Real-time Form 4 intelligence. Smarter insider tracking.
YoY shift: Neutral
Year-over-year tone shift - average net-tone change across Risk Factors and MD&A vs the prior 10-K. This filing is -0.00pp more bearish than last year's.
Why YoY instead of absolute: the LM lexicon has ~6.6× more negative words than positive (legal/risk-disclosure language is heavy on hedging), so every 10-K reads bearish on raw tone. Year-over-year change strips that bias and surfaces the actual shift in management's framing.
Tone shift by section
The two components the gauge averages: how Risk Factors and MD&A each shifted in net tone versus last year's 10-K. The headline above is their average, so a green needle over a soft section just means the other section carried it.
Risk Factors
-0.07pp
Flat
Net-tone change vs last year's 10-K.
MD&A
+0.06pp
Flat
Net-tone change vs last year's 10-K.
Per-snippet highlights
Sentence-level sentiment highlighting with category and subcategory filters is coming once the snippet-scoring pipeline lands. For now, dig into the actual section text on the Sections tab.
Language change vs prior 10-K
Risk Factors (Item 1A) - words with the biggest YoY frequency increase
Negative rising
recession+5
failures+3
concerns+3
conflict+3
negative+2
Positive rising
attractive+2
profitability+1
best+1
effective+1
advantage+1
Risk Factors (Item 1A)
12,755 words
ITEM 1A. RISK FACTORS.
We face many significant risks in the operation of our business and may face significant unforeseen risks as well. Also, in the second half of 2018 we embarked upon our new business plan and, therefore, we face all of the risks of doing business with a model in which our Company does not have a significant history. The material risks of this business plan are set forth below, but there may be additional risks that we do not anticipate, which could materially adversely affect our results of operations and financial condition. An investment in our voting common stock should be considered speculative.
Business Plan Risks
We have a limited operating history under our business plan and our business plan may not be successful.
We face all of the risks inherent in establishing an unseasoned business, including limited capital, unanticipated administrative costs, uncertain product markets, possible lack of market acceptance of new annuity products, and corresponding lack of significant revenues, as well as intense competition from better-capitalized and more seasoned annuity issuers with respect to any annuity products we may seek to create and distribute. We have no control over general economic conditions, competitors’ products, or their pricing and customer demand and we have limited control over necessary costs of marketing in seeking to build and expand our business. Such costs may be significantly higher than we anticipate. For example, our general and administrative costs in 2022 were higher than we expected. There can be no assurance that our proposed business plan will be economically or result in significant revenues to the extent that we profits, and the likelihood of any must be considered in light of our of operating history under our recently reconstituted executive , our business plan, and our limited capital. The of a seasoned operating history makes it to predict our future revenues or results of operations.
Language change vs prior 10-K
MD&A (Item 7) - words with the biggest YoY frequency increase
Negative rising
losses+12
negative+8
loss+5
accident+2
termination+2
Positive rising
gain+3
positive+3
attractive+3
best+3
stable+3
MD&A (Item 7)
11,677 words
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
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 “Special Cautionary Note Regarding Forward-Looking Statements,” “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.
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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 – insurance, reinsurance, and asset management. We seek to reinsure a significant portion 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 return on our capital.
Our business plan provides that we will seek to utilize American Life and its technology, product development and administration capabilities to distribute insurance products through third-party marketing organizations. As part of this plan, American Life has obtained a “B++” (“Good”) A.M. Best financial strength rating and an A.M. Best bbb+ long-term issuer credit rating. American Life is seeking to become licensed to sell insurance in additional states. We cannot make any assurance that our business plan will achieve economic success and we anticipate that full implementation of our business plan will take place over several years. Some of these material risks include market non-acceptance of our new products, non-acceptance of our products by our IMOs and their agents, shortcomings or failures in our technology or encountering other problems that we may not be able to overcome, and unforeseendifficulties in obtaining coverage from financially capable reinsurance providers.
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Our use of IMOs could face several difficulties that could adversely affect our results of operations and financial condition .
We create and sell annuity products through IMOs that provide the sales agents and infrastructure in order to sell our products. This strategy entails several significant risks, including the possibility that our IMOs will not be able to successfully sell our products or will not devote sufficient time and attention to sell our products. We have no control over any IMOs and, therefore, any sales success regarding our products will be substantially dependent upon the efforts of those organizations and their sales agents. Also, we have concentrated channels of product distribution because although we have 27 IMOs as of December 31, 2022, we presently do not distribute our products through other distribution channels such as banks and broker-dealers. If any one of our IMOs does not perform within our expectations, our results of operation could be materially adversely affected and our financial condition would suffer.
Our strategy to reinsure the annuity policies we write may not be successful.
As part of our business plan, American Life intends to cede its annuity policies to other companies through reinsurance agreements. However, American Life will remain liable with respect to ceded insurance should any reinsurer fail to meet the obligations assumed by that reinsurer. The failure of any one of American Life’s reinsurers would likely have a material adverse economic effect on American Life, and the value of our voting common stock would likely decline significantly as well. Thus, it is critical that we adequately assess the financial strength of our reinsurers on an ongoing basis. If we fail to adequately assess reinsurer payment risk including the sufficiency of any amounts of collateral we may hold as security for claims payments we may require them to back up their potential obligations, we could be faced with severe economic consequences in the event any reinsurer does not meet its financial obligations to the policyholders of the annuities that we cede to the reinsurer. Also, we have a concentrated group of reinsurers, which heightens the risks we face should any reinsurer not meet its obligations to annuitants who purchase annuities from us.
We face a risk of unavailability and increased cost of reinsurance.
Market conditions beyond our control determine the availability and cost of the reinsurance we may seek to purchase. We can offer no assurance that reinsurance will remain continuously available to us to the same extent and on the same terms and rates as are currently available to us. If we are unable to maintain our current level of reinsurance or to purchase new reinsurance in amounts that we consider sufficient and at prices that we consider acceptable, we would either have to accept an increase in our net insurance liability exposures or reduce our annuity issuances. A reinsurer’s insolvency or inability to make payments under the terms of a reinsurance treaty could subject us to credit risk with respect to our ability to recover amounts due from reinsurers. Because of these risks, we may not be able to collect all amounts due to us from reinsurers. Further, reinsurance coverage may not be available to us in the future at commercially reasonable rates or at all.
We may be unable to expand insurance operations to other states to any significant degree.
A significant part of our business plan is expanding the ability of American Life to sell insurance in more states. At present, American Life is licensed to sell insurance in 24 states and the District of Columbia. While we are seeking to expand to additional states, we cannot assure you that these efforts will be successful, and to the extent they are not, our ability to achieve product scale and significant annuity sales will be adversely affected. Our results of operations and future prospects will in turn be adversely affected.
Our business success depends, in part, on effective information technology systems and on continuing to develop and implement improvements in our technology.
We depend in large part on our technology systems for conducting our business, as well as for providing the data and analytics we utilize to manage our business. Our business success is dependent on maintaining the effectiveness of existing technology systems and on continuing to develop and enhance technology systems in a cost efficient manner. System development projects may not deliver the benefits we expect, or may be replaced or become obsolete more quickly than expected, which could result in increased expenses. If we do not effectively and efficiently manage and upgrade our technology systems, or if the costs of doing so are higher than we expect, our ability to provide services to new and existing customers in a cost-effective manner and our ability to implement our business plan could be adversely impacted.
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We are faced with credit risks of our counterparties, which may have a material adverse effect on our operating results and financial condition.
In our investments we are exposed to many different industries, issuers and counterparties, and we routinely execute transactions with counterparties in the financial services industry, including brokers and dealers, commercial banks, investment banks, and other institutions. Many of these transactions expose us to credit risk in the event of default of the counterparty. In addition, with respect to secured transactions, our credit risk may be exacerbated when the collateral that we hold cannot be realized upon or is liquidated at prices not sufficient to recover the full amount due to us. We may have further exposure to these issuers in our holdings in unsecured debt instruments and derivative transactions of these issuers. There can be no guarantee that any such realized losses or impairments to the carrying value of these assets would not materially and adversely affect our results of operations and financial condition.
In addition to exposure to credit risks related to our investment portfolio, we are exposed to credit risks in several other areas of our business operations as discussed above and credit risks in our operations related to reinsurance. The collectability of reinsurance recoverables is subject to uncertainty arising from a number of factors, including changes in market conditions, whether insured losses meet the qualifying conditions of the reinsurance contract, and whether reinsurers, or their affiliates, have the financial capacity and willingness to make payments under the terms of a reinsurance treaty or contract. Since we are primarily liable to an insured for the full amount of insurance coverage, our inability to collect a material recovery from a reinsurer could have a material adverse effect on our operating results and financial condition.
We operate in a highly competitive industry, and our business will suffer if we are unable to compete effectively.
The operating results of insurance companies are subject to significant fluctuations due to competition, economic conditions, interest rates, investment performance, maintenance of insurance ratings from rating agencies such as A.M. Best and other factors. The insurance business is intensely competitive. Our ability to compete with other insurance companies is dependent upon, among other things, our ability to attract and retain IMOs to market our insurance products, our ability to develop competitive and profitable products, and our ability to obtain acceptable financial strength ratings. In connection with the development and sale of products, American Life encounters competition from other insurance companies, most of whom offer annuity products and have financial and human resources substantially greater than American Life’s, as well as competition from other investment alternatives available to potential annuitants.
American Life competes with several hundred other insurance companies in the United States. Most of these companies have greater financial resources, longer business histories, and more diversified lines of insurance and annuity product offerings than American Life. These larger companies also generally have large sales forces. We also face competition from direct mail and email sales marketers. We may not be able to compete successfullyagainst these competitors.
Changes in the tax laws could adversely affect our business.
Congress has from time to time considered possible legislation that would eliminate the deferral of taxation on the accretion of value within certain annuity products. This and similar legislation could adversely affect the sale of annuities and life insurance compared with other financial products if such legislation were to be enacted. In addition, we could be unable to attract reinsurance capital. There can be no assurance as to whether any such legislation will be enacted or, if enacted, whether such legislation would contain provisions with possible adverse effects on any annuity products that we develop.
