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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 September 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 November 11, 2002: 346,007,133
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(Dollars in millions)
ASSETS
September 30, December 31,
2002 2001
---- ----
(unaudited)
Investments:
Actively managed fixed maturities at fair value (amortized cost: 2002 - $19,481.6;
2001 - $22,422.8).......................................................................... $19,785.4 $21,818.5
Retained interests in securitization trusts at fair value (amortized cost: 2002 - $526.0;
2001 - $876.1)............................................................................. 526.0 710.1
Equity securities at fair value (cost: 2002 - $156.2; 2001 - $257.3)......................... 139.1 227.0
Mortgage loans............................................................................... 1,281.3 1,228.0
Policy loans................................................................................. 538.8 635.8
Venture capital investment in AT&T Wireless Services, Inc. (cost: 2002 - $14.2; 2001- $39.0). 17.7 155.3
Other invested assets ....................................................................... 337.9 292.4
---------- -----------
Total investments........................................................................ 22,626.2 25,067.1
Cash and cash equivalents:
Held by the parent company................................................................... 109.4 152.2
Held by the parent company in segregated accounts............................................ - 54.7
Held by subsidiaries......................................................................... 1,498.8 2,853.9
Accrued investment income....................................................................... 653.7 688.6
Finance receivables............................................................................. 2,572.3 3,810.7
Finance receivables - securitized............................................................... 13,947.7 14,198.5
Cost of policies purchased...................................................................... 1,220.9 1,657.8
Cost of policies produced....................................................................... 2,050.5 2,570.2
Reinsurance receivables......................................................................... 957.3 663.0
Income tax assets............................................................................... 79.8 678.1
Goodwill........................................................................................ 100.0 3,695.4
Assets held in separate accounts and investment trust .......................................... 704.7 2,376.3
Cash held in segregated accounts for investors.................................................. 432.4 550.2
Cash held in segregated accounts related to servicing agreements and securitization
transactions................................................................................. 1,197.2 994.6
Assets of discontinued operations............................................................... 2,542.5 -
Other assets.................................................................................... 1,592.2 1,420.9
----------- -----------
Total assets............................................................................. $52,285.6 $61,432.2
========= =========
(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 (DEFICIT)
September 30, December 31,
2002 2001
---- ----
(unaudited)
Liabilities:
Liabilities for insurance and asset accumulation products:
Interest-sensitive products.............................................................. $13,944.6 $15,787.7
Traditional products..................................................................... 7,826.0 8,172.8
Claims payable and other policyholder funds.............................................. 933.9 1,005.5
Liabilities related to separate accounts and investment trust............................ 704.7 2,376.3
Liabilities related to certificates of deposit........................................... 2,124.1 1,790.3
Investor payables.......................................................................... 432.4 550.2
Guarantee liability related to interests in securitization trusts held by others........... 198.6 39.9
Other liabilities.......................................................................... 1,977.2 1,699.3
Liabilities of discontinued operations..................................................... 2,458.8 -
Investment borrowings...................................................................... 843.1 2,242.7
Notes payable:
Direct corporate obligations............................................................. 4,016.7 4,087.6
Direct finance obligations:
Master repurchase agreements........................................................... 465.8 1,670.8
Credit facility collateralized by retained interests in securitizations................ 512.3 507.3
Other borrowings....................................................................... 76.4 349.8
Related to securitized finance receivables structured as collateralized borrowings....... 14,662.9 14,484.5
--------- ---------
Total liabilities.................................................................... 51,177.5 54,764.7
--------- ---------
Minority interest:
Company-obligated mandatorily redeemable preferred securities of subsidiary trusts......... 1,919.9 1,914.5
Shareholders' equity (deficit):
Preferred stock............................................................................ 501.7 499.6
Common stock and additional paid-in capital (no par value, 1,000,000,000 shares
authorized, shares issued and outstanding: 2002 - 346,007,133; 2001 - 344,743,196)....... 3,497.3 3,484.3
Accumulated other comprehensive income (loss).............................................. 130.4 (439.0)
Retained earnings (deficit)................................................................ (4,941.2) 1,208.1
---------- ----------
Total shareholders' equity (deficit)................................................. (811.8) 4,753.0
----------- ----------
Total liabilities and shareholders' equity (deficit)................................. $52,285.6 $61,432.2
========= =========
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 Nine months ended
September 30, September 30,
-------------------- -------------------
2002 2001 2002 2001
---- ---- ---- ----
Revenues:
Insurance policy income.......................................................... $ 902.6 $ 986.7 $2,726.2 $3,005.5
Net investment income:
Insurance and fee-based segment general account assets......................... 371.4 429.9 1,163.2 1,290.3
Finance segment assets......................................................... 533.3 582.1 1,647.2 1,698.9
Equity-indexed and separate account products................................... (32.6) (29.7) (106.3) (87.7)
Venture capital loss related to investment in AT&T Wireless Services, Inc...... (6.6) (87.4) (106.6) (84.0)
Other.......................................................................... 3.7 2.4 9.4 20.0
Gain (loss) on sale of finance receivables....................................... (31.3) 6.0 (13.9) 21.6
Gain on sale of interest in riverboat............................................ - - - 192.4
Net realized investment losses .................................................. (271.7) (156.6) (524.9) (302.7)
Impairment charge related to retained interests in securitization transactions... (701.3) (345.2) (701.3) (386.9)
Fee revenue and other income..................................................... 85.5 105.0 257.3 333.8
-------- --------- -------- --------
Total revenues............................................................... 853.0 1,493.2 4,350.3 5,701.2
-------- --------- -------- --------
Benefits and expenses:
Insurance policy benefits........................................................ 883.4 893.8 2,469.9 2,685.7
Provision for losses............................................................. 286.5 193.8 735.2 420.5
Interest expense................................................................. 372.5 396.8 1,113.1 1,221.0
Amortization..................................................................... 200.2 207.4 635.2 610.8
Other operating costs and expenses............................................... 348.1 338.8 963.2 1,024.4
Goodwill impairment.............................................................. 500.0 - 500.0 -
Special charges.................................................................. 88.2 14.7 213.0 70.5
-------- --------- -------- --------
Total benefits and expenses.................................................. 2,678.9 2,045.3 6,629.6 6,032.9
-------- --------- -------- --------
Loss before income taxes, minority interest, discontinued operations,
extraordinary gain (loss) and cumulative effect of accounting change...... (1,825.9) (552.1) (2,279.3) (331.7)
Income tax expense (benefit):
Tax benefit on period income................................................. (487.8) (182.3) (640.3) (91.5)
Valuation allowance for deferred tax assets.................................. 311.4 - 1,314.4 -
