MIDWEST HOLDING INC. The following Management's Discussion and Analysis ("MD&A") is intended to help
the reader understand the financial condition of the Company as of
June 30, 2022 , compared with December 31, 2021 , and the results of operations
for the three
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and six months endedJune 30, 2022 , compared with corresponding periods in 2021 ofMidwest Holding Inc. and its consolidated subsidiaries. The MD&A is provided as a supplement to, and should be read in conjunction with, our Consolidated Financial Statements and the accompanying notes to the Consolidated Financial Statements ("Notes") presented in "Part 1 - Item 1. Financial Statements" of this Report and our Form 10-K for the year endedDecember 31, 2021 ("2021 Form 10-K"), including the sections entitled "Part I - Item 1A. Risk Factors," and "Part II - Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations."
Cautionary Note Regarding Forward-Looking Statements and Risk Factors
Except for certain historical information contained herein, this report contains certain statements that may be considered "forward-looking statements" within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and Section 27A of the Securities Act of 1933, as amended (the "Securities Act"), and such statements are subject to the safe harbor created by those sections. All statements, other than statements of historical fact, are statements that could be deemed forward-looking statements, including without limitation: any projections of revenues, earnings, cash flows, capital expenditures, or other financial items; any statement of plans, strategies, and objectives of management for future operations; any statements concerning new products or services, or developments; any statements regarding future economic conditions or performance; and any statements of belief and any statement of assumptions underlying any of the foregoing. Words such as "believe," "may," "could," "expects," "estimates," "projects," "should," "intends," "will," "anticipates," and "likely," and variations of these words, or similar expressions, terms, or phrases, are intended to identify such forward-looking statements. Forward-looking statements are inherently subject to risks, assumptions, and uncertainties, many of which cannot be predicted or quantified, which could cause future events and actual results to differ materially from those set forth in, contemplated by, or underlying the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in "Item 1A. Risk Factors" of our 2021 Form 10-K and [below in Part III - Other Information - Item 1A Risk Factors.]
Factors that may cause our actual results to differ materially from those contemplated or projected, forecast, estimated or budgeted in such forward-looking statements include among others, the following possibilities:
? our business plan, particularly including our reinsurance strategy, may not
prove to be successful;
? the success of our recent changes in executive leadership;
? our reliance on third-party insurance marketing organizations to market and
sell our insurance products through a network of independent agents;
? adverse changes in the ratings obtained from independent rating agencies;
? failure to maintain adequate reinsurance;
? our inability to expand our insurance operations outside the 22 states and
? our insurance products may not achieve significant market acceptance;
? we may continue to experience operating losses in the foreseeable future;
? the possible loss or retirement of one or more of our key executive personnel;
? intense competition, pricing competition, the entry of new competitors, and the
introduction of new products by new and existing competitors;
adverse state and federal legislation or regulation, including limitations on
? premium levels, increases in minimum capital and reserve requirements, benefit
mandates and tax treatment of insurance products;
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fluctuations in interest rates causing a reduction of investment income or
? increase in interest expense and in the market value of interest-rate sensitive
investments;
? failure to obtain new customers, retain existing customers, or reductions in
policies in force by existing customers;
higher service, administrative, or general expense due to the need for
? additional marketing, administrative or management information systems
expenditures related to implementation of our business plan;
? changes in our liquidity due to changes in asset and liability matching;
? possible claims relating to sales practices for insurance products;
? accuracy of management's assumptions and estimates;
? variability of statutory capital required to be held by insurance or
reinsurance entities; and
? lawsuits in the ordinary course of business.
All such forward-looking statements speak only as of the date of this report. You are cautioned not to place undue reliance on such forward-looking statements. We expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in the events, conditions, or circumstances on which any such statements are based.
Overview of Company and Business Model
Midwest Holding Inc. ("Midwest," "the Company," "we," "our," or "us") was incorporated onOctober 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"), 1505Capital LLC ("1505 Capital"), and our sponsored captive reinsurance company,Seneca Reinsurance Company, LLC ("Seneca Re"). We are a financial services company focused on helping people plan and secure their future by providing technology-enabled and services-oriented solutions to support individuals' retirement through our annuity products. We distribute our annuities through independent distributors who are primarily independent marketing organizations ("IMOs"). Our operations are comprised of three distinct, inter-connected businesses. We seek to reinsure substantially all of our annuity policies with third-party reinsurers and our captive reinsurance subsidiary, Seneca Re. Our third-party reinsurers include traditional reinsurers and capital markets reinsurers, who are third-party investors, seeking exposure to reinsurance revenue and typically do not have their own reinsurance platforms or insurance-related operations. We also have the flexibility to selectively retain assets and liabilities associated with our policies for a period of time when we expect that doing so will provide an attractive return on our capital. We believe that our operating capabilities and technology platform provide annuity distributors and reinsurers with flexible and cost-effective solutions. We seek to create value through our ability to provide the distributors and reinsurers with annuity product innovation, speed to market for new products, competitive rates and commissions, and streamlined customer and agent experiences. Our capital model allows us to support increasing annuity sales volumes with capital capacity provided by reinsurers although, in connection with plans for future growth, we continue to monitor our need (if any) for additional capital. We provide an end-to-end solution to manage annuity products that includes a broad set of product development, distribution support, policy administration, and asset/liability management services. Our technology platform enables us to efficiently develop, sell and administer a wide range of products. Our asset management services are also provided to third-party insurers and reinsurers. We currently offer annuity products, consisting of multi-year guaranteed annuity ("MYGA") and fixed indexed annuity ("FIA") policies, through IMOs that in turn distribute our products and services to independent insurance agents in 22
states and the
