Note 1. Nature of Operations and Basis of Presentation

Nature of Operations

Midwest Holding Inc. (“Midwest,” “the Company,” “we,” “our,” or “us”) was incorporated in Nebraska on October 31, 2003 for the primary purpose of operating a financial services company. The Company is in the life and annuity insurance business and operates through its wholly owned subsidiary, American Life & Security Corp. (“American Life”). As discussed in Note 3, on June 28, 2018, we underwent a change in control as a result of the closing of a Loan, Convertible Preferred Stock and Convertible Senior Secured Note Purchase Agreement dated May 9, 2018 with a non-affiliated third party, Xenith Holdings LLC, a Delaware limited liability company (“Xenith”). On April 2, 2019, we obtained a 51% ownership in 1505 Capital, a Delaware limited liability company, that was established in 2018 to provide financial and investment advisory and management services to clients and related investment activities. 1505 Capital’s financial results are consolidated with the Company’s from the date of its acquisition.

Management evaluates the Company as one reporting segment in the life insurance industry. The Company is primarily engaged in the underwriting and marketing of annuity products and life insurance through American Life. The product offerings, the underwriting processes, and the marketing processes are similar. The Company’s historical product offerings consisted of a multi-benefit life insurance policy that combined cash value life insurance with a tax deferred annuity and a single premium term life product. These product offerings were underwritten, marketed, and managed as a group of similar products on an overall portfolio basis. The American Life presently offers two products, a multi-year guaranteed annuity ("MYGA") and a fixed indexed annuity (“FIA”).

Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with United States of America generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions from the Securities and Exchange Commission (“SEC”) Quarterly Report on Form 10‑Q, including Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. The information contained in the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10‑K for the year ended December 31, 2019 (“2019 Form 10‑K”), should be read in connection with the reading of these interim unaudited consolidated financial statements.

Certain GAAP policies that significantly affect the determination of financial condition, results of operations and cash flows, are summarized in our 2019 Form 10‑K.

In the opinion of management, these statements include all normal recurring adjustments necessary for a fair presentation of the Company’s results. Operating results for the three months ended March 31, 2020, are not necessarily indicative of the results that may be expected for the full year ending December 31, 2020. All intercompany accounts and transactions have been eliminated in consolidation and certain immaterial reclassifications have been made to the prior period results to conform to the current period’s presentation with no impact on results of operations or total stockholders’ equity.

Investments

All fixed maturities and a portion of the equity securities owned by the Company are considered available-for-sale and are included in the consolidated financial statements at their fair value as of the financial statement date. Bond premiums and discounts are amortized using the scientific-yield method over the term of the bonds. Realized gains and losses on securities sold during the year are determined using the specific identification method. Unrealized holding gains and losses, net of applicable income taxes, are included in accumulated other comprehensive income.

Declines in the fair value of available-for-sale securities below their amortized cost are evaluated to assess whether any other-than-temporary impairment loss should be recorded. In determining if these losses are expected to be other-than-temporary, the Company considers severity of impairment, duration of impairment, forecasted recovery period, industry outlook, the financial condition of the issuer, issuer credit ratings, and the intent and ability of the Company to hold the investment until the recovery of the cost.

The recognition of other-than-temporary impairment losses on debt securities is dependent on the facts and circumstances related to the specific security. If the Company intends to sell a security or it is more likely than not that the Company would be required to sell a security prior to recovery of the amortized cost, the difference between amortized cost and fair value is recognized in the statement of comprehensive income as an other-than-temporary impairment. If the Company does not expect to recover the amortized basis, does not plan to sell the security and if it is not more likely than not that the Company would be required to sell a security before the recovery of its amortized cost, the recognition of the other-than-temporary impairment is bifurcated. The Company recognizes the credit loss portion in the income statement and the noncredit loss portion in accumulated other comprehensive loss. The credit component of an other-than-temporary impairment is determined by comparing the net present value of projected cash flows with the amortized cost basis of the debt security. The net present value is calculated by discounting the Company’s best estimate of projected future cash flows at the effective interest rate implicit in the fixed income security at the date of acquisition. Cash flow estimates are driven by assumptions regarding probability of default, including changes in credit ratings, and estimates regarding timing and amount of recoveries associated with a default. The Company has analyzed the securities portfolio and determined that there was not an other-than-temporary impairment for the three months ended March 31, 2020.

