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| Share Name | Share Symbol | Market | Type |
|---|---|---|---|
| Midwest Holding Inc | NASDAQ:MDWT | NASDAQ | Common Stock |
| Price Change | % Change | Share Price | Bid Price | Offer Price | High Price | Low Price | Open Price | Shares Traded | Last Trade | |
|---|---|---|---|---|---|---|---|---|---|---|
| 0.00 | 0.00% | 26.99 | 26.00 | 27.05 | 0 | 01:00:00 |
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
COMMISSION FILE NUMBER 001-39812
(Exact name of registrant as specified in its charter)
Delaware |
| 20-0362426 |
(State or other jurisdiction of | (I.R.S. Employer Identification No.) | |
incorporation or organization) | ||
2900 S. 70th, Suite 400, Lincoln, NE | 68506 | |
(Address of principal executive offices) | (Zip Code) | |
Registrant’s telephone number, including area code: (402) 489-8266
Securities registered pursuant to Section 12(b) of the Act:
Title of each class: |
| Trading Symbol(s): Name of Each Exchange on Which Registered |
Voting Common Stock, $0.001 par value | MDWT The NASDAQ Stock Market, LLC |
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐
Indicate by check mark whether the registrant has submitted electronically, if any, every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer ☐ |
| Accelerated filer ☐ |
Non-accelerated filer ☒ | Smaller reporting company ☒ | |
Emerging growth company ☐ |
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or reviewed financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Act). Yes ☐ No ☒
As of November 14, 2022, there were 3,727,976 shares of the registrant’s Voting Common Stock, par value $0.001 per share, issued and outstanding.
1
MIDWEST HOLDING INC.
FORM 10-Q
TABLE OF CONTENTS
PART I – FINANCIAL INFORMATION
Item No. |
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7 | ||||
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Management’s Discussion and Analysis of Financial Condition and Results of Operations | 42 | |||
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62 | ||||
| ||||
62 |
PART II – OTHER INFORMATION
Item No. |
| Item Caption |
| Page |
63 | ||||
63 | ||||
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63 | ||||
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63 | ||||
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63 | ||||
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64 | ||||
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65 |
2
PART I – FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
MIDWEST HOLDING INC.
CONSOLIDATED BALANCE SHEETS
| September 30, 2022 |
| December 31, 2021 | |||
(In thousands, except share information) | (Unaudited) | |||||
Assets |
|
|
|
| ||
Fixed maturities, available for sale, at fair value | $ | 1,048,081 | $ | 683,296 | ||
Mortgage loans on real estate, held for investment |
| 204,423 |
| 183,203 | ||
Derivative instruments (See Note 5) | 11,840 | 23,022 | ||||
Equity securities, at fair value (cost: $10,256 in 2022 and $22,158 in 2021) | 9,325 | 21,869 | ||||
Other invested assets | 78,569 | 35,293 | ||||
Investment escrow | 344 | 3,611 | ||||
FHLB stock | 501 | 500 | ||||
Preferred stock | 21,579 | 18,686 | ||||
Notes receivable | 6,189 | 5,960 | ||||
Policy loans |
| 21 |
| 87 | ||
Total investments |
| 1,380,872 |
| 975,527 | ||
Cash and cash equivalents |
| 208,664 |
| 142,013 | ||
Deferred acquisition costs, net | 39,377 | 24,530 | ||||
Premiums receivable | 364 | 354 | ||||
Accrued investment income | 23,915 | 13,623 | ||||
Reinsurance recoverables (See Note 9) | 5,791 | 38,579 | ||||
Intangible assets |
| 700 |
| 700 | ||
Property and equipment, net |
| 1,990 |
| 386 | ||
Operating lease right of use assets | 2,179 | 2,360 | ||||
Receivable for securities sold | 13,026 | 19,732 | ||||
Other assets |
| 9,190 |
| 2,113 | ||
Total assets | $ | 1,686,068 | $ | 1,219,917 | ||
Liabilities and Stockholders’ Equity |
|
|
|
| ||
Liabilities: |
|
|
|
| ||
Benefit reserves | $ | 12,953 | $ | 12,941 | ||
Policy claims |
| 2,963 |
| 237 | ||
Deposit-type contracts (See Note 11) |
| 1,537,583 |
| 1,075,439 | ||
Advance premiums |
| 2 |
| 1 | ||
Deferred gain on coinsurance transactions |
| 35,464 |
| 28,589 | ||
Lease liabilities (See Note 13): | ||||||
Operating lease | 2,192 | 2,364 | ||||
Payable for securities purchased | 20,941 | 5,546 | ||||
Other liabilities | 34,100 | 9,044 | ||||
Total liabilities |
| 1,646,198 |
| 1,134,161 | ||
Stockholders’ Equity: |
|
| ||||
Preferred stock, $0.001 par value; authorized 2,000,000 shares; no shares issued and outstanding as of September 30, 2022 or December 31, 2021 |
|
| ||||
Voting common stock, $0.001 par value; authorized 20,000,000 shares; 3,727,976 shares and outstanding as of September 30, 2022 and 3,737,564 at , respectively; non-voting common stock, $0.001 par value, 2,000,000 shares authorized; no shares issued and outstanding September 30, 2022 and December 31, 2021, respectively |
| 4 |
| 4 | ||
Additional paid-in capital |
| 138,166 |
| 138,452 | ||
Treasury stock | (175) | (175) | ||||
Accumulated deficit |
| (53,276) |
| (70,159) | ||
Accumulated other comprehensive (loss) income |
| (52,943) |
| 2,634 | ||
Total Midwest Holding Inc.'s stockholders' equity | 31,776 | 70,756 | ||||
Noncontrolling interests | 8,094 | 15,000 | ||||
Total stockholders' equity |
| 39,870 |
| 85,756 | ||
Total liabilities and stockholders' equity | $ | 1,686,068 | $ | 1,219,917 | ||
See Notes to Consolidated Financial Statements.
3
MIDWEST HOLDING INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(Unaudited)
Three months ended September 30, | Nine months ended September 30, | ||||||||||||
(In thousands, except per share data) |
| 2022 |
| 2021 |
| 2022 |
| 2021 | |||||
Revenues |
|
|
|
|
|
| |||||||
Investment income, net of expenses | $ | 12,938 | $ | 6,196 | $ | 29,721 | $ | 12,303 | |||||
Net realized gain (loss) on investments (See Note 4) |
| 4,135 |
| (2,115) |
| (14,676) | (2,704) | ||||||
Amortization of deferred gain on reinsurance transactions | 1,239 | 662 | 3,251 | 1,711 | |||||||||
Service fee revenue, net of expenses | 118 | 628 | 1,632 | 1,738 | |||||||||
Other revenue |
| 569 |
| 400 |
| 1,530 | 1,007 | ||||||
Total revenue |
| 18,999 |
| 5,771 |
| 21,458 |
| 14,055 | |||||
Expenses |
|
|
|
|
|
|
|
| |||||
Interest credited |
| 5,682 |
| 284 |
| (6,489) | 1,868 | ||||||
Benefits | 1,351 | — | 2,345 | — | |||||||||
Amortization of deferred acquisition costs |
| 1,193 |
| 753 |
| 3,095 | 1,780 | ||||||
Salaries and benefits |
| 3,751 |
| 4,025 |
| 12,366 | 11,466 | ||||||
Other operating expenses |
| 2,317 |
| 4,124 |
| (1,744) | 6,769 | ||||||
Total expenses |
| 14,294 |
| 9,186 |
| 9,573 |
| 21,883 | |||||
Net income (loss) before income tax expense |
| 4,705 |
| (3,415) |
| 11,885 |
| (7,828) | |||||
Income tax benefit (expense) (See Note 8) |
| (1,250) |
| 351 |
| (3,848) | (1,828) | ||||||
Net income (loss) after income tax benefit (expense) | 3,455 | (3,064) | 8,037 | (9,656) | |||||||||
Less: Income attributable to noncontrolling interest | (3,976) | — | (8,846) | — | |||||||||
Net income (loss) attributable to Midwest Holding Inc. | 7,431 | (3,064) | 16,883 | (9,656) | |||||||||
Comprehensive income (loss): |
|
|
|
|
|
|
|
| |||||
Unrealized gains (losses) on investments arising during the three months ended September 2022 and 2021, net of offsets, net of tax ($5.4 million and $0.2 million, respectively); unrealized gains (losses) on investments arising during the nine months ended September 2022 and 2021, net of offsets, net of tax ($10.4 million and $0.2 million, respectively) |
| (26,114) |
| 1,085 |
| (55,483) | 2,421 | ||||||
Less: Reclassification adjustment for net realized losses on investments, net of offsets during the three months ended September 2022 and 2021 (net of tax ($19.9 million) and $0.1 million, respectively); reclassification adjustment for net realized losses on investments, net of offsets during the nine months ended September 2022 and 2021 (net of tax ($24.9 million) and $0.4 million, respectively) |
| (952) |
| (505) |
| (94) | (1,611) | ||||||
Other comprehensive income (loss) |
| (27,066) |
| 580 |
| (55,577) |
| 810 | |||||
Comprehensive loss | $ | (19,635) | $ | (2,484) | $ | (38,694) | $ | (8,846) | |||||
Impairment | |||||||||||||
Total other-than-temporary impairment | 346 | — | 880 | — | |||||||||
Net other-than-temporary impairment loss recognized in net income | $ | 346 | $ | — | $ | 880 | $ | — | |||||
Income (Loss) per common share | |||||||||||||
Basic | $ | 1.99 | $ | (0.82) | $ | 4.52 | $ | (2.58) | |||||
Diluted | $ | 1.96 | $ | (0.82) | $ | 4.45 | $ | (2.58) | |||||
See Notes to Consolidated Financial Statements.
4
MIDWEST HOLDING INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(Unaudited)
Three months ended September 30, | |||||||||||||||||||||
Additional | |||||||||||||||||||||
Treasury | Common | Paid-In | Retained | Noncontrolling | Total | ||||||||||||||||
(In thousands) |
| Stock |
| Stock |
| Capital |
| Earnings |
| AOCI* |
| Interest |
| Equity | |||||||
Balance at June 30, 2022 | $ | (175) | $ | 4 | $ | 138,838 | $ | (60,707) | $ | (25,877) | $ | 12,413 | $ | 64,496 | |||||||
Net income |
| — |
| — |
| — |
| 7,431 |
| — |
| — |
| 7,431 | |||||||
Employee stock options | — | — | (672) | — | — | — | (672) | ||||||||||||||
Unrealized gains on investments, net of taxes | — | — | — | — | (27,066) | — | (27,066) | ||||||||||||||
Noncontrolling interest | — | — | — | — | — | (4,319) | (4,319) | ||||||||||||||
Balance, September 30, 2022 | $ | (175) | $ | 4 | $ | 138,166 | $ | (53,276) | $ | (52,943) | $ | 8,094 | $ | 39,870 | |||||||
Balance at June 30, 2021 | $ | (175) | $ | 4 | $ | 135,233 | $ | (60,114) | $ | 6,661 | $ | — | $ | 81,609 | |||||||
Net (loss) | — | — | — | (3,064) | — | — | (3,064) | ||||||||||||||
Additional capital raise related expenses | — | — | 7 | — | — | — | 7 | ||||||||||||||
Employee stock options | — | — | 996 | — | — | — | 996 | ||||||||||||||
Unrealized gains on investments, net of taxes | — | — | — | — | 580 | — | 580 | ||||||||||||||
Balance, September 30, 2021 | $ | (175) | $ | 4 | $ | 136,236 | $ | (63,178) | $ | 7,241 | $ | — | $ | 80,128 | |||||||
Nine months ended September 30, | |||||||||||||||||||||
Additional | |||||||||||||||||||||
Treasury | Common | Paid-In | Retained | Noncontrolling | Total | ||||||||||||||||
(In thousands) |
| Stock |
| Stock |
| Capital |
| Earnings |
| AOCI* |
| Interest |
| Equity | |||||||
Balance, December 31, 2021 | $ | (175) | $ | 4 | $ | 138,452 | $ | (70,159) | $ | 2,634 | $ | 15,000 | $ | 85,756 | |||||||
Net income | — | — | — | 16,883 | — | — | 16,883 | ||||||||||||||
Employee stock options | — | — | (286) | — | — | — | (286) | ||||||||||||||
Unrealized gains on investments, net of taxes | — | — | — | — | (55,577) | — | (55,577) | ||||||||||||||
Noncontrolling interest | — | — | — | — | — | (6,906) | (6,906) | ||||||||||||||
Balance, September 30, 2022 | $ | (175) | $ | 4 | $ | 138,166 | $ | (53,276) | $ | (52,943) | $ | 8,094 | $ | 39,870 | |||||||
Balance at December 31, 2020 | $ | (175) | $ | 4 | $ | 133,592 | $ | (53,522) | $ | 6,431 | $ | — | $ | 86,330 | |||||||
Net (loss) |
| — |
| — |
| — |
| (9,656) |
| — |
| — |
| (9,656) | |||||||
Additional capital raise related expenses | — | — | (121) | — | — | — | (121) | ||||||||||||||
Employee stock options | — | — | 2,765 | — | — | — | 2,765 | ||||||||||||||
Unrealized losses on investments, net of taxes | — | — | — | — | 810 | — | 810 | ||||||||||||||
Balance, September 30, 2021 | $ | (175) | $ | 4 | $ | 136,236 | $ | (63,178) | $ | 7,241 | $ | — | $ | 80,128 | |||||||
*Accumulated other comprehensive income (loss)
See Notes to Consolidated Financial Statements.
5
MIDWEST HOLDING INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
| Nine months ended September 30, | |||||
(In thousands) | 2022 |
| 2021 | |||
Cash Flows from Operating Activities: |
|
|
|
| ||
Income (loss) attributable to Midwest Holding, Inc. | $ | 16,883 | $ | (9,656) | ||
Adjustments to arrive at cash provided by operating activities: |
|
|
|
| ||
Net premium and discount on investments |
| (6,982) |
| (1,529) | ||
Depreciation and amortization |
| 229 |
| 38 | ||
Stock options |
| (287) |
| 2,765 | ||
Amortization of deferred acquisition costs | 3,095 | 1,780 | ||||
Deferred acquisition costs capitalized | (18,285) | (12,449) | ||||
Net realized loss on investments |
| 14,676 |
| 2,704 | ||
Deferred gain on coinsurance transactions |
| 6,875 |
| 9,601 | ||
Changes in operating assets and liabilities: |
|
|
|
| ||
Reinsurance recoverable | 33,698 | (6,659) | ||||
Interest and dividends due and accrued |
| (10,292) |
| (5,368) | ||
Premiums receivable |
| (10) |
| (20) | ||
Deposit-type liabilities | (17,245) | — | ||||
Policy liabilities |
| 2,740 |
| 14,763 | ||
Receivable and payable for securities | 22,100 | — | ||||
Other assets and liabilities |
| 17,697 |
| 4,947 | ||
Net cash provided by operating activities |
| 64,892 |
| 917 | ||
Cash Flows from Investing Activities: |
|
|
|
| ||
Fixed maturities available for sale: |
|
|
|
| ||
Purchases |
| (692,348) |
| (480,700) | ||
Proceeds from sale or maturity |
| 296,179 |
| 204,452 | ||
Mortgage loans on real estate, held for investment |
|
| ||||
Purchases | (75,985) | (97,075) | ||||
Proceeds from sale | 58,033 | 25,749 | ||||
Derivatives | ||||||
Purchases | (22,981) | (14,496) | ||||
Proceeds from sale | 3,232 | 4,314 | ||||
Equity securities | ||||||
Purchases | — | (38,972) | ||||
Proceeds from sale | 12,772 | — | ||||
Other invested assets | ||||||
Purchases | (48,302) | (58,437) | ||||
Proceeds from sale | 3,334 | 34,965 | ||||
Purchase of restricted common stock | (1) | (500) | ||||
Preferred stock | (2,893) | (3,128) | ||||
Net change in policy loans |
| 66 |
| (9) | ||
Net purchases of property and equipment |
| (1,830) |
| (54) | ||
Net cash (used in) investing activities |
| (470,724) |
| (423,891) | ||
Cash Flows from Financing Activities: |
|
|
|
| ||
Net transfer to noncontrolling interest | (6,906) | — | ||||
Capital contribution | — | (121) | ||||
Receipts on deposit-type contracts |
| 509,660 |
| 367,446 | ||
Withdrawals on deposit-type contracts |
| (30,271) |
| (14,543) | ||
Net cash provided by financing activities |
| 472,483 |
| 352,782 | ||
Net increase (decrease) in cash and cash equivalents |
| 66,651 |
| (70,192) | ||
Cash and cash equivalents: |
|
|
|
| ||
Beginning |
| 142,013 |
| 151,679 | ||
Ending | $ | 208,664 | $ | 81,487 | ||
Supplementary information |
|
|
|
| ||
Cash paid for taxes | $ | 2,870 | $ | 3,711 | ||
See Notes to Consolidated Financial Statements.
6
MIDWEST HOLDING INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1. Nature of Operations and Basis of Presentation
Nature of Operations
Midwest Holding Inc. (“Midwest,” “the Company,” “we,” “our,” or “us”) was incorporated in Nebraska on October 31, 2003, for the primary purpose of operating a financial services company. The Company redomesticated from the State of Nebraska to the State of Delaware on August 27, 2020. The Company is in primarily the life and annuity insurance business and operates through its wholly owned subsidiaries, American Life & Security Corp. (“American Life”), and 1505 Capital LLC (“1505 Capital”) as well as through its sponsored captive reinsurance company, Seneca Reinsurance Company, LLC (“Seneca Re”).
American Life is a Nebraska-domiciled life insurance company that is currently licensed to sell, underwrite, and market life insurance and annuity products in 22 states and the District of Columbia.
Effective March 12, 2020, Seneca Re, a Vermont limited liability company, was formed by Midwest to operate as a sponsored captive insurance company for the purpose of insuring and reinsuring various types of risks of its participants through one or more protected cells and to conduct any other business or activity that is permitted for sponsored captive insurance companies under Vermont insurance regulations. On March 30, 2020, Seneca Re received its Certification of Authority to transact the business of a captive insurance company. On May 12, 2020, Midwest contributed $0.3 million to Seneca Re for a 100% ownership interest. On April 15, 2020, Midwest entered into an operating agreement with Seneca Re and as of September 30, 2022, Seneca Re has three incorporated cells, Seneca Incorporated Cell, LLC 2020-01 (“SRC1”) and Seneca Re Protected Cell 2021-03 (“SRC3”) which are consolidated in our financial statements, as well as Seneca Re Protected Cell LLC 2022-04 (“SRC4”) which was incorporated on June 29, 2022, and is not consolidated into our financial statements.
Midwest owned a 100% interest in SRC1 by contributing a total of $21.4 million. On December 30, 2021, Midwest closed the sale of approximately 70% of SRC1 to a subsidiary of ORIX Corporation USA (“ORIX USA”) for $15.0 million. Under the terms of the agreement, Midwest now holds a 30% ownership interest in SRC1. ORIX Advisers, LLC, another subsidiary of ORIX USA, is the manager of the assets underlying SRC1’s reinsurance obligations going forward, replacing Midwest’s asset management arm, 1505 Capital.
On April 2, 2019, we obtained a 51% ownership in 1505 Capital, a Delaware limited liability company, that was established in 2018 to provide financial and investment advisory and management services to clients and related investment activities. On June 15, 2020, we purchased the remaining 49% ownership in 1505 Capital for $0.5 million. 1505 Capital’s financial results have been consolidated with the Company’s since the date of its acquisition.
On July 27, 2020, American Life entered into a reinsurance agreement (the “Reinsurance Agreement”) with a new protected cell formed by Seneca Re (Seneca Incorporated Cell, LLC 2020-02 (“SRC2”)). SRC2 was capitalized by Crestline Management, L.P. (“Crestline”), a significant shareholder of Midwest via a Crestline subsidiary, Crestline Re SPC1. The Reinsurance Agreement, which was effective as of April 24, 2020, and was entered into pursuant to a Master Letter Agreement (the “Master Agreement”) dated and effective as of April 24, 2020, among American Life, Seneca Re and Crestline. The Reinsurance Agreement supports American Life’s new business production by providing reinsurance capacity for American Life to write certain kinds of fixed and multi-year guaranteed annuity products. Concurrently with the Reinsurance Agreement:
| ● | American Life and SRC2 each entered into investment management agreements with Crestline, pursuant to which Crestline manages the assets that support the reinsured business; and |
| ● | American Life and SRC2 entered into a trust agreement whereby SRC2 maintains for American Life’s benefit a trust account that supports the reinsured business. |
Under the Master Agreement, Crestline agreed to provide reinsurance funding for a quota share percentage of 25% of the liabilities of American Life arising from its multi-year guaranteed annuities (“MYGA”) and a quota share percentage of 40% for American Life’s fixed indexed annuity (“FIA”) products. The Master Agreement expires on April 24, 2023.
7
In addition, pursuant to the Master Agreement (as subsequently amended), the parties thereto have agreed to enter into a separate agreement whereby, among other things and subject to certain conditions, American Life will agree to reinsure additional new business production to one or more reinsurers formed and/or capitalized by Crestline, Midwest or an appropriate affiliate will be compensated for providing administrative services to certain advisory clients of Crestline, and American Life will consider investing in certain assets originated or sourced by Crestline.
On June 26, 2021, the Nebraska Department of Insurance (‘NDOI”) issued its non-disapproval of the Modified Coinsurance Agreement (“Modco AEG Agreement”) of American Life with American Republic Insurance Company (“AEG”), an Iowa domiciled reinsurance company. The agreement closed on June 30, 2021. Under the Modco AEG Agreement, American Life cedes to AEG, on a modified coinsurance basis, 20% quota share of certain liabilities with respect to its MYGA-5 business and an initial 20% quota share of certain liabilities with respect to its FIA products. American Life has established a Modco Deposit Account to hold the assets for the Modco Agreement. The initial settlement included net premium of $37.5 million and net reserves of $34.8 million for the modified coinsurance account. The amount paid to the Modified Deposit Account from AEG was $2.4 million.
