The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our financial statements and the related notes appearing elsewhere in this report.
From our inception, we have raised approximately $17.5 million through sales of shares of voting common stock in several private placements exempt from registration under Section 4(2) of the Securities Act of 1933 and an intrastate public offering in the State of Nebraska.
On June 20, 2010, American Life acquired Capital Reserve in exchange for a cash payment of approximately $1.9 million. This transaction added approximately a like amount of assets to American Life. Further, with the insurance charters acquired from Capital Reserve, we obtained access to additional markets in Missouri and Kansas. Capital and surplus of Capital Reserve as of December 31, 2013 and 2012 was $1,290,459 and $1,405,707, respectively. Capital Reserve generated a $115,248 and $77,652 net loss for the years ended December 31, 2013 and 2012, respectively.
On November 8, 2010, the Company entered into an agreement to acquire all of the issued and outstanding capital stock of Old Reliance. American Life merged into Old Reliance following the purchase, with the survivor changing its name to American Life & Security Corp. In the transaction, the sole shareholder of Old Reliance received: (i) approximately $1.6 million in cash, (ii) $500,000 in the form of a surplus debenture and (iii) 150,000 shares of voting common stock of the Company ($750,000 fair value). On November 8, 2010, prior to signing the stock purchase agreement with American Life, Old Reliance had assets of approximately $19 million and for the period from January 1, 2010 through November 8, 2010, income of approximately $1.4 million, and expenses of approximately $1.7 million. The transaction, including the merger, was consummated on August 3, 2011.
The Company commenced its third party administrative (“TPA”) services in 2012 by first offering the services to its wholly-owned subsidiary and other consolidated entities. Later, the Company expanded its services to other non-consolidated entities as an additional revenue source. These agreements, for various levels of administrative services on behalf of each company, generate fee income for the Company. Services provided to each company vary based on their needs and can include some or all aspects of back-office accounting and policy administration. We have been able to perform our TPA services using our existing in-house resources.
Shareholders who perfect dissenters’ rights under applicable state law will receive cash in lieu of Midwest voting common stock.
The Exchange Agreements require the approval of the shareholders of both Great Plains and Security Capital. We have filed a Registration Statement on Form S-4 (the "Registration Statement") with the Securities and Exchange Commission (SEC) pursuant to which we are registering 4,120,261 shares of our voting common stock, which we believe is the maximum number of our shares that will be issuable in connection with both Exchange Agreements assuming the Great Plains and Security Capital shareholders approve the agreements. The Registration Statement also contains proxy statement materials which solicit the approval of the shareholders of Great Plains and Security Capital. The SEC has not yet declared the Registration Statement effective as of the filing date of this Report, and we intend to update it after the filing of this Report and submit to the SEC an amended Registration Statement.
In addition to the SEC declaring the Registration Statement effective and to shareholder approval, each Exchange Agreement contains numerous conditions precedent and representations and warranties that must be satisfied (or waived) in order for the stock exchange and related transactions to close. We cannot provide any assurance that the exchange of shares or other transactions contemplated by either Exchange Agreement will be consummated.
You may read a copy of the Registration Statement we have filed with the SEC, which contains copies of the Exchange Agreements and other related documents, at the SEC’s Public Reference Room, 100 F Street, N.E., Washington, D.C. 20549. You may obtain information on the operation of the SEC’s Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains an internet website (http://www.sec.gov) that contains an electronic copy of the Registration Statement. You may also obtain a copy of the Registration Statement, free of charge, by going to the Investor section of Midwest’s website (www.midwestholding.com) or by written or oral request to Mark A. Oliver at 2900 South 70th Street, Suite 400, Lincoln, Nebraska 68506, telephone: (402) 489-8266. Information contained in the Registration Statement or on Midwest’s website or that can be accessed through Midwest's website does not constitute a part of this Report. Midwest has included its website address as an inactive textual reference only. Information contained on Midwest’s website is not incorporated by reference into this Report, and you should not consider information contained Midwest’s website to be part of this Report or any amendment thereto.
The accounting and reporting policies of the Company are in accordance with accounting principles generally accepted in the United States of America. Preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. The following is an explanation of the Company’s accounting policies and the estimates considered most significant by management. These accounting policies inherently require significant judgment and assumptions and actual operating results could differ significantly from management’s estimates determined using these policies. We believe the following accounting policies, judgments and estimates are the most critical to the understanding of the results of operations and financial position. A detailed discussion of significant accounting policies is provided in this report in Note 1 - Nature of Operations and Summary of Significant Accounting Policies in the Notes to Consolidated Financial Statements.
