UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

FORM 10-Q

 

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

 

For the quarterly period ended September 30, 2017

 

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)

 

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

 

Large accelerated filer	☐	Accelerated filer	☐
Non-accelerated filer	☐   (Do not check if a smaller reporting company)	Smaller reporting company	☒
		Emerging growth company	☒

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

 

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 November 9, 2017, GWG Holdings, Inc. had 5,813,555 shares of common stock outstanding.

 

 

 

GWG HOLDINGS, INC.

 

Index to Form 10-Q

for the Quarter Ended September 30, 2017

 

		Page No.
PART I.	FINANCIAL INFORMATION
Item 1.	Financial Statements	1
	Condensed Consolidated Balance Sheets as of September 30, 2017, and December 31, 2016	1
	Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2017 and 2016	2
	Condensed Consolidated Statements of Cash Flows for the three and nine months ended September 30, 2017 and 2016	3
	Consolidated Statement of Changes in Stockholders’ Equity	5
	Notes to Condensed Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	28
Item 4.	Controls and Procedures	58
PART II.	OTHER INFORMATION
Item 5.	Other Information	59
Item 6.	Exhibits	60
SIGNATURES		61

 

 

PART I—FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

 

		September 30, 2017				December 31, 2016
		(unaudited)
A S S E T S
Cash and cash equivalents		$	115,345,481			$	78,486,982
Restricted cash			5,819,230				37,826,596
Investment in life insurance policies, at fair value			620,097,938				511,192,354
Secured MCA advances			2,623,657				5,703,147
Life insurance policy benefits receivable			14,597,000				5,345,000
Deferred taxes, net			4,384,546				-
Other assets			3,824,200				4,688,103
TOTAL ASSETS		$	766,692,052			$	643,242,182
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
LIABILITIES
Senior Credit Facilities		$	201,978,580			$	156,064,818
Series I Secured Notes			-				16,404,836
L Bonds			413,060,517				381,312,587
Accounts payable			3,715,236				2,226,712
Interest payable			13,521,174				16,160,599
Other accrued expenses			2,792,521				1,676,761
Deferred taxes, net			-				2,097,371
TOTAL LIABILITIES			635,068,028				575,943,684
STOCKHOLDERS’ EQUITY
CONVERTIBLE PREFERRED STOCK
(par value $0.001; shares authorized 40,000,000; shares outstanding 2,694,725 and 2,640,521; liquidation preference of $20,210,000 and $19,804,000 as of September 30, 2017 and December 31, 2016, respectively)			19,408,980				19,701,133
REDEEMABLE PREFERRED STOCK
(par value $0.001; shares authorized 100,000; shares outstanding 99,080 and 59,183; liquidation preference of $99,080,000 and $59,183,000 as of September 30, 2017 and December 31, 2016, respectively)			96,106,633				59,025,164
SERIES 2 REDEEMABLE PREFERRED STOCK
(par value $0.001; shares authorized 150,000; shares outstanding 48,316 and 0; liquidation preference of $48,316,000 and $0 as of September 30, 2017 and December 31, 2016, respectively)			44,721,747				-
COMMON STOCK
(par value $0.001: shares authorized 210,000,000; shares issued and outstanding 5,813,555 and 5,980,190 as of September 30, 2017 and December 31, 2016, respectively)			5,814				5,980
Additional paid-in capital			-				7,383,515
Accumulated deficit			(28,619,150	)			(18,817,294	)
TOTAL STOCKHOLDERS’ EQUITY			131,624,024				67,298,498
TOTAL LIABILITIES & EQUITY		$	766,692,052			$	643,242,182

 

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

 

 

 GWG HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

 

		Three Months Ended								Nine Months Ended
		September 30, 2017				September 30, 2016				September 30, 2017				September 30, 2016
REVENUE
Gain on life insurance policies, net		$	14,421,353			$	13,509,755			$	45,117,438			$	51,606,815
MCA income			100,367				286,225				480,526				654,441
Interest and other income			175,323				124,998				855,009				341,098
TOTAL REVENUE			14,697,043				13,920,978				46,452,973				52,602,354
EXPENSES
Interest expense			13,275,407				10,942,790				38,765,647				29,856,601
Employee compensation and benefits			3,792,096				2,912,463				10,696,455				8,450,168
Legal and professional fees			1,657,090				586,830				3,934,027				3,097,312
Provision for MCA advances			28,000				-				906,000				400,000
Other expenses			2,771,196				2,863,212				8,434,617				7,208,057
TOTAL EXPENSES			21,523,789				17,305,295				62,736,746				49,012,138
INCOME (LOSS) BEFORE INCOME TAXES			(6,826,746	)			(3,384,317	)			(16,283,773	)			3,590,216
INCOME TAX EXPENSE (BENEFIT)			(2,764,243	)			(1,428,130	)			(6,481,917	)			1,478,617
NET INCOME (LOSS)			(4,062,503	)			(1,956,187	)			(9,801,856	)			2,111,599
Preferred stock dividends			3,548,165				1,041,178				7,447,022				2,153,333
NET INCOME (LOSS) ATTRIBUTABLE TO COMMON SHAREHOLDERS		$	(7,610,668	)		$	(2,997,365	)		$	(17,248,878	)		$	(41,734	)
NET INCOME (LOSS) PER SHARE
Basic		$	(1.31	)		$	(0.50	)		$	(2.96	)		$	(0.01	)
Diluted		$	(1.31	)		$	(0.50	)		$	(2.96	)		$	(0.01	)
WEIGHTED AVERAGE SHARES OUTSTANDING
Basic			5,797,800				5,978,322				5,829,808				5,962,938
Diluted			5,797,800				5,978,322				5,829,808				5,962,938

  

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

 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(unaudited)

 

		Three Months Ended								Nine Months Ended
		September 30, 2017				September 30, 2016				September 30, 2017				September 30, 2016
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss)		$	(4,062,503	)		$	(1,956,187	)		$	(9,801,856	)		$	2,111,599
Adjustments to reconcile net income (loss) to net cash flows from operating activities:
Change in fair value of life insurance policies			(20,181,732	)			(21,073,226	)			(49,301,067	)			(53,846,155	)
Amortization of deferred financing and issuance costs			2,344,541				2,765,743				6,508,692				6,077,905
Deferred income taxes			(2,764,243	)			(1,428,130	)			(6,481,917	)			1,478,617
Preferred stock dividends payable			333,391				333,565				1,034,139				663,614
(Increase) decrease in operating assets:
Life insurance policy benefits receivable			(7,627,000	)			700,000				(9,252,000	)			(6,129,022	)
Other assets			102,437				419,836				970,767				(617,630	)
Increase (decrease) in operating liabilities:
Due to related party			(3,429	)			(80,949	)			(13,214	)			(182,730	)
Accounts payable and other accrued expenses			(415,471	)			(3,216,990	)			1,840,616				(2,024,234	)
NET CASH FLOWS USED IN OPERATING ACTIVITIES			(32,274,009	)			(23,536,338	)			(64,495,840	)			(52,468,036	)
CASH FLOWS FROM INVESTING ACTIVITIES
Investment in life insurance policies			(25,199,692	)			(25,770,326	)			(67,321,363	)			(74,470,362	)
Carrying value of matured life insurance policies			2,333,039				1,078,889				7,716,847				7,381,132
Investment in Secured MCA advances			-				(1,965,896	)			(39,671	)			(7,613,310	)
Proceeds from Secured MCA advances			826,621				220,911				2,250,323				1,246,703
NET CASH FLOWS USED IN INVESTING ACTIVITIES			(22,040,032	)			(26,436,422	)			(57,393,864	)			(73,455,837	)
CASH FLOWS FROM FINANCING ACTIVITIES
Net borrowings on (repayments of) Senior Credit Facilities			56,887,491				(10,761,048	)			49,787,954				6,238,952
Payments for issuance of senior debt			(3,937,907	)			-				(5,128,319	)			-
Payments for redemption of Series I Secured Notes			(6,815,406	)			(541,275	)			(16,613,667	)			(6,264,018	)
Proceeds from issuance of L Bonds			30,271,873				64,350,430				87,016,343				135,477,090
Payments for issuance and redemption of L Bonds			(19,752,717	)			(14,373,447	)			(58,949,880	)			(37,036,922	)
Transfer from (payments to) restricted cash			40,340,401				(4,527,232	)			32,007,366				(13,346,126	)
Issuance (repurchase) of common stock			30				31,515				(1,603,526	)			244,185
Proceeds from issuance of preferred stock			25,211,870				20,786,332				86,692,811				31,287,541
Payment for issuance and redemption of preferred stock			(1,291,420	)			(2,556,859	)			(7,013,857	)			(4,174,773	)
Payment of preferred stock dividends			(3,548,165	)			(1,041,178	)			(7,447,022	)			(2,153,333	)
NET CASH FLOWS PROVIDED BY FINANCING ACTIVITIES			117,366,050				51,367,238				158,748,203				110,272,596
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS			63,052,009				1,394,478				36,858,499				(15,651,277	)
CASH AND CASH EQUIVALENTS
BEGINNING OF PERIOD			52,293,472				17,379,350				78,486,982				34,425,105
END OF PERIOD		$	115,345,481			$	18,773,828			$	115,345,481			$	18,773,828

  

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

 

 

 GWG HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS – CONTINUED

(unaudited)

 

		Three Months Ended								Nine Months Ended
		September 30, 2017				September 30, 2016				September 30, 2017				September 30, 2016
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Interest paid		$	17,478,000			$	10,808,000			$	45,101,000			$	27,207,000
Premiums paid		$	12,927,000			$	11,785,000			$	35,533,000			$	29,225,000
Stock-based compensation		$	270,000			$	162,000			$	350,000			$	213,000
Payments for exercised stock options		$	164,000			$	-			$	264,000			$	-
NON-CASH INVESTING AND FINANCING ACTIVITIES
Series I Secured Notes:
Conversion of accrued interest and commissions payable to principal		$	-			$	47,000			$	-			$	234,000
L Bonds:
Conversion of accrued interest and commissions payable to principal		$	477,000			$	854,000			$	1,382,000			$	1,515,000
Series A Preferred Stock:
Issuance of Series A Preferred Stock in lieu of cash dividends		$	161,000			$	170,000			$	499,000			$	509,000
Investment in life insurance policies included in accounts payable		$	966,000			$	1,603,000			$	966,000			$	1,603,000

 

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

 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY

(unaudited)

 

		Preferred Stock				Preferred				Common				Common Stock				Additional Paid-in				Accumulated				Total
		Shares				Stock				Shares				(par)				Capital				Deficit				Equity
Balance, December 31, 2015			2,781,735			$	20,784,841				5,941,790			$	5,942			$	14,563,834			$	(19,209,203	)		$	16,145,414
Net loss			-				-				-				-				-				391,909				391,909
Issuance of common stock			-				-				36,450				36				244,149				-				244,185
Redemption of Series A Preferred Stock			(239,749	)			(1,788,451	)			1,950				2				19,498				-				(1,768,951	)
Issuance of Series A Preferred Stock			98,535				704,743				-				-				-				-				704,743
Issuance of Redeemable Preferred Stock			59,183				59,025,164				-				-				(4,133,525	)			-				54,891,639
Preferred stock dividends			-				-				-				-				(3,537,288	)			-				(3,537,288	)
Issuance of stock options			-				-				-				-				226,847				-				226,847
Balance, December 31, 2016			2,699,704			$	78,726,297				5,980,190			$	5,980			$	7,383,515			$	(18,817,294	)		$	67,298,498
Net income			-				-				-				-				-				(9,801,856	)			(9,801,856	)
Issuance of common stock			-				-				33,810				34				320,970				-				321,004
Redemption of common stock			-				-				(200,445	)			(200	)			(1,603,360	)			-				(1,603,560	)
Issuance of Series A Preferred Stock			71,237				498,659				-				-				-				--				498,659
Redemption of Series A Preferred Stock			(17,033	)			(126,997	)			-				-				-				-				(126,997	)
Issuance of redeemable preferred stock			88,822				85,082,425				-				-				(2,338,457	)			-				82,743,968
Redemption of redeemable preferred stock			(609	)			(608,777	)			-				-				-				-				(608,777	)
Dividends paid							(3,670,488	)			-				-				(3,776,534	)			-				(7,447,022	)
Issuance of stock options							336,241				-				-				13,866				-				350,107
Balance, September 30, 2017			2,842,121			$	160,237,360				5,813,555			$	5,814			$	-			$	(28,619,150	)		$	131,624,024

  

*Preferred stock dividends were paid from additional paid-in capital until the latter was exhausted in the second quarter of 2017. Subsequent dividends were charged against the carrying values of the respective series of the Company’s preferred stock, resulting in a difference between the Company’s preferred stock book balances and liquidation preference of the respective series of preferred stock.

 

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

 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

(1)	Nature of Business and Summary of Significant Accounting Policies

 

Nature of Business – We are a financial services company committed to disrupting and transforming the life insurance industry and related industries. We built our business by creating opportunities for consumers to obtain significantly more value for their life insurance policies in a secondary market as compared to the traditional options offered by the insurance industry. We are enhancing and extending these activities through innovation in our products and services, business processes, financing strategies, and advanced epigenetic technologies. At the same time, we are creating opportunities for investors to receive income and capital appreciation from our investment activities in the life insurance and related industries.

 

GWG Holdings, Inc. and all of its subsidiaries are incorporated and organized in Delaware. Unless the context otherwise requires or we specifically so indicate, all references in these footnotes to “we,” “us,” “our,” “our Company,” “GWG,” or the “Company” refer to GWG Holdings, Inc. and its subsidiaries collectively and on a consolidated basis. References to the full names of particular entities, such as “GWG Holdings, Inc.” or “GWG Holdings,” are meant to refer only to the particular entity referenced.

 

On December 7, 2015, GWG Holdings formed a wholly owned subsidiary, GWG MCA, LLC. On January 13, 2016, GWG MCA, LLC was converted to a corporation and became GWG MCA Capital, Inc. GWG MCA Capital, Inc. was formed to provide cash advances to small businesses.