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We operate our core business through three subsidiaries under one reportable segment. American Life is aNebraska -domiciled life insurance company that is currently licensed to sell, underwrite, and market life insurance and annuity products in 22 states and theDistrict of Columbia . In late 2018, American Life obtained a financial strength rating of B++ ("Good") fromA.M. Best Company ("A.M. Best"), a leading rating agency for insurance companies, that was affirmed inDecember 2020 andFebruary 2022 .A.M. Best also upgraded American Life's long-term issuer credit rating to bbb+ from bbb inDecember 2020 which was affirmed inFebruary 2022 . All of our annuities are written by American Life. Our other insurance subsidiary, Seneca Re, is aVermont -domiciled sponsored captive reinsurance company established in early 2020 to reinsure various types of risks on behalf of American Life and third-party capital providers through special purpose reinsurance entities known as "protected cells." Through Seneca Re, we assist capital market investors in establishing and licensing new protected cells. We also own 1505 Capital, which is anSEC registered investment adviser that provides financial, investment advisory, and management services. AtJune 30, 2022 , 1505 Capital had approximately$471.1 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 seek to create value for our distribution and reinsurance partners by facilitating product innovation, rapid speed to market for new products, competitively priced products, streamlined customer and agent experience, and efficient technology-enabled operations. We generate fee income from reinsurers in the form of ceding commissions, policy administration fees, and asset management fees. We typically receive upfront ceding commissions and expense reimbursements at the time the policies are reinsured and policy administration fees over the policy lifetimes. We also earn asset management fees on the assets we hold that support the obligations of a majority of our reinsurers. In investing on behalf of our insurance and reinsurance company subsidiaries, we seek to maximize yield by constructing portfolios that include a diversified portfolio of bonds, mortgages, private credit and structured securities (including collateralized loan obligations), while minimizing the difference in duration between our investment assets and liabilities. By reinsuring a significant portion of the annuity policies we issue, the level of capital needed for American Life is significantly less than retaining all of the business on its books. We believe this "capital light" approach has the potential to produce enhanced returns for our business compared to a traditional insurance company capital structure. This strategy helps alleviate our insurance regulatory capital requirements because policies that are reinsured require substantially less capital and surplus than policies retained by us. As ofJune 30, 2022 , approximately 61% of the deposits received in 2022 for our annuity products were ceded to reinsurance vehicles capitalized by third party reinsurers or held in protected cells within Seneca Re for future reinsurance transactions. We receive ceding commissions and expense reimbursement from reinsurers at the time we cede our primary insurance liabilities to them, providing meaningful cash flow. During the three months endedJune 30, 2022 and 2021, we generated$2.5 million and$4.3 million , respectively, in upfront ceding commissions. For the six months endedJune 30, 2022 and 2021, we generated$4.4 million and$6.6 million , respectively, in upfront ceding commissions. On our balance sheet is an item "deferred gains on reinsurance" equaling$32.2 million and$28.6 million as ofJune 30, 2022 , andDecember 31, 2021 , respectively which will be earned as revenue over the relevant reinsured annuity contract periods. Amortization of the deferred gain on reinsurance was$1.0 million and$0.6 million for the three months endedJune 30, 2022 and 2021, respectively, and was recognized as revenue under GAAP. Amortization of the deferred gain on reinsurance was$2.0 million and$1.1 million for the six months endedJune 30, 2022 and 2021, respectively, and was recognized as revenue under GAAP. For the three months endedJune 30, 2022 and 2021, we generated negative$0.1 million and positive$8.9 million of revenue from investment income, realized gains on investments, ceding commissions earned, policy administration, and asset management fees. For the six months endedJune 30, 2022 and 2021, we generated$2.5 million and$8.3 million of revenue from investment income, realized gains on investments, ceding commissions earned, policy administration, and asset management fees. 43 Table of Contents Through our ancillary services businesses we administer the policies we issue and offer asset management services to our reinsurance partners for a fee. Through Seneca Re, we also assist capital market investors in establishing and licensing new special purpose reinsurance entities. We believe our broad service offering provides a growing and valuable fee stream and expect that our policy administration and asset management fee income will increase as we grow our number of administered policies and the associated assets that we manage. In the future, we expect to have opportunities to increase our policy administration and asset management revenue by providing these services on a stand-alone basis to new customers. Our Products Through American Life we presently issue several MYGA and FIA products. American Life presently offers fixed annuity products, consisting of two MYGAs, two FIAs, and two bonus plans associated with the FIA product. It is not presently offering any traditional life insurance products. Fixed annuities are a type of insurance contract in which the policyholder makes one or more premium deposits, earning interest at a crediting rate determined in relation to a specific market index, on a tax deferred basis. MYGAs are insurance contracts under which the policyholder makes deposits and earns a crediting rate guaranteed for a specified number of years before it may be changed. American Life's MYGA products are three and five-year single premium deferred individual annuity contracts, providing consumers with an attractive, low risk, predictable and tax-deferred investment option. American Life's FIA products are long-term (7 and 10-year) annuity products with interest rates that are tied, in part, to published stock market indices chosen by customers. The FIA products are modified single premium annuity contracts designed for individuals seeking to benefit from potential market gains with fully protected principal. American Life began selling its MYGA and FIA products in 2019. In 2021, we introduced two new indexes into the selections on FIA products. The S&P 500 ESG index for fixed annuities is comprised of a subset of S&P 500 companies built to meet the increasing needs of investors seeking socially responsible investments aligned with a mainstream index which is published byS&P Dow Jones Indices (S&P DJI). Our second index introduced in 2021, the Goldman Sachs Xenith Index is a multi-asset strategy that uses an anticipated macro regime, as identified by a leading economic indicator, to make asset allocations. By using a leading economic indicator, the Goldman Sachs Xenith Index differs from indices that rely on a backward-looking methodology alone. Instead of relying purely on the S&P 500 Index for exposure toU.S. equities, the index employs an intraday overlay that can reduce equity exposure based on intra-day trading "signals". As a result, the strategy incorporates real-time market movements, in addition to other factors, in its methodology. We expect to expand American Life's product line in the future. Depending on market demand, we expect to consider having American Life write a variety of insurance products, including fixed deferred, fixed indexed and other annuities. Any new insurance products we create must be filed with and approved by appropriate state insurance regulatory authorities before being offered to the public. American Life's MYGA and FIA products were developed using an independent consulting actuary, and we expect that any new products will utilize similar services. Our long-term plan is to broaden our products to life and Medicare supplements under attractive market conditions. 44
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The table below sets forth American Life's MYGA and FIA deposits received during
the three and six months ended
Three months ended June 30, Six months ended June 30,
2022 2021 2022 2021
Deposits Deposits Deposits
(In thousands) Deposits Received(1) Received(1) Received(1) Received(1)
Annuity Premium
MYGA $ 70,230 $ 26,191 $ 95,694 $ 35,560
FIA 85,804 99,674 158,452 213,959
Total issued $ 156,034 $ 125,865 $ 254,146 $ 249,519
1) Under generally accepted accounting principles in the United States of
America ("GAAP"), these products are defined as deposit-type contracts;
therefore, the deposits received are accounted for under GAAP as deposit-type
liabilities on our balance sheet and premiums received are not recognized as
revenue in our consolidated statement of comprehensive loss. Under Statutory
Accounting Principles ("SAP"), the MYGA and FIA premiums received are treated as
premiums written and as revenue when earned.
