American Equity Investment Life Holding Company

Good morning, and welcome to American Equity Investment Life Holding Company's conference call to discuss third quarter 2012 earnings. Our earnings release and financial supplement can be found on our website at www.american-equity.com.

Presenting on today's call are John Matovina, Chief Executive Officer; Ted Johnson, Chief Financial Officer; and Ron Grensteiner, President of the Life 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 available on our website shortly after today's call.

It is now my pleasure to introduce John Matovina.

Thank you, Julie, and good morning, everyone. Welcome to the call.

As we reported yesterday afternoon, operating earnings for the third quarter were $22.2 million or $0.34 per diluted share. That includes the effect of DAC unlocking in the quarter, which was about $0.07 a share.

And just as a reminder, unlocking includes the typical revisions to DAC and deferred sales inducements, and now also similar revisions that we make in the assumptions for our liability for future benefits under the lifetime income benefit rider. We also modified our assumptions that we use to determine the index annuity embedded derivatives to be consistent with the changes to DAC, but the outcome of that exercise is not relevant to operating income, but does have an effect on the GAAP reported net income.

Relative to Q2, our operating income would've been -- excluding the unlocking, would've been essentially flat to a slight decrease. It goes without saying, results continue to be held back by the low interest rate environment and the high cash balances that we've been experiencing, resulting from calls of government agency securities.

And just as kind of a refresher on that, the callable government agency securities have been a cornerstone of our investment portfolio going back to the inception of the company.

Through the years, they provided very acceptable yields that met our spread requirements without any risk-based capital charges. Now over the last several years though we've gone through several cycles of calls of these securities as their rates have moved lower.

And each time, we reinvested a portion of this, our debt [indiscernible] in callable government agency securities with the lower yields. [indiscernible] we reinvested at lower yields, kept the cash balances low, but [indiscernible] periods, and that's what's upon us now.

And actually, if you look back at 2011 in terms of purchases and calls of agency securities, we were a net purchaser in 2011 with 3.1 billion in calls and 3.7 billion in purchases. However, in the current environment, we've been unwilling to reinvest back in the agency securities with the yields under 4%.

And thus far in 2012, we've only purchased 1.2 billion of the agency -- callable agency securities, of which 500 million was purchased at a premium to par, in other words, that yields of 1% or less, compared to over 3-point -- or 3.6 billion in calls. And as a result, it gives you the background on why the excess cash persists.

And unfortunately, we've got some additional calls on the horizon.

Ted will comment more fully on those -- more fully about those in his segment of the report or call.

But part of that buildup of cash is a result of the fact that it is more challenging to find investments meeting our credit quality duration and yield requirements in sufficient size. However, we think longer-term, we can find those securities.

And over time, we're comfortable that we'll be able to restore our investment spread to our 3% target, once the excess cash is fully invested and if necessary then, making any adjustments to rates to policyholders if necessary, as we've done in the past. A couple of quick comments about sales, and you'll hear more from those -- on those from Ron, the sales pace did pick up in the third quarter, as a competitive environment was more favorable to us.

As we commented last call, we lost sales in the first half of 2012 to certain competitors who were more aggressive in the product pricing. Many of those competitors have made adjustments, and there were numerous adjustments in the June, July timeframe, that leveled the playing field and translated into the $65 million increase in sales that we had in the third quarter relative to Q2.

Many of those adjustments from our competitors were to the lifetime income benefit rider rather than the base crediting rates. And the feedback we were getting from our distribution or have been getting from the distribution all year long is that, that lifetime income benefit rider has been an important product feature in preserving sales in the low interest rate environment.

And as usual, Ron's commentary will -- remarks will include commentary on the competitive environment. So with that, let me turn the call over to Ted to give you some additional details on the financial results.

Thank you, John. Each quarter, we compare actual results to our deferred acquisition costs and deferred sales inducement models.

When variances emerge between our estimates and our actual results, we determine whether an unlocking is necessary. Historically, we have unlocked our DAC and DSI models in the third, but this could occur in any quarter, and more frequently than once a year.