 

On August 25, 2016, GWG Holdings formed a wholly owned subsidiary, Actüa Life & Annuity Ltd., renamed to Life Epigenetics Inc. (“Life Epigenetics”) in August 2017, to engage in various life insurance related businesses and activities related to its exclusive license for “DNA Methylation Based Predictor of Mortality” technology.

 

Use of Estimates – The preparation of our consolidated financial statements in conformity with GAAP requires management to make significant estimates and assumptions affecting the reported amounts of assets and liabilities at the date of the consolidated financial statements, as well as the reported amounts of revenue during the reporting period. We regularly evaluate estimates and assumptions, which are based on current facts, historical experience, management’s judgment, and various other factors that we believe to be reasonable under the circumstances. Our actual results may differ materially and adversely from our estimates. The most significant estimates with regard to these consolidated financial statements relate to (1) the determination of the assumptions used in estimating the fair value of our investments in life insurance policies and (2) the value of our deferred tax assets and liabilities.

 

Cash and Cash Equivalents – We consider cash in demand deposit accounts and temporary investments purchased with an original maturity of three months or less to be cash equivalents. We maintain our cash and cash equivalents with highly rated financial institutions. The balances in our bank accounts may exceed Federal Deposit Insurance Corporation limits. We periodically evaluate the risk of exceeding insured levels and may transfer funds as we deem appropriate.

 

Life Insurance Policies – Accounting Standards Codification 325-30, Investments in Insurance Contracts permits a reporting entity to account for its investments in life insurance policies using either the investment method or the fair value method. We elected to use the fair value method to account for our life insurance policies. We initially record our purchase of life insurance policies at the transaction price, which is the amount paid for the policy, inclusive of all external fees and costs associated with the acquisition. At each subsequent reporting period, we re-measure the investment at fair value in its entirety and recognize the change in fair value as unrealized gain (revenue) in the current period, net of premiums paid.

 

In a case where our acquisition of a policy is not complete as of a reporting date, but we have nonetheless advanced direct costs and deposits for the acquisition, those costs and deposits are recorded as “other assets” on our balance sheet until the acquisition is complete and we have secured title to the policy. On September 30, 2017 and December 31, 2016, a total of $0 and $42,000, respectively, of our “other assets” comprised direct costs and deposits that we had advanced for life insurance policy acquisitions.

 

We also recognize realized gain (or loss) from a life insurance policy upon one of the two following events: (1) our receipt of notice or verified mortality of the insured; or (2) our sale of the policy (upon filing of change-of-ownership forms and receipt of payment). In the case of mortality, the gain (or loss) we recognize is the difference between the policy benefits and the carrying values of the policy once we determine that collection of the policy benefits is realizable and reasonably assured. In the case of a policy sale, the gain (or loss) we recognize is the difference between the sale price and the carrying value of the policy on the date we receive sale proceeds.

 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

Other Assets – Life Epigenetics is engaged in various life insurance related businesses and activities related to its exclusive license for the “DNA Methylation Based Predictor of Mortality” technology for the life insurance industry. The cost of entering into this license agreement is included in “other assets.”

 

Stock-Based Compensation – We measure and recognize compensation expense for all stock-based payments at fair value over the requisite service period. We use the Black-Scholes option pricing model to determine the weighted-average fair value of options. For restricted stock grants, fair value is determined as of the closing price of our common stock on the date of grant. Stock-based compensation expense is recorded in general and administrative expenses based on the classification of the employee or vendor. The determination of fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as by assumptions regarding a number of subjective variables. These variables include, but are not limited to, the expected stock price volatility over the term of the awards.

 

The risk-free interest rate is based on the U.S. Treasury rates at the date of grant with maturity dates approximately equal to the expected life at grant date. Volatility is based on the standard deviation of the average continuously compounded rate of return of five selected comparable companies over the previous 52 weeks. We have not historically issued any common stock dividends and do not expect to do so in the foreseeable future.

 

Deferred Financing and Issuance Costs – Loans advanced to us under our senior credit facility with LNV Corporation, as described in Note 6, are reported net of financing costs, including issuance costs, sales commissions and other direct expenses, which are amortized using the straight-line method over the term of the facility.  We had no loans advanced to us under our senior credit facility with Autobahn Funding Company during the nine months ended September 30, 2017, as described in Note 5. The Series I and L Bonds, as respectively described in Notes 7 and 8, are reported net of financing costs, which are amortized using the interest method over the term of those borrowings. The Series A Convertible Preferred Stock (“Series A”), as described in Note 9, is reported net of financing costs (including the fair value of warrants issued), all of which were fully amortized using the interest method as of September 30, 2017. Selling and issuance costs of Redeemable Preferred Stock (“RPS”) and Series 2 Redeemable Preferred Stock (“RPS 2”), described in Notes 10 and 11, are netted against additional paid-in-capital, if any, and then against the outstanding balance of the preferred stock.

 

Earnings (loss) per Share – Basic earnings (loss) per share attributable to common shareholders are calculated using the weighted-average number of shares outstanding during the reported period. Diluted earnings (loss) per share are calculated based on the potential dilutive impact of our Series A, RPS, RPS 2, warrants and stock options. Due to our net loss for the three and nine months ended September 30, 2017 and 2016, there are no dilutive securities.

 

Recently Issued Accounting Pronouncements – On April 7, 2015, the FASB issued Accounting Standards Update No. 2015-03, Simplifying the Presentation of Debt Issuance Costs (“ASU 2015-03”), as part of its simplification initiative. ASU 2015-03 changes the presentation of debt issuance costs by presenting those costs in the balance sheet as a direct deduction from the related debt liability. Amortization of the costs is reported as interest expense. We adopted ASU 2015-03 effective January 1, 2016, as required for public reporting entities.

 

On February 25, 2016, the FASB issued Accounting Standards Update 2016-02 Leases (“ASU 2016-02”). The new guidance is effective for fiscal years beginning after December 15, 2018. ASU 2016-02 provides more transparency and comparability in the financial statements of lessees by recognizing all leases with a term greater than twelve months on the balance sheet. Lessees will also be required to disclose key information about their leases. Early adoption is permitted. We are currently evaluating the impact of the adoption of this pronouncement and have not yet adopted ASU 2016-02 as of September 30, 2017.

 

In March 2016, the FASB issued Accounting Standards Update 2016-09 (“ASU 2016-09”) to simplify the accounting for stock compensation related to the following items: income tax accounting, award classification, estimation of forfeitures, and cash flow presentation. The new guidance is effective for fiscal years beginning after December 15, 2016. We adopted ASU 2016-09 effective January 1, 2017. The impact of the adoption was not material to the financial statements.

 

(2)	Restrictions on Cash

 

Under the terms of our senior credit facility with LNV Corporation (discussed in Note 6), we are required to maintain a collection account that is used to collect policy benefits from pledged policies, pay interest and other charges under the facility, and distribute funds to pay down the facility. The agents for the lenders authorize disbursements from these accounts. At September 30, 2017 and December 31, 2016, there was a balance of $5,819,000, and $37,827,000, respectively, in these restricted cash accounts.

 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

(3)	Investment in Life Insurance Policies

 

Life insurance policies are valued based on unobservable inputs that are significant to their overall fair value. Changes in the fair value of these policies are recorded as gain or loss on life insurance policies, net of premiums paid on those policies, in our consolidated statements of operations. Fair value is determined on a discounted cash flow basis that incorporates life expectancy assumptions generally derived from reports obtained from widely accepted life expectancy providers, other than insured lives covered under small face amount policies (i.e., $1 million in face value benefits or less), assumptions relating to cost-of-insurance (premium) rates and other assumptions. The discount rate we apply incorporates current information about discount rates applied by other public reporting companies owning portfolios of life insurance policies, the discount rates observed in the life insurance secondary market, market interest rates, the estimated credit exposure to the insurance companies that issued the life insurance policies and management’s estimate of the operational risk premium a purchaser would require to receive the future cash flows derived from our portfolio as a whole. Management has discretion regarding the combination of these and other factors when determining the discount rate. As a result of management’s analysis, a discount rate of 10.54% was applied to our portfolio as of September 30, 2017 as compared to 10.96% as of December 31, 2016.

 

A summary of our policies, organized according to their estimated life expectancy dates as of the reporting date, is as follows:

 

		As of September 30, 2017												As of December 31, 2016
Years Ending December 31,		Number of Policies				Estimated Fair Value				Face Value				Number of Policies				Estimated Fair Value				Face Value
2017			2			$	2,016,000			$	2,125,000				11			$	14,837,000			$	16,939,000
2018			9				13,222,000				16,564,000				23				30,830,000				42,564,000
2019			57				63,926,000				88,967,000				55				57,556,000				88,858,000
2020			94				88,281,000				148,908,000				93				85,414,000				159,814,000
2021			88				87,710,000				162,525,000				86				73,825,000				158,744,000
2022			91				78,940,000				174,699,000				66				56,909,000				147,222,000
2023			84				63,439,000				168,821,000				64				44,953,000				128,581,000
Thereafter			425				222,564,000				860,018,000				292				146,868,000				618,953,000
Totals			850			$	620,098,000			$	1,622,627,000				690			$	511,192,000				1,361,675,000

  

We recognized life insurance benefits of $9,747,000 and $5,300,000 during the three months ended September 30, 2017 and 2016, respectively, related to policies with a carrying value of $2,333,000 and $1,078,000, respectively, and as a result recorded realized gains of $7,414,000 and $4,222,000, respectively. We recognized life insurance benefits of $39,657,000 and $34,367,000 during the nine months ended September 30, 2017 and 2016, respectively, related to policies with a carrying value of $7,716,000 and $7,381,000, respectively, and as a result recorded realized gains of $31,941,000 and $26,986,000.

 

Reconciliation of gain on life insurance policies:

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2017				2016				2017				2016
Change in estimated probabilistic cash flows		$	12,568,000			$	12,955,000			$	40,033,000			$	34,078,000
Unrealized gain on acquisitions			7,217,000				11,668,000				25,863,000				29,509,000
Premiums and other annual fees			(13,174,000	)			(11,784,000	)			(36,124,000	)			(29,225,000	)
Change in discount rates (1)			7,987,000				(378,000	)			12,130,000				460,000
Change in life expectancy evaluation (2)			(5,370,000	)			(2,285,000	)			(13,974,000	)			(3,199,000	)
Face value of matured policies			9,747,000				5,300,000				39,657,000				34,367,000
Fair value of matured policies			(4,554,000	)			(1,966,000	)			(22,468,000	)			(14,383,000	)
Gain on life insurance policies, net		$	14,421,000			$	13,510,000			$	45,117,000			$	51,607,000

 

(1) The discount rate applied to estimate the fair value of the portfolio of life insurance policies we own was 10.54% as of September 30, 2017, compared to 10.96% as of December 31, 2016 and 11.07% as of September 30, 2016.  The carrying value of policies acquired during each quarterly reporting period is adjusted to current fair value using the fair value discount rate applied to the entire portfolio as of that reporting date.

(2) The change in fair value due to updating independent life expectancy estimates on certain life insurance policies in our portfolio.

 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

We currently estimate that premium payments and servicing fees required to maintain our current portfolio of life insurance policies in force for the next five years, assuming no mortalities, are as follows:

 

Years Ending December 31,		Premiums				Servicing				Premiums and Servicing Fees
Three months ending December 31, 2017		$	16,915,000			$	1,587,000			$	18,502,000
2018			54,931,000				1,587,000				56,518,000
2019			60,916,000				1,587,000				62,503,000
2020			68,728,000				1,587,000				70,315,000
2021			77,522,000				1,587,000				79,109,000
2022			87,424,000				1,587,000				89,011,000
		$	366,436,000			$	9,522,000			$	375,958,000

 

Management anticipates funding the majority of the premium payments estimated above with additional borrowing capacity, created as the premiums and servicing costs of pledged life insurance policies become due, under the amended and restated senior credit facility with LNV Corporation as described in Note 6. Management anticipates funding premiums and servicing costs of non-pledged life insurance policies from proceeds from the receipt of policy benefits from our portfolio of life insurance policies and net proceeds from our offering of L Bonds and RPS 2. The proceeds of these capital sources may also be used for the purchase, financing, and maintenance of additional life insurance policies.

 

(4)	Fair Value Definition and Hierarchy

 

Accounting Standards Codification 820, Fair Value Measurements and Disclosures (“ASC 820”) establishes a hierarchical disclosure framework that 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 and actively 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 maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring the use of observable inputs whenever available. Observable inputs are inputs that market participants would use in pricing the asset or liability developed based on market data obtained from independent sources. Unobservable inputs are inputs that reflect assumptions about how market participants price an asset or liability based on the best available information. 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 on 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.

 

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 our portfolio of life insurance policies is determined on a quarterly basis by our 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. The discount rate incorporates current information about discount rates applied by other reporting companies owning portfolios of life insurance policies, the discount rates observed in the life insurance secondary market, market interest rates, the estimated credit exposure to the insurance company that issued the life insurance policy and management’s estimate of the operational risk premium a purchaser would require to receive the future cash flows derived from our portfolio as a whole. Management has discretion regarding the combination of these and other factors when determining the discount rate.

 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

These inputs are then used to estimate the discounted cash flows from the portfolio using the Model Actuarial Pricing System probabilistic portfolio price model, which estimates the cash flows using various mortality probabilities and scenarios. The valuation process includes a review by senior management as of each valuation date. We also engage a third-party expert to independently test the accuracy of the valuations using the inputs we provide on a quarterly basis. See Exhibit 99.1 filed herewith.

