A of our Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2017.
Our Business and Profitability
We specialize in the sale of individual annuities (primarily deferred annuities) and, to a significantly lesser extent, we also sell life insurance policies. Under U.S. generally accepted accounting principles ("GAAP"), premium collections for deferred annuities are reported as deposit liabilities instead of as revenues. Similarly, cash payments to policyholders are reported as decreases in the liabilities for policyholder account balances and not as expenses. Sources of revenues for products accounted for as deposit liabilities are net investment income, surrender charges assessed against policy withdrawals and fees deducted from policyholder account balances for lifetime income benefit riders, net realized gains (losses) on investments and changes in fair value of derivatives. Components of expenses for products accounted for as deposit liabilities are interest sensitive and index product benefits (primarily interest credited to account balances and changes in lifetime income benefit rider reserves), changes in fair value of embedded derivatives, amortization of deferred sales inducements and deferred policy acquisition costs, other operating costs and expenses and income taxes.
Our business model contemplates continued growth in invested assets and non-GAAP operating income while maintaining a high quality investment portfolio that will not experience significant losses from impairments of invested assets. We are committed to maintaining a high quality investment portfolio with limited exposure to below investment grade securities and other riskier assets. Growth in invested assets is predicated on a continuation of our high sales achievements of the last five years while at the same time maintaining a high level of retention of the funds received. The economic and personal investing environments continued to be conducive for high sales levels as retirees and others look to put their money in instruments that will protect their principal and provide them with consistent cash flow sources in their retirement years. However, our sales have slowed since the first half of 2016 as competition in our distribution channels escalated, rates from several of our competitors were appreciably above prior levels, and there continues to be uncertainty regarding the Department of Labor ("DOL") conflict of interest fiduciary rule.
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),
our ability to manage our operating expenses and
income taxes.

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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,
 
2017
 
2016
 
2017
 
2016
Average yield on invested assets
4.43%
 
4.46%
 
4.45%
 
4.52%
Aggregate cost of money
1.73%
 
1.89%
 
1.75%
 
1.91%
Aggregate investment spread
2.70%
 
2.57%
 
2.70%
 
2.61%
 
 
 
 
 
 
 
 
Impact of:
 
 
 
 
 
 
 
Investment yield - additional prepayment income
0.05%
 
0.04%
 
0.06%
 
0.05%
Cost of money effect of over hedging
0.06%
 
0.02%
 
0.06%
 
0.01%
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, 2016. With respect to our fixed index annuities, the cost of money includes the average crediting rate on amounts allocated to the fixed rate strategy, expenses we incur to fund the annual index credits and where applicable, minimum guaranteed interest credited. Proceeds received upon expiration of call options purchased to fund annual index credits are recorded as part of the change in fair value of derivatives, and are largely offset by an expense for interest credited to annuity policyholder account balances. See Critical Accounting Policies - Policy Liabilities for Fixed Index Annuities and Financial Condition - Derivative Instruments included in Management's Discussion and Analysis in our Annual Report on Form 10-K for the year ended December 31, 2016.
We are currently in the midst of an unprecedented period of low interest rates and low yields for investments with the credit quality we prefer which presents a strong headwind to achieving our target rate for investment spread. In response to this 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 2017 and 2016 periods reflect the benefits from these reductions.
Renewal rate adjustments covering $16 - 17 billion of policyholder account values began on September 1, 2016. In addition, we began applying renewal rate adjustments on $7.4 billion of policyholder account values beginning on December 6, 2016. These adjustments will continue to be implemented over the next 3 to 6 months on policy anniversary dates and are expected to reduce a portion of the 0.47% cost of money differential between existing rates and guaranteed minimum rates we had at September 30, 2017.
Investment yields available to us in the first nine months of 2017 increased compared to the last six months of 2016, however they remain below our portfolio rate. Investment yields at these levels will continue to put downward pressure on our investment spread and product returns.
Life insurance companies are subject to the NAIC risk-based capital ("RBC") requirements which are intended to be used by insurance regulators as an early warning tool to identify deteriorating or weakly capitalized insurance companies for the purpose of initiating regulatory action. Rating agencies utilize a form of RBC to partially determine capital strength of insurance companies. Our RBC ratio at December 31, 2016 was 342%, and our estimated RBC ratio at September 30, 2017 was 375%.
Results of Operations for the Three and Nine Months Ended September 30, 2017 and 2016
Annuity deposits by product type collected during the three and nine months ended September 30, 2017 and 2016, were as follows:
 
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
Product Type
 
2017
 
2016
 
2017
 
2016
 
 
(Dollars in thousands)
Fixed index annuities
 
$
871,760

 
$
1,291,236

 
$
3,021,791

 
$
4,504,784

Annual reset fixed rate annuities
 
20,142

 
13,877

 
55,855

 
46,448

Multi-year fixed rate annuities
 
16,434

 
225,937

 
73,870

 
1,161,527

Single premium immediate annuities
 
6,505

 
11,730

 
17,037

 
25,357

Total before coinsurance ceded
 
914,841

 
1,542,780

 
3,168,553

 
5,738,116

Coinsurance ceded
 
81,451

 
416,233

 
261,484

 
1,471,488

Net after coinsurance ceded
 
$
833,390

 
$
1,126,547

 
$
2,907,069

 
$
4,266,628


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Table of Contents

Annuity deposits before and after coinsurance ceded decreased 41% and 26%, respectively, during the third quarter of 2017 compared to the same period in 2016, and decreased 45% and 32%, respectively, during the nine months ended September 30, 2017 compared to the same period in 2016. The decrease in sales for the three and nine months ended September 30, 2017 primarily reflects continued competitive pressures within each of our distribution channels. In addition, low interest rates and the continuation of the equity bull market continue to be headwinds for sales of guaranteed income products. The relatively smaller decline in net sales compared to gross sales is due to a decrease in coinsurance ceded premiums as a result of significantly lower sales of multi-year rate guaranteed ("MYGA") fixed annuity product which are substantially coinsured, a reduction in the portion of Eagle Life Insurance Company's ("Eagle Life") fixed index annuity sales that are coinsured and lower sales of Eagle Life's fixed index annuity products.
We coinsure 80% of the annuity deposits received from MYGA fixed annuity products and 50% of the fixed index annuities sold by Eagle Life through broker/dealers and banks. Prior to January 1, 2017, we coinsured 80% of the annuity deposits received from MYGA fixed annuity products and 80% of the fixed index annuities sold by Eagle Life.
Net income (loss), in general, has been positively impacted by the growth in the volume of business in force and the investment spread earned on this business. The average amount of annuity account balances outstanding (net of annuity liabilities ceded under coinsurance agreements) increased 7% to $47.3 billion for the third quarter of 2017 and 8% to $46.5 billion for the nine months ended September 30, 2017 compared to $44.1 billion and $43.0 billion for the same periods in 2016. Our investment spread measured in dollars was $290.1 million for the third quarter of 2017 and $855.6 million for the nine months ended September 30, 2017 compared to $252.7 million and $745.2 million for the same periods in 2016. As previously mentioned, our investment spread has been negatively impacted by the extended low interest rate environment (see Net investment income).
Net income (loss) 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 (loss) for the three and nine months ended September 30, 2017 and 2016 was negatively impacted by decreases in the discount rates used to estimate the fair value of our embedded derivative liabilities during the periods. 
Net income for the three and nine months ended September 30, 2017 was negatively impacted by an $18.4 million pretax loss on the extinguishment of our 6.625% Notes due 2021, which reduced net income by $10.8 million. See Note 6 to our unaudited consolidated financial statements for additional information.
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. In addition, we periodically revise the assumptions used in determining reserves held for lifetime income benefit riders as experience develops that is different from our assumptions.
Net income (loss) for the 2017 and 2016 periods includes effects from unlocking and revisions to assumptions used in determining reserves for lifetime income benefit riders as follows:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2017
 
2016
 
2017
2016
 
(Dollars in thousands)
Increase (decrease) in amortization of deferred sales inducements
$
(34,274
)
 
$
17,868

 
$
(34,274
)
$
35,760

Increase (decrease) in amortization of deferred policy acquisition costs
(48,198
)
 
22,080

 
(48,198
)
48,164

Increase in interest sensitive and index product benefits
21,608

 
42,002

 
21,608

42,002

Effect on net income (loss)
39,196

 
(52,859
)
 
39,196

(81,224
)
We review these assumptions quarterly and as a result of this review, we made adjustments to assumptions used in the calculation of amortization of deferred policy acquisition costs and deferred sales inducements in the third quarter of 2017. The most significant revisions to such assumptions were account balance true-ups which were favorable to us due to stronger index credits than we assumed due to strong equity market performance and adjustments to generally decrease lapse rate assumptions to reflect better persistency experienced than assumed. The favorable impact of the account balance true-ups and lapse rate assumption changes was partially offset by reductions in estimated future gross profits attributable to revisions to assumptions used in determining reserves held for lifetime income benefit riders described below as well as an increase in estimated expenses associated with a reinsurance agreement with an unaffiliated reinsurer.
Based on the results of our 2016 review, we made adjustments to lower future investment spread assumptions during the first quarter of 2016 as actual investment spreads being earned showed investment spread and gross profits being less than what we were assuming in our models due to decreases in the average yield earned on invested assets resulting from the continued low interest rate environment. We made further adjustments in the third quarter of 2016 to extend the period of time in which we assume investment spread will grade up to our long-term spread targets by an additional two years as yields obtained on investments purchased in the third quarter of 2016 were much lower than we had anticipated as a result of the overall decline in investment yields that followed the Brexit Vote. In addition, during the third quarter of 2016, revisions to assumptions used in determining reserves held for lifetime income benefit riders described below resulted in a decrease in estimated future gross profits.

