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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2002
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
------ -------
Commission File Number 1-9250
Conseco, Inc.
Indiana No. 35-1468632
------------------------ ------------------------------
State of Incorporation IRS Employer Identification No.
11825 N. Pennsylvania Street
Carmel, Indiana 46032 (317) 817-6100
- -------------------------------------- --------------
Address of principal executive offices Telephone
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days: Yes [x] No [ ]
Shares of common stock outstanding as of August 7, 2002: 346,008,013
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(Dollars in millions)
ASSETS
June 30, December 31,
2002 2001
---- ----
(unaudited)
Investments:
Actively managed fixed maturities at fair value (amortized cost: 2002 - $21,370.3;
2001 - $23,127.8)........................................................................... $20,791.9 $22,347.0
Interest-only securities at fair value (amortized cost: 2002 - $177.9; 2001 - $131.3)......... 207.1 141.7
Equity securities at fair value (cost: 2002 - $233.5; 2001 - $257.3).......................... 213.0 227.0
Mortgage loans................................................................................ 1,378.0 1,228.0
Policy loans.................................................................................. 541.3 635.8
Venture capital investment in AT&T Wireless Services, Inc. (cost: 2002 - $26.8; 2001- $39.0).. 51.2 155.3
Other invested assets ........................................................................ 327.4 292.4
--------- ---------
Total investments......................................................................... 23,509.9 25,027.2
Cash and cash equivalents:
Held by the parent company.................................................................... 203.5 152.2
Held by the parent company in segregated accounts............................................. 55.4 54.7
Held by subsidiaries.......................................................................... 1,210.3 2,853.9
Accrued investment income........................................................................ 691.2 688.6
Finance receivables.............................................................................. 3,080.1 3,810.7
Finance receivables - securitized................................................................ 14,529.7 14,198.5
Cost of policies purchased....................................................................... 1,388.9 1,657.8
Cost of policies produced........................................................................ 2,308.7 2,570.2
Reinsurance receivables.......................................................................... 1,466.9 663.0
Income tax assets................................................................................ 55.2 678.1
Goodwill......................................................................................... 600.0 3,695.4
Assets held in separate accounts and investment trust ........................................... 2,107.9 2,376.3
Cash held in segregated accounts for investors................................................... 446.9 550.2
Cash held in segregated accounts related to servicing agreements and securitization
transactions.................................................................................. 951.9 994.6
Other assets..................................................................................... 2,306.9 1,420.9
-------- ---------
Total assets.............................................................................. $54,913.4 $61,392.3
========= =========
(continued on next page)
The accompanying notes are an integral part
of the consolidated financial statements
2
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET, continued
(Dollars in millions)
LIABILITIES AND SHAREHOLDERS' EQUITY
June 30, December 31,
2002 2001
---- ----
(unaudited)
Liabilities:
Liabilities for insurance and asset accumulation products:
Interest-sensitive products.............................................................. $15,433.9 $15,787.7
Traditional products..................................................................... 7,929.3 8,172.8
Claims payable and other policyholder funds.............................................. 987.4 1,005.5
Liabilities related to separate accounts and investment trust............................ 2,107.9 2,376.3
Liabilities related to certificates of deposit........................................... 2,037.5 1,790.3
Investor payables.......................................................................... 446.9 550.2
Other liabilities.......................................................................... 2,501.3 1,699.3
Investment borrowings...................................................................... 604.9 2,242.7
Notes payable:
Direct corporate obligations............................................................. 4,012.4 4,087.6
Direct finance obligations:
Master repurchase agreements........................................................... 907.4 1,670.8
Credit facility collateralized by retained interests in securitizations................ 506.3 507.3
Other borrowings....................................................................... 9.6 349.8
Related to securitized finance receivables structured as collateralized borrowings....... 14,977.5 14,484.5
--------- ---------
Total liabilities.................................................................... 52,462.3 54,724.8
--------- ---------
Minority interest:
Company-obligated mandatorily redeemable preferred securities of subsidiary trusts......... 1,918.1 1,914.5
Shareholders' equity:
Preferred stock............................................................................ 501.5 499.6
Common stock and additional paid-in capital (no par value, 1,000,000,000 shares
authorized, shares issued and outstanding: 2002 - 346,006,584; 2001 - 344,743,196)....... 3,499.4 3,484.3
Accumulated other comprehensive loss....................................................... (295.9) (439.0)
Retained earnings (deficit)................................................................ (3,172.0) 1,208.1
--------- ---------
Total shareholders' equity........................................................... 533.0 4,753.0
--------- ---------
Total liabilities and shareholders' equity........................................... $54,913.4 $61,392.3
========= =========
The accompanying notes are an integral part
of the consolidated financial statements
3
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
(Dollars in millions, except per share data)
(unaudited)
Three months ended Six months ended
June 30, June 30,
------------------- ----------------
2002 2001 2002 2001
---- ---- ---- ----
Revenues:
Insurance policy income............................................................ $ 884.5 $1,023.6 $ 1,841.7 $2,052.8
Net investment income:
Insurance and fee-based segment general account assets........................... 408.0 464.7 825.1 913.3
Finance segment assets........................................................... 553.6 555.4 1,113.9 1,116.8
Equity-indexed and separate account products..................................... (135.0) (44.1) (203.6) (120.1)
Venture capital gain (loss) related to investment in AT&T Wireless Services, Inc. (23.7) 50.5 (100.0) 3.4
Other............................................................................ 3.3 6.7 5.7 17.6
Gain on sale of finance receivables................................................ 10.2 6.7 17.4 15.6
Gain on sale of interest in riverboat.............................................. - - - 192.4
Net realized investment losses .................................................... (260.4) (40.3) (290.8) (153.6)
Impairment charge related to retained interests in securitization transactions..... - (33.8) - (41.7)
Fee revenue and other income....................................................... 81.4 112.9 171.8 228.8
--------- -------- --------- --------
Total revenues................................................................. 1,521.9 2,102.3 3,381.2 4,225.3
--------- -------- --------- --------
Benefits and expenses:
Insurance policy benefits.......................................................... 682.5 900.1 1,477.7 1,775.1
Provision for losses............................................................... 250.3 111.0 448.7 226.7
Interest expense................................................................... 372.7 407.0 741.4 826.0
Amortization....................................................................... 256.7 276.2 452.9 428.7
Other operating costs and expenses................................................. 288.9 352.4 622.3 699.3
Special charges.................................................................... 133.0 16.2 202.5 55.8
--------- -------- ---------- --------
Total benefits and expenses.................................................... 1,984.1 2,062.9 3,945.5 4,011.6
--------- -------- --------- --------
Income (loss) before income taxes, minority interest, extraordinary gain (loss)
and cumulative effect of accounting change.................................. (462.2) 39.4 (564.3) 213.7
Income tax expense (benefit):
Tax expense (benefit) on period income......................................... (160.2) 31.0 (191.6) 89.3
Valuation allowance for deferred tax assets.................................... 1,003.0 - 1,003.0 -
--------- -------- --------- --------
Income (loss) before minority interest, extraordinary gain (loss)
and cumulative effect of accounting change................................... (1,305.0) 8.4 (1,375.7) 124.4
Minority interest:
Distributions on Company-obligated mandatorily redeemable preferred securities
of subsidiary trusts, net of income taxes....................................... 29.2 29.1 58.4 61.3
--------- -------- --------- --------
Income (loss) before extraordinary gain (loss) and cumulative effect of
accounting change............................................................ (1,334.2) (20.7) (1,434.1) 63.1
Extraordinary gain (loss) on extinguishment of debt, net of income taxes.............. 1.1 (5.0) 5.1 (4.7)
Cumulative effect of accounting change for goodwill impairment........................ - - (2,949.2) -
---------- --------- --------- --------
Net income (loss).............................................................. (1,333.1) (25.7) (4,378.2) 58.4
Preferred stock dividends............................................................. .9 4.6 1.9 8.5
--------- -------- --------- --------
Net income (loss) applicable to common stock................................... $(1,334.0) $ (30.3) $(4,380.1) $ 49.9
========= ======== ========= ========
(continued)
The accompanying notes are an integral part
of the consolidated financial statements.
