Good morning, and welcome to the FGL Holdings third quarter 2018 earnings conference call and webcast. All participants are in a listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by 0. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star, then 1 on your telephone keypad. To withdraw your question, please press star then 2. Please note this event is being recorded. I would now like to turn the conference over to Diana Hickert-Hill, Senior Vice President of Marketing, Investor Relations, and Communications. Please go ahead.
Thank you, operator, good morning, everyone. We appreciate you joining our earnings call. Today, we will discuss our financial results for the third quarter of 2018, which ended on September 30th. You can find the financial information for FGL Holdings on the investor section of our website, fglife.bm. Today's presenters include Chris Blunt, President and Chief Executive Officer, and Dennis Vigneault, Executive Vice President and Chief Financial Officer. Some of the comments we make during the conference call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act. We do not intend to update any comments on this call to reflect new information, subsequent events, or changes in strategy. A number of risks and uncertainties exist that could cause our actual results to differ materially from those expressed or implied.
We discuss these factors in detail in the Form 10-K that we filed with the SEC on March 15th of this year. During this conference call, we may refer to non-GAAP financial measures that we believe may be meaningful to investors. Please refer to our third quarter earnings release, financial supplement, and investor presentation that we posted to our website. These documents contain a reconciliation of non-GAAP financial measures to GAAP. Finally, all comparison comments today will be to the third quarter of 2017 unless we state otherwise. I will now turn the call over to Chris.
Thank you, Diana, good morning, everyone. Before I talk about our third quarter results, I wanted to take a couple minutes to report on how we're progressing against the strategic initiatives and priorities we outlined at our investor day earlier this year. First, as you know, one of our top priorities has been to work on securing ratings upgrades, which would accelerate organic growth and provide us with greater strategic flexibility. You may remember that AM Best raised our outlook on our rating from stable to positive in March. We've been cautiously optimistic that we could secure an upgrade by the end of the year. At this time, we do not believe the upgrade will occur this year, remain optimistic that we'll secure an upgrade to A-minus in 2019 after we file our full year 2018 statutory financials.
Second, we stated that we were focused on driving profitable organic growth in our existing businesses. I'll go through our detailed top-line results in a minute, but it's clear we've made great progress on this objective. Most importantly, we explained that we would continue to be disciplined in writing new business at or above our return targets, and I'm pleased to report our sales this year have exceeded our new business profitability targets. Third, we believe that by partnering with Blackstone on investment management, we'd be able to leverage their world-class origination, structuring, and underwriting capabilities to execute our portfolio rotation. To date, we've focused on reducing corporate bond holdings, which are largely BBB rated, in favor of investment-grade structured securities sourced by Blackstone.
2018 is a transitional year. There is no doubt that when completed, this repositioning will be accretive to portfolio yields and net investment income while improving diversification and the overall risk profile. Dennis will go into more details on the portfolio reposition in a minute. Next, we highlighted that the transaction would bring us significant advantages because we now have a reinsurance company in Bermuda that we can use to pursue block and flow reinsurance business. We're achieving success here as well. We expect to generate more than $175 million of flow reinsurance deposits in our first year and have a number of potential transactions that we believe will drive significant growth in 2019. We also pointed out that growing our reinsurance business is a high priority because it helps diversify our business and ultimately will help lower our overall effective tax rate.
We also stated that M&A would be part of our strategy and that we are open to looking at whole companies as well as blocks of business. Leveraging the deal expertise of our sponsors and management team, we've evaluated and continue to evaluate a number of different opportunities. We look at each target in a disciplined manner and with a focus on areas we know well, annuities and life insurance. Although we have not completed a transaction to date, we're active in the market, and given the deep M&A experience of our board and leadership team, we remain confident in our ability to execute our acquisition strategy as the right accretive opportunities arise. Finally, we stated that we want to take an opportunity sometime in the first year to clean up our capital structure and eliminate the overhang created by the outstanding warrants.
In October, we did just that and completed a successful tender for 92% of the outstanding warrants. As you can see, we've made tremendous progress in just our first three quarters as a new company, and we're excited about the position we're in as we work to wrap up our first year. Now turning to our third quarter results, our sales totaled $894 million in the quarter, up 51% from last year. We're seeing these results come from across our product portfolio, in line with the overall market demand. FIA sales totaled $631 million in the quarter, up 49% over last year and up 15% over the second quarter. Year-to-date, FIA sales are $1.6 billion, up 23% over last year. Our multi-year guaranteed annuity or MYGA sales were $211 million in the quarter, up 29% from last year.
Year to date, MYGA sales were $573 million, up 28% from last year. In previous calls, we've noted that we expected strong annuity sales this year. This strong sales momentum is coming from a number of factors, attractive market demographics, strong long tenure relationships we have with our distribution partners, our distribution partners increasing confidence in our company's future and capital strength, recruitment of new agents who want to sell our products to meet their client needs. In fact, new agents have accounted for 11% of our FIA sales year to date, our comprehensive competitive product portfolio that meets a range of consumer needs, the successful launch of new products, including a new performance-based income and accumulation product series in February, which has contributed 10% of our FIA sales so far this year, and the elimination of the distraction from the Department of Labor rule.