On November 10, 2021, Midwest purchased 100% ownership of an intermediary holding company for $5.7 million, which company thereupon contributed capital of $5.5 million to purchase 100% of SRC3 Class A and B capital stock. Also, on November 10, 2021, American Life and SRC3 entered into a Funds Withheld and Modified Coinsurance Agreement, whereby, SRC3 agreed to provide reinsurance funding for a quota share percentage of 45% of the liabilities of American Life arising from its MYGA and quota share percentage of 45% of American Life’s FIA products.
On September 30, 2022, American Life entered into a reinsurance agreement (the “Reinsurance Agreement”) with a new protected cell formed by Seneca Re (Seneca Incorporated Cell, LLC 2022-04 (“SRC4”)). SRC4 was capitalized by loans from Embrace Software, Inc (“Embrace”) and Tillman Networks LLC (“Tillman”). The Reinsurance Agreement was effective as of July 1, 2022, among American Life and Seneca Re. The Reinsurance Agreement supports American Life’s new business production by providing reinsurance capacity for American Life to write certain kinds of fixed and multi-year guaranteed annuity products. Under the Reinsurance Agreement, SRC4 agreed to provide reinsurance funding for a quota share percentage of 45% of the liabilities of American Life arising from its MYGA-5 products and a quota share percentage of 10% for MYGA-3 products. American Life has established a Modco Deposit Account, a Funds Withheld custody account, and a Trust Account pursuant to the Reinsurance Agreement. The initial settlement included net premium of $21.4 million and net reserves of $21.5 million for the modified coinsurance account.
Also on September 30, 2022, American Life entered into an Investment Management Agreement (“IMA”) with CoVenture Management, LLC (“CoVenture”) naming CoVenture as the manager of certain assets held by American Life on behalf of SRC4.
Management evaluates the Company as one reporting segment in the life insurance industry. The Company is primarily engaged in the underwriting and marketing of annuity products through American Life, and then reinsuring such products with third-party reinsurers, and since May 13, 2020, with Seneca Re protected cells. American Life’s legacy product offerings consisted of a multi-benefit life insurance policy that combined cash value life insurance with a tax deferred annuity and a single premium term life product. American Life presently offers six annuity products: two MYGAs, two FIAs, and two bonus plans associated with the FIA product. It is not presently offering any traditional life insurance products.
Basis of Presentation
These financial statements include all adjustments, consisting of only normal recurring adjustments, which are necessary to make our financial position at September 30, 2022, and the results of our operations for the three and nine months ended September 30, 2022 and 2021 not misleading. As permitted by the rules and regulations of the Securities and Exchange Commission (“SEC”), the accompanying condensed consolidated financial statements do not include all disclosures normally required by generally accepted accounting principles in the United States of America (“GAAP”). These financial statements should be read in conjunction with the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2021 on file with the SEC. In our opinion, the condensed consolidated financial statements are a fair presentation of the financial position, results of operations, changes in stockholders’ equity and cash flows for the periods presented. The results of operations for the three and nine months ended September 30, 2022, are not necessarily indicative of the results of operations to be expected for the full fiscal year ending December 31, 2022.
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The following is a summary of our significant accounting policies and estimates. These accounting policies inherently require significant judgment and assumptions, and actual operating results could differ significantly from management’s estimates determined using these policies. We believe the following accounting policies, judgments and estimates are the most critical to the understanding of our results of operations and financial position. All intercompany accounts and transactions have been eliminated in consolidation and certain immaterial reclassifications have been made to the prior period results to conform to the current period’s presentation with no impact on results of operations or total stockholders’ equity.
Fixed Maturities
All fixed maturities owned by the Company are considered available-for-sale and are included in the consolidated financial statements at their fair value as of the financial statement date. Premiums and discounts on fixed maturity debt instruments are amortized using the scientific-yield method over the term of the instruments. Realized gains and losses on securities sold during the year are determined using the specific identification method. Unrealized holding gains and losses, net of applicable income taxes, are included in accumulated other comprehensive income (loss).
Declines in the fair value of available-for-sale securities below their amortized cost are evaluated to assess whether any other-than-temporary impairment loss should be recorded. In determining if these losses are expected to be other-than-temporary, the Company considers severity of impairment, duration of impairment, forecasted recovery period, industry outlook, the financial condition of the issuer, issuer credit ratings, and the intent and ability of the Company to hold the investment until the recovery of the cost.
The recognition of other-than-temporary impairment losses on debt securities is dependent on the facts and circumstances related to the specific security. If the Company intends to sell a security or it is more likely than not that the Company would be required to sell a security prior to recovery of the amortized cost, the difference between amortized cost and fair value is recognized in the statement of comprehensive income as an impairment. If the Company does not expect to recover the amortized basis, does not plan to sell the security, and if it is not more likely than not that the Company would be required to sell a security before the recovery of its amortized cost, the recognition of the impairment is bifurcated. The Company recognizes the credit loss portion as realized losses and the noncredit loss portion in accumulated other comprehensive loss. The credit component of other-than-temporary impairment is determined by comparing the net present value of projected cash flows with the amortized cost basis of the debt security. The net present value is calculated by discounting the Company’s best estimate of projected future cash flows at the effective interest rate implicit in the fixed income security at the date of acquisition. Cash flow estimates are driven by assumptions regarding probability of default, including changes in credit ratings, and estimates regarding timing and amount of recoveries associated with a default. The Company had no impairments recognized in this asset class as of September 30, 2022, 2021, or as of December 31, 2021.
Investment income consists of interest, dividends, gains and losses from equity method investments, and real estate income, which are recognized on an accrual basis along with the amortization of premiums and discounts.
Certain available-for-sale investments are maintained as collateral under funds withheld (“FW”) and modified coinsurance (“Modco”) agreements but the assets and total returns or losses on the asset portfolios belong to the third-party reinsurers. American Life has treaties with several third-party reinsurers that have FW and ModCo provisions. In a Modco agreement, the ceding entity retains the assets equal to the modified coinsurance reserves retained. In a FW agreement, assets that would normally be paid over to a reinsurer are withheld by the ceding company to permit statutory credit for unauthorized reinsurers to reduce the potential credit risk. The unrealized gains/losses on those investments are passed through to the third-party reinsurers as either a realized gain or loss on the Consolidated Statements of Comprehensive Loss.
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Mortgage loans on real estate, held for investment
Mortgage loans on real estate, held for investment are carried at unpaid principal balances. Interest income is recognized in net investment income at the contract interest rate when earned. A mortgage loan is considered to be impaired when it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the mortgage agreement. Valuation allowances for impairments on mortgage loans are established based upon losses expected by management to be realized in connection with future dispositions or settlements of mortgage loans, including foreclosures. The Company establishes valuation allowances for estimated impairments on an individual loan basis as of the balance sheet date. Such valuation allowances are based on the excess carrying value of the loan over the present value of expected future cash flows discounted at the loan’s original effective interest rate and disposition of collateral. These evaluations are revised as conditions change and new information becomes available. As of September 30, 2022, the Company held one asset valued at $7.7 million with a total impairment of $0.9 million. No such impairments were recognized as of December 31, 2021.
Derivative Instruments
Derivatives are used to hedge the risks experienced in our ongoing operations, such as equity, interest rate and cash flow risks, or for other risk management purposes, which primarily involve managing liability risks associated with our indexed annuity products and reinsurance agreements. Derivatives are financial instruments whose values are derived from interest rates, foreign exchange rates, financial indices, or other underlying notional amounts. Derivative assets and liabilities are carried at fair value on the consolidated balance sheets.
To qualify for hedge accounting, at the inception of the hedging relationship, the Company must formally document our designation of the hedge as a cash flow or fair value hedge and our risk management objective and strategy for undertaking the hedging transaction. In this documentation, we would identify how the hedging instrument is expected to hedge the designated risks related to the hedged item, the method that would be used to retrospectively and prospectively assess the hedging instrument’s effectiveness and the method which would be used to measure ineffectiveness. A derivative designated as a hedging instrument must be assessed as being highly effective in offsetting the designated risk of the hedged item. Hedge effectiveness would be formally assessed at inception and periodically throughout the life of the designated hedging relationship.
During the last quarter of 2020, the Company began investing in futures to hedge the fluctuations in various aspects of our business. The formal documentation and hedge effectiveness was not completed at the date we entered into those futures contracts; therefore, they do not qualify for hedge accounting. The futures change in fair market values were recorded on our consolidated statement of comprehensive loss as realized gains or (losses).
Additionally, reinsurance agreements written on a FW or Modco basis contain embedded derivatives on our annuity products. Gains or (losses) associated with the performance of assets maintained in the modified coinsurance deposit and funds withheld accounts are reflected as realized gains or (losses) in the consolidated statement of comprehensive loss.
Equity Securities
Equity securities at September 30, 2022, consisted of exchange traded funds (“ETFs”). The ETFs are carried at fair value with the change in fair value recorded through realized gains and losses in the Consolidated Statements of Comprehensive Loss. As of September 30, 2022, and December 31, 2021, we held $9.3 million and $21.9 million of ETFs, respectively.
Federal Home Loan Bank
American Life purchased Federal Home Loan Bank of Topeka (“FHLB”) common stock on May 5, 2021. This investment was to solidify our membership with FHLB Topeka. The carrying value of FHLB stock approximates fair value since the Company can redeem the stock with FHLB at cost. As a member of the FHLB, the Company is required to purchase this stock, which is carried at cost and classified as restricted equity securities.
Membership allows access to various funding arrangements to provide a source of additional liquidity. As of September 30, 2022, the Company had pledged assets with a market value of $37.9 million to FHLB to allow a borrowing capacity of $34.5 million. As of September 30, 2022 and 2021 and December 31, 2021, there were no such outstanding funding arrangements.
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Other invested assets
Other invested assets of approximately $78.6 million primarily consist of approximately $45.0 million of collateral loans, and $33.6 million of private credit, and equipment leases. Also, we had an initial investment of $19.0 million investment in a private fund between American Life and an unaffiliated entity, PF Collinwood Holdings, LLC (“PFC”), with American Life owning 100% of the entity effective January 2021. No gain or loss was recognized from the repackaging of PFC. The statement value approximates the fair value of the PFC investment as of September 30, 2022, and December 31, 2021, of $13.9 million and $14.5 million, respectively, with the change in fair market value recorded in unrealized gains and losses in equity on the balance sheet. On February 2, 2022, we established a special purpose vehicle, Python Asset Holding LLC, with American Life owning 100% of the entity with an initial investment of $7.4 million. As of September 30, 2022, our investment in Python was carried at the net investment value (“NAV”) plus approximately $0.3 million of investment income.
Investment escrow
The Company held in escrow $0.3 million and $3.6 million as of September 30, 2022, and December 31, 2021, respectively. The funds held in escrow were used to settle mortgage loan investments that closed in October 2022, and January 2022, respectively.
Preferred Stock
The Company held a perpetual preferred stock investment of $10.0 million as of September 30, 2022, and December 31, 2021, respectively. The change in fair market value is recorded in net investment income on the Statement of Comprehensive Loss.
In 2020 American Life entered into a series of transactions with an unaffiliated entity, Ascona Group Holdings Ltd (“AGH”). Through these transactions American Life acquired preferred equity in AGH in British Pound Sterling (“GBP”) of 3.6 million along with warrants bearing no initial assigned value. American Life subsequently created a special purpose vehicle, Ascona Asset Holding LLC (“AAH”), to hold the preferred equity and warrants, and later created Ascona Collinwood HoldCo LLC (“ACH”) to be the sole member of AAH. American Life and Crestline Re SP1 own 74% and 26%, respectively, of ACH. American Life is carrying the preferred equity and warrants at a market value in USD of $9.3 million as of September 30, 2022, and $8.7 million as of December 31, 2021. The change in market value for the preferred stock and warrants of $1.9 million was recorded in net investment income on the Consolidated Statements of Comprehensive Loss. Of the $1.9 million of investment income $0.5 million was attributable to the noncontrolling interest held by Crestline Re SP1.
Notes receivable
The Company held notes receivable carried at fair value of $6.2 and $6.0 million as of September 30, 2022, and December 31, 2021, respectively between American Life and a related party. The note receivable has an annual interest rate of 5% which is paid-in-kind (“PIK”) interest per annum that increases the outstanding note balance. This note was rated BBB+ by a nationally recognized statistical rating organization. This note matures on June 18, 2050. See Note 18 – Related Party – Chelsea for details regarding this note.
Policy loans
Policy loans are carried at unpaid principal balances. Interest income on policy loans is recognized in net investment income at the contract interest rate when earned. No valuation allowance is established for these policy loans as the amount of the loan is fully secured by the death benefit of the policy and cash surrender value.
Cash and cash equivalents
The Company considers all liquid investments with original maturities of three months or less when purchased to be cash equivalents. As of September 30, 2022, and December 31, 2021, the Company held approximately GBP 0.2 million and GBP 2.2 million in several of our custody accounts, respectively. The USD equivalent held was approximately $0.2 million and $3.0 million, respectively. As of September 30, 2022, and December 31, 2021, the Company held less than approximately Euro 0.1 million and 9.3 million, respectively. The USD equivalent held was approximately $0.1 million and $10.6 million, respectively. For the three months ended September 30, 2022, and 2021, we had realized gains of approximately $0.8 million and $0.1
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million respectively, related to the change in the foreign currency exchange rate of the GBP and Euro that were recorded in realized (losses) gains on investments in the Consolidated Statements of Comprehensive Loss. For the nine months ended September 30, 2022, and 2021, we had realized gains of $1.3 million approximately and $0.1 million respectively, related to the change in the foreign currency exchange rate of the GBP and Euro that were recorded in realized (losses) gains on investments in the Consolidated Statements of Comprehensive Loss. The Company had no money market investments as of September 30, 2022, and December 31, 2021.
Deferred acquisition costs
Deferred acquisition costs (“DAC”) consist of incremental direct costs, net of amounts ceded to third-party reinsurers, that result directly from and are essential to the contract acquisition transaction and would not have been incurred by the Company had the contract acquisition not occurred. These costs are capitalized, to the extent recoverable, and amortized over the life of the premiums produced. The Company evaluates the types of acquisition costs it capitalizes. The Company capitalizes agent compensation and benefits and other expenses that are directly related to the successful acquisition of contracts. The Company also capitalizes expenses directly related to activities performed by the Company, such as underwriting, policy issuance, and processing fees incurred in connection with successful contract acquisitions.
Recoverability of deferred acquisition costs is evaluated periodically by comparing the current estimate of the present value of expected pretax future profits to the unamortized asset balance. If this current estimate is less than the existing balance, the difference is charged to expense. The Company performs a recoverability analysis annually in the fourth quarter unless events occur which in management’s judgement require an immediate review. The Company performed a recoverability analysis during the fourth quarter of 2021 and determined that all DAC balances were recoverable as of December 31, 2021. The Company determined that no events occurred in the nine months ended September 30, 2022, that suggest a review should be undertaken.
Property and equipment
Property and equipment are stated at cost net of accumulated depreciation. Annual depreciation is primarily computed using straight-line methods for financial reporting and straight-line and accelerated methods for tax purposes. Furniture and equipment is depreciated over 3 to 7 years and computer software and equipment is generally depreciated over 3 years. Depreciation expense totaled $0.1 million and less than $0.1 million for the three months ended September 30, 2022, and 2021, respectively. Depreciation expense totaled $0.2 million and less than $0.1 million for the nine months ended September 30, 2022, and 2021, respectively. Accumulated depreciation totaled $1.3 million and $1.1 million as of September 30, 2022, and December 31, 2021, respectively.
During the first quarter of 2021, the Company began the implementation of a new cloud-based enterprise resource planning and enterprise performance management system. The Company capitalized related consultation and support expenses relating to this system and began amortizing these fees over a period of five years starting in 2022. The useful life of the system has been estimated at five years in accordance with guidance in ASC 350, Intangibles – Goodwill and Other (as updated by ASU 2018-15). At September 30, 2022, and December 31, 2021, the Company had capitalized approximately $1.4 million and $1.2 million of expenses incurred respectively. This software was implemented in the first quarter of 2022.
Maintenance and repairs are expensed as incurred. Replacements and improvements which extend the useful life of the asset are capitalized. The net book value of assets sold or retired are removed from the accounts, and any resulting gain or loss is reflected in earnings.
Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. An impairment loss is recognized if the carrying amount of an asset may not be recoverable and exceeds estimated future undiscounted cash flows of the asset. A recognized impairment loss reduces the carrying amount of the asset to its fair value. The Company determined that no such events occurred that in the periods covered by the Consolidated Financial Statements would indicate the carrying amounts may not be recoverable.
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Reinsurance
In the normal course of business, the Company seeks to limit any single exposure to losses on large risks by purchasing reinsurance. The amounts reported in the Consolidated Balance Sheets as reinsurance recoverable include amounts billed to reinsurers on losses paid as well as estimates of amounts expected to be recovered from reinsurers on insurance liabilities that have not yet been paid. Reinsurance recoverable on unpaid losses are estimated based upon assumptions consistent with those used in establishing the liabilities related to the underlying reinsured contracts. Insurance liabilities are reported gross of reinsurance recoverable. Management believes the recoverables are appropriately established. The Company generally strives to diversify its credit risks related to reinsurance ceded. Reinsurance does not extinguish the Company’s primary liability under the policies written. Therefore, the Company regularly evaluates the financial condition of its reinsurers including their activities with respect to claim settlement practices and commutations and establishes allowances for uncollectible reinsurance recoverable as appropriate. There were no allowances established as of September 30, 2022, and 2021, or December 31, 2021.
We seek to reinsure substantially all of our new annuity policies with a variety of reinsurers in exchange for upfront ceding commissions, expense reimbursements and administrative fees. Under these reinsurance agreements, we expect there will be a monthly or quarterly settlement of premiums, claims, surrenders, collateral, and other administration fees. We believe this will help preserve American Life’s capital while supporting its growth because American Life will have lower capital requirements when its business is reinsured due to lower overall financial exposure versus retaining the insurance policy business itself. See Note 9 below for further discussion of our reinsurance activities.
There are two main categories of reinsurance transactions: 1) “indemnity,” where we cede a portion of our risk but retain the legal responsibility to our policyholders should our reinsurers not meet their financial obligations; and 2) “assumption,” where we transfer the risk and legal responsibilities to the reinsurers. The reinsurers are required to acquire the appropriate regulatory and policyholder approvals to convert indemnity policies to assumption policies.
Our reinsurers may be domestic or foreign capital markets investors or traditional reinsurance companies seeking to assume U.S. insurance business. We plan to mitigate the credit risk relating to reinsurers generally by requiring other financial commitments from the reinsurers to secure the reinsured risks (such as posting substantial collateral). It should be noted that under indemnity reinsurance agreements American Life remains exposed to the credit risk of its reinsurers. If one or more reinsurers become insolvent or are otherwise unable or unwilling to pay claims under the terms of the applicable reinsurance agreement, American Life retains legal responsibility to pay policyholder claims, which, in such event would likely materially and adversely affect the capital and surplus of American Life.
Midwest formed Seneca Re in early 2020, followed by Seneca Incorporated Cell, LLC 2020-01 (“SRC1”) and Seneca Incorporated Cell, LLC 2021-03 (“SRC3”), which are consolidated in our financial statements. Midwest sold 70% ownership of SRC1 to ORIX USA on December 30, 2021, and retained 30% ownership. Midwest maintains control over SRC1 and we continue to consolidate SRC1 in our financial statements and eliminate the noncontrolling interest. Additionally, Seneca Re has established Seneca Incorporated Cell, LLC 2022-04, however management has determined that Midwest does not control the entity and thus it is not consolidated into these financial statements.
Some reinsurers are not and may not be “accredited” or qualified as reinsurers under Nebraska law and regulations. In order to enter into reinsurance agreements with such reinsurers and to reduce potential credit risk, American Life holds a deposit or withholds funds from the reinsurer or requires the reinsurer to maintain a trust that holds assets backing up the reinsurer’s obligation to pay claims on the annuity policies American Life issues. The reinsurer may also appoint an investment manager for such funds, which in some cases may be our investment adviser subsidiary, 1505 Capital, to manage these assets pursuant to guidelines adopted by us that are consistent with Nebraska insurance investment statutes and applicable insurance regulations.
American Life currently has treaties with several third-party reinsurers and one related party reinsurer. In a Modco agreement, the ceding entity retains the assets equal to the modified coinsurance reserves retained. In a FW agreement, assets that would normally be paid over to a reinsurer are withheld by the ceding company to permit statutory credit for unauthorized reinsurers, to reduce the potential credit risk. Under those provisions with third-party reinsurers, the assets backing the treaties are maintained by American Life as investments but the assets and total returns or losses on the investments are owned by the reinsurers. Under GAAP, this arrangement is considered an embedded derivative as discussed in Comprehensive loss and Note 5 – Derivative Instruments below.
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Assets carried as investments on American Life’s financial statements for the third-party reinsurers contained cumulative unrealized losses of approximately $14.4 million as of September 30, 2022, and cumulative unrealized gains of $0.2 million at December 31, 2021, respectively. The terms of the contracts with the third-party reinsurers provide that the changes in unrealized gains and losses on the portfolios accrue to the third-party reinsurers. To recognize changes in the third-party unrealized gain (loss), American Life records the year-to-date change in the Consolidated Statements of Comprehensive Loss and in amounts recoverable from third-party reinsurers on the Consolidated Balance Sheet. As of September 30, 2022, American Life recognized a current year gain in the embedded derivative of $14.6 million and a gain in the embedded derivative of $0.9 million for the comparable period in 2021. For further discussion see Note 5. Derivative Instruments, below.
Benefit reserves
The Company establishes liabilities for amounts payable under insurance policies, including traditional life insurance and annuities. Generally, amounts are payable over an extended period of time. Liabilities for future policy benefits of traditional life insurance have been computed by a net level premium method based upon estimates at the time of issue for investment yields, mortality, and withdrawals. These estimates include provisions for experience less favorable than initially expected. Mortality assumptions are based on industry experience expressed as a percentage of standard mortality tables.
Policy claims
Policy claims are based on reported claims plus estimated incurred but not reported claims developed from trends of historical data applied to current exposure.