The principal variances since the last unlocking in the third quarter of 2011 were shortfalls in investment spread due to excess cash and in the investment portfolio, and less surrender charge gain due to lower surrenders of policies than model. The shortfall in surrenders means we are retaining more account values than we assumed, and we will continue to earn spread on these funds in future periods.

The assumption revisions and the unlocking performed in this quarter include reducing investment spread and surrender gained assumptions in the near-term projection period to reflect current experience by grading that experience back to longer-term pricing assumptions over time to reflect our view that the current experience is temporary rather than long-term.

The unlocking process this quarter resulted in a decrease in the combined DAC and DSI balances of $9.7 million on an operating income basis, and corresponding increases and amortization of DAC of $7.3 million and of deferred sales inducements on $2.4 million. Much of the increased amortization results from the revised investment spread assumptions for excess cash.

This impact is partially mitigated by the surrender gain assumptions revisions, which resulted in larger account balances in-force over the amortization period, and ultimately more spread income than previously modeled.

We also made revisions to our assumptions for determining the liability for future benefit to be paid under the living income benefit rider to be consistent with the assumption changes for the determination of DAC and DSI.

This process and outcome of this revision is similar to the DAC and DSI unlocking concept. Revisions this quarter decreased the liability for future benefits and decreased interest-sensitive and index product benefits by $2.2 million, offsetting the negative impact of the DAC and DSI unlocking on third quarter operating income.

You can expect that future unlocking exercises will also involve evaluations of the assumptions used in determining the liability for future benefits to be paid under the living income benefit rider. Investment spread for the third quarter was 2.62%, and total invested assets at September 30 were $26 billion, $23.4 billion on an amortized cost basis.

Invested assets will grow by an additional $1.9 billion as we invest the excess cash balance.

The spread result for the quarter was 8 basis points less than the previous quarter's spread of 2.7%.

On an adjusted basis, third quarter spread was 2.86% compared to 2.95% in the second quarter. The average cash balance during the third quarter was $1.7 billion, resulting in foregone investment income of 29 basis points, compared to $1.4 billion in the second quarter and 27 basis points.

Offsetting the cost of liquidity was 4 basis points from prepayment income on commercial real estate, mortgages and RMBS securities. In addition, we had 1 basis point benefit from over hedging in the third quarter.

The cost of money declined to 2.55% in the third quarter from 2.64% in the second quarter. The decline reflects management's actions to maintain spreads by adjusting rates to policyholders.

We anticipate achieving an additional 20 to 25 basis point reduction in the cost of money over the next 12 months based upon rate adjustments already implemented.

We will make further reductions in policyholder rates as necessary to restore our investment spread to the 3% target.

We have approximately 63 basis points of room to reduce rates on index annuity policies before minimum guarantees would cause spread compression. This is demonstrated on Page 12 of the financial supplement.

During the third quarter, we purchased $1.2 billion of new fixed income securities at an average yield of 3.93%, and we funded $137.6 million of new commercial mortgage loans at an average yield of 4.79%.

The majority of the security purchases were investment grade corporate bonds, with the remainder primarily being structured securities, including residential and commercial mortgage-backed securities. Call sales maturities and pay-downs of fixed income securities for the third quarter were $1.3 billion, with an average yield of 5.31%.

For the remainder of 2012, $932 million with an average yield of 3.18% has been or is expected to be called, and $949 million with an average yield of 3.37% is callable in the first 4 months of 2013.

All of these securities have coupon rates greater than 4%, with the majority ranging from 4% to 4.27%, and are expected to be called based upon current interest rates. Operating costs and expenses for the quarter were $18.6 million, compared to $18.9 million in the second quarter, fairly flat quarter-to-quarter, and $15.9 million in the third quarter of 2011.

The increase from third quarter 2011 is primarily related to the prospective adoption of the revised accounting to guidance for deferred policy acquisition cost, which resulted in $2.2 million of additional expense recognized in the third quarter of 2012. This amount relates to home-office expenses that were previously deferred and amortized over the life of the underlying policies.

Book value per share excluding AOCI of $16.07 is down $0.27 from June 30, book value of $16.34 due to the net loss in the third quarter and the induced conversion of the 8% trust preferred securities, which converted that $8.10 per share.

