CITIZENS, INC. 10-Q

Item 1. FINANCIAL STATEMENTS CITIZENS, INC. AND CONSOLIDATED SUBSIDIARIES Consolidated Balance Sheets (In thousands) June 30, 2020 December 31, 2019 Assets (Unaudited) Investments: Fixed maturities available-for-sale, at fair value (amortized cost: $ 1,295,628 and $ 1,293,853 in 2020 and 2019, respectively) $ 1,417,317 1,377,959 Equity securities, at fair value 20,698 16,033 Policy loans 84,171 82,005 Real estate held-for-sale 2,571 2,571 Other long-term investments (portion measured at fair value $ 9,079 in 2020; less allowance for losses of $ 11 in 2020) 9,452 385 Short-term investments — 1,301 Total investments 1,534,209 1,480,254 Cash and cash equivalents 52,375 46,205 Accrued investment income 16,884 17,453 Receivable for securities 3,320 — Reinsurance recoverable 2,971 3,696 Deferred policy acquisition costs 145,494 149,249 Cost of insurance acquired 12,574 13,455 Goodwill and other intangible assets 13,573 13,575 Property and equipment, net 16,592 5,904 Due premiums 11,952 12,656 Other assets (less allowance for losses of $ 472 in 2020) 2,992 2,489 Total assets $ 1,812,936 1,744,936 See accompanying Notes to Consolidated Financial Statements. June 30, 2020 | 10-Q 2 Table of Contents DRAFT 6 CITIZENS, INC. AND CONSOLIDATED SUBSIDIARIES Consolidated Balance Sheets, Continued (In thousands, except share amounts) June 30, 2020 December 31, 2019 Liabilities and Stockholders' Equity (Unaudited) Liabilities: Policy liabilities: Future policy benefit reserves: Life insurance $ 1,235,083 1,218,757 Annuities 77,954 76,380 Accident and health 882 1,031 Dividend accumulations 31,672 29,211 Premiums paid in advance 41,803 43,102 Policy claims payable 9,204 8,059 Other policyholders' funds 19,976 18,192 Total policy liabilities 1,416,574 1,394,732 Commissions payable 1,913 2,514 Current federal income tax payable 47,730 44,622 Deferred federal income tax payable 15,320 12,428 Payable for securities in process of settlement 1,517 — Other liabilities 40,089 30,804 Total liabilities 1,523,143 1,485,100 Commitments and contingencies ( Note 7 ) Stockholders' Equity: Common stock: Class A, no par value, 100,000,000 shares authorized, 52,490,804 and 52,364,993 shares issued and outstanding in 2020 and 2019, respectively, including shares in treasury of 3,135,738 in 2020 and 2019 261,901 261,515 Class B, no par value, 2,000,000 shares authorized, 1,001,714 shares issued and outstanding in 2020 and 2019 3,184 3,184 Accumulated deficit ( 75,975 ) ( 70,969 ) Accumulated other comprehensive income: Net unrealized gains on fixed maturity securities, net of tax 111,694 77,117 Treasury stock, at cost ( 11,011 ) ( 11,011 ) Total stockholders' equity 289,793 259,836 Total liabilities and stockholders' equity $ 1,812,936 1,744,936 See accompanying Notes to Consolidated Financial Statements. June 30, 2020 | 10-Q 3 Table of Contents DRAFT 6 CITIZENS, INC. AND CONSOLIDATED SUBSIDIARIES Consolidated Statements of Operations and Comprehensive Income (Loss) (Unaudited) Three Months Ended June 30, Six Months Ended June 30, (In thousands, except per share amounts) 2020 2019 2020 2019 Revenues: Premiums: Life insurance $ 40,185 42,313 80,131 83,293 Accident and health insurance 248 345 509 668 Property insurance 1,063 1,146 2,173 2,307 Net investment income 14,915 15,315 30,084 29,111 Realized investment gains (losses), net 1,448 ( 2,869 ) 142 3,092 Other income 482 616 1,024 801 Total revenues 58,341 56,866 114,063 119,272 Benefits and Expenses: Insurance benefits paid or provided: Claims and surrenders 27,754 27,024 54,203 50,057 Increase in future policy benefit reserves 8,237 9,472 17,708 21,771 Policyholders' dividends 1,328 1,423 2,561 2,605 Total insurance benefits paid or provided 37,319 37,919 74,472 74,433 Commissions 6,714 8,384 14,567 16,268 Other general expenses 11,139 11,949 22,612 26,081 Capitalization of deferred policy acquisition costs ( 3,731 ) ( 5,412 ) ( 8,740 ) ( 10,240 ) Amortization of deferred policy acquisition costs 6,061 6,931 12,180 13,208 Amortization of cost of insurance acquired 401 418 769 837 Total benefits and expenses 57,903 60,189 115,860 120,587 Income (loss) before federal income tax 438 ( 3,323 ) ( 1,797 ) ( 1,315 ) Federal income tax expense 1,465 1,242 2,814 7,052 Net income (loss) ( 1,027 ) ( 4,565 ) ( 4,611 ) ( 8,367 ) Per Share Amounts: Basic and diluted losses per share of Class A common stock ( 0.02 ) ( 0.09 ) ( 0.09 ) ( 0.17 ) Basic and diluted losses per share of Class B common stock ( 0.01 ) ( 0.04 ) ( 0.05 ) ( 0.08 ) Other Comprehensive Income: Unrealized gains on fixed maturity securities: Unrealized holding gains arising during period 80,508 31,220 37,579 60,021 Reclassification adjustment for losses (gains) included in net income (loss) ( 87 ) ( 81 ) 45 23 Unrealized gains on fixed maturity securities, net 80,421 31,139 37,624 60,044 Income tax expense on unrealized gains on fixed maturity securities 5,774 2,163 3,047 4,188 Other comprehensive income 74,647 28,976 34,577 55,856 Total comprehensive income $ 73,620 24,411 29,966 47,489 See accompanying Notes to Consolidated Financial Statements. June 30, 2020 | 10-Q 4 Table of Contents DRAFT 6 CITIZENS, INC. AND CONSOLIDATED SUBSIDIARIES Consolidated Statements of Stockholders' Equity (Unaudited) Common Stock Accumulated deficit Accumulated other comprehensive income (loss) Treasury stock Total Stock-holders' equity (In thousands) Class A Class B Balance at December 31, 2019 $ 261,515 3,184 ( 70,969 ) 77,117 ( 11,011 ) 259,836 Accounting standards adopted January 1, 2020 — — ( 395 ) — — ( 395 ) Comprehensive income (loss): Net income (loss) — — ( 3,584 ) — — ( 3,584 ) Unrealized investment gains (losses), net — — — ( 40,070 ) — ( 40,070 ) Total comprehensive income (loss) — — ( 3,584 ) ( 40,070 ) — ( 43,654 ) Stock-based compensation ( 53 ) — — — — ( 53 ) Balance at March 31, 2020 261,462 3,184 ( 74,948 ) 37,047 ( 11,011 ) 215,734 Comprehensive income (loss): Net income (loss) — — ( 1,027 ) — — ( 1,027 ) Unrealized investment gains (losses), net — — — 74,647 — 74,647 Total comprehensive income (loss) — — ( 1,027 ) 74,647 — 73,620 Stock-based compensation 439 — — — — 439 Balance at June 30, 2020 $ 261,901 3,184 ( 75,975 ) 111,694 ( 11,011 ) 289,793 Balance at December 31, 2018 $ 259,793 3,184 ( 69,599 ) 5,366 ( 11,011 ) 187,733 Comprehensive income (loss): Net income (loss) — — ( 3,802 ) — — ( 3,802 ) Unrealized investment gains (losses), net — — — 26,880 — 26,880 Total comprehensive income (loss) — — ( 3,802 ) 26,880 — 23,078 Stock-based compensation 1,083 — — — — 1,083 Balance at March 31, 2019 260,876 3,184 ( 73,401 ) 32,246 ( 11,011 ) 211,894 Comprehensive income (loss): Net income (loss) — — ( 4,565 ) — — ( 4,565 ) Unrealized investment gains (losses), net — — — 28,976 — 28,976 Total comprehensive income (loss) — — ( 4,565 ) 28,976 — 24,411 Stock-based compensation 127 — — — — 127 Balance at June 30, 2019 $ 261,003 3,184 ( 77,966 ) 61,222 ( 11,011 ) 236,432 See accompanying Notes to Consolidated Financial Statements. June 30, 2020 | 10-Q 5 Table of Contents DRAFT 6 CITIZENS, INC. AND CONSOLIDATED SUBSIDIARIES Consolidated Statements of Cash Flows (Unaudited) Six Months Ended June 30, (In thousands) 2020 2019 Cash flows from operating activities: Net income (loss) $ ( 4,611 ) ( 8,367 ) Adjustments to reconcile net gain (loss) to net cash provided by operating activities: Realized investment (gains) losses on sale of investments and other assets ( 142 ) ( 3,092 ) Net deferred policy acquisition costs 3,440 2,968 Amortization of cost of insurance acquired 769 837 Depreciation 422 848 Amortization of premiums and discounts on investments 4,683 7,288 Stock-based compensation 632 1,587 Deferred federal income tax benefit ( 76 ) ( 94 ) Change in: Accrued investment income 569 ( 453 ) Reinsurance recoverable 725 208 Due premiums 704 2,768 Future policy benefit reserves 17,593 21,629 Other policyholders' liabilities 4,091 1,688 Federal income tax payable 3,108 7,146 Commissions payable and other liabilities ( 2,690 ) ( 284 ) Other, net ( 665 ) ( 3,271 ) Net cash provided by (used in) operating activities 28,552 31,406 Cash flows from investing activities: Purchases of fixed maturity securities, available-for-sale ( 113,141 ) ( 111,729 ) Sales of fixed maturity securities, available-for-sale 2,982 10,414 Maturities and calls of fixed maturity securities, available-for-sale 101,852 48,568 Purchases of equity securities ( 4,473 ) — Principal payments on mortgage loans 5 4 Increase in policy loans, net ( 2,166 ) ( 721 ) Sales of other long-term investments and real estate — 6,996 Purchases of other long-term investments ( 9,140 ) — Purchases of property and equipment ( 38 ) ( 388 ) Maturities of short-term investments 1,300 7,940 Purchases of short-term investments — ( 2,455 ) Net cash provided by (used in) investing activities ( 22,819 ) ( 41,371 ) See accompanying Notes to Consolidated Financial Statements. June 30, 2020 | 10-Q 6 Table of Contents DRAFT 6 CITIZENS, INC. AND CONSOLIDATED SUBSIDIARIES Consolidated Statements of Cash Flows, Continued (Unaudited) Six Months Ended June 30, (In thousands) 2020 2019 Cash flows from financing activities: Annuity deposits $ 2,928 3,053 Annuity withdrawals ( 2,245 ) ( 3,635 ) Other ( 246 ) ( 377 ) Net cash provided by (used in) financing activities 437 ( 959 ) Net increase (decrease) in cash and cash equivalents 6,170 ( 10,924 ) Cash and cash equivalents at beginning of year 46,205 45,492 Cash and cash equivalents at end of period $ 52,375 34,568 SUPPLEMENTAL DISCLOSURES OF NONCASH INVESTING AND FINANCING ACTIVITIES: During the six months ended June 30, 2020 and 2019, various fixed maturity issuers exchanged securities with book values of $ 3.1 million and $ 11.9 million, respectively, for securities of equal value. The Company had net unsettled security trades of $ 1.8 million at June 30, 2020 and $ 5.0 million at June 30, 2019. The Company recognized right-of-use assets of $ 12.0 million in exchange for new operating lease liabilities during the six months ended June 30, 2020. See accompanying Notes to Consolidated Financial Statements. June 30, 2020 | 10-Q 7 Table of Contents DRAFT 6 CITIZENS, INC . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited ) (1) FINANCIAL STATEMENTS BASIS OF PRESENTATION AND CONSOLIDATION The consolidated financial statements include the accounts and operations of Citizens, Inc. ("Citizens" or the "Company"), a Colorado corporation, and its wholly-owned subsidiaries, CICA Life Insurance Company of America ("CICA"), CICA Life Ltd. ("CICA Ltd."), Citizens National Life Insurance Company ("CNLIC"), Security Plan Life Insurance Company ("SPLIC"), Security Plan Fire Insurance Company ("SPFIC"), Magnolia Guaranty Life Insurance Company ("MGLIC") and Computing Technology, Inc. ("CTI"). All significant inter-company accounts and interactions have been eliminated. Citizens and its wholly-owned subsidiaries are collectively referred to as the "Company", "we", "us" or "our". The consolidated balance sheets as of June 30, 2020, the consolidated statements of operations and comprehensive income (loss) and stockholders' equity for the three and six months ended June 30, 2020 and June 30, 2019 and cash flows for the six months ended June 30, 2020 and June 30, 2019 have been prepared by the Company without audit. In the opinion of management, all normal and recurring adjustments to present fairly the financial position, results of operations, and changes in cash flows at June 30, 2020 and for comparative periods have been made. The consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles ("U.S. GAAP") for interim financial information and with the instructions to Form 10-Q adopted by the Securities and Exchange Commission ("SEC"). Accordingly, the consolidated financial statements do not include all the information and footnotes required for complete financial statements and should be read in conjunction with the Company’s consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2019. Operating results for the interim periods disclosed herein are not necessarily indicative of the results that may be expected for a full year or any future period. We provide primarily life insurance and a small amount of health insurance policies through our insurance subsidiaries - CICA, CICA Ltd., CNLIC, SPLIC and MGLIC. CICA and CNLIC issued ordinary whole-life policies, credit life and disability, and accident and health related policies, throughout the Midwest and southern U.S. until they ceased most domestic sales beginning January 1, 2017. CICA Ltd. primarily issues endowment and ordinary whole-life policies to non-U.S. residents. SPLIC offers final expense and home service life insurance in Louisiana, Arkansas and Mississippi. SPFIC writes a limited amount of property insurance in Louisiana and Arkansas. MGLIC provides industrial life policies through independent funeral homes in Mississippi. CTI provides data processing systems and services to the Company. USE OF ESTIMATES The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates include those used in the evaluation of credit allowances on fixed maturity securities, actuarially determined assets and liabilities and assumptions, tests of goodwill impairment, valuation allowance on deferred tax assets, valuation of uncertain tax positions and contingencies relating to litigation and regulatory matters. Certain of these estimates are particularly sensitive to market conditions, and deterioration and/or volatility in the worldwide debt or equity markets could have a material impact on the consolidated financial statements. June 30, 2020 | 10-Q 8 Table of Contents DRAFT 6 CITIZENS, INC . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited ) SIGNIFICANT ACCOUNTING POLICIES For a description of our significant accounting policies, see Note 1. Summary of Significant Accounting Policies in the notes to our consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2019, which should be read in conjunction with these accompanying consolidated financial statements. Investment securities. We assess all available-for-sale ("AFS") fixed maturity securities in an unrealized loss position for expected credit losses. First, we assess whether we intend to sell, or it is more likely than not that we will be required to sell, the security before recovery of its amortized cost. If either of the criteria is met, the security's amortized cost is written down to its fair value. For AFS fixed maturity securities that do not meet either criteria, we evaluate whether the decline in fair value has resulted from credit losses or other factors. In making this assessment, management considers the extent to which fair value is less than amortized cost, any changes to the rating of the security by a rating agency, and adverse conditions specifically related to the security, among other factors. Any impairment that has not been recorded through an allowance for credit losses is recognized in accumulated other comprehensive income on our consolidated balance sheets. Changes in the allowance for credit losses are recorded through realized capital losses. The Company made a policy election to exclude accrued interest from the amortized cost of AFS fixed maturity securities and report accrued interest separately in accrued investment income in the consolidated balance sheets. AFS fixed maturity securities are placed on non-accrual status when we no longer expect to receive all contractual amounts due. Accrued interest receivable is reversed against interest income when a security is placed on non-accrual status. Accordingly, we do not recognize an allowance for credit loss against accrued interest receivable. We initially estimate the fair value of investments in private equity limited partnerships by reference to the transaction price. Subsequently, we obtain the fair value of these investments from net asset value information provided by the general partner or manager of the investments, the financial statements of which are audited annually. Recognition of investment income on these funds is delayed due to the availability of the related financial statements, which are generally obtained from the partnerships' general partners. As a result, our private equity investments are generally reported on a three-month delay. These investments are included in other long-term investments. (2) ACCOUNTING PRONOUNCEMENTS ACCOUNTING STANDARDS RECENTLY ADOPTED In June 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2016-13, Financial Instruments-Credit Losses (Topic 326), with the main objective to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. The ASU requires a financial asset (or a group of financial assets) measured at amortized cost to be presented at the net amount expected to be collected. The allowance for credit losses is a valuation account that is deducted from the amortized cost of the financial asset(s) to present the net carrying value at the amount expected to be collected on the financial asset. The income statement reflects the measurement of credit losses for newly recognized financial assets, as well as the increases or decreases of expected credit losses that have taken place during the period. Credit losses on AFS fixed maturity securities should be measured in a manner similar to current U.S. GAAP; however, the credit losses are recorded through an allowance for credit losses rather than as a write-down. This approach is an improvement to prior U.S. GAAP because an entity will be able to record reversals of credit losses (in situations in which the estimate of credit losses declines) in current period net income, which in turn should align the income statement recognition of credit losses with the reporting period in which changes occur. Prior U.S. GAAP prohibited reflecting those improvements in current-period earnings. The Company adopted this standard effective January 1, 2020 using the modified retrospective approach. The adoption resulted in an increase in accumulated deficit of $ 0.4 million related to agents' debit balance collectability. June 30, 2020 | 10-Q 9 Table of Contents DRAFT 6 CITIZENS, INC . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited ) In September 2018, the FASB issued ASU No. 2018-15, Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That is a Service Contract. This ASU requires an entity in a cloud computing arrangement (i.e. hosting arrangement) that is a service contract to follow the internal-use software guidance in ASC 350-40 to determine which implementation costs to capitalize as assets or expense as incurred. Capitalized implementation costs should be presented in the same line item on the balance sheet as amounts prepaid for the hosted service, if any (generally as an "other asset"). The capitalized costs will be amortized over the term of the hosting arrangement, with the amortization expense being presented in the same income statement line item as the fees paid for the hosted service. We adopted this standard effective January 1, 2020. The adoption had no impact on our consolidated financial statements. ACCOUNTING STANDARDS NOT YET ADOPTED In August 2018, the FASB issued ASU No. 2018-12, Financial Services-Insurance (Topic 944): Targeted Improvements to the Accounting for Long-Duration Contracts. This ASU amends four key areas of the accounting and impacts disclosures for long-duration insurance and investment contracts: • Requires updated assumptions for liability measurement. Assumptions used to measure the liability for traditional insurance contracts, which are typically determined at contract inception, will now be reviewed at least annually, and, if there is a change, updated, with the effect recorded in net income; • Standardizes the liability discount rate. The liability discount rate will be a market-observable discount rate (upper-medium grade fixed-income instrument yield), with the effect of rate changes recorded in other comprehensive income; • Provides greater consistency in measurement of market risk benefits. The two previous measurement models have been reduced to one measurement model (fair value), resulting in greater uniformity across similar market-based benefits and better alignment with the fair value measurement of derivatives used to hedge capital market risk; • Simplifies amortization of deferred acquisition costs. Previous earnings-based amortization methods have been replaced with a more level amortization basis; and • Requires enhanced disclosures. The new disclosures include rollforwards and information about significant assumptions and the effects of changes in those assumptions. For calendar-year public companies, the changes will be effective on January 1, 2022. In July 2020, the FASB tentatively agreed to defer the original effective date by one year. If finalized, the new guidance will be effective for annual and interim reporting periods beginning January 1, 2023, however early adoption is permitted. The Company is evaluating the impact this guidance will have on our consolidated financial statements. This new guidance is expected to have a material impact on our consolidated financial statements. No other new accounting pronouncement issued or effective during the year had, or is expected to have, a material impact on our consolidated financial statements. (3) SEGMENT INFORMATION The Company has two reportable segments: Life Insurance and Home Service Insurance. The Life Insurance and Home Service Insurance portions of the Company constitute separate businesses. CICA, CICA Ltd. and CNLIC constitute the Life Insurance segment, and SPLIC, SPFIC and MGLIC constitute the Home Service Insurance segment. In addition to the Life Insurance and Home Service Insurance business, the Company also operates other non-insurance ("Other Non-Insurance Enterprises") portions of the Company, which primarily include the Company's IT and Corporate-support functions, and are included in the tables presented below to properly reconcile the segment information with the consolidated financial statements of the Company. The accounting policies of the reportable segments and Other Non-Insurance Enterprises are presented in accordance with U.S. GAAP and are the same as those used in the preparation of the consolidated financial June 30, 2020 | 10-Q 10 Table of Contents DRAFT 6 CITIZENS, INC . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited ) statements. The Company evaluates profit and loss performance based on U.S. GAAP income before federal income taxes for its two reportable segments. The Company's Other Non-Insurance Enterprises are the only reportable difference between segments and consolidated operations. Life Insurance Home Service Insurance Other Non-Insurance Enterprises Consolidated Three Months Ended June 30, 2020 (In thousands) Revenues: Premiums $ 30,062 11,434 — 41,496 Net investment income 11,345 3,256 314 14,915 Realized investment gains, net 391 924 133 1,448 Other income 482 — — 482 Total revenue 42,280 15,614 447 58,341 Benefits and expenses: Insurance benefits paid or provided: Claims and surrenders 20,888 6,866 — 27,754 Increase in future policy benefit reserves 7,384 853 — 8,237 Policyholders' dividends 1,319 9 — 1,328 Total insurance benefits paid or provided 29,591 7,728 — 37,319 Commissions 3,294 3,420 — 6,714 Other general expenses 4,446 4,591 2,102 11,139 Capitalization of deferred policy acquisition costs ( 2,716 ) ( 1,015 ) — ( 3,731 ) Amortization of deferred policy acquisition costs 5,419 642 — 6,061 Amortization of cost of insurance acquired 127 274 — 401 Total benefits and expenses 40,161 15,640 2,102 57,903 Income (loss) before federal income tax expense $ 2,119 ( 26 ) ( 1,655 ) 438 June 30, 2020 | 10-Q 11 Table of Contents DRAFT 6 CITIZENS, INC . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited ) Life Insurance Home Service Insurance Other Non-Insurance Enterprises Consolidated Six Months Ended June 30, 2020 (In thousands) Revenues: Premiums $ 59,881 22,932 — 82,813 Net investment income 22,825 6,588 671 30,084 Realized investment gains (losses), net 1,126 ( 793 ) ( 191 ) 142 Other income 1,006 18 — 1,024 Total revenue 84,838 28,745 480 114,063 Benefits and expenses: Insurance benefits paid or provided: Claims and surrenders 41,048 13,155 — 54,203 Increase in future policy benefit reserves 15,530 2,178 — 17,708 Policyholders' dividends 2,544 17 — 2,561 Total insurance benefits paid or provided 59,122 15,350 — 74,472 Commissions 7,772 6,795 — 14,567 Other general expenses 9,394 8,907 4,311 22,612 Capitalization of deferred policy acquisition costs ( 6,637 ) ( 2,103 ) — ( 8,740 ) Amortization of deferred policy acquisition costs 10,737 1,443 — 12,180 Amortization of cost of insurance acquired 245 524 — 769 Total benefits and expenses 80,633 30,916 4,311 115,860 Income (loss) before federal income tax expense $ 4,205 ( 2,171 ) ( 3,831 ) ( 1,797 ) June 30, 2020 | 10-Q 12 Table of Contents DRAFT 6 CITIZENS, INC . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited ) Life Insurance Home Service Insurance Other Non-Insurance Enterprises Consolidated Three Months Ended June 30, 2019 (In thousands) Revenues: Premiums $ 32,140 11,664 — 43,804 Net investment income 11,612 3,325 378 15,315 Realized investment gains (losses), net 68 152 ( 3,089 ) ( 2,869 ) Other income 614 1 1 616 Total revenue 44,434 15,142 ( 2,710 ) 56,866 Benefits and expenses: Insurance benefits paid or provided: Claims and surrenders 21,316 5,708 — 27,024 Increase in future policy benefit reserves 8,519 953 — 9,472 Policyholders' dividends 1,413 10 — 1,423 Total insurance benefits paid or provided 31,248 6,671 — 37,919 Commissions 4,676 3,708 — 8,384 Other general expenses 6,458 5,332 159 11,949 Capitalization of deferred policy acquisition costs ( 4,020 ) ( 1,392 ) — ( 5,412 ) Amortization of deferred policy acquisition costs 6,053 878 — 6,931 Amortization of cost of insurance acquired 138 280 — 418 Total benefits and expenses 44,553 15,477 159 60,189 Loss before federal income tax expense $ ( 119 ) ( 335 ) ( 2,869 ) ( 3,323 ) June 30, 2020 | 10-Q 13 Table of Contents DRAFT 6 CITIZENS, INC . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited ) Life Insurance Home Service Insurance Other Non-Insurance Enterprises Consolidated Six Months Ended June 30, 2019 (In thousands) Revenues: Premiums $ 63,054 23,214 — 86,268 Net investment income 21,781 6,411 919 29,111 Realized investment gains (losses), net 5,525 636 ( 3,069 ) 3,092 Other income 797 2 2 801 Total revenue 91,157 30,263 ( 2,148 ) 119,272 Benefits and expenses: Insurance benefits paid or provided: Claims and surrenders 38,478 11,579 — 50,057 Increase in future policy benefit reserves 19,832 1,939 — 21,771 Policyholders' dividends 2,585 20 — 2,605 Total insurance benefits paid or provided 60,895 13,538 — 74,433 Commissions 9,049 7,219 — 16,268 Other general expenses 12,663 10,402 3,016 26,081 Capitalization of deferred policy acquisition costs ( 7,722 ) ( 2,518 ) — ( 10,240 ) Amortization of deferred policy acquisition costs 11,494 1,714 — 13,208 Amortization of cost of insurance acquired 260 577 — 837 Total benefits and expenses 86,639 30,932 3,016 120,587 Income (loss) before federal income tax expense $ 4,518 ( 669 ) ( 5,164 ) ( 1,315 ) June 30, 2020 | 10-Q 14 Table of Contents DRAFT 6 CITIZENS, INC . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited ) (4) STOCKHOLDERS' EQUITY AND RESTRICTIONS EARNINGS PER SHARE The following tables set forth the computation of basic and diluted earnings per share. Three Months Ended June 30, 2020 2019 (In thousands, except per share amounts) Basic and diluted earnings per share: Numerator: Net loss $ ( 1,027 ) ( 4,565 ) Net loss allocated to Class A common stock $ ( 1,017 ) ( 4,519 ) Net loss allocated to Class B common stock ( 10 ) ( 46 ) Net loss $ ( 1,027 ) ( 4,565 ) Denominator: Weighted average shares of Class A outstanding - basic 49,345 49,229 Weighted average shares of Class A outstanding - diluted 49,528 49,280 Weighted average shares of Class B outstanding - basic and diluted 1,002 1,002 Basic and diluted loss per share of Class A common stock $ ( 0.02 ) ( 0.09 ) Basic and diluted loss per share of Class B common stock ( 0.01 ) ( 0.04 ) Six Months Ended June 30, 2020 2019 (In thousands, except per share amounts) Basic and diluted earnings per share: Numerator: Net loss $ ( 4,611 ) ( 8,367 ) Net loss allocated to Class A common stock $ ( 4,565 ) ( 8,283 ) Net loss allocated to Class B common stock ( 46 ) ( 84 ) Net loss $ ( 4,611 ) ( 8,367 ) Denominator: Weighted average shares of Class A outstanding - basic 49,322 49,229 Weighted average shares of Class A outstanding - diluted 49,506 49,280 Weighted average shares of Class B outstanding - basic and diluted 1,002 1,002 Basic and diluted loss per share of Class A common stock $ ( 0.09 ) ( 0.17 ) Basic and diluted loss per share of Class B common stock ( 0.05 ) ( 0.08 ) CAPITAL AND SURPLUS Each of our regulated insurance subsidiaries is required to meet stipulated regulatory capital requirements. These include capital requirements imposed by the U.S. National Association of Insurance Commissioners ("NAIC") and the Bermuda Monetary Authority ("BMA"). All insurance subsidiaries exceeded the minimum capital requirements at June 30, 2020. June 30, 2020 | 10-Q 15 Table of Contents DRAFT 6 CITIZENS, INC . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited ) CICA Ltd. is a wholly-owned subsidiary of Citizens and is domiciled in Bermuda. The BMA requires insurers domiciled in Bermuda to maintain available statutory economic capital and surplus at a level equal to or in excess of its enhanced capital requirement (“ECR”), which the Company calculates by using the Bermuda Solvency Capital Requirement (“BSCR”). The BMA has established a target capital level (“TCL”) that requires insurers to maintain available statutory economic capital and surplus equal to 120 % of its ECR. We normally experience fluctuations in the fair values of our assets and liabilities, which impact our ECR ratio. As of March 31, 2020, CICA Ltd.’s available statutory economic capital and surplus was below the TCL by $ 8.9 million. Two key components of available statutory economic capital and surplus were adversely affected at March 31, 2020 due to the disruption that the COVID-19 pandemic has had on the worldwide economy: 1) the fair value of our assets decreased, and 2) interest rates prescribed by the BMA decreased resulting in an increase of our statutory economic insurance liabilities. Since CICA Ltd. failed to meet the TCL at March 31, 2020, we complied with applicable regulations by notifying the BMA in writing and filing a report with the BMA within the required timeframe to provide details of the circumstances leading to the failure. We have had several detailed discussions with the BMA during the second quarter of 2020 and continue to provide details on CICA Ltd.’s financial performance, interest rate sensitivities and corporate strategies. At June 30, 2020, CICA Ltd. was above the TCL threshold and although we continue to hold discussions with the BMA, there has been no capital or management action required. (5) INVESTMENTS The Company invests primarily in fixed maturity securities, which totaled 89.2 % of total cash and invested assets at June 30, 2020, as shown below. Carrying Value (In thousands, except for %) June 30, 2020 December 31, 2019 Amount % Amount % Cash and invested assets: Fixed maturity securities $ 1,417,317 89.2 % $ 1,377,959 90.2 % Equity securities 20,698 1.3 % 16,033 1.1 % Policy loans 84,171 5.3 % 82,005 5.4 % Real estate and other long-term investments 12,023 0.8 % 2,956 0.2 % Short-term investments — — % 1,301 0.1 % Cash and cash equivalents 52,375 3.4 % 46,205 3.0 % Total cash and invested assets $ 1,586,584 100.0 % $ 1,526,459 100.0 % June 30, 2020 | 10-Q 16 Table of Contents DRAFT 6 CITIZENS, INC . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited ) The following tables represent the amortized cost, gross unrealized gains and losses and fair value of fixed maturities as of the dates indicated. Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value June 30, 2020 (In thousands) Fixed maturity securities: Available-for-sale: U.S. Treasury securities $ 9,570 2,070 — 11,640 U.S. Government-sponsored enterprises 3,503 1,378 — 4,881 States and political subdivisions 427,529 28,965 675 455,819 Corporate: Financial 193,818 20,018 555 213,281 Consumer 157,302 20,113 1,450 175,965 Energy 81,201 4,854 1,904 84,151 All Other 255,584 27,951 1,048 282,487 Commercial mortgage-backed 278 — 7 271 Residential mortgage-backed 118,250 23,467 — 141,717 Asset-backed 48,491 165 1,672 46,984 Foreign governments 102 19 — 121 Total fixed maturity securities $ 1,295,628 129,000 7,311 1,417,317 Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value December 31, 2019 (In thousands) Fixed maturity securities: Available-for-sale: U.S. Treasury securities $ 9,709 1,638 — 11,347 U.S. Government-sponsored enterprises 3,516 1,015 — 4,531 States and political subdivisions 512,239 24,285 240 536,284 Corporate: Financial 169,146 13,094 135 182,105 Consumer 148,575 12,591 464 160,702 Energy 74,315 4,765 115 78,965 All Other 212,714 16,022 420 228,316 Commercial mortgage-backed 1,105 — 5 1,100 Residential mortgage-backed 118,130 12,223 66 130,287 Asset-backed 44,302 11 110 44,203 Foreign governments 102 17 — 119 Total fixed maturity securities $ 1,293,853 85,661 1,555 1,377,959 June 30, 2020 | 10-Q 17 Table of Contents DRAFT 6 CITIZENS, INC . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited ) Most of the Company's equity securities are diversified stock and bond mutual funds. Fair Value (In thousands) June 30, 2020 December 31, 2019 Equity securities: Stock mutual funds $ 2,796 3,274 Bond mutual funds 11,810 12,311 Common stock 1,064 134 Non-redeemable preferred stock 5,028 314 Total equity securities $ 20,698 16,033 VALUATION OF INVESTMENTS Available-for-sale securities are reported in the consolidated financial statements at fair value. Equity securities are measured at fair value with the change in fair value recorded through net income. The Company recognized net realized gains of $ 1.3 million and $ 0.2 million on equity securities held for the three and six months ended June 30, 2020 and gains of $ 0.2 million and $ 0.8 million for the same periods ended June 30, 2019. In the first quarter of 2019, the Company sold its former corporate office in Austin, Texas for a gross sales price of $ 7.5 million, resulting in a gain on the sale of $ 5.5 million. The building was owned by CICA within our Life Insurance segment. An impairment loss of $ 3.1 million was recorded during the second quarter of 2019 related to our Citizens Academy training facility property located near Austin, Texas. It was determined during the quarter that the property met the held-for-sale criteria. As a result, this investment was reclassified from real estate held for investment to real estate held-for-sale. This resulted in an impairment loss of $ 3.1 million as the carrying amount of the property was written down to the net realizable value. This investment is considered a Level 3 asset in the fair value hierarchy and is reported within other non-insurance enterprises. The Company monitors all fixed maturity securities on an on-going basis relative to changes in credit ratings, market prices, earnings trends and financial performance, in addition to specific region or industry reviews. The Company evaluates whether a credit impairment exists for fixed maturity securities by considering primarily the following factors: (a) changes in the financial condition of the security's underlying collateral; (b) whether the issuer is current on contractually obligated interest and principal payments; (c) changes in the financial condition, credit rating and near-term prospects of the issuer; and (d) the payment structure of the