10-K 1 f10k2014_gwgholdings.htm ANNUAL REPORT

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

 

 

FORM 10-K

 

☒ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2014

 

or

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES ACT OF 1934

 

For the transition period from _________ to ________

 

Commission File Number:  None

 

 

 

GWG HOLDINGS, INC.

(Exact name of registrant as specified in its charter)

 

Delaware   26-2222607

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

 

220 South Sixth Street, Suite 1200

Minneapolis, MN  55402

(Address of principal executive offices, including zip code)

 

(612) 746-1944

(Registrant’s telephone number, including area code)

 

 

  

Securities registered pursuant to Section 12(b) of the Act:

Common Stock

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☐   No ☒

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes ☐   No ☒

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒   No ☐

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒   No ☐

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K ☐

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. 

 

  Large accelerated filer Accelerated filer
  Non-accelerated filer Smaller reporting company

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ☐ Yes   ☒ No 

 

As of March 13, 2015, GWG Holdings, Inc. had 5,870,193 shares of common stock outstanding.

 

 

 

 
 

 

GWG HOLDINGS, INC.

 

Index to Form 10-K

for the Fiscal Year Ended December 31, 2014

 

PART I 3
   
ITEM 1. Business. 3
ITEM 1A. Risk factors. 20
ITEM 1B. Unresolved staff comments. 28
ITEM 2. Properties. 29
ITEM 3. Legal proceedings. 29
ITEM 4. Mine safety disclosures. 29
     
PART II 30
   
ITEM 5. Market for the registrant’s common equity, related shareholder matters and issuer purchases of equity securities. 30
ITEM 6. Selected Financial Data. 30
ITEM 7. Management’s discussion and analysis of financial condition and results of operations. 31
ITEM 7A. Quantitative and qualitative disclosures about market risk. 43
ITEM 8. Consolidated financial statements and supplementary data 44
ITEM 9. Changes in and disagreements with accountants on accounting and financial disclosure. 68
ITEM 9A. Controls and procedures. 68
ITEM 9B. Other information. 68
     
PART III 69
   
ITEM 10. Directors, executive officers and corporate governance. 69
ITEM 11. Executive compensation and related-party transaction disclosures. 74
ITEM 12. Security ownership of certain beneficial owners and management and related shareholder matters. 76
ITEM 13. Certain relationships and related transactions, and director independence. 78
ITEM 14. Principal accounting fees and services. 78
     
PART IV 79
   
ITEM 15. Exhibits, financial statement schedules. 79
     
SIGNATURES 81

 

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PART I

 

ITEM 1.        BUSINESS.

 

Overview

 

GWG Holdings, Inc. is a specialty finance company and a leader in the life settlement market. A life settlement is the sale of an existing life insurance policy to a third party for more than its cash surrender value, but less than the face value of the policy benefit. There are a number of reasons that a policy owner may choose to sell his or her life insurance policy. Among others, the policy owner may no longer need or want his or her policy, he or she may wish to purchase a different kind of life insurance policy, or the premium payments may no longer be affordable.  We target our life settlement offerings toward consumers, 65 years and older, owning life insurance who can benefit from realizing the actuarial value of their life insurance policy. We believe the value proposition of our services to the consumers we serve is very high, as we have found that we typically offer a multiple of the cash surrender value offered by the insurance carrier issuing the policy. Consumers, 65 years and older, represent the fastest growing demographic segment in the United States according to the U.S. Census Bureau. These consumers, and their families, are faced with a variety of challenges as they seek to address their post-retirement financial needs. We believe that for older consumers owning life insurance, our life settlement services provide a unique and valuable financial solution for their post-retirement financial needs.

 

To address this growing need, we recently have expanded our services by offering consumers a range of options to access the actuarial value of their life insurance, including (i) purchasing all of their life insurance policy for cash, (ii) purchasing a portion of their life insurance policy for cash and allowing them to retain a portion of their policy benefit with no future premium obligation, (iii) allowing for the conversion of their life insurance policy towards payments for long term care, and (iv) allowing the consumer to gift a portion of their life insurance to family or a charity with no future premium obligation. All of our services involve our purchase or financing of life insurance assets from consumers in the secondary market at a discount to the face value of the policy benefit we obtain. In cases where we purchase a life insurance policy, we continue paying the policy premiums until maturity, in order to collect the policy benefit upon the insured’s mortality. In this way, we hope to profit from the difference between our cost of obtaining and financing a life insurance asset, and the face value of the policy benefit we receive upon the mortality of the insured.

 

In addition to our goal of providing consumers with value-added services based upon the actuarial value of their life insurance policies, we seek to build a profitable and large portfolio of life insurance assets that are well diversified in terms of insurance carriers, mortality profiles and the medical conditions of insureds. We believe that successfully diversifying our assets will lower our overall risk exposure and provide our portfolio of life insurance assets with greater actuarial stability and more reliable returns. To obtain the growth and diversification we seek, we have raised capital through a variety of financing efforts that have included the public offering of our common stock, private and public offerings of structured debt securities, private offerings of preferred stock, and a senior secured revolving credit facility.

 

Our business was organized in February 2006. As a parent holding company, GWG Holdings was incorporated on March 19, 2008, as a limited liability company. On June 1, 2011, GWG Holdings converted from a Delaware limited liability company to a Delaware corporation through the filing of statutory articles of conversion. In connection with the conversion, each class of limited liability company membership interests in GWG Holdings, LLC was converted into shares of common stock of GWG Holdings, Inc.

 

Since our formation in 2006, we have evaluated over 37,000 policies and acquired over $1.7 billion in face value of life insurance policy benefits in the secondary market. In 2008, after selling approximately $1 billion in face value of life insurance policy benefits, we adopted our current buy-and-hold strategy of investing in portfolio life insurance assets and offering investors the opportunity to finance our ownership of the portfolio. As of December 31, 2014, we owned approximately $779 million in face value of life insurance policy benefits with an aggregate cost basis (i.e., acquisition and related premiums and financing costs) of approximately $276 million.

 

On September 24, 2014, we consummated an initial public offering of our common stock resulting in the sale of 800,000 shares of common stock at $12.50 per share. In connection with this offering, we started listing our common stock on The NASDAQ Capital Market under the ticker symbol “GWGH” effective September 25, 2014.

 

GWG Holdings, Inc. (GWG Holdings) facilitates the purchase of life insurance policies through its wholly owned subsidiary, GWG Life, LLC (GWG Life), and GWG Life’s subsidiaries, GWG Trust (Trust), GWG DLP Funding II, LLC (DLP II) and DLP II’s wholly owned subsidiary, GWG DLP Master Trust II (the Trust II). All of these entities are legally organized in Delaware. Unless the context otherwise requires or we specifically so indicate, all references in this report to "we", "us", "our", "our Company", "GWG", or the "Company" refer to these entities collectively. We are based in Minneapolis, Minnesota.

 

Market

 

The market for the consumers we serve is large.  According to the American Council of Life Insurers Fact Book 2014 (ACLI), individuals owned over $11.4 trillion in face value of life insurance policies in the United States in 2013. This figure includes all types of policies, including term and permanent insurance known as whole life, universal life, variable life, and variable universal life. The ACLI reports that the lapse and surrender rate of individual life insurance policies for 2013 was 5.7%, amounting to over $639 billion in face value of policy benefits surrendered in 2013 alone. These figures do not include group-owned life insurance, such as employer-provided life insurance, the market for which totaled over $8.2 trillion of face value of life insurance policies in the United States in 2013, which insurance policies exhibit similar lapse and surrender rates, according to the ACLI. Consumers owning life insurance generally allow policies to lapse or surrender the policies for a variety of reasons, including: (i) the life insurance is no longer needed; (ii) unrealistic original earnings assumptions made when the policy was purchased; (iii) increasing premium payment obligations as the insured ages; (iv) changes in financial status or outlook which cause the insured to no longer require life insurance; (v) other financial needs that make the insurance unaffordable; or (vi) a desire to maximize the policy’s investment value.

 

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The secondary market for life insurance has developed in response to the large volume of policy lapses and surrenders. Rather than allowing a policy to lapse as worthless, or surrendering a life insurance policy at a fraction of its inherent value, the secondary market can be a source of significant value to consumers. The inherent actuarial value of a policy in the life insurance secondary market often exceeds the cash surrender value offered by the insurance carrier. Without the development of the secondary market, insurance carriers would maintain monopsony power over the options offered to consumers who no longer want, need or can afford their life insurance.

 

Although still relatively new and still emerging, the secondary market for life insurance policies, as reported by Conning Research & Consulting (Conning), grew from $2 billion in face value of benefits purchased in 2002, to over $12 billion in face value of benefits purchased in 2008. During and after the 2009 credit crisis, the secondary market for life insurance contracted significantly, evidenced by Conning’s report that investors purchased approximately $2 billion in face value of life insurance benefits in 2012. Nevertheless, Conning reports that consumer demand for continued development of the secondary market remains strong, and there are indications of strengthening interest among investors. Conning maintains that, given the current economic condition and investor sentiment, the secondary market will likely grow, and the market’s largest growth will likely come from companies that attract capital to purchase the assets. We believe that socio-economic and demographic trends further support the long-term development and growth of the secondary market for life insurance, and that the secondary market for life insurance represents a significant and expanding market opportunity. In support of this belief, Conning reports that the net market potential for policies sold in the secondary market exceeded $109 billion in 2012, and is expected to grow to $151 billion by 2019.

 

Our Business Model

 

We believe that we are uniquely positioned to capitalize on this opportunity by providing value-added services to the consumers we serve and new investment opportunities for investors, where both participants can profit. To participate and compete in our growing market, we have spent and intend to continue to spend significant resources: (i) developing a robust operational platform and systems for originating and purchasing life insurance policies; (ii) obtaining requisite licensure to participate in the life insurance secondary market; (iii) developing financing resources, strategies, and capabilities for servicing a large portfolio of life insurance policies; (iv) recruiting and developing a professional management team; and (v) establishing strategic relationships for delivering our services.

 

We generally transact directly with the policy owner who originally purchased the life insurance in the primary market. Historically, we have purchased policies in the secondary market through a network of life insurance agents, life insurance brokers, and licensed providers who assist policy owners in accessing the secondary market. We expect to expand our origination practice by marketing directly to consumers through various marketing initiatives.

 

Before acquiring a life insurance asset, we value the related life insurance policy by conducting an underwriting review. Our present underwriting review process generally involves obtaining two life expectancy estimates on each insured from third-party medical-actuarial firms, and then averaging these two estimates. On occasion, we may obtain more than two life expectancy estimates, in which case we average the two life expectancy estimates that we believe are the most reliable, based on our own analyses and conclusions. In this regard, the two life expectancy estimates we ultimately choose to average may not always be the most conservative estimates we obtain. From time to time and as permitted by applicable borrowing covenants, we may modify our underwriting review process. For example, we recently changed our definition of a “small face policy” as a policy having a face value equal to or less than $1,000,000 in policy benefits. Prior to this change, a small face policy was one having a face value equal to or less than $250,000. For small face policies, rather than obtaining life expectancy estimates from third-party medical-actuarial firms, we may employ a modified underwriting review process involving the use of a combination of standard mortality tables, actuarial or medical consultants, and our own analysis to develop a life expectancy estimate for an insured. We seek to purchase life insurance policies issued by rated life insurance companies with investment grade credit ratings by Standard & Poor’s (AAA through BBB-), Moody’s (Aaa through Baa3), or A.M. Best Company (aaa through bbb). As of December 31, 2014, approximately 99.1% of life insurance policies in our portfolio were issued by companies rated “BBB-” or better under Standard & Poor’s rating system. Many of our current underwriting review processes, including our policy of obtaining two life expectancy estimates from medical actuarial firms as described above, are undertaken in satisfaction of obligations under our revolving credit facility. In the future we may modify our underwriting review process if permitted under our borrowing arrangements.

 

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All of our services are premised on financial and actuarial modeling that assigns a present value to the face value of an insurance policy benefit. In this regard, the value we assign to a life insurance asset in the secondary market is primarily a function of: (i) the face value of the life insurance policy or portion thereof we may wish to acquire; (ii) the estimated life expectancy of the individual insured under the policy; (iii) the premiums expected to be paid over the life of the insured; (iv) market competition from other purchasers in the secondary market; and (v) the particular underwriting characteristics of the policy, relative to the characteristics of our portfolio of life insurance assets as a whole.

 

The types of policies we typically, but not always, acquire are universal life insurance policies. Universal life insurance is a type of permanent life insurance in which premium payments above the cost of insurance are credited to the “cash value” of the policy. The cash value is credited each month with interest based on the terms of the insurance policy agreement. If a universal life insurance policy were to lapse, the insured or other owner of the policy would nonetheless have a right to receive the “cash surrender value” of the policy. The cash surrender value is the cash value of the policy, less any surrender charges imposed by the insurance company for a cash value distribution. Our services provide greatest value to a consumer when the actuarial value of the life insurance policy benefit exceeds the cash surrender value of the policy—which is often the case. We also provide services to consumers who own term life insurance. Unlike permanent universal life insurance, term life insurance does not have a cash value associated with it. Nevertheless, most term insurance policies permit the policy to be converted into permanent universal life insurance. In the future, we may consider offering services in conjunction with variable universal life insurance, which differs from universal insurance in that the “variable” component of the policy involves the ownership of securities inside the policy.

 

Portfolio Summary

 

Our portfolio of life insurance policies, owned by our subsidiaries as of December 31, 2014, is summarized below:

 

Total portfolio face value of policy benefits  $779,099,000 
Average face value per policy  $2,677,000 
Average face value per insured life  $2,940,000 
Average age of insured (yrs.)   82.8 
Average life expectancy estimate (yrs.)   6.5 
Total number of policies   291 
Number of unique lives   265 
Gender67% Males; 33% Females 
Number of smokers   3 
Largest policy as % of total portfolio   1.28%
Average policy as % of total portfolio   0.34%
Average annual premium as % of face value   3.37%

  

Competitive Strengths

 

●           Industry Experience: We have actively participated in the development of the secondary market of life insurance as a principal purchaser and financier within the asset class since 2006. Our position within the marketplace has allowed us to gain a deep understanding of the life insurance secondary market. We have participated in the leadership of various industry associations and forums, including the Life Insurance Settlement Association (LISA) and the Insurance Studies Institute (ISI). Our experience gives us confidence in building a company to compete in the industry and acquire a portfolio of life insurance policies that will perform to our expectations.

 

●           Operational Platform: We have built and continue to refine and develop both an operational platform and systems for efficiently tracking, processing, and servicing life insurance policies that we believe provide competitive advantages when participating in the life insurance secondary marketplace.

 

●           Origination and Underwriting Practices: We seek to use underwriting review processes and file documentation standards that generally meet published guidelines for rated securitizations of life insurance portfolios. We purchase life insurance policies we consider to be non-contestable and that meet our underwriting criteria and reviews. We consider a life insurance policy to be “non-contestable” once applicable state law prohibits the insurer from challenging the validity of the policy due to fraud. In this regard, state non-contestability laws generally require a period of one to two years to elapse after the initial issuance of the policy before that policy is considered non-contestable. Non-contestability laws do not, however, prevent an insurer from challenging the validity of a policy procured by fraud for lack of an insurable interest at the time at which the policy was purchased, such as is the case with so-called “stranger-originated” life insurance policies. To the extent we use modified methodologies for estimating life expectancies for small face policies, those modified methodologies may not meet published guidelines for rated securitizations of life insurance portfolios.

 

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●           Origination Relationships and Strategies: We have established origination relationships with life insurance policy brokers and insurance agents who submit policies for our purchase or financing. Our referral base knows our underwriting standards for purchasing life insurance policies in the secondary market, which provides confidence in our bidding and closing processes and streamlines our own due-diligence process. We expect to expand our origination methodology and channels with the proceeds of this offering (e.g., the addition of direct-to-consumer marketing).

 

●           Life Expectancy Methodology: We generally rely on two life expectancy estimates obtained from independent third-party medical-actuarial underwriting firms to arrive at a life expectancy estimate we use for valuing a life insurance asset. For a majority of our life insurance asset purchases, we rely on estimates obtained from 21st Services and AVS Underwriting to develop our life expectancy estimate. We may, however, also obtain and use life expectancy estimates from other medical-actuarial underwriting firms. As explained above, we may from time to time modify our underwriting review processes, including our methodology for arriving at life expectancy estimates we use in ascribing value to a life insurance asset.

 

●           Pricing Software and Methodology: To calculate our expected returns on the investments we make in life insurance assets, we use actuarial pricing methodologies and software tools built by a leading independent actuarial service firm and currently supported by Modeling Actuarial Pricing Systems, Inc. (“MAPS”).

 

●           Financing Strategy: We have actively developed a diversified financing strategy for accessing capital markets in support of our buy-and-hold strategy for our portfolio of life insurance policies, ranging from institutional bank financing to a network of broker-dealers registered with the Financial Industry Regulatory Authority (“FINRA”), many of whom have participated in one or more of our Series I Secured note financing, our Series A Preferred Stock financing, or our earlier L Bond financing (such L Bonds originally issued under the name “Renewable Secured Debentures” and renamed “L Bonds”). If in the future we decide to offer different kinds of investment products, we expect to leverage the network of broker-dealers that we have built over time.

 

Our business also involves certain challenges and risks described in the “Risk Factors” section of this form.

 

Acquiring Life Insurance Assets

 

We seek to offer our services nationwide. In general, we work directly with consumers in states where we hold proper licensure, and in states where we are not licensed we work through other licensed providers. Historically, sourcing policy assets typically begins with life insurance agents and financial advisors (“agents”) that identify consumers owning life insurance who could benefit from the extraction of value from their life insurance in the secondary market. The agents typically work with professional life insurance policy brokers specializing in packaging the policies for presentation to participants in the secondary market. Their packaging includes obtaining medical records on the insured, life expectancy estimates from medical-actuarial firms, current insurance policy illustrations, and other information needed to properly evaluate the policy. The only parties able to evaluate the policies are regulated licensed “providers.” Once the providers have evaluated the policy, offers are made to the owner through a competitive auction process whereby brokers facilitate competing offers from providers, concurrently negotiating fees.

 

We maintain membership affiliations and representation within key industry groups, such as the Life Insurance Settlement Association. Our Executive Chairman, Paul Siegert, currently serves on the board of the Life Insurance Settlement Association. We typically sponsor events and/or maintain a trade booth at events where we are able to maintain contacts with existing life settlement brokers and meet new brokers who submit policies for purchase.

 

We are developing new channels for acquiring life insurance assets by soliciting consumers directly, which may eliminate fees we pay brokers and competition we experience when a policy is auctioned through a broker. While these new channels are as yet unproven, we believe that consumer awareness of the life insurance secondary market is relatively low while the consumer value proposition is very high. As a result, these new channels may provide a significant growth opportunity for our business.

 

Life Insurance Policy Underwriting and Investment Process

 

The process used to value and underwrite life insurance policies is relatively new and continues to be refined. We underwrite and service all the life insurance policies that we purchase. When we identify a life insurance policy that meets our criteria, we seek to invest in the policy at a discount sufficient to provide us with an expected internal rate of return that meets our internal guidelines. Once our offer to invest in a policy is accepted, we enter into a purchase agreement with the seller. This agreement gives us the right to, among other things, pay premiums, collect policy benefits, file collateral assignments, change the ownership, and obtain medical records. The general terms and conditions of the agreement are standardized and regulated by most states.

 

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We maintain an underwriting department with experience in underwriting life insurance policies for investment. The underwriting due diligence process consists of a careful review and analysis of available materials related to a life insurance policy and the covered individual. The goal of the underwriting process is to make an informed investment decision with respect to the life insurance policy. While we believe that our underwriting policies and practices are consistent with industry best practices, it is possible that the processes may change or may not accurately reflect actual mortality experience or catch fraud or deception by sellers. To the extent the underwriting is not accurate or we are subject to fraud or deception by sellers, the performance of policies may be different from expected results, which could adversely affect our profitability.

 

Life Insurance Policy Characteristics

 

We typically invest in universal life insurance policies whose insureds are 65 years or older and whose actuarial life expectancies are estimated to be less than 168 months (14 years). In some cases, however, we invest in term life insurance policies that are convertible into universal life insurance policies, depending upon the analysis of the life insurance policy and the insured’s life expectancy estimate. The life expectancy estimate is the number of months the insured is expected to live based upon 50% mortality (meaning roughly half of the individuals with similar age, sex, smoking and medical statuses will have experienced mortality within that number of months), which is in turn based upon actuarial tables.

 

We invest only in life insurance assets that have been in force for more than two years from the policy issuance date and meet our other underwriting guidelines. We reserve the right to disqualify some life insurance companies or categories of life insurance policies for purchasing in our sole discretion.

 

Pricing Life Insurance Policies

 

Pricing involves an analysis of both the policy and the insured. An analysis of the insurance policy starts with an illustration obtained from the insurance company providing a schedule of level premium payments until the insured reaches age 125. Then, utilizing pricing software now owned by Modeling Actuarial Pricing Systems, Inc. (“MAPS”), we reverse engineer the premium schedule of the policy to determine a premium schedule that provides for the minimum payments required to keep the policy in effect. An analysis of the insured involves an actuarial evaluation of the insured’s probable mortality at different points in the future—the mortality curve. This analysis covers the insured’s entire projected lifespan using life expectancy estimates generated by third-party medical-actuarial underwriting firms or generated from base actuarial tables in the case of small face policies.

 

In determining the life expectancy estimate, we presently require two life expectancy estimates from independent third-party medical-actuarial underwriting firms, unless the life insurance policy is a small face policy (defined by us as a policy with $1,000,000 in face value benefits or less), in which case we may use a life expectancy estimate derived from base actuarial mortality table assumptions. When a life expectancy estimate is obtained from a medical-actuarial firm, the health of the insured is summarized by the underwriters in a written health assessment based on a review of the insured’s historical and current medical records. Underwriting assesses the characteristics and health risks of the insured in order to quantify them into a mortality rating representing the life expectancy estimate. We currently average the life expectancy estimates provided by two independent medical-actuarial underwriting firms to form our life expectancy estimate for life insurance policies other than small face policies. In some cases, we may obtain more than two life expectancy estimates. In those cases, we average the two life expectancy estimates that we believe are the most reliable of those we have received, based on our own analyses and conclusions. In this regard, the two life expectancy estimates we ultimately choose to average may not always be the most conservative. If in the future we believe our business model will benefit from changes in our underwriting process and if such revisions are permitted under our borrowing covenants, we may change our underwriting processes and policies, including our present policy under which we generally obtain two life expectancy estimates from independent third-party medical-actuarial firms (other than for small face policies).

 

By combining the optimized premiums and the insured’s life expectancy estimate within the MAPS software, we generate detailed information, including the expected mortality curve over the insured’s total projected lifespan; the expected premiums and related costs over the insured’s total projected lifespan; the expected policy benefit paid over the insured’s total projected lifespan; the account values within the policy; and the expected internal rate of return we will achieve at various investment amounts. From this information, we are able to calculate the present value of the life insurance policy by discounting the anticipated cash flows at the targeted internal rate of return using the probabilistic pricing methodology used by the MAPS program. The actuarial value of the life insurance policy asset is the present value of the policy’s cash flows discounted at an expected internal rate of return. We intend that our investments in life insurance assets will generate yields in excess of our borrowing and operating costs.

 

On September 15, 2014, 21st Services announced changes to its mortality tables primarily for insureds age 90 and older, as well as updated adjustment factors designed to better underwrite seniors with multiple impairments. We expect medical-actuarial underwriting firms to continue improving and refining their underwriting methodology. Future changes may impact the life expectancies of insureds within our portfolio and the value of those policies, which may in turn affect our results of operations. We generally expect to incorporate any such changes to the policies within our portfolio when and as we value that portfolio from time to time.

 

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Portfolio Administration

 

We have developed a comprehensive administration and servicing platform to manage the life insurance assets we own. This allows us to safeguard our life insurance assets and to process and report on the assets in our portfolio. We regularly contact each insurance company on every policy we own to verify policy account values and to confirm the correct application of premium payments made, and the resulting account values inside the life insurance policy after application of the premium payment and the deduction of the cost of insurance. We typically maintain little account value inside the policy and seek to make only minimum premium payments necessary to keep the life insurance policy in force until the next scheduled premium payment.

 

In addition to policy servicing, we monitor insureds by periodically contacting them directly, or their appointed representatives, to confirm their location and health status. We monitor the social security database for mortalities as well as online obituary databases. When we are notified of an insured’s mortality, we are required to obtain a copy of the death certificate and present it to the life insurance company for payment of the face value of the policy benefit.

 

Portfolio Management

 

We realize profits by earning a spread between the cost of our investment in our life insurance assets and the face value of the policy benefits paid upon the insured’s mortality. We believe that building and managing a profitable portfolio of life insurance policies is complex, requires considerable technical knowledge and resources, and is subject to numerous regulations. We have developed extensive experience and discipline to work toward a stable and profitable portfolio. We update our actuarial projections each month for the portfolio based on the life expectancy estimates, premium payments made, and mortalities experienced. These data points combine to provide us with future forecasted cash flows with respect to our portfolio of life insurance assets. These forecasted future cash flows, along with our current financial position, are combined in a comprehensive model that includes detailed assumptions as to interest rates, financing costs, life insurance asset acquisitions, and capital markets activities. This comprehensive financial model enables us to closely monitor and manage our necessary capital reserves and attempt to project our future profitability.

 

While we believe our portfolio of life insurance assets represents a balanced and stable portfolio of life insurance assets, we seek to grow the size of the portfolio in order to further mitigate risk, enhance diversification, and improve our profitability. In order to assess the stability of our portfolio, we analyze longevity risk, which is the risk of the insured living longer than his or her life expectancy estimate. Longevity risk is the single largest variable affecting the returns on an investment in life insurance assets and the ability to predict the portfolio’s value over time. Research by A.M. Best and others indicates that, as the number of insured lives increase within a portfolio of life insurance policies, there is a decrease in the standard deviation of the value of the portfolio—i.e., longevity risk is reduced with an increase in the number of insured lives. While Standard & Poor’s has indicated that statistical credibility is unlikely to be achieved with a pool of less than 1,000 lives, a study published in 2014 by A.M. Best concluded that at least 300 lives is sufficient to narrow the band of expected cash flow volatility using the Monte Carlo simulations, which is the same methodology we use to evaluate our portfolios. Our internal analysis of our portfolio, which as of December 31, 2014 consisted of 265 lives, resulted in a standard deviation that is comparable with the A.M. Best measurement for a portfolio of 200 lives. We believe this result is due to the specific portfolio make up of our portfolio relative to the variation in underlying life expectancy estimates. Further, A.M. Best recommends that no one life should comprise more than 3.33% of the face value of an entire portfolio or collateral pool. As of December 31, 2014, the largest face value policy on one life in our portfolio represented approximately 1.28% of the total portfolio. We intend to maintain a well-diversified portfolio as we continue to expand our investments in life insurance assets.