Investment income consists of interest, dividends, gains and losses from equity method investments, and real estate income, which are recognized on an accrual basis and amortization of premiums and discounts.

Mortgage loans on real estate, held for investment

Mortgage loans on real estate, held for investment are carried at unpaid principal balances. Interest income on mortgage loans on real estate, held for investment is recognized in net investment income at the contract interest rate when earned. A mortgage loan is considered to be impaired when it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the mortgage agreement. Valuation allowances on mortgage loans are established based upon losses expected by management to be realized in connection with future dispositions or settlements of mortgage loans, including foreclosures. The Company establishes valuation allowances for estimated impairments on an individual loan basis as of the balance sheet date. Such valuation allowances are based on the excess carrying value of the loan over the present value of expected future cash flows discounted at the loan’s original effective interest rate. These evaluations are revised as conditions change and new information becomes available. No such valuation allowance was established as of March 31, 2020.

Investment escrow

The Company held in escrow as of December 31, 2019, cash used to settle a mortgage loan that closed in January 2020. As of March 31, 2020, the Company did not hold any cash related to investments in escrow.

Other invested assets

The Company purchases and sells leases in its investment portfolio. As of March 31, 2020, the Company owned several lease investments.

Derivative Instruments

Derivatives are used to hedge the risks experienced in our ongoing operations, such as equity, interest rate and cash flow risks, or for other risk management purposes, which primarily involve managing liability risks associated with our indexed annuity products and reinsurance agreements. Derivatives are financial instruments whose values are derived from interest rates, foreign exchange rates, financial indices or other underlying notional amounts. Derivative assets and liabilities are carried at fair value on the consolidated balance sheets.

To qualify for hedge accounting, at the inception of the hedging relationship, we would formally document our designation of the hedge as a cash flow or fair value hedge and our risk management objective and strategy for undertaking the hedging transaction. In this documentation, we would identify how the hedging instrument is expected to hedge the designated risks related to the hedged item, the method that would be used to retrospectively and prospectively assess the hedging instrument’s effectiveness and the method which would be used to measure ineffectiveness. A derivative designated as a hedging instrument must be assessed as being highly effective in offsetting the designated risk of the hedged item. Hedge effectiveness is formally assessed at inception and periodically throughout the life of the designated hedging relationship.

In the fourth quarter of 2019, the Company began investing in options to hedge our interest rate risks on our FIA product. Options typically do not qualify for hedge accounting; therefore, we chose not to use hedge accounting for our options that we currently have. We value our derivatives at fair market value with the offset being recorded on our income statement as a realized gain or (loss).

Additionally, reinsurance agreements written on a funds withheld or modified coinsurance basis contain embedded derivatives on our fixed indexed annuity product. Gains or (losses) associated with the performance of assets maintained in the modified coinsurance deposit and funds withheld accounts are reflected as realized gains or (losses ) in the income statement.

Preferred Stock

Preferred stock of a non-affiliated company was purchased during the third quarter of 2019. The Company believes the cost of the preferred stock equals fair market value as of March 31, 2020.

Policy loans

Policy loans are carried at unpaid principal balances. Interest income on policy loans is recognized in net investment income at the contract interest rate when earned. No valuation allowance is established for these policy loans as the amount of the loan is fully secured by the death benefit of the policy and cash surrender value.

Cash and cash equivalents

The Company considers all liquid investments with original maturities of three months or less when purchased to be cash equivalents. At March 31, 2020 and December 31, 2019, the Company had no cash equivalents. At March 31, 2020, the Company held approximately 1.0 million in Great British Pounds in cash in two of our custody accounts. The USD equivalent held was approximately $1.2 million.

Deferred acquisition costs

Deferred acquisition costs (“DAC”) consist of incremental direct costs, net of amounts ceded to reinsurers, that result directly from and are essential to the contract acquisition transaction and would not have been incurred by the Company had the contract acquisition not occurred. These costs are capitalized, to the extent recoverable, and amortized over the life of the premiums produced. The Company evaluates the types of acquisition costs it capitalizes. The Company capitalizes agent compensation and benefits and other expenses that are directly related to the successful acquisition of contracts. The Company also capitalizes expenses directly related to activities performed by the Company, such as underwriting, policy issuance, and processing fees incurred in connection with successful contract acquisitions.