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Table of Contents

The 2017 and 2016 revisions to reserves held for lifetime income benefit riders were consistent with the revisions used in the calculation of amortization of deferred policy acquisition costs and deferred sales inducements described above. The 2017 revisions were primarily due to the lapse rate assumption changes described above and changes to our account value growth projections which generated an increase in interest sensitive and index product benefits and a decrease in net income for 2017. The 2016 revisions were primarily due to actual index credits on policies being lower than projected over the past four quarters which generated an increase in interest sensitive and index product benefits and a decrease in net income for 2016.
Non-GAAP operating income (loss) increased to $87.2 million in the third quarter of 2017 and $210.5 million for the nine months ended September 30, 2017 compared to $(4.7) million and $66.4 million for the same periods in 2016.
In addition to net income (loss), we have consistently utilized non-GAAP operating income (loss), a non-GAAP financial measure commonly used in the life insurance industry, as an economic measure to evaluate our financial performance. Non-GAAP operating income (loss) equals net income (loss) adjusted to eliminate the impact of items that fluctuate from quarter to quarter in a manner unrelated to core operations, and we believe measures excluding their impact are useful in analyzing operating trends. The most significant adjustments to arrive at non-GAAP operating income (loss) eliminate the impact of fair value accounting for our fixed index annuity business and are not economic in nature but rather impact the timing of reported results. We believe the combined presentation and evaluation of non-GAAP operating income (loss) together with net income (loss) provides information that may enhance an investor's understanding of our underlying results and profitability.
Non-GAAP operating income (loss) is not a substitute for net income (loss) determined in accordance with GAAP. The adjustments made to derive non-GAAP operating income (loss) are important to understand our overall results from operations and, if evaluated without proper context, non-GAAP operating income (loss) 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 (loss), 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 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 (loss) as part of their review of our overall financial results.
The adjustments made to net income (loss) to arrive at non-GAAP operating income (loss) for the three and nine months ended September 30, 2017 and 2016 are set forth in the table that follows:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2017
 
2016
 
2017
 
2016
 
(Dollars in thousands)
Reconciliation of net income (loss) to non-GAAP operating income (loss):
 
 
 
 
 
 
 
Net income (loss)
$
56,957

 
$
(7,420
)
 
$
137,842

 
$
(37,553
)
Adjustments to arrive at non-GAAP operating income (loss):
 
 
 
 
 
 
 
Net realized (gains) losses and net OTTI losses on investments, net of offsets
(916
)
 
(1,008
)
 
(4,417
)
 
752

Change in fair value of derivatives and embedded derivatives - index annuities, net of offsets
47,835

 
9,400

 
116,383

 
160,078

Change in fair value of derivatives - debt
(357
)
 
(1,049
)
 
(139
)
 
2,483

Litigation reserve, net of offsets

 
(1,957
)
 

 
(1,957
)
Income taxes
(16,281
)
 
(2,689
)
 
(39,127
)
 
(57,426
)
Non-GAAP operating income (loss)
$
87,238

 
$
(4,723
)
 
$
210,542

 
$
66,377

The amounts disclosed in the reconciliation above are presented net of related adjustments to amortization of deferred sales inducements and deferred policy acquisition costs where applicable.
Non-GAAP operating income (loss) for the 2017 and 2016 periods includes effects from unlocking and revisions to assumptions used in determining reserves for living income benefit riders as follows:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2017
 
2016
 
2017
 
2016
 
(Dollars in thousands)
Increase (decrease) in amortization of deferred sales inducements
$
(31,317
)
 
$
18,055

 
$
(31,317
)
 
$
36,127

Increase (decrease) in amortization of deferred policy acquisition costs
(43,716
)
 
21,493

 
(43,716
)
 
47,765

Increase in interest sensitive and index product benefits
21,608

 
42,002

 
21,608

 
42,002

Effect on non-GAAP operating income (loss)
34,405

 
(52,600
)
 
34,405

 
(81,202
)

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Table of Contents

Annuity product charges (surrender charges assessed against policy withdrawals and fees deducted from policyholder account balances for lifetime income benefit riders) increased 9% to $51.9 million in the third quarter of 2017 and 15% to $144.1 million for the nine months ended September 30, 2017 compared to $47.7 million and $125.3 million for the same periods in 2016. The components of annuity product charges are set forth in the table that follows:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2017
 
2016
 
2017
 
2016
 
(Dollars in thousands)
Surrender charges
$
13,521

 
$
13,819

 
$
41,051

 
$
40,381

Lifetime income benefit riders (LIBR) fees
38,410

 
33,856

 
103,055

 
84,923

 
$
51,931

 
$
47,675

 
$
144,106

 
$
125,304

 
 
 
 
 
 
 
 
Withdrawals from annuity policies subject to surrender charges
$
119,103

 
$
117,223

 
$
341,244

 
$
334,510

Average surrender charge collected on withdrawals subject to surrender charges
11.4
%
 
11.8
%
 
12.0
%
 
12.1
%
 
 
 
 
 
 
 
 
Fund values on policies subject to LIBR fees
$
5,279,268

 
$
4,789,359

 
$
14,643,535

 
$
12,668,190

Weighted average per policy LIBR fee
0.73
%
 
0.71
%
 
0.70
%
 
0.67
%
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 and increases in the average fees being charged as compared to prior periods. See Interest sensitive and index product benefits below for corresponding expense recognized on lifetime income benefit riders.
Net investment income increased 8% to $500.2 million in the third quarter of 2017 and 8% to $1.5 billion for the nine months ended September 30, 2017 compared to $463.6 million and $1.4 billion for the same periods in 2016. The increases were principally attributable to the growth in our annuity business and corresponding increases in our invested assets. Average invested assets excluding derivative instruments (on an amortized cost basis) increased 8% to $45.2 billion for the third quarter of 2017 and 9% to $44.4 billion for the nine months ended September 30, 2017 compared to $41.7 billion and $40.6 billion for the same periods in 2016.
The average yield earned on average invested assets was 4.43% for the third quarter of 2017 and 4.45% for the nine months ended September 30, 2017 compared to 4.46% and 4.52% for the same periods in 2016. The decreases in yield earned on average invested assets were attributable to the investment of new premiums and portfolio cash flows during 2017 and 2016 at rates below the overall portfolio yield partially offset by lower cash balances. The average yield on fixed income securities purchased and commercial mortgage loans funded during the three and nine months ended September 30, 2017 was 4.39% and 4.12%, respectively, compared to 3.31% and 3.64% for the same periods in 2016. The average balance for cash and short-term investments was $116.2 million and $143.1 million during the three and nine months ended September 30, 2017 compared to $1.2 billion and $1.0 billion for the same periods in 2016. The unfavorable impact from lower new money investment yields was offset by non-trendable investment income items which added five and six basis points to the average yield on invested assets for the three and nine months ended September 30, 2017 and four and five basis points to the average yield on invested assets for the three and nine months ended September 30, 2016.
Change in fair value of derivatives consists of call options purchased to fund annual index credits on fixed index annuities, and an interest rate swap and interest rate caps that hedge our floating rate subordinated debentures. The components of change in fair value of derivatives are as follows:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2017
 
2016
 
2017
 
2016
 
(Dollars in thousands)
Call options:
 
 
 
 
 
 
 