While we don't have industry-wide data for the third quarter yet, we expect that it will be another very strong quarter for annuity sales and perhaps another record quarter. Turning to our Index Universal Life or IUL business, we delivered $7 million of target premium in the quarter, up modestly from last year and about flat with the second quarter. On the flow reinsurance front, our deposits totaled $45 million in the quarter and $132 million year to date. We expect total flow reinsurance deposits to exceed $175 million for the full year. We are very bullish on our ability to grow our flow reinsurance business at F&G Re, and are in discussions on a couple opportunities that we believe could drive nice growth in 2019. It's been an outstanding quarter from a top-line basis.
With that, I'll turn the call over to Dennis to discuss our results in more detail.
Okay. Thanks, Chris, and good morning, everyone. Today I'll focus my comments on the following. Earnings, including any areas where results were impacted by purchase accounting, the investment portfolio performance and progress on the reposition, an update on our plans related to tax reform, and lastly, some thoughts on capital and liquidity. Adjusted operating income available to common shareholders for the third quarter was $62 million or $0.29 per share, compared to $65 million or $0.30 per share last year. I'll note that both periods benefited from some favorable items that although a part of our overall operating performance, are not consistent period to period. Beginning with the third quarter of 2018, there were $10 million of benefits from two items.
First, $5 million of favorable actual to expected mortality in the immediate annuity product line, which by its nature, and given the average age of the policy holders, will have variability quarter to quarter. We also had $5 million of favorable adjustments related to lower amortization of intangibles from the annual assumption review. The third quarter of last year benefited primarily from $21 million of favorable adjustments for lower amortization from the annual assumption review, and an out-of-period actuarial item. These items are part of the company's overall financial performance, and we highlight them to provide insight to the financial and operational trends. The trended details of these items can be found in our quarterly financial supplement. AOI, after considering these items, was $52 million in Q3, an increase of $8 million or 18% over the prior year.
This strong growth in AOI was driven by invested asset growth, a lower effective tax rate, disciplined expense management, and stable underlying trends in net investment income and net spreads. For the first nine months of 2018, we reported $181 million of adjusted operating income or $0.84 per share. This is up nearly 25% compared to $145 million or $0.68 per share in the prior year. Our outlook for 2018 AOI available to common shareholders remains in the range of $235 million-$245 million, or $1.09-$1.14 earnings per share when adjusted for the recent warrant tender we closed in Q4. That's relative to our previously provided outlook of $1.10-$1.15 of earnings per share. To recap, we successfully completed a warrant tender, and 92% of the warrants were exchanged for 7.2 million of common shares and $64 million in cash.
This action cleaned up the capital structure, provides great value for warrant shareholders at a 35% premium, and reduced the ultimate potential dilution at max warrant valuation by more than 7% or 16 million shares. The additional common shares issued will be reflected commencing in the fourth quarter. I'll now turn to the investment portfolio performance for which we have provided additional information in the presentation. Overall, the portfolio is performing well and the portfolio reposition is progressing, albeit at a slower pace, to ensure that we optimize the ultimate earnings lift we realize. More on how we see this developing in a few moments. I would highlight that in addition to purchase accounting effects, this quarter's results also reflect the full grade-in of the annualized 30-basis point investment fees under the new Blackstone Investment Management agreement.
Let's walk through the quarter's results, and then I'll turn to progress on the reposition. Average assets under management totaled $25.4 billion at September 30th, reflecting an increase of $4.9 billion over last year and included $1.8 billion of net asset flows over last year. Growth of about 9% year to date, excluding the PGAAP impacts, which were $1.2 billion for the mark on the portfolio and $1.9 billion of additional assets from the Front Street Re inclusion and FGL Holdings at the merger date. As a reminder, the purchase accounting or PGAAP mark-to-market aspect is a non-cash adjustment, which will amortize as a reduction to net investment income over the remaining asset life. GAAP earn yield on the investment portfolio was 4.13% for the third quarter.
This is down about 90 basis points than the 5% pre-merger yield in the third quarter of 2017, reflecting the net impact of PGAAP, higher planned investment fees, which were partially offset by portfolio reposition lift. It's important to note that on a statutory basis, which is not impacted by PGAAP, the economic yield was approximately 4.9%. It's also important to note that this yield on both a GAAP and statutory basis will continue to expand as we further reposition the portfolio to enhance investment income and earnings. Net investment income overall was $267 million in the quarter compared to $261 million in the prior year. Let me break that down for you into its component pieces. This reflects a $29 million increase from net asset growth and $11 million from the portfolio reposition lift.
