American Equity Investment Life Holding Co (AEL) 2010 Q3 法說會逐字稿

Good morning, and welcome to American Equity Investment Life Holding Company's conference call to discuss third quarter 2010 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 Waugaman, 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 on 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 Waugaman.

Good morning, and welcome to the call. As we announced last night, we've had a very solid quarter in terms of our operating earnings, which came in at $27.6 million, that's $0.45 per diluted share. That's basically flat, down just 2% year-over-year compared to the same period in 2009. It's down approximately 5% compared to the second quarter of 2010, which was a record quarter of operating earnings. That dip is attributable primarily to the impact of higher cash balances we held during the course of the quarter, and that temporarily depressed our investment income. With the deployment of that money into permanent investments, we expect to see the investment income and yield resume to expected levels. John will discuss that in more detail.

The higher cash balances is one symptom of the very low interest rate environment we're operating in, which continues to be a very significant factor for us in asset management. Our return on equity in terms of operating income was over 14%, again, based on the trailing 12 months, so continues to be very strong.

Our biggest news for the quarter is sales. We had a record quarter of $1.2 billion. We've really seen the pace of sales pick up in the latter half of 2010. For the first six months of the year, we were operating at about a $300 million a month run rate, and that has increased up to $400 million a month, and over that level in the latter half, and Ron will discuss that, of course, in great detail.

As we continue to see strong sales growth, we're very focused on our capital strength and our RBC ratio. At the end of September, that ratio was estimated at 363% of Company actioned level, so very strong, we're very satisfied with the RBC at that level. It is well above our previous target of 300%, and we are strongly considering moving that to 350%. On a pro forma basis, our RBC ratio would remain above 350% at year-end 2010, even with the additional growth we're seeing. And we believe that continuing to manage above 350% is an important step towards improving our ratings, which is a significant management goal.

As we look to book value per share, we're at an all time high of $18.03 including our Accumulated Other Comprehensive Income. Our Other Comprehensive Income is at a higher level than it's been in the past. That is also a reflection of the very low interest rate environment, coupled with the diversification of assets we've seen over the last several years. Those two things have put us in an unrealized gain position in our Available For Sale Securities that's much higher than we've ever seen in the past. Excluding Accumulated Other Comprehensive Income, book value per share is $14.55. We also have a calculation of that, which excludes the impact of FAS133 on book value, and John will discuss that.

Lastly, as you know, we completed a convertible note transaction in the third quarter. The amount of that transaction was $200 million. The purpose was to refinance our fully drawn line of credit, which stood at that time at $150 million. Because of the accounting treatment for the transaction, our adjusted debt to cap ratio went down slightly even though the face amount of the deal exceeded the refinance amount of the line of credit, and we continue to work on putting a new line of credit in place.

That convertible debt transaction is labeled convertible, but actually gets settled in cash, both in terms of the principal amount, stated interest, and the value of conversion except in very limited circumstances. We did use a call spread structure to elevate the effective conversion premium, which is at $16 a share, thus there's no EPS dilution until our stock price exceeds that level, which is a problem that we hope to have. With the completion of that transaction, all the debt that we have coming due in the fourth quarter of 2011 has now been addressed, and moved into longer term capital instruments.

And with that, I'll turn it over to John to discuss the results in greater detail.

Thank you, Wendy. And good morning, everyone. Thanks for joining the call.

We'll go right into some of the financial results, and start with investment spread, which is always the key driver of our profitability for the reporting periods. Spread remained above 3%, or 300 basis points, at 3.09% for the quarter. That's down from the record level of the previous quarter, at 323 basis points, but as I say, still above that 3% threshold. And as you may recall, our target thresholds are down in the 2.75% to 2.90% range. On a year to date basis, the spread was 316 basis points compared to 303 basis points for the same period in 2009.

We have several non-recurring items affecting spread for the quarter, and on a normalized basis, we would have calculated the spread to be about 3.19%. Those non-recurring items are the same items we've been talking about in the previous two quarters. We have the higher cash balances from the strong flow of the premium, as well as the calls of agency bonds, resulting in elevated cash balances in the quarters, and then we have the benefits on the cost of money side from hedging. We've been in over-hedged positions relative to the index block for several quarters now, and that's producing a positive effect on spread results.