Gain (loss) on option expiration
$
238,428

 
$
(14,299
)
 
$
676,793

 
$
(259,497
)
Change in unrealized gains/losses
124,132

 
117,566

 
340,208

 
332,407

Interest rate swap
63

 
647

 
(411
)
 
(2,979
)
Interest rate caps
(98
)
 
(120
)
 
(712
)
 
(1,103
)
 
$
362,525

 
$
103,794

 
$
1,015,878

 
$
68,828


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Table of Contents

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, 2017 and 2016 is as follows:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2017
 
2016
 
2017
 
2016
S&P 500 Index
 
 
 
 
 
 
 
Point-to-point strategy
1.0 - 8.7%
 
0.0 - 8.2%
 
1.0 - 13.3%
 
0.0 - 8.2%
Monthly average strategy
0.6 - 8.8%
 
0.0 - 8.0%
 
0.1 - 10.6%
 
0.0 - 8.0%
Monthly point-to-point strategy
0.0 - 13.6%
 
0.0 - 4.1%
 
0.0 - 15.2%
 
0.0 - 4.1%
Fixed income (bond index) strategies
0.0 - 5.9%
 
0.0 - 10.0%
 
0.0 - 5.9%
 
0.0 - 10.0%
The change in fair value of derivatives is also influenced by the aggregate cost of options purchased. The aggregate cost of options 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, 2016.
Net realized gains on investments, excluding OTTI losses include gains and losses on the sale of securities and impairment losses on mortgage loans on real estate which fluctuate from year to year due to changes in the interest rate and economic environment and the timing of the sale of investments, as well as gains (losses) recognized on real estate owned due to any sales and impairments on long-lived assets. See Note 3 to our unaudited consolidated financial statements for a detailed presentation of the types of investments that generated the gains (losses).
Losses on available for sale fixed maturity securities were realized primarily due to strategies to reposition the fixed maturity security portfolio that resulted in improved net investment income, risk or duration profiles as they pertain to our asset liability management. Securities were sold at losses in 2017 and 2016 due to our long-term fundamental concern with the issuer's ability to meet their future financial obligations. 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 decreased to $0.5 million in the third quarter of 2017 and $1.6 million for the nine months ended September 30, 2017 compared to $3.0 million and $13.1 million for the same periods in 2016. See Financial Condition - Other Than Temporary Impairments and Note 3 to our unaudited consolidated financial statements for additional discussion of other than temporary impairments recognized during the periods presented.
Interest sensitive and index product benefits increased 80% to $501.0 million in the third quarter of 2017 and 186% to $1.4 billion for the nine months ended September 30, 2017 compared to $278.9 million and $487.7 million for the same periods in 2016. The components of interest sensitive and index product benefits are summarized as follows:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2017
 
2016
 
2017
 
2016
 
(Dollars in thousands)
Index credits on index policies
$
375,019

 
$
126,653

 
$
1,068,522

 
$
142,084

Interest credited (including changes in minimum guaranteed interest for fixed index annuities)
64,704

 
71,766

 
196,843

 
204,739

Lifetime income benefit riders
61,305

 
80,524

 
127,398

 
140,912

 
$
501,028

 
$
278,943

 
$
1,392,763

 
$
487,735

The increases 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 $382.9 million and $1.1 billion for the three and nine months ended September 30, 2017, compared to $128.3 million and $144.3 million for the same periods in 2016. The decreases in interest credited were primarily due to lower crediting rates on annuity liabilities receiving a fixed rate of interest. The decreases in benefits recognized for lifetime income benefit riders were due to a decrease in the impact of revisions of assumptions used in determining reserves held for lifetime income benefit riders in 2017 as compared to 2016 (See Net income (loss) above for a discussion of the impact of revisions of assumptions), which was offset by increases in the number of policies with lifetime income benefit riders which correlates to the increases in fees discussed in Annuity product charges.
The reserve (net of coinsurance ceded) held for lifetime income benefit riders was $660.8 million and $533.4 million at September 30, 2017 and December 31, 2016, respectively.

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Table of Contents

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% and 88% of our net annuity account values at September 30, 2017 and September 30, 2016, respectively. The increases in amortization from these factors have been affected by amortization associated with fair value accounting for derivatives and embedded derivatives utilized in our fixed index annuity business, amortization associated with net realized gains (losses) on investments and net OTTI losses recognized in operations. Fair value accounting for derivatives and embedded derivatives utilized in our fixed index annuity business creates differences in the recognition of revenues and expenses from derivative instruments including the embedded derivative liabilities in our fixed index annuity contracts. The change in fair value of the embedded derivatives will not correspond to the change in fair value of the derivatives (purchased call options), because the purchased call options are one-year options while the options valued in the fair value of embedded derivatives cover the expected lives of the contracts which typically exceed ten years. Amortization of deferred sales inducements is summarized as follows:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2017
 
2016
 
2017
 
2016
 
(Dollars in thousands)
Amortization of deferred sales inducements before gross profit adjustments
$
37,149

 
$
78,178

 
$
173,178

 
$
212,358

Gross profit adjustments:
 
 
 
 
 
 
 
Fair value accounting for derivatives and embedded derivatives
(22,444
)
 
(9,825
)
 
(63,168
)
 
(84,532
)
Net realized gains (losses) on investments and net OTTI losses recognized in operations
2

 
892

 
717

 
(430
)
Amortization of deferred sales inducements after gross profit adjustments
$
14,707

 
$
69,245

 
$
110,727

 
$
127,396

See Net income (loss) and Non-GAAP operating income (loss) above for discussion of the impact of unlocking on amortization of deferred sales inducements for the three and nine months ended September 30, 2017 and 2016. 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, 2016.
Change in fair value of embedded derivatives includes changes in the fair value of our fixed index annuity embedded derivatives (see Note 5 to our unaudited consolidated financial statements). The components of change in fair value of embedded derivatives are as follows:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2017
 
2016
 
2017
 
2016
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
Fixed index annuities - embedded derivatives
$
41,140

 
$
41,561

 
$
121,026

 
$
421,193

Other changes in difference between policy benefit reserves computed using derivative accounting vs. long-duration contracts accounting
188,562

 
102,843

 
507,819

 
273,371

 
$
229,702

 
$
144,404

 
$
628,845

 
$
694,564

The change in fair value of the fixed index annuity embedded derivatives resulted from (i) changes in the expected index credits on the next policy anniversary dates, which are related to the change in fair value of the call options acquired to fund those index credits discussed above in Change in fair value of derivatives; (ii) changes in discount rates used in estimating our embedded derivative liabilities; and (iii) the growth in the host component of the policy liability. The amounts presented as "Other changes in difference between policy benefit reserves computed using derivative accounting vs. long-duration contracts accounting" represents the total change in the difference between policy benefit reserves for fixed index annuities computed under the derivative accounting standard and the long-duration contracts accounting standard at each balance sheet date, less the change in fair value of our fixed index annuities embedded derivative. See Critical Accounting Policies - Policy Liabilities for Fixed Index Annuities included in Management's Discussion and Analysis in our Annual Report on Form 10-K for the year ended December 31, 2016. The primary reasons for the increase in the change in fair value of the fixed index annuity embedded derivatives during the three months ended September 30, 2017 were a higher level of index credits during the three months ended September 30, 2017 as compared to the same period of 2016 and a larger decrease in the discount rate used in estimating the fair value of our liability during the three months ended September 30, 2017 as compared to the same period of 2016 which were offset by a decrease in the expected index credits on the next policy anniversary dates resulting from a smaller increase in the fair value of the call options acquired to fund these index credits during the three months ended September 30, 2017 as compared to the same period in 2016. The primary reasons for the decrease in the change in fair value of the fixed index annuity embedded derivatives during the nine months ended September 30, 2017 were a smaller decrease in the discount rate used in estimating the fair value of our liability during the nine months ended September 30, 2017 as compared to the same period of 2016, a decrease in the expected index credits on the next policy anniversary dates resulting from a smaller increase in the fair value of the call options acquired to fund these index credits during the nine months ended September 30, 2017 as compared to the same period of 2016 offset by a higher level of index credits during the nine months ended September 30, 2017 as compared to the same period of 2016. The discount rates used in estimating our embedded derivative liabilities fluctuate based on changes in the general level of interest rates.

