American Equity Investment Life Holding Co (AEL) 2009 Q1 法說會逐字稿

Welcome to American Equity Investment Life Holding Company's First-Quarter 2009 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.

Good morning, and welcome to American Equity Investment Life Holding Company's Conference Call to discuss first-quarter 2009 earnings. Our earnings release and financial supplement can be found on our website at www.american-equity.com. Presenting on today's call are Wendy Carlson, President and Chief Executive Officer; John Matovina, Chief Financial Officer and Vice Chairman; 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 Wendy Carlson.

Good morning, and welcome to the call. We're very pleased to report excellent results for the first quarter of 2009 with record operating earnings of $23.3 million, which is $0.42 per diluted common share. This represents a 38% increase over the same period last year where operating earnings were $16.9 million, or $0.29, and that all translates into a return on operating -- of operating income on equity of 11.8%, so a very strong quarter in terms of the earnings result.

As an overview, there are several areas I'd like to highlight before we move into the detailed presentations by John and Ron. First of all, the most noteworthy aspect of the quarter is the very strong sales environment we're in presently for fixed annuity products, including both fixed rate and indexed products.

Our annuity sales during the quarter increased 27% to over $652 million, which is -- compares to $514 million a year ago. There are really a number of factors that are flowing into the increase in sales and the strong demand right now. Ron is going to drill down into those, but as a overview, we would attribute it, I suppose, first of all, to equity market volatility, which makes our products and principal protection very, very attractive. We remain very proud of the fact that none of our policyholders have ever lost a dime of account value due to market volatility, and the benefit of that has never been more clear or more valuable than it is in today's environment.

We've also seen rates on competing CD products at relatively low levels that has traditionally been a factor that increases demand for fixed annuity products. And last, but certainly not least, we've seen a lot of pulling back by our competitors or pulling out, resulting in decreased competition, we think, related to their diminished capacity as a result of the financial crisis.

We're feeling very good as a management team that we've appropriately postured American Equity to take advantage of this opportunity, and we're looking forward to an excellent year of sales in '09.

Another important aspect of the quarter was spread management. We saw our aggregate spreads at 297 basis points for the quarter. That reflects both increasing yield on the portfolio, as John will discuss, as well as a decrease in our cost of money. Spread management is the heart of our financial results. It's a key driver of earnings results, and the reason that we've got a record quarter for the first quarter of '09.

Lots of focus by management and others on asset quality and performance, which remains very satisfactory with relatively low levels of OTTI-related write-downs. We've seen a big swing now in the fourth quarter to the first quarter with the rule changes that were implemented by the FASB in the first quarter.

As I'm sure you're aware, we now report only the credit-related portion of declines in market values as a realized loss under the modified OTTI rules. That resulted in a large reclassification of the write-downs that we took in the fourth quarter, such that we recovered 80 -- close to $84 million of value written down into retained earnings with adjustments from the original $95.7 million that were written down, so only a small piece deemed to be credit-related.

That brings me to capital management. At a time where we are growing, and as indicated by sales at a 25% to 30% rate, maintaining capital adequacy is our number one priority, and something we're thinking about, and talking about on literally a daily basis. There are a variety of initiatives underway. We're analyzing a variety of scenarios which could emerge over the next three years. We're going to talk about that more a little bit later in the call, but rest assured that we have capital adequacy squarely in mind, and in our planning for this year, as we take advantage of this sales opportunity.

Last, I'll note that we've got our hearing tomorrow in Washington in the D.C. Circuit Court of Appeals in our industry litigation against the SEC involving Rule 151(a) and the status of our products. That's a very big day, a lot of interest in the hearing and the outcome of that lawsuit. So, we will be very, very interested in how that goes tomorrow, although a decision will take a couple of months after the hearing date before we have a final conclusion.

So with that, I'll turn it over to John for the detailed financial report.

Thank you, Wendy, and good morning to everyone. Welcome to the call. Wendy -- as Wendy remarked, we had a very excellent spread in the quarter at 2.97%, and that was driven by a combination of higher yield on invested assets as well as a lower cost of money. The first quarter yield was 6.3%, up 16 basis points from first quarter a year ago, and up a couple of basis points from where our fourth-quarter yield was at 6.28%.

The higher yields do reflect the fact that we -- for about 15 months now, investment yields available to us have been higher than the historical rates. We have had, over these past 15 months, a significant number of the agency securities called, and the reinvestment of those proceeds have been invested at higher rates than what the portfolio had, and what rates were in existence on the securities that were called.

In the first quarter, there was a $1.1 billion of called securities having a blended yield of about 6%. The new money was reinvested security-wise -- $1.5 billion of securities that was allocated, $245 million back into agencies, $758 million into high-grade corporate, and $516 million into high-grade prime mortgage-backed securities. The average yield on those purchases was 6.79%.

We also funded another $47 million of new commercial mortgages, which -- just a reminder, those are all underwritten directly by American Equity staff. We do not purchase CMBS securities, and those mortgages were funded at a rate of 6.72%. Our emphasis on purchases remains to buy only high credit-quality securities rated in any IC class as 1 or 2, which are going to be the two investment-grade classes.