 

We also believe our portfolio represents a profitable portfolio. In order to assess the profitability, we analyze the future cash flows expected from our portfolio of life insurance assets. The standard practice within the insurance industry is to analyze the timing of uncertain future cash flows through stochastic modeling, or Monte Carlo simulations. We continue to analyze the expected internal rates of return and spread against borrowing costs represented by our portfolio. As of December 31, 2014, the expected internal rate of return on our portfolio of life insurance assets was 11.78% and our weighted-average borrowing costs to finance our portfolio were 7.24%.

 

Portfolio Credit Risk Management

 

The life insurance assets in which we invest represent obligations of third-party life insurance companies to pay the benefits under the relevant policy. We rely on the payment of policy benefits by life insurance companies as our sole source of revenue collection. Accordingly, the possible insolvency of a life insurance company is a significant risk to our business. To manage this risk, we seek to invest in life insurance assets that are issued by insurance companies with investment-grade ratings from either A.M. Best, Moody’s or Standard & Poor’s. To further mitigate risk, we seek to have no more than 20% of our aggregate face value of policy benefits in our portfolio issued by any one life insurance company. In addition, to assure diversity and stability in our portfolio, we regularly review the various metrics of our portfolio relating to credit risk. We track industry rating agency reports and industry journals and articles in order to gain insight into possible financial problems of life insurance companies. Finally, we only invest in those life insurance policies that meet the underwriting standards established in the indenture governing our debt securities, as applicable.

 

8
 

 

As of December 31, 2014, 93.1% of insurance companies in our portfolio hold an investment-grade rating by Standard & Poor’s (BBB- or better), and the highest percentage of face value of policy benefits issued by one life insurance company within our portfolio was 14.55%. Of the 44 insurance companies that insure the policies we own, ten companies insure approximately 72.47% of total face value of policy benefits and the other 34 insurance companies insure the remaining approximately 27.53% of total face value of policy benefits. The concentration risk of our ten largest insurance company holdings as of December 31, 2014 is set forth in the table below.

 

 

 

Rank

  Policy Benefits   Percentage
of Policy
Benefit Amount
  

 

 

Insurance Company

  Ins. Co. S&P
Rating
1  $113,380,000    14.55%  AXA Equitable Life Insurance Company  A+
2  $89,470,000    11.48%  John Hancock Life Insurance Company (U.S.A.)  AA-
3  $76,672,000    9.84%  Transamerica Life Insurance Company  AA-
4  $58,769,000    7.54%  Jefferson-Pilot Life Insurance Company  AA-
5  $56,215,000    7.22%  ING Life Insurance and Annuity Company  A-
6  $42,735,000    5.49%  Massachusetts Mutual Life Insurance Company  AA+
7  $41,750,000    5.36%  American General Life Insurance Company  A+
8  $30,500,000    3.92%  Pacific Life Insurance Company  A+
9  $28,450,000    3.65%  West Coast Life Insurance Company  AA-
10  $26,661,000    3.42%  Metropolitan Life Insurance Company  AA-
         72.47%      

 

Servicing Agents

 

We have contracted with Wells Fargo Bank to provide servicing, collateral agent, and trustee services with respect to certain life insurance policies owned by DLP II. We have contracted with Bank of Utah to provide trustee services with respect to all other life insurance policies we own. Wells Fargo Bank provides services for certain life insurance policies in connection with ownership and tracking of life insurance policies we own, including paying premiums, posting of payments (receipts) of the life insurance policies, certain monitoring, enforcement of rights and payer notifications, and related services. We reserve the right to service and provide collateral agent services for certain life insurance policies directly, or appoint additional or an alternative third-party servicer in the future.

 

Our Portfolio

 

Our portfolio of life insurance policies, owned by our subsidiaries as of December 31, 2014, is summarized below:

 

Total portfolio face value of policy benefits  $779,099,000 
Average face value per policy  $2,677,000 
Average face value per insured life  $2,940,000 
Average age of insured (yrs.)   82.8 
Average life expectancy estimate (yrs.)   6.5 
Total number of policies   291 
Number of unique lives   265 
Gender67% Males; 33% Females 
Number of smokers   3 
Largest policy as % of total portfolio   1.28%
Average policy as % of total portfolio   0.34%
Average annual premium as % of face value   3.37%

 

9
 

 

Our portfolio of life insurance policies, owned by our subsidiaries as of December 31, 2014, organized by the insured’s current age and the associated policy benefits, is summarized below:

 

Distribution of Policy Benefits by Current Age of Insured

 

Min Age  Max Age  Policy Benefits   Weighted Average
Life Expectancy (yrs.)
  Percentage of Total
Policy Benefits
 
90  95   31,997,000   3.18   4.11%
85  89   240,218,000   4.75   30.83%
80  84   289,762,000   7.06   37.19%
75  79   168,198,000   8.08   21.59%
70  74   40,767,000   9.43   5.23%
65  69  $8,157,000   7.29   1.05%
Total     $779,099,000   6.53   100.00%

 

Our portfolio of life insurance policies, owned by our subsidiaries as of December 31, 2014, organized by the insured’s current age and number of policies owned, is summarized below:

 

Distribution of Policies by Current Age of Insured

 

Min Age  Max Age  Policies   Weighted Average
Life Expectancy (yrs.)
  Percentage of Total
Policies
 
90  95   15   3.18   5.16%
85  89   93   4.75   31.96%
80  84   100   7.06   34.36%
75  79   57   8.08   19.59%
70  74   20   9.43   6.87%
65  69   6   7.29   2.06%
Total      291   6.53   100.00%

 

Our portfolio of life insurance policies, owned by our subsidiaries as of December 31, 2014, organized by the insured’s estimated life expectancy estimates and associated policy benefits, is summarized below:

 

Distribution of Policies by Current Life Expectancies of Insured

 

Min LE
(Months)
  Max LE
(Months)
  Policy Benefits   Percentage of Total
Policy Benefits
 
144  161  $11,502,000    1.48%
120  143   63,357,000    8.13%
96  119   148,624,000    19.08%
72  95   218,480,000    28.04%
48  71   216,827,000    27.83%
11  47   120,309,000    15.44%
Total     $779,099,000    100.00%

 

We track concentrations of pre-existing medical conditions among insured individuals within our portfolio based on information contained in life expectancy reports. We track these medical conditions within the following ten primary disease categories: (1) cancer, (2) cardiovascular, (3) cerebrovascular, (4) dementia, (5) diabetes, (6) multiple, (7) neurological disorders, (8) no disease, (9) other, and (10) respiratory diseases. Our primary disease categories are summary generalizations based on the ICD-9 codes we track on each insured individuals within our portfolio. ICD-9 codes, published by the World Health Organization, are used worldwide for medical diagnoses and treatment systems, as well as morbidity and mortality statistics. Currently, cardiovascular is the only primary disease category within our portfolio that represents a concentration of over 10%.

 

10
 

 

Our portfolio of life insurance policies, owned by our subsidiaries as of December 31, 2014, organized by the primary disease categories of the insured and associated policy benefits, is summarized below:

 

Distribution of Policy Benefits by Primary Disease Category

 

Primary Disease Category  Policy Benefits   Percentage of Total Policy Benefits 
Cancer  $57,450,000    7.37%
Cardiovascular   130,874,000    16.80%
Cerebrovascular   24,462,000    3.14%
Dementia   62,949,000    8.08%
Diabetes   63,617,000    8.16%
Multiple   201,363,000    25.85%
Neurological disorders   16,104,000    2.07%
No disease   94,468,000    12.12%
Other   86,612,000    11.12%
Respiratory diseases   41,200,000    5.29%
Total policy benefits  $779,099,000    100.00%

 

The primary disease category represents a general category of impairment. Within the primary disease category, there are a multitude of sub-categorizations defined more specifically by ICD-9 codes. For example, a primary disease category of cardiovascular includes subcategorizations such as atrial fibrillation, heart valve replacement, coronary atherosclerosis, etc. In addition, individuals may have more than one ICD-9 code describing multiple medical conditions within one or more primary disease categories. Where an individual’s ICD-9 codes indicate medical conditions in more than one primary disease categories, we categorize the individual as having multiple primary disease categories. We expect to continue to develop and refine our identification and tracking on the insured individuals medical conditions as we manage our portfolio of life insurance policies.

 

The complete detail of the portfolio of all life insurance policies, owned by our subsidiaries as of December 31, 2014, organized by the current age of the insured and the associated policy benefits, sex, estimated life expectancy, issuing insurance carrier, and the credit rating of the issuing insurance carrier is set forth below.

 

Life Insurance Portfolio Detail

(as of December 31, 2014) 

 

   Face Amount   Gender  Age
(ALB)
  LE
(mo.)
  Insurance Company  S&P Rating
1  $1,100,000   Male  94  31.2  ING Life Insurance and Annuity Company  A-
2  $1,500,000   Female  94  35.0  Aviva Life Insurance Company  A-
3  $4,000,000   Male  94  36.9  MetLife Investors USA Insurance Company  AA-
4  $3,200,000   Male  94  29.3  West Coast Life Insurance Company  AA-
5  $1,000,000   Female  93  41.1  Transamerica Life Insurance Company  AA-
6  $264,000   Female  93  26.9  Lincoln Benefit Life Company  BBB+
7  $250,000   Male  92  24.1  Transamerica Life Insurance Company  AA-
8  $2,500,000   Male  91  23.8  Columbus Life Insurance Company  AA
9  $500,000   Male  91  18.1  John Hancock Life Insurance Company (U.S.A.)  AA-
10  $2,000,000   Female  91  17.0  Pruco Life Insurance Company  AA-
11  $3,000,000   Male  91  50.5  West Coast Life Insurance Company  AA-
12  $5,000,000   Female  91  56.7  American General Life Insurance Company  A+
13  $5,000,000   Female  91  36.1  John Hancock Life Insurance Company (U.S.A.)  AA-
14  $1,682,773   Female  90  55.0  Hartford Life and Annuity Insurance Company  BBB+
15  $1,000,000   Male  90  29.4  State Farm Life Insurance Company  AA-
16  $5,000,000   Male  90  36.2  John Hancock Life Insurance Company (U.S.A.)  AA-
17  $1,000,000   Male  90  11.7  ING Life Insurance and Annuity Company  A-
18  $3,100,000   Female  90  37.9  Lincoln Benefit Life Company  BBB+
19  $1,500,000   Female  90  71.4  Jefferson-Pilot Life Insurance Company  AA-
20  $3,000,000   Female  90  37.4  Jefferson-Pilot Life Insurance Company  AA-
21  $600,000   Female  90  25.2  Columbus Life Insurance Company  AA
22  $3,500,000   Female  89  60.7  John Hancock Life Insurance Company (U.S.A.)  AA-
23  $5,000,000   Female  89  21.8  Lincoln National Life Insurance Company  AA-

 

11
 

 

   Face Amount   Gender  Age
(ALB)
  LE
(mo.)
  Insurance Company  S&P Rating
24  $1,203,520   Male  89  48.0  Columbus Life Insurance Company  AA
25  $5,000,000   Female  89  44.2  ING Life Insurance and Annuity Company  A-
26  $1,350,000   Female  89  39.8  Jefferson-Pilot Life Insurance Company  AA-
27  $2,500,000   Female  89  11.3  AXA Equitable Life Insurance Company  A+
28  $2,500,000   Female  89  11.3  AXA Equitable Life Insurance Company  A+
29  $715,000   Female  89  64.7  Jefferson-Pilot Life Insurance Company  AA-
30  $1,000,000   Female  89  55.0  United of Omaha Life Insurance Company  A+
31  $3,500,000   Female  89  45.3  Lincoln National Life Insurance Company  AA-
32  $5,000,000   Female  88  53.2  Massachusetts Mutual Life Insurance Company  AA+
33  $8,985,000   Male  88  35.7  Massachusetts Mutual Life Insurance Company  AA+
34  $2,225,000   Female  88  91.0  Transamerica Life Insurance Company  AA-
35  $2,500,000   Female  88  52.3  American General Life Insurance Company  A+
36  $2,500,000   Male  88  43.8  Pacific Life Insurance Company  A+
37  $1,103,922   Female  88  67.4  Sun Life Assurance Company of Canada (U.S.)  AA-
38  $1,000,000   Female  88  69.8  Transamerica Life Insurance Company  AA-
39  $250,000   Female  88  69.8  Transamerica Life Insurance Company  AA-
40  $500,000   Male  88  66.1  Lincoln National Life Insurance Company  AA-
41  $800,000   Male  88  77.4  Lincoln National Life Insurance Company  AA-
42  $5,000,000   Male  88  57.6  AXA Equitable Life Insurance Company  A+
43  $1,500,000   Male  88  46.0  John Hancock Life Insurance Company (U.S.A.)  AA-
44  $1,500,000   Male  88  46.0  John Hancock Life Insurance Company (U.S.A.)  AA-
45  $3,000,000   Female  88  86.5  Massachusetts Mutual Life Insurance Company  AA+
46  $1,500,000   Male  88  50.4  Union Central Life Insurance Company  A+
47  $3,000,000   Male  88  36.8  American General Life Insurance Company  A+
48  $1,050,000   Male  88  49.9  John Hancock Life Insurance Company (U.S.A.)  AA-
49  $4,785,380   Female  88  47.9  John Hancock Life Insurance Company (U.S.A.)  AA-
50  $1,803,455   Female  88  53.5  Metropolitan Life Insurance Company  AA-
51  $1,529,270   Female  88  53.5  Metropolitan Life Insurance Company  AA-
52  $5,000,000   Male  88  56.5  John Hancock Life Insurance Company (U.S.A.)  AA-
53  $4,000,000   Female  88  76.8  Transamerica Life Insurance Company  AA-
54  $1,000,000   Male  88  59.5  AXA Equitable Life Insurance Company  A+
55  $3,000,000   Male  88  47.9  Jefferson-Pilot Life Insurance Company  AA-
56  $2,000,000   Male  88  51.3  John Hancock Life Insurance Company (U.S.A.)  AA-
57  $500,000   Female  87  72.6  Sun Life Assurance Company of Canada (U.S.)  AA-
58  $5,000,000   Female  87  35.9  Penn Mutual Life Insurance Company  A+
59  $100,000   Female  87  62.3  American General Life Insurance Company  A+
60  $100,000   Female  87  62.3  American General Life Insurance Company  A+
61  $200,000   Male  87  52.9  Lincoln Benefit Life Company  BBB+
62  $4,445,467   Male  87  63.1  Penn Mutual Life Insurance Company  A+
63  $7,500,000   Male  87  54.6  Jefferson-Pilot Life Insurance Company  AA-
64  $250,000   Male  87  76.8  Metropolitan Life Insurance Company  AA-
65  $800,000   Male  87  59.9  National Western Life Insurance Company  A
66  $3,600,000   Female  87  62.3  AXA Equitable Life Insurance Company  A+
67  $3,000,000   Male  87  55.9  Transamerica Life Insurance Company  AA-
68  $2,500,000   Male  87  52.4  Transamerica Life Insurance Company  AA-
69  $1,000,000   Female  87  55.4  West Coast Life Insurance Company  AA-
70  $2,000,000   Female  87  55.4  West Coast Life Insurance Company  AA-
71  $2,000,000   Female  87  79.9  U.S. Financial Life Insurance Company  A+
72  $1,000,000   Female  87  31.7  John Hancock Life Insurance Company (U.S.A.)  AA-
73  $4,513,823   Female  87  27.4  Aviva Life Insurance Company  A-
74  $5,000,000   Female  87  38.8  Transamerica Life Insurance Company  AA-
75  $1,000,000   Female  87  40.0  New York Life Insurance Company  AA+
76  $10,000,000   Female  87  76.7  West Coast Life Insurance Company  AA-
77  $6,000,000   Female  87  60.8  Sun Life Assurance Company of Canada (U.S.)  AA-
78  $5,570,000   Female  87  51.7  ING Life Insurance and Annuity Company  A-
79  $5,570,000   Female  87  51.7  ING Life Insurance and Annuity Company  A-
80  $3,000,000   Male  87  87.6  AXA Equitable Life Insurance Company  A+

 

12
 

 

   Face Amount   Gender  Age
(ALB)
  LE
(mo.)
  Insurance Company  S&P Rating
81  $1,200,000   Male  87  64.8  Transamerica Life Insurance Company  AA-
82  $5,000,000   Male  87  85.9  Lincoln National Life Insurance Company  AA-
83  $1,000,000   Male  86  65.6  John Hancock Life Insurance Company (U.S.A.)  AA-
84  $2,000,000   Male  86  65.6  John Hancock Life Insurance Company (U.S.A.)  AA-
85  $5,000,000   Male  86  53.5  Jefferson-Pilot Life Insurance Company  AA-
86  $500,000   Female  86  59.6  Beneficial Life Insurance Company  N/A
87  $8,500,000   Male  86  85.8  Massachusetts Mutual Life Insurance Company  AA+
88  $2,000,000   Male  86  102.6  ING Life Insurance and Annuity Company  A-
89  $2,000,000   Male  86  102.6  ING Life Insurance and Annuity Company  A-
90  $2,000,000   Male  86  102.6  ING Life Insurance and Annuity Company  A-
91  $1,000,000   Female  86  89.2  ING Life Insurance and Annuity Company  A-
92  $500,000   Male  86  86.6  Metropolitan Life Insurance Company  AA-
93  $1,000,000   Male  86  29.6  Transamerica Life Insurance Company  AA-
94  $200,000   Female  86  92.4  Lincoln National Life Insurance Company  AA-
95  $1,365,000   Female  86  89.7  Transamerica Life Insurance Company  AA-
96  $1,000,000   Male  86  44.2  Massachusetts Mutual Life Insurance Company  AA+
97  $1,800,000   Male  86  56.7  John Hancock Variable Life Insurance Company  AA-
98  $2,000,000   Male  86  89.4  Transamerica Life Insurance Company  AA-
99  $2,000,000   Male  86  66.3  Jefferson-Pilot Life Insurance Company  AA-
100  $1,425,000   Male  85  86.2  John Hancock Life Insurance Company (U.S.A.)  AA-
101  $2,328,547   Male  85  48.8  Metropolitan Life Insurance Company  AA-
102  $2,000,000   Male  85  48.8  Metropolitan Life Insurance Company  AA-
103  $3,000,000   Female  85  75.7  Transamerica Life Insurance Company  AA-
104  $2,000,000   Male  85  68.7  AXA Equitable Life Insurance Company  A+
105  $1,750,000   Male  85  68.7  AXA Equitable Life Insurance Company  A+
106  $2,000,000   Male  85  39.0  Transamerica Life Insurance Company  AA-
107  $5,000,000   Male  85  77.8  ING Life Insurance and Annuity Company  A-
108  $1,000,000   Male  85  64.6  John Hancock Life Insurance Company (U.S.A.)  AA-
109  $2,000,000   Female  85  89.6  AXA Equitable Life Insurance Company  A+
110  $3,000,000   Female  85  88.2  Sun Life Assurance Company of Canada (U.S.)  AA-
111  $1,000,000   Male  85  51.6  John Hancock Life Insurance Company (U.S.A.)  AA-
112  $1,500,000   Male  85  53.6  ING Life Insurance and Annuity Company  A-
113  $1,500,000   Male  85  53.6  ING Life Insurance and Annuity Company  A-
114  $3,750,000   Male  85  80.5  AXA Equitable Life Insurance Company  A+
115  $1,500,000   Male  85  84.0  AXA Equitable Life Insurance Company  A+
116  $5,000,000   Female  85  97.2  American General Life Insurance Company  A+
117  $1,500,000   Male  85  53.7  Transamerica Life Insurance Company  AA-
118  $829,022   Female  85  29.1  Hartford Life and Annuity Insurance Company  BBB+
119  $5,000,000   Male  85  93.8  ING Life Insurance and Annuity Company  A-
120  $4,000,000   Female  85  54.1  ING Life Insurance and Annuity Company  A-
121  $3,500,000   Female  84  112.4  Lincoln Benefit Life Company  BBB+
122  $1,000,000   Male  84  58.7  ING Life Insurance and Annuity Company  A-
123  $500,000   Male  84  45.4  Genworth Life Insurance Company  BBB+
124  $1,500,000   Female  84  113.6  Lincoln Benefit Life Company  BBB+
125  $1,000,000   Male  84  62.6  Hartford Life and Annuity Insurance Company  BBB+
126  $1,000,000   Female  84  88.1  John Hancock Life Insurance Company (U.S.A.)  AA-
127  $2,000,000   Female  84  103.2  Lincoln Benefit Life Company  BBB+
128  $2,500,000   Female  84  68.5  American General Life Insurance Company  A+
129  $4,000,000   Male  84  41.3  John Hancock Life Insurance Company (U.S.A.)  AA-
130  $1,000,000   Male  84  86.6  John Hancock Life Insurance Company (U.S.A.)  AA-
131  $1,703,959   Male  84  72.2  Jefferson-Pilot Life Insurance Company  AA-
132  $2,700,000   Male  84  66.2  John Hancock Life Insurance Company (U.S.A.)  AA-
133  $500,000   Male  84  22.3  Great Southern Life Insurance Company  N/A
134  $5,000,000   Female  84  101.7  AXA Equitable Life Insurance Company  A+
135  $6,000,000   Female  84  115.4  American General Life Insurance Company  A+
136  $7,600,000   Female  84  103.2  Transamerica Life Insurance Company  AA-
137  $2,500,000   Male  84  64.1  AXA Equitable Life Insurance Company  A+

 

13
 

 

   Face Amount   Gender  Age
(ALB)
  LE
(mo.)
  Insurance Company  S&P Rating
138  $3,000,000   Male  84  64.1  Lincoln National Life Insurance Company  AA-
139  $3,000,000   Female  84  48.1  AXA Equitable Life Insurance Company  A+
140  $10,000,000   Female  84  62.7  American National Insurance Company  A
141  $500,000   Male  84  29.2  West Coast Life Insurance Company  AA-
142  $750,000   Male  84  93.8  West Coast Life Insurance Company  AA-
143  $5,000,000   Male  84  79.5  Jefferson-Pilot Life Insurance Company  AA-
144  $2,000,000   Male  83  44.2  National Life Insurance Company  A
145  $5,000,000   Male  83  70.3  AXA Equitable Life Insurance Company  A+
146  $500,000   Male  83  105.6  Metropolitan Life Insurance Company  AA-
147  $4,200,000   Female  83  123.7  Transamerica Life Insurance Company  AA-
148  $2,000,000   Male  83  90.8  Pacific Life Insurance Company  A+
149  $3,000,000   Male  83  66.0  Metropolitan Life Insurance Company  AA-
150  $1,500,000   Male  83  80.8  Jefferson-Pilot Life Insurance Company  AA-
151  $3,500,000   Female  83  93.6  AXA Equitable Life Insurance Company  A+
152  $1,500,000   Male  83  29.4  Pacific Life Insurance Company  A+
153  $5,000,000   Male  83  78.4  AXA Equitable Life Insurance Company  A+
154  $3,000,000   Female  83  99.0  MetLife Investors USA Insurance Company  AA-
155  $2,275,000   Male  83  96.3  ING Life Insurance and Annuity Company  A-
156  $4,500,000   Male  83  78.8  AXA Equitable Life Insurance Company  A+
157  $2,000,000   Female  83  103.1  Jefferson-Pilot Life Insurance Company  AA-
158  $3,500,000   Male  83  77.4  AXA Equitable Life Insurance Company  A+
159  $3,000,000   Male  83  45.1  U.S. Financial Life Insurance Company  A+
160  $750,000   Male  83  87.1  John Hancock Life Insurance Company (U.S.A.)  AA-
161  $1,900,000   Male  83  71.2  American National Insurance Company  A
162  $500,000   Male  83  50.5  New York Life Insurance Company  AA+
163  $500,000   Male  83  50.5  New York Life Insurance Company  AA+
164  $250,000   Male  83  36.7  Jackson National Life Insurance Company  AA
165  $10,000,000   Male  83  84.4  AXA Equitable Life Insurance Company  A+
166  $2,300,000   Male  83  25.2  American General Life Insurance Company  A+
167  $6,217,200   Female  83  111.4  Phoenix Life Insurance Company  B+
168  $5,000,000   Male  83  89.1  Jefferson-Pilot Life Insurance Company  AA-
169  $3,500,000   Female  82  97.6  Jefferson-Pilot Life Insurance Company  AA-
170  $1,000,000   Male  82  73.9  Lincoln National Life Insurance Company  AA-
171  $5,000,000   Female  82  62.1  Massachusetts Mutual Life Insurance Company  AA+
172  $2,500,000   Female  82  77.2  ING Life Insurance and Annuity Company  A-
173  $5,000,000   Female  82  80.9  Sun Life Assurance Company of Canada (U.S.)  AA-
174  $1,250,000   Female  82  66.1  Columbus Life Insurance Company  AA
175  $5,000,000   Male  82  81.1  Transamerica Life Insurance Company  AA-
176  $4,000,000   Male  82  61.7  Jefferson-Pilot Life Insurance Company  AA-
177  $5,000,000   Male  82  115.9  American General Life Insurance Company  A+
178  $1,995,000   Female  82  85.8  Transamerica Life Insurance Company  AA-
179  $350,000   Male  82  40.7  Reassure America Life Insurance Company  AA
180  $1,500,000   Male  82  61.9  Pacific Life Insurance Company  A+
181  $3,000,000   Male  82  73.5  Protective Life Insurance Company  AA-
182  $1,500,000   Male  82  73.5  American General Life Insurance Company  A+
183  $10,000,000   Male  82  86.5  New York Life Insurance Company  AA+
184  $2,000,000   Female  82  122.3  Transamerica Life Insurance Company  AA-
185  $2,000,000   Male  82  76.7  Ohio National Life Assurance Corporation  AA-
186  $1,000,000   Male  82  76.7  Ohio National Life Assurance Corporation  AA-
187  $550,000   Male  81  110.7  Genworth Life Insurance Company  BBB+
188  $1,000,000   Female  81  104.0  Jefferson-Pilot Life Insurance Company  AA-
189  $5,000,000   Male  81  79.8  AXA Equitable Life Insurance Company  A+
190  $7,000,000   Male  81  94.2  Genworth Life Insurance Company  BBB+
191  $10,000,000   Male  81  121.5  John Hancock Life Insurance Company (U.S.A.)  AA-
192  $5,000,000   Male  81  98.8  AXA Equitable Life Insurance Company  A+
193  $1,680,000   Female  81  74.9  AXA Equitable Life Insurance Company  A+
194  $1,000,000   Male  81  72.6  AXA Equitable Life Insurance Company  A+