Recoverability of deferred acquisition costs is evaluated periodically by comparing the current estimate of the present value of expected pretax future profits to the unamortized asset balance. If this current estimate is less than the existing balance, the difference is charged to expense. The Company performs a recoverability analysis annually in the fourth quarter unless events occur which require an immediate review. The Company determined that no events occurred in the three months ended March 31, 2020 that suggest a review should be undertaken.

Property and equipment

Property and equipment are stated at cost net of accumulated depreciation. Annual depreciation is primarily computed using straight-line methods for financial reporting and straight-line and accelerated methods for tax purposes. Furniture and equipment is depreciated over 3 to 7 years and computer software and equipment is generally depreciated over 3 years. Depreciation expense totaled $10,316 and $9,506 for the three months ended March 31, 2020 and 2019, respectively. Accumulated depreciation totaled $985,796 and $975,480 as of March 31, 2020 and December 31, 2019, respectively.

Maintenance and repairs are expensed as incurred. Replacements and improvements which extend the useful life of the asset are capitalized. The net book value of assets sold or retired are removed from the accounts, and any resulting gain or loss is reflected in earnings.

Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. An impairment loss is recognized if the carrying amount of an asset may not be recoverable and exceeds estimated future undiscounted cash flows of the asset. A recognized impairment loss reduces the carrying amount of the asset to its fair value. Management has determined that no such events occurred in the three months ended March 31, 2020 that would indicate the carrying amounts may not be recoverable.

Reinsurance

As indicated in our 2019 Form 10-K, reinsurance is an integral part of our business plan. We expect to reinsure substantially all of our new insurance policies with a variety of third party reinsurers in exchange for upfront ceding commissions, expense reimbursements and administrative fees. Under these reinsurance agreements, we expect there will be a monthly or quarterly settlement of premiums, claims, surrenders, collateral and other administration fees. We believe this will help preserve American Life’s capital while supporting its growth because American Life will have lower capital requirements when its business is reinsured due to lower overall financial exposure versus retaining the insurance policy business itself.

There are two main categories of reinsurance transactions: 1) “indemnity,” where we cede a portion of our risk but retain the legal responsibility to our policyholders should our reinsurers not meet their financial obligations; and 2) “assumption,” where we transfer the risk and legal responsibilities to the reinsurers. The reinsurers are required to acquire the appropriate regulatory and policyholder approvals to convert indemnity policies to assumption policies.

Our reinsurers may be domestic or foreign capital markets investors or traditional reinsurance companies seeking to assume U.S. insurance business. We plan to mitigate the credit risk relating to reinsurers generally by requiring other financial commitments from the reinsurers to secure the reinsured risks (such as posting substantial collateral). It should be noted that under indemnity reinsurance agreements American Life remains exposed to the credit risk of its reinsurers. If one or more reinsurers becomes insolvent or is otherwise unable or unwilling to pay claims under the terms of the applicable reinsurance agreement, American Life retains legal responsibility to pay policyholder claims, which, in such event would likely materially and adversely affect the capital and surplus of American Life.

Some reinsurers are not and may not be “accredited” or qualified as reinsurers under Nebraska Law. In order to enter into reinsurance agreements with such reinsurers and to reduce potential credit risk, American Life may hold a deposit or withhold funds from the reinsurer or require the reinsurer to maintain a trust that holds assets backing up the reinsurer’s obligation to pay claims on the business it assumes. The reinsurer may also appoint an investment manager for such funds, which is some cases may be our investment adviser subsidiary, 1505 Capital, to manage these assets pursuant to guidelines adopted by us that are consistent with state investment statutes and reinsurance regulations.

American Life has treaties with two third-party reinsurers that have funds withheld provisions. Under those provisions, the assets backing the treaties are maintained by American Life as investments but the assets and total returns or losses on the investments are owned by the reinsurers. Under GAAP this arrangement is considered an embedded derivative as discussed in Note 6 to our consolidated financial statements above. As a result of recent market volatility, assets carried as investments on American Life’s financial statements for the third-party reinsurers contained unrealized losses of approximately $23.2 million as of March 31, 2020. The terms of the contracts with the third party reinsurers provide that unrealized losses on the portfolios accrue to the reinsurers. We account for this loss pass through by recording equivalent realized gains on our income statement. Accordingly, the unrealized losses on the assets held by American Life were offset by a gain in the embedded derivative of $23.2 million.

American Life currently has five reinsurance agreements in effect and has earned ceding commissions on four out of those agreements. See Note 9 to the consolidated financial statements in this report for further information on each of our reinsurance agreements.