That was partially offset by $17 million of the non-cash premium amortization and $17 million of higher planned fees. The after-tax non-cash impact of the premium amortization was $11 million or $0.05 per diluted share. Net investment income in the third quarter was down $15 million compared to the second quarter. There were a couple of drivers in there that I'll highlight. First, we had $5 million of bond prepayment income in the second quarter that did not reoccur, $3 million from higher cash balances during the quarter as we timed sales early in the quarter to minimize any realized losses as we reposition the portfolio. $2 million of unfavorable impact during the third quarter related to CLO redemptions held at a premium. Lastly, a planned step-up in the annualized 30 basis point management fee of $7 million.
Offsetting this was a $2 million sequential increase in the quarterly portfolio lift run rate to $11 million. We are now once again fully invested as of the end of the quarter and do not expect material cash drag as we complete the remainder of the reposition. Given the progress on phase 2 shift from public corporates and munis to structures, we expect net yields, NII, and net investment spreads to resume quarterly growth in Q4. Net investment spread for our core product FIAs, which have historically achieved a range of 280 to 300 basis points, have now been reset post PGAAP for the non-cash premium amort and the increases in the fees. Page 11 in the earnings presentation posted to the website lays out the trend in net investment spread since the transaction closed.
You can see, the underlying trends are squarely within our targeted range, which reflects very stable policyholder option and crediting costs and overall profit margins. We've discussed at Investor Day and on our call since, the portfolio transition will play out over several quarters, and fluctuations are to be expected as that work progresses. Overall, we are confident that the gross annualized lift in NII we've forecasted will be achieved, and when combined with the runoff of the non-cash PGAAP premium amortization, will drive sustainable increases in reported net investment spreads. Let me shift to a few details on where we're putting money to work. Fixed income asset purchases during the quarter totaled $2.4 billion at an average net yield of 5.23%. Those purchases were primarily in structured securities such as CLOs, mortgage-backed securities, and ABS, and represent both repositioning and new money flows.
On a year-to-date basis, we have purchased $7.6 billion of fixed income assets at a weighted average NAIC rating of about 1.5 and an average book yield of 5%. Overall, we are seeing meaningful benefits on new money flows and generating higher risk-adjusted returns than we've achieved historically. Let me share some further details on the reposition of the in-force that's coming in four phases. First, you'll recall we executed the block transaction. That was $2.7 billion in the first quarter. We picked up 150 basis points of yield at an average quality of 1.5. We extended duration a bit because we had flexibility within the portfolio. This trade will provide $40 million of annualized gross net investment income lift for the full year 2019, with about $33 million of that for 2018.
Secondly, with respect to structured products, we've got a $5 billion rotation underway that will be fully repositioned by early 2019. We are taking a disciplined approach to achieve targeted opportunities. Although it's progressing a bit slower than planned, we are pleased with the results we're achieving. Under this phase, we're taking a blend of relatively low-yielding public corporate structures and munis migrating into higher-yielding structured assets, both CLOs under a mandate with Blackstone's GSO, capital and real estate debt investing with a mandate with BRED, Blackstone's Real Estate Debt Manager. As of today, we have completed in excess of $3 billion of the targeted $5 billion rotation. This trade will provide approximately $60 million-$75 million of gross annualized net investment income lift, with about $12 million of that uplift being realized in 2018.
We continue to favor these structured assets, which provide attractive yields, significantly enhanced credit protection, and floating rate upside relative to corporate public bonds. We expect this asset class to be about 35% of the portfolio once completed. This action will reduce the overall duration of the portfolio while supporting the ALM profile, cash flow testing, and provides flexibility to manage the portfolio irrespective of the rate environment. Again, this phase will wrap up in the first quarter of 2019. Third, with respect to alternative assets, this program is well underway as we grade towards a targeted funded allocation of 5% of the overall portfolio. At this time, we have just over $400 million of funded assets. We'll be at about $1.7 billion of commitments and $500 million-$600 million funded by year-end.
A good portion of that will further fund in 2019 and the remainder by the end of 2020. On average, we're assuming a net 12% return over the life of those investments. Our alternative asset allocation will be across a wide range of assets, including private equity, real estate, credit, and multi-strategy types sourced by Blackstone in both Blackstone managed investments and other third-party managers. Overall, once completed, we believe the shift to alternatives will add approximately $100 million-$125 million of gross annualized net investment income lift. Finally, we are pursuing some additional portfolio optimizations across other operating subsidiaries. The combined actions there will generate about $20 million on a gross annualized basis once that's completed, most likely at the end of the first quarter of 2019 as well. Let me shift to a few comments on where we are with tax reform.