 

14
 

 

   Face Amount   Gender  Age
(ALB)
  LE
(mo.)
  Insurance Company  S&P Rating
195  $2,502,000   Male  81  160.5  Transamerica Life Insurance Company  AA-
196  $3,000,000   Female  81  114.2  West Coast Life Insurance Company  AA-
197  $1,250,000   Male  81  107.8  Metropolitan Life Insurance Company  AA-
198  $1,250,000   Female  81  81.7  Principal Life Insurance Company  A+
199  $2,000,000   Male  81  46.4  Jefferson-Pilot Life Insurance Company  AA-
200  $8,000,000   Male  81  90.7  AXA Equitable Life Insurance Company  A+
201  $3,000,000   Male  81  106.2  John Hancock Life Insurance Company (U.S.A.)  AA-
202  $1,000,000   Male  81  63.2  AXA Equitable Life Insurance Company  A+
203  $1,750,000   Male  81  90.3  AXA Equitable Life Insurance Company  A+
204  $250,000   Male  81  87.3  American General Life Insurance Company  A+
205  $1,210,000   Male  81  73.3  Lincoln National Life Insurance Company  AA-
206  $2,000,000   Male  80  33.6  Metropolitan Life Insurance Company  AA-
207  $3,000,000   Male  80  119.2  Principal Life Insurance Company  A+
208  $2,000,000   Female  80  97.4  Pacific Life Insurance Company  A+
209  $2,000,000   Female  80  96.0  Transamerica Life Insurance Company  AA-
210  $130,000   Male  80  57.5  Genworth Life Insurance Company  BBB+
211  $500,000   Male  80  55.0  Transamerica Life Insurance Company  AA-
212  $6,000,000   Male  80  132.1  AXA Equitable Life Insurance Company  A+
213  $1,000,000   Male  80  133.2  Empire General Life Assurance Corporation  AA-
214  $4,000,000   Male  79  88.8  Jefferson-Pilot Life Insurance Company  AA-
215  $4,300,000   Female  79  119.2  American National Insurance Company  A
216  $3,000,000   Male  79  99.3  ING Life Insurance and Annuity Company  A-
217  $5,000,000   Male  79  99.5  John Hancock Life Insurance Company (U.S.A.)  AA-
218  $7,000,000   Male  79  95.0  Lincoln Benefit Life Company  BBB+
219  $3,000,000   Male  79  49.6  Pacific Life Insurance Company  A+
220  $3,000,000   Male  79  49.6  Minnesota Life Insurance Company  A+
221  $3,000,000   Male  79  49.6  Prudential Life Insurance Company  AA-
222  $5,000,000   Male  79  87.2  Pacific Life Insurance Company  A+
223  $5,000,000   Male  79  87.2  Pacific Life Insurance Company  A+
224  $5,000,000   Male  79  122.7  Principal Life Insurance Company  A+
225  $6,000,000   Male  79  116.7  AXA Equitable Life Insurance Company  A+
226  $750,000   Male  79  78.3  Lincoln National Life Insurance Company  AA-
227  $476,574   Male  79  80.8  Transamerica Life Insurance Company  AA-
228  $3,601,500   Male  79  103.2  Transamerica Life Insurance Company  AA-
229  $1,000,000   Male  79  100.0  Sun Life Assurance Company of Canada (U.S.)  AA-
230  $2,250,000   Male  79  103.6  Massachusetts Mutual Life Insurance Company  AA+
231  $5,000,000   Female  79  126.5  ING Life Insurance and Annuity Company  A-
232  $3,000,000   Male  79  105.0  Principal Life Insurance Company  A+
233  $1,000,000   Male  78  120.2  Metropolitan Life Insurance Company  AA-
234  $5,000,000   Male  78  98.0  John Hancock Life Insurance Company (U.S.A.)  AA-
235  $1,009,467   Male  78  56.8  John Hancock Life Insurance Company (U.S.A.)  AA-
236  $5,000,000   Male  78  64.7  John Hancock Life Insurance Company (U.S.A.)  AA-
237  $4,000,000   Male  78  57.9  MetLife Investors USA Insurance Company  AA-
238  $3,750,000   Male  78  66.8  AXA Equitable Life Insurance Company  A+
239  $5,000,000   Male  78  87.2  John Hancock Life Insurance Company (U.S.A.)  AA-
240  $2,500,000   Male  78  97.2  Massachusetts Mutual Life Insurance Company  AA+
241  $2,500,000   Male  78  97.2  Massachusetts Mutual Life Insurance Company  AA+
242  $2,000,000   Female  78  65.3  Transamerica Life Insurance Company  AA-
243  $500,000   Female  78  126.4  Columbus Life Insurance Company  AA
244  $5,000,000   Male  78  128.5  Jefferson-Pilot Life Insurance Company  AA-
245  $500,000   Male  78  75.6  John Hancock Life Insurance Company (U.S.A.)  AA-
246  $5,000,000   Male  77  113.6  Transamerica Life Insurance Company  AA-
247  $1,000,000   Male  77  118.9  Metropolitan Life Insurance Company  AA-
248  $1,750,000   Male  77  71.5  John Hancock Life Insurance Company (U.S.A.)  AA-
249  $750,000   Male  77  15.5  U.S. Financial Life Insurance Company  A+
250  $2,840,000   Male  77  108.7  Transamerica Life Insurance Company  AA-
251  $1,000,000   Female  77  85.0  John Hancock Life Insurance Company (U.S.A.)  AA-

 

 

15
 

 

   Face Amount   Gender  Age
(ALB)
  LE
(mo.)
  Insurance Company  S&P Rating
252  $600,000   Male  77  94.4  Protective Life Insurance Company  AA-
253  $490,620   Male  76  97.1  Ameritas Life Insurance Corporation  A+
254  $4,000,000   Male  76  77.3  Massachusetts Mutual Life Insurance Company  AA+
255  $7,000,000   Female  76  134.4  Pacific Life Insurance Company  A+
256  $2,000,000   Male  76  131.5  Transamerica Life Insurance Company  AA-
257  $3,000,000   Male  76  115.1  Protective Life Insurance Company  AA-
258  $1,000,000   Male  76  93.9  Pacific Life Insurance Company  A+
259  $150,000   Male  76  117.6  Genworth Life Insurance Company  BBB+
260  $5,000,000   Male  76  69.2  West Coast Life Insurance Company  AA-
261  $2,000,000   Female  76  131.3  Aviva Life Insurance Company  A-
262  $850,000   Male  75  77.5  New York Life Insurance Company  AA+
263  $5,000,000   Male  75  161.2  Prudential Life Insurance Company  AA-
264  $3,000,000   Male  75  65.3  Aviva Life Insurance Company  A-
265  $5,000,000   Male  75  41.2  Lincoln Benefit Life Company  BBB+
266  $8,000,000   Male  75  115.2  Metropolitan Life Insurance Company  AA-
267  $200,000   Male  75  80.9  ING Life Insurance and Annuity Company  A-
268  $4,000,000   Female  74  156.8  American General Life Insurance Company  A+
269  $3,000,000   Female  74  128.5  General American Life Insurance Company  AA-
270  $300,000   Male  74  24.0  Lincoln National Life Insurance Company  AA-
271  $2,000,000   Male  74  111.2  American General Life Insurance Company  A+
272  $1,000,000   Male  73  80.4  United of Omaha Life Insurance Company  A+
273  $500,000   Male  73  45.7  Midland National Life Insurance Company  A+
274  $3,000,000   Male  73  86.6  AXA Equitable Life Insurance Company  A+
275  $2,500,000   Male  72  110.9  American General Life Insurance Company  A+
276  $1,167,000   Male  72  37.1  Transamerica Life Insurance Company  AA-
277  $1,500,000   Male  72  125.8  Metropolitan Life Insurance Company  AA-
278  $2,500,000   Male  71  132.0  Lincoln National Life Insurance Company  AA-
279  $2,500,000   Male  71  132.0  John Hancock Life Insurance Company (U.S.A.)  AA-
280  $600,000   Male  71  99.4  AXA Equitable Life Insurance Company  A+
281  $2,000,000   Male  71  116.2  New York Life Insurance Company  AA+
282  $2,000,000   Male  71  116.2  New York Life Insurance Company  AA+
283  $3,000,000   Male  71  89.3  John Hancock Life Insurance Company (U.S.A.)  AA-
284  $500,000   Male  70  107.3  Transamerica Life Insurance Company  AA-
285  $500,000   Male  70  107.3  North American Company for Life And Health Insurance  A+
286  $2,000,000   Male  68  129.1  Transamerica Life Insurance Company  AA-
287  $1,000,000   Male  68  129.1  Genworth Life Insurance Company  BBB+
288  $2,000,000   Male  68  62.0  MetLife Investors USA Insurance Company  AA-
289  $2,000,000   Male  68  62.0  MetLife Investors USA Insurance Company  AA-
290  $156,538   Female  67  121.5  New York Life Insurance Company  AA+
291  $1,000,000   Male  66  59.3  Lincoln National Life Insurance Company  AA-
    779,099,037                

 

 

(1) The insured’s age is current as of the measurement date.
(2) The insured’s life expectancy estimate, other than for a small face value insurance policy (defined by us as a policy with $1 million in face value benefits or less), is the average of two life expectancy estimates provided by independent third-party medical-actuarial underwriting firms at the time of purchase, actuarially adjusted through the measurement date. Numbers in this column represent months. For more information, see disclosure under the caption “Pricing Life Insurance Policies.”

 

Competition

 

We encounter significant competition in the life insurance purchasing and financing business from numerous companies, including hedge funds, investment banks, secured lenders, specialty life insurance finance companies and life insurance companies themselves. Many of these competitors have greater financial and other resources than we do and may have significantly lower cost of funds because they have greater access to insured deposits or the capital markets. Moreover, some of these competitors have significant cash reserves and can better fund shortfalls in collections that might have a more pronounced impact on companies such as ours. They also have greater market share. In the event that certain better-financed life insurance companies make a significant effort to compete against our business or the secondary market in general, we would experience significant challenges with our business model.

 

16
 

 

Competition can take many forms, including the pricing of the financing, transaction structuring, timeliness and responsiveness in processing a seller’s application and customer service. Some competitors may outperform us in these areas. Some competitors target the same type of life insurance clients as we do and generally have operated in the markets we service for a longer period of time. Increased competition may result in increased costs of purchasing policies or may affect the availability and quality of policies that are available for our purchase. These factors could adversely affect our profitability by reducing our return on investment or increasing our risk.

 

Government Regulation

 

The life insurance sector is highly regulated at both the federal and state levels. We are subject to federal and state regulation and supervision in the life insurance purchasing and finance business. There are significant regulations in many states that require us to obtain specific licenses or approvals to be able to purchase life insurance policies in those states. We continually research and monitor regulations and apply for the appropriate licenses in the required states.

 

Governments at both the federal and state levels have continued to review the impact of the business on the life insurance industry. Moreover, recent federal government actions with respect to insurance companies have increased the federal government’s role in regulating the insurance industry. Recently we have seen legislative efforts by state governments to mandate the sale or liquidation of life insurance policies as part of the Patient Protection and Affordable Care Act in order to increase the number of Americans covered by health insurance and decrease the cost of health care. This legislative effort is designed to monetize all assets of the insured prior to eligibility for health care provided under the Patient Protection and Affordable Care Act. These efforts may affect the number of life insurance policies available for purchase and their attractiveness.

 

State statutes typically provide state regulatory agencies with significant powers to interpret, administer and enforce the laws relating to the purchase of life insurance policies in those states. Under statutory authority, state regulators have broad discretionary power and may impose new licensing requirements, interpret or enforce existing regulatory requirements in different ways or issue new administrative rules (even if not contained in state statutes). State regulators may also impose rules that are generally adverse to our industry. Because the life insurance secondary market is relatively new and because of the history of certain abuses in the industry, we believe it is likely that state regulation will increase and grow more complex in the foreseeable future. We cannot, however, predict what any new regulation would specifically involve or how it might affect our industry or our business.

 

Any adverse change in present laws or regulations, or their interpretation, in one or more states in which we operate (or an aggregation of states in which we conduct a significant amount of business) could result in a curtailment or termination of operations in such jurisdictions by us, or cause us to modify our operations in a way that adversely affects our ultimate profitability. Any such action could have a corresponding material and negative impact on our results of operations and financial condition, primarily through a material decrease in revenues, and could also negatively affect our general business prospects.

 

The Securities and Exchange Commission (the “SEC”) has, on occasion, attempted to regulate the purchase of non-variable life insurance policies as transactions in securities under federal securities laws. In July of 2010, the SEC issued a Staff Report of its Life Settlement Task Force. In that report, the Staff recommended that certain types of purchased life insurance policies be classified as securities. The SEC has not taken any position on the Staff Report, and there is no indication if the SEC will take any action to implement the recommendations of the Staff Report. In addition, there has been several federal court cases in which transactions involving the purchase and fractionalization of life insurance contracts have been held to be transactions in securities under the federal Securities Act of 1933. We presently believe that the matters discussed in the Staff Report, and existing case law, do not impact our current business model since our purchases of life settlements are distinguishable in our view from those cases that have been held by courts, and advocated by the Staff Report, to be transactions in securities. For example, we are not involved in fractionalization of any life insurance policies, and we presently do not purchase variable life insurance policies.

 

If federal law were to change, whether by action of the Congress or through the courts, with the result that purchases of non-fractionalized and non-variable life insurance policies would be considered transactions in “securities,” we would be in violation of existing covenants under our revolving credit facility which require us to not operate or be characterized as an “investment company” under the Investment Company Act of 1940. This could in the short-term or long-term affect our liquidity and increase our cost of capital and operational expenses, all of which would adversely affect our operating results. It is possible that such an outcome could threaten the viability of our business and our ability to satisfy our obligations as they come due.

 

With respect to state securities laws, almost all states currently treat the sale of a life insurance policy as a securities transaction under state laws, although some states exclude from the definition of a security the original sale from the insured or the policy owner to the life settlement provider. To date, due to the manner in which we conduct and structure our activities and the availability, in certain instances, of exceptions and exemptions under securities laws, such laws have not adversely impacted our business model.

 

17
 

 

State Life Settlement License Requirements

 

State laws differ as to the extent to which purchasers of life insurance policies are required to be licensed by a state regulatory agency. We may elect to conduct life insurance policy purchasing only in those states in which we are licensed or where no licensure is required. The licensing requirements differ from state to state, but where they exist, they typically require the payment of licensing fees, periodic reporting, and submission to audit by state regulators. We do not intend to purchase any life insurance policies in any states that require a license or similar qualification without first obtaining such license or qualification or purchasing through a licensed provider in that state.

 

The table below identifies all states (and the District of Columbia) in which we can conduct business directly with the seller of a life insurance policy or through a licensed provider. An asterisk (*) indicates that the state does not require licensing. In those states identified in the right-hand column, we can purchase policies through our provider relationships with Magna Administrative Services, Inc. Abacus Settlements, LLC, and Lotus Life, LLC. If our relationships with either Magna Administrative Services, Abacus Settlements or Lotus Life were to end, for any reason, we believe we would be able to enter into a relationship with a replacement provider shortly thereafter.

 

States Where   States Where We Conduct Business
We Conduct Business Directly   Through Other Licensed Providers
Alabama*   Colorado
Arizona   Georgia
Arkansas   Idaho
California   Nevada
Connecticut   New Jersey
Delaware    
District of Columbia*    
Florida    
Hawaii    
Illinois    
Indiana    
Iowa    
Kansas    
Kentucky    
Louisiana    
Maine    
Maryland    
Massachusetts    
Michigan*    
Minnesota    
Mississippi    
Missouri*    
Nebraska    
New Mexico*    
New York    
North Carolina    
Ohio    
Oklahoma    
Oregon    
Pennsylvania    
Rhode Island    
South Carolina*    
South Dakota*    
Tennessee    
Texas    
Virginia    
Washington    
Wisconsin    
Wyoming*    

 

18
 

 

We are not presently able to conduct business in the following states due to the fact that we neither have a license to operate in the state nor do we have a relationship with another licensed provider in such state: Alaska, Montana, New Hampshire, North Dakota, Utah, Vermont, and West Virginia.

 

Health Insurance Portability and Accountability Act (HIPAA)

 

HIPAA requires that holders of medical records maintain such records and implement procedures in ways designed to assure the privacy of patient records. HIPAA has precipitated widespread changes in record keeping, including patient consent forms and access restrictions in data processing software. In order to carry out our business, we receive medical records and obtain a release to share such records with a defined group of persons. We are entitled to have access to patient information, take on the responsibility for preserving the privacy of that information, and use the information only for purposes related to the life insurance policies.

 

Employees

 

We employ approximately 40 employees.

 

Properties

 

Our principal executive offices are located at 220 South Sixth Street, Suite 1200, Minneapolis, Minnesota 55402. At that location, we lease 11,695 square feet of space for a lease term expiring in August 2015. We believe that these facilities are adequate for our current needs and that suitable additional space will be available as needed.

 

Company Website Access and SEC Filings

 

The Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), are filed with the SEC. The Company is subject to the informational requirements of the Exchange Act and files or furnishes reports, proxy statements and other information with the SEC.

 

Our general website address is www.gwglife.com. Our website has a wealth of information about our company, its mission, and our specialty finance business. It also has tools that could be used by our potential clients, financial advisors and investors alike.

 

Legal Proceedings

 

Our Chief Executive Officer, Jon R. Sabes, and our corporate secretary and Executive Vice President of Originations and Servicing, Steven F. Sabes, who together beneficially own approximately 74.8% of our common stock, are involved in litigation relating to claims by a bankruptcy trustee for loan payments made to an affiliate, Opportunity Finance, LLC. The litigation stems in part from the 2010 conviction of an individual operating a fraudulent business which filed for bankruptcy in 2008. The bankruptcy trustee alleges that loan repayments to Opportunity Finance were avoidable transfers under preference or other legal theories and seeks to recover amounts for other creditors of the bankruptcy estate. Case No. 08-45257 (U.S. Bankruptcy Court District of Minnesota). Such payments may ultimately be deemed to be avoidable transfers under preference or other legal theories. In addition, GWG Holdings invested $1.0 million in Opportunity Finance, LLC in 2006 and was repaid and received $176,948 of interest income from that investment in 2007. To date, no claim has been made against the Company.

 

While we believe there are numerous meritorious defenses to the claims made by the bankruptcy trustee and others, and we are advised that the defendants in that action will vigorously defend against the trustee’s claims, such defendants may not prevail in the litigation. If the bankruptcy trustee or a successful private plaintiff sought to sell or transfer the equity interests of Jon R. Sabes or Steven F. Sabes as a result of the litigation, there could be a change in control of the Company and our business together with all of our investors, including investors in our debentures, could be materially and adversely impacted. Such adverse results would likely arise in connection with negative change-in-control covenants contained in our revolving credit facility agreements, the breach of those covenants and an ensuing event of default under such facility. In addition, if the bankruptcy trustee or a private plaintiff sought to sell or transfer the equity interests of Jon R. Sabes or Steven F. Sabes as a result of the litigation, such transfers would adversely affect holders of our previously issued L Bonds by reducing the number of shares of common stock of GWG Holdings that have been pledged as collateral security for our obligations under the debentures. Regardless of the outcome of this litigation, these matters may distract management and reduce the time and attention that they are able to devote to our business.

 

19
 

 

ITEM 1A.        RISK FACTORS.

 

Our business involves a number of challenges and risks. In addition to the other information in this report, you should consider carefully the following risk factors in evaluating us and our business. Moreover, the risks described below are not the only ones that we face. Additional risks not presently known to us or that we currently deem immaterial may also affect our business, financial condition, operating results, or prospects.

 

Risks Related to Our Business and Industry

 

Material changes in the life insurance secondary market, a relatively new and evolving market, may adversely affect our operating results, business prospects and our ability to repay our debt obligations.

 

Our sole business is the purchase and ownership of life insurance policies acquired in the secondary market, which is a relatively new and evolving market. The success of our business and our ability to satisfy our debt obligations depends in large part on the continued development of the secondary market for life insurance, including the solvency of life insurance companies to pay the face value of the life insurance benefits, both of which will critically impact the performance of the life insurance policy assets we own. We expect that the development of the secondary market will primarily be impacted by a variety of factors such as the interpretation of existing laws and regulations (including laws relating to insurable interests), the passage of new legislation and regulations, mortality improvement rates, and actuarial understandings and methodologies. Importantly, all of the factors that we believe will most significantly affect the development of the life insurance secondary market are beyond our control. Any material and adverse development in the life insurance secondary market could adversely affect our operating results, our access to capital, our ability to repay our various debt and other obligations, and our business prospects and viability. Because of this, an investment in our securities generally involves greater risk as compared to investments offered by companies with more diversified business operations in more established markets.

 

We have a relatively limited history of operations and our earnings and cash flows may be volatile, resulting in uncertainty about our ability to service and repay our debt when and as it comes due.

 

We are a company with a limited history, which makes it difficult to accurately forecast our earnings and cash flows. During the year ended December 31, 2014, we incurred a net loss of $6.0 million, and in the year ended December 31, 2013, we incurred a net loss of $0.2 million. Our lack of a significant history and the evolving nature of the market in which we operate make it likely that there are risks inherent in our business that are yet to be recognized by us or others, or not fully appreciated, and that could result in us earning less than we anticipate or even suffering further anticipated or unanticipated losses. As a result of the foregoing an investment in our company’s securities necessarily involves uncertainty about the stability of our earnings, cash flows and, ultimately, our ability to service and repay our debt. In addition, any earnings volatility we experience may adversely affect the market price of our common stock.

 

The valuation of our principal assets on our balance sheet requires us to make material assumptions that may ultimately prove to be incorrect. In such an event, we could suffer significant losses that could materially and adversely affect our results of operations and eventually cause us to be in default of restrictive covenants contained in our borrowing agreements.

 

Our principal asset is a portfolio of life insurance policies purchased in the secondary market, comprising approximately 88% of our total assets at December 31, 2014 and 85% of our total assets at December 31, 2013. Those assets are considered “Level 3” fair value measurements under ASC 820, Fair Value Measurements and Disclosures, as there is currently no active market where we are able to observe quoted prices for identical assets. As a result, our valuation of those assets on our balance sheet incorporates significant inputs that are not observable. Fair value is defined as an exit price representing the amount that would be received if assets were sold or that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability.

 

A Level 3 fair value measurement is inherently uncertain and creates additional volatility in our financial statements that is not necessarily related to the performance of the underlying assets. As of December 31, 2014 and 2013, we estimated the fair value discount rate for our portfolio to be 11.43% and 11.69%, respectively. If in the future we determine that a higher discount rate is required to ascribe fair value to a similarly situated portfolio of life insurance policies, we could experience significant losses materially affecting our results of operations. It is also possible that significant losses of this nature could at some point cause us to fall out of compliance with borrowing covenants contained in our various borrowing agreements. This could result in acceleration of our loan balances under the revolving credit facility or securities issued under our indenture, such as our Series I Secured Notes and our L Bonds, which we may not be able to repay. As a result, we may be forced to seek additional debt or equity financing to repay such debt amounts, and additional financing may not be available on terms acceptable to us, if at all. If we are unable to repay our debt when it comes due, then our senior lender or the holders of our Series I Secured Notes and L Bonds, or both would have the right to foreclose on our assets.

 

20
 

 

We  report non-GAAP financial measures to our lender under our revolving credit facility pursuant to financial covenants in the related borrowing documents. This presents operating results not subject to the valuation volatility associated with the discount rate we choose, thus presenting the actuarial performance we expect within our portfolio of life insurance policies at the expected internal rate of return against the costs we incur over the same period. Nevertheless, our reported GAAP earnings may in the future be volatile for reasons that do not bear an immediate relationship to the cash flows we experience.

 

For further disclosure relating to the risks associated with the valuation of our assets, see the risk factor below “If actuarial assumptions we obtain from third-party providers . . . .”

 

Our actual results from our life insurance portfolio may not match our expected results, which could adversely affect our ability to service and grow our portfolio for diversification.

 

Our business model relies on achieving actual results that are in line with the results we expect to attain from our investments in life insurance policy assets. In this regard, we believe that the larger the portfolio we own, the greater the likelihood that we will achieve our expected results. To our knowledge, rating agencies generally suggest that portfolios of life insurance policies containing enough policies on individual lives to achieve actuarial stability in receiving expected cash flows from underlying mortality. For instance, in a study published in 2012, A.M. Best concluded that at least 300 lives are necessary to narrow the band of cash flow volatility and achieve actuarial stability, while Standard & Poor’s has indicated that stability is unlikely to be achieved with a pool of less than 1,000 lives. As of December 31, 2014, we owned $779 million in face value of life insurance policies covering 265 lives. Accordingly, while there is a risk with a portfolio of any size that actual yield may be less than expected; we believe that the risk we face is presently more significant given the size of our current portfolio as compared to rating agency recommendations.

 

Although we plan to expand the number of life insurance policies we own using proceeds raised from our continuous offering of L Bonds, we may be unable to meet this goal if sufficient financing from capital sources is not available or is available only on unfavorable or unacceptable terms. Furthermore, even if our portfolio reaches the size we desire, we still may experience differences between the actuarial models we use and actual mortalities.