 

The following table reconciles the beginning and ending fair value of our Level 3 investments in our portfolio of life insurance policies for the periods ended September 30, as follows:

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2017				2016				2017				2016
Beginning balance		$	577,050,000			$	431,820,000			$	511,192,000			$	356,650,000
Purchases			25,199,000				25,770,000				67,321,000				74,470,000
Maturities (initial cost basis)			(2,333,000	)			(1,078,000	)			(7,716,000	)			(7,381,000	)
Net change in fair value			20,182,000				21,073,000				49,301,000				53,846,000
Ending balance		$	620,098,000			$	477,585,000			$	620,098,000			$	477,585,000

 

In the past, we periodically updated the independent life expectancy estimates on the insured lives in our portfolio, other than insured lives covered under small face amount policies (i.e., $1 million in face value benefits or less), on a continuous rotating three-year cycle, and through that effort attempted to update life expectancies for approximately one-twelfth of our portfolio each quarter. Currently, however, the terms of our senior credit facility with LNV Corporation require us to update the independent life expectancy estimates every two years beginning from the date of the amended facility.

 

The following table summarizes the inputs utilized in estimating the fair value of our portfolio of life insurance policies:

 

		As of September 30, 2017				As of December 31, 2016
Weighted-average age of insured, years *			81.7				81.6
Weighted-average life expectancy, months *			82.6				83.2
Average face amount per policy		$	1,909,000			$	1,973,000
Discount rate			10.54	%			10.96	%

  

(*) Weighted average by face amount of policy benefits

 

Life expectancy estimates and market discount rates for a portfolio of life insurance policies are inherently uncertain and the effect of changes in estimates may be significant. For example, if the life expectancy estimates were increased or decreased by four and eight months on each outstanding policy, and the discount rates were increased or decreased by 1% and 2%, while all other variables were held constant, the fair value of our investment in life insurance policies would increase or decrease as summarized below:

 

Change in Fair Value of the Investment in Life Insurance Policies

 

 

		Change in life expectancy estimates
		minus 8 months				minus 4 months				plus 4 months				plus 8 months
September 30, 2017		$	83,536,000			$	41,411,000			$	(40,893,000	)		$	(81,069,000	)
December 31, 2016		$	69,253,000			$	34,601,000			$	(33,846,000	)		$	(67,028,000	)

 

		Change in discount rate
		minus 2%				minus 1%				plus 1%				plus 2%
September 30, 2017		$	65,263,000			$	31,222,000			$	(28,708,000	)		$	(55,167,000	)
December 31, 2016		$	53,764,000			$	25,728,000			$	(23,668,000	)		$	(45,491,000	)

 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

Other Fair Value Considerations

 

The carrying value of receivables, prepaid expenses, accounts payable and accrued expenses approximate fair value due to their short-term maturities and low credit risk. Using the income-based valuation approach, the estimated fair value of our L Bonds, having an aggregate face value of $424,778,000 as of September 30, 2017, is approximately $434,374,000 based on a weighted-average market interest rate of 6.68%. The carrying value of the senior credit facility reflects interest charged at the commercial paper rate or 12-month LIBOR, as applicable, plus an applicable margin. The margin represents our credit risk, and the strength of the portfolio of life insurance policies pledged against the debt. The overall rate reflects market, and the carrying value of the facility approximates fair value.

 

GWG MCA participated in the merchant cash advance industry by directly advancing sums to merchants and lending money, on a secured basis, to companies that advance sums to merchants. Each quarter, we review the carrying value of these advances and loans, and determine if an impairment reserve is necessary. At September 30, 2017 one of our secured loans was potentially impaired. Specifically, the secured loan to Nulook Capital LLC had an outstanding balance of $2,001,000 and a loan loss reserve of $1,506,000 at September 30, 2017. We deem fair value to be the estimated collectible value on each loan or advance made from GWG MCA. Where we estimate the collectible amount to be less than the outstanding balance, we record a reserve for the difference, referred to as an impairment charge. We recorded an impairment charge of $28,000 and $906,000 for the three and nine months ended September 30, 2017, respectively.

 

The following table summarizes outstanding warrants related to the Company’s initial public offering as of September 30, 2017:

 

Month issued		Warrants issued				Fair value per share				Risk free rate				Volatility				Term
September 2014			16,000			$	1.26				1.85	%			17.03	%			5 years
			16,000

 

(5)	Credit Facility – Autobahn Funding Company LLC

 

On September 12, 2017, we terminated our $105 million senior credit facility with Autobahn Funding Company LLC, the Credit and Security Agreement governing the facility as well as the related pledge agreement, pursuant to which our obligations under the facility were secured. We had paid off in full all obligations under the facility on September 14, 2016, and since that date, we have had no amounts outstanding under the facility.

 

The Credit and Security Agreement contained certain financial and non-financial covenants, and we were in compliance with these covenants during the nine months ended September 30, 2017 until the date of termination.

 

(6)	Credit Facility – LNV Corporation

 

On September 27, 2017, we entered into an amended and restated senior credit facility with LNV Corporation as lender through our subsidiary GWG DLP Funding IV, LLC. The Amended and Restated Loan Agreement governing the facility makes available a total of up to $300,000,000 in credit with a maturity date of September 27, 2029. Additional advances are available under the Amended and Restated Loan Agreement at the LIBOR rate as defined in the Amended and Restated Loan Agreement. Advances are available as the result of additional borrowing base capacity, created as the premiums and servicing costs of pledged life insurance policies become due. Interest will accrue on amounts borrowed under the Amended and Restated Loan Agreement at an annual interest rate, determined as of each date of borrowing or quarterly if there is no borrowing, equal to (A) the greater of 12-month LIBOR or the federal funds rate (as defined in the agreement) plus one-half of one percent per annum, plus (B) 7.50% per annum. The effective rate at September 30, 2017 was 7.52%. The interest rate effective October 1, 2017 was 9.31%. Interest payments are made on a quarterly basis.

 

As of September 30, 2017, approximately 86.6% of the total face value of our portfolio is pledged to LNV Corporation. The amount outstanding under this facility was $212,513,000 at September 30, 2017 and $162,725,000 at December 31, 2016. Obligations under the facility are secured by a security interest in DLP IV’s assets, for the benefit of the lenders under the Amended and Restated Loan Agreement, through an arrangement under which Wells Fargo serves as securities intermediary. The life insurance policies owned by DLP IV do not serve as direct collateral for the obligations of GWG Holdings under the L Bonds. The difference between the outstanding balance as of September 30, 2017 and the carrying amount relates to unamortized debt issuance costs.

 

The Amended and Restated Loan Agreement does not require DLP IV to maintain a reserve account for future premiums.

 

The Amended and Restated Loan Agreement has certain financial and nonfinancial covenants, and we were in compliance with these covenants at September 30, 2017 and with the covenants in the original Loan Agreement at December 31, 2016.

 

(7)	Series I Secured Notes

 

Series I Secured Notes were legal obligations of GWG Life and were privately offered and sold from August 2009 through June 2011. On September 8, 2017, we redeemed all outstanding Series I Secured Notes for an aggregate of $6,815,000.

 

The Series I Secured Notes were governed by an Intercreditor Agreement, a Third Amended and Restated Note Issuance and Security Agreement dated November 1, 2011, as amended, and a related Pledge Agreement. Upon the redemption of the Series I Secured Notes and the termination of all obligations outstanding thereunder, those agreements were terminated effective as of September 8, 2017.

 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

(8)

L Bonds

 

Our L Bonds are legal obligations of GWG Holdings. Obligations under the L Bonds are secured by the assets of GWG Holdings and by GWG Life, as a guarantor, and are subordinate to the obligations under our senior credit facilities (see Notes 5 and 6). We began publicly offering and selling L Bonds in January 2012 under the name “Renewable Secured Debentures.” These debt securities were re-named “L Bonds” in January 2015. L Bonds are publicly offered and sold on a continuous basis under a registration statement permitting us to sell up to $1.0 billion in principal amount of L Bonds. We are party to an indenture governing the L Bonds dated October 19, 2011, as amended (“Indenture”), under which GWG Holdings is obligor, GWG Life is guarantor, and Bank of Utah serves as indenture trustee. The Indenture contains certain financial and non-financial covenants, and we were in compliance with these covenants at September 30, 2017 and December 31, 2016.

 

Effective September 1, 2016, we ceased selling 6-month and 1-year L Bonds until further notice. In addition, effective September 1, 2016, the L Bond interest rates that we offer changed to 5.50%, 6.25%, 7.50% and 8.50% for the 2-, 3-, 5- and 7-year L Bonds, respectively. The bonds have renewal features under which we may elect to permit their renewal, subject to the right of bondholders to elect to receive payment at maturity. Interest is payable monthly or annually depending on the election of the investor.

 

At September 30, 2017 and December 31, 2016, the weighted-average interest rate of our L Bonds was 7.35% and 7.23%, respectively. The principal amount of L Bonds outstanding was $424,778,000 and $387,067,000 at September 30, 2017 and December 31, 2016, respectively. The difference between the amount of outstanding L Bonds and the carrying amount on our balance sheets is due to netting of unamortized deferred issuance costs, cash receipts for new issuances and payments of redemptions in process. Amortization of deferred issuance costs was $2,076,000 and $4,931,000 for the three and nine months ended September 30, 2017 and $2,073,000 and $5,362,000 for the three and nine months ended September 30, 2016. Future expected amortization of deferred financing costs as of September 30, 2017 is $14,462,000 in total over the next seven years.

 

Future contractual maturities of L Bonds, and their related unamortized deferred financing costs, at September 30, 2017 are as follows: 

 

Years Ending December 31,		Contractual Maturities				Unamortized Deferred Financing Costs
Three months ending December 31, 2017		$	17,059,000			$	104,000
2018			108,717,000				1,652,000
2019			133,174,000				4,294,000
2020			63,523,000				2,763,000
2021			28,703,000				1,350,000
Thereafter			73,602,000				4,299,000
		$	424,778,000			$	14,462,000

 

(9)	Series A Convertible Preferred Stock

 

From July 2011 through September 2012, we privately offered shares of Series A of GWG Holdings at $7.50 per share. In the offering, we sold an aggregate of 3,278,000 shares for gross consideration of $24,582,000. Holders of Series A were entitled to cumulative dividends at the rate of 10% per annum, paid quarterly.

 

As of September 30, 2017, we issued an aggregate of 544,000 shares of Series A in satisfaction of $3,808,000 in dividends on the Series A, and an aggregate of 696,000 shares of Series A were converted into 522,000 shares of our common stock. As of September 30, 2017, we had 2,695,000 Series A shares outstanding with respect to which we incurred aggregate issuance costs of $2,838,000, all of which is included as a component of additional paid-in capital.

 

Purchasers of Series A in our offering received warrants to purchase an aggregate of 416,000 shares of our common stock at an exercise price of $12.50 per share. The grant date fair value of these warrants was $428,000. As of September 30, 2017, all of these warrants have expired and none of them had been exercised.

 

The terms of the Series A permit us to redeem Series A shares at a price equal to 110% of their liquidation preference ($7.50 per share) at any time.

 

On October 9, 2017 all shares of Series A were redeemed with a redemption payment equal to the sum of: (i) $8.25 per Series A share and (ii) all accrued but unpaid dividends.

 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

(10)	Redeemable Preferred Stock

 

On November 30, 2015, our public offering of up to 100,000 shares of Redeemable Preferred Stock (“RPS”) at $1,000 per share was declared effective. Holders of RPS are entitled to cumulative dividends at the rate of 7% per annum, paid monthly. Dividends on the RPS are recorded as a reduction to additional paid-in capital, if any, then to the outstanding balance of the preferred stock if additional paid-in-capital has been exhausted. Under certain circumstances described in the Certificate of Designation for the RPS, additional shares of RPS may be issued in lieu of cash dividends. 

 

The RPS ranks senior to our common stock and pari passu with our Series A and RPS 2, and entitles its holders to a liquidation preference equal to the stated value per share (i.e., $1,000) plus accrued but unpaid dividends. Holders of RPS may presently convert their RPS into our common stock at a conversion price equal to the volume-weighted average price of our common stock for the 20 trading days immediately prior to the date of conversion, subject to a minimum conversion price of $15.00 and in an aggregate amount limited to 15% of the stated value of RPS originally purchased by such holder from us and still held by such holder.

 

Holders of RPS may request that we redeem their RPS at a price equal to their stated value plus accrued but unpaid dividends, less an applicable redemption fee, if any. Nevertheless, the Certificate of Designation for RPS permits us complete discretion to grant or decline redemption requests. Subject to certain restrictions and conditions, we may also redeem shares of RPS without a redemption fee upon a holder’s death, total disability or bankruptcy. In addition, after one year from the date of original issuance, we may, at our option, call and redeem shares of RPS at a price equal to their liquidation preference.

 

On March 31, 2017, we closed the RPS offering to investors having sold 99,127 shares of RPS for an aggregate gross consideration of $99,127,000 and incurred approximately $7,019,000 of related selling costs.

 

At the time of its issuance, we determined that the RPS contained two embedded features: (1) optional redemption by the holder; and (2) optional conversion by the holder. We determined that each of the embedded features met the definition of a derivative and that the RPS should be considered an equity host for the purposes of assessing the embedded derivatives for potential bifurcation. Based on our assessment under Accounting Standards Codification 470 “Debt” (“ASC 470”) we do not believe bifurcation of either the holder’s redemption or conversion feature is appropriate.

 

(11)	Series 2 Redeemable Preferred Stock

 

On February 14, 2017, our public offering of up to 150,000 shares of Series 2 Redeemable Preferred Stock (“RPS 2”) at $1,000 per share was declared effective. Holders of RPS 2 are entitled to cumulative dividends at the rate of 7% per annum, paid monthly. Dividends on the RPS 2, when payable, will be recorded as a reduction to additional paid-in capital, if any, then to the outstanding balance of the preferred stock if additional paid-in-capital has been exhausted. Under certain circumstances described in the Certificate of Designation for the RPS 2, additional shares of RPS 2 may be issued in lieu of cash dividends.

 

The RPS 2 ranks senior to our common stock and pari passu with our Series A and RPS, and entitles its holders to a liquidation preference equal to the stated value per share (i.e., $1,000) plus accrued but unpaid dividends. Holders of RPS 2 may, less an applicable conversion discount, if any, convert their RPS 2 into our common stock at a conversion price equal to the volume-weighted average price of our common stock for the 20 trading days immediately prior to the date of conversion, subject to a minimum conversion price of $12.75 and in an aggregate amount limited to 10% of the stated value of RPS 2 originally purchased by such holder from us and still held by such holder.

