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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.
Welcome to American Equity Investment Life Holding Company's Second Quarter 2020 Conference Call.
At this time, for opening remarks and introductions, I would like to turn the call over to Julie LaFollette, Coordinator of Investor Relations.
Good morning, and welcome to American Equity Investment Life Holding Company's conference call to discuss second quarter 2020 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 Anant Bhalla, Chief Executive Officer; Ted Johnson, Chief Financial Officer; and Jeff Lorenzen, Chief Investment Officer. During his portion of the call, Jeff Lorenzen will be referring to the financial and business facts overview slide deck available on our Investor Relations website at www.american-equity.com.
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 Anant Bhalla.
Thank you, Julie. Good morning, everyone, and thank you for joining us this morning. While both the human cost of the COVID-19 pandemic and the associated broader macroeconomic environment remain uncertain, American Equity remains focused on its purpose of converting retail client savings into the dignity of a paycheck for life by providing secure retirement income and principal protected accumulation. We do this with general account annuity products that we bring to market through intermediaries across channels with a historically dominant position in the independent agent channel and with superior service at the lowest operating cost structure in our industry. The pandemic-induced uncertainties of 2020 make this a reset year for most industries. At American Equity, we have been focused on protecting our ways of working, starting with our employees and distribution partners and then our balance sheet. I'll cover more on that in a minute. But a strong defense will enable a renewed vigor in playing offense in the marketplace. Therefore, we are also using this time to reboot our business strategy for execution over the coming years.
To play a strong defense in the second quarter, we bolstered our balance sheet by raising an additional $300 million in preferred equity. This provides us a strong capital cushion to weather turbulence from ratings migrations in our investment portfolio. Jeff will touch on this in a bit later, but I want to note that ratings migrations and credit losses were well within the parameters we laid out on our first quarter call, negatively affecting our risk-based capital ratio by 9 points when taken together. The estimated risk-based capital ratio at American Equity Life as of June 30 was 389% compared to 396% on our last earnings call.
While currently held at the holding company, net proceeds from the $300 million raise provide an additional 27 points of available capital cushion, if deemed as necessary in the future. In essence, we have available capital on the balance sheet that would indicate that we are operating at well north of 400% RBC to weather ratings migration and credit losses through a period of extended economic uncertainty. With no debt maturity till 2027, we are operating from a position of strength when it comes to dealing with a multi-quarter or multiyear economic recession from the current pandemic.
Having now been in the CEOC for 5 months, I can share that our strategic vision extends over multiple horizons. The first few years of this strategy are what we are internally calling Horizon 1, during which we will transform into the next chapter of American Equity dubbed as AEL 2.0. In Horizon 1, our single focus is on dominating the retail annuity business through distribution partners in the independent agent and financial institution channels, while building new capabilities that modernize how we do that and how we capture a greater share of the economics in both the distribution and asset management value chain. At the end of the day, we are in the business of raising assets from policyholders at a certain cost of fund, and we invest those to earn spread, net of the cost of risk capital. Therefore, we want to be in the top half of the industry players, or even in the first quartile in some capabilities, when it comes to raising funds and then investing those funds. Our plans over the coming years are focused on execution around these 2 areas while we retool and modernize how we go to market.
Looking at sales for the quarter. Gross sales of $559 million fell 21% compared to the first quarter of 2020, driven by declines in sales at American Equity Life and Eagle Life of 18% and 34%, respectively. Given the limitations that COVID-19 pandemic has placed on face-to-face meeting and the need for social distancing, sales pipelines for us and for our industry has slowed down. In the second quarter, pending average 1,243 apps at American Equity Life and currently stands at 1,060. As part of our accumulation product refresh, in June, we introduced the destinations 9 and 10 Fixed Index Annuity, which includes the Destination Index we co-developed and co-branded with Bank of America. This is a rules-based, multi-asset sector index strategy that combines 3 well-established transparent assets, low volatility S&P 500 Equities, 10-year U.S. treasury bond and gold using 2 time-tested investment principles of risk parity and momentum.
