MIDWEST HOLDING INC. – 10-Q – MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The following Management's Discussion and Analysis ("MD&A") is intended to assist the reader in understanding the financial condition of the Company as ofSeptember 30, 2021 , compared withDecember 31, 2020 , and the results of operations for the three and nine months endedSeptember 30, 2021 , compared with corresponding periods in 2020 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, 2020 ("2020 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," "hopes," "estimates," "projects," "intends," "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 2020 Form 10-K and below in Part III - Other Information - Item 1A Risk Factors. 39 Table of Contents 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 We are a technology-enabled, services-oriented annuity platform and financial services company formed onOctober 31, 2003 . We design and develops in-demand annuity products that are distributed through independent distribution channels, to a large and growing demographic ofU.S. retirees. We originate, manage and transfer these annuities through reinsurance arrangements to asset managers and other third-party investors, who are seeking financially attractive products. We also provide the operational and regulatory infrastructure and expertise to enable asset managers and third-party investors to form, capitalize and manage their own reinsurance capital vehicles. We operate our business primarily through three subsidiaries, American Life, 1505 Capital, and Seneca Re. American Life is licensed to sell, underwrite, and market life insurance and annuity products in 22 states and theDistrict of Columbia and has pending applications in additional states. We also provide insurance company administrative services through a division known as "m.pas" that was formed in 2019. 1505 Capital provides investment advisory and related asset management services. Seneca Re reinsures various types of the life insurance risks through one or more single purposes entities or "protected cells."
In 2018, we began implementation of a new business plan with the purpose of
leveraging technology and reinsurance to distribute insurance products through
independent marketing organizations ("IMOs").
American Life's sales force continues to grow, with eight third-party IMOs presently offering our products. American Life obtained an A.M. Best Rating of B++ inDecember 2018 that was affirmed in 2020.A.M. Best also upgraded American Life's long-term issuer credit rating to bbb+ from bbb inDecember 2020 . Beginning in mid-2019, American Life began ceding portions of its MYGA and FIA annuity business to third-party insurance companies and Seneca Re that we refer to as "quota shares." For detailed information see "Note 9 - Reinsurance" to our Consolidated Financial Statements included in this Form 10-Q. EffectiveMarch 12, 2020 , we formed Seneca Re for the purpose of reinsuring various types of risks through one or more single purpose entitles, or "protected cells." OnMarch 30, 2020 , Seneca Re received its certificate of authority to transact business as a captive insurance company. OnMay 12, 2020 , we contributed$300 to Seneca Re for a 100% ownership interest. Seneca Re has one incorporated cell,Seneca Incorporated Cell, LLC 2020-01 ("SRC1") as ofSeptember 30, 2021 . We contributed a total of$15.0 million throughDecember 31, 2020 to capitalize SRC1, which is consolidated in our financial statements. EffectiveApril 24, 2020 , we raised capital of$5.2 million from various third-party investors and issued 231,655 shares of voting common stock at$22.50 per share. Also, onApril 24, 2020 , we signed a securities purchase agreement withCrestline Assurance Holdings LLC ("Crestline") for additional capital of$10.0 million and issued 444,444 shares of our voting common stock to Crestline at$22.50 per share. OnAugust 10, 2020 , Midwest filed Articles of Amendment of Amended and Restated Articles of Incorporation ("Amendment") that changed the total number of shares it is authorized to issue to 22 million shares of common stock, of which 20 million were designated as voting common stock with a par value of$0.001 per share and two million shares were designated as non-voting common stock with a par value of$0.001 per share. The Amendment also provides for two million 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 ofAugust 27, 2020 . Fractional shares were not issued in connection with the reverse stock split but were paid in cash. The Company paid approximately$175 for those fractional shares and is now holding treasury stock represented by that amount. Outstanding shares as ofSeptember 30, 2021 andDecember 31, 2020 were 3,737,564. All prior periods disclosed in this report have been restated to reflect the reverse stock split per share amounts. OnDecember 21, 2020 , Midwest completed a$70 million public offering of one million shares of its voting common stock at a price of$70.00 per share. OnDecember 17, 2020 , the voting common stock was listed on theNasdaq Capital
Market under 40 Table of Contents
the ticker symbol "MDWT." The aggregate net proceeds from the offering were
approximately
commissions but before other offering expenses.
