American Equity Investment Life: An Undiscovered Gem (NYSE:AEL)

American Equity Investment Life (NYSE:AEL) is one of those under the radar companies that you love to come across. Although the company has very little following, it has a fantastic business model based on its status in the fixed index annuity world.

The company has also built a strong, conservative investment portfolio full of investment-grade bonds that will help it remain profitable during the continuing Covid-19 pandemic.

Let’s check it out.

Overview

American Equity Investment Life Holding Company operates in the creation, marketing, issuances, and underwriting of annuity and life insurance products. Based in West Des Moines, Iowa, and established in 1995, the company has a current market cap of $1.93 Billion and a market price of $25.65, as of writing this article.

AEL operates through two main segments:

  • American Equity Investment Life Insurance Company
  • American Equity Investment Life Insurance Company of New York

The company sells the majority of its fixed annuity products through independent agents, and currently has policyholder funds under management of $53 billion.

American Equity Investment Life is a leader in the industry, within the annuity sales.

The company has been a top-three fixed annuity producer in the independent agent channel for 18 out of the last 19 years.

Source: American Equity Investment Life, April 2020 Financial Overview, slide 11.

American Equity Investment Life has approximately 42 NMOs with nearly 21,000 independent agents that drive the bus, and that bus is the fixed indexed annuities, which accounts for 96.2 percent of account values.

The first quarter of 2020 continued the success for the company as they saw a non-GAAP income of $154.1 million with $1.67 diluted per share, compared to $112.4 million and $0.97 comparatively for the same quarter of 2019. The company has also had non-GAAP operating income growth over the last three years, from $285.1 million to $548.2 million.

As a life insurance company, they earn the majority of their income from the investment spread, which is currently at 264 basis points, which is well within the target spread of 245-275 bps. AEL has seen continued pressure on earned yield with lower interest rates and higher cash balances. But the company is offsetting by decreasing liability costs as they have been lowering crediting rates slowly.

American Equity Investment Life ended the quarter with assets under management of $52.078 billion, with $47.704 billion of that in fixed maturity securities. All of that was a reduction from the previous quarter as a result of amortized cost reductions and a credit loss of $28,332 million in the first quarter of 2020.

The investment portfolio has 98 percent of the fixed securities with a rating of NAIC 1 and NAIC 2 designation, and the overall credit quality remains high, with a weighted average of A-. In fact, 58 percent of the portfolio is rated AAA, and 39% percent is rated Baa. The bottom line is the company’s fixed income portfolio is 98 percent investment grade.

The company is also growing its ROE, with the current quarter of 18.8 percent, and a book value per share of $35.59.

A few more notes indicating the strength of the company’s balance sheet, the total adjusted statutory capital has grown 11.9 percent CAGR since 2008. And the company has had an average RBC (risk-based capital) ratio of 350 percent since 2008, with the year ending 2019 with excess adjusted capital of $996 million, which exceeds the regulatory RBC of 275 percent that is required by revolving credit facilities.

The company over the years has also worked to reduce its leveraging, which has allowed it to grow the stockholders’ equity and drop the debt to capital from 44.5 percent in 2008 to the current level of 14.9 percent.

Now that we know a little bit about the company, let’s move on to the growth story.

Growth Story

As I mentioned above, the bread and butter of American Equity Investment Life are the fixed index annuity sales. What are fixed annuities, you ask? Here is a slide from the company explaining the product than I ever could.

Source: American Equity Investment Life April 2020 Financial Overview, slide 6

The company’s main growth will come from the continued aging of the population, as the average age of the typical policyholder is 63. With the population aging expected to rise over the next forty years, that provides the company with growth opportunities in the coming years.

As an aside, only 2.8 percent of the current policyholders are under the age of 44.

In addition to the growing market of an older population, there will be a growing attraction to fixed index annuities, as evidenced by the following slide from the company.

Source: American Equity Investment Life April 2020 Financial Overview, slide 9

As seen from the above slide, there has been strong, consistent growth over the last seven years in index annuity sales, to the tune of 11.64 percent CAGR.

Along with the growth of annuity sales, there is also room for fixed index annuities as the desire for more stable investments grow, especially with the low yields that are currently offered in the Treasury markets.

The company is earning a spread of 2.64 percent on the investment spread from this segment of the business, which grew from 2.58 percent from 2019.