Given our current participation rates for both the 1- and 2-year strategies, destinations 9 and 10 illustrate very well. During the quarter, we moved almost entirely to an employee wholesaler model at Eagle Life for both the bank and broker-dealer channels. While third-party wholesalers were helpful to get us started in the financial institution space, we needed to make this transition to be in charge of our own destiny, drive greater alignment with our wholesaling resources and to scale up in focused accounts for Eagle Life's product line. In part reflecting this transitional period at Eagle Life, pending averaged 93 apps and currently stands at 53. With some new talent hires made and more expected over the coming few months, we expect meaningful sales growth at Eagle Life to start in 2021.
In terms of access to shelf space, we recently added LPL Financial and have been approved at Truist Bank for both the former BB&T and SunTrust distribution Systems. The key for Eagle Life is the disciplined execution of our refreshed product and sales strategy, first, at existing firms and then by signing up more focused firms over time.
Turning to financial results for the second quarter of 2020. We reported non-GAAP operating earnings available to common shareholders of $93 million or $1.01 per share compared to $100 million or $1.09 per share for the second quarter of 2019. Results for the second quarter of 2020 were impacted by lower investment spread and an increase in accretion of the liability for lifetime income benefit guarantees.
Now I would like to turn the call over to Ted for additional comments on second quarter financial results.
Thank you, Anant. We had one discrete item this quarter we recognized at $10 million or $0.07 per share mark-to-market loss on investment partnerships that flowed through investment income and operating earnings per share.
The average yield on invested assets was 4.12% in the second quarter of 2020 compared to 4.36% in the first quarter. The decrease was primarily attributable to a 3 basis point reduction in the benefit from bond prepayment income, a 7 basis point reduction from investment partnership mark-to-market, a 6 basis point decline from the decrease in yield on floating rate investments and a 6 basis point reduction from interest foregone due to the buildup of cash.
The aggregate cost of money for annuity liabilities was 173 basis points, up 1 basis point from the first quarter of 2020. The cost of money in the second quarter was negatively affected by 1 basis point of hedging loss, driven by minimal over-hedging gains and the 2 basis point cost of an index credit macro-hedge compared to 5 basis points of gains from the over-hedging of index-linked credit in the first quarter. Excluding hedging losses and gains, the decline in the adjusted cost of money reflects a year-over-year decrease in option costs due to our active renewal rate management. Investment spread for the second quarter was 239 basis points. Trendable spread, which we define as excluding the impact of additional prepayment income, the effect of hedging gains and losses and other nontrendable investment income items was 245 basis points in the second quarter compared to 253 basis points in the first quarter. In our analysis of trendable spread this quarter, we have excluded the reduction in effective yield of 8 basis points resulting from the mark-to-market investment partnership losses. The average yield on investments acquired in the quarter was 4.58%, gross of fees, compared to 3.49% in the first quarter of the year. We purchased $93 million of fixed income securities at a rate of 3.74%, originated $193 million of commercial mortgage loans at a rate of 3.91% and purchased $154 million of residential mortgage loans at 5.92% gross of fees.
Option costs were basically flat sequentially for the second quarter at 154 basis points at American Equity Life only, and at 162 basis points for American Equity Life and Eagle Life combined. Reflecting the decline in equity market volatility and actions we took in June to reduce participation rates on $4.3 billion of policyholder funds and S&P 500 annual point-to-point and monthly average strategies, the cost of options at American Equity Life has dropped from a high of 173 basis points for the hedge week ended March 24 to a current level of 136 basis points.
Over the same time period, the cost of options for American Equity Life and Eagle Life combined fell from 190 basis points to 140 basis points. Should the yields available to us decrease or the cost of money rise, we continue to have flexibility to reduce our rates, if necessary, and could decrease our cost of money by roughly 65 basis points if we reduce current rates to guaranteed minimums. This is up from the 63 basis points we cited on our first quarter call. The liability for lifetime income benefit riders increased $95 million, $26 million above the first quarter level. Relative to the first quarter, reserve accretion was negatively affected by the relatively low level of index credits, renewal rate management activity and somewhat higher lifetime income benefit rider utilization, reflecting the original quarterly sales patterns in certain cohorts.