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Table of Contents

Interest expense on notes and loan payable increased 10% to $7.6 million in the third quarter of 2017 and 16% to $24.0 million for the nine months ended September 30, 2017 compared to $6.9 million and $20.6 million for the same periods in 2016. The increase in interest expense for the three months ended September 30, 2017 was attributable to interest expense on the $500 million senior unsecured notes due 2027 (the “2027 Notes”) issued on June 16, 2017 which was partially offset by a decrease in interest expense as a result of the redemption of our $400 million 6.625% notes due 2021 (the “2021 Notes”) on July 17, 2017. The increase in interest expense for the nine months ended September 30, 2017 was attributable to interest expense on the $100 million term loan originated on September 30, 2016 and prepaid on June 16, 2017 and interest expense on the 2027 Notes which was partially offset by a decrease in interest expense as a result of the redemption of the 2021 Notes.
Amortization of deferred policy acquisition costs, in general, has been increasing each period due to the growth in our annuity business and the deferral of policy acquisition costs incurred with respect to sales of annuity products. The increases in amortization from these factors have been affected by amortization associated with fair value accounting for derivatives and embedded derivatives utilized in our fixed index annuity business and amortization associated with net realized gains (losses) on investments and net OTTI losses recognized in operations. As discussed above, fair value accounting for derivatives and embedded derivatives utilized in our fixed index annuity business creates differences in the recognition of revenues and expenses from derivative instruments including the embedded derivative liabilities in our fixed index annuity contracts. Amortization of deferred policy acquisition costs is summarized as follows:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2017
 
2016
 
2017
 
2016
 
(Dollars in thousands)
Amortization of deferred policy acquisition costs before gross profit adjustments
$
52,456

 
$
106,777

 
$
244,230

 
$
299,729

Gross profit adjustments:
 
 
 
 
 
 
 
Fair value accounting for derivatives and embedded derivatives
(29,631
)
 
(9,919
)
 
(83,085
)
 
(100,858
)
Net realized gains (losses) on investments and net OTTI losses recognized in operations
198

 
1,250

 
1,103

 
(385
)
Amortization of deferred policy acquisition costs after gross profit adjustments
$
23,023

 
$
98,108

 
$
162,248

 
$
198,486

See Net income (loss) and Non-GAAP operating income (loss) above for discussion of the impact of unlocking on amortization of deferred policy acquisition costs for the three and nine months ended September 30, 2017 and 2016. 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, 2016.
Other operating costs and expenses increased 14.5% to $28.8 million in the third quarter of 2017 and 4.5% to $82.3 million for the nine months ended September 30, 2017 compared to $25.1 million and $78.8 million for the same periods in 2016 and are summarized as follows:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2017
 
2016
 
2017
 
2016
 
 
 
 
 
(Dollars in thousands)
Salary and benefits
$
15,693

 
$
12,111

 
$
42,752

 
$
38,939

Risk charges
7,391

 
7,688

 
21,590

 
21,747

Other
5,698

 
5,334

 
17,983

 
18,100

Total other operating costs and expenses
$
28,782

 
$
25,133

 
$
82,325

 
$
78,786

The three months ended September 30, 2017 reflect an increase in salary and benefits of $1.2 million due to an increased number of employees related to our growth and an increase of $2.7 million related to expense recognized under our short-term incentive compensation program and other bonus programs as compared to the same period in 2016. These increases were offset by a decrease of $0.2 million in expenses related to a retirement agreement with our former executive chairman. The nine months ended September 30, 2017 reflect an increase in salary and benefits of $3.0 million due to an increased number of employees related to our growth, and increase of $2.9 million related to expense recognized under our short-term incentive compensation program and other bonus programs as compared to the same period in 2016 and an increase of $1.2 million related to a deferred compensation liability that is based upon the value of our common stock as compared to the same period in 2016. These increases were offset by a decrease of $3.2 million in expenses related to a retirement agreement with our former executive chairman.
The decrease in reinsurance risk charges expense for the three and nine months ended September 30, 2017 as compared to the same period in 2016 was due to a lower risk charge percentage which was included in an October 1, 2016 amendment to the reinsurance agreement which was partially offset by growth in our policyholder liabilities subject to the reinsurance agreement pursuant to which we cede excess regulatory reserves to an unaffiliated reinsurer. The regulatory reserves ceded at September 30, 2017 and 2016 were $724.9 million and $603.0 million, respectively.

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Other expenses increased for the three months ended September 30, 2017 as compared to the same period in 2016 primarily as a result of nonrecurring expense items that impacted the three months ended September 30, 2016 as described below. Other expenses adjusted for these nonrecurring items for the three months ended September 30, 2017 decreased from the same period in 2016 due to decreases in general expenses that vary from period to period based on the level of annuity deposits collected. Other expenses decreased for the nine months ended September 30, 2017 as compared to the same period in 2016 primarily as a result of decreases in general expenses that vary from period to period based on the level of annuity deposits collected. Other expenses for the three and nine months ended September 30, 2016 benefited from the release of a litigation liability of $2.8 million. The benefit was offset by by the write-off of debt issuance costs of $0.4 million related to the termination of our November 2013 credit facility during the third quarter of 2016 and expenses of $0.6 million and $0.7 million for the three and nine months ended September 30, 2016 for spending related to the Department of Labor's fiduciary rule.
Income tax expense (benefit) was $29.8 million in the third quarter of 2017 and $70.7 million for the nine months ended September 30, 2017 compared to $(3.6) million and $(19.8) million for the same periods in 2016. The changes in income tax expense (benefit) were primarily due to changes in income (loss) before income taxes. The effective income tax rates for the three and nine months ended September 30, 2017 were 34.4% and 33.9%, respectively, and 32.4% and 34.5% for the same periods in 2016, respectively.
Income tax expense (benefit) and the resulting effective tax rate are based upon two components of income (loss) before income taxes ("pretax income (loss)") that are taxed at different tax rates. Life insurance income is generally taxed at an effective rate of approximately 35.6% 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 (the "non-life insurance group") is generally taxed at an effective tax rate of 41.5% reflecting the combined federal / state income tax rates. The effective income tax rates resulting from the combination of the income tax provisions for the life / non-life sources of income (loss) vary from period to period based primarily on the relative size of pretax income (loss) from the two sources.
The change in the effective income tax rate for the three and nine months ended September 30, 2017 as compared to the same periods in 2016 is primarily attributable to changes in the two components of income (loss) before income taxes described above and the level of permanent tax adjustments compared to pretax income (loss). In addition, the effective income tax rate for the three and nine months ended September 30, 2017 was impacted by a change in accounting for income taxes related to share-based compensation that reduced income tax expense by approximately $0.2 million and $1.8 million during the three and nine month periods ended September 30, 2017.


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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, 2017
 
December 31, 2016
 
Carrying
Amount
 
Percent
 
Carrying
Amount
 
Percent
 
(Dollars in thousands)
Fixed maturity securities:
 
 
 
 
 
 
 
United States Government full faith and credit
$
11,935

 
%
 
$
11,805

 
%
United States Government sponsored agencies
1,302,075

 
2.7
%
 
1,344,787

 
3.0
%
United States municipalities, states and territories
4,093,632

 
8.4
%
 
3,926,950

 
8.8
%
Foreign government obligations
240,400

 
0.5
%
 
236,341

 
0.5
%
Corporate securities
29,752,910

 
60.9
%
 
27,191,243

 
60.8
%
Residential mortgage backed securities
1,146,822

 
2.4
%
 
1,254,835

 
2.8
%
Commercial mortgage backed securities
5,532,483

 
11.3
%
 
5,365,235

 
12.0
%
Other asset backed securities
2,598,026

 
5.3
%
 
1,806,123

 
4.0
%
Total fixed maturity securities
44,678,283

 
91.5
%
 
41,137,319

 
91.9
%
Mortgage loans on real estate
2,611,426

 
5.3
%
 
2,480,956

 
5.5
%
Derivative instruments
1,235,125

 
2.5
%
 
830,519

 
1.9
%
Other investments
328,299

 
0.7
%
 
308,774

 
0.7
%
 
$
48,853,133

 
100.0
%
 
$
44,757,568

 
100.0
%
Fixed Maturity Securities
Our fixed maturity security portfolio is managed to minimize risks such as interest rate changes and defaults or impairments while earning a sufficient and stable return on our investments. The largest portion of our fixed maturity securities are in investment grade (NAIC designation 1 or 2) publicly traded or privately placed corporate securities.
A summary of our fixed maturity securities by NRSRO ratings is as follows:
 