I'll kind of go into the various aspects of the portfolio. Commercial mortgages at the end of the quarter were $2.35 billion. That's just under 18% of the invested assets, and as a percentage, that's down slightly from where it was at year-end. We haven't been funding new mortgages at the same pace that we have in the past, so we've had a slight net decrease there and we -- as I say, we continue to get attractive rates on what we do fund. And we remain committed to the underwriting practices that we've employed, dating all the way back to 2001 when we first entered the commercial mortgage arena.

We do have -- in terms of potential problems in mortgages, we do have two mortgages in foreclosure. Actually, one is now out of foreclosure and is into real estate owned and we are -- have a very live prospect to sell that property that would result in no loss to us.

There is a second foreclosure that was instituted in the first quarter, a little bit ironic that the property is fully leased. The tenant rents more than cover the mortgagor's obligations to us in terms of principal, interest, and escrow, but for whatever reason, he decided to stop paying his mortgage, and we instituted foreclosure proceedings against him. We do already have an assignment of rents on that, so it -- that one too would be expected to be resolved without any loss to us.

We also have a few mortgages, probably ten or less, where we've made some modifications on a temporary basis where we've allowed the borrowers to be on interest-only for a short period of time with the expectation that -- once that interest-only period ends, that they would revert back to amortization, and we would get right back to the position we expected to be.

For those reasons, and the underwriting criterias that we've talked about in the past, we don't have any loan loss allowance for the mortgages, and don't believe one is necessary, either on an individual basis, or in any kind of aggregate concept that might be looked at.

We've done a lot of analysis of the mortgages, stress testing of the portfolio. One of the stress tests that we ran would have shown that -- at a 3.25% delinquency default rate ratio, at 20% severity of loss, that the pre-tax loss on the portfolio would be at 6.5 basis points, so quite small.

And just to kind of remind you of why this portfolio performed well, and why the risk of loss is relatively remote, it does go back to the underwriting practices. American Equity has never chased the cap rates down in the underwriting process. Our strategy has always been that cap rates at those levels would ultimately revert back to mean levels, and so, during the time period of 2004 to 2007, when rates through the industry came down, we kept our funding rates at the 8.5% to 9% level.

Another key element of our underwriting has always been the fact that we required 25% hard cash equity in front of every loan. And, of course, we've avoided areas of the commercial loan market that would be characterized by more aggressive underwriting criteria. So, all in all, we continue to feel very strong that the commercial mortgage portfolio has been safely underwritten, and that their -- the exposure to loss is minimal.

On the RMBS, all of the securities are performing. We -- the new purchases have all been in prime collateral, pre-2006 vintages, and they were purchased at a discount. The average cost was about 91.6% of principal, so that provides a further measure of protection, should those securities experience any issues.

We have had some ratings migration on our Alt-A and a few of our prime to lower NAIC ratings, and that has resulted in some increased capital requirements. However, all of our securities continue to be AAA -- well, they were AAA at the time of purchase, but a reminder that we are in the senior most tranches of every security that we own. And, as a result of that, our credit loss should be reasonably minimal, and I think that's been borne out by what's happened in the adjustments to OTTI that were booked through the new FSP, the reversal of a significant portion of that $73 million of credit loss on the fourth-quarter RMBS, and a very nominal amount in the first quarter on additional securities that were written down.

The OTTI on the RMBS has not had any impact on our statutory capital at this point in time, because the statutory requirements for impairment assessment are not as stringent as GAAP. The simplest way would be to say that statutory allows for an undiscounted cash flow analysis, and due to the high quality of what we do have, there has been no statutory impairments.

The statutory accounting guidance is -- was scheduled to change, but that has been postponed, and we would anticipate -- we can't predict what the NAIC and regulators would do, but given the trend of statutory accounting rules, we would expect the harmonization of statutory with GAAP over the course of this year, and are not anticipating that there will be any significant statutory exposure on the RMBS.

During the quarter, there are $13.4 million of credit-related impairments. $9.5 million of that is on perpetual preferred stocks where we -- they continue to perform. They continue to pay dividends, but in the evaluation of the OTTI status, we are unable to affirmatively predict recoveries and prices of those securities.

And under the guidance that the SEC has given the FASB and practitioners and accountants, the -- if perpetual preferred securities are rated below investment grade, you're unable to evaluate them like you would a debt security. And when you're forced to go to an equity-type evaluation, it's difficult to overcome an other-than-temporary-impairment conclusion. We did have $2.2 million of impairments on residential mortgage-backed securities in the quarter, and another $1.7 million on corporate securities.

Kind of going back to spread and cost of money, cost of money was 3.33% in the first quarter. That's down 22 basis points from the first quarter of '08, and continued the trend that started in '08 coming out of the significant rate adjustments to policy terms that were made throughout 2007. We continue to have very acceptable cost on both new money and renewal. Even with the market volatility, as measured by the VICS, has continued to be at a very high level, relative to the historical standards that were going back to 2007 and prior.

Going forward, the cost of money is perhaps going to be a little more predictable. We have seen a steady increase over the past several quarters with more policyholder funds allocated to the fixed-rate strategy on new business. That's now up to over 50%, so in a fixed-rate strategy, we don't have the issue of the hedging and whether or not we've got the hedging effectiveness, so there's more predictability.