security. The Company's best estimate of expected future cash flows used to determine the credit loss amount is a quantitative and qualitative process. Quantitative review includes information received from third-party sources such as financial statements, pricing and rating changes, liquidity and other statistical information. Qualitative factors include judgments related to business strategies, economic impacts on the issuer, overall judgment related to estimates and industry factors as well as the Company's intent to sell the security, or if it is more likely than not that the Company would be required to sell a security before recovery of its amortized cost. The Company's best estimate of future cash flows involves assumptions including, but not limited to, various performance indicators, such as historical and projected default and recovery rates, credit ratings, and current delinquency rates. These assumptions require the use of significant management judgment and include the probability of issuer default and estimates regarding timing and amount of expected recoveries, which may include estimating the underlying collateral value. In addition, projections of expected future fixed maturity security cash flows may change based upon new information regarding the performance of the issuer. Any credit losses are presented as an allowance rather than as a write-down on AFS fixed maturity securities management does not intend to sell or believes that it is more likely than not we will be required to sell. We adopted ASU 2016-13 using the prospective transition approach for fixed maturity securities for which other-than-temporary impairment had been recognized prior to January 1, 2020. As a result, the amortized cost remains the same before and after adoption. The effective interest rate on these fixed maturity securities was not changed. June 30, 2020 | 10-Q 18 Table of Contents DRAFT 6 CITIZENS, INC . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited ) Amounts previously recognized in accumulated other comprehensive income as of January 1, 2020 relating to improvements in cash flow expected to be collected will be accreted into income over the remaining life of the asset. Recoveries of amounts previously written off relating to improvements in cash flows after January 1, 2020 will be recorded in earnings when received. For the three and six months ended June 30, 2020, the Company recorded no credit valuation losses on fixed maturity securities and recognized no fixed maturity investment impairments for the three and six months ended June 30, 2019. The following table presents the fair values and gross unrealized losses of fixed maturity securities that are not deemed to have credit losses, aggregated by investment category and length of time that individual securities have been in a continuous loss position at June 30, 2020. June 30, 2020 Less than 12 months Greater than 12 months Total (In thousands, except for # of securities) Fair Value Unrealized Losses # of Securities Fair Value Unrealized Losses # of Securities Fair Value Unrealized Losses # of Securities Fixed maturities: Available-for-sale securities: States and political subdivisions $ 15,281 640 19 $ 525 35 2 $ 15,806 675 21 Corporate: Financial 24,114 555 25 — — — 24,114 555 25 Consumer 22,907 1,121 21 1,368 329 1 24,275 1,450 22 Energy 26,644 1,904 34 — — — 26,644 1,904 34 All Other 29,026 1,048 33 — — — 29,026 1,048 33 Commercial mortgage-backed 218 7 1 — — — 218 7 1 Residential mortgage-backed 86 — 1 — — — 86 — 1 Asset-backed 42,222 1,672 40 — — — 42,222 1,672 40 Total fixed maturities $ 160,498 6,947 174 $ 1,893 364 3 $ 162,391 7,311 177 In each category of our fixed maturity securities described below, we do not intend to sell our investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost bases. While the losses are currently unrealized, we continue to monitor all fixed maturity securities on an on-going basis as future information may become available which could result in an allowance being recorded. States and political subdivisions. The Company's investments in states and political subdivisions were purchased at a premium, relative to their face amount, and the contractual cash flows are guaranteed by the respective state or political subdivision. Accordingly, it is expected that the securities will not be settled at a price less than the amortized cost bases of the Company's investments. Corporate. We did not recognize credit losses on corporate securities with unrealized losses that were due to interest rate sensitivity and changes in credit spreads. We believe that fluctuations caused by movements in interest rates and credit spreads have little bearing on the recoverability of our investments. While we are experiencing unrealized losses across several corporate sectors, the energy and automobile sectors have been impacted the most and some issuers within these sectors have been downgraded to below investment grade. We have assessed our exposure in the energy sector and believe our investments have access to sufficient liquidity to meet their debt obligations. The auto industry has been able to issue debt during the quarter which has increased their liquidity significantly. The automobile sector is included in the Consumer subtotal above. June 30, 2020 | 10-Q 19 Table of Contents DRAFT 6 CITIZENS, INC . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited ) Asset-backed. Our asset-backed securities are primarily senior tranches of pools of aircraft leases to airlines around the world. If an airline was to go bankrupt and default on its lease, the trust would repossess the plane and relet or sell it. There have been no defaults on leases to date, however the leases contain a feature that allows lessors to defer their lease payments for three months, with the funds recaptured with interest when payments resume. Several of the lessors have requested this deferral. We do not expect to realize any losses for these securities and see the current valuations as a result of general market conditions. Currently all of these securities are rated investment grade. The following table presents the fair values and gross unrealized losses of fixed maturity securities that are not deemed to have other than temporary impairments ("OTTI"), aggregated by investment category and length of time that individual securities have been in a continuous loss position at December 31, 2019. December 31, 2019 Less than 12 months Greater than 12 months Total (In thousands, except for # of securities) Fair Value Unrealized Losses # of Securities Fair Value Unrealized Losses # of Securities Fair Value Unrealized Losses # of Securities Fixed maturities: Available-for-sale securities: States and political subdivisions $ 24,064 163 24 $ 1,961 77 6 $ 26,025 240 30 Corporate: Financial 13,581 135 15 — — — 13,581 135 15 Consumer 22,671 464 20 — — — 22,671 464 20 Energy 4,208 34 4 898 81 2 5,106 115 6 All Other 22,437 285 30 2,771 135 3 25,208 420 33 Commercial mortgage-backed 1,100 5 2 — — — 1,100 5 2 Residential mortgage-backed 1,656 65 11 91 1 3 1,747 66 14 Asset-backed 36,039 110 27 — — — 36,039 110 27 Total fixed maturities $ 125,756 1,261 133 $ 5,721 294 14 $ 131,477 1,555 147 We have reviewed the securities in an unrealized loss position for the period ended December 31, 2019 and determined that no OTTI exists that has not been recognized based on our evaluation of the credit worthiness of the issuers and the fact that we do not intend to sell the investments nor is it likely that we will be required to sell the securities before recovery of their amortized costs bases which may be maturity. The amortized cost and fair value of fixed maturity securities at June 30, 2020 by contractual maturity are shown in the table below. Actual maturities may differ from contractual maturities because borrowers may have the right to June 30, 2020 | 10-Q 20 Table of Contents DRAFT 6 CITIZENS, INC . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited ) call or prepay obligations with or without call or prepayment penalties. Securities not due at a single maturity date have been reflected based upon final stated maturity. June 30, 2020 Amortized Cost Fair Value (In thousands) Fixed maturity securities: Due in one year or less $ 75,437 75,900 Due after one year through five years 104,138 110,410 Due after five years through ten years 224,482 243,865 Due after ten years 891,571 987,142 Total fixed maturity securities $ 1,295,628 1,417,317 The Company uses the specific identification method of the individual security to determine the cost basis used in the calculation of realized gains and losses related to security sales. Three Months Ended Six Months Ended Fixed Maturity Securities, Available-for-Sale June 30, June 30, (In thousands) 2020 2019 2020 2019 Proceeds $ 5,363 2,755 6,303 10,414 Gross realized gains $ 123 107 123 109 Gross realized losses $ 19 182 57 365 The Company sold five and six available-for-sale fixed maturity securities during the three and six months ended June 30, 2020 and sold ten and twenty available-for-sale fixed maturity securities during the three and six months ended June 30, 2019. No equity securities were sold during the three and six months ended June 30, 2020 and 2019. (6) FAIR VALUE MEASUREMENTS Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. We hold available-for-sale fixed maturity securities, which are carried at fair value. We also report our equity securities at fair value with changes in fair value reported through the consolidated statements of operations and comprehensive income (loss). Fair value measurements are generally based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect our view of market assumptions in the absence of observable market information. We utilize valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. All assets and liabilities carried at fair value are required to be classified and disclosed in one of the following three categories: • Level 1 - Quoted prices for identical instruments in active markets. • Level 2 - Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs or whose significant value drivers are observable. • Level 3 - Instruments whose significant value drivers are unobservable. Level 1 primarily consists of financial instruments whose value is based on quoted market prices such as U.S. Treasury securities and actively traded mutual fund and stock investments. June 30, 2020 | 10-Q 21 Table of Contents DRAFT 6 CITIZENS, INC . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited ) Level 2 includes those financial instruments that are valued by independent pricing services or broker quotes. These pricing models are primarily industry-standard models that consider various inputs, such as interest rates, credit spreads and foreign exchange rates for the underlying financial instruments. All significant inputs are observable or derived from observable information in the marketplace or are supported by observable levels at which transactions are executed in the marketplace. Financial instruments in this category primarily include corporate securities, U.S. Government-sponsored enterprise securities, securities issued by states and political subdivisions and certain mortgage and asset-backed securities. Level 3 is comprised of financial instruments whose fair value is estimated based on non-binding broker prices utilizing significant inputs not based on or corroborated by readily available market information. Real estate held-for-sale is in this category. There were no securities in this category at June 30, 2020. The following tables set forth our assets that are measured at fair value on a recurring basis as of the dates indicated. June 30, 2020 Level 1 Level 2 Level 3 Total Fair Value (In thousands) Financial Assets Fixed maturities available-for-sale U.S. Treasury and U.S. Government-sponsored enterprises $ 11,640 4,881 — 16,521 States and political subdivisions — 455,819 — 455,819 Corporate 51 755,833 — 755,884 Commercial mortgage-backed — 271 — 271 Residential mortgage-backed — 141,717 — 141,717 Asset-backed — 46,984 — 46,984 Foreign governments — 121 — 121 Total fixed maturities available-for-sale 11,691 1,405,626 — 1,417,317 Equity securities Stock mutual funds 2,796 — — 2,796 Bond mutual funds 11,810 — — 11,810 Common stock 1,064 — — 1,064 Non-redeemable preferred stock 5,028 — — 5,028 Total equity securities 20,698 — — 20,698 Other long-term investments (1) — — — 9,079 Total financial assets $ 32,389 1,405,626 — 1,447,094 (1) In accordance with Subtopic 820-10, certain investments that are measured at fair value using the net asset value per share (or its equivalent) practical expedient have not been classified in the fair value hierarchy. The fair value amounts presented in this table are intended to permit reconciliation of the fair value hierarchy to the amounts presented in the balance sheet. June 30, 2020 | 10-Q 22 Table of Contents DRAFT 6 CITIZENS, INC . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited ) December 31, 2019 Level 1 Level 2 Level 3 Total Fair Value (In thousands) Financial Assets Fixed maturities available-for-sale U.S. Treasury and U.S. Government-sponsored enterprises $ 11,348 4,530 — 15,878 States and political subdivisions — 536,284 — 536,284 Corporate 52 650,036 — 650,088 Commercial mortgage-backed — 1,100 — 1,100 Residential mortgage-backed — 130,287 — 130,287 Asset-backed — 44,203 — 44,203 Foreign governments — 119 — 119 Total fixed maturities available-for-sale 11,400 1,366,559 — 1,377,959 Equity securities Stock mutual funds 3,274 — — 3,274 Bond mutual funds 12,311 — — 12,311 Common stock 134 — — 134 Non-redeemable preferred stock 314 — — 314 Total equity securities 16,033 — — 16,033 Total financial assets $ 27,433 1,366,559 — 1,393,992 FINANCIAL INSTRUMENTS VALUATION FINANCIAL INSTRUMENTS CARRIED AT FAIR VALUE Fixed maturity securities, available-for-sale. At June 30, 2020, our fixed maturity securities, valued using a third-party pricing source, totaled $ 1.4 billion for Level 2 assets and comprised 97.1 % of total reported fair value of our financial assets. The Level 1 and Level 2 valuations are reviewed and updated quarterly through testing by comparisons to separate pricing models, other third-party pricing services, and back tested to recent trades. In addition, we obtain information annually relative to the third-party pricing models and review model parameters for reasonableness. There were no Level 3 assets at June 30, 2020. For the six months ended June 30, 2020, there were no material changes to the valuation methods or assumptions used to determine fair values, and no broker or third-party prices were changed from the values received. Equity securities. Our equity securities are classified as Level 1 assets as their fair values are based upon quoted market prices. Other long-term investments. We initially estimate the fair value of investments in private equity limited partnerships by reference to the transaction price. Subsequently, we obtain the fair value of these investments from net asset value information provided by the general partner or manager of the investments, the financial statements of which are audited annually. We hold an investment in a private equity fund that invests in privately-originated, performing senior secured debt primarily in middle market North America-based companies. Our unfunded commitment as of June 30, 2020 is $ 35.9 million. This investment is not redeemable because distributions from the funds will be received when the underlying investments of the funds are liquidated. The fund has a 10 year term but this life could be extended at the fund manager’s discretion in one year increments. We hold an investment in a term asset-backed securities liquidity facility private equity fund, established by the U.S. Federal Reserve, that provides financing to U.S. company market participants for levered asset purchases with a June 30, 2020 | 10-Q 23 Table of Contents DRAFT 6 CITIZENS, INC . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited ) focus on asset-backed, commercial mortgage and collateralized loan obligation markets. Our unfunded commitment for this fund as of June 30, 2020 is $ 14.9 million. This investment is not redeemable because distributions from the funds will be received when the underlying investments of the funds are liquidated. The fund is expected to be liquidated in 3 years but this life could be extended at the fund manager's discretion in one year increments. We review the fair value hierarchy classifications each reporting period. Changes in the observability of the valuation attributes may result in a reclassification of certain financial assets. Such reclassifications are reported as transfers in and out of Level 3 at the beginning fair value for the reporting period in which the changes occur. There were no transfers in or out of Level 3 during the six months ended June 30, 2020. FINANCIAL INSTRUMENTS NOT CARRIED AT FAIR VALUE Estimates of fair values are made at a specific point in time, based on relevant market prices and information about the financial instruments. The estimated fair values of financial instruments presented below are not necessarily indicative of the amounts the Company might realize in actual market transactions. The carrying amount and fair value for the financial assets and liabilities on the consolidated balance sheets not otherwise disclosed for the periods indicated are as follows: June 30, 2020 December 31, 2019 (In thousands) Carrying Value Fair Value Carrying Value Fair Value Financial Assets: Mortgage loans $ 162 200 177 210 Policy loans 84,171 84,171 82,005 82,005 Short-term investments — — 1,301 1,301 Cash and cash equivalents 52,375 52,375 46,205 46,205 Financial Liabilities: Annuity - investment contracts 58,670 66,499 56,878 60,667 Mortgage loans. Mortgage loans are secured principally by residential properties. Weighted