We currently lease approximately 10,131 square feet of office space at 2900 South 70th Street, Suite 400, Lincoln, Nebraska 68506. This lease was executed October 17, 2013 and expires on January 31, 2024.
The following discussion of our financial condition and results of operations should be read in conjunction with the financial statements and the notes to those statements included in this Annual Report on Form 10-K. However, these forward-looking statements involve many risks and uncertainties including those referred to herein. Our actual results could differ materially from those indicated in such forward-looking statements as a result of certain factors, such as those set forth herein under “Risk Factors”. We are under no duty to update any of the forward-looking statements after the date of this registration statement to conform these statements to actual results.
On August 10, 2020, Midwest filed Articles of Amendment of Amended and Restated Articles of Incorporation (“Amendment”) that changed the total number of shares that it is authorized to issue to 22,000,000 shares of common stock, of which 20,000,000 were designated as voting common stock with a par value of $0.001 per share and 2,000,000 shares were designated as non-voting common stock with a par value of $0.001 per share. The Amendment also provides for 2,000,000 shares of authorized preferred stock with a par value of $0.001 per share. The Amendment provided that upon effectiveness, each 500 shares of common stock either issued or outstanding would be converted into one share of voting common stock through a reverse stock split. The Amendment was effective as of August 27, 2020. Fractional shares were not issued in connection with the reverse stock split but were paid in cash. The Company paid approximately $175,000 for those fractional shares and is now holding treasury stock represented by that amount. Outstanding shares as of December 31, 2020 were 3,737,564 and as restated for December 31, 2019 were 2,042,670. All prior periods disclosed in this 10-Q have been restated to reflect the reverse stock split per share amounts.
On December 21, 2020, Midwest completed a public offering of 1,000,000 shares of its voting common stock offered by the Company at a price to the public of $70.00 per share. On December 17, 2020, Midwest voting common stock was listed on the Nasdaq Capital Market under the ticker symbol “MDWT.” The aggregate net proceeds to the Company were approximately $65.1 million, after deducting underwriting discounts and commissions.
Midwest used the net proceeds of the offering to support the growth of its insurance subsidiaries, American Life with a capital contribution of $50.0 million and Seneca Re with a capital contribution of $7.5 million.
We continue to closely monitor developments related to the COVID-19 pandemic to assess any potential adverse impact on our business. Due to the evolving and highly uncertain nature of this pandemic, it currently is not possible to provide a longer-term estimate of potential insurance or reinsurance exposure or the indirect effects the pandemic may have on our results of operations, financial condition or liquidity. Management implemented the Company’s business continuity plan in early March 2020 and operated through July 2020 with the majority of employees working remotely. Operations continued as normal despite a sharp increase in sales during the period. We continue to monitor the Center for Disease Control and Prevention and State of Nebraska guidelines regarding employee safety.
Our management will continue to monitor our investments and cash flows to evaluate the impact as this pandemic evolves.
Our accounting and reporting policies are in accordance with generally accepted accounting principles in the United States of America (“GAAP”). Preparation of our consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. The following is a summary of our significant accounting policies and estimates. These accounting policies inherently require significant judgment and assumptions, and actual operating results could differ significantly from management’s estimates determined using these policies. We believe the following accounting policies, judgments and estimates are the most critical to the understanding of our results of operations and financial position. For further discussion of our accounting policies and estimates see “Note 1 - Nature of Operations and Summary of Significant Accounting Policies” to our Consolidated Financial Statements.
American Life has a long-term investment policy aimed at protecting capital and earning attractive risk adjusted returns while maintaining compliance with Nebraska’s insurance investment laws. Our investments are managed by our senior management team, who have many years of asset management experience, along with the advice of 1505 Capital, which was established in 2018 to provide financial and investment advisory and management services to clients and related investment, trading and financial activities, including American Life.
We expect to reinsure most of the risks associated with our issued annuities. Our reinsurers may be domestic, foreign or capital markets investors seeking to assume U.S. insurance business. In most reinsurance transactions, American Life will remain exposed to the credit risk of reinsurers, or the risk that one or more reinsurers may become insolvent or otherwise unable or unwilling to pay for policyholder claims. We seek to mitigate the credit risk relating to reinsurers by generally either requiring that the reinsurer post substantial collateral or make other financial commitments as a security for the reinsured risks. Under these reinsurance agreements, there typically is a monthly or quarterly settlement of premiums, claims, surrenders, collateral, and other administration fees.