4
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS, continued
(Dollars in millions, except per share data)
(unaudited)
Three months ended Six months ended
June 30, June 30,
------------------ -------------------
2002 2001 2002 2001
---- ---- ---- ----
Income (loss) per common share:
Basic:
Weighted average shares outstanding................................... 346,005,000 337,773,000 345,607,000 334,454,000
=========== =========== =========== ===========
Income (loss) before extraordinary gain (loss) and cumulative effect
of accounting change............................................... $(3.86) $(.08) $ (4.15) $ .16
Extraordinary gain (loss) on extinguishment of debt................... - (.01) .01 (.01)
Cumulative effect of accounting change................................ - - (8.53) -
------ ----- ------- -----
Net income (loss)................................................. $(3.86) $(.09) $(12.67) $. 15
====== ===== ======= =====
Diluted:
Weighted average shares outstanding................................... 346,005,000 337,773,000 345,607,000 350,337,000
=========== =========== =========== ===========
Income (loss) before extraordinary gain (loss) and cumulative effect
of accounting change.............................................. $(3.86) $(.08) $ (4.15) $ .15
Extraordinary gain (loss) on extinguishment of debt................... - (.01) .01 (.01)
Cumulative effect of accounting change................................ - - (8.53) -
------ ----- ------- -----
Net income (loss)................................................. $(3.86) $(.09) $(12.67) $ .14
====== ===== ======= =====
The accompanying notes are an integral part
of the consolidated financial statements.
5
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
(Dollars in millions)
(unaudited)
Common stock Accumulated other Retained
Preferred and additional comprehensive earnings
Total stock paid-in capital loss (deficit)
----- ----- --------------- ---- -------
Balance, January 1, 2002............................. $ 4,753.0 $499.6 $3,484.3 $(439.0) $ 1,208.1
Comprehensive loss, net of tax:
Net loss........................................ (4,378.2) - - - (4,378.2)
Change in unrealized depreciation of
investments (net of applicable income tax
expense of $82.4)............................. 143.1 - - 143.1 -
---------
Total comprehensive loss.................... (4,235.1)
Issuance of shares for stock options and for
employee benefit plans.......................... 15.1 - 15.1 - -
Payment-in-kind dividends on convertible
preferred stock................................. 1.9 1.9 - - -
Dividends on preferred stock...................... (1.9) - - - (1.9)
--------- ------ -------- ------- ---------
Balance, June 30, 2002............................... $ 533.0 $501.5 $3,499.4 $(295.9) $(3,172.0)
========= ====== ======== ======= =========
Balance, January 1, 2001............................. $4,374.4 $486.8 $2,911.8 $(651.0) $1,626.8
Comprehensive income, net of tax:
Net income...................................... 58.4 - - - 58.4
Change in unrealized depreciation of
investments (net of applicable income tax
expense of $117.0)............................ 204.6 - - 204.6 -
---------
Total comprehensive income.................. 263.0
Issuance of shares pursuant to stock purchase
contracts related to FELINE PRIDES.............. 496.6 - 496.6 - -
Issuance of shares for stock options and for
employee benefit plans.......................... 15.5 - 15.5 - -
Payment-in-kind dividends on convertible
preferred stock................................. 8.5 8.5 - - -
Dividends on preferred stock...................... (8.5) - - - (8.5)
--------- ------ -------- ------- --------
Balance, June 30, 2001............................... $ 5,149.5 $495.3 $3,423.9 $(446.4) $1,676.7
========= ====== ======== ======= ========
The accompanying notes are an integral part
of the consolidated financial statements.
6
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(Dollars in millions)
(unaudited)
Six months ended
June 30,
-------------------
2002 2001
---- ----
Cash flows from operating activities:
Insurance policy income....................................................................... $ 1,557.9 $ 1,775.6
Net investment income......................................................................... 1,837.1 1,953.4
Fee revenue and other income.................................................................. 158.3 214.8
Insurance policy benefits..................................................................... (1,261.4) (1,396.7)
Interest expense.............................................................................. (726.4) (812.3)
Policy acquisition costs...................................................................... (271.0) (354.1)
Special charges............................................................................... (33.3) (11.8)
Other operating costs......................................................................... (669.4) (777.5)
Taxes......................................................................................... (114.5) (85.4)
---------- -----------
Net cash provided by operating activities................................................... 477.3 506.0
---------- -----------
Cash flows from investing activities:
Sales of investments.......................................................................... 11,498.9 10,301.4
Maturities and redemptions of investments..................................................... 766.8 559.0
Purchases of investments...................................................................... (11,764.7) (10,643.1)
Cash received from the sale of finance receivables, net of expenses........................... 619.6 683.6
Principal payments received on finance receivables............................................ 4,323.7 4,047.0
Finance receivables originated................................................................ (4,423.0) (6,072.5)
Other......................................................................................... (105.0) (83.9)
---------- -----------
Net cash provided (used) by investing activities ........................................... 916.3 (1,208.5)
---------- -----------
Cash flows from financing activities:
Amounts received for deposit products......................................................... 2,304.2 1,943.7
Withdrawals from deposit products............................................................. (2,537.2) (2,245.5)
Issuance of notes payable..................................................................... 4,259.6 6,185.5
Payments on notes payable..................................................................... (5,434.7) (5,970.2)
Ceding commission received on reinsurance transaction......................................... 83.0 -
Change in cash held in restricted accounts for settlement of borrowings....................... 34.5 (4.8)
Investment borrowings......................................................................... (1,637.8) 819.0
Issuance of common and convertible preferred shares........................................... - 4.1
Dividends on preferred shares and distributions on Company-obligated
mandatorily redeemable preferred securities of subsidiary trusts............................ (56.8) (65.6)
---------- -----------
Net cash provided (used) by financing activities.......................................... (2,985.2) 666.2
---------- -----------
Net decrease in cash and cash equivalents................................................. (1,591.6) (36.3)
Cash and cash equivalents, beginning of period................................................... 3,060.8 1,663.6
---------- -----------
Cash and cash equivalents, end of period......................................................... $ 1,469.2 $ 1,627.3
========== ===========
The accompanying notes are an integral part
of the consolidated financial statements.
7
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
The following notes should be read together with the notes to the
consolidated financial statements included in the 2001 Form 10-K of Conseco,
Inc. ("we", "Conseco" or the "Company").
Conseco is a financial services holding company with subsidiaries operating
throughout the United States. Our insurance subsidiaries develop, market and
administer supplemental health insurance, annuity, individual life insurance and
other insurance products. Conseco Finance Corp. ("Conseco Finance"), a wholly
owned subsidiary of Conseco, originates, securitizes and services manufactured
housing, home equity, home improvement, retail credit, consumer finance and
floorplan loans. Conseco's operating strategy is to grow its business by
focusing its resources on the development and expansion of profitable products
and strong distribution channels, to seek to achieve superior investment returns
through active asset management and to control expenses.
During 2001, we began the process of non-renewing our major medical lines
of business. These lines of business are referred to herein as the "discontinued
major medical business."
LIQUIDITY ISSUES
As we announced on August 9, 2002, the Company did not make its August 2002
interest payments on its 6.4 percent senior and guaranteed senior notes due in
2003 and 2004 and 8.75 percent senior and guaranteed senior notes due in 2004
and 2006. The failure to make the interest payments on these notes within the
30-day grace period constitutes a default under the notes. If the Company does
not cure the non-payment of interest within 30 days of their occurrence, an
event of default will occur which will give the holders of the notes the right
to accelerate the maturity of all principal and past due interest, which
aggregated $1.1 billion on August 9, 2002. If the maturity of these notes is
accelerated, we would be unable to satisfy these obligations.
The Company is not in compliance with the debt to capitalization ratio we
agreed to maintain pursuant to our bank credit agreement and the guarantees of
bank loans to current and former directors, officers and key employees to
purchase shares of the Company's common stock (the "D&O loans"). We have
received from the relevant lenders a waiver of the covenant violation effective
as of June 30, 2002 through September 9, 2002. The debt to capitalization ratio
is defined as: (1) the sum of (i) the principal amount of all of our
indebtedness, (ii) accrued, unpaid interest and (iii) accrued, unpaid dividends
on Company-obligated mandatorily redeemable preferred securities of subsidiary
trusts; divided by (2) our total capitalization, as defined. This ratio must not
exceed 0.400 to 1.0 as of June 30, 2002 and 0.375 to 1.0 as of September 30,
2002. The ratio was 0.406 to 1.0 as of June 30, 2002. If we are not able to
extend the covenant waiver, the covenant violation gives the lenders the right
to declare all borrowings under the credit agreement and guarantees due and
payable. The aggregate balance due under this facility, including unpaid
interest, was approximately $1.5 billion on August 9, 2002. If the maturity of
the bank debt is accelerated, we would be unable to satisfy these obligations.