Midwest used the net proceeds of the offering to support the growth of its
insurance subsidiaries, American Life, with a capital contribution of
million
the proceeds were designated for general corporate purposes.
OnJune 26, 2021 , the NDOI issued its non-disapproval of the Modified Coinsurance Agreement ("Modco AEG Agreement") withAmerican Republic Insurance Company ("AEG"), anIowa domiciled reinsurance company. The agreement closed onJune 30, 2021 . Under the Modco AEG Agreement, American Life ceded toAEG , on a modified coinsurance ("Modco") basis, 20% quota share of certain liabilities with respect to its multi-year guaranteed annuity MYGA-5 business and an initial 20% quota share of certain liabilities with respect to its fixed indexed annuity FIA. American Life has established a Modco Deposit Account to hold the assets for the Modco AEG Agreement.
Also on
which was recorded as a reduction of Midwest's investment in SRC1.
COVID-19
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 earlyMarch 2020 and operated throughJuly 2020 with the majority of employees working remotely. The employees returned to the office onJuly 8, 2020 . Operations continued as normal despite a sharp increase in sales during the period. We continue to monitor theCenter for Disease Control and Prevention andState of Nebraska guidelines regarding employee safety. Market conditions in the third quarter of 2021 resulted in continued low interest rate spreads and positive equity markets. The overall economy continued to look positive, but concerns rose around employment participation, consumer confidence and the housing market beginning to show signs of slowing down. The spread of theCovid-19 Delta variant continued to impact certain areas of theU.S.
Our management will continue to monitor our investments and cash flows to
evaluate the impact as this pandemic evolves.
Industry Trends and Market Conditions
Interest Rate Environment
Overall, interest rates remain at low levels and are expected to remain there in the short term given the market support occurring through buying and seeking higher yields by investors. We seek to address our interest rate risk through managing the duration of the liabilities and purchasing and holding high quality, long-term assets that mirror that duration.
Competition
We are operating in a highly competitive market with various sizes of diversified financial institutions, established insurance and reinsurance companies. Our annuity market is being impacted by the growing aging population and the need to evaluate their retirement options. We believe our technology and customer service along with our ability to structure solutions position us to provide value to annuity consumers through various distribution channels.
Unrealized Losses; Embedded Derivatives
American Life 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 41 Table of Contents our Consolidated Financial Statements. Assets carried as investments on American Life's financial statements for the third-party reinsurers contained unrealized gains of approximately$2.0 million as ofSeptember 30, 2021 compared to unrealized gains of approximately$4.4 million as ofSeptember 30, 2020 . The terms of the contracts with the third-party reinsurers provide that unrealized gains on the portfolios accrue to the third-party reinsurers. We account for these unrealized gains by recording equivalent realized losses on our Consolidated Statements of Comprehensive Loss. Accordingly, the unrealized gains on the assets held by American Life on behalf of the third-party reinsurers were offset by recording an embedded derivative gain of$900 and$4.4 million , respectively. If prices of investments fluctuate, the unrealized losses of the third-party reinsurers may also fluctuate; therefore, the associated embedded derivative gain (loss) recognized by us forSeptember 30, 2021 andDecember 31, 2020 , would be reduced accordingly.