Industry Trends and Market Conditions
Market
We participate in a large U.S. market that we expect to grow in part due to a number of demographic trends. As measured by annual premiums written, annuities are the largest product line in the life, annuity, and accident and health sector. Annuities play an important role in retirement planning by providing individuals with stable, tax-efficient sources of income. In 2020 annuity premium, accounted for$295 billion of annual premiums, or approximately 31% of the$963 billion of total annual life, annuity, and accident and health premiums according to theInsurance 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 theU.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. TheU.S. population over 65 years old is forecast to grow from 56 million in 2020 to an estimated 81 million in the next 20 years, according to theU.S. Census Bureau , Population Estimates and Projections. This study also forecasted thatU.S. population aged over 65 years old is expected to grow by 44% from 2020 to 2040, while the totalU.S. population is expected to grow by only 12%. Annuities in theU.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 2020, approximately 77% ofU.S. individual annuity sales occurred through independent distributors, including independent agents, broker-dealers, and banks, representing an increase from approximately 70% in 2016 according toU.S. Individual Annuities, 2020 Year in Review,Life Insurance Marketing and Research Association ("LIMRA"), 2021. Independent agents are the second largest distribution channel, behind independent broker-dealers, accounting for approximately 19% ofU.S. individual annuity sales in 2020. IMOs provide independent agents with access to annuity products along with operational support services and functionality to support the distribution services of the agents. The infrastructure and support services provided by IMOs to independent agents are critical to the success of independent agents and their ability to serve their customers and generate additional sales. We believe that capital markets investors have been actively seeking investing in and acquiring insurance and reinsurance companies in recent years. Fixed annuities provide upfront premiums and stable, long-term payment obligations and are thus attractive sources of liability-funded assets for a variety of traditional and alternative asset managers and investors. However, there are significant regulatory and operational hurdles for capital providers looking to enter the insurance market. These hurdles are exacerbated by the limited legacy administrative capabilities, product development processes and technology systems, of traditional insurers and reinsurers. We provide asset managers and investors the ability to seamlessly access funding from annuities through a variety of reinsurance entities that we can form quickly and operate efficiently with lower upfront and ongoing regulatory and operating costs. 45
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State expansion efforts have taken more time than anticipated, as states would like to see a more meaningful historical financial footprint. We are working diligently to file in more states, responding and providing increased information to regulators and discussing how the model ensures policyholders are protected, given the capital held and supported by the use of reinsurance. We currently distribute annuity products through eight third-party IMOs. We believe our product development, prompt policy processing, operating flexibility and speed to market make us a desirable partner for insurance distributors. We are seeking to grow by increasing volumes with our current IMOs and by establishing new IMO relationships.
Competition
We operate in highly competitive markets with a variety of participants, including insurance companies, financial institutions, asset managers, and reinsurance companies. These companies compete in various forms in the annuity market, for investment assets and for services. We seek to build strong relationships along with offering technology-enabled and services-oriented solutions for our partners. Our experience indicates that the market for annuities is dynamic. The combination of the treasury market experiencing the unprecedented rate increases and the volatility in the market resulting from the war inUkraine and related economic uncertainties due to inflation has opened up investment opportunities that allow us, and our reinsurance partners, to support more competitive rates for annuities. Based on our experience with COVID, we expect this investment environment to be conducive to our business model. We have been reviewing policy pricing along with reinsurer appetite to ensure we continue to grow our business while managing risk. We have recently taken pricing action on both our FIA and MYGA products and continue to monitor our competitiveness in the market. We have also increased our focus on marketing, reestablishing, and expanding our relationships on the distribution side through various channels and are reallocating or adding resources relating to this initiative. As a result, we experienced encouraging sales in the second quarter of 2022. However, we expect competition in our market to remain intense particularly from other well established entities providing annuity products. Given potential premium growth, we have capacity to cover the capital needs of writing new business through existing reinsurers although, in connection with plans for future growth, we continue to monitor our need (if any) for additional capital. Additionally, we have a number of potential reinsurance transactions in the pipeline that may close later in the year.
Interest Rate Environment
TheFederal Reserve continued increasing short-term interest rates in the second quarter of 2022, compared to the historically low levels in the same period in 2021 and the expectation communicated fromU.S. federal banking officials is for rate increases to continue during the remainder of 2022. We seek to address our interest rate risk through managing the duration of the liabilities and purchasing and holding quality, long-term assets mirroring that duration.