If an uncured event of default occurs with respect to a series of notes, it
could result in the acceleration of and immediate maturity of all of our notes
and our credit facility and the guarantees of the D&O loans through
cross-acceleration and cross-default provisions contained in the governing
instruments. At June 30, 2002, such indebtedness totaled $4.6 billion. We would
be unable to satisfy all of our obligations then due and payable under the
credit facility, the guarantee related to the D&O loans and the senior notes.
On August 9, 2002, we announced that, in addition to exercising the 30 day
grace period on bond interest payments as described above, we have engaged
financial and legal advisors to begin discussions with our debt holders with a
goal of restructuring the capital of the parent company. We cannot predict
whether any restructuring will be effected out-of-court or through a Chapter 11
bankruptcy proceeding, nor can we predict how long any restructuring of our debt
will be required to
8
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
implement. If we are unable to achieve a consensual restructuring, we will be
unable to satisfy all of our debt obligations and we will be forced to petition
for relief under the U.S. Bankruptcy Code.
As more fully described in "Liquidity for finance operations" within
"Management's Discussion and Analysis of Financial Condition and Results of
Operations", absent the waiver, a violation by the Company of the debt to
capitalization ratio covenant under its bank credit agreements would result in
cross-defaults under certain repurchase and other credit facilities utilized by
the finance subsidiary to finance loan inventory and daily operations. We have
received from the relevant lenders a waiver of the covenant violation effective
as of June 30, 2002 through September 9, 2002. These facilities are secured with
finance receivables, retained interests in securitizations and other assets. The
aggregate outstanding balance of these master repurchase agreements and other
facilities was $1.4 billion as of June 30, 2002. The repurchase facilities are
commonly referred to as warehouse facilities. Upon the occurrence of an event
of default under these warehouse facilities, the parties that provide this
financing may exercise various remedies, which vary among the facilities and
include retaining income generated by the financed loans, affecting a permanent
purchase of the financed loans, accelerating repayment of outstanding amounts
and reducing the size of or terminating the facility. The exercise of these
rights by one or more of the providers of these credit facilities would cross
default other credit facilities and would thereupon entitle certain other
warehouse lenders to declare an event of default under their respective credit
facilities and accelerate their respective indebtedness. The finance subsidiary
would pursue waivers in the event that a default occurs (if Conseco is
unsuccessful in extending its waiver of the debt to capitalization ratio
covenant). There can be no assurance that we can obtain such waivers and as such
any exercise of their rights by these providers would have a material adverse
effect on the ability of the finance subsidiary to finance its loan inventory
and to originate new loans. The recent adverse developments concerning the
parent company's liquidity have adversely affected the cost at which our finance
subsidiary can obtain funding in the securitization market and may adversely
affect our access to this market. In addition, our finance subsidiary lenders
have reduced and/or restricted access to available funding facilities. There can
be no assurance that our finance subsidiary will be able to continue to make new
loans and fund its operations.
As more fully described in "Liquidity for insurance and fee-based
operations" within "Management's Discussion and Analysis of Financial Condition
and Results of Operations", our insurance subsidiaries claim-paying ratings were
downgraded by A.M. Best on July 12, 2002 to B++ and the ratings remain "under
review with negative implications". We believe that A.M. Best will soon lower
this rating. The downgrade may cause sales of our insurance products to fall and
policyholder redemptions and lapses to increase. If such activity was unusually
high, it could cause a material adverse impact on our financial results and
liquidity. Also, the recent adverse developments concerning the parent company's
liquidity will make obtaining approvals for dividends from insurance regulatory
authorities more difficult in the future, if we request such approvals.
The accompanying consolidated financial statements have been prepared on a
going concern basis, which assumes continuity of operations and realization of
assets and satisfaction of liabilities in the ordinary course of business. The
financial statements do not include any adjustments that might result from the
outcome of the uncertainties summarized above.
BASIS OF PRESENTATION
Our unaudited consolidated financial statements reflect normal recurring
adjustments that are necessary to present fairly Conseco's financial position
and results of operations on a basis consistent with that of our prior audited
consolidated financial statements. As permitted by rules and regulations of the
Securities and Exchange Commission applicable to quarterly reports on Form 10-Q,
we have condensed or omitted certain information and disclosures normally
included in financial statements prepared in accordance with generally accepted
accounting principles ("GAAP"). We have also reclassified certain amounts from
the prior periods to conform to the 2002 presentation. These reclassifications
have no effect on net income or shareholders' equity. Results for interim
periods are not necessarily indicative of the results that may be expected for a
full year.
As described in the note to the consolidated financial statements entitled
"Cumulative Effect of Accounting Change", the Company has completed the goodwill
impairment test required by Statement of Financial Accounting Standards No. 142,
"Goodwill and Other Intangible Assets" ("SFAS 142") and has recorded the
cumulative effect of the accounting change of $2,949.2 million. Pursuant to the
transitional rules of SFAS 142, such effect is reflected in the consolidated
financial statements for the quarter ended March 31, 2002. Accordingly, the
consolidated financial statements of the Company as of March 31, 2002 and for
the three months then ended have been restated to reflect the change.
9
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
When we prepare financial statements in conformity with GAAP, we are
required to make estimates and assumptions that significantly affect various
reported amounts of assets and liabilities, and the disclosure of contingent
assets and liabilities at the date of the financial statements and revenues and
expenses during the reporting periods. For example, we use significant estimates
and assumptions in calculating values for the cost of policies produced, the
cost of policies purchased, interest-only securities, certain investments,
servicing rights, goodwill, liabilities for insurance and asset accumulation
products, liabilities related to litigation, guaranty fund assessment accruals,
liabilities related to guarantees of securitized debt issued in conjunction with
certain sales of finance receivables and liabilities related to guarantees of
bank loans and the related interest loans to certain current and former
directors, officers and key employees, gain on sale of finance receivables,
allowance for credit losses on finance receivables and the reliance on
generating adequate future taxable income to support deferred income tax assets.
If our future experience differs from these estimates and assumptions, our
financial statements could be materially affected.
The accompanying financial statements include the accounts of the Company
and all of its wholly-owned subsidiaries. Our consolidated financial statements
exclude the results of material transactions between us and our consolidated
affiliates, or among our consolidated affiliates.
We follow the requirements of Statement of Financial Accounting Standards
No. 140, "Accounting for the Transfer and Servicing of Financial Assets and
Extinguishment of Liabilities" ("SFAS 140") and related authoritative guidance
in determining whether the special purpose entities formed in conjunction with
the securitization of the finance receivables we originate and the
securitization of certain investment portfolios are consolidated. Subsequent to
September 8, 1999, we have structured the securitizations in a manner that
requires the special purpose entities to be consolidated. See "Revenue
Recognition for Sales of Finance Receivables and Amortization of Servicing
Rights." For certain other special purpose entities related to our investment
portfolio, we consider the requirements of EITF Topic D-14 in determining
whether to consolidate such entities. We consolidate such entities if: (i) an
independent third party has not made a substantial capital investment in the
entity; (ii) such independent third party does not control the activities of the
entity; and (iii) the independent party does not retain substantial risks and
rewards of the special purpose entity's assets.
10
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
CUMULATIVE EFFECT OF ACCOUNTING CHANGE
The FASB issued SFAS 142, in June 2001. Under the new rule, intangible
assets with an indefinite life are no longer amortized in periods subsequent to
December 31, 2001, but are subject to annual impairment tests (or more frequent
under certain circumstances), effective January 1, 2002. The Company has
determined that all of its goodwill has an indefinite life and is therefore
subject to the new rules.
Pursuant to SFAS 142, the goodwill impairment test has two steps. The first
step was required to be completed by June 30, 2002 and the second step, if
necessary, was required to be completed by December 31, 2002. Any resulting
impairment is required under SFAS 142 to be recorded in the quarter ended March
31, 2002. For Conseco, the first step consisted of comparing the estimated fair
value of each of the business units comprising our insurance segment to the
unit's book value. Since all of our goodwill relates to the insurance segment
(which is also a reportable segment), the goodwill impairment test is not
relevant to the finance business. If the estimated fair value exceeds the book
value, the test is complete and goodwill is not impaired. If the fair value is
less than the book value, the second step of the impairment test must be
performed, which compares the implied fair value of the applicable business
unit's goodwill with the book value of that goodwill to measure the amount of
goodwill impairment, if any.