Consolidated Results of Operations - Three Months Ended
2020
Comprehensive Net Loss
In this section, unless otherwise noted the discussion compares the three months
ended
A net loss was incurred compared to net income primarily due to the following:
1. Total loss drivers: a)There are three components associated with our FIA products: 1) the fair market value of the derivative asset entered into in order to mitigate the fluctuation of the embedded liability on our policyholder contracts, 2) the change in the fair market value of the embedded liability, and 3) the option allowance related to our third-party reinsurers that are marked to market at the end of the period. The change in the market value of the option derivative assets decreased, resulting in a realized loss of$2.6 million compared to a gain of approximately$1.9 million . The interest credited was$300 and$400 , respectively. The embedded derivative liability decrease was included in the overall interest credited. The decrease in the embedded liability resulted in an decrease in our interest credited of approximately$41 . In 2020, interest credited was higher due to the increase in the embedded liability. The third component resulted in a loss resulting from the mark-to-market increase of the embedded liability of approximately$900 on our options allowance with the third-party reinsurers which is presented in other operating expenses compared to a mark-to-market decrease of approximately$100 . b)American Life has treaties with several third-party reinsurers that have FW andModco provisions. As a result of the changes in market prices, the assets held on behalf of the third-party reinsurers had unrealized gains of approximately$2.0 million and$4.4 million atSeptember 30, 2021 andSeptember 30, 2020 , respectively. The terms of the contracts with the third-party reinsurers provide that unrealized gains or losses on the asset portfolios accrue to the third-party reinsurers. We account for the change in these unrealized gains or losses by recording equivalent realized gains or losses on our Consolidated Statements of Comprehensive Loss. We recorded the decrease in the unrealized gains as a realized gain of$1.3 million compared to a realized loss of$4.1 million . c)Certain assets are recorded on a statutory basis at the lower of cost or market. We have unrealized gains on these assets of approximately$2.0 million which were passed through to the reinsurers through the settlement process as a realized loss on our consolidated financials outside the GAAP embedded derivative total return swap discussed above. We did not have any unrealized gains or losses in 2020 that were recorded at the lower of cost or market.
Expense drivers: Our most material expense is salaries and benefits which
2. increased
operating expenses benefits due to increasing our personnel and expenses to
service our new business growth. 42 Table of Contents Revenues The following summarizes the sources of our revenue for the periods indicated: Three months ended September 30, (In thousands) 2021 2020
Investment income, net of expenses $ 6,196 $ 434 Net realized gains (loss)on investments (See Note 4) (2,115) (1,951) Amortization of deferred gain on reinsurance 662 293 Service fee revenue, net of expenses 628
590 Other revenue 400 117 $ 5,771 $ (517) Premium revenue: The introduction of our MYGA and FIA products discussed below generated a large volume of new business; however, these products are defined as investment contracts andU.S. GAAP requires that premiums be deferred as deposit-type liabilities on our Consolidated Balance Sheets. American Life expects to introduce additional versions of these annuity products later in 2021. Investment Loss, net of expenses: The components of our net investment loss are as follows: Three months ended September 30, (In thousands) 2021 2020 Fixed maturities income $ 6,373 $ 322 Mortgage loans 938 81 Other invested assets 74 63 Gross investment income 7,385 466 Less investment expenses (1,189) (32)
Investment income, net of expenses $ 6,196 $
434
Investment income, net of expenses, was$6.2 million , compared to$400 . Investment income, net of expenses, consists of investment income generated from our retained investment assets that are not ceded to reinsurers. The increase in investment income was due to the investment income earned on the 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 with attractive yields and risk-return profiles. On a gross consolidated basis, our investment portfolio (excluding cash) was$942.8 million as ofSeptember 30, 2021 compared to$518.2 million as ofDecember 31, 2020 , as a result of proceeds from our MYGA and FIA product sales. Net realized losses on investments: Net realized losses on investments were losses of$2.1 million compared to$2.0 million , which included a gain of$1.3 million and a loss of$4.1 million from a total return swap embedded derivative in 2021 and 2020, respectively. In 2021, there were net realized losses of$2.6 million related to derivatives we own to hedge the obligations to