 

Holders of RPS 2 may request that we redeem their RPS 2 shares at a price equal to their liquidation preference, less an applicable redemption fee, if any. Nevertheless, the Certificate of Designation for RPS 2 permits us complete discretion to grant or decline requests for redemption. Subject to certain restrictions and conditions, we may also redeem shares of RPS 2 without a redemption fee upon a holder’s death, total disability or bankruptcy. In addition, we may, at our option, call and redeem shares of RPS 2 at a price equal to their liquidation preference (subject to a minimum redemption price, in the event of redemptions occurring less than one year after issuance, of 107% of the stated value of the shares being redeemed).

 

As of September 30, 2017, we had sold 48,316 shares of RPS 2 for aggregate gross consideration of $48,316,000, and incurred approximately $2,322,000 of selling costs related to the sale of those shares.

 

At the time of its issuance, we determined that the RPS 2 contained two embedded features: (1) optional redemption by the holder; and (2) optional conversion by the holder. We determined that each of the embedded features met the definition of a derivative and that the RPS 2 should be considered an equity host for the purposes of assessing the embedded derivatives for potential bifurcation. Based on our assessment under ASC 470 we do not believe bifurcation of either the holder’s redemption or conversion feature is appropriate.

 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

(12)	Income Taxes

 

We had a current income tax liability of $0 as of both September 30, 2017 and December 31, 2016. The components of deferred income tax expense (benefit) for the three and nine months ended September 30, 2017 and 2016, respectfully, consisted of the following:

 

		Three Months Ended								Nine Months Ended
		September 30,				September 30,				September 30,				September 30,
		2017				2016				2017				2016
Deferred:
Federal		$	(2,095,000	)		$	(1,082,000	)		$	(4,912,000	)		$	1,121,000
State			(669,000	)			(346,000	)			(1,570,000	)			358,000
Total income tax expense (benefit)		$	(2,764,000	)		$	(1,428,000	)		$	(6,482,000	)		$	1,479,000

 

We provide for a valuation allowance when it is not considered “more likely than not” that our deferred tax assets will be realized. At both September 30, 2017 and December 31, 2016, based upon all available evidence, we 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 and other capital losses.

  

The Company is engaged in acquiring of life insurance policies and holding them to maturity. Due to the nature of holding policies and the aging of the underlying insureds, Management believes the Company likely will recognize taxable income as the policies in our portfolio start maturing at an accelerated rate in the near future. Management has evaluated and concluded on the material accuracy of our deferred tax carrying amounts.

 

Accounting Standards Codification 740, Income Taxes requires the reporting of certain tax positions that do not meet a threshold of “more likely than not” to be recorded as uncertain tax benefits. It is 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.

 

Under our 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 September 30, 2017 and December 31, 2016, we recorded no accrued interest or penalties related to uncertain tax positions.

 

Our income tax returns for tax years ended December 31, 2013, 2014, 2015 and 2016 remain open to examination by the Internal Revenue Service and various state taxing jurisdictions. Our tax return for tax year 2012 has now been examined by the IRS (finalized April of 2015) but is open for examination by various state taxing jurisdictions.

 

(13)	Common Stock

 

In September 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, and net proceeds of approximately $8.6 million after the payment of underwriting commissions, discounts and expense reimbursements. In connection with this offering, we listed our common stock on the Nasdaq Capital Market under the ticker symbol “GWGH.” 

 

In conjunction with the initial public offering our Company issued warrants to purchase 16,000 shares of our common stock at an exercise price of $15.63 per share. As of September 30, 2017 none of these warrants had been exercised. The weighted average remaining life of these warrants at September 30, 2017 was 2.0 years.

 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

(14)	Stock Incentive Plan

 

We adopted our 2013 Stock Incentive Plan in March 2013, as amended on June 1, 2015 and May 5, 2017. The Compensation Committee of our Board of Directors is responsible for the administration of the plan. Participants under the plan may be granted incentive stock options and non-statutory stock options; stock appreciation rights; stock awards; restricted stock; restricted stock units; and performance shares. Eligible participants include officers and employees of GWG Holdings and its subsidiaries, members of our Board of Directors, and consultants. As of September 30, 2017, 3,000,000 common stock options are issuable under the plan.

 

Stock Options

 

Through September 30, 2017, we had outstanding stock options for 1,514,000 shares of common stock to employees, officers, and directors under the plan. Options for 762,000 shares have vested, and the remaining options are scheduled to vest over three years. The options were issued with an exercise price between $6.35 and $10.38 for those beneficially owning more than 10% of our common stock, and between $4.83 and $10.76 for all others, which is equal to the estimated market price of the shares on the date of grant. The expected annualized volatility used in the Black-Scholes model valuation of options issued during the period was 34.9%. 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. As of September 30, 2017, stock options for 682,000 shares had been forfeited and stock options for 120,000 shares had been exercised.

  

Outstanding stock options:

 

		Vested				Un-vested				Total
Balance as of December 31, 2015			483,703				569,912				1,053,615
Granted during the year			22,500				608,350				630,850
Vested during the year			251,788				(251,788	)			-
Exercised during the year
Forfeited during the year			(19,926	)			(82,140	)			(102,066	)
Balance as of December 31, 2016			738,065				844,334				1,582,399
Granted year-to-date			40,100				228,300				268,400
Vested year-to-date			218,218				(218,218	)			-
Exercised year-to-date			(92,000	)			-				(92,000	)
Forfeited year-to-date			(142,119	)			(102,315	)			(244,434	)
Balance as of September 30, 2017			762,264				752,101				1,514,365

  

Compensation expense related to unvested options not yet recognized is $488,000. We expect to recognize this compensation expense over the next three years ($103,000 in 2017, $267,000 in 2018, $103,000 in 2019, and $15,000 in 2020).

 

Stock Appreciation Rights (SARs)

 

As of September 30, 2017, we have issued SARs for 280,472 shares of common stock to employees. The strike price of the SARs was between $7.84 and $10.38, which was equal to the market price of the common stock at the date of issuance. As of September 30, 2017, 149,000 of the SARs were vested. On September 30, 2017 the market price of GWG’s common stock was $10.07.

 

Outstanding Stock Appreciation Rights:

 

		Vested				Un-vested				Total
Balance as of December 31, 2015			-				-				-
Granted during the year			106,608				133,127				239,735
Forfeited during the year			-				-				-
Balance as of December 31, 2016			106,608				133,127				239,735
Granted during the year			4,063				36,674				40,737
Vested during the year			38,197				(38,197	)			-
Forfeited during the year			-				-				-
Balance as of September 30, 2017			148,868				131,604				280,472

 

The liability for the SARs as of September 30, 2017, recorded within Other accrued expenses, was $307,000. Employee compensation and benefits expense for SARs of ($9,000) and $303,000 was recorded during the three and nine months ended September 30, 2017.

 

Upon the exercise of SARs, the Company is obligated to make cash payment equal to the positive difference between the fair market value of the Company’s common stock on the date of exercise less the fair market value of the common stock on the date of grant.

 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

 

(15)	Other Expenses

 

The components of “Other expenses” on our Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2017 and 2016 are as follows:

 

		Three months ended September 30,								Nine months ended September 30,
		2017				2016				2017				2016
Contract Labor		$	130,041			$	218,884			$	311,314			$	717,111
Marketing			485,510				423,041				1,686,943				1,234,372
Information Technology			410,903				194,653				1,093,011				522,552
Servicing and Facility Fees			276,826				520,235				855,928				680,208
Travel and Entertainment			249,684				272,785				767,958				838,111
Insurance and Regulatory			415,817				452,814				1,239,670				1,107,088
Charitable Contributions			42,093				277,508				462,103				279,682
General and Administrative			760,322				503,292				2,017,690				1,828,933
		$	2,771,196			$	2,863,212			$	8,434,617			$	7,208,057

 

(16)	Net Loss per Common Share

 

We have outstanding Series A, RPS and RPS 2, as respectively described in Notes 9, 10 and 11. The Series A, RPS and RPS 2 are anti-dilutive to our net loss or income attributable to common shareholders calculation at both September 30, 2017 and 2016. We also issued warrants to purchase common stock in conjunction with the sale of Series A (see Note 9), which have expired as of September 30, 2017. Both those warrants and our vested stock options are anti-dilutive at both September 30, 2017 and 2016.

 

(17)	Commitments

 

We are party to an office lease with U.S. Bank National Association as the landlord. On September 1, 2015, we entered into an amendment to our original lease that expanded the leased space to 17,687 square feet and extended the term through October 2025. Under the amended lease we are obligated to pay base rent plus common area maintenance and a share of building operating costs. Rent expenses under this agreement were $121,000 and $344,000 during the three and nine months ended September 30, 2017 and $102,000 and $306,000 for the three and nine months ended September 30, 2016.

 

Minimum lease payments under the amended lease are as follows:

 

Three months ending December 31, 2017		$	64,000
2018			266,000
2019			275,000
2020			284,000
2021			293,000
2022			302,000
Thereafter			904,000
		$	2,388,000

 

(18)	Contingencies

 

Litigation – In the normal course of business, we are involved in various legal proceedings. In the opinion of management, any liability resulting from such proceedings would not have a material adverse effect on our financial position, results of operations or cash flows.

 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

(19)	Guarantee of L Bonds

 

We are publicly offering and selling L Bonds under a registration statement declared effective by the SEC, as described in Note 8. Our obligations under the L Bonds are secured by substantially all the assets of GWG Holdings, a pledge of all our common stock held individually by our largest stockholders, and by a guarantee and corresponding grant of a security interest in substantially all the assets of GWG Life. As a guarantor, GWG Life has fully and unconditionally guaranteed the payment of principal and interest on the L Bonds. GWG Life’s equity in DLP IV serve as collateral for our L Bond obligations. Substantially all of our life insurance policies are held by DLP IV and the Trust. The policies held by DLP IV are not collateral for the L Bond obligations as such policies are pledged to the senior credit facility with LNV Corporation.

 

The consolidating financial statements are presented in lieu of separate financial statements and other related disclosures of the subsidiary guarantor and issuer, because management does not believe that separate financial statements and related disclosures would be material to investors. There are currently no significant restrictions on the ability of GWG Holdings or GWG Life, the guarantor subsidiary, to obtain funds from its subsidiaries by dividend or loan, except as described in these notes. A substantial majority of insurance policies we currently own are subject to a collateral arrangement with LNV Corporation described in Note 6. Under this arrangement, we are required to maintain a collection account that is used to collect policy benefits from pledged policies, pay interest and other charges under the facility, and distribute funds to pay down the facility.

 

The following represents consolidating financial information as of September 30, 2017 and December 31, 2016, with respect to the financial position, and for the three and nine months ended September 30, 2017 and 2016, with respect to results of operations and cash flows of GWG Holdings and its subsidiaries. The parent column presents the financial information of GWG Holdings, the primary obligor for the L Bonds. The guarantor subsidiary column represents the financial information of GWG Life, the guarantor subsidiary of the L Bonds, presenting its investment in DLP IV and the Trust under the equity method. The non-guarantor subsidiaries column presents the financial information of all non-guarantor subsidiaries, including DLP IV and the Trust.

 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

Condensed Consolidating Balance Sheets

 

September 30, 2017		Parent				Guarantor Subsidiary				Non-Guarantor Subsidiaries				Eliminations				Consolidated
A S S E T S
Cash and cash equivalents		$	31,382,104			$	82,587,231			$	1,376,146			$	-			$	115,345,481
Restricted cash			-				2,647,121				3,172,109				-				5,819,230
Investment in life insurance policies, at fair value			-				45,962,331				574,135,607				-				620,097,938
Secured MCA advances			-				-				2,623,657				-				2,623,657
Life insurance policy benefits receivable			-				-				14,597,000				-				14,597,000
Deferred taxes, net			4,384,546				-				-				-				4,384,546
Other assets			1,883,433				2,013,796				61,584				(134,613	)			3,824,200
Investment in subsidiaries			519,803,823				385,753,794				-				(905,557,617	)			-
TOTAL ASSETS		$	557,453,906			$	518,964,273			$	595,966,103			$	(905,692,230	)		$	766,692,052
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
LIABILITIES
Senior credit facility		$	-			$	-			$	201,978,580			$	-			$	201,978,580
L Bonds			413,060,517				-				-				-				413,060,517
Accounts payable			1,062,708				1,259,708				1,392,820				-				3,715,236
Interest and dividends payable			10,541,613				-				2,980,582				(1,021	)			13,521,174
Other accrued expenses			1,165,044				1,351,379				409,690				(133,592	)			2,792,521
TOTAL LIABILITIES			425,829,882				2,611,087				206,761,672				(134,613	)			635,068,028
STOCKHOLDERS’ EQUITY
Member’s capital			-				516,353,186				389,204,431				(905,557,617	)			-
Convertible preferred stock			19,408,980				-				-				-				19,408,980
Redeemable preferred stock and Series 2 redeemable preferred stock			140,828,380				-				-				-				140,828,380
Common stock			5,814				-				-				-				5,814
Accumulated deficit			(28,619,150	)			-				-				-				(28,619,150	)
TOTAL STOCKHOLDERS’ EQUITY			131,624,024				516,353,186				389,204,431				(905,557,617	)			131,624,024
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY		$	557,453,906			$	518,964,273			$	595,966,103			$	(905,692,230	)		$	766,692,052

 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

Condensed Consolidating Balance Sheets (continued)

 

