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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Hello, and welcome to the American Equity Investment Life Holding Company's Second Quarter 2019 Conference Call. At this time, for opening remarks and introductions, I will turn the call over to Julie LaFollette, Coordinator of Investor Relations. You may begin.
Thank you. Good morning, and welcome to American Equity Investment Life Holding Company's conference call to discuss second quarter 2019 earnings. Our earnings release and financial supplement can be found on our website at www.american-equity.com. Non-GAAP financial measures discussed on today's call and reconciliations of non-GAAP financial measures to the most comparable GAAP measures can be found in those documents.
Presenting on today's call are John Matovina, Chief Executive Officer; Ted Johnson, Chief Financial Officer; and Ron Grensteiner, President of American Equity Investment Life Insurance Company.
Some of the comments made during this call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act. There are a number of risks and uncertainties that could cause actual results to differ materially from those expressed or implied. Factors that could cause the actual results to differ materially are discussed in detail in our most recent filings with the SEC. An audio replay will be made available on our website shortly after today's call.
It is now my pleasure to introduce John Matovina.
Thank you, Julie. Good morning, everyone, and thank you for joining us this morning. Our second quarter results were again solid, giving us a strong first half of the year. Non-GAAP operating income from the -- for the quarter was $100 million or $1.09 per share, and that's a new record for any quarter that did not include the benefit from assumption revisions. As we typically talk about the 3 key metrics that drive our financial performance are growing our invested assets and policyholder funds under management, generating a high level of operating earnings on net growing asset base through our investment spread and then minimizing impairment losses in our investment portfolio.
So for the second quarter on those measures, we delivered 1.6% sequential growth and 5% trailing 12-month growth in policyholder funds under management. On a trailing 12-months basis, we generated a 16% non-GAAP operating return on average equity, excluding the impact of our actuarial assumption reviews. And our investment impairment losses, net of recoveries and after the effects of deferred acquisition costs and income taxes were just 1/10 of 1% of average equity.
The growth in policyholder funds under management was driven by $1.4 billion of net sales in the quarter, which brings the number to $4.6 billion for the trailing 12 months. Sales are benefiting from new products we introduced last year and the improvements in our competitive position, dating back to the beginning of last year's fourth quarter. And as usual, you'll hear more about the sales environment and competition from Ron a little bit later.
Investment spread in the quarter increased sequentially, reflecting a modest increase in the trendable investment spread as well as a greater benefit from nontrendable investment spread items that affected both investment yield and the cost of money. The cost of option purchases was slightly higher than in the first quarter, but still remained below the weighted average cost of 2018 purchases. And Ted will have more details on investment spread in his remarks.
Our NAIC risk-based capital ratio rebounded during the quarter to 369%, now stands 9 points higher than the year-end level of 360%. During the quarter, we executed several transactions, which Ted will discuss, that increased our statutory capital and surplus and reduced our required capital. The benefits from these actions more than offset the increase in required capital from growth in the statutory balance sheet and the negative impact from lower statutory net income attributable to lower option expiration proceeds and related index credits.
So I'll be back at the end of the call for some closing remarks. And now I'd like to turn the call over to Ted Johnson for additional comments on second quarter financial results.
Thank you, John. As we reported yesterday afternoon, we had non-GAAP operating income of $100 million or $1.09 per share for the second quarter of 2019 compared to non-GAAP operating income of $87 million or $0.95 per share for the second quarter of 2018, an increase of 15%, both on a dollar and per share basis.
Investment spread for the second quarter was 263 basis points, up 5 basis points from the first quarter as a result of a 2-basis-point decline in the cost of money and a 3-basis-point increase in the average yield on invested assets. Trendable spread in the second quarter was 254 basis points compared to 252 basis points in the first quarter of this year.
Average yield on invested assets was 4.51% in the second quarter of 2019 compared to 4.48% in the first quarter of 2019. This increase was attributable to an increase in the benefit from nontrendable investment income items from 2 basis points in the first quarter to 5 basis points in the second quarter of this year. The impact from the decline in short-term yields on the $4.9 billion of floating rate instruments in our investment portfolio negatively affected our average yield by 1 basis point.
The average yield on fixed income securities purchased and commercial mortgage loans funded in the second quarter was 4.42% compared to 4.69% in the first quarter of 2019. During the quarter, we purchased $1.3 billion of fixed income securities, of which $372 million were higher-yielding asset-backed and structured securities. The higher allocation to asset-backed and structured securities in the second quarter tempered the impact from the general decline in interest rates and mild spread tightening in certain asset classes.