For the third quarter, assuming current equity market levels, we expect an increase in the liability for lifetime income benefit riders in the $80 million to $100 million range. Deferred acquisition costs and deferred sales inducement amortization decreased by $9 million sequentially, reflecting the decrease in adjusted gross profits and the renewal rate management activity and lifetime income benefit rider utilization cited above, offset, in part, by the effect of the low level of index credits. For the third quarter, assuming current equity market levels, we expect combined deferred acquisition costs and deferred sales inducement amortization in the range of $90 million to $110 million.
Operating expenses declined from the first quarter by $1.7 million, primarily reflecting lower sales promotion activity.
Now I'll turn the call over to Jeff to discuss our investment portfolio.
Thank you, Ted. Good morning, everybody. I'll be referencing Pages 31 through 36 of the Financial & Business Facts Overview Slide deck available on our Investor Relations website at www.american-equity.com.
Generally speaking, we were happy with investment portfolio performance during the quarter, which was well within expected tolerances. Before starting my overview of the investment portfolio, I'll comment on the $27.6 million of credit losses in the quarter and the $10 million mark-to-market loss from investment partnerships. Roughly $18.3 million of credit losses came from write-downs of domestic oil drillers. The remaining $9.3 million reflect a smattering of write-downs primarily on RMBS and CMBS. Mark-to-market investment partnership losses came from partnership investments in energy, rail, car, aircraft and hotels. Current value of our investment partnership holdings is $82 million.
Turning to Page 31 of the slide deck, the overall investment portfolio remains in a resilient position. Our net unrealized gain on the investment portfolio increased from $500 million at the end of March to $3.8 billion at the end of June, reflecting tighter investment spreads and lower risk-free rates. We saw a small decrease in the percentage of our fixed maturity portfolio rated investment grade, but 97% of the fixed maturities are still rated NAIC 1 and 2, well within acceptable range.
On Page 32, we highlight our corporate bond portfolio. It is of excellent credit quality with 96% rated investment-grade and is broadly diversified across credit sectors. Holdings and what we identified specifically as COVID-19 exposed on our first quarter call are quite manageable. Roughly $1.1 billion of the corporate portfolio was downgraded during the quarter, at least 1 NAIC level. More than half of those downgrades were from NAIC 1 to NAIC 2.
On our first quarter call, we highlighted our oil sector holdings. Overall, we had $2.6 billion of investments in the energy sector with 68% of our holdings, midstream, integrated and refining, not at significant risk. We have $55 million of investments in oil drillers, of which offshore drillers have a total value of $8.2 million. We have written down our offshore names to $0.11 on the dollar. Our retail portfolio, which totaled $784 million at the end of June was stable with $29 million of investments downgraded from NAIC 3 to NAIC 4.
Turning to Page 33. Our CLO portfolio is performing as expected during the time of stress. Approximately $69 million of our holdings were downgraded 1 NAIC level during the quarter, all from any NAIC 2 to NAIC 3. Across our CLO portfolio, the percentage of underlying loans rated CCC by Standard & Poor's has grown from 3.6% as of March 31 to 10.22% as of June 30. While this level is elevated, it is in line with the general market. That said, CLOs have a self-curing mechanism. Once CCC's exceeded test threshold, normally around 7.5%, over-collateralization test triggers occur and cash flows diverted from the equity tranche to pay down the senior-most tranche, which ultimately strengthens the CLO.
On Page 34, we provide an overview of our CMBS portfolio. The portfolio held steady in the quarter with the ratings distribution basically unchanged. We had $115 million of downgrades of 1 NAIC level or more, most from any NAIC 1 to NAIC 2. As a reminder, 23% of the portfolio was within single asset, single borrower, or SASB, transactions. All of the portfolio was purchased after the great financial crisis and we significantly curtailed new purchases since 2016.
