future economic conditions in the markets in which we compete that could be less favorable than expected and could have impacts on demand for our products and services;
our ability to grow and develop our Agency business through expansion of retail call centers, online sales, wholesale operations and other areas of opportunity;
increased competition in our businesses, including the potential impacts of aggressive price competition by other insurance companies, payment of higher commissions to agents that could affect demand for our insurance products and impact the ability to grow and retain agents in our Agency Segment and the entry of new competitors and the development of new products by new or existing competitors, resulting in a reduction in the demand for our products and services;
We provide life insurance protection targeted to the middle American market. We believe there is a substantial unmet need for life insurance, particularly among domestic households with annual incomes of between $50,000 and $125,000, a market we refer to
as our target Middle Market. We differentiate our product and service offerings through innovative product design and sales processes, with an emphasis on rapidly issued products that are not medically underwritten at the time of sale.
We conduct our business through our two operating subsidiaries, Fidelity Life, an Illinois-domiciled life insurance company, and Efinancial, a call center-based insurance agency. Efinancial sells Fidelity Life products through its own call center distribution platform, independent agents and other marketing organizations. Efinancial, in addition to offering Fidelity Life products, sells insurance products of unaffiliated carriers. We report our operating results in three segments: Agency, Insurance and Corporate.
This segment primarily consists of the operations of Efinancial. Efinancial is a call center-based insurance agency that markets life insurance for Fidelity Life and unaffiliated insurance companies. Efinancial’s primary operations are conducted through employee agents from three call center locations, which we refer to as our retail channel. In addition, Efinancial operates as a wholesale agency, assisting independent agents that desire to work for the carriers that Efinancial represents, which we refer to as our wholesale channel. Efinancial also generates insurance lead sales revenue through its eCoverage web presence. For the years ended December 31, 2019 and December 31, 2018, our Agency Segment revenue earned 78% and 81% through the retail channel, 8% and 3% through the wholesale channel, and 14% and 15% through insurance lead sales revenue, respectively.
Agency Segment expenses consist of marketing costs to acquire potential customers, salary and bonuses paid to our employee agents, salary and other costs of employees involved in managing the underwriting process for our insurance applications, sales management, agent licensing, training and compliance costs. Other Agency Segment expenses include costs associated with financial and administrative employees, facilities rent, and information technology. After payroll, the most significant Agency Segment expense is the cost of acquiring leads. We are able to partially offset our sales leads expense through advertising revenues from individuals who click on specific advertisements while viewing one of our web pages, and through the resale of leads that are not well suited for our call center. For years ended December 31, 2019 and December 31, 2018, these offsetting revenues were $6.3 million and $7.6 million, respectively, which reduced our total agency expenses by approximately 11% and 13%, respectively. Our Agency Segment recognizes income (loss) to the extent that commissions and other revenue exceed (are less than) our marketing and overhead costs for the period.
Core Life - Our Core Life insurance business is the primary business of the Insurance Segment. Core Life represents a significant portion of the insurance business written by Fidelity Life since it resumed independent operations in 2005. Our Core Life business consists of in­force policies that are considered to be of high strategic importance to Fidelity Life.
We have not accepted new policies in these legacy lines since 2006 or prior, and these lines are considered to be in “run-off” with a declining number of policies in force each period. We recognize income on the Closed Block and annuities and assumed life to the extent that premium revenues and net investment income exceed the benefit expenses and operating expenses (including paid and accrued policyholder dividends) of these lines of business. On the two annuity lines, we recognize income (loss) to the extent that our net investment income earned exceeds (are less than) benefit expenses (direct annuities) and amounts credited on policy deposits (assumed annuities) and operating expenses of the two lines.
Annuities and Assumed Life - We have assumed reinsurance commitments with respect to annuity contract-holder deposits and a block of life insurance contracts that were ceded by former affiliates of Fidelity Life. On March 29, 2019, one of these former affiliates recaptured the majority of the assumed block of life business. The annuity deposits were ceded to Fidelity Life through two contracts entered into in the early 1990s. These annuity and assumed life deposits are now largely in run­off, with only minor amounts of new deposits each year. There are minimal remaining surrender charges associated with the assumed annuity contracts.