Pursuant to the transitional rules of SFAS 142, we have completed the
two-step impairment test during the second quarter of 2002 and, as a result of
that test, we recorded the cumulative effect of the accounting change for the
goodwill impairment charge of $2,949.2 million for the quarter ended March 31,
2002. The first quarter of 2002 impairment charge is reflected in cumulative
effect of an accounting change in the accompanying consolidated statement of
operations for the six months ended June 30, 2002, and the consolidated
financial statements for the quarter ended March 31, 2002 have been
retroactively restated. Subsequent impairment tests will be performed on an
annual basis in the fourth quarter of each year, or more frequently if
circumstances indicate a possible impairment. Subsequent impairment charges, if
any, would be classified as an operating expense.
The significant factors used to determine the amount of the impairment
included analyses of industry market valuations, historical and projected
performance of our insurance segment, discounted cash flow analyses and the
market value of our capital. The valuation utilized the best available
information, including assumptions and projections we considered reasonable and
supportable. The assumptions we used to determine the discounted cash flows
involve significant judgments regarding the best estimate of future premiums,
expected mortality and morbidity, interest earned and credited rates,
persistency and expenses. The discount rate used was based on an analysis of the
weighted average cost of capital for several insurance companies and considered
the specific risk factors related to Conseco. Pursuant to the guidance in SFAS
142, quoted market prices in active markets are the best evidence of fair value
and shall be used as the basis for measurement, if available. Management
believes that the assumptions and estimates used are reasonable given all
available facts and circumstances. However, if projected cash flows are not
realized in the future, we may be required to recognize additional impairments.
Prior to the adoption of SFAS 142, we determined whether goodwill was
recoverable from projected undiscounted net cash flows for the earnings of our
subsidiaries over the remaining amortization period. If we determined that
undiscounted projected cash flows were not sufficient to recover the goodwill
balance, we would reduce its carrying value with a corresponding charge to
expense or shorten the amortization period. Cash flows considered in such an
analysis were those of the business acquired, if separately identifiable, or the
product line that acquired the business, if such earnings were not separately
identifiable.
11
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
Changes in the carrying amount of goodwill for the six months ended June
30, 2002 and 2001, are as follows:
Six months ended
June 30,
----------------
2002 2001
---- ----
Goodwill balance, beginning of period....................................... $ 3,695.4 $3,800.8
Amortization expense........................................................ - (54.9)
Impairment charge........................................................... (2,949.2) -
Reduction of tax valuation contingencies established at acquisition date
for acquired companies.................................................. (146.2) -
Goodwill related to businesses sold......................................... - (35.8)
--------- --------
Goodwill balance, end of period............................................. $ 600.0 $3,710.1
========= ========
12
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
In accordance with SFAS 142, we discontinued the amortization of goodwill
expense effective January 1, 2002. The following information summarizes the
impact of goodwill amortization on income before extraordinary charge, net
income and the respective earnings per share amounts for the periods presented
in our consolidated statement of operations:
Three months ended Six months ended
June 30, June 30,
------------------ -----------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars in millions, except per share data)
Reported income (loss) before extraordinary gain (loss) and
cumulative effect of accounting change...................... $(1,334.2) $(20.7) $(1,434.1) $ 63.1
Add back: goodwill amortization............................... - 28.4 - 54.9
--------- ------ --------- -------
Adjusted income (loss) before extraordinary gain (loss) and
cumulative effect of accounting change...................... $(1,334.2) $ 7.7 $(1,434.1) $ 118.0
========= ====== ========= =======
Reported net income (loss) applicable to common stock........... $(1,333.1) $(30.3) $(4,378.2) $ 49.9
Add back: goodwill amortization................................ - 28.4 - 54.9
--------- ------ --------- -------
Adjusted net income (loss) applicable to common stock........... $(1,333.1) $(1.9) $(4,378.2)(a) $ 104.8
========= ===== ========= =======
Basic earnings per share:
Reported income (loss) before extraordinary gain (loss) and
cumulative effect of accounting change...................... $(3.86) $(.08) $ (4.15) $.16
Add back: goodwill amortization................................ - .08 - .17
------ ----- ------- ----
Adjusted income (loss) before extraordinary gain (loss) and
cumulative effect of accounting change...................... $(3.86) $ - $ (4.15) $.33
====== ===== ======== ====
Reported net income (loss) applicable to common stock........... $(3.86) $(.09) $(12.67) $.15
Add back: goodwill amortization................................ - .08 - .17
------ ----- ------- ----
Adjusted net income (loss) applicable to common stock........... $(3.86) $(.01) $(12.67) $.32
====== ===== ======= ====
Diluted earnings per share:
Reported income (loss) before extraordinary gain (loss)
and cumulative effect of accounting change.................. $(3.86) $(.08) $ (4.15) $.15
Add back: goodwill amortization............................... - .08 - .16
------ ----- ------- ----
Adjusted income (loss) before extraordinary gain (loss)
and cumulative effect of accounting change.................. $(3.86) $ - $ (4.15) $.31
====== ===== ======= ====
Reported net income (loss) applicable to common stock........... $(3.86) $(.09) $(12.67) $.14
Add back: goodwill amortization................................ - .08 - .16
------ ----- ------- ----
Adjusted net income (loss) applicable to common stock........... $(3.86) $(.01) $(12.67) $.30
====== ===== ======= ====
- ------------------
(a) Adjusted net income for the six months ended June 30, 2002, includes
the cumulative effect of the accounting change for goodwill impairment of
$2,949.2 million.
13
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
The following summarizes the effect of the goodwill impairment charge on
our results of operations for the three months ended March 31, 2002 (dollars in
millions, except per share data):
Net loss, applicable to common stock as reported................ $ (96.9)
Cumulative effect of accounting change.......................... (2,949.2)
---------
Net loss, as adjusted........................................... $(3,046.1)
=========
Net loss per common share:
Basic:
Net loss, as reported..................................... $ (.28)
Cumulative effect of accounting change.................... (8.54)
------
Net loss, as adjusted..................................... $(8.82)
======
Diluted:
Net loss, as reported..................................... $ (.28)
Cumulative effect of accounting change.................... (8.54)
------
Net loss, as adjusted..................................... $(8.82)
======
ACCOUNTING FOR INVESTMENTS
We classify our fixed maturity securities into three categories: (i)
"actively managed" (which we carry at estimated fair value); (ii) "trading"
(which we carry at estimated fair value); and (iii) "held to maturity" (which we
carry at amortized cost). We had no fixed maturity securities in the "trading"
or "held to maturity" categories at June 30, 2002.
Accumulated other comprehensive loss is primarily comprised of unrealized
losses on actively managed fixed maturity investments. Such amounts, included in
shareholders' equity as of June 30, 2002, and December 31, 2001, were as
follows:
June 30, December 31,
2002 2001
---- ----
(Dollars in millions)
Unrealized losses on investments...................................................... $(524.5) $(816.0)
Adjustments to cost of policies purchased and cost of policies produced............... 67.9 133.9
Deferred income tax benefit........................................................... 167.2 249.6
Other................................................................................. (6.5) (6.5)
------- -------
Accumulated other comprehensive loss............................................. $(295.9) $(439.0)
======= =======
VENTURE CAPITAL INVESTMENT IN AT&T WIRELESS SERVICES, INC.
At December 31, 2001, our venture capital investments consisted of 12.6
million shares of TeleCorp PCS, Inc. ("TeleCorp") a company in the wireless
communication business. In the first quarter of 2002, AT&T Wireless Services,
Inc. ("AWE") acquired TeleCorp. Pursuant to the merger agreement, our shares of
TeleCorp were converted into 11.4 million shares of AWE. Upon the completion of
the merger, there were no restrictions on our ability to sell our interest in
AWE. In the second quarter of 2002, Conseco sold 7.7 million shares of AWE
generating net proceeds of $61.3 million. Our investment in AWE is carried at
estimated fair value, with changes in fair value recognized as investment income
(loss). The Company currently intends to sell its remaining holdings of AWE
common stock.