 
September 30, 2017
 
December 31, 2016
Rating Agency Rating
 
Carrying
Amount
 
Percent of
Fixed Maturity
Securities
 
Carrying
Amount
 
Percent of
Fixed Maturity
Securities
 
 
(Dollars in thousands)
Aaa/Aa/A
 
$
27,665,208

 
61.9
%
 
$
26,431,700

 
64.3
%
Baa
 
15,596,239

 
34.9
%
 
13,002,964

 
31.6
%
Total investment grade
 
43,261,447

 
96.8
%
 
39,434,664

 
95.9
%
Ba
 
958,470

 
2.1
%
 
1,048,379

 
2.5
%
B
 
116,619

 
0.3
%
 
155,619

 
0.4
%
Caa
 
141,994

 
0.3
%
 
79,763

 
0.2
%
Ca and lower
 
199,753

 
0.5
%
 
418,894

 
1.0
%
Total below investment grade
 
1,416,836

 
3.2
%
 
1,702,655

 
4.1
%
 
 
$
44,678,283

 
100.0
%
 
$
41,137,319

 
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
6
 
Ca and lower
For most of the bonds held in our portfolio the NAIC designation matches the NRSRO equivalent rating. However, for certain loan-backed and structured securities, as defined by the NAIC, the NAIC rating is not always equivalent to the NRSRO rating presented in the previous table. The NAIC has adopted revised rating methodologies for certain loan-backed and structured securities comprised of non-agency residential mortgage backed securities ("RMBS") and commercial mortgage backed securities ("CMBS"). The NAIC’s objective with the revised rating methodologies for these structured securities is to increase the accuracy in assessing expected losses and use the improved assessment to determine a more appropriate capital requirement for such structured securities. The revised methodologies reduce regulatory reliance on rating agencies and allow for greater regulatory input into the assumptions used to estimate expected losses from structured securities.
The use of this process by the SVO may result in certain non-agency RMBS and CMBS being assigned a NAIC designation that is higher than the equivalent NRSRO rating. The NAIC designations for non-agency RMBS and CMBS are based on security level expected losses as modeled by an independent third party (engaged by the NAIC) and the statutory carrying value of the security, including any purchase discounts or impairment charges previously recognized. Evaluation of non-agency RMBS and CMBS held by insurers using the NAIC rating methodologies is performed on an annual basis.
As stated previously, our fixed maturity security portfolio is managed to minimize risks such as defaults or impairments while earning a sufficient and stable return on our investments. Our strategy has been to invest primarily in investment grade fixed maturity securities. Investment grade is NAIC 1 and 2 securities and Baa3/BBB- and better securities on the NRSRO scale. This strategy meets the objective of minimizing risk while also managing asset capital charges on a regulatory capital basis.
A summary of our fixed maturity securities by NAIC designation is as follows:
 
 
September 30, 2017
 
December 31, 2016
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
 
$
26,653,735

 
$
28,133,264

 
$
28,133,264

 
63.0
%
 
$
25,607,268

 
$
26,507,798

 
$
26,507,798

 
64.5
%
2
 
14,618,128

 
15,264,374

 
15,264,374

 
34.2
%
 
13,037,592

 
13,295,648

 
13,295,648

 
32.3
%
3
 
1,156,976

 
1,149,258

 
1,151,198

 
2.6
%
 
1,201,059

 
1,155,702

 
1,163,761

 
2.8
%
4
 
102,604

 
98,308

 
98,308

 
0.2
%
 
154,226

 
137,188

 
137,188

 
0.3
%
5
 
19,492

 
22,271

 
22,271

 
%
 
17,475

 
24,664

 
24,664

 
0.1
%
6
 
12,326

 
8,868

 
8,868

 
%
 
13,160

 
8,260

 
8,260

 
%
 
 
$
42,563,261

 
$
44,676,343

 
$
44,678,283

 
100.0
%
 
$
40,030,780

 
$
41,129,260

 
$
41,137,319

 
100.0
%
The amortized cost and fair value of fixed maturity securities at September 30, 2017, 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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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, 2017
 
 
 
 
 
 
 
Fixed maturity securities, available for sale:
 
 
 
 
 
 
 
United States Government full faith and credit
2

 
$
6,870

 
$
(139
)
 
$
6,731

United States Government sponsored agencies
17

 
1,020,484

 
(33,698
)
 
986,786

United States municipalities, states and territories
56

 
213,754

 
(6,494
)
 
207,260

Foreign government obligations
2

 
64,324

 
(1,712
)
 
62,612

Corporate securities:
 
 


 
 
 
 
Finance, insurance and real estate
84

 
996,931

 
(34,894
)
 
962,037

Manufacturing, construction and mining
62

 
566,461

 
(17,554
)
 
548,907

Utilities and related sectors
56

 
555,508

 
(14,439
)
 
541,069

Wholesale/retail trade
28

 
327,692

 
(10,774
)
 
316,918

Services, media and other
167

 
1,661,065

 
(73,657
)
 
1,587,408

Residential mortgage backed securities
14

 
53,505

 
(2,266
)
 
51,239

Commercial mortgage backed securities
294

 
2,308,060

 
(68,317
)
 
2,239,743

Other asset backed securities
123

 
795,788

 
(14,650
)
 
781,138

 
905

 
$
8,570,442

 
$
(278,594
)
 
$
8,291,848

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

 
$
76,986

 
$
(1,940
)
 
$
75,046

 
 
 
 
 
 
 
 
December 31, 2016
 
 
 
 
 
 
 
Fixed maturity securities, available for sale:
 
 
 
 
 
 
 
United States Government full faith and credit
3

 
$
7,693

 
$
(288
)
 
$
7,405

United States Government sponsored agencies
18

 
1,042,461

 
(46,913
)
 
995,548

United States municipalities, states and territories
113

 
485,802

 
(22,393
)
 
463,409

Foreign government obligations
4

 
54,626

 
(5,080
)
 
49,546

Corporate securities:
 
 

 
 
 
 
Finance, insurance and real estate
175

 
2,101,158

 
(78,144
)
 
2,023,014

Manufacturing, construction and mining
155

 
1,568,588

 
(57,577
)
 
1,511,011

Utilities and related sectors
137

 
1,511,082

 
(50,835
)
 
1,460,247

Wholesale/retail trade
63

 
687,650

 
(20,810
)
 
666,840

Services, media and other
301

 
3,417,783

 
(161,407
)
 
3,256,376

Residential mortgage backed securities
25

 
87,169

 
(3,554
)
 
83,615

Commercial mortgage backed securities
407

 
3,266,304

 
(117,014
)
 
3,149,290

Other asset backed securities
112

 
918,403

 
(20,703
)
 
897,700

 
1,513

 
$
15,148,719

 
$
(584,718
)
 
$
14,564,001

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

 
$
76,825

 
$
(8,059
)
 
$
68,766

The decrease in unrealized losses from December 31, 2016 to September 30, 2017 was primarily due to a decrease in interest rates in addition to price improvements due to tighter credit spreads during the nine months ended September 30, 2017. The 10-year U.S. Treasury yields at September 30, 2017 and December 31, 2016 were 2.33% and 2.45%, respectively. The 30-year U.S. Treasury yields at September 30, 2017 and December 31, 2016 were 2.86% and 3.06%, respectively.

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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, 2017
 
 
 
 
 
 
 
 
1
 
$
5,389,744

 
64.4
%
 
$
(171,528
)
 
61.2
%
2
 
2,404,394

 
28.7
%
 
(66,031
)
 
23.5
%
3
 
494,807

 
5.9
%
 
(30,067
)
 
10.7
%
4
 
63,350

 
0.8
%
 
(6,038
)
 
2.2
%
5
 
11,896

 
0.1
%
 
(3,177
)
 
1.1
%
6
 
4,643

 
0.1
%
 
(3,693
)
 
1.3
%
 
 
$
8,368,834

 
100.0
%
 
$
(280,534
)
 
100.0
%
December 31, 2016
 
 
 
 
 
 
 
 
1
 
$
8,754,856

 
59.8
%
 
$
(330,920
)
 
55.8
%
2
 
5,091,437

 
34.8
%
 
(176,557
)
 
29.8
%
3
 
657,549

 
4.5
%
 
(60,689
)
 
10.3
%
4
 
119,986

 
0.8
%
 
(17,786
)
 
3.0
%
5
 
8,744

 
0.1
%
 
(1,920
)
 
0.3
%
6
 
8,254

 
%
 
(4,905
)
 
0.8
%
 
 
$
14,640,826

 
100.0
%
 
$
(592,777
)
 
100.0
%
Our investments' gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities (consisting of 906 and 1,514 securities, respectively) have been in a continuous unrealized loss position at September 30, 2017 and December 31, 2016, along with a description of the factors causing the unrealized losses is presented in Note 3 to our unaudited consolidated financial statements in this Form 10-Q, which is incorporated by reference in this Item 2.