Cash balances in the quarter averaged $884 million, that's up from $261 million in the second quarter, and $364 million in the first quarter, and there were higher levels of agency calls during the quarter. The actual cash balance, as we view it in terms of what we would see earmarked for permanent investment, was just under $1 billion at September 30. If you look at our supplement, you add up the combination of short term investments, and then what's shown below for cash balances, you get a number that's above $1 billion, but there's a certain portion of that that is collateral we hold for the derivatives index annuity call options, and then normal operating cash.

And also included in that, we don't consider for the permanent investment at this point is the $60 million to $65 million of cash at the holding company, which is the balance of the proceeds from the recent convertible debt transaction, and the one in fourth quarter of 2009. And those funds are earmarked for the retirement of about $75 million of convertible notes that has a put in 2011, so those notes are still on the balance sheet, but the cash is available to redeem them if we can get that done, or will be there at the time they're put to us.

Going back to the spread side, the cash reflects the high liquidity from the sales of bonds and calls. We've been somewhat cautious in the reinvestment of those funds, looking for the appropriate assets to meet spread targets and credit quality. Cash balances today have been moved down to about $575 million to $600 million from that $1 billion mark, although I should add that we're facing, over the balance of this quarter, close to $1.8 billion in anticipated calls of agency securities. So that means Jeff Lorenzen and his team have got their work cut out for them to get that money reinvested.

In our Q, we'll have some additional disclosures about the anticipated calls, a little broader than what you've seen in some of the previous items. And just to give you a couple of the highlights, calls after this quarter, first quarter of 2011, there's about $1.5 billion that based upon the current rate environment, we would anticipate to be called, and another $745 million in the second quarter, same caveat based upon the current rate environment. So the call activity is likely to continue for several more quarters.

Adjusting for those cash balances, and using the assumption that we would have invested them at the rate that we purchased investments during the quarter, we calculate that our yield on investment assets would have increased about 27 basis points from 598 to 625. Other items affecting yield in the quarter, we did have a fairly sizable amount of make whole income on a private placement. We had slightly higher prepayment income from calls of commercial mortgage loans, and our MVS portfolio, the income from paydowns was elevated by about $1 million there. So, round numbers, we had $2.5 billion of what we would view as not necessarily recurring income in the quarter. That elevated investment yield and spread by approximately 6 basis points.

Flipping over to the cost of money, it continues to come down. It was 2.89% in the quarter compared to 3.25% for the third quarter of 2009. Option costs remain low. We're also now realizing the benefit of adjustments to new money rates that were implemented in July, although that's on a much smaller piece than the overall block of business, and it really would not have had much impact on third quarter 2010, but it will start filtering in over the next several quarters.

Our hedging benefit for the quarter was $4.4 million. That compares to about $4.8 million in the second quarter, and $5.2 million in the first quarter, and that would correlate out to about 11 basis points on the cost of money calculation. So, adding the 11 back, we would have been at about 3% cost of money for the quarter, excluding the benefit of hedging. We still -- looks like for this quarter there's going to be some over-hedging benefit again, although my expectation is it may not be quite as great as we've had in the last several quarters.

Net investment income for the quarter, $260 million, up 8% year-over-year. That's a combination of the yields on invested assets that we were discussing, as well as the growth in total invested assets, which are now $18.5 billion, that would be a 15% year-over-year increase. First of all, turning to calls. The calls for the quarter, $1.8 billion, the average yield on those was 6.06%. We put out $2.3 billion of investments into fixed income securities. The average yield there was 5.39%, and we funded $66 million of new commercial mortgage loans with an average yield of 6.42%.

Our ability to manage our spreads has really not been impacted by these declining yields. As we've talked about frequently in the past, we can reset rates on the anniversaries, and still have a cushion against the base rates and minimum guarantees on fund values. To that end, we've modified some disclosures in the supplement that talk about the relationship of rates to ultimate minimum guarantees, if you care to go look at that detail.

And as I said earlier, we've reduced new money rates in July, but we have not made any renewal rate adjustments for the last seven quarters. And at the present time, we don't contemplate any, but we obviously have the capacity to do so should the ultimate outcome of the calls and reinvestments result in lower rates that precipitate cost of money adjustments to maintain spreads at desired levels.

