Nov 7, 2017
Operator
Welcome to the American Equity Investment Life Holding Company's Third Quarter 2017 Conference Call. At this time, for opening remarks and introductions, I would like to turn the call over to Julie LaFollette, Director of Investor Relations.
Julie LaFollette
Good morning, and welcome to American Equity Investment Life Holding Company's conference call to discuss third quarter 2017 earnings. Our earnings release and financial supplement can be found on our website at www.american-equity.com.
Non-GAAP financial measures discussed on today's call and reconciliations of non-GAAP financial measures to the most comparable GAAP measures can be found in those documents. Presenting on today's call are John Matovina, Chief Executive Officer; Ted Johnson, Chief Financial Officer; Ron Grensteiner, President of American Equity Life Insurance Company.
Some of the comments made during this call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act. There are a number of risks and uncertainties that could cause actual results to differ materially from those expressed or implied.
Factors that could cause the actual results to differ materially are discussed in detail in our most recent filings with the SEC. An audio replay will be made available on our website shortly after today's call.
And it is now my pleasure to introduce John Matovina.
John Matovina
Thank you, Julie. Good morning everyone, and thank you for joining us this morning.
Our core third quarter financial results remain strong and they continued the solid trends we saw on the first half of the year. Non-GAAP operating income for the quarter was $87.2 million or $0.96 per share.
Excluding the impact of the actuarial assumption reviews and the loss on extinguishment of debt our operating income would have been $63.6 million or $0.70 per share. So as a reminder, the three key areas that drive our financial performance are growing invested assets and policyholder funds under management generating a high level of operating earnings on the growing asset base through investment spread, and then minimizing impairment losses in our investment portfolio.
For the third quarter of 2017 we delivered 1.5% sequential growth in policyholder funds under management, that translates into a 7.1% increase on a trailing 12 month basis. On a trailing 12 month basis we generated a 12.3% non-GAAP operating return on average equity that excludes the impact of the actuarial assumption reviews and the losses on extinguishment of debt.
And our investment impairment losses after the effects of deferred acquisition cost and income taxes were less than 0.01% of average equity. The growth in policyholder funds under management for the quarter was driven by $915 million in gross sales.
Our product offerings have not been as competitive as they've been in prior periods. However since late June, we captured higher new money yields on investments which allowed us to enhance our product offerings and competitive positioning in September and October.
You'll hear more about those from Ron but bit later. We had a modest sequential decrease in our investment spread in the third quarter primarily reflecting a lower benefit from bond transactions and prepayment income.
The investment spread also benefited from the higher new money yields on investments. In our low level of impairment losses once again reflects our continuing commitment to a high-quality investment portfolio.
I'll be back at the end of the call for some closing remarks but now I’d like to turn the call over to Ted Johnson for additional comments on third quarter financial results.
Ted Johnson
Thank you, John. As we reported yesterday afternoon, we had non-GAAP operating income of $87.2 million or $0.96 per share for the third quarter of 2017 compared to our non-GAAP operating loss of $4.7 million or $0.05 per share for the third quarter of 2016.
We had one to three item in the third quarter of 2017 and $18.4 million pretax loss on extinguishment of our 6.625% notes due in 2021 since 15 of $13.3 million of redemption premium and the write-off of 5.1 million of debt issuance costs. The loss on extinguishment of debt reduced both net income and operating income by $10.8 million or $0.12 per share.
Third quarter 2017 operating income included a net benefit of $34.4 million or $0.38 per share from revisions to actuarial assumptions. On a pretax basis, the revisions reduced amortization of deferred policy acquisition cost and deferred sales inducements by $75 million, an increased liability for future payments under lifetime income benefit riders by $21.6 million for a net pretax increase in operating income of $53.4 million.
Revisions to actuarial assumptions in the third quarter of 2016 increased amortization of deferred policy acquisition cost and deferred sales inducements and the liability for future payments under lifetime income benefit riders by $81.6 million and reduced operating income by $52.6 million or $0.60 per share. The third quarter unlocking of deferred policy acquisition cost and deferred sales inducements assumptions was primarily driven by higher than it been modeled account values which translates to increase projections of expected gross profits in future periods.
The increase in the liability for future payments under lifetime income benefit riders was driven by changes to our account value growth projections. Although interest credits were well above expectations, the benefit from this was more than offset both by decreases and our assumptions for expected lapses, as well as changes in our assumptions for future account value growth.