We continue to await clarification from Tax and Treasury on the topic of gross versus net for affiliated reinsurance. You'll recall that earlier this year, we made a tax planning election to have our Bermuda-based affiliated company treated as a U.S. taxpayer. This election has maintained flexibility for our reinsurance platform to ensure we don't have any exposure to BEAT. We estimate our effective tax rate on a reported AOI basis will be 19%-20% for the full year. At this time, we have positioned the business such that if Treasury guidance is met, we could release the previously accrued tax expense at the 21% rate and resume new business reinsurance. If it's gross or guidance is delayed until 2019, we could recapture all of the affiliated business and repatriate the majority of the capital from Bermuda by year-end.
If the BEAT guidance is delayed until 2019 and ultimately ends up net, we would resume affiliate reinsurance next year. Separate from BEAT, we are working on third-party strategies and opportunities to grow our reinsurance platform. These strategies should reduce our overall effective tax rate to about 15% over time. Flow reinsurance and block M&A pipeline is very active, and we are making good progress developing several opportunities. Let me wrap up my comments, a few thoughts on capital and other topics. We finished the third quarter in a strong capital position with an estimated risk-based capital or RBC ratio of about 460%, including the expected adjustments for tax reform. Without tax reform, to help put this on a comparable basis to the peer group, that would've been about 485% RBC ratio.
Looking ahead, we are managing capital to fund new business, maintain that RBC ratio at greater than 450%, and secure ratings upgrades. I will note that S&P affirmed our ratings in September. With regard to liquidity and deployable capital, we have approximately $300 million on hand comprised of insurance company surplus, available debt capacity, and holding company assets. One note on accounting matters. In the quarter, we identified an error in the newly implemented PGAAP reserve calculation model that over-accrued the FAS 133 liability since the merger. The cumulative impact, net of intangible amortization and taxes, was $44 million. The error is both qualitatively and quantitatively immaterial to any one quarter, but it is material in the aggregate, resulting in a material weakness in internal controls, which is now fully remediated as of 9/30/2018.
This error does not require any restatement of previously issued financial statements, but rather will be corrected as each period affected is included as a comparative period in this quarter's and future quarters' financial statements. A summary of those amounts and periods can be found in the Form 10-Q filed last night in footnote two. To be clear, these adjustments do not impact AOI as the FAS 133 impacts are fully removed from that calculation. Since the merger closing, we have good momentum in executing on the strategy, and we have delivered strong growth again this quarter. To recap the indicative outlook provided for 2018, we see top line annuity sales above 20% of annual growth overall while achieving our profitability and capital targets.
Our AOI expectation remains within a range of $235 million-$245 million or EPS of $1.09-$1.14 per share adjusted for the warrant exchange. We will continue to maintain RBC at greater than 450%. We view 2018 as a transformational year following our merger transaction and remain very focused on achieving these objectives. With that, I'll turn the call back to the operator to begin the Q&A.
We will now begin the question and answer session. The first question comes from John Barnidge of Sandler O'Neill +. Please go ahead.
Thank you. How quickly do you think you can get to that 15% tax rate driven by reinsurance, or at the very least below 20%?
Hey, good morning, John. It's Dennis. Great question. I would estimate that to get to that 15%, we need somewhere in a range of $7 billion or $8 billion of liabilities and assets under management sitting in that offshore platform. One way to think about it is it'll come from two factors. It'll come both from flow reinsurance deals that we currently have and are working on to increase. As I mentioned, we've got a nice pipeline building, and for just two, three quarters outside of the merger close. I'm excited and optimistic about 2019 and getting some of those under our belt in addition to the one that we already have that's going to generate $175 million this year. The other avenue that we're actively working is block reinsurance. Again, that pipeline is full. Blocks, they come in all sizes and shapes.
We could get there with one single transaction. We certainly have the capital availability and resources to do that. It could come in a series of smaller block, $2 billion, $3 billion, $4 billion type transactions. I believe we will make material progress on building that offshore business in 2019. I can't give you an exact estimate as to when that will happen. We've got a great pipeline, and as soon as something breaks, we'll be back to update you.
Okay, great. Thank you. My other question, you bought back the warrants in the quarter. It's good to see the capital structure cleaned up a bit. The stock's really lagged and is now trading around book value ex AOCI. Why not pursue some level of share repurchases or just have a share repurchase authorization out there?
Yeah, fair question. As we entered the quarter and as we've been thinking about the capital structure throughout this year, our first priority was get to the warrants and get those cleaned up. Now with that under our belt, we'll certainly, as we think about future capital deployment, certainly organic growth is our number 1 priority, as you can see from our sales performance thus far in the quarter and thus far this year to date. We're really having a great year. That is our number 1 priority. Then after that, we'd look at share buybacks, M&A, dividends, all the things you'd expect. We just got the warrant wrapped up, and we'll certainly be considering other alternatives for capital redeployment.
Great. Thank you for the answers. I'll requeue.
The next question comes from John Nadel of UBS. Please go ahead.