Under the Internal Revenue Code of 1986, income taxes payable by policyholders on investment earnings is deferred during the accumulation period of certain annuity and life insurance products. This favorable tax treatment may give certain insurance products a competitive advantage over other non-insurance products. To the extent that the Internal Revenue Code may be revised to reduce the tax-deferred status of annuity and life insurance products, or to increase the tax-deferred status of competing products, American Life and its industry as a whole would be adversely affected with respect to their ability to sell products. In addition, annuity and related life insurance products are often used to fund estate tax obligations. We cannot predict what future tax initiatives may be proposed with respect to the estate tax or other taxes that may materially adversely affect us.
Some of our investments are relatively illiquid.
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We hold certain investments that may lack liquidity, such as certain fixed maturity securities (including collateralized loan obligations and mortgage loans). We do not have the present intent to sell, nor is it more likely than not that we will be required to sell, debt securities in an unrealized loss position. Investment losses, however, may be realized to the extent liquidity needs require the disposition of debt securities in unfavorable interest rate, liquidity, or credit spread environments.
We have exposure to mortgage loans on real estate, which could cause declines in the value of our investment portfolio.
Securities and other capital markets products with respect to mortgage lending may become less liquid than conventional securities such as stocks and bonds. The value of our investments in mortgage loans may be negatively impacted by an unfavorable change in or increased uncertainty regarding delinquency rates, and refinancing availability. In addition, commercial mortgages are sensitive to the strength of the related underlying mortgage loans, the U.S. economy, and the supply and demand for commercial real estate. The value of our investments in mortgage loans and determination in loss allowances regarding such investments may be negatively impacted by declining loan to value ratios, especially with respect to loan to value ratios that exceed 80%. For the year ended December 31, 2022, our commercial mortgage loans investment portfolio had approximately $4.7 million in loans at or exceeding an 80% loan-to-value ratio compared to zero for the preceding year. Deterioration in the performance of the residential and commercial mortgage sector, including as a result of the COVID-19 pandemic or additional risk of loss in connection with increasing loan-to-value ratios, could cause declines in the value of that portion of our investment portfolio. The carrying value of our mortgage loans on real estate as of December 31, 2022 and 2021, was $227 million and $183.2 million, respectively. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
Changes in regulations regarding suitability of product sales and fiduciary/best interest standards may affect our operations and profitability.
Our annuity sales practices are subject to strict regulation. State insurance regulators are becoming more active in adopting and enforcing suitability standards with respect to sales of annuities. In addition, our insurance operations may be impacted by actions taken by the NAIC, the U.S. standard setting and regulatory support organization created and governed by the chief insurance regulatory authorities of the 50 states, the District of Columbia and the five U.S. territories. Some states have enacted or proposed legislation to impose new or expanded fiduciary/best interest standards on broker dealers, investment advisors and/or insurance agents providing services to customers. At the federal level, the U.S. Department of Labor (the “DOL”) adopted a new prohibited transaction exemption, effective on February 16, 2021, which allows the payment of compensation to investment advice fiduciaries who comply with the exemption’s requirements and imposes a best interest standard of conduct for retail investment advice, including recommendations to “roll over” assets from a qualified retirement plan to an individual retirement account (“IRA”) or from one IRA to another IRA. The DOL has also indicated in its regulatory agenda that it plans to issue proposed rulemaking related to fiduciary advice. Any material changes to the standards governing our sales practices, including applicable laws and regulations, could adversely affect our business, results of operations and financial condition.
The inability to obtain upgrades to our financial strength and other ratings from A.M. Best, or the possibility of a downgrade in our ratings, may have a material adverse effect on our competitive position, the marketability of our annuity product offerings, and our liquidity, operating results, financial condition, and prospects.
Financial strength ratings are important factors in establishing the competitive position of insurance companies and generally have an effect on an insurance company’s business. Many insurance buyers, agents, brokers, and secured lenders use the ratings assigned by A.M. Best and other agencies to assist them in assessing the financial strength and overall quality of the companies from which they are considering purchasing insurance or in determining the financial strength of the company that provides insurance with respect to the collateral they hold. American Life currently has an A.M. Best financial strength rating of B++ (Good) and long-term issuer credit rating of bbb+. A.M. Best ratings are derived from an in-depth evaluation of an insurance company’s balance sheet strengths, operating performances, and business profiles. A.M. Best evaluates, among other factors, the company’s capitalization, underwriting leverage, financial leverage, asset leverage, capital structure, quality and appropriateness of reinsurance, adequacy of reserves, quality and diversification of assets, liquidity, profitability, spread of risk, revenue composition, market position, management, market risk, and event risk. On an ongoing basis, rating agencies such as A.M. Best review the financial performance and condition of insurers and may downgrade or change the outlook on an insurer’s ratings due to, for example, a change in an insurer’s statutory capital, a reduced confidence in management, or a host of other considerations that may or may not be under the insurer’s control. All ratings are subject to continuous review; therefore, the retention of these ratings cannot be assured. A downgrade in any of these ratings could have a material adverse effect on our competitiveness, the marketability of our product offerings, and our ability to grow in the marketplace.
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Our new insurance products and other products we may develop may not achieve market penetration.
As discussed elsewhere in this Annual Report on Form 10-K, our marketing strategy is focused on the sale of MYGA and FIA products through IMOs. These products may not achieve market acceptance or penetration to any meaningful degree, and any significant sales of these products cannot be assured, nor can we assure that any other insurance products we attempt to sell will achieve any degree of sustained marketing success. We are seeking to streamline the costs of developing and placing our annuity products into the marketplace to be sold by IMOs. We may encounter unexpected development costs or lack of IMO acceptance of our products, in which case our financial results would be disappointing.
We are highly dependent upon Georgette Nicholas, our Chief Executive Officer, and Mike Minnich, our President, and the loss of either of these officers could materially and adversely affect our business.
Our ability to operate successfully is dependent primarily upon the efforts of Georgette Nicholas and Mike Minnich, our key executive officers. The loss of the services of either of these individuals could have a material adverse effect on our ability to pursue our business plan. We have employment agreements with Ms. Nicholas and Mr. Minnich and we have limited “key person” life insurance on Mr. Minnich, but there are no restrictions on their termination of employment with us.
Midwest is a holding company whose principal operating subsidiary is American Life.
Midwest depends primarily on reimbursement of costs from American Life, Seneca Re, and 1505 Capital and has no other significant source of revenue. Our change in control that occurred in 2018 with the infusion of capital from Xenith, discussed above, along with net proceeds of the 2020 public offering of our voting common stock, may not provide adequate long-term financing to support our contemplated expansion of American Life’s business or any continued reimbursements to Midwest. If there is not a substantial expansion of American Life’s business, it may not be able to provide funds to Midwest to enable Midwest to meet its obligations. American Life is also restricted by state insurance laws as to fund transfers, by way of dividends or otherwise, to Midwest.
Our investment adviser subsidiary is subject to numerous laws and regulations with substantial compliance costs.
Our wholly owned investment adviser subsidiary, 1505 Capital, is subject to substantial regulation. It is registered with the SEC as an investment adviser, is subject to examination by the SEC, and is required to file detailed reports with the SEC concerning its business. It is subject to the Investment Advisers Act of 1940 as well as other state securities laws regarding the conduct of its business. Compliance with these regulations is time consuming and is a burden on the operations of 1505 Capital. There can be no assurance that 1505 Capital will not be adversely affected by the results of any future examination.
We have experienced significant operating losses and may not be able to reverse them in the foreseeable future.
We commenced our business plan in mid-2018 and introduced our first annuity products in 2019. We incurred substantial operating losses in 2021 and 2020, and there can be no assurance of our future profitability. Because ceding commissions from reinsurance are amortized over the life of the policy, we expect several years of insurance policy sales growth will be necessary until we consistently achieve net income on a GAAP basis.
American Life may encounter regulatory difficulties or fail as a result of being inadequately capitalized.
American Life must have adequate capital and surplus capital, calculated in accordance with SAP prescribed by state insurance regulatory authorities to meet regulatory requirements in Nebraska, the state of domicile of American Life. It had approximately $69.9 million of capital and surplus (based upon SAP) as of December 31, 2022. Because we have embarked upon a business plan under which we write new insurance business and seek to cede a substantial amount of the risk to third-party reinsurers, the NDOI may require additional amounts of capital and surplus to support the expanded business of American Life going forward. The amount of capital and surplus of American Life ultimately required will be based on certain “risk-based capital” standards established by statute and regulation administered by the NDOI. The “risk-based capital” system establishes a framework for evaluating the adequacy of the minimum amount of capital and surplus, calculated in accordance with SAP, necessary for an insurance company to support its overall business operations. It identifies insurers that may be inadequately capitalized by reviewing certain inherent risks of each insurer’s
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assets and liabilities and its mix of net premiums written. Insurers falling below a calculated threshold may be subject to varying degrees of regulatory action, including supervision, rehabilitation, or liquidation. If American Life fails to maintain required capital levels in accordance with the “risk-based capital” system, its ability to conduct business would be compromised and our ability to expand our insurance business would be significantly reduced absent a prompt infusion of capital into American Life.
We may execute an acquisition strategy, which could cause our business and future growth prospects to suffer.
We may at some time pursue acquisitions of insurance-related companies. If we were to pursue acquisitions, we would compete with other companies, most of which have greater financial and other resources than us. Further, if we were to succeed in consummating acquisitions, our business, financial condition, and results of operations may be negatively affected because:
some of the acquired businesses may not achieve anticipated revenues, earnings, or cash flows;
we may have to assume liabilities that were not disclosed or exceed estimates;
we may be unable to integrate acquired businesses successfully and realize anticipated economic, operational, and other benefits in a timely manner;
acquisitions could disrupt our on-going business, distract our management, and divert our financial and human resources;
we may experience difficulties operating in markets in which we have no or only limited direct experience; and
of the potential for loss of customers and key employees of any acquired company.
Risks Related to Our Voting Common Stock
Ownership of shares of Midwest voting common stock involves substantial risk, and the entire value of those shares may be lost.
Shares of our voting common stock constitute a high-risk, speculative investment in a business that has incurred substantial losses in the past and may incur losses in the future. No assurance can be given that any of the potential benefits envisioned by our business plan will prove to be available to our stockholders, nor can any assurance be given as to the financial return, if any, which may result from ownership of our voting common stock. The entire value of your shares of Midwest voting common stock may be lost.
The market price and trading volume of our voting common stock have been volatile, which has resulted in, and could continue to result in rapid and substantial losses for our stockholders.