The revisions to our assumptions used to determine the liability for the lifetime income benefit rider under GAAP had no effect on our regulatory reserves as actuarial guidelines for regulatory reserves mandate that reserves for fixed indexed annuities with lifetime income benefit riders be computed assuming that policyholders act with 100% efficiency and elect payment streams that maximize the value of their policies on a net present value basis. Investment spread for the third quarter was 270 basis points down two basis points from the second of 2017 as a result of a two basis point decrease in the average yield on invested assets.
Average yield on invested assets was 4.43 in the third quarter compared to 4.45 in the second quarter. The decrease in the average yield in the quarter reflected a lower benefit from non-trendable investment income items which added five basis points to the third quarter average yield on invested assets compared to eight basis points from such items in the second quarter of 2017.
Non-trendable investment income in the third quarter of 2017 consisted entirely of fees from bond transactions and prepayment income. The contribution from an acceleration of the rate of pay downs on residential mortgage-backed securities was diminimus in the quarter.
The average yield on fixed income securities purchased and commercial mortgage loans funded in the third quarter was 4.39 compared to 3.96 in the second quarter of 2017 and 4.13 in the first quarter of 2017. The higher rate in third quarter reflects an increase in the amount of NAIC 2 rated structured assets purchased.
In October we invested new money at 4.40. The aggregate cost of money for annuity liabilities was 173 basis points flat with the second quarter.
The benefit from overhedging the obligations for index linked interest was six basis points in both the third and second quarters of 2017. We continue to have flexibility to reduce our crediting rates if necessary and could decrease our cost of money by approximately 47 basis points if we reduce current rates to guaranteed minimums.
This is up from 46 basis points at the end of the second quarter. Interest expense on notes payable for the quarter was $7.6 million that's down from $8.7 million in the second quarter.
Interest expense decreased due to the refinancing of our 6.625% notes due in 2021 with 5% notes due in 2027. The 6.625% notes were redeemed on July 17 and we recognized $1.2 million of interest expense for the 16 days the 6.625% notes were outstanding during the third quarter.
Other operating costs and expenses in the third quarter were $28.7 million which was a $2.8 million increase on a sequential basis. Half of this amount was related to the reduction in the liability for payments expected to be made pursuant to the retirement agreement with our former executive chairman that we recognized in the second quarter.
The remainder of the increase primarily reflects higher salaries and increases and incentive compensation accruals. Our estimated risk-based capital ratio at September 30 is 3.75 up from 3.66 at the end of this year's second quarter.
The increase in the RBC ratio included four points from a decline in required capital for production and we estimate - which we estimate using a 12 month sales. The increase in our adjusted statutory capital and surplus exceeded the increase in required capital from growth in assets and reserves and accounted for the remainder of the third quarter increase in our RBC ratio.
Now I'll turn the call over to Ron to discuss sales, marketing and competition.
Ronald Grensteiner
Thank you, Ted. Good morning, everyone.
As we reported yesterday, gross sales for the third quarter of 2017 were $915 million, this is down from sales of $1.5 billion in the third quarter of 2016 and $1.2 billion in this year's second quarter. Third quarter 2016 sales included $226 million of non-core multiyear guaranteed annuity sales of which 80% was coinsured.
Third quarter 2017 had just $16 million of sales from multi-year products. Net sales for the quarter were $834 million compared to $1.1 billion a year earlier and $1.1 billion in the second quarter of this year.
As a reminder, beginning this year we are retaining 50% of all Eagle Life fixed indexed annuity sales up from 20% previously. Recent reports from several of our competitors suggest that industry fixed indexed annuity sales were down on a sequential basis.
We believe low interest rates and the continuation of the equity bull market are the biggest headwinds for sales. We're not sure how much if at all implementation of the Department of Labor's fiduciary rule on June 9 affected the sequential decline in sales.
Conversation surrounding the rule have been muted particularly since the announcement of a potential further delay of certain aspects of the rule beyond January 1, 2018. The market in each of our distribution channels remain competitive in the third quarter although we saw several rate reductions in September and a significant competitor in the independent agent channel lowered participation rates on accumulation products and payout rates on its guaranteed income products in early October.
Independent agents continue to shift their emphasis from guaranteed income to accumulation products focused on upside potential. We addressed this shift by placing more emphasis in our marketing efforts on our Choice Series at American Equity Life.
The Choice Series accounted for 22% of American Equity Life sales in the third quarter versus 17% in the second quarter. In September it accounted for 25% of sales.