-------- --------- -------- --------
Loss before minority interest, discontinued operations, extraordinary
gain (loss) and cumulative effect of accounting change..................... (1,649.5) (369.8) (2,953.4) (240.2)
Minority interest:
Distributions on Company-obligated mandatorily redeemable preferred securities
of subsidiary trusts, net of income taxes..................................... 29.2 29.1 87.6 90.4
-------- --------- -------- --------
Loss before discontinued operations, extraordinary gain (loss) and cumulative
effect of accounting change................................................ (1,678.7) (398.9) (3,041.0) (330.6)
Discontinued operations............................................................. (90.3) (9.3) (162.1) (14.5)
Extraordinary gain (loss) on extinguishment of debt, net of income taxes............ - .7 5.1 (4.0)
Cumulative effect of accounting change for goodwill impairment...................... - - (2,949.2) -
-------- --------- -------- --------
Net loss..................................................................... (1,769.0) (407.5) (6,147.2) (349.1)
Preferred stock dividends........................................................... .2 3.1 2.1 11.6
--------- --------- -------- --------
Net loss applicable to common stock.......................................... $(1,769.2) $(410.6) $(6,149.3) $(360.7)
========= ======= ========= =======
(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 Nine months ended
September 30, September 30,
------------------- ------------------
2002 2001 2002 2001
---- ---- ---- ----
Loss per common share:
Basic:
Weighted average shares outstanding................................... 346,008,000 340,276,000 345,741,000 336,395,000
=========== =========== =========== ===========
Loss before discontinued operations, extraordinary gain (loss)
and cumulative effect of accounting change......................... $(4.85) $(1.18) $ (8.80) $(1.02)
Discontinued operations............................................... (.26) (.03) (.47) (.04)
Extraordinary gain (loss) on extinguishment of debt................... - - .01 (.01)
Cumulative effect of accounting change................................ - - (8.53) -
------ ------ ------- ------
Net loss.......................................................... $(5.11) $(1.21) $(17.79) $(1.07)
====== ====== ======= ======
Diluted:
Weighted average shares outstanding................................... 346,008,000 340,276,000 345,741,000 336,395,000
=========== =========== =========== ===========
Loss before discontinued operations, extraordinary gain (loss)
and cumulative effect of accounting change........................ $(4.85) $(1.18) $(8.80) $(1.02)
Discontinued operations............................................... (.26) (.03) (.47) (.04)
Extraordinary gain (loss) on extinguishment of debt................... - - .01 (.01)
Cumulative effect of accounting change................................ - - (8.53) -
------ ------ ------ ------
Net loss.......................................................... $(5.11) $(1.21) $(17.79) $(1.07)
====== ====== ======= ======
The accompanying notes are an integral part
of the consolidated financial statements.
5
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (DEFICIT)
(Dollars in millions)
(unaudited)
Common stock Accumulated other Retained
Preferred and additional comprehensive earnings
Total stock paid-in capital income (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........................................ (6,147.2) - - - (6,147.2)
Change in unrealized appreciation
(depreciation) of investments (net of
applicable income tax expense of $324.0)...... 569.4 - - 569.4 -
--------
Total comprehensive loss.................... (5,577.8)
Change in shares for stock options and for
employee benefit plans.......................... 13.0 - 13.0 - -
Payment-in-kind dividends on convertible
preferred stock................................. 2.1 2.1 - - -
Dividends on preferred stock...................... (2.1) - - - (2.1)
-------- ------ -------- ------- ----------
Balance, September 30, 2002.......................... $ (811.8) $501.7 $3,497.3 $ 130.4 $(4,941.2)
======== ====== ======== ======= =========
Balance, January 1, 2001............................. $4,374.4 $486.8 $2,911.8 $(651.0) $ 1,626.8
Comprehensive income, net of tax:
Net loss........................................ (349.1) - - - (349.1)
Change in unrealized depreciation of
investments (net of applicable income tax
expense of $200.0)............................ 350.6 - - 350.6 -
--------
Total comprehensive income.................. 1.5
Issuance of shares pursuant to stock purchase
contracts related to FELINE PRIDES.............. 496.6 - 496.6 - -
Issuance of shares pursuant to acquisition of
ExlServices.com, Inc............................ 52.6 - 52.6 - -
Issuance of shares for stock options and for
employee benefit plans.......................... 20.5 - 20.5 - -
Payment-in-kind dividends on convertible
preferred stock................................. 11.6 11.6 - - -
Dividends on preferred stock...................... (11.6) - - - (11.6)
-------- ------ -------- ------- ---------
Balance, September 30, 2001.......................... $4,945.6 $498.4 $3,481.5 $(300.4) $ 1,266.1
======== ====== ======== ======= =========
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)
Nine months ended
September 30,
--------------------
2002 2001
---- ----
Cash flows from operating activities:
Insurance policy income....................................................................... $ 2,313.1 $ 2,646.1
Net investment income......................................................................... 2,723.6 2,906.9
Fee revenue and other income.................................................................. 236.6 300.9
Insurance policy benefits..................................................................... (1,810.4) (2,060.1)
Interest expense.............................................................................. (1,013.1) (1,184.5)
Policy acquisition costs...................................................................... (391.4) (515.6)
Special charges............................................................................... (46.7) (21.1)
Other operating costs......................................................................... (1,143.9) (1,129.8)
Taxes......................................................................................... (130.4) (97.6)
--------- ---------
Net cash provided by operating activities................................................... 737.4 845.2
--------- ---------
Cash flows from investing activities:
Sales of investments.......................................................................... 15,592.4 15,185.1
Maturities and redemptions of investments..................................................... 1,143.9 941.3
Purchases of investments...................................................................... (15,771.7) (15,998.2)
Cash received from the sale of finance receivables, net of expenses........................... 1,450.6 787.4
Principal payments received on finance receivables............................................ 6,196.6 6,315.2
Finance receivables originated................................................................ (6,401.8) (9,268.0)
Other......................................................................................... (139.2) (128.4)
--------- ---------
Net cash provided (used) by investing activities ........................................... 2,070.8 (2,165.6)
--------- ---------
Cash flows from financing activities:
Amounts received for deposit products......................................................... 3,465.0 3,296.1
Withdrawals from deposit products............................................................. (4,228.6) (3,419.2)
Issuance of notes payable..................................................................... 6,034.3 9,015.0
Payments on notes payable..................................................................... (7,918.0) (8,228.6)
Ceding commission received on reinsurance transaction......................................... 83.0 -
Change in cash held in restricted accounts for settlement of borrowings....................... (210.7) (81.9)
Investment borrowings......................................................................... (1,399.6) 709.0
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............................ (86.2) (95.0)
--------- ---------
Net cash provided (used) by financing activities.......................................... (4,260.8) 1,199.5
--------- ---------
Net decrease in cash and cash equivalents................................................. (1,452.6) (120.9)
Cash and cash equivalents, beginning of period................................................... 3,060.8 1,663.6
---------- ---------
Cash and cash equivalents, end of period......................................................... $ 1,608.2 $ 1,542.7
========== =========
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, sells and services manufactured
housing, home equity, home improvement, retail credit, consumer finance and
floorplan loans.