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"), theUnited 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. OnNovember 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-monthU.S. Dollar LIBOR settings at the end ofDecember 2021 , but to extend the publication of the remainingU.S. Dollar LIBOR settings (overnight and one, three, six and 12-monthU.S. Dollar LIBOR) until the end ofJune 2023 . The IBA intends to share the results of the consultation with theFCA 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 newU.S. Dollar LIBOR contracts by the end of 2021. We are in the process of analyzing and identifying our securities, financial instruments and contracts that utilize LIBOR (collectively "LIBOR Instruments") to determine if we have any material exposure to the transition from LIBOR. To the extent we hold LIBOR Instruments, the terms of these instruments may have fallback provisions that provide for an alternative reference rate when LIBOR ceases to exist. For securities without adequate fallback provisions already in place, legislation governing securities underNew York law has been enacted to provide a safe harbor for transition to the recommended 46
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alternative reference rate. In addition, federal legislation has been introduced
to provide the same protection for securities not governed by
Notwithstanding, in preparation for the phase out of LIBOR, we may need to renegotiate our LIBOR Instruments that utilize LIBOR. However, these efforts may not be successful in mitigating the legal and financial risk from changing the reference rate in our LIBOR Instruments. Furthermore, the discontinuation of LIBOR may adversely impact our ability to manage and hedge exposures to fluctuations in interest rates using derivative instruments. As a result, the transition of our LIBOR Instruments to alternative reference rates may result in adverse changes to the net investment income, fair market value and return on those investments. We intend to continue evaluating and monitor the risks associated with the LIBOR transition which include identifying and monitoring our exposure to LIBOR, monitoring the market adoption of alternative reference rates and ensuring operational processes are updated to accommodate alternative rates. Due to uncertainty surrounding alternative rates, we are unable to predict the overall impact of this change at this time, although we have experienced no adverse effect to our investment portfolio
from this transition to date. COVID-19 We continue to closely monitor developments related to the COVID-19 pandemic to assess any potential adverse impact on our business. It is currently not possible to provide a longer-term estimate of potential insurance or reinsurance exposure or the indirect effects the pandemic may have on our results of operations, financial condition or liquidity. We continue to monitor theCenter for Disease Control and Prevention andState of Nebraska guidelines regarding employee safety. Our management continues to monitor our investments and cash flows to evaluate any impact.
Critical Accounting Policies and Estimates
Part II - Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations included in our 2021 Form 10-K contains a detailed discussion of our critical accounting policies and estimates. This report should be read in conjunction with the "Critical Accounting Policies and Estimates" discussed in our 2021 Form 10-K MD&A.
Derivatives
The Company has entered into certain derivative instruments to hedge FIA products that guarantee the return of principal to our policyholders and credit interest based on a percentage of the gain in a specified market index. To hedge against adverse changes in equity indices, the Company entered into contracts to buy equity indexed options. The change in fair value of the derivatives for hedging the FIA index credits and the related embedded derivative liability fluctuate from period to period based on the change in the market interest rates. The indexed reserves are measured at fair value for the current period and future periods. We hedge with options in seeking to align with the terms of our FIA products, which are between seven and ten years. We have analyzed our hedging strategy on our FIA products and, while the correlation of the hedges to the FIA products is not matched dollar for dollar, we believe the hedges are effective as ofJune 30, 2022 . American Life also has agreements with several third-party reinsurers that have funds withheld ("FW") and modified coinsurance ("Modco") provisions under which the assets related to the reinsured business are maintained by American Life as collateral; however, ownership of the assets and the total return on the asset portfolios belong to the third-party reinsurers. Under GAAP, this arrangement is considered an embedded derivative as discussed in "Note 5 - Derivative Instruments" to our Consolidated Financial Statements. Assets carried as investments on American Life's financial statements for the third-party reinsurers contained unrealized losses of approximately$2.9 million as ofJune 30, 2022 , and unrealized gains of$0.2 million as ofDecember 31, 2021 , respectively. The terms of the contracts with the third-party reinsurers provide that the changes in unrealized gains on the portfolios accrue to the third-party reinsurers. Accordingly, the change in unrealized gains on the assets held by American Life were offset by gains in the embedded derivative of$3.1 million and a loss in the embedded derivative of$0.4 million as ofJune 30, 2022 , and 2021, respectively. We account for this unrealized gain (loss) pass-through by recording an equivalent realized gain or (loss) on our Consolidated Statements of Comprehensive Loss and in amounts payable to our third-party reinsurers on the Consolidated Balance Sheets. 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. 47
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Consolidated Results of Operations - the three months ended
Comprehensive Net Income (Loss)
In this section, unless otherwise noted the discussion below first compares the
three months ended
We incurred a comprehensive loss of$9.0 million in 2022 compared to$5.4 million . Our revenues decreased to($0.1) million from positive$8.9 million driven by unrealized losses from derivatives used to hedge FIA exposure of$23.6 million due to changes in in theFederal Reserve interest rate, offset by increases in fee revenue and investment income. Our expenses decreased to negative$1.4 million from$13.1 million due primarily to the interest rate increases resulting in losses in the embedded derivative creating negative interest credited on our FIA products and a gain from passing the losses of the mark-to-market on the reinsurance option allowances. These decreases in expense were offset by increases in consulting related to new software implementation.
Other reasons for the increase in Consolidated Statements of Comprehensive Loss included:
Taxes. Our GAAP effective tax rates were unusually high in comparison to 2021.
The increase was primarily due to our change in valuation allowances. We
1) expect our effective rates to decrease throughout the remainder of 2022. Note
8 to our Financial Statements provides further information relating to this
tax rate increase.
Change in Realized Investment Losses (Gains). This
2) to a loss of
increase in interest rates in 2022 decreased the value of our fixed-income
investments to a much greater extent than occurred in 2021.