The fixed rates are at 3.25% to 3.35%, new money at 3.35%, the renewals at 3.25%, and the new money just recently went to 3.35%. On a competitive standpoint, there aren't really any competitive pressures at the moment. There -- or have been in the last number of months on either the new money or renewal money basis, so we have reasonable expectations that the cost of money is going to remain stable and would not anticipate any increases.

The deferred acquisition costs and sales inducements -- we had a very large unlocking adjustment in the fourth quarter, and we're back to normal in the current quarter, although we do have slightly elevated amounts of amortization that's a carry-over from the unlocking impact.

Turning to GAAP net income briefly, the GAAP net income was $26.5 million, so a little bit higher than the operating income this quarter. That included about a $700,000 positive impact from realized gains and losses. What's really helping there is the fact that even after the other-than-temporary impairments are adjusted for DAC, and then taxes, we did have a reduction in the valuation allowance that was put up in the 2008 $3.6 million reduction, so that swung the whole entire net impact to a positive level.

And then, the FAS 133 impact for the quarter was a positive result of $2.5 million. Just a reminder, if you look at comparisons of GAAP net income this quarter to first quarter a year ago, first quarter a year ago was $48.1 million and was significantly higher than normal expectations, or quarterly results, due to the adoption of FAS 157 in that quarter, which had about a $40 million impact on first-quarter '08 net income.

Capitalization remains very high at $1.2 billion, excluding the AOCL. That's a $45 million increase from year-end, which would be the net income as well as the cumulative effect of the adoption of the new -- the standards for other-than-temporary impairments.

We did borrow $25 million under our line of credit. We -- and used that money to make capital infusion into the Life Company, part of the capital management that Wendy was discussing earlier, relative to the sales outlook. There is $50 million remaining under that line of credit that would be available for future capital needs to support growth if necessary.

Our adjusted debt-to-capital ratio was essentially level at just under 30%, and we continue to have plenty of liquidity available in our repurchase agreement lines, if we would need liquidity for any reason at the insurance company. And that remains highly unlikely these days, given the strong cash flows we have from new business.

Kind of shifting back to assets, the watch list of securities did grow from the fourth quarter. The total amortized cost is up about $119 million from $336 million to $455 million, and the unrealized value is up from $104 million to $145 million. That increase is primarily due to some additional RMBS downgrade. We're looking at those securities, or monitoring those securities, to see if further deterioration would result in any credit loss, although if that were to occur, I would anticipate it would be a similar experience to the type of credit loss we had in the first quarter, a relatively small amount relative to the asset base.

And then, we did have about $50 million of additional corporate securities added to the watch list. There is a concentration there of about $34 million in a couple of securities, which are private-placement issuers, registered investment to companies or business development corporations, where they have excellent asset protection, but they've been put on the watch list primarily because the debt is undergoing some discussions in terms of restructuring.

But, by nature of the business activities of those entities, they were required to have assets equal to 200% of their debt, so they had a very strong equity position on the front end. And while they've fallen below that 200% level, they continue to be supported by excellent equity. So, we have those securities on the watch list, but are anticipating the outcomes of those discussions with the issuers will result in enhanced credit positions, and would not expect to suffer any losses on those securities.

And, with that, I'll let Ron tell you a little more about the sales and production.

Thank you, John. Good morning, everyone. It's my pleasure to be on the call this morning. As Wendy indicated, we're very pleased to announce first-quarter sales of $653 million, which is up 27% over the first quarter of 2008, and the first quarter of 2008 was $515 million.

Sales are very strong today, as consumers flock to safe-money products in this economic downturn. They're obviously looking for principal protection, which we can provide for them. They're also looking for guaranteed income products for a very uncertain future. The CD rates are not terrific either these days, as the current safe-money people look to achieve some better yields than they can get at the CDs.

Another reason for strong sales today is that many of our competitors are either pulling back, or they're getting out of the market completely, due to some financial constraints. Their strategies that they employ are reducing commissions to the field force. They're terminating some of the agents. They are discontinuing products. They're increasing some of the fees on some of their annuities, increasing minimum premiums and other items such as that.

Agents, on the other hand, need a place to put their business, and due to American Equity's unique position that we have sales capacity this year, we're able to give those agents a home, and so that's exactly what we're going to do.

Our pending count is at a record -- it hit a record in April, I should say, at just over 5,200 cases. It has moderated today, where it has settled in around 5,000 cases. Prior to 2009, we had never broken the 5,000 barrier, and as a comparison, in January, we were at 1,800 pending cases. And last year, of all of 2008, we never broke 3,000 so a good indicator that the demand for our products is high.

While we certainly are enjoying increased sales and increased production, we are cognizant that we have to keep an eye on suitability issues. The emotions in our business are real high today, as consumers are not real happy with insurance companies that they're reading about in the press, and some of the agents are somewhat disgruntled on what insurance companies are doing to them, as far as terminations and such, so we're cognizant of that. We are watching it, and we've communicated to the field force that we're paying particularly close attention to suitability issues.

One program that we're very excited about is our new commission structure, which will be going into effect on June 1st of this year. Over the years, competition has really been driven by high bonuses and high commissions, which are typically paid all up front, once the policy is issued. We felt the time was right, today, to move towards paying commissions over multiple years. Frankly, this is something that the health insurance and the life insurance-dominated insurance companies have been doing for a long time.