The average yield on fixed income securities purchased and commercial mortgage loans funded in July was 3.75%. The July new money yield reflects continued declines in available yields and a lower allocation to asset-backed and structured securities. Our expectation for the remainder of the year is for new money yields to range from 150 basis points to 200 basis points over the 10-year treasury yield.
The average cost of money for annuity liabilities was 188 basis points, down 2 basis points from the first quarter of 2019. The benefit from overhedging of index-linked interest obligations was 4 basis points in the second quarter compared to 2 basis points in the first quarter.
We estimate that the trendable cost of money declined by 2 basis points in the second quarter. Option costs increased slightly in the second quarter as volatility declined, but we're still well below levels paid during most of 2018.
Continuing the trend of the last few quarters, the change in product mix away from bonus products to non-bonus products, increased the cost of money by approximately 2 basis points in the second quarter compared to the first quarter. Non-bonus products, which include American Equity AssetShield and Choice and Select -- and Eagle Select series have a lower requirement compared to bonus products, as a bonus needs to be recouped through a higher investment spread. The decline in the cost of money continues to benefit from the renewal rate reductions we initiated last October on $35 billion of policyholder funds under management. Given the decline in yields available from fixed income securities and other fixed income instruments, we will begin reducing caps on $9.9 billion of monthly point-to-point index strategy policyholder funds under management later this month. We expect this reduction to produce annual savings in the cost of 21 basis points on the $9.9 billion and 4 basis points on our entire in-force when fully implemented over the next 12 to 15 months.
Our most recent renewal rate reduction was determined several weeks ago and does not consider the decrease in investment yields of the last few days. Should the yields available to us remain at current levels or the cost of money rise, we continue to have flexibility to reduce our crediting rates if necessary, and could decrease our cost of money by roughly 58 basis points if we reduce current rates to guaranteed minimums. This is down from 61 basis points at the end of the first quarter.
Operating expenses decreased 4% sequentially in the quarter, the sequential decrease in operating expenses reflected a $2.2 million decrease in miscellaneous items such as legal fees and consulting fees, offset in part by $600,000 in additional risk charges for excess regulatory reserves ceded to an unaffiliated reinsurer as a result of an increase in the excess regulatory reserves ceded. The increase in the reserve credit resulted from the replacement of the previous reinsurance agreement with a new agreement effective April 1, 2019. The impact from increasing the excess regulatory reserves ceded was partially offset by a 12.5% decrease in the risk charge rate.
Our estimated risk-based capital ratio at June 30 is 369% compared to 352% at the end of March and 360% at the end of 2018. The increase in the estimated RBC ratio reflects a $50 million cash contribution from the holding company to American Equity Life. The increase in -- the increase in reserve credit I just mentioned and the sale of certain holdings of lower-rated securities, including PG&E.
As John commented in his opening remarks, our RBC ratio continues to be negatively impacted by lower statutory net income in 2019 attributable to lower option expiration proceeds and lower index credits. Net index credits were just 1% of account value in the first 6 months of 2019 compared to 1.4% in the fourth quarter of last year and 3.6% to 5.4% in each of the first 3 quarters of 2018. Assuming current equity market levels, we expect third quarter option expiration proceeds and index credits to remain soft, but rebound in the fourth quarter. Although low option expiration proceeds and related index credits can affect statutory capital and surplus, and risk-based capital in the short run, over the long run, market movements tend to even out, and we expect the policies to perform in line with pricing expectations.
Now I'll turn the call over to Ron to discuss sales, marketing and competition.
Thank you, Ted. Good morning, everyone. As we reported yesterday, second quarter gross and net sales were $1.5 billion and $1.4 billion, respectively, representing increases of 25% and 33% from second quarter 2018 sales. On a sequential basis, sales increased 21%, both before and after coinsurance.
In addition to the gain in gross sales, the year-over-year increase in net sales reflects a reduction in the coinsurance percentage for Eagle Life's reinsured products from 50% to 20% and increased sales of Eagle Life's fixed index annuities that are not reinsured.
In the independent agents channel, gross sales increased 18% sequentially driven by increases in sales of both accumulation and guaranteed income fixed index annuity products. Combined sales for AssetShield and the Choice series by primary accumulation products for independent agents were 46% of American Equity Life's fixed index annuity sales in the second quarter compared to 41% in the first quarter of 2019. IncomeShield accounted for 40% of sales in the second quarter compared to 39% of sales in the first quarter of 2019, and was the best-selling guaranteed lifetime income product in the independent agent channel in the first quarter.