FIA policyholders; such losses were partially offset by a decrease in the mark-to-market change in embedded derivative liability within interest credited expense and 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. The majority of our call options are based on the S&P 500 index which increased 1% in 2021, compared to an increase of 8% in 2020; the value of our FIA hedging options tends to increase in rising equity markets and decrease in declining markets, such as the stock market sell-off experienced towards the end of the third quarter of 2021. Also included in the realized losses is the lower of cost or market realized loss of$2.0 million . American Life has treaties with several reinsurers that have FW coinsurance provisions, under which the assets backing the treaties are maintained by American Life as collateral but the assets and total return on the asset portfolios belong to the reinsurers. Under GAAP this arrangement is considered an embedded derivative as discussed in Note 5 - Derivative Instruments to our Consolidated Financial Statements. The change in fair value of the total return swap is included in net realized gains or losses on investments. Assets carried as investments on American Life's financial statements for the third-party reinsurers contained unrealized gains of approximately$2.0 million and$4.1 million as ofSeptember 30, 2021 and 2020, respectively. The terms of the contracts with the third-party reinsurers provide that unrealized gains or
losses on the portfolios 43 Table of Contents
accrue to the third-party reinsurers. We recorded the unrealized gains accrued
to third-party reinsurers via a total return swap a realized gain of
million
Amortization of deferred gain on reinsurance: The flat performance or slight increase in 2021 was due to higher amortization of the deferred gain on reinsurance, driven in part by slightly higher reinsured premiums during the period. Service fee revenue, net of expenses: Service fee revenue, net of expenses, consists of fee revenue generated by our internal asset manager 1505 Capital for asset management services provided to third-party clients, some of whom are our reinsurers. The flat performance was due primarily to the flat performance in the level of asset management services provided by 1505 Capital to third-party clients. Other revenue: Other revenue consists of revenue generated by us for providing ancillary services such as third-party administration ("TPA") to clients. The increase in 2021 was due to the increased provision of ancillary services, including TPA, to clients.
Expenses
Our expenses for the periods indicated are summarized in the table below:
Three months ended September 30, (In thousands) 2021 2020 Interest credited $ 284 $ 380 Benefits - (3)
Amortization of deferred acquisition costs 753
235 Salaries and benefits 4,025 1,444 Other operating expenses 4,124 1,706 $ 9,186 $ 3,762 Interest credited: The decrease was primarily due to the FIA product and the decrease in the fair market value of the embedded derivative liability owned by us to FIA policyholders, offset by interest credited related to the MYGA product This decrease in this liability owed to FIA policyholders is partially hedged by our net realized loss on investments, as referenced above, which resulted in a$2.6 million decrease in the fair market value of derivative assets used to partially hedge this obligation to FIA policyholders. Interest credited related to our retained FIA policies was approximately negative$500 and approximately positive$100 , respectively. Management's estimated, amortized cost of servicing our retained FIA policies was approximately$2.4 million and$400 , respectively.
Benefits: Death benefits changed insignificantly.
Amortization of deferred acquisition costs: The increase was due to the deferred acquisition costs deferred on the sale of American Life's MYGA and FIA products where we retained approximately 49% of the business in 2021 compared to the 55% retained in 2020.
Salaries and benefits: The increase was due to the addition of personnel to
service our new business growth. We continue to hire more in-house expertise to
service our growth initiatives.
Other operating expenses: Other operating expenses were approximately
million
FIA products contain embedded derivative liabilities, which are market driven.
The reinsurers that reinsure our FIA products pay an option allowance to
American Life to purchase derivative assets used to hedge the FIA embedded
? derivative liabilities. The mark-to-market on those option allowances increased
during the period. As a result, American Life incurred
to the reinsurers. The derivative assets utilized to partially hedge this
mark-to-market option allowance resulted in a
net realized (loss) gains on investments, as referenced above. 44 Table of Contents
Other increases in other expenses related to legal fees of
initiatives; taxes, licenses and fees of approximately
?
to increased audit costs resulting from the auditing complexities involved in
implementing on our business plan.
