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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-K
[ X ] Annual report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
For the fiscal year ended December 31, 2003 or
[ ] Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 [No Fee Required]
For the transition period from to
---- ----
Commission file number: 001-31792
Conseco, Inc.
Delaware No. 75-3108137
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State of Incorporation IRS Employer Identification No.
11825 N. Pennsylvania Street
Carmel, Indiana 46032 (317) 817-6100
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Address of principal executive offices Telephone
Securities registered pursuant to Section 12(b)of the Act:
Title of each class
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Common Stock, par value $0.01 per share
Series A Warrants
Securities registered pursuant to Section 12(g)of the Act:
Class A Senior Cumulative Convertible Exchangeable Preferred Stock,
par value $0.01 per share
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 [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ X ]
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [X] No[ ]
At June 30, 2003, the last business day of the Registrant's Predecessor's
most recently completed second fiscal quarter, the aggregate market value of the
Registrant's Predecessor's common equity held by nonaffiliates was approximately
$9,400,000.
Indicate by check mark whether the Registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. Yes [X] No [ ]
Shares of common stock outstanding as of March 9, 2004: 100,115,772
DOCUMENTS INCORPORATED BY REFERENCE: None.
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PART I
ITEM 1. BUSINESS OF CONSECO.
Conseco, Inc., a Delaware corporation ("CNO"), is the holding company for a
group of insurance companies operating throughout the United States that
develop, market and administer supplemental health insurance, annuity,
individual life insurance and other insurance products. CNO became the successor
to Conseco, Inc., an Indiana corporation ("Old Conseco"), in connection with our
bankruptcy reorganization. The terms "Conseco," the "Company," "we," "us," and
"our" as used in this report refer to CNO and its subsidiaries and, unless the
context requires otherwise, Old Conseco and its subsidiaries.
We focus on serving the senior and middle-income markets, which we believe
are attractive, high growth markets. We sell our products through three
distribution channels: career agents, professional independent producers (some
of whom sell one or more of our product lines exclusively) and direct marketing.
As of December 31, 2003, we had $2.8 billion of shareholders' equity and $29.9
billion of assets. For the four months ended December 31, 2003, we had $1,505.5
million of revenues and $96.3 million of net income.
We conduct our business operations through two primary operating segments,
based primarily on method of product distribution, and a third segment comprised
of businesses in run-off. Prior to September 30, 2003, we conducted our
insurance operations through one segment. In the fourth quarter of 2003, we
implemented changes contemplated in our restructuring plan to conduct our
business through the following segments:
o Bankers Life, which consists of the businesses of Bankers Life and
Casualty Company ("Bankers Life and Casualty") and Colonial Penn Life
Insurance Company ("Colonial Penn"). Bankers Life and Casualty markets
and distributes Medicare supplement insurance, life insurance,
long-term care insurance and fixed annuities to the senior market
through approximately 4,000 exclusive career agents and sales
managers. Colonial Penn markets graded benefit and simplified issue
life insurance directly to consumers through television advertising,
direct mail, the internet and telemarketing. Both Bankers Life and
Casualty and Colonial Penn market their products under their own brand
names.
o Conseco Insurance Group, which markets and distributes specified
disease insurance, Medicare supplement insurance, and certain life and
annuity products to the senior and middle-income markets through over
500 independent marketing organizations ("IMOs") that represent over
9,100 producing independent agents. This segment markets its products
under the "Conseco" brand.
o Other Business in Run-off, which includes blocks of business that we
no longer market or underwrite and are managed separately from our
other businesses. This segment consists of long-term care insurance
sold through independent agents and major medical insurance.
We also have a corporate segment, which consists of holding company
activities and certain noninsurance company businesses that are not related to
our operating segments.
OUR RECENT EMERGENCE FROM BANKRUPTCY
On December 17, 2002 (the "Petition Date"), Old Conseco and certain of its
non-insurance company subsidiaries filed voluntary petitions for relief under
Chapter 11 of Title 11 of the United States Bankruptcy Code (the "Bankruptcy
Code") in the United States Bankruptcy Court for the Northern District of
Illinois, Eastern Division (the "Bankruptcy Court"). We emerged from bankruptcy
protection under the Sixth Amended Joint Plan of Reorganization (the "Plan"),
which was confirmed pursuant to an order of the Bankruptcy Court on September 9,
2003 (the "Confirmation Date"), and became effective on September 10, 2003 (the
"Effective Date"). Upon the confirmation of the Plan, we implemented fresh start
accounting in accordance with Statement of Position 90-7 "Financial Reporting by
Entities in Reorganization under the Bankruptcy Code" ("SOP 90-7"). References
to "Predecessor" refer to Old Conseco prior to August 31, 2003. References to
"Successor" refer to the Company on and after August 31, 2003, after giving
effect to the implementation of fresh start reporting. Our accounting and
actuarial systems and procedures are designed to produce financial information
as of the end of a month. Accordingly, for accounting convenience purposes, we
applied the effects of fresh start accounting on August 31, 2003. The activity
of the Company for the period from September 1, 2003 through September 10, 2003
is therefore included in the Successor's statement of operations and excluded
from the Predecessor's statement of operations.
The Plan generally provided for the full payment or reinstatement of
allowed administrative claims, priority claims, fully secured claims and certain
intercompany claims, and the distribution of new equity securities (including
warrants) to
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partially secured and unsecured creditors of our Predecessor. Holders of claims
arising under our Predecessor's $1.5 billion senior bank credit facility also
received a pro rata interest in our Senior Credit Facility. Holders of our
Predecessor's common stock and preferred stock did not receive any distribution
under the Plan, and these securities, together with all other prepetition
securities and the $1.5 billion senior bank credit facility of our Predecessor,
were cancelled on the Effective Date.
On the Effective Date, under the terms of the Plan, we emerged from the
bankruptcy proceedings with a capital structure consisting of:
o our $1.3 billion Senior Credit Facility;
o approximately 34.4 million shares of Class A Preferred Stock with an
initial aggregate liquidation preference of approximately $859.7
million;
o 100.0 million shares of common stock, excluding shares issued to our
new non-executive chairman upon his appointment and shares issued or
to be issued to directors, officers or employees under a new equity
incentive plan; and
o warrants to purchase 6.0 million shares of our common stock (the
"Series A Warrants ").
Under the terms of the Plan, we distributed the equity securities to the
creditors of our Predecessor in the amounts outlined below:
o lenders under our Predecessor's senior bank credit facility and
director and officer loan program received approximately 34.4 million
shares of our Class A Preferred Stock, with an initial aggregate
liquidation preference of $859.7 million;
o holders of our Predecessor's senior notes received approximately 32.3
million shares of our common stock;
o holders of our Predecessor's guaranteed senior notes received
approximately 60.6 million shares of our common stock;
o holders of our Predecessor's general unsecured claims received
approximately 3.8 million shares of our common stock; and
o holders of trust preferred securities issued by our Predecessor's
subsidiary trusts received approximately 1.5 million shares of our
common stock and Series A Warrants to purchase 6.0 million shares of
our common stock at an exercise price of $27.60 per share.
The distribution of our common stock summarized above represents
approximately 98 percent of all of the shares of common stock to be distributed
under the Plan. As of December 31, 2003, approximately 1.8 million of our
outstanding shares of common stock have been reserved for distribution under the
Plan in respect of disputed claims, the resolution of which is still pending. If
reserved shares remain after resolution of these disputed claims, then the
reserved shares will be reallocated to other general unsecured creditors of our
Predecessor as provided for under the Plan.
For a complete discussion of the distributions provided for under the Plan,
you should refer to the complete text of the Plan confirmed by the Bankruptcy
Court, which is filed as an exhibit to this Form 10-K.
OTHER INFORMATION
As part of our Chapter 11 reorganization, we sold substantially all of the
assets of our Predecessor's finance business and exited this line of business.
Our finance business was conducted through our Predecessor's indirect
wholly-owned subsidiary, Conseco Finance Corp. ("CFC"). We accounted for our
finance business as a discontinued operation in 2002 once we formalized our
plans to sell it. On April 1, 2003, CFC and 22 of its direct and indirect
subsidiaries, which collectively comprised substantially all of the finance
business, filed liquidating plans of reorganization with the Bankruptcy Court in
order to facilitate the sale of this business. The sale of the finance business
was completed in the second quarter of 2003. We did not receive any proceeds
from this sale in respect of our interest in CFC, nor did any creditors of our
Predecessor. As of March 31, 2003, we ceased to include the assets and
liabilities of CFC on our Predecessor's consolidated balance sheet.
During the third quarter of 2002, Conseco entered into an agreement to sell
Conseco Variable Insurance Company
3
("CVIC"), one of its wholly-owned subsidiaries 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 a discontinued operation in all periods
presented in the consolidated statement of operations included in this Form
10-K. See the note to the consolidated financial statements entitled "Financial
Information Regarding CVIC."
During 2001, we stopped renewing a large portion of our major medical lines
of business. These lines of business are included in our Other Business in
Run-off Segment. Unless otherwise noted, the collected premium information
provided in Item 1 excludes amounts related to the business of CVIC that was
sold.
CNO is the Successor to Old Conseco. We emerged from bankruptcy on the
Effective Date. Old Conseco was organized in 1979 as an Indiana corporation and
commenced operations in 1982. Our executive offices are located at 11825 N.
Pennsylvania Street, Carmel, Indiana 46032, and our telephone number is (317)
817-6100. Our annual reports on Form 10-K, quarterly reports on Form 10-Q,
current reports on Form 8-K and amendments to those reports filed or furnished
pursuant to Section 13(a) or 15(d) of the Securities Exchange Act are available
free of charge on our web site at www.conseco.com as soon as reasonably
practicable after they are electronically filed with, or furnished to, the SEC.
These filings are also available to the public on the SEC's website at
www.sec.gov. In addition, the public may read and copy any document we file at
the SEC's Public Reference Room located at 450 Fifth Street, NW, Washington,
D.C. 20549. The public may obtain information on the operation of the Public
Reference Room by calling the SEC at 1-800-SEC-0330.
Data in Item 1 are provided as of December 31, 2003, or for the year then
ended (as the context implies), unless otherwise indicated.
MARKETING AND DISTRIBUTION
Insurance
Our insurance subsidiaries develop, market and administer supplemental
health insurance, annuity, individual life insurance and other insurance
products. We sell these products through three primary distribution channels:
career agents, professional independent producers (many of whom sell one or more
of our product lines exclusively) and direct marketing. We had over $1.3 billion
of premium and asset accumulation product collections during the four months
ended December 31, 2003, $2.9 billion in the eight months ended August 31, 2003,
and $4.6 billion during 2002.
Our insurance subsidiaries collectively hold licenses to market our
insurance products in all fifty states, the District of Columbia, and certain
protectorates of the United States. Sales to residents of the following states
accounted for at least 5 percent of our 2003 collected premiums: Florida (8.1
percent), Illinois (6.8 percent), Texas (6.6 percent) and California (6.5
percent).
We believe that people purchase most types of life insurance, accident and
health insurance and annuity products only after being contacted and solicited
by an insurance agent. Accordingly, we believe the success of our distribution
system is largely dependent on our ability to attract and retain agents who are
experienced and highly motivated. A description of the primary distribution
channels is as follows:
Career Agents. This agency force of approximately 4,000 agents working from
140 branch offices, permits one-on-one contact with potential policyholders and
promotes strong personal relationships with existing policyholders. The career
agents sell primarily Medicare supplement and long-term care insurance policies,
senior life insurance and annuities. In 2003, this distribution channel
accounted for $2,177.0 million, or 52 percent, of our total collected premiums.
These agents sell only Bankers Life and Casualty policies and typically visit
the prospective policyholder's home to conduct personalized "kitchen-table"
sales presentations. After the sale of an insurance policy, the agent serves as
a contact person for policyholder questions, claims assistance and additional
insurance needs.
Professional Independent Producers. This distribution channel consists of a
general agency and insurance brokerage distribution system comprised of
independent licensed agents doing business in all fifty states, the District of
Columbia, and certain protectorates of the United States. In 2003, this
distribution channel accounted for $1,301.6 million, or 31 percent, of our total
collected premiums. The collected premium amounts summarized in the preceding
sentence exclude the collected premiums in our Other Business in Run-off segment
which were originally sold through professional independent producers. During
2003, premiums collected attributed to that segment were $598.3 million, or 14
percent, of total collected premiums.
Professional independent producers are a diverse network of independent
agents, insurance brokers and marketing organizations. Marketing organizations
typically recruit agents for the Conseco Insurance Group segment by advertising
our products and commission structure through direct mail advertising or through
seminars for insurance agents and brokers.
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These organizations bear most of the costs incurred in marketing our products.
We compensate the marketing organizations by paying them a percentage of the
commissions earned on new sales generated by the agents recruited by such
organizations. Certain of these marketing organizations are specialty
organizations that have a marketing expertise or a distribution system relating
to a particular product, such as flexible-premium annuities for educators.
During 1999 and 2000, the Conseco Insurance Group segment purchased four
organizations that specialize in marketing and distributing supplemental health
products. One of these organizations was sold in September 2003. In 2003, these
organizations accounted for $234.4 million, or 5.6 percent, of our total
collected premiums.
During the second quarter of 2003, we decided to emphasize the sale of
specified disease and Medicare supplement insurance policies through this
distribution channel. We also decided to de-emphasize annuity and life insurance
sales and eliminate long-term care insurance sales through this channel of
distribution.
Direct Marketing. This distribution channel is engaged primarily in the
sale of graded benefit life insurance policies. In 2003, this channel accounted
for $104.0 million, or 3 percent, of our total collected premiums.
Products
The premium collection tables presented on pages 5, 6, 8 and 10 combine the
2003 premium collections of the Predecessor (for the eight months ended August
31, 2003) and premium collections of the Successor (for the four months ended
December 31, 2003). Combining premium collections for these periods facilitates
comparison of these amounts which were not affected by the adoption of fresh
start accounting. Please refer to "Item 7 - Management's Discussion and Analysis
of Consolidated Financial Condition and Results of Operations - Premium and
Asset Accumulation Product Collections" for a summary of 2003 premium
collections by the Predecessor and Successor. The following table summarizes
premium collections by major category and segment for the years ended December
31, 2003, 2002 and 2001 (dollars in millions):
Total premium collections
Years ended
December 31,
----------------------------
2003 2002 2001
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Supplemental health:
Bankers Life............................................................ $1,167.5 $1,159.4 $1,097.4
Conseco Insurance Group................................................. 797.3 830.3 784.1
Other Business in Run-off............................................... 598.3 844.0 1,200.1
-------- -------- --------
Total supplemental health........................................... 2,563.1 2,833.7 3,081.6
-------- -------- --------
Annuities:
Bankers Life........................................................... 952.2 740.9 513.1
Conseco Insurance Group................................................. 92.1 351.9 710.6
-------- -------- --------
Total annuities..................................................... 1,044.3 1,092.8 1,223.7
-------- -------- --------
Life:
Bankers Life............................................................ 161.3 139.0 286.3
Conseco Insurance Group................................................. 412.2 498.0 553.3
-------- -------- --------
Total life........................................................... 573.5 637.0 839.6
-------- -------- --------
Total premium collections ................................................ $4,180.9 $4,563.5 $5,144.9
======== ======== ========
5
Our insurance companies offer the following products:
Supplemental Health
Supplemental Health Premium Collections (dollars in millions)
Years ended
December 31,
----------------------------
2003 2002 2001
---- ---- ----
Medicare Supplement:
Bankers Life................................................................. $ 644.7 $ 663.9 $ 656.7
Conseco Insurance Group...................................................... 384.6 369.9 318.4
--------- -------- --------
Total..................................................................... 1,029.3 1,033.8 975.1
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Long-Term Care:
Bankers Life ................................................................ 509.4 482.9 425.3
Conseco Insurance Group(1) .................................................. N/A N/A N/A
Other Business in Run-off ................................................... 402.6 434.5 463.0
-------- -------- --------
Total..................................................................... 912.0 917.4 888.3
-------- -------- --------
Specified disease products from
Conseco Insurance Group..................................................... 355.1 368.6 371.8
-------- -------- --------
Major medical business included in the Other Business in
Run-off...................................................................... 195.7 409.5 737.1
-------- -------- --------
Other
Bankers Life ................................................................ 13.4 12.6 15.4
Conseco Insurance Group...................................................... 57.6 91.8 93.9
-------- -------- --------
Total..................................................................... 71.0 104.4 109.3
-------- -------- --------
Total-- Supplemental Health...................................................... $2,563.1 $2,833.7 $3,081.6
======== ======== ========
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(1) We have ceased writing long-term care through Conseco Insurance Group and
all major medical insurance. Accordingly, we classify the associated
collected premiums as part of "Other Business in Run-off."
Supplemental health products include Medicare supplement, long-term care
and specified disease insurance and major medical insurance business in run-off.
During 2003, we collected supplemental health premiums of $2,563.1 million or 61
percent of our total premiums collected. During 2003, we collected Medicare
supplement premiums of $1,029.3 million, long-term care premiums of $912.0
million, specified disease premiums of $355.1 million, major medical premiums of
$195.7 million and other supplemental health premiums of $71.0 million. Medicare
supplement, long-term care, specified disease, major medical and other
supplemental health premiums represented 25 percent, 22 percent, 8 percent, 5
percent and 1 percent, respectively, of our total premiums collected in 2003.
Sales of supplemental health products are affected by the financial strength
ratings assigned to our insurance subsidiaries by independent rating agencies.
See "Competition" below.
The following describes our major supplemental health products:
Medicare Supplement. Medicare supplement collected premiums were $1,029.3
million during 2003 or 25 percent of our total collected premiums. Medicare is a
two-part federal health insurance program for disabled persons and senior
citizens (age 65 and older). Part A of the program provides protection against
the costs of hospitalization and related hospital and skilled nursing home care,
subject to an initial deductible, related coinsurance amounts and specified
maximum benefit levels. The deductible and coinsurance amounts are subject to
change each year by the federal government. Part B of Medicare covers doctor's
bills and a number of other medical costs not covered by Part A, subject to
deductible and
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coinsurance amounts for "approved" charges.
Medicare supplement policies provide coverage for many of the medical
expenses which the Medicare program does not cover, such as deductibles,
coinsurance costs (in which the insured and Medicare share the costs of medical
expenses) and specified losses which exceed the federal program's maximum
benefits. Our Medicare supplement plans automatically adjust coverage to reflect
changes in Medicare benefits. In marketing these products, we concentrate on
individuals who have recently become eligible for Medicare by reaching the age
of 65. We offer a higher first-year commission to agents for sales to these
policyholders and competitive premium pricing for our policyholders.
Approximately 33 percent of new sales of Medicare supplement policies in 2003
were to individuals who have recently reached the age of 65.
Both Bankers Life and Conseco Insurance Group sell Medicare supplement
insurance.
Long-Term Care. Long-term care collected premiums were $912.0 million
during 2003 or 22 percent of our total collected premiums. Long-term care
products provide coverage, within prescribed limits, for nursing home, home
healthcare, or a combination of both nursing home and home healthcare expenses.
The long-term care plans are sold primarily to retirees and, to a lesser degree,
to older self-employed individuals and others in middle-income levels.
Current nursing home care policies cover incurred and daily fixed-dollar
benefits available with an elimination period (which, similar to a deductible,
requires the insured to pay for a certain number of days of nursing home care
before the insurance coverage begins), subject to a maximum benefit. Home
healthcare policies cover the usual and customary charges after a deductible or
elimination period and are subject to a daily or weekly maximum dollar amount,
and an overall benefit maximum. We monitor the loss experience on our long-term
care products and, when necessary, apply for rate increases in the jurisdictions
in which we sell such products. Regulatory approval is required to increase our
premiums on these products.
The long-term care insurance blocks of business sold through the
professional independent producer distribution channel were largely underwritten
by certain of our subsidiaries prior to their acquisition by Conseco in 1996 and
1997. The performance of these blocks of business has been significantly less
favorable than our expectations when the blocks were acquired. As a result, we
ceased selling new long-term care policies through this distribution channel.
We continue to sell long-term care insurance through the career agent
distribution channel. The long-term care business sold through Bankers Life's
career agents was underwritten using stricter underwriting and pricing standards
than our acquired blocks of long-term care business included in the Other
Business in Run-off segment. The performance of this block has been better and
more predictable than the acquired business.
Specified Disease Products. Specified disease collected premiums were
$355.1 million during 2003 or 8 percent of our total collected premiums. These
policies generally provide fixed or limited benefits. Cancer insurance and
heart/stroke products are guaranteed renewable individual accident and health
insurance policies. Payments under cancer insurance policies are generally made
directly to, or at the direction of, the policyholder following diagnosis of, or
treatment for, a covered type of cancer. Heart/stroke policies provide for
payments directly to the policyholder for treatment of a covered heart disease,
heart attack or stroke. The benefits provided under the specified disease
policies do not necessarily reflect the actual cost incurred by the insured as a
result of the illness and benefits are not reduced by any other medical
insurance payments made to or on behalf of the insured.
Approximately 76 percent of our specified disease policies inforce (based
on a count of policies) are sold with return of premium or cash value riders.
The return of premium rider generally provides that after a policy has been in
force for a specified number of years or upon the policyholder reaching a
specified age, we will pay to the policyholder, or a beneficiary under the
policy, the aggregate amount of all premiums paid under the policy, without
interest, less the aggregate amount of all claims incurred under the policy. Our
specified disease products are sold through the independent distribution network
of Conseco Insurance Group.
Major Medical. Our major medical business is included in our Other Business
in Run-off segment. Sales of our major medical health insurance products were
targeted to self-employed individuals, small business owners, large employers
and early retirees. Various deductible and coinsurance options were available,
and most policies require certain utilization review procedures. The
profitability of this business depends largely on the overall persistency of the
business inforce, claim experience and expense management. During 2001, we
decided to discontinue a large block of major medical business by not renewing
these policies because this business was not profitable. During 2003, we
collected major medical premiums of $195.7 million, or 5 percent of our total
collected premiums.
7
Other Supplemental Health Products. Other supplemental health product
collected premiums were $71.0 million, or 1 percent of our total collected
premiums. These products include various other products such as disability
income insurance. We no longer actively market these products.
Annuities
Annuity premium collections (dollars in millions)
Years ended
December 31,
----------------------------
2003 2002 2001
---- ---- ----
Equity-indexed annuity
Bankers Life ............................................................ $ 15.1 $ 30.4 $ 41.4
Conseco Insurance Group.................................................. 54.3 189.7 339.5
-------- -------- --------
Total equity-indexed annuity premium collections ..................... 69.4 220.1 380.9
-------- -------- --------
Other fixed annuity
Bankers Life ............................................................ 937.1 710.5 471.7
Conseco Insurance Group.................................................. 37.8 162.2 371.1
-------- -------- --------
Total fixed annuity premium collections .............................. 974.9 872.7 842.8
-------- -------- --------
Total annuity collections................................................... $1,044.3 $1,092.8 $1,223.7
======== ======== ========
During 2003, we collected annuity premiums of $1,044.3 million or 25
percent of our total premiums collected. Annuity products include equity-indexed
annuity, traditional fixed rate annuity and market value-adjusted annuity
products sold through both Bankers Life and Conseco Insurance Group. Annuities
offer a tax-deferred means of accumulating savings for retirement needs, and
provide a tax-efficient source of income in the payout period. Our major source
of income from annuities is the spread between the investment income earned on
the underlying general account assets and the interest credited to
contractholders' accounts.
More than our other products, annuities are affected by the financial
strength ratings assigned to our insurance subsidiaries by independent rating
agencies. Many of our professional independent agents discontinued marketing our
annuity products after A.M. Best Company ("A.M. Best") lowered the financial
strength ratings assigned to our insurance subsidiaries. In addition, the
annuity business we were selling through this distribution channel required more
statutory capital and surplus than our other insurance products. Accordingly, we
took actions in our Conseco Insurance Group segment to de-emphasize new sales of
annuity products sold through professional independent producers. Instead, we
focused on the sale of products that are less ratings sensitive and capital
intensive. Career agents selling annuity products in the Bankers Life segment
are less sensitive in the near-term to A.M. Best ratings, since these agents
only sell our products. Accordingly, we continue to actively market annuities
through Bankers Life. In order to maintain Bankers Life's career agency
distribution force during the bankruptcy process, we provided certain sales
inducements to purchasers of annuities and sales incentives to our career
agents.
The following describes the major annuity products:
Equity-Indexed Annuities. These products accounted for $69.4 million, or 2
percent, of our total premium collections during 2003. The account value (or
"accumulation value") of these annuities is credited with interest at an annual
minimum guaranteed average rate over the term of the contract of 3 percent (or,
including the effect of applicable sales loads, a 1.7 percent compound average
interest rate over the term of the contracts), but the annuities provide for
potentially higher returns based on a percentage (the "participation rate") of
the change in the Standard & Poor's 500 Index ("S&P 500 Index") during each year
of their term. We have the discretionary ability to annually change the
participation rate, which currently ranges from 50 percent to 100 percent, and
may include a first-year "bonus" participation rate, similar to the bonus
interest described below for traditional fixed rate annuity products, which
generally ranges from an additional 10 percent to 20 percent. The minimum
guaranteed values are equal to:
o 90 percent of premiums collected for annuities for which premiums are
received in a single payment (single-premium deferred annuities, or
"SPDAs"), or 75 percent of first year and 87.5 percent of renewal
premiums collected for annuities which allow for more than one payment
(flexible premium deferred annuities, or "FPDAs"); plus
8
o interest credited on such percentage of the premiums collected at an
annual rate of 3 percent.
The annuity provides for penalty-free withdrawals of up to 10 percent of
premiums in each year after the first year of the annuity's term. Other
withdrawals from SPDA products are generally subject to a surrender charge of 9
percent over the eight year contract term at the end of which the contract must
be renewed or withdrawn. Other withdrawals from FPDA products are subject to a
surrender charge of 12 percent to 20 percent in the first year, declining 1.2
percent to 1.3 percent each year, to zero over a 10 to 15 year period, depending
on issue age. We purchase S&P 500 Index Call Options ("S&P 500 Call Options") in
an effort to offset, or "hedge," potential increases to policyholder benefits
resulting from increases in the S&P 500 Index to which the product's return is
linked.
Other Fixed Rate Annuities. These products include fixed rate SPDAs, FPDAs
and single-premium immediate annuities ("SPIAs"). These products accounted for
$974.9 million, or 23 percent, of our total premium collections during 2003. Our
fixed rate SPDAs and FPDAs typically have an interest rate (the "crediting
rate") that is guaranteed by the Company for the first policy year, after which
we have the discretionary ability to change the crediting rate to any rate not
below a guaranteed minimum rate. The guaranteed rate on annuities written
recently ranges from 3 percent to 4 percent, and the rate on all policies
inforce ranges from 3 percent to 6 percent. The initial crediting rate is
largely a function of:
o the interest rate we can earn on invested assets acquired with the new
annuity fund deposits;
o the costs related to marketing and maintaining the annuity products;
and
o the rates offered on similar products by our competitors.
For subsequent adjustments to crediting rates, we take into account current and
prospective yields on investments, annuity surrender assumptions, competitive
industry pricing and the crediting rate history for particular groups of annuity
policies with similar characteristics.
In 2003, approximately 85 percent of our new annuity sales were "bonus"
products. The initial crediting rate on these products specifies a bonus
crediting rate ranging from 1 percent to 6 percent of the annuity deposit for
the first policy year only. After the first year, the bonus interest portion of
the initial crediting rate is automatically discontinued, and the renewal
crediting rate is established. As of December 31, 2003, crediting rates on our
outstanding traditional annuities were at an average rate, excluding bonuses, of
4.1 percent.
The policyholder is typically permitted to withdraw all or part of the
premium paid plus the accumulated interest credited to his or her accumulation
value, subject in virtually all cases to the assessment of a surrender charge
for withdrawals in excess of specified limits. Most of our traditional annuities
provide for penalty-free withdrawals of up to 10 percent of the accumulation
value each year, subject to limitations. Withdrawals in excess of allowable
penalty-free amounts are assessed a surrender charge during a penalty period
which generally ranges from five to 12 years after the date a policy is issued.
The initial surrender charge is generally 6 percent to 12 percent of the
accumulation value and generally decreases by approximately 1 to 2 percentage
points per year during the penalty period. Surrender charges are set at levels
intended to protect us from loss on early terminations and to reduce the
likelihood of policyholders terminating their policies during periods of
increasing interest rates. This practice is intended to lengthen the effective
duration of policy liabilities and enable us to maintain profitability on such
policies.
SPIAs accounted for $29.5 million, or .7 percent, of our total premiums
collected in 2003. SPIAs are designed to provide a series of periodic payments
for a fixed period of time or for life, according to the policyholder's choice
at the time of issue. Once the payments begin, the amount, frequency and length
of time for which they are payable are fixed. SPIAs often are purchased by
persons at or near retirement age who desire a steady stream of payments over a
future period of years. The single premium is often the payout from a terminated
annuity contract. The implicit interest rate on SPIAs is based on market
conditions when the policy is issued. The implicit interest rate on our
outstanding SPIAs averaged 6.7 percent at December 31, 2003.
We also offered a multibucket annuity product which provides for different
rates of cash value growth based on the experience of a particular market
strategy. Earnings are credited to this product based on the market activity of
a given strategy, less management fees, and funds may be moved between cash
value strategies. Portfolios available include high-yield bond, investment-grade
bond, convertible bond and guaranteed-rate portfolios. During 2003, this product
accounted for $3.5 million, or .1 percent, of our total premiums collected.
Sales of this product were discontinued in 2003.
In October 2002, we sold Conseco Variable Insurance Company, a company
engaged in the variable annuity business. In connection with that sale, we
agreed with the buyer not to engage in the variable annuity business for a
period of three years. We no longer offer variable annuity products.
9
Life
Life insurance premium collections (dollars in millions)
Years ended
December 31,
---------------------------
2003 2002 2001
---- ---- ----
Interest-sensitive life products
Bankers Life............................................................... $ 34.2 $ 34.2 $ 33.7
Conseco Insurance Group.................................................... 266.5 339.1 386.9
------ ------ ------
Total interest-sensitive life premium collections....................... 300.7 373.3 420.6
------ ------ ------
Traditional life
Bankers Life............................................................... 127.1 104.8 252.6
Conseco Insurance Group.................................................... 145.7 158.9 166.4
------ ------ ------
Total traditional life premium collections.............................. 272.8 263.7 419.0
------ ------ ------
Total life insurance premium collections...................................... $573.5 $637.0 $839.6
====== ====== ======
Life products include traditional, interest-sensitive and other life
insurance products. These products are currently sold through both Bankers Life
and Conseco Insurance Group. During 2003, we collected life insurance premiums
of $573.5 million, or 14 percent, of our total collected premiums. In April
2003, we took actions to de-emphasize new sales of several of our life insurance
products through Conseco Insurance Group's professional independent producers.
Sales of life products are affected by the financial strength ratings assigned
to our insurance subsidiaries by independent rating agencies. See "Competition"
below. The decrease in traditional life premiums collected in the Bankers Life
segment in 2002 and 2003 compared to 2001 is primarily due to a first quarter
2002 reinsurance transaction. The reinsurance transaction is discussed further
in the note to the consolidated financial statements entitled "Summary of
Significant Accounting Policies - Reinsurance".
Interest-Sensitive Life Products. These products include universal life
products that provide whole life insurance with adjustable rates of return
related to current interest rates. They accounted for $300.7 million, or 7.2
percent of our total collected premiums in 2003. These products are marketed
through professional independent producers and, to a lesser extent, career
agents. The principal differences between universal life products and other
interest-sensitive life insurance products are policy provisions affecting the
amount and timing of premium payments. Universal life policyholders may vary the
frequency and size of their premium payments, and policy benefits may also
fluctuate according to such payments. Premium payments under other
interest-sensitive policies may not be varied by the policyholders.
Traditional Life. These products accounted for $272.8 million, or 6.5
percent, of our total collected premiums in 2003. Traditional life policies,
including whole life, graded benefit life and term life products, are marketed
through professional independent producers, career agents and direct response
marketing. Under whole life policies, the policyholder generally pays a level
premium over an agreed period or the policyholder's lifetime. The annual premium
in a whole life policy is generally higher than the premium for comparable term
insurance coverage in the early years of the policy's life, but is generally
lower than the premium for comparable term insurance coverage in the later years
of the policy's life. These policies, which we continue to market on a limited
basis, combine insurance protection with a savings component that gradually
increases in amount over the life of the policy. The policyholder may borrow
against the savings generally at a rate of interest lower than that available
from other lending sources. The policyholder may also choose to surrender the
policy and receive the accumulated cash value rather than continuing the
insurance protection. Term life products offer pure insurance protection for a
specified period of time -- typically five, 10 or 20 years. We stopped selling
most term life products through the professional independent producer
distribution channel during the second quarter of 2003.
Traditional life products also include graded benefit life insurance
products. Graded benefit life products accounted for $79.4 million, or 1.9
percent, of our total collected premiums in 2003. Graded benefit life insurance
products are offered on an individual basis primarily to persons age 50 to 80,
principally in face amounts of $350 to $10,000, without medical examination or
evidence of insurability. Premiums are paid as frequently as monthly. Benefits
paid are less than the face amount of the policy during the first two years,
except in cases of accidental death. Our Bankers Life segment markets graded
10
benefit life policies under the Colonial Penn brand name using direct response
marketing techniques. New policyholder leads are generated primarily from
television and print advertisements.
ACQUISITIONS
From 1982 to 1998, Old Conseco acquired 19 insurance groups and related
businesses and Green Tree Financial Corporation (renamed "Conseco Finance
Corp.") These acquisitions were primarily responsible for the Company's
historical growth. CNO is currently prohibited from making acquisitions pursuant
to its $1.3 billion credit agreement.
INVESTMENTS
40|86 Advisors, Inc. ("40|86 Advisors"), a registered investment adviser
and wholly-owned subsidiary of Conseco, Inc., manages the investment portfolios
of our insurance subsidiaries. 40|86 Advisors had approximately $28.5 billion of
assets (at fair value) under management at December 31, 2003, of which $24.4
billion were assets of our subsidiaries and $4.1 billion were assets managed by
40|86 Advisors for third parties. Our general account investment philosophy is
to maintain a largely investment-grade diversified fixed-income portfolio,
maximize the spread between the investment income we earn and the yields we pay
on investment products within acceptable levels of risk, provide adequate
liquidity, construct our asset portfolio with attention to expected liability
durations and other requirements and maximize total return through active
investment management. In the four months ended December 31, 2003, we recognized
net realized investment gains of $11.8 million and in the eight months ended
August 31, 2003, we recognized net realized investment losses of $5.4 million.
During 2002, we recognized net realized investment losses of $556.3 million,
compared to net realized investment losses of $340.0 million during 2001. The
net realized investment losses during 2002 included:
o $556.8 million of writedowns of fixed maturity investments, equity
securities and other invested assets as a result of conditions which
caused us to conclude a decline in fair value of the investment was
other than temporary; and
o $.5 million of net gains from the sales of investments (primarily
fixed maturities) which generated proceeds of $19.5 billion.
During 2002, we recognized other-than-temporary declines in value of
several of our investments, including K-Mart Corp., Amerco, Inc., Global
Crossing, MCI Communications, Mississippi Chemical, United Airlines and
Worldcom, Inc.
Investment activities are an integral part of our business as investment
income is a significant component of our total revenues. Profitability of many
of our insurance products is significantly affected by spreads between interest
yields on investments and rates credited on insurance liabilities. Although
substantially all credited rates on SPDAs and FPDAs may be changed annually
(subject to minimum guaranteed rates), changes in crediting rates may not be
sufficient to maintain targeted investment spreads in all economic and market
environments. In addition, competition, minimum guaranteed rates and other
factors, including the impact of the level of surrenders and withdrawals, may
limit our ability to adjust or to maintain crediting rates at levels necessary
to avoid narrowing of spreads under certain market conditions. As of December
31, 2003, the average yield, computed on the cost basis of our actively managed
fixed maturity portfolio, was 5.6 percent, and the average interest rate
credited or accruing to our total insurance liabilities was 4.7 percent.
We manage the equity-based risk component of our equity-indexed annuity
products by:
o purchasing S&P 500 Call Options in an effort to hedge such risk; and
o adjusting the participation rate to reflect the change in the cost of
such options (such cost varies based on market conditions).
Accordingly, we are able to focus on managing the interest rate spread component
of these products.
We seek to balance the interest rate risk inherent in our invested assets
with the interest rate characteristics of our insurance liabilities. We attempt
to manage this exposure by measuring the duration of our fixed maturity
investments and insurance liabilities. Duration measures the expected change in
the fair value of assets and liabilities for a given change in interest rates.
For example, if interest rates increase by 1 percent, the fair value of a fixed
maturity security with a duration of 5 years is expected to decrease in value by
approximately 5 percent. When the estimated durations of assets and liabilities
are similar, exposure to interest rate risk is minimized because a change in the
value of assets should be largely offset by a change in the value of
liabilities.
We calculate duration using our estimates of future asset and liability
cash flows. These cash flows are discounted
11
using appropriate interest rates based on the current yield curve and investment
type. Duration is determined by calculating the present value of the cash flows
using different interest rates, and measuring the change in value. At December
31, 2003, the duration of our fixed maturity investments (as modified to reflect
prepayments and potential calls) was approximately 6.7 years and the duration of
our insurance liabilities was approximately 7.2 years. The difference between
these durations indicates that our investment portfolio had a shorter duration
and, consequently, was less sensitive to interest rate fluctuations than that of
our liabilities at that date. We generally seek to minimize the gap between
asset and liability durations.
For information regarding the composition and diversification of the
investment portfolio of our subsidiaries, see "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Investments."
COMPETITION
Each of the markets in which we operate is highly competitive, and our
highly leveraged capitalization, our ratings downgrades and our recent
bankruptcy proceedings have had a material adverse impact on our ability to
compete in these markets. The financial services industry consists of a large
number of companies, many of which are larger and have greater capital,
technological and marketing resources, access to capital and other sources of
liquidity at a lower cost, broader and more diversified product lines and larger
staffs than those of Conseco. An expanding number of banks, securities brokerage
firms and other financial intermediaries also market insurance products or offer
competing products, such as mutual fund products, traditional bank investments
and other investment and retirement funding alternatives. We also compete with
many of these companies and others in providing services for fees. In most
areas, competition is based on a number of factors, including pricing, service
provided to distributors and policyholders and ratings. Conseco's subsidiaries
must also compete with their competitors to attract and retain the allegiance of
agents, insurance brokers and marketing companies.
In the individual health insurance business, insurance companies compete
primarily on the basis of marketing, service and price. Pursuant to federal
regulations, the Medicare supplement products offered by all companies have
standardized policy features. This increases the comparability of such policies
and has intensified competition based on factors other than product features.
See "Insurance Underwriting" and "Governmental Regulation." In addition to
competing with the products of other insurance companies, commercial banks,
thrifts, mutual funds and broker dealers, our insurance products compete with
health maintenance organizations, preferred provider organizations and other
health care-related institutions which provide medical benefits based on
contractual agreements.
An important competitive factor for life insurance companies is the ratings
they receive from nationally recognized rating organizations. Agents, insurance
brokers and marketing companies who market our products and prospective
purchasers of our products use the ratings of our insurance subsidiaries as one
factor in determining which insurer's products to market or purchase. Ratings
have the most impact on our annuity and interest-sensitive life insurance
products. Insurance financial strength ratings are opinions regarding an
insurance company's financial capacity to meet the obligations of its insurance
policies in accordance with their terms. They are not directed toward the
protection of investors, and such ratings are not recommendations to buy, sell
or hold securities.
In July 2002, A.M. Best downgraded the financial strength ratings of our
primary insurance subsidiaries from "A- (Excellent)" to "B++ (Very good)" and
placed the ratings "under review with negative implications." On August 14,
2002, A.M. Best again lowered the financial strength ratings of our primary
insurance subsidiaries from "B++ (Very good)" to "B (Fair)". A.M. Best ratings
for the industry currently range from "A++ (Superior)" to "F (In Liquidation)"
and some companies are not rated. An "A++" rating indicates superior overall
performance and a superior ability to meet ongoing obligations to policyholders.
The "B" rating is assigned to companies which have, on balance, fair balance
sheet strength, operating performance and business profile, when compared to the
standards established by A.M. Best, and a fair ability in A.M. Best's opinion to
meet their current obligations to policyholders, but are financially vulnerable
to adverse changes in underwriting and economic conditions. The "B" ratings
reflected A.M. Best's view of the uncertainty surrounding our restructuring
initiatives and the potential adverse financial impact on our subsidiaries. On
September 11, 2003, A.M. Best affirmed its financial strength ratings of our
primary insurance companies ("B (Fair)") and removed the ratings from under
review. On October 3, 2003, A.M. Best assigned a positive outlook to all of our
ratings. According to A.M. Best's press release, the assignment of a positive
outlook to our ratings reflects its favorable view of our bankruptcy
reorganization and a number of management initiatives, including the sale of the
GM building, sale of CFC, restructuring of our investment portfolios, expense
reductions, merging of certain subsidiaries, stabilization of surrenders and a
commitment in the near-to-medium-term to focus on selling higher margin products
with lower capital requirements.
On August 2, 2002, Standard & Poor's Corporation ("S&P") downgraded the
financial strength ratings of our primary insurance companies from BB+ to B+. On
November 19, 2003, S&P assigned a "BB-" counterparty credit and financial
strength rating to our primary insurance companies, with the exception of
Conseco Senior Health Insurance Company (the issuer of most of our long-term
care business in our Other Business in Run-off segment), which was assigned a
"CCC"
12
rating. S&P financial strength ratings range from "AAA" to "R" and some
companies are not rated. Rating categories from "BB" to "CCC" are classified as
"vulnerable", and pluses and minuses show the relative standing within a
category. In S&P's view, an insurer rated "BB" has marginal financial security
characteristics and although positive attributes exist, adverse business
conditions could lead to an insufficient ability to meet financial commitments.
In S&P's view, an insurer rated "CCC" has very weak financial security
characteristics and is dependent on favorable business conditions to meet
financial commitments.
On July 1, 2003, Moody's Investors Services, Inc. ("Moody's") downgraded
the financial strength ratings of our primary insurance companies from Ba3 to
B3. On December 4, 2003, Moody's assigned a "Ba3" rating to our primary
insurance companies, with the exception of Conseco Senior Health Insurance
Company, which was assigned a "Caa1" rating. Moody's financial strength ratings
range from "Aaa" to "C". Rating categories from "Ba" to "C" are classified as
"vulnerable" by Moody's, and may be supplemented with numbers "1", "2", or "3"
to show relative standing within a category. In Moody's view, an insurer rated
"Ba" offers questionable financial security and the ability of the insurer to
meet policyholder obligations may be very moderate and thereby not
well-safeguarded in the future. In Moody's view, an insurer rated "Caa" offers
very poor financial security and may default on its policyholder obligations, or
there may be elements of danger with respect to punctual payment of policyholder
obligations and claims.
The ratings downgrades have generally caused sales of our insurance
products to decline and policyholder redemptions and lapses to increase. In some
cases, the downgrades have also caused defections among our independent agent
sales force and increases in the commissions we must pay in order to retain
them. These events have had a material adverse effect on our financial results.
Further downgrades by A.M. Best, S&P or Moody's would likely have further
material and adverse effects on our financial results and liquidity.
A.M. Best, S&P and Moody's each reviews its ratings from time to time. We
cannot provide any assurance that the ratings of our insurance subsidiaries will
remain at their current levels or predict the impact any downgrades could have
on our business.
INSURANCE UNDERWRITING
Under regulations promulgated by the National Association of Insurance
Commissioners ("NAIC") (an association of state regulators and their staffs) and
adopted as a result of the Omnibus Budget Reconciliation Act of 1990, we are
prohibited from underwriting our Medicare supplement policies for certain
first-time purchasers. If a person applies for insurance within six months after
becoming eligible by reason of age, or disability in certain limited
circumstances, the application may not be rejected due to medical conditions.
Some states prohibit underwriting of all Medicare supplement policies. For other
prospective Medicare supplement policyholders, such as senior citizens who are
transferring to our products, the underwriting procedures are relatively
limited, except for policies providing prescription drug coverage.
Before issuing long-term care or comprehensive major medical products to
individuals and groups, we generally apply detailed underwriting procedures
designed to assess and quantify the insurance risks. We require medical
examinations of applicants (including blood and urine tests, where permitted)
for certain health insurance products and for life insurance products which
exceed prescribed policy amounts. These requirements vary according to the
applicant's age and may vary by type of policy or product. We also rely on
medical records and the potential policyholder's written application. In recent
years, there have been significant regulatory changes with respect to
underwriting certain types of health insurance. An increasing number of states
prohibit underwriting and/or charging higher premiums for substandard risks. We
monitor changes in state regulation that affect our products, and consider these
regulatory developments in determining the products we market and where we
market them.
Most of our life insurance policies are underwritten individually, although
standardized underwriting procedures have been adopted for certain low
face-amount life insurance coverages. After initial processing, insurance
underwriters review each file and obtain the information needed to make an
underwriting decision (such as medical examinations, doctors' statements and
special medical tests). After collecting and reviewing the information, the
underwriter either:
o approves the policy as applied for, or with an extra premium charge
because of unfavorable factors; or
o rejects the application.
We underwrite group insurance policies based on the characteristics of the group
and its past claim experience. Graded benefit life insurance policies are issued
without medical examination or evidence of insurability. There is minimal
underwriting on annuities.
13
LIABILITIES FOR INSURANCE AND ACCUMULATION PRODUCTS
At December 31, 2003, the total balance of our liabilities for insurance
and asset accumulation products was $24.8 billion. These liabilities are often
payable over an extended period of time and the profitability of the related
products is dependent on the pricing of the products and other factors.
Differences between our expectations when we sold these products and our actual
experience could result in future losses.
We calculate and maintain reserves for the estimated future payment of
claims to our policyholders based on actuarial assumptions. For our supplemental
health insurance business, we establish an active life reserve plus a liability
for due and unpaid claims, claims in the course of settlement and incurred but
not reported claims, as well as a reserve for the present value of amounts not
yet due on claims. Many factors can affect these reserves and liabilities, such
as economic and social conditions, inflation, hospital and pharmaceutical costs,
changes in doctrines of legal liability and extra-contractual damage awards.
Therefore, the reserves and liabilities we establish are necessarily based on
extensive estimates, assumptions and historical experience. Establishing
reserves is an uncertain process, and it is possible that actual claims will
materially exceed our reserves and have a material adverse effect on our results
of operations and financial condition. Our financial results depend
significantly upon the extent to which our actual claims experience is
consistent with the assumptions we used in determining our reserves and pricing
our products. If our assumptions with respect to future claims are incorrect,
and our reserves are insufficient to cover our actual losses and expenses, we
would be required to increase our liabilities, which would negatively affect our
operating results.
Liabilities for insurance products are calculated using management's best
judgments of mortality, morbidity, lapse rates, investment experience and
expense levels that are based on our past experience and standard actuarial
tables.
REINSURANCE
Consistent with the general practice of the life insurance industry, our
subsidiaries enter into both facultative and treaty agreements of indemnity
reinsurance with other insurance companies in order to reinsure portions of the
coverage provided by our insurance products. Indemnity reinsurance agreements
are intended to limit a life insurer's maximum loss on a large or unusually
hazardous risk or to diversify its risk. Indemnity reinsurance does not
discharge the original insurer's primary liability to the insured. Our reinsured
business is ceded to numerous reinsurers. We believe the assuming companies are
able to honor all contractual commitments, based on our periodic review of their
financial statements, insurance industry reports and reports filed with state
insurance departments.
As of December 31, 2003, the policy risk retention limit was generally $.8
million or less on the policies of our subsidiaries. Reinsurance ceded by
Conseco represented 27 percent of gross combined life insurance inforce and
reinsurance assumed represented 2.7 percent of net combined life insurance
inforce. Our principal reinsurers at December 31, 2003 were as follows (dollars
in millions):
Ceded life A.M. Best
Name of Reinsurer insurance inforce rating
- ----------------- ----------------- ----------
Swiss Re Life and Health America Inc.................................... $ 5,627.8 A+
Security Life of Denver Life Insurance Company.......................... 5,110.5 A+
Reassure America Life Insurance Company................................. 3,491.4 A+
RGA Reinsurance Company................................................. 1,417.0 A+
Munich American Reassurance Company..................................... 1,170.6 A+
Lincoln National Life Insurance Company................................. 1,079.6 A+
Revios Reinsurance U.S. Inc............................................. 924.8 A-
All others.............................................................. 4,609.5 (1)
---------
$23,431.2
=========
- ---------------------
(1) No other single reinsurer assumed greater than 3 percent of the total ceded
business inforce.
EMPLOYEES
At December 31, 2003, we had approximately 4,350 employees, of which 4,200
were full time employees, including 1,900 employees supporting our Bankers Life
segment and 2,300 employees supporting both our Conseco Insurance Group
14
segment and our Other Business in Run-Off segment. None of our employees are
covered by a collective bargaining agreement. We believe that we have good
relations with our employees.
GOVERNMENTAL REGULATION
Our insurance businesses are subject to extensive regulation and
supervision by the insurance regulatory agencies of the jurisdictions in which
they operate. This regulation and supervision is primarily for the benefit and
protection of customers, and not for the benefit of investors or creditors.
State laws generally establish supervisory agencies with broad regulatory
authority, including the power to:
o grant and revoke business licenses;
o regulate and supervise trade practices and market conduct;
o establish guaranty associations;
o license agents;
o approve policy forms;
o approve premium rates for some lines of business;
o establish reserve requirements;
o prescribe the form and content of required financial statements and
reports;
o determine the reasonableness and adequacy of statutory capital and
surplus;
o perform financial, market conduct and other examinations;
o define acceptable accounting principles;
o regulate the type and amount of permitted investments; and
o limit the amount of dividend and of surplus debenture principal and
interest payments that can be paid without obtaining regulatory
approval.
In addition to the limitations imposed by the laws described above, most
states have also enacted laws or regulations with respect to the activities of
insurance holding company systems, including acquisitions, the payment of
ordinary and extraordinary dividends by insurance companies, the terms of
surplus debentures, the terms of transactions between insurance companies and
their affiliates and other related matters. Various notice and reporting
requirements generally apply to transactions between insurance companies and
their affiliates within an insurance holding company system, depending on the
size and nature of the transactions. These requirements may include prior
regulatory approval or prior notice for certain material transactions.
Currently, the Company and its insurance subsidiaries have registered as holding
company systems pursuant to such laws and regulations in the domiciliary states
of the insurance subsidiaries, and they routinely report to other jurisdictions.
We recently were subject to consent orders with the Commissioner of
Insurance for the State of Texas that, among other things, restricted the
ability of our insurance subsidiaries to pay any dividends to any non-insurance
company parent without prior approval. The Texas Department of Insurance
formally released the consent orders on November 19, 2003. We have agreed with
the Department of Insurance for the State of Texas to provide prior notice of
certain transactions, including up to 30 days prior notice for the payment of
dividends to any non-insurance company parent, and periodic reporting of
information concerning our financial performance and condition.
Most states have also enacted legislation or adopted administrative
regulations that affect the acquisition (or sale) of control of insurance
companies. The nature and extent of such legislation and regulations vary from
state to state. Generally, these regulations require an acquirer of control to
file detailed information concerning such acquirer and the plan of acquisition,
and to obtain administrative approval prior to the acquisition of control.
"Control" is generally defined as the direct or indirect power to direct or
cause the direction of the management and policies of a person and is rebuttably
15
presumed to exist if a person or group of affiliated persons directly or
indirectly owns or controls 10 percent or more of the voting securities of
another person.
On the basis of statutory statements filed with state regulators annually,
the NAIC calculates certain financial ratios to assist state regulators in
monitoring the financial condition of insurance companies. A "usual range" of
results for each ratio is used as a benchmark. In the past, variances in certain
ratios of our insurance subsidiaries have resulted in inquiries from insurance
departments, to which we have responded. These inquiries have not led to any
restrictions affecting our operations.
In addition, the NAIC issues model laws and regulations, many of which have
been adopted by state insurance regulators, relating to:
o reserve requirements;
o Company action level risk-based capital ratio standards ("RBC");
o codification of insurance accounting principles;
o investment restrictions;
o restrictions on an insurance company's ability to pay dividends; and
o product illustrations.
The Model Act provides a tool for insurance regulators to determine the
levels of statutory capital and surplus an insurer must maintain in relation to
its insurance and investment risks and whether there is a need for possible
regulatory attention. The Model Act provides four levels of regulatory
attention, varying with the ratio of the insurance company's total adjusted
capital (defined as the total of its statutory capital and surplus, asset
valuation reserve ("AVR") and certain other adjustments) to its RBC:
o if a company's total adjusted capital is less than 100 percent but
greater than or equal to 75 percent of its RBC (the "Company Action
Level"), the company must submit a comprehensive plan to the
regulatory authority proposing corrective actions aimed at improving
its capital position;
o if a company's total adjusted capital is less than 75 percent but
greater than or equal to 50 percent of its RBC (the "Regulatory Action
Level"), the regulatory authority will perform a special examination
of the company and issue an order specifying the corrective actions
that must be taken;
o if a company's total adjusted capital is less than 50 percent but
greater than or equal to 35 percent of its RBC (the "Authorized
Control Level"), the regulatory authority may take any action it deems
necessary, including placing the company under regulatory control; and
o if a company's total adjusted capital is less than 35 percent of its
RBC (the "Mandatory Control Level"), the regulatory authority must
place the company under its control.
In addition, the Model Act provides for an annual trend test if a company's
total adjusted capital is between 100 percent and 125 percent of its RBC at the
end of the year. The trend test calculates the greater of the decrease in the
margin of total adjusted capital over RBC:
o between the current year and the prior year; and
o for the average of the last 3 years.
It assumes that such decrease could occur again in the coming year. Any
company whose trended total adjusted capital is less than 95 percent of its RBC
would trigger a requirement to submit a comprehensive plan as described above
for the Company Action Level.
Refer to the section entitled "Statutory Information" within "Management's
Discussion and Analysis of Financial Condition and Results of Operations" for
more information on our RBC ratios.
16
The NAIC has adopted model long-term care policy language providing
nonforfeiture benefits and has proposed a rate stabilization standard for
long-term care policies. Various bills are proposed from time to time in the
U.S. Congress which would provide for the implementation of certain minimum
consumer protection standards for inclusion in all long-term care policies,
including guaranteed renewability, protection against inflation and limitations
on waiting periods for pre-existing conditions. Federal legislation permits
premiums paid for qualified long-term care insurance to be treated as
tax-deductible medical expenses and for benefits received on such policies to be
excluded from taxable income.
Our insurance subsidiaries are required under guaranty fund laws of most
states in which we transact business to pay assessments up to prescribed limits
to fund policyholder losses or liabilities of insolvent insurance companies.
Assessments can be partially recovered through a reduction in future premium
taxes in some states.
Most states mandate minimum benefit standards and loss ratios for accident
and health insurance policies. We are generally required to maintain, with
respect to our individual long-term care policies, minimum anticipated loss
ratios over the entire period of coverage of not less than 60 percent. With
respect to our Medicare supplement policies, we are generally required to attain
and maintain an actual loss ratio, after three years, of not less than 65
percent. We provide to the insurance departments of all states in which we
conduct business annual calculations that demonstrate compliance with required
minimum loss ratios for both long-term care and Medicare supplement insurance.
These calculations are prepared utilizing statutory lapse and interest rate
assumptions. In the event that we fail to maintain minimum mandated loss ratios,
our insurance subsidiaries could be required to provide retrospective refunds
and/or prospective rate reductions. We believe that our insurance subsidiaries
currently comply with all applicable mandated minimum loss ratios.
NAIC model regulations, adopted in substantially all states, created 10
standard Medicare supplement plans (Plans A through J). Plan A provides the
least extensive coverage, while Plan J provides the most extensive coverage.
Under NAIC regulations, Medicare insurers must offer Plan A, but may offer any
of the other plans at their option. Our insurance subsidiaries currently offer
nine of the model plans. We have declined to offer Plan J, due in part to its
high benefit levels and, consequently, high costs to the consumer.
The federal government does not directly regulate the insurance business.
However, federal legislation and administrative policies in several areas,
including pension regulation, age and sex discrimination, financial services
regulation, securities regulation, privacy laws and federal taxation, do affect
the insurance business. Legislation has been introduced from time to time in
Congress that could result in the federal government assuming some role.
Numerous proposals to reform the current health care system (including
Medicare) have been introduced in Congress and in various state legislatures.
Proposals have included, among other things, modifications to the existing
employer-based insurance system, a quasi-regulated system of "managed
competition" among health plans, and a single-payer, public program. Changes in
health care policy could significantly affect our business. For example, Federal
comprehensive major medical or long-term care programs, if proposed and
implemented, could partially or fully replace some of Conseco's current
products.
During recent years, the health insurance industry has experienced
substantial changes, including those caused by healthcare legislation. Recent
federal and state legislation and legislative proposals relating to healthcare
reform contain features that could severely limit or eliminate our ability to
vary our pricing terms or apply medical underwriting standards with respect to
individuals which could have the effect of increasing our loss ratios and
adversely affecting our financial results. In particular, Medicare reform and
legislation concerning prescription drugs could affect our ability to price or
sell our products.
The United States Department of Health and Human Services has issued
regulations under the Health Insurance Portability and Accountability Act
("HIPAA") relating to standardized electronic transaction formats, code sets and
the privacy of member health information. These regulations, and any
corresponding state legislation, will affect our administration of health
insurance.
A number of states have passed or are considering legislation that would
limit the differentials in rates that insurers could charge for health care
coverages between new business and renewal business for similar demographic
groups. State legislation has also been adopted or is being considered that
would make health insurance available to all small groups by requiring coverage
of all employees and their dependents, by limiting the applicability of
pre-existing conditions exclusions, by requiring insurers to offer a basic plan
exempt from certain benefits as well as a standard plan, or by establishing a
mechanism to spread the risk of high risk employees to all small group insurers.
Congress and various state legislators have from time to time proposed changes
to the health care system that could affect the relationship between health
insurers and their customers, including external review. We cannot predict with
certainty the effect that any proposals, if adopted, or legislative developments
could have on our insurance businesses and operation.
17
The asset management activities of 40|86 Advisors are subject to federal
and state securities, fiduciary (including the Employee Retirement Income
Security Act of 1974, as amended) and other laws and regulations. The Securities
and Exchange Commission (the "SEC"), the National Association of Securities
Dealers, state securities commissions and the Department of Labor are the
principal regulators of our asset management operations.
FEDERAL INCOME TAXATION
The annuity and life insurance products marketed and issued by our
insurance subsidiaries generally provide the policyholder with an income tax
advantage, as compared to other savings investments such as certificates of
deposit and bonds, in that income taxation on the increase in value of the
product is deferred until it is received by the policyholder. With other savings
investments, the increase in value is generally taxed as earned. Annuity
benefits and life insurance benefits, which accrue prior to the death of the
policyholder, are generally not taxable until paid. Life insurance death
benefits are generally exempt from income tax. Also, benefits received on
immediate annuities (other than structured settlements) are recognized as
taxable income ratably, as opposed to the methods used for some other
investments which tend to accelerate taxable income into earlier years. The tax
advantage for annuities and life insurance is provided in the Internal Revenue
Code (the "Code"), and is generally followed in all states and other United
States taxing jurisdictions.
Recently, Congress enacted legislation to lower marginal tax rates, reduce
the federal estate tax gradually over a ten-year period, with total elimination
of the federal estate tax in 2010, and increase contributions that may be made
to individual retirement accounts and 401(k) accounts. While these tax law
changes will sunset at the beginning of 2011 absent future congressional action,
they could in the interim diminish the appeal of our annuity and life insurance
products. Additionally, Congress has considered, from time to time, other
possible changes to the U.S. tax laws, including elimination of the tax deferral
on the accretion of value within certain annuities and life insurance products.
It is possible that further tax legislation will be enacted which would contain
provisions with possible adverse effects on our annuity and life insurance
products.
Our insurance company subsidiaries are taxed under the life insurance
company provisions of the Code. Provisions in the Code require a portion of the
expenses incurred in selling insurance products to be deducted over a period of
years, as opposed to immediate deduction in the year incurred. This provision
increases the tax for statutory accounting purposes, which reduces statutory
earnings and surplus and, accordingly, decreases the amount of cash dividends
that may be paid by the life insurance subsidiaries.
At December 31, 2003, Conseco had net federal income tax loss carryforwards
of $3.6 billion available (after taking into account the reduction in tax
attributes due to the cancellation of indebtedness in bankruptcy and the loss
resulting from the worthlessness of our investment in CFC, all of which is
subject to various statutory restrictions) for use on future tax returns. These
carryforwards will expire as follows: $11.2 million in 2004, $4.6 million in
2005; $.2 million in 2006; $5.8 million in 2007; $6.6 million in 2008; $10.5
million in 2009; $4.2 million in 2010; $2.5 million in 2011; $16.0 million in
2012; $43.4 million in 2013; $6.9 million in 2014; $60.4 million in 2016; $41.5
million in 2017; $3,399.5 million in 2018; $.7 million in 2019; $5.5 million in
2020; and $1.0 million in 2022.
Our income tax expense includes deferred income taxes arising from
temporary differences between the financial reporting and tax bases of assets
and liabilities, capital loss carryforwards and net operating loss carryforwards
("NOLs"). In assessing the realization of our deferred income tax assets, we
consider whether it is more likely than not that the deferred income tax assets
will be realized. The ultimate realization of our deferred income tax assets
depends upon generating future taxable income during the periods in which our
temporary differences become deductible and before our NOLs expire. In addition,
the use of our NOLs is dependent, in part, on whether the IRS ultimately agrees
with the tax position we plan to take in our current and future tax returns.
With respect to the deferred tax asset, we assess the need for a valuation
allowance on a quarterly basis.
A valuation allowance of $2.4 billion has been provided for the entire
balance of net deferred income tax assets at December 31, 2003, as we believe
the realization of such assets in future periods is uncertain. We reached this
conclusion after considering the losses realized by the Company in recent years,
the uncertainties related to the tax treatment for the worthlessness of our
investment in CFC, and the likelihood of future taxable income exclusive of
reversing temporary differences and carryforwards.
18
ITEM 2. PROPERTIES.
Our headquarters and the administrative operations of our Conseco Insurance
Group segment are located on a Company-owned 146-acre corporate campus in
Carmel, Indiana, immediately north of Indianapolis. The ten buildings on the
campus contain approximately 854,500 square feet of space and house Conseco's
executive offices and certain administrative operations of its subsidiaries.
Management believes that Conseco's offices are adequate for its current needs.
Our Bankers Life segment is primarily administered from two facilities in
Chicago. Bankers Life has 177,000 square feet in downtown Chicago, Illinois,
leased under an agreement whereby 107,000 square feet are leased until 2018 and
70,000 square feet are leased until 2008. We also lease approximately 130,000
square feet of space in a second Chicago facility. This lease expires in October
2004, at which time the operations of this facility will be moved to a new
location (with approximately 222,000 square feet) in downtown Chicago under a
lease with a life of approximately 10 years. We own an office building in
Philadelphia, Pennsylvania (127,000 square feet), which serves as the
administrative center for the direct marketing operation of our Bankers Life
segment. We occupy approximately 60 percent of this space, with the remainder
leased to tenants. We also lease 206 sales offices in various states totaling
approximately 507,000 square feet. These leases are short-term in length, with
remaining lease terms expiring between 2004 and 2009.
ITEM 3. LEGAL PROCEEDINGS.
Legal Proceedings
We are involved on an ongoing basis in lawsuits (including purported class
actions) relating to our operations, including with respect to sales practices,
and we and current and former officers and former directors are defendants in a
pending class action lawsuit asserting claims under the securities laws. The
ultimate outcome of these lawsuits cannot be predicted with certainty and we
have estimated the potential exposure for each of the matters and have recorded
a liability if a loss is deemed probable.
Securities Litigation
Since we announced our intention to restructure our capital on August 9,
2002, a total of eight purported securities fraud class action lawsuits have
been filed in the United States District Court for the Southern District of
Indiana. The complaints name us as a defendant, along with certain of our
current and former officers. These lawsuits were filed on behalf of persons or
entities who purchased our Predecessor's common stock on various dates between
October 24, 2001 and August 9, 2002. In each case the plaintiffs allege claims
under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as
amended (the "Exchange Act") and allege material omissions and dissemination of
materially misleading statements regarding, among other things, the liquidity of
Conseco and alleged problems in CFC's manufactured housing division, allegedly
resulting in the artificial inflation of our Predecessor's stock price. On March
13, 2003, all of these cases were consolidated into one case in the United
States District Court for the Southern District of Indiana, captioned Franz
Schleicher, et al. v. Conseco, Inc., Gary Wendt, William Shea, Charles Chokel
and James Adams, et al., Case No. 02-CV-1332 DFH-TAB. The lawsuits were stayed
as to all defendants by order of the United States Bankruptcy Court for the
Northern District of Illinois. The stay was lifted on October 15, 2003. The
plaintiffs have filed a consolidated class action complaint with respect to the
individual defendants. We expect to be filing a motion to dismiss in March 2004.
Our liability with respect to these lawsuits was discharged in the Plan and our
obligation to indemnify individual defendants who were not serving as one of our
officers or directors on the Effective Date is limited to $3 million in the
aggregate under the Plan. Our liability to indemnify individual defendants who
were serving as an officer or director on the Effective Date, of which there is
one such defendant, is not limited by the Plan. We believe these lawsuits are
without merit and intend to defend them vigorously. The ultimate outcome of
these lawsuits cannot be predicted with certainty.
Other Litigation
Collection efforts by the Company and its wholly owned subsidiary, Conseco
Services, LLC, related to the 1996-1999 director and officer loan programs have
been commenced against various past board members and executives with
outstanding loan balances. In addition, certain former officers and directors
have sued the companies for declaratory relief concerning their liability for
the loans. Currently, we are involved in litigation with Stephen C. Hilbert,
James D. Massey, Dennis E. Murray, Sr., Rollin M. Dick, James S. Adams, Maxwell
E. Bublitz, Ngaire E. Cuneo, David R. Decatur, Donald F. Gongaware and Bruce A.
Crittenden. The specific lawsuits include: Hilbert v. Conseco, Case No. 03A
04283 (Bankr. Northern District, Illinois); Conseco Services v. Hilbert, Case
No. 29C01-0310 MF 1296 (Circuit Court, Hamilton County, Indiana); Murray and
Massey v. Conseco, Case No. 1:03-CV-1482 LJM-WTL (Southern District, Indiana);
Conseco Services v. Adams, et al, Case No. 29DO2- 0312-CC-1035(Circuit Court,
Hamilton County, Indiana); Conseco v. Adams, et al, Case
19
No. 03A 04545, (Bankr. Northern District, Illinois) Dick v. Conseco Services,
Case No. 29 D01-0207-PL-549 (Superior Court, Hamilton County, Indiana); Conseco
Services v. Dick, et al., Case No. 06C01-0311-CC-356 (Circuit Court, Boone
County, Indiana); Stephen C. Hilbert v. Conseco, Inc. and Kroll Inc., Case No.
29D02-0312-PL-1026 (Superior Court, Hamilton County, Indiana) and Crittenden v.
Conseco, Case No. IP02-1823-C B/S (Southern District, Indiana). The Company and
Conseco Services, LLC believe that all amounts due under the director and
officer loan programs, including all applicable interest, are valid obligations
owed to the companies. As part of the Plan, we have agreed to pay 45 percent of
any net proceeds recovered in connection with these lawsuits, in an aggregate
amount not to exceed $30 million, to former holders of our Predecessor's trust
preferred securities that did not opt out of a settlement reached with the
committee representing holders of these securities. We are required to use the
balance of any net proceeds recovered in connection with these lawsuits to pay
down our Senior Credit Facility. Any remaining proceeds will be used to
contribute capital to our insurance subsidiaries. We intend to prosecute these
claims to obtain the maximum recovery possible. Further, with regard to the
various claims brought against the Company and Conseco Services, LLC by certain
former directors and officers, we believe that these claims are without merit
and intend to defend them vigorously. The ultimate outcome of the lawsuits
cannot be predicted with certainty.
In October 2002, Roderick Russell, on behalf of himself and a class of
persons similarly situated, and on behalf of the ConsecoSave Plan, filed an
action in the United States District Court for the Southern District of Indiana
against our Predecessor, Conseco Services, LLC and certain of our current and
former officers (Roderick Russell, et al. v Conseco, Inc., et al., Case No.
1:02-CV-1639 LJM). The purported class action consists of all individuals whose
401(k) accounts held common stock of our Predecessor at any time since April 28,
1999. The complaint alleges, among other things, breaches of fiduciary duties
under ERISA by continuing to permit employees to invest in our Predecessor's
common stock without full disclosure of the Company's true financial condition.
We filed a motion to dismiss the complaint in December 2002. This lawsuit was
stayed as to all defendants by order of the Bankruptcy Court. The stay was
lifted on October 15, 2003. It is expected that the plaintiffs will be amending
their complaint in March or April of 2004. On February 13, 2004, the Company's
fiduciary insurance carrier, RLI Insurance Company filed a declaratory judgment
action asking the court to find no liability under its policy for the claims
made in the Russell matter (RLI Insurance Company v. Conseco, Inc., Stephen
Hilbert, et al., Case No. 1:04-CV-0310DFH-TAB (Southern District, Indiana.)) We
believe the lawsuits are without merit and intend to defend them vigorously. The
ultimate outcome of the lawsuit cannot be predicted with certainty.
On June 24, 2002, the heirs of a former officer, Lawrence Inlow, commenced
an action against our Predecessor, Conseco Services, LLC and two former officers
in the Circuit Court of Boone County, Indiana (Inlow et al. v. Conseco, Inc., et
al., Cause No. 06C01-0206-CT-244). The heirs assert that unvested options to
purchase 756,248 shares of our Predecessor's common stock should have been
vested at Mr. Inlow's death. The heirs further claim that if such options had
been vested, they would have been exercised, and that the resulting shares of
common stock would have been sold for a gain of approximately $30 million based
upon a stock price of $58.125 per share, the highest stock price during the
alleged exercise period of the options. We believe the heirs' claims are without
merit and will defend the action vigorously. The maximum exposure to the Company
for this lawsuit is estimated to be $33 million. The heirs did not file a proof
of claim with the Bankruptcy Court. Subject to dispositive motions which are yet
to be filed, the matter will continue to trial against Conseco Services, LLC and
the other co-defendants on September 13, 2004. The ultimate outcome cannot be
predicted with certainty.
On June 27, 2001, two suits against the Company's subsidiary, Philadelphia
Life Insurance Company (now known as Conseco Life Insurance Company), both
purported nationwide class actions seeking unspecified damages, were
consolidated in the U.S. District Court, Middle District of Florida (In Re PLI
Sales Litigation, Cause No. 01-MDL-1404), alleging among other things,
fraudulent sales and a "vanishing premium" scheme. Philadelphia Life filed a
motion for summary judgment against both named plaintiffs, which motion was
granted in June 2002. Plaintiffs appealed to the 11th Circuit. The 11th Circuit,
in July 2003, affirmed in part and reversed in part, allowing two fraud counts
with respect to one plaintiff to survive. The plaintiffs' request for a
rehearing with respect to this decision has been denied. Philadelphia Life has
filed a summary judgment motion with respect to the remaining claims. This
summary judgment was denied in February 2004. Philadelphia Life believes this
lawsuit is without merit and intends to defend it vigorously. The ultimate
outcome of the lawsuit cannot be predicted with certainty.
On December 1, 2000, the Company's former subsidiary, Manhattan National
Life Insurance Company, was named in a purported nationwide class action seeking
unspecified damages in the First Judicial District Court of Santa Fe, New Mexico
(Robert Atencio and Theresa Atencio, for themselves and all other similarly
situated v. Manhattan National Life Insurance Company, an Ohio corporation,
Cause No. D-0101-CV-2000-2817), alleging among other things fraud by
non-disclosure of additional charges for those policyholders paying via premium
modes other than annual. We retained liability for this litigation in connection
with the sale of Manhattan National Life in June 2002. We believe this lawsuit
is without merit and intend to defend it vigorously. The ultimate outcome of the
lawsuit cannot be predicted with certainty.
20
On December 19, 2001, four of the Company's subsidiaries were named in a
purported nationwide class action seeking unspecified damages in the District
Court of Adams County, Colorado (Jose Medina and others similarly situated v.
Conseco Annuity Assurance Company, Conseco Life Insurance Company, Bankers
National Life Insurance Company and Bankers Life and Casualty Company, Cause No.
01-CV-2465), alleging among other things breach of contract regarding alleged
non-disclosure of additional charges for those policy holders paying via premium
modes other than annual. On July 14 and 15, 2003 the plaintiff's motion for
class certification was heard and the Court took the matter under advisement. On
November 10, 2003, the Court denied the motion for class certification. On
January 26, 2004, the plaintiff appealed the trial court's ruling denying class
certification. All further proceedings have been stayed pending the outcome of
the appeal. The defendants believe this lawsuit is without merit and intend to
defend it vigorously. The ultimate outcome of the lawsuit cannot be predicted
with certainty.
The Company's subsidiaries, Conseco Life Insurance Company and Bankers Life
and Casualty Company, have recently been named in multiple purported class
actions and individual lawsuits alleging, among other things, breach of contract
with regard to a change made in the way monthly deductions are calculated for
insurance coverage. This change was the adjustment of a non-guaranteed element,
which was not in the applicable policy form. The specific lawsuits include:
David Barton v. Conseco Life Insurance Company, Case No. 04-20048-CIV-MORENO
(Southern District, Florida); Stephen Hook, an individual, on behalf of himself
and all others similarly situated v. Conseco Life Insurance Company and Bankers
Life and Casualty Company and Does 1 through 10, Case No. CGC-04-428872
(Superior Court, San Francisco County, California); Donald King, as Trustee of
the Irrevocable Trust of Arnold L. King v. Conseco Life Insurance Company, Case
No. 1: 04CV0163 (Northern District, Ohio); Michael S. Kuhn, on behalf of himself
and all others similarly situated v. Conseco Life Insurance Company and Does 1
through 100, Case No. 03-416786 (Superior Court, San Francisco County,
California); Sidney H. Levine and Judith A. Levine v. Conseco Life Insurance
Company, Mark F. Peters Insurance Services, Inc. Hon. John Garamendi (in his
capacity as Insurance Commissioner for the State of California) and Does 1
through 10, Case No. 04 CV 125 LAB (BLM) (Southern District, California); Alene
P. Mangelson, as Trustee for the Ned L. Mangelson Life Insurance Trust, Marie M.
Berg and Michelle M. Wilcox on behalf of themselves and all others similarly
situated v. Conseco Life Insurance Company, Case No. 29D02-0312-PL-1034
(Superior Court, Hamilton County, Indiana); Edward M. Medvene, an Individual,
and Sherwin Samuels and Miles Rubin, as Trustees of the Edward Medvene 2984
Insurance Trust v. Conseco Life Insurance Company, Case No. CV04-846-AHM (MCX)
(Central District, California). We believe these lawsuits are without merit and
intend to defend them vigorously. The ultimate outcome of the lawsuits cannot be
predicted with certainty.
On February 7, 2003, the Company's subsidiary, Conseco Life Insurance
Company, was named in a purported Texas statewide class action seeking
unspecified damages in the County Court of Cameron County, Texas. On February
12, 2004, the complaint was amended to allege a purported nationwide class and
to name Conseco Services, LLC as an additional defendant (Lawrence Onderdonk and
Yolanda Carrizales v. Conseco Life Insurance Company, Conseco Services, LLC, and
Pete Ramirez, III, Cause No. 2003-CCL-102-C). The purported class consists of
all former Massachusetts General Flexible Premium Adjustable Life Insurance
Policy policyholders who were converted to Conseco Life Flexible Premium
Adjustable Life Insurance Policies and whose accumulated values in the
Massachusetts General policies were applied to first year premiums on the
Conseco Life policies. The complaint alleges, among other things, civil
conspiracy to convert the accumulated cash values of the plaintiffs and the
class, and the violation of insurance laws nationwide. We believe this lawsuit
is without merit and intend to defend it vigorously. The ultimate outcome of the
lawsuit cannot be predicted with certainty.
On December 30, 2002 and December 31, 2002, five suits were filed in
various Mississippi counties against Conseco Life Insurance Company (Kathie
Allen, et al. v. Conseco Life Insurance Company, et al., Circuit Court of Jones
County, Mississippi, Cause No. 2002-448-CV12; Malcolm Bailey, et al. v. Conseco
Life Insurance Company, et al., Circuit Court of Claiborne County, Mississippi,
Cause No. CV-2002-371; Anthony Cascio, et al. v. Conseco Life Insurance Company,
et al, Circuit Court of LeFlore County, Mississippi, Cause No.
CV-2002-0242-CICI; William Garrard, et al. v. Conseco Life insurance Company, et
al., Circuit Court of Sunflower County, Mississippi, Cause No. CV-2002-0753-CRL;
and William Weaver, et al. v. Conseco Life Insurance Company, et al., Circuit
Court of LeFlore County, Mississippi, Cause No. CV-2002-0238-CICI) alleging,
among other things, a "vanishing premium" scheme. Conseco Life removed all of
the cases to the U.S. District Courts in Mississippi. In September 2003,
plaintiffs' motion to remand was denied in the Garrard and Weaver matters, but
granted in the Cascio matter. In November 2003, Conseco Life again removed the
Cascio matter to U.S. District Court. Conseco Life awaits the court's ruling on
Plaintiff's motion to remand in the Allen matter. In Bailey the parties have
agreed to stay in Federal court and the plaintiffs amended their complaint on
January 15, 2004 to allege purported nationwide class action allegations
regarding alleged wrongful collection of charges under the policy. On January
30, 2004 we filed a motion to dismiss or in alternative, motion for summary
judgment. Conseco Life believes the lawsuits are without merit and intends to
defend them vigorously. The ultimate outcome of the lawsuits cannot be predicted
with certainty.