Our RBC at September 30 was estimated at 336% based upon trailing 12-month annual sales. This is down slightly from second quarter and year-end 2011.

With that, I'll turn the call over to Ron to talk about sales and production.

Thank you, Ted. Good morning, everyone.

As John mentioned, we had a satisfactory third quarter with $982 million, compared to $917 million in the second quarter. Our total sales through the third quarter are $2.87 billion, which has us on pace for the third biggest year in the history of the company.

Sales did pick up as we predicted in the third quarter, as our competitors made numerous changes to rates and commissions.

Last quarter, I mentioned 18 competitors made 40 announcements of changes in the first half of the year. In the third quarter, 14 companies made over 20 announcements of additional changes, with our primary competitors making multiple changes.

And the playing field is level, and we believe it is, we feel that we have an edge over our competition due to our excellent reputation for customer service and years of relationship building. At the beginning of the quarter, our pending count was around 2,700.

It has increased during the quarter to the 2,900 to 3,000 range today.

It's hard to know what the fourth quarter will bring. More than likely, we'll need to make some adjustments of our own that will create a sense of urgency until the changes take effect.

And then after that, it depends on whether our primary competition makes their own adjustments, and I suspect they will. One of our primary competitors has already made a rate change announcement.

There is no doubt this is a tough market for fixed annuities. And we have to be realistic, but we also have to be optimistic.

And there's lots of reasons to be optimistic for fixed index annuity sales. And for starters, stock market volatility has really left permanent scars on a lot of people's minds.

Consider the downturn in 2001, and then the rebuild to 2008, and then another downturn, and then the rebuild again, and people are retiring now maybe if they have all their money that they had in 2001. Also as defined benefit plans disappear, retirees are looking for guaranteed income solutions, lifetime income benefit riders provide those guarantees that people are seeking.

What other retirement tools allow you to predict to the penny what your retirement income will be in 5, 10, even 20 years from now. Also, rates on fixed annuities may be low, but they're still higher than other safe money alternatives.

And throw into the mix the indexed link interest even makes it more attractive. For example, in the third quarter, our average index credit was 4.3%.

Our highest was 18.02%. Now you had to be in the right day for that.

But overall, 4.3% isn't too shabby in this environment. I also imagine that a lot of people have more liquidity than usual these days as they're afraid to tie their money up for extended periods of times or maybe afraid to make a wrong decision.

But with that said, we never take all of one's money, and there's always a portion of people's money that is allocated into the fundamental, retirement tools like fixed annuities.

And finally, there are more positive articles today about our products in the press today than ever before. Even the federal government is saying good things about annuities for tools for retirement income.

Well, we just returned from our agent convention, in which we had 247 agents and marketing company representatives. The agents had to write at least $3 million in paid premium for the convention period, which runs 1 year from July to June.

Including guests and home-office folks, we had a crowd of 533 people.

The top 10 producers at the convention wrote in excess of $11.7 million and more. The top 3 wrote over $18 million.

And the top producer was just short of $20 million.

And I think this is a testament that even in today's economic environment that we have plenty of professional producers, who promote the real benefits of our products. Agents understand this will be successful, but the ones that need higher rates and premium bonuses more than likely are going to have a tough fourth quarter and probably a tough year next year.

Well, we're very focused at American Equity, working with our current agents in order to get them actively producing for our company. For brand new agents, we have a special campaign through phone calls and letters, where we try to get their first piece of business while we're still fresh on their minds.

Of course, our ultimate goal is to make them Gold Eagle members. And to refresh your memory, Gold Eagle members are producers who have produced at least $1 million in sales annually.

And in exchange, they receive American Equity stock options, some marketing dollars and other benefits. We feel the stock option benefit is very unique, and gives our best producers an opportunity to be owners of our great company.

And once we get a producer to be Gold Eagle members and experience our culture and service, we have a really good chance of building a relationship and keeping them producers for multiple years.

Historically, our Gold Eagle members have been responsible for about 57%, 58% of our annual sales. To date, we have 23,700 agents, which is down from its peak of 52,000 in 2008.