Here, I wanted to give you a little bit of a flavor of what this commission structure would look like. Most of our producers would get 75% of their current commissions upon policy issue, and then, in the thirteenth month, we would pay them one-half of the remaining balance, plus 5% interest. And then, we would pay them the remaining portion of the commission in the twenty-fifth month, plus 15% interest. So, ultimately, by recognizing the time value of money, the producer is going to receive more compensation with this program than under the current program.

From our standpoint, from the company's standpoint, this presents a positive impact on statutory earnings and statutory capital. And, from the marketing standpoint, our message is that this is going to give us a method to be a home for the agents, to be able to take increased sales volume, and we're going to be able to do both of those without jeopardizing the company's financials, or our ratings.

And another message that we're delivering is that, while other companies are pulling back or getting out, we are, in essence, creating that home for them, and we're giving them a commission increase, when you consider that we're paying them interest on the money while we're holding it. And that interest amounts to about a 7.5% effective yield, so, gosh, that's not too shabby when you consider what other alternatives there are.

We understand that this new strategy may drive away some of the weaker agents. We feel that this is a very positive mood for us. It's going to have an added benefit of good persistency because, to receive the additional commission, the policy needs to stay in force, so that's a plus.

But, really, in a nutshell, we think that the time is right for this. It's a good program for American Equity. It's a good program for our agents. And, if it's a good program for us and our agents, it's obviously a good program for our policyholders. This probably needed to be done a long time ago. We think that the competition will follow, and if the competition follows, ultimately, it's going to be very good for the industry, and I think it's a very positive move.

So with that, I'm going to turn it back over to Wendy.

With Ron's very positive report on sales, that brings us back to the question of all the things that we are doing to maintain capital adequacy to support new sales in '09. And really, our focus is to be able to have capacity to increase sales at about a 30% level that would bring us to around $3 billion of new sales, and still maintain an RBC ratio well in excess of 300, preferably in the 330 to 350 range.

To analyze this issue, we've done very extensive modeling. We've become more and more sophisticated over the years, and our modeling effort includes people from many different areas within the company, including our actuarial department and investment department, as well as our financial staff, so a lot of people involved in looking at the various scenarios.

And, as we think about scenarios, we've analyzed a number of different production scenarios of differing levels, as well as modeled the impact of different steps we can take to support our capital.

The first thing that we have focused on is the commission restructuring that Ron just described. Now, that does have a very positive benefit to our statutory earnings and capital by deferring a portion of that commission expense, which is a very significant expense on our statutory financial statements. And we've estimated that, with the program that we'll be implementing, that over the next 3 years on a cumulative basis, we could write approximately $900 million more in new annuities than we could have under the old structure. So, that will be very positive.

John mentioned that we have additional capacity on our line of credit of $50 million. We would anticipate drawing that down in a couple of increments over the course of the year in order to support the sales growth as needed. We do have a very favorable rate of interest on that, and it would not have a meaningful impact on our leverage ratios.

We do have a very, very strong liquidity right now from new sales, and calls of assets in our portfolio, so at the moment, liquidity needs are being more than adequately addressed from those sources. Should we need a backup source of liquidity, we do have repo lines in place at the Life Company that we've utilized extensively over the last number of years, but on which we have a zero balance right now, and there is hundreds of millions of dollars of capacity on our repo lines, should we need some type of temporary liquidity source, although that seems very unlikely at the moment. So, that $50 million from the line of credit is another added benefit to our capital ratio.

Lastly, we are working on the expansion of one of our reinsurance treaties with Hanover. It's a treaty we entered into at the end of '05 that gives us reserve relief on the reserve requirements related to the 10% penalty-free withdrawals in the products. We are required to reserve at a 10% level, but utilization actually runs around 3%, 3.5%. So under that treaty, Hanover provides the reserves for the excess of that 10% that does not get utilized.

Since '05, we've introduced a number of new products that aren't included in that treaty, and so, by amending the treaty to include those products, we estimate that we can get about a $50 million pre-tax statutory benefit that would help support our capital adequacy as well.

Those are not the only things we're working on. Those are the things that have the highest likelihood of being completed, although there are a number of other transactions and ideas on the drawing board.

John mentioned that we've seen a ratings migration in our portfolio of our RMBS securities and, particularly, in the Alt-A component of that, and that is a particular focus of ours. If we were to crunch our RBC ratio number at the end of March in the way that we normally do, which requires an annualization of that three-month period for the entire year, we would, on a temporary basis, see that ratio fall below 300%, which is directly attributable to the increased capital requirements caused by the downgrades in some of these Alt-A securities.

That troubles us greatly, because we think it's not an accurate reflection of the risk of credit loss in our RMBS portfolio. We think that that overstates the risk by a significant margin. As John noted, although securities are performing, there have been no missed payments of dividends and interest. We own the highest tranches of the pools in all cases, and one of the aspects of a ratings downgrade is that it's a blanket adjustment to the whole pool that affects all tranches equally, even if you're in the highest tranche, which would take a much higher level of loss severity to sustain any kind of a loss. And so it, in a disproportionate manner, requires us to put up additional capital to support those securities.