Trading and prices of our voting common stock were highly volatile in 2022 and could be subject to wide fluctuations in the future. There are many factors that will impact our stock price and trading volume, including, but not limited to, the factors listed above under “Risks Related to Our Business.” In addition, the low trading volume in our voting common stock may fluctuate and cause significant price variations to occur. If the market price of our voting common stock declines significantly, you may be unable to resell your shares at or above your purchase price, if at all. Some of the factors that could negatively affect our share price or result in fluctuations in the price or trading volume of our voting common stock include:
operating results that vary from the expectations of investors and securities analysts;
significant sales of our voting common stock or other securities in the open market;
lack of interest in our voting common stock from institutions, securities analysts, and retail investors;
quarterly variations in our operating results;
the financial projections we may provide to the public, any changes in these projections or our ability to meet these projections;
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changes in investment valuations;
changes (including legislative and regulatory changes) in the industries in which we operate;
announcements by us or companies in our industries of significant contracts, acquisitions, dispositions, strategic partnerships, joint ventures, capital commitments, plans, prospects, service offerings or operating results;
additions or departures of key personnel;
future sales of our securities;
developments in the financial markets and worldwide or regional economies, including bank failures and concerns of an economic downturn or recession;
announcements of innovations or new products, solutions, or services by us or our competitors;
variations in interest rates; and
changes in accounting principles.
Stock markets in the United States have experienced significant price and volume fluctuations. Market fluctuations, as well as general political and economic conditions such as the global COVID-19 pandemic and the associated economic and market disruption, acts of terrorism, war, such as the conflict between Russia and Ukraine, prolonged economic uncertainty, a recession, or interest rate or currency rate fluctuations, could adversely affect the market price of our voting common stock.
Our failure to meet the continued listing requirements of The Nasdaq Capital Market could result in a delisting of our voting common stock.
Our shares of voting common stock are listed on The Nasdaq Capital Market. If we fail to satisfy the continued listing requirements of The Nasdaq Capital Market, Nasdaq may take steps to delist our voting common stock. Such a delisting would likely have a negative effect on the price of our voting common stock, and would impair your ability to sell our voting common stock when you wish to do so. In the event of a delisting, we would take actions to restore our compliance with Nasdaq’s listing requirements, but we can provide no assurance that any such action taken by us would allow our voting common stock to become listed again, stabilize the market price or improve the liquidity of our voting common stock, or prevent future non-compliance with Nasdaq’s listing requirements.
As a smaller reporting company, we are subject to scaled disclosure requirements that may make it more challenging for investors to analyze our results of operations and financial prospects.
Currently, we are a “smaller reporting company,” which generally means that our outstanding common stock held by non-affiliates had a market value of less than $250 million as of the last business day of our second fiscal quarter. As a “smaller reporting company,” we are able to provide simplified executive compensation disclosures in our filings; are exempt from the provisions of Section 404(b) of the Sarbanes Oxley Act requiring that independent registered public accounting firms provide an attestation report on the effectiveness of internal control over financial reporting; and have certain other decreased disclosure obligations in our filings with the SEC, including being required to provide only two years of audited financial statements in annual reports. Consequently, for so long as we qualify as a “smaller reporting company,” we may continue to take advantage of these exemptions and it may be more challenging for investors to analyze our results of operations and financial prospects. We cannot predict if investors will find our common stock less attractive because we may rely on these exemptions. If some investors find our common stock less attractive as a result, there may be a less active trading market for our common stock and our stock price may be more volatile. Further, a material weakness in internal controls may remain undetected for a longer period because of our extended exemption from the auditor attestation requirements under Section 404(b) of the Sarbanes-Oxley Act.
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There may be future issuances or resales of our voting common stock which may materially and adversely affect the market price of our voting common stock.
Subject to any required state insurance regulatory approvals, we are not restricted from issuing additional shares of our voting common stock in the future, including securities convertible into, or exchangeable or exercisable for, shares of our voting common stock. Our issuance of additional shares of voting common stock in the future will dilute the ownership interests of our then existing stockholders.
The sale of a substantial number of shares of our voting common stock or securities convertible into, or exchangeable or exercisable for, shares of our voting common stock, whether directly by us in future offerings or by our existing stockholders in the secondary market, the perception that such issuances or resales could occur or the availability for future issuances or resale of shares of our voting common stock or securities convertible into, or exchangeable or exercisable for, shares of our voting common stock could materially and adversely affect the market price of our voting common stock and our ability to raise capital through future offerings of equity or equity-related securities on attractive terms or at all.
In addition, our Board is authorized to designate and issue preferred stock without further stockholder approval, and we may issue other equity and equity-related securities that are senior to our voting common stock in the future for a number of reasons, including, without limitation, to support operations and growth, to maintain our capital ratios, and to comply with any future changes in regulatory standards.
Our executive officers and directors own a substantial number of shares of our voting common stock. This will enable them to significantly influence the vote on all matters submitted to a vote of our stockholders.
As of December 31, 2022, our executive officers and directors beneficially owned 603,547 shares of our voting common stock, representing approximately 16.2% of the outstanding shares of our voting common stock.
Accordingly, our executive officers and directors, through their beneficial ownership of our voting common stock, will be able to significantly influence the vote on all matters submitted to a vote of our stockholders, including the election of directors, amendments to our certificate of incorporation or bylaws, mergers or other business combination transactions, and certain sales of assets outside the regular course of business. The interests of our executive officers and directors may not coincide with the interests of our other stockholders, and they could take actions that advance their own interests to the detriment of our other stockholders.
The indemnification rights provided to our directors, officers, and employees may result in substantial expenditures by us and may discourage lawsuits against them.
Our certificate of incorporation and Delaware law provide for broad indemnification of our directors, officers and employees. Our indemnification obligations could result in us incurring substantial expenditures to cover the costs of settlement or damage awards against directors, officers and employees, which we may be unable to recoup. These provisions and resultant costs may also discourage us from bringing an action against our directors and officers for breaches of their fiduciary duties, and may similarly discourage the filing of derivative litigation by our stockholders against our directors or officers even though such actions, if successful, might otherwise benefit us and our stockholders.
We do not expect to pay any cash dividends to stockholders.
To date, we have never declared or paid any cash dividends to our stockholders and do not expect to do so for the foreseeable future. The declaration, payment, and amount of any future dividends will be made at the discretion of our Board, and will depend upon, among other things, the results of our operations, cash flows and financial conditions, operating and capital requirements, and other factors as the Board considers relevant. In addition, our ability to pay cash dividends depends, in part, upon on the ability of American Life to provide us with payments from its operations, which are subject to prior regulatory approval for the most part. As an insurance company, American Life is subject to significant regulatory restrictions limiting its ability to declare and make payments or dividends to Midwest.
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If securities or industry analysts do not publish research or reports about our business, or if they issue adverse or misleading opinions regarding us, our voting common stock price and trading value could decline.
The trading market for our voting common stock is influenced by research and reports that industry or securities analysts publish about us or our business. If any of the analysts who cover us issue an adverse or misleading opinion regarding us, our business model, or our voting common stock performance, or if our target operating results fail to meet the expectations of analysts, our voting common stock price would likely decline. If one or more of these analysts cease coverage of us or fail to publish reports on us regularly, we could lose visibility in the financial markets, which in turn could cause our stock price and trading volume to decline.
Anti-takeover provisions and the regulations to which we may be subject may make it more difficult for a third- party to acquire control of us, even if the change in control would be beneficial to our stockholders.
We are a holding company incorporated in Delaware. Anti-takeover provisions in Delaware law and our certificate of incorporation and bylaws, as well as regulatory approvals required under state insurance laws, could make it more difficult for a third- party to acquire control of us and may prevent stockholders from receiving a premium for their shares of voting common stock. Our certificate of incorporation provides that our Board may issue up to 2,000,000 shares of preferred stock, in one or more series, without stockholder approval and with such terms, preferences, rights, and privileges as the Board may deem appropriate. These provisions, the control of our executive officers and directors over the election of our directors, and other factors may hinder or prevent a change in control, even if the change in control would be beneficial to, or sought by, our stockholders.
Eight individuals currently serve on our Board, which is divided into three classes with staggered three-year terms. At each annual meeting of stockholders, a class of directors is to be elected for a three-year term to succeed the directors of the same class whose terms are then expiring. As a result, a portion of our Board will be elected each year. Our certificate of incorporation authorizes our Board to fix the number of directors from time to time by a resolution of the majority of our Board. Any additional directorships resulting from an increase in the number of directors will be distributed among the three classes so that, as nearly as possible, each class shall consist of one-third of the directors. The division of our Board into three classes with staggered three-year terms may delay or prevent a change of our management or a change in control. Between stockholder meetings, directors may be removed by our stockholders only for cause, and the Board may appoint new directors to fill the vacancies. These provisions may prevent a stockholder from removing incumbent directors and simultaneously gaining control of the Board by filling the resulting vacancies with its own nominees. Consequently, the existence of these provisions may have the effect of deterringhostile takeovers, which could depress the market price of our voting common stock.
General Risks
The ongoing events resulting from the COVID-19 pandemic, and the uncertainty regarding future similar events, could have an adverse impact on our financial condition, results of operations, cash flows, liquidity, and prospects.
We continue to closely monitor developments related to the coronavirus (COVID-19) pandemic to assess potential adverse impacts on our business. Due to the evolving and highly uncertain nature of this pandemic, it currently is not possible 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 the Company’s business continuity plan in early March 2020 and operated through July 2020 with the majority of employees working remotely. Operations continued as normal despite a sharp increase in sales during the period. We continue to monitor the Centers for Disease Control and Prevention and Nebraska guidelines regarding employee safety.