 

Differences between our expectations and actuarial models on the one hand, and actual mortality results on the other hand, could have a materially adverse effect on our operating results and cash flow. In such a case, we may face liquidity problems, including difficulties servicing our remaining portfolio of policies and servicing our outstanding debt obligations. Continued or material failures to meet our expected results could decrease the attractiveness of our securities in the eyes of potential investors making it even more difficult to obtain capital needed to service our portfolio, grow the portfolio to obtain desired diversification, and service our existing debt.

 

We critically rely on debt financing for our business. Any inability to borrow could adversely affect our business operations, our ability to satisfy our obligations under the debentures and, ultimately, our viability.

 

To date, we have chosen to finance our business principally through the issuance of debt, including debt incurred by DLP II under a senior revolving credit facility provided by Autobahn/DZ Bank (which we refer to throughout this report as our “revolving credit facility”), our Series I Secured Notes and our L Bonds. Our revolving credit facility is secured by all of the assets of DLP II, has a maximum amount of $100 million, and the outstanding balance at December 31, 2014 was approximately $72 million. Obligations under the revolving credit facility have a scheduled maturity date of December 31, 2016, and obligations under our Series I Secured Notes and L Bonds have scheduled maturities as indicated below in the risk factor “If a significant number of holders . . . .,” Our debt arrangements comprise the most important sources of financing on which our business critically relies to grow our portfolio life insurance policies and maintain those policies.

 

Our business model expects that we will have continued access to financing to enable us to purchase a large and diversified portfolio of life insurance policies and pay the attendant premiums and costs of maintaining the portfolio, all while satisfying our current interest and principal repayment obligations under our revolving credit facility and other indebtedness. We expect to refinance our revolving credit facility, either through renewal or replacement, when it comes due on December 31, 2016. Pending the due date or refinancing of our revolving credit facility, we expect that proceeds from our life insurance policies will first be used to satisfy our obligations under that facility, as required by the agreement governing the revolving credit facility. Accordingly, until we achieve sufficient cash flows derived from the portfolio of life insurance policy benefits, we expect to rely on the proceeds from our ongoing offering of L Bonds to satisfy our ongoing financing and liquidity needs. Nevertheless, continued access to financing and liquidity under the revolving credit facility or otherwise is not guaranteed. For example, general economic conditions could limit our access to financing, as could regulatory or legal pressures exerted on us, our financiers, or those involved in our general plan of financing such as brokers, dealers, and registered investment advisors. If we are unable to borrow under the revolving credit facility or otherwise for any reason, or to renew or replace the revolving credit facility when it comes due in December 2016, our business would be adversely impacted and our ability to service and repay our obligations would be compromised.

 

21
 

 

Our investments in life insurance policies have inherent risks, including fraud and legal challenges to the validity of the policies, which we will be unable to eliminate and which may adversely affect our results of operations.

 

When we purchase a life insurance policy, we underwrite the purchase of the policy to mitigate certain risks associated with insurance fraud and other legal challenges to the validity of the policy. For example, to the extent the insured is not aware of the existence of the policy, the insured does not exist, or the insurance company does not recognize the policy, the insurance company may cancel or rescind the policy thereby causing the loss of an investment in that policy. In addition, if an insured’s medical records have been altered in such a way as to shorten a life expectancy as reported, this may cause us to overpay for the related policy. Finally, we may experience legal challenges from insurance companies claiming that the insured failed to have an insurable interest at the time the policy was originally purchased or that the policy owner made fraudulent disclosures to the insurer at the time the policy was purchased (e.g., disclosures pertaining to the health status of the insured or the existence or sources of premium financing), or challenges from the beneficiaries of an insurance policy claiming, upon mortality of the insured, that the sale of the policy to us was invalid.

 

To mitigate these risks, we require a current verification of coverage from the insurance company, complete a due-diligence investigation of the insured and accompanying medical records, review the life insurance policy application, require a policy to have been in force for at least two years before purchasing, and require a legal review of any premium financing associated with the life insurance policy to determine an appropriate insurable interest existed. Nevertheless, we do not expect that these steps will eliminate the risk of fraud or legal challenges to the life insurance policies we purchase. Furthermore, changes in laws or regulations or the interpretation of existing laws or regulations, may prove our due-diligence and risk-mitigation efforts inadequate if policies within our portfolio are successfully challenged. These changes or alterations in interpretation may inhibit our ability to purchase new policies with confidence. If a significant face amount of policies were invalidated for reasons of fraud or any other reason, our results of operations would be adversely affected, perhaps materially.

 

Every acquisition of a life insurance policy necessarily requires us to materially rely on information provided or obtained by third parties. Any misinformation or negligence in the course of obtaining information could materially and adversely affect the value of the policies we own.

 

The acquisition of each life insurance policy is negotiated based on variables and particular facts that are unique to the life insurance policy itself and the health of the insured. The facts we obtain about the policies and the insured at the time at which the policy is applied for and obtained are based on factual representations made to the insurance company by the insured, and the facts the insurance company independently obtains in the course of its own due-diligence examination, such as facts concerning the health of the insured and whether or not there is an insurable interest present when the policy was issued. Any misinformation or negligence in the course of obtaining information relating to an insurance policy or insured could materially and adversely impact the value of the life insurance policies we own and could, in turn, adversely affect our financial condition, results of operations, and the value of any investment in our securities.

 

Our business is subject to state regulation and changes in state laws and regulations governing our business, or changes in the interpretation of such laws and regulations, could negatively affect our business.

 

When we purchase a life insurance policy, we are subject to state insurance regulations. Over the past years, we have seen a dramatic increase in the number of states that have adopted legislation and regulations from model laws promulgated by either the National Association of Insurance Commissioners (NAIC) or by the National Conference of Insurance Legislators (NCOIL). These laws are essentially consumer protection statutes responding to abuses that arose early in the development of our industry, some of which may persist. Today, almost every state has adopted some version of either the NAIC or NCOIL model laws, which generally require the licensing of purchasers of and brokers for life insurance policies, the filing and approval of purchase agreements, and the disclosure of transaction fees. These laws also require various periodic reporting requirements and prohibit certain business practices deemed to be abusive.

 

State statutes typically provide state regulatory agencies with significant powers to interpret, administer, and enforce the laws relating to the purchase of life insurance policies. Under statutory authority, state regulators have broad discretionary power and may impose new licensing requirements, interpret or enforce existing regulatory requirements in different ways or issue new administrative rules. State regulators may also impose rules that are generally adverse to our industry. Because the life insurance secondary market is relatively new and because of the history of certain abuses in the industry, we believe it is likely that state regulation will increase and grow more complex during the foreseeable future. We cannot, however, predict what any new regulation would specifically involve.

 

22
 

 

Any adverse change in present laws or regulations, or their interpretation, in one or more states in which we operate (or an aggregation of states in which we conduct a significant amount of business) could result in our curtailment or termination of operations in such jurisdictions, or cause us to modify our operations in a way that adversely affects our profitability. Any such action could have a corresponding material and negative impact on our results of operations and financial condition, primarily through material decrease in revenues, and could also negatively affect our general business prospects.

 

If federal regulators or courts conclude that the purchase of life insurance in the secondary market constitutes, in all cases, a transaction in securities, we could be in violation of existing covenants under our revolving credit facility, which could result in significantly diminished access to capital. We could also face increased operational expenses. The materialization of any of these risks could adversely affect our operating results and possibly threaten the viability of our business.

 

The SEC has, on occasion, attempted to regulate the purchase of non-variable universal life insurance policies as transactions in securities under federal or state securities laws. In July 2010, the SEC issued a Staff Report of its Life Settlement Task Force. In that report, the Staff recommended that certain types of purchased insurance policies be classified as securities. The SEC has not taken any position on the Staff Report, and there is no indication if the SEC will take any action to implement the recommendations of the Staff Report. In addition, there have been several federal court cases in which transactions involving the purchase and fractionalization of life insurance contracts have been held to be transactions in securities under the federal Securities Act of 1933. We believe that the matters discussed in the Staff Report and existing case law, do not impact our current business model since our purchases of life settlements are distinguishable from those cases that have been held by courts, and advocated by the Staff Report, to be transactions in securities. For example, neither we nor any of our affiliates are involved in the fractionalization of life insurance policies, and we presently do not purchase variable life insurance policies.

 

As a practical matter, the widespread application of federal securities laws to our purchases of life insurance policies, either through the expansion of the definition of what constitutes a “security,” the expansion of the types of transactions in life insurance policies that would constitute transactions in “securities,” or the elimination or limitation of available exemptions and exceptions (whether by statutory change, regulatory change, or administrative or court interpretation) could burden us and other companies operating in the life insurance secondary market through the imposition of additional processes in the purchase of life insurance policies or the imposition of additional corporate governance and operational requirements through the application of the federal Investment Company Act of 1940. Any such burdens could be material. In particular, we might be placed in a position where we might be in violation of existing covenants under our revolving credit facility requiring us not to operate or be characterized as an “investment company” under the Investment Company Act of 1940, which could in the short or long term affect our liquidity and increase our cost of capital and operational expenses, all of which would adversely affect our operating results. It is possible that such an outcome could threaten the viability of our business and our ability to satisfy our obligations as they come due.

 

Being a public company results in additional expenses and diverts management’s attention, and could also adversely affect our ability to attract and retain qualified officers and directors.

 

We have been a public reporting company since January 31, 2012. As a public reporting company, we are subject to the reporting requirements of the Securities Exchange Act of 1934. These requirements generate significant accounting, legal, and financial compliance costs, and make some activities more difficult, time consuming or costly, and may place significant strain on our personnel and resources. The Securities Exchange Act of 1934 requires, among other things, that we maintain effective disclosure controls and procedures and internal control over financial reporting. In order to establish the requisite disclosure controls and procedures and internal control over financial reporting, significant resources and management oversight are required.

 

As a result, management’s attention may be diverted from other business concerns, which could have an adverse and even material effect on our business, financial condition, and results of operations. These rules and regulations may also make it more difficult and expensive for us to obtain director and officer liability insurance. If we are unable to obtain appropriate director and officer insurance, our ability to recruit and retain qualified officers and directors, especially those directors who may be deemed independent, could be adversely impacted.

 

23
 

 

Our business and prospects may be adversely affected by changes, lack of growth, or increased competition in the life insurance secondary market.

 

The growth of the life insurance policy secondary market and our expansion within the market may be negatively affected by a variety of factors beyond our control, including:

 

the inability to locate sufficient numbers of life insurance policy sellers and agents to source life sellers;

 

the inability to convince life insurance policy owners of the benefits of selling their life insurance policy;

 

competition from other companies in the life insurance secondary market;

 

negative publicity about the life insurance secondary market based on actual or perceived abuses; and

 

the adoption of additional governmental regulation.

 

The relatively new and evolving nature of the market in which we operate makes these risks unique and difficult to quantify. Nevertheless, contractions in the secondary market for life insurance policies, whether resulting from general economic conditions, regulatory or legal pressures, or otherwise (including regulatory pressures exerted on us or others involved in the secondary market for life insurance or involved with participants in that market), could make participation in the market generally less desirable. This could, in turn, depress the prices at which life insurance policies on the secondary market are bought and sold. As indicated elsewhere in this report, decreases in the value of life insurance policies on the secondary market could negatively affect our results of operations and our financial condition since the value of our policy portfolio is marked to market on a quarterly basis.

 

Changes in general economic conditions could adversely impact our business.

 

Changes in general economic conditions, including, for example, interest rates, investor sentiment, changes specifically affecting the insurance industry, competition, technological developments, political and diplomatic events, tax laws, and other factors not known to us today, can substantially and adversely affect our business and prospects. For example, changes in interest rates may increase our cost of capital and ability to raise capital, and have a corresponding adverse impact on our operating results. While we may engage in certain hedging activities to mitigate the impact of these changes, none of these conditions are or will be within our control.

 

If actuarial assumptions we obtain from third-party providers and rely on to model our expected returns on our investments in life insurance policies change, our operating results and cash flow could be adversely affected, as well as the value of our collateral and our ability to service our debt obligations.

 

The expected internal rate of return we calculate we will earn when purchasing a life insurance policy is based upon a probability curve estimate of how long the insured will live—an actuarial life expectancy estimate. We presently obtain actuarial life expectancy estimates from third-party medical-actuarial underwriting companies. In the case of small face policies, which we currently define as life insurance policies with $1.0 million or less in face value of policy benefits, we may choose not to obtain life expectancies from third-party medical-actuarial firms, but rather use standard mortality tables to develop our own life expectancy of an insured. All actuarial life expectancies are subject to interpretation and change based on evolving medical technology, actuarial data, and analytical techniques. Any increase in the actuarial life expectancy estimates of insureds within our portfolio could have a materially adverse effect on our operating results and cash flow. Adverse impacts on the value of our life insurance policy portfolio or our cash flow could in turn impair the value of the collateral we have pledged to our creditors and our ability to service our debt and obligations as they come due.

 

For example, on January 22, 2013, 21st Services, an independent provider of life expectancy analysis and related services for the life settlement industry in general, announced advancements in its underwriting methodology, resulting in revised life expectancy mortality tables for life settlement transactions. These revised actuarial calculations had an adverse effect on the valuation of portfolio at December 31, 2012. It is possible that the life expectancies we presently use will again change in the future or that the life expectancy assumptions will fail substantially to meet actuarial estimates, and that any such failure could have a materially adverse effect on our business.

 

On September 15, 2014, 21st Services announced further changes to its mortality tables primarily for insureds age 90 and older, as well as updated adjustment factors designed to better underwrite seniors with multiple impairments. Although these changes represent small portions of 21st Services’ historical underwritings and were not material to the Company’s portfolio of life insurance policies, we expect medical-actuarial underwriting firms to continue improving and refining their underwriting methodology. As a result, we will continue to monitor developments in medical-actuarial methodologies. We generally expect to incorporate such changes to our portfolio when we update our life expectancy reports.

 

24
 

 

In addition to actuarial life expectancies, we rely on pricing and premium forecasting software models developed by third-party actuarial companies for the valuation of policies we purchase, future mortality revenues, and the calculation of anticipated internal rates of return. These pricing models forecast the estimated future premiums due as well the future mortalities based on the survival probabilities of the insureds over their life expectancies. It is possible that the actuarial tables we presently use will again change the future or that the mortality assumptions will fail substantially to meet actuarial estimates, and that any such failure could have a materially adverse effect on our business.

 

We rely on estimated rates of mortality for the actuarial assumptions we use when valuing life insurance policies and forecasting the performance of our portfolio, and we also rely on other estimates derived from statistical methodologies for projecting our future cash flows, among other things. If our estimates prove to be incorrect, it could materially and adversely affect our ability to satisfy our debt service and repayment obligations.

 

If we assume we will receive cash inflows from policies sooner than we actually do, we may not be able to make payment on our debt obligations in a timely manner, or at all. Moreover, a significant medical discovery or advance that results in mortality improvements among seniors, above historically predicted actuarial rates could have a material adverse effect on our life insurance policy investments.

 

For example, we use a modeling method for projecting cash flows known as the “probabilistic method.” This is an actuarial method that uses a mortality curve to project the likely flow of policy benefits to us, and attempts to reflect the probability that each premium must be paid. Since we have owned our current insurance policy portfolio we have in fact experienced fewer cash flows from policy benefits than projected in the early stages of ownership of our current life insurance policy portfolio using this method. We had expected to receive approximately $108.7 million cumulative policy benefits as of December 31, 2014, and in fact received $46.6 million. This has resulted in greater than expected premium payments, increasing such expected payments from an expected $79.7 million to $84.2 million. Barring significant mortality improvements (i.e., medical discoveries or advancements relating to the medical conditions of insureds), however, the fact that actual results have differed from the expectations derived from the probabilistic method of projecting cash flows should ordinarily result in greater cash flows later in the portfolio’s servicing period.

 

We update and revise our projected future cash flows each month using the probabilistic method to reflect the actual experience within our life insurance policy portfolio to date. We use the current future cash flow projection to generate our expected internal rate of return on the life insurance policy portfolio we own. We would expect to change our method of calculating our future cash flows only if leading actuarial firms determined that such a methodology was no longer the most appropriate means of projecting cash flows from a life insurance policy portfolio. Any change to the pricing model, methodology, premium forecasting assumptions, cash flow projections, or the mortality assumptions accompanied therewith that increase the projected cost of insurance premiums or decrease the probability of mortality could have a material and adverse impact on our results of operations and cash flows. Ultimately, this could adversely affect our ability to meet our debt service and repayment obligations and our viability.

 

Risks Unique to Our Company

 

We may not be able to raise the capital that we are seeking, and may be unable to meet our overall business objectives of growing a larger, more statistically diverse portfolio of life insurance policies without the proceeds from our continuous offering of L Bonds.

 

Our offering of L Bonds has been the principal means by which we have raised the funds needed to meet our goal of growing a larger and more statistically diverse portfolio that is more likely to meet our cash flow projections. While we plan to continue financing our business, if we are unable to continue to do so for any reason we may be unable to meet our goal. In addition, if holders of our Series I Secured Notes or L Bonds were to fail to renew those securities with the frequency we have historically experienced, and actual cash flows from our portfolio of life insurance policies do not occur as our actuarial projections have forecasted, we could be forced to sell our investments in life insurance policies in order to service or satisfy our debt-related obligations. If we are forced to sell investments in life insurance policies or our entire portfolio, we may be unable to sell them at prices we believe are appropriate, and may not be able to sell them at prices that approximate the discount rate we have applied to value our portfolio, particularly if our sale of policies occurs at a time when we are (or are perceived to be) in distress. In any such event, our business and the value of our securities, including our debt securities and common stock, may be materially and adversely impacted.

 

25
 

 

We depend upon cash distributions from our subsidiaries, and contractual restrictions on distributions to us or adverse events at one of our operating subsidiaries could materially and adversely affect our ability to pay our debts and to continue to operate our business.

 

GWG Holdings, Inc. is a holding company. As a holding company, we conduct our operations through our operating subsidiaries, and our only significant assets are the capital stock of our subsidiaries. Accordingly, our ability to meet our cash obligations, including our obligations under the L Bonds, depends in material part upon the ability of our subsidiaries to make cash distributions to us. In this regard, the ability of our subsidiaries to make distributions to us is, and will continue to be, restricted by certain negative covenants in the agreement governing our revolving credit facility. DLP Funding II is the borrower under our revolving credit facility (see note 5 to our consolidated financial statements). The significant majority of the insurance policies we own are subject to a collateral arrangement with the agent for our revolving credit lender, as described in note 2 to our consolidated financial statements. Under this arrangement, collection and escrow accounts are used to fund purchases of and premiums for our insurance policies and to pay interest and other charges under the revolving credit facility. The lender and its agent must authorize all disbursements from these accounts, including any distributions to GWG Life. Distributions are limited to an amount that would result in the borrowers (us) realizing an annualized rate of return on the equity funded amount for such assets of not more than 18%, as determined by the agent. After such amount is reached, the credit agreement requires that excess funds be used to fund repayments or a reserve account in a certain amount, before any additional distributions may be made.

 

If any of the above limitations were to materially impede the flow of cash to us, such fact would materially and adversely affect our ability to service and repay our debt, including obligations under the L Bonds and Series I Secured Notes. In addition, any adverse event at the subsidiary level, such as a declaration of bankruptcy, liquidation or reorganization or an event of default under our revolving credit facility, could materially and adversely affect the ability of our subsidiaries to make cash distributions to us. Just as with a material contractual impediment to cash flow, any such subsidiary corporate event would materially and adversely affect our ability to service and repay our debt, including obligations under the L Bonds, and negatively impact our ability to continue operations.

 

If a significant number of holders of our Series I Secured Notes and L Bonds demand repayment of those instruments instead of renewing them, and at such time we do not have sufficient capital on hand to fund such repayment (and do not otherwise have access to sufficient capital), we may be forced to liquidate some of our life insurance assets, which could have a material and adverse impact on our results of operations and financial condition.

 

As of December 31, 2014 we had approximately $186.4 million of L Bonds outstanding. In addition, our direct and wholly owned subsidiary, GWG Life, had issued and outstanding approximately $28.0 million in Series I Secured Notes as of December 31, 2014. By virtue of GWG Life’s full and unconditional guarantee of obligations under the L Bonds, and other agreements contained in or made in connection with the indenture, the L Bonds are pari passu in right of payment and collateral with the Series I Secured Notes. The indenture governing the L Bonds, and the note issuance and security agreement governing the Series I Secured Notes, each provide for cross defaults upon an event of default under the provisions of the other agreement (i.e., an event of default under the note issuance and security agreement will constitute an event of default under the indenture for the L Bonds, and vice-versa).

 

The terms of the Series I Secured Notes have renewal features. Since we first issued our Series I Secured Notes, we have experienced $133.7 million in maturities, of which $104.0 million has renewed for an additional term as of December 31, 2014. This has provided us with an aggregate renewal rate of approximately 78% for investments in our Series I Secured Notes. The terms of the L Bonds also have renewal features. Since we first issued our L Bonds, we have experienced $62.3 million in maturities, of which $41.4 million has renewed for an additional term as of December 31, 2014. This has provided us with an aggregate renewal rate of approximately 66% for investments in the currently outstanding L Bonds. Future contractual maturities of Series I Secured Notes and L Bonds at December 31, 2014 are as follows:

 

Years Ending December 31,  Series I Secured Notes   L Bonds   Total 
2015  $13,887,000   $63,375,000   $77,262,000 
2016   8,242,000    50,270,000    58,512,000 
2017   4,713,000    29,546,000    34,259,000 
2018   754,000    13,551,000    14,305,000 
2019   347,000    14,262,000    14,609,000 
Thereafter   104,000    15,373,000    15,477,000 
   $28,047,000   $186,377,000   $214,424,000 

 

If investors holding existing indebtedness with short-term maturities do not elect to renew and we do not, at such time, have access to sufficient capital or have not raised sufficient capital by other financing efforts, we may need to liquidate some of our investments in life insurance policies earlier than anticipated. In such an event, we may be unable to sell those life insurance policies at prices we believe are fair or otherwise appropriate and such sales could have a material and adverse impact on our results of operations.

 

26
 

 

Because we intend to hold our life insurance policies to their maturity, we therefore measure our debt coverage ratio against our current cost of financing, which may not reflect the sale price of our life insurance policies if we were to liquidate them.

 

We intend to hold our life insurance policy investments until they are paid out at the mortality of the insured. As a result, we measure our debt coverage ratio based on the portfolio’s gross expected yield against the interest cost of our total debt obligations to finance the portfolio. The debt coverage ratio, expressed as a percentage, is defined as the ratio of (i) total amounts outstanding on any indebtedness for borrowed money, over (ii) the net present asset value of all life insurance assets we own, plus any cash held in our accounts. For this purpose, the net present asset value of our life insurance assets is calculated as the present value of the life insurance portfolio’s expected future cash flows discounted at the weighted-average interest rate of the indebtedness for the previous month. Under the indenture, the maximum amount of such securities we may issue at any time is limited to an amount such that our debt coverage ratio does not exceed 90%. This limitation is designed to provide some comfort to holders of our debt that the value of our assets exceeds our obligations to those holders. Nevertheless, the debt coverage ratio (as calculated) is not based on the fair value of our life insurance assets, which may be different — greater or less—than the amount we would receive if we were forced to sell those assets in the marketplace. Furthermore, mere compliance with the debt coverage ratio does not contemplate or account for the significant transactional costs that could be associated with a sale of all or any significant portion of our portfolio.

 

Our controlling stockholders and principal executives are involved in litigation “clawback” claims, and it is possible that the trustee may assert claims against our company or that other adverse outcomes could negatively affect the Company.

 

Our Chief Executive Officer, Jon R. Sabes, and our corporate secretary and Executive Vice President of Originations and Servicing, Steven F. Sabes, who together beneficially own or control approximately 74.8% of our common stock, are subject to litigation relating to claims by a bankruptcy trustee for loan payments made to an affiliate, Opportunity Finance, LLC. The litigation stems from the 2010 conviction of an individual operating a fraudulent business, which business filed for bankruptcy in 2008. The bankruptcy trustee alleges that loan repayments to Opportunity Finance were avoidable transfers under preference or other legal theories and seeks to recover amounts for other creditors of the bankruptcy estate. Case No. 08-45257 (U.S. Bankruptcy Court District of Minnesota). Such payments may ultimately be deemed to be avoidable transfers under preference or other legal theories. In addition, GWG Holdings invested $1.0 million in Opportunity Finance, LLC in 2006 and was repaid and received $176,948 of interest income from that investment in 2007.  To date no claim has been made against the Company.

 

While we believe there are numerous meritorious defenses to the claims made by the bankruptcy trustee and others, and we are advised that the defendants in that action will vigorously defend against the trustee’s claims, such defendants may not prevail in the litigation. If the bankruptcy trustee or a successful private plaintiff sought to sell or transfer the equity interests of Jon R. Sabes or Steven F. Sabes as a result of the litigation, there could be a change in control of the Company, and our business together with all of our investors, including investors in our debentures, could be materially and adversely impacted. Such adverse results would likely arise in connection with negative change-in-control covenants contained in our revolving credit facility agreements, the breach of those covenants and an ensuing event of default under such facility. In addition, if the bankruptcy trustee or a private plaintiff sought to sell or transfer the equity interests of Jon R. Sabes or Steven F. Sabes as a result of the litigation, such transfers would adversely affect holders of our previously issued L Bonds by reducing the number of shares of common stock of GWG Holdings that have been pledged as collateral security for our obligations under the debentures. Finally, regardless of the outcome of this litigation, these matters may distract management and reduce the time and attention that they are able to devote to our business.

 

The loss of the services of our current executives or other key employees, or the failure to attract additional key individuals, would materially adversely affect our business operations and prospects.

 

Our financial success is dependent to a significant degree upon the efforts of our current executive officers and other key employees. In addition, our revolving credit facility requires Messrs. Jon R. Sabes and Steven F. Sabes to generally remain active within the business. We have entered into employment agreements with Messrs. Jon R. Sabes, Steven F. Sabes, Paul A. Siegert, William B. Acheson, Michael D. Freedman and Jon L. Gangelhoff. Nevertheless, there can be no assurance that these individuals will continue to provide services to us. A voluntary or involuntary termination of employment could have a materially adverse effect on our business operations if we were not able to attract qualified replacements in a timely manner. At present, we do not maintain key-man life insurance policies for any of these individuals. In addition, our success and viability is also dependent to a significant extent upon our ability to attract and retain qualified personnel in all areas of our business, especially our sales, policy acquisition, and financial management team. If we were to lose the members of these service teams, we would need to replace them with qualified individuals in a timely manner or our business operations and prospects could be adversely impacted.

