Caution Regarding Forward-Looking Statements
The following discussion of our financial condition and results of operations should be read in conjunction with the financial statements and the notes to those statements included in this Annual Report on Form 10-K and it includes many forward-looking statements which involve many risks and uncertainties including those referred to herein. Our actual results could differ materially from those indicated in such forward-looking statements as a result of certain factors, such as those set forth herein under "Summary of Risks Associated with our Business and Voting Common Stock" and "Risk Factors." We are under no duty to update any of the forward-looking statements after the date of this annual report to conform these statements to actual results.
Midwest Holding Inc.("Midwest," "the Company," "we," "our," or "us") was incorporated in Nebraskaon October 31, 2003for the purpose of operating a financial services company. We redomesticated from the State of Nebraskato the State of Delawareon August 27, 2020. 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"). Management evaluates the Company as one reporting segment in the life insurance industry. We are 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 as described below. American Life presently offers five annuity products, two MYGAs, a FIA, and two bonus plans associated with the FIA product. It is not presently offering any traditional life insurance products. 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 is a Nebraska-domiciled life insurance company, which is also commercially domiciled in Texas, that is currently licensed to sell, underwrite, and market life insurance and annuity products in 22 states and the District of Columbia. In early 2020, Seneca Re, a Vermontlimited liability company, was formed by us to operate as a Vermontlicensed sponsored captive insurance company to reinsure various types of risks on behalf of American Life and third party capital providers through one or more special purpose entities known as "protected cells." On April 15, 2020, Midwest entered into an operating agreement with Seneca Re and as of December 31, 2021, Seneca Re had two protected cells, Seneca Incorporated Cell, LLC2020-01 ("SRC1") and Seneca Incorporated Cell, LLC2021-03 ("SRC3") and both of which are consolidated in our financial statements. 1505 Capital LLC("1505 Capital"), a Delawarelimited liability company, is an SECregistered investment adviser. Its financial results have been consolidated with ours since the date of its acquisition on June 15, 2020. . At December 31, 2021, 1505 Capital had approximately $405 milliontotal third-party assets under management. On April 24, 2020, we entered into a Securities Purchase Agreement with Crestline Assurance Holdings LLC, a Delawarelimited liability company ("Crestline Assurance"), Xenith Holdings LLC, and Vespoint LLC, pursuant to which Crestline Assurance purchased 444,444 shares of our voting common stock, at $22.50per share for $10.0 million. With the net proceeds we contributed $5.0 millionto American Life. Also, effective as of April 24, 2020, in a separate transaction, we sold 231,655 shares of common stock to various investors in a private placement at $22.50per share for $5.227 millionOn 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, LLC2020-02 ("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 LetterAgreement (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 36 Table of Contents production by providing reinsurance capacity for American Life to write certain kinds of FIAs and MYGAs. 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 MYGAs and a quota share percentage of 40% for American Life's FIAs. The Master Agreement expires on April 24, 2023. In addition, pursuant to the Master Agreement, 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 refer potential advisory clients to Crestline, and American Life will consider investing in certain assets originated or sourced by Crestline. Effective December 8, 2020, American Life entered into a novation agreement with SRC2 and Crestline Re SPC, for and on behalf of Crestline Re SP1, under which the above-described reinsurance, trust and related asset management agreements were novated and replaced with substantially similar agreements entered into by American Life and Crestline Re SP1. In December 2020, we completed a public offering of our voting common stock for gross proceeds of $70.0 million(see Note 17 to the Consolidated financial statements herein). In connection therewith, our common stock was approved for listing and began trading on the Nasdaq Capital Market under the symbol "MDWT."
non-disapproval of the Amended Coinsurance Agreement (“Modco AEG Agreement”) of
American life with
domiciled reinsurance company. The agreement ended on
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 income of $37.5 millionand net statutory reserves of $34.8 millionfor the modified coinsurance account. The amount paid to the Modified Deposit Account from AEGwas $2.4 million. On November 10, 2021, Midwest purchased 1,000 shares of Common Stock, $.01par value per share for a total purchase price of $5.7 millionfor 100% ownership in an intermediary holding company. Also, on November 10, 2021, Seneca Re Protected Cell 2021-03 ("SRC3") was granted a Certificate of Authority by the Vermont Department of Financial Regulation. The intermediary holding company contributed capital of $5.5 millionto 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 December 30, 2021, Midwest closed the sale of approximately 70% of SRC1 to a subsidiary of ORIX Corporation USAfor $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, will be the manager of the assets underlying SRC1's reinsurance obligations going forward, replacing Midwest's asset management arm, 1505 Capital LLC.