Our sense is that we increased our market share in the second quarter. We entered the quarter with a very attractive 50% participation rate for the S&P 500 annual point-to-point strategy on AssetShield 10 and guaranteed income generated by the IncomeShield series that matched or exceeded most of the companies in the guaranteed income market space. While the sales environment in the independent agent channel remain competitive for the most part, competitors acted rationally.
We continue to see most competitors bring down crediting rates and guaranteed income through the quarter, although a few have held steady, particularly with regards to income. Reflecting the decline in interest rates since year-end, we took our own actions to lower caps, participation rates and declared rates. As mentioned on our first quarter earnings call, in mid-April, we lowered participation rates and caps on S&P 500 annual point-to-point strategies for accumulation products. Since that call, we've taken actions twice, effective June 19 and today, reducing caps and participation rates for our S&P 500 annual point-to-point strategies as well as our volatility-controlled S&P 500 Dividend Aristocrats Excess Return strategies.
To put these changes into context, the S&P 500 annual point-to-point participation rates on AssetShield 10 or Choice 10 with MVA are now at 40% compared with 54% at the start of the year. Participation rates on the volatility-controlled Dividend Aristocrats Excess Return 1-year and 2-year strategies are now at 105% and 150%, respectively, compared with 120% and 175%, respectively, at the start of the year.
Over the coming months, our marketing team will be emphasizing the 2-year term Dividend Aristocrats Excess Return strategy, as with historical returns even after our latest change, continue to illustrate very well against competing accumulation products featuring hybrid indices.
Also effective today, we reduced payout factors for the lifetime income benefit riders available with our guaranteed income products. The reductions in payout factors will reduce guaranteed income on our best-selling IncomeShield products by roughly 6.5% to 7%. While the reduction in payout factors means we will no longer be as competitive with the highest levels of income available in the marketplace, we will still be competitive with several key competitors. We would not be surprised if competitors make reductions to guaranteed income.
Turning to pending. Pending business at American Equity Life averaged 3,156 applications during the second quarter compared to 3,063 applications in the first quarter and 3,146 applications when we reported first quarter earnings. Pending this morning stands at 2,905 compared to 2,341 a year ago.
Gross sales at Eagle Life increased 39% sequentially and 25% over the second quarter of 2018, reflecting the addition of 1 of the country's 15 largest banks based on assets as a distributor. We are seeing meaningful sales from this relationship, and it was our third largest sales relationship in the first half of the year.
We've also seen a boost from the introduction of a 5 and 7-year surrender charge products, which have become favored in the broker-dealer channel. Eagle Select Focus 5 became the best-selling product at Eagle Life in the month of June. At current run rates, we still see the possibility of 7 accounts producing sales of $50 million or higher in 2019. However, sales trends could change following reductions in participation rates similar to those made at American Equity Life that are effective today. At least one competitor is still offering caps at the 6% level in the broker-dealer channel and a numbers still have caps north of 5% in both banks and broker dealers. Select 8, Eagle Life's best-selling product for the entire second quarter currently offers a cap of 4%.
Crediting rates on multi-year guaranteed annuities are super competitive and may be siphoning off some sales from fixed index annuities as well. We have completed the initial build-out of Eagle Life's employee wholesaler force with the addition of 2 new hires, meeting our goal of 12 for the year. We started the year with 4. Our employee wholesalers are working with those accounts not willing to work with third-party wholesalers and are also assisting our third-party wholesalers. Our employee wholesalers are now working with 6 accounts.
We continue to put significant emphasis on account acquisition and hope to bring on at least 2 new meaningful accounts by year-end. Pending applications today at Eagle Life stand at 285 applications compared to 380 applications when we reported first quarter earnings and 263 a year ago.
And with that, I'll turn the call back over to John for closing remarks.
Thank you, Ted and Ron. We are pleased with our second quarter results, which included record operating income for a non-unlocking quarter and our largest quarter for sales since the third quarter of 2016. We're also pleased with the rebound in our regulatory capital ratio, which benefited from the replacement of the reinsurance agreement, under which we cede redundant regulatory reserves. Although the reductions in investment yields the last few days have added another element of uncertainty to our near-term outlook, we are optimistic that we'll have a strong second half of the year.
In addition to spread management, key initiatives for the remainder of 2019 will be to continue to increase our footprint in the bank and broker-dealer channels and to introduce some new annuity products that would complement our current product lineup.
Our long-term outlook remains favorable due to the growing number of Americans who need attractive fixed index annuity products that offer principal protection with guaranteed lifetime income. According to some recently released statistics from LIMRA, the number of retirees in the U.S. is expected to grow from 50 million today to 72 million in 2035. 1 in 4, 65-year-old man of average health will live to age 93 and 1 in 4 65-year-old women will live to age 96. We believe favorable demographics, product evolution and historical favorable results signal significant market share growth potential for fixed index annuities.