Hey, good morning. The first question, if I think about the operating income this year against your full-year targets, and I strip out some of the one-time items, I think you mentioned about $10 million this quarter as an example, you're tracking a bit below the full-year target. I'm just curious, would you characterize that shortfall as driven primarily by the timing of the repositioning of the portfolio and the commensurate investment income uplift, or are there any other contributing factors that you would point to?
Yeah. Good morning, John.
Good morning.
I would characterize it as timing on the reposition, I would also note that we do have blocks, unlike some of our peers that are strictly FIAs, we do have an IUL business, and we do have some legacy blocks of business, single premium immediate annuity being the largest one. Although less predictable quarter to quarter, we do consider that income as part of our core operating earnings. As we look forward and as we think about the full year, there are some shortfalls as we think about net investment income, we've got a diverse business, and our guidance was predicated on an all-in view when we spoke in Investor Day.
Yeah, no. Listen, I appreciate that. I mean, the mortality gain this quarter may be a little bit outsized, when you spread it out over the year to date, it's certainly something that's within the realm of possibilities, right? That's sort of what you're saying?
Yeah. One more thing I would add, I would just say that beyond those two categories of income items, there's no other underlying issues or things that we're concerned about or aren't right in line with our expectations. As I mentioned, the top line's coming in great. Profit and margins.
Yep
Core underlying spreads are performing. Expenses are in lockstep with our forecast, we're being very disciplined there, capital is in great shape. It's really just.
Yep
the speed of the reposition as we try to be prudent and maximize the economic gains that we expect to get.
Okay. That's helpful. I just wanted to make sure about on the other factors, if there was anything there. The second question is just a little bit nitpicky, but cost of crediting and options increased, I guess seven or eight basis points quarter-over-quarter versus the second quarter. Is there anything in particular driving that? Is the cost of options simply higher?
Although there are a few basis points of differential quarter-to-quarter, we're not seeing any trends that give us any pause when you look at it on a year-to-date basis, year-over-year.
Yep.
I think they're actually down. They're sort of in the range of normal fluctuation. Again, we watch it every quarter, but there's nothing that gives us pause.
Okay. Last one real quick. If average alternative investments, I don't know, let's call it $500, $600, $700 million average during 2019, can we think about generating that 10%-12% targeted yield that quickly, or is there a ramp that you guys would expect to achieving that yield over time?
Yeah, great question, and an important one. As you know, there's a J curve to how these assets not only get funded, but then the speed at which and the rate at which the return starts to materialize. We're going to have to take throughout 2019, and it'll probably continue into 2020 as we continue that ramp and we complete the full funding.
Yep.
Some of the earlier assets that are already funded now start to peak maturity. Some of those have lower income earlier on and much greater payouts above that 12% in later years. It's a mix.
Okay.
I think we'll be in the ballpark of that 12% and on our way to that 12% as we sort of get into the middle of 2020. It could come faster. Some of the speed at which these things fund are a bit unpredictable.
Got you. That's helpful. Thanks, Dennis.
Yeah, sure.
The next question comes from Pablo Singzon of J.P. Morgan. Please go ahead.
Hi, good morning. I just wanted to follow up on your earnings guidance of $235 million-$245 million this year. Is that dependent on hitting your spread margin guidance of about 195-200 points for 2018? If yes, it seems like that would imply a meaningful uptick from spreads, at least in the third quarter. I just wanted to get your perspective on that.
Yeah. As we think about that range of 235-245, we're looking at our outlook for how the net investment income due to the reposition and just net asset flows is going to mature and build in the fourth quarter, how that's going to the earn rate on the portfolio, given what Raj and the Blackstone team have accomplished on the structured portfolio. We are not seeing, as I mentioned earlier, any meaningful shifts in our interest credit and option cost or policyholder behavior. We feel good about that 235-245 range. There isn't any specific factor that we're watching that would give me, if it doesn't play out exactly as forecasted, is going to take us off of that. I think the business is operating.
There'll be deviations, basis points here and there, whether it's net investment income, interest in option cost, and ultimately net spreads quarter to quarter. We're confident that we're going to land in that range. Certainly, there's nothing from the net spread factor that's going to take that off course.
Okay, thanks. My second question was, just looking at slide 11 of the deck, there was about an 11-point uptick in PGAAP amortization sequentially. Is that 72-point drag a good run rate, or should it revert back to around 50 points where it was in the first half of this year? Thanks.
Yeah, sure. Great question, happy to clarify. That PGAAP amort and expenses includes both the investment expenses related to the portfolio management and PGAAP. That's why you see the increase. In the third quarter, our rate that we're paying Blackstone as planned increased. There was a $7 million nominal dollar impact increase in that expense in the third quarter. We're now at an annualized 30-basis point run rate as we look out and go forward. We had a lower rate in the first half of the year.
I see. Around 70 points is a good level?