We have received at least 1 application from 7,746 agents, which is 1/3 of our total in 2012.

And of those, 876 have qualified or are on track to qualify for Gold Eagle membership. And this count is -- makes our Gold Eagles those that are there and on track are responsible for over 60% of our business so far this year.

And if that percentage holds, that will be a record high.

The bottom line is we are improving our effectiveness in getting our agents to produce, and we are efficient by canceling the agents who would just can't seem to convert.

Finally, I know you know that I'll mention the policyholder appreciation events. Since the inception of the program a little over 2 years ago, we've had 51 events, with 9,800 policyholders and 668 agents in attendance.

number one, to say thank you for entrusting us with their money; next, we want to give them an introduction to American Equity, a little history lesson in what some of our basic business philosophies are all about; next, we give them an overview of our financials, the fact that we're rock-solid; and finally, we cover the A, B, C's, 1, 2, 3's of fixed annuities. Every time we do one of these of events, it takes about an hour.

We feed them a nice buffet lunch, give away some door prizes and send them home. There's no selling.

But every time we do one, we hold these events, the outcomes are nearly identical. We have people that come up to us and say things like, "We're going to sleep better tonight."

Or they say something like, "We trust our advisor's judgment, but hearing and seeing you is really icing on the cake. So we are still the only company that does this type of program.

We can't put any hard numbers as far as our success. But we know by the many cards, letters, phone calls and stories that we are making a difference.

We will continue to hold these events for the foreseeable future, and our policyholders are entitled to hear directly from the people who are watching over their money. And so with that, I'll turn it over to John.

Thank you, Ron, and Ted. Before we get to Q&A, I'll make a couple of comments about the paragraph in the press release concerning litigation settlement, and that litigation settlement is what we called the McCormack litigations here at the company.

It's probably more fully described in our 10-Q and 10-K filings. We have been in mediation discussions with the plaintiff's counsel for well over a year now.

Those have gone I guess not at a very fast pace since considering how they've been over 12 months. But the developments in the third quarter did meet the appropriate accounting criteria for the establishment of an accrued liability for the anticipated settlement of that action on both the GAAP and statutory accounting basis, and that accounting criteria, being that the loss contingency from a settlement is both probable and estimable.

The GAAP liability of $17.5 million represents our best estimate of the probable loss with respect to the litigation. Our statutory amount is slightly higher than that, but it is reflected in our third quarter RBC, and that stems from differences in statutory GAAP accounting for 1 element of the proposed settlement.

We don't have a settlement agreement just yet nor court approval, so more actions are necessary before this matter is finalized, which makes that estimated liability subject to revision. But as it say, it does represent the best estimate that we have today of the loss there.

And of course, we do deny the liabilities for the claims to certify the purported class and the action, but believe the settlement is in the best interest of the company, the policyholders, agents and shareholders, and removes from that overhang the fact that this lawsuit has been out there since, I think, 2005 or '06. It got us quite a long period of time.

And so, we'd remove that as a potential negative contingency against the company if the settlement proceeds under the terms that we expect or our basis for a liability. Ron commented a little bit about sales outlook.

The Q4 sales are off to a good start. However, as we've commented on many occasions in the past, we're not going to pursue sales growth and market share at the expense of acceptable profits.

And it's been now 12 months since we've had a rate adjustment on new business. We've been rather patient in that regard.

But certainly, investment yields have moved against us, and it's time to make new money rate adjustments again, then those will be likely made very promptly or within a very short period of time after this call. Those adjustments might weaken our competitive posture if the -- some competitors don't follow suit.

But as Ron commented, one of the competitors has already made adjustments this quarter, so it might be an indication that others are going to follow suit. And of course, whenever we do make these adjustments, it typically leads to an increased sales activity, so there could be some uptick in fourth quarter sales from the rate adjustment.

Looking at the outlook for our spread management, we're going to continue to deploy that cash. However, if the current interest rate environment persists, it's very likely going to be the second half of next year before we reach a fully invested position.

The average cash balances for Q4 could be higher than -- even at the high Q3 levels given the current sales trends, the expected calls and investment options. We would anticipate making some progress in Q1 of 2013 as we've only got $250 million of bonds expected to be called in that quarter, and most of those are callable in March, so we'd be at the tail end of the quarter.