In addition, the Company and its subsidiaries are involved on an ongoing
basis in other lawsuits and arbitrations
21
(including purported class actions) related to their operations. The ultimate
outcome of all of these other legal matters pending against the Company or its
subsidiaries cannot be predicted, and, although such lawsuits are not expected
individually to have a material adverse effect on the Company, such lawsuits
could have, in the aggregate, a material adverse effect on the Company's
consolidated financial condition, cash flows or results of operations.
Other Proceedings
On September 18, 2003, the Company received a grand jury subpoena from the
U.S. District Court for the Southern District of Indiana in connection with a
Department of Justice investigation requiring production of documents relating
to the valuation of interest-only securities held by CFC, our Predecessor's
former finance subsidiary, contemporaneous earnings estimates for the
Predecessor, certain personnel records and other accounting and financial
disclosure records for the period June 1, 1998 to June 30, 2000. The Company has
subsequently received follow-up grand jury document subpoenas concerning other
matters. All of these follow-up requests have been limited to the time period
prior to the December 17, 2002 bankruptcy filing. The Company has been advised
by the Department of Justice that neither it nor any of its current directors or
employees are subjects or targets of this investigation. The Company is
cooperating fully with the Department of Justice investigation.
On March 10, 2004, we entered into a settlement with the SEC in connection
with the SEC's investigation of events in and before the spring of 2000,
including CFC's accounting for its interest-only securities and servicing
rights. These issues were among those addressed in our Predecessor's writedown
and restatement in the spring of 2000, and were the subject of shareholder class
action litigation, which we settled in the second quarter of 2003. Without
admitting or denying the SEC's findings, we consented to the entry of a
cease-and-desist order requiring future compliance with periodic reporting,
record keeping, internal control and other provisions of the securities laws.
The settlement did not impose any fine or monetary penalty, or require us to
restate any of our historical financial statements.
On October 29, 2003, the New York Attorney General served Conseco Life
Insurance Company of Texas ("Conseco Life") with a document subpoena concerning
customer transfers between mutual fund subaccounts offered by CVIC, a former
wholly-owned subsidiary of Conseco Life, that occurred prior to the sale of CVIC
to an unrelated third party in October 2002. The SEC served the Company with a
similar subpoena shortly after we received the Attorney General's subpoena.
Certain of our employees have also received subpoenas regarding duties they
previously performed in respect of annuity sales by CVIC. The purchase agreement
pursuant to which CVIC was sold contains indemnification provisions with respect
to certain liabilities relating to Conseco Life's period of ownership, including
provisions concerning certain business activities (including marketing
activities) of CVIC. Conseco Life and the Company have cooperated with the
Attorney General and the SEC in producing documents responsive to their
subpoenas. In January 2004, the Company received telephonic notification of a
potential enforcement action by the Attorney General and a Wells notification
from the SEC regarding alleged market timing on the part of holders of variable
annuity policies issued by CVIC. The Company and its affiliates have not issued
any variable annuity policies since the sale of CVIC. The Company and Conseco
Life believe, based on the information obtained and supplied to the
investigators to date, that CVIC violated no federal or state law prior to the
October 2002 sale. The investigations are in a preliminary stage and their
outcome cannot be predicted with certainty. The Company and Conseco Life are
cooperating fully with the Attorney General and the SEC in these investigations.
The deadline to file administrative claims in the bankruptcy proceeding was
October 9, 2003. The Plan provides that all such claims must be paid in full, in
cash. We are reviewing all timely filed administrative claims and may resolve
disputes regarding allowance of such claims in the Bankruptcy Court. The amount
of known disputed administrative claims as of March 1, 2004, was approximately
$2.0 million.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
22
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS.
MARKET INFORMATION
The following table sets forth the ranges of high and low sales prices per
share for our common stock on the New York Stock Exchange during the period
after our emergence from bankruptcy. There have been no dividends paid or
declared on our common stock during this period.
Period Market price
------------------
High Low
---- ---
2003:
September 11-30, 2003................................... $22.50 $17.70
Fourth Quarter.......................................... 22.18 18.05
As of February 23, 2004, there were approximately 66,700 holders of the
outstanding shares of common stock, including individual participants in
securities position listings.
DIVIDENDS
The Company does not anticipate declaring or paying cash dividends on its
common stock in the foreseeable future, and is currently prohibited from doing
so pursuant to its $1.3 billion credit agreement.
23
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA.
Predecessor
-----------------------------------------------------
Successor
----------
As of or for the As of or for the
four months eight months
ended ended
December 31, August 31, Years ended December 31,
--------------------------------------
2003 2003 2002 2001 2000 1999
---- ---- ---- ---- ---- ----
(Amounts in millions, except per share data)
STATEMENT OF OPERATIONS DATA(a)
Insurance policy income.............................. $1,005.8 $2,204.3 $3,602.3 $3,992.7 $ 4,170.7 $3,990.4
Net investment income................................ 474.6 969.0 1,334.3 1,550.0 1,578.1 2,287.7
Net realized investment gains (losses) .............. 11.8 (5.4) (556.3) (340.0) (304.8) 80.0
Total revenues....................................... 1,505.5 3,202.2 4,450.4 5,492.0 5,581.4 6,315.3
Interest expense on corporate notes payable and
investment borrowings (contractual interest:
$268.5 for the eight months ended August 31,
2003; and $345.3 for 2002)......................... 36.8 202.5 341.9 400.0 454.3 300.2
Total benefits and expenses.......................... 1,356.0 1,030.0 6,082.6 5,735.4 6,358.9 5,301.2
Income (loss) before income taxes, minority
interest, discontinued operations and cumulative
effect of accounting change........................ 149.5 2,172.2 (1,632.2) (243.4) (777.5) 1,014.1
Cumulative effect of accounting change, net of
income tax......................................... - - (2,949.2) - (55.3) -
Net income (loss).................................... 96.3 2,201.7 (7,835.7) (405.9) (1,191.2) 595.0
Preferred stock dividends ........................... 27.8 - 2.1 12.8 11.0 1.5
Net income (loss) applicable to common stock......... 68.5 2,201.7 (7,837.8) (418.7) (1,202.2) 593.5
PER SHARE DATA
Net income, basic.................................... $.68
Net income, diluted.................................. .67
Book value per common share outstanding.............. $19.28
Weighted average shares outstanding for basic
earnings........................................... 100.1
Weighted average shares outstanding for diluted
earnings........................................... 143.5
Shares outstanding at period-end..................... 100.1
BALANCE SHEET DATA - AT PERIOD END
Total investments.................................... $22,796.7 $22,018.3 $21,783.7 $25,067.1 $25,017.6 $26,431.6
Goodwill ........................................... 952.2 99.4 100.0 3,695.4 3,800.8 3,927.8
Total assets......................................... 29,920.1 28,318.1 46,509.0 61,432.2 58,589.2 52,185.9
Corporate notes payable and commercial paper ........ 1,300.0 - - 4,085.0 5,055.0 4,624.2
Liabilities subject to compromise.................... - 6,951.4 4,873.3 - - -
Total liabilities.................................... 27,102.5 30,519.5 46,637.9 54,764.7 51,810.9 43,990.6
Company-obligated mandatorily redeemable
preferred securities of subsidiary trusts....... - - 1,921.5 1,914.5 2,403.9 2,639.1
Shareholders' equity (deficit)....................... 2,817.6 (2,201.4) (2,050.4) 4,753.0 4,374.4 5,556.2
STATUTORY DATA(b)
Statutory capital and surplus........................ $1,514.1 $ 1,064.4 $ 1,649.8 $ 1,881.8 $ 2,170.5
Asset valuation reserve ("AVR")...................... 40.9 11.6 105.1 266.8 362.8
Total statutory capital and surplus and AVR.......... 1,555.0 1,076.0 1,754.9 2,148.6 2,533.3
- -------------
(a) Our financial condition and results of operations have been significantly
affected during the periods presented by the discontinued finance
operations. Please refer to the section of Management's Discussion and
Analysis of Consolidated Financial Condition and Results of Operations
entitled "Financial Condition and Results of Operations of CFC -
Discontinued Finance Operations" for additional information.
(b) We have derived the statutory data from statements filed by our insurance
subsidiaries with regulatory authorities and have prepared the statutory
data in accordance with statutory accounting principles, which vary in
certain respects from GAAP.
24
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL
CONDITION AND RESULTS OF OPERATIONS.
In this section, we review the consolidated financial condition of Conseco
at December 31, 2003, and the consolidated results of operations for: (i) the
four months ended December 31, 2003; (ii) the eight months ended August 31,
2003; and (iii) the years ended December 31, 2002 and 2001 and, where
appropriate, factors that may affect future financial performance. Please read
this discussion in conjunction with the consolidated financial statements and
notes included in this Form 10-K.
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
Our statements, trend analyses and other information contained in this
report and elsewhere (such as in filings by Conseco with the Securities and
Exchange Commission, press releases, presentations by Conseco or its management
or oral statements) relative to markets for Conseco's products and trends in
Conseco's operations or financial results, as well as other statements, contain
forward-looking statements. Forward-looking statements typically are identified
by the use of terms such as "anticipate," "believe," "plan," "estimate,"
"expect," "project," "intend," "may," "will," "would," "contemplate,"
"possible," "attempts," "seeks," "should," "could," "goal," "target," "on
track," "comfortable with," "optimistic" and similar words, although some
forward-looking statements are expressed differently. You should consider
statements that contain these words carefully because they describe our
expectations, plans, strategies and goals and our beliefs concerning future
business conditions, our results of operations, financial position, and our
business outlook or they state other "forward-looking" information based on
currently available information. The "Risk Factors" section of this Item 7
provides examples of risks, uncertainties and events that could cause our actual
results to differ materially from the expectations expressed in our
forward-looking statements. Assumptions and other important factors that could
cause our actual results to differ materially from those anticipated in our
forward-looking statements include, among other things:
o the potential adverse impact of our Predecessor's Chapter 11 petition
on our business operations, and relationships with our customers,
employees, regulators, distributors and agents;
o our ability to operate our business under the restrictions imposed by
our senior bank credit facility or future credit facilities;
o our ability to improve the financial strength ratings of our insurance
company subsidiaries and the impact of recent rating downgrades on our
business;
o our ability to obtain adequate and timely rate increases on our
supplemental health products including our long-term care business;
o general economic conditions and other factors, including prevailing
interest rate levels, stock and credit market performance and health
care inflation, which may affect (among other things) our ability to
sell products and access capital on acceptable terms, the market value
of our investments, and the lapse rate and profitability of policies;
o our ability to achieve anticipated synergies and levels of operational
efficiencies;
o customer response to new products, distribution channels and marketing
initiatives;
o mortality, morbidity, usage of health care services, persistency and
other factors which may affect the profitability of our insurance
products;
o performance of our investments;
o changes in the Federal income tax laws and regulations which may
affect or eliminate the relative tax advantages of some of our
products;
o increasing competition in the sale of insurance and annuities;
o regulatory changes or actions, including those relating to regulation
of the financial affairs of our insurance companies, including the
payment of dividends to us, regulation of financial services affecting
(among other things) bank sales and underwriting of insurance
products, regulation of the sale, underwriting and pricing of
products, and
25
health care regulation affecting health insurance products;
o the ultimate outcome of lawsuits filed against us and other legal and
regulatory proceedings to which we are subject; and
o the risk factors or uncertainties listed from time to time in our
filings with the Securities and Exchange Commission.
Other factors and assumptions not identified above are also relevant to the
forward-looking statements, and if they prove incorrect, could also cause actual
results to differ materially from those projected.
All written or oral forward-looking statements attributable to us are
expressly qualified in their entirety by the foregoing cautionary statement. Our
forward-looking statements speak only as of the date made. We assume no
obligation to update or to publicly announce the results of any revisions to any
of the forward-looking statements to reflect actual results, future events or
developments, changes in assumptions or changes in other factors affecting the
forward-looking statements.
OVERVIEW
We are a holding company for a group of insurance companies operating
throughout the United States that develop, market and administer supplemental
health insurance, annuity, individual life insurance and other insurance
products. We focus on serving the senior and middle-income markets, which we
believe are attractive, high growth markets. We sell our products through three
distribution channels: career agents, professional independent producers (some
of whom sell one or more of our product lines exclusively) and direct marketing.
We conduct our business operations through two primary operating segments,
based primarily on method of product distribution, and a third segment comprised
of businesses in run-off. Prior to September 30, 2003, we conducted our
insurance operations through one segment. In the fourth quarter of 2003, we
implemented changes contemplated in our restructuring plan to conduct our
business through the following segments:
o Bankers Life, which consists of the businesses of Bankers Life and
Casualty and Colonial Penn. Bankers Life and Casualty markets and
distributes Medicare supplement insurance, life insurance, long-term
care insurance and fixed annuities to the senior market through
approximately 4,000 exclusive career agents and sales managers.
Colonial Penn markets graded benefit and simplified issue life
insurance directly to consumers through television advertising, direct
mail, the internet and telemarketing. Both Bankers Life and Casualty
and Colonial Penn market their products under their own brand names.
o Conseco Insurance Group, which markets and distributes specified
disease insurance, Medicare supplement insurance, and certain life and
annuity products to the senior and middle-income markets through over
500 IMOs that represent over 9,100 producing independent agents. This
segment markets its products under the "Conseco" brand.
o Other Business in Run-off, which includes blocks of business that we
no longer market or underwrite and are managed separately from our
other businesses. This segment consists of long-term care insurance
sold through independent agents and major medical insurance.
We also have a corporate segment, which consists of holding company
activities and certain noninsurance company businesses that are not related to
our operating segments.
We have restated all historical periods presented in "Management's
Discussion and Analysis of Financial Condition and Results of Operations" to
reflect our new segments.
We emerged from bankruptcy protection under our Plan, which was confirmed
pursuant to an order of the Bankruptcy Court on September 9, 2003, and became
effective on September 10, 2003. Upon the confirmation of the Plan, we
implemented fresh start accounting in accordance with SOP 90-7. Our accounting
and actuarial systems and procedures are designed to produce financial
information as of the end of a month. Accordingly, for accounting convenience
purposes, we applied the effects of fresh start accounting on August 31, 2003.
The activity of the Company for the period September 1, 2003 through September
10, 2003 is therefore included in the Successor's statement of operations and
excluded from the Predecessor's statement of operations. We believe the net
income impact of the use of the convenience date is immaterial.
In accordance with SOP 90-7, we restated all of our assets and liabilities
to their current estimated value, reestablished
26
shareholders' equity at the reorganization value determined in connection with
our Plan and recorded the portion of the reorganization value which could not be
attributed to specific tangible or identified intangible assets as goodwill. As
a result, our financial statements for periods following August 31, 2003, are
not comparable with those prepared before that date.
For the four months ended December 31, 2003 (the period after our emergence
from bankruptcy), net income after dividends on our convertible exchangeable
preferred stock totaled $68.5 million, or 67 cents per diluted share. Results
for the four month period included net after-tax gains of $3.4 million from
realized investment gains and venture capital losses.
Despite low ratings and our decisions to discontinue or curtail sales in
certain products in order to conserve capital coming out of bankruptcy,
collected premiums in our core products have been relatively stable in the post
bankruptcy period.
The past year was a year of transition for us. We continue to focus on the
factors that we believe are most important to achieving our number one business
objective - improved ratings for our insurance subsidiaries:
o Combined statutory earnings (loss) (a non-GAAP measure) totaled $286.1
million and $(465.0) million in 2003 and 2002, respectively. Included
in such earnings (loss) are net realized capital gains (losses), net
of income taxes, of $32.8 million and $(516.1) million in 2003 and
2002, respectively. The 2003 statutory results included several
positive income items resulting from the sale of the GM Building in
the third quarter, as well as expense reductions and other operating
improvements.
o Combined statutory capital and surplus (a non-GAAP measure) at
December 31, 2003, was $1.5 billion, up from $1.1 billion at year-end
2002.
o Combined RBC ratio (a non-GAAP measure) was 287 percent at December
31, 2003, up from 166 percent at year-end 2002.
Our other major goals for 2004 are to reduce our capital cost, strengthen
our balance sheet and improve our execution on the basics of our business by:
o Further reducing operating expenses and improving the efficiency of
our operations across all business functions.
o Continuing our focus on the acquired blocks of long-term care business
in the Other Business in Run-off segment.
o Consolidating and streamlining our back-office systems to reduce
complexity, lower our costs and improve customer service.
o Expanding our career agent segment (Bankers Life) into new geographic
markets.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements in accordance with GAAP requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Management has made estimates in the past
that we believed to be appropriate but were subsequently revised to reflect
actual experience. If our future experience differs materially from these
estimates and assumptions, our results of operations and financial condition
could be affected.
We base our estimates on historical experience and other assumptions that
we believe are reasonable under the circumstances. We continually evaluate the
information used to make these estimates as our business and the economic
environment change. The use of estimates is pervasive throughout our financial
statements. The accounting policies and estimates we consider most critical are
summarized below. Additional information on our accounting policies is included
in the note to our consolidated financial statements entitled "Summary of
Significant Accounting Policies".
27
Critical Accounting Policies Related to our Continuing Business
Investments
At December 31, 2003, the carrying value of our investment portfolio was
$22.8 billion. The accounting risks associated with these assets relate to the
recognition of income, our determination of other-than-temporary impairments and
our estimation of fair values.
We defer any fees received or costs incurred when we originate investments.
We amortize fees, costs, discounts and premiums as yield adjustments over the
contractual lives of the investments. We consider anticipated prepayments on
structured securities in determining estimated yields on such securities.
Adjustments to yields as a result of actual prepayments being different than
anticipated are recognized as investment income (loss).
When we sell a security (other than trading securities or venture capital
investments), we report the difference between the sale proceeds and the
amortized cost (determined based on specific identification) as a realized
investment gain or loss.
We regularly evaluate all of our investments for possible impairment based
on current economic conditions, credit loss experience and other
investee-specific developments. If there is a decline in a security's net
realizable value that is other than temporary, the decline is recognized as a
realized loss and the cost basis of the security is reduced to its estimated
fair value. During the four months ended December 31, 2003, we recorded $9.6
million of writedowns of fixed maturities, equity securities and other invested
assets as a result of conditions that caused us to conclude a decline in the
fair value of the investments was other than temporary. During the eight months
ended August 31, 2003, we recorded writedowns of fixed maturity investments,
equity securities and other invested assets totaling $51.3 million.
If a decline in value is determined to be other than temporary and the cost
basis of the security is written down to fair value, we review the circumstances
which caused us to believe that the decline was other than temporary with
respect to other investments in our portfolio. If such circumstances exist with
respect to other investments, those investments are also written down to fair
value. Future events may occur, or additional or updated information may become
available, which may necessitate future realized losses of securities in our
portfolio. Significant losses in the carrying value of our investments could
have a material adverse effect on our earnings in future periods.
Our evaluation of investments for impairment requires significant judgments
to be made, including: (i) the identification of potentially impaired
securities; (ii) the determination of their estimated fair value; and (iii)
assessment of whether any decline in estimated fair value is other than
temporary. Our periodic assessment of whether unrealized losses are "other than
temporary" also requires significant judgment. Factors considered include: (i)
the extent to which market value is less than the cost basis; (ii) the length of
time that the market value has been less than cost; (iii) whether the unrealized
loss is event driven, credit-driven or a result of changes in market interest
rates; (iv) the near-term prospects for improvement in the issuer and/or its
industry; (v) whether the investment is investment grade and our security
analyst's view of the investment's rating and whether the investment has been
downgraded since its purchase; (vi) whether the issuer is current on all
payments in accordance with the contractual terms of the investment and is
expected to meet all of its obligations under the terms of the investment; (vii)
our ability and intent to hold the investment for a period of time sufficient to
allow for any anticipated recovery; and (viii) the underlying asset and
enterprise values of the issuer. If new information becomes available or the
financial condition of the investee changes, our judgments may change resulting
in the recognition of a realized investment loss at that time. At December 31,
2003, our net accumulated other comprehensive income included gross unrealized
losses on investments of $34.5 million; we consider all such declines in
estimated fair value to be temporary.
Estimated fair values for our investments are determined based on estimates
from nationally recognized pricing services, broker-dealer market makers and
internally developed methods. Our internally developed methods require us to
make judgments about the security's credit quality, liquidity and market spread.
Below-investment grade securities have different characteristics than
investment grade corporate debt securities. Risk of loss upon default by the
borrower is significantly greater with respect to below-investment grade
securities than with other corporate debt securities. Below-investment grade
securities are generally unsecured and are often subordinated to other creditors
of the issuer. Also, issuers of below-investment grade securities usually have
higher levels of debt and are more sensitive to adverse economic conditions,
such as recession or increasing interest rates, than are investment grade
issuers. We attempt to reduce the overall risk in the below-investment grade
portfolio, as in all investments, through careful credit analysis, strict
investment policy guidelines, and diversification by issuer and/or guarantor and
by industry.
During the four months ended December 31, 2003, we sold $604.9 million of
fixed maturity investments which
28
resulted in gross realized investment losses (before income taxes) of $7.3
million. During the first eight months of 2003, we sold $2.7 billion of fixed
maturity investments which resulted in gross realized investment losses (before
income taxes) of $62.4 million. Securities sold at a loss are sold for a number
of reasons including but not limited to: (i) changes in the investment
environment; (ii) expectation that the market value could deteriorate further;
(iii) desire to reduce our exposure to an issuer or an industry; (iv) changes in
credit quality; and (v) our analysis indicating there is a high probability that
the security is other-than-temporarily impaired.
We seek to manage the relationship between the estimated duration of our
invested assets and the expected duration of our insurance liabilities. When the
estimated durations of assets and liabilities are similar, exposure to interest
rate risk is minimized because a change in the value of assets should be largely
offset by a change in the value of liabilities. A mismatch of the durations of
invested assets and insurance liabilities could have a significant impact on our
results of operations and financial position. See "-- Quantitative and
Qualitative Disclosures About Market Risks" for additional discussion of the
duration of our invested assets and insurance liabilities.
For more information on our investment portfolio and our critical
accounting policies related to investments, see the note to our consolidated
financial statements entitled "Investments".
Value of Policies Inforce at the Effective Date and Cost of Policies
Produced
In conjunction with the implementation of fresh start accounting, we
eliminated the historical balances of our Predecessor's cost of policies
purchased and cost of policies produced as of the Effective Date and replaced
them with the value of policies inforce.
The cost assigned to the right to receive future cash flows from contracts
existing at August 31, 2003 is referred to as the value of policies inforce. We
also defer renewal commissions paid in excess of ultimate commission levels
related to the existing policies in this account. The balance of this account is
amortized, evaluated for recovery, and adjusted for the impact of unrealized
gains (losses) in the same manner as the cost of policies produced described
below. We expect to amortize approximately 10 percent of the December 31, 2003
balance of value of policies inforce in 2004, 10 percent in 2005, 9 percent in
2006, 8 percent in 2007 and 8 percent in 2008.
The cost of policies produced are those costs that vary with, and are
primarily related to, producing new insurance business. These amounts are
amortized using the interest rate credited to the underlying policy: (i) in
relation to the estimated gross profits for investment and universal life-type
products; or (ii) in relation to future anticipated premium revenue for other
products. The amortization for investment and universal life-type products is
adjusted retrospectively when estimates of current or future gross profits and
margins to be realized from a group of products and contracts are revised.
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 produced 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.
At December 31, 2003, the combined balance of the value of policies inforce
and cost of policies produced was $3.1 billion. The recovery of these costs is
dependent on the future profitability of the related business.
Each year, we evaluate the recoverability of the unamortized balance of the
value of policies inforce and the cost of policies produced. We consider
estimated future gross profits or future premiums, expected mortality or
morbidity, interest earned and credited rates, persistency and expenses in
determining whether the balance is recoverable. If we determine a portion of the
unamortized balance is not recoverable, it is charged to amortization expense.
The assumptions we use to amortize and evaluate the recoverability of the
value of policies inforce and the cost of policies produced involve significant
judgment. A revision to these assumptions could have a significant adverse
effect on our results of operations and financial position.
Goodwill
Upon our emergence from bankruptcy, we revalued our assets and liabilities
to current estimated fair value and established our capital accounts at the
reorganization value determined in connection with the Plan. We recorded the
$1,141.6 million of the reorganization value which could not be attributed to
specific tangible or identified intangible assets as
29
goodwill. Under current accounting rules (which became effective January 1,
2002) goodwill is not amortized but is subject to an annual impairment test (or
more frequently if there is an indication that an impairment may exist). We
obtained an independent appraisal of our business in connection with the
preparation of the Plan which indicated no impairment of our goodwill existed.
However, we cannot assure you that we will not have to recognize impairment
charges in the future.
Although the goodwill balance will not be subject to amortization, it will
be reduced by future use of our net deferred income tax assets (including the
deferred tax assets associated with tax operating loss carryforwards) existing
at August 31, 2003 (which balance was reduced by $189.4 million in the four
months ended December 31, 2003). A valuation allowance has been provided for the
remaining balance of such net deferred income tax assets due to the
uncertainties regarding their realization. See "-- Income Taxes" below for
further discussion.
Income Taxes
Our income tax expense includes deferred income taxes arising from
temporary differences between the financial reporting and tax bases of assets
and liabilities, capital loss carryforwards and net operating loss
carryforwards. In assessing the realization of deferred income tax assets, we
consider whether it is more likely than not that the deferred income tax assets
will be realized. The ultimate realization of our deferred income tax assets
depends upon generating future taxable income during the periods in which our
temporary differences become deductible and before our net operating loss
carryforwards expire. In addition, the use of our net operating loss
carryforwards is dependent, in part, on whether the IRS ultimately agrees with
the tax position we plan to take in our current and future tax returns. With
respect to the deferred income tax assets, we assess the need for a valuation
allowance on a quarterly basis.
At the time of our emergence from bankruptcy, we established a valuation
allowance for the entire balance of net deferred income tax assets as we
believed that the realization of such net deferred income tax assets in future
periods was uncertain. As of December 31, 2003, we continue to believe that the
realization of our net deferred income tax asset is uncertain and continue to
maintain a valuation allowance for the entire balance of net deferred income tax
assets. We reached this conclusion after considering the losses realized by the
Company in recent years, the uncertainties related to the tax treatment for the
worthlessness of our investment in CFC (which is more fully discussed below),
and the likelihood of future taxable income exclusive of reversing temporary
differences and carryforwards.
As of December 31, 2003, we had approximately $3.6 billion of net operating
loss carryforwards (after taking into account the reduction in tax attributes
described in the paragraph which follows and the loss resulting from the
worthlessness of our Predecessor's investment in CFC discussed below), which
expire as follows: $11.2 million in 2004; $4.6 million in 2005; $.2 million in
2006; $5.8 million in 2007; $6.6 million in 2008; $10.5 million in 2009; $4.2
million in 2010; $2.5 million in 2011; $16.0 million in 2012; $43.4 million in
2013; $6.9 million in 2014; $60.4 million in 2016; $41.5 million in 2017;
$3,399.5 million in 2018; $.7 million in 2019; $5.5 million in 2020; and $1.0
million in 2022. The timing and manner in which we will utilize the net
operating loss carryforwards in any year or in total may be limited by various
provisions of the Code (and interpretation thereof) and our ability to generate
sufficient future taxable income in the relevant carryforward period.
The Code provides that any income realized as a result of the cancellation
of indebtedness (cancellation of debt income or "CODI") in bankruptcy will
reduce certain tax attributes, including net operating loss carryforwards. We
realized an estimated $2.5 billion of CODI when we emerged from bankruptcy.
Accordingly, our net operating loss carryforwards were reduced by $2.5 billion.
The following paragraphs summarize some of the various limitations and
contingencies which exist with respect to the future utilization of the net
operating loss carryforwards.
We realized an estimated $5.4 billion tax loss in 2003 as a result of our
investment in CFC. In consultation with our tax advisors and based on relevant
provisions of the Code, we intend to treat this loss as an ordinary loss,
thereby increasing our net operating loss carryforward. We have requested a
pre-filing examination by the IRS to confirm that this loss should be treated as
an ordinary loss. If the IRS were to disagree with our conclusion and such
determination ultimately prevailed, the loss would be treated as a capital loss,
which would only be available to reduce future capital gains for the next 5
years. The procedures related to the pre-filing examination are in process, but
are not expected to be completed before August 2004.
The Code limits the extent to which losses realized by a non-life entity
(or entities) may offset income from a life insurance company (or companies) to
the lesser of: (i) 35 percent of the income of the life insurance company; or
(ii) 35 percent of the total loss. There is no limitation with respect to the
ability to utilize net operating losses generated by a life insurance company.
Subsequent to our emergence from bankruptcy, we reorganized certain of our
subsidiaries to improve their capital position and, as a result, the loss
related to CFC was realized by a life insurance company. Accordingly, we
30
believe the loss should be treated as a life insurance loss and would not be
subject to the limitations described above. However, if the IRS were to disagree
with our conclusion and such determination ultimately prevailed, the loss
related to CFC would be subject to the limitation described in the first
sentence of this paragraph.
The timing and manner in which we will be able to utilize some or all of
our net operating loss carryforward may be limited by Section 382 of the Code.
Section 382 imposes limitations on a corporation's ability to use its net
operating losses if the company undergoes an ownership change. Because we
underwent an ownership change pursuant to our reorganization, we have determined
that this limitation applies to us. In order to determine the amount of this
limitation we must determine how much of our net operating loss carryforward
relates to the period prior to our emergence from bankruptcy (which amount will
be subject to the Section 382 limitation) and how much relates to the period
after emergence (which amount will not be subject to the Section 382
limitation). Pursuant to the Code, we may: (i) allocate the current year tax
loss on a pro rata basis to determine earnings (loss) post- and pre-emergence;
or (ii) specifically identify transactions in each period and record them in the
period in which they actually occurred. We intend to elect the latter, which we
believe will result in a substantial portion of the loss related to CFC being
treated as post-emergence and therefore not subject to the Section 382
limitation. Any losses that are subject to the Section 382 limitation will only
be utilized by us up to approximately $140 million per year, with any unused
amounts carried forward to the following year.
The reduction of any portion of our deferred income tax valuation allowance
(including the deferred tax assets associated with net operating loss
carryforwards) existing as of August 31, 2003, will be accounted for as a
reduction of goodwill when eliminated pursuant to SOP 90-7. If all goodwill is
eliminated, any additional reduction of the valuation allowance existing at
August 31, 2003 will be accounted for as a reduction of other intangible assets
until exhausted and thereafter as an addition to paid-in-capital. Goodwill was
reduced by $189.4 million during the four months ended December 31, 2003 due to
a reduction in the valuation allowance for net deferred income tax assets
established at the Effective Date.
Liabilities for Insurance Products
At December 31, 2003, the total balance of our liabilities for insurance
and asset accumulation products was $24.8 billion. These liabilities are often
payable over an extended period of time and the profitability of the related
products is dependent on the pricing of the products and other factors.
Differences between our expectations when we sold these products and our actual
experience could result in future losses.
We calculate and maintain reserves for the estimated future payment of
claims to our policyholders based on actuarial assumptions. For our supplemental
health insurance business, we establish an active life reserve plus a liability
for due and unpaid claims, claims in the course of settlement and incurred but
not reported claims, as well as a reserve for the present value of amounts not
yet due on claims. Many factors can affect these reserves and liabilities, such
as economic and social conditions, inflation, hospital and pharmaceutical costs,
changes in doctrines of legal liability and extra-contractual damage awards.
Therefore, the reserves and liabilities we establish are necessarily based on
extensive estimates, assumptions and historical experience. Establishing
reserves is an uncertain process, and it is possible that actual claims will
materially exceed our reserves and have a material adverse effect on our results
of operations and financial condition. Our financial results depend
significantly upon the extent to which our actual claims experience is
consistent with the assumptions we used in determining our reserves and pricing
our products. If our assumptions with respect to future claims are incorrect,
and our reserves are insufficient to cover our actual losses and expenses, we
would be required to increase our liabilities, which would negatively affect our
operating results.
Liabilities for insurance products are calculated using management's best
judgments of mortality, morbidity, lapse rates, investment experience and
expense levels that are based on our past experience and standard actuarial
tables.
31
In accordance with SOP 90-7, the Successor established insurance
liabilities and an asset for the value of policies inforce at the Effective Date
using current assumptions. Adjustments to the Predecessor's liabilities for
insurance and asset accumulation products as of August 31, 2003 are summarized
below (dollars in millions):
Predecessor Fresh start Successor
balance sheet adjustments balance sheet
------------- ----------- -------------
Liabilities for insurance and asset accumulation products: Traditional and
limited payment products:
Traditional life insurance products............................... $ 1,885.3 $ 320.3 $ 2,205.6
Limited pay annuities............................................. 880.0 140.0 1,020.0
Individual accident and health ................................... 5,245.8 1,887.9 7,133.7
Group life and health............................................. 692.0 136.7 828.7
Unearned premiums................................................. 3.3 - 3.3
--------- -------- ---------
Total liabilities for traditional and limited payment products. 8,706.4 2,484.9 11,191.3
--------- -------- ---------
Interest-sensitive products:
Investment contracts ............................................. 8,489.8 132.9 8,622.7
Universal life-type products ................................. 3,994.6 (15.4) 3,979.2
--------- -------- ---------
Total liabilities for interest-sensitive products.............. 12,484.4 117.5 12,601.9
--------- -------- ---------
Other liabilities for insurance and asset accumulation products:
Separate accounts and investment trusts .......................... 87.7 - 87.7
Claims payable and other policyholder funds ...................... 897.1 (10.3) 886.8
--------- -------- ---------
Total other liabilities for insurance and asset accumulation
products................................................... 984.8 (10.3) 974.5
--------- -------- ---------
Total liabilities for insurance and asset accumulation products......... $22,175.6 $2,592.1 $24,767.7
========= ======== =========
The following provides explanations for the fresh-start adjustment to
insurance liabilities related to our insurance inforce at the Effective Date.
Traditional insurance and limited pay products
In accordance with Statement of Financial Accounting Standards No. 60,
"Accounting and Reporting by Insurance Enterprises" and Statement of Financial
Accounting Standards No. 97, "Accounting and Reporting by Insurance Enterprises
for certain Long-Duration Contracts and for Realized Gains and Losses from the
Sale of Investments" ("SFAS 97"), the Predecessor used the original actuarial
assumptions determined when traditional long-duration and limited payment
insurance contracts were issued in determining liability calculations through
the fresh start date, provided the resulting liabilities were adequate to
provide for future benefits and expenses under the related contracts. This
accounting principle is referred to as the "lock in" principle and is only
applicable to traditional insurance and limited pay products. The use of
assumptions that are locked in at the time of issue means that absent loss
recognition, the same assumptions are used in accounting for a particular block
of business unless the block is subject to purchase or fresh start accounting.
At the Effective Date, the Successor established insurance liabilities at
the present value of future benefits and expenses associated with the policies,
by using current best-estimate assumptions with provisions for adverse
deviation. Such assumptions include estimates as to investment yields,
mortality, morbidity, withdrawals, lapses and maintenance expenses. The current
best-estimate assumptions for these blocks of business differ from the original
actuarial assumptions determined when the business was acquired or issued as
further described in the following paragraphs.
Due to the current interest rate environment and the requirement to mark
the value of the investment portfolio to market, we changed our assumptions
related to future investment earnings. The weighted average expected yield on
our investment portfolio decreased to approximately 5.6 percent at the Effective
Date from 6.7 percent at December 31, 2002. Approximately $.9 billion of the
fresh-start increase to insurance liabilities is the result of changes in future
expected investment earnings.
32
The performance of our long-term care business (especially the acquired
block originally sold through independent agents) has generally been unfavorable
relative to the Predecessor's assumptions established when these blocks of
business were acquired. For example, variance in actual versus estimated
morbidity, lapses and expenses have been unfavorable to original assumptions.
Approximately $1.4 billion of the increase to insurance liabilities is the
result of changes in non-interest assumptions for our long-term care policies.
Our assumption changes for long-term care business included: (i) changes in
morbidity assumptions from estimates made when the business was acquired to
recent Company experience; (ii) changes in mortality assumptions related to
certain blocks of this business from the 1958 and 1980 Commissioners Standard
Ordinary Mortality table to the 1983 Group Annuity Mortality table; and (iii)
changes in ultimate lapse ratios from a range of approximately 3 percent to 5.5
percent prior to the adoption of fresh start accounting to a range of 2 percent
to 3.5 percent.
Interest-sensitive products subject to requirements of SFAS 97
The insurance liability for asset accumulation products (such as deferred
annuities and universal life products) is generally equal to current
policyholder account balances. These balances generally do not change as a
result of the adoption of fresh start accounting. The fresh-start adjustment to
insurance liabilities for interest-sensitive products primarily results from:
(i) the adoption of SOP 03-01 as of the Effective Date; and (ii) certain
Predecessor insurance liabilities that were different from the present value of
estimated future benefits as of August 31, 2003.
The adoption of SOP 03-01 as of the Effective Date required a change in
methodology regarding persistency bonuses provided to policyholders who continue
to keep their policies inforce for a stated period of time. The Predecessor
recognized the cost of this benefit over the period prior to the time the
benefit is credited in proportion to estimated gross profits and assumed a
certain number of policies would terminate before the benefit was credited.
Under SOP 03-01, the cost for such benefits is recognized ratably over the
period prior to the time the benefit is credited without assuming policy
terminations. Insurance liabilities increased by approximately $.1 billion as a
result of the adoption of SOP 03-01.
In addition, the insurance liabilities for certain Predecessor insurance
liabilities were different than the present value of estimated future benefits
as of the Effective Date.
The Predecessor had previously established an insurance liability related
to certain business, to recognize the future loss expected to be recognized for
the former practice of reducing the cost of insurance charges to amounts below
the level permitted under the provisions of the policy. The Predecessor
amortized this liability into income in proportion to estimated gross profits on
the business, consistent with SFAS 97 requirements for unearned revenues. The
Predecessor had previously decided to discontinue the practice of providing this
nonguaranteed benefit. Accordingly, the remaining insurance liability
established for this benefit was no longer required at August 31, 2003,
resulting in a $.1 billion reduction to reserves in conjunction with our
adoption of fresh-start accounting.
The liabilities established for our equity-indexed annuity products
(including the value of options attributable to policyholders for the estimated
life of the annuity contract and accounted for as embedded derivatives) are
established pursuant to different accounting rules than other interest-sensitive
products. At the Effective Date, the present value of estimated future benefits
for our equity-indexed products exceeded the value of the Predecessor's
liabilities by $.2 billion, resulting in a fresh-start adjustment.
Liabilities for Loss Contingencies Related to Lawsuits and Our Guarantees
of Bank Loans and Related Interest Loans
We are involved on an ongoing basis in lawsuits relating to our operations,
including with respect to sales practices, and we and current and former
officers and directors are defendants in pending class action lawsuits asserting
claims under the securities laws and in derivative lawsuits. The ultimate
outcome of these lawsuits cannot be predicted with certainty. We recognize an
estimated loss from these loss contingencies when we believe it is probable that
a loss has been incurred and the amount of the loss can be reasonably estimated.
However, it is difficult to measure the actual loss that might be incurred
related to litigation. The ultimate outcome of these lawsuits could have a
significant impact on our results of operations and financial position.
In conjunction with the Plan, $481.3 million principal amount of bank loans
made to certain former directors and certain current and former officers and key
employees to enable them to purchase common stock of Old Conseco were
transferred to the Company. These loans had been guaranteed by Old Conseco. We
received all rights to collect the balances due pursuant to the original terms
of these loans. In addition, we hold loans to participants for interest on the
bank loans which total approximately $220 million. The former bank loans and the
interest loans are collectively referred to as the "D&O loans." We regularly
evaluate the collectibility of these loans in light of the collateral we hold
and the creditworthiness of the participants. At December 31, 2003, we have
estimated that approximately $51.0 million of the
33
D&O balance (which is included in other assets) is collectible (net of the cost
of collection). An allowance has been established to reduce the recorded balance
of the D&O loans to this balance.
Pursuant to the settlement that was reached with the Official Committee of
the Trust Originated Preferred Securities ("TOPrS") Holders and the Official
Committee of Unsecured Creditors in the Plan, the former holders of TOPrS
(issued by Old Conseco's subsidiary trusts and eliminated in our reorganization)
who did not opt out of the bankruptcy settlement, will be entitled to receive 45
percent of any proceeds from the collection of certain D&O loans in an aggregate
amount not to exceed $30 million. We have established a liability of $23.1
million (which is included in other liabilities), representing our estimate of
the amount which will be paid to the former holders of TOPrS pursuant to the
settlement.
RISK FACTORS
Conseco and its businesses are subject to a number of risks including
general business and financial risk factors. Any or all of such factors, which
are enumerated below, could have a material adverse effect on the business,
financial condition or results of operations of Conseco. Also see "Cautionary
Statement Regarding Forward-Looking Statements" above.
Our recent bankruptcy may continue to disrupt our operations and hamper our
efforts to restore confidence in the "Conseco" brand, which may contribute
to lower sales, increased agent attrition and policyholder lapses and
redemptions.
The announcement of our intention to seek a restructuring of our capital in
August 2002 and our subsequent filing of bankruptcy petitions in December 2002
caused significant disruptions in our operations. We believe that adverse
publicity in national and local media concerning our distressed financial
condition and disputes with former members of our management caused sales of our
insurance products to decline and policyholder lapses and redemptions to
increase. For example, our total premium collections decreased 8.4 percent to
$4,180.9 million for the year ended December 31, 2003, compared to 2002. In
addition, withdrawals from annuities and other investment-type products exceeded
deposits received by $615.4 million during the year ended December 31, 2003. In
addition, we experienced increased agent attrition, which in some cases led us
to increase agents' commissions or sales incentives in order to retain agents.
For example, the number of producing agents selling products through the Conseco
Insurance Group segment decreased by approximately 45 percent to 9,100 at
December 31, 2003 compared to a year earlier. The number of career agents
selling products through the Bankers Life segment remained at approximately
4,000 throughout 2003. We implemented agent sales incentive programs to retain
the career agency force during periods of negative media coverage, decreased
ratings and increased competitive activity from agents selling competitors'
products. The total cost for the agent incentive programs during 2003 was $17
million. While we cannot quantify with specificity the portion of these adverse
changes that were caused by our distressed financial condition and the
associated negative publicity, we believe that these events contributed
significantly to these trends. Although we believe that the successful
completion of the bankruptcy and our continuing restructuring efforts will
reverse these trends and will enable us to restore confidence in the "Conseco"
brand among customers, agents, regulators and our other constituencies, we only
recently emerged from bankruptcy and there have not yet been any significant
improvements in these trends. It may take several quarters of operating results
following our emergence to determine the extent of our operational and
reputational recovery from these events.
Legal proceedings that arose in the context of our bankruptcy may continue
to disrupt our operations and hamper our efforts to restore confidence in
the "Conseco" brand, which may negatively impact our financial results and
liquidity.
We continue to be involved in various legal proceedings that arose in the
context of our restructuring. For example, since our August 2002 announcement
that we would seek to restructure our capital, we and/or our Predecessor and
several of our former, and in some instances current, officers and directors
have been named as defendants in lawsuits, including class action lawsuits,
alleging, among other things, securities fraud and breaches of fiduciary duty
under ERISA. While the Company was discharged from pre-petition obligations, it
still owes indemnity to certain officers and directors. Our ultimate financial
exposure on this indemnity may be limited by the availability of insurance, but
not all of the cases relating to periods prior to our bankruptcy are so limited
and we cannot predict with certainty what our ultimate liability in such cases
may be.
We are also involved in, and have been subject to subpoena with respect to,
federal and/or state investigations relating to the marketing of variable
annuities by our Predecessor's former indirect subsidiary, Conseco Variable
Insurance Company, and the accounting for certain interest-only securities by
our Predecessor's finance subsidiary, which was sold in connection with our
reorganization. We have also commenced litigation against certain of our former
officers and directors in connection with our efforts to collect amounts
outstanding under our Predecessor's director and officer loan programs.
We believe that adverse publicity in national and local media concerning
the above proceedings may hamper our efforts to restore confidence in the
"Conseco" brand, and impose impediments to our customers' willingness to
continue to buy our products and our ability to attract new customers.
Similarly, the adverse publicity concerning these proceedings may make it more
difficult for us to attract and retain agents and independent marketing
organizations to market our products. While we believe that these events have
affected, and may continue to affect, our customers' and agents' willingness to
do business with us, we cannot quantify the extent of these effects with
specificity. See "Item 3. Legal Proceedings".
34
A failure to improve and maintain the financial strength ratings of our
insurance subsidiaries could cause us to experience lower sales, increased
agent attrition and increased policyholder lapses and redemptions.
An important competitive factor for our insurance subsidiaries is the
ratings they receive from nationally recognized rating organizations. Agents,
insurance brokers and marketing companies who market our products and
prospective purchasers of our products view ratings as an important factor in
determining which insurer's products to market or purchase. This is especially
true for annuity, interest-sensitive life insurance and long-term care products.
Our insurance companies' financial strength ratings were downgraded by all of
the major rating agencies beginning in July 2002 in connection with the
financial distress that ultimately led to our Predecessor's bankruptcy. The
current financial strength ratings of our insurance subsidiaries from A.M. Best,
S&P and Moody's are "B (Fair)", "BB-" and "Ba3", respectively, except that the
current financial strength ratings of Conseco Senior Health Insurance Company
from A.M. Best, S&P and Moody's are "B (Fair)", "CCC" and "Caa1", respectively.
A "B" rating from A.M. Best is the seventh highest of 16 possible ratings. A
"BB-" rating from S&P is the thirteenth highest of 21 possible ratings, and a
"CCC" rating from S&P is the eighteenth highest of 21 possible ratings. A "Ba3"
rating from Moody's is the thirteenth highest of 21 possible ratings, and a
"Caal" rating from Moody's is the seventeenth highest of 21 possible ratings.
Most of our competitors have higher financial strength ratings and we believe it
is critical for us to improve our ratings to be competitive. The lower ratings
assigned to our insurance subsidiaries were one of the primary factors causing
sales of our insurance products to decline and policyholder redemptions and
lapses to increase during 2002 and 2003. We also experienced increased agent
attrition, which in some cases led us to increase commissions or sales
incentives in an effort to retain them. These events have had a negative effect
on our ability to market our products and attract and retain agents, which in
turn has negatively affected our financial results.
Our Plan contemplated that our insurance subsidiaries would achieve an "A"
category rating from A.M. Best approximately by the end of 2004. In order to
achieve this rating, we believe that we will have to demonstrate to the rating
agencies a sustained improvement in our financial results, a lower debt to total
capital ratio, and improved risk-based capital ratios of our insurance
subsidiaries. If we fail to achieve and maintain an "A" category rating from
A.M. Best, sales of our insurance products could fall further, we may face
further defections among our independent and career sales force, and existing
policyholders may redeem or allow their policies to lapse, adversely affecting
our financial results. If we experience a ratings downgrade from our current
ratings, our product sales would likely decline significantly, we would likely
experience substantial defections among our independent and career sales force,
and our existing policyholders would likely redeem or allow their policies to
lapse at higher rates. In addition, events that may cause the ratings agencies
to downgrade our financial strength ratings may also cause us to be in breach of
covenants under our senior credit facility, which would entitle our lenders to
accelerate these borrowings. We presently do not have sufficient liquidity to
repay these borrowings if they were to be accelerated, and we cannot assure you
that we would have such liquidity in the future or that we would be able to
borrow money from other lenders to enable us to refinance these loans. If that
is not possible, we may be forced to seek bankruptcy protection again.
Our senior credit facility may restrict our ability to engage in activities
that may be beneficial to our future growth and profitability.
We continue to have significant indebtedness after our emergence from
bankruptcy. The following chart contains the aggregate amount of our debt
payment obligations, including estimated interest, for each of the next five
years (dollars in millions):
5 Year
2004 2005 2006 2007 2008 total
---- ---- ---- ---- ---- -----
Scheduled principal payments...... $ 53.0 $ 53.0 $103.0 $153.0 $153.0 $515.0
Projected interest payments....... 107.2 101.3 97.1 88.1 76.2 469.9
------ ------ ------- ------- ------- ------
Total debt service................ $160.2 $154.3 $200.1 $241.1 $229.2 $984.9
====== ====== ====== ====== ====== ======
As of December 31, 2003 our debt to total capital ratio was 32 percent.
This ratio is higher than the ratio of most of our competitors. In order to
raise our financial strength ratings, we will need to improve this ratio by
lowering our indebtedness, increasing our equity capital or through a
combination of both.
S&P and Moody's have assigned ratings on our senior secured debt of "B-
(Weak)" and "Caa1 (Very Poor)", respectively. In S&P's view, an obligation rated
"B-" is more vulnerable to nonpayment, but the obligor currently has the
capacity to meet its commitment on the obligation. S&P has a total of 22
separate categories in which to rate senior debt, ranging from "AAA (Extremely
Strong)" to "D (Payment Default)". A "B-" rating is the seventeenth highest
rating. In Moody's view, an obligation rated "Caa" is of poor standing and may
be in default, or there may be present elements of danger with respect to
principal or interest. Moody's has a total of 21 separate categories in which to
rate senior debt, ranging from "Aaa (Exceptional)" to "C (Lowest Rated)". A
"Caa" rating is the seventeenth highest rating. Our current senior debt ratings
may restrict our access to capital, and therefore our ability to refinance our
outstanding debt.
We intend to consider from time to time various strategic alternatives to
enhance shareholder value, including but not limited to acquisitions,
dispositions, business combinations, joint ventures and strategic alliances. Our
ability to enter into these types of transactions is generally limited by the
terms of our senior credit facility, even if we believe that a specific
transaction would contribute to our future growth and profitability. If we do
enter into a strategic transaction, that transaction may cause our indebtedness
to increase, may not result in the benefits we anticipate or may cause us to
incur greater costs or suffer greater disruptions in our business than we
anticipate, and could therefore negatively impact our business and operating
results.
If we fail to meet or maintain various covenants and financial ratios under
our senior credit facility, our lenders are entitled to accelerate the
repayment of these loans; if the loans are accelerated and we do not have
sufficient liquidity to repay them, we may be forced to seek bankruptcy
protection again.
Our senior credit facility imposes a number of covenants and financial
ratios that we must meet or maintain. For example, we must:
o have earnings before interest, taxes, depreciation and amortization of
greater than or equal to $490 million for the two quarters ended March
31, 2004, and increasing over time to $1,296.0 million for the four
quarters ending March 31, 2010 (such amount was approximately $290
million for the one quarter period ended December 31, 2003);
o have a debt to total capitalization (excluding unrealized gains
(losses)) ratio of .356 to 1.0 or less at December 31, 2003 with such
ratio decreasing over time to .20 to 1.0 at June 30, 2008 and
remaining level thereafter. At December 31, 2003, such ratio was .334
to 1.0;
o have an interest coverage ratio of greater than 1.0 to 1.0 for the
quarter ending December 31, 2003 and increasing over time to 4.50 to
1.0 for the four quarters ending December 31, 2009 and remaining level
thereafter. Such ratio was greater than 1.25 to 1.0 for the quarter
ending December 31, 2003.
Although we believe we are on track to meet and/or maintain these covenants
and financial ratios, our ability to do so may be affected by events outside of
our control. If we default under these requirements, the lenders could declare
all outstanding borrowings immediately due and payable, the aggregate amount of
which is $1.3 billion as of December 31, 2003. We presently do not have
sufficient liquidity to repay these borrowings if they were to be accelerated,
and we cannot assure you that we would have such liquidity in the future or that
we would be able to borrow money from other lenders to enable us to refinance
these loans. Accordingly, if we default under these requirements and the loans
are accelerated, we may be forced to seek bankruptcy protection again.
35
Our ability to meet our obligations may be constrained by our subsidiaries
ability to distribute cash to us.
Conseco and CDOC, Inc. ("CDOC"), our wholly owned subsidiary and a
guarantor under the senior credit facility, are holding companies with no
business operations of their own. As a result, they depend on their operating
subsidiaries for cash to make principal and interest payments on debt, and to
pay administrative expenses and income taxes. The cash they receive from
insurance subsidiaries consists of dividends and distributions, principal and
interest payments on surplus debentures, fees for services, tax-sharing
payments, and from our non-insurance subsidiaries, loans and advances. A
deterioration in the financial condition, earnings or cash flow of the
significant subsidiaries of Conseco or CDOC for any reason could limit their
ability to pay cash dividends or other disbursements to Conseco and CDOC, which,
in turn, would limit the ability of Conseco and CDOC to meet debt service
requirements and satisfy other financial obligations, including payment of any
cash dividends with respect to our preferred stock.
The ability of our insurance subsidiaries to pay dividends is subject to
state insurance department regulations and is based on the financial statements
of our insurance subsidiaries prepared in accordance with statutory accounting
practices prescribed or permitted by regulatory authorities, which differ from
GAAP. These regulations generally permit dividends to be paid from statutory
earned surplus of the insurance company for any 12-month period in amounts equal
to the greater of, or in a few states, the lesser of:
o statutory net gain from operations or statutory net income for the
prior year; or
o 10 percent of statutory capital and surplus as of the end of the
preceding year.
Any dividends in excess of these levels require the approval of the
director or commissioner of the applicable state insurance department. The
following table sets forth the aggregate amount of dividends and other
distributions that our insurance subsidiaries would have been able to pay to us
in each of the last two fiscal years without obtaining specific approval from
state insurance regulators, assuming that the Texas consent order released in
November 2003 had not been in effect (dollars in millions):
2003 2002
---- ----
Dividends.......................................................... $340.6 $230.8
Surplus debenture interest......................................... 52.1 56.0
------- -------
Total that was available to be paid............................ $392.7 $286.8
====== ======
The results of operations of our insurance business will decline if our
premium rates are not adequate or if we are unable to obtain regulatory
approval to increase rates.
We set the premium rates on our health insurance policies based on facts
and circumstances known at the time we issue the policies and on assumptions
about numerous variables, including the actuarial probability of a policyholder
incurring a claim, the probable size of the claim, maintenance costs to
administer the policies and the interest rate earned on our investment of
premiums. In setting premium rates, we consider historical claims information,
industry statistics, the rates of our competitors and other factors, but we
cannot predict with certainty what the actual claims on our products will be. If
our actual claims experience proves to be less favorable than we assumed and we
are unable to raise our premium rates, our financial results may be adversely
affected.
Most of our supplemental health policies allow us to increase premium rates
when warranted by our actual claim experience. Such rate increases must be
approved by the applicable state insurance departments, and we are required to
submit actuarial claims data to support the need for the rate increases. The
re-rate application and approval process on supplemental health products is a
normal recurring part of our business operations and reasonable rate increases
are typically approved by the state departments provided that they are supported
by actual claim experience and are not unusually large in either dollar amount
or percentage increase. For policy types on which rate increases are a normal
recurring event, our estimates of insurance liabilities assume we will be able
to raise rates if the blocks warrant such increases in the future.
The loss ratios for our long-term care products included in the Other
Business in Run-off segment have increased in recent periods and exceeded 103
percent during the four months ended December 31, 2003. We will have to raise
rates or take other actions with respect to some of these policies or this
business will continue to be unprofitable and our financial results will be
adversely affected. During 2002 and 2003, we filed for and received approval on
rate increases totaling $44 million and $37 million, respectively, relating to
this long-term care business that had approximately $400 million of collected
premium.
We review the adequacy of our premium rates regularly and file proposed
rate increases on our products when we believe existing premium rates are too
low. It is possible that we will not be able to obtain approval for premium rate
increases from currently pending requests or requests filed in the future. If we
are unable to raise our premium rates because we fail to obtain approval for a
rate increase in one or more states, our net income may decrease. Moreover, in
some instances our ability to exit unprofitable lines of business is limited by
the guaranteed renewal feature of the policy. In that situation we cannot exit
the business without regulatory approval, which may require that we continue to
service certain products at a loss for an extended period of time. For example,
most of our long-term care business is guaranteed renewable, meaning we cannot
terminate these policies without regulatory approval. Therefore, without
approval of necessary rate increases, we may have no other option but to operate
this business at a loss for an extended period of time.
If we are successful in obtaining regulatory approval to raise premium
rates, the increased premium rates may reduce the volume of our new sales and
cause existing policyholders to allow their policies to lapse. This could result
in significantly higher claim costs as a percentage of premiums if healthier
policyholders who can get coverage elsewhere allow their policies to lapse,
while policies related to less healthy policyholders continue in force. This
would reduce our premium income and profitability in future periods. Increased
lapse rates also could require us to expense all or a portion of the value of
policies inforce and/or the cost of policies produced relating to lapsed
policies in the period in which those policies lapse, adversely affecting our
financial results in that period.
36
On home health care policies issued in certain areas of Florida and other
states, payments for the benefit of policyholders have exceeded the premiums we
receive by a significant amount. We are currently aggressively seeking rate
increases and pursuing other actions on many of these long-term care policies.
Some states have regulatory provisions that may allow non-renewal of guaranteed
renewable policies in cases of extreme financial distress of the insurer. To
date, we have not received any regulatory relief under any of these provisions
relating to its troubled long-term care business.
The limited historical claims experience on our long-term care products
could negatively impact our operations if our estimates prove wrong and we
have not adequately set premium rates.
In setting premium rates, we consider historical claims information and
other factors, but we cannot predict with certainty what the actual claims on
our products will be. This is particularly true in the context of setting
premium rates on our long-term care insurance products, for which we have
relatively limited historical claims experience. Long-term care products tend to
have lower frequency of claims than other health products such as Medicare
supplement or specified disease, but when claims are incurred on long-term care
policies they tend to be much higher in dollar amount. Also, long-term care
products have a much longer tail, meaning that claims are incurred much later in
the life of the policy, than other supplemental health products. As a result of
these product traits, longer historical experience is necessary in order to
price products appropriately.
Our Bankers Life segment has offered long-term care insurance since 1985.
Bankers Life's experience on its long-term care blocks has generally been within
its pricing expectations. Our acquired blocks of long-term care insurance
included in the Other Business in Run-off segment were acquired through
acquisitions completed in 1996 and 1997. The majority of the business was
written between 1990 and 1997. The experience on these acquired blocks has
generally been worse than the acquired companies' original pricing expectations.
We have requested and received approval for numerous premium rate increases in
recent years on these blocks. Even with the various rate increases, these blocks
experienced loss ratios of 103 percent in the four months ended December 31,
2003, 170 percent in the eight months ended August 31, 2003, 139 percent in 2002
and 96 percent in 2001. If future claims experience proves to be worse than
anticipated as our long-term care blocks continue to age, our financial results
could be adversely affected.
Our reserves for future insurance policy benefits and claims may prove to
be inadequate, requiring us to increase liabilities and resulting in
reduced net income and shareholders' equity.
We calculate and maintain reserves for the estimated future payment of
claims to our policyholders based on assumptions made by our actuaries. For life
insurance business, our limit of risk retention for each policy is generally $.8
million or less; amounts above $.8 million are ceded to reinsurers. For our
health insurance business, we establish an active life reserve plus a liability
for due and unpaid claims, claims in the course of settlement, and incurred but
not reported claims, as well as a reserve for the present value of amounts on
claims not yet due. For our long-term care insurance business, we establish
reserves based on the same assumptions and estimates of factors that we consider
when we set premium rates. Many factors can affect these reserves and
liabilities, such as economic and social conditions, inflation, hospital and
pharmaceutical costs, regulatory actions, changes in doctrines of legal
liability and extra-contractual damage awards. Therefore, the reserves and
liabilities we establish are necessarily based on estimates, assumptions and
prior years' statistics. Establishing reserves is an uncertain process, and it
is possible that actual claims will materially exceed our reserves and have a
material adverse effect on our results of operations and financial condition. We
have recently incurred significant losses which have exceeded our expectations
as a result of actual claim costs and persistency of our long-term care business
included in the Other Business in Run-off segment. For example, we increased
claim reserves by $130 million during 2002 and $85 million during the eight
months ended August 31, 2003 as a result of adverse developments and changes in
our estimates of ultimate claims for these products. Our financial performance
depends significantly upon the extent to which our actual claims experience is
consistent with the assumptions we used in setting our reserves and pricing our
policies. If our assumptions with respect to future claims are incorrect, and
our reserves are insufficient to cover our actual losses and expenses, we would
be required to increase our liabilities and it could result in a default under
our senior credit facility.
Recently enacted and pending or future legislation could adversely affect
the financial performance of our insurance operations.
During recent years, the health insurance industry has experienced
substantial changes, including those caused by healthcare legislation. Recent
federal and state legislation and legislative proposals relating to healthcare
reform contain features that could severely limit or eliminate our ability to
vary our pricing terms or apply medical underwriting standards with respect to
individuals, which could have the effect of increasing our loss ratios and have
an adverse effect on our financial results. In particular, Medicare reform and
legislation concerning prescription drugs could affect our ability to price or
sell our products or maintain our blocks in force.
Proposals currently pending in Congress and some state legislatures may
also affect our financial results. These proposals include the implementation of
minimum consumer protection standards for inclusion in all long-term care
policies, including: guaranteed premium rates; protection against inflation;
limitations on waiting periods for pre-existing conditions; setting standards
for sales practices for long-term care insurance; and guaranteed consumer access
to information about insurers (including lapse and replacement rates for
policies and the percentage of claims denied). Enactment of any of these
proposals could adversely affect our financial results.
Tax law changes could adversely affect our insurance product sales and
profitability.
We sell deferred annuities and certain life insurance products which we
believe are attractive to purchasers, in part, because policyholders generally
are not subject to United States Federal income taxes on increases in policy
values until some form of distribution is made. Recently, Congress enacted
legislation to lower marginal tax rates, reduce the federal estate tax gradually
over a ten-year period, with total elimination of the federal estate tax in
2010, and increased contributions which may be made to individual retirement
accounts and 401(k) accounts. While these tax law changes will expire at the
beginning of 2011 absent future congressional action, they could in the interim
diminish the appeal of our annuity and life insurance products since the benefit
of tax deferral is not as great if tax rates are lower and because fewer people
may purchase these products if they are able to contribute more money to
individual retirement accounts and 401(k) accounts. Additionally, Congress has
considered, from time to time, other possible changes to the U.S. tax laws,
including elimination of the tax deferral on the accretion of value within
certain annuities and life insurance products, which would make these products
less attractive to prospective purchasers and therefore likely to reduce our
sales of these products.
Our results of operations may be negatively impacted if we are unable to
achieve the goals of the initiatives we have undertaken with respect to the
restructuring of our principal insurance businesses.
Our Conseco Insurance Group segment has experienced declining sales and
expense levels that exceed product pricing. We have adopted several initiatives
designed to improve these operations, including focusing sales efforts on higher
margin products; reducing operating expenses by eliminating or reducing the
costs of marketing certain products; personnel reductions and streamlined
administrative procedures; increasing retention rates on our more profitable
blocks of inforce business; stabilizing the profitability of the long-term care
block of business in run-off sold through independent agents through premium
rate increases, improved claim adjudication procedures and other actions as
necessary; and combining certain legal insurance entities to improve the
efficient use of capital and eliminate the costs of separate financial reporting
requirements. Conseco Insurance Group has 23 separate policy administration
systems for its three main lines of business: life, health and annuities. Many
of these redundancies, which our current initiatives are intended to address,
result from the substantial number of acquisitions undertaken by our
Predecessor. Between 1982 and 1997, our Predecessor completed 19 transactions
involving the acquisition of 44 separate insurance companies. Our future
performance depends, in part, on our ability to successfully integrate these
prior acquisitions. This process of integration may involve unforeseen expenses,
complications and delays, including, among other things, further difficulties in
integrating the systems and operations of the acquired companies, and our
current initiatives may be inadequate to address such issues. In addition, some
of our initiatives have only recently been adopted, and we cannot assure you
that they will be successfully implemented. Our initiatives include the
elimination of duplicate processing systems by converting all similar business
currently accounted for on multiple systems to a single system. We expect to
spend over $35 million on capital expenditures in 2004 (including amounts
related to these initiatives). Even if we are able to successfully implement
these measures, we cannot assure you that these measures alone will improve our
results of operations.
37
Our investment portfolio is subject to several risks which may diminish the
value of our invested assets and negatively impact our profitability.
The values of the assets in our investment portfolio are subject to
numerous factors, which are difficult to predict, and are in many instances
beyond our control. These factors include, but are not limited to, the
following:
o Changes in interest rates can reduce the value of our investments.
Actively managed fixed maturity investments comprised 87 percent of
our total investments as of December 31, 2003. The value of these
investments can be affected by changing levels of market interest
rates. For example, an increase in interest rates of 10 percent could
reduce the value of our actively managed fixed maturity investments
and short-term investments (net of corresponding changes in the value
of insurance intangibles) by approximately $625 million, in the
absence of other factors.
o Our actively managed fixed maturity investments are subject to a
deterioration in the ability of the issuer to make timely repayment of
the securities. This risk is significantly greater with respect to
below investment grade securities, which comprised 3.9 percent of our
actively managed fixed maturity investments as of December 31, 2003.
We have sustained substantial credit-related investment losses in
recent periods when a number of large, highly leveraged issuers
experienced significant financial difficulties resulting in our
recognition of other-than-temporary impairments. For example, we have
recognized other-than-temporary declines in value of several of our
investments, including K-Mart Corp., Amerco, Inc., Global Crossing,
MCI Communications, Mississippi Chemical, United Airlines and
Worldcom, Inc. We have recorded writedowns of fixed maturity
investments, equity securities and other invested assets as a result
of conditions which caused us to conclude a decline in the fair value
of the investment was other than temporary as follows: $9.6 million in
the four months ended December 31, 2003; $51.3 million in the eight
months ended August 31, 2003; $556.8 million in 2002; and $361.7
million in 2001.
In order to reduce our exposure to similar credit losses, we have taken a
number of specific steps, including:
o reducing the percentage of below investment grade fixed
maturity investments from 5.9 percent at December 31, 2001 to
3.9 percent at December 31, 2003;
o implementing conservative portfolio compliance guidelines
which generally limit our exposure to single issuer risks; and
o expanding our portfolio reporting procedures to proactively
identify changes in value related to credit risk in a more
timely manner.
o Our structured security investments, which comprised 29 percent of our
actively managed fixed maturity investments at December 31, 2003, are
subject to risks relating to variable prepayment and default on the
assets underlying such securities, such as mortgage loans. To the
extent that structured security investments prepay faster than the
expected rate of repayment, refinancing or default on the assets
underlying the securities, such investments, which have a cost basis
in excess of par, may be redeemed at par, thus resulting in a loss. In
order to mitigate this risk, we have adopted policies that generally
direct our investment in structured securities to securities with
contractual or structured protections against prepayment risk.
o Our need for liquidity to fund substantial product surrenders or
policy claims may require that we maintain highly liquid, and
therefore lower-yielding, assets, or that we sell assets at a loss,
thereby further eroding the performance of our portfolio.
Accordingly, we are subject to the risk that our investments may decline in
value. We have sustained substantial investment losses in the past and may again
in the future. Because a substantial portion of our net income is derived from
returns on our investment portfolio, significant losses in the portfolio may
have a direct and materially adverse impact on our result of operations. In
addition, losses on our investment portfolio could reduce the investment returns
which we are able to credit to our customers on certain of our products, thereby
impacting our sales and further eroding our financial performance.
A decline or increased volatility in the securities markets, and other
economic factors, may adversely affect our business, particularly certain
of our life insurance products and annuities.
Fluctuations in the securities markets and other economic factors may
adversely affect sales and/or policy surrenders of our annuities and life
insurance policies. For example, volatility in the equity markets may cause
potential new purchasers of equity-indexed annuities to refrain from purchasing
these products and may cause current policyholders to surrender their policies
for the cash value or reduce their investments. Our sales of these products
decreased significantly in 2001 and 2002 during periods of significant declines
in the equity markets. In addition, significant or unusual volatility in the
general level of interest rates could negatively impact sales and/or lapse rates
on certain types of insurance products.
We are subject to further risk of loss notwithstanding our reinsurance
agreements.
We transfer exposure to some of the risks we face to others through
reinsurance arrangements. Under these arrangements, other insurers assume a
portion of our losses and expenses associated with reported and unreported
claims in exchange for a portion of policy premiums. As of December 31, 2003,
our reinsurance receivables totaled $930.5 million. Our ceded life insurance in
force totaled $23.4 billion. Our seven largest reinsurers accounted for 80
percent of our ceded life insurance in force. The availability, amount and cost
of reinsurance depend on general market conditions and may vary significantly.
Furthermore, we face credit risk with respect to reinsurance. When we obtain
reinsurance, we are still liable for those transferred risks if the reinsurer
cannot meet its obligations. Therefore, the inability of our reinsurers to meet
their
38
financial obligations may require us to increase liabilities, thereby reducing
our net income and shareholders' equity.
Our goodwill and other intangible assets are subject to impairment tests,
which may require us to reduce shareholders' equity.
Upon our emergence from bankruptcy, we revalued our assets and liabilities
to estimated fair value as of August 31, 2003 and established our capital
accounts at the reorganization value determined in conjunction with our
bankruptcy plan. We recorded the $1,141.6 million of reorganization value that
could not be attributed to specific tangible or identified intangible assets as
goodwill.
Under GAAP, we are required to evaluate our goodwill and other intangible
assets for impairment on an annual basis, or more frequently if there is an
indication that an impairment may exist. If certain criteria are met, we are
required to record an impairment charge. We obtained independent appraisals to
determine the value of the Company in conjunction with the preparation of our
bankruptcy plan which indicated no impairments of our goodwill or other
intangible assets existed. However, we cannot assure you that we will not have
to recognize an impairment charge in future periods.
The appraisals prepared to determine the value of our subsidiaries are
based on numerous estimates and assumptions which, though considered reasonable
by management, may not be realized, and are inherently subject to significant
business, economic and competitive uncertainties and contingencies, many of
which are beyond our control. These estimates and assumptions had a significant
effect on the determination of our reorganization value and the amount of
goodwill we recognized. Accordingly, if our actual experience differs from our
estimates and assumptions, it is possible we will have to recognize an
impairment charge in future periods.
Our business is subject to extensive regulation, which limits our operating
flexibility and could negatively impact our financial results.
Our insurance business is subject to extensive regulation and supervision
in the jurisdictions in which we operate. Our insurance subsidiaries are subject
to state insurance laws that establish supervisory agencies with broad
administrative powers relative to granting and revoking licenses to transact
business, regulating sales and other practices, approving premium rate
increases, licensing agents, approving policy forms, setting reserve and
solvency requirements, determining the form and content of required statutory
financial statements, limiting dividends and prescribing the type and amount of
investments we can make.
We have been operating under heightened scrutiny from state insurance
regulators. For example, our insurance subsidiaries domiciled in Texas, Bankers
National Life Insurance Company and Conseco Life Insurance Company of Texas, on
behalf of itself and its subsidiaries, entered into consent orders with the
Commissioner of Insurance for the State of Texas on October 30, 2002, which were
formally released on November 19, 2003. These consent orders applied to all of
our insurance subsidiaries and, among other things, restricted the ability of
our insurance subsidiaries to pay dividends and other amounts to the parent
company without regulatory consent. Notwithstanding the release of these consent
orders, we have agreed with the Texas Department of Insurance to provide prior
notice of certain transactions, including up to 30 days prior notice for the
payment of dividends by an insurance subsidiary to any non-insurance company
parent, and to periodically provide information concerning our financial
performance and condition. As noted above, state laws generally provide state
insurance regulatory agencies with broad authority to protect policyholders in
their jurisdictions. Accordingly, we cannot assure you that regulators will not
seek to assert greater supervision and control over our insurance subsidiaries'
businesses and financial affairs.
Our insurance subsidiaries are also subject to risk-based capital
requirements. These requirements were designed to evaluate the adequacy of
statutory capital and surplus in relation to investment and insurance risks
associated with asset quality, mortality and morbidity, asset and liability
matching and other business factors. The requirements are used by states as an
early warning tool to discover potential weakly-capitalized companies for the
purpose of initiating regulatory action. Generally, if an insurer's risk-based
capital falls below specified levels, the insurer would be subject to different
degrees of regulatory action depending upon the magnitude of the deficiency. The
2003 statutory annual statements filed with the state insurance regulators of
each of our insurance subsidiaries reflected total adjusted capital in excess of
the levels subjecting the subsidiaries to any regulatory action. However, as a
result of losses on the long-term care business within the Other Business in
Run-Off segment, the risk-based capital ratio of one of our subsidiaries is near
the level which would require it to submit a comprehensive plan aimed at
improving its capital position. Furthermore, we may not be able to maintain the
risk-based capital ratios of our subsidiaries above levels that could give rise
to regulatory action.
Our insurance subsidiaries may be required to pay assessments to fund
policyholder losses or liabilities and this may negatively impact our
financial results.
The solvency or guaranty laws of most states in which an insurance company
does business may require that company to pay assessments up to certain
prescribed limits to fund policyholder losses or liabilities of other insurance
companies that become insolvent. Insolvencies of insurance companies increase
the possibility that these assessments may be required. These assessments may be
deferred or forgiven under most guaranty laws if they would threaten an
insurer's financial strength and, in certain instances, may be offset against
future premium taxes. We cannot estimate the likelihood and amount of future
assessments. Although past assessments have not been material, if there were a
number of large insolvencies, future assessments could be material and could
have a material adverse effect on our financial results and financial position.
Changing interest rates may adversely affect our results of operations.
Our profitability may be directly affected by the level of and fluctuations
in interest rates. While we monitor the interest rate environment and have
previously employed hedging strategies designed to mitigate the impact of
changes in interest rates, our financial results could be adversely affected by
changes in interest rates. Our spread-based insurance and annuity business is
subject to several inherent risks arising from movements in interest rates,
especially if we fail to anticipate or respond to such movements. First,
interest rate changes can cause compression of our net spread between interest
earned on investments and interest credited on customer deposits, thereby
adversely affecting our results. Our ability to adjust for such a compression is
limited by virtue of the guaranteed minimum rates that we must credit to
policyholders on certain of our products, as well as by the fact that we are
able to reduce the crediting rates on most of our products only at limited,
pre-established intervals. Approximately 40 percent of our insurance liabilities
were subject to interest rates that may be reset annually; 45 percent have a
fixed explicit interest rate for the duration of the contract; 10 percent have
credited rates which approximate the income we earned; and the remainder have no
explicit interest rates. Second, if interest rate changes produce an
unanticipated increase in surrenders of our spread-based products, we may be
forced to sell invested assets at a loss in order to fund such surrenders. The
profits from many non-spread-based insurance products, such as long-term care
policies, are adversely affected when interest rates decline because we may be
unable to reinvest the cash flows generated from premiums received and our
investment portfolio at the interest rates anticipated when we sold the
policies. Finally, changes in interest rates can have significant effects on the
performance of our structured securities portfolio, including collateralized
mortgage obligations, as a result of changes in the prepayment rate of the loans
underlying such securities. We follow asset/liability strategies that are
designed to mitigate the effect of interest rate changes on our profitability
but do not currently employ derivative instruments for this purpose. We may not
be successful in implementing these strategies and achieving adequate investment
spreads.
39
We use computer models to simulate the cash flows expected from our
existing insurance business under various interest rate scenarios. These
simulations help us measure the potential gain or loss in fair value of our
interest-sensitive financial instruments. With such estimates, we seek to manage
the relationship between the duration of our assets and the expected duration of
our liabilities. When the estimated durations of assets and liabilities are
similar, exposure to interest rate risk is minimized because a change in the
value of assets should be largely offset by a change in the value of
liabilities. At December 31, 2003, the adjusted modified duration of our fixed
maturity securities and short-term investments was approximately 6.7 years and
the duration of our insurance liabilities was approximately 7.2 years. We
estimate that our fixed maturity securities and short-term investments (net of
corresponding changes in the value of insurance intangibles) would decline in
fair value by approximately $625 million if interest rates were to increase by
10 percent from their December 31, 2003 levels. This compares to a decline in
fair value of $595 million based on amounts and rates at December 31, 2002. The
calculations involved in our computer simulations incorporate numerous
assumptions, require significant estimates and assume an immediate change in
interest rates without any management of the investment portfolio in reaction to
such change. Consequently, potential changes in value of our financial
instruments indicated by the simulations will likely be different from the
actual changes experienced under given interest rate scenarios, and the
differences may be material. Because we actively manage our investments and
liabilities, our net exposure to interest rates can vary over time.
Our net income and revenues will suffer if policyholder surrender levels
differ significantly from our assumptions.
Surrenders of our annuities and life insurance products can result in
losses and decreased revenues if surrender levels differ significantly from
assumed levels. At December 31, 2003, approximately 18 percent of our total
insurance liabilities, or approximately $4.5 billion, could be surrendered by
the policyholder without penalty. The surrender charges that are imposed on our
fixed rate annuities typically decline during a penalty period which ranges from
five to twelve years after the date the policy is issued. Surrenders and
redemptions could require us to dispose of assets earlier than we had planned,
possibly at a loss. Moreover, surrenders and redemptions require faster
amortization of the acquisition costs associated with the original sale of a
product, thus reducing our net income. We believe policyholders are generally
more likely to surrender their policies if they believe the issuer is having
financial difficulties, or if they are able to reinvest the policy's value at a
higher rate of return in an alternative insurance or investment product.
For example, policyholder redemptions of annuity and, to a lesser extent,
life products increased following the downgrade of our A.M. Best financial
strength rating to "B (Fair)" in August of 2002. When redemptions are greater
than our previous assumptions, we are required to accelerate the amortization of
insurance intangibles to write off the balance associated with the redeemed
policies. We recorded additional amortization related to higher redemptions and
changes to our lapse assumptions of $203.2 million in 2002.
Litigation and regulatory investigations are inherent in our business and
may harm our financial strength and reduce our profitability.
Insurance companies historically have been subject to substantial
litigation resulting from claims, disputes and other matters. In addition to the
traditional policy claims associated with their businesses, insurance companies
typically face policyholder suits and class action suits. The class action and
policyholder suits are often in connection with insurance sales practices,
policy and claims administration practices and other market conduct issues.