We would also point out that the actual credit loss on our Alt-A RMBS securities has been relatively nominal, approximately $9.5 million of credit-related losses. That -- if you look just to the pool of securities that have experienced write-downs, that represents about 2.2% of that block of $426 million in value. If you look at our whole portfolio of MBS securities, it represents well below 1%, and the actual percentage is 0.35% of total RMBS securities, so that the RBC impact of that ratings migration is something that has our attention.

One of the things that we're focusing on to address that is a Re-Remic-type structure, which is becoming a hot topic in the investment world these days, and that is a way of reinstating the higher level ratings and reducing the capital requirements associated with the securities by creating a new structure that would hold those securities. It involves a number of steps, it involves a number of accounting issues, all of which we are reviewing, but that has the potential to be a very good answer to the RBC impact of those securities.

As John mentioned, we're also looking at -- or watching what the NEIC is doing with respect to the statutory rules, regarding write-downs and how those flow through statutory capital. It's conceivable that the RBC rules may also change because of some of the disparities that I mentioned a minute ago. So there is a lot of moving pieces to our RBC ratio. As we've done our modeling and our scenario testing, the testing would indicate that with the kinds of steps I've been discussing, and particularly those things we know we can get accomplished, that we could, in fact, write $3 billion of business, and maintain an acceptable margin of RBC above our 300% target.

We are also monitoring the capital markets. We want to be ready if opportunities should emerge. We certainly don't have any particular transactions on the drawing board right now. Couldn't answer questions about what specifically we might look at or think about. But we are keeping a close eye on it so that, if the right window opens up, we can walk through it.

Some of you might have noticed that we re-upped our shelf registration last month, and the old shelf that we had up was expiring, and we wanted to make sure that we had a current shelf up. It's a universal shelf that would allow us to do any type of capital transaction, and so we're prepared, if the right opportunity comes along, but it would be very difficult to define this morning what that opportunity looks like.

So, with that, I will turn it back over the Operator for questions.

Thank you. (Operator Instructions) And your first question will come from the line of Randy Binner from FBR. Please proceed.

Hi. Good morning. Thank you.

Hi, Randy.

Hi.

Just a few -- I -- you laid out a lot on RBC, and so, I was hoping maybe we could just go through some of the items and think about how they might affect the RBC equation. With the commission restructuring, did I get that right, Wendy? - that it was about $300 million more a year that it would allow you to write?

Well, it's $900 million over three years.

Yes.

It's not exactly $300 million per year. This year, we will be implementing it June 1, so we get a little lesser benefit this year than we would in later years.

Okay. And so that's -- I guess, it's effectively commission deferral, which generally, that doesn't have a benefit in statutory accounting, I thought, or maybe I'm missing the concept there. Could you provide more color on that?

Well, no, it absolutely does have a very direct statutory benefit, because it basically means your commission expense, all of which is expense for statutory purposes, is reduced in the first year to the actual amount of the cash outlay, and it defers, until those later years, the balance of that commission payment. So, it has the effect of increasing statutory earnings in the year of deferral, which increases your statutory capital and surplus.

Okay. So the cash -- I've got it. The cash actually goes out the door later. Understood.

Is there a way of -- if we think again, back to the RBC equation. So if we have $1.2 billion in the numerator, I mean is that something that helps on the denominator? And I mean, is there a way to kind of handicap it in RBC points?

We have handicapped it in RBC points, but I'm not sure that information would really be meaningful to you on this call. There's a variety of different factors that flow through that, and I think it's probably beyond the scope of our discussion this morning to get into all of that. But, yes, we have handicapped it, and that was the basis for my conclusion, that we could increase sales by around 30% and still stay above 300% RBC.

Okay. And then the repo lines at the life co, that's hundreds of millions of dollars of availability. Two quick questions there. Are there -- is there a rating requirement that that collateral would have to have? And if you were to do that, would that have a negative impact on RBC?

Excuse me. The collateral all has to be -- at least the lines we have now, we use agency securities for the collateral. There is some RBC impact from using the -- from having the securities pledged and actually borrowing any money. But that -- and that number -- those lines have been in our RBC in the past; they were out at year-end because the borrowings were down to zero, Randy.

Okay. So -- but if they're tapped, that has a marginal RBC impact?

Right.

Okay. And just real quick then. On the reinsurance treaty with Hanover, that's a benefit -- I guess that's a benefit that would go -- the $50 million, would I read that as a benefit to the denominator in the RBC equation?

And that's pre-tax, so after tax, it's going to be 65% of that, and that is an estimate.

Okay. This is -- I think this will be helpful for me and some other folks. Can you quantify the ratings? I mean, I guess you said the majority of the move in RBC in the quarter was from the ratings drift. So that answers that.

And, just to reiterate, so the combination of all those things, as you said, Wendy, I mean, it still seems like some combination of those things could support the $3 billion sales target, as everything is currently situated?

Yes. That would be our conclusion.

Okay. Let me drop back in the queue. Thank you very much.

Your next question will come from the line of Steven Schwartz from Raymond James and Associates. Please proceed.

Hey, good morning, everybody.

Hi, Steve.

Hey. What was statutory operating income and statutory net income for the quarter?