If the COVID-19 pandemic and associated economic slowdown continues it could adversely impact our future results of operations, financial condition, cash flows, liquidity, and prospects in a number of ways, including:
Our investment portfolio (and, specifically, the valuations of investment assets we hold) could be materially and adversely affected as a result of market developments from the pandemic and uncertainty regarding its outcome. Moreover, changes in interest rates, reduced liquidity, or a slowdown in the U.S. or global economic conditions may also adversely affect the values and cash flows of these assets. Our investments in mortgages and asset-backed securities could be negatively affected by
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delays or failures of borrowers to make payments of principal and interest when due or delays or moratoriums on foreclosures or enforcement actions with respect to delinquent or defaulted mortgages imposed by governmental authorities. Further, extreme market volatility may leave us unable to react to market events in a prudent manner consistent with accepted investment practices in dealing with more orderly markets;
Potential impacts on our operations due to efforts to mitigate the pandemic, including government mandated shutdowns, requests or orders for employees to work remotely, and other social distancing measures, which could result in an adverse impact on our ability to conduct our business, including our ability to sell policies, and adjust certain claims;
Potential impacts on morbidity could adversely affect the potential profitability of our annuity products;
We also outsource certain critical business activities to third parties such as our IMOs. As a result, we rely upon the successful implementation and execution of the business continuity planning of such entities in the current environment. While we monitor the business continuity activities of these third parties, successful implementation and execution of their business continuity strategies are largely outside our control. If one or more of the third parties on whom we rely for critical business activities experience operational difficulties or failures as a result of the impacts from the spread of COVID-19, it may have a material adverse effect on our business, financial condition, results of operations, liquidity, and cash flows; and
Potential impacts of COVID-19 on reinsurers and the cost and availability of reinsurance.
Finally, we cannot predict how legal and regulatory responses to concerns about COVID-19 and related public health issues, including responses to any future outbreaks of communicable diseases, will impact our business. The continued spread of COVID-19 and its variants has led to disruption and volatility in the global capital markets which could increase our funding costs and limit our access to the capital markets. Accordingly, we may in the future have difficulty accessing capital on attractive terms, or at all, which could have a material adverse effect on our business, results of operations, financial condition and liquidity.
Catastrophes may adversely impact liabilities for policyholder claims and reinsurance availability.
Claims resulting from catastrophic events could harm our financial results, profitability, and financial condition. Catastrophic events could impact our insurance business by significantly impacting our assumptions as to mortality, morbidity, and other rates, as well as product sales. Catastrophic events may also reduce economic activity in affected areas, which could harm our prospects for new business. In addition, catastrophes could cause unanticipated financial strain on our insureds as well as increase the cost of reinsurance to us and decrease the availability of reinsurance, which could in turn harm our business, results of operations, or financial condition.
Claimsloss reserves may be inadequate.
We maintain loss reserves to cover estimated liabilities for unpaidlosses and loss expenses, including legal and other fees, as well as other claims and settlement costs for reported and unreportedclaims incurred as of the end of each accounting period. Loss reserves do not represent an exact calculation of liability. Rather, reserves represent an estimate of what we expect the ultimate settlement and administration of claims will cost. These estimates, which generally involve actuarial projections, are based on the assessment of facts and circumstances then known, as well as estimates of future trends in claimsseverity, frequency, and other factors. The variables described above are affected by both internal and external events, such as changes in claims handling procedures, economic inflation, judicial and litigation trends, and legislative changes. Many of these items are not directly quantifiable in advance. Additionally, there may be a significant delay between the occurrence of the insured event and the time it is reported to us.
Reserve estimates are continually refined as experience develops and further claims are reported and settled. Adjustments to reserves are reflected in the results of the periods in which such estimates are changed. Because setting reserves is inherently uncertain, we cannot assure that our current reserves will prove adequate in light of subsequent events, including for example the uncertainties relating to the COVID-19 pandemic. Accordingly, the ultimate settlement of losses may be significantly greater or less than the loss and loss expense reserves as of the date of the balance sheet. If our loss reserves are determined to be inadequate, we will be required to increase loss reserves at the time of such determination with a corresponding decrease in our profitability. If the increase in loss reserves is large enough, we could incur a net loss and a net reduction of our capital.
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Adverse capital and credit market conditions may significantly affect our ability to meet liquidity needs and access the capital required to operate our business.
In the insurance industry, liquidity refers to the ability of an insurance company to generate adequate amounts of cash from its normal operations, including from its investment portfolio, in order to meet its financial commitments, which are principally obligations under the insurance policies it has written.
The capital and credit markets have historically experienced significant volatility and disruption. In some cases, the markets have exerted downward pressure on the availability of liquidity and credit capacity. In the event that we need access to additional capital to pay our operating expenses, or increase the amount of insurance that we seek to underwrite, or otherwise grow our business, our ability to obtain such capital may be limited and the cost of any such capital may be significant. In addition, the availability of additional financing will depend on a variety of factors, including capital and credit market conditions, the availability of credit generally and specifically to the financial services industries, market liquidity, our creditworthiness, as well as the possibility that customers or capital providers could develop a negative perception of our long or short-term financial prospects if we incur large investment losses or if our level of business activity decreases. Similarly, our access to capital may be impaired if regulatory authorities or rating agencies take negative actions against us. Our internal sources of liquidity may prove to be insufficient, and we may not be able to successfully obtain additional financing on favorable terms, or at all. As such, we may be forced to issue securities with terms and conditions that may be unfavorable to us, to accept an unattractive cost of capital or to sell certain assets, any of which could decrease our profitability and significantly reduce our financial flexibility. If a combination of these factors occurs, our internal sources of liquidity may prove to be insufficient and, in such case, we may not be able to successfully obtain additional financing on terms favorable to us.
The transition from LIBOR to alternative reference “benchmark” interest rates is uncertain and could adversely affect the value of or the interest rates on our investments and obligations indexed to LIBOR, as well as the revenue and expenses associated with those assets and obligations.
LIBOR is an interest rate benchmark that has been widely used in financial contracts around the world for decades. In July 2017, the United Kingdom’s Financial Conduct Authority (“FCA”), which regulates the London Interbank Offered Rate (“LIBOR”), announced that it intended to phase out LIBOR by the end of 2021. Following discussions with the FCA and other official sector bodies, the Intercontinental Exchange Benchmark Administration announced in March 2021 that the publication of certain USD LIBOR settings will continue through June 30, 2023. The Alternative Reference Rates Committee of the Federal Reserve Board (“ARRC”), a group of market participants convened to help ensure a successful transition away from LIBOR, has recommended the Secured Overnight Financing Rate (“SOFR”) as its preferred alternative reference rate and has proposed a transition plan and timeline designed to encourage the adoption of SOFR from LIBOR.
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, federal legislation has been enacted to provide a safe harbor for transition to the recommended alternative reference rate.
Notwithstanding the availability of statutory guidance on fallback procedures, 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, including SOFR, 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 and ensuring operational processes are updated to accommodate alternative rates. Due to uncertainty surrounding the effect of adopting or transitioning to alternative rates, such as SOFR, we are unable to predict the overall impact of this change at this time.
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The insurance industry is subject to numerous laws and regulations, and compliance costs and/or changes in the regulatory environment that could adversely affect our business.
Our insurance operations are subject to government regulation in each of the states in which we conduct business. Such regulatory authority is vested in state agencies that are concerned primarily with the protection of policyholders rather than shareholders. These state insurance regulatory authorities have broad administrative powers dealing with all aspects of the insurance business, including, among other areas, regulation of the advertising and marketing of insurance, privacy of policyholders, acquisitions of regulated insurance entities, payment of dividends, reinsurance, the form and content of insurance policies (including pricing), operating and agent licenses, regulation of premium rates, premium tax increases, rating and underwriting restrictions and limitations, asset and reserve valuation requirements, enterprise risk management, surplus requirements, the type or amount of investments, accounting standards, Risk-Based Capital (“RBC”) requirements, statutory reserve and capital requirements, assessments by guaranty associations, affiliate transactions, and unfair trade and claims practice.
In addition, our insurance operations may be impacted by actions taken by the NAIC. A primary mandate of the NAIC is to benefit state insurance regulatory authorities and consumers by promulgating model insurance laws and regulations for adoption by the states. The NAIC also provides standardized insurance industry accounting and reporting guidance through the NAIC Accounting Manual. However, model insurance laws and regulations are only effective when adopted by the states, and statutory accounting and reporting principles continue to be established by individual state laws, regulations, and permitted practices. Changes to the NAIC Accounting Manual or modifications by the various state insurance departments may adversely affect the statutory capital and surplus of American Life. See “Regulation” for further discussion.
The NAIC and state insurance regulators reexamine existing laws and regulations on an ongoing basis, and focus on insurance company investments and solvency issues, risk-based capital guidelines, interpretations of existing laws, the development of new laws, the implementation of non-statutory guidelines, and the circumstances under which dividends may be paid. Future NAIC initiatives, and other regulatory changes, could have a material adverse impact on our insurance business. There can be no assurance that American Life will be able to satisfy the regulatory requirements of the NDOI or a similar department in any other state in which it transacts business. A significant component of our business plan is to reinsure a significant portion of the insurance policies that we issue. It should be assumed that state regulators will monitor carefully the financial strength of any third-party reinsurer and in certain instances may require that sufficient funds be reserved by us in order to alleviate risks associated with reinsurers being unable to meet their financial commitments in the case of claims on insurance policies with a reinsurer. This oversight may result in our operations being less economically successful than we are seeking and could adversely affect our result of operations and therefore the value of our voting common stock.
In addition, as the owner of a life insurance subsidiary, Midwest is itself regulated by the NDOI and, to a lesser extent, by the various state insurance regulatory authorities of those U.S. jurisdictions where American Life is licensed. All U.S. states have enacted legislation requiring each insurance holding company and each insurance company in an insurance holding company system to register with the insurance regulatory authority of the insurance company’s state of domicile (in the case of American Life, Nebraska) and to furnish annually financial and other information concerning the operations of companies within the holding company system that materially affect the operations, management, or financial condition of the insurers within such system (generally referred to as “insurance holding company acts”). Under such laws, among other requirements, transactions between Midwest and its regulated insurance subsidiaries and affiliates must be fair and reasonable and, if material or of a specified category, they require prior notice and approval or non-disapproval by the state of domicile of each insurance company that is party to the transaction. In addition, under such laws, a state insurance authority usually must approve in advance the direct or indirect acquisition of 10% or more of the voting securities of an insurance company domiciled in its state.
In addition, American Life generally may not pay dividends without giving prior notice thereof to the NDOI and generally may not pay extraordinary dividends without obtaining the prior approval or non-disapproval of such regulators. The laws and regulations prohibit an insurer from, without regulatory approval, paying an “extraordinary” dividend, which is generally defined as any dividend paid from other than earned surplus or exceeding certain thresholds specified in the applicable state insurance laws.