During the fourth quarter of 2001, the parent company transferred 4.6
million shares of TeleCorp common stock to certain investment trusts. Conseco's
insurance subsidiaries hold substantially all of the economic interests in the
trusts. Pursuant to
14
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
SFAS 140 and other authoritative guidance, the transfer of the shares to the
trust is not a sale and the accounts of the trusts are consolidated with the
accounts of the Company. The parent company received cash of $60.3 million (the
market value of the shares on the date of transfer) in exchange for the shares
transferred to the trusts. After the transfer of the common shares, Conseco
continues to recognize in its consolidated financial statements the change in
the market value of the common shares, with changes in fair value recognized as
investment income (loss).
At June 30, 2002, our holdings of AWE common stock included: 2.7 million
shares valued at $15.1 million (all of which were sold in July 2002 generating
net proceeds of $14.4 million); 4.1 million shares valued at $23.6 million which
are held in the investment trusts described in the previous paragraph; and 1.0
million shares valued at $5.9 million which are held as collateral for a $12.4
million investment borrowing transaction and are subject to a forward sale
contract pursuant to which the Company has agreed to sell between .6 million and
1.0 million shares of AWE common stock for $15.5 million on November 15, 2006.
The number of shares purchased will be based on the $15.5 million purchase price
and the price of AWE common stock at the purchase date. However, such price will
be no lower than $14.9862 per share and no higher than $24.3527 per share
pursuant to the terms of the forward sale contract.
The forward contract is a derivative that is required to be
marked-to-market each period. Since the hedged asset (i.e., a portion of the
shares of AWE which we own) is required to be carried at market value, the hedge
rules of SFAS 133 (as defined under the caption "Accounting for Derivatives")
are not applicable. However, since the value of the derivative will fluctuate in
relation to the change in value of the related AWE common stock, we expect the
forward contract to act as a hedge and reduce earnings volatility associated
with the AWE common stock. At June 30, 2002, the value of the derivative was
$6.5 million. The market values of AWE and many other companies in AWE's
business sector have declined significantly in recent periods. We recognized
venture capital investment gains (losses) of $(23.7) million and $50.5 million
in the second quarters of 2002 and 2001, respectively, related to this
investment. Such venture capital investment gains (losses) were $(100.0) million
and $3.4 million in the first six months of 2002 and 2001, respectively.
FINANCE RECEIVABLES AND RETAINED INTERESTS IN SECURITIZATION TRUSTS
During the first six months of 2002, we completed five securitization
transactions, securitizing $2.3 billion of finance receivables. These
securitizations were structured in a manner that requires them to be accounted
for as secured borrowings, whereby the loans and securitization debt remain on
our balance sheet, rather than as sales, pursuant to SFAS 140. Such accounting
method is referred to as the "portfolio method".
We classify the finance receivables transferred to the securitization
trusts and held as collateral for the notes issued to investors as "finance
receivables-securitized." The average interest rate earned on these receivables
at June 30, 2002, was approximately 12.5 percent. We classify the notes issued
to investors in the securitization trusts as "notes payable related to
securitized finance receivables structured as collateralized borrowings."
We also completed various loan sale transactions. During the first six
months of 2002, we sold $.3 billion of finance receivables which generated net
gains of $17.4 million. We also recognized a loss of $47.3 million related to
the sale of $.4 billion of certain finance receivables sold as part of our cash
raising initiatives in order to meet our debt obligations. See "Special Charges"
elsewhere in the notes to the consolidated financial statements. In the first
six months of 2001, we sold $1.5 billion of receivables including: (i) our
$802.3 million vendor services loan portfolio (which was marked-to-market in the
fourth quarter of 2000 and no additional gain or loss was recognized in the
first six months of 2001); (ii) $568.4 million of high-loan-to-value mortgage
loans; and (iii) $96.4 million of other loans. These sales resulted in net gains
of $15.6 million in the first six months of 2001. The Company entered into a
servicing agreement on the high-loan-to-value mortgage loans sold. Pursuant to
the servicing agreement, the servicing fees payable to the Company are senior to
all other payments of the trust which purchased the loans. The Company also
holds a residual interest in certain other cash flows of the trust. The Company
did not provide any guarantees with respect to the performance of the loans
sold.
15
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
The following table summarizes our finance receivables - securitized by
business line (there were no such finance receivables related to discontinued
lines):
June 30, December 31,
2002 2001
---- ----
(Dollars in millions)
Continuing lines:
Manufactured housing............................................................... $ 7,516.7 $ 6,940.4
Mortgage services.................................................................. 5,749.0 5,658.2
Retail credit...................................................................... 818.0 878.9
Consumer finance - closed-end...................................................... 486.5 580.8
Floorplan.......................................................................... 316.3 436.9
--------- ---------
14,886.5 14,495.2
Less allowance for credit losses................................................... 356.8 296.7
--------- ---------
Total finance receivables - securitized.......................................... $14,529.7 $14,198.5
========= =========
16
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
The following table summarizes our other finance receivables by business
line and categorized as either: (i) a part of our continuing lines; or (ii) a
part of our discontinued lines:
June 30, December 31,
2002 2001
---- ----
(Dollars in millions)
Continuing lines:
Manufactured housing............................................................... $ 215.4 $ 609.3
Mortgage services.................................................................. 860.4 1,128.9
Retail credit...................................................................... 1,931.5 1,811.1
Consumer finance - closed-end...................................................... 8.6 6.3
-------- --------
3,015.9 3,555.6
Less allowance for credit losses................................................... 102.9 111.6
-------- --------
Net other finance receivables for continuing lines............................... 2,913.0 3,444.0
-------- --------
Discontinued lines.................................................................... 173.8 379.7
Less allowance for credit losses................................................... 6.7 13.0
-------- --------
Net other finance receivables for discontinued lines............................. 167.1 366.7
-------- --------
Total other finance receivables.................................................. $3,080.1 $3,810.7
======== ========
The changes in the allowance for credit losses included in finance
receivables (both securitized and other portfolios) were as follows:
Three months ended Six months ended
June 30, June 30,
------------------ -----------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars in millions)
Allowance for credit losses, beginning of period................ $439.9 $ 312.1 $ 421.3 $ 306.8
Additions to the allowance:
Provision for losses......................................... 158.3 111.0 316.7 226.7
Change in allowance due to purchases and sales of certain
finance receivables........................................ 1.6 2.9 3.9 (5.5)
Credit losses................................................... (133.4) (107.8) (275.5) (209.8)
------ ------- ------- -------
Allowance for credit losses, end of period...................... $466.4 $ 318.2 $ 466.4 $ 318.2
====== ======= ======= =======
The securitizations structured prior to September 8, 1999, met the
applicable criteria to be accounted for as sales. At the time the loans were
securitized and sold, we recognized a gain and recorded our retained interest
represented by the interest-only security. The interest-only security represents
the right to receive, over the life of the pool of receivables: (i) the excess
of the principal and interest received on the receivables transferred to the
special purpose entity over the principal and interest paid to the holders of
other interests in the securitization; and (ii) contractual servicing fees. In
some of those securitizations, we also retained certain lower-rated securities
that are senior in payment priority to the interest-only securities. Such
retained securities (classified as actively managed fixed maturity securities)
had a par value, fair value and amortized cost of $733.9 million, $511.6 million
and $687.8 million, respectively, at June 30, 2002.
17
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
The interest-only securities on our balance sheet represent an allocated
portion of the cost basis of the finance receivables in the securitization
transactions accounted for as sales related to transactions structured prior to
September 8, 1999. Our interest-only securities and other retained interests in
those securitization transactions are subordinate to the interests of other
investors. Their values are subject to credit, prepayment, and interest rate
risk on the securitized finance receivables. We determine the discount rate to
value these securities based on our estimates of current market rates of
interest for securities with similar yield, credit quality and maturity
characteristics. We include the difference between estimated fair value and the
amortized cost of the interest-only securities (after adjustments for
impairments required to be recognized in earnings) in "accumulated other
comprehensive loss, net of taxes." We used the following assumptions to adjust
the amortized cost to estimated fair value at June 30, 2002 and December 31,
2001. If actual performance differs from these assumptions, we may be required
to recognize additional impairment charges related to the value of our
interest-only securities and servicing rights.