We've got the -- we don't have the operating income right here, but we've got the actual statutory--

Yes. Statutory gain from operations was $19.6 million. Statutory net income was $9.1 million. The statutory capital in surplus went up by $20 million, so we had $9 million of net income, we had the $25 million of net income -- or capital contribution, and there were unrealized losses that they're -- most statutory investments are carried at cost. There are a few that are carried at market, preferred stocks, below class three, and bonds in class six. So we did have an $11 million, $12 million unrealized statutory loss that offset the other two items.

Okay. So -- just so I'm clear on this, you started the year at total adjusted capital, I think on a company action level, of about $1 billion, or 0.012. You added $25 million from one of the credit lines, you added $9 million in net earnings, you've got a take-away of $11 million for the unrealized losses. So that leaves you at 1.035. And if you're suggesting that you're below $300 million, we'd have company action level required capital of about $345 million, which would be up from $292 million. Credit migration account for all of that? Or was it growth in reserves?

No, some of it's growth in reserves, but the lion's share is going to be credit migration.

Ah. Okay. All right. That's interesting.

John, could you possibly go over -- you mentioned, if you can go over the numbers again that you threw out vis-a-vis the stress test, and maybe tell us what the assumptions were for that? I'm referring to the commercial real estate?

The assumption was reasonably simple. It was at 3.25% delinquency default rate or default rate.

Okay.

On the total portfolio, and that the pre-tax loss percentage would be 20%.

So does that -- what kind of drop in commercial real estate price does that equate to?

Well, I'll put it -- I don't think he specifically put that into a drop in commercial real estate prices. He gave me another number here. If commercial real estate values were to decrease by 35%, and he's working off of the appraised values at the time the loans were issued, we have about -- at a 65% loan-to-value ratio, we have $600 million that's at loan-to-value ratios of 65% or higher. So the assumption was if every loan we had at a loan-to-value ratio of 65% or more, if we lost everything on top of that 65%, what would be the loss? And that loss is $40 million or 17 basis points.

No, you lost me. Can you try explaining that again?

Take the loan-to-value ratios on all our mortgages; any mortgage that's got a loan-to-value ratio of below 65% has no exposures.

Okay.

That's the first assumption. The second assumption would be any exposure above 65% is a total loss. That total loss would be $40 million.

Okay. Alright.

So that's a 35% decline in values.

Okay. And then, just one for Ron. Ron, you were touting in the press release a brand new product. Well, first, the new commission structure. That's on all products? Or is that just on the new product?

That commission structure is on all the products, with the exception of a multi-year guarantee product that we have and some of the products that have lower commissions already.

Okay. Can you give us a quick rundown on the new product?

Well, the new product is called Retirement Gold. It is a fixed indexed annuity. It's a product that has all the traditional strategies that we've always had.

It -- one of the attractions of it is it does have a bonus, a premium bonus, of 12% and it's a little bit different than our other products in that the bonus is vested for surrender charge purposes over a 14-year period, but the bonus is part of the contract value and it's part of the death benefit and it's part of the withdrawal value and all those other types of things. It's a product that we felt we needed to compete with some of the other companies that are putting out high bonus, short surrender charge products, and this is basically our answer to it, where we could come out with a high bonus, but vest that bonus out over 14 years.

Okay. Thank you.

And I want to add one comment to Ron's about that product. It does have higher spread requirements, so it's been priced that way too. Our rate on that is not quite as good as the rate we have on the Bonus Gold product, which has been our best seller for a number of years now.

Thank you.

Your next question will come from the line of Bill Devlin from Titan Capital Management.

Thank you. We had a couple of questions.

First of all, relative to the watch list, we heard some of the details, but didn't catch, from a big picture perspective, we recognized that the watch list doubled back in the third quarter. But would you please tell us kind of, proportionally, what happened in the fourth quarter, and then, what happened in total during the first quarter?

Bill, I'm not sure I'm that -- remembering what happened from third to fourth specifically. There would have been the addition of the RMBS going from the third to the fourth, but I don't have the third quarter -- all quarters here in front of me to probably give that question the proper answer.

In going from the fourth to the first, though, the increase would have been some additional RMBS securities, which were further ratings downgrades happening in the RMBS, and that's about $70 million. And then several corporate securities, the most significant of which would have been these two private placement issuers that are the business development company, registered investment companies, where they've fallen below their requirement to maintain assets of 200% of debt. And part of the reason they've fallen below that level, I believe, is -- they've reported, is the impact of accounting standard, FAS 157, that deals with market values on investments. And a lot of the investments in these entities are going to be private-type investments, so the pricing of them would have been an issue for them.

So they fell below the standard of 200% debt coverage, which would have triggered perhaps a technical default on some of their debt, and so, they're on the watch list for just monitoring the resolution of the outcomes, but they continue to have a fairly substantial equity underpinning because of that requirement on the 200% assets-to-debt require-- ratio.

Okay. And I'm sorry, I didn't ask my question very clearly. Since we don't know the base of where the watch list started, what was the percentage increase or percentage change in the watch list in the first quarter, relative to the fourth quarter?

The -- we went from four -- we went from $336 million of amortized costs to $455 million. So that's a 30% increase.

Okay. That is helpful. And then, in your 10-K, you make reference to the number or percentage of your portfolio that is callable, not only in the first quarter, but over the course of 2009. And from what you're saying, is this actually working to your advantage, right now, to have these securities called? Or are we understanding that correctly?