During the third quarter of 2002, Conseco entered into an agreement to sell
Conseco Variable Insurance Company ("CVIC"), its wholly-owned subsidiary and the
primary writer of its variable annuity products. The sale was completed in
October 2002. The operating results of CVIC have been reported as discontinued
operations in all periods presented in the accompanying consolidated statement
of operations. For the purpose of our September 30, 2002 consolidated balance
sheet, the assets and liabilities of CVIC are each combined and presented
separately in the consolidated balance sheet. See the note to the consolidated
financial statements entitled "Discontinued Operations."
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 "major
medical business in run-off."
EVENTS OF DEFAULT AND LIQUIDITY ISSUES
As we announced on August 9, 2002, Conseco did not make its August 2002
interest payments on its 6.4% senior notes due 2003, 6.4% guaranteed senior
notes due 2004, 8.75% senior notes due 2004, and 8.75% guaranteed senior notes
due 2005. Since the August 9, 2002 announcement, Conseco has not made any
interest or principal payments on any of its direct corporate obligations, nor
has Conseco made any distributions on its Company-obligated mandatorily
redeemable preferred securities of subsidiary trusts. The failure to make the
interest payments on these notes within the 30-day grace period constituted an
event of default under the notes which gave the holders of the notes the right
to accelerate the maturity of all principal and past due interest. We did not
pay the $224.9 million of principal (plus accrued interest) that was due on
October 15, 2002 under the terms of the 8.5% notes due October 15, 2002.
Conseco's default with respect to the payment of principal on these notes also
resulted in defaults under approximately $4.0 billion principal amount of debt
obligations, approximately $481.3 million principal amount of bank loans to
current and former directors, officers and key employees (the "D&O loans") which
Conseco has guaranteed (as further described in the note to our consolidated
financial statements entitled "Guarantees") and approximately $1.9 billion of
trust preferred securities through cross-default provisions contained in the
respective governing instruments. If the holders of such indebtedness or
preferred securities exercised their rights to accelerate the maturity of all
principal and interest due, we would be unable to satisfy these obligations.
The Company is not in compliance with certain covenants under its bank
credit agreement and the guarantees of the D&O loans. Although Conseco received
a waiver of the covenant violations from the relevant lenders, the waiver, as
extended, expired on October 17, 2002. Conseco has obtained forbearance
agreements from the relevant lenders, pursuant to which the lenders have agreed
to temporarily refrain from exercising default-related remedies with respect to
certain specified events of default under the bank credit agreement and the
guarantees of the D&O loans. These forbearance agreements expire on November 27,
2002, and are subject to various conditions. The Company is currently in
negotiations with the relevant lenders to extend the expiration date of these
forbearance agreements, although we cannot assure you that we will be able to do
so.
The Company is currently in negotiations with its senior lenders, the D&O
lenders, certain holders of its senior notes and certain holders of its trust
originated preferred securities with the goal of fundamentally restructuring the
Company's capital. The noteholders have formed an informal committee that has
retained Fried, Frank, Harris, Shriver & Jacobson and Houlihan Lokey Howard &
Zukin Capital as its advisors. The holders of trust originated preferred
securities have formed an informal committee that has retained Saul Ewing LLP
and Raymond James & Associates as its advisors. The Company and its advisors
have been engaged in discussions with these creditors and their representatives
regarding the terms of a potential restructuring plan, including the conversion
of a significant amount of Conseco's debt into common equity. If an agreement on
such a plan is reached, the Company would present the plan for judicial approval
under Chapter 11 of the U.S. Bankruptcy Code, which provides for companies to
reorganize and continue to operate as going concerns. The Company is not
currently in a position to predict the outcome of these discussions. As a result
of our current defaults, certain debt holders of the Company could at any time
file an involuntary petition against the Company under the U.S. Bankruptcy Code
although we
8
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
are not aware of any current efforts to do so.
Conseco's leveraged condition and liquidity difficulties have severely
impacted the operations of Conseco Finance, principally by eliminating Conseco
Finance's access to the securitization markets, historically its main source of
funding. The loss of access to the securitization markets has severely affected
Conseco Finance's ability to originate, purchase and sell loans. In addition,
Conseco Finance has historically relied on these markets to finance the sale of
repossessed manufactured housing units which often minimized the loss on
defaulted loans. Our inability to access this market for repossessed
manufactured housing units will slow down the liquidation of our repossessed
units as well as force us to place a greater reliance on the manufactured
housing wholesale channel at higher severity rates, resulting in higher losses
on these portfolios. In addition, market valuations of Conseco Finance's
securitization trusts have decreased due to uncertainty regarding Conseco
Finance's liquidity position and its ability to continue to provide servicing
for the securitized portfolios, thereby, reducing the value of our retained
interests pledged as collateral on our residual facility.
Conseco Finance's remaining liquidity sources (excluding its bank
subsidiaries) are a warehouse and a residual facility with Lehman Brothers, Inc.
and certain affiliates thereof (collectively referred to herein as "Lehman") and
a credit facility with U.S. Bank National Association ("U.S. Bank"). Conseco
Finance's diminished access to the securitization markets and the constrained
liquidity under its other funding sources have had a material adverse effect on
Conseco Finance's business and results of operations.