We made changes to our lifetime income benefit rider in early July to recognize lower valuation interest rates used to compute statutory reserves for policies issued in 2017. We also discontinued our no fee version of the rider which was popular with our agents.
Many of our competitors did not make similar adjustments which negatively affected our competitive position for guaranteed income which was less than our significant competitors too much at the quarter. Due to the higher investment yields we have been capturing, we made several product changes in September and October 3.
Fee accumulation products, we raised participation and cap rates on American Equities Choice and Eagle Life select products. When coupled with the optional market value adjustment rider we introduced earlier this year, Choice 10 and Select 10 now offer some of the highest participation rates in the market among annual reset fixed index annuities.
We believe these offerings compare very well with the proprietary index multi-year term products which have been quite popular in the market. Rather than a proprietary index, our products contract value growth is based on the S&P 500, a transparent public index with 60-years of history that a policyholder can easily track.
We believe proprietary indices add another level of complexity to a safe money insurance product and do not offer a significant growth advantage. Higher investment yields also led us to improvements in our guaranteed income products.
In September we raised rollup rates on our bonus products back to pre-July levels. In October we introduced a new lifetime income benefit rider for our Foundation Gold fixed index annuity.
Lifetime income on the Foundation Gold is very attractive particularly in many important age deferral combinations where we expect to higher guaranteed income than offered by our significant competitors. Also since we charge rider fees based on contract values rather than income account values, our fees are the lowest in the market making Foundation Gold even more attractive on a net of fee basis.
We are emphasizing to our agents that fees matter and that they should be an important factor when comparing annuities with lifetime income guarantees for their clients. In addition we are again offering the no fee lifetime income rider on the Foundation Gold.
We believe we are the best in the best competitive position particularly at American Equity than we have been since last year. However we will continue to work on new products and features to enhance our competitiveness even further.
Turning to current sales trends, pending business at American Equity Life averaged 2,196 applications during the third quarter and was 1,985 at the end of September compared to 2,206 applications when we reported second quarter 2017 earnings. Pending hit a low of 1,907 on September 7 but now stands at 2,178 applications.
Pending at Eagle Life stands at 213 applications today up from – excuse me, 134 when we reported second quarter earnings. As we noted in the past, sales momentum in the bank of broker dealer channels tend to change much more quickly than an independent channel.
Our distribution footprint in Eagle Life continues to grow in the third quarter. We added one new wholesaler, three new selling agreements and 513 representatives.
In total we have nine wholesaling distribution partners, 58 selling agreements and 5,829 representatives. And with that, I'll turn the call back over to John.
John Matovina
Thank you, Ted and Ron. We are pleased with our third-quarter results as spread and non-GAAP operating earnings exclusive of the impact from revisions to actuarial assumptions and the loss on extinguishment of debt remain stable despite continued headwinds from low interest rates.
Although sales were down sequentially in the third quarter, we are pleased with momentum at Eagle Life which is carried over into the first part of the fourth quarter. Regaining momentum at American Equity Life may take longer but our products are now more competitive and we believe the value proposition we've always offered independent agents transparent products, attractive renewal crediting history, an unparalleled service remains as attractive as ever.
We are optimistic that the Department of Labor will finalize the delay of the implementation of its fiduciary rule to July 1, 2019 and hopeful that regulations unduly burdening distribution of annuities by independent agents will be substantially revised. While the eventual outcome of the fiduciary rule remains uncertain, we remain prepared to respond and grow our business.
Our long-term outlook remains favorable due to the growing number of Americans who need attractive fixed index annuity products that offer principal protection with guaranteed lifetime income and the fiduciary rule won't change this. While we look to continue to expand our investment horizon, the credit quality of our investment portfolio will remain high and we will maintain our discipline of avoiding excessive credit risk.
As we stated many times in the past, we offer sleep insurance and that implies a promise to our agents and our policyholders that they can trust us to be there when they need their money whether that be tomorrow or decades from now. So on behalf of the entire American Equity team, thank you for your time and attention this morning and I'll turn the call back to the operator for questions.
Operator
[Operator Instructions] Our first question comes from line of Erik Bass with Autonomous Research. Your line is now open.
Erik Bass
Had a question for Jeff, and I was just hoping that he could provide some more detail on the type of assets that you're purchasing that have allowed you to increase the new money yield on how you view the relative risk reward on those assets.