December 31, 2016		Parent				Guarantor Subsidiary				Non-Guarantor Subsidiaries				Eliminations				Consolidated
A S S E T S
Cash and cash equivalents		$	28,481,047			$	49,360,952			$	644,983			$	-			$	78,486,982
Restricted cash			-				2,117,649				35,708,947				-				37,826,596
Investment in life insurance policies, at fair value			-				41,277,896				469,914,458				-				511,192,354
Secured MCA advances			-				-				5,703,147				-				5,703,147
Life insurance policy benefits receivable			-				-				5,345,000				-				5,345,000
Other assets			3,854,233				2,056,822				810,640				(2,033,592	)			4,688,103
Investment in subsidiaries			429,971,148				352,337,037				-				(782,308,185	)			-
TOTAL ASSETS		$	462,306,428			$	447,150,356			$	518,127,175			$	(784,341,777	)		$	643,242,182
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
LIABILITIES
Senior credit facilities		$	-			$	-			$	156,064,818			$	-			$	156,064,818
Series I Secured Notes			-				16,404,836				-				-				16,404,836
L Bonds			381,312,587				-				-				-				381,312,587
Accounts payable			853,470				731,697				641,545				-				2,226,712
Interest and dividends payable			9,882,133				3,743,277				2,535,189				-				16,160,599
Other accrued expenses			862,369				544,032				2,303,952				(2,033,592	)			1,676,761
Deferred taxes, net			2,097,371				-				-				-				2,097,371
TOTAL LIABILITIES			395,007,930				21,423,842				161,545,504				(2,033,592	)			575,943,684
STOCKHOLDERS’ EQUITY
Member’s capital			-				425,726,514				356,581,671				(782,308,185	)			-
Convertible preferred stock			19,701,133				-				-				-				19,701,133
Redeemable preferred stock			59,025,164				-				-				-				59,025,164
Common stock			5,980				-				-				-				5,980
Additional paid-in capital			7,383,515				-				-				-				7,383,515
Accumulated deficit			(18,817,294	)			-				-				-				(18,817,294	)
TOTAL STOCKHOLDERS’ EQUITY			67,298,498				425,726,514				356,581,671				(782,308,185	)			67,298,498
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY		$	462,306,428			$	447,150,356			$	518,127,175			$	(784,341,777	)		$	643,242,182

 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

Condensed Consolidating Statements of Operations

For the three months ended September 30, 2017		Parent				Guarantor Subsidiary				Non-Guarantor Subsidiaries				Eliminations				Consolidated
REVENUE
Policy servicing income		$	-			$	125,525			$	-			$	(105,525	)		$	20,000
Gain on life insurance policies, net			-				2,780,544				11,640,809				-				14,421,353
MCA income			-				-				100,367				-				100,367
Interest and other income			40,044				(12,115	)			139,498				(12,104	)			155,323
TOTAL REVENUE			40,044				2,893,954				11,880,674				(117,629	)			14,697,043
EXPENSES
Policy servicing fees			-				-				105,525				(105,525	)			-
Interest expense			9,907,959				253,422				3,126,130				(12,104	)			13,275,407
Employee compensation and benefits			2,140,675				1,413,103				238,318				-				3,792,096
Legal and professional fees			746,939				246,691				663,460				-				1,657,090
Provision for MCA advances			-				-				28,000				-				28,000
Other expenses			1,743,730				711,528				315,938				-				2,771,196
TOTAL EXPENSES			14,539,303				2,624,744				4,477,371				(117,629	)			21,523,789
INCOME (LOSS) BEFORE EQUITY IN INCOME OF SUBSIDIARIES			(14,499,259	)			269,210				7,403,303				-				(6,826,746	)
EQUITY IN INCOME OF SUBSIDIARIES			7,672,513				8,263,120				-				(15,935,633	)			-
INCOME (LOSS) BEFORE INCOME TAXES			(6,826,746	)			8,532,330				7,403,303				(15,935,633	)			(6,826,746	)
INCOME TAX BENEFIT			(2,764,243	)			-				-				-				(2,764,243	)
NET INCOME (LOSS)			(4,062,503	)			8,532,330				7,403,303				(15,935,633	)			(4,062,503	)
Preferred stock dividends			3,548,165				-				-				-				3,548,165
NET LOSS ATTRIBUTABLE TO COMMON SHAREHOLDERS		$	(7,610,668	)		$	8,532,330			$	7,403,303			$	(15,935,633	)		$	(7,610,668	)

 

For the three months ended September 30, 2016		Parent				Guarantor Subsidiary				Non-Guarantor Subsidiaries				Eliminations				Consolidated
REVENUE
Policy servicing income		$	-			$	-			$	-			$	-			$	-
Gain on life insurance policies, net			-				-				13,509,755				-				13,509,755
MCA income			-				-				286,225				-				286,225
Interest and other income			75,808				30,126				83,313				(64,249	)			124,998
TOTAL REVENUE			75,808				30,126				13,879,293				(64,249	)			13,920,978
EXPENSES
Policy servicing fees			-				-				-				-				-
Interest expense			8,705,950				554,938				1,746,151				(64,249	)			10,942,790
Employee compensation and benefits			1,718,683				1,038,058				155,722				-				2,912,463
Legal and professional fees			263,917				297,804				25,109				-				586,830
Other expenses			1,464,498				803,106				595,608				-				2,863,212
TOTAL EXPENSES			12,153,048				2,693,906				2,522,590				(64,249	)			17,305,295
INCOME (LOSS) BEFORE EQUITY IN INCOME OF SUBSIDIARIES			(12,077,240	)			(2,663,780	)			11,356,703				-				(3,384,317	)
EQUITY IN INCOME OF SUBSIDIARIES			8,692,923				11,361,329				-				(20,054,252	)			-
INCOME BEFORE INCOME TAXES			(3,384,317	)			8,697,549				11,356,703				(20,054,252	)			(3,384,317	)
INCOME TAX BENEFIT			(1,428,130	)			-				-				-				(1,428,130	)
NET INCOME			(1,956,187	)			8,697,549				11,356,703				(20,054,252	)			(1,956,187	)
Preferred stock dividends			1,041,178				-				-				-				1,041,178
NET INCOME ATTRIBUTABLE TO COMMON SHAREHOLDERS		$	(2,997,365	)		$	8,697,549			$	11,356,703			$	(20,054,252	)		$	(2,997,365	)

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited) 

Condensed Consolidating Statements of Operations (continued)

For the nine months ended September 30, 2017		Parent				Guarantor Subsidiary				Non-Guarantor Subsidiaries				Eliminations				Consolidated
REVENUE
Policy servicing income		$	-			$	311,800			$	-			$	(291,800	)		$	20,000
Gain on life insurance policies, net			-				4,481,555				40,635,883				-				45,117,438
MCA income			-				-				480,526				-				480,526
Interest and other income			194,273				36,895				683,141				(79,300	)			835,009
TOTAL REVENUE			194,273				4,830,250				41,799,550				(371,100	)			46,452,973
EXPENSES
Policy servicing fees			-				-				291,800				(291,800	)			-
Interest expense			27,495,867				930,837				10,418,243				(79,300	)			38,765,647
Employee compensation and benefits			6,179,032				4,163,873				353,550				-				10,696,455
Legal and professional fees			1,524,510				687,240				1,722,277				-				3,934,027
Provision for MCA advances			-				-				906,000				-				906,000
Other expenses			5,291,881				2,244,577				898,159				-				8,434,617
TOTAL EXPENSES			40,491,290				8,026,527				14,590,029				(371,100	)			62,736,746
INCOME (LOSS) BEFORE EQUITY IN INCOME OF SUBSIDIARIES			(40,297,017	)			(3,196,277	)			27,209,521				-				(16,283,773	)
EQUITY IN INCOME OF SUBSIDIARIES			24,013,244				29,569,105				-				(53,582,349	)			-
INCOME (LOSS) BEFORE INCOME TAXES			(16,283,773	)			26,372,828				27,209,521				(53,582,349	)			(16,283,773	)
INCOME TAX BENEFIT			(6,481,917	)			-				-				-				(6,481,917	)
NET INCOME (LOSS)			(9,801,856	)			26,372,828				27,209,521				(53,582,349	)			(9,801,856	)
Preferred stock dividends			7,447,022				-				-				-				7,447,022
NET LOSS ATTRIBUTABLE TO COMMON SHAREHOLDERS		$	(17,248,878	)		$	26,372,828			$	27,209,521			$	(53,582,349	)		$	(17,248,878	)

 

For the nine months ended September 30, 2016		Parent				Guarantor Subsidiary				Non-Guarantor Subsidiaries				Eliminations				Consolidated
REVENUE
Policy servicing income		$	-			$	13,417			$	-			$	(13,417	)		$	-
Gain on life insurance policies, net			-				-				51,606,815				-				51,606,815
MCA income			-				-				654,441				-				654,441
Interest and other income			181,828				31,137				282,259				(154,126	)			341,098
TOTAL REVENUE			181,828				44,554				52,543,515				(167,543	)			52,602,354
EXPENSES
Policy servicing fees			-				-				13,417				(13,417	)			-
Interest expense			23,323,987				1,856,909				4,829,831				(154,126	)			29,856,601
Employee compensation and benefits			4,894,006				3,151,107				405,055				-				8,450,168
Legal and professional fees			1,642,252				1,308,959				146,101				-				3,097,312
Other expenses			4,241,825				2,197,133				1,169,099				-				7,608,057
TOTAL EXPENSES			34,102,070				8,514,108				6,563,503				(167,543	)			49,012,138
INCOME (LOSS) BEFORE EQUITY IN INCOME OF SUBSIDIARIES			(33,920,242	)			(8,469,554	)			45,980,012				-				3,590,216
EQUITY IN INCOME OF SUBSIDIARIES			37,510,458				46,497,731				-				(84,008,189	)			-
INCOME BEFORE INCOME TAXES			3,590,216				38,028,177				45,980,012				(84,008,189	)			3,590,216
INCOME TAX EXPENSE			1,478,617				-				-				-				1,478,617
NET INCOME			2,111,599				38,028,177				45,980,012				(84,008,189	)			2,111,599
Preferred stock dividends			2,153,333				-				-				-				2,153,333
NET INCOME ATTRIBUTABLE TO COMMON SHAREHOLDERS		$	(41,734	)		$	38,028,177			$	45,980,012			$	(84,008,189	)		$	(41,734	)

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

Condensed Consolidating Statements of Cash Flows

 

For the three months ended September 30, 2017		Parent				Guarantor Subsidiary				Non-Guarantor Subsidiaries				Eliminations				Consolidated
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss)		$	(4,062,503	)		$	8,532,330			$	7,403,303			$	(15,935,633	)		$	(4,062,503	)
Adjustments to reconcile net income to net cash flows from operating activities:
Equity of subsidiaries			(7,672,513	)			(8,263,120	)			-				15,935,633				-
Change in fair value of life insurance policies			-				(3,609,194	)			(16,572,538	)			-				(20,181,732	)
Amortization of deferred financing and issuance costs			2,075,632				134,445				134,464				-				2,344,541
Deferred income taxes			(2,764,243	)			-				-				-				(2,764,243	)
Preferred stock dividends payable			333,391				-				-				-				333,391
(Increase) decrease in operating assets:
Life insurance policy benefits receivable			-				-				(7,627,000	)			-				(7,627,000	)
Other assets			(38,552,777	)			51,740,361				330,547				(13,415,694	)			102,437
Increase (decrease) in operating liabilities:
Due to related party			807,511				(10,940	)			(800,000	)			-				(3,429	)
Accounts payable and accrued expenses			693,285				(844,072	)			(264,684	)			-				(415,471	)
NET CASH FLOWS USED IN OPERATING ACTIVITIES			(49,142,217	)			47,679,810				(17,395,908	)			(13,415,694	)			(32,274,009	)
CASH FLOWS FROM INVESTING ACTIVITIES
Investment in life insurance policies			-				-				(25,199,692	)			-				(25,199,692	)
Carrying value of matured life insurance policies			-				505,000				1,828,039				-				2,333,039
Proceeds from Secured MCA advances			-				-				826,621				-				826,621
NET CASH FLOWS USED IN INVESTING ACTIVITIES			-				505,000				(22,545,032	)			-				(22,040,032	)
CASH FLOWS FROM FINANCING ACTIVITIES
Net borrowings on senior credit facilities			-				-				56,887,491				-				56,887,491
Payments for issuance of senior debt			-								(3,937,907	)			-				(3,937,907	)
Payments for redemption of Series I Secured Notes			-				(6,815,406	)			-				-				(6,815,406	)
Proceeds from issuance of L Bonds			30,271,873				-				-				-				30,271,873
Payments for issuance and redemption of L Bonds			(19,752,717	)			-				-				-				(19,752,717	)
Payments to restricted cash			-				1,807,105				38,533,296				-				40,340,401
Issuance of member capital			-				37,959,462				(51,375,156	)			13,415,694				--
Issuance of common stock			30				-				-				-				30
Proceeds from issuance of preferred stock			25,211,870				-				-				-				25,211,870
Payments for issuance and redemption of preferred stock			(1,291,420	)			-				-				-				(1,291,420	)
Payments of preferred stock dividends			(3,548,165	)			-				-				-				(3,548,165	)
NET CASH FLOWS PROVIDED BY FINANCING ACTIVITIES			30,891,471				32,951,161				40,107,724				13,415,694				117,366,050
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS			(18,250,746	)			81,135,971				166,784								63,052,009
CASH AND CASH EQUIVALENTS
BEGINNING OF THE PERIOD			49,632,850				1,451,260				1,209,362				-				52,293,472
END OF THE PERIOD		$	31,382,104			$	82,587,231			$	1,376,146			$	-			$	115,345,481

 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

Consolidating Statements of Cash Flows (continued)

 