Conseco Finance is currently in violation of several financial covenants
required by its warehouse and residual facilities. Conseco Finance has entered
into a forbearance agreement with Lehman pursuant to which Lehman has agreed to
temporarily refrain from exercising any rights arising from events of default
that occurred under the warehouse and residual facilities as of the date of such
forbearance agreement, including certain events of default triggered by Conseco
Finance not being in compliance with certain financial covenants. This
forbearance agreement expires on November 29, 2002 and is subject to various
conditions. In addition, Conseco Finance was not in compliance with various
financial covenants with respect to its bank credit facility. Conseco Finance is
currently in the process of attempting to obtain a forbearance or similar
agreement. Absent the forbearance or similar agreement, the covenant violation
gives the lender the right to declare all borrowings under the bank credit
facility due and payable ($75.0 million was outstanding pursuant to this
facility at September 30, 2002).
Conseco Finance's residual facility is collateralized by retained interests
in securitizations. Conseco Finance is required to maintain collateral based on
current estimated fair values in accordance with the terms of such facility. Due
to the decrease in the estimated fair value of its retained interests, Conseco
Finance's collateral was $128.9 million deficient at September 30, 2002 (as
calculated in accordance with the relevant transaction documents). Conseco
Finance has executed a forbearance agreement with Lehman in which, among other
things, Lehman has agreed not to cause accelerated repayment of the residual
facility based on the collateral deficiency through November 29, 2002. Under the
terms of the forbearance agreement, Lehman is retaining certain cash flows from
Conseco Finance's retained interests pledged to this facility and applying these
cash flows to the margin deficit. Conseco Finance is currently unable to provide
sufficient additional collateral or repay this credit facility.
On October 22, 2002, Conseco announced that its board of directors approved
a plan to seek new investors or acquirers for Conseco's finance businesses and
that it had engaged the investment banking firms of Lazard Freres & Co. LLC and
Credit Suisse First Boston to pursue various alternatives, including securing
new investors and/or selling Conseco Finance's three lines of business: (i)
manufactured housing; (ii) mortgage services; and (iii) consumer finance.
The book value of Conseco's investment in Conseco Finance was approximately
$1.2 billion at September 30, 2002. It currently seems highly unlikely that the
net proceeds to Conseco from any of the various alternatives will result in such
value.
As described in "Liquidity for insurance and fee-based operations" within
"Management's Discussion and Analysis of Financial Condition and Results of
Operations", A.M. Best has further downgraded the financial strength ratings of
our primary insurance subsidiaries to "B (fair)". The downgrade has caused sales
of our insurance products to fall and policyholder redemptions and lapses to
increase, which has had a material adverse effect on our financial results.
Since the August 2002 announcement of our restructuring, we have been
working closely with insurance regulators in each of the states in which our
insurance subsidiaries are domiciled (including Arizona, Illinois, Indiana, New
York, Pennsylvania and Texas) in connection with their monitoring of the
operations and financial status of our insurance subsidiaries. The Commissioner
of Insurance for the State of Texas has
9
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
acted as the lead regulator among the foregoing states and has coordinated the
oversight and monitoring efforts associated with our financial restructuring.
On October 30, 2002, Bankers National Life Insurance Company and Conseco
Life Insurance Company of Texas (on behalf of itself and its subsidiaries), our
two insurance subsidiaries domiciled in Texas, each entered into consent orders
with the Commissioner of Insurance for the State of Texas whereby they agreed:
(i) not to request any dividends or other distributions before January 1, 2003
and, thereafter, not to pay any dividends or other distributions to parent
companies outside of the insurance system without the prior approval of the
Texas Insurance Commissioner; (ii) to continue to maintain sufficient
capitalization and reserves as required by the Texas Insurance Code; (iii) to
request approval from the Texas Insurance Commissioner before making any
disbursements not in the ordinary course of business; (iv) to complete any
pending transactions previously reported to the proper insurance regulatory
officials prior to and during Conseco's restructuring, unless not approved by
the Texas Insurance Commissioner; (v) to obtain a commitment from Conseco and
CIHC, Incorporated ("CIHC"), our intermediate holding company, to maintain their
infrastructure, employees, systems and physical facilities prior to and during
Conseco's restructuring; and (vi) to continue to permit the Texas Insurance
Commissioner to examine its books, papers, accounts, records and affairs. The
consent orders do not prohibit the payment of fees in the ordinary course of
business pursuant to existing administrative, investment management and
marketing agreements with our non-insurance subsidiaries.
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 and if Conseco or any of its
subsidiaries are unable to continue as going concerns.
DELISTING OF COMMON STOCK AND OTHER LISTED SECURITIES
After the issuance of our press release on August 9, 2002, the New York
Stock Exchange ("NYSE") halted trading in Conseco's common stock and all of its
other listed securities. The Securities and Exchange Commission subsequently
granted the NYSE's application for removal from listing and registration with
respect to the following Conseco securities: (i) common stock; (ii) 8.125%
senior notes due 2003; (iii) 10.5% senior notes due 2004; (iv) 9.16% trust
originated preferred securities; (v) 8.70% trust originated preferred
securities; (vi) 9% trust originated preferred securities; and (vii) 9.44% trust
originated preferred securities, effective on the opening of the trading session
on September 25, 2002.
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 and Goodwill Impairment", 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.
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, retained
10
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
interest in securitization trusts (including interest-only securities and
certain lower-rated securities that are senior in payment priority to the
interest-only securities (the "B-2 securities")), certain investments, servicing
rights, goodwill, liabilities for insurance and asset accumulation products, the
guarantee liability related to interests in securitization trusts, 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 "Finance
Receivables and Retained Interests in Securitization Trusts"). 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 third party does not retain substantial risks and rewards of the
special purpose entity's assets.
CUMULATIVE EFFECT OF ACCOUNTING CHANGE AND GOODWILL IMPAIRMENT
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 that goodwill to measure the amount of
goodwill impairment, if any.
Pursuant to the transitional rules of SFAS 142, we 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 the cumulative effect of
an accounting change in the accompanying consolidated statement of operations
for the nine months ended September 30, 2002, and the consolidated financial
statements for the quarter ended March 31, 2002 have been retroactively restated
to reflect this change. 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 are
classified as an operating expense. As described below, the Company performed an
impairment test in the quarter ended September 30, 2002, as a result of
circumstances which indicated a possible impairment.