Amounts received as payment for annuities are recognized as deposits to policyholder account balances and included in future insurance policy benefits. Annuity premiums are shown as a financing activity in the consolidated statement of cash flows. Revenues from these contracts are comprised of fees earned for administrative and policyholder services, which are recognized over the period of the annuity contracts and included in other revenue. Through our reinsurance contracts, revenues are earned through ceding commissions, which are capitalized, and our independent consulting actuary determines the amounts to be recognized as income over the period of the annuity contracts. Deferred coinsurance ceding commissions are shown as an operating activity in the consolidated statement of cash flows. Revenues from asset management services are recognized as earned.
Derivatives are used to hedge the risks experienced in our ongoing operations, such as equity, interest rate and cash flow risks, or for other risk management purposes, which primarily involve managing liability risks associated with our FIA product and reinsurance agreements. Derivatives are financial instruments whose values are derived from interest rates, foreign exchange rates, financial indices, or other underlying notional amounts. Derivative assets and liabilities are carried at fair value on the consolidated balance sheets.
To qualify for hedge accounting, at the inception of the hedging relationship, we formally document our designation of the hedge as a cash flow or fair value hedge and our risk management objective and strategy for undertaking the hedging transaction identifying how the hedging instrument is expected to hedge the designated risks related to the hedged item, the method to retrospectively and prospectively assess the hedging instrument’s effectiveness and the method to be used to measure ineffectiveness. A derivative designated as a hedging instrument must be assessed as being highly effective in offsetting the designated risk of the hedged item. Hedge effectiveness is also assessed periodically throughout the life of the designated hedging relationship.
Additionally, reinsurance agreements written on a funds withheld basis contain embedded derivatives on our FIA product. Gains or (losses) associated with the performance of assets maintained in the relevant deposit and funds withheld accounts are reflected as realized gains or (losses) in the income statement.
4. Net investment income increased to $4.0 million due to the growth of our investment portfolio and the increased retention of our business.
5. Service fee revenue, net of expenses increased by approximately $1.7 million due to Midwest purchasing the remaining 49% interest in June of 2020. This increase is also due to the increased size of the investment portfolio that they are managing for third-parties.
Investment income, net of expenses: The components of net investment income for 2020 and 2019 were as follows:
Net realized gains on investments: The net realized gains on investments for the year ended December 31, 2020 was $2,550,396 and included a loss of $2,910,608 from an embedded derivative and $3,466,272 of net realized gains related to derivatives utilized to hedge the obligations to FIA policyholders; the net realized gains related to derivatives utilized to hedge the obligations to FIA policyholders is offset by expenses, including interest credited expenses and other operating expenses The increase in net realized gains on investments was primarily due to favorable trading activity.
Interest credited: The increase was due to the increase in the retention on the sales of the new MYGA and FIA products during the year of 2020 compared to the 5% retention on the FIA product only in 2019 that was classified as deposit-type funds. The increase is also due to the consolidation of the SRC1 entity which includes the interest credited for the deposit-type contracts held on its books.
● Midwest had non-recurring expenses related to the Xenith note that was converted to common stock in 2019 of $1.0 million.
Most investments on our balance sheets are held on behalf of our reinsurers as collateral under our reinsurance agreements. As a result, our investment allocations are largely a function of our collective reinsurer investment allocations. While the reinsurers own the investment risk on these assets, we typically restrict their investment allocations via control over the selection of the asset manager as well as asset restrictions set forth in investment guidelines. Additionally, in many of our reinsurance agreements, our affiliate investment manager, 1505 Capital, is selected as the asset manager.
We expect that our MYGA and FIA products sales will cause an increase in investable assets in future periods.