As a component of its ongoing efforts to remain compliant with the U.S. insurance regulatory regime, we file detailed annual reports with respect to American Life with the NDOI and all of the states in which American Life is licensed. Also, the business and accounts of American Life are subject to examination by the NDOI, as well as inquiries including investigations of the various insurance regulatory authorities of the states in which American Life is licensed.
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Development of annuity and life insurance products involves the use of certain assumptions, and the inaccuracy of these assumptions could adversely affect profitability.
In our insurance business, we must make certain assumptions as to expected mortality, lapse rates, and other factors in developing the pricing and other terms of insurance products. These assumptions are based on industry experience and are reviewed and revised regularly to reflect actual experience on a current basis. However, variation of actual experience from that assumed in developing such terms may affect a product’s profitability or sales volume and in turn adversely impact our revenues and profitability.
If we underestimate our liability for future policy benefits, our results of operations could suffer.
Liabilities established for future life insurance policy benefits are based upon a number of factors, including certain assumptions such as mortality, morbidity, lapse rates, and crediting rates. Unforeseen events like epidemics or pandemics could arise and have an adverse effect on our assumptions as to morbidity and mortality. If we underestimate future policy benefits, we will incur additional expenses at the time we become aware of the inadequacy. As a result, our losses would increase and our ability to achieve profits would suffer.
Fluctuations in interest rates could cause a reduction in investment income or adversely affect the market value of interest-rate sensitive investments, which could adversely affect our business and could cause our debt service obligations to increase significantly.
Interest rate fluctuations may impair an insurance company’s ability to pay policyholder benefits with operating and investment cash flows, cash on hand and other cash sources. Our annuity products expose us to the risk that changes in interest rates will reduce any spread, or the difference between the amounts that American Life is required to pay under the contracts and the amounts American Life is able to earn on its investments intended to support its obligations under its annuity contracts. Spread is a key component of net revenues.
To the extent that interest rates credited are less than those generally available in the marketplace, policyholder lapses, policy loans and surrenders, and withdrawals of annuity contracts may increase as contract holders seek to purchase products with perceived higher returns. This process may result in cash outflows requiring that American Life sell investments at a time when the prices of those investments are adversely affected by the increase in market interest rates, which may result in realized investment losses.
Increases in market interest rates may also negatively affect profitability. In periods of increasing interest rates (such as those the U.S. and certain foreign markets are currently experiencing), we may not be able to replace invested assets with higher yielding assets needed to fund the higher crediting rates that may be necessary to keep interest sensitive products competitive. American Life, therefore, may have to accept a lower spread and thus lower profitability or face a decline in sales and greater surrender of existing annuity contracts.
Additionally, borrowings under our Revolving Credit Facility (as defined below) are at variable rates of interest and expose us to interest rate risk. The recent rise in interest rates has increased our cost of borrowing.
We are subject to extensive regulation.
As stated above, we are subject to extensive state regulatory oversight in the jurisdictions in which we do business, as well as federal oversight with respect to certain portions of our business. Changes in state regulations, or in the interpretation or application of existing state laws or regulations, may adversely impact our pricing, capital requirements, reserve adequacy, or exposure to litigation and could increase the costs of our regulatory compliance.
Changes are often implemented by state regulators in order to benefit policyholders to the detriment of insurers. State insurance regulators and the NAIC continually reexamine existing laws and regulations and may impose changes in the future that put further regulatory burdens on us and, thus, could have an adverse effect on our results of operations and financial condition.
In addition, state insurance laws, rather than federal bankruptcy laws, govern the liquidation or restructuring of insurance companies. Virtually all states in which we operate require that we bear a portion of the losssuffered by some insureds as the result of impaired or insolvent insurance companies via participation in state guaranty associations. The effect of these and similar arrangements could reduce our profitability in any given period and/or limit our ability to grow our business. Finally, some insurers of the programs or
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associations to make payments to insureds for losses could have a material adverse effect on our results of operations and financial condition.
From time to time, increased scrutiny has been placed upon the U.S. insurance regulatory framework by both federal and state legislators and regulators. A number of state legislatures have considered or enacted legislative measures that alter, and in many cases increase, state authority to regulate insurance and reinsurance companies. In addition to legislative initiatives of this type, the NAIC and insurance regulators are regularly involved in a process of reexamining existing laws and regulations and their application to insurance and reinsurance companies.
We cannot predict the effect that any proposed or future federal or state legislation or change in the interpretation or application of existing laws or regulations may have on our financial condition or results of operations.
A failure to comply with rules and regulations in a jurisdiction could lead to disciplinary action, the imposition of fines or the revocation of the license, permission or authorization necessary to conduct our businesses in that jurisdiction, all of which could have a material adverse effect on the continued conduct of business in a particular jurisdiction.
The impact on potential customers and vendors of sustained or significant deterioration in economic conditions, including due to concerns of a potential economic downturn or recession, could adversely affect our business.
We are exposed to risks associated with the potential financial instability of our customers, many of whom may be adversely affected by an economic slowdown or recession, inflation, or rising interest rates. As a result of macroeconomic challenges currently or potentially affecting the economy of the U.S. and other parts of the world, customers may experience serious cash flow problems and other financial difficulties. In addition, events in the U.S. or foreign markets, such as the COVID-19 pandemic, the rising rate of inflation that the U.S. is currently experiencing, bank failures, and the conflict between Russia and Ukraine, may continue to impact the global economy and capital markets. The impact of such events is difficult to predict. As a result, customers and potential customers may modify, delay, or cancel plans to purchase our products. Additionally, if customers are not successful in generating sufficient incomes, they may not be able to pay, or may delay payment of, premiums and other amounts that are owed to us. Any liability of current or potential customers to pay us for our products may adversely affect our earnings and cash flow.
A general economic slowdown or recession could potentially adversely affect us in the form of consumer behavior, particularly through decreased demand for our products. In addition, we are susceptible to risks associated with the potential financial instability of the vendors on which we rely to provide services or to whom we delegate certain functions. The same conditions that may affect our customers also could adversely affect our vendors, causing them to significantly and quickly increase their prices or reduce their output. Our business depends on our ability to perform, in an efficient and uninterrupted fashion, our necessary business functions, and any interruption in the services provided by third parties could also adversely affect us.
Defaults on commercial mortgage loans and volatility in performance may adversely affect our results of operations and financial condition.
A decline in the commercial real estate market within the U.S. resulting from changes in interest rates, real estate market conditions or an economic downturn or recession may have a negative impact on the value of our commercial mortgage loan portfolio. Negative developments across a certain property type or the occurrence of a negative event within a geographic region may have a significant negative impact, based on concentration within that property type or geographic region. Our operations and financial condition may be adversely affected from an increase in borrower defaults within our commercial mortgage loan portfolio. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
Our valuation of investments and the determinations of the amount of allowances and impairments taken on our investments may include methodologies, estimations and assumptions that are subject to differing interpretations and, if changed, could materially adversely affect our results of operations or financial condition.
Fixed maturities, equity securities and derivatives represent the majority of assets and liabilities reported at fair value on our Consolidated Balance Sheets. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (an exit price). Fair value estimates are made based on available market information and judgments about the financial instrument at a specific point in time. Considerable judgment is often
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required to develop estimates of fair value, and the use of different assumptions or valuation methodologies may have a material effect on the estimated fair value amounts.
As an example, our registered independent accounting firm has identified the valuation of embedded derivatives of fixed indexed annuities as a critical audit matter. Our FIA contracts allow the policyholder to elect a fixed interest rate return or an equity market component for which interest credited is based on the performance of certain stock market indices. The equity market option is an embedded derivative. The fair value of the embedded derivatives is computed as the present value of death, surrender, and partial withdrawal benefits attributable to the excess of the projected policy contract values over the projected minimum guaranteed contract values. The projections of policy contract values are based on assumptions for future policy growth, which included assumptions for expected index credits on the next policy anniversary date, future equity option cost developed based on the participation rate, cap rate, strike rate, volatility assumption, time to expiration, and risk-free rates using the Black Scholes formula and grow at the risk-free interest rates over the term of the index period, guaranteed minimum renewal interest rate, and policyholder assumptions including mortality, lapses, partial withdrawal rates, and the utilization of benefit riders. Because of the significant subjectivity and estimation of the valuation inputs, the valuation of our embedded derivatives could vary significantly as conditions change and new information and becomes available. Decreases in value may have a material adverse effect on our results of operation or financial condition.
Our determination of the amount of allowances and impairments varies by investment type and is based on our periodic evaluations and assessments of known and inherent risks associated with the respective asset class. Such evaluations and assessments are revised as conditions change and new information becomes available. We update our evaluations regularly and make changes in allowances and impairments in operations. Market volatility, including as a result of the COVID-19 pandemic, inflation, bank failures, and the conflict between Russia and Ukraine, can make it more difficult to value our securities if trading in such securities becomes less frequent. In addition, a forced sale by holders of large amounts of a security, whether due to insolvency, liquidity, or other issues with respect to such holders, could result in declines in the price of a security. There can be no guarantee that we have accurately assessed the level of impairments taken and allowances reflected in our financial statements. Furthermore, additional impairments may need to be taken or allowances provided for in the future. Impairments result in charges to earnings in the period taken, and historical trends may not be indicative of future impairments or allowances.
A breach of information security or other unauthorized data access could have an adverse impact on our business and reputation.
In the ordinary course of business, we collect, process, transmit, and store large quantities of personally identifiable information, customer financial and health information, and proprietary business information (“Sensitive Information”). The secure processing, storage, maintenance, and transmission of Sensitive Information are vital to our operations and business strategies. Although we undertake substantial efforts to reasonably protect Sensitive Information, including internal processes and technological defenses that are preventative, and other commercially reasonable controls designed to provide multiple layers of security and detection, Sensitive Information maintained by us may be vulnerable to attacks by computer hackers, to physical theft by other third-party criminals, or to other compromise due to employee error or malfeasance. Attacks may include both sophisticated cyber-attacks perpetrated by organized crime groups, “activists,” or state sponsored groups, as well as non-technical attacks ranging from sophisticated social engineering to simple extortion or threats, which can lead to unauthorized access or disclosure, disruption or further attacks. Such events may expose us to civil and criminal liability, or regulatory action, harm our reputation among customers, deter people from purchasing our products, cause system interruptions, require significant technical, legal, and other remediation expenses, and otherwise have an adverse impact on our business. Third parties to whom we outsource certain functions are also subject to the risks outlined above, and if a third-party suffers a breach of information security involving our Sensitive Information, the breach may result in substantial costs and other negative consequences, including a material adverse effect on our business, financial condition, results of operations, and liquidity. We offer no guarantees that we will be able to implement information security measures to prevent all breaches of information security.