State insurance departments focus on sales practices and product issues in their
market conduct examinations. Negotiated settlements of class action and other
lawsuits have had a material adverse effect on the business, financial condition
and results of operations of insurance companies. We are, in the ordinary course
of our business, a plaintiff or defendant in actions arising out of our
insurance business, including class actions and reinsurance disputes, and, from
time to time, are also involved in various governmental and administrative
proceedings and investigations. Our subsidiary, Philadelphia Life Insurance
Company, which is now known as Conseco Life Insurance Company, is a defendant in
two purported nationwide class action lawsuits alleging fraudulent sales
practices and seeking unspecified damages in Florida federal court. Five
lawsuits were also filed in Mississippi state court against Conseco Life
Insurance Company alleging similar claims. Our former subsidiary, Manhattan
National Life Insurance Company, is a defendant in a purported nationwide class
action lawsuit alleging fraud by non-disclosure of additional charges for
policyholders wishing to pay premiums on other than an annual basis and seeking
unspecified damages in New Mexico state court. Four of our subsidiaries have
also been named in purported nationwide class action lawsuits seeking
unspecified damages in Colorado state court alleging claims similar to those
alleged in the New Mexico suit naming Manhattan National Life Insurance Company.
We believe that these lawsuits are without merit and intend to defend them
vigorously. The ultimate outcome of these lawsuits, however, cannot be predicted
with certainty, and although we do not presently believe that any of these
lawsuits, individually, are material, they could, in the aggregate, have a
material adverse effect on our financial condition. Because our insurance
subsidiaries were not part of our bankruptcy proceedings, the bankruptcy
proceedings did not result in the discharge of any claims, including claims
asserted in litigation, against our insurance subsidiaries. See "Item 3 -- Legal
Proceedings" above.
40
Competition from companies that have greater financial resources, broader
arrays of products, higher ratings and stronger financial performance may
impair our ability to retain existing customers and sales representatives,
attract new customers and sales representatives and maintain or improve our
financial results.
The supplemental health insurance, annuity and individual life insurance
markets are highly competitive. Competitors include other life and accident and
health insurers, commercial banks, thrifts, mutual funds and broker-dealers.
Many of our competitors are larger companies that have superior financial
strength ratings, and greater capital, technological and marketing resources,
and have access to capital at a lower cost. Recent industry consolidation,
including business combinations among insurance and other financial services
companies, has resulted in larger competitors with even greater financial
resources. Furthermore, recent changes in federal law have narrowed the
historical separation between banks and insurance companies, enabling
traditional banking institutions to enter the insurance and annuity markets and
further increase competition. This increasing competition may harm our ability
to maintain or increase our profitability. In addition, because the actual cost
of products is unknown when they are sold, we are subject to competitors who may
sell a product at a price that does not cover its actual cost. Accordingly, if
we do not also lower our prices for similar products, we may lose market share
to these competitors. If we lower our prices to maintain market share, our
profitability will decline. There are many life and health insurance companies
in the United States, most of which currently enjoy higher financial strength
ratings than we do. Some of these companies may pay higher commissions and
charge lower premium rates, and many companies have more substantial resources.
Publicity about our recent financial difficulties, including our bankruptcy,
caused agents to place business with other insurers, and we may not be able to
recapture business from these agents following our emergence from bankruptcy.
We must attract and retain sales representatives to sell our insurance and
annuity products. Strong competition exists among insurance and financial
services companies for sales representatives. We compete with other insurance
and financial services companies for sales representatives primarily on the
basis of our financial position, financial strength ratings, support services
and compensation and product features. Our competitiveness for such agents also
depends upon the relationships we develop with these agents. If we are unable to
attract and retain sufficient numbers of sales representatives to sell our
products, our ability to compete and our revenues would suffer.
If we are unable to attract and retain independent agents for the
distribution of products sold through the Conseco Insurance Group segment,
sales of our products will decline.
Our Conseco Insurance Group segment markets and distributes its products,
including specified disease insurance, Medicare supplement insurance,
equity-indexed life insurance and equity-indexed annuities, exclusively through
independent agents. As a result, our ability to maintain our relationships with
these organizations is critical to our financial performance. This ability is
dependent upon, among other things, the compensation we offer independent
distributors and the overall attractiveness of our products to their customers.
In addition, the distribution of our life insurance and annuity products through
this channel is particularly sensitive to the financial strength ratings of our
insurance subsidiaries. The downgrades of our ratings in 2002, as well as our
bankruptcy, caused significant defections among our independent agents and
increased our costs of retaining them, which had a material adverse effect on
our results of operations. In the event that we are unable to attract and retain
qualified independent distributors of our products, our operations and financial
results may be materially adversely affected.
We may require additional capital in the future, which may not be available
or may only be available on unfavorable terms.
Our future capital requirements depend on many factors, including our
ability to write new business successfully and to establish premium rates and
reserves at levels sufficient to cover losses. We may need to raise additional
funds through future financings and, if we are unable to do so, we may need to
curtail our growth and reduce our assets. Any equity or debt financing, if
available at all, may be on terms that are not favorable to us. In the case of
equity financings, dilution to our shareholders could result. If we cannot
obtain adequate capital on favorable terms or at all, our business, operating
results and financial condition could be adversely affected.
A broad range of uncertainties arising out of world events may adversely
affect the insurance industry and financial markets.
Terrorist attacks in New York City and Washington, D.C. on September 11,
2001 adversely affected commerce throughout the United States and resulted in
significant disruption to the insurance industry and significant declines and
volatility in financial markets. The continued threat of terrorism within the
United States and abroad, the military action and heightened security measures
in response to that threat and the risk of global outbreaks of illnesses such as
SARS may cause additional disruptions to the insurance industry, reduced
economic activity and continued volatility in markets throughout the world,
which may adversely impact our financial results.
Our financial results would be negatively impacted if we are required to
indemnify the purchasers of businesses that we have recently sold.
We are subject to retained liabilities and indemnification obligations
related to businesses we have sold. For example, we retained liabilities for
certain purported class action litigation in connection with our disposal of
Manhattan National Life Insurance Company in June 2002. In addition, the
agreement entered into in connection with our sale of CVIC imposes continuing
indemnification obligations with respect to liabilities relating to our period
of ownership of CVIC, and the agreement entered into in connection with our sale
of CFC imposes continuing tax sharing obligations with respect to tax
liabilities relating to our period of ownership of CFC. We cannot assure you
that we will not be subject to claims with respect to these continuing or
residual obligations, or that any such claims would not be material.
41
RESULTS OF OPERATIONS:
Due to the application of fresh start accounting, the reported historical
financial statements of our Predecessor for periods prior to August 31, 2003
generally are not comparable to our financial statements prepared after that
date. Therefore, our results of operations have not been combined with those of
our Predecessor. Please read this discussion in conjunction with the
consolidated financial statements and notes included in this Form 10-K.
After our emergence from bankruptcy, we began to manage our business
operations through two primary operating segments, based on method of product
distribution, and a third segment comprised of business in run-off. We refer to
these segments as: (i) Bankers Life; (ii) Conseco Insurance Group; and (iii)
Other Business in Run-Off. Prior to its disposition effective March 31, 2003, we
also had a finance segment. We also have a corporate segment, which consists of
holding company activities and certain noninsurance company businesses that are
not related to our other operating segments. The following tables and narratives
summarize the operating results of our segments for the periods presented as we
currently manage them (dollars in millions):
Successor Predecessor
------------- ----------------------------------
Four months Eight months Years
ended ended ended
December 31, August 31, December 31,
-----------------
2003 2003 2002 2001
---- ---- ---- ----
Earnings (losses) before taxes:
Bankers Life .................................................. $ 85.5 $ 159.6 $ 136.5 $ 289.3
Conseco Insurance Group........................................ 94.3 299.9 (211.5) 186.0
Other Business in Run-off...................................... 12.8 (171.3) (216.8) (106.0)
Corporate operations........................................... (43.1) 1,884.0 (1,340.4) (612.7)
------ -------- --------- -------
Income (loss) before income taxes, minority
interest, discontinued operations and
cumulative effect of accounting change...................... $149.5 $2,172.2 $(1,632.2) $(243.4)
====== ======== ========= =======
General: Conseco, Inc. is the top tier holding company for a group of
insurance companies operating throughout the United States that develop, market
and administer supplemental health insurance, annuity, individual life insurance
and other insurance products. We distribute these products through a career
agency force and direct response marketing (which, together, represent our
Bankers Life segment) and through professional independent producers (which
represent our Conseco Insurance Group segment). Our Other Business in Run-off
segment consists of: (i) long-term care products written in prior years through
independent agents; (ii) small group and individual major medical business which
we began to nonrenew in 2001; and (iii) other group major medical business which
we no longer actively market. Most of the long-term care business in run-off
relates to business written by certain of our subsidiaries prior to their
acquisitions by Conseco in 1996 and 1997.
42
Bankers Life (dollars in millions)
Successor Predecessor
------------- ----------------------------------
Four months Eight months Years
ended ended ended
December 31, August 31, December 31,
-----------------
2003 2003 2002 2001
---- ---- ---- ----
Premiums and asset accumulation product collections:
Annuities................................................... $ 253.8 $ 698.4 $ 740.9 $ 513.1
Supplemental health......................................... 407.9 759.6 1,159.4 1,097.4
Life........................................................ 58.6 102.7 139.0 286.3
-------- -------- -------- --------
Total premium collections................................. $ 720.3 $1,560.7 $2,039.3 $1,896.8
======== ======== ======== ========
Average liabilities for insurance products:
Annuities:
Mortality based......................................... $ 325.7 $ 286.5 $ 271.7 $ 257.6
Equity-linked........................................... 262.9 264.8 301.0 320.8
Deposit based........................................... 3,156.2 2,847.7 2,248.4 1,864.3
Health.................................................... 2,620.8 1,916.3 1,712.0 1,497.6
Life:
Interest sensitive...................................... 333.0 324.4 311.6 300.0
Non-interest sensitive.................................. 747.3 652.4 654.0 1,083.2
-------- -------- -------- --------
Total average liabilities for insurance
products, net of reinsurance ceded.................. $7,445.9 $6,292.1 $5,498.7 $5,323.5
======== ======== ======== ========
Revenues:
Insurance policy income..................................... $ 456.8 $ 892.7 $1,300.1 $1,400.1
Net investment income:
General account invested assets........................... 128.9 253.4 382.2 391.9
Equity-indexed products based on the change in value of the
S&P 500 Call Options.................................... 6.6 4.8 (14.8) (15.5)
Trading account income related to policyholder and reinsurer
accounts................................................ 5.2 - - -
Change in value of embedded derivatives related to modified
coinsurance agreements.................................. (5.2) - - -
Net realized investment gains (losses).................... 3.4 5.5 (128.7) (43.5)
Fee revenue and other income................................ .5 .2 1.3 1.2
-------- -------- -------- --------
Total revenues.......................................... 596.2 1,156.6 1,540.1 1,734.2
-------- -------- -------- --------
Expenses:
Insurance policy benefits................................... 338.2 705.6 973.4 1,002.7
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life products
other than those listed below........................... 50.6 89.5 116.9 105.5
Equity-indexed products based on S&P 500 Index............ 7.0 - .6 .6
Amortization related to operations.......................... 62.3 113.4 171.9 198.4
Amortization related to net realized investment gains (losses) - .5 (3.2) (5.0)
Interest expense on investment borrowings................... .8 3.4 4.6 6.1
Other operating costs and expenses.......................... 51.8 84.6 94.4 130.6
Special charges............................................. - - 45.0 6.0
-------- -------- -------- --------
Total benefits and expenses............................. 510.7 997.0 1,403.6 1,444.9
-------- -------- -------- --------
Income before income taxes, minority interest, discontinued
operations and cumulative effect of accounting change....... $ 85.5 $ 159.6 $ 136.5 $ 289.3
======== ======== ======== ========
(continued)
43
(continued from previous page)
Successor Predecessor
------------- -----------------------------------
Four months Eight months Years
ended ended ended
December 31, August 31, December 31,
-------------------
2003 2003 2002 2001
---- ---- ---- ----
Health loss ratios:
All health lines:
Insurance policy benefits................................. $283.7 $578.5 $840.9 $770.8
Loss ratio (a)............................................ 73.11% 75.30% 74.06% 70.23%
Medicare Supplement:
Insurance policy benefits................................. $133.3 $283.3 $437.6 $443.1
Loss ratio (a)............................................ 62.79% 66.39% 67.15% 66.87%
Long-Term Care:
Insurance policy benefits................................. $148.0 $287.2 $394.3 $316.2
Loss ratio (a)............................................ 86.06% 86.08% 83.69% 75.31%
Interest-adjusted loss ratio (b).......................... 60.04% 69.26% 67.95% 60.91%
Other:
Insurance policy benefits................................. $2.4 $8.0 $9.0 $11.5
Loss ratio (a)............................................ 63.79% 101.05% 71.21% 76.45%
- ----------------
(a) We calculate loss ratios by taking the related product's: (i) insurance
policy benefits; divided by (ii) insurance policy income.
(b) We calculate the interest-adjusted loss ratio for Bankers Life's long-term
care products by taking the product's: (i) insurance policy benefits less
interest income on the accumulated assets which back the insurance
liabilities; divided by (ii) policy income. Interest income is an important
factor in measuring losses on this product. The net cash flows from
long-term care products generally result in the accumulation of amounts in
the early years of a policy (accounted for as reserve increases) which will
be paid out as benefits in later policy years (accounted for as reserve
decreases). Accordingly, as the policies age, the loss ratio will typically
increase, but the increase in the change in reserve will be partially
offset by investment income earned on the assets which have accumulated.
The interest-adjusted loss ratio reflects the effects of the investment
income offset.
Total premium collections were $720.3 million in the four months ended
December 31, 2003; $1,560.7 million in the eight months ended August 31, 2003;
and $2,039.3 million and $1,896.8 million in 2002 and 2001, respectively.
Bankers Life's annuity premium collections in 2003 were positively impacted by
sales inducements provided to purchasers of our annuities and sales incentives
to our career agents. These programs ended at various times during the second
quarter of 2003. Premium collections on Bankers Life's other products have been
negatively impacted by the A.M. Best ratings downgrade to "B (Fair)." See "--
Premium and Asset Accumulation Product Collections" for further analysis.
Average liabilities for insurance products, net of reinsurance ceded, were
$7.4 billion in the four months ended December 31, 2003; $6.3 billion in the
eight months ended August 31, 2003; and $5.5 billion and $5.3 billion in 2002
and 2001, respectively. The increase in such liabilities through August 31, 2003
is primarily due to increases in annuity reserves. As discussed above under "--
Total premium collections", annuity premium collections in our Bankers Life
segment were positively impacted during 2003 by sales inducements and
incentives. The increase in such liabilities for the four months ended December
31, 2003 reflects the adoption of fresh start accounting. Bankers Life's average
life reserves decreased by $417.6 million, or 30 percent in 2002 as compared to
2001, primarily due to a first quarter 2002 reinsurance transaction which ceded
approximately $400 million of liabilities to the assuming company. The
reinsurance transaction is discussed further in the note to the consolidated
financial statements entitled "Summary of Significant Accounting Policies -
Reinsurance."
Insurance policy income is comprised of: (i) premiums earned on policies
which provide mortality or morbidity coverage; and (ii) fees and other charges
made against other policies. See "Premium and Asset Accumulation Product
Collections" for further analysis.
44
Net investment income on general account invested assets (which excludes
income on policyholder and reinsurer accounts) was $128.9 million in the four
months ended December 31, 2003; $253.4 million in the eight months ended August
31, 2003; and $382.2 million and $391.9 in 2002 and 2001, respectively. The
average balance of general account invested assets was $7.0 billion in the four
months ended December 31, 2003; $6.6 billion in the eight months ended August
31, 2003; and $6.1 billion and $5.7 billion in 2002 and 2001, respectively. The
yield on these assets was 5.5 percent in the four months ended December 31,
2003; 5.7 percent in the eight months ended August 31, 2003; and 6.3 percent and
6.9 percent in 2002 and 2001, respectively. The decrease in yield for the four
months ended December 31, 2003, reflects the adoption of fresh start accounting
which effectively reset the yields to market rates at August 31, 2003. The
decrease in yield in the other periods reflects the lower interest rate
environment prevailing during the periods presented and the resulting lower
rates earned on invested assets. In 2002, net investment income and the average
balance of general account invested assets both reflect the transfer of a
portion of our investment portfolio to the reinsurer pursuant to the
above-mentioned first quarter 2002 reinsurance transaction.
Net investment income related to equity-indexed products based on the
change in value of the S&P 500 Call Options represents the change in the
estimated fair value of Bankers Life's S&P 500 Index Call Options which are
purchased in an effort to cover certain benefits accruing to the policyholders
of our equity-indexed products. Our equity-indexed products are designed so that
the investment income spread earned on the related insurance liabilities should
be more than adequate to cover the cost of the S&P 500 Call Options and other
costs related to these policies. Option costs that are attributable to benefits
provided were $2.9 million in the four months ended December 31, 2003; $7.7
million in the eight months ended August 31, 2003; and $15.2 million and $16.0
million in 2002 and 2001, respectively. These costs are reflected in the change
in market value of the S&P 500 Call Options included in the investment income
amounts. Net investment income (loss) related to equity-indexed products before
this expense was $9.5 million in the four months ended December 31, 2003; $12.5
million in the eight months ended August 31, 2003; and $.4 million and $.5
million in 2002 and 2001, respectively. Such amounts were partially offset by
the corresponding charge (credit) to amounts added to policyholder account
balances for equity-indexed products based on S&P 500 Index of $7.0 million in
the four months ended December 31, 2003; nil in the eight months ended August
31, 2003; and $.6 million in both 2002 and 2001. Such income and related charge
fluctuate based on the value of options embedded in the segment's equity-indexed
annuity policyholder account balances subject to this benefit and to the
performance of the S&P 500 Index to which the returns on such products are
linked.
Change in value of embedded derivatives related to modified coinsurance
agreements are described in the note to our consolidated financial statements
for the period ended December 31, 2003 entitled "Summary of Significant
Accounting Policies - Accounting for Derivatives." We have transferred the
specific block of investments related to these agreements to our trading
securities account, which we carry at estimated fair value with changes in such
value recognized as trading account income. We expect the change in the value of
the embedded derivatives largely to be offset by the change in value of the
trading securities.
Net realized investment gains (losses) fluctuate from period to period.
During the four months ended December 31, 2003, net realized investment gains in
our Bankers Life segment included: (i) $8.6 million of net gains from the sales
of investments (primarily fixed maturities), net of (ii) $5.2 million of
writedowns of fixed maturity investments, equity securities and other invested
assets as a result of conditions which caused us to conclude a decline in fair
value of the investment was other than temporary. During the first eight months
of 2003, we recognized net investment gains of $5.5 million. During the first
eight months of 2003, the net realized investment gains included: (i) $20.5
million of net gains from the sales of investments (primarily fixed maturities),
net of (ii) $15.0 million of writedowns of fixed maturity investments, equity
securities and other invested assets as a result of conditions which caused us
to conclude a decline in fair value of the investment was other than temporary.
During 2002 and 2001, Bankers Life recognized net realized investment losses of
$128.7 million and $43.5 million, respectively. The net realized investment
losses during 2002 included: (i) $138.5 million to write down certain securities
to fair value due to an other-than-temporary decline in value (including issuers
who have faced significant problems: K-Mart Corp., Amerco, Inc., Global
Crossing, MCI Communications, Mississippi Chemical, United Airlines and
Worldcom, Inc.); and (ii) $9.8 million of net gains from the sales of
investments (primarily fixed maturities). The net realized investment losses
during 2001 included writedowns of $69.4 million related to: (i) the impact of
higher default rate assumptions on certain structured investments; (ii) losses
on investments held in our private equity portfolio; and (iii) the writedown of
certain securities to fair value due to an other-than-temporary decline in value
or our plan to sell the securities in connection with investment restructuring
activities (including issuers who have faced significant problems: Sunbeam
Corp., Enron Corp., Crown Cork & Seal Company Inc., Global Crossing Ltd. and
K-Mart Corp.).
Insurance policy benefits fluctuated as a result of the factors summarized
in the explanations for loss ratios related to specific products which follow.
Loss ratios are calculated by taking the related insurance product's: (i)
insurance policy benefits; divided by (ii) policy income.
45
The loss ratios on Bankers Life's Medicare supplement products have
generally been approximately equal to our expectations. Governmental regulations
generally require us to attain and maintain a ratio of total benefits incurred
to total premiums earned (as calculated based on amounts reported for statutory
accounting purposes), after three years, of not less than 65 percent on these
products. The loss ratio for the four months ended December 31, 2003, reflected
the elimination of $5.8 million of reserve redundancies based on the ultimate
development of reserves at August 31, 2003.
The loss ratios on Bankers Life's long-term care products have generally
been within our range of expectations. The net cash flows from our long-term
care products generally result in the accumulation of amounts in the early years
of a policy (accounted for as reserve increases) which will be paid out as
benefits in later policy years (accounted for as reserve decreases).
Accordingly, as the policies age, the loss ratio will typically increase, but
the increase in the change in reserve will be partially offset by investment
income earned on the assets which have accumulated. The interest-adjusted loss
ratio for long-term care products is calculated by taking the insurance
product's: (i) insurance policy benefits less interest income on the accumulated
assets which back the insurance liabilities divided by (ii) policy income. The
loss ratio on Bankers Life's long-term care products during 2001 reflected the
elimination of reserve redundancies based on the ultimate development of
reserves at December 31, 2000. The decrease in the interest-adjusted loss ratio
for the four months ended December 31, 2003, is primarily due to the adoption of
fresh start accounting which increased the reserves on this block of business.
The loss ratios on our other products fluctuate due to the smaller size of
these blocks of business. The loss ratios on this business have generally been
within our expectations.
Amounts added to policyholder account balances for annuity products and
interest-sensitive life products were $50.6 million in the four months ended
December 31, 2003; $89.5 million in the eight months ended August 31, 2003; and
$116.9 million and $105.5 million in 2002 and 2001, respectively. The increases
are primarily due to increases in annuity reserves. The weighted average
crediting rates for these products were 4.4 percent for the four months ended
December 31, 2003; 4.2 percent for the eight months ended August 31, 2003; and
4.6 percent and 4.9 percent in 2002 and 2001, respectively.
Amounts added to equity-indexed products based on S&P 500 Index correspond
to the related investment income accounts described above.
Amortization related to operations includes amortization of the value of
policies inforce at the Effective Date, cost of policies produced and the cost
of policies purchased (such amortization is collectively referred to as
"amortization of insurance intangibles"). Insurance intangibles are amortized:
(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. Bankers Life's amortization expense was generally
within our range of expectations given the related premium revenue and gross
profits for the periods.
Amortization related to net realized investment gains (losses) represents
the increases or decreases in amortization which result from realized investment
gains or losses. When we sell securities at a gain (loss) and reinvest the
proceeds at a different yield, we increase (reduce) the amortization of
insurance intangibles in order to reflect the change in future expected yields.
Sales of fixed maturity investments resulted in an increase (decrease) in the
amortization of insurance intangibles of nil in the four months ended December
31, 2003; $.5 million in the eight months ended August 31, 2003; and $(3.2)
million and $(5.0) million in 2002 and 2001, respectively.
Interest expense on investment borrowings fluctuates along with our
investment borrowing activities and the interest rates thereon. Average
investment borrowings in our Bankers Life segment (excluding borrowings related
to the GM building) were $173.6 million during the four months ended December
31, 2003; $263.7 million during the eight months ended August 31, 2003; and
$452.2 million and $222.4 million in 2002 and 2001, respectively. The weighted
average interest rates on such borrowings (excluding borrowings related to the
GM building) were 1.4 percent during the four months ended December 31, 2003;
1.9 percent during the eight months ended August 31, 2003; and 1.0 percent and
2.7 percent during 2002 and 2001, respectively.
Other operating costs and expenses in our Bankers Life segment were $51.8
million in the four months ended December 31, 2003; $84.6 million in the eight
months ended August 31, 2003; and $94.4 million and $130.6 million in 2002 and
2001, respectively. Increases in these expenses in 2003 are primarily related to
increased policy acquisition costs which were non-deferrable. Such expenses
decreased in 2002 by $36.2 million, or 28 percent compared to 2001, reflecting
cost cutting programs implemented in the Bankers Life segment.
Special charges in 2002 included: (i) a loss of $39.0 million on a
reinsurance transaction entered into as part of our cash raising initiatives;
and (ii) other items totaling $6.0 million primarily related to severance
benefits and costs incurred with the transfer of certain customer service and
backroom operations to our former India subsidiary. Special charges in 2001 were
$6.0 million. Such charges primarily related to severance benefits and costs
incurred
46
in conjunction with the transfer of certain customer service and backroom
operations to our former India subsidiary.
47
Conseco Insurance Group (dollars in millions)
Successor Predecessor
------------- -----------------------------------
Four months Eight months Years
ended ended ended
December 31, August 31, December 31,
------------------
2003 2003 2002 2001
---- ---- ---- ----
Premiums and asset accumulation product collections:
Annuities..................................................... $ 18.1 $ 74.0 $ 351.9 $ 710.6
Supplemental health........................................... 272.0 525.3 830.3 784.1
Life.......................................................... 131.5 280.7 498.0 553.3
--------- --------- --------- ---------
Collections on insurance products........................... $ 421.6 $ 880.0 $ 1,680.2 $ 2,048.0
========= ========= ========= =========
Average liabilities for insurance and asset accumulation:
Annuities:
Mortality based............................................. $ 243.5 $ 171.0 $ 175.0 $ 198.8
Equity-linked............................................... 1,561.4 1,514.7 1,983.1 2,311.4
Deposit based............................................... 4,027.8 4,245.4 5,352.1 5,993.4
Separate accounts and investment trust liabilities.......... 50.1 401.3 672.6 738.0
Health........................................................ 2,288.3 2,046.8 1,981.6 1,969.7
Life:
Interest sensitive.......................................... 3,349.8 3,407.8 3,798.7 3,733.2
Non-interest sensitive...................................... 1,483.3 1,493.9 1,327.6 1,399.8
--------- --------- --------- ---------
Total average liabilities for insurance and asset
accumulation products................................... $13,004.2 $13,280.9 $15,290.7 $16,344.3
========= ========= ========= =========
Revenues:
Insurance policy income............................................ $ 398.5 $ 892.8 $ 1,454.9 $ 1,377.4
Net investment income:
General account invested assets............................... 240.9 562.2 982.0 1,114.2
Equity-indexed products based on the change in value of the
S&P 500 Call Options........................................ 35.5 20.4 (85.7) (98.7)
Separate account assets....................................... - - - (5.4)
Trading account income related to policyholder and
reinsurer accounts.......................................... 13.2 - - -
Change in value of embedded derivatives related to modified
coinsurance agreements...................................... (1.0) - - -
Net realized investment gains (losses)........................ 9.5 (17.1) (368.1) (209.1)
Fee revenue and other income....................................... .5 17.0 25.4 31.4
--------- --------- --------- ---------
Total revenues.............................................. 697.1 1,475.3 2,008.5 2,209.8
--------- --------- --------- ---------
Expenses:
Insurance policy benefits.......................................... 290.5 461.3 998.2 977.5
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life products
other than those listed below............................... 94.9 218.4 379.7 417.8
Equity-indexed products based on S&P 500 Index................ 35.8 66.6 (.9) .2
Separate account liabilities.................................. - - - (5.4)
Amortization related to operations................................. 63.3 202.7 566.0 356.9
Amortization related to net investment gains (losses).............. 1.1 (.9) (24.6) (32.3)
Interest expense on investment borrowings.......................... 1.6 4.7 10.2 19.7
Other operating costs and expenses................................. 115.6 222.6 292.1 273.9
Special charges.................................................... - - (.7) 15.5
--------- --------- --------- ---------
Total benefits and expenses................................. 602.8 1,175.4 2,220.0 2,023.8
--------- --------- --------- ---------
Income (loss) before income taxes, minority interest, discontinued
operations and cumulative effect of accounting change......... $ 94.3 $ 299.9 $ (211.5) $ 186.0
========= ========= ========= =========
(continued)
48
(continued from previous page)
Successor Predecessor
------------- ----------------------------------
Four months Eight months Years
ended ended ended
December 31, August 31, December 31,
-----------------
2003 2003 2002 2001
---- ---- ---- ----
Health loss ratios:
All health lines:
Insurance policy benefits.................................. $171.4 $381.3 $550.7 $533.1
Loss ratio (a)............................................. 64.92% 70.95% 66.36% 66.97%
Medicare Supplement:
Insurance policy benefits.................................. $86.5 $167.2 $217.6 $192.8
Loss ratio (a)............................................. 66.57% 65.49% 61.28% 61.81%
Specified Disease:
Insurance policy benefits.................................. $74.5 $184.7 $259.5 $250.9
Loss ratio (a)............................................. 61.61% 75.77% 69.61% 67.35%
Interest-adjusted loss ratio (b)........................... 30.64% 46.33% 42.10% 41.70%
Other:
Insurance policy benefits.................................. $10.4 $29.4 $73.6 $89.4
Loss ratio (a)............................................. 79.11% 76.66% 72.22% 80.09%
- -------------
(a) We calculate loss ratios by taking the related product's: (i) insurance
policy benefits; divided by (ii) insurance policy income.
(b) We calculate the interest-adjusted loss ratio for Conseco Insurance Group's
specified disease products by taking the product's: (i) insurance policy
benefits less interest income on the accumulated assets which back the
insurance liabilities; divided by (ii) policy income. Interest income is an
important factor in measuring losses on this product. The net cash flows
from specified disease products generally result in the accumulation of
amounts in the early years of a policy (accounted for as reserve increases)
which will be paid out as benefits in later policy years (accounted for as
reserve decreases). Accordingly, as the policies age, the loss ratio will
typically increase, but the increase in the change in reserve will be
partially offset by investment income earned on the assets which have
accumulated. The interest-adjusted loss ratio reflects the effects of the
investment income offset.
Collections on insurance products were $421.6 million in the four months
ended December 31, 2003; $880.0 million in the eight months ended August 31,
2003; and $1.7 billion and $2.0 billion in 2002 and 2001, respectively. Premium
collections through the independent agents in our Conseco Insurance Group
segment have been negatively impacted by the A.M. Best ratings downgrade to "B
(Fair)"in August 2002 and our decision to de-emphasize the sale of certain
products. See "Premium and Asset Accumulation Product Collections" for further
analysis.
Average liabilities for insurance and asset accumulation products were
$13.0 billion in the four months ended December 31, 2003; $13.3 billion in the
eight months ended August 31, 2003; and $15.3 billion and $16.3 billion in 2002
and 2001, respectively. The decrease in such liabilities is primarily due to the
increase in policyholder redemptions and lapses following the downgrade of our
A.M. Best financial strength rating to "B (Fair)"in August 2002. See "--
Liquidity for insurance operations" for additional discussion of the A.M. Best
ratings downgrade.
Insurance policy income is comprised of: (i) premiums earned on policies
which provide mortality or morbidity coverage; and (ii) fees and other charges
made against other policies. See "-- Premium and Asset Accumulation Product
Collections" for further analysis.
Net investment income on general account invested assets (which excludes
income on policyholder and reinsurer accounts) was $240.9 million in the four
months ended December 31, 2003; $562.2 million in the eight months ended August
31, 2003; and $982.0 million and $1,114.2 million in 2002 and 2001,
respectively. The average balance of general account invested assets was $12.7
billion in the four months ended December 31, 2003; $13.7 billion in the eight
months ended August 31, 2003; and $15.0 billion and $16.0 billion in 2002 and
2001, respectively. The yield on these assets was 5.7 percent in the four months
ended December 31, 2003; 6.2 percent in the eight months ended August 31, 2003;
and 6.5 percent and 7.0 percent in 2002 and 2001, respectively. The decrease in
yield for the four months ended December 31, 2003
49
reflects the adoption of fresh start accounting which effectively reset the
yields to market rates at August 31, 2003. The decrease in yield in 2002
reflected general decreases in market interest rates between 2002 and 2001.
Net investment income related to equity-indexed products based on the
change in value of the S&P 500 Call Options represents the change in the
estimated fair value of Conseco Insurance Group's S&P 500 Index Call Options
which are purchased in an effort to cover certain benefits accruing to the
policyholders of our equity-indexed products. Our equity-indexed products are
designed so that the investment income spread earned on the related insurance
liabilities should be more than adequate to cover the cost of the S&P 500 Call
Options and other costs related to these policies. Option costs that are
attributable to benefits provided were $16.3 million in the four months ended
December 31, 2003; $45.8 million in the eight months ended August 31, 2003; and
$82.3 million and $103.0 million in 2002 and 2001, respectively. These costs are
reflected in the change in market value of the S&P 500 Call Options included in
the investment income amounts. Net investment income (loss) related to
equity-indexed products before this expense was $51.8 million in the four months
ended December 31, 2003; $66.2 million in the eight months ended August 31,
2003; and $(3.4) million and $4.3 million in 2002 and 2001, respectively. Such
amounts were partially offset by the corresponding charge (credit) to amounts
added to policyholder account balances for equity-indexed products of $35.8
million in the four months ended December 31, 2003; $66.6 million in the eight
months ended August 31, 2003; and $(.9) million and $.2 million in 2002 and
2001, respectively. Such income and related charge fluctuate based on the value
of options embedded in the segment's equity-indexed annuity policyholder account
balances subject to this benefit and to the performance of the S&P 500 Index to
which the returns on such products are linked.
Net investment income (loss) from separate account assets is offset by a
corresponding charge (credit) to amounts added to policyholder account balances
for separate account liabilities. Such income (loss) and related charge (credit)
fluctuated in relationship to total separate account assets and the return
earned on such assets.
Trading account income related to policyholder and reinsurer accounts
represents the income on trading security accounts established on August 31,
2003, which are designed to act as a hedge for embedded derivatives related to:
(i) Conseco Insurance Group's equity-indexed products; and (ii) certain modified
coinsurance agreements. In addition, such income includes the income on
investments backing the market strategies of certain annuity products which
provide for different rates of cash value growth based on the experience of a
particular market strategy. The income on our trading account securities is
designed to substantially offset: (i) the change in value of embedded
derivatives related to modified coinsurance agreements described below; and (ii)
certain amounts included in insurance policy benefits.
Change in value of embedded derivatives related to modified coinsurance
agreements are described in the note to our consolidated financial statements
entitled "Summary of Significant Accounting Policies - Accounting for
Derivatives." We have transferred the specific block of investments related to
these agreements to our trading securities account, which we carry at estimated
fair value with changes in such value recognized as trading account income. The
change in the value of the embedded derivatives has largely been offset by the
change in value of the trading securities.
Net realized investment gains (losses) fluctuate from period to period.
During the four months ended December 31, 2003, we recognized net realized
investment gains in our Conseco Insurance Group segment which included: (i)
$13.4 million of net gains from the sales of investments (primarily fixed
maturities), net of (ii) $3.9 million of writedowns of fixed maturity
investments, equity securities and other invested assets as a result of
conditions which caused us to conclude a decline in fair value of the investment
was other than temporary. During the first eight months of 2003, we recognized
net realized investment losses of $17.1 million. During the first eight months
of 2003, the net realized investment losses included: (i) $16.8 million of net
gains from the sales of investments (primarily fixed maturities) net of; (ii)
$33.9 million of writedowns of fixed maturity investments, equity securities and
other invested assets as a result of conditions which caused us to conclude a
decline in fair value of the investment was other than temporary. During 2002
and 2001, we recognized net realized investment losses of $368.1 million and
$209.1 million, respectively, in our Conseco Insurance Group segment. The net
realized investment losses during 2002 included: (i) $365.2 million to write
down certain securities to fair value due to an other-than-temporary decline in
value (including issuers who have faced significant problems: K-Mart Corp.,
Amerco, Inc., Global Crossing, MCI Communications, Mississippi Chemical, United
Airlines and Worldcom, Inc.); and (ii) $2.9 million of net losses from the sales
of investments (primarily fixed maturities). The net realized investment losses
during 2001 included writedowns of $209.6 million related to: (i) the impact of
higher default rate assumptions on certain structured investments; (ii) losses
on investments held in our private equity portfolio; and (iii) the writedown of
certain securities to fair value due to an other-than-temporary decline in
value, or our plan to sell the securities in connection with investment
restructuring activities (including issuers who have faced significant problems:
Sunbeam Corp., Enron Corp., Crown Cork & Seal Company Inc., Global Crossing Ltd.
and K-Mart Corp.).
Fee revenue and other income primarily represents income earned by a
subsidiary (which was sold in September 2003) which earned fees for marketing
insurance products of other companies.
50
Insurance policy benefits fluctuated as a result of the factors summarized
in the explanations for loss ratios related to specific products which follow
and, in the eight months ended August 31, 2003, as a result of a change in
estimates of future losses on certain policies, as discussed below in further
detail. Loss ratios are calculated by taking the related insurance product's:
(i) insurance policy benefits; divided by (ii) policy income.
The loss ratios on Conseco Insurance Group's Medicare supplement products
have generally been within our range of expectations. Governmental regulations
generally require us to attain and maintain a ratio of total benefits incurred
to total premiums earned (as calculated based on amounts reported for statutory
accounting purposes), after three years, of not less than 65 percent on these
products. The loss ratios in 2002 and 2001 reflected eliminations of reserve
redundancies based on the ultimate development of reserves at December 31, 2001
and December 31, 2000.
The loss ratio on Conseco Insurance Group's specified disease products
reflected higher than expected incurred claims on certain cancer insurance
policies during the first eight months of 2003. These policies generally provide
fixed or limited benefits. Payments under cancer insurance policies are
generally made directly to, or at the direction of, the policyholder following
diagnosis of, or treatment for, a covered type of cancer. We had favorable
claims experience in the four months ended December 31, 2003. Approximately 76
percent of our specified disease policies inforce (based on policy count) are
sold with return of premium or cash value riders. The return of premium rider
generally provides that after a policy has been inforce for a specified number
of years or upon the policyholder reaching a specified age, we will pay to the
policyholder, or a beneficiary under the policy, the aggregate amount of all
premiums paid under the policy, without interest, less the aggregate amount of
all claims incurred under the policy. Accordingly, the net cash flows from these
products generally result in the accumulation of amounts in the early years of a
policy (accounted for as reserve increases) which will be paid out as benefits
in later policy years (accounted for as reserve decreases). Accordingly, as the
policies age, the loss ratio will typically increase, but the increase in the
change in reserve will be partially offset by investment income earned on the
assets which have accumulated. The loss ratios on Conseco Insurance Group's
specified disease products in 2002 and 2001 were within our expectations. The
interest-adjusted loss ratio for specified disease products is calculated by
taking the insurance product's: (i) insurance policy benefits less interest
income on the accumulated assets which back the insurance liabilities; divided
by (ii) policy income.
The loss ratios on Conseco Insurance Group's other products fluctuate due
to the smaller size of these blocks of business. The loss ratios on this
business have generally been within our expectations.
In August 2003, we decided to change a non-guaranteed element of certain
Conseco Insurance Group policies. This element was not required by the policy
and the change will eliminate the former practice of reducing the cost of
insurance charges to amounts below the level permitted under the provisions of
the policies. As a result of this decision, our estimates of future expected
gross profits on these products used as a basis for amortization of insurance
intangibles and the establishment of insurance liabilities has changed. We
adjusted the total amortization and reserve charge we had recorded since the
acquisition of these policies as a result of the change to our earlier estimates
in accordance with Statement of Financial Accounting Standards No. 97,
"Accounting and Reporting by Insurance Enterprises of Certain Long-Duration
Contracts and for Realized Gains and Losses from the Sale of Investments." The
effect of the change in estimate was a $220.2 million reduction to insurance
policy benefits and a $39.8 million reduction to amortization recorded in the
eight months ended August 31, 2003.
Amounts added to policyholder account balances for annuity products and
interest-sensitive life products were $94.9 million in the four months ended
December 31, 2003; $218.4 million in the eight months ended August 31, 2003; and
$379.7 million and $417.8 million in 2002 and 2001, respectively. The decreases
during the 2003 periods and 2002 are primarily due to a smaller block of annuity
business inforce and changes in the weighted average crediting rates. The
weighted average crediting rates for these products were 4.0 percent for the
four months ended December 31, 2003; 4.4 percent for the eight months ended
August 31, 2003; and 4.3 percent and 4.4 percent in 2002 and 2001, respectively.
Amounts added to equity-indexed products based on S&P 500 Index correspond
to the related investment income accounts described above.
Amortization related to operations includes amortization of insurance
intangibles. Conseco Insurance Group's amortization recorded in the eight months
ended August 31, 2003 was affected by the change in estimates of future losses
on certain policies described above under "insurance policy benefits."
Policyholder redemptions of annuity and, to a lesser extent, life products
increased following the downgrade of our A.M. Best financial strength rating to
"B (Fair)" in August of 2002. When redemptions are greater than our previous
assumptions, we are required to accelerate the amortization of insurance
intangibles to write off the balance associated with the redeemed policies.
Amortization in the periods presented has fluctuated as a result of the
acceleration of the amortization of insurance intangibles associated with policy
redemptions
51
and changes in future lapse assumptions with respect to the policies inforce. In
2002, we changed the lapse assumptions used to determine the amortization of
insurance intangibles related to certain universal life products and our
annuities to reflect our then current estimates of future lapses. For certain
universal life products, we changed the ultimate lapse assumption from: (i) a
range of 6 percent to 7 percent to; (ii) a tiered assumption based on the level
of funding of the policy of a range of 2 percent to 10 percent. We recorded
additional amortization related to higher redemptions and changes to our lapse
assumptions of $203.2 million in 2002. Policyholder redemptions during the 2003
periods have generally been consistent with our revised lapse assumptions.
As a result of economic developments, actual experience of our products and
changes in our expectations, we changed our investment yield assumptions used in
calculating the estimated gross profits to be earned on our annuity products in
2001. Such changes resulted in additional amortization of insurance intangibles
of $27.8 million in 2001.
Amortization related to net realized investment gains (losses) represents
the increases or decreases in amortization which result from realized investment
gains or losses. When we sell securities at a gain (loss) and reinvest the
proceeds at a different yield, we increase (reduce) the amortization of
insurance intangibles in order to reflect the change in future expected yields.
Sales of fixed maturity investments resulted in an increase (decrease) in the
amortization of insurance intangibles of $1.1 million in the four months ended
December 31, 2003; $(.9) million in the eight months ended August 31, 2003; and
$(24.6) million and $(32.3) million in 2002 and 2001, respectively.
Interest expense on investment borrowings fluctuates along with Conseco
Insurance Group's investment borrowing activities and the interest rates
thereon. Average investment borrowings (excluding borrowings related to the GM
building) were $304.2 million during the four months ended December 31, 2003;
$403.4 million during the eight months ended August 31, 2003; and $639.1 million
and $618.1 million during 2002 and 2001, respectively. The weighted average
interest rates on such borrowings (excluding borrowings related to the GM
building) were 1.6 percent during the four months ended December 31, 2003; 1.7
percent during the eight months ended August 31, 2003; and 1.6 percent and 3.2
percent during 2002 and 2001, respectively.
Other operating costs and expenses were $115.6 million in the four months
ended December 31, 2003; $222.6 million in the eight months ended August 31,
2003; and $292.1 million and $273.9 million in 2002 and 2001, respectively.
Increases in these expenses in 2003 and 2002 are primarily related to increased
policy acquisition costs which were non-deferrable.
Special charges in 2002 included: (i) a gain of $4.0 million on asset sale
transactions entered into as part of our cash raising initiatives; and (ii)
other expenses totaling $3.3 million primarily related to severance benefits and
costs incurred with the transfer of certain customer service and backroom
operations to our former India subsidiary. Special charges in 2001 were $15.5
million. The 2001 charges primarily related to severance benefits and costs
incurred in conjunction with the transfer of certain customer service and
backroom operations to our former India subsidiary.
52
Other Business in Run-Off (dollars in millions)
Successor Predecessor
------------- -----------------------------------
Four months Eight months Years
ended ended ended
December 31, August 31, December 31,
------------------
2003 2003 2002 2001
---- ---- ---- ----
Premiums and asset accumulation product collections:
Long-term care............................................... $ 134.6 $ 268.0 $ 434.5 $ 463.0
Major medical............................................... 39.3 156.4 409.5 737.1
-------- -------- -------- --------
Total premium collections............................... $ 173.9 $ 424.4 $ 844.0 $1,200.1
======== ======== ======== ========
Average liabilities for other business in run-off:
Long-term care............................................... $3,296.2 $1,977.9 $1,768.7 $1,639.0
Major medical................................................ 103.8 120.0 225.2 407.1
-------- -------- -------- --------
Total average liabilities for other business in run-off,
net of reinsurance ceded.............................. $3,400.0 $2,097.9 $1,993.9 $2,046.1
======== ======== ======== ========
Revenues:
Insurance policy income...................................... $ 150.5 $ 418.8 $ 847.3 $1,215.2
Net investment income on general account invested assets..... 55.3 101.5 155.8 166.7
Net realized investment gains (losses)....................... (.7) 6.3 (58.2) (24.6)
Fee revenue and other income................................. .9 - .8 1.2
-------- -------- -------- ---------
Total revenues........................................... 206.0 526.6 945.7 1,358.5
-------- -------- -------- --------
Expenses:
Insurance policy benefits.................................... 150.7 597.3 864.6 1,089.6
Amortization related to operations........................... 6.3 25.7 112.2 160.1
Interest expense on investment borrowings.................... - .2 .6 2.0
Other operating costs and expenses........................... 36.2 74.7 185.1 212.8
-------- -------- -------- --------
Total benefits and expenses.............................. 193.2 697.9 1,162.5 1,464.5
-------- -------- -------- --------
Income (loss) before income taxes, minority interest,
discontinued operations and cumulative effect of
accounting change...................................... $ 12.8 $ (171.3) $ (216.8) $ (106.0)
======== ======== ======== ========
Health loss ratios:
Long-Term Care:
Insurance policy benefits.................................. $136.9 $458.1 $595.9 $446.4
Loss ratio (a)............................................. 103.32% 169.76% 139.11% 96.44%
Interest-adjusted loss ratio (b)........................... 65.84% 134.58% 110.19% 73.13%
Major medical:
Insurance policy benefits.................................. $13.8 $139.2 $268.7 $643.2
Loss ratio (a)............................................. 77.29% 93.43% 64.15% 85.61%
- -----------
(a) We calculate loss ratios by taking the related product's: (i) insurance
policy benefits; divided by (ii) insurance policy income.
(b) We calculate the interest-adjusted loss ratio for long-term care products
included in this segment by taking the product's: (i) insurance policy
benefits less interest income on the accumulated assets which back the
insurance liabilities; divided by (ii) policy income. Interest income is an
important factor in measuring losses on this product. The net cash flows
from long-term care products generally result in the accumulation of
amounts in the early years of a policy (accounted for as reserve increases)
which will be paid out as benefits in later policy years (accounted for as
reserve decreases). Accordingly, as the policies age, the loss ratio will
typically increase, but the increase in the change
53
in reserve will be partially offset by investment income earned on the
assets which have accumulated. The interest-adjusted loss ratio reflects
the effects of the investment income offset.
Total premium collections in this segment were $173.9 million in the four
months ended December 31, 2003; $424.4 million in the eight months ended August
31, 2003; and $844.0 million and $1,200.1 million in 2002 and 2001,
respectively. We have ceased marketing the long-term care business included in
this segment. Accordingly, collected premiums will decrease over time. Decreases
in long-term care premium collections are the result of policy lapses, partially
offset by premium rate increases. We have ceased marketing and have not renewed
our major medical business, which has resulted in the significant reduction in
major medical collected premiums. See "-- Premium and Asset Accumulation Product
Collections" for further analysis.
Average liabilities for other business in run-off, net of reinsurance ceded
were $3.4 billion in the four months ended December 31, 2003; $2.1 billion in
the eight months ended August 31, 2003; and $2.0 billion in both 2002 and 2001.
The increase in 2003 reflects the adoption of fresh start accounting as further
discussed under "-- Critical Accounting Policies -- Liabilities for Insurance
Products."
Insurance policy income is comprised of premiums earned on the segment's
long-term care and major medical policies. See "-- Premium and Asset
Accumulation Product Collections" for further analysis.
Net investment income on general account invested assets was $55.3 million
in the four months ended December 31, 2003; $101.5 million in the eight months
ended August 31, 2003; and $155.8 million and $166.7 million in 2002 and 2001,
respectively. The average balance of general account invested assets was $2.8
billion in the four months ended December 31, 2003; $2.5 billion in the eight
months ended August 31, 2003; and $2.4 billion and $2.3 billion in 2002 and
2001, respectively. The yield on these assets was 5.8 percent in the four months
ended December 31, 2003; 6.1 percent in the eight months ended August 31, 2003;
and 6.6 percent and 7.2 percent in 2002 and 2001, respectively. The decrease in
yield for the four months ended December 31, 2003 reflects the adoption of fresh
start accounting which effectively reset the yields to market rates at August
31, 2003.
Net realized investment gains (losses) fluctuate from period to period.
During the four months ended December 31, 2003, net realized investment losses
in our Other Business in Run-off segment included: (i) $.2 million of net losses
from the sales of investments; and (ii) $.5 million of writedowns of investments
as a result of conditions which caused us to conclude a decline in fair value of
the investment was other than temporary. During the first eight months of 2003,
we recognized net realized investment gains of $6.3 million. During the first
eight months of 2003, the net realized investment gains included: (i) $8.7
million of net gains from the sales of investments (primarily fixed maturities);
net of (ii) $2.4 million of writedowns of fixed maturity investments, equity
securities and other invested assets as a result of conditions which caused us
to conclude a decline in fair value of the investment was other than temporary.
During 2002 and 2001, we recognized net realized investment losses in the Other
Business in Run-off segment of $58.2 million and $24.6 million, respectively.
The net realized investment losses during 2002 included: (i) $51.8 million to
writedown certain securities to fair value due to an other-than-temporary
decline in value (including issuers who have faced significant problems: K-Mart
Corp., Amerco, Inc., Global Crossing, MCI Communications, Mississippi Chemical,
United Airlines and Worldcom, Inc.); and (ii) $6.4 million of net losses from
the sales of investments (primarily fixed maturities). The net realized
investment losses during 2001 included writedowns of $21.9 million related to:
(i) the impact of higher default rate assumptions on certain structured
investments; (ii) losses on investments held in our private equity portfolio;
and (iii) the writedown of certain securities to fair value due to an
other-than-temporary decline in value or our plan to sell the securities in
connection with investment restructuring activities (including issuers who have
faced significant problems: Sunbeam Corp., Enron Corp., Crown Cork & Seal
Company Inc., Global Crossing Ltd. and K-Mart Corp.).
Insurance policy benefits fluctuated primarily as a result of the factors
summarized below related to loss ratios in the blocks of long-term care business
in this segment. Loss ratios are calculated by taking the product's: (i)
insurance policy benefits; divided by (ii) policy income.
This segment includes long-term care insurance inforce, substantially all
of which was issued through independent agents by certain of our subsidiaries
prior to their acquisitions by Conseco in 1996 and 1997. The loss experience on
these products has been worse than we expected. Although we anticipated a higher
level of benefits to be paid out on these products as the policies age, the paid
claims have exceeded our projections. We are experiencing adverse developments
on home health care policies issued in certain areas of Florida and other
states. This adverse experience is reflected in the higher loss ratios in the
eight months ended August 31, 2003. We are aggressively seeking rate increases
and pursuing other actions on certain of these long-term care policies. We hired
an actuarial consulting firm to help evaluate the adequacy of this segment's
long-term care reserves given our recent adverse experience and claim reserve
deficiencies. Based on the results of their study and our internal evaluations,
we modified our claim continuance tables to reflect longer benefit payment
periods
54
consistent with our current estimate of future loss experience. Accordingly,
claim reserves increased by approximately $85 million in the eight months ended
August 31, 2003, most of which was due to the new continuance tables. Excluding
the increase in claim reserves, the loss ratio for the eight months ended August
31, 2003, would have been 138 percent and the interest-adjusted loss ratio for
the eight months ended August 31, 2003, would have been 103 percent. The
decrease in the long-term care loss ratio for the four months ended December 31,
2003 reflects the adoption of fresh start accounting.
During 2002, we conducted an extensive examination of the assumptions used
to estimate our claim reserves for long-term care products sold through our
independent agent distribution channel. The examination was prompted by the
continuing claim reserve deficiencies that we were experiencing based on the
assumptions and estimates made by our actuaries. We engaged an independent
actuarial firm to assist in the examination.
Our prior estimates for long-term care reserves were based on claim
continuance tables using experience for the period from January 1, 1990 through
September 30, 1999. These tables are used to estimate the length of time an
insured will receive covered long-term care for an incurred event. In 2002, we
completed studies which indicated that the average length of time an insured
will receive covered care had increased in recent periods. In addition, we have
experienced significant fluctuations in claim inventories for these products.
Accordingly, our actuaries and the independent actuarial firm concluded that
estimates of future claim payments for incurred claims using the more recent
data reflecting the longer covered care time periods were more appropriate than
estimates based on prior data. The changes in estimation in calculating the
reserves resulted in an increase to insurance policy benefits of $130.0 million
in 2002. Excluding this adjustment related to the change in estimate, insurance
policy benefits on long-term care policies would have been $465.9 million, the
loss ratio for the year ended December 31, 2002 would have been 109 percent, and
the interest-adjusted loss ratio for the year ended December 31, 2002 would have
been 80 percent.
The net cash flows from long-term care products generally result in the
accumulation of amounts in the early years of a policy (accounted for as reserve
increases) which will be paid out as benefits in later policy years (accounted
for as reserve decreases). Accordingly, as the policies age, the loss ratio will
typically increase, but the increase in the change in reserve will be partially
offset by investment income earned on the assets which have accumulated. The
interest-adjusted loss ratio for long-term care products is calculated by taking
the insurance product's: (i) insurance policy benefits less interest income on
the accumulated assets which back the insurance liabilities; divided by (ii)
policy income.
The loss ratio on the major medical business increased in the eight months
ended August 31, 2003, primarily due to adverse claim experience. The loss ratio
on the major medical business decreased during 2002. This decrease resulted
primarily from lower than expected claims experience as the business began
running off following our decision, in 2001, to begin nonrenewing major medical
business.
Amortization related to operations includes amortization of insurance
intangibles. The decrease in amortization expense for the four months ended
December 31, 2003 reflects the adoption of fresh start accounting, and also
reflects the relatively small amount of value of policies inforce associated
with the business comprising this segment. In 2001, we stopped renewing portions
of our major medical lines of business in several unprofitable states in
accordance with the contractual terms of the policies. As a result, we
determined that approximately $77.4 million of insurance intangibles would not
be recoverable. Such amount is recorded as amortization related to operations.
Interest expense on investment borrowings fluctuates along with our
investment borrowing activities which have not been significant in this segment.
Other operating costs and expenses were $36.2 million in the four months
ended December 31, 2003; $74.7 million in the eight months ended August 31,
2003; and $185.1 million and $212.8 million in 2002 and 2001, respectively. The
decreases in expenses were due primarily to expense reductions in the major
medical operations. Since our decision in 2001 to nonrenew the small group and
individual major medical business, the total number of employees dedicated to
major medical has been reduced by approximately 550 during the period June 30,
2001 through December 31, 2003.
55
Corporate (dollars in millions)
Successor Predecessor
------------- ----------------------------------
Four months Eight months Years
ended ended ended
December 31, August 31, December 31,
----------------
2003 2003 2002 2001
---- ---- ---- ----
Corporate operations:
Interest expense on corporate debt............................... $(34.4) $ (194.2) $ (325.5) $(369.6)
Investment income ............................................... .7 16.2 14.0 39.7
Provision for losses related to stock purchase plan.............. - (55.6) (240.0) (169.6)
Venture capital income (loss) related to investment in AT&T
Wireless Service, Inc. ( "AWE "), net of related expenses...... (5.5) 10.5 (99.3) (23.4)
Fee revenue and other income..................................... 11.4 17.1 59.2 68.5
Net realized investment losses................................... (.4) (.1) (1.3) (62.8)
Other items...................................................... (14.9) (40.4) (182.7) (137.8)
Goodwill amortization............................................ - - - (108.2)
Gain on sale of interest in riverboat............................ - - - 192.4
Special charges.................................................. - - (52.2) (58.9)
Gain on extinguishment of debt................................... - - 1.8 17.0
Goodwill impairment.............................................. - - (500.0) -
Reorganization items............................................. - 2,130.5 (14.4) -
------ -------- --------- -------
Income (loss) before income taxes and minority interest........ $(43.1) $1,884.0 $(1,340.4) $(612.7)
====== ======== ========= =======
Interest expense on corporate debt in the four months ended December 31,
2003 includes interest expense on the Senior Credit Facility. Interest expense
decreased in the eight months ended August 31, 2003 primarily as a result of our
ceasing to accrue interest on notes payable (excluding Predecessor's senior
credit facility, the guaranteed senior notes and certain secured senior notes).
Interest expense decreased in 2002 as a result of the repayment of debt and
lower interest rates. The average debt outstanding was $4.1 billion and $4.5
billion in 2002 and 2001, respectively. The average interest rate on such debt
was 8.0 percent and 8.2 percent in 2002 and 2001, respectively.
Investment income primarily included income earned on short-term
investments held by the Corporate segment and the income from our investment in
a riverboat casino (prior to its sale in the first quarter of 2001) and
miscellaneous other income.
Provision for losses and expense related to stock purchase plan represents
the non-cash provision we established in connection with our guarantees of bank
loans to approximately 155 current and former directors, officers and key
employees and our related loans for interest. The funds from the bank loans were
used by the participants to purchase approximately 18.0 million shares of our
Predecessor's common stock. In the first eight months of 2003 and in 2002 and
2001, we established provisions of $55.6 million, $240.0 million and $169.6
million, respectively, in connection with these guarantees and loans. We
determined the reserve based upon the value of the collateral held by the banks.
At December 31, 2002, the reserve for losses on the loan guarantees totaled
$660.0 million. The outstanding principal balance on the bank loans was $481.3
million. In addition, our Predecessor provided loans to participants for
interest on the bank loans totaling $179.2 million. During 2002, our Predecessor
purchased $55.5 million of loans from the banks utilizing cash held in a
segregated cash account as collateral for our guarantee of the bank loans
(including accrued interest, the balance on these loans was $56.7 million at
December 31, 2002).
In conjunction with the Plan, the $481.3 million principal amount of bank
loans was transferred to the Company. We received all rights to collect the
balances due pursuant to the original terms of these loans. In addition, we hold
loans to participants for interest on the bank loans which total approximately
$220 million. The former bank loans and the interest loans are collectively
referred to as the "D&O loans." We regularly evaluate the collectibility of
these loans in light of the collateral we hold and the creditworthiness of the
participants. At December 31, 2003, we have estimated that approximately $51.0
million of the D&O balance (which is included in other assets) is collectible
(net of the cost of collection). An allowance has been established to reduce the
recorded balance of the D&O loans to this balance.
Venture capital income (loss) relates to our investment in AT&T Wireless
("AWE"), a company in the wireless communication business. Our investment in AWE
was carried at estimated fair value, with changes in fair value recognized as
investment income (loss). We sold all of our holdings in AWE during the fourth
quarter of 2003.
56
Fee revenue and other income includes: (i) revenues we receive for managing
investments for other companies; and (ii) fees received for marketing insurance
products of other companies. In 2002 and 2001, this amount included $16.7
million and $5.4 million, respectively, of affiliated fee revenue earned by our
subsidiary in India. Such revenue is eliminated in consolidation. Excluding such
affiliated income, fee revenue and other income decreased primarily as a result
of a decrease in the market value of investments managed for others, upon which
these fees are based. We sold our India subsidiary in the fourth quarter of 2002
and have substantially eliminated the customer service and other operations
conducted there. Fee revenue and other income in the four months ended December
31, 2003, includes $5.6 million of interest received on a Federal income tax
refund.
Net realized investment losses often fluctuate from period to period.
During 2002 and 2001, we recorded writedowns in the Corporate segment totaling
$1.3 million and $60.7 million, respectively, on certain securities due to an
other than temporary decline in value.
Other items include general corporate expenses, net of amounts charged to
subsidiaries for services provided by the corporate operations. During the first
eight months of 2003, disputes with certain of our insurance carriers were
resolved and a previously established liability of $40 million (which was
established in 2002) was released which was substantially offset by increases to
various litigation reserves of $30 million. This amount includes expenses in
2002 and 2001 related to our subsidiary in India which was sold in the fourth
quarter of 2002.
Goodwill amortization in 2001 was $108.2 million. Pursuant to Statement of
Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets"
("SFAS 142"), 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 frequently under certain circumstances) effective January 1,
2002.
Gain on sale of interest in riverboat represents the gain recognized in the
first quarter of 2001 as a result of our sale of our 29 percent ownership
interest in the riverboat casino in Lawrenceberg, Indiana, for $260 million.
Special charges in the Corporate segment for 2002 included: (i) a loss of
$20.0 million associated with the sale of our India subsidiary; (ii) $17.7
million related to debt modification and refinancing transactions; (iii) other
items totaling $22.0 million; partially offset by (iv) net gains of $7.5 million
related to the sale of certain non-core assets. Special charges in this segment
for 2001 included: (i) litigation accrual and expenses of $23.8 million; (ii)
severance benefits of $2.9 million; (iii) losses related to office closings and
the sale of artwork totaling $6.8 million; (iv) losses related to disputed
reinsurance balances totaling $8.5 million; and (v) other losses totaling $16.9
million.
During 2002, we recognized a gain on the extinguishment of debt as we
repurchased $77.4 million par value of our Predecessor's notes payable resulting
in a gain of $1.8 million.
During 2001, we repurchased $893.8 million par value of our Predecessor's
notes payable resulting in a gain of $17.0 million.
In 2002, we recognized a goodwill impairment of $500.0 million as discussed
in greater detail in the notes to the consolidated financial statements.
Reorganization items in the eight months ended August 31, 2003 included:
(i) $3,151.4 million related to the gain on the discharge of prepetition
liabilities; (ii) $(950.0) million related to fresh start adjustments; and (iii)
$(70.9) million related to professional fees associated with our bankruptcy
proceedings which are expensed as incurred in accordance with SOP 90-7. In 2002,
we incurred reorganization items of $14.4 million related to professional fees
associated with our bankruptcy proceedings.
PREMIUM AND ASSET ACCUMULATION PRODUCT COLLECTIONS
In accordance with GAAP, insurance policy income as shown in our
consolidated statement of operations consists of premiums earned for policies
that have life contingencies or morbidity features. For annuity and universal
life contracts without such features, premiums collected are not reported as
revenues, but as deposits to insurance liabilities. We recognize revenues for
these products over time in the form of investment income and surrender or other
charges.
Agents, insurance brokers and marketing companies who market our products
and prospective purchasers of our products use the ratings of our insurance
subsidiaries as an important factor in determining which insurer's products to
market or purchase. Ratings have the most impact on our annuity and
interest-sensitive life insurance products. Our insurance
57
companies' financial strength ratings were downgraded by all of the major rating
agencies beginning in July, 2002, in connection with the financial distress that
ultimately led to our Predecessor's bankruptcy. The current financial strength
ratings of our insurance subsidiaries (with the exception of Conseco Senior
Health Insurance Company) from A.M. Best, S&P and Moody's are B (Fair), BB- and
Ba3, respectively. The current financial strength ratings of Conseco Senior
Health Insurance Company from A.M. Best, Standard & Poor's and Moody's are B
(Fair), CCC and Caa1, respectively. For a description of the ratings issued by
these firms and additional information on our ratings, see "Management's
Discussion and Analysis of Financial Condition and Results of Operations --
Liquidity for Insurance Operations." Many of our competitors have higher
financial strength ratings and we believe it is critical for us to improve our
ratings to be competitive. The lowered ratings assigned to our insurance
subsidiaries were one of the primary factors causing sales of our insurance
products to decline and policyholder redemptions and lapses to increase during
2002 and 2003. We also experienced increased agent attrition, which in some
cases led us to increase commissions or sales incentives in an effort to retain
them.
We set the premium rates on our health insurance policies based on facts
and circumstances known at the time we issue the policies and on assumptions
about numerous variables, including the actuarial probability of a policyholder
incurring a claim, the probable size of the claim, and the interest rate earned
on our investment of premiums. In setting premium rates, we consider historical
claims information, industry statistics, the rates of our competitors and other
factors. If our actual claims experience proves to be less favorable than we
assumed and we are unable to raise our premium rates, our financial results may
be adversely affected. Our estimates of insurance liabilities assume we will be
able to raise rates if future experience results in blocks of our health
insurance business becoming unprofitable. We generally cannot raise our health
insurance premiums in any state unless we first obtain the approval of the
insurance regulator in that state. We review the adequacy of our premium rates
regularly and file rate increases on our products when we believe existing
premium rates are too low. It is possible that we will not be able to obtain
approval for premium rate increases from currently pending requests or requests
filed in the future. If we are unable to raise our premium rates because we fail
to obtain approval for a rate increase in one or more states, our net income may
decrease. If we are successful in obtaining regulatory approval to raise premium
rates due to unfavorable actual claims experience, the increased premium rates
may reduce the volume of our new sales and cause existing policyholders to allow
their policies to lapse. This could result in anti-selection if healthier
policyholders allow their policies to lapse. This would reduce our premium
income and profitability in future periods. Increased lapse rates also could
require us to expense all or a portion of our insurance intangibles relating to
lapsed policies in the period in which those policies lapse, adversely affecting
our financial results in that period.
Our insurance segments sell insurance products through three primary
distribution channels -- career agents and direct marketing (our Bankers Life
segment) and independent producers (our Conseco Insurance Group segment). Our
career agency force in the Bankers Life segment sells primarily Medicare
supplement and long-term care insurance policies, senior life insurance and
annuities. These agents visit the customer's home, which permits one-on-one
contact with potential policyholders and promotes strong personal relationships
with existing policyholders. Bankers Life's direct marketing distribution
channel is engaged primarily in the sale of "graded benefit life" insurance
policies which are sold directly to the policyholder. Our independent producer
distribution channel in the Conseco Insurance Group segment consists of a
general agency and insurance brokerage distribution system comprised of
independent licensed agents doing business in all fifty states, the District of
Columbia, and certain protectorates of the United States. Independent producers
are a diverse network of independent agents, insurance brokers and marketing
organizations.
58
Total premiums and accumulation product collections were as follows:
Bankers Life (dollars in millions):
Successor Predecessor
------------- -----------------------------------
Four months Eight months Years
ended ended ended
December 31, August 31, December 31,
------------------
2003 2003 2002 2001
---- ---- ---- ----
Premiums collected:
Annuities:
Equity-indexed (first-year)..................................... $ 5.1 $ 10.0 $ 30.4 $ 41.4
------ -------- -------- --------
Other fixed (first-year)........................................ 247.7 685.4 707.1 469.1
Other fixed (renewal)........................................... 1.0 3.0 3.4 2.6
------ -------- -------- --------
Subtotal - other fixed annuities.............................. 248.7 688.4 710.5 471.7
------ -------- -------- --------
Total annuities............................................... 253.8 698.4 740.9 513.1
------ -------- -------- --------
Supplemental health:
Medicare supplement (first-year)................................ 20.5 37.6 75.8 74.4
Medicare supplement (renewal)................................... 205.1 381.5 588.1 582.3
------ -------- -------- --------
Subtotal - Medicare supplement................................ 225.6 419.1 663.9 656.7
------ -------- -------- --------
Long-term care (first-year)..................................... 24.6 48.7 87.7 87.8
Long-term care (renewal)........................................ 153.3 282.8 395.2 337.5
------ -------- -------- --------
Subtotal - long-term care..................................... 177.9 331.5 482.9 425.3
------ -------- -------- --------
Other health (first-year)....................................... .3 .8 1.0 1.2
Other health (renewal).......................................... 4.1 8.2 11.6 14.2
------ -------- -------- --------
Subtotal - other health....................................... 4.4 9.0 12.6 15.4
------ -------- -------- --------
Total supplemental health..................................... 407.9 759.6 1,159.4 1,097.4
------ -------- -------- --------
Life insurance:
First-year...................................................... 15.3 25.1 37.5 50.2
Renewal......................................................... 43.3 77.6 101.5 236.1
------ -------- -------- --------
Total life insurance.......................................... 58.6 102.7 139.0 286.3
------ -------- -------- --------
Collections on insurance products:
Total first-year premium collections on insurance products..... 313.5 807.6 939.5 724.1
Total renewal premium collections on insurance products......... 406.8 753.1 1,099.8 1,172.7
------ -------- -------- --------
Total collections on insurance products....................... $720.3 $1,560.7 $2,039.3 $1,896.8
====== ======== ======== ========
Annuities in the Bankers Life segment include equity-indexed and other
fixed annuities sold to the senior market through our career agents. In order to
maintain our career agency distribution force during the parent company's
Chapter 11 reorganization process, we provided certain sales inducements to
purchasers of annuities and sales incentives to our career agents. These
programs ended at various times during the second quarter of 2003. Annuity
collections from career agents totaled $253.8 million in the four months ended
December 31, 2003; $698.4 million in the eight months ended August 31, 2003; and
$740.9 million and $513.1 million in 2002 and 2001, respectively. Annuity
premium collections in 2003 were favorably impacted by the sales inducements and
incentives discussed above. In addition, the minimum guaranteed crediting rates
on certain of our annuity products were very attractive. We recently introduced
new annuity products which have lower minimum guaranteed crediting rates. As a
result of the elimination of the sales inducements and incentives and the lower
minimum guaranteed crediting rates, sales of fixed rate annuity products have
declined.
Supplemental health products in the Bankers Life segment include Medicare
supplement, long-term care and other insurance products distributed through our
career agency force. Our profits on supplemental health policies depend on the
overall level of sales, the length of time the business remains inforce,
investment yields, claim experience and expense management.
59
Collected premiums on Medicare supplement policies in the Bankers Life
segment were $225.6 million in the four months ended December 31, 2003; $419.1
million in the eight months ended August 31, 2003; and $663.9 million and $656.7
million in 2002 and 2001, respectively. Collected premiums have been affected by
new sales levels, which have declined in the Bankers Life segment since our
ratings downgrades.
Premiums collected on Bankers Life's long-term care policies totaled $177.9
million in the four months ended December 31, 2003; $331.5 million in the eight
months ended August 31, 2003; and $482.9 million and $425.3 million in 2002 and
2001, respectively. New sales of long-term care policies through our career
agents have declined since our ratings downgrades, as reflected in the declines
in first-year collected premiums in 2003.
Other health products include various other health insurance products which
we have not been actively marketing. Premiums collected totaled $4.4 million in
the four months ended December 31, 2003; $9.0 million in the eight months ended
August 31, 2003; and $12.6 million and $15.4 million in 2002 and 2001,
respectively.
Life products in our Bankers Life segment are sold primarily to the senior
market through our career agents and our direct response distribution channel.
Life premiums collected in this segment totaled $58.6 million in the four months
ended December 31, 2003; $102.7 million in the eight months ended August 31,
2003; and $139.0 million and $286.3 million in 2002 and 2001, respectively. The
decrease in life premiums collected in 2002 and 2003 compared to 2001 is
primarily due to a first quarter 2002 reinsurance transaction. The reinsurance
transaction is discussed further in the note to the consolidated financial
statements entitled "Summary of Significant Accounting Policies - Reinsurance".
The A.M. Best ratings downgrade to "B (Fair)" has not had a significant impact
on sales of life products through these channels.
60
Conseco Insurance Group (dollars in millions)
Successor Predecessor
------------- -----------------------------------
Four months Eight months Years
ended ended ended
December 31, August 31, December 31,
------------------
2003 2003 2002 2001
---- ---- ---- ----
Premiums collected:
Annuities:
Equity-indexed (first-year)...................................... $ 5.2 $ 32.8 $ 162.6 $ 306.2
Equity-indexed (renewal)......................................... 4.2 12.1 27.1 33.3
------ ------ -------- --------
Subtotal - equity-indexed annuities............................ 9.4 44.9 189.7 339.5
------ ------ -------- --------
Other fixed (first-year)......................................... 1.6 14.3 134.9 339.8
Other fixed (renewal)............................................ 7.1 14.8 27.3 31.3
------ ------ -------- --------
Subtotal - other fixed annuities............................... 8.7 29.1 162.2 371.1
------ ------ -------- --------
Total annuities................................................ 18.1 74.0 351.9 710.6
------ ------ -------- --------
Supplemental health:
Medicare supplement (first-year)................................. 16.0 36.5 90.8 47.0
Medicare supplement (renewal).................................... 118.2 213.9 279.1 271.4
------ ------ -------- --------
Subtotal - Medicare supplement................................. 134.2 250.4 369.9 318.4
------ ------ -------- --------
Specified disease (first-year)................................... 10.0 19.7 36.8 42.1
Specified disease (renewal)...................................... 108.7 216.7 331.8 329.7
------ ------ -------- --------
Subtotal - specified disease................................... 118.7 236.4 368.6 371.8
------ ------ -------- --------
Other health (first-year)........................................ 4.3 9.7 12.9 10.3
Other health (renewal)........................................... 14.8 28.8 78.9 83.6
------ ------ -------- --------
Subtotal - other health........................................ 19.1 38.5 91.8 93.9
------ ------ -------- --------
Total supplemental health...................................... 272.0 525.3 830.3 784.1
------ ------ -------- --------
Life insurance:
First-year....................................................... 9.0 20.6 59.2 69.9
Renewal.......................................................... 122.5 260.1 438.8 483.4
------ ------ -------- --------
Total life insurance........................................... 131.5 280.7 498.0 553.3
------ ------ -------- --------
Collections on insurance products:
Total first-year premium collections on insurance products....... 46.1 133.6 497.2 815.3
Total renewal premium collections on insurance products.......... 375.5 746.4 1,183.0 1,232.7
------ ------ -------- --------
Total collections on insurance products........................ $421.6 $880.0 $1,680.2 $2,048.0
====== ====== ======== ========
Annuities in our Conseco Insurance Group segment include equity-indexed
annuities and other fixed annuities sold through professional independent
producers. Many professional independent producers discontinued marketing our
annuity products after A.M. Best lowered our financial strength ratings.
Accordingly, we took actions to reduce our expenses related to marketing these
products through this distribution channel, and began to focus instead on the
sale of products that were less ratings sensitive. Total annuity collected
premiums in this segment were $18.1 million in the four months ended December
31, 2003; $74.0 million in the eight months ended August 31, 2003; and $351.9
million and $710.6 million in 2002 and 2001, respectively.
We introduced our first equity-indexed annuity product in 1996. The
accumulation value of these annuities is credited with interest at an annual
guaranteed minimum rate of 3 percent (or, including the effect of applicable
sales loads, a 1.7 percent compound average interest rate over the term of the
contracts). These annuities provide for potentially higher returns based on a
percentage of the change in the S&P 500 Index during each year of their term. We
purchase S&P 500 Call Options in an effort to hedge increases to policyholder
benefits resulting from increases in the S&P 500 Index. Total collected premiums
for this product were $9.4 million in the four months ended December 31, 2003;
$44.9 million in the eight months ended August 31, 2003; and $189.7 million and
$339.5 million in 2002 and 2001, respectively. The decreases
61
can be attributed to (i) the general stock market performance in recent years
which has made other investment products more attractive to certain customers
and (ii) the effect of the A.M. Best ratings downgrade to "B (Fair)."
Other fixed rate annuity products include SPDAs, FPDAs and SPIAs, which are
credited with a declared rate. SPDA and FPDA policies typically have an interest
rate that is guaranteed for the first policy year, after which we have the
discretionary ability to change the crediting rate to any rate not below a
guaranteed minimum rate. The interest rate credited on SPIAs is based on market
conditions existing when a policy is issued and remains unchanged over the life
of the SPIA. Annuity premiums on these products were $8.7 million in the four
months ended December 31, 2003; $29.1 million in the eight months ended August
31, 2003; and $162.2 million and $371.1 million in 2002 and 2001, respectively.
The decreases can be attributed to the effect of the A.M. Best ratings
downgrade.
Supplemental health products in our Conseco Insurance Group segment include
Medicare supplement, specified disease and other insurance products distributed
through professional independent producers. Our profits on supplemental health
policies depend on the overall level of sales, the length of time the business
remains inforce, investment yields, claim experience and expense management.
Collected premiums on Medicare supplement policies in the Conseco Insurance
Group segment were $134.2 million in the four months ended December 31, 2003;
$250.4 million in the eight months ended August 31, 2003; and $369.9 million and
$318.4 million in 2002 and 2001, respectively. Collected premiums have been
affected by the decrease in new Medicare supplement sales since our ratings
downgrades.
Premiums collected on specified disease products totaled $118.7 million in
the four months ended December 31, 2003; $236.4 million in the eight months
ended August 31, 2003; and $368.6 million and $371.8 million in 2002 and 2001,
respectively. Collected premiums have been affected by decreases in new sales
since our ratings downgrades.
Other health products include disability income, dental and various other
health insurance products. We no longer actively market many of these products.
The disability income and dental products have been marketed to school systems
located in nearly all states. Premiums collected totaled $19.1 million in the
four months ended December 31, 2003; $38.5 million in the eight months ended
August 31, 2003; and $91.8 million and $93.9 million in 2002 and 2001,
respectively.
Life products in the Conseco Insurance Group segment are sold through
professional independent producers. Life premiums collected totaled $131.5
million in the four months ended December 31, 2003; $280.7 million in the eight
months ended August 31, 2003; and $498.0 million and $553.3 million in 2002 and
2001, respectively. The A.M. Best ratings downgrade to "B (Fair)" has negatively
affected our sales of life products. We stopped actively marketing many of our
life insurance products sold through the professional independent producer
channel in the second quarter of 2003.
62
Other Business in Run-Off (dollars in millions)
Successor Predecessor
------------- -----------------------------------
Four months Eight months Years
ended ended ended
December 31, August 31, December 31,
------------------
2003 2003 2002 2001
---- ---- ---- ----
Premiums collected:
Long-term care:
First-year.................................................. $ .6 $ 3.2 $ 10.0 $ 17.4
Renewal..................................................... 134.0 264.8 424.5 445.6
------ ------ ------ --------
Subtotal - long-term care................................. 134.6 268.0 434.5 463.0
------ ------ ------ --------
Major medical:
Group (first-year).......................................... - - .5 16.4
Group (renewal)............................................. 36.7 152.4 315.1 354.5
------ ------ ------ --------
Subtotal - group major medical............................ 36.7 152.4 315.6 370.9
------ ------ ------ --------
Individual (first-year)..................................... - - 15.6 112.8
Individual (renewal)........................................ 2.6 4.0 78.3 253.4
------ ------ ------ --------
Subtotal - individual major medical....................... 2.6 4.0 93.9 366.2
------ ------ ------ --------
Total major medical...................................... 39.3 156.4 409.5 737.1
------ ------ ------ --------
Collections on insurance products:
Total first-year premium collections on insurance products .6 3.2 26.1 146.6
Total renewal premium collections on insurance products..... 173.3 421.2 817.9 1,053.5
------ ------ ------ --------
Total collections on insurance products................... $173.9 $424.4 $844.0 $1,200.1
====== ====== ====== ========
As described elsewhere, the Other Business in Run-off segment includes: (i)
long-term care products written in prior years through independent agents; and
(ii) group and individual major medical business in run-off.