We continue to closely monitor developments related to the COVID-19 pandemic to assess any potential adverse impact on our business. Due to the evolving and highly uncertain nature of this pandemic, it currently is 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. Management implemented our business continuity plan in early
March 2020and operated through July 2020with the majority of employees working remotely. Operations continued as normal despite a sharp increase in sales during the period. We continue to monitor the Center for Disease Control and Preventionand State of Nebraskaguidelines regarding employee safety. Our management continues to monitor our investments and cash flows to evaluate the impact as this pandemic evolves. 37
Industry trends and market conditions
Interest rate environment
Overall, interest rates remained at historically low levels in 2021, however the
Federal Reserveis expected to begin increasing short-term interest rates in early 2022. We seek to address our interest rate risk through managing the duration of the liabilities and purchasing and holding high quality, long-term assets that mirror that duration.
We are operating in a highly competitive market with various sizes of diversified financial institutions, established insurance and reinsurance companies. Our annuity market is being impacted by the growing aging population and the need to evaluate their retirement options. We believe our technology and customer service along with our ability to structure solutions position us to provide value to annuity consumers through various distribution channels.
Discontinuation of Libor
The Financial Conduct Authority("FCA"), the U.K.regulator of the LondonInterbank Offered Rate ("LIBOR"), previously indicated that it intends to stop persuading or 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 FCAand 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 population of 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 Yorklaw 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 Yorklaw. 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 to evaluate and monitor 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.
Significant Accounting Policies and Estimates
Our accounting and reporting policies are in accordance with GAAP. Preparation of our Consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. 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. Our accounting policies, judgments and estimates have not changed significantly over our disclosed accounting periods. For further discussion of our accounting policies and estimates see "Note 1 - Nature of Operations and Summary of Significant Accounting Policies" to our Consolidated financial statements.
38 Table of Contents Valuation of Investments
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 bonds. 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. 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, 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. As of
December 31, 2020, the Company analyzed its securities portfolio and determined that an impairment of approximately $35,000should be recorded for one debt security, an impairment of $500,000was recognized on a preferred stock, and a valuation allowance of $777,000established on one lease. The valuation allowance on the lease of $777,000was released as of March 31, 2021due to the sale of the investment. The Company had no impairment to recognize as of December 31, 2021. Investment income consists of interest, dividends, gains and losses from the equity method of accounting for certain 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 Modcoprovisions. In a Modcoagreement, 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, through the fair value of our total return swap, as either a realized gain or loss on the Consolidated Statements of Comprehensive Loss.
We assess the recoverability of indefinite-lived intangible assets at least annually or whenever events or circumstances suggest that the carrying value of an identifiable indefinite-lived intangible asset may exceed the sum of the future discounted cash flows expected to result from its use and eventual disposition. If the asset is considered to be impaired, the amount of any impairment is measured as the difference between the carrying value and the fair value of the impaired asset. Our indefinite-lived intangible assets consist of American Life's state licenses. We compared the carrying value to the current costs of obtaining licenses in those states. As of
December 31, 2021, the sum of the fair value of those licenses exceeded the carrying value of the indefinite-lived intangible assets. 39 Table of Contents Reinsurance We expect to reinsure most of the risks associated with our issued annuities. Our reinsurers may be domestic, foreign or capital markets investors seeking to assume U.S.insurance business. In most reinsurance transactions, American Life will remain exposed to the credit risk of reinsurers, or the risk that one or more reinsurers may become insolvent or otherwise unable or unwilling to pay for policyholder claims. We seek to mitigate the credit risk relating to reinsurers by generally either requiring that the reinsurer post substantial collateral or make other financial commitments as a security for the reinsured risks. Under these reinsurance agreements, there typically is a monthly or quarterly settlement of premiums, claims, surrenders, collateral, and other administration fees. In a typical reinsurance transaction, we receive a ceding commission and reimbursement of certain expenses at the time liabilities are reinsured, plus ongoing fees for the administration of the business ceded. Our reinsurers are typically not "accredited" or qualified as reinsurers under Nebraskalaw. In order to receive credit for reinsurance for transactions with these reinsurers and to reduce potential credit risk, we usually hold collateral from the reinsurer on a FW basis or require the reinsurer to maintain a trust that holds assets backing up its obligation to pay claims on the business it assumes. In some cases, the reinsurer may appoint an investment manager to manage these assets pursuant to guidelines approved by us that are consistent with state investment statutes and regulations relating to reinsurance. When our investment advisor subsidiary, 1505 Capital, is appointed to manage these assets, we receive additional ongoing asset management fees.