Our FIA products have three components influencing our Consolidated Statements of Comprehensive Loss:
The derivatives we purchase to hedge interest rate risk we would otherwise face from our FIA. We carry these derivatives at fair value on our Consolidated Balance Sheets, recording the change in fair value in our Consolidated Statements of Comprehensive Loss as either a realized gain or realized loss. In 2022, the decrease in the market value of the derivative option assets was$14.3 million compared to a decrease of$3.7 million in 2021.
The embedded derivative in our FIAs. We carry this derivative at fair value as
of the balance sheet date, with the change in fair value recorded in the
interest credited line of our Consolidated Statements of Comprehensive Loss.
Interest credited for all of our products was a negative
1) compared to
derivative related to our FIAs was included in overall interest credited.
Reflecting our risk management strategy, the change in the value of the
embedded derivative equaled the change in the value of option contracts we use
to hedge this exposure.
The option budget reinsurers pay us to purchase derivative assets. We mark
these assets to market at each balance sheet date. Separately, we record a
payable to the reinsurers that is owed to a reinsurer when a policy is
surrendered, an annuitant dies, or a policy lapses. We compare what the
2) reinsurer paid for the original option budget to the market value at the end
of the period. The change in the market value is added to or subtracted from
the payable to the reinsurer to cover the reinsurer's obligations to the
policyholder. This change in market value that resulted in negative
million was included in our other operating expense in 2022 compared to a
positive $1.3 million in 2021.
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Revenues
The following summarizes our revenue sources for the periods indicated:
Three months ended June 30,
(In thousands) 2022
2021
Investment income, net of expenses $ 10,541 $
3,220
Net realized gains (loss) on investments (12,636)
4,060
Amortization of deferred gain on reinsurance 1,043
588
Service fee revenue, net of expenses 416
672
Other revenue 514 358
$ (122) $ 8,898 Premium revenue: Our MYGA and FIA products generated significant cash flows in 2022 and 2021; however, as indicated above, these products are defined as investment contracts underU.S. GAAP. Accordingly the funds we received from our customers under these contracts were recorded on our balance sheet as a deposit-type liability - and not as premium revenue. Investment income, net of expenses: The components of our net investment income are as follows: Three months ended June 30, (In thousands) 2022 2021 Fixed maturities income$ 15,347 $ 4,088 Mortgage loans 2,963 367 Other invested assets 3,705 96 Other interest income (9) 81 Gross investment income 12,795 4,632 Less investment expenses (2,254) (1,412)
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 net proceeds from sales of our MYGA and FIA products that were not ceded to reinsurers during the period, as well as deployment of excess cash towards credit investments. As ofJune 30, 2022 , andDecember 31, 2021 , on a gross consolidated basis, our investment portfolio (excluding cash) was$1.2 billion and$975.5 million , respectively. Net realized losses on investments: Net realized losses on investments were$12.6 million in 2022 compared to net realized gain of$4.1 million in 2021. The figure included a gain of$1.1 million and a loss of$0.8 million from a total return swap embedded derivative in 2022 and 2021, respectively. In 2022, there were net realized losses of$14.3 million related to derivative options we own to hedge the obligations to FIA policyholders; such losses were partially offset by an increase in the mark-to-market change in embedded derivative liability within interest credited expense and an increase in FIA-related mark-to-market option allowance expense flowing through other operating expenses. The change in fair value of FIA hedging derivatives is driven by the performance of the indices upon which our call options are based. American Life has treaties with several third-party reinsurers and one related party reinsurer. In aModco agreement, the ceding entity retains the assets equal to the modified coinsurance reserves retained. In a FW agreement, assets that would normally be paid over to a reinsurer are withheld by the ceding company to permit statutory credit for unauthorized reinsurers, to reduce potential credit risk. Under this provision with third-party reinsurers, the assets backing the treaties are maintained by American Life as investments but the assets and total returns or losses on the investments are owned by the reinsurers. Under GAAP, this arrangement is considered an embedded derivative as discussed in Comprehensive Loss to our Consolidated Financial Statements. Assets carried as investments on American Life's financial statements for the third-party reinsurers contained unrealized losses of approximately$2.9 million and gains of$0.2 million as ofJune 30, 2022 , andDecember 31, 2021 respectively. The terms of the contracts with the third-party reinsurers provide that the changes in unrealized gains on the portfolios accrue to the third- 49
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party reinsurers. Accordingly, the unrealized losses on the assets held by
American Life were offset by gains in the embedded derivative of
Amortization of deferred gain on reinsurance: The increase in 2022 to
Service fee revenue, net of expenses: Service fee revenue, net of expenses, consists of fee revenue generated by 1505 Capital, for asset management services provided to third-party clients, some of whom are our reinsurers. The decrease in this revenue, to$0.4 million in 2022 from$0.7 million in 2021, was due primarily to assets managed by 1505 Capital. Other revenue: Other revenue consists of revenue generated by us for providing ancillary services such as third-party administration ("TPA") to clients and policy surrender charges. The increase in 2022 was primarily due to increased policy surrender charges. Expenses
Our expenses for the periods indicated are summarized below:
Three months ended June 30,
(In thousands) 2022 2021
Interest credited $ (5,496) $ 3,931
Benefits 1 0
Amortization of deferred acquisition costs 1,052 524
Salaries and benefits 4,298 4,514
Other operating expenses (2,240) 4,174
$ (1,392) $ 13,143 Interest credited: The increase was primarily due to the interest credited in 2022 relating to the MYGA products of approximately$0.9 million and$0.5 million for 2022 and 2021, respectively, offset by interest credited related on our retained FIA policies of approximately negative$6.4 million and$3.4 million for 2022 and 2021, respectively. The FIA interest credited is related to the fair market value of the embedded derivative which is owed to policyholders and which experienced a sharp decline due to increases in theFederal Reserve interest rates, partially offset by the realized gain on our total return swap that is included in the net realized gain on investments above.
Amortization of deferred acquisition costs: The increase was due to the acquisition costs relating to the sale of MYGA and FIA products where we retained approximately 62% of the business in 2022 compared to the 32% retained in 2021. These figures include the deferred acquisition cost ("DAC") of the Seneca Re protected cells, SRC1 and SRC3.