Interests Interests
Manufactured Home equity/ Consumer/ held by held by
June 30, 2002 housing home improvement equipment Total others Conseco
- ------------- ------- ---------------- --------- ----- ------ -------
(Dollars in millions)
Interest-only securities at fair value............ $ 116.0 $ 141.6 $ 7.8 $ 265.4 $(58.3) $207.1
Cumulative principal balance of sold finance
receivables at June 30, 2002................... 16,481.7 4,099.2 966.4 21,547.3
Weighted average stated customer interest rate
on sold finance receivables.................... 9.8% 11.9% 10.5%
Assumptions to determine estimated fair value
of interest-only securities at June 30, 2002:
Expected prepayment speed as a percentage
of principal balance of sold finance
receivables (a)............................ 7.1% 16.5% 18.4%
Expected nondiscounted credit losses as a
percentage of principal balance of
related finance receivables (a)............ 11.3% 7.1% 6.0%
Weighted average discount rate .............. 16.0% 16.0% 16.0%
Interests Interests
Manufactured Home equity/ Consumer/ held by held by
December 31, 2001 housing home improvement equipment Total others Conseco
- ----------------- ------- ---------------- --------- ----- ------ -------
(Dollars in millions)
Interest-only securities at fair value............ $ 32.3 $ 155.8 $ 8.8 $ 196.9 $(55.2) $141.7
Cumulative principal balance of sold finance
receivables at December 31, 2001............... 17,732.2 4,947.4 1,210.1 23,889.7
Weighted average stated customer interest rate on
sold finance receivables....................... 9.8% 12.0% 10.6%
Assumptions to determine estimated fair value of
interest-only securities at December 31, 2001:
Expected prepayment speed as a percentage
of principal balance of sold finance
receivables (a)............................ 7.1% 17.4% 18.8%
Expected nondiscounted credit losses as a
percentage of principal balance of related
finance receivables (a).................... 11.7% 7.4% 6.1%
Weighted average discount rate............... 16.0% 16.0% 16.0%
18
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
(a) The valuation of interest-only securities is affected not only by the
projected level of prepayments of principal and net credit losses, but also
by the projected timing of such prepayments and net credit losses. Should
such timing differ materially from our projections, it could have a
material effect on the valuation of our interest-only securities.
Additionally, such valuation is determined by discounting cash flows over
the entire expected life of the receivables sold.
Under current accounting rules (pursuant to EITF Issue No. 99-20
"Recognition of Interest Income and Impairments on Purchased and Retained
Beneficial Interests in Securitized Financial Assets" (" EITF 99-20")) which we
adopted effective July 1, 2000, declines in the value of our interest-only
securities are recognized when: (i) the fair value of the retained beneficial
interests are less than their carrying value; and (ii) the timing and/or amount
of cash expected to be received from the retained beneficial interests have
changed adversely from the previous valuation which determined the carrying
value of the retained beneficial interests. When both occur, the retained
beneficial interests are written down to fair value.
We recognized an impairment charge (net of adjustments to the valuation
allowance associated with our servicing rights) of $41.7 million in the first
six months of 2001 for the interest-only securities that were not performing as
well as expected based on our previous valuation estimates. No such impairment
charge was recognized in the first six months of 2002.
The following table summarizes certain cash flows received from and paid to
the securitization trusts during the three and six month periods ended June 30,
2002 and 2001 (dollars in millions):
Three months Six months
ended June 30, ended June 30,
---------------- --------------
2002 2001 2002 2001
---- ---- ---- ----
Servicing fees received................................................. $ 10.8 $17.9 $ 22.6 $ 42.4
Cash flows from interest-only securities, net........................... (31.3) 1.8 (30.5) 7.9
Cash flows from retained bonds.......................................... 28.0 17.4 52.6 34.9
Servicing advances paid................................................. (69.1) (195.4) (155.4) (399.9)
Repayment of servicing advances......................................... 65.7 193.1 148.8 388.0
We have projected that the adverse manufactured housing default experience
in 2001 and the first half of 2002 will improve over time beginning in the third
quarter of 2002. As a result of these assumptions, we project that payments
related to guarantees issued in conjunction with the sales of certain finance
receivables will exceed the gross cash flows from the interest-only securities
by approximately $55 million during the remainder of 2002 and $65 million in
2003. We project the gross cash flows from the interest-only securities will
exceed the payments related to guarantees issued in conjunction with the sales
of certain finance receivables by approximately $5 million in 2004 and $15
million in 2005 and by approximately $530 million in all years thereafter. These
projected payments are considered in the projected cash flows we use to value
our interest-only securities. There can be no assurance that we will have
adequate liquidity to make such guarantee payments.
Effective September 30, 2001, we transferred substantially all of our
interest-only securities into a securitization trust. The transaction provided a
means to finance a portion of the value of our interest-only securities by
selling some of the cash flows to Lehman Brothers, Inc. and affiliates
(collectively "Lehman"). The transfer was accounted for as a sale in accordance
with SFAS 140. However, no gain or loss was recognized because the aggregate
fair value of the interest retained by the Company and the cash received from
the sale were equal to the carrying value of the interest-only securities prior
to their transfer to the trust. The trust is a special purpose entity and is not
consolidated pursuant to SFAS 140. We received a trust security representing an
interest in the trust equal to 85 percent of the estimated future cash flows of
the interest-only securities held in the trust. Lehman purchased the remaining
15 percent interest. The value of the interest purchased by Lehman was $58.3
million at June 30, 2002. The Company continues to be the servicer of the
finance receivables underlying the interest-only securities transferred to the
trust. Lehman has the ability to accelerate the principal payments related to
their interest after a stated period. Until such time, Lehman is required to
maintain a 15 percent interest in the estimated future cash flows of the trust.
By aggregating the interest-only securities into one structure, the impairment
test for these securities are conducted on a single set of cash flows
representing the Company's 85 percent interest in the trust. Accordingly,
adverse changes in cash flows from one interest-only security are offset by
positive changes in another. The new structure does not avoid an
19
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
impairment charge if sufficient positive cash flows in the aggregate are not
available. Further, increases in cash flows above the adverse cash flows cannot
be recognized in earnings.
The following table summarizes quantitative information about
delinquencies, net credit losses, and components of managed finance receivables:
Principal balance
60 days or more Net credit
Principal balance past due losses
------------------------- --------------------------- ---------------
Six months
June 30, December 31, June 30, December 31, ended June 30,
---------------
2002 2001 2002 2001 2002 2001
---- ---- ---- ---- ---- ----
(Dollars in millions)
Type of finance receivables
Manufactured housing................... $24,608.1 $25,575.1 $614.3 $610.5 $289.7 $277.9
Home equity/home improvement........... 10,859.4 11,851.4 125.7 139.9 124.8 125.5
Consumer............................... 4,011.8 4,198.8 78.7 112.6 123.4 99.4
Commercial............................. 512.6 1,377.0 6.3 16.2 14.8 34.9
--------- --------- ------ ------ ------ ------
Total managed receivables.............. 39,991.9 43,002.3 825.0 879.2 552.7 537.7
Less finance receivables securitized
and repossessed assets............ 21,683.9 24,297.3 406.8 464.9 277.2 327.9
--------- --------- ------ ------ ------ ------
Finance receivables held on balance
sheet before allowance for credit
losses and deferred points and
other, net........................ 18,308.0 18,705.0 $418.2 $414.3 $275.5 $209.8
====== ====== ====== ======
Less allowance for credit losses....... 466.4 421.3
Less deferred points and other, net.... 231.8 274.5
--------- ---------
Finance receivables held on
balance sheet....................... $17,609.8 $18,009.2
========= =========
20
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
Activity in the interest-only securities account was as follows:
Six months ended
June 30,
-------------------
2002 2001
---- ----
(Dollars in millions)
Balance, beginning of period................................................................... $141.7 $432.9
Investment income........................................................................... 10.0 31.7
Cash paid (received):
Gross cash received....................................................................... (32.9) (32.2)
Guarantee payments related to clean-up calls (a).......................................... 9.3 14.7
Guarantee payments related to bonds held by others........................................ 26.1 12.6
Guarantee payments related to retained bonds (included in actively managed
fixed maturities)....................................................................... 37.3 11.7
Impairment charge to reduce carrying value.................................................. - (47.8)
Sale of securities related to a discontinued line........................................... - (12.4)
Change in interest purchased by Lehman in conjunction with securitization transaction....... (3.1) -
Change in unrealized appreciation recorded in shareholders' equity.......................... 18.7 47.5
------ ------
Balance, end of period......................................................................... $207.1 $458.7
====== ======
- --------------------
(a) During the first six months of 2002 and 2001, clean-up calls were exercised
for certain securitizations that were previously recognized as sales. The
interest-only securities related to these securitizations had previously
been separately securitized with other interest-only securities in
transactions recognized as sales. The Company holds the residual interests
issued by the securitization trusts. The terms of the residual interests
require the holder to make payments to the securitization trust when a
clean-up call related to an underlying trust (a trust which issued
interest-only securities held by the securitization trust) occurs. These
payments are used to accelerate principal payments to the holders of the
other securities issued by the securitization trusts. During the first six
months of 2002 and 2001, the Company was required to make payments to the
securitization trusts. These payments increased our basis in the retained
interests, as the related liability assumed by the Company (and reflected
in the value of the retained interest) was extinguished.