Retail is 35% of the portfolio or $1.8 billion and mall exposure is $727 million or approximately 41% of retail. Nearly 60% of the mall exposure is within SASB transactions and high-quality names that we continue to feel good about. Looking at the performance of the underlying loans, 9% are in special servicing status, 11% of underlying loans have been modified, usually allowing forbearance for 3 months with missed payments to be paid back over the next 12 months. There is some overlap between the 2 categories. So it's not 1:1.
Turning to Page 35, our commercial mortgage loan portfolio has performed quite well. CM1 loans are, as a percentage of total drop by 2 points to 79% in the quarter, but the entire portfolio remains CM1 or CM2. Through the end of June, all payments were current except one loan. We had total request for relief on about 215 loans. Of those, we provided various types of payment relief on a total of 8 loans with an unpaid balance of just $28 million for a total of deferred principal payments of $278,000.
Finally, just to put things in to context on Page 36, we show the estimated capital sensitivity to a 12- to 18-month economic recession, consistent with Federal Reserve CCAR stress test that we presented on our first quarter call. This scenario is in line with and maybe a little even worse than actual experience during the great financial crisis. What we found is an expected decrease of roughly 75 risk-based capital points, mostly stemming from the increase in required capital needed to support ratings migration. To date, we have just seen 8 points of risk-based capital decrease due to ratings migration and 1 point from credit. As a reminder, the total expected decline in RBC from the March 31, 2020 level would occur over a 12- to 18-month period did not assume statutory operating earnings, any capital contributions or any mitigating management actions. We are, of course, actively engaged to minimize this impact.
To sum up, this is just the first full quarter of economic life with the pandemic, but we feel really good about our portfolio performance and positioning.
Now I'll turn the call back over to Anant for closing remarks.
Thank you, Jeff. While the macro headwinds are real, our leaders are pivoting to a focused approach for executing our refreshed strategy for Horizon 1. Over the last 3 months, we have worked closely with third-party consulting talent to give us an informed outsider's view of what we're doing right and how to do it better and what we are doing wrong and how to fix it. American Equity, like any company over the years, has developed internal beliefs that need to be questioned and if found wanting, need to be jettisoned. We found some believes to be fact like the importance of service and renewal crediting history in the sales decision by an independent agent. All else equal, service and strong renewal crediting history will get us a sale. On the other hand, we came to realize that in certain environments, a transparent, easily understood, multi-asset class index could perform well and should be an added arrow in the producer's quiver, case in point, destinations 10. Additionally, product design needs to anchor in both client and distribution insights and equally importantly, in an ability to source and underwrite assets that produce appropriate risk-adjusted returns. The latter reflecting both the risk of ultimate loss and ratings migration risk. Therefore, strategic and tactical asset allocation will be of paramount importance. And the work that our leadership team is doing to very diligently expand into nontraditional core fixed income asset classes will be even more accelerated with a focus on investments, providing strong structural or contractual cash flow support. Case in point is the partnership we executed this quarter with a leading specialist firm across the whole residential lending ecosystem from origination to servicing and disposition of nonperforming assets in the nonqualified mortgage whole loan market. This is a good example of how we approach new sectors, not just trying to buy securities at an attractive valuation, but with an approach to manage the underlying collateral through both the ups and downs of an economic cycle.
While Eagle Life's sales growth targets are not our primary focus for 2020, the residential nonqualified mortgage loans we are purchasing match up very well with our liabilities at Eagle Life, enabling us to lift our caps on Eagle Select Focus 5 and 7 to levels at least equal to our nearest competitor at accounts where we have distribution footprint.
With that, I will end our prepared remarks. On behalf of all my teammates at American Equity, thank you for your time and support.
Operator, can we open up the line for questions, please?
[Operator Instructions] Your first question comes from Pablo Singzon with JPMorgan.
So I found your commentary on asset management interesting. I guess just to follow-up on what you've said, very broadly, what kind of changes are you considering for your asset management capabilities? Is it partnering with more third-party managers, expanding your in-house staff, maybe acquiring a small platform with broader capabilities? If you can sort of expand on how you're thinking about the asset management function of AEL?