Deposit-type contracts
Deposit-type contracts consist of amounts on deposit associated with deferred annuities, premium deposit funds and supplemental contracts without life contingencies.
Deferred gain on coinsurance transactions
American Life has entered into several reinsurance contracts where it has earned or is earning ceding commissions. These ceding commissions are recorded as a deferred liability and amortized over the life of the business ceded. American Life receives commission and administrative expenses from reinsurance transactions that represent recovery of acquisition costs. These remittances first reduce the DAC associated with the reinsured blocks of business with the remainder being included in the deferred gain on coinsurance transactions that is also being amortized.
Income taxes
The Company is subject to income taxes in the U.S. federal and various state jurisdictions. Tax regulations within each jurisdiction are subject to the interpretation of the related tax laws and regulations and require significant judgment to apply. With few exceptions, the Company is no longer subject to U.S. federal, state, or local tax examinations by tax authorities for the years before 2019. The Company is not currently under examination for any open years for income taxes. The provision for income taxes is based on income as reported in the financial statements. The income tax provision is calculated under the asset and liability method. Deferred tax assets are recorded based on the differences between the financial statement and tax basis of assets and liabilities at the enacted tax rates. The principal assets and liabilities giving rise to such differences are investments, insurance reserves, and DAC. A deferred tax asset valuation allowance is established when there is uncertainty that such assets would be realized. The Company has no uncertain tax positions that it believes are more-likely-than not that the benefit will not to be realized. When applicable, the Company recognizes interest accrued related to unrecognized tax benefits and penalties in income tax expense.
Revenue recognition and related expenses
Amounts received as payment for annuities are recognized as deposits to policyholder account balances and are included in deposit-type liabilities. Revenues from these contracts are comprised of fees earned for administrative and contract-holder services and cost of insurance, which are recognized over the period of the contracts, and included in revenue. Deposits are shown as a financing activity in the consolidated statements of cash flows.
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Revenues on traditional life insurance products consist of direct and assumed premiums reported as earned when due.
Liabilities for future policy benefits are provided and acquisition costs are amortized by associating benefits and expenses with earned premiums to recognize related profits over the life of the contracts. Acquisition costs are amortized over the expected life of the annuity contracts.
Service fee revenue is comprised of third-party administration (“TPA”) fees and investment management fees:
| ● | TPA fees are related to accounting services performed based on service agreements with varying lengths. Revenue associated with TPA fees are only recognized when the services are performed, which is typically on a monthly or quarterly basis. |
| ● | Investment management fees are based on the total assets managed for each client at a contracted rate. The length of term on the contracts varies by client. The Company accrues investment management fees and recognizes revenue based on the market value of the client’s assets at the end of the applicable period, at the client’s contracted rate. |
Comprehensive loss
Comprehensive loss is comprised of net income (loss) and other comprehensive loss. Other comprehensive loss includes unrealized gains and losses from fixed maturities classified as available for sale and unrealized gains and losses from foreign currency transactions, net of applicable taxes. American Life has treaties with several third-party reinsurers that have FW and Modco provisions. Under those provisions, the assets backing the treaties are maintained by American Life as collateral but are owned by the third-party reinsurers; thus, the total return on the asset portfolio belongs to the third-party reinsurers. Under GAAP this is considered an embedded derivative as discussed above under “Reinsurance” and in Note 5 below.
Assets carried as investments on American Life’s financial statements for the third-party reinsurers contained cumulative unrealized losses of approximately $14.4 million as of September 30, 2022, and cumulative unrealized gains of $0.2 million as of December 31, 2021, respectively. The terms of the contracts with the third-party reinsurers provide that the changes in unrealized gains and losses on the portfolios accrue to the third-party reinsurers. To recognize changes in the third-party unrealized gain (loss), American Life records the year-to-date change in the Consolidated Statements of Comprehensive Loss and in amounts recoverable from third-party reinsurers on the Consolidated Balance Sheet. As of September 30, 2022, American Life recognized a current year gain in the embedded derivative of $14.6 million and a gain in the embedded derivative of $0.9 million for the comparable period in 2021. For further discussion see Note 5. Derivative Instruments below.
Basic income (loss) per share for the three months ended September 30, 2022, and 2021, was $1.99 and ($0.82), respectively, which included a current period gain of $11.3 million and of gain of $0.9 million, respectively. Basic income (loss) per share for the nine months ended September 30, 2022, and 2021, was $4.52 and ($2.58), respectively, which included the aforementioned gains of $14.6 million and of gain of $0.9 million, respectively.
Adoption of New Accounting Standards
In January 2020, the FASB issued ASU No. 2020-1, Equity Securities (Topic 321), Investments-Equity Method and Joint Ventures (Topic 323), and Derivatives and Hedging (Topic 815)-Clarifying the Interactions between Topic 321, Topic 323, and Topic 815. The amendments in this update clarify certain interactions between the guidance to account for certain equity securities under Topic 321, the guidance to account for investments under the equity method of accounting in Topic 323, and the guidance in Topic 815, which could change how an entity accounts for an equity security under the measurement alternative or a forward contract or purchased option to purchase securities that, upon settlement of the forward contract or exercise of the purchased option, would be accounted for under the equity method of accounting or the fair value option in accordance with Topic 825, Financial Instruments. This amendment was adopted effective January 1, 2021 with no impact to our financial statements.
In August 2018, the FASB issued ASU No. 2018-15, Intangibles—Goodwill and Other—Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computer Arrangement That is a Service Contract. Under ASU No. 2018-15, the amendment aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop
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or obtain internal-use software. The accounting for the service element of a hosting arrangement that is a service contract is not affected by the amendments in this update. In order to determine which costs can be capitalized, we are to follow the guidance in Subtopic 350-40. Cost for implementation activities in the application development stage are capitalized depending on the nature of the costs, while costs incurred during the preliminary project and the post-implementation stage are expensed as the activities are performed. The amendments in this update are effective for public business entities for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. The amendments in this update should be applied either retrospectively or prospectively to all implementation costs incurred after the date of adoption. As of September 30, 2022, and December 31, 2021, the Company had analyzed and capitalized $1.4 and $1.2 million of cloud-based software cost respectively.
Future adoption of New Accounting Standards
In August 2018, the FASB issued ASU No. 2018-12, Financial Services—Insurance (Topic 944): Targeted Improvements to the Accounting for Long-Duration Contracts, as amended by ASU 2019-09, Financial Services —Insurance (Topic 944). The new guidance (i) prescribes the discount rate to be used in measuring the liability for future policy benefits for traditional and limited payment long-duration contracts, and requires assumptions for those liability valuations to be updated after contract inception, (ii) requires more market-based product guarantees on certain separate account and other account balance long-duration contracts to be accounted for at fair value, (iii) simplifies the amortization of DAC for virtually all long duration contracts, and (iv) introduces certain financial statement presentation requirements, as well as significant additional quantitative and qualitative disclosures. The new standard becomes effective for reporting periods after December 15, 2024, and interim periods within fiscal years beginning after December 15, 2024 for companies eligible as smaller reporting companies. Early application of the amendments in Update 2018-12 is permitted. We anticipate that the adoption of ASU 2018-12 will have a broad impact on our consolidated financial statements and related disclosures and will require us to make changes to certain of our processes, systems and controls. The Company is evaluating the impact this guidance will have on the results of operations and financial position.
In November 2019, the FASB issued ASU No. 2019-11, Codification Improvements to Topic 326, Financial Instruments—Credit Losses. The amendments in this update include items brought to the FASB’s attention by stakeholders to clarify the guidance in the amendments in ASU 2016-13, Financial Instruments – Credit Losses (Topic 326) which was issued in June 2016. These updated amendments clarify that receivables arising from operating leases are not within the scope of Subtopic 326-20. Under ASU 2016-13, the incurred loss impairment methodology in current GAAP is replaced with a methodology that reflects expected credit losses that is referred to as the current expected credit loss (“CECL”) methodology. The measurement of expected credit losses under the CECL methodology is applicable to financial assets measured at amortized cost, including loan receivables and held-to maturity debt securities. It also applies to off-balance sheet credit exposures, not accounted for as insurance (loan commitments, standby letters of credit financial guarantees, and other instruments). In additions ASU 2016-13 made changes to the accounting for available for sale debt securities. One such change is to require credit losses to be presented as an allowance rather than a write-down on available for sale debt securities management does not intend to sell or believes that it is more likely than not they will be required to sell. The new standard becomes effective for reporting periods beginning after December 15, 2022, and for most affected instruments must be adopted using a modified retrospective approach, with a cumulative effect adjustment recorded to beginning retained earnings.
The Company’s implementation activities continue to be performed in evaluation of the impact of this guidance will have on the results of operations and financial position. The Company utilizes the modified retrospective method and the prospective transition approach for fixed maturities for which other-than-temporary impairment has been recognized prior to January 1, 2023. As of the three months ended September 30, 2022, $346 million of other-than-temporary impairment has been recognized, compared to $0 in the prior year
Note 2. Assets and Liabilities Associated with Business Held for Sale
On November 30, 2018, American Life entered into an Assumption and Indemnity Reinsurance Agreement (“Reinsurance Agreement”) with Unified Life Insurance Company (“Unified”), a Texas domiciled stock insurance company. The Reinsurance Agreement provides that American Life ceded and Unified agreed to reinsure, on an indemnity reinsurance basis, 100% of the liabilities and obligations under substantially all of American Life’s life, annuity and health policies (“Policies”). The Agreement closed on December 10, 2018.
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After the closing of the Reinsurance Agreement, Unified prepared and delivered certificates of assumption and other materials to policyholders of American Life in order to effect an assumption of the Policies by Unified. Unified is obligated to indemnify American Life against all liabilities and claims and all of its policy obligations from and after July 1, 2018. Unified estimated that 80% to 90% of the policyholder would convert to assumptive, where American Life would no longer be responsible for the obligations to the policyholders, by the end of 2019.
The consideration paid by Unified to American Life under the Reinsurance Agreement upon closing was $3.5 million (“Ceding Commission”), subject to minor settlement adjustments. At closing, American Life transferred the Statutory Reserves and Liabilities, as defined in the Reinsurance Agreement, directly related to the policies, to Unified. The Ceding Commission is being amortized on a straight-line basis over the life of the policies. When the policies are converted to assumptive, meaning American Life has no liability exposure for those policies, the remaining Ceding Commission will be recognized in our Consolidated Statement of Comprehensive Loss.
An assessment of the assets and liabilities held for sale was performed as of December 31, 2021 and management believed that the remaining policyholder contracts will not be converted; therefore, those remaining policy contracts were reclassified to continuing operations and are no longer called out as discontinued operations.
Note 3. Non-controlling Interest
On December 30, 2021, Midwest closed the sale of approximately 70% of SRC1 to ORIX USA for $15.0 million. Under the terms of the agreement, Midwest holds a 30% ownership interest in SRC1. ORIX Advisers, LLC, another subsidiary of ORIX USA, is the manager of the assets underlying SRC1’s reinsurance obligations, replacing Midwest’s asset management arm, 1505 Capital LLC. As of September 30, 2022, Midwest recognized the original purchase of $15.0 million less $9.3 million of earnings as noncontrolling interest in the equity section of the Consolidated Balance Sheets.
In 2020 American Life entered into a series of transactions with an unaffiliated entity, Ascona Group Holdings Ltd (“AGH”). Through this transactions American Life acquired preferred equity in AGH in British Pound Sterling (“GBP”) of 3.6 million along with warrants bearing no initial assigned value. American Life subsequently created a special purpose vehicle, Ascona Asset Holding LLC (“AAH”), to hold the Preferred Equity and Warrants, and later created Ascona Collinwood HoldCo LLC (“ACH”) to be the sole member of AAH. American Life and Crestline Re SP1 own 74% and 26%, respectively, of ACH. American Life is carrying the preferred equity at a market USD value of $6.8 million as of September 30, 2022, and $8.7 million as of December 31, 2021. The change in market value for the nine months ended September 30, 2022, of $1.9 million for the preferred stock and warrants was recorded in net investment income on the Consolidated Statements of Comprehensive Loss. Of the $1.9 million of investment income, $0.5 million was attributable to noncontrolling interest.
17
Note 4. Investments
The cost or amortized cost and estimated fair value of investments as of September 30, 2022, and December 31, 2021, were as follows:
Gross | Gross | |||||||||||
Amortized | Unrealized | Unrealized | Estimated | |||||||||
(In thousands) |
| Cost |
| Gains |
| Losses |
| Fair Value | ||||
September 30, 2022: |
|
|
|
|
|
|
|
| ||||
Fixed maturities: |
|
|
|
|
|
|
|
| ||||
Bonds: | ||||||||||||
U.S. government obligations | $ | 1,589 | $ | — | $ | 94 | $ | 1,495 | ||||
Mortgage-backed securities |
| 228,052 |
| 281 |
| 16,990 |
| 211,343 | ||||
Asset-backed securities | 38,415 | 65 | 3,831 | 34,648 | ||||||||
Collateralized loan obligations | 298,976 | 755 | 24,357 | 275,375 | ||||||||
States and political subdivisions-general obligations |
| 104 |
| — |
| 3 |
| 102 | ||||
States and political subdivisions-special revenue |
| 136 |
| — |
| 16 |
| 121 | ||||
Corporate |
| 43,665 |
| 335 |
| 6,076 |
| 37,924 | ||||
Term loans | 477,034 | 1,656 | 2,168 | 476,522 | ||||||||
Redeemable preferred stock | 14,283 | — | 3,732 | 10,551 | ||||||||
Total fixed maturities | $ | 1,102,254 | $ | 3,092 | $ | 57,267 | $ | 1,048,081 | ||||
Mortgage loans on real estate, held for investment | 204,423 | — | — | 204,423 | ||||||||
Derivatives | 32,103 | 3,395 | 23,658 | 11,840 | ||||||||
Common Stock | 501 | — | — | 501 | ||||||||
Equity securities | 10,256 | — | 931 | 9,325 | ||||||||
Other invested assets | 77,764 | 1,011 | 206 | 78,569 | ||||||||
Investment escrow | 344 | — | — | 344 | ||||||||
Preferred stock | 22,535 | 291 | 1,247 | 21,579 | ||||||||
Notes receivable | 6,189 | — | — | 6,189 | ||||||||
Policy loans | 21 | — | — | 21 | ||||||||
Total investments | $ | 1,456,390 | $ | 7,789 | $ | 83,309 | $ | 1,380,872 | ||||
December 31, 2021: |
|
|
|
|
|
|
|
| ||||
Fixed maturities: |
|
|
|
|
|
|
|
| ||||
Bonds: | ||||||||||||
U.S. government obligations | $ | 1,855 | $ | 32 | $ | 5 | $ | 1,882 | ||||
Mortgage-backed securities |
| 55,667 |
| 368 |
| 755 |
| 55,280 | ||||
Asset-backed securities | 24,675 | 443 | 167 | 24,951 | ||||||||
Collateralized loan obligations | 272,446 | 2,928 | 851 | 274,523 | ||||||||
States and political subdivisions-general obligations |
| 105 |
| 9 |
| — |
| 114 | ||||
States and political subdivisions-special revenue |
| 4,487 |
| 1,129 |
| 4 |
| 5,612 | ||||
Corporate |
| 35,392 |
| 1,846 |
| 99 |
| 37,139 | ||||
Term loans | 268,794 | 441 | 1,767 | 267,468 | ||||||||
Trust preferred | 2,218 | 19 | — | 2,237 | ||||||||
Redeemable preferred stock | 14,282 | 53 | 245 | 14,090 | ||||||||
Total fixed maturities | $ | 679,921 | $ | 7,268 | $ | 3,893 | $ | 683,296 | ||||
Mortgage loans on real estate, held for investment | 183,203 | — | — | 183,203 | ||||||||
Derivatives | 18,654 | 6,391 | 2,023 | 23,022 | ||||||||
Federal Home Loan Bank (FHLB) stock | 500 | — | — | 500 | ||||||||
Equity securities | 22,158 | — | 289 | 21,869 | ||||||||
Other invested assets | 34,491 | 813 | 11 | 35,293 | ||||||||
Investment escrow | 3,611 | — | — | 3,611 | ||||||||
Preferred stock | 14,885 | 3,801 | — | 18,686 | ||||||||
Notes receivable | 5,960 | — | — | 5,960 | ||||||||
Policy loans | 87 | — | — | 87 | ||||||||
Total investments | $ | 963,470 | $ | 18,273 | $ | 6,216 | $ | 975,527 | ||||
18
The following table shows the distribution of the credit ratings of our portfolio of fixed maturity securities by carrying value as of September 30, 2022, and December 31, 2021.
Reflecting the quality of securities maintained by us as of September 30, 2022, and December 31, 2021, 93.0% and 92.8%, respectively, of all fixed maturity securities were investment grade. The BB and below also includes maturities that have no rating.
The following table summarizes, for all fixed maturity securities in an unrealized loss position as of September 30, 2022, and December 31, 2021, the estimated fair value, pre-tax gross unrealized loss, and number of securities by consecutive months they have been in an unrealized loss position.
19
Our security positions resulted in a gross unrealized loss position as of September 30, 2022, that was greater than the gross unrealized loss position at December 31, 2021 due to increases in the Federal Reserve interest rates. We performed an analysis and determined that there were no additional indicators other than the increase in the interest rates that would indicate a cash flow testing analysis should be performed. No impairment was required as of September 30, 2022, or December 31, 2021.
See the discussion above under “Comprehensive loss” in Note 1 regarding unrealized gains/losses on investments that are owned by our reinsurers and the corresponding offset in the associated embedded derivatives.
The Company purchases and sells equipment leases in its investment portfolio. As of September 30, 2022, the Company owned several leases, all of which were performing. No impairment was required as of September 30, 2022, or December 31, 2021.
The amortized cost and estimated fair value of fixed maturities as of September 30, 2022, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. No securities due in the next year are in an unrealized loss position, therefore no impairments were recognized as of September 30, 2022.
The Company is required to hold assets on deposit for the benefit of policyholders in accordance with statutory rules and regulations. As of September 30, 2022, and December 31, 2021, these required deposits had a total amortized cost of $3.0 million and $3.0 million and fair values of $2.8 million and $3.0 million, respectively.
Mortgage Loans:
Mortgage loans consist of the following:
(In thousands) | September 30, 2022 | December 31, 2021 | ||||
1-4 Family | $ | 69,639 | $ | 72,324 | ||
Hospitality | 12,622 | 12,822 | ||||
Land | 35,563 | 15,904 | ||||
Multifamily (5+) | 32,862 | 31,583 | ||||
Retail | 20,407 | 17,655 | ||||
Other | 33,330 | 32,915 | ||||
Total mortgage loans | $ | 204,423 | $ | 183,203 | ||
Geographic Locations:
As of September 30, 2022, the commercial mortgages loans were secured by properties geographically dispersed primarily throughout the United States with the largest concentrations in New York (26%), California (7%), Florida (5%), Arizona (5%) and non-US (9%). As of December 31, 2021, the commercial mortgages loans were secured by properties geographically dispersed with the largest concentrations in loans secured by properties in Delaware (34%) New York (32%), Arizona (4%), California (4%), and non-US (9%).
20
The loan-to-value ratio is expressed as a percentage of the amount of the loan relative to the value of the underlying property. A loan-to-value ratio in excess of 100% indicates the unpaid loan amount exceeds the underlying collateral. The following represents the loan-to-value ratio of the commercial mortgage loan portfolio, excluding those under development, net of valuation allowances. As of September 30, 2022, the Company held one asset valued at $7.7 million with an impairment of $0.9 million. No such valuations were established as of December 31, 2021.
The components of net investment income for the three and nine months ended September 30, 2022, and 2021, were as follows:
Proceeds for the three months ended September 30, 2022, and 2021, from sales of investments classified as available-for-sale were $81.2 million and $72.0 million, respectively. Gross gains of $0.3 million and $0.4 million and gross losses of $1.5 million and $0.3 million were realized on those sales during the three months ended September 30, 2022, and 2021, respectively. Proceeds for the nine months ended September 30, 2022, and 2021, from sales of investments classified as available-for-sale were $106.3 million and $204.5 million, respectively. Gross gains of $1.2 million and $2.2 million and gross losses of $1.1 million and $0.5 million were realized on those sales during the nine months ended September 30, 2022, and 2021, respectively.
The proceeds included those assets associated with the third-party reinsurers. The gains and losses relate only to the assets retained by American Life. Unrealized gain/loss included as part of net investment income were $1.8 million and $1.9 million for the three months ended September 30, 2022, and 2021, respectively.
Note 5. Derivative Instruments
The Company enters into derivative instruments to manage risk, primarily equity, interest rate, credit, foreign currency and market volatility. The derivative instruments are to hedge fixed indexed annuity products that guarantee the return of principal to the policyholders and credit interest based on a percentage of the gain in a specified market index. To hedge against adverse changes in equity indices, the Company entered into contracts to buy equity indexed options.
21
The following is a summary of the asset derivatives not designated as hedges embedded in our FIA product as of September 30, 2022, and December 31, 2021:
At September 30, 2022, the value of the embedded derivative considers all amounts projected to be paid in excess of the minimum guarantee (the amounts payable without any indexation increases) over future periods. The host contract reflects the minimum guaranteed values.
Due to Federal Reserve rate increases, our securities positions resulted in unrealized losses at September 30, 2022, and December 31, 2021, reported in accumulated other comprehensive income on the balance sheet. The embedded derivative related to the asset portfolio belonging to the third-party reinsurers offset these unrealized losses. The unrealized losses as of September 30, 2022, were $14.4 million compared to unrealized gains of $0.2 million as of December 31, 2021.
The following table summarizes the impact of those embedded derivatives related to the FW provision where the total return on the asset portfolio is passed through to the third-party reinsurers:
Assets carried as investments on American Life’s financial statements for the third-party reinsurers contained cumulative unrealized losses of approximately $14.4 million as of September 30, 2022, and cumulative unrealized gains of $0.2 million as of December 31, 2021, respectively. The terms of the contracts with the third-party reinsurers provide that the changes in unrealized gains on the portfolios accrue to the third-party reinsurers. Accordingly, the change in unrealized losses on the assets held by American Life were offset by gains in the embedded derivative of $14.6 million and a gain in the embedded derivative of $0.9 million as of September 30, 2022, and 2021, respectively. We account for this unrealized (loss) pass-through by recording an equivalent realized gain on our Consolidated Statements of Comprehensive Loss and in amounts payable to our third-party reinsurers on the Consolidated Balance Sheets.