Consolidated Results of Operations - Nine months ended
In this section, unless otherwise noted the discussion compares the nine months
ended
Net Loss
Net loss increased compared to net income primarily due to the following:
1. Total losses drivers:
a)As indicated above, there are three components associated with our FIA products: 1) the fair market value of the derivative asset entered into in order to mitigate the fluctuation of the embedded liability on our policyholder contracts, 2) the change in the fair market value of the embedded liability, and 3) the option allowance related to our third-party reinsurers that are marked to market at the end of the period. The change in the market value of the option derivative assets decreased resulting in a realized loss of$4.3 million compared to a gain of$2.0 million . The interest credited was$1.9 million compared to$500 . The embedded derivative liability increase was included in the overall interest credited. The third component resulted in a gain resulting from the mark-to-market decrease of the embedded liability of$1.9 million on our options allowance with the third-party reinsurers which is presented in other operating expenses compared to a mark-to-market decrease of approximately$200 . b)As discussed above, American Life has treaties with several third-party reinsurers that have FW andModco provisions. The assets held on behalf of the third-party reinsurers had unrealized gains of approximately$2.0 million atSeptember 30, 2021 and$4.4 million atSeptember 30, 2020 . The terms of the contracts with the third-party reinsurers provide that unrealized gains or losses on the asset portfolios accrue to the third-party reinsurers. We account for the change in unrealized gains or losses related to the third-party reinsurers by recording equivalent but opposite realized gains or losses on our Consolidated Statements of Comprehensive Loss. We recorded the decrease in the unrealized gains as a realized gain of$900 compared to a realized gain of$4.4 million . c)Certain assets are recorded on a statutory basis at the lower of cost or market. We have unrealized gains on these assets of approximately$2.0 million which were passed through to the reinsurers through the settlement process as a realized loss on our consolidated financials outside the GAAP embedded derivative total return swap discussed above. We did not have any unrealized gains or losses in 2020 that were recorded at the lower of cost or market.
Expense drivers: Increase of
2. increase of
due to increasing our personnel and expenses to implement our business growth plan. 45 Table of Contents Revenues: The following summarizes the sources of our revenue for the periods indicated: Nine months ended September 30, (In thousands) 2021 2020 Investment income, net of expenses $ 12,303 $ 1,277 Net realized (loss) gains on investments (See Note 4) (2,704) 7,829 Amortization of deferred gain on reinsurance 1,711 814 Service fee revenue, net of expenses
1,738 1,359 Other revenue 1,007 134 $ 14,055$ 11,413 Premium revenue: The introduction of our MYGA and FIA products discussed above generated a large volume of new business; however, these products are defined as investment contracts andU.S. GAAP requires that premiums be deferred as deposit-type liabilities on our Consolidated Balance Sheets. American Life expects to introduce additional versions of these annuity products in the later in 2021. Investment loss, net of expenses: The components of our net investment loss are as follows: Nine months ended September 30, (In thousands) 2021 2020 Fixed maturities $ 13,103$ 1,364 Mortgage loans 1,479 81 Other invested assets 225 63 Other interest income 266 - Gross investment income 15,073 1,508 Less: investment expenses (2,770) (231)
Investment income, net of expenses $ 12,303$ 1,277 Investment income, net of expenses, consists of investment income generated from our retained investment assets that are not ceded to reinsurers. The increase in investment income was due to the investment income earned on the 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 with attractive yields and risk-return profiles.
On a gross consolidated basis, our investment portfolio (excluding cash) was
American Life ceded
reinsurers.