Salaries and benefits: The decrease to
Other operating expenses: Other operating expenses were approximately
Our FIA products have embedded derivatives included in the account value that
are market driven. The FIA reinsurers pay an option allowance to American Life
to purchase derivatives. As of
? those allowances were in a negative position so American Life incurred
million and
reinsurers for that market value true-up. As the market fluctuates going forward, the mark-up of the option allowance will go up or down.
Offset due to increases in other operating expenses of approximately
? million was due to fees to consultants to assist in implementing our business
plan and new accounting software, increased audit and actuarial costs, and
overhead office expenses to support the planned growth of our business.
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Taxes
Income tax expense decreased by $2.9 million to negative $2.1 million in 2022
from $0.7 million in 2021. This change was primarily driven by the change in the
reinsurance modified coinsurance tax reserves discussed.
Consolidated Results of Operations - Six Months Ended
Comprehensive Net Income (Loss)
In this section, unless otherwise noted the discussion below first compares the
six months ended
We incurred a comprehensive loss of$19.1 million in 2022 compared to a comprehensive loss of$6.4 million in 2021. Our revenues decreased to$2.5 million from$8.2 million reflecting an overall increase in investment income and fee revenue; offset by realized losses due to the increases in theFederal Reserve interest rate. Our expenses decreased to a negative$4.7 million from$12.7 million , primarily due to theFederal Reserve interest rate increases resulting in losses in the embedded derivative creating negative interest credited on our FIA product and a gain from passing the losses of the mark-to-market on the reinsurance option allowances. These decreases in expense were offset by increases in consulting fees.
Other reasons for the increase in Consolidated Statements of Comprehensive Loss:
Taxes. Our GAAP effective tax rates were unusually high in 2022 compared to
2021. The increase was primarily due to our change in valuation allowances.
1) We expect the effective rates will decrease throughout the remainder of 2022.
Note 8 to our Financial Statements provides further information related to
this increase in tax rate.
Change in Realized Investment Losses (Gains). This change was a loss of
2) million in 2022 compared with a loss of
rates in 2022 decreased the value of our fixed-income investments to a much
greater extent than occurred in 2021.
Our FIA products have three components influencing our Consolidated Statements of Comprehensive Loss:
The derivatives we purchase to hedge interest rate risk we would otherwise face from our FIA. We carry these derivatives at fair value on our Consolidated Balance Sheets, recording the change in fair value in our Consolidated Statements of Comprehensive Loss as either a realized gain or realized loss. In 2022, the decrease in the market value of the derivative option assets was$27.1 million compared to the decrease in market value of the derivative option assets of$1.7 million in 2021 in our net realized gain on investments.
The embedded derivative in our FIAs. We carry this derivative at fair value as
of the balance sheet date, with the change in fair value recorded in the
interest credited line of our Consolidated Statements of Comprehensive Loss.
Interest credited for all of our products was a negative
1) compared with
derivative related to our FIAs was included to the overall interest credited.
Reflecting our risk management strategy, the change in the value of the
embedded derivative equaled the change in the value of option contracts we use
to hedge this exposure.
The option budget reinsurers pay us to purchase derivative assets. We mark
these assets to market at each balance sheet date. Separately, we record a
payable to the reinsurers that is owed to a reinsurer when a policy is
surrendered, an annuitant dies, or a policy lapses. We compare what the
2) reinsurer paid for the original option budget to the market value at the end
of the period. The change in the market value is added to or subtracted from
the payable to the reinsurer to cover the reinsurer's obligations to the
policyholder. This change in market value that resulted in negative
million was included in our other operating expense in 2022 compared to a
negative $4.1 million expense in 2021.
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Revenues
The following summarizes our revenue sources for the periods indicated:
Six months ended June 30,
(In thousands) 2022 2021
Investment income, net of expenses $ 16,783 $ 6,107
Net realized losses on investments (18,810)
(589)
Amortization of deferred gain on reinsurance 2,012
1,048
Service fee revenue, net of expenses 1,514 1,110
Other revenue 962 607
$ 2,461 $ 8,283 Premium revenue: Our MYGA and FIA products generated significant cash flows in 2022 and 2021; however, as indicated above, these products are defined as investment contracts underU.S. GAAP. Accordingly the funds we received from our customers under these contracts were recorded on our balance sheet as a deposit-type liability - and not as premium revenue. Investment income, net of expenses: Our net investment income components are as follows: Six months ended June 30, (In thousands) 2022 2021 Fixed maturities$ 20,393 $ 7,068 Mortgage loans 3,246 540 Other invested assets 2,632 152 Other interest income (6,902) 152 Gross investment income 19,369 7,912 Less: investment expenses (2,586) (1,805)
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. As ofJune 30, 2022 , andDecember 31, 2021 , on a gross consolidated basis, our investment portfolio (excluding cash) was$1.2 billion and$975.5 million , respectively. Net realized losses on investments: Net realized losses on investments were$18.8 million in 2022 compared to a loss of$0.6 million in 2021. The figure included a gain of$3.1 million and a loss of$0.4 million from a total return swap embedded derivative in 2022 and 2021, respectively. In 2022, there were net realized losses of$27.1 million related to derivative options we own to hedge the obligations to FIA policyholders; such losses were partially offset by an increase in the mark-to-market change in embedded derivative liability within interest credited expense and an increase in FIA-related mark-to-market option allowance expense flowing through other operating expenses. The change in fair value of FIA hedging derivatives is driven by the performance of the indices upon which our call options are based. American Life has treaties with several third-party reinsurers and one related party reinsurer. In aModco agreement, the ceding entity retains the assets equal to the modified coinsurance reserves retained. In a FW agreement, assets that would normally be paid over to a reinsurer are withheld by the ceding company to permit statutory credit for unauthorized reinsurers, to reduce potential credit risk. Under these provisions with third-party reinsurers, the assets backing the treaties are maintained by American Life as investments but the assets and total returns or losses on the investments are owned by the reinsurers. Under GAAP, this arrangement is considered an embedded derivative as discussed in Comprehensive Loss to our Consolidated Financial Statements. Assets carried as investments on American Life's financial statements for the third-party reinsurers contained unrealized losses of approximately$2.9 million as ofJune 30, 2022 , and unrealized gains of$0.2 million as ofDecember 31, 2021 , respectively. The terms of the contracts with the third-party reinsurers provide that the changes in unrealized gains on the portfolios accrue to the third-party reinsurers. Accordingly, the change in unrealized gains and losses on the assets held by American Life were 52
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offset by gains in the embedded derivative of$3.1 million and a loss in the embedded derivative of$0.4 million as ofJune 30, 2022 , and 2021, respectively. We account for this unrealized gain (loss) pass-through by recording an equivalent realized gain or (loss) on our Consolidated Statements of Comprehensive Loss and in amounts payable to our third-party reinsurers on the Consolidated Balance Sheets.