Combining the growth of annuity sales, an aging population seeking safe, secure investments, and a growing investment spread is helping continue to the profitability of American Equity Investment Life.

Another strength of the company is the investment portfolio. Currently, the investment portfolio is carrying a fair value of $47.704 billion, with 97.9 percent of the portfolio carrying an NAIC rating of 1 or 2, which are the highest ratings you can achieve. In other words, the portfolio is primarily “investment grade.”

Currently, the maturity status of the portfolio has less than 1 percent maturing in less than a year, with over 90 percent maturing in over the next five years. Given the status of the yields in the Treasury market, the longer maturity allows the company to continue to benefit from the higher yields while waiting for the current yields to rise, hopefully.

The company does pay a dividend with an annual payout of $0.30 per share and a current yield of 1.23 percent. The dividend has a payout ratio of 5.99 percent and has a five-year growth rate of 8.45 percent.

Now, none of that is earth-shattering, but it helps with the overall picture of the company. The company is committed to the dividend, as it has grown the dividend over the last 15 years, but frankly, most of our gains from the company will come from share appreciation. On the bright side, with a payout ratio of less than 6 percent, I would say that the dividend is safe.

Next, moving on to the risks associated with the company.

Risks

As with any company that is dependent on interest rates for profitability, American Equity Investment Life is going to face headwinds for the foreseeable future as the low-interest-rate environment is likely to continue for at least the next calendar and longer.

One impact that Covid-19 is likely to have on the company is the rising mortality rates, which will have an impact on the costs associated with the life insurance policies. All of which will drive claims higher and cause the company to operate at an underwriting loss.

Another risk that the company mentions in their latest 10-q is the impact that Covid-19 will have on employment, which we have already witnessed with record numbers of people unemployed. The company could experience a drop in sales of annuities as a result of lower employment, as well as an increase in withdrawal rates as people seek more liquidity to help pay for things such as mortgages.

As mentioned above, the other risk associated with Covid-19 for the company is the investment portfolio. Being that the vast majority of the portfolio tied up in fixed securities, they are interest-rate sensitive and may be adversely affected by the fluctuations of the Treasury markets.

The fair value of the portfolio, comprised of mostly bonds will fluctuate depending on the markets, but more now with the unknowns associated with the economy going forward, and the likelihood of more defaults in both the bond market and commercial real estate markets.

Overall, the company has prepared itself as much as anyone can during this time for any unforeseen circumstances, and any life insurance company is going to face interest rate risks now and into the short-term future.

But I think overall, based on the credit strength of both the company and the investment portfolio, they are built to weather the ongoing storm.

Let’s move on to what is a good price for the company.

Valuation

Starting with book value per share, the company has grown its book value per share from $16.07 in 2010 to the current level of $38.50, a 9.13 percent CAGR.

That kind of growth is nice, but I think I have a few other tidbits to share with you. The company carries an A+ value rating from Seeking Alpha and a Quant rating of 4.74, which indicates extremely bullish. The company is also ranked number one in the quant rating for its industry.

On the valuation side, I like to use an excess return model for life insurance companies. I will share my assumptions so you can play along at home. All financials will be TTM for the company based on the latest 10-Q.

Assuming:

  • Return on Equity – 9%
  • Retention Ratio – 94.62%
  • Expected Growth Rate – 8.52%
  • Cost of equity – 9.04%
    • Beta – 1.4
    • Risk-free Rate – 0.64%
    • Risk premium – 6%

All of which yields us a value of $30.96 a share, which gives us an approximate 20 percent margin of safety if my assumptions are incorrect.

Final Thoughts

Based on all of my research for this article, I believe that American Equity Investment Life is currently a buy at these prices, which is currently $25.95 at the time of this article.

Although the company has little following, I think it is a gem among life insurance companies, and it deserves the strong quant rating it currently holds.

American Equity Investment Life has a long history of growth and has a long runway ahead of potential in the fixed index annuity space, where it is one of the market leaders.

Life insurance is a tricky business, and it is extremely dependent on interest rates, which will be rocky for some time. But the company has built a foundation that can sustain itself through the bumps ahead.

I don’t currently own shares, but I plan on adding next month as part of my monthly allocation.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in AEL over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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