So on behalf of the entire American Equity team, thank you for your time and attention this morning. We'll now turn the call back to the operator for questions.
[Operator Instructions] Our first question comes from the line of Randy Binner with B. Riley.
I just wanted to start off by saying congrats to John on your retirement. And we'll miss working with you.
Thank you. Feeling's mutual.
I wanted to talk a little bit just about the in-force data that Ted gave out. So the cap reduction on, I think, it's $9 billion of business is a blended 4 basis points that you would have expect to improve the cost of money by. So I just want to review if that's correct. And then if you could do another 58 basis points pass that 4 basis points, or if the 4 was in the 58 basis points that would take you down to minimum guarantees.
The -- you're right, it's on the $9 billion or $9.6 billion. Overall, that would reduce the cost of money on the whole in-force by 4 basis points. Now that hasn't been implemented yet. So it's not included in the 58 basis points that you see, it will bring the 58 basis points down. And as we put new business on, that can push it up some, but it's not reflected in the 58 basis points that I quoted.
Okay. And then -- and that is going to be put on, so we can think about that from a modeling perspective, kind of going into 2020? Is that the right cadence in the model?
It's over a 12- to 15-month period. So starting here at the end of August is when we're starting to implement that.
And then I think you touched on a number of kind of market comments in the call, but I'm just trying to ask the question again, or maybe you can dig a little deeper. I mean do -- we have a pretty significant move in the 10-year treasury yield. Obviously, it's very recent. But do you have a sense out there in talking with your wholesalers, talking with agents or as part of industry groups, what other insurance companies are planning to do as far as taking action on their in-force blocks?
This is John, Randy. Quite frankly, I don't know that those conversations ever really take place among the groups you suggested relative to in-force blocks. You might get a little scuttlebutt here or there. There certainly seems to be, obviously, active conversation about new money rates because that's what they're selling today. But we've often said that the whole in-force renewal rate management is not subject to a lot of public discussion. And in fact, one of our messages to distribution is the renewal rate integrity that we do have, even though we've been reducing rates for quite a while, and the fact that our rates are published on our website, where agents can get a look at them. But there's -- it's a long way of saying that there's just not a lot of public discussion about what others do for renewal rate activity.
Our next question comes from the line of Erik Bass with Autonomous Research.
First, I had a question for Ron. Just in general, are you seeing any change in consumer appetite for indexed annuities following the pricing changes that you and others have made? And then related, John mentioned potentially introducing new products, I think, in the second half of the year. Would these be traditional FIAs? Or would you consider adjacent products such as buffered annuities?
Well, first of all, I think the appetite by consumers has been pretty decent up to this point. Now with these most recent changes that we just undertook today and as we continue to see rates slide, that's yet to be determined. But up until this point, our sales are reflective of the consumers' desire to have products like FIA. So as far as new initiatives, we're not interested in buffer annuities at this point. We don't plan to in the near term be in the securities market because they are securities, buffer annuities are. But we have our mind set on perhaps -- and it's too early in the stage to talk specifics, but one area that we don't have on the independent agent channel is indexing income. We're really, really strong on guaranteed income. And we feel like if we come out with the right indexing income rider that maybe we could steal some of that market share from our competitors. So that's it.
Got it. And then, I guess, a question for Ted. I think that assumed index credits to policyholders had the most impact on your LIBR reserve. How much of an input is interest rates to this assumption? And can you talk about how you set the rate assumption?
I mean, certainly, as we go forward and we look at how we set reserves and what are our assumptions. Partly, I guess, what directly or indirectly goes into that model is what are the level of caps and par rates, et cetera, on the in-force block of business. So we do have to take into consideration in de -- decreases in interest rates on what potential renewal rate actions and how that might impact the LIBR reserve.
Got it. So it's more a function of how your pricing changes in kind of the terms on the product. So it's sort of a second derivative of interest rates as opposed to kind of a direct assumption that you make?
Correct.
Our next question comes from the line of Ryan Krueger with KBW.
First, on the renewal rate actions on the -- that you already started to implement on the $35 billion, how much additional benefit do you anticipate from those relative to what you've already achieved?
Well, we started doing those last October. And I think, overall, we felt that, that would take down the overall cost of money on the total in-force by 5 basis points. We're getting towards the end of that, so there's maybe a basis point or 2 left of that.
Okay. And then, I guess, for this quarter, I think 2 things that were pretty, I think, fairly favorable were the DAC amortization rate and lower living benefit reserves over the last couple of quarters. I guess can you discuss to what extent you view those 2 factors as sustainable going forward?