AMORTIZATION OF THE COST OF POLICIES PURCHASED
The cost assigned to the right to receive future cash flows from contracts
existing at the date of an acquisition is referred to as the cost of policies
purchased which is an intangible asset subject to amortization. We amortize
these costs using the interest rate credited to the underlying policy: (i) in
relation to the estimated gross profits for universal life-type and
investment-type products; or (ii) in relation to future anticipated premium
revenue for other products.
When we realize a gain or loss on investments backing our universal life or
investment-type products, we adjust the amortization to reflect the change in
estimated gross profits from the products due to the gain or loss realized and
the effect of the event on future investment yields. We also adjust the cost of
policies purchased for the change in amortization that would have been recorded
if actively managed fixed maturity securities had been sold at their stated
aggregate fair value and the proceeds reinvested at current yields. We include
the impact of this adjustment in accumulated other comprehensive income (loss)
within shareholders' equity.
The amortization related to the cost of policies purchased was $100.7
million and $144.3 million in the first six months of 2002 and 2001,
respectively. The Company expects to amortize approximately 13 percent of the
December 31, 2001, balance of cost of policies purchased in 2002, 11 percent in
2003, 8 percent in 2004, 10 percent in 2005 and 7 percent in 2006.
21
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
EARNINGS PER SHARE
A reconciliation of income (loss) before extraordinary gain (loss) and
cumulative effect of accounting change and shares used to calculate basic and
diluted earnings per share is as follows:
Three months ended Six months ended
June 30, June 30,
------------------ -------------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars in millions
and shares in thousands)
Income (loss) before extraordinary gain (loss) and cumulative
effect of accounting change........................................ $(1,334.2) $(20.7) $(1,434.1) $63.1
Preferred stock dividends............................................. (.9) (4.6) (1.9) (8.5)
--------- ------ --------- -----
Income (loss) before extraordinary gain (loss) and
cumulative effect of accounting change applicable to
common ownership for basic earnings per share.................. (1,335.1) (25.3) (1,436.0) 54.6
Effect of dilutive securities......................................... - - - -
--------- ------ --------- -----
Income (loss) before extraordinary gain (loss) and
cumulative effect of accounting change applicable to
common ownership and assumed conversions for
diluted earnings per share.................................... $(1,335.1) $(25.3) $(1,436.0) $54.6
========= ====== ========= =====
Shares:
Weighted average shares outstanding for basic earnings per share... 346,005 337,773 345,607 334,454
Effect of dilutive securities on weighted average shares:
Stock options...................................................... - - - 13,263
Employee benefit plans............................................. - - - 2,620
Dilutive potential common shares................................. - - - 15,883
--------- ------- ------- -------
Weighted average shares outstanding for diluted earnings
per share...................................................... 346,005 337,773 345,607 350,337
========= ======= ======= =======
There were no dilutive common stock equivalents during the 2002 periods and
the three month period ended June 30, 2001 because of the net loss realized by
the Company during such periods.
22
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
The following summarizes the equivalent common shares for securities that
were not included in the computation of diluted earnings per share during the
three and six months ended June 30, 2002 and 2001, because doing so would have
been antidilutive in the periods presented. Such securities could potentially
dilute earnings per share in future periods.
Three months ended Six months ended
June 30, June 30,
------------------- -----------------
2002 2001 2002 2001
---- ---- ---- ----
(Shares in thousands)
Equivalent common shares that were antidilutive during the period:
Stock options....................................................... 3,351 14,147 2,914 -
Employee benefit plans.............................................. 889 3,055 907 -
Assumed conversion of convertible preferred stock................... 28,414 27,305 28,273 27,170
------ ------ ------ ------
Antidilutive equivalent common shares............................. 32,654 44,507 32,094 27,170
====== ====== ====== ======
BUSINESS SEGMENTS
We manage our business operations through two segments, based on the
products offered, in addition to the corporate segment.
Insurance and fee-based segment. Our insurance and fee-based segment
provides supplemental health, annuity and life insurance products to a broad
spectrum of customers through multiple distribution channels, each focused on a
specific market segment. These products are primarily marketed through career
agents, professional independent producers and direct marketing. Fee-based
activities include services performed for other companies, including: (i)
investment management; and (ii) insurance product marketing.
Finance segment. Our finance segment provides a variety of finance products
including: loans for the purchase of manufactured housing, home improvements and
various consumer products, home equity loans, private label credit card
programs, and floorplan financing. These products are primarily marketed through
intermediary channels such as dealers, vendors, contractors and retailers.
Corporate and other segment. Our corporate segment includes certain
investment activities, such as our venture capital investment in AWE, and, prior
to its sale, our ownership interest in the riverboat casino in Lawrenceburg,
Indiana. In addition, the corporate segment includes interest expense related to
the Company's corporate debt, special corporate charges, income (loss) from the
discontinued major medical business and other income and expenses. Corporate
expenses are net of charges to our subsidiaries for services provided by the
corporate operations.
23
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
Segment operating information was as follows:
Three months ended Six months ended
June 30, June 30,
------------------ ----------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars in millions)
Revenues:
Insurance and fee-based segment:
Insurance policy income:
Annuities................................................. $ 44.5 $ 32.6 $ 81.1 $ 58.5
Supplemental health....................................... 564.1 555.4 1,137.3 1,111.6
Life...................................................... 133.2 209.0 315.0 416.6
Other..................................................... 28.8 32.6 59.3 66.0
Net investment income (a)................................... 267.4 413.0 613.6 777.8
Fee revenue and other income (a)............................ 25.1 26.3 53.5 52.3
Net investment losses (a)................................... (260.4) (40.3) (290.8) (153.6)
-------- -------- -------- --------
Total insurance and fee-based segment revenues.......... 802.7 1,228.6 1,969.0 2,329.2
-------- -------- -------- --------
Finance segment:
Net investment income:
Interest-only securities (a).............................. 5.1 16.6 10.0 31.7
Manufactured housing...................................... 236.7 210.5 462.1 409.9
Mortgage services......................................... 194.7 191.1 389.8 391.7
Consumer/credit card...................................... 110.0 106.6 221.1 215.5
Commercial................................................ 13.1 35.9 36.9 72.3
Other (a)................................................. - - - 7.3
Gain on sale of finance receivables......................... 10.2 6.7 17.4 15.6
Fee revenue and other income................................ 63.1 87.7 131.2 175.3
Impairment charge related to retained interests in
securitization transactions............................... - (33.8) - (41.7)
-------- -------- -------- --------
Total finance segment revenues.......................... 632.9 621.3 1,268.5 1,277.6
-------- -------- -------- --------
Corporate and other:
Net investment income....................................... 3.3 6.7 5.7 17.6
Venture capital income (loss) related to investment in AWE.. (23.7) 50.5 (100.0) 3.4
Gain on sale of interest in riverboat....................... - - - 192.4
Revenue from the discontinued major medical business........ 118.8 201.0 259.8 416.9
Other income................................................ - - - .9
-------- -------- -------- --------
Total corporate segment revenues........................ 98.4 258.2 165.5 631.2
-------- -------- -------- --------
Eliminations.................................................. (12.1) (5.8) (21.8) (12.7)
-------- -------- -------- --------
Total revenues.......................................... 1,521.9 2,102.3 3,381.2 4,225.3
-------- -------- -------- --------
Expenses:
Insurance and fee-based segment:
Insurance policy benefits................................... 598.7 727.5 1,307.0 1,437.7
Amortization................................................ 239.5 206.3 413.0 357.9
Interest expense on investment borrowings................... 3.7 12.2 11.2 16.7
Other operating costs and expenses.......................... 124.8 148.3 268.8 297.1
Special charges............................................. 42.8 3.6 48.1 12.7
-------- -------- -------- --------
Total insurance and fee-based segment expenses............ 1,009.5 1,097.9 2,048.1 2,122.1
-------- -------- -------- --------
(continued)
24
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
(continued from previous page)
Three months ended Six months ended
June 30, June 30,
------------------ ----------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars in millions)
Finance segment:
Provision for losses........................................ $ 158.3 $ 111.0 $ 316.7 $ 226.7
Interest expense............................................ 286.0 306.6 575.5 628.2
Special charges............................................. 9.3 2.4 56.5 16.2
Other operating costs and expenses.......................... 148.0 157.4 302.6 320.7
-------- -------- -------- --------
Total finance segment expenses............................ 601.6 577.4 1,251.3 1,191.8
-------- -------- -------- --------
Corporate and other:
Interest expense on corporate debt.......................... 80.2 93.6 155.4 193.5
Provision for losses and expenses related to stock
purchase plan............................................. 100.0 - 140.0 -
Expenses from the discontinued major medical
business.................................................. 118.8 261.8 259.8 485.6
Other corporate expenses, less charges to subsidiaries for
services provided......................................... 5.2 9.3 14.8 6.1
Special charges and other................................... 80.9 28.7 97.9 25.2
-------- -------- -------- --------
Total corporate segment expenses.......................... 385.1 393.4 667.9 710.4
-------- -------- -------- --------
Eliminations.................................................. (12.1) (5.8) (21.8) (12.7)
-------- -------- -------- --------
Total expenses............................................ 1,984.1 2,062.9 3,945.5 4,011.6
-------- -------- -------- --------
Income (loss) before income taxes, minority interest, extraordinary
gain (loss)and cumulative effect of accounting change:
Insurance and fee-based operations.......................... (206.8) 130.7 (79.1) 207.1
Finance operations.......................................... 31.3 43.9 17.2 85.8
Corporate interest expense and other items.................. (286.7) (135.2) (502.4) (79.2)
-------- -------- -------- -------
Income (loss) before income taxes, minority interest,
extraordinary gain (loss) and cumulative effect of
accounting change..................................... $ (462.2) $ 39.4 $ (564.3) $ 213.7
======== ======== ======== =======
- --------------------
(a) It is not practicable to provide additional components of revenue by
product or service.