Moving off spread, another item for the quarter, DAC and deferred sales inducement amortization. We did have our first unlocking since the fourth quarter of 2008. The unlocking this quarter increased amortization by about $1.7 million, which on an after tax basis would be $0.02 a share. There were several principal items that were part of that unlocking. No one you can necessarily point to individually. We did true-up our account values or balances, which is customary to do that when you do an unlocking. The actual balances had exceeded the model balances because of the strong index credits that have been being added to policy holder accounts for the last several quarters.

We also made adjustments to our lapse rates. We talked, not so much on this call, but in some of our presentations in the past, and it's in the investor presentation or financial overview that's on our website each quarter, that we have consistently experienced, or had better lapse experience, surrender experience, than what our pricing indicates. So there were adjustments into the DAC models to bring those -- bring the model more in line with what experience is. We also had some incorporation of profitability assumptions on our lifetime income benefit rider to more accurately reflect the expectations there.

We also had, on the positive side, a correction of an immaterial error on our single premium annuity accounting for primarily DAC and something called a deferred profit liability. That added about $0.01 a share to the income and operating income for the quarter, so the net impact of DAC unlocking in these single premium annuities would have been a reduction of $0.01 a share in the operating income.

On a recoverability basis, DAC and sales inducements are definitely recoverable. We approach that from two ways. The fundamental accounting way is to project out your gross profits from your business, discount them at present values, and compare that to your DAC balances, and that analysis always yields a very highly result as you would expect. We have very strong spreads that will support the recoverability of DAC.

We also do each quarter a liquidation type analysis. We apply our surrender charges to the account balances to figure out if everybody surrendered on a hypothetical basis today, how much income would that produce in surrender charge, and then compare that to the DAC balance. And that ratio is now 105% coverage, so a 5% cushion. And that ratio is certainly benefiting from the adjustment we made to commission payments a year ago, where the initial commission that was formerly paid is now paid in three installments, 75% at the time of sale, and then 12.5% on the first and second anniversary.

Expenses for the quarter were basically level at $16.2 million, compared to $16.7 million last quarter. Legal expenses remain at elevated levels due to, that we were preparing in the quarter for a trial of one of the lawsuits that's been described in the 10-Q's and 10-K's now for numerous quarters. And the 10-Q that's being filed today will disclose that the trial in the Stevens case, which is northern California, started last week, and now will be ongoing unless we can reach settlement or come up with some other resolution prior to a full trial.

Realized gains and losses in the quarter, we had net realized gains of $11.3 million, $22 million on a year to date basis. We are generating gains this year, primarily for tax planning purposes. As everyone knows, we've had recognized other than temporary impairments going back to 2008, and on a declining basis coming forward. Some of those impairments are actual economic losses, for instance, the Perpetual Preferred Stocks of the Government Agencies.

For tax purposes, we've been converting the Other Than Temporary Impairments into realized tax losses, selling the securities, and at the same time, selling securities that we have gains in to be in a tax neutral position. We need to do that because, for tax purposes, you can only deduct capital losses on securities against capital gains, so we have to have the right character of income to achieve tax efficiency.

So most of those gains are coming from corporate bonds and preferred stocks. In the realized gain line, also happens to be, though, where the adjustments or any impairments or loan loss allowances for commercial mortgages are included. They're not part of the impairments number that follows after that.

During the quarter, we increased our general loan loss allowance at commercial mortgages from $1.1 million, which is the amount that was created in the second quarter of 2010, up to $1.7 million, so a $600,000 increase. And we also had some additional specific losses on three properties that added $1 million to the loan loss allowance during the quarter.

Our impairments in the quarter were $4 million, $8 million year-to-date. $1.8 million of the $4 million is in RMBS securities where we've already taken, as a group of securities, significant impairments, and these would represent refinements I think of some of the earlier analysis of those securities as additional data becomes available and forecasts of the performances of securities are revised. We also had impairments on $2.2 million of corporate bonds. That relates to two securities, which following the completion of the quarter, those companies had earnings announcements, and it was the judgment of our analysts that following those announcements and their assessment of the ongoing prospects of those companies that we should be selling those securities.