 

27
 

 

We are an “emerging growth company” and our election to delay adoption of new or revised accounting standards applicable to public companies may result in our financial statements not being comparable to those of some other public companies. As a result of this and other reduced disclosure requirements applicable to emerging growth companies, our securities may be less attractive to investors.

 

As a public reporting company with less than $1.0 billion in revenue during our last fiscal year, we qualify as an “emerging growth company” under the Jumpstart Our Business Startups Act of 2012, or the JOBS Act. An emerging growth company may take advantage of certain reduced reporting requirements and is relieved of certain other significant requirements that are otherwise generally applicable to public companies. In particular, as an emerging growth company we:

 

are not required to obtain an attestation and report from our auditors on our management’s assessment of our internal control over financial reporting pursuant to the Sarbanes-Oxley Act of 2002;

 

are not required to provide a detailed narrative disclosure discussing our compensation principles, objectives and elements and analyzing how those elements fit with our principles and objectives (commonly referred to as “compensation discussion and analysis”);

 

are not required to obtain a non-binding advisory vote from our stockholders on executive compensation or golden parachute arrangements (commonly referred to as the “say-on-pay,” “say-on-frequency” and “say-on-golden-parachute” votes);

 

are exempt from certain executive compensation disclosure provisions requiring a pay-for-performance graph and CEO pay ratio disclosure;

 

may present only two years of audited financial statements and only two years of related Management’s Discussion & Analysis of Financial Condition and Results of Operations, or MD&A; and

 

are eligible to claim longer phase-in periods for the adoption of new or revised financial accounting standards under §107 of the JOBS Act.

 

We intend to take advantage of all of these reduced reporting requirements and exemptions, including the longer phase-in periods for the adoption of new or revised financial accounting standards under §107 of the JOBS Act. Our election to use the phase-in periods may make it difficult to compare our financial statements to those of non-emerging growth companies and other emerging growth companies that have opted out of the phase-in periods under §107 of the JOBS Act.

 

Certain of these reduced reporting requirements and exemptions were already available to us due to the fact that we also qualify as a “smaller reporting company” under SEC rules. For instance, smaller reporting companies are not required to obtain an auditor attestation and report regarding management’s assessment of internal control over financial reporting; are not required to provide a compensation discussion and analysis; are not required to provide a pay-for-performance graph or CEO pay ratio disclosure; and may present only two years of audited financial statements and related MD&A disclosure.

 

Under the JOBS Act, we may take advantage of the above-described reduced reporting requirements and exemptions for up to five years after our initial sale of common equity pursuant to a registration statement declared effective under the Securities Act of 1933, or such earlier time that we no longer meet the definition of an emerging growth company. In this regard, the JOBS Act provides that we would cease to be an “emerging growth company” if we have more than $1.0 billion in annual revenues, have more than $700 million in market value of our common stock held by non-affiliates, or issue more than $1.0 billion in principal amount of non-convertible debt over a three-year period. Furthermore, under current SEC rules we will continue to qualify as a “smaller reporting company” for so long as we have a public float (i.e., the market value of common equity held by non-affiliates) of less than $75 million as of the last business day of our most recently completed second fiscal quarter.

 

We cannot predict if investors will find our securities less attractive due to our reliance on these exemptions. If investors were to find our securities less attractive as a result of our election, we may have difficulty raising all of the proceeds we seek in our continuous offering of the L Bonds. In addition, the market price of our common stock may suffer.

 

ITEM 1B.        UNRESOLVED STAFF COMMENTS.

 

Not applicable.

 

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ITEM 2.        PROPERTIES.

 

Our principal executive offices are located at 220 South Sixth Street, Suite 1200, Minneapolis, Minnesota 55402. At that location, we lease 11,695 square feet of space for a lease term expiring in August 2015. We believe that these facilities are adequate for our current needs and that suitable additional space will be available as needed.

 

ITEM 3.        LEGAL PROCEEDINGS.

 

None.

 

ITEM 4.        MINE SAFETY DISCLOSURES.

 

Not applicable.

 

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PART II

 

ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.

 

On September 24, 2014, we consummated an initial public offering of our common stock which resulted in the sale of 800,000 shares of common stock at $12.50 per share. The sale resulted in net proceeds of approximately $8.6 million after the deduction of underwriting commissions, discounts, and expense reimbursements. In connection with this offering, our common stock was listed on The NASDAQ Capital Market under the ticker symbol “GWGH” effective September 25, 2014. We used the net proceeds from the offering to promote and advertise the opportunities for consumers owning life insurance and investors to profit from participating in the secondary market for life insurance policies, to purchase additional life insurance policies in the secondary market, to pay premiums on our life insurance policy assets, to fund its portfolio operations, and for working capital purposes.

 

The following table shows the high and low sales for our common stock for the periods indicated, as reported by NASDAQ:

 

Quarter Ended  High   Low 
September 30, 2014  $17.47   $10.25 
December 31, 2014  $10.25   $6.05 

 

As of March 13, 2015 we had 133 holders of record of our common stock.

 

Our Form S-1 registration statement relating to our public offer and sale of “Renewable Secured Debentures” (File Nos. 333-174887 and 333-174887-01) was declared effective by the SEC on January 31, 2012, and our offering of those securities commenced on such date. The debentures – since renamed “L Bonds” – are secured in part by a guarantee from our subsidiary GWG Life and an associated grant of a security interest in substantially all of the assets of GWG Life, which guarantee was also registered as a security under the referenced registration statement. Arque Capital Ltd. served as our managing broker-dealer and underwriter for the offering.

 

The registration statement covered up to $250 million in principal amount of securities. From January 31, 2012 through December 31, 2014, we sold a total of $207,266,000 in principal amount of securities, and incurred associated underwriting commissions, and expenses paid or payable to underwriters in the amount of $11,535,000 of which $5,653,000 was amortized. As of December 31, 2014 we had $186,377,000 of those previously issued L Bonds outstanding plus $2,288,000 of subscriptions in process, less unamortized selling costs of $5,882,000, resulting in aggregate net proceeds of $182,783,000. None of the payments for offering expenses were directly or indirectly made to our directors or officers (or their associates), our affiliates, or to persons owning 10% or more of any class of our equity securities.

 

We used the net proceeds from the offering to acquire additional life insurance policies, as indicated below under the "Use of Proceeds" caption in the "Management's Discussion and Analysis of Financial Condition and Results of Operation" section of this report (Item 7). No net proceeds were used for direct or indirect payments to our directors or officers (or their associates), our affiliates, or to persons owning 10% or more of any class of our equity securities.

 

Unregistered Sales of Securities

 

In 2014 and 2013, our wholly owned subsidiary, GWG Life, sold $160,000 and $196,000, respectively, in principal amount of Series I Secured Notes in consideration of reinvested interest and commissions payable on account of earlier issued notes. GWG Holdings is a guarantor of GWG Life’s obligations under the Series I Secured Notes. The notes were offered and sold solely to accredited investors pursuant to a private placement exemption under Section 4(a)(2) of the Securities Act of 1933, and Regulation D/Rule 506 thereunder. Arque Capital Ltd. was the managing broker-dealer for the offering of the notes.

 

In 2014 and 2013, we issued 110,584 and 82,606 shares, respectively, of Series A Preferred Stock as in-kind dividends payable on account of the preferred stock. The preferred stock was issued solely to accredited investors in a private placement under Section 4(a)(2) of the Securities Act of 1933, and Regulation D/Rule 506 thereunder.

 

ITEM 6.        SELECTED FINANCIAL DATA.

 

Not applicable.

 

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

 

You should read the following discussion in conjunction with the consolidated financial statements and accompanying notes and the information contained in other sections of this report. This discussion and analysis is based on the beliefs of our management, as well as assumptions made by, and information currently available to, our management. The statements in this discussion and analysis concerning expectations regarding our future performance, liquidity and capital resources, as well as other non- historical statements, are forward-looking statements. These forward-looking statements are subject to numerous risks and uncertainties. Our actual results could differ materially from those suggested or implied by any forward-looking statements. Please see the “Risk Relating to Forward-Looking Statements” section of this form.

 

Overview

 

We are engaged in the emerging secondary market for life insurance policies. We acquire life insurance policies in the secondary market from policy owners desiring to sell their policies at a discount to the face value of the insurance benefit. Once we purchase a policy, we continue paying the policy premiums in order to ultimately collect the face value of the insurance benefit. We generally seek to hold the individual policies to maturity, in order to ultimately collect the policy’s face value upon the insured’s mortality. Our strategy is to build a profitable and large portfolio of policies that is diversified in terms of insurance carriers and the medical conditions of insureds. We believe that diversification among insureds, insurers, and medical conditions will lower our overall risk exposure, and that a larger number of individual policies (diversification in overall number) will provide our portfolio with greater actuarial stability.

 

In 2014, we recognized $13.9 million of revenue from the receipt of $18.0 million in policy benefits. In addition, we recognized revenue from the change in fair value of our life insurance policies, net of premiums and carrying costs, of $16.5 million. In 2014, interest expense, including amortization of the deferred financing costs and preferred stock dividends, was $26.7 million, and selling, general and administrative expenses were $12.1 million. Income tax benefit in 2014 was $2.4 million. Our net loss in 2014 was $6.0 million.

 

In 2013, we recognized $12.0 million of revenue from the receipt of $16.6 million in policy benefits. In addition, we recognized revenue from the change in fair value of our life insurance policies, net of premiums and carrying costs, of $17.5 million. In 2013, interest expense, including amortization of the deferred financing costs and preferred stock dividends, was $20.8 million, and selling, general and administrative expenses were $10.3 million. Income tax expense in 2013 was $2.2 million. Our net loss in 2013 was $0.2 million.

 

To date, we have financed our business principally through the issuance of debt, including debt incurred by our subsidiary DLP Funding II under a senior revolving credit facility provided by Autobahn/DZ Bank, Series I Secured Notes issued by our subsidiary GWG Life and our registered public offerings of L Bonds. See the “Liquidity and Capital Resources” caption below.

 

Critical Accounting Policies

 

Critical Accounting Estimates

 

The preparation of our consolidated financial statements in accordance with the Generally Accepted Accounting Principles (GAAP) requires us to make judgments, estimates, and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. We base our judgments, estimates, and assumptions on historical experience and on various other factors believed to be reasonable under the circumstances. Actual results could differ materially from these estimates. We evaluate our judgments, estimates, and assumptions on a regular basis and make changes accordingly. We believe that the judgments, estimates, and assumptions involved in the accounting for the valuation of investments in life insurance policies have the greatest potential impact on our consolidated financial statements and accordingly believe these to be our critical accounting estimates. Below we discuss the critical accounting policies associated with these estimates as well as certain other critical accounting policies.

 

Ownership of Life Insurance Policies—Fair Value Option

 

Our primary business involves the purchasing and financing of life insurance policies. As such, we account for the purchase of life insurance policies in accordance with Financial Accounting Standards Board’s Accounting Standards Codification (FASB ASC) 325-30, Investments in Insurance Contracts, which requires us to use either the investment method or the fair value method. We have elected to account for these life insurance policies as investments using the fair value method.

 

We initially record our purchase of life insurance policies at the transaction price, which is the amount paid for the policy, inclusive of all fees and costs associated with the acquisition. The fair value of our investment in the portfolio of insurance policies is evaluated at the end of each reporting period. Changes in the fair value of the portfolio of life insurance policies are based on periodic evaluations and are recorded as changes in fair value of life insurance policies in our consolidated and combined statement of operations. The fair value is determined as the net present value of the life insurance portfolio’s future expected cash flows that incorporates current life expectancy estimates and discount rate assumptions.

 

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In addition to reporting our results of operations and financial condition based on the fair value of our life insurance policies as required by GAAP, management also makes calculations and evaluates our financial condition based on the weighted average expected internal rate of return of the policies and other non-GAAP financial measures. See “Non-GAAP Financial Measures” below.

 

Valuation of Insurance Policies

 

Unobservable inputs, as discussed below, are a critical component of our estimate for the fair value of our investments in life insurance policies. We currently use a probabilistic method of estimating and valuing the projected cash flows of our portfolio of life insurance policies, which we believe to be the preferred and most prevalent valuation method in the industry. In this regard, the most significant assumptions we make are the life expectancy estimates of the insureds and the discount rate applied to the projected cash flows to be derived from our portfolio.

 

In determining life expectancy estimates, we generally use actuarial medical reviews from independent medical underwriters. These medical underwriters evaluate the health of the insured by reviewing historical and current medical records. This evaluation is performed to produce an estimate of the insured’s mortality—a life expectancy report. In the case of a small face policy ($1.0 million face value of policy benefits or less), we may use one life expectancy report or estimate life expectancy based on a modified methodology which does not use actuarial medical reviews from independent medical underwriters. The life expectancy estimate represents a range of probabilities for the insured’s mortality against a group of cohorts with the same age, sex and smoking status. These mortality probabilities represent a mathematical curve known as a mortality curve, which is then used to generate a series of expected cash flows from the life insurance policy over the expected lifespan of the insured. A discount rate is used to calculate the net present value of the expected cash flows. The discount rate represents the internal rate of return we expect to earn on investments in a policy or in the portfolio as a whole at the stated fair value. The discount rate used to calculate fair value of our portfolio incorporates the guidance provided by ASC 820, Fair Value Measurements and Disclosures. Many of our current underwriting review processes, including our policy of obtaining actuarial medical reviews from independent medical underwriters as described above, are undertaken in satisfaction of obligations under our revolving credit facility. As a result, we may in the future modify our underwriting review processes if permitted under our borrowing arrangements.

 

The table below provides the discount rate used to estimate the fair value of our portfolio of life insurance policies for the period ending:

 

  December 31, 2014   December 31, 2013  
  11.43% 11.69%

  

 

The change in the discount rate incorporates current information about discount rates applied by other reporting companies owning portfolios of life insurance policies, discount rates observed by us in the life insurance secondary market, market interest rates, the credit exposure to the issuing insurance companies, and our estimate of the risk premium a purchaser would require to receive the future cash flows derived from our portfolio of life insurance policies. Because we use the discount rate to arrive at the fair value of our portfolio, the rate we choose necessarily assumes an orderly and arms-length transaction (i.e., a non-distressed transaction in which neither seller nor buyer is compelled to engage in the transaction).

 

We engaged a third party, Model Actuarial Pricing Systems (MAPS), to prepare a third-party valuation of our life settlement portfolio. MAPS owns and maintains the portfolio pricing software we use. MAPS processed policy data, future premium data, life expectancy estimate data, and other actuarial information we supplied to calculate a net present value for our portfolio using the specified discount rate of 11.43%. MAPS independently calculated the net present value of our portfolio of 291 policies to be $282.9 million, which is the same fair value estimate we used on the balance sheet as of December 31, 2014, and furnished us with a letter documenting its calculation. A copy of such letter is filed as Exhibit 99.1 to this report.

 

JOBS Act

 

On April 5, 2012, the Jumpstart Our Business Startups Act of 2012, or JOBS Act, was enacted. Section 107 of the JOBS Act provides that an “emerging growth company” can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act of 1933 for complying with new or revised accounting standards. This means that an “emerging growth company” can make an election to delay the adoption of certain accounting standards until those standards would apply to private companies. We have elected to delay such adoption of new or revised accounting standards and, as a result, we may not comply with new or revised accounting standards at the same time as other public reporting companies that are not “emerging growth companies.” This exemption will apply for a period of five years following our first sale of common equity securities under an effective registration statement or until we no longer qualify as an “emerging growth company” as defined under the JOBS Act, whichever is earlier.

 

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Deferred Income Taxes

 

FASB ASC 740, Income Taxes, requires us to recognize deferred tax assets and liabilities for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. A valuation allowance is established for any portion of deferred tax assets that is not considered more likely than not to be realized.

 

We have provided a valuation allowance against the deferred tax asset related to a note receivable, which has been charged-off for financial reporting purposes, because we believe that, when realized for tax purposes, it will result in a capital loss that will not be utilized because we have no expectation of generating a capital gain within the applicable carryforward period. Therefore, we do not believe that it is more likely than not that the deferred tax asset will be realized.

 

We have also provided a valuation allowance against the deferred tax asset related to a tax basis capital loss generated with respect to our settlement and subsequent disposal of an earlier investment in Athena Structured Funds PLC (see “Notes to Consolidated Financial Statements” Note 9). As we have no expectation of generating capital gains with the applicable carry-forward period, we do not believe that it is more likely than not that the deferred asset will be realized.

 

A valuation allowance is required to be recognized to reduce deferred tax assets to an amount that is more likely than not to be realized. Realization of deferred tax assets depends upon having sufficient past or future taxable income in periods to which the deductible temporary differences are expected to be recovered or within any applicable carryback or carryforward periods. We believe that it is more likely than not that we will be able to realize all of our deferred tax assets other than those which are expected to result in a capital loss.

 

Deferred Financing and Issuance Costs

 

Financing costs incurred to obtain financing under the revolving credit facility have been capitalized and are amortized using the straight-line method over the term of the revolving credit facility. The Series I Secured Note obligations are reported net of issuance costs, sales commissions, and other direct expenses, which are amortized using the interest method over the term of each respective borrowing. The L Bonds are reported net of issuance costs, sales commissions, and other direct expenses, which are amortized using the interest method over the term of each respective borrowing. The Series A Preferred Stock is reported net of issuance costs, sales commissions, including the fair value of warrants issued, and other direct expenses, which are amortized using the interest method as interest expense over a three-year redemption period. As of December 31, 2014 these costs have been fully amortized.

 

Risk Relating to Forward-Looking Statements

 

Certain matters discussed in this section of this report, and elsewhere in this report, are forward-looking statements. We have based these forward-looking statements on our current expectations and projections about future events. Nevertheless, these forward-looking statements are subject to risks, uncertainties and assumptions about our operations and the investments we make, including, among other things, factors discussed in the “Risk Factors” section of this report and the following:

 

changes in the secondary market for life insurance;
our limited operating history;
the valuation of assets reflected on our financial statements;
the reliability of assumptions underlying our actuarial models;
our reliance on debt financing;
risks relating to the validity and enforceability of the life insurance policies we purchase;
our reliance on information provided and obtained by third parties;
federal, state and FINRA regulatory matters;
competition in the secondary market of life insurance;
the relative illiquidity of life insurance policies;
our ability to satisfy our debt obligations if we were to sell our entire portfolio of life insurance policies;
life insurance company credit exposure;

 

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general economic outlook, including prevailing interest rates;
performance of our investments in life insurance policies;
financing requirements;
litigation risks; and
restrictive covenants contained in borrowing agreements.

 

Forward-looking statements can generally be identified by the use of words like “believes,” “could,” “possibly,” “probably,” “anticipates,” “estimates,” “projects,” “expects,” “may,” “will,” “should,” “seek,” “intend,” “plan,” “expect” or “consider,” or the negative of these expressions or other variations, or by discussions of strategy that involve risks and uncertainties. All forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual transactions, results, performance or achievements to be materially different from any future transactions, results, performance or achievements expressed or implied by such forward-looking statements. We caution you that the forward-looking statements in this report are only estimates and predictions, or statements of current intent. Actual results or outcome or actions that we ultimately undertake, could differ materially from those anticipated in the forward-looking statements due to risks, uncertainties or actual events differing from the assumptions underlying these statements.

 

Principal Revenue and Expense Items

 

We earn revenues from the following three primary sources.

 

Policy Benefits Realized. We recognize the difference between the face value of the benefits and carrying values of the policy when an insured event has occurred and determine that settlement and collection of the policy benefits is realizable and reasonably assured. Revenue from a transaction must meet both criteria in order to be recognized. We generally collect the face value of the life insurance policy from the insurance company within 45 days of the insured’s mortality.

 

Change in Fair Value of Life Insurance Policies. We have elected to carry our investments in life insurance policies at fair value in accordance with ASC 325-30, Investments in Life Insurance Contracts. Accordingly, we value our investments in our portfolio of life insurance policies each reporting period in accordance with the fair value principles discussed herein, which includes the expected payment of premiums for future periods.

 

Sale of a Life Insurance Policy or a Portfolio of Life Insurance Policies. In an event of a sale of a policy, we recognize gain or loss as the difference between the price and the carrying value of the policy on the date of the receipt of payment on such sale.

 

Our main components of expense are summarized below.

 

Selling, General and Administrative Expenses. We recognize and record expenses incurred in our business operations, including operations related to the purchasing and servicing of life insurance policies. These expenses include professional fees, salaries, and sales and marketing expenditures.

 

Interest Expense. We recognize and record interest expenses associated with the costs of financing our life insurance portfolio for the current period. These expenses include interest paid to our senior lender under our revolving credit facility, as well as all interest paid on our debentures and other outstanding indebtedness such as our subsidiary Secured Notes and dividends on convertible, redeemable preferred stock. When we issue long-term indebtedness, we amortize the issuance costs associated with such indebtedness over the outstanding term of the financing, and classify it as interest expense.

 

Results of Operations — 2014 Compared to 2013

 

The following is our analysis of the results of operations for the periods indicated below. This analysis should be read in conjunction with our consolidated financial statements and related notes.

 

Revenue.  Years Ended December 31, 
   2014   2013 
Revenue recognized from the receipt of policy benefits  $13,864,000   $12,036,000 
Revenue recognized from the change in fair value of life insurance policies, net of premiums and carrying costs   16,552,000    17,478,000 
Gain on life settlements, net  $30,416,000   $29,514,000 
The change in fair value related to new policies acquired during the year  $8,502,000   $27,475,000 

 

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The change in the discount rate incorporates current information about discount rates applied by other reporting companies owning portfolios of life insurance policies, discount rates observed by us in the life insurance secondary market, market interest rates, the credit exposure to the issuing insurance companies and our estimate of the risk premium a purchaser would require to receive the future cash flows derived from our portfolio of life insurance policies. Because we use the discount rate to arrive at the fair value of our portfolio, the rate we choose necessarily assumes an orderly and arms-length transaction (i.e., a non-distressed transaction in which neither seller nor buyer is compelled to engage in the transaction). The discount rate applied to estimate the fair value of the portfolio of life insurance policies we own was 11.43% as of December 31, 2014, compared to 11.69% for the same date in 2013. The decrease in discount rate was due to both an increase in the size of our portfolio and the diversity of policies held in our portfolio of life insurance policies that resulted in a lower anticipated risk premium to a potential buyer. The carrying value of policies acquired during each quarterly reporting period are adjusted to their current fair value using the fair value discount rate applied to the entire portfolio as of that reporting date.

 

Expenses. Interest expense, including amortization of the deferred financing costs as well as preferred stock dividends, was $26.7 million during 2014 compared to $20.8 million during 2013, an increase of $5.9 million. $4.4 million of the increase was due to increased average debt outstanding and $1.5 million of the increase was due to increased issuance costs being amortized during 2014. Selling, general, and administrative expenses were $12.1 million, and $10.3 million for 2014 and 2013, respectively; an increase of $1.8 million. We employed more staff and hired additional members to our Business Development and executive teams in 2014. Our regular compensation and benefit expenses were higher in 2014 than they were in 2013. However, our total employee compensation and benefit expenses decreased by $0.1 million due to an $0.8 million one-time bonus paid in 2013 to the original members equal to the tax effect on them as a result of the conversion from an LLC to a corporation. Legal and professional expenses went up by $0.6 million due to increased compliance work. Marketing, recruiting and other expenses went up by $1.3 million due to the implementation of a direct marketing campaign, increased activity related to our public offering of L-Bonds and increased expenses from the build out of our Business Development and executive teams.

 

Income Tax Expense. In 2014, the Company realized income tax benefits of $2.4 million. In 2013, we recorded an income tax expense of $2.2 million. The effective tax rate for the 12 months ended December 31, 2014 and 2013, was 28.7% and 109.8%, respectively, compared to a statutory rate of 43%. In 2014 and 2013, there were significant permanent differences between income before income taxes and taxable income. The primary permanent difference between our effective tax rate and the statutory federal rate are the accrual of preferred stock dividend expense, state income taxes, and other non-deductible expenses. The dividends charged to interest expense were $2.4 million and $2.5 million in 2014 and 2013, respectively.

 

   Year Ended   Year Ended 
   December 31, 2014   December 31, 2013 
Statutory federal income tax (benefit)  $(2,844,000)   34.0%  $673,000    34.0%
State income taxes, net of federal benefit   (374,000)   4.5%   298,000    15.1%
Series A Preferred Stock dividends   826,000    (9.9)%   860,000    43.4%
Other permanent and temporary differences   (10,000)   0.1%   343,000    17.3%
Total income tax expense (benefit)  $(2,402,000)   28.7%  $2,174,000    109.8%

 

The most significant temporary differences between GAAP net income and taxable net income are the treatment of interest costs with respect to the acquisition of the life insurance policies and revenue recognition with respect to the mark-to-market of life insurance portfolio.

 

Liquidity and Capital Resources

 

We finance our business through a combination of policy benefit revenues, origination fees, equity offerings, debt offerings, and a credit facility. We have used our debt offerings and credit facility primarily for policy acquisition, policy servicing, and portfolio related financing expenditures. We charge an intercompany origination fee in the amount of one to four percent of the face value of a life insurance policy’s benefit when we acquire the related life insurance policy. The origination fee we charge is included in the total purchase price we pay for a life insurance policy for purposes of our valuation and expected internal rate of return calculations, but is not netted against the purchase price we pay to a seller of an insurance policy. We generated cash flows of $1.6 million and $3.7 million from origination fees in 2014 and 2013, respectively. Profits from intercompany origination fees for life insurance policies retained by the Company are eliminated from our consolidated statements of operations. As such, the origination fees collected under our life insurance policy financing arrangements are reflected in our consolidated statements of cash flows as cash flows from financing activities as they are received from borrowings used to finance the acquisition of life insurance policies. Our revolving bank line allows DLP II to borrow the funds necessary to pay origination fees to GWG Life. Our borrowing agreements allow us to use net proceeds of the L Bonds for policy acquisition, which includes origination fees. If the policy acquisition is not financed, no fees are included in the consolidated cash flows. See “Cash Flows” below for further information. We determine the value of life insurance policies in accordance with ASC 325-30, Investments in Insurance Contracts, using the fair value method. Under the fair value method, the initial investment is recorded at the transaction price. Because the origination fees are paid from a wholly owned subsidiary to the parent company, these fees are not included in the transaction price as reflected in our consolidated financial statements. For further discussion on our accounting policies for life settlements, please refer to note 1 to our consolidated financial statements.