Future Policy Benefits
We establish liabilities for amounts payable under our policies, including annuities. Generally, amounts are payable over an extended period of time. Under GAAP, our annuities are treated as deposit liabilities, where we use account value in lieu of future policy reserves. Our FIA reserves are calculated by an independent consulting actuary and our MYGA reserves equal the account value from our policy administration system. We currently do not offer traditional life insurance products. Income Taxes Deferred tax assets are recorded based on the differences between the financial statement and tax basis of assets and liabilities at the applicable tax rates. The principal assets and liabilities giving rise to these differences are investments, insurance reserves, and deferred acquisition costs. A deferred tax asset valuation allowance is established when there is uncertainty that such tax assets would be realized. We have no uncertain tax positions that we believe are more-likely-than not that the benefit will not be realized.
Amounts received as payment for annuities are recognized as deposits to policyholder account balances and included deposit-type contract liabilities. Annuity premiums are shown as a financing activity in the consolidated statement of cash flows. Revenues from these contracts are comprised of fees earned for administrative and policyholder services, which are recognized over the period of the annuity contracts and included in other revenue. Through our reinsurance contracts, revenues are earned through ceding commissions, which are capitalized, and our independent consulting actuary determines the amounts to be recognized as income over the period of the annuity contracts. Deferred coinsurance ceding commissions are shown as an operating activity in the consolidated statement of cash flows. Revenues from asset management services are recognized as earned. 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 FIA product 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, we 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 identifying how the hedging instrument is expected to hedge the designated risks related to the hedged item, the method to retrospectively, and prospectively assess the hedging instrument's effectiveness and the method to be used to measure ineffectiveness. A derivative 40
designated as a hedging instrument must be assessed as being highly effective in offsetting the designated risk of the hedged item. Hedge effectiveness is also assessed periodically throughout the life of the designated hedging relationship. In late 2019, we began investing in options to hedge our interest rate risks on our FIA product. Options typically do not qualify for hedge accounting; therefore, we chose not to use hedge accounting for the related options that we currently have. We value our derivatives at fair market value with the offset being recorded on our consolidated statement of comprehensive loss as a realized gain or (loss).
In addition, reinsurance agreements written on an FW basis contain
derivatives on our FIA product. Gains or (losses) associated with
the performance of the assets held in the relevant deposit and the funds retained
accounts are reflected as realized gains or (losses) in our consolidated accounts.
statement of comprehensive loss.
The Company entered into derivative instruments to hedge FIA 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. The change in fair value of the derivatives for hedging the FIA index credits and the related embedded derivative liability fluctuated from period to period based 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 that align with the terms of our FIA product which is between three and seven years. We have analyzed our hedging strategy on our FIA product and believe it is effective as of
December 31, 2021. American Life also has agreements with several third-party reinsurers that have FW and Modcoprovisions 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 unrealized gains as of December 31, 2021and 2020, of approximately $ 161,000and $2.9 million, respectively. The terms of the contracts with the third-party reinsurers provide that unrealized gains on the portfolios accrue to the third-party reinsurers. We account for these unrealized gains by recording equivalent realized gains or losses on our consolidated statement of comprehensive loss. Accordingly, the unrealized gains on the assets held by American Life on behalf of the third-party reinsurers were offset by recording an embedded derivative gain of $2.7 millionand loss of $2.9 millionas of December 31, 2021and 2020, respectively. 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. Net Loss
In this section, unless otherwise specified, the discussion below first compares
We incurred a comprehensive loss of
$20.1 millionin 2021 compared with a comprehensive loss of $6.6 millionin 2020. Our revenues increased to $30.1 millionfrom $10.6 milliondriven by an overall increase in investment income and realized gains along with fee revenue. But our expenses increased by an even greater amount in dollar terms - to $41.9 millionfrom $21.4 million. Driving the increase in expenses was significant increases in our salaries and benefits and in our other operating expenses. The increase in expenses were to support potential growth of the business from increases costs to attract talent, legal and consulting to support transactions, investment structures, and state expansion along with technology initiatives. 41
Other reasons for the increase in the consolidated statement of comprehensive income in 2021
Taxes. Our GAAP effective tax rate was 35.6% in 2021, compared to 14.7% in
1) 2020. Note 8 of our financial statements provides additional information
to this increase in the tax rate.