Yeah, I think that's in the right ballpark. What will drive that off, take that off course, and we'll certainly update as we go forward is the PGAAP amortization as we're repositioning the portfolio and selling down some of those assets. The associated amortization with those assets, all of which are not fully identified, will shift. As those are sold, the PGAAP amortization will fluctuate. As we wrap through fully phase 2, we'll be able to give a clearer picture at the end of the first quarter next year as to what that amort run rate residual will be each quarter. Then combined with expenses, we'll give you a good insight as to what that total number will be. We need two more quarters to finish that reposition to get that thing to settle down.
Thanks. I'll requeue.
The next question comes from Andrew Kligerman of Credit Suisse. Please go ahead.
Good morning. Back on that 8% sequential basis point increase in crediting rates. If I understand the response, it was due to some bumpiness in the options?
Well, that's an all-in crediting rate that includes not just our FIA product, but also our other legacy lines like the SPIA block, et cetera, as well as IUL. There's pieces in there. When you break that apart into FIA versus the other products, there's no material trend or anything that gives us pause in those minor quarterly fluctuations.
Okay, it's kind of a bumpiness around what then?
Well, Andrew, we actively look at and adjust the crediting rates on business that's maturing as part of our annual reset cycle. There are fluctuations or maturing blocks of business. You have to think about it as we're putting on individually priced tranches of business 12 times a year. As those individual tranches cycle through and mature.
I see.
normal policyholder runoff, there's just going to be quarterly fluctuations. Some carriers sort of set their prices and sort of a set it and forget it, and then don't actively manage their crediting rate strategies at the time of renewal. We are a net spread focused on the bottom line carrier, and we actively manage the business to deliver the net spreads that we put on the books at the time we write the business. Over the course of the life and those tranches of business, there'll be quarterly fluctuations.
I see. Based on what you've said, would it be appropriate to kind of model for something near where the credited interest rate settled out this quarter, and then secondly, not to anticipate any upticks?
I think there will be, to the point, I think there will be quarterly fluctuations, plus and minus.
Okay
to the rate of crediting rates.
Right. No trend right now? You're not seeing any pressure to raise rates?
No trend right now that I could say, yeah, there's a permanent shift in the rate of crediting.
Got it. Lastly, I'm just curious, as you look at this flow reinsurance and you speak with potential clients, you're competing with the traditionals like RGA or companies more focused the way you are, like Athene. What's the F&G pitch to win a flow reinsurance deal?
Yeah. Hi, Andrew. This is Chris. We really partner with carriers to help them design and develop products. There's a lot of carriers out there that don't have index product capabilities that have captive distribution or other forms of distribution that are interested in being able to provide their advisors with index product capabilities. I think what we're able to do from a reinsurance company led by our former chief actuary, John O'Shaughnessy, is to really partner with them closely to develop product, help design it, help them get it implemented on their systems, and then help them manage that in-force block as it's written. That's really the relationship that's been developed, and those are the relationships that we're looking at continuing to develop over time. That's generally not something that RGA and others do.
I see. Thanks a lot.
The next question comes from Kenneth Lee of RBC Capital. Please go ahead.
Hi. Thanks for taking my question. Just one on potential inorganic growth opportunities. You mentioned in your prepared remarks you could look at block transactions or whole companies. I'm just wondering what kind of return hurdles would you be expecting for either blocks or whole companies, and under what scenarios would a whole company acquisition make sense, and what kind of liabilities could these be? Thanks.
Yeah. Good morning, Kenneth. I think we have stated consistently that we're looking at mid-teens returns, and we're trying to drive ROEs higher than they're already at. We're going to be very disciplined on our pricing, but we're looking to price things in mid-teen ROEs, things that would be accretive to ROE. We've said that we're interested in primarily annuity blocks and life insurance, the things that we know well. We probably would stay away from things like long-term care and other liabilities that we think we don't have a great advantage, not sure that those are favorable to our business.
Gotcha. Just one follow-up. In terms of the potential ratings upgrade, what drove the change in the timeframe expectations? Thanks.
Yeah, I think what drove it is just a recognition that the positive outlook is in March. Generally, AM Best wants to see a full year of results before they're going to take action following the positive outlook. We've had a lot going on this year. They're very pleased with the progress and the strengthening of the capital. They're pleased with the capabilities that we're getting on the investment management side, and they just want to see us land the full year 2018 statutory financials and have a conversation about one year after the positive outlook.
Okay, great. Thank you very much.
The next question comes from Alex Scott of Goldman Sachs. Please go ahead.
Hey, good morning. The first one I had was just a follow-up on the increase in the option costs. Could you describe the kind of cap rate adjustments that you're having to make right now to sort of offset some of the things you're seeing in the option market having to do with volatility, and do you expect any of that to cause a take up in surrenders at all?
Yeah. Great question. Good morning. This is Dennis. Without getting into the specific pricing actions on various tranches of business, what I will say is we have a pretty methodical and purposeful approach to setting crediting rates at time of renewal. Our goal is to manage and maintain business and recognize and realize the returns that we get at the outset when we put the business on the books. You should not expect, and our policy and practice is not to take radical changes to our crediting rates. These are minor tweaks as we manage the various tranches of business that when in the aggregate, we look at the profitability that comes out. We're satisfied that it's meeting our aggregate returns. We're not expecting any of our actions to drive any discernible shift in our policyholder behavior.