Well, the lower DAC amortization, again, I think that was more driven by the mix of what was rolling off versus what's coming on. You see some of the older business that's rolling off. That's higher acquisition costs, higher K-factor, albeit a higher spread target with that, with a higher K-factor rolling off and the newer business coming on, which is non-premium bonus products, lower acquisition with a lower K-factor that is driving that. When you go to the LIBR reserve, some of that is a function of newer business coming on and the volume of that business coming on and the pattern of the increase in the reserve, albeit the newer business when it comes on, that growth in the SOP reserve is lower in the beginning and there's a bigger differential where the fees are in excess of that growth of reserve and then changes over time. Both of those, once again, those patterns and whether they continue are subject to unlocking. And as typical in the third quarter, we'll look at our assumptions and make decisions on unlocking, which will reset the patterns for both of those as we go forward.
When you talk about LIBR [indiscernible] there's a little bit of seasonality in that, but I think we've seen over year-over-year, that kind of drives what you're seeing to over the past few quarters.
Our next question comes from the line of Dan Bergman with Citi.
I guess, to start, I know you touched on this a little bit earlier, but with all the product and pricing changes over the past few months, I just wanted to see if there's any further sense you give around how competitive your current product features are, maybe post those August changes relative to your competitors? And then how that compares to recent levels of competitiveness, and then if there's any noticeable difference you're seeing between the independent and bank, broker-dealer channels?
Well, with the current changes, we still feel like we're going to be in the hunt. When we look at a couple of key competitors, they've been making changes right along with us. And when we look at different illustrations and what the outcome is of our products compared to theirs, we're actually just as good or even better in a lot of cases. So in the end, it just depends on is the consumer willing to take the rates that we can afford to pay given everybody is kind of in the same boat? And are they going to choose to not do anything and put it under the mattress or buy CD or what, we don't know. But relative to competition on an accumulation basis, I think we're actually pretty good as far as our rates go.
On the income side, I would say that we are probably one of the first companies to make some changes to guaranteed income. We're not going to be at the top, but we're going to be [ decent. ] And we have our eyes on a couple of competitors that we knock heads with on a regular basis, we're right there with them. So that's another important facet there.
In the bank and broker-dealer side, that's a little bit different in that we are one of the only companies that have a participation rate strategy in the banks and broker-dealers. Our participation rate is 40% on our best-selling product, the Select 8, which actually, if you do the back testing performs better than a 6% cap. There aren't any 6% caps out there in the broker-dealer -- or excuse me, in the bank channel anymore. Most of those caps are in the mid- to low 5%. And we don't have any caps that high, our cap on our best-selling product in the bank and broker-dealer channel was 4%. So that's kind of a long-winded way of saying that even after the changes, we're still pretty competitive, but it just depends on how low the consumers are willing to accept -- to continue to buy them.
Got it. That's really, really helpful. And then maybe one, just on the yield, it looks like the core yield ex the nontrendable item has been pretty steady in the mid 4.4% range over the past few quarters. Given that sounds like the new money yield in the second half is likely to be below that range, assuming there's not an uptick in rates. And there's potentially some pressure on the floating rate portfolio. I just wanted to see if you could provide any thoughts around how we should expect the core yield to trend? And how quickly we would expect any pressure from the current rate environment to manifest itself in a lower overall yield?
Well, we don't have any projection on that to specifically answer your question. Obviously, we have new money coming in that will be invested at those lower yields. I'm not sure what the expected asset -- maturities of assets might be that would be another influence. But yes, we're obviously not going to have 10% of the portfolio turnover in the next 6 months, but what the number is, I really couldn't speculate on.
Our next question comes from the line of John Barnidge with Sandler O'Neill.
You had increased surrender activity in the quarter, it was the highest level since 2012, [ on a percent ] of beginning period assets. Is there any color you can provide on this? And maybe what your expectations for surrender activity going forward would be?
We did see a little bit of an uptick in surrender charge. That was when I looked at the detail, we do have a product structure that has a 10-year surrender charge [ wallet, ] albeit it has a bonus vesting that goes longer than that. Some of the products we noticed that was being surrendered was related to that product, but nothing really unusual in respect to surrenders continue to be below what our estimates are. And we expect -- we expected surrenders, when you look back at 2018, I guess, that's -- right now, for the first half of 2019, expected surrenders were 2.4%, and actual was 2.2%. So it's still below our assumptions, but we did see a little bit of an uptick from the prior quarter.
Okay. And then on the internal wholesalers, you've clearly been ramping that up. Can you talk about maybe expected ramp-up time for each wholesaler to get some production and really roughly what you think each wholesaler can contribute in time to volume?