The recognition of other-than-temporary impairment losses on debt securities is dependent on the facts and circumstances related to the specific security. If the Company intends to sell a security or it is more likely than not that the Company would be required to sell a security prior to recovery of the amortized cost, the difference between amortized cost and fair value is recognized in the income statement as an other-than-temporary impairment. As it relates to debt securities, if the Company does not expect to recover the amortized basis, does not plan to sell the security and if it is not more likely than not that the Company would be required to sell a security before the recovery of its amortized cost, the recognition of the other-than-temporary impairment is bifurcated. The Company recognizes the credit loss portion through earnings in the income statement and the noncredit loss portion in accumulated other comprehensive loss. The credit component of an other-than-temporary impairment is determined by comparing the net present value of projected cash flows with the amortized cost basis of the debt security. The net present value is calculated by discounting the Company’s best estimate of projected future cash flows at the effective interest rate implicit in the fixed income security at the date of acquisition. Cash flow estimates are driven by assumptions regarding probability of default, including changes in credit ratings, and estimates regarding timing and amount of recoveries associated with a default.
Amounts received under our multi-benefit policy form are allocated to the life insurance portion of the multi-benefit life insurance arrangement and the annuity portion based upon the signed policy.
A detailed discussion of new accounting standards is provided in Note 1 - Nature of Operations and Summary of Significant Accounting Policies in the Notes to Consolidated Financial Statements.
When American Life commenced operations in September 2009, we began to receive premium income from the sales of life insurance. Capital Reserve, acquired in 2010, has had minimal impact on operations as it has no premium income or related expenses. Management expects the premium writings in American Life and Great Plains to increase in the next few years as the business continues to expand, and as assets and policy reserves grow, expects investment income to grow also. An evaluation of the best use of the assets obtained in the acquisitions of Capital Reserve and Old Reliance is ongoing.
Insurance revenues are primarily generated from premium revenues and investment income. Insurance revenues for the years ended December 31, 2013 and 2012 are summarized in the table below.
Investment income, net of expenses: The components of net investment income for the years ended December 31, 2013 and 2012 are as follows:
Miscellaneous income: Miscellaneous income in the year ended December 31, 2013 was $246,328 compared to $103,175 in the year ended December 31, 2012. The increase in miscellaneous income is attributable to third-party administration fee income earned in 2013 from non-consolidated entities.
Realized gain on deconsolidation of Hot Dot, Inc.: The realized gain on deconsolidation of Hot Dot, Inc. for the year ended December 31, 2012 was $278,513. The gain was a result from the deconsolidation of Hot Dot during the third quarter of 2012.
Death and other benefits: Death and other policy benefits were $676,524 in the year ended December 31, 2013 compared to $814,306 in the year ended December 31, 2012. The decrease in death and other policy benefits for the year ended December 31, 2013 is primarily attributable to a reduction of claims experienced on final expense and burial policies. Death benefits on the traditional life products were nominal in 2013 and 2012.
Increase in benefit reserves: The increase in benefit reserves was $1,282,878 in the year ended December 31, 2013 compared to $993,103 in the year ended December 31, 2012. The increase in benefit reserves increased for the year ended December 31, 2013 compared to the same period in 2012 primarily due to the consolidation of Great Plains Financial, which included 12 months of expense compared to 3 months in 2012.
Amortization of deferred acquisition costs: Incremental direct costs that result directly from and are essential to the contract acquisition transaction and would not have been incurred by the Company had the contract acquisition not occurred, are capitalized and amortized over the life of the premiums produced. The majority of these acquisition expenses consist of commissions paid to agents, underwriting costs, and certain marketing expenses. In accordance with accounting principles generally accepted in the United States of America (GAAP), these costs are capitalized, to the extent recoverable, and amortized over the life of the premiums produced. The amortization of such costs was $861,840 in the year ended December 31, 2013, compared to $631,121 in the year ended December 31, 2012. The increase in amortization, results from an increase in the balances of deferred acquisition costs period over period. During the first quarter of 2012, the Company recorded a one-time adjustment related to our estimated amortization period for recognizing deferred acquisition costs creating a negative amortization amount of $233,195.