Pablo, the answer is a combination of all of those. So when we think of small and midsize asset managers, any of those combinations could work for us, specifically sectors that -- the first sector we're really looking at very hard is real estate, across the spectrum of residential and other opportunities there.
Got it. And then, I guess, a numbers question, maybe best for Ted. So the investment loss on the limited partnership you booked in the second quarter, is it to be able to expect that you might recoup some of that in the third quarter?
Pablo, in regards to that, some of those entities are in partnerships that we mark-to-market were COVID-related. So it's hard to say what recovery would be from that. Hopefully, we wouldn't see further decline. But as I said, some of those partnerships were energy, transportation, hotel leisure, so they were COVID-impacted. So recovery would be less than those type of partnerships.
And our next question comes from Dan Bergman with Citi.
In terms of sales, it seems like there's been somewhat of a divergence in the industry this quarter with some companies, it seems like maybe one is more associated with alternative capital providers seeing pretty strong results, but most others in kind of more depressed sales levels. So I just wanted to see if you'd agree with that assessment. And if so, kind of any thoughts on the drivers? I guess maybe said differently, how much of the slowdown in sales that you've seen, would you say is due to industry-wide pressure versus your products maybe screening is a little bit less competitive versus some others?
This is Ron, Ron Grensteiner. We'd probably agree with your assessment. It's a mixed bag. I think the majority of the companies, though, have sales lower in the second quarter like they did in the first quarter. I think there are some outliers that maybe have a little bit of success. I think the things that we point to for those companies, though, they might have been a little bit stronger in the multiyear guaranteed annuities versus the fixed indexed annuities. When you're limited to social distancing and some virtual sales, the multiyear guaranteed products are a little bit easier sale to make than a fixed indexed annuity.
But overall, it's been a mixed bag. So I agree with your assessment.
I mean adding a little bit to what Ron said which is just spot on, which is we do like the fact that the fixed index annuity business more than the MYGA business, and we think that's a more sustainable business. You can go after opportunities in the MYGA business based on asset sourcing, but that's a much shorter business versus the FIA business.
Got it. And then in terms of just spreads, I guess, if interest rates stay at current levels, is there any color you can provide on how much incremental pressure on yields from floating rate assets we might expect in the third quarter? And -- but beyond the third quarter, is there any further downside pressure? Or would that be mainly finished? And then related to that, how much of any of that pressure do you think you're going to be offset with renewal rate actions versus lower option costs? Just any kind of general thoughts on that would be really helpful.
This is Ted. So in regards to the floating rate, we would expect where LIBOR is that and the majority of that reset in the third week of the quarter that we'll probably see another 7 to 8 basis points and decline in yield from the decrease in the rates on the floating rate. Going forward, assuming that investment partnerships don't decline any further, that won't occur. So that was 8 basis points that occurred this quarter. And then probably drag from as we go forward is maybe from reinvesting at rates lower than the portfolio yield, could be a couple of basis [indiscernible] but offsetting that is going to be -- if we -- as we go through the year, make the determination depending on the economic environment and start to reallocate our cash balance, which we're holding a very liquid cash balance, about $1.4 billion. If we started to reallocate that and put that into some alpha [ generating assets, so ] that would also offset some of the decline in yield that we'll see from the floating rate.
And our next question comes from Mark Hughes with Truist Securities.
Anant, I'm curious with your review of the business and looking at making some adjustments. Any thoughts on the state of technology? Any particular investments you might need to make over the next year or so?
Mark, great question. Yes. We -- from a technology point of view, we, over the years, having been one of the founding players in this fixed index annuity business have met distribution where it wanted to be met. When it comes to -- which has been a lot around phone service, face-to-face interaction. When it comes to customer experience, there is a shift towards wanting more self-service and online and that's probably an area where we are going to look to do that. As we look beyond Horizon 1, it probably means that having a low-cost operating cost structure, if we can continue to do that with the lowest cost structure in the industry, that may open up other options for us to explore down the road.