Change in unrealized investment gains. This change was
2) compared to
greatly increased the value of our fixed income investments
than was the case in 2021.
Our FIA products have three components that influence our consolidated statement of
The derivatives we purchase to hedge stock market risk we would otherwise face from our FIA. We carry these derivatives at fair value on our balance sheet, recording the change in fair value in our consolidated statement of comprehensive loss as either a realized gain or realized loss. In 2021, the increase in the market value of the derivative assets was
$2.7 millioncompared to the market value of the derivative assets of $3.5 millionin 2020 in our net realized gain on investments.
The derivative integrated into our AIFs. We account for this derivative at fair value,
with the change in fair value recorded in the credited interest line of our
consolidated statement of comprehensive income. On all of our products,
1) the interest credited was
The decrease in the value of the embedded derivative related to our AIFs was
included in this aggregate interest credited. Reflecting our risk management,
the change in the value of the embedded derivative is equal to the change in the
value of the option contracts we use to hedge that exposure.
Option budget reinsurers pay us to buy derivative assets. We mark
these assets to be marketed in each period. Separately, we record an amount payable to the
reinsurers which is due to a reinsurer when a policy is surrendered, a
the annuitant dies or a policy lapses. We compare what the reinsurer paid for the
2) initial option budget at market value at the end of the period. the
change in market value is added to or subtracted from the amount payable to the
reinsurer to cover the obligations of the reinsurer towards the policyholder. This
change in market value has resulted in a
operating expenses in 2021 compared to
American Life has treaties with several third-party reinsurers that have funds withheld and modified coinsurance provisions. As a result of changes in interest rates, assets held on behalf of the third-party reinsurers had unrealized gains of approximately
$161,000and $2.9 millionat December 31, 2021and 2020, respectively. The terms of the contracts with the third-party reinsurers provide that unrealized gains or losses on the asset portfolio accrue to the reinsurers. We account for the change in these unrealized gains or losses by recording equivalent realized gains or losses on our consolidated statement of comprehensive loss. We recorded the decrease in the unrealized gains as a realized gain of $2.7 millionin 2021 compared to a realized loss of $2.9 millionin 2020. Consolidated Results of Operations - Years Ended December 31, 2021and 2020
Here is a summary of our sources of income:
Year ended December 31, (In thousands) 2021 2020 Investment income, net of expenses
Net realized gains on investments (See Note 4) 7,752
Amortization of deferred gain on reinsurance 3,022
Service fee revenue, net of expenses 2,343 1,960 Other revenue 1,209 189
$ 30,063 $ 10,582
Premium revenue: The introduction of our MYGA and FIA products generated a large volume of new business in 2021 and 2020; however, 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, importantly, as premium revenue. 42
Investment income, net of expenses: The components of net investment income for
The years 2021 and 2020 were as follows:
Year ended December 31, (In thousands) 2021 2020 Fixed maturities
$ 16,443 $ 3,661Mortgage loans 185 992 Other invested assets 665 103 Other interest income 298 - Gross investment income 17,591 4,756 Less: investment expenses (1,854) (709)
Investment income, net of expenses
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 with attractive yields and risk-return profiles. As of
December 31, 2021and 2020, on a gross consolidated basis, our investment portfolio (excluding cash) was $975.5 millionand $518.2 million, respectively, as a result of proceeds from our MYGA and FIA product sales.
Net realized gains on investments: Net realized gains on investments were
a gain of
$2.7 millionand a loss of $2.9 millionfrom a total return swap embedded derivative in 2021 and 2020, respectively. In 2021, there were net realized gains of $2.7 millionrelated to derivatives we own to hedge the obligations to FIA policyholders; such gains 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 reinsurers that have funds withheld coinsurance provisions, under which the assets backing the treaties are maintained by American Life as collateral but the assets and total return on the asset portfolios belong to the reinsurers. Under GAAP this arrangement is considered an embedded derivative as discussed in Note 5 - Derivative Instruments to our Consolidated financial statements. The change in fair value of the total return swap is included in net realized gains or losses on investments. Assets carried as investments on American Life's financial statements for the third-party reinsurers contained unrealized gains of approximately $161,000and $2.9 millionfor years ended December 31, 2021and 2020, respectively. The terms of the contracts with the third-party reinsurers provide that unrealized gains or losses on the portfolios accrue to the third-party reinsurers. We recorded the unrealized gains accruing to third-party reinsurers via a total return swap resulting in a realized gain of $2.7 millionand a realized loss of $2.9 millionin 2021 and 2020, respectively.