Long-term care premiums collected in this segment totaled $134.6 million in
the four months ended December 31, 2003; $268.0 million in the eight months
ended August 31, 2003; and $434.5 million and $463.0 million in 2002 and 2001,
respectively. Most of the long-term care premiums in this segment relate to
business written by certain of our subsidiaries prior to their acquisitions by
Conseco in 1996 and 1997. We ceased selling new long-term care policies through
professional independent producers in the second quarter of 2003. As a result,
decreases in this segment's long-term care collected premiums reflect policy
lapses partially offset by premium rate increases.
Group major medical premiums totaled $36.7 million in the four months ended
December 31, 2003; $152.4 million in the eight months ended August 31, 2003; and
$315.6 million and $370.9 million in 2002 and 2001, respectively. We no longer
actively market new sales of group products. In early 2002, we decided to stop
renewing all inforce small group business and discontinued new sales.
Individual major medical premiums collected were $2.6 million in the four
months ended December 31, 2003; $4.0 million in the eight months ended August
31, 2003; and $93.9 million and $366.2 million in 2002 and 2001, respectively.
In the second half of 2001, we stopped renewing a large portion of our major
medical lines of business. In early 2002, we decided to stop renewing all
inforce individual major medical business and discontinued new sales.
INVESTMENTS
Our investment strategy is to: (i) maintain a predominately
investment-grade fixed income portfolio; (ii) provide adequate liquidity to meet
our cash obligations to policyholders and others; and (iii) maximize current
investment income and total investment return through active investment
management. Consistent with this strategy, investments in fixed maturity
securities, mortgage loans and policy loans made up 94 percent of our $22.8
billion investment portfolio at December 31, 2003. The remainder of the invested
assets were equity securities, venture capital investments and other invested
assets.
63
The following table summarizes the composition of our investment portfolio
as of December 31, 2003 (dollars in millions):
Carrying Percent of
value total investments
----- -----------------
Actively managed fixed maturities................................................ $19,840.1 87%
Equity securities................................................................ 74.5 -
Mortgage loans................................................................... 1,139.5 5
Policy loans..................................................................... 503.4 2
Trading securities............................................................... 915.1 4
Partnership investments.......................................................... 192.6 1
Other invested assets............................................................ 131.5 1
--------- ---
Total investments............................................................. $22,796.7 100%
========= ===
Insurance statutes regulate the type of investments that our insurance
subsidiaries are permitted to make and limit the amount of funds that may be
used for any one type of investment. In light of these statutes and regulations
and our business and investment strategy, we generally seek to invest in United
States government and government-agency securities and corporate securities
rated investment grade by established nationally recognized rating organizations
or in securities of comparable investment quality, if not rated.
The following table summarizes the carrying values of our fixed maturity
securities by industry category as of December 31, 2003 (dollars in millions):
Percent of
Carrying value fixed maturities
-------------- ----------------
Mortgage-backed securities........................................................... $ 5,851.0 29.5%
Bank & Finance....................................................................... 2,713.5 13.7
Manufacturing........................................................................ 2,169.6 10.9
Utilities............................................................................ 1,322.1 6.7
Services............................................................................. 1,142.6 5.8
Communications....................................................................... 1,058.6 5.3
Asset-backed securities.............................................................. 761.6 3.8
Agri/Forestry/Mining................................................................. 761.1 3.8
Government (US)...................................................................... 733.6 3.7
Transportation....................................................................... 498.3 2.5
Retail/Wholesale..................................................................... 486.2 2.5
Other................................................................................ 2,341.9 11.8
--------- -----
Total fixed maturity securities................................................... $19,840.1 100.0%
========= =====
Our fixed maturity securities consist predominantly of publicly traded
securities. We classify securities issued in the Rule 144A market as publicly
traded. Our privately traded securities comprise less than 1 percent of our
total fixed maturity securities portfolio and consist almost entirely of
mortgage-backed securities.
The following table sets forth fixed maturity investments at December 31,
2003, classified by rating categories. The category assigned is the highest
rating by a nationally recognized statistical rating organization or, as to
$661.5 million fair value of fixed maturities not rated by such firms, the
rating assigned by the NAIC. For purposes of the table, NAIC Class 1 is included
in the "A" rating; Class 2, "BBB-"; Class 3, "BB-"; and Classes 4-6, "B+ and
below" (dollars in millions).
64
Percent of
Amortized Carrying fixed
Investment rating cost value maturities
- ----------------- ---- ----- ----------
AAA...................................................................... $ 7,069.6 $ 7,131.8 36%
AA....................................................................... 1,592.5 1,624.5 8
A........................................................................ 4,918.2 5,018.3 25
BBB+..................................................................... 1,959.1 2,013.8 10
BBB...................................................................... 2,401.9 2,450.4 13
BBB-..................................................................... 794.9 825.3 4
--------- --------- ---
Investment grade..................................................... 18,736.2 19,064.1 96
--------- --------- ---
BB+ ..................................................................... 191.2 199.0 1
BB ..................................................................... 156.4 163.5 1
BB- ..................................................................... 149.0 158.5 1
B+ and below............................................................. 237.9 255.0 1
--------- --------- ---
Below investment grade............................................... 734.5 776.0 4
--------- --------- ---
Total fixed maturity securities................................... $19,470.7 $19,840.1 100%
========= ========= ===
The following table summarizes investment yields earned over the past three
years on the general account invested assets of our insurance subsidiaries.
General account investments exclude our venture capital investment in AWE,
separate account assets, the value of S&P 500 Call Options and the investments
held by CFC (dollars in millions).
Successor Predecessor
------------- -----------------------------------
Four months Eight months Years
ended ended ended
December 31, August 31, December 31,
------------------
2003 2003 2002 2001
---- ---- ---- ----
Weighted average general account invested assets as defined:
As reported .............................................. $23,045.4 $23,311.5 $23,407.2 $23,716.2
Excluding unrealized appreciation (depreciation) (a)...... 22,499.5 22,777.3 23,481.0 23,992.3
Net investment income on general account invested assets......... 425.1 917.1 1,520.0 1,672.8
Yields earned:
As reported............................................... 5.5% 5.9% 6.5% 7.1%
Excluding unrealized appreciation (depreciation) (a)...... 5.7% 6.0% 6.5% 7.0%
- ----------------------
(a) Excludes the effect of reporting fixed maturities at fair value as
described in the note to our consolidated financial statements entitled
"Investments".
Although investment income is a significant component of total revenues,
the profitability of certain of our insurance products is determined primarily
by the spreads between the interest rates we earn and the rates we credit or
accrue to our insurance liabilities. At December 31, 2003, the average yield,
computed on the cost basis of our actively managed fixed maturity portfolio, was
5.6 percent, and the average interest rate credited or accruing to our total
insurance liabilities (excluding interest rate bonuses for the first policy year
only and excluding the effect of credited rates attributable to variable or
equity-indexed products) was 4.7 percent.
Actively Managed Fixed Maturities
Our actively managed fixed maturity portfolio at December 31, 2003,
included primarily debt securities of the United States government, public
utilities and other corporations, and structured securities. Structured
securities included mortgage-backed securities, collateralized mortgage
obligations ("CMOs"), asset-backed securities and commercial mortgage-backed
securities.
65
At December 31, 2003, our fixed maturity portfolio had $403.8 million of
unrealized gains and $34.4 million of unrealized losses, for a net unrealized
gain of $369.4 million. Estimated fair values for fixed maturity investments
were determined based on estimates from: (i) nationally recognized pricing
services (92 percent of the portfolio); (ii) broker-dealer market makers (5
percent of the portfolio); and (iii) internally developed methods (3 percent of
the portfolio).
At December 31, 2003, approximately 3.4 percent of our invested assets (3.9
percent of fixed maturity investments) were fixed maturities rated
below-investment grade by nationally recognized statistical rating organizations
(or, if not rated by such firms, with ratings below Class 2 assigned by the
NAIC). We plan to maintain approximately the present level of investments in
below-investment-grade fixed maturities. These securities generally have greater
risks than other corporate debt investments, including risk of loss upon default
by the borrower, and are often unsecured and subordinated to other creditors.
Below-investment-grade issuers usually have higher levels of indebtedness and
are more sensitive to adverse economic conditions, such as recession or
increasing interest rates, than are investment-grade issuers. We are aware of
these risks and monitor our below-investment-grade securities closely. At
December 31, 2003, our below-investment-grade fixed maturity investments had an
amortized cost of $734.5 million and an estimated fair value of $776.0 million.
We continually evaluate the creditworthiness of each issuer whose
securities we hold. We pay special attention to those securities whose market
values have declined materially for reasons other than changes in interest rates
or other general market conditions. We evaluate the realizable value of the
investment, the specific condition of the issuer and the issuer's ability to
comply with the material terms of the security. Information reviewed may include
the recent operational results and financial position of the issuer, information
about its industry, information about the variety of factors affecting the
issuer's performance and other information. 40|86 Advisors employs a staff of
experienced securities analysts in a variety of specialty areas who compile and
review such data. If evidence does not exist to support a realizable value equal
to or greater than the carrying value of the investment, and such decline in
market value is determined to be other than temporary, we reduce the carrying
amount to its fair value, which becomes the new cost basis. We report the amount
of the reduction as a realized loss. We recognize any recovery of such
reductions in the cost basis of an investment as investment income over the
remaining life of the investment (but only to the extent our current valuations
indicate such amounts will ultimately be collected), upon the sale, repayment or
other disposition of the investment. We recorded writedowns of fixed maturity
investments, equity securities and other invested assets totaling $9.6 million
in the four months ended December 31, 2003 and $51.3 million in the eight months
ended August 31, 2003. Our investment portfolio is subject to the risks of
further declines in realizable value. However, we attempt to mitigate this risk
through the diversification and active management of our portfolio.
As of December 31, 2003, our fixed maturity investments in substantive
default (i.e., in default due to nonpayment of interest or principal) or
technical default (i.e., in default, but not as to the payment of interest or
principal) had an amortized cost of $15.1 million and a carrying value of $16.6
million. 40|86 Advisors employs a staff of experienced professionals to manage
non-performing and impaired investments. There were no other fixed maturity
investments about which we had serious doubts as to the ability of the issuer to
comply with the material terms of the instrument on a timely basis.
When a security defaults, our policy is to discontinue the accrual of
interest and eliminate all previous interest accruals, if we determine that such
amounts will not be ultimately realized in full. Investment income forgone due
to defaulted securities was $5.3 million in the four months ended December 31,
2003; $12.1 million in the eight months ended August 31, 2003; and $60.4 million
and $17.6 million for the years ended December 31, 2002 and 2001, respectively.
At December 31, 2003, fixed maturity investments included $5.9 billion of
structured securities (or 29 percent of all fixed maturity securities). CMOs are
backed by pools of mortgages that are segregated into sections or "tranches"
that provide for reprioritizing of retirement of principal. Pass-through
securities receive principal and interest payments through their regular pro
rata share of the payments on the underlying mortgages backing the securities.
The yield characteristics of structured securities differ from those of
traditional fixed-income securities. Interest and principal payments for
mortgage-backed securities occur more frequently, often monthly. Mortgage-backed
securities are subject to risks associated with variable prepayments. Prepayment
rates are influenced by a number of factors that cannot be predicted with
certainty, including: the relative sensitivity of the underlying mortgages
backing the assets to changes in interest rates; a variety of economic,
geographic and other factors; and the repayment priority of the securities in
the overall securitization structures.
In general, prepayments on the underlying mortgage loans and the securities
backed by these loans increase when prevailing interest rates decline
significantly relative to the interest rates on such loans. The yields on
mortgage-backed securities purchased at a discount to par will increase when the
underlying mortgages prepay faster than expected. The yields on mortgage-backed
securities purchased at a premium will decrease when the underlying mortgages
prepay faster than expected. When interest rates decline, the proceeds from the
prepayment of mortgage-backed securities may be reinvested at lower rates than
we were earning on the prepaid securities. When interest rates increase,
prepayments on mortgage-backed securities decrease, as fewer underlying
mortgages are refinanced. When this occurs, the average maturity and duration of
66
the mortgage-backed securities increase, which decreases the yield on
mortgage-backed securities purchased at a discount, because the discount is
realized as income at a slower rate, and increases the yield on those purchased
at a premium as a result of a decrease in the annual amortization of the
premium.
Pursuant to fresh start reporting, we were required to mark all of our
investments to market value. The current interest rate environment is much lower
than when most of our investments were purchased. Accordingly, the fresh start
values of our investments generally exceed the par values of such investments.
The amount of value exceeding par is referred to as a "purchase premium" which
is amortized against future income. If prepayments in any period are higher than
expected, purchase premium amortization is increased. In periods of unexpectedly
high prepayment activity, the increased amortization will reduce net investment
income.
The following table sets forth the par value, amortized cost and estimated
fair value of mortgage-backed securities, summarized by interest rates on the
underlying collateral at December 31, 2003 (dollars in millions):
Par Amortized Estimated
value cost fair value
----- ---- ----------
Below 4 percent.............................................................. $ 60.4 $ 63.4 $ 63.8
4 percent - 5 percent........................................................ 1,193.1 1,138.2 1,145.8
5 percent - 6 percent........................................................ 998.6 990.5 1,005.8
6 percent - 7 percent........................................................ 2,816.2 2,916.6 2,932.2
7 percent - 8 percent........................................................ 579.5 613.4 618.6
8 percent and above.......................................................... 79.8 84.7 84.8
-------- -------- --------
Total structured securities (a).................................... $5,727.6 $5,806.8 $5,851.0
======== ======== ========
- --------------------
(a) Includes below-investment grade structured securities with an amortized
cost and estimated fair value of $2.1 million.
The amortized cost and estimated fair value of structured securities at
December 31, 2003, summarized by type of security, were as follows (dollars in
millions):
Estimated Fair Value
---------------------
Percent of
Amortized fixed
Type Cost Amount maturities
- ---- ---- ------ ----------
Pass-throughs and sequential and targeted amortization classes............... $3,690.6 $3,718.1 19%
Planned amortization classes and accretion-directed bonds.................... 714.0 713.6 3
Commercial mortgage-backed securities........................................ 1,215.8 1,234.7 6
Subordinated classes and mezzanine tranches.................................. 183.8 181.9 1
Other........................................................................ 2.6 2.7 -
-------- -------- --
Total structured securities (a)........................................... $5,806.8 $5,851.0 29%
======== ======== ==
- --------------------
(a) Includes below-investment grade structured securities with an amortized
cost and estimated fair value of $2.2 million.
Pass-throughs and sequential and targeted amortization classes have similar
prepayment variability. Pass-throughs historically provide the best liquidity in
the mortgage-backed securities market. Pass-throughs are also used frequently in
the dollar roll market and can be used as the collateral when creating
collateralized mortgage obligations. Sequential classes are a series of tranches
that return principal to the holders of the transaction's various tranches in
sequence. Targeted amortization classes offer slightly better structure in
return of principal than sequentials when prepayment speeds are close to the
speed at the time of creation.
Planned amortization classes and accretion-directed bonds are generally
some of the most stable and liquid instruments in the mortgage-backed securities
market. Planned amortization class bonds adhere to a fixed schedule of principal
payments as long as the underlying mortgage collateral experiences prepayments
within a certain range. Changes in prepayment rates are first absorbed by
support or companion classes. This insulates the planned amortization class from
the consequences of both faster prepayments (average life shortening) and slower
prepayments (average life extension).
Commercial mortgage-backed securities ("CMBS") are bonds secured by
commercial real estate mortgages. Commercial real estate encompasses income
producing properties that are managed for economic profit. Property types
67
include multi-family dwellings including apartments, retail centers, hotels,
restaurants, hospitals, nursing homes, warehouses, and office buildings. The
CMBS market currently offers high yields, strong credits, and call protection
compared to similar-rated corporate bonds. Most CMBS have strong call protection
features where borrowers are locked out from prepaying their mortgages for a
stated period of time. If the borrower does prepay any or all of the loan, they
will be required to pay prepayment penalties.
Subordinated and mezzanine tranches are classes that provide credit
enhancement to the senior tranches. The rating agencies require that this credit
enhancement not deteriorate due to prepayments for a period of time, usually
five years of complete lockout followed by another period of time where
prepayments are shared pro rata with senior tranches. Subordinated and mezzanine
tranches bear a majority of the risk of loss due to property owner defaults.
Subordinated bonds are generally rated "AA" or lower; we typically do not hold
securities rated lower than "BB".
During the four months ended December 31, 2003, we sold $604.9 million of
fixed maturity investments which resulted in gross investment losses (before
income taxes) of $7.3 million. During the first eight months of 2003, we sold
$2.7 billion of fixed maturity investments which resulted in gross investment
losses (before income taxes) of $62.4 million. Securities sold at a loss are
sold for a number of reasons including but not limited to: (i) changes in the
investment environment; (ii) expectation that the market value could deteriorate
further; (iii) desire to reduce our exposure to an issuer or an industry; (iv)
changes in credit quality; and (v) our analysis indicating there is a high
probability that the security is other-than-temporarily impaired. As discussed
in the notes to our consolidated financial statements, the realization of gains
and losses affects the timing of the amortization of the cost of policies
produced and the cost of policies purchased related to universal life and
investment products.
Venture Capital Investment in AT&T Wireless Services, Inc.
Our venture capital investment in AWE was made by our subsidiary which
engages in venture capital investment activity. AWE is a company in the wireless
communication business. In December 2003, we sold the remaining 4.1 million
shares of AWE common stock. In 2002, we sold 10.3 million shares of AWE common
stock which generated proceeds of $75.7 million. At December 31, 2002, we held
4.1 million shares of AWE common stock with a value of $25.0 million. We
recognized venture capital investment income (losses) of $(5.5) million in the
four months ended December 31, 2003; $10.5 million in the eight months ended
August 31, 2003; and $(99.3) million and $(42.9) million in 2002 and 2001,
respectively, related to this investment.
Other Investments
At December 31, 2003, we held mortgage loan investments with a carrying
value of $1,139.5 million (or 5.0 percent of total invested assets) and a fair
value of $1,174.1 million. Mortgage loans were substantially comprised of
commercial loans. Noncurrent mortgage loans were insignificant at December 31,
2003. Realized losses on mortgage loans were not significant in any of the past
three years. At December 31, 2003, we had no allowance for losses on mortgage
loans (mortgage loans were recorded at market values at August 31, 2003, in
conjunction with our adoption of fresh start accounting). Approximately 8
percent, 7 percent, 7 percent and 6 percent of the mortgage loan balance were on
properties located in New York, Massachusetts, Florida and Pennsylvania,
respectively. No other state accounted for more than 5 percent of the mortgage
loan balance.
The following table shows the distribution of our mortgage loan portfolio
by property type as of December 31, 2003 (dollars in millions):
Number of Carrying
loans value
----- -----
Retail.......................................................................... 415 $ 907.2
Office building................................................................. 48 159.9
Industrial...................................................................... 18 39.1
Multi-family.................................................................... 13 16.3
Other........................................................................... 53 17.0
--- --------
Total mortgage loans......................................................... 547 $1,139.5
=== ========
68
The following table shows our mortgage loan portfolio by loan size (dollars
in millions):
Number Principal
of loans balance
-------- -------
Under $5 million................................................................ 491 $ 719.7
$5 million but less than $10 million............................................ 43 296.4
$10 million but less than $20 million........................................... 13 149.7
---- --------
Total mortgage loans......................................................... 547 $1,165.8
=== ========
The following table summarizes the distribution of maturities of our
mortgage loans (dollars in millions):
Number Principal
of loans balance
-------- -------
2004............................................................................ 13 $ 7.1
2005............................................................................ 14 7.1
2006............................................................................ 14 2.3
2007............................................................................ 28 8.7
2008............................................................................ 21 24.3
after 2008...................................................................... 457 1,116.3
--- --------
Total mortgage loans......................................................... 547 $1,165.8
=== ========
At December 31, 2003, we held $915.1 million of trading securities. We
carry trading securities at estimated fair value; changes in fair value are
reflected in the statement of operations. At August 31, 2003, we established
trading security accounts which are designed to act as a hedge for embedded
derivatives related to: (i) our equity-indexed annuity products; and (ii)
certain modified coinsurance agreements. See the note to the consolidated
financial statements entitled "Summary of Significant Accounting Policies -
Accounting for Derivatives" for further discussion regarding the embedded
derivatives and the trading accounts. In addition, the trading account includes
the investments backing the market strategies of our multibucket annuity
products.
Other invested assets also include: (i) S&P 500 Call Options; and (ii)
certain nontraditional investments, including investments in limited
partnerships and promissory notes.
As part of our investment strategy, we enter into reverse repurchase
agreements and dollar-roll transactions to increase our return on investments
and improve our liquidity. Reverse repurchase agreements involve a sale of
securities and an agreement to repurchase the same securities at a later date at
an agreed-upon price. Dollar rolls are similar to reverse repurchase agreements
except that the repurchase involves securities that are only substantially the
same as the securities sold. We enhance our investment yield by investing the
proceeds from the sales in short-term securities pending the contractual
repurchase of the securities at discounted prices in the forward market. In many
cases, such transactions arise from the market demand for mortgage-backed
securities to form CMOs. At December 31, 2003, we had investment borrowings of
$387.3 million. Such investment borrowings (excluding borrowings related to the
GM building) averaged approximately $488.9 million during the four months ended
December 31, 2003; and $689.1 million during the eight months ended August 31,
2003 and were collateralized by investment securities with fair values
approximately equal to the loan value. The weighted average interest rate on
such borrowings (excluding borrowings related to the GM building) was 1.5
percent during the four months ended December 31, 2003; and 1.8 percent during
the eight months ended August 31, 2003. The primary risk associated with
short-term collateralized borrowings is that the counterparty might be unable to
perform under the terms of the contract. Our exposure is limited to the excess
of the net replacement cost of the securities over the value of the short-term
investments (which was not material at December 31, 2003). We believe that the
counterparties to our reverse repurchase and dollar-roll agreements are
financially responsible and that counterparty risk is minimal.
69
CONSOLIDATED FINANCIAL CONDITION
Changes in the Consolidated Balance Sheet
Changes in our consolidated balance sheet between December 31, 2003 and
December 31, 2002, reflect: (i) the reorganization of our capital structure
pursuant to the Plan; and (ii) the effect of the sale of CFC.
In accordance with GAAP, we record our actively managed fixed maturity
investments, equity securities and certain other invested assets at estimated
fair value with any unrealized gain or loss (excluding impairment losses which
are recognized through earnings), net of tax and related adjustments, recorded
as a component of shareholders' equity. At December 31, 2003, we increased the
carrying value of such investments by $375.2 million as a result of this fair
value adjustment.
Our capital structure was determined in accordance with the terms of the
Plan and consisted of: (i) our $1.3 billion Senior Credit Facility; (ii) Class A
Preferred Stock with an aggregate liquidation preference of $887.5 million as of
December 31, 2003; (iii) warrants to purchase six million shares of common
stock; and (iv) 100 million shares of new common stock. Our capital structure as
of December 31, 2003, is as follows (dollars in millions):
Total capital:
Corporate notes payable ..................................................... $1,300.0
Shareholders' equity:
Class A Preferred stock .................................................. 887.5
Common stock.............................................................. 1.0
Additional paid-in capital................................................ 1,641.9
Accumulated other comprehensive income.................................... 218.7
Retained earnings......................................................... 68.5
--------
Total shareholders' equity............................................ 2,817.6
--------
Total capital......................................................... $4,117.6
========
The following table summarizes certain financial ratios as of and for the
four months ended December 31, 2003:
Book value per common share.................................................... $19.28
Ratio of earnings to fixed charges.............................................. 1.79x
Ratio of earnings to fixed charges and preferred dividends...................... 1.46x
Debt to total capital ratios:
Corporate debt to total capital.............................................. 32%
Corporate debt and preferred stock to total capital.......................... 53%
Contractual Obligations
The Company's significant contractual obligations as of December 31, 2003,
are set forth below (dollars in millions):
Payment due in
-------------------------------------------------------
Total 2004 2005-2006 2007-2008 Thereafter
----- ---- --------- --------- ----------
Notes payable........................ $1,300.0 $ 53.0 $156.0 $306.0 $ 785.0
Insurance liabilities (a)............ 792.4 91.0 134.3 85.4 481.7
Investment borrowings................ 387.3 387.3 - - -
Operating leases..................... 117.0 23.0 40.2 29.7 24.1
-------- ------ ------ ------ --------
Total............................ $2,596.7 $554.3 $330.5 $421.1 $1,290.8
======== ====== ====== ====== ========
- -------------
(a) Such liabilities are comprised primarily of supplemental contracts without
life contingencies and structured settlements.
Refer to the notes to the consolidated financial statements entitled "Notes
Payable - Direct Corporate Obligations" and
70
"Commitments and Contingencies" for additional information on notes payable
and operating leases.
Liquidity for Insurance Operations
Our insurance operating companies generally receive adequate cash flow from
premium collections and investment income to meet their obligations. Life
insurance and annuity liabilities are generally long-term in nature.
Policyholders may, however, withdraw funds or surrender their policies, subject
to any applicable surrender and withdrawal penalty provisions. We seek to
balance the duration of our invested assets with the estimated duration of
benefit payments arising from contract liabilities.
In July 2002, A.M. Best downgraded the financial strength ratings of our
primary insurance subsidiaries from "A- (Excellent)" to "B++ (Very good)" and
placed the ratings "under review with negative implications." On August 14,
2002, A.M. Best again lowered the financial strength ratings of our primary
insurance subsidiaries from "B++ (Very Good)" to "B (Fair)". A.M. Best ratings
for the industry currently range from "A++ (Superior)" to "F (In Liquidation)"
and some companies are not rated. An "A++" rating indicates superior overall
performance and a superior ability to meet ongoing obligations to policyholders.
The "B" rating is assigned to companies which have, on balance, fair balance
sheet strength, operating performance and business profile, when compared to the
standards established by A.M. Best, and a fair ability in A.M. Best's opinion to
meet their current obligations to policyholders, but are financially vulnerable
to adverse changes in underwriting and economic conditions. The rating reflected
A.M. Best's view of the uncertainty surrounding our restructuring initiatives
and the potential adverse financial impact on our subsidiaries. On September 11,
2003, A.M. Best affirmed its financial strength ratings of our primary insurance
companies ("B (Fair)") and removed the ratings from under review, indicating
that the ratings outlook is positive. On October 3, 2003, A.M. Best assigned a
positive outlook to all of our ratings. According to a press release issued by
A.M. Best, the assignment of a positive outlook to Conseco's ratings reflects
their favorable view of our bankruptcy reorganization and a number of management
initiatives including the sale of the GM building, sale of CFC, restructuring of
our investment portfolios, expense reductions, merging of certain subsidiaries,
stabilization of surrenders and a commitment in the near-to-medium term to focus
on selling higher margin products with lower capital requirements.
On August 2, 2002, S&P downgraded the financial strength rating of our
primary insurance companies from BB+ to B+. On November 19, 2003, S&P assigned a
"BB-" counterparty credit and financial strength rating to our primary insurance
companies, with the exception of Conseco Senior Health Insurance Company, which
was assigned a "CCC" rating. S&P financial strength ratings range from "AAA" to
"R" and some companies are not rated. Rating categories from "BB" to "CCC" are
classified as "vulnerable", and pluses and minuses show the relative standing
within a category. In S&P's view, an insurer rated "BB" has marginal financial
security characteristics and although positive attributes exist, adverse
business conditions could lead to an insufficient ability to meet financial
commitments. In S&P's view, an insurer rated "CCC" has very weak financial
security characteristics and is dependent on favorable business conditions to
meet financial commitments. On July 1, 2003, Moody's downgraded the financial
strength rating of our primary insurance companies from "Ba3" to "B3". On
December 4, 2003, Moody's assigned a "Ba3" rating to our primary insurance
companies with the exception of Conseco Senior Health Insurance Company, which
was assigned a "Caa1" rating. Moody's financial strength ratings range from
"Aaa" to "C". Rating categories from "Ba" to "C" are classified as "vulnerable"
by Moody's, and may be supplemented with numbers "1", "2", or "3" to show
relative standing within a category. In Moody's view, an insurer rated "Ba"
offers questionable financial security and the ability of the insurer to meet
policyholder obligations may be very moderate and thereby not well safeguarded
in the future. In Moody's view, an insurer rated "Caa" offers very poor
financial security and may default on its policyholder obligations or there may
be elements of danger with respect to punctual payment of policyholder
obligations and claims.
The lowered ratings assigned to our insurance subsidiaries caused sales of
our insurance products to decline and policyholder redemptions and lapses to
increase during 2002 and 2003. We also experienced increased agent attrition,
which in some cases led us to increase commissions or sales incentives we must
pay in order to retain them. These events have had a material adverse effect on
our financial results.
As more fully described in the note to our consolidated financial
statements entitled "Statutory Information", our two insurance subsidiaries
domiciled in Texas entered into consent orders with the Texas Department of
Insurance, which were formally released on November 19, 2003. The consent orders
applied to all of our insurance subsidiaries and, among other things, restricted
the ability of our insurance subsidiaries to pay any dividends or other
distributions to any non-insurance company parent without prior approval. State
laws generally provide state insurance regulatory agencies with broad authority
to protect policyholders in their jurisdictions. Accordingly, we cannot assure
you that the regulators will not seek to assert greater supervision and control
over our insurance subsidiaries' businesses and financial affairs. We have
agreed with the Texas Department of Insurance to provide prior notice of certain
transactions, including up to 30 days prior notice for the payment of dividends
by an insurance subsidiary to any non-insurance company parent, and periodic
reporting of information
71
concerning our financial performance and condition.
Our insurance subsidiaries experienced increased lapse rates on annuity
policies during 2002. Aggregate annuity surrenders have declined in 2003. We
believe that the diversity of the investment portfolios of our insurance
subsidiaries and the concentration of investments in high-quality, liquid
securities provide sufficient liquidity to meet foreseeable cash requirements of
our insurance subsidiaries. We believe our insurance subsidiaries could readily
liquidate sufficient portions of their investments, if lapses were to increase
to the levels experienced in 2002.
Liquidity of the Holding Companies
Pursuant to the Plan, we entered into the Senior Credit Facility. The
Senior Credit Facility consists of two tranches: Tranche A -- $1.0 billion; and
Tranche B -- $0.3 billion. See the note to the consolidated financial statements
entitled "Notes Payable - Direct Corporate Obligations" for further discussion
related to the Senior Credit Facility. Principal repayments are due as follows
(dollars in millions):
Tranche A Tranche B
--------- ---------
June 30, 2004.................................................... $ 50.0 $ 3.0
June 30, 2005................................................... 50.0 3.0
June 30, 2006..................................................... 50.0 1.5
December 31, 2006................................................. 50.0 1.5
June 30, 2007..................................................... 75.0 1.5
December 31, 2007................................................. 75.0 1.5
June 30, 2008..................................................... 75.0 1.5
December 31, 2008................................................. 75.0 1.5
June 30, 2009..................................................... - 1.5
September 10, 2009................................................ 500.0 -
December 31, 2009................................................. - 1.5
September 10, 2010................................................ - 282.0
-------- ------
$1,000.0 $300.0
======== ======
At December 31, 2003, Conseco Inc. and CDOC held unrestricted cash of $27.9
million and additional restricted cash of $17.3 million held in trust for the
payment of bankruptcy-related professional fees. In addition, our other non-life
insurance companies held unrestricted cash of approximately $61.0 million which
could be upstreamed to the parent companies if needed.
Conseco Inc. and CDOC are holding companies with no business operations of
their own; they depend on their operating subsidiaries for cash to make
principal and interest payments on debt, and to pay administrative expenses and
income taxes. The cash Conseco and CDOC receive from insurance subsidiaries
consists of dividends and distributions, principal and interest payments on
surplus debentures, fees for services, tax-sharing payments, and from our
non-insurance subsidiaries, loans and advances. A further deterioration in the
financial condition, earnings or cash flow of the material subsidiaries of
Conseco or CDOC for any reason could further limit such subsidiaries' ability to
pay cash dividends or other disbursements to Conseco and/or CDOC, which, in
turn, would limit Conseco's and/or CDOC's ability to meet debt service
requirements and satisfy other financial obligations.
The ability of our insurance subsidiaries to pay dividends is subject to
state insurance department regulations and is based on the financial statements
of our insurance subsidiaries prepared in accordance with statutory accounting
practices prescribed or permitted by regulatory authorities, which differ from
GAAP. These regulations generally permit dividends to be paid from statutory
earned surplus of the insurance company for any 12-month period in amounts equal
to the greater of (or in a few states, the lesser of): (i) statutory net gain
from operations or net income for the prior year; and (ii) 10 percent of
statutory capital and surplus as of the end of the preceding year. Any dividends
in excess of these levels require the approval of the director or commissioner
of the applicable state insurance department. Also, we have agreed with the
Texas Department of Insurance to provide up to 30 days prior notice of the
payment of dividends by an insurance subsidiary to any non-insurance company
parent. As described under the caption "-- Statutory Information", we recently
were subject to consent orders with the Commissioner of Insurance for the State
of Texas that, among other things, restricted the ability of our insurance
subsidiaries to pay any dividends to any non-insurance company parent without
prior approval. If our financial condition were to deteriorate, we may be
required to enter into similar orders in the future. In addition, we may need to
contribute additional capital to improve the RBC ratios of our insurance
subsidiaries and this could affect the ability of our top tier insurance
subsidiary to pay dividends.
72
Our cash flow may be affected by a variety of factors, many of which are
outside of our control, including insurance and banking regulatory issues,
competition, financial markets and other general business conditions. We cannot
assure you that we will possess sufficient income and liquidity to meet all of
our liquidity requirements and other obligations.
If an insurance company subsidiary were to be liquidated, that liquidation
would be conducted under the insurance law of its state of domicile by such
state's insurance regulator as the receiver with respect to such insurer's
property and business. In the event of a default on our debt or our insolvency,
liquidation or other reorganization, our creditors and stockholders will not
have the right to proceed against the assets of our insurance subsidiaries or to
cause their liquidation under federal and state bankruptcy laws.
We have adopted several initiatives designed to reduce the expense levels
that exceed product pricing at our Conseco Insurance Group segment. These
initiatives include the elimination of duplicate processing systems by
converting all similar systems to a single system. We expect to spend over $35
million on capital expenditures in 2004 (including amounts related to the
aforementioned initiatives). We believe we have adequate cash flows from
operations to fund these initiatives.
Under our Senior Credit Facility, we have agreed to a number of covenants
and other provisions that restrict our ability to engage in various financing
transactions and pursue certain operating activities without the prior consent
of the lenders under the Senior Credit Facility. We have also agreed to meet or
maintain various financial ratios. Our ability to meet these financial covenants
may be affected by events beyond our control. These requirements represent
significant restrictions on the manner in which we may operate our business. If
we default under any of these requirements (subject to certain remedies), the
lenders could declare all outstanding borrowings, accrued interest and fees to
be immediately due and payable. If that were to occur, we cannot assure you that
we would have sufficient liquidity to repay or refinance this indebtedness or
any of our other debts. In January 2004, the Senior Credit Facility was amended
to remove requirements that our insurance subsidiaries maintain minimum A.M.
Best financial strength ratings. In March 2004, the Senior Credit Facility was
amended to change the definition of a financial ratio we are required to
maintain. The change was needed to clarify how the ratio is calculated. The
definition in the amended facility is consistent with calculations used to
determine the original covenant levels.
MARKET-SENSITIVE INSTRUMENTS AND RISK MANAGEMENT
Our spread-based insurance business is subject to several inherent risks
arising from movements in interest rates, especially if we fail to anticipate or
respond to such movements. First, interest rate changes can cause compression of
our net spread between interest earned on investments and interest credited on
customer deposits, thereby adversely affecting our results. Second, if interest
rate changes produce an unanticipated increase in surrenders of our spread-based
products, we may be forced to sell investment assets at a loss in order to fund
such surrenders. At December 31, 2003, approximately 18 percent of our total
insurance liabilities (or approximately $4.5 billion) could be surrendered by
the policyholder without penalty. Finally, changes in interest rates can have
significant effects on the performance of our structured securities portfolio,
including collateralized mortgage obligations, as a result of changes in the
prepayment rate of the loans underlying such securities. We follow
asset/liability strategies that are designed to mitigate the effect of interest
rate changes on our profitability. However, there can be no assurance that
management will be successful in implementing such strategies and achieving
adequate investment spreads.
We seek to invest our available funds in a manner that will fund future
obligations to policyholders, subject to appropriate risk considerations. We
seek to meet this objective through investments that: (i) have similar cash flow
characteristics to the liabilities they support; (ii) are diversified among
industries, issuers and geographic locations; and (iii) make up a predominantly
investment-grade fixed maturity securities portfolio. Many of our products
incorporate surrender charges, market interest rate adjustments or other
features to encourage persistency.
We seek to maximize the total return on our investments through active
investment management. Accordingly, we have determined that our entire portfolio
of fixed maturity securities is available to be sold in response to: (i) changes
in market interest rates; (ii) changes in relative values of individual
securities and asset sectors; (iii) changes in prepayment risks; (iv) changes in
credit quality outlook for certain securities; (v) liquidity needs; and (vi)
other factors. From time to time, we invest in securities for trading purposes,
although such investments account for a relatively small portion of our total
portfolio.
The profitability of many of our products depends on the spreads between
the interest yield we earn on investments and the rates we credit on our
insurance liabilities. In addition, changes in competition and other factors,
including the impact of the level of surrenders and withdrawals, may limit our
ability to adjust or to maintain crediting rates at levels necessary to avoid
narrowing of spreads under certain market conditions. Approximately 40 percent
of our insurance
73
liabilities were subject to interest rates that may be reset annually; 45
percent have a fixed explicit interest rate for the duration of the contract; 10
percent have credited rates which approximate the income earned by the Company;
and the remainder have no explicit interest rates. As of December 31, 2003, the
average yield, computed on the cost basis of our actively managed fixed maturity
portfolio, was 5.6 percent, and the average interest rate credited or accruing
to our total insurance liabilities (excluding interest rate bonuses for the
first policy year only and excluding the effect of credited rates attributable
to variable or equity-indexed products) was 4.7 percent.
We use computer models to simulate the cash flows expected from our
existing insurance business under various interest rate scenarios. These
simulations help us to measure the potential gain or loss in fair value of our
interest rate-sensitive financial instruments. With such estimates, we seek to
manage the relationship between the duration of our assets and the expected
duration of our liabilities. When the estimated durations of assets and
liabilities are similar, exposure to interest rate risk is minimized because a
change in the value of assets should be largely offset by a change in the value
of liabilities. At December 31, 2003, the adjusted modified duration of our
fixed maturity securities and short-term investments was approximately 6.7 years
and the duration of our insurance liabilities was approximately 7.2 years. We
estimate that our fixed maturity securities and short-term investments (net of
corresponding changes in the value of insurance intangibles) would decline in
fair value by approximately $625 million if interest rates were to increase by
10 percent from their December 31, 2003 levels. This compares to a decline in
fair value of $595 million based on amounts and rates at December 31, 2002. The
calculations involved in our computer simulations incorporate numerous
assumptions, require significant estimates and assume an immediate change in
interest rates without any management of the investment portfolio in reaction to
such change. Consequently, potential changes in value of our financial
instruments indicated by the simulations will likely be different from the
actual changes experienced under given interest rate scenarios, and the
differences may be material. Because we actively manage our investments and
liabilities, our net exposure to interest rates can vary over time.
We are subject to the risk that our investments will decline in value. This
has occurred in the past and may occur again. During the four months ended
December 31, 2003, we recognized net realized investment gains of $11.8 million.
The net realized investment gains during the four months ended December 31,
2003, included: (i) $21.4 million of net gains from the sales of investments
(primarily fixed maturities) which generated proceeds of $5.2 billion; net of
(ii) $9.6 million of writedowns of fixed maturity investments, equity securities
and other invested assets as a result of conditions which caused us to conclude
a decline in fair value of the investment was other than temporary. During the
first eight months of 2003, we recognized net realized investment losses of $5.4
million. The net realized investment losses during the first eight months of
2003 included: (i) $45.9 million of net gains from the sales of investments
(primarily fixed maturities) which generated proceeds of $5.4 billion; net of
(ii) $51.3 million of writedowns of fixed maturity investments, equity
securities and other invested assets as a result of conditions which caused us
to conclude a decline in fair value of the investment was other than temporary.
During 2002, we recognized net realized investment losses of $556.3 million,
compared to net realized investment losses of $340.0 million during 2001. The
net realized investment losses during 2002 included: (i) $556.8 million of
writedowns of fixed maturity investments, equity securities and other invested
assets as a result of conditions which caused us to conclude a decline in fair
value of the investment was other than temporary; net of (ii) $.5 million of net
gains from the sales of investments (primarily fixed maturities) which generated
proceeds of $19.5 billion. During 2002, we recognized other-than-temporary
declines in value of several of our investments including K-Mart Corp., Amerco,
Inc., Global Crossing, MCI Communications, Mississippi Chemical, United Airlines
and Worldcom, Inc.
The operations of the Company are subject to risk resulting from
fluctuations in market prices of our equity securities and venture-capital
investments. In general, these investments have more year-to-year price
variability than our fixed maturity investments. However, returns over longer
time frames have been consistently higher. We manage this risk by limiting our
equity securities and venture-capital investments to a relatively small portion
of our total investments.
Our investment in S&P 500 Call Options is closely matched with our
obligation to equity-indexed annuity holders. Market value changes associated
with that investment are substantially offset by an increase or decrease in the
amounts added to policyholder account balances for equity-indexed products.
Inflation
Inflation rates may impact the financial statements and operating results
in several areas. Fluctuations in rates of inflation influence interest rates,
which in turn impact the market value of the investment portfolio and yields on
new investments. Inflation also impacts the portion of our insurance policy
benefits for certain medical coverages affected by increased costs. Operating
expenses, including payrolls, are impacted to a certain degree by the inflation
rate.
74
FINANCIAL CONDITION AND RESULTS OF OPERATIONS OF CFC - DISCONTINUED FINANCE
OPERATIONS
As part of our Chapter 11 reorganization, we sold substantially all of the
assets of our Predecessor's finance business and exited from this line of
business. Our finance business was conducted through our Predecessor's indirect
wholly-owned subsidiary, CFC. We accounted for our finance business as a
discontinued operation in 2002 once we formalized our plans to sell it. On April
1, 2003, CFC and 22 of its direct and indirect subsidiaries, which collectively
comprised substantially all of the finance business, filed liquidating plans of
reorganization with the Bankruptcy Court in order to facilitate the sale of this
business. The sale of the finance business was completed in the second quarter
of 2003. We did not receive any proceeds from this sale in respect of our
interest in CFC, nor did any creditors of our Predecessor. The consolidated
statement of operations reflects the operations of the discontinued finance
business in the caption "Discontinued operations" for all periods. The following
tables and narratives discuss CFC's financial condition and results of
operations during the periods presented in our consolidated financial
statements.
75
Operating Results of the Discontinued Finance Operations (dollars in millions):
2002 2001
---- ----
Contract originations:
Manufactured housing...................................................................... $ 1,026.7 $ 2,499.5
Mortgage services......................................................................... 2,535.9 3,043.7
Retail credit............................................................................. 3,237.9 3,585.8
Consumer finance - closed-end............................................................. 37.1 -
Other lines (discontinued in early 2002 or previous periods).............................. 476.8 2,188.3
---------- ---------
Total................................................................................... $ 7,314.4 $11,317.3
========== =========
Sales of finance receivables:
Manufactured housing...................................................................... $ 398.8 $ 3.6
Mortgage services......................................................................... 1,738.7 833.8
Consumer finance - closed-end............................................................. 3.3 -
Other lines (discontinued in early 2002 or previous periods).............................. 462.9 802.3
---------- ---------
Total................................................................................... $ 2,603.7 $ 1,639.7
========== =========
Managed receivables (average):
Manufactured housing...................................................................... $24,482.8 $25,979.1
Mortgage services......................................................................... 10,643.5 12,555.5
Retail credit............................................................................. 2,702.7 2,248.0
Consumer finance - closed-end............................................................. 1,218.6 1,735.2
Other lines (discontinued in early 2002 or previous periods).............................. 709.4 1,856.4
--------- ---------
Total................................................................................... $39,757.0 $44,374.2
========= =========
Revenues:
Net investment income:
Finance receivables and other........................................................... $ 2,074.2 $ 2,169.7
Retained interest....................................................................... 75.0 125.3
Gain (loss) on sale of finance receivables................................................ (49.5) 26.9
Impairment charges........................................................................ (1,449.9) (386.9)
Fee revenue and other income.............................................................. 273.8 335.8
--------- ---------
Total revenues.......................................................................... 923.6 2,270.8
--------- ---------
Expenses:
Provision for losses...................................................................... 950.0 537.7
Finance interest expense.................................................................. 1,130.0 1,234.4
Gain on extinguishment of debt............................................................ (6.3) (9.9)
Other operating costs and expenses........................................................ 616.0 642.4
Special charges........................................................................... 121.9 21.5
Reorganization items...................................................................... 17.3 -
--------- ---------
Total expenses.......................................................................... 2,828.9 2,426.1
--------- ---------
Loss before income taxes................................................................ $(1,905.3) $ (155.3)
========= =========
76
General: CFC had historically provided financing for manufactured housing,
home equity, home improvements, consumer products and equipment, and consumer
and commercial revolving credit. As a result of the formalization of the plan to
sell the finance business and the filing of petitions under the Bankruptcy Code,
the finance business is being accounted for as a discontinued business in
Conseco's consolidated financial statements. See the note to our consolidated
financial statements entitled "Our Recent Emergence From Bankruptcy" for
additional information. CFC's finance products included both fixed-term and
revolving loans and leases. CFC also marketed physical damage and other credit
protection relating to the loans it serviced.
After September 8, 1999, CFC no longer structured securitizations in a
manner that resulted in recording a sale of the loans. Instead, new
securitization transactions were structured to include provisions that entitled
CFC to repurchase assets transferred to the special purpose entity when the
aggregate unpaid principal balance reached a specified level. Until these assets
were repurchased, however, the assets remained the property of the special
purpose entity and were not available to satisfy the claims of creditors of CFC.
In addition, CFC's securitization transactions were structured so that CFC, as
servicer for the loans, was able to exercise significant discretion in making
decisions about the serviced portfolio. Pursuant to Financial Accounting
Standards Board Statement No. 140, "Accounting for the Transfer and Servicing of
Financial Assets and Extinguishments of Liabilities" ("SFAS 140"), such
discretion required the securitization transactions to be accounted for as
secured borrowings whereby the loans and securitization debt remained on the
balance sheet, rather than as sales.
The change to the structure of CFC's securitizations had no effect on the
total profit CFC recognized over the life of each new loan, but it changed the
timing of profit recognition. Under the portfolio method (the accounting method
required for CFC securitizations which were structured as secured borrowings),
CFC recognized: (i) earnings over the life of new loans as interest revenues
were generated; (ii) interest expense on the securities which were sold to
investors in the loan securitization trusts; and (iii) provisions for losses. As
a result, CFC's reported earnings from new loans securitized in transactions
accounted for under the portfolio method were lower in the period in which the
loans were securitized (compared to CFC's historical method) and higher in later
periods, as interest spread was earned on the loans.
Old Conseco's leveraged condition and liquidity difficulties severely
impacted the operations of CFC, principally by eliminating CFC's access to the
securitization markets. The securitization markets had been CFC's main source of
funding. The loss of access to the securitization markets severely affected
CFC's ability to originate, purchase and sell loans. In addition, CFC
historically relied on these markets to finance the sale of repossessed
manufactured housing units which had historically lowered the loss on defaulted
loans. CFC's inability to access this market for repossessed manufactured
housing units forced CFC to utilize the wholesale channel to dispose of its
repossessed units, resulting in higher losses on these portfolios. Increased
losses resulted in significant reductions in cash flow from servicing and
residual income, as well as CFC being obligated to incur increased amounts of
guarantee liabilities on certain securitizations. Additionally, market
valuations of CFC's securitization trusts decreased due to uncertainty regarding
CFC's liquidity position and its ability to continue to provide servicing for
the securitized portfolios, thereby, reducing the value of CFC's retained
interest pledged as collateral on its residual facility.
CFC's liquidity sources (excluding its bank subsidiaries) were a warehouse
and a residual facility with Lehman and a postpetition financing facility. CFC's
diminished access to the securitization markets and the constrained liquidity
under its other funding sources had a material adverse effect on CFC's business
and results of operations, resulting in CFC's petition for relief under the
Bankruptcy Code. On December 19, 2002, shortly after the filing of the Chapter
11 Cases, CFC obtained debtor-in-possession ("DIP") financing provided by U.S.
Bank and FPS DIP LLC, an affiliate of Fortress Investment Group LLC
("Fortress"), J.C. Flowers & Co. LLC. ("Flowers") and Cerberus Capital
Management, L.P. ("Cerberus"). The DIP financing motion was granted by the
Bankruptcy Court on January 14, 2003. On April 14, 2003, the Bankruptcy Court
approved an amendment to the DIP facility to increase the maximum permitted
borrowings thereunder, from $125 million to $150 million.
At December 31, 2002, CFC was in violation of several financial covenants
required by its warehouse and residual facilities. CFC entered into a
forbearance agreement with Lehman pursuant to which Lehman 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 CFC not being in
compliance with certain financial covenants.
CFC's residual facility was collateralized by retained interests in
securitizations. CFC was 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, CFC's collateral
was deficient at December 31, 2002 (as calculated in accordance with the
relevant transaction documents). Under the terms of the forbearance agreement,
Lehman agreed not to cause accelerated repayment of the residual facility based
on the collateral deficiency. However, Lehman retained certain cash flows from
CFC's retained interests pledged to this facility and applied these cash flows
to the margin deficit.
77
On October 22, 2002, Conseco announced that its board of directors approved
a plan to seek new investors or acquirers for CFC's 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 CFC's three primary lines of business: (i) manufactured
housing; (ii) mortgage services; and (iii) consumer finance. On December 19,
2002, CFC announced that it had signed a purchase agreement for the sale of
substantially all of its assets to CFN. The Bankruptcy Court approved bidding
and sales procedures pursuant to which the assets of CFC were sold in a public
auction supervised by the Trustee appointed by the Bankruptcy Court, on March 4
and 5 of 2003. On March 14, 2003, the Bankruptcy Court approved the sale of
substantially all of the CFC assets to CFN and GE. These sales transactions were
completed in the second quarter of 2003.
Prior to Conseco's October 22, 2002 announcement, CFC was undertaking
efforts to restructure its manufactured housing business. Originations had been
significantly curtailed and CFC began analyzing potential approaches to reducing
the negative cash flow that resulted from the servicing of this portfolio and
the payment of guarantees on the B-2 securities issued in connection with
securitizations of manufactured housing receivables. As a result of CFC's
decreased liquidity position and inability to sell manufactured housing loans in
the wholesale market at reasonable prices, CFC suspended originating
manufactured housing loans November 25, 2002. As part of the Chapter 11
bankruptcy filing, CFC requested a change in the servicing fee structure for the
servicing of manufactured housing portfolios. The contractual servicing rate was
50 bps per annum on receivable balances. On December 18, 2002 the Bankruptcy
Court approved an interim order to increase the servicing rate for the
manufactured housing portfolios to the lesser of 125 bps per annum based on the
balance of the receivables or the costs incurred to service the manufactured
portfolio as defined in the motion. During the first quarter of 2003, CFC
reached an agreement with bondholders to amend the servicing agreement for the
manufactured housing portfolios, which was approved by the Bankruptcy Court on
March 14, 2003. The amendment provided for an increase in the servicing fee to
125 bps per annum for one year following closing of the sale of the assets to
CFN Investment Holdings, LLC and to 115 bps per annum for subsequent periods
based on average unpaid principal balance of finance receivables, excluding
those in repossession status.
During 2000 and 2001, management completed several actions with respect to
CFC, including: (i) the sale, closing or runoff of several units (including
asset-based lending, vendor leasing, bankcards, transportation and park
construction, which are collectively referred to as the "other lines"); (ii)
monetization of certain on-balance sheet financial assets through sales or as
collateral for additional borrowings; and (iii) cost savings and restructuring
of ongoing businesses such as streamlining of loan origination operations in the
manufactured housing and home equity divisions. The transactions CFC completed
to raise cash during 2001 and 2000 included: (i) the sale of a $568.4 million
portfolio of high-loan-to-value loans (which generated $80 million of cash after
repayment of debt collateralized by the loans); (ii) the sale of a $802.3
million portfolio of vendor services loans (which generated $180 million of cash
after repayment of debt collateralized by the loans); (iii) the sale of a 15
percent interest in the interest-only securities and new borrowing agreements
collateralized by the interest-only securities (which generated cash of $100
million); (iv) the sale of substantially all of the bankcard (Visa and
Mastercard) portfolio (which generated $154 million of cash); (v) the sale of
$216.1 million of asset-backed loans (which generated $43 million of cash after
repayment of debt collateralized by the loans); (vi) the sale of a $566.0
million portfolio of loans which financed the purchase of trucks (which
generated $30 million of cash after repayment of debt collateralized by the
loans); and (vii) new or revised borrowing agreements which provided financing
for loans not previously pledged under other borrowing agreements (which
generated over $300 million of cash). The cash generated from these transactions
was primarily used toward the reduction of debt due to Old Conseco of $674.1
million in 2000 and $537.2 million in 2001. These courses of action have caused
significant fluctuations in account balances.
Loan originations in 2002 were $7.3 billion, down 35 percent from 2001.
Loan originations in 2001 were $11.3 billion, down 33 percent from 2000. Given
CFC's limited liquidity and inability to access the securitization market, CFC
discontinued originating certain types of loans. CFC limited future originations
primarily to loans that could be sold at a profit in whole-loan sale
transactions. CFC discontinued originating manufactured housing loans in
November 2002. These decisions and continued constraints on liquidity resulted
in origination volume which is significantly lower than in prior periods.
Sales of finance receivables in 2002 and 2001 include the sale of $2.1
billion and $.8 billion, respectively, of finance receivables, on which CFC
recognized a loss of $17.1 million and a gain of $26.9 million, respectively.
These sales are further explained below under "Gain on sale of finance
receivables". CFC also sold $.5 billion and $.8 billion of certain other finance
receivables in 2002 and 2001, respectively, as part of CFC's cash raising
arrangements.
Managed receivables include finance receivables recorded on CFC's
consolidated balance sheet and those managed by CFC but held by trusts
applicable to holders of asset-backed securities sold in securitizations
structured in a manner that
78
resulted in gain-on-sale revenue. Average managed receivables decreased to $39.8
billion in 2002, down 10 percent from 2001.
Net investment income on finance receivables and other consists of: (i)
interest earned on finance receivables; and (ii) interest income on short-term
and other investments. Such income decreased by 4.4 percent, to $2,074.2
million, in 2002 and increased by 17 percent, to $2,169.7 million, in 2001,
consistent with the changes in average on-balance sheet finance receivables. The
weighted average yields earned on finance receivables and other investments were
11.5 percent and 12.6 percent during 2002 and 2001, respectively. The average
yields decreased due to the declining interest rate environment, change in
product mix of the portfolio and rising delinquencies primarily in CFC's
manufactured housing business.
Net investment income on retained interests is the income recognized on the
retained interests in securitizations CFC retained after it sold finance
receivables. Such income decreased by 40 percent, to $75.0 million, in 2002 and
by 31 percent, to $125.3 million, in 2001. The decrease was consistent with the
change in the average balance of retained interests. The weighted average yields
earned on retained interests were 12.3 percent and 14.4 percent during 2002 and
2001, respectively. As a result of the change in the structure of CFC's
securitizations, securitization transactions were accounted for as secured
borrowings and CFC did not recognize gain-on-sale revenue or additions to
retained interests from such transactions. In addition, the balance of the
retained interests was reduced by $1,077.2 million in 2002 and $264.8 million in
2001 due to impairment charges. Impairment charges are further explained below.
The weighted average yield was also adversely affected by the decline in
guarantee payments received on certain lower-rated securities in the fourth
quarter of 2002.
Gain (loss) on sales of finance receivables resulted from various loan sale
transactions in 2002 and 2001. During 2002, CFC sold $2.1 billion of finance
receivables which generated net losses of $17.1 million. In 2002, CFC also
recognized a $32.4 million loss to reduce the value of unsecuritized finance
receivables, which were being held for eventual sale and had market values below
their cost basis. During 2001, CFC sold $1.6 billion of finance receivables
which included: (i) $802.3 million vendor services loan portfolio (the value of
which was reduced in the fourth quarter of 2000 since the market value of these
loans exceeded their cost basis, and no additional gain or loss was recognized
in 2001); (ii) $568.4 million of high-loan-to-value mortgage loans; and (iii)
$269.0 million of other loans. These sales resulted in net gains of $26.9
million.
Fee revenue and other income included servicing income, commissions earned
on insurance policies written in conjunction with financing transactions and
other income from late fees. Such income decreased by 18 percent, to $273.8
million, in 2002 and by 8.2 percent, to $335.8 million, in 2001. Such decreases
were primarily due to decreases in commission income as a result of reduced
origination activities and the termination of sales of single premium credit
life insurance. In addition, as a result of the change in the structure of CFC's
securitizations, CFC no longer recorded an asset for servicing rights at the
time of its securitizations, nor did CFC record servicing fee revenue; instead,
the entire amount of interest income was recorded as investment income. The
amount of servicing income (which is net of the amortization of servicing assets
and liabilities) was $83.9 million in 2002 and $115.3 million in 2001.
Provision for losses related to finance operations increased by 77 percent,
to $950.0 million, in 2002 and by 56 percent, to $537.7 million, in 2001. These
amounts relate to CFC's on-balance sheet finance receivables. CFC's credit
losses as a percentage of related loan balances for the on-balance sheet
portfolio increased over the last several quarters (2.26 percent, 2.36 percent,
2.53 percent, 2.61 percent, 2.76 percent and 3.74 percent for the quarters ended
September 30, 2001, December 31, 2001, March 31, 2002, June 30, 2002, September
30, 2002 and December 31, 2002, respectively). The increases to the provision
and CFC's credit losses were due to many factors including: (i) CFC's inability
to finance the sale of repossessed assets, resulting in CFC's use of wholesale
markets to sell such assets through which recovery rates were significantly
lower; (ii) the natural increase in delinquencies in some of CFC's products as
they aged into periods in which CFC had historically experienced higher
delinquencies; (iii) the increase in retail credit receivables which typically
experienced higher credit losses; (iv) economic factors which had resulted in an
increase in defaults; and (v) a decrease in the manufactured housing recovery
rates when repossessed properties were sold given current industry levels of
repossessed assets. At December 31, 2002 and 2001, the 60-days-and-over
delinquencies as a percentage of on-balance sheet finance receivables were 3.21
percent and 2.19 percent, respectively. Under the portfolio method, CFC
estimated an allowance for credit losses based upon its assessment of current
and historical loss experience, loan portfolio trends, the value of collateral,
prevailing economic and business conditions, and other relevant factors.
Increases in CFC's allowance for credit losses were recognized as expense based
on CFC's current assessments of such factors. For loans previously recorded as
sales, the anticipated discounted credit losses over the expected life of the
loans were reflected through a reduction in the gain-on-sale revenue recorded at
the time of securitization or through impairment charges when assessments of
estimated losses had changed.
At December 31, 2002, CFC had a total of 20,918 unsold manufactured housing
properties (11,939 of which relate to off-balance sheet securitizations) in
repossession, compared to 15,057 properties (10,814 of which relate to
off-balance sheet
79
securitizations) at December 31, 2001. CFC reduced the value of repossessed
property to its estimate of net realizable value upon repossession. CFC
liquidated 25,017 managed manufactured housing units at an average loss severity
rate (the ratio of the loss realized to the principal balance of the foreclosed
loan) of 65 percent in 2002 compared to 25,750 units at an average loss severity
rate of 57 percent in 2001. The loss severity rate related to the on-balance
sheet manufactured housing portfolio was 59 percent in 2002, compared to 49
percent in 2001. The higher industry levels of repossessed manufactured homes
which existed in the marketplace in 2002, adversely affected recovery rates,
specifically wholesale severity, as other lenders (including lenders who had
exited the manufactured home lending business) acted to more quickly dispose of
repossessed manufactured housing inventory. Additionally, the higher level of
repossessed inventory that existed in the marketplace made it more difficult for
CFC to liquidate its inventory at rates it had recovered in the past. CFC also
believed the higher average severity rate in 2002 related to the on-balance
sheet manufactured housing portfolio was partially due to the increased age of
such portfolio.
During the quarter ended September 30, 2002, CFC's ability to access the
securitization markets was eliminated. The securitization markets had been CFC's
main source of funding for loans made to purchasers of repossessed manufactured
homes. CFC believed that its severity rates had been historically positively
impacted when it used retail channels to dispose of repossessed inventory (where
the repossessed units were sold through company-owned sales lots or its dealer
network). Since CFC was no longer able to fund the loans made on repossessed
homes sold through these channels, sales through these channels decreased and
CFC had to rely on the wholesale channel to dispose of repossessed manufactured
housing units, through which recovery rates were significantly lower.
CFC believed that its historical loss experience had been favorably
affected by various loss mitigation policies. Under one such policy, CFC worked
with the defaulting obligor and its dealer network to find a new buyer who met
CFC's underwriting standards and was willing to assume the defaulting obligor's
loan. Under other loss mitigation policies, CFC permitted qualifying obligors
(obligors who were currently unable to meet the obligations under their loans,
but were expected to be able to meet them in the future under modified terms) to
defer scheduled payments or CFC reduced the interest rate on the loan, in an
effort to avoid loan defaults.
Due to the prevailing economic conditions in 2002 and 2001, CFC increased
the use of the aforementioned mitigation policies. Based on past experience, CFC
believed these policies would reduce the ultimate losses it recognized. If CFC
applied loss mitigation policies, CFC generally reflected the customer's
delinquency status as not being past due. Accordingly, the loss mitigation
policies favorably impacted CFC's delinquency ratios. CFC attempted to
appropriately reserve for the effects of these loss mitigation policies when
establishing loan loss reserves. These policies were also considered when CFC
determined the value of its retained interests in securitization trusts. Loss
mitigation policies were applied to 10.7 percent of average managed accounts in
2002 compared to 8.8 percent in 2001. Such loss mitigation policies were applied
to 3.0 percent, 2.7 percent, 2.8 percent and 2.2 percent of average managed
accounts during the first, second, third and fourth quarters of 2002,
respectively. Due to CFC's liquidity limitations, many loss mitigation policies
were curtailed in the fourth quarter of 2002.
Finance interest expense decreased by 8.5 percent, to $1,130.0 million, in
2002 and increased by 7.1 percent, to $1,234.4 million, in 2001. Such decrease
was primarily the result of: (i) lower average borrowing rates; and (ii)
decreased borrowings to fund the decreased finance receivables. CFC's average
borrowing rate was 6.1 percent and 7.0 percent during 2002 and 2001,
respectively. The decrease in average borrowing rates in 2002 as compared to
2001 was primarily due to the decrease in the general interest rate environment
between periods and the repurchase and retirement of some of CFC's public debt.
Other operating costs and expenses included the costs associated with
servicing CFC's managed receivables, non-deferrable costs related to originating
new loans and other operating costs. Such expense decreased by 4.1 percent, to
$616.0 million, in 2002 and by 15 percent, to $642.4 million, in 2001. In 2002,
CFC accrued $26.8 million pursuant to judgments issued in two arbitration
proceedings. Excluding the litigation accrual, such costs had decreased due to
the realization of the benefits from cost saving initiatives and a decrease in
origination volumes. In 2001, CFC began to realize some of the cost savings from
its restructuring.
Special charges in 2002 included: (i) the loss of $96.0 million related to
the sales of certain finance receivables of $463 million and $1.6 million of
additional loss related to receivables required to be repurchased from the
purchaser of the vendor services receivables pursuant to the repurchase clauses
in the agreements; (ii) a $39.4 million charge for costs associated with various
modifications to financing arrangements and recognition of deferred expenses for
terminated warehouse facilities; (iii) a $16.3 million charge for the
abandonment of computer processing systems; (iv) a $38.1 million benefit due to
the reduction in the value of the warrant held by Lehman to purchase five
percent of CFC, which was expected to have no value due to CFC's bankruptcy
proceedings; and (v) restructuring and other charges of $6.7 million. Special
charges recorded in 2001 included: (i) the loss related to the sale of certain
finance receivables of $11.2 million; (ii)
80
severance benefits, litigation reserves and other restructuring charges of $12.8
million; (iii) a $7.5 million charge related to the decision to discontinue the
sale of certain types of life insurance in conjunction with lending
transactions; and (iv) a $10.0 million benefit due to the reduction in the value
of the warrant held by Lehman to purchase five percent of CFC which was caused
by a decrease in the value of CFC. These charges are described in greater detail
in the note to Conseco's consolidated financial statements entitled "Financial
Information Regarding CFC."
Reorganization items were professional fees associated with CFC's
bankruptcy proceedings which were expensed as incurred in accordance with SOP
90-7.
Impairment charges represented reductions in the value of CFC's retained
interests in securitization trusts (including interest-only securities and
servicing rights) recognized as a loss. CFC carried interest-only securities at
estimated fair value and servicing rights at the lower of cost or fair value.
Fair value was determined by discounting the projected cash flows over the
expected life of the receivables sold using current prepayment, default, loss,
interest rate and servicing cost assumptions. CFC considered any potential
payments related to the guarantees of certain lower-rated securities issued by
the securitization trusts in the projected cash flows used to determine the
value of its retained interests. When declines in value considered to be other
than temporary occurred, CFC reduced the amortized cost to estimated fair value
and recognized a loss. The assumptions used to determine new values were based
on the internal evaluations of CFC's management. Under accounting rules
(pursuant to Emerging Issues Task Force Issue No. 99-20, "Recognition of
Interest Income and Impairment on Purchased and Retained Beneficial Interests in
Securitized Financial Assets" ("EITF 99-20")) which were adopted on July 1,
2000, declines in the value of CFC's retained interests were recognized when:
(i) the fair value of the security was less than its carrying value; and (ii)
the timing and/or amount of cash expected to be received from the security had
changed adversely from the previous valuation which determined the carrying
value of the security. When both occurred, the security was written down to fair
value. The assumptions used to determine new values for CFC's retained interests
were based on internal evaluations.
The determination of the value of CFC's retained interests in
securitization trusts required significant judgment. CFC recognized significant
charges when the retained interests did not perform as well as anticipated based
on CFC's assumptions and expectations. In securitizations to which these
retained interests related, CFC had retained certain contingent risks in the
form of guarantees of certain lower-rated securities issued by the
securitization trusts. As of December 31, 2002, the total amount of these
guarantees was approximately $1.4 billion. CFC considered any potential payments
related to these guarantees in the projected cash flows used to determine the
value of its retained interests. See the note to Conseco's consolidated
financial statements entitled "Financial Information Regarding CFC."
During 2002, CFC's ability to access the securitization markets was
eliminated. The securitization markets had been CFC's main source of funding for
loans made to purchasers of repossessed manufactured homes. CFC believed that
its loss severity rates historically had been positively impacted when it used
retail channels to dispose of repossessed inventory (where the repossessed units
were sold through company-owned sales lots or CFC's dealer network). Since CFC
was no longer able to fund the loans made on repossessed homes, sales through
these channels ceased and CFC relied on the wholesale channel to dispose of
repossessed manufactured housing units, through which recovery rates were
significantly lower. Accordingly, CFC changed the loss severity assumptions used
to value its retained interests to reflect the higher loss severity CFC expected
to experience in the future. In addition, CFC's previous assumptions reflected
its belief that the adverse manufactured housing default experience in recent
periods would continue through the first half of 2002 and then improve over
time. Default experience did not improve as expected. Accordingly, CFC increased
the default assumptions used to value its retained interests to reflect CFC's
future expectations based on then current default rates.
CFC's access to liquidity was further limited during the fourth quarter of
2002. CFC was unable to access alternative funding sources to replace the
financing it previously obtained through the securitization markets. Further,
CFC continued to experience high levels of delinquencies and foreclosures. As a
result of the inability to obtain financing, CFC was required to suspend all
originations of manufactured housing loans, including the financing of
repossessed manufactured housing units, in the fourth quarter of 2002. In
addition, CFC discontinued the use of some of its loss mitigation strategies
including its inventory loan assumption program. Prices of used manufactured
housing units in the wholesale channels were at historical lows due to the high
levels of repossessed manufactured housing inventories available in the market.
Accordingly, CFC increased the loss severity and default assumptions used to
value its retained interests to reflect CFC's future expectations based on
current experience. During 2002, CFC increased the assumption for the expected
rates of loss severity (the expected weighted average ratio of losses realized
to the principal balance of the foreclosed loans) from 65.4 percent to 89.5
percent. CFC increased the assumption for the expected rates of default (the
expected weighted average constant ratio of defaulting loans to the balance of
all loans sold) from 2.34 percent to 2.97 percent.
As a result of the requirements of EITF 99-20 and the assumption changes
described above, CFC recognized an impairment charge of $1,077.2 million in 2002
for the retained interests. CFC also recognized a $336.5 million increase in
81
the valuation allowance related to its servicing rights as a result of the
changes in assumptions in 2002. The valuation allowance related to the servicing
rights increased as a result of changes to the expected future cost of servicing
the finance receivables. The levels of delinquent and defaulting loans caused
servicing costs to increase. Such assumptions reflected the subordination of the
servicing fees to other cash flows in certain securitization transactions. In
addition, CFC recognized impairment charges of: (i) $29.3 million to establish a
valuation allowance for advances CFC was required to make to the securitization
trusts which are estimated to be uncollectible; and (ii) $6.9 million to
establish a liability of guarantee payments due to certain holders of
lower-rated securities issued by the securitization trusts which CFC was unable
to pay.
CFC recognized an impairment charge of $386.9 million in 2001 which
included an impairment charge of $264.8 million related to its interest-only
securities. During 2001, CFC's interest-only securities did not perform as well
as anticipated. In addition, CFC's expectations regarding future economic
conditions changed. Accordingly, CFC increased its loss severity assumptions
related to the performance of the underlying loans to be consistent with its
expectations. CFC increased the assumption for the expected rates of loss
severity (the expected weighted average ratio of losses realized to the
principal balance of the foreclosed loans) from 59.8 percent to 65.4 percent.
The impairment charge also included a $122.1 million increase in the valuation
allowance related to CFC's servicing rights as a result of the changes in
assumptions. CFC carries its servicing rights at the lower of carrying value or
estimated fair value. Refer to "Finance Receivables and Retained Interests in
Securitization Trusts - Retained Interests in Securitization Trusts" for
additional discussion of the impairment charge and interest-only securities.
82
Finance Receivables and Retained Interests in Securitization Trusts Held by
CFC
Finance Receivables
CFC completed several actions in an attempt to raise cash and improve its
financial position and results of operations. These actions caused significant
fluctuations in account balances. See the section above entitled "Operating
Results of the Discontinued Finance Operations" for a description of such
actions. Finance receivables, including receivables which serve as collateral
for the notes issued to investors in securitization trusts of $12,460.0 million
at December 31, 2002, summarized by business line and categorized as either a
part of CFC's primary lines or a part of other lines (discontinued in previous
periods), were as follows (dollars in millions):
December 31,
------------
2002
----
Primary lines:
Manufactured housing....................................................................... $ 7,124.8
Mortgage services.......................................................................... 5,266.6
Retail credit.............................................................................. 2,240.6
Consumer finance - closed-end.............................................................. 443.5
---------
15,075.5
Less allowance for credit losses........................................................... 646.9
---------
Net finance receivables - for primary lines.............................................. 14,428.6
---------
Other lines (discontinued in previous periods)................................................ 71.4
Less allowance for credit losses........................................................... 16.9
---------
Net finance receivables - for other lines................................................ 54.5
---------
Total finance receivables................................................................ $14,483.1
=========
Managed finance receivables by loan type were as follows (dollars in
millions):
December 31,
------------
2002
----
Primary lines:
Fixed term................................................................................. $32,901.6
Revolving credit........................................................................... 2,255.5
Other lines (discontinued in previous periods)................................................ 125.4
---------
Total.................................................................................... $35,282.5
=========
Number of contracts serviced:
Fixed term contracts - continuing lines.................................................... 978,000
Revolving credit accounts - continuing lines............................................... 835,000
Other lines (discontinued in previous periods)............................................. 54,000
---------
Total.................................................................................... 1,867,000
=========
Approximately 9 percent, 8 percent, 7 percent and 6 percent of the loans
that CFC serviced were in Texas, North Carolina, Florida and Georgia,
respectively. No other state comprised more than 5 percent of the loans
serviced. In addition, no single contractor, dealer or vendor accounted for more
than 1 percent of the total contracts CFC originated.
83
The credit quality of managed finance receivables was as follows:
December 31,
------------
2002
----
60-days-and-over delinquencies as a percentage of managed finance
receivables at period end:
Manufactured housing..................................................................... 3.62%
Mortgage services (a).................................................................... 1.47
Retail credit............................................................................ 3.14
Consumer finance - closed-end............................................................ .91
Other lines (discontinued in early 2002 or previous periods)............................. 8.58
Total.................................................................................. 3.00%
Net credit losses incurred during the last twelve months as a percentage of
average managed finance receivables during the period:
Manufactured housing..................................................................... 3.09%
Mortgage services........................................................................ 2.66
Retail credit............................................................................ 6.33
Consumer finance - closed-end............................................................ 3.09
Other lines (discontinued in early 2002 or previous periods)............................. 3.98
Total.................................................................................. 3.21%
Repossessed collateral inventory as a percentage of managed finance receivables
at period end (b):
Manufactured housing..................................................................... 3.58%
Mortgage services (c).................................................................... 5.97
Retail credit............................................................................ .35
Consumer finance - closed-end............................................................ 1.75
Other lines (discontinued in early 2002 or previous periods)............................. 3.38
Total.................................................................................. 3.92%
- --------------------
(a) 60-days-and-over delinquencies excluded loans in the process of
foreclosure.
(b) Ratio of: (i) outstanding loan principal balance related to the repossessed
inventory (before writedown) to: (ii) total receivables. CFC wrote down the
value of its repossessed inventory to estimated realizable value at the
time of repossession.
(c) Repossessed collateral inventory included loans in the process of
foreclosure.
84
The credit quality of on-balance sheet finance receivables was as follows:
December 31,
------------
2002
----
60-days-and-over delinquencies as a percentage of on-balance sheet
finance receivables at period end:
Manufactured housing..................................................................... 4.61%
Mortgage services (a).................................................................... 1.30
Retail credit............................................................................ 3.14
Consumer finance - closed-end............................................................ 1.14
Other lines (discontinued in early 2002 or previous periods)............................. 9.77
Total.................................................................................. 3.21%
Net credit losses incurred during the last twelve months as a percentage of
average on-balance sheet finance receivables during the period:
Manufactured housing..................................................................... 4.35%
Mortgage services........................................................................ 2.07
Retail credit............................................................................ 6.33
Consumer finance - closed-end............................................................ 2.54
Other lines (discontinued in early 2002 or previous periods)............................. 2.97
Total.................................................................................. 3.74%
Repossessed collateral inventory as a percentage of on-balance sheet finance
receivables at period end (b) (c):
Manufactured housing..................................................................... 4.93%
Mortgage services (d).................................................................... 6.02
Retail credit............................................................................ .35
Consumer finance - closed-end............................................................ 2.08
Other lines (discontinued in early 2002 or previous periods)............................. 2.85
Total.................................................................................. 4.56%
- --------------------
(a) 60-days-and-over delinquencies excluded loans in the process of
foreclosure.
(b) Ratio of: (i) outstanding loan principal balance related to the repossessed
inventory (before writedown) to: (ii) total receivables.
(c) Although the ratio is calculated using the outstanding loan principal
balance related to the repossessed inventory, the repossessed inventory was
written down to net realizable value at the time of repossession or
completed foreclosure.
(d) Repossessed collateral inventory included loans in the process of
foreclosure.
These ratios increased during 2002 primarily as a result of the factors
described above under "Provision for losses related to finance operations."
Retained Interests in Securitization Trusts
As stated above in the section entitled "Operating Results of the
Discontinued Finance Operations", CFC changed the manner in which it structured
securitization of loans on September 8, 1999. The securitizations structured
prior to the September 8, 1999, announcement met the applicable criteria to be
accounted for as sales. At the time the loans were securitized and sold, CFC
recognized a gain and recorded its retained interest represented by the
interest-only security. The interest-only security represented 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. CFC
considered any potential payments related to the guarantees of certain
lower-rated securities issued by the securitization trusts in the projected cash
flows used to determine the value of its interest-only securities. In some of
those securitizations, CFC also retained certain lower-rated securities that
were senior in payment priority to the interest-only securities. Such retained
securities had a par value, fair market value and amortized cost of $718.7
million, $611.5 million and $548.0 million, respectively, at December 31, 2002.
The interest-only securities and subordinated securities were carried at
estimated fair value. On a quarterly basis, CFC estimated the fair value of
these securities by discounting the projected future cash flows using current
assumptions. If CFC determined that the differences between the estimated fair
value and the book value of these securities was a temporary difference, CFC
adjusted shareholders' equity. At December 31, 2002, this adjustment increased
the carrying value of the retained interests by $63.5 million to $252.6 million.