Note 6. Fair Values of Financial Instruments
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. We use valuation techniques that are consistent with the market approach, the income approach and/or the cost approach. Inputs to valuation techniques refer to the assumptions that market participants would use in pricing the asset or liability. Inputs may be observable, meaning those that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from independent sources, or unobservable, meaning those that reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. In that regard, accounting standards establish
22
a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:
| ● | Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date. |
| ● | Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data. |
| ● | Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability. |
A review of fair value hierarchy classifications is conducted on a quarterly basis. Changes in the valuation inputs, or their ability to be observed, may result in a reclassification for certain financial assets or liabilities. Reclassifications impacting Level 3 of the fair value hierarchy are reported as transfers in/out of the Level 3 category as of the beginning of the period in which the reclassifications occur.
A description of the valuation methodologies used for assets measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.
Level 1 measurements
There were no assets or liabilities classified as level 1 at September 30, 2022, or December 31, 2021.
Level 2 measurements
Cash: The carrying value of cash approximates the fair value because of the short maturity of the instruments.
Investment escrow: The Company had escrow funds of as of September 30, 2022, and December 31, 2021, of $0.3 million and $3.6 million, respectively. These escrow funds were used to settle mortgage loans that did not close until October and January 2022, respectively. The money held in escrow at September 30, 2022, and December 31, 2021 was carried at cost.
Fixed maturity securities: Fixed maturity securities are recorded at fair value on a recurring basis utilizing a third-party pricing source such as the Automated Valuation Service (“AVS”) Securities Valuation Office (“SVO”) pricing. The valuations are reviewed and validated quarterly through random testing by comparisons to separate pricing models or other third-party pricing services. For the nine months ended September 30, 2022, and the year ended December 31, 2021, there were no material changes to the valuation methods or assumptions used to determine fair values, and no broker or third-party prices were changed from the values received.
Derivatives: Derivatives are reported at fair market value utilizing a third-party pricing indexes such as the Standard & Poor’s (“S&P”) 500 index and the S&P Multi-Asset Risk Control (“MARC”) 5% index.
Equity securities: Equity securities at September 30, 2022, and December 31, 2021, consisted of exchange traded funds (“ETFs”) that are recorded at fair value utilizing a third-party pricing source with the change in fair value recorded through realized gains and losses on the Consolidated Statement of Comprehensive Loss. As of September 30, 2022, and December 31, 2021 we held $9.3 million and $21.9 million, respectively of ETFs.
Notes receivable: The Company held in notes receivable as of September 30, 2022, and December 31, 2021, a note of $6.2 million and $6.0 million respectively, that includes paid-in-kind (“PIK”) interest. The note receivable is between American Life and Chelsea Holdings Midwest LLC with an interest rate of 5% per annum that was rated BBB+ by a nationally recognized statistical rating organization (“NRSRO”). This note is being carried at cost plus PIK interest.
23
Level 3 measurements
Term loans: The assets classified as term loans are carried at unpaid principal net of amortization of discount or accretion, which approximates fair value or carried at fair market value based on a valuation using market standard valuation methodologies. The inputs used to measure the fair value of these assets are classified as Level 3 within the fair value hierarchy.
Mortgage loans on real estate, held for investment: Mortgage loans are generally stated at principal amounts outstanding, net of deferred expenses and allowance for loan loss. Interest on loans is recognized on an accrual basis at the applicable interest rate on the principal amount outstanding. Loan origination fees and direct costs, as well as premiums and discounts, are amortized as level yield adjustments over the respective loan terms. Unamortized net fees or costs are recognized upon early repayment of the loans. Loan commitment fees are generally deferred and amortized on an effective yield basis over the term of the loan. Impaired loans are generally carried on a non-accrual status. Loans are ordinarily placed on non-accrual status when, in management’s opinion, the collection of principal or interest is unlikely, or when the collection of principal or interest is 90 days or more past due. As of September 30, 2022, the Company held one asset valued at $7.7 million with an impairment of $0.9 million. No such valuations were established as of December 31, 2021.
Other invested assets: Other invested assets include collateral loans, private credit investments, equipment leases, and a private fund investment. The collateral loans, private credit investments, and equipment leases are carried at amortized cost which approximates fair value. The private fund investment is carried at statement value with approximates fair value of the fund. The inputs used to measure these assets are classified as Level 3 within the fair value hierarchy.
Federal Home Loan Bank (FHLB) stock: The carrying value of FHLB stock approximates fair value since the Company can redeem such stock with FHLB at cost. As a member of the FHLB, the Company is required to purchase this stock, which is carried at cost and classified as restricted equity securities.
Preferred stock: The perpetual preferred stock held as of September 30, 2022, and December 31, 2021, of $10.0 million was carried at fair market utilizing a third-party pricing source such as AVS SVO pricing, along with other non-observable inputs. The valuations are reviewed and validated quarterly through random testing by comparisons to separate pricing models or other third-party pricing services.
As of September 30, 2022, the fair market value of the Ascona preferred stock and warrants was $7.2 million and $2.0 million, respectively. As of December 31, 2021, the fair market value of the Ascona preferred stock and warrants was $4.9 million and $3.8. million, respectively. The Ascona preferred stock and warrants have no readily available market value; therefore, a valuation of the investments was prepared by a third-party.
Policy loans: Policy loans are stated at unpaid principal balances. As these loans are fully collateralized by the cash surrender value of the underlying insurance policies, the carrying value of the policy loans approximates their fair value.
Deposit-type contracts: The fair value for direct and assumed liabilities under deposit-type insurance contracts (accumulation annuities) is calculated using a discounted cash flow approach. Cash flows are projected using actuarial assumptions and discounted to the valuation date using risk-free rates adjusted for credit risk and nonperformance risk of the liabilities. The fair values for insurance contracts other than deposit-type contracts are not required to be disclosed.
Embedded derivative for equity-indexed contracts: The Company has embedded derivatives in its FIA policyholder obligations. These embedded derivatives are carried at the fair market value as of September 30, 2022, and December 31, 2021. The fair value of the embedded derivative component of our FIA obligation is estimated at each valuation date by projecting policy contract values and minimum guaranteed contract values over the expected lives of the contracts and discounting the excess of projected contract value amounts at the applicable risk-free interest rates adjusted for our nonperformance risk related to those obligations. The projections of FIA policy contract values are based on best estimate assumptions for future policy growth and decrements including lapse, partial withdrawal and mortality rates. The best estimate assumptions for future policy growth include assumptions for expected index credits on the next policy anniversary date which are derived from fair values of the underlying equity call options purchased to fund such index credits and the present value of expected costs of annual call options purchased in the future by us to fund index credits beyond the next policy anniversary. The projections of minimum guaranteed contract values include the same best estimate assumptions for policy decrements as assumptions used to project policy contract values.
24
The following table presents the Company’s fair value hierarchy for those financial instruments measured at fair value on a recurring basis as of September 30, 2022, and December 31, 2021.
25
There were no transfers of financial instruments between any levels during the nine months ended September 30, 2022, or for the year ended December 31, 2021.
Accounting standards require disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis. The methodologies for estimating the fair value of financial assets and financial liabilities that are measured at fair value on a recurring basis are discussed above. As of September 30, 2022, and December 31, 2021, there were no financial assets or financial liabilities measured at fair value on a non-recurring basis.
The following disclosure contains the carrying values, estimated fair values and their corresponding placement in the fair value hierarchy for financial assets and financial liabilities as of September 30, 2022, and as of December 31, 2021, respectively:
December 31, 2021 | |||||||||||||||
Fair Value Measurements Using | |||||||||||||||
Quoted Prices in | |||||||||||||||
Active Markets | Significant Other | Significant | |||||||||||||
for Identical Assets | Observable | Unobservable | |||||||||||||
Carrying | and Liabilities | Inputs | Inputs | Fair | |||||||||||
(In thousands) |
| Amount |
| (Level 1) |
| (Level 2) |
| (Level 3) |
| Value | |||||
Assets: | |||||||||||||||
Policy loans | $ | 87 | $ | — | $ | — | $ | 87 | $ | 87 | |||||
Cash equivalents |
| 142,013 |
| — |
| 142,013 |
| — |
| 142,013 | |||||
Liabilities: |
|
|
|
|
|
|
|
|
|
| |||||
Policyholder deposits (deposit-type contracts) |
| 1,075,439 |
| — |
| — |
| 1,075,439 |
| 1,075,439 | |||||
26
The following table presents a reconciliation of the beginning balance for all assets and liabilities measured at fair value on a recurring basis using level three inputs during the nine months ended September 30, 2022:
The following table presents a reconciliation of the beginning balance for all investments measured at fair value on a recurring basis using level three inputs during the year ended December 31, 2021:
Significant Unobservable Inputs—Significant unobservable inputs occur when we could not obtain or corroborate the quantitative detail of the inputs. This applies to fixed maturity securities, preferred stock, mortgage loans and certain derivatives, as well as embedded derivatives in liabilities. Additional significant unobservable inputs are described below.
Interest sensitive contract liabilities – embedded derivative – Significant unobservable inputs we use in the fixed indexed annuities embedded derivative of the interest sensitive contract liabilities valuation include:
27
| ● | Nonperformance risk – For contracts we issue, we use the credit spread, relative to the US Department of the Treasury (Treasury) curve based on our public credit rating as of the valuation date. This represents our credit risk for use in the estimate of the fair value of embedded derivatives. |
| ● | Option budget – We assume future hedge costs in the derivative’s fair value estimate. The level of option budgets determines the future costs of the options and impacts future policyholder account value growth. |
| ● | Policyholder behavior – We regularly review the lapse and withdrawal assumptions (surrender rate). These are based on our initial pricing assumptions updated for actual experience. Actual experience may be limited for recently issued products. |
Preferred equity and warrants – Significant unobservable inputs we use in the preferred equity and warrants include discount rates and earnings before interest, taxes, depreciation, and amortization (“EBITDA”) Multiples.
| ● | EBITDA Multiple -The warrants valued using a market approach guideline public company method ("GCPM") using a multiplier of EBITDA. |
| ● | Discount Rates - For the preferred equity, discounted cash flow models are used to assist with the calculation the fair value. |
The following summarizes the unobservable inputs for available for sale and trading securities and the embedded derivatives of fixed indexed annuities:
28
Note 7. Earnings Per Share
The Company has 20 million voting common shares authorized, two million non-voting common shares authorized, and two million preferred shares authorized. There were 3,727,976 voting common shares issued and as of September 30, 2022, and 3,737,564 issued and as of September 30, 2021, and no nonvoting or preferred shares outstanding as of those dates.
Three months ended September 30, | Nine months ended September 30, | |||||||||||
| 2022 |
| 2021 |
| 2022 |
| 2021 | |||||
(In thousands, except per share amounts) | ||||||||||||
Numerator: | ||||||||||||
Net income (loss) attributable to Midwest Holding, Inc. | $ | 7,431 | $ | (3,064) | $ | 16,883 | $ | (9,656) | ||||
Denominator: | ||||||||||||
Weighted average common shares outstanding | 3,736,933 | 3,737,564 | 3,791,082 | 3,737,564 | ||||||||
Effect of dilutive securities: | ||||||||||||
Stock options and deferred compensation agreements | 52,000 | — | 52,000 | — | ||||||||
Denominator for earnings (loss) per common share | 3,788,933 | 3,737,564 | 3,843,082 | 3,737,564 | ||||||||
Income (loss) per common share | $ | 1.99 | $ | (0.82) | $ | 4.52 | $ | (2.58) | ||||
Income (loss) per common share, diluted | $ | 1.96 | $ | (0.82) | $ | 4.45 | $ | (2.58) | ||||
29
Note 8. Income Tax Matters
Significant components of the Company’s deferred tax assets and liabilities as of September 30, 2022, and December 31, 2021, were as follows:
(In thousands) |
| September 30, 2022 |
| December 31, 2021 | ||
Deferred tax assets: |
|
|
|
| ||
Loss carryforwards | $ | 2,235 | $ | 2,244 | ||
Capitalized costs |
| 91 |
| 127 | ||
Stock option granted | 1,001 | 1,060 | ||||
Policy acquisition costs | 5,705 | 3,640 | ||||
Charitable contribution carryforward | — | — | ||||
General business credits | 6 | 6 | ||||
Derivative option allowance | — | 510 | ||||
Sec 163(j) limitation | 173 | 171 | ||||
Benefit reserves |
| 10,871 |
| 6,720 | ||
Property and equipment | 73 | 33 | ||||
Impairments | 403 | — | ||||
Unrealized losses on investments | 14,049 | — | ||||
Other | 1,464 | 1,464 | ||||
Total deferred tax assets |
| 36,071 |
| 15,975 | ||
Less valuation allowance |
| (31,363) |
| (14,431) | ||
Total deferred tax assets, net of valuation allowance |
| 4,708 |
| 1,544 | ||
Deferred tax liabilities: |
|
|
|
| ||
Unrealized losses on investments |
| — |
| 1,084 | ||
Intangible assets |
| 147 |
| 147 | ||
Derivative option allowance |
| 3,810 |
| — | ||
Bond Discount | 751 | 313 | ||||
Property and equipment |
| — |
| — | ||
Total deferred tax liabilities |
| 4,708 |
| 1,544 | ||
Net deferred tax assets | $ | — | $ | — | ||
As of September 30, 2022, and December 31, 2021, the Company recorded a valuation allowance of $31.4 million and $14.4 million, respectively, on the deferred tax assets to reduce the total to an amount that management believes will ultimately be realized. Realization of deferred tax assets is dependent upon sufficient future taxable income during the period that deductible temporary differences and carryforwards are expected to be available to reduce taxable income.
There was income tax expense of $1.3 million and tax benefit of $0.4 million for the three months ended September 30, 2022, and 2021, respectively. There was income tax expense of $3.8 million and $1.8 million for the nine months ended September 30, 2022, and 2021, respectively. This differed from the amounts computed by applying the statutory U.S. federal income tax rate of 21% to pretax income, as a result of the following:
Section 382 of the Internal Revenue Code limits the utilization of U.S. net operating loss (“NOL”) carryforwards following a change of control, which occurred on June 28, 2018. As of September 30, 2022, the deferred tax assets included the expected tax benefit attributable to federal NOLs of $6.9 million. The federal NOLs generated prior to June 28, 2018, which are subject to Section 382 limitations can be carried forward. If not utilized, the NOLs of $1.0 million prior to 2017 will expire through the year of 2032, and the NOLs generated June 28, 2018, and after, do not expire and will carry forward indefinitely, but their utilization in any carry forward year is limited to 80% of taxable income in that year. The Company believes that it is more
30
likely than not that the benefit from federal NOL carryforwards will not be realized; thus, we have recorded a full valuation allowance of $1.5 million on the deferred tax assets related to these federal NOL carryforwards.
Note 9. Reinsurance
A summary of significant reinsurance, including our 100% legacy life business reinsured, amounts affecting the accompanying Consolidated Balance Sheets as of September 30, 2022, and December 31, 2021, respectively, are as follows:
(In thousands) |
| September 30, 2022 |
| December 31, 2021 | ||
Assets: |
|
|
|
| ||
Reinsurance recoverables | $ | 5,791 | $ | 38,579 | ||
Liabilities: | ||||||
Deposit-type contracts | ||||||
Direct | $ | 1,537,583 | 1,075,439 | |||
Reinsurance ceded | (832,109) | (647,632) | ||||
Retained deposit-type contracts | $ | 705,474 | $ | 427,807 | ||
The table below is a summary of our 100% legacy life business reinsured for the three and nine months ended September 30, 2022 and 2021:
The following table provides a summary of the significant reinsurance balances recoverable on paid and unpaid policy claims by third-party reinsurers as of September 30, 2022:
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The following table provides a summary of the significant reinsurance balances recoverable on paid and unpaid policy claims by reinsurer as of December 31, 2021:
Our securities positions resulted in changes in the unrealized gains position as of September 30, 2022, compared to December 31, 2021, that is reported in accumulated other comprehensive income on the Consolidated Balance Sheets. As discussed in Note 1, American Life has treaties with several third-party reinsurers that have FW and Modco provisions. Under those provisions, the assets backing the treaties are maintained by American Life as collateral but the assets and total returns or losses on the asset portfolios belong to the third-party reinsurers. Under GAAP this arrangement is considered an embedded derivative as discussed in Note 5. Assets carried as investments on American Life’s financial statements for the third-party reinsurers contained cumulative unrealized losses of approximately $14.4 million as of September 30, 2022, and cumulative unrealized gains of $0.2 million at December 31, 2021, respectively. The terms of the contracts with the third-party reinsurers provide that the changes in unrealized gains and losses on the portfolios accrue to the third-party reinsurers. To recognize changes in the third-party unrealized gain (loss), American Life records the year-to-date change in the Consolidated Statements of Comprehensive Loss and in amounts recoverable from third-party reinsurers on the Consolidated Balance Sheets. As of September 30, 2022, American Life recognized a current year gain in the embedded derivative of $14.6 million and a loss in the embedded derivative of $0.9 million for the comparable period in 2021.
On June 26, 2021, the NDOI issued its non-disapproval of the Modified Coinsurance Agreement (“Modco AEG Agreement”) with American Republic Insurance Company (“AEG”), an Iowa domiciled reinsurance company. The agreement closed on September 30, 2021. Under the Modco AEG Agreement, American Life cedes to AEG, on a modified coinsurance basis, 20% quota share of certain liabilities with respect to its multi-year guaranteed annuity MYGA-5 business and an initial 20% quota share of certain liabilities with respect to its fixed indexed annuity FIA. American Life has established a Modco Deposit Account to hold the assets for the Modco Agreement. The initial settlement included net premium income of $37.5 million and net statutory reserves of $34.8 million for the modified coinsurance account. The amount paid to the Modified coinsurance deposit account from AEG was $2.4 million.
On November 10, 2021, the NDOI issued its non-disapproval of the Funds Withheld and Modified Coinsurance Agreement with SRC3, whereby, SRC3 agreed to provide reinsurance funding for a quota share percentage of 45% of the liabilities of American Life arising from its MYGA products and a quota share percentage of 45% of American Life’s FIA products. American Life has established a FW and Modco Deposit Account to hold the assets for the FW and Modco Agreement. The initial settlement included net premium income of $37.5 million and net statutory reserves of $43.6 million.
On September 30, 2022, American Life entered into a reinsurance agreement (the “Reinsurance Agreement”) with a new protected cell formed by Seneca Re (Seneca Incorporated Cell, LLC 2022-04 (“SRC4”)). SRC4 was capitalized by loans from Embrace Software, Inc (“Embrace”) and Tillman Networks LLC (“Tillman”). The Reinsurance Agreement was effective as of July 1, 2022, among American Life and Seneca Re. The Reinsurance Agreement supports American Life’s new business production by providing reinsurance capacity for American Life to write certain kinds of fixed and multi-year guaranteed annuity products. Under the Reinsurance Agreement, SRC4 agreed to provide reinsurance funding for a quota share percentage of 45% of the liabilities of American Life arising from its MYGA-5 products and a quota share percentage of 10% for MYGA-3 products. American Life has established a Modco Deposit Account, a Funds Withheld custody account, and a Trust Account pursuant to the Reinsurance Agreement. The initial settlement included net premium of $21.4 million and net reserves of $21.5 million for the modified coinsurance account.
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Also on September 30, 2022, American Life entered into an Investment Management Agreement (“IMA”) with CoVenture Management, LLC (“CoVenture”) naming CoVenture as the manager of certain assets held by American Life on behalf of SRC4.
Under GAAP, ceding commissions are deferred on the Consolidated Balance Sheets and are amortized over the period of the policyholder contracts. The tables below show the ceding commissions from the reinsurers excluding SRC1 and what was earned on a GAAP basis for the three and nine months ended September 30, 2022, and 2021:
Nine months ended September 30, | ||||||||||||||||||||||||
(In thousands) | 2022 | 2021 | ||||||||||||||||||||||
Reinsurer | Gross Ceding Commission | Expense | Interest on Ceding Commission | Earned | Gross Ceding Commission | Expense | Interest on Ceding Commission | Earned | ||||||||||||||||
Unified Life Insurance Company | $ | — | $ | — | $ | — | $ | 20 | $ | — | $ | — | $ | — | $ | — | ||||||||
Ironbound Reinsurance Company Limited | — | — | 146 | 381 | — | 424 | 160 | 358 | ||||||||||||||||
Ascendant Re | — | — | 70 | 250 | 496 | 1,106 | 69 | 163 | ||||||||||||||||
US Alliance Life and Security Company | — | — | 41 | 259 | 2 | 125 | 46 | 195 | ||||||||||||||||
Crestline SP1 | 4,497 | 7,026 | 271 | 1,669 | 5,623 | 11,052 | 180 | 813 | ||||||||||||||||
American Republic Insurance Company | 2,971 | 4,859 | 90 | 592 | 3,160 | 5,849 | 26 | 146 | ||||||||||||||||
SRC4 | 878 | 783 | 5 | 80 | — | — | — | — | ||||||||||||||||
$ | 8,346 | $ | 12,668 | $ | 623 | $ | 3,251 | $ | 9,281 | $ | 18,556 | $ | 481 | $ | 1,675 | |||||||||
(1) Includes acquisition and administrative expenses, commission expense allowance and product development fees.
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The table below shows the ceding commissions deferred on each reinsurance transaction on a GAAP basis:
| 1) | These reinsurance transactions on our legacy life insurance business received gross ceding commissions on the effective dates of the transaction. The difference between the statutory net adjusted reserves and the GAAP adjusted reserves plus the elimination of DAC and value of business acquired related to these businesses reduces the gross ceding commission with the remaining deferred and amortized over the lifetime of the blocks of business. |
| 2) | These reinsurance transactions include the ceding commissions and expense allowances which are accounted for as described in (1). |
The use of reinsurance does not relieve American Life of its primary liability to pay the full amount of the insurance benefit in the event of the failure of a reinsurer to honor its contractual obligation for all blocks of business except what is included in the Unified transaction. The reinsurance agreement with Unified discharges American Life’s responsibilities once all the policies have changed from indemnity to assumptive reinsurance. No reinsurer of business ceded by American Life has failed to pay policy claims (individually or in the aggregate) with respect to our ceded business.