Employee error, misconduct, or excessive risks may be difficult to detect and prevent and could adversely affect us.
Persons who conduct our business, including executive officers and other members of management, other employees and our IMOs and their sales agents, do so in part by making decisions and choices that involve exposing us to risk. These include decisions such as setting underwriting guidelines and standards, product design and pricing, determining what assets to purchase for investment and when to sell them, deciding which business opportunities to pursue, and other business decisions. Losses may result from, among other things, excessive risk, fraud, errors, failure to document transactions properly, failure to obtain proper internal authorization, or failure to comply with regulatory requirements. Although we employ controls and procedures designed to monitor business decisions and
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prevent us from taking excessive risks, it is not always possible to deter or prevent employee misconduct or errors in judgment, and the precautions that we take to prevent and detect this activity may not be effective in all cases. The impact of those losses and excessive risks could harm our reputation and have a material adverse effect on our financial condition and business operations.
We face a risk of noncompliance with and enforcement action under the anti-money laundering statutes and regulations.
A major focus of governmental policy on financial institutions in recent years has been aimed at combating money laundering and terrorist financing. The USA PATRIOT Act of 2001 substantially broadened the scope of United States anti-money laundering laws and regulations by imposing significant new compliance and due diligence obligations, creating new crimes and penalties and expanding the extra territorial jurisdiction of the United States, and by expanding the categories of financial institutions to which such laws and regulations apply to include some categories of insurance companies. Certain financial institutions are also prohibited from entering into specified financial transactions and account relationships and must use enhanced due diligence procedures in their dealings with certain types of high risk clients and implement a written client identification program. Financial institutions must take certain steps to assist government agencies in detecting and preventing money laundering and report certain types of suspicious transactions without notifying the affected clients. Regulatory authorities routinely examine financial institutions to ensure that they have policies and procedures reasonably designed to comply with applicable requirements and for compliance with the policies and procedures and these substantive obligations. Failure of a financial institution to maintain and implement adequate programs, including policies and procedures, to combat money laundering and terrorist financing, or to comply with all of the relevant laws or regulations, could have serious legal and reputational consequences for the institution. Regulatory authorities have imposed cease and desist orders and civil money penaltiesagainst institutions found to be violating these obligations. We and our subsidiaries are subject to anti-money laundering statutes and certain regulations, and our compliance obligations under these rules may result in increased costs and allocation of internal resources.
Litigation or regulatory actions could have a material adverse impact on us.
Current and future litigation or regulatory investigations and actions in the ordinary course of operating our business, including class action lawsuits, may negatively affect us by resulting in the payment of substantial awards or settlements, increasing legal and compliance costs, requiring us to change certain aspects of our business operations, diverting management attention from other business issues, harming our reputation with customers, or making it more difficult to retain current customers and to recruit and retain employees or IMOs.
Guarantees within certain of our products may adversely affect our financial condition or results of operations.
We offer guarantees which may include a return of no less than the total deposits made on the contract less any customer withdrawals, total deposits made on the contract less any customer withdrawals plus a minimum return, or the highest contract value on a specified anniversary date minus any customer withdrawals following the contract anniversary. These guarantees can also include benefits payable in the event of death, upon annuitization, upon periodic withdrawal, or at specified dates during the accumulation period.
Periods of significant and sustained downturns in equity markets, increased equity volatility, and/or reduced interest rates could result in an increase in the valuation of the future policy benefit or policyholder account balance liabilities associated with such products, resulting in a reduction of our potential profitability. We use risk management techniques including product design, asset liability management, reinsurance and hedge strategies to manage the risk associated with liability exposures and the volatility of net income associated with these liabilities.
We remain ultimately liable for the specific guaranteed benefits and are subject to the risk that reinsurers or derivative counterparties are unable or unwilling to pay. In addition, we are subject to the risk that hedging and other risk management procedures prove ineffective, or the estimates and assumptions made in connection with their use fail to reflect or correspond to the actual liability exposure, or that unanticipated policyholder behavior or mortality, combined with adverse market events, produces economic losses beyond the scope of the risk management techniques employed. We are also subject to the risk that the cost of hedging these guaranteed minimum benefits may materially increase. These risks, individually or collectively, may have a material adverse effect on our financial condition or results of operations.
We regularly analyze overall risk position at the enterprise level and decide how much risk to retain (that is, to hold capital) and how much risk to transfer off the balance sheet. This decision considers the cost of transferring risk, the concentration of the risk, and our
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tolerance for volatility. Residual risk for which we hold capital may lead to earnings volatility. We cannot assure you that our hedging strategy will successfully mitigate any risks we may hedge.
Deviations from assumptions regarding future persistency, mortality, morbidity, and interest rates used in calculating reserve amounts could have a material adverse impact on our results of operations or financial condition.
Our profitability depends significantly upon the extent to which the actual experience is consistent with the assumptions we use in setting prices for our products and establishing liabilities for future policy benefits and claims. Such amounts are established based on estimates by actuaries of how much we will need to pay for future benefits and claims. The process of calculating reserve amounts for a life insurance company involves the use of a number of assumptions, including those related to persistency (how long a contract stays with a company), mortality (the likelihood of death or the likelihood of survival), morbidity (likelihood of sickness or disability), and interest rates (the rates expected to be paid or received on financial instruments, including insurance or investment contracts).
Pricing of our annuity products is also based in part upon expected persistency of these products, which is the probability that a policy or contract will remain in force from one period to the next. Persistency within our annuities business may be significantly impacted by the value of guaranteed minimum benefits contained in many of our annuity products being higher than current account values, in light of poor equity market performance or extended periods of low interest rates, as well as other factors. Persistency could be adversely affected generally by developments affecting client perceptions of us, including perceptions arising from adverse publicity. Many of our products also provide our customers with wide flexibility with respect to the amount and timing of premium deposits and the amount and timing of withdrawals from the policy’s value.
Some of our products and services are complex and are sold through IMOs and their agents, and a failure of the IMOs and their agents to properly explain our products and services or their misrepresentation in connection therewith could have an adverse effect on our business, results of operations and financial condition.
Some of our products are complex and all of our products are presently sold through IMOs and their agents. Therefore, we are primarily reliant on our IMOs and their agents in our distribution channel to describe and explain our products to potential customers. The intentional or unintentionalmisrepresentation of our products and services in advertising materials or other external communications, or inappropriate activities by the IMOs or their agents, could adversely affect our business reputation and prospects, as well as lead to potential regulatory actions or litigation.
Expectations relating to environmental, social, and governance (“ESG”) considerations could expose us to potential liabilities, increased costs, and reputational harm.
Governmental authorities, non-governmental organizations, customers, investors, external stakeholders and employees are increas-ingly sensitive to ESG considerations, such as diversity and inclusion, sustainability, climate change, cyber-security and data privacy. This focus on ESG considerations may lead to increased compliance costs associated with running our business. Responding to ESG concerns, implementing ESG initiatives and achieving ESG goals involves risks and uncertainties, requires investment, and depends in part on third-party performance or data that is outside of our control. We risk negative stockholder reaction, including from proxy advisory services, as well as damage to our brands and reputation, if we fail, or are perceived to fail, to adhere to any public statements about ESG matters, comply fully with developing interpretations of ESG laws and regulations or meet evolving and varied stakeholder expectations and standards. In addition, some stakeholders may disagree with any of our ESG goals and initiatives. If we do not meet the evolving and varied ESG expectations of our customers, investors and other stakeholders, we could experience reduced demand for our products and services, loss of customers and other negative effects on our business, results of operations and the market price of our common stock, and could be exposed to government enforcement actions or private litigation.
attractive
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. 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 reduce our insurance regulatory capital requirements because policies that are reinsured require substantially less capital and surplus than policies retained by us.
As of December 31, 2022, approximately 43% 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 operate our core business through four subsidiaries under one reportable segment. American Life & Security Corp. (“American Life”) is a Nebraska-domiciled life insurance company, currently licensed to sell, underwrite, and market life insurance and annuity products in 24 states and the District of Columbia. 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, in December 2018. That rating was affirmed in March 2023 when A.M. Best also revised its outlook for American Life from Positive to Stable. 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.
Midwest Capital Corp was established as a holding company and is the immediate parent of Seneca Incorporated Cell, LLC 2021-03 (“SRC3”), both of which are consolidated into our financial statements.
Our fourth subsidiary, 1505 Capital, is an SEC registered investment adviser providing financial, investment advisory, and management services. Our asset management services are available to third-party insurers and reinsurers. At December 31, 2022, 1505 Capital had approximately $501.9 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. 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 platform enables us to efficiently develop, sell and administer a wide range of annuity products.
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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 2021, annuity premiums accounted for $319 billion of annual premiums, or approximately 30% of the $1.1 trillion 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 forecasted 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 independent from the insurance companies that issue annuities. Independent distribution channels serve as the primary and a growing source of annuity distribution. In 2021, 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 2017 according to U.S. Individual Annuities, 2021 Year in Review, Life Insurance Marketing and Research Association (“LIMRA”), 2022. Independent agents are the second largest distribution channel, behind independent broker-dealers, accounting for approximately 19% of U.S. individual annuity sales in 2021. 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 state insurance regulators would like to see a more fully developed historical financial footprint. We are working diligently to file in more states, responding and providing increased information to regulators and discussing how our business model ensures policyholders are protected, given the capital held and supported by the use of reinsurance.
We currently distribute annuity products through 27 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.
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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 as 2022 unfolded. However, we expect competition in our market to remain intense particularly from other well established entities providing annuity products.
Interest Rate Environment
The Federal Reserve has continued increasing short-term interest rates, compared to the historically low levels in 2021 and the expectation communicated from U.S. federal banking officials is for rate increases to continue. 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.
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, federal legislation has been enacted to provide a safe harbor for transition to the recommended alternative reference rate.
Notwithstanding the availability of statutory guidance on fallback procedures, 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, including the Secured Overnight Financing Rate (“SOFR”), may result in adverse changes to the net investment income, fair market value and return on those investments. We in-tend to continue evaluating and monitoring the risks associated with the LIBOR transition which include identifying and monitoring our exposure to LIBOR and ensuring operational processes are updated to accommodate alternative rates. Due to uncertainty surrounding the effect of adopting or transitioning to alternative rates such as SOFR, we are unable to predict the overall impact of this change at this time.