85
The assumptions CFC used to determine new values were based on its internal
evaluations. Although CFC's management believed its methodology was reasonable,
many of the assumptions and expectations underlying CFC's determinations were
not possible to predict with certainty. Largely as a result of adverse changes
in the underlying assumptions (as discussed above in the section entitled
"Operating Results of the Discontinued Finance Operations"), CFC recognized
impairment charges of $1,077.2 million in 2002 and $386.9 million ($250.4
million after tax) in 2001 to reduce the book value of interest-only securities
and servicing rights as described above under "Operating Results of the
Discontinued Finance Operations."
In conjunction with the sale of certain finance receivables, CFC provided
guarantees related to the principal and interest payments of certain lower-rated
securities issued to third parties by the securitization trusts. Such securities
had a total principal balance outstanding of $1.4 billion at December 31, 2002.
CFC considered any potential payments related to these guarantees in the
projected net cash flows used to determine the value of its retained interests.
At December 31, 2002, the net deficit value of CFC's retained interests of
$(74.1) million, reflected estimated guarantee payments related to bonds held by
others of $326.7 million.
Effective September 30, 2001, CFC transferred substantially all of its
interest-only securities into a securitization trust. The transaction provided a
means to finance a portion of the value of its interest-only securities by
selling some of the cash flows 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 CFC 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. CFC
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 $20.4 million at December 31, 2002. CFC
continued to be the servicer of the finance receivables underlying the
interest-only securities transferred to the trust. Lehman had the ability to
accelerate the principal payments related to their interest after a stated
period. Until such time, Lehman was 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 were conducted on a single set of cash flows representing CFC's 85
percent interest in the trust. Accordingly, adverse changes in cash flows from
one interest-only security may be offset by positive changes in another. The new
structure did not avoid an impairment charge if sufficient positive cash flows
in the aggregate were not available (such as was the case at December 31, 2002).
CFC carried its servicing rights at the lower of carrying value or
estimated fair value stratified by product type and year of securitization. To
the extent the recorded amount exceeds the fair value for a given strata, CFC
established a valuation allowance through a charge to earnings. Such valuation
allowance increased by $336.5 million in 2002. The fees CFC received for
servicing the securitized portfolio were often subordinate to the interests of
other security holders in the trusts.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The information included under the caption "Market-Sensitive Instruments
and Risk Management" in Item 7. "Management's Discussion and Analysis of
Consolidated Financial Condition and Results of Operations" is incorporated
herein by reference.
86
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
Index to Consolidated Financial Statements
Page
----
Report of Independent Auditors - Successor period..................................................................... 88
Report of Independent Auditors - Predecessor periods.................................................................. 89
Consolidated Balance Sheet at December 31, 2003 (Successor)
and December 31, 2002 (Predecessor)............................................................................... 90
Consolidated Statement of Operations for the four months ended December 31, 2003 (Successor),
eight months ended August 31, 2003, and the years ended December 31, 2002 and 2001 (Predecessor).................. 92
Consolidated Statement of Shareholders' Equity for the four months ended December 31, 2003 (Successor),
eight months ended August 31, 2003, and the years ended December 31, 2002 and 2001 (Predecessor).................. 94
Consolidated Statement of Cash Flows for the four months ended December 31, 2003 (Successor),
eight months ended August 31, 2003, and the years ended December 31, 2002 and 2001 (Predecessor).................. 97
Notes to Consolidated Financial Statements............................................................................ 98
87
Report of Independent Auditors
To the Shareholders and Board of Directors
Conseco, Inc.
In our opinion, the accompanying consolidated balance sheet and the related
consolidated statements of operations, shareholders' equity (deficit) and cash
flows present fairly, in all material respects, the financial position of
Conseco, Inc. and subsidiaries (Successor Company) at December 31, 2003 and the
results of their operations and their cash flows for the period from September
1, 2003 through December 31, 2003 in conformity with accounting principles
generally accepted in the United States of America. These financial statements
are the responsibility of the Company's management; our responsibility is to
express an opinion on these financial statements based on our audits. We
conducted our audits of these statements in accordance with auditing standards
generally accepted in the United States of America, which require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 1 to the consolidated financial statements, the United
States Bankruptcy Court for the Northern District of Illinois, Eastern Division
confirmed the Company's Sixth Amended Joint Plan of Reorganization (the "Plan")
on September 9, 2003. The provisions of the plan are described in detail in Note
1. The Plan was substantially consummated on September 10, 2003 and the Company
emerged from bankruptcy. In connection with its emergence from bankruptcy, the
Company adopted fresh start accounting as of August 31, 2003.
/s/ PricewaterhouseCoopers LLP
--------------------------------
PricewaterhouseCoopers LLP
Indianapolis, Indiana
March 10, 2004
88
Report of Independent Auditors
To the Shareholders and Board of Directors
Conseco, Inc.
In our opinion, the accompanying consolidated balance sheet and the related
consolidated statements of operations, shareholders' equity (deficit) and cash
flows present fairly, in all material respects, the financial position of
Conseco, Inc. and subsidiaries (Predecessor Company) at December 31, 2002 and
the results of their operations and their cash flows for the period from January
1, 2003 through August 31, 2003, and for each of the two years in the period
ended December 31, 2002 in conformity with accounting principles generally
accepted in the United States of America. These financial statements are the
responsibility of the Company's management; our responsibility is to express an
opinion on these financial statements based on our audits. We conducted our
audits of these statements in accordance with auditing standards generally
accepted in the United States of America, which require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by
management, and evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 1 to the consolidated financial statements, the Company
filed a petition on December 17, 2002 with the United States Bankruptcy Court
for the Northern District of Illinois, Eastern Division for reorganization under
the provisions of Chapter 11 of the Bankruptcy Code. The Company's Sixth Amended
Joint Plan of Reorganization (the "Plan") was substantially consummated on
September 10, 2003 and the Company emerged from bankruptcy. In connection with
its emergence from bankruptcy, the Company adopted fresh start accounting.
As discussed in Note 4 to the consolidated financial statements, the Company
adopted Statement of Financial Accounting Standards No. 142, "Goodwill and Other
Intangible Assets" in 2002.
/s/ PricewaterhouseCoopers LLP
-------------------------------
PricewaterhouseCoopers LLP
Indianapolis, Indiana
March 10, 2004
89
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(Dollars in millions)
ASSETS
Successor Predecessor
------------- -------------
December 31, December 31,
2003 2002
---- ----
Investments:
Actively managed fixed maturities at fair value (amortized cost:
2003 - $19,470.7; 2002 - $18,989.8)............................................... $19,840.1 $19,417.4
Equity securities at fair value (cost: 2003 - $71.8; 2002 - $161.4)................. 74.5 156.0
Mortgage loans...................................................................... 1,139.5 1,308.3
Policy loans........................................................................ 503.4 536.2
Trading securities.................................................................. 915.1 -
Venture capital investment in AT&T Wireless Services, Inc. at fair
value (cost: 2003 - $ -; 2002 - $14.2)........................................... - 25.0
Other invested assets .............................................................. 324.1 340.8
--------- ---------
Total investments................................................................. 22,796.7 21,783.7
Cash and cash equivalents:
Unrestricted........................................................................ 1,228.7 1,217.6
Restricted.......................................................................... 31.9 51.3
Accrued investment income................................................................ 315.5 389.8
Value of policies in force at the Effective Date......................................... 2,949.5 -
Cost of policies purchased............................................................... - 1,170.0
Cost of policies produced................................................................ 101.8 2,014.4
Reinsurance receivables.................................................................. 930.5 934.2
Income tax assets........................................................................ 24.6 101.5
Goodwill................................................................................. 952.2 100.0
Other intangible assets.................................................................. 155.2 -
Assets held in separate accounts and investment trust ................................... 37.7 447.0
Assets of discontinued operations........................................................ - 17,624.3
Other assets............................................................................. 395.8 675.2
--------- ---------
Total assets...................................................................... $29,920.1 $46,509.0
========= =========
(continued on next page)
The accompanying notes are an integral part
of the consolidated financial statements.
90
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET (Continued)
(Dollars in millions)
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)
Successor Predecessor
------------- -------------
December 31, December 31,
2003 2002
---- ----
Liabilities:
Liabilities for insurance and asset accumulation products:
Interest-sensitive products........................................................ $12,480.4 $13,122.7
Traditional products............................................................... 11,431.8 8,318.2
Claims payable and other policyholder funds........................................ 892.3 909.2
Liabilities related to separate accounts and investment trust...................... 37.7 447.0
Other liabilities.................................................................... 573.0 673.5
Liabilities of discontinued operations............................................... - 17,624.3
Investment borrowings................................................................ 387.3 669.7
Notes payable - direct corporate obligations......................................... 1,300.0 -
--------- ---------
Total liabilities not subject to compromise...................................... 27,102.5 41,764.6
--------- ---------
Liabilities subject to compromise.................................................... - 4,873.3
--------- ---------
Total liabilities................................................................ 27,102.5 46,637.9
--------- ---------
Commitments and Contingencies
Minority interest:
Company-obligated mandatorily redeemable preferred securities
of subsidiary trusts............................................................... - 1,921.5
Shareholders' equity (deficit):
Preferred stock...................................................................... 887.5 501.7
Common stock ($0.01 par value, 8,000,000,000 shares authorized,
shares issued and outstanding at December 31, 2003 - 100,115,772; no par
value, 1,000,000,000 shares authorized; shares issued
and outstanding at December 31, 2002 - 346,007,133)................................ 1.0 3,497.0
Additional paid-in-capital........................................................... 1,641.9 -
Accumulated other comprehensive income............................................... 218.7 580.6
Retained earnings (deficit).......................................................... 68.5 (6,629.7)
--------- ---------
Total shareholders' equity (deficit)............................................. 2,817.6 (2,050.4)
--------- ---------
Total liabilities and shareholders' equity (deficit)............................. $29,920.1 $46,509.0
========= =========
The accompanying notes are an integral part
of the consolidated financial statements.
91
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
(Dollars in millions, except per share data)
Successor Predecessor
------------- -----------------------------------
Years
Four months Eight months ended
ended ended December 31,
December 31, August 31, ------------------
2003 2003 2002 2001
---- ---- ---- ----
Revenues:
Insurance policy income..................................... $1,005.8 $ 2,204.3 $ 3,602.3 $3,992.7
Net investment income:
General account assets................................... 427.0 933.3 1,534.1 1,712.5
Policyholder and reinsurer accounts...................... 53.1 25.2 (100.5) (119.6)
Venture capital income (loss) related to investment in
AT&T Wireless Services, Inc............................ (5.5) 10.5 (99.3) (42.9)
Net realized investment gains (losses) ..................... 11.8 (5.4) (556.3) (340.0)
Gain on sale of interest in riverboat....................... - - - 192.4
Fee revenue and other income................................ 13.3 34.3 70.1 96.9
-------- --------- --------- --------
Total revenues........................................... 1,505.5 3,202.2 4,450.4 5,492.0
-------- --------- --------- --------
Benefits and expenses:
Insurance policy benefits................................... 967.9 2,138.7 3,332.5 3,588.5
Provision for losses........................................ - 55.6 240.0 169.6
Interest expense (contractual interest: $268.5 for the eight
months ended August 31, 2003; and $345.3 for 2002)....... 36.8 202.5 341.9 400.0
Amortization................................................ 132.9 341.4 822.9 766.8
Other operating costs and expenses.......................... 218.4 422.3 736.2 747.1
Goodwill impairment......................................... - - 500.0 -
Special charges............................................. - - 96.5 80.4
Gain on extinguishment of debt.............................. - - (1.8) (17.0)
Reorganization items........................................ - (2,130.5) 14.4 -
-------- --------- --------- --------
Total benefits and expenses.............................. 1,356.0 1,030.0 6,082.6 5,735.4
-------- --------- --------- --------
Income (loss) before income taxes, minority interest,
discontinued operations and cumulative effect of
accounting change...................................... 149.5 2,172.2 (1,632.2) (243.4)
Income tax expense (benefit):
Tax expense (benefit) on period income (loss)............ 53.2 (13.5) 53.1 (57.6)
Valuation allowance for deferred tax assets.............. - - 811.2 -
-------- --------- --------- --------
Income (loss) before minority interest, discontinued
operations and cumulative effect of accounting
change................................................. 96.3 2,185.7 (2,496.5) (185.8)
Minority interest:
Distributions on Company-obligated mandatorily
redeemable preferred securities of subsidiary
trusts, net of income taxes.............................. - - 173.2 119.5
-------- --------- --------- --------
Income (loss) before discontinued operations and
cumulative effect of accounting change ................ 96.3 2,185.7 (2,669.7) (305.3)
Discontinued operations, net of income taxes.................... - 16.0 (2,216.8) (100.6)
Cumulative effect of accounting change, net of income taxes..... - - (2,949.2) -
-------- --------- --------- --------
Net income (loss)........................................ 96.3 2,201.7 (7,835.7) (405.9)
Preferred stock dividends (contractual
distributions for 2002 of $2.1)............................. 27.8 - 2.1 12.8
-------- --------- --------- --------
Net income (loss) applicable to common stock............. $ 68.5 $ 2,201.7 $(7,837.8) $ (418.7)
======== ========= ========= ========
(continued)
The accompanying notes are an integral part
of the consolidated financial statements.
92
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS (Continued)
(Dollars in millions, except per share data)
Successor
-----------
Four months
ended
December 31,
2003
----
Earnings per common share:
Basic:
Weighted average shares outstanding...................... 100,110,000
===========
Net income............................................... $.68
====
Diluted:
Weighted average shares outstanding...................... 143,486,000
===========
Net income............................................... $.67
====
The accompanying notes are an integral part
of the consolidated financial statements.
93
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (DEFICIT)
(Dollars in millions)
Common stock Accumulated other
Preferred and additional comprehensive Retained
Total stock paid-in capital income (loss) earnings
----- ----- --------------- ------------- --------
Predecessor balance, December 31, 2000............... $4,374.4 $486.8 $2,911.8 $(651.0) $1,626.8
Comprehensive loss, net of tax:
Net loss........................................ (405.9) - - - (405.9)
Change in unrealized depreciation of
investments (net of applicable income tax
expense of $121.8)............................ 212.0 - - 212.0 -
--------
Total comprehensive loss.................... (193.9)
Issuance of shares pursuant to stock purchase
contracts related to FELINE PRIDES.............. 496.6 - 496.6 - -
Issuance of shares pursuant to acquisition of
ExlService.com, Inc............................. 52.1 - 52.1 -
Issuance of shares for stock options and for
employee benefit plans.......................... 23.8 - 23.8 - -
Payment-in-kind dividends on convertible
preferred stock................................. 12.8 12.8 - - -
Dividends on preferred stock...................... (12.8) - - - (12.8)
-------- ------ -------- ------- --------
Predecessor balance, December 31, 2001............... $4,753.0 $499.6 $3,484.3 $(439.0) $1,208.1
(continued on following page)
The accompanying notes are an integral part
of the consolidated financial statements.
94
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (DEFICIT) (Continued)
(Dollars in millions)
Common stock Accumulated other
Preferred and additional comprehensive Retained
Total stock paid-in capital income (loss) earnings (deficit)
----- ----- --------------- ------------ ------------------
Predecessor balance, December 31, 2001
(carried forward from prior page) ............. $ 4,753.0 $499.6 $3,484.3 $(439.0) $ 1,208.1
Comprehensive loss, net of tax:
Net loss..................................... (7,835.7) - - - (7,835.7)
Change in unrealized depreciation
of investments and other (net of
applicable income tax expense of nil)...... 1,019.6 - - 1,019.6 -
---------
Total comprehensive loss................. (6,816.1)
Issuance of shares for stock options and for
employee benefit plans....................... 12.7 - 12.7 - -
Payment-in-kind dividends on convertible
preferred stock.............................. 2.1 2.1 - - -
Dividends on preferred stock................... (2.1) - - - (2.1)
--------- ------ -------- -------- ---------
Predecessor balance, December 31, 2002............ $(2,050.4) $501.7 $3,497.0 $ 580.6 $(6,629.7)
(continued on following page)
The accompanying notes are an integral part
of the consolidated financial statements.
95
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (DEFICIT) (Continued)
(Dollars in millions)
Common stock Accumulated other
Preferred and additional comprehensive Retained
Total stock paid-in capital income (loss) earnings (deficit)
----- ----- --------------- ------------ ------------------
Predecessor balance, December 31, 2002
(carried forward from prior page).............. $(2,050.4) $501.7 $3,497.0 $ 580.6 $(6,629.7)
Comprehensive income, net of tax:
Net income................................... 2,201.7 - - - 2,201.7
Change in unrealized appreciation
of investments (net of applicable
income tax benefit of nil)................. (151.6) - - (151.6) -
---------
Total comprehensive income............... 2,050.1
Change in shares for employee benefit plans.... .3 - .3 - -
--------- ------ -------- ------- ---------
Predecessor balance, August 31, 2003.............. - 501.7 3,497.3 429.0 (4,428.0)
Elimination of Predecessor's
equity securities.............................. (3,999.0) (501.7) (3,497.3) - -
Issuance of Successor's
equity securities.............................. 2,500.0 859.7 1,640.3 - -
Fresh start adjustments........................... 3,999.0 - - (429.0) 4,428.0
--------- ------ -------- ------- ---------
Successor balance, August 31, 2003................ 2,500.0 859.7 1,640.3 - -
Comprehensive income, net of tax:
Net income................................... 96.3 - - - 96.3
Change in unrealized appreciation
of investments (net of applicable
income tax expense of $123.0).............. 218.7 - - 218.7 -
---------
Total comprehensive income............... 315.0
Issuance of shares for stock options and for
employee benefit plans..................... 2.6 - 2.6 - -
Payment-in-kind dividends on convertible
exchangeable preferred stock............... 27.8 27.8 - - -
Dividends on preferred stock................. (27.8) - - - (27.8)
--------- ------ -------- ------- ---------
Successor balance, December 31, 2003.............. $ 2,817.6 $887.5 $1,642.9 $ 218.7 $ 68.5
========= ====== ======== ======= =========
The accompanying notes are an integral part
of the consolidated financial statements.
96
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(Dollars in millions)
Successor Predecessor
-------------- -----------------------------------
Years
Four months Eight months ended
ended ended December 31,
December 31, August 31, ------------------
2003 2003 2002 2001
---- ---- ---- ----
Cash flows from operating activities:
Insurance policy income...................................... $ 876.3 $ 1,876.2 $ 3,041.3 $ 3,518.8
Net investment income........................................ 431.4 933.5 3,323.9 3,913.6
Fee revenue and other income................................. 13.3 34.3 307.1 389.1
Insurance policy benefits.................................... (567.9) (1,466.1) (1,996.9) (2,792.8)
Interest expense............................................. (25.5) - (1,279.6) (1,570.5)
Policy acquisition costs..................................... (111.6) (287.5) (509.2) (667.0)
Special charges.............................................. - - (47.2) (29.5)
Reorganization items......................................... - (26.5) (31.7) -
Other operating costs........................................ (254.7) (360.8) (1,406.1) (1,466.8)
Taxes........................................................ 77.8 44.2 (105.9) 29.8
-------- --------- --------- ---------
Net cash provided by operating activities................ 439.1 747.3 1,295.7 1,324.7
-------- --------- --------- ---------
Cash flows from investing activities:
Sales of investments......................................... 5,163.7 5,378.9 19,465.4 24,179.7
Maturities and redemptions of investments.................... 1,003.2 1,854.7 1,623.9 1,381.4
Purchases of investments..................................... (5,593.3) (7,385.9) (19,879.4) (25,509.5)
Cash received from the sale of finance receivables,
net of expenses............................................ - - 2,372.9 867.2
Finance receivables originated............................... - - (7,877.9) (12,320.3)
Principal payments received on finance receivables........... - - 8,294.0 8,611.3
Cash held by Conseco Finance Corp. and classified as
assets held by discontinued operations..................... - - (562.3) -
Change in restricted cash.................................... (6.8) 26.2 3.4 27.3
Other........................................................ 1.4 (19.6) (27.6) (136.7)
-------- --------- --------- ---------
Net cash provided (used) by investing activities ........ 568.2 (145.7) 3,412.4 (2,899.6)
-------- --------- --------- ---------
Cash flows from financing activities:
Amounts received for deposit products........................ 479.6 1,272.7 4,584.8 4,204.8
Withdrawals from deposit products............................ (583.5) (1,784.2) (5,682.8) (4,489.4)
Issuance of notes payable.................................... - - 6,671.9 12,160.5
Payments on notes payable.................................... - - (10,481.3) (10,480.5)
Ceding commission received on reinsurance transaction........ - - 83.0 -
Change in cash held in restricted accounts for settlement
of borrowings.............................................. - - (13.0) (241.8)
Investment borrowings........................................ (837.1) (145.3) (1,573.0) 2,022.9
Issuance of common and convertible preferred shares.......... - - - 4.1
Dividends on common and preferred shares and
distributions on Company-obligated mandatorily
redeemable preferred securities of subsidiary trusts....... - - (86.2) (181.2)
-------- --------- --------- ---------
Net cash provided (used) by financing activities......... (941.0) (656.8) (6,496.6) 2,999.4
-------- --------- --------- ---------
Net increase (decrease) in cash and cash equivalents..... 66.3 (55.2) (1,788.5) 1,424.5
Cash and cash equivalents, beginning of the period.............. 1,162.4 1,217.6 3,006.1 1,581.6
-------- --------- --------- ---------
Cash and cash equivalents, end of the period.................... $1,228.7 $ 1,162.4 $ 1,217.6 $ 3,006.1
======== ========= ========= =========
The accompanying notes are an integral part
of the consolidated financial statements.
97
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
1. OUR RECENT EMERGENCE FROM BANKRUPTCY
Conseco, Inc., a Delaware corporation ("CNO"), is a holding company for a
group of insurance companies operating throughout the United States that
develop, market and administer supplemental health insurance, annuity,
individual life insurance and other insurance products. CNO became the successor
to Conseco, Inc., an Indiana corporation ("Old Conseco"), in connection with our
bankruptcy reorganization. The terms "Conseco", the "Company", "we", "us", and
"our" as used in this report refer to CNO and its subsidiaries and, unless the
context requires otherwise, Old Conseco and its subsidiaries. We focus on
serving the senior and middle-income markets, which we believe are attractive,
high growth markets. We sell our products through three distribution channels:
career agents, professional independent producers (some of whom sell one or more
of our product lines exclusively) and direct marketing.
We conduct our business operations through two primary operating segments,
based on method of product distribution, and a third segment comprised of
businesses in run-off:
o Bankers Life, which consists of the businesses of Bankers Life and
Casualty Company ("Bankers Life and Casualty") and Colonial Penn Life
Insurance Company ("Colonial Penn"). Bankers Life and Casualty markets
and distributes Medicare supplement insurance, life insurance,
long-term care insurance and fixed annuities to the senior market
through approximately 4,000 exclusive career agents and sales
managers. Colonial Penn markets graded benefit and simplified issue
life insurance directly to consumers through television advertising,
direct mail, the internet and telemarketing. Both Bankers Life and
Casualty and Colonial Penn market their products under their own brand
names.
o Conseco Insurance Group, which markets and distributes specified
disease insurance, Medicare supplement insurance, and certain life and
annuity products to the senior and middle-income markets through over
500 independent marketing organizations ("IMOs") that represent over
9,100 producing independent agents. This segment markets its products
under the "Conseco" brand.
o Other Business in Run-off, which includes blocks of business that we
no longer market or underwrite and are managed separately from our
other businesses. This segment consists of long-term care insurance
sold through independent agents and major medical insurance.
We also have a corporate segment, which consists of holding company
activities and certain noninsurance company businesses that are not related to
our operating segments.
On December 17, 2002 (the "Petition Date"), Old Conseco and certain of its
non-insurance company subsidiaries filed voluntary petitions for relief under
Chapter 11 of Title 11 of the United States Bankruptcy Code (the "Bankruptcy
Code") in the United States Bankruptcy Court for the Northern District of
Illinois, Eastern Division (the "Bankruptcy Court"). We emerged from bankruptcy
protection under the Sixth Amended Joint Plan of Reorganization (the "Plan"),
which was confirmed pursuant to an order of the Bankruptcy Court on September 9,
2003 (the "Confirmation Date"), and became effective on September 10, 2003 (the
"Effective Date"). Upon the confirmation of the Plan, we implemented fresh start
accounting in accordance with Statement of Position 90-7 "Financial Reporting by
Entities in Reorganization under the Bankruptcy Code" ("SOP 90-7"). References
in these consolidated financial statements to "Predecessor" refer to Old Conseco
prior to August 31, 2003. References to "Successor" refer to the Company on and
after August 31, 2003, after giving effect to the implementation of fresh start
reporting. Our accounting and actuarial systems and procedures are designed to
produce financial information as of the end of a month. Accordingly, for
accounting convenience purposes, we applied the effects of fresh start
accounting on August 31, 2003. The activity of the Company for the period from
September 1, 2003 through September 10, 2003 is therefore included in the
Successor's statement of operations and excluded from the Predecessor's
statement of operations. We believe the net income impact of the use of a
convenience date is immaterial.
The Plan generally provided for the full payment or reinstatement of
allowed administrative claims, priority claims, fully secured claims and certain
intercompany claims, and the distribution of new equity securities (including
warrants) to partially secured and unsecured creditors of our Predecessor.
Holders of claims arising under our Predecessor's $1.5 billion senior bank
credit facility also received a pro rata interest in our Senior Credit Facility.
Holders of our Predecessor's common stock and preferred stock did not receive
any distribution under the Plan, and these securities, together with all other
prepetition securities and the $1.5 billion senior bank credit facility of our
Predecessor, were cancelled on the Effective Date.
98
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
On the Effective Date, under the terms of the Plan, we emerged from the
bankruptcy proceedings with a capital structure consisting of:
o our $1.3 billion Senior Credit Facility;
o approximately 34.4 million shares of Class A Preferred Stock with an
initial aggregate liquidation preference of approximately $859.7
million;
o 100.0 million shares of common stock, excluding shares issued to our
new non-executive chairman upon his appointment and shares issued or
to be issued to directors, officers or employees under a new equity
incentive plan; and
o warrants to purchase 6.0 million shares of our common stock (the
"Series A Warrants ").
Under the terms of the Plan, we distributed the equity securities to the
creditors of our Predecessor in the amounts outlined below:
o lenders under our Predecessor's senior bank credit facility and
director and officer loan program received approximately 34.4 million
shares of our Class A Preferred Stock, with an initial aggregate
liquidation preference of $859.7 million;
o holders of our Predecessor's senior notes received approximately 32.3
million shares of our common stock;
o holders of our Predecessor's guaranteed senior notes received
approximately 60.6 million shares of our common stock;
o holders of our Predecessor's general unsecured claims received
approximately 3.8 million shares of our common stock; and
o holders of trust preferred securities issued by our Predecessor's
subsidiary trusts received approximately 1.5 million shares of our
common stock and Series A Warrants to purchase 6.0 million shares of
our common stock at an exercise price of $27.60 per share.
The distribution of our common stock summarized above represents
approximately 98 percent of all of the shares of common stock to be distributed
under the Plan. As of December 31, 2003, approximately 1.8 million of our
outstanding shares of common stock have been reserved for distribution under the
Plan in respect of disputed claims, the resolution of which is still pending. If
reserved shares remain after resolution of these disputed claims, then the
reserved shares will be reallocated to other general unsecured creditors of our
Predecessor as provided for under the Plan.
As part of our Chapter 11 reorganization, we sold substantially all of the
assets of our Predecessor's finance business and exited this line of business.
Our finance business was conducted through our Predecessor's indirect
wholly-owned subsidiary, Conseco Finance Corp. ("CFC"). We accounted for our
finance business as a discontinued operation in 2002 once we formalized our
plans to sell it. On April 1, 2003, CFC and 22 of its direct and indirect
subsidiaries, which collectively comprised substantially all of the finance
business, filed liquidating plans of reorganization with the Bankruptcy Court in
order to facilitate the sale of this business. The sale of the finance business
was completed in the second quarter of 2003. We did not receive any proceeds
from this sale in respect of our interest in CFC, nor did any creditors of our
Predecessor. As of March 31, 2003, we ceased to include the assets and
liabilities of CFC on our Predecessor's consolidated balance sheet. See the note
to the consolidated financial statements entitled "Financial Information
Regarding CFC" for information regarding this discontinued operation.
2. BASIS OF PRESENTATION
The accompanying consolidated financial statements have been prepared in
accordance with SOP 90-7. Accordingly, all prepetition liabilities subject to
compromise as of December 31, 2002, have been segregated in the Predecessor's
consolidated balance sheet and classified as "liabilities subject to compromise"
at the estimated amount of allowable claims.
99
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
Pursuant to SOP 90-7, professional fees associated with the Chapter 11
cases are expensed as incurred and reported as reorganization items. Interest
expense was reported only to the extent that it was paid during the Chapter 11
cases. The Company recognized expenses associated with the Chapter 11 cases for
fees payable to professionals to assist with the Chapter 11 cases totaling $70.9
million in the eight months ended August 31, 2003, and $14.4 million in 2002.
Upon our emergence from bankruptcy, we implemented fresh start reporting in
accordance with SOP 90-7. These rules required the Company to revalue its assets
and liabilities to current estimated fair value, re-establish shareholders'
equity at the reorganization value determined in connection with the Plan, and
record any portion of the reorganization value which cannot be attributed to
specific tangible or identified intangible assets as goodwill. As a result, the
Company's financial statements for periods following August 31, 2003, will not
be comparable with those of Old Conseco prepared before that date.
During the third quarter of 2002, Old 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. See the note to the consolidated financial
statements entitled "Financial Information Regarding CVIC."
During 2001, we stopped renewing a large portion of our major medical lines
of business. These lines of business are referred to herein as the "major
medical business in run-off". These actions had a significant effect on the
Predecessor's operating results during 2001. These lines had pre-tax losses of
$130.3 million in 2001 including a write off of $77.4 million of the cost of
policies produced and the cost of policies purchased related to this business
that is not recoverable.
On July 31, 2001, we completed the acquisition of ExlService.com, Inc.
("Ex1"), a firm that specializes in customer service and backroom outsourcing
with operations in India. Old Conseco issued 3.4 million shares of our common
stock in exchange for Ex1's common stock. The total value of the transaction was
$52.1 million. The Old Conseco Board of Directors (without Gary C. Wendt, the
Company's former Chief Executive Officer, voting) approved the transaction,
after receiving the recommendation of a special committee of outside directors.
Mr. Wendt was one of the founders of Exl. Mr. Wendt and his wife owned 20.3
percent of Exl and his other relatives owned an additional 9.4 percent. Mr.
Wendt and his wife received 692,567 shares of Old Conseco common stock in the
transaction (worth approximately $9.7 million at the time the agreement was
negotiated). However, these shares were restricted until Old Conseco recovered
its $52.1 million acquisition price through cost savings achieved by
transferring work to Exl and/or pre-tax profits from services provided to third
parties by Exl. The shares also become unrestricted upon a change of control of
51 percent of the outstanding shares of Old Conseco common stock. In November
2002, Old Conseco completed the sale of Exl and recognized a loss of $20.0
million on the transaction. Old Conseco had previously written off a significant
portion of the value of this investment in conjunction with the impairment
charge related to goodwill pursuant to the Company's adoption of Statement of
Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets"
("SFAS 142") described below under "Recently Issued Accounting Standards". Since
Old Conseco did not recover the acquisition price prior to its sale of Exl, the
shares held by Mr. Wendt and his wife remained restricted and were cancelled
pursuant to the Plan.
For certain other special purpose entities related to our investment
portfolio, we consider the requirements of Emerging Issues Task Force Issue
Topic D-14, "Transactions Involving Special-Purpose Entities" ("EITF 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. See the note to the
consolidated financial statements entitled "Investments in Variable Interest
Entities" for additional information.
The accompanying financial statements include the accounts of the Company
and all of its wholly owned insurance subsidiaries. Our consolidated financial
statements exclude the results of material transactions between us and our
consolidated affiliates, or among our consolidated affiliates. We reclassified
certain amounts in our 2002 and 2001 consolidated financial statements and notes
to conform with the 2003 presentation. These reclassifications have no effect on
net income (loss) or shareholders' equity (deficit).
100
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
3. FRESH START REPORTING
Upon the confirmation of the Plan on September 9, 2003, we implemented
fresh start reporting in accordance with SOP 90-7. However, in light of the
proximity of this date to the August month end, for accounting convenience
purposes, we have reported the effects of fresh start accounting as if they
occurred on August 31, 2003. We engaged an independent financial advisor to
assist in the determination of our reorganization value as defined in SOP 90-7.
We determined a reorganization value, together with our financial advisor, using
various valuation methods, including: (i) selected comparable companies
analysis; and (ii) actuarial valuation analysis. These analyses are necessarily
based on a variety of estimates and assumptions which, though considered
reasonable by management, may not be realized, and are inherently subject to
significant business, economic and competitive uncertainties and contingencies,
many of which are beyond our control. Changes in these estimates and assumptions
may have had a significant effect on the determination of our reorganization
value. The estimated reorganization value of the Company was calculated to be
approximately $3.7 billion to $3.9 billion. We selected the midpoint of the
range, $3.8 billion, as the reorganization value. Such value was confirmed by
the Bankruptcy Court on the Confirmation Date.
101
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
Under fresh start reporting, a new reporting entity is considered to be
created and the Company is required to revalue its assets and liabilities to
current estimated fair value, re-establish shareholders' equity at the
reorganization value determined in connection with the Plan, and record any
portion of the reorganization value which can not be attributed to specific
tangible or identified intangible assets as goodwill. In addition, all
accounting standards that are required to be adopted in the financial statements
within twelve months following the adoption of fresh start accounting were
adopted as of August 31, 2003. Adjustments to the Predecessor's consolidated
balance sheet as of August 31, 2003, to reflect the discharge of debt, change in
capital structure and the fair value of our assets and liabilities are presented
in the following table (dollars in millions):
Debt Fresh
Predecessor discharge and start Successor
balance sheet(a) reorganization(b) adjustments balance sheet
---------------- ----------------- ----------- -------------
Assets:
Investments .............................................. $22,018.3 $ - $1,043.5 (c) $23,101.3
39.5 (d)
Cash and cash equivalents................................. 1,187.5 - 28.4 (c) 1,215.9
Accrued investment income................................. 304.6 - - 304.6
Value of policies in force at the Effective Date.......... - - 3,102.6 (e) 3,102.6
Cost of policies purchased................................ 1,099.2 - (1,099.2) (e) -
Cost of policies produced................................. 2,019.5 - (2,019.5) (e) -
Reinsurance receivables................................... 878.3 - 44.3 (f) 922.6
Goodwill.................................................. 99.4 - 1,042.2 (f) 1,141.6
Other intangible assets................................... - - 157.8 (f) 157.8
Income tax assets......................................... 88.0 - - 88.0
Assets held in separate accounts and investment trust..... 87.7 - - 87.7
Other assets.............................................. 535.6 - 10.1 (f) 545.7
--------- ----------- -------- ---------
Total assets......................................... $28,318.1 $ - $2,349.7 $30,667.8
========= =========== ======== =========
Liabilities:
Liabilities for insurance and asset accumulation products. $22,175.6 $ - $2,592.1 (g) $24,767.7
Other liabilities......................................... 868.1 - (23.2) (f) 875.7
30.8 (c)
Investment borrowings..................................... 524.4 - 700.0 (c) 1,224.4
Notes payable - direct corporate obligations.............. - 1,300.0 - 1,300.0
--------- ----------- -------- ---------
Total liabilities not subject to compromise.......... 23,568.1 1,300.0 3,299.7 28,167.8
Liabilities subject to compromise......................... 6,951.4 (6,951.4) - -
--------- ----------- -------- ---------
Total liabilities ................................... 30,519.5 (5,651.4) 3,299.7 28,167.8
--------- ----------- -------- ---------
Shareholders' equity (deficit):
Convertible preferred stock............................... 501.7 - (501.7) -
Convertible exchangeable preferred stock.................. - 859.7 - 859.7
Common stock and additional paid-in capital............... 3,497.3 1,640.3 (3,497.3) 1,640.3
Retained earnings (accumulated deficit)................... (6,629.4) 3,151.4 3,478.0 -
Accumulated other comprehensive income.................... 429.0 - (429.0) -
--------- ----------- -------- ---------
Total shareholders' equity (deficit)................. (2,201.4) 5,651.4 (950.0) 2,500.0
--------- ----------- -------- ---------
Total liabilities and shareholders' equity (deficit).......... $28,318.1 $ - $2,349.7 $30,667.8
========= =========== ======== =========
102
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
- -----------------
(a) Predecessor balance sheet as of August 31, 2003, prior to the
recording of the discharge of prepetition liabilities and the effects
of the fresh start adjustments.
(b) The fresh start balance sheet reflects the reorganization value for
Conseco of $3,800.0 million. After deducting from Conseco's
reorganization value the long-term indebtedness of Conseco at the
Effective Date, consisting of $1,300.0 million of indebtedness under
the new senior secured bank credit facility, the total equity of
Conseco is $2,500.0 million. After deducting from Conseco's total
equity the value of the new Preferred Stock of $859.7 million, the
value of the new common stock is $1,640.3 million. These adjustments
also reflect the gain on the discharge of prepetition liabilities.
(c) In accordance with a new accounting pronouncement, the Company was
required to consolidate the assets and liabilities of the partnership
which owned the General Motors building into its balance sheet. As a
result of the consolidation and the adoption of fresh start accounting
we increased our investment in the General Motors building by $1,043.5
million and recognized the following other assets and liabilities held
by the partnership which owns the General Motors building: (i) cash of
$28.4 million; (ii) other liabilities of $30.8 million; and (iii) a
note payable of $700 million. We sold the General Motors building in
September 2003 at a value that was approximately equal to the fresh
start value. The note payable of the partnership was paid in full and
the net proceeds from the sale were distributed to the partners.
(d) The values of our mortgage loans, policy loans and other invested
assets were adjusted to market value at the Effective Date. In
addition, the cost basis of our actively managed fixed maturities was
increased to recognize all of the unrealized appreciation based on the
Predecessor cost basis at the Effective Date.
(e) The Company's historical cost of policies purchased and cost of
policies produced are eliminated and replaced with the value of
policies in force at the Effective Date. The value of policies in
force reflects the estimated fair value of the Company's business in
force and represents the portion of the estimated reorganization value
allocated to the value of the right to receive future cash flows from
the policies in force on the Effective Date.
A discount rate of 12 percent was used to determine the value of
policies in force and is the rate of return which management of the
Company (with assistance from an independent actuarial firm) believes
would be required by a purchaser of the business based on conditions
existing as of the Effective Date. In determining such rate of return,
the following factors, among others, are considered.
o The magnitude of the risks associated with each of the actuarial
assumptions used in determining the expected cash flows.
o Market rates of interest that would be applicable to an
acquisition of the business.
o The perceived likelihood of changes in insurance regulations and
tax laws.
o The complexity of the business.
o Prices paid for similar blocks of business.
(f) Assets and liabilities are adjusted to reflect their estimated fair
market value. The portion of the reorganization value that could not
be attributed to specific tangible or identified intangible assets has
been recorded as goodwill.
(g) The Company establishes reserves for insurance policy benefits based
on assumptions as to investment yields, mortality, morbidity,
withdrawals and lapses. These reserves include amounts for estimated
future payment of claims based on actuarial assumptions. Many factors
can affect these reserves, such as economic conditions, inflation,
hospital and pharmaceutical costs, changes in doctrines of legal
liability and extra contractual damage awards. The balance is based on
the Company's best estimate (with assistance from an independent
actuarial firm) of the future performance of this business, given
recent and expected future changes in experience. Adjustments to the
Predecessor's liabilities for insurance and asset accumulation
products are further discussed in the note to the consolidated
financial statements entitled "Liabilities for Insurance and Asset
Accumulation Products".
103
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The following summary explains the significant accounting policies we use
to prepare our financial statements. We prepare our financial statements in
accordance with generally accepted accounting principles ("GAAP"). We follow the
accounting standards established by the Financial Accounting Standards Board
("FASB"), the American Institute of Certified Public Accountants ("AICPA") and
the Securities and Exchange Commission (the "SEC").
Investments
We classify our fixed maturity securities into three categories: (i)
"actively managed" (which we carry at estimated fair value with any unrealized
gain or loss, net of tax and related adjustments, recorded as a component of
shareholders' equity (deficit)); (ii) "trading" (which we carry at estimated
fair value with changes in such value recognized as trading income); and (iii)
"held to maturity" (which we carry at amortized cost). We had no fixed maturity
securities classified as held to maturity during the periods presented in these
financial statements.
At August 31, 2003, we established trading security accounts which are
designed to act as a hedge for embedded derivatives related to: (i) our
equity-indexed annuity products; and (ii) certain modified coinsurance
agreements. See the note entitled "Accounting for Derivatives" for further
discussion regarding the embedded derivatives and the trading accounts. In
addition, the trading account includes the investments backing the market
strategies of our multibucket annuity products. The change in market value of
these securities is substantially offset by the change in insurance policy
benefits for these products. Our trading securities totaled $915.1 million at
December 31, 2003. The change in the market value of these securities is
recognized currently in investment income (classified as income from
policyholder and reinsurer accounts).
Equity securities include investments in common stock and non-redeemable
preferred stock. We carry these investments at estimated fair value. We record
any unrealized gain or loss, net of tax and related adjustments, as a component
of shareholders' equity. When declines in value considered to be other than
temporary occur, we reduce the amortized cost to estimated fair value and
recognize a loss in the statement of operations.
Mortgage loans held in our investment portfolio are carried at amortized
unpaid balances, net of provisions for estimated losses.
Policy loans are stated at their current unpaid principal balances.
Venture capital investment in AT&T Wireless Services, Inc. ("AWE") is
carried at fair value, with changes in such value recognized as investment
income (loss). In December 2003, we sold the remaining 4.1 million shares of AWE
common stock. In 2002, we sold 10.3 million shares of AWE common stock which
generated proceeds of $75.7 million. At December 31, 2002, we held 4.1 million
shares of AWE common stock with a value of $25.0 million. We recognized venture
capital investment income (losses) of $(5.5) million in the four months ended
December 31, 2003; $10.5 million in the eight months ended August 31, 2003; and
$(99.3) million and $(42.9) million in 2002 and 2001, respectively, related to
this investment.
Other invested assets include: (i) Standard & Poor's 500 Index Call Options
("S&P 500 Call Options"); and (ii) certain non-traditional investments. We carry
the S&P 500 Call Options at estimated fair value as further described below
under "Accounting for Derivatives". Non-traditional investments include
investments in certain limited partnerships and promissory notes; we account for
them using either the cost method, or for investments in partnerships, the
equity method.
We defer any fees received or costs incurred when we originate investments.
We amortize fees, costs, discounts and premiums as yield adjustments over the
contractual lives of the investments. We consider anticipated prepayments on
mortgage-backed securities in determining estimated future yields on such
securities.
When we sell a security (other than trading securities or venture capital
investments), we report the difference between the sale proceeds and amortized
cost (determined based on specific identification) as a realized investment gain
or loss.
We regularly evaluate all of our investments based on current economic
conditions, credit loss experience and other investee-specific developments. If
there is a decline in a security's fair value that is other than temporary, we
treat it as a
104
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
realized investment loss and reduce the cost basis of the security to its
estimated fair value.
Cash and Cash Equivalents
Cash and cash equivalents include commercial paper, invested cash and other
investments purchased with original maturities of less than three months. We
carry them at amortized cost, which approximates estimated fair value.
Provision for Losses
During 2003, 2002 and 2001, we established additional provisions for losses
related to our guarantees of bank loans and the related interest loans to
approximately 155 current and former directors, officers and key employees for
the purchase of the common stock of Old Conseco (see the note to the
consolidated financial statements entitled "Commitments and Contingencies" for
additional information on this provision).
Cost of Policies Produced
In conjunction with the implementation of fresh start accounting, we
eliminated the historical balance of Old Conseco's cost of policies produced as
of August 31, 2003 and replaced it with the value of policies in force at the
Effective Date.
The costs that vary with, and are primarily related to, producing new
insurance business in the period after August 31, 2003 are referred to as cost
of policies produced. We amortize these costs (using the interest rate credited
to the underlying policy for universal life or investment-type products and the
projected investment earnings rate for other products): (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 produced 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 (deficit).
When we replace an existing insurance contract with another insurance
contract with substantially different terms, all unamortized cost of policies
produced related to the replaced contract is immediately written off. When we
replace an existing insurance contract with another insurance contract with
substantially similar terms, we continue to defer the cost of policies produced
associated with the replaced contract. Such costs related to the replaced
contracts which continue to be deferred were nil in the four months ended
December 31, 2003; $2.9 million in the eight months ended August 31, 2003; and
$7.6 million and $10.0 million in 2002 and 2001, respectively.
We regularly evaluate the recoverability of the unamortized balance of the
cost of policies produced. We consider estimated future gross profits or future
premiums, expected mortality or morbidity, interest earned and credited rates,
persistency and expenses in determining whether the balance is recoverable. If
we determine a portion of the unamortized balance is not recoverable, it is
charged to amortization expense.
Value of Policies Inforce at the Effective Date
In conjunction with the implementation of fresh start accounting, we
eliminated the historical balances of Old Conseco's cost of policies purchased
and cost of policies produced as of the Effective Date and replaced them with
the value of policies inforce as of the Effective Date.
The cost assigned to the right to receive future cash flows from contracts
existing at August 31, 2003 is referred to as the cost of policies inforce as of
the Effective Date. We also defer renewal commissions paid in excess of ultimate
commission levels related to the existing policies in this account. The balance
of this account is amortized, evaluated for recovery, and adjusted for the
impact of unrealized gains (losses) in the same manner as the cost of policies
produced described above.
The discount rate we used to determine the value of the cost of policies
inforce as of the Effective Date is the rate of
105
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
return which management of the Company (with assistance from an independent
actuarial firm) believes would be required by a purchaser of the business based
on conditions existing as of the Effective Date. In determining this required
rate of return, we considered many factors including: (i) the magnitude of the
risks associated with each of the actuarial assumptions used in determining
expected future cash flows; (ii) market rates of interest that would be
applicable to an acquisition of the business; (iii) the likelihood of changes in
projected future cash flows that might occur if there are changes in insurance
regulations and tax laws; (iv) the compatibility of the business with our future
business plans that may favorably affect future cash flows; (v) the complexity
of the business; and (vi) recent prices (i.e., discount rates used in
determining valuations) paid by others to acquire similar blocks of business.
The weighted average discount rate we used to determine the value of business
inforce as of the Effective Date was 12 percent.
The Company expects to amortize approximately 10 percent of the December
31, 2003 balance of the value of policies inforce at the Effective Date in 2004,
10 percent in 2005, 9 percent in 2006, 8 percent in 2007 and 8 percent in 2008.
Goodwill
Upon our emergence from bankruptcy, we revalued our assets and liabilities
to current estimated fair value and established our capital accounts at the
reorganization value determined in connection with the Plan. We recorded the
$1,141.6 million of the reorganization value which could not be attributed to
specific tangible or identified intangible assets as goodwill. Under current
accounting rules (which became effective January 1, 2002) goodwill is not
amortized but is subject to an annual impairment test (or more frequent under
certain circumstances). We obtained an independent appraisal of our business in
connection with the preparation of the Plan and our implementation of fresh
start accounting.
Although the goodwill balance will not be subject to amortization, it will
be reduced by future use of the Company's net deferred income tax assets
(including the tax operating loss carryforwards) existing at August 31, 2003
(such balance was reduced by $189.4 million in the four months ended December
31, 2003). A valuation allowance has been provided for the remaining balance of
such net deferred income tax assets due to the uncertainties regarding their
realization. See the note entitled "Income Taxes" for further discussion.
Changes in the carrying amount of goodwill are as follows (dollars in
millions):
Successor
-------------
Four months
ended
December 31,
2003
----
Goodwill balance, beginning of period................................ $1,141.6
Recognition of tax valuation reserve established at the
Effective Date.................................................. (189.4)
--------
Goodwill balance, end of period...................................... $ 952.2
========
Reorganization Items
Reorganization items represent amounts the Predecessor incurred as a result
of its Chapter 11 reorganization, and are presented separately in the
consolidated statement of operations. These items consist of the following
(dollars in millions):
Eight months Year
ended ended
August 31, 2003 December 31, 2002
--------------- -----------------
Gain on discharge of prepetition liabilities.................. $ 3,151.4 $ -
Fresh start adjustments....................................... (950.0) -
Professional fees............................................. (70.9) (14.4)
--------- ------
Total reorganization items................................ $ 2,130.5 $(14.4)
========= ======
106
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
Liabilities Subject to Compromise
Under the Bankruptcy Code, actions by creditors to collect indebtedness
owed prior to the Petition Date were stayed and certain other prepetition
contractual obligations could not be enforced against the Filing Entities. The
Filing Entities received approval from the Court to pay certain prepetition
liabilities including employee salaries and wages, benefits and other employee
obligations. All other prepetition liabilities were classified as "liabilities
subject to compromise" in the December 31, 2002 consolidated balance sheet.
The following table summarizes the components of the liabilities included
in the line "liabilities subject to compromise" in our consolidated balance
sheet at December 31, 2002 (dollars in millions):
Predecessor
-----------
Other liabilities:
Liability for guarantee of bank loans to former directors and
current and former officers and key employees of Old Conseco
to purchase common stock of Old Conseco......................... $ 480.8
Interest payable................................................... 171.6
Accrual for distributions on Company-obligated mandatorily
redeemable preferred securities of subsidiary trusts of
Old Conseco..................................................... 90.1
Liability for retirement benefits pursuant to executive
employment agreements........................................... 22.6
Liability for deferred compensation................................ 2.3
Other liabilities.................................................. 48.8
--------
Total other liabilities subject to compromise................... 816.2
Notes payable - direct corporate obligations........................... 4,057.1
--------
Total liabilities subject to compromise......................... $4,873.3
========
Other Intangible Assets
In conjunction with our adoption of fresh start accounting, we identified
certain intangible assets other than goodwill. We determined the value of these
assets with assistance from an independent valuation firm. In accordance with
SFAS 142, other intangible assets with indefinite lives are not amortized, but
are subject to impairment tests on an annual basis (or more frequent under
certain circumstances). SFAS 142 requires intangible assets with finite useful
lives to be amortized over their estimated useful lives and to be reviewed for
impairment in accordance with Statement of Financial Accounting Standards No.
144, "Accounting for Impairment or Disposal of Long-Lived Assets" ("SFAS 144").
We amortize the value of our career agency force and our independent agency
force over their estimated useful lives of 15 years using the straight line
method. We continually evaluate the reasonableness of the useful lives of these
assets.
107
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
The following summarizes other identifiable intangible assets as of
December 31, 2003 (dollars in millions):
Successor
---------
Indefinite lived other intangible assets:
Trademarks and tradenames...................................... $ 25.1
State licenses and charters.................................... 17.0
------
Total indefinite lived other intangible assets............. 42.1
------
Finite lived other intangible assets:
Career agency force............................................ 64.7
Independent agency force....................................... 49.8
Other.......................................................... 1.2
Less accumulated amortization.................................. (2.6)
------
Total finite lived other intangible assets................. 113.1
------
Total other intangible assets..................................... $155.2
======
Assets Held in Separate Accounts and Investment Trust
Separate accounts are funds on which investment income and gains or losses
accrue directly to certain policyholders. The assets of these accounts are
legally segregated. They are not subject to the claims that may arise out of any
other business of Conseco. We report separate account assets at market value;
the underlying investment risks are assumed by the contractholders. We record
the related liabilities at amounts equal to the market value of the underlying
assets. We record the fees earned for administrative and contractholder services
performed for the separate accounts in insurance policy income.
In addition, prior to its liquidation in the third quarter of 2003, we held
investments in a trust for the benefit of the purchasers of certain products of
our asset management subsidiary. Because we held the residual interests in the
cash flows from the trust and actively managed its investments, we were required
to include the accounts of the trust in our consolidated financial statements.
We recorded the fees earned for investment management and other services
provided to the trust as fee revenue. See the caption "Brickyard Trust" in the
note to the consolidated financial statements entitled "Investments in Variable
Interest Entities" for further information on these investments.
Recognition of Insurance Policy Income and Related Benefits and Expenses on
Insurance Contracts
Generally, we recognize insurance premiums for traditional life and
accident and health contracts as earned over the premium-paying periods. We
establish reserves for future benefits on a net-level premium method based upon
assumptions as to investment yields, mortality, morbidity, withdrawals and
dividends. We record premiums for universal life-type and investment-type
contracts that do not involve significant mortality or morbidity risk as
deposits to insurance liabilities. Revenues for these contracts consist of
mortality, morbidity, expense and surrender charges. We establish reserves for
the estimated present value of the remaining net costs of all reported and
unreported claims.
Reinsurance
In the first quarter of 2002, we completed a reinsurance agreement pursuant
to which we ceded 80 percent of the inforce traditional life business of our
subsidiary, Bankers Life and Casualty Company, to Reassure America Life
Insurance Company (rated A+ by A.M. Best Company, or "A.M. Best"). The total
insurance liabilities ceded pursuant to the contract were approximately $400
million. The reinsurance agreement and the related dividends of $110.5 million
were approved by the appropriate state insurance departments and the dividends
were paid to Old Conseco. The ceding commission approximated the amount of the
cost of policies purchased and cost of policies produced related to the ceded
business.
On June 28, 2002, we completed a reinsurance transaction pursuant to which
we ceded 100 percent of the traditional life and interest-sensitive life
insurance business of our subsidiary, Conseco Variable Insurance Company, to
Protective Life Insurance Company (rated A+ by A.M. Best). The total insurance
liabilities ceded pursuant to the contract were
108
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
approximately $470 million. Our insurance subsidiary received a ceding
commission of $49.5 million.
During the second quarter of 2002, one of our subsidiaries, Colonial Penn
Life Insurance Company (formerly known as Conseco Direct Life Insurance
Company), ceded a block of graded benefit life insurance policies to an
unaffiliated company pursuant to a modified coinsurance agreement. Our
subsidiary received a ceding commission of $83.0 million. The cost of policies
purchased and the cost of policies produced were reduced by $123.0 million and
we recognized a loss of $39.0 million related to the transaction.
In the normal course of business, we seek to limit our exposure to loss on
any single insured or to certain groups of policies by ceding reinsurance to
other insurance enterprises. We currently retain no more than $.8 million of
mortality risk on any one policy. We diversify the risk of reinsurance loss by
using a number of reinsurers that have strong claims-paying ratings. If any
reinsurer could not meet its obligations, the Company would assume the
liability. The likelihood of a material loss being incurred as a result of the
failure of one of our reinsurers is considered remote. The cost of reinsurance
is recognized over the life of the reinsured policies using assumptions
consistent with those used to account for the underlying policy. The cost of
reinsurance ceded totaled $92.1 million in the four months ended December 31,
2003; $196.4 million in the eight months ended August 31, 2003; and $327.8
million and $249.4 million in 2002 and 2001, respectively. We deduct this cost
from insurance policy income. In each case, the ceding Conseco subsidiary is
contingently liable for claims reinsured if the assuming company is unable to
pay. Reinsurance recoveries netted against insurance policy benefits totaled
$94.3 million in the four months ended December 31, 2003; $199.2 million in the
eight months ended August 31, 2003; and $323.6 million and $201.3 million in
2002 and 2001, respectively.
From time-to-time, we assume insurance from other companies. Any costs
associated with the assumption of insurance are amortized consistent with the
method used to amortize the cost of policies produced described above.
Reinsurance premiums assumed totaled $31.9 million in the four months ended
December 31, 2003; $57.3 million in the eight months ended August 31, 2003; and
$78.7 million and $146.0 million in 2002 and 2001, respectively.
See "Accounting for Derivatives" for a discussion of the derivative
embedded in the payable related to certain modified coinsurance agreements.
Income Taxes
Our income tax expense includes deferred income taxes arising from
temporary differences between the financial reporting and tax bases of assets
and liabilities, capital loss carryforwards and net operating loss
carryforwards. In assessing the realization of deferred income tax assets, we
consider whether it is more likely than not that the deferred income tax assets
will be realized. The ultimate realization of our deferred income tax assets
depends upon generating future taxable income during the periods in which our
temporary differences become deductible and before our net operating loss
carryforwards expire. In addition, the use of the Company's net ordinary loss
carryforwards is dependent, in part, on whether the IRS ultimately agrees with
the tax position we plan to take in our current and future tax returns. We
evaluate the realizability of our deferred income tax assets by assessing the
need for a valuation allowance on a quarterly basis. As of December 31, 2003, a
valuation allowance has been provided for the entire balance of the net deferred
tax asset as the realization of the net deferred tax asset is uncertain.
Investment Borrowings
As part of our investment strategy, we may enter into reverse repurchase
agreements and dollar-roll transactions to increase our investment return or to
improve our liquidity. We account for these transactions as collateral
borrowings, where the amount borrowed is equal to the sales price of the
underlying securities. Reverse repurchase agreements involve a sale of
securities and an agreement to repurchase the same securities at a later date at
an agreed-upon price. Dollar rolls are similar to reverse repurchase agreements
except that, with dollar rolls, the repurchase involves securities that are
substantially the same as the securities sold (rather than being the same
security). Such borrowings (excluding borrowings related to the GM building)
averaged $488.9 million during the four months ended December 31, 2003; $689.1
million during the eight months ended August 31, 2003; and $1,155.8 million
during 2002. These borrowings were collateralized by investment securities with
fair values approximately equal to the loan value. The weighted average interest
rates on such borrowings were 1.5 percent during the four months ended December
31, 2003; 1.8 percent during the eight months ended August 31, 2003; and 1.3
percent during 2002. The primary risk associated with short-term collateralized
borrowings is that a counterparty will be unable to perform under the terms of
the contract. Our exposure is limited to the excess of the net replacement cost
of the securities over the value
109
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
of the short-term investments (such excess was not material at December 31,
2003). We believe the counterparties to our reverse repurchase and dollar-roll
agreements are financially responsible and that the counterparty risk is
minimal.
Use of Estimates
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, the value of policies inforce at the Effective Date,
certain investments, assets and liabilities related to income taxes, goodwill,
liabilities for insurance and asset accumulation products, liabilities related
to litigation, guaranty fund assessment accruals and liabilities related to
guarantees of bank loans and the related interest loans to certain former
directors and certain current and former officers and key employees. If our
future experience differs from these estimates and assumptions, our financial
statements would be materially affected.
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. We are 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 $19.1 million during the four months
ended December 31, 2003; $53.5 million during the eight months ended August 31,
2003; and $97.5 million and $119.0 million during 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-indexed products before this expense was $61.3 million in the four months
ended December 31, 2003; $78.7 million in the eight months ended August 31,
2003; and $(3.0) million and $4.8 million in 2002 and 2001, respectively. These
amounts were substantially offset by the corresponding charge to insurance
policy benefits. The estimated fair value of the S&P 500 Call Options was $97.2
million and $32.8 million at December 31, 2003 and 2002, respectively. We
classify these instruments as other invested assets. The Company accounts for
the options attributed 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"). We record the changes 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 $214.7 million and $301.9 million at December 31, 2003 and 2002,
respectively. We have transferred a specified block of investments which are
equal to the balance of these liabilities to our trading securities account,
which we carry at estimated fair value with changes in such value recognized as
investment income (classified as investment income from policyholder accounts).
The change in value of these trading securities should largely offset the
portion of the change in the value of the embedded derivative which is caused by
interest rate fluctuations.
On June 29, 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 4.75 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 matched the terms of the senior notes, the gain or loss
on the swap and the senior notes was generally equal and offsetting (although
the effective interest rate on our debt was affected).
In early October 2001, we terminated these interest rate swap agreements
for cash proceeds of $19.0 million (the value of the terminated swap
agreements). No gain was recognized upon the termination of the interest rate
swap agreements. Instead, the change in the fair value of the senior notes
recorded while the interest rate swaps were outstanding was amortized as a
reduction to interest expense over the remaining life of our senior notes until
such notes were discharged in accordance
110
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
with the Plan.
In October 2001, we also entered into new interest rate swap agreements to
replace the terminated agreements which converted the fixed rate on our 10.75%
senior notes to a variable rate based on LIBOR plus 5.7525 percent. 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 was amortized as additional interest expense over
the remaining life of our senior notes until such notes were discharged in
accordance with the Plan.
The Company entered into a forward sale contract related to a portion of
its venture capital investment in AWE. Such contract was carried at market
value, with the change in such value being recognized as venture capital income
(loss). The value of the derivative fluctuated in relation to the AWE common
stock it related to. In the third quarter of 2002, we agreed with the
counterparties to unwind the forward sale contract. The net effect of unwinding
the forward purchase contract resulted in a small gain.
If the counterparties for the derivatives we hold fail to meet their
obligations, we may have to recognize a loss. We limit our exposure to such a
loss by diversifying among several counterparties believed to be strong and
creditworthy. At December 31, 2003, all of the counterparties were rated "A" or
higher by Standard & Poor's Corporation ("S&P").
The FASB's Derivative Implementation Group issued SFAS No. 133
Implementation Issue No. B36, "Embedded Derivatives: Modified Coinsurance
Arrangements and Debt Instruments that Incorporate Credit Risk Exposures that
are Unrelated or Only Partially Related to the Creditworthiness of the Obligor
of Those Instruments" ("DIG B36") in April 2003. DIG B36 addresses specific
circumstances under which bifurcation of an instrument into a host contract and
an embedded derivative is required. DIG B36 requires the bifurcation of a
derivative from the receivable or payable related to a modified coinsurance
agreement, where the yield on the receivable and payable is based on a return of
a specified block of assets rather than the creditworthiness of the ceding
company. We implemented this guidance on August 31, 2003, in conjunction with
our adoption of fresh start accounting. We have determined that certain of our
reinsurance payable balances contain embedded derivatives. Such derivatives had
an estimated fair value of $20.9 million and $27.2 million at August 31, 2003
and December 31, 2003, respectively. We record the change in the fair value of
these derivatives as a component of investment income (classified as investment
income from policyholder and reinsurer accounts). We have transferred the
specific block of investments related to these agreements to our trading
securities account, which we carry at estimated fair value with changes in such
value recognized as investment income (also classified as investment income from
reinsurer accounts). The change in value of these trading securities should
largely offset the change in value of the embedded derivatives.
Multibucket Annuity Product
The Company's multibucket annuity is a fixed annuity product that credits
interest based on the experience of a particular market strategy. Policyholders
allocate their annuity premium payments to several different market strategies
based on different asset classes within the Company's investment portfolio.
Interest is credited to this product based on the market return of the given
strategy, less management fees, and funds may be moved between different
strategies. The Company guarantees a minimum return of premium plus
approximately 3 percent per annum over the life of the contract. The investments
backing the market strategies of these products are designated by the Company as
trading securities. The change in the fair value of these securities is
recognized currently in investment income (classified as income from
policyholder and reinsurer accounts) which is substantially offset by the change
in insurance policy benefits for these products.
Accounting for Stock Options
In December 2002, the FASB issued Statement of Financial Accounting
Standards No. 148, "Accounting for Stock-Based Compensation - Transition and
Disclosure", an Amendment of FASB Statement No. 123 ("SFAS 148"), which provides
three alternative methods of transition to the fair value method of accounting
for stock options. SFAS 148 also amends the disclosure requirements of Statement
of Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" ("SFAS 123").
111
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
We apply Accounting Principles Board Opinion No. 25, "Accounting for Stock
Issued to Employees" and related interpretations in accounting for our stock
option plans. Had compensation cost been determined based on the fair value at
the grant dates for awards granted after January 1, 1995, consistent with the
method of SFAS 123, the Company's pro forma net income (loss) and pro forma
earnings (loss) per share would have been as follows (dollars in millions,
except per share amounts):
Successor Predecessor
---------------- ---------------------------------------------
Years
Four months Eight months ended
ended ended December 31,
December 31, August 31, --------------------
2003 2003 2002 2001
---- ---- ---- ----
Net income (loss), as reported .................. $96.3 $2,201.7 $(7,835.7) $(405.9)
Less stock-based employee compensation
expense determined under the fair value
based method for all awards, net of income
taxes....................................... .4 7.2 12.4 28.2
----- -------- --------- -------
Pro forma net income (loss)...................... $95.9 $2,194.5 $(7,848.1) $(434.1)
===== ======== ========= =======
Earnings per share:
Basic, as reported.......................... $.68
====
Basic, pro forma............................ $.68
====
Diluted, as reported........................ $.67
====
Diluted, pro forma.......................... $.67
====
Pro forma compensation expense in the eight months ended August 31, 2003,
has been reduced by $5.0 million due to the reversal of expense for options that
were not vested upon cancellation of the outstanding stock options of the
Predecessor.
Fair Values of Financial Instruments
We use the following methods and assumptions to determine the estimated
fair values of financial instruments:
Investment securities. For fixed maturity securities (including redeemable
preferred stocks) and for equity and trading securities, we use quotes from
independent pricing services, where available. For investment securities
for which such quotes are not available, we use values obtained from
broker-dealer market makers or by discounting expected future cash flows
using a current market rate appropriate for the yield, credit quality, and
(for fixed maturity securities) the maturity of the investment being
priced.
Venture capital investment in AWE. We carry this investment at estimated
fair value based on quoted market prices.
Cash and cash equivalents. The carrying amount for these instruments
approximates their estimated fair value.
Mortgage loans and policy loans. We discount future expected cash flows for
loans included in our investment portfolio based on interest rates
currently being offered for similar loans to borrowers with similar credit
ratings. We aggregate loans with similar characteristics in our
calculations. The market value of policy loans approximates their carrying
value.
Other invested assets. We use quoted market prices, where available. When
quotes are not available, we estimate the fair value based on: (i)
discounted future expected cash flows; or (ii) independent transactions
which establish a value for our investment. When we are unable to estimate
a fair value, we assume a market value equal to carrying value.
Insurance liabilities for interest-sensitive products. We discount future
expected cash flows based on interest rates currently being offered for
similar contracts with similar maturities.
112
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
Investment borrowings and notes payable. For publicly traded debt, we use
current market values. For other notes, we use discounted cash flow
analyses based on our current incremental borrowing rates for similar types
of borrowing arrangements.
Here are the estimated fair values of our financial instruments (dollars in
millions):
Successor Predecessor
-------------------- -------------------
December 31, December 31,
2003 2002
-------------------- -------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
------ ----- ------ -----
Financial assets:
Actively managed fixed maturities....................................... $19,840.1 $19,840.1 $19,417.4 $19,417.4
Equity securities ...................................................... 74.5 74.5 156.0 156.0
Mortgage loans.......................................................... 1,139.5 1,174.1 1,308.3 1,335.7
Policy loans............................................................ 503.4 503.4 536.2 536.2
Trading securities...................................................... 915.1 915.1 - -
Venture capital investment in AT&T Wireless
Services, Inc......................................................... - - 25.0 25.0
Other invested assets................................................... 324.1 324.1 340.8 340.8
Cash and cash equivalents............................................... 1,260.6 1,260.6 1,268.9 1,268.9
Financial liabilities:
Insurance liabilities for interest-sensitive
products (a).......................................................... 12,480.4 12,480.4 13,122.7 13,122.7
Investment borrowings................................................... 387.3 387.3 669.7 669.7
Notes payable:
Corporate (b)......................................................... 1,300.0 1,300.0 - -
Company-obligated mandatorily redeemable
preferred securities of subsidiary trusts............................. - - 1,921.5 9.7
- --------------------
(a) The estimated fair value of the liabilities for interest-sensitive
products was approximately equal to its carrying value at December 31,
2003 and 2002. This was because interest rates credited on the vast
majority of account balances approximate current rates paid on similar
products and because these rates are not generally guaranteed beyond
one year. We are not required to disclose fair values for insurance
liabilities, other than those for interest-sensitive products.
However, we take into consideration the estimated fair values of all
insurance liabilities in our overall management of interest rate risk.
We attempt to minimize exposure to changing interest rates by matching
investment maturities with amounts due under insurance contracts.
(b) At December 31, 2002, corporate notes payable were classified as
liabilities subject to compromise.
Cumulative Effect of Accounting Change and Goodwill Impairment Related to
Predecessor
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 determined
that all of its goodwill had an indefinite life and was therefore subject to the
new rules. The Company adopted SFAS 142 on January 1, 2002.
Pursuant to the transitional rules of SFAS 142, we completed the two-step
impairment test during 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. The impairment charge is reflected in the cumulative effect of
an accounting change in the accompanying consolidated statement of operations
for the year ended December 31, 2002. Subsequent impairment charges are
classified as an operating expense. As described below, the Company performed an
impairment test in 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
113
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
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.
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. 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 the preparation of the Plan, we retained an outside
actuarial consulting firm to assist in valuing our insurance subsidiaries. That
valuation work and our internal evaluation were used in performing the
additional impairment tests that resulted in an impairment charge to goodwill of
$500.0 million. The charge is reflected in the line item entitled "Goodwill
impairment" in our consolidated statement of operations for the year ended
December 31, 2002. The most significant changes made to the January 1, 2002
valuation that resulted in the additional 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. Management believes that the assumptions and estimates used
were reasonable given all available facts and circumstances at the time made.
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 Predecessor's goodwill for the eight
months ended August 31, 2003, and the year ended December 31, 2002, are as
follows (dollars in millions):
Predecessor
-----------------------------------
Eight months Year
ended ended
August 31, December 31,
2003 2002
---- ----
Goodwill balance, beginning of period....................................... $100.0 $ 3,695.4
Cumulative effect of accounting change...................................... - (2,949.2)
Impairment charge........................................................... - (500.0)
Reduction of tax valuation contingencies established at acquisition date
for acquired companies.................................................. (.6) (146.2)
------ ---------
........................................................................
Goodwill balance, end of period............................................. $ 99.4 $ 100.0
====== =========
114
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 and
cumulative effect of accounting change; and net income for the periods presented
in our consolidated statement of operations for periods prior to January 1, 2002
(dollars in millions, except per share data):
Predecessor
-----------
Year ended
December 31,
2001
----
Reported loss before discontinued operations
and cumulative effect of accounting change............................................... $(305.3)
Add back: goodwill amortization.............................................................. 108.2
-------
Adjusted loss before discontinued operations
and cumulative effect of accounting change................................................ $(197.1)
=======
Reported net loss applicable to common stock................................................. $(418.7)
Add back: goodwill amortization.............................................................. 109.6
-----
Adjusted net loss applicable to common stock.................................................. $(309.1)
=======
Recently Issued Accounting Standards
Pursuant to SOP 90-7, we have implemented the provisions of accounting
principles required to be adopted within twelve months of the adoption of fresh
start accounting. The following summarizes the new accounting pronouncements we
have recently adopted:
The FASB's Derivative Implementation Group issued DIG B36 in April 2003.
DIG B36 addresses specific circumstances under which bifurcation of an
instrument into a host contract and an embedded derivative is required. DIG B36
requires the bifurcation of a derivative from the receivable or payable related
to a modified coinsurance agreement, where the yield on the receivable and
payable is based on a return of a specified block of assets rather than the
creditworthiness of the ceding company. We implemented this guidance on August
31, 2003, in conjunction with our adoption of fresh start accounting. See the
note entitled "Accounting for Derivatives" for a discussion of the impact of
implementing this guidance.
The FASB issued Financial Accounting Standards No. 149 "Amendment of SFAS
No. 133 on Derivative Instruments and Hedging Activities" ("SFAS 149") in April
2003. SFAS 149 amends and clarifies accounting for derivative instruments,
including certain derivative instruments embedded in other contracts, and for
hedging activities under Statement of Financial Accounting Standards No. 133,
"Accounting for Derivative Instruments and Hedging Activities." Except for
certain implementation guidance included in SFAS 149 which is already effective,
the new guidance is effective for: (i) contracts entered into or modified after
June 30, 2003; and (ii) hedging relationships designated after June 30, 2003.
The adoption of SFAS 149 did not have a material impact on the Company's
consolidated financial statements.
The FASB issued Financial Accounting Standards No. 150, "Accounting for
Certain Financial Instruments with Characteristics of Both Liabilities and
Equity" ("SFAS 150") in May 2003. SFAS 150 establishes standards for classifying
and measuring certain financial instruments that embody obligations of the
issuer and have characteristics of both liabilities and equity. For example,
mandatorily redeemable preferred stock is required to be classified as a
liability pursuant to SFAS 150. SFAS 150 is effective immediately for financial
instruments entered into or modified after May 31, 2003, and for all other
financial instruments beginning with the third quarter of 2003. Effective July
1, 2003, Old Conseco's Company-obligated mandatorily redeemable preferred
securities of subsidiary trusts, or TOPrS, with an aggregate carrying value of
$1,921.5 million, were reclassified to liabilities pursuant to the provisions of
SFAS 150. The adoption of SFAS 150 does not impact the financial statements of
Conseco subsequent to the Effective Date since the Company-obligated mandatorily
redeemable preferred securities of subsidiary trusts are no longer outstanding.
The Accounting Standards Executive Committee of the American Institute of
Certified Public Accountants issued Statement of Position 03-01 "Accounting and
Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration
Contracts and for Separate Accounts" ("SOP 03-01") in July 2003. SOP 03-01
provides guidance on several insurance
115
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
company disclosure and accounting matters including the appropriate accounting
for: (i) separate accounts; (ii) additional interest (for example, persistency
bonus) accruing to the investment contract holder; (iii) the liability for
contracts where the amounts assessed against the contract holder each period are
assessed in a manner that is expected to result in profits in earlier years and
losses in subsequent years; (iv) potential benefits to annuity holders in
addition to their account balance; (v) sales inducements to contract holders;
and (vi) other provisions. The Company recently sold most of its separate
account business. Accordingly, the new guidance related to separate accounts
will have no impact on the Company's consolidated financial position, results of
operations or cash flows. As a result of our adoption of fresh start accounting,
we were required to revalue our insurance product liabilities and record them at
their estimated fair market value. In calculating the value of the liabilities
for insurance and asset accumulation products, we followed the guidance of SOP
03-01. We have changed the way we classify the costs related to sales
inducements in accordance with the new guidance. However, such change was not
material. Our reserve for sales inducement persistency bonus benefits was $282.8
million at December 31, 2003, and $278.6 million at August 31, 2003.
In January 2003, the FASB issued FIN 46, which requires expanded
disclosures for and, in some cases, consolidation of significant investments in
variable interest entities ("VIE"). A VIE is an entity in which the equity
investors do not have the characteristics of a controlling financial interest,
or do not have sufficient equity at risk for the entity to finance its
activities without additional subordinated financial support from other parties.
Under FIN 46, a company is required to consolidate a VIE if it is the primary
beneficiary of the VIE. FIN 46 defines primary beneficiary as the party which
will absorb a majority of the VIE's expected losses or receive a majority of the
VIE's expected residual returns, or both.
The Company has investments in various types of VIEs, some of which require
additional disclosure under FIN 46, and several of which require consolidation
under FIN 46. As further discussed in the note to the consolidated financial
statements entitled "Investments in Variable Interest Entities", we have
consolidated all of our investments in VIEs. The adoption of the consolidation
requirements of FIN 46 did not have a material impact on our financial condition
or results of operations. The note entitled "Investments in Variable Interest
Entities" includes the expanded disclosures required by FIN 46.
The FASB issued FASB Interpretation No. 45, "Guarantor's Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others" ("FIN 45") in November 2002. FIN 45 requires certain
guarantees to be recognized as liabilities at fair value. In addition, it
requires a guarantor to make new disclosures regarding its obligations. We
implemented the new disclosure requirements as of December 31, 2002. FIN 45's
liability recognition requirement is effective on a prospective basis for
guarantees issued or modified after December 31, 2002. The adoption of FIN 45
did not impact the Company's results of operations or financial condition.
The FASB issued Statement of Financial Accounting Standards No. 146,
"Accounting for Exit or Disposal Activities" ("SFAS 146") in June 2002. SFAS 146
addresses financial accounting and reporting for costs that are associated with
exit and disposal activities and supersedes Emerging Issues Task Force Issue No.
94-3, "Liability Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)"
("EITF 94-3"). SFAS 146 is required to be used to account for exit or disposal
activities that are initiated after December 31, 2002. The provisions of EITF
94-3 shall continue to apply for an exit activity initiated prior to the
adoption of SFAS 146. SFAS 146 requires companies to recognize costs associated
with exit or disposal activities when they are incurred rather than at the date
of commitment to an exit or disposal plan. The Company adopted the provisions of
SFAS 146 on January 1, 2003. The initial adoption of SFAS 146 did not have an
impact on the Company's consolidated financial statements.
The FASB issued Statement of Financial Accounting Standards No. 145,
"Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No.
13, and Technical Corrections" ("SFAS 145") in April 2002. Under previous
guidance all gains and losses resulting from the extinguishment of debt were
required to be aggregated and, if material, classified as an extraordinary item,
net of related income tax effect. SFAS 145 rescinds that guidance and requires
that gains and losses from extinguishments of debt be classified as
extraordinary items only if they are both unusual and infrequent in occurrence.
SFAS 145 also amends previous guidance to require certain lease modifications
that have economic effects similar to sale-leaseback transactions to be
accounted for in the same manner as sale-leaseback transactions. The Company
adopted SFAS 145 on January 1, 2003. Prior period amounts related to
extraordinary gains on the extinguishment of debt have been reclassified in
accordance with the new guidance.
The FASB issued SFAS 144 in August 2001. This standard addresses the
measurement and reporting for impairment of all long-lived assets. It also
broadens the definition of what may be presented as a discontinued operation in
the
116
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
consolidated statement of operations to include components of a company's
business segments. SFAS 144 requires that long-lived assets currently in use be
written down to fair value when considered impaired. Long-lived assets to be
disposed of are written down to the lower of cost or fair value less the
estimated cost to sell. The Company adopted this standard on January 1, 2002. We
followed this standard in determining when it was appropriate to recognize
impairments on assets we decided to sell as part of our efforts to raise cash.
We also followed this standard in determining that our variable annuity business
line and CFC should be presented as discontinued operations in our consolidated
financial statements (see the note to the consolidated financial statements
entitled "Discontinued Operations").