The table below shows the ceding commissions earned on the four most recent reinsurance transactions where American Life is earning ceding commissions on a statutory accounting principles basis:


		Three months ended March 31,
		2020				2019
Reinsurer	Effective Date of Transaction	Ceding Commission Earned		Expense Allowances(1)		Ceding Commission Earned		Expense Allowances(1)
US Alliance Life and Security Company	September 2017	$	15,262	$	—	$	15,262	$	—
Unified Life Insurance Company	July 2018		60,609		—		702,788		—
Ironbound Reinsurance Company Limited	July 2019		674,645		673,612		—		—
SDA Annuity & Life Re	November 2019		298,982		548,464		—		—
		$	1,049,498	$	1,222,076	$	718,050	$	—

(1)

Includes: acquisition and administrative expenses, commission expense allowance and product development fees.

Under GAAP, the ceding commission is deferred on the balance sheet and are amortized over the period of the policyholder contracts. The tables below shows the ceding commissions from the reinsurers and what was earned on a GAAP accounting basis:


	Three months ended March 31,
	2020										2019
Reinsurer	Gross Ceding Commission		Expense Allowances(1)		Commissions and Acquisition Expenses		Interest on Ceding Commissions		Earned Ceding Commission		Earned Ceding Commission
US Alliance Life and Security Company	$	-	$	-	$	-	$	-	$	12,094	$	25,816
Unified Life Insurance Company		-		-		-		-		67,451		780,231
Ironbound Reinsurance Company Limited		674,645		673,612		615,111		53,602		95,740		—
SDA Annuity & Life Re		298,982		548,464		503,207		12,966		7,153		—
	$	973,627	$	1,222,076	$	1,118,318	$	66,568	$	182,438	$	806,047

(1)

Includes: acquisition and administrative expenses, commission expense allowance and product development fees.

The tables below show the ceding commissions deferred on each reinsurance transaction on a GAAP accounting basis:


		March 31, 2020		December 31, 2019
Reinsurer	Effective Date of Transaction	Deferred Ceding Commission		Deferred Ceding Commission
US Alliance Life and Security Company(1)	September 2017	$	846,581	$	858,675
Unified Life Insurance Company(1)	July 2018		515,444		582,894
Ironbound Reinsurance Company Limited(2)	July 2019		5,741,686		5,060,359
SDA Annuity & Life Re(2)	November 2019		1,508,424		1,076,267
		$	8,612,135	$	7,578,195

(1)

These reinsurance transactions received gross ceding commissions on the effective dates of the transaction. The difference between the statutory net adjusted reserves and the GAAP adjusted reserves plus the elimination of DAC and VOBA related to these businesses reduces the gross ceding commission with the remaining deferred and amortized over the lifetime of the blocks of business.

(2)

These reinsurance transactions include the ceding commissions and expense allowances which are accounted for as described in (1).

Benefit reserves

The Company establishes liabilities for amounts payable under insurance policies, including traditional life insurance and annuities. Generally, amounts are payable over an extended period of time. Liabilities for future policy benefits of traditional life insurance have been computed by a net level premium method based upon estimates at the time of issue for investment yields, mortality and withdrawals. These estimates include provisions for experience less favorable than initially expected. Mortality assumptions are based on industry experience expressed as a percentage of standard mortality tables.

Policy claims

Policy claims are based on reported claims plus estimated incurred but not reported claims developed from trends of historical data applied to current exposure.

Deposit-type contracts

Deposit-type contracts consist of amounts on deposit associated with deferred annuity riders, premium deposit funds and supplemental contracts without life contingencies.

Deferred gain on ceding commissions

American Life has entered into several indemnity reinsurance contracts where it is earning ceding commissions. These ceding commissions are recorded as a deferred liability and amortized over the life of the business ceded. American Life receives commission, administrative, and option allowances from reinsurance transactions that represent recovery of acquisition costs. These allowances first reduce the DAC associated with that reinsured block of business with the remainder being included in the deferred gain on ceding commissions to also be amortized.