In terms of new investments, we have recently lowered our rates for new commercial mortgage loans for much of this year. The competition has been below 4% on rates that they've been willing to make those loans at.

And we were slightly above that 4% rate. Our best rate is now slightly below that.

So we would hope that we can pick up some more flow into commercial mortgage loans, which do provide better yields than what we're seeing in securities these days. And we would prefer to attract more funds into that asset class, which actually we've seen a small net decrease in the year in funds invested in the commercial mortgages, as there's been more prepayments and pay-downs in what we've been able to issue at the yields that we were offering.

The renewal rate adjustments that we talked about a year ago are still being implemented on a small group of policies that have yet to cycle through their anniversary date. That renewal rate adjustment has been extended to some additional policies.

The cutoff last year was policies issued through clearly November of 2009. So we've extended at the policies issued after November 2009, so there'll be some small incremental benefit from lower rates there.

And of course, we will implement additional adjustments in 2013 as necessary as the investment yield crystallizes in terms of the permanent investment of the cash and indicates what the target rate we need to achieve in order to get back to that target 3% spread.

So with that, we'll turn the call over to the audience for questions.

Just a couple of quick ones. The explanations are all very good.

On McCormack, I just want to clarify kind of from your perspective, John, that I mean is this the only major kind of purported class action out there? Is this the main piece of litigation that you've been tracking over the last year and kind of looking forward?

Yes, it is.

And I mean, is there any sense of timing about where -- what point you might be able to settle this? I mean, I think it's in the mediation.

So does that -- I mean is that -- I know the timeframe has been kind of extended, but is it getting closer? Any sense of timing would be helpful.

I'm not very good at legal stuff to know timing. I do know that we now have a draft of a settlement agreement.

My recollection of the experience on Stephens was that went through several rounds of negotiation. Typically, you seem to get hung up on the little points as opposed to the big broad-based terms of -- and the broad base of terms have been agreed to through the mediator in terms of anticipated benefits or benefits to the class and legal fees in that.

So I don't want to hazard a guess on what the timeframe might be, but I guess I can say that draft of the settlement agreement has been received, but we haven't responded to it yet. It was just received I think one day last week.

And then, once the settlement is agreed to though, you've got to get it to go through the court process. And there again, I profess to being not having a lot of practical experience to know how long that might take.

You'd be subject to the court's calendar in some respects. And then always in these things, once the court approves the settlement, you have to have it sitting out there for a period of time for people to object.

So it's not going to be I don't think a real fast or short process for the end, but it's headed down that path.

Okay. And then just a kind of bottom line, I mean again, I mean there's not another McCormack or Stephens in the pipeline, right?

I mean, we've been -- there's been litigation risks with AEL for years and years. So it seems like that a lot of this is kind of coming to a close based on what you know now.

Is that a safe kind of assumption?

That is a safe assumption. I'm not aware of anything else, and don't know that anybody else in American Equity is either.

Right, okay. And then just a real kind of quick, I hope, follow-up on Ted's commentary around the DAC adjustment.

The way I'm understanding the explanation is that you're contemplating in your DAC, this is the negative DAC unlock associated with a tighter investment spread. That is, of course, a function of the elevated cash balance.

And in your commentary there, it sounds like you plan to be fully invested sometime in the kind of the second half of '13. So just tying all that together, can we say that the DAC charge taken here kind of fully anticipates being fully invested by later in '13?

And if you're not then, would that potentially expose you to kind of further negative unlocks?

That has what -- well, that is what's been factored into the DAC model, is us being fully invested on in the second half of 2013. So that's already all been factored in, and it wouldn't be -- come up in an unlocking in a future period.

Okay. And then I guess the bond, kind of the new money rates seems kind of low.

But I mean you're assuming kind of the current level of reinvestment yields? Or are you kind of factoring that to get a little bit better over the next 12 months?

This is John, Randy. The level of investment yields is a factor, but the more determinant factor is the actual spread.

So the anticipation is that rate adjustments will be -- will also be made as necessary to get there.