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Table of Contents

The amortized cost and fair value of fixed maturity securities in an unrealized loss position and the number of months in a continuous unrealized loss position (fixed maturity securities that carry an NRSRO rating of BBB/Baa or higher are considered investment grade) were as follows:
 
Number of
Securities
 
Amortized
Cost
 
Fair Value
 
Gross
Unrealized
Losses
 
 
 
(Dollars in thousands)
September 30, 2017
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
Investment grade:
 
 
 
 
 
 
 
Less than six months
356

 
$
2,901,696

 
$
2,872,628

 
$
(29,068
)
Six months or more and less than twelve months
277

 
3,219,795

 
3,114,663

 
(105,132
)
Twelve months or greater
208

 
1,982,276

 
1,877,553

 
(104,723
)
Total investment grade
841

 
8,103,767

 
7,864,844

 
(238,923
)
Below investment grade:
 
 
 
 
 
 
 
Less than six months
11

 
30,577

 
29,754

 
(823
)
Six months or more and less than twelve months
6

 
28,888

 
27,687

 
(1,201
)
Twelve months or greater
48

 
484,196

 
444,609

 
(39,587
)
Total below investment grade
65

 
543,661

 
502,050

 
(41,611
)
 
906

 
$
8,647,428

 
$
8,366,894

 
$
(280,534
)
 
 
 
 
 
 
 
 
December 31, 2016
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
Investment grade:
 
 
 
 
 
 
 
Less than six months
1,265

 
$
12,767,396

 
$
12,374,177

 
$
(393,219
)
Six months or more and less than twelve months
69

 
669,022

 
621,784

 
(47,238
)
Twelve months or greater
90

 
970,424

 
901,674

 
(68,750
)
Total investment grade
1,424

 
14,406,842

 
13,897,635

 
(509,207
)
Below investment grade:
 
 
 
 
 
 
 
Less than six months
15

 
132,087

 
126,236

 
(5,851
)
Six months or more and less than twelve months
10

 
80,535

 
72,830

 
(7,705
)
Twelve months or greater
65

 
606,080

 
536,066

 
(70,014
)
Total below investment grade
90

 
818,702

 
735,132

 
(83,570
)
 
1,514

 
$
15,225,544

 
$
14,632,767

 
$
(592,777
)

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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, 2017
 
 
 
 
 
 
 
Investment grade:
 
 
 
 
 
 
 
Less than six months
1

 
$
6,357

 
$
5,194

 
$
(1,163
)
Six months or more and less than twelve months

 

 

 

Twelve months or greater

 

 

 

Total investment grade
1

 
6,357

 
5,194

 
(1,163
)
Below investment grade:
 
 
 
 
 
 
 
Less than six months
2

 
4,744

 
3,792

 
(952
)
Six months or more and less than twelve months

 

 

 

Twelve months or greater
6

 
62,311

 
42,124

 
(20,187
)
Total below investment grade
8

 
67,055

 
45,916

 
(21,139
)
 
9

 
$
73,412

 
$
51,110

 
$
(22,302
)
 
 
 
 
 
 
 
 
December 31, 2016
 
 
 
 
 
 
 
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
1

 
19,930

 
15,961

 
(3,969
)
Six months or more and less than twelve months

 

 

 

Twelve months or greater
10

 
85,831

 
58,436

 
(27,395
)
Total below investment grade
11

 
105,761

 
74,397

 
(31,364
)
 
11

 
$
105,761

 
$
74,397

 
$
(31,364
)

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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, 2017
 
 
 
 
 
 
 
Due in one year or less
$

 
$

 
$

 
$

Due after one year through five years
227,227

 
220,147

 

 

Due after five years through ten years
1,938,492

 
1,889,146

 

 

Due after ten years through twenty years
1,761,076

 
1,706,986

 

 

Due after twenty years
1,486,294

 
1,403,449

 
76,986

 
75,046

 
5,413,089

 
5,219,728

 
76,986

 
75,046

Residential mortgage backed securities
53,505

 
51,239

 

 

Commercial mortgage backed securities
2,308,060

 
2,239,743

 

 

Other asset backed securities
795,788

 
781,138

 

 

 
$
8,570,442

 
$
8,291,848

 
$
76,986

 
$
75,046

 
 
 
 
 
 
 
 
December 31, 2016
 
 
 
 
 
 
 
Due in one year or less
$

 
$

 
$

 
$

Due after one year through five years
177,550

 
172,375

 

 

Due after five years through ten years
4,943,504

 
4,806,216

 

 

Due after ten years through twenty years
2,736,298

 
2,621,945

 

 

Due after twenty years
3,019,491

 
2,832,860

 
76,825

 
68,766

 
10,876,843

 
10,433,396

 
76,825

 
68,766

Residential mortgage backed securities
87,169

 
83,615

 

 

Commercial mortgage backed securities
3,266,304

 
3,149,290

 

 

Other asset backed securities
918,403

 
897,700

 

 

 
$
15,148,719

 
$
14,564,001

 
$
76,825

 
$
68,766

International Exposure
We hold fixed maturity securities with international exposure. As of September 30, 2017, 19% of the carrying value of our fixed maturity securities was comprised of corporate debt securities of issuers based outside of the United States and debt securities of foreign governments. Our investment professionals analyze each holding for credit risk by economic and other factors of each country and industry. The following table presents our international exposure in our fixed maturity portfolio by country or region:
 
September 30, 2017
 
Amortized
Cost
 
Carrying Amount/
Fair Value
 
Percent
of Total
Carrying
Amount
 
(Dollars in thousands)
 
 
GIIPS (1)
$
273,831

 
$
300,363

 
0.7%
Asia/Pacific
433,826

 
455,299

 
1.0%
Non-GIIPS Europe
3,151,119

 
3,298,559

 
7.4%
Latin America
296,528

 
307,757

 
0.7%
Non-U.S. North America
1,324,106

 
1,396,125

 
3.1%
Australia & New Zealand
788,773

 
804,233

 
1.8%
Other
1,961,943

 
1,993,598

 
4.5%
 
$
8,230,126

 
$
8,555,934

 
19.2%
(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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All of the securities presented in the table above are denominated in U.S. dollars and all are investment grade (NAIC designation of either 1 or 2), except for the following:
 
September 30, 2017
 
Amortized Cost
 
Carrying Amount/
Fair Value
 
(Dollars in thousands)
GIIPS (1)
$
28,726

 
$
31,694

Asia/Pacific
11,000

 
9,707

Non-GIIPS Europe
139,950

 
139,052

Latin America
64,081

 
58,220

Non-U.S. North America
104,836

 
108,380

 
$
348,593

 
$
347,053

Watch List
At each balance sheet date, we identify invested assets which have characteristics (i.e. significant unrealized losses compared to amortized cost and industry trends) creating uncertainty as to our future assessment of an other than temporary impairment. As part of this assessment, we review not only a change in current price relative to its amortized cost but the issuer's current credit rating and the probability of full recovery of principal based upon the issuer's financial strength. Specifically for corporate issues we evaluate the financial stability and quality of asset coverage for the securities relative to the term to maturity for the issues we own. A security which has a 25% or greater change in market price relative to its amortized cost and a possibility of a loss of principal will be included on a list which is referred to as our watch list. We exclude from this list securities with unrealized losses which are related to market movements in interest rates and which have no factors indicating that such unrealized losses may be other than temporary as we do not intend to sell these securities and it is more likely than not we will not have to sell these securities before a recovery is realized. In addition, we exclude our residential and commercial mortgage backed securities as we monitor all of our residential and commercial mortgage backed securities on a quarterly basis for changes in default rates, loss severities and expected cash flows for the purpose of assessing potential other than temporary impairments and related credit losses to be recognized in operations. At September 30, 2017, the amortized cost and fair value of securities on the watch list (all fixed maturity securities) are as follows:
General Description
 
Number of
Securities
 
Amortized
Cost
 
Unrealized
Gains (Losses)
 
Fair Value
 
Months in
Continuous
Unrealized
Loss Position
 
Months
Unrealized
Losses
Greater
Than 20%
 
 
 
 
(Dollars in thousands)
 
 
 
 
Below investment grade
 
 
 
 
 
 
 
 
 
 
 
 
Corporate securities:
 
 
 
 
 
 
 
 
 
 
 
 
Energy
 
4
 
$
29,057

 
$
(4,531
)
 