Critical 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.
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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 impairmentloss 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 impairmentlosses 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 $35,000 should be recorded for one debt security, an impairment of $500,000 was recognized on a preferred stock, and a valuation allowance of $777,000 established on one lease. The valuation allowance on the lease of $777,000 was released as of March 31, 2021 due to the sale of the investment. As of December 31, 2022, the Company held one asset valued at $7.7 million with a total impairment of $1.4 million. No such impairments were recognized as of December 31, 2021.
Investment income consists of interest, dividends, gains and losses, 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, through the fair value of our total return swap, as either a realized gain or loss on the Consolidated Statements of Comprehensive Loss.
Intangibles
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, 2022, the sum of the fair value of those licenses exceeded the carrying value of the indefinite-lived intangible assets. These amounts are carried on our balance sheet in Other Assets.
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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 Nebraska law. 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.
Recognition of Revenues
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 Statements 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 Statements 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
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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 Statements of Comprehensive Loss as a realized gain or (loss).
Additionally, reinsurance agreements written on a FW basis contain embedded derivatives on our FIA product. Gains or (losses) associated with the performance of assets maintained in the relevant deposit and funds withheld accounts are reflected as realized gains or (losses) in our Consolidated Statements of Comprehensive Loss.
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 againstadverse 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 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 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 December 31, 2022.
American Life also has agreements with several third-party reinsurers that have FW and 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 4 — 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 as of December 31, 2022 and cumulative unrealized gains as of December 31, 2021, of approximately $10.5 million and $0.2 million, 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. We account for these unrealized gains by recording equivalent realized gains or losses on our Consolidated Statements 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 $10.6 million and loss of $2.8 million as of December 31, 2022 and 2021, 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 Income (Loss)
In this section, unless otherwise noted the discussion below compares the year ended December 31, 2022 to the year ended December 31, 2021.
We incurred a comprehensive loss of $46.9 million including unrealized loss of $54.0 million, mainly from the fixed maturity portfolio, resulting in net income to Midwest of $7.1 million for the year ended December 31, 2022. This compares to a comprehensive loss of $20.4 million including unrealized loss of $3.8 million, resulting in net loss of $16.6 million to Midwest last year.
Overall, revenues were flat year over year being impacted by realized losses of $14.9 million for the year ended December 31, 2022 versus a gain of $7.8 million in the prior year. Investment income increased due to the growth in the retained portfolio and from higher interest rates. Policy administration fees were up due to the increase in deposit liabilities through annuity premiums written in 2022 of $715.8 million versus $471.6 million in the prior year. Amortization of deferred ceded premium grew as we added new reinsurers and the portfolio continues to age. Service fee revenue was consistent with prior years as AUM was $502 million versus $405 million in the prior year.
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Overall, expenses were down, driven by negative interest credited and benefitting from the option allowance (see point 3 below). Controllable expenses increased 42% from $41.3 million to $58.8 million compared to 62% growth in deposit liabilities through annuity premiums written for the year. Salaries and benefits increased (after the exclusion of a one-time accelerated vesting of stock options) with additional personnel, repositioning and retaining of personnel to support growth and given tight labor market. Increase in Other expenses was driven by consulting, legal and accounting fees to support distribution, state expansion, and capital initiatives, along with technology initiatives.
The effective tax rate was 90.6% compared to 40.1% for the year ended December 31, 2022 and 2021, respectively. Our primary insurance entities, American Life, SRC1, and SRC3, are taxed on a statutory basis. GAAP defers the recognition of income related to premiums received until they are earned across the life of the contract. Statutory principles though recognize premiums as income in the period they are received, creating the difference between the two statements of income. See Note 9 to our financial statements for further information related to the income tax expense.
Our FIA products have three components influencing our Consolidated Statements of Comprehensive Loss:
The embedded derivative in our FIAs . We carry this derivative at fair value, with the change in fair value recorded in the interest credited line of our Consolidated Statements of Comprehensive Loss. Across our FIA products, interest credited was negative $17.2 million in 2022 compared with positive $4.2 million in 2021. Reflecting our risk management, the change in the value of the embedded derivative corresponds to the change in the value of option contracts we use to hedge this exposure.
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 Statements of Comprehensive Loss as either a realized gain or realized loss. In 2022, the market value of the derivative assets was $15.9 million compared to $2.7 million in 2021 in our net unrealized gain on investments.
The option budget reinsurers pay us to purchase derivative assets. We mark these assets to market each period. 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 resulted in a negative $11.2 million expense and was included in our other operating expense in 2022 compared to a $2.4 million expense in the prior year.
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 losses of approximately $10.5 million and gains of $0.2 million at December 31, 2022 and 2021, 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 Statements of Comprehensive Loss. We recorded the decrease in the unrealized gains as a realized gain of $10.6 million in 2022 compared to a realized loss of $2.8 million in 2021.
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Consolidated Results of Operations - Years Ended December 31, 2022 and 2021
Revenues
The following summarizes the sources of our revenue:
Year ended December 31,
(In thousands)
Premiums
Investment income, net of expenses
Net realized (losses) gains on investments
Amortization of deferred gain on reinsurance
Policy administration fees
Service fee revenue, net of expenses
Other revenue
Premium revenue: Sales of our MYGA and FIA products generated a large volume of new business in 2022 and 2021; however, these products are defined as investment contracts under 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 net investment income for 2022 and 2021 were as follows:
Year ended December 31,
(In thousands)
Fixed maturities
Mortgage loans
Other invested assets
Other interest (expense) income
Gross investment income
Less: investment expenses
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, 2022 and 2021, on a gross consolidated basis, our investment portfolio (excluding cash) was $1,615.0 million and $975.5 million, respectively, as a result of proceeds from our MYGA and FIA product sales, reflecting both retained premium proceeds as well as assets held on behalf of our reinsurers.
Net realized losses on investments: Net realized losses on investments were $14.9 million in 2022 compared with gains of $7.8 million in 2021. The figures include a gain of $10.6 million and a loss of $2.8 million from a total return swap embedded derivative in 2022 and 2021, respectively. In 2022, there were net realized losses of $14.5 million related to derivatives 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 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 4 — 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 losses of approximately $10.5 million and gains of approximately $0.2 million for the years ended December 31, 2022 and 2021,
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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 and losses accruing to third-party reinsurers via a total return swap resulting in a realized gain of $10.6 million and a realized loss of $2.8 million in 2022 and 2021, respectively.
Amortization of deferred gain on reinsurance: The increase in 2022 to $4.8 million from $3.0 million in 2021 was due to higher deferred gain on reinsurance, driven in part by higher reinsured premiums during 2022.
Policy administration fees: Policy administration fees includes fees received for the servicing and initiation of policies ceded to our reinsurers. Also included are fees surrendered by policy holders for early termination of their contracts. The increase of revenue to $2.1 million in 2022 from $0.8 million in 2021 was driven primarily by the increase in policies written and ceded, as well as additional policy holder early termination.
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 $2.4 million in 2022 from $2.3 million in 2021, 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 administrative services for clients.
Expenses
Our expenses for the periods indicated are summarized in the table below:
Year ended December 31,
(In thousands)
Interest credited
Benefits
Amortization of deferred acquisition costs
Salaries and benefits
Other operating expenses
Interest credited : The decrease was primarily due to the interest credited across all our products in 2022. Interest credited for our retained MYGA products was positive $7.2 million while interest credited related to our retained FIA policies was negative $17.2 million in 2022. MYGA and FIA interest credited were positive $2.8 million and $4.2 million for 2021, 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: This refers to death benefits on our policies, which saw an increase to $3.2 million in 2022 compared with 2021’s 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 57% of the business in 2022 compared to the 50% retained in 2021. These figures include the Seneca Re protected cells, SRC1 and SRC3, and DAC amortization.
Salaries and benefits The slight decrease to $16.2 million compared with $16.9 million was due to changes in upper management, offset by continued costs incurred to attract and add personnel to service our business growth combined with significantly lower costs 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.
Other operating expenses : Other operating expenses were approximately $7.4 million lower due primarily to:
Our FIA product has embedded derivatives included in the account value. Those derivatives are market driven. The reinsurers that reinsure the FIA products pay an option allowance to American Life to purchase derivatives. As of December 31, 2022,
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the mark-to-market adjustment on those allowances was in a positive position so American Life incurred a negative $11.2 million expense payable to the reinsurers for that mark-up. As the market fluctuates going forward, the mark up of the option allowance could go up or down.
Increases of other expenses related to legal and consulting fees of $2.1 million related primarily to efforts to secure new additional capital sources and the expansion of our business into new jurisdictions.
Taxes
Income tax expense increased by $2.8 million to $7.6 million in 2022 from $4.8 million in 2021. This change was primarily driven by the change in the reinsurance modified coinsurance tax reserves.
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.
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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, 2022 and 2021. Increases in fixed maturity securities primarily resulted from the sale of our MYGA and FIA products during 2022.
December 31, 2022
December 31, 2021
Carrying
Percent
Carrying
Percent
(In thousands)
Value
of Total
Value
of Total
Fixed maturity securities:
Bonds:
U.S. government obligations
Mortgage-backed securities
Asset-backed securities
Collateralized loan obligations
States and political subdivisions-general obligations
States and political subdivisions-special revenue
Corporate
Term loans
Trust preferred
Redeemable preferred stock
Total fixed maturity securities
Mortgage loans on real estate, held for investment
Derivatives
Equity securities
Other invested assets
Investment escrow
Federal Home Loan Bank stock
Preferred stock
Notes receivable
Policy Loans
Cash and cash equivalents
Total investments, including cash and cash equivalents
The following table shows the distribution of the credit ratings of our portfolio of fixed maturity securities by carrying value as of December 31, 2022 and 2021.
December 31, 2022
December 31, 2021
Carrying
Carrying
(In thousands)
Value
Percent
Value
Percent
AAA and U.S. Government
BBB
Total investment grade
BB and below
Total
Reflecting the quality of securities maintained by us, 91.9% and 92.8% of all fixed maturity securities were investment grade as of December 31, 2022 and 2021, respectively.
We expect that our MYGA and FIA products sales will result in an increase in investable assets in future periods.
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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.