For the three months ended September 30, 2016		Parent				Guarantor Subsidiary				Non-Guarantor Subsidiaries				Eliminations				Consolidated
CASH FLOWS FROM OPERATING ACTIVITIES
Net income		$	(1,956,187	)		$	8,697,549			$	11,356,703			$	(20,054,252	)		$	(1,956,187	)
Adjustments to reconcile net loss to net cash flows from operating activities:
Equity of subsidiaries			(8,692,924	)			(11,361,328	)			-				20,054,252				-
Change in fair value of life insurance policies			-				-				(21,073,226	)			-				(21,073,226	)
Amortization of deferred financing and issuance costs			2,072,879				81,849				611,015				-				2,765,743
Deferred income taxes			(1,428,130	)			-				-				-				(1,428,130	)
Preferred stock dividends payable			333,565				-				-				-				333,565
(Increase) decrease in operating assets:
Life insurance policy benefits receivable			-				-				700,000				-				700,000
Other assets			(54,428,152	)			(54,272,589	)			-				109,120,577				419,836
Increase (decrease) in operating liabilities:
Due to related party			(64,249	)			(16,700	)			-				-				(80,949	)
Accounts payable and other accrued expenses			155,980				2,172,227				(5,545,197	)			-				(3,216,990	)
NET CASH FLOWS USED IN OPERATING ACTIVITIES			(64,007,218	)			(54,698,992	)			(13,950,705	)			109,120,577				(23,536,338	)
CASH FLOWS FROM INVESTING ACTIVITIES
Investment in life insurance policies			-				-				(25,770,326	)			-				(25,770,326	)
Carrying value of matured life insurance policies			-				-				1,078,889				-				1,078,889
Investment in Secured MCA advances			-				-				(1,965,896	)							(1,965,896	)
Proceeds from Secured MCA advances			-				-				220,911				-				220,911
NET CASH FLOWS USED IN INVESTING ACTIVITIES			-				-				(26,436,422	)			-				(26,436,422	)
CASH FLOWS FROM FINANCING ACTIVITIES
Net repayment of senior credit facilities			-				-				(10,761,048	)			-				(10,761,048	)
Payments for redemption of Series I Secured Notes			-				(541,275	)			-				-				(541,275	)
Proceeds from issuance of L Bonds			64,350,430				-				-				-				64,350,430
Payments for issuance and redemption of L Bonds			(14,373,447	)			-				-				-				(14,373,447	)
Payments to restricted cash			-				486,283				(5,013,515	)			-				(4,527,232	)
Issuance of member capital			-				52,304,345				56,816,232				(109,120,577	)			-
Issuance of common stock			31,515				-				-				-				31,515
Proceeds from issuance of preferred stock			20,786,332				-				-				-				20,786,332
Payments for issuance and redemption of preferred stock			(2,485,304	)			-				(71,555	)			-				(2,556,859	)
Payments of preferred stock dividends			(1,041,178	)			-				-				-				(1,041,178	)
NET CASH FLOWS PROVIDED BY FINANCING ACTIVITIES			67,268,348				52,249,353				40,970,114				(109,120,577	)			51,367,238
NET INCREASE IN CASH AND CASH EQUIVALENTS			3,261,130				(2,449,639	)			582,987				-				1,394,478
CASH AND CASH EQUIVALENTS
BEGINNING OF THE PERIOD			10,051,621				6,822,484				505,245				-				17,379,350
END OF THE PERIOD		$	13,312,751			$	4,372,845			$	1,088,232			$	-			$	18,773,828

 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

Consolidating Statements of Cash Flows (continued)

 

For the nine months ended September 30, 2017		Parent				Guarantor Subsidiary				Non-Guarantor Subsidiaries				Eliminations				Consolidated
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss)		$	(9,801,856	)		$	26,372,828			$	27,209,521			$	(53,582,349	)		$	(9,801,856	)
Adjustments to reconcile net loss to net cash flows from operating activities:
Equity of subsidiaries			(24,013,243	)			(29,569,106	)			-				53,582,349				-
Change in fair value of life insurance policies			-				(4,803,015	)			(44,498,052	)			-				(49,301,067	)
Amortization of deferred financing and issuance costs			4,931,441				208,829				1,368,422				-				6,508,692
Deferred income taxes			(6,481,917	)			-				-				-				(6,481,917	)
Preferred stock dividends payable			1,034,139				-				-				-				1,034,139
(Increase) decrease in operating assets:
Life insurance policy benefits receivable			-				-				(9,252,000	)			-				(9,252,000	)
Other assets			(65,691,037	)			(3,794,004	)			788,726				69,667,082				970,767
Increase (decrease) in operating liabilities:
Due to related party			1,897,406				(10,620	)			(1,900,000	)			-				(13,214	)
Accounts payable and other accrued expenses			2,331,255				(2,407,918	)			1,917,279				-				1,840,616
NET CASH FLOWS USED IN OPERATING ACTIVITIES			(95,793,812	)			(14,003,006	)			(24,366,104	)			69,667,082				(64,495,840	)
CASH FLOWS FROM INVESTING ACTIVITIES
Investment in life insurance policies			-				-				(67,321,363	)			-				(67,321,363	)
Carrying value of matured life insurance policies			-				1,256,576				6,460,271				-				7,716,847
Investment in Secured MCA advances			-				-				(39,671	)			-				(39,671	)
Proceeds from Secured MCA advances			-				-				2,250,323				-				2,250,323
NET CASH FLOWS USED IN INVESTING ACTIVITIES			-				1,256,576				(58,650,440	)			-				(57,393,864	)
CASH FLOWS FROM FINANCING ACTIVITIES
Net repayment of senior credit facilities			-				-				49,787,954				-				49,787,954
Payments for issuance of senior debt							(1,076,118	)			(4,052,201	)			-				(5,128,319	)
Payments for redemption of Series I Secured Notes			-				(16,613,667	)			-				-				(16,613,667	)
Proceeds from issuance of L Bonds			87,016,343				-				-				-				87,016,343
Payments for issuance and redemption of L Bonds			(58,949,880	)			-				-				-				(58,949,880	)
Payments to restricted cash			-				(529,472	)			32,536,838				-				32,007,366
Issuance of member capital			-				64,191,966				5,475,116				(69,667,082	)			-
Payments for issuance and redemption of common stock			(1,603,526	)			-				-				-				(1,603,526	)
Proceeds from issuance of preferred stock			86,692,811				-				-				-				86,692,811
Payments for issuance and redemption of preferred stock			(7,013,857	)			-				-				-				(7,013,857	)
Payments of preferred stock dividends			(7,447,022	)			-				-				-				(7,447,022	)
NET CASH FLOWS PROVIDED BY FINANCING ACTIVITIES			98,694,869				45,972,709				83,747,707				(69,667,082	)			158,748,203
NET INCREASE IN CASH AND CASH EQUIVALENTS			2,901,057				33,226,279				731,163				-				36,858,499
CASH AND CASH EQUIVALENTS
BEGINNING OF THE PERIOD			28,481,047				49,360,952				644,983				-				78,486,982
END OF THE PERIOD		$	31,382,104			$	82,587,231			$	1,376,146			$	-			$	115,345,481

 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

Consolidating Statements of Cash Flows (continued)

  

For the nine months ended September 30, 2016		Parent				Guarantor Subsidiary				Non-Guarantor Subsidiaries				Eliminations				Consolidated
CASH FLOWS FROM OPERATING ACTIVITIES
Net income		$	2,111,599			$	38,028,177			$	45,980,012			$	(84,008,189	)		$	2,111,599
Adjustments to reconcile net income to net cash flows from operating activities:
Equity of subsidiaries			(37,510,459	)			(46,497,730	)			-				84,008,189				-
Change in fair value of life insurance policies			-				-				(53,846,155	)			-				(53,846,155	)
Amortization of deferred financing and issuance costs			5,982,802				(1,364,614	)			1,459,717				-				6,077,905
Deferred income taxes			1,478,617				-				-				-				1,478,617
Preferred stock dividends payable			663,614				-				-				-				663,614
(Increase) decrease in operating assets:
Life insurance policy benefits receivable			-				-				(6,129,022	)							(6,129,022	)
Other assets			(114,885,990	)			(92,168,163	)			-				206,436,523				(617,630	)
Increase in operating liabilities:
Due to related party			(2,867,225	)			(15,505	)			2,700,000				-				(182,730	)
Accounts payable and accrued expenses			2,396,503				2,889,525				(7,310,262	)			-				(2,024,234	)
NET CASH FLOWS USED IN OPERATING ACTIVITIES			(142,630,539	)			(99,128,310	)			(17,145,710	)			206,436,523				(52,468,036	)
CASH FLOWS FROM INVESTING ACTIVITIES
Investment in life insurance policies			-				-				(74,470,362	)			-				(74,470,362	)
Carrying value of matured life insurance policies			-				-				7,381,132				-				7,381,132
Investment in Secured MCA advances			-				-				(7,613,310	)			-				(7,613,310	)
Proceeds from Secured MCA advances			-				-				1,246,703				-				1,246,703
NET CASH FLOWS USED IN INVESTING ACTIVITIES			-				-				(73,455,837	)			-				(73,455,837	)
CASH FLOWS FROM FINANCING ACTIVITIES
Net borrowings on senior credit facilities			-				-				6,238,952				-				6,238,952
Payments for redemption of Series I Secured Notes			-				(6,264,018	)			-				-				(6,264,018	)
Proceeds from issuance of L Bonds			135,477,090				-				-				-				135,477,090
Payments for issuance and redemption of L Bonds			(37,036,922	)			-				-				-				(37,036,922	)
Payments to restricted cash			-				(2,335,768	)			(11,010,358	)			-				(13,346,126	)
Issuance of common stock			244,185				-				-				-				244,185
Proceeds from issuance of preferred stock			31,215,986				-				71,555				-				31,287,541
Payments for issuance and redemption of preferred stock			(4,095,878	)			-				(78,895	)			-				(4,174,773	)
Payments of preferred stock dividends			(2,153,333	)			-				-				-				(2,153,333	)
Issuance of member capital			-				110,118,219				96,318,304				(206,436,523	)			-
NET CASH FLOWS PROVIDED BY FINANCING ACTIVITIES			123,651,128				101,518,433				91,539,558				(206,436,523	)			110,272,596
NET INCREASE IN CASH AND CASH EQUIVALENTS			(18,979,411	)			2,390,123				938,011				-				(15,651,277	)
CASH AND CASH EQUIVALENTS
BEGINNING OF THE PERIOD			32,292,162				1,982,722				150,221				-				34,425,105
END OF THE PERIOD		$	13,312,751			$	4,372,845			$	1,088,232			$	-			$	18,773,828

 

 

GWG HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

(20)	Concentrations

 

We mostly purchase life insurance policies written by life insurance companies having investment-grade ratings by independent rating agencies. As a result, there may be certain concentrations of policies with life insurance companies. The following summarizes the face value of insurance policies with specific life insurance companies exceeding 10% of the total face value of our portfolio.

 

Life insurance company		September 30,				December 31,
		2017				2016
John Hancock			14.92	%			14.36	%
AXA Equitable			12.24	%			13.42	%
Lincoln National			11.27	%			11.22	%

 

The following summarizes the number of insurance policies held in specific states exceeding 10% of the total face value of our portfolio:

 

State of Residence		September 30,				December 31,
		2017				2016
Florida			19.76	%			19.42	%
California			19.06	%			20.72	%

 

(21)	Subsequent Events

 

Since September 30, 2017, eight policies covering seven individuals have matured. The combined life insurance benefits of these policies were $14,953,000.

 

Since September 30, 2017, we have issued approximately $18,277,000 of L Bonds.

 

Since September 30, 2017, we have issued approximately $13,037,000 of RPS 2.

 

On October 9, 2017, all shares of Series A were redeemed with a redemption payment equal to the sum of (i) $8.25 per share of Series A and (ii) all accrued but unpaid dividends calculated at an annual rate of $0.75 per share, for an aggregate of $22,252,000.

 

On October 23, 2017, we entered into an Amended and Restated Indenture with GWG Life, LLC, as guarantor, and Bank of Utah, as trustee, for the purposes of (i) eliminating references to the Series I Secured Notes that had been governed by the original indenture and were fully paid off as described in this report (and replacing those references, where appropriate, with general references to pari passu debt that may be incurred in the future), (ii) eliminating references to an intercreditor agreement that had been entered into for the benefit of the holders of the Series I Secured Notes, and (iii) updating and otherwise clarifying certain provisions of the original Indenture. Our L Bonds are presently the only securities that have been issued under the Amended and Restated Indenture.

 

Also on October 23, 2017, we entered into an Amended and Restated Pledge and Security Agreement with GWG Life, LLC, Jon R. Sabes and Steven F. Sabes, each as a grantor, and Bank of Utah, as the collateral trustee, for the purposes of (i) amending and restating the terms under which it and the other grantors have granted a security interest for the obligations owing in respect of the L Bonds issued under the Amended and Restated Indenture to be consistent with the Amended and Restated Indenture described above, and (ii) updating and otherwise clarifying certain provisions of the original Pledge and Security Agreement.

 

 

ITEM 2.

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

 

You should read the following discussion in conjunction with the condensed 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.

 

Risk Relating to Forward-Looking Statements

 

This report contains forward-looking statements that reflect our current expectations and projections about future events. Actual results could differ materially from those described in these forward-looking statements.

 

The words “believe,” “could,” “possibly,” “probably,” “anticipate,” “estimate,” “project,” “expect,” “may,” “will,” “should,” “seek,” “intend,” “plan,” “expect,” or “consider” and similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements. Forward-looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from such statements.  Many of the forward-looking statements contained in this report can be found in our MD&A discussion and in the updates we provide in Part II, Item 5 “Other Information.” 

 

Such risks and uncertainties include, but are not limited to:

 

●	changes in the secondary market for life insurance;
●	changes resulting from the evolution of our business model and strategy with respect to the life insurance industry;
●	our limited operating history;
●	the valuation of assets reflected on our financial statements;
●	the reliability of assumptions underlying our actuarial models, including our life expectancy estimates;
●	our reliance on debt financing and continued access to the capital markets;
● ●	our history of operating losses; risks relating to the validity and enforceability of the life insurance policies we purchase;
●	risks relating to our ability to license and effectively apply technologies to improve and expand the scope of our business;
●	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;
●	cost-of-insurance (premium) increases on our life insurance policies;
●	general economic outlook, including prevailing interest rates;
●	performance of our investments in life insurance policies;
●	financing requirements;
●	risks associated with the merchant cash advance business;
●	the various risks associated with our attempts to commercialize our M-Panel technology;
●	litigation risks;
●	restrictive covenants contained in borrowing agreements; and
●	our ability to make cash distributions in satisfaction of dividend obligations and redemption requests.