Net Loss: Net loss was ($2,217,920) for the year ended December 31, 2013, compared to a net loss of ($2,519,309) for the year ended December 31, 2012. The decrease in net loss was primarily attributable to an overall increase in premiums, investment income, and miscellaneous income described above and an overall decrease in expenses. As such, a share of the net loss is attributable to other noncontrolling owners, as described below.
Loss attributable to noncontrolling interests: Midwest owns approximately 60% of the capital stock of Security Capital Corporation, approximately 24.7% of the capital stock of Hot Dot on the deconsolidation date of September 12, 2012, and approximately 25.7% of Great Plains Financial. Security Capital is consolidated on Midwest’s financial statements, Hot Dot was consolidated on Midwest’s financial statements through September 12, 2012 prior to being deconsolidated, and Great Plains Financial was consolidated on Midwest’s financial statements beginning on October 1, 2012. The loss attributable to noncontrolling interests on Midwest’s financial statements for the year ended December 31, 2013 represents the net loss of Great Plains Financial to the other, non-controlling shareholders of Great Plains Financial. The loss attributable to noncontrolling interests on Midwest’s financial statements for the year ended December 31, 2012 represents the allocation of pro rata portions of the net loss of Hot Dot to the other, noncontrolling shareholders. Security Capital has not had any income or expense for the past two years. The loss attributable to noncontrolling interests was ($267,481) for the year ended December 31, 2013, compared to ($861,622) for the year ended December 31, 2012. The decrease in loss attributable to noncontrolling interests reflects a decreased net loss incurred by Great Plains compared to the net loss incurred by Hot Dot in the periods presented. Both Security Capital and Hot Dot are development stage enterprises that have not generated significant income to offset their expenses.
Net loss attributable to Midwest Holding Inc.: Net loss attributable to Midwest Holding Inc. was ($1,950,439) for the year ended December 31, 2013 compared to a net loss of ($1,657,687) for the year ended December 31, 2012. The increase in the net loss for the year ended December 31, 2013 compared to same period in 2012 was primarily attributable to the change in net loss attributable to noncontrolling interests partially offset by lower salary and other operating expenses. We expect our losses to continue in the future as we incur costs to grow our life insurance business.
The Company’s overall investment philosophy is reflected in the allocation of its investments. The Company emphasizes investment grade debt securities, with smaller holdings in equity securities, real estate, held for investment, mortgage loans on real estate, held for investment, policy loans, and other investments. The following table shows the carrying value of our investments by investment category and cash and cash equivalents, and the percentage of each to total invested assets as of December 31, 2013 and 2012.
Increases in fixed maturity securities primarily resulted from additional purchases made by American Life and Great Plains Life during the first and second quarters of 2013.
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.
The Company attempts to mitigate its exposure to adverse interest rate movements through staggering the maturities of the fixed maturity investments and through maintaining cash and other short term investments to assure sufficient liquidity to meet its obligations and to address reinvestment risk considerations. Due to the composition of our book of insurance business, we believe it is unlikely that we would encounter large surrender activity due to an interest rate increase that would force the disposal of fixed maturities at a loss.
Premium income, deposits to policyholder account balances, and investment income are the primary sources of funds while withdrawals of policyholder account balances, investment purchases, policy benefits in the form of claims, and operating expenses are the primary uses of funds. To ensure we will be able to pay future commitments, the funds received as premium payments and deposits are invested in primarily fixed income securities. Funds are invested with the intent that the income from investments, plus proceeds from maturities, will meet the ongoing cash flow needs of the Company. The approach of matching asset and liability durations and yields requires an appropriate mix of investments. The Company’s investments consist primarily of marketable debt securities that could be readily converted to cash for liquidity needs. Cash flow projections and cash flow tests under various market interest scenarios are also performed annually to assist in evaluating liquidity needs and adequacy. We currently anticipate that available liquidity sources and future cash flows will be adequate to meet our needs for funds.
Net cash provided by operating activities was $512,765 for the year ended December 31, 2013. The primary sources of cash from operating activities were from premium receipts, collection amounts due from reinsurers and net investment income. The primary uses of cash from operating activities were from payments of commissions to agents and settlement of policy liabilities. Net cash used in investing activities was $3,438,815. The primary source of cash was from sales of available for sale securities. Offsetting this source of cash was the Company’s purchases of investments in available for sale securities, the net change in policy loans and the purchase of property and equipment. Net cash provided by financing activities was $1,957,473. The primary source of cash was receipts on deposit type contracts. These were offset by repurchases of common stock and payments made by the Company on its surplus notes.