A couple -- no, mention -- maybe if you could talk about at what's going on, if anything, in the broker-dealer channel?

Yes. The broker-dealer channel's still somewhat dormant because of rate environment and unwilling to put product out there at very unacceptable spreads.

Okay. And then just wondering, the RMBS position that you have, I gather there are new NAIC rules regarding the valuation in capital.

Any idea, Ted, how that might affect you?

We've been following that closely, as the industry has also. It's really going to be in December until we get the actual models to see how it actually affects and how many of our securities that will affect.

So it's a little difficult to estimate right now until we get the actual models. And the models will not be released until December.

Okay. My follow-up is given the kind of uncertainty about what may happen, I think it was a line in your press release about possibly expanding into other asset classes including CMBS.

Is that really reasonable given this uncertainty?

Well, go ahead, Jeff. Jeff Lorenzen is here in the room with us, too.

In the CMBS space, what we're focused on right now is not the secondary pieces that are going to be more susceptible to changes in the NAIC process. It's been the new issue, which are coming out with much better subordination and tighter constraints around the structure.

So at this point in time, all of the new issue items or the new issue CMBS, we believe are more than covered through this new stress testing of the NAIC is going to go through.

On the lawsuit, are there any terms of the proposed settlement that would impact the way you design products or sell your annuities? Or is it purely financial sorts of terms?

There's nothing in there, Paul, that would impact product design that I can think of. No.

No, this concerns -- it's kind of the litigation is a sales practice litigation item, so...

Does the settlement require you to make any changes to your supervision of agents, sales, practices, anything like that?

One, we don't have a formal settlement yet, but...

There's nothing in the settlement that's material in the draft so far, that around supervision of agents that would change any profits or sales practices that we currently have.

My recollection, too, from something like I think those kinds of things typically end up in a settlement agreement. But given the fact that the things that they think existed back when the lawsuit was filed, the suitability and all the other procedures have evolved to such a state that we're probably way ahead of what might be inserted into some formal settlement document.

That was certainly my perception on the Stephens lawsuit that was settled in early 2011. I know it had some provisions in it about adjustments to practices on that, and we were already substantially in compliant, if not fully compliant, with whatever that might have put forth in that document.

And I will certainly think that we would have some very similar in this situation as well.

Okay, great. And then as you look forward to repricing the product you said likely over the near term, are you making any changes in the way you price the product to account for higher RBC charges on your investment portfolio?

Not specifically, no.

Okay. And then just last question, as you look at adjusting the pricing and changing the products, are you considering any changes to commission structures or commission rates?

Or do you expect to address the lower investment rates solely through product feature changes?

Everything will be on the table in terms of the evaluation. Immediately, rate adjustments are going to occur.

We'll be thinking about 2013. In late 2011, we -- part of the product or adjustments we made were to reflect the fact that statutory valuation rates were going to be lower in 2012, and that's potentially another consideration for 2013.

So we've got to give serious thought to the overall product design, including all elements, rates, bonuses, commissions for 2013.

The other operating expenses have been about $19 million the last couple of quarters. As we look at 2013, should we think about that same sort of level?

Or are there going to be natural increases in that?

This is John, Mark. I think they could probably increase a little bit, but I wouldn't expect any significant increases in expenses.

Okay. And then, I was on a little bit late, the amortization as we look in Q4 and into next year, what should that trend be like?

Obviously, you had the unlocking this quarter. What level should we anticipate in the current quarter?

Ted's looking through his notes. Ted?

In amortization, as a percentage of gross profit was at 58% without the unlocking.

Would we just assume that 58% level?

I'd have to go look there. I need to look at another sheet that I don't have in here that would do the projected on what the estimated gross profit percentage would be.

I'll have to get back for you later.

Intuitively, it should not be any higher than that. It'd be my guess from years of experience looking at those details.

It's kind of a onetime issue, and then we go back to a more normal trend or the prior trends?

I mean, I think the unlocking for the fact that it's -- the negative impact is likely going to reduce amortization pressure on the next several quarters is my take. Ted's got some information, I know, in our file so he can look at and give you a call back and provide more detail on that, more color.

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.