5. INVESTMENTS
At December 31, 2003, the amortized cost and estimated fair value of
actively managed fixed maturities and equity securities were as follows (dollars
in millions):
Successor
-------------------------------------------------
Gross Gross Estimated
Amortized unrealized unrealized fair
cost gains losses value
---- ----- ------ -----
Investment grade:
Corporate securities.......................................... $11,169.7 $279.8 $13.7 $11,435.8
United States Treasury securities and obligations of
United States government corporations and agencies.......... 1,068.9 14.1 1.7 1,081.3
States and political subdivisions............................. 608.4 5.9 2.4 611.9
Debt securities issued by foreign governments................. 84.6 1.6 - 86.2
Structured securities ........................................ 5,804.6 59.2 14.9 5,848.9
Below-investment grade (primarily corporate securities).......... 734.5 43.2 1.7 776.0
--------- ------ ----- ---------
Total actively managed fixed maturities..................... $19,470.7 $403.8 $34.4 $19,840.1
========= ====== ===== =========
Equity securities................................................ $ 71.8 $ 2.8 $ .1 $ 74.5
========= ====== ===== =========
At December 31, 2002, the amortized cost and estimated fair value of
actively managed fixed maturities and equity securities were as follows (dollars
in millions):
Predecessor
-----------------------------------------------
Gross Gross Estimated
Amortized unrealized unrealized fair
cost gains losses value
---- ----- ------ -----
Investment grade:
Corporate securities.......................................... $10,529.0 $517.5 $293.9 $10,752.6
United States Treasury securities and obligations of
United States government corporations and agencies.......... 442.4 25.2 9.0 458.6
States and political subdivisions............................. 418.0 23.2 .9 440.3
Debt securities issued by foreign governments................. 83.3 7.3 - 90.6
Structured securities ........................................ 6,082.0 336.3 4.2 6,414.1
Below-investment grade (primarily corporate securities).......... 1,435.1 17.1 191.0 1,261.2
--------- ------ ------ ---------
Total actively managed fixed maturities..................... $18,989.8 $926.6 $499.0 $19,417.4
========= ====== ====== =========
Equity securities................................................ $ 161.4 $ 4.5 $ 9.9 $ 156.0
========= ====== ====== =========
117
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
Accumulated other comprehensive income is primarily comprised of unrealized
gains on actively managed fixed maturity investments. These amounts, included in
shareholders' equity (deficit) as of December 31, 2003 and 2002, were as follows
(dollars in millions):
Successor Predecessor
--------- -----------
December 31, December 31,
2003 2002
---- ----
Net unrealized gains on investments.................................................. $ 375.2 $448.1
Adjustment to value of policies inforce at the Effective Date........................ (33.5) -
Adjustments to cost of policies purchased and cost of policies produced.............. - (95.3)
Deferred income tax asset (liability)................................................ (123.0) 249.6
Other................................................................................ - (21.8)
------- ------
Accumulated other comprehensive income........................................ $ 218.7 $580.6
======= ======
Concentration of Actively Managed Fixed Maturity Securities
The following table summarizes the carrying values of our fixed maturity
securities by industry category as of December 31, 2003 (dollars in millions):
Percent of
Carrying value fixed maturities
-------------- ----------------
Mortgage-backed securities........................................................... $ 5,851.0 29.5%
Bank & Finance....................................................................... 2,713.5 13.7
Manufacturing........................................................................ 2,169.6 10.9
Utilities............................................................................ 1,322.1 6.7
Services............................................................................. 1,142.6 5.8
Communications....................................................................... 1,058.6 5.3
Asset-backed securities.............................................................. 761.6 3.8
Agri/Forestry/Mining................................................................. 761.1 3.8
Government (US)...................................................................... 733.6 3.7
Transportation....................................................................... 498.3 2.5
Retail/Wholesale..................................................................... 486.2 2.5
Other................................................................................ 2,341.9 11.8
--------- -----
Total fixed maturity securities................................................... $19,840.1 100.0%
========= =====
Below-Investment Grade Securities
At December 31, 2003, the amortized cost of the Company's fixed maturity
securities in below-investment grade securities was $734.5 million, or 3.8
percent of the Company's fixed maturity portfolio. The estimated fair value of
the below-investment grade portfolio was $776.0 million, or 106 percent of the
amortized cost. The value of these securities varies based on the economic terms
of the securities, structural considerations and the creditworthiness of the
issuer of the securities. Recently a number of large, highly leveraged issuers
have experienced significant financial difficulties, which resulted in our
recognition of other-than-temporary impairments.
Below-investment grade securities have different characteristics than
investment grade corporate debt securities. Risk of loss upon default by the
borrower is significantly greater with respect to below-investment grade
securities than with other corporate debt securities. Below-investment grade
securities are generally unsecured and are often subordinated to other creditors
of the issuer. Also, issuers of below-investment grade securities usually have
higher levels of debt and are more sensitive to adverse economic conditions,
such as recession or increasing interest rates, than are investment grade
issuers. The Company attempts to reduce the overall risk in the below-investment
grade portfolio, as in all investments, through careful credit analysis, strict
investment policy guidelines, and diversification by issuer and/or guarantor and
by industry.
118
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
Contractual Maturity
The following table sets forth the amortized cost and estimated fair value
of actively managed fixed maturities at December 31, 2003, by contractual
maturity. Actual maturities will differ from contractual maturities because
borrowers may have the right to call or prepay obligations with or without call
or prepayment penalties. Most of the mortgage-backed securities shown below
provide for periodic payments throughout their lives (dollars in millions).
Estimated
Amortized fair
cost value
---- -----
Due in one year or less...................................................................... $ 103.9 $ 105.1
Due after one year through five years........................................................ 1,256.0 1,271.2
Due after five years through ten years....................................................... 5,229.6 5,318.3
Due after ten years.......................................................................... 7,074.4 7,294.5
--------- ---------
Subtotal................................................................................. 13,663.9 13,989.1
Structured securities (a).................................................................... 5,806.8 5,851.0
--------- ---------
Total actively managed fixed maturities ............................................. $19,470.7 $19,840.1
========= =========
- --------------------
(a) Includes below-investment grade mortgage-backed securities with both
an amortized cost and estimated fair value of $2.1 million.
Net Investment Income
Net investment income consisted of the following (dollars in millions):
Successor Predecessor
-------------- -------------------------------------
Years
Four months Eight months ended
ended ended December 31,
December 31, August 31, -----------------
2003 2003 2002 2001
---- ---- ---- ----
Fixed maturities.............................................. $381.7 $812.8 $1,375.2 $1,510.7
Venture capital investment income (loss)...................... (5.5) 10.5 (99.3) (42.9)
Trading income related to policyholder and reinsurer accounts. 10.9 - - -
Equity securities............................................. 1.8 8.9 13.2 17.8
Mortgage loans................................................ 31.5 66.9 99.0 90.2
Policy loans.................................................. 10.7 23.0 32.6 35.9
Change in value of S&P 500 Call Options related to
equity-indexed products.................................... 42.2 25.2 (100.5) (114.2)
Other invested assets......................................... 7.9 28.4 15.7 24.6
Cash and cash equivalents..................................... 4.2 11.5 27.6 60.5
Separate accounts............................................. - - - (5.4)
------- ------ -------- --------
Gross investment income.................................... 485.4 987.2 1,363.5 1,577.2
Less investment expenses...................................... 10.8 18.2 29.2 27.2
------ ------ -------- --------
Net investment income...................................... $474.6 $969.0 $1,334.3 $1,550.0
====== ====== ======== ========
The carrying value of fixed maturity investments and mortgage loans not
accruing investment income totaled $50.7 million, $169.6 million and $140.2
million at December 31, 2003, 2002 and 2001, respectively.
119
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
Net Realized Investment Gains (Losses)
Net realized investment gains (losses) were included in revenue as follows
(dollars in millions):
Successor Predecessor
--------------- -----------------------------------
Years
Four months Eight months ended
ended ended December 31,
December 31, August 31, -----------------
2003 2003 2002 2001
---- ---- ---- ----
Fixed maturities:
Gross gains................................................ $27.6 $129.0 $ 260.8 $ 295.8
Gross losses............................................... (7.3) (62.4) (251.8) (260.3)
Other-than-temporary decline in fair value................. (3.7) (44.7) (500.6) (293.2)
----- ------ ------- -------
Net realized investment gains (losses) from fixed
maturities.......................................... 16.6 21.9 (491.6) (257.7)
Equity securities.............................................. - (3.4) (7.5) (1.8)
Mortgages...................................................... - (15.6) (1.4) (1.9)
Other-than-temporary decline in fair value of equity securities
and other invested assets.................................. (5.9) (6.6) (56.2) (68.5)
Other ......................................................... 1.1 (1.7) .4 (10.1)
----- ------ ------- -------
Net realized investment gains (losses)................ $11.8 $ (5.4) $(556.3) $(340.0)
===== ====== ======= =======
During the four months ended December 31, 2003, we recognized net realized
investment gains of $11.8 million. Such net realized investment gains during the
four months ended December 31, 2003 included: (i) $21.4 million of net gains
from the sales of investments (primarily fixed maturities) which generated
proceeds of $5.2 billion; net of (ii) $9.6 million of writedowns of fixed
maturity investments, equity securities and other invested assets as a result of
conditions which caused us to conclude a decline in fair value of the investment
was other-than-temporary. During the first eight months of 2003, we recognized
net realized investment losses of $5.4 million. The net realized investment
losses during the first eight months of 2003 included: (i) $45.9 million of net
gains from the sales of investments (primarily fixed maturities) which generated
proceeds of $5.4 billion; net of (ii) $51.3 million of writedowns of fixed
maturity investments, equity securities and other invested assets as a result of
conditions which caused us to conclude a decline in fair value of the investment
was other than temporary. At December 31, 2003, fixed maturity securities in
default as to the payment of principal or interest had an aggregate amortized
cost of $15.1 million and a carrying value of $16.6 million. Net realized
investment losses during 2002 included: (i) $556.8 million of writedowns of
fixed maturity investments, equity securities and other invested assets as a
result of conditions which caused us to conclude a decline in fair value of the
investment was other than temporary; net of (ii) $.5 million of net gains from
the sales of investments (primarily fixed maturities). Net realized investment
losses during 2001 included: (i) $361.7 million of writedowns of fixed maturity
investments, equity securities and other invested assets as a result of
conditions which caused us to conclude a decline in fair value of the investment
was other than temporary; and (ii) $21.7 million of net gains from the sales of
investments (primarily fixed maturities).
During the four months ended December 31, 2003, we sold $604.9 million of
fixed maturity investments which resulted in gross investment losses (before
income taxes) of $7.3 million. During the first eight months of 2003, we sold
$2.7 billion of fixed maturity investments which resulted in gross investment
losses (before income taxes) of $62.4 million. Securities sold at a loss are
sold for a number of reasons including: (i) changes in the investment
environment; (ii) expectation that the market value could deteriorate further;
(iii) desire to reduce our exposure to an issuer or an industry; (iv) changes in
credit quality; and (v) our analysis indicating there is a high probability that
the security is other-than-temporarily impaired.
120
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
The following summarizes the investments sold at a loss during the first
eight months of 2003 which had been continuously in an unrealized loss position
exceeding 20 percent of the amortized cost basis prior to the sale for the
period indicated (there were no such investments sold at a loss during the four
months ended December 31, 2003)(dollars in millions):
At date of sale
-----------------------------
Number of Amortized Estimated Fair
Period issuers cost value
------ ------- ---- -----
Less than 6 months prior to sale.......................... 16 $32.0 $24.0
Greater than or equal to 6 and less than or equal to
12 months prior to sale................................ 8 40.6 25.7
Greater than 12 months prior to sale...................... 20 39.8 23.7
Investments with Other-Than-Temporary Losses
During the four months ended December 31, 2003, we recorded writedowns of
fixed maturity investments and equity securities totaling $9.6 million as
further described in the following paragraphs:
During the four months ended December 31, 2003, we recognized a loss of
$5.7 million related to our holdings in a holding company for small investment
management related firms. Alleged irregularities at one subsidiary of the
holding company regarding late trading and market timing activities on behalf of
clients have made it probable that the value of the subsidiary has been
substantially diminished, negatively affecting the value of investments in the
holding company. Accordingly, we concluded the decline in fair value was other
than temporary.
During the four months ended December 31, 2003, we recognized a loss of
$3.3 million related to our holdings in a utility plant in Brazil. This utility
has experienced reduced earnings and cash flow, local corporate law and
regulatory issues and has been impacted by economic difficulties in Brazil.
Accordingly, we concluded the decline in fair value was other than temporary.
In addition to the specific investments discussed above, we recorded $.6
million of writedowns related to various other fixed maturities.
During the eight months ended August 31, 2003, we recorded writedowns of
fixed maturity investments, equity securities and other invested assets totaling
$51.3 million as further described in the following paragraphs:
During the eight months ended August 31, 2003, we recognized a loss of
$11.1 million to record certain commercial loans at their estimated fair value
as we intended to liquidate them and use the proceeds to repay the senior
financing used to acquire the loans. No additional gain or loss was recognized
upon the ultimate disposition of the loans.
During the eight months ended August 31, 2003, we recorded writedowns of
$9.6 million related to holdings of a fixed income security in a trust which
leases airplanes and related equipment. We believe that the collateral
supporting these investments has eroded and, therefore, we concluded the decline
in fair value was other than temporary.
During the eight months ended August 31, 2003, we recorded writedowns of
$8.4 million related to our holdings of fixed maturity investments in a major
airline that has filed bankruptcy. Although our investments are backed by
collateral, our analysis of the value of the underlying collateral indicated
that the decline in fair value of the investment is other than temporary.
During the eight months ended August 31, 2003, we recorded writedowns of
$4.2 million related to our investment in a limited partnership organized for
the purpose of making, owning, managing and disposing of investments. Our
analysis of the financial condition of the partnership indicated that the
decline in fair value was other than temporary.
121
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
During the eight months ended August 31, 2003, we recorded writedowns of
$3.7 million related to our holdings of fixed maturity investments in a
fertilizer company that has filed for bankruptcy. A significant portion of its
production capacity was rendered unprofitable due to high raw material costs and
was temporarily idled. Accordingly, we concluded that the decline in fair value
was other than temporary.
During the eight months ended August 31, 2003, we recorded writedowns of
$1.8 million related to holdings in a health care company that has had financial
problems due to financial misstatements, substantial regulatory and litigation
exposure and its failure to meet debt service requirements. The adverse effect
on liquidity and access to capital may force this issuer to file for bankruptcy.
Accordingly, we concluded the decline in fair value was other than temporary.
During the eight months ended August 31, 2003, we recorded writedowns of
$1.5 million related to holdings of a fixed income security of a finance company
that has had significant financial and liquidity problems. Accordingly, we
concluded the decline in fair value was other than temporary.
In addition to the specific investments discussed above, we recorded $11.0
million of writedowns related to various other fixed maturity investments. No
other writedown of a single issuer exceeded $1.5 million.
Recognition of Losses
We regularly evaluate all of our investments for possible impairment based
on current economic conditions, credit loss experience and other
investee-specific developments. If there is a decline in a security's net
realizable value that is other than temporary, the decline is recognized as a
realized loss and the cost basis of the security is reduced to its estimated
fair value.
Our evaluation of investments for impairment requires significant judgments
to be made including: (i) the identification of potentially impaired securities;
(ii) the determination of their estimated fair value; and (iii) assessment of
whether any decline in estimated fair value is other than temporary. If new
information becomes available or the financial condition of the investee
changes, our judgments may change resulting in the recognition of an investment
loss at that time.
Our periodic assessment of whether unrealized losses are "other than
temporary" requires significant judgment. Factors considered include: (i) the
extent to which market value is less than the cost basis; (ii) the length of
time that the market value has been less than cost; (iii) whether the unrealized
loss is event driven, credit-driven or a result of changes in market interest
rates; (iv) the near-term prospects for improvement in the issuer and/or its
industry; (v) whether the investment is investment-grade and our view of the
investment's rating and whether the investment has been downgraded since its
purchase; (vi) whether the issuer is current on all payments in accordance with
the contractual terms of the investment and is expected to meet all of its
obligations under the terms of the investment; (vii) our ability and intent to
hold the investment for a period of time sufficient to allow for any anticipated
recovery; and (viii) the underlying current and prospective asset and enterprise
values of the issuer and the extent to which our investment may be affected by
changes in such values.
If a decline in value is determined to be other than temporary and the cost
basis of the security is written down to fair value, we review the circumstances
which caused us to believe that the decline was other than temporary with
respect to other investments in our portfolio. If such circumstances exist with
respect to other investments, those investments are also written down to fair
value. Future events may occur, or additional or updated information may become
available, which may necessitate future realized losses of securities in our
portfolio. Significant losses in the carrying value of our investments could
have a material adverse effect on our earnings in future periods.
The following table sets forth the amortized cost and estimated fair value
of those actively managed fixed maturities with unrealized losses at December
31, 2003, by contractual maturity. Actual maturities will differ from
contractual maturities because borrowers may have the right to call or prepay
obligations with or without call or prepayment penalties. Most of the structured
securities shown below provide for periodic payments throughout their lives
(dollars in millions).
122
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
Estimated
Amortized fair
cost value
----------- -----------
Due in one year or less................................................................... $ 37.8 $ 37.7
Due after one year through five years..................................................... 86.8 84.7
Due after five years through ten years.................................................... 556.9 550.9
Due after ten years....................................................................... 457.0 445.8
-------- --------
Subtotal............................................................................... 1,138.5 1,119.1
Structured securities..................................................................... 1,691.0 1,676.0
-------- --------
Total.................................................................................. $2,829.5 $2,795.1
======== ========
The following summarizes the investments in our portfolio rated
below-investment grade or classified as equity-type securities which have been
continuously in an unrealized loss position exceeding 20 percent of the cost
basis for the period indicated as of December 31, 2003 (dollars in millions):
Number Cost Unrealized Estimated
Period of issuers basis loss fair value
------ ---------- ----- ---- ----------
Less than 6 months(1)............................... 2 $.4 $.1 $.3
-----------------------
(1) No single issuer in this category had an unrealized loss
exceeding $.5 million.
Our investment strategy is to maximize over a sustained period and within
acceptable parameters of risk, investment income and total investment return
through active investment management. Accordingly, we may sell securities at a
gain or a loss to enhance the total return of the portfolio as market
opportunities change. While we have both the ability and intent to hold
securities with unrealized losses until they mature or recover in value, we may
sell securities at a loss in the future because of actual or expected changes in
our view of the particular investment, its industry, its type or the general
investment environment.
Based on management's current assessment of these securities and other
investments with unrealized losses at December 31, 2003, the Company believes
the issuers of the securities will continue to meet their obligations (or with
respect to equity-type securities, the investment value will recover to its cost
basis). The Company has no current plans to sell these securities and has the
ability to hold them to maturity. The recognition of an other-than-temporary
impairment through a charge to earnings may be recognized in future periods if
management later concludes that the decline in market value below the cost basis
is other than temporary.
Investment in General Motors Building
During the summer of 2003, we successfully enforced our contractual right
to buy out our 50 percent equity partner in the GM building, a landmark 50-story
office tower in New York City. After obtaining an award in arbitration, and
confirming that award in the New York court system, we finally settled our
differences with our equity partner, thus permitting us to put the building up
for sale. On September 26, 2003, we sold our investment in the GM building. We
received cash of $636.8 million, which was approximately equal to the value
established upon the adoption of fresh start accounting.
Our investment in the GM building was made through a partnership which
acquired the building in 1998 for $878 million. The initial capital structure of
the partnership consisted of: (i) a $700 million senior mortgage; (ii) $200
million of subordinated debt with a stated fixed return of 12.7 percent
payable-in-kind, and the opportunity to earn an additional residual return; and
(iii) $30 million of partnership equity, owned 50 percent by Conseco and 50
percent by an affiliate of
123
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
Donald Trump. A Trump affiliate also served as general manager of the acquired
building. We owned 100 percent of the subordinated debt.
The $30 million of partnership equity represented less than 10 percent of
the total capital of the partnership. In addition, the subordinated debt was
intended to absorb virtually all expected losses and receive a significant
portion of expected residual returns. Based on our 100 percent ownership of the
subordinated debt, we were the primary beneficiary of the GM building. The
partnership was consolidated in our financial statements effective August 31,
2003 in accordance with the requirements of FIN 46, which was implemented in
conjunction with fresh start accounting. The August 31, 2003 fresh start balance
sheet reflected the following balances of the partnership: the GM building at
$1,336.3 million; cash of $28.4 million; and a non-recourse loan of $700 million
(classified as an investment borrowing). Net investment income for the four
months ended December 31, 2003, reflects $2.9 million related to this investment
(representing our equity interest in the income from the building for the 26
days prior to the sale).
Structured Securities
At December 31, 2003, fixed maturity investments included $5.9 billion of
structured securities (or 29 percent of all fixed maturity securities).
Structured securities include mortgage-backed securities, collateralized
mortgage obligations, asset-backed securities and commercial mortgage-backed
securities. The yield characteristics of structured securities differ from those
of traditional fixed-income securities. Interest and principal payments for
mortgage-backed securities occur more frequently, often monthly. Mortgage-backed
securities are subject to risks associated with variable prepayments. Prepayment
rates are influenced by a number of factors that cannot be predicted with
certainty, including: the relative sensitivity of the underlying mortgages
backing the assets to changes in interest rates; a variety of economic,
geographic and other factors; and the repayment priority of the securities in
the overall securitization structures.
In general, prepayments on the underlying mortgage loans and the securities
backed by these loans increase when prevailing interest rates decline
significantly relative to the interest rates on such loans. The yields on
mortgage-backed securities purchased at a discount to par will increase when the
underlying mortgages prepay faster than expected. The yields on mortgage-backed
securities purchased at a premium will decrease when the underlying mortgages
prepay faster than expected. When interest rates decline, the proceeds from the
prepayment of mortgage-backed securities may be reinvested at lower rates than
we were earning on the prepaid securities. When interest rates increase,
prepayments on mortgage-backed securities decrease as fewer underlying mortgages
are refinanced. When this occurs, the average maturity and duration of the
mortgage-backed securities increase, which decreases the yield on
mortgage-backed securities purchased at a discount, because the discount is
realized as income at a slower rate, and increases the yield on those purchased
at a premium as a result of a decrease in the annual amortization of the
premium.
Pursuant to fresh start reporting, we were required to mark all of our
investments to market value. The current interest rate environment is much lower
than when most of our investments were purchased. Accordingly, the fresh start
values of our investments generally exceed the par values of such investments.
The amount of value exceeding par is referred to as a "purchase premium" which
is amortized against future income. If prepayments in any period are higher than
expected, purchase premium amortization is increased. In periods of unexpectedly
high prepayment activity, the increased amortization will reduce net investment
income.
124
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
The following table sets forth the par value, amortized cost and estimated
fair value of structured securities, summarized by interest rates on the
underlying collateral at December 31, 2003 (dollars in millions):
Par Amortized Estimated
value cost fair value
----- ---- ----------
Below 4 percent..................................................................... $ 60.4 $ 63.4 $ 63.8
4 percent - 5 percent............................................................... 1,193.1 1,138.2 1,145.8
5 percent - 6 percent............................................................... 998.6 990.5 1,005.8
6 percent - 7 percent............................................................... 2,816.2 2,916.6 2,932.2
7 percent - 8 percent............................................................... 579.5 613.4 618.6
8 percent and above................................................................. 79.8 84.7 84.8
-------- -------- --------
Total structured securities (a).............................................. $5,727.6 $5,806.8 $5,851.0
======== ======== ========
- ----------------
(a) Includes below-investment grade structured securities with both an
amortized cost and estimated fair value of $2.1 million.
The amortized cost and estimated fair value of structured securities at
December 31, 2003, summarized by type of security, were as follows (dollars in
millions):
Estimated fair value
-----------------------
Percent
Amortized of fixed
Type cost Amount maturities
- ---- ---- ------ ----------
Pass-throughs and sequential and targeted amortization classes.......... $3,690.6 $3,718.1 19%
Planned amortization classes and accretion-directed bonds............... 714.0 713.6 3
Commercial mortgage-backed securities................................... 1,215.8 1,234.7 6
Subordinated classes and mezzanine tranches............................. 183.8 181.9 1
Other................................................................... 2.6 2.7 -
-------- -------- --
Total structured securities (a).................................. $5,806.8 $5,851.0 29%
======== ======== ==
- -------------------------
(a) Includes below-investment grade structured securities with both an
amortized cost and estimated fair value of $2.1 million.
Pass-throughs and sequential and targeted amortization classes have similar
prepayment variability. Pass-throughs historically provide the best liquidity in
the mortgage-backed securities market. Pass-throughs are also used frequently in
the dollar roll market and can be used as the collateral when creating
collateralized mortgage obligations. Sequential classes are a series of tranches
that return principal to the holders in sequence. Targeted amortization classes
offer slightly better structure in return of principal than sequentials when
prepayment speeds are close to the speed at the time of creation.
Planned amortization classes and accretion-directed bonds are some of the
most stable and liquid instruments in the mortgage-backed securities market.
Planned amortization class bonds adhere to a fixed schedule of principal
payments as long as the underlying mortgage collateral experiences prepayments
within a certain range. Changes in prepayment rates are first absorbed by
support or companion classes. This insulates the planned amortization class from
the consequences of both faster prepayments (average life shortening) and slower
prepayments (average life extension).
Commercial mortgage-backed securities ("CMBS") are bonds secured by
commercial real estate mortgages. Commercial real estate encompasses income
producing properties that are managed for economic profit. Property types
include multi-family dwellings including apartments, retail centers, hotels,
restaurants, hospitals, nursing homes, warehouses, and office buildings. The
CMBS market currently offers high yields, strong credits, and call protection
compared to similar-rated corporate bonds. Most CMBS have strong call protection
features where borrowers are locked out from prepaying their mortgages for a
stated period of time. If the borrower does prepay any or all of the loan, they
will be required to pay
125
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
prepayment penalties.
Subordinated and mezzanine tranches are classes that provide credit
enhancement to the senior tranches. The rating agencies require that this credit
enhancement not deteriorate due to prepayments for a period of time, usually
five years of complete lockout, followed by another period of time where
prepayments are shared pro rata with senior tranches. Subordinated and mezzanine
tranches bear a majority of the risk of loss due to property owner defaults.
Subordinated bonds are generally rated "AA" or lower; we typically do not hold
securities rated lower than "BB".
Mortgage Loans
At December 31, 2003, the mortgage loan balance was primarily comprised of
commercial loans. Approximately 8 percent, 7 percent, 7 percent and 6 percent of
the mortgage loan balance were on properties located in New York, Massachusetts,
Florida and Pennsylvania, respectively. No other state comprised greater than 5
percent of the mortgage loan balance. Less than one percent of the mortgage loan
balance was noncurrent at December 31, 2003. At December 31, 2003, we had no
allowance for losses on mortgage loans (mortgage loans were recorded at market
values at August 31, 2003, in conjunction with our adoption of fresh start
accounting). Our allowance for loss on mortgage loans was $3.5 million at
December 31, 2002.
Investment Borrowings
Our investment borrowings (excluding borrowings related to the GM building)
averaged approximately $488.9 million during the four months ended December 31,
2003; $689.1 million during the eight months ended August 31, 2003; and $1,155.8
million during the year ended December 31, 2002 and were collateralized by
investment securities with fair values approximately equal to the loan value.
The weighted average interest rates on such borrowings (excluding borrowings
related to the GM building) were 1.5 percent during the four months ended
December 31, 2003; 1.8 percent during the eight months ended August 31, 2003;
and 1.3 percent during the year ended December 31, 2002.
Other Investment Disclosures
Life insurance companies are required to maintain certain investments on
deposit with state regulatory authorities. Such assets had an aggregate carrying
value of $127.3 million and $144.5 million at December 31, 2003 and 2002,
respectively.
Conseco had three investments in excess of 10 percent of shareholders'
equity at December 31, 2003 and two investments in excess of 10 percent of
shareholders' equity at December 31, 2002, (other than investments issued or
guaranteed by the United States government or a United States government agency)
which are summarized below (dollars in millions):
2003 2002
--------------------------- -------------------------
Amortized Estimated Amortized Estimated
Issuer cost fair value cost fair value
------ ---- ---------- ---- ----------
Federal Home Loan Mortgage
Corporation.......................... $355.6 $364.5
Federal Home Loan Bank................. 312.3 314.9
Investors Guaranty Assurance........... 283.7 283.7 $305.0 $283.7
Carmel Fifth, LLC...................... 212.7 212.5
126
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
6. LIABILITIES FOR INSURANCE AND ASSET ACCUMULATION PRODUCTS
These liabilities consisted of the following (dollars in millions):
Successor Successor Predecessor
--------- ------------- -----------
Interest
Withdrawal Mortality rate December 31, December 31,
assumption assumption assumption 2003 2002
---------- ---------- ---------- ---- ----
Future policy benefits:
Interest-sensitive products:
Investment contracts.................... N/A N/A (c) $ 8,552.0 $ 8,856.8
Universal life-type contracts........... N/A N/A N/A 3,928.4 4,265.9
--------- ---------
Total interest-sensitive products..... 12,480.4 13,122.7
--------- ---------
Traditional products:
Traditional life insurance contracts.... Company (a) 5% 2,312.4 1,891.3
experience
Limited-payment annuities............... Company (b) 6% 1,003.7 846.5
experience,
if applicable
Individual and group accident and
health ............................... Company Company 6% 8,115.7 5,580.4
experience experience --------- ---------
Total traditional products............ 11,431.8 8,318.2
--------- ---------
Claims payable and other policyholder
funds ................................... N/A N/A N/A 892.3 909.2
Liabilities related to separate accounts
and investment trust...................... N/A N/A N/A 37.7 447.0
--------- ---------
Total................................... $24,842.2 $22,797.1
========= =========
- --------------------
(a) Principally, modifications of the 1965 - 70 and 1975 - 80 Basic, Select and
Ultimate Tables.
(b) Principally, the 1984 United States Population Table and the NAIC 1983
Individual Annuitant Mortality Table.
(c) In 2003, all of this liability represented account balances where future
benefits are not guaranteed. In 2002: (i) approximately 96 percent of this
liability represented account balances where future benefits are not
guaranteed; and (ii) approximately 4 percent represented the present value
of guaranteed future benefits determined using an average interest rate of
approximately 6 percent.
127
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
The Company establishes reserves for insurance policy benefits based on
assumptions as to investment yields, mortality, morbidity, withdrawals, lapses
and maintenance expenses. These reserves include amounts for estimated future
payment of claims based on actuarial assumptions. The balance is based on the
Company's best estimate (with assistance from an independent actuarial firm) of
the future policyholder benefits to be incurred on this business, given recent
and expected future changes in experience.
In accordance with SOP 90-7, the Successor established insurance
liabilities and an asset for the value of policies inforce at the effective date
using current assumptions. Adjustments to the Predecessor's liabilities for
insurance and asset accumulation products as of August 31, 2003 are summarized
below (dollars in millions):
Predecessor Fresh start Successor
balance sheet adjustments balance sheet
------------- ----------- -------------
Liabilities for insurance and asset accumulation products:
Traditional and limited payment products:
Traditional life insurance products .............................. $ 1,885.3 $ 320.3 $ 2,205.6
Limited pay annuities............................................ 880.0 140.0 1,020.0
Individual accident and health ................................... 5,245.8 1,887.9 7,133.7
Group life and health ............................................ 692.0 136.7 828.7
Unearned premiums ................................................ 3.3 - 3.3
--------- -------- ---------
Total liabilities for traditional and limited payment products. 8,706.4 2,484.9 11,191.3
--------- -------- ---------
Interest-sensitive products:
Investment contracts ............................................. 8,489.8 132.9 8,622.7
Universal life-type products ................................. 3,994.6 (15.4) 3,979.2
--------- -------- ---------
Total liabilities for interest-sensitive products.............. 12,484.4 117.5 12,601.9
--------- -------- ---------
Other liabilities for insurance and asset accumulation products:
Separate accounts and investment trusts .......................... 87.7 - 87.7
Claims payable and other policyholder funds ...................... 897.1 (10.3) 886.8
--------- -------- ---------
Total other liabilities for insurance and asset accumulation
products................................................... 984.8 (10.3) 974.5
--------- -------- ---------
Total liabilities for insurance and asset accumulation products......... $22,175.6 $2,592.1 $24,767.7
========= ======== =========
The following provides explanations for the fresh-start adjustment to
insurance liabilities related to our insurance inforce at the effective date.
Traditional insurance and limited pay products
In accordance with Statement of Financial Accounting Standards No. 60,
"Accounting and Reporting by Insurance Enterprises" and Statement of Financial
Accounting Standards No. 97, "Accounting and Reporting by Insurance Enterprises
for certain Long-Duration Contracts and for Realized Gains and Losses from the
Sale of Investments" ("SFAS 97"), the Predecessor used the original actuarial
assumptions determined when traditional long-duration and limited payment
insurance contracts were issued in determining liability calculations through
the fresh start date, provided the resulting liabilities were adequate to
provide for future benefits and expenses under the related contracts. This
accounting principle is referred to as the "lock in" principle and is only
applicable to traditional insurance and limited pay products. The use of
assumptions that are locked in at the time of issue means that absent loss
recognition, the same assumptions are used in accounting for a particular block
of business unless the block is subject to purchase or fresh start accounting.
At the Effective Date, the Successor established insurance liabilities at
the present value of future benefits and
128
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
expenses associated with the policies, by using current best-estimate
assumptions with provisions for adverse deviation. Such assumptions include
estimates as to investment yields, mortality, morbidity, withdrawals, lapses and
maintenance expenses. The current best-estimate assumptions for these blocks of
business differ from the original actuarial assumptions determined when the
business was acquired or issued as further described in the following
paragraphs.
Due to the current interest rate environment and the requirement to mark
the value of the investment portfolio to market, we changed our assumptions
related to future investment earnings. The weighted average expected yield on
our investment portfolio decreased to approximately 5.6 percent at the Effective
Date from 6.7 percent at December 31, 2002. Approximately $.9 billion of the
fresh-start increase to insurance liabilities is the result of changes in future
expected investment earnings.
The performance of our long-term care business (especially the acquired
block originally sold through independent agents) has generally been unfavorable
relative to the Predecessor's assumptions established when these blocks of
business were acquired. For example, variance in actual versus estimated
morbidity, lapses and expenses have been unfavorable to original assumptions.
Approximately $1.4 billion of the increase to insurance liabilities is the
result of changes in non-interest assumptions for our long-term care policies.
Our assumption changes for long-term care business included: (i) changes in
morbidity assumptions from estimates made when the business was acquired to
recent Company experience; (ii) changes in mortality assumptions related to
certain blocks of this business from the 1958 and 1980 Commissioners Standard
Ordinary Mortality table to the 1983 Group Annuity Mortality table; and (iii)
changes in ultimate lapse ratios from a range of approximately 3 percent to 5.5
percent prior to the adoption of fresh start accounting to a range of 2 percent
to 3.5 percent.
Interest-sensitive products subject to requirements of SFAS 97
The insurance liability for asset accumulation products (such as deferred
annuities and universal life products) is generally equal to current
policyholder account balances. These balances generally do not change as a
result of the adoption of fresh start accounting. The fresh-start adjustment to
insurance liabilities for interest-sensitive products primarily results from:
(i) the adoption of SOP 03-01 as of the Effective Date; and (ii) certain
Predecessor insurance liabilities that were different from the present value of
estimated future benefits as of August 31, 2003.
The adoption of SOP 03-01 as of the effective date required a change in
methodology regarding persistency bonuses provided to policyholders who continue
to keep their policies inforce for a stated period of time. The Predecessor
recognized the cost of this benefit over the period prior to the time the
benefit is credited in proportion to estimated gross profits and assumed a
certain number of policies would terminate before the benefit was credited.
Under SOP 03-01, the cost for such benefits is recognized ratably over the
period prior to the time the benefit is credited without assuming policy
terminations. Insurance liabilities increased by approximately $.1 billion as a
result of the adoption of SOP 03-01.
In addition, the insurance liabilities for certain Predecessor insurance
liabilities were different than the present value of estimated future benefits
as of the Effective Date.
The Predecessor had previously established an insurance liability related
to certain business, to recognize the future loss expected to be recognized for
the former practice of reducing the cost of insurance charges to amounts below
the level permitted under the provisions of the policy. The Predecessor
amortized this liability into income in proportion to estimated gross profits on
the business, consistent with SFAS 97 requirements for unearned revenues. The
Predecessor had previously decided to discontinue the practice of providing this
nonguaranteed benefit. Accordingly, the remaining insurance liability
established for this benefit was no longer required at August 31, 2003,
resulting in a $.1 billion reduction to reserves in conjunction with our
adoption of fresh-start accounting.
The liabilities established for our equity-indexed annuity products
(including the value of options attributable to policyholders for the estimated
life of the annuity contract and accounted for as embedded derivatives) are
established pursuant to different accounting rules than other interest-sensitive
products. At the Effective Date, the present value of estimated future benefits
for our equity-indexed products exceeded the value of the Predecessor's
liabilities by $.2 billion, resulting in a fresh-start adjustment.
129
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
Changes in the unpaid claims reserve and liabilities related to accident
and health insurance were as follows (dollars in millions):
December 31,
--------------------------------------
2003 2002 2001
---- ---- -----
Balance, beginning of the period..................................... $1,461.3 $1,360.4 $1,368.4
Less reinsurance ceded............................................ (52.8) (104.1) (29.8)
------- -------- --------
1,408.5 1,256.3 1,338.6
-------- -------- --------
Incurred claims related to:
Current year...................................................... 1,718.5 1,945.1 1,957.2
Prior year (a).................................................... 22.4 13.7 (80.0)
-------- -------- --------
Total incurred................................................. 1,740.9 1,958.8 1,877.2
-------- -------- --------
Interest on claim reserves........................................... 68.7 71.5 72.4
-------- -------- --------
Paid claims related to:
Current year...................................................... 978.2 1,171.2 1,239.8
Prior year........................................................ 743.2 706.9 792.1
-------- -------- --------
Total paid..................................................... 1,721.4 1,878.1 2,031.9
-------- -------- --------
Balance, end of the period........................................... 1,496.7 1,408.5 1,256.3
Reinsurance ceded................................................. 31.8 52.8 104.1
-------- -------- --------
$1,528.5 $1,461.3 $1,360.4
======== ======== ========
- -------------
(a) Such amounts will fluctuate based upon the estimation procedures used to
determine the amount of unpaid losses. Such estimates are the result of
ongoing analysis related to recent loss development trends.
130
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
7. INCOME TAXES
The components of income tax expense (benefit) were as follows (dollars in
millions):
Successor Predecessor
-------------- ----------------------------------
Years
Four months Eight months ended
ended ended December 31,
December 31, August 31, -----------------
2003 2003 2002 2001
---- ---- ---- ----
Current tax provision (benefit).................................. $(14.4) $(13.5) $ 53.1 $ 132.2
Deferred tax provision (benefit)................................. 67.6 - - (189.8)
------ ------ ------ -------
Income tax expense (benefit) on period income........... 53.2 (13.5) 53.1 (57.6)
Valuation allowance.............................................. - - 811.2 -
------ ------ ------ -------
Total income tax expense (benefit)...................... $ 53.2 $(13.5) $864.3 $ (57.6)
====== ====== ====== =======
The income tax expense (benefit) recorded in 2002 has been allocated
entirely to continuing operations before the following items: minority interest,
discontinued operations, cumulative effect of accounting change and other
comprehensive income. This accounting treatment is required because the
calculation of income tax expense is the same, both "with and without" the items
other than continuing operations discussed above.
A reconciliation of the U.S. statutory corporate tax rate to the effective
rate reflected in the consolidated statement of operations is as follows:
Successor Predecessor
--------------- ----------------------------------
Years
Four months Eight months ended
ended ended December 31,
December 31, August 31, -----------------
2003 2003 2002 2001
---- ---- ---- ----
U.S. statutory corporate rate.................................... 35.0% 35.0% (35.0)% (35.0)%
Valuation allowance.............................................. - 25.8 49.6 -
Gain on debt restructuring....................................... - (39.7) - -
Subsidiary stock basis adjustment................................ - (21.8) - -
Net deferred benefits not recognized in the current period....... - - 27.7 -
Nondeductible goodwill amortization and impairment............... - - 10.9 15.9
Other nondeductible expenses..................................... .8 (.1) (.1) (.9)
State taxes...................................................... .7 .2 (.2) 3.0
Provision for tax issues and other............................... (.9) - - (6.7)
---- ----- ----- -----
Effective tax rate...................................... 35.6% (.6)% 52.9% (23.7)%
==== ====== ===== =====
Conseco and its affiliates are currently under examination by the Internal
Revenue Service for tax years ending December 31, 1999 through December 31,
2001. The outcome of these examinations is not expected to result in material
adverse deficiencies, but may result in utilization or adjustment to the income
tax loss carryforwards reported below.
131
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
The components of the Company's income tax assets and liabilities were as
follows (dollars in millions):
Successor Predecessor
----------- -----------
December 31, December 31,
2003 2002
---- ----
Deferred tax assets:
Net operating loss carryforwards:
Portion attributable to CFC worthless investment............................... $1,183.0 $ -
Other.......................................................................... 84.2 615.0
Deductible temporary differences:
Actively managed fixed maturities.............................................. - 196.0
Capital loss carryforwards..................................................... 411.2 112.8
Interest-only securities....................................................... - 536.3
Insurance liabilities.......................................................... 1,591.3 750.4
Allowance for loan losses...................................................... - 252.2
Reserve for loss on loan guarantees............................................ 217.2 229.2
Debt obligations............................................................... - 39.4
Other.......................................................................... - 14.0
-------- --------
Gross deferred tax assets.................................................... 3,486.9 2,745.3
-------- --------
Deferred tax liabilities:
Actively managed fixed maturities.............................................. (33.4) -
Cost of policies purchased and cost of policies produced....................... (716.3) (773.8)
Unrealized appreciation........................................................ (123.0) (126.2)
Other.......................................................................... (252.1) (125.7)
-------- --------
Gross deferred tax liabilities............................................... (1,124.8) (1,025.7)
-------- --------
Valuation allowance............................................................ (2,362.1) (1,719.6)
-------- --------
Net deferred tax assets...................................................... - -
-------- --------
Current income taxes prepaid.......................................................... 24.6 66.9
Income tax liabilities classified as liabilities of discontinued operations........... - 34.6
-------- --------
Net income tax assets................................................................. $ 24.6 $ 101.5
======== ========
Our income tax expense includes deferred income taxes arising from
temporary differences between the financial reporting and tax bases of assets
and liabilities, capital loss carryforwards and net operating loss
carryforwards. The net deferred tax assets totaled $2,362.1 million at December
31, 2003. In assessing the realization of our deferred income tax assets, we
consider whether it is more likely than not that the deferred income tax assets
will be realized. The ultimate realization of our deferred income tax assets
depends upon generating future taxable income during the periods in which our
temporary differences become deductible and before our net operating loss
carryforwards expire. We evaluate the realizability of our deferred income tax
assets by assessing the need for a valuation allowance on a quarterly basis.
Based upon information existing at the time of our emergence from bankruptcy, we
established a valuation allowance against our entire balance of net deferred
income tax assets as we believed that the realization of such net deferred
income tax assets in future periods was uncertain. As of December 31, 2003, we
continue to believe that the realization of our net deferred income tax asset is
uncertain and that a valuation allowance is required for our entire balance of
net deferred income tax assets. We reached this conclusion after considering the
losses realized by the Company in recent years, the uncertainties related to the
tax treatment for the worthlessness of our investment in CFC, (which is more
fully discussed below), and the likelihood of future taxable income exclusive of
reversing temporary differences and carryforwards.
132
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
As of December 31, 2003, we had about $3.6 billion of net operating loss
carryforwards (after taking into account the reduction in tax attributes
described in the paragraph which follows and the loss resulting from the
worthlessness of CFC discussed below), which expire as follows: $11.2 million in
2004; $4.6 million in 2005; $.2 million in 2006; $5.8 million in 2007; $6.6
million in 2008; $10.5 million in 2009; $4.2 million in 2010; $2.5 million in
2011; $16.0 million in 2012; $43.4 million in 2013; $6.9 million in 2014; $60.4
million in 2016; $41.5 million in 2017; $3,399.5 million in 2018; $.7 million in
2019; $5.5 million in 2020; and $1.0 million in 2022. The timing and manner in
which we will utilize the net operating loss carryforwards in any year or in
total may be limited by various provisions of the Internal Revenue Code (the
"Code") (and interpretation thereof) and our ability to generate sufficient
future taxable income in the relevant carryforward period.
The Code provides that any income realized as a result of the cancellation
of indebtedness (cancellation of debt income or "CODI") in bankruptcy, will
reduce certain tax attributes including net operating loss carryforwards. We
realized an estimated $2.5 billion of CODI when we emerged from bankruptcy.
Accordingly, our net operating loss carryforwards were reduced by $2.5 billion.
The following paragraphs summarize some of the various limitations and
contingencies which exist with respect to the future utilization of the net
operating loss carryforwards.
The Company realized an estimated $5.4 billion tax loss in 2003 as a result
of its investment in CFC. In consultation with our tax advisors and based on
relevant provisions of the Code, the Company intends to treat this loss as an
ordinary loss, thereby increasing the Company's net operating loss carryforward.
The Company has requested a pre-filing examination by the IRS to confirm that
this loss should be treated as an ordinary loss. If the IRS were to disagree
with our conclusion and such determination ultimately prevailed, the loss would
be treated as a capital loss, which would only be available to reduce future
capital gains for the next 5 years. The procedures related to the pre-filing
examination are in process, but are not expected to be completed before August
2004.
The Code limits the extent to which losses realized by a non-life entity
(or entities) may offset income from a life insurance company (or companies) to
the lesser of: (i) 35 percent of the income of the life insurance company; or
(ii) 35 percent of the total loss. There is no limitation with respect to the
ability to utilize net operating losses generated by a life insurance company.
Subsequent to our emergence from bankruptcy, we reorganized certain of our
subsidiaries to improve their capital position. As a result of the
reorganization, the loss related to CFC was realized by a life insurance
company. Accordingly, we believe the loss should be treated as a life insurance
loss and would not be subject to the limitations described above. However, if
the IRS were to disagree with our conclusion and such determination ultimately
prevailed, the loss related to CFC would be subject to the limitation described
in the first sentence of this paragraph.
The timing and manner in which the Company will be able to utilize some or
all of its net operating loss carryforward may be limited by Section 382 of the
Code. Section 382 imposes limitations on a corporation's ability to use its net
operating losses if the company undergoes an ownership change. Because the
Company underwent an ownership change pursuant to its reorganization, we have
determined that this limitation applies to the Company. In order to determine
the amount of this limitation we must determine how much of our net operating
loss carryforward relates to the period prior to our emergence from bankruptcy
(such amount will be subject to the 382 limitation) and how much relates to the
period after emergence (such amount will not be subject to the 382 limitation).
Pursuant to the Code, we may: (i) allocate the current year tax loss on a pro
rata basis to determine earnings (loss) post- and pre-emergence; or (ii)
specifically identify transactions in each period and record it in the period it
actually occurred. We intend to elect the latter, which we believe will result
in a substantial portion of the loss related to CFC being treated as post
emergence and therefore not subject to the Section 382 limitation. Any losses
that are subject to the Section 382 limitation will only be utilized by the
Company up to approximately $140 million per year with any unused amounts
carried forward to the following year.
The reduction of any portion of our deferred income tax valuation allowance
(including the net operating loss carryforwards) existing as of August 31, 2003,
will be accounted for as a reduction of goodwill when utilized pursuant to SOP
90-7. If all goodwill is eliminated, any additional reduction of the valuation
allowance existing at August 31, 2003 will be accounted for as a reduction of
other intangible assets until exhausted and thereafter as an addition to
paid-in-capital. Goodwill was reduced by $189.4 million during the four months
ended December 31, 2003, due to a reduction in the valuation allowance for net
deferred income tax assets established at the Effective Date.
At December 31, 2003, Conseco had $1.2 billion of capital loss
carryforwards. These carryforwards will expire as follows: $2.7 million in 2005;
and $5.5 million in 2006; $484.4 million in 2007; and $682.2 million in 2008.
133
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
8. NOTES PAYABLE - DIRECT CORPORATE OBLIGATIONS
This note contains information regarding the following notes payable that
were direct corporate obligations of the Company as of December 31, 2003 and
2002 (dollars in millions).
Successor Predecessor
----------- -----------
December 31, December 31,
2003 2002
---- ----
$1.3 billion credit agreement................................................ $1,300.0 $ -
$1.5 billion senior credit facility.......................................... - 1,531.4
8.5% senior notes due 2002................................................... - 224.9
8.5% guaranteed senior notes due 2003........................................ - 1.0
8.125% senior notes due 2003................................................. - 63.5
6.4% senior notes due 2003................................................... - 234.1
6.4% guaranteed senior notes due 2004........................................ - 14.9
10.5% senior notes due 2004.................................................. - 24.5
8.75% senior notes due 2004.................................................. - 423.7
8.75% guaranteed senior notes due 2006....................................... - 364.3
6.8% senior notes due 2005................................................... - 99.2
6.8% guaranteed senior notes due 2007........................................ - 150.8
9.0% senior notes due 2006................................................... - 150.8
9.0% guaranteed senior notes due 2008........................................ - 399.2
10.75% senior notes due 2008................................................. - 37.6
10.75% guaranteed senior notes due 2009...................................... - 362.4
-------- --------
Total principal amount.................................................. 1,300.0 4,082.3
Unamortized net discount related to issuance of notes payable ............... - (34.0)
Unamortized fair market value of terminated interest rate swap
agreements (as described in the note entitled "Summary of
Significant Accounting Policies")..................................... - 8.8
-------- --------
Less amounts subject to compromise........................................... - (4,057.1)
-------- --------
Direct corporate obligations............................................ $1,300.0 $ -
======== ========
134
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
Pursuant to the Plan, we entered into a senior secured bank credit facility
with a principal balance of $1.3 billion (the "New Credit Facility"). The New
Credit Facility consists of two tranches: Tranche A - $1.0 billion; and Tranche
B - $.3 billion. Principal repayments are due as follows (dollars in millions):
Tranche A Tranche B
--------- ---------
June 30, 2004......................................................... $ 50.0 $ 3.0
June 30, 2005......................................................... 50.0 3.0
June 30, 2006......................................................... 50.0 1.5
December 31, 2006..................................................... 50.0 1.5
June 30, 2007......................................................... 75.0 1.5
December 31, 2007..................................................... 75.0 1.5
June 30, 2008......................................................... 75.0 1.5
December 31, 2008..................................................... 75.0 1.5
June 30, 2009......................................................... - 1.5
September 10, 2009.................................................... 500.0 -
December 31, 2009..................................................... - 1.5
September 10, 2010.................................................... - 282.0
-------- ------
$1,000.0 $300.0
======== ======
Tranche A and Tranche B borrowings bear interest, payable monthly, based on
either an offshore rate or a base rate. Offshore rates are equal to LIBOR plus
an applicable margin based on the rating of the Company's senior secured
long-term debt securities by Moody's Investors Service, Inc. ("Moody's") or S&P.
Base rates are equal to: (i) the greater of: (a) the Federal funds rate plus .50
percent; or (b) Bank of America's prime rate; plus (ii) an applicable margin
based on the rating of the Company's senior secured long-term debt securities by
Moody's or S&P. With respect to Tranche A, the LIBOR rate may not be less than
2.00 percent through September 30, 2004, or less than 2.50 percent thereafter.
With respect to Tranche B, the LIBOR rate may not be less than 2.25 percent
through September 30, 2004, or less than 2.75 percent thereafter. The range of
applicable margins are summarized in the following table:
Offshore Base rate
rate margin margin
----------- ---------
Tranche A...................................................... 3.75% - 5.25% 1.75% - 3.25%
Tranche B...................................................... 5.75% - 7.25% 3.75% - 5.25%
On December 31, 2003, the interest rates on our Tranche A and Tranche B
borrowings were 7.25 percent and 9.50 percent, respectively.
Pursuant to the New Credit Facility, the Company is required to make
mandatory prepayments with all or a portion of the proceeds from the following
transactions or events including: (i) the issuance of certain indebtedness; (ii)
equity issuances; (iii) certain asset sales or casualty events; (iv) a certain
percentage of amounts received or recovered with respect to the D&O loans; and
(v) excess cash flow as defined in the credit agreement. Proceeds not used to
prepay indebtedness must generally be: (i) used to redeem a portion of our
Preferred Stock; or (ii) contributed to the capital of our insurance
subsidiaries.
The New Credit Facility requires the Company to maintain various financial
ratios and balances, as defined in the agreement including: (i) a debt-to-total
capitalization ratio of less than .356:1.0 or less at December 31, 2003, and
decreasing over time to .200:1.0 at June 30, 2008 (such ratio was .334:1.0 at
December 31, 2003); (ii) an interest coverage ratio greater than or equal to
1.00:1.0 for the quarter ending December 31, 2003, and increasing over time to
4.50:1.0 for the year ending December 31, 2009 (such ratio was greater than
1.25:1.0 for the quarter ending December 31, 2003); (iii) EBITDA, as defined in
the credit agreement, greater than or equal to $490.0 million for the two
quarters ended March 31, 2004, and increasing over time to $1,296.0 million for
the four quarters ending March 31, 2010; (iv) an aggregate risk-based capital
ratio, as defined in the credit agreement, greater than or equal to 158 percent
at December 31, 2003, and increasing over time to 225 percent at March 31, 2006
(such ratio was 287 percent at December 31, 2003); (v) minimum individual
risk-based
135
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
capital ratios for certain insurance companies as of the end of each fiscal year
(such minimum ratios were exceeded at December 31, 2003); (vi) minimum levels of
statutory capital and surplus, as defined in the credit agreement (statutory
capital and surplus at December 31, 2003 exceeded such requirements); and (vii)
minimum investment portfolio requirements (such minimum investment portfolio
requirements were met at December 31, 2003).
The New Credit Facility prohibits or restricts, among other things: (i) the
payment of cash dividends on the Company's common or preferred stock; (ii) the
repurchase of our common stock; (iii) the issuance of additional debt or capital
stock; (iv) liens; (v) asset dispositions; (vi) affiliate transactions; (vii)
certain investment activities; (viii) change in business; and (ix) prepayment of
indebtedness (other than the New Credit Facility). The obligations under our New
Credit Facility are guaranteed by Conseco's current and future domestic
subsidiaries, other than: (i) its insurance companies; (ii) subsidiaries of the
insurance companies; or (iii) certain immaterial subsidiaries as defined in the
credit agreement. This guarantee was secured by granting liens on substantially
all the assets of the guarantors including the capital stock of our top tier
insurance company, Conseco Life Insurance Company of Texas.
Pursuant to the New Credit Facility, the Company is required to pay a fee
of $6.5 million on June 30, 2004, unless all borrowings under the credit
agreement have been repaid.
The outstanding notes payable that were direct corporate obligations of Old
Conseco prior to our emergence from bankruptcy and the $1.5 billion senior
credit facility were discharged in accordance with the Plan.
In April 2002, Old Conseco completed an exchange of approximately $1.3
billion aggregate principal amount of newly issued guaranteed notes for its
senior unsecured notes held by "qualified institutional buyers," institutional
"accredited investors", or non-U.S. persons in transactions outside the United
States. The bonds which were exchanged had identical principal and interest
components, but the new bonds had extended maturities in exchange for an
enhanced ranking in Old Conseco's capital structure. The purpose of the exchange
offer was to extend the maturity profile of the existing notes in an effort to
improve Old Conseco's financial flexibility and to enhance its future ability to
refinance public debt. The new notes were guaranteed on a senior subordinated
basis by CIHC. As a result, the new notes were structurally senior to the
existing notes. The new notes were not registered under the Securities Act of
1933, as amended, and could not be offered or sold in the United States absent
registration or an exemption from registration. Old Conseco entered into a
registration rights agreement for the benefit of each exchange participant in
which we agreed to file, and did file, an exchange offer registration statement
with the SEC with respect to the new notes. However, as a result of the decision
to restructure Old Conseco's capital, Old Conseco did not make the registered
exchange offer. Accordingly, the affected notes accrued additional interest as
liquidated damages under the registration rights agreement.
In connection with the exchange offer Old Conseco issued: (i) $991,000 of
8.5% senior notes due October 15, 2003, in exchange for an equal amount of 8.5%
Original Notes due October 15, 2002 (the "8.5% Exchange Notes"); (ii)
$14,936,000 of 6.4% senior notes due February 10, 2004 in exchange for an equal
amount of 6.4% Original Notes due February 10, 2003 (the "6.4% Exchange Notes");
(iii) $364,294,000 of 8.75% senior notes due August 9, 2006 in exchange for an
equal amount of 8.75% Original Notes due February 9, 2004 (the "8.75% Exchange
Notes"); (iv) $150,783,000 of 6.8% senior notes due June 15, 2007 in exchange
for an equal amount of 6.8% Original Notes due June 15, 2005 (the "6.8% Exchange
Notes"); (v) $399,200,000 of 9.0% senior notes due April 15, 2008 in exchange
for an equal amount of 9.0% Original Notes due October 15, 2006 (the "9.0%
Exchange Notes"); and (vi) $362,433,000 of 10.75% senior notes due June 15, 2009
in exchange for an equal amount of 10.75% Original Notes due June 15, 2008 (the
"10.75% Exchange Notes").
During 2002, we repurchased $77.4 million par value of our Predecessor's
notes payable resulting in a gain on the extinguishment of debt of $1.8 million.
During 2001, we repurchased $893.8 million par value of our Predecessor's
notes payable resulting in a gain on the extinguishment of debt of $17.0
million.
136
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
9. COMMITMENTS AND CONTINGENCIES
Litigation
We are involved on an ongoing basis in lawsuits (including purported class
actions) relating to our operations, including with respect to sales practices,
and we and current and former officers and former directors are defendants in a
pending class action lawsuit asserting claims under the securities laws. The
ultimate outcome of these lawsuits cannot be predicted with certainty and we
have estimated the potential exposure for each of the matters and have recorded
a liability if a loss is deemed probable.
Securities Litigation
Since we announced our intention to restructure our capital on August 9,
2002, a total of eight purported securities fraud class action lawsuits have
been filed in the United States District Court for the Southern District of
Indiana. The complaints name us as a defendant, along with certain of our
current and former officers. These lawsuits were filed on behalf of persons or
entities who purchased our Predecessor's common stock on various dates between
October 24, 2001 and August 9, 2002. In each case the plaintiffs allege claims
under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as
amended (the "Exchange Act") and allege material omissions and dissemination of
materially misleading statements regarding, among other things, the liquidity of
Conseco and alleged problems in CFC's manufactured housing division, allegedly
resulting in the artificial inflation of our Predecessor's stock price. On March
13, 2003, all of these cases were consolidated into one case in the United
States District Court for the Southern District of Indiana, captioned Franz
Schleicher, et al. v. Conseco, Inc., Gary Wendt, William Shea, Charles Chokel
and James Adams, et al., Case No. 02-CV-1332 DFH-TAB. The lawsuits were stayed
as to all defendants by order of the United States Bankruptcy Court for the
Northern District of Illinois. The stay was lifted on October 15, 2003. The
plaintiffs have filed a consolidated class action complaint with respect to the
individual defendants. We expect to be filing a motion to dismiss in March 2004.
Our liability with respect to these lawsuits was discharged in the Plan and our
obligation to indemnify individual defendants who were not serving as one of our
officers or directors on the Effective Date is limited to $3 million in the
aggregate under the Plan. Our liability to indemnify individual defendants who
were serving as an officer or director on the Effective Date, of which there is
one such defendant, is not limited by the Plan. We believe these lawsuits are
without merit and intend to defend them vigorously. The ultimate outcome of
these lawsuits cannot be predicted with certainty.
Other Litigation
Collection efforts by the Company and its wholly owned subsidiary, Conseco
Services, LLC, related to the 1996-1999 director and officer loan programs have
been commenced against various past board members and executives with
outstanding loan balances. In addition, certain former officers and directors
have sued the companies for declaratory relief concerning their liability for
the loans. Currently, we are involved in litigation with Stephen C. Hilbert,
James D. Massey, Dennis E. Murray, Sr., Rollin M. Dick, James S. Adams, Maxwell
E. Bublitz, Ngaire E. Cuneo, David R. Decatur, Donald F. Gongaware and Bruce A.
Crittenden. The specific lawsuits include: Hilbert v. Conseco, Case No. 03A
04283 (Bankr. Northern District, Illinois); Conseco Services v. Hilbert, Case
No. 29C01-0310 MF 1296 (Circuit Court, Hamilton County, Indiana); Murray and
Massey v. Conseco, Case No. 1:03-CV-1482 LJM-WTL (Southern District, Indiana);
Conseco Services v. Adams, et al, Case No. 29DO2- 0312-CC-1035(Circuit Court,
Hamilton County, Indiana); Conseco v. Adams, et al, Case No. 03A 04545, (Bankr.
Northern District, Illinois) Dick v. Conseco Services, Case No. 29
D01-0207-PL-549 (Superior Court, Hamilton County, Indiana); Conseco Services v.
Dick, et al., Case No. 06C01-0311-CC-356 (Circuit Court, Boone County, Indiana);
Stephen C. Hilbert v. Conseco, Inc. and Kroll Inc., Case No. 29D02-0312-PL-1026
(Superior Court, Hamilton County, Indiana) and Crittenden v. Conseco, Case No.
IP02-1823-C B/S (Southern District, Indiana). The Company and Conseco Services,
LLC believe that all amounts due under the director and officer loan programs,
including all applicable interest, are valid obligations owed to the companies.
As part of the Plan, we have agreed to pay 45 percent of any net proceeds
recovered in connection with these lawsuits, in an aggregate amount not to
exceed $30 million, to former holders of our Predecessor's trust preferred
securities that did not opt out of a settlement reached with the committee
representing holders of these securities. We are required to use the balance of
any net proceeds recovered in connection with these lawsuits to pay down our
Senior Credit Facility. Any remaining proceeds will be used to contribute
capital to our insurance subsidiaries. We intend to prosecute these claims to
obtain the maximum recovery possible. Further, with regard to the various claims
brought against the Company and Conseco Services, LLC by certain former
directors and officers, we believe that these claims are without merit and
intend to defend them vigorously. The ultimate outcome of the lawsuits
137
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
cannot be predicted with certainty.
In October 2002, Roderick Russell, on behalf of himself and a class of
persons similarly situated, and on behalf of the ConsecoSave Plan, filed an
action in the United States District Court for the Southern District of Indiana
against our Predecessor, Conseco Services, LLC and certain of our current and
former officers (Roderick Russell, et al. v Conseco, Inc., et al., Case No.
1:02-CV-1639 LJM). The purported class action consists of all individuals whose
401(k) accounts held common stock of our Predecessor at any time since April 28,
1999. The complaint alleges, among other things, breaches of fiduciary duties
under ERISA by continuing to permit employees to invest in our Predecessor's
common stock without full disclosure of the Company's true financial condition.
We filed a motion to dismiss the complaint in December 2002. This lawsuit was
stayed as to all defendants by order of the Bankruptcy Court. The stay was
lifted on October 15, 2003. It is expected that the plaintiffs will be amending
their complaint in March or April of 2004. On February 13, 2004, the Company's
fiduciary insurance carrier, RLI Insurance Company filed a declaratory judgment
action asking the court to find no liability under its policy for the claims
made in the Russell matter (RLI Insurance Company v. Conseco, Inc., Stephen
Hilbert, et al., Case No. 1:04-CV-0310DFH-TAB (Southern District, Indiana.)) We
believe the lawsuits are without merit and intend to defend them vigorously. The
ultimate outcome of the lawsuit cannot be predicted with certainty.
On June 24, 2002, the heirs of a former officer, Lawrence Inlow, commenced
an action against our Predecessor, Conseco Services, LLC and two former officers
in the Circuit Court of Boone County, Indiana (Inlow et al. v. Conseco, Inc., et
al., Cause No. 06C01-0206-CT-244). The heirs assert that unvested options to
purchase 756,248 shares of our Predecessor's common stock should have been
vested at Mr. Inlow's death. The heirs further claim that if such options had
been vested, they would have been exercised, and that the resulting shares of
common stock would have been sold for a gain of approximately $30 million based
upon a stock price of $58.125 per share, the highest stock price during the
alleged exercise period of the options. We believe the heirs' claims are without
merit and will defend the action vigorously. The maximum exposure to the Company
for this lawsuit is estimated to be $33 million. The heirs did not file a proof
of claim with the Bankruptcy Court. Subject to dispositive motions which are yet
to be filed, the matter will continue to trial against Conseco Services, LLC and
the other co-defendants on September 13, 2004. The ultimate outcome cannot be
predicted with certainty.
On June 27, 2001, two suits against the Company's subsidiary, Philadelphia
Life Insurance Company (now known as Conseco Life Insurance Company), both
purported nationwide class actions seeking unspecified damages, were
consolidated in the U.S. District Court, Middle District of Florida (In Re PLI
Sales Litigation, Cause No. 01-MDL-1404), alleging among other things,
fraudulent sales and a "vanishing premium" scheme. Philadelphia Life filed a
motion for summary judgment against both named plaintiffs, which motion was
granted in June 2002. Plaintiffs appealed to the 11th Circuit. The 11th Circuit,
in July 2003, affirmed in part and reversed in part, allowing two fraud counts
with respect to one plaintiff to survive. The plaintiffs' request for a
rehearing with respect to this decision has been denied. Philadelphia Life has
filed a summary judgment motion with respect to the remaining claims. This
summary judgment was denied in February 2004. Philadelphia Life believes this
lawsuit is without merit and intends to defend it vigorously. The ultimate
outcome of the lawsuit cannot be predicted with certainty.
On December 1, 2000, the Company's former subsidiary, Manhattan National
Life Insurance Company, was named in a purported nationwide class action seeking
unspecified damages in the First Judicial District Court of Santa Fe, New Mexico
(Robert Atencio and Theresa Atencio, for themselves and all other similarly
situated v. Manhattan National Life Insurance Company, an Ohio corporation,
Cause No. D-0101-CV-2000-2817), alleging among other things fraud by
non-disclosure of additional charges for those policyholders paying via premium
modes other than annual. We retained liability for this litigation in connection
with the sale of Manhattan National Life in June 2002. We believe this lawsuit
is without merit and intend to defend it vigorously. The ultimate outcome of the
lawsuit cannot be predicted with certainty.
On December 19, 2001, four of the Company's subsidiaries were named in a
purported nationwide class action seeking unspecified damages in the District
Court of Adams County, Colorado (Jose Medina and others similarly situated v.
Conseco Annuity Assurance Company, Conseco Life Insurance Company, Bankers
National Life Insurance Company and Bankers Life and Casualty Company, Cause No.
01-CV-2465), alleging among other things breach of contract regarding alleged
non-disclosure of additional charges for those policy holders paying via premium
modes other than annual. On July 14 and 15, 2003 the plaintiff's motion for
class certification was heard and the Court took the matter under advisement. On
November 10, 2003, the Court denied the motion for class certification. On
January 26, 2004, the plaintiff appealed the trial court's ruling denying class
certification. All further proceedings have been stayed pending the outcome of
the appeal. The defendants believe this lawsuit is without merit and intend to
defend it vigorously. The ultimate outcome of the lawsuit
138
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
cannot be predicted with certainty.
The Company's subsidiaries, Conseco Life Insurance Company and Bankers Life
and Casualty Company, have recently been named in multiple purported class
actions and individual lawsuits alleging, among other things, breach of contract
with regard to a change made in the way monthly deductions are calculated for
insurance coverage. This change was the adjustment of a non-guaranteed element,
which was not in the applicable policy form. The specific lawsuits include:
David Barton v. Conseco Life Insurance Company, Case No. 04-20048-CIV-MORENO
(Southern District, Florida); Stephen Hook, an individual, on behalf of himself
and all others similarly situated v. Conseco Life Insurance Company and Bankers
Life and Casualty Company and Does 1 through 10, Case No. CGC-04-428872
(Superior Court, San Francisco County, California); Donald King, as Trustee of
the Irrevocable Trust of Arnold L. King v. Conseco Life Insurance Company, Case
No. 1: 04CV0163 (Northern District, Ohio); Michael S. Kuhn, on behalf of himself
and all others similarly situated v. Conseco Life Insurance Company and Does 1
through 100, Case No. 03-416786 (Superior Court, San Francisco County,
California); Sidney H. Levine and Judith A. Levine v. Conseco Life Insurance
Company, Mark F. Peters Insurance Services, Inc. Hon. John Garamendi (in his
capacity as Insurance Commissioner for the State of California) and Does 1
through 10, Case No. 04 CV 125 LAB (BLM) (Southern District, California); Alene
P. Mangelson, as Trustee for the Ned L. Mangelson Life Insurance Trust, Marie M.
Berg and Michelle M. Wilcox on behalf of themselves and all others similarly
situated v. Conseco Life Insurance Company, Case No. 29D02-0312-PL-1034
(Superior Court, Hamilton County, Indiana); Edward M. Medvene, an Individual,
and Sherwin Samuels and Miles Rubin, as Trustees of the Edward Medvene 2984
Insurance Trust v. Conseco Life Insurance Company, Case No. CV04-846-AHM (MCX)
(Central District, California). We believe these lawsuits are without merit and
intend to defend them vigorously. The ultimate outcome of the lawsuits cannot be
predicted with certainty.
On February 7, 2003, the Company's subsidiary, Conseco Life Insurance
Company, was named in a purported Texas statewide class action seeking
unspecified damages in the County Court of Cameron County, Texas. On February
12, 2004, the complaint was amended to allege a purported nationwide class and
to name Conseco Services, LLC as an additional defendant (Lawrence Onderdonk and
Yolanda Carrizales v. Conseco Life Insurance Company, Conseco Services, LLC, and
Pete Ramirez, III, Cause No. 2003-CCL-102-C). The purported class consists of
all former Massachusetts General Flexible Premium Adjustable Life Insurance
Policy policyholders who were converted to Conseco Life Flexible Premium
Adjustable Life Insurance Policies and whose accumulated values in the
Massachusetts General policies were applied to first year premiums on the
Conseco Life policies. The complaint alleges, among other things, civil
conspiracy to convert the accumulated cash values of the plaintiffs and the
class, and the violation of insurance laws nationwide. We believe this lawsuit
is without merit and intend to defend it vigorously. The ultimate outcome of the
lawsuit cannot be predicted with certainty.
On December 30, 2002 and December 31, 2002, five suits were filed in
various Mississippi counties against Conseco Life Insurance Company (Kathie
Allen, et al. v. Conseco Life Insurance Company, et al., Circuit Court of Jones
County, Mississippi, Cause No. 2002-448-CV12; Malcolm Bailey, et al. v. Conseco
Life Insurance Company, et al., Circuit Court of Claiborne County, Mississippi,
Cause No. CV-2002-371; Anthony Cascio, et al. v. Conseco Life Insurance Company,
et al, Circuit Court of LeFlore County, Mississippi, Cause No.
CV-2002-0242-CICI; William Garrard, et al. v. Conseco Life insurance Company, et
al., Circuit Court of Sunflower County, Mississippi, Cause No. CV-2002-0753-CRL;
and William Weaver, et al. v. Conseco Life Insurance Company, et al., Circuit
Court of LeFlore County, Mississippi, Cause No. CV-2002-0238-CICI) alleging,
among other things, a "vanishing premium" scheme. Conseco Life removed all of
the cases to the U.S. District Courts in Mississippi. In September 2003,
plaintiffs' motion to remand was denied in the Garrard and Weaver matters, but
granted in the Cascio matter. In November 2003, Conseco Life again removed the
Cascio matter to U.S. District Court. Conseco Life awaits the court's ruling on
Plaintiff's motion to remand in the Allen matter. In Bailey the parties have
agreed to stay in Federal court and the plaintiffs amended their complaint on
January 15, 2004 to allege purported nationwide class action allegations
regarding alleged wrongful collection of charges under the policy. On January
30, 2004 we filed a motion to dismiss or in alternative, motion for summary
judgment. Conseco Life believes the lawsuits are without merit and intends to
defend them vigorously. The ultimate outcome of the lawsuits cannot be predicted
with certainty.
In addition, the Company and its subsidiaries are involved on an ongoing
basis in other lawsuits and arbitrations (including purported class actions)
related to their operations. The ultimate outcome of all of these other legal
matters pending against the Company or its subsidiaries cannot be predicted,
and, although such lawsuits are not expected individually to have a material
adverse effect on the Company, such lawsuits could have, in the aggregate, a
material adverse effect on the Company's consolidated financial condition, cash
flows or results of operations.
139
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
Other Proceedings
On September 18, 2003, the Company received a grand jury subpoena from the
U.S. District Court for the Southern District of Indiana in connection with a
Department of Justice investigation requiring production of documents relating
to the valuation of interest-only securities held by CFC, our Predecessor's
former finance subsidiary, contemporaneous earnings estimates for the
Predecessor, certain personnel records and other accounting and financial
disclosure records for the period June 1, 1998 to June 30, 2000. The Company has
subsequently received follow-up grand jury document subpoenas concerning other
matters. All of these follow-up requests have been limited to the time period
prior to the December 17, 2002 bankruptcy filing. The Company has been advised
by the Department of Justice that neither it nor any of its current directors or
employees are subjects or targets of this investigation. The Company is
cooperating fully with the Department of Justice investigation.
On March 10, 2004, we entered into a settlement with the SEC in connection
with the SEC's investigation of events in and before the spring of 2000,
including CFC's accounting for its interest-only securities and servicing
rights. These issues were among those addressed in our Predecessor's writedown
and restatement in the spring of 2000, and were the subject of shareholder class
action litigation, which we settled in the second quarter of 2003. Without
admitting or denying the SEC's findings, we consented to the entry of a
cease-and-desist order requiring future compliance with periodic reporting,
record keeping, internal control and other provisions of the securities laws.
The settlement did not impose any fine or monetary penalty, or require us to
restate any of our historical financial statements.
On October 29, 2003, the New York Attorney General served Conseco Life
Insurance Company of Texas ("Conseco Life") with a document subpoena concerning
customer transfers between mutual fund subaccounts offered by CVIC, a former
wholly-owned subsidiary of Conseco Life, that occurred prior to the sale of CVIC
to an unrelated third party in October 2002. The SEC served the Company with a
similar subpoena shortly after we received the Attorney General's subpoena.
Certain of our employees have also received subpoenas regarding duties they
previously performed in respect of annuity sales by CVIC. The purchase agreement
pursuant to which CVIC was sold contains indemnification provisions with respect
to certain liabilities relating to Conseco Life's period of ownership, including
provisions concerning certain business activities (including marketing
activities) of CVIC. Conseco Life and the Company have cooperated with the
Attorney General and the SEC in producing documents responsive to their
subpoenas. In January 2004, the Company received telephonic notification of a
potential enforcement action by the Attorney General and a Wells notification
from the SEC regarding alleged market timing on the part of holders of variable
annuity policies issued by CVIC. The Company and its affiliates have not issued
any variable annuity policies since the sale of CVIC. The Company and Conseco
Life believe, based on the information obtained and supplied to the
investigators to date, that CVIC violated no federal or state law prior to the
October 2002 sale. The investigations are in a preliminary stage and their
outcome cannot be predicted with certainty. The Company and Conseco Life are
cooperating fully with the Attorney General and the SEC in these investigations.
The deadline to file administrative claims in the bankruptcy proceeding was
October 9, 2003. The Plan provides that all such claims must be paid in full, in
cash. We are reviewing all timely filed administrative claims and may resolve
disputes regarding allowance of such claims in the Bankruptcy Court. The amount
of known disputed administrative claims as of March 1, 2004 was approximately
$2.0 million.
Guaranty Fund Assessments
The balance sheet at December 31, 2003, includes: (i) accruals of $11.5
million, representing our estimate of all known assessments that will be levied
against the Company's insurance subsidiaries by various state guaranty
associations based on premiums written through December 31, 2003; and (ii)
receivables of $5.8 million that we estimate will be recovered through a
reduction in future premium taxes as a result of such assessments. At December
31, 2002, such guaranty fund assessment related accruals were $11.5 million and
such receivables were $7.5 million. These estimates are subject to change when
the associations determine more precisely the losses that have occurred and how
such losses will be allocated among the insurance companies. We recognized
expense (benefit) for such assessments of $1.2 million in the four months ended
December 31, 2003; $4.1 million in the eight months ended August 31, 2003; and
$(1.7) million and $6.5 million in 2002 and 2001, respectively.
Guarantees
In conjunction with the Plan, $481.3 million principal amount of bank loans
made to certain former directors and
140
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
certain current and former officers and key employees to enable them to purchase
common stock of Old Conseco were transferred to the Company. These loans had
been guaranteed by Old Conseco. We received all rights to collect the balances
due pursuant to the original terms of these loans. In addition, we hold loans to
participants for interest on the bank loans which total approximately $220
million. The former bank loans and the interest loans are collectively referred
to as the "D&O loans." We regularly evaluate the collectibility of these loans
in light of the collateral we hold and the credit worthiness of the
participants. At December 31, 2003, we have estimated that approximately $51.0
million of the D&O balance (which is included in other assets) is collectible
(net of the cost of collection). An allowance has been established to reduce the
recorded balance of the D&O loans to this balance.
Pursuant to the settlement that was reached with the Official Committee of
the Trust Originated Preferred Securities ("TOPrS") Holders and the Official
Committee of Unsecured Creditors in the Plan, the former holders of TOPrS
(issued by Old Conseco's subsidiary trusts and eliminated in our reorganization)
who did not opt out of the bankruptcy settlement, will be entitled to receive 45
percent of any proceeds from the collection of certain D&O loans in an aggregate
amount not to exceed $30 million. We have established a liability of $23.1
million (which is included in other liabilities), representing our estimate of
the amount which will be paid to the former holders of TOPrS pursuant to the
settlement.
In accordance with the terms of the Company's former Chief Executive
Officer's employment agreement, Bankers Life and Casualty Company, a
wholly-owned subsidiary of the Company, is the guarantor of the former
executive's nonqualified supplemental retirement benefit. The liability for such
benefit at December 31, 2003 and 2002 was $15.6 million and $14.8 million,
respectively, and is included in the caption "Other liabilities" in the
liability section of the consolidated balance sheet.
Leases
The Company rents office space, equipment and computer software under
noncancellable operating leases. Rental expense was $19.1 million in the four
months ended December 31, 2003; $26.7 million in the eight months ended August
31, 2003; and $41.5 million and $45.3 million in 2002 and 2001, respectively.