$
24,526

 
4 - 53
 
0 - 33
Industrials
 
1
 
4,984

 
(2,209
)
 
2,775

 
35
 
26
Materials
 
1
 
3,990

 
228

 
4,218

 
 
Telecommunications
 
1
 
2,100

 
(23
)
 
2,077

 
39
 
Other asset backed securities:
 
 
 
 
 
 
 
 
 
 
 
 
Financials
 
2
 
6,236

 
(3,671
)
 
2,565

 
52 - 78
 
29 - 33
 
 
9
 
$
46,367

 
$
(10,206
)
 
$
36,161

 
 
 
 
We have determined that the unrealized losses of the securities on the watch list are temporary as we do not intend to sell these securities and it is more likely than not we will not have to sell these securities before recovery of their amortized cost. Our analysis of these securities and their credit performance at September 30, 2017 is as follows:
Corporate securities:
Energy, Industrials and Materials: The decline in the value of these securities relates to ongoing operational issues related to the decline in certain commodity prices specific to their businesses. The decline in these commodity prices creates financial challenges as the companies realign to accommodate the lower prices. These issuers will be stressed greater than the average company due to their price sensitivity and the specific position they hold in the supply chain. We recognized an other than temporary impairment on one security during the third quarter of 2016 due to our evaluation of the operating performance and the credit worthiness of the issuer. While the remaining issuers have seen their financial and profitability profile weakened, we have determined that the remaining securities were not other than temporarily impaired due to our evaluation of the operating performance and the credit worthiness of the issuer.
Telecommunications:  The decline in the value of this security is the result of regional economic recessionary pressure in Brazil and an increase in competition in the markets it operates. This issuer has seen weakened performance and heightened risk. We recognized an other than temporary impairment on this security during the first quarter of 2016 due to our evaluation of the operating performance and the credit worthiness of the issuer.

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Table of Contents

Other asset backed securities:
Financials:  The decline in value of one of the asset backed securities is due to poor performance in the underlying pool of student loans. The investment is backed by a guarantee from the for-profit education services provider. We have determined that this security was not other than temporarily impaired, because 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 the other asset backed security is related directly to the decline in oil prices and the financial stability of its operator. The issuer has direct exposure to the oil market as its primary business is deep water drilling. As oil prices have declined the operator of the deep water vessel has experienced financial pressure on its balance sheet. We recognized other than temporary impairments on this security during the second quarter of 2017, the second quarter of 2016 and the third quarter of 2015.
Other Than Temporary Impairments
We have a policy and process to identify securities in our investment portfolio for which we should recognize impairments. See Critical Accounting Policies—Evaluation of Other Than Temporary Impairments included in Management's Discussion and Analysis in our Annual Report on Form 10-K for the year ended December 31, 2016. During the three month period ended September 30, 2017, we recognized an OTTI of $0.3 million on a residential mortgage backed security that had not been previously impaired and during the three and nine month periods ended September 30, 2017 and 2016, we recognized additional credit losses on previously impaired residential mortgage backed securities. Several factors led us to believe the full recovery of amortized cost is not expected on the residential mortgage backed securities. During the nine months ended September 30, 2017 and 2016, we recognized additional impairments of $0.3 million and $3.5 million, respectively, on an asset backed security as sales of similar assets during the second quarters of 2017 and 2016 led us to conclude that the asset backing our security was worth less than our previous estimates. During the three months ended September 30, 2016, we recognized an OTTI of $3.0 million related to a corporate security issued by a Brazilian metals and mining company as developments during this period led us to the conclusion that we will not be able to fully recover our amortized cost basis. During the nine months ended September 30, 2016, we recognized an OTTI of $3.9 million on a corporate security issued by a Brazilian telecommunications company due to developments in 2016 that led us to the conclusion that we will not be able to fully recover our amortized cost basis due to liquidity concerns. The OTTI that we recognized during the nine months ended September 30, 2016 on commercial mortgage backed securities was due to our intent to sell the securities, which were in an unrealized loss position at the reporting date.
Several factors led us to believe that full recovery of amortized cost is not expected on the securities for which we recognized credit losses and reclassified OTTI from accumulated other comprehensive income to net income. A discussion of these factors, our policy and process to identify securities that could potentially have impairment that is other than temporary and a summary of OTTI is presented in Note 3 to our unaudited consolidated financial statements in this Form 10-Q, which is incorporated by reference in this Item 2.
Mortgage Loans on Real Estate
Our commercial mortgage loan portfolio consists of mortgage loans collateralized by the related properties and diversified as to property type, location and loan size. Our mortgage lending policies establish limits on the amount that can be loaned to one borrower and other criteria to attempt to reduce the risk of default. Our commercial mortgage loans on real estate are reported at cost, net of loan loss allowances and deferred prepayment fees. At September 30, 2017 and December 31, 2016, the largest principal amount outstanding for any single mortgage loan was $21.3 million and $20.9 million, respectively, and the average loan size was $3.4 million and $3.2 million, respectively. In addition, the average loan to value ratio for the overall portfolio was 53.8% and 53.7%, at September 30, 2017 and December 31, 2016, respectively, based upon the underwriting and appraisal at the time the loan was made. This loan to value is indicative of our conservative underwriting policies and practices for making commercial mortgage loans and may not be indicative of collateral values at the current reporting date. Our current practice is to only obtain market value appraisals of the underlying collateral at the inception of the loan unless we identify indicators of impairment in our ongoing analysis of the portfolio, in which case, we either calculate a value of the collateral using a capitalization method or obtain a third party appraisal of the underlying collateral. The commercial mortgage loan portfolio is summarized by geographic region and property type in Note 4 to our unaudited consolidated financial statements, 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, 2017, we had commitments to fund commercial mortgage loans totaling $113.9 million, with fixed interest rates ranging from 4.00% to 4.50%. During 2017 and 2016, 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, 2017, we received $166.2 million in cash for loans being paid in full compared to $243.9 million for the nine months ended September 30, 2016. 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.

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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, 2017
 
December 31, 2016
 
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
$
1,817,500

 
69.4
%
 
$
1,781,928

 
71.5
%
Greater than or equal to 1.2 and less than 1.5
612,851

 
23.4
%
 
517,697

 
20.8
%
Greater than or equal to 1.0 and less than 1.2
123,662

 
4.7
%
 
122,115

 
4.9
%
Less than 1.0
66,743

 
2.5
%
 
68,879

 
2.8
%
 
$
2,620,756

 
100.0
%
 
$
2,490,619

 
100.0
%
Approximately 94% of our mortgage loans (based on principal outstanding) that have a debt service coverage ratio of less than 1.0 are performing under the original contractual loan terms at September 30, 2017.
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, 2017
 
December 31, 2016
 
(Dollars in thousands)
Impaired mortgage loans with an allowance
$
6,728

 
$
4,640

Impaired mortgage loans with no related allowance
1,476

 
1,591

Allowance for probable loan losses
(2,049
)
 
(1,327
)
Net carrying value of impaired mortgage loans
$
6,155

 
$
4,904

At September 30, 2017, we had no commercial mortgage loans that were delinquent (60 days or more past due at the reporting date) in their principal and interest payments.
Derivative Instruments
Our derivative instruments primarily consist of call options purchased to provide the income needed to fund the annual index credits on our fixed index annuity products. The fair value of the call options is based upon the amount of cash that would be required to settle the call options obtained from the counterparties adjusted for the nonperformance risk of the counterparty. The nonperformance risk for each counterparty is based upon its credit default swap rate. We have no performance obligations related to the call options.
None of our derivatives qualify for hedge accounting, thus, any change in the fair value of the derivatives that are not classified as equity is recognized immediately in the consolidated statements of operations. A presentation of our derivative instruments along with a discussion of the business strategy involved with our derivatives is included in Note 5 to our unaudited consolidated financial statements in this Form 10-Q, which is incorporated by reference in this Item 2.
Liquidity and Capital Resources
Our insurance subsidiaries continue to have adequate cash flows from annuity deposits and investment income to meet their policyholder and other obligations. Net cash flows from annuity deposits and funds returned to policyholders as surrenders, withdrawals and death claims were $1.1 billion for the nine months ended September 30, 2017 compared to $2.7 billion for the nine months ended September 30, 2016, with the decrease attributable to a $1.4 billion decrease in net annuity deposits after coinsurance and a $240.3 million (after coinsurance) increase in funds returned to policyholders. We continue to invest the net proceeds from policyholder transactions and investment activities in high quality fixed maturity securities and fixed rate commercial mortgage loans.
We, as the parent company, are a legal entity separate and distinct from our subsidiaries, and have no business operations. We need liquidity primarily to service our debt (senior notes and subordinated debentures issued to subsidiary trusts), pay operating expenses and pay dividends to stockholders. Our assets consist primarily of the capital stock and surplus notes of our subsidiaries. Accordingly, our future cash flows depend upon the availability of dividends, surplus note interest payments and other statutorily permissible payments from our subsidiaries, such as payments under our investment advisory agreements and tax allocation agreement with our subsidiaries. These sources provide adequate cash flow for us to meet our current and reasonably foreseeable future obligations.