Net realized (loss) gains on investments: Net realized losses on investments were$2.7 million compared to a gain of$7.8 million , which included a gain of$900 and$4.4 million , respectively, from a total return swap embedded derivative in 2021 and 2020, respectively. There were net realized losses in 2021 of$4.3 million related to equity derivatives we own to hedge the obligations to FIA policyholders; such losses were partially offset by a decrease in the mark-to-market change in embedded derivative liability within interest credited expense and decrease in FIA-related mark-to-market option allowance expense flowing through other operating expenses. The change in fair value of FIA hedging derivatives are driven by the performance of the indices upon which our call options are based. Also included in the realized losses for 2021 is the lower of cost or market realized loss of$2.0 million . The majority of our call options are based on the S&P 500 index which increased 16% in 2021, compared to an increase of 4% in 2020; the value of our FIA hedging options tends to increase in rising equity markets and decrease in declining markets, such as the stock market sell-off experienced towards the end of the third quarter of 2021. American Life has treaties with several reinsurers that have FW coinsurance provisions, under which the assets backing the treaties are maintained by American Life as collateral but the assets and total return on the asset portfolios belong to the reinsurers. Assets carried as investments on American Life's financial statements for the third-party reinsurers contained unrealized gains of approximately$2.0 million and unrealized losses of approximately$4.4 million as ofSeptember 30, 2021 46 Table of Contents and 2020, respectively. We recorded the unrealized loss accrued to third-party reinsurers via a total return swap sinceDecember 30, 2021 , as a realized gain of$900 compared to a realized loss of$4.4 million in 2020. Amortization of deferred gain on reinsurance: The increase was due to higher amortization of the deferred gain on reinsurance, driven in part by slightly higher reinsured premiums. Service fee revenue, net of expenses: Service fee revenue, net of expenses, consists of fee revenue generated by our internal asset manager 1505 Capital for asset management services provided to clients, some of whom are our reinsurers. The slight increase was due primarily to the slight increase in the level of asset management services provided by 1505 Capital to clients. Other revenue: Other revenue consists of revenue generated by us for providing ancillary services such as third-party administration ("TPA") to clients. The increase was due to the increased provision of ancillary services, including TPA, to clients.
Expenses are summarized in the table below.
Nine months ended September 30, (In thousands) 2021 2020 Interest credited $ 1,868 $ 464 Benefits - (6)
Amortization of deferred acquisition costs 1,780
376 Salaries and benefits 11,466 3,624 Other operating expenses 6,769 5,337 $ 21,883 $ 9,795 Interest credited: The increase was due primarily due interest credited relating to the MYGA product, offset by the decrease in the fair market value of the embedded derivative liability owned by us to FIA policyholder, partially hedged by our net realized loss on the investments, as referenced above, which saw a$4.3 million decrease in the fair market value of derivative assets used to partially hedge this obligation to the FIA policyholders. Interest credited related to our retained FIA policies was approximately positive$38 and$100 , respectively. Management's estimated, amortized cost of servicing our retained FIA policies was$4.3 million and$500 , respectively.
Benefits: Death benefits changed insignificantly.
Amortization of deferred acquisition costs: The increase was due to the deferred acquisition costs deferred on the sale of American Life's MYGA and FIA products where we retained approximately 47% of the business in 2021 compared to the 36% retained in 2020. Management expects the retained business to decrease during the last half of 2021 as we cede this business to new third-party reinsurers.
Salaries and benefits: The increase was due to the addition of personnel to
service our new business growth. We continue to hire more in-house expertise to
service our growth initiatives.
Other operating expenses: Other operating expenses were approximately
million
Decrease:
Due to the valuation completed in June of 2020 on an investment in an
? unaffiliated reinsurance company, an impairment of
full value of the preferred stock whereas no impairment was recorded in 2021.
FIA products contain embedded derivative liabilities, which are market driven.
The reinsurers that reinsure our FIA products pay an option allowance to
? American Life to purchase derivative assets used to hedge the FIA embedded
derivative liabilities. The mark-to-market on those option allowances decreased during the period. As 47 Table of Contents
a result, American Life incurred
reinsurers. The derivative assets utilized to partially hedge this
mark-to-market option allowance saw a
realized (loss) gains on investments, as referenced above.
Increases:
Increases in other expenses related to taxes, licenses and fees of
approximately
? examination fees; audit and actuarial expenses of
costs, legal fees of
assist implementing our business plan, and
support our growth of the business.