Our Insurance Segment revenues consist of net insurance premiums, net investment income, and net realized gains (losses) on investments. Our distributors consist of Efinancial and the independent insurance agencies that we contract with to sell our insurance products to the customers (policyholders) who buy our insurance policies. We recognize premium revenue from our policyholders. We purchase reinsurance coverage to help manage the risk on our insurance policies by paying, or ceding, a portion of the policyholder premiums to the reinsurance companies. Our net insurance premiums reflect amounts collected from policyholders, plus premiums assumed under reinsurance agreements less premiums ceded to reinsurance companies. Net investment income represents primarily interest income earned on fixed maturity security investments that we purchase with cash flows from our premium revenues. We also realize gains and losses on sales of investment securities. These investments support our liability for policy reserves and provide the capital required to operate our insurance business. Capital requirements are primarily established by regulatory authorities. See “Note 2-Investments” and “Business-Risk-Based Capital (RBC) Requirements.”
In order for our insurance operations to be profitable, we must achieve product experience consistent with our pricing assumptions. We price our products using a number of assumptions that are designed to support the desired level of profitability. Our operating results will be affected by variances between our pricing assumptions and our actual experience. The key pricing assumptions made are:
Investment Returns. We earn income on the investments held to support reserves and capital requirements. The amount of net investment income that we recognize will vary depending on the amount of invested assets that we own, the types of investments we own, the interest rates earned and amount of dividends received on our investments. If the actual amount of net investment income earned is less than projected, our products may not generate the desired level of profitability.
Operating Expenses. Our level of operating expenses affects our reported net income (loss). Our general operating expenses include expenses that vary based on the growth in our revenues and expenses that are fixed regardless of revenue growth. As discussed above, we have experienced operating losses principally because our operating expenses and corporate overhead exceed our revenues, and our inability to defer a majority of our commission expense on policies produced by our affiliated agency, Efinancial.
Our critical accounting policies are described in Note 1-Basis of Presentation and Summary of Significant Accounting Policies to our consolidated financial statements included elsewhere in this Form 10-K. The accounting policies discussed in this section are those that we consider to be the most critical to an understanding of our consolidated financial statements. The preparation of the consolidated financial statements in conformity with GAAP requires management to use judgment in making estimates and assumptions that affect reported amounts of assets, liabilities, revenues, expenses and related disclosures. We regularly evaluate our estimates and judgments based on historical experience, market indicators and other relevant factors and circumstances. Actual results may differ from these estimates under different assumptions or conditions and may affect our financial position and results of operations.
Level 3-Fair values are derived from valuation techniques in which one or more significant inputs are unobservable. Level 3 instruments include less liquid securities for which significant inputs are unobservable in the market, such as structured securities with complex features that require significant management assumptions or estimation in the fair value measurement. Level 3 hierarchy requires the use of observable market data when available.
Level 3 fair value classification consists of investments in structured securities where the fair value of the security is determined by a pricing service using internal pricing models where one or more of the significant inputs is unobservable in the marketplace, or there is a single broker/dealer quote. The fair value of a broker-quoted asset is based solely on the receipt of an updated quote from a single market maker or a broker-dealer recognized as a market participant. The Company does not adjust broker quotes when used as the fair value measurement for an asset.
The credit loss component of fixed maturity security impairment is calculated as the difference between amortized cost of the security and the present value of the expected cash flows of the security. The present value is determined using the best estimate of cash flows discounted at the effective rate implicit to the security at the date of purchase or prior impairment. The methodology and assumptions for estimating the cash flows vary depending on the type of security. For mortgage-backed and asset-backed securities, cash flow estimates, including prepayment assumptions, are based on data from widely accepted third-party sources or internal estimates. In addition to prepayment assumptions, cash flow estimates vary based on assumptions regarding the underlying collateral characteristics, expectations of delinquency and default rates, and structural support, including subordination and guarantees. If the present value of the modeled expected cash flows equals or exceeds the amortized cost of a security, no credit loss exists and the security is considered to be temporarily impaired. If the present value of the expected cash flows is less than amortized cost, the security is determined to be other-than-temporarily impaired for credit reasons and is recognized as an OTTI loss in earnings. The portion of the OTTI that is not considered a credit loss, is recognized as OTTI in accumulated comprehensive income.