Amortization of deferred gain on reinsurance: The increase in 2022 to
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$1.5 million in 2022 from$1.1 million in 2021, was due primarily to an increase in the assets managed by 1505 Capital. Other revenue: Other revenue consists of revenue generated by providing ancillary services such as third-party administration ("TPA") to clients and policy surrender charges. The increase in 2022 was primarily due to increased policy surrender charges. Expenses
Our expenses for the periods indicated are summarized below:
Six months ended June 30,
(In thousands) 2022 2021
Interest credited $ (12,170) $ 1,585
Benefits 994 -
Increase in benefit reserves - 0Amortization of deferred acquisition costs 1,902 1,027
Salaries and benefits 8,615 7,441
Other operating expenses (4,060) 2,645
$ (4,719) $ 12,698 Interest credited: The decrease was primarily due to the interest credited in 2022 relating to the MYGA products of approximately negative$2.0 million and$0.8 million for 2022 and 2021, respectively, offset by interest credited related on our retained FIA policies of approximately negative$14.2 million and negative$0.6 million for 2022 and 2021, respectively. The FIA interest credited is related to the fair market value of the embedded derivative which is owed to policyholders which experienced a sharp decline due to the increases in theFederal Reserve interest rates, partially offset by the realized gain on our total return swap that is included in the net realized gain on investments above. Amortization of deferred acquisition costs: The increase was due to the acquisition costs relating to the sale of American Life's MYGA and FIA products where we retained approximately 61% of the business in 2022 compared to the 46% retained in 2021. These figures include the DAC of Seneca Re protected cells, SRC1 and SRC3. Salaries and benefits The increase to$8.6 million compared with$7.4 million was due to costs incurred to attract and add personnel to service our business growth and the cost related to non-cash stock consideration. We have hired more in-house expertise to service our growth initiatives and reduce the reliance on third-party providers.
Other operating expenses: Other operating expenses were approximately
Our FIA products have embedded derivatives included in the account value that
are market driven. The FIA reinsurers pay an option allowance to American Life
to purchase derivatives. As of
? those allowances were in a negative position so American Life incurred
million and
reinsurers for that market value true-up. As the market fluctuates going forward, the mark-up of the option allowance will go up or down.
Offset due to increases in other operating expenses of approximately
? million was due to fees to consultants to assist in implementing our business
plan and new accounting software, increased audit and actuarial costs, and
overhead office expenses to support our plan growth of our business.
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Taxes
Income tax expense increased by
Investments
Most investments on our Consolidated Balance Sheets are held on behalf of our reinsurers as collateral under our reinsurance agreements. As a result, our investment allocations are largely a function of our collective reinsurer investment allocations. While the reinsurers have the investment risk on these assets, we typically restrict their investment allocations via control over the selection of the asset managers as well as asset restrictions set forth in investment guidelines and control over the investment managers. In many of our reinsurance agreements, 1505 Capital acts as the asset manager for the invested assets for a fee. Our investment guidelines relate primarily to collateralized loan obligations, corporate bonds, commercial mortgages on real estate, mortgage-backed securities, and term loans. The duration of our investments is 5 to 10 years in line with that of our liabilities. We do allow non-U.S. dollar denominated investments where the foreign exchange risk is hedged back toU.S. dollars. The following table shows the carrying value of our investments by investment category and cash and cash equivalents, and the percentage of each to total invested assets as ofJune 30, 2022 , andDecember 31, 2021 . Increases in fixed maturity securities primarily resulted from the proceeds of our new MYGA and FIA products during 2022. Most of the investments as ofJune 30, 2022 , andDecember 31, 2021 are held as collateral for our reinsurers. June 30, 2022 December 31, 2021 Carrying Percent Carrying Percent (In thousands) Value of Total Value of Total Fixed maturity securities: Bonds: U.S. government obligations$ 2,029 0.2 %$ 1,882 0.2 % Mortgage-backed securities 142,022 10.6 55,280 4.9 Asset-backed securities 37,068 2.8 24,951 2.2 Collateralized loan obligations 218,326 16.3 274,523 24.6 States and political subdivisions-general obligations 203 -
114 - States and political subdivisions-special revenue 131 - 5,612 0.5 Corporate 35,032 2.6 37,139 3.3 Term loans 448,127 33.5 267,468 24 Trust preferred 0 - 2,237 0.2 Redeemable preferred stock 11,533 0.9 14,090 1.3 Total fixed maturity securities 894,471 66.9 683,296 61.1 Mortgage loans on real estate, held for investment 193,902 14.5 183,203 16.4 Derivatives 7,190 0.5 23,022 2.1 Equity securities 11,925 0.9 21,869 2 Other invested assets 71,170 5.3 35,293 3.2 Investment escrow 1,491 0.1 3,611 0.3
Federal Home Loan Bank (FHLB) stock 500 -
500 - Preferred stock 22,072 1.7 18,686 1.7 Notes receivable 6,111 0.5 5,960 0.5 Policy Loans 22 - 87 - Cash and cash equivalents 128,964 9.6 142,013 12.7 Total investments, including cash and cash equivalents$ 1,337,818 100.0 %$ 1,117,540 100.0 % 54 Table of Contents The following table shows the distribution of the credit ratings of our portfolio of fixed maturity securities by carrying value as ofJune 30, 2022 , andDecember 31, 2021 . June 30, 2022 December 31, 2021 Carrying Carrying (In thousands) Value Percent Value Percent AAA and U.S. Government$ 8,168 0.9 %$ 2,674 0.4 % AA 452 0.1 482 0.1 A 308,991 34.5 168,141 24.6 BBB 545,247 61.0 462,699 67.7 Total investment grade 862,858 96.5 633,996 92.8 BB and below 31,613 3.5 49,300 7.2 Total$ 894,471 100.0 %$ 683,296 100.0 %
Approximately 96.5% and 92.8% of all fixed maturity securities were investment
grade as of
We expect that the net proceeds from our MYGA and FIA products sales will continue to result in an increase in investable assets in future periods.