The significant factors used to determine the amount of the initial
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
11
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
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.
On August 14, 2002, our insurance subsidiaries' financial strength ratings
were downgraded by A.M. Best to "B (fair)" and on September 8, 2002, the Company
defaulted on its public debt. See note to the consolidated financial statements
entitled "Events of Default and Liquidity Issues". These developments caused
sales of our insurance products to fall and policyholder redemptions and lapses
to increase. The adverse impact on our insurance subsidiaries resulting from the
ratings downgrade and parent company default required that an additional
impairment test be performed as of September 30, 2002, in accordance with SFAS
142.
In connection with our negotiations with debt holders, we retained an
outside actuarial consulting firm to assist in valuing our insurance
subsidiaries. That valuation work was used in performing the additional
impairment tests that resulted in an impairment charge to goodwill in third
quarter 2002 of $500.0 million. The charge is reflected in the line item
entitled "Goodwill impairment" in our consolidated statement of operations for
the three and nine months ended September 30, 2002. The most significant changes
made to the January 1, 2002 valuation that resulted in the third quarter 2002
impairment charge were: (i) reduced estimates of projected future sales of
insurance products; (ii) increased estimates of future policyholder redemptions
and lapses; and (iii) a higher discount rate to reflect the current rates used
by the market to value life insurance companies as of September 30, 2002.
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.
Changes in the carrying amount of goodwill for the nine months ended
September 30, 2002 and 2001, are as follows:
Nine months ended
September 30,
-----------------
2002 2001
---- ----
(Dollars in millions)
Goodwill balance, beginning of period....................................... $ 3,695.4 $3,800.8
Amortization expense........................................................ - (82.3)
Cumulative effect of accounting change...................................... (2,949.2) -
Impairment charge........................................................... (500.0) -
Reduction of tax valuation contingencies established at acquisition date
for acquired companies.................................................. (146.2) -
Goodwill related to the acquisition of ExlServices, Inc..................... - 47.2
Goodwill related to businesses sold......................................... - (35.8)
--------- --------
Goodwill balance, end of period............................................. $ 100.0 $3,729.9
========= ========
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 discontinued operations,
extraordinary gain (loss) and cumulative effect of accounting change; net
income; and the respective earnings per share amounts for the periods presented
in our consolidated statement of operations:
Three months ended Nine months ended
September 30, September 30,
------------------- ------------------
2002 2001 2002(a) 2001
---- ---- ---- -----
(Dollars in millions, except per share data)
Reported loss before discontinued operations, extraordinary
gain (loss) and cumulative effect of accounting change...... $(1,678.7) $(398.9) $(3,041.0) $(330.6)
Add back: goodwill amortization............................... - 27.4 - 82.3
--------- ------- --------- -------
Adjusted loss before discontinued operations, extraordinary
gain (loss) and cumulative effect of accounting change...... $(1,678.7) $(371.5) $(3,041.0) $(248.3)
========= ======= ========= =======
Reported net loss applicable to common stock.................... $(1,769.2) $(410.6) $(6,149.3) $(360.7)
Add back: goodwill amortization................................ - 27.4 - 82.3
--------- ------- --------- -------
Adjusted net loss applicable to common stock.................... $(1,769.2) $(383.2) $(6,149.3) $(278.4)
========= ======= ========= =======
Basic earnings per share:
Reported loss before discontinued operations, extraordinary
gain (loss) and cumulative effect of accounting change...... $(4.85) $(1.18) $(8.80) $(1.02)
Add back: goodwill amortization................................ - .08 - .24
------ ------ ------ ------
Adjusted loss before discontinued operations, extraordinary
gain (loss) and cumulative effect of accounting change...... $(4.85) $(1.10) $(8.80) $ (.78)
====== ====== ====== ======
Reported net loss applicable to common stock.................... $(5.11) $(1.21) $(17.79) $(1.07)
Add back: goodwill amortization................................ - .08 - .24
------ ------ ------- ------
Adjusted net loss applicable to common stock.................... $(5.11) $(1.13) $(17.79) $ (.83)
====== ====== ======= ======
Diluted earnings per share:
Reported loss before discontinued operations, extraordinary
gain (loss) and cumulative effect of accounting change...... $(4.85) $(1.18) $(8.80) $(1.02)
Add back: goodwill amortization............................... - .08 - .24
------ ------ ------ ------
Adjusted loss before discontinued operations, extraordinary
gain (loss) and cumulative effect of accounting change...... $(4.85) $(1.10) $(8.80) $ (.78)
====== ====== ====== ======
Reported net loss applicable to common stock.................... $(5.11) $(1.21) $(17.79) $(1.07)
Add back: goodwill amortization................................ - .08 - .24
------ ------ ------- ------
Adjusted net loss applicable to common stock.................... $(5.11) $(1.13) $(17.79) $ (.83)
====== ====== ======= ======
- ------------------
(a) Adjusted net loss for the nine months ended September 30, 2002,
includes the cumulative effect of the accounting change for goodwill
impairment of $2,949.2 million (calculated as of January 1, 2002 as
required by SFAS 142) and the goodwill impairment operating charge of
$500.0 million.
13
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
The following summarizes the impact of the cumulative effect of the
accounting change for goodwill impairment 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 September 30, 2002.
Accumulated other comprehensive income (loss) is primarily comprised of
unrealized gains (losses) on actively managed fixed maturity investments. Such
amounts, included in shareholders' equity as of September 30, 2002, and December
31, 2001, were as follows:
September 30, December 31,
2002 2001
---- ----
(Dollars in millions)
Unrealized gains (losses) on investments.............................................. $278.2 $(816.0)
Adjustments to cost of policies purchased and cost of policies produced............... (60.1) 133.9
Deferred income tax asset (liability)................................................. (75.8) 249.6
Other................................................................................. (9.5) (6.5)
Accumulated other comprehensive loss related to discontinued operations............... (2.4) -
------ -------
Accumulated other comprehensive income (loss).................................... $130.4 $(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 first nine months of 2002, Conseco sold 10.3 million shares of AWE
generating net proceeds of $75.7 million. Our investment in AWE is carried at
estimated fair value, with changes in fair value recognized as investment income
(loss).