So, our intent changed from a hold until recovery, to a planned sale in the fourth quarter, and those securities, I believe, have actually been sold now. So, the impairment was taken of $2.2 million for the declines in value that existed at September 30, and the securities will be sold in the fourth quarter.

Commercial mortgage loan status, we have now, with the events of the quarter, total real estate owned, we have nine properties for $19.3 million. We have another 20 loans that are in what we call work-out or temporary modification. Those are the loans we've described in the 10-Q as being where we've made, for the most part, temporary payment adjustments allowing for an interest-only payment for a short period of time.

And then we have three loans in foreclosure, with an aggregate principle balance of $10.7 million. We've already set aside $6.4 million of loan loss allowance for those properties, so the conversion from foreclosure to REO should not have any significant further impact in terms of loss recognition.

Our watch list of securities that was published in the supplement is down to three securities with an unrealized loss of $2.1 million. Turning to a couple of accounting items, to summarize my remarks, Wendy commented about our convertible debt issuance in the quarter, $200 million of new convertible notes. The accounting treatment for those -- those instruments are similar to the instruments that we had in place, issued in 2004 and 2009, with some slight differences that are very key to the accounting treatment.

The earlier issues under applicable accounting rules, we have to bifurcate the equity and debt components of those securities, and in the earlier issues, the planned settlement of the conversion option is through net shares. Therefore, that bifurcation results in a discount to the notes, and an increase in equity. And then we have EPS dilution under the treasury stock method, when the stock price exceeds the conversion price, and that is now happening in 2010 for the issue that was done in the fourth quarter of 2009. The conversion price there is $9.69, so we're now having dilution on that issue, and in the 10-Q you'll see in the EPS footnote table, footnote 10, you'll see a quantification of some 729,000 shares at that dilution.

On the new issue, the conversion option, Wendy commented about the convertible note hedge. The conversion option is going to be settled in cash. And one of the aspects of the note hedge is that we've purchased a call option that will provide us with the cash to pay the incremental conversion value above principal. Because of that cash conversion, or cash payment for the conversion, the bifurcation of that instrument results in liability treatment as opposed to equity treatment.

Similarly, the purchase call option is considered an asset mark to market through the income statement each quarter. The mark to market on the purchase call option, and the conversion option in the instruments offset each other, so there is no income statement impact from those because they are going to pay off in same amounts of cash. And then similarly, there's no EPS dilution then because cash settlement means there won't be any incremental shares issued.

The other side of the note hedge was the warrant. The warrant is given equity treatment for purposes of accounting, so it was recorded as an increase to additional paid in capital. The changes in value of that warrant do not affect the balance sheet or the income statement in any way. All we really have there then is the potential dilution, which, as Wendy said, we would love to experience, from an increase in the stock price to something above the $16 per share strike price that's set on that warrant.

And then relative to debt to capital ratios, the ratios as we reported in the supplement are down slightly from year-end, even though we've had this sizable debt issue, and that's principally because, under the applicable accounting, the conversion option is discounted. That was a $37 million number, so the accounting value for debt only increased by $163 million from the issuance of these notes. We redeemed $150 million of notes, so we only had a small net increase in the debt balance of $13 million. And of course, now we have, in the third quarter, incremental equity from the issuance of the warrants, as well as our net income.

The book value per share numbers, one of the things that we've been seeing in the last several quarters is we've consistently had net income lower than our operating income due to the impacts of FAS133 on the index annuity business. The same factors that are causing unrealized gains in the bond portfolio, i.e., the decline in interest rates, is having a negative effect on the embedded derivative liability. So it's our estimate that if we remove the FAS133 noise from the book value calculation, which ultimately will happen over time as the policies reach maturity and that. Book value per share has been penalized by $1.53 on a cumulative basis from the impact of FAS133. So, when we look at our $14.55 book value, excluding Other Comprehensive Income, we're really looking at a number that's about [$16.08] on the basis of the operating income we report.

Then lastly, before I turn it over to Ron, on a statutory basis, our statutory net income has been very strong. We're at $170 million for the nine months, end of September 30. That's up slightly, or about $25 million from the June 30 number. The third quarter was at a slower pace from the earlier quarters, as a result of a higher effective tax rate.