Future required minimum rental payments as of December 31, 2003, were as follows
(dollars in millions):
2004 ........................................................................... $ 23.0
2005 ........................................................................... 21.5
2006 ........................................................................... 18.7
2007 ........................................................................... 15.6
2008 ........................................................................... 14.1
Thereafter........................................................................ 24.1
------
Total..................................................................... $117.0
======
141
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
10. OTHER DISCLOSURES
Postretirement Plans
One of our insurance subsidiaries has a noncontributory, unfunded deferred
compensation plan for qualifying members of its career agency force. Benefits
are based on years of service and career earnings. The liability recognized in
the consolidated balance sheet for the agents' deferred compensation plan was
$64.7 million and $54.2 million at December 31, 2003 and 2002, respectively.
Included as an adjustment to accumulated other comprehensive income (loss) as of
December 31, 2002, was a $9.1 million adjustment representing the additional
minimum liability associated with this plan. Substantially all of this liability
represents vested benefits. Costs incurred on this plan, primarily representing
interest on unfunded benefit costs were $1.5 million in the four months ended
December 31, 2003; $4.0 million in the eight months ended August 31, 2003; and
$5.1 million and $4.9 million during 2002 and 2001, respectively.
The Company provides certain health care and life insurance benefits for
certain eligible retired employees under partially funded and unfunded plans in
existence at the date on which certain subsidiaries were acquired. Certain
postretirement benefit plans are contributory, with participants' contributions
adjusted annually. Actuarial measurement dates of September 30 and December 31
are used for our postretirement benefit plans. Amounts related to the
postretirement benefit plans were as follows (dollars in millions):
Postretirement
benefits
-------------------------------
Successor Predecessor
----------- -----------
December 31, December 31,
2003 2002
---- ----
Benefit obligation, beginning of year....................... $ 24.6 $ 24.5
Interest cost........................................... 1.4 1.6
Plan participants' contributions........................ .4 1.1
Actuarial loss (gain)................................... (1.1) .4
Benefits paid........................................... (2.7) (3.0)
------ ------
Benefit obligation, end of year............................. $ 22.6 $ 24.6
====== ======
Fair value of plan assets, beginning of year................ $ 1.1 $ 2.0
Actual return on plan assets............................ - -
Employer contributions.................................. 1.6 2.1
Benefits paid........................................... (2.7) (3.0)
------ ------
Fair value of plan assets, end of year...................... $ - $ 1.1
====== ======
Funded status............................................... $(22.6) $(23.5)
Unrecognized net actuarial loss (gain)...................... - (7.1)
Unrecognized prior service cost............................. - (1.4)
------ ------
Prepaid (accrued) benefit cost....................... $(22.6) $(32.0)
====== ======
Plan assets as of December 31, 2002, consisted of an investment in the
Conseco Fixed Income Fund offered by Conseco Fund Group. The Conseco Fixed
Income Fund invested primarily in investment-grade debt securities.
142
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
We used the following weighted average assumptions to calculate:
2003 2002
---- ----
Benefit obligations:
Discount rate.............................................. 6.2% 6.5%
Net periodic cost:
Discount rate.............................................. 6.5% 7.0%
Expected return on plan assets............................. 4.6% 4.6%
The following assumed health care cost trend rates were used to determine
our postretirement benefit obligation:
2003 2002
---- ----
Initial healthcare cost trend rate 10.0% 11.5%
Ultimate health care cost trend rate 6.0% 5.0%
Year the rate reaches the ultimate trend rate 2014 2015
A one percentage point change in the assumed health care cost trend rate
would have the following effects (dollars in millions):
One Percentage Point
------------------------------
Increase Decrease
-------- --------
Effect on the postretirement benefit obligation $1.5 $(1.4)
Effect on the net periodic post retirement benefit cost .1 (.1)
Components of the cost we recognized related to postretirement plans were
as follows (dollars in millions):
Postretirement
benefits
---------------------------------------------------
Successor Predecessor
--------- -----------------------------------
Years
Four months Eight months ended
ended ended December 31,
December 31, August 31, -----------------
2003 2003 2002 2001
---- ---- ---- ----
Interest cost.................................................... $ .5 $ .9 $1.6 $1.5
Expected return of plan assets................................... - - (.1) (.1)
Amortization of prior service cost............................... - (.1) (.2) (1.0)
Recognized net actuarial loss.................................... (.3) (.5) (.5) (.1)
---- ---- ---- ----
Net periodic cost (benefit)............................... $ .2 $ .3 $ .8 $ .3
==== ==== ==== ====
The Company has qualified defined contribution plans for which
substantially all employees are eligible. Company contributions, which match
certain voluntary employee contributions to the plan, totaled $6.6 million in
2002 and $4.7 million in 2001. No employer contributions were made during the
2003 periods. Prior to 2002, employer matching contributions were made in Old
Conseco common stock. For the first nine months of 2002, employer matching
contributions were made in cash. In September 2002, the plans were amended to
make future employer matching contributions discretionary. Effective January 1,
2004, the Company resumed making matching contributions in cash.
Trust Preferred Securities
Prior to 2003, certain wholly-owned subsidiary trusts had issued preferred
securities in public offerings. The trusts used the proceeds from these
offerings to purchase subordinated debentures from Conseco. The terms of the
preferred securities
143
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
were parallel to the terms of the debentures, which accounted for substantially
all trust assets. The preferred securities were to be redeemed on a pro rata
basis, to the same extent as the debentures were repaid. Under certain
circumstances involving a change in law or legal interpretation, the debentures
could be distributed to the holders of the preferred securities. Our obligations
under the debentures and related agreements, taken together, provided a full and
unconditional guarantee of payments due on the preferred securities. The
debentures issued to the subsidiary trusts and the common securities purchased
by Conseco from the subsidiary trusts were eliminated in the consolidated
financial statements. The Trust Preferred Securities guaranteed by Old Conseco
prior to our emergence from bankruptcy were discharged in accordance with the
Plan.
On February 16, 2001, the trust preferred securities component of the
FELINE PRIDES were retained by the Company (and subsequently retired) as payment
under the stock purchase contract in accordance with their terms and, as a
result, we issued 11.4 million shares of Old Conseco common stock to the holders
of the FELINE PRIDES. The $496.6 million carrying value of the FELINE PRIDES
that were retired (and used for payment pursuant to the stock purchase
contracts) was transferred from minority interest to common stock and additional
paid-in capital.
Trust Preferred Securities at December 31, 2002, were as follows:
Year Carrying Distribution Earliest/mandatory
issued Par value value rate redemption dates
------ --------- ----- ---- ----------------
(Dollars in millions)
Trust Originated Preferred Securities................ 1999 $ 300.0 $ 296.5 9.44% 2004/2029
Trust Originated Preferred Securities ............... 1998 500.0 496.9 8.70 2003/2028
Trust Originated Preferred Securities................ 1998 230.0 228.1 9.00 2003/2028
Capital Securities................................... 1997 300.0 300.0 8.80 2027
Trust Originated Preferred Securities................ 1996 275.0 275.0 9.16 2001/2026
Capital Trust Pass-through Securities................ 1996 325.0 325.0 8.70 2026
-------- --------
$1,930.0 $1,921.5
======== ========
Reclassification Adjustments Included in Comprehensive Income
The changes in unrealized appreciation (depreciation) included in
comprehensive income are net of reclassification adjustments for after-tax net
gains (losses) from the sale of investments included in net income (loss) of
approximately $545 million and $240 million for the years ended December 31,
2002 and 2001, respectively. Such changes for the 2003 periods were not
significant.
Sale of Interest in Riverboat
In the first quarter of 2001, the Company sold its 29 percent ownership
interest in the riverboat casino in Lawrenceberg, Indiana, for $260 million. We
recognized a net gain on the sale of $192.4 million.
144
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
11. SPECIAL CHARGES
2002
The following table summarizes the special charges incurred by the Company
during 2002, which are further described in the paragraphs which follow (dollars
in millions):
Loss related to reinsurance transactions and businesses sold to raise cash..... $47.5
Costs related to debt modification and refinancing transactions................ 17.7
Expenses related to the termination of the former chief financial officer...... 6.5
Other items.................................................................... 24.8
-----
Special charges before income tax benefit.................................. $96.5
=====
Loss related to debt modification and reinsurance transactions and
businesses sold to raise cash
We completed various asset sales and reinsurance transactions to raise cash
which resulted in net losses of $47.5 million in 2002. These amounts included:
(i) a loss of $39.0 million related to the reinsurance of a portion of our life
insurance business; (ii) a loss of $20.0 million associated with the sale of our
subsidiary in India; partially offset by (iii) asset sales resulting in a net
gain of $11.5 million.
Costs related to debt modification and refinancing transactions
In conjunction with the various modifications to borrowing arrangements
(including the debt exchange offer completed in April 2002), entered into in
2002 we incurred costs of $17.7 million which are not permitted to be deferred
pursuant to GAAP.
Expenses related to termination of the former chief financial officer
The employment of Old Conseco's chief financial officer was terminated in
the first quarter of 2002. As a result, the vesting provisions associated with
the restricted stock issued to the chief financial officer pursuant to his
employment agreement were accelerated. We recognized a charge of $5.1 million
related to the immediate vesting of such restricted stock in the first quarter
of 2002. In addition, we recognized severance benefits of $1.4 million
associated with the termination.
Other items
Other items include expenses incurred: (i) in conjunction with the transfer
of certain customer service and backroom operations to our India subsidiary;
(ii) for severance benefits related to the transfer of such operations; and
(iii) for other items which are not individually significant. The Company sold
its India subsidiary in the fourth quarter of 2002 and has significantly reduced
the customer service and backroom operations conducted there.
2001
The following table summarizes the special charges incurred by the Company
during 2001, which are further described in the paragraphs which follow (dollars
in millions):
Organizational restructuring:
Severance benefits.................................................................... $ 12.4
Office closings and sale of artwork................................................... 7.9
Transfer of certain customer service and backroom operations to our
India subsidiary.................................................................... 10.6
Amounts related to disputed reinsurance balances......................................... 8.5
Litigation expenses...................................................................... 23.8
Other items.............................................................................. 17.2
------
Special charges before income tax benefit............................................. $ 80.4
======
145
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
Severance benefits
During 2001, Conseco undertook several restructuring actions in an effort
to improve the Company's operations and profitability. The planned changes
included moving a significant number of jobs to India. Pursuant to GAAP, the
Company is required to recognize the costs associated with most restructuring
activities as the costs are incurred. However, costs associated with severance
benefits are required to be recognized when the costs are: (i) attributable to
employees' services that have already been rendered; (ii) relate to obligations
that accumulate; and (iii) are probable and can be reasonably estimated. Since
the severance costs associated with our planned activities met these
requirements, we recognized a charge of $12.4 million in 2001.
Office closings and sale of artwork
In conjunction with our restructuring activities, we closed certain
offices, which resulted in the abandonment of certain leasehold improvements.
Further, certain antiques and artwork, formerly displayed in the Company's
executive offices were sold. We recognized losses of $7.9 million related to
these actions in 2001.
Amounts related to disputed reinsurance balances
During 2001, we discontinued marketing certain medical insurance products.
Several reinsurers who assumed most of the risks associated with these products
disputed the reinsurance receivables due to us. We established an allowance of
$8.5 million for disputed balances that were ultimately written off due to their
uncollectibility.
Litigation expenses
Litigation expenses primarily include the cost and proposed settlement
related to our securities litigation class action lawsuit which was subsequently
settled in the second quarter of 2003.
Other items
Other items include expenses incurred: (i) for consulting fees with respect
to services provided related to various debt and organizational restructuring
transactions; (ii) pursuant to the terms of the employment agreement for our
chief executive officer; and (iii) for other items which are not individually
significant.
12. SHAREHOLDERS' EQUITY
Pursuant to the Plan, CNO issued 34.4 million shares of Preferred Stock
with an aggregate liquidation preference of approximately $859.7 million. The
Preferred Stock has a par value of $.01 per share and a liquidation preference
of $25 per share. Dividends are payable at a rate equal to 10.5 percent of the
liquidation preference per share, payable semi-annually on March 1 and September
1. This rate will increase to 11 percent beginning September 11, 2005. These
dividends are payable in additional shares of Preferred Stock until the later
of: (i) September 10, 2005; or (ii) the beginning of the first fiscal quarter
after which our primary insurance companies have received a financial strength
rating of at least "A-" by A.M. Best. Thereafter, dividends are payable, at our
option, in cash or additional shares of Preferred Stock. The Preferred Stock may
be redeemed by CNO, in whole or in part, at any time in cash equal to the
liquidation preference plus cumulative unpaid dividends thereon.
The Preferred Stock is convertible, at the option of the holder, into
common stock of CNO at any time on or after September 30, 2005. The conversion
rate is equal to the total liquidation preference plus cumulative unpaid
dividends thereon divided by $20.35 which was the average price of CNO's common
stock, as defined, for each of the trading days in the 60 calendar day period
immediately preceding January 8, 2004.
The Preferred Stock is exchangeable, at the option of the holder, into
common stock of CNO at any time on or after September 10, 2013. The exchange
rate is equal to the total liquidation preference plus cumulative unpaid
dividends thereon divided by the average market price of CNO's common stock, as
defined, for the ten trading days ending on the date of exchange. The maximum
number of common shares that can be issued shall not exceed the greater of: (i)
7.84 billion shares of common stock; or (ii) the number of authorized but
unissued shares of CNO's common stock. In addition, CNO, at its
146
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
option, may pay cash in an amount equal to the liquidation preference in lieu of
delivering the exchanged common stock.
The holders of the Preferred Stock will be entitled to voting rights
beginning September 30, 2005 or earlier if there is: (i) a reduction in the
financial strength rating assigned to any of our active material insurance
subsidiaries (as defined) by A.M. Best; (ii) an event of default under our
credit agreement; (iii) the occurrence of a material adverse regulatory event,
as defined, with respect to any of our material insurance subsidiaries (as
defined); or (iv) a failure to maintain various financial ratios and balances.
Pursuant to the Plan, we issued 6.0 million Series A Warrants (the
"Warrants") entitling the holders to purchase shares of CNO common stock at a
price of $27.60 per share. The Warrants expire on September 10, 2008. The
exercise price and number of common shares issuable are subject to adjustment
based on the occurrence of certain events, including: (i) stock dividends; (ii)
stock splits; and (iii) the issuance of instruments or securities which are
exercisable for or convertible into shares of common stock entitling the holders
to purchase shares of common stock at a price per share that is less than the
market price on the date of issuance.
On the Effective Date, the Successor adopted a new long-term incentive
plan, which permits the grant of CNO incentive or non-qualified stock options
and restricted stock awards to certain directors, officers and employees of CNO
and certain other individuals who perform services for the Company. A maximum of
10 million shares may be issued under the plan. Restricted share grants are
limited to 3.3 million shares. During September 2003, the Company granted
options to purchase 500,000 shares of CNO common stock at $16.40 per share and
500,000 restricted shares of CNO common stock to the Chief Executive Officer in
accordance with his employment agreement. These options and restricted stock
vest over the next four years. In addition, the Company granted options to
purchase 500,000 shares of CNO common stock at $19.61 per share and 500,000
restricted shares of CNO common stock to the non-executive Chairman of the Board
of Directors in accordance with his agreement. These options and restricted
shares vest over the next three years.
Changes in the number of shares of common stock outstanding during the four
months ended December 31, 2003, the eight months ended August 31, 2003 and the
years ended December 31, 2002 and 2001 were as follows (shares in thousands):
Successor Predecessor
--------------- -----------------------------------
Years
Four months Eight months ended
ended ended December 31,
December 31, August 31, -----------------
2003 2003 2002 2001
---- ---- ---- ----
Balance, beginning of period...................................... - 346,007 344,743 325,318
Issuance of shares pursuant to Plan........................... 100,000 - - -
Stock options exercised....................................... - - 6 432
Stock warrants exercised...................................... - - - 3,327
Shares issued in conjunction with the acquisition of Exl...... - - - 3,411
Shares issued pursuant to stock purchase contracts related
to the FELINE PRIDES....................................... - - - 11,351
Shares issued under employee benefit compensation plans....... 116 - 1,258 904
Cancelled pursuant to the Plan................................ - (346,007) - -
------ -------- ------- -------
Balance, end of period............................................ 100,116 - 346,007 344,743
======= ======== ======= =======
In February 2001, the Company issued 11.4 million shares of Old Conseco
common stock pursuant to stock purchase contracts related to the FELINE PRIDES.
This transaction is discussed in further detail in the note to the consolidated
financial statements entitled "Other Disclosures".
The Predecessor's 1994 Stock and Incentive Plan authorized the granting of
options to employees and directors of the Company to purchase up to 24 million
shares of Old Conseco common stock at a price not less than its market value on
the date the option was granted. In 1997, the Company adopted the 1997
Non-qualified Stock Option Plan, which authorized the granting of non-qualified
options to employees of the Company to purchase shares of Old Conseco common
stock.
147
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
A summary of the Company's stock option activity and related information
for the four months ended December 31, 2003, the eight months ended August 31,
2003 and the years ended December 31, 2002 and 2001, is presented below (shares
in thousands):
Successor Predecessor
------------ ------------------------------------------------
Years
Four months Eight months ended
ended ended December 31,
December 31, August 31, ------------------------
2003 2003 2002 2001
---- ---- ---- ----
Weighted Weighted Weighted Weighted
average average average average
exercise exercise exercise exercise
Shares price Shares price Shares price Shares price
------ ----- ------ ----- ------ ----- ------ -----
Outstanding at the beginning of
the period........................... - $ - 23,520 $15.95 40,292 $15.01 36,107 $18.38
Options granted......................... 1,000 18.01 - - 2,572 3.57 8,609 6.32
Exercised............................... - - - - (6) 1.51 (432) 9.88
Cancelled pursuant to the Plan.......... - - (17,438) 18.29 - - - -
Forfeited or terminated................. - - (6,082) 9.26 (19,338) 12.35 (3,992) 27.27
----- ------- -------- ------
Outstanding at the end of the year...... 1,000 18.01 - 23,520 15.95 40,292 15.01
===== ======= ======== ======
Options exercisable at the end of
the period........................... - - 13,593 13,591
===== ======= ======== ======
Available for future grant.............. 7,982 - 52,668 34,903
===== ======= ======== ======
All outstanding stock options of the Predecessor were cancelled pursuant to
the Plan.
148
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
The following table summarizes information about stock options outstanding
at December 31, 2003 (shares in thousands):
Options outstanding Options exercisable
---------------------------------------- ------------------------
Number Remaining Exercise Number Exercise
Exercise prices outstanding life (in years) price exercisable price
- --------------- ----------- --------------- ----- ----------- -----
$16.40.............................. 500 9.75 $16.40 - -
19.61.............................. 500 9.75 19.61 - -
----- ---
1,000 -
===== ===
We estimated the fair value of each option grant used to determine the pro
forma amounts summarized above using the Black-Scholes option valuation model
with the following weighted average assumptions for the four months ended
December 31, 2003, the eight months ended August 31, 2003 and the years ended
December 31, 2002 and 2001:
Successor Predecessor
------------- -------------------------------------------------
Years
Four months Eight months ended
ended ended December 31,
December 31, August 31, ------------------------------
2003 Grants 2003 Grants 2002 Grants 2001 Grants
----------- ------------ ----------- -----------
Weighted average risk-free interest rates.. 3.7% - 4.7% 4.8%
Weighted average dividend yields........... 0.0% - 0.0% 0.0%
Volatility factors......................... 35% - 40% 40%
Weighted average expected life............. 6.1 years - 6.4 years 6.4 years
Weighted average fair value per share...... $7.71 - $1.73 $3.04
149
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
A reconciliation of net income (loss) and shares used to calculate basic
and diluted earnings per share is as follows (dollars in millions and shares in
thousands):
Successor Predecessor
------------ ------------------------------------
Years
Four months Eight months ended
ended ended December 31,
December 31, August 31, ---------------------
2003 2003 2002 2001
---- ---- ---- ----
Net income (loss):
Net income (loss).................................... $ 96.3 $2,201.7 $(7,835.7) $(405.9)
Preferred stock dividends............................ (27.8) - (2.1) (12.8)
------ -------- --------- -------
Income (loss) applicable to common
ownership for basic earnings per share........... 68.5 2,201.7 (7,837.8) (418.7)
Effect of dilutive securities........................ 27.8 - - -
------ -------- --------- -------
Income (loss) applicable to common ownership
and assumed conversions for diluted earnings
per share.......................................... $ 96.3 $2,201.7 $(7,837.8) $(418.7)
====== ======== ========= =======
Shares:
Weighted average shares outstanding for basic
earnings per share................................. 100,110
-------
Effect of dilutive securities on weighted average shares:
Preferred stock...................................... 43,257
Stock options, warrants and employee
benefit plans (a).................................. 119
-------
Dilutive potential common shares..................... 43,376
-------
Weighted average shares outstanding for diluted
earnings per share................................... 143,486
=======
- -------------
(a) The dilutive effect is determined under the treasury stock method using the
average market price during the period.
Basic earnings per common share ("EPS") is computed by dividing income
applicable to common stock by the weighted average number of common shares
outstanding for the period. Restricted shares are not included in basic EPS
until vested. Diluted EPS reflects the potential dilution that could occur if
the Preferred Stock were converted into common stock, the options were exercised
and the restricted stock was vested. The dilution from options and restricted
shares are calculated using the treasury stock method.
150
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
13. OTHER OPERATING STATEMENT DATA
Insurance policy income consisted of the following (dollars in millions):
Successor Predecessor
------------ ---------------------------------------
Years
Four months Eight months ended
ended ended December 31,
December 31, August 31, --------------------
2003 2003 2002 2001
---- ---- ---- ----
Traditional products:
Direct premiums collected......................... $1,477.9 $3,264.3 $5,100.2 $5,426.3
Reinsurance assumed............................... 31.9 57.3 78.7 146.0
Reinsurance ceded................................. (92.1) (196.4) (327.8) (249.4)
-------- -------- -------- --------
Premiums collected, net of reinsurance...... 1,417.7 3,125.2 4,851.1 5,322.9
Change in unearned premiums....................... (15.4) 13.5 (19.7) 1.9
Less premiums on universal life and products
without mortality and morbidity risk which are
recorded as additions to insurance liabilities (528.2) (1,266.4) (1,792.7) (1,828.2)
-------- -------- -------- --------
Premiums on traditional products with
mortality or morbidity risk, recorded
as insurance policy income............... 874.1 1,872.3 3,038.7 3,496.6
Fees and surrender charges on interest-sensitive
products ......................................... 131.7 332.0 563.6 496.1
-------- -------- -------- --------
Insurance policy income..................... $1,005.8 $2,204.3 $3,602.3 $3,992.7
======== ======== ======== ========
The five states with the largest shares of 2003 collected premiums were
Florida (8.1 percent), Illinois (6.8 percent), Texas (6.6 percent), and
California (6.5 percent). No other state accounted for more than 5 percent of
total collected premiums.
Other operating costs and expenses were as follows (dollars in millions):
Successor Predecessor
------------ ---------------------------------------
Years
Four months Eight months ended
ended ended December 31,
December 31, August 31, -------------------
2003 2003 2002 2001
---- ---- ---- ----
Commission expense.................................. $ 66.4 $117.9 $195.1 $218.6
Salaries and wages.................................. 70.5 136.3 215.1 206.0
Other............................................... 81.5 168.1 326.0 322.5
------ ------ ------ ------
Total other operating costs and expenses..... $218.4 $422.3 $736.2 $747.1
====== ====== ====== ======
151
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
Changes in the value of policies inforce at the Effective Date were as
follows (dollars in millions):
Successor
-----------
Four months
ended
December 31,
2003
----
Successor balance, beginning of the period........................................................ $3,102.6
Additional acquisition expense................................................................ 2.4
Amortization.................................................................................. (122.0)
Amounts related to fair value adjustment of actively managed fixed maturities................. (33.5)
--------
Successor balance, end of the period.............................................................. $2,949.5
========
Based on current conditions and assumptions as to future events on all
policies inforce, the Company expects to amortize approximately 10 percent of
the December 31, 2003 balance of the value of policies inforce at the Effective
Date in 2004, 10 percent in 2005, 9 percent in 2006, 8 percent in 2007 and 8
percent in 2008. The discount rate used to determine the amortization of the
value of policies inforce at the Effective Date averaged 5 percent in the four
months ended December 31, 2003.
Changes in the cost of policies purchased were as follows (dollars in
millions):
Predecessor
---------------------------------------
Twelve months
Eight months ended
ended December 31,
August 31, -----------------
2003 2002 2001
---- ---- ----
Balance, beginning of the period...................................................... $1,170.0 $1,657.8 $1,954.8
Additional acquisition expense on acquired policies............................... 7.4 11.3 12.5
Amortization...................................................................... (74.1) (215.5) (242.0)
Amounts related to fair value adjustment of actively managed fixed maturities..... 4.7 (81.9) (49.0)
Reinsurance transactions.......................................................... - (73.4) -
Net amounts related to discontinued operations ................................... - (66.6) (13.9)
Amounts related to sales of subsidiaries.......................................... - (60.0) -
Other ............................................................................ (8.8) (1.7) (4.6)
Elimination of Predecessor balance................................................ (1,099.2) - -
-------- -------- --------
Balance, end of the period............................................................ $ - $1,170.0 $1,657.8
======== ======== ========
The discount rates used to determine the amortization of the cost of
policies purchased averaged 7 percent in the eight months ended August 31, 2003,
7 percent in 2002 and 6 percent in 2001.
152
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
Changes in the cost of policies produced were as follows (dollars in
millions):
Successor Predecessor
-------------- -----------------------------------
Years
Four months Eight months ended
ended ended December 31,
December 31, August 31, -----------------
2003 2003 2002 2001
---- ---- ---- ----
Balance, beginning of the period.................................. $ - $2,014.4 $2,570.2 $2,480.5
Additions...................................................... 110.1 280.1 486.0 612.8
Amortization................................................... (8.3) (252.8) (544.3) (396.3)
Amounts related to fair value adjustment of actively
managed fixed maturities..................................... - (20.5) (121.0) (28.2)
Reinsurance transactions....................................... - - (134.6) -
Net amounts related to discontinued operations................. - - (103.3) 15.0
Amounts related to sales of subsidiaries....................... - - (140.8) -
Other.......................................................... - (1.7) 2.2 (113.6)
Elimination of Predecessor balance............................. - (2,019.5) -
------ -------- -------- --------
Balance, end of the period........................................ $101.8 $ - $2,014.4 $2,570.2
====== ======== ======== ========
In 2001, the Company stopped renewing portions of our major medical lines
of business in several unprofitable states in accordance with the contractual
terms of the policies. As a result, we determined that approximately $77.4
million of the cost of policies produced and the cost of policies purchased
would not be recoverable. Such amount is recorded as amortization in the
accompanying statement of operations.
Policyholder redemptions of annuity and, to a lesser extent, life products
have increased in recent periods. We experienced additional redemptions
following the downgrade of our A.M. Best financial strength rating to "B (fair)"
in August of 2002. When redemptions are greater than our previous assumptions,
we are required to accelerate the amortization of our cost of policies produced
and cost of policies purchased to write off the balance associated with the
redeemed policies. Accordingly, amortization expense has increased. In 2002, we
changed the lapse assumptions used to determine the amortization of the cost of
policies produced and the cost of policies purchased related to certain
universal life products and our annuities to reflect our then current estimates
of future lapses. For certain universal life products, we changed the ultimate
lapse assumption from: (i) a range of 6 percent to 7 percent; to (ii) a tiered
assumption based on the level of funding of the policy of a range of 2 percent
to 10 percent. We recorded additional amortization of the cost of policies
produced and the cost of policies purchased related to higher redemptions and
changes to our lapse assumptions of $203.2 million in 2002.
The cost of policies produced and the cost of policies purchased are
amortized in relation to the estimated gross profits to be earned over the life
of our annuity products. As a result of economic developments, actual experience
of our products and changes in our expectations, we changed our investment yield
assumptions used in calculating the estimated gross profits to be earned on our
annuity products. Such changes resulted in additional amortization of the cost
of policies produced and the cost of policies purchased of $35.0 million (of
which $7.2 million related to discontinued operations) in 2001.
153
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
14. CONSOLIDATED STATEMENT OF CASH FLOWS
The following disclosures supplement our consolidated statement of cash
flows (dollars in millions):
Successor Predecessor
-------------- ----------------------------------
Years
Four months Eight months ended
ended ended December 31,
December 31, August 31, ----------------
2003 2003 2002 2001
---- ---- ---- ----
Non-cash items not reflected in the investing and financing activities
section of the consolidated statement of cash flows:
Issuance of common stock under stock option and employee
benefit plans.................................................. $ 2.6 $ - $12.7 $ 19.7
Issuance of convertible preferred shares......................... 27.8 5.3 2.1 12.8
Value of FELINE PRIDES retired and transferred from minority
interest to common stock and additional paid-in capital........ - - - 496.6
Issuance of common stock in connection with the acquisition
of Exl......................................................... - - - 52.1
Decrease in notes payable-direct corporate obligations and
increase in other liabilities reflecting the estimated fair value
of interest rate swap agreements............................... - - - 13.5
The effect on our consolidated balance sheet of implementing fresh start
accounting is discussed in the note to the consolidated financial statements
entitled "Fresh Start Reporting". Such non-cash adjustments are not reflected in
our consolidated statement of cash flows.
154
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
The following reconciles net income (loss) to net cash provided by
operating activities (dollars in millions):
Successor Predecessor
-------------- ----------------------------------
Years
Four months Eight months ended
ended ended December 31,
December 31, August 31, ---------------
2003 2003 2002 2001
---- ---- ---- ----
Cash flows from operating activities:
Net income (loss)................................................. $ 96.3 $2,201.7 $(7,835.7) $ (405.9)
Adjustments to reconcile net income (loss) to
net cash provided by operating activities:
Interest-only securities investment income.................... - - (10.6) (51.5)
Cash received from interest-only securities, net.............. - - (73.3) 14.3
Servicing income.............................................. - - (83.9) (115.3)
Cash received from servicing activities....................... - - 46.9 71.7
Provision for losses.......................................... - 55.6 1,160.8 707.2
(Gain) loss on sale of finance receivables.................... - - 49.5 (26.9)
Amortization and depreciation................................. 144.7 369.8 1,017.8 848.0
Income taxes.................................................. 131.0 31.4 758.3 (140.7)
Insurance liabilities......................................... 207.2 265.8 509.5 334.4
Accrual and amortization of investment income................. 20.1 43.2 227.9 97.2
Deferral of cost of policies produced and purchased........... (111.6) (287.5) (509.2) (667.0)
Gain on sale of interest in riverboat......................... - - - (192.4)
Impairment charges............................................ - - 1,514.4 386.9
Goodwill impairment........................................... - - 500.0 -
Special charges............................................... - - 171.2 72.4
Reorganization items.......................................... - (2,157.0) - -
Cumulative effect of accounting change........................ - - 2,949.2 -
Minority interest............................................. - - 173.2 183.9
Net realized investment (gains) losses........................ (11.8) 5.4 673.7 413.7
Discontinued operations....................................... - (16.7) 93.1 -
Gain on extinguishment of debt................................ - - (8.1) (26.9)
Other......................................................... (36.8) 235.6 (29.0) (178.4)
------- -------- --------- --------
Net cash provided by operating activities................... $ 439.1 $ 747.3 $ 1,295.7 $1,324.7
======= ======== ========= ========
At December 31, 2003, restricted cash consisted of: (i) of $17.3 million
held in trust for the payment of bankruptcy-related professional fees; and (ii)
$14.6 million of cash held by three investment trusts (which are further
described in the note to the consolidated financial statements entitled
"Investments in Variable Interest Entities").
155
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
15. STATUTORY INFORMATION (BASED ON NON-GAAP MEASURES)
Statutory accounting practices prescribed or permitted by regulatory
authorities for the Company's insurance subsidiaries differ from GAAP. The
Company's insurance subsidiaries reported the following amounts to regulatory
agencies, after appropriate elimination of intercompany accounts among such
subsidiaries (dollars in millions):
2003 2002
---- ----
Statutory capital and surplus.................................................................... $1,514.1 $1,064.4
Asset valuation reserve.......................................................................... 40.9 11.6
Interest maintenance reserve..................................................................... 217.4 311.3
-------- --------
Total...................................................................................... $1,772.4 $1,387.3
======== ========
The statutory capital and surplus shown above included investments in
upstream affiliates, all of which were eliminated in the consolidated financial
statements prepared in accordance with GAAP, as follows (dollars in millions):
2003 2002
---- ----
Securitization debt issued by special purpose entities and guaranteed by our
finance subsidiary, all of which was purchased by our insurance subsidiaries
prior to the acquisition of CFC................................................................. $ - $ 2.0
Preferred and common stock of intermediate holding company......................................... 159.0 146.4
Other ............................................................................................. - 2.5
------ ------
Total........................................................................................ $159.0 $150.9
====== ======
Statutory earnings build the capital adequacy required by ratings agencies
and regulators. Statutory earnings and fees and interest paid by the insurance
companies to the parent company create the "cash flow capacity" the parent
company needs to meet its obligations, including debt service. The combined
statutory net income (loss) (a non-GAAP measure) of our life insurance
subsidiaries was $286.1 million, $(465.0) million and $(137.8) million in 2003,
2002 and 2001, respectively. Included in such net income (loss) are net realized
capital gains (losses), net of income taxes, of $32.8 million, $(516.1) million
and $(188.0) million in 2003, 2002 and 2001, respectively. In addition, the
insurance subsidiaries incur fees and interest to Conseco or its non-life
subsidiaries; such amounts totaled $85.8 million, $194.8 million and $279.2
million in 2003, 2002 and 2001, respectively.
The ability of our insurance subsidiaries to pay dividends is subject to
state insurance department regulations. These regulations generally permit
dividends to be paid from statutory earned surplus of the insurance company for
any 12-month period in amounts equal to the greater of (or in a few states, the
lesser of): (i) statutory net gain from operations or statutory net income for
the prior year; or (ii) 10 percent of statutory capital and surplus as of the
end of the preceding year. Any dividends in excess of these levels require the
approval of the director or commissioner of the applicable state insurance
department. During 2002, our insurance subsidiaries paid dividends to Conseco
totaling $240.0 million. In 2003, a non-cash dividend of $4.5 million
representing affiliated common stock was paid to CDOC.
On October 30, 2002, Bankers National Life Insurance Company and Conseco
Life Insurance Company of Texas (on behalf of itself and all other Conseco
insurance subsidiaries), our 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 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,
156
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
records and affairs. The consent orders were formally released on November 19,
2003. We have agreed with the Texas Insurance Department to provide prior notice
of certain transactions, including up to 30 days prior notice of the payment of
dividends by an insurance subsidiary to any non-insurance company parent, and
periodic reporting of information concerning our financial performance and
condition.
The National Association of Insurance Commissioners' Risk-Based Capital for
Life and/or Health Insurers Model Act (the "Model Act") provides a tool for
insurance regulators to determine the levels of statutory capital and surplus an
insurer must maintain in relation to its insurance and investment risks and
whether there is a need for possible regulatory attention. The Model Act
provides four levels of regulatory attention, varying with the ratio of the
insurance company's total adjusted capital (defined as the total of its
statutory capital and surplus, AVR and certain other adjustments) to its company
action level risk based capital ("RBC"): (i) if a company's total adjusted
capital is less than 100 percent but greater than or equal to 75 percent of its
RBC (the "Company Action Level"), the company must submit a comprehensive plan
to the regulatory authority proposing corrective actions aimed at improving its
capital position; (ii) if a company's total adjusted capital is less than 75
percent but greater than or equal to 50 percent of its RBC (the "Regulatory
Action Level"), the regulatory authority will perform a special examination of
the company and issue an order specifying the corrective actions that must be
taken; (iii) if a company's total adjusted capital is less than 50 percent but
greater than or equal to 35 percent of its RBC (the "Authorized Control Level"),
the regulatory authority may take any action it deems necessary, including
placing the company under regulatory control; and (iv) if a company's total
adjusted capital is less than 35 percent of its RBC (the "Mandatory Control
Level"), the regulatory authority must place the company under its control. In
addition, the Model Act provides for an annual trend test if a company's total
adjusted capital is between 100 percent and 125 percent of its RBC at the end of
the year. The trend test calculates the greater of the decrease in the margin of
total adjusted capital over RBC: (i) between the current year and the prior
year; and (ii) for the average of the last 3 years. It assumes that such
decrease could occur again in the coming year. Any company whose trended total
adjusted capital is less than 95 percent of its RBC would trigger a requirement
to submit a comprehensive plan as described above for the Company Action Level.
The 2003 statutory annual statements filed with the state insurance
regulators of each of our insurance subsidiaries reflected total adjusted
capital in excess of the levels subjecting the subsidiaries to any regulatory
action. However, as a result of losses on the long-term care business within the
Other Business in Run-off segment, the RBC ratio of one of our subsidiaries is
near the level which would require it to submit a comprehensive plan aimed at
improving its capital position.
The consolidated RBC ratio for our insurance subsidiaries was approximately
287 percent at December 31, 2003. We calculate the consolidated RBC ratio by
assuming all of the assets, liabilities, capital and surplus and other aspects
of the business of our insurance subsidiaries are combined together in one
insurance subsidiary, with appropriate intercompany eliminations.
Our insurance subsidiaries hold principal protected senior notes of three
trusts which invest in fixed maturities, mortgages, preferred stock, common
stock and limited partnerships. We consolidate the trusts in our financial
statements prepared in accordance with GAAP and at December 31, 2003, the
estimated fair value of the trust investments slightly exceeded their GAAP book
value. During the fourth quarter of 2003, the trusts began liquidating their
portfolios, a process which is expected to be completed in the first quarter of
2004. Under statutory accounting practices, which differ from GAAP, realized
capital losses of $45.9 million were recorded on the fourth quarter 2003 partial
redemption of the senior notes issued by the trusts that are owned by the
insurance subsidiaries. Additional statutory realized capital losses of $94.9
million were recorded at December 31, 2003 since a decision had been made to
redeem the remaining senior notes at amounts less than their amortized cost. The
total statutory realized losses of $140.8 million on the senior notes were
included in the interest maintenance reserve.
16. BUSINESS SEGMENTS
After our emergence from bankruptcy, we began to manage our business
operations through two primary operating segments, based on method of product
distribution, and a third segment comprised of business in run-off. We refer to
these segments as: (i) Bankers Life; (ii) Conseco Insurance Group; and (iii)
Other Business in Run-Off. Prior to its disposition effective March 31, 2003, we
also had a finance segment (which is reflected in our discontinued operations in
the consolidated statement of operations). We also have a corporate segment,
which consists of holding company activities and certain noninsurance company
businesses that are not related to our other operating segments. Prior period
segment data has been reclassified to conform to the current period
presentation.
157
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
Operating information regarding our segments was as follows (dollars in
millions):
Successor Predecessor
-------------- ----------------------------------
Years
Four months Eight months ended
ended ended December 31,
December 31, August 31, -----------------
2003 2003 2002 2001
---- ---- ---- ----
Revenues:
Bankers Life:
Insurance policy income:
Annuities........................................... $ 17.3 $ 32.9 $ 39.6 $ 31.4
Supplemental health................................. 384.2 760.4 1,122.8 1,082.5
Life................................................ 51.5 91.5 125.1 271.2
Other............................................... 3.8 7.9 12.6 15.0
Net investment income (a)................................ 135.5 258.2 367.4 376.4
Fee revenue and other income (a)......................... .5 .2 1.3 1.2
Net realized investment gains (losses) (a)............... 3.4 5.5 (128.7) (43.5)
------- ------- ------- -------
Total Bankers Life segment revenues............. 596.2 1,156.6 1,540.1 1,734.2
------- ------- ------- -------
Conseco Insurance Group:
Insurance policy income:
Annuities........................................... 8.8 51.6 121.3 56.8
Supplemental health................................. 250.9 499.0 727.9 684.4
Life................................................ 125.7 303.9 503.8 524.5
Other............................................... 13.1 38.3 101.9 111.7
Net investment income (a)................................ 288.6 582.6 896.3 1,010.1
Fee revenue and other income (a)......................... .5 17.0 25.4 31.4
Net realized investment gains (losses) (a)............... 9.5 (17.1) (368.1) (209.1)
------- ------- ------- -------
Total Conseco Insurance Group
segment revenues............................ 697.1 1,475.3 2,008.5 2,209.8
------- ------- ------- -------
Other Business in Run-Off:
Insurance policy income - supplemental health............ 150.5 418.8 847.3 1,215.2
Net investment income (a)................................ 55.3 101.5 155.8 166.7
Fee revenue and other income (a)......................... .9 - .8 1.2
Net realized investment gains (losses) (a)............... (.7) 6.3 (58.2) (24.6)
------- ------- ------- -------
Total Other Business in Run-Off
segment revenues............................ 206.0 526.6 945.7 1,358.5
------- ------- ------- -------
Corporate:
Net investment income (a)................................ .7 16.2 14.0 39.7
Venture capital gain (loss) related to investment in AWE. (5.5) 10.5 (99.3) (23.4)
Gain on sale of interest in riverboat.................... - - - 192.4
Net realized investment gains (losses) (a)............... (.4) (.1) (1.3) (62.8)
Fee and other income..................................... 11.4 17.1 59.2 68.5
------- ------- ------- -------
Total corporate segment revenues................ 6.2 43.7 (27.4) 214.4
------- ------- ------- -------
Eliminations................................................ - - (16.5) (24.9)
------- ------- ------- -------
Total revenues.................................. 1,505.5 3,202.2 4,450.4 5,492.0
------- ------- ------- -------
(continued on next page)
158
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
(continued from previous page)
Successor Predecessor
-------------- ----------------------------------
Years
Four months Eight months ended
ended ended December 31,
December 31, August 31, -----------------
2003 2003 2002 2001
---- ---- ---- ----
Expenses:
Bankers Life:
Insurance policy benefits................................ 395.8 795.1 1,090.9 1,108.8
Amortization............................................. 62.3 113.9 168.7 193.4
Interest expense on investment borrowings................ .8 3.4 4.6 6.1
Other operating costs and expenses....................... 51.8 84.6 94.4 130.6
Special charges.......................................... - - 45.0 6.0
------- --------- --------- --------
Total Bankers Life segment expenses................. 510.7 997.0 1,403.6 1,444.9
------- --------- --------- --------
Conseco Insurance Group:
Insurance policy benefits................................ 421.2 746.3 1,377.0 1,390.1
Amortization............................................. 64.4 201.8 541.4 324.6
Interest expense on investment borrowings................ 1.6 4.7 10.2 19.7
Other operating costs and expenses....................... 115.6 222.6 292.1 273.9
Special charges.......................................... - - (.7) 15.5
------- --------- --------- --------
Total Conseco Insurance Group segment expenses...... 602.8 1,175.4 2,220.0 2,023.8
------- --------- --------- --------
Other Business in Run-Off:
Insurance policy benefits................................ 150.7 597.3 864.6 1,089.6
Amortization............................................. 6.3 25.7 112.2 160.1
Interest expense on investment borrowings................ - .2 .6 2.0
Other operating costs and expenses....................... 36.2 74.7 185.1 212.8
------- --------- --------- --------
Total Other Business in Run-Off segment expenses.... 193.2 697.9 1,162.5 1,464.5
------- --------- --------- --------
Corporate:
Interest expense on corporate debt....................... 34.4 194.2 325.5 369.6
Provision for losses and interest expense related to
stock purchase plan................................. - 55.6 240.0 169.6
Amortization related to operations....................... - - .6 108.2
Interest expense on investment borrowings................ - - 1.0 2.6
Other operating costs and expenses....................... 14.9 40.4 181.1 135.2
Goodwill impairment...................................... - - 500.0 -
Gain on extinguishment of debt........................... - - (1.8) (17.0)
Reorganization items..................................... - (2,130.5) 14.4 -
Special charges.......................................... - - 52.2 58.9
------- --------- --------- --------
Total corporate segment expenses.................... 49.3 (1,840.3) 1,313.0 827.1
------- --------- --------- --------
Eliminations................................................ - - (16.5) (24.9)
------- --------- --------- --------
Total expenses...................................... 1,356.0 1,030.0 6,082.6 5,735.4
------- --------- --------- --------
Income (loss) before income taxes, minority interest, discontinued
operations and cumulative effect of accounting change:
Bankers Life........................................ 85.5 159.6 136.5 289.3
Conseco Insurance Group............................. 94.3 299.9 (211.5) 186.0
Other Business in Run-Off........................... 12.8 (171.3) (216.8) (106.0)
Corporate operations................................ (43.1) 1,884.0 (1,340.4) (612.7)
------- --------- --------- --------
Income (loss) before income taxes, minority
interest, discontinued operations and
cumulative effect of accounting change....... $ 149.5 $ 2,172.2 $(1,632.2) $ (243.4)
======= ========= ========= ========
- -------------------
(a) It is not practicable to provide additional components of revenue by
product or services.
159
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
Segment balance sheet information was as follows (dollars in millions):
Successor Predecessor
----------- -----------
December 31, December 31,
2003 2002
---- ----
Assets:
Bankers Life......................................................................... $ 9,826.2 $ 8,306.8
Conseco Insurance Group.............................................................. 16,343.0 17,121.6
Other Business in Run-Off............................................................ 3,511.2 2,831.7
Corporate............................................................................ 239.7 624.6
Assets of discontinued operations.................................................... - 17,624.3
--------- ---------
Total assets.................................................................... $29,920.1 $46,509.0
========= =========
Liabilities:
Bankers Life......................................................................... $ 8,338.1 $ 6,774.3
Conseco Insurance Group.............................................................. 13,774.9 14,924.7
Other Business in Run-Off............................................................ 3,511.2 2,138.8
Corporate............................................................................ 1,478.3 5,175.8
Liabilities of discontinued operations............................................... - 17,624.3
--------- ---------
Total liabilities............................................................... $27,102.5 $46,637.9
========= =========
The following tables present selected financial information of our segments
(dollars in millions):
Value of Cost of
policies policies
inforce produced
at the and cost
Effective of policies Insurance
Segment Date purchased liabilities Goodwill
- ------- ---- --------- ----------- --------
2003
- ----
Bankers Life................................ $1,328.5 $ 83.3 $ 8,092.5 $172.5
Conseco Insurance Group..................... 1,394.0 18.5 13,251.1 779.7
Other Business in Run-off................... 227.0 - 3,498.6 -
-------- ------- ---------- ------
Total.................................... $2,949.5 $ 101.8 $24,842.2 $952.2
======== ======= ========= ======
2002
- ----
Bankers Life................................ $ - $1,165.5 $ 6,323.6 $100.0
Conseco Insurance Group..................... - 1,760.8 14,350.4 -
Other Business in Run-off................... - 258.1 2,123.1 -
------- -------- --------- ------
Total.................................... $ - $3,184.4 $22,797.1 $100.0
======= ======== ========= ======
160
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
17. QUARTERLY FINANCIAL DATA (UNAUDITED)
We compute earnings per common share for each quarter independently of
earnings per share for the year. The sum of the quarterly earnings per share may
not equal the earnings per share for the year because of: (i) transactions
affecting the weighted average number of shares outstanding in each quarter; and
(ii) the uneven distribution of earnings during the year. Quarterly financial
data (unaudited) was as follows (dollars in millions, except per share data).
Predecessor Successor
------------------------------ ----------------------
Two months One month
ended ended
1st Qtr. 2nd Qtr. August 31 September 30 4th Qtr.
-------- -------- --------- ------------ --------
2003
- ----
Revenues..................................................... $1,237.2 $1,230.1 $734.9 $366.3 $1,139.2
Income (loss) before income taxes, minority interest and
discontinued operations.................................... (47.5) (39.3) 2,259.0 37.8 111.7
Net income (loss)............................................ (19.0) (20.6) 2,241.3 24.2 72.1
Income (loss) per common share:
Basic:
Net income............................................ $.19 $.50
Diluted:
Net income............................................ $.17 $.49
Predecessor
----------------------------------------------
1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr.
-------- -------- -------- --------
2002
- ----
Revenues................................................................ $1,258.5 $ 990.4 $990.8 $1,210.7
Loss before income taxes, minority interest, discontinued operations,
and cumulative effect of accounting change ........................... (85.7) (386.9) (952.9) (206.7)
Net loss................................................................ (3,045.1) (1,333.1) (1,769.0) (1,688.5)
18. INVESTMENTS IN VARIABLE INTEREST ENTITIES
The Company has investments in various types of special purpose entities
and other entities, some of which are VIEs under FIN 46, as described in the
note to the consolidated financial statements entitled "Summary of Significant
Accounting Policies". The following are descriptions of our significant
investments in VIEs:
Brickyard Trust
Brickyard Loan Trust ("Brickyard") was a collateralized debt obligation
trust which participated in an underlying pool of commercial loans. The trust
was formed by the Predecessor and was fully liquidated in the third quarter of
2003. The initial capital structure of Brickyard consisted of $575 million of
senior financing provided by unrelated third party investors and $127 million of
notes and subordinated certificates owned by the Company and others. As a result
of our 85 percent ownership interest in the subordinated certificates, we were
the primary beneficiary of Brickyard. In accordance with ARB 51 "Consolidated
Financial Statements", Brickyard was consolidated in our financial statements
because: (i) our investment management subsidiary, 40|86 Advisors, Inc. was the
investment manager; and (ii) we owned a significant interest in the subordinated
certificates.
In the fourth quarter of 2002, the trust decided to begin the process of
liquidating its portfolio of commercial loans. The trust planned to use the
proceeds to: (i) repay the senior debt; and (ii) distribute residual proceeds to
the subordinated certificate holders. As a result of the trust's intent to sell
the commercial loans in the near future, we determined the decline in value of
certain commercial loans was other than temporary. Accordingly, we recognized
the decline in value of $45.5 million in 2002 as a realized loss and the cost
basis of the commercial loans was reduced to estimated fair value. We included
the $410.2
161
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
million carrying value of the commercial loans which served as collateral for
Brickyard's obligations in "assets held in separate accounts and investment
trust" at December 31, 2002. Such carrying value approximated the estimated fair
value of the trust's assets. The liabilities and minority interest of the trust
totaled $392 million at December 31, 2002 and included: (i) $384 million of
amounts due to the holders of the senior note obligations (including principal
amount due plus accrued interest less $92 million in a cash reserve account held
for the benefit of the senior note holders); and (ii) $8 million representing
the interests of the minority holders of the subordinated certificates. These
amounts were included in "liabilities related to separate accounts and
investment trust". The senior note obligations of the trust had no recourse to
the general credit of the Company.
The trust sold all of the commercial loans, repaid the senior notes and
distributed its remaining assets to the subordinated certificate holders during
the third quarter of 2003. We recognized an impairment loss of $11.1 million
during the second quarter of 2003 to record an other than temporary decline in
the value of certain of the trust's commercial loans. No additional gain or loss
was recognized upon the ultimate disposition of Brickyard.
Other Investment Trusts
In December 1998, Old Conseco formed three investment trusts which invest
in various fixed maturity, limited partnership and other types of investments.
The initial capital structure of each of the trusts consisted of: (i)
principal-protected senior notes; (ii) subordinated junior notes; and (iii)
equity. The senior principal-protected notes are collateralized by zero coupon
treasury notes with par values and maturities matching the par values and
maturities of the principal-protected senior notes. Conseco's life insurance
subsidiaries own 100 percent of the senior principal-protected notes. Certain of
Conseco's non-life insurance subsidiaries own all of the subordinated junior
notes, which have a preferred return equal to the total return on the trusts'
assets in excess of principal and interest on the senior notes. The equity of
the trusts is owned by unrelated third parties.
The three investment trusts are VIEs under FIN 46 because the trusts'
equity represents significantly less than 10 percent of total capital and the
subordinated junior notes were intended to absorb expected losses and receive
virtually all expected residual returns. Based on our 100 percent ownership of
the subordinated junior notes, we are the primary beneficiary of the investment
trusts. All three trusts are consolidated in our financial statements. The
carrying value of the total invested assets in the three trusts was
approximately $228 million and $382 million at December 31, 2003 and 2002,
respectively, which also represents Conseco's maximum exposure to loss as a
result of our ownership interests in the trusts. The trusts have no obligations
or debt to outside parties. During the fourth quarter of 2003, the trusts began
liquidating their portfolios, a process which is expected to be completed in the
first quarter of 2004. The investments held by the trusts are reflected in our
investments in the consolidated balance sheet.
Investment in General Motors Building
See the note to the consolidated financial statements entitled
"Investments" for a discussion of this investment.
19. FINANCIAL INFORMATION REGARDING CFC
As part of our Chapter 11 reorganization, we sold substantially all of the
assets of our Predecessor's finance business and exited from this line of
business. Our finance business was conducted through our Predecessor's indirect
wholly-owned subsidiary, CFC. We accounted for our finance business as a
discontinued operation in 2002 once we formalized our plans to sell it. On April
1, 2003, CFC and 22 of its direct and indirect subsidiaries, which collectively
comprised substantially all of the finance business, filed liquidating plans of
reorganization with the Bankruptcy Court in order to facilitate the sale of this
business. The sale of the finance business was completed in the second quarter
of 2003. We did not receive any proceeds from this sale in respect of our
interest in CFC, nor did any creditors of our Predecessor. As of March 31, 2003,
we ceased to include the assets and liabilities of CFC on our Predecessor's
consolidated balance sheet. The consolidated statement of operations reflects
the operations of the discontinued finance business in the caption "Discontinued
operations" for all periods. Our December 31, 2002 consolidated balance sheet
includes the total assets of the finance segment in the caption "Assets of
discontinued operations" and the total liabilities of the finance segment in the
caption "Liabilities of discontinued operations".
162
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
The following summarizes selected balance sheet information of CFC as of
December 31, 2002:
CFC
CONSOLIDATED BALANCE SHEET INFORMATION
December 31, 2002
(Dollars in millions)
2002
----
ASSETS
Retained interests in securitization trusts at fair value (amortized cost:
2002 - $189.1)............................................................................ $ 252.6
Cash and cash equivalents..................................................................... 562.3
Cash held in segregated accounts for investors in securitizations............................. 394.7
Cash held in segregated accounts related to servicing agreements and
securitization transactions................................................................ 998.4
Finance receivables........................................................................... 2,023.1
Finance receivables - securitized............................................................. 12,460.0
Receivables due from Conseco, Inc.(a)......................................................... 276.1
Other assets.................................................................................. 997.7
---------
Total assets........................................................................... $17,964.9
=========
LIABILITIES AND SHAREHOLDER'S DEFICIT
Liabilities:
Investor payables.......................................................................... $ 394.7
Guarantee liability related to interests in securitization trusts held by others........... 326.7
Liabilities related to certificates of deposit............................................. 2,326.0
Servicing liability........................................................................ 333.4
Income tax liability....................................................................... 34.6
Other liabilities.......................................................................... 279.1
Notes payable:
Related to securitized finance receivables structured as collateralized borrowings....... 13,069.7
Debtor in possession facilities.......................................................... 82.0
---------
Total liabilities not subject to compromise......................................... 16,846.2
---------
Liabilities subject to compromise ............................................................ 1,204.9
---------
Total liabilities................................................................... 18,051.1
---------
Shareholder's deficit:
Preferred stock (a)........................................................................ 750.0
Common stock and additional paid-in capital (a)............................................ 1,209.4
Accumulated other comprehensive income (net of applicable deferred
income tax benefit: 2002 - $(63.8)) (a)................................................. 110.6
Retained deficit (a)....................................................................... (2,156.2)
---------
Total shareholder's deficit......................................................... (86.2)
---------
Total liabilities and shareholder's deficit......................................... $17,964.9
=========
- -----------------
(a) Intercompany accounts were eliminated when consolidated with Conseco and
its other wholly-owned subsidiaries.
163
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
The following summarizes selected statement of operations information of
CFC for the years ended December 31, 2002 and 2001:
CFC
CONSOLIDATED STATEMENT OF OPERATIONS INFORMATION (a)
for the years ended December 31, 2002 and 2001
(Dollars in millions)
2002 2001
---- ----
Revenues:
Net investment income:
Finance receivables and other.......................................... $ 2,062.4 $2,150.1
Retained interests..................................................... 75.0 125.3
Affiliated (b)......................................................... 11.8 19.6
Gain (loss) on sale of finance receivables............................... (49.5) 26.9
Servicing income......................................................... 83.9 115.3
Impairment charges....................................................... (1,449.9) (386.9)
Fee revenue and other income............................................. 189.9 220.5
--------- -------
Total revenues..................................................... 923.6 2,270.8
--------- -------
Expenses:
Provision for losses..................................................... 950.0 537.7
Interest expense - affiliated (b)........................................ 10.3 28.5
Interest expense......................................................... 1,119.7 1,205.9
Other operating costs and expenses....................................... 608.0 639.4
Other operating costs and expenses - affiliated (b)...................... 8.0 3.0
Gain on extinguishment of debt......................................... (6.3) (9.9)
Special charges.......................................................... 121.9 21.5
Reorganization items..................................................... 17.3 -
--------- -------
Total expenses..................................................... 2,828.9 2,426.1
--------- -------
Loss before income taxes........................................... (1,905.3) (155.3)
Income tax expense (benefit):
Tax (benefit) expense on period income................................... 36.8 (52.6)
Valuation allowance for deferred tax assets.............................. 245.3 -
---------- -------
Net loss........................................................... (2,187.4) (102.7)
Preferred stock dividends payable to Conseco (b)............................ 67.5 67.5
--------- -------
Net loss applicable to common stock................................ $(2,254.9) $(170.2)
========= =======
164
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
- ----------------
(a) CFC's statement of operations information has been presented as a
discontinued operation in Conseco's consolidated financial statements for
the periods summarized.
(b) Intercompany accounts were eliminated when consolidated with Conseco and
its other wholly-owned subsidiaries.
The following table reconciles CFC's loss before cumulative effect of
accounting change as presented on the previous page to the amount included in
discontinued operations in the accompanying consolidated statement of operations
(dollars in millions):
2002 2001
---- ----
Net loss.................................................................. $(2,187.4) $(102.7)
Income taxes(a)........................................................... 282.1 -
Net expenses eliminated in consolidation, net of
income tax............................................................. 6.5 7.7
Impairment charge related to investment in CFC............................ (64.5) -
--------- -------
Loss recognized as discontinued operations................................ $(1,963.3) $ (95.0)
========= =======
- -------------
(a) Amount is considered in determining the income tax expense in the
consolidated statement of operations.
Summary of Significant Accounting Policies
Significant accounting policies, not described in the note to the
consolidated financial statements entitled "Summary of Significant Accounting
Policies," which are more relevant to CFC are discussed below:
Retained Interest in Securitization Trusts
Retained interests in securitization trusts represent the right to receive
certain future cash flows from securitization transactions structured prior to
CFC's September 8, 1999 announcement (see "Revenue Recognition for Sales of
Finance Receivables and Amortization of Servicing Rights" below). Such cash
flows generally are equal to the value of the principal and interest to be
collected on the underlying financial contracts of each securitization in excess
of the sum of the principal and interest to be paid on the securities sold and
contractual servicing fees. CFC carried retained interests at estimated fair
value. We determined fair value by discounting the projected cash flows over the
expected life of the receivables sold using current prepayment, default, loss
and interest rate assumptions. CFC determined the appropriate discount rate to
value these securities based on it's estimates of current market rates of
interest for securities with similar yield, credit quality and maturity
characteristics. The discount rate was 16 percent at December 31, 2002. CFC
recorded any unrealized gain or loss determined to be temporary, net of tax, as
a component of shareholders' equity. Declines in value are considered to be
other than temporary when: (i) the fair value of the security is less than its
carrying value; and (ii) the timing and/or amount of cash expected to be
received from the security has changed adversely from the previous valuation
which determined the carrying value of the security. When declines in value
considered to be other than temporary occurred, CFC reduced the amortized cost
to estimated fair value and recognize a loss in the statement of operations. The
assumptions used to determine new values were based on CFC's internal
evaluations.
Finance Receivables
Finance receivables included manufactured housing, home equity, home
improvement, retail credit and floor plan loans. CFC carried finance receivables
at amortized cost, net of an allowance for credit losses.
CFC deferred fees received and costs incurred when it originated finance
receivables. CFC amortized deferred fees, costs, discounts and premiums over the
estimated lives of the receivables. CFC included such deferred fees or costs in
the amortized cost of finance receivables.
165
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
CFC generally stopped accruing investment income on finance receivables
after three consecutive months of contractual delinquency.
Finance receivables transferred to securitization trusts in transactions
structured as securitized borrowings are classified as finance receivables -
securitized. These receivables were held as collateral for the notes issued to
investors in the securitization trusts. Finance receivables held by CFC that had
not been securitized are classified as finance receivables.
Provision for Losses
The provision for credit losses was based upon an assessment of current and
historical loss experience, loan portfolio trends, prevailing economic and
business conditions, and other relevant factors. In management's opinion, the
provision was sufficient to maintain the allowance for credit losses at a level
that adequately provided for losses inherent in the portfolio.
CFC reduced the carrying value of finance receivables to net realizable
value at the earlier of: (i) six months of contractual delinquency; or (ii) when
it took possession of the property securing the finance receivable.
Liabilities Related to Certificates of Deposit
These liabilities related to the certificates of deposits issued by CFC's
bank subsidiaries. The liability and interest expense account were also
increased for the interest which accrued on the deposits. At December 31, 2002,
the weighted average interest crediting rate on these deposits was 3.5 percent.
Revenue Recognition for Sales of Finance Receivables and Amortization of
Servicing Rights
Subsequent to September 8, 1999, CFC generally structured its
securitizations in a manner that required them to be accounted for under the
portfolio method, whereby the loans and securitization debt remain on CFC's
balance sheet pursuant to Financial Accounting Standards Board Statement No.
140, "Accounting for the Transfer and Servicing of Financial Assets and
Extinguishments of Liabilities" ("SFAS 140"). The ratings downgrades and other
events that followed the Company's August 9, 2002, announcement, eliminated
CFC's access to the securitization markets.
For securitizations structured prior to September 8, 1999, CFC accounted
for the transfer of finance receivables as sales. In accordance with GAAP, CFC
recognized a gain, representing the difference between the proceeds from the
sale (net of related sale costs) and the carrying value of the component of the
finance receivable sold. CFC determined such carrying value by allocating the
carrying value of the finance receivables between the portion sold and the
interests retained (generally interest-only securities, servicing rights and, in
some instances, other subordinated securities), based on each portion's relative
fair values on the date of the sale.
CFC amortized the servicing rights it retained after the sale of finance
receivables in proportion to, and over the estimated period of, net servicing
income.
CFC evaluated servicing rights for impairment on an ongoing basis,
stratified by product type and securitization period. To the extent that the
recorded amount exceeded the fair value for any strata, CFC established a
valuation allowance through a charge to earnings. If CFC determined, upon
subsequent measurement of the fair value of these servicing rights, that the
fair value equaled or exceeded the amortized cost, any previously recorded
valuation allowance would be deemed unnecessary and restored to earnings.
Liabilities Subject to Compromise
Under the Bankruptcy Code, actions by creditors to collect indebtedness CFC
owed prior to the Petition Date were stayed and certain other prepetition
contractual obligations were not enforced against the Finance Company Debtors.
CFC received approval from the Bankruptcy Court to pay certain prepetition
liabilities including employee salaries and wages, benefits, and other employee
obligations. All other prepetition liabilities were classified as "liabilities
subject to compromise" in CFC's December 31, 2002 consolidated balance sheet.
166
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
The following table summarizes the components of the liabilities included
in the line "liabilities subject to compromise" in CFC's consolidated balance
sheet as of December, 2002 (dollars in millions):
Other liabilities:
Liability for litigation................................................... $ 38.8
Accounts payable and accrued expenses...................................... 65.8
--------
Total other liabilities subject to compromise.......................... 104.6
--------
Preferred stock dividends payable to Conseco, Inc............................. 153.6
--------
Notes payable:
Master repurchase agreements (a)........................................... 174.4
Credit facility collateralized by retained
interests in securitizations (a) ........................................ 497.7
Due to Conseco, Inc........................................................ 273.2
Other borrowings........................................................... 1.4
--------
Total notes payable subject to compromise.............................. 946.7
--------
Total liabilities subject to compromise................................ $1,204.9
========
- ----------------
(a) The Finance Company Debtors have guaranteed these facilities.
Finance Receivables and Retained Interests in Securitization Trusts
During 2002, CFC completed six securitization transactions, securitizing
$2.7 billion of finance receivables. These securitizations were structured in a
manner that required them to be accounted for as secured borrowings, whereby the
loans and securitization debt remained on CFC's balance sheet, rather than as
sales, pursuant to SFAS 140. Such accounting method is referred to as the
"portfolio method".
CFC classified 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 on these receivables was
approximately 12.4 percent at December 31, 2002. CFC classified the notes issued
to investors in the securitization trusts as "notes payable related to
securitized finance receivables structured as collateralized borrowings".
Conseco's leveraged condition and liquidity difficulties eliminated CFC's
ability to access the securitization markets. This required CFC to pursue whole
loan sales to maintain availability under its warehouse facilities for new
originations. Accordingly, CFC classified its unsecuritized finance receivables
as held for sale which required the assets to be carried at the lower of cost or
market. At December 31, 2002, CFC had an allowance of $47.1 million for certain
finance receivables with current estimated market values below cost.
During 2002, CFC completed various loan sale transactions. CFC sold $2.1
billion of finance receivables which generated net losses of $49.5 million. CFC
also recognized a loss of $96.0 million related to the sale of $.5 billion of
certain finance receivables sold as part of its cash raising initiatives in
order to meet its debt obligations. See "Special Charges" elsewhere in the notes
to the consolidated financial statements.
167
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
The following table summarizes CFC's finance receivables - securitized by
business line (dollars in millions):
December 31,
------------
2002
----
Primary lines:
Manufactured housing...................................................................... $ 6,965.3
Mortgage services......................................................................... 5,005.9
Retail credit............................................................................. 641.5
Consumer finance - closed-end............................................................. 407.7
---------
13,020.4
Less allowance for credit losses.......................................................... 560.4
---------
Total finance receivables - securitized................................................. $12,460.0
=========
The following table summarizes CFC's other finance receivables by business
line and categorized as either a part of CFC's primary lines or a part of other
lines (discontinued in previous periods) (dollars in millions):
December 31,
------------
2002
----
Primary lines:
Manufactured housing...................................................................... $ 159.5
Mortgage services......................................................................... 260.7
Retail credit............................................................................. 1,599.1
Consumer finance closed-end............................................................... 35.8
--------
2,055.1
Less allowance for credit losses.......................................................... 86.5
--------
Net other finance receivables for primary lines......................................... 1,968.6
--------
Other lines (discontinued in previous periods)............................................... 71.4
Less allowance for credit losses.......................................................... 16.9
--------
Net other finance receivables for other lines........................................... 54.5
--------
Total other finance receivables......................................................... $2,023.1
========
168
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
The changes in CFC's allowance for credit losses included in finance
receivables (both securitized and other portfolios) were as follows (dollars in
millions):
2002 2001
---- ----
Allowance for credit losses, beginning of year.......................................... $421.3 $306.8
Additions to the allowance:
Provision for losses................................................................. 950.0 537.7
Change in allowance due to purchases and sales of certain
finance receivables................................................................ (21.3) (.1)
Credit losses........................................................................... (686.2) (423.1)
------ ------
Allowance for credit losses, end of year................................................ $663.8 $421.3
====== ======
169
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, CFC recognized a gain and recorded its retained interest
represented by the interest-only security and servicing rights. The
interest-only security represented 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, CFC also retained
B-2 securities. CFC's net retained interests in securitization trusts at
December 31, 2002 are summarized below (dollars in millions):
December 31, 2002
-------------------------
Amortized Estimated
cost fair value
---- ----------
Retained interests in securitization trusts:
Interests securitized in the form of B-2 securities............. $ 548.0 $ 611.5
Interest-only securities........................................ (358.9) (358.9)
------- -------
Total retained interests, excluding guarantee liabilities... 189.1 252.6
Guarantee liability related to interests in securitization
trusts held by others........................................... (326.7) (326.7)
------- -------
Total retained interests, net of guarantee liabilities...... $(137.6) $ (74.1)
======= =======
During 2002, CFC recognized no gain on sale related to securitized
transactions.
The retained interests in securitization trusts on CFC's balance sheet
represented an allocated portion of the cost basis of the finance receivables in
the securitization transactions accounted for as sales. CFC's retained interests
in those securitization transactions were subordinate to the interests of other
investors. Their values were subject to credit, prepayment, and interest rate
risk on the securitized finance receivables. Management of CFC determined the
discount rate to value these securities based on CFC's estimates of current
market rates of interest for securities with similar yield, credit quality and
maturity characteristics. CFC included 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 income (loss), net of taxes."
The determination of the value of CFC's retained interests in
securitization trusts required significant judgment. CFC recognized significant
charges when the interest-only securities did not perform as well as anticipated
based on its assumptions and expectations. In securitizations to which these
retained interests related, CFC retained certain contingent risks in the form of
guarantees of certain lower-rated securities issued by the securitization
trusts. As of December 31, 2002, the total nominal amount of these guarantees
was approximately $1.4 billion. CFC considered any potential payments related to
these guarantees in the projected cash flows used to determine the value of its
retained interests. The discounted present value of the expected future payments
related to the guarantees were classified as the "Guarantee liability related to
interests in securitization trusts held by others" in CFC's balance sheet. The
$1.4 billion nominal amount of these guarantees represented the par value of the
guaranteed lower-rated securities. During 2002 and 2001, interest and principal
payments related to such guarantees totaled $45.5 million and $32.7 million,
respectively. CFC suspended guarantee payments in the fourth quarter of 2002.
Together, the interest-only securities and the B-2 securities, represented
CFC's retained interests in these securitization trusts.
During 2002, CFC's ability to access the securitization markets was
eliminated. The securitization markets were CFC's main source of funding for
loans made to purchasers of repossessed manufactured homes. CFC believed 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 its dealer network). Since CFC was no longer able to
fund the loans made on repossessed homes sold through these channels, sales
through these channels decreased and CFC had to use the wholesale channel to
dispose of repossessed manufactured housing units, through which recovery rates
are
170
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
significantly lower. Accordingly, CFC changed the loss severity assumptions used
to value its retained interests to reflect the higher loss severity expected to
be experienced in the future. In addition, CFC's previous assumptions reflected
its belief that the adverse manufactured housing default experience in recent
periods would continue through the first half of 2002 and then improve over
time. Accordingly, CFC increased the default assumptions it used to value its
retained interests to reflect its future expectations. CFC's home equity/home
improvement assumptions were adjusted to reflect recent default experience as
well as CFC's future expectations.
The Company adopted the requirements of EITF 99-20 effective July 1, 2000.
Under EITF 99-20, declines in the value of CFC's 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, CFC recognized an impairment charge of $1,077.2 million in 2002
for the retained beneficial interests. CFC also recognized a $336.5 million
increase in the valuation allowance as a result of changes to the expected
future cost of servicing the finance receivables. The levels of delinquent and
defaulting loans caused servicing costs to increase.
CFC recognized an impairment charge of $386.9 million in 2001, for the
interest-only securities that were not performing as well as expected based on
its previous valuation estimates.
The following table summarizes certain cash flows received from and paid to
the securitization trusts during 2002 (dollars in millions):
Servicing fees received......................................................... $ 46.9
Cash flows from retained interests, net of guarantee payments................... 22.3
Servicing advances paid......................................................... (275.9)
Repayment of servicing advances................................................. 257.1
During the third quarter and again in the fourth quarter of 2002, CFC
changed the assumptions used to estimate the value of its retained interests to:
(i) project higher severity losses related to the defaults, reflecting CFC's
inability to finance the sale of repossessed manufactured homes resulting in
reliance on the wholesale disposition channel for repossessed manufactured
homes; and (ii) project higher rates of default in the future, based on its then
current expectations.
Effective September 30, 2001, CFC transferred substantially all of its
interest-only securities into a securitization trust. The transaction provided a
means to finance a portion of the value of its interest-only securities by
selling some of the cash flows 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 CFC 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. CFC
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 $20.4 million at December 31, 2002. CFC
continued to be the servicer of the finance receivables underlying the
interest-only securities transferred to the trust. Lehman had the ability to
accelerate the principal payments related to their interest after a stated
period. Until such time, Lehman was 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 CFC'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 did not avoid an impairment charge if sufficient positive cash flows
in the aggregate were not available (such as was the case at December 31, 2002).
On December 2, 2002, CFC elected not to make approximately $4.7 million in
guarantee payments of which $.6 million was owed to outside third parties.
171
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
At December 31, 2002, key economic assumptions used to determine the
estimated fair value of CFC's retained interests in securitizations and the
sensitivity of the current fair value of residual cash flows to immediate 10
percent and 20 percent changes in those assumptions were as follows (dollars in
millions):
Home equity/ Interests Interests
Manufactured home Consumer/ held by held by
housing improvement equipment Total others Conseco
------- ----------- --------- ----- ------ -------
Carrying amount/fair value of retained interests:
Retained interests................................. $ 24.6 $ 234.4 $ 14.0 $ 273.0 $(20.4) $ 252.6
Guarantee liability................................ (299.7) (5.8) (21.2) (326.7) - (326.7)
Servicing liabilities.............................. (320.1) (5.9) (7.4) (333.4) - (333.4)
--------- -------- ------ ------- ------ -------
Total retained interests....................... $ (595.2) $ 222.7 $(14.6) $(387.1) $(20.4) $(407.5)
========= ======== ======= ======= ====== =======
Cumulative principal balance of sold finance
receivables at December 31, 2002................... $15,429.6 $3,723.2 $787.2 $19,940.0
Weighted average life in years.......................... 6.9 3.6 2.5 6.1
Weighted average stated customer interest rate
on sold finance receivables........................ 9.7% 11.9% 10.5% 10.2%
Assumptions to determine estimated fair value
of retained interests at December 31, 2002:
Expected prepayment speed as a percentage
of principal balance of sold finance receivables (a) 7.1% 18.9% 18.0% 9.8%
Impact on fair value of 10 percent decrease........ $(6.7) $2.0 $(.6) $(5.3)
Impact on fair value of 20 percent decrease........ (18.1) 5.9 (1.1) (13.3)
Impact on fair value of 10 percent increase........ 8.0 (1.3) .4 7.1
Impact on fair value of 20 percent increase........ 15.8 (1.9) .9 14.8
Expected nondiscounted credit losses as a percentage of
principal balance of related finance receivables (a) 20.3% 9.0% 11.7% 17.9%
Impact on fair value of 10 percent decrease........ $26.8 $17.4 $2.2 $46.4
Impact on fair value of 20 percent decrease........ 115.3 37.6 5.2 158.1
Impact on fair value of 10 percent increase........ (6.3) (15.8) (2.0) (24.1)
Impact on fair value of 20 percent increase........ (30.3) (30.3) (3.5) (64.1)
Weighted average discount rate.......................... 16.0% 16.0% 16.0% 16.0%
Impact on fair value of 10 percent decrease........ $(11.8) $20.3 $.9 $9.4
Impact on fair value of 20 percent decrease........ (24.4) 43.6 2.0 21.2
Impact on fair value of 10 percent increase........ 11.2 (17.8) (1.0) (7.6)
Impact on fair value of 20 percent increase........ 21.6 (33.5) (1.8) (13.7)
172
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
- ----------------------
(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 CFC's projections, it
could have a material effect on the valuation of its retained interests.
Additionally, such valuation is determined by discounting cash flows over
the entire expected life of the receivables sold.
These sensitivities are hypothetical and should be used with caution. As
the figures indicate, changes in fair value based on a 10 percent variation in
assumptions generally cannot be extrapolated because the relationship of the
change in assumption to the change in fair value may not be linear. Also, in
this table, the effect of a variation in a particular assumption on the fair
value of the retained interest is calculated without changing any other
assumption; in reality, changes in one factor may result in changes in another
(for example, increases in market interest rates may result in lower prepayments
and increased credit losses), which might magnify or counteract the
sensitivities.
The following table summarizes quantitative information about
delinquencies, net credit losses, and components of managed finance receivables
(dollars in millions):
Principal balance
60 days or more Net credit
Principal balance past due losses
-------------------------- ------------------ ------
for the year ended
at December 31, December 31,
----------------------------------------------- --------------------
2002 2002 2002
---- ---- ----
Type of finance receivables
- ---------------------------
Manufactured housing...................... $23,022.4 $ 803.3 $ 756.3
Home equity/home improvement.............. 8,842.8 122.6 282.7
Consumer.................................. 3,334.6 83.8 219.3
Commercial................................ 82.7 6.5 17.7
--------- -------- --------
Total managed receivables................. 35,282.5 1,016.2 1,276.0
Less finance receivables securitized
and repossessed assets................. 19,908.8 528.5 589.8
--------- -------- --------
Finance receivables held on balance sheet
before allowance for credit losses and
deferred points and other, net......... 15,373.7 $ 487.7 $ 686.2
======== ========
Less allowance for credit losses.......... 663.8
Less deferred points and other, net....... 226.8
---------
Finance receivables held on
balance sheet.......................... $14,483.1
=========
173
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
The following schedule reconciles CFC's retained interests, net of
guarantee liabilities, from the beginning to the end of the years presented
(dollars in millions):
2002 2001
---- ----
Balance, beginning of year......................................................... $ 670.2 $927.5
Investment income............................................................... 75.0 125.3
Cash paid (received):
Gross cash received........................................................... (67.8) (132.6)
Guarantee payments related to clean-up calls (a).............................. - 45.3
Guarantee payments related to interests held by others........................ 45.5 32.7
Impairment charge to reduce carrying value...................................... (1,077.2) (264.8)
Sale of securities related to a discontinued line and other..................... 15.9 (12.4)
Change in interest purchased by Lehman in conjunction with
securitization transaction.................................................... 34.8 (55.2)
Transfer to servicing rights in conjunction with securitization transaction..... - (50.0)
Change in unrealized appreciation (depreciation) recorded in shareholders'
equity (deficit).............................................................. 229.5 54.4
------- ------
Balance, end of year............................................................... $ (74.1) $670.2
======= ======
- -----------------------
(a) During 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. CFC
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 2001, CFC was required to make payments to the securitization
trusts. These payments increased CFC's basis in the retained interests, as
the related liability assumed by CFC (and reflected in the value of the
retained interest) was extinguished.