Well, it takes time, of course. And we have a variety of different situations for our employee wholesalers. We have 6 that they're responsible for, 6 accounts that they're responsible for. So there -- and that's a mixture of financial institutions and some independent broker-dealers. The one in particular, independent broker-dealer has representatives across the United States, and that is a little bit more difficult to get ramped up because that's literally one-to-one, hand-to-hand combat, so to speak. And the key, though, will be bringing on additional accounts. We are confident that, hopefully, by the end of the year, we'll be able to talk about 2 additional significant accounts that will go along ways and keeping those employee wholesalers busy. When we do our research, kind of the breakeven point for our employee wholesalers is about $15 million of sales. If they -- if we have an account that they're working on that writes north of $15 million, that's kind of where it becomes more cost-effective for employee wholesaler than it does for a third-party wholesaler.
So we're at 12 because of anticipation of additional accounts and also just to help to cover the accounts in our current footprint. As far as time that it takes, John, that's a good question. I don't have a handle on how long it's going to take for all this to come to fruition. But our heads are down and they're very motivated to make a difference for Eagle Life.
Our next question comes from the line of Alex Scott with Goldman Sachs.
The first question I had was a follow-up on the DAC. I heard you mentioned that, I guess, there was maybe a higher K-factor, higher DAC balances on some of the stuff that was rolling off. When I think about some of that activity and also lower rates, I mean, I think you commented on the LIBR reserve a bit, but would you expect there to be any impact on DAC as we kind of approach the 3Q review? And would that, I guess, result in higher K-factors going forward? When we consider fully baking in some of those new assumptions in the DAC going forward?
So if we go back to third quarter, our last time we did the assumption review, I believe what we were there, we said -- we had put into our assumptions in the DAC model that our spread was pretty much equal to where we currently were at, which was approximately 249, 250 basis points was our reported spread then. And we had that going up over a 5-year period of time to 256 basis points as our ultimate spread number that we are grading up to. We'll have to assess that here. We've had some near-term changes in rates and it -- depending on whether these rates stay at this level or change, but we'll have to take that in consideration as we look at what ultimate spread we believe that we're grading back up to in the DAC model. And if we decide to make that be lower, obviously, that would have a negative DAC unlocking effect.
Got it. Okay. And then in terms of the lifetime income benefit rider. I mean maybe some impact one way or the other with the actuarial review, but would you expect changes similar to what you're just describing? I guess -- but before you're talking about reducing cap rates and how that might impact the LIBR reserve, could that result in needing to accrue more LIBR reserve as a percentage of EGPs out into the future, following the 3Q review? I mean is that something that we should be thinking about?
Well, that could be a possibility if you overall make a change in assumption, what the overall returns are going to be and what the caps and participation rates are going to be, that could have a negative effect on your LIBR reserve and the fact that it could accrue at a higher rate. We're using a variety of stochastic scenarios and coming up with -- what those potential returns and credits could be to those policyholders.
And then just mechanically, can you help me understand why reducing cap rates on some of the policies would impact the LIBR reserve? I guess I'm just not as familiar with how that calculation works.
It's a [ less ] opportunity that, that -- I mean if you reduce the cap rate on an in-force policy, that reduces the opportunity of what the level of the index credit can be to their base policy. So the differential between their benefit base, their income account value and their actual account value could be greater in your projection period going forward. [ It means you ] need to set up more SOP 03-1 reserves.
And so the amount that the benefit base is rolling up is not necessarily the same as the cap rate. Does that like to remain at the original cap rate? Or how does that work?
Sorry, I don't really...
The benefit base rolls up at a constant rate set at policy issue, subject to a change when the policy gets to something we call the reset date, which often might be 10 years from the original issue date and can be extended in earlier policies at the same rate, in current policies at a lower rate. But the question then with caps is, how much of that guaranteed increase is going to be funded with policy returns. And if you reduce the caps, you're going to fund less with policy returns and more is going to come out of the spread.
Our next question comes from the line of John Nadel with UBS.
Just following up and thinking about new money rate. I know the new money rate in the second quarter was really close to your overall portfolio rate. But I'm wondering, given the more recent drop in rates, and obviously, anything can happen from here, but I'm wondering if you can give us a sense on a closer to a real-time basis, what that new money rate looks like relative to the 4.42% that you achieved in the second quarter?
Well, the new money rate adjustments that are going in today were based upon knowledge of a 10-year treasury at 2% and expectations that we were not going to repeat the 4.42%. Obviously, those calls were made several weeks ago, and we had no insight into the recent happenings in rates. So what's happened to yields over the last few days is not in any of our new money pricing at this point in time.