That tax rate is coming from an accounting change method that we filed for that, taxes in the first two quarters were computed on the basis of the method that we had requested. The indications from the IRS is that they're going to approve a change in method, but on a modified basis from what we had requested. It's still going to be beneficial to us, just not as beneficial, and so our tax rate moves up from like 34% for the June 30 year-to-date to 41%, September 30 year-to-date.

Our statutory equity or surplus is $1.36 billion. That together with about $61 million of AVR gives us adjusted capital of $1.4 billion, which for those of you who are trying to find some of the details of RBC, that's one of the components of the RBC capital calculation, the $1.4 billion of adjusted capital. And that's up from $1.239 billion at the end of the year. The high statutory earnings, plus a modest increase in the AVR, are giving us a very large increase, and that's helping the RBC ratio elevate from the 337 level that we had reported at the end of the year.

And I'm a little bit exhausted. With that, Ron, I'll turn it over to you, and let you talk about sales.

Thank you, John. Good morning, everyone. What a quarter it was, in this third quarter. We have several broken records, and a very healthy sales trend to report. First of all, we had our highest record day in the history of the Company, with $45 million through the door in mid-September. We had a record month in September in the history of the Company, with $439 million of paid business, and all this leads, of course, to as Wendy reported, a record quarter for the Company at $1.22 billion, so an unbelievable quarter for American Equity. And that's an increase of 24% over the third quarter of 2009, and an increase of 17% over the second quarter of 2010. So, year-to-date, through three quarters, we're standing at just at $3.114 billion of paid premium for American Equity.

Also, the sales trends are looking very attractive. Our average pending count in July was 3,841 cases. By the end of the quarter, in September, it was 4,577 cases. It averaged in October 4,676 cases, and today, our pending count is just over 4,900 cases. So, very positive signs for what looks to be a strong fourth quarter.

Factors that are influencing our strong sales, no surprises here. The overall market environment, as the market -- stock market seems to be very volatile yet, and CD rates are about as low as they can go, I think, so that as American Equity and fixed annuities view it as a good safe money place. 151A success has certainly helped. There were a lot of people that I think were paralyzed with 151A, not knowing what direction they should go, so with the victory over 151A, that certainly has helped a lot of people refocus on fixed annuities, which perhaps was their core business before 151A.

Another big part of our success is just sticking to some core principles that we instituted 15 years ago, like example product pricing integrity, making sure that we have our pricing mix set for the long term. And meanwhile, some of our competitors today, again, are lowering premium bonuses, and lowering payout factors on their lifetime benefit riders and cutting commissions. So, once again, a little bit of a repeat. Not as big as last year, but we are starting to see some of our competitors do those things, which is driving producers to American Equity.

Another factor is, we're continuing to focus on our key distribution relationships, and our team is on the road all of the time. Our team is led by Kirby Wood, who is Senior Vice President and National Marketing Director. With Kirby and his six regional guys and myself, plus we have a few others that are on the road on a regular basis. We're out visiting agencies, special events, and a lot of personal producer one on one visits. So, sometimes there's just no substitution for good old-fashioned hard work, and that certainly has been a factor of our increasing sales, as well.

And also having the best service in the business doesn't hurt either, and what it really boils down to, it's really not rocket science. It's things like answering the phones, and issuing policies accurately and on time, and sending out supplies accurately and on time. It's the things that we've talked about for years and years and years that have really helped us and come home to roost now, when some other companies are struggling. The producers are really seeing the real value of American Equity through relationships and service and our pricing integrity.

I'm very proud of our home office staff. They work very, very hard to ensure our success with the great levels of service that we have. And we have a very proud team here, and I'm certainly proud of all of them, as well.

Our Gold Eagle count, if you count those that have actually qualified, and those that are on time to qualify, we're at about 951, so we're coming real close to our goal of 1,000. I think that's a goal that we will make and exceed. Just to refresh your memory, the Gold Eagle agents are our best producers. Those are agents that write at least $1 million in paid premium for the calendar year. Last year, for 2009, we had 891 Gold Eagle agents for the year. We're well ahead of that pace, and have 1,000 in our sights.