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 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 13 to our consolidated financial statements. As of December 31, 2022, American Life maintained sufficient capital and surplus to comply with regulatory requirements.
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 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.
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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 all investments at fair value.
allows bonds to be carried at amortized cost or fair value based on the rating received from the Securities Valuation Office of the 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 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.
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The table below sets forth our SAP net income (loss) for 2022 and 2021 for each of our insurance subsidiaries and then reconciled to GAAP.
Year ended December 31,
(In thousands)
Consolidated GAAP net income (loss)
Exclude: Midwest non-insurance transaction entities (American Life & Seneca Re)
GAAP net gain (loss) of statutory insurance entities
GAAP net income (loss) by statutory insurance entity:
American Life
Seneca Re Incorporated Cell 01
Seneca Re Incorporated Cell 03
GAAP net gain (loss)
Reconciliation of GAAP and SAP
GAAP net income (loss) of American Life
Increase (decrease) due to:
Deferred acquisition costs
Coinsurance transactions
Carrying value of reserves
Foreign exchange and derivatives
Gain (loss) on sale of investments, net of asset valuation reserve
Other
SAP net income (loss) of American Life
GAAP net loss of Seneca Re Incorporated Cell 01
Increase (decrease) due to:
Deferred acquisition costs
Coinsurance transactions
Carrying value of reserves
Gain on sale of investments, net of asset valuation reserve
Other gain (loss)
SAP net income (loss) of Seneca Re Incorporated Cell
GAAP net loss of Seneca Re Incorporated Cell 03
Increase (decrease) due to:
Deferred acquisition costs
Coinsurance transactions
Carrying value of reserves
Gain on sale of investments, net of asset valuation reserve
Other
SAP net income (loss) of Seneca Re Incorporated Cell 03
SAP net gain (loss) of statutory insurance entities
Key Operating and Non-GAAP Measures
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 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 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 Statements of Comprehensive Loss.
Year ended December 31,
(In thousands)
Annuity Premiums (SAP)
Annuity direct written premiums
Ceded premiums
Net premiums retained
The increase in annuity direct written premiums reflect strong sales throughout 2022, even in 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.
Operating Metric – Fees Received for Reinsurance
Year ended December 31,
(In thousands)
Fees received for reinsurance (1)
Fees received for reinsurance - total
(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.
For the year ended December 31, 2022, fees received for reinsurance increased by $0.9 million compared to the prior year period due to higher ceded premiums. For the year ended December 31, 2022, the components of fees received for reinsurance included $4.8 million of amortization of deferred gain on reinsurance from our Consolidated Statements of Comprehensive Loss and $9.5 million of deferred coinsurance ceding commission from our Consolidated Statements of Cash Flows.
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Reconciliation – Management Expenses to GAAP Expenses
Year ended December 31,
Management Expenses
Management interest credited
Amortization of deferred acquisition costs
Expenses related to retained business
Management expenses - total
Year ended December 31,
Salaries and benefits - GAAP
Other operating expenses - GAAP
Subtotal
Adjustments:
Less: Stock-based compensation
Less: Mark-to-market option allowance
Year ended December 31,
Management Interest Credited
Interest credited - GAAP
Adjustments:
Less: FIA interest credited - GAAP
Add: FIA options cost - amortized - GAAP
Management interest credited
Year ended December 31,
Reconciliation - Management Expenses to GAAP Expenses
Total expenses - GAAP
Adjustments:
Less: Benefits
Less: Stock-based compensation
Less: Mark-to-market option allowance
Less: FIA interest credited - GAAP
Add: FIA options cost - amortized - GAAP
Management expenses - total
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.
For the year ended December 31, 2022, GAAP general and administrative expenses totaled $35.0 million compared to $24.6 million for the prior year. For the year ended December 31, 2022, as disclosed above, included in these expenses is mainly salaries, benefits
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and other operating expenses, along with less than $0.1 million of non-cash stock-based compensation and $11.2 million of 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, 2022, GAAP interest credited totaled negative $10.2 million compared to positive $ 7.0 million for the prior year. For the year ended December 31, 2022, as disclosed above, included in these expenses is GAAP interest credited related to our retained FIA policies of approximately negative $17.2 million.
Liquidity and Capital Resources
Investments
Information regarding our investment portfolio, which is comprised primarily of investment grade, fixed maturity securities, is presented in Part IV - Item 15, Exhibits and Financial Statement Schedules and in Part II - Item 8, Note 3 of the Consolidated Financial Statements in this report.
Comparative Cash Flows
At December 31, 2022 and 2021, we had cash and cash equivalents totaling $191.4 and $142.0 million, respectively. Our short-term liquidity requirements, within a 12 month operating cycle, are for the timely payment of claims and benefits to policyholders, operating expenses, interest payments and federal income taxes. Cash flow generated from operations has been, and is expected to be, adequate to meet our operating cash needs in the next 12 months. Cash flow in excess of operational needs has been used to fund business growth. Long-term liquidity requirements, beyond one year, are principally for the payment of future insurance and annuity benefits.
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. As our state expansion continues, we expect an increase in our sales of our MYGA and FIA products. However, our ability to continue to meet our future liquidity requirements will depend on, among other things, our ability to achieve anticipated levels of cash flows generated from operations and our ability to manage costs and working capital successfully, all of which are subject to general economic, financial, competitive and other factors beyond our control. In the event we require any additional capital, we may be required to raise additional funds, including through the sale of capital stock or debt in the public capital markets or in privately negotiated transactions, and there can be no assurance that we will be able to raise any such financing on terms acceptable to us or at all. If such funds are not available in the future, we may be required to delay or significantly modify our operations, each of which could have a material adverse impact on our results of operations or financial condition. For additional information, refer to Part I, Item 1A. Risk Factors —General Risks— Adverse capital and credit market conditions may significantly affect our ability to meet liquidity needs and access the capital required to operate our business.
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.
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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,
(In thousands)
Net cash provided by (used in) operating activities
Net cash (used in) investing activities
Net cash provided by financing activities
Net increase (decrease) in cash and cash equivalents
Cash and cash equivalents:
Beginning of period
End of period
Cash Provided by Operating Activities
Net cash provided by operating activities was $73.2 million for the year ended December 31, 2022, which was comprised primarily of a decrease in receivable and payable for securities of $12.5 million, capitalized DAC of $23.9 million, net realized loss on investments of $14.9 million, accrued investment income of $11.5 million, and amounts recoverable from reinsurers of $29.0 million. These were offset by deposit-type liabilities of $3.4 million, and an increase in deferred coinsurance ceding commission to $9.5 million.
Cash Used in Investing Activities
Net cash used for investing activities for 2022 was $708.7 million. The primary source of cash used was from our purchase of investments from sales of the MYGA and FIA products of $1,258.3 million. Offsetting this use of cash was our sale of investments of $573.2 million.
Cash Flow Provided by Financing Activities
Net cash provided by financing activities in 2022 was $684.9 million. The primary source of cash was net receipts on the MYGA and FIA products of $715.8 million.
As of December 31, 2022, we held $198.1 million of cash, U.S. government and agency fixed maturity securities and public equity securities (excluding non-redeemable preferred stocks and foreign equity securities) which, under normal market conditions, could be rapidly liquidated. Certain remote events and circumstances could constrain our liquidity. Those events and circumstances include, for example, a catastrophe resulting in extraordinary losses, a downgrade of our Senior Notes rating to noninvestment grade status or a downgrade in our insurance subsidiaries' financial strength ratings. The rating agencies also consider the interdependence of our individually rated entities; therefore, a rating change in one entity could potentially affect the ratings of other related entities.
Capital Resources
We have determined the amount of capital which is needed to adequately fund and support business growth, primarily based on risk-based capital formulas including those developed by the NAIC. Historically, our insurance subsidiary has generated capital in excess of such needed levels. If necessary, we also have other potential sources of liquidity that could provide for additional funding to meet corporate obligations. Our regulated insurance subsidiary is subject to various regulatory restrictions which limit the amount of annual dividends or other distributions, including loans or cash advances, available to us without prior approval of the insurance regulatory authorities. The aggregate amount of dividends that may be paid in 2023 from our insurance subsidiary without prior regulatory approval is approximately $7.4 million. We anticipate that our sources of capital will continue to generate sufficient capital to meet the needs for business growth and debt interest payments. Additional information is contained in Part II - Item 8, Note 13 of the Consolidated Financial Statements in this report.
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Total capital was $1,806.4 million at December 31, 2022, including $25.0 million of short-term and long-term debt. Total debt represented 1.38% of total capital including net unrealized investment gains on fixed maturity securities (1.39% of total capital excluding net unrealized investment gains on fixed maturity securities*) at December 31, 2022.
Stockholders’ equity was $34.4 million at December 31, 2022, including net unrealized investment gains on fixed maturity securities of negative $51.4 million after taxes and the related impact of DAC associated with annuity contracts with account values. The market value of our common stock and the market value per share were $47.0 million and $12.62, respectively, at December 31, 2022.
The Company did not pay dividends in the year ended December 31, 2022.
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, 2022, and 2021, the RBC ratio of American Life was 558% and 764%, respectively.
On November 22, 2022, the Company entered into a three-year senior secured revolving credit agreement (“Credit Agreement”) with Royal Bank of Canada and other lenders with a capacity of $30 million (the “Revolving Credit Facility”). The maturity date of the Credit Agreement is November 22, 2025. The obligations under the Credit Agreement are secured by a first priority lien on a variety of our assets. The balance of the revolving credit was $25.0 million at December 31, 2022, with $5.0 million unutilized credit.
Under the terms of the Credit Agreement, the Company has the option of selecting an applicable variable interest rate of (a) an adjusted term standard overnight financing rate (“SOFR”), plus an applicable margin or (b) a base rate, plus an applicable margin. Depending on our debt to capitalization ratio, the applicable margin can range from 2.50% to 3.25% for the base rate and from 3.50% to 4.25% for an adjusted term SOFR loan.
At its November 2022 meeting, the Company’s Board of Directors approved the “FHLB Program Recommendations and Strategy Document” that allowed for FHLB funding to be used for spread lending business, beginning in the fourth quarter of 2022. The strategy initially utilizes FHLB advances of up to 5% of American Life’s balance sheet. As of December 31, 2022, we had $29.0 million of borrowings outstanding with the Federal Home Loan Bank (“FHLB”).
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.