No, I appreciate that. I mean I don't know you could sit in the room every day and respond to rates, right? And now...
But we were contemplating a 2% -- we had 2% 10-year treasuries, and we had expectations that the shift in asset allocations, the higher percentage of the asset-backed and structured securities was not going to persist for the balance of the year. And so we're looking at rates, maybe not necessarily as low as what the July outcome was but lower than 4.42%.
Got you. Understood. And then -- and it's a good segue of thinking about asset-backed. I had a question, the NAIC over the weekend seemed to be moving toward taking a much more serious and significant review of CLOs as we head into -- maybe it's year-end '19, maybe it's going to take them longer, but applying more specific stress testing to those assets as opposed to maybe simply relying on credit ratings in the current formulaic risk charges under RBC. I'm just wondering, how big has the CLO portfolio gotten for you guys at this point? I know it's been part of your strategy over the past year or so. And how confident are you in sort of the underlying true credit quality of those assets and the protections you have under a stressed scenario?
The portfolio -- the CLO portfolio is between 9% and 10%. It's at the higher end of our allocation of what we're going to be long term. We feel very comfortable with the overall performance of the collateral and the evaluation of the collateral. We stress test using stochastic models of multiple scenarios that would even be worse than what we would see in the '07, '08, '09 period. And in those scenarios, our collateral performs with minimal losses. So from an actual loss of capital, we see very low-risk in our portfolio. We look at it from 3 perspectives, we look at it at the manager level, we look at it at the -- well 4 levels: the manager level, the collateral level, the structure of the transaction itself and then the dynamic stochastic stress testing through [ index ] to run multiple stress scenarios to allow us to really be able to assess the performance of the underlying loans in those CLO structures.
I would point out the most recent communication, the NAIC put out was also referencing combo CLOs and relooking at those and re-rating those. We do not have any combo CLOs. So we're not going to have a capital reduction related to that. But certainly, they're looking at CLOs overall. But we don't have any combo ones.
Thanks for that clarification. I know that's been a trouble spot, too. So the last quick one I have is just for you, John. As the Board is under -- has started a search for your successor, and congratulations, are both internal and external candidates being considered? And maybe you could sort of give us a sense for what the 2 or 3 most important characteristics of a successor might be?
Well, the answer is yes, both internal and external, be considered. The -- I don't know that you can boil down to just 2 or 3 characteristics that are going to rise to the top and be the most important.
Okay. Is -- let me -- can I rephrase it then? Is industry -- is direct industry experience critical?
Industry experience is important. I don't know that I would -- it would be identified as critical.
Our next question comes from the line of Marcos Holanda with Raymond James.
Do you guys break out how much of your FIA book is running minimal guarantees?
If you look in our investor supplement, we do break it out in there and some tables that shows you both from a fixed rate and an index or if it's par rate or a cap rate, what's running at minimums versus what is -- has a differential.
Okay. And pivoting to capital and the bump up in RBC this quarter. Does -- could this suggest that maybe 2 or 3 years from here that we could see AEL managing with excess capital? Or this is sort of just idiosyncratic to the quarter?
I think it's really specific to the current environment we're in, as we kind of talked on the call. We can go through periods of time where we have low index credits, below average, and that can have a negative effect on our own organic growth of our capital. Albeit over time it'll even out, but at this period of time, we're seeing a lower growth in our organic capital, and we took actions to solidify that so we can continue with our business plan. Now I don't necessarily think that, that point -- that at some point in time, we would have excess capital in the future, that's really dependent on -- I mean, one, economic factors, but also two, what the level of our production is, of how much new business we put on in the future.
We've always been a company that have utilized our organic capital growth through sales and we continue to believe that we should be able to do that.
Okay. Yes. And then, I guess my final question would be if maybe you guys can perhaps comment, if the SEC standard is having any effect in your business? And also, maybe you guys could spend a minute and talk about annuities and direct-to-consumer and your partnership with Kindur.
This is John. In the SEC best interest, certainly, it's going to apply to registered reps that are selling annuities [ in a listed addition ] to securities products. But we're not aware that there's going to be any restrictions on what they can sell. They're just going to have to comply with the best interest standard as it rolls out. And Ron, you can talk about Kindur.
Yes, from Kindur standpoint, they are continuing to learn how to engage and put on customers. They have -- increasing their presence online. They're getting a lot of people to engage with them and give them private information and such. We haven't received any fixed annuity applications yet, but we are very optimistic for the future. We think that they're a smart group of people that knows what they're doing. And we're still thrilled to be partners with them and know that, they will be a meaningful account into the future.