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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 2017, up to $272.7 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 $1.6 billion of statutory earned surplus at September 30, 2017.
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 A.M. Best and Standard and Poor's. Both regulators and rating agencies could become more conservative in their methodology and criteria, including increasing capital requirements for our insurance subsidiaries which, in turn, could negatively affect the cash available to us from insurance subsidiaries. As of September 30, 2017, we estimate American Equity Life has sufficient statutory capital and surplus, combined with capital available to the holding company, to meet this rating objective. However, this capital may not be sufficient if significant future losses are incurred or a rating agency modifies its rating criteria and access to additional capital could be limited.
The transfer of funds by American Equity Life is also restricted by a covenant in our line of credit agreement which requires American Equity Life to maintain a minimum risk-based capital ratio of 275% and a minimum level of statutory surplus equal to the sum of 1) 80% of statutory surplus at June 30, 2016, 2) 50% of the statutory net income for each fiscal quarter ending after June 30, 2016, and 3) 50% of all capital contributed to American Equity Life after June 30, 2016. American Equity Life's risk-based capital ratio was 342% at December 31, 2016. 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, 2017, were $44.5 million. In addition, we have a $150 million revolving line of credit, with no borrowings outstanding, available through September 2021 for general corporate purposes of the parent company and its subsidiaries. We also have the ability to issue equity, debt or other types of securities through one or more methods of distribution under a currently effective shelf registration statement on Form S-3. The terms of any offering would be established at the time of the offering, subject to market conditions.
On June 16, 2017, we issued $500 million aggregate principal amount of senior unsecured notes due 2027 which bear interest at 5.0% per year and will mature on June 15, 2027 (the “2027 Notes”). We used the net proceeds from the issuance of the 2027 Notes to prepay our $100 million term loan that was scheduled to mature in 2019 on June 16, 2017, and to redeem the 2021 Notes on July 17, 2017. We paid $413.3 million to redeem the 2021 Notes which included an early redemption premium equal to 3.313% of the $400 million principal amount of the 2021 Notes.
New Accounting Pronouncements
See Note 1 to our unaudited consolidated financial statements, which is incorporated by reference in this Item 2.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
We seek to invest our available funds in a manner that will maximize shareholder value and fund future obligations to policyholders and debtors, subject to appropriate risk considerations. We seek to meet this objective through investments that: (i) consist substantially of investment grade fixed maturity securities; (ii) have projected returns which satisfy our spread targets; and (iii) have characteristics which support the underlying liabilities. Many of our products incorporate surrender charges, market interest rate adjustments or other features to encourage persistency.
We seek to maximize the total return on our available for sale investments through active investment management. Accordingly, we have determined that our available for sale portfolio of fixed maturity securities is available to be sold in response to: (i) changes in market interest rates; (ii) changes in relative values of individual securities and asset sectors; (iii) changes in prepayment risks; (iv) changes in credit quality outlook for certain securities; (v) liquidity needs; and (vi) other factors.

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Table of Contents

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 term loan and 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, 2017, 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.
If interest rates were to increase 10% (29 basis points) from levels at September 30, 2017, we estimate that the fair value of our fixed maturity securities would decrease by approximately $1.0 billion. The impact on stockholders' equity of such decrease (net of income taxes and certain adjustments for changes in amortization of deferred policy acquisition costs and deferred sales inducements) would be a decrease of $317.5 million in accumulated other comprehensive income and a decrease in stockholders' equity. The models used to estimate the impact of a 10% change in market interest rates incorporate numerous assumptions, require significant estimates and assume an immediate and parallel change in interest rates without any management of the investment portfolio in reaction to such change. Consequently, potential changes in value of our financial instruments indicated by the simulations will likely be different from the actual changes experienced under given interest rate scenarios, and the differences may be material. Because we actively manage our investments and liabilities, our net exposure to interest rates can vary over time. However, any such decreases in the fair value of our fixed maturity securities (unless related to credit concerns of the issuer requiring recognition of an other than temporary impairment) would generally be realized only if we were required to sell such securities at losses prior to their maturity to meet our liquidity needs, which we manage using the surrender and withdrawal provisions of our annuity contracts and through other means. See Financial Condition - Liquidity for Insurance Operations included in Management's Discussion and Analysis in our Annual Report on Form 10-K for the year ended December 31, 2016.
At September 30, 2017, 37% of our fixed income securities have call features, of which 2.7% ($1.2 billion) were subject to call redemption. Another 0.3% ($125.6 million) will become subject to call redemption during the next twelve months. Approximately 73% of our fixed income securities that have call features are not callable until within six months of their stated maturities. We have reinvestment risk related to these redemptions to the extent we cannot reinvest the net proceeds in assets with credit quality and yield characteristics similar to the redeemed bonds. Such reinvestment risk typically occurs in a declining rate environment. Should rates decline to levels which tighten the spread between our average portfolio yield and average cost of interest credited on annuity liabilities, we have the ability to reduce crediting rates (caps, participation rates or asset fees for index annuities) on most of our annuity liabilities to maintain the spread at our targeted level. At September 30, 2017, 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. The difference between proceeds received at expiration of these options and index credits, as shown in the following table, is primarily due to over-hedging as a result of policyholder behavior being different than our expectations.
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2017
 
2016
 
2017
 
2016
 
(Dollars in thousands)
Annual index credits to policyholders on their anniversaries
$
375,019

 
$
126,653

 
$
1,068,522

 
$
142,084

Proceeds received at expiration of options related to such credits
382,949

 
128,293

 
1,088,018

 
144,343

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

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Table of Contents

Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
In accordance with the Securities Exchange Act Rules 13a-15(e) and 15d-15(e), our management, under the supervision of our Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report on Form 10-Q. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the design and operation of our disclosure controls and procedures were effective as of September 30, 2017 in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by us in the reports that we file or submit under the Exchange Act.
There were no changes in our internal control over financial reporting that occurred during the quarter ended September 30, 2017 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
See Note 7 - Commitments and Contingencies to the unaudited consolidated financial statements, which is incorporated by reference in this Item 1, for litigation and regulatory disclosures.
Item 1A. Risk Factors
Our 2016 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 federal regulation may affect our annuity sales and profitability in our Form 10-Q for the quarterly period ended June 30, 2017. There have been no other material changes to the Risk Factors during the nine months ended September 30, 2017.
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, 2017.

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Item 6. Exhibits
Exhibit No.
 
Description
 
Method of Filing
 
 
Filed herewith
 
 
Filed herewith
 
 
Filed herewith
 
 
Filed herewith
 
 
Filed herewith
101.INS
 
XBRL Instance Document
 
Filed herewith
101.SCH
 
XBRL Taxonomy Extension Schema Document
 
Filed herewith
101.CAL
 
XBRL Taxonomy Extension Calculation Linkbase Document
 
Filed herewith
101.DEF
 
XBRL Taxonomy Extension Definition Linkbase Document
 
Filed herewith
101.LAB
 
XBRL Taxonomy Extension Label Linkbase Document
 
Filed herewith
101.PRE
 
XBRL Taxonomy Extension Presentation Linkbase Document
 
Filed herewith


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Table of Contents

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

Date:
November 9, 2017
 
AMERICAN EQUITY INVESTMENT LIFE
 
 
 
 
HOLDING COMPANY
 
 
 
 
 
 
 
 
 
By:
/s/ John M. Matovina
 
 
 
 
 
John M. Matovina, Chief Executive Officer and President
 
 
 
 
 
(Principal Executive Officer)
 
 
 
 
 
 
 
 
 
By:
/s/ Ted M. Johnson
 
 
 
 
 
Ted M. Johnson, Chief Financial Officer and Treasurer
 
 
 
 
 
(Principal Financial Officer)
 
 
 
 
 
 
 
 
 
By:
/s/ Scott A. Samuelson
 
 
 
 
 
Scott A. Samuelson, Vice President and Chief Accounting Officer
 
 
 
 
 
(Principal Accounting Officer)
 



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