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IFT > SEC Filings for IFT > Form 10-Q on 2-Nov-2012All Recent SEC Filings

Show all filings for IMPERIAL HOLDINGS, INC.

Form 10-Q for IMPERIAL HOLDINGS, INC.


2-Nov-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion summarizes the significant factors affecting the consolidated operating results, financial condition, liquidity, and cash flows of our Company as of and for the periods presented below and should be read in conjunction with the financial statements and accompanying notes included with this Quarterly Report on Form 10-Q. This discussion contains forward-looking statements that are based on the beliefs of our management, as well as assumptions made by, and information currently available to, our management. Actual results could differ materially from those discussed in or implied by forward-looking statements as a result of various factors. See "Forward-Looking Statements."

Overview

We were founded in December 2006 as a Florida limited liability company and in connection with our initial public offering, on February 3, 2011, Imperial Holdings, Inc. succeeded to the business of Imperial Holdings, LLC and its assets and liabilities.

Imperial Holdings, Inc. (the "Company" or "Imperial") operates in two reportable business segments: life finance (formerly referred to as premium finance) and structured settlements. In the life finance business, the Company earns revenue/income from interest charged on loans, loan origination fees, agency fees from referring agents, changes in the fair value of life insurance policies that the Company acquires and receipt of death benefits with respect to matured life insurance policies it owns. The Company voluntarily terminated its premium finance business in connection with the USAO Investigation. See "Legal Proceedings." In the structured settlement business, the Company purchases structured settlement receivables at a discounted rate and sells these receivables to third parties.

Our Annual Report on Form 10-K for the fiscal year ended December 31, 2011 provides additional information about our business, operations and financial condition.

Recent Developments, Uncertainties & Outlook

In connection with the Non-Prosecution Agreement, Imperial voluntarily terminated its premium finance business. Accordingly, the Company did not recognize any agency fees during the three months ended March 31, 2012 and, once the Company's remaining premium finance loans mature, the Company will no longer recognize revenue from interest income or origination fees. The only material revenue that the Company expects to recognize from the premium finance business in 2012 is from changes in fair value of life settlements acquired upon default and strategic sales of certain life insurance policies in its portfolio that were acquired upon default of premium finance loans. As a result, we expect our revenue in our Life Finance segment to be materially lower in 2012 than in prior year.

Additionally, the Company's ability to generate new business in the life finance segment continued to be limited in the first quarter of 2012 as the Company originated no premium finance loans and, in order to conserve capital, did not purchase policies through life settlement-related acquisitions. As a consequence, the Company's portfolio of life insurance policies is smaller than previously projected, which may result in more volatility and adversely affect the portfolio's performance.

In the structured settlements segment, on January 12, 2012, the Company resumed financing non-life contingent structured settlements using its dedicated facility for those receivables after signing an acknowledgement that provided for certain payments in respect of, the transfer of the ownership of certain lock-box accounts associated with the facility. The Company also continued to fund life-contingent structured settlements under a forward purchase and sale arrangement entered into on December 30, 2011. However, this new arrangement compressed the Company's margins as it required the Company to sell life-contingent structured settlements during the first quarter of 2012 at a discount rate that was 200 basis points higher than the rate used in the prior facility. As of the filing of this Form 10-Q, the discount rate under this forward purchase and sale arrangement is currently 50 basis points higher than the rate used in the prior facility.

The Company has also expended considerable resources resolving the USAO Investigation, as well as responding to the SEC Investigation and related litigation, advancing indemnification costs on behalf of certain employees and in conducting an independent investigation of the facts and circumstances surrounding the USAO Investigation. As of March 31, 2012 the Company's legal and related fees in respect of these matters was $12.4 million, including $5.5 million incurred during the three months ended March 31, 2012. Moreover, the Company's D&O carriers have disputed several of the claims and reserved their rights, and the Company's primary D&O carrier filed a declaratory judgment action on June 13, 2012 seeking a judgment that the claims submitted by the Company are precluded under a prior and pending litigation exemption.