Investments
A majority of the 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 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. 1505 Capital had approximately$407 million of total third-party assets under management as ofSeptember 30, 2021 . The investment guidelines typically includeU.S. government bonds, corporate bonds, commercial mortgages, asset backed securities, municipal bonds, mutual funds and collateral loans. The duration of our investments is 5 to 10 years in line with that of our liabilities. We do allow non-U.S. dollar denominated investments where the foreign exchange risk is hedged back toU.S. dollars. The following table shows the carrying value of our investments by investment category and cash and cash equivalents, and the percentage of each to total invested assets as ofSeptember 30, 2021 andDecember 31, 2020 . Increases in fixed maturity securities primarily resulted from the sale of our new MYGA and FIA products during 2021. A majority of the investments as ofSeptember 30, 2021 andDecember 31, 2020 are held as collateral for our reinsurers. September 30, 2021 December 31, 2020 Carrying Percent Carrying Percent (In thousands) Value of Total Value of Total Fixed maturity securities: U.S. government obligations$ 1,981 0.2 %$ 6,164 0.9 % Mortgage-backed securities 55,245 5.4 14,757 2.2 Collateralized loan obligations 310,653 30.3 221,774 33.1 States and political subdivisions -- general obligations 117 - 118 - States and political subdivisions -- special revenue 6,230 0.6 6,202 0.9 Trust preferred 16,397 1.6 2,285 0.3 Corporate 266,158 26.0 125,863 18.9 Total fixed maturity securities 656,781 64.1 377,163 56.3 Mortgage loans on real estate, held for investment 168,184 16.4 94,990 14.2 Derivatives 17,262 1.7 11,361 1.7 Equity securities 38,910 3.8 - - Other invested assets 47,021 4.6 21,897 3.3 Investment escrow 1,307 0.1 3,174 0.5
Federal Home Loan Bank (FHLB) stock 500 -
- - Preferred stock 6,934 0.7 3,898 0.6 Notes receivable 5,885 0.6 5,666 0.8 Policy Loans 55 - 46 - Cash and cash equivalents 81,487 8.0 151,679 22.6 Total investments, including cash and cash equivalents$ 1,024,326 100.0 %$ 669,874 100.0 % 48 Table of Contents
The following table shows the distribution of the credit ratings of our
portfolio of fixed maturity securities by carrying value as of
2021
September 30, 2021 December 31, 2020 Carrying Carrying (In thousands) Value Percent Value Percent AAA and U.S. Government$ 2,892 0.4 %$ 3,071 0.8 % AA 573 0.1 5,818 1.5 A 144,482 22.0 49,445 13.1 BBB 386,980 58.9 247,636 65.7 Total investment grade 534,927 81.4 305,970 81.1 BB and other 121,854 18.6 71,193 18.9 Total$ 656,781 100.0 %$ 377,163 100.0 % Reflecting the quality of securities maintained by us, 81.4% and 81.1% of all fixed maturity securities were investment grade as ofSeptember 30, 2021 andDecember 31, 2020 , respectively.
We expect that 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, while 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 though are not required 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 amongst 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 accounting for deferred taxes on a different basis. For further discussion regarding SAP as well as
net loss of American Life 49 Table of Contents under SAP, see Note 14 to our Consolidated Financial Statements. American Life maintains sufficient capital and surplus to comply with regulatory requirements as ofSeptember 30, 2021 . 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 as regards 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 as regards policyholders, in addition to capital contributions from us. 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 as SAP:
• requires that we exclude certain assets, called non-admitted assets, from the
Consolidated Balance Sheets.
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 can be admitted on a statutory
Consolidated Balance Sheets.
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
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 unearned premiums and loss reserves are presented net of related
reinsurance rather than on a gross basis as reported under GAAP.
requires that we record reserves liabilities and expenses, while we record all
• transactions related to the annuity products under GAAP as a deposit-type
contract liability.
requires 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 as it is reported under GAAP. Our insurance
subsidiaries must file with the insurance regulatory authorities an "Annual
Statement" which reports, among other items, net loss and surplus as regards
policyholders, which is called stockholders' equity under GAAP. 50 Table of Contents
The following reconciles our GAAP net loss to our SAP net loss for the periods
indicated.
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