Amortization of deferred gain on reinsurance: The increase in 2021 to
reinsurance, partly thanks to higher reinsurance premiums in 2021.
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 increase in this revenue, to
$2.3 millionin 2021 from $1.9 millionin 2020, was due primarily to the level of asset management services provided by 1505 Capital to third-party clients. Other revenue: Other revenue consists of revenue generated by us for providing ancillary services such as third-party administration ("TPA") to clients. The increase in 2021 was due to an increased provision of ancillary services, including TPA, to clients and policy charges. 43 Table of Contents Expenses
Our expenses for the periods indicated are summarized in the table below:
Year ended December 31, (In thousands) 2021 2020 Interest credited
$ 7,012 $ 4,225Benefits 6 (5) Amortization of deferred acquisition costs 2,886 670
Salaries and benefits 16,926 6,347 Other operating expenses 15,104 10,200
$ 41,934 $ 21,437
Interest credited: The increase was primarily due to the interest credited in 2021 relating to the MYGA product of
$2.8 million. Interest credited related to our retained FIA policies was approximately positive $4.2 millionand $3.4 millionfor 2021 and 2020, respectively. The FIA interest credited is related to the fair market value of the embedded derivative which is owed to policyholders. This was partially offset by the realized gain on our total return swap that is included in the net realized gain on investment above.
Benefits: These include death benefits, inherited life insurance policies,
which has not changed significantly in 2021 compared to 2020 death benefits.
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 50% of the business in 2021 compared to the 45% retained in 2020. These figures include the Seneca Re protected cells, SRC1 and SRC3, DAC amortization. Salaries and benefits The significant increase to
$16.9 millioncompared with $6.4 millionwas due to costs incurred to attract and add personnel to service our business growth and the cost related to non-cash stock consideration. We are hiring more in-house expertise to service our growth initiatives and reduce the reliance on third-party providers. Salaries and benefits in 2021 included non-cash stock consideration of approximately $5.0 millionrelating to the vesting of stock options of a former Co-CEOs, upon resigning from our Company. The remaining increase in salaries and benefits was related to bonuses to paid to retain talent.
Other operating expenses: Other operating expenses were approximately
Our AIF product has embedded derivatives included in the account value. Those
derivatives are market driven. Reinsurers who reinsure FIA products
pay an option allowance to American Life to purchase derivatives. From
position so that American Life suffered a
reinsurers for this increase. As the market fluctuates in the future, the brand
the amount of the option allowance could increase or decrease.
Increase in other expenses related to the legal fees of
? mainly to regulatory matters and consultation on the execution of
reinsurance operations partially or not carried out.
Increases in other expenses related to taxes, licenses and
increased actuarial costs; consultants to support the implementation of our activity
plan and office overhead to support business growth.
Income tax expense increased by
modified coinsurance tax reserves of reinsurance.