American Life monitors several factors that it considers relevant to satisfy itself as to the ongoing ability of a reinsurer to meet all obligations of the reinsurance agreements. These factors include the credit rating of the reinsurer, the financial strength of the reinsurer, significant changes or events of the reinsurer, and any other relevant factors. If American Life believes that any reinsurer would not be able to satisfy its obligations with American Life, separate contingency reserves may be established. As of September 30, 2022, and December 31, 2021, no contingency reserves were established.
American Life seeks to reinsure a significant amount of its new insurance policies with a variety of reinsurers in exchange for upfront ceding commissions, expense reimbursements and administrative fees. American Life may retain some business with the intent to reinsure some or all at a future date.
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Retained and Reinsured Balance Sheets
The table below shows the retained and reinsurance condensed balance sheets:
| September 30, 2022 | December 31, 2021 | ||||||||||||||||
(In thousands) | Retained | Reinsured | Consolidated | Retained | Reinsured | Consolidated | ||||||||||||
Assets |
|
|
|
| ||||||||||||||
Total investments | $ | 693,180 | $ | 687,692 | $ | 1,380,872 | $ | 414,418 | $ | 561,109 | $ | 975,527 | ||||||
Cash and cash equivalents | 112,859 | 95,805 | 208,664 | 95,406 | 46,607 | 142,013 | ||||||||||||
Accrued investment income | 8,790 | 15,125 | 23,915 | 3,853 | 9,770 | 13,623 | ||||||||||||
Deferred acquisition costs, net | 39,377 | — | 39,377 | 24,530 | — | 24,530 | ||||||||||||
Reinsurance recoverables | 49,264 | (43,109) | 6,155 | — | 38,579 | 38,579 | ||||||||||||
Other assets | 43,796 | (16,711) | 27,085 | 27,834 | (2,189) | 25,645 | ||||||||||||
Total assets | $ | 947,266 | $ | 738,802 | $ | 1,686,068 | $ | 566,041 | $ | 653,876 | $ | 1,219,917 | ||||||
Liabilities and Stockholders’ Equity |
|
|
|
|
|
| ||||||||||||
Liabilities: |
|
|
|
|
|
| ||||||||||||
Policyholder liabilities | $ | 815,958 | $ | 737,544 | $ | 1,553,502 | $ | 427,807 | $ | 660,811 | $ | 1,088,618 | ||||||
Deferred gain on coinsurance transactions | 35,464 | — | 35,464 | 28,589 | — | 28,589 | ||||||||||||
Other liabilities | 55,974 | 1,258 | 57,232 | 23,889 | (6,935) | 16,954 | ||||||||||||
Total liabilities | $ | 907,396 | $ | 738,802 | $ | 1,646,198 | $ | 480,285 | $ | 653,876 | $ | 1,134,161 | ||||||
Stockholders’ Equity: |
|
|
|
|
|
| ||||||||||||
Voting common stock | 4 | — | 4 | 4 | — | 4 | ||||||||||||
Additional paid-in capital | 137,991 | — | 137,991 | 138,277 | — | 138,277 | ||||||||||||
Accumulated deficit | (53,276) | — | (53,276) | (70,159) | — | (70,159) | ||||||||||||
Accumulated other comprehensive income (loss) | (52,943) | — | (52,943) | 2,634 | — | 2,634 | ||||||||||||
Total Midwest Holding Inc.'s stockholders' equity | $ | 31,776 | $ | — | $ | 31,776 | $ | 70,756 | $ | — | $ | 70,756 | ||||||
Noncontrolling interest | 8,094 | — | 8,094 | 15,000 | — | 15,000 | ||||||||||||
Total stockholders' equity | 39,870 | — | 39,870 | 85,756 | — | 85,756 | ||||||||||||
Total liabilities and stockholders' equity | $ | 947,266 | $ | 738,802 | $ | 1,686,068 | $ | 566,041 | $ | 653,876 | $ | 1,219,917 | ||||||
Note 10. Long-Term Incentive Plans
On June 11, 2019, our Board of Directors approved the Midwest Holding Inc. Long-Term Incentive Plan (the “2019 Plan”) that reserves up to 102,000 shares of our voting common stock for award issuances. It provides for the grant of options, restricted stock awards, restricted stock units, stock appreciation rights, performance units, performance bonuses, stock awards and other incentive awards to eligible employees, consultants and eligible directors, subject to the conditions set forth in the 2019 Plan. Shareholder approval of the plan occurred on June 11, 2019. All awards are required to be established, approved, and/or granted by the compensation committee of our Board.
On November 16, 2020, our Board of Directors adopted a new equity incentive plan titled the 2020 Long-Term Incentive Plan (the "2020 Plan") that reserves up to 350,000 shares of voting common stock for award issuances. The terms of the 2020 Plan are essentially the same as the 2019 Plan. On June 29, 2021, the 2020 Plan was approved by the shareholders. On June 14, 2022, the board approved the addition of 150,000 shares of voting common stock to be added to the 2020 Plan for future awards and these shares were approved by our stockholders.
In accordance with the stockholder-approved equity incentive plans above, we have granted stock options to employees and directors for the purchase of common stock at exercise prices at the date of the grants and restricted stock unit awards. We calculate the fair value and compensation at grant date using the Black Scholes Model. Stock options become exercisable under various vesting schedules (typically to four years) and generally expire in ten years after the date of grant. Using the Black Scholes Model, we calculate compensation expense for option share units on a straight-line basis over the requisite service periods, accounting for forfeitures as they occur.
Restricted Stock and Restricted Stock Units
On November 16, 2020, the Company awarded 18,597 shares of restricted stock, and on November 11, 2021, it awarded 5,089 restricted stock units (“RSUs”).
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The restricted stock award of 18,597 shares had a grant date fair value of $41.25 per share and was subject to time-based vesting requirements of increments sixty days after each of the first four anniversary dates of the grant date. The recipient of the award resigned on March 31, 2022, and received a total of 5,812 vested shares in connection with his termination of employment, while the remaining 12,785 shares of restricted stock were forfeited.
The 5,089 RSUs were granted to our non-employee directors and had a grant date fair value of $24.34 per share and vested on June 14, 2022, the date of the Company’s 2022 annual meeting of stockholders. The RSU compensation expense was calculated using the grant date fair value and is amortizing on a straight-line basis over the requisite service periods. Total compensation recognized in connection with the RSUs was approximately $0.4 million with none recognized in the third quarter of 2022.
On June 14, 2022, the Company granted 18,718 RSUs to our non-employee directors with a grant date fair value of $11.22 per share. The RSUs will vest at the earlier of the date of our 2023 annual meeting of stockholders or June 14, 2023.
The compensation expense relating to these awards was calculated using the grant date fair value and is amortized on a straight-line basis over the requisite service periods.
The table below identifies the assumptions used in the Black Scholes Model to calculate the compensation expense:
September 30, | December 31, | |||
2022 | 2021 | |||
Expected volatility | 4.16% - 4.26% | 4.4% - 66.3% | ||
Weighted-average volatility | 35.4% | 38.9% | ||
Expected term (in years) | 2 - 7 | 2 - 7 | ||
Risk-free rate | 1.79% - 3.49% | .8% - 1.5% |
For the three months ended September 30, 2022 and 2021, we amortized the compensation expense related to the 2019 and 2020 Plans over the vesting tranches which resulted in expenses and a decrease in additional paid in capital of approximately $0.7 million and an increase in additional paid in capital of approximately $1.0 million, respectively.
For the nine months ended September 30, 2022, and 2021, we amortized the compensation expense related to the 2019 and 2020 Plans over the vesting tranches which resulted in expenses and a decrease in additional paid in capital of approximately $0.3 million and an increase of approximately $2.8 million, respectively.
The tables below show the outstanding options, restricted stock, and restricted stock units under the 2019 and 2020 Plans as of September 30, 2022, and December 31, 2021, respectively:
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| (1) | Restricted stock and restricted stock units do not have an exercise price. |
The tables below show the outstanding vested and nonvested stock options and restricted stock units as of September 30, 2022, and December 31, 2021
Weighted Average | Weighted Average | ||||||
Outstanding, Non vested options | 379,488 | $ | 38.51 | 9.8 | |||
Outstanding, Vested options | 85,957 | 43.91 | |||||
Outstanding, Non vested restricted | 23,686 | 44.05 | 8.5 | ||||
Outstanding, Vested restricted | - | - | - | ||||
Outstanding at December 31, 2021 | 489,131 | $ | 38.62 | 9.2 |
Note 11. Deposit-Type Contracts
The Company’s deposit-type contracts represent the contract value that has accrued to the benefit of policyholders as of the balance sheet date. Liabilities for these deposit-type contracts are included without reduction for potential surrender charges. This liability is equal to the accumulated account deposits, plus interest credited, and less policyholder withdrawals.
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The following table provides information about deposit-type contracts as of September 30, 2022, and December 31, 2021:
Note 12. Contingencies and Commitments
Contingent Commitments: We have entered into commitments related to certain investments, where draws or additional funding can be requested under the terms of the agreements. These commitments are inclusive of third-party reinsurer commitments and were approximately $212.7 million as of September 30, 2022. Of the approximately $212.7 million in unfunded commitments at September 30, 2022, approximately $75.7 million related to American Life. The remaining $137.0 million represented commitments that have been made by our reinsurance partners. The table shows when different dollar amounts of commitments will expire. The ability of borrowers to request additional funds under these lending agreements varies considerably from loan to loan.
Legal Proceedings: We are involved in litigation incidental to our operations from time to time. We are not presently a party to any legal proceedings other than litigation arising in the ordinary course of our business, and we are not aware of any claims that could materially affect our financial position or results of operations.
Regulatory Matters: State regulatory bodies and other regulatory bodies regularly make inquiries and conduct examinations or investigations concerning the Company’s compliance with laws in relation to, but not limited to, insurance and securities matters. American Life is licensed in 22 states and the District of Columbia as of September 30, 2022 and has pending applications in additional states as of September 30, 2022.
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Note 13. Leases
Our operating lease activities consist of leases for office space and equipment and do not include variable lease payments.
Supplemental balance sheet information as of September 30, 2022, and December 31, 2021, are as follows:
(In thousands) |
| Classification |
| September 30, 2022 |
| December 31, 2021 | ||
Assets |
|
|
|
|
|
| ||
Operating |
| Operating lease right-of-use assets | $ | 2,179 | $ | 2,360 | ||
Liabilities |
|
|
|
|
|
| ||
Operating lease |
| Operating lease liabilities | $ | 2,192 | $ | 2,364 | ||
Our operating leases expenses for the three months ended September 30, 2022, and 2021, were approximately $3,300 and $2,700, respectively. Operating leases expenses for the nine months ended September 30, 2022, and 2021, were approximately $10,000 and $7,700, respectively.
Minimum contractual obligations for our operating leases as of September 30, 2022, are as follows:
(In thousands) |
| Operating Leases | |
2022 | $ | 86 | |
2023 |
| 342 | |
2024 |
| 342 | |
2025 | 342 | ||
2026 | 345 | ||
2027 and after | 1,758 | ||
Total remaining lease payments | $ | 3,215 | |
The cash flows related to operating leases was approximately $6,600 and $5,000 as of September 30, 2022, and 2021, respectively.
The weighted average remaining lease terms of our operating leases were approximately nine years and one year as of September 30, 2022, and 2021, respectively. The weighted average discount rate used to determine the lease liabilities for operating leases was 8% as of September 30, 2022, and 2021, respectively. The discount rate used for operating leases was based on our incremental borrowing rate.
Note 14. Statutory Net Income and Surplus
American Life is required to prepare statutory financial statements in accordance with statutory accounting practices prescribed or permitted by the Nebraska Department of Insurance and the Vermont Department of Insurance. Statutory practices primarily differ from GAAP by charging policy acquisition costs to expense as incurred, establishing future policy benefit liabilities using different actuarial assumptions as well as valuing investments and certain assets and accounting for deferred taxes on a different basis.
The following table represents the net gains or (losses) as filed in the statutory-basis annual statement with the Nebraska Department of Insurance for American Life and the Vermont Department of Insurance for SRC1 and SRC3:
Three months ended September 30, | Nine months ended September 30, | |||||||||||
(In thousands) | 2022 |
| 2021 | 2022 |
| 2021 | ||||||
American Life | $ | (1,836) | $ | 316 | $ | 16,055 | $ | 2,595 | ||||
SRC1 | $ | 1,129 | $ | 1,624 | $ | 181 | $ | (1,430) | ||||
SRC3 | $ | 1,951 | $ | — | $ | 960 | $ | — | ||||
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The following table represents the Capital and Surplus as filed in the statutory-basis annual statement with the Nebraska Department of Insurance for American Life and the Vermont Department of Insurance for SRC1 and SRC3:
(In thousands) | September 30, 2022 | December 31, 2021 | ||||
American Life | $ | 50,757 | $ | 74,011 | ||
SRC1 | $ | 8,597 | $ | 8,415 | ||
SRC3 | $ | 5,860 | $ | 3,150 | ||
The following tables represent the premium sales as filed in the statutory-basis annual statement with the Nebraska Department of Insurance for American Life and the Vermont Department of Insurance for SRC1 and SRC3:
Three months ended September 30, | Nine months ended September 30, | |||||||||||
(In thousands) | 2022 |
| 2021 | 2022 |
| 2021 | ||||||
American Life | $ | 141,602 | $ | 21,386 | $ | 272,218 | $ | 89,632 | ||||
SRC1 | $ | - | $ | (61) | $ | - | $ | 37,764 | ||||
SRC3 | $ | 174 | $ | — | $ | 23,931 | $ | — | ||||
State insurance laws require American Life to maintain certain minimum capital and surplus amounts on a statutory basis. American Life is subject to regulations that restrict the payment of dividends from statutory surplus and may require prior approval from its domiciliary insurance regulatory authorities. American Life is also subject to risk-based capital (“RBC”) requirements that may further affect its ability to pay dividends. American Life’s statutory capital and surplus as of September 30, 2022, and December 31, 2021, exceeded the amount of statutory capital and surplus necessary to satisfy regulatory requirements, including the RBC requirements as of those dates.
As of December 31, 2020, American Life had an invested asset that was impaired as a result of the fair market of the underlying collateral being valued less that the book value. This was a non-admitted asset for statutory accounting purposes. This asset was held in our modified coinsurance account for a third-party reinsurer, so it was passed through to the reinsurer as a reduction of the investment income earned by the reinsurer. As of March 31, 2021, this invested asset was sold for a loss of $2.4 million that was passed through to the reinsurer as a reduction of its investment income earned.
As of September 30, 2022, and December 31, 2021, American Life did not hold any participating policyholder contracts where dividends were required to be paid.
Note 15. Third-Party Administration
The Company commenced its third-party administrative (“TPA”) services in 2012 as an additional revenue source. These services are offered to non-affiliated entities. These agreements, for various levels of administrative services on behalf of each customer, generate fee income for the Company. Services provided vary based on each customer’s needs and can include some or all aspects of back-office accounting and policy administration. TPA fee income earned for TPA administration during the three months ended September 30, 2022, and 2021, were less than $0.1 million, for both periods. TPA fee income earned for TPA administration during the nine months ended September 30, 2022 and 2021 was $0.1 million and $0.3 million, respectively. As of September 30, 2022, 1505 Capital had $494.5 million of third-party assets under management.
Note 16. Equity
Preferred stock
As of September 30, 2022, and December 31, 2021, the Company had two million shares of preferred stock authorized but none were issued or outstanding.
Common Stock
Our voting common stock is traded on The Nasdaq Capital Market under the symbol “MDWT.” Midwest has authorized 20 million shares of voting common stock and two million shares of non-voting common stock. As of September 30, 2022, Midwest had 3,727,976 and as of December 31, 2021, Midwest had 3,737,564 shares of voting common stock and . As of those dates, there were no shares of Midwest’s non-voting common stock issued or outstanding.
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Midwest holds approximately 4,500 shares of voting common stock in its treasury.
Additional paid-in capital
Additional paid-in capital is primarily comprised of the cumulative cash that exceeds the par value received by the Company in conjunction with past issuances of its shares. It also is increased by the amortization expense of the consideration calculated at inception of the stock option grants as discussed in Note 10 – Long-Term Incentive Plans above.
Accumulated Other Comprehensive Income (AOCI)
AOCI represents the cumulative other comprehensive income (loss) (OCI) items that are reported separate from net income (loss) and detailed on the Consolidated Statements of Comprehensive Loss. AOCI includes the unrealized gains and losses on investments and DAC, net of offsets and taxes are as follows:
(In thousands) | Unrealized | ||
Balance at December 31, 2020 | $ | 6,431 | |
Other comprehensive (loss) before reclassifications, net of tax |
| (1,422) | |
Less: Reclassification adjustments for losses realized in net income | (2,375) | ||
Balance, December 31, 2021 | 2,634 | ||
Other comprehensive (loss) before reclassifications, net of tax | (55,483) | ||
Less: Reclassification adjustments for losses realized in net income, net of tax | (94) | ||
Balance, September 30, 2022 | $ | (52,943) | |
Note 17. Deferred Acquisition Costs
The following table represents a roll forward of DAC, net of reinsurance:
(In thousands) |
| September 30, 2022 | December 31, 2021 | |||
Beginning balance | $ | 24,530 | $ | 13,456 | ||
Additions | 18,378 | 13,402 | ||||
Amortization | (4,536) | (2,886) | ||||
Interest | 852 | 632 | ||||
Impact of unrealized investment losses | 153 | (74) | ||||
Ending Balance | $ | 39,377 | $ | 24,530 | ||
Note 18. Related Parties
Crestline
On April 24, 2020, we entered into a securities purchase agreement with Crestline Assurance Holdings LLC (“Crestline”) an institutional alternative investment management firm under which we issued 444,444 shares of our voting common stock to Crestline. We contributed $5.0 million of the net proceeds to American Life and used $3.3 million of the proceeds to capitalize Seneca Re and its first protected cell. We also entered into a Stockholders Agreement along with Xenith and Vespoint that grants Crestline certain rights. Also, Douglas K. Bratton, a principal of Crestline, was appointed as a director of both our board of directors and the American Life board of directors.
In addition, on April 24, 2020, American Life entered into a three-year master letter agreement and related reinsurance, trust and asset management agreement with Seneca Re and a Crestline affiliate regarding the flow of annuity reinsurance and related asset management, whereby Crestline agreed to provide reinsurance funding for a quota share percentage of 25% of the
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liabilities of American Life arising from its MYGA and quota share percentage of 40% of American Life’s FIA products. From inception through September 30, 2022, American Life had ceded $393.0 million face amount of annuity premiums to Crestline SP1. American Life received total ceding commissions, inception-to-date, of $17.4 million and expense reimbursements of $31.4 million in connection with these transactions as of September 30, 2022.
The Reinsurance Agreement also contains the following agreements:
| ● | American Life and Crestline SP1 each entered into investment management agreements with Crestline, pursuant to which Crestline manages the assets that support the reinsured business; and |
| ● | American Life and Crestline SP1 entered into a trust agreement whereby Crestline maintains for American Life’s benefit a trust account that supports the reinsured business. |
On September 16, 2022, Midwest Holding and Crestline executed a Letter of Understanding (the “Understanding”) relating to the Stockholders Agreement. The Company and Crestline agreed that Mr. Bratton would resign from the boards of directors of the Company and ALSC. Notwithstanding the foregoing, the parties agreed that Mr. Bratton’s resignation and Crestline’s decision to no longer appoint a director does not constitute a permanent waiver of Crestline’s rights under the Agreement to appoint a Crestline Designated Director. The Company and Crestline agreed that the foregoing described agreement will remain in place until the earlier to occur of the date (i) the parties reach written agreement otherwise, (ii) that Crestline is no longer an affiliate of a life insurance entity it recently acquired and (iii) on which Crestline no longer has the right to elect or appoint a member and Observer to the board of directors of the Company.
Currently, Crestline has approximately $373.5 million assets under management and is a subadvisor on approximately $174.2 million of additional investments.
Chelsea
On June 29, 2020 Midwest’s subsidiary, American Life, purchased a 17% interest in Financial Guaranty UK Limited through an economic interest in Chelsea Holdings Midwest LLC. American Life has a note receivable from Chelsea Holdings Midwest LLC with an interest rate of 5% per annum that was rated BBB+ by a nationally recognized statistical rating organization (“NRSRO”) and Class B preferred shares in Chelsea Holdings Midwest LLC. The note is being carried at cost plus PIK of $6.2 million and the preferred shares are carried at a fair market value of $2.3 million, based upon valuations received from an independent third-party, as of September 30, 2022.
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The following Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand the financial condition of the Company as of September 30, 2022, compared with December 31, 2021, and the results of operations for the three and nine months ended September 30, 2022, compared with corresponding periods in 2021 of Midwest Holding Inc. and its consolidated subsidiaries. The MD&A is provided as a supplement to, and should be read in conjunction with, our Consolidated Financial Statements and the accompanying notes to the Consolidated Financial Statements (“Notes”) presented in “Part 1 – Item 1. Financial Statements” of this Report and our Form 10-K for the year ended December 31, 2021 (“2021 Form 10-K”), including the sections entitled “Part I – Item 1A. Risk Factors,” and “Part II – Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
Cautionary Note Regarding Forward-Looking Statements and Risk Factors
Except for certain historical information contained herein, this report contains certain statements that may be considered “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and such statements are subject to the safe harbor created by those sections. All statements, other than statements of historical fact, are statements that could be deemed forward-looking statements, including without limitation: any projections of revenues, earnings, cash flows, capital expenditures, or other financial items; any statement of plans, strategies, and objectives of management for future operations; any statements concerning new products or services, or developments; any statements regarding future economic conditions or performance; and any statements of belief and any statement of assumptions underlying any of the foregoing. Words such as “believe,” “may,” “could,” “expects,” “estimates,” “projects,” “should,” “intends,” “will,” “anticipates,” and
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“likely,” and variations of these words, or similar expressions, terms, or phrases, are intended to identify such forward-looking statements. Forward-looking statements are inherently subject to risks, assumptions, and uncertainties, many of which cannot be predicted or quantified, which could cause future events and actual results to differ materially from those set forth in, contemplated by, or underlying the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in “Item 1A. Risk Factors” of our 2021 Form 10-K and [below in Part III – Other Information – Item 1A Risk Factors.]