It's got positives and negatives, I guess. We've long enjoyed the credit rating on those agency securities and the excellent yields they've provided as a stable base in the portfolio.

So we don't necessarily want to see them go, because the reinvestment then happens to be into higher yields, but those higher yields come with higher capital requirements and they've been reinvested into single-A and BBB bonds, or AAA mortgage-backed securities. In hindsight, part of that reinvestment was into some of the mortgage-backed securities that have now been downgraded.

The -- it is very true that we're picking up yield and our spread is widening, but there's a counterbalancing impact from the higher capital requirements.

That's a very good point. That makes sense.

And then one final question, would you please discuss what it is relative to the Wells notice that the SEC actually wants to see you do?

Well this, Bill, as we understand it, and let me start by saying that we got this notice on Monday. Honestly, it came as a shock. It was not something that was expected, and we're just trying to get our arms around it, and there's not a whole lot to say beyond what's been in our 8-K and our press release. As we understand it, the focus is on proxy statements from '04 to '06 and disclosures around American Equity Investment Service Company.

So, on a go-forward basis, I don't know that there's anything that they're looking to change. I think it's a looking back at that period, and the disclosures in that period.

Thank you both.

Your next question will come from the line of Jonathan Shafter from Boston Provident.

Hi. A few questions.

The first is, I believe, going through the statements, you have reinsurance exposure to EquiTrust, which has received downgradings recently from A.M. Best. And I'm just trying to get a sense of what is the, at this point, the aggregate exposure there, and what happens to statutory capital requirements as a result of the recent downgrade?

Is that incorporated into the risk-based capital numbers you discussed dipping below 300? And do those requirements really pick up if, I think, EquiTrust is still on a negative watch list, if it continues to be downgraded there?

And then second, I well may have missed this, but I did try and go through prior statements, and regarding the Wells notice on the proxy, it's unclear to me what exactly is it that the SEC is -- has issue with that was, they claim, not disclosed? I understand you don't want to talk too much about this, but I'm just trying to get a sense of what the big picture of the issue is here.

Let me address that one first and then I'll turn it over to John to talk about EquiTrust and the co-insurance. And as I said, we really can't speak to specifics at this point other than what has been previously disclosed.

We -- just a little history, we've been an SEC reporting company since 1999. We became a 34 Act reporting company on a voluntary basis four years before we actually went public. And so, we've subjected ourselves to the -- living in the fishbowl of the SEC disclosures for a very long period of time, and we've always worked very hard and believe that those disclosures were complete and accurate.

So, at this point, other than saying that, and saying that we also have a history of fighting things pretty hard when we think that we've been wronged, and that's what we're going to do here. And beyond that, it's premature for us to comment.

Okay. And on EquiTrust?

On EquiTrust, the amount of co-insurance is about $1.5 million on a GAAP-basis; the statutory value would be something less. That number is a separate line in the financial supplement called co-insurance deposits, right below --.

$1.5 million?

$1.5 billion. Excuse me.

Okay. Yes.

Yes.

I thought I had really missed the materiality of the issue here.

All right. The label is co-insurance deposits in the supplement.

The statutory RBC or RBC formulas for reinsurance do not have any recognition of the rating of the reinsuring entity. So it's a flat charge of 0.008 is the percentage that's applied to the statutory reserves that are co-insured. So that -- it is unaffected by whatever has happened or may happen to EquiTrust--

And when A.M. Best is doing its calculations. I believe they do employ some kind of sliding scale, relative to the rating of the reinsurer, don't they? In their risk-based capital?

You're talking about A.M. Best BCAR, and it's been a while since I've been into that specifically. I -- to know for sure whether they do or they don't adjust reinsurance. I would say though that the numbers that we've gotten from A.M. Best through the years on the BCAR have been substantially above the threshold for -- that they've set numerically for our current rating.

The -- they have, I think, it's a 130 BCAR for the A-, a 175 for A++ and we've been up above 250, 260, 270 for the last four or five years. So I -- we -- to the point where our BCAR ratio has not been any kind of discussion point with them because we're comfortably above where the rating's been.

Okay. So you guys aren't concerned about the EquiTrust downgrade? It's just not a material issue?

Not at the moment. No.

Okay. Thank you.

Your next question is a follow-up from the line of Randy Binner with FBR.

Hi. Thanks. So kind of getting away from RBC details, just maybe, Wendy, if you could run through, maybe, any progress or updated thoughts on how you might deal with a scenario where the SEC does decide to make it -- equity indexed annuities a registered product?

Sure.

Just curious what that could look like on the other side, if the SEC decides to move forward.

Sure. A couple of, three, thoughts. One, we've been planning for that scenario. We feel strongly about our position in the litigation, but there's always a risk that that rule will go into effect. We've got two years until January of 2011 to get ready for that.

Lots of activity underway here to prepare for that, including working on a product that we think will be submitted for registration here within the next few weeks, continued expansion of our broker dealer and continuing to work on other aspects of that, including our wholesale distribution channels. So lots of activity on that front.

From a modeling standpoint, in looking at profitability on a go-forward basis, we have modeled the scenario where we continue on as we are now over the next two years, because the rule doesn't take into effect -- doesn't go into effect for two years.