average interest rates for these loans were approximately 6.4 % at June 30, 2020 and December 31, 2019. At June 30, 2020, maturities ranged from 8 to 20 years. Management estimated the fair value using an annual interest rate of 6.25 % at June 30, 2020. Our mortgage loans are considered Level 3 assets in the fair value hierarchy. Policy loans. Policy loans had a weighted average annual interest rate of 7.7 % at June 30, 2020 and December 31, 2019, and no specified maturity dates. The aggregate fair value of policy loans approximates the carrying value reflected on the consolidated balance sheets. Policy loans are an integral part of the life insurance policies we have in force, cannot be valued separately and are not marketable. Therefore, the fair value of policy loans approximates the carrying value and policy loans are considered Level 3 assets in the fair value hierarchy. Other. The fair value of short-term investments and cash and cash equivalents approximate carrying value and are characterized as Level 1 assets in the fair value hierarchy. Annuity liabilities. The fair value of the Company's liabilities under annuity contract policies, which are considered Level 3 liabilities, was estimated at June 30, 2020 using discounted cash flows based upon spot rates ranging from 0.40 % to 2.39 % adjusted for various risk adjustments and 1.67 % to 3.02 % at December 31, 2019. The fair value of liabilities under all insurance contracts are taken into consideration in the overall management of interest rate risk, June 30, 2020 | 10-Q 24 Table of Contents DRAFT 6 CITIZENS, INC . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited ) which seeks to minimize exposure to changing interest rates through the matching of investment maturities with amounts due under insurance contracts. The following table summarizes the carrying amounts of other long-term investments. Carrying Value (In thousands) June 30, 2020 December 31, 2019 Other long-term investments: Private equity $ 9,079 — FHLB common stocks 190 187 Mortgage loans 162 177 All other investments 21 21 Total other long-term investments $ 9,452 385 We are a member of the Federal Home Loan Bank ("FHLB") of Dallas and such membership requires members to own stock in the FHLB. Our FHLB stock is carried at amortized cost, which approximates fair value. (7) COMMITMENTS AND CONTINGENCIES QUALIFICATION OF LIFE PRODUCTS We have previously reported that a portion of the life insurance policies issued by our subsidiary insurance companies failed to qualify for the favorable U.S. federal income tax treatment afforded by Sections 7702 and 72(s) of the Internal Revenue Code ("IRC") of 1986. Further, we have determined that the structure of our policies sold to non-U.S. persons, which were novated to CICA Ltd. effective July 1, 2018 , may have inadvertently generated U.S. source income over time, which caused tax withholding and information reporting requirements for the Company under Chapters 3 and 4 of the IRC. For the novated policies sold to non-U.S. persons, we expect to settle any past liabilities with the Internal Revenue Service ("IRS") related to tax withholding and information reporting failures. The Company has continued to refine its estimate of the tax, penalty and interest exposure and expenses related to these tax issues, as described below for the current reporting period. The products have been and continue to be appropriately reported as life insurance under U.S. GAAP for financial reporting. In December 2019, the Company submitted corrected withholding tax returns to the IRS in order to establish the tax liability amount for failing to withhold tax and report the U.S. source income generated by the novated policies to remediate the noncompliance matter described above. With the continued uncertainty that remains, including the acceptance of the submitted withholding tax returns, IRS review of our submission, and future negotiations, our estimated liability was approximately $ 10.0 million, after tax, as of June 30, 2020 related to the projected agreement with the IRS. The probability weighted range of financial estimates relative to this issue is $ 7.4 million to $ 52.5 million, after tax. This estimated range includes projected taxes and interest and penalties payable to the IRS, as well as estimated increased payout obligations to current holders of non-compliant domestic life insurance policies expected to result from remediation of those policies. Accruals for loss contingencies are recorded when it is probable that a liability has been incurred and the amount can be reasonably estimated. The process of determining our best estimate and the estimated range is a complex undertaking including insight from external consultants and involved management’s judgment based upon a variety of factors known at the time. The amount of our liabilities and expenses depends on a number of uncertainties, including the number of prior tax years for which we may be liable to the IRS and the methodology applicable to the calculation of the tax liabilities for policies. Given the range of potential outcomes and the significant variables assumed in establishing our estimates, actual amounts incurred may exceed our reserve and could exceed the high end of our estimated range of liabilities and expenses. To the extent the amount reserved by the Company is insufficient to meet the actual amount of our liabilities and expenses, or if our estimates of those liabilities and June 30, 2020 | 10-Q 25 Table of Contents DRAFT 6 CITIZENS, INC . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited ) expenses change in the future, our financial condition and results of operations may be materially adversely affected. Management believes that based upon current information, we have recorded the best estimate liability to date. LITIGATION AND REGULATORY ACTIONS From time to time we are subject to legal and regulatory actions relating to our business. We may incur defense costs, including attorneys' fees, and other direct litigation costs associated with defending claims. If we suffer an adverse judgment as a result of litigation claims, it could have a material adverse effect on our business, results of operations and financial condition. (8) INCOME TAXES Our provision for income taxes may not have the customary relationship of taxes to income. CICA Ltd., a wholly owned subsidiary of Citizens, is considered a controlled foreign corporation for federal tax purposes. As a result, the insurance activity of CICA Ltd. is subject to Subpart F of the IRC and is included in Citizens’ taxable income. For the three and six months ended June 30, 2020, the Subpart F income inclusion generated $ 0.7 million and $ 1.4 million of federal income tax expense, respectively. A reconciliation between the U.S. corporate income tax rate and the effective income tax rate is as follows: Three Months Ended June 30, 2020 2019 (In thousands, except for %) Amount % Amount % Federal income tax expense: Expected tax expense (benefit) $ 92 21.0 % $ ( 698 ) 21.0 % Foreign income tax rate differential ( 489 ) ( 111.6 ) % ( 196 ) 5.9 % Tax-exempt interest and dividends-received deduction ( 38 ) ( 8.7 ) % ( 59 ) 1.8 % Annualized effective tax rate adjustment 229 52.3 % ( 55 ) 1.7 % Adjustment of prior year taxes ( 83 ) ( 18.9 ) % — — % Effect of uncertain tax position 1,028 234.7 % 1,224 ( 36.8 ) % CICA Ltd. Subpart F income 717 163.7 % 884 ( 26.6 ) % Other 9 2.1 % 142 ( 4.3 ) % Total federal income tax expense $ 1,465 334.6 % $ 1,242 ( 37.3 ) % Six Months Ended June 30, 2020 2019 (In thousands, except for %) Amount % Amount % Federal income tax expense: Expected tax expense (benefit) $ ( 377 ) 21.0 % $ ( 276 ) 21.0 % Foreign income tax rate differential ( 1,039 ) 57.8 % ( 111 ) 8.4 % Tax-exempt interest and dividends-received deduction ( 78 ) 4.3 % ( 118 ) 9.0 % Annualized effective tax rate adjustment 846 ( 47.1 ) % 3,264 ( 248.2 ) % Adjustment of prior year taxes ( 88 ) 4.9 % — — % Effect of uncertain tax position 2,043 ( 113.7 ) % 2,416 ( 183.7 ) % CICA Ltd. Subpart F income 1,392 ( 77.5 ) % 1,595 ( 121.4 ) % Other 115 ( 6.4 ) % 282 ( 21.4 ) % Total federal income tax expense $ 2,814 ( 156.7 ) % $ 7,052 ( 536.3 ) % June 30, 2020 | 10-Q 26 Table of Contents DRAFT 6 CITIZENS, INC . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited ) Income tax expense consists of: Six Months Ended June 30, 2020 2019 (In thousands) Federal income tax expense: Current $ 2,890 7,146 Deferred ( 76 ) ( 94 ) Total federal income tax expense $ 2,814 7,052 The components of deferred federal income taxes are as follows: Net Deferred Tax Asset (Liability) (In thousands) June 30, 2020 December 31, 2019 Deferred tax assets: Future policy benefit reserves $ 2,689 2,641 Net operating and capital loss carryforwards 160 230 Investments 644 702 Deferred intercompany loss 2,901 3,539 Fixed assets 482 — Lease liability 2,627 238 Other 442 700 Total gross deferred tax assets 9,945 8,050 Deferred tax liabilities: Deferred policy acquisition costs, cost of insurance acquired and intangible assets ( 8,390 ) ( 8,417 ) Unrealized gains on investments available-for-sale ( 10,101 ) ( 7,300 ) Tax reserves transition liability ( 4,110 ) ( 4,483 ) Right of use lease asset ( 2,627 ) ( 238 ) Other ( 37 ) ( 40 ) Total gross deferred tax liabilities ( 25,265 ) ( 20,478 ) Net deferred tax liability $ ( 15,320 ) ( 12,428 ) (9) LEASES The Company leases home office space in Austin, Texas for Citizens and in Bermuda for CICA Ltd. as well as several district office locations related to our Home Service Insurance segment across Louisiana, Mississippi and Arkansas, which are classified as operating leases. Certain operating leases include renewal options that extend the lease terms. The exercise of lease renewal options is at our sole discretion when it is reasonably certain that we will exercise such option . Leases with an initial term of 12 months or less are immaterial to the consolidated financial statements and are recognized as lease expense on a straight-line basis over the lease term and not recorded on the consolidated balance sheet. See our Annual Report on Form 10-K for the year ended December 31, 2019 for a comprehensive discussion of leases. June 30, 2020 | 10-Q 27 Table of Contents DRAFT 6 CITIZENS, INC . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited ) The Company has $ 12.5 million of undiscounted lease liability remaining as of June 30, 2020. The Company evaluates its estimated incremental borrowing rate, which is derived from information available at lease commencement date, in determining present value of lease payments. The table below summarizes the number of weighted-average years remaining in our operating lease liabilities. Lease Term June 30, 2020 Weighted-average remaining lease term (in years) Operating leases 9.6 We recorded the lease right-of-use asset in Other Assets and the lease liability in Other Liabilities on our consolidated balance sheets. Cash payments related to lease liabilities were $ 0.3 million and $ 0.7 million for the three and six months ended June 30, 2020 and were reported in operating cash flows. Maturities of our remaining operating lease liabilities as of June 30, 2020 are as follows: (In thousands) Operating Lease Payments Maturity of Lease Liabilities 2020 $ 739 2021 1,414 2022 1,274 2023 1,273 2024 1,305 After 2024 8,160 Total lease payments 14,165 Interest expense ( 1,659 ) Present value of lease liabilities $ 12,506 In January 2019, the Company entered into a long-term lease agreement with an unrelated party for its new home office in Austin, Texas. The leased area is now under construction to our specifications, which requires the Company to recognize the related lease right of use asset and liability of $ 12.0 million. The building is expected to be completed in the fourth quarter of 2020. The Company does not engage in lease agreements among related parties. (10) RELATED PARTY TRANSACTIONS The Company has various routine related party transactions in conjunction with our holding company structure, such as a management service agreement related to costs incurred, a tax sharing agreement between entities, and inter-company dividends and capital contributions. There were no changes related to these relationships during the six months ended June 30, 2020. See our Annual Report on Form 10-K for the year ended December 31, 2019 for a comprehensive discussion of related party transactions. (11) SUBSEQUENT EVENTS The Company has evaluated the impact of subsequent events as defined by the accounting guidance through the date this report was issued. June 30, 2020 | 10-Q 28 Table of Contents DRAFT 6 CITIZENS, INC . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited ) CHANGE IN CONTROL On July 29, 2020, a change in control of the Company occurred, and the Harold E. Riley Foundation (the “Foundation”), a charitable organization established under 501(c)(3) of the Internal Revenue Code, is now the owner of 100 % of the Company’s Class B common stock. Prior to the change in control, the Harold E. Riley Trust (the “Trust”) was the beneficial owner of 100 % of the Company’s Class B common stock. The Trust documents provided that upon Harold Riley’s death, which occurred in 2017, the Class B common stock would transfer from the Trust to the Foundation. Because the Class B common stock elects a simple majority of the Board of Directors of the Company, this transfer constitutes an acquisition of control by the Foundation, which requires prior regulatory approvals by the insurance regulators of Colorado, Louisiana, Mississippi and Texas, the states in which the Company's insurance subsidiaries are domiciled. On July 29, 2020, Colorado’s stipulated requirements from their order dated May 21, 2020 relating to the approval of acquisition of control by the Foundation were fulfilled. Accordingly, Colorado, Louisiana, Mississippi and Texas insurance regulators have all now approved the acquisition of control of the Company by the Foundation. Additionally, the Bermuda Monetary Authority has provided its consent of the change in control. Thus, all regulatory approvals and requirements have been met to effectuate the change in control to the Foundation. Upon receipt of notice of the requisite regulatory approvals for the change in control, the Company transferred the Class B common stock from the Trust, as record holder, to the Foundation and, as such, control over the Company’s Class B common stock is now being exercised by the Foundation. RESIGNATION OF CHIEF EXECUTIVE OFFICER On July 29, 2020, following the change in control of the Company, Mr. Kolander notified the Company of his intention to resign from his position as Chief Executive Officer and President and as a member of the Board of Directors, and terminated the Employment Agreement by and between the Company and Mr. Kolander dated January 1, 2019 (the “2019 Employment Agreement”). Pursuant to Sections 1(e) and 6(g) of the 2019 Employment Agreement, Mr. Kolander terminated the 2019 Employment Agreement due to a “change in control,” which occurred upon the regulatory approval of the transfer of the shares of the Company’s Class B common stock from the Trust to the Foundation. Mr. Kolander’s resignation and separation from employment and a member of the Board of Directors will be effective no later than August 10, 2020. In connection with Mr. Kolander’s resignation and separation from employment, Mr. Kolander signed a Chief Executive Officer Separation of Service and Consulting Agreement (the “Separation and Consulting Agreement”) with the Company and the Release attached as Exhibit “A” thereto, each dated July 29, 2020. Because Mr. Kolander signed the Release, pursuant to Sections 6(g) and (h) of the Employment Agreement, Mr. Kolander will be entitled to the cash severance amount set forth in Sections 6(g) and (h) of the 2019 Employment Agreement (which equals $ 8.8 million), less required withholdings and deductions. Additionally, all outstanding Restricted Stock Units held by Mr. Kolander will be fully vested on the date that Mr. Kolander resigns and separates from employment. The cash severance amount will be paid on the date that is six months and one day following the date that Mr. Kolander resigns and separates from employment. Thus the financial impact to the Company will occur in the third quarter of 2020 and the related expense will be recognized. To assist in the orderly transition of his duties and responsibilities, Mr. Kolander entered into the Separation and Consulting Agreement with the Company. Under the Separation and Consulting Agreement, Mr. Kolander agreed to provide leadership transition guidance and business continuity assistance to the Company as a consultant from the separation date through December 31, 2020. Mr. Kolander will provide no more than 14 hours of consulting services per week at a rate of $ 14,000 per week. The consulting period can be terminated by either party upon 30 days written notice. The above summary of the Separation and Consulting Agreement is qualified by reference in its entirety to the Separation and Consulting Agreement, which was filed as an exhibit to our Current Report on Form 8-K filed on July 30, 2020 . June 30, 2020 | 10-Q 29 Table of Contents DRAFT 6 CITIZENS, INC . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited ) APPOINTMENT OF INTERIM CHIEF EXECUTIVE OFFICER On July 29, 2020, the Board of Directors appointed Gerald W. Shields, a member of the Company’s Board of Directors, as Interim Chief Executive Officer, to be effective upon Mr. Kolander’s separation from employment. Following his appointment, Mr. Shields will continue to serve as Vice Chairman of the Board of Directors, but will step down from the Audit Committee, the Compensation Committee and the Executive Committee as of such date. June 30, 2020 | 10-Q 30 Table of Contents DRAFT 6 CITIZENS, INC. MANAGEMENT'S DISCUSSION & ANALYSIS