We just also completed our agent's convention and Chairman's Club. We had over 500 very enthused people in San Diego in the last couple of weeks. We had a wonderful time, and sent the producers back home, reenergized and relaxed and focused on American Equity. It was a very successful trip.

Our Chairman's Club, which is our top 10 producing agents, we had that trip as well. Last year, to be in our top 10 producing agents, the number 10 producer had just south of $8 million for the qualification period. This year for the Chairman's Club, the number 10 agent had just north of $12 million. So, the competition in that area has increased quite a bit, too, as have our sales at the Company.

Finally, we continue to have huge success with our policy holder appreciation events. These have really been unique events where we go to various cities across the country, and we give them a little bit of history on American Equity. Give them some assurances that the Company is rock solid financially. We give them a brief overview, not the kind of stuff that would make their eyes glaze over, but just a sense that American Equity is strong financially, and we also take the time to just reaffirm the valuable benefits of fixed annuities. And it's truly the basics, the ABC's, one, two, threes, talking about tax deferral, and avoidance of probate, and guaranteed income, and these types of things.

And I have to tell you that 10 times out of 10, every one of them is the same. We have these people come up to us, and tell us how much they appreciate us coming to their city, and they tell us how they know they are going to sleep a little bit better tonight, and we hear those sound bites that reconfirm the reason that we're doing them in the first place. And that is, people say, we didn't really know much about your company, it was sure nice to hear more about you and how solid you are. Or, my fixed annuity really is doing a great job for me, and it reconfirms their purchase of a fixed annuity.

They've just been great, great events. So far, we've been in 11 cities. We've had 2,130 policy holders attend these events. We've had 140 Gold Eagle producers attend these events, and it really, really is quite the festive atmosphere, and it's good for everybody involved.

As a matter of fact, we're leaving today to go to Arizona where we'll have two events. And we're expecting to see 600 policy holders at two separate events in Arizona later this week, so it's highly unlikely that any of our competitors will go down this road. And if they do, I'm certain that the CEO, the President and the Executive Chairman will be there in person to deliver this message. So, we're very high on these programs, and we'll continue to make this a part of our programming and marketing in 2011.

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

Thank you, Ron. Just a couple of brief additional comments. John mentioned our California lawsuit, the Stevens case in northern California. Trial has begun in that case with pretrial motions, opening statements and testimony is expected to begin this week. This is the first phase of that trial, which includes the issue of placement of surrender charges on our policies. Subsequent phases will begin in early 2011. We do feel we have a very strong defense, and are going to litigate vigorously throughout that period. As John commented, that will result in some elevated legal expenses over the next couple of quarters.

In southern California, where we have another case pending, that continues to languish behind suits brought against other carriers, and there's nothing happening on that at the moment.

Finally, with respect to Eagle Life, our new subsidiary, work continues to build out sales for that new subsidiary. It's now licensed in 40 states. We continue to work on building relationships with broker dealers, and we have an important hiring decision to make to get moving on that front.

With that, I will turn it back over to the operator for questions.

Thank you very much.

(Operator Instructions)

One moment. Your first question comes from the line of Paul Sarran of Macquarie Research Equities. Please proceed, sir.

Good morning. Since you just mentioned it, can you just give us a little bit more color on what the hiring decision at Eagle Life is, what position you're looking to fill?

Sure, it would be a national sales director type position.

Okay.

And then the one question I wanted to ask was, recognizing that you don't necessarily have a lot of excess capital and you're growing pretty quickly, have you given any thought to using some re-insurance or co-insurance to manage new business capital strain as you've done before in order to free up capital that you could use for share buybacks, knowing that your stock is trading at a pretty decent discount to book value?

We're certainly cognizant of using tools available to us to make sure that our capital adequacy remains very strong. Right now, we have no plans to utilize any additional tools because we feel that our -- the strength of our earnings from our existing assets is sufficient to support the growth that we're seeing. I have to say it's unlikely in the near future that we would be buying back shares even though they're at a very attractive price, because we believe that we need that capital and want that capital in place to support our growth.

All right. Thanks for the answer.

And your next question comes from the line of Randy Binner of FBR Capital Markets. Please proceed.