Income taxes

The Company is subject to income taxes in the U.S. federal and various state jurisdictions. Tax regulations within each jurisdiction are subject to the interpretation of the related tax laws and regulations and require significant judgment to apply. With few exceptions, the Company is no longer subject to U.S. federal, state or local tax examinations by tax authorities for the years before 2015. The Company is not currently under examination for any open years. The provision for income taxes is based on income as reported in the financial statements. The income tax provision is calculated under the asset and liability method. Deferred tax assets are recorded based on the differences between the financial statement and tax basis of assets and liabilities at the enacted tax rates. The principal assets and liabilities giving rise to such differences are investments, insurance reserves, and deferred acquisition costs. A deferred tax asset valuation allowance is established when there is uncertainty that such assets would be realized. The Company has no uncertain tax positions that it believes are more-likely-than not that the benefit will not to be realized. When applicable, the Company recognizes interest accrued related to unrecognized tax benefits and penalties in income tax expense.

Revenue recognition and related expenses

Amounts received as payment for annuities are recognized as deposits to policyholder account balances and included in future insurance policy benefits. Revenues from these contracts are comprised of fees earned for administrative and contract-holder services and cost of insurance, which are recognized over the period of the contracts, and included in revenue. Deposits are shown as a financing activity in the consolidated statements of cash flows.

Revenues on traditional life insurance products consist of direct and assumed premiums reported as earned when due.

Liabilities for future policy benefits are provided and acquisition costs are amortized by associating benefits and expenses with earned premiums to recognize related profits over the life of the contracts. Acquisition costs are amortized over the expected life of the annuity contracts.

Comprehensive loss

Comprehensive loss is comprised of net loss and other comprehensive income (loss). Other comprehensive income (loss) includes unrealized gains and losses from marketable securities classified as available for sale and unrealized gains and losses from foreign currency transactions, net of applicable taxes. American Life has treaties with two third-party reinsurers that have funds withheld and modified coinsurance provisions. Under those provisions, the assets backing the treaties are maintained by American Life as collateral but are owned by the reinsurers, thus, the total return on the asset portfolio belongs to the reinsurers. Under GAAP this is considered an embedded derivative as discussed in Note 6 below. As a result of recent volatility, the investments carried by American Life for the third-party reinsurers contained unrealized losses of approximately $23.2 million as of March 31, 2020. The terms of the contracts with the third-party reinsurers, provided that unrealized losses on the portfolios shall accrue to the reinsurers. We account for this loss pass through by booking equivalent realized gains on our income statement. Accordingly, for the first quarter of 2020, our recognized embedded derivative gains were $23.2 million.

The remaining unrealized loss of approximately $3.3 million is related to the investments retained by American Life. The majority of these unrealized losses are related to our asset-backed securities or collateralized loan obligations (“CLOs”). CLOs are typically illiquid and are intended to be held to maturity thus loss risk is minimal, the Company has monitored the underlying unrealized losses and believe they pose little chance of loss in the long-term due to the quality of the underlying credits.

Basic earnings per share in the first quarter of fiscal 2020 were $0.021 which included the aforementioned gain of $23.2 million. Basic loss per share in the first quarter of fiscal 2020 without the aforementioned gain was ($0.002).

Common and preferred stock and earnings (loss) per share

The par value per each Company share is $0.001 with 1,970,000,000 voting common shares authorized, 20,000,000 non-voting common shares authorized, and 10,000,000 preferred shares authorized. On June 18, 2019, Xenith exercised the right to convert its 1,500,000 Series C preferred stock and the $19,100,000 notes payable to voting common stock at the conversion rate of approximately $0.02 per common share. At March 31, 2020 and December 31, 2019, the Company had 1,023,408,553 voting common shares issued and outstanding.

The Series C preferred shares were converted by Xenith to voting common shares on June 18, 2019 at a rate of approximately $0.02 per share for 72,854,474 voting common shares. The stated annual dividend rate on the Series C preferred shares was 8%. At the time of the conversion, Xenith forgave all previously accrued dividends from June 28, 2018 through the conversion date.

Loss per basic share attributable to the Company’s common stockholders was computed based on the weighted average number of shares outstanding during each period. The weighted average number of shares outstanding during the three months ended March 31, 2020 and the year ended December 31, 2019 were 1,023,408,553 and 576,594,387 shares, respectively.

Loss per diluted share attributable to the Company’s common stockholders was computed based on the average shares outstanding and options granted under our Long-Term Incentive Plan (“LTIP”), as if all were vested and exercised, which for the three months ended March 31, 2020 and the year ended December 31, 2019 were 1,361,622,261 and 577,541,406 shares, respectively.