At the time of the Company's initial public offering, the Company intended to hold the majority of the life insurance policies it acquired to maturity while strategically trading in and out of certain policies. In light of the USAO Investigation,


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the SEC Investigation, the related shareholder litigation and the related unbudgeted expenses incurred by the Company, the Company is re-examining its strategy and cash management objectives. We estimate that we will need to pay $19.2 million in premiums to keep our current portfolio of life insurance policies in force from April 1, 2012 through December 31, 2012 and an additional $26.1 million to keep the portfolio in force through 2013. As of March 31, 2012, we had approximately $62.7 million of cash, cash equivalents, and marketable securities, including $691,000 of restricted cash. As of September 30, we had approximately $41.8 million of cash and cash equivalents, and marketable securities including $1.1 million of restricted cash. Additionally, we have not yet experienced the mortalities of insureds or received the resulting death benefits from our life insurance policies (other than from policies with subrogation rights that are not reported on our balance sheet and that are considered contingent assets). We expect the lack of mortalities of insureds to continue at least through 2012. We believe we have sufficient cash and cash equivalents to pay the premiums necessary to keep the life insurance policies that we own in force and our operating expenses through at least 2012 although we will need to proactively manage our cash in advance of any liquidity shortfall. Based on our current internal forecast, we anticipate a liquidity shortfall in the third quarter of 2013. If we do not begin to experience mortalities and collect the related death benefits in a timely manner prior to that time, we will need to seek additional capital to pay the premiums, by means of debt or equity financing or the sale of some of the policies that we own. We may also seek to reduce our operating expenses in order to preserve the value of our existing portfolio of policies, and/or, under certain scenarios, lapse or sell certain of our policies or some combination of the above. The lapsing of policies, if any, would create losses as the assets would be written down to zero.

Critical Accounting Policies

Critical Accounting Estimates

The preparation of the financial statements requires us to make judgments, estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. We base our judgments, estimates and assumptions on historical experience and on various other factors that are believed to be reasonable under the circumstances. Actual results could differ materially from these estimates under different assumptions and conditions. We evaluate our judgments, estimates and assumptions on a regular basis and make changes accordingly. We believe that the judgments, estimates and assumptions involved in the accounting for the loan impairment valuation, allowance for doubtful accounts, income taxes, valuation of structured settlements and the valuation of investments in life settlements have the greatest potential impact on our financial statements and accordingly believe these to be our critical accounting estimates. Below we discuss the critical accounting policies associated with the estimates, as well as selected other critical accounting policies.

Life Finance Loans Receivable

We report loans receivable acquired or originated by us at cost, adjusted for any deferred fees or costs in accordance with Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") 310-20, Receivables-Nonrefundable Fees and Other Costs, discounts, and loan impairment valuation. All loans are collateralized by life insurance policies. Interest income is accrued on the unpaid principal balance on a monthly basis based on the applicable rate of interest on the loans.

In accordance with ASC 310, Receivables, we specifically evaluate all loans for impairment based on the fair value of the underlying policies as collectability is primarily collateral dependent. The loans are considered to be collateral dependent as the repayment of the loans is expected to be provided by the underlying insurance policies. In the event of default, the borrower typically relinquishes ownership of the policy to us in exchange for our release of the debt (or we enforce our security interests in the beneficial interests in the trust that owns the policy). For loans that have lender protection insurance, we make a claim against the lender protection insurance policy and, subject to terms and conditions of the lender protection insurance policy, our lender protection insurer has the right to direct control or take beneficial ownership of the policy upon payment of our claim. For loans without lender protection insurance, we have the option of selling the policy or maintaining it on our balance sheet for investment.

We evaluate the loan impairment valuation on a monthly basis based on our periodic review of the estimated value of the underlying collateral. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. The loan impairment valuation is established as losses on loans are estimated and the provision is charged to earnings. Once established, the loan impairment valuation cannot be reversed to earnings.