There was OTTI on fixed maturity securities in the amount of $41 thousand and $0 for the years ended December 31, 2019 and December 31, 2018, respectively.
Our mortgage loans are held on commercial real estate and are stated at the aggregate unpaid principal balances, net of any write-downs and valuation allowances. We identify loans for evaluation of impairment primarily based on the collection experience of each loan. Mortgage loans are considered impaired when, based on current information and events, it is probable that we will be unable to collect principal or interest amounts according to the contractual terms of the loan agreement. Impairment is measured on a loan by loan basis based on the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral. Impairments are included in net realized investment gains (losses) in the Consolidated Statements of Operations.
For our Insurance Segment, the costs of acquiring new business are deferred to the extent that they are directly related to the successful acquisition of insurance contracts. Deferred acquisition costs include commissions paid in the first policy year that are in excess of the ultimate renewal commissions payable on the policy. For any of our policies for which we do not pay renewal commissions, the deferred acquisition costs (at the segment level) include all commissions paid in the first year. For policies for which we pay levelized commissions over the life of the policy, we expense the first-year commission and therefore do not defer any other commission expense. We also defer costs associated with policy underwriting and issuance related to the successful acquisition of insurance contracts. Non-deferred first year acquisition costs that are expensed as incurred include expenses that do not meet the definition of a deferrable cost, which includes the acquisition costs incurred on insurance applications that do not result in an in-force policy (unsuccessful efforts).
The primary reserve method that is used in calculation of our future policy benefit reserves is the net level premium method. The net level premium method requires that the future policy benefit reserves are accrued as a level proportion of the premium paid by the policyholder. In applying this method, we use a number of actuarial assumptions that represent management’s best estimate at the time the contract was issued with the addition of a margin for adverse deviation. Actuarial assumptions include estimates of morbidity, mortality, policy persistency, discount rates and expenses over the life of the contracts.
In connection with our premium deficiency testing on our most significant business lines, we performed sensitivity analyses on our Core Life, Non-Core Life, Closed Block, and annuities and assumed life business lines to capture the effect that certain key assumptions have on expected future cash flows, and the impact of those assumptions on the adequacy of DAC balances and GAAP benefit reserves. The sensitivity tests are performed independently, without consideration for any correlation among the key assumptions.
Because of one-time activity in the Closed Block resulting from large number of policies hitting their annual increasing scale premium period after their 20 year level period expired in December 2019, the September 30, 2019 Closed Block premium deficiency testing had materially different results from testing done at a December 31, 2019 valuation date. At September 30, 2019, the DAC was still recoverable in the Closed Block on both the baseline test and the three sensitivity tests noted above. At December 31, 2019, premium deficiency testing resulted in the Closed Block having a DAC reduction of $4.8 million. This would be the same value regardless of the sensitivity tests above, because any changes to mortality, investment yield, or expenses would result in dividend changes of an offsetting amount and would not change the amount of DAC reduction.
We amortize the domain site intangible assets on a straight-line basis over a useful life of ten years and software intangible assets are amortized over a useful life of four years using an accelerated amortization method. Contract-based intangible assets are amortized on a straight-line basis over a useful life of primarily five years, with the exception of some distribution contracts where the
The determination of the estimated fair value and estimated useful lives of intangible assets require the exercise of considerable management judgment. If the actual useful life is less than that assumed or the pattern of benefits is shorter than that used in developing the initial estimates, we could write down the carrying value of intangible assets and reduce our reported income, or increase our reported loss.