Factors that may cause our actual results to differ materially from those contemplated or projected, forecast, estimated or budgeted in such forward-looking statements include among others, the following possibilities:
| ● | our business plan, particularly including our reinsurance strategy, may not prove to be successful; |
| ● | the success of our recent changes in executive leadership; |
| ● | our reliance on third-party insurance marketing organizations to market and sell our insurance products through a network of independent agents; |
| ● | adverse changes in the ratings obtained from independent rating agencies; |
| ● | failure to maintain adequate reinsurance; |
| ● | our inability to expand our insurance operations outside the 22 states and District of Columbia in which we are currently licensed; |
| ● | our annuity products may not achieve significant market acceptance; |
| ● | we may continue to experience operating losses in the foreseeable future; |
| ● | the possible loss or retirement of one or more of our key executive personnel; |
| ● | intense competition, pricing competition, the entry of new competitors, and the introduction of new products by new and existing competitors, many of whom have capital and human resources in excess of ours; |
| ● | adverse state and federal legislation or regulation, including limitations on premium levels, increases in minimum capital and reserve requirements, benefit mandates and tax treatment of insurance products; |
| ● | fluctuations in interest rates causing a reduction of investment income or increase in interest expense and in the market value of interest-rate sensitive investments; |
| ● | failure to obtain new customers, retain existing customers, or reductions in policies in force by existing customers; |
| ● | higher service, administrative, or general expense due to the need for additional marketing, administrative or management information systems expenditures related to implementation of our business plan; |
| ● | changes in our liquidity due to changes in asset and liability matching; |
| ● | possible claims relating to sales practices for insurance products; |
| ● | accuracy of management’s assumptions and estimates; |
| ● | variability of statutory capital required to be held by insurance or reinsurance entities; and |
| ● | lawsuits in the ordinary course of business. |
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All such forward-looking statements speak only as of the date of this report. You are cautioned not to place undue reliance on such forward-looking statements. We expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in the events, conditions, or circumstances on which any such statements are based.
Overview of Company and Business Model
Midwest Holding Inc. (“Midwest,” “the Company,” “we,” “our,” or “us”) was incorporated on October 31, 2003 for the purpose of operating a financial services company. We are in the annuity insurance business and operate through our wholly owned subsidiaries, American Life & Security Corp. (“American Life”), 1505 Capital LLC (“1505 Capital”), and our sponsored captive reinsurance company, Seneca Reinsurance Company, LLC (“Seneca Re”).
We are a financial services company focused on helping people plan and secure their future by providing technology-enabled and services-oriented solutions to support individuals’ retirement through our annuity products. We distribute our annuities through independent distributors who are primarily independent marketing organizations (“IMOs”). Our operations are comprised of three distinct, inter-connected businesses. We seek to reinsure substantially all of our annuity policies with third-party reinsurers and our captive reinsurance subsidiary, Seneca Re. Our third-party reinsurers include traditional reinsurers and capital markets reinsurers, who are investors seeking exposure to reinsurance revenue and typically do not have their own reinsurance platforms or insurance-related operations. We also have the flexibility to selectively retain assets and liabilities associated with our policies for a period of time when we expect that doing so will provide an attractive return on our capital.
We believe that our operating capabilities and technology platform provide annuity distributors and reinsurers with flexible and cost-effective solutions. We seek to create value through our ability to provide the distributors and reinsurers with annuity product innovation, speed to market for new products, competitive rates and commissions, and streamlined customer and agent experiences. Our capital model allows us to support increasing annuity sales volumes with capital capacity provided by reinsurers although, in connection with plans for future growth, we continue to monitor any need for additional capital.
We provide an end-to-end solution to manage annuity products that includes a broad set of product development, distribution support, policy administration, and asset/liability management services. Our technology platform enables us to efficiently develop, sell and administer a wide range of annuity products. Our asset management services are also provided to third-party insurers and reinsurers.
We currently offer annuity products, consisting of multi-year guaranteed annuity (“MYGA”) and fixed indexed annuity (“FIA”) policies, through IMOs that in turn distribute our products and services to independent insurance agents in 22 states and the District of Columbia. We further provide IMOs with our product development expertise, administrative capabilities and technology platform.
We operate our core business through three subsidiaries under one reportable segment. American Life is a Nebraska-domiciled life insurance company that is licensed to sell, underwrite, and market life insurance and annuity. In late 2018, American Life obtained a financial strength rating of B++ (“Good”) from A.M. Best Company (“A.M. Best”), a leading rating agency for insurance companies, that was affirmed in December 2020 and February 2022. A.M. Best also upgraded American Life’s long-term issuer credit rating to bbb+ from bbb in December 2020, which was affirmed in February 2022. All of our annuities are written by American Life.
Our other insurance subsidiary, Seneca Re, is a Vermont-domiciled sponsored captive reinsurance company established in early 2020 to reinsure various types of risks on behalf of American Life and third-party capital providers through special purpose reinsurance entities known as “protected cells.” Through Seneca Re, we assist capital market investors in establishing and licensing new protected cells. We also own 1505 Capital, which is an SEC registered investment adviser that provides financial, investment advisory, and management services. At September 30, 2022, 1505 Capital had approximately $494.5 million total third-party assets under management.
We seek to deliver long-term value by growing our annuity volumes and generating profitable fee-based revenue. We generate fees and other revenue based on the gross deposits received on the annuity policies we issue, reinsure, and administer.
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We seek to create value for our distribution and reinsurance partners by facilitating product innovation, rapid speed to market for new products, competitively priced products, streamlined customer and agent experience, and efficient technology-enabled operations. We generate fee income from reinsurers in the form of ceding commissions, policy administration fees, and asset management fees. We typically receive upfront ceding commissions and expense reimbursements at the time the policies are reinsured and policy administration fees over the policy lifetimes. We also earn asset management fees on the assets we hold that support the obligations of a majority of our reinsurers. In investing on behalf of our insurance and reinsurance company subsidiaries, we seek to maximize yield by constructing portfolios that include a diversified portfolio of bonds, mortgages, private credit and structured securities (including collateralized loan obligations), while minimizing the difference in duration between our investment assets and liabilities.
By reinsuring a significant portion of the annuity policies issued, the level of capital needed for American Life is significantly less than retaining all of the business on its books. We believe this “capital light” approach has the potential to produce enhanced returns for our business compared to a traditional insurance company capital structure. This strategy helps alleviate our insurance regulatory capital requirements because policies that are reinsured require substantially less capital and surplus than policies retained by us.
As of September 30, 2022, approximately 45% of the deposits received in 2022 for our annuity products were ceded to reinsurance vehicles capitalized by third party reinsurers or held in protected cells within Seneca Re for future reinsurance transactions.
We receive ceding commissions and expense reimbursement from reinsurers at the time we cede our primary insurance liabilities to them, providing meaningful cash flow. During the three months ended September 30, 2022, and 2021, we generated $5.5 million and $4.3 million, respectively, in upfront ceding commissions. For the nine months ended September 30, 2022 and 2021, we generated $9.5 million and $9.3 million, respectively, in upfront ceding commissions. On our balance sheet is an item “deferred gains on reinsurance” equaling $35.5 million and $28.6 million as of September 30, 2022, and December 31, 2021, respectively which will be earned as revenue over the relevant reinsured annuity contract periods. Amortization of the deferred gain on reinsurance was $1.2 million and $0.7 million for the three months ended September 30, 2022, and 2021, respectively, and was recognized as revenue under GAAP. Amortization of the deferred gain on reinsurance was $3.3 million and $1.7 million for the nine months ended September 30, 2022, and 2021, respectively, and was recognized as revenue under GAAP.
For the three months ended September 30, 2022, and 2021, we generated $19.0 million and $5.8 million of revenue from investment income, realized gains on investments, ceding commissions earned, policy administration, and asset management fees. For the nine months ended September 30, 2022 and 2021, we generated $21.5 million and $14.1 million of revenue from investment income, realized gains on investments, ceding commissions earned, policy administration, and asset management fees.
Through our ancillary services businesses we administer the policies we issue and offer asset management services to our reinsurance partners for a fee. Through Seneca Re, we also assist capital market investors in establishing and licensing new special purpose reinsurance entities. We believe our broad service offering provides a growing and valuable fee stream and expect that our policy administration and asset management fee income will increase as we grow our number of administered policies and the associated assets that we manage. In the future, we expect to have opportunities to increase our policy administration and asset management revenue by providing these services on a stand-alone basis to new customers.
Our Products
Through American Life we presently issue several MYGA and FIA products. American Life presently offers fixed annuity products, consisting of two MYGAs, two FIAs, and two bonus plans associated with the FIA product. It is not presently offering any traditional life insurance products. Fixed annuities are a type of insurance contract in which the policyholder makes one or more premium deposits, earning interest at a crediting rate determined in relation to a specific market index, on a tax deferred basis. MYGAs are insurance contracts under which the policyholder makes deposits and earns a crediting rate guaranteed for a specified number of years before it may be changed. American Life’s MYGA products are three and five-year single premium deferred individual annuity contracts, providing consumers with an attractive, low risk, predictable and tax-deferred investment option. American Life’s FIA products are long-term (7 and 10-year) annuity products with interest rates that are tied, in part, to published stock market indices chosen by customers. The FIA products are modified single premium annuity contracts
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designed for individuals seeking to benefit from potential market gains with fully protected principal. American Life began selling its MYGA and FIA products in 2019.
In 2021, we introduced two new indexes into the selections on FIA products. The S&P 500 ESG index for fixed annuities is comprised of a subset of S&P 500 companies built to meet the increasing needs of investors seeking socially responsible investments aligned with a mainstream index which is published by S&P Dow Jones Indices (S&P DJI).
Our second index introduced in 2021, the Goldman Sachs Xenith Index is a multi-asset strategy that uses an anticipated macro regime, as identified by a leading economic indicator, to make asset allocations. By using a leading economic indicator, the Goldman Sachs Xenith Index differs from indices that rely on a backward-looking methodology alone. Instead of relying purely on the S&P 500 Index for exposure to U.S. equities, the index employs an intraday overlay that can reduce equity exposure based on intra-day trading "signals". As a result, the strategy incorporates real-time market movements, in addition to other factors, in its methodology.
We expect to expand American Life’s product line in the future. Depending on market demand, we expect to consider having American Life write a variety of insurance products, including fixed deferred, fixed indexed and other annuities. Any new insurance products we create must be filed with and approved by appropriate state insurance regulatory authorities before being offered to the public. American Life’s MYGA and FIA products were developed using an independent consulting actuary, and we expect that any new products will utilize similar services. Our long-term plan is to broaden our products to life and Medicare supplements under attractive market conditions.
The table below sets forth American Life’s MYGA and FIA deposits received during the three and nine months ended September 30, 2022 and 2021:
1) Under generally accepted accounting principles in the United States of America (“GAAP”), these products are defined as deposit-type contracts; therefore, the deposits received are accounted for under GAAP as deposit-type liabilities on our balance sheet and premiums received are not recognized as revenue in our consolidated statement of comprehensive loss. Under Statutory Accounting Principles (“SAP”), the MYGA and FIA premiums received are treated as premiums written and as revenue when earned.
Industry Trends and Market Conditions
Market
We participate in a large U.S. market that we expect to grow in part due to a number of demographic trends. As measured by annual premiums written, annuities are the largest product line in the life, annuity, and accident and health sector. Annuities play an important role in retirement planning by providing individuals with stable, tax-efficient sources of income. In 2020 annuity premium, accounted for $295 billion of annual premiums, or approximately 31% of the $963 billion of total annual life, annuity, and accident and health premiums according to the Insurance Information Institute. The most common annuities are fixed and variable and can be written on an individual or group basis. Our current products are MYGAs and FIAs written on an individual basis.
An increasing portion of the U.S. population is of retirement age and is expected to increase the retirement income needs of retirees. The number of people of retirement age has increased significantly since 2010, driven by the aging of the “Baby Boomer” generation. The U.S. population over 65 years old is forecast to grow from 56 million in 2020 to an estimated 81 million by 2040, according to the U.S. Census Bureau, Population Estimates and Projections. This study also forecasted that U.S. population aged over 65 years old is expected to grow by 44% from 2020 to 2040, while the total U.S. population is expected to grow by only 12%. Annuities in the U.S. are distributed through a number of channels, most of which are
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independent from the insurance companies that issue annuities. Independent distribution channels serve as the primary and a growing source of annuity distribution. In 2020, approximately 77% of U.S. individual annuity sales occurred through independent distributors, including independent agents, broker-dealers, and banks, representing an increase from approximately 70% in 2016 according to U.S. Individual Annuities, 2020 Year in Review, Life Insurance Marketing and Research Association (“LIMRA”), 2021. Independent agents are the second largest distribution channel, behind independent broker-dealers, accounting for approximately 19% of U.S. individual annuity sales in 2020. IMOs provide independent agents with access to annuity products along with operational support services and functionality to support the distribution services of the agents. The infrastructure and support services provided by IMOs to independent agents are critical to the success of independent agents and their ability to serve their customers and generate additional sales.
We believe that capital markets investors have been actively seeking investing in and acquiring insurance and reinsurance companies in recent years. Fixed annuities provide upfront premiums and stable, long-term payment obligations and are thus attractive sources of liability-funded assets for a variety of traditional and alternative asset managers and investors. However, there are significant regulatory and operational hurdles for capital providers looking to enter the insurance market. These hurdles are exacerbated by the limited legacy administrative capabilities, product development processes and technology systems, of traditional insurers and reinsurers. We provide asset managers and investors the ability to seamlessly access funding from annuities through a variety of reinsurance entities that we can form quickly and operate efficiently with lower upfront and ongoing regulatory and operating costs.
State expansion efforts have taken more time than anticipated, as states would like to see a more meaningful historical financial footprint. We are working diligently to file in more states, responding and providing increased information to regulators and discussing how the model ensures policyholders are protected, given the capital held and supported by the use of reinsurance.
We currently distribute annuity products through eight third-party IMOs. We believe our product development, prompt policy processing, operating flexibility and speed to market make us a desirable partner for insurance distributors. We are seeking to grow by increasing volumes with our current IMOs and by establishing new IMO relationships.
Competition
We operate in highly competitive markets with a variety of participants, including insurance companies, financial institutions, asset managers, and reinsurance companies. These companies compete in various forms in the annuity market, for investment assets and for services. We seek to build strong relationships along with offering technology-enabled and services-oriented solutions for our partners. Our experience indicates that the market for annuities is dynamic. The combination of the treasury market experiencing the unprecedented rate increases and the volatility in the market resulting from the war in Ukraine and related economic uncertainties due to inflation has opened up investment opportunities that allow us, and our reinsurance partners, to support more competitive rates for annuities. Based on our experience with COVID, we expect this investment environment to be conducive to our business model. We have been reviewing policy pricing along with reinsurer appetite to ensure we continue to grow our business while managing risk. We have recently taken pricing action on both our FIA and MYGA products and continue to monitor our competitiveness in the market. We have also increased our focus on marketing, reestablishing, and expanding our relationships on the distribution side through various channels and are reallocating or adding resources relating to this initiative. As a result, we experienced encouraging sales in the second and third quarters of 2022. However, we expect competition in our market to remain intense particularly from other well established entities providing annuity products.
Given potential premium growth, we have capacity to cover the capital needs of writing new business through existing reinsurers although, in connection with plans for future growth, we continue to monitor our need (if any) for additional capital. Additionally, we have a number of potential reinsurance transactions in the pipeline that may close later in the year.
Interest Rate Environment
The Federal Reserve continued increasing short-term interest rates in the third quarter of 2022, compared to the historically low levels in the same period in 2021 and the expectation communicated from U.S. federal banking officials is for rate increases to continue during the remainder of 2022. We seek to address our interest rate risk through managing the duration of the liabilities and purchasing and holding quality, long-term assets mirroring that duration.
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If interest rates were to rise, we believe the yield on our floating rate investments and the yield on new investment purchases would rise. We also believe our products would therefore be more attractive to consumers and our annuities sales would increase.
Discontinuation of LIBOR
The Financial Conduct Authority (“FCA”), the United Kingdom regulator of the London Interbank Offered Rate ("LIBOR"), previously indicated that it intends to stop compelling panel banks to submit quotes used to determine LIBOR after 2021. On November 30, 2020, the Intercontinental Exchange (“ICE”) Benchmark Administration (“IBA”), the administrator of LIBOR, announced a consultation regarding its intention to cease the publication of one week and two-month U.S. Dollar LIBOR settings at the end of December 2021, but to extend the publication of the remaining U.S. Dollar LIBOR settings (overnight and one, three, six and 12-month U.S. Dollar LIBOR) until the end of June 2023. The IBA intends to share the results of the consultation with the FCA and publish a summary of the responses. U.S. bank regulators acknowledged the announcement and, subject to certain limited exceptions, advised banks to cease writing new U.S. Dollar LIBOR contracts by the end of 2021.
We are in the process of analyzing and identifying our securities, financial instruments and contracts that utilize LIBOR (collectively “LIBOR Instruments”) to determine if we have any material exposure to the transition from LIBOR. To the extent we hold LIBOR Instruments, the terms of these instruments may have fallback provisions that provide for an alternative reference rate when LIBOR ceases to exist. For securities without adequate fallback provisions already in place, legislation governing securities under New York law has been enacted to provide a safe harbor for transition to the recommended alternative reference rate. In addition, federal legislation has been introduced to provide the same protection for securities not governed by New York law.
Notwithstanding, in preparation for the phase out of LIBOR, we may need to renegotiate our LIBOR Instruments that utilize LIBOR. However, these efforts may not be successful in mitigating the legal and financial risk from changing the reference rate in our LIBOR Instruments. Furthermore, the discontinuation of LIBOR may adversely impact our ability to manage and hedge exposures to fluctuations in interest rates using derivative instruments.
As a result, the transition of our LIBOR Instruments to alternative reference rates may result in adverse changes to the net investment income, fair market value and return on those investments. We intend to continue evaluating and monitoring the risks associated with the LIBOR transition which include identifying and monitoring our exposure to LIBOR, monitoring the market adoption of alternative reference rates and ensuring operational processes are updated to accommodate alternative rates. Due to uncertainty surrounding alternative rates, we are unable to predict the overall impact of this change at this time, although we have experienced no adverse effect to our investment portfolio from this transition to date.
COVID-19
We continue to closely monitor developments related to the COVID-19 pandemic to assess any potential adverse impact on our business. It is currently not possible to provide a longer-term estimate of potential insurance or reinsurance exposure or the indirect effects the pandemic may have on our results of operations, financial condition or liquidity. We continue to monitor the Center for Disease Control and Prevention and State of Nebraska guidelines regarding employee safety. Our management continues to monitor our investments and cash flows to evaluate any impact.
Critical Accounting Policies and Estimates
Part II – Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our 2021 Form 10-K contains a detailed discussion of our critical accounting policies and estimates. This report should be read in conjunction with the “Critical Accounting Policies and Estimates” discussed in our 2021 Form 10-K MD&A.
Derivatives
The Company has entered into certain derivative instruments to hedge FIA products that guarantee the return of principal to our policyholders and credit interest based on a percentage of the gain in a specified market index. To hedge against adverse changes in equity indices, the Company entered into contracts to buy equity indexed options. The change in fair value of the derivatives for hedging the FIA index credits and the related embedded derivative liability fluctuate from period to period based
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on the change in the market interest rates. The indexed reserves are measured at fair value for the current period and future periods. We hedge with options in seeking to align with the terms of our FIA products, which are between seven and ten years. We have analyzed our hedging strategy on our FIA products and, while the correlation of the hedges to the FIA products is not matched dollar for dollar, we believe the hedges are effective as of September 30, 2022.
American Life also has agreements with several third-party reinsurers that have funds withheld (“FW”) and modified coinsurance (“Modco”) provisions under which the assets related to the reinsured business are maintained by American Life as collateral; however, ownership of the assets and the total return on the asset portfolios belong to the third-party reinsurers. Under GAAP, this arrangement is considered an embedded derivative as discussed in “Note 5 — Derivative Instruments” to our Consolidated Financial Statements. Assets carried as investments on American Life’s financial statements for the third-party reinsurers contained cumulative unrealized losses of approximately $14.4 million as of September 30, 2022, and cumulative unrealized gains of $0.2 million at December 31, 2021, respectively. The terms of the contracts with the third-party reinsurers provide that the changes in unrealized gains and losses on the portfolios accrue to the third-party reinsurers. To recognize changes in the third-party unrealized gain (loss), American Life records the year-to-date change in the Consolidated Statements of Comprehensive Loss and in amounts recoverable from third-party reinsurers on the Consolidated Balance Sheet. As of September 30, 2022, American Life recognized a current year gain in the embedded derivative of $14.6 million and a gain in the embedded derivative of $0.9 million for the comparable period in 2021. If prices of investments fluctuate, the unrealized gains or losses of the third-party reinsurers may also fluctuate; therefore, the associated embedded derivative gain (loss) recognized by us would be increased or decreased accordingly.
Consolidated Results of Operations – the three months ended September 30, 2022, and 2021
Comprehensive Net Income (Loss)
In this section, unless otherwise noted the discussion below first compares the three months ended September 30, 2022, to the three months ended September 30, 2021.
We incurred a comprehensive loss of $19.6 million compared to a comprehensive loss of $2.5 million in 2021. Our revenues increased to $19.0 million from $5.8 million driven by unrealized losses from derivatives used to hedge FIA exposure of $31.0 million due to changes in in the Federal Reserve interest rate, offset by increases in fee revenue and investment income. Our expenses increased to $14.3 million from $9.2 million due primarily to the interest rate increases resulting in losses in the embedded derivative creating negative interest credited on our FIA products and a gain from passing the losses of the mark-to-market on the reinsurance option allowances. These decreases in expense were offset by increases in consulting related to new software implementation.