In order to originate premium finance transactions our lenders required that we procure lender protection insurance. This lender protection insurance mitigates our exposure to losses which may be caused by declines in the fair value of the underlying policies. At the end of each reporting period, for loans that have lender protection insurance, a loan impairment


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valuation is established if the carrying value of the loan receivable exceeds the amount of coverage. The lender protection insurance program was terminated as of December 31, 2010, and all loans originated after December 31, 2010, do not carry lender protection insurance coverage. Thus, for all loans originated in 2011 and beyond, a loan impairment valuation is established if the carrying value of a loan receivable exceeds the fair value of the underlying collateral. The provision for losses on loans receivable has increased during the three months ended March 31, 2012 as a result of the decline in the estimated fair value of the collateral due to the higher discount rate applied in the fair value model. See Notes 6, 10 and 11 to the accompanying consolidated and combined financial statements.


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Fair Value Option

As of July 1, 2010, we elected to adopt the fair value option, in accordance with ASC 825, Financial Instruments, to record newly-acquired structured settlements at fair value. We have the option to measure eligible financial assets, financial liabilities, and commitments at fair value on an instrument-by-instrument basis. This option is available when we first recognize a financial asset or financial liability or enter into a firm commitment. Subsequent changes in the fair value of assets, liabilities, and commitments where we have elected the fair value option are recorded in our consolidated and combined statement of operations. We have made this election for our structured settlement assets because it is our intention to sell these assets within the next twelve months, and we believe it significantly reduces the disparity that exists between the GAAP carrying value of these structured settlements and our estimate of their economic value.

Fair Value Measurement Guidance

We follow ASC 820, Fair Value Measurements and Disclosures, which defines fair value as an exit price representing the amount that would be received if an asset were sold or that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions the guidance establishes a three-level fair value hierarchy that prioritizes the inputs used to measure fair value. Level 1 relates to quoted prices in active markets for identical assets or liabilities. Level 2 relates to observable inputs other than quoted prices included in Level 1. Level 3 relates to unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Our investments in life insurance policies and structured settlements are considered Level 3 assets as there is currently no active market where we are able to observe quoted prices for identical assets and our valuation model incorporates significant inputs that are not observable. Our impaired loans are measured at fair value on a non-recurring basis, as the carrying value is based on the fair value of the underlying collateral. The method used to estimate the fair value of impaired collateral-dependent loans depends on the nature of the collateral. For collateral that has lender protection insurance coverage, the fair value measurement is considered to be Level 3 as the insured value is an observable input to the Company, but not observable to market participants. For collateral that does not have lender protection insurance coverage, the fair value measurement is considered to be Level 3 as the estimated fair value is based on a model whose significant inputs are the life expectancy of the insured and the discount rate, which are not observable.

Ownership of Life Insurance Policies

In the ordinary course of business, a large portion of our borrowers default by not paying off the loan and relinquish ownership of the life insurance policy to us in exchange for our release of the obligation to pay amounts due. We also buy life insurance policies in the secondary and tertiary markets. We account for life insurance policies that we own as investments in life settlements (life insurance policies) in accordance with ASC 325-30, Investments in Insurance Contracts, which requires us to use either the investment method or the fair value method. The election is made on an instrument-by-instrument basis and is irrevocable. We have elected to account for these life insurance policies as investments using the fair value method.

We initially record investments in life settlements at the transaction price. For policies acquired upon relinquishment by our borrowers, we determine the transaction price based on fair value of the acquired policies at the date of relinquishment. The difference between the net carrying value of the loan and the transaction price is recorded as a gain (loss) on loan payoffs and settlement. For policies acquired for cash, the transaction price is the amount paid.

Valuation of Insurance Policies

Our valuation of insurance policies is a critical component of our estimate for the loan impairment valuation and the fair value of our investments in life settlements (life insurance policies). We currently use a probabilistic method of valuing life insurance policies, which we believe to be the preferred valuation method in the industry. The most significant assumptions which we estimate are the life expectancy of the insured and the discount rate.