44 Table of Contents 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 own the investment risk on these assets, we typically restrict their investment allocations via control over the selection of the asset manager as well as asset restrictions set forth in investment guidelines and control over the investment manager. In many of our reinsurance agreements, 1505 Capital acts as the asset manager for a fee. Our investment guidelines typically include
U.S.government bonds, corporate bonds, commercial mortgages, asset backed securities, municipal bonds, and collateral 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 December 31, 2021and 2020. Increases in fixed maturity securities primarily resulted from the sale of our MYGA and FIA products during 2021. December 31, 2021 December 31, 2020 Carrying Percent Carrying Percent (In thousands) Value of Total Value of Total Fixed maturity securities: Bonds: U.S. government obligations $ 1,8820.2 % $ 6,1640.9 % Mortgage-backed securities 55,280 4.9 14,757 2.2 Asset-backed securities 24,951 2.2 7,450 1.1 Collateralized loan obligation 274,523 24.6 214,324 32.0 States and political subdivisions -- general obligations 114 - 118 - States and political subdivisions -- special revenue 5,612 0.5 6,202 0.9 Corporate 37,139 3.3 125,863 18.9 Term Loans 267,468 23.9 - - Trust preferred 2,237 0.2 2,285 0.3 Redeemable preferred stock 14,090 1.3 - - Total fixed maturity securities 683,296 61.1 377,163 56.3 Mortgage loans on real estate, held for investment 183,203 16.4 94,990 14.2 Derivatives 23,022 2.1 11,361 1.7 Equity securities 21,869 2.0 - - Other invested assets 35,293 3.2 21,897 3.3 Investment escrow 3,611 0.3 3,174 0.5
Federal Home Loan Bank (FHLB) stock 500 -
- - Preferred stock 18,686 1.7 3,898 0.6 Notes receivable 5,960 0.5 5,666 0.8 Policy Loans 87 - 46 - Cash and cash equivalents 142,013 12.7 151,679 22.6 Total investments, including cash and cash equivalents
$ 1,117,540100.0 % $ 669,874100.0 % 45 Table of Contents The following table shows the distribution of the credit ratings of our portfolio of fixed maturity securities by carrying value as of December 31, 2021and 2020. December 31, 2021 December 31, 2020 Carrying Carrying (In thousands) Value Percent Value Percent AAA and U.S. Government $ 2,6740.4 % $ 3,0710.8 % AA 482 0.1 5,818 1.5 A 168,141 24.6 49,445 13.1 BBB 462,699 67.7 247,636 65.7 Total investment grade 633,996 92.8 305,970 81.1 BB and other 49,300 7.2 71,193 18.9 Total $ 683,296100.0 % $ 377,163100.0 %
Reflecting the quality of the securities we hold, 92.8% and 81.1% of all
fixed-maturity securities were of high quality
We expect our sales of MYGA and FIA products 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 balance sheet as collateral, our reinsurers bear the market risks related to these investments, while 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 though 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 amongst 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.
Legal accounting and regulation
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 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 to our 46
consolidated financial statements. From
maintained sufficient capital and surplus to comply with regulations
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 as regards 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 as regards policyholders, in addition to capital contributions from us. 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 disallowed assets, from
requires us to expense policy acquisition costs when incurred, whereas GAAP
? allows us to defer and amortize policy acquisition costs over the
? dictates the amount of a deferred tax asset that we can allow on a
statutory balance sheet.
requires us to carry certain investments at cost or amortized cost, whereas we
? recognize other investments at fair value; however, GAAP requires us to record
all investments at fair value.
allows bonds to be recognized at amortized cost or at fair value depending on the rating
? received from
recognized at fair value under GAAP.
makes it possible to recognize income from ceding commissions when they are posted if the cost of
? the acquisition and renewal of the associated company exceeds the disposal commissions,
but under GAAP, this revenue is deferred and recognized over the period covered.
requires that we record reserves in liabilities and expenses for policies
? writing, while we record all transactions related to annuity products under
GAAP as deposit type contract liabilities.
requires that a provision for reinsurance liabilities be established for reinsurance
recoverable on paid losses older than 90 days and for unsecured amounts
? recoverable from unregistered reinsurers. Under GAAP, there is no charge for
unsecured amounts ceded to an unlicensed insurance company
the affiliate’s state of domicile and a reserve for uncollectible reinsurance is
charged to profits rather than to surplus or equity.
requires an additional eligibility test described in the declarations on the
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 supervisory authorities an “annual declaration” which
reports, among other items, net income (loss) and surplus as regards policyholders, which is called stockholders' equity under GAAP. 47 Table of Contents
The table below shows our SAP net profit (loss) for 2021 and 2020 for each
of our insurance subsidiaries, then reconciled with GAAP.