Following up on Paul there, the assumption would be that it's really the A rating from AM Best that would be the goal, so I'd be curious to get color on why you would think you need that? You've been very successful with the A minus rating, but a lot of your competitors are A rated. Is it to keep up with Aviva and Allianz? Is it that larger carriers might offer these products post 151A? What is it that makes you want to strive for that A now?

Actually, Randy, we would also be focused on S&P and Fitch, which carry ratings on us, and their financial strength ratings on us are at the BBB plus level. One goal would be to get those ratings up to an A level, whether it's A dash or something higher. We think that that would improve the perception of the strength of the Company in the market and elsewhere, and that's the primary reason it is a goal.

The A minus is serving us just fine with AM Best in terms of our competitive position in connection with Allianz and Aviva, so, while an A would be nice and could be helpful incrementally, we're pretty satisfied with the A dash from AM Best.

And the timing on AM Best? That's annually near the end of the year?

We've already had our management meeting with S&P and they've issued their report; and they've come out with a positive outlook on the rating. We recently had our management meeting with AM Best, and so some time before the end of the year, they will make their rating decision.

All right. Thank you.

And Randy, I would comment as to AM Best that we certainly think we deserve a higher level of rating than our A dash excellent, based upon the financial characteristics of the Company.

All right. Thank you.

Your next question comes from the line of Steven Schwartz of Raymond James & Associates. Please proceed.

Good morning, everybody. I'm sure AM Best appreciated those comments.

It's no secret, I think, our expectations.

I have a few, if I may?

The first question I'd like to touch upon is actually, if we can go to the supplement just so I understand what's going on with some of the disclosure now on page nine where you have the credited rate versus the ultimate minimum guaranteed rate. John, basically, what this table is saying here is that you've got about -- I don't know, call it $2.6 million at a 0.5% differential or less and then everything else is plenty of room to lower. Is that the right way to say that?

Yes, that is the right way to say that and the change is down at the bottom in those three lines. The product structure on the index business and now one of the current generation of traditional fixed products -- prior to 2007, we had one minimum guaranteed rate that also then served as the minimum rate we could use for the fixed rate strategy.

The current design of products, we have the ultimate minimum guaranteed rate that is applied to something less than 100% of premium, and then with the fixed rate strategy we always have a 1% rate that we can drop the fixed rate strategy to. So, we have more flexibility on that business to lower fixed rates. Now there's a financial calculation that would say that you realistically can't go down to 1% and stay there for a long period of time without having the ultimate minimum guarantee rate be -- come into play. It was an attempt to take that book of the business and show that we've still got 96 basis points on the $1.3 billion and 73 basis points before we get down to that ultimate minimum guarantee on that business.

Okay.

And then follow me here, if you would? Just taking the numbers of cash or potential cash coming in from agency calls, that was approximately about 25% of your assets, somewhere around there. Assuming you were fully invested this quarter, you'd be around $617 million. Assuming all that money is called, you invested at $539 million.

Obviously, it doesn't include anything you might get for commercial mortgages. The portfolio would be around something like $595 million to $600 million. Is there a process in place already or announced rates such that the cost of money is going to come down to make up that difference?

I'm not sure, one, I agree with your math. The numbers we were running a while back -- we haven't run one currently -- would have shown yields staying above 6% from reinvestment. But I certainly would look into that and will --

Again, I'm not including commercial mortgages so that could be the difference.

It was just reinvesting them all at -- what rate are you assuming the call bond? That might be the difference. What rate are you assuming that the bonds that are being called away are earning?

Right. Yes. I was assuming 6.17%. I didn't realize they were 6.06%

For instance, the calls for this quarter, there's a number at 5.50%. Those are coupon paying securities. There's some zeros at 5.70%. 5.86%. 5.62%.

So even better, in a sense?

Yes.

Okay.

But the rates have been announced as such to be able to make up where ever that goes down to? The new money rates or whatever you're going to be crediting?

If all those calls happen, it's very likely we would lower new money rates again.

Okay. You'd have to lower them again, okay, which we know you have room for.

And then, if I may, one other? Something completely different.

The NAIC Model Act, the suitability act, was passed in Iowa. There has been some trade press, if you will, comments about the compliance needs upon the IMOs in terms of training and in fact training on specific products, something that the BDs and banks already do, but maybe the IMOs don't. Can you discuss that and what may that -- what that might mean in terms of costs and things like that?