In determining the life expectancy estimate, we analyze medical reviews from independent secondary market life expectancy providers ("LE providers"). Historically, the Company has procured the majority of its life expectancy reports from two life expectancy report providers and currently uses AVS Underwriting, LLC ("AVS") life expectancy reports for valuation purposes. The LE provider reviews the medical records and identifies all medical conditions it feels are relevant to the life expectancy of the insured. Debits and credits are then assigned by the LE provider to the individual's health based on these medical conditions. The debit or credit that an LE provider assigns to a medical condition is derived from the experience of mortality attributed to this condition in the portfolio of lives that it monitors. The health of the insured is summarized by the LE provider into a life assessment of the individual's life expectancy expressed both in terms of months and in mortality factor.


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The resulting mortality factor represents an indication as to the degree to which the given life can be considered more or less impaired than a standard life having similar characteristics (e.g. gender, age, smoking, etc.). For example, a standard insured (the average life for the given mortality table) would carry a mortality rating of 100%. A similar but impaired life bearing a mortality rating of 200% would be considered to have twice the chance of dying earlier than the standard life.

The probability of mortality for an insured is then calculated by applying the life expectancy estimate to a mortality table. The mortality table is created based on the rates of death among groups categorized by gender, age, and smoking status. By measuring how many deaths occur before the start of each year, the table allows for a calculation of the probability of death in a given year for each category of insured people. The probability of mortality for an insured is found by applying the mortality rating from the life expectancy assessment to the probability found in the actuarial table for the insured's age, sex and smoking status. The Company applies an actuarial table developed by a third party. In contrast, in pricing trades, we believe many market participants generally reference a table developed by the U.S. Society of Actuaries known as the 2008 Valuation Basic Table, or the 2008 VBT. The table used by the Company to value its life settlements is generally more conservative in that it applies the mortality experience of an insured population that is representative of participants in the life settlement market. Because of the relative greater wealth of the insured whose life insurance policy is sold into the life settlement market, and thus their access to superior healthcare, these individuals tend to live longer than the general population. This is referred to by participants in the life settlement market as the "wealth effect." The Company believes the modified table is consistent with modified tables used by market participants and third party medical underwriters.

The mortality rating is used to create a range of possible outcomes for the given life and assign a probability that each of the possible outcomes might occur. This probability represents a mathematical curve known as a mortality curve. This curve is then used to generate a series of expected cash flows over the remaining expected lifespan of the insured and the corresponding policy. A discounted present value calculation is then used to determine the price of the policy. If the insured dies earlier than expected, the return will be higher than if the insured dies when expected or later than expected.

The calculation allows for the possibility that if the insured dies earlier than expected, the premiums needed to keep the policy in force will not have to be paid. Conversely, the calculation also considers the possibility that if the insured lives longer than expected, more premium payments will be necessary. Based on these considerations, each possible outcome is assigned a probability and the range of possible outcomes is then used to create a price for the policy.

As is the case with most market participants, the Company uses life expectancies that are provided by third-party life expectancy providers. These are estimates of an insured's remaining years. If all of the insured lives in the Company's life settlement portfolio live six months shorter or longer than the life expectancies provided by these third parties, the change in fair market value would be as follows (dollars in thousands):

                                                    Change in
                        LE Mths Adj     Value         Value
                        +6               85,149        (17,146 )
                        -               102,295             -
                        -6              121,682         19,387

The Company believes that investors in esoteric assets such as life insurance policies typically target yields averaging between 12% - 17% for investments of more than a 5 year duration, which is consistent with the Company's historical use of a 15%-17% discount rate to value its life insurance policies prior to the third quarter of 2011.