 

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As of December 31, 2014 and 2013, we had approximately $51.2 million and $43.2 million, respectively, in combined available cash and available borrowing base surplus capacity under our revolving credit facility for the purpose of purchasing additional life insurance policies, paying premiums on existing policies, paying portfolio servicing expenses, and paying principal and interest on our outstanding financing obligations.

 

In September 2012, we concluded a Series A Preferred Stock offering, having received an aggregate $24.6 million in subscriptions for our Series A preferred stock. These subscriptions consisted of $14.0 million in conversions of outstanding Series I Secured Notes and $10.6 million of new investments. We have used the proceeds from the sale of our Series A Preferred Stock to fund our operational expenditures.

 

In June 2011, we registered a $250.0 million debt offering of our Renewable Secured Debentures (subsequently renamed L Bonds) with the SEC. The registration became effective on January 31, 2012. Through December 31, 2014, the total amount of these L Bonds sold, including renewals, was $248.7 million. As of December 31, 2014, we had approximately $186.4 million in principal amount of L Bonds outstanding.

 

On September 24, 2014, we consummated an initial public offering of its common stock resulting in the sale of 800,000 shares of common stock at $12.50 per share and net proceeds of approximately $8.6 million after the deduction of underwriting commissions, discounts and expense reimbursements. We used the net proceeds from the offering to promote and advertise the opportunities for consumers owning life insurance and investors to profit from participating in the secondary market for life insurance policies, to purchase additional life insurance policies in the secondary market, to pay premiums on our life insurance policy assets, to fund our portfolio operations, and for working capital purposes.

 

In November 2009, our wholly owned subsidiary GWG Life commenced private placement of Series I Secured Notes to accredited investors only. This offering was closed in November 2011. As of December 31, 2014, we had approximately $28.0 million in principal amount of Series I Secured Notes outstanding.

 

The weighted-average interest rate of our outstanding Series I Secured Notes as of December 31, 2014 and December 31, 2013 was 8.37% and 8.35%, respectively, and the weighted average maturity at those dates was 2.01 and 2.49 years, respectively. The Series I Secured Notes have renewal features. Since we first issued our Series I Secured Notes, we have experienced $133.7 million in maturities, of which as of December 31, 2014, $104.0 million has renewed for an additional term. This has provided us with an aggregate renewal rate of approximately 78% for investments in these securities.

 

The weighted-average interest rate of our outstanding L Bonds as of December 31, 2014 and December 31, 2013 was 7.45% and 7.53%, respectively, and the weighted average maturity at those dates was 3.45 and 3.69 years, respectively. Our L Bonds have renewal features. Since we first issued our L Bonds, we have experienced $62.3 in maturities, of which as of December 31, 2014, $41.4 million has renewed for an additional term. This has provided us with an aggregate renewal rate of approximately 66% for investments in these securities. Future contractual maturities of Series I Secured Notes and L Bonds at December 31, 2014 are:

 

Years Ending December 31,  Series I Secured Notes   L Bonds   Total 
2015  $13,887,000   $63,375,000   $77,262,000 
2016   8,242,000    50,270,000    58,512,000 
2017   4,713,000    29,546,000    34,259,000 
2018   754,000    13,551,000    14,305,000 
2019   347,000    14,262,000    14,609,000 
Thereafter   104,000    15,373,000    15,477,000 
   $28,047,000   $186,377,000   $214,424,000 

 

The L Bonds and Series I Secured Notes are secured by all our assets, and are subordinate to our revolving credit facility with Autobahn/DZ Bank. The L Bonds and Series I Secured Notes are pari passu with respect to a security interest in our assets pursuant to an intercreditor agreement (see notes 6 and 7 to our consolidated financial statements).

 

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We maintain a $100 million revolving credit facility with Autobahn/DZ Bank through GWG Life’s wholly owned subsidiary DLP II. As of December 31, 2014 and December 31, 2013, we had $72.2 and $79.0 million outstanding, respectively, under the revolving credit facility and maintained an available borrowing base surplus of $20.6 and $3.9 million, respectively (see note 5 to our consolidated financial statements).

 

We expect to meet our ongoing operational capital needs through a combination of policy benefit revenues, origination fees, and proceeds from financing transactions. We expect to meet our policy acquisition, servicing, and financing capital needs principally from the receipt of policy benefit revenues from our portfolio of life insurance policies, net proceeds from our offering of L Bonds, and from our revolving credit facility. Because we only receive origination fees when we purchase a policy, our receipt of those fees is contingent upon our consummation of policy purchases, which is, in turn, contingent upon our receipt of external funding. Despite capital market conditions that are still recovering from the credit crisis, including a prolonged credit crisis, we have demonstrated continued access to credit and financing markets. Furthermore, we expect that policy benefit payments will increase as the average age of the insureds increase and mortality events occur over time which trend we expect to experience more significantly in 2015 with steady increase until 2018. As a result of the foregoing, we estimate that our liquidity and capital resources are sufficient for our current and projected financial needs. Nevertheless, if we are unable to continue our offering of L Bonds for any reason (or if we become unsuccessful in selling L Bonds), and we are unable to obtain capital from other sources, we expect that our business would be materially and adversely affected. In addition, our business would be materially and adversely affected if we did not receive the policy benefits we forecast and if holders of our L Bonds or Series I Secured Notes failed to renew with the frequency we have historically experienced. In such a case, we could be forced to sell our investments in life insurance policies to service or satisfy our debt-related obligations and continue to pay policy premiums.

 

Capital expenditures have historically not been material and we do not anticipate making material capital expenditures in 2015 or beyond.

 

Debt Financings Summary

 

We had the following outstanding debt balances as of December 31, 2014:

 

Issuer/Borrower  Principal
Amount
Outstanding
   Weighted
Average
Interest Rate
 
GWG Holdings, Inc. - L Bonds  $186,377,000    7.45%
GWG Life Settlements, LLC  - Series I Secured Notes   28,047,000    8.37%
GWG DLP Funding II, LLC - Revolving credit facility   72,161,000    6.24%
Total  $286,585,000    7.24%

 

Our total credit facility and other indebtedness balance as of December 31, 2014 and December 31, 2013 was $286.6 million and $243.6 million, respectively. At December 31, 2014, the total outstanding face amount under our Series I Secured Notes outstanding was $28.0 million, less unamortized selling costs of $0.4 million, resulting in a carrying amount of $27.6 million. At December 31, 2013, the total outstanding face amount under our Series I Secured Notes outstanding was $29.7 million, less unamortized selling costs of $0.4 million, resulting in a carrying amount of $29.3 million. At December 31, 2014, the total outstanding face amount of L Bonds was $186.4 million plus $2.3 million of subscriptions in process, less unamortized selling costs of $5.9 million resulting in a carrying amount of $182.8 million. At December 31, 2013, the total outstanding face amount of L Bonds outstanding was $134.9 million plus $1.9 million of subscriptions in process, less unamortized selling costs of $5.2 million, resulting in a carrying amount of $131.6 million. At December 31, 2014, the fair value of our investments in life insurance policies of $282.8 million plus our cash balance of $30.7 million and our restricted cash balance of $4.3 million, totaled $317.8 million, representing an excess of portfolio assets over secured indebtedness of $31.2 million. At December 31, 2013, the fair value of our investments in life insurance policies of $234.7 million plus our cash balance of $33.4 million and our restricted cash balance of $5.8 million, totaled $273.9 million, representing an excess of portfolio assets over secured indebtedness of $30.3 million. At December 31, 2013 our weighted average cost of capital was approximately 7.20%. The L Bonds and Series I Secured Notes are secured by all our assets and are subordinate to our revolving credit facility with Autobahn/DZ Bank. The L Bonds and Series I Secured Notes are pari passu with respect to a security interest in our asset pursuant to an intercreditor agreement.

 

37
 

 

The following forward-looking table seeks to illustrate the impact of a hypothetical sale of our portfolio of life insurance assets at various discount rates in order to satisfy our debt obligations as of December 31, 2014. In all cases, the sale of the life insurance assets owned by DLP II will be used first to satisfy all amounts owing under the revolving credit facility with Autobahn/ DZ Bank. The net sale proceeds remaining after satisfying all obligations under the revolving credit facility would be applied to L Bonds and Series I Secured Notes on a pari passu basis.

 

Portfolio Discount Rate  10%  11%  12%  13%  14%  15%
Value of portfolio  $302,562,000   $288,566,000   $275,638,000   $263,672,000   $252,573,000   $242,260,000 
Cash and cash equivalents   34,959,000    34,959,000    34,959,000    34,959,000    34,959,000    34,959,000 
Total assets   337,521,000    323,525,000    310,597,000    298,631,000    287,532,000    277,219,000 
Revolving credit facility Autobahn/DZ Bank   72,161,000    72,161,000    72,161,000    72,161,000    72,161,000    72,161,000 
Net after revolving credit facility,   265,360,000    251,364,000    238,436,000    226,470,000    215,371,000    205,058,000 
Series I Secured Notes and L Bonds   214,424,000    214,424,000    214,424,000    214,424,000    214,424,000    214,424,000 
Net after Series I Secured Notes and L Bonds   50,936,000    36,940,000    24,012,000    12,046,000    947,000    (9,366,000)
Impairment to Series I Secured Notes and L Bonds   No impairment    No impairment    No impairment    No impairment    No impairment   Impairment 

 

The table illustrates that our ability to fully satisfy amounts owing under the L Bonds and Series I Secured Notes would likely be impaired upon the sale of all our life insurance assets at a price equivalent to a discount rate of approximately 14.09% or higher. At December 31, 2013 the impairment occurred at discount rate of approximately 14.41% or higher. The discount rates used to calculate the fair value of our portfolio for mark-to-market accounting were 11.43% and 11.69% as of December 31, 2014 and December 31, 2013, respectively.

 

The table does not include any allowance for transactional fees and expenses associated with a portfolio sale (which expenses and fees could be substantial), and is provided to demonstrate how various discount rates used to value our portfolio could affect our ability to satisfy amounts owing under our debt obligations, in light of our senior secured lender’s right to priority payments. You should read the above table in conjunction with the information contained in other sections of this report, including our discussion of discount rates included under the “— Critical Accounting Policies — Valuation of Insurance Policies” caption above. This discussion and analysis is based on the beliefs of our management, as well as assumptions made by, and information currently available to, our management. The forward-looking presentation above is subject to numerous risks and uncertainties. Our actual results could differ materially from those suggested or implied by the above table. Please see the caption “Risk Relating to Forward-Looking Statements” above.

 

Cash Flows

 

The payment of premiums and servicing costs to maintain life insurance policies represents our most significant requirement for cash disbursement. When a policy is purchased, we are able to calculate the minimum premium payments required to maintain the policy in-force. Over time as the insured ages, premium payments will increase; however, the probability of actually needing to pay the premiums decreases since mortality becomes more likely. These scheduled premiums and associated probabilities are factored into our expected internal rate of return and cash-flow modeling described herein. Beyond premiums, we incur policy servicing costs, including annual trustee and tracking costs, and debt servicing costs, including principal and interest payments. Until we receive a stable amount of proceeds from the policy benefits, we intend to pay these costs from our credit facility, when permitted, and through the issuance of debt securities, including the L Bonds.

 

The amount of payments for anticipated premiums and servicing costs that we will be required to make over the next five years to maintain our current portfolio, assuming no mortalities, is set forth in the table below.

 

Year  Premiums   Servicing   Premiums and Servicing 
2015  $26,349,000   $349,000   $26,698,000 
2016   28,857,000    349,000    29,206,000 
2017   32,365,000    349,000    32,714,000 
2018   35,341,000    349,000    35,690,000 
2019   39,423,000    349,000    39,772,000 
Total  $162,335,000   $1,745,000   $164,080,000 

 

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For the quarter end dates set forth below, the following table illustrates the total amount of face value of policy benefits owned, and the trailing 12 months of life insurance policy benefits collected and premiums paid on our portfolio. The trailing 12-month benefits/premium coverage ratio indicates the ratio of policy benefits received to premiums paid over the trailing 12-month period from our portfolio of life insurance policies.

 

 

 

 

Quarter End Date

  Portfolio
Face Amount
   12-Month
Trailing
Benefits Collected
   12-Month
Trailing Premiums Paid
   12-Month
Trailing
Benefits/
Premium
Coverage Ratio
 
March 31, 2012  $482,455,000   $4,203,000   $14,977,000    28.06%
June 30, 2012   489,255,000    8,703,000    15,412,000    56.47%
September 30, 2012   515,661,000    7,833,000    15,837,000    49.46%
December 31, 2012   572,245,000    7,350,000    16,597,000    44.28%
March 31, 2013   639,755,000    11,350,000    18,044,000    62.90%
June 30, 2013   650,655,000    13,450,000    19,182,000    70.11%
September 30, 2013   705,069,000    18,450,000    20,279,000    90.98%
December 31, 2013   740,648,000    16,600,000    21,733,000    76.38%
March 31, 2014   771,940,000    12,600,000    21,930,000    57.46%
June 30, 2014   784,652,000    6,300,000    22,598,000    27.88%
September 30, 2014   787,964,000    4,300,000    23,121,000    18.60%
December 31, 2014   779,099,000    18,050,000    23,265,000    77.58%

 

We believe that the portfolio cash flow results set forth above are consistent with our general investment thesis: that the life insurance policy benefits we receive will continue to increase over time in relation to the premiums we are required to pay on the remaining polices in the portfolio. Nevertheless, we expect that our portfolio cash flow results on a period-to-period basis will remain inconsistent until such time as we achieve our goal of acquiring a larger, more diversified portfolio of life insurance policies in order to obtain more normalized actuarial results. For example, we had expected to receive a greater amount of insurance benefits for the periods ended December 31, 2013 and December 31, 2014 than we actually experienced. As our receipt of life insurance policy benefits increase, we expect to begin servicing and paying down our outstanding indebtedness, or alternatively purchasing additional life insurance policies, from these cash flows.

 

The life insurance policies owned by DLP II are subject to a collateral arrangement with the agent to our revolving credit lender, as described in note 5 to the consolidated financial statements. Under this arrangement, collection and escrow accounts are used to fund purchases and premiums of the insurance policies and to pay interest and other charges under our revolving credit facility. The lender and its agent must authorize all disbursements from these accounts, including any distributions to GWG Life or Holdings. Distributions are limited to an amount that would result in the borrowers (DLP II, GWG Life, and Holdings) realizing an annualized rate of return on the equity funded amount for such assets of not more than 18%, as determined by the agent. After such amount is reached, the credit agreement requires that excess funds be used to fund repayments or a reserve account in a certain amount before any additional distributions may be made. In the future, these arrangements may restrict the cash flows available for payment of principal and interest on our debt obligations.

 

Use of Proceeds – Earlier Issued L Bonds

 

As indicated above, in June 2011, we filed a registration statement for a $250.0 million debt offering of Renewable Secured Debentures (subsequently renamed L Bonds) with the SEC, which registration statement was declared effective on January 31, 2012. Through December 31, 2014, the total amount of these L Bonds sold, including renewals, was $248.7 million. The actual use of proceeds from the sale of L Bonds from January 31, 2012 to December 31, 2014 (excluding renewals), is as follows:

 

Gross Offering Proceeds  $206,882,000      
Net Offering Proceeds   194,840,000      
Held in Short-Term Investments   30,358,000      
Net Offering Proceeds Used  $164,482,000    100%
Purchase Policies   68,838,000    42%
Payment of Premiums   29,746,000    18%
Payment of Principal and Interest   48,655,000    30%
Other Expenditures   17,243,000    10%

 

Inflation

 

Changes in inflation do not necessarily correlate with changes in interest rates. We presently do not foresee any material impact of inflation on our results of operations in the periods presented in our consolidated financial statements.

 

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Off-Balance Sheet Arrangements

 

Operating Lease - We entered into an office lease with U.S. Bank National Association as the landlord. The lease was effective April 22, 2012 with a term through August 31, 2015. The lease is for 11,695 square feet of office space located at 220 South Sixth Street, Minneapolis, Minnesota. We are obligated to pay base rent plus common area maintenance and a share of the building operating costs. The minimum lease payment under the lease agreement is $0.1 million in 2015.

 

Credit Risk

 

We review the credit risk associated with our portfolio of life insurance policies when estimating its fair value. In evaluating the policies’ credit risk we consider insurance company solvency, credit risk indicators, economic conditions, ongoing credit evaluations, and company positions. We attempt to manage our credit risk related to life insurance policies typically by purchasing policies issued only from companies with an investment grade credit rating by either Standard & Poor’s, Moody’s, or A.M. Best Company. As of December 31, 2014, 99.07% of our life insurance policies, by face value benefits, were issued by companies that maintained an investment grade rating (BBB or better) by Standard & Poor’s.

 

Interest Rate Risk

 

Our credit facility is floating-rate financing. In addition, our ability to offer interest rates that attract capital (including in our continuous offering of L Bonds) is generally impacted by prevailing interest rates. Furthermore, while our other indebtedness provides us with fixed-rate financing, our debt coverage ratio is calculated in relation to our total cost of financing. Therefore, fluctuations in interest rates impact our business by increasing our borrowing costs, and reducing availability under our debt financing arrangements. Furthermore, we calculate our portfolio earnings based upon the spread generated between the return on our life insurance portfolio and the cost of our financing. As a result, increases in interest rates will reduce the earnings we expect to achieve from our investments in life insurance policies.

 

Non-GAAP Financial Measures

 

We use non-GAAP financial measures when evaluating our financial results, for planning and forecasting purposes, and for maintaining compliance with covenants contained in our borrowing agreements. Non-GAAP financial measures disclosed by management are provided as additional information to investors in order to provide them with an alternative method for assessing our financial condition and operating results. These non-GAAP financial measures are not in accordance with GAAP and may be different from non-GAAP measures used by other companies, including other companies within our industry. This presentation of non-GAAP financial information is not meant to be considered in isolation or as a substitute for comparable amounts prepared in accordance with GAAP. See the notes to our consolidated financial statements and our audited financial statements contained herein.

 

We have elected to carry our investments in life insurance policies at fair value in accordance with ASC 325-30, Investments in Life Insurance Contracts. Accordingly, we value our investments in life insurance policies at the conclusion of each reporting period in accordance with GAAP fair value accounting principles. In addition to GAAP, we are required to report non-GAAP financial measures to Autobahn/DZ Bank under certain financial covenants made to that lender under our revolving credit facility. As indicated above, we also use non-GAAP financial reporting to manage and evaluate the financial performance of our business.

 

GAAP-based fair value requires us to mark-to-market our investments in life insurance policies, which by its nature, is based upon Level 3 measurements that are unobservable. As a result, this accounting treatment imports financial market volatility and subjective inputs into our financial reporting. We believe this type of reporting is at odds with one of the key attractions for purchasing and owning a portfolio life insurance policies: the non-correlated nature of the returns to be derived from such policies. Therefore, in contrast to a GAAP-based fair valuation, we seek to measure the accrual of the actuarial gain occurring within the portfolio of life insurance policies at their expected internal rate of return based on statistical mortality probabilities for the insureds (using primarily the insured’s age, sex, health and smoking status). The expected internal rate of return tracks actuarial gain occurring within the policies according to a mortality table as the insureds’ age increases. By comparing the actuarial gain accruing within our portfolio of life insurance policies against our costs during the same period, we can estimate, manage and evaluate the overall financial profitability of our business without regard to mark-to-market volatility. We use this information to balance our life insurance policy purchasing and manage our capital structure, including the issuance of debt and utilization of our other sources of capital, and to monitor our compliance with borrowing covenants. We believe that these non-GAAP financial measures provide information that is useful for investors to understand period-over-period operating results separate and apart from fair value items that may, or could, have a disproportionately positive or negative impact on results in any particular period.

 

40
 

 

Our credit facility requires us to maintain a “positive net income” and “tangible net worth” each of which are calculated on an adjusted non-GAAP basis on the method described above, without regard to GAAP-based fair value measures. In addition, our revolving credit facility requires us to maintain an “excess spread,” which is the difference between (i) the weighted average of our expected internal rate of return of our portfolio of life insurance policies and (ii) the weighted average of our credit facility’s interest rate. These calculations are made using non-GAAP measures in the method described below, without regard to GAAP-based fair value measures.

 

In addition, the indenture under which our L Bonds were and continue to be issued, and the note issuance and security agreement under which our Series I Secured Notes were issued, require us to maintain a “debt coverage ratio” designed to ensure that the expected cash flows from our portfolio of life insurance policies is able to adequately service our total outstanding indebtedness. In addition, our L Bond indenture requires us to maintain a “subordination ratio” limiting the total amount of indebtedness that can be issued senior in rank to the L Bonds and Series I Secured Notes. These ratios are calculated using non-GAAP measures in the method described below, without regard to GAAP-based fair value measures.

 

Adjusted Non-GAAP Net Income. Our credit facility requires us to maintain a positive net income calculated on an adjusted non-GAAP basis. We calculate the adjusted net income by recognizing the actuarial gain accruing within our life insurance policies at the expected internal rate of return of the policies we own without regard to fair value. We net this actuarial gain against our costs during the same period to calculate our net income on a non-GAAP basis.

 

   Years Ended December 31, 
   2014   2013 
GAAP net income  $(5,963,000)  $(195,000)
Unrealized fair value gain (1)   (39,928,000)   (39,338,000)
Adjusted cost basis increase (2)   44,833,000    38,627,000 
Accrual of unrealized actuarial gain (3)   30,427,000    21,822,000 
Total adjusted non-GAAP net income (4)  $29,369,000   $20,916,000 

 

 
(1) Reversal of unrealized fair value gain of life insurance policies for current period.
(2)Adjusted cost basis is increased to include those acquisition and servicing expenses which are not capitalized by GAAP.
(3)Accrual of actuarial gain at expected internal rate of return based on investment cost basis for the period.
(4)We must maintain an annual positive consolidated net income, calculated on a non-GAAP basis, to maintain compliance with our revolving credit facility with DZ Bank/Autobahn.

 

Adjusted Non-GAAP Tangible Net Worth. Our revolving credit facility requires us to maintain a tangible net worth in excess of $15 million calculated on an adjusted non-GAAP basis. We calculate the adjusted tangible net worth by recognizing the actuarial gain accruing within our life insurance policies at the expected internal rate of return of the policies we own without regard to fair value. We net this actuarial gain against our costs during the same period to calculate our tangible net worth on a non-GAAP basis.

 

   As of December 31, 
   2014   2013 
GAAP net worth (1)  $22,390,000   $19,231,000 
Less intangible assets (2)   (8,132,000)   (6,068,000)
GAAP tangible net worth   14,258,000    13,163,000 
Unrealized fair value gain (3)   (154,672,000)   (114,744,000)
Adjusted cost basis increase (4)   147,673,000    106,201,000 
Accrual of unrealized actuarial gain (5)   80,122,000    49,666,000 
Total adjusted non-GAAP tangible net worth (6)  $87,381,000   $54,286,000 

 

 

(1)Includes termination of redeemable member’s interest prior to corporate conversion and preferred stock classified as temporary equity.
(2)Unamortized portion of deferred financing costs and pre-paid insurance.
(3)Reversal of cumulative unrealized fair value gain or loss of life insurance policies.
(4)Adjusted cost basis is increased by acquisition and servicing expenses which are not capitalized under GAAP.
(5)Accrual of cumulative actuarial gain at expected internal rate of return based on investment cost basis.
(6)We must maintain a total adjusted non-GAAP tangible net worth of $15 million to maintain compliance with our revolving credit facility with DZ Bank/Autobahn.

 

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Excess Spread. Our revolving credit facility requires us to maintain a 2.00% “excess spread” between our weighted-average expected internal rate of return of our portfolio of life insurance policies and the credit facility’s interest rate. A presentation of our excess spread and our total excess spread is set forth below. Management uses the “total excess spread” to gauge expected profitability of our investments, and uses the “excess spread” to monitor compliance with our borrowing.

 

   As of
December 31, 2014
   As of
December 31, 2013
 
Weighted-average expected IRR (1)   11.78%   12.21%
Weighted-average revolving credit facility interest rate (2)   6.24%   6.19%
Excess spread (3)   5.54%   6.02%
Total weighted-average interest rate on indebtedness for borrowed money (4)   7.24%   7.20%
Total excess spread (5)   4.54%   5.01%

 

 

(1)This represents the weighted-average expected internal rate of return of the life insurance policies as of the measurement date based upon our investment cost basis of the insurance policies and the expected cash flows from the life insurance portfolio. Our investment cost basis is calculated as our cash investment in the life insurance policies, without regard to GAAP-based fair value measurements, and is set forth below:

 

  Investment Cost Basis  As of
December 31,
2014
   As of
December 31,
2013
 
  GAAP fair value  $282,883,000   $234,673,000 
  Unrealized fair value gain (A)   (154,672,000)   (114,744,000)
  Adjusted cost basis increase (B)   147,673,000    106,201,000 
  Investment cost basis (C)  $275,884,000   $226,130,000 

 

  (A) This represents the reversal of cumulative unrealized GAAP fair value gain of life insurance policies.
  (B) Adjusted cost basis is increased to include those acquisition and servicing expenses that are not capitalized by GAAP.
  (C) This is the full cash investment cost basis in life insurance policies from which our expected internal rate of return is calculated.