Other reasons for the increase in comprehensive loss included:
| 1) | Taxes. We expect our effective rates to decrease throughout the remainder of 2022. Note 8 to our Financial Statements provides further information relating to this tax rate increase. |
| 2) | Change in Realized Investment Losses (Gains). This $6.0 million change moved to a gain of $4.1 million in 2022 from a loss of $2.1 million in 2021. The increase in interest rates in 2022 decreased the value of our fixed-income investments to a much greater extent than occurred in 2021. |
Our FIA products have three components impacting our Consolidated Statements of Comprehensive Loss:
| 1) | The derivatives we purchase to hedge interest rate risk we would otherwise face from our FIA. We carry these derivatives at fair value on our Consolidated Balance Sheets, recording the change in fair value in our Consolidated Statements of Comprehensive Loss as either a realized gain or realized loss. In 2022, the decrease in the market value of the derivative option assets was $23.1 million compared to an increase of $0.7 million in 2021. |
| 2) | The embedded derivative in our FIAs. We carry this derivative at fair value as of the balance sheet date, with the change in fair value recorded in the interest credited line of our Consolidated Statements of Comprehensive Loss. Interest credited for all our products was $5.7 million in 2022 compared to $0.3 million in 2021. The decrease in the value of the embedded derivative related to our FIAs was included in overall interest credited. Reflecting our risk |
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| management strategy, the change in the value of the embedded derivative equaled the change in the value of option contracts we use to hedge this exposure. |
| 3) | The option budget reinsurers pay us to purchase derivative assets. We mark these assets to market at each balance sheet date. Separately, we record a payable to the reinsurers that is owed to a reinsurer when a policy is surrendered, an annuitant dies, or a policy lapses. We compare what the reinsurer paid for the original option budget to the market value at the end of the period. The change in the market value is added to or subtracted from the payable to the reinsurer to cover the reinsurer’s obligations to the policyholder. This change in market value that resulted in $2.2 million and was included in our other operating expense in 2022 compared to expense of $0.9 million in 2021. |
Revenues
The following summarizes our revenue sources for the periods indicated:
Three months ended September 30, | ||||||
(In thousands) | 2022 |
| 2021 | |||
Investment income, net of expenses | $ | 12,938 | $ | 6,196 | ||
Net realized gains (loss) on investments |
| 4,135 |
| (2,115) | ||
Amortization of deferred gain on reinsurance |
| 1,239 |
| 662 | ||
Service fee revenue, net of expenses | 118 | 628 | ||||
Other revenue |
| 569 |
| 400 | ||
$ | 18,999 | $ | 5,771 | |||
Premium revenue: Our MYGA and FIA products generated significant cash flows in 2022 and 2021; however, as indicated above, these products are defined as investment contracts under U.S. GAAP. Accordingly, the funds we received from our customers under these contracts were recorded on our balance sheet as a deposit-type liability – and not as premium revenue.
Investment income, net of expenses: The components of our net investment income were as follows:
Investment income, net of expenses consisted, of investment income generated from our retained investment assets that are not ceded to reinsurers. The increase was due to the investment income earned on our bonds and mortgage loans purchased with net proceeds from sales of our MYGA and FIA products that were not ceded to reinsurers during the period, as well as deployment of excess cash towards credit investments. As of September 30, 2022, and December 31, 2021, on a gross consolidated basis, our investment portfolio (excluding cash) was $1.4 billion and $975.5 million, respectively.
Net realized losses on investments: Net realized gains on investments were $4.1 million in 2022 compared to a net realized loss of $2.1 million in 2021. The figure included a gain of $11.5 million and $0.9 million from a total return swap embedded derivative in 2022 and 2021, respectively. In 2022, there were net realized losses of $7.2 million related to derivative options we own to hedge the obligations to FIA policyholders; such losses were partially offset by an increase in the mark-to-market change in embedded derivative liability within interest credited expense and an increase in FIA-related mark-to-market option allowance expense flowing through other operating expenses. The change in fair value of FIA hedging derivatives is driven by the performance of the indices upon which our call options are based.
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American Life has treaties with several third-party reinsurers and one related party reinsurer. In a Modco agreement, the ceding entity retains the assets equal to the modified coinsurance reserves retained. In a FW agreement, assets that would normally be paid over to a reinsurer are withheld by the ceding company to permit statutory credit for unauthorized reinsurers, to reduce potential credit risk. Under these provisions, the assets backing the treaties are maintained by American Life as investments but the assets and total returns or losses on the investments are owned by the reinsurers. Under GAAP, this arrangement is considered an embedded derivative as discussed in Comprehensive Loss to our Consolidated Financial Statements.
Assets carried as investments on American Life’s financial statements for the third-party reinsurers contained unrealized losses of approximately $14.4 million and gains of $0.2 million as of September 30, 2022, and December 31, 2021, respectively. The terms of the contracts with the third-party reinsurers provide that the changes in unrealized gains on the portfolios accrue to the third-party reinsurers. Accordingly, the unrealized losses on the assets held by American Life were offset by gains in the embedded derivative of $14.6 million and $0.2 million as of September 30, 2022, and 2021, respectively.
Amortization of deferred gain on reinsurance: The increase in 2022 to $1.2 million from $0.7 million in 2021 was due to higher deferred gain on reinsurance, driven in part by higher reinsured premiums during 2022.
Service fee revenue, net of expenses: Service fee revenue, net of expenses, consists of fee revenue generated by 1505 Capital, for asset management services provided to third-party clients, some of whom are our reinsurers. The decrease in this revenue, to $0.1 million in 2022 from $0.6 million in 2021, was due primarily to a decline in third-party assets managed by 1505 Capital.
Other revenue: Other revenue consists of revenue generated by us for providing ancillary services such as third-party administration (“TPA”) to clients and policy surrender charges. The increase in 2022 was primarily due to increased policy surrender charges.
Expenses
Our expenses for the periods indicated are summarized below:
Three months ended September 30, | |||||
(In thousands) | 2022 |
| 2021 | ||
Interest credited | $ | 5,682 | $ | 284 | |
Benefits | 1,351 | 0 | |||
Amortization of deferred acquisition costs |
| 1,193 |
| 753 | |
Salaries and benefits |
| 3,751 |
| 4,025 | |
Other operating expenses |
| 2,317 |
| 4,124 | |
$ | 14,294 | $ | 9,186 | ||
Interest credited: The increase was primarily due to the interest credited in 2022 relating to the MYGA products of approximately $2.6 million and $0.8 million for 2022 and 2021, respectively, offset by interest credited related on our retained FIA policies of approximately $3.0 million and $(0.5) million for 2022 and 2021, respectively. The FIA interest credited is related to the fair market value of the embedded derivative, which is owed to policyholders. It experienced a sharp decline due to the 2022 increases in the Federal Reserve interest rates, partially offset by the realized gain on our total return swap that is included in the net realized gain on investments above.
Amortization of deferred acquisition costs: The increase was due to the acquisition costs relating to the sale of MYGA and FIA products where we retained approximately 55% of the business in 2022 compared to the 49% retained in 2021. These figures include the deferred acquisition cost (“DAC”) of the Seneca Re protected cells, SRC1 and SRC3.
Salaries and benefits: The decrease to $3.8 million compared with $4.0 million was due to slightly lower costs.
Other operating expenses: Other operating expenses were approximately $1.8 million lower due primarily to:
| ● | Our FIA products have embedded derivatives included in the account value that are market driven. The FIA reinsurers pay an option allowance to American Life to purchase derivatives. As of September 30, 2022, and 2021, the mark-to-market on those allowances were in a negative position so American Life incurred $2.2 million and $4.3 million, |
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| respectively, of income and receivable from the reinsurers for that market value true-up. As the market fluctuates going forward, the mark-up of the option allowance will go up or down. |
| ● | Offset due to increases in other operating expenses of approximately $1.1 million was due to building foundational capabilities to support growth along with costs that are variable with increased premiums written related to technology support, distribution, product design and premium taxes. |
Taxes
Income tax expense increased by $1.6 million to an expense of $1.2 million in 2022 from a benefit of $0.4 million in 2021. This change was primarily driven by the change in the reinsurance modified coinsurance tax reserves discussed.
Consolidated Results of Operations - Nine months Ended September 30, 2022, and 2021
Comprehensive Net Income (Loss)
In this section, unless otherwise noted the discussion below first compares the nine months ended September 30, 2022, to the nine months ended September 30, 2021.
We incurred a comprehensive loss of $38.7 million in 2022 compared to a comprehensive loss of $8.8 million in 2021. Our revenues increased to $21.5 million from $14.1 million reflecting an overall increase in investment income and fee revenue; offset by realized losses due to the increases in the Federal Reserve interest rate. Our expenses decreased to $9.6 million from $21.9 million, primarily due to the Federal Reserve interest rate increases resulting in losses in the embedded derivative creating negative interest credited on our FIA product and a gain from passing the losses of the mark-to-market on the reinsurance option allowances. These decreases in expense were offset by increases in consulting fees.
Other reasons for the increase in Consolidated Statements of Comprehensive Loss:
| 1) | Taxes. We expect the effective rates will decrease throughout the remainder of 2022. Note 8 to our Financial Statements provides further information related to this increase in tax rate. |
| 2) | Change in Realized Investment Losses (Gains). This change was a loss of $14.7 million in 2022 compared with a loss of $2.7 million in 2021. The increase in interest rates in 2022 decreased the value of our fixed-income investments to a much greater extent than occurred in 2021. |
Our FIA products have three components influencing our Consolidated Statements of Comprehensive Loss:
| 1) | The derivatives we purchase to hedge interest rate risk we would otherwise face from our FIA. We carry these derivatives at fair value on our Consolidated Balance Sheets, recording the change in fair value in our Consolidated Statements of Comprehensive Loss as either a realized gain or realized loss. In 2022, the decrease in the market value of the derivative option assets was $31.0 million compared to the decrease in market value of the derivative option assets of $4.5 million in 2021 in our net realized gain on investments. |
| 2) | The embedded derivative in our FIAs. We carry this derivative at fair value as of the balance sheet date, with the change in fair value recorded in the interest credited line of our Consolidated Statements of Comprehensive Loss. Interest credited for all of our products was a negative $6.5 million in 2022 compared with $1.9 million in 2021. The decrease in the value of the embedded derivative related to our FIAs was included to the overall interest credited. Reflecting our risk management strategy, the change in the value of the embedded derivative equaled the change in the value of option contracts we use to hedge this exposure. |
| 3) | The option budget reinsurers pay us to purchase derivative assets. We mark these assets to market at each balance sheet date. Separately, we record a payable to the reinsurers that is owed to a reinsurer when a policy is surrendered, an annuitant dies, or a policy lapses. We compare what the reinsurer paid for the original option budget to the market value at the end of the period. The change in the market value is added to or subtracted from the payable to the reinsurer |
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| to cover the reinsurer’s obligations to the policyholder. This change in market value that resulted in negative $2.2 million was included in our other operating expense in 2022 compared to a negative $4.3 million expense in 2021. |
Revenues
The following summarizes our revenue sources for the periods indicated:
Nine months ended September 30, | ||||||
(In thousands) | 2022 |
| 2021 | |||
Investment income, net of expenses | $ | 29,721 | $ | 12,303 | ||
Net realized losses on investments |
| (14,676) |
| (2,704) | ||
Amortization of deferred gain on reinsurance |
| 3,251 |
| 1,711 | ||
Service fee revenue, net of expenses | 1,632 | 1,738 | ||||
Other revenue |
| 1,530 |
| 1,007 | ||
$ | 21,458 | $ | 14,055 | |||
Premium revenue: Our MYGA and FIA products generated significant cash flows in 2022 and 2021; however, as indicated above, these products are defined as investment contracts under U.S. GAAP. Accordingly, the funds we received from our customers under these contracts were recorded on our balance sheet as a deposit-type liability – and not as premium revenue.
Investment income, net of expenses: Our net investment income components are as follows:
Investment income, net of expenses consisted of investment income generated from our retained investment assets that are not ceded to reinsurers. The increase was due to the investment income earned on our bonds and mortgage loans purchased with the sales of our MYGA and FIA products that were not ceded to reinsurers during the period, as well as deployment of excess cash towards credit investments. As of September 30, 2022, and December 31, 2021, on a gross consolidated basis, our investment portfolio (excluding cash) was $1.4 billion and $975.5 million, respectively.
Net realized losses on investments: Net realized losses on investments were $14.7 million in 2022 compared to a loss of $2.7 million in 2021. The figure included a gain of $14.6 million and $0.9 million from a total return swap embedded derivative in 2022 and 2021, respectively. In 2022, there were net realized losses of $35.9 million related to derivative options we own to hedge the obligations to FIA policyholders; such losses were partially offset by an increase in the mark-to-market change in embedded derivative liability within interest credited expense and an increase in FIA-related mark-to-market option allowance expense flowing through other operating expenses. The change in fair value of FIA hedging derivatives is driven by the performance of the indices upon which our call options are based.
American Life has treaties with several third-party reinsurers and one related party reinsurer. In a Modco agreement, the ceding entity retains the assets equal to the modified coinsurance reserves retained. In a FW agreement, assets that would normally be paid over to a reinsurer are withheld by the ceding company to permit statutory credit for unauthorized reinsurers, to reduce potential credit risk. Under these provisions with third-party reinsurers, the assets backing the treaties are maintained by American Life as investments but the assets and total returns or losses on the investments are owned by the reinsurers. Under GAAP, this arrangement is considered an embedded derivative as discussed in Comprehensive Loss to our Consolidated Financial Statements.
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Assets carried as investments on American Life’s financial statements for the third-party reinsurers contained unrealized losses of approximately $14.4 million as of September 30, 2022, and unrealized gains of $0.2 million as of December 31, 2021, respectively. The terms of the contracts with the third-party reinsurers provide that the changes in unrealized gains on the portfolios accrue to the third-party reinsurers. Accordingly, the change in unrealized gains and losses on the assets held by American Life were offset by gains in the embedded derivative of $14.6 million and a loss in the embedded derivative of $0.9 million as of September 30, 2022, and 2021, respectively. We account for this unrealized gain (loss) pass-through by recording an equivalent realized gain or (loss) on our Consolidated Statements of Comprehensive Loss and in amounts payable to our third-party reinsurers on the Consolidated Balance Sheets.
Amortization of deferred gain on reinsurance: The increase in 2022 to $3.3 million from $1.7 million in 2021 was due to higher deferred gain on reinsurance, driven in part by higher reinsured premiums during 2022.
Service fee revenue, net of expenses: Service fee revenue, net of expenses, consists of fee revenue generated by 1505 Capital, for asset management services provided to third-party clients, some of whom are our reinsurers. The decrease in this revenue, to $1.6 million in 2022 from $1.71 million in 2021, was due primarily to the assets managed by 1505 Capital.
Other revenue: Other revenue consists of revenue generated by providing ancillary services such as third-party administration (“TPA”) to clients and policy surrender charges. The increase in 2022 was primarily due to increased policy surrender charges.
Expenses
Our expenses for the periods indicated are summarized below:
Nine months ended September 30, | |||||
(In thousands) | 2022 |
| 2021 | ||
Interest credited | $ | (6,489) | $ | 1,868 | |
Amortization of deferred acquisition costs |
| 3,095 |
| 1,780 | |
Salaries and benefits |
| 12,366 |
| 11,466 | |
Other operating expenses |
| (1,744) |
| 6,769 | |
$ | 9,573 | $ | 21,883 | ||
Interest credited: The decrease was primarily due to the interest credited in 2022 relating to the MYGA products of approximately negative $4.6 million and $1.8 million for 2022 and 2021, respectively, offset by interest credited related on our retained FIA policies of approximately negative $11.1 million and $0.1 million for 2022 and 2021, respectively. The FIA interest credited is related to the fair market value of the embedded derivative which is owed to policyholders which experienced a sharp decline due to the increases in the Federal Reserve interest rates, partially offset by the realized gain on our total return swap that is included in the net realized gain on investments above.
Amortization of deferred acquisition costs: The increase was due to the acquisition costs relating to the sale of American Life’s MYGA and FIA products where we retained approximately 58% of the business in 2022 compared to the 47% retained in 2021. These figures include the DAC of Seneca Re protected cells, SRC1 and SRC3.
Salaries and benefits: The increase to $12.4 million compared with $11.5 million was due to costs incurred to attract and add personnel to service our business growth and the cost related to non-cash stock consideration. We have hired more in-house expertise to service our growth initiatives and reduce the reliance on third-party providers.
Other operating expenses: Other operating expenses were approximately $8.5 million lower due primarily to:
| ● | Our FIA products have embedded derivatives included in the account value that are market driven. The FIA reinsurers pay an option allowance to American Life to purchase derivatives. As of September 30, 2022 and 2021, the mark-to-market on those allowances were in a negative position so American Life incurred $13.9 million and $1.9 million, respectively, of income and receivable from the reinsurers for that market value true-up. As the market fluctuates going forward, the mark-up of the option allowance will go up or down. |
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| ● | Offset due to increases in other operating expenses of approximately $2.5 million was due to fees to consultants to assist in implementing our business plan and new accounting software, increased audit and actuarial costs, and overhead office expenses to support our plan growth of our business. |
Taxes
Income tax expense increased by $2.0 million to $3.8 million in 2022 from $1.8 million in 2021. This change was primarily driven by the change in the reinsurance modified coinsurance tax reserves discussed above.
Investments
Most investments on our Consolidated Balance Sheets are held on behalf of our reinsurers as collateral under our reinsurance agreements. As a result, our investment allocations are largely a function of our collective reinsurer investment allocations. While the reinsurers have the investment risk on these assets, we typically restrict their investment allocations via control over the selection of the asset managers as well as asset restrictions set forth in investment guidelines and control over the investment managers. In many of our reinsurance agreements, 1505 Capital acts as the asset manager for the invested assets for a fee.
Our investment guidelines relate primarily to collateralized loan obligations, corporate bonds, commercial mortgages on real estate, mortgage-backed securities, and term loans. The duration of our investments is 5 to 10 years in line with that of our liabilities. We do allow non-U.S. dollar denominated investments where the foreign exchange risk is hedged back to U.S. dollars.
The following table shows the carrying value of our investments by investment category and cash and cash equivalents, and the percentage of each to total invested assets as of September 30, 2022, and December 31, 2021. Increases in fixed maturity securities primarily resulted from the proceeds of our new MYGA and FIA products during 2022. Most of the investments as of September 30, 2022, and December 31, 2021 are held as collateral for our reinsurers.
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The following table shows the distribution of the credit ratings of our portfolio of fixed maturity securities by carrying value as of September 30, 2022, and December 31, 2021.
Approximately 93% and 92.8% of all fixed maturity securities were investment grade as of September 30, 2022, and December 31, 2021, respectively.
We expect that the net proceeds from our MYGA and FIA products sales will continue to result in an increase in investable assets in future periods.
Market Risks of Financial Instruments
The primary market risks affecting the investment portfolio are interest rate risk, credit risk and liquidity risk. With respect to investments that we hold on our Consolidated Balance Sheets as collateral, our reinsurers bear the market risks related to these investments, and we bear the market risks on any net retained investments.
Interest Rate Risk
Interest rate risk arises from the price sensitivity of investments to changes in interest rates. Interest and dividend income represent the greatest portion of an investment’s return for most fixed maturity securities in stable interest rate environments. The changes in the fair value of such investments are inversely related to changes in market interest rates. As interest rates fall, the interest and dividend streams of existing fixed-rate investments become more valuable and fair values rise. As interest rates rise, the opposite effect occurs. Our liabilities also have interest rate risk although GAAP does not require our liabilities to be marked to market. We mitigate interest rate risk by monitoring and matching the duration of assets compared to the duration of liabilities.
Credit Risk
We are exposed to credit risk through counterparties and within the investment portfolio. Credit risk relates to the uncertainty associated with an obligor’s ability to make timely payments of principal and interest in accordance with the contractual terms of an instrument or contract. We manage our credit risk through diversification of investments among many corporations and numerous industries. Additionally, our investment policy limits the size of holding in any particular issuer.
Liquidity Risk
We are exposed to liquidity risk when liabilities come due. In order to pay a policyholder, we may need to liquidate assets. If our assets are illiquid assets, we might be unable to convert an asset into cash without giving up capital and income due to a lack of buyers or an inefficient market. We seek to mitigate this risk by keeping a portion of our investment portfolio in liquid investments.
Statutory Accounting and Regulations
Our primary insurance subsidiary, American Life, is required to prepare statutory financial statements in accordance with SAP prescribed by the NDOI. SAP primarily differs from GAAP by charging policy acquisition costs to expense as incurred, establishing future benefit liabilities using actuarial assumptions as well as valuing investments and certain assets and
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accounting for deferred taxes on a different basis. For further discussion regarding SAP as well as net income (loss) of American Life under SAP, see Note 14 – Statutory Net Income and Surplus to our Consolidated Financial Statements. As of September 30, 2022, American Life maintained sufficient capital and surplus to comply with regulatory requirements.
