our ability to grow and develop our insurance business and successfully develop and market new products and new distribution channels;
our inability to maintain or grow our strategic partnerships or our inability to realize synergies from our relationship with Insurance Capital Group, our controlling shareholder;
financial market conditions, including, but not limited to, changes in interest rates and the level and trends of stock market prices causing a reduction of investment income or realized losses and reduction in the value of our investment portfolios;
increased competition in our business, 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, 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;
the potential impact on our reported net income that could result from the adoption of future accounting standards issued by the Public Company Accounting Oversight Board or the Financial Accounting Standards Board or other standard-setting bodies; and
We provide life insurance protection targeted to middle class America. Industry data indicates there is a substantial unmet need for life insurance, particularly among domestic households with annual incomes of between $40,000 and $125,000, a market we refer to as the Middle Market. We also offer fixed interest and fixed index annuities, and we intend to introduce variable rate annuity products in 2019.
We conduct our business primarily through our insurance company subsidiary, Federal Life. Federal Life sells its life insurance and annuity products through independent agents.
Our revenues consist of insurance premiums, spreads on annuity contracts, net investment income, and net realized gains/(losses) on investments. Our distributors consist of the independent insurance agencies that we contract with to sell our insurance products to the ultimate 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 company. 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 and dividends from equity securities that we purchase with cash flows from our premium revenues and royalties from oil and gas interests that we acquired in the 1930s and 1940s. These investments support our liability for policy reserves and provide the capital required to operate our insurance business. Regulatory authorities primarily establish capital requirements.
Expenses consist of benefits paid to policyholders or their beneficiaries under life insurance policies and distributions on annuity contracts. Benefit expenses also include additions to the reserve for future policyholder and annuity holder benefits to recognize our estimated future obligations under the policies and annuity contracts. Insurance benefit expenses are shown net of amounts ceded under our reinsurance contracts. We also incur policy acquisition costs that consist of commissions paid to agents, policy underwriting and issue costs, and variable sales costs. A portion of these policy acquisition costs are deferred and expensed over the life of the insurance policies acquired during the period. Our insurance operations also incur overhead costs for functional and administrative staff to support insurance operations, financial reporting, and information technology. We recognize income (loss) on operations to the extent that premium revenues, net investment income, and realized gains (losses) exceed (are less than) benefit expenses and general operating expenses for the period.
The low interest rate environment has resulted in our current reinvestment yields being lower than the overall portfolio yield, primarily for our investments in fixed maturity securities. Although the Federal Reserve has raised key short-term interest rates multiple times since the end of 2015, medium and long-term interest rates remain at low levels. If medium and long-term interest rates remain at their current level, our portfolio yields can be expected to continue to decline in future periods. With the additional capital provided by the IPO, we may rebalance our investment portfolio to seek higher yields on our securities investments. Higher yielding investments usually are associated with higher investment risks, which may result in us recognizing higher other than temporary impairments (“OTTIs”).
Assuming the investment rate is our average rate of 3.95%, as of December 31, 2018, for the period from January 1, 2019 through December 31, 2019, and credit spreads remain unchanged from levels as of December 31, 2018, we estimate that the unfavorable impact to net interest margins compared to the average interest rate of securities maturing and prepaying would be approximately $77,000 in 2019.
We use our historical experience to develop our assumptions as to the amount and timing of future policy lapses. If actual policy lapse rates exceed the lapse rates assumed in pricing our products, we will experience a faster write-off of our deferred acquisition costs and lower premium revenues. If a policy lapses within a few years after issuance, we may not receive enough premium to cover all of our acquisition costs for the policy.
Our critical accounting policies are described in Note 2 - Significant Accounting Policies to our audited consolidated financial statements included elsewhere in this Form 10-K. The preparation of our audited 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.
Results of Operations for the Two Years Ended December 31, 2018 and 2017
For the year ended December 31, 2018, we had a loss before taxes of $4.8 million compared to a loss before taxes of $1.9 million for the year ended December 31, 2017. This increase of $2.9 million in loss before taxes was primarily due to lower insurance revenues and reduced realized investment gains, and the increase in operating costs and expenses due to higher reorganization expenses.
For the year ended December 31, 2018, income tax expense was $20,000 compared to an income tax expense of $34,000 for the year ended December 31, 2017. The decrease in income tax expense was due to changes in taxable investment income within Americana and FED Mutual Financial Services, Inc.
For the year ended December 31, 2018, net investment income was $8.4 million compared to $8.5 million for the year ended December 31, 2017. This decrease of $0.1 million (1.1%) is mainly due to lower income from Americana and from real estate, and lower yields on invested assets due to lower interest rates, partially offset by lower investment expenses and higher income from cash and cash equivalents. The following table provides detail of the components of net investment income by asset type:
One key measure of our investment income is the book yield on our holdings of fixed maturity securities. Book yield is the effective interest rate, before investment expenses, that we earn on these investments. The following table provides our book yield for the years ended December 31, 2018 and 2017:
(1) Book yield is calculated as the percent of net investment income to the average amortized cost of the underlying fixed income investments for the period.
For the year ended December 31, 2018, policyholder benefits were $13.9 million compared with $13.7 million for the year ended December 31, 2017. This increase of $0.2 million (1.1%) resulted primarily from less deferred sales inducement capitalization.
(1) Average credited rate is calculated as the percent of interest credited to average reserves for the period.
Dividends to policyholders remained flat at $66,000 for the years ended December 31, 2018 and 2017.