Jeffrey Lorenzen
I'm not going to get into details as specific securities but in general what we’re doing is realigning the portfolio. We are looking more in a structured asset segment of the market.
What we have done is a deep dive analysis looking through longer-term patterns of default and loss recoveries in different asset classes and we're finding that certain structures within the structured assets and other segments of the market offer very attractive default and loss recovery profiles much better than what we might see on the corporate side and is allowing us to shift into other asset classes where we can see some additional yield due to illiquidity or less liquidity. Our portfolio we have ample liquidity, we have very, very public open portfolio and as a result we felt we could take on several percent more of illiquidity and not have any impact to the portfolio.
Erik Bass
I guess we have seen a number of insurers that are talking about similar things of trading liquidity for yields and purchasing more structured securities and certainly some spreads on those assets that have come in. So I guess how much value do you still see in this area in the market and the spreads do become unattractive are there other avenues that you could pivot to meet the target returns - new money returns that you need for the new products?
Jeffrey Lorenzen
We have seen spreads come in. We still think there's opportunities there.
They do offer attractive value still at this point in time. We had several other asset classes that were pursuing that - could continue to offer some enhancements to yield that would offset any spread compression that we’re seeing in other sectors.
John Matovina
One follow-up to that too is as you know, if yields do come in because the space gets crowded that's not going to just affect us it's going to affect others looking to be in the same [budget] but the same space and I think consistent with our history we would adjust product terms to reflect the investment yields we get, not just accept lower returns based upon potential declines and yields.
Erik Bass
And can you quantify how much more yield you need to achieve in terms to meet the target returns on the reprice products?
John Matovina
The product pricing that we're using reflects the target returns.
Erik Bass
I think you are sort of just under 4% new money last quarter and now at 4.4% so is that sort of the - I guess change in yield assumption to think about?
Ted Johnson
The 4.4% supports the crediting rates that we have on products today.
Erik Bass
Got it. Thank you.
Ted Johnson
Crediting rates and lifetime income rider terms.
Operator
Our next question comes from the line of Randy Binner with B. Riley.
Your line is now open.
Weston Bloomer
This is Weston Bloomer on for Randy. Pending counts have trended lower over the past few quarters pricing change to the competitive environment and change to the income benefit rider.
Do you guys feel like that has stabilized and generally speaking I'd expect pending counts to accelerate in the fourth quarter. Do you still expect that to be the case or maybe this delayed a bit?
Thank you.
Ronald Grensteiner
This is Ron, as I reported pending did dip lower than typical in September, but we're starting to see it rebound I think the rebound is due to us increasing our competitiveness by capturing that higher yield raising some participation rates, increasing some income and some of our competitors backing off on some of their terms have helped us as well. So we're really in a competitive position today, but I can't predict what the fourth quarter is going to look like for pending.
John Matovina
This is John I wouldn’t necessarily consider fourth quarter seasonally up mean it's happened that way in the past, but that's not necessarily always the case.
Operator
Our next question comes from the line of Kenneth Lee with RBC Capital Markets. Your line is now open.
Kenneth Lee
So I just had a question in terms of the competitive activity. It sounds as if some competitors might be lowering some benefits on accumulation and guaranteed fee income products and at the same time you guys are changing terms as well September/October.
Just want to get a clear sense at this point how do yield product stack up versus competitors it is sort of like the most competitive versus close the top any kind of color there?
Ronald Grensteiner
When we look at accumulation type product that's our Choice 10 for example, we have perhaps the highest if not close to the highest if not the highest participation rate out there on our tenure chassis it's a 52% participation rate on an annual reset. So that's attracting some good attention.
So participation rates very competitively. When you look at our caps we’re certainly in the hunt, but we’re not the highest on caps.
When you look at our income, we did make some great strides on improving our guaranteed income particularly in October when we introduced a new version of the rider on our Foundation Gold. When we look at our top competitors and when I say top competitors those that are stay in the top 10 we don't have the highest guaranteed income, but when you look at our peer group or our fiercest competitors for lack of better word, we're right there even with them and in a lot of cases higher than them on guaranteed income.
So we really feel like we’re in the best place we've been for some time.
Kenneth Lee
And then in terms of the potential to further lower the cost of money, in terms of competitive activity should we expect any kind of constraint on how much further you can lower the cost of money just based on the increased level of competitive activity?