14
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
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 these
trusts. Pursuant to 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 September 30, 2002, our holdings of AWE common stock included 4.1
million shares valued at $17.7 million which are held in the investment trusts
described in the previous paragraph. In addition, during the third quarter of
2002, we entered into an agreement to unwind the forward sale contract (which
was entered into in 2001) pursuant to which we held 1.0 million AWE shares as
collateral for a $12.5 million investment borrowing transaction. The net effect
of unwinding the forward purchase contract resulted in an immaterial gain.
The forward contract was a derivative that was required to be
marked-to-market each period. Since the hedged asset (i.e., a portion of the
shares of AWE that we owned) was required to be carried at market value, the
hedge rules of SFAS 133 (as defined under the caption "Accounting for
Derivatives") were not applicable. However, since the value of the derivative
fluctuated in relation to the change in value of the related AWE common stock,
the forward contract acted as a hedge and reduced earnings volatility associated
with the AWE common stock. 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 losses of $6.6 million and $87.4 million
in the third quarters of 2002 and 2001, respectively, related to this
investment. Such venture capital investment losses were $106.6 million and $84.0
million in the first nine months of 2002 and 2001, respectively.
FINANCE RECEIVABLES AND RETAINED INTERESTS IN SECURITIZATION TRUSTS
During the first nine months of 2002, Conseco Finance completed six
securitization transactions, securitizing $2.7 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 September 30, 2002, was approximately 12.4 percent. We classify the notes
issued to investors in the securitization trusts as "notes payable related to
securitized finance receivables structured as collateralized borrowings."
As discussed in the note to the consolidated financial statements entitled
"Events of Default and Liquidity Issues", Conseco's leveraged condition and
liquidity difficulties have eliminated Conseco Finance's ability to access the
securitization markets. This has required Conseco Finance to pursue whole loan
sales to maintain availability under its warehouse facilities for new
originations. Accordingly, Conseco Finance has classified certain of its
unsecuritized finance receivables as held for sale which requires the assets to
be carried at the lower of cost or market. At September 30, 2002, we have an
allowance of $27.4 million for certain finance receivables with current market
values below cost.
During the 2002 and 2001 periods, Conseco Finance completed various loan
sale transactions. During the first nine months of 2002, Conseco Finance sold
$1.2 billion of finance receivables which generated net losses of $13.9 million.
We also recognized a loss of $94.4 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 nine months of 2001, we
sold $1.6 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 nine months of
2001); (ii) $568.4 million of high-loan-to-value mortgage loans; and (iii)
$191.1 million of other loans. These sales resulted in net gains of $21.6
million in the first nine months of 2001.
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):
September 30, December 31,
2002 2001
---- ----
(Dollars in millions)
Continuing lines:
Manufactured housing............................................................. $ 7,268.2 $ 6,940.4
Mortgage services................................................................ 5,657.6 5,658.2
Retail credit.................................................................... 897.8 878.9
Consumer finance - closed-end.................................................... 444.7 580.8
Floorplan........................................................................ 130.2 436.9
--------- ---------
14,398.5 14,495.2
Less allowance for credit losses................................................. 450.8 296.7
--------- ---------
Total finance receivables - securitized........................................ $13,947.7 $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 a part of our continuing lines or a part of our
discontinued lines:
September 30, December 31,
2002 2001
---- ----
(Dollars in millions)
Continuing lines:
Manufactured housing............................................................... $ 268.9 $ 609.3
Mortgage services.................................................................. 386.8 1,128.9
Retail credit...................................................................... 1,955.4 1,811.1
Consumer finance - closed-end...................................................... 15.5 6.3
-------- --------
2,626.6 3,555.6
Less allowance for credit losses................................................... 112.5 111.6
-------- --------
Net other finance receivables for continuing lines............................... 2,514.1 3,444.0
-------- --------
Discontinued lines.................................................................... 65.0 379.7
Less allowance for credit losses................................................... 6.8 13.0
-------- --------
Net other finance receivables for discontinued lines............................. 58.2 366.7
-------- --------
Total other finance receivables.................................................. $2,572.3 $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 Nine months ended
September 30, September 30,
------------------ -----------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars in millions)
Allowance for credit losses, beginning of period................ $ 466.4 $ 318.2 $ 421.3 $ 306.8
Additions to the allowance:
Provision for losses......................................... 234.2 134.2 550.9 360.9
Change in allowance due to purchases and sales of certain
finance receivables........................................ 1.4 3.7 5.3 (1.8)
Credit losses................................................... (131.9) (101.3) (407.4) (311.1)
------- ------- ------- -------
Allowance for credit losses, end of period...................... $ 570.1 $ 354.8 $ 570.1 $ 354.8
======= ======= ======= =======
17
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
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 and servicing rights. 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
B-2 securities (certain lower-rated securities that are senior in payment
priority to the interest-only securities). Our net retained interests in
securitization trusts at September 30, 2002 and December 31, 2001 are summarized
below:
September 30, 2002 December 31, 2001
------------------------- ----------------------
Amortized Estimated Amortized Estimated
cost fair value cost fair value
---- ---------- ---- ----------
(Dollars in millions)
Retained interests in securitization trusts:
Interests securitized in the form of B-2 securities............. $ 554.2 $ 554.2 $704.9 $528.5
Interest-only securities........................................ (28.2) (28.2) 171.2 181.6
------- ------- ------ ------
Total retained interests, excluding guarantee liabilities... 526.0 526.0 876.1 710.1
Guarantee liability related to interests in securitization
trusts held by others........................................... (198.6) (198.6) (39.9) (39.9)
------- ------- ------ ------
Total retained interests, net of guarantee liabilities...... $ 327.4 $ 327.4 $836.2 $670.2
======= ======= ====== ======
The retained interests in securitization trusts on our balance sheet
represent an allocated portion of the cost basis of the finance receivables in
the securitization transactions accounted for as sales. Our 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 retained interests (after adjustments for impairments
required to be recognized in earnings) in "accumulated other comprehensive loss,
net of taxes."
The determination of the value of our retained interests in securitization
trusts requires significant judgment. The Company has recognized significant
charges when the interest-only securities did not perform as well as anticipated
based on our assumptions and expectations. Our current valuation of retained
interests may prove inaccurate in future periods. In securitizations to which
these retained interests relate, Conseco Finance has retained certain contingent
risks in the form of guarantees of certain lower rated securities issued by the
securitization trusts. As of September 30, 2002, the total nominal amount of
these guarantees was approximately $1.4 billion. We consider any potential
payments related to these guarantees in the projected cash flows. The discounted
present value of the expected future payments related to the guarantees are
classified as the "Guarantee liability related to interests in securitization
trusts held by others" in the accompanying consolidated balance sheet. See the
note to the consolidated financial statements entitled "Guarantees."