 

We caution you that the foregoing list of factors is not exhaustive. Forward-looking statements are only estimates and predictions, or statements of current intent. Actual results, outcomes 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.

 

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 are an emerging growth company and have elected to delay our 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 (September 2019) or until we no longer qualify as an “emerging growth company” as defined under the JOBS Act, whichever is earlier.

 

 

Overview

 

We are a financial services company committed to disrupting and transforming the life insurance industry and related industries. We built our business by creating opportunities for consumers to obtain significantly more value for their life insurance policies in a secondary market as compared to the traditional options offered by the insurance industry. We are enhancing and extending these activities through innovation in our products and services, business processes, financing strategies, and advanced epigenetic technologies. At the same time, we are creating opportunities for investors to receive income and capital appreciation from our investment activities in the life insurance and related industries. 

 

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 significant 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 valuing our investments in life insurance policies and evaluating deferred taxes 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

 

We account for the purchase of life insurance policies in accordance with Accounting Standards Codification 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 all of our life insurance policies using the fair value method.

 

The fair value of our life insurance policies is determined as the net present value of the life insurance portfolio’s future expected cash flows (policy benefits received and required premium payments) that incorporates current life expectancy estimates and discount rate assumptions.

 

Fair Value Components – Medical Underwriting

 

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, 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 expected future cash flows to be derived from our portfolio.

 

The 2015 Valuation Basic Table (“2015 VBT”) finalized by the Society of Actuaries is based on a much larger dataset of insured lives, face amount of policies and more current information compared to the dataset underlying the 2008 Valuation Basic Table. The 2015 VBT dataset includes 266 million policies compared to the 2008 VBT dataset of 75 million. The experience data in the 2015 VBT dataset includes 2.55 million claims on policies from 51 insurance carriers. Life expectancies implied by the 2015 VBT are generally longer for male and female nonsmokers between the ages of 65 and 80, while smokers and insureds of both genders over the age of 85 have significantly lower life expectancies. We adopted the 2015 VBT in our valuation process in June 2016.

 

For life insurance policies with face amounts greater than $1 million and that are not pledged under any senior credit facility (approximately 9% of our portfolio by face amount of policy benefits) we attempt to update the independent life expectancy estimates on a continuous rotating three year cycle. For life insurance policies with face amounts greater than $750,000 that are pledged under the LNV senior credit facility (approximately 82% of our portfolio by face amount of policy benefits) we are presently required to update the independent life expectancy estimates every two years beginning from the date of the amended facility.

 

We conduct medical underwriting on the life insurance policies we own with life expectancy reports produced by independent third-party medical-actuarial underwriting firms.  Each life expectancy report summarizes the underlying insured person’s medical history based on the underwriter’s review of recent and historical medical records. We obtain two such life expectancy reports for almost all policies, except for small face value insurance policies (i.e., a policy with $1 million in face value benefits or less). For valuation purposes, we average the life expectancy estimates, expressed as the number of months at which the individual will have a 50% probability of mortality.

 

Our prior experience in updating independent life expectancy estimates has generally resulted in shorter life expectancies of the updated insureds within our portfolio, but often not as short as we had projected. This has resulted in reductions to the fair value of our portfolio in the amounts of $5.4 million and $14.0 million for the three and nine months ended September 30, 2017, respectively. As our life insurance portfolio continues to grow, we may experience additional and material adjustments to the fair value of our portfolio due to updating independent life expectancy estimates.

 

 

In August 2017, Phoenix Life Insurance Company announced pending cost-of-insurance rate increases for certain life insurance policies that will be effected on the policy anniversary dates after November 2017. We identified two affected policies in our portfolio. We are aware of one additional pending cost-of-insurance increase affecting one other policy in our portfolio.

 

Fair Value Components – Required Premium Payments

 

We must pay the premiums on the life insurance policies within our portfolio in order to collect the policy benefit. The same probabilistic model and methodologies used to generate expected cash inflows from the life insurance policy benefits over the expected life of the insured are used to estimate cash outflows due to required premium payments. Premiums paid are offset against revenue in the applicable reporting period.

 

Fair Value Components – Discount Rate

 

A discount rate is used to calculate the net present value of the expected cash flows. The discount rate used to calculate fair value of our portfolio incorporates the guidance provided by Accounting Standards Codification 820, Fair Value Measurements and Disclosures.

 

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

 

	September 30, 2017		December 31, 2016
	10.54%		10.96%

 

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, credit exposure to the issuing insurance companies, and our estimate of the operational risk premium a purchaser would require to receive the future cash flows derived from our portfolio of life insurance policies. Management has discretion regarding the combination of these and other factors when determining the discount rate. The discount rate we choose 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), which is consistent with related GAAP guidance. 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.

 

We engaged Model Actuarial Pricing System, Inc. (“MAPS”) to prepare a calculation of our life insurance 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 to calculate a net present value for our portfolio using the specified discount rate of 10.54%. MAPS independently calculated the net present value of our portfolio of 850 policies to be $620.1 million and furnished us with a letter documenting its calculation. A copy of such letter is filed as Exhibit 99.1 to this report.

 

Deferred Income Taxes

 

Under Accounting Standards Codification 740, Income Taxes, deferred tax assets and liabilities are recognized 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 deferred tax assets that are not considered “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 or sufficient tax planning strategies.

  

 

Principal Revenue and Expense Items

 

We earn revenues from the following three primary sources.

 

●

Life Insurance Policy Benefits Realized. We recognize the difference between the face value of the policy benefits and carrying value when an insured mortality event has occurred and we determine that 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 our notification of the insured’s mortality.

 

●

Change in Fair Value of Life Insurance Policies. We value our portfolio investments for each reporting period in accordance with the fair value principles discussed herein, which reflects the expected receipt of policy benefits in future periods as shown in our consolidated financial statements, net premium costs.

 

●	Sale of a Life Insurance Policy. In the event of a sale of a policy, we recognize 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.

  

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 salaries and benefits, sales, marketing, occupancy and other 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 lenders under our senior credit facilities, interest paid on our L Bonds and other outstanding indebtedness. When we issue debt, we amortize the financing costs (commissions and other fees) associated with such indebtedness over the outstanding term of the financing, and classify it as interest expense.

 

Results of Operations — Three and Nine Months Ended September 30, 2017 Compared to the Same Periods in 2016 

 

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. 

  

		Three Months Ended September 30,								Nine Months Ended September 30,
		2017				2016				2017				2016
Revenue recognized from maturities of life insurance contracts		$	7,414,000			$	4,222,000			$	31,941,000			$	26,986,000
Revenue recognized from change in fair value of life insurance contracts			20,182,000				21,073,000				49,300,000				53,846,000
Premiums and other annual fees			(13,175,000	)			(11,785,000	)			(36,124,000	)			(29,225,000	)
Gain on life insurance contracts, net		$	14,121,000			$	13,510,000			$	45,117,000			$	51,607,000
Other income			276,000				411,000				1,336,000				995,000
Total revenue		$	14,697,000			$	13,921,000			$	46,453,000			$	52,602,000
Number of policies matured			8				4				27				16
Face value of matured policies		$	9,747,000			$	5,300,000			$	39,657,000			$	34,367,000
The change in fair value related to new policies acquired during the period		$	7,217,000			$	11,668,000			$	25,863,000			$	29,509,000

 

The discount rate applied to estimate the fair value of the portfolio of life insurance policies we own was 10.54% as of September 30, 2017, compared to 10.96% as of December 31, 2016 and 11.07% as of September 30, 2016.  The carrying value of policies acquired during each quarterly reporting period is adjusted to current fair value using the fair value discount rate applied to the entire portfolio as of that reporting date.

 

 

Expenses.

 

		Three Months Ended September 30,												Nine Months Ended September 30,
		2017				2016				Increase/ Decrease				2017				2016				Increase/ Decrease
Interest expense (including amortization of deferred financing costs)			13,275,000				10,943,000				2,332,000	(1)			38,766,000				29,857,000				8,909,000	(1)
Employee compensation and benefits		$	3,792,000			$	2,912,000			$	880,000	(2)		$	10,696,000			$	8,450,000			$	2,246,000	(2)
Legal and professional expenses			1,657,000				587,000				1,070,000	(3)			3,934,000				3,097,000				837,000	(3)
Provision for MCA loans			28,000				-				28,000	(4)			906,000				400,000				506,000	(4)
Other expenses			2,772,000				2,863,000				(91,000	)(5)			8,435,000				7,208,000				1,227,000	(5)
Total expenses		$	21,524,000			$	17,305,000			$	4,219,000			$	62,737,000			$	49,012,000			$	13,725,000

 

(1)	Increase is due to the increase in our average debt outstanding.
(2)	Increase is due to hiring of additional members to our sales and policy acquisition teams.  At September 30, 2017 we employed 73 employees and on September 30, 2016 we employed 67 employees.
(3)	Increase is due to increased legal fees associated with MCA collections.
(4)	Increase is due to impairment of the Nulook loan due to decreased recovery estimates.
(5)	Increase is due to sales and marketing costs associated with growing and servicing our network of independent financial advisors and appointed agents.

 

Deferred Income Taxes.

 

The Company is engaged in acquiring of life insurance policies and holding them to maturity. Due to the nature of holding policies and the aging of the underlying insureds, Management believes the Company likely will recognize taxable income as the policies in our portfolio start maturing at an accelerated rate in the near future. Management has evaluated and concluded on the material accuracy of our deferred tax carrying amounts.

 

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

 

		Three Months Ended September 30,																Nine Months Ended September 30,
		2017								2016								2017								2016
Statutory federal income tax (benefit)		$	(2,321,000	)			34.0	%		$	(1,151,000	)			34.0	%		$	(5,537,000	)			34.0	%		$	1,221,000				34.0	%
State income taxes (benefit), net of federal benefit			(440,000	)			6.5	%			(216,000	)			6.4	%			(1,049,000	)			6.4	%			240,000				6.7	%
Other permanent differences			(3,000	)			0.0	%			(61,000	)			1.8	%			104,000				(0.6	)%			18,000				0.5	%
Total income tax expense (benefit)		$	(2,764,000	)			40.5	%		$	(1,428,000	)			42.2	%		$	(6,482,000	)			39.8	%		$	1,479,000				41.2	%

 

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

 

 

Liquidity and Capital Resources

 

We finance our business through a combination of life insurance policy benefit receipts, equity offerings, debt offerings, and our senior credit facility. We have used our debt offerings and our senior credit facility primarily for policy acquisition, policy servicing, and portfolio-related financing expenditures including paying principal and interest.

 

As of September 30, 2017 and December 31, 2016, we had approximately $135.8 million and $121.7 million, respectively, in combined available cash, cash equivalents, and policy benefits receivable 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 maturing, outstanding financing obligations. Additional future borrowing base capacity for premiums and servicing costs, created as the premiums and servicing costs of pledged life insurance policies become due, exists under the amended and restated senior credit facility with LNV Corporation. As of the same periods, we had no amounts under our senior credit facility with Autobahn Funding Company.

 

Financings Summary

 

We had the following outstanding debt balances as of September 30, 2017 and December 31, 2016:

 

		As of September 30, 2017								As of December 31, 2016
Issuer/Borrower		Principal Amount Outstanding				Weighted Average Interest Rate				Principal Amount Outstanding				Weighted Average Interest Rate
GWG Holdings, Inc. – L Bonds		$	424,778,000				7.35	%		$	387,067,000				7.23	%
GWG Life, LLC – Series I Secured Notes			-								16,614,000				8.68	%
GWG DLP Funding III, LLC – Autobahn credit facility (see Note 5)			-				N/A				-				N/A
GWG DLP Funding IV, LLC – LNV senior credit facility (see Note 6) (1)			212,513,000				7.52	%			162,725,000				7.34	%
Total		$	637,291,000				7.40	%		$	566,406,000				7.30	%

 

(1)

Weighted average interest rate effective October 1, 2017 is 9.31%.

 

On September 8, 2017, we redeemed all of the outstanding Series I Secured Notes for an aggregate of $6.8 million.

 

The Series I Secured Notes were governed by an Intercreditor Agreement, a Third Amended and Restated Note Issuance and Security Agreement dated November 1, 2011, as amended, and a related Pledge Agreement. Upon the redemption of the Series I Secured Notes and the termination of all obligations outstanding thereunder, those agreements were terminated effective as of September 8, 2017.

 

In June 2011, we concluded a private placement offering of Series A for new investors, having received an aggregate $24.6 million in subscriptions for our Series A. These subscriptions consisted of $14.0 million in conversions of outstanding Series I Secured Notes into Series A and $10.6 million of new investments.

 

As of September 30, 2017 and December 31, 2016, respectively, we had approximately $20.1 million and $19.7 million of Series A stated value outstanding. On October 9, 2017, we exercised our contractual right to call for the redemption of the Series A Preferred Stock and all related outstanding warrants and paid an aggregate of approximately $22.2 million.

 

In January 2012, we began publicly offering up to $250.0 million in debt securities (initially named “Renewable Secured Debentures” and subsequently renamed “L Bonds”) that was completed in January 2015.

 

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 and net proceeds of approximately $8.6 million after the deduction of underwriting commissions, discounts and expense reimbursements.

 

In January 2015, we began publicly offering up to $1.0 billion of L Bonds as a follow-on to our earlier $250.0 million public debt offering. Through September 30, 2017, the total amount of these L Bonds sold, including renewals, was $799.4 million. As of September 30, 2017 and December 31, 2016, respectively, we had approximately $424.8 million and $387.1 million in principal amount of L Bonds outstanding.

 

In October 2015, we began publicly offering up to 100,000 shares of our RPS at a per-share price of $1,000. As of September 30, 2017, we had issued approximately $99.1 million stated value of RPS. As of September 30, 2017, we no longer offer RPS.