We believe that the USAO Investigation along with certain unfavorable court decisions unrelated to the Company contributed to a contraction in the life settlement marketplace. This perceived softening in the market was also corroborated by third party consultants engaged by the Company and is consistent with discussions involving the Company and other market participants. In general, since the onset of the credit crisis in 2007, capital has been limited and credit has been costly for the purchase of life insurance policies in the secondary and tertiary markets. In light of the USAO Investigation and publicly available information about the Company when given the choice to invest in a policy that was associated with the Company's premium finance business and a policy without such an association, all else being equal, the Company believes that an investor would generally opt to invest in the policy that was not associated with the Company's premium finance business. Accordingly, the Company viewed a further adjustment to its discount rates as necessary at December 31, 2011 because of the changes in the market along with the increased perceived risk premium that a market participant would require to transact in a policy associated with the Company and further adjusted its discount rates, resulting in a weighted average discount rate of 24.31% calculated based on death benefit.


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While the Company believes that since entering into the Non-Prosecution Agreement, market participants will require less of a risk premium to transact in policies associated with the Company, at March 31, 2012, the Company considered the discount rate based on information that was then available and, in doing so, determined that further adjustments to discounts rates in its fair value model for non-premium financed and premium financed investment in life settlements was not warranted at that time.

As of March 31, 2012, the Company owned 197 policies with an aggregate investment in life settlements of $102.3 million. Of these 197 policies, 154 were previously premium financed and are valued using discount rates that range from 18.65% - 32.25%. The remaining 43 policies are valued using a discount rate of 16.65%.

The discount rate incorporates current information about market interest rates, the credit exposure to the insurance company that issued the life insurance policy and our estimate of the risk premium an investor in the policy would require. The extent to which the fair value could vary in the near term has been quantified by evaluating the effect of changes in the weighted average discount rate on the death benefit used to estimate the fair value. If the weighted average discount rate were increased or decreased by 1/2 of 1% and the other assumptions used to estimate fair value remained the same, the change in fair market value would be as follows (dollars in thousands):

             Wtd. Avg Rate    Rate Adj.        Value        Change in Value
             24.09%                 -.50 %     105,014                 2,719
             24.59%                   -        102,295                    -
             25.09%                 +.50 %      99,686                (2,608 )

Future changes in the discount rate which we used to value life insurance policies could have a material effect on our yield on life settlement transactions, which could have a material adverse effect on our business, financial condition and results of our operations.

At the end of each reporting period we re-value the life insurance policies using our valuation model in order to update our loan impairment valuation for loans receivable and our estimate of fair value for investments in policies held on our balance sheet. This includes reviewing our assumptions for discount rates and life expectancies as well as incorporating current information for premium payments and the passage of time.

Revenue/Income Recognition

Our primary sources of revenue/income are in the form of unrealized change in fair value of life settlements, agency fees, interest income, origination fee income, servicing income and realized gains on sales of structured settlements. Our revenue/income recognition policies for these sources of revenue/income are as follows:

Unrealized Change in Fair Value of Life Settlements-The Company acquires certain life insurance policies through purchases in the secondary and tertiary markets and others as a result of certain of the Company's borrowers defaulting on premium finance loans and relinquishing the underlying policy to the Company in exchange for being released from further obligations under the loan. We initially record these investments at the transaction price, which is the fair value of the policy for those acquired upon relinquishment or the amount paid for policies acquired for cash. The fair value of the investment in insurance policies is evaluated at the end of each reporting period. Changes in the fair value of the investment based on evaluations are recorded as changes in fair value of life settlements in our consolidated and combined statement of operations. The fair value is determined on a discounted cash flow basis that incorporates current life expectancy assumptions. The discount rate incorporates current information about market interest rates, the credit exposure to the insurance company that issued the life insurance policy and our estimate of the risk premium an investor in the policy would require.

Agency Fees-Agency fees are paid by the referring life insurance agents based on negotiations between the parties and are recognized at the time a life finance loan is funded. Because agency fees are not paid by the borrower, such fees do not accrue over the term of the loan. A separate . . .

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