Ted Johnson
I think we've said in the past we have a - really good renewal rate history out there in the marketplace, it is somewhat difficult sometimes to be able to see what competition has done with their renewal rate. I don't think our constraint is necessarily around what competition has done, it's purely more of a factor of us managing our spread and where we're at with that in regards to renewal rates.
And currently where we're at with yield, we're optimistic that right now we’re okay with where we’re at with renewal rates.
John Matovina
This is John, one follow-up on that. I know we said on several occasions in the past that the competitive environment for new money is a very open and everybody sees what everybody else is doing but on renewal rates that competitive history is not part of really the competitive environment.
We certainly trumpet to the field force a very what we think is an attractive renewal rate crediting history, but that's not an element of competition I don't think among the carriers or something the agents look very closely at.
Kenneth Lee
And just one last follow-up, just what was mentioned earlier in terms of the realigning of the investment portfolio, should we read that as something one that reposition existing investments or is it sort of just once again focused on mainly the new money side?
Ronald Grensteiner
Right now that focus is on the new money side, there's not been any realignment of the existing portfolio.
Operator
Our next question comes from the line of Pablo Singzon with JPMorgan. Your line is now open.
Pablo Singzon
So first question is for Ron, given all the products changes you made, do you think there is still financial flexibility to make your products more competitive and competitors respond in kind or do you think you have maximized potential changes for now?
Ronald Grensteiner
Pablo we're always looking for opportunities to become more competitive. There's things that we can for example on our guaranteed lifetime income the longer you guarantee the rollup period, your income amount maybe lower in those early years, but if you shorten the rollup periods say from 20 years to 10 years we're able to offer higher guaranteed income during that 10 years.
So we could say well let’s just do a five year guarantee and that could increase our income even more. So we always have to look at the levers we have available to move and what’s the competition doing.
And so to answer your question I wouldn’t say we’ve maximized our opportunity we’re always looking for ways to get better.
Ted Johnson
Pablo this is Ted. With pricing of products it always start with the opportunities that are available to invest new money so really that’s where it started when the returns that we are targeting on our products.
And so certainly the opportunities to make our products more competitive always starts with the opportunities to be able to invest that money and what yields we can invest that and always stay in price discipline in making sure that we’re targeting the appropriate return. We feel that where we're at right now in the yield we’re obtaining has allowed us to as Ron has already said position ourselves very, very competitively within the marketplace and we’ll continue to look at opportunities or ways that we can structure products to continue to make ourselves competitive out there.
The marketplace is dynamic, people make great changes where we’re at right now we're very competitive and we’ll respond appropriately as we see competition make changes.
Pablo Singzon
My follow-up is, so one of your competitors recently announced the reinsurance you could have seen for sales to banks and brokers. Do you expect more companies to use similar structures and how do you think that changes competitive dynamics in the market for you?
Ted Johnson
I would expect they’re going to be continue that people will look at onshore companies that don't have the tax efficiencies of the offshore platform. We’ll continue to look for opportunities like that obviously we've been utilizing that opportunity ourselves with our relationship with the theme through Eagle Life and able to allow us to have some profit-sharing or sharing in some of the efficiencies they have with their offshore platform.
So it wouldn't surprise me that you will see other companies out there outside of us in Lincoln look for those opportunities.
Operator
[Operator Instructions] Our next question comes from the line of Alex Scott with Goldman Sachs. Your line is now open.
Alex Scott
So this one is on just how you think about the required capital for new business and just given some of the shifts in the way that you’re investing new money kind of in the context of your asset leverage being a bit higher than peers, would you need to think about asset leverage being lower on new business with that need to come to come down over time as you execute this.
John Matovina
As we execute on investing new money with a slightly different investment strategy, as we price products we have to take that into consideration in regards to the capital ratios that we would be targeting so that is being taken into consideration. I hope that's answering your question.
Ronald Grensteiner
But the real answer is, there hasn't been that much shift in the required capital in terms of the investments we're buying. And maybe we got a little bit more Class 2s than we have Class 1s, I think I looked we went from 64 - it was a one percentage point change between Class 1 and Class 2, 1 down and Class 2 up.
So we really haven't done much to alter the capital requirements in the business.
Operator
I'm showing no further questions at this time. I’d like to turn the call back to Ms.
LaFollette for any closing remarks.
Julie LaFollette
Thank you for your interest in American Equity and for participating in today's call. Should you have any follow-up questions please feel free to contact us.
Operator
Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program and you may now disconnect.
Everyone, have a great day.