Our next question comes from the line of Pablo Singzon with JPMorgan.
So I was wondering if you could provide a rule of thumb, seeing you have a sensitivity of your portfolio to short-term interest rates. You called out a 1 point sequential decline in the yield from lower rates. But just given the lag in LIBR resets, you think there could be a residual impact in the second half from lower rates in the first half of 2019?
I think if you continue to see pressure on -- with the Fed wanting to cut short-term rates, we will see some of that give back in that yield over the second half of the year. We can't say if you just take the percent of the portfolio, and you take an adjustment and you can back into kind of a rough number about what that basis point decline would be, but there's going to be some impact from it, I'm sure.
Okay. And then a second question, just a follow-up on the comments about the 2018 assumption review. So on the one hand, rates have declined materially since last year. But then the other -- your actual spreads since the third quarter of last year actually have been above your long-term assumption, which I suppose would create a buffer. You also have discretion in adjusting crediting rates. So I guess the question is, in your past assumption reviews have you accounted for a potential in-force actions? And I presume you're able to offset a decent amount of lower rates from in-force actions when assumptions [ set in ].
Yes. When we do our assumption review, we do take into consideration our ability to adjust rates on in-force. We have to also look at what our practice has been over time on how we adjust rates, but we can take that into consideration, and we always do when we look forward in setting assumptions. And the other side of that, too, is we do take into consideration, into a conservative level, what we believe we always reference core spread, but we also know that there's going to be some level of nontrendable items, either from prepayments or through overhedging that we need to take into consideration, too, but we try to be conservative with our estimates when we do that.
Got it. And then just a last question for Ron. So several large carriers, such as [indiscernible] And Lincoln have been trying to grow in the agency channel by partnering with super IMOs. It seems like these super IMOs, at least based on data from 3 or 4 years ago, account for a decent chunk of industry sales. It seems like these [ types ] have not had a large impact on American Equity sales. Can you confirm if that's the case? And secondly, maybe just provide more commentary on what's going on there, under the hood there?
Well, if you're talking about super IMOs, we have seen some consolidation in the industry level.
Hold on 1 second. When you say Super IMOs, Pablo, are you talking like something like the Nexus group?
Yes. Or Market Synergy.
Okay. So now why don't we partner with -- why don't we sell through those groups? Is that...
Well, we -- from the marketing companies that are part of their groups, we already have contracts with most of them individually. So it doesn't make sense for us to allow them to combine all of their production under one umbrella when we already have contracts with the majority of them. In general, excluding those groups, we have seen some consolidations. There are fewer IMOs today probably than there were 5 years ago, when I look at our distribution of our top marketing companies. When you look at, say 15 to 20 that write a fair amount of business with us. There's probably 5 of them that have either gotten purchased or consolidated with a larger IMO for efficiencies. So the universe has gotten a little bit smaller, but I don't anticipate that it's going to go against us.
Got it. So it seems like the -- these [ industry types ] haven't siphoned off sales from your -- from the distribution relationships you have with the individual IMOs, right? Is this sort of the message?
Yes. They haven't siphoned anything. If they siphon it away, they probably have made arrangements with some other insurance companies that have agreed to do what we haven't to this point. As I said, because we already have contracts with them individually.
Got it. Okay. And then, John, just best of luck with your retirement. It was a pleasure working with you.
Thank you.
[Operator Instructions] Our next question comes from the line of Mark Hughes from SunTrust.
I think you had suggested that you anticipate lower index credits in the third quarter, based presumably on the equity market activity here. Does that necessarily imply that you would see less benefit of overhedging in the quarter as well?
It could. Yes. I think we were mostly referencing the lower index credits in relation to organic growth of regulatory capital that -- in periods of time where we have lower index credits, we see lower statutory income. So you can also -- you could also look at that and say that in -- typically in periods of time of lower index credits, we have lower overhedging results.
But then that's how you've got at least an easier comp in the fourth quarter, I think, was your point as well?
Based upon where equity markets are, we felt that -- and if, albeit, we don't see drastic changes. And obviously, a lot has happened in the last few days and continues to happen. We would expect index credits to rebound in the fourth quarter.
Okay. And John, I hope you are one of the -- 1 in 4 that make it to age 93.
So do I. Provided, I stay in good health. Yes, indeed. Thank you. I'd like to be shooting my age on the golf course, in the 90s, how's that?
I'm showing no further questions at this time. I would now like to turn the call back over to Julie LaFollette for final remarks.
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.
Ladies and gentlemen, that concludes today's call. Thank you for participating. You may now disconnect. Everyone, have a wonderful day.