174
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
Income Taxes
CFC's income tax expense included deferred income taxes arising from
temporary differences between the financial reporting and tax bases of assets
and liabilities. These amounts were reflected in the balance of deferred income
tax assets which totaled $925.7 million at December 31, 2002. In assessing the
realization of deferred income tax assets, CFC considered whether it was more
likely than not that the deferred income tax assets would be realized. The
ultimate realization of deferred income tax assets depended upon generating
future taxable income during the periods in which temporary differences became
deductible. CFC evaluated the realizability of its deferred income tax assets by
assessing the need for a valuation allowance on a quarterly basis. A valuation
allowance of $925.7 million had been provided for the entire net deferred tax
asset balance as of December 31, 2002, as CFC believed that the realization of
such assets in future periods was uncertain. The components of CFC's income tax
assets and liabilities were as follows (dollars in millions):
2002
----
Deferred tax assets (liabilities):
Net operating loss carryforwards................................................................. $ 193.3
Deductible timing differences:
Interest-only securities...................................................................... 536.3
Unrealized appreciation....................................................................... (22.4)
Allowance for loan losses..................................................................... 252.2
Other......................................................................................... (33.7)
-------
Total deferred tax assets................................................................. 925.7
Valuation allowance....................................................................... (925.7)
-------
Net deferred tax liability................................................................ -
Current income taxes payable....................................................................... (34.6)
-------
Net income tax liabilities................................................................. $ (34.6)
=======
Income tax expense (benefit) was as follows (dollars in millions):
2002 2001
---- ----
Current tax provision............................................................... $ 36.8 $ 59.5
Deferred tax benefit................................................................ - (112.1)
----- ------
Income tax expense (benefit)................................................ 36.8 (52.6)
Valuation allowance................................................................. 245.3 -
------ ------
Net income tax expense (benefit)............................................ $282.1 $(52.6)
====== ======
The income tax benefit differed from that computed at the applicable
federal statutory rate (35 percent) for the following reasons (dollars in
millions):
2002 2001
---- ----
Tax benefit on loss before income taxes at statutory rate........................... $(666.8) $(54.0)
Valuation allowance................................................................. 245.3 .2
Net deferred benefits not recognized in the current period.......................... 761.0 -
State taxes, net.................................................................... (57.4) 1.2
------- ------
Income tax expense (benefit)................................................. $ 282.1 $(52.6)
======= ======
At December 31, 2002, CFC had $552.4 million of net operating loss
carryforwards. The carryforwards were to expire as follows: $54.7 in 2018;
$273.6 in 2020; and $224.1 in 2022.
175
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
Pension Plan of CFC
CFC provided certain pension benefits for certain eligible retired
employees under a partially funded plan. Amounts related to the pension plan
were as follows (dollars in millions):
Pension benefits
----------------
2002
----
Benefit obligation, beginning of year................................... $14.8
Interest cost....................................................... .9
Actuarial loss...................................................... 7.1
Benefits paid....................................................... (4.6)
-----
Benefit obligation, end of year......................................... $18.2
=====
Fair value of plan assets, beginning of year............................ $14.2
Actual return on plan assets........................................ (1.1)
Employer contributions.............................................. .4
Benefits paid....................................................... (4.6)
-----
Fair value of plan assets, end of year.................................. $ 8.9
=====
Funded status........................................................... $(9.3)
Unrecognized net actuarial loss......................................... 12.9
-----
Prepaid benefit cost............................................. $ 3.6
=====
CFC used the following weighted average assumptions to calculate benefit
obligations for its 2002 valuations: postretirement discount rate of
approximately 5.0 percent; preretirement discount rate of approximately 6.0
percent; and an expected return on plan assets of approximately 9.0 percent.
Beginning in 2000, as a result of plan amendments, no assumption for
compensation increases was required. Included as an adjustment to accumulated
other comprehensive income (loss) is a $12.7 million adjustment representing the
additional minimum liability associated with this plan.
176
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
Components of the cost CFC recognized related to its pension plan were as
follows (dollars in millions):
Pension benefits
----------------
2002 2001
---- ----
Interest cost....................................................................... $ .9 $ 1.1
Expected return of plan assets...................................................... (1.1) (1.5)
Settlement loss..................................................................... 2.2 1.3
Recognized net actuarial loss....................................................... .6 .3
----- -----
Net periodic cost............................................................ $ 2.6 $ 1.2
===== =====
Notes Payable, Representing Direct Finance Obligations (Excluding Notes
Payable Related to Securitized Finance Receivables Structured as
Collateralized Borrowings)
Notes payable (excluding notes payable related to securitized finance
receivables structured as collateralized borrowings) of CFC at December 31,
2002, were as follows (interest rates as of December 31, 2002) (dollars in
millions):
2002
----
Master repurchase agreements ("Warehouse Facilities") due on various
dates in 2003 (3.10%)........................................................................ $ 176.3
Residual facility collateralized by retained interests in securitizations
due 2004 ("Residual Facility") (3.88%)....................................................... 497.7
Debtor in possession facility due May 2003 (10.0%).............................................. 82.0
Note payable to Conseco (2.91%)................................................................. 273.2
Other........................................................................................... 1.4
-------
Total principal amount..................................................................... 1,030.6
Unamortized net discount and deferred fees...................................................... (1.9)
-------
Direct finance obligations................................................................. $1,028.7
========
As of the Petition Date, CFC's remaining liquidity sources were a warehouse
facility (the "Warehouse Facility") and a residual facility ("Residual
Facility") with Lehman and a bank credit facility with U.S. Bank and together
with the Warehouse Facility and Residual Facility, the "CFC Facilities". The
direct borrower under (i) the Warehouse Facility was CFC's non-debtor subsidiary
Green Tree Finance Corp. - Five ("GTFC"), and (ii) the Residual Facility was
CFC's non-debtor subsidiary Green Tree Residual Finance Corp. I ("GTRFC"). The
Warehouse Facility and the Residual Facility were fully guaranteed by CFC and,
up to an aggregate of $125 million, by CIHC. CFC was the direct borrower under
the U.S. Bank Facility, which was also guaranteed by CIHC up to an aggregate of
$125 million.
Prior to the Petition Date, CFC was in default under the CFC Facilities as
a result of (i) cross-defaults triggered by Old Conseco's defaulting on its debt
obligations, (ii) cross-defaults among the U.S. Bank Facility, the Warehouse
Facility and the Residual Facility, (iii) failure to make payments required by
CFC's guarantees of payments on B-2 securities, which were issued to investors
in certain finance receivable securitization transactions; and (iv) breaches of
several financial covenants under the CFC Facilities. CFC entered into
forbearance agreements with Lehman with respect to the Warehouse Facility and
Residual Facility and with U.S. Bank with respect to U.S. Bank Facility,
pursuant to which Lehman and U.S. Bank agreed to temporarily refrain from
exercising any rights arising from events of default that occurred under each
CFC Facility prior to the Petition Date.
The Warehouse Facility was a repurchase facility under which primarily
newly originated manufactured housing, home equity, home improvement and
recreational vehicle loans originated by CFC or affiliates of CFC and
transferred to GTFC were sold by GTFC to Lehman with an agreement to repurchase
those loans at a later date and at a higher price. The price differential
reflected the cost of financing. The Warehouse Facility provided funding to CFC
for new loan originations.
177
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
The Warehouse Facility and the Residual Facility were cross-collateralized.
The Residual Facility was collateralized by retained interests in
securitizations. CFC was 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, CFC's collateral
was deficient at December 31, 2002 (as calculated in accordance with the
relevant transaction documents, which provide that Lehman calculates the value
of CFC's collateral within its sole discretion). Pursuant to the forbearance
agreement entered into with Lehman on December 20, 2002, Lehman agreed not to
accelerate the repayment of the Residual Facility based on the collateral
deficiency. Under the terms of this forbearance agreement, Lehman retained the
cash flows from CFC's retained interests pledged under this facility and applied
those cash flows to the margin deficit. The filing by Old Conseco, CIHC and CFC
of a Chapter 11 petition triggered additional defaults under the CFC Facilities.
On December 19, 2002, shortly after the filing of the Chapter 11 Cases, CFC
obtained the FPS DIP provided by U.S. Bank and FPS DIP LLC, an affiliate of
Fortress Investment Group LLC ("Fortress"), J.C. Flowers & Co. LLC. ("Flowers")
and Cerberus Capital Management, L.P. ("Cerberus"). The DIP financing is for up
to $125,000,000. The DIP financing motion was granted by the Bankruptcy Court on
January 14, 2003.
From time to time, CFC failed to comply with certain covenants regarding
the maximum permissible variance of the budgets provided to the FPS DIP lenders
in connection with the FPS DIP. In each instance, CFC obtained appropriate
waivers.
On December 20, 2002, CFC, GTFC, and GTRFC, entered into several agreements
with Lehman: (the "Lehman December 20 Agreements") (i) providing that Lehman
temporarily refrain from exercising any rights arising from events of default
that occurred under each relevant CFC Facility (including, but not limited to,
those arising out of Old Conseco, CIHC and CFC filing for Chapter 11 relief);
(ii) indirectly providing CFC with up to $25,000,000 in postpetition financing
by allowing GTFC to provide intercompany loans to CFC with cash flows obtained
from the Warehouse Facility; (iii) decreasing the capacity of the Warehouse
Facility to a maximum of $250,000,000; and (iv) otherwise amending the Warehouse
Facility and the Residual Facility. These agreements were subject to a number of
conditions.
As a result of CFC's defaults and the Lehman December 20 Agreements, CFC
could not draw funds from the Residual Facility.
During 2002, CFC repurchased $46.9 million par value of its senior
subordinated notes and medium term notes resulting in a gain on the
extinguishment of debt of $6.3 million. In March 2002, CFC completed a tender
offer pursuant to which it purchased $75.8 million par value of its senior
subordinated notes due June 2002. The purchase price was equal to 100 percent of
the principal amount of the notes plus accrued interest. The remaining principal
amount outstanding of $58.5 million (including $23.7 million held by Conseco) of
the senior subordinated notes was retired at maturity on June 3, 2002.
In April 2002, CFC completed a tender offer pursuant to which it purchased
$158.5 million par value of its medium term notes due September 2002 and $3.7
million par value of its medium term notes due April 2003. The purchase price
was equal to 100 percent of the principal amount of the notes plus accrued
interest. In June 2002, CFC tendered for the remaining $8.2 million par value of
its medium term notes due September 2002. Pursuant to the tender offer $5.5
million par value of the notes was tendered in July. The purchase price was
equal to 101 percent of the principal amount of the notes plus accrued interest.
The remaining principal amount outstanding of the medium term notes after giving
effect to both tender offers and other debt repurchases completed prior to the
tender offers of $2.7 million was retired at maturity on September 26, 2002.
During 2001, CFC repurchased: $55.4 million par value of its 10.25% senior
subordinated notes due June 2002 for $51.9 million, resulting in a gain on the
extinguishment of debt of $3.4 million; and $34.0 million par value of its 6.5%
medium term notes due September 2002 for $27.5 million, resulting in a gain on
the extinguishment of debt of $6.5 million.
178
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
Notes Payable Related to Securitized Finance Receivables Structured as
Collateralized Borrowings
Notes payable related to securitized finance receivables structured as
collateralized borrowings were $13,069.7 million at December 31, 2002. The
principal and interest on these notes were paid using the cash flows from the
underlying finance receivables which served as collateral for the notes.
Accordingly, the timing of the principal payments on these notes was dependent
on the payments received on the underlying finance receivables which back the
notes. In some instances, CFC was required to advance principal and interest
payments even though the payments on the underlying finance receivables which
back the notes had not yet been received. The average interest rate on these
notes was 6.7 percent at December 31, 2002. The notes payable balance also
included amounts related to financing transactions securitized by: (i)
capitalized expenses related to the refurbishment of repossessed assets; and
(ii) principal and interest advances. The outstanding liability on these
facilities at December 31, 2002 was $85 million.
Special Charges
2002
The following table summarizes the special charges incurred by CFC during
2002, which are further described in the paragraphs which follow (dollars in
millions):
Loss related to assets sold to raise cash...................................... $ 97.6
Costs related to debt modification and refinancing transactions................ 39.4
Reduction in value of Lehman warrant........................................... (38.1)
Abandonment of computer processing system...................................... 16.3
Other items.................................................................... 6.7
------
Special charges before income tax benefit.................................. $121.9
======
Loss related to assets sold to raise cash
CFC completed various asset sales which resulted in net losses of $97.6
million in 2002. Such amounts included the loss of $96.0 million related to the
sales of $463 million of certain finance receivables and $1.6 million of
additional loss related to receivables required to be repurchased from the
purchaser of the vendor services receivables pursuant to the repurchase clauses
in the agreements.
Costs related to debt modification and refinancing transactions
In conjunction with the various modifications to borrowing arrangements and
refinancing transactions and the recognition of deferred expenses for terminated
financing arrangements, CFC incurred costs of $39.4 million in 2002 which were
not permitted to be deferred pursuant to GAAP.
Reduction in value of Lehman warrant
As partial consideration for a financing transaction, Conseco Finance
issued a warrant to Lehman which permitted the holder to purchase 5 percent of
Conseco Finance at a nominal price. The holder of the warrant or Conseco Finance
may cause the warrant and any stock issued upon its exercise to be purchased for
cash at an appraised value in May 2003. Since the warrant permitted cash
settlement at fair value at the option of the holder of the warrant, it was
included in other liabilities and was measured at fair value, with changes in
its value reported in earnings. The estimated fair value of the warrant at
December 31, 2002 was nil based on current valuations of Conseco Finance.
Accordingly, CFC recorded a $38.1 million reduction in the value of the warrant
during 2002.
Abandonment of computer processing systems
In 2002, CFC incurred a $16.3 million charge for the abandonment of certain
computer processing systems. CFC is abandoning such systems given the recent
changes to its business and its decision to no longer originate certain types of
loans.
179
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
2001
The following table summarizes the special charges incurred by CFC during
2001, which are further described in the paragraphs which follow (dollars in
millions):
Severance benefits, litigation reserves and other restructuring charges................... $ 20.3
Loss related to sale of certain finance receivables....................................... 11.2
Change in value of warrant................................................................ (10.0)
------
Special charges before income tax benefit............................................ $ 21.5
======
Severance benefits, litigation reserves and other restructuring charges
During 2001, Conseco developed plans to change the way it operates. Such
changes were undertaken in an effort to improve CFC's operations and
profitability. The planned changes included moving a significant number of jobs
to India, where a highly-educated, low-cost, English-speaking labor force was
available. Pursuant to GAAP, CFC was required to recognize the costs associated
with most restructuring activities as the costs were incurred. However, costs
associated with severance benefits are required to be recognized when the costs
are: (i) attributable to employees' services that have already been rendered;
(ii) relate to obligations that accumulate; and (iii) are probable and can be
reasonably estimated. Since the severance costs associated with their planned
activities met these requirements, CFC recognized a charge of $6.2 million in
2001 related to severance benefits and other restructuring charges. CFC also
recognized charges of: (i) $7.5 million related to its decision to discontinue
the sale of certain types of life insurance in conjunction with lending
transactions; and (ii) $6.6 million related to certain litigation matters.
Loss related to the sale of certain finance receivables
During 2001, CFC recognized a loss of $2.2 million on the sale of $11.2
million of finance receivables. Also, during 2001, the purchaser of certain
credit card receivables returned certain receivables pursuant to a return of
accounts provision included in the sales agreement. Such returns and the
associated losses exceeded the amounts CFC initially anticipated when the
receivables were sold. CFC recognized a loss of $9.0 million related to the
returned receivables.
Change in value of warrant
As partial consideration for a financing transaction, CFC issued a warrant
which permits the holder to purchase 5 percent of Conseco Finance at a nominal
price. The holder of the warrant or CFC may cause the warrant and any stock
issued upon its exercise to be purchased for cash at an appraised value in May
2003. Since the warrant permitted cash settlement at fair value at the option of
the holder of the warrant, it was included in other liabilities and was measured
at fair value, with changes in its value reported in earnings. The estimated
fair value of the warrant at December 31, 2001 was $38.1 million. The estimated
value was determined based on discounted cash flow and market multiple valuation
techniques. During 2001, CFC recognized a $10.0 million benefit as a result of
the decreased value of the warrant (which was classified as a reduction to
special charges).
20. FINANCIAL INFORMATION REGARDING CVIC
In October 2002, Conseco Life Insurance Company of Texas (a wholly-owned
subsidiary of the Company) completed the sale of CVIC to Inviva, Inc.
("Inviva"). CVIC marketed tax qualified annuities and certain employee
benefit-related insurance products through professional independent agents.
Pursuant to SFAS 144, CVIC is accounted for as a discontinued operation. Our
consolidated statement of operations reflects the operations of CVIC in the
caption "Discontinued operations" for all periods. The consideration received
from Inviva at closing (subject to adjustment based upon the adjusted statutory
balance sheet of CVIC at September 30, 2002) totaled $83.7 million, of which
$35.0 million was in the form of Series D Preferred Shares (the "Preferred
Shares") issued by Inviva and the remainder was in cash. The purchase price was
finalized in July 2003, which reduced the amount of Preferred Shares received by
$10.5 million. In addition, Conseco Life Insurance Company of Texas received a
dividend of approximately $75 million from CVIC immediately prior to the
closing. We recognized a loss on the sale of $93.1 million. There was no income
tax benefit recognized on the transaction. As part of the CVIC sale, Conseco
agreed that it would not engage in the variable annuity or variable insurance
business for a period of three years after the closing.
180
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
The Preferred Shares accrued dividends (in-kind) at an annual rate of 19
percent through October 15, 2003, but no dividends accrued after that date. In
October 2003, $10.0 million of the Preferred Shares were redeemed by Inviva. Our
insurance subsidiary that holds these shares may elect to exchange the Preferred
Shares for non-voting common stock of JNF Holding Company, Inc., a wholly-owned
subsidiary of Inviva, ("JNF") that now owns all of the stock of CVIC. After the
exchange has occurred, such JNF common stock may be repurchased by JNF at any
time at 115 percent of the stated value of the Preferred Shares plus accrued and
unpaid dividends thereon immediately prior to the exchange.
The following summarizes selected financial information of CVIC (dollars in
millions):
Years ended
December 31,
-------------------
2002 2001
---- ----
Insurance policy income.............................................................. $ 30.5 $ 73.0
Net investment income................................................................ (217.3) (61.7)
Net realized investment losses....................................................... (76.7) (34.3)
Total revenues....................................................................... (263.3) (23.0)
Insurance policy benefits............................................................ (234.7) (81.7)
Amortization......................................................................... 117.4 33.7
Total expenses....................................................................... (102.9) (17.4)
Pre-tax loss......................................................................... (160.4) (5.6)
Net loss............................................................................. $(101.6) $ (5.6)
Income taxes......................................................................... (58.8)(a) -
Loss on sale of CVIC................................................................. (93.1) -
------- ------
Amount classified as discontinued operations..................................... $(253.5) $ (5.6)
======= ======
- ---------------
(a) Amount is considered in determining the income tax expense in the
consolidated statement of operations.
181
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS AND FINANCIAL
DISCLOSURE.
None.
ITEM 9A. CONTROLS AND PROCEDURES
Conseco's management, under the supervision and with the participation of
the Chief Executive Officer and the Chief Financial Officer, evaluated the
effectiveness of Conseco's disclosure controls and procedures (as defined in
Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as
amended). Based on this evaluation, the Chief Executive Officer and Chief
Financial Officer concluded that, as of December 31, 2003, Conseco's disclosure
controls and procedures were effective to ensure that information required to be
disclosed by Conseco in reports that it files or submits under the Securities
Exchange Act of 1934 is recorded, processed, summarized and reported within the
time periods specified in the Securities and Exchange Commission's rules and
forms.
There were no significant changes in Conseco's internal controls over
financial reporting that occurred during the quarter ended December 31, 2003,
that have materially affected, or are reasonably likely to materially affect,
Conseco's internal controls over financial reporting.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
Executive Officers
Our executive officers are as follows:
Name Age Position with Conseco
---- --- ---------------------
Eugene M. Bullis................................ 58 Executive Vice President and Chief Financial
Officer
Eric R. Johnson................................. 43 President, 40|86 Advisors, Inc.
William S. Kirsch............................... 47 Executive Vice President, General Counsel
and Secretary
John R. Kline................................... 46 Senior Vice President and Chief Accounting
Officer
William J. Shea................................. 56 Director, President and Chief Executive Officer
Eugene M. Bullis has been executive vice president and chief financial
officer since November 2002. From 2000 until 2002, Mr. Bullis served as chief
financial officer of Managed Ops.Com, Inc. From 1999 until 2000 he was executive
vice president and chief financial officer of Manufacturers Services, Ltd. and
from 1998 to 1999 he served as senior vice president and chief financial officer
of Physicians Quality Care.
Eric R. Johnson has been president and chief executive officer of 40|86
Advisors, Inc. (formerly Conseco Capital Management, Inc.), Conseco's
wholly-owned registered investment advisor, since September 2003 and has held
various positions since joining Conseco Capital Management, Inc. in 1997.
William S. Kirsch has been executive vice president, general counsel and
secretary since September 2003. His professional corporation, William S. Kirsch,
P.C., is a partner in the law firm Kirkland & Ellis LLP. Mr. Kirsch has been
with Kirkland & Ellis LLP since 1981.
John R. Kline has been senior vice president and chief accounting officer
since July 2002. Mr. Kline has served in various accounting and finance
capacities with Conseco since 1990.
William J. Shea has served as a director of Conseco and its Predecessor
since September 2002. He has served as president and chief executive officer of
Conseco since October 2002 and was president and chief operating officer from
September 2001 until October 2002. Before joining Conseco, Mr. Shea served as
CEO of View Tech, Inc. (integrated video-conferencing solutions) from 1998 until
2000. From 1994 to 1998, he was vice chairman and from 1992 to 1998 chief
financial officer of Bank Boston Corporation.
182
Messrs. Shea, Bullis and Kline served as officers, and Mr. Shea served as a
director, of our Predecessor company, which filed a bankruptcy petition on
December 17, 2002. Mr. Shea and Mr. Bullis also served as directors and/or
officers of several subsidiaries of our Predecessor that also filed bankruptcy
petitions on December 17, 2002.
Directors
Our directors are as follows:
Name Age Position with Conseco
---- --- ---------------------
R. Glenn Hilliard(2)(3)(5) ........................ 61 Non-Executive Chairman
Philip R. Roberts(1)(4) ........................... 62 Director
Neal Schneider(1)(4) .............................. 59 Director
Michael S. Shannon(2)(3) .......................... 45 Director
William J. Shea(4)(5) ............................. 56 Director, President and Chief Executive Officer
Michael T. Tokarz(2)(3)............................ 54 Director
John G. Turner(1)(4)(5) ........................... 64 Director
- -------------
(1) Member of the Audit and Enterprise Risk Committee
(2) Member of the Governance and Strategy Committee
(3) Member of the Human Resources and Compensation Committee
(4) Member of the Investment Committee
(5) Member of the Executive Committee
R. Glenn Hilliard became the non-executive chairman of our board of
directors in September 2003. Mr. Hilliard has been Chairman and CEO of Hilliard
Group, LLC, an investment and consulting firm, since June 2003. From 1999 until
his retirement in April 2003, Mr. Hilliard served as chairman and CEO of ING
Americas. From 1994 to 1999 he was chairman and CEO of ING North America.
Philip R. Roberts joined our board of directors in September 2003. Since
2000, Mr. Roberts has been principal of Roberts Ventures L.L.C., consultant for
merger and acquisition and product development for investment management firms.
From 1996 until 2000, Mr. Roberts served as chief investment officer of trust
business for Mellon Financial Corporation and headed its institutional asset
management businesses from 1990 to 1996.
Neal Schneider joined our board of directors in September 2003. Since June
2002, Mr. Schneider has been a partner of Smart and Associates, LLP, a business
advisory and accounting firm. Between August 2000 and June 2002, he was an
independent consultant. Until his retirement in August 2000, Mr. Schneider spent
34 years with Arthur Andersen & Co., including service as partner in charge of
the Worldwide Insurance Industry Practice and the North American Financial
Service Practice. Mr. Schneider is Chairman of the Board of PMA Capital
Corporation.
Michael S. Shannon joined our board of directors in September 2003. Mr.
Shannon is co-founder and has been president and chief executive officer since
1992 of KSL Recreation Corporation (owner and operator of golf courses and
destination resorts in the U.S.). Mr. Shannon was lead director of ING Americas
before joining our board. Mr. Shannon is a director of Startek, Inc.
Michael T. Tokarz joined our board of directors in September 2003. Mr.
Tokarz has been a managing member of the Tokarz Group, LLC (venture capital
investments) since 2002. He was a general partner with Kohlberg Kravis Roberts &
Co. from 1985 until he retired in 2002. Mr. Tokarz is also a director of Walter
Industries, Inc, Idex Corp. and MEVC Draper Fisher Jurvetson Fund I Inc.
John G. Turner joined our board of directors in September 2003. Mr. Turner
has been chairman of Hillcrest Capital Partners, a private equity investment
firm since 2002. Mr. Turner served as chairman and CEO of ReliaStar Financial
Corp. from 1991 until it was acquired by ING in 2000. After the acquisition he
became vice chairman and a member of the executive committee for ING Americas
until his retirement in 2002. Mr. Turner is a director of Hormel Foods
Corporation, Shopko Stores, Inc. and ING Funds.
183
Board of Directors
Our board of directors is currently comprised of seven members, divided
into two classes as follows: Messrs. Shea, Roberts and Tokarz are Class I
directors, and Messrs. Hilliard, Schneider, Shannon and Turner are Class II
directors. The term of office of the Class I directors expires at our 2004
annual meeting of stockholders and the term of office of the initial Class II
directors expires at our 2005 annual meeting of stockholders. Other than the
term of office of the initial Class II directors, the term of office of each
Class of directors will expire at the next succeeding annual meeting of
stockholders. Accordingly, the term of office of the Class I directors expires
at the 2004 annual meeting of stockholders, at which time three new directors
will be elected for a one year term, and the term of office of the Class II
directors, as well as the Class I directors elected at the 2004 annual meeting
of stockholders, will expire at the 2005 annual meeting of stockholders, at
which time seven new directors will be elected.
The initial Class I and Class II directors are those directors elected in
connection with the adoption of our certificate of incorporation on September
10, 2003. At each annual meeting of stockholders, directors to replace those of
a class or classes whose terms expire at such annual meeting will be elected to
hold office until the next succeeding annual meeting and until their respective
successors have been duly elected and qualified. If the number of directors is
changed, any newly created directorships or decrease in directorships will be so
apportioned among the classes as to make all classes as nearly equal in number
as practicable.
With the exception of Mr. Shea, our President and Chief Executive Officer,
our board of directors has determined that all of our directors meet the
independence requirements of the New York Stock Exchange.
Board Committees
Audit and Enterprise Risk Committee. The Audit and Enterprise Risk
Committee's functions, among others, are to recommend the appointment of
independent accountants; review the arrangements for and scope of the audit by
independent accountants; review the independence of the independent accountants;
consider the adequacy of the system of internal accounting controls and review
any proposed corrective actions; review and monitor the Company's compliance
with legal and regulatory requirements; and discuss with management and the
independent accountants our draft annual and quarterly financial statements and
key accounting and/or reporting matters. The audit committee currently consists
of Messrs. Schneider, Roberts and Turner, with Mr. Schneider serving as chairman
of the committee and as "audit committee financial expert," as defined under SEC
rules promulgated under the Sarbanes-Oxley Act. All current members of the Audit
and Enterprise Risk Committee are "independent" within the meaning of the new
regulations adopted by the SEC and the listing requirements adopted by the NYSE
regarding audit committee membership. A copy of the Audit and Enterprise Risk
Committee's charter is available on our website at www.conseco.com.
Governance and Strategy Committee. The Governance and Strategy Committee is
responsible for, among other things, establishing criteria for board membership;
considering, recommending and recruiting candidates to fill new positions on the
board; reviewing candidates recommended by shareholders; considering questions
of possible conflicts of interest involving board members, executive officers
and key employees. It is also responsible for developing principles of corporate
governance and recommending them to the board for its approval and adoption,
reviewing periodically these principles of corporate governance to insure that
they remain relevant and are being complied with. The Governance and Strategy
Committee currently consists of Messrs. Hilliard, Tokarz and Shannon, with Mr.
Tokarz serving as chairman of the committee. All current members of the
Governance and Strategy Committee are "independent" within the meaning of the
new listing requirements adopted by the NYSE regarding nominating committee
membership. A copy of the Governance and Strategy Committee's charter is
available on our website at www.conseco.com. The Governance and Strategy
Committee does not have a written policy regarding stockholder nominations for
director candidates. The Governance and Strategy Committee will, however,
consider candidates for director nominees put forward by stockholders. Our
bylaws establish an advance notice procedure with regard to certain matters,
including stockholder nominations for directors, to be brought before a meeting
of stockholders at which directors are to be elected. In the case of an annual
meeting, notice must be received by the Secretary of the Company not less than
60 days nor more than 90 days prior to the first anniversary of the preceding
year's annual meeting. In the case of a special meeting of stockholders at which
directors are to be elected, notice of a stockholder nomination must be received
by the Secretary of the Company no later than the close of business on the 10th
day following the earlier of the day on which notice of the date of the meeting
was mailed or public disclosure of the meeting was made. A nomination will not
be considered if it does not comply with these notice procedures and any
additional requirements set forth in our bylaws. Please note that these
requirements are separate from the SEC's requirements to have a stockholder
nomination or other proposal included in our proxy statement.
184
Human Resources and Compensation Committee. The Human Resources and
Compensation Committee is responsible for, among other things, approving overall
compensation policy; recommending to the board the compensation of the Chief
Executive Officer and other senior officers; and reviewing and administering our
incentive compensation and equity award plans. The Human Resources and
Compensation Committee currently consists of Messrs. Hilliard, Tokarz and
Shannon, with Mr. Shannon serving as chairman of the committee. All current
members of the Human Resources and Compensation Committee are "independent"
within the meaning of the new listing requirements adopted by the NYSE regarding
compensation committee membership. A copy of the Human Resources and
Compensation Committee's charter is available on our website at www.conseco.com.
Investment Committee. The Investment Committee is responsible for, among
other things, reviewing investment policies, strategies and programs; overseeing
the investment of funds in accordance with policies and limits approved by it;
and reviewing the quality and performance of our investment portfolios and the
alignment of asset duration to liabilities. The Investment Committee currently
consists of Messrs. Shea, Schneider, Roberts and Turner, with Mr. Roberts
serving as chairman of the committee. A copy of the Investment Committee's
charter is available on our website at www.conseco.com.
Executive Committee. Subject to the requirements of applicable law,
including our certificate of incorporation and bylaws, the Executive Committee
is responsible for exercising, as necessary, the authority of the board of
directors in the management of our business affairs during intervals between
board meetings. The Executive Committee currently consists of Messrs. Hilliard,
Shea and Turner, with Mr. Turner serving as chairman of the committee. A copy of
the Executive Committee's charter is available on our website at
www.conseco.com.
Compensation Committee Interlocks
None of the members of the Human Resources and Compensation Committee is or
has been an officer or employee of our Company. None of our executive officers
serves, or served during 2003, as a member of the board of directors or
compensation committee of any entity that has one or more executive officers
serving on our board of directors or Human Resources and Compensation Committee.
Director Compensation
Our non-employee directors (other than our non-executive chairman) receive
an annual cash retainer of $70,000. The chairman of the Audit and Enterprise
Risk Committee receives an additional annual cash fee of $30,000, and directors
who serve as chairman of one of our other board committees receive an additional
annual cash fee of $20,000. Each member of the Audit and Enterprise Risk
Committee also receives an annual cash retainer of $30,000. Directors are also
entitled to receive $70,000 in annual equity awards under the Conseco, Inc. 2003
Long-Term Equity Incentive Plan. Directors are reimbursed for out-of-pocket
expenses incurred in connection with the performance of their responsibilities
as directors.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Exchange Act requires Conseco's directors and
executive officers, and each person who is the beneficial owner of more than 10
percent of any class of Conseco's outstanding equity securities, to file with
the SEC initial reports of ownership and reports of changes in ownership of
common stock and other equity securities of Conseco. Specific due dates for
these reports have been established by the SEC, and Conseco is required to
disclose any failure by such persons to file such reports for fiscal year 2003
by the prescribed dates. Officers, directors and greater than ten percent
beneficial owners are required by SEC regulations to furnish Conseco with copies
of all reports filed with the SEC pursuant to Section 16(a) of the Exchange Act.
To Conseco's knowledge, based solely on review of the copies of reports
furnished to Conseco and written representations that no other reports were
required, all filings required pursuant to Section 16(a) of the Exchange Act
applicable to Conseco's officers, directors and greater than 10 percent
beneficial owners were timely made by each such person during the year ended
December 31, 2003.
Code of Ethics
We have adopted a Code of Business Conduct and Ethics that applies to all
officers, directors and employees regarding their obligations in the conduct of
the Company's affairs. A copy of the Code of Business Conduct and Ethics is
available on our website at www.conseco.com.
185
ITEM 11. EXECUTIVE COMPENSATION.
Summary Compensation Table
The following Summary Compensation Table sets forth the cash compensation
and certain other compensation paid to each person who served as chief executive
officer and the other five most highly compensated individuals who served as
executive officers of Conseco in 2003 (collectively, the "named executive
officers") for services rendered during 2003.
Long-Term Compensation
Awards
-----------------------------
Number of
Securities
Annual Compensation Restricted Underlying
---------------------------- Stock Options/SARs All Other
Name and Principal Position Year Salary Bonus(1) Other(2) Awards(3)(in shares)(4) Compensation(5)
- --------------------------- ---- ------ -------- -------- -------- ------------- ---------------
William J. Shea......................... 2003 $1,026,122 $2,000,000 $13,569,000 500,000 $ 68,379
President and Chief Executive Officer 2002 774,038 1,100,000 $87,625 -- -- 3,677
2001 147,756 250,000 340,000 450,000 92
Edward M. Berube(6)..................... 2003 660,000 660,000 -- -- 774
President, Bankers Life and Casualty 2002 660,000 660,000 -- -- 5,500
2001 660,000 693,000 -- 100,000 269,778
Maxwell E. Bublitz(7)................... 2003 497,372 762,375 -- -- 703,031
Senior Vice President, Investments 2002 700,000 450,000 -- -- 6,790
2001 625,000 450,000 -- 25,000 6,750
Eugene M. Bullis(8)(9).................. 2003 609,135 2,400,000 5,467,500 -- 162,090
Executive Vice President and 2002 243,590 600,000 -- -- --
Chief Financial Officer
Eric R. Johnson(8)(10).................. 2003 505,961 1,600,000 1,640,250 -- 180
President, 40|86 Advisors, Inc.
John R. Kline(8)(11).................... 2003 275,000 171,875 1,093,500 -- 270
Senior Vice President and 2002 214,571 1,052,500 -- -- 6,310
Chief Accounting Officer
- ------------------
(1) Bonus amounts shown for 2003 include payments approved by the Bankruptcy
Court.
(2) Includes for Mr. Shea $68,541 relating to his personal use of Company
aircraft in 2002.
(3) The amounts shown in this column represent the value of the award of shares
of restricted stock based on the closing price of the common stock on the
dates of grant.
(4) No stock appreciation rights have been granted.
(5) For 2003, the amounts reported in this column represent the following
amounts paid for the named executive officers: (i) severance payment (Mr.
Bublitz, $650,000); (ii) accrued vacation payment (Mr. Bublitz, $51,538);
(iii) amounts imputed as income for accommodation and business commuting
expenses (Mr. Shea, $65,170 and Mr. Bullis, $130,337); (iv) relocation
expenses (Mr. Bullis, $30,979); (v) individual life insurance premiums (Mr.
Shea, $2,435 and Mr. Bublitz, $1,290); and (vi) group life insurance
premiums (Mr. Shea, $774, Mr. Berube, $774, Mr. Bublitz, $203, Mr. Bullis,
$774, Mr. Johnson, $180 and Mr. Kline, $270).
(6) Mr. Berube's employment was terminated in February 2004.
(7) Mr. Bublitz' employment was terminated in September 2003.
186
(8) No compensation information is reported for years prior to the year in
which the named executive officer became an executive officer of the
Company.
(9) Mr. Bullis' employment commenced in July 2002.
(10) Mr. Johnson became an executive officer in September 2003.
(11) Mr. Kline became an executive officer in July 2002.
Non-Executive Chairman Agreement
On June 18, 2003, our Predecessor entered into an agreement with R. Glenn
Hilliard pursuant to which Mr. Hilliard provided consulting services to our
Predecessor during the pendency of the Chapter 11 cases and agreed to serve as
our non-executive chairman for an initial term of four years following our
emergence from bankruptcy. This agreement, which became effective upon our
emergence from bankruptcy, was negotiated with our Predecessor's creditors
committee and was approved by the Bankruptcy Court in connection with the
approval of the Plan. The agreement provides for (i) an annual director's fee of
$1,000,000 for the first two years of the term, and director's fees similar to
those paid to similarly situated non-executive chairmen for the latter two years
of the term; (ii) a signing bonus of 98,119 shares of common stock, which were
issued shortly after our emergence from bankruptcy; and (iii) a retention bonus
of $1,500,000, payable as soon as practicable following the first anniversary of
our emergence from bankruptcy, and a retention bonus of $750,000, payable as
soon as practicable following the second anniversary of our emergence from
bankruptcy. Under the agreement, we also issued Mr. Hilliard options to purchase
500,000 shares of common stock and 500,000 shares of restricted stock, all of
which are subject to vesting, pursuant to the Conseco, Inc. 2003 Long-Term
Equity Incentive Plan. The agreement also provides that Mr. Hilliard will
receive a grant of options to purchase 0.25% of our then-outstanding common
stock and a restricted stock grant of 0.25% of our then-outstanding common
stock, all of which will be subject to vesting, as soon as practicable following
the first anniversary of our emergence from bankruptcy. After the second
anniversary of our emergence from bankruptcy, the agreement provides that Mr.
Hilliard will receive the same equity-based compensation as other non-employee
members of our board of directors. Under the agreement, Mr. Hilliard is entitled
to a gross-up for excise tax payments under Section 280G of the Internal Revenue
Code. Mr. Hilliard also receives a monthly allowance of $3,000 per month for
office space and related expenses in connection with the maintenance of an
office in Atlanta, Georgia. If Mr. Hilliard's service as non-executive chairman
ends as a result of his death, disability, removal other than for cause or
failure to be re-elected (each a "qualifying termination") before the first
anniversary of our emergence from bankruptcy, he is entitled to receive the
prorated portion of his first-year retention bonus. If Mr. Hilliard's service as
non-executive chairman ends as a result of a qualifying termination after the
first anniversary but before the second anniversary of our emergence from
bankruptcy, he is entitled to receive the prorated portion of his second-year
retention bonus. In addition, upon a qualifying termination, vesting of
previously granted options and restricted stock will occur as if Mr. Hilliard
continued to serve through the next anniversary of our emergence from bankruptcy
following his separation. Mr. Hilliard has agreed not to commence full-time
employment with any other company during the 18-month period following our
emergence from bankruptcy, and Mr. Hilliard is subject to a non-competition
clause under the agreement in the event his service with us terminates prior to
the end of the term. On December 30, 2003, Mr. Hilliard, who serves as one of
our independent directors, agreed to irrevocably waive his right to receive
compensation with respect to services rendered by him to our Predecessor prior
to our emergence from bankruptcy.
Employment Agreements
Chief Executive Officer. On May 27, 2003, our Predecessor entered into an
employment agreement with William J. Shea pursuant to which he would serve as
our President and Chief Executive Officer for an initial term of three years.
This agreement, which became effective upon our emergence from bankruptcy, was
negotiated with our Predecessor's creditors committee and was approved by the
Bankruptcy Court in connection with the approval of the Plan. The agreement
provides for an annual base salary of $1,000,000, an annual performance-based
bonus with a target of 100% of base salary, and an emergence bonus of
$1,000,000, which was paid shortly after our emergence from bankruptcy. Under
the agreement, we issued Mr. Shea options to purchase 500,000 shares of common
stock and 500,000 shares of restricted stock, all of which are subject to
vesting, pursuant to the Conseco, Inc. 2003 Long-Term Equity Incentive Plan. The
agreement also provides that Mr. Shea will receive a retirement benefit of
$500,000 per year and term life insurance with a face amount of $1,500,000. Mr.
Shea's retirement benefit is guaranteed by our subsidiaries, Conseco Services
LLC and Conseco Life Insurance Company of Texas. Mr. Shea is also entitled to a
gross-up for excise tax payments under Section 280G of the Internal Revenue
Code. If Mr. Shea is terminated by Conseco without just cause or resigns for
good reason, he will be entitled to a payment of $6,250,000 and a pro rata
portion of the greater of (i) his annual bonus for the year in which the
separation occurs or (ii) $500,000. In addition, vesting of previously granted
options and restricted stock will occur as if Mr. Shea were employed through the
next anniversary of our emergence from bankruptcy following his separation. Mr.
Shea is subject to a non-
187
competition clause under the agreement in the event his service with Conseco
terminates prior to the end of the term.
Chief Financial Officer. We have entered into an employment agreement,
effective September 10, 2003, with Eugene M. Bullis pursuant to which he would
serve as our Executive Vice President and Chief Financial Officer for a term of
three years. The agreement provides for an annual base salary of $600,000, an
annual performance-based bonus with a target of 100% of base salary and an
emergence bonus of $1,200,000, which was paid shortly after our emergence from
bankruptcy. Mr. Bullis is also entitled to a future success bonus of $1,200,000
to be paid on the third anniversary of the agreement, subject to acceleration
triggers under which one-third of the $1,200,000 future success bonus would be
paid upon the occurrence of each of: (i) the first refinancing of our Class A
Preferred Stock and Senior Credit Facility, (ii) our obtaining a financial
strength rating from A.M. Best of "A-" or higher, and (iii) achievement of
agreed upon expense reductions. Under the agreement, we will provide Mr. Bullis
with an initial equity award comprised of options to purchase 250,000 shares of
common stock with an exercise price equal to fair market value on the date of
grant and 250,000 shares of restricted stock, all of which will be subject to
vesting, pursuant to the Conseco, Inc. 2003 Long-Term Equity Incentive Plan. The
agreement also provides that Mr. Bullis will receive a supplemental retirement
benefit of $250,000 per year, one-third of which will vest each anniversary of
the agreement. We will provide Mr. Bullis a life insurance policy with a face
value of $600,000 and cover the cost of certain relocation expenses. If Mr.
Bullis is terminated by the Company without just cause, the unpaid amount of his
supplemental retirement benefit will vest and any unpaid portion of the
$1,200,000 future success bonus will become due and payable. In addition,
vesting of previously granted options and restricted stock will occur as if Mr.
Bullis were employed through the next anniversary of our emergence from
bankruptcy following his separation. In the event of a change of control of the
Company, all previously granted options and restricted stock will vest. In the
event that Mr. Bullis' employment is terminated 6 months prior to or within 2
years after a change of control, the unvested amount of his supplemental
retirement benefit will vest and any unpaid portion of the $1,200,000 future
success bonus will become due and payable. In addition, if Mr. Bullis'
employment is terminated 6 months prior to a change of control, all of his
unvested options and restricted stock will vest, retroactive to the date of
termination, upon the occurrence of the change of control. Mr. Bullis is subject
to a non-competition clause under the agreement in the event his service with
Conseco terminates prior to the end of the term.
Chief Accounting Officer. Effective July 15, 2002, our Predecessor entered
into an employment agreement with John R. Kline pursuant to which he would serve
as our Senior Vice President and Chief Accounting Officer for an initial term of
two years. The agreement provides for an annual salary of at least $275,000,
bonuses at the discretion of Conseco, a signing bonus of $865,000 subject to
payment to Conseco in a pro rata amount in the event Mr. Kline voluntarily
leaves Conseco (based on the portion of the two year period remaining after the
date of such voluntary termination of employment), a severance allowance upon
termination of employment and other fringe benefits.
President, 40|86 Advisors, Inc. 40|86 Advisors, Inc., a wholly-owned
investment management subsidiary of Conseco, Inc. that manages the investment
portfolios of our insurance subsidiaries, has entered into an employment
agreement, effective September 10, 2003, with Eric R. Johnson pursuant to which
he would serve as 40|86 Advisors' President for a term of three years. The
agreement provides for an annual base salary of $500,000, an annual
performance-based bonus with a target of 100% of base salary and a bonus of
$950,000 that was paid in January 2004. Mr. Johnson is also entitled to a future
success bonus of $950,000 to be paid on the third anniversary of the agreement,
subject to acceleration triggers under which one-third of the $950,000 future
success bonus would be paid upon the occurrence of each of: (i) the first
refinancing of our Class A Preferred Stock and Senior Credit Facility, (ii) our
obtaining a financial strength rating from A.M. Best of "A-" or higher, and
(iii) the achievement of mutually agreed-upon improvements in investment return
and quality. Under the agreement, we will provide Mr. Johnson with an initial
equity award comprised of options to purchase 150,000 shares of common stock
with an exercise price equal to fair market value on the date of grant and
75,000 shares of restricted stock, all of which will be subject to vesting,
pursuant to the Conseco, Inc. 2003 Long-Term Equity Incentive Plan. We will
provide Mr. Johnson a life insurance policy with a face value of $500,000. If
Mr. Johnson is terminated by 40|86 Advisors without just cause, any unvested
portion of the $950,000 future success bonus will become due and payable. In the
event of a change of control of the Company, all previously granted options and
restricted stock will vest. In the event that Mr. Johnson's employment is
terminated 6 months prior to or within 2 years after a change of control, any
unvested portion of the $950,000 future success bonus will become due and
payable. In addition, if Mr. Johnson's employment is terminated 6 months prior
to a change of control, all of his unvested options and restricted stock will
vest, retroactive to the date of termination, upon the occurrence of the change
of control. Mr. Johnson is subject to a non-competition clause under the
agreement in the event his service with 40|86 Advisors terminates prior to the
end of the term.
188
Conseco, Inc. 2003 Long-Term Equity Incentive Plan
Overview. As of the effective date of the Plan, the Bankruptcy Court,
pursuant to the confirmation order approving the Plan, approved, and our board
of directors adopted, the Conseco, Inc. 2003 Long-Term Equity Incentive Plan.
The purpose of the plan is to promote our long-term growth and profitability by
providing selected directors, officers and employees of the Company and its
subsidiaries, as well as other persons who provide services to us, with
incentives to maximize stockholder value and otherwise contribute to our
success, and enable us to attract, retain and reward the best available persons
for positions of responsibility.
Types of awards. The plan provides for the grant of stock options and
restricted stock to eligible participants.
Eligibility. Directors, officers and employees of the Company and its
subsidiaries, as well as other individuals performing significant services for
us, or to whom we have extended an offer of employment, will be eligible to
receive awards under the plan. In each case, the Human Resources and
Compensation Committee of the board of directors will select the actual
participants and determine the amounts and terms of their awards.
Share reserve/limitations. 10,000,000 shares of our common stock are
available for issuance under the plan. Of these 10,000,000 shares, only
3,333,333 may be granted in the form of restricted stock.
Administration. The Human Resources and Compensation Committee of our board
of directors administers the plan. Our board of directors also has the authority
to administer the plan and to take all actions that the Human Resources and
Compensation Committee is otherwise authorized to take under the plan.
Terms of Awards. The exercise price of an option issued under the plan may
not be less than 100% of the fair market value of our common stock on the date
the option is granted. The Human Resources and Compensation Committee
determines, in connection with each grant under the plan, when options become
exercisable and when they expire. The Human Resources and Compensation Committee
also determines the vesting periods of restricted stock granted under the plan.
Change in Control. The Human Resources and Compensation Committee may
provide, in award agreements, for appropriate adjustments to option and
restricted stock awards, including the acceleration of vesting, if a change in
control of the Company occurs.
Amendment and Termination. The Human Resources and Compensation Committee
or our board of directors may amend or terminate the plan at any time, as long
as the amendment or termination does not negatively affect any options or
restricted stock that have been previously granted under the plan without the
consent of the holders, but cannot increase the number of shares available for
issuance under the plan, materially modify the requirements for eligibility
under the plan, or materially increase the benefits to participants under the
plan without the approval of stockholders. Unless earlier terminated, the plan
will terminate on September 10, 2013.
Stock Options
The following table sets forth certain information concerning the exercise
in 2003 of options to purchase common stock by the named executive officers and
the unexercised options to purchase common stock held by such individuals as of
December 31, 2003.
189
Aggregated Option Exercises in 2003 and Year-End Option Values
Number of Securities
Underlying Unexercised Value of Unexercised
Options (in shares) at In-the-Money Options at
Number of December 31, 2003 December 31, 2003(1)
Shares Acquired Value --------------------------- ------------------------------
Name on Exercise Realized Exercisable Unexercisable Exercisable Unexercisable
- ---- ----------- -------- ----------- ------------- ----------- -------------
William J. Shea - - - 500,000 - $2,700,000
Edward M. Berube - - - - - -
Maxwell E. Bublitz - - - - - -
Eugene M. Bullis - - - - - -
Eric R. Johnson - - - - - -
John R. Kline - - - - - -
- -------------
(1) The value is calculated based on the aggregate amount of the excess of
$21.80 (the last sale prices of the Common Stock as reported by the NYSE
for the last business day of 2003) over the relevant exercise prices.
The following table sets forth certain information concerning options to
purchase common stock granted in 2003 to the named executive officers.
Option Grants in 2003
Individual Grants
-----------------------------------------------------------------------------------------------
Potential Realizable Value at
Assumed Annual Rates of
% of Total Stock Price Appreciation for
Number of Options Granted Per Share Options Term
Securities Underlying to Employees in Exercise Expiration -------------------------
Name Options Granted 2003 Price Date 5% 10%
- ---- -------------------- ---------------- ------------ ----------- ---------- ----------
William J. Shea(1) 500,000 100% $16.40 9/29/13 $6,777,686 $15,649,462
Edward M. Berube - - - - - -
Maxwell E. Bublitz - - - - - -
Eugene M. Bullis - - - - - -
Eric R. Johnson - - - - - -
John R. Kline - - - - - -
- -------------
(1) The options reported are non-qualified stock options which vest in four
equal annual installments beginning September 29, 2004.
190
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS.
The following table sets forth certain information concerning the
beneficial ownership of our common stock as of March 1, 2004 by each person
known to us who beneficially owns more than 5% of the outstanding shares of our
common stock, each of our directors, each of our named executive officers and
all of our directors and executive officers as a group.
Shares
Beneficially Owned
Name and Address Number Percentage
---------------- ------ ----------
FMR Corp (1)................................................ 7,040,780 7.0%
Angelo, Gordon & Co., L.P.(2).............................. 5,716,487 5.7
R. Glenn Hilliard (3)....................................... 598,119 *
William J. Shea ............................................ 700,000 *
Neal Schneider.............................................. 5,526 *
Philip R. Roberts........................................... 5,526 *
John G. Turner.............................................. 5,526 *
Michael T. Tokarz .......................................... 5,526 *
Michael S. Shannon ......................................... 5,526 *
Eugene M. Bullis............................................ 250,000 *
Eric R. Johnson............................................ 75,000 *
John R. Kline .............................................. 50,000 *
All directors and executive officers as a group
(11 persons) ........................................... 1,700,749 (4) 1.7
- --------------------------
* Less than 1%.
(1) Based solely on the Schedule 13G filed with the SEC on February 17, 2004 by
FMR Corp. The business address of FMR Corp. is 82 Devonshire Street,
Boston, Massachusetts 02019.
(2) Based solely on the Schedule 13G filed with the SEC on September 22, 2003
by Angelo, Gordon & Co., L.P. ("Angelo, Gordon"); John M. Angelo, in his
capacities as general partner of AG Partners, L.P., the sole general
partner of Angelo, Gordon, and as the chief executive officer of Angelo,
Gordon; and Michael L. Gordon, in his capacities as the other general
partner of AG Partners, L.P., the sole general partner of Angelo, Gordon,
and as the operating officer of Angelo, Gordon. The business address of
each of Angelo, Gordon, Mr. Angelo and Mr. Gordon is 245 Park Avenue, New
York, New York 10167.
(3) Includes 98,119 shares held by a charitable foundation, of which Mr.
Hilliard is a trustee. He disclaims beneficial ownership of such shares.
(4) Includes 1,585,000 shares of restricted stock held by directors and
executive officers which has not yet vested.
191
Equity Compensation Plan Information
The following table sets forth information about the Company's common stock
that may be issued under the Conseco Inc. 2003 Long-Term Incentive Plan as of
December 31, 2003:
Number of securities
remaining available for
Number of securities future issuance under
to be issued upon Weighted-average equity compensation
exercise of exercise price of plans (excluding
outstanding options, outstanding options, securities reflected in
Plan category warrants or rights warrants or rights first column)
------------- ------------------ ------------------ -------------
Equity compensation
plans approved by
security holders.................... 1,000,000 $18.01 7,982,370
Equity compensation
plans not approved
by security holders........... - - -
---------- ----- ---------
Total............................... 1,000,000 $18.01 7,982,370
========= ====== =========
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
Beginning in 1996, our Predecessor adopted stock purchase plans (the
"Purchase Plans") to encourage direct, long-term ownership of its common stock
by directors, executive officers and certain key employees. Purchases of common
stock under the Purchase Plans were financed by personal loans made to the
participants from banks. These loans were collateralized by the common stock
purchased. Approximately 170 directors, officers and key employees of our
Predecessor and its subsidiaries participated in the Purchase Plans and
purchased an aggregate of approximately 19.0 million shares of our Predecessor's
common stock offered under the Purchase Plans. Our Predecessor guaranteed the
loans but had recourse to the participants if it incurred a loss under the
guarantees. As a result of the Plan, Conseco acquired the right to collect these
loans from the participants. The only current director or executive officer that
had an outstanding Purchase Plan loan during 2003 was Mr. Johnson, who had
borrowed $205,903, relating to his purchase of 5,000 shares under the Purchase
Plans. Mr. Johnson repaid this loan in full in 2003.
In addition, our Predecessor provided loans to the participants for the
interest payments payable on the guaranteed bank loans. The largest amount owed
during 2003 by Mr. Johnson on the loan to cover interest was $58,912. Mr.
Johnson repaid his interest payment loan in full in January 2004. The interest
payment loans bore interest at a variable annual rate equal to the lowest annual
rate our Predecessor paid under its most recent senior credit facility.
192
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.
Aggregate fees billed to the Company for the years ended December 31, 2003
and 2002, by PricewaterhouseCoopers LLP were as follows (dollars in millions):
Year ended
December 31,
-------------
2003 2002
---- ----
Audit fees (a)........................................................ $5.0 $3.9
Audit-related fees (b)................................................ .3 .8
Tax fees (c).......................................................... 2.2 1.2
All other fees (d).................................................... .1 .1
---- ----
Total.............................................................. $7.6 $6.0
==== ====
- --------------------
(a) Audit fees were for professional services rendered for the audits of
Conseco's consolidated financial statements, statutory and subsidiary
audits, issuance of comfort letters, consents, and assistance with review
of documents filed with the SEC.
(b) Audit-related fees primarily include services provided for advisory
services for Sarbanes-Oxley Section 404, employee benefit plan audits, and
other assurance related services.
(c) Tax fees primarily include services provided for tax compliance, tax advice
and tax planning.
(d) Other fees relate to software licensing fees.
The Audit and Enterprise Risk Committee has adopted a policy requiring
pre-approval of all audit and permissible non-audit services provided by the
independent auditors. These services may include audit services, audit-related
services, tax services and other services. The Audit Committee of the
Predecessor adopted a policy for pre-approval of audit and permissible non-audit
services provided by the independent auditors in December 2002. Prior to that
time, there was no specific policy. In 2002, all audit fees were pre-approved;
approximately 20 percent of the audit-related services were pre-approved; but
none of the 2002 tax or other services were pre-approved.
In 2003, all new engagements of the independent auditors were pre-approved
by the Audit and Enterprise Risk Committee for all audit, audit-related, tax and
other services.
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a) 1. Financial Statements. See Index to Consolidated Financial
Statements on page 87 for a list of financial statements included
in this Report.
2. Financial Statement Schedules. The following financial statement
schedules are included as part of this Report immediately
following the signature page:
Schedule II -- Condensed Financial Information of Registrant
(Parent Company)
Schedule IV -- Reinsurance
All other schedules are omitted, either because they are not applicable,
not required, or because the information they contain is included elsewhere in
the consolidated financial statements or notes.
3. Exhibits. See Exhibit Index immediately preceding the Exhibits
filed with this report.
(b) Reports on Form 8-K
A report on Form 8-K dated November 18, 2003, was filed with the
Commission to report under Item 7, a press release with financial
information for the quarter ended September 30, 2003.
193
SIGNATURES
Pursuant to the requirements of Section 13 of the Securities Exchange Act
of 1934, the Registrant has duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized, this 15th day of March, 2004.
CONSECO, INC.
By: /s/ William J. Shea
--------------------
William J. Shea, President and
Chief Executive Officer
194
Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated:
Signature Title (Capacity) Date
- --------- ---------------- ----
/s/ WILLIAM J. SHEA President, Chief Executive Officer March 15, 2004
- ----------------------------------- and Director
William J. Shea (Principal Executive Officer)
/s/ EUGENE M. BULLIS Executive Vice President March 15, 2004
- ------------------------------------ and Chief Financial Officer
Eugene M. Bullis (Principal Financial Officer)
/s/ JOHN R. KLINE Senior Vice President March 15, 2004
- ------------------------------------ and Chief Accounting Officer
John R. Kline (Principal Accounting Officer)
/s/ R. GLENN HILLIARD Chairman of the Board March 15, 2004
- ------------------------------------
R. Glenn Hilliard
/s/ NEAL SCHNEIDER Director March 15, 2004
- ------------------------------------
Neal Schneider
/s/ PHILIP R. ROBERTS Director March 15, 2004
- ------------------------------------
Philip R. Roberts
/s/ JOHN G. TURNER Director March 15, 2004
- ------------------------------------
John G. Turner
/s/ MICHAEL T. TOKARZ Director March 15, 2004
- ------------------------------------
Michael T. Tokarz
/s/ MICHAEL S. SHANNON Director March 15, 2004
- ------------------------------------
Michael S. Shannon
195
Report of Independent Auditors on Financial Statement Schedules
To the Shareholders and Board of Directors
Conseco, Inc.
Our report on the consolidated financial statements of Conseco, Inc. and
subsidiaries (Successor Company) is included on page 87 of this Form 10-K. In
connection with our audit of such financial statements, we have also audited the
related financial statement schedules at December 31, 2003 and for the period
from September 1, 2003 through December 31, 2003 listed in the index on page 193
of this Form 10-K. In our opinion, the financial statement schedules referred to
above, present fairly, in all material respects, the information set forth
therein when read in conjunction with the related financial statements.
As discussed in Note 1 to the consolidated financial statements, the United
States Bankruptcy Court for the Northern District of Illinois, Eastern Division
confirmed the Company's Sixth Amended Joint Plan of Reorganization (the "Plan")
on September 9, 2003. The provisions of the plan are described in detail in Note
1. The Plan was substantially consummated on September 10, 2003 and the Company
emerged from bankruptcy. In connection with its emergence from bankruptcy, the
Company adopted fresh start accounting as of August 31, 2003.
/s/PricewaterhouseCoopers LLP
- -------------------------------
PricewaterhouseCoopers LLP
Indianapolis, Indiana
March 10, 2004
196
Report of Independent Auditors on Financial Statement Schedules
To the Shareholders and Board of Directors
Conseco, Inc.
Our report on the consolidated financial statements of Conseco, Inc. and
subsidiaries (Predecessor Company) is included on page 87 of this Form 10-K. In
connection with our audits of such financial statements, we have also audited
the related financial statement schedules at December 31, 2002 and for the
period from January 1, 2003 through August 31, 2003, and for each of the two
years in the period ended December 31, 2002 listed in the index on page 193 of
this Form 10-K. In our opinion, the financial statement schedules referred to
above, present fairly, in all material respects, the information set forth
therein when read in conjunction with the related financial statements.
As discussed in Note 1 to the consolidated financial statements, the Company
filed a petition on December 17, 2002 with the United States Bankruptcy Court
for the Northern District of Illinois, Eastern Division for reorganization under
the provisions of Chapter 11 of the Bankruptcy Code. The Company's Sixth Amended
Joint Plan of Reorganization (the "Plan") was substantially consummated on
September 10, 2003 and the Company emerged from bankruptcy. In connection with
its emergence from bankruptcy, the Company adopted fresh start accounting.
/s/PricewaterhouseCoopers LLP
- -------------------------------
PricewaterhouseCoopers LLP
Indianapolis, Indiana
March 10, 2004
197
CONSECO, INC. AND SUBSIDIARIES
SCHEDULE II
Condensed Financial Information of Registrant (Parent Company)
Balance Sheet
(Dollars in millions)
ASSETS
Successor Predecessor
------------ ------------
December 31, December 31,
2003 2002
---- ----
Cash and cash equivalents:
Unrestricted.......................................................................... $ 11.1 $ 15.6
Restricted............................................................................ 17.3 -
Other invested assets..................................................................... .1 .1
Investment in wholly-owned subsidiaries (eliminated in consolidation)..................... 4,150.2 4,661.2
Receivable from subsidiaries (eliminated in consolidation)................................ .6 414.4
Income tax assets......................................................................... 1.7 137.0
Other assets.............................................................................. 67.0 66.7
-------- ---------
Total assets.................................................................... $4,248.0 $ 5,295.0
======== =========
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)
Liabilities:
Notes payable......................................................................... $1,300.0 $ -
Payable to subsidiaries (eliminated in consolidation)................................. 45.4 -
Liabilities subject to compromise..................................................... - 4,865.8
Affiliated liabilities subject to compromise.......................................... - 558.1
Other liabilities..................................................................... 85.0 -
-------- ---------
Total liabilities............................................................... 1,430.4 5,423.9
-------- --------
Commitments and Contingencies
Company-obligated mandatorily redeemable preferred securities of
subsidiary trusts..................................................................... - 1,921.5
Shareholders' equity (deficit):
Preferred stock....................................................................... 887.5 501.7
Common stock and additional paid-in capital ($.01 par value, 8,000,000,000
shares authorized, shares issued and outstanding at December 31, 2003 -
100,115,772; no par value, 1,000,000,000 shares authorized, shares
issued and outstanding: 2002 - 346,007,133) ....................................... 1,642.9 3,497.0
Accumulated other comprehensive income (loss)......................................... 218.7 580.6
Retained earnings (deficit)........................................................... 68.5 (6,629.7)
-------- ---------
Total shareholders' equity (deficit)............................................ 2,817.6 (2,050.4)
-------- ---------
Total liabilities and shareholders' equity (deficit)............................ $4,248.0 $ 5,295.0
======== =========
The accompanying notes are an integral part
of the condensed financial information.
198
CONSECO, INC. AND SUBSIDIARIES
SCHEDULE II
Condensed Financial Information of Registrant (Parent Company)
Statement of Operations
(Dollars in millions)
Successor Predecessor
-------------- -------------------------------
Years
Four months Eight months ended
ended ended December 31,
December 31, August 31, ----------------
2003 2003 2002 2001
---- ---- ---- ----
Revenues:
Net investment income.............................................. $ .1 $ 3.7 $ 2.4 $ 15.0
Dividends from subsidiaries (eliminated in consolidation).......... - - - 24.0
Fee and interest income from subsidiaries (eliminated in
consolidation)................................................... - .2 27.2 96.0
Net investment losses.............................................. - (1.9) - (12.1)
Other income....................................................... 5.6 .2 1.5 .8
------ -------- --------- -------
Total revenues................................................. 5.7 2.2 31.1 123.7
------ -------- --------- -------
Expenses:
Interest expense on notes payable (contractual interest: $268.5 for
the eight months ended August 31, 2003; and $345.3 for 2002)..... 34.3 194.0 325.3 369.2
Provision for loss................................................. - 15.9 147.2 169.6
Intercompany expenses (eliminated in consolidation)................ .1 6.7 1.2 3.0
Operating costs and expenses....................................... 14.6 (5.6) 94.1 69.7
Special charges.................................................... - - 25.7 36.7
Gain on extinguishment of debt..................................... - - (1.8) (17.0)
Reorganization items, net.......................................... - (2,133.8) 14.4 -
------ -------- --------- -------
Total expenses................................................. 49.0 (1,922.8) 606.1 631.2
------ -------- --------- -------
Loss before income taxes, equity in undistributed earnings of
subsidiaries, distributions on company-obligated mandatorily
redeemable preferred securities of subsidiary trusts,
discontinued operations and cumulative effect of
accounting change............................................ (43.3) 1,925.0 (575.0) (507.5)
Income tax expense (benefit):
Tax benefit on period income....................................... (6.1) 8.5 (108.2) (181.4)
Valuation allowance for deferred tax assets........................ - - 753.9 -
------ -------- --------- -------
Income (loss) before equity in undistributed earnings of
subsidiaries, distributions on Company-obligated mandatorily
redeemable preferred securities of subsidiary trusts,
discontinued operations and cumulative effect of
accounting change............................................ (37.2) 1,916.5 (1,220.7) (326.1)
Equity in undistributed earnings of subsidiaries before discontinued
operations, and cumulative effect of accounting change
(eliminated in consolidation)...................................... 133.5 269.2 (1,275.8) 140.3
------ -------- --------- -------
Loss before distributions on Company-obligated mandatorily
redeemable preferred securities of subsidiary trusts,
discontinued operations and cumulative effect of
accounting change............................................ 96.3 2,185.7 (2,496.5) (185.8)
Distributions on Company-obligated mandatorily redeemable
preferred securities of subsidiary trusts (contractual
distributions for 2002 of $179.8).................................. - - 173.2 119.5
------ -------- --------- -------
Loss before discontinued operations,
and cumulative effect of accounting change................... 96.3 2,185.7 (2,669.7) (305.3)
Discontinued operations of subsidiaries, net of income taxes.......... - 16.0 (2,216.8) (100.6)
Cumulative effect of accounting change of subsidiaries, net
of income taxes.................................................... - - (2,949.2) -
------ -------- --------- -------
Net loss....................................................... 96.3 2,201.7 (7,835.7) (405.9)
Preferred stock dividends (contractual distributions for 2002
of $2.1)........................................................... 27.8 - 2.1 12.8
------ -------- --------- -------
Loss applicable to common stock................................ $ 68.5 $2,201.7 $(7,837.8) $(418.7)
====== ======== ========= =======
The accompanying notes are an integral part
of the condensed financial information.
199
CONSECO, INC. AND SUBSIDIARIES
SCHEDULE II
Condensed Financial Information of Registrant (Parent Company)
Statement of Cash Flows
(Dollars in millions)
Successor Predecessor
------------ ---------------------------------
Years
Four months Eight months ended
ended ended December 31,
December 31, August 31, ----------------
2003 2003 2002 2001
---- ---- ---- ----
Cash flows from operating activities:
Net income (loss)................................................... $ 96.3 $2,201.7 $(7,835.7) $ (405.9)
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Equity in undistributed earnings of consolidated subsidiaries *. (133.5) (269.2) 1,275.8 (140.3)
Discontinued operations of subsidiaries......................... - (16.0) 2,216.8 100.6
Cumulative effect of accounting change of subsidiaries.......... - - 2,949.2 -
Provision for loss on loan guarantees........................... - 15.9 147.2 169.6
Net investment losses........................................... - 1.9 - 12.1
Income taxes ................................................... 19.6 8.8 (243.1) (162.7)
(Gain) loss on extinguishment of debt........................... - - (1.8) (17.0)
Distributions on Company-obligated mandatorily redeemable
preferred securities of subsidiary trusts..................... - - 173.2 183.9
Reorganization items and special charges........................ - (2,157.0) 10.2 32.1
Other-affiliated*............................................... 16.8 42.0 927.4 256.1
Other........................................................... (8.1) 163.8 191.9 32.9
------- -------- --------- ---------
Net cash provided (used) by operating activities................ (8.9) (8.1) (188.9) 61.4
------- -------- --------- ---------
Cash flows from investing activities:
Sales and maturities of investments................................... - - 16.0 33.1
Investments and advances to consolidated subsidiaries*................ - (3.5) (121.3) (12.9)
Purchases of investments.............................................. - - (56.7) (49.5)
Change in restricted cash............................................. (17.3) - - -
Payments from subsidiaries*........................................... .8 5.5 414.0 950.1
------- -------- --------- ---------
Net cash provided (used) by investing activities................ (16.5) 2.0 252.0 920.8
------- -------- --------- ---------
Cash flows from financing activities:
Issuance of common and convertible preferred shares................... - - - 4.1
Issuance of notes payable and commercial paper........................ - - - 404.9
Payments on notes payable............................................. - - (75.5) (1,349.4)
Issuance of notes payable to affiliates*.............................. 27.0 - - -
Dividends to subsidiaries*............................................ - - (36.0) (36.0)
Dividends and distributions on Company-obligated mandatorily
redeemable preferred securities of subsidiary trusts................ - - (86.2) (181.2)
------- -------- --------- ---------
Net cash provided (used) by financing activities................ 27.0 - (197.7) (1,157.6)
------- -------- --------- ---------
Net increase (decrease) in cash and cash equivalents............ 1.6 (6.1) (134.6) (175.4)
Cash and cash equivalents, beginning of the period.................... 9.5 15.6 150.2 325.6
------- -------- --------- ---------
Cash and cash equivalents, end of the period.......................... $ 11.1 $ 9.5 $ 15.6 $ 150.2
======= ======== ========= =========
* Eliminated in consolidation
The accompanying notes are an integral part
of the condensed financial information.
200
CONSECO, INC. AND SUBSIDIARIES
SCHEDULE II
Notes to Condensed Financial Information
1. Basis of Presentation
The condensed financial information should be read in conjunction with the
consolidated financial statements of Conseco, Inc. The condensed financial
information includes the accounts and activity of the parent company.
201
CONSECO, INC. AND SUBSIDIARIES
SCHEDULE IV
Reinsurance
(Dollars in millions)
Successor Predecessor
--------- ----------------------------
2003 2002 2001
---- ---- ----
Life insurance inforce:
Direct....................................................... $85,830.2 $94,098.3 $116,075.0
Assumed...................................................... 1,753.8 3,380.7 1,996.5
Ceded ....................................................... (23,431.2) (26,368.9) (26,088.6)
--------- --------- ----------
Net insurance inforce.................................. $64,152.8 $71,110.1 $ 91,982.9
========= ========= ==========
Percentage of assumed to net........................... 2.7% 4.8% 2.2%
=== === ===
Successor Predecessor
-------------- -----------------------------------
Years
Four months Eight months ended
ended ended December 31,
December 31, August 31, ------------------
2003 2003 2002 2001
---- ---- ---- ----
Premiums recorded as revenue for generally accepted accounting principles:
Direct..................................................... $ 934.3 $2,011.4 $ 3,287.8 $ 3,600.0
Assumed.................................................... 31.9 57.3 78.7 146.0
Ceded...................................................... (92.1) (196.4) (327.8) (249.4)
------- ------- --------- ---------
Net premiums........................................... $ 874.1 $1,872.3 $ 3,038.7 $ 3,496.6
======= ======== ========= =========
Percentage of assumed to net........................... 3.6% 3.1% 2.6% 4.2%
=== === === ===
202
EXHIBIT INDEX
Exhibit
No. Description
--- -----------
2.1 Sixth Amended Joint Plan of Reorganization of Conseco, Inc. and
affiliated Debtors, incorporated by reference to Exhibit 2.2 of our
Current Report on Form 8-K filed September 15, 2003.
2.2 Order Confirming Reorganizing Debtors' Sixth Amended Joint Plan of
Reorganization, incorporated by reference to Exhibit 2.3 of our Current
Report on Form 8-K filed September 15, 2003.
3.1 Amended and Restated Certificate of Incorporation of Conseco, Inc.,
incorporated by reference to Exhibit 3.1 of our Current Report on Form
8-K filed September 15, 2003.
3.2 Second Amended and Restated Bylaws of Conseco, Inc., incorporated by
reference to Exhibit 3.2 of our Registration Statement on Form S-1 filed
January 29, 2004 (No. 333-112312).
4.1 Certificate of Designations relating to Class A Senior Cumulative
Convertible Exchangeable Preferred Stock of Conseco, Inc., incorporated
by reference to Exhibit 4.1 of our Current Report on Form 8-K filed
September 15, 2003.
4.2 Series A Warrant Agreement between Conseco, Inc. and Wachovia Bank, N.A.,
as Warrant Agent, incorporated by reference to Exhibit 4.2 of our Current
Report on Form 8-K filed September 15, 2003.
10.1 Credit Agreement dated as of September 10, 2003 among Conseco, Inc., Bank
of America, N.A., as Agent, and other financial institutions,
incorporated by reference to Exhibit 10.1 of our Current Report on Form
8-K filed September 15, 2003.
10.2 Amendment No. 1 to Credit Agreement dated as of January 15, 2004 among
Conseco, Inc., Bank of America, N.A., as Agent, and other financial
institutions, incorporated by reference to Exhibit 10.2 of our
Registration Statement on Form S-1 filed January 29, 2004 (No.
333-112312).
10.3 Amendment No. 2 to Credit Agreement dated as of March 5, 2004 among
Conseco, Inc., Bank of America, N.A., as Agent, and other financial
institutions.
10.4 Guarantee and Security Agreement dated as of September 10, 2003 among
Conseco, Inc., the Subsidiary Guarantors Party Thereto and Bank of
America, N.A., as Agent, incorporated by reference to Exhibit 10.4 of our
Quarterly Report on Form 10-Q for the quarter ended September 30, 2003.
10.5 Common Stock Registration Rights Agreement dated as of September 10,
2003, incorporated by reference to Exhibit 10.2 of our Current Report on
Form 8-K filed September 15, 2003.
10.6 Preferred Stock Registration Rights Agreement dated as of September 10,
2003, incorporated by reference to Exhibit 10.3 of our Current Report on
Form 8-K filed September 15, 2003.
10.7 Employment Agreement dated as of May 27, 2003 between Conseco, Inc. and
William J. Shea, incorporated by reference to Exhibit 10.5 of our
Quarterly Report on Form 10-Q for the quarter ended September 30, 2003.
10.8 Agreement dated as of June 18, 2003 between Conseco, Inc. and R. Glenn
Hilliard, incorporated by reference to Exhibit 10.6 of our Quarterly
Report on Form 10-Q for the quarter ended September 30, 2003.
10.9 Amendment dated as of December 30, 2003 to Agreement dated as of June 18,
2003 between Conseco, Inc. and R. Glenn Hilliard, incorporated by
reference to Exhibit 10.8 of our Registration Statement on Form S-1 filed
January 29, 2004 (No. 333-112312).
10.10 Employment Agreement dated as of September 10, 2003 between Conseco, Inc.
and Eugene M. Bullis, incorporated by reference to Exhibit 10.9 of our
Registration Statement on Form S-1 filed January 29, 2004 (No.
333-112312).
10.11 Employment Agreement dated as of July 15, 2002 between Conseco, Inc. and
John R. Kline, incorporated by reference to Exhibit 10.10 of our
Registration Statement on Form S-1 filed January 29, 2004 (No.
333-112312).
EXHIBIT INDEX
Exhibit
No. Description
--- -----------
10.12 Employment Agreement dated as of September 10, 2003 between 40|86
Advisors, Inc. and Eric R. Johnson, incorporated by reference to Exhibit
10.11 of our Registration Statement on Form S-1 filed January 29, 2004
(No. 333-112312).
10.13 Conseco, Inc. 2003 Long-Term Equity Incentive Plan, incorporated by
reference to Exhibit 4 of our Registration Statement on Form S-8 (No.
333-108835).
12.1 Computation of Ratio of Earnings to Fixed Charges, Preferred Dividends
and Distributions on Company-Obligated Mandatorily Redeemable Preferred
Securities of Subsidiary Trusts.
21.1 Subsidiaries of Conseco, Inc., incorporated by reference to Exhibit 21.1
of our Registration Statement on Form S-1 filed January 29, 2004 (No.
333-112312).
23.1 Consent of PricewaterhouseCoopers LLP.
31.1 Certification Pursuant to the Securities Exchange Act Rule
13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.2 Certification Pursuant to the Securities Exchange Act Rule
13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
COMPENSATION PLANS AND ARRANGEMENTS
10.7 Employment Agreement dated as of May 27, 2003 between Conseco, Inc. and
William J. Shea, incorporated by reference to Exhibit 10.5 of our
Quarterly Report on Form 10-Q for the quarter ended September 30, 2003.
10.8 Agreement dated as of June 18, 2003 between Conseco, Inc. and R. Glenn
Hilliard, incorporated by reference to Exhibit 10.6 of our Quarterly
Report on Form 10-Q for the quarter ended September 30, 2003.
10.9 Amendment dated as of December 30, 2003 to Agreement dated as of June 18,
2003 between Conseco, Inc. and R. Glenn Hilliard, incorporated by
reference to Exhibit 10.8 of our Registration Statement on Form S-1 filed
January 29, 2004 (No. 333-112312).
10.10 Employment Agreement dated as of September 10, 2003 between Conseco, Inc.
and Eugene M. Bullis, incorporated by reference to Exhibit 10.9 of our
Registration Statement on Form S-1 filed January 29, 2004 (No.
333-112312).
10.11 Employment Agreement dated as of July 15, 2002 between Conseco, Inc. and
John R. Kline, incorporated by reference to Exhibit 10.10 of our
Registration Statement on Form S-1 filed January 29, 2004 (No.
333-112312).
10.12 Employment Agreement dated as of September 10, 2003 between 40y86
Advisors, Inc. and Eric R. Johnson, incorporated by reference to Exhibit
10.11 of our Registration Statement on Form S-1 filed January 29, 2004
(No. 333-112312).
10.13 Conseco, Inc. 2003 Long-Term Equity Incentive Plan, incorporated by
reference to Exhibit 4 of our Registration Statement on Form S-8 (No.
333-108835).