 

 

On February 14, 2017, we began publicly offering up to 150,000 shares of RPS 2 at a per-share price of $1,000. As of September 30, 2017, we have issued approximately $48.3 million stated value of RPS 2.

 

The weighted-average interest rate of our outstanding Series I Secured Notes as of December 31, 2016 was 8.68%, and the weighted-average maturity was 1.14 years.  As of September 8, 2017, all of the Series I Secured Notes had been paid in full and all obligations thereunder had been terminated.

 

The weighted-average interest rate of our outstanding L Bonds as of September 30, 2017 and December 31, 2016 was 7.35% and 7.23%, respectively, and the weighted-average maturity at those dates was 2.35 and 2.13 years, respectively. Our L Bonds have renewal features. Since we first issued our L Bonds, we have experienced $374.6 million in maturities, of which $223.7 million has renewed through September 30, 2017 for an additional term. This has provided us with an aggregate renewal rate of approximately 60% for investments in these securities. Effective September 1, 2016, we discontinued the sales and renewals of 6-month and 1-year L Bonds.

 

Future contractual maturities of L Bonds at September 30, 2017 are:

 

Years Ending December 31,		L Bonds
Three months ending December 31, 2017		$	17,059,000
2018			108,717,000
2019			133,174,000
2010			63,523,000
2021			28,703,000
2022			31,755,000
Thereafter			41,847,000
		$	424,778,000

 

The L Bonds are secured by all of our assets, and are subordinate to our senior credit facility with LNV Corporation (and senior credit facility with Autobahn Funding Company until its termination on September 12, 2017).

 

On September 12, 2017, we terminated our $105 million senior credit facility with Autobahn Funding Company LLC. We had paid off in full all obligations under the facility on September 14, 2016, and since that date, we had no balances outstanding on the facility.

 

On September 27, 2017, we entered into a $300 million amended and restated senior credit facility with LNV Corporation in which DLP IV is the borrower. We intend to use the proceeds from this facility to grow and maintain our portfolio of life insurance policies, for liquidity and for general corporate purposes. As of September 30, 2017 we had approximately $212.5 million outstanding under the LNV senior credit facility.

 

We expect to meet our ongoing operational capital needs through a combination of the receipt of policy benefits from our portfolio of life insurance policies and net proceeds from our L Bonds and RPS 2 offerings. We expect to meet our policy acquisition, servicing, and financing capital needs principally from the receipt of policy benefits from our portfolio of life insurance policies, net proceeds from our offering of L Bonds and RPS 2, and from our senior credit facility with LNV Corporation. We estimate that our liquidity and capital resources are sufficient for our current and projected financial needs for at least the next twelve months given current assumptions. However, if we are unable to continue our offerings for any reason (or if we become unsuccessful in selling our securities), and we are unable to obtain capital from other sources, our business will be materially and adversely affected. In addition, our business will be materially and adversely affected if we do not receive the policy benefits we forecast and if holders of our L Bonds fail 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 and other obligations. A sale under such circumstances may result in significant impairment of the realized value of our portfolio.

 

Capital expenditures have historically not been material and we do not anticipate making material capital expenditures in 2017 or beyond.

 

 

Debt Financing Summary

 

The table below reconciles the face amount of our outstanding debt to the carrying value shown on our balance sheet:

 

		As of September 30, 2017				As of December 31, 2016
Total senior facilities and other indebtedness
Face amount outstanding		$	212,513,000			$	162,725,000
Unamortized selling costs			(10,535,000	)			(6,660,000	)
Carrying amount		$	201,978,000			$	156,065,000
Series I Secured Notes:
Face amount outstanding		$	-			$	16,614,000
Unamortized selling costs			-				(209,000	)
Carrying amount		$	-			$	16,405,000
L Bonds:
Face amount outstanding		$	424,778,000			$	387,067,000
Subscriptions in process			2,744,000				5,882,000
Unamortized selling costs		$	(14,462,000	)		$	(11,636,000	)
Carrying amount		$	413,060,000			$	381,313,000

 

Portfolio Assets and Secured Indebtedness 

 

At September 30, 2017, the fair value of our investments in life insurance policies of $620.1 million plus our cash balance of $115.3 million and our restricted cash balance of $5.8 million, plus matured policy benefits receivable of $14.6 million, totaled $755.9 million representing an excess of portfolio assets over secured indebtedness of $118.6 million. At December 31, 2016, the fair value of our investments in life insurance policies of $511.2 million plus our cash balance of $78.5 million and our restricted cash balance of $37.8 million, plus matured policy benefits receivable of $5.3 million, totaled $632.9 million, representing an excess of portfolio assets over secured indebtedness of $66.4 million.

 

The following forward-looking table seeks to illustrate the impact that a hypothetical sale of our portfolio of life insurance assets at various discount rates would have on our ability to satisfy our debt obligations as of September 30, 2017. In all cases, the sale of the life insurance assets owned by DLP IV will be used first to satisfy all amounts owing, if any, under our senior credit facility with LNV Corporation (as of September 12, 2017, we terminated our credit facility with Autobahn Funding Company). The net sale proceeds remaining after satisfying all obligations under the senior credit facility with LNV Corporation would be applied to L Bonds on a pari passu basis.

 

Portfolio Discount Rate			10%				11%				12%				13%				14%				15%				16%
Value of portfolio		$	636,627,000			$	606,597,000			$	578,955,000			$	553,450,000			$	529,864,000			$	508,007,000			$	487,710,000
Cash, cash equivalents and policy benefits receivable			135,762,000				135,762,000				135,762,000				135,762,000				135,762,000				135,762,000				135,762,000
Total assets			772,389,000				742,359,000				714,717,000				689,212,000				665,626,000				643,769,000				623,472,000
Senior credit facility			212,513,000				212,513,000				212,513,000				212,513,000				212,513,000				212,513,000				212,513,000
Net after senior credit facility			559,876,000				529,846,000				502,204,000				476,699,000				453,113,000				431,256,000				410,959,000
L Bonds			424,778,000				424,778,000				424,778,000				424,778,000				424,778,000				424,778,000				424,778,000
Net after L Bonds			135,098,000				105,068,000				77,426,000				51,921,000				28,335,000				6,478,000				(13,819,000	)
Impairment to L Bonds			No impairment				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 would likely be impaired upon the sale of all our life insurance assets at a price equivalent to a discount rate of approximately 15.32% or higher. At December 31, 2016, the likely impairment occurred at a discount rate of approximately 13.94% or higher. The discount rate used to calculate the fair value of our portfolio was 10.54% and 10.96% at September 30, 2017 and December 31, 2016.

 

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. This table also does not include the yield maintenance fee, which could be substantial, we are required to pay in certain circumstances under our senior credit facility with LNV Corporation. 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 — Fair Value Components – Discount Rate” 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.

 

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. Nevertheless, the probability we will actually be required to pay the premiums decreases as mortality becomes more likely. These scheduled premiums and associated probabilities are factored into our expected internal rate of return and cash-flow modeling. Beyond premiums, we incur policy servicing costs, including annual trustee, tracking costs, and debt servicing costs, including principal and interest payments all of which are excluded from our internal rate of return (“IRR”) calculations. Until we receive a sufficient amount of proceeds from the policy benefits, we intend to pay these costs from our senior credit facility with LNV Corporation, when permitted, and through the issuance of debt securities, including the L Bonds, and equity securities including our preferred stock offerings. 

 

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.

 

Years Ending December 31,		Premiums				Servicing				Premiums and Servicing Fees
Three months ending December 31, 2017		$	16,915,000			$	1,587,000			$	18,502,000
2018			54,931,000				1,587,000				56,518,000
2019			60,916,000				1,587,000				62,503,000
2020			68,728,000				1,587,000				70,315,000
2021			77,522,000				1,587,000				79,109,000
2022			87,424,000				1,587,000				89,011,000
		$	366,436,000			$	9,522,000			$	375,958,000

  

Our anticipated premium expenses are subject to the risk of increased cost-of-insurance charges (i.e., premium charges) for the universal life insurance policies we own. In August 2017, Phoenix Life Insurance Company announced pending cost-of-insurance rate increases for certain life insurance policies that will be effected on the policy anniversary dates after November 2017. We identified two affected policies in our portfolio. We are aware of one additional pending cost-of-insurance increase affecting one other policy in our portfolio. As a result, we expect that our premium expense will increase and the fair value of the policy and our portfolio will be negatively impacted once the insurer has specified and implemented the proposed increases. Except as noted above, we are not aware of cost-of-insurance increases by other insurers, but we are aware that cost-of-insurance increases have become more prevalent in the industry. Thus, we may see additional insurers implementing cost-of-insurance increases in the future.

 

 

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 realized and premiums paid on our portfolio. The trailing 12-month benefits/premium coverage ratio indicates the ratio of policy benefits realized 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 Realized				12-Month Trailing Premiums Paid				12-Month Trailing Benefits/ Premium Coverage Ratio
December 31, 2014			779,099,000				18,050,000				23,265,000				77.6	%
March 31, 2015			754,942,000				46,675,000				23,786,000				196.2	%
June 30, 2015			806,274,000				47,125,000				24,348,000				193.5	%
September 30, 2015			878,882,000				44,482,000				25,313,000				175.7	%
December 31, 2015			944,844,000				31,232,000				26,650,000				117.2	%
March 31, 2016			1,027,821,000				21,845,000				28,771,000				75.9	%
June 30, 2016			1,154,798,000				30,924,000				31,891,000				97.0	%
September 30, 2016			1,272,078,000				35,867,000				37,055,000				96.8	%
December 31, 2016			1,361,675,000				48,452,000				40,240,000				120.4	%
March 31, 2017			1,447,558,000				48,189,000				42,753,000				112.7	%
June 30, 2017			1,525,363,000				49,295,000				45,414,000				108.5	%
September 30, 2017			1,622,627,000				53,742,000				46,559,000				115.4	%

 

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 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.

 

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.

 

Off-Balance Sheet Arrangements

 

We are party to an office lease with U.S. Bank National Association as the landlord. On September 1, 2015, we entered into an amendment that expanded the leased space to 17,687 square feet and extended the term through October 31, 2025 (see Note 17).

 

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 September 30, 2017, 96.5% 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 senior credit facilities are floating-rate financing. In addition, our ability to offer interest and dividend rates that attract capital (including in our continuous offering of L Bonds and RPS 2) is generally impacted by prevailing interest rates. Furthermore, while our L Bond and RPS 2 offerings provide us with fixed-rate debt and equity financing, our debt coverage ratio is calculated in relation to the interest rate on all of our debt financing. Therefore, fluctuations in interest rates impact our business by increasing our borrowing costs, and reducing availability under our debt financing arrangements. We calculate our portfolio earnings based upon the spread generated between the return on our life insurance portfolio and the total 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

 

Non-GAAP financial measures disclosed by our management are provided as additional information to investors in order to provide 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 our consolidated financial statements and our financial statements contained herein.

 

We use non-GAAP financial measures for management’s assessment of our financial condition and operating results without regard to GAAP fair value standards. The application of current GAAP fair value standards, especially during a period of significant growth of our portfolio and our company may result in current period GAAP financial results that may not be reflective of our long-term earnings potential or overall financial condition. Management believes that our non-GAAP financial measures permit investors to understand long-term earnings performance without regard to the volatility in GAAP financial results that can, and does, occur during this stage of our portfolio and company growth.

 

Therefore, in contrast to a GAAP fair valuation, we seek to measure the accrual of the actuarial gain occurring within the portfolio of life insurance policies at our expected internal rate of return (exclusive of future interest costs) 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 adjusted operating costs during the same period, we can estimate, manage and evaluate the overall financial performance of our business without regard to fair value 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 can have a disproportionately positive or negative impact on GAAP results in any particular reporting period.

 

Our senior credit facility with Autobahn/DZ Bank, which we terminated effective as of September 12, 2017, required us to maintain a “positive net income” and “tangible net worth,” each of which were calculated on an adjusted non-GAAP basis using the method described below, without regard to GAAP-based fair value measures. In addition, our senior credit facility with Autobahn/DZ Bank required 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 the Autobahn/DZ Bank senior credit facility’s interest rate.

 

 

In addition, the note issuance and security agreement governing our Series I Secured Notes, which we terminated effective as of September 8, 2017, and the Indenture governing our L Bonds requires us to maintain a “debt coverage ratio” designed to provide reasonable assurance that the buy and hold value of our portfolio plus certain short term assets exceed our total outstanding indebtedness. This ratio is calculated using non-GAAP measures in the method described below, again without regard to GAAP-based fair value measures.

 

Non-GAAP Investment Cost Basis		As of September 30, 2017				As of December 31, 2016
GAAP fair value		$	620,098,000			$	511,192,000
Unrealized fair value gain (1)			(313,926,000	)			(264,625,000	)
Adjusted cost basis increase (2)			303,941,000				248,377,000
Non-GAAP investment cost basis (3)		$	610,113,000			$	494,944,000

 

(1)	This represents the reversal of cumulative unrealized GAAP fair value gain of life insurance policies.
(2)	Adjusted cost basis is increased to include interest, premiums and servicing fees that are expensed under GAAP.
(3)	This is the non-GAAP cost basis in life insurance policies from which our expected internal rate of return is calculated.

 

Excess Spread. Management uses the “total excess spread” to gauge expected profitability of our investments. The expected IRR of our portfolio is based upon future cash flow forecasts derived from a probabilistic analysis of our policy benefits received and policy premiums paid in relation to our non-GAAP investment cost basis (“Expected IRR”).  

  

		As of September 30, 2017				As of December 31, 2016
Expected IRR (1)			10.55	%			11.34	%
Total weighted-average interest rate on indebtedness for borrowed money (2)			7.40	%			7.30	%
Total excess spread (3)			3.15	%			4.04	%

 

(1)	Excludes IRR realized on matured life insurance policies which are substantial.
(2)	Represents the weighted-average interest rate paid on all interest-bearing indebtedness as of the measurement date, determined as follows:

 

	Indebtedness		As of September 30, 2017				As of December 31, 2016
	Senior credit facility with LNV Corporation		$	212,513,000			$	162,725