Again, these are minor tweaks across multiple tranches, multiple years' worth of business, and it's a very purposeful process, and you shouldn't expect to see any significant change. In the aggregate, we manage it regularly. Again, that's why we're not concerned, and there's really no underlying unfavorable trend that's going on with the option cost in interest credit. It's just normal fluctuation, and we manage for the long haul and for the bottom line.
Got it. On excess capital, I just had one there on, it looked like there was a bit of a modest decline in deployable sort of excess, and I think that's just mechanically the RBC ratio coming down a little bit quarter-over-quarter. How much of that's driven by just growth in new business kind of exceeding levels that can be capitalized with the capital coming off of the existing book? Would you expect that to continue at these sort of levels of the sales?
I would say, certainly, we're very pleased with the strong top-line performance. We're slightly ahead of our outlook from last quarter when we updated everybody. We've been managing that very effectively. The biggest driver is just the $64 million of cash that we used for the warrant tender. The rest of it is just sort of a rounding error.
Okay. One more quick one if I could. One of your peers has mentioned the lifetime income benefit reserves for the industry may be understated. Any thoughts you have on that? What level of lifetime income benefit reserve do you guys hold? Any kind of color that you have on sort of discount rates used and any kind of impact you'd expect from the new FASB guidance that came out recently?
I guess I would sum it up like this. When you think about the underlying assumptions for income benefit riders, it's pretty tough for anyone to look across the industry and say, "Here's what our number is, and here's what we think the industry should be in general." There are mortality, lapse, and other election assumptions that all impact those reserve levels. Most importantly, the level of roll-up rates and whether or not they are capped or not is a huge driver of the level of reserves that any carrier would be required to hold.
There are some legacy blocks of older business out there where roll-up rates were lifetime, and that adds significant cost as opposed to our block of business and more current vintages of business across the industry, where roll-up rates typically are for 10 years or the initial life of the product, and then the company has full discretion to reset or not at that time. Our particular block of business has limits on those roll-up rates. They are capped. On a comparable basis, we would have a much lower need for income rider reserves relative to someone who had a block of business with those high guarantee and unlimited uncapped benefit type roll-ups. We're very comfortable. I'm not really going to get into the specifics of the actual level of reserves. We're very comfortable with our reserves.
We've got a very tight reserving process, and we're very comfortable there. On the discount rate, we're still working through that, and I really don't have an update for everyone at this time.
All right. Thank you.
We have a follow-up question from John Barnidge of Sandler O'Neill. Please go ahead.
Hey, thank you. You guys had a small long-term care block that was acquired with the original transaction. I know you've talked previously about wanting to divest that. Can you maybe talk about what you're seeing on an opportunity on that? Thank you.
Yeah. Good morning, John. Yeah, thanks for the question. We have explored and continue to explore what our opportunities are with the block. Just to put it in comparison, it's something like $200 million of reserves. It's a very small block for us. We think it's well managed. We've been able to get the rate increases through, and we haven't received a mark on the business that we found acceptable given the quality of the overall business. We are not actively marketing it at this point in time. We're going to continue to manage that business and explore a future opportunity down the road to take another look at it maybe later in 2019 or 2020.
Do you have a morbidity improvement assumption in there, and how does that compare with the experience of the block?
Yeah, there's not a material morbidity assumption in there, and everything's been performing in line with the assumptions in the block. Most importantly, we have been very successful. 2018 rate increases or 2017, sorry, rate increases got pushed through. It's generally performing. The other benefit we have here as well is, Raj and the Blackstone team are actively working on repositioning that portfolio, to squeeze out a little extra, in investment income. Again, it's sort of a managerial distraction. It's not an economic issue that we're that concerned about.
Great. Thank you very much.
We have a follow-up question from Pablo Singzon. Please go ahead.
Thanks for taking my follow-up question. Dennis, I'm getting a tax rate below 20% for this quarter. I just wanted to confirm if that's the case, and if yes, what drove that and where you see the tax rate in the fourth quarter.
We were a couple of points down. I want to say it was like 17% on an AOI basis. We just had some minor true-ups to, I think it was a val rate allowance in one of our smaller entities. I'm sorry. I'm quoting the wrong-ish topic. It was a credit for a DRD deduction that we were able to book in the quarter. That'll influence the overall rate for the year, but we're not going to be at 17%. Again, we're still accruing at that 21% rate. That'll bring us down the benefit this quarter slightly to that. As we potentially line up the business in light of the BEAT and for recapturing that business, we are looking to optimize. There's a chance we may squeeze out a few tax benefits as we recapture that block of business, the ModCo business from Bermuda.