Together, the interest-only securities and the B-2 securities, represent
our retained interests in these securitization trusts.
During the quarter ended September 30, 2002, Conseco Finance's ability to
access the securitization markets was eliminated. The securitization markets are
Conseco Finance's main source of funding for loans made to purchasers of
repossessed manufactured homes. Conseco Finance believes that its loss severity
rates were positively impacted when it used retail channels to dispose of
repossessed inventory (where the repossessed units are sold through
company-owned sales lots or our dealer network). Since Conseco Finance is no
longer able to fund the loans made on repossessed homes sold through these
channels, sales through these channels have decreased and we must place greater
reliance on the wholesale channel to dispose of repossessed manufactured housing
units, through which recovery rates are typically significantly lower.
Accordingly, we changed the loss severity assumptions we use to value our
retained interests to reflect the higher loss severity we expect to experience
in the future. In addition, our previous assumptions reflected our belief that
the adverse manufactured housing
18
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
default experience in recent periods would continue through the first half of
2002 and then improve over time. Given recent circumstances, default experience
is not expected to improve as previously planned. Accordingly, we increased the
default assumptions we use to value our retained interests to reflect our future
expectations. Our home equity/home improvement assumptions have also been
adjusted to reflect recent default experience as well as our future
expectations.
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 retained interests
in securitization trusts 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 as an
other-than-temporary impairment.
As a result of the requirements of EITF 99-20 and the assumption changes
described above, we recognized an impairment charge (net of adjustments to the
valuation allowance associated with our servicing rights) of $585.5 million in
the first nine months of 2002 for the retained beneficial interests. We also
recognized a $115.8 million increase in the valuation allowance related to our
servicing rights as a result of the changes in assumptions in the first nine
months of 2002.
We recognized an impairment charge of $386.9 million in the first nine
months of 2001 for the interest-only securities that were not performing as well
as expected based on our previous valuation estimates.
We used the following assumptions to adjust the amortized cost of retained
interests to estimated fair value at September 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 retained
interests. Many of the assumptions and expectations underlying our valuation are
not possible to predict with certainty and may change adversely in the future as
a result of factors beyond our control.
Interests Interests
Manufactured Home equity/ Consumer/ held by held by
September 30, 2002 housing home improvement equipment Total others Conseco
- ------------------ ------- ---------------- --------- ----- ------ -------
(Dollars in millions)
Retained interests, net of guarantee
liabilities, at fair value....................... $ 82.4 $ 276.5 $ 11.1 $ 370.0 $(42.6) $327.4
Cumulative principal balance of sold finance
receivables at September 30, 2002................ 15,950.9 3,925.2 870.4 20,746.5
Weighted average stated customer interest rate
on sold finance receivables...................... 9.8% 12.0% 10.5%
Assumptions to determine estimated fair value
of retained interests at September 30, 2002:
Expected prepayment speed as a percentage
of principal balance of sold finance
receivables (a).............................. 7.2% 19.1% 18.1%
Expected nondiscounted credit losses as a
percentage of principal balance of
related finance receivables (a).............. 15.4% 9.3% 8.3%
Weighted average discount rate ................ 16.0% 16.0% 16.0%
19
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
Interests Interests
Manufactured Home equity/ Consumer/ held by held by
December 31, 2001 housing home improvement equipment Total others Conseco
- ----------------- ------- ---------------- --------- ----- ------ -------
(Dollars in millions)
Retained interests, net of guarantee
liabilities, at fair value..................... $ 307.1 $ 389.5 $ 28.8 $ 725.4 $(55.2) $670.2
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
retained interests 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%
- -------------------
(a) The valuation of retained interests in securitization trusts 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 retained interests. Additionally, such valuation is determined
by discounting cash flows over the entire expected life of the
receivables sold.
The following table summarizes certain cash flows received from and paid to
the securitization trusts during the three and nine month periods ended
September 30, 2002 and 2001 (dollars in millions):
Three months Nine months
ended September 30, ended September 30,
----------------------- -------------------
2002 2001 2002 2001
---- ---- ---- ----
Servicing fees received.............................................. $ 11.0 $ 13.7 $ 33.6 $ 56.1
Cash flows from retained interests................................... 1.9 32.8 24.6 78.5
Servicing advances paid.............................................. (66.5) (185.0) (221.9) (584.9)
Repayment of servicing advances...................................... 59.9 183.8 208.7 571.8
During the quarter ended September 30, 2002, we changed the assumptions
used to estimate the value of our retained interests to: (i) project higher
rates of default in the future, based on our current expectations; and (ii)
project higher severity losses related to the defaults, reflecting our inability
to finance the sale of repossessed manufactured homes. 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 retained interests by approximately $15 million during the
remainder of 2002, $75 million in 2003, $25 million in 2004 and $1 million in
2005. These projected payments are considered in the projected cash flows we use
to value our retained interests. Without additional liquidity in the near
future, Conseco Finance will be unable to make these projected guarantee
payments when such payments are required to be made. We project the gross cash
flows from the retained interests will exceed the payments related to guarantees
issued in conjunction with the sales of certain finance receivables by
approximately $1,105 million in all years thereafter.
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
20
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
to 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 qualifying 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 $42.6
million at September 30, 2002. Conseco Finance 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
tests for these securities are conducted on a single set of cash flows
representing Conseco Finance'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 impairment
charge if sufficient positive cash flows in the aggregate are not available
(such as was the case at September 30, 2002).