Market Risks of Financial Instruments
The primary market risks affecting the investment portfolio are interest rate risk, credit risk and liquidity risk. With respect to investments that we hold on our Consolidated Balance Sheets as collateral, our reinsurers bear the market risks related to these investments, and we bear the market risks on any net retained investments.
Interest Rate Risk
Interest rate risk arises from the price sensitivity of investments to changes in interest rates. Interest and dividend income represent the greatest portion of an investment's return for most fixed maturity securities in stable interest rate environments. The changes in the fair value of such investments are inversely related to changes in market interest rates. As interest rates fall, the interest and dividend streams of existing fixed-rate investments become more valuable and fair values rise. As interest rates rise, the opposite effect occurs. Our liabilities also have interest rate risk although GAAP does not require our liabilities to be marked to market. We mitigate interest rate risk by monitoring and matching the duration of assets compared to the duration
of liabilities. Credit Risk We are exposed to credit risk through counterparties and within the investment portfolio. Credit risk relates to the uncertainty associated with an obligor's ability to make timely payments of principal and interest in accordance with the contractual terms of an instrument or contract. We manage our credit risk through diversification of investments among many corporations and numerous industries. Additionally, our investment policy limits the size of holding
in any particular issuer. Liquidity Risk
We are exposed to liquidity risk when liabilities come due. In order to pay a policyholder, we may need to liquidate assets. If our assets are illiquid assets, we might be unable to convert an asset into cash without giving up capital and income due to a lack of buyers or an inefficient market. We seek to mitigate this risk by keeping a portion of our investment portfolio in liquid investments.
Statutory Accounting and Regulations
Our primary insurance subsidiary, American Life, is required to prepare
statutory financial statements in accordance with SAP prescribed by the NDOI.
SAP primarily differs from GAAP by charging policy acquisition costs to expense
as incurred, establishing future benefit liabilities using actuarial assumptions
as well as valuing investments and certain assets and
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accounting for deferred taxes on a different basis. For further discussion regarding SAP as well as net income (loss) of American Life under SAP, see Note 14 - Statutory Net Income and Surplus to our Consolidated Financial Statements. As ofJune 30, 2022 , American Life maintained sufficient capital and surplus to comply with regulatory requirements. We have reported our insurance subsidiaries' assets, liabilities and results of operations in accordance with GAAP, which varies from SAP. The following items are principal differences between SAP and GAAP. SAP:
? requires that we exclude certain assets, called non-admitted assets, from the
balance sheet.
requires us to expense policy acquisition costs when incurred, while GAAP
? allows us to defer and amortize policy acquisition costs over the estimated
life of the policies.
? dictates how much of a deferred income tax asset that we can admit on a
statutory balance sheet.
requires that we record certain investments at cost or amortized cost, while we
? record other investments at fair value; however, GAAP requires that we record
investments that have a readily obtainable valuation at fair value. Investments
without a valuation are carried at amortized cost.
allows bonds to be carried at amortized cost or fair value based on the rating
? received from the
Insurance Commissioners ("NAIC"), while they are recorded at fair value for
GAAP.
allows ceding commission income to be recognized when written if the cost of
? acquiring and renewing the associated business exceeds the ceding commissions,
but under GAAP such income is deferred and recognized over the coverage period.
requires that we record reserves in liabilities and expense for policies
? written, while we record all transactions related to the annuity products under
GAAP as deposit-type contract liabilities. Requires that a provision for reinsurance liability be established for
reinsurance recoverable on paid losses aged over 90 days and for unsecured
? amounts recoverable from unauthorized reinsurers. Under GAAP there is no charge
for uncollateralized amounts ceded to a company not licensed in the insurance
affiliate's domiciliary state and a reserve for uncollectable reinsurance is
charged through earnings rather than surplus or equity.
requires an additional admissibility test outlined in Statements on Statutory
Accounting Principles, No. 101, and the change in deferred income tax is
reported directly in capital and surplus, rather than being reported as a
? component of income tax expense under GAAP. Our insurance subsidiaries must
file with the insurance regulatory authorities an "Annual Statement" which
reports, among other items, net income (loss) and surplus as regards
policyholders, which is called stockholders' equity under GAAP.
State insurance laws and regulations govern the operations of all insurers and
reinsurers such as our insurance and reinsurance company subsidiaries. These
various laws and regulations require that insurance companies maintain minimum
amounts of statutory surplus regarding policyholders and risk-based capital and
determine the dividends that insurers can pay without prior approval from
regulators. The statutory net income of American Life is one of the primary
sources of additions to our statutory surplus, in addition to capital
contributions from us.
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