Year ended December 31, (In thousands) 2021 2020 Consolidated GAAP net loss
Exclude: Midwest non-insurance trading entities (American Life & Seneca Re) (6,961)
(342) GAAP net loss of statutory insurance entities
GAAP net loss by statutory insurance entity: American Life
$ (8,742) $ (15,970)Seneca Re Protected Cell 01 (321) 3,872 Seneca Re Protected Cell 03 (613) - SAP net loss $ (9,676) $ (12,098)Reconciliation of GAAP and SAP GAAP net loss of American Life
(8,742) (15,970) Increase (decrease) due to: Deferred acquisition costs (34,451) (30,787) Coinsurance transactions 171,687 91,331 Carrying value of reserves (133,028) (42,389)
Foreign exchange and derivatives - (3,944) Gain on sale of investments, net of asset valuation reserve (1,861) 7,160 Other 40 (19) SAP net (loss) income of American Life
GAAP net (loss) income of Seneca Re Protected Cell 01 (321) 3,872 Increase (decrease) due to: Deferred acquisition costs (3,343) (17,808) Coinsurance transactions 37,763 147,503 Carrying value of reserves (36,995) (138,999) Gain on sale of investments, net of asset valuation reserve 1,847 (4,001) Other 45 - SAP net loss of Seneca Re Protected Cell
GAAP net income of Seneca Re Protected Cell 03
(613) - Increase (decrease) due to: Deferred acquisition costs (10,325) - Coinsurance transactions 88,704 - Carrying value of reserves (84,865) -
Gain on sale of investments, net of asset valuation reserve 282 - Other (34) - SAP net loss of Seneca Re Protected Cell 03
$ (6,851)$ - SAP net loss of statutory insurance entities
We discuss below non-GAAP financial measures that 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 and financial operations
• facilitate internal comparisons of the historical operational performance of our
• review and assess the operational performance of our management team;
• analyze and evaluate financial and strategic planning decisions regarding
future transactions; and
• plan and prepare future annual operating budgets and determine the
operational investment levels.
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. 48 Table of Contents
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 into an individual annuity in a given period. We typically transfer all or 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 involving portfolios of annuity premiums. The following table sets 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 statement of comprehensive
loss Year ended December 31, (In thousands) 2021 2020
Annuity premiums (SAP)
Annuity Direct Written Premiums
(237,411) (228,125) Net premiums retained
$ 234,235 $ 187,436The increase in annuity direct written premiums reflect strong sales in the first half of 2021, while the third and fourth quarters encountered a challenging sales environment, in which competitors were pricing rates on annuity products aggressively. We sell annuities through the IMO channel. We aim to grow annuity direct written premiums 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 also aim to distribute to new channels, including the registered investment advisor (RIA) channel as well as the bank and broker-dealer channels. The increase in ceded premiums was attributable primarily to the increase in annuity direct written premiums discussed above.
Operating Metric – Fees Received for Reinsurance
Year ended December 31, (In thousands) 2021 2020 Fees received for reinsurance(1) Fees received for reinsurance - total
$ 13,412 $ 12,457(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 coinsurance ceding commission, which is a line item from our GAAP Consolidated Statements of Cash Flows.
Commissions received for reinsurance are defined as the net commissions received for
reinsurance transactions entered into during the period and includes cessions
committee. We calculate the fees received for reinsurance by adding two
components: 1) amortization of the deferred gain on reinsurance which is a line
item of our GAAP Consolidated Statements of Comprehensive Income; and 2)
deferred coinsurance ceding commission, which is a line item in our GAAP
Consolidated Statements of Cash Flows.
For the year ended
December 31, 2021, fees received for reinsurance increased by $1.0 millioncompared to the prior year period due to higher ceded premiums. For the year ended December 31, 2021, the components of fees received for reinsurance included $3.0 millionof amortization of deferred gain on reinsurance from our GAAP Consolidated Statements of Comprehensive (Loss) Income and $10.4 millionof deferred coinsurance ceding commission from our GAAP Consolidated Statements of Cash Flows. 49
Reconciliation – Management fees and GAAP fees
Year ended December 31, 2021 2020 Management Expenses G&A
$ 24,632 $ 12,942Management interest credited 8,757 2,098
Amortization of deferred acquisition costs 2,886
Expenses related to retained business 11,643
2,768 Management expenses - total
$ 36,275 $ 15,710Year ended December 31, 2021 2020 G&A Salaries and benefits - GAAP $ 16,926 $ 6,347
Other operating expenses - GAAP 15,104
Less: Stock-based compensation (4,981)
Less: Mark-to-market option allowance (2,417)
$ 24,632 $ 12,942Year ended December 31, 2021 2020 Management Interest Credited Interest credited - GAAP $ 7,012 $ 4,225Adjustments: Less: FIA interest credited - GAAP (4,169)
Add: FIA options cost - amortized 5,914
1,305 Management interest credited
$ 8,757 $ 2,098Year ended December 31, 2021 2020 Reconciliation - Management Expenses to GAAP Expenses Total expenses - GAAP $ 41,934 $ 21,437Adjustments: Less: Benefits (6) 5
Less: Stock-based compensation (4,981)
Less: Mark-to-market option allowance (2,417)
Less: FIA interest credited - GAAP (4,169)
Add: FIA options cost - amortized 5,914
1,305 Management expenses - total
$ 36,275 $ 15,71050 Table of Contents
Operating Metric – Management and General and Administrative 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. For the year ended
December 31, 2021, GAAP general and administrative expenses totaled $41.9 millioncompared to $21.4 millionfor the prior year. For the year ended December 31, 2021, as disclosed above, included in these expenses is mainly salaries, benefits and other operating expenses, along with $5.0 millionof non-cash stock-based compensation and $2.4 millionof non-cash mark-to-market expense of our derivative option allowance, which we exclude in our management G&A.