Our investment strategy and guidelines are developed by management and approved by our board of directors. Our investment strategy 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 annuity deposits. To help maintain liquidity we establish the duration of invested assets within a tolerance to the policy liability duration. The investments 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. We also maintain a small equity portfolio consisting of investments in exchange-traded funds and an investment in a commercial real estate fund. With the additional capital provided by the IPO, we may rebalance our investment portfolio to seek higher yields on our securities investments. Higher yielding investments usually are associated with higher investment risks, which may result in us recognizing higher other than temporary impairment charges.
Asset quality guidelines applied on a portfolio basis and for individual issues that establish a minimum asset quality standard for portfolios and establish minimum asset quality standards for investment purchases and investment holding;
Diversification guidelines that limit the exposure of the total portfolio to investment sectors.
The following table shows the distribution of the fixed maturity securities by quality rating using the rating assigned by Standard & Poor’s, a nationally recognized statistical rating organization. Over the periods presented, we have maintained a consistent weighted average bond quality rating of “A.” Ratings assigned by Moody’s or other rating agencies have been used for securities not rated by Standard & Poor’s.
At December 31, 2018, we had total assets of $279.7 million compared to total assets of $257.1 million at December 31, 2017. The increase in total assets primarily results from the net proceeds from the issuance of common stock of $33.1 million. The increase in assets as a result of stock issuance is offset by lower fair values on fixed maturity securities of $4.0 million due to higher interest rates, and a decrease in separate account asset of $4.0 million due to benefit payments and lower underlying asset values caused by market declines.
At December 31, 2018, we had total liabilities of $226.8 million compared to $225.8 million at December 31, 2017. This increase of $1.0 million was primarily due to an increase of $6.5 million in policyholder account balances as a result of index annuity sales, offset by a decrease in separate account liabilities of $4.0 million.
Total equity increased from $31.4 million at December 31, 2017 to $52.9 million as of December 31, 2018. This increase in equity of $21.6 million (68.8%) was due to the issuance of common stock resulting in additional paid in capital of $33.1 million offset by a total comprehensive loss of $11.5 million comprised of a net loss of $4.8 million and other comprehensive loss of $6.7 million. The other comprehensive loss for the period was mostly due to the reversal of unrealized gains on our fixed maturity securities available for sale, caused by rising interest rates.
Our principal sources of funds are from premium revenues, investment income, and proceeds from the sale and maturity of investments. The Company’s primary uses of funds are for payment of life policy benefits, contractholder withdrawals on annuity contracts, new business acquisition costs for our insurance operations (commissions, underwriting, and issue costs), general operating expenses, and purchases of investments. Our investment portfolio is structured to provide funds periodically over time, through investment income and maturities, to provide for the payment of policy benefits and contractholder withdrawals.
Based on our current business plan, we expect that projected cash flows from operations, as well as the net proceeds from the IPO, will provide us with sufficient liquidity to fund our anticipated growth for at least the next several years. However, if our growth exceeds our expectations or we have unanticipated capital requirements to support our growth, we may have to raise additional capital or take other steps to support our premium writings, including obtaining additional reinsurance. If we cannot obtain adequate capital or reinsurance on favorable terms or at all, we may be unable to support future growth or operating requirements and, as a result, our business, financial condition, and results of operations could be adversely affected.
We are members of the Federal Home Loan Bank of Chicago (“FHLBC”). As a member we are able to borrow on a collateralized basis from the FHLBC. We own FHLBC common stock with a book value of $10,000, which allows us to borrow from the FHLBC. Interest on borrowed funds is charged at variable or fixed rates established from time to time by the FHLBC based on the interest rate option selected at the time of the borrowing. There were no borrowings from FHLBC during either 2018 or 2017.
Federal Life’s ability to pay dividends to the Company is limited by the insurance laws of the State of Illinois. All shareholder dividends are subject to notice filings with the Illinois Insurance Director. The maximum amount of dividends that can be paid by Illinois life insurance companies to shareholders without 30 days prior notice to the director of the Illinois Department of Insurance is the greater of (i) statutory net income for the preceding year or (ii) 10% of statutory surplus as of the preceding year-end.
Federal Life is a party to service and cost sharing agreements with Americana and FED Mutual Financial Services, Inc. pursuant to which certain costs and expenses incurred by Federal Life on behalf of Americana and FED Mutual Financial Services, Inc. are allocated to such entities and paid to Federal Life. During the year ended December 31, 2018, Americana paid $50,000 and FED Mutual Financial Services, Inc. paid $6,000 to Federal Life for such services. During the year ended December 31, 2017, Americana paid $50,000 and FED Mutual Financial Services, Inc. paid $6,000 to Federal Life for such services. All related party transactions eliminate in consolidation.
In addition to the minimum statutory requirement, Federal Life is subject to risk-based capital (“RBC”) requirements adopted by state insurance regulators. A company’s “authorized control level RBC” is a measure of the amount of capital appropriate for an insurance company to support its overall business operations in light of its size, growth, and risk profile. RBC standards are used by regulators to determine appropriate regulatory actions for insurers that show signs of weak or deteriorating conditions. Companies that do not maintain total adjusted capital (“TAC”) in excess of the company’s “company action level RBC,” which is two times its “authorized control level RBC,” may be required to take specific actions at the direction of state insurance regulators. Federal Life’s TAC at December 31, 2018 of $27.3 million significantly exceeded its “company action level RBC,” which was $5.9 million at December 31, 2018.
As a smaller reporting company, as defined by Rule 12b-2 of the Exchange Act and Item 10(f)(1) of Regulation S-K, the Company has elected to comply with certain scaled disclosure reporting obligations, and therefore is not required to provide the information required by Item 303(a)(5) of Regulation S-K.
See Note 2 to our audited consolidated financial statements in this Form 10-K beginning on page 33, which is incorporated by reference in this Item 7, for new accounting pronouncement disclosures.
The audited consolidated financial statements are included as part of this report on Form 10-K on pages 33 through 65.