And then, we've modeled a situation, beginning in 2011, where initially, we see sales decline as we build that broker-dealer channel up, and then, pick up steam again in the later years beyond that.

We've also included, in that analysis, some additional expense beginning in year 2010, reflecting the additional expense we think we'll incur, having to be in the broker-dealer channel, if that should emerge. And in that scenario, the company, because we have, now, a good base of assets under management beneath us. As you know we've built the assets up to over $17 billion now in our 14-year history, and so, with a couple more years of growth, that base of assets under management support ongoing profitability, even if we were to see production fall in 2011, as a result of the rule.

So we continue to see good in the modeled results. We would continue to see projected good net income and GAAP net income and statutory net income just at an incrementally lower level than we would see under some of our stronger production scenarios if we remain purely in the fixed rate and fixed indexed annuity markets.

Okay. That was very helpful. I don't suppose you would care to quantify what you think the sales could go to in 2011?

We've tried to model it very conservatively. So we've actually modeled a 50% drop off in sales that year, and then, watch them -- we've projected growth and fairly rapid recovery of that. But we wanted to look at worst case scenario and, even in that kind of a scenario, it would still show that we're quite profitable.

Okay. So down to $1.5 billion. And then, in 2010, any quantitative estimate of how much that might increase the expense line?

We've added a couple of million dollars per year to the expenses, pre-tax, as a rough estimate.

Okay. And you said there was a product potentially going in for registration in two weeks. I mean, would that be the shell, if you will, of a product that would be a registered product?

Oh, yes, that would be the registration statement for a registered product. And --

Okay. So it's the registration statement. Okay. Would the product be different, Wendy?

It's -- in some ways, yes. So we've given an awful lot of thought to what we think will be successful in a broker-dealer channel, and the kind of characteristics the product needs to have, and what registered reps and broker-dealers think is a strong selling point in that channel versus our traditional independent agent channel. And those things are not always the same, and we've wanted to be very prudent about putting together a product that we thought would be successful in that channel.

We thought it would be perhaps superficial to think that we could just take, purely, one of our existing products and register it, and have it be successful in a different channel.

So it preserves what -- the heart of fixed indexed annuity as a guarantee of account value and the opportunity to earn a fixed interest or indexed interest on an annual basis, and so, the heart of the product is still there.

Things like commission structures, and bonus structures, those are all things that we've tinkered with, because we think that the reception is different in the broker-dealer channel than it is in our traditional one.

Would the commission have to be more up front? I mean, what would that difference look like in the commission structure?

Actually, what we think has trailed our more prevalent in the broker-dealer channel and so it's -- we've built in flexibility, but we wanted to be sure we had the flexibility to pay a trail.

Okay. Great. Thank you.

Yes.

Your next question will come from the line of Paul Sarran from FPK.

Thanks. Just first, a quick clarification on the reinsurance. Estimated $50 million impact. Was that a $50 million impact to total adjusted capital, or to the company action level, or something else?

That adjusts -- adjusted capital by -- on a pre-tax basis, so a little more than $30 million on an after-tax basis. There is some offsetting adjustment to the required capital too, but I don't -- that's less significant than what you get from the actual increase to adjusted capital.

Right. Okay.

On the -- when you do your scenario analysis, that shows you that you can do 30% sales growth on the year, what kind of realized losses are you assuming in there and what kind of, I guess, ratings drift from either downgrades or from agency securities being called and reinvested into corporate securities? What kind of impact on RBC are you assuming from ratings shift in the portfolio?

There was no ratings shift included in that number. It's the expectation that the impact from the ratings shift will be dealt with through the Re-Remic type structure.

Okay. Do you think that -- but what kind of impact do you think the Re-Remic structure could have, as far as a positive impact?

Well I'll get -- it could have substantial. It's too early to give you any specific number, Paul, because we don't have any specific transactions in mind. But the things have shown -- that we've seen from a couple of people, it's a dramatic increase in terms of what it does by moving securities out of class five, up -- back into class one.

Okay. But nonetheless, you -- this is the transaction that you think could get done by the end of the year?

Oh, absolutely. Yes.

Okay. And then, just one quick other question -- n the business development companies that are on the watch list, what was the magnitude? As far as amortized costs?

The amortized cost is $34 million or so. Let's see here. $34 million, and the market value is about $20 million.

Okay. And the -- if they trigger a technical default by crossing that 200% equity that -- should that -- how does that compare to the debt that you hold? Is that senior to yours, or subordinated, or is it the same debt? I mean, what happens to your holdings if that happens?

Paul, I'm going to have to call you back on that one. I'm sorry. I just don't know the specific, and I really wouldn't want to speculate without getting the confirmation from our investment people. My perception is that we're not sitting exposed, that we're at the top level or at equal levels with any other debt holders.

Okay. That's helpful.

And I know one of the restructurings, at least that I kind of remember, is that the expected outcome is that we're going to receive a senior interest and a securitized or collateralized interest that we don't already have.

Okay. That makes sense. And I'll follow up on the specifics after the call. That's all the questions I had. Thanks.

That does conclude today's question and answer session. I would now like to turn the call back over to Julie for closing comments.

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.

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a wonderful day.