 

(2)This is the weighted-average revolving credit relating to our revolving credit facility interest rate as of the measurement date.
(3)We must maintain an excess spread of 2.00% relating to our revolving credit facility to maintain compliance under such facility.
(4)Represents the weighted-average interest rate paid on all outstanding indebtedness as of the measurement date, determined as follows:

 

 

 

Outstanding Indebtedness

  As of
December 31,
2014
   As of
December 31,
2013
 
  Revolving credit facility  $72,161,000   $79,000,000 
  Series I Secured Notes   28,047,000    29,744,000 
  L Bonds   186,377,000    134,891,000 
  Total  $286,585,000   $243,635,000 

 

  Interest Rates on Indebtedness    
  Revolving credit facility   6.24%   6.19%
  Series I Secured Notes   8.37%   8.35%
  L Bonds   7.45%   7.53%
  Weighted-average interest rates on indebtedness   7.24%   7.20%

 

(5)Calculated as the weighted average expected IRR (1) minus the weighted average interest rate on indebtedness for borrowed money (4).

 

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Debt Coverage Ratio and Subordination Ratio. Our L Bond and Series I Secured Notes borrowing covenants require us to maintain a “debt coverage ratio” of less than 90%. The “debt coverage ratio” is calculated by dividing the sum of our total indebtedness by the sum of our cash and cash equivalents and the net present value of the life insurance portfolio. The “subordination ratio” for our L Bonds is calculated by dividing the total indebtedness that is senior to L Bonds and Series I Secured Notes by the sum of the company’s cash and cash equivalents and the net present value of the life insurance portfolio. The “subordination ratio” must be less than 50%. For purposes of both ratio calculations, the net present value of the life insurance portfolio is calculated using a discount rate equal to the weighted average interest rate of all indebtedness.

 

As of December 31,  2014   2013 
Life insurance portfolio policy benefits  $779,099,000   $740,648,000 
Discount rate of future cash flows   7.24%   7.20%
Net present value of life insurance portfolio policy benefits  $347,786,000   $302,761,000 
Cash and cash equivalents   34,959,000    39,283,000 
Total Coverage   382,745,000    332,044,000 
           
Revolving credit facility   72,161,000    79,000,000 
Series I Secured Notes   28,047,000    29,744,000 
L Bonds   186,377,000    134,891,000 
Total Indebtedness  $286,585,000   $243,635,000 
           
Debt Coverage Ratio   74.88%   71.23%
Subordination Ratio   18.85%   23.10%

 

As of December 31, 2014, we were in compliance with both the debt coverage ratio and the subordination ratio as required under our related financing agreements for both the L Bonds and Series I Secured Notes.

 

ITEM 7A.        QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

 

Not applicable.

 

43
 

 

ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

REPORT OF INDEPENDENT
REGISTERED PUBLIC
ACCOUNTING FIRM

 

To the Shareholders, Audit Committee and Board of Directors

 

GWG Holdings, Inc.

Minneapolis, MN

 

We have audited the accompanying consolidated balance sheets of GWG Holdings, Inc. as of December 31, 2014 and 2013, and the related consolidated statements of operations, changes in stockholders' equity, and cash flows for the years then ended. These consolidated financial statements are the responsibility of the company's management responsibility is to express an opinion on these consolidated financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The company is not required to have nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of its internal control over financial reporting as basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of GWG Holdings, Inc. as of December 31, 2014 and 2013 and the results of their operations and their cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.

 

/s/ Baker Tilly Virchow Krause, LLP

Minneapolis, Minnesota

March 13, 2015

 

44
 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

 

   December 31,
2014
   December 31,
2013
 
A S S E T S
Cash and cash equivalents  $30,662,704   $33,449,793 
Restricted cash   4,296,053    5,832,970 
Investment in life settlements, at fair value   282,883,010    234,672,794 
Deferred financing costs, net   1,569,400    357,901 
Policy benefits receivable   1,750,000    - 
Other assets   1,909,362    1,067,018 
TOTAL ASSETS  $323,070,529   $275,380,476 
           
L I A B I L I T I E S & S T O C K H O L D E R S’ E Q U I T Y (DEFICIT)
LIABILITIES        
Revolving credit facility  $72,161,048   $79,000,000 
Series I Secured Notes payable   27,616,578    29,275,202 
L Bonds   182,782,884    131,646,062 
Accounts payable   1,203,575    839,869 
Interest payable   11,128,519    7,209,408 
Other accrued expenses   514,435    504,083 
Deferred taxes, net   5,273,555    7,675,174 
TOTAL LIABILITIES   300,680,594    256,149,798 
           
COMMITMENTS AND CONTINGENCIES (NOTES 13 AND 14)          
           
CONVERTIBLE, REDEEMABLE PREFERRED STOCK          
(par value $0.001; shares authorized 40,000,000; shares outstanding 3,368,109; liquidation preference of $25,261,000 on December 31, 2013)   -    24,722,693 
           
STOCKHOLDERS’ EQUITY (DEFICIT)          
           
CONVERTIBLE PREFERRED STOCK          
(par value $0.001; shares authorized 40,000,000; shares outstanding 2,738,966; liquidation preference of $20,542,000 on December 31, 2014)   20,527,866    - 
           
COMMON STOCK          
Common stock (par value $0.001: shares authorized  210,000,000; shares outstanding  5,870,193 and 4,562,000 on December 31, 2014 and 2013)   5,870    4,562 
Additional paid-in capital   16,257,686    2,942,000 
Accumulated deficit   (14,401,486)   (8,438,577)
TOTAL STOCKHOLDERS’ EQUITY (DEFICIT)   22,389,936    (5,492,015)
           
TOTAL LIABILITIES & EQUITY (DEFICIT)  $323,070,529   $275,380,476 

 

The accompanying notes are an integral part of these Consolidated Financial Statements.

 

45
 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

 

   Year Ended 
   December 31,
2014
   December 31,
2013
 
REVENUE        
Gain on life settlements, net  $30,416,127   $29,513,642 
Gain on termination of agreement with Athena Securities Ltd.   -    3,252,400 
Interest and other income   60,448    298,732 
TOTAL REVENUE   30,476,575    33,064,774 
           
EXPENSES          
Interest expense   26,716,798    20,762,644 
Employee compensation and benefits   4,969,636    5,043,848 
Legal and professional fees   2,339,235    1,754,209 
Other expenses   4,815,434    3,525,261 
TOTAL EXPENSES   38,841,103    31,085,962 
           
(LOSS) INCOME BEFORE INCOME TAXES   (8,364,528)   1,978,812 
Income tax (benefit) expense   (2,401,619)   2,173,767 
           
NET LOSS   (5,962,909)   (194,955)
Loss attributable to preferred shareholders   (138,374)   (806,624)
LOSS ATTRIBUTABLE TO COMMON SHAREHOLDERS  $(6,101,283)  $(1,001,579)
           
NET LOSS PER COMMON SHARE          
Basic  $(1.24)  $(0.21)
Diluted  $(1.24)  $(0.21)
           
WEIGHTED AVERAGE SHARES OUTSTANDING          
Basic   4,909,657    4,758,699 
Diluted   4,909,657    4,758,699 

 

The accompanying notes are an integral part of these Consolidated Financial Statements.

 

46
 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY

 

   Preferred Stock   Preferred   Common   Common Stock   Additional Paid-in   Accumulated   Total 
   Shares   Stock   Shares   (par)   Capital   Deficit   Equity 
                             
Balance, December 31, 2012   -   $-    4,994,500    4,995    6,976,838    (8,243,622)   (1,261,789)
                                    
Net income   -    -    -    -    -    (194,955)   (194,955)
                                    
Repurchase of common stock   -    -    (432,500)   (433)   (3,251,967)   -    (3,252,400)
                                    
Issuance of stock options   -    -    -    -    23,753    -    23,753 
                                    
Accretion of preferred stock to liquidation value   -    -    -    -    (806,624)   -    (806,624)
                                    
Balance, December 31, 2013   -   $-    4,562,000   $4,562   $2,942,000   $(8,438,577)  $(5,492,015)
                                    
Net income   -    -    -    -    -    (5,962,909)   (5,962,909)
                                    
Issuance of common stock   -    -    800,000    800    8,642,990    -    8,643,790 
                                    
Series A Preferred Stock conversion   -    -    508,193    508    4,956,591    -    4,957,099 
                                    
Reclassification of preferred stock from temporary equity to permanent equity due to initial public offering (*)   2,710,214    20,326,605    -    -    -    -    20,326,605 
                                    
Issuance of preferred stock   28,752    201,261    -    -    -    -    201,261 
                                    
Issuance of stock options   -    -    -    -    122,412    -    122,412 
                                    
Extension and issuance of warrants   -    -    -    -    47,120    -    47,120 
                                    
Accretion of preferred stock to liquidation value   -    -    -    -    (453,427)   -    (453,427)
                                    
Balance, December 31, 2014   2,738,966   $20,527,866    5,870,193   $5,870   $16,257,686   $(14,401,486)  $22,389,936 

 

* Subject to the terms of the Certificate of Designation for Series A Convertible Preferred Stock, the listing of our common stock on The Nasdaq Capital Market on September 25, 2014 resulted in the termination of a redemption right in favor of the holders of such preferred stock. Preferred stock that is not redeemable by a shareholder is treated as stockholders’ equity as shown in the table above.

 

The accompanying notes are an integral part of these Consolidated Financial Statements.

 

47
 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CASH FLOWS

 

   Year Ended 
   December 31,
2014
   December 31,
2013
 
CASH FLOWS FROM OPERATING ACTIVITIES        
Net loss  $(5,962,909)  $(194,955)
Adjustments to reconcile net loss to net cash flows used in operating activities:          
Gain on life settlements, gross   (39,928,003)   (39,337,542)
Amortization of deferred financing and issuance costs   3,804,795    2,470,390 
Deferred income taxes   (2,401,619)   2,173,767 
Convertible, redeemable preferred stock issued in lieu of cash dividends   774,085    623,899 
Convertible, redeemable preferred stock dividends payable   (116,207)   255 
Gain upon termination of agreement with Athena Securities Ltd.   -    (3,252,400)
(Increase) decrease in operating assets:          
Due from related parties   (291)   8,613 
Insurance benefits receivable   (1,750,000)   2,850,000 
Other assets   (2,347,050)   (566,418)
Increase in operating liabilities:          
Accounts payable   363,706    369,809 
Interest payable   4,638,876    3,418,432 
Other accrued expenses   457,376    50,642 
           
NET CASH FLOWS USED IN OPERATING ACTIVITIES   (42,467,241)   (31,385,508)
           
CASH FLOWS FROM INVESTING ACTIVITIES          
Investment in life settlements   (12,292,401)   (34,997,500)
Proceeds from settlement of life settlements   4,185,813    4,563,896 
             NET CASH FLOWS USED IN INVESTING ACTIVITIES   (8,106,588)   (30,433,604)
           
CASH FLOWS FROM FINANCING ACTIVITIES          
Net proceeds from (repayment of) revolving credit facility   (6,838,952)   8,000,000 
Payments for redemption of Series I Secured Notes payable   (2,268,379)   (8,671,624)
Proceeds from issuance of L Bonds   65,713,297    85,260,976 
Payment of deferred issuance costs for L Bonds   (4,104,876)   (4,320,542)
Payments for redemption of L Bonds   (14,429,017)   (8,143,363)
Issuance of common stock   8,642,990    - 
Proceeds from (uses of) restricted cash   1,536,916    (3,739,878)
Redemption of convertible, redeemable preferred stock   (465,239)   (613,708)
             NET CASH FLOWS PROVIDED BY FINANCING ACTIVITIES   47,786,740    67,771,861 
           
             NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS   (2,787,089)   5,952,749 
           
CASH AND CASH EQUIVALENTS          
BEGINNING OF PERIOD   33,449,793    27,497,044 
END OF PERIOD  $30,662,704   $33,449,793 

 

The accompanying notes are an integral part of these Consolidated Financial Statements.

 

48
 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CASH FLOWS – CONTINUED

 

   Year Ended 
   December 31,
2014
   December 31,
2013
 
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION        
Interest and preferred dividends paid  $16,931,000   $13,627,000 
           
NON-CASH INVESTING AND FINANCING ACTIVITIES          
Non-cash conversion of Series I Secured Notes  $-   $912,000 
Warrants issued to purchase common stock  $47,000   $- 
Options issued to purchase common stock  $122,000   $24,000 
Accrued interest payable on Series I Secured Notes added to principal  $151,000   $185,000 
Accrued interest payable on L Bonds added to principal  $452,000   $141,000 
Conversion of Series A Preferred Stock into common stock   $4,957,000   $- 
Reclassification of Series A Preferred Stock to permanent equity due to initial public offering  $20,327,000   $- 
Issuance of preferred stock in lieu of cash dividends   $774,000   $624,000 

 

The accompanying notes are an integral part of these Consolidated Financial Statements.

 

49
 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

( 1 ) Nature of business and summary of significant accounting policies

 

Nature of business - GWG Holdings, Inc. (GWG Holdings) and subsidiaries, located in Minneapolis, Minnesota, facilitates the purchase of life insurance policies for its own investment portfolio through its wholly owned subsidiary, GWG Life, LLC (GWG Life), and its subsidiaries, GWG Trust (Trust), GWG DLP Funding II, LLC (DLP II) and its wholly-owned subsidiary, GWG DLP Master Trust II (the Trust II). All of these entities are legally organized in Delaware. Unless the context otherwise requires or we specifically so indicate, all references in this report to "we", "us", "our", "our Company", "GWG", or the "Company" refer to these entities collectively.

 

Use of estimates - The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. The Company regularly evaluates estimates and assumptions. The Company bases its estimates and assumptions on current facts, historical experience, and various other factors that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities and the accrual of costs and expenses that are not readily apparent from other sources. The actual results experienced by the Company may differ materially and adversely from the Company’s estimates. To the extent there are material differences between the estimates and the actual results, future results of operations will be affected. The most significant estimates with regard to these consolidated financial statements relates to (1) the determination of the assumptions used in estimating the fair value of the investment in life insurance policies, and (2) the value of deferred tax assets and liabilities.

 

Cash and cash equivalents - The Company considers cash in demand deposit accounts and temporary investments purchased with an original maturity of three months or less to be cash equivalents. The Company maintains its cash and cash equivalents with highly rated financial institutions. From time to time, the Company’s balances in its bank accounts exceed Federal Deposit Insurance Corporation limits. The Company periodically evaluates the risk of exceeding insured levels and may transfer funds as it deems appropriate. The Company has not experienced any losses with regards to balances in excess of insured limits or as a result of other concentrations of credit risk.

 

Life settlements - ASC 325-30, Investments in Insurance Contracts, allows a reporting entity the election to account for its investments in life settlements using either the investment method or the fair value method. The election shall be made on an instrument-by-instrument basis and is irrevocable. Under the investment method, an investor shall recognize the initial investment at the purchase price plus all initial direct costs. Continuing costs (policy premiums and direct external costs, if any) to keep the policy in force shall be capitalized. Under the fair value method, an investor shall recognize the initial investment at the purchase price. In subsequent periods, the investor shall re- measure the investment at fair value in its entirety at each reporting period and shall recognize the change in fair value in current period income net of premiums paid. The Company uses the fair value method to account for all life settlements.

 

The Company recognizes realized gains (revenue) from life settlement contracts upon one of the two following events:

 

1) Receipt of mortality notice or verified obituary of insured; or

2) Sale of policy and filing of change of ownership forms and receipt of payment

 

The Company recognizes the difference between the face value of the insurance benefits and carrying values of the policy when an insured event has occurred and the Company determines that settlement and ultimate collection of the face value of the insurance benefits is realizable and reasonably assured. Revenue from a transaction must meet both criteria in order to be recognized. In an event of a sale of a policy the Company recognizes gain or loss as the difference between the sale price and the carrying value of the policy on the date of the receipt of payment on such sale.

 

Deposits and initial direct costs advanced on unsettled policy acquisitions are recorded as other assets until policy ownership has been transferred to the Company. Such deposits and direct cost advances were $27,000 and $201,000 at December 31, 2014 and 2013, respectively.

 

Deferred financing and issuance costs – Costs incurred to obtain financing under the revolving credit facility, as described in note 5, have been capitalized and are amortized using the straight-line method over the term of the revolving credit facility. Amortization of deferred financing costs was $358,000 and $455,000 for the years ended December 31, 2014 and 2013, respectively. As of December 31, 2014 those costs have been fully amortized. The Series I Secured Notes payable, as described in note 6, are reported net of issuance costs, sales commissions and other direct expenses, which are amortized using the interest method over the term of each respective borrowing. The L Bonds, as described in note 7, are reported net of issuance costs, sales commissions and other direct expenses, which are amortized using the interest method over the term of each respective borrowing. The Series A Preferred Stock, as described in note 8, is reported net of issuance costs, sales commissions, including the fair value of warrants issued, and other direct expenses, which are amortized using the interest method as interest expense over the three-year redemption period.

 

50
 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

Earnings (loss) per share - Basic per share earnings (loss) attributable to non-redeemable interests is calculated using the weighted-average number of shares outstanding during the period. Diluted earnings per share is calculated based on the potential dilutive impact, if any, of the Company’s convertible preferred stock, and outstanding warrants, and stock options. Due to the net loss reported for the years ended December 31, 2014 and 2013, all preferred stock, stock options and warrants are anti-dilutive.

 

Subsequent events - Subsequent events are events or transactions that occur after the balance sheet date but before consolidated financial statements are issued. The Company recognizes in the consolidated financial statements the effects of all subsequent events that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing the consolidated financial statements. The Company’s consolidated financial statements do not recognize subsequent events that provide evidence about conditions that did not exist at the date of the balance sheet but arose after the balance sheet date and before the consolidated financial statements are available to be issued. The Company evaluates subsequent events and transactions that occur after the balance sheet date up to the date that the consolidated financial statements are filed for potential recognition or disclosure.

 

Recently adopted pronouncements - Pronouncements issued by the FASB or other authoritative accounting standards groups with future effective dates are either not applicable or are not expected to be significant to the Company.

 

( 2 ) Restrictions on cash

 

The Company is required by its lenders to maintain collection and escrow accounts. These accounts are used to fund the acquisition, pay annual premiums of insurance policies, pay interest and other charges under the revolving credit facility, and collect policy benefits. DZ Bank AG, as agent for Autobahn Funding Company, LLC, the lender for the revolving credit facility as described in note 5, authorizes the disbursements from these accounts. At December 31, 2014 and December 31, 2013 there were balances of $4,296,000, and $5,833,000, respectively, maintained in these restricted cash accounts.

 

( 3 ) Investment in life insurance policies

 

The life insurance policies (Level 3 fair value measurements) are valued based on unobservable inputs that are significant to the overall fair value measurement. Changes in the fair value of these instruments are recorded in gain or loss on life insurance policies in the consolidated statements of operations (net of the cash premiums paid on the policies). The fair value is determined on a discounted cash flow basis that incorporates life expectancy assumptions. Life expectancy reports have been obtained from widely accepted life expectancy providers. The discount rate incorporates current information about market interest rates, the credit exposure to the insurance company that issued the life insurance policy, and our estimate of the risk premium an investor in the policy would require. As a result of management’s analysis, discount rates of 11.43% and 11.69% were applied to the portfolio as of December 31, 2014 and 2013, respectively.

 

A summary of the Company’s life insurance policies accounted for under the fair value method and their estimated maturity dates, based on remaining life expectancy, is as follows:

 

   As of December 31, 2014   As of December 31, 2013 
Years Ending December 31,  Number of Contracts   Estimated Fair Value   Face Value   Number of Contracts   Estimated Fair Value   Face Value 
2015   3   $5,063,000   $6,000,000    4   $5,065,000   $6,750,000 
2016   7    8,144,000    11,550,000    8    8,174,000    13,750,000 
2017   17    21,916,000    35,542,000    25    33,345,000    63,916,000 
2018   30    41,994,000    76,206,000    33    37,243,000    80,318,000 
2019   45    47,303,000    106,973,000    34    32,844,000    89,295,000 
2020   41    43,429,000    102,614,000    34    27,741,000    75,644,000 
2021   36    29,789,000    90,921,000    33    29,041,000    111,770,000 
Thereafter   112    85,245,000    349,293,000    92    61,220,000    299,205,000 
Totals   291   $282,883,000   $779,099,000    263   $234,673,000   $740,648,000 

 

51
 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

The Company recognized insurance benefits of $18,050,000 and $16,600,000 during 2014 and 2013, respectively, related to policies with a carrying value of $4,186,000 and $4,564,000, respectively. The Company recorded realized gains of $13,864,000 and $12,036,000 on such policies. Subsequent to December 31, 2014, four policies covering three individuals have matured. The combined insurance benefits of these policies were $21,125,000. The Company recorded realized gains of $18,194,000 on four policies.

 

Reconciliation of gain on life settlements:

 

   Years Ended December 31, 
   2014   2013 
Change in fair value  $39,928,000   $39,338,000 
Premiums and other annual fees   (23,376,000)   (21,860,000)
Policy maturities   13,864,000    12,036,000 
Gain on life settlements, net  $30,416,000   $29,514,000 

 

The estimated expected premium payments to maintain the above life insurance policies in force for the next five years, assuming no mortalities, are as follows:

 

Years Ending December 31,    
2015  $26,349,000 
2016   28,857,000 
2017   32,365,000 
2018   35,341,000 
2019   39,423,000 
   $162,335,000 

 

Management anticipates funding the estimated premium payments as noted above with proceeds from the DZ Bank revolving credit facility and through additional debt and equity financing as well as from cash proceeds from maturities of life insurance policies. The proceeds of these capital sources are also intended to be used for the purchase, financing, and maintenance of additional life insurance policies.

 

( 4 ) Fair value definition and hierarchy

 

ASC 820 establishes a hierarchical disclosure framework which prioritizes and ranks the level of market price observability used in measuring assets and liabilities at fair value. Market price observability is affected by a number of factors, including the type of investment, the characteristics specific to the investment and the state of the marketplace including the existence and transparency of transactions between market participants. Assets and liabilities with readily available active quoted prices or for which fair value can be measured from actively quoted prices in an orderly market generally will have a higher degree of market price observability and a lesser degree of judgment used in measuring fair value. ASC 820 establishes a three-level valuation hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e., the “exit price”) in an orderly transaction between market participants at the measurement date.

 

The hierarchy is broken down into three levels based on the observability of inputs as follows:

 

Level 1 - Valuations based on quoted prices in active markets for identical assets or liabilities that the Company has the ability to access. Since valuations are based quoted prices that are readily and regularly available in an active market, valuation of these products does not entail a significant degree of judgment.
  
Level 2 - Valuations based on one or more quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly.
  
Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement.

 

52
 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

The availability of observable inputs can vary by types of assets and liabilities and is affected by a wide variety of factors, including, for example, whether an instrument is established in the marketplace, the liquidity of markets and other characteristics particular to the transaction. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. Accordingly, the degree of judgment exercised by management in determining fair value is greatest for assets and liabilities categorized in Level 3.

 

Level 3 Valuation Process

 

The estimated fair value of the Company’s portfolio of life settlements is determined on a quarterly basis by the Company’s portfolio management committee, taking into consideration changes in discount rate assumptions, estimated premium payments and life expectancy estimate assumptions, as well as any changes in economic and other relevant conditions. These inputs are then used to estimate the discounted cash flows using the Model Actuarial Pricing System (MAPS), probabilistic portfolio price model, which estimates the cash flows using various probabilities and scenarios. The valuation process includes a review by senior management as of each valuation date. Management has also engaged a third party expert to independently test the accuracy of the valuations using the inputs provided by management on a quarterly basis.

 

Life insurance policies, as well as the portfolio taken as a whole, represent financial instruments recorded at fair value on a recurring basis. The following table reconciles the beginning and ending fair value of the Company’s Level 3 investments in its portfolio of life insurance policies for the years ending December 31, as follows:

 

   Years Ended December 31, 
   2014   2013 
Beginning balance  $234,673,000   $164,317,000 
Purchases   12,468,000    35,582,000 
Maturities (cash in excess of carrying value)   (4,186,000)   (4,564,000)
Net change in fair value   39,928,000    39,338,000 
Ending balance  $282,883,000   $234,673,000 

 

The fair value of a portfolio of life insurance policies is based on information available to the Company at the reporting date. Fair value is based upon a discounted cash flow model that incorporates life expectancy estimate assumptions. Life expectancy estimates are obtained from independent, third-party widely accepted life expectancy estimate providers at policy acquisition. The life expectancy values of each insured, as determined at policy acquisition, are rolled down monthly for the passage of time by the MAPS actuarial software the Company uses for ongoing valuation of its portfolio of life insurance policies. The discount rate incorporates current information about discount rate applied by other reporting companies owning portfolios of life insurance policies, discount rates observed in the life insurance secondary market, market interest rates, the credit exposure to the insurance company that issued the life insurance policy and management’s estimate of the risk premium a purchaser would require to receive the future cash flows derived from our portfolio of life insurance policies.

 

On September 15, 2014, 21st Services announced changes to its mortality tables primarily for insureds age 90 and older, as well as updated adjustment factors designed to better underwrite seniors with multiple impairments. These changes represent small portions of 21st Services’ historical underwritings. We expect medical-actuarial underwriting firms to continue improving and refining their underwriting methodology.

 

The fair value of life insurance policies is estimated using present value calculations of estimated cash flows based on the data specific to each individual life insurance policy. Estimated future policy premium payments are calculated based on the terms of the policy and the premium payment history. The following summarizes the unobservable inputs utilized in estimating the fair value of the portfolio of life insurance policies:

 

   As of
December 31,
2014
   As of
December 31,
2013
 
Weighted average age of insured   82.8    82.1 
Weighted average life expectancy, months*   78.4    87.0 
Average face amount per policy  $2,677,000   $2,816,000 
Discount rate   11.43%   11.69%

 

* Standard life expectancy as adjusted for insured’s specific circumstances.