ACCOUNTING FOR DERIVATIVES
Our equity-indexed annuity products provide a guaranteed base rate of
return and a higher potential return linked to the performance of the Standard &
Poor's 500 Index ("S&P 500 Index") based on a percentage (the participation
rate) over an annual period. At the beginning of each policy year, a new index
period begins. The Company is able to change the participation rate at the
beginning of each index period, subject to contractual minimums. We buy S&P 500
Call Options in an effort to hedge potential increases to policyholder benefits
resulting from increases in the S&P 500 Index to which the product's return is
linked. We include the cost of the S&P 500 Call Options in the pricing of these
products. Policyholder account balances for these annuities fluctuate in
relation to changes in the values of these options. We reflect changes in the
estimated market value of these options in net investment income. Option costs
that are attributable to benefits provided were $52.2 million and $61.5 million
in the first six months of 2002 and 2001, respectively. These costs are
reflected in the change in market value of the S&P 500 Call Options included in
investment income. Net investment income (loss) related to equity-
25
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
indexed products before this expense was $(18.2) million and $5.4 million in the
first six months of 2002 and 2001, respectively. Such amounts were substantially
offset by the corresponding charge to insurance policy benefits. The estimated
fair value of the S&P 500 Call Options was $15.9 million and $49.8 million at
June 30, 2002 and December 31, 2001, respectively. We classify such instruments
as other invested assets. The Company accounts for the options issued to the
policyholder for the estimated life of the annuity contract as embedded
derivatives as defined by Statement of Financial Accounting Standards No. 133,
"Accounting for Derivative Instruments and Hedging Activities", as amended by
Statement of Financial Accounting Standards No. 137, "Deferral of the Effective
Date of FASB Statement No. 133" and Statement of Financial Accounting Standards
No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging
Activities" (collectively referred to as "SFAS 138"). The Company records the
change in the fair values of the embedded derivatives in current earnings as a
component of policyholder benefits. The fair value of these derivatives, which
are classified as "liabilities for interest-sensitive products", was $376.2
million and $491.2 million at June 30, 2002 and December 31, 2001, respectively.
In 2001, we entered into interest rate swap agreements to convert the fixed
rate on our senior notes (10.75 percent) to a variable rate based on LIBOR plus
5.7525 percent. In accordance with the requirements of SFAS 138, the change in
the fair value of the interest rate swap and the gain or loss on the hedged
senior notes attributable to the hedged interest rate risk were recorded in
current-period earnings. Because the terms of the interest rate swap agreements
substantially match the terms of the senior notes, the gain or loss on the swap
and the senior notes will generally be equal and offsetting (although the
effective interest rate on our debt would be affected).
At December 31, 2001, "notes payable-direct corporate obligations" was
decreased by $13.5 million, to reflect the estimated fair value of such interest
rate swap agreements. Such interest rate swap agreements were terminated in
April 2002 generating cash proceeds of $3.5 million. Such amount represented
$11.9 million of cash due to the Company pursuant to the terms of the swaps, net
of $8.4 million which represented the fair value of the interest rate swaps on
the date of termination. The $8.4 million will be amortized as additional
interest expense over the remaining life of our senior notes.
The Company entered into a forward sale contract related to a portion of
its venture capital investment in AWE. Such contract is carried at market value,
with the change in such value being recognized as venture capital income (loss).
The value of the derivative fluctuates in value in relation to the AWE common
stock it relates to. See "Venture Capital Investment in AT&T Wireless Services,
Inc." above for additional information.
If the counterparties for the derivatives we hold fail to meet their
obligations, Conseco may have to recognize a loss. Conseco limits its exposure
to such a loss by diversifying among several counterparties believed to be
strong and creditworthy. At June 30, 2002, all of the counterparties were rated
"A" or higher by Standard & Poor's Corporation.
GUARANTEES
In conjunction with certain sales of finance receivables, our finance
subsidiary provided guarantees aggregating approximately $1.4 billion at June
30, 2002. We consider any potential payments related to these guarantees in the
projected net cash flows used to determine the value of our interest-only
securities. If we have to make more payments on these guarantees than
anticipated, or we experience higher than anticipated rates of repayment,
including due to foreclosure or charge-offs, or any adverse changes in our
assumptions used for valuation, we would be required to recognize additional
impairment charges. During the first six months of 2002 and 2001, interest and
principal payments related to such guarantees on bonds held by others totaled
$26.1 million and $12.6 million, respectively. There can be no assurance that we
will have adequate liquidity to make such guarantee payments.
We have guaranteed bank loans totaling $537.3 million to approximately 155
current and former directors, officers and key employees. As described in the
note to the consolidated financial statement entitled "Liquidity Issues", the
Company has violated a debt to capitalization ratio loan covenant which could
result in the immediate acceleration of our obligation pursuant to the Company's
guarantee. We have requested from the relevant lenders a waiver of the covenant
violation effective as of June 30, 2002 through September 9, 2002. There can be
no assuarance that we can obtain such waivers. The funds were used by the
participants to purchase approximately 18.0 million shares of Conseco common
stock in open market or negotiated transactions with independent parties. Such
shares are held by the bank as collateral for the loans. In addition, Conseco
has provided loans to participants for interest on the bank loans totaling
$159.0 million. During the third quarter of 2000, the Company negotiated a new
guarantee with the banks which expires on December 31, 2003, and made it
available to participants who qualified and chose to participate in a new
lending program.
26
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
A key goal of the program is to reduce the balance of each participant's
bank and interest loans to $25 per share of stock purchased through the program.
Such reductions are to occur through cash payments and pay for performance
programs. In order to receive the pay for performance program benefits,
participants in the new program are required to put to the Company, 75 percent
of the value in excess of $25 per share of the shares purchased through this
program, as determined on December 31, 2003. A subsidiary of Conseco has pledged
$55.3 million of cash collateral in conjunction with the guarantee of a portion
of the bank loans. Conseco also granted a security interest in most of its
assets in conjunction with the guarantee of a portion of the bank loans. During
the first six months of 2002, we established a noncash provision in connection
with these guarantees and loans of $140.0 million. Such provision is incl