We have reported our insurance subsidiaries’ assets, liabilities and results of operations in accordance with GAAP, which varies from SAP. The following items are principal differences between SAP and GAAP. SAP:
| ● | requires that we exclude certain assets, called non-admitted assets, from the balance sheet. |
| ● | requires us to expense policy acquisition costs when incurred, while GAAP allows us to defer and amortize policy acquisition costs over the estimated life of the policies. |
| ● | dictates how much of a deferred income tax asset that we can admit on a statutory balance sheet. |
| ● | requires that we record certain investments at cost or amortized cost, while we record other investments at fair value; however, GAAP requires that we record investments that have a readily obtainable valuation at fair value. Investments without a valuation are carried at amortized cost. |
| ● | allows bonds to be carried at amortized cost or fair value based on the rating received from the Securities Valuation Office of the National Association of Insurance Commissioners (“NAIC”), while they are recorded at fair value for GAAP. |
| ● | allows ceding commission income to be recognized when written if the cost of acquiring and renewing the associated business exceeds the ceding commissions, but under GAAP such income is deferred and recognized over the coverage period. |
| ● | requires that we record reserves in liabilities and expense for policies written, while we record all transactions related to the annuity products under GAAP as deposit-type contract liabilities. |
| ● | Requires that a provision for reinsurance liability be established for reinsurance recoverable on paid losses aged over 90 days and for unsecured amounts recoverable from unauthorized reinsurers. Under GAAP there is no charge for uncollateralized amounts ceded to a company not licensed in the insurance affiliate’s domiciliary state and a reserve for uncollectable reinsurance is charged through earnings rather than surplus or equity. |
| ● | requires an additional admissibility test outlined in Statements on Statutory Accounting Principles, No. 101, and the change in deferred income tax is reported directly in capital and surplus, rather than being reported as a component of income tax expense under GAAP. Our insurance subsidiaries must file with the insurance regulatory authorities an “Annual Statement” which reports, among other items, net income (loss) and surplus as regards policyholders, which is called stockholders’ equity under GAAP. |
State insurance laws and regulations govern the operations of all insurers and reinsurers such as our insurance and reinsurance company subsidiaries. These various laws and regulations require that insurance companies maintain minimum amounts of statutory surplus regarding policyholders and risk-based capital and determine the dividends that insurers can pay without prior approval from regulators. The statutory net income of American Life is one of the primary sources of additions to our statutory surplus, in addition to capital contributions from us.
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The table below sets forth our SAP net income (loss) for each of the three and nine months ended September 30, 2022 and 2021 for each of our insurance subsidiaries and then reconciled to GAAP.
Three months ended September 30, | Nine months ended September 30, | ||||||||||
(In thousands) | 2022 | 2021 | 2022 | 2021 | |||||||
Consolidated GAAP net income (loss) | $ | 7,431 | $ | (3,064) | $ | 16,883 | $ | (9,659) | |||
Exclude: Midwest non-insurance transaction entities (American Life & Seneca Re) | 4,685 | (1,708) | 8,541 | (4,090) | |||||||
GAAP net gain (loss) of statutory insurance entities | $ | 2,746 | $ | (1,356) | $ | 8,342 | $ | (5,569) | |||
GAAP net income (loss) by statutory insurance entity: | |||||||||||
American Life | $ | 10,720 | $ | (3,314) | $ | 22,270 | $ | (6,595) | |||
Seneca Re Protected Cell 01 | (5,474) | 1,958 | (13,009) | 1,029 | |||||||
Seneca Re Protected Cell 03 | (2,499) | — | (919) | — | |||||||
SAP net gain (loss) | $ | 2,747 | $ | (1,356) | $ | 8,342 | $ | (5,566) | |||
Reconciliation of GAAP and SAP | |||||||||||
GAAP net income (loss) of American Life | 10,720 | (3,314) | 22,270 | (6,595) | |||||||
Increase (decrease) due to: | |||||||||||
Deferred acquisition costs | (11,350) | (7,300) | (27,196) | (27,976) | |||||||
Coinsurance transactions | 160,131 | 38,031 | 317,875 | 141,019 | |||||||
Carrying value of reserves | (153,093) | (28,103) | (297,028) | (102,774) | |||||||
Foreign exchange and derivatives | 14,659 | — | 35,025 | — | |||||||
Gain (loss) on sale of investments, net of asset valuation reserve | (22,915) | 926 | (35,096) | (1,146) | |||||||
Other | 13 | 76 | 205 | 67 | |||||||
SAP net income (loss) of American Life | $ | (1,835) | $ | 316 | $ | 16,055 | $ | 2,595 | |||
GAAP net income (loss) of Seneca Re Protected Cell 01 | (5,474) | 1,958 | (13,009) | 1,029 | |||||||
Increase (decrease) due to: | |||||||||||
Deferred acquisition costs | 482 | 325 | 1,592 | (4,397) | |||||||
Coinsurance transactions | 74 | (61) | 222 | 37,764 | |||||||
Carrying value of reserves | (706) | (1,064) | (6,257) | (36,847) | |||||||
Gain on sale of investments, net of asset valuation reserve | 8,324 | 100 | 18,113 | 1,895 | |||||||
Other gain (loss) | (266) | (101) | (480) | (874) | |||||||
SAP net income (loss) of Seneca Re Protected Cell | $ | 2,434 | $ | 1,157 | $ | 181 | $ | (1,430) | |||
GAAP net income (loss) of Seneca Re Protected Cell 03 | (2,499) | — | (919) | — | |||||||
Increase (decrease) due to: | |||||||||||
Deferred acquisition costs | (3,224) | — | (2,703) | — | |||||||
Coinsurance transactions | 942 | — | 24,698 | — | |||||||
Carrying value of reserves | 3,239 | — | (24,450) | — | |||||||
Gain on sale of investments, net of asset valuation reserve | 2,613 | — | 4,398 | — | |||||||
Other | (16) | — | (64) | — | |||||||
SAP net income (loss) of Seneca Re Protected Cell 03 | $ | 1,055 | $ | — | $ | 960 | $ | — | |||
SAP net gain (loss) of statutory insurance entities | $ | 1,654 | $ | 1,473 | $ | 17,196 | $ | 1,165 | |||
Key Operating and Non-GAAP Measures
In addition to our GAAP results, below we provide non-GAAP financial measures that our management uses in conjunction with GAAP financial measures as an integral part of managing our business and to, among other things:
| ● | monitor and evaluate the performance of our business operations and financial performance; |
| ● | facilitate internal comparisons of the historical operating performance of our business operations; |
| ● | review and assess the operating performance of our management team; |
| ● | analyze and evaluate financial and strategic planning decisions regarding future operations; and |
| ● | plan for and prepare future annual operating budgets and determine appropriate levels of operating investments. |
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Management believes the use of these non-GAAP measures, together with the relevant GAAP measures provides information that may enhance understanding of our results by investors. Non-GAAP financial measures used by us may be calculated differently from, and therefore may not be comparable to, similarly titled measures used by other companies. These non-GAAP financial measures should be considered along with, but not as alternatives to, our operating performance measures as prescribed by GAAP.
Operating Metric – Annuity Premiums
We monitor annuity premiums as a key operating metric in evaluating the performance of our business. Annuity premiums, also referred to as sales or direct written premiums, do not correspond to revenues under GAAP, but are relevant metrics to understand our business performance. Under SAP, our annuity premiums received are treated as premium revenue. Our premium metrics include all sums paid by an individual annuitant in a given period. We typically transfer a substantial portion of the premium and policy obligations to reinsurers. Ceded premium represents the premium we transfer to reinsurers in a given period. Retained premium represents the portion of premium received during a given period that was not ceded to reinsurers and will either be reinsured in a subsequent period or retained by us. We typically retain premiums prior to transferring them to reinsurers to facilitate block and other reinsurance transactions.
The following tables set forth premiums received under SAP. Under GAAP these products are defined as deposit-type contracts; therefore, the premium revenue is accounted under GAAP as deposit-type liabilities on our Consolidated Balance Sheets and is not recognized in our Consolidated Statements of Comprehensive Loss
Nine months ended September 30, | |||||
(In thousands) | 2022 | 2021 | |||
Annuity Premiums (SAP) | |||||
Annuity direct written premiums | $ | 509,660 | $ | 367,446 | |
Ceded premiums | (213,761) | (193,632) | |||
Net premiums retained | $ | 295,899 | $ | 173,814 | |
Starting in the fourth quarter of 2021, sales of our annuity products decreased compared to like prior periods, and the competitive decrease continued through the first quarter of 2022. We took pricing action on both our FIA and MYGA products that were a key factor in sales rebounding in the second quarter of 2022 and we monitor our competitiveness in the market on an ongoing basis. We are seeking to grow annuities through the IMO channel by further developing our relationships with existing IMOs and increasing the number of IMO partners that distribute our annuity products, as well as increasing the number of states in which we are licensed to sell our annuity products. We are also seeking to distribute to new channels, including the registered investment advisor (RIA) channel as well as the bank and broker-dealer channels.
Operating Metric – Fees Received for Reinsurance
Three months ended September 30, | Nine months ended September 30, | |||||||||||
(In thousands) | 2022 |
| 2021 |
| 2022 |
| 2021 | |||||
Fees received for reinsurance(1) | ||||||||||||
Fees received for reinsurance - total | $ | 4,500 | $ | 3,589 | $ | 10,126 | $ | 11,312 | ||||
(1) Consists of: 1) amortization of deferred gain on reinsurance, which is a line item from our GAAP Consolidated Statements of Comprehensive Loss; and 2) deferred gain on coinsurance transactions, which is a line item from our GAAP Consolidated Statements of Cash Flows.
Fees received for reinsurance are the net fees received for reinsurance transactions completed during the period and includes ceding commission.
For the three months ended September 30, 2022, fees received for reinsurance decreased 65% compared to the like period in the prior year due to lower reinsurance volumes. For the three months ended September 30, 2022, and 2021, the components of fees received for reinsurance included $1.2 million of amortization of deferred gain on reinsurance from our GAAP Consolidated Statements of Comprehensive Loss and $3.3 million of deferred gain on coinsurance transactions from our GAAP Consolidated Statements of Cash Flows.
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For the nine months ended September 30, 2022, fees received for reinsurance decreased 39% compared to the like period in the prior year due to lower reinsurance volumes. For the nine months ended September 30, 2022, and 2021, the components of fees received for reinsurance included $3.3 million of amortization of deferred gain on reinsurance from our GAAP Consolidated Statements of Comprehensive Loss and $6.9 million of deferred coinsurance ceding commission from our GAAP Consolidated Statements of Cash Flows.
Reconciliation – Management Expenses to GAAP Expenses
Three months ended September 30, | Nine months ended September 30, | |||||||||||
| 2022 |
| 2021 |
| 2022 |
| 2021 | |||||
Management Expenses |
|
|
|
|
|
| ||||||
G&A | $ | 8,962 | $ | 6,212 | $ | 24,814 | $ | 17,357 | ||||
Management interest credited | 4,752 | 3,230 | 10,594 | 6,110 | ||||||||
Amortization of deferred acquisition costs | 1,193 | 753 | 3,095 | 1,780 | ||||||||
Expenses related to retained business | 5,945 | 3,983 | 13,689 | 7,890 | ||||||||
Management expenses - total | $ | 14,907 | $ | 10,195 | $ | 38,503 | $ | 25,247 | ||||
Three months ended September 30, | Nine months ended September 30, | |||||||||||
2022 |
| 2021 |
| 2022 |
| 2021 | ||||||
G&A | ||||||||||||
Salaries and benefits - GAAP | $ | 3,751 | $ | 4,025 | $ | 12,366 | $ | 11,466 | ||||
Other operating expenses - GAAP | 2,317 | 4,124 | (1,744) | 6,769 | ||||||||
Subtotal | 6,068 | 8,149 | 10,622 | 18,235 | ||||||||
Adjustments: | ||||||||||||
Less: Stock-based compensation | 670 | (996) | 287 | (2,765) | ||||||||
Less: Mark-to-market option allowance | 2,224 | (941) | 13,905 | 1,887 | ||||||||
G&A | $ | 8,962 | $ | 6,212 | $ | 24,814 | $ | 17,357 | ||||
Three months ended September 30, | Nine months ended September 30, | |||||||||||
2022 |
| 2021 |
| 2022 |
| 2021 | ||||||
Management Interest Credited | ||||||||||||
Interest credited - GAAP | $ | 5,682 | $ | 284 | $ | (6,489) | $ | 1,868 | ||||
Adjustments: | ||||||||||||
Less: FIA interest credited - GAAP | (3,041) | 549 | 11,124 | (38) | ||||||||
Add: FIA options cost - amortized - GAAP | 2,111 | 2,397 | 5,959 | 4,280 | ||||||||
Management interest credited | $ | 4,752 | $ | 3,230 | $ | 10,594 | $ | 6,110 | ||||
Three months ended September 30, | Nine months ended September 30, | |||||||||||
2022 |
| 2021 |
| 2022 |
| 2021 | ||||||
Reconciliation - Management Expenses to GAAP Expenses | ||||||||||||
Total expenses - GAAP | $ | 14,294 | $ | 9,186 | $ | 9,573 | $ | 21,883 | ||||
Adjustments: | ||||||||||||
Less: Benefits | (1,351) | — | (2,345) | — | ||||||||
Less: Stock-based compensation | 670 | (996) | 287 | (2,765) | ||||||||
Less: Mark-to-market option allowance | 2,224 | (941) | 13,905 | 1,887 | ||||||||
Less: FIA interest credited - GAAP | (3,041) | 549 | 11,124 | (38) | ||||||||
Add: FIA options cost - amortized - GAAP | 2,111 | 2,397 | 5,959 | 4,280 | ||||||||
Management expenses - total | $ | 14,907 | $ | 10,195 | $ | 38,503 | $ | 25,247 | ||||
Operating Metric – Management and G&A Expenses
In addition to total expenses, we utilize management expenses as an economic measure to evaluate our financial performance. Management expenses consist of total GAAP expenses adjusted to eliminate items that fluctuate from quarter to quarter in a manner unrelated to core operations, which we believe are useful in analyzing operating trends. The most significant adjustments to arrive at management expenses include the use of management interest credited (as discussed below), the exclusion of stock-based compensation and the exclusion of the mark-to-market option allowance expense (included in other operating expenses) payable to reinsurers to cover their obligations under FIA policies we have reinsured with them. We believe the combined presentation and evaluation of total expenses together with management expenses provides information that can enhance an investor’s understanding of our underlying operating results.
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For the three months ended September 30, 2022, the sum of salaries and benefits and other operating expenses totaled $6.1 million compared to $8.1 million for the three months ended September 30, 2021. For the three months ended September 30, 2022, as disclosed above, included in these expenses is mainly salaries, benefits and other operating expenses, along with $2.2 million of non-cash mark-to-market option allowance of our derivative option allowance, which we exclude in our management G&A.
For the nine months ended September 30, 2022, the sum of salaries and benefits and other operating expenses totaled $10.6 million compared to $18.2 million for the nine months ended September 30, 2021. For the nine months ended September 30, 2022, as disclosed above, included in these expenses is mainly salaries, benefits and other operating expenses, along with $13.9 million of non-cash mark-to-market option allowance of our derivative option allowance, which we exclude in our management G&A.
Liquidity and Capital Resources
At September 30, 2022, and December 31, 2021, we had cash and cash equivalents totaling $208.7 compared to $142.0 million, respectively. We believe that our existing cash and cash equivalents will be sufficient to fund our anticipated operating expenses and capital transaction expenditures for the foreseeable future. We have not seen an impact on our cash flows related to the COVID-19 pandemic during the last two years. In the event we are successful in furthering our state expansion, we expect an increase in our sales of our MYGA and FIA products.
The NAIC has established minimum capital requirements in the form of risk based capital (“RBC”) that factors the type of business written by an insurance company, the quality of its assets and various other aspects of its business to develop a minimum level of capital known as “authorized control level risk-based capital” and compares this level to adjusted statutory capital that includes capital and surplus as reported under SAP, plus certain investment reserves. Should the ratio of adjusted statutory capital to control level RBC fall below 200%, a series of remedial actions by the affected company would be required. The RBC calculation is performed annually and as of December 31, 2021, the RBC ratio of American Life was 764%.
Comparative Cash Flows
Cash flow is an important component of our business model because we receive annuity premiums and invest them upon receipt for our reinsurers and us and for the benefit of our policyholders.
The following table summarizes our cash flows from operational, investing and financing activities for the periods indicated.
Nine months ended September 30, | ||||||
2022 |
| 2021 | ||||
(In thousands) | ||||||
Net cash provided by (used in) operating activities | $ | 64,892 | $ | 917 | ||
Net cash provided by (used in) investing activities | (470,724) | (423,891) | ||||
Net cash provided by (used in) financing activities | 472,483 | 352,782 | ||||
Net increase (decrease) in cash and cash equivalents | 66,651 | (70,192) | ||||
Cash and cash equivalents: | ||||||
Beginning of period | 142,013 | 151,679 | ||||
End of period | $ | 208,664 | $ | 81,487 | ||
Cash Provided by Operating Activities
Net cash provided by operating activities was $64.9 million for the nine months ended September 30, 2022, which was comprised primarily of an increase in realized losses on investments of $14.7 million, an increase in recoverable from reinsurers of $33.7 million, a receivable for securities of $22.1 million, and an increase in other assets and liabilities of $17.7 million. These were offset by a decrease in deposit type liabilities of $17.2 million, and an increase in interest and dividends due and accrued of $10.3 million.
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Cash Used in Investing Activities
Net cash used for investing activities for the nine months ended September 30, 2022, was $470.7 million. The primary use of cash resulted from our purchase of investments from sales of the MYGA and FIA products of $839.6 million. Offsetting this use of cash was our sale of investments in available-for-sale securities for proceeds of $373.6 million.
Cash Flow Provided by Financing Activities
Net cash provided by financing activities for the nine months ended September 30, 2022, was $472.5 million. The primary source of cash was net receipts on the MYGA and FIA products of $509.7 million. The primary use of cash was withdrawals on those products of $30.3 million and $6.9 million transferred to noncontrolling interest.
Impact of Inflation
Insurance premiums are established before the amount of losses and loss adjustment expenses, and the extent to which inflation may affect such losses and expenses, are known. We attempt, in establishing premiums, to anticipate the potential impact of inflation. If, for competitive reasons, premiums cannot be increased to anticipate inflation, this cost would be absorbed by us. Inflation also affects the rate of investment return on our investment portfolio with a corresponding effect on investment income.
Off-Balance Sheet Arrangements
We have off-balance sheet arrangements, disclosed in Note 12. Contingencies and Commitments below, that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
Contractual Obligations
As a “smaller reporting company,” the Company is not required to provide a table of contractual obligations required pursuant to this Item.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
As a “smaller reporting company,” the Company is not required to provide disclosure pursuant to this Item.
ITEM 4. CONTROLS AND PROCEDURES.
We have established disclosure controls and procedures to ensure, among other things, material information relating to our Company, including our consolidated subsidiaries, is made known to our officers who certify our financial reports and to the other members of our senior management and our Board of Directors.
Management, (with the participation of our principal executive officer and principal financial officer), carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act as of September 30, 2022. Based on this evaluation, our principal executive and financial officers concluded that, as of the end of the period covered in this report, our disclosure controls and procedures along with the related internal controls over financial reporting were effective to provide reasonable assurance that the information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in SEC rules and forms, and is accumulated and communicated to our management, including our principal executive officers and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure.
There were no significant changes with respect to the Company’s internal control over financial reporting or any other factors that materially affect, or are reasonably likely to materially affect, internal control over financial reporting during the quarter ended September 30, 2022.
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PART II – OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
We are involved in litigation incidental to our operations from time to time. We are not presently a party to any legal proceedings other than litigation arising in the ordinary course of our business, and we are not aware of any claims that could materially affect our financial position or results of operations.
ITEM 1A. RISK FACTORS.
There have not been any changes to our risk factors previously disclosed in our 2021 Annual Report on Form 10-K.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.
None
ITEM 3. DEFAULTS UPON SENIOR SECURITIES.
None.
ITEM 4. MINE SAFETY DISCLOSURES.
Not applicable.
ITEM 5. OTHER INFORMATION.
On November 9, 2022, the Board of Directors of the Company (the “Board”) approved and adopted non-substantive changes to its Amended and Restated Bylaws (the “Revised Bylaws”), such as including gender neutral language, adding appropriate cross references, and amending Article V regarding officer appointments to add that the Board may appoint a secretary and one or more executive vice presidents. The Revised Bylaws became effective immediately upon their approval and adoption by the Board. The Revised Bylaws are filed with this report as Exhibit 3.
Also on November 9, 2022, the Board approved and adopted certain changes to the Company’s Code of Business Conduct and Ethics (the “Code of Ethics”), largely incorporating another governance document entitled Code of Conduct and Conflicts of Interest Policy for All Members of the Boards of Directors of Midwest Holding Inc. and American Life & Security Corp. (the “Conflicts of Interest Policy”). Because by its terms the Code of Ethics has always applied to all directors, officers, and employees of the Company, and the Conflicts of Interest Policy only to directors, the Board agreed to merge the Conflicts of Interest Policy into the Code of Ethics (with the resulting version described herein as the “Revised Code of Ethics”). Certain other non-substantive changes were made in the Revised Code of Ethics, including adding explanatory language, realigning procedures for reporting violations, clarifying lines of communication with the press and other third parties, and establishing standards for the delivery and receipt of gifts and entertainment. The Revised Code of Ethics became effective immediately upon its approval and adoption by the Board and, as a result, the Conflicts of Interest Policy is no longer in effect. The Revised Code of Ethics is filed with this report as Exhibit 3.
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ITEM 6. EXHIBITS.
EXHIBIT |
| DESCRIPTION |
3.1 | Amended and Restated Bylaws of Midwest Holding Inc. as Revised November 9, 2022 | |
14.1 | Code of Business Conduct and Ethics of Midwest Holding Inc. as Revised November 9, 2022 | |
31.1* | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |
31.2* | Certification of Chief Accounting Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |
32.1* | ||
32.2* | ||
101.INS * | Inline XBRL Instance Document. | |
101.SCH * | Inline XBRL Taxonomy Extension Schema Document. | |
101.CAL * | Inline XBRL Taxonomy Extension Calculation Linkbase Document. | |
101.LAB * | Inline XBRL Taxonomy Extension Label Linkbase Document. | |
101.PRE * | Inline XBRL Taxonomy Extension Presentation Linkbase Document. | |
101.DEF * | Inline XBRL Taxonomy Extension Definition Linkbase Document. | |
104 | Cover Page Interactive Data File. Formatted as Inline XBRL and contained in Exhibit 101. |
*Filed herewith.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Dated: November 14, 2022
MIDWEST HOLDING INC. | ||
| ||
By: | /s / Georgette Nicholas | |
Name: | Georgette Nicholas | |
Title: | Chief Executive Officer | |
| ||
By: | /s / Daniel S. Maloney | |
Name: | Daniel S. Maloney | |
Title: | Principal Accounting Officer | |
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