 

53
 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

These assumptions are, by their nature, inherently uncertain and the effect of changes in estimates may be significant. The techniques used in estimating the present value of estimated cash flows are derived from valuation techniques generally used in the industry that include inputs for the asset that are not based on observable market data. The extent to which the fair value could reasonably vary in the near term has been quantified by evaluating the effect of changes in significant underlying assumptions used to estimate the fair value. If the life expectancy estimates were increased or decreased by four and eight months on each outstanding policy and the discount factors were increased or decreased by 1% and 2%, while all other variables are held constant, the fair value of the investment in life insurance policies would increase or (decrease) by the amounts summarized below:

 

   Changes in fair value of life insurance policies 
Change in life expectancy estimates  plus
8 months
   minus
8 months
   plus
4 months
   minus
4 months
 
                 
December 31, 2014  $(38,864,000)  $40,634,000   $(19,664,000)  $20,130,000 
                     
December 31, 2013  $(34,382,000)  $36,152,000   $(17,417,000)  $17,865,000 

 

Change in discount rate  plus 2%   minus 2%   plus 1%   minus 1% 
                 
December 31, 2014  $(24,085,000)  $28,179,000   $(12,502,000)  $13,522,000 
                     
December 31, 2013  $(22,944,000)  $27,063,000   $(11,933,000)  $12,959,000 

 

Other Fair Value Considerations

 

Carrying value of receivables, prepaid expenses, accounts payable and accrued expenses approximate fair value due to their short-term maturities and low credit risk. The estimated fair value of the Company’s Series I Secured Notes payable and L Bonds is approximately $216,837,000 based on a weighted-average market interest rate of 7.17% based on an income approach, the combined face value of these notes is $214,424,000 as of December 31, 2014. The carrying value of the revolving credit facility reflects interest charged at the commercial paper rate plus an applicable margin. The margin represents our credit risk, and the strength of the portfolio of life insurance policies collateralizing the debt. The overall rate reflects market, and the carrying value of the revolver approximates fair value. All of the financial instruments are Level 3 fair value measurements.

 

The Company has issued warrants to purchase common stock in connection with the issuance of its convertible preferred stock. Warrants were determined by the Company as permanent equity. The fair value measurements associated with the warrants, measured at issuance represent Level 3 instruments.

 

As of December 31, 2014:

Month issued  Warrants
Issued
   Fair value
per share
   Risk
free rate
   Volatility   Term
December 2011   68,937   $0.22    0.42%   25.25%  5 years
March 2012   38,130   $0.52    0.38%   36.20%  5 years
June 2012   161,840   $1.16    0.41%   47.36%  5 years
July 2012   144,547   $1.16    0.41%   47.36%  5 years
September 2012   2,500   $0.72    0.31%   40.49%  5 years
September 2014   16,000   $1.26    1.85%   17.03%  5 years
    431,954                   

 

Volatility is based upon the weekly percentage change in the stock price of selected comparable insurance companies. In June 2012, we evaluated the comparable companies used, and made certain changes to those used. The percentage change is calculated on the average price of those selected stocks at the weekly close of business for the year preceding the balance sheet date. We compare annual volatility based on this weekly information.

 

In conjunction with the Company’s recent initial public offering, the Company issued a warrant for the purchase of up 16,000 shares of the Company’s common stock to the underwriters of the initial public offering.

 

54
 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

( 5 ) Credit facilities

 

Revolving credit facility – Autobahn Funding Company LLC

 

On July 15, 2008, DLP II and United Lending entered into a revolving credit facility pursuant to a Credit and Security Agreement (Agreement) with Autobahn Funding Company LLC (Autobahn), providing the Company with a maximum borrowing amount of $100,000,000. Autobahn is a commercial paper conduit that issues commercial paper to investors in order to provide funding to DLP II. DZ Bank AG Deutsche Zentral-Genossenschaftsbank (DZ Bank) acts as the agent for Autobahn. The original Agreement was to expire on July 15, 2013. On January 29, 2013, GWG Holdings, together with GWG Life and DLP II, entered into an Amended and Restated Credit and Security Agreement with Autobahn, extending the facility expiration date to December 31, 2014. On May 29, 2014, GWG Holdings, together with GWG Life and DLP II, entered into an Amendment No. 1 to Amended and Restated Credit and Security Agreement with Autobahn and DZ Bank (as committed lender and Agent). The amendment was entered into for the purpose of extending the maturity date for borrowings under the agreement to December 31, 2016. The amount outstanding under this facility as of December 31, 2014 and 2013 were $72,161,000 and $79,000,000, respectively.

 

The Agreement requires DLP II to pay, on a monthly basis, interest at the commercial paper rate plus an applicable margin, as defined in the Agreement. The effective rate was 6.24% at December 31, 2014 and 6.19% at December 31, 2013. The weighted average effective interest rate (excluding the unused line fee) was 6.24% and 6.14% for the years ended December 31, 2014 and 2013, respectively. The Agreement also requires payment of an unused line fee on the unfunded amount under the revolving credit facility. The note is secured by substantially all of DLP II assets which consist primarily of life insurance policies.

 

The Agreement has certain financial and nonfinancial covenants. The Company was in compliance with these covenants at December 31, 2014 and December 31, 2013. The Agreement generally prohibits the Company from:

 

changing its corporate name, offices, and jurisdiction of incorporation;
changing any deposit accounts or payment instructions to insurers;
changing any operating policies and practices such that it would be reasonably likely to adversely affect the collectability of any asset in any material respect;
merging or consolidating with, or selling all or substantially all of its assets to, any third party;
selling any collateral or creating or permitting to exist any adverse claim upon any collateral;
engaging in any other business or activity than that contemplated by the Agreement;
incurring or guaranteeing any debt for borrowed money;
amending the Company’s certificate of incorporation or bylaws, making any loans or advances to, investments in, or paying any dividends to, any person unless both before and after any such loan, advance, investment or dividend there exists no actual event of default, potential event of default or termination event;
removing an independent director on the board of directors except for cause or with the consent of the lender; or
making payment on or issuing any Series I Secured Notes or L Bonds, or amending any agreements respecting such notes or bonds, if an event of default, potential event of default, or termination event exists or would arise from any such action.

 

In addition, the Company has agreed to maintain (i) a positive consolidated net income on a Non-GAAP basis (as defined and calculated under the Agreement) for each complete fiscal year; (ii) a tangible net worth on a Non-GAAP basis (as defined and calculated under the Agreement) of not less than $15 million; and (iii) maintain a borrowing base surplus or cash cushion sufficient to pay 12 months of premiums and facility fees.

 

Consolidated net income and tangible net worth as of and for the four quarters ended December 31, 2014, as calculated under the Agreement, was $29,369,000 and $87,381,000 respectively.

 

Advances under the Agreement are subject to a borrowing base formula, which limits the availability of advances based on attributes of policies pledged to the facility. Over-concentration of policies by insurance carrier, over-concentration of policies by insurance carriers with ratings below a AA- rating, and the premiums and facility fees reserve are the three primary factors which might limit availability of funds on the facility. Total funds available for additional borrowings under the borrowing base formula criteria at December 31, 2014 and December 31, 2013, were $20,585,000 and $3,937,000 respectively.

 

55
 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

On July 15, 2008, GWG Holdings delivered a performance guaranty in favor of Autobahn pursuant to which it guaranteed the obligations of GWG Life, in its capacity as the seller and master servicer, under the Credit and Security Agreement and related documents. In January 2013 and May 2014 in connection with the Amended and Restated Credit and Security Agreement and Amendment No. 1 to Amended and Restated Credit and Security Agreement, GWG Holdings delivered a reaffirmation of its performance guaranty. The obligations of GWG Holdings under the performance guaranty and subsequent reaffirmation do not extend to the principal and interest owed by DLP II as the borrower under the credit facility.

 

( 6 ) Series I Secured Notes payable

 

Series I Secured Notes payable have been issued in conjunction with the GWG Series I Secured Notes private placement memorandum dated August 25, 2009 (last revised November 15, 2010). Series I Secured Notes are secured by assets of GWG Life and are subordinate to our revolving credit facility (see note 5). On June 14, 2011, the Company closed the offering to additional investors; however, existing investors may elect to continue advancing amounts outstanding upon maturity subject to the Company’s option. Series I Secured Notes have maturity dates ranging from six months to seven years with fixed interest rates varying from 5.65% to 9.55% depending on the term of the note. Interest is payable monthly, quarterly, annually or at maturity depending on the terms of the note. At December 31, 2014 and December 31, 2013, the weighted-average interest rate of Series I Secured Notes was 8.37% and 8.35%, respectively. The notes are secured by assets of GWG Life. The principal amount outstanding under these Series I Secured Notes was $28,047,000 and $29,744,000 at December 31, 2014 and December 31, 2013, respectively. The difference between the amount outstanding on the Series I Secured Notes and the carrying amount on the consolidated balance sheet is due to netting of unamortized deferred issuance costs. Overall, interest expense includes amortization of deferred financing and issuance costs of $552,000 and $606,000 in 2014 and 2013, respectively. Future expected amortization of deferred financing costs is $430,000 in total over the next six years.

 

Future contractual maturities of Series I Secured Notes payable and future amortization of their deferred financing costs at December 31, 2014 are as follows:

 

Years Ending December 31,  Contractual Maturities   Amortization of Deferred Financing Costs 
2015  $13,887,000   $92,000 
2016   8,242,000    161,000 
2017   4,713,000    134,000 
2018   754,000    30,000 
2019   347,000    8,000 
Thereafter   104,000    5,000 
   $28,047,000   $430,000 

 

( 7 ) Renewable Secured Debentures (subsequently renamed L Bonds) 

The Company registered with the SEC, effective January of 2012, the offer and sale of $250,000,000 of Renewable Secured Debentures (subsequently renamed “L Bonds”). The debentures are secured by assets of GWG Holdings and GWG Life and are subordinate to our revolving credit facility (see note 5). L Bonds have maturity dates ranging from six months to seven years with fixed interest rates varying from 4.25% to 9.50% depending on the term of the note. Interest is payable monthly, annually or at maturity depending on the terms of the debenture. At December 31, 2014 and December 31, 2013, the weighted-average interest rate of L Bonds was 7.45% and 7.53%, respectively. The amount outstanding under these L Bonds was $186,377,000 and $134,891,000 at December 31, 2014 and December 31, 2013, respectively. The difference between the amount outstanding on the L Bonds and the carrying amount on the consolidated balance sheets is due to netting of unamortized deferred issuance costs and cash receipts for new issuances in process. Amortization of deferred issuance costs was $3,537,000 and $1,843,000 in 2014 and 2013, respectively. Future expected amortization of deferred financing costs as of December 31, 2014 is $5,882,000 in total over the next seven years. Subsequent to December 31, 2014, the Company has issued approximately an additional $19,051,000 in principal amount of L Bonds.

 

The use of proceeds from the issuances of L Bonds is limited to the following: (1) payment of commissions on sales of L Bonds, (2) payment of offering expenses, (3) purchase of life insurance policies, (4) payment of premiums on life insurance policies, (5) payment of principal and interest on L Bonds, (6) payment of portfolio operations expenses, and (7) general working capital.

 

Future contractual maturities of L Bonds and future amortization of their deferred financing costs at December 31, 2014 are as follows:

 

Years Ending December 31,  Contractual Maturities   Amortization of Deferred Financing Costs 
2015  $63,375,000   $871,000 
2016   50,270,000    1,578,000 
2017   29,546,000    1,253,000 
2018   13,551,000    668,000 
2019   14,262,000    670,000 
Thereafter   15,373,000    842,000 
   $186,377,000   $5,882,000 

56
 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

The Company entered into an Indenture effective October 19, 2011 with Holdings as obligor, GWG Life as guarantor, and Bank of Utah as trustee for the benefit of the debenture holders. The Indenture has certain financial and nonfinancial covenants. The Company was in compliance with these covenants at December 31, 2014 and 2013.

 

( 8 ) Convertible preferred stock

 

The Company offered 3,333,333 shares of convertible redeemable preferred stock (Series A Preferred Stock) for sale to accredited investors in a private placement on July 31, 2011. The offering of Series A Preferred Stock concluded on September 2, 2012 and resulted in 3,278,000 shares being issued for gross consideration of $24,582,000. As of December 31, 2014, 277,000 shares have been issued as a result of conversion of $1,936,681 in dividends into shares of Series A Preferred Stock and 678,000 shares have been converted to 508,000 shares of the Company’s common stock. The Series A Preferred Stock was sold at an offering price of $7.50 per share. Series A Preferred Stock has a preferred yield of 10% per annum, and each share has the right to convert into 0.75 shares of the Company’s common stock. Series A preferred shareholders also received three-year warrants to purchase, at an exercise price per share of $12.50, one share of common stock for every 40 shares of Series A Preferred Stock purchased. The warrants are exercisable immediately. Upon their original issuance, these warrants had a three-year exercise period. Effective August 1, 2014, the Board of Directors authorized the extension of the warrant exercise period for an additional two years. In the Certificate of Designations for the Series A Preferred Stock dated July 31, 2011, the Company agreed to permit preferred shareholders to sell their shares back to the Company for the stated value of $7.50 per share, plus accrued dividends, according to the following schedule:

 

Up to 33% of the holder’s unredeemed shares one year after issuance:
Up to 66% of the holder’s unredeemed shares two years after issuance; and
Up to 100% of the holder’s unredeemed shares three years after issuance.

 

The Company’s obligation to redeem its Series A preferred stock terminated upon the Company completing a registration of its common stock with the SEC which occurred on September 24, 2014 (See Note 11). As such, the convertible redeemable preferred stock was reclassified from temporary equity to permanent equity. The Company may redeem the Series A preferred shares at a price equal to 110% of their liquidation preference ($7.50 per share) at any time. As of December 31, 2014, the Company had redeemed an aggregate of 145,000 shares of Series A preferred stock. The Series A Preferred Stock shares (i) were convertible, at the election of the Company, into common stock of the Company in the event of either a registered offering of the Company’s common stock with the SEC aggregating gross proceeds of at least $5.0 million and at a price equal to or greater than $11.00 per share; (ii) remain convertible at the option of each holder; and (iii) are required to be converted upon the consent of shareholders holding at least a majority of the then-outstanding Series A preferred stock. In connection with the Company’s initial public offering, the Company elected to cause the conversion of 677,566 shares of preferred stock into 508,193 shares of common stock. As of December 31, 2014, the Company had 2,739,000 shares of Series A Preferred Stock outstanding with gross consideration of $20,528,000 (including cash proceeds, conversion of Series I Secured Notes and accrued interest on Series I notes, and conversion of preferred dividends payable). The Company incurred Series A Preferred Stock issuance costs of $2,838,000, all of which was included as a component of additional paid in capital as of December 31, 2014.

 

The Company determined that the grant date fair value of the outstanding warrants attached to the Series A Preferred Stock was $428,000 for warrants outstanding as of December 31, 2014. The Company may redeem outstanding warrants prior to their expiration, at a price of $0.01 per share upon 30 days written notice to the investors at any time after (i) the Company has completed a registration of its common stock with the SEC and (ii) the volume of weighted-average sale price per share of common stock equals or exceeds $14.00 per share for ten consecutive trading days ending on the third business day prior to proper notice of such redemption.

 

In conjunction with the Company’s initial public offering a warrant for purchase of up to 16,000 shares of the Company’s common stock was issued to the underwriters of the initial public offering. These warrants are not exercisable prior to March 17, 2015 and expire on September 18, 2019. Total warrants outstanding as of December 31, 2014, were 431,954 with a weighted-average remaining life of 2.43 years. Total warrants outstanding at December 31, 2013, were 415,955 with a weighted-average remaining life of 1.34 years. As of December 31, 2014, none of these warrants have been exercised.

 

Dividends on the Series A Preferred Stock may be paid in either cash or additional shares of Series A Preferred Stock at the election of the holder and approval of the Company. The dividends are reported as an expense and included in the caption interest expense in the consolidated statements of operations. The Company declared and accrued dividends of $2,428,000 and $2,528,000 in 2014 and 2013, respectively, pursuant to a board resolution declaring the dividend. 111,000 and 89,000 shares of Series A Preferred Stock were issued in lieu of cash dividends in 2014 and 2013, respectively. The shares issued in lieu of cash dividends were issued at $7.00 per share. As of December 31, 2014, GWG Holdings has $513,000 of accrued preferred dividends which were paid or converted to shares of Series A Preferred Stock on January 15, 2015.

 

57
 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

( 9 ) Income taxes

 

The Company did not have any current income taxes for the years ended December 31, 2014 or 2013. The components of deferred income tax benefit for 2014 and income tax expense for 2013, consisted of the following:

 

Income tax provision (benefit):  2014   2013 
Deferred:        
Federal  $(1,820,000)  $1,826,000 
State   (582,000)   348,000 
Total income tax expense (benefit)  $(2,402,000)  $2,174,000 

 

The following table provides a reconciliation of our income tax expense (benefit) at the statutory federal tax rate to our actual income tax expense (benefit):

 

   2014   2013 
Statutory federal income tax  $(2,844,000)   (34.0)%  $673,000    34.0%
State income taxes, net of federal benefit   (374,000)   (4.5)%   298,000    15.1%
Series A Preferred Stock dividends   826,000    9.9%   860,000    43.4%
Other permanent differences   (10,000)   (0.1)%   343,000    17.3%
Total income tax expense (benefit)  $(2,402,000)   (28.7)%  $2,174,000    109.8%

 

The primary differences between the Company’s December 31, 2014 effective tax rate and the statutory federal rate are the accrual of nondeductible preferred stock dividend expense of $2,428,000, state taxes, and other non-deductible expenses. The most significant temporary differences between GAAP net income and taxable net income are the treatment of interest costs with respect to the acquisition of the life insurance policies and revenue recognition with respect to the mark-to-market of life insurance portfolio.

 

The tax effects of temporary differences that give rise to deferred income taxes were as follows:

 

   2014   2013 
Deferred tax assets :        
Note receivable from related party  $2,023,000   $2,023,000 
Net operating loss carryforwards   4,517,000    2,596,000 
Other assets   272,000    164,000 
Subtotal   6,812,000    4,783,000 
Valuation allowance   (2,164,000)   (2,164,000)
Net deferred tax asset   4,648,000    2,619,000 
           
Deferred tax liabilities:          
Investment in life settlements   (9,922,000)   (10,294,000)
Net deferred tax assets  $(5,274,000)  $(7,675,000)

 

At December 31, 2014 and 2013, the Company had federal net operating loss (NOL) carryforwards of $11,163,000 and $4,182,000, respectively, and aggregate state NOL carryforwards of approximately $7,334,000 and $2,748,000, respectively. The NOL carryforwards will begin to expire in 2031. Future utilization of NOL carryforwards is subject to limitations under Section 382 of the Internal Revenue Code. This section generally relates to a more than 50 percent change in ownership over a three-year period. We currently do not believe that any issuance of common stock has resulted in an ownership change under Section 382.

 

The Company provides for a valuation allowance when it is not considered more likely than not that our deferred tax assets will be realized. At both December 31, 2014 and 2013 based upon all available evidence, the Company has provided a valuation allowance of $2,164,000, against deferred tax assets related to the likelihood of recovering the tax benefit of a capital loss on a note receivable from a related entity. Management believes all other deferred tax assets are recoverable.

 

ASC 740, Income Taxes, requires the reporting of certain tax positions which do not meet a threshold of "more-likely-than-not" to be recorded as uncertain tax benefits. It management's responsibility to determine whether it is "more-likely-than-not" that a tax position will be sustained upon examination, including resolution of any related appeals or litigation, based upon the technical merits of the position. Management has reviewed all income tax positions taken or expected to be taken for all open years and determined that the income tax positions are appropriately stated and supported. The Company does not anticipate that the total unrecognized tax benefits will significantly change prior to December 31, 2015.

 

58
 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

Under the Company’s accounting policies, interest and penalties on unrecognized tax benefits, as well as interest received from favorable tax settlements are recognized as components of income tax expense. At December 31, 2014 and 2013, the Company has recorded no accrued interest or penalties related to uncertain tax positions.

 

The Company’s income tax returns for tax years ended December 31, 2012, 2013, and 2014, when filed, remain open to examination by the Internal Revenue Service and various state taxing jurisdictions.

 

( 10 ) Common Stock

 

On September 24, 2014, GWG consummated an initial public offering of its common stock which resulted in the sale of 800,000 shares of common stock at $12.50 per share. The sale resulted in net proceeds of approximately $8.6 million after the deduction of underwriting commissions, discounts and expense reimbursements. In connection with this offering, the Company listed its common stock on The NASDAQ Capital Market under the ticker symbol “GWGH” effective September 25, 2014. The Company used the net proceeds from the offering to promote and advertise the opportunities for consumers owning life insurance and investors to profit from participating in the secondary market for life insurance policies, purchase additional life insurance policies in the secondary market, pay premiums on the Company’s life insurance policy assets, fund its portfolio operations, and for working capital purposes.

 

On July 11, 2011, GWG entered into a Purchase and Sale Agreement with Athena Securities Group, Ltd. and Athena Structured Funds PLC. Under this agreement, GWG issued to Athena Securities Group, Ltd. (Athena) 494,500 shares of common stock, which was equal to 9.9% of GWG’s outstanding shares, in exchange for shares equal to 9.9% of the outstanding shares in Athena Structured Funds, PLC and cash of $5,000. This 2011 agreement had contemplated cooperative efforts by the parties aimed at developing a security and related offering in Europe or Ireland, the proceeds of which would be used to finance the acquisition of life-insurance related assets in the United States. In 2013, GWG sought to terminate the 2011 agreement due to a changing regulatory environment in Europe that negatively affected the likelihood of consummating the contemplated offering of securities, and the Company’s dissatisfaction with Athena’s performance under the 2011 agreement. As a result, in June 2013 GWG entered into a second Purchase and Sale Agreement with Athena Securities Ltd. and Athena. This agreement effected the termination of the 2011 agreement. The June 2013 agreement contained mutual general releases of claims and substantially unwound certain capital stock transactions that had been effected under the 2011 agreement. In particular, Athena returned to GWG for redemption 432,500 shares of the Company’s common stock, and retained 62,000 common shares in recognition of their earlier efforts under the 2011 agreement. For GWG’s part, the Company sold back to Athena all of its ownership in Athena Structured Funds, PLC that it had originally acquired under the 2011 agreement. Presently, GWG has no ongoing business relationship with Athena.

 

Stock split— On June 24, 2014, the Company’s Board of Directors and majority stockholders approved a joint resolution to effect an amendment to the Company’s Certificate of Incorporation to effect a reverse split of the issued and outstanding common stock on a 2-for-1 basis. The effective date of the amendment and reverse stock split was June 24, 2014. In lieu of fractional shares, stockholders received cash payments in an amount equal to the fraction to which the stockholder would otherwise be entitled multiplied by the price of the common stock, as determined by the Board of Directors of the Company, but adjusted so as to give effect to the reverse stock split. The par value of the common stock remained at $0.001 per share.

 

( 11 ) Stock Incentive Plan

 

The Company adopted the GWG Holdings, Inc. 2013 Stock Incentive Plan on March 27, 2013. The plan was subsequently revised on March 4, 2015. The plan is administered by Compensation Committee of the Board of Directors of the Company. The Company’s Chief Executive Officer may, on a discretionary basis and without committee review or approval, grant incentives to new employees of the Company who are not Officers of the Company. Incentives under the plan may be granted in one or a combination of the following forms: (a) incentive stock options and non-statutory stock options; (b) stock appreciation rights; (c) stock awards; (d) restricted stock; (e) restricted stock units; and (f) performance shares. Eligible participants include officers and employees of the company, members of the Board of Directors, and consultants or other independent contractors. 2,000,000 shares are issuable under the plan. No person shall receive grants of stock options and SARs under the plan that exceed, in the aggregate 400,000 shares of common stock in any one year. The term of each stock option shall be determined by the committee but shall not exceed ten years. Vested stock options may be exercised in whole or part by the holder giving notice to the Company. The holder of the option may provide payment for the exercise price or surrender shares equal to the exercise price.

 

59
 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

The Company issued stock options for 745,601 shares of common stock to employees, officers, and directors of the Company through December 31, 2014. Options for 314,288 shares have vested, and the remaining options will vest over three years. The options were issued with an exercise price between $8.20 and $9.01 for those owning more than 10% of the Company’s stock and between $7.46 and $10.25 for others, which is equal to the estimated market price of the shares on the date of grant valued using Black-Scholes binomial option pricing model. The expected volatility used in the Black-Scholes model valuation of options issued during the year was 17.03% annualized. The annual volatility rate is based on the standard deviation of the average continuously compounded rate of return of five selected comparable companies over the previous 52 weeks. Forfeiture rate of 15% is based on historical Company information and expected future trend. As of December 31, 2014, stock options for 63,166 shares were forfeited and stock options for 334 shares were exercised.

 

In September 2014, we entered into a stock option agreement (the Agreement) with a new management employee (the Employee) granting the Employee the right to purchase up to 318,000 of the Company’s common stock at an exercise price of $12.50. The grant of such rights to purchase the Company’s common stock was treated as an inducement grant and was issued outside the GWG Holdings Inc. 2013 Stock Incentive Plan. The Agreement specifies that, among other things, options to purchase 159,000 shares of the Company’s common stock will vest with the Employee ratably on the first, second and third anniversary of the date of the Agreement. The remaining 159,000 options will vest quarterly using a formula based upon the closing price of the Company’s common stock on the last business day of such quarter. The maximum number of these remaining options that will vest with the Employee is 53,000 in each successive one-year period beginning on the date of the Agreement.

 

Outstanding stock options:

 

   Vested   Un-vested   Total 
Balance as of December 31, 2013   195,000    210,250    405,250 
Granted during the year   64,450    565,901    630,351 
Vested during the year   72,089    (72,089)   - 
Exercised during the year   (334)   -    (334)
Forfeited during the year   (16,917)   (18,249)   (35,166)
Expired during the year   -    -    - 
Balance as of December 31, 2014   314,288    685,813    1,000,101 

 

Compensation expense related to un-vested options not yet recognized is $591,000. We expect to recognize this compensation expense over the next three years ($221,000 in 2015, $212,000 in 2016, and $158,000 in 2017). The Company issues new common stock for options exercised.

 

( 12 ) Net loss per common share

 

The Company began issuing Series A Preferred Stock September, 1, 2011, as described in note 8. The Series A Preferred Stock is anti-dilutive to the net loss per common share calculation at December 31, 2014 and 2013. The Company has also issued warrants to purchase common stock in conjunction with the sale of convertible preferred stock, discussed in note 8. The warrants and vested stock options are anti-dilutive at December 31, 2014 and 2013 and have not been included in the fully diluted net loss per common share calculation.

 

As of December 31,  2014   2013 
NET LOSS   (5,962,909)   (194,955)
(Loss) attributable to preferred shareholders