We'll have more to update on that, of course, when we chat in fourth quarter.
Got it.
20%-21% is where we're going to be.
Perfect. Just following up on your comments regarding SPIA mortality. It's been favorable for three quarters this year, and I understand that it can fluctuate, but I was wondering if you could give us perspective on whether or not it's been a net positive or negative longer term.
Yeah. It's a great question. If you were to go back to 2014, 2015, 2016, we had several quarters where in one particular tranche of that block, there's about $3 billion, almost $4 billion of legacy reserves on the books for that. We have one particular tranche that's about $300 million of reserves that's older age, impaired risk. The average age on that portfolio of customers is 93 or 94 years old at this point. We had several quarters in those historical periods where mortality was unfavorable. Throughout 2018, we have had three quarters of favorability. As I look forward, just given the characteristics of that policyholder group, average age 93, 94, I would like to think there is more favorable mortality results to come out of that block.
We're going through our annual planning cycle now, we'll probably put a pin on what our estimate is sometime in December. There will be volatility fluctuations quarter to quarter, maybe in that plus $5 million range, if it turns positive. Certainly, I don't see anything. Maybe slightly less than that if we do have a quarter or two of unfavorability, nothing material to the downside. I think it's more likely a favorable item as we go forward, that block continues to run off given the average age.
Okay. Thank you.
Sure. Thank you.
There's a follow-up question from John Nadel from UBS. Please go ahead.
Thanks for the follow-up. Two, if I could. First is, I just want to make sure I understand the comments about the 30 basis point Blackstone fee. Was there a catch-up related to that that worked through the third quarter, or is that just you're pointing it out because it stepped up from the original 22.5 basis points to the 30 basis points this quarter?
Yeah. It was a step-up, a planned step-up in the rate. The first quarter was 10 basis points, second quarter was 20 basis points, third quarter went to 30 basis points on an annualized basis. I believe the step-up impact Q2 to Q3 was $7 million pre-tax.
Got you. Okay. Thank you. The second question is more of a follow-up around capital deployment, capital management, potential for a buyback. I'll put it in this context. Rather than your stock price relative to GAAP book value. If I think back, if I've got the numbers right, I think back in 2009 when Apollo bought Aviva's U.S. Life and Annuity business, I believe the valuation was something like 60% of statutory book value. If I look at your stock today, your stock's trading at about 68, let's call it round number 70% of statutory book. I'll tell you, nine years later, it's clearly a significantly better operating environment. I would expect that Apollo would have had to pay something much greater than 60% of statutory book if that deal were done today.
How is there any real opportunity to deploy capital in a block transaction or even organic growth that is better than buying back your own stock here?
Yeah. Fair question. It's certainly something that we're evaluating as we think about our capital deployment plans for 2019 and beyond. I just want to check the numbers. I don't have it handy right here, but I believe our stat book value is just over somewhere between $8 and $850, as opposed to the current share price being at a significant discount to that. I think it's probably trading right on top or slightly less than current stat book value.
I was thinking about your statutory book adjusted for the interest maintenance reserve and the AVR.
Fair point.
I think that's north of $11.
Yeah, you're right. That's about $11. A little over 11 bucks.
Yeah.
Fair question, and look, as we're in the middle of our planning cycle and thinking about where are the best and most accretive places we can put capital. That's certainly on the list, and given where we are today, in today's trading environment. I don't have an answer for you today other than you make a very astute observation, and it's on our list, and we're thinking about it.
Okay. I think that's really important for shareholders to understand is that at least from the maybe, Chris, you can comment, but from sort of a board perspective, I realize there's a real desire to grow. Buying back the shares is not something that's off the table.
No, it's certainly not off the table. The board is having active discussions about capital. I think at this point in time, I think you've heard others comment. We do think that there are significant inorganic opportunities that we're pursuing that we think would provide better long-term value at this point in time. It is an active conversation, and we're trying to balance that with the other comments we hear from time to time, which is people can't get a large position in the shares because there's not a lot of liquidity in the stock. We're kind of trying to balance all of that and continue to believe that we have an opportunity to deploy our capital in new business and inorganic as a higher priority right now. It's an active conversation. It's not off the table, and we'll continue to consider it.
My two cents, I have very little sympathy for people not being able to buy a bigger position. Thanks.
All right.
Thanks, John.
ladies and gentlemen, this will conclude our question and answer session. I would now like to turn the conference back over to CEO Chris Blunt for closing remarks.
Thank you very much for your time this morning and your interest and investment in our company. I think we're demonstrating we've got strong sales momentum. Our AOI is growing significantly. We're delivering ROEs in excess of 15%, and we are just really creating real value that's going to emerge over the next several quarters, and we look forward to updating you on that as we go along in 2019. Thank you very much, and have a great rest of the day.
Thank you, sir. Ladies and gentlemen, the conference has now concluded. Thank you for attending today's presentation. You may now disconnect.