Operating Metric – Management Interest Credited
We utilize management interest credited, a component of management expenses, as an economic measure to evaluate our financial performance. GAAP interest credited contains significant technical considerations related to fair value accounting with respect to the mark-to-market change in the FIA embedded derivative liability and change in actuarial valuation of the FIA reserve, both of which are sensitive to changes in the market as well as changes in actuarial assumptions. Due to these technical considerations that we believe are less meaningful to management and investors, we exclude the GAAP interest credited expense related to our FIA products and include the amortized cost of options we purchase to service our FIA policy obligations. The sum of GAAP interest credited related to our multi-year guaranteed annuity ("MYGA") products and the amortized cost of options we purchase to service our FIA products constitutes management interest credited. For the year ended
December 31, 2021, GAAP interest credited totaled $7.0 millioncompared to $4.2 millionfor the prior year. For the year ended December 31, 2021, as disclosed above, included in these expenses is GAAP interest credited related to our retained FIA policies of approximately positive $4.2 million. For the year ended December 31, 2021, as disclosed above in the Management's Discussion and Analysis of Financial Condition and Results of Operations.
Cash and capital resources
December 31, 2021and 2020, we had cash and cash equivalents totaling $142.0compared $151.7 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. As our state expansion continues, we expect an increase in our sales of our MYGA and FIA products. The NAIC has established minimum capital requirements in the form of 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. As of December 31, 2021, and 2020, the RBC ratio of American Life was 764.069% and 1,092,205%, respectively. In December, 2020, Midwest contributed $50.0 millionof the capital raise which was reflected in the high 2020 RBC ratio. American Life had a legacy block of business that was ceded off to a third-party reinsurer on July 1, 2018through an indemnity reinsurance agreement that transferred 90% to the assumptive reinsurer, resulting in American Life transferring all the risk and financial obligations of those policyholders
to the third-party reinsurer. 51 Table of Contents 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. See the Consolidated Statements of Cash Flow in our Consolidated financial statements for more detailed information. Year ended December 31, 2021 2020 (In thousands) Net cash used in operating activities
Net cash used in investing activities (452,407)
Net cash provided by financing activities 468,079
Net (decrease) increase in cash and cash equivalents (9,666)
107,963 Cash and cash equivalents: Beginning of period 151,679 43,716 End of period
$ 142,013 $ 151,679
Cash flows used in operating activities
Net cash used for operating activities was
$25.3 millionfor the year ended December 31, 2021, which was comprised primarily of an increase in receivable and payable for securities $14.2 million, capitalized DAC of $14.0 million, net realized gain on investments of $7.8 million, accrued investment income of $6.8 million, and amounts recoverable from reinsurers of $6.4 million, and. These were offset by deposit-type liabilities of $24.4 million, and an increase in deferred coinsurance ceding commission due to a third-party reinsurance transaction of $10.4 million.
Cash used in investing activities
Net cash used for investing activities for 2021 was
$452.4 million. The primary source of cash used was from our purchase of investments from sales of the MYGA and FIA products of $977.8 million. Offsetting this use of cash was our sale of investments of $525.7 million.
Cash flow from financing activities
Net cash provided by financing activities in 2021 was
the main source of cash was net receipts on MYGA and FIA products from
Off-balance sheet arrangements
We do not have any off-balance sheet arrangements 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 that is material to investors.
SECTION 7A. QUANTITATIVE AND QUALITATIVE INFORMATION ON MARKET RISK.
As a small reporting company, we are not required to disclose
in accordance with this article.