And then just kind of a very broad question for you, Jeff. When you think about the portfolio, how much support do you think there has been on valuations related to Fed actions? And as the government support tapers, do you think that means much for your holdings?
I think on maybe some of the structured assets, there's been quite a bit of lift, especially in like CMBS and CLOs on the higher quality tranches. It's kind of helped lift the whole capital stack on the structured asset side. Across the other asset classes, I think there's been a strong enough demand just from cash that's available in the market wanting to get put to work. I mean you're seeing single like corporate spreads at 90, 94 basis points on the index, and that's almost close to pre-pandemic level. So I think we've seen, on the public credit side, we've seen quite a bit of curing. And I think that's been more around demand and comfort that the economy is showing some signs of starting back up. But I do think the Fed buying of some of the structure side has really help prop up some of those valuations.
And our next question comes from the line of Pablo Singzon with JPMorgan.
So the first one was for Ted. Ted, you had mentioned that the cost of options was flat sequentially, and I was wondering if you could provide more color on how that's looking into the third quarter. Is it better, flat, more expensive? Just any color you can provide there?
Sure, Pablo. So as I said before on the call here, the cost of options at American Equity Life during the second quarter averaged about 154 basis points. So the hedge week ended July 28, the cost of options at American Equity Life was 136 basis points. Volatility of that was most extreme, the cost of options at AEL went to 170 basis points. But we certainly have seen some retraction in that.
Got it. And then on the new money rate, it seems like you got a good rate in the second quarter. I was wondering if that's more reflective of sort of one-off deals you saw in the market. And I know that the available yields can change depending on when -- which can buy. But do you think that's more one-off or reflective of what you can actually purchase in this market on an ongoing basis?
Yes. And I'm going to talk about new money rate in two different pieces. One on putting actual money coming in on new business, that's probably around the [ 3.50% ], maybe up to the [ 3.75% ] would be our expectation. But as we go forward and we talk about our total purchase, that actually could go higher as we do reallocation of cash or funds coming off of the portfolio, maybe some corporates that are supporting in-force business and allocate those into other alpha generating assets.
Got it. And then last one for me. And it's for you again, Ted, it's a question about the assumption review. And I'm not going to ask you what it will look like, but maybe it would be helpful if you could serve just elaborate on your process for setting interest rate assumptions. What inputs do you consider? What methodology do you apply? And I guess, more specifically, if you're using something like an interest rate generator, how sensitive is out of the current market levels versus historical long-term trend and maybe a more subjective forward-looking assumption?
Yes. As we've talked about before, when we unlocked, we were using a [ 3.80% ]. It was a 4% 20-year treasury that we were grading to. We backed that down to about [ 3.80%. ] I mean, certainly, we're going to look at the current economic environment, the current economic forecast and what projected out into the future interest rates look at look like over a very long period of time, but we do need to take all of that into consideration as we look at what that great period would be and over what period we need to reassess our grade period of 20 years, and we need to reassess what that ultimate would be. But the process is going to be looking at all of those [Audio Gap] into the process and using judgment to assume what overall long-term interest rates will look like over that period of time.
And our next question comes from the line of Erik Bass with Autonomous Research.
This is actually Alec in for Eric. Can you just talk about the changes at Eagle Life and how you see the opportunity for that business looking out to '21 and sort of how quickly you think the sales can ramp?
It's Anant, I'll start. So Eagle life for us is a really important channel, but we've been very measured in how we build it out. We've got product now over there back on some of the new assets we are originating. That's very competitive. And we clearly have pivoted to a more sustainable wholesaling strategy, which is we have predominantly our own wholesalers going in. But in many regards, it's a significant reboot, which means you need to get the right talent and the right seats on the bus, which is why we think the 2021 ramp upwards. Over the long term, that is a multibillion-dollar channel for us, but it's going to take us 12 to 18 months to talk about volume in the billions over there, is the way I would guide
And I'm not showing any further questions at this time. I would now like to turn the conference over to Ms. Julie LaFollette for any further 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, this concludes today's conference call. Thank you for your participation. You may now disconnect. Everyone, have a good day.