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
--------------------------- ---------------------------- ---------------------
Nine months
September 30, December 31, September 30, December 31, ended September 30,
---------------------
2002 2001 2002 2001 2002 2001
---- ---- ---- ---- ---- ----
(Dollars in millions)
Type of finance receivables
Manufactured housing.................. $23,918.3 $25,575.1 $675.4 $610.5 $438.2 $411.4
Home equity/home improvement.......... 10,043.7 11,851.4 127.7 139.9 184.6 181.7
Consumer.............................. 4,010.4 4,198.8 85.9 112.6 172.0 148.9
Commercial............................ 236.6 1,377.0 4.5 16.2 17.6 35.3
--------- --------- ------ ------ ------ ------
Total managed receivables............. 38,209.0 43,002.3 893.5 879.2 812.4 777.3
Less finance receivables securitized
and repossessed assets........... 20,857.1 24,297.3 425.6 464.9 405.0 466.2
--------- --------- ------ ------ ------ ------
Finance receivables held on balance
sheet before allowance for credit
losses and deferred points and
other, net....................... 17,351.9 18,705.0 $467.9 $414.3 $407.4 $311.1
====== ====== ====== ======
Less allowance for credit losses...... 570.1 421.3
Less deferred points and other, net... 261.8 274.5
--------- ---------
Finance receivables held on
balance sheet...................... $16,520.0 $18,009.2
========= =========
21
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
The following schedule reconciles our retained interests, net of guarantee
liabilities, from the beginning to the end of the periods presented:
Nine months ended
September 30,
2002 2001
---- ----
(Dollars in millions)
Balance, beginning of period................................................................... $ 670.2 $ 927.5
Additions during the period................................................................. 9.7 -
Investment income........................................................................... 69.7 102.5
Cash paid (received):
Gross cash received....................................................................... (61.3) (98.7)
Guarantee payments related to clean-up calls (a).......................................... - 34.9
Guarantee payments related to interests held by others.................................... 36.7 20.2
Impairment charge to reduce carrying value.................................................. (585.5) (264.8)
Sale of securities related to a discontinued line and other................................. 9.3 (12.4)
Change in interest purchased by Lehman in conjunction with securitization transaction....... 12.6 (52.2)
Transfer to servicing rights in conjunction with securitization transactions................ - (50.0)
Change in unrealized appreciation (depreciation) recorded in shareholders' deficit.......... 166.0 28.5
------- -------
Balance, end of period......................................................................... $ 327.4 $ 635.5
======= =======
- ---------------------------
(a) During the first nine months of 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 nine
months of 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.
In the third quarter of 2002, we completed a securitization that was
structured in a manner that met the applicable criteria to be accounted for as a
sale. We recorded a loss of $10.7 million and a retained interest of $9.7
million on the sale of $180 million of loans.
AMORTIZATION OF THE COST OF POLICIES PURCHASED
The cost assigned to the right to receive future cash flows from insurance
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
insurance 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 $169.4
million and $197.9 million in the first nine months of 2002 and 2001,
respectively. The Company expects to amortize approximately 15 percent of the
December 31, 2001,
22
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
balance of cost of policies purchased in 2002, 14 percent in 2003, 11 percent in
2004, 10 percent in 2005 and 8 percent in 2006.
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 Nine months ended
September 30, September 30,
-------------------- -------------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars in millions
and shares in thousands)
Income (loss) before discontinued operations, extraordinary
gain (loss) and cumulative effect of accounting change............. $(1,678.7) $(398.9) $(3,041.0) $(330.6)
Preferred stock dividends............................................. (.2) (3.1) (2.1) (11.6)
--------- ------- --------- ------
Loss before discontinued operations, extraordinary
gain (loss) and cumulative effect of accounting change
applicable to common ownership for basic earnings per share.... (1,678.9) (402.0) (3,043.1) (342.2)
Effect of dilutive securities......................................... - - - -
--------- ------- --------- -------
Loss before discontinued operations, extraordinary gain (loss) and
cumulative effect of accounting change applicable to common
ownership andassumed conversions
for diluted earnings per share................................. $(1,678.9) $(402.0) $(3,043.1) $(342.2)
========= ======= ========= =======
Shares:
Weighted average shares outstanding for basic and diluted
earnings per share.............................................. 346,008 340,276 345,741 336,395
======= ======= ======= =======
There were no dilutive common stock equivalents during the 2002 and 2001
periods because of the net loss realized by the Company during such periods.
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 nine months ended September 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 Nine months ended
September 30, September 30,
--------------------- -------------------
2002 2001 2002 2001
---- ---- ---- ----
(Shares in thousands)
Equivalent common shares that were antidilutive during the period:
Stock options....................................................... - 9,769 100 12,098
Employee benefit plans.............................................. 4,089 3,063 3,810 2,768
Assumed conversion of convertible preferred stock................... 28,698 27,578 28,415 27,306
------ ------ ------ ------
Antidilutive equivalent common shares............................. 32,787 40,410 32,325 42,172
====== ====== ====== ======
23
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
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 investment
management and insurance product marketing.
Finance segment. Our finance segment provides a variety of finance products
including: (i) loans for the purchase of manufactured housing, home improvements
and various consumer products; (ii) home equity loans; (iii) private label
credit card programs; and (iv) 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
major medical business in run-off and other income and expenses. Corporate
expenses are net of charges to our subsidiaries for services provided by the
corporate operations.
24
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
Segment operating information was as follows:
Three months ended Nine months ended
September 30, September 30,
------------------ ------------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars in millions)
Revenues:
Insurance and fee-based segment:
Insurance policy income:
Annuities................................................. $ 48.2 $ 19.3 $ 111.3 $ 63.8
Supplemental health....................................... 568.6 554.1 1,705.9 1,665.7
Life...................................................... 155.0 198.8 469.8 595.4
Other..................................................... 28.8 30.9 88.1 96.9
Net investment income (a)................................... 335.1 396.5 1,045.5 1,183.6
Fee revenue and other income (a)............................ 21.5 25.2 74.9 77.5
Net realized investment losses (a).......................... (271.7) (156.6) (524.9) (302.7)
-------- -------- -------- --------
Total insurance and fee-based segment revenues.......... 885.5 1,068.2 2,970.6 3,380.2
-------- -------- -------- --------
Finance segment:
Net investment income:
Retained interest (a)..................................... 23.5 33.7 69.7 102.5
Manufactured housing...................................... 216.1 214.0 659.3 604.0
Mortgage services......................................... 174.9 200.6 548.7 576.4
Consumer/credit card...................................... 114.4 111.7 334.2 325.9
Commercial................................................ 7.4 26.7 44.3 99.0
Other (a)................................................. - - - 7.3
Gain (loss) on sale of finance receivables.................. (31.3) 6.0 (13.9) 21.6
Fee revenue and other income................................ 70.1 82.1 201.3 257.4
Impairment charge related to retained interests in
securitization transactions............................... (701.3) (345.2) (701.3) (386.9)
-------- -------- -------- --------
Total finance segment revenu