Interest rate risk arises from the price sensitivity of investments to changes in interest rates. Interest and dividend income represent the greatest portion of an investment’s return for most fixed maturity securities in stable interest rate environments. The changes in the fair value of such investments are inversely related to changes in market interest rates. As interest rates fall, the interest and dividend streams of existing fixed-rate investments become more valuable and fair values rise. As interest rates rise, the opposite effect occurs. Our liabilities also have interest rate risk though GAAP does not require our liabilities to be marked to market. We mitigate interest rate risk by monitoring and matching the duration of assets compared to the duration of liabilities.
We are exposed to credit risk through counterparties and within the investment portfolio. Credit risk relates to the uncertainty associated with an obligor’s ability to make timely payments of principal and interest in accordance with the contractual terms of an instrument or contract. We manage our credit risk through diversification of investments amongst many corporations and numerous industries. Additionally, our investment policy limits the size of holding in any particular issuer.
Consolidated Financial Statements. American Life maintains sufficient capital and surplus to comply with regulatory requirements as of December 31, 2020.
• 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 all investments at fair value.
• allows bonds to be carried at amortized cost or fair value based on the rating received from the Securities Valuation Office of the NAIC, while they are recorded at fair value for GAAP.
• monitor and evaluate the performance of our business operations and financial performance;
• facilitate internal comparisons of the historical operating performance of our business operations;
• plan for and prepare future annual operating budgets and determine appropriate levels of operating investments.
Non-GAAP financial measures used by us may be calculated differently from, and therefore may not be comparable to, similarly titled measures used by other companies. These non-GAAP financial measures should be considered along with, but not as alternatives to, our operating performance measures as prescribed by GAAP.
Our adjusted revenue represents the revenue we receive and retain taking into account the reinsurance transactions we complete. We define adjusted revenue as revenue including the impact of reinsurance transactions completed during the relevant period and excluding the total return on the asset portfolios that are owned by reinsurers but held by us, which in the table below is the net realized (gains) losses on investments. We hold these assets primarily to reduce potential credit risk of the reinsurers. Under our agreements with reinsurers, the assets backing the reinsurance agreements are typically maintained by us as collateral but the assets and the total return on the asset portfolios are received by the reinsurers. We receive ceding commissions from reinsurers based on ceded premium in a given period, the products reinsured and the terms of the reinsurance agreements. The revenue we receive from ceding commissions is recognized and earned immediately under SAP upon the completion of a reinsurance transaction in which we have ceded premiums to reinsurers. There is no collectability risk as the commissions are paid to us in full in cash when the policies are written and there are no further expenses associated with the collected premiums. The adjustment for deferred coinsurance ceding commission is a line item entry derived directly from our GAAP consolidated statements of cash flows in our Consolidated Financial Statements. Our management uses adjusted revenue as an internal measure of our underlying business performance and it provides useful insights into our results of operations.
The following table sets forth a reconciliation of net loss to adjusted net income (loss) for the years ended December 31, 2020 and 2019, respectively:
The NAIC has established minimum capital requirements in the form of RBC that factors the type of business written by an insurance company, the quality of its assets and various other aspects of its business to develop a minimum level of capital known as “authorized control level risk-based capital” and compares this level to adjusted statutory capital that includes capital and surplus as reported under SAP, plus certain investment reserves. Should the ratio of adjusted statutory capital to control level RBC fall below 200%, a series of remedial actions by the affected company would be required. As of December 31, 2020, and 2019, the RBC ratio of American Life was 1,092,205% and 840%, respectively.
American Life had a legacy block of business that was ceded off to a third-party reinsurer on July 1, 2018 through an indemnity reinsurance agreement that transferred 90% to assumptive reinsurer, resulting in American Life transferring all the risk and financial obligations of those policyholders to the third-party reinsurer.
Cash flow is an important component of our business model because we receive annuity premiums and invest them upon receipt for our reinsurers and us and for the benefit of our policyholders.
Net cash used for operating activities was $16,243,887 for the year ended December 31, 2020, which was comprised primarily of an increase in deferred coinsurance ceding commission due to a third-party reinsurance transaction of $10,620,562, an increase in policy liabilities of $10,042,046 primarily due to the increase in deposit type contracts ceded to reinsurers, an increase in our other assets and liabilities due to a payable for securities of $1,525,320. These were offset by capitalized deferred acquisition costs of $13,974,666, accrued investment income of $5,295,636, and the amounts recoverable from reinsurers of $4,477,126.
We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.