Sure.

There were actually two differences in the new suitability model compared to the old one. One was the need for a secondary review of every single sale at the home office, and that review can't occur at the IMO level, which the prior act authorized. There is no additional cost to American Equity from that because we already do secondary reviews of every single case for suitability and have done that for a number of years now.

In term of the training piece, a number of states have gradually been adopting heightened training requirements and so now rolling out a training program on a national basis is something that we already have available. It just hasn't been required in all states, and so the additional cost from that for American Equity will be very minimal.

Okay, thank you.

And you have a follow-up question from the line of Randy Binner of FBR Capital Markets. Please proceed.

Great, thanks.

I just wanted to touch on the Stevens case a little bit more if we could. Is there anyway for you to quantify how much higher that quarterly run rate legal costs might be?

It's very difficult to try to quantify that, Randy. Legal costs have been elevated for the last couple of quarters as we've been working towards trial preparation and having ongoing discovery. I don't know that they'll be elevated significantly above those levels because that was intensive work on the part of our legal teams, but it could be somewhat higher, and it would be just impossible for me to speculate where that number is going to go.

Okay. Then I'll follow up with one that's probably going to be more difficult.

You're taking this case to trial, if I understand the comments correctly. In that analysis of bringing it to trial, is there any quantification of what the potential downside is if the jury goes against you?

It's -- one of the aspects of this case is that -- and I guess first of all, let me correct that last statement. This first part of the trial is not being tried to a jury. It will be decided by the judge.

If there should be an adverse ruling on liability. One of the problems in the case is measurement of damages, because in most cases with our policy holders in California and elsewhere, their annuities have performed very well and it's hard to show that they've suffered any damage as a result of the claims that are there, so that will be a hotly disputed issue as is the issue of liability.

All right. I'll leave it at that. Thank you very much.

And your next question comes from the line of Mark Hughes of SunTrust. Please proceed.

Thank you. Good morning.

The sales success in the quarter, how much of that was market share versus growth of the overall market?

And related to that, why have competitors been cutting back in terms of crediting rates and bonuses, that sort of thing?

It's probably too early to know as far as market share. Through the second quarter, it appeared that annuity sales this year were going to be above 2009 by a small margin. We haven't seen any third quarter numbers yet to indicate that the trend is still going up. The feeling however is that sales are -- or the market is increasing overall. Like I said, I can't really say how much we think it is. But with that, we also think that perhaps we are getting a little bit bigger market share in addition to the market being a little bit bigger. Visiting with some of my associates in the field, they tell us that we're doing good as far as market share goes. When we get these third quarter numbers, we'll be a little bit more intelligent on that.

As far as your comments about the competition. I think it goes back to what I mentioned a little bit earlier. We try to put products out that from a pricing standpoint make sense and if you price them for the long term, you shouldn't have to in most cases adjust premiums and commissions. We just always have felt that several of our competitors have, perhaps, been a little bit too aggressive in their pricing. And now that we're in the situation that we're in, they're having to get commissions and bonuses back in line to keep their profits or capital, whichever it might be, in line with their own expectations. Probably the best color I can give you on those two things.

How about the commercial mortgage origination -- a little lower sequentially. Any pattern or just worked out that way this quarter?

This is Jeff Lorenzen, Chief Investment Officer.

Really, what we're seeing is much more activity from other borrowers, or I should say, lenders, in the market which is really starting to bring some of the cap rates and some of the overall yields down in that space. It's been harder for us to put loans on the book that we would feel comfortable with for the long term. They're getting picked through. There's the haves and the have nots in terms of the mortgage market.

We're clearly trying to stay in the real high quality, well-underwritten note market and that has become much more competitive over the last six months. I think we noted that in the second quarter call as well that there are a lot more lenders that are coming into the market, a lot more insurance companies. The banks are becoming much more competitive than they had been in the first half of the year.

Thank you.

There are no more questions in the queue at this time. I would like to turn the call back over to Julie LaFollette for any closing remarks.

Thank you for you interest in American Equity and for participating in today's call. If you have any follow-up questions, please feel free to contact us.

Ladies and gentlemen, this concludes today's conference call. You may now disconnect your lines and have a nice day.