Interim impairment testing may be performed when events or changes in circumstances indicate that the carrying amount of the intangible assets may not be recoverable. Amortizable intangible assets are tested for impairment based on undiscounted cash flows, which requires the use of estimates and judgment, and, if impaired, are written down to fair value based on discounted cash flows. For years ended December 31, 2019 and December 31, 2018, we have not recorded an impairment of intangible assets.
As of December 31, 2019, we had a 100% valuation allowance recorded against the deferred tax assets related to the non-life subgroup of our tax return because we determined that it is more likely than not that these assets will not be recoverable. The recording of the valuation allowance increases our federal income tax expense which in turn reduces our reported net income or increases our net loss as applicable. Our recorded net deferred tax asset is shown in the following table. The balances for each period are shown based on the life/non-life portions of the consolidated federal tax returns and in total.
Net investment income consists of income generated from our investment portfolio and is recorded net of related expenses incurred to manage our investments. Net investment income primarily consists of interest income earned on fixed maturity investments and dividends earned on our equity holdings, net of related expenses incurred to manage our investments. Net investment income earned on assets required to support insurance reserves, annuity deposits and related regulatory capital requirements is allocated to our Insurance Segment. Any other net investment income is recorded in the Corporate Segment.
For the year ended December 31, 2019, total benefits and expenses were $155.5 million compared to $140.2 million for the year ended December 31, 2018. This increase of $15.3 million includes increases in operating costs and expenses of $8.6 million primarily due to costs related to accelerated vesting of incentive compensation related to the completion of the IPO and other enterprise initiatives. In addition, there were increases in net life insurance benefits and amortization of deferred policy acquisition costs.
For the year ended December 31, 2019, we had a loss before taxes of $20.2 million compared to a loss before taxes of $16.2 million for the year ended December 31, 2018. This increased loss of $4.0 million was primarily due to increases in operating expenses and claim benefits, partially offset by higher net insurance premiums and earned commissions.
For the year ended December 31, 2019, insurance lead sales were $6.3 million compared to $7.6 million for the year ended December 31, 2018. This decrease of $1.3 million was primarily due to a management decision to reduce external lead sales and maximize retail channel sales.
For the year ended December 31, 2019, general operating expenses were $52.6 million compared to $50.5 million for the year ended December 31, 2018. This increase of $2.1 million was due to a $2.7 million increase in overhead expenses, primarily due to $0.9 million of accelerated vesting of incentive compensation related to the completion of the IPO and increases in non-agent staff costs. This increase was partially offset by lower variable cost of sales of $0.6 million, which was mainly driven by lower retail earned commissions.
See “Note 2-Investments” in the Notes to the Consolidated Financial Statements included in this Form 10-K.
For the year ended December 31, 2019, interest credited was $3.2 million compared to $3.6 million for the year ended December 31, 2018. This decrease of $0.4 million was due to lower interest credited on assumed fixed annuity contract-holder account balances.
The Closed Block was funded based on a model developed to forecast the future cash flows of the Closed Block which is referred to as the “actuarial calculation.” The actuarial calculation projected the anticipated future cash flows of the Closed Block as established at the initial funding. We compare the actual results of the Closed Block to expected results from the actuarial calculation as part of the annual assessment of the current level of policyholder dividends. The assessment of policyholder dividends includes projections of future experience of the Closed Block policies and the investment experience of the Closed Block assets. The review of Closed Block experience also includes consideration of whether policyholder dividend obligations should be recorded to reflect favorable Closed Block experience that has not yet been reflected in the dividend scales. The recorded policyholder dividend obligations at December 31, 2019 and December 31, 2018 totaled $11.5 million and $9.4 million, respectively, and consisted of favorable policy experience on the Closed Block policies ($9.1 million and $8.7 million, respectively) and unrealized gains on the Closed Block fixed maturity security portfolio holdings ($2.4 million and $0.7 million, respectively).
The block where there are no dividends expected had a significant number of policies issued in December 1999 which had level premiums for the first 20 durations, followed by premiums which increased significantly in duration 21 as the premiums from that point forward go to an annually increasing scale. The approximate increase in premiums going from the 20th to the 21st duration is 1300%. Direct policies are a mixture of annual, semi-annual, quarterly, and monthly premium payment modes, whereas ceded policies are all annual premium mode. Therefore, both direct and ceded premiums increased significantly in 2019 on the Closed Block compared to the prior year as this group of policies ended their level term with larger impacts effecting ceded premiums more than direct premiums as a result of these modal differences.
The impact of the eliminations for intercompany transactions primarily consists of the sales by our Agency Segment of life products of our Insurance Segment. The eliminations represent the amounts required to eliminate the intercompany transactions as recorded in our segment results, and in particular, to eliminate any intersegment profits resulting from such transactions. Our segment results follow the accounting principles and methods applicable to each segment as if the intercompany transactions were with unaffiliated organizations:
Our investment strategy and guidelines are developed by management and approved by the investment committee of Fidelity Life’s Board of Directors. Our investment strategy related to our Insurance Segment is designed to maintain a well-diversified, high quality fixed income portfolio that will provide adequate levels of net investment income and liquidity to meet our policyholder obligations under our life insurance policies and our assumed annuity deposits. To help maintain liquidity, we establish the duration of invested assets within a tolerance to the policy liability duration. The investments of our Insurance Segment are managed with an emphasis on current income within quality and diversification constraints. The focus is on book yield of the fixed income portfolio as the anticipated portfolio yield is a key element used in pricing our insurance products and establishing policyholder crediting rates on our annuity contracts.
Net realized investment gains (losses) are subject to general economic trends and in particular correlate generally with movements in the major equity market indexes. The amounts classified as realized gains and losses in our Consolidated Statements of Operations include amounts realized from sales of investments, mark-to-market adjustments on investments classified as trading securities, equity holdings and investments that use the equity method of accounting (limited partnership interests) and other-than-temporary impairments of individual securities related to credit impairments.
We also record capital appreciation/depreciation on our available-for-sale fixed maturity securities. At December 31, 2019 and December 31, 2018, we had Accumulated Other Comprehensive Income (Loss) from mark-to-market adjustment of our available-for-sale fixed income securities totaling $11.1 million and $10.2 million (net of federal income taxes and reserve), respectively.
At December 31, 2019, we had total assets of $721.8 million compared to total assets at December 31, 2018 of $655.0 million, an increase of $66.8 million. The invested asset base increased $39.8 million primarily due to short-term investment increase of $29.8 million related to cash received from the completion of the IPO and increase in market value changes of $18.3 million, partially offset by net sales of invested assets. In addition, the commissions and agent balances receivable increased by $9.4 million, primarily resulting from the adoption of the Revenue Recognition accounting standard effective January 1, 2019 (see “Note 1-Summary of Significant Accounting Policies - Accounting Standards Adopted” in the Notes to the Consolidated Financial Statements included in this Form 10-K). Cash and cash equivalents increased $16.9 million primarily related to cash from the IPO, partially offset by operations and timing of claim payments and collection of reinsurance recoverables. In addition to the above items, Other assets increased $4.8 million primarily due to an increase in due premium and internally developed software, partially offset by costs incurred in prior years related to the IPO, previously classified in Other assets and now included in Additional paid-in capital. This increase was partially offset by a $3.7 million decrease in Reinsurance recoverables, as a result of a $4.8 million decrease in ceded policy and claim reserves, offset by an increase of $1.1 million related to timing of settlements of reinsurance recoverables. In addition, Deferred income taxes decreased $1.2 million due to changes related to investment market gains, partially offset by a deferred income tax benefit.
At December 31, 2019, we had total liabilities of $509.4 million compared to total liabilities of $482.8 million at December 31, 2018, an increase of $26.6 million. Future policy benefits and claims increased $15.4 million, primarily due to a $39.6 million increase in Core and Non-Core lines due to growth and maturity of the underlying blocks of business, offset by a decrease of $18.7 million in the Closed Block and a $5.5 million decrease in annuities and assumed life, primarily related to the recapture of the majority of an assumed life block of business. Reinsurance liabilities and payables increased $9.2 million, primarily due to timing of reinsurance settlements. Debt increased $7.2 million related to additional net borrowings under our commission financing agreement with Hannover Life. Policyholder dividend obligations related to the Closed Block increased $2.1 million, primarily related to changes in the market value of invested assets. Offsetting these increases were changes in Policyholder account balances, which decreased by $5.5 million, largely due to annuity payments and Other liabilities of $1.1 million, primarily related to changes in operating accruals.
Depending on the product sold, a portion or all of the agent’s commission may be paid as a cash advance to the agent and most of the underwriting and policy issue costs are paid at the time the initial policy is issued, whereas the premiums may be paid throughout the policy year, and
The resulting negative first year cash flows from sales of new policies is partially offset by positive cash flows from insurance policy renewals. The continued sales growth in our Insurance operations has resulted in a net cash decrease from operations. Cash flows from reinsurance collections will vary from period to period based on claims activity.
For the year ended December 31, 2019, we had a net increase in cash of $16.9 million compared to net increase of $9.2 million for the year ended December 31, 2018. Cash from operating activities decreased by $7.0 million mainly due to higher premium volume offset by higher general operating expenses. Cash from investing activity decreased primarily due to net purchases of short-term investments from IPO proceeds. Cash provided by financing activities increased due to net proceeds from the completion of the IPO.
Due to the continued growth in Fidelity Life’s sales of new insurance policies and the dividends to VHI ($5.0 million in 2019 and $7.0 million in 2018 to provide working capital), Fidelity Life’s statutory surplus has been declining. The accounting principles applicable to regulatory reporting require that insurance companies expense all policy acquisition costs as incurred. Acquisition expenses attributable to Fidelity Life’s increasing new business growth have resulted in net losses being reported for regulatory reporting purposes. Regulatory accounting principles allow limited recognition of the future benefits of deferred tax assets. Accordingly, we recognize no income tax benefit that would offset our operating losses for regulatory reporting purposes.
We own a diversified portfolio of investments including cash, bonds, commercial mortgages, and common stock. Each of these investments is subject, in varying degree, to market risk that can affect their return and their fair value. Bonds are the majority of our investments and include debt issues of corporations, residential and commercial mortgage-backed securities or other asset-backed securities, U.S. Treasury securities, or obligations of U.S. Government Sponsored Enterprises and are classified as fixed maturity investments in our financial statements. Our investment portfolios are subject to market risks.
Credit risk is the risk of loss due to an adverse change in the financial condition of a specific debt issuer or, in the case of a securitized investment, adverse change in the assets being securitized. We address credit risk by establishing minimum rating standards for investments that our portfolio managers can acquire and, in the case of a downgrade, continue to hold the investment. For our core fixed income portfolio, which comprises a significant majority of our invested assets, only investment grade securities (minimum credit rating for new investments is BBB- as established by Standard & Poor’s or a comparable nationally recognized statistical rating organization) can be purchased and such portfolio managers must maintain an overall credit rating for the portfolio of at least A-. Through our portfolio managers, we monitor the financial condition of all the issues of securities that we own. As an additional step to reduce our exposure to credit risk, we have established diversification guidelines limiting the total amount of holding by issuer and by investment sector.
Equity market risk is the risk that we will incur economic losses due to adverse changes in equity prices. Adverse changes in equity prices can arise from both the movements of broad markets based on investor behavior or other general economic factors and also from adverse changes in an individual company’s stock price. We manage our equity market risk primarily by limiting our exposure to individual issuers and by maintaining liquid holdings such that we are able to find a ready market should we want to lower our exposure to equity markets. Our individual stock holdings are managed by a specialty manager with portfolio guidelines that include limits on industry exposures and the size of investments in individual issuers. At December 31, 2019 and December 31, 2018, we had $5.2 million and $4.8 million of exposure to equity market risk in our Insurance Segment through holdings of individual equity securities, respectively.
All applicable adopted accounting pronouncements have been reflected in our consolidated financial statements as